Professional Documents
Culture Documents
Dear Students,
It’s a general rule that no matter how well you are prepared for the exam, you
will definitely have sleepless nights wandering about the completion of your
course. The tough time is when you still can’t make out what to do when you
are sleepy as well as you want to study.
To bring out productiveness in that time, a capsule or a question from this
compilation in those moments will utilize that spare time and will help you to
score some marks for your exam.
This theory compilation is an honest endeavour to cover past fifteen year’s
examination theory questions of CA – Final and CMA – Final examination (Lat-
est syllabus) in the form of capsules. It also includes the questions which had
been asked in Revision Test Papers of ICAI and ICMAI as well as latest Case-
Study based questions that may peep in future examinations. All you have to
do is start reading these questions and make a note of points in each ques-
tion. Wherever it is possible and relevant you must substantiate the explana-
tions with suitable examples and illustrations while writing your answer in
exam.
This compilation will help you to attempt and score at least twenty percent of
your examination question paper.
Make sure that you do not leave the reading of this material for the day be-
fore your exam. Give appropriate time in your schedule for these questions
as well. A few marks which you can score from these can change your entire
score and thereby your career.
A kind suggestion is given to you that this material should not be read in isola-
tion and your class notes of the subject should always be referred for better
understanding.
Have fun!
With Best Wishes,
Chapter 1|
Basic Cost Concepts
18 Capsules
Answer
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 Ac-
counting variable costs represent marginal cost.
Differential cost is the change (increase or decrease) in the total cost
(variable as well as fixed) due to change in the level of activity, technol-
ogy or production process or method of production.
The main point which distinguishes marginal cost and differential is that
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 mar-
ginal costing only variable cost changes due to change in the level of
activity.
2 Write short notes on Period Costs and Product Costs. Why should prod-
uct cost be computed?
[May 1999]
Answer
Period Costs are costs which are not assigned to the products but are
charged against the revenue of the period in which they are incurred.
Under absorption costing, Non-manufacturing costs like Selling and Dis-
tribution costs are recognized as period costs. These costs are not in-
cluded in inventory valuation.
Product costs are costs which are assigned to the product and are in-
cluded in inventory valuation. These are also called as Inventoriable
costs. Under absorption costing, all manufacturing costs are recognized
as product costs.
The purpose of computing product costs are as under:
(a) Preparation of financial statements with focus on inventory valua-
tion.
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Answer
Discretionary costs can be explained with the help of following two
important features:—
(i) They arise from periodic (usually yearly) decisions regarding the
maximum outlay to be incurred.
(ii) They are not tied to a clear cause and effect relationship between
inputs and outputs.
Examples of discretionary costs includes: advertising, public relations,
executive training, teaching, research, health care and management
consulting services. The note worthy feature of discretionary costs is
that mangers are seldom confident that the “correct” amounts are be-
ing spent.
Answer
To control discretionary costs control points/parameters may be estab-
lished. But these points need to be devised individually. For research
and development function to control discretionary costs, dates may be
established for submitting major reports to management. For advertis-
ing and sales promotion, such costs may be controlled by pre-setting
targets. In the case of employees benefits, discretionary costs may be
controlled by calling a meeting of employees union and making them
aware that the company would meet only the fixed costs and the vari-
able costs should be met by them.
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Answer
6 Pick out from each of the following items, costs that can be classified
under committed fixed costs or discretionary fixed costs.
(a) Annual increase of salary and wages of administrative staff by 5%
as per agreement.
(b) New advertisement for existing products is recommended by the
Marketing Department for achieving sales quantities that were
budgeted or at the beginning of the year.
(c) Rents paid for the factory premises for the past 6 months and the
rents payable for the next six months. Production is going on in
the factory.
(d) Research costs on a product that has reached maturity phase in
its life cycle and the research costs which may be needed on intro-
ducing a cheaper substitute into the market for facing competi-
tion.
(e) Legal consultancy fees payable for patent rights on a new prod-
uct. Patent rights have been applied for.
Answer
(a) Committed
(b) Discretionary
(c) Committed
(d) Discretionary
(e) Committed
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Answer
Opportunity cost is the value of benefit sacrificed in favour of an alter-
native course of action. In other words, it is the revenue foregone by
not making the best alternative use. These are also called as Imputed or
Hypothetical or Implicit Costs.
These costs are never incorporated into formal accounting systems be-
cause they do not incorporate cash receipts or cash outflows.
They are very relevant while examining alternative proposals or objects.
For instance, when deciding whether or not to allocate to a project it
is highly desirable to consider if the money could produce a better or
worse return if invested elsewhere.
If there are more than one alternative then opportunity cost is the maxi-
mum of benefits foregone.
(i) Decision making – Opportunity costs apply to the use of scarce re-
sources, where resources are not secure, there is no sacrifice from
the use of these resources. Where a course of action requires the
use of scarce resources, it is necessary to incorporate the lost prof-
it which will be foregone from using scarce resources.
If resources have no alternative use only the additional cash flow
resulting from the course of action should be included in decision
making as relevant cost.
(ii) Cost control – The conventional variance analysis will report an
adverse usage variance and adverse sales volume variance. How-
ever, the failure to achieve the budgeted optimum level of output
may be due to inefficient usage of scarce resources. The foregone
contribution should therefore be charged to the manger respon-
sible for controlling the usage of scarce resources and not to the
sales manager because the failure to achieve the budgeted sales
is due to the failure to use scarce resources efficiently.
Thus if resources are scarce, the usage variance should reflect the
acquisition cost plus budgeted contribution per unit of the scarce
resources. If the lost sales is made good in subsequent periods, the
real opportunity cost will consists of lost interest arising from delay
in receiving the net cash-flows and not the foregone contribution.
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Answer
Three applications of direct costing are as follows:
(a) Stock valuation
(b) Minimum quantity to be produced to recover pattern or mould
cost,
(c) Close down decisions – like closing down of a department or shop.
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specified purpose as for example, designing, set up, etc. ABC sys-
tem calculates the costs of individual activities and assigns costs to
cost objects such as products or services on the basis of the activi-
ties consumed to produce the product or provide the service.
Answer
The classification of cost is as under:
i. By Element: Material, Labour and Overhead.
ii. By Cost Centre: Direct and Indirect.
iii. By Behaviour: Fixed, Variable and Semi Variable.
iv. By Function: Production, Administration, Research and Develop-
ment, Selling and Distribution.
v. By Controllability: Controllable and Non Controllable.
vi. By Normality: Normal and Abnormal.
Answer
Particulars Cost Reduction Cost Control
1. Permanence Permanent, Real and genu- Could be a temporary sav-
ine savings in cost ing also
2. Nature of Saving in Cost per unit Saving either in Total Cost
Saving or Cost per unit
3. Nature of If presumes the existence It does not focus on costs
process of concerned potential sav- independent of revenue
ings in norms or standards nor considers product at-
and therefore it is a correc- tributes as given. It is a
tive process. wholistic control process.
4. Performance It is not concerned with The process involves set-
Evaluation maintenance of perfor- ting up a target, investigat-
mance according to stand- ing variances and taking re-
ards. medial measures to correct
them.
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Answer
Particulars Cost Reduction Cost Management
Meaning It is the permanent re- It is a system that establishes
duction in the unit cost of linkages between costs and
goods or services without revenues and relates them
affecting their quality or with the product to maximize
suitability for their intend- Firm’s profits.
ed use.
Objective Critical examination of Optimal utilization of resourc-
each aspect of business es to enhance the operating
and their analysis and re- income of the business entity.
view to improve the effi-
ciency and effectiveness so
as to reduce costs through
techniques of value Analy-
sis. Work study, standardi-
sation etc.
Nature of It presumes the existence It does not focus on costs in-
process of concealed potential sav- dependent of revenue nor
ings in norms or standards considers product attributes
and therefore it is a correc- as given. It is a wholisti control
tive process. process.
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Answer
The essential requisites of an effective information system are :—
(i) Design – Any information system should be properly designed af-
ter ascertaining the information requirements of different levels o
management and managed by professionally trained persons.
(ii) Database – An information system should maintain a database
and store all types of information required for taking a variety of
decisions.
(iii) Support – The system must receive support from all levels of man-
agement otherwise it will loose its value to the end users.
(iv) Flexibility – It should be flexible to meet the changing information
requirements of its executives.
(v) Reporting – An information system should be supported with an
effective reporting system which should be timely, accurate, eco-
nomical and in proper format.
Answer
Operational activities require full details about the transactions in-
volved. Operational databases satisfy the requirements of data for day
to day operations as opposed to decision making. The attributes of op-
erational databases for operational activities are:—
(i) Consistency – Consistent information ensures greater validity.
Information from different sources about the same transactions
should tend to confirm and support the other.
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16 A large company makes a variety of tools for use in the course of man-
ufacture of its products and also repairs them during the course of
manufacture of its products. Discuss the treatment of costs of tools in
pricing of the company’s products and outline the procedure to control
such costs.
[RTP]
Answer
The accounting treatment of various type of tools are:
(i) Special Purpose tools – the entire cost including its repair cost is
charged to the job for which it is made.
(ii) Tools for Standard Production – The life of such tools are deter-
mined in terms of hours or units of output and charged to jobs
accordingly.
The repair cost of such tools shall be charged on the same basis.
Procedure to Control Costs:
(i) A plan should be devised for classification of all tools.
(ii) The location of each tool or set of tools may be determined so that
their movement can be tracked and also the inventory thereof can
be taken at periodical intervals.
(iii) Maintain proper documentation of issue of tools to any depart-
ment or a job.
(iv) Analysis of hours for which tools have been used during a period
should be made at regular intervals.
(v) Depreciation of tools should be computed and charged to the jobs
on an equitable basis.
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Answer
It is an activity centre of a business organization entrusted with a spe-
cial task. It is a unit of function of a business organization headed by an
executive responsible for its performance.
Types of Responsibility Centers:
(1) Cost Centre – A Centre for which a standard amount of cost is
predetermined and used for control whose primary responsibility
is cost reduction and cost control.
(2) Revenue Centre – A centre devoted to raising revenue only whose
duty is to look after the task of generating sales revenue.
(3) Profit Centre – A centre whose performance is measured in terms
of income earned and cost incurred i.e. profit earning.
(4) Investment Centre – A centre responsible for earning profits and
also for asset utilization.
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Chapter 2|
Activity Based Costing
15 Capsules
Answer
It focuses on activities as the fundamental cost objects and uses the
costs of these activities as building blocks for compiling the costs of
other objects.
According to CIMA, it is defined as “Cost attribution to cost units on
the basis of benefits received from indirect activities i.e. ordering,
setting-up, assuring quality etc”. Under activity based costing costs are
accumulated for each activity as a separate cost object.
The collected costs are applied to products based on the benefits
received from various activities. The final product costs are built up
from the costs of the specific activities undergone. In the first stage the
activity driven overhead cost is charged to activity based cost pools and
in the second stage cost driver based rates are derived to charge cost to
product lines. The cost driver based rates are based on activities.
Activities based costing can be used for:
(a) Pricing of products;
(b) Design and development of new products.
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6 What are the areas in which activity based information is used for deci-
sion making?
[Nov 2000]
Answer
The areas in which Activity based information is used for making are as
under:
(i) Pricing
(ii) Market segmentation and distribution channels
(iii) Make-or-buy decisions and outsourcing
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10 Give two examples for each of the following categories in activity based
costing:
(i) Unit level activities
(ii) Batch level activities
(iii) Product level activities
(iv) Facility level activities.
Answer
(i) Unit level
(a) Use of indirect materials
(b) Inspection or testing of every item produced or say every
100th item produced
(c) Indirect consumable
(ii) Batch level
(a) Material ordering
(b) Machine set up costs
(c) Inspection of products – like first item of every batch
(iii) Product level
(a) Designing the product
(b) Producing parts to a certain specification
(c) Advertising costs, if advertisement is for individual products
(iv) Facility level
(a) Maintenance of buildings
(b) Plant security
(c) Production manager’s salaries
(d) Advertising campaigns promoting the company
11 “Cost can be managed only at the point of commitment and not at the
point of incidence. Therefore, it is necessary to manage cost drivers to
manage cost.” Explain the statement with reference to structural and
executional cost drivers.
[Nov 2007]
Answer
A firm commits costs at the time of designing the product and deciding
the method of production. It also commits cost at the time of deciding
the delivery channel (e.g. delivery through dealers or own retail stores).
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Costs are incurred at the time of actual production and delivery. There-
fore, no significant cost reduction can be achieved at the time when the
costs are incurred. Therefore, it is said that costs can be managed at the
point of commitment.
Cost drivers are factors that drive consumption of resources. Therefore,
management of cost drivers is essential to manage costs.
Structural cost drivers are those which can be managed by effecting
structural changes. Examples of structural cost drivers are scale of oper-
ation, scope of operation (i.e. degree of vertical integration), complex-
ity, technology and experience or learning. Thus, structural cost drivers
arise from the business model adopted by the company.
Executional cost drivers can be managed by executive decisions, exam-
ples of executional cost drivers are capacity utilization, plant layout ef-
ficiency, product configuration and linkages with suppliers and custom-
ers. It is obvious that cost drivers can be managed only at the point of
structural and operating decisions, which commit resources to various
activities.
Answer
In the traditional system of assigning manufacturing overheads, over-
heads are first allocated and apportioned to cost centres (production
and support service cost centres) and then absorbed to cost objects
(e.g. products). Under ABC, overheads are first assigned to activities or
activity pools (group of activities) and then they are assigned to cost
objects.
Thus, ABC is a refinement over the traditional costing system. Usually
cost centres include a series of different activities. If different products
create different demands on those activities, the traditional costing
system fails to determine the product cost accurately. In that situation,
it becomes necessary to use different rates for different activities or
activity pools.
The following are the reasons for adoption of ABC by manufacturing
and non-manufacturing industries:
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Chapter 3|
Budgeting, Performance
Measurement and Theory of
Constraints
22 Capsules
Answer
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 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 i.e.
zero base.
Answer
The Zero Base Budgeting involves the following steps:
(i) Corporate objectives should be established and laid down in de-
tails.
(ii) Decide about the extent to which the techniques of ZBB is to be
applied.
(iii) Identify those areas where decisions are required to be taken.
(iv) Develop decision programmes and rank them in order of prefer-
ences.
(v) Preparation of budget, that is translating decision packages into
practicable units/items and allocating financial resources.
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Answer
Advantages of ZBB:
(i) It provides a systematic approach for evaluation of different activi-
ties and ranks them in order of preference for allocation of scare
resource.
(ii) It ensures that the various functions undertaken by the organisa-
tion are critical for the achievement of its objectives and are being
performed in the best way.
(iii) It provides an opportunity to the management to allocate resourc-
es for various activities only after having a thorough cost-benefit
analysis.
(iv) The area of wasteful expenditure can be easily identified and elim-
inated.
(v) Departmental budgets are closely linked with corporate objec-
tives.
(vi) The technique can also be used for the introduction and imple-
mentation of the system of ‘management by objective’.
Limitations of ZBB:
(i) Various operational problems are likely to be faced in implement-
ing the technique.
(ii) The full support of top management is required.
(iii) It is time consuming as well as costly.
(iv) It requires proper trained managerial staff.
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Answer
(i) Traditional Budgeting would be appropriate as the company has
already done extensive ZBB in current year and moreover there
will be only slight change in the activity level for which major de-
falcations are not expected.
(ii) ZBB would be appropriate as it would compel the manager to sub-
stantiate and explain any changes occurring in sales.
(iii) ZBB would be appropriate as it would bind all the functional man-
agers with their responsibilities as well as they would have to ex-
ecute their work with full honesty when they know that they will
have to furnish every detail of a penny from scratch.
(iv) TB would be appropriate as resources are already in short supply
in the current year and their allocations to the budgeted activity
is strict and restricted that means that the company already has a
sound policy for achieving it’s plan. ZBB would not yield any new
results or hidden misappropriations.
Answer
A flexible budget is a budget which, by recognizing the difference be-
tween fixed, semi-variable and variable costs, is designed to change in
relation to the level of activity attained.
E.g. seasonal products , industries influenced by change in fashion, In-
dustries which keep on introducing new products / new designs.
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Answer
A single budget system may be conflicting in planning and motivation,
and planning and performance evaluation roles as below:
(i) Planning and motivation roles – Demanding budgets that may
not be achieved may be appropriate to motivate maximum perfor-
mance but they are unsuitable for planning purposes. For these, a
budget should be a set based on easier targets that are expected
to be met.
(ii) Planning and performance evaluation roles – For planning pur-
poses budgets are set in advance of the budget period based on
an anticipated set of circumstances or environment. Performance
evaluation should be based on a comparison of active perfor-
mance with an adjusted budget to reflect the circumstance under
which managers actually operated.
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Answer
Bench marking is the process of identifying and learning from the best
practices anywhere in the world. It is a powerful tool for continuous
improvement. To contribute to efficient, effective and ethical bench
marking, individuals agree for themselves and their organisation to
be abided by the following principles for the benchmarking with other
organisations.
Suggested benchmarking code of conduct:
(i) Principle of legality
(ii) Principle of exchange
(iii) Principle of confidentiality
(iv) Principle of use
(v) Principle of first party contact
(vi) Principle of third party contact
(vii) Principle of preparation
Answer
The Benchmarking is of following types:
(i) Competitive benchmarking – It involves the comparison of com-
petitors products, processes and business results with own.
(ii) Strategic benchmarking – It is similar to the process benchmark-
ing in nature but differs in its scope and depth.
(iii) Global benchmarking: It is a benchmarking through which distinc-
tion in international culture, business processes and trade prac-
tices across companies are bridged and their ramification for busi-
ness process improvement are understood and utilized.
(iv) Process benchmarking – It involves the comparison of an or-
ganisation critical business processes and operations against best
practice organization that performs similar work or deliver similar
services.
(v) Functional Benchmarking or Generic Benchmarking – This type
of benchmarking is used when organisations look to benchmark
with partners drawn from different business sectors or areas of
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Answer
Balanced score card is a set of financial and non-financial measures relating
to a company’s critical success factors. It is an approach which provides
information to management to assist in strategy implementation.
Therefore, the components to be included in the balanced score card
must flow from strategy. The targets should be measurable and must
flow from strategy and corporate plan of the company. It is necessary
that managers should agree to the components and targets because
in absence of a consensus, managers may not commit to the targets
established by the top management / the board of directors. Moreover,
the functions are interdependent and results in one functional area/
perspective (e.g. innovation and learning) have direct bearing on the
results in other functional area/perspective (e.g. customer perspective).
Therefore, it is not sufficient that individual managers agree to their
targets. Successful implementation requires that the top management
builds an overall consensus on the components and targets of the
balanced score card. Negotiation undermines the fundamental principle
that the components and targets should flow from strategy. As a result,
an approach to establish targets through negotiation defeats the very
purpose of balanced score card.
Answer
Feedback System operates by measuring some aspects of the process-
ing, being controlled and adjusting when the measuring indicates that
the process is deviating from plan.
It is a link between planning and control.
Some examples of feedback system are: MIS Reports, Periodical Perfor-
mance Reports, Variance Reports, etc. which provide information by
comparing planned and actual outcomes.
Budget may be viewed as an activity plan and Budgetory Control as a
Feedback System.
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Answer
The theory of constraints (TOC) describes methods to maximize operat-
ing income when faced with some bottleneck and some non bottleneck
operations. The main concept is to maximise the rate of manufacturing
output i.e. throughput of the firm.
The three key measurements in TOC:
(1) Throughput contribution = revenues minus the direct materials
cost of the goods sold.
(2) Investments = the sum of materials costs in direct materials,
work–in–process, and finished goods inventories; R & D costs; and
costs of equipment and buildings.
(3) Operating costs equal all costs of operations (other than direct
materials) incurred to earn throughput contribution. Operating
costs include salaries & wages, rent utilities, & depreciation.
The objective of TOC is to increase throughput contribution while de-
creasing investments and operating costs. TOC considers a short – run
time horizon & assumes that operating costs are fixed costs.
The steps in managing bottleneck operations:
Step 1: Recognize that the bottleneck operation determines throughput
contribution of the entire system.
Step 2: Find the bottleneck operation by identifying operations with
large quantities of inventory waiting to be worked on.
Step 3: Keep the bottleneck operation busy and subordinate all non bot-
tleneck operations to the bottleneck operation. That is, the needs of
the bottleneck operation determine the product schedule of non bot-
tleneck operations.
The important concept behind TOC is that the production rate of the
entire factory is set at the pace of the bottleneck the constraining re-
source. Hence, in order to achieve the best result TOC emphasizes the
importance of removing bottlenecks or limiting factor. If they cannot be
removed they must be coupled with in the best to be drawn to identify
the bottlenecks or binding constraints.
TOC identifies three types of cost:
a. Throughput contribution = Sales revenue- direct material cost. (Di-
rect material cost includes purchased components and materials
handling costs.)
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21 What are the steps to be followed to find the optimum production mix
as per Throughput Accounting?
Answer
1. Find throughput accounting ratio for each input or resource or de-
partment.
Toal requirement × 100
Throughout accounting ratio for a department =
Total availibility
If the resource is a limiting factor, the above ratio will be greater than 1.
2. Select highest Ratio and consider that department as the only lim-
iting factor.
3. Rank the products according to their Throughput contribution per
unit of Limiting factor
Or
Sales − Material cost
Product return per time period =
Time period in Bottleneck
4. Allocate the resource according to the rank and find the optimum
production.
If a Product has a ratio of less than one the organisation loses money
every time it is produced.
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22 Classify the following items under three measures used in the theory
of constraints:
(i) Research and Development Cost
(ii) Rent / utilities
(iii) Raw materials used for production
(iv) Depreciation
(v) Labour cost
(vi) Stock of raw materials
(vii) Sales
(viii) Cost of equipments and buildings
Answer
(i) Investments
(ii) Operating Expenses
(iii) Throughput Contribution
(iv) Operating Expenses
(v) Operating Expenses
(vi) Investments
(vii) Throughput Contribution
(viii) Investments
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Chapter 4|
Relevant Costing, Marginal
Costing and Decision Making
22 Capsules
1 Explain with one example each that sunk cost is irrelevant in making
decisions, but irrelevant costs are not sunk costs.
[May 2001]
Answer
Sunk cost is a historical cost incurred in the past. In other words it is a
cost of a resource already acquired. Future decisions in respect of this
resource will not be affected by it. For example, book value of machin-
ery. Hence sunk costs are irrelevant in decision making. Irrelevant costs
are not necessary sunk costs. For example, when a comparison of two
alternative production methods using the same material quantity is
made, then direct material cost is not affected by the decision but this
material cost is not sunk cost.
Answer
A relevant cost is a future cost which differs between alternatives. It can
also be defined as any cost which is affected by decisions at hand. For
any decision for an offer, usually the following costs are considered as
relevant :
a. Differential or Variable Costs
b. Avoidable or Discretionary Fixed Costs
c. Opportunity Costs
The following costs are irrelevant costs for decision making –
a. Historical or Sunk Costs
b. Committed Fixed Costs
c. Apportioned Fixed Costs
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Answer
Margin of Safety – Margin of safety is the excess of sales over the break-
even sales. It may also be considered as the excess of production over
break-even point. It can be expressed in value as well as in percentage.
The size of margin of safety shows the strength of the business. Small
size of margin of safety indicates that the firm has large fixed expenses
and is more vulnerable to changes in sales. In other words, if the margin
of safety is large, a slight fall in sales may not affect the business very
much but when it is small then a slight fall in sales may adversely affect
the business.
Margin of safety is also immensely useful for making inter-firm compari-
son. This is being done by calculating their margin of safety ratio.
Measures for improving margin of safety:
Margin of safety can be improved by taking the following measures:—
(i) Increasing the selling price, provided the demand is inelastic so as
to absorb the increased prices.
(ii) Reduction in fixed expenses.
(iii) Reduction in variable expenses
(iv) Increasing the sales volume provided capacity is available.
(v) Substitution or introduction of a product mix such that more prof-
itable lines are introduced.
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Answer
The limitations of break even chart are as follows:
(1) While preparing a break-even chart, it is assumed that revenue
and costs can be represented with the help of straight lines. It may
not always be true.
(2) The preparation of a break-even chart requires the segregation of
semi-variable costs into fixed and variable components. It may not
always be possible to segregate semi-variable costs into fixed and
variable elements accurately. There may be situations when semi-
variable costs cannot be split.
(3) A break-even chart assumes that selling price and variable cost
per unit are constant at all levels of activity. It may not always be
true. Selling price as well as variable cost may either increase or
decrease with the change in volume. Fixed costs also tend to vary
beyond a certain output.
(4) When a firm produces a number of products the apportionment
of fixed expenses over various products may be different and of-
ten it may be done arbitrarily.
(5) A Break-even chart assumes that business condition will not
change.
(6) A break-even chart does not consider the amount of capital em-
ployed in the business, a very important factor for determining
profitability of a concern.
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Answer
Important factors to be considered in “Marginal Costing Decisions” are
as follows:
(i) Whether the product or production makes a contribution,
(ii) In the selection alternatives, additional fixed costs if any should be
considered.
(iii) The continuity of demand after new decision and its impact on
selling price are to be considered.
(iv) Non-cost factors such as the need to keep labour force intact and
governmental attitude are also to be taken into account.
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Answer
Semi-variable costs as the name suggests are partly fixed and partly
variable. The methods for separating the semi-variable costs into their
fixed and variable elements have been discussed briefly as under:
(i) Graphical method – Under this method, a large number of obser-
vations regarding the total costs at different levels of output are
plotted on a graph with the output on the X-axis and the total cost
on the Y-axis. Then, draw by judgment, a line of “best fit”, which
passes through all or most of the points is drawn. The point at
which this line cuts the Y-axis indicates the total fixed cost compo-
nent in the total cost. If a line is drawn at this point parallel to the
X-axis, this indicates the fixed cost. The variable cost at any level
of output, is derived by deducting this fixed cost element from the
total cost.
(ii) High points and low points method – Under this method, the dif-
ference between the total cost at highest and lowest volume is
divided by the difference between the sales value at the highest
and lowest volume. The quotient thus obtained gives the rate of
variable cost in relation to sales value. The fixed cost is the remain-
der; i.e., total cost minus variable cost.
(iii) Comparison by period or level of activity method – Under this
method, the variable cost per unit may be determined by compar-
ing two levels of output with the amount of expenses at those
levels. Since the fixed element does not change, therefore the
variable elements of cost may be ascertained with the help of the
following formula:
Change in the amount of expenses
Change in Quantity
(iv) Least square method – This is the best method of separating
semi-variable costs into their fixed and variable elements. It is a
statistical method and is based on finding out a line of best fit for a
number of observations. The method uses the linear equation y =
mx + c; where ‘m’ represents the variable element of cost per unit,
‘C’ represents the total fixed cost, ‘y’ represents the total cost, ‘x’
represents the volume of output. The total cost is thus split into
fixed and variable elements by solving this equation.
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8 “Cost is not the only criterion for deciding in favour of shut down” –
Briefly explain.
[May 2000]
Answer
Cost is not only criterion for deciding in the favour of shut down. Non-
cost factors worthy of consideration in this regard are as follows:
(i) 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,
(ii) In the face of competition it may difficult to re-establish the mar-
ket for the product.
(iii) 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.
9 Explain, how Cost Volume Profit (CVP) - based sensitivity analysis can
help mangers cope with uncertainty.
[Nov 2000]
Answer
Sensitivity analysis focuses on how a result will be changed if the origi-
nal estimates or the underlying assumptions change.
Cost Volume Profit (CVP) – based sensitivity analysis can help mangers
to provide answers to the following questions to cope with uncertainty.
(1) What will be the profit if the sales mix changes from that originally
predicted?
(2) What will be the profit if fixed costs increase by 10% and variable
costs decline by 5%?
The use of spreadsheet packages has enabled mangers to develop CVP
computerised models which can answer the above questions. Manag-
ers can now consider alternative plans by keying the information into
a computer, which can quickly show changes both graphically and nu-
merically. Thus mangers can study various combinations of changes in
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selling prices, fixed costs, variable costs and product mix, and can react
quickly without waiting for formal reports from the accountant. In this
manner the use of CVP based sensitivity analysis can help mangers to
cope up with uncertainty.
Answer
Marginal costing is defined as the ascertainment of marginal cost and of
the effect on profit of changes in volume or type of output by differen-
tiating between fixed costs and variable costs.
Limitations of Marginal Costing Techniques:
The limitations of using the marginal costing technique are as follows:
(1) It is difficult to classify exactly the expenses into fixed and vari-
able category. Most of the expenses are neither totally variable
nor wholly fixed.
(2) Contribution itself is not a guide unless it is linked with the key
factor.
(3) Sales staff may mistake marginal cost for total cost and sell at a
price; which will result in loss or low profits. Hence, sales staff
should be cautioned while giving marginal cost.
(4) Overheads of fixed nature cannot altogether be excluded par-
ticularly in large contracts, while valuing the work-in-progress. In
order to show the correct position fixed overheads have to be in-
cluded in work-in-progress.
(5) Some of the assumptions regarding the behaviour of various costs
are not necessarily true in a realistic situation. For example, the
assumption that fixed cost will remain static throughout is not cor-
rect.
Answer
In CVP analysis, the usual assumption is that the total sales line and
variable cost line will have linear relationship, that is, these lines will be
straight lines. However, in actual practice it is unlikely to have a linear
relationship for two reasons, namely:
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(i) after the saturation point of existing demand, the sales value may
show a downward trend.
(ii) the average unit variable cost declines initially, reflecting the fact
that, as output increase the firm will be able to obtain bulk dis-
counts on the purchase of raw materials and can also benefit from
division of labour. When the plant is operated at further higher
levels of output, due to bottlenecks and breakdowns the variable
cost per unit will tend to increase. Thus the law of increasing costs
may operate and the variable cost per unit may increase after
reaching a particular level of output.
In such cases, the contribution will not increase in linear propor-
tion i.e. based on the phenomenon of diminishing marginal pro-
ductivity, the total cost lie will not be straight, as assumed but will
be of curvilinear shape. This situation will give rise to two break
even points. The optimum profit is earned at the point where the
distance between sales and total cost is the greatest.
Loss TC
TR
Curvilinear - CVP
Profit
Answer
When absorption costing method is used, production fixed overheads
are charged to products and are included in product costs. Consequent-
ly, the closing stocks are valued on total cost (including fixed overheads)
basis. The net effect is that the charge of fixed overheads to P/L account
gets reduced, if the closing stock is greater than the opening stock. This
situation has the effect of inflating the profit for the period.
Where stock levels are likely to fluctuate significantly, profits may be
distorted if calculated on absorption costing basis. If marginal costing is
used, since the fixed costs are charged off to P/L account as period cost,
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such a situation will not arise. The impact of using absorption costing on
profits can be summarised as under:
(a) When sales are equal to production, profits will be the same un-
der absorption costing and marginal costing.
(b) If production is higher than sales, the absorption costing will post
higher profits that marginal costing.
(c) If sales are in excess of production, absorption costing will show
lower profits than marginal costing.
Since profit calculation in absorption costing can produce strange re-
sult, the managers may deliberately alter the stock levels to influence
the profits if absorption costing is used. Hence, it is true to say that if
absorption costing method is used managers have the incentive to over
produce to show better result.
Answer
The factors involved in decisions relating to expansion of capacity are
enumerated as below:
(i) Additional fixed overheads involved should be considered.
(ii) Possible decrease in selling price due to increased production ca-
pacity.
(iii) Whether the demand id sufficient to absorb the increased produc-
tion.
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In addition to the relevancy of costs, the other factors and costs that
should be taken into account at the time of deciding the products mix
are:
(i) The available production capacity
(ii) The limiting factor(s)
(iii) Contribution per unit of the limiting factor
(iv) Market demand for the products.
(v) Opportunity costs
15 State the relative economics of the “make vs. buy” decision in manage-
ment control.
[Nov 2001]
Answer
Generally for taking a make vs. buy decision comparison is made be-
tween the supplier’s price and the marginal cost of making plus the op-
portunity cost. Make vs. buy decision is a strategic decision, and, there-
fore, both short-term as well as well as long-term thinking about various
cost and other aspects needs to be done.
A company generally buys a component instead of making it under fol-
lowing situations:
(1) If it costs less to buy rather than to manufacture it internally;
(2) If the return on the necessary investment to be made to manufac-
ture is not attractive enough;
(3) If the company does not have the requisite skilled manpower to
make;
(4) If the concern feels that manufacturing internally will mean ad-
ditional labour problem;
(5) If adequate managerial manpower is not available to take charge
of the extra work of manufacturing;
(6) If the component shows much seasonal demand resulting in a
considerable risk of maintaining inventories;
(7) If transport and other infrastructure facilities are adequately avail-
able;
(8) If the process of making is confidential or patented;
(9) If there is risk of technological obsolescence for the component
such that it does not encourage capital investment in the compo-
nent.
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Answer
It is justifiable to sell at a price below marginal cost for a limited period.
The circumstances may be:
(i) Where materials are of perishable nature.
(ii) Where stocks have been accumulated in large quantities and the
market prices have fallen. This will save the carrying cost of stocks,
e.g., electronic goods – market prices fall due to quick obsoles-
cence or advanced technological replenishment.
(iii) It is essential to reduce the prices to such an extent in order to
popularize a new product.
(iv) Where such reduction enables the firm to boost the sales of other
products having larger profit margin.
Answer
Differential costing can be used for all short, medium and long term
decisions. When two levels of activities are being considered, or while
choosing between competing alternatives differential cost analysis is
essential. The differential cost is useful for decision making in the fol-
lowing areas:
(a) Capital expenditure decisions
(b) Make or buy decision
(c) Production planning
(d) Sales mix decision
(e) Production or product decision
(f) Change in level or nature of an activity.
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Answer
The characteristic features of a data-base created for operational con-
trol and decision making are as under:
(i) There should be a file structure that facilitates the association of
one internal record with other internal records.
(ii) There should be cross functional integration of files.
(iii) Independence of program / data file for ease of updating and
maintenance of data base.
(iv) There must be common standards throughout with respect to
data definitions, record formats and other data descriptions.
(v) A data dictionary should be available.
Answer
Incremental cost technique: It is a technique used in the preparation
of ad-hoc information in which only cost and income differences be-
tween alternative courses of action are taken into consideration. This
technique is applicable to situations where fixed costs alter.
The essential pre-requisite for making managerial decisions by using
incremental cost technique, is to compare the incremental costs with
incremental revenues. So long as the incremental revenue is greater
than incremental costs, the decision should be in favour of the proposal.
Applications of incremental cost techniques in making managerial de-
cisions:
The important areas in which incremental cost analysis could be used
for managerial decision making are as under:
(i) Introduction of a new product
(ii) Discontinuing a product, suspending or closing down a segment of
the business
(iii) Whether to process a product further or not
(iv) Acceptance of an additional order form a special customer at low-
er than existing price
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Answer
The objective of distribution is getting the right goods to the places at
the right time for the optimal cost. The basic output of a distribution
system is that the customers should get the delivery of their orders in
minimum number of days keeping in mind the cost of deliveries.
The decision making tools for this purpose are – (a) Linear Programming
(Transportation Models) (b) Inventory Models.
Answer
The relevant considerations are:
(1) Type of product – Large manufacturers of consumer goods may
find it profitable to sell their products direct to consumers through
their own retail or chain stores. For certain other products, normal
route of manufacture to wholesaler and then to retailer may be
used.
(2) Type of market – In the seller’s market, the product or service
should be distributed at the least cost. In a buyer’s market the
product should penetrate the market by adopting cost effective
channels of distribution since the competition would be intense.
(3) Industry Practices – Any firm in any industry will have to follow
the industry practices in deciding the channel of distribution.
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Answer
In an inflationary situation, prices rise rapidly and the firm may decide
to buy large quantities immediately and hold inventories anticipating
further increase in prices. However it is not prudent to hold large
inventories even in an inflationary situation due to the following
reasons:
(i) Increase in stockholding costs like interest on capital, wastages,
etc.
(ii) Possible availabilities of cheaper substitutes at a later date in
future.
(iii) Possible new sources of supply at a competitive rate.
(iv) Possibility of fall in prices.
Therefore, even in an inflationary condition, it is sufficient if the firm
hold the normal level of inventory in order to operate its business
without incurring stock out costs.
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Chapter 5|
TQM, Value Chain Analysis and
Business Process Reengineering
17 Capsules
Answer
The essential requirements for successful implementation of TQM are:
(a) Commitment – Quality improvement must be everyone’s job.
Clear commitment from the top management, steps necessary to
provide an environment for changing attitudes and breaking down
barriers to quality improvement must be provided. Support and
training for this must be extended.
(b) Culture – Proper training must be given to effect changes in cul-
ture and attitude.
(c) Continuous Improvement – Recognition of room for improvement
continually as a process, and not merely a one-off programme.
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Answer
The benefits accruing from the implementation of a Total Quality Man-
agement programme in an organisation are:
a. There will be increased awareness of quality culture in the organi-
zation.
b. It will lead to commitment to continuous improvement.
c. It will focus on customer satisfaction.
d. A greater emphasis on team work will be achieved.
Answer
The critical success factors of TQM are:
a. Focus on customer needs.
b. Everyone in the organisation should be involved.
c. Focus on continuous improvement.
d. Design quality in product and production process.
e. Effective performance measurement system.
f. Rewards and performance measurements should be renewed.
g. Appropriate training and education to everyone to understand the
aim of TQM.
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Answer
The Four P’s quality improvement principles are as below:
(a) People – It will quickly become apparent that some individuals
are not ideally suited to the participatory process. Lack of enthu-
siasm will be apparent from a generally negative approach and a
tendency to have prearranged meeting which coincide with the
meetings of TQM teams.
(b) Process – The rhetoric and inflexibility of a strict Deming approach
will often have a demotivating effect on group activity.
(c) Problem – Experience suggests that the least successful groups
are those approaching problems that are deemed to be too large
provide meaningful solutions within a finite time period.
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The six business functions contained in the value chain are (i) Research
and Development, (ii) Design (iii) Production (iv) Marketing (v) Distribu-
tion and (vi) Customer service.
The objective of value chain is to serve as means of increasing the
customer satisfaction and managing costs effectively. Coordination of
the individual parts of the value chain activities creates conditions to
improve customer satisfaction in terms of cost efficiency, quality and
delivery. A firm which performs value chain activities more efficiently
and at a lower cost than its competitors will be able to gain competitive
advantage. The following methodology should be adopted.
a. The firm should identify the industry value chain and then assign
costs, revenues and assets to value activities.
b. Diagnose the cost drivers regulating each value activity.
c. Develop sustainable cost advantage either by controlling cost driv-
ers better than competitors or by reconfiguring the chain value.
By analyzing costs, revenues and assets in each activity systematically
a company can achieve low cost. Thus value chain helps managers in
deciding how to apply the organization’s valuable physical and human
resources to each linked process so as to achieve cost effectiveness.
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11 What steps are involved in value chain analysis approach for assessing
competitive advantages?
Answer
Most corporations define their mission as one of creating products and
services. In contrast, the other companies are acutely aware of the stra-
tegic importance of individual activities within their value chain, They
are concentrating on those activities that allow them to capture maxi-
mum value for their customers and themselves. These firms use the
value chain analysis approach to better understand which segments,
distribution channels, price points, product differentiation, selling prep-
ositions and value chain configuration will yield them the greatest com-
petitive advantage.
The way the value chain approach helps these organizations to assess
competitive advantage includes the use of following steps of analysis:
(i) Internal cost analysis – to determine the sources of profitability
and the relative cost positions of internal value creating process-
es;
(ii) Internal differentiation analysis – to understand the sources of
differentiation with internal value-creating process; and
(iii) Vertical linkage analysis – to understand the relationships and as-
sociated costs among external suppliers and customers in order
to maximize the value delivered to customers and to minimize the
cost.
The value chain approach used for assessing competitive advantages
is an integral part of the strategic planning process. Like strategic plan-
ning, value chain analysis is a continuous process of gathering, evaluat-
ing and communicating information for business decision-making.
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to the next may alter the implications of value chain analysis. Or-
ganisations, should ensure that the value chain analysis is valid
for future periods. Otherwise, the value chain analysis must be
repeated under new conditions.
(b) Identifying stages in an industry’s value chain is limited by the abil-
ity to locate at least one firm that participates in a specific stage.
Breaking a value stage into two or more stages when an outside
firm does not compete in these stages is strictly judgement.
(c) Finding the costs, revenues and assets for each value chain activity
sometimes presents serious difficulties. There is much experimen-
tation underway that may provide better approaches. Having at
least one firm operate in each value chain activity helps to identify
external prices for goods and services transferred between value
chains. For intermediate products or services with no external or
competitive market information, transfer prices must be estimat-
ed on the basis of the best information available.
(d) Isolating cost drivers for each value-creating activity, identifying
value chain linkages across activities, and computing supplier and
customer profit margins present serious challenges. The use of
full cost assumes that the full capacity of the value chain activity’s
facilities is used to derive the costs. Plant and manufacturing per-
sonnel and vendors of equipment are good sources for capacity
information. They can also be helpful in estimating the current or
replacement cost of the assets. Independent companies, for valu-
ation services for assets must exist.
(e) Despite the calculational difficulties, experience indicates that
performing value chain analysis can yield firms invaluable infor-
mation for their competitive situation, cost structure, and linkages
with suppliers and customers.
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Answer
Traditional Management Value Chain Analysis
Accounting
It focuses on internal informations. It focuses on external informations.
Application of single cost driver at Application of multiple cost drivers
the overall firm level is taken. i.e. structural and executional are
taken for each value added activity.
It assumes that cost reduction must Exploits linkages throughout the val-
be found in the value added process. ue chain i.e. within firm, with suppli-
ers and customers.
Insights for strategic decisions some- Identity cost driver at the individual
what limited in traditional manage- activity level and develop cost / dif-
ment accounting. ferentiation advantage either by
controlling those drivers better than
competitors by reconfiguring the
value chain.
Answer
Value analysis can do cost reduction in the following manner:
a. By identifying and removing unnecessary components in a prod-
uct which had utility earlier.
b. By introducing component substitution at a lesser cost without af-
fecting the quality of the product.
c. By simplifying the product design.
d. By introducing alternative methods with less cost but improved
efficiency.
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matter where they are in any major city in the world). These types of
visionary goals require rethinking the way most organizations do busi-
ness, careful redesign, They will additionally need very sophisticated
supporting information systems and a transformation from a traditional
organizational structure to a network type organization.
In resuming, the whole process of BPR in order to achieve the above
mentioned expected results is based on key steps-principles which in-
clude redesign, retool, and reorchestrate. Each step-principle embodies
the actions and resources as presented in the table below.
REDESIGN RETOOL REORCHESTRATE
• Simplify • Networks Synchronize
• Standardize • Intranets • processes
• Empowering • Extranets • IT
• Employeeship • WorkFlow • Human resources
• Groupware
• Measurements
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Chapter 6|
Pricing Decision and Pareto
Analysis
14 Capsules
Answer
Penetrating pricing Policy means a pricing policy for penetrating mass
market as quickly as possible through lower price offers. This method
is also used for pricing a new product. In order to popularise a new
product penetrating pricing policy is used initially. The company may
not earn profit by resorting to this policy during the initial stage. Later
on, the price may be increased as and when the demand picks up. Pen-
etrating pricing policy can also be adopted at any stage of the product
life cycle for products whose market is approached with low initial price.
The use of this policy by the existing concerns will discourage the new
concerns to enter the market. The pricing policy is also known as “stay-
out-pricing”.
Features:
(i) It is a policy of using a low price as the principal instrument for
penetrating mass markets early.
(ii) This method is used for pricing a new product and to popularize it
initially.
(iii) 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.
(iv) The low price policy is introduced for the sake of long term sur-
vival and profitability and hence it has to receive careful consid-
eration before implementation. It needs an analysis of the scope
for market expansion and hence considerable amount of research
and forecasting are necessary before determining the price.
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Circumstances:
The circumstances in which penetrating pricing can be adopted are:
(1) Elastic demand – The demand of the product is high when price
is low. Hence, lower prices mean large volumes and hence more
profits.
(2) Mass Production – When there are substantial savings in large-
scale production, increase in demand is sustained by the adoption of
low pricing policy.
(3) Frighten off competition – The prices fixed at a low-level acts 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 known as “stay-out-
pricing”.
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3 Explain the concept of cost plus pricing. What are its advantages and
disadvantages?
[May 2000]
Answer
The most common method of price fixing in a business is to arrive at full
cost, add a margin of profit and then set the selling price. During the
world wars, the concept of cost plus pricing became very much preva-
lent, as most of the defence contracts were priced at full cost plus a
pre-agreed quantum of profit.
In cost plus pricing, the capacity utilisation of the concern has an impor-
tant bearing and unless the same is considered on a realistic basis the
determination of cost would get vitiated.
At present, in Government sometimes Tariff Commission, Bureau of In-
dustrial Cost & Prices (BICP) are required to fix prices of certain products
and services. They mainly adopt a system of cost plus pricing. Similarly,
government has also set up a separate agency to fix prices for pharma-
ceutical products.
Advantages:
(i) It is a fair method and recovery of full costs is assured under it.
(ii) It leaves out scope for any uncertainty.
(iii) After arriving at full cost, the profit percentage can be flexibly ad-
justed to take care of market competition.
Disadvantages:
(i) Covering full cost all the time may ignore the competition.
(ii) It can lead to a distorted price fixation unless the cost is deter-
mined in a scientific manner.
(iii) It ignores the concepts of Marginal Costing, Incremental Costing
etc.
(iv) It is difficult to predetermine capacity utilization.
Answer
It may be justifiable to sell at a price below marginal cost for a limited
period under the following circumstances:
(i) Where materials are of perishable nature
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(ii) Where stocks have been accumulated in large quantities and the
market prices have fallen.
(iii) To popularize a new product
(iv) Where such reduction enables the firm to boost the sale of other
products having larger profit margin.
(v) To capture foreign markets
(vi) To obviate shut down costs
(vii) To retain future market
Answer
Two pricing practices in which non-cost reasons are important when
setting price are:—
(i) Price discrimination – This is the practice of charging to some cus-
tomers a higher price than that charged to other customers e.g.
Airlines tickets for business travellers and economy travellers are
priced differently.
These are illustrated as under :
(a) Price discrimination on the basis of customer : In this case,
the same product is charged at different prices to different
customers. It is, however, potentially disruptive of customer
relations.
(b) Price discrimination based on product version : In this case,
case, a slightly different product is charged at a different
price regardless of its cost-price relationship. If, for example,
a table with wooden top can be sold at ` 400, a table with
sunmica top costing ` 175 extra is sold at ` 575. The higher
premium in the latter case does not necessarily reflect the
higher production cost.
(c) Price discrimination based on place : An example of this
method is the sets in cinema theatre where the front seats
are charged at lower rates than the back seats.
(d) Price discrimination based on time : An example of this
method is the practice of giving off-season concession in sale
of fans or refrigerators just after the summer season.
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the cost to manufacture them but only Gillette blades fitted and these
were sold at a price of 5 cents. The blades cost only 1 cent to manufac-
ture and so Gillette made large profits once it had captured the cus-
tomer.
10 State the pricing policy most suitable in each of the following independ-
ent situations:
(i) The company makes original equipments and does defence con-
tract work. There are other companies which also undertake such
projects.
(ii) The product made by a company is new to the market. It is expect-
ed to enjoy a long term demand. Competition is expected very
soon, since the product will be desirable to most customers.
(iii) Stock of processed ready to eat products, whose shelf life will
soon be over in the next 2 months. The product is going to be
discontinued.
(iv) A company sells a homogeneous product in a highly competitive
market.
(v) ‘A’ is a new product for the company and the market and meant
for large scale production and long term survival in the market.
Demand is expected to be elastic.
(vi) ‘B’ is a new product for the company, but not for the market. B’s
success is crucial for the company’s survival in the long term.
(vii) ‘C’ is a new product to the company and the market. It has an
inelastic market. There needs to be as assured profit to cover high
initial costs and the usual sources of capital have uncertainties
blocking them.
(viii) ‘D’ is a perishable item, with more than 80% of its shelf life over.
Answer
(i) Sealed bid pricing or Cost Plus Pricing
(ii) Penetration pricing
(iii) Marginal cost pricing
(iv) Going rate pricing
(v) Penetration pricing
(vi) Going rate pricing
(vii) Skimming the cream pricing
(viii) Marginal cost pricing
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Answer
The general guidelines to be used in adopting a pricing policy are as
under:
(i) The pricing policy should encourage optimum utilization of re-
sources.
(ii) The pricing policy should work towards a better balance between
demand and supply.
(iii) The pricing policy should promote exports.
(iv) The pricing policy should serve as an incentive to the manufactur-
ers to maximize production by adopting improved technology.
(v) The pricing policy should avoid adverse effects on the rest of the
economy.
Answer
Pareto analysis is based on the 80.20 rule that was a phenomenon ob-
served by Vilfred Pareto. According to him 80% of wealth of Milan in It-
aly was owned by 20% of its citizens. The phenomenon can be observed
in many different business situations & the management can follow it in
various circumstances to direct management attention to the key con-
trol mechanism or planning aspects.
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Chapter 7|
Service Sector
5 Capsules
Answer
Service organizations predominantly have indirect costs and are hence
ideal for implementation of ABC. However, the following features of ser-
vice organizations may create problems for application of ABC –
(1) Production and consumption of many services are inseparable.
Hence the specific costs of rendering each service cannot be as-
certained with reasonable accuracy. Also, difficulties are faced in
apportionment of common expenses incurred over various ser-
vices.
(2) Most services are intangible. This creates problems in the iden-
tification of appropriate cost driver in respect of each activity or
service rendered.
(3) Service outputs vary from day to day. Hence the quantity of cost
driver has to be carefully determined by recording, observing and
averaging out the service outputs over a considerable period of
time.
(4) Pricing strategies depend on customer in case of service organiza-
tion. Such ad hoc pricing strategies may render the application of
ABC system infructuous.
(5) Many service organisations have not previously had a costing sys-
tem and much of the information required to set up a ABC system
will be non-existent. Therefore introduction of ABC may be expen-
sive.
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Service Sector
Answer
The different methods used are:
(1) Supply and Labour Billing – Service companies such as appliance
repair shops, automobile repair shops arrive at prices by using two
computations, one for labour and other for materials and parts.
(2) Pure Labour Billing – If materials and parts are not part of service
being performed, then only direct labour costs are used as basis
for determining price.
(3) Cost plus pricing – with a cost based approach, a mark up percent-
age is used to cover overhead costs and profit margin, in addition
to the direct costs of labour, material and parts.
(4) Service oriented based billing – Using ABC techniques, Direct La-
bour and Overhead costs are ascertained. The desired margin is
added to determine the service charges.
Answer
a. Job costing method – The cost of a particular service is obtained
by assigning costs to a distinct identifiable service. e.g. Job Costing
method is used in service sectors – like Accounting Firm, Adver-
tisement campaign.
b. Process Costing method – Cost of a service is obtained by assign-
ing costs to masses of similar unit and then computing cost per
unit on an average basis. e.g. Retail banking, postal delivery, credit
card etc.
c. Hybrid method – Combination of both (a) & (b) above.
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Standard Costing
Chapter 8|
Standard Costing
9 Capsules
Answer
MATERIAL QUANTITY STANDARDS:
The following procedure is usually followed for setting material quantity
standards:
(a) Standardisation of products – Detailed specifications, blueprints,
norms for normal wastage etc., of products along with their de-
signs are settled.
(b) Product classification – Detailed classified list of products to be
manufactured are prepared.
(c) Standardisation of material – Specifications, quality, etc., of ma-
terials to be used in the standard products are settled.
(d) Preparation of bill of materials – A bill of material for each prod-
uct or part showing the symbol or code, description and quantity
of each material to be used is prepared.
(e) Test runs – Sample or test runs under regulated conditions may be
useful in setting quantity standards in a precise manner.
LABOUR QUANTITY STANDARDS:
The following are the steps involved in setting labour quantity stand-
ards:
(a) Standardisation of product, as explained above.
(b) Product classification, as defined earlier.
(c) Standardisation of methods: Selection of proper machines to use
proper sequence and method of operations.
(d) Manufacturing layout: A plan of operation for each product listing
the operations to be performed is prepared.
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(e) Time and motion study is conducted for selecting the best way of
completing the job or motions to be performed by workers and
the standard time which an average worker will take for each job.
(f) The operator is given training to perform the job or operations in
the best possible manner.
Answer
The crux of standard costing lies in variance analysis. Standard costing
is the technique whereby standard costs are predetermined and sub-
sequently compared with the recorded actual costs. It is a technique
of cost ascertainment and cost control. It establishes predetermined
estimates of the cost of products and services based on management’s
standards of efficient operation. It thus lays emphasis on “what the cost
should be”. These should be costs are when compared with the actual
costs. The difference between standard cost and actual cost of actual
output is defined as the variance. The variance in other words in the
difference between the actual performance and the standard perfor-
mance. The calculations of variances are simple. A variance may be fa-
vourable or unfavourable. If the actual cost is less than the standard
cost, the variance is favourarable but if the actual cost is more than
the standard cost, the variance will be unfavourable. They are easily ex-
pressible and do not provide detailed analysis to enable management of
exercise control over them. It is not enough to know the figures of these
variances from month to month. We infact are required to trace their
origin and causes of occurrence for taking necessary remedial steps to
reduce / eliminate them.
A detailed probe into the variance particularly the controllable vari-
ances help the management to ascertain:
(i) the amount of variance
(ii) the factors or causes of their occurrence
(iii) the responsibility to be laid on executives and departments and
(iv) corrective actions which should be taken to obviate or reduce the
variances.
Mere calculation and analysis of variances is of no use. The success of
variance analysis depends upon how quickly and effectively the correc-
tive actions can be taken on the analysed variances. In fact variance
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Standard Costing
Answer
The three distinct groups of variances that arise in standard costing are:
(i) Variances of efficiency – These are the variance, which arise due
to efficiency or inefficiency in use of material, labour etc.
(ii) Variances of prices and rates – These are the variances, which
arise due to changes in procurement price and standard price.
(iii) Variances due to volume – These represent the effect of differ-
ence between actual activity and standard level of activity.
Answer
The statement give in the question highlights practical difficulties faced
by our industries today.
When the current environmental conditions are different from the an-
ticipated environmental conditions (prevailing at the time of setting
standard or plans) the use of routine analysis of variance for measuring
managerial performance is not desirable / suitable.
The variance analysis can be useful for measuring managerial perfor-
mance if the variances computed are determined on the basis of revised
targets / standards based on current actual environmental conditions.
In order to deal with the above situation i.e. to measure managerial
performance with reference to material, labour and sales variances, it is
necessary to proceed and compute the following variances.
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Standard Costing
Standard Costing
Answer
The variances computed can be accounted in three different ways which
are illustrated as below:
(1) PARTIAL PLAN:
The following points are noteworthy:
(a) Variances are computed at the end of the period.
(b) No separate account is opened to record the variances.
(c) The Work in Progress Control account records all its cost at
actual cost price only.
(d) The difference in WIP Control account at the end of the pe-
riod represents the variance, the reason of which is analysed
then only.
(e) The closing value of WIP and FG is shown at standard cost
price.
(f) Raw material inventories are valued at actual cost.
(g) Material price variance is calculated for the actual quantity
consumed in production.
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Standard Costing
Goods stock. Here the assumption made is that the quantity vari-
ance is abnormal and price variance is normal.
Sometimes favourable variances may also be carried forward to subse-
quent years for adjustment against the adverse variances instead of the
above treatments.
Answer
Standard Costing Budgetary Control
It is a system of accounting where It is a planning exercise made by the
predetermined costs are used for management in setting budgets for
analysis of variances and control of the forthcoming period and analysis
the entire organizations. of actual with the budgeted figures
and corrective action is initiated if
any deviations are identified.
Standard may be expressed both in Budgets are mainly expressed in
quantitative and monetary meas- monetary terms.
ures.
It is concerned with ascertainment It is concerned with the overall prof-
and control of costs. itability and financial position of the
concern.
Any variance – adverse or favour- It puts emphasis more on excess
able is investigated. over the budget.
It is determined for each element of It is determined for a specific period.
cost.
It is introduced primarily to ascer- It is introduced to state in figures as
tain the efficiency and effectiveness approved plan of action relating to a
of cost performance. particular period.
Standards are usually limited to Budgets are set for all departments
manufacturing activities only. in the organization.
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Chapter 9|
Target and Life Cycle Costing
14 Capsules
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3 What is Target Costing and what are the stages to the methodology?
[Nov 2000]
Answer
Target Costing is a management tool used for reducing a product cost
over its entire life cycle. It is driven by external Market factors. Market-
ing management prior to designing and introducing a new product de-
termines a target market price. This target price is set at a level that will
permit the company to achieve a desired market share and sales vol-
ume. A desired profit margin is then deducted to determine the target
maximum allowable product cost. Target costing also develops methods
for achieving those targets and means to test the cost effectiveness of
different cost-cutting scenarios.
Stages to the methodology:
(1) Conception (planning) Phase – Under this stage of life cycle, com-
petitors products are to be analysed, with regard to price, quality,
service and support, delivery and technology. The features which
consumers would like to have like consumer value etc. established.
After preliminary testing, the company may be asked to pinpoint a
market niche, it believes, is under supplied and which might have
some competitive advantage.
(2) Development phase – The design department should select the
most competitive product in the market and study in detail the
requirement of material, manufacturing process along with com-
petitors cost structure. The firm should also develop estimates of
internal cost structure based on internal cost of similar products
being produced by the company.
If possible the company should develop both the cost structures
(competitors and own) in terms of cost drivers for better analysis
and cost reduction.
(3) Production phase – This phase concentrates its search for bet-
ter and less expensive products, cost benefit analysis in different
features of a product priority wise, more towards less expensive
means of production, as well as production techniques etc.
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Answer
Target cost is the difference between estimated selling price of a pro-
posed product with specified functionality and quality and the target
margin. This is a cost management technique that aims to produce and
sell products that will ensure the target margin. It is an integral part of
the product design. While designing the product, the company needs to
understand what value target customers will assign to different attrib-
utes and different aspects of quality. This requires use of techniques like
value engineering and value analysis. Intensive marketing research is
required to understand customer preferences and the value they assign
to each attribute and quality parameter. This insight is required to be
developed must before the product is introduced. The company plays
within the space between the maximum attributes and quality that the
company can offer and the minimum acceptable to target customers.
Therefore in absence of intensive marketing research, the target costing
technique cannot be used effectively.
Answer
Target costing may assist control of costs and pricing of product as
under:
(i) Target costing considers the price that ought to be charged by a
company to achieve a given market share.
(ii) Target costing should take life cycle costs in to consideration.
(iii) If there is a gap between the target cost and expected cost, ways
and means of reducing or eliminating it can be explored.
(iv) The target cost may be used for controlling costs by comparison.
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Answer
The main steps are:
Step 1: Identify the market requirements as regards design, utility, and
need for a new product or improvements of existing product.
Step 2: Set Target selling price based on customer’s expectations and
sales forecasts.
Step 3: Set Target Production Volume based on relationships between
price and volume.
Step 4: Establish Target Profit Margin for each product, based on the
company’s long term profit objectives, projected volumes,
course of action, etc.
Step 5: Set Target cost or Allowable cost per unit for each product. Tar-
get cost is the difference between Target SP and Target Profit
Margin.
Step 6: Determine Current Cost of producing the new product, based
on available resources and conditions.
Step 7: Set Cost Reduction targets in order to reduce the current cost
to the target cost.
Step 8: Analyse the cost reduction target into various components and
identify cost reduction opportunities using Value Engineering
and Value Analysis and Activity Based Costing.
Step 9: Achieve Cost Reduction and Target Profit by Effective Imple-
mentation of cost reduction decisions.
Step 10: Focus on further possibilities of cost reduction i.e. continuous
improvement program.
7 Define Value Engineering and Value Analysis. What are the issues that
need to be dealt with during a value engineering review.
[May 1993, May 1996, May 2000]
Answer
Value Engineering involves searching for opportunities to modify the
design of each component or part of a product to reduce cost, but with-
out reducing the functionality or quality of the product.
Value Analysis entails studying the activities that are involved in produc-
ing the product to detect non value adding activities that may be elimi-
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8 What is the relationship between Target Costing and Life Cycle Costing?
Answer
Target costing and life cycle costing can be regarded as relatively modern
advances in management accounting, so it is worth first looking at the
taken by conventional costing.
Typically, conventional costing attempts to work out the cost of produc-
ing an item incorporating the costs of resources that are currently used
or consumed. Therefore, for each unit made the classical variable costs
of material direct labour and variable overheads are included (the total
of these is the marginal cost of productional, together with a share of
the fixed production costs. The fixed production costs can be includ-
ed using a conventional overhead absorption rate or they can be ac-
counted for using activity-based costing (ABC). ABC is more complex but
almost certainly more accurate. However, whether conventional over-
head treatment or ABC is used the overheads incorporated are usually
based on the budgeted overheads for the current period.
Once the total absorption cost of units has been calculated, a mark-up
(or gross gross profit percentage) is used to determine the selling price
and the profit per unit. The mark-up is chosen so that if the budgeted
sales are achieved, the organization should make a profit.
There are two flaws in this approach:
1. The product’s price is based on its cost, but no one might want to
buy at that price. The product might incorporate features which
customers do not value and therefore do not want to pay for, and
competitors’ products might be cheaper, or at least offer better
value for money. This flaw is addressed by target costing.
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2. The costs incorporated are the current costs only. They are mar-
ginal costs plus a share of the fixed costs for the current account-
ing period. There may be other important costs which are not
part of these categories, but without which the goods could not
have been made. Examples include the research and development
costs and any close down costs incurred at the end of the prod-
uct’s life. Why have these costs been excluded, particularly when
selling prices have to be high enough to ensure that the product
makes a profit. To make a profit, total revenue must exceed total
costs in the long term.
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13 What are the costs that you would include in product life cycle cost?
[May 2007]
Answer
The costs are included in different stages of the product life cycle :
Development phase – R & D cost / Design cost.
Introduction phase – Promotional cost / Capacity costs.
Growth phase / Maturity – Manufacturing cost / Distribution costs /
Product support cost.
Decline / Replacement phase – Plants reused / sold / scrapped / related
costs.
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Answer
The various stages in Product Life Cycle are:
(i) Market research – It identifies the products which customers
want, how much they are prepared to pay for it and how much
quantity they intend to buy.
(ii) Specification – It provides details such as required life; maximum
permissible maintenance costs, manufacturing costs, units re-
quired, delivery date, expected performance of the product.
(iii) Design – Proper drawings and process schedules are defined.
(iv) Prototype manufacture – Prototype may be used to develop the
product and eventually to demonstrate that it meets the require-
ments of the specifications.
(v) Development – Testing and changing to meet the requirements
after the initial run as a product when first made rarely meets the
specification.
(vi) Tooling – Tooling up for production means building a production
line, building expensive jigs, buying the necessary tool and equip-
ments.
(vii) Manufacture – It involves the purchase of raw material and com-
ponents, use of labour to make and assemble the product.
(viii) Selling – Stimulating and creating demand for the product when
the product is available for sale.
(ix) Distribution – The product should be distributed to the sales out-
lets and to the customers.
(x) Product support – The manufacturer or supplier should make sure
that spares and expert servicing facilities are available for the en-
tire life of the product.
(xi) Decommissioning or Replacement – When a manufacturing
product comes to an end, the plant used to build the product
must be sold, scrapped, or replaced in way that is acceptable to
the society.
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Chapter 10|
Transfer Pricing
9 Capsules
Answer
Usually a conflict between a division of the company and the company
as a whole is faced by the management of decentralized units when
products or services are exchanged among different divisions of the
company. Such a conflict becomes more significant in the case of those
concerns where profitability is used as criteria for evaluating the perfor-
mance of each division.
The essence of decentralization is reflected in the freedom to make de-
cisions. Under such a set up it is expected. That the top management
should not interfere with the decision making process of its subordi-
nates beading different units. In other words, management of decen-
tralized units is given autonomy with regard to decision-making. In this
system top management is expected to preserve ‘autonomy in decision
making’. The management of such companies also expects that each
division should not only achieve its own objective – necessary for eval-
uating the performance but should also achieve the objective of goal
congruence.
A divisional head in a company under aforesaid set up is free to use
a price as a transfer price for goods and services, which may provide
incentive. Such a transfer price may fail to achieve the objective of
‘Goal congruence’ (which means a perfect congruence between divi-
sion’s goal and the goal of the company. In case of failure of a division
to achieve the objective of ‘Goal congruence’ the management of the
company may dictate their transfer price. Such a interference of man-
agement of the company is usually the main basis of conflict between a
division and the company as a whole.
Further this conflict is aggravated if the management advocates the
transfer of goods and services at cost. As such, the transfer price will
not reflect a good picture about the performance of the transferring
division. The profitability of the transferring division will not be known
by the use of such a transfer price.
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Transfer Pricing
2 What should be the basis of transfer pricing, if unit variable cost and
unit selling price are not constant?
[Nov 1999]
Answer
If unit variable cost and unit selling price were not constant then the
main problem that would arise while fixing the transfer price of a prod-
uct would be as follows:
There is an optimum level of output for a firm as a whole. This is so be-
cause there is a certain level of output beyond which its net revenue will
not rise. The ideal transfer price under these circumstances will be that
which will motivate these managers to produce at this level of output.
Essentially, it means that some division in a business house might have
to produce its output at a level less than its full capacity and in all such
cases a transfer price may be imposed centrally.
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(ii) In case, the external market for the transferred good is not reason-
able competitive, following two situations may arise in this case:
If there is idle capacity – Under this situation opportunity cost will be
zero hence minimum transfer price should be equal to the additional
outlay costs incurred upto the point of transfer (sometimes approxi-
mated by variable costs).
If there is no idle capacity – Under this situation opportunity cost should
be added to outlay costs for determining minimum transfer price.
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Transfer Pricing
Answer
The Possible disadvantages of treating divisions as profit centres are as
follows:
(1) Divisions may compete with each other and may take decisions to
increase profits at the expense of other divisions thereby overem-
phasizing short term results.
(2) It may adversely affect co-operation between the divisions and
lead to lack of harmony in achieving organizational goals of the
company. Thus it is hard to achieve the objective of goal congru-
ence.
(3) It may lead to reduction I the company’s overall total profits.
(4) The cost of activities, which are common to all divisions, may be
greater for decentralized structure than centralized structure. It
may thus result in duplication of staff activities.
(5) Top management looses control by delegating decision making to
divisional managers. There are risks of mistakes committed by the
divisional managers, which the top management, may avoid.
(6) Series of control reports prepared for several departments may
not be effective from the point of view of top management.
(7) It may under utilize corporate competence.
(8) It leads to complications associated with transfer pricing prob-
lems.
(9) It becomes difficult to identity and defines precisely suitable profit
centres.
(10) It confuses division’s results with manager’s performance.
Answer
The goals of transfer pricing are that it should:
(1) provide information that motivates divisional managers to take
good economic decisions which will improve the divisional profits
and ultimately the profits of the company as a whole.
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(2) provide information which will be useful for evaluating the divi-
sional performance.
(3) seek to achieve goal congruence.
(4) ensure that divisional autonomy is not undermined.
Answer
The method of transfer pricing depends on whether the transferor is a
cost centre or a profit centre. If it is a cost centre then transfer will take
place at cost (may or may not include fixed cost). If it is a profit centre
then transfer will take place at a sale price. For the determination of
selling price, different techniques are available:
A. Absorption Costing Pricing – The transfer price comprises of (Ac-
tual prime costs + Overhead recovered + Mark up).
B. Marginal Costing Pricing – Here transfer price is = Variable Costs +
Contribution.
C. Pricing at Market Price – The transfer prices of goods and services
are based on competitive market prices.
D. Pricing at Bargained or Negotiated Price – Each decentralised unit
is considered as an independent unit and transfer price are ar-
rived at by negotiations or bargaining between the buying division
and the selling division. This system fosters a business like attitude
amongst the divisions of the company.
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Transfer Pricing
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Chapter 11|
MRP, MRP-II, ERP and JIT
14 Capsules
Answer
It is a management information system providing a basis for production
decisions when what is manufactured has a composite structure and
when lead items are important features. Obviously, the ability of the
system to deliver what is required in the correct place at the correct
time will be dependent on the quality of information which is put into
the computer model.
Aims of material requirement planning :
1. Determine for final products namely, what should be produced
and at what time.
2. Ascertaining the required units of production of sub-assemblies.
3. Determining the requirement for materials based on an up-to-
date bill of materials file (BOM).
4. Computing inventories, WIP, batch sizes and manufacturing and
packaging lead times.
5. Controlling inventory by ordering bought-in components and raw
materials in relation to the order received or forecast rather than
the more usual practice of ordering from stock-level indicators.
Benefits:
Detailed forecast of the inventory position is highlighted period by
period.
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Answer
Enterprise resource planning (ERP) software attempts to integrate all
departments and functions across a company into a single computer
system that can serve all those different departments’ particular needs.
In fact ERP combines all computerized departments together with the
help of a single integrated software that runs off a single database so
that various departments can more easily share information and com-
municate with each other
Benefits of ERP:
a. Product costing.
b. Inventory management.
c. Distribution and delivery of products.
d. E-commerce.
e. Automatic control of quality.
f. Sales service.
g. Improved production planning.
h. Quick response to change in market condition.
i. Competitive edge by improving business process.
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Answer
Some of the major features of “Enterprise Resource Planning” (ERP) ar-
eas are as follows:
(i) ERP facilitates company-wide integrated information system cov-
ering all functional areas like manufacturing, selling and distribu-
tion, payables, receivables, inventory etc.
(ii) It performs core activities and increases customer services there-
by augmenting the corporate image.
(iii) ERP bridges the information gap across organization.
(iv) ERP provides complete integration of systems.
(v) It is a solution for better project management.
(vi) It allows automatic induction of latest technologies like electronic
fund transfer (EFT), Electronic Data Interchange (EDI), Internet, In-
tranet, Video Conferencing, E-commerce etc.
(vii) ERP eliminates most business problems like material shortage,
productivity enhancements, customer service, cash management
etc.
(viii) It provides business intelligence tools.
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Answer
Just-in-time inventory concept aims at giving the following advantages:
1. Drastic reduction in investment on inventories can be achieved.
2. Total cost of operations can be reduced substantially.
3. Quality of components and materials can be maintained with the
help of quality control system.
4. Storage cost can be saved to the maximum.
5. Loss due to evaporation, sublimation, deterioration, obsoletion,
pilferage, theft can be brought to the minimum.
6. Cost of inventory accounting can also be reduced.
7. Prices of components and materials can be kept within reasonable
limits with the help of long-term contracts with the suppliers.
8. Production flow can be maintained un-interrupted on the guaran-
tee of on time supplies being given by the suppliers.
The following disadvantages may also come up:
1. A break in the flow of supplies for a very short period shall lead to
stoppage of production due to stock out.
2. Un-mended wrong supply may either spoil the production or
cause its stoppage.
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12 Write short notes on Accounting for Pull System – Back Flush Costing
and discuss the problems associated with it.
Answer
Traditional cost accounting systems track the sequence of raw materials
and components moving through the production systems, and as a con-
sequence are called ‘sequential tracking systems’. As JIT system is differ-
ent, it requires own cost accounting system. The absence of stock makes
choices about inventory valuation systems unnecessary and the rapid
conversion of direct material into cost of goods sold simplifies the cost
accounting system. The approach is known as back flush accounting.
Backflush accounting delays the recording of costs until after the events
have taken place, then standard costs are used to work backwards to
‘flush’ out the manufacturing costs.
The event that triggers the records kept in backflush accounting is the
sale of goods.
This is the system used by TOYOTA in its UK factory. In true Japanese
style it manipulates employees to behave in a certain way. First, em-
ployees must concentrate on achieving sales because cost of sales is
the trigger – nothing gets recorded until the sale is made. Second, there
is no benefit in producing goods for inventory. In traditional systems,
which have a finished goods inventory, managers can increase profit by
producing more goods than are sold in a period because an increase in
finished goods inventory reduced the cost of sales in traditional finan-
cial accounts.
The back flush accounting model cannot be applied in all organizations.
It can only be applied where a JIT type system is in operation.
The advantages of it is that it is less time consuming and less expensive
than traditional system.
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Answer
JIT provides competitive advantage in the following ways:
(i) Stocks of raw materials and finished goods are eliminated, stock
holding costs are avoided.
(ii) JIT aims at elimination of non-value added activities and elimina-
tion of cost in this direction will improve competitive advantage.
(iii) It affords flexibility to customer requirements where the company
can manufacture customized products and the competitive advan-
tage is thereby improved.
(iv) It focuses the direction of performance based production of high
quality product.
(v) It minimize waiting times and transportation costs.
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Answer
JIT approach helps in the reduction of costs/increase in prices as follows:
(i) Immediate detection of defective goods being manufactured so
that early correction is ensured with least scrapping.
(ii) Eliminates/reduces WIP between machines within working cell.
(iii) OH costs in the form of rentals for inventory, insurance, mainte-
nance costs etc. are reduced.
(iv) Higher product quality ensured by the JIT approach leads to high-
er premium in the selling price.
(v) Detection of problem areas due to better production/scrap re-
porting/labour tracing and inventory accuracy lead to reduction in
costs by improvement.
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Chapter 12|
Quantitative Techniques (QT)
20 Capsules
LINEAR PROGRAMMING
1 What is Linear Programming? What are the conditions for its applica-
bility? State its applications and limitations.
[Nov 2000, May 2007]
Answer
Linear Programming is a mathematical technique for determining the
optimal allocation of resources and obtaining a particular objective,
when there are alternative uses of resources. The resources may be as
materials, machines, manpower, time or various inputs. The objective
may be profit maximisation or cost minimization.
Conditions for a linear programming problem:
The term linear programming problem defines a particular class of pro-
gramming problems which should meet the following conditions:
(a) There must be decision variables or processes which the decision
maker may use at different levels. These decision variables must
be non – negative.
(b) The decision maker must have a maximisation (profit) or minimi-
zation (cost) objective that he wishes to achieve. Further, the de-
cision maker should be able to describe his objective by using a
linear function involving decision variables.
(c) The action of the decision maker must be constrained that is the
decision variables must be operated at levels which do not violate
the limitations placed on the decision variables.
(d) The decision variables must be interrelated and must be expressed
in terms of linear mathematical equations or inequalities.
Applicability or uses of linear programming:
Linear programming can be used to find optional solutions under con-
straints.
(a) In production – Product mix under capacity constraints to mini-
mise costs/maximise profits along with marginal costing, Inven-
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2 What are the steps for obtaining a Graphical Solution of a Linear Pro-
gramming Problem along with the formulation.
Answer
Step 1: Define an Objective Function – it is generally denoted by the
letter Z. It is a linear equation that has to be maximised or mini-
mised.
Step 2: Identify the Constraints – These are a set of linear equalities or
inequalities that express the restrictions on the resources. The
solution to the problem must satisfy all the constraints.
Step 3: Graphical Solution:
(a) Convert the inequations of constraints into equations.
(b) Plot the equations on the plane of graph.
(c) Obtain the feasible region and ensure that it is bounded.
(d) Construct matrix E of the extreme points and matrix C from
the co – efficient of the objective function.
(e) Find matrix product EC. For maximisation select row having
the largest element and for minimisation select row having
the smallest element.
(f) The objective function is optimised corresponding to the
same row elements.
A multiple solution to the problem may exist. The optimised value of Z,
however, remains the same.
SIMPLEX
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ASSIGNMENT
If no row or column containing only one zero can be located then box
any zero arbitrarily and draw two lines – one passing through the row
and the other through the column of the boxed zero. Repeat this pro-
cess till all the zeros are either boxed or are covered by a line.
If however, you are not able to box all the zeros even after applying the
process as given above, then it indicates that the lines drawn in the pre-
vious step to cover the zeros was not the minimum. Recheck that step
and then follow through.
In case, the number of lines that can be drawn is less than the order of
the matrix then apply the following procedure:
a. Locate the smallest uncovered element
b. Subtract this value from all the uncovered elements and add this
value to the junction elements.
c. Repeat these steps till the minimum number of lines that can be
drawn to cover all the zeros is exactly equal to the order of the
matrix.
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TRANSPORTATION
Answer
The methods by which initial feasible solution can be arrived at in a
transportation model are as under:
(a) North West Corner Method.
(b) Least Cost Method.
(c) Vogel’s Approximation Method (VAM).
2 What are the steps in initial solution by North West Corner Rule for a LP
Transportation problem?
Answer
The following steps are followed:
(a) Allocate the top left hand corner (North West Corner) with the
minimum of the availability and requirement.
(b) Proceed right along the row allocating successive cells till the row
exhausts.
(c) Proceed downwards along the column allocating successive cells
till the column exhausts.
(d) Repeat the process till all rows and columns are exhausted.
Limitation of this method: It does not consider the cost of transporta-
tion from origin to destination.
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3 What are the steps in initial solution by Least Cost Method for a LP
Transportation problem?
Answer
In this method the cost of transportation from each origin to all the des-
tinations are taken into consideration. The following steps are followed:
(a) Locate the least cost cell and allocate as much as possible to that
cell.
(b) Proceeding with progressively higher cost cells, repeat the process
till all the rows and columns are exhausted, hatching each row or
column that is exhausted.
Note: If at any point there is a tie in the lowest cost cell then select the
one where maximum allocation is possible.
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(b) Free float: The time by which the actual completion of an activ-
ity can be delayed without affecting the total float of succeeding
activities.
Free Float = Total Float – Slack of Head Event
(Slack implies L- E of the event)
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5. Start by crashing that activity which has the least crashing cost
slope and progress with ones in order of increasing cost slopes
(Keeping in mind that an activity can be crashed only till its crash
time).
6. If at any point there happens to be more than one critical path
then select different sets of activities such that crashing all the
activities in each set reduces all the critical paths at the same time.
To make the sets select an activity from each path. If the same ac-
tivity exists in any other path, put a dash there. If you cannot put
a dash, discard that particular combination. Crash that set which
has the least total crashing cost.
7. Stop crashing if any one of the longest path is exhausted fully i.e.
crashed till its crash time.
8. Prepare a cost table which shows the direct crashing cost, the
direct normal cost and the total indirect cost for all the reduced
project durations. The duration which gives the least cost is the
optimum project duration and the corresponding total cost is the
optimum project cost.
9. To find the Optimum cost of the project, stop crashing at the point
where total crashing cost is more than the indirect cost.
10. To find the Minimum Duration of the project, regardless of cost,
continue crashing even if the crashing cost is more than the indi-
rect cost. However, crashing will stop the moment any one of the
longest path is fully exhausted.
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Answer
The PERT and CPM models are similar in terms of their basic structure,
rationale and mode of analysis. However, there are certain distinctions
between PERT and CPM networks which are enumerated below:
(1) CPM is activity oriented i.e. CPM network is built on the basis of
activities. Also results of various calculations are considered in
terms of activities of the project. On the other hand, PERT is even
oriented.
(2) CPM is a deterministic model i.e. it does not take into account
the uncertainties involved in the estimation of time for execution
of a job or an activity. It completely ignores the probabilistic ele-
ment of the problem. PERT, however, is a probabilistic model. It
uses three estimates of the activity time; optimistic, pessimistic
and most likely, with a view to take into account time uncertainty.
Thus, the expected duration for each activity is probabilistic and
expected duration indicates that there is fifty percent probability
of getting the job done within that time.
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(3) CPM lays dual emphasis on time and cost and evaluates the trade-
off between project cost and project item. By deploying additional
resources, it allows the critical path project manager to manipu-
late project duration within certain limits so that project duration
can be shortened at an optimal cost. On the other hand, PERT is
primarily concerned with time. It helps the manger to schedule
and coordinate various activities so that the project can be com-
pleted on scheduled time.
(4) CPM is commonly used for those projects which are repetitive in
nature and where one has prior experience of handling similar
projects. PERT is generally used for those projects where time re-
quired to complete various activities are not known as prior. Thus,
PERT is widely used for planning and scheduling research and de-
velopment project.
Answer
Dummy activity is a hypothetical activity which consumes no resource
or time. It is represented by dotted lines and is inserted in the network
to clarify an activity pattern under the following situations.
(i) To make activities with common starting and finishing events dis-
tinguishable i.e. to remove duplicate errors.
(ii) To identify and maintain the proper precedence relationship be-
tween activities that are not connected by events i.e. to remove
dangling errors.
(iii) To bring all “loose ends” to a single initial and single terminal
event.
SIMULATION
2 How would you use the Monte Carlo Simulation method in inventory
control?
[May 2008]
Answer
Monte Carlo Simulation is the earliest mathematical Model of real situ-
ations in inventory control:
The steps involved in carrying out Monte Carlo simulation are:
Step 1 : Define the problem and select the measure of effectiveness of
the problem that might be inventory shortages per period.
Step 2 : Identify the variables which influence the measure of effective-
ness significantly for example, number of units in inventory.
Step 3 : Determine the proper cumulative probability distribution of
each variable selected with the probability on vertical axis and
the values of variables on horizontal axis.
Step 4 : Get a set of random numbers.
Step 5 : Consider each random number as a decimal value of the cumu-
lative probability distribution with the decimal enter the cumu-
lative distribution plot from the vertical axis. Project this point
horizontally, until it intersects cumulative probability distribu-
tion curve. Then project the point of intersection down into
the vertical axis.
Step 6 : Then record the value generated into the formula derived from
the chosen measure of effectiveness. Solve and record the val-
ue. This value is the measure of effectiveness for that simulated
value. Repeat above steps until sample is large enough for the
satisfaction of the decision maker.
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LEARNING CURVE
1 Explain the concept ‘Learning curve’. How can it be applied for Cost
management?
[May 2007]
Answer
The first time when a new operation is performed, both the workers
and the operating procedures are untried. As the operation is repeated
and the workers become more familiar with work, labour efficiency in-
creases and the labour cost per unit declines. This process continues for
some time and a regular rate of decline in cost per unit can be estab-
lished. This rate can be used to predict future labour costs. The learn-
ing process starts from the point when the first unit comes out of the
production line. In other words ‘Learning curve’ is a function that meas-
ures how labour hours per unit decline as units of production increase
because workers are learning and becoming better at their jobs.
Cost Management Application:
a. Learning curve is useful in analysing cost volume profit relation-
ship. The company can set low price of its product to generate
high demand. As the production increases, cost per unit drops.
b. It helps in budgeting and profit planning.
c. It enables the company in price fixation. In particular, the com-
pany can fix a lower price for repeat orders.
d. It helps the design engineers to take suitable decisions based on
expected rates of improvement.
e. It helps in price negotiations.
f. It is useful in setting standards and in performance evaluation.
Answer
As the production quantity of a given item is doubled, the cost of the
item decreases at a fixed rate. This phenomenon is the basic premise on
which the theory of learning curve has been formulated. As the quantity
produced doubles, the absolute amount of cost increase will be succes-
sively smaller but the rate of decrease will remain fixed. It occurs due to
the following distinctive features of manufacturing environment:
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Answer
The learning curve does not apply to very experienced people for the
same job, since time taken can never tend to become zero or reduce
very considerably after a certain range of output. This is the limitation
of the learning curve.
(i) Data entry is a manual job so learning rate theory may be applied.
Calculation of inventory is a computerized job. Learning rate ap-
plies only to manual labour.
(ii) Learning rate should not be applied to a new process which the
firm has never tried before.
(iii) The workers are shifted even before completion of one unit of
work. Hence learning rate will not apply.
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NOTE
NOTE