Scmpe Crash Book 1 (Oct 21)

INDEX
CA FINAL – NEW SYLLABUS
STRATEGIC COST MANAGEMENT &

PERFORMANCE EVALUATION
CRASH COURSE
[Oct 2021 Edition]
Compiled By CA Devang Kothari
CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

INDEX

INDEX
INDEX
CH TOPIC PAGE NO.

1 INTRODUCTION TO STRATEGIC COST MGMT 1.1
2 MODERN BUSINESS ENVIRONMENT 2.1
3 LEAN SYSTEMS & INNOVATION 3.1
4 COST MANAGEMENT TECHNIQUES 4.1
5 DECISION MAKING 5.1
6 PRICING DECISIONS 6.1
7 PERFORMANCE MEASUREMENT & 7.1
EVALUATION
8 TRANSFER PRICING 8.1
9 STRATEGIC ANALYSIS OF OPERATING 9.1
INCOME
10 BUDGETARY CONTROL 10.1
11 STANDARD COSTING 11.1

INDEX
General Guidelines for answering SCMPE Paper:
 In all practical questions, Give detailed explanations for each item of cost
that you take relevant and also for each item of cost that you don't take as
relevant.
 Always give interpretations for all your practical answers calculated.
(Especially for Variance Answers, Relevant Costing, Make or Buy, New
Offer Acceptance, Transfer Pricing, etc.
 In interpretation of variances, give probable reasons why that variance
might have happened.
 Don’t write like you just want to reach the final answer, its not CPT or
MCQs. Write as if you are explaining the situation to your client. Final
answer has less weightage, explanations carry more weightage.
 This applies not only for theory questions and case studies, rather its more
important for all practical questions also.
 Notice the explanation given for most questions in this “Additional
Questions” sheet. You need to draft such explanation for every question in
the exam.
 Budgets Chapter is now more of theory & case studies, practical have been
done just to revise some IPCC calculations.
 Read Skill Assessment sheet given by ICAI at the end of this material for
better idea on what to include in your answers.
 Check out my revision videos for final revision.
 Also refer summary notes given along with the revision videos from the link
in video description

CH – 01 INTR ODUCTION TO STRA TEGIC COST MGMT
CHAPTER INTRODUCTION TO STRATEGIC

01 COST MANAGEMNT
CHAPTER SUMMARY (THEORY)
1. PORTER’S VALUE CHAIN ANALYSIS: [By Michael Porter]

To identify and analyze various activities that add value to the final product, try to eliminate
Non-Value Added Activities. Classification:
Primary Activities Secondary Activities
(1) Inbound Logistics (Getting RM) (1) Procurement (Purchasing RM)
(2) Operations (Production) (2) Tech. Development (Tech. for
Production)
(3) Outbound Logistics (FG Delivery)
(4) Marketing & Sales (Advertising, Pricing) (3) HR Mgmt. (Recruitment, Appraisals)
(5) Service (After Sales Service) (4) Firm Infra. (Planning, finance, legal)
2. FRAMEWORK FOR VALUE CHAIN ANALYSIS: [i.e. How to Do?]

A. Industry Structure Analysis (Porter’s 5 Forces Analysis):
Forces that determine profit potential of a firm in the industry:
(1) Bargaining power of buyers:
(2) Bargaining power of suppliers:
(3) Threat of substitute products or services:
(4) Threat of new entrants:
(5) Intensity of competition/ rivalry amongst firms:
B. Core Competencies Analysis:
Unique skill or technological knowhow that creates distinctive customer value. It comes
from 2 sources: Resources & Capabilities
C. Segmentation Analysis:
Analyze competitive advantages or disadvantages of different segments.
3. ASSESSING COMPETITIVE ADVANTAGE: [i.e. by using Value Chain Analysis]

A. Differentiation Advantage:
01. 1 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

 To make a product perceived as superior so that customers are willing to pay premium.
 How?: Superior Quality, Superior Innovation or Superior Customer Responsiveness
 Then: Increase SP & get more Profit, or keep less SP & get more Market Share
 Use VCA to identify areas of Differentiation – ‘Internal Differentiation Analysis’:
o Identify the customer’s value creating processes
o Evaluate differentiation strategies for enhancing customer value (eg: Product features,
better marketing, excellent customer service, brand image, etc)
o Determine the best sustainable differentiation strategies
B. Low Cost Advantage:
 To make the total costs of our product, lower than those of competitors.
 How?: Low Cost Material, Innovative Tech, Low Cost Distribution, Economies of Scale.
 Then: Decrease SP & get more Market Share, or keep Same SP & get more Profit
 Use VCA to identify areas of Low Cost – ‘Internal Cost Analysis’:
o Identify the firm’s value-creating processes (i.e. identify activities)
o Determine cost of each value creating process (i.e. cost of each activity)
o Identify the cost drivers for each process
o Identify the links between processes (eg: more automation can reduce labour cost)
o Evaluate the opportunities for achieving relative cost advantage
C. Focus Strategy:
 Concentrates only on a specific segment – i.e. a ‘Niche’
4. VALUE SHOP MODEL OR SERVICE VALUE CHAIN

It is to solve specific problems of the customers, rather than creating value by producing
products (mostly for customized service industry). Primary Activities are different:
(1) Problem finding and acquisition. (3) Problem solving.
(2) Choosing among solutions. (4) Execution and control/evaluation.

PRACTICALS SUMMARY
 ACTIVITY BASED COSTING:
It is an advanced method for adding overheads to product cost, in which different Oh Rate
is created for each different activity in the company.
i.e separate rate for each item of cost, and each such rate will be based on different base
(not always taking base of hours)
Traditional Method assumes that all Oh are dependent on Hours, i.e. product which takes
more production hours, will incur more Oh. ABC rectifies this mistake because taking more
hours may not always lead to incurring more Oh.
Eg:
Particulars Product A Product B
Total Production Units 1,000 Units 1,000 Units
Hours p.u. 6 Hrs p.u. 4 Hrs p.u.
No. of RM Purchase Orders 12 (Monthly) 360 (Daily)
No. of Production Batches 10 Batches 100 Batches
Total Production Oh: ₹1,00,000
(1) Traditional Method:
₹ , ,
→ Budgeted Oh Absorption Rate = = = ₹10/Hr
,
→ ∴ Oh cost of each Product: Product A Product B

(Oh Rate × Hours) ₹10 × 6 Hrs ₹10 × 4 Hrs
= ₹60 = ₹ 40
(2) ABC Method:
→ Total Production Oh: ₹1,00,000
Material Ordering Cost Machine Setup Cost

₹37,200 ₹62,800
(based on No. of Orders) (based on No. of Batches)
→ Conclusion: Product B requires more No. of Orders as well as more No. of Batches, hence
it must be given more amount of Oh cost which is not happening in Traditional Method.
Q.01. TRADITIONAL METHOD V/S ABC METHOD

You have been appointed as a management consultant by XYZ ltd – a key manufacturer of
machining tools. You need to analyse how application of activity-based costing (ABC) to
costing of the company’s product lines would improve product costing and help it price its
product offerings in a more efficient manner.

Details of the four products and relevant information are given below for one period:
Product P Q R S
Output in units 150 120 60 90
Costs per unit Rs Rs Rs Rs
Direct material 50 60 40 80
Direct labour 32 24 18 20
Machine hours (per unit) 5 4 3 2
The four products are similar and are usually produced in production runs of 15 units and
sold in batches of 10 units.
The production overhead is currently absorbed by using a machine hour rate, and the total
of the production over head has been analysed as follows:
Rs
Machine department costs (rent, Business, rates, depreciation and 18,960
Supervision)
Set-up costs 5,600
Stores receiving 4,000
Inspection/quality control 1,620
Material handling and dispatch 7,980
You have identified cost drivers to be used are as follows for the overhead costs shown:
Cost Cost Driver
Set-up costs Number of production runs
Stores receiving Requisitions raised
Inspection/quality control Number of production runs
Materials handling and dispatch Orders executed
The number of requisitions raised on the stores was 20 for each product and the number of
orders executed was 42, each order being for a batch of 10 of a product.
Requirements
(a) Calculate the total costs for each product if all overhead costs are absorbed on a machine
hour basis.
(b) Calculate the total cost of each product, using activity-based costing.
(c) Compare the two costs under the two scenarios and identify the implications this could
have on pricing and profit.
SOLUTION: (a) Traditional Absorption Costing Method:
(1) Budgeted Absorption Rate:
Budgeted OH (Rs) 38,160

(÷) Budgeted Base (M.Hrs) 1,590

Absorption Rate (Rs/M.Hr) 24
(2) Product Cost p.u.:
Particulars P Q R S
DM (Given) 50 60 40 80
DL (Given) 32 24 18 20
OH: [Rs 24/M.Hr x (5,4,3,2) M.Hr] 120 96 72 48
TC p.u. 202 180 130 148
(b) Activity Based Costing Method:
(1) Cost Driver Rate:
M Setup Str Insp M.H
Activity Cost Pool (Rs) 18,960 5,600 4,000 1,620 7,980
(÷) Cost Drivers 1,590 28 80 28 42
M.Hr Runs Req. Runs Ord.
Cost Driver Rates (Rs) 11.92 200 50 57.86 190
Per M.Hr Per Runs Per Req. Per Runs Per Ord.
(2) Product Cost p.u.:
Particulars P Q R S
Units 150 120 60 90
DM (Given) 50 60 40 80
DL (Given) 32 24 18 20
OH:
M [Rs 11.92/M.Hr x (5,4,3,2) M.Hr] 59.62 47.70 35.77 23.85
Setup [Rs 200/Run x (10,8,4,6) Runs ÷ Units] 13.33 13.33 13.33 13.33
Str [Rs 50/Req x (20,20,20,20) Req ÷ Units] 6.67 8.33 16.67 11.11
Insp [Rs 57.86/Run x (10,8,4,6) Runs ÷ Units] 3.86 3.86 3.86 3.86
M.H. [Rs 190/Ord x (15,12,6,9) Ord ÷ Units] 19.00 19.00 19.00 19.00
TC p.u. 184.48 176.22 146.63 171.15
Q.02. ABC METHOD & TARGET COSTING

NEC Ltd. manufactures two parts ‘P’ and ‘Q’ for Computer Industry.
P : Annual production and sales of 1,00,000 units at a selling price of Rs 100.05 per unit.
Q : Annual production and sales of 50,000 units at a selling price of Rs 150 per unit.

Direct and Indirect costs incurred on these two parts are as follows: (Rs in thousand)
Particulars of Costs P Q Total
Direct Material Cost (Variable) 4,200 3,000 7,200
Labour Cost (Variable) 1,500 1,000 2,500
Direct Machining Cost (See Note)* 700 550 1,250
Indirect Costs:
Machine Setup Cost 462
Testing Cost 2,375
Engineering Cost 2,250
Note: Direct machining costs represents the cost of machine capacity dedicated to the
production of each product. These costs are fixed and are not expected to vary over the long-
run horizon.
Additional information is as follows:
P Q
Production Batch Size 1,000 units 500 units
Set-up Time per batch 30 hours 36 hours
Testing Time per unit 5 hours 9 hours
Engineering Cost incurred on each product 8.40 lakhs 14.10 lakhs
A foreign competitor has introduced product very similar to ‘P’. To maintain the company’s
share and profit, NEC Ltd. has to reduce the price to Rs 86.25. The company calls for a
meeting and comes up with a proposal to change design of product ‘P’. The expected effect
of new design is as follows:
 Direct Material cost is expected to decrease by Rs 5 per unit.
 Labour cost is expected to decrease by Rs 2 per unit.
 Machine time is expected to decrease by 15 minutes, previously it took 3 hours to produce
1 unit of ‘P’. The machine will be dedicated to the production of new design.
 Set up time will be 23 hours for each set up.
 Time required for testing each unit will be reduced by 1 hour.
 Engineering cost and batch size will be unchanged.
Required:
(a) Company management identifies that cost driver for Machine set-up costs is ‘Set up hours
used in batch setting’ and for testing costs is ‘testing time’. Engineering costs are assigned
to products by special study. Calculate the full cost per unit for ‘P’ and ‘Q’ using Activity-
Based Costing.
(b) What is the Mark-up on full cost per unit of P?
(c) What is the Target Cost per unit for new design to maintain the same mark up percentage
on full cost per unit as it had earlier? Assume cost per unit of cost drives for the new
design remains unchanged.

(d) Will the new design achieve the cost reduction target?
(e) List 4 possible management actions that the NEC Ltd. should take regarding new design.
SOLUTION:



(e) Possible management actions regarding new design:
(1) Try to further decrease DM Cost by making further changes in the product design.
(2) Try to further decrease DL Cost by making changes in the product design. Machine
time is already being saved, but machine cost is fixed cost. So they must think of using
this saved machine time to reduce the DL time (by doing more automation).
(3) Setup and Testing Oh might be possible to decrease further by eliminating some
activity, increasing scale of production, or by increasing the batch size.
(4) As the new design does not achieve the target cost, company may still sell at the target
SP by decreasing some profit margin.
(5) Company must study the decrease in demand that would happen if they charge little
higher SP in this new design, because if this decrease in demand is not very
significant, then it might be overall more suitable for the company to keep this design
and charge little higher SP and loose some demand.
Note – 1: Direct Machining Cost:

The question states that the Direct Machining Cost is regarding a machine dedicated to
Product P and that it is a fixed cost. So now, even if the new design of P will save some
Machine Time, then also this spare time cannot be used anywhere else. This spare time can
also not be used in making more units of P as it is mentioned that the units of P are supposed
to be maintained. Thus, there is no change in the Direct Machining Cost for the new design
as there is no monetary benefit for the 15 mins saved.
Note – 3: Cost of Unused Capacity:
In case of Fixed Oh, while calculating the Oh Rate, full capacity will be taken as the base,
whether full capacity is used or not. By this method, if any unused capacity remains in the
co., then it will lead to Cost of Unused Capacity that is not allotted to any product, this cost is
shown separately in the P&L.
Note – 2: Absorption Rate for New Design:
Once a Cost Driver Rate is calculated, then this same rate will apply to all products in the
company, even to new products or new designs of the products.

CASE SUMMARY
1. PORTER’S 5 FORCES: [May 19 RTP]
WDG is a family owned business. The family owns 80% of the shares. The remaining 20% is
owned by six non- family shareholders. It manufactures Cardboard Boxes for customers
which are mainly manufacturers of shoes, cloths, crackers etc. Now, the board is considering
to join the Paper Tubes market as well. Paper Tubes, also known as Cardboard Tubes, are
cylinder- shaped components that are made with Cardboard. Paper Tubes can be used for a
wide range of functions. Paper Tubes are usually ordered in bulk by many industries that rely
Paper Tubes include food processing, shipping and the postal service, automotive
manufacturing, material handling, textile, pulp and paper, packaging, and art etc. The Paper
Tubes cost approximately 1% - 3% of the total cost of the customer’s finished goods. The
information about Paper Tubes is as follows:
(i) The Paper Tubes are made in machines of different size. The lowest cost machine is
of ₹1,89,000 including GST @ 5% and only one operator is required to run this machine. Two
days training program is required to enable untrained person to run such a machine efficiently
and effectively. A special paper is used in making Paper Tubes and this paper remains in
short supply.
(ii) Presently, five major manufacturers of Paper Tubes have a total market share of 75%,
offer product ranges which are similar in size and quality. The market leader currently has
24% share and the four remaining competitors hold on average 12.75% share. The annual
market growth is 3% per annum during recent years.
(iii) A current report “Insight on Global Activities of Foreign Based MNCs” released the
news that now MNC’s are planning to expand their packaging operations in overseas market
by installing automated machines to produce Paper Tubes of any size.
(iv) Another company, HEG manufactures a small, however increasing, range of Plastic
Tubes which are capable of housing small products such as foils and paper-based products.
Currently, these tubes are on an average 15% more costly than the equivalent sized Paper
Tubes.
Required: ASSESS whether WDG should join the Paper Tubes market as a performance
improvement strategy?
SOLUTION:
To assess the feasibility of joining Paper Tubes market, Michael Porter’s ‘five forces model’
can be used. It analyses the competitive environment of an industry. It is an important tool
for understanding the competitive structure of a particular industry. This complete analysis
includes five forces: buyer’s bargaining power, supplier’s bargaining power, the threat of
substitute products, the threat of new entrants and the intra industry competition.
While applying this model to the above case, it can be observed that the low cost of the
machine along with the fact that an untrained person will only need two day’s training as to
be able to operate a machine, will form comparatively low costs of entry to the market.
Therefore, WDG may reasonably consider high threat of new entrants.

Customer’s (buyer) power could be high since customers buy Paper Tubes in bulk along with
the fact that there is insignificant difference between the products of alternative suppliers.
Paper Tubes cost approximately 1% - 3% of the total cost of the customer’s finished goods
also indicates that customer’s power is high.
The fact that the special paper from which the tubes are made remain in short supply, signals
high threat from suppliers. Hence, suppliers may raise their prices that would result in
reduction of profit.
Five major players with 75% market share, offer product ranges which are similar in size and
quality, besides, the market is a slow growing i.e. annual growth of 3% p.a., indicate high
rivalry among competitors.
A little real threat from a substitute product exist since HEG manufactures a narrow range of
Plastic Tubes. This threat might go up if the product range of HEG is expanded or the price
of Plastic Tubes goes down sharply.
Major threat from potential new entrants can be seen, as foreign MNCs are planning to joining
this market and it seems that these giant corporations might be able to gain economies of
scale from automated machines and large production lines with manufacturing flexibility.
WDG might enter this market due to low capital investment but this would also lead to other
potential entrants. The easy entry, threat of substitute, the existence of established
competitors in the market, the possible entry of a MNCs, and competitors struggling due to
slow growth market are putting the potential of WDG into the question to achieve any sort of
competitive advantage.
Joining this market might be a good move, if WDG would be able manufacture Paper Tubes
at lowest cost within the industry. To assess feasibility, WDG must take into consideration all
possible synergies between its existing operations of Card Boxes and the proposed
operations of Paper Tubes.
From the available information, joining the market for Paper Tubes does not seem to be
attractive. Thus, WDG should go for other alternative performance improvement strategy.

CH – 02 MOD ERN BUSIN ESS EN VIRONMENT
CHAPTER MODERN BUSINESS

02 ENVIRONMENT
CHAPTER SUMMARY & PRACTICALS
A. COST OF QUALITY (COQ)
Cost of Good Quality is incurred in order to reduce the Cost of Poor Quality, so that overall
Cost of Quality is minimum. It is measured in terms of PAF model i.e. Prevention, Appraisal
& Failure (Internal & External).
1. Prevention Cost: It means costs incurred to prevent poor quality. It will decrease
Appraisal Cost and Failure Cost.
Eg: Training Costs, Quality improvement costs, supplier evaluation, etc.
2. Appraisal Cost: It means costs incurred to check quality. It will decrease Failure Cost.
Eg: Checking incoming materials, Inspection Cost (in-process and final), calibration and
checking of equipments, etc.
3. Internal Failure Cost: It means costs associated to defects found before the customer
receives the product. It will decrease External Failure Costs.
Eg: Process loss, defectives produced, scrap generated, rework or rectification,
downtime, delays, contribution lost, etc.
4. External Failure Cost: It means costs associated to defects found after the customer
receives the product. It will lead to customer dissatisfaction.
Eg: Sales return, repairs & servicing, warrany claims, customer complaints, sales lost,
contribution lost, etc
Note: all these costs are identified as compared to an ideal situation in which no defectives
are produced at all and no Cost of Quality is incurred.

For practicals, calculate COQ for each option given in the question, then choose the one
where COQ is minimum. However, also mention in the analysis that long term reputation of
the brand is also important to consider which is not considered by COQ calculations.
Q.01. COQ
A company produces and sells a single product. The cost data per unit for the year 2017 is
predicted as below:
per unit
Direct Material 35
Direct Labour 25
Variable Overheads 15
Selling Price 90
The company has forecast that demand for the product during the year 2017 will be 28,000
units. However, to satisfy this level of demand, production quantity will be increased?
There are no opening stock and closing stock of the product.
The stock level of material remains unchanged throughout the period.
The following additional information regarding costs and revenue are given:
― 12.5% of the items delivered to customers will be rejected due to specification failure and
will require free replacement. The cost of delivering the replacement item is Rs 5 per unit.
― 20% of the items produced will be discovered faulty at the inspection stage before they
are delivered to customers.
― 10% of the direct material will be scrapped due to damage while in storage. Due to above,
total quality costs for the year is expected to be Rs 10,75,556.
The company is now considering the following proposal:
(1) To introduce training programmes for the workers which, the management of the company
believes, will reduce the level of faulty production to 10%. This training programme will
cost Rs 4,50,000 per annum.
(2) To avail the services of quality control consultant at an annual charges of Rs 50,000 which
would reduce the percentage of faulty items delivered to customers to 9.5%.
Required
(a) PREPARE a statement of expected quality costs the company would incur if it accepts
the proposal. Costs are to be calculated using the four recognised quality costs heads.
(b) Would you RECOMMEND the proposal? Give financial and non-financial reasons.

SOLUTION: (a)

(b) Recommendation:
On purely financial grounds the company should not accept the proposal because there is an
increase of ₹51,130 in quality costs. However, there may be other factors to consider as the
company may enhance its reputation as a company that cares about quality products and
this may increase the company’s market share.
On balance the company should accept the proposal to improve its long-term performance.

Q.02. COQ
The CEO of P Limited is concerned with the amounts of resources currently spent on
customers warranty claims. Each box of its product is printed with the logo: “satisfaction
guaranteed or your money back”. P is having difficulty competing with X Limited because it
does not have the reputation for high quality that X Limited enjoys. Since the warranty claims
are so high, the CEO of P Limited would like to assess what costs are being incurred to
ensure the quality of the product. Following information is collected from various departments
within the company relating to 2018-19:
Rs.
Warranty claims 4,25,000
Employee training costs 1,20,000
Rework 3,00,000
Lost profits from lost customers due to impaired reputation 8,10,000
Cost of rejected units 50,000
Sales return processing 1,75,000
Testing 1,70,000
For the year 2019-20, the CEO is considering spending the following amounts on a new
quality programme:
Rs.
Inspect raw material 1,20,000
Reengineer the production process to improve product quality 7,50,000
Supplier screening and certification 30,000
Preventive maintenance on plant equipment 70,000
P expects the new quality programme to save costs by the following amounts:
Rs.
Reduction in lost profits from lost sales due to impaired reputation 8,00,000
Reduction in rework costs 2,50,000
Reduction in warranty costs 3,25,000
Reduction in sales return processing 1,50,000
Required:
(i) PREPARE a Cost of Quality Statement for the year 2018-19 showing the percentage of
the total costs of quality incurred in each cost category.
(ii) PREPARE a cost benefit analysis of the new quality programme showing how the quality
initiative will affect each cost category.
(iii) STATE how the manager trade-offs among the four categories of quality costs.
[May 20 MTP (10 Marks)]

SOLUTION: (i) Present COQ:

Particulars Rs % of Total COQ
A. Prevention Costs:Employee Training 1,20,000 5.85%
B. Appraisal Costs: Testing 1,70,000 8.29%
C. Internal Failure: Rework 3,00,000
Rejections 50,000
3,50,000 17.07%
D. External Failure: Warranty 4,25,000
Lost Customers 8,10,000
Sales Return 1,75,000
14,10,000 68.78%
∴ Total COQ 20,50,000 100%
(ii) Proposed COQ:
Particulars Rs Extra Cost / Savings
A. Prevention Costs:Employee Training 1,20,000
Re-engineering 7,50,000
Supplier Screening 30,000
Preventive Maint. 70,000
9,70,000 Extra Cost = 8,50,000
B. Appraisal Costs: Testing 1,70,000
Inspection of RM 1,20,000
2,90,000 Extra Cost = 1,20,000
C. Internal Failure: Rework 50,000
Rejections 50,000
1,00,000 Savings = 2,50,000
D. External Failure: Warranty 1,00,000
Lost Customers 10,000
Sales Return 25,000
1,35,000 Saving = 12,75,000
∴ Total COQ 14,95,000 Net Saving = 5,55,000

(iii)
Investment in prevention costs and appraisal costs (also known as costs of good quality),
reduces internal and external failure costs (also known as cost of poor quality).
Costs incurred before actual production begins, to prevent defects and other product quality
issues, are known as preventive costs. In the given example, reengineering production
process, screening / certification of suppliers and preventive maintenance of equipment are
preventive costs. Likewise, appraisal costs are incurred to ensure that activities conform to
desired quality requirements. They are incurred in all stages of production. In the given
example inspection of raw material is an appraisal cost.
While preventive and appraisal costs would not directly improve the quality of the product,
they would definitely reduce internal failure costs like rework costs or external failure costs
like sales returns or warranty claims. These would also enhance the reputation of the product
for its standard of quality. Conversely, it follows that internal failure costs may be preferable
to external failure costs since it affects the company’s brand image.
Costs incurred to ensure conformance to quality will ensure higher chances of detection of
defects in the product. At the same time ensuring zero defective rate may require huge
resources and therefore may be costly. Instead, companies may have the ability to absorb
costs incurred due to rework, warranty claims or lost sales. Therefore, they must determine
a reasonable threshold defective rate that is acceptable, a normal cost in business
operations. Tools for quality production management like Total Quality Management (TQM)
will help in determining the optimum cost of quality that the company is willing to bear. TQM
focus on continuous improvement of an organization’s business activities. This creates an
awareness of quality that the company comes to expect from various processes. Things
need to be done right the first time, consequently eliminating defects and waste from
operations. At the same time, an in-depth knowledge of business processes provides
information that can help the management set acceptable threshold limits for reasonable level
of defects it is willing to bear.
Q.03. COQ
Cool Air Private Ltd. manufactures electronic components for cars. Car manufacturers are
the primary customers of these products. Raw material components are bought, assembled
and the electronic car components are sold to the customers.
The market demand for these components is 500,000 units per annum. Cool Air has a market
share of 100,000 units per annum (20% market share) for its products. Below are some of
the details relating to the product:
Selling price ₹2,500 per unit
Raw material cost ₹900 per unit
Assembly & machine cost ₹500 per unit
Delivery cost ₹100 per unit
Contribution ₹1,000 per unit

The customers due to defects in the product return 5,000 units each year. They are replaced
free of charge by Cool Air. The replaced components cannot be repaired and do not have
any scrap value. If these defective components had not been supplied, that is had the sale
returns due to defective units been nil, customers’ perception about the quality of the product
would improve. This could yield 10% increase in market share for Cool Air, that is demand
for its products could increase to 150,000 units per annum. Required
(i) ANALYZE, cost of poor quality per annum due to supply of defective items to customers.
(ii) The company management is considering a proposal to implement an inspection process
immediately before delivery of products to the customers. This would ensure nil sales
returns. The cost of having such a facility would be ₹2 crores per annum, this would
include materials and equipment for quality check, overheads and utilities, salaries to
quality control inspectors etc. ANALYZE the net benefit, if any, to the company if it
implements this proposal.
(iii)Quality control investigations reveal that defective production is entirely on account of
inferior quality raw material components procured from a large base of 30 suppliers.
Currently there is no inspection at the procurement stage to check the quality of these
materials. The management has a proposal to have inspectors check the quality control
at the procurement stage itself. Any defective raw material component will be replaced
free of cost by the supplier. This will ensure that no product produced by Cool Air is
defective. The cost of inspection for quality control (materials, equipment, salaries of
inspectors etc.) would be ₹4 crores per annum. ANALYZE the net benefit to the company
if it implements this proposal? Please note that scenarios in questions (ii) and (iii) are
independent and not related to each other.
(iv)Between inspection at the end of the process and inspection at the raw material
procurement stage, ADVISE a better proposal to implement (a) in terms of profitability and
(b) in terms of long term business strategy? [May 19 RTP]
SOLUTION:
(i) Present Cost of Quality:
[AS compared to situation if no defectives were produced] (₹)
Cost of free replacements [5,000 Units @ ₹1,500 p.u. (VC)] 75,00,000
(+) CL on additional market share lost [50,000 Units @ ₹1,000] 5,00,00,000
∴ Total Cost of Quality (Cost of Poor Quality) 5,75,00,000
Notes:
Customer demand for Cool Air’s products is 100,000 units per annum. However, 5,000
defective units supplied are to be replaced free of charge by the company. The cost of
replacement would include raw material cost, assembly & machining cost and delivery cost
of 5,000 units ₹ (900+500+100) per unit = ₹1,500 per unit.
Further, if there were no defectives, then the sale return would not happen and in that case,
market share would have increased by 50,000 units. But because of defectives, market share
is lost, and so eventually contribution is lost (@ ₹1,000 p.u.) on these units

(ii) Proposed Cost of Quality and Net Benefit of inspection before delivery:
[AS compared to situation if no defectives were produced] (₹)
(+) Cost of defectives produced [7,500 Units @ ₹1,400 p.u. (VC)] 1,05,00,000
(+) Cost of Inspection: 2,00,00,000
∴ Total Cost of Quality 3,05,00,000
∴ Net Benefit of Inspection is that the Cost of Quality is decreasing from ₹5,75,00,000 to
₹3,05,00,000, i.e. saving of ₹2,70,00,000. ∴ Inspection must be conducted.
Notes:
If inspection is done immediately before delivery to customers, then this would ensure that
defective units are not delivered to customers and hence sales return will be zero. However,
inspection immediately before delivery means it is after production, and such inspection does
not prevent production of defective units. Hence production cost of defective units is still
incurred, (i.e. all VC except delivery cost = ₹1,400. As the inspection is done before delivery,
defectives are identified before delivery and accordingly, delivery is not done for these units).
Also, now that no defectives are delivered to customers, so there is no sales return, so there
is no contribution lost. Total sales will be now 1,50,000 Units. But in that case the defectives
production will also be on 1,50,000 Units. If 1,00,000 Units production had 5,000 Units
defectives, then 1,50,000 Units production would have proportionately 7,500 Units defective.
Cost of Defectives given above is a cost of poor quality, while the Cost of inspection given
above is a cost of good quality. So, notice in the above working that when cost of good quality
is incurred, then the cost of poor quality goes down, thereby even decreasing total COQ.
(iii) Proposed Cost of Quality and Net Benefit of inspection on procurement:

Cost of Quality is only the cost of the inspection: ₹4,00,00,000
∴ Net Benefit of Inspection is that the Cost of Quality is decreasing from ₹5,75,00,000 to
₹4,00,00,000, i.e. saving of ₹1,75,00,000. ∴ Inspection must be conducted.
Notes:
If inspection is done on procurement of raw materials, then this would ensure that defective
units are not produced at all and hence sales return will again be zero. Also, now that no
defectives are delivered to customers, so there is no sales return, so there is no contribution
lost also. Thus, the Cost of Poor Quality will now be zero.
(iv) Inspection before delivery v/s Inspection on procurement:

(a) The proposal to implement inspection immediately before delivering goods to the
customers results in a net benefit of ₹2,70,00,000 per annum. Alternately, the proposal to
implement inspection at the raw material procurement stage results in a net benefit of
₹1,75,00,000 per annum. Therefore, from a profitability point of view, inspection
immediately before delivery of goods to the customer would the preferred option.

(b) The drawback of inspection before delivery is that (1) it cannot prevent production of
defective goods and (2) information regarding the root cause of defective production, in
this case, supply of defective raw materials will not get tracked. Therefore, inspection at
the end of production does not contribute to resolving the root cause of defective
production. On the other hand, inspection at the procurement stage can eliminate
production of defective goods. This will ensure a much higher quality of production, better
utilization of resources and production capacity. Therefore, from a long-term strategy point
of view, inspection at the raw material procurement stage will be very beneficial. Currently
the cost of ensuring this highest quality of production (0% defects) is ₹4 crores per annum.
The cost of ensuring 100% quality is quite high, such that the net benefit to the company
is lesser than the other proposal. However, due to its long-term benefit, Cool Air may
consider some minimum essential quality control checks at the procurement stage.
Although selective quality check might not ensure complete elimination of defective
production, it can contribute towards reducing it. At the same time cost of selective quality
check would not be so high as to override its benefits. To determine the extent of quality
control inspection, Cool Air should determine its tolerance limit for defective production
and do an analysis of the quality / cost trade-off.
B. TOTAL QUALITY MANAGEMENT (TQM)

TQM aims at improving the quality of organizations outputs through continuous improvement
of internal practices (like Kaizen). This requires ensuring that things are done right the first
time and that defects and waste are eliminated from operations.
Practical questions of TQM involve same kind of calculations as COQ. Basic theory in TQM
includes the following topics:
1. Six C’s of TQM:
(1) Commitment of top management to TQM
(2) Culture & attitude change to make ‘quality’ a normal part of everyone’s job.
(3) Continuous Improvement in long term, searching for ways to do a job better.
(4) Co-operation of employees.
(5) Customer Focus: Perfect service with zero defects to internal & external people.
(6) Control: To monitor improvements and correct deficiencies.
2. Deming’s 14 Point Methodology: [Refer Book]
3. PDCA Cycle:
It describes the activities a company needs to perform in order to incorporate continuous
improvement in its operation. This cycle, is also referred to as the Deming wheel. The circular
nature of this cycle shows that continuous improvement is a never-ending process.

C. BUSINESS EXCELLENCE MODEL

It is a philosophy for developing and strengthening the management systems and processes
of an organization to improve performance and create value for stakeholders. Creating value
for stakeholder means fulfilling what the stakeholder needs. Stakeholders includes
customers, shareholders, employees, society, etc. Companies should achieve excellence in
all aspects of its operations, not just achieve excellence, but also to sustain it.
Eg:  EFQM Excellence Model  Baldrige Criteria for Performance Excellence
 Singapore BE Framework  Australian Business Excellence Framework
 Japan Quality Award Model 
EFQM EXCELLENCE MODEL: [Refer Case 3 from Class]
It was developed by the European Foundation for Quality Management. It can help the
company understand the cause and effect relationships between what their organization does
and the results it achieves. It has 3 components:
1. Fundamental Concepts of Excellence:
It means to identify what defines excellence for the company, in which areas does the
company want to excel:
 Adding value for customers: fulfill customer needs
 Creating a sustainable future: fulfill society and environment needs
 Developing organizational capability: To identify that what is the company capable of
being great at, so that it can differentiate from competitors.
 Harnessing creativity & innovation: Promote a working environment that encourages
creativity and innovation.
 Leading with vision, inspiration & integrity: Tone at the top defines rest of the company.
 Managing with agility: Capable to identify & respond to opportunities & threats.
 Succeeding through the talent of people: better the people, better is the organization.
Atmosphere of teamwork required.

 Sustaining Outstanding Results: This is not a 1 time exercise, it is required to sustain

this excellence in long term.
2. Criteria (i.e. Enablers & Results):
Enablers covers what an organization does (its objective) and how it does it (strategy to
achieve it).
(1) Leadership: It must take the correct decisions at the correct time
(2) Strategy: Operations must be planned & implemented as per the strategy to achieve
the organizational goals.
(3) People: They must be motivated and well managed with a work culture that opens
opportunities for personal development also.
(4) Partnerships & Resources: with other organizations, vendors, service providers, etc.
(5) Processes, Products & Services: should be managed and continuously improved.
Results are what the organization achieves for each Stakeholder. KPIs must be
developed for each stakeholder.
(1) Customer Results: Check whether the customers are satisfied, loyal, increasing or not.
(2) People Results: Check whether employees are skilled, motivated having lesser
turnover and whether company has access to hire required talent?
(3) Society Results: Check whether its CSR objectives are being met or not.
(4) Business Results: Check whether it is giving the required ROI that investors demand.
Note: Enablers enable achievement of Results.
3. RADAR:
Tool for analyzing the performance:

CASE STUDY – 1: BUSINESS EXCELLENCE:

As a guest lecturer at a symposium for Business Excellence where you are giving a lecture
on “Sustaining Business Excellence”. A manufacturer of a fashion clothing line is one of the
participants at the symposium. He has the following query:
“We are an apparel company that manufacture and sell our fashion clothing and accessories
directly through 30 stores spread across India. Shortly we are planning to establish similar
outlets overseas. Our business is under constant change due to changing customer trends.
At the same time, we are the largest company in our industry segment in India, both in terms
of market share and profits. We have a satisfied base of customers who are loyal to our
brand. Shareholders are also satisfied stakeholders due to good returns provided on their
investments. What woul d be the relevance of Business Excellence model to our company?
Thank you!”
You are required to frame an appropriate response to this query.
Required
(i) EXPLAIN the importance of business excellence to an organization.
(ii) LIST the tool available to achieve and sustain excellence.
(iii)APPLY the fundamentals of EFQM model on the apparel company.
(iv)EXPLAIN the relationship between various criteria of the model in general terms.
SOLUTION:
(i) Importance of Business Excellence to an organization:
Business Excellence is a philosophy for developing and strengthening the management
systems and processes of an organization to improve performance and create value for
stakeholders. Stakeholders in an organization are not limited to shareholders (business)
alone. They include also customers, employees (people) and society. What an organization
does impact all the stakeholders in different ways, yet they are all interlinked to each other.
Customers’ needs are of paramount importance to companies. Yet given uncertain
conditions, shareholders demand challenging return on their investments. Employees need
more from their company than just their pay-check. They want the company to enable to grow
their knowledge and experience that can improve their career growth. Society expects
companies to operate ethically and for the overall betterment of the society and environment.
For several years businesses have been operating under challenging circumstances. For
example, landline phones have been entirely replaced by mobile phones. Television
programs can be watched seamlessly on internet enabled mobile phones. Not just this,
today’s smartphones have computing capability much more than the computers that were
used in Apollo Mission to send the first man to moon! The proliferation of mobile phones has
changed not just the telecom industry but also others like communication, banking, e -
commerce etc. The pace of change is both exhilarating and challenging.
To manage this complex scenario, a company cannot focus on only one aspect of their
operations. Optimize processes, delivery quality to customers, manage employee talents,
earn required return on investment while managing to be a socially responsible organization.

In short, the company should achieve excellence in all aspects of its operations. This is
business excellence. Business excellence principles emerged because of development of
quality drive into traditional business management. It is imperative not just to achieve
excellence but also to sustain it.
Business excellence models are holistic tools that help companies develop stakeholder
focused strategy. Each operation within a company enables a corresponding result. Business
models present a formal, standardized cause effect relationship between different operations
(enablers) and their resultant consequences. If the company want to achieve a different
result, it has to do things differently. This can be better analysed through these models.
Continuous improvement on various operations will ultimately lead to excellence. More
importantly, these models need to be used to sustain and maintain excellence to retain their
competitive advantage. They are not to be taken as one time exercise by the company.
Assessments using this model have to be made periodically so that timely a ction can be
taken to achieve the desired result.
(ii) Tools available to achieve and sustain excellence

Some of the popular business excellence models are (i) the European Foundation Quality
Management (EFQM) model (ii) Baldrige Criteria for Performance Excellence (iii) Singapore
BE Framework (iv) Japan Quality Award Model and (iv) Australian Business Excellence
Framework.
(iii) EFQM model on the apparel company

The apparel company is a well-established player in the industry. It is a growing company
that is looking to expand its operations overseas. To achieve business excellence in this
environment, the company could adopt the EFQM model, which is a popular model.
The EFQM model was developed by the European Foundation for Quality Management. The
model provides an all-round view of the organization and it can be used to determine how
different methods fit together and complement each other. It can help the company
understand the cause and effect relationships between what their organization does and the
results it achieves. Creating an EFQM Management Document gives the organization a
holistic overview of its strategic goals, the key approaches it has adopted and the key results
it has achieved.
The fundamental concepts for excellence are the basic principles that describe the essential
foundation for any organization to achieve sustainable excellence. With respect to the
company they can be detailed as below:
(a) Adding value to customers: Companies need to understand their customers, their needs,
anticipate their needs and make use of opportunities to fulfil their expectations.
In the current case, fashion apparel business is ever changing and dynamic due to the
changing trends in customer’s tastes. This could differ across locations within India and
abroad. In the era of e-commerce, competition would be cut-throat. Before going to “how”
it can meet customer’s needs, the company should be clear on “what” need of the
customer it can satisfy. For example, should the company cater to Indian apparel market,
western apparel market, men or women or children apparel market etc. Once the “what”

is clear, the company should have mechanisms in place to find out and anticipate
customer tastes. Accordingly, it should structure its operations to add value to the
customers in terms of quality, availability, support, and experience.
(b) Creating a sustainable future: Society and environment (People and Planet of Triple
Bottom-line concept) play a major role in ensuring the sustainability of business. A
company should have as much positive impact on its surroundings and try to minimize
any negative impact on the same. Here, the company should assess the environmental
impact of its operations, measures to minimize adverse impacts, business impact on the
society etc. For example, leather is contended to be harmful to the environme nt since it
requires the skin of animals specially cattle hide, needs huge amount of energy and
chemicals to process it. This has a negative environmental impact. As regards societal
impact, suppliers of cloth to the apparel company should not indulge in l abor malpractice
like child labor and should adhere to safety standards within its factories. The company
should procure cloth only from suppliers who adhere to such standards.
(c) Developing Organizational Capability: Companies need to manage change w ithin the
organization and beyond. The company should identify “what it is capable of being great
at?” in order to differentiate it from its competitors. For example, the apparel company
may have the capability of tracking its inventory at the stores on re al time basis. As soon
as the inventory falls below a certain level, the stores issues fresh products to stock up.
This ensures that there are no stock outs at the retail outlet. This ability to track inventory
real time and ability to stock up quickly may be unique to the company that gives it a
competitive edge. Another can be the ability to quickly change the apparel production to
meet changing trends. Likewise, the company should identify and develop unique
capabilities to have a competitive edge in the market.
(d) Harnessing creativity and innovation: Continuous improvement and innovation brings
value to the company. The company should promote a working environment that enables
and appreciates creativity and innovation. For example, new apparel desi gns can be
promoted to test the market. If found feasible, the company can go for mass production
of the same.
(e) Leading with vision, inspiration, and integrity: The tone at the top defines the rest of the
company. The leaders and management of the company should have a clear vision of
what the company wants to achieve, develop strategy to achieve it, work with integrity and
ethics. Leaders shape the future of the organization.
(f) Managing with agility: Agility would be the capability to identify and effectively respond to
opportunities and threats. For example, although the apparel company is in an
expansionary phase, it should consider the threat, yet opportunity of using e - commerce
as a platform to reach out to customers directly. Physical stores are becoming largely
redundant due to online platforms, a threat the company should recognize and act upon.
(g) Succeeding through the talent of people: An organization is only as good as the people
who work in it. There should be an atmosphere of teamwork that enable achievement of
organizational and personal goals. Performance evaluation, reward and recognition
programs, training and talent network are ways to cultivate talent within the organization.
(h) Sustaining outstanding results: Use of EFQM model is not a onetime exercise. Constant
and periodic evaluation is required to keep up and sustain excellence.

(iv) Relationship between various criteria of the model

The criteria of the model are comprised of 5 enablers and 4 results. Enablers covers what an
organization does (its objective) and how it does it (strategy, use of resources to achieve it).
(a) Leadership: A leader defines the organization’s culture. They enable the organization to
achieve its goals by taking the correct decisions at the correct time. To do this the y should
have sufficient skill, work as per the company’s code of conduct and should be ethical in
their dealings.
(b) Strategy: Operations should be planned and directed as per a clearly defined strategy.
The company’s vision and mission statement with respect to its various stakeholders are
the goals that the organization wishes to achieve. Strategy (plan) enables the company
to achieve these goals.
(c) People: Excellence is possible only if the people working in the company wish to achieve
it. They must be motivated, recognized, and managed to enable them to work towards the
company’s vision and mission. The work culture should be that this opens up opportunities
for personal development as well. This would cultivate a bond with the organization, which
enables people working within to strive for excellence.
(d) Partnerships and resources: Effective management of partnerships that the company has
with other organizations is critical to success. Partners could be external vendors,
suppliers, and service providers. The services of partners enable business to operate
smoothly. Resources, both tangible and intangible should be managed optimally. Tangible
resources can be financial (cash, bank accounts) and physical assets (machinery,
building, land etc.). Intangible resources would be intellectual property rights, information
technology, licenses etc. Proper management of resources enables optimal results.
(e) Processes, Products, and Services: They should be managed and continuously improved
to create value for stakeholders.
Results are what the organization achieves following its operations and decisions. As
explained before, the stakeholders of the company are investors (business), people
(employees), customers and society. In order to track performance, the company has to
develop Key Performance Indicators (KPI)s for each of the stakeholder groups. Results
should be tracked periodically. Changes to targets and benchmarks should be continuously
made to reflect the current objectives that the company wants to achieve. Some of the results
that the company can look at are:
(a) Customer results: Are the customers of the company satisfied with the products and
service? How does the company fare in terms of brand loyalty? Is the customer base
growing to indicate increasing market share?
(b) People results: Does the company have skilled and motivated employees? What is the
employee turnover with reasons for the same? Does the company have proper access to
hire required talent? Are the employees motivated, trained, recognized, and rewarded for
their performance? What is performance measurement system, is it robust and accurate
to measure performance?
(c) Society results: Is the company a good corporate citizen. Are the objectives of corporate
social responsibility being met? If the organization is a not for profit organization, is it
meeting its objectives and goals?

(d) Business results: Is a for profit organization achieving the required return on investment,
profitability that the shareholders and other investor demand? Has the company been
able to manage financial and other risks properly?
Enablers enable achievement of results. EFQM model documents this flo w and symbiosis in
a structured way. It highlights the strength and weakness of the enablers. With this
information, the company can alter its operations and strategy to achieve desired results. On
assessment, there is a flow from results to enablers. If the results have been achieved,
enablers continue to operate status quo. If the results fall short of targets, changes have to
be made to enablers to improve performance.
Therefore, it can be concluded the EFQM model encourages constant self-assessment to
achieve excellence.
When a company wins an excellence award based on a business excellence model, it gains
in stature within the industry. This recognition could work to its advantage financially and
otherwise.
D. THEORY OF CONSTRAINTS (TOC)

The theory of constraints focuses on revenue and cost management when faced with
bottlenecks. Bottleneck resource means the one due to which overall production is getting
restricted. TOC suggests that bottleneck resource should be fully utilised while non-
bottleneck resource should not be utilized to 100% of their capacity since it would result in
inventory build up before bottleneck resource. TOC involves 3 measures:
(1) Throughput: (like Contribution) = Sales – Unit level variable expenses (Generally DL is
considered as fixed and hence not included in variable expenses).
(2) Investment: = assets required to convert materials into throughput.
(3) Operating Expenses: (like Fixed Costs) Includes direct labour and all operating and
maintenance expenses
Objectives of management are increasing throughput, minimizing investment and decreasing
operating expenses.
Note: For practical questions – how to identify bottleneck:
 Calculate maximum production of each department/resource.
 Bottleneck Production = whichever is lowest
 This bottleneck production indicates maximum overall production.
 If overall production needs to be increased, then bottleneck capacity must be increased.
E. THROUGHPUT ACCOUNTING (TA)

It believes that accounting should monitor the rate at which businesses make money. Thus,
it focuses on the return per product per bottleneck hour. It treats only direct material as
variable and all labour and overhead costs as fixed.

Throughput per Bottleneck Minute

Throughput Accounting TA Ratio
Factory Cost per Bottleneck Minute
If the TA ratio is greater than 1 the product in question is “profitable” because, if all capacity
were devoted to that product, the throughput generated would exceed the total factory cost.
Q.04. IDENTIFYING BOTTLENECK (FOR ONLY 1 PRODUCT)

X Ltd. produces only 1 product A. It is produced after passing through 3 departments:
Particulars D1 D2 D3
Normal Capacity Hours 10,000 20,000 15,000
Required Hours p.u. of A 2.5 1 0.5
Identify Bottleneck Dept and the maximum possible units of A.
SOLUTION:
Particulars D1 D2 D3
Required Hours p.u. of A 2.5 4 3
∴ Max Production in each Dept. 4,000 3,000 5,000
∴ Overall Max Production of A: 3,000 Units
[i.e. Bottleneck Production] [… w. e. is ↓]
Q.05. IDENTIFYING BOTTLENECK (FOR MULTIPLE PRODUCTS) & APPLYING TOC

A company produces 3 products A, B and C. Following information is available for a period.
Production
A B C
Contribution(Sales – Direct Materials) Rs 24 Rs 20 Rs 12
Machine hours required per unit:
Machine 1 12 4 2
Machine 2 18 6 3
Machine 3 6 2 1
Estimated sales demand 200 200 200
It is given that machine capacity is limited to 3,200 hours, 4,900 hours & 2,000 hours for each
machine, you are required to analyze the above information and apply TOC process to
remove the constraint.
SOLUTION:
Total Hours required for fulfilling complete demand:
M1: (12 Hr × 200 Units of A) + (4 Hr × 200 Units of B) + (2 Hr × 200 Units of C) = 3,600 Hrs

Particulars M1 M2 M3
Total Hours Required: 3,600 5,400 1,800
∴ Shortage 400 500 -
∴ Capacity Utilization % 112.5% 110.2% 90%
Bottleneck is the resource that has the Maximum Capacity Utilization % above 100%.
∴ Bottleneck is M1
Applying TOC to remove the Constraint: [i.e. ranking and allotment taking M1 as Key Factor]
Particulars A B C
Max Demand 200 200 200
Contribution [Throughput] 24 20 12
(÷) Hours p.u. of M1 12 4 2
∴ Contribution per Hour 2 5 6
∴ Ranking 3 2 1
Allotment:
- Of 3,200 M1 Hours 2,000 800 400
- Of Units 166 200 200
Q.06. THROUGHPUT ACCOUNTING RATIO

ZED produces two types of products Z and D at its manufacturing plant. Both the products
are produced using the same materials, machinery and skilled labour. Machine hours
available for the year is 4,000 hours.
Particulars Z D
Selling Price per unit ₹16,000 ₹4,000
Material Costs per unit ₹7,000 ₹1,200
Machine Hours per unit 1.6 hrs. 0.8 hrs.
Maximum Annual Demand 2,000 units 1,600 units
Online Booking (already accepted for) 400 units 1,200 units
Due to poor productivity levels, late order and declining profits over recent years, the CEO
has suggested the introduction of throughput accounting in the company.
The total of all factory costs is ₹1,42,60,000, excluding material.
Required [Nov 20 RTP Q4]

(i) Using throughput accounting, PREPARE statement to determine the optimum production
mix and maximum profit for the next year.
(ii) CALCULATE the amount of profit lost due to acceptance of online booking of the
products.
(iii) RECOMMEND the options to be followed in order to avoid any loss of profit.
(iv) LIST various ways through which price customization could be done.
(v) Given that products Z and D are respectively in ‘maturity stage’ and ‘introduction stage’
of their life cycle. STATE the most appropriate pricing policy that could be followed by
the ZED for Z and D as per their life cycle.
SOLUTION: (i) Identifying the Bottleneck i.e. Key Factor:
→ Total Hours Required for entire annual demand: = 4,480 Hrs
= (1.6 Hrs × 2000 Units of Z) + (0.8 Hrs × 1,600 Units of D)
→ Total Hours Available during the year: = 4,000 Hrs
∴ Machine Hours availability is the Bottleneck (Key Factor)
Optimum production mix and maximum profit:
Particulars Z D
Max. Demand Units 2,000 1,600
Min. Commitment (Orders already accepted) 400 1,200
Selling Price p.u. ₹ 16,000 4,000
(-) Material Costs p.u. ₹ 7,000 1,200
∴ Throughput p.u. (Contri. p.u.) 9,000 2,800
(÷) Machine Hrs p.u. 1.6 0.8
∴ Throughput/Hr (Contri./Hr) 5,625 3,500
(÷) Factory Cost/Hr [₹1,42,60,000 ÷ 4,000 Hrs] 3,565 3,565
∴ T.A. Ratio 1.58 0.98
∴ Ranking: 1 2
→ Allotment:
 Of Min. Commitment M.Hrs [400×1.6 & 1,200×0.8] 640 960
 Of Bal. M.Hrs [4,000 – 640 – 960] 2,400 -
∴ Total M.Hrs Allotment 3,040 960
∴ Total Units Allotment (Optimum Production Mix) 1,900 1,200
Total Throughput (Contri) [@ ₹(9000,2800)p.u.] 171,00,000 33,60,000
204,60,000
(-) FC (142,60,000)
∴ Profit 62,00,000

(ii) If there was no online booking done (i.e. no Minimum Commitment):

Particulars Z D
Max. Demand Units 2,000 1,600
∴ Allotment of 4,000 M.Hrs 3,200 800
∴ Total Units Allotment (Optimum Production Mix) 2,000 1,000
Total Throughput (Contri) [@ ₹(9000,2800)p.u.] 180,00,000 28,00,000
208,00,000
(-) FC (142,60,000)
∴ Profit 65,40,000
∴ Profit Lost due to online booking of products = ₹65,40,000 - ₹62,00,000 = ₹3,40,000
(iii) Recommendation
Option-1: Throughput accounting ratio is the throughput return earned in an hour divided by
the factory cost (labour and overheads) incurred by the factory in one hour. Factory cost is
generally fixed in nature. A ratio above 1 signifies that the throughput return is greater than
the factory cost and therefore the product is profitable. Product Z has a throughput accounting
ratio of 1.58 while Product D has a throughput accounting ratio of 0.98, this indicates that
hourly return from Product A can cover the hourly factory cost,, it is profitable. Product D does
not yield enough hourly return to cover the hourly factory cost, it is not profitable. Therefore,
ZED should consider ways of improving throughput accounting ratio of Product D (i.e. above
1.0). TA ratio could be improved by:
 Increasing the selling price of the Product D but the demand may fall.
 Reducing the material cost per unit as well as operating costs. However, there may be
quality issues.
 Improving efficiency e.g. increase number of units that are made in each bottleneck hour.
 Raising up bottleneck so that more hours are available of bottleneck resource.
Option-2: ZED has to prioritize production of Product Z since it is more profitable than Product
D. As per the throughput accounting ratio, Product D does not yield sufficient return per hour
to cover the hourly overhead cost therefore, gets second priority over Product Z.
Since machine hours are the bottle neck, if production for entire 4,000 hours is focused on
Product Z, return yielded would be sufficient to cover the factory overheads. However,
Product Z has a maximum demand of 2,000 units, that requires 3,200 machine hours (2,000
units × 1.6 hours per unit of production). Remaining 800 machine hours can be devoted to
Product D, during which 1,000 units can be produced (800 machine hours / 0.8 hours per
unit). Maximum demand for Product D is 1,600 units. Therefore, the balance demand of 600
units of Product D will remain unsatisfied.
However, to meet unsatisfied demand of Product D, ZED may consider the option of sub-
contracting either a part of whole of the production of Product D . This way it can meet the
entire demand for Product D for 1,600 units. If it subcontracts the entire production of Product
D, it can also scale down its in-house capacity. Sub-contracting decision requires suitable
cost benefit analysis. Moreover, the risk associated with outsourcing like unsatisfactory
quality and service or failure of supplier cannot be ignored.

(iv)
Pricing of a product is sometimes customized keeping taste, preference, and perceived value
of a customer into consideration. Price customization is done in the following ways:
 Based on product line: When products are customized as per the customer’s
requirements, pricing can be adapted based on the customer’s specifications. Standard
products can have a base price, to which the company can top-up charges to any
additional customization.
 Based on customer’s past behavior: Customers with good payment record have
established their credit-worthiness. To sustain business, they may be extended additional
discounts as compared to other customers.
 Based on demographics: Different pricing strategies may be adopted based on age or
social status. For example, railway fare discounts for senior citizens or concessional price
tickets for military personnel.
 Based on time differential: Different price for different time periods. If a customer extends
a long-term contract, an additional discount may be extended since business is contracted
for a longer period of time. Example, discounted price for data usage provided by a
broadband service provider if subscription paid for six months or more.
Apart from the above accounting principles, other macro economic and legal factors should
also be given importance while chalking out a pricing strategy.
(v)
Product Z is given to be in the maturity stage, 3rd stage of product life cycle. It is characterized
by an established market for the product. After rapid growth in sale volume in the previous
stages, growth of sales for the product will saturate. Competition would be high due to large
number of rivals in the market, this may lead to decreasing market share. Unit selling price
may remain constant since the market is well established. Occasional offers may be used to
tempt customers, otherwise this stage will mark consolidation of the market.
Product D is in the introduction stage, the first stage of product life cycle. Penetration pricing
is adopted to charge a low price in the initial stage for penetrating the market as quickly as
possible. For a new product this low price strategy will popularize the product. Once the
market is established, the price may be increased. Penetration pricing will be suitable when:
(i) Demand for the product is elastic, more demand when prices are low.
(ii) Large scale production of the product yields economies of scale.
(iii) Threat of competition requires prices to be set low as it serves as an entry barrier.
However, if Product D is a highly innovative product, it may adopt Skimming price policy. It
will differentiate from other products leading to a revolutionary impact on market and
customer behavior. Customers may not mind paying a premium for the unique product. Focus
is on promoting the product to gain market share. Skimming price policy may work when:
(i) There seem to be no competitors providing similar products.
(ii) Demand is inelastic.
Over time, competitors can reverse engineer and offer similar products. Therefore, the price
may be lowered in the long run to retain market share.

F. SUPPLY CHAIN MANAGEMENT (SCM)

It involves all activities starting from getting materials from vendors, producing finished goods
out these materials, storage in warehouse and distribution centers that deliver to retailers and
finally selling the product to ultimate customers. Purpose is to give the customers what they
want, when and where they want, at the price they want. For that, we need to analyze the
value chain (refer Porter’s Value Chain Analysis from chapter 1)
TYPES:
Push Model
Under Push model stocks are produced on the basis of anticipated demand. Then these
goods are pushed to the customers.
Pull Model
Under Pull model stocks are produced in response to the actual demand, i.e. demand pulls
the production. This approach focuses on selling what the customer really wants, rather than
selling what we have.
UPSTREAM SCM: (Transaction with suppliers)

Factors to consider while choosing a supplier:
 Bargaining power of buying organization depends on that whether the suppliers' businesses
larger or smaller.
 To avail bulk discount, purchase from single supplier is advisable. However, to avoid the
risk of failed deliveries, multiple suppliers are advisable.
 Cost, Quality, and Speed of Delivery
 Make or Buy and Outsourcing
Use of Information Technology:
 E-Sourcing: electronic invitation to tenders and request to submit quotations.
 E-Purchasing: Purchase orders dispatched automatically through an extranet to suppliers
 E-Payments: for faster payment with zero error.
DOWNSTREAM SCM: (Transaction with customers)
Relationship Marketing:
 To keep existing customers and to attract new customers.
 6 Types of markets: Internal Markets, Referral Markets, Influence Markets, Recruitment’s
Markets, Supplier’s Markets, Customer’s Markets.
Customer Account Profitability (CAP)
Calculate and analyze customer-wise profitability. It is a five-step process:
1. Analyse the customer base and split it into the segments (Platinum, Gold, Iron, Lead, etc.)

2. Calculate the annual revenues earned from the customer

3. Calculate the annual costs of serving the segment
4. Identify and retain quality customers
5. Re-engineer / eliminate the unprofitable segments
Customers Lifetime Value (CLV)
It is the net present value of the projected future cash flows from a lifetime of customer
relationship. Profits are identified from each customer by ABC model. It depends on
judgements made regarding duration of relationships, frequency of repeat orders, customer
loyalty, etc.
Q.07. CLV
Cineworld is a movie theater is located in a town with many colleges and universities around
it. The town has a substantial student population, most of whom are avid movie goers.
Business for Cineworld has been slow in the recent years due to the advent of streaming
websites, that show the latest and popular movies online. However, the management of
Cineworld continue to feel students would still enjoy the watching movies on big-screen, along
with the facilities and ambience that only a movie theater can offer. Accordingly, they have
framed a plan to attract students by offering discounts on movie tickets.
The average time a student spends at the college or university is 4 years, which i s the
average duration of any course. For a nominal one-time subscription fee, Cineworld plans to
offer students discounts on movie tickets for a period of 4 years. By attracting more footfalls,
Cineworld targets to cross sell it food & beverages and souvenirs. This would help it sustain
a reasonable revenue each year.
Cineworld would attract attention to the plan by initially offering free tickets, food and
beverage and gift vouchers. This one time initial expense, net of the one -time subscription
fee collected, would cost ₹5,000 per student. On subscription to the plan, the viewership and
purchases of each student is expected to be as follows:
Particulars Years 1 and 2 Years 3 and 4
Spend on movie tickets per year 2,000 1,500
Spend on food and beverage per year 4,000 3,000
Spend on souvenirs and accessories per year 2,250 750
Assumptions
(1) Only 50% of the subscribers are expected to visit the theatres in years 3 and 4.
(2) Across all years, only 75% of the subscribers who visit the theatre are expected to buy
food and beverage.
(3) Only 25% of the subscribers who visit are expected to buy souvenirs in years 1 and 2,
and 10% of them in years 3 and 4.
[PVIFA of ₹1 for 4 years at 10% = 3.169 and PVIFA of ₹1 for 2 years at 10% = 1.735.]
Required: CALCULATE the customer lifetime value per subscriber for the above plan.

SOLUTION:
CASE STUDY – 2: SCM:

Sun Electronics manufactures and sells various electronic goods like mobile phones, laptops,
televisions, refrigerator etc. The company sells these goods through the 30 stores situated in
different parts of the country. The store managers place a request to the centralised team
situated in Mumbai on a monthly basis. One store can send only one requisition per month.
The requirements of the stores are forwarded to the production planning team which is
responsible for scheduling the manufacturing of these products. Once the goods are
manufactured, the goods are sent to a central warehouse in Mumbai and are dispatched to
different stores according to the store requirements. The time taken from placing a request
from store to the delivery of product to the store takes about 30-40 days on an average. In
the process the company procures parts from more than 100 vendors. The company has
faced quality related issues with many vendors leading to delay in production.
The average holding period of inventory in Sun Electronics is very high at 45 days as against
an industry average of 15 days. Since the order to delivery time at a store is very high, the
company has traditionally allowed high inventory holding to reduce the stock outs at store
level. The company is under severe pressure to improve its working capital cycle.
A high amount of inventory held at each store also means that the products become obsolete
quickly. In case of products like mobile phones, new and upgraded versions are available in
the market as early as six months from the date of initial launch of a particular model. A
significant portion of inventory of mobile phones becomes obsolete every year. The company
generally resorts to a discounted sale to liquidate such obsolete models.
The management at Sun Electronics has identified e-commerce as an opportunity for faster
growth, both in terms of revenues and profitability. The company is considering launch of its
own e-commerce website to sell all products which are currently being sold in physical stores.
Depending upon the success of online sales, the company might choose to optimize and
close certain physical stores in the next couple of years.

The management of the company is cognizant of the fact that existing inventory procurement
and management system will not fit in the new e-commerce business. E-commerce works on
a inventory light model and quick as well as on time delivery of products of the customers.
The fact that customers could be from a location other than those where Sun Electronics has
physical presence makes the matter complex.
Required
The company is considering implementation of a supply chain management system. Will a
supply chain management system be of use to Sun Electronics in light of the e-commerce
venture? You are required to EXPLAIN the concept of Supply Chain Management and
EVALUATE the applicability of in the current case.
SOLUTION:
Issue
Sun electronics manufactures and sells various electronic products through its physical
stores. The existing manufacturing system does not take into consider the demand of
products in the market. Store managers are allowed to submit only one order per month. A
high level of inventory can be seen at Sun Electronics as compared to the industry average.
The store managers tend to keep high level of inventories as a safeguard against stock-outs.
Whereas, keeping inventory to meet customer requirement is good, high level of inventories
due to inefficient processes is not advisable.
The company also has a longer working cycle because of a long order to deliver time and
excess holding of inventory. A significant amount of working capital is blocked due to this
practice. Technology changes rapidly and the company is expected to roll out latest products
in the market. A product like mobile gets outdated very soon and the company has to resort
to discounted sales. This results in financial losses to the company.
The company has identified an opportunity in e-commerce. E-commerce businesses require
leaner models and faster response time. The production must be based on the demand from
the customer and not on an ad-hoc basis. In the following paragraphs, the importance of
supply chain management (SCM) and its applicability in the current case is discussed.
Supply Chain Management (SCM)

Supply Chain Management can be defined as the management of flow of products, services
and information, which begins from the origin of products and ends at the product’s
consumption at consumer’s end. SCM also involves movement and storage of raw material,
work-in-progress and finished goods. In other words, supply chain management involves
management of all activities associated with moving goods from the raw materials stage to
the end user. An important objective of SCM is to correlate the production and distribution of
goods and services with demand of the product.
The following are the various activities which an organisation carries out to meet the customer
requirements (Primary activities under value chain model) -
 Inbound Logistics covering procurement and related activities.
 Operations covering conversion of raw materials into finished products

 Outbound Logistics covering movement of products from plants to end users

 Marketing and Sales
 Service
Supply Chain Management looks each of the above activities as integrated and interrelated
to each other. None of the activities can be looked in silos. In the case of Sun Electronics,
there is a restriction on number of orders which a store manager can place. This would lead
to excess ordering because of the fear of stock-outs.
The customer demand is completely ignored and hence the production is not in sync with the
market demand. This could lead to excess production, higher inventory holding and longer
working capital cycles.
The facts presented in the case indicate the following problems at Sun Electronics:
 Production planning is not based on customer demand & is done on an ad-hoc basis.
 Inventory Holding period is very high (45 days against an industry average of 15 days).
 The working capital cycle is longer.
 The time take to fulfil an order from the store is very high.
 The production is dispatched to a central warehouse for further deliveries to the stores.
This could be an inefficient process.
 Liquidation of products at discount for products with low shelf life.
SCM Process and applicability to Sun Electronics
The SCM process is explained below:
 Plan - The first step in SCM process is to develop a plan to address the requirements of
the customer. Sun Electronics must shift its focus from ad hoc and predetermined
production planning to understanding the requirements of customers. Production must be
planned based on the demand of products. The focus must be on producing what the
customer wants.
 Develop (procure) - In this step, the materials required for production is sourced from
various suppliers. A good relationship with supplier is required to ensure that the
parts/materials are received as and when required by the production team. It is also
important that the vendors supply quality material which is not the case in Sun Electronics.
The company must select suppliers which are dependable and can deliver quality
products in the stipulated time. The company must focus in reducing the lead time
required for sourcing materials which will reduce the inventory holding period.
 Make - The third step is making or manufacturing the products required by the customer.
This is quite different from the existing practice in Sun Electronics where store mangers
are allowed to place only one order. This would mean that the company is not considering
the ever changing demands and tastes of the customers.
 Deliver - The fourth stage is to deliver the products manufactured for the customers. This
stage is concerned with logistics. The time required to deliver to the store in case of Sun
Electronics is very high. The company must evaluate if the centralised warehouse is
causing delay in delivery of products to the stores.

Logistics is one of the important component of the entire supply chain process. Right from
procurement of material, movement of raw material in the plants and final delivery of
products of customers, logistics play a critical role. An excellent system must be in place
to ensure that the movement of materials and final product are uninterrupted.
Warehousing also plays an important role in today’s business environment. The company
has a centralised warehouse to meet the needs of all its stores. This would not be the
most efficient way. The company must evaluate creation of additional storage facility
which would ensure timely delivery of goods to the stores. Newer products can reach the
market faster.
Benefits of SCM to Sun Electronics
SCM looks at the entire value chain process as an integrated process. There is a seamless
flow of information and products between suppliers and customers. The customer’s
requirements would be captured to plan the production. The suppliers would be intimated to
supply the materials according the the production plan. An effective logistics system ensures
that movement of materials is seamless. Sun Electronics can also consider implementing an
integrated ERP which would also interact with vendors on real time basis.
The following benefits of SCM can be envisaged for Sun Electronics -
 Better Customer Service as customer is supplied with what he wants in the minimum time.
 Better delivery mechanism for goods.
 Improves productivity across various functions and departments.
 Minimises cost (both direct and indirect).
 Reduces the inventory holding time and improves the working capital cycle.
 Enhances inventory management and assists in implementation of JIT systems.
 Assists companies in minimising wastes and reduce costs.
 Improves supplier relationship.
E-Commerce and SCM

The SCM is the backbone of E-commerce industry. Customers buying products online want
deliveries to be faster. Another distinct feature of e-commerce is that buyers could be located
in any corner of the country and not just restricted to the cities where Sun Limited has physical
presence. This definitely means that the company must have an effective Supply Chain
Management in place which could meet the customer’s requirement.
The existing practice of one order per month from each store would not work in the e-
commerce space. Orders can come at anytime and from anywhere. Supply Chain
Management would be required for success of e-commerce business.
Customer Orders
The company must have an effective mechanism to capture customer orders and feed it into
the production planning on a real time basis. An integrated ERP system would be required
for this purpose. Any delay in intimating the production team would mean delay in production
and delivery which would not be taken positively by the customers. The existing system of
one order per month from a store would not fit the purpose. A real time flow of information
would mean lower inventory holding.

Procurement
The material requirements must be communicated to suppliers seamlessly. The company
must identify those vendors who can delivery quality materials in the required time frame. A
delay in supplies would delay the production process. A company cannot afford this in e-
commerce business. Automatic exchange of information using EDI (Electronic Data
Interchange) or Integrated ERP systems would ensure that the vendors receive material
requirements in a timely manner.
Production
As discussed earlier, the production must be in accordance with the customer order. This
requires a shift in approach of the production team. Business environments have shifted from
“Customer will buy what we produce” to “We have to produce what the customers require”.
The company would ideally not produce products to store them and sell later.
Logistics
Logistics would be the backbone of entire e-commerce set up. Right from sourcing of
materials to delivery of products at the customer’s door step, logistics would play an important
role. If the company has an in-house logistics facility, the logistics team must be trained with
the requirement of the new business. If the company has outsourced the logistics, vendors
must be briefed about the requirements of the e-commerce. The company might have to tie
up with new logistic vendors to avoid any delay in deliveries.
G. GAIN SHARING ARRANGEMENTS

A supplier agrees to perform his side of the contract with no guarantee of receiving a
payment. Instead, any payment received is based upon the benefits that emerge to the
customer because of the supplier’s work. This is risky for the supplier, because he could
spend a fortune and walk away with nothing. Alternatively, if the benefits to the customer are
substantial, the supplier could find itself rewarded with a large return.
Gain can be in the form of cost savings from reducing the cost of supplies, implementing new
skill and technologies, revised delivery time, improvements in operations etc. The gain is not
necessarily financial, although financial benefits are expected to occur frequently. With
emphasis on greater openness, gain-sharing deals are a win-win situation for suppliers and
their customers.
H. OUTSOURCING
It means to reduce costs or improve efficiency by shifting tasks, operations, jobs or processes
to another party for a span of time.
It can be done at the premises or outside. It can be for products or even for services, even
for part of a product.

CASE STUDY – 3: GAIN SHARING:

Raya Health Care Limited is a leading healthcare service provider in Mumbai, it has
approximately 450 potential beds, it provides diagnostic and day care speciality facilities also.
In diagnostic centres they are using traditional devices for CT Scan and MRI which are not
enough as per demand. Patients waited more than weeks for CT and MRI scans, this problem
can cause delay in diagnosing illness; waste of time and other resources; not just in radiology
but throughout the healthcare system.
Raya has planned to outsource CT scan and MRI services to Livlife, which has world-class
international chain of diagnostic centre. Livlife promise to provide radiologist report within 24
hours. However, finance manager of Raya doubt that it will not be a profitable arrangement.
For the satisfaction of Raya, Livlife has entered an agreement to provide its services to Raya
with no guarantee of receiving payment. Raya agrees to the following conditions:
 Cost savings generated in first year, the same will be retained by Livlife.
 Cost savings generated in second and third year will be shared between Raya and Livlife
at a ratio of 30%:70%.
 Cost savings generated in the fourth year will be passed to Raya.
 Any cost savings generated by an idea proposed exclusively by Raya that does not
require capital investment by Livlife will be immediately passed along to Raya.
DISCUSS the agreement between Raya and Livlife.
SOLUTION:
The agreement between Raya and Livlife is Gain Sharing Arrangement. Gain sharing (also
known as cost saving sharing) arrangement is an approach to the review and adjustment of
an existing contract, or series of contracts, where the adjustment provides benefits to both
parties. A fundamental form of gain-sharing is where a supplier agrees to perform its side of
the contract with no guarantee of receiving a payment. Instead, any payment received is
based upon the benefits that emerge to the customer as a result of the successful completion
of the supplier’s side of the bargain.
Livlife and Raya has also entered into such arrangement. This is clearly a risky stance for the
supplier i.e. Livlife, because it could spend a fortune and walk away with nothing.
Alternatively, if the benefits to Raya are substantial, Livlife could find itself rewarded with a
large return. Cost savings might be attained from reducing the cost of supplies, implementing
new skill and technologies, revised delivery time, improvements in operations etc.
The gain, benefit, or advantage to be shared is not necessarily financial, although financial
benefits are expected to occur frequently. The Raya, for instance, will not necessarily take
cost savings in the form of a lower contract value but might require a higher specification for
medical treatment. However, to assess any financial benefit, both parties have to provide
each other with access to relevant cost numbers to determine the basis for the assessment
of the benefit and the calculation and sharing of the benefit.
Many contracts involving these arrangements have emphasis on greater openness and
shared development and improvement. In the given case gain-sharing deals are, on the face
of it, a win- win situation for both Raya and Livlife, interest of both are aligned. Livlife is trying
to save costs of Raya while Raya is trying to get world class services.


CH – 03 LEAN SYSTEM & INNOVA TION
CHAPTER
LEAN SYSTEMS & INNOVATION
03
CHAPTER SUMMARY
LEAN SYSTEM means a system of waste minimization. There are generally 7 type of wastes:
1) Overproduction: Producing ahead of demand.
2) Inventory: Having more inventory than is minimally required (WIP of FG)
3) Waiting: Waiting includes products waiting on the next production step.
4) Motion: People or equipment moving or walking more than is required.
5) Transportation: Moving products that is not actually required to perform the process.
6) Rework from defects: Non-right first time.
7) Over Processing: Unnecessary work elements (non-value added activities).
A. JUST IN TIME (JIT)

It means to produce (FG) or procure (RM) only when required, rather than accumulating them
in stock. It is a Pull System which responds to demand.
CHANGES IMPOSED BY JIT:

1. Reduces Raw Material Inventory & Improves Quality:
 Small order quantities of materials received at exact time when needed.
 Material Delivered straight to the production floor.
 Visit supplier sites to provide assistance for improving quality
 Install a system of auto-ordering.
2. Reduces WIP & Scrap:
 If machine setup is long and expensive, then company tends to produce more units in
each setup. This will increase WIP and FG inventory, increase carrying cost, obsolesce.
It will also increase defectives as defect might me identified only after batch completion.
Thus we need to shorten the machine setup time, by making a video tape of the setup
and studying this tape to eliminate some steps.


 If there is difference in the operating speeds of consecutive machines, then there will be
inventory build-up in front of the slow machine. Defect, if any, may remain undiscovered
until the next machine process it, and by that time, more defectives get produced. This
problem must be resolved under JIT. 2 methods to resolve:
- A “Kanban Card” is a notification that a downstream machine sends to the upstream
machine authorizing the production (∴ Pull System).
- Related machines are grouped into working cells, run by a single operator.
 When 1 worker was attending only 1 machine, it was monotonous and boring for him,
now he handles many machines in the cell so its more interesting for him.
 Employees must be empowered, i.e. they are allowed to stop the machine when they
see a problem.
3. Change in Accounting System (Backflushing):
 Now that there are daily shipments of materials, so there is lots of paperwork regarding
payables. There is no receiving paperwork, so there is no way to determine whether
deliveries have been made or not.
 Payables problem can be solved by making consolidated monthly payments.
 But to get an assurance of the deliveries made, companies use “Backflushing”.
 “Backflushing” is an accounting system in which 1st we determine the quantity of finished
goods produced during the period, and then multiply these quantities by the materials
listed on the bill of materials for each product. Thus, we obtain total theoretical quantity
of each material that should have been used. (Adjusted for process losses, if any)
 Supplier payments are also done based on this theoretical quantity.
 There is no need for suppliers to send invoices, since the company relies solely on its
internal production records to complete payments.
 Problems in Backflushing:
- Production quantity reported might go wrong is there is high labour turnover and low
level of labour training.
- Both Normal as well as Abnormal losses must be correctly reported so that it can be
adjusted to get real consumption.
- Tracing the lot of a specific material is impossible in JIT which might be required in
case of a recall. However certain high-end softwares do make it possible.
- Inventory accuracy may also be very low.
ESSENTIAL PREREQUISITES OF JIT:

- Low variety of goods - Vendor reliability - TQM - Defect free materials
- Good communication - Demand stability - Preventive maintenance

IMPACT OF JIT ON:

1. Waste Costs: Decrease as all wastes are eliminated.
2. Overheads: Decrease as material handling, quality inspection, space required reduces
3. Product Prices: With better quality of product and delivery, customers willing to pay higher.
NOTES FOR PRACTICAL QUESTION OF JIT:

Calculate cost with & without JIT:
Costs Without JIT: Costs with JIT:
 Carrying cost on inventory,  Increase in Purchase Cost
 Quality checking, material handling costs  Overtime Premium Paid
 Inventory Insurance  Stock Out Costs (like Contribution Lost)
 Warehouse Rent and other Exps.
Q.01. JIT FOR RAW MATERIALS

A manufacturer is considering implementing Just in time inventory system for some of its raw
material purchases. As per the current inventory policy, raw materials required for 1 month’s
production and finished goods equivalent to the level of 1 week’s pro duction are kept in
stock. This is done to ensure that the company can cater to sudden spurt in consumers’
demand. However, the carrying cost of inventory has been increasing recently. Hence, the
consideration to move to a more robust just in time purchasing system that can reduce the
inventory carrying cost. Details relevant to raw material inventory are given below:
 Average inventory of raw material held by the company throughout the year is ₹1 crore.
Procurement of raw material for the year is ₹12 crore. By moving to just in time procurement
system, the company aims at eliminating holding this stock completely in its warehouse.
Instead, suppliers of these materials are ready to provide the goods as per its production
requirements on an immediate basis. Suppliers will now be responsible for quality check of
raw material such that the raw material can be used in the assembly line as soon as it is
delivered at the company’s factory shop floor.
 Increased quality check service done by the suppliers as well as to compensate them for
the risk of holding the inventory to provide just in time service, the company is willing to pay
a higher price to procure raw material. Therefore, procurement cost will increase by 30%,
total procurement cost will be ₹15.6 crore p.a.. Consequently, quality check and material
handling cost for the company would reduce by ₹1 crore p.a.. Similarly, insurance cost on
raw material inventory of ₹20 lakh p.a. need not be incurred any longer.
 Raw material is stored in a warehouse that costs the company rent of ₹3 crore p.a.. On
changing to Just in time procurement, this warehouse space would no longer be required.
 Production is 150,000 p.a.. The company plans to maintain its finished goods inventory
equivalent to 1 week’s production. Despite this, in order to have a complete cost benefit

analysis, the management is also factoring the possibility of production stoppages due to
unavailability of raw material from the suppliers. This could happen due to of delay in
delivery or non-conformance of goods to the standard required. Labor works in one 8-hour
shift per day and will remain idle if there is no material to work on. Due to stoppage of
production for the above reason, it is possible to have stockout of 3,000 units p.a.. Stockout
represents lost sales opportunity due to unavailability of finished goods, the customer walks
away without purchasing any product from the company. Therefore, in order to reduce this
opportunity cost and to make up for the lost production hours, labor can work overtime that
would cost the company ₹10 lakh p.a.. This is the maximum capacity in terms of hours that
the labor can work. With this overtime, stockout can reduce to 2,000 units.
 Currently, sale price of phone is ₹5,000 per unit, variable production cost is ₹2,000 per unit
while variable selling, general and administration (SG&A) cost is ₹750 per unit. Raw
material procurement cost is currently ₹800 per unit, that will increase by 30% to ₹1,040
per unit under Just in time inventory system.
 On an average, the long-term return on investment for the company is 15% per annum.
Required
(i) CALCULATE the benefit or loss if the company decides to move from current system to
Just in Time procurement system.
(ii) RECOMMEND factors that the management needs to consider before implementing the
just in time procurement system.
[Nov 18 RTP]
SOLUTION: (i) Benefit or Loss of JIT:



(ii) Factors to consider before implementing JIT:
The company plans to eliminate its raw material inventory altogether. Raw material will be
delivered as per production schedule directly at the factory shop floor, from where, production
will begin. The management should therefore carefully consider the following points:
(a) The entire production process has to be detailed and integrated sequentially. This is
essential to know because it should be known in advance when in the sub - assembly
process is each raw material is required and in what quantity.
(b) Since production is dependent on delivery and quality of raw material, heavy reliance is
being placed on suppliers. They should be able to guarantee timely delivery of raw
material of the appropriate quality. The company is paying a premium of 30% of original
cost, that is ₹240 per unit (₹1,040 - ₹800 per unit) in order to ensure the same. Each unit
gives a contribution of ₹ 2,010 per unit, which is 40.2% of the sale price per unit. Lost
sales opportunities due to unavailability of raw material or non-conformance of the
material can result in substantial losses to the company. While, portion of this has been
factored while doing the cost benefit analysis of implementing Just-in-time systems, it
needs careful consideration and monitoring even after implementation. Therefore, to
hedge its loss, the management and suppliers should agree on penalties or costs the
supplier should incur should there be any delay or non-conformance in quality of materials
beyond certain thresholds.
(c) Accurate prediction of sales trends is important to determine the production schedule and
finished goods planning.
(d) Continuous monitoring of the system even after implementation is essential to ensure
smooth operations. Management commitment and leadership support is essential for its
successful implementation and working.
Q.02. JIT FOR FINISHED GOODS

KP Ltd. (KPL) manufactures and sells one product called “KEIA”. Managing Director is not
happy with its current purchasing and production system. There has been considerable
discussion at the corporate level as to use of ‘Just in Time’ system for “KEIA”. As per the
opinion of managing director of KPL Ltd. –
“Just-in-time system is a pull system, which responds to demand, in contrast to a push
system, in which stocks act as buffers between the different elements of the system such as
purchasing, production and sales. By using Just in Time system, it is possible to reduce
carrying cost as well as other overheads”.
KPL is dependent on contractual labour which has efficiency of 95%, for its production. The
labour has to be paid for minimum of 4,000 hours per month to which they produce 3,800
standard hours.

For availing services of labour above 4,000 hours in a month, KPL has to pay overtime rate
which is 45% premium to the normal hourly rate of Rs110 per hour. For avoiding this overtime
payment, KPL in its current production and purchase plan utilizes full available normal
working hours so that the higher inventory levels in the month of lower demand would be able
to meet sales of month with higher demand level. The cost of holding inventory is Rs70 per
month for each standard hour of output that is held in inventory.
KPL has forecast the demand for its products for the first six months of year as follows:
Month Jan’18 Feb’18 Mar’18 Apr’18 May’18 Jun’18
Demand (Std. Hrs.) 3,150 3,760 4,060 3,350 3,650 4,830
Following other information is given:
(a) All other production costs are either fixed or are not driven by labour hours worked.
(b) Production and sales occur evenly during each month and at present there is no stock at
the end of Dec’17.
(c) The labour are to be paid for their minimum contracted hours in each month irrespective
of any purchase and production system.
Required: COMMENT on managing director’s view. [May 18 RTP]
SOLUTION:
(1) Statement Showing ‘Inventory Holding Cost’ under Current System
Particulars Jan Feb Mar Apr May Jun
Opening Inventory* (A) --- 650 690 430 880 1,030
Add: Production* 3,800 3,800 3,800 3,800 3,800 3,800
Less: Demand* 3,150 3,760 4,060 3,350 3,650 4,830
Closing Inventory* (B) 650 690 430 880 1,030 ---
Average Inventory [(A+B) ÷ 2] 325 670 560 655 955 515
Inventory Holding Cost @ Rs 70 22,750 46,900 39,200 45,850 66,850 36,050
(*) in terms of standard labour hours
∴ Inventory Holding Cost for the six months = Rs 2,57,600
(Rs 22,750 + Rs 46,900 + Rs 39,200 + Rs 45,850 + Rs 66,850 + Rs 36,050)
(2) Calculation of Relevant Overtime Cost under JIT System
Particulars Jan Feb Mar Apr May Jun
Demand* 3,150 3,760 4,060 3,350 3,650 4,830
Production* 3,150 3,760 4,060 3,350 3,650 4,830
Normal Availablility* 3,800 3,800 3,800 3,800 3,800 3,800
Shortage (=Overtime*) (C) --- --- 260 ---- ---- 1,030
Actual Overtime Hours [C ÷ 0.95] --- --- 273.68 ---- ---- 1,084.21
Overtime Payment @ Rs 159.50 [110+45%] --- --- 43,652 ---- ---- 1,72,931

(*) in terms of standard labour hours

Total Overtime payment = Rs 2,16,583
(Rs 43,652 + Rs 1,72,931)
Therefore, saving in JIT system = Rs 2,57,600 – Rs 2,16,583
= Rs 41,017
(3) Comments:
Though KPL is saving Rs 41,017 by changing its production system to Just-in-time but it has
to consider other factors as well before taking any final call which are as follows:-
(i) KPL has to ensure that it receives materials from its suppliers on the exact date and at
the exact time when they are needed. Credentials and reliability of supplier must be
thoroughly checked.
(ii) To remove any quality issues, the engineering staff must visit supplier’s sites and examine
their processes, not only to see if they can reliably ship high-quality parts but also to
provide them with engineering assistance to bring them up to a higher standard of product.
(iii) KPL should also aim to improve quality at its process and design levels with the purpose
of achieving “Zero Defects” in the production process.
(iv) KPL should also keep in mind the efficiency of its work force. KPL must ensure that
labour’s learning curve has reached at steady rate so that they are capable of performing
a variety of operations at effective and efficient manner. The workforce must be
completely retrained and focused on a wide range of activities.
B. KAIZEN
Kaizen philosophy implies that small, incremental changes routinely applied and sustained
over a long period result in significant improvements. It aims to involve workers from multiple
functions and levels in the organization working together to improve a process.
 Gradual improvements, at an acceptable cost. Radical change or disruptive innovation is
not expected.
 Focus on eliminating waste, improving systems, and improving productivity by value chain
analysis (Ch-01)
 Continually improving the standards to achieve long-term sustainable improvements. (i.e.
like Cost Reduction, not Cost Control). However it should not reduce quality of product.
 Collective decision making, employee involvement.
CASE STUDY – 1: KAIZEN:

Zen Limited is a leading mobile manufacturing company and sells its mobile phone across
the world. In a fast-changing technological environment, Zen has been able to maintain its
leadership in smartphones segment for third year in a row now. Though the revenues have

grown year on year, the costs have increased at a higher rate in the mobile phone industry
as a whole.
“We have been leaders in revenue. We must lead in cost reduction front as well. I believe we
can achieve this with improvements overtime, however minor they might be!”
– This is what the CEO of Zen has told its directors in a recently concluded board meeting.
The net profit margins of the company has fallen from 10% in 2016 to 8% in 2017 owing to
rise in raw material & repair cost. Another significant rise in the cost was on account of repairs
of mobiles which are under warranty. There was an increase in these repair costs by 1.5
crores which represents 1% of the total turnover of the company.
The process of repairs/ replacement of under warranty product is outlined below:
 The company own 200 repair centres in various cities in India.
 A customer whose phone is under warranty and requires replacement/ repair visits any of
the 200 centres to deposit the faulty mobile phone.
 The technician at service centres examines the phone and the service centre sends the
phone to a centralised repair centre at Mumbai. The phones are sent to Mumbai even for
minor repairs which can be done locally if requisite infrastructure is provided to the service
centres.
 The phones are sent in batches. Each service centre creates 3-4 batches of mobile
phones in a day. (A recent study showed that the batches could be combined into a single
batch per day)
 The phones are repaired in Mumbai’s centralised centres and sent back to the respective
service centres for handing them back to the customer. The phones which are repaired
are sent in separate batches and those which are replaced are sent in separate batches.
Required:
You are working as a Finance Manager in Zen. The finance director has approached you to
understand whether the minor improvement would be useful given the size of the company.
The Finance Director has asked you to examine the process of warranty repairs and
replacement and submit a report covering the following aspects:
(i) What is the CEO referring to when he says “minor improvements”?
(ii) What are the benefits of such minor improvements?
(iii)Apply the above process to the warranty claim process and explain how the process can
be improved.
(iv)Any other matter which you consider relevant.
SOLUTION:
Issue
Zen limited is a leader in manufacturing of mobiles and is concerned about increasing costs.
The increase in warranty related costs has been significant in the current year as compared
to previous year. This has reduced the net profit of the company by 1% of sales.
Applicability of Kaizen Costing

“Kaizen” is a Japanese word which means “Change for Better”. In business parlance, Kaizen
is used to refer to small and continuous improvement across all functions, processes and
employees. Kaizen costing is a cost reduction system. Yashihuro Moden defines Kaizen
Costing as "the maintenance of present cost levels for products currently being manufactured
via systematic efforts to achieve the desired cost level.”
Toyota Production System is considered as a pioneer in Kaizen Costing. Though the model
was used for eliminating wastage from production at factory initially, the concept can be
applied in any of the processes in a business. Since Kaizen is a continuous improvement
process, a radical change or disruptive innovation is not expected in Kaizen costing.
The following are the key features of Kaizen -
− Kaizen processes focus on eliminating waste in the systems and processes of an
organisation, improving productivity and achieving sustained continual improvement.
− Application of small, incremental changes routinely applied and sustained over a long
period can lead to significant improvements.
− It aims to involve workers from multiple functions and levels in the organisation.
− A value chain analysis helps to quickly identify opportunities to eliminate wastage
− Although incremental changes can often be too small to be seen, Kaizen can be very
effective in the long run. An airline which identified that 75% of its flyers would leave the
olive from salad, the airline decided to remove it from its servings. This saved the airline
$ 40,000 per year. Another example is where an airline stopped printing its logo in the
rubbish bags as it did not add value saved over $ 300,000 per year.
The CEO is referring to Kaizen costing when he mentions minor improvements to save costs
over time. Kaizen costing takes into consideration various costs such as costs of supply
chain, manufacturing costs, marketing, sales, distribution costs etc.
Benefits of Kaizen Costing
− Kaizen reduces waste in areas such as employees waiting time, transportation, excess
inventory etc., which leads to improved efficiency in overall business processes and
systems.
− A company applying Kaizen philosophy can achieve cost reduction through small
incremental improvements and cost savings.
− Kaizen looks at functions and processes at all levels of organisation and requires
participation of all employees and massive as well as open communication system. This
participative approach improves teamwork across the organisation.
− Product improvement using Kaizen is likely to result in less number of defective products
leading to customer satisfaction and reduction in warranty related costs.
− The reduction in wastage, improved efficiency and cost reduction improves the overall
profitability of the company.
Implementation of Kaizen in the Current Case
The implementation of Kaizen as a cost reduction techniques can take several forms. The
key question to ask for implementation is - “Can we eliminate waste?”. The waste can take
several forms like -

− Unnecessary movement of material and men - Travelling for meeting in cases where a
video conferencing could help.
− Unwanted part in a product which if removed is not likely to impact the performance of the
product. (Nano sim card has reduced a significant portion of use fibre boards as compared
to the traditional sim cards.)
− Defects which involve extra cost in terms of reworks.
− Waiting time - A simple example could be locating for files in your computer which has not
be arranged properly. This leads to waste of time.
The above is just an indicative list where improvements can be made. However, an important
point to note is that reduction of waste should not be done by compromising the quality of
product. Apple launched iPhone 5c as a budget phone by using plastic material instead of
Aluminium. The market did not like the product as it was considered to be an inferior product
as compared to iPhone 5s.
Another way of looking at Kaizen is asking following questions -
− Can we eliminate functions from the production process without compromising the quality
and utility of end products? - Removing unnecessary movements of material and men.
− Can we eliminate some durability? - Use of unbreakable plastic for producing disposable
glasses would be waste of resources
− Can we minimise design? - e.g. use of Nano Sims.
− Can we substitute parts of the product being manufactured?
− Can we take supplier’s assistance to get better quality parts?
− Is there a better way? - This is a question which must be asked continuously to ensure
that the improvement is not a one-time exercise.
(The above questions also form a part of the Value Engineering Process)
Application of Kaizen at Zen Limited
The current warranty claim process at Zen involves movement of mobile phones from various
service centres across the country to a centralised centre in Mumbai. The possible
improvements in the claim process is explained below -
− The company needs to analyse whether it requires to own 200 centres by itself across the
country. The company can evaluate closing down centres with less customer footfalls or
outsource the ones which are not located at the strategic location. This would save some
cost to the company.
− The current process requires each service centre to send the faulty mobile phones back
to Mumbai for repair. This is done even in case of minor repairs which can be handled
locally. The company can provide necessary infrastructure to the service centres to carry
out minor repairs locally. This would save logistics cost of sending the phones to Mumbai
and back to service centre. The company should analyse the past data to understand the
proportion of phones which require minor repair. Repairing the phones locally would also
reduce the turnaround time and the customer will get back the phone faster.

− The current process is to send phones in 3-4 batches in a day. This effectively means
creating 3-4 consignments, documents for dispatches and incurring extra costs for
transportation. Combining the phones in a single batch would reduce the cost of
transportation and administrative cost as well.
− The phones can be sent back from Mumbai in single batch instead of creating multiple
batches to save transportation costs.
The above improvements must be revisited continuously to derive required benefit from
Kaizen process.
Apart from eliminating waste in the warranty claim process, the company must also identify
root causes of increase in warranty claims in the current year as compared to previous year.
Every phone being sent back for repair/replacement involves avoidable cost. The company
must also revisit the manufacturing process and quality control processes to eliminate
wastage in production process and improve quality.
− Zen can consider producing better quality mobiles at the manufacturing process to reduce
the warranty claims.
− The pattern of warranty claim must be analysed to understand whether there is certain
common problem related to repair claims. If the issue has some relation with parts used
in mobile, the issue can be taken up with supplier of such parts.
C. 5S
It explains how a work space should be organized. It is the foundation for the 8 pillars of TPM.
1. Sort: remove unnecessary & unused items. (use Color coding done)
2. Set in Order: arrange the necessary items into most efficient and accessible way. It makes
items easy to find, and saves space, ensures FIFO.
3. Shine: clean the workplace and upkeeping of machines.
4. Standardize: the best practices in operations (SOP). Ensure they are performed correctly
and consistently.
5. Sustain: not one-time-exercise, it needs to be sustained. Training, motivation, monitoring
& audits must be performed to ensure that employees do this without being told.
D. TOTAL PRODUCTIVE MAINTAINENCE (TPM)

It is for maintenance of machines in top working condition to avoid breakdowns & delays.
PILLARS OF TPM:
Foundation: 5S: Organizing the workplace.
P-1: Autonomous Maintenance: Give autonomy to employees to eliminate defects at source.
P-2: Focussed Improvement (Kaizen): Minor improvements continuously applied.

P-3: Planned Maintenance: Preventive Maintenance, Breakdown Maintenance, Corrective

Maintenance, and Maintenance Prevention to ensure zero breakdowns.
P-4: Early Management: Shortening the time for product and equipment development by
Engineering and Re-engineering Processes.
P-5: Quality Maintenance: deliver highest quality product.
P-6: Education & Training: to improve knowledge, skills and morale of employees
P-7: Office TPM: apply TPM in admin work.
P-8: Safety, Health, and Environment: have zero accidents and zero health damages
PERFORMANCE MEASUREMENT IN TPM: (For Practicals)

It is done in terms of Overall Equipment Effectiveness (OEE).
Particulars Hours
Total time:
(-) Time Lost: Break Time:
Preventive Maintenance & Setup Time
∴ Planned Production Time
(-) Time Lost: Unplanned Downtime:
∴ Time Available (Actual Operating Time)
∴ Std Time for Actual Production: Actual Production Units
(-) Units Rejected -
∴ Good Production Units -
(1) Availability Ratio (%) = 100 - Time Losses

.
(2) Performance Ratio (%) = 100 - Speed Losses
(3) Quality Ratio (%) = 100 - Quality Losses (i.e. ‘Yield’)
(4) OEE (%) = Availability % × Performance % × Quality %

Ideal values for the OEE component measures are:
Availability > 90%; Performance > 95%; Quality > 99%
Accordingly, OEE at World Class Performance would be approximately 85%.
Note:
.
Ideal Cycle Time =
CASE STUDY – 2: TPM:

Super Refineries Limited is a leading oil refining company operating in India. The company
has three plants - one each situated in North, South and West. The company has a refining

capacity of 30 million barrels. The company currently enjoys a 40% share of the domestic
market. The plants run on all 365 days in a year and operate at 100% of the capacity. The
company currently does not have any maintenance schedule in place for its plant and
machinery. Any repair requirement of plant and machinery is carried out on ad-hoc basis.
The company has implemented Total Quality Management (TQM) to ensure that the
company rolls out top quality products. The company did not receive any complaints from its
customers regarding poor quality of products or products not meeting the specifications. The
entire production team is quite excited with superior quality of products.
However, in the last three months, about 30% of the dispatches to customers were delayed.
This comes at a time when the entire plant had to be shut for maintenance activity due to
breakdown in the machineries for a week. The company also witnessed 20% rejection of the
final products. The customers claimed that the products did not meet the specification agreed
by them with the company. The Director of Refineries is worried about the worsening situation
of production at plants. Another concern for the director is the increase in number of accidents
and loss of productive time due to this.
The chairman of the company convened an urgent meeting of the Board of Directors to
understand the impact and reasons of the situation at production plants. A key issue
highlighted by plant supervisors is that the scheduled maintenance activity for plants was
never carried out. The underlying assumption for not carrying out such maintenance activity
was - “Since the plant is running smoothly, there is no requirement of preventive maintenance
activity. Such activities cost a lot in terms of money and also cause loss of productive time
which could otherwise be used for production”. The maintenance departments and production
department functioned in silos with almost no co-ordination amongst themselves. The most
critical parts of the plant were not maintained for a long time.
The chairman called you after the meeting and asked you to help him understand the current
issue at the plant. “We had Total Quality Management (TQM) in place at all our plants. I
understand from the production director that TQM is working as intended. Why are we facing
the breakdown problem inspite of having a TQM in place”- said the Chairman.
Required: The Chairman has asked you to quickly prepare a note highlighting the following:
(i) What could be the likely losses arising due to breakdown of machinery due to non-
maintenance?
(ii) What kind of maintenance programme could address the issue being faced by the
company?
(iii)EXPLAIN the key features of such programme.
(iv)COMPARE the programme identified above and TQM.
(v) What are the various types of maintenance practices that the company can implement?
SOLUTION:
Issue
Super Refineries Limited has implemented a Total Quality Management and is known for
producing top quality products. The company enjoys 40% market share in the domestic
market. The plants operate at 100% capacity and on all days of the year. This indicates that
the company does not carry out preventive and corrective maintenance. The company has

not received any complaints with respect to quality from its customers. This can be attributed
a solid TQM in place.
However, in the last three months, the company has faced delayed in supplies and customer
rejections. The delay in supplies could be attributed to the breakdown in the machineries.
The production could have been of an inferior quality if the production managers would have
rushed to meet the production deadlines due to loss of production time owing to breakdown.
The discussions at the board meeting indicate that the company has not prioritized preventive
maintenance. Maintenance is being carried out on an ad-hoc basis with a proper preventive
maintenance schedule. The company is concerned about costs of maintenance and hence
no preventive maintenance was carried out. Further, there is no co-ordination between the
production team and maintenance team.
Losses Arising Due to Breakdown
The following are the losses which can be associated with the breakdown of machinery at
Super Refineries Limited -
 Equipment failure leading to unexpected loss of time - The production at plants was
interrupted and the supplies to customers were delay in case of Super Refinery Limited.
 Idle waits and stoppages due to ad hoc maintenance requirements. Since the interruption
is unplanned, the productive labour time is wasted.
 Production of inferior quality products causes financial losses. The company would also
incur additional costs to remake the product without any additional revenues.
 The company would also incur losses in terms of additional set up costs. Every time a
machine breaks down, a significant amount of time would be wasted in setting up the
production processes again.
Total Productive Maintenance (TPM)
Based on the facts of the case, it is very clear that the company has not prioritised
maintenance. The company can use TPM philosophy to address the issue.
TPM is a maintenance philosophy aimed at eliminating production losses due to faulty
equipment. The objective of TPM is to keep equipments (plant, machinery etc) in such a
position to produce expected quality products at the maximum capacity with no unscheduled
stops. This also includes attaining:
 Zero breakdowns.
 Zero downtimes.
 Zero failures attributed to poor condition of equipment.
 No loss of efficiency or production capacity due to the equipment.
The concept was initially applied to equipment i.e., plant and machinery. Of late, the concept
has also been extended to processes and employees. TPM focusses in keeping equipment
and employees in top working condition to avoid any breakdowns and delays in
manufacturing process.
Traditionally, maintenance work has been considered as a responsibility of the Maintenance
Team which is different from the production team. Total Productive Maintenance seeks to

involve workers in all departments and levels in ensuring the effective operations of the plant.
When both the teams work in alignment, learnings can be shared with each other. The
production team also takes ownership of maintenance requirement. A sole focus on higher
production without taking care of maintenance requirement can hamper the long-term
production requirements, as could be seen in the case of Super Refinery Limited.
Features
 Traditional maintenance is centred in the maintenance department. However, TPM seeks
to involve workers at all departments and levels. There is a great amount of co-ordination
between the production and maintenance team in TPM.
 Autonomous maintenance focusses on training operators to be able to take care of minor
maintenance tasks. This relieves specialised maintenance staff to focus on critical issues.
 TPM focusses on achieving and sustaining zero loses with respect to minor stops,
measurement and adjustments, defects, and unavoidable downtimes.
 Planned Maintenance is aimed to have trouble free machines and equipment producing
defect free products for total customer satisfaction. The approach here is proactive
maintenance instead of reactive maintenance. Super Refinery limited had a reactive
approach to maintenance where maintenance was carried out on an ad hoc basis.
 TPM emphasises on training of workers across all levels and departments. The ultimate
objective is to have a factory full of skilled workers.
The issues faced by Super Refinery Limited due to unplanned shutdowns can be addressed
using a Total Productive Maintenance philosophy.
The following are the Eight Pillars or Principles of TPM -
(1) Autonomous Maintenance (5) Focused Improvement
(2) Planned Maintenance (6) Early Equipment Management
(3) Quality Maintenance (7) Education and Training
(4) Office TPM (8) Safety, Health and Environment
TQM and TPM
Total Quality Management (TQM) and Total Productive Maintenance are often used
interchangeably. However, TQM and TPM are considered as two different approaches. TQM
attempts to increase the quality of goods, services and concomitant customer satisfaction by
raising awareness of quality concerns across the organisation. In other words, TQM focuses
on the quality of the product, while TPM focuses on the equipment used to produce the
products. By preventing equipment break-down, improving the quality of the equipment and
by standardising the equipment, the quality of the products increases. TQM and TPM can
both result in an increase of quality. However, the approach of each is different. TPM can be
seen as a way to help achieving the goal of TQM.
Super Refinery Limited has implemented TQM and is delivering high quality products to its
customers. TQM focusses on the end product being supplied to the customer. In the process
of producing high quality and volumes of products, the maintenance aspect of plant and
machinery was ignored by all. This led to breakdowns and unplanned shutdown of the plant
and machineries. The TPM philosophy would focus on the equipment which support
production of high quality products under TQM.

Types of Maintenance under TPM

Breakdown Maintenance
No maintenance is carried out unless the equipment actually fails. This is the approach taken
by Super Refineries Limited currently. This type of maintenance is used when the equipment
failure does not impact the operations and production significantly and the only cost incurred
is the cost of repair. This is not advisable in case of Super Refineries as breakdown of
machineries have led to significant delays in deliveries and poor quality of production.
Preventive Maintenance
It is a daily maintenance (cleaning, inspection, oiling and re-tightening), designed to retain
the healthy condition of equipment and prevent failure through the prevention of deterioration,
periodic inspection or equipment condition diagnosis, to measure deterioration. This can be
compared with a routine and periodic maintenance activity of a vehicle.
Corrective Maintenance
Corrective maintenance focusses on making machines easier to clean and maintain. There
could be reconfiguration of certain parts of the machines (say, a lubricating pipe) to ensure
that the maintenance staff can carry out maintenance effectively and easily.
Maintenance Prevention
Through the analysis of maintenance data, the maintenance technicians can work with the
designers of our machines to create machines that are more reliable. Maintenance and
repairs that are required can be made as simple and as easy as possible to reduce time,
save money and improve safety.
Autonomous Maintenance
In case of autonomous maintenance, minor and day to day repairs are carried out by the
operators of plant themselves instead of waiting for technicians. Activities like lubricating, bolt
tightening etc. are done along with minor repairs by the floor workers or operators.
Maintenance team is called only when sophisticated and highly technical maintenance work
is required. You may change the tires of your car on your own but to repair a puncture or
wheel alignment, you visit a technician.
Conclusion
Super Refinery Limited should implement a TPM which would complement and support the
TQM philosophy. This would also address the issue of the production team and maintenance
team not working in co-ordination. Down time for maintenance should not be considered as
a cost or unproductive activity. This should be an integral part of the overall manufacturing
plan. This would ensure that emergency and unplanned downtime are kept to a minimum.
Q.03. TPM – OEE MEASURE

APZ Company Ltd. manufactures spare parts and can be called "high volume based"
manufacturing environment. The company is using the system of Total Productive
Maintenance for maintaining and improving the integrity of manufacturing process. There are
several different automated manufacturing machines located in the plant, through which
manufacturing of spare parts are done and supplied to cater the demand in the market.

A 12 hour shift is scheduled to produce a spare part in APZ Company Ltd. as shown in the
schedule below. The shift has three 15 minute breaks and a 10 minute clean up period.
Production Schedule for Automated machine A 10:
Cycle: 10 (seconds), Spare parts Manufactured: 3,360,
SCRAP: 75, Unplanned Downtime: 36 minutes
Required
(i) CALCULATE OEE (Overall Equipment Effectiveness) and comment on it.
SOLUTION: (i)
Total time: [12Hrs] 720 Min
(-) Planned Break & Cleanup: [(3 × 15 Min) + (1 × 10 Min)] (55 Min)
∴ Planned Production Time: 665 Min
(-) Unplanned Downtime: (36 Min)
∴ Time Available (Actual Operating Time) 629 Min
∴ Std Time of Production [3360 Un × 10 sec. ÷ 60sec/min] 560 Min
(-) Units rejected [ 75 Un]
∴ Good prodn: [3285 Un]
(1) Availability Ratio = = = 94.59%

.
(2) Performance Ratio = = = 89.03%
(3) Quality Ratio = = = 97.77%
(4) ∴ OEE = 0.9459 × 0.8903 × 0.9777 = 82.34%

Comment:
Since the OEE is very close to 85% i.e. world class performance level, company should take
measures to improve it and strive to attain 85% level. Availability Ratio of the machine is
94.59% exceeding the ideal value of > 90% which is good but the Performance and Quality
Ratios need attention as they are below their ideal values of > 95% and > 99% respectively.
E. CELLULAR MANUFACTURING
Cellular Manufacturing is about applying Time & Motion Study to manufacturing industries. It
is a sub section of JIT, in which one or more machines & processes are put together and
considered as one ‘Cell’. Multiple such cells are used in assembly line, each cell
accomplishes a certain task. Cellular Manufacturing focuses on 2 things: (1) Grouping of
Machines [Grouping Technology (GT)], & (2) Arrangement of Machines.
 These cells are arranged in a ‘U’ shaped design, so that the supervisor can watch over the
entire production without moving much.

 Scattered processes are merged, so it reduces flow time, flow distance, floor space,
inventory, scrap and rework, etc.
 Quality control is facilitated as problems can be easily detected and underperforming cells
can be easily isolated.
 It improves employee cohesiveness and scales it down to a more manageable level.
 Cells are designed to maintain a specific flow volume, so they are not flexible.
 One or more machines are grouped together based on parts manufactured by them.
‘Part Family’ = group of similar parts
‘Machine Cell’ = group of machines arranged to process a particular part family
 ‘Clustering Methods’ are used to decide how to make grouping (Very Important):
Part Family Grouping Machine Cell Grouping Machine-Part Grouping

(Rank Order Clustering)
Inter-Cell Movements: If a part requires to move to another cell:
 Design effective inter-cellular material handling mechanisms
 Duplicate machines
 Subcontract that process
 Redesign that part so that it doesn’t need inter-cell movement.
Q.04. CELLULAR MANUFACTURING – RANK ORDER CLUSTERING

It has been resolved that cellular manufacturing shall be adopted in order to improve
productivity, in the recent board meeting of Raptor Bearing and Shaft Limited. In favour of the
resolution, Mr. Nayak (the executive director) who is responsible for production and operation
function gave a briefing over different layouts of cells. The Managing Director, Mr. Syal
believes that each possible cell formation and layout need to be studied in advance by a
cross functional team.
Chief HR officer Mr. Mishra shown his concern over the utility of cellular manufacturing to
enhance productivity. In response to him, Mr. Nayak mentioned ‘Although scientific
management is quite an old theory of management pronounced by Frederick Winslow Taylor,
which analyses and synthesizes workflows with the objective of improving economic
efficiency, especially labour productivity; but still has relevance. This relevance multi-folds
when Time and Motion studies are considered in nexus with cellular manufacturing’.
You are a part of the cross-functional team as a representative of Management Accounting
Division. The team started with the study of different possible layouts and machine cell
designs. While analysing the production flow it is observed that 6 different parts (P1, P2, P3,
P4, P5 and P6) are complexly involved in processing at 5 different machines (Mb, Mc, Md,
Me, and Mf). Part-Machine Incident Matrix for Production Flow Analysis is:
P1 P2 P3 P4 P5 P6
Mb 1 1
Mc 1 1 1

Md 1 1
Me 1 1 1
Mf 1 1 1
Required:
(i) DISCUSS the concern expressed by Mr. Mishra over the utility of cellular manufacturing.
(ii) EXPLAIN on utility of at-least three machine cell designs, which can be used.
(iii)FIND logical part families and machine groups based upon Part-Machine Incident Matrix
to showcase Machine-Part grouping using Rank Order Clustering Algorithm.
[May 21 RTP]
SOLUTION: (i) Utility of Cellular manufacturing:
Cellular manufacturing is a lean way to enhance productivity by improving (reducing) the
performance in the context of time and motion involved in the production.
Cellular manufacturing is an application of Group Technology in the manufacturing in which
all or a portion of a firm’s manufacturing system has been converted into manufacturing cells.
Here is important to note that a manufacturing cell is a cluster of machines or processes
located in close proximity and dedicated to the manufacturing of a family of parts.
Cellular Manufacturing results in following benefits to improve productivity–
(a) Reduce setup times by using part family tooling and sequencing.
(b) Reduce flow times by reducing material handling and transit time and using smaller batch
sizes (even single piece flow – this also results in the requirement of less floor space).
(c) Reduce lead time.
(d) Reduced work-in-process inventory.
(e) Better use of human resources. Hence, reduced direct labour but heightened sense of
employee participation.
(f) Better scheduling, easier to control, and automate.
(g) Increased use of equipment & machinery, hence reduced investment on it.
Hence, concern expressed by Mr. Mishra, regarding the utility of cellular manufacturing to
enhance productivity is not material.
(ii) Machine-Cell Designs:
The Machine Cell Design can be classified based on the number of machines and the degree
to which the material flow is mechanized between the machines.
(a) Single Machine Cell consists of a machine plus supporting fixtures and tooling to make
one or more part families. This can be applied (useful) to work parts that are made by
one type of process such as turning or milling.
(b) Group Machine Cell with manual handling consists of more than one machine used
collectively to one or more part families and no provision for mechanical part movement
between machines. In this, human operators run the cell and perform material handling.

Note: If the size of the part is huge or there is a large number of machines in the cell,
then regular handling crew may be required.
Preferable cell shape is U-shaped (single/few workers). U shape is useful in the
movement of multi-functional workers.
Since the design simply includes certain machines in the group and restrict their use
for specified part family hence often achieved without rearranging the process type
layout; So, bring the cost-saving (on rearranging) but lock-in material handling benefits
of group technology.
(c) Group Machine Cell with semi-integrated handling consists of more than one machine
used collectively to one or more-part families and uses a mechanical handling system,
such as conveyor, to move parts between machines in the cell.
Note: There may be in-line layout (identical or similar routing - machines are laid along
a conveyor to match the processing sequence) and loop layout (allows parts to
circulate in the handling system and permits different processing steps in the different
parts in the system).
(d) Flexible Manufacturing System is a highly automated machine cell in group technology
that combines automated processing stations with a fully integrated material handling.
(iii) Rank Order Clustering Algorithm to form machine-part groups: (Refer Book)
Steps:
(1) Calculate Binary Weights (BW) – for each column [2n… 22,21,20]
(2) Calculate Decimal Equivalent (DE) – for the opposite direction (Row) – i.e. sum of BW
where there is “1”
(3) Rank the DE
(4) Rearrange table to make it in sequence of Ranking
(5) Repeat by starting with BW of each Row.
(6) Continue until no rearrangement is needed
(7) Make Groups of combinations having similar DE.
1st Repetition:
P1 P2 P3 P4 P5 P6 DE Rank
Mb 1 1 10 4
Mc 1 1 1 7 5
Md 1 1 48 2
Me 1 1 1 11 3
Mf 1 1 1 52 1
BW: 32 16 8 4 2 1

2nd Repetition:
P1 P2 P3 P4 P5 P6 BW
Mf 1 1 1 16
Md 1 1 8
Me 1 1 1 4
Mb 1 1 2
Mc 1 1 1 1
DE 24 24 6 17 7 5
RANK 1 2 5 3 4 6
3rd Repetition:
P1 P2 P4 P5 P3 P6 DE RANK
Mf 1 1 1 56 1
Md 1 1 48 2
Me 1 1 1 7 4
Mb 1 1 6 5
Mc 1 1 1 13 3
BW 32 16 8 4 2 1
4th Repetition:
P1 P2 P4 P5 P3 P6 BW
Mf 1 1 1 16
Md 1 1 8
Mc 1 1 1 4
Me 1 1 1 2
Mb 1 1 1
DE 24 24 20 7 3 6
RANK 1 2 3 4 6 5
5th Repetition:
P1 P2 P4 P5 P6 P3 DE RANK
Mf 1 1 1 56 1
Md 1 1 48 2
Mc 1 1 1 14 3
Me 1 1 1 7 4
Mb 1 1 5 5
BW 32 16 8 4 2 1

∴ Final Grouping:
Particulars Cell 1 Cell 2
Machines: M f & Md Mc, Me & Mb
Parts: P1, P2 & P4 P5, P6 & P3
Comments
It is essential to understand that the cells are not totally independent. Since P4, which is
member of cell1, needs processing in Mc. But machine Mc belongs to cell 2. So, some
amount of intercell movement/ change will take place in this situation. In general, these moves
may become unavoidable in real life circumstances. There are various alternative ways of
eliminating intercell moves in a cellular manufacturing system like– redesigning the part so
that the machine belongs to other cell is no longer required for processing, subcontracting
the part/ adding the necessary machines in the cell. The cell designer should evaluate the
consequences of each of these ways and take suitable measures/ ways to minimise these
moves.
F. SIX SIGMA
It is quality improvement technique to eliminate defects that affects customer satisfaction. By
measuring defects in a process, a company can develop ways to eliminate them and
practically achieve “zero defects” i.e. 3.4 defects per million opportunities or getting things
right 99.99966% of the time.
IMPLEMENTATION OF SIX SIGMA:
1. DMAIC: 2. DMADV:
For existing business process. Phases: To develop new processes or products:
 Define the problem  Define the customer deliverables.

 Measure current performance.  Measure and determine customer needs
 Analyze to find root cause.  Analyze process to meet customer needs.
 Improve process, eliminate root causes.  Design a process to meet customer needs.
 Control means maintaining the improved  Verify the design performance and ability to
process and future process performance. meet customer needs.
DMAIC is used under the following cases: DMDAV is used under the following cases:
- Existing product or process. - New product or process.
- Part of ongoing continuous improvement. - Process already optimized using DMAIC.
- Project have strategic importance.
- Only a single process needs to be altered. - Multiple process need to be altered.
- Competitor’s actions are stable. - Competitor’s performance is changing.
- Customer’s behaviour is unchanging. - Customer’s behaviour is changing.
- Technology is stable. - Technology is growing.
- Short term benefits - Long term benefits

G. PI & BPR
BPR focuses on amending existing processes, while PI attempts to implement new
processes. Process Innovation (PI) could be in the following areas: Production, Delivery, or
Support Services.
Business Process Reengineering (BPR) means fundamental rethinking and radical redesign
of business processes to achieve dramatic improvements in areas such as cost, quality,
service, and speed.
CASE STUDY – 3: BPR:

ANA is one of Country ‘I’’s top footwear companies and other equipment. Since its foundation
in 1988, ANA has been one of the all-inclusive footwear brand that is committed to nurturing
the youth across the world through sports to contribute to society. Over more than three
decades, the company inherits its values and provides own products while capturing the
changes in the social environment. It’s state-of-the-art production facilities are located
strategically across the Country ’I’ and produces all kinds of footwear. ANA is best known for
its high ethical standards towards its workers, suppliers and the environment and voluntarily
publish CSR report every year.
Organizational Structure and Footwear Market
ANA is organized into conventional functional departments such as procurement on order
basis, sales, and finance, most of which have their non-reliable excel sheet-based systems
for planning and reporting. Consequently, it often fails to generate accurate, timely and
consistent information to monitor its own performance, thus, company faces failures in
achieving the performance and delivery targets set by its retail customers.
In Country ‘I’, footwear market is competitive and seasonal. Retailers, who are ANA’s
customers, for footwear, they have two main demands, they want –
(i) footwear at lower prices to pass it on to consumers.
(ii) suppliers to meet performance and delivery targets relating to lead times and quality.
In order to comply with the retailer’s demands, ANA’s competitors have discontinued all their
own manufacturing facilities and outsourced all production to suppliers, who have much
larger production lines and lower costs. To reduce the shipment cost over long distances,
competitors have invested in advanced procurement software to consolidate orders so that
each 40-foot shipping container gets fully loaded. Purchase invoice processing is also
automated via the integration of information systems into the supplier ’s software.
Proposal of Outsourcing
In order to mitigate costs, it has been proposed to outsource the manufacture of footwear, to
a Chinese Supplier 3,750 km away. A comparison of the average cost of manufacturing and
the cost of outsourcing footwear is given below–
Particulars Manufacturing Outsourcing
Average manufacturing cost per pair BND 625 ---
Purchase cost per pair --- CNY 28

Notes-
(1) Country ‘I’’s home currency is the BND.
(2) Exchange Rate 1CNY = 18 BND.
(3) In addition to the purchase cost from the supplier, ANA will be subject to pay for shipping
costs at the rate of BND 40,000 for each large, standard sized shipping container,
regardless of the number of units in it. Each container can contain maximum 5,000 pairs.
(4) Custom tariffs are expected to change soon, footwear imports into ANI’s home country
might be subject to 10% basic custom duty (plus 1% social welfare surcharge on duty) on
the assessable value of imports excluding shipping costs.
Therefore, to implement the proposal, restructuring of functional departments into multi-
disciplinary teams are needed to serve major buyer accounts. Each team is required to
perform all activities, related to the buyer account management from order taking (sales
order) to procurement to arranging shipping and after sales services. Team members dealing
with buyers will work in ANA’s corporate office, while those like QC etc. managing quality and
supplier audits, will work at the manufacturing site of Chinese Supplier. Teams will be given
greater independence to selling prices to reflect market conditions or setting a price based
on the value of the product in the perception of the customer . Many support staff will work
as helper roles, or be offered new jobs opportunities overseas after the restructuring.
Expert Advise
Prof. WD, Performance Management Consultant has advised ANA that the proposal has
features of re-engineered processes and can be defined as business process re-engineering
(BPR). Prof. advised, for evaluating the proposal, ANA should consider software
development for full front-end order entry, purchasing, and inventory management solution
which may be required along with ethical aspect of the proposed changes.
Required
(i) ADVISE on information system which would be required for the reengineering.
(ii) ASSESS the likely impact of reengineering on the ANA’s high ethical standards and
accordingly on business performance.
(iii)EVALUATE how the BPR proposal can improve ANA’s performance in relation to retail
customers.
SOLUTION:
(i) Advise on Information System
Combining several jobs into one, permitting workers to make more decision themselves,
defining different versions of processes for simple cases vs complex ones, minimizing
situations when one person check someone else’s work, and reorganizing jobs to give
individuals more understanding and more responsibility are characteristics of re- engineered
processes.
In ANA, outlays can be saved by rearranging staff into multidisciplinary teams, for example,
reducing number of excess staff at different stages – cutting, preparation, finish etc. These
savings can be utilized in additional costs such as investment in new information systems.

Hammer and Champy stress the use of information technology as a catalyst for major
changes. BPR organizes work around customer processes rather than functional hierarchies.
Presently, ANA’s departments have their own excel sheet-based systems for planning and
reporting which is unreliable and inconsistent. They are inadequate to provide the accurate,
timely and consistent data which ANA needs to meet its own performance and delivery
targets. There must a shared database that should be accessible by all parts of the functional
teams. This should have real time updation, so that employees in different time zones can
use updated data. The database should include financial data and non - financial data, like
cost information, data related to lead times and quality. Information systems must be featured
with all required reports like performance report, budget report etc.
In addition, ANA is required to invest in special system as advised by Prof. WD for full front-
end order entry, purchasing, and inventory management solution to minimize shipping costs
by ensuring that the shipping containers get fully loaded and to integrate with supplier’s
information systems to automate purchase invoicing.
Overall, ANA must analyze that whether the benefits of information technology are worthy.
(ii) Assessment of Likely Impact of Re-engineering on Ethical Standards
Workers
ANA is famous for its high ethical standards towards workers and staff. Because of adopting
BPR proposal, manufacturing staff are likely to be unemployed. Competitors, have already
shutdown their factories, these workers may not be able to find analogous jobs.
Employees who continue in work may become disappointed if they think the application of
BPR to all products. This may reduce productivity, increase staff turnover or difficulties in
recruiting new staff. In addition, they may also be demotivated if they are appointed in
unfamiliar roles, or may not be willing to learn new skills.
Some of staff members may be motivated by the opportunity to perform new types of work,
learn new skills or work outside India. This maybe enhance their individual performance.
Suppliers
Any association with non-ethical practices, for example, if the Chinese supplier is indulged in
using non-acceptable working practices, could seriously spoil ANA’s reputation for high
ethical standards. This could undermine financial performance because customers may not
buy its products, or possible investors might refuse from providing capital. Staff members
located at the manufacturing site is responsible for supplier audits, which may assist to
mitigate this risk.
Environment
ANA should consider the environmental impact of importing goods from long distances. The
environmental related credentials of the Chinese Supplier are not known. Since, ANA
voluntarily publishes a corporate sustainability report, any distortion in its performance on
environmental issues might undermine the financial performance.
(iii) Evaluation of BPR Proposal in relation to Retailer’s Demand
Lower Prices

In order to sell footwear at lower prices, there is proposal to reduce costs by outsourcing
production to supplier. The current average production cost of manufacturing is BND 625.00
per unit. The cost of purchase from an external supplier is BND 512, which is BND 504
(CNY18 × BND28) purchase cost, plus BND 8 (BND 40,000/ 5,000) shipping cost. This
18.08% (113/ 625) saving is a substantial improvement in financial performance, but not a
dramatic one. It may be noted that BPR is a methodology that should be applied only when
radical or dramatic change is required. Further, exchange rate movements may also slash
the cost saving significantly. In the near future, expected changes to international trade tariffs
will increase the unit cost to CNY30.83 (CNY28.00 × 110.10%) i.e. 554.94 in BND and reduce
the cost saving to just 11.21% (70.06/ 625).
Meeting Performance Targets
Lead times
Current lead times for customer orders are not ascertainable. Since the proposed Chinese
Supplier is 3,750 km away, consignment will take several weeks to be imported by sea. This
may increase lead times substantially, although may be set off by faster production times in
supplier’s plant. As ANA’s sales are seasonal, retailers may order in advance, decreasing the
long lead times. In order to decrease shipping costs, shipping containers must be full,
meaning that deliveries must be in larger quantities.
Quality
ANA is already known for manufacturing high quality footwears. The quality of the new
supplier’s footwear needs to be checked. Any distortion in the quality of footwear will
deteriorate its reputation and decrease long-term business performance since only few
customers would order. Quality standards checking is more difficult while using outside
suppliers, especially at long distance, than manufacturing in ANA’s own factory. In BPR, work
is done where it makes most sense to do so. In this aspect, having employees responsible
for quality checking and supplier audits (working at the manufacturing site, abroad) will assist
ANA in sustaining the best supplier relationship management.

CH – 04 COST MANAGEMEN T TECHN IQU ES
CHAPTER
COST MANAGEMENT TECHNIQUES
04
CHAPTER SUMMARY
A. COST CONTROL V/S COST REDUCTION

DIFFERENCE:
Cost Reduction Cost Control
 Real and permanent.  Not necessarily permanent
 Quality retained.  No such guarantee.
 Analysis and challenge of standards.  Standards are not examined.
 Applicable to all areas of business.  Applicable only to those items of cost for
which standards can be set.
 Emphasis on future costs.  Emphasis on present and past costs.
 Cost reduction is a corrective measure.  Cost Control is a preventive measure.
SCOPE OF COST REDUCTION: (i.e. methods or where to achieve cost reduction)
 Product Design: Change in product design to use cheaper or high yield materials, reducing
production time, standardization and simplification of variety, etc.
 Organization: of each function, assignment of tasks, communications, etc.
 Factory Layout Equipment: Replace plants, introduce new techniques, expansion, etc. to
eliminate wastage of men & materials and maximize usage of facilities.
 Production Plan Program: Eliminate faulty production methods, change plant layouts and
incentive schemes to reduce wastage of men & material. Control Oh costs.
B. TARGET COSTING
First determine what SP customer will pay, next determine the profit required and deduct it
from the SP. The remaining amount now left is now used as budget cost to make the product.
Target costing mainly involves Cost Reduction in order to reach the Target Cost.
Target Cost might be the target total cost, or might be any component of cost which is targeted
to be achieved. Eg: (₹) (₹) (₹)

Target SP Target SP Target SP

(-) Target Profit (-) Target Profit (-) Target Profit
∴ Total Cost Required ∴ Total Cost Required ∴ Total Cost Required
(-) Target Given Costs (-) DL & OH given (-) DM & OH given
∴ Target Cost Required ∴ Target DM Required ∴ Target DL Required
This target cost is compared with the existing cost and accordingly comment whether target
is achieved or not. If not achieved, then give suggestions of how to achieve it.
COMPONENTS OF TARGET COSTING SYSTEM:

Value Analysis & Value Engineering is scientific approach to cost reduction without reducing
quality. Value Analysis is for existing products, while Value Engineering is for new products.
 Eliminate functions
 Eliminate some durability
 Minimize the design by using fewer parts or giving fewer features
 Design the product better: design that can be created in only a specific manner
 Substitute parts: for less expensive components or materials
 Steps can be consolidated, accomplished by one person
 Take supplier’s assistance: redesign their processes to suit our needs.
 Is there any other better way?
However, we must also comment that the decrease in production time might put unwanted
pressure on the design and implementation.
TARGET COSTING – STEPS:

Step 1: Importance to market driven prices and need of customer.
Step 2: Identify customer requirements
Step 3: Establish target price
Step 3A: Determine the volume of product
Step 3B: Establish the target profit margin
Step 4: Determine the target cost
Step 4A: Balance target cost and requirement
Step 5: Establish the target costing process
Step 6: Brainstorm and analyse to reduce the cost
Step 6A: Establish product cost models
Step 7: Closing down the gap
Step 7A: Reduce the indirect cost
Step 8: Measure the results

MOST USEFUL SITUATIONS FOR TARGET COSTING

Target costing is most useful in situations where the majority of product costs are locked in
during the designing phase (like in manufacturing industries). In the services industries, cost
reduction can be done during the “production” phase. Following companies benefit most:
 Assembly-oriented industries, as opposed to repetitive-process industries
 Companies having diversification of the products.
 Companies having automations
 Companies having shorter product life cycle.
 Companies implementing JIT.
Q.01. TARGET COSTING

Kowloon Toy Company (KTC) expects to successfully launch Toy “H” based on a Disney
character. KTC must pay 15% royalty on the selling price to the Disneyland. KTC targets a
selling price of ₹100 per toy and profit of 25% on selling price.
The following are the cost data forecast: ₹/Toy
Component H1 8.50
Component H2 7.00
Labour: 0.40 hr. @ ₹60 per hr. 24.00
Product Specific Overheads 13.50
In addition, each toy requires 0.6 kg of other materials, which are supplied at a cost of ₹16
per kg. with a normal 4% substandard quality, which is not usable in the manufacture.
Required: DETERMINE if the above cost structure is within the target cost. If not, what
should be the extent of cost reduction?
SOLUTION: (1) Target Cost: (₹/Toy)
Target Selling Price 100.00
Less: Royalty @15% 15.00
Less: Profit @ 25% 25.00
Target Cost 60.00
(2) Existing Cost:
₹ / Toy
Component H1 8.50
Component H2 7.00
Labour (0.40 hr. × ₹ 60 per hr.) 24.00
Product Specific Overheads 13.50
Other Material (0.6 kg / 96% × ₹16) 10.00
Total Cost of Manufacturing 63.00

(3) Total Cost of Manufacturing is ₹ 63 while Target Cost is ₹ 60. Company KTC should make
efforts to reduce its manufacturing cost by ₹ 3 to achieve Target Selling Price of ₹100.
[Note: The 4% substandard material given in the question is 4% of the material supplied, not
4% of the material consumed. Hence every 96 kg consumption would require 100 kg supply]

Storewell Industries Ltd. manufactures standard heavy duty steel storage racks for industrial
use. Each storage rack is sold for ₹750 each. The company produces 10,000 racks per
annum. Relevant cost data per annum are as follows:
Cost Component Budget Actual Actual Cost p.a. (₹)
Direct Material 5,00,000 sq. ft. 5,20,000 sq. ft. 20,00,000
Direct Labour 90,000 hrs. 1,00,000 hrs. 10,00,000
Machine Setup 15,000 hrs. 15,000 hrs. 1,50,000
Mechanical Assembly 200,000 hrs. 200,000 hrs. 30,00,000
The actual and budgeted operating levels are the same. Actual and standard rates of material
procurement and hourly labor rate are also the same. Any variance in cost is solely on
account of difference in the material usage and hours required to complete production.
Aggressive pricing from competitors has driven down sales. A comparable rack is available
in the market for ₹675 each. Vishal, the marketing manager has determined that in order to
maintain the company’s existing market share of 10,000 racks, Storewell Industries must
reduce the price of each rack to ₹675. Required:
(i) Calculate the current cost and profit per unit. IDENTIFY the non -value added activities in
the production process.
(ii) Calculate the new target cost p.u. for sales price of ₹675 if the profit per unit is maintained.
(iii)RECOMMEND what strategy Storewell Industries should adopt to attain target cost
calculated in (ii) above. [May 18 RTP, May 20 MTP (20 Marks)]
SOLUTION: (i) Current Cost and Profit p.u.: (₹)

Direct Material 20,00,000
Direct Labour 10,00,000
Machine Setup 1,50,000
Mechanical Assembly 30,00,000
Total Cost 61,50,000
(÷) Units 10,000 Units
Cost p.u. 615
Profit p.u. [₹750 - ₹615] 135
The current cost is ₹615 p.u. while the profit is ₹135 p.u. Machine setup is the time required
to get the machines and the assembly line ready for production. 15,000 hours spent on setting
up does not add value to the storage racks directly. Hence, it is a non-value add activity.

(ii) New Target Cost p.u.:

New sale price per rack is ₹675 per unit. The profit per unit needs to be maintained at ₹135
per unit. Hence, the new target cost per unit = new selling price per unit – required profit per
unit = ₹675 - ₹135 = ₹540 per unit.
(iii) Recommendation:
As explained above, current cost per unit is ₹615 while the target cost per unit is ₹540. Hence,
the cost has to be reduced at least by ₹75 per unit. Analysis of the cost data shows the
variances between the budget and actual material usage and labor hours. It is given that the
material procurement rate and labor hour rate is the same for budgets and actuals. Hence,
the increment in cost of direct materials and labor is due to inefficient use of material and
labor hours to complete the same level of production of 10,000 storage racks.
Corrective actions to address these inefficiencies could result in the following savings:
(a) Inefficiencies resulted in use of extra 20,000 sq. ft. of material:
₹ , ,
→ Material cost per sq. ft. = = = ₹3.85 /Sft
, ,
∴ Extra 20,000 Sft. consn resulted in extra cost @ ₹3.85/Sft. = ₹77,000.

∴ For 10,000 racks, this translates to a saving of = ₹7.70 p.u.
(b) Inefficiencies resulted in extra 10,000 hrs. to be spent in production:
₹ , ,
→ Labor cost per hr. = = = ₹10 per hr.
. , ,
∴ Extra 10,000 Hrs resulted in extra cost @ ₹10/Hr. = ₹1,00,000.

∴ For 10,000 racks, this translates to a saving of = ₹10 p.u.
(c) Machine setup cost is a non-value added cost. Value analysis can be done to determine
if the setup time of 15,000 hrs. can be reduced. However, since these activities have been
carried out for a reason, car e should be taken to ensure that this change should not
adversely impact the production activity later down the stream.
(d) Mechanical assembly cost is almost half of the total cost. These are costs incurred during
the production process on the assembly line. Value analysis can be done to determine if
the production process can be made more efficient. For example, the process can be
streamlined, such that steps can be combined that can be handled by fewer people.
Similarly, value analysis / value engineering can focus on the product design.
Some questions to raise may be:
- Can the product be designed better to make the production more efficient?
- Can the design be minimized to include fewer parts and thus make it easier and
efficient to manufacture?
- Can be substitute parts to make it more efficient? Or
- Is there simply a better way of producing the same product?
While target costing is a dynamic and corrective approach, care must the taken the
product quality, characteristics and utility are maintained.


NEC Ltd., forms a Committee consisting of its Production, Marketing, and Finance Directors
to prepare a budget for the next year. The Committee submits a draft budget as below:
Particulars ₹
Selling Price per unit 50
Less: Direct Material Cost per unit 9
Direct Labour Cost per unit 9
Variable Overhead per unit (3 hrs. @ ₹2) 6
∴ Contribution per unit 26
(×) Budgeted Sales Quantity 25,000 units
∴ Budgeted Contribution (25,000 × ₹26) 6,50,000
Less: Budgeted Fixed Cost 5,00,000
∴ Budgeted Profit 1,50,000
The Management is not happy with the budgeted profit as it is almost equal to the previous
year's profit. Therefore, it asks the Committee to prepare a budget to earn at least a profit of
₹3,00,000. To achieve the target profit, the Committee reports with following suggestions:
The unit selling price should be raised to ₹55.
The sales volume should be increased by 5,000 units.
To attain this increase in sales, the company should spend ₹40,000 for advertising.
The production time per unit should be reduced.
To win the acceptance of the workers in this regard the hourly rate should be increased by
₹3 besides an annual group bonus of ₹30,000.
There is no change in the amount and rates of other expenses. The company has sufficient
production capacity.
As the implementation of the above proposal needs the acceptance of the work force to
increase the speed of work and to reduce the production time per unit, the Board wants to
know the extent of reduction in per unit production time. Required:
(i) CALCULATE the target production time per unit and the time to be reduced per unit.
(ii) IDENTIFY the other problems that may arise in production due to decrease in unit
production time and also suggest the remedial measures to be taken.
(iii)State the most suitable situation for adoption of Target Costing. [Nov 18 Exam (20 Marks)]
SOLUTION: (i) Production target time:

Particulars ₹
Target Profit Required 3,00,000
(+) FC [₹5,00,000 + ₹40,000 + ₹30,000] 5,70,000
∴ Target Contribution Required 8,70,000

(÷) Units [(25,000 + 5,000) Units] 30,000

∴ Target Contri. p.u. Required 29
∴ Target (DL + VOH) Cost Required 17
[SP – Contri. p.u. – DM p.u.] = [55 – 29 – 9]
(÷) (DL + VOH) Rate per L.Hr. [₹(6+2) per L.Hr] 8
∴ Target L.Hrs p.u. required 2.125 L.Hrs
∴ Target L.Hrs to be reduced [3 Hrs – 2.125 Hrs] 0.875 L.Hrs
(ii) Problem
The target-costing method is applicable particularly for repetitive manufacturing. It should
however be recognised that some products often bear a high degree of repetition and that
there often are considerable repetitions where reduction targets could com e into play as a
framework for improving design. Working under pressure to finish new design assignments
in a short time may take development resources away from efforts to optimise or re-engineer
production processes. If approaching product design as an activity to be optimised
independently there is a risk that target costing may not succeed to satisfactorily addressing
overall performance, so in short decrease in unit production time may lead to unwanted
pressure on design and its implementation stage.
Remedial Measures
As a remedial action organisation should retain strong control over the design teams headed
by a good team leader. This person must have an exceptional knowledge of the design
process, good interpersonal skills, and a commitment to staying within both time and cost
budgets for a design project. If the time is too short even an organisation may reject a project
for the time being. Later, it can be tried out with new cost reduction methods or less expensive
materials to achieve target cost and control overall production activities.
(iii) Target costing is most useful in situations where the majority of product costs are
locked in during the product design phase. This is the case for most manufactured products,
but few services. In the services area, such as consulting, the bulk of all activities can be
reconfigured for cost reduction during the “production” phase, which is when services are
being provided directly to the customer. In the services environment, the “design team” is still
present but is more commonly concerned with streamlining the activities conducted by the
employees providing the service, which can continue to be enhanced at any time, not just
when the initial services process is being laid out.

Pixel Limited is a toy manufacturing company. It sells toys through its own retail outlets. It
purchases materials needed to manufacture toys from a number of different suppliers.
Recently, due to the entry of few reputed foreign brands in the toy market and particularly in
the segment in which Pixel Ltd. is doing business, it is facing a threat to operate profitably.
Each toy requires 4 kg of materials at ₹19/kg and 5% of all materials supplied by the suppliers
are found to be substandard. Labour hour requirement for each toy is 0.4 hour at ₹120/hour.

Market research has determined that selling price will be ₹240 per toy. The company requires
a profit margin of 15% of the selling price. Expected demand for toy in the coming year will
be 50,000 toys. Sales and variable overhead per unit for the four quarters of the year is:
Q1 Q2 Q3 (Festive season) Q4 (Festive season)
Sales (units) 7,500 9,000 15,500 18,000 ꞏ
Variable overhead per unit (₹) 22 22 24 25
Total fixed overheads are expected to be ₹6,25,000 for each quarter.
The production manager has decided to produce 12,500 units in each quarter. Inventory
holding costs will be ₹18 per unit of average inventory per quarter. Inventory holding costs
are not included in above.
Normal production capacity per quarter is 15,000 toys. The company can produce further
up to 6,000 units per quarter by resorting to overtime working. Overtime wages will be at
150% of normal wage rate. Assume zero opening inventory.
Required:
(a) (i) CALCULATE the cost gap that exists between the total cost per toy as per the
production plan and the target cost per toy.
(ii) DISCUSS how just-in-time purchasing and just-in-time production will remove the
cost gap calculated in (i) above. Show calculations in support of your answer.
(b) EXPLAIN, how implementation of JIT production method can be a major source of
competitive advantage and success of the company. [Nov 19 Exam (20 Marks)]
SOLUTION:


Note:
As per the present production plan, they are producing fixed 12,500 units every quarter
irrespective of the demand. This means that they follow the Principle of ‘Production to Stock’
instead of ‘Production to Demand’ (i.e. Push System). Hence in this case they will have
accumulated inventory on which they will incur holding cost as calculated above. Also, in this
system, we do not need to produce > 15,000 units in any quarter because they have
accumulated stock. Thus they do not incur any Overtime Premium.
(a) (ii) JIT Plan:
If JIT is followed for production, then it means that in every quarter, production is done only
to the extent of demand of that quarter (i.e. Pull System). Thus during non-festive seasons,
production is less and during festive seasons, production required will be more. Hence, if
during festive season, production required is > 15,000 units, then we also need to pay
Overtime Premium. Thus under this JIT System, there will not be inventory accumulated in
any quarter and hence no inventory holding cost in any quarter.
If JIT is followed in material purchasing, it means that material is received at the last moment.
So in JIT, it has to be assumed that the material supplier will himself do the quality checking
before sending material. So now the material that we receive will not contain any substandard
material.



(iii) Benefits of JIT:
CASE STUDY – 1: TARGET COSTING:

Kaveri Ltd. (KL) is a manufacturer of bikes in India and it sells them in India and outside India.
KL has just launched the World’s smallest and most affordable bike called ‘Zingaroo’. The
bike is mounted with all-aluminium, single cylinder, air cooled, 99.2 cc engine. The engine
makes just over 8 bhp power and 8 Nm of torque, but it stakes claim to be the fuel-efficient
bike, with a claimed figure of 88 kmpl. It has been creating competition for two wheelers as
none of the Indian companies as well as foreign companies, offer a bike for such a
competitive price within the reach of middle class family.
KL has adopted target costing technique in manufacturing this bike. For KL, maintaining
target- price was difficult. During the designing and production process of bike, input costs
increased frequently. However, KL designed various components especially for bike to
maintain the target price. Though, one curiosity how this can be done in the future when input
costs are bound to increase further.
Many environmentalists have opposed the manufacture of this bike, because they believe
that mass production of small bike (about 2.5 lakh bike every year) will create heavy pollution.
Many people believe that this small bike is not up to the safety standards due to lightweight
and use of aluminium and plastic frames. The design of this bike is entirely different from that
of other bikes. This also causes a doubt that the existing bike mechanics would be able to
repair or not. Durability of bike is another issue in the Indian environment. Further,
performance of ‘Zingaroo’ more or less depends upon the condition of roads and traffic
system.
After the launch of ‘Zingaroo’, many other national and international automobile companies
are also planning to manufacture small bike which will create tough competition in near future.
Now you being a strategic performance analyst of KL, answer the following questions:
(i) IDENTIFY strategy which KL has adopted for ‘Zingaroo’ bike?
(ii) After adopting target costing, IDENTIFY issues and challenges faced by KL and suggest
the remedial action to be taken to solve these issues?
SOLUTION:
(i) KL has adopted Low Cost Strategy for “Zingaroo” bike since the main purpose of
manufacturing this bike was to make it cheapest and affordable.

(ii) The issues and challenges faced by KL and their remedial action are as follows:
Maintaining of Target Price
‘Zingaroo’ bike is one of the world’s cheapest and smallest bike. Maintaining target-price
proved to be a big challenge for the KL since input cost of bike are bound to increase further
in future. The initial value engineering may not uncover all possible cost savings. Thus,
Kaizen Costing may be designed to repeat many of the value engineering steps for as long
as a bike is produced, constantly refining the process and thereby stripping out extra costs.
Environmental Issues
Many environmentalists have opposed the manufacture of bike as they believe that mass
production of small bikes will create heavy pollution since automobile pollution is already a
big problem for a country like India. For this issue, ‘Zingaroo’ bike can be prepared based on
BS emission norms. These norms restrict the pollution created by any motor vehicle.
Safety Issues
Since ‘Zingaroo’ bike is made of aluminium and plastic frames so this may also create safety
issues for the customers. For such issues, KL should meet safety standards. Further, KL
should make people aware that ‘Safety is Primary’/ ‘Drive Safely’.
Servicing/ Repairing Facilities
The design of ‘Zingaroo’ bike is entirely different from that of other bikes. This causes a doubt
that the existing bike mechanics would be able to repair or not. For such problem, creation of
a good network of service center can be a solution i.e. repair center should be established
on required places.
Durability
Durability of ‘Zingaroo’ bike is another issue in the Indian environment. The performance of
bike more or less depends upon the condition of roads and traffic system. For such issues,
tyre quality and hydraulic brake system should be compatible to the roads and traffic system.
Global Competition
After the launch of ‘Zingaroo’, many other national and international automobile companies
are also planning to manufacture a small bike, which will be a big challenge for the KL in the
near future. To face such competition, it may adopt Kaizen Costing technique. The cost
reductions resulting from Kaizen Costing are much smaller than those achieved with Value
Engineering but are still worth the effort since competitive pressures are likely to force down
the price of ‘Zingaroo’ over time, and any possible cost savings allow KL to still attain its
targeted profit margins while continuing to reduce cost.

C. LIFE CYCLE COSTING

It involves identifying the costs and revenue over a product’s entire life i.e. from inception to
decline, to maximize the profit generated from a product over its total life cycle.
I. Introduction II. Growth III. Maturity IV. Decline

New product, so less Sales increases very Sales increase slowly Demand disappears &
awareness rapidly due to Overcapacity Sales decline
Focus on increasing Focus on maximizing Focus on maximizing Focus on new
product awareness. market share profits while trying to products
maintain market share
Focus on buyers that
by diversification
are most ready to buy.
Competition negligible Competitors enter Intensified Competitors decline
competition
Product refinements Adding features or Competitive pricing Price Cutting
not possible. lowering prices to
Pricing: ‘Penetration’ attract buyers
of ‘Skimming’
No profits exist Profits rising Profits start Profits decline
decreasing
High promotional exp. Same promotional More focus on Low promotional exp.
exp. or slightly higher. distribution.
Product cost is high Product cost reduce Product cost constant Product cost increase
Adnl Note for Maturity Stage: Customers move to other products. So High R&D budgets.
Population growth and replacement demand govern future sales in maturity stage
Q.05. LIFE CYCLE COSTING

Amber Ltd. is a leading company in the Footwear Industry. The company has four factories
in different locations with state of the art equipments. Due to competition in the market,
company is continually reviewing its product range and enhancing its existing products by
developing new models to satisfy the demands of its customers.
The company currently has a production capacity of 3,500 standard hours per week.

Product 'Comfort' was introduced to the market six months ago and is now about to enter the
maturity stage of its life cycle. However, research by the marketing department indicates that
demand of the product 'Comfort' in the market is price sensitive. The likely market responses
are as follows:
Selling price per unit (₹) 1,750 1,600 1,525 1,450 1,300
Sales demand per week (units) 550 725 1,000 1,150 1,200
The variable cost per unit of manufacturing 'Comfort' is ₹750. Standard hours used to
manufacture one unit is 2 hours.
Product 'Sports' was introduced to the market two months ago using a penetration pricing
policy and is now about to enter its growth stage. Each unit has a variable cost of ₹545 and
takes 2.50 standard hours to produce. Market research has indicated that there is a linear
relationship between its selling price and the number of units demanded, of the form P = a -
bx. At a selling price of ₹ 1,000 per unit demand is expected to be 1,000 units per week. For
every ₹ 100 increase in selling price the weekly demand will reduce by 200 units and for
every ₹ 100 decrease in selling price the weekly demand will increase by 200 units.
Product 'Ethnic' is currently being developed and which is about to be launched in the market.
This is a highly innovative designer product which the company believes that it will have a
revolutionary impact on the market and consumer behaviour. The company has decided to
use a market skimming approach to pricing this product during its introduction stage.
Required:
(a) (i) ADVISE which of the above five selling prices should be charged for product
'Comfort', in order to maximize its contribution during its maturity stage.
(ii) CALCULATE the number of units to be produced of product 'Sports' in order to utilize
all of the spare capacity from your answer to (i) above and the selling price per unit of
product 'Sports' during its growth stage.
(b) COMPARE penetration and skimming pricing strategies during the introduction stage,
using product 'Ethnic' to illustrate your answer.
(c) EXPLAIN with reasons, for each of the stages of 'Ethnic's product life cycle, the changes
that would be expected in the (i) average unit production cost (ii) unit selling price
[May 19 Exam (20 Marks)]
SOLUTION:



(b) Price Strategies of Ethnic:
“Ethnic” is given to be a highly innovative product that is about to be launched into the market.
The product with unique features that will differentiate it from other products leading to a
revolutionary impact on market and customer behavior. There seem to be no competitors
providing similar products.
Skimming Price Strategy is adopted to charge high prices in the introduction stage in order
to recover costs. Skimming Price will be suitable for “Ethnic” because:
 Market for the product is not yet established. Initially high promotional expense may have
to be incurred to create customer awareness and build a market for the product.
 Due to its innovative feature, the customers would not mind paying a premium for the unique
product offering. Demand would be inelastic.
 The market demand is unknown. Initial capital outlay to produce this product may be high,
resulting in high cost of production.
 Production and promotional costs in the initial years is likely to be high. Therefore, a higher
selling price would help Amber Ltd. to recover the costs. Since demand is likely to be
inelastic, charging a premium may not be a problem.
 The price can be gradually reduced once the market for the product is established.
Competitors may reverse engineer and offer similar products, due to which price may have
to be lowered in the long run to retain customers.

Penetration Pricing is adopted to charge a low price in the initial stage for penetrating the
market as quickly as possible. For a new product, this low-price strategy will popularize the
product. Once the market is established, the price may be increased. Penetration pricing will
be suitable when:
 Demand for the product is elastic, more demand when prices are low.
 Large scale production of the product yields economies of scale.
 Threat of competition requires prices to be set low. It serves as an entry barrier to
prospective competitors as well.
Product “Ethnic” is an innovative product that the manufacturer believes will change the whole
market once it is launched. A strategy of penetration pricing could be effective in discouraging
potential new entrants to the market. However, the product is believed to be unique and as
such demand is likely to be fairly inelastic. In this instance a policy of penetration pricing could
significantly reduce revenue without a corresponding increase in sales. Thus, this strategy is
not suitable for “Ethnic”.
(c) Ethnic's product life cycle
1. Introduction Stage
As explained in (b) above, at the Introduction Stage of Lifecycle, due to high cost of production
and initial promotion expenditure, the unit cost of production will be high. Using Skimming
Price Policy, the unit selling price will also be high.
2. Growth Stage
Product awareness among customers would result in increased demand. Therefore, scale of
production likely to increase. The new market segment would attract competitors, who are
likely to reverse engineer and offer similar products in the market. Promotional activities and
marketing activities need to continue to maintain and gain market share.
Thus, the unit selling price would reduce from the introduction stage due to following reasons:
 Competitors offering similar product would take away the uniqueness feature of “Ethnic”.
 Again, to gain market share, the unit selling price may have to be lowered to make it
attractive to a larger segment of customers.
The unit cost of production is also likely to reduce due to the following reasons:
 Increased production would result in increased material procurement from suppliers.
 Bulk purchasing discounts can be negotiated with them to lower cost of production.
 Learning curve and experience would enable the labor force to become more efficient. This
leads to higher production with the same level of resources leading to cost savings.
 Large production batches due to increase in scale of work will reduce Variable Oh p.u.
 Economies of scale would result due to Fixed Oh cost spread over larger number of units.
3. Maturity Stage
The third phase of Product Life-Cycle that is characterized by an established market for
“Ethnic”. After rapid growth in sale volume in the previous stages, growth of sales for the
product will saturate. Competition would be high due to large number of rivals in the market,
this may lead to decreasing market share.
It is likely that the price of the product will be lowered further at the maturity stage in a bid to
preserve sales volumes. The company may attempt to preserve sales volumes by employing

an extension strategy rather than reducing the selling price. For example, they may introduce
product add-ons to the market that are compatible with “Ethnic”.
Unit production cost will remain constant
 Direct material cost will remain constant. If procurement is lower than the growth phase, it
might even lead to slightly higher prices since supplier may not extend bulk discounts.
 The benefits of efficient production due to the effect of learning and experience may also
have waned. Therefore, unit labour cost is also likely to remain constant.
 Since scale of production is no longer increasing, the unit variable overhead costs are also
likely to remain constant.
4. Decline Stage
This last stage in the product cycle is characterized by saturated market, declining sales,
change in customer’s tastes etc. Profitability may slowly start decreasing with fall in sales.
At the decline stage, Product “Ethnic” is likely to have been surpassed by more advanced
products in the market and consequently will become obsolete. The company will not want
to incur inventory holding costs for an obsolete product and is likely to sell “Ethnic” at marginal
cost or perhaps lower.
Sales volumes at the decline stage are likely to be low as the product is surpassed by new
exciting products that have been introduced to the market. Furthermore, the workforce may
be less interested in manufacturing a declining product and may be looking to learn new
skills. For both of these reasons, unit production costs are likely to increase in this stage.
Q.06. LIFE CYCLE COSTING

MNP Co. Ltd. makes digital watches. The company is preparing a product life cycle budget
for a new watch. Development on the new watch is to start shortly. Estimates are as under:
Life Cycle Units Manufactured & Sold 2,40,000 Marketing:
Selling Price Per Watch ₹500 Variable Cost Per Batch ₹24
Life Cycle Costs: Fixed Costs ₹8 Lakh
R&D and Design Cost ₹80 Lakh Distribution:
Manufacturing: Variable Cost Per Watch ₹240
Variable Cost Per Watch ₹120 Watches Per Batch 96
Variable Cost Per Batch ₹4,000 Fixed Costs ₹45 Lakh
Watches Per Batch 300 Customer Service Cost Per ₹10
Fixed Costs ₹112 lakh Watch
Required: [May 18 Exam (15 Marks)]
(i) CALCULATE the budgeted life cycle operating income for, the new watch.
(ii) What percentage of the budgeted total product life cycle costs will be incurred by the end
of the R&D and design stage?
(iii)An analysis reveals that 75% of the budgeted total life cycle costs of new watch will be
locked in at the R&D and design stage. What are the implications for managing costs of
the new watch?

SOLUTION:

(iii) Implications of managing cost of new watch:

Approximately 75% of a product’s cost are committed (i.e. decided, no incurred) during the
planning and design stage. At this stage product designers determine the product’s design
and the production process. In contrast, the majority of costs are incurred at the
manufacturing stage, but they have already become locked in at the planning and design
stage and are difficult to alter.
The pattern of cost commitment and incurrence will differ based on the industry and specific
product introduced. For developing a watch, company needs to incur only ₹80 lacs for its
R&D and design Cost. So, Cost Management of company can be most effectively exercised
during the planning and design stage of its new watch and not at the manufacturing stage
when the product design and processes have already been determined and costs have been
committed. At manufacturing stage only cost containment is possible rather than on cost
management. An understanding of life-cycle costs and how they are committed and incurred
at different stages throughout a product’s life cycle of the watch will also led to the emergence
of target costing, that focuses on managing costs during product’s planning & design phase.
D. PARETO ANALYSIS (80:20 Rule)

 In Product Pricing: Approximately 80% of total sales revenue comes from 20% of
products. Thus, delegate pricing decision for these 80% less imp. products to lower mgmt.

 In Customer Profitability Analysis: Approximately 20% of customers generate 80% of

the profits.
 In ABC Analysis- Stock Control: Approximately 20% of the total quantity of stock may
account for about 80% of its value. Thus we must concentrate on this small quantity (20%)
of stock which are more valuable.
 In Activity Based Costing: 20% of an organization’s cost drivers are responsible for 80%
of the total cost. Thus, controlling these cost drivers is imp.
 In Quality Control: 80% of reported problems can usually be traced to 20% of the causes.
Thus we must concentrate on rectifying these 20% causes.
STEPS FOR PARETO ANALYSIS PRACTICAL QUESTIONS:

(1) Identify the Factor based on which Pareto Analysis needs to be done (i.e. Sales, Profit,
Contribution, Cost, etc).
(2) Arrange items in decreasing order of the factor value.
(3) Find Total Value of the Factor and 80% of that Total Value.
(4) Add the values from top until addition reaches this 80% of Total Value.
Q.07. PARETO ANALYSIS

Generation 2050 Technologies Ltd. develops cutting-edge innovations that are powering the
next revolution in mobility and has nine tablet smart phone models currently in the market
whose previous year financial data is given below:
Model Sales (Rs ’000) Profit-Volume (PV) Ratio
Tab - A001 5,100 3.53%
Tab - B002 3,000 23.00%
Tab - C003 2,100 14.29%
Tab - D004 1,800 14.17%
Tab - E005 1,050 41.43%
Tab - F006 750 26.00%
Tab - G007 450 26.67%
Tab - H008 225 6.67%
Tab - I009 75 60.00%
Required
(a) Using the financial data, carry out a Pareto Analysis (80/20 rule) of Sales and Contribution.
(b) DISCUSS your findings with appropriate Recommendations.
SOLUTION: “Pareto Analysis”

Model Sales % of Cumulative Model Cont. % of Cumulative

(Rs’000) Total Total (Rs’000) Total Total %
Sales Cont.
Pareto Analysis Sales Pareto Analysis Contribution
A001 5,100 35.05% 35.05% B002 690 30.87% 30.87%
B002 3,000 20.62% 55.67% E005 435 19.47%* 50.34%
C003 2,100 14.43% 70.10% C003 300 13.42% 63.76%
D004 1,800 12.37% 82.47% D004 255 11.41% 75.17%
E005 1,050 7.22% 89.69% F006 195 8.73%* 83.90%
F006 750 5.15% 94.84% A001 180 8.05% 91.95%
G007 450 3.09% 97.93% G007 120 5.37% 97.32%
H008 225 1.55% 99.48% I009 45 2.01% 99.33%
I009 75 0.52% 100.00% H008 15 0.67% 100.00%
14,550 100.00% 2,235 100.00%
Recommendations
Pareto Analysis is a rule that recommends focus on most important aspects of the decision
making in order to simplify the process of decision making. The very purpose of this analysis
is to direct attention and efforts of management to the product or area where best returns can
be achieved by taking appropriate actions.
Pareto Analysis is based on the 80/20 rule which implies that 20% of the products account
for 80% of the revenue. But this is not the fixed percentage rule; in general sense it means
that a few of the products, goods or customers may make up most of the value for the firm.
In present case, five models namely A001, B002, C003, D004 account for 80% of total sales
where as 80% of the company’s contribution is derived from models B002, E005, C003, D004
and F006.
Models B002 and E005 together account for 50.34% of total contribution but having only
27.84% share in total sales. So, these two models are the key models and should be the top
priority of management. Both C003 and D004 are among the models giving 80% of total
contribution as well as 80% of total sales so; they can also be clubbed with B002 and E005
as key models. Management of the company should allocate maximum resources to these
four models.
Model F006 features among the models giving 80%of total contribution with relatively lower
share in total sales. Management should focus on its promotional activities.
Model A001 accounts for 35.05% of total sales with only 8.05% share in total contribution.
Company should review its pricing structure to enhance its contribution.
Models G007, H008 and I009 have lower share in both total sales as well as contribution.
Company can delegate the pricing decision of these models to the lower levels of
management, thus freeing themselves to focus on the pricing decisions for key models.

Q.08. PARETO ANALYSIS

The information given below pertains to ABC Enterprises, a specialized car garage door
installation company. ABC Enterprises use to get multiple service calls from the customers
with variety of requirements. They may have to Install, Replace, Adjust or Lubricate some
part or other to make the door functional. They work with 5 parts as given in the table, namely
Door, Motor, Track, Trimmer and T -Lock.
Type of Service
Parts Install Replace Adjust Lube Total
1 Door 2 5 1 0 8
2 Motor 3 2 16 9 30
3 Track 5 0 6 6 17
4 Trimmer 14 6 0 0 20
5 T-Lock 5 0 1 0 6
6 Miscellaneous 0 2 1 1 4
Total 29 15 25 16 85
Required
(i) Using the above data, carry out a Pareto Analysis (80/20 rule) of Total Parts.
(ii) Using the same data carry out the second level Pareto Analysis on the type of services
with respect to Motors only.
(iii)Give your RECOMMENDATIONS on the basis of your calculations in (i) and (ii) above.
SOLUTION:
(i) Statement Showing “Pareto Analysis of Total Parts”
Parts No. of Items % of Total Items Cumulative Total
Motor 30 35.29 35.29%
Trimmer 20 23.53 58.82%
Track 17 20.00 78.82%
Door 8 9.41 88.23%
T-Lock 6 7.06 95.29%
Miscellaneous 4 4.71 100.00%
(ii) Statement Showing “Pareto Analysis of Type of Services (Motor)”
Type of Services No. of Items % of Total Items Cumulative Total
Adjust 16 53.33 53.33%
Lube 9 30.00 83.33%
Install 3 10.00 93.33%

Replace 2 6.67 100.00%

30
(iii) Recommendations:
Pareto Analysis is a rule that recommends focus on most important aspects of the decision
making in order to simplify the process of decision making. The very purpose of this analysis
is to direct attention and efforts of management to the product area where best returns can
be achieved by taking appropriate actions.
Pareto Analysis is based on the 80/20 rule which implies that 20% of the products account
for 80% of the revenue. But this is not the fixed percentage rule. In general business sense,
it means that a few of the products, goods or customers may make up most of the value for
the firm.
The present case stands in a difference to 80/20 rule. Because the company installs doors,
they sometimes have multiple service calls to install each door piece by piece. They may
have to install, replace, adjust, or lubricate some part to get the door working properly. They
work with five main parts: door, motor, track, trimmer and t- lock. The service calls with
reference to motors are heavy and accounted for as much as 35.29% of the number of calls
attended. Motor together with trimmer accounted for 58.82%. So, these two parts are to be
considered as key parts and ABC enterprises must be ever ready to cater to all provisional
requirements for attending these classes without any inordinate delay. Any delay in service
these calls is likely to damage its service rendering reputation within a very short span of
time. Further, the second level Pareto Analysis on motors has revealed a particular reference
to the service problems related to motors. Adjustments and Lubrication issues cover up
83.33% of the total service problems exclusively connected to Motors. So, ABC Enterprise
must direct its best efforts and develop specific expertise to solve these problems in the best
interest of the customers.
E. ENVIRONMENT MANAGEMENT ACCOUNTING (EMA)

EMA identifies and estimates the costs of environment-related activities and seeks to control
these costs by environmental decision making.
For practical questions of EMA, we need to identify environmental costs by ABC method.
ENVIRONMENTAL INFORMATION
Physical Environmental Information includes the physical flow of energy, water, material etc.
Monetary Environmental Information accounts for environmental costs
ENVIRONMENTAL COST
1 – Generic Classification:

 Internal Environmental Costs: Incurred out  External Environmental Costs: Imposed on

of pocket, impacts income statement. society at large, but not borne by the company.
If organisation incurs a reasonable amount of internal environmental cost then the external
adverse impact will be less.
2 – US-EPA Classification:
 Conventional Costs: Resources used  Contingent Costs:
 Potentially Hidden Costs: Hidden in OHs.  Relationship & Corporate Image Costs:
3 – Hansen and Mendoza Classification:
Each category of cost must be expressed as a percentage of sales revenues or operating
costs so that comparisons can be made. Categories are:
 Prevention Costs: Eg pollution control  Appraisal Costs: Eg Monitoring & testing
 Internal Failure Costs: i.e. Costs of  External Failure Costs: i.e. activities
activities that have been produced but not performed after discharging waste into the
discharged. Eg Disposing toxic material. environment. Eg Cleaning the contamination
4 – The UNDSD Classification:
 Cost to protect environment  Costs of Waste
IDENTIFICATION & MEASUREMENT OF ENVIRONMENTAL COSTS

1. Input-Output Analysis:
2. Flow Cost Accounting: It involves keeping a track of material flows and losses occurring
at various stages of production. Costs are identified under 3 main categories: (1) Materials
involved in various processes, (2) System – in house handling costs & (3) Delivery &
disposal – i.e. flows leaving the company, eg transport cost.
3. Life Cycle Costing: Consider full environment costs over the entire life of the product.
4. Activity Based Costing (ABC): Allocate environment cost based on activities.
Q.09. EMA
Excel Ltd. is the leading manufacturer and exporter of high quality leather products - Product
A and Product B. Selling price per unit of Product A and Product B is ₹620 and ₹420
respectively. Both the products pass through three processes - Tanning, Dyeing and
Finishing during manufacturing process. Allocation of costs per unit of leather products
manufactured among the processes are given below:
Particulars Tanning Dyeing Finishing Total
Direct Materials per unit 140 180 140 460
Direct Labour per unit 90 120 90 300
Cost allocation to Product A 70% 50% 70%
Cost allocation to Product B 30% 50% 30%

General overheads per unit of leather products manufactured are ₹230 which is allocated
equally between Product A and Product B. Above cost allocation is the basis for the decisions
regarding pricing of the products.
In this Industry, all the major production processes have environmental impact at all stages
of the process, including generation of waste, emission of harmful gases, noise pollution,
water contamination etc.
The management of the company is worried about the above environmental impact and has
taken initiative to preserve the environment like - research and development activities aimed
at reducing pollution level, planting trees, treatment of harmful gases and airborne emissions,
wastewater treatment etc.
The management of the company desires to adopt Environmental Management Accounting
as a part of strategic decision making process. Pricing of products should also factor in
environmental cost generated by each product.
General overheads per unit of leather products manufactured are ₹230 which includes:
Treatment cost of harmful gases ₹ 80
Wastewater treatment cost ₹100
Cost of planting of trees ₹ 20
Process wise information related to generation of wastewater and harmful gases is as below:
Tanning Dyeing Finishing Total
Wastewater generated (litres per week) 900 600 0 1,500
Emission of harmful gases (cc per week) 400 300 100 800
Cost allocation to Product A 70% 50% 70%
Cost allocation to Product B 30% 50% 30%
The remaining overheads cost and cost of planting trees can be allocated equally between
Product A and Product B. Required:
(a) Product wise profitability based on the original cost allocation.
(b) Product wise profitability based on activity based costing (Environment driven costs).
(c) ANALYZE the difference in product profitability as per both the methods.
[Nov 18 RTP, May 19 Exam (9 Marks)]
SOLUTION:

Thus we see that in Part (a), Environmental Oh are hidden iniside General Oh. In Part (b),
when Environmental Oh are recognised as a separate activity, then we realize that Product
A has high amount of Environmental Costs because of which eventually Product A turns out

to be less profitable than Product B. If company continues to allocate Oh Equally, they will
focus more on selling Product because if ‘appears’ to be more profitable. However, in reality,
it is less profitable than B. This, we realize only when we follow ABC method.
CASE STUDY – 2: EMA:

Shandaar Bangle Ltd (SBL) have been recognized as a manufacturers and exporters of high
quality Bangles, designed and manufactured using optimum quality raw material, sourced
from trustworthy vendors of the market.
Manufacturing Process
The process of manufacture of glass bangles is highly skilled labour oriented one comprising
of the following main operations:
Glass Melting Phase → Parison Making Phase → Spiral/Coil Forming Phase
In first phase, glass batch materials like sand, soda ash, lime stone feldspar, borax etc. with
other additives and colouring materials in a suitable proportion are mixed manually and fed
into the pot places in pot furnace. The raw material is melted in the furnace at a temperature
of about 1300 – 1400 (°C) to obtain molten glass.
In second phase, molten glass is drawn from the pot of the furnace with the help of the iron
pipe and formed into gob to gather required quantity of glass for formation into parisons on
iron plates. The parisons of different colours are joined together and reheated in an auxiliary
furnace to obtain required designs.
In third phase, the reheated parison is then transferred to ‘Belan Furnace’ from which the
glass is further drawn into spiral/ coil of bangles on the spindle counted and rotated manually
at uniform rate of revaluation synchronizing with the manually at the other end of the furnace.
Spiral are then taken out from the spindle and cut with the help of a pencil cutter to separate
out the single pieces of bangles from spiral. These cut or un-joined bangles are then sent for
joining of end, finishing cutting & polishing, decoration etc. The finished products are then
neatly packed for sale.
Environmental Impact
But unfortunately, these processes have environmental impact at all stages of the process,
including emissions of airborne pollution in the form of ashes, gases, noise and vibration.
Conditions of the Workplace
Due to limitations of maintaining appropriate temperature for melting and moulding of the
glass, furnaces are kept burning. Therefore, workers have to work with such working
conditions continuously without proper leisure time.
The above-mentioned factors become more harmful while working in immense heat and
sound which is normally higher than permissible levels.
Health Impact
A recent study has revealed adverse impact of pollution over workers and people who are
living in nearby area.
Management Initiatives

The management of company is worried about environmental impact and health impact and
has taken certain initiatives in taking care of environment like- batch house cyclonic dust
collector, noise absorbing device, natural gas fired furnace, better refractory materials,
training for waste minimization, treatment of solid waste, research and development activities
aimed at reducing pollution level, planting trees, treatment of nitrogen oxide and other harmful
gases.
Required
Management desires to adopt environmental management accounting as a part of strategic
decision making process.
(i) EXPLAIN the requirement to have environmental management accounting and
IDENTIFY the SBL’s environmental prevention, appraisal, and failure costs.
(ii) ANALYZE the appropriateness of SBL incorporating the following in implementing
Environmental Management Accounting:
 Activity Based Costing
 Life Cycle Costing
 Input Output Analysis
(iii) EXPLAIN the need of non-financial consideration in decision making and suggest safety
measures that can be taken into consideration for workers.
SOLUTION:
Environmental management accounting (EMA) is the generation and analysis of both
financial and non-financial information in order to support internal environmental
management processes i.e. identification, prioritization, quantification and recording of
environmental cost into business decision.
By adopting EMA, SBL will have following benefits:
 Product Pricing.
 Budgeting.
 Investment Appraisal.
 Calculating Investing Options.
 Designing, Calculating Costs, Savings and Benefits of Environment Projects.
 Setting Quantified Performance Targets.
 Assessment of Annual Environmental Costs.
 Environmental Performance Evaluation, Indicators and Benchmarking.
 External Reporting- Disclosure of Environmental Expenditures, Investments and
Liabilities.
Environmental Costs of SBL
 Environmental Prevention Cost: These costs are basically incurred in relation to activities
undertaken to prevent the production of waste that could harm the environment.

Company’s efforts to minimize the effect of its activities on the environment like installing
batch house cyclonic dust collector, natural gas fired furnace, better refractory materials,
training for waste minimization, research and development activities, noise absorbing
device and planting trees can be classified as Environmental Preventive Cost.
 Environmental Appraisal Costs: It means costs incurred in relation to activities undertaken
to determine whether product processes and other activities within firm are complying with
environment standards.
SBL may perform ‘Contamination Test’ to observe the environment compatibility of its
processes can be categorized under environmental appraisal cost.
 Environmental Failure Cost: It means cost incurred in relation to activities dealing with
pollution arising from the activities of entity includes costs related to treatment harmful
gases and treatment of solid waste.
Appropriateness of Techniques for Identification and Allocation
Activity Based Costing
This costing technique would help the SBL to separate environmental costs from the general
overheads and allocate them to glass bangles by identifying appropriate drivers of these
environmental cost. Possible activities for environmental costs and their drivers are:
Activity Cost Drivers
Planting of trees Number of trees planted
Solid waste removal Volume of such waste
Research and development activities Man hours worked for such activities
Treatment of nitrogen oxide (in the same way, Volume of nitrogen oxide treated
activity and related cost driver for other gases
would be determined)
Life Cycle Costing
By using this costing in EMA, SBL would be able to identify, record and control the
environmental costs relating to various stages in the life of glass bangles. At each of following
stage environmental cost would be incurred:
 In raw material stage, some natural product would be purchased.
 In manufacturing stage, emission and treatment of nitrogen oxide & other gases and
treatment of solid waste.
 In marketing and distribution stage, environmental cost relating to transportation of glass
bangles to various customers.
Input /Output Analysis
Here detail analysis of input and output of a system is done for the purpose of assessment
of ecological wellbeing of entity’s products, processes and other activities. This technique is
based on the fact that whatever goes into the system has to come out of it.

In case of SBL, it can evaluate the volume of sand, soda ash, lime stone feldspar, borax etc.
and the resulting volume of output i.e. glass bangles. This would enable SBL to allocate and
analyses environmental cost attributable to input and output of glass bangles.
Non-Financial Considerations
Entities generally give emphasis on financial measures such as earnings and accounting
returns but little emphasis on drivers of value such as customer and employee satisfaction,
innovation and quality. Due to which mostly companies could not continue in long term. So
for the purpose of achieving long-term organizational strategies, non-financial consideration
should be taken into account. Without this it may be that company achieve short term goal
but would be difficult to achieve long term goal.
In SBL, it can be clearly seen that there is great impact on health of workers. By creating a
safe and healthy environment for employees, SBL can improve productivity, business
performance, staff morale and employee engagement. Further, SBL will also be able to
reduce – accidents/ work related ill health/ sick pay costs as well as insurance costs. A
healthy workforce can demonstrate corporate responsibility. If SBL look after employees,
business is likely to have a more positive public image.
To create safe and healthy environment following measures can be taken into consideration:
 Safety monitoring system.
 Workers must be trained.
 Recruitment of more workers.
 First aid kit should be available.
 Protective glasses, clothes, gloves should be provided.
Regular health check-up camps and awareness programs.


CH – 05 DEC ISION MAK ING
CHAPTER
DECISION MAKING
05
CHAPTER SUMMARY (PRACTICALS)
A. CVP ANALYSIS
BASIC FORMULAE:
1. To find Output (units) required to earn a target To find Sales (₹) required to earn a target
𝑂 𝑆𝑎𝑙𝑒𝑠
profit: profit:
𝑈𝑛𝑖𝑡𝑠 . . ₹ / %
So whenever we want the answer in Units → then divide “per unit rate” & whenever we
want the answer in ₹ → then divide “percentage (%) rate”
2. 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 % 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
3. Break Even Point (BEP): Margin of Safety (MoS):

→ Level of Sale at which profit = 0 → Level of Total Sale above the BEP
→ At BEP, Total Contribution = FC → During MoS, FC = 0. ∴ Total Contri = Profit
𝐵𝐸𝑃 𝐹𝐶 𝑀𝑜𝑆 𝑃𝑟𝑜𝑓𝑖𝑡
𝑈𝑛𝑖𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝. 𝑢. 𝑈𝑛𝑖𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝. 𝑢.
𝐵𝐸𝑃 𝐹𝐶 𝑀𝑜𝑆 𝑃𝑟𝑜𝑓𝑖𝑡
₹ 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 % ₹ 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 %
𝐵𝐸𝑃 𝐵𝐸𝑃 𝑀𝑜𝑆 𝑀𝑜𝑆
100 100
% 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 % 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
𝐹𝐶 𝑃𝑟𝑜𝑓𝑖𝑡
100 100
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
CVP ANALYISIS GENERAL NOTES:

4. Whenever we need to calculate profit for a given sales, and BEP is already known, then
profit can be calculated by short-cut method – i.e. for the sales above BEP, any
contribution earned, itself becomes profit.
5. While applying High – Low method, if the FC changes, then High – Low method is not
applicable, we need to reverse the effect of FC change in the Total Cost, then apply High
– Low method. Then later, the FC change can be reapplied. (Refer Q ____)

6. P/V Ratio % changes only if SP p.u. or VC p.u. changes, it does not change because of
change in units.
7. With the increase in sales units, BEP (Units) & BEP (Rs) remains same, but BEP (%)
keeps changing.
8. If Elasticity of Demand is given as unity (i.e. ‘1’), the it means that with the increase in SP,
Units decrease to an extent such that Total Sale Value remains same.
MULTI-PRODUCT BEP (Ratio Method):

9. When the company has multiple products, each having different contribution p.u., but the
fix costs incurred in the company is ‘Common Fix Costs’ for all products, then the BEP
depends on ‘which product is sold’. That, in turn depends on the ratio of past sales
experience given in the question. Thus, in such case, BEP cannot be calculated unless
such ratio of sales is given in the question.
10. If the ratio given is ratio of Sales Units, then start calculation by assuming no. of Sales
Units equal to the ratio given.
11. If the ratio given is ratio of Sales Rs, then start calculation by assuming value of Sales Rs
equal to the ratio given.
12. If there is shortage of available units in any one category, then 1st calculate the
contribution lost due to the shortage, then recover that lost contribution by selling units of
another available category. (Refer Q ___)
BEP WITH OPENING STOCK (Step-Wise Method):

13. FC is 1st recovered from the units which are sold 1st (depending on FIFO / LIFO / WAM).
Then the remaining FC is recovered from the units which are sold next. Thus, FC is
recovered Step-Wise. (Refer Q ___)
THUS, COMPARISON:
14.Multi – Product BEP (i.e. Ratio Method) BEP With Opening Stock (i.e. Step-Wise Method)
→ There is more than 1 Contribution → There is more than 1 Contribution p.u., but FC
p.u., but FC is Common. is Common.
→ All these Contribution p.u. are → All these Contribution p.u. are earned one –
earned together (at same time) after – another (Step Wise)
→ ∴ Ratio of sale must be given. → ∴ Ratio is not needed.
→ ∴ Ratio Method is followed (Q___) → ∴ Step-Wise Method is followed (Q___)
→ Eg: Multi-Product BEP, BEP with → Eg: BEP with Opening Stock under FIFO /
Opening Stock under WAM LIFO, BEP when initial units are sold at discount,
etc

Q.01. RATIO METHOD – MULTI-PRODUCT BEP

S Ltd. manufactures three products X, Y and Z. The unit selling prices of these products are
Rs 50, Rs. 30 and Rs 20 respectively. The corresponding Variable Cost to Sales Ratio is
20%, 30% and 50%. The total fixed costs are Rs 59,83,000.
Required: Calculate Overall BEP, Product-wise BEP & Overall P/V Ratio assuming:
A. the proportion (Quantity wise) in which these products are manufactured and sold are
20%, 30% and 50% respectively
B. the proportion (Value wise) in which these products are manufactured and sold are 20%,
30% and 50% respectively.
SOLUTION: (A) If Ratio of Quantity is given:

(B) If Ratio of Value is given:
Q.02. STEP-WISE METHOD – BEP WITH OPG STOCK

A Pharmaceutical company produces formulations having a shelf life of one year. The
company has an opening stock of 30,000 boxes on 1st January, 2005 and expected to
produce 1,30,000 boxes as was in the just ended year of 2004. Expected sale would be
1,50,000 boxes. Costing department has worked out escalation in cost by 25% on variable
cost and 10% on fixed cost. Fixed cost for the year 2004 is Rs 40 per unit. New price
announced for 2005 is Rs 100 per box. Variable cost on opening stock is Rs 40 per box. You
are required to compute breakeven volume for the year 2005.
SOLUTION:

EXTRA QUESTION: SOLVE ABOVE Q AGAIN IF LIFO METHOD IS FOLLOWED BY CO.
EXTRA QUESTION: SOLVE ABOVE Q AGAIN IF WAM IS FOLLOWED BY CO.

Q.03. RATIO METHOD OF BEP

Entertain U Ltd. hires an air-conditioned theatre to stage plays on weekend evenings. One
play is staged per evening. The following are the seating arrangements:
VIP rows - the first 3 rows of 30 seats per row, priced at Rs.320 per seat.
Middle level - the next 18 rows of 20 seats per row, priced at Rs.220 per seat.
Last level - 6 rows of 30 seats per row, priced at Rs.120 per seat.
For each evening a drama troupe has to be hired at Rs.71,000, rent has to be paid for the
theatre at Rs.14,000 per evening and air conditioning and other stage arrangements charges
work out to Rs.7,400 per evening. Every time a play is staged, the drama troupe’s friends
and guests occupy the first row of the VIP class, free of charge due to passes granted them.
The troupe ensures that 50% of the remaining seats of the VIP class and 50% of the seats
of the other two classes are sold to outsiders in advance and the money is passed on to
Entertain U. The troupe also finds for every evening, a sponsor who puts up his advertisement
banner near the stage and pays Entertain U a sum of Rs 9,000 per evening.
Entertain U supplies snacks during the interval free of charge to all the guests in the hall,
including the VIP free guests. The snacks cost Entertain U Rs 20 per person. Entertain U
sells the remaining tickets and observes that for every 1 seat demanded from the last level,
there are 3 seats demanded from the middle level and 1 seat demanded from the VIP level.
You may assume that in case any level is filled, the visitor buys the next higher or lower level,
subject to availability.
(a) You are required to calculate the number of seats that Entertain U has to sell in order to
break-even and give the category wise total seat occupancy at BEP.
(b) Instead of the given pattern of demand, if Entertain U finds that the demand for VIP, Middle
and Last level is in the ratio 2:2:5, how many seats each category will Entertain U have to
sell in order to break-even.?
SOLUTION:


Notes:
1. BEP is the level of sales required to recover Fixed Costs. However, if any Fixed Income
is given, then it must be deducted from Fixed Cost because now only the remaining Fixed
Cost needs to be recovered from the Sales
2. Snacks provided to the VIP guests for free is considered as fixed cost because it does not
depend on the number of seats we sell. These seats are given free, so they will definitely
be occupied and we will definitely incur snacks cost on them. Thus it is fixed cost.
3. There is no Opportunity Cost on the VIP seats given for free because there is no Other
Opportunity. Opportunity Cost exists if there is another opportunity in which this income
can be earned. However in this question, there is no other opportunity, the VIP seats must
be given free in any case, hence no Opportunity Cost.
4. If BEP units required indicates shortage of available seats in any category, this will lead
to shortage of contribution to be collected. This shortage of contribution must then be
recovered by doing extra sale in another category where seats are available (middle level)
A. CVP ANALYSIS
MERGED PLANT BEP:
15. If plant capacities are merged, then to find BEP of the merged plant, 1st find the basic data
of the merged plant (like Contirbution p.u. & P/V Ratio). To do this, 1st convert all individual
plants into 100% capacity then add their data to get data of merged plant.
INDIFFERENCE POINT (IDP):

, . .
16. 𝐼𝐷𝑃
. .
17. Rule for selection: if usage is more than IDP, only then, choose the option with higher FC.
(Higher FC is affordable only if usage is more than IDP)
18. If there are 3 options, 1st arrange all options in increasing order of FC. Then calculate FC
only between adjacent options. i.e. option 1 & 2; then option 2 & 3. Don’t calculate IDP
between Option 1 & 3 unless specifically asked.
Q.04. INDIFFERENCE POINT

A Practicing CA now spends Rs.0.90 per km. On taxi fares for his clients work. He is
considering two other alternatives, the purchase of a new small car or an old bigger car.
Items New Small Car (Rs) Old Bigger Car (Rs)

Purchase Price 35,000 20,000

Sales Price, after 5 years 19,000 12,000
Repairs and Servicing, per annum 1,000 1,200
Taxes and Insurance, per annum 1,700 700
Mileage per litre 10 Kms 7 kms
Petrol Price, per litre 3.50 3.50
He estimates that he travels 10,000 km annually, which of the three alternatives will be
cheapest? If his practice expands and has to do 19,000 km. Per annum, what should be his
decision? At how many km. per annum will the cost of the two cars break-even?
SOLUTION:
Note: Here the IDP between Taxi and New Small Car (10,727 Kms) is of no use at all. This
IDP will be useful only if middle option of Old Big Car does not exist.

A. CVP ANALYSIS
BEP WITH SVC (BATCH LEVEL COST):
19. [Method – 2] Consider SVC as VC and convert it to SVC p.u. Now Calculate Contribution
p.u. using this SVC p.u. Then calculate BEP with the Contribution. This BEP is
approximate BEP (i.e. Minimum BEP). The correct BEP will definitely come above this
BEP.
20. Now consider SVC as FC and find BEP by trying batches above this BEP. (Trial & Error
method) [Refer Q ___]
21. Similarly, follow such trial & error methods whenever any factor of BEP is changing. (i.e.
SP changes, or VC changes, or FC changes)
Q.05. BEP WITH SEMI-VARIABLE COST (BATCH COST)

Calculate Break-Even-Point for a train journey between Delhi and Jaipur where cost of an
Engine is Rs. 80,000 and of Bogie is Rs. 16,000. Capacity of a bogie is 70 passengers and
each ticket is priced at Rs.600. Variable Cost per ticket is Rs.100.
SOLUTION: SP = ₹600 p.u.; VC = ₹100 p.u.; FC = ₹80,000;
SVC = ₹16,000/Bogie; Bogie Size = 70 Passengers.

Q.06. CVP WITH ABC

A company manufactures cycles for both adults and children. Given below is information
about cycles made for children–
Particulars Traditional Method ABC Method
Monthly Demand and Production 10,000 units 10,000 units
Selling Price ₹8,000 per unit ₹8,000 per unit
Variable Cost per unit ₹7,500 per unit ₹7,500 per unit
Fixed Cost p.m. (as identified under each cost system) ₹10,00,000 p.m. ₹8,00,000 p.m.
Fixed costs of ₹10,00,000 per month under Traditional CVP analysis are those that do not
vary with respect to volume. Following an Activity Based Costing study, fixed cost that do not
vary as per volume or any other cost driver has been identified to be ₹8,00,000 per month.
The study revealed a milling machine is used to cut metal into steer support. Production of
these steer support takes place in batches of 25 units. Once a batch for children’s cycle is
finished, the next batch would be that for adult cycles. Therefore, after each batch there would
be a set-up change. If 10,000 children’s cycles have to be produced, number of set-ups
required = 10,000 steer support / 25 per batch = 400 set-ups. Each set-up costs ₹500,
comprising of material costs like change of oil, jig etc. This cost was previously pooled
together with fixed cost under traditional CVP analysis.
(i) FIND the break-even point per month and profit per month under the traditional CVP
method and the Activity Based CVP method.
(ii) As a plant manager, you would like to keep the number of set-ups minimum since they
reduce the capacity of the machine. Suppose that at any time the milling machine can be
used to produce other type of cycles like adult cycles, sports cycles etc. Therefore, you
propose to increase the batch size of children’s steer support to 50 units in one batch.
The number of set-ups will reduce from 400 (10,000 units / 25 units) to 200 (10,000 units

/ 50 units). Due to larger batch production, additional inventory storage area would be
required to store that will cost the company ₹50,000 per month extra. ANALYSE the
impact on BEP (units per month) and profits per month.
(iii)When should labour cost be factored into the calculation of cost of a set-up? Explain.
(iv)How can number of set-ups and set-up cost impact flexibility of the milling machine?
SOLUTION: (i) Profit per month & BEP:
Traditional Method:
→ SP p.u. 8,000 → BEP =
. . .
(-) VC p.u. (7,500) ₹ , ,
=
₹ . .
∴ Contri p.u. 500
= 2,000 Units
(×) Total Units 10,000
∴ Total Contri. 50,00,000
(-) FC (10,00,000)
∴ Profit 40,00,000
ABC Method:
→ SP p.u. 8,000 → BEP =
. . .
(-) VC p.u. (7,500) ₹ , , ₹ , ,
=
∴ Contri p.u. 500 ₹ . .
(×) Total Units 10,000 = 2,000 Units

(-) FC – Others (8,00,000)
(-) FC – Milling Machine (2,00,000)
[₹500/Setup × 400 Setups]
∴ Profit 40,00,000
Although, the BEP units and the profit per month are same under both methods, ABC method
has brought forth the point that there are 400 set-ups being performed per month. This would
give the management more information to work with in order to improve operations.
(ii) BEP (units per month) and profit per month under Activity Based CVP analysis: Batch
size increased from 25 to 50 units, monthly set-ups reduce from 400 to 200 per month.
→ SP p.u. 8,000 → BEP =
. . .
(-) VC p.u. (7,500) ₹ , , ₹ , ,
=
₹ . .
∴ Contri p.u. 500
(×) Total Units 10,000 = 1,900 Units

(-) FC – Others (8,00,000)

(-) FC – Addnl storage (50,000)

(-) FC – Milling Machine (1,00,000)
[₹500/Setup × 200 Setups]
∴ Profit 40,50,000
Analysis: Thus, by increasing the batch-size, the capacity of the machine can be increased.
The time freed by reducing set-ups from 400 per month to 200 per month can now be used
to produce parts for other cycles. Since the number of set-ups would reduce, so will the
monthly set-up costs. Even after off-setting the increase in storage cost, profits have
increased by ₹50,000 per month (₹40,50,000 - ₹40,00,000 per month). Consequently, break-
even point has reduced from 2,000 units per month to 1,900 units per month. This reduction
is due to the savings in the overall set-up costs due to lower number of set-ups.
(iii) Inclusion of labor cost in the cost of set-up would depend on their availability:
 Cost of temporary labour hired for particular set-up or cost of outsourcing of set-up
activities would be included in set-up costs.
 Cost of permanent labour used for set-up, who are otherwise idle would not be included
in set-up costs since the salaries paid to them has to be incurred anyway, it is a sunk cost.
 However, where permanent labour is used for set-up, who are otherwise fully engaged in
the production process and additional labour supplies are unavailable in the short term,
the opportunity cost of labour needs to be considered.
(iv) Set-ups reduces the production utility of a machine. Lower number of set-ups or lower
set-up time can improve the utilization of the machine. This also gives the company flexibility
to keep changing the batches produced at the milling machine to cater to children’s cycles
and adult cycles as per its requirement. The other factor that impacts flexibility of production
would be the set-up costs. Lower the set-up costs, higher the flexibility to change batches
produced at the milling machine to cater to each type of cycle.
B. RELEVANT COSTING
MEANING:
1. Means expected future costs that differ under different alternatives. All variable costs need
not be relevant, and all fixed costs need not be irrelevant.
2. Sunk Cost: = Cost which is already incurred, Not Relevant for decision making.
3. Opportunity Cost: = Income of next best option that is sacrificed. It is Relevant for
decision making. However, Opportunity Cost exists only if another opportunity is given in
the question, and that opportunity is sacrificed.

RC FOR MATERIALS:
4. Not in stock, specially purchased: = Current Purchase Price
5. In stock, regular in use: = Current Purchase Price + Contri. Lost (if any)
6. In Stock, not in regular use (Eg: Obsolete = Opportunity Cost (OC) = NRV
Material)
7. If Obsolete Mat. as above has any other = Opportunity Cost (OC)
alternative use. = NRV or Net Savings of that alternative use
(whichever is higher)
8. If Obsolete Mat. as above has any = OC of Obsolete Mat. or Total Cost of
substitute available Substitute
(whichever is lower)
RC FOR LABOUR (CASUAL LABOUR, i.e. VARIABLE COST):

9. If available in abundant = Labour Cost Paid
10. If in short supply = Labour Cost Paid + Contri. Lost
RC FOR LABOUR (PERMANENT LABOUR, i.e. FIXED COST):
11. If sitting idle = Nil
12. If Busy = Only Contri. Lost
13. If nothing is mentioned, then assume Labour is Variable Cost (i.e. Casual Labour)
RC FOR OVERHEADS:
14. If Variable Oh are based on labour, then it must be considered even on permanent labour.
15. If Fix Oh absorption rate is given in the question, then ignore this rate, as Fix Oh is relevant
only if the total increases due to the new offer.
16. Any Fix Cost is Relevant only to the extent it is Avoidable.
17. If a dept. is working at full capacity and this dept. is required for new offer, then Relevant
Cost will be VC + Contribution Lost (Both).
RC FOR MACHINE:
18. = Value now – Value after use
19. If not in use, in stock = Sale Value Before – Sale Value After use
20. If Purchased new, and then no other use = Current Purchase Cost – Sale Value After
after this new offer use
21. If Purchased new, and then transfer to = Current Purchase Cost – Cost after use.
other existing business.

GENERAL RULES:
22. Identify all relevant costs on total basis as far as possible.
23. Relevant Cost is always identified for company as a whole, not department-wise. So if the
new offer gives contribution lost in any other department, then it must also be considered.
24. ‘Replacement Cost’ = Current Purchase Cost
25. In case of question based on bankruptcy, then for deciding price for new customer, we
shall charge the following items:
(1) Cost of Completion (if required),
(2) Cost of Modifications (if new customer requests), &
(3) Opportunity cost of materials & parts already used in it (i.e. Scrap Value or Savings of
Alternate use)
VARIANCE RECONCILIATION BY RELEVANT COSTING METHOD:

26. 1ST present Variance Reconciliation by Marginal Costing Method (Refer Chapter 12).
27. Now identify the key factor (Material or Labour) and if this key factor Quantity is wasted,
then identify contribution lost due this wastage of key factor Quantity.
28. This contribution lost is the variance that must be removed from CMVV and added to the
respective key factor Quantity variance (Eg MUV or LTV).
29. Write analysis that why are we shifting contribution lost. That’s it. 😊


Q.07. RELEVANT COSTING

Mahlla Griha Udyog Industries is considering to supply its products-a special range of
namkeens to a departmental store. The contract will last for 50 weeks, and the details are:
Rs.
Material: X (in stock-at original cost) 1,50,000
Y (on order-on contract) 1,80,000
Z (to be ordered) 3,00,000
Labour: Skilled 5,40,000
Non-skilled 3,00,000
Supervisory 1,00,000
General Overheads 10,80,000
Total cost 26,50,000
Price offered by department store 18,00,000
Net Loss 8,50,000
Should the contract be accepted if the following additional information is considered?
i) Mat X is obsolete. It can only be used on another product, the material for which is
available at Rs 1,35,000 (X requires some adaptation to be used and costs Rs 27,000).
ii) Material Y is ordered for some other product which is no longer required. It now has a
residual value of Rs 2,10,000)
iii) Skilled labour can work on other contracts which are presently operated by semi-skilled
labour at a cost of Rs 5,70,000.
iv) Non-skilled labour are specifically employed for this contract.
v) Supervisor staff will remain whether or not the contract is accepted. Only two of them can
replace other-positions where the salary is Rs 35,000.
vi) Overheads are charged at 200% of skilled labour. Only Rs 1,25,000 would be avoidable,
if the contract is not accepted.
SOLUTION:
Particulars Rs
Mat – X [Rs 1,35,000 – Rs 27,000] 1,08,000
Mat – Y [Obsolete - ∴ NRV] 2,10,000
Mat – Z [Current Purch. Cost] 3,00,000
Lab – SK [Replacement Cost] 5,70,000
Lab – US [Labour Cost Paid] 3,00,000
Lab – Sup [Replacement Cost] 35,000
Gen Oh [Only Avoidable Oh] 1,25,000

∴ Total Relevant Cost: 16,48,000

& Total Revenue: 18,00,000
∴ Offer must be accepted.
Note-1: Mat X is obsolete, but it has alternative use for another product. This means that if
new offer is rejected, then Mat X can be used in another product, so it will save material
purchase cost in another product of ₹1,35,000 after spending adaptation cost of ₹27,000.
Thus net savings of ₹1,08,000.
Note-2: RC of Skilled Labour:
Present Situation: Proposal Accepted: Proposal Rejected:
₹5.70 L paid to Semi-Skilled ₹5.70 L paid to Semi-Skilled ₹5.70 L paid to Semi-Skilled
Labour for Other Contracts. Labour for Other Contracts. Labour for Other Contracts.
& OR
₹5.4 L paid to Skilled ₹5.4 L paid to Skilled
Labour for New Proposal Labour for Other Contracts
↓ ↓
∴ Need Both ∴ Need Only Skilled
∴ RC of ₹5.70 L is incurred only if proposal accepted.

Thus, ₹5.40 L will anyways be paid to Skilled Labour whether new offer is accepted or
rejected. However ₹5.70 L is paid to Semi-Skilled Labour only if new offer is accepted. Thus
Relevant Cost is ₹5.70 L
If new offer is accepted, we require both the labour – i.e. Skilled Labour for New Offer & Semi-
Skilled Labour for Other Contracts. While, if New Offer is rejected, then Skilled Labour can
still work on Other Contracts. Thus, because of New Offer, only Semi-Skilled Labour turns
out to be extra cost.

Color paints is a manufacturer of industrial dyes. It has received an order for 200 kgs of
powder dye that needs to be customized to certain specifications. The job would require the
following materials:
Material Total units Units Book value of the Realizable Replacement
required already in units in inventory value cost
inventory (₹ per unit) (₹ per unit) (₹ per unit)
A 2,000 0 NA NA 8
B 3,000 1,200 7 8 10
C 2,000 1,400 12 9 14
D 500 500 9 12 15

 Material B is used regularly in production of all types of dyes that Color plaints produces.
Therefore, any stock used towards this job order would need to be replaced to meet other
production demands.
 Inventory of material C and D are from stock that was purchased in excess previously.
Material C has no other use other than for this special order. Material D can be used as a
substitute for 700 units of material Z which currently costs ₹ 11 per unit. The company
does not have any inventory of material Z currently.
ANALYSE the relevant costs of material while deciding whether to accept the order or not?
SOLUTION: [May 20 MTP (10 Marks)]
Particulars Rs
Mat – A [2,000 Units @ Rs 8 p.u.] 16,000
Mat – B [3,000 Units @ Rs 10 p.u.] 30,000
Mat – C [1,400 Units @ Rs 9 p.u., & 600 Units @ Rs 14 p.u.] 21,000
Mat – D [700 Units @ Rs 11 p.u.] 7,700
Total Relevant Cost 74,700
Thus, order must be accepted if offered selling price is more that this relevant cost.
Notes:
Mat – A: The requirement of 2,000 units of Mat - A has to be purchased entirely since there
are no units in stock. Therefore, the relevant cost is taken as replacement cost @ ₹ 8 p.u..
Mat – B: There is a requirement of 3,000 units of Material B, of which 1,200 units are in stock.
B is used regularly in the production of all types of dyes. If the 1,200 units in stock are used,
they need to be replenished (replaced) in order to meet production demands of other dyes.
In addition, for the special order, additional 1,800 units of Material B is required to be procured
from the market. Therefore, all 3,000 units of Material B has to be procured if the special
order is undertaken. The relevant cost will be the replacement cost @ ₹ 10 p.u.
Mat – C: There is a requirement of 2,000 units of Material C, of which 1,400 units are in stock.
The balance 600 units have to be procured at the replacement (market) price of ₹ 14 per unit,
which would be ₹ 8,400. Material C has no other use, so if the special order is not undertaken
the stock of 1,400 units can be sold at ₹ 9 per unit. So, the opportunity cost of undertaking
this order is ₹ 12,600. Therefore, the relevant cost for Material C is procurement cost of 600
units plus the opportunity cost of not disposing the current stock of 1,400 units.
Mat – D: The entire requirement of 500 units of Material D is in stock. If the special order is
not accepted, Color paints has two options (i) sell the excess material at ₹ 12 per unit or (ii)
use it as a substitute for Material Z, which would otherwise need to be procured.
(i) NRV = 500 units × ₹ 12 per unit = ₹ 6,000
(ii) Saving of alternate use: Material D can be used as a substitute for 700 units of Material
Z. So if the special order is not accepted, then use of D in place of Z could save the purchase
cost of Z = 700 Units @ ₹ 11 p.u. = ₹ 7,700.
Both options (i) and (ii) represent opportunity cost if the special order is accepted. The

relevant cost for Material D, if the special order is accepted would be higher of either of these
two opportunity costs. The higher opportunity cost of that of procuring Material Z from the
market at ₹ 7,700. Therefore, the relevant cost for Material D is ₹ 7,700.

Intervero Ltd., a small engineering company, operated a job order costing system. It has been
invited to tender for a comparatively large job, which is outside the range of its normal
activities, and since there is surplus capacity, the management is keen to quote as Iower
price as possible. It is decided that the opportunity should be treated in isolation without any
possibility of its leading to further work of a similar nature (although such a possibility does
exist). A low price will not have repercussions on Intervero's regular work. The estimating
department has spent 100 hours on work in connection with the quotation and they have
incurred traveling expense of Rs. 550 in connection with a visit to the prospective customers'
factory. The following cost estimates has been prepared on the basis of their study.
Cost Estimate
Direct material and components: (Rs.)
2,000 units of A at Rs. 25 per unit 50,000
200 units of B at Rs. 10 per unit 2,000
Other material and components to be bought 12,500
64,500
Direct labour:
700 hrs. of skilled labour at Rs. 3.50 per hour 2,450
1,500 hrs of unskilled labour at Rs. 2 per hour 3,000
Overhead:
Department P-200 hrs. at Rs. 25 per hour 5,000
Department Q-400 hrs. at Rs. 20 per hour 8,000
Estimating department:
100 hours at Rs. 5 per hour 500
Travelling expenses 550
Planning department:
300 hrs. at Rs. 5 per hour 1,500
85,500
The following information has been brought together:
(a) Material A: This is a regular stock item. The stock holding is more than sufficient for this
job. The material currently held has an average cost of Rs. 25 per unit but the current
replacement cost is Rs 20 per unit.
(b) Material B: A stock of 4,000 units of B is currently held in the stores. This material is slow
moving and the stock is the residue of a batch bought seven years ago at a cost of Rs.

10 per unit. B currently costs Rs. 24 per unit but the resale value is only Rs. 18 per unit.
A foreman has pointed out that B could be used as a substitute for another type of
regularly used raw material which costs Rs. 20 per unit.
(c) Direct Labour: The work force is paid on a time basis. The company has adopted no
redundancy policies which mean that skilled workers are frequently moved to jobs which
do not make proper use of their skills. The wages included in the cost estimate are for the
mix of labour which the job ideally requires. It seems likely, if the job is obtained then most
of the 2,200 hours of direct labour will be performed by skilled staff receiving Rs. 3.50/hr.
(d) Overhead: Department P: It is a department of Intervero Ltd. that is working at full
capacity. The department is treated as a profit centre and it uses a transfer price of Rs.
25 per hour for charging out its processing time to other departments. This charge is
calculated as follows:
Particulars Rs.
Estimated variable cost per machine hour 10
Fixed departmental overhead 8
Departmental profit 7
Total 25
Department P's facilities are frequently hired out to other firms and a charge of Rs. 30 per
hour is made. There is a steady demand from outside customers for the use of these
facilities.
(e) Overhead: Department Q uses a transfer price of Rs. 20 for charging out machine
processing time to other Department. This charge is calculated as follows:
Particulars Rs.
Estimated variable cost per machine hour 8
Fixed departmental overhead 9
Departmental profit 3
Total 20
(f) Estimating department: This department charges out its time to specific jobs using a
rate of Rs. 5 per hour. The average wage rate within the department is Rs. 2.50 per hour
but the higher rate is justified as being necessary to cover departmental overheads and
the work done on unsuccessful quotations.
(g) Planning department: This department also uses a charging out rate which is intended
to cover all departmental costs.
(h) The offer received for the above contract is Rs. 70,000.
Required: You are required to restate the cost estimate by using an opportunity cost
approach. Make any assumptions that you deem to be necessary and briefly justify each of
the figures that you give.
SOLUTION:
Particulars Rs

Mat-A [Rs 20 p.u. x 2,000 Units] 40,000

Mat-B [Rs 20 p.u. x 200 Units] 4,000
Other Mat. Bought 12,500
Lab-SK [Permanent] -
Lab-US [Not Likely Used] -
OH-P [Rs 30/hr x 200 Hrs] 6,000
OH-Q [Rs 8/hr x 400 Hrs] 3,200
Est. Dept. [Sunk Cost] -
Planning Dept. [Absorption] -
Total Relevant Cost 65,700
Sale Value 70,000
Profit 4,300
Ans: Offer must be accepted
Notes:
 Material A is a regularly used item. Therefore, if used on the new offer, then the present
stock needs to be replaced. Hence, the replacement cost is considered.
 Material B is slow moving i.e. obsolete. Therefore, opportunity cost i.e. ₹20 or ₹18,
whichever is more should be considered.
 The entire job will be performed by skilled workers (unskilled jobs also). This implies
skilled workers are idle at present and since the company follows no redundancy policy
and their wages will be paid on time basis whether the contract is accepted or not. This
means that skilled labour is permanent and it is idle. Hence, relevant cost is zero.
 Department P is a profit centre and is working at full capacity at present and has a steady
demand from outside for its facilities at ₹30 per hour. So if new offer uses dept. P, then it
will loose hire charges from other firms of ₹30/hr. Contribution lost on hire charges to other
firms is ₹30 - ₹10 = ₹20/hr. ∴ Relevant Cost = VC +CL = ₹10 + ₹20 = ₹30/hr.
 Department Q is not at full capacity so only the variable overheads of ₹8/hr should be
considered.
 All other costs mentioned are sunk costs or not relevant.

B. RELEVANT COSTING
BANKRUPTCY SITUATIONS:
Q.10. RELEVANT COSTING - BANKRUPTCY

Engineers Ltd. is just ready to deliver a machine specially designed for Durables & Co. When
it is learnt that the latter has gone bankrupt, an enquiry comes from another firm Steady
Enterprises, which can accept the machine meant for Durables & Co. if certain alterations
are done to suit Steady Enterprises' needs and the-price is attractive.
Costs incurred on the machine for Durables & Co. Amount (Rs.)
Direct materials 5,60,000
Direct labour 4,00,000
Variable overhead 1,40,000
Fixed overhead 3,00,000
Fixed selling and distribution overhead 1,00,000
Total 15,00,000
Notes: If the negotiation with Steady Enterprises fails, part of the material used may be dealt
with as under:
(i) Brass materials - could be sold as scrap for Rs. 1,00,000
(ii) Steel material - could be sold as scrap for Rs. 26,000, but to sell it as scrap some 100
hours labour will be hired at Rs. 10 per hour to bring it to saleable condition.
(iii)Balance material have to be removed at a cost of Rs. 5,000, but will have a nil sale value.
Price quoted to Durables & Co. was Rs.18,00,000.
To cater to Steady Enterprises needs, the alteration cost will be:

Particulars Department M Department A

Direct material Rs.10,000 Rs.5,000
Direct labour 10 men for 2 months @ Rs 6 women for 2 months @ Rs
3,000 per man per month 2,000 per women per month
Variable overhead 20% of direct labour cost 25% of direct labour cost
Fixed overhead 60% of direct labour cost 50% of direct labour cost
Notes:
(i) Materials required are already in stock and valued at cost. If the work for Steady
Enterprises is not undertaken, the company has the following choice:
 Material for Department M, will be used for another job.
 Material for Department A, lying as it is for some years, will remain put on quick sale
for Rs. 3,000. The present market prices for the materials for M and A are Rs. 12,000
and Rs. 6,000 respectively.
(ii) Department M is currently working at full capacity earning a contribution of Rs.3 towards
fixed overhead and profit per Rs.1 of labour.
(iii)Department A is presently working at 40% of its capacity, but as per agreement with the
Union, its present work force of 24 women cannot be reduced. A worker in this department
gets Rs. 2,000 a month as wages. In order to utilize its labour, Department A undertakes
some off-loading work for Rs. 32,500 per month from a sister concern when the workload
in Department A falls below 50% capacity. Variable cost associated with the off-loading
work is Rs. 4,000 per month. The conversion work for Steady Enterprises will mean 25%
additional workload for Department A for two months.
The pattern and specification of the original machine could be sold to a customer for Rs.
60,000. For supervision of the job for Steady Enterprises, a temporary Supervisor would be
needed for 2 months at an agreed salary of Rs. 10,000. He will be a person deputed by
Steady Enterprises. The company charges all indirect & supervisory salaries to fix overhead.
Durables & Co. has already made an earnest money deposit of Rs. 1,80,000 for the machine.
As per terms of the contract this deposit stands forfeited and Engineers Ltd. is now free to
treat the sum as miscellaneous income. Taxation may be ignored.
Required: Engineers Ltd. seeks your advice for the minimum price, based on relevant costs
only, for the quotation it will make to Steady Enterprises.
SOLUTION:
Particulars Rs
Cost of completion: 0
Cost of Modifications:
Mat-M 12,000
Mat-A 3,000
Lab-M Paid [Rs 3,000 p.m. x 2M x 10] 60,000

Lab-M Contri. Lost [60,000 x 3] 1,80,000

Lab-A Paid [Permanent] 0
Lab-A Contri. Lost [(32,500-4,000) p.m. x 2M] 57,000
V-OH-M (On Lab Cost) [20% of Rs 60,000] 12,000
V-OH-A (On Lab Cost) [25% of (2000x2x6)] 6,000
OC of Existing Materials:
Brass 1,00,000
Steel [26,000-(100x10)] 25,000
Bal. mat. [0 - 5,000] (5,000)
Patterns & Specs 60,000
Supervisor 10,000
Total Relevant Cost (Min Price) 5,20,000
Notes:
 If Variable Oh are based on Labour Cost, then Variable Oh will be Relevant Cost even if
Labour is Permanent Labour
 Dept. A is Permanent Labour, so labour cost paid is not relevant, but contribution lost, if
any, is relevant. Presently they are working at 40% capacity (i.e. < 50%). So presently,
they can take the Off-Loading Work giving contribution of ₹28,500 p.m. If New Offer is
rejected, then also this contribution will continue. However, if New Offer is accepted, then
it would utilize 25% additional capacity making the total capacity utilized as 65% (i.e. >
50%). So now in this case Dept A cannot take the Off-Loading Work for the next 2 months
due to the New Offer. Hence contribution of ₹28,500 p.m. is lost for 2 months.
 Balance Material has negative NRV. This means that if the New Offer is accepted, then
company will save removal cost of the balance material because if New Offer is accepted,
then we don’t need to remove that balance material.

Tuscan Reel Ltd. manufacturers a range of films extensively used in the Cinema industry.
The films, once manufactured, are packed in circular containers and stored in specially
constructed crates lined with "Protecto”. These crates are manufactured and maintained by
a special department within the company and the departmental costs last year are as under:
(Rs)
Direct Materials (including "Protecto”) 1,40,000
Direct Labour 1,00,000
Overheads:
Department Manager 16,000
Depreciation of Machine 30,000

Maintenance of Machine 7,200

Rent (Portion of Warehouse) 9,000
Other Miscellaneous Costs 31,500
Administration Overhead (20% of Direct Costs) 48,000
Max Associates have approached the Tuscan Reel Ltd., offering to make all the
crates required on a four-year contract for Rs 2,50,000 per annum and/or to maintain them
for further Rs 50,000 per annum.
The following data are relevant:
(i) The machine used in the department cost Rs 2,40,000 four years ago and will last for
four more years. It could be currently sold for Rs 50,000.
(ii) The stock of "Protecto" was acquired last year for Rs 2,00,000 and 1/5th was used last
year and included in the material cost. Its original cost was Rs 1,000 per ton, but the
replacement cost is Rs 1,200 per ton; and it could be currently sold for Rs 800 per ton.
(iii) The department has acquired warehouse space for Rs 18,000 per annum. It uses only
one-half of the space; the rest is idle.
(iv) If the department were closed, the manager will be transferred to another department;
but all the labour force will be made redundant, and the terminal benefits to be met with
amount to Rs 15,000 per annum. In that event, Max Associates will undertake to
manufacture and maintain the crates.
If Tuscan Reel continued to maintain crates, but left their manufacture to Max Associates:
(i) The machine will not be required.
(ii) The manager will remain in the department.
(iii) The warehouse space requirements will not be reduced.
(iv) Only 10% of all materials will be used.
(v) Only one worker will be dispensed with and taking the terminal benefit to be met into
account, the saving will be Rs 5,000 per annum.
(vi) The miscellaneous costs will be reduced by 80%.
If Tuscan Reel continued to manufacture crates, but left their maintenance to Max:
(i) The machine will be required.
(ii) The manager will remain in the department.
(iii) The warehouse space will be required.
(iv) 90% of all the materials will be required.
(v) The labour force will continue.
(vi) The miscellaneous cost will be reduced by 20%.
Assuming that for the four-year period, there is no significant change envisaged in the pattern
of other costs, you are required to evaluate the alternate courses of action with supporting
figures of each flows over the four-year per and advise accordingly.

SOLUTION:
Particulars Option-1 Option-2 Option-3
Outsource Outsource Outsource
Manufacture Maint. Both
Savings:
Mat-Protecto Sold off 1,15,200 12,800 1,28,000
[160 Tons x 90% x [160 Tons x 10% x [160 Tons x Rs
Rs 800] Rs 800] 800]
Mat-Others Saved 3,60,000 40,000 4,00,000

DL 20,000 - 3,40,000
Dept Manager - - -
Machine Sold off 50,000 - 50,000
Machine Maint. 28,800 - 28,800
W/h Rent - - 72,000
Misc Costs 1,00,800 25,200 1,26,000
Less: Fees of Outsourcing: (10,00,000) (2,00,000) (12,00,000)
Net Benefit of Outsourcing: (3,25,200) (1,22,000) (55,200)
C. KEY FACTOR PRODUCT MIX DECISIONS
BASIC STEPS:
1. Calculate Contribution per Key Factor and do Ranking of all products based on that.

2. Allocate the total Key Factor to these products in sequence of the Ranking up to the
maximum demand of each product.
3. Convert this Key Factor allotment into Units allotment to get the Product Mix.
4. If minimum commitment is given for any product, then 1st allot the minimum commitment,
then allot remaining Key Factor based on ranking to all
5. If any unsuitable key factor is given, then 1st allot the unsuitable key factor to the products
where it suits, then allot the remaining key factor to all products based on ranking.
6. If maximum demand is not given, the entire key factor is given to the best product, hence
we will produce only 1 product then.
IF EXTRA KEY FACTOR IS GIVEN (Eg Overtime):

7. Use extra it for the product in which demand is still unsatisfied from basic allotment.
8. If there are more than 1 such products then try using extra key factor for both, finally chose
the one in which extra profit is maximum.
9. Extra key factor must be used only if it gives extra profits.
Q.12. KEY FACTOR & PRODUCT MIX DECISIONS

A firm produces 5 different products from a single raw material. Raw material is available at
Rs. 6 per kg. The labour rate is Rs. 8 per hour for all products. The factory overhead rate is
Rs. 8 per hour, comprising Rs. 5.60 per hour as fixed overhead (for 21,000 labour hours) and
Rs. 2.40 per hour as variable overhead. The Selling Commission is 10 percent of the product
price. Suggest a suitable sales mix which will maximise the Company's profits, and calculate
the total profit under your suggestion in each of the following cases:
Product Market Selling price Labour hours Raw material required
demands (units) per unit (Rs.) required per unit per unit (gms)
A 4000 32.00 1.00 700
B 3600 30.00 0.80 500
C 4500 48.00 1.50 1500
D 6000 36.00 1.10 1300
E 5000 44.00 1.40 1500
(a) If there is no restriction.
(b) If maximum total units that can be sold is 22,000 units
(c) If maximum raw material available is 18,000 kg
(d) If maximum labour hours available are 21,000 hrs
(e) If in answer of (b) above, it is possible to increase sales of any one product by 1,500 units
without any additional fixed costs but by spending an additional Rs 15,000 on
advertisement.

(f) If in case (d) above, 3,500 hours of overtime working is possible. It will result in additional
fixed overheads of Rs. 20,000, a doubling of labour rates and a 50 percent increase in
variable overheads.
(g) If in case (c) above, a minimum commitment to sell 1,000 units of D and 3,000 units of E
has to be fulfilled.
(h) If in case (d) above, out of total 21,000 hrs available, 8,000 hrs are unsuitable for A, B &
C, it is suitable only to D & E.
SOLUTION:




C. KEY FACTOR PRODUCT MIX DECISIONS

MULTIPLE KEY FACTORS:
10. If there are 2 products (Product X & Y) and more than 1 key factors, then there are 2
possible methods to solve: Trial & Error Method, or Graph Method (Linear Programming
Problem Method)
11. In case of Trial & Error Method,
Trial 1: 1st try if X is rank 1 and make allotment accordingly, then
Trial 2: try if Y is rank 1 and make allotment accordingly,
Trail 3: then make equations to use entire key factors for X & Y, and solve these equations
to get values of X &Y.
Now choose the trial which gives maximum Contribution.
12. In case of Graph Method,
Objective Function is to maximize Contribution from X & Y,
Identify Equations for conditions and plot them all on a graph,
Find common area of the graph and end points of that common area,
Calculate total contribution for each point of the common area,
Now choose the trial which gives maximum Contribution.
Q.13. MULTIPLE KEY FACTOR & PRODUCT MIX DECISIONS

X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of X Ltd.
facilitates production of anyone spare part for a particular period of time. The following are
the cost and other information for the production of the two different spare parts P and Q:
Per unit Part P Part Q
Alloy usage @ ₹12.5/Kg 1.6 kgs 1.6 kgs
Machine Time : Machine A 0.6hrs 0.25hrs
Machine Time : Machine B 0.5hrs 0.55hrs
Target Price (Rs) 145 115
Total hours available: Machine A 4,000 hours, Machine B 4,500 hours.
Variable overheads per machine hour: Machine A : Rs 80, Machine B : Rs 100
(a) Identify the spare part which will optimise contribution at the offered price.
(b) If Y Ltd. reduces target price by 10% and offers Rs 60 per hour of un utilised machine
hour, what will be the total contribution from the spare part identified above?
(c) Calculate total contribution of most profitable mix if both parts can be produced & supplied.
SOLUTION:



Graph:
Q.14. MULTIPLE KEY FACTOR & PRODUCT MIX DECISIONS

A company manufactures two products. Each product passes through two departments A
and B before it becomes a finished product. The data for the year are as under:
Product X Product Y
Maximum Sales Potential (in units) 7,400 10,000
Product unit data:
Selling Price p.u. Rs 90 Rs 80
Machine hrs. p.u.
Department A hrs. @ Rs40/ hr. 0.50 0.30
Department B hrs. @ Rs 60/ hr. 0.40 0.45

Maximum Capacity of Department A is 3,400 hrs. and Department B is 3,640 hrs.

Maximum Quantity of Direct Materials available is 17,000 kgs. Each product requires 2 kg. of
Direct Materials. The Purchase Price of direct materials is Rs 5/ kg.
(a) FIND optimum product mix.
(b) In view of the aforesaid production capacity constraints, the company has decided to
produce only one of the two products during the year. Which of the two products should
be produced and sold in the year to maximise profit? State the number of units of that
product and relevant contribution.
SOLUTION: WN-1: Contribution per unit: X: Rs 36 p.u.; Y: Rs 15.5 p.u.
WN-2: Check which factor is limiting factor:
Particulars Material Hours in Department A Hours in Department B
Required: X 14,800 kg. 3,700 hrs. 2,960 hrs.
Required: Y 20,000 kg. 3,000 hrs. 4,500 hrs.
Total Requirement 34,800 kg. 6,700 hrs. 7,460 hrs.
Available Resources 17,000 kg. 3,400 hrs. 3,640 hrs.
Shortage 17,800 kg. 3,300 hrs. 3,820 hrs.
Hence all the three resources are limiting factors.
(a) LINEAR PROGRAMMING METHOD (GRAPH METHOD):
Maximize Function: 36X + 31Y
Constraints: Mat: 2X + 2Y ≤ 17,000; Demand X: X ≤ 7,400
Dept-A: 0.50X + 0.30Y ≤ 3,400; Demand Y: Y ≤ 10,000
Dept-B: 0.40X + 0.45Y ≤ 3,640
Plotting these equations in a graph:

∴ Points in Graph: ∴ Total Contri. (36X × 31Y)

P: X = 6,800, Y = 0 [X axis point] Rs 2,44,000
Q: X = 4,250, Y = 4,250 [Mat & Dept A Intersection] Rs 2,84,750
R: X = 4,171, Y = 4,381 [Dept A & Dept B Intersection] * (Not Possible)
S: X = 3,700, Y = 4,800 [Mat & Dept B Intersection] Rs 2,82,000
T: X = 0, Y = 8089 [Y axis point] Rs 2,50,759
Ans: ∴ Point Q is the best product mix - i.e. 4,250 Units of X & 4,250 Units of Y
* Combination R (4,171, 4,381) is not possible as it is satisfying three conditions out of above
four conditions. To produce combination R (4,171, 4,381), requirement of the material will be
17,104 Kgs. (2 Kg × 4,171 units + 2 Kg × 4,381 units). However, material is available 17,000
Kgs. Accordingly, this combination is not possible.
(b) Produce any 1 Product only:
Trial – 1: If X is rank 1, (i.e. produce only X) Trial – 2: If Y is rank 1, (i.e. produce only Y)
→ Max Units of X: → Max Units of Y:
Demand 7,400 Units Demand 10,000 Units
Mat: 17,000 Kg ÷ 2 Kg p.u. 8,500 Units Mat: 17,000 Kg ÷ 2 Kg p.u. 8,500 Units
A: 3,400 Hrs ÷ 0.5 Hrs p.u. 6,800 Units A: 3,400 Hrs ÷ 0.3 Hrs p.u. 11,333 Units
B: 3,640 Hrs ÷ 0.4 Hrs p.u. 9,100 Units B: 3,640 Hrs ÷ 0.45 Hrs p.u. 8,089 Units
∴ Overall Max 6,800 Units ∴ Overall Max 8,089 Units
[Bottleneck, … w. e. is ↓] [Bottleneck, … w. e. is ↓]
∴ Total Contri. [@ Rs 36 p.u.] Rs 2,44,800 ∴ Total Contri. [@ Rs 31 p.u.] Rs 250,759
Ans: ∴ Trial – 2 is Better, 8,089 Units of Y will be most profitable giving contri. of Rs 2,50,759.
D. MAKE OR BUY DECISIONS

1. Compare Relevant Cost of Make v/s Relevant Cost of Buy. Choose whichever is cheaper.
2. Indifference point between Make & Buy: Make only if the requirement is more than IDP,
otherwise Buy.
3. If this requirement is predicted is wrong, then due to that the decision to Make or Buy
would go wrong. Now in this case we calculate the cost of prediction error. i.e. difference
between Actual cost incurred v/s Cost that would have been incurred if requirement were
predicted correct. [Refer Q ___]
4. If question involves key factor also, then make as much as possible with the given key
factor (based on ranking), remaining requirement is Buy. However, for that purpose,
ranking is done based on Savings per key factor. Savings = Difference between RC of
Make & RC of Buy. Selling price is never considered here.

5. If Fixed Cost of make is Batch Level Cost, then also check for making 1 batch less if the
last batch is not fully used. [Refer Q ___]
6. Make or But with Capital Budgeting – Decide by calculating NPV of Make option, if it is
positive, then, make, otherwise buy.
7. General Analysis: If buy is chosen then company will have spare capacity, using it they
can satisfy more demand. But if there is no more demand, then company may lay-off
workers to reduce capacity. Also discuss quality and timely issues if buy option is selected.
Q.15. MAKE OR BUY DECISIONS

DBA, manufactures and sells 25,000 table fans annually. One of the components required
for fans is purchased from an outside supplier at a price of ₹ 190 per unit. Annually it is
purchasing 25,000 components for its usage. The Production Manager is of the opinion that
if all the components are produced at own plant, it is possible to maintain better quality in the
finished product. Further, he proposed that the in-house production of the component with
other items will provide more flexibility to increase the annual production by another 5,000
units. He estimates the cost of making the component as follows:
₹ per unit
Direct materials 80
Direct labour 75
Factory overhead (70% variable) 40
Total cost 195
The proposal of the Production Manager was referred to the Marketing Manager for his
remarks. He pointed out that to market the additional units, the overall unit price should be
reduced by 5% and additionally ₹ 1,00,000 p.m. should be incurred for advertising. Present
selling price and contribution per fan are ₹ 2,500 and ₹ 600 respectively. No other increase
or decrease in all other expenses as a result of this proposal will arise. Required:
Since making cost of the component is more than the buying cost, Management asks you to:
(i) ANALYSE the make or buy decision on unit basis and total basis.
(ii) RECOMMEND the most profitable alternative. [Nov 18 Exam (10 Marks)]
SOLUTION: (i) Analysis:

DBA purchases 25,000 units of components to manufacture 25,000 fans annually. The
external purchase price per component is ₹ 190 per unit. It has the option of manufacturing
these components in house. The cost structure to manufacture these components would be:
Cost Structure Cost per component unit (₹ )
Direct Materials 80
Direct Labor 75
Variable Factory Overhead (70% of ₹ 40) 28
Total 183

If DBA decides to manufacture the components in-house, the financial impact would be:
(a) Production Capacity will increase from 25,000 fans to 30,000 fans.
(b) Variable Cost of Production of fan would be ₹ 1,710 [(2,500 - 600) -190] per unit.
(c) Fixed Factory Overhead of ₹ 12 per component would be incurred irrespective of whether
component is produced or not. Therefore, this cost is not considered.
(d) Increase in advertising expense would be ₹ 100,000 per month or ₹ 12,00,000 annually.
(e) Overall selling price would reduce from the current rate of ₹ 2,500 per fan to ₹ 2,375 (95%
of ₹ 2,500) per fan.
(f) ∴ Profit Statement:
Particulars Present Proposed
Units 25,000 30,000
SP p.u. 2,500 2,375
(-) Component Cost [Buy] 190 [Make] 183
(-) Other VC 1710 1710
∴ Contri. p.u. 600 482
∴ Total Contri. 1,50,00,000 1,44,60,000
∴ Contri. Lost - 5,40,000
(+) Additional Advtg Cost - 12,00,000
∴ Total Loss - 17,40,000
(ii) Recommendation:
As explained above, if production increases from 25,000 fans to 30,000 fans, it would not be
profitable to make these components in house. Overall profit decreased by ₹ 17,40,000.
However, DBA may prefer to make component, even though it could be financially beneficial
to buy from outside supplier. Sometimes qualitative factors become very import ant and can
override some financial benefit. This can be coupled with uncertainty about the supplier ’s
ability or intention to maintain the price, quality, delivery dates of the components etc.
Alternatively, DBA may continue with the sale of 25,000 units without any price reduction and
advertising expenses. The component required for the 25,000 fans may be produced
internally at a cost of ₹ 183 per unit instead of buying at Rs 190 p.u. In this situation, the
contribution shall be increased by ₹ 1,75,000 (₹ 7 ×25,000 units).
Thus, DBA may choose the alternative after due and careful consideration of the facts
illustrated above.

Q.16. MAKE OR BUY DECISIONS WITH KEY FACTOR

Agrocaps Ltd., engaged in manufacturing agricultural machinery, is preparing its annual
budget for the coming year. The company has a metal pressing capacity of 20,000 hours,
which will be insufficient for manufacture of all requirements of components A, B, C, and D.
1 unit of the machine requires 20 component A, 32 component B, 15 component C & 28 D.
Total demand of the machine is expected to be 100 units.
The data for the current year are given below:
Standard production cost per unit of component
A B C D
Variable Costs' (Rs.):
Direct materials 37 27 25 44
Direct wages 10 8 22 40
Direct expenses 10 20 10 60
Fixed overhead (Rs.) 5 4 11 20
Total production costs (Rs.) 62 59 68 164
Direct expenses relate to the use of the metal presses which costs Rs. 10 per hour, to
operate. Fixed overheads, absorbed as a percentage of direct wages pertain to general cost
of the company as a whole. Other variable cost involved in assembling the components to
complete the machine production is Rs 213 per unit of the machine.
Supply of all or any part of the total component requirements can be obtained at following
prices, each delivered to the factory: A at Rs 60, B at Rs 59, C at Rs 52 and D at Rs 168.
Second shift operations would increase direct wages by 25 per cent over the normal shift and
fixed overhead by Rs. 500 for each 1,000 (or part thereof) second shift hours worked.
You are required to present, with calculations:
(a) Which component and what quantities should be manufactured in the 20,000 hours of
press time available? Also make profit statement of the company for your answer.
(b) Whether it would be profitable to make any of the balance of components required on a
second shift basis instead of buying them from outside suppliers. Also determine final
profit of the company for your answer.
(c) If a supplier is ready to supply an entire ready machine at Rs 8,785 per unit, then how
many machines must be made using the 20,000 hours of press time available? Also,
determine profit of the company for your answer.
(d) In part (c) as above, whether it would be profitable to make any of the balance number of
entire machines on a second shift basis instead of buying them from outside suppliers.
Also determine final profit of the company for your answer.
(e) What should the company do, if the Fixed Overhead given are not general company costs,
rather the Fixed Oh are completely avoidable if they stop manufacturing everything (i.e.
buy all machines from outside supplier). Answer by making profit statement for this option.
SOLUTION: General Format for “Make of Buy of RM with KF”:

Note: For deciding which RM to make and which to buy, we will not consider that which RM
has lesser RC of Make. Rather we must consider which RM has higher Savings of Make as
compared to Buy. Rule is – to make those RM which give highest savings with least use of
KF, rest of the RM must buy. Thus ranking is also based on savings per KF rather than
contribution per KF.



Q.17. MAKE OR OUTSOURCE DECISIONS WITH KEY FACTOR

Golden Pet Ltd. specialises in the manufacture of one litre plastic bottles. The firm's
customers include dairy processors, fruit juice manufacturers and manufacturers of edible
oils. The bottles are produced by a process called blow moulding. A machine heats plastic to
the melting point. A bubble of molten plastic is formed inside a mould, and a jet of hot air is
forced into the bubble. This blows the plastic into the shape of the mould. The machine
releases the moulded bottle, an employee trims off any flashing (excess plastic around the
edge) and the bottle is complete.
The firm has four moulding machines, each capable of producing 100 bottles per hour. The
firm estimates that the variable cost of producing a plastic bottle is 20 paise. The bottles are
sold for 50 paise each.
Management has been approached by a local toy company that would like the firm to produce
a moulded plastic toy for them. The toy company is willing to pay Rs 3.00 per unit for toy. The
variable cost to manufacture the toy will be Rs 2.40. In addition, Golden Pet Ltd. would have
to incur a cost of Rs 20,000 to construct the needed mould exclusively for this order. Because
the toy uses more plastic and is of a more intricate shape than a bottle, a moulding machine
can produce only 40 units per hour. The customer wants 1,00,000 units. Assume that Golden
Pet Ltd. has the total capacity of 10,000 machine hours available during the period in which

the toy company wants the delivery of toys. The firm's fixed costs, excluding the costs to
construct the toy mould, during the same period will be Rs 2,00,000. Required:
(a) If the management predicts that demand for bottles will require the use of 7,500 machine
hours or less during the period, should the special order be accepted? Give reasons.
(b) If the management predicts that demand for bottles will be higher than its ability to produce
bottles, should the order be accepted? Why?
(c) If the management has located a firm that has just entered the moulded plastic business.
This firm has considerable excess capacity and more efficient moulding machine and is
willing to subcontract the toy job, or any portion of it, for Rs 2.80 per unit. It will construct
its own toy mould. Determine Golden Pet Ltd 's minimum expected excess machine hour
capacity needed to justify producing any portion of the order itself rather than
subcontracting it entirely.
(d) The management predicted that it would have 1,600 hours of excess machine hour
capacity available during the period. Consequently, it accepted the toy order and
subcontracted 36,000 units to the other plastic company. In fact, demand for bottles
turned out to be 9,00,000 units for the period. The firm was able to produce only 8,40,000
units because it had to produce the toys. What was the cost of the prediction error failure
to predict demand correctly? [May 18 Exam (10 Marks)]
SOLUTION:

Analysis:
If it is possible to ‘Buy’ toys at ₹2.8 p.u., then the new offer of selling toys is always acceptable.
If we have enough spare capacity, then we can ‘Make & Sell’. And, even if we do not have
spare capacity, then we can ‘Buy & Sell’. In both cases, we are getting profit. Now, we just
need to decide whether to ‘Make & Sell’ or ‘Buy & Sell’.
If ‘Make’ is cheaper, then we must chose ‘Make & Sell’. However, if ‘Make’ option involves
Fixed Cost also, then the decision would depend on Indifference Point (IDP). The above
calculation of IDP of 50,000 Units of Toy indicates that if we must choose ‘Make’ only if units
are more than 50,000. In the given question, demand is more than 50,000 units of toy, but
spare capacity available may not be for over 50,000 units of toy. Capacity is measured in
hours. Hence IDP is converted in terms of Hours. IDP of 1,250 hour means that we must
choose ‘Make’ only if spare hours available are more than 1,250 hours & remaining units we
buy. If spare hours available are lesser than 1,250 hours, then don’t make anything, rather,
all units we must buy.
Thus 1,250 hours are the minimum spare capacity hours needed to justify making a portion
of toys instead of buying them all.


Aditya Ltd. manufactures four products A-1, B-2, C-3 and D-4 in Gurgaon and one product
F-1 in Faridabad. Aditya Ltd. operates under Just-in-time (JIT) principle and does not hold
any inventory of either finished goods or raw materials.
Company has entered into an agreement with M Ltd. to supply 10,000 units per month of
each product produced from Gurgaon unit at a contracted price. Aditya Ltd. is bound to supply
these contracted units to M Ltd. without any fail. Following are the details related with non-
contracted units of Gurgaon unit. (Amount in Rs)
A-1 B-2 C-3 D-4
Selling Price per unit 360.00 285.00 290.00 210.00

Direct Labour @ Rs 45 per hour 112.50 67.50 135.00 67.50

Direct Material M-1 @ Rs 50 per kg. 50.00 100.00 --- 75.00
Direct Material M-2 @ Rs 30 per litre. 90.00 45.00 60.00 ---
Variable Overhead (varies with labour hrs) 12.50 7.50 15.00 7.50
Variable Overhead (varies with machine hrs) 9.00 12.00 9.00 15.00
Total Variable Cost 274.00 232.00 219.00 165.00
Machine Hours per unit 3 hours 4 hours 3 hours 5 hours
Maximum Demand per month (units) 90,000 95,000 80,000 75,000
The products manufactured in Gurgaon unit use direct material M-1 and M-2 but product F-1
produced in Faridabad unit is made by a distinct raw material Z. Material Z is purchased from
the outside market at Rs 200.00 per unit. One unit of F-1 requires one unit of material Z.
Material Z can also be manufactured at Gurgaon unit but for this 2 hours of direct labour, 3
hours of machine time and 2.5 litres of material M-2 will be required.
The Purchase manager has reported to the production manager that material M-1 and M-2
are in short supply in the market and only 6,50,000 Kg. of M-1 and 6,00,000 litre of M-2 can
be purchased in a month. Required:
(a) CALCULATE whether Aditya Ltd. should manufacture material Z in Gurgoan unit or
continue to purchase it from the market to manufacture F in Faridabad unit.
(b) CALCULATE the optimum monthly usage of Gurgaon unit’s available resources and
make decision accordingly.
(c) CALCULATE the purchase price of material Z at which your decision in (a) can be
sustained.
SOLUTION:

(b) With Consideration of availability of Gurgaon resources:

If we consider the availability of resources of Gurgaon, then if appears that Gurgaon unit
currently has shortage of Material M-2 as explained below. Thus, Material M-2 becomes
Key Factor for Gurgaon Unit. Now, if Gurgaon is asked to manufacture even 1 unit of Z,
then it will have to decrease external sale of some of its products in order to free up
Material M-2 for making Z. Thus, making Z in Gurgaon will lead to some Contribution Lost
which must be added to RC of Making Z.
Product Z also requires Material M-2, so now if Z is manufactured in Gurgaon, then M-2
required to making Z must be released from one of the existing products of Gurgaon.
Naturally, if will be released from the last ranking product which gives least contribution per
ltr of M-2, ie. Product A. Thus, for manufacturing Z in Gurgaon, we need to sacrifice some
external sale of Product A to release litres of M-2.
Product A is giving contribution/ltr of ₹28.67. If these litres of M-2 are used in making Z, then
Gurgaon will face contribution lost of ₹28.67/ltr of M-2 for 2.5 ltr used in making Z.

(c) Now, considering available resources of Gurgaon, ‘Make’ will be better only if the
purchase price of Z becomes more than RC of making Z, i.e. Purchase Price > ₹255.68 p.u.

SEZ Limited produces three products S, Q and L which use the same resources but in varying
quantities. Product S uses one unit of component P which is purchased from outside suppliers
at, ₹120 per unit. Details of the three products are as follows: (₹)
S Q L
Annual Demand (units) 9,000 5,700 7,800
Selling Price 310 275 224
Component P 120 - -
Direct materials (₹8 per kg.) 24 32 24
Skilled labour (₹40 per hour) 20 60 40
Unskilled labour (₹24 per hour) 18 24 36
Variable Overhead (₹6 per machine hour) 18 24 24
Annual fixed costs are ₹15,00,000
Maximum availability of skilled labour is 16,200 hours. Other resources are sufficient to meet
the annual demand/sales.
Engineering division of the company came forward with a proposal to make the component
'P' in house with the following costs break up :
Direct materials (₹8 per kg.) ₹24
Skilled labour (₹40 per hour) ₹40
Unskilled labour (₹24 per hour) ₹ 8
Variable Overhead (₹6 per machine hour) ₹18
₹90
For in-house making of the component 'P' there will not be any change in the annual fixed
costs of the company. The company can either buy the component 'P' or make it in house.

RECOMMEND the optimum production plan and profit for the year. Show calculation in
support of your answer. [Nov 19 Exam (10 Marks)]
SOLUTION:
(1) Presently the company buys all requirement of Component P from outside suppliers at
₹120 p.u. Presently the company has only 16,200 Skilled Labour hours available. Thus,
presently these Skilled Labour hours must have been utilized based on ranking as follows:
Present allotment of 16,200 Skilled Labour hours:
Particulars S Q L
Total Demand of FG (Units) 9,000 5,700 7,800
SP p.u. 310 275 224
(-) VC p.u.:
Component P Buy 120 - -
DM 24 32 24
Skilled Labour (@ ₹40/Hr) 20 60 40
Unskilled Labour 18 24 36
VOH 18 24 24
∴ Contribution p.u. 110 135 100
(÷) Hrs p.u. (Skilled Lab ÷ ₹40/Hr) 0.5 1.5 1
∴ Contribution / Hr 220 90 100
Ranking 1 3 2
∴ Allotment:
 Of KF (Total 16,200 Skilled Lab. Hours) 4,500 3,900 7,800
 Of Units Produced 9,000 2,600 7,800
Present Profit Statement:
Particulars S Q L
Contribution p.u. 110 135 100
(×) Units of Allotment 9,000 2,600 7,800
∴ Total Contribution: 9,90,000 3,51,000 7,80,000
∴ Overall Total Contribution: 21,21,000
(-) FC (15,00,000)
∴ Overall Profit 6,21,000
(2) If company plans to make Component P in house, then it will incur Variable Cost in making
Component P and it will also incur Contribution Lost on some external sale as Skilled
Labour hours is limited and Component P requires Skilled Labour hours to make. In such
Skilled Labour hours will be reduced from the last ranking products in present allotment.

→ Units of Component P required (= Units of Product S) 9,000 Units

(×) hours per unit of Component P 1 Hr p.u.
∴ Total Hours required for making Component P 9,000 Hrs
& Total Hours presently allotted to last rank i.e. Q 3,900 Hrs
Thus, making Component P would require sacrifice of all units of Product Q, but still hours
released are not enough, so then it also requires sacrifice of some units of S or L. Now if
Component P is made in house, then hours needed for 1 unit of Product S will increase
(0.5 Hrs + 1 Hr = 1.5 Hrs p.u.). Accordingly, we need to do a revised allotment of hours
and revised profit stmt as follows:
Proposed allotment of 16,200 Skilled Labour hours:
Particulars S Q L
Total Demand of FG (Units) 9,000 5,700 7,800
SP p.u. 310 275 224
(-) VC p.u.:
Component P Make 90 - -
DM 24 32 24
Skilled Labour (@ ₹40/Hr) 20 60 40
Unskilled Labour 18 24 36
VOH 18 24 24
∴ Contribution p.u. 140 135 100
(÷) Hrs p.u. (Skilled Lab ÷ ₹40/Hr) 1.5 1.5 1
∴ Contribution / Hr 93.33 90 100
Ranking 2 3 1
∴ Allotment:
 Of KF (Total 16,200 Skilled Lab. Hours) 8,400 - 7,800
 Of Units Produced 5,600 - 7,800
Present Profit Statement:
Particulars S Q L
Contribution p.u. 140 135 100
(×) Units of Allotment 5,600 - 7,800
∴ Total Contribution: 7,84,000 - 7,80,000
∴ Overall Total Contribution: 15,64,000
(-) FC (15,00,000)
∴ Overall Profit 64,000
Recommendation

When component P is purchased, annual profits would be ₹6,21,000. When component P is

manufactured in-house, annual profits would be ₹64,000, a reduction of ₹557,000 per year.
Therefore, component P has to be bought externally. Optimum production plan would be
Product S – 9,000 units, Product Q – 2,600 units, Product L – 7,800 units
The decision to outsource make or buy decision might have strategic implications for the SEZ
and should be formulated from strategic perspective with senior management’s involvement.
E. NEW OFFER ACCEPTANCE

1. Decide by calculating Relevant Cost of new offer. If new offer is in addition to existing
production, then all Variable costs of new offer are relevant, Fix costs are relevant only if
incurred specifically for the new offer, or if they are avoidable.
2. Selling Price of New Offer = RC of New Offer + Profit required from New Offer.
3. When there are more than 1 types of products, then capacity is always measured in terms
of Hours, not Units.
Q.20. NEW OFFER ACCEPTANCE

Somesh of Agra presently operates his plant at 80% of the normal capacity to manufacture a
product only to meet the demand of Government of Tamil Nadu under a rate contract. He
supplies the product for Rs 4,00,000 and earns a profit of 20% on sale realization. Direct cost
per unit is constant. The indirect costs as per his budget projections are:
Indirect costs 20000 units 22500 25000 units
(80% capacity) Rs. (90% capacity) Rs. (100& capacity Rs.)
Variable 80,000 90,000 1,00,000
Semi variable 40,000 42,500 45,000
Fixed 80,000 80,000 80,000
He has received an order for the product equal to 20% of his present operation's. Additional
packing charges on this order will be Rs 1,000. Arrive at the price to be quoted for the export
order to give him a profit margin of 10% on the export price.
SOLUTION:


A Ltd., operating at 75% level of activity produces and sells two products X and Y. The cost
sheets of these two products are as under:
Product X Product Y
Units produced and sold 3,000. 2,000.
Per Unit Rs Per Unit Rs
Direct materials 10 20
Direct Labour 20 20
Factory Overheads (40% fixed) 25 15
Administration and selling overheads (60% fixed) 40 25
Total cost per unit 95 80
Selling price per unit 115 95
Factory overheads are absorbed on the basis of machine hour which is the limiting factor.
The machine hour rate is Rs. 10 per hour.
The Company receives an offer from Japan for the purchase of product X at a price of Rs.
87.50 per unit. Alternatively, the Company has another offer form Bangkok for the purchase
of product Y at a price of Rs. 77.50 per unit. In both the cases, a special packing charge of
Rs. 2.50 per unit has to be borne by the Company. The Company can accept either of the
two export orders by utilising the balance of 25% of its capacity.
Required: Advise the Company with detailed workings as to which proposal should be
accepted and prepare a statement showing the overall profitability of the Company after
incorporating the export propoosal suggested by you.
SOLUTION:


Souvenir Ltd. manufactures medals for winners of athletic events and other contests. Its
manufacturing plant has the capacity to produce 10,000 medals each month. The company
has current production and sales level of 7,500 medals per month. The current domestic
market price of the medal is Rs150.
The cost data for the month of March, 2013 is as under:
(Rs)
Variable Costs (that vary with units produced):

Direct Materials 2,62,500

Direct Manufacturing Labour 3,00,000
Variable Costs (that vary with number of batches):
Set-ups; Materials Handling; Quality Control (150 batches × ₹500 / batch) 75,000
Fixed Costs:
Manufacturing Costs 2,75,000
Marketing Costs 1,75,000
Souvenir Ltd. has received a special one-time-only order for 2,500 medals at Rs100 per
medal. Souvenir Ltd. makes medals for its existing customers in batch size of 50 medals (150
batches x 50 medals per batch = 7,500 medals).
The special order for 2,500 medals requires Souvenir Ltd. to manufacture the medals in 25
batches of 100 each. Required:
(a) Should Souvenir Ltd. accept the special order? Why? Explain briefly.
(b) Suppose the plant capacity was 9,000 medals instead of 10,000 medals each month. The
special order must be taken either in full or rejected totally. Should Souvenir Ltd. accept
the special order? Why? Explain briefly.
SOLUTION:
(a) Capacity is 10,000 Units
→ Present Capacity utilized: 7,500 Units
∴ Spare Capacity available: 2,500 Units
Capacity required for New Offer: 2,500 Units
∴ Enough Spare Capacity is available for New Offer to be accepted without Opportunity Cost.
→ New Offer: [2,500 Units]
Sales [@ Rs 100 p.u.] 2,50,000
(-) DM [@ Rs 35 p.u.] 87,500
(-) DL [@ Rs 40 p.u.] 1,00,000
(-) SVC [25 Batches @ Rs 500 / Batch] 12,500
∴ Profit 50,000
Ans: ∴ New Offer is acceptable
(b) Capacity is 9,000 Units
→ Present Capacity utilized: 7,500 Units
∴ Spare Capacity available: 1,500 Units
Capacity required for New Offer: 2,500 Units
∴ If New Offer is accepted, then there will be Loss of 1,000 Units of regular sale, this must be
evaluated as an Opportunity Cost.

→ Profit Lost on 1,000 Units of regular sale:

Sales [@ Rs 150 p.u.] 1,50,000
(-) DM [@ Rs 35 p.u.] 35,000
(-) DL [@ Rs 40 p.u.] 40,000
(-) SVC [20 Batches @ Rs 500 / Batch] 10,000
∴ Profit 65,000
Ans: ∴ Profit Lost on regular Sale > Profit Earned on New Offer
∴ New Offer must be Rejected.
F. OTHER GENERAL NOTES

1. Shutdown Point (SDP) is the level of sales below which it is better to shutdown business
temporarily, rather than continue with higher losses.
SDP is the level of sales below which, ‘Loss if Continue’ > ‘Loss if Shutdown’
Calculation – By Formula: SDP

. . . / %
Avoidable FC = Total FC if Continue – Total FC if Shutdown

Total FC if Shutdown includes: Cost of Reopening, Training, Repairs, etc
If estimated level of operation is more than SDP, then continue, otherwise shutdown.
Calculation – By Comparison: Shutdown if ‘Loss of Continue’ > ‘Loss of Shutdown’
2. Carrying cost of additional inventory also must be considered for new offer evaluation if
the carrying cost rate is given. Find inventory value of RM, WIP, and FG. Then take Total
Inventory Value × Carrying Cost Rate.
3. Bottleneck is that department due to which the maximum production is restricted. Identify
max. production of each department, then overall max production is which ever is lowest.
Now at this production, only the bottleneck dept is fully utilized, rest of the dept. still have
spare capacity left.
4. Return of Capital Employed (ROCE) = Return in Investment (ROI) =
5. Expansion decision question may require you to make a format of flexible budget as per
your CA Intermediate syllabus.
6. Overtime working means same workers are made to sit extra hours, hence we have to
pay them high overtime premium (mostly 50%). 2nd shift working means new set of
workers are hired for the extra work, in this case we may pay same rate or little extra rate,
however we will also incur extra fix costs like recruitment, etc.
Thus, overtime has higher VC while 2nd shift has extra FC. ∴ We can decide by IDP.

Q.23. SHUT-DOWN POINT

Universe Ltd. manufactures 20,000 units of 'X' in a year at its normal production capacity.
The unit cost as to variable costs and fixed costs at this level are Rs 13 and Rs 4 respectively.
Selling Price per unit is Rs 20.
Due to trade depression, it is expected that only 2,000 units of 'X' can be sold during the next
year. The management plans to shut-down the plant. The fixed costs for the next year then
is expected to be reduced to Rs 33,000. If the plant is shut down, plant maintenance would
cost Rs. 8,000 and on reopening of the factory, cost of overhauling the plant and cost of
training and engagement of new personnel would amount to Rs. 3,000 and Rs. 1,000
respectively. Should the plant to be shut-down? What is the shut-down point?
SOLUTION:
Q.24. NEW PRODUCT INTRODUCTION

PQR Ltd. is considering introducing a new product at a price of Rs. 105 per unit. PQR Ltd.’s
controller has complied the following incremental cost information based on an estimate of
1,20,000 units of sales annually for the new product:

Direct material cost Rs.36,00,000

Direct Laour cost Rs.24,00,000
Flexible manufacturing support Rs.12,00,000
Sales commission 10% of sales
Capacity related cost Rs.20,00,000
The average inventory levels for the new product are estimated as follows:
Raw Material: 2 months’ production
Work in progress (100% complete for Material and 50% complete for labor and Flexible
manufacturing support): 1 month production
Finished goods: 2 months’ production
Annual inventory carrying costs not included in the flexible manufacturing support listed
earlier are estimated to be 12% of inventory value. In addition, The sales manager expects
the instruction of new product to result in a reduction in sales of existing product from 3,00,000
to 2,40,000 units. The contribution margin for the existing product is Rs. 20 per unit.
Prepare a statement showing the budgeted impact on PQR’s profile on the introduction of the
product. Should the new product be introduced?
SOLUTION:

Q.25. OVERTIME V/S NIGHT SHIFT

Marvellous Manufacturers produce a single product. The Company's annual normal
production is 5 lakhs units of output on a single shift of eight-hour a day basis in terms of a
standard input of 1 lakh direct labour hours. Last year's income statement is given below:
(Rs)
Sales (7 lakh units @ Rs 2.50) 17,50,000
Less: Variable Expenses
Direct Material 2,80,000
Direct Labour (1,40,000 hours @ Rs 3.50) 4,90,000
Overtime Premium 1,40,000
Miscellaneous 2,10,000
Contribution Margin 6,30,000
Less: Fixed Expenses 5,30,000
Net Income 1,00,000
Management is concerned about the overtime working done last year (overtime is paid at
double the normal rate) and wants to investigate the possibility of working a second shift. The
cost accountant of the company estimates that a second shift would increase costs as follows:
an additional factory supervisor at Rs 30,000 per annum, a night shift allowance of 60 paise
per direct labour hour and an increase in security and administrative costs of Rs 40,500 a
year. Management requires you as their consultant to answer these questions with workings:
(a) If instead of working overtime a second shift had been introduced at the beginning of last
year itself, would profits have been better? If so by how much?
(b) At what capacity level it would be advantageous to the company to change from overtime
working to a second shift?
(c) This year it is estimated that there will be, on last year's figures, 20% increase in units
sold, 10% increase in selling price, 5% increase in direct material cost per unit and a direct
labour rate increase of Rs 0.30 per hour. Assuming that the overtime working would be
continued, prepare an income statement for the year based on the current estimates; if a
second shift working were to be introduced, with an increase in night shift allowance of 6
paise per direct labour hour, what would have been the savings in cost?
SOLUTION:

Analysis: This means that if the extra hours required are more than 24,310 hours, then it
would be advisable to do a second shift. However, if the required hours are expected to be
lesser than 24,310 hours, then overtime would be a better option.
Q.26. OTHERS
‘S’ manages the school canteen (approximately 1,600 students) at Noida. The current cash
payment system requires three clerks (paid ₹ 90 per hour), employed for about 4 hours a
day. The canteen operates approximately 240 days a year.
‘S’ is considering a Wireless Cash Management System (WCMS), where a student could just
swipe an ID Card for payment. This system would cost ₹ 1,25,000 to setup and ₹ 36,000 per

year to operate. ‘S’ believes that he could manage with one clerk if he were to implement the
system. Required:
ADVISE ‘S’ on the choice of a plan, assuming working life of WCMS as 5 years. (Ignore the
time vale of money) [May 20 MTP (5 Marks)]
SOLUTION: Net savings if WCMS is implemented:

Particulars Rs
Savings in Clerk Salary over 5 years 8,64,000
[2 Clerks × Rs 90/hr × 4 Hrs × 240 Days × 5 Years]
(-) Costs of WCMS: Setup Cost (1,25,000)
Operation Cost [Rs 36,000 × 5 Years] (1,80,000)
∴ Net Savings 5,59,000
Ans: Thus, financially, it seems that the WCMS must be implemented. But the relevant Non-
Financial Considerations must also be seen. The WCMS may be a lot more efficient, but
more rigid. For instance, what if, a student forgets to bring his/ her card or transaction failure
due to connectivity issue, and may not have enough cash to pay. Automated systems may
be less able to handle these situations. Having clerks may add an aspect of flexibility and a
human aspect that is hard to quantify.
G. HOW TO ANSWER ANALYSIS

1. Give interpretation for every CVP Analysis calculation done, eg BEP, MOS, SDP, IDP,
BEP by Ratio Method, BEP by Step-Wise Method, BEP with SVC, etc. Also give your
recommendation in the given case based on this interpretation.
2. Explain the logic behind the calculation method as explained in rules for calculation above.
3. For all relevant costing calculations, give explanation for each item that why is it relevant
or why is it not relevant. Explain why is any item is sunk cost or opportunity cost. Finally
give your recommendation.
4. For Key Factor questions, explain that key factor will limit production, also explain that
this key factor might become bottleneck, so, explain bottleneck also. Finally give your
recommendation.
5. For Make or Buy decisions, analyze Relevant Costs as explained in point 3 above and
give recommendation.
6. Give interpretation of IDP between Make or Buy if asked and give recommendation.

CHAPTER SUMMARY (CASES)

1. ETHICAL & NON FINANCIAL CONSIDERATIONS: [Nov 19 RTP]
Nutty Bites produces many edible snacks that are very popular especially among children.
Peanuts, Peanut oil are essential ingredients in many of its products. They are currently
facing this ethical issue –
“Medical studies have indicated peanut allergic reactions are on the rise. The prevalence is
more profound among children. Reactions can range from hives around the mouth to
potentially life threatening reactions when exposed even to the slightest trace of peanuts.
There is growing media campaign to force companies like Nutty Bites to make disclosure
about the presence of peanut on its package labelling”
Nutty Bites is a mid-size company that has a growing market. Risk to peanut exposure can
come not just from the presence of peanuts in its products. Some of its bought-in ingredients
(raw material input) are cooked in peanut oil. There are risks of “cross- contamination”
amongst products. Let us say, an equipment has been used produce cookies that has
peanuts. Next, the equipment is used, without being cleaned, to produce chips that does not
have peanuts as an ingredient. Some portion of the peanuts / peanut oil could contaminate
that specific batch of chips produced. Since labels of chips would not mention “peanuts” as
an ingredient, it poses a potential risk of causing allergic reaction to a customer unaware of
this contamination.
Management of Nutty Bites has called for a meeting to discuss this issue. “The issue need
not be addressed at all. After-all Nutty Bites is doing nothing against the law” is the opinion
of many members on the board of the company.
Required
(i) EXPLAIN why Nutty Bites should attempt to address this issue.
(ii) STATE potential benefits that business can garner by addressing this issue.
(iii)RECOMMEND, with reasons, the avenues available to Nutty Bites to address this ethical
issue.
(iv)EVALUATE the recommended solutions.
SOLUTION:
(i) Modern organizations have a moral duty of care to a wider range of stakeholders
not just its owners / investors. In this case, it owes a duty of care to anybody who consumes
its products. The presence of peanuts or peanut oil makes it a potential “health hazard” to
some consumers. Food safety is a fiduciary duty that Nutty Bites owes to the society.
Corporate Social Responsibility (CSR) is the duty an organization has towards a wider
community.
(ii) Addressing this ethical issue will help Nutty Bites to become a morally responsible
organization. The long- term benefits to its business could be as follows:
(a) Avoid bad publicity that could potentially damage its reputation and brand image.
(b) Avoid potential legal action for tort, committing a civil wrong.

(c) Operating environment within the business is more ethical, giving a sense of well-being
to its employees.
(iii) Following could be some of the responses that it could take to address the issue:
(a) A clear warning in the ingredients box that the factory uses peanuts while manufacturing
some of its products. This should be included even in products that do not contain
peanuts, to avoid any harm due to risk of cross- contamination. Customers who suffer this
allergy, would then be aware of the potential risk of consuming products of Nutty Bites.
Protection from potential lawsuits counters any loss of business for Nutty Bites.
(b) Segregate areas to have separate processing lines for products with peanuts / peanut oil
and those without it. If possible, have segregated staff for the two production lines in order
to avoid the risk of cross-contamination. If this is not possible, staff have to be well trained
on the risks of cross-contamination. Gloves need to be provided while handling material
during production of food products. This should be changed each time staff handle
production changes from “peanut variety” to the “non-peanut variety”.
(c) Equipment should be thoroughly cleaned while switching production from one variety to
another. Fewer changeovers in the production cycle, that is producing products in larger
batches, reduces the number of switches during production of different varieties of food
products.
(d) Storage of peanut material should be well segregated and monitored to avoid
contamination.
(e) If Nutty Bites has the resources, it could invest in pharma companies that are finding a
medical solution to this problem. The food industry could benefit from research and
development of treatments to address this life-threatening allergy. A break-through would
address a societal problem, while also having a positive impact for growth of Nutty Bites.
(iv) Risk of product safety is an important issue that needs constant review. Review would
be of the production process, storage, material handling as well as ingredient of purchased
raw materials. The benefit of constant review is that Nutty Bites can immediately identify
danger of contamination. For example, is a supplier of raw material changes the production
of the ingredients to include peanut / peanut oil, then Nutty Bites can be immediately aware
of the change due to its review process. In case of any future litigation, Nutty Bites could
defend itself by proving that it had a robust review process in place.
On the other hand, constant review requires time and money, with an ever-present possibility
of contamination. It is not feasible to ensure complete safety. Reviewers / quality inspectors
could become negligent once the process is well established. This could lead to instances
of contamination, even with a review process in place.
To conclude, Nutty Bites is morally responsible to spread awareness that some of its products
may contain allergy causing peanuts / peanut oil. It should streamline its storage and
production process to avoid risk of cross-contamination.

2. CVP ANALYSIS: [Nov 19 RTP Q9]
Hotel Nikko, Zeeland, an affordable leisure hotel resort is an ideal retreat to escape, unwind
and enjoy peace of mind. Set amid expansive tropical greenery in the enclave of Zeeland,
Hotel Nikko is designed for pleasure, where services reign supreme and Italian -style
architecture of its 25 classic rooms harmonize with nature. Hotel Nikko, Zeeland is a
beachfront resort that features a good choice of swim-up pool bar, gym, and variety of
restaurants. A wide array of water sport activities like surfing, sailing, jet skiing etc. are
available from beach operators at walking distance. The hotel is synonymous with enjoyment
and value for money, with a large choice of very attractive “All Inclusive” packages.
Nikko charges guests ZD 2,700 per room per night, irrespective of single or double
occupancy. The variable cost is ZD 900 per occupied room per night. The Nikko is available
throughout 365 days a year and has a 75% budgeted occupancy rate. Fixed costs are
budgeted at ZD 9 million and are incurred evenly during the year.
During the second quarter (Q2) of the year, usually the room occupancy rates remains
substantially below the levels expected at other quarters of the year. Nikko is expecting to
sell 900 occupied room nights during Q2. Management is considering strategy to improve
profitability, including closing the Nikko for the duration of Q2 or adopting one possible option:
There is scope to extend the Nikko by creating enough space to run a Rustic Chic, Italian
Style restaurant to serve its guests. The annual revenues, costs and sales volumes for the
combined operations are given in the above graph.
Note: Zeeland’s home currency is the ZD. Required: ANALYZE the profit improvement plan.
SOLUTION: → The Present Profit of Hotel Nikko:

Total Room Days = 25 Rooms × 365 days × 75% = 6,844
Profit = Total Contribution – Fixed Cost

= 6, 844 room days × (ZD 2,700 – ZD 900) - ZD 90,00,000

= ZD 33,19,200
→ If Nikko is Shut Down during Q2:
Loss of Contribution = {900 Room Days × (ZD 2,700 - ZD900)} = ZD 16,20,000
Nikko should not close its hotel during Q2. The fixed costs will still be incurred and closure
would result in lost contribution of ZD16,20,000. This in turn would decrease annual profits
by ZD16,20,000. Plus, Nikko could lose guests at other quarters of the year, particularly their
regular business customers, who may perceive the Nikko as being non-reliable.
→ Proposal of Opening an Italian Restaurant:
Opening a restaurant will increase the fixed costs of the Nikko from ZD 9 million p.a. to ZD
12 million p.a. (See Graph). Thus, annual increment of ZD 3 million.
Average Revenue per occupied room will rise from ZD 2,700 to ZD 3,636.36... (ZD 30 Million
÷ 8,250 rooms, see graph) because increasing guest expenditure in Italian restaurant.
The total cost predicted at a level of 8,250 occupied rooms is ZD 23.75 million which means
the variable costs must be ZD 11.75 million (ZD 23.75 million – ZD 12 million fixed costs).
This is a variable cost per occupied room of ZD 1,424.24; which is an increase of ZD 524.24.
Consequently, the breakeven point has gone up from 5,000 to 5,425 (as shown in the
diagram) occupied rooms so the Nikko is required to sell more room nights to cover costs.
However, budgeted occupancy is now 7,310 occupied room nights which is 80.11%
occupancy (7,310/9,125). This provides a margin of safety of 1,885 occupied room nights or
25.79%. At 7,310 occupied room nights, Nikko’s budgeted profit would be ZD 41,70,597
{7,310 × (ZD 3,636.36 – ZD 1,424.24) – 12 million} which is more than present budgeted
profit by ZD 8,51,397. So, it is better for Nikko to go for opening an Italian Restaurant.


CH – 06 PR IC ING D EC ISION
CHAPTER
PRICING DECISION
06
CHAPTER SUMMARY
A. PRICING UNDER DIFFERENT MARKET STRUCTURES

Types of markets: Perfect Competition, Monopoly, Monopolistic Competition & Oligopoly.
PRICING BY PROFIT MAXIMIZATION MODEL:
Law of demand states that with the increase in price, demand (quantity) decreases. Thus, we
must set the best price such that the overall profit is maximum. This can be done by 2 ways:
A. Trial & Error Method:
Calculate total contribution at different given prices using the given quantities. Choose the
price which gives maximum total contribution. This method gives approximate answer.
B. Equation Method:
“Profit is maximum at the price when MC = MR.” Steps:
(1) Identify linear equation for demand v/s price as: P = a – bQ
→ Where, a = Price at which quantity is zero
Change in Price
b = Slope of the line =
Change in Quantity
(2) Find Total Revenue (TR) based on this Price (P):

∴ TR = P × Q = (a – bQ) × Q = aQ – bQ2
(3) Find Marginal Revenue (MR), means the revenue from 1 extra unit sold:
∴ MR = Differentiation of TR with respect to Quantity (Q)
∴ MR = of (TR) = of (aQ – bQ2) = a – 2bQ. ∴ MR = a – 2bQ
(4) Marginal Cost (MC) = Variable Cost p.u. (given)

(5) Now take MC = MR i.e. Step (3) = Step (4), make equation, solve and find Q. This Q
indicates Equilibrium Quantity, i.e. best quantity to sell.
(6) Using this Equilibrium Quantity (Q), find Price (P) from “P = a – bQ”. This Price (P)
indicates the Equilibrium Price, i.e. the best possible price at which profit is maximum.

B. PRINCIPLES OF PRODUCT PRICING

Cost should not be considered as an important determinant of price, rather profit
maximization is. Important determinants of price are competitive situations and elasticities.
Price Customization:
- Based on product line - Based on customer’s past behaviour
- Based on demographics - Based on time differential
Price Sensitivity:
It measures the customer’s behaviour to the change in price
Unique Value Effect – Low sensitivity
Substitute Awareness – High sensitivity
Difficult Comparison Effect – Low sensitivity
Total Expenditure Effect – if it is small portion of income, then Low sensitivity
End Benefit Effect – if it is small portion of end product cost, then Low sensitivity
Shared Cost Effect – Low sensitivity
Sunk Investment Effect – Low sensitivity
Price Quality Effect – if perceived quality is high, then Low sensitivity
Inventory Effect – if not storable, then Low sensitivity.
C. PRICING METHODS
COST-BASED PRICING METHOD:
Price = Full Cost (Including depre) + Profit. However, in this case, Overheads allocation is
arbitrary, not precise. In that case, it might be taken as: Price = Variable cost + Markup (to
include Fixed cost & Profits). Markup / Profit might also be based on desired ROI.
COMPETITION-BASED PRICING METHODS:

Pricing is based on what competitors are charging. Hence even if costs or demand change,
still company does not change its price unless competitor changes his price.
 Going Rate Pricing: Applicable when there is high competition & homogenous product &
is difficult to measure costs. There is no pricing decision to make, focus on cost control.
 Sealed Bid Pricing: Firm offers a price based on expectation what competitors will offer.
However price is still not quoted below the marginal cost.
 Value Based Pricing: i.e. pricing based on customer’s perception of its value:
o Objective Value or True Economic Value (TEV): Pricing based on benefits that a product
is intended to deliver to the consumers relative to the other products.
TEV = Cost of the Next Best Alternative + Value of Performance Differential
i.e. = Price of a comparable product + Value of additional features
o Perceived Value: Price that a consumer is willing to pay.

Pricing must be such that it creates value for the customer. It should create incentive to
purchaser to buy the product and to seller to sell the product.
PRICING IN RECESSION & PRICING BELOW MARGINAL COST:
During recession, a firm may continue to sell at a price less than the total cost but above the
marginal cost for a limited period. Benefits:
- Retain employees, - Prevent machine idleness,
- Prevent competition from acquiring our customers.
Pricing below marginal cost might be followed only in following cases:
- Perishable product - Stocks accumulated and market prices fallen
- To save carrying costs - To promote new product
- To boost sales of another related product that has good profits.
PRICING OF NEW PRODUCTS:

1. Revolutionary Product: It is new for the market, it can create its own value, has potential
of becoming the market leader. It will enjoy a premium price as a reward for its innovation.
2. Evolutionary Product: It is just an upgraded version with few additional characteristics.
It will enjoy good price, but not as much as Revolutionary Product.
3. Me-too Product: Its emergence is a result of the success of a revolutionary product. They
are market followers, Price Takers.
4. Skimming Price:
It is a policy of high prices during the launch of a new product, in sync with high
promotional expenses initially. In later years, prices are gradually reduced. Reasons:
 Cream crowd is inelastic to price, so take maximum benefit of it.
 In the initial period when the demand is not known, it covers the initial cost of production
 Huge promotional cost in initial period.
5. Penetration Price:
It is a policy of using low prices during the launch of a new product, for penetrating markets
ensuring long term survival and long term profitability. It needs an analysis of the scope
for market expansion.
Purpose is to popularize the new product and discourage new competitors.
6. Predatory Pricing:
Means very low pricing (even making loss), intending to drive competitors out of the
market or create barriers to entry. It is adopted when:
 Demand is elastic,
 There will be substantial savings on large scale production, &
 There is threat of competition.

D. OTHER TOPICS
PRICE ADJUSTMENT POLICIES:
Pricing might be adjusted because of:
- Distributor’s Discounts - Quantity Discounts - Cash Discounts
- Price Discrimination - Geographic Pricing
SENSITIVITY ANALYSIS IN PRICING DECISIONS:

It is an analysis to study how sales and costs will respond to internal & external changes.
External changes: Market Demand, Changes in Market Prices, Exchange Rate Fluctuation.
Internal changes: Initial Outlay, R & D, Production Cost, Marketing Costs, Launch Dates,
Product Prices
PRICING OF SERVICES: ISSUES:

 Each service transaction is likely to have distinct pricing structure when services are
unique to each customer.
 If customer also participates in service providing, then pricing must also accommodate
the intangible costs that a customer may have to bear with.
 In certain services, prices are government regulated.
 In some cases, prices are collectively fixed by trade associations.
E. NOTES FOR OTHER PRACTICAL QUESTIONS

1. When Profit required is given:
Step – 1: Assume SP p.u. = 𝑥 and find profit using this,
Step – 2: Calculate Profit Required,
Now equate Step – 1 & Step – 2 to find 𝑥 i.e. SP p.u.
2. List SP means MRP, if discount is offered on this List SP, then treat the discount just like
a cost in the above method.
3. If profit required is not given, then follow profit maximization model explained earlier.
4. If new offer is obtained for one of the Joint Products, then other product will also have to
be produced. Accordingly SP of this additional other product might have to be reduced.
5. If there are 2 products, and both require same contribution per hour, then take overall
contribution per hour also same.
6. If ‘Minimum SP’ is asked, then take Profit = 0. In this, if the product is well established,
then SP = VC + FC. However, if it is a new product, then SP = Only VC.

PRACTICALS
Q.01. PRICING BASED ON ROI

Find the selling price of an article whose cost for production & sale at 1,00,000 units are:
Material Rs. 50,000, Labour Rs. 40,000, Production Overheads are absorbed @ 100% of
Prime cost, Administration Overheads are absorbed @ Re 0.70 per unit produced; Selling
and Distribution Overheads are recovered @ 1 0% on sales.
The fixed portion of capital employed is Rs. 30,000 and the varying portion is 40% of sales.
A profit of 8% net on capital employed after payment of tax at 40% of the earnings is desired.
SOLUTION:
Q.02. PRICING BASED ON DEMAND

Novice Ltd. is about to introduce a new product with the following estimates:
Price per unit (in Rs) Demand (in thousand units)
30.00 400
31.50 380

33.00 360
34.50 340
36.00 315
37.50 280
39.00 240
Costs:
Direct material Rs 12 per unit Direct labour Rs 3 per unit
Variable overhead Rs 3 per unit Selling expenses 10% on sales
Fixed production Oh Rs 14,40,000 Administration expenses Rs 10,80,000
Judging from the estimates, determine the tentative price of the new product to earn
maximum profit.
SOLUTION:
→ Calculate Total Contribution for all SP levels:
SP p.u. (₹) Demand (Units) Total Contribution [@ SP – 18 – 10% of SP]
30.00 400 = ₹(30.00 – 18 – 3.00) × 400 units = ₹3,600
31.50 380 = ₹(31.50 – 18 – 3.15) × 380 units = ₹3,933
33.00 360 = ₹(33.00 – 18 – 3.30) × 360 units = ₹4,212
34.50 340 = ₹(34.50 – 18 – 3.45) × 340 units = ₹4,437
36.00 315 = ₹(36.00 – 18 – 3.60) × 315 units = ₹4,536
37.50 280 = ₹(37.50 – 18 – 3.75) × 280 units = ₹4,410
39.00 240 = ₹(39.00 – 18 – 3.90) × 240 units = ₹4,104
→ When multiple SP are given, then choose the SP at which Total Profit is Maximum. But in
this question, FC remains same for all SP, thus choose SP at which Total Contribution is
Maximum. Thus, best SP here is ₹36 p.u.
Q.03. PRICING OF JOINT PRODUCT

Rational Ltd. produces 3,00,000 kgs. of S and 6,00,000 kgs. of Y from an input of 9,00,000
kgs. of raw material- Z simultaneously The selling price of S is Rs 8 per kg and that of Y is
Rs 6 per kg.
Processing costs amount to Rs 54 lakhs per month as under:
Raw material- Z- 9,00,000 kgs. at Rs 3 per kg Rs 27,00,000
Variable processing costs Rs 18,00,000
Fixed processing costs Rs 9,00,000
Total Rs 54,00,000

There is an offer to purchase 60,000 kgs of Y additionally at a price of Rs4 per kg. The existing
market for Y will not be affected by accepting the offer. But the price of S is likely to be
decreased uniformly on all sales.
Find the minimum reduced average price for S to sustain the increased sales.
SOLUTION:
Note: New Offer is sustainable if Total Additional Revenue is ≥ Additional Cost of New Offer.
Q.04. PRICING OF 2 PRODUCTS

R.T. Ltd, want to fix proper selling prices for their products ‘A’ and ‘B’ which they are newly
introducing in the market. Both these products will be manufactured in Department D which
is considered as a Profit Centre. The estimated data are as under:
A B
Annual Production (Units) 1,00,000 2,00,000
Direct Materials per unit Rs 15.00 Rs 14.00
Direct Labour per unit (Direct Labour Hour Rate Rs 3) Rs 9.00 Rs 6.00
The proportion of Overheads other than interest, chargeable to the 2 products are as under:

Factory Overheads (50% Fixed) 100% of Direct Wages, Administration Overheads (100%
Fixed) 10% of Factory Cost, Selling and Distribution Overheads (50% Variable) Rs 3 and Rs
4 respectively per unit of products A and B.
The fixed capital investment in the Department is Rs 50 Lakhs. The working capital
requirement is equivalent to 6 months stocks of cost of sales of both the products. For this
project a term loan amounting to Rs 40 lakhs has been obtained from Financial Institutions
at an interest rate of 14% per annum. 50% of the working capital needs are met by Bank
Borrowing carrying interest at 18% per annum. The Department is expected to give a return
of 20% on its capital employed. You are required to:
(i) Fix the selling prices of products A and B such that the contribution per direct labour hour
is the same for both the products;
(ii) Prepare a statement showing in detail the overall profit of the Department.
SOLUTION:

Q.05. PRICING BASED ON CONTRIBUTION ON INVESTMENT

LMV Limited manufactures product Z in departments A and B which also manufacture other
products using same plant and machinery. The information of product Z is as follows:
Items Department A (Rs) Department B (Rs)
Direct Material per unit 30 25
Direct Labour per unit (Rs 10 per hour) 30 40
Overhead Rates:
Fixed 8 per hour 4 per hour
Variable 6 per hour 3 per hour
Value of Plant and Machinery 25 lakhs 15 lakhs
Overheads are recovered on the basis of direct labour hours. Variable selling and distribution
overheads relating to product Z are amounting to Rs 30, 000 per month. The product requires
a working capital of Rs 4, 00,000 at the target volume of 1,500 units per month occupying 30
per cent of practical capacity.
You are required:
(a) To calculate the price of product Z to yield a contribution to cover 21 percent rate of return
on investment.

(b) Set the minimum selling price of the product if (1) the product is well established in the
market; (2) the product is first time launched in the market.
SOLUTION:
Q.06. PRICING BASED ON LEARNING CURVE

DK International is developing a new product. During its expected life, 16,000 units of the
product will be sold for ₹102 per unit. Production will be in batches of 1,000 units throughout
the life of the product. The direct labour cost is expected to reduce due to the effects of
learning for the first eight batches produced. Thereafter, the direct labour cost will remain
constant at the same cost per batch as in the 8th batch. The direct labour cost of the first
batch of 1,000 units is expected to be ₹55,000 and a 90% learning effect is expected to occur.
The direct material and other non-labour related variable costs will be ₹50 per unit throughout
the life of the product. There are no fixed costs that are specific to the product.

The learning index for a 90% learning Curve = - 0.152; 8-0ꞏ152 = 0.729; 7-0ꞏ152 = 0.744
Required:
(i) CALCULATE the expected direct labour cost of the 8th batch.
(ii) CALCULATE the expected contribution to be earned from the product over its lifetime.
(iii)CALCULATE the rate of learning required to achieve a lifetime product contribution of
₹5,00,000, assuming that a constant rate of learning applies throughout the product's life.
SOLUTION:

Q.07. PRICING BASED ON PROFIT MAXIMIZATION MODEL

Baithway India Ltd. (BIL) is a premier multi-discipline company. BIL manufactures a diverse
range of products viz. Pressure Vessels, Wagons, Steel Castings etc. To manufacture
Wagons, BIL undertake structural fabrication jobs and manufacturing, retrofitting of EOT
crane. It is presently the flagship company of the Baithway Group comprising of renowned
companies such as Krishna Agriculture, Chiang Phosphate etc. The Group was launched
with the idea of one virtual company with diversified businesses, and is based on four
fundamental principles - Collaboration, Sustainability, Inclusiveness and being Global.
Baithway India Ltd. has two Divisions namely, Bogie Division (BD) and Wagon Division (WD)
for manufacturing of Wagon. ‘BD’ manufactures Bogies and ‘WD’ manufactures various type

of Wagons like Freight Wagon, Tank Wagon, Special Wagon etc. To manufacture a Wagon,
‘WD’ needs 4 Bogies. ‘BD’ is the only manufacturer of the Bogies and supplies both ‘WD’ and
outside customers. Details of ‘BD’ and ‘WD’ for the coming financial year are as follows:
BD WD
Fixed Costs (₹) 9,20,20,000 16,45,36,000
Variable Cost per unit (₹) 2,20,000 4,80,000*
Capacity per month (units) 320 12
* excluding transfer costs
Market research has indicated that the demands in the market for Baithway India Ltd.’s
products at different quotations are as follows-
For Bogies: Quotation price of ₹3,20,000 no tender will be awarded, but demand will
increase by 30 Bogies with every ₹10,000 reduction in the unit price below ₹3,20,000.
For Wagons: Quotation price of ₹17,10,000 no tender will be awarded, but the demand for
Wagons will be increased by 2 Wagons with every ₹50,000 reduction in the unit price below
₹17,10,000.
Further, ‘BD’ is the only manufacturer of Bogies but due to increased demand, competitors
are entering the market. The division is reviewing its pricing policy and carrying out some
market research. After the market research, the division ‘BD’ has decided to introduce new
type of “E” Class Bogies in the market and to obtain the patent right for such unique Bogies.
High growth in future characterizes this Class.
Required
(i) CALCULATE the unit quotation price of the Wagon that will maximise Baithway India
Ltd.’s profit.
(ii) CALCULATE the unit quotation price of the Wagon that is likely to emerge if the divisional
managers of ‘BD’ and ‘WD’ both set quotation prices calculated to maximise divisional
profit from sales to outside customers and the transfer price is set at market selling
(quotation) price. [Note: If P = a – bQ then MR = a – 2bQ]
(iii)RECOMMEND appropriate pricing strategy while introducing the “E” Class Bogies.
SOLUTION:


(iii) Recommendations:
Whenever a new product is launched into the market, management can adopt either
Skimming or Penetration strategy.
The idea behind Skimming Strategy is to intentionally keep a price high to recover the high
R&D and marketing expenses associated with developing a new product. For Price Skimming
to work, the product must be perceived as having unique advantage over its competing
products, very difficult to copy or protected by patents.
Division ‘BD’ may follow Skimming Strategy by taking advantage of the distinctive features of
Bogie “E”. High prices in the early stages of a Bogies’ life cycle are expected to generate high
initial cash flows, this will help the division to recover the high development costs it would
incur. Further, this new Bogie “E” is protected from competition through entry barrier. Such
barrier is patent.
With Penetration Strategy, a low price is initially charged for the product rather than high
prices. The idea behind this is that the price will make the product accessible to many buyers
and therefore the high sales will compensate for the lower prices being charged. This
penetration pricing is adopted for rapid market acceptance, maximum sales and discouraging
competition from the market, however this strategy is not for all companies since it requires
a cost structure and scale economics that remain unaffected by narrow profits margin.
The circumstances which may favor a penetration pricing policy are:
 Highly elastic demand for the product, i.e. the lower the price, the higher the demand. This
situation is not mentioned in this case for Bogies “E”.
 If significant economies of scale could be achieved so that higher sales volumes would
result in reductions in costs. However, in this case, it cannot be ascertained.
 Where entry barriers are low, however in this case, new competitors cannot enter the
market as Bogies “E” is protected by patent.
 If company desires to shorten the initial period of the product’s life-cycle to enter the growth
and maturity stages quickly, however, there is no evidence the division ‘BD’ wish to do this.
Overall, due to the uniqueness, heavy R&D cost, and barrier to entry for competitor, a market
skimming pricing strategy is appears to be the most appropriate pricing strategy for Bogie E.


CH – 08 TRAN SFER PR IC ING
CHAPTER
TRANSFER PRICING
08
CHAPTER SUMMARY & PRACTICALS
A. BASICS
Transfer Price (TP): When a division of a company sells units to another division within the
same company, then in is called transfer, and the price charged by the seller division from
the buyer division is called Transfer Price.
Each division is a Profit Center, so each division manager wants to maximize profits of his
division. We need to decide TP such that Overall Profit of the company is maximized and it
is equally acceptable to both division managers.
NOTE:
1. TP decision does not affect overall profit of the company as a whole.
2. TP decision will affect overall profit of the company if demand is based on the price. (i.e.
when demand schedule is given in the question)

METHODS OF TP:
1. Market Based TP: TP = Market Price,
(Used when Division A was working at Full Capacity)
2. Cost Based TP: TP = Cost (either only VC or TC)
(Used when Profit is centralized, so Division A does not want any divisional Profit)
3. Cost + Mark-up: TP = Cost + Fix % Profit
4. Standard Cost TP: TP = Standard Cost
(It motivates Division A to do Cost Control)
B. NEGOTIATED TRANSFER PRICE

TP is negotiated between Min TP & Max TP:
→ Min TP = Min TP below which the seller division is not ready to sell
= VC of Transfer (Excluding V-S&D that are not incurred on Transfer)
+ Contribution Lost (if any) on Transfer (if Seller was at Full Capacity)
[This indicates the min price which seller wants so that it recovers whatever
cost it incurred on transfer and also recovers whatever contribution it lost due
to transferring these units internally.]
→ Max TP = Max TP above which the buyer division is not ready to buy
= (1) “Total Cost” of ready material from outside
(–) Additional cost required to make the transferred material usable
[This indicates the max price which buyer is ready to pay so that he does not
incur cost more than if he buy the product from outside.]
----------------------------------------- OR -------------------------------------------------
(2) Net Marginal Revenue = (S.P – Other Var. Costs) of buyer division
[This indicates the max price which buyer is ready to pay so that he does not
incur loss on selling his final product, i.e. max material price that he will pay for
zero profit on sale of final product.]
-----------------------------------------------------------------------------------------------
… … … whichever is Lower
Conclusion:
- Transfer only that much units in which Min TP < Max TP.
- If Min TP < Max TP then for the best of the company as whole, transfer must be done. Now,
if the decided TP is already given in the question, but this decided TP is not in the range of
Min TP to Max TP, then the divisions would not prefer doing transfer as it will affect the
divisional performance severely. This is when there will be conflict of “Goal Congruence”
between the divisional decision and company decision.

Notes / Revision:
1. Fixed Costs must also be included in calculating Min TP if:
- the seller division has no other external sale “&”
- the fixed cost is specifically incurred for that seller department.
2. Fixed Costs must also be included in calculating Max. TP (i.e. Net Marginal Revenue) if:
- the fixed cost is specifically incurred for that transfer.
3. But in general, if nothing is given, then always assume that the Fixed Cost is common
fixed cost of the company, i.e. not specific Fixed Cost, hence always ignore.
4. If “Partial Transfer” is allowed, then more than 1 Min. TP might be needed. Calculate
Minimum TP on per unit basis separately for each type of contribution lost.
5. If “Partial Transfer” is not allowed, then only 1 Min. TP is needed. Calculate this Minimum
TP by taking total of VC + CL (if any) + Specific FC (if any) of total units of transfer, and
then divide total units of transfer in that.
6. While calculating Maximum TP, “Total Cost” includes any cost incurred until the material
from outside is ready for use in the company. (eg. Inward transport cost).
7. If the questions asks to explain “Behavioral Consequences”, then explain that why any
division will or will not accept the transfer. Explain the effect of the transfer on the divisional
profit or divisional ROI and compare with divisional profit when no transfer is done.
8. The net benefit of doing internal transfer, to the company as a whole, is always equal to
(Max TP – Min TP). [Refer Q _____ ]
9. If divisions do not agree to do transfer in spite of Min TP < Max TP, then to resolve this
conflict, suggest methods like: (1) Dual Rate Transfer Pricing Method & (2) Two Part
Transfer Pricing Method. Explain these only in theory.
10. If the seller division has multiple products and has a key factor, then for transfer,
contribution lost may be of a product other than the product which is transferred.
Contribution will be lost of the product which was last ranking.
11. For fixing a transfer price, best method is “Shared Profit Transfer Pricing Method” in which
profit is shared in ratio as follows:
1st Priority: Ratio of divisional profits when no transfer is done.
2nd Priority: Ratio of Cost incurred in each division.
3rd Priority: Equal Ratio.
12. If demand schedule is given in the question (i.e. different units demanded at different SP),
then we need to follow trial and error method by calculating contribution at each different
price and choosing the price which gives highest total contribution.
13. General format of Profit Statement:
Particulars Division A Division B Overall Co.
Units: Ext
T/f

Sales: Ext
T/f -
(-) VC: T/fd Mat -
Purch Mat.
OVC (Other DM, DL, VOH)
V-S&D Oh (for Divi-A, only on Ext.)
∴ Total Contribution
(-) FC
Profit
Q.01. MIN TP & MAX TP CALCULATIONS:

X Ltd, has 2 divisions namely A & B, Both divisions have full autonomy over their operating
decisions. Division A produces Product P and Division B produces Product Q. Product P
may be used for producing Product Q with little alteration.
Division A provides the following information:
Demand of Product P in external market: 18000 units @ Rs, 30 per unit
Variable Cost (including Variable Selling Cost of Rs. 2 per unit not incurred on internal
transfer): Rs 20 per unit
Division B provides the following information:
Division B requires 5000 units of Product P to be used in production of Product Q.
However, Division B has to incur Rs, 5 per unit as additional cost to make Product P useable
for the production of Product Q. Independent supply of Product R is available in the market
which is refined form of Product P at a price of Rs. 32 and on which no further alteration is
required and it can be directly used for the production of Product Q.
Required: Calculate minimum and the maximum transfer price and state whether internal
transfer is profitable or not in each of the following alternative cases:
(a) If the production capacity of Division A is limited to 25,000 units of Product P.
(b) If the production capacity of Division A is limited to 20,000 units of Product P (Partial
Transfer not allowed).
(c) If the production capacity of Division A is limited to 20,000 units of Product P (Partial
Transfer allowed).
(d) If the production capacity of Division A is limited to 18,000 units of Product P.
SOLUTION: Max. TP = Total Cost of ready material from outside: = ₹32
(–) Adnl cost to make transferred mat. usable = (₹5) = ₹27
OR Net Marginal Revenue = (S.P – Other VC): = NA
… … … whichever is Lower = ₹27


Q.02. NET BENEFIT OF TRANSFER:

APC Ltd. has two divisions- Division X and Division Y with full profit responsibility. Division X
produces components 'Gex' which is supplied to both division Y and external customers.
Division Y produces a product called 'Gextin' which incorporates component 'Gex'. For one
unit of 'Gextin' two units of component 'Gex' and other materials are used.
Till date, Division Y has always bought component 'Gex' from division X at ₹50 per unit since
the lowest price at which the component 'Gex' could have been bought by Y was ₹52 p.u..
Division X charges the same price for component 'Gex' to both, division Y and external
customers. However, it does not incur Selling and Distri. costs when transferring internally.

Division Y has received a proposal from a new supplier who has offered to supply component
'Gex' for ₹47 per unit at least for the next three years.
Manager of Division Y requests the manager of Division X to supply component 'Gex' at or
below, ₹47 per unit. Manager of Division X is. not ready to reduceꞏ the transfer price since
the divisional performance evaluation is done based on profit margin ratio of the division.
The following additional information is made available to you :
Component 'Gex'₹ Product 'Gextin'₹

Selling Price per unit 50 180
Less: Variable Costs
Direct Materials
Component 'Gex' - 100
Other materials 12 22
Direct labour 16 13
Manufacturing Overhead 2 5
Selling and Distribution Costs 4 2
Contribution per unit 16 38
Annual fixed costs ₹40,00,000 ₹20,00,000
Annual external demand (units) 3,00,000 1,20,000
Capacity of plant (units) 5,00,000 1,50,000
Required
(i) CALCULATE the present profit of each division and the company as a whole.
(ii) ANALYSE the impact on the total annual profits of each division and the company as a
whole if Division Y accepts the offer of the new supplier.
(iii)In the changed scenario, DISCUSS why the top management should intervene and advise
a suitable transfer price for component 'Gex' for resolving transfer pricing conflict which
promotes goal congruence through efficient performance of the concerned division.
[Nov 19 Exam (10 Marks)]
SOLUTION:

Impact on Profit if Division Y accepts the offer of new supplier:

[i.e. Impact on Profit if No Transfer is done]
Particulars Division X Division Y Overall Co.
Profit If Transfer is Done 49,60,000 25,60,000 75,20,000
Profit if Transfer is Not Done 8,00,000 32,80,000 40,80,000
∴ Change in Profit - 41,60,000 + 7,20,000 - 34,40,000
Reasons for Change in Profit:

Division X:
Contribution Lost on Transfer Sale: [2,40,000 Units @ ₹(50-30)] ₹48,00,000
(-) Contribution earned on Ext. Sale: [ 40,000 Units @ ₹(50-34)] (₹6,40,000)
∴ Net Decrease in Profit - ₹41,60,000
Division Y:
Savings in Material Purchase Cost: [2,40,000 Units @ ₹(50-47)] ₹7,20,000
∴ Net Increase in Profit + ₹7,20,000
Overall Company:
Extra Cost of Buying Material: [2,40,000 Units @ ₹(47-30)] ₹40,80,000
(-) Contribution earned on Ext. Sale: [ 40,000 Units @ ₹(50-34)] (₹6,40,000)
∴ Net Decrease in Profit ₹34,40,000

But, TP given is ₹50 p.u., Thus, there is Conflict of Goal Congruence as explained in (ii).
Q.03. NET BENEFIT OF TRANSFER:

Great Vision manufactures a wide range of optical products including lenses and surveillance
cameras. Division ‘A’ manufactures the lenses while Division ‘B’ manufactures surveillance
cameras. The lenses that Division ‘A’ manufactures is of standard quality that has a number
of applications. Due to huge demand in the market for its products Division ‘A’ is operating at
full capacity. It sells its lenses in the open market for ₹140 per lens, the variable cost of
production for each lens is ₹110, while the total cost of production is ₹125 per lens.
The total production cost of a camera by Division ‘B’ is ₹400 each. Currently Division ‘B’
procures lens from foreign vendors, the cost per lens would be ₹170 each. The management
of Great vision has proposed that to take advantage of in-house production capabilities and
consequently the procurement cost of the lens would reduce. It is proposed that Division ‘B’
should buy an average of 5,000 lenses each month from Division ‘A’ at ₹120 per lens. The
estimate cost of a surveillance camera is as below:
Other components purchased from external vendors 150
Cost of lens purchased from Division ‘A’ 120
Other variable costs 30
Fixed overheads 50
Total cost of a camera 350
Each surveillance camera is sold for ₹410. The margin for each camera is low since
competition in the market is high. Any increase in the price of a camera would reduce the
market share. Therefore, Division ‘B’ cannot pay Division ‘A’ beyond ₹120 per lens procured.

Great vision’s management uses Return on investments (ROI) as a scale to measure the
divisional performance and marginal costing approach for decision making.
Required
(i) ANALYZE the behavioral consequences of each division when Division ‘A’ supplies
lenses to Division ‘B’ at ₹120 per lens? Substantiate your answer based on the information
given in the problem.
(ii) ANALYZE if it would be beneficial to the company as a whole for Division ‘A’ to supply the
lenses to Division ‘B’ at ₹120 per lens.
(iii)Do you feel that the divisional managers should accept the inter-divisional transfers in
principle? If yes, CALCULATE the range of transfer price?
(iv)ADVISE alternate transfer pricing models that the chief executive of the company can
consider in order to change the attitude of the divisional heads if they are against the
transfer pricing policy.
(v) Calculate range of transfer price, if Division A has excess capacity & can accommodate
the internal requirement of 5,000 lens per month within the current operations.
[Nov 18 RTP]
SOLUTION:
Min. TP = VC of Lens + CL on Ext. Sale of Lens
= ₹110 + ₹30 = ₹140
Max. TP = Total Cost of ready material from outside = ₹170
OR Net Marginal Revenue = (S.P – Other Var. Costs) = 410-150-30 = ₹230
… … … whichever is Lower = ₹170
∴ Min.TP Max. TP. ∴ Transfer must be done.
[Note: Here analysis is done based on ROI because Total Cost of production p.u. is given,
this Total Cost of production p.u. can be taken as investment to calculate ROI]
(i) Analysis of Behavioral Consequences
Division ‘A’ has huge demand for its lenses enabling it to operate at full capacity. External
sales yield a contribution of ₹30 per lens sold (₹140 - ₹110). Likewise, each sale yields a
profit ₹15 per lens (₹140 - ₹125). This yields an ROI of 12% (₹15 ÷ Total cost of ₹125).
If Division ‘A’ sells lens to Division ‘B’ at ₹120 per lens, it contribution reduces to ₹10 per
lens (₹120 - ₹110) while overall it shows a loss of ₹5 per lens (₹120 - ₹125). The loss of
₹5 per lens indicates (i) only partial recovery of fixed cost of production and (ii) opportunity
cost in the form of loss of profit from external sales. This would therefore result in lower
divisional profit for Division ‘A’.
Consequently, the manager of Division ‘A’ would not accept the transfer price of ₹120 per
lens. Lower profitability due to internal sales may demotivate the division. Due to the
benefits of internal procurement, the management of Great vision may want to increase
the capacity of Division ‘A’ or infuse more investment to expand its operations. However,
due to inability to recover fixed costs in its entirety from internal sales the ROI of the
division is impacted, therefore divisional performance would be perceived to be lower.

Therefore, it may oppose decisions as this would lead to higher fixed costs. At an overall
level, such opposition may be detrimental to the company, leading to sub optimization of
resources.
The current total cost of production for Division ‘B’ is ₹400 per camera. Each sale yields
a profit of ₹10 per camera (₹410 - ₹400). Therefore, the current ROI is 2.50% (₹10 ÷ Total
Cost of ₹400). If the lens is procured from Division ‘A’ at ₹120 per lens, instead of buying
from outside vendors at ₹170, Division ‘B’ can get a benefit of ₹50 per camera due to
lower procurement cost. Then, Division ‘B’ can earn a contribution of ₹110 per lens sold
(₹410 - variable cost of ₹300) and a profit of ₹60 per camera (₹410 - total cost of ₹350).
Therefore, ROI improves to 17.14% (₹60 ÷ Total Cost of ₹350). By procuring the lenses
internally, the profit of the division improves substantially. Consequently, the manager of
Division ‘B’ would accept the transfer price of ₹120 per camera.
(ii) Analysis of Overall Benefit to the Company (from internal transfer)
The fixed costs in both divisions are irrelevant as they will always remain same whether
transfer is done or not. The Min. TP that Division A must get is ₹140 as its full capacity is
currently being used for outside sale. The Max. TP that Division B would be ready to pay
is ₹170 because the buy price from foreign vendors is ₹170.
As Min. TP < Max. TP, therefore, from the overall viewpoint, internal transfer must be
done. Net benefit to the company as a whole will be = ₹170 - ₹140 = ₹30 p.u. on 5,000
Lenses, i.e. ₹1,50,000
This net benefit indicates that if transfer is done, then Division ‘A’ loses contribution of ₹30
p.u. that it was getting on external sale. This is an opportunity cost to the company. While
Division ‘B’ gets greater contribution on its external sale by ₹60 p.u. due to decrease in
its cost of lens. Thus net benefit of transfer is ₹(60 – 30) = ₹30
This can also be explained as follows: For 1 Unit of Transfer, from company viewpoint:
If transfer is done:
B earns greater contri. by selling FG made from trfd mat. ₹(410 - 150 - 110 - 30): ₹120
If transfer not done:
A will earn contri on the lens sold outside: ₹(140 - 110): ₹ 30
B will earn lesser contri. on lens purch from outside: ₹(410 - 150 - 170 - 30): ₹ 60
∴ Additional Contri for the company due to transfer: ₹ 30
Please note that the internal transfer price affects profitability of individual division but does
not affect the company’s overall profitability.
(iii)Range of Transfer Price
As explained above, the company gets a net benefit of ₹150,000 per month by procuring
the lenses internally. Therefore, the divisional managers should accept the transfer pricing
model. At the same time, neither division should be at a loss due to this arrangement.
When the transfer price is ₹120 per lens, Division ‘A’ bears the loss, which will impact
assessment of the division’s performance. Therefore, an acceptable range for transfer
price should be worked out. This can be done as below:

Min. TP = ₹140 (as calculated earlier)

Since the supplying division is operating at full capacity, it has no incentive to sell the
goods to the purchasing division at a price lower than the market price. If the internal order
is accepted, capacity is diverted towards this sale. Hence the supplying division would
additionally charge the lost contribution from external sales that had to be curtailed. By
doing so, the division will be indifferent whether the sale is an external or internal one.
Therefore, the minimum transfer price (which would be set by Division ‘A’) = marginal cost
per lens + opportunity cost per lens = ₹110 + ₹30 per lens = ₹140 per lens. In other words,
the minimum transfer price would be the external sale price of each lens.
Max. TP = ₹ 170 (as calculated earlier)
Therefore, Division ‘B’ would pay a maximum price, equivalent to the current external
price of ₹170 per lens.
Therefore, the acceptable TP would range from ₹140 p.u. to ₹170 p.u. The divisional
managers may negotiate a mutually acceptable transfer price between this range.
(iv)Advise on Alternative to Current Transfer Pricing System
To resolve conflicts the following transfer pricing methods have been suggested:
Dual Rate Transfer Pricing System [Write theory from page 9.5]
Thus, Division A records transfer at its market price of ₹140 so that it gets same
contribution, while Division B records the transfer at variable cost of ₹110.
Two Part Transfer Pricing System [Write theory from page 9.5]
Thus, transfer must be done at price of ₹110 + some lumpsum charge towards fix cost as
decided by the company.
The proposed transfer price of ₹120, is a two-part price that enables Division ‘A’ to recover
the marginal cost of production of a lens as well as portion of the fixed cost. However, as
explained in part (i) above, this price is insufficient to provide a reasonable return to
Division ‘A’. Therefore, the management along with the divisional managers have to
negotiate a price that is reasonable to Division ‘A’ while not exceeding the current
procurement price of ₹170 per lens for Division ‘B’. As explained in part (iii) of the solution,
in the given case, the range of ₹140 to ₹170 per lens, would help resolve this conflict.
(v) Range of Transfer Price where Division ‘A’ has excess capacity
Min. TP = ₹110 (only variable cost)
This ensures that the Division ‘A’ is able to recoup at least its additional outlay of ₹110
per lens incurred on account of the transfer. Fixed cost is a sunk cost hence ignored.
Since capacity can be utilized further, it would be optimum for Division ‘A’ to charge only
the marginal cost for internal transfer. Division ‘B’ gets the advantage getting the goods
at a lower cost than market price.
Max. TP = ₹170 (same as earlier)
Maximum transfer price would be ₹170, the external market price beyond which Division
‘B’ will be unwilling a higher price to Division ‘A’.
Hence, when Division ‘A’ has excess capacity, TP must be in the range of ₹110 to ₹170.

Q.04. TRANSFER PRICE WITH KEY FACTOR:

Division Z is a profit centre, which produces four products – A, B, C and D. Each product is
sold in the external market also. Data for the period is as follows:
A B C D
Market price per unit Rs. 150 Rs. 146 Rs. 140 Rs. 130
Variable cost of production per unit Rs. 130 Rs. 100 Rs. 90 Rs. 85
Labour hours required per unit 3 4 2 3
Maximum Sales in the External Market (Units) 2800 2500 2300 1600
Product D can be transferred to division Y, but the maximum quantity that might be required
for transfer is 2,500 units of D. Division Y can purchase the same product at a slightly cheaper
price of Rs 118 per unit instead of receiving transfers of product D from division Z.
What should be transfer price for each unit for 2,500 units of D, if the total labour hours
available in division Z are: (i) 20,000 hours? (ii) 30,000 hours?
SOLUTION: (i) Total Labour Hours Available is 20,000 Hours
Particulars A B C D
Max Ext. Demand: 2,800 2,500 2,300 1,600
C p.u. 20 46 50 45
Hrs p.u. 3 4 2 3
C / Hr 6.6667 11.5 25 15
Ranking 4 3 1 2
Allotment:
- Of 20,000 Hours 600 10,000 4,600 4,800
- Of Units for Ext. Sale 200 2,500 2,300 1,600
→ Total Hours required for t/f of D = 2,500 Units x 3 hrs p.u. = 7,500 Hrs
Spare Capacity Available = 0 Hours
→ 1st Min. TP (by releasing 600 hours from ext. sale of A; i.e. for t/f of 1st 200 units of D)
= VC of D + CL on ext sale of A for 1 Unit D
= Rs 85 p.u. + (Rs 6.6667/Hr x 3 Hrs) = Rs 105 p.u.
→ 2nd Min. TP (by releasing 6,900 hrs from ext. sale of B; i.e. for t/f of next 2,300 units of D)
= VC of D + CL on ext sale of B for 1 Unit D
= Rs 85 p.u. + (Rs 11.5/Hr x 3 Hrs) = Rs 119.5 p.u.
→ Max. TP (Market Price) = Rs 115 p.u.
∴ For the 1st 200 Units, as Min. T.P. < Max. T.P., 200 Units must be transferred.
But for the remaining 2,300 Units, Min T.P. > Max T.P., so it must not be transferred.
Thus, only 200 units must be transferred, balance 2,300 units must be bought.

(ii) Total Labour Hours Available is 30,000 Hours

Particulars A B C D
Max Ext. Demand: 2,800 2,500 2,300 1,600
C p.u. 20 46 50 45
Hrs p.u. 3 4 2 3
C / Hr 6.6667 11.5 25 15
Ranking 4 3 1 2
Allotment:
- Of 30,000 Hours 8,400 10,000 4,600 4,800
- Of Units for Ext. Sale 2,800 2,500 2,300 1,600
→ Total Hours required for t/f of D = 2,500 Units x 3 hrs p.u. = 7,500 Hrs
Spare Capacity Available = 2,200 Hrs
→ 1st Min. TP (from 2,200 hours spare capacity; i.e. for t/f of 1st 733 units of D)
= Only VC of D
= Rs 85 p.u. = Rs 85 p.u.
→ 2nd Min. TP (by releasing 5,300 hrs from ext. sale of A; i.e. for t/f of next 1,767 units of D)
= VC of D + CL on ext sale of A for 1 Unit D
= Rs 85 p.u. + (Rs 6.6667/Hr x 3 Hrs) = Rs 105 p.u.
→ Max. TP (Market Price) = Rs 115 p.u.
∴ Both Min TP < Max TP. Thus, transfer of entire 2,500 units must be done.
Q.05. TRANSFER PRICE WITH VARIABLE DEMAND:

A company is organized on decentralized lines, with each manufacturing division operating
as a separate profit centre. Each division manager has full authority to decide on sale of
division's output to outsiders or to other divisions. Division AB manufactures a single
standardized product. Some output is sold externally and remaining is transferred to division
XY where it is a subassembly in the manufacture of the division product. The unit cost of
division AB and division XY is as follows:
Division AB (Rs.) Division XY (Rs.)
Transfer from division AB to XY - 42.00
Direct Material 6.00 35.00
Direct Labour 3.00 4.50
Direct expenses 3.00 -
Variable manufacturing overheads 3.00 18.00
Fixed manufacturing overheads 6.00 18.00

Variable selling and packing expenses 3.00 2.50

24.00 120.00
Division AB sold 40,000 units annually at the standard price of Rs. 45 in external market. In
additions to the external sales, 10,000 units are transferred annually to division XY at internal
price of Rs. 42 per unit. Variable selling and packing expenses are not incurred by supplying
division- for the internal transfer of the product. Division XY incorporates the transferred
goods into more advance product. The manager of division XY disagrees with the basis used
to set the transfer price. He argues that transfer price should be made at variable cost since
he claims that his division is taking output that AB should be unable to sell at price Rs. 45.
He also submitted a report of the relationship between selling price and demand to support
of his disagreement, the report of customer demand at various selling prices for division AB
and for division XY is as follows:
Division AB Division XY
Selling Price per unit (Rs.) 30 45 60 120 135 150
Demand (Units) 60,000 40,000 20,000 15,000 10,000 5,000
The company has sufficient capacity to meet demand at various selling prices. Internal
transfer demanded units will be decided by XY division.
Required:
(a) To calculate divisional profitability and overall profitability of company if division AB
transfers demanded units to XY at price of Rs. 42.
(b) To calculate divisional profitability and overall profitability of company if division AB
transfers demanded units to XY at variable cost.
(c) In place of internal transfers, AB division can sell 10,000 units of their product in new
external market without effecting existing market, at price Rs. 32 per unit and XY division
can purchase these units at the rate of Rs. 31 in open market. Calculate company's profit
by following above strategies.
SOLUTION:
Note:
Generally TP decisions do not affect overall profit of the company because, TP is sales for
Division A and same TP is cost for Division B. This is true only when demand for final product
is constant.
However, if the demand for the final product is variable (i.e. it depends on SP), then TP
decision will affect overall profit of the company. If TP charged is very high, then Division B
will have higher input cost, so Division B will charge higher SP for final product. Now, due to
higher SP, demand of final product will fall and thereby reducing the overall profit of company.
Hence such higher TP is not advisable from overall company viewpoint, we must suggest a
TP which will maximize overall profit and is acceptable to both divisions.


Notes:
(a) If TP = ₹42, then best External SP decided by Division XY = ₹135 p.u.
(b) If TP = ₹15, then best External SP decided by Division XY = ₹120 p.u.
Overall Company Profit is maximum when External SP is ₹120 p.u. Thus, ₹120 p.u. is the
best External SP for the Company. This shows that when TP = VC, then the decision taken
by Division XY will be same as decision taken by the Company (i.e. No Conflict). But, if TP is
set higher like TP = Market Price (₹42), then Division XY would set the External SP also
higher at ₹135 p.u. which will decrease the demand and thereby giving profit lesser than the
maximum profit. (i.e. conflict in Division Decision and Company Decision).

Q.06. TRANSFER PRICE WITH VARIABLE DEMAND AND LIMITED CAPACITY:

X Ltd. has two divisions namely A & B functioning autonomously. Division A produces Product
P and Division B produces Product Q. Product P is used in the production of Product Q.
Particulars Division A Division B
Units Price Units Price
Sales demand of Product in External Market 3000 30 3000 100
7000 25 7000 90
10000 20 10000 80
Variable Cost Per unit Rs. 15
Additional Processing Cost Per unit Rs. 40
Production capacity 10000
Fixed Cost Rs. 50,000 Rs. 150,000
One unit of Product P is required for producing one unit of Product Q.
Outside Supply of Product P is available at the following prices (Applicable on all units
Purchased):
Quantity Price
0-3000 30
3001 - 7000 25
7001 - 10000 20
Required:
(a) Determine the operating level for both the divisions which will maximise their profits
assuming no internal transfer and prepare the profitability statement at that level.
(b) Determine the operating level which will maximise the profit of the organisation as a
whole (i.e. internal transfer can take place) and prepare the profitability statement and
comment whether it is the same operating level which maximise the division's profit.
(c) Recommend the transfer price between A & B which will be favourable for both the
divisions and prepare the profitability statement on that transfer price.

SOLUTION:



Q.07. CAPACITY EXPANSION:

B Ltd. makes three products X, Y and Z in Divisions X, Y and Z respectively. The following
information is given:
X Y Z
Direct Mat (Rs p.u) (excluding material X for Divisions Y and Z) 8 22 40
Direct Labour Rs / Unit) 4 6 8
Variable Overhead (Rs / Unit) 2 2 2
Selling price to outside customers (Rs / Unit) 25 65 90
Existing capacity (no. of units) 6,000 3,000 3,000
Maximum external Market demand (no of units) 5,000 5,500 5,000
Additional fixed cost to install additional capacity (Rs) 45,000 9,000 23,100
Maximum additional units that can be produced by adnl capacity 6,000 2,000 2,250
Y and Z need material X as their input. Material X is available in the market at Rs 23 per unit.
Defectives can be returned to suppliers at their cost. Division X supplies the material free
from defects and hence is able to sell at Rs 25 per unit. Each unit of Y and Z require one unit
of X as input with slight modification.
If Y purchases from outside at Rs 23 per unit, it has to incur Rs 3 per unit as modification and
inspection cost. If Y purchases from Division X, it has to incur, in addition to the transfer price,
Rs 2 per unit to modify it.
If Z gets the material from Division X, it can use it after incurring a modification cost, of

Rs 1 per unit. If Z buys material X from outside, it has to either inspect and modify it at its
own shop floor at Rs 5 per unit or use idle labour from Division X at Rs 3 per unit. Division X
will lend its idle labour as per Z's requirement even if Z purchases the material from outside.
The transfer prices are at the discretion of the Divisional Managers and will remain
confidential. Assume no restriction on quantities of inter-division transfers or purchases.
Required: DISCUSS the best strategy for each division and for the company as a whole.
SOLUTION:
5) Note: In this Question, demand is not fluctuating based on SP, thus TP decision will not
affect the overall profit of the company. We can choose any TP between Min TP & Max TP
for our analysis. We shall choose TP = Max TP so that: (a) Division X has some motivation
to do expansion, & (b) Division Y & Z will incur same cost for material as if material is
purchased from outside.

Q.08. 3 DIVISIONS:
A company is engaged In the manufacture of edible oil. It has three divisions as under:
(1) Harvesting oil seeds and transportation thereof to the oil mill.
(2) Oil Mill, which processes oil seeds and manufactures edible oil.
(3) Marketing Division, which packs edible oil in 2 kg containers for sale at ₹150 / container.
The Oil Mill has a yield of 1000 kgs. of oil from 2,000 kg. of oil seeds during a period The
Marketing Division has a yield of 500 cans of edible oil of 2 kg. each from every 1,000 kg. of
oil. The net weight per can is 2 kg. of oil.
The cost data for each division for the period are as under:
Harvesting Division:

Variable cost per kg. of oil seed Rs. 2.50

Fixed cost per kg. of oil seed Rs. 5.00
Oil Mill Division:
Variable cost of processed edible oil Rs. 10.00 per kg.
Fixed cost of processed edible oil Rs. 7.50 per kg.
Marketing Division:
Variable cost per Can of 2 kg. of oil Rs. 3.75
Fixed cost per can of 2 kg. of oil Rs. 8.75
The fixed costs are calculated on the basis of the estimated quantity of 2,000 kg. of oil seeds
harvested, 1,000 kg. of processed oil and 500 cans of edible oil packed by the aforesaid
divisions respectively during the period under review.
The other oil mills buy the oil seeds of same quality at Rs. 12.50 per kg. in the market. The
market price of edible oil processed by the oil mill, if sold without being packed in the
marketing division is Rs. 62.50 per kg. of oil.
Required:
(a) Compute the overall profit of the company of harvesting 2,000 kg. of oil seeds, processing
it into edible oil and selling the same in 2 kg, cans as for the period under review.
(b) Compute transfer prices that will be used for internal transfers from Harvesting Division
to Oil Mill Division and from Oil Mill Division to Marketing Division under the following
pricing methods: (1) Shared contribution in relation to variable costs; and (2) Market price.
(c) Which transfer pricing method will each divisional manager prefer to use?
SOLUTION: (a) Overall Profit of present level:
Particulars Overall
Sales: Ext 75,000
T/f -
(-) VC: T/f Mat -
OVC (5,000 + 10,000 + 1,875) (16,875)
Total Contri. 58,125
(-) FC: (10,000 + 7,500 + 4,375) (21,875)
Profit 36,250
(b), (c)
(1) Shared Contribution Method:
Particulars H O M Overall
Sales: Ext - - 75,000 75,000
T/f 22,222 66,666 -

(-) VC: T/f Mat - (22,222) (66,666) -

OVC (5,000) (10,000) (1,875) (16,875)
Total Contri. 17,222 34,444 6459 58,125
(-) FC: (10,000) (7,500) (4,375) (21,875)
Profit 7,222 26,944 2,084 36,250
∴ T.P. : Rs 11.11 p.u. Rs 66.66 p.u.
(2) Market Price Method:
Particulars H O M Overall
Sales: Ext - - 75,000 75,000
T/f 25,000 62,500 -
(-) VC: T/f Mat - (25,000) (62,500) -
OVC (5,000) (10,000) (1,875) (16,875)
Total Contri. 20,000 27,500 10,625 58,125
(-) FC: (10,000) (7,500) (4,375) (21,875)
Profit 10,000 20,000 6,250 36,250
∴ T.P. : Rs 12.50 p.u. Rs 62.50 p.u.
C. MULTINATIONAL TRANSFER PRICING

1. TP is affected by Taxes and Duties of the Countries involved. Eg:
(1) If Buyer is in country with higher Income Tax, then TP must be set Higher.
(2) If Buyer is in country with higher Import Duty, then TP must be set Lower.
(3) If Buyer is in country with higher Income Tax & higher Import Duty, then Refer Eg.
2. In such cases, the decided TP is always given in the question. Transfer decision is taken
by calculating net benefit if transfer is done: (₹)

For A: Increase in Total Contribution on the units transferred:

(-) Additional Tax paid on extra contribution
For B: (-) Increase in Cost because of material obtained from transfer:
(+) Tax saved on extra cost
∴ Net Benefit
Q.09. MULTINATIONAL TP:

Winger Ltd, has two divisions in two different countries-Alfa in Alfino and Beta in Betanos.
Alfa is a single product company. Its product is 'S'. Alfa's maximum capacity is 10,00,000
units of S in a year. At present it sells 9,00,000 units of S to external customers @ ₹150 p.u..
Division Beta purchases 2,50,000 units of S each year from local Supplier in Betanos in local
currency which is equivalent to ₹130 p.u.
In the interest of maximizing group's profit, it is suggested that Beta buy all its need of
2,50,000 units of S from Alfa. Alfa is agreeable to supply Beta's need @ ₹144 p.u. This
transfer price is lesser than the market price of ₹150 as no marketing expenses will be
incurred on intergroup trade. This would give Alfa the same contribution as an external sale,
i.e. ₹60 p.u. Alfa would give Beta's orders priority and so some external orders could no
longer be met. Required:
Should Beta continue to purchase from the local supplier in Betanos or switch to Alfa in order
to maximize the group profit under each of the following scenarios?
(a) The tax rate in Alfino is 30% and the tax rate in Betanos is 50%.
(b) The tax rate in Alfino is 50% and the tax rate in Betanos is 10%.
(Assume that changes in contribution can be used as basis for calculating changes in tax and
that Division Beta generates sufficient profit from other activities to absorb any tax benefits.)
SOLUTION:

Q.10. MULTINATIONAL TP:

Standard Corporation Inc. (SCI) is a US based company engaged in manufacturing and
marketing of Printers and Scanners. It has subsidiaries spreading across the world which
either manufactures or sales Printers and Scanners using the brand name of SCI.
The Indian subsidiary of the SCI buys an important component for the Printers and Scanners
from the Chinese subsidiary of the same MNC group. The Indian subsidiary buys 1,50,000
units of components per annum from the Chinese subsidiary at CNY (¥) 30 per unit and pays
a total custom duty of 29.5% of value of the components purchased.
A Japanese MNC which manufactures the same component which is used in the Printer and
Scanners of SCI, has a manufacturing unit in India and is ready to supply the same
component to the Indian subsidiary of SCI at Rs 320 per unit.
The SCI is examining the proposal of the Japanese manufacturer and asked its Chines
subsidiary to presents its views on this issue. The Chinese subsidiary of the SCI has informed
that it will be able to sell 1,20,000 units of the components to the local Chinese manufactures
at the same price i.e. ¥ 30 per unit but it will incur inland taxes @ 10% on sales value. Variable
cost per unit of manufacturing the component is ¥ 20 per unit. The Fixed Costs of the
subsidiaries will remain unchanged.
The Corporation tax rates and currency exchange rates are as follows:
Corporation Tax Rates Currency Exchange Rates
China 25% 1 US Dollar ($) = Rs 61.50
India 34% 1 US Dollar ($) = ¥ 6.25
USA 40% 1 CNY (¥) = Rs 9.80
Required
(a) PREPARE a financial appraisal for the impact of the proposal by the Japanese
manufacturer to supply components for Printers and Scanners to Indian subsidiary of SCI.
[Present your solution in Indian Currency and its equivalent.]
(b) IDENTIFY other issues that would be considered by the SCI in relation to this proposal.
(Note: While doing this problem use the only information provided in the problem itself and
ignore the actual taxation rules or treaties prevails in the above mentioned countries)
SOLUTION:

(b) Other Issues:

As calculated above, financially it is advisable to stop doing transfer and accept proposal of
local supply from Japanese MNC. However, in this case, there may be other financial issues
that the company must consider as follows:
 Check the reliability of local supplier, whether he will be able to give uninterrupted supply.
 Check whether local supplier can deliver for long term or not.
 This decision may change if there are changes in some fiscal policy in future, like: change
in tax rates, duties, etc.
 Also consider possibilities of increase/decrease in external sales of Chinese Subsidiary in
future, because if local sale of this Chinese Subsidiary decreases, then it may again be
available to do transfer.
 Company should consider laws regarding repatriation of profits to the US because if transfer
is done, then Chinese Subsidiary will have high profits and if transfer is not done, then
Indian Subsidiary will have high savings. The holding company is US based, so they must
consider the profit repatriation laws of India & China for that matter.
D. GENERAL NOTES
1. Give explanation for Min TP and Max TP every time. For Eg: why take contribution lost or
why not take it; why is Max TP taken as Market Price of ready material or as Net Marginal
Revenue. Explain the logic behind the rules of Min TP and Max TP that’s done in class.
2. Explain what does this Min TP and Max TP indicate as mentioned in the rules for
calculations above.
3. Give your suggestions that the decided TP must be between Min TP and Max TP. Also
say that if it is not between this range, then what will happen, what will be the response
of each division in that case. Describe conflict of goal congruence if this happens.
4. If question asks to make profit statement with and without transfer, then, also analyze why
is the profit different in case of with and without transfer. Analyze for each divisional profit
individually and for the overall company profit. Give reasons for the difference in profit.
Accordingly explain the benefits of doing transfer.
5. Any transfer price between Min TP and Max TP, will resolve conflict and promote goal
congruence.
6. If the divisions do not agree to this TP, then last option is to use Dual Rate Transfer Pricing
Method, or Two-Part TP Method.

CH – 10 BUDGETARY CON TROL
CHAPTER
BUDGETARY CONTROL
10
CHAPTER SUMMARY (THEORY)

1. FEED-BACK CONTROL & FEED-FORWARD CONTROL:
Feed-back Control Feed-forward Control
 i.e. Reaction after an action has taken place  i.e. Control mechanism to prevent error
 1st make error, then take corrective actions  Control before error happens
 eg: Cost Control  eg: Cost Reduction
2. BEHAVIOURAL ASPECTS AND PARTICIPATIVE BUDGET (Bottom-Up Budget):

Divisional Managers must be involved in setting budgets & targets for their division.
Benefits of participation:
 If targets are set by managers themselves, then they wont find it too challenging
 Managers tend to give more efforts to reach the targets. Because if the targets were too
difficult, then performance will deteriorate.
Problems of Participation:
 Mangers will focus on short term goals, mostly only financial. Ignores non-financial aspects.
 They may pursue the targets at the cost of other critical resources.
 They may set slack targets (Budget Slack)
3. BEYOND BUDGETING:
Traditional Budgeting Beyond Budgeting
Targets and Rewards  Incremental targets  Stretch goals
 Fixed incentives  Relative targets and rewards
Planning and Controls  Fixed annual plans  Continuous planning
 Variance controls  KPI’s & rolling forecasts
Resource and  Pre-allocated resources  Resources on demand
Coordination  Central coordination  Dynamic Coordination
Organizational  Central control  Local control of goals/ plans
Culture  Focus on managing numbers  Focus on value creation

CASE (THEORY)
1. FEED-BACK & FEED FORWARD CONTROL:

Real Petroleum Corporation manufactures lubricant oils for motor vehicles (two wheelers,
four wheelers and heavy vehicles). The company offers lubricant oils in various packages
ranging from a 100 ml pouch to a 200 litres drum. About 70% of lubricant sales comprise are
made in the form of 900 ml ‘cans’. The process of manufacturing and packaging lubricant oils
are given below:
 Base oil of required grade are imported from middle east.
 The base oil are blended with additives at the manufacturing plants at specified
temperatures to produce lubricant oils.
 The oil is stored for a day to bring the temperature to normal.
 The plant has an automated bottling facility. The operator is required to preset the quantity
and number of ‘cans’ to be filled in a computerised system. No manual intervention is
required thereafter.
 The product is filled in ‘cans’ at the first stage of packaging with 900 ml of product.
 Caps are fixed on the ‘cans’ and sealed at the second stage of packaging.
 The product is weighed at third stage of packaging (a conversion factor is used to cover
volume into weight) before the ‘cans’ are packed into a carton.
Any ‘can’ having lesser quantity of oil is removed before the ‘cans’ are packed into the
cartons. The ‘cans’ which are short filled cannot be reused. Once the seal is broken, the ‘can’
is of no use. There is no process by which the oil in short filled ‘can’ could be reused. Hence
the product is wasted.
The company is considering a proposal to add a component in its packaging unit to avoid
losses arising out of quantity issues in packaging. The component will be installed after the
first stage of packaging. The component will measure the volume of product and will forward
the ‘can’ for capping and sealing only if the quantity in ‘cans’ is correct. In case the ‘can’ does
not have required volume of product, the ‘can’ will be topped up with balance product before
the capping and sealing process. The company will be able to achieve 0% wastage due to
short filling after implementation of new system.
Required
Using the context of control systems, IDENTIFY and EXPLAIN the type of control which is
existing in the company and the type of control which is proposed.
SOLUTION
What is Control?
Control is a management function of establishing benchmarks and comparing actual
performance against the benchmarks and taking corrective actions. Control is required at all

levels of organisation to ensure that the organisation achieves its intended objective. There
are two types of control systems - Feedback Control and Feed-forward Control.
Feedback Control
Feedback Control is a control activity that takes place after a process is complete. It is also
known as post action control. If any problem is identified after a process is complete, a
corrective action is taken to rectify the problem. Feedback control provides information only
after the process is complete and sometimes a significant time is lost to take corrective action.
Feedback-based systems have the advantage of being simple and easy to implement.
Real Petroleum currently has a feedback control mechanism in place. The actual volume of
the product is measured at the end of the packaging process. The current control process is
that any ‘can‘ which is short filled is not packed in the carton. This ensures that a lower
quantity of product is not supplied into the market. The current control system, however leads
to product losses as identification of short-filled ‘cans’ at the end of process is not useful to
the production process. In case, there is a huge variation in the final packaging, the packaging
system can be reviewed to ensure that such problems do not acquire in the future.
Feed-forward Control
Feed-forward Control is also referred to as a preventive control. The rationale behind feed-
forward control is to foresee potential problems and take corrective action to ensure that the
final output is as expected. Feed-forward controls are desirable because they allow
management to prevent problems rather than having to cure them later. Feed-forward control
are costly to implement as it requires additional investment and resources. These are
designed to detect deviation some standard or goal to allow correction to be made before a
particular sequence of actions is completed
The proposed system in Real Petroleum is a Feed-forward control. In this case, any short
filling is identified in the packaging process itself and corrective action is taken to ensure that
the final packed ‘can’ has proper quantity of product. The new process is beneficial to the
company as the wastage arising out of the packaging process can be avoided. The savings
must be compared with the cost required to modify the packaging process before finalising
on whether the new system should be implemented or not.


CH – 11 STA NDARD COSTING
CHAPTER
STANDARD COSTING
11
CHAPTER SUMMARY (PRACTICALS)

Standard Costing is a method of ‘Cost Control’, i.e. to find the difference between Standard
& Actual Cost and analyze those differences into further reasons.
A. MATERIAL VARIANCES
DATA TABLE FORMAT:
STD AS GIVEN STD FOR ACT ACT
TYPE For Prodn. For Prodn. For Prodn.
Q P AQ P AQ P A
CALCULATION:
MCV = Std. Cost for Act. O/p – Act. Cost =

MPV = AQ(SP - AP) MUV = SP(SQ - AQ)
MMV = SP(TAQ in SM - TAQ in AM) MYV = Avg. SP(TSQ - TAQ)

1. In the formula for MPV, AQ is multiplied because if any price is saved, then it is saved on
entire quantity actually consumed.
2. In the formula for MUV, SP is multiplied because, AP contains some savings, and that
savings has already been recognized for entire actual quantity while calculating the MPV,
hence now while calculating the MUV, consider there is no price savings, hence use SP.
3. If material quantity and FG quantity both are measured in same Unit of Measurement,
then the difference in these quantities would indicate processing loss. In some questions,
instead of giving Standard Quantity of FG production Units, Normal Loss is given. In such
cases, Standard Quantity of FG production Units can be found by → Material Quantity –
Normal Loss = FG Quantity.
4. Presentation of variances calculations must be done in a chart format. If it is not possible
to fit that format in presentation, then calculations may be shown as separate workings,
but then atleast, final answers of variances must be shown in a chart format.
INTERPRETATIONS:
5. MCV indicates that how much of the total extra cost was incurred because of materials.
6. MPV indicates extra material cost because of higher price paid.
7. MUV indicates extra material cost because of extra quantity of materials used.
8. MYV indicates extra material cost because of change in total quantity of materials used.
9. MMV indicates extra material cost because of change in quantity ratio of each material. ∴
if MMV is positive, it means expensive mat. is saved and cheaper mat. is used more.
GENERAL RULES FOR WRITING INTERPRETATIONS:

10. Explain general meaning of each specific variance as mentioned in points 5 to 9 above.
11. Give interpretation of the variance for this question specifically.
12. Give examples of possible reasons for this saving or extra cost, i.e. why is AP or AQ more
or less, or even may be Standards are set very high or low.
Eg: if MPV is Adverse, then it may be because increase in general price level, or because
of the purchase not bargaining good price, or because maybe standard price was wrongly
set too high.
13. Also explain joint interpretation between 2 variances that may be interdependent. Eg.
MPV is Adverse because Quantity used was very less hence company lost some bulk
discounts that it would have otherwise got.
14. Give joint interpretations of Mix Variance and Yield Variance.

Q.01. MATERIAL VARIANCES (CLG STK @ FIFO - NORMAL)

Eskay Ltd. produces an article by blending two basic raw materials. The following standards
have been set up for raw materials:
Material Standard mix Standard price kg.
A 40% Rs.4
B 60% Rs.3
The standard loss in processing is 15%, During September, the company produced 1,700kg,
of finished output. The position of stock and purchases for the month of September is:
Material Opening Stock (Kg) Closing Stock (Kg) Purchase
[Valued @ ₹(4,3) p.u] Kg. Cost Rs.
A 35 5 800 3400
B 40 50 1200 3000
Required: Calculate all material variances if Closing stock is valued by FIFO.
SOLUTION: If Closing Stock @ FIFO (Normal Method):
Data Table Format:
Q P AQ P AQ P A

Variance Calculations:


Interpretations: (See Summary Notes)
MPV ON PURCHASES:
15. Generally MPV is calculated based on Actual Quantity (AQ) Consumed.
16. But MPV is calculated based on Actual Quantity Purchased instead of Actual Quantity
Consumed if the following words are given in the question:
“MPV is calculated at the time of receiving the materials” or
“MPV is calculated on purchases” or
“Material Stock is valued at Standard Cost”
17. In this method, MPV of entire actual purchase quantity is borne by the actual production
units. ∴ unused materials (closing stock) are valued at standard cost.
18. Whenever RM Closing Stock is valued at Standard Price, then the Consumption cost will
also be different, in such case Material Variances will tally only if MPV is calculated on
Actual Quantity Purchased. (Refer Q ____)
Q.02. MATERIAL VARIANCES (MPV ON PURCHASE)

Required: Calculate Material Variances in Q.01. if Closing stock is valued at standard price.
SOLUTION: If Closing Stock @ SP (MPV on Purchase Method):
(Only MPV and MCV will change, MUV and its components remain same)

Data Table Format:

Q P AQ P AQ P A
Conclusion:
This alternate method is applicable only if Closing Stock of RM is valued as SP. In such case,
we don’t need to calculate WN-1 (i.e. Cost of Consumption and Rate of Consumption).
Instead, MPV can be calculated as ‘MPV on Purchases’

MATERIAL QUALITY COST VARIANCE:

19. = Material Cost Variance + Rework Cost Variance + Material Scrap Value Variance
20. Rework Cost Variance = Standard Rework Cost – Actual Rework Cost.
21. Material Scrap Value Variance = Act. Scrap Value – Std. Scrap Value
B. LABOUR VARIANCES
CALCULATION:
1. Calculations are same as Material Variances, just replace Quantity (Q) with Hours (H) and
Price (P) with Rate (R).
INTERPRETATION:
2. Follow same rules as interpretations in Material Variances.
IDLE TIME VARIANCE:
3. Idle Time means time which is wasted, time for which wages are paid but no work is done.
4. Types of Idle Time:
(a) Normal Idle Time: It is already estimated, and hence cannot be avoided. Eg: Lunch
Breaks and Tea Breaks, etc.
(b) Abnormal Idle Time: It is not estimated, it should have been avoided. Eg: Power
Failure, Material Shortage, Machine Breakdown, etc.
5. Only for Abnormal Idle Time, we need to express a separate variance called Idle Time
Variance. Normal Idle Time cannot be avoided, i.e. cannot be controlled, hence there is
no need for making variance for Normal Idle Time. But for Abnormal Idle Time, we must
calculate a variance which indicates the labour cost wasted because of the time wasted.
IDLE TIME VARIANCE CALCULATION:

LCV = Std. Cost for Act. O/p – Act. Cost
LRV = AH(SR - AR) LTV = SR(SH - AH)
LMV = SR (TAAH in SM - TAAH in AM) ITV = SR (IH) LYV = Avg. SR (TSH - TAAH)
6. It is calculated only if Abnormal Idle Time is specifically given in the question.
7. Make no change in the data table of labour, rather idle hours are shown in separate data
table like this → Actual Hours (AH) - Idle Hours (IH) = Actual Active Hours (AAH)
8. Make no change in the 1st 3 Labour Variances i.e. LCV, LRV & LTV. Idle Time Variance
(ITV) is shown as an additional component under the LTV
9. ITV = SR (IH). However, this formula will always give answer positive, we need to make
it negative as it indicates the labour cost wasted. ITV is always negative.

10. As ITV is shown as additional component under the LTV, then now all 3 components of
LTV will not tally with the total LTV. We need to make corresponding changes in the other
2 components of LTV, i.e. in LMV and LYV. In both these other 2 components, now
instead of using ‘AH’, we must use ‘AAH’.
C. OVERHEAD VARIANCES
CALCULATION:
1. VOH Cost Variance = Std. Cost for Act. O/p – Act. Cost =
Rate Var. = AQ(SR – AR) Time Var. = SR(SQ – AQ)

2. FOH Cost Variance = Std. Cost for Act. O/p – Act. Cost =
Budget Variance Volume Variance = SR/Unit (Volume Gain / (Lost))

= Budget - Actual
Efficiency Variance Capacity Variance (Revised) Calender Variance
= SR/hr (SH - AH) BH in SR/ Days
= SR/hr AH – =
act. Days Day Gain/Lost
INTERPRETATIONS OF FIX OVERHEAD VARIANCES:

3. Standard Fix OH of Actual Production, indicates ‘Recovered Fix OH’ (Absorbed Fix OH),
i.e. Fix Oh recovered from the customers when they paid the selling price of the product
for all actual units sold.
4. Thus Fix OH cost variance indicates the extra Fix OH actually incurred over & above the
Fix OH actually recovered from the customers.
5. Budget variance indicates the extra cost as compared to the original budget.
6. Volume variance indicates the total extra money recovered from customers due to extra
units produced. (as compared to original budget)
Q.03. FIX OH VARIANCES

A company has a normal capacity of 120 machines, working 8 hours per day of 25 days in a
month. The fixed overheads are budgeted at Rs.1,44,000 per month. The standard time
required to manufacture one unit of product is 4 hours.
In April, 2008, the company worked 24 days of 840 machine hours per day and produced
5,305 units of output. The actual fixed overheads were Rs.1, 42,000.
Compute: Fixed Overheads Variances
SOLUTION: Data Table Format:

FOH Budget Standard Actual

FOH (Rs) ₹1,44,000 ? = ₹1,27,320 ₹1,42,000
Units 6,000 Units 5,305 Units 5,305 Units
Hours 24,000 Hrs ? = 21,220 Hrs 20,160 Hrs
Days 25 Days - 24 Days
SR/Unit = ₹24 / Unit SR/Hr = ₹6 / Hr SR/Day = ₹5,760 / Day
WN: BH in Actual Days: 25 Days (Budgeted) → 24,000 Hrs
24 Days (Actual) → ? = 23,040 Hrs
FOH Cost Variance = Std. Cost for Act. O/p – Act. Cost = ₹1,27,320 – 1,42,000
= - ₹14,680 (A)
= Budget - Actual = 24 [- 695 Units]
= 144000 - 142000 = - ₹16,680 (A)
= + ₹2,000 (F)
= SR/hr (SH - AH) = SR/hr AH – BH in =

SR/ Days
= 6 (21220-20160) = 6 (20160-23040) = 5760 [ -1 Day]
= + ₹6,360 (F) = - ₹17,280 (A) = - ₹5,760 (A)
Q.04. FIX OH VARIANCES

T Ltd. provides you the following information:
Standard Oh Absorption Rate / Hour Rs.3
Standard Oh Absorption Rate / Unit Rs.18
Budgeted Production 7,500 Units
Actual Production 7,610 Units
Actual Overheads Rs.1,45,360 out of which Rs.45,360 were Fixed
Actual Hours 46,830
Overheads are based on the following Flexible Budget:
Production (units) 6000 6750 8250
Total overheads 117000 126000 144000
Required: Calculate all Overhead Variances.


TYPE For 1 Unit Prodn. For 7,610 Un Prodn. For 7,610 Un Prodn.
H R AH R AH R A
VOH 6* 2 12 45,660 2 91,320 46,830 2.1354 1,00,000
FOH (Rs)
Units
Hours
Days
SR/Unit = SR/Hr = SR/Day =
Working Notes:
VOH Cost Var. = Std. Cost for Act. O/p – Act. Cost = - ₹ 8,680 (A)
Rate Var. = AQ(SR – AR) Time Var. = SR(SQ – AQ)

= 46,830 (2 – 2.1354) = 2 (45,660 – 46,830)
= - ₹6,340 (A) = - ₹2,340 (A)
FOH Cost Variance = Std. Cost for Act. O/p – Act. Cost = + ₹300 (F)

= Budget - Actual = 6 [+ 110 Units]
= - ₹ 360 (A) = + ₹ 660 (F)
= SR/hr (SH - AH) = SR/hr AH – BH in =

SR/ Days
= 1 (45660-46830) = 1 [+ 1,830 Hours] =-
= - ₹1,170 (A) = + ₹1,830 (F)

D. GENERAL NOTES
1. If production details are missing in the question, then consider that the standard given in
the question, itself is the standard for actual.
2. ITV need not be calculated for Variable Oh Variances and Fix Oh Variances.
3. For Fix Oh and Variable Oh variances, if the hours are missing, take it same as hours for
labour variances.
4. If there is only 1 category of cost in standard, then Mix Variance will be = 0. ∴ Yield
Variance = Quantity Variance. ∴ Only 3 Variances need to be shown.
5. If there is only 1 category in standard and more categories in actual, then also mix
variance will be = 0. ∴ Yield Variance = Quantity Variance. ∴ Only 3 Variances need to be
shown.
6. If there is 2 categories in standard and 3 in actual, then mix variance cannot be
calculated, only Cost, Rate and Quantity Variance will be calculated based on Avg Rate.
7. Alternate names of variances:
Labour Mix Variance = Labour Gang Variance
Labour Time Variance = Labour Efficiency Variance
Labour Yield Variance = Labour Sub-Efficiency Variance
Variable Oh Cost Variance = Variable Oh Expense Variance
Variable Oh Rate Variance = Variable Oh Expenditure Variance
Variable Oh Time Variance = Variable Oh Efficiency Variance
Fix Oh Cost Variance = Fix Oh Expense Variance
Fix Oh Budget Variance = Fix Oh Expenditure Variance
8. Check whether actual data is on monthly basis or annual basis and accordingly convert
the budget data.
9. If type of Overheads not specified in the question, then apply format of Fix Oh Variances
E. REVENUE VARIANCES - SALES

PRODUCT VARIANCES PERIOD VARIANCES
1. Actuals are compared with ‘Standard for Actuals are compared with ‘Standard for
Actual Production’ Actual Period’
2. Eg: Cost Variances like: Material, Labour, Eg: Revenue Variances like: Sales
VOh, FOh Variances Variances & Profit Variances
3. Variance = Std. – Act. Variance = Act. – Std.
4. Under Period Variances, variance is also calculated for the reduction in units because,
this reduction in units is the reason why sales/profit has decreased, hence that also is a
mistake that must be corrected in the next year.

CALCULATION:
5. Total Sales Variance = Act. Sales – Bud. Sales =
SPV = AO (ASP - SSP) SVV = SSP (AO - SO)
SMV = SSP (TAO in AM - TAO in SM) SQV = Avg. SSP (TAO - TSO)
Market Size Variance Market Share Variance

= Avg. SSP (Change in = Avg. SSP (Change in
Units due to Mkt Size) Units due to Mkt Share)
6. Market Size Variance indicates how much sales did the company lose because the entire
industry sales has decreased. It is not fault of the company as it is due to external industry
factors. Thus Market Size Variance is also an example of Planning Variance.
7. Market Share Variance indicates how much sales did the company lose because
decrease in its share out of entire industry sale. This is the fault of the company as
company sale has decreased even if industry sale did not decrease. Thus Market Share
Variance is also an example of Operating Variance.
Q.05. SALES VARIANCES

Apollo Ltd makes Masks (Disposable & Reusable). Budgeted and Actual Data for 2021 are:
Budgeted Actual
Products
SP p.u. VC p.u. FC Units Contr p.u. VC p.u. FC Units
Disposable 24 14 14,000 7,000 12 10 16,000 10,000
Reusable 100 60 6,000 3,000 20 50 5,000 2,000
Total 20,000 10,000 21,000 12,000
Apollo Ltd. derived its total unit sales budget from the internal management estimate of a
20% market share. Industry sales forecast was of 50,000 units but at the end of the year the
association reported actual industry sales of 75,000 units due to 2nd wave of a pandemic.
Required: Compute all possible Sales Variances & comment on it
SOLUTION: Sales Variances:
Sales Data Table:
TYPE Q P A Q P A Q P A
Sales For 12 Month For Month For 12 Month
D 7,000 24 1,68,000 10,000 22 2,20,000
R 3,000 100 3,00,000 2,000 70 1,40,000
10,000 46.8 4,68,000 12,000 3,60,000

Data for Market Size & Share Variance: (For Total Units Only)
Budgeted Units Bud. Units of Act. Mkt Size Actual Units
= 50,000 Units × 20% = 75,000 Units × 20%
= 10,000 Units = 15,000 Units = 12,000 Units
Variance Calculation:
Total Sales Variance = Act. Sales – Bud. Sales = 360000 – 468000 = - ₹1,08,000 (A)
SPV = AO (ASP - SSP) SVV = SSP (AO - SO)

D: 10000 (22 – 24) = - 20000 D: 24 (10000–7000) = +72000
R: 2000 (70 -100) = - 60000 R: 100 (2000 – 3000) = -100000
- ₹80,000 (A) - ₹28,000 (A)
SMV = SSP (TAO in AM - TAO in SM) SQV = Avg. SSP (TAO - TSO)
D: 24 (10000–8400) = + 38400
R: 100 (2000 – 3600) = -160000 = 46.8 (12000 – 10000)
- ₹1,21,600 (A) = + ₹93,600 (F)
Market Share Variance Market Size Variance

= Avg. SSP (Change in = Avg. SSP (Change in
Units due to Mkt Share) Units due to Mkt Size)
= 46.8 (12,000 – 15,000) = 46.8 (15,000 – 10,000)
= - ₹1,40,400 (A) = + ₹2,34,000 (F)
Comments: Refer Summary Notes.
E. REVENUE VARIANCES - PROFIT

8. Total Profit Variance = Act. Profit – Bud. Profit =
Std. Cost for Volume

SPV = AO (ASP - SSP) TCV = – Act. Cost PMVV = SPR
Act. Prodn Gain/(Lost)
PMMV = SPR (TAO in AM - TAO in SM) PMQV = Avg. SPR (TAO - TSO)

= Avg. SPR (Change in = Avg. SPR (Change in

9. Under Profit Variances, once PMVV is calculated, then the effect of decrease in profit due
to decrease in units is already given. Now any other change in profit is because of SPV
or TCV on the Actual Units only. Hence, SPV and TCV are calculated considering only
the Actual Units of Production. Thus, all Cost Variances ignored the effect of Units Lost.
Q.06. PROFIT VARIANCES

Required: Compute all possible Profit Variances in Q.05. & comment on it
SOLUTION: Profit Variances:
Profit Data Table: [Profit Amount = (SP – VC) × Units – FC]
Profit For 12 Month For Month For 12 Month
D 7,000 8 56,000 10,000 10.4 1,04,000
R 3,000 38 1,14,000 2,000 17.5 35,000
10,000 17 1,70,000 12,000 1,39,000
Cost - D For 7,000 Units For 10,000 Units For 10,000 Units
All VC: ? ? -? ? 1,40,000 ? ? 1,00,000
(₹14 p.u.) (10000×14) (10000×10)
FC: - - 14,000 - - 20,000 - - 16,000

∴ TC 1,60,000 1,16,000
Cost - R For 3,000 Units For 2,000 Units For 2,000 Units
All VC: ? ? -? ? 1,20,000 ? ? 1,00,000
(₹60 p.u.) (2000×60) (2000×50)
FC: - - 6,000 - - 4,000 - - 5,000

∴ TC 1,24,000 1,05,000
Data for Market Size & Share Variance: (For Total Units Only) (Same as last question)
Total Profit Variance = Act. Profit – Bud. Profit = 139000 – 170000 = - ₹31,000 (A)
SPV = AO (ASP - SSP) Std. Cost for Volume

TCV = – Act. Cost PMVV = SPR
(Same as in Sales Var) Act. Prodn Gain/(Lost)
D: 10000 (22 – 24) = TCV-D = 160000 TCV-R = 124000 D: 8 (+3,000 Units) =
R: 2000 (70 -100) = ___ – 116000 – 105000 R: 38 (- 1,000 Units) = ____
- ₹80,000 (A) = + ₹44,000 (F) = + ₹19,000 (F) - ₹14,000 (A)

PMMV = SPR (TAO in AM - TAO in SM) PMQV = Avg. SPR (TAO - TSO)
D: 8 (10000–8400) = +12800
R: 38 (2000 – 3600) = -60800 = 17 (12000 – 10000)
- ₹48,000 (A) = + ₹34,000 (F)

= Avg. SPR (Change in = Avg. SPR (Change in
= 17 (12,000 – 15,000) = 17 (15,000 – 10,000)
= - ₹51,000 (A) = + ₹85,000 (F)
Comments: Refer Summary Notes.
E. REVENUE VARIANCES - CONTRIBUTION

10. Total Contribution Variance = Act. Contribution – Bud. Contribution =
Std. VC for Volume

SPV = AO (ASP - SSP) VCV = – Act. VC CMVV = SCR
CMMV = SCR (TAO in AM - TAO in SM) CMQV = Avg. SCR (TAO - TSO)

= Avg. SCR (Change in = Avg. SCR (Change in
11. Assume production units = sold units in budget and in actual, unless specifically given
different, or if stock is given.
12. Alternate names of variances: Profit Margin = Sales Margin
Sales Price Variance = Profit Margin Price Variance = Contribution Price Variance
13. If actual costs are not given, the use standard costs to find profit in actual also.
Q.07. CONTRIBUTION VARIANCES

Required: Compute all possible Contribution Variances in Q.05. & comment on it
SOLUTION: Contribution Variances:
Contribution Data Table: [Contribution Amount = (SP – VC) × Units]


Contri For 12 Month For Month For 12 Month
D 7,000 10 70,000 10,000 12 1,20,000
R 3,000 40 1,20,000 2,000 20 40,000
10,000 19 1,90,000 12,000 1,60,000
Cost - D For 7,000 Units For 10,000 Units For 10,000 Units
Only VC: ? ? -? ? 1,40,000 ? ? 1,00,000
(₹14 p.u.) (10000×14) (10000×10)
Cost - R For 3,000 Units For 2,000 Units For 2,000 Units
Only VC: ? ? -? ? 1,20,000 ? ? 1,00,000
(₹60 p.u.) (2000×60) (2000×50)
Data for Market Size & Share Variance: (For Total Units Only) (Same as last question)
Total Contri Variance = Act. Contri – Bud. Contri = 160000 – 190000 = - ₹30,000 (A)
SPV = AO (ASP - SSP) Std. VC for Volume

VCV = – Act. VC CMVV = SCR
(Same as in Sales Var) Act. Prodn Gain/(Lost)
D: 10000 (22 – 24) = VCV-D = 140000 TCV-R = 120000 D: 10 (+3,000 Units) =
R: 2000 (70 -100) = ___ – 100000 – 100000 R: 40 (- 1,000 Units) = ____
- ₹80,000 (A) = + ₹40,000 (F) = + ₹20,000 (F) - ₹10,000 (A)
CMMV = SCR (TAO in AM - TAO in SM) CMQV= Avg. SCR (TAO - TSO)
D: 10 (10000–8400) = +16000
R: 40 (2000 – 3600) = -64000 = 19 (12000 – 10000)
- ₹48,000 (A) = + ₹38,000 (F)

= Avg. SCR (Change in = Avg. SCR (Change in
= 19 (12,000 – 15,000) = 19 (15,000 – 10,000)
= - ₹57,000 (A) = + ₹95,000 (F)
Comments: Same like Profit Variances.

Q.08. REVENUE VARIANCES (GENERAL)

ZM Inc. is a family run business based in Country Z. It is a manufacturer of two types of
flooring rolls, one for industrial usage and the other for domestic residential use, throughout
mainland of Country Z. The company started with the production of residential domestic
flooring. It is now an established player in this market. In the recent years, the company
pioneered into making flooring rolls for industrial usage. The management has the following
information about the budgeted and actual data for 2019:
Particulars Static Budget Actual Result
Industrial Domestic Total Industrial Domestic Total
Unit Sales in Rolls ( ‘000) 200 600 800 270 570 840
Contribution Margin (Z$ in millions) 10.00 24.00 34.00 12.825 15.390 28.215
In late 2018, a marketing research estimated market volume for industrial and domestic
flooring at 8m Rolls. Actual market volume for 2019 was 7m Rolls. Actual sales trend of ZM
Inc. is indicative of the sales trends for individual products in the future years, it is likely that
they might continue to sell a similar sales trajectory. A newly appointed accountant has
computed following variances:
Required: Assuming yourself as a performance management expert of ZM, the CEO has
asked you to ADVISE strategic inputs on ‘two types of flooring rolls’ to help out her in strategic
decision making. [May 20 MTP (10 Marks)]
SOLUTION: Note: “Sales Variance” mentioned in this question is actually “Contribution

Variance”. Also, Contribution Price variance has not been calculated by the accountant
here, but for better analysis and comments, we shall calculate it. Assume Variable cost
variance is zero, so we can take contribution rate itself as SP rate for the variance
Calculations of all contribution variances: Data Table Format: (in million Z$)
TYPE
Q R A Q R A Q R A
Contri. For 12 Month For Month For 12 Month
Indus 0.20 50 10 0.27 47.5 12.825

Dom 0.60 40 24 0.57 27 15.390

0.80 42.5 34 0.84 28.125
Budgeted Market Size = 8m, Std qty given = 0.8m. ∴ Budgeted Market share = 10%.
Actual Market Size = 7m, ∴ Budgeted Share of Actual Size = 10% of 7m = 0.7m units
Total Contribution Variance = Act. Contri. – Bud. Contri. = 28.125 – 34 = - Z$5.875m
Volume
CPV = AO (ASP - SSP) CMVV = SCR
Gain/(Lost)
I: 0.27 (47.5-50) = - 0.675 I: 50 (+0.07) = + 3.5
D: 0.57 (27 – 40) = - 7.41 D: 40 (-0.03) = - 1.2
= - Z$ 8.085m = + Z$ 2.3m
CMMV = SCR (TAO in AM - TAO in SM) CMQV = Avg. SCR (TAO - TSO)
I: 50 (0.27 – 0.21) = +3
D: 40 (0.57 – 0.63) = - 2.4 = 42.5 (0.84 – 0.80)
[0.84 in 2:6] = + Z$ 0.6m = + Z$ 1.7m
Market Share Variance Market Size Variance:

= 42.5 (0.84 – 0.70) = 42.5 (0.70 – 0.80)
= + Z$ 5.95m = - Z$ 4.25m
Analysis of Variances:
It can be seen that total unit sales increased by 0.04m rolls resulted in a favorable volume
variance. Therefore, a potential increase of Z$2.3 m in contribution was achieved as a result
of change in sales volume compared with budgeted volume. The volume variance is further
divided into a quantity and mix variance. In the case of ZM, quantity variance came out to be
favorable 1.70 m and the sales mix variance came out to be 0.60 m favorable. ZM’s quantity
variance can be further subdivided into market size and share variances. ZM gain 2% market
share from 10% budgeted share to the actual share of 12%. The Z$5.95m favorable market
share variance is the effect of the decline in contribution margin. Market size variance is
Z$4.25 m adverse as actual market size decreased compared to budgeted market size.
Further, it appears that accountant has committed a blunder in the computation of variances
related to contribution. He/She completely ignored the price variance which is a substantial
part of the analysis. Price variance is Z$ 8.085m adverse (refer above computations) and
having significant impact on the contribution margin. Revised variances after the computation
of price variance are calculated above.

Strategic Inputs:
The expected demand for industrial flooring rolls was 0.20 m units. Against this the actual
sales has been 2.70 m rolls. Even after adjustment for the sales mix that could have resulted
in a proportional volume of 2.10 m units. The actual sales is higher than projections. Actual
contribution margin of Z$47.5 is marginally lower than standard contribution margin of Z$50
per unit. ZM may have cut its selling price to maintain or gain market share. This indicates
that the industrial flooring rolls are in the Growth Phase of product life cycle. Due to increase
in demand, there is a possibility of higher sales and profits to be made in future years.
The expected demand for domestic residential flooring rolls was 0.60 m units. Against this
the actual sales has been 5.70 m rolls. After adjustment for the sales mix given the increased
sales volume, sales should have been 6.30 m units as per the standard sales mix ratio. Actual
sales is lower than the expectations. Actual contribution margin of Z$27 per roll is significantly
lower than the standard contribution margin of Z$40. ZM may have sold these at substantially
reduced price to increase the sales volume. This indicates that the domestic residential
flooring rolls might be in the Decline Stage of product life cycle.
The market size for flooring rolls has reduced from an expectation of 8 m rolls to 7 m rolls.
Therefore, the market size has shrunk significantly for the year 2019. This is a threat to
profitability of business. The management has to understand the reasons behind this
shrinkage. For example, dwindling demand maybe on account of cheaper substitutes
available for flooring rolls. The management has to take cognizance of this threat to business.
A positive for ZM is that its actual market share for flooring rolls was higher than expected at
12%. An increase in market share would have a beneficial impact on the company’s
profitability. Also, despite the shrinkage in market size, demand for industrial flooring rolls
seems to be on the rise. This could be an opportunity for the management to consider.
As explained above, the industrial flooring rolls seem to be in the Growth Stage of product
life cycle, while the domestic residential rolls are in the Decline Stage. Industrial flooring rolls
have a higher contribution margin per roll as compared to domestic residential rolls.
Accordingly, ZM may consider phasing out domestic flooring rolls and concentrate on
industrial flooring rolls. In view of shrinking market conditions, it would be more profitable to
phase out the weaker product and concentrate on the fast moving and profitable product. At
the same time, since domestic flooring roll still has significant demand, the strategy to phase
out this product may have to be done in a phased and well-planned manner. In view of the
shrinking market size, ZM should not end up losing its market share due to phasing out
domestic flooring rolls.
Q.09. REVENUE VARIANCES (GENERAL)

A company is planning to improve its profit level at least by 10% from the preliminary budget
estimates of a profit of ₹32,80,000 for the coming year. It has worked out the following profit
improvement plan:
(i) In the year just concluded the sales of the company were 10% of the total market of
12,00,000 units. For the preparation of the original budget estimate, the same market
demand and the same share of market for the company was envisaged. Now it has been
estimated that the total market demand will increase by 18% and the company's market
share will increase to 11% from the present level of 10%.

(ii) The products are sold in two sizes - large and medium. The sales mix of each size was
50:50 so far. Now it is planned that the sales will be 40% of large and 60% of medium.
The medium packs and large packs have a contribution of ₹10 and ₹8 per pack
respectively. The budget proposes to raise the price in such a manner that the contribution
per pack will increase by ₹0.60 for each size.
(iii)There will be an additional expenditure on sales promotion worth ₹78,000.
(iv)The company proposes to save ₹9,000 by saving on interest cost in the coming year by
better financial management.
You are required to draw a profit improvement plan in financial terms and spell out separately
the effect of various factors on profit. [May 18 Exam (10 Marks)]
SOLUTION:
Note: Generally Profit Variances are calculated by comparing “Budget & Actual”. However in
this question, Actual Data is not given. Instead, we are given “Prelim Budget & Revised
Budget”. So, to identity effect of various factors on profit, we can calculate Profit Variances
between “Prelim Budget & Revised Budget”.
Note: Data is given here in the form of Contribution, hence instead of using Profit Variances,
we can use Contribution Variances and Fix Oh Variances to analyze Profit.
Note: VC is not given, so it can be assumed that VC remains same. SP is also not given, but
it is mentioned in the question that SP was raised. Now, if VC is constant, then SPV can be
calculated by taking difference in Contri. p.u.
Contribution Data Table:
PRELIM BUD (BUD) REVISED BUD (ACT)
Contri For 12 Month For Month For 12 Month
L 60,000 8 62,304 8.6
M 60,000 10 93,456 10.6
1,20,000 10,80,000 1,55,760 15,26,448
Data for Market Size & Share Variance: (For Total Units Only)
Note: Actual Market Size = 12,00,000 Units + 18% Incr in Market Demand = 14,16,000 Units
= 12,00,000 Units × 10% = 14,16,000 Units × 10% = 14,16,000 Units × 11%
= 1,20,000 Units = 1,41,600 Units = 1,55,760 Units
Total Contri Variance = Act. Contri – Bud. Contri = 1526448 - 1080000 = + ₹4,46,448 (F)
Std. VC for Volume

SPV = AO (ASP - SSP) VCV = – Act. VC CMVV = SCR
L: 62304(8.6 – 8) = =0 L: 8 (+2,304 Units) =

M: 93456(10.6-10) = ___ M: 10(+33,456 Units) = _____

+ ₹93,456 (F) + ₹3,52,992 (F)
CMMV = SCR (TAO in AM - TAO in SM) CMQV= Avg. SCR (TAO - TSO)
L: 8 (62304-77880) =
M: 10 (93456-77880) = _____ = 9 (155760-120000)
+ ₹31,152 (F) = + ₹3,21,840 (F)

= 9 (155760-141600) = 9 (141600-120000)
= + ₹1,27,440 (F) = + ₹1,94,400 (F)
Profit Improvement Plan:
Profit is expected to increase because of various factors as follows:
Reason for Increase in Profit: (₹)
Due to increase in SP [SPV] + 93,456 (F)
Due to change in mix of L & M [CMVV] + 31,152 (F)
Due to increase in Market Share + 1,27,440 (F)
Due to increase in Market Size + 1,94,400 (F)
∴ Total Increase in Contribution: + 4,46,448 (F)
Additional Exp on Sales Promotion - 78,000 (A)
Interest Savings + 9,000 (F)
∴ Net Increase in Profit + 3,77,448 (F)
₹ , ,
∴ % Increase in Profit from Prelim Budget 100 11.51%
₹ , ,
Ans: Thus, the revised budget is achieving more than 10% increase in Profit.
F. RECONCILIATIONS
A. Profit Reconciliation B. Contribution Reconciliation C. Cost Reconciliation

Budgeted Profit Budgeted Contribution
(±) PMVV (±) CMVV
∴ Standard Profit ∴ Standard Contribution Standard Cost
(±) All Other Variances (±) All Other Variable Variances (±) All Cost Variances
∴ Actual Profit ∴ Actual Contribtion ∴ Actual Cost

Rule: Rule: Rule:

(+) Favourable Var. (+) Favourable Var. (+) Adverse Var.
(-) Adverse Var. (-) Adverse Var. (-) Favourable Var.
Types of Profit Reconciliations (1st see basic Profit Reconciliation for Q.06.
(1) By Absorption Costing (2) By Marginal Costing (3) By Relevant Costing

Show all variances as Make Following changes in Make Following changes in
above, including: Absorption Costing Reco: Marginal Costing Reco:
- PMVV & - PMVV change to CMVV - Contri Lost due to key factor
quantity wastage is shifted to
- FOHVV - FOHVV is ‘Zero’
Quantity variance of CMVV.
Note: Methods to make Profit Statements:
These 2 methods are just for presenting profit statements, not for making Selling Price
Calculations. i.e Selling Price is always calculated using rate method for fix costs.
ABSORPTION COSTING METHOD MARGINAL COSTING METHOD
1. Both variable and fix costs are taken in Only variable costs are taken in product
product costs (i.e. COP) costs (i.e. COP)
2. Fixed costs are taken in product costs Fixed costs are taken separately on total
based on rate basis. basis.
3. Difference in total fix cost is then later No such adjustment is needed as directly
adjusted to get the final profit. [under total fix costs has been taken.
absorption / over absorption].
4. Stock valuation contains both fix and Stock valuation contains only variable
variable costs costs
5. Fix costs are treated as product costs. Fix costs are treated as period costs
6. Format (of concept): Format (of concept):
Sales Sales
(-) COS [Var & Fix (@Rate)] (-) V - COS
∴ Profit ∴ Contribution
(±) Difference in fix costs (-) Fix Costs (Total)
∴ Adjusted Profit ∴ Profit
7. FOHVV indicates extra recovery of Fix Oh. Now, under Marginal Costing Method, FOH
are not recovered from product cost. Hence no FOHVV in marginal costing method.
However, FOHBV will still come.
8. When Stock is zero, then Actual Profit as per Absorption Costing is same as Actual Profit
as per Marginal Costing.

Q.10. RECONCILIATION
The following information is available for X Ltd. which produces only one product:
Budget for January (₹) Actual for January (₹)
Sales: [2,000 units @ ₹50] 1,00,000 Sales: [1,900 units] 91,200
Production costs: [2,000 units] Production costs: [1,900 units]
DM: [4,000 Kg @ ₹2.5] 10,000 Direct: [3,876 Kgs] 10,659
DL: [10,000 Hrs @ ₹4] 40,000 Direct: [9,785 Hrs] 41,097
Production Oh: 30,000 Production Oh: 33,000
Budgeted Profit 20,000 Actual Profit 6,444
Prepare the following Reconciliations:
(a) Profit Reconciliation by Absorption Costing Method
(b) Profit Reconciliation by Marginal Costing Method
(c) Profit Reconciliation by Relevant Costing Method if:
(1) Labour is Scarce, OR (2) Material is Scarce OR (3) Nothing is Scarce
Also comment on the efficiency of the Sales Manager for not using the scarce resources.
(d) Contribution Reconciliation
(e) Cost Reconciliation
SOLUTION:
Note: For Oh, if nothing is mentioned, then variances will be calculated as if it is Fix Oh.
(a) Profit Reconciliation by Absorption Costing Method
Data Table Format:
TYPE
Q R A Q R A Q R A
PR. FOR 1 M FOR 1 M FOR 1 M
2,000 10 20,000 1,900 6,444
VC FOR 2,000 UNITS FOR 1,900 UNITS FOR 1,900 UNITS
Mat 4,000 2.5 10,000 3,800 2.5 9,500 3,876 2.75 10,659
Lab 10,000 4 40,000 9,500 4 38,000 9,785 4.2 41,097
FC Budget Standard Actual
FOH (₹) 30,000 28,500 33,000
Units 2,000 1,900 1,900
Hours 10,000 9,500 10,450
TC 76,000 84,756
SR/Unit: 15;

Total Profit Variance = Act. Profit – Bud. Profit = 6444 - 20000 = - ₹13,556 (A)

= 1,900 (48-50) = 76000 – 84756 = 10 (- 100 Units)
= - ₹3,800 (A) = - ₹8,756 (A) = - ₹1,000 (A)
Components of Total Cost Variances (Answers):
Mat: MPV = - ₹ 969 (A) & MUV = - ₹ 190 (A) ∴ MCV= - ₹1,159 (A)
Lab: LRV = - ₹1,957 (A) & LTV = - ₹1,140 (A) ∴ LCV = - ₹3,097 (A)
Fix Oh: BUD = - ₹3,000 (A) & VOL = - ₹1,500 (A) ∴ CV = - ₹4,500 (A)
TCV = - ₹8,756 (A)
Profit Reconciliation by Absorption Costing Method: (₹)
Budgeted Profit 20,000
Add/Less: Variances:
PMVV (1,000)
Standard Profit for Actual Units: 19,000
SPV (3,800)
TCV: -
MPV (969)
MUV (190)
LRV (1,957)
LTV (1,140)
FOH BV (3,000)
FOH VV (1,500)
Actual Profit 6,444
(b) Profit Reconciliation by Marginal Costing Method:

→ Budgeted Contribution = Sales – VC = ₹1,00,000 - ₹10,000 - ₹40,000 = ₹50,000
₹ ,
→ Std Contribution Rate (SCR) = = ₹25 p.u.
,
Volume
→ CMVV = SCR = 25 [- 100 Units] = - ₹2,500 (A)
Gain/(Lost)
Profit Reconciliation by Marginal Costing Method: (₹)

CMVV (2,500)
SPV (3,800)
TCV: -
MPV (969)
MUV (190)
LRV (1,957)
LTV (1,140)
FOH BV (3,000)
FOH VV – Not Applicable
Actual Profit 6,444
(c) Profit Reconciliation by Relevant Costing Method:

(1) If Mat is (2) If Labour (3) Nothing
Scarce is Scarce is Scarce
Budgeted Profit 20,000 20,000 20,000
CMVV (1,550) (1,075) (2,500)
Standard Profit for Actual Units: 18,450 18,450 17,500
SPV (3,800) (3,800) (3,800)
TCV: - - -
MPV (969) (969) (969)
MUV (1,140) (190) (190)
LRV (1,957) (1,957) (1,957)
LTV (1,140) (2,565) (1,140)
FOH BV (3,000) (3,000) (3,000)
Actual Profit 6,444 6,444 6,444
WN-1: When Material is scarce:
Based on conventional method, MUV is - ₹190(A). [i.e. ₹2.5 (3,800 Kg – 3,876 Kg)]
This means that Material has been wasted. If the material is scarce, then MCV based on
Relevant Costing should also include the Contribution Lost due to this material wastage,
because this is not the fault of the Sales Manager (or of Market Demand), rather it is fault of
the Production Manager that he used excess quantity of materials.

Excess material usage of 76 Kg leads to 38 Units lost, and so contribution lost of 38 Units @
₹25 p.u. is ₹950. ∴ Total MUV based on Relevant Costing, when material is scarce will be:
MUV = ₹190 (A) + ₹950 (A) = ₹1,140 (A).
Since labour is not scarce, labour variances are identical to conventional method.
This loss of 38 Units is not the fault of the Sales Manager (or of Market Demand), rather it
was the responsibility of Production Manager to use material efficiently. Hence, loss of
contribution from 38 units should be excluded while computing CMVV.
∴ CMVV = ₹2,500 (A) – ₹950 (A) = ₹1,550 (A)
WN-2: When Labour is scarce:
Based on conventional method, LTV is - ₹1,140(A). [i.e. ₹4 (9,500 Hrs – 9,785 Hrs)]
This means that Labour Hours have been wasted. If the labour is scarce, then LCV based on
Relevant Costing should also include the Contribution Lost due to this labour wastage,
because this is not the fault of the Sales Manager (or of Market Demand), rather it is fault of
the Workers that they used excess Hours.
Excess labour usage of 285 Hrs leads to 57 Units lost, and so contribution lost of 57 Units @
₹25 p.u. is ₹1,425. ∴ Total LTV based on Relevant Costing, when labour is scarce will be:
LTV = ₹1,140 (A) + ₹1,425 (A) = ₹2,565 (A).
Now, since material is not scarce, material variances are identical to conventional method.
This loss of 57 Units is not the fault of the Sales Manager (or of Market Demand), rather it
was the responsibility of the workers to use hours efficiently. Hence, loss of contribution from
57 units should be excluded while computing CMVV.
∴ CMVV = ₹2,500 (A) – ₹1,425 (A) = ₹1,075 (A)
WN-3: When Nothing is scarce: = Same as Reconciliation by Marginal Costing Method
Comment on Efficiency and Responsibility of the Sales Manager:
In general, Gross Profit is the joint responsibility of sales managers as well as of production
managers. On one hand the sales manager is responsible for the sales revenue part, on the
other hand the production manager is accountable for the cost-of-goods-sold component.
However, it is the top management who needs to ensure that the target profit is achieved by
the organization. The sales manager is accountable for prices, volume, and mix of the
product, whereas the production manager must control the costs of materials, labour, factory
overheads and quantities of production. The purchase manager must purchase materials at
budgeted prices. The personnel manager must employ right people at the right place with
appropriate wage rates. The internal audit manager must ensure that the budgetary figures
for sales and costs are being adhered by all departments which are directly or indirectly
involved in contribution of making profit. Thus, sales manager is not responsible for
contribution lost due to excess usage or inefficient usage of resources in case of scarce
resources. Hence, such contribution lost must be excluded from the CMVV.

(d) Contribution Reconciliation

→ Budgeted Contribution = Sales – VC = ₹1,00,000 - ₹10,000 - ₹40,000 = ₹50,000
₹ ,
→ Std Contribution Rate (SCR) = = ₹25 p.u.
,
→ Actual Contribution = Sales – VC = ₹91,200 - ₹10,659 - ₹41,097 = ₹39,444

Total Contri Variance = Act. Contri – Bud. Contri = 39444 - 50000 = - ₹10,556 (A)
SPV = AO (ASP - SSP) Std. VC for Volume

VCV = – Act. VC CMVV = SPR
[Same as SPV in Profit Var] Act. Prodn Gain/(Lost)
= 1,900 (48-50) = 47500 – 51756 = 25 (- 100 Units)
= - ₹3,800 (A) = - ₹4,256 (A) = - ₹2,500 (A)
Contribution Reconciliation: (₹)
Budgeted Contribution 50,000
CMVV (2,500)
Standard Contribution for Actual Units: 47,500
SPV (3,800)
TCV: -
MPV (969)
MUV (190)
LRV (1,957)
LTV (1,140)
FOH BV – Not Applicable
Actual Contribution 39,444
(e) Cost Reconciliation

Standard Cost for Actual Units: 76,000
Add/Less: Cost Variances:: [Add Adverse & Less Favourable] -
MPV 969
MUV 190
LRV 1,957
LTV 1,140

FOH BV 3,000
FOH VV 1,500
Actual Cost 84,756
G. OTHER ADJUSTMENTS
STOCK ADJUSTMENTS:
1. If actual production units and actual sold units are different, then use base of actual
Production units for all cost variances calculations, while for all profit & sales variances
calculation, use base of actual Sold units
2. Closing stock (i.e. unsold units) are always valued at Standard Cost. Thus unsold units
do not contain any variance. So, even though cost variances were calculated on
production units, still this entire variance same applies to Sold units also, because unsold
units do not contain any variance. Thus Profit Reconciliation still tallies in spite of having
variances calculated on all production units.
3. Logic for Stock valuation at Standard Cost and its impact on Variances: Cost sheet format:
Particulars Actual (₹)
RM Purch
(+) Opg. RM
(-) Clg RM
∴ RM Cons
(+) DL
(+) OH
∴ FC
(+) Opg. WIP
(-) Clg. WIP
∴ COP
(+) Opg. FG
(-) Clg. FG
∴ COGS / COS
Q.11. PROFIT RECONCILIATION & STOCK ADJUSTMENT

The following information is available for X Ltd. which produces only one product:
Budget for January (₹) Actual for January (₹)
Sales: [2,000 units @ ₹50] 1,00,000 Sales: [1,800 units] 86,400

Production costs: [2,000 units] Production costs: [1,900 units]

DM: [4,000 Kg @ ₹2.5] 10,000 Direct: [3,876 Kgs] 10,659
DL: [10,000 Hrs @ ₹4] 40,000 Direct: [9,785 Hrs] 41,097
Production Oh: 30,000 Production Oh: 33,000
(+) Opg FG [100 units @ ₹40] 4,000
(–) Clg FG [200 units @ ₹40] (8,000)
Total Production Cost 80,000 Total Production Cost 80,756
Budgeted Profit 20,000 Actual Profit 5,644
Prepare Profit Reconciliation by Absorption Costing Method
TYPE Q R A Q R A Q R A
PR. FOR 1 M FOR 1 M FOR 1 M
2,000 10 20,000 1,800 5,644
VC FOR 2,000 UNITS FOR 1,900 UNITS FOR 1,900 UNITS
Mat 4,000 2.5 10,000 3,800 2.5 9,500 3,876 2.75 10,659
Lab 10,000 4 40,000 9,500 4 38,000 9,785 4.2 41,097
FC Budget Standard Actual
FOH (₹) 30,000 28,500 33,000
Units 2,000 1,900 1,900
Hours 10,000 9,500 10,450
TC 76,000 84,756
SR/Unit: 15;
Total Profit Variance = Act. Profit – Bud. Profit = 5644 - 20000 = - ₹14,356 (A)

= 1,800 (48-50) = 76000 – 84756 = 10 (- 200 Units)
= - ₹3,600 (A) = - ₹8,756 (A) = - ₹2,000 (A)
Components of Total Cost Variances (Answers):
Mat: MPV = - ₹ 969 (A) & MUV = - ₹ 190 (A) ∴ MCV= - ₹1,159 (A)
Lab: LRV = - ₹1,957 (A) & LTV = - ₹1,140 (A) ∴ LCV = - ₹3,097 (A)
Fix Oh: BUD = - ₹3,000 (A) & VOL = - ₹1,500 (A) ∴ CV = - ₹4,500 (A)
TCV = - ₹8,756 (A)

Profit Reconciliation by Absorption Costing Method: (₹)

PMVV (2,000)
SPV (3,600)
TCV: -
MPV (969)
MUV (190)
LRV (1,957)
LTV (1,140)
FOH BV (3,000)
FOH VV (1,500)
Actual Profit 5,644
WIP IN STANDARD COSTING:
1. WIP means units remaining incomplete at the end of a year.
2. Generally, cost variances are calculated based on ‘Standard Cost for Actual Production’.
But, some of the CY actual costs are now incurred on WIP units also, hence the cost
variances will be calculated based on ‘Standard Cost for Equivalent Actual Production
Units of CY’ in this case.
3. The Equivalent Production Units may be different for material and labour based on the %
level of completion given.
4. For variance calculation, Equivalent units used will always be Equivalent units of CY. But
for valuation of WIP, Equivalent units used will be either of only CY (FIFO method) or of
CY+Opening (WAM).
5. Format for Equivalent Units of CY (Used for Variance Data Table, and for FIFO Valuation):
Total For Mat For Lab For OH

Particulars
Units % Units % Units % Units
1) Units Completed: -
Based on % of
a) Out of Opg WIP
Incompletion
b) Out of CY IP
2) Clg WIP

∴ Equi Units
6. Format for Equivalent Units of CY + Opening (Used only for WAM Valuation):
Total For Mat For Lab For OH

Particulars
Units % Units % Units % Units
1) Units Completed: 100 100 100
2) Clg WIP
∴ Equi Units
7. Closing WIP valuation can be asked: @ Standard Cost, or
@ Actual Cost [FIFO Method or WAM]
8. Calculation of Units Completed:
Particulars Units
Input Units
(+) Opg WIP
(-) Clg WIP
∴ Completed Units ?
(+) Opg FG
(-) Clg FG
∴ Sold Units
Q.12. WIP
GFE Associates undertake to prepare Property Tax returns. They use the weighted average
method and actual costs for financial reporting purpose. However, for internal reporting, they
use a standard cost system. The standards, on equivalent performance, have been
established as follows:
Labour per return 10 hrs. @ Rs 30 per hour
Overhead per return 10 hrs. @ Rs 15 per hour
For June 2012 performance, budgeted overhead is Rs108,000 for the standard labour hours
allowed.
The following additional information pertains to the month of June 2012:
June 1 Returns in process (25% complete) 180 Nos.
Returns started in Jun 820 Nos.
June 30 Returns in process (80% complete) 200 Nos.
Cost Data
June 1 Returns in process:

Labour Rs 16,000
Overheads 8,000
June 1 to 30 Labour (4,000 hrs.) 2,00,000
Overheads 1,00,000
You are required to compute:
(a) The labour rate Variance, labour efficiency variance, overhead volume and overhead
expenditure variance.
(b) For each cost element, equivalent units of performance and actual cost per equi. unit.
(c) Actual cost of returns in process on June 30
(d) The standard cost per return, and
SOLUTION: (a) Variances:

Equivalent Units ‘of CY’:
Data Table Format: [For Equivalent Units of CY]

TYPE
Q R A Q R A Q R A
For 1 unit Prodn. For 915 units Prodn. For 915 units Prodn.
Lab: 10 30 300 9,150 30 2,74,500 4,000 50 2,00,000
FOH (Rs) ₹1,08,000 ₹1,37,250 ₹1,00,000
Units 720 units 915 units 915 units
Hours
LRV = AH (SR – AR) = 4,000 (30 – 50) =- ₹80,000 (A)
LEV = SR (SH – AH) = 30 (9,150 – 4,000) = + ₹1,54,500 (F)

OHVV = SR p.u. [Vol. Gained] = ₹150 [+ 195 units] =+ ₹29,250 (F)

OHEV = Bud OH – Act Oh = 108000 – 100000 =+ ₹8,000 (F)
EXTRA DISCUSSION – TYPES OF VALUATION OF CLG WIP:

ANSWER TO ORIGINAL Q.12.:

(b) Labour Overheads
Equivalent Units of mixture: 960 Units 960 Units
Actual Cost p.u. of mixture: ₹225 p.u. ₹112.5 p.u.
(c) Clg WIP Valuation at Actual Cost by WAM = ₹54,000
(d) Std Cost p.u. (Given in Question):
Labour ₹300 p.u.
Overhead ₹150 p.u.
Total ₹450 p.u.
Q.13. MISSING FIGURES – FIND ACTUALS

The following is the Operating Statement of a company for April 2012:
(Rs)
Budgeted Profit 2,00,000
Variances: Favourable Adverse
Sales Volume 8,000
Price 19,200
Direct Material Price 9,920
Usage 12,800
Direct Labour Rate 7,200
Efficiency 7,200
Fixed Overheads Efficiency 4,800
Capacity 8,000
Expenditure 2,800 _____
34,000 45,920 11,920 (A)
Actual Profit 188,080

Additional information is as under:

Budget for the year 1,20,000 units
Budgeted fixed overheads Rs 9,60,000 per annum
Standard cost of one unit of product is:
Direct Materials 5 kg.@ Rs8 per kg.
Direct Labour 2 hours @ Rs6 per hour
Fixed overheads are absorbed on direct labour hour basis.
Profit 25% on sales
Prepare the Financial Profit / Loss Statement for April, 2012 in the following format:
Account Qty./ Hours Rate / Price (Rs) Actual Value (Rs)
Sales
Direct Materials
Direct Labour
Fixed Overheads
Total Costs
Profit
SOLUTION:

Actual P&L:
Account Qty./ Hours Rate / Price (Rs) Actual Value (Rs)
Sales 9,600 units [Bal Fig] ₹7,87,200
Direct Materials 49,600 Kg ₹8.2/Kg ₹4,06,720
Direct Labour 18,000 Hrs ₹6.4/Hr ₹1,15,200
Fixed Overheads - - ₹77,200
Total Costs ₹5,99,120
Profit [Given] ₹1,88,080
COMPARISON:
Q.13. →
Q.14. →
Q.14. MISSING FIGURES – FIND BUDGET

The budgeted output of a single product manufacturing company for the year ending 31st
March was 5,000 units. The financial results in respect of the actual output of 4,800 units
achieved during the year were as under:
Rs
Direct material 29,700
Direct wages 44,700
Variable overheads 72,750
Fixed overheads 39,000
Profit 36,600
Sales 2,22,750
The standard wage rate is Rs 4.50/Hr and the standard variable overhead rate is Rs 7.50/Hr.
The cost accounts recorded the following variances for the year:
Variances Favourable ₹ Adverse ₹
Material price 300

Material usage – 600

Wage rate 750 –
Labour efficiency – 2,250
Variable overhead expenditure 3,000 –
Variable overhead efficiency – 3,750
Fixed overhead expenditure – 1,500
Selling price 6,750 –
(a) Prepare a statement showing the original budget.
(b) Prepare the standard product cost sheet per unit.
(c) Prepare a reconciliation of original budgeted profit and actual profit.
SOLUTION: (a)

Q.15. MISSING FIGURES

Apple Ltd., is following three variances method to analyse and understand production
overhead variances. The three variances for a particular year were reported as given below:
Production overhead expenditure variance ₹94,000 A
Production overhead volume variance ₹1,00,000 F
Production overhead efficiency variance ₹48,000 F

The other particulars furnished from the records of the company are:
Standard machine hours for the year 11,500
Closing balance in the Production Overhead Control Account ₹18,00,000
Fixed overhead rate per hour ₹125
Variable overhead rate per hour ₹80
Required: COMPUTE the following by considering the additional information also:
(i) Actual machine hours (ii) Budgeted machine hours
(iii) Total Fixed Production Overhead amount (iv) Applied Production Overhead amount
Additional Information
 Expenditure variance was computed totally for fixed and variable overheads.
 Volume variance is applicable to fixed overhead only.
 Efficiency variance is applicable only to variable overhead and fixed overhead efficiency
variance was already included in volume variance. [Nov 18 Exam (10 Marks)]
SOLUTION:

Note – 1: “Closing Balance in Production Overhead Control Account” indicates the

accumulated balance of past Under / Over Absorption carried forward from previous years. It
does not indicate Actual Overheads. It is of no use in this question and is therefore ignored.
Note – 2: Actual Overheads in this example can be calculated as follows:
→ Total Oh Variance = - 94,000 +1,00,000 + 48,000 = + ₹54,000 (F)
→ Total Oh Variance = Total Standard Oh – Total Actual Oh
∴ + ₹54,000 = ₹23,57,500 – Total Actual Oh
∴ Total Actual Oh = ₹23,57,500 – ₹54,000 = ₹23,03,500
PLANNING & OPERATING VARIANCES:
1. This is calculated only when there is any revision in the standards, i.e. change in standard
but which is not controllable. Eg. Increase in market prices, or increase in quantity
consumed due to no fault of the company.
2. In such case we need to separate the variance which is not due to fault of the company,
rather it is due to external factors, thus it is not controllable. These variances are called
“Planning Variance” (Eg. Market Size Variance).
3. The balance variance left after separating Planning Variance is called as Operating
Variance. These are the variances due to operations of the company.
4. Calculation:
Traditional Variance = Std – Act
Planning Variance = Std – Revised Std. Operating Variance = Revised Std – Act
5. Analysis:
Planning Variance v/s Operating Variances must be analyzed in each such question.
Planning Variance indicate the variance which is not controllable, company performance
will be measured only based on Operating Variances. Analyzing Traditional Variances will
give a wrong idea as it might show lesser variance if Planning & Operating Variances get
off-set. Or sometimes it might show excess variance if Planning & Operating Variances
add up. You need to explain for each question that what is the problem if company uses
Traditional Variances for performance measurement and what is the benefit if the
company separates Planning & Operating Variances.
6. Generally Planning Variances are always uncontrollable, however, in some cases,
Planning Variances might be further classified as controllable and uncontrollable. This
happens if any of the change in market price was controllable by management decisions.
(Refer Q ____).

Q.16. PLANNING & OPERATING VARIANCES AND VARAINCES BY ABC

JPY Limited produces a single product. It has recently automated part of its manufacturing
plant and adopted Total Quality Management (TQM) and Just-in- Time manufacturing
system. No inventories are held for material as well as for finished product. The company
currently uses absorption costing system. Following are related to 4th quarter of 2020-21:
Budget Actual
Production and Sales 1,00,000 units 1,10,000 units
Direct Materials 2,00,000 kg. @ ₹30/kg 2,50,000 kg. @ ₹31.20/kg.
Direct Labour Hours 25,000 hrs. @ ₹300/ hr 23,000 hrs. @ ₹300/ hr.
Fixed Production Overhead ₹3,20,000 ₹3,60,000
Production overheads are absorbed on the basis of direct labour hours.
The CEO intends to introduce activity based costing system along with TQM and JIT for better
cost management. A committee has been formed for this purpose. The committee has further
analysed and classified the production overhead of fourth quarter as follows:
Budget Actual
Costs:
Material Handling ₹96,000 ₹1,24,000
Set Up ₹2,24,000 ₹2,36,000
Activity:
Material Handling (orders executed) 8,000 8,500
Set Up (production runs) 2,000 2,100
Revision of standards relating to fourth quarter were made as below:
Original Standard Revised Standard
Material Content per unit 2 kg 2.25 kg
Cost of Material ₹30 per kg ₹31 per kg
Direct Labour Hours 15 minutes 12 minutes
Required
(i) CALCULATE Planning and Operational Variances relating to material price, material
usage, labour efficiency, and labour rate.
(ii) Calculate overhead expenditure and efficiency variance using ABC principles.
SOLUTION: (i) Material & Labor Variances - Data Table Format:
TYPE
Q R A Q R A Q R A
For 1 Unit Prodn. For 1,10,000 Units Prodn. For 1,10,000 Units Prodn.
Mat: 2 30 2,20,000 30 66,00,000 2,50,000 31.2 78,00,000

2.25 31 2,47,500 31 76,72,500

Lab: 0.25 300 27,500 300 82,50,000 23,000 300 69,00,000

0.20 22,000 300 66,00,000
Material Variance Calculations:
Traditional Variances: (Original Standard – Actual)
MCV = Std. Cost for Act. O/p – Act. Cost = 66,00,000 – 78,00,000 = - ₹12,00,000 (A)
MPV = AQ(SP - AP) MUV = SP(SQ - AQ)

= 2,50,000 (30 – 31.2) = 30 (2,20,000 – 2,50,000)
= - ₹3,00,000 (A) = - ₹9,00,000 (A)
Planning Variances: (Original Standard – Revised Standard)
MCV = Std. Cost for Act. – Rev Std. Cost = 66,00,000 – 76,72,500 = - ₹10,72,500 (A)
MPV = RSQ(SP - RSP) MUV = SP(SQ - RSQ)

= 2,47,500 (30 – 31) = 30 (2,20,000 – 2,47,500)
= - ₹2,47,500 (A) = - ₹8,25,000 (A)
Operating Variances: (Revised Standard – Actual)
MCV = Rev Std. Cost for Act. – Act. Cost = 76,72,500 – 78,00,000 = - ₹1,27,500 (A)
MPV = AQ(RSP - AP) MUV = RSP(RSQ - AQ)

= 2,50,000 (31 – 31.2) = 31 (2,47,500 – 2,50,000)
= - ₹50,000 (A) = - ₹77,500 (A)
Labour Variance Calculations:
Traditional Variances: (Original Standard – Actual)
LCV = Std. Cost for Act. O/p – Act. Cost = 82,50,000 - 69,00,000 = + ₹13,50,000 (F)
LRV = AH(SR - AR) LEV = SR(SH - AH)

= 23,000 (300 – 300) = 300 (27,500 – 23,000)
=0 = + ₹13,50,000 (F)
Planning Variances: (Original Standard – Revised Standard)
LCV = Std. Cost for Act. – Rev. Std Cost = 82,50,000 – 66,00,000 = + ₹16,50,000 (F)
LRV = RSH(SR - RSR) LEV = SR(SH - RSH)

= 300 (27,500 – 22,000)
=0 = + ₹16,50,000 (F)

Operating Variances: (Revised Standard – Actual)

LCV = Rev Std. Cost for Act. – Act. Cost = 66,00,000 - 69,00,000 = - ₹3,00,000 (A)
LRV = AH(RSR - AR) LEV = RSR(RSH - AH)

= 300 (22,000 – 23,000)
=0 = - ₹3,00,000 (A)
(ii) Overhead Variances -
Note: By ABC approach, Quantity of OH will be measured in terms of the Cost Driver, not in
terms of Hrs. Data Table Format:
TYPE
Q R A Q R A Q R A
For 1,00,000 Units Prodn. For 1,10,000 Units Prodn. For 1,10,000 Units Prodn.
Mat Hand. 8,000 12 96,000 8,800 12 1,05,600 8,500 14.5882 1,24,000

Setup 2,000 112 2,24,000 2,200 112 2,46,400 2,100 112.3810 2,36,000
Oh Variance Calculations:
OH Expenditure Variance (i.e. Rate Var.) OH Efficiency Variance (i.e. Time Var.)
= AQ(SR – AR) = SR(SQ – AQ)
Mat Hand: = 8,500 (12-14.5882) Mat Hand: = 12 (8,800 – 8,500)
= - ₹22,000 (A) = + ₹3,600 (F)
Setup: = 2,100 (112 – 112.3810) Setup: = 112 (2,200 – 2,100)
= - ₹800 (A) = + ₹11,200 (F)
Q.17. PLANNING & OPERATING VARIANCE (CONTROLLABLE / UNCONTROLLABLE)

Managing Director of Petro-KL Ltd (PTKLL) thinks that Standard Costing has little to offer in
the reporting of material variances due to frequently change in price of materials.
PTKLL can utilize one of two equally suitable raw materials and always plan to utilize the raw
material which will lead to cheapest total production costs. However, PTKLL is frequently
trapped by price changes and the material actually used often provides, after the event, to
have been more expensive than the alternative which was originally rejected.
During last accounting period, to produce a unit of ‘P’ PTKLL could use either 2.50 Kg of ‘PG’
or 2.50 kg of ‘PD’. PTKLL planned to use ‘PG’ as it appeared it would be cheaper of the two
and plans were based on a cost of ‘PG’ of ₹1.50 per Kg. Due to market movements, the
actual prices changed and if PTKLL had purchased efficiently the cost would have been:
‘PG’ ₹2.25 per Kg; ‘PD’ ₹2.00 per Kg
Production of ‘P’ was 1,000 units and usage of ‘PG’ amounted to 2,700 Kg at a total cost of
₹6,480/-
Required: CALCULATE the material variance for ‘P’ by:

(i) Traditional Variance Analysis; and

(ii) An approach which distinguishes between Planning and Operational Variances.
(iii) ANALYSE how planning and operational variances approached the variances.
(iv) ANALYSE how the advanced variances are useful to your organisation.

TYPE
Q R A Q R A Q R A
For Prodn. For Prodn. For Prodn.

(iii) Analysis: Traditional variance analysis is applied based on the assumption that whole
of the variance is due to operational deficiencies and the planning associated with setting the
original standard is perfectly correct. But this assumption is not practical. When the conditions
are volatile and dynamic, traditional variances need to be analysed into planning and
operational variances. Planning variances try to explain the extent to which the original
standard needs to be adjusted to reflect changes in operating conditions between the current
situation and that imagined when the standard was originally derived. Planning variances are
generally not controllable and may need to revise to cater the changes due to environmental/
technological changes at a later stage. In certain situation planning variances can be
considered controllable as well. Whereas operational variances explain the extent to which
adjusted standards have been achieved. Operational variances are calculated after the
planning variances have been established and are thus a realistic way of assessing
performance. So, it Indicates a reality check of traditional variance analysis.
In PTKLL, as per traditional approach total variances are - ₹2,730 (A), out of which - ₹855
(A) accounts for total operational variance and - ₹1,875 (A) is for total planning variance. It is
necessary to analyse planning variances further. The planning variance of - ₹1,875 (A) can
be divided into an uncontrollable variance of - ₹1,250 (A) and a controllable variance of -
₹625 (A). Similarly, total operational variance can be sub classified as adverse price variance
of - ₹2,430 (A) and adverse usage variance of - ₹300 (A). This analysis gives a clearer
indication of the inefficiency of the purchasing function by the concerned department.
Performance of the staff of the purchasing department should be evaluated/rewarded/ based
on variances which are controllable. If an adverse uncontrollable variance of - ₹1,250 (A) is
reported in the performance reports this is likely to lead to dysfunctional motivation effects to
the purchase department.
(iv) Analysis: In today’s cutthroat competition managers must react quickly and accurately
to the changes in technology, price fluctuation, consumer tastes, laws and regulations,
economic conditions, political conditions, and international conditions etc. which are changing
rapidly and dramatically. Accordingly, management accountant should be able to provide
necessary inputs by a proper analysis of the things that pertains to his/her area like effect of
changes in price. The unique features of advanced variance analysis are that, it considers
different market conditions and changes in the dynamic environment.
Advanced variances classify variances into controllable and uncontrollable variances and
helps the management to find out reasons for adverse variances so that corrective action can
be taken. Similarly, if any adverse variances have arrived, because of changes in the market
condition like inflation, it has to be differentiated from the other variances.
PTKLL is a type of organization where management of performance can be done only through
advanced variance analysis. Advanced variance analysis here shows that it has adverse
planning variance as well as adverse operational variance. Further, the emergence of
controllable and uncontrollable variances makes it a perfect case of advance variance
analysis. In PTKLL, sharp price changes which lead to the choice of expensive alternative
and efficiency of purchase department need to be analyzed, reported, and dealt separately
by the joint effort of the management accountant and the top management. Hence, advanced
variance analysis in PTKLL is an absolute necessity.

BUDGET RATIOS:
1. Efficiency Ratio = × 100,
2. Activity Ratio = × 100,
3. Capacity Ratio = × 100,
4. Calender Ratio = × 100,
5. Idle Capacity Ratio = × 100,
6. Standard Capacity Usage Ratio = × 100,

.
7. Actual Capacity Usage Ratio = × 100,

.
8. Actual Usage of Budgeted Capacity Ratio = × 100.
INVESTIGATION OF VARIANCES:
1. Conducting investigation will help to reduce the Cost of Correction when something goes
wrong. It will not reduce the chances of things going wrong, but it will just help to reduce
the cost of correction after it goes wrong, because company will be better prepared to
face that situation now.
2. Question will be to decide whether to do investigation or not. It is decided by comparing
Total Cost with Investigation v/s Total Cost without Investigation
3. Total Cost with Investigation:
Cost of Investigation
(+) Average Cost of Correction [= Cost of Correction × Probability of things going wrong]
4. Total Cost without Investigation:
Average Cost of Correction [= Cost of Correction × Probability of things going wrong]
LEARNING CURVE EFFECT:
1. It is a theory which says that when workers perform same kind of work repeatedly again
and again, then due to experience, they learn. They learn to do that work faster, thereby
reducing the time taken for each additional unit produced.
2. It is measured in terms of a Learning Rate. Eg. A Learning Rate of 80% means that every
time when Units become double, then the Average Time p.u. becomes 80% of previous.
Please note that this applies to Average Time p.u. of all these units, it does not apply to
every next unit.
3. In variance calculation this concept is used to calculate the Standard Time required for
Actual Production.
4. Calculation: y a x b . Where, y = Average Time p.u., & x = Units,
a = Time for 1st Unit, & b = Learning Coefficient = [Mostly Given]

5. Learning generally stops after certain units, thus, this formula is applied only upto that
number of units. After that, each unit produced takes same time as the time taken for only
that last unit.
Step-1: Calculate Avg Time p.u. for Last Unit and Total Time for that,
Step-2: Calculate Avg Time p.u. for 2nd Last Unit and Total Time for that,
Step-3: Time taken for Last 1 Unit = Step 1 – Step 2.
Eg: Learning Rate 80% means - when units become double, then Avg Hrs p.u. becomes 80%

Note: This method of calculation applies only until learning continues, After some units, when
the learning stops, then the time taken for each of remaining unit is equal to the time taken
by the last unit when learning stopped.
Q.18. LEARNING CURVE EFFECT

City International Co. is a multiproduct firm and operates standard costing and budgetary
control system. During the month of June firm launched a new product. An extract from
performance report prepared by Sr. Accountant is as follows:
Particulars Budget Actual
Output 30 units 25 units
Direct Labour Hours 180.74 hrs. 118.08 hrs.
Direct Labour Cost Rs 1,19,288 Rs 79,704
Sr. Accountant prepared performance report for new product on certain assumptions but later
on he realized that this new product has similarities with other existing product of the
company. Accordingly, the rate of learning should be 80% and that the learning would cease
after 15 units. Other budget assumptions for the new product remain valid.
The original budget figures are based on the assumption that the labour has learning rate of
90% and learning will cease after 20 units, and thereafter the time per unit will be the same
as the time of the final unit during the learning period, i.e. the 20th unit. The time taken for
1st unit is 10 hours.
Required Show the variances that reconcile the actual labour figures with revised budgeted
figures in as much detail as possible.
Note: The learning index values for a 90% and a 80% learning curve are −0.152 and −0.322
respectively. [log 2 = 0.3010, log 3 = 0.47712, log 5 = 0.69897, log 7 = 0.8451, antilog of
0.6213 = 4.181, antilog of 0.63096 = 4.275]

SOLUTION:

Data Table Format:

TYPE
Q R A Q R A Q R A
For 30 units Prodn. For 25 units Prodn. For 25 units Prodn.
Lab 180.74 660 1,19,288 91.365 660 60,301 118.08 675 79,704
LCV = Std. Cost for Act. O/p – Act. Cost = 60301 – 79704 = - ₹19,403 (A)
LRV = AH(SR - AR) LTV = SR(SH - AH)

= 118.08 (660 – 675) = 660 (91.365 – 118.08)
= - ₹1,771 (A) = - ₹17,632 (A)
ACCOUNTING FOR VARIANCES:
1. Purpose: to show Variances separately in P&L like this:
Particulars Dr. (₹) Particulars Cr. (₹)
COS (Std) Sales
Variances (Adv)
∴ Profit
PARTIAL PLAN SINGLE PLAN
2. All variances are removed together at the end Variances are removed as and when
of the year, in WIP account. incurred (at source), in the respective A/Cs.
Eg: MPV is recorded at the time of Purch.,
∴ Purch. Debit in SLC A/c @ SP
MUV is recorded at time of Consumption. ∴
Consn taken to WIP A/c is @ SP
3. Eg: if MPV = -10, and MUV = -20:
→ SLC Dr. 120
→ SLC Dr. 130
MPV Dr. 10
To GLC 130
To GLC 130
------------ & ------------ ------------ & ------------
→ WIP Dr. 100
→ WIP Dr. 130
MUV Dr. 20
To SLC 130
To SLC 120
4. All costs debit in control accounts are actual All costs debit in control accounts are @ SP

5. All costs taken to WIP A/c are act. (even OH) All costs taken to WIP are @ SP & SQ
6. All variances are adjusted in the WIP A/c. No more variances need be adjusted in
(MPV is normal MPV) WIP A/c.
7. ∴ Closing RM is @ AP ∴ Closing RM is @ SP
8. All transfers from WIP to FG and further are always at Standard Cost.
9. WIP Stock and FG Stock are always at Standard Cost.
Q.19. ACCOUNTING FOR VARIANCES

XYZ & Co. manufactures product ‘Gamma’. The standard costs are as follows:
Per unit (Rs)
Material – 1 Kg. at 6 per Kg. 6
Labour – 2.5 Hrs. at Rs 4 per Hr. 10
Overhead – 2.5 Hrs. at Rs 2 per Hr. 5
Standard cost 21
Overhead rate is ₹2/hour, the budgeted overhead being Rs 2,000 for 1,000 budgeted hours.
Other information for the month of Nov’2012 is as follows:
Materials: Opening stock 400 Kgs. at Rs 6.00 per Kg.
Purchase 500 Kgs. at Rs 7.00 per Kg.
Issued to production 450 Kgs.
Direct labour: 925 Hours at Rs 4.40 per Hour.
Overhead: Rs 2,100
During this month, 360 units are completed and in respect of 40 units, it is estimated that they
are complete as to materials, but half complete as to labour and overhead. 300 units are sold
at Rs 30 per unit during the month.
Prepare: Cost Control Accounts, Variance Accounts & Trial Balance assuming that company
follows: A. Partial Plan Method or B. Single Plan Method for Accounting of Variances
SOLUTION:
Equivalent Units of Production: For Mat For Lab & Oh
Completed Units: 360 360
Closing WIP: 40 50% of 40
∴ Equivalent Units of Production: 400 380
Data Table Format:
TYPE
Q R A Q R A Q R A
FOR 1 UNITS FOR 400 UNITS FOR 400 UNITS
MAT 1 6 6 400 6 2400 450 ? ?

FOR 1 UNITS FOR 380 EQ. UNITS FOR 380 EQ. UNITS
LAB 2.5 4 10 950 4 3800 925 4.4 4070
OH Budget Standard Actual
OH (Rs) 2,000 1900 2100
Units 400 380 380
Hours 1,000 950 925
Partial Plan Single Plan
(Clg Mat is valued by FIFO) (Clg Mat is valued at SP)
Pur: 500Kg @ ₹7 = ₹3,500
(+) Opg Mat: 400Kg @ ₹6 = ₹2,400
-
(–) Clg Mat: 450Kg @ ₹7 = ₹3,150
∴ Consn: 450Kg @ ₹? = ₹2,750
∴ AP of Consumption = ₹6.1111/Kg AP of Purchase = ₹7/Kg
MPV (Normal) = AQ Cons (SP – AP) MPV (On Purch) = AQ Purch (SP – AP)
= 450 (6 – 6.1111) = 500 (4 – 7)
= - ₹50 (A) = - ₹500 (A)
Answers to other Cost Variances:
MAT: MUV = -300; LAB: LRV = -370; LTV = +100; OH: Bud = -100; Vol = -100
Accounting:
A. Partial Plan Method: Stores Ledger Control A/c (SLC)
Particulars Dr (Rs) Particulars Cr (Rs)
Opg Mat. 2,400 WIP [Consumed] 2,750
GLC [Purchase] 3,500 Clg Mat. [450Kg @ ₹7] 3,150
Wages Control A/c

GLC 4,070 WIP 4,070
Factory Overhead Control A/c
GLC 2,100 WIP 2,100

WIP A/c
SLC 2,750 MPV (Normal) 50
Wages 4,070 MUV 300
OH 2,100 LRV 370
LTV 100 OHBV 100
OHVV 100
FG [Completed] [@ Std] 7,560
(360 Units @ ₹21)
Clg WIP [@ Std] 540

(40 Units @ ₹(6 + 50% of 15))
Finished Goods Stock A/c

WIP (360 Units @ ₹21) 7,560 COS (300 Units @ ₹21) 6,300
Clg FG (60 Units @ ₹21) 1,260
Costing P & L A/c

COS [Std] 6,300 Sales 9,000
MPV (Normal) 50 LTV 100
MUV 300
LRV 370
OHBV 100
OHVV 100
∴ Profit 1,880
General Ledger Control A/c (GLC)

Sales 9,000 Opg Bal (= SLC Opg) 2,400
SLC 3,500
Wages 4,070
Clg Bal 3,070 Oh 2,100

Closing Trial Balance

Particulars Dr (Rs) Cr (Rs)
SLC 3,150
WIP 540
FG 1,260
GLC 3,070
P&L 1,880
4,950 4,950
B. Single Plan Method:

Stores Ledger Control A/c (SLC)
Opg Mat. [400Kg @ ₹6] 2,400 WIP [Cons] [400Kg @ ₹6] 2,750
GLC [Purch] [500Kg @ ₹6] 3,500 MUV [ 50Kg @ ₹6] 300
Clg Mat. [450Kg @ ₹6] 2,700
Wages Control A/c

GLC [925Hr @ ₹4] 3,700 WIP [950Hr @ ₹4] 3,800
LTV [ 25Hr @ ₹4] (F) 100
Factory Overhead Control A/c

GLC [Actual] 2,100 WIP [Std] 1,900
OHBV 100
OHVV 100
WIP Control A/c

SLC 2,400
Wages 3,800 FG [Completed] [@ Std] 7,560
(360 Units @ ₹21)
OH 1,900 Clg WIP [@ Std] 540

(40 Units @ ₹(6 + 50% of 15))

Finished Goods Stock A/c

WIP (360 Units @ ₹21) 7,560 COS (300 Units @ ₹21) 6,300
Clg FG (60 Units @ ₹21) 1,260
Costing P & L A/c

COS [Std] 6,300 Sales 9,000
MPV (On Purch) 500 LTV 100
MUV 300
LRV 370
OHBV 100
OHVV 100
∴ Profit 1,430
General Ledger Control A/c (GLC)

Sales 9,000 Opg Bal (= SLC Opg) 2,400
SLC [500Kg @ ₹7]
3,500
MPV
Wages [925Hr @ ₹4.4]
4,070
LRV
Clg Bal 3,070 Oh 2,100
Closing Trial Balance

Particulars Dr (Rs) Cr (Rs)
SLC 2,700
WIP 540
FG 1,260
GLC 3,070
P&L 1,430
4,500 4,500

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INDEX

CA FINAL – NEW SYLLABUS

STRATEGIC COST MANAGEMENT &

[Oct 2021 Edition]

Compiled By CA Devang Kothari

CH TOPIC PAGE NO.

General Guidelines for answering SCMPE Paper:

CHAPTER INTRODUCTION TO STRATEGIC

CHAPTER SUMMARY (THEORY)

1. PORTER’S VALUE CHAIN ANALYSIS: [By Michael Porter]

2. FRAMEWORK FOR VALUE CHAIN ANALYSIS: [i.e. How to Do?]

3. ASSESSING COMPETITIVE ADVANTAGE: [i.e. by using Value Chain Analysis]

4. VALUE SHOP MODEL OR SERVICE VALUE CHAIN

01. 2 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

→ ∴ Oh cost of each Product: Product A Product B

Material Ordering Cost Machine Setup Cost

Q.01. TRADITIONAL METHOD V/S ABC METHOD

01. 3 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

(÷) Budgeted Base (M.Hrs) 1,590

Q.02. ABC METHOD & TARGET COSTING

01. 6 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

Note – 1: Direct Machining Cost:

01. 8 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

01. 9 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

01. 10 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

CHAPTER MODERN BUSINESS

CHAPTER SUMMARY & PRACTICALS

A. COST OF QUALITY (COQ)

02. 2 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

02. 3 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

02. 4 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

SOLUTION: (i) Present COQ:

02. 5 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

02. 6 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

02. 7 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

(iii) Proposed Cost of Quality and Net Benefit of inspection on procurement:

(iv) Inspection before delivery v/s Inspection on procurement:

02. 8 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

B. TOTAL QUALITY MANAGEMENT (TQM)

2. Deming’s 14 Point Methodology: [Refer Book]

02. 9 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

C. BUSINESS EXCELLENCE MODEL

02. 10 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

 Sustaining Outstanding Results: This is not a 1 time exercise, it is required to sustain

02. 11 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

CASE STUDY – 1: BUSINESS EXCELLENCE:

02. 12 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

(ii) Tools available to achieve and sustain excellence

(iii) EFQM model on the apparel company

02. 14 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

(iv) Relationship between various criteria of the model

D. THEORY OF CONSTRAINTS (TOC)

E. THROUGHPUT ACCOUNTING (TA)

Throughput per Bottleneck Minute

Q.04. IDENTIFYING BOTTLENECK (FOR ONLY 1 PRODUCT)

Q.05. IDENTIFYING BOTTLENECK (FOR MULTIPLE PRODUCTS) & APPLYING TOC

Q.06. THROUGHPUT ACCOUNTING RATIO

02. 18 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

02. 19 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

(ii) If there was no online booking done (i.e. no Minimum Commitment):

02. 21 CA FINAL – STRATEGIC COST MGMT & PERFORMANCE EVALUATION Compiled by CA Devang Kothari

F. SUPPLY CHAIN MANAGEMENT (SCM)

UPSTREAM SCM: (Transaction with suppliers)