MSC504 Cost Management ExMBA

MSC504
Cost & Management Accounting
Preeti Roy
Assistant Professor
Indian Institute of Technology Dhanbad
preetir@iitism.ac.in
Aug - Dec, 2023
Preeti Roy (IIT(ISM) Dhanbad) MSC504 Monsoon, 2023 1 / 110

The required reference books:
• 4th edition by Bhimani,A., Hongreen, C.T., Datar, S.M., Foster, G.

∗ Management and Cost Accounting
• 6th edition by Atkinson, A.A., Kaplan, R.S., Matsumura, E.M., and
Young, S.M.
∗ Management Accounting: Information for Decision-Making and
Strategy Execution
• Case Study as provided by instructor
• Availability - Wed (4:30 to 5:30 pm) at Room No 108.

Course Grading
• Case Study/ Quizzes - 30% (30 marks)
• Mid-term - 40% (28 marks)
• Final-term - 60% (42 marks)
Teaching Assistants:
• Swati Mohapatra (mohapatraswati.19dr0164@ms.iitism.ac.in)
• A. Pranay Kumar

Why Management Accounting?
Let’s travel back in time!!

• In September 2010 Research in Motion (RIM), the producer of the Black-
Berry smartphone, announced that PlayBook, its entry into the hot
tablet market, would be introduced in the first quarter of 2011, that
was against the expectation of its December launch.
• It caused a 3% decline in the value of RIM’s shares.
• RIM experienced competition from Apple’s iPad launch.
• RIM was in a situation of overhauling its corporate strategy and
business unit strategy.
The strategic decisions that RIM faced required relevant and timely infor-
mation, much of which is supplied by management accounting information.

What is Management Accounting?
Management accounting is the process of supplying the managers and em-
ployees in an organization with relevant information, both financial and
non-financial, for making decisions, allocating resources, and monitoring, eval-
uating, and rewarding performance.
Management accounting information includes:

• Example: Reported expense of an operating department, such as, the
assembly department of an automobile plant or electronics company.
• cost of producing a product, delivering a service, performing an

activity or business process.

Financial Accounting vs Management Accounting

Why was Management Accounting needed?
• Large companies replaced market mechanisms with internal resource
allocations to multiple lines of business.
• Concept of Integrated companies.
• Example: An automobile company might want to compare the cost per-
formance of a division that makes transmissions with that of an inde-
pendent supplier.
• Rather than focusing on organizational unit performance - the focus
was on quality, service, and customer and employee performance.
• Classifying cost of products or services and indirect & support costs.
• With increasing complexity, monitoring, and management of costs.

Case
A U.S. automobile components plant had recently been reorganized so that

quality and employee teamwork was to be the guiding principles for all
managers and workers. One production worker described the difference:
• In the old production environment, we were not paid to think. The foreman told us what to do, and
we did it even if we knew he was wrong. Now, the team decides what to do. Our voices are heard.
All middle management has been cut out, including foremen and superintendents. Management
relies on us, the team members, to make decisions. Salary people help us make these decisions; the
production and manufacturing engineers work for us. They are always saying, “We work for you.
What do you need?” And they listen to us.
∗ The plant controller commented as follows: In traditional factories, the financial system viewed
people as variable costs. If you had a production problem, you sent people home to reduce your
variable costs. Here, we do not send people home. Our production people are viewed as problem
solvers, not as variable costs.
Required.
• What information needs did the production workers have in the old environment?
• What information do you recommend be supplied to the production workers in the new
environment that emphasizes quality, defect reduction, problem-solving, and teamwork?

Case - Answer
Old information environment:
• Productivity expected in terms of the number of work pieces per day;
Quality norms such as acceptable rejection rates in terms of
percentage; Equipment maintenance and utilization standards;
Material usage norms and so on.
• non-financial information and quantitative targets - command and
control method, minimal information on the level of production that
can result in layoff.
New Information Environment:
• People are part of decision-making; direct control from management;
segregation of business units, information on competitors and target
output; plan product scheduling and assembling, develop new
techniques of minimizing idle time, wastage, and movement of
workers.

Concept of Balance Score Card
The problem of identifying the right mix of financial and non-financial
measures to perform strategic tasks.
• Consider: If a company is spending on its intangible assets, it is incur-
ring expense, ROI falls, but it has increased value of intangible assets.
• Balance Scorecard: Measures organizational performance across four
different but linked perspectives that are derived from the organiza-
tion’s mission, vision, and strategy.

How to create a Balance Score Card

Example:

Required:
Assumptions
• Why would a company with Infosys’s history find the Balanced
Scorecard important for managing its growth and monitoring its
performance?
• What customer measures would you recommend that Infosys use in
its Balanced Scorecard?
• What employee measures would you recommend that Infosys use in
its Balanced Scorecard?

Costs in Decision Making
Its importance:
• Pricing
• Product Planning
• Budgeting
• Performance Evaluation
What is cost?
Resources sacrificed or forgone to achieve a specific objective.
Cost Object: Any activity or item for which a separate measurement of cost
is desired.
Cost Driver: Any factor that affects total costs.
For example: Cost driver for production - no. of units produced, no. of set-
ups, direct manufacturing labour costs

Cost System
• A costing system accounts for costs in two basic stages – Accumulation
& then Assignment.
∗ Cost Accumulation: is the collection of cost data in some
organised way through an accounting system.
∗ Cost Allocation: After accumulation, cost system allocates or
traces the cost to cost objects.
∗ Tracing: Costs that are traced to a cost object are direct costs.
∗ Allocation: Costs that are allocated to a cost object are indirect
costs.
Example: Airbus of 100 business-class seats to be installed in an A340
aeroplane to be sold to BA.
The 100-seat purchase by Airbus could first be coded to the materials
account, then subsequently assigned to a department, then reassigned to
a product, and finally reassigned to a customer.

Cost Assignment Methods

Direct vs Indirect Costs
• Direct costs of a cost object are costs that are related to the
particular cost object and that can be traced to it in an economically
feasible (cost-effective) way.
• Indirect costs of a cost object are costs that are related to the
particular cost object but cannot be traced to it in an economically
feasible (cost-effective) way. Indirect costs are allocated to the cost
object using a cost allocation method.
Example: Take a tennis racket as a cost object. The cost of the carbon
fibre used to make that racket is a direct cost.
The cost of lighting in the factory where the racket was made is an indirect
cost of the racket.

Classify the Costs as Direct/ Indirect
• Salary of factory manager.
• Supervisor’s salary for department 1.
• Salary of sales manager.
• Sales commission paid on the product sold.
• Depreciation on equipment for department 1.
• Computer operating costs.
• Factory electricity.
• Wages for production employees.

Practice Question

Methods of cost allocation
1. Traditional Method
• Traditional costing is optimal when indirect costs are low compared
to direct costs. Common steps in the traditional costing process are:
∗ Identify indirect costs & estimate indirect costs for the appropriate
period (month, quarter, year).
∗ Choose a cost driver with a causal link to the cost (labour hours,
machine hours).
∗ Estimate an amount for the cost-driver for the appropriate period
(labour hours per quarter, etc.).
∗ Compute the predetermined overhead rate.
∗ Apply overhead to products using the predetermined overhead
rate.
∗ Predetermined Overhead Rate = Estimated Overhead Costs /
Estimated Cost-Driver Amount

Some common bases for apportionment:
• Floor Area Occupied: - Lighting, Heating, Rent, rates, depreciation on
building, building repairs.
• Capital Values: - Depreciation of plant & machinery, insurance on
building, maintenance of plant & machinery.
• Direct Labour Hours/ Machine Hours: - Insurance of jigs, tools and
fixtures, repairs and maintenance, works management remuneration.
• Number of workers employed: - canteen, accident insurance,

medical, pension, supervision, wages department.

2. ABC (Activity Based Costing)
• The ABC system also uses a two-stage overhead allocations: (i) tracing
costs to activities and (ii) tracing costs from activities to products/jobs.
∗ Tracing costs to activities: Some of the activities are related to
production volume (such as production runs, salary of supervisors
and so on) but others are not (such as inspection/handling of
materials, setting up equipment and so on). The cost of resources
consumed in performing these activities are grouped into cost pools.
∗ Assigning costs to products/jobs using cost drivers as a measure of
activity: Identifying the linkage between activities and cost objects
and serve as quantitative measures of the output of activities - the
central innovation of ABC system.

An example

Practice 1

Practice 2
A company manufactures a range of goods. Production overheads are
absorbed on the basis of Direct Labour Hours. The company instituted
the ABC system recently and wanted to measure the difference in the cost
of production.

Applicability and Limitations of ABC
• The ABC system is a much applicable to both manufacturing & service
companies.
• Benefits:
∗ Better cost control
∗ It leads to better decision-making by management with the
combined effect would be production of the same volume and mix of
products with fewer resources.
• Limitations:
∗ it is costly to develop and maintain
∗ it is used to develop full costs and does not measure the
incremental costs needed to produce an item.

Cost Classification by Behavior
• Activity – a quantitative measure of a firm’s output of goods or
services
• Such as: - Number of Chrysler vans, pair of Nike shoes, tons of
cement produced
• Variable Costs – costs that change proportionately (in total) with the
activity level within a relevant range of activity
• Relevant range: is a band of volume in which a specific relationship
exists between cost and volume.
• Fixed Costs – costs that do not change in total as activity level changes
within a relevant range of activity
• Example: Publishing a magazine
• Variable Costs: Cost of paper, cost of ink, sales commission, cost of
lubricants for machines, cost of operating press
• Fixed Costs: Rent on building, Salaries to reporters, depreciation on
printing

Examples of Variable Cost
• Merchandising companies – cost of goods sold.
• Manufacturing companies – direct materials, direct labor, and
variable overhead.
• Merchandising and manufacturing companies – commissions,
shipping costs, and clerical costs such as invoicing.
• Service companies – supplies, travel, and clerical.

Total Variable and Fixed Costs

Variable and Fixed Cost per unit

Relevant Range
• Step-Up Cost: remain fixed over limited ranges of volumes but

increase by a lump sum when volume increases beyond maximum
amounts.

Total Costs

Practice Question

Mixed Cost
• Mixed costs are costs that have both a fixed and a variable
component.
• Suppose that Days Computers has 10 sales representatives, each
earning a salary of $30,000 per year plus a commission of $50 per
computer sold.
• The activity is selling, and the activity driver is units sold.
• Y = F + VX
• Y = 300000 + 50X
• Suppose 10,000 units are sold.

Mixed Costs

Segregation of Fixed and Variable Component
• High-Low Method: It pre-selects the two points that will be used to

compute the parameters F and V.
• V = (Y2 - Y1)/(X2 - X1
• F = Y2 - VX2 OR Y1 - VX1
• Y = $625 - $13.75X
• Issue is that it considers outliers.
• Scatterplot Method: Make a diagram in which actual costs recorded
in past periods are plotted (on the vertical axis) against the volume of
levels in those periods ( on the horizontal axis).
• A scattergraph allows one to visually fit a line to the points on the
scattergraph. In doing so, the line chosen should appear to best fit
the points.
• Lets plot a line using two points i.e., (100, $2,000) and (0, $800)
• Y = $800 - $12X
• Issue is that the predicted material handling costs at 350 moves is
$5000 in scatterplot method and $5437.50 in high-low cost method.

• Least-Square Method: This approach provides two mathematical
properties that are missing in all previous methods.
• Here, an arbitrary line (Y = F - VX) has been drawn.
• The closeness of each point to the line can be measured by the
vertical distance of the point from the line. This vertical distance is the
difference between the actual cost and the cost predicted by the line.
For point 8, this is E8 = Y8 - F + VX8, where Y8 is the ac-tual cost, F +
VX8 is the predicted cost, and the deviation is represented by E8.

• Least-Square Method

Practice Question

Product Costs

Product Costing
• Electron, Inc. produces 10,000 calculators in one month.
• Variable manufacturing costs are:
∗ $6/unit for material
∗ $1/unit for direct labor
∗ $1/unit for variable overhead.
• Fixed manufacturing overhead is $50,000/month.
• What is the Unit cost?

Income Statement of Manufacturing Company

Example of Cost Sheet of manufacturing company
• From the following information, prepare a cost sheet for period
ended on 31st March 2023.
• Opening stock of raw materials - Rs. 12,500
• Purchases of raw materials- Rs.1,36,000
• Closing stock of raw materials- Rs.8,500
• Direct wages - Rs.54,000
• Direct expenses - Rs.12,000
• Factory overheads 100% of direct wages
• Office and administrative overheads 20% of works cost
• Selling and distribution overheads- Rs.26,000
• Cost of opening stock of finished goods- Rs.12,000
• Cost of Closing stock of finished goods- Rs.15,000
• Profit on cost 20%

Practice Question

Items to be excluded from Costs
• Cash discount, Interest payment, preliminary expenses written off,
goodwill written off, Provision for taxation & bad debts, donations,
Payment of income tax & dividend, profit/ loss on sale of fixed assets
etc.
• Scrap Treatment: unavoidable residual material arising in certain

manufacturing process – deducted either from factory overheads or
factory cost while preparing a cost sheet.

Relevant Costs
• Sunk Costs: All costs incurred in the past that cannot be changed by
any decision made now or in the future. Example: Company procured
a special – purpose machine for Rs 50,000 several years ago for
making a product that is now obsolete and no longer being sold.
• Out-of-pocket Costs: The wages of the person setting up a machine
for a new production run are an out-of-pocket cost. However, the cost
of the lost opportunity to produce profitable output during the setup
time is not an out-of-pocket cost.
• Opportunity Costs: The opportunity cost of investment in a financial
company for one year is the debenture interest foregone. If a firm is
not investing its surplus fund in the 9% debenture issue of another
firm, it could be earning 7.5% p.a. from investment in a financial
company.

Absorption and Marginal Costing
Introduction
• Before we allocate all manufacturing costs to products regardless of
whether they are fixed or variable. This approach is known as
Absorption costing/Full costing.
• However, from the behavioural classification of cost, it could be
realized that only variable costs are relevant to decision-making. This
concept is known as Marginal costing/Variable costing.

Absorption Costing
• It is a costing system which treats all manufacturing costs including
both the fixed and variable costs as product costs.
• Conventional Income Statement:
∗ Revenue
∗ Less: Cost of goods sold, which include direct material, direct
labor, variable overhead and fixed overhead
∗ equals Gross profit
∗ Less: Selling and administrative expenses
∗ equals Net income before taxes
∗ Less: Income taxes
∗ equals Net income after taxes

Marginal Costing
• It is a costing system which treats only the variable manufacturing
costs as product costs.
• Closing inventories of work in progress or finished goods are valued
at marginal (variable) production cost.
• The fixed manufacturing overheads are regarded as period cost.
• Conventional Income Statement:

∗ Revenue
∗ Less: minus All Variable manufacturing costs (direct labor + direct
material + variable overhead)
∗ Equals Contribution margin
∗ Less: Fixed manufacturing costs/ Fixed selling and administrative
costs
∗ equals Net income before taxes
∗ Less: Income taxes
∗ equals Net income after taxes

Basic Assumptions of Marginal Costing
• For any given period of time, fixed costs will be the same, for any
volume of sales and production (provided that the level of activity is
within the ‘relevant range’). Therefore, by selling an extra item of
product or service the following will happen.
∗ Revenue will increase by the sales value of the item sold.

∗ Costs will increase by the variable cost per unit.
∗ Profit will increase by the amount of contribution earned from the
extra item.

Example:
• Lasersave, Inc., a company that recycles used toner cartridges for
laser printers, began operations in August and manufactured 1,000
cartridges during the month with the following costs:
Direct materials $ 5,000
Direct labor 15,000
Variable overhead 3,000
Fixed overhead 20,000
Total manufacturing cost $43,000
During August, 1,000 cartridges were sold at a price of $60.
Variable marketing cost was $1.25 per unit, and fixed marketing and administrative expenses were
$12,000.
• The unit product cost of each toner cartridge is $43 ($43,000/1,000 units). This amount includes
direct materials ($5), direct labor ($15), variable overhead ($3), and fixed overhead ($20).

Disadvantage of Absorption Costing
• What happens when the company produces for inventory?
• The whole purpose of manipulating income by producing for

inventory is to increase profit above what it would have been without
the extra production.
Variable Costing
• What happens when the company produces for inventory?

Process

Example:
• Given the following data compute the cost of production under both
the methods.
∗ Direct material per unit = Rs.5.00

∗ Direct labour cost per unit = Rs.9.00
∗ Variable manufacturing overhead per unit = Re.0.60
∗ Total fixed manufacturing overhead per period = Rs.92,000
∗ Number of units produced during the period = 10,000 units and
sold = 8,000 units
∗ Opening inventory of finished goods – Nil
∗ Sale price per unit – Rs.35
∗ Variable selling & administration expenses – Rs.1. 20 per unit
∗ Fixed selling & administration expenses - Rs.58,000

Practice
• The following information for a company that produced a single
product during January to March, 20XX: (Figures in Rs.)
∗ Selling price per unit= Rs 100

∗ Direct materials per unit= Rs 20
∗ Direct Labour per unit= Rs 10
∗ Variable manufacturing overhead per unit = Rs 5
∗ Total fixed manufacturing overhead per period = Rs.30,000
∗ Budgeted activity was expected to be 1000 units each month
∗ Variable selling & administration expenses – Rs.4 p.u.
∗ Fixed selling & administration expenses - Rs.1000
∗ Production and sales for each month were as follows:
∗ Units sold - JAN 1000; FEB 800; MARCH 1100
∗ Unit produced - JAN 1000; FEB 1300; MARCH 900

Practice
• India Integrated Ltd. produces a single product which is bottled and
sold in cases. The normal annual level of operations, on which the
production fixed overhead absorption is based, is 36,000 cases. From
the following information prepare profit statements using Marginal
and Absorption costing:

Break-Even Analysis
Break-even Analysis
• Breakeven analysis examines the short run relationship between
changes in volume and changes in total sales revenue, expenses and
net profit.
• Also known as C-V-P analysis (Cost Volume Profit Analysis) Uses of
such analysis
• C-V-P analysis is an important tool in terms of short-term planning
and decision making.
• It looks at the relationship between costs, revenue, output levels and
profit.
• Short run decisions where C-V-P is used include choice of sales mix,
pricing policy etc.

Decision Making and Breakeven Analysis
• How many units must be sold to breakeven?
• How many units must be sold to achieve a target profit?
• Should a special order be accepted?
• How will profits be affected if we introduce a new product or service?

Key Terminologies
• Break even point - the point at which a company makes neither a
profit or a loss.
• Contribution per unit - the sales price minus the variable cost per
unit. It measures the contribution made by each item of output to the
fixed costs and profit of the organisation.
• Margin of safety - a measure in which the budgeted volume of sales
is compared with the volume of sales required to break even.
• Marginal Cost – cost of producing one extra unit of output.

Formulas
• Unit Selling Price - Unit Variable cost = Unit Contribution
• Unit Contribution X Units Sold = Total Contribution
• Total Contribution = Total Fixed Cost + Profit

Break-even Formulas

Break-even Chart

Margin of Safety
• The difference between budgeted or actual sales and the breakeven
point.
• The margin of safety may be expressed in units or revenue terms.
• Shows the amount by which sales can drop before a loss will be
incurred.
• Margin of Safety Ratio (MSR)= (Budgeted Sales – Break Even Sales)/
Budgeted Sales
• Relation between M/S Ratio, Profit, Contribution Ratio:
Profit = M/S X Contribution Ratio

Example 1
Using the following data, calculate the breakeven point and margin of
safety in units:
• Selling Price = €50
• Variable Cost = €40
• Fixed Cost = €70,000
• Budgeted Sales = 7,500 units

Target Profits
• What if a firm doesn’t just want to breakeven – it requires a target
profit
• Contribution per unit will need to cover profit as well as fixed costs
• Required profit is treated as an addition to fixed costs

Example 2
Using the following data, calculate the level of sales required to generate a
profit of €10,000:
• Selling Price = €35
• Variable Cost = €20
• Fixed Cost = €50,000

Limitations of B/E Analysis
• Costs are either fixed or variable
• Fixed and variable costs are clearly discernable over the whole range
of output
• Production = Sales
• One product/constant sales mix
• Selling price remains constant Efficiency remains unchanged
• Volume is the only factor affecting costs

Comprehensive Question
A company produces single product which sells for Rs 20 p.u. VC is 15 p.u.
Fixed Overhead is Rs 6,30,000.
Required:
• Calculate the sales value needed to earn a profit of 10% on sales.
Answer: Consider sales as x
Using formula: Operating Income = Contribution X Qty - FC
We get: 10% X 20x = 5x - 630000 = 120000 units
• Calculate the sales price p.u. to bring the BEP down to Rs 1,20,000.
Answer: BEP = FC/ (SPU - VPU)
120000 = 630000 / y - 15 = Rs 20.25
• If the desired profit is Rs 60,000, what is the Margin of Safety?
Answer: First calculate the sales at desired profit of Rs 60,000
Operating Income + FC / Contribution = Sales at Rs 60,000
Margin of safety = Sales at 60000 - Sales at BEP = 12000 units
• If the Fixed Costs increase by Rs 1,00,000, what is the new BEP?
Answer: New BEP = 730000/5 = 146000 units

Multiple Product Analysis
• More-Power Company has decided to offer two models of sanders: a
regular sander to sell for $40 and a mini-sander, to sell for $60. The
marketing department is convinced that 75,000 regular sanders and
30,000 mini-sanders can be sold during the coming year.
• Break-even for the regular sander is 15,625 and Break-even for the
mini sander is 15,000 units.
• Issue is: No break-even point for the firm as a whole has yet been
identified.

Multiple Product Analysis - Sales Mix Approach
• If More-Power plans on selling 75,000 regular sanders and 30,000
mini-sanders, then the sales mix in units is 5:2.
• Alternatively, the sales mix can be represented by the percent of total
revenue contributed by each product. The regular sander accounts
for 62.5 percent of total revenue, and the mini-sander accounts for
the remaining 37.5 percent.
• Break-even point is 9,285.71 packages.

• More-Power must sell 46,429 regular sanders (5 X 9,285.71) and
18,571 mini sanders (2 X 9,285.71) to break even.

• Verification through Income Statement

• ABC Ltd. manufactures and sells 4 types of products under the brand
names, A, B, C and D. The sales mix in value comprises 100/3%,
125/3%, 50/3%, and 25/3% of A, B,C, and D. The total budgeted sales
(100% capacity) are Rs 60,000 p.m. Operating Costs are as follows:
Variable costs (on S.P.):
A: 60% B: 68% C: 80% D:40%
Fixed Costs is Rs 14,700 p.m.
Calculate the break-even point for the products on an overall basis.
• If it is proposed to increase the capacity by acquiring 30% additional
space and plant. It results in increase in Fixed costs by Rs 4,000 p.m.
Plot the break-event chart and determine from the chart at what
capacity utilisation same profits as before will be produced after the
extensions have been made.

Comprehensive Example 2
A company manufactures a single product with a capacity of 1,50,000
units p.a. The summarized profitability statement for the year is as under:
Sales: 1,00,000 units @ Rs 15 p.u.
Cost of sales:
DM: 3,00,000
DL: 2,00,000
Production OH: Variable 60,000 Fixed 3,00,000
Administrative OH: (fixed) 1,50,000
Selling OH: Variable 90,000 Fixed 1,50,000
Profit: 2,50,000
You are required to evaluate the following questions:
• What will be the amount of sales to earn a target profit of 25% on sales if the packing is improved at
a cost of Rs 1 p.u,
• There is an offer from a large retailer for purchasing 30,000 units p.u. subject to providing a packing
with a different brand name at a cost of Rs 2 p.u, However in this case, there will be no selling and
distribution expenses. Also this will not effect the company’s existing business. What is be the
break-even price from this offer?
• If an expenditure of Rs 3,00,000 is made on advertising, the sales would increase to 1,20,000 units @
Rs 18 p.u. Will that expenditure be justified?
• If the S.P.is reduced by Rs 2 p.u., there will be 100% capacity utilisation. Will the reduction in S.P. be
justified?
Comprehensive Example 3
• When volume is 3,000 units, the average cost is Rs 4 p.u. When
volume is 4,000 units, the average cost is Rs 3.5 p.u. The break-even
point is 5,000 units. Find the Price-Volume Ratio.
• ABC Ltd. has fixed costs of Rs 2,00,000. It has 2 products that it can
sell, A & B. The company sells these products at a rate of 2 units of A
to 1 unit of B. The unit contribution is Re 1 p.u. for A and Rs 2 p.u. for
B. How many units of A & B would be sold at the break-even point?
• If Margin of safety is 40% of sales. Find fixed cost when profit is Rs
2,00,000.

Sales Mix Approach under capacity constraints
• A company manufactures 3 products. The budgeted quantity, selling
prices and unit costs are as under:
A B C
Raw Materials (@ Rs 20 per kg) 80 40 20
Direct Wages (@Rs 5 per hour) 5 15 10
Variable Overheads 10 30 20
Fixed Overheads 9 22 18
Budgeted production (in units) 6,400 3,200 2,400
Selling Price p.u. 140 120 90
• Required:
1. Set the optimal sales mix and determine the profit, if the supply of
raw materials is restricted to 18,400 kg.

Tactical Decision Making
Tactical Decision Making
• Tactical decision-making consists of choosing among alternatives with
an immediate or limited end in view.
• Tends to be short-run in nature.
• The immediate objective is to exploit idle productive capacity so that
short-run profits can be increased.

Tactical Decision Making Process
• Recognize and define the problem.
• Identify alternatives as possible solutions to the problem, and
eliminate alternatives that are not feasible.
• Identify the predicted costs and benefits associated with each feasible
alternative. Eliminate the costs and benefits that are not relevant to
the decision.
• Compare the relevant costs and benefits for each alternative, and
relate each alternative to the overall strategic goals of the firm and
other important qualitative factors.
• Select the alternative with the greatest benefit which also supports
the organization’s strategic objectives.

Relevant Costs and Revenues
• Relevant costs (revenues) are future costs (revenues) that differ
across alternatives.
• Illustration: Avicom, Inc., a company that makes jet engines for
commercial aircraft. A supplier has approached the company and
offered to sell one component, nacelles (enclosures for jet engines),
for what appears to be an attractive price. The company is now faced
with a make-or-buy decision.
• cost of direct materials used to produce the nacelles is $270,000 per
year. Should this cost be a relevant cost?
• Since the cost of direct materials differs across alternatives ($270,000
for the make alternative and $0 for the buy alternative), it is a relevant
cost.

Irrelevant Costs
• Avicom uses machinery to manufacture nacelles. This machinery was
purchased five years ago and is being depreciated at an annual rate
of $50,000.
• cost to heat and cool the plant—$40,000 per year—is allocated to
different production departments, including the department that
produces nacelles, which receives $4,000 of the cost. Is this $4,000
relevant?

Cost relevancy based on activity resource usage

Examples for Tactical Decision Making
• 1. Make or Buy:
Talmage Company produces a mechanical part used in one of its
engines. An outside supplier has offered to sell a part (Part 34B) for
$4.75. The company normally produces 100,000 units of the part
each year.

• Answer

• 2. Keep or Drop
A B C
Production (units) 3,000 2,000 5,000
Rs Rs Rs
Material Cost 18 26 30
Wages 7 9 10
VOH 2 3 3
FOH 5 8 9
Total Cost 32 46 52
SP 40 60 61
Profit 8 14 9
• The management wants to discontinue one line and gives you the
assurance that production in two other lines rise by 50%. They intend
to discontinue the link that produces Article A as it is less profitable.
• Do you agree to the scheme? Do you think line A should be
discontinued?

• 3. Special Order:
Polarcreme, Inc., an ice-cream company, is operating at 80% of its
productive capacity. Assume a similar condition exists for
non-unitlevel activities. The company has a capacity of 20 million
half-gallon units. The company expects to produce 8 million units
each of regular and premium ice cream.

An ice-cream distributor from a geographic region not normally
served by the company has offered to buy 2 million units of premium
ice cream at $1.75 per unit.
• The company estimates that the special order will increase the
purchase orders by 10,000, receiving orders by 20,000, and setups by
13.
Should the company accept this order or reject it?

Huber GmbH manufactures quality bath towels at its highly
automated Heidelberg plant. The plant has a production capacity of
48 000 towels each month.
• Current monthly production is 30 000 towels @ 20 each. Retail
department stores account for all existing sales.
• The manufacturing costs per unit of €12 consist of direct materials €6
(all variable), direct manufacturing labour €2 (€0.50 of which is
variable), and manufacturing overhead €4 (€1 of which is variable).
The marketing costs per unit are €7 (€5 of which is variable).
• Huber GmbH has no R&D costs or product design costs. Marketing
costs include distribution costs and customer-service costs.
• A luxury hotel chain offers to buy 5000 towels per month at €11 a
towel for each of the next three months. No subsequent sales to this
customer are anticipated. No marketing costs will be necessary for
the 5000-unit one-off special order. The acceptance of this special
order is not expected to affect the selling price or the quantity of
towels sold to regular customers.
• Should Huber GmbH accept the hotel chain’s offer?
• 4. Decision to Sell or Process Further
Delrio is an agricultural corporation that produces and sells fresh
produce and canned food products. The approximate cost of all the
harvesting activities is $200 per load.
• Tomatoes are sorted into two grades (A and B). Each load produces
about 1,000 pounds of Grade A tomatoes (sent to supermarket) and
500 pounds of Grade B tomatoes (sent for production of
catsup/sauce).
• The manager of the canning plant requested that the Grade A
tomatoes be used for a Delrio hot sauce.
• The hot sauce production would require using all of the Grade A
output. Grade A tomatoes are sold to large supermarkets for $0.40
per pound.
• Whether to sell Grade A tomatoes at split-off or to process them
further and sell the hot sauce?
• Hot sauce sells for $1.50 per bottle. The additional processing costs,
including only resources acquired as needed and increases in activity
capacity, amount to $1,000.
Budgeting & Control
Basics
• Budget is a financial and/or quantitative statement prepared prior to
a defined period of time, of the policy to be pursued during that
period for the purpose of achieving a given objective.
• Purposes of Budgeting:
∗ It forces managers to plan.
∗ It provides resource information that can be used to improve
decision-making.
∗ It aids in the use of resources and employees by setting a
benchmark that can be used for the subsequent evaluation of
performance.
∗ It improves communication and coordination.

Sales Budget
• A Sales Budget shows forecast of expected sales in the future period
[may be prepared product wise, territories/area/country wise,
customer group wise, salesmen wise as well as time wise like quarter
wise, month wise etc.]
∗ Analysis of past sales: (for the last 5-10 years)
∗ Estimates given by the sales staff
∗ Market Potential Analysis.
∗ Dependent Factor: (the demand for petrol and diesel is dependent
on the number of vehicles plying through the roads.
• Generic Format:
∗ Amount needed for current requirements
∗ (+) Amount desired for future needs
∗ (-) What is already on hand
∗ = Amount to be acquired

Production & Material Purchase Budget
• Production Budget: This budget shows the production target to be
achieved in the next year or the future period.
∗ The principal budget factor can be sales demand or the
production capacity or availability of raw material or the inventory.
∗ The production budget is normally prepared for a period of one
year and then broken down on monthly basis.
∗ Production targets are decided by adding the budgeted closing
inventory in the sales forecast and subtracting the opening inventory
from the total of the same.
• Generic Format:
∗ Planned sales quantity (as per sales budget)
∗ (+) Desired ending inventory
∗ = Units to be produced
• Generic Format of the Material Purchase Budget:

∗ Units to be produced x Raw material required per unit produced
∗ (+) Desired ending inventory
∗ = Raw materials to be acquired
Comprehensive example

Cash Budget
• An estimate of cash receipts and cash payments prepared for each
month.
∗ In this budget all expected payments, revenue as well as capital
and all receipts, revenue and capital are taken into consideration.
∗ The main purpose of cash budget is to predict the receipts and
payments in cash so that the firm will be able to find out the cash
balance at the end of the budget period – can plan for either investing
the surplus or raise necessary amount to finance the deficit.
∗ Cash Budget is prepared in various ways, but the most popular
form is the Receipt & Payment method.

Cash Budget- example

Master Budget
• Also called as ‘Comprehensive Budget’, it is a consolidation of all the
functional budgets & shows the projected Profit and Loss Account
and Balance Sheet of the business organization.
∗ For preparation of this budget, all functional budgets are
combined together and the relevant figures are incorporated in
preparation of the projected Profit and Loss Account and Balance
Sheet.

Master Budget- example

Master Budget- solution

Flexible Budget
• A flexible budget is developed for a relevant range of production and
is prepared for different levels of capacity utilization (e.g.: levels of
50%, 60%, 70%, 80%, 90% and 100% ) - a series of fixed budgets
prepared for different levels of activity - facilitates performance
measurement & evaluation.
∗ While preparing flexible budget, it is necessary to study the
behavior and estimate of costs and divide them in fixed, variable &
semi variable and associate them with the chosen level of activity.
∗ Finally the profit or loss at different levels of activity will be
computed by comparing the costs with the revenues.

Flexible Budget- example

Flexible Budget - Variance Analysis

Flexible Budget & Variance Analysis
• Direct materials: 2.00 square metres of cloth input allowed per output unit (jacket) manufactured,
at €30 standard cost per square metre.
• Direct manufacturing labour: 0.80 manufacturing labour-hours of input allowed per output unit
manufactured, at €20 standard cost per hour.
• Direct marketing labour: 0.25 marketing labour-hours of input allowed per output unit sold, at €24
standard cost per hour.
• Variable manufacturing overhead: allocated on the basis of 1.20 machine-hours per output unit
manufactured, at €10 standard cost per machine-hour.
• Variable marketing overhead: allocated on the basis of 0.125 direct marketing labourhours per
output unit sold, at €40 standard cost per hour.

• The actual results and the flexible-budget amounts for each category of direct costs for the 10000
actual output units in April 2008 are:


Flexible Budget & Variance Analysis - Practice Question

Thank You
Open for Questions/ Comments

MSC504 Cost Management ExMBA

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MSC504

Cost & Management Accounting

Aug - Dec, 2023

Preeti Roy (IIT(ISM) Dhanbad) MSC504 Monsoon, 2023 1 / 110

• 4th edition by Bhimani,A., Hongreen, C.T., Datar, S.M., Foster, G.

• Case Study as provided by instructor

• Availability - Wed (4:30 to 5:30 pm) at Room No 108.

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• Case Study/ Quizzes - 30% (30 marks)

• Mid-term - 40% (28 marks)

• Final-term - 60% (42 marks)

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Let’s travel back in time!!

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Management accounting information includes:

• cost of producing a product, delivering a service, performing an

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A U.S. automobile components plant had recently been reorganized so that

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• Number of workers employed: - canteen, accident insurance,

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• Step-Up Cost: remain ﬁxed over limited ranges of volumes but

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• High-Low Method: It pre-selects the two points that will be used to

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• Scrap Treatment: unavoidable residual material arising in certain

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