CA FINAL

STRATEGIC COST MANAGEMENT &

PERFORMANCE EVALUATION

Paper - 05
[New Syllabus]

VOLUME - I

-BY-
CA MANOJ SHARMA
 preface
This book titled “Strategic Cost Management & Performance Evaluation” is designed
& developed for CA Final [New Syllabus] students. The chapters have been so
designed that students find them easy to understand.

This book is written to build up the concepts of Costing among the students.
Chapters are covered along with Examples and Practical Problems from ICAI study
material and practice manual which gives brief explanation and logic about the
concept also helps students to practice. After all – Practice Makes Man Perfect..!!

The journey of writing the book started 21 years ago. The refinement happened
in these years emerged into this edition. My 21 years of teaching experience in
this subject is comprised in this book which will be really helpful for the students.

While writing this book I was giving more importance to the psychology of students
so that they find it to be more interesting and not just a regular text book sort
of thing. So, it was really important for me while designing this book to create
curiosity among the students about the subject.

No need to fear by this subject. This subject is really very fascinating and student
can score excellent marks..

A special thanks to my TEAM MSS-Cool for their untiring support.

“If a child is not learning by the way of teaching; here I teach in a way the
child can learn.”

May good luck be your best friend in whatever you do and may trouble be always
a stranger to you.

Best Of Luck My Dear Students..

CA MANOJ SHARMA

[YOUR FRIEND & MENTOR]

MSS-Cool
 -INDEX-
CA final - SCMPE

Volume I:

Sr No. Chapters Pages

1 Introduction to Strategic Cost Management 1.1 - 1.13

2 Modern Business Environment 2.1 - 2.64

3 Lean System & Innovation 3.1 – 3.62

4 Cost Management Techniques 4.1 – 4.51

5 Cost Management by Specific Sector Removed by ICAI

6 Decision Making 6.1 – 6.85

7 Pricing Decision 7.1 – 7.50

 INTRODUCTION TO

CONTENTS.. 1. STRATEGIC COST

MANAGEMENT

 Traditional Cost Management

 Strategic Cost Management
 Strategic Framework V/S Value Chain Analysis
 Superior Performance And Competitive Advantage
 Value Chain Approach For Assessing Competitive
Advantage
 Mission, Vision, Objective And SCM
 Value Chain Shop Model
 Role And Management Accountant
Error! Reference source not found.
 [1. 2]

TRADITIONAL COST MANAGEMENT

Traditional cost management system involves allocation of costs and overheads to the production and
focusses largely on cost control and cost reduction. The underlying assumption was that with reduced costs
(direct) and overheads a firm could earn better profits. It involves comparing actual results with the
standard expectations (typically budget or standard costs) and analysing the difference. This process
is also know as variance analysis.

Limitations:
1) Ignores Competition, Market Growth, and Customer Requirement.
2) Excessive Focus on Cost Reduction
3) Ignore Dynamics of Marketing and Economics
4) Limited Focus on Review and Improvisation
5) Reactive Approach
6) Short-term Outlook

STRATEGIC COST MANAGEMENT

Strategic cost management is the application of cost management techniques so that they improve the
strategic position of a business as well as control costs.
It also involves integrating cost information with the decision-making framework to support the overall
organisational strategy. It is not limited to controlling costs but using cost information for management
decision making.
Example
The following information is extracted from the financial statements of a company producing products
A & B. If the company stops producing product B, the sale of A would fall down by 25%.
Particulars A B
Revenue 60 35
Cost of Sales 35 25
Gross Profit 25 10
Overheads 5 12
Net Profit 20 -2

Analysis
If the information provided above is approached using a traditional cost management technique, the
company might decide to stop production of B because it has a very overhead cost and also results in a
loss of Rs.2 lacs. It thus appears to be prudent to close down the production of B.
However, with additional information that sale of product A would fall down by 25% if B is not sold
the decision might change. The company would lose 5 lacs (25% of 20 lacs) because of reduced sales
of A. The net loss for the company if it decides to stop production of B is 3 lacs (2 lacs of savings from
B and 5 lacs of loss of profits from A). Hence the decision to stop of production B is not prudent.

Strategic cost management can be referred to as “the managerial use of cost information explicitly
directed at one or more of the four stages of strategic management”:

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Developement
Developing and
and communicating
carrying out
Formulating implementing to strategies
tactics to
Strategies controls to throughout the
implement the
monitor the organization.
strategies.
success of

Necessity of Strategic Cost Management

 It is cost analysis in a broader context where the strategic elements become more explicit and formal
strengthening the strategic position of the company.
 Cost data is analysed and used strategically to develop alternate measures to gaining sustainable
competitive advantages.
 SCM gives a clear understanding of the company’s cost structure in search of sustainable
competitive advantage.
 SCM is the managerial use of cost information explicitly directed to the four stages of strategic
management – formulation, communication, implementation and control.
 SCM helps in overall recognition of cost relationships among the activities in the value chain and
the process of managing these relationships to the company’s competitive advantage.
Traditional vs. Strategic Cost Management
Points Traditional Cost Management Strategic Cost Management
Time Span Short term concept Long term concept
Focus Internal Both internal and external
Each value activity has a separate cost
Cost driver driver. So, not based on volume but on
Based on volume of the product.
concept activities associated with the manufacturing
of the product.
Score keeping, attention directing
Objective Cost leadership or product differentiation.
and problem solving.
Primary objective is cost containment –
Cost
Primary objective is cost reduction. cost reduction and value improvement at
Reduction
the same time.
Risk taking and ability to adapt itself with
Approach Risk – averse.
changing environment.

Components of Strategic Cost Management

Strategic Cost Management primary revolves around three business themes –
1) Strategic positioning analysis.
2) Cost driver analysis and
3) Value Chain analysis,

1) Strategic Positioning Analysis

Strategic Positioning Analysis is a company’s relative position within its industry matters for
performance. Strategic positioning reflects choices a company makes about the kind of value it will
create and how that value will be created differently than rivals.

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Strategic Positioning Analysis is concerned with impact of external and internal environment on the
overall strategy of a company. It is important to take account of the future and to assess whether the
current strategy is a suitable fit with the strategic position.
The following factors affect the strategic position of a company:
1) Organisations values, culture and systems
2) External Environment
3) Internal Environment (Resources and competencies)
External environment can be analysed using models like PESTEL (Political, Economic, Social,
Technological, Environmental and Legal factors) and Porter’s 5 forces

2) Cost Driver Analysis

Cost is caused or driven by various factors which are interrelated. Cost is not a simple function of
volume or output as considered by traditional cost accounting systems.

Cost driver concept is explained in 2 broad ways in strategic cost management parlance –
1) Structural cost drivers and
2) Executional cost drivers.
Structural cost drivers are the organisational factors which affect the costs of a firm’s product. These
factors drive costs of a organisation in varied ways. The scale and scope of operation of a company will
impact the costs. A larger scale of operations is likely to give an advantage of economies of scale. The
usage of technology and complexity of operations also determine the costs of various activities within
a firm. The experience or learning curve also impacts the costs being incurred by a firm. The product
development process could be costlier earlier and cheaper in later stages of a lifecycle. A simple volume
based cost allocation would not be appropriate in such cases.
Executional cost drivers are based on firm’s operational decision on how the various resources are
employed to achieve the goals and objectives. These cost drivers are determined by management style
and policy. The participation of workforce towards continuous improvement, importance of total quality
management, efficiency of plant layout etc. are examples of executional cost drivers.
3) Value Chain Analysis
Value-chain analysis is a process by which a firm identifies & analyses various activities that add value
to the final product. The idea is to identify those activities which do not add value to the final
product/service and eliminate such non-value adding activities.
Porter describes the value chain as “internal processes or activities a company performs to design,
produce, market, deliver and support its product.” He further stated that “a firm’s value chain and the
way it performs individual activities are a reflection of its history, its strategy, its approach of
implementing its strategy, and the underlying economics of the activities themselves.”

Primary Activities and Secondary Activities:

The activities undertaken by a firm can be broadly classified into Primary activities and Secondary
activities.
Primary activities are those which are directly involved in transforming of inputs (Raw Material) into
outputs (Finished Products) or in provision of service.
Secondary activities (also known as support activities) support the primary activities. Though,
secondary activities are not directly involved in creation of product, it doesn't mean that they are of less
importance as compared to primary activities.
Primary Activities include:

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1) Inbound Logistics: These are activities concerned with receiving, storing, and distributing the
inputs (raw materials) to the production process. The relationship with suppliers is a key component
in this process.
2) Operations: These activities involve transforming inputs into final product. Activities such as
machining, packaging, testing and equipment maintenance form part of Operations.
3) Outbound Logistics: These activities involve collecting, storing and distributing the products from
the factory line to end consumers. This may include finished goods warehousing, delivery vehicle
operation, order processing and scheduling.
4) Marketing and Sales: Marketing and Sales provide the means by which the customers are made
aware of the product. The activities include advertising, promotion, distribution channel selection,
sales force management and pricing policy.
5) Service: This includes activities related to after sales service like Installation, repair and parts
replacement.
Support Activities include:
1) Procurement involves purchasing of raw material, supplies and other consumables required as
inputs for the primary activities.
2) Technological Development includes technical knowledge, equipment, hardware, software and
any other knowledge which is used in the transformation of inputs to outputs.
3) Human Resource Management includes activities around selection, recruitment, placement,
training, appraisal, rewards and promotion; management development; and labour/ employee
relations.
4) Firm Infrastructure consists of activities such as planning, finance, accounting, legal, government
affairs and quality management.

STRATEGIC FRAMEWORKS FOR VALUE CHAIN ANALYSIS

Value Chain analysis requires internal information (for internal value chain) and external information
(for industry value chain). The Value Chain analysis requires strategic framework for organising varied
information.
3 strategic framework for Value Chain analysis:
(I) (II) (III)
Industry Structure Analysis Core Competencies Analysis Segmentation Analysis

(I) Industry Structure Analysis (Porter’s 5 forces analysis)

The five forces suggested by Porter’s play an important role in determining profit potential of the firms
in an industry. Michael Porter developed a five factors model as a way to organise information about
an industry structure to evaluate its potential attractiveness.
Factors which influence profitability are:
(1) Bargaining power of buyers:
The bargaining power of buyers generally determines the ability of buyer to push the price down.
This happens when the buyers are concentrated or when the volume purchased by buyers is very
high. In other words, when the bargaining power of buyers is high, they would be in a position to
dictate terms to the firm. A buyer also has higher bargaining power if the cost of switching suppliers
is very low. A higher bargaining power results in lower profitability. Large companies have a high
bargaining power when they buy from small suppliers.
(2) Bargaining power of suppliers:

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The bargaining power of supplier is relatively higher when the input is important to the buying firm
or when there are very few suppliers of the input. The suppliers could also dictate terms if the input
supplied is not replaceable or when an alternate input is not available. Microsoft dominates the
operating system business of computers and laptops and can dictate terms to its buyers as buyers
do not have multiple options to choose from. The profitability of companies can shrink if the
suppliers have a higher bargaining power.
(3) Threat of substitute products or services:
When multiple and close substitutes are available in the market for a particular product, customers
are likely to switch suppliers easily. A firm in such a case must resort to competitive pricing to
retain its customers. When few substitutes exist for a product, consumers are willing to pay a
potentially high price. If close substitutes for a product exist, then there is a limit to what price
customers are willing to pay. The problem becomes severe if substitutes are available at much
cheaper price (case of launch of Reliance Jio). A company should strive to build its brand and
customer loyalty to thwart the threat of substitutes. Substitutes could be from within the industry or
from a different industry. The paper industry faces threats from e-book market. When more people
switch to public transport as trains, the demand for vehicles comes down.

(4) Threat of new entrants:

The threat of new entrants largely depends on the barrier to entry and perceived profitability in an
industry. If an industry is profitable and the barriers to entry are low, new firms could enter the
industry leading to excess supplies and reduced prices. Some examples of barriers to entry are
intensive capital requirement, sophisticated technology, legal factors, limited access to raw material
& labour etc. Industries which require huge amount of capital or sophisticated technical knowhow
might not have a high threat of new firms entering into the industry. Airline industry is a case where
very few new firms enter the business because of the capital requirements. Another barrier to entry
could be legislation which restricts newer firms to start the business, like in the case of defense
industry. Certain industries (for example medicines) are largely driven by patents and new firms
might find it difficult to enter the industry. An industry where threat of new entrants is low is more
profitable than an industry where new entrants can easily enter the industry.
(5) Intensity of competition/ rivalry amongst firms:
Some markets are more competitive than others. In highly competitive industries, firms resort to
cut-throat competition to win more customers. The competitive rivalry is higher when an industry
has high number of firms and is lower when there are few large players dominating the market. The
intensity of competition is higher:
 When firms are of more or less equal size.
 Extra capacity exists in the industry
 Difficulty in differentiation in the products.
 High exit barriers - This is a case where the exit costs are high and hence firms must continue
in the industry despite excess capacity at industry level.
 Higher fixed costs - Firms would want to produce as much as possible to keep the unit costs
low leading to surplus capacity.
Since these five forces are ever-changing, Porter’s framework needs to be employed as a dynamic
analytical tool. This is because competition is a dynamic process; equilibrium is never reached and
industry structures are constantly being reformed. The five forces analysis helps a firm to better
understand the industry value chain and its competitive environment.
(II) Core Competence Analysis
Core Competency is a distinctive or unique skill or technological knowhow that creates distinctive
customer value. The core competencies are a function of the collective skillset of people, organisation
structure resources & technological knowhow.

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A core competency is the primary source of an organisation’s competitive advantage. The competitive
advantage could result from cost leadership or product differentiation.
There are three tests useful for identifying a core competence.
1) End product benefit
2) Access to a wide variety of market
3) Difficult for competitors to imitate.

Core competencies stem from two sources:

Resources: Resources are factors that enable a company to create value for customers. They can be
tangible (land, buildings, inventory, machinery, money etc) or intangible (employee’s skills, brand,
patent, technology etc.). The more difficult a resource is to imitate, the more valuable is the resource
for the company. The algorithms used by Google to deliver search results are not easily imitated by
competition. Similarly, the secret formula of concentrates used by soft drinks manufacturers like Coca
Cola are hard to copy.
Capabilities: Capabilities refer to the company’s ability to co-ordinate resources and put them to
productive use. Availability of resources by themselves does not guarantee core competency and
success. Capabilities stem from organisational structure, processes and control systems.

Applying the value chain approach to core competencies for competitive advantage includes the
following steps:
 Validate core competencies in current businesses:
 Leverage competencies to the value chains of other existing businesses:
 Use core competencies to reconfigure the value chains of existing businesses:
 Use core competencies to create new value chains:
Segmentation Analysis
A single industry might be a collection of different market segments. Motor vehicle industry, for
example, can be seen as a composite of tyre, glass, battery, metals etc. Not all firms in an industry
participate in all segments. The structural characteristics of different industry segments need to be
examined.
This analysis will reveal the competitive advantages or disadvantages of different segments. A firm
may use this information to decide to exit the segment, to enter a segment, reconfigure one or more
segments, or embark on cost reduction/ differentiation programs.

Identify Analyse
Identify key success
segmentation Construct a Analyse segment attractiveness broad
factors for each
variables and segmentation matrix attractiveness versus narrow
segment
categories segment scope.

1) Identify segmentation variables and categories: An industry might be divided into multiple
segments depending upon the nature and complexity of the industry. The segmentation could be
based on the nature of products or geographies or customers.
2) Construct a segmentation matrix: After the segments are identified, a segmentation matrix
(generally two way) can be created. ITC could create a matrix based on the nature of products
(Cigarettes, Hotels, Textile, Paper etc) and geographies (North, East, West and South). Another way
could be to create a matrix using products and distribution channel (wholesale, retail, direct).
3) Analyse segment attractiveness: The segmentation matrix could be used to evaluate profitability
and performance of each of the segment. The interrelationship between various segments (say
distribution channels, similar products) must also be considered while analysing segmental
attractiveness.
4) Identify key success factors for each segment: Each segment identified must be assessed with a
relevant measure of performance. It could be quality of product, service, timeliness of delivery etc.

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A single performance measure across all segments is not advisable. A measure which suits the
service segment will not suit the manufacturing segment.
5) Analyse attractiveness of broad versus narrow segment scope: The company must identify
whether it wants to be in a broad segment or a narrow one. Narrower segments could be risky for
business as a single segment could be vulnerable to the competition. Multiple segments help a
company to spread costs across the various segments. The company might also be in a position to
use the competency of one segment in other segments. Some firms might abandon certain segments
because of lack of profitability. The competitive advantage of each segment may be identified in
terms of low cost and/or differentiation.

SUPERIOR PERFORMANCE & COMPETITIVE ADVANTAGE

The ultimate objective of a for-profit company is to achieve superior performance in comparison to
their competitors. A company which attains superior performance gets a definitive competitive
advantage. The company’s profitability is improved with superior performance which leads to the
maximisation of shareholder’s wealth.
In order to survive and prosper in an industry, firms must meet two criteria:
 They must supply what customers want to buy and
 They must survive competition.
A firm’s overall competitive advantage derives from the difference between the value it offers to
customers and its cost of creating that customer value.
In order to attain superior performance and attain competitive advantage, a firm must have distinctive
competencies. Distinctive competencies can take any of the following two forms:
 An offering or differentiation advantage. If customers perceive a product or service as superior,
they become more willing to pay a premium price relative to the price they will have to pay for
competing offerings. Example: Customers of Apple pay a higher price for its products.
 Relative low-cost advantage, under which customers gain when a company’s total costs undercut
those of its average competitor. Example: A company which can provide similar products at
much lower costs.

Differentiation Advantage (Product Differentiation)

A differentiation advantage can be achieved by adopting the following techniques:
1) Superior Quality: The customers are offered a better-quality product in the similar price range.
The quality of product or service offering is such that the company becomes a preferred choice of
its customers.
2) Superior Innovation: The company continuously offers innovative products ahead of its
competition.
3) Superior Customer Responsiveness: The company produces products or provides services which
are aligned with customer’s expectation. The company also focusses on overall customer service
and works towards parameters like reducing waiting time, on time delivery etc.
Once a company has successfully differentiated its offering, management may exploit the advantage in
one of two ways viz., either; increase price until it just offsets the cost of improvement in customer
benefits, thus maintaining current market share; or price below the “full premium” level in order to
build market share.
Value chain analysis can identify the points at which Differentiation Advantage can be achieved by:
i. Producing products which are superior to competitors by virtue of design, knowhow,
performance, etc.
ii. Offering superior after-sales service by outstanding distribution.
iii. Expanding the product range

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iv. Superior packaging of the product.
v. Making brand strength

Low-Cost Advantage (Cost Leadership)

A firm enjoys a relative cost advantage if its total costs are lower than those of its competitors. This
relative cost advantage enables a business to do one of the following:
 Charge a lower price than its competitors for its product or services in order to gain market share
and still maintain current profitability; or
 Match with the price of competing products or services and increase its profitability.
A company must choose a strategy in which it can lower its cost and thereby gain a competitive
advantage. Many sources of cost advantage exist - access to low-cost raw materials; innovative process
technology; low-cost access to distribution channels or customers; and superior operating management.
A company might also gain a relative cost advantage by exploiting economies of scale in some markets.
Value chain analysis is central to identifying where cost savings can be made at various stages in the
value chain. Value chain analysis can identify the points at which Low Cost Advantage can be achieved:
 Reduce costs by copying rather than creating designs, using cheaper materials and other cheaper
resources, reducing labour costs and increasing labour productivity.
 Attaining economies of scale by high-volume sales.
 Use high-volume purchasing to get discounts for bulk purchase.
 Locating in areas where cost advantage exists or government support is possible.
 Gaining learning and experience curve benefits.
The company must look at its value chain, which consists of all of its functions ― production,
marketing, R&D, customer service, information systems, materials management, human resources ―
to determine each one’s role in lowering the cost structure and/ or increasing customers’ perceived
utility through differentiation of its product or service.

THE VALUE CHAIN APPROACH FOR ASSESSING

COMPETITIVE ADVANTAGE

The value chain model can be used by business to assess the competitive advantage. Companies must
not only focus on the end product/ service but also on the process/ activities involved in creation of
these products/ services. The value chain approach can be used to better understand the competitive
advantage in the following areas.
Assessing Competitive (1) Internal Cost Analysis
Advantage
(2) Internal Differentiation Analysis
(3) Vertical Linkage Analysis

(1) Internal Cost Analysis

Identify the source of profitability. The following steps are generally used to carry out an internal
cost analysis.
i. Identify the firm’s value-creating processes: This is the first step in which a firm identifies
its value-creating processes. Traditionally, businesses organise themselves into various cost,
revenue and profit centres. The businesses are also organised on a functional structure with
different layers of hierarchy. These types of classification or organisation does not help firm
understand the contribution of each activity.
The key is to classify activities to understand their true contribution to the firm’s competitive
advantage. Example - firms might have distinctive advantage in their procurement process or
inbound logistics.

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ii. Determine the portion of the total cost of the product or service attributable to each value
creating process: The next step is to trace or assign costs and assets to each value-creating
process identified. A company might use estimates to assign costs to the value creating
activities. The costs of support activities must also be allocated to get a full picture of costs.
Example: A new ERP system might reduce the inbound logistics costs with proper inventory
management but would increase the cost on IT front. Unless such costs are identified and
allocated, the analysis would not give a clear picture. Many of the processes identified may be
instrumental for achieving competitive advantage.
iii. Identify the cost drivers for each process: The company identifies the factors which drive
costs. A change in cost driver leads to a change in the overall cost. The next step of internal
cost analysis is to identify the factor or cost determinants for each value-creating process. Once
the factors driving costs are identified, business can assign priority in its cost management
activities.
Management accounting systems may not reveal the causes or factors for the significant
individual costs. The use of a single output or volume measures to assign costs can also be
misleading at times. Multiple cost drivers usually provide more useful information and analysis.
The companies are using activity based costing to gain a better understanding of the resources
consumed and costs incurred for a certain activity.
iv. Identify the links between processes: The value chain analysis considers individual value
activities as separate and discrete. However, the individual activities are not independent and
are not expected to function in silos. Most activities within a value chain are interdependent
and the linkages between the various activities might impact the total cost. The cost
improvement programs in one value chain may lower or increase cost in other processes. An
increase in automation might reduce the manpower cost but would also increase the technology
cost.
v. Evaluate the opportunities for achieving relative cost advantage: Traditionally firms and
businesses have adopted across the board cost reduction. Such an approach (E.g. reduce costs
under all heads by 15%) does not solve the actual problem as the costs are not reduced
strategically. Such an approach might lead to forceful reduction of costs in certain areas like
marketing which might impact the sales.
Certain activities might provide a larger opportunity for reducing costs while other activities
might require that costs are incurred at current level or may be even at higher levels. Using the
value chain approach, a company goes beyond simple across-the-board cuts and attempts to
lower cost and improve efficiency within each value-creating process.
Reducing process input costs often means negotiating lower wages or moving production to
countries with cheaper labour costs. Suppliers might be willing to drop their prices if the
company negotiates long-term contracts. Companies also use buyer-seller partnerships to gain
advantages in cost, quality, time, flexibility, delivery and technology.
(2) Internal Differentiation Analysis
Companies can also use value chain analysis to create and offer superior differentiation to the
customers. The focus is on improving the value perceived by customers on the companies’ products
and service offering. The firms must identify and analyse the value creating process and carry out
a differentiation analysis.
i. Identify the customer’s value creating processes: The company must identify various activities
in its value chain which are undertaken to deliver products/ services to its customers.
Differentiation comes from the way various activities are performed and the way in which value
chain is structured.
ii. Evaluate differentiation strategies for enhancing customer value: The company seeks to
evaluate various strategies which could enhance the customer value. The strategies which a
company can implement to enhance the customer value are:
 Superior features in product - e.g. Premium cars, Phones etc.
 Using effective marketing & distribution channels - e.g. on time delivery.

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 Excellent Customer Service - e.g. timeliness of repairs at effective cost, cleanliness at hotels
etc.
 Having a superior brand image - e.g. Apple, Google, Tata
 Offering better quality product at competitive prices.
iii. Determine the best sustainable differentiation strategies: The activities which could enhance
differentiation must be identified. A company must identify those strategies which could create
sustainable product/ service differentiation. The selection of strategy must be according to the
availability of resources.

(3) Vertical Linkage Analysis

A company generates competitive advantage not only through linkages of internal processes within
a firm but also through linkages between a firm’s value chain and that of a suppliers or users. A
vertical linkage analysis includes all upstream and downstream activities throughout the industry.
The analysis encompasses activities beginning at source of raw material and ending at the final
delivery of products to the customers. A company must have an understanding of not only its
internal value chain but also of the industry value chain.

Example - A company manufactures cars using various components like chassis, steering wheel,
tyres, axles etc. The company does not manufacturer all the components in-house and are purchased
from third party suppliers. The company focusses on assembly line which is its core competency.
However, certain parts, which are critical to the car are manufactured in-house. This is a strategic
choice to gain a competitive advantage.
In another case, a company could identify that there is virtually no competition in a particular
process of the value chain. In such a case, it is less likely that the company might get a competitive
price for the components it purchases. If there is only a single battery manufacturer, the car company
might end up paying higher price. Such a situation could lead to a competitive disadvantage. A
company might also carry out negotiations with its suppliers after an analysis of industry value
chain. This generally happens when the company observes that certain section of value chain is
charging excessive margin.

VISION, MISSION AND OBJECTIVES & SCM

A company’s mission statement is a statement of the company’s reason to be. It seeks to answer the
question - “Why does the company exist?”. It is a statement of organisation purpose and helps in
addressing the following questions-
(i) What kind of product or services will the company offer?
(ii) Which is the primary market for its offering?
(iii) What type of customers does the company seek to target?
(iv) What is the area of operations (geographies)?
It might also include a statement of organisation value and major goals. A company’s mission statement
must be customer focused and not product focused.
The fundamental purpose of strategic planning and management is to align the vision and mission
statements. A company’s strategy is directed towards achieving a sustained competitive advantage. As
discussed earlier, a competitive advantage is achieved by product differentiation and cost leadership.
Strategic cost management is hence closely linked to the vision, mission and objectives of the company.
In the SCM frame work, effective cost management involves a broad focus which Porter calls the value
chain. It is a strategic tool used to analyse internal firm activities. Its goal is to recognize, which
activities are the most valuable (i.e. are the source of cost or differentiation advantage) to the firm and
which ones could be improved to provide competitive advantage. Cost leadership can be achieved

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through techniques like target costing. Product differentiation is directly proportional to market
movements and changing business requirements.

VALUE SHOP MODEL OR SERVICE VALUE CHAIN

The concept of value shop came in to lime light holding the hand of Mr. James. D. Thompson in the
year of 1967. However, it took more than thirty years to name the concept as ‘Value shop’. In 1998 Mr.
Charles B. Stabell and Mr. Oystein D. Fjeldstad in their research work properly defined the concept of
‘Value Shop’.
This concept aims to serve companies from service sector. In value shop principle, no value addition
takes place. It only deals with the problem, figure-out the main area requires its service and finally
comes with the solution.
This approach is designed to solve customer problems rather than creating value by producing output
from an input of raw materials.
Value shops mobilizes resources (say: people, knowledge or money) to solve specific problems such as
curing an illness or delivering a solution to a business problem. The ‘problem’ could also be how to
exploit an opportunity.
In the value shop they are:
 Problem finding and acquisition.
 Problem solving.
 Choosing among solutions.
 Execution and control/evaluation
Infrastructure
Human Resource Management
Technology development
Procurement

Problem
Control/
Finding and
Evaluation
Aquisition

Problem
Execution
Solving

Choice

The management in a value shop focuses on areas like problem and opportunity assessment,
resource mobilization, project management, solutions delivery, outcome measurement, and learning

INTRODUCTION TO SCM CA MANOJ SHARMA

 [1. 13]

THE ROLE OF THE MANAGEMENT ACCOUNTANT

Today, management accountants must also bring skills in activity-based costing, benchmarking, re-
engineering, target costing, life-cycle costing, economic value analysis, total quality management
and value chain analysis.
Value chain analysis is a team effort. Management accountants need to collaborate with engineering,
production, marketing, distribution and service professionals to focus on the strengths, weaknesses,
opportunities and threats identified in the value chain analysis results.
By championing the use of value chain analysis, the management accountant enhances the firm’s value
and demonstrates the value of the finance staff to the firm’s growth and survival.

INTRODUCTION TO SCM CA MANOJ SHARMA

 2. MODERN BUSINESS
ENVIRONMENT

 Modern Business Environment

CONTENTS..

 Cost of Quality (COQ)

 Total Quality Management (TQM)
 The Business Excellence Model
 Theory of Constraints
 Throughput Accounting
 Supply Chain Management
 Gain Sharing Arrangements
 Outsourcing
 [2. 2 ]

MODERN BUSINESS ENVIRONMENT

Business technology has advanced business functions and operations to new levels. The role of accounting
is one of the most reliable functions in business.
The main revolution has been the transition from a seller’s market to a buyer’s market. Earlier the supplier
or service provider dictated the dimensions of a transaction:

1) Price Determined by a “cost plus” approach

2) Response time Determined by the supplier
3) Quality Determined by the service/ product provider
4) Performance Dictated to the customer

From a Sellers’ Market to Buyers’ Market

This environment is characterized by:
 Globalization of the world economy.
 Fierce competition among organizations within and across countries.
 Global excess capacities in production, services, and in some areas of development.
 Using new managerial methods.
 Availability and accessibility of data and knowledge.
 Timely availability of materials and services.
 Ease of global travel and transportation.

COST OF QUALITY (COQ)

Quality is concerned with conformance to specification; ability to satisfy customer expectations and
value for money. Recognising the importance of cost of quality is important in terms of continuous
improvement process.
The cost of control/conformance and the cost of failure of control/non- conformance is the
quantitative measure of COQ.
It is the sum of the costs related to prevention and detection of defects and the costs incurred due to
occurrences of defects.

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 [2. 3 ]
Views Regarding Cost Of Quality

Today view of quality cost among practitioners seems fall into THREE categories:

1. Higher quality means higher cost

• Quality attributes such as performance and features cost more in terms of

labour, material, design, and other costly resources

2. The resultant savings are greater than the cost of improving quality

• The savings result from less rework, scrap, and other direct expenses
related to defects.

3. Quality costs are those incurred in excess

• of those that would have been incurred if product was built or service
performed exactly right the first time

Components Of Cost Of Quality

The COQ costs in two broad categories namely ‘Price of Conformance’ and ‘Price of Non-
conformance’.
These two can be bifurcated further in to prevention & appraisal costs and internal & external failure costs.
Hence, COQ is often referred as PAF (Prevention, appraisal & failure) model.
In other words, ‘Price of Conformance’ is known as ‘Cost of Good quality’ and ‘Price of Non-
conformance’ is often termed as ‘Cost of Poor Quality’.

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 [2. 4 ]
Prevention Costs Appraisal Costs Internal Failure External Failure Costs
Costs

The costs incurred The need of control in Internal Failure Fail to reach design
for preventing the product and services to Cost associated quality standards are not
poor quality of ensure high quality level with defects detected until after
products and in all stages, conformance found BEFORE transfer to the customer.
services may be to quality standards and the customer AFTER the product or
termed as performance receives the service is delivered and
Prevention Cost requirements is product or then the defects is found
Appraisal Costs service then it is an external failure.

Quality Engineering Inspection Scrap Revenue Loss

Quality Training Product Acceptance Rework Warranties

Quality Audits Packaging Inspection Re-Inspection Discount Due to Defects

Design Review Field Testing Re-Testing Product Liability

Quality Circles etc Continuing Supplier Repair etc Warranty etc

Verification etc

The total quality costs are then the sum of

all these costs.

 In its simplest form, COQ can be calculated in terms of effort (hours/days).

 A better approach will be to calculate COQ in terms of money (converting the effort into money and
adding any other tangible costs like test environment setup).
 The best approach will be to calculate COQ as a percentage of total cost. This allows for
comparison of COQ across projects or companies.
 To ensure impartiality, an external person say the accountant must determine the Cost of Quality
of a project/ product rather than a person who is a core member of the project/ product team (Say,
someone from the Accounts Department).

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 [2. 5 ]
OPTIMAL COQ

It is generally accepted that an increased

expenditure in prevention and appraisal is likely
to result in a substantial reduction in failure
costs. Because of the trade off, there may be an
optimum operating level in which the combined
costs are at a minimum.

Steps Of Application Of PAF Model

The prevention, appraisal, and failure (PAF) model is the most widely accepted method for
measuring and classifying quality costs. Follow this five-step process.

MODERN BUSSINESS ENVIRONMENT CA MANOJ SHARMA

 [2. 6 ]
Que 1: SM
Livewell Limited is a manufacturing company that produces a wide range of consumer products for
home consumption. Among the popular products are its energy efficient and environment friendly
LED lamps. The company has a quality control department that monitors the quality of production.
As per the recent cost of poor quality report, the current rejection rate for LED lamps is 5% of units
input. 5,000 units of input go through the process each day. Each unit that is rejected results in a
`200 loss to the company. The quality control department has proposed few changes to the inspection
process that would enable early detection of defects. This would reduce the overall rejection rate
from 5% to 3% of units input. The improved inspection process would cost the company `15,000
each day.
Required
(i) ANALYSE the proposal and suggest if it would be beneficial for the company to implement
it.
(ii) After implementation, ANALYSE the maximum rejection rate beyond which the proposal
ceases to be beneficial?

Solution-
(i) Analysis of the proposal to make changes to the inspection process:

The company wants to reduce the cost of poor quality on account of rejected items from the process.
The current rejection rate is 5% that is proposed to be improved to 3% of units input.

The expected benefit to the company can be worked out as follows:

The units of input each day = 5,000. At the current rate of 5%, 250 units of input are rejected each
day. It is proposed to reduce rejection rate to 3%, that is 150 units of input rejected each day.
Therefore, improvements to the inspection process would reduce the number of units rejected by 100
units each day. The resultant cost of poor quality would reduce by `20,000 each day (100 units of
input × `200 cost of one rejected unit).

The cost of implementing these additional controls to the inspection process would be `15,000 each
day.

The net benefit to the company on implementing the proposal would be `5,000 each day. Therefore,
the company should implement the proposal.

(ii) Analysis of maximum rejection rate beyond which the proposal ceases to be beneficial

The cost of improving controls to the inspection process is `15,000 each day. The number of units of
input processed each day is 5,000. The cost of rejection is `200 per unit.

It makes sense to implement the improvements to controls only if the benefit is greater than the cost
involved. To find out the point where the benefits equal the cost, solve the following equation.

MODERN BUSSINESS ENVIRONMENT CA MANOJ SHARMA

 [2. 7 ]
Let the number of reduction in rejections each day due to improved controls be R. At `200 per unit,
benefits from reduction in rejection would be `200 × R.
At what point, would this be equal to the cost of control of `15,000 per day?
Solving `200 × R = `15,000; R = 75 units. That is if the improvements to inspection process control
reduces the number of rejections by 75 units each day, the benefit to the company would be `15,000
each day.
That is if the rejection rate improves by 1.5% (75 units / 5,000 units) then the benefits accruing to
the company will equal the cost incurred.
In other words, when the rejection rate is 3.5% (current rate 5% - improvement of 1.5% to the rate)
or below, the proposal will be beneficial. In this range, the savings to the cost of poor quality will be
more than the cost involved. For example, as explained above, when the improved rejection rate is
3%, the net benefit to the company is `5,000 each day.
Beyond 3.5% rejection rate, the proposal will result in savings to the cost of poor quality that is less
than the cost involved of `15,000 each day.

Que 2: SM
CIMZ is a new banking company which is about to open its first branch in INDIA. CIMZ believes
that in order to win customers from the market, it needs to offer potential customers a new banking
experience. Other banking companies are focusing on interest rates and bank charges, whereas CIMZ
believes that quality and timely availability of service is an important factor to attract customers.
Required
EXPLAIN how Total Quality Management would enable CIMZ to gain competitive advantage in the
banking sector
Solution-
Total Quality Management is a management philosophy. It concerns itself with managing the
processes and people to make sure that the customer is satisfied at each and every stage. This means
making the needs of the customer the priority, expanding the relationship beyond traditional services
and incorporating the customer’s needs in the company’s business plan and corporate strategy. In
TQM, the concept of “quality” is perceived exclusively from the frame of reference of the customer.
These customers can be internal, such as, those working in another department and there can be
external customers who are the end recipients of the product or services. The organisation should
attempt for continuous improvement in the quality that it delivers with the ultimate aim of achieving
zero defects in this quality.
TQM should be view as an investment rather than as a cost that should be minimised. There are many
ways in which investment can be made in TQM.:
 fine-tuning the product mix,
 fine-tuning of the processes of ensuring quality,
 introducing employee development programmes with the nature of an academic course,
 empowering the employees professionally and personally,

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 [2. 8 ]
 improving the top management commitment to quality,
 monitoring of the performances and proper rewarding based on achievements,
 ensuring the customer satisfaction etc.
CIMZ could provide its employees with training in the technical aspects of banking practice as well
as in customer care. Customers would thus get a better service not only technically but also from a
customer care perspective. This should lead to smaller customer complaints and greater customer
satisfaction. It could also motivate customers to recommend others to use this bank
TQM also requires CIMZ to respond to its customer’s requirements immediately for example by
providing more staff to reduce the lengths of queues in festive/ seasonal/ busy time. If Bank could
also be opened for longer hours to allow customers to complete their bank related requirements and
have meetings with bank employees at a time that is more convenient for the customer, this would
lead to more satisfaction to customers.
In long run, if bank continue to follow TQM, the bank would have higher profits and competitive
advantage in banking sector despite incurring additional expenditure to improve quality.

Que 3: SM
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 Limited 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 evaluate what costs are being incurred to ensure the quality of the product.
Following information is collected from various departments within the company relating to 2019-
20:
Particulars of Costs (`)
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 2020-21, the CEO is considering spending the following amounts on a new quality
programme:
(`)
Inspect raw material 1,20,000
Reengineer the production process to improve product quality 7,50,000

MODERN BUSSINESS ENVIRONMENT CA MANOJ SHARMA

 [2. 9 ]
Supplier screening and certification 30,000
Preventive maintenance on plant equipment 70,000

P Limited expects the new quality programme to save costs by the following amounts:
(`)
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 2019-20 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

Solution-
(i) Cost of Quality Statement
For the year 2019-20
Particulars of Costs Cost Incurred (`) Total Cost % of Total
Incurred (`) Costs of
Quality
Preventive Costs:
Employee training 1,20,000 1,20,000 5.85%
Appraisal Costs:
Testing 1,70,000 1,70,000 8.29%
Internal Failure Costs:
Rework 3,00,000
Cost of rejected units 50,000 3,50,000 17.08%
External Failure Costs:
Lost profits from lost sales 8,10,000
due to impaired reputation
Sales return processing 1,75,000

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 [2. 10 ]
Warranty costs 4,25,000 14,10,000 68.78%
Total Cost of Quality 20,50,000 100%

(ii) Cost Benefit Analysis of New Quality Programme

Particulars of Costs Additional Total New

(Costs) / Cost (Costs) / Cost
Savings (`)
Saving (`)
Preventive Costs:
Reengineer the production process (7,50,000)
Supplier screening and certification (30,000) (8,50,000)
Preventive maintenance on equipment (70,000)
Appraisal Costs:
Inspect Raw Materials (1,20,000)
Internal Failure Costs:
Reduction in rework costs 2,50,000
External Failure Costs:
Reduction of lost profits from lost sales 8,00,000
Reduction from sales return 1,50,000
Reduction from warranty costs 3,25,000

Total Savings/ (Costs) from Quality Programme 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.

MODERN BUSSINESS ENVIRONMENT CA MANOJ SHARMA

 [2. 11 ]
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.

Que 4: SM
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%.
MODERN BUSSINESS ENVIRONMENT CA MANOJ SHARMA
 [2. 12 ]
Required
(i) 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.
(ii) Would you RECOMMEND the proposal? Give financial and non-financial reasons.

Solution-
(i) Statement of ‘Expected Quality Costs’

Particulars Current Proposed

Situation ( ) Situation ( )

Prevention Costs --- 4,50,000

Appraisal Costs --- 50,000

External Failure Costs 3,20,000 2,35,120

Internal Failure Costs 7,55,556 3,91,538

Total Quality Costs 10,75,556 11,26,658

Workings
External Failure Cost

Particulars Current Situation Proposed Situation

Customer’s Demand…(A) 28,000 units 28,000 units

Number of units Dispatched to Customers…(B) 32,000 units 30,939 units

28,000 units 28,000 units
87.5% 90.5%

Number of units Replaced…(B) – (A) 4,000 units 2,939 units

External Failure Cost

{4,000 units × (35+25+15+5)}; 3,20,000 2,35,120
{2,939 units × (35+25+15+5)}

Internal Failure Cost

Particulars Current Situation Proposed Situation

Number of units Dispatched to

32,000 units 30,939 units
Customers

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 [2. 13 ]
Number of units Produced & Rejected …(B) 40,000 units 34,377 units
32000 units 30939 units
80% 80%

Number of units Discovered Faulty … B) – (A) 8,000 units 3,438 units

Cost of Faulty Production …(D)

{8,000 units × (35+25+15)}; 6,00,000 2,57,850
{3,438 units × (35+25+15)}

Material Scrapped 4,444.44 units 3,819.67 units

40000 units x 10% 34377 units x 10%
90% 90%

Cost of Material Scrapped …(E)

1,55,556 1,33,688
{4,444.44 units × 35}; {3,819.67 units × 35}

Internal Failure Cost…(D)+(E) 7,55,556 3,91,538

(ii) Recommendation
On purely financial grounds the company should not accept the proposal because there is an
increase of Rs. 51,102 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.

Que 5: SM
EKS Ltd. Manufactures a single product, which requires three components. The company purchases
one of the components from three suppliers. DE Ltd., PE Ltd. and ZE Ltd. The following information
are available.
DE Ltd. PE Ltd. ZE Ltd.
Price quoted by supplier (per hundred units) `240 `234 `260
% of Defective of total receipts 3% 5% 2%
If the defectives are not detected they are utilized in production causing a damage of `200 per 100
units of the component. Total requirements are 12,000 units of the components.
The company intends to introduce a system of inspection for the components on receipt. The
inspection cost is estimated at `26 per 100 units of the components. Such as inspection will be able
to detect only 90% of the defective components received. No payment will be made for components
found to be defective in inspection.
MODERN BUSSINESS ENVIRONMENT CA MANOJ SHARMA
 [2. 14 ]
Required
(i) ADVICE whether inspection at the point of receipt is justified?
(ii) Which of the three suppliers should be asked to supply?

Solution-
A: Statement Showing Computation of Effective Cost before Inspection
Particulars DE Ltd. PE Ltd. ZE Ltd.
Units Supplies (No.s) 12,000 12,000 12,000
Defectives Expected (No.s) 360 600 240
Costs:
Purchase of Components 28,800 28,080 31,200
Add: Production Damage on Defective Components 720 1,200 480
(@ `200 per 100 components)
Total 29,520 29,280 31,680
Good Components (Nos.) 11,640 11,400 11,760
Cost per 100 Good Components 253.61 256.84 269.39

B: Statement Showing Computation of Effective Cost after Inspection

Particulars DE Ltd. PE Ltd. ZE Ltd.
Units Supplies (No.s) 12,000 12,000 12,000
Defects Not Expected (No.s) 36 60 24
Defectives Expected (No.s) 324 540 216
Components Paid For 11,676 11,460 11,784
Costs:
Purchase of Components 28,022.40 26,816.40 30,638.40
Add: Inspection Cost 3,120.00 3,120.00 3,120.00
Add: Production Damage on Defective Components 72.00 120.00 48.00
(@ `200 per 100 components)
Total 31,214.40 30,056.40 33,806.40
Good Components (Nos.) 11,640 11,400 11,760
Cost per 100 Good Components 268.16 263.65 287.47

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 [2. 15 ]
Advice Whether Inspection at the Point of Receipt is Justified
On comparing the cost under situation, A and B shown above, we find that it will not be economical
to install a system of inspection.
Further we also need to consider that presently many organizations are undergoing Just in Time (JIT)
implementation. JIT aims to find a way of working and managing to eliminate wastes in a process.
Achievement of this is ensured through eliminating the need to perform incoming inspection.
Inspection does not reduce the number of defects, it does not help in improving quality. In general
inspection, does not add value to the product. It simply serves as a means of identifying defects the
supplier has failed to recognize subsequent to the manufacturing of the product.
As a matter of fact, organizations implementing JIT are seeking eventually to eliminate the need for
performing incoming inspection activities through a combination of reducing the supplier base,
selection through qualification and vendor development. Vendor development and its proper
management seeks to assist the supplier who maintains an interest in striving to provide 100% defect-
free materials and parts.
So, to decision whether inspection at the point of receipt is justified or not will also depend on
Qualitative factors as well.
(ii) On comparing the buying cost of components under different situations, as analysed and advised
above, if company decides not to install a system of inspection, supplier DE would be cheaper
otherwise supplier PE would be cheaper and company may choose supplier accordingly.

Que 6: SM
H Automobile Group is among top 20 business houses in India. It has been founded in the year 1930,
at the height of India's movement for independence from the British, the group has an illustrious
history. H’s footprint stretches over a wide range of industries, spanning automobiles (two wheelers
manufacturer and three wheelers manufacturer). H’s headquarter is located at Hyderabad. Bike
Production is one of segment of H Group. Management of H wants to analyse the following actual
information for the April.

Cost Data
Customer Complaints Centre Cost 35 per hr.
Equipment Testing Cost 18 per hr.
Warranty Repair Cost 1,560 per bike
Manufacturing Rework Cost 228 per bike
Volume and Activity Data
Bikes Requiring Manufacturing Rework 3,200 bikes
Bikes Requiring Warranty Repair 2,600 bikes
Production Line Equipment Testing 1,600 hrs.
Time

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 [2. 16 ]
Customer Complaints Centre Time 2,000 hrs.
Additional Information
Due to the quality issues in the month, the bike production line experienced unproductive 'down time'
which cost `7,70,000. H carried out a quality review of its existing suppliers to enhance quality levels
during the month at a cost of `1,25,000.
Required
(i) PREPARE a statement showing ‘Total Quality Costs’.
(ii) ADVISE any TWO measures to reduce the non- conformance cost

Solution-
(i) Statement Showing ‘Total Quality Costs’
Particulars of Costs `
Prevention Costs
Supplier Review 1,25,000
Appraisal Costs
Equipment Testing (`18 × 1,600 hrs.) 28,800
Internal Failure Costs
Down Time 7,70,000
Manufacturing Rework (`228 × 3,200 bikes) 7,29,600
External Failure Costs
Customer Complaints (`35 × 2,000 hrs.) 70,000
Warranty Repair (`1,560 × 2,600 bikes) 40,56,000
Total Quality Costs 57,79,400

(ii) The reporting of quality costs highlights the cost of quality activities at H. The total quality
costs statement clearly displays the relationship between conformance costs (prevention and
appraisal costs) and non-conformance costs (internal failure and external failure costs) and the drivers
of a reduction in the overall spending on quality. Statement indicates that only 2.16% of the total
quality cost is the cost of preventing quality problems while 0.50% is the cost of appraisal activities.
Thus, prevention and appraisal costs make up only 2.66% of total quality costs. In contrast, 97.34%
of quality control costs are incurred for internal and external failure costs. Following two measures
can be used to reduce non- conformance cost:
Total Productive Maintenance (TPM) is a system of maintaining and improving the integrity of
production and quality system through keeping all equipment in top working condition so as to avoid
breakdowns and delays in manufacturing processes. It involves identifying machines in every
division (including planning, manufacturing, maintenance) and then planning & executing a
maintenance programme covering their entire useful life.
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 [2. 17 ]
In this scenario, TPM will help in reducing internal failure cost (i.e. downtime and manufacturing
rework cost), which constitutes 25.95% of total quality cost, by keeping all equipment in good
working conditions so that there is no downtime or machine breakdown and ensuring that all
equipment run smoothly. If machines work properly, the chances of rework will reduce, ultimately
will also reduce chances of warranty repair and customer complaints (comprising 71.39% of total
quality cost which is the major part of total quality cost).

Total Quality Management (TQM) aims at improving the quality of organisational output,
including goods and services, through continual improvement of internal practices. Its objective is to
eradicate waste and increase efficiency without compromising with the quality. It requires that
company maintain this quality standards in all aspects of business by ensuring that things are done
right the first time so that defects and waste are eliminated from operation.
It appears that H is not a TQM company at present due to huge disparity between conformance costs
and non-conformance costs. In order to make H to be successful, all staff at H must be engaged in
the improvement process and share in the continuous improvement ethos. In order to establish a
reputation as a high- quality bike manufacturer H must ensure staff are focused on quality and
attitudes changed toward the importance of conformance activities, for instance, H can conduct third
party inspection of raw material at supplier’s workplace leading to maintenances of quality standards.
Overall, while applying above two measures, in the H, consideration must therefore be given to the
optimum balance between the costs of conformance and the costs of non- conformance.

Que 7: SM
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 5,00,000 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

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 [2. 18 ]
10% increase in market share for Cool Air, that is demand for its products could increase to 1,50,000
units per annum.
Required
(i) ANALYZE, the cost of poor quality per annum due to supply of defective items to the
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 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?

Solution-
(i) Customer demand for Cool Air’s products is 1,00,000 units per annum. However, 5,000 defective
units supplied are to be replaced free of charge by the company. Therefore, the total number of items
supplied to customers per annum = 1 ,00,000 + 5,000 units = 1,05,000 units. The cost of replacement
would include raw material cost, assembly & machining cost and delivery cost of 5,000 units = 5,000
units × (900+500+100) per unit = 5,000 units × `1,500 per unit = `75,00,000 per annum. Further, had
the sale returns not happened, market share would have increased by 50,000 units. Contribution is
`1,000 per unit, for 50,000 units contribution would be `5,00,00,000. Therefore, the cost of poor
quality per annum = cost of replacement + contribution from lost sales =
`75,00,000 + `5,00,00,000 = `5,75,00,000 per annum.

(ii) Inspection at the end of the process would detect defects before delivery to the customers. This would
ensure that the sale returns would be nil. Given in the problem, 5,000 units supplied are defective
and would need to be replaced, in other words, they need to be manufactured again. In other words,
inspection after production, before delivery to customers would not prevent production of defective
units. However, compared to the current scenario, since these defective units have not yet been
delivered to the customer, the cost for additional delivery of replaced products would be saved. This

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 [2. 19 ]
savings in the extra delivery cost = 5,000 units × `100 per unit = `5,00,000 per annum. Further, had
the sale returns not happened, market share would have increased by 50,000 units. Contribution is
`1,000 per unit, for 50,000 units it would be `5,00,00,000 per annum. However, additional failure
cost for 2,500 units due to increase in sales from 1,00,000 to 1,50,000 units would be incurred. Since
these defective units have not yet been delivered to the customer, this cost would be net of delivery
cost. This additional failure cost = 2,500 units × `1,400 per unit = `35,00,000 per annum. Therefore,
the total benefit from the inspection process before delivery to customers = savings on delivery costs
+ contribution from incremental sales - additional failure cost = `5,00,000 + `5,00,00,000 - `35,00,000
= `4,70,00,000 per annum. The cost to the company to maintain good quality of its products through
inspection = `2,00,00,000 per annum. Therefore, the net benefit to the company would be
`2,70,00,000 per annum
(iii) Inspection of raw material at the procurement stage could entirely eliminate defective production.
The benefit would be two-fold, the current replacement cost for 5,000 units will no longer be
incurred. Secondly, due to better customer perception, market share would increase, resulting in an
increased contribution / revenue to the company. In other words, the cost of poor quality will be nil.
As explained in solution (i), the cost of poor quality per annum = cost of replacement + contribution
from lost sales = `75,00,000 + `5,00,00,000 = `5,75,00,000 per annum. This would be the benefit by
implementing the proposal.
Cool Air has to incur an inspection cost to ensure this highest standard of quality (0% defects) which
would cost `4,00,00,000 per annum. Therefore, the net benefit to the company would be `1,75,00,000
per annum.

(iv)
(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 at the end of the production process 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.

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 [2. 20 ]

Que 8: PM
Queenstown Furniture (QF) manufactures high-quality wooden doors within the forests of
Queenstown since 1952. Management is having emphasize on creativity, engineering,
innovation and experience to provide customers with the door they desire, whether it is a
standard design or a one-of-a-kind custom door. The following information pertains to
operations during April:

Processing time 9.0 hrs.* Waiting 6.0 hrs.*

time

Inspection time 1.5 hr.* Move time 7.5 hrs.*

Units per batch 60 units

(*) average time per batch

Required
Compute the following operational measures:
(i) Average non-value-added time per batch

(ii) Average value added time per batch

(iii) Manufacturing cycle efficiency

(iv) Manufacturing cycle time

Solution-
(i) Average Non Value Added Time per batch
= Inspection Time + Waiting Time + Move Time
= 1.5 hr. + 6.0 hrs. + 7.5 hrs.
= 15 hrs.
(ii) Average Value Added Time per batch
= Processing Time
= 9 hrs.
(iii) Manufacturing Cycle Efficiency
= Processing Time
Processing Time + Inspection Time + Waiting Time + Move Time
9.0 ℎ𝑟𝑠
=
9.0 hrs. + 1.5 hr. + 6.0 hrs. + 7.5 hrs
= 37.5%

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 [2. 21 ]
(iv) Manufacturing Cycle Time
Total Production
=
Time Units per Batch
24 hrs
=
60 𝑢𝑛𝑖𝑡𝑠
= 0.40 hrs per unit

Que 9: PM
Hindustan Bikes Ltd. (HBL) formerly known as HELCO is an Indian multinational company.
It’s headquarter is located in Bengaluru, India. It has been founded in the year 1990 as a
manufacturer of locomotives. The company is presently listed locally as well as in
international stock market. HBL’s parent company is Hindustan Group. The management of
HBL recognizes the need to establish a culture at the company so that -
“Do the right things, right the first time, every time”.
Management has provide you following actual information for the most recent month of the
current year:
Cost Data `

Customer Support Centre Cost 35 per hr.

Equipment Testing Cost 18 per hr.

Warranty Repair Cost 1,560 per bike

Manufacturing Rework Cost 228 per bike

Volume and Activity Data

Bikes Requiring Manufacturing Rework 3,200 bikes

Bikes Requiring Warranty Repair 2,600 bikes

Production Line Equipment Testing Time 1,600 hrs.

Customer Support Centre Time 2,000 hrs.

Additional information
HBL carried out a quality review of its existing suppliers to enhance quality levels during the
month at a cost of ` 1,25,000. Due to the quality issues in the month, the bike production line
experienced unproductive 'down time' which cost ` 7,70,000.
Required
(1) Prepare a statement showing ‘Total Quality Cost’.

Solution:
Statement Showing “Total Quality Cost”

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 [2. 22 ]
Particulars of Costs `

Prevention Costs

Supplier Review 1,25,000

Appraisal Costs

Equipment Testing (`18 × 1,600 hrs.) 28,800

Internal Failure Costs

Down Time 7,70,000

Manufacturing Rework (`228 × 3,200 bikes) 7,29,600

External Failure Costs

Customer Support (`35 × 2,000 hrs.) 70,000

Warranty Repair (`1,560 × 2,600 bikes) 40,56,000

Total Quality Costs 57,79,400

Que 10: PM
NZ Ltd. implemented a quality improvement programme and had the following results:

Particulars 2012 2013

(Figures in ` ’000)

Sales 6,000 6,000

Scrap 600 300

Rework 500 400

Production Inspection 200 240

Product Warranty 300 150

Quality Training 75 150

Materials Inspection 80 60

Required
(i) Classify the quality costs as prevention, appraisal, internal failure and external failure
and express each class as a percentage of sales.
(ii) Compute the amount of increase in profits due to quality improvement.

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 [2. 23 ]
Solution
(i) Statement Showing Classification of Quality Costs”

2012 2013

‘000 % of ‘000 % of sales

sales

Prevention:

Quality Training 75 1.25% 150 2.50%

Appraisal:

Product Inspection 200 3.33..% 240 4.00%

Materials Inspection 80 1.33..% 60 1.00%

Internal Failure:

Scrap 600 10.00% 300 5.00%

Rework 500 8.33..% 400 6.66..%

External Failure:

Product Warranty 300 5.00% 150 2.5

Total 1,755 29.25% 1,300 21.66..%

(ii) Cost reduction was effected by 7.583% (29.25 – 21.66..) of sales, which is an increase in
profit by `4,54,980.

Que 11: PM
7 Star Sports Co. (7SSC) is engaged in the manufacture of cricket bats. Following table shows
the budgeted figures for the coming year:

Particulars ` per unit

Selling Price 4,800

Less: Components (1 Set) 1,200

Assembling Costs 2,000

Delivery Cost 800

Contribution 800

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 [2. 24 ]
Components like willow, rubber grip and handle bar in a set, are bought in and an assembling
process carried out to transform them into a single bat. Market is intensely competitive where
7SSC currently holds 30% market share. Annual demand of these bats is 1,00,000 units.
On reviewing previous performance it is revealed that 3% of the bats supplied to customers
were returned for free replacement because of faults. Defective components, which are
initially bought in to assembling process, are held responsible for this. These returned bats
cannot be repaired and have no scrap value. Supply of faulty bats to customers could be
eliminated by implementing an inspection process immediately before the goods are
delivered. This would improve customer perception thus resulting in an increase of 5% in
current market share (making in all a total share of 35%).
Required
(i) Calculate the quality non-conformance cost for the coming year, based on the budgeted
figures and sales returns rate.
(ii) Calculate the impact on profitability due to implementation of inspection process for the
bats

Solution
(i) Calculation of Quality Non- Conformance Cost
Annual Sales = 1,00,000 × 30%
= 30,000 units
Number of returned bats which are replaced free of cost =
3
= 30000 ×
97
= 928 units
Cost of 928 units that are replaced free of charge = 928 × `4,000
= 37,12,000 (A)
Contribution Lost (Market Share) due to faulty bats = `35,04,000 (B)
So, Total Quality Non-Conformance Cost [(A) + (B)] = `72,16,000

Statement Showing “Contribution Lost (Market Share) due to faulty bats”

Particulars ‘000

Sales (5,000 units × `4,800) 24,000

Less: Variable Cost [(`1,200 units + `2,000 + `800) × 20,000

5,000 units)]

Less: Relevant Cost of faulty bats [155units x (`2,000 + 496

1,200)]

Contribution 3,504
3%
No. of Faulty Bats = 155 (5000 𝑢𝑛𝑖𝑡𝑠 × )
97%

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 [2. 25 ]
(ii) Impact on Profitability due to implementation of inspection process
Implementing inspection process before delivery to the customer would eliminate risk of supplying
faulty bat to the customer. This would lead to improvement in customer perception, thus increasing
market share to 35%.
Additional Contribution due to increase in market share = `35,04,000 (C)
Saving in the Delivery Cost on 928 faulty bats = 928 units × `800
= ` 7,42,400 (D)
Total Increase in Profit [(C) + (D)] = ` 42,46,400

Que 12: PM
Thomson Ltd. makes and sells a single product; the unit specifications are as follows:

Direct Materials X : 8 sq. metre at ` 40 per square metre

Machine Time : 0.6 Running hours

Machine cost per gross hour : Rs. 400
Selling price : 1,000

Thomson Ltd. requires to fulfil orders for 5,000 product units per period. There are no stock of
product units at the beginning or end of the period under review. The stock level of material X
remains unchanged throughout the period.
Thomson Ltd. is planning to implement a Quality Management Programme (QPM). The
following additional information regarding costs and revenues are given as of now and after
implementation of Quality Management Programme.

Before the implementation of QMP After the implementation of QMP

5% of incoming material from suppliers scrapped due to Reduced to 3%.

poor receipt and storage organisation.
4% of material X input to the machine process is wasted Reduced to 2.5%
due to processing problems.
Inspection and storage of Material X costs ` 1 per square No change in the unit rate
metre purchased.

Inspection during the production cycle, calibration checks Reduction of 40% of the existing cost.
on inspection equipment vendor rating and other checks
cost ` 2,50,000 per period

Production Qty. is increased to allow for the Reduction to 7.5%

downgrading of 12.5% of the production units at the final
inspection stage. Down graded units are sold as seconds
at a discount of 30% of the standard selling price.

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 [2. 26 ]
Production Quantity is increased to allow for return from Reduction to 2.5%
customers (these are replaced free of charge) due to
specification failure and account for 5% of units actually
delivered to customer.
Product liability and other claims by customers is Reduction to 1%.
estimated at 3% of sales revenue from standard product
sale.
Machine idle time is 20% of Gross machine hrs used (i.e. Reduction to 12.5%.
running hour = 80% of gross/hrs.).

Sundry costs of Administration, Selling and Distribution Reduction by 10% of the

total – ` 6,00,000 per period. existing.

Prevention programme costs ` 2,00,000 Increase to ` 6,00,000.

The Total Quality Management Programme will have a reduction in Machine Run Time
required per product unit to 0.5 hr.
Required
(a) Prepare summaries showing the calculation of (i) Total production units (pre
inspection), (ii) Purchase of Materials X (square metres), (iii) Gross Machine Hours.
(b) In each case, the figures are required for the situation both before and after the
implementation of the Quality Management Programme so that orders for 5,000 product
units can be fulfilled.

(c) Prepare Profit and Loss Account for Thomson Ltd. for the period showing the profit
earned both before and after the implementation of the Total Quality Programme.

Solution-

Particulars Existing After TQM Programme

Total Production Units

(Pre inspection)

Total Sales Requirements 5,000 5,000

Specification Losses 5% 250 2.5% 125

5,250 5,125

Downgrading at Inspection 12.5 750 7.5 416

( × 5250) ( × 5125)
87.5 92.5

Total Units Before Inspection 6,000 5,541

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 [2. 27 ]
Purchase of Material ‘X’
(Sq Mtr)

Material Required to meet Pre 6,000 x 8 48,000 5,541 x 8 44,328

Inspection
Production Requirement (SqMtr)

Processing Loss 4 2,000 2.5 1,137

( × 48000) ( × 44328)
96 97.5
Input to the Process 50,000 45,465

Scrapped Material 5 2,632 3 1,406

( × 50000) ( × 45465)
95 97

Total Purchases 52,632 46,871

Gross Machine Hours

Initial Requirements 6,000 x 0.6 3,600 5,541 x 0.5 2,771

Idle Time 20 900 12.5 396

( × 3600) ( × 2771)
80 87.5
Gross Time 4,500 3,167

Profit and Loss Statement

Particulars Existing After TQM Programme

(`) (`)

Sales Revenue 5,000 Units x ` 1,000 50,00,000 5,000 Units x ` 1,000 50,00,000

Sales Downgraded 750 Units x ` 700 5,25,000 416 Units x ` 700 2,91,200

55,25,000 52,91,200

Costs:

Material 52,632 Sq Mtr x ` 40 21,05,280 46,871Sq Mtr x ` 40 18,74,840

Inspection and Storage 52,632 Sq Mtr x ` 1 52,632 46,871Sq Mtr x ` 1 46,871

Costs
Machine Cost 4,500 Hrs x ` 400 18,00,000 3,167 Hrs x ` 400 12,66,800

Inspection and Other Cost 2,50,000 ` 2,50,000 x 60% 1,50,000

Product Liability 3% x ` 50,00,000 1,50,000 1% x ` 50,00,000 50,000

Sundry Cost of Selling, 6,00,000 ` 6,00,000 x 90% 5,40,000

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 [2. 28 ]
Distribution and

Administration

Preventive Programme
2,00,000 6,00,000
Cost
51,57,912 45,28,511

Net Profit 3,67,088 7,62,689

TOTAL QUALITY MANAGEMENT (TQM)

TQM is a management philosophy that seeks to integrate all organizational functions (marketing,
finance, design, engineering, and production, customer service, etc.) to focus on meeting customer
needs and organizational objectives.

CIMA defines ‘Total Quality Management’ as

 “Integrated and comprehensive system of planning and controlling all business functions
 so that products or services are produced which meet or exceed customer expectations.
 TQM is a philosophy of business behaviour, embracing principles
 such as employee involvement, continuous improvement at all levels and customer focus,
 as well as being a collection of related techniques aimed at improving quality
 such as full documentation of activities, clear goal-setting and performance measurement from the
customer perspective.”

TQM is a management strategy aimed at embedding awareness of quality in all organizational

processes.
TQM is a comprehensive management system which:
 Focuses on meeting owner’s/ customer’s needs, by providing quality services at a reasonable
cost.
 Focuses on continuous improvement.
 Recognizes role of everyone in the organization.
 Views organization as an internal system with a common aim.
 Focuses on the way tasks are accomplished.
 Emphasizes teamwork.

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Six C’S of TQM

The Six Cs for successful implementation of a Total Quality Management (TQM) process is depicted as
follows:

1. Commitment 2. Culture 3. Continuous Improvement

•It is not sufficient to delegate •negative perceptions must be •Recognition that TQM is a
‘quality’ issues to a single changed to encourage ‘process’ not a ‘programme’
person since this will not individual contributions and necessitates that we are
provide an environment for to make ‘quality’ a normal committed in the long term
changing attitudes and part of everyone’s job to the never-ending search
breaking down the barriers to for ways to do the job better.
quality improvement.
•Such expectations must be
made clear, together with the
support and training
necessary to their
achievement.

4. Co-operation 5. Customer Focus 6. Control

•The on-the-job experience of •TQM implementations focus •The need for control
all employees must be fully entirely on the external mechanisms is necessary in
utilised and their customer to the exclusion of customer service and
involvement and co- internal relationships; they employee empowerment.
operation sought in the will not survive in the short Unless procedures are in
development of term unless they foster the place improvements cannot
improvement strategies and mutual respect necessary to be monitored and measured
associated performance preserve morale and nor deficiencies corrected
measures employee participation

Deming’s 14 Points Methodology

1) "Create constancy of purpose towards improvement". Replace short-term

reaction with long-term planning”
2) "Adopt the new philosophy". The implication is that management should
actually adopt his philosophy, rather than merely expect the workforce to do
so.
3) "Cease dependence on inspection". If variation is reduced, there is no need
to inspect manufactured items for defects, because there won’t be any.
4) "Move towards a single supplier for any one item." Multiple suppliers mean
variation between feedstock”
5) "Improve constantly and forever". Constantly strive to reduce variation.

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 [2. 30 ]
6) "Institute training on the job". If people are inadequately trained, they will
not all work the same way, and this will introduce variation.
7) "Institute leadership". Deming makes a distinction between leadership and
mere supervision. The latter is quota and target- based.
8) "Drive out fear". Deming sees management by fear as counter- productive in
the long term, because it prevents workers from acting in the organisation’s
best interests.
9) "Break down barriers between departments". Another idea central to TQM
is the concept of the ‘internal customer’, that each department serves not the
management, but the other departments that use its outputs.
10) "Eliminate slogans". Another central TQM idea is that it’s not people who
make most mistakes - it’s the process they are working within. Harassing the
workforce without improving the processes they use is counter- productive
11) "Eliminate management by objectives". Deming saw production targets as
encouraging the delivery of poor-quality goods.
12) "Remove barriers to pride of workmanship". Many of the other problems
outlined reduce worker satisfaction.
13) "Institute education and self- improvement".
14) "The transformation is everyone’s job".

The Plan–Do–Check–Act (PDCA) Cycle

Deming developed the Plan – Do – Check – Act cycle. PDCA Cycle 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.

PLAN
• Establish objectives
and develope action
plans

ACT DO
• Take corrective action • Implement the
process planned

CHECK
• Measure the
effectiveness of new
process

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Implementation Of TQM

Implementation of TQM is a strategic Decision. The first and foremost step in this process
involves collecting the data related to the organization’s current reality.
TQM will help to solve organisational problem such as a very unstable funding base, weak
administrative systems, lack of managerial skill, or poor employee morale. Management audit
helps in identifying the current levels of organizational functioning and areas in need of change.

Criticisms of TQM
 The focus on documentation of process and ill-measurable outcomes;
 The emphasis on quality assurance rather than improvement; and
 An internal focus which is at odds with the alleged customer orientation.
Carlzon has revived the customer focus with an emphasis on Total Employee Involvement (TEI)
culminating in the empowerment of the ‘front-line’ of customer service troops.
Features of empowerment:
 Loyalty to the vision of the company through the pursuit of tough, visible goals;
 Recognition of satisfied customers and motivated employees as the true assets of a company;
 Delegation of decision-making to the point of responsibility by eliminating hierarchical tiers of
authority to allow direct and speedy response to customer needs; and
 Decentralisation of management to make best use of the creative energy of the workforce.

THE BUSINESS EXCELLENCE MODEL

Business Excellence (BE) is a philosophy for
developing and strengthening the management
systems and processes of an organization to
improve performance and create value for
stakeholders

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EFQM Excellence Model

The EFQM Excellence Model (European model) provides an all-round view of the organisation and it can
be used to determine how different methods fit together and complement each other. Based on the
needs of the organisation, this model can be used with other tools of improvement to attain
sustainable excellence.
The EFQM model is a practical, non -prescriptive tool that enables organizations to understand the cause
and effect relationships between what their organisation does and the results it achieves.

3 Components of EFQM

The Fundamental, concepts of excellence

The Criteria, conceptual framework

The RADAR, logic assessment framework

(1) THE FUNDAMENTAL CONCEPTS

The Fundamental, concepts of Excellence are the basic principles that describe the essential
foundation for any organization to achieve sustainable excellence.
These fundamental concepts can be seen in figure:

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 [2. 33 ]

(2) THE EFQM EXCELLENCE MODEL CRITERIA

The EFQM conceptual model helps organizations to realize in practice the fundamental concepts and to
understand the cause- and-effect relationships between what the organization does and the results it
achieves.
The EFQM Excellence Model is also a self-assessment model for an organization that wants to assess its
level of excellence. It is based on nine criteria.
There are 5 'Enablers' and
4 'Results'.
The 'Enabler' criteria
cover what an
organization does.
The 'Results' criteria
cover what an
organization achieves.
'Results' are caused by
'Enablers'.

The dynamic nature of the

model is emphasised by the arrows as shown in the diagram. The model helps the enablers by innovation
and learning leading to improved results. The Model's nine boxes, shown above, represent the criteria
against which to assess an organisation's progress towards excellence.
Each criterion consists of a number of sub-criterion, including the elements that need to be considered
for the organization to achieve excellence in its business, and which are indicative of what can be
considered good practice; these are further evaluated using the RADAR logic assessment
framework.

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 [2. 34 ]
(3) RADAR (RESULTS – APPROACHES – DEPLOY – ASSESS -
REFINE) LOGIC ASSESSMENT FRAMEWORK
It is a management and evaluation tool for analysing the performance of an organization (refer below
figure).

It is used as an underlying basis of the scoring system of the EFQM Excellence Award and can help to
lead changes and manage improvement projects.

Baldrige Criteria For Performance Excellence

This model provides the foundation for most of the business excellence models adopted around
the world. The framework is build round the SEVEN categories i.e.
1) Leadership,
2) Strategic planning,
3) Customer and market focus,
4) Measurement analysis and knowledge management,
5) Workforce,
6) Process management and
7) Business results.

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 [2. 35 ]
Business Excellence Model & Organizational Culture

Business Excellence approach focuses on strengthening the internal function and

communication, looks towards the cultivation of strong ties with consumers and can be
incorporated into the culture.
Excellence cannot be attained if the staffs are forced to conform to certain norms. They have
to be critically managed and motivated.
Employees feel accredit when they are considered important elements in pursuit of excellence
as they learn new skills.
A feeling of association is developed and employees start believing in the management
philosophies when the organization tries to achieve excellence. For achieving business excellence
effective leadership is equally important to manage all the resources efficiently.
A strong and empathetic leader, effective communication system, employee empowerment,
employee motivation, innovative and creative culture are some of the strategies to make the
employees feel connected to the management philosophy of the organization.

THEORY OF CONSTRAINTS
During the 1980s Goldratt and Cox advocated a new approach to production management called
OPTIMISED PRODUCTION TECHNOLOGY (OPT).
OPT is based on the principle that profits are expanded by increasing the throughput of the plant. The
OPT approach determines what prevents throughput being higher by distinguishing between
bottleneck and non-bottleneck resources.
This approach advocates that bottleneck resources/activities should be fully utilised while non-
bottleneck resources/activities should not be utilized to 100% of their capacity since it would result
in increase in inventory.
Goldratt developed the concept and eventually gave it the name the Theory of Contraints (TOC).

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Operational Measures Of Theory Of Constraints

The theory of constraints focuses on revenue and cost management when faced with bottlenecks. It
advocates the use of three key measures. These are:

Based on these three measures, the objectives of management can be expressed as increasing
throughput, minimizing investment and decreasing operating expenses.

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Goldratt’s Five-Step Method For Improving Performance

The theory of constraints describes the

process of identifying and taking steps to
remove the bottlenecks that restrict
output.
The theory of constraints considers short-
run time horizons and assumes other
current operating costing to be fixed costs.

The key steps in managing bottleneck resources are as follows:

1. Identifying the System Bottlenecks:
This step involves identification of constraints which restrict output from being expanded.
2. Describe How to Exploit the Bottlenecks:
Having identified the bottlenecks it becomes the focus of attention since only the bottleneck
can restrict or enhance the flow of products. It is therefore essential to ensure that the bottleneck
activity is fully utilised. Decision regarding the optimum-mix of products to be produced by the
bottleneck activity must be made.
3. Subordinate Everything :
Else to the Decision in Step-2: This step requires that the optimum production of bottleneck
activity should determine the production schedule of the non- bottleneck activities.
Let us consider an organisation dealing with a product which requires multiple parts and processed
on different machines. With multiple parts in a product, dependencies arise among operations; some
operations cannot be started until parts from previous operations are available. Waiting time
appear for two reasons:
a. Parts that require processing at a bottleneck machine must wait in line until the bottleneck
machine is free, and
b. Parts made on non-bottleneck machines must wait until parts coming off the bottleneck
machines arrive.
Therefore, the workers of non-bottleneck machines should not be motivated to improve their
productivity if the additional output cannot be processed by bottleneck machine. Producing more
non-bottleneck output results in increase in WIP inventories and no increase in sales volume.

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Therefore, the preferred course of action is that bottleneck machine should setup pace for non-
bottleneck machine.
4. Elevate the System Bottlenecks or Increase Bottleneck Efficiency and Capacity:
This step involves taking action to remove (that is elevate) the constraint. This might involve
replacing a bottleneck machine with a faster one or providing additional training for a slow
worker or changing of the design of the product to reduce the processing time required by a
bottleneck activity.
5. Repeat the Process as a New Constraint Emerges:
If the bottleneck activity has been elevated and replaced by a new bottleneck activity it is necessary
to return to step 1 and repeat the process.

Que 13: SM
Z Plus Security (ZPS) manufactures surveillance camera equipment that are sold to various office
establishments. The firm also installs the equipment at the client’s place to ensure that it works properly.
Each camera is sold for `2,500. Direct material cost of `1,000 for each camera is the only variable cost.
All other costs are fixed. Below is the information for manufacturing and installation of this equipment:

Particulars Manufacture Installation

Annual Capacity (camera units) 750 500

Actual Yearly Production and Installation (camera 500 500

units)

Required
The questions below are separate scenarios and are not related to each other.
(i) IDENTIFY the bottleneck in the operation cycle that ZPS should focus on improving. Give
reasoning for your answer.
(ii) An improvement in the installation technique could increase the number of installations to 550
camera units. This would involve total additional expenditure of `40,000. ADVISE ZPS whether
they should implement this technique?
(iii) Engineers have identified ways to improve manufacturing technique that would increase
production by 150 camera units. This would involve a cost `100 per camera unit due to necessary
changes to made in direct materials. ADVISE ZPS whether they should implement this new
technique.
Solution:
(i) Identification of Bottleneck: Installation of cameras is the bottleneck in the operation cycle. The
annual capacity for manufacturing and installation are given to be 750 camera units and 500 camera
units respectively. Actual capacity utilization is 500 camera units, which is the maximum capacity
for the installation process. Although, ZPS can additionally manufacture 250 camera units, it is
constrained by the maximum units that can be installed. Therefore, the number of units
manufactured is limited to 500 camera units, subordinating to the bottleneck installation operation.
Therefore, ZPS should focus on improving the installation process.

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(ii) Improving Capacity of Installation Technique: Every camera sold increases the through put
contribution by `1,500 per camera unit (sale price `2,500 per camera unit less direct material cost
`1,000 per camera unit). By improving the current installation technique an additional 50 camera
units can be sold and installed. This would involve total additional expenditure of `40,000. Hence,
the incremental benefit would be:

Particulars Amount (`)

Increase in throughput contribution 75,000

(additional 50 camera units `1,500 per camera unit)

Less: Increase in total expenditure 40,000

Incremental benefit 35,000

Since the annual incremental benefit is `35,000 per annum, ZPS should implement this improvement
to installation technique, the current bottleneck operation.
(iii) Improving Manufacturing Capacity: Every camera sold increases the throughput contribution by
`1,500 per camera unit (sale price `2,500 per camera unit less direct material cost `1,000 per camera
unit). By improving the current manufacturing technique an additional 150 camera units can
produced. This would involve a cost `100 per camera unit due to necessary changes to made in direct
materials. Therefore, number of units manufactured can increase to 650 camera units. However,
production of 150 camera units will not translate into additional sales, because each sale also
requires installation by ZPS. In a year only 500 camera installations can be made, leading to an
inventory pile up of 150 camera units. This is detrimental to ZPS, since it does not earn any
contribution by holding inventory. Therefore, ZPS should not go ahead with the proposal to improve
the manufacturing technique.

Que 14: SM
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.
Information relating to products are as follows:

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 400 units 1,200 units

for)

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.

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The total of all factory costs is ₹1,42,60,000, excluding material.
Required
(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) Statement Showing Machine Hours

Product Maximum Machine Total

Demand Hours/ Unit Machine
Hours

Z 2,000 units 1.6 3,200

D 1,600 units 0.8 1,280

Total machine hours required to meet maximum demand 4,480

Machine hours available 4,000

Shortage of machine hours 480

‘Machine hours’ is the bottleneck activity

Statement of Ranking

Particulars Z D

Selling Price per unit ₹16,000 ₹4,000

Less: Material Costs per unit ₹7,000 ₹1,200

Throughput per unit ₹9,000 ₹2,800

Machine Hour Required per unit 1.6 0.8

Throughput Return per hour ₹9,000/1.6 ₹2,800/0.8

= ₹5,625 = ₹3,500

Throughput Accounting (TA) Ratio 5,625/3,565 3,500/3,565

(throughput return per hour/ cost per factory=1.58 =0.98
hour)

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Ranking I II

Cost per factory hour = ₹1,42,60,000/ 4,000 hrs. = ₹3,565

Optimum Production Plan

Product No of units Machine hr. Total Machine T/P per Total T/P
per unit hrs. hr. ₹
₹

Z (online orders) 400 1.6 640 5,625 36,00,000

D (online orders) 1,200 0.8 960 3,500 33,60,000

Z 2,400/1.6 1.6 2,400 5,625 1,35,00,000

=1,500 (b/f)

Total 2,04,60,000

Less: Total Factory Costs 1,42,60,000

Profit 62,00,000

(ii) Had there been no online booking first product Z should be produced = 2,000 units using 3,200
machine hours (2,000 × 1.6). Because of online booking already accepted for 1,200 units of product
D, unfulfilled demand of product Z = 2,000 -1,900 = 100 units.

Machine Hrs. Required for 100 units of Z (100 × 1.6) 160 hrs.

Throughput Lost for Product Z (160 hrs. × 5,625) ₹9,00,000

Throughput Return Earned for Product D (160 hrs. × 3,500) ₹5,60,000

Throughput lost ₹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.

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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.
Overall, to enhance profitability or avoid any type of loss of profit, ZED may consider the options
recommended above with a long term perspective.
(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) The life-cycle of a product has 4 stages namely Introductory stage, Growth stage, Maturity stage and
Decline stage.
Product Z is given to be in the maturity stage. This third stage of product life cycle 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.

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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. It serves as an entry barrier to
prospective competitors as well.
However, if Product D is a highly innovative product, it may adopt Skimming price policy. The product
with unique features will differentiate it from other products leading to a revolutionary impact on market
and customer behavior. Customers may not mind paying a premium for the unique product offering.
Focus may be 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.

Que 15: PM
H. Ltd. manufactures three products. The material cost, selling price and bottleneck resource details per
unit are as follows:

Particulars Product X Product Product

Y Z

Selling Price (Rs.) 66 75 90

Material & Other Variable Cost (Rs.) 24 30 40

Bottleneck Resource Time (Minutes) 15 15 20

Budgeted factory costs for the period are 2,21,600. The bottlneck resources time available is
75,120 minutes per period.
Required
(i) Company adopted throughput accounting and products are ranked according to ‘product return per
minute’. Select the highest rank product.
(ii) CALCULATE throughput accounting ratio and comment on it.

Solution:

(i) Calculation of Rank According to ‘Product Return per minute’

Particulars X Y Z

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Selling Price 66 75 90

Variable Cost 24 30 40

Throughput Contribution 42 45 50

Minutes per unit 15 15 20

Contribution per minute 2.8 3 2.5

Ranking II I III

(ii) Ranking Based on ’TA Ratio’

Contribution per minute 2.80 3.00 2.50

Factory Cost per minute (2,21,600 / 75,120) 2.95 2.95 2.95

TA Ratio (Cont. per minute / Cost per minute) 0.95 1.02 0.85

Ranking Based on TA Ratio II I III

Comment
Product Y yields more contribution compared to average factory contribution per minute, whereas X and
Z yield less.
Advantages and Disadvantages

Advantages Disadvantages

Reduction in inventory. Focus on short-term goals as opposed to long-term

with ABC.

More productive machines. Main emphasis on increasing sales and volume, not
quality as opposed to Total Quality Management.

Ability to meet shorter lead times. Might result in loss of the overall picture while looking
at specific constraints.

More flexible. Focuses on the push approach as opposed to pull

approach of JIT.

Better customer service. Valid only if applied to the total supply chain
process including management, production,
resources and support.

Better product mix. Dependent on circumstances, operating expenses

under TOC/TA are regarded as fixed, which is
Better customer relationship. simplistic in the view of detractors. Therefore, TOC and
TA are basically the same thing as variable costing.

Conclusion

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TOC/TA-based approach as a direct costing approach may be more suitable for short term product mix
decisions. This approach is clear than approaches that allocate indirect costs more or less arbitrarily
(Boyd and Cox, 2002). On balance, it may be considered that TOC should not be ignored due to the
comprehensibility of the approach. TOC is a tool and not a philosophy.

Que 16: PM
Phi Ltd. produces 4 products P, Q, R and S by using three different machines X, Y and Z.
Each machine capacity is limited to 6,000 hours per month. The details given below are for
July, 2013:

Particulars P Q R S

Selling Price p.u. (`) 10,000 8,000 6,000 4,000

Variable Cost p.u. (`) 7,000 5,600 4,000 2,800

Machine Hours Required p.u.

Machine X 20 12 4 2

Machine Y 20 18 6 3

Machine Z 20 6 2 1

Expected Demand (units) 200 200 200 200

Required
1. Find out the bottleneck activity.
2. Allocate the machine hours on the basis of the bottleneck.
3. Ascertain the profit expected in the month if the monthly fixed cost amounts
to` 9,50,000.
4. Calculate the unused spare hours of each machine

Solution:
Mach.

Time Required for Products (Hours) Total Time Machine

Time Avail. Utilization
P Q R S

4,000
2,400 800 400
(200 units
X (200 units × (200 units × (200 units × 7,600 6,000 126.67%
×
12 hours) 4 hours) 2 hours)
20 hours)

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4,000
3,600 1,200 600
(200
Y (200 units × (200 units × (200 units × 9,400 6,000 156.67%
units ×
18 hours) 6 hours) 3 hours)
20 hours)

4,000
1,200 400 200
(200
Z (200 units × (200 units × (200 units × 5,800 6,000 96.67%
units ×
6 hours) 2 hours) 1 hours)
20 hours)

Since Machine Y has the highest machine utilization it represents the bottleneck activity. Hence
Product Ranking & Resource Allocation should be based on Contribution/Machine Hour of
Machine Y.
(ii)

Allocation of Resources

Particulars P Q R S Machin Spare

e Capaci
Utilizati ty
on

Selling Price per unit (`) 10,000 8,000 6,000 4,000

Variable Cost per unit (`) 7,000 5,600 4,000 2,800

Contribution per unit (`) 3,000 2,400 2,000 1,200

Time Required in 20 18 6 3
Machine ‘Y’ (hrs.)

Contribution per Machine 150 133.33 333.33 400

Hour (`)

Rank III IV II I

Allocation of Machine ‘Y’ 4,000 200 1,200 600 6,000

time (hrs.)
(200 (Balance) (200 (200
units × units × 6 units
20 hrs.) hrs.) ×3
hrs.)

Production (units) 200 11.11 200 200

(200 hrs. /
18 hrs.)

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Allocation of Machine ‘X’ 4,000 133.32 800 400 5,333.32 666.68
time (hrs.)
(200 (11.11 (200 (200
units × units × 12 units × 4 units
20 hrs.) hrs.) hrs.) ×2
hrs.)

Allocation of Machine ‘Z’ 4,000 66.66 400 200 4,666.66 1,333.3

time (hrs.) 4
(200 (11.11 (200 (200
units × units × 6 units × 2 units
20 hrs.) hrs.) hrs.) ×1
hr.)

(iii) Calculation of Expected Profit

Particulars Amount (`)

P (200 units × ` 3,000) 6,00,000

Q (11.11 units × ` 2,400) 26,664

R (200 units × ` 2,000) 4,00,000

S (200 units × ` 1,200) 2,40,000

Total Contribution 12,66,664

Less: Fixed Cost 9,50,000

Expected Profit 3,16,664

(iv) Unused Spare

Hours Machine ‘X’

Particulars Amount (`)

Machine Hours Available 6,000.00 hrs.

Less: Machine Hours Utilized 5,333.32 hrs.

Spare Hours 666.68 hrs.

Machine ’Z’

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Particulars Amount (`)

Machine Hours Available 6,000.00 hrs.

Less: Machine Hours Utilized 4,666.66 hrs.

Spare Hours 1,333.34 hrs.

While calculating Production (units) of Product ‘Q’ on the basis of allocated hours, round
figure (complete units) can also be considered and rest of the solution will be changed
accordingly.

THROUGHPUT ACCOUNTING
Throughput term defined, by Goldratt, ‘as sales minus material and component costs. Similar to
contribution except material is considered the only variable cost’. Goldratt argues that labour costs
should be treated as fixed’. In Goldratt’s analysis ‘operating expense is all non-material costs’ and
‘inventory cost is defined as the cost of assets employed’.
Variable cost accounting presentation based on the definition of throughput (sales minus material
and component costs).
Sometimes referred to as super variable costing because only material costs are treated as variable
Throughput Accounting Ratio:

Throughput per Bottleneck Minute

Factory Cost per Bottleneck Minute

Galloway and Waldron define factory cost in the same way that Goldratt defines operating expense.
See throughput.
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. If there
was a bottleneck products could be ranked by a variant of the TA ratio (although the ranking is the
same as that derived by the use of throughput per bottleneck minute).
Other Performance Ratios suggested include:

𝑻𝒉𝒓𝒐𝒖𝒈𝒉𝒑𝒖𝒕 𝑻𝒉𝒓𝒐𝒖𝒈𝒉𝒑𝒖𝒕
𝒂𝒏𝒅
𝑳𝒂𝒃𝒐𝒖𝒓 𝑪𝒐𝒔𝒕 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑪𝒐𝒔𝒕

Que 17 - PM
BTS Ltd. produces three products A, B and C. The following information is available for a period:

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 [2. 49 ]
A B C

Contribution (per unit) ` 30 ` 25 ` 15

[Sales – Direct materials]

Machine hours required per unit of production:

Throughout Accounting
Hours
Ratio
A B C

Machine 1 10 2 4 133.33%

Machine 2 15 3 6 200.00%

Machine 3 5 1 2 66.67%
Estimated sales demand for A, B and C are 500 units each and machine capacity is limited to
6,000 hours for each machine.
Required
Analyse the above information and apply theory of constraints process to remove the constraints.
How many units of each product will be made?
Solution:
Throughout Accounting Ratio is highest for ‘Machine 2’. Accordingly ‘Machine 2’ is the
bottleneck. Total 6,000 ‘Machine 2’ hours are available.
Contribution per unit of Bottleneck Machine hour

Particulars A B C

Contribution per unit (`) …(A) 30 25 15

‘Machine 2’ Hours …(B) 15 3 6

Contribution per ‘Machine 2’ hours …(C) = (A) / (B) 2 8.33 2.50

Ranking …(D) 3 1 2

Maximum Demand …(E) 500 500 500

‘Machine 2’ Hours Required …(F) = (B) x (E) 7,500 1,500 3,000

‘Machine 2’ Hours Available …(G) 1,500* 1,500 3,000

(Balance)

Units …(H) = (G) / (B) 100 500 500

(*) [6,000 hrs – 1,500 hrs – 3,000hrs]

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SUPPLY CHAIN MANAGEMENT

The term supply chain can be referred to as the entire network of organisations working together to
design, produce, deliver and service products. In other words all activities associated with the flow and
transformation of goods from raw material to end user- is called supply chain.
The transformation of product from node to node includes activities such as
 Production Planning
 Purchasing
 Material Management
 Distribution
 Customer Service
 Forecasting

The Global Supply Chain Forum (GSCF) defines Supply chain management as the “integration
of key business processes from end user through original suppliers that provides products, services,
and information that add value for customers and other stakeholders”.

The following EIGHT supply chain management processes are included in the GSCF framework:

1) Customer Relationship Management, to manage and analyse customer’s interaction and data
throughout the life cycle with the main motive of improving business relations

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2) Supplier Relationship Management, provides the structure for how relationships with suppliers
are developed and maintained.

3) Customer Service Management, provides the key points of contact for administering product
and service agreements.

4) Demand Management, provides the structure for optimising the customer's requirements with
supply chain capabilities.

5) Order Fulfilment, includes all activities necessary to define customer requirements, design the
logistics network, and fill customer orders.

6) Manufacturing Flow Management, includes all activities necessary to move products through
the plants and to obtain, implement and manage manufacturing flexibility in the supply chain.

7) Product Development and Commercialization, provides the structure for developing and
bringing to market new products jointly with customers and suppliers.

8) Returns Management, includes all activities related to returns, reverse logistics, gatekeeping,
and avoidance.

Types Of Supply Chain- Push And Pull

Suppliers give their products to manufacturer or distributers who further send it to retailers. Although
customers are the source of the profits, they are at the end of the chain in the ‘push’ model.

Push Model
Under Push model stocks are produced on the basis of anticipated demand. Demand forecasting
can be done via a variety of sophisticated techniques may be from operations research area or data
mining.

Manufacturer Distributer Retailer Customer

 Supply to Forecast
 Production Based on Forecast
 Inventory Based on Forecast
 Stock Based on Forecast
 Purchase What is Available

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Pull Model
Under Pull model stocks are produced in response to the actual demand. This new business model
is less products centric and more directly focused on the individual consumer – a more marketing -
oriented approach.

Manufacturer Distributer Retailer Customer

 Supply to Order
 Produce to Order
 Automatically Replenish Warehouse
 Automatically Replenish Stock
 Customer Orders
Electronic connections are used in the pull model to bring out the needs of customers.
 Electronic supply chain connectivity gives end customers the opportunity to give direction to
suppliers, for example about the precise specifications of the products they want.
 Ultimately, customers have a direct voice in the functioning of the supply chain.

Upstream And Downstream Flow

A supply chain begins right from the supplier and finally ends on end customer or consumer. In the total
chain there are flows of material, information and capital or finance.
When the flow relates to supplier it is termed as upstream flow.
If the flow is with consumers or customers it is named as downstream flow. For instance,
upstream and downstream include flows as demonstrated in the below tabular format:

Upstream Downstream
Material Returns, Repairs, After-Sales Service Products, Parts

Information Orders, Point of Sale Data Capacity, Delivery Schedules

Capital / Finance Payments Invoices, Pricing, Credit Terms

Upstream Supplier Chain Management

Management of transactions with suppliers are termed as upstream supply chain management.

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Relationship
with Suppliers
Upstream Supply

Use of Information
Technology

Relationship With Suppliers

Supplier capabilities of innovation, quality, reliability and costs/price reductions and agility to
reduce risk factors all have witnessed significant changes when aligned with key suppliers.

Supplier Strategy:
To possess a commendable influence on the whole upstream flow, organization has to build up a
set of strategies which in turn results in control over suppliers.
This strategy is likely to take account of matters such as the following:
1) Sources

Location and availability of source. The bargaining power of buying organization depends on that
whether the suppliers' businesses larger or smaller than the buying organization. In the era of
globalization companies choose suppliers from different parts of world.

2) Number of Suppliers

In the event the buying company wants to avail huge discount bulk purchase from single supplier is
advisable. However, if requirement is to avoid the risk of failed deliveries organization may prefer several
or multiple suppliers.

3) Cost, Quality, and Speed of Delivery

These factors are closely interrelated and the strategy will probably need to make compromises to achieve
the right balance.

4) Make or Buy and Outsourcing

Depending upon the application of various strategic cost management techniques, decision on to produce
or to outsource.

Use of Information Technology:

E-Procurement is the electronic methods beginning from identification of the organization’s

requirements and end on payment.

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E-Procurement includes E-Sourcing, E-Purchasing and E-Payment.

1) E-Sourcing

In E-Sourcing organization provide electronic invitation to tenders and request them to submit their
quotations. Especially organization which may opt to choose tenders from different countries. E-
Sourcing is the best possible way to find out the best supplier among others. This process reduces the
cost, time and effort associated with the selection of supplier than it is required in traditional
method.

2) E-Purchasing

In recent years, organizations are shifting from centralized purchasing to decentralization. Usage of
technology has resulted in lesser time, lower cost & better result in product selection and ordering.
Features of an E-Purchasing system-
o Electronic catalogues for core/standard items.
o Recurring requisitions/shopping lists for regularly purchased items. The standard shopping lists
form the basis of regular orders and the lists can have items added or deleted for each specific order.
o Electronic purchase orders dispatched automatically through an extranet to suppliers.
o Detailed management information reporting capabilities.
3) E-Payment

After purchasing from the best possible supplier payment also takes place through electronic mode
invoicing and fund transfer. E-Payment results in faster payment with zero error which is
expected in manual form.

E-Procurement is beneficial for organization as it results in lower cost, lesser time, quick
ordering, selection of best supplier, control over inventory, better purchase and sales, greater
financial transparency etc. even a small problem in technology can crash the whole system in
few moments.

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Downstream Supply Chain Management

Management of transactions with consumers or customers are termed as downstream

supply chain management.

A) Relationship Marketing
The Relationship marketing helps the organization to keep existing customer and to attract new
customers through helpful staff, quality service / product, appropriate prices and proper customer care
etc.
Six Markets Model identifies the six key “market domain” where organizations may consider
directing their marketing activities.

1) Internal Markets Internal markets include internal departments and staff. Staff have the
ability to determine customer oriented corporate culture

2) Referral Markets Referral Markets include two main categories: existing customers who
recommend their suppliers to others and referral sources such as a
consultancy firm that may refer work to a law firm.

3) Influence Markets Influence Markets represent entities and individuals, which have the ability to
influence the marketing environment of a firm may include financial
analysts, shareholders, the business press, the government, and
consumer groups

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4) Recruitment’s Firms have to manage its relationships with recruitment markets such as
Markets commercial recruitment agencies, universities and institutes in order to
have access to potential employees who possess the required skills for the
job position.

5) Supplier’s Supplier Markets refer to traditional suppliers as well as organizations with

Markets which the firm has some form of strategic alliance to gain benefits such as
better quality, faster reach-to-market, original and creative products, and
lower levels of inventory.

6) Customer’s Customer Markets represent all existing and prospective customers as well
Markets as intermediaries. It is the way firms provide services affects the market
and helps in gaining customers.

Gordon (1998) states that there are six dimensions that illustrate how relationship marketing differs
from the historical definition.
These are that:
Relationship marketing
 seeks to create new value for customers and then share it with these customers.
 recognises the key role that customers have both as purchasers and in defining the value they wish
to receive.
 businesses are visualised to design and align process.
 represents continuous cooperative effort between buyers and sellers.
 recognises the value of customer’s purchasing lifetimes (i.e. Customer Lifetime Value).
 even searches for the chain of relations that can be drawn within the organisation. Customer’s wants
and values are created between the organisation and its main stakeholders, including suppliers,
distribution channels, intermediaries, and shareholders.

B) Customers Relationship Management

Relation includes relations with customers, assisting in customer retention and driving sales
growth. Customers under different channels are compiled through CRM.
The staff dealing with customers get a detailed information about customer’s personal
information, purchase history, buying preferences and concerns. Organizations must ensure
customers are satisfied with their products and services for higher customer retention.
In simpler words, CRM is knowing the needs of the customers and providing them with best
possible solution.
1) Analysis of Customers and their Behaviour
Analysis of customers is necessary based on geographical location or purchasing characteristics. For
industrial customer expectation of benefits - quality, discount, serviceability, size of the should be taken
into consideration.

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During such analysing process, management should keep in mind the physiological need, safety need,
social need, status/ ego need and self-fulfilment need of existing and future customers.
2) Customers Account Profitability (CAP)
Understanding the underlying components of cost and addressing specific causes of poor profitability
associated with specific customers will significantly improve bottom-line performance.
Undertaking a customer account profitability improvement initiative is a five-step process:

Customer Profitability Analysis is best conducted with a technique known as Activity Based Costing or
ABC analysis. The net profit coming from each customer which can be calculated by revenue less costs
done by this tool.

Re-engineer/
annual
r

These costs are not only manufacturing and distribution costs but also sales costs, marketing costs,
services cost and any other related costs which have to be undertaken to service the customer.
After finalisation of cost customers are divided into different profit tiers. This principle is best
observed in the banking industry with credit card as a product.
Customers are basically classified into FOUR TYPES

Platinum
Customer
Gold
Most Customer
Profitable Iron
Profitable Customer
Lead
Low Profit Customer
But
Desirable Unprofitable
&
Undesirable

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3) Customers Lifetime Value (CLV)
Customer Life time value is the present value of net profit that we derive from a customer over the
entire lifetime of relationship with that particular customer. It is the net present value of the projected
future cash flows from a lifetime of customer relationship. It is an essential tool used in marketing to focus
on more profitable customers and stop servicing non-profitable customers.
First of all, we need to ascertain the profits generated from each customer. ABC model helps in
associating direct costs and revenues to a particular customer over a period of time to ascertain the profit
margins from that particular customer.
To ascertain the lifetime value, judgments with regards to the duration of relationships have to be made.
These require detailed analysis of the strength of relationships, the likelihood, frequency and amount of
repeated or additional purchases, competitive products, customer loyalty etc.
Thus, profit margins are then discounted at the firm’s cost of capital or any other rate that may be
determined by the organisation to arrive at the CLV.

4) Customer’s Selection, Acquisition, Retention and Extension

Customer Selection – Type of customer which the company needs to target has to be selected.
 Who are we targeting?
 What is their value?
 Where do we reach them?
 Customer Acquisition – A relationship needs to be developed with in new customers.
 Methods of acquiring customers include traditional off-line techniques (e.g. advertising,
direct mail, etc.) and online techniques (e.g. search engine marketing, online PR, online
partnerships, interactive adverts, opt-in e-mail, viral marketing, etc.).
Customer Retention - Keeping existing customers.
 Emphasis on understanding customer needs to ensure better customer satisfaction.
 Ensure ongoing service quality by focussing on tangibles, reliability, responsiveness,
assurance and empathy.
 E-techniques for retaining customers are personalisation, mass customisation, extranets, opt-
in e-mail and online communities.
Customer Extension - The products bought by the customers need to be increased.
 "Re-sell" similar products to previous sales
 "Cross-sell" closely related products
 "Up-sell" more expensive products

C) The use of Information Technology in Downstream Supply Chain Management

In managing downstream supply chain organizations link their sales system to the purchasing
system of its customer through Electronic Data Change. Using E-Business, they sale products.

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Intelligence gathering is used to monitor the online customer transactions. E-mail is the way
through which organization keeps touch with customers. Use of IT results in quick action,
reduction in associated cost and saving in time.`
D) Brand Strategy
Specially branding of product makes a huge difference in its appeal to customers. Branding can be usage of logo
or specific colour or any other means which makes the product or service distinctively visible among others.

Que 18-

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.

Given that 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.

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Solution:
Customer lifetime value per subscriber can be found by calculating the present value of the revenue
that is generated over the period of 4 years. This netted out with the cost incurred to attract
subscribers, would give the customer lifetime value per subscriber.

Sr. Particulars Revenue (per PVIFA PV of Probability of Net

year) Revenue Usage Revenue
No.

1 Net cost of 5,0

attracting students 00
(onetime expense)
2 Net revenue from movie
tickets

Years 1-2 2,000 1.735 3,470 100% 3,470

Years 3-4 (refer note 1) 1,500 1.434 2,151 50% 1,076

3 Sale of food and beverages

Years 1-2 4,000 1.735 6,940 75% 5,205

Years 3-4 (refer note 2) 3,000 1.434 4,302 37.5% 1,613

4 Sale of souvenirs and

accessories

Years 1-2 2,250 1.735 3,904 25% 976

Years (refer note 3) 750 1.434 1,076 5% 54

5 Total revenue (Steps 12,394

2+3+4)

6 Net revenue from 7,394

subscription plan
(steps 5-1)

Note 1:
PVIFA (10%, 4 years) = 3.169 and PVIFA (10%, 2 years) is 1.735. Therefore , PVIF for
years 3 and 4 = PVIFA (10%, 4 years) - PVIFA (10%, 2 years) = 3.169 - 1.735 = 1.434.
Note 2:
Only 50% of the subscribers are expected to attend in years 3 and 4. Out of those only 75%
are expected to buy food and beverage. Therefore, only 38% of the subscribers (75% of 50%
subscribers who visit) are expected to buy souvenirs in years 3 and 4.

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Note 3:
Only 50% of the subscribers are expected to attend in years 3 and 4. Out of those only 10%
are expected to buy souvenirs. Therefore, only 5% of the subscribers (10% of 50%
subscribers who visit) are expected to buy souvenirs in years 3 and 4
Present value of total revenue generated over the four -year period by a customer is `12,393
while the corresponding expense is `5,000. Therefore, the customer lifetime value per
subscriber is `7,393. Cineworld has to multiply this with the expected number of subscribers
each year, to find out if this would be a profitable proposition.

More Information On Key Business Processes

1) Procurement Process
Communication systems, such as Electronic Data Interchange (EDI) and Internet Linkage, are used
by purchasing departments.
To obtain products and materials from outside suppliers, various activities involving resource
planning, supply sourcing, negotiation, order placement, inbound transportation, storage,
handling, and quality assurance, etc. have to be done many of which include the responsibility to
coordinate with suppliers on matters of scheduling, supply continuity (inventory), hedging, and research
into new sources or programs.
2) Manufacturing Flow Management Process
Flexibility in Manufacturing processes in order to respond to market changes is a must. Orders are
processes operating on a just-in-time (JIT) basis in minimum lot sizes. Thus, shorter cycle times,
would mean improved responsiveness and efficiency in meeting customer demand. This process
manages activities related to planning, scheduling, and supporting manufacturing operations,
such as work-in-process storage, handling, transportation, and time phasing of components,
inventory at manufacturing sites, etc.
3) Product Development and Commercialization
Here, customers and suppliers must be integrated into the product development process in order
to reduce the time to market.
For the firms to have a competitive edge, as product life cycles get shorter, the appropriate
products and services should be developed and successfully launched at even shorter time
schedules.
According to Lambert and Cooper (2000), managers of the product development and
commercialization process must:
1. Closely coordinate with customer relationship management so that they are able to
identify customer-articulated needs;
2. select materials and suppliers in aggregate with procurement; and
3. Enhance production technology in the manufacturing flow to manufacture and
integrate into the best supply chain flow for the given combination of product and
markets.

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Mixing the suppliers for the new product development process was shown to have a
major impact on product target cost, quality, delivery, and market share.
4) Physical Distribution
This concerns the movement of a finished product or service to customers. In
physical distribution, the customer is the final destination of a marketing channel, and
the availability of the product or service is a vital part of each channel participant's
marketing effort. It is also through the physical distribution process that the time and
space of customer service become an integral part of marketing. Thus, it links a
marketing channel with its customers (i.e., it links manufacturers, wholesalers,
and retailers).

Service Level Agreements (SLA)

An agreement between the customer and service provider is termed as a service-level
agreement.
This can be a legally binding formal or an informal "contract". The agreement may be between
separate organisation or within different teams of the organisation.
To ensure that SLAs are consistently met, agreements are often designed with specific lines of
differentiation and the parties involved are required to meet regularly to create an open
forum for communication.

Benefits Of Supply Chain

SCM fetches tangible benefits such as SCM results in information visibility

 Inventory reduction,  New/ improved processes,

 Personnel reduction,  Customer responsiveness,
 Productivity improvement;  Standardization: Flexibility &
globalization of business
 - Order management improvement
performance.
 - Financial cycle improvement etc.

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GAIN SHARING ARRANGEMENTS

Gain sharing 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. This is clearly a risky stance for the supplier,
because it 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. In this situation, the supplier could almost be described as taking an equity stake
in the customer rather than entering into a contract with it.
There must be no rewards for the suppliers to achieve a higher return through adversarial behaviour or by
hiding behind the contract.
Gain-sharing deals are, on the face of it, a win-win situation for suppliers and their customers.

OUTSOURCING

Outsourcing (also sometimes referred to as "contracting out") is a business practice used

by companies to reduce costs or improve efficiency by shifting tasks, operations, jobs or
processes to another party for a span of time.
Outsourcing is a cost- saving measure, and practising this can have a significant impact on
manufacturing.
Outsourcing is not limited to manufacturing. Giving services to customer such as those in
a call center, and computer programming jobs are also outsourced by companies seeking ways
to reduce costs.
A part of product may even be purchased from outside this would be within the purview
of outsourcing, such as components for computer equipment. The component can be purchased
for a lower cost than it would be for the company to manufacture that component themselves,
and the component may be of higher quality. Outsourcing is often an integral part of
downsizing or reengineering.
Advantages of Outsourcing
 Outsourcing helps in cost savings. The lower cost of operation and labour, and Reduction
in overhead costs makes it attractive to outsource.
 It frees an organization from investments in technology, infrastructure and people that
make up the bulk of a back-end process capital expenditure.
 It gives businesses flexibility in staffing, manpower management, helps in cost savings.

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Disadvantages of Outsourcing
 One of the biggest disadvantages is the risk of losing sensitive data and the loss of
confidentiality.
 Control of operations and deliverables of activities outsourced.
 Inexperienced worker or improper process can lead to quality problems.

-----

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CONTENTS.. 3. LEAN SYSTEM AND

INNOVATION

 Lean System
 Just In Time (JIT)
 Kaizen Costing
 5S
 Total Productive Maintenance (TPM)
 Cellular Manufacturing/ One Piece Flow
Production System
 Process Innovation
 Business Process Reengineering

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LEAN SYSTEM
Lean System is an organized method for waste minimization without sacrificing
productivity within a manufacturing system.
Lean implementation emphasizes the importance of optimizing work flow through
strategic operational procedures while minimizing waste and being adaptable.
Waste is any step or action in a process that is not required to complete a process
successfully (called “Non-Value Adding”). When Waste is removed, onlythe steps that are
required (called “Value-Adding”) to deliver a satisfactory product or service to the
customer remain in the process.

7 Types of Wastes:

Transportation

Inventory

Waiting

Motion

Over Processing

Over Production

Defects

TECHNIQUES OF LEAN SYSTEM

Six Sigma
Cellular
Manufacturi
Total ng/ One-
Productive Piece Flow
5S Maintenance Production
Kaizen (TPM) Systems
Costing
Just-in-Time
(JIT)

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Principles of Lean Manufacturing Characteristics of Lean Manufacturing
o Perfect first-time quality o Zero waiting time
o Waste minimization o Zero inventory
o Continuous improvement o Pull processing
o Flexibility o Continuous flow of production
o Continuous finding ways of
reducing process time

JUST – IN – TIME (JIT)

A just in time approach is a collection of ideas that streamline a company’s production
process activities to such an extent that wastage of all kinds viz., of time, material, and
labour is systematically driven out of the process.
CIMA defines:
Just-in-time (JIT):
“System whose objective is to produce or to procure products or components as they are
required by a customer or for use, rather than for stock. just-in-time system 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”.
Just-in-time Production:
“Production system which is driven by demand for finished products, whereby each
component on a production line is produced only when needed for the next stage”.
Just-in-time Purchasing:
Purchasing system in which material purchases are contracted so that the receipt and
usage of material, to the maximum extent possible, coincide”.

A complete JIT system begins with production, includes deliveries to a company’s

production facilities, continues through the manufacturing plant, and even includes the types of
transactions processed by the accounting system.

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suppliers on the exact date

supplier sites to examine
and at the exact time when
they are needed supplier's processes

Shorten the setup times

to operate a multitude of

machine systems
limited maintenance

“Process that vastly reduces the amount of raw materials inventory and improves the quality
of received parts”

2 ways to reduce excessive WIP inventory and detective parts-

1. Kanban Card: Which is a notification card that a downstream machine sends to
each machine that feeds it parts, authorizing the production of just enough
components to fulfill the production requirements being authorized in turn by the next
machine furtherdownstream. Thisisalsoknown as a “pull” system, sincekanbansare
initiated at the end of the production process, pulling work authorizations through the
production system. With this approach, there is no way for work-in-process
inventory to build up in the production system, since it can be created only with a
kanban authorization.
2. Group machines into working cells: A working cell is a small cluster of
machines which can berunby a singlemachineoperator.
Thisindividualmachineoperator takeseach output part from machine to machine within
the cell; and thus there is no way for work- in-process to build up between machines.
Also, this operator can immediately identify defective output which otherwise is
difficult for each machine of the cell. This configuration has the additional benefit of lower
maintenance costs since the smaller machines used in a machine cell are generally
much simpler than the large, automated machinery they replace. Also, because the
new machines are so small, it is much easier to reconfigure the production facility
when it is necessary to produce different products, avoidingthe large expense of
carefully repositioning and aligning equipment.
Both kanbans and machine cells should beused together—they are not mutually exclusive.

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JIT Aims at →
Meeting customer Providing products
Providing high at the lowest
demand in a timely quality products
manner possible total cost.

5 Features Of JIT Production System:

1. Material – handling cost are reduced.
2. Labour idle time gets reduced.
3. Apply TQM to eliminate defects. JIT creates urgency for eliminating defects as quickly
as possible.
4. Place emphasis on reducing set-up time which makes production in smaller batches
economical and reducing inventory levels. Thus, company can respond to customer
demand faster.
5. Carefully selected suppliers capable of delivering high quality materials in a timely
manner directly at the shop – floor, reducing the material receipt time.

Essential Pre-Requisites Of A JIT System

1. Low variety of goods
2. Vendor reliability
3. Good communication
4. Demand stability
5. TQM
6. Defect free materials
7. Preventive maintenance

IMPACT OF JIT ON:

A. B. C.
Product Overhead Waste
Prices Costs Costs

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A) Product Prices: When a company achieves a higher level of product quality, along with ability
to deliver products on the dates required, customers may be willing to pay a premium. This
is particularly true in industries where quality or delivery reliability is low. If customers are
highly sensitive to these two factors, it may be possible to increase prices substantially.
Alternatively, if these factors are not of great importance, or if customers place a higher
degree of importance on other factors, then there will be no opportunity for a price
increase.
B) Overhead Costs: The costs of material handling, facilities, and quality inspection decline
when a JIT system is installed. In addition, the reduction of all types of inventory results in a
massive reduction in the amount of space required for the warehouse facility. Since all costs
associated with the warehouse are assigned to the overhead cost pool, the amount of
overhead is reduced when the costs of staff, equipment, fixed assets, facilities, and rent
associated with the warehouse are sharply cut back.
C) Waste Costs: A characteristic of the JIT system is its continuous focus on eliminating all
waste from a system. This can be a waste of assets, excessive inventory. It can also be a
waste of time, in the case of assets it may include unused assets for long periods of time
(e.g., work-in- process inventory held in a production queue). It can also be a waste of
materials, such as unnecessary levels of obsolete inventory, defective products, rework, and
the like. When fully installed, a JIT system vastly reduce all these types of waste. When
this happens, there is a sharp drop in several aspects of a product’s costs.

Performance Measurements In A JIT System

 One of the key measurements in a traditional system is machine utilization:

This is used to ensure that every asset a company purchases is being thoroughly utilized.
It is particularly important in cases where there has been a large investment in automation or
large, high-speed machinery, since these items are quite expensive and should be used to the
utmost.
This is not a desirable end result in a JIT environment, where producing only what is actually
needed is the underlying rule.
Also, machine cells in a JIT system tend to be smaller and less costly than the highly
automated (and expensive) juggernauts used in more traditional systems, so there is less need
to justify the investment in these smaller machines by proving that they have been heavily
used. In short, machine utilization measurements can be discarded under JIT
environment.
 Another inappropriate measurement is any type of piece rate tracking for each
employee:
This is a common measure in the textile industry, where employees are paid extra if they
exceed certain production volume targets. However, a JIT system focuses on producing only
what is needed, so an employee who has incentives to create vast piles of parts is
producing contrary to the rules of the system. Accordingly, any piece rate system must be
eliminated and replaced with measures that focus instead on the quality of output or the
number of employee suggestions for improving the system, which are much more
important outcomes in a JIT system.

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 Any type of direct labour efficiency tracking is highly inappropriate in a JIT
system:
A JIT system does not focus on how fast an employee works—only on the quality of
the products manufactured.
Also, labour variance measurements require considerable employee time tracking, which
forces workers to fill in a time sheet, punch a clock, or use a barcoding system to track
what they are doing and what job they are working on.
All this labour tracking is a non-value-added activity, which is something a JIT system
strive to avoid as an unnecessary activity. Consequently, the management accounting
staff should advocate the complete elimination of all labour variance measurements.
 Installing a JIT system does not mean that there should be a complete elimination
of operational measures:
There are still several measures that are highly relevant to operations. Some of them
are:
i. Inventory Turnover:
Those who have installed JIT systems emphasize the extraordinarily high inventory
turnover that they now experience, which is the case in most instances. The turnover levels
of such well-known JIT companies as Toyota have been known to exceed 70 per
year, as opposed to the levels of 2 to 10 per year that are more common for companies
with other types of manufacturing systems. This measure is best subdivided into
smaller parts, so that one can determine the turnover levels for raw materials, work in
process, and finished goods.
ii. Setup Time Reduction:
The shortest possible setup intervals are crucial for the success of short production
runs, so this is a major JIT measurement.
It is best to measure it by machine, rather than in the aggregate, since an aggregate
measure does not reveal enough information about which equipment requires more setup
time reduction work.
iii. Customer Complaints:
A JIT system is partly based on the premise that product quality will be superb.
Consequently, any hint from customers that there are product problems should be
greeted with the gravest concern and investigated immediately. The accumulation of
customer complaints and their dissemination to management should be considered a
major JIT measure.
iv. Scrap:
Little waste should be generated by a JIT system, which means that materials scrap
should be driven down to exceedingly low levels. The cost of scrap (especially when
supported by a detailed list of items that were scrapped) is of particular concern as a JIT
system is being implemented, since it helps to identify problem areas requiring further
management attention.
v. Cost of quality:
One focus of JIT is on creating high-quality products, so it is reasonable to keep track of the
full cost of quality (which comprises defect control costs, failure costs, and the cost of lost
sales) on a trend line. Managers want to see the details behind this measure, so that
they know where the largest quality costs still reside in the company and can then
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work to reduce them.

vi. Customer Service:

This measure really has several components—delivering products on the dates
required by customers, shipping full orders to customers, and not having products
returned because of poor quality. This measure can be summarized in a variety of
ways or reported at the component level, but the main issue is to measure and post the
information for all to see, so that the company focuses strongly on providing the
highest possible degree of customer service.
vii. Ideas Generated:
A JIT system works best when employees pitch in with hundreds of suggestions for
improvements that, when taken in total, result in a vastly improved, efficient
operation. The amount of idea generation going on can be measured by the number
of ideas per worker, the number of ideas suggested in total, the number of ideas
implemented, or the proportion of ideas suggested that are implemented.

Back-Flushing In A JIT System

Back-flushing requires no data entry of any kind until a finished product is completed. At
that time the total amount finished is entered into the computer system, which multiplies it
by all the components listed in the bill of materials for each item produced.
This yields a lengthy list of components that should have been used in the production process
and which are subtracted from the beginning inventory balance to arrive at the amount of
inventory that should now be left on hand.

Problems with back-flushing that must be corrected before it will work properly -
 Production reporting:
₋ The total production figure entered into the system must be absolutely correct, or else
the wrong component types and quantities will be subtracted from stock.
₋ This is a particular problem when there is high turnover or a low level of training to
the production staff that records this information, which leads to errors.
 Scrap reporting:
₋ All abnormal scrap must be diligently tracked and recorded; otherwise these
materials will fall outside the black-flushing system and will not be charged to
inventory.
₋ Since scrap can occur anywhere in a production process, a lack of attention by any of
the production staff can result in an inaccurate inventory.
 Lot tracing:
₋ Lot tracing is impossible under the back-flushing system. It is required when a
manufacturer need to keep records of which production lots were used to create a
product in case all the items in a lot must be recalled.
₋ Only a picking system can adequately record this information. Some computer system
allows picking and back-flushing system to coexist, so that pick transactions for lot
tracing purpose can still be entered in the computer.
₋ Lot tracing may then still be possible if the right software is available; however, this
feature is generally present only on high-end systems.

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 Inventory accuracy:
₋ The inventory balance may be too high at all times because the back- flushing
transaction that relieves inventory usually does so only once a day, during which time
other inventory is sent to the production process; this makes it difficult to maintain an
accurate set of inventory records in the warehouse.

Benefits Of Back-Flushing
1. By making the suppliers participant in the ‘just-in-time" method of production, they
could maintain the least inventory level.

2. Suppliers could see real time the status of the supplies, bill settlement and host of other
parameters.

3. All active participants of a process, for instance, the process from a supplier to the
dealer can handle change management with the help of a particular solution and a defined
process.
4. Set up times are significantly reduced in the warehouse. Cutting down the set-up time to
be more productive allowed the company to improve their bottom line to look more
efficient.
5. Having employee focused on specific areas of the system allowed them to process
goods faster instead of having them vulnerable to fatigue from doing too many jobs at once
and simplifies the tasks at hand.
6. Increase emphasis on the supplier relationships.

KAIZEN COSTING
Lean manufacturing is founded on the idea of kaizen, or continual improvement.
Continuous improvement is the continual examination and improvement of existing
processes and is very different from approaches such as business process re-engineering
(BPR), which seeks to make radical one-off changes to improve an organization's operations
and processes.
Kaizen Costing Chart use by Daihatsu Motor Company (Osaka, Japan)

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Principles Of Kaizen Costing

1. The system seeks gradual improvements in the existing situation, at an

acceptable cost.

2. It encourages collective decision making and application of knowledge.

3. There are no limits to the level of improvements that can be implemented.

4. Kaizen involves setting standards and then continually improving these

standards to achieve long-term sustainable improvements.

5. The focus is on eliminating waste, improving systems, and improving

productivity.

6. Involves all employees and all areas of the business.

5S
5S is the name of a workplace organization method that uses a list of five Japanese words:

Seiri Seiton Seiso Seiketsu Shitsuke

(“Sort”) (“Set in order”) (“Shine”) (“Standardize”) (“Sustain”)

It explains how a work space should be organized for efficiency and effectiveness by
identifying and storing theitems used, maintaining the area and items, and sustaining
the new order.

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• Make work easier by eliminating obstacles and evaluate

necessary items with regard to cost or other factors.
Sort (Seiri)
• Reduce chances of being disturbed with unnecessary items.
Prevent accumulation of unnecessary items

• Arrange all necessary items into their most efficient and

accessible arrangements so that they can be easily selected
for use and make workflow smooth and easy.
Set In Order (Seiton) • Ensure first-in-first-out FIFO basis, so that it is easy to find
and pick up necessary items.
• Place components according to their uses, with the
frequently used components being neared to the work

• Clean your workplace on daily basis completely or set

cleaning frequency
Shine (Seiso) • Keep workplace safe, easy to work, clean and pleasing to
work in. In an unfamiliar environment, people must be able
to detect any problems within 50 feet

• Standardize the best practices in the work area.

Standardize
(Seiketsu) • Maintain high standards, orderliness, everything in order
and according to its standard

• Not harmful to anyone, training and discipline, to maintain

Sustain (Shitsuke) proper order. Training is goal-oriented process. Its resulting
feedback is necessary monthly

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TOTAL PRODUCTIVE MAINTENANCE (TPM)

Total Productive Maintenance (TPM) is a system of maintaining and improving the integrity
of production and quality systems. This is done through the machines, equipment,
processes, and employees that add to the value in Business Organisation.
TPM helps in keeping all equipment in top working condition so as to avoid breakdowns and
delays in manufacturing processes.

How TPM can be introduced in the organization?

The introduction of TPM follows 4 Main Phases:

1) Preparation 2) Introduction 3) Implementati 4) Institutionaliz

Stage: Stage: on Stage: ing stage:

• Establish a • Initialization • This is done • This is the

suitable of TPM, with the help stage of
environment information to of eight getting TPM
and suppliers, activities awards
conducting customers, referred as
programme and other eight pillars of
awareness stakeholders TPM

TPM Strategy focuses on EIGHT PILLARS of success with 5S strategy as foundation.

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Foundation & About Techniques

Pillars
Foundation: 5S TPM starts with 5S. It deals with Seiri (sort), Seiton (set in order)
organizing a workplace which Seiso, (shine), Seiketsu
helps to recognize the uncover (standardize), Shitsuke, (sustain).
problems.
P-1: Autonomous Operation of equipment without Cleaning, Lubricating, Visual
Maintenance breakdown and eliminating the Inspection, Tightening of Loosened
defects at source through active Bolts etc.
employee participation.
P-2: Focused This pillar is about the minor Kaizen Register, Kaizen Summary
Improvement improvements made on Sheet, Why-Why Analysis,
(Kaizen) continuous basis. This pillar aims Summary of Losses.
to reduce losses in the workplace
that affect efficiencies.
P-3: Planned This is proper maintenance system Preventive Maintenance,
Maintenance adopted for improvement in Breakdown Maintenance,
reliability and maintainability of Corrective Maintenance, and
equipment. It aims to have zero Maintenance Prevention.
breakdown and optimum
maintenance cost.
P-4: Early This focuses on shortening the Engineering and Re-engineering
Management time required for product and Processes.
equipment development.
P-5: Quality This is towards achieving Root Cause Analysis, Customer
Maintenance customer satisfaction through Data Analysis.
delivery of highest quality product.
P-6: Education & It aims to improve knowledge/ Training Calendar, Policies for
Training skills and enhance morale of Education and Training, On-site
employees. Training etc.
P-7: Office TPM This refers to application of TPM Analyzing processes and procedure
techniques in administration to towards increased Office
improve productivity and efficiency Automation.
in the functions with elimination of
losses.
P-8: Safety, Health, Above all the safety of worker is Drama, Safety Slogans, Quizzes,
and Environment utmost importance. It aims to have Posters Making to create awareness
zero accidents and zero health related to safety.
damages.

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Performance Measurement In TPM

The most important approach to the measurement of TPM performance is known as
Overall Equipment Effectiveness (OEE) measure. The calculation of OEE measure
requires the identification of “SIX BIG LOSSES”
1. Equipment Failure/ Breakdown
2. Set-up/ Adjustments
3. Idling and Minor Stoppages
4. Reduced Speed
5. Reduced Yield and
6. Quality Defects and Rework
The first two losses refer to time losses and are used to calculate the availability of equipment.
The third and fourth losses are speed losses that determine performance efficiency of
equipment. The last two losses are regarded as quality losses.
Performance × Availability × Quality = OEE %
OEE may be applied to any individual assets or to a process. It is unlikely that any
manufacturing process can run at 100% OEE. According to Dal et al (2000), Nakajima (1998)
suggested that ideal values for the OEE component measures are:

Availability > 90%

Performance > 95%
Quality > 99%
Accordingly, OEE at World Class Performance would be approximately 85%. Kotze
(1993) contradicted, that an OEE figure greater than 50% is more realistic and therefore more
useful as an acceptable target.

Connection Between TQM and TPM

The connection between TQM and TPM are summarized below:
 TQM and TPM make company more competitive by reducing costs, improving
customer satisfactions and slashing lead times.
 Involvement of the workers into all phases of TQM and TPM is necessary.
 Both processes need fundamental training and education of participants.
 TPM and TQM take long time to notice sustained tangible benefits.
 Commitment from top managements are necessary for success of the implementation.

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CELLULAR MANUFACTURING/ ONE PIECE FLOW

PRODUCTION SYSTEM
A Sub Section of JIT and Lean System is Cellular Manufacturing. It encompasses a group
technology. The goals of cellular manufacturing are:
 To move as quickly as possible,
 Make a wide variety of similar products,
 Making as little waste as possible.

In the assembly line multiple cells are used. Each cell comprises of one or more machines
which accomplish a certain task. The product moves from one cell to the next, each station
completing part of the manufacturing process. U-shaped design is given to these cells
because this allows for the supervisor to move less and have the ability to more readily watch
over the entire process.
Flexibility in operations is its biggest advantage. Changes are easy to make as the machines
are automatic. Variety, of product scaling is possible and minor changes to the overall design
are made possible changing the overall design.
Reduction is the extra steps gives massive Gains on implementation in productivity and
quality while simultaneously reducing the amount of inventory, space and lead time required
to create a product. It is for this reason that the one-piece-flow cell has been called "the
ultimate in lean production”.

Implementation Process
Step1: the parts to be made must be grouped by similarity (in design or manufacturing
requirements) into families.
Step2: systematic analysis of each family must be performed; typically in the form of
production flow analysis (PFA) for manufacturing families, or in the examination of
design/product data for design families. This analysis can be time consuming and costly,
but is important because a cell needs to be created for each family of parts.
Step3: There are also a number of mathematical models and algorithms to aid in
planning a cellular manufacturing center, which take into account a variety of important
variables such as, "multiple plant locations, multi-market allocations with production
planning and various part mix."
Step4: Once these variables are determined with a given level of uncertainty, optimizations
can be performed to minimize factors such as, "total cost of holding, inter-cell material
handling, external transportation, fixed cost for producing each part in each plant,
machine and labor salaries.”

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Difficulties In Creating Flow
Following difficulties need to be considered and addressed to create efficient flow in
cellular manufacturing:
 Exceptional Elements
 Machine Distances
 Bottleneck Machines and Parts
 Machine Location and Relocation
 Part Routing
 Cell Load Variation
 Inter and Intracellular Material Transferring
 Cell Reconfiguring
 Dynamic Part Demands and
 Operation and Completion Times

Benefits And Costs

Benefits
Scattered processes are merged to form short focused paths which reduces flow time,
flow distance, floor space, inventory, handling, scheduling transactions, and scrap and
rework. Thus cells lead to simplified, higher validity costing.
Production and quality controls are facilitated. The segmentation of the production process
allows problems to be easily located and it is more clear which parts are affected by the
problem.
The small cell structure improves group cohesiveness and scales the manufacturing
process down to a more manageable level for the workers.
Workers can more easily see problems or possible improvements within their own cells and tend
to be more self-motivated to propose changes. These improvements that are instigated by
the workers themselves cause less and less need for management, so over time
overhead costs can be reduced.
Costs & Limitations
Cells are typically designed to maintain a specific flow volume of parts being produced.
Should the demand or necessary quantity decrease, the cells may have to be realigned to
match the new requirements, which is a costly operation, and one not typically required in
other manufacturing setups.

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SIX SIGMA
Engineer Bill Smith introduced Six Sigma while working at Motorolain 1986.
It is quality improvement technique whose objective to eliminate defects in any aspect that
affects customer satisfaction.
The premise of Six Sigma is that by measuring defects in a process, a company can develop
ways to eliminate them and practically achieve “zero defects”.
Six sigma can be used with balanced scorecard by providing more rigorous measurement
system based on statistics.
The PRIMARY FOCUS of Six Sigma:

Primary Focus -

Customer Satisfaction
Decision Based Data-Driven Facts
Management, Improvements, Processes
Proactive Management Team
Collaboration Within Business
Goal for Perfection

Numerical Concept Of Six Sigma

'Sigma' is a statistical term that measures how far a process deviates from perfection. The
higher the sigma number, the closer the process is to perfection.
The values of Defect Percentage
Six Sigma is 3.4 defects per million opportunities or getting things right 99.99966% of
the time. It is possible to develop ways of reducing defects by measuring the level of defects
in a process and discovering the causes.

The Value of the Defect Percentage Under Various Sigma Levels

Sigma Defects per Million Percentage Percentag Quality/

Level Opportunities Defective e Yield Profitability
(DPMO) (%) (%)
1σ 6,91,462 69 31 Loss
2σ 3,08,538 31 69 Non-
Competitive

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3σ 66,807 6.7 93.3 Average Industries
4σ 6,210 0.62 99.38 Above Average
5σ 233 0.023 99.977 Below Maximum
Productivity
6σ 3.4 0.0034 99.99966 Near Perfection

The second last column (in above table) indicates the percentage of values that lie within the
control limits. The more popular measure, the number of defects per million opportunities, is
indicated in second column.
It may not be possible to achieve 'perfect Six Sigma' but relevant benefits can be achieved
from a rise from one Sigma Level to another.

Implementation Of Six Sigma

There are two methodologies for the implementation of Six Sigma-

DMAIC:
This method is very robust. It is used to improve existing business process. To produce
dramatic improvement in business process, many entities have used it successfully.

It has FIVE PHASES:

CONTROL
ANALYSE the means
DEFINE the IMPROVE the
MEASURE the process to maintaining the
problem, the process by
process to determine root improved process
project goals and addressing and
determine current causes of and future
customer eliminating the
performance. variation and process
requirements. root causes.
poor performance performance.

DMAIC is used under the following circumstances:

 A product or process exists.
 The project is part of ongoing continuous improvement process.
 Only a single process needs to be altered.
 Competitor’s actions are stable.
 Customer’s behavior is unchanging.
 Technology is stable.

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DMADV:
The application of these methods is aimed at creating a high-quality product keeping
in mind customer requirements at every stage of the product.
It is an improvement system which is used to develop new processes or products at Six
Sigma quality levels.

It has FIVE PHASES:

MEASURE and DESIGN VERIFY the

DEFINE the ANALYZE the
determine design
project goals and process options (detailed) the
customer needs performance and
customer to meet the process to meet
and ability to meet
deliverables. customer needs. customer needs.
specifications. customer needs.

DMDAV is used under the following circumstances:

 A product or process is not in existence
 Existing process has been optimised using either DMAIC or some other process.
 Project have strategic importance.
 Multiple process need to be altered.
 Competitor’s performance is changing.
 Customer’s behaviour is changing.
 Technology is growing.

Similarities between DMADV and DMAIC

 Both of these six sigma methodologies are based on defects per million opportunities
(DPMO).
 Both DMADV and DMAIC use the same kind of six sigma quality management tools.
 Customer’s needs are the basic parameter for both six sigma methodologies.

Both DMADV and DMAIC are fundamental six sigma methodologies for improving quality
of product/process.
“DMAIC deals with improving some existing process to make it align with customer’s
needs while DMADV deals with new design or redesign.”

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Difference DMAIC and DMADV

DMAIC DMADV
Review the existing processes and fixes Emphases on the design of the product and
problem(s) processes.
More reactive process. Proactive process.
Increase the capability. Increase the capacity.
Rupee benefits quantified rather quickly. Rupee benefits more difficult to quantify
and tend to be much more long term.
Examples of DMAIC problem-solving Examples of procedures that the DMADV
methods: development method is designed to
 Reduce the cycle time to process a address:
patent.  Add a new service
 Reduce the number of errors in sales  Create a real-time system.
list.  Create a multiple-source lead tracking
 Improve search time for critical system
information.

Quality-Management Tools
Six Sigma utilizes many established Quality-Management Tools. Below are just a few of
them.
1. Control Chart – It is astatistical chart, monitors variance inaprocess over time andalerts
the business to unexpected variance which may cause defects.
2. Histogram – Histogram helps in prioritizing factors and identify which are the areas that
needs utmost attention immediately.
3. Pareto Diagram – Pareto chart revolves around the concept of 80-20 rule i.e. 80% of
the defects of a process come from 20% of the causes. It focuses on the problems that have
the greatest potential for improvement.
4. Process Mapping – It is a work flow diagram of how things get done. It helps reduce
cycle time and defects.
5. Root Cause Analysis – A root cause is a factor that caused a non-conformance and
should be permanently eliminated through process improvement.
6. Statistical Process Control – The application of statistical methods to analyze data,
study and monitor process capability and performance.
7. Tree Diagram – Graphically shows the key goals, their sub-goals, and key tasks. It
inspires team members to expand their thinking when creating solutions.
8. Cause and Effects Diagrams – Cause–and–effect diagram helps in identifying the
various causes (or factors) of a given effect (orproblem).

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Limitations Of Six Sigma
1. Six Sigma focuses on quality only.
2. Six Sigma does not work well with intangible results.
3. Substantial infrastructure investment is required.
4. Six Sigma is complicated for some tasks.
5. Not all products need to meet Six Sigma standards.
6. Six Sigma focuses on specific type of process only.
7. There are lot to real time barriers which needs to be resolved while translating the
theoretical concepts into practical applications.

Lean Of Six Sigma

Lean Six Sigma is the combination of Lean and Six Sigma which help to achieve greater
results that had not been achieved if Lean or Six Sigma would have been used individually.
It increases the speed and effectiveness of any process within any organization.
It helps to Maximize Profits, Build Better Teams, Minimize Costs, and Satisfy Customers.

PROCESS INNOVATION AND BUSINESS PROCESS

REENGINEERING
BPR focuses on amending existing processes, while PI attempts to implement new
processes into an organisation. In many ways, PI is more radical than BPR, because it is
changing the overall structure of an organisation, whereas BPR is streamlining
processes that are already in place.

PROCESS INNOVATION
Process Innovation means the implementation of a new or significantly improved
production or delivery method (including significant changes in techniques, equipment
and/ or software). Changes, improvements, increase on product or service capability done
by addition in manufacturing or logical system, ceasing to use a process, simple capital
replacement or extension, changes resulting purely from changes in factor prices,
customization, regular seasonal and other cyclical changes, trading of new or significantly
improved products are not considered innovations.
The process of innovating new solutions could fall into one of these areas:
1) Production: This is related to processes, equipment and technology to enhance
manufacturing or production processes. This includes computer software.
2) Delivery: Delivery process innovations involve tools, techniques and software
solutions to help in supply chain and delivery systems. This includes barcodes,
tracking systems or shipping software.

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3) Support Services: Innovations in processes aren’t limited to simply production or
delivery, but also areas including purchasing, maintenance and accounting.

BUSINESS PROCESS REENGINEERING

Hammer defines Business Process Reengineering (BPR) as
 “The fundamental rethinking and radical redesign of business
 processes, to achieve dramatic improvements,
 in critical contemporary measures of
 performance, such as cost, quality, service, and speed.”

Business

Dramatic
Business
Processes

Thus, the four key components of BPR are as follows:

1. Fundamental rethinking of business processes requires management to challenge
the very basic assumptions under which it operates and to ask such rudimentary
questions as “Why do we do what we do?” and “Why do we do it the way we do it?”
2. Radical redesign relies on a fresh-start, clean-slate approach to examining an
organization’s business processes. This approach focuses on answers to the question,
“If we were a brand- new business, how would we operate our company?”
3. Achieving dramatic improvements in performance measurements is related to the
preceding two elements. The fundamental rethinking and radical redesign of business
processes are aimed toward making quantum leaps in performance, however measured.
BPR is not about improvement inquality, speed, andthelike thatison theorder of 10%.
For example, the reengineering of Ford’s procurement process reduced the number of
persons employed in the process by 75%.
4. Reengineering focuses on end-to-end business processes rather than on the
individual activities that comprise the processes. BPR is concerned with the results of the
process (i.e., with those activities that add value to the process). This cross- functional
focus has been used for many years by manufacturing companies. Reengineering would
apply that view to all business processes.
Example
Consider the activities such as receiving a customer’s order, checking the customer’scredit,
verifying inventory availability, accepting the order, picking the goods in the warehouse, and
shipping the goods to the customer, as discrete activities. Reengineering would change our

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emphasis bybreaking down the walls among the separate functions and departments. Instead
of order taking, picking, shipping, and so forth, the entire process of “order fulfilment” would
be examined and would concentrate on those activities that add value for the customer. The
customer is not concerned with the individual tasks that an organisation undertakes to fill an order
nor is the customer concerned with how the company organizes itself to carry out those jobs. The
customer is concerned only with getting the right goods, in the proper quantities, in
satisfactory condition, and at the agreed-upon time and price.

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PRINCIPLES OF BPR

Treat geographically dispersed

Principles of Business Process Re-
engineering
centralized

Line parallel activities instead of

integrating their results

1. Organize around outcomes, not tasks

This principle argues that an organisation should have one person perform all the steps
in a process; design the job around an objective or outcome rather than a single
task.
For example, at an electronics company a “customer service representative” takes a
customer order, translates the order into internal codes for the ordered items’ components,
requisitions, receives, and assembles the item, and delivers and installs the item. As a
result, one person is responsible for getting the item to the customer and for answering
customer questions during the process. Notice that while this eliminates many handoffs,
numerous errors, delays, and misunderstandings, it also eliminates the traditional
segregation of duties that organisations normally associate with the order fulfilment process.

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2. Have those who need the results of a process perform the process
Departments in organizations are organized around specialized functions performed for
customers for the output of other units.
In some situations, reengineering can provide “customers” with more timely service
and reduce the overhead needed to coordinate the activities of these units by having
customers provide their own service.
For example, in exchange for the promise of more timely repairs, an electronic
equipment manufacturer asked its large customers to perform some of their own routine
repairs and to carry the spare parts inventory required for their own machines. Now,
customers make some repairs themselves using spare parts stored on site. The field
service representatives, who had been making all repairs, answer customer calls and
guide customers through a repair process using a diagnosis support system (an expert
system). A computerized inventory management system monitors the spare parts
inventories. Field service representatives are dispatched only for complex problems. The
electronics manufacturer achieved better customer service and lower inventory
carrying costs.
3. Integrate the processing of information into the work process that produces the
information
At Ford Motor Company, the receiving department and the receiving system -
produced and processed information about the goods received instead of
sending it to accounts payable. The receiving system compared the goods received
with the order and took appropriate action (send the goods back or create a payable).
Notice again, the relaxing of segregation of duties. Management must evaluate and
accept the risks associated with the increased opportunity for unauthorized or
inaccurate transaction.
4. Treat geographically dispersed resources as though they were centralized
Decentralized resources typically provide better service to their customers at the
expense of creating redundant operations and lost economies of scale.
At Hewlett-Packard (HP), a major computer and peripherals manufacturer, 50
decentralized purchasing factions provided excellent responsiveness and service to the
plants, but prevented HP from benefiting from quantity discounts. After
reengineering, HP has a centralized purchasing function that creates and maintains a
centralized database of vendors with whom they have negotiated contracts.
Decentralized units can access the database to execute their own purchase orders.
5. Line parallel activities instead of integrating their results
If parallel activities have been created, use communications networks, shared
databases, and teleconferencing to coordinate activities that must eventually come
together.
For example, in the loan application process, decisions by one function that will affect
the loan decision must be immediately communicated to other functions.
6. Put the decision point where the work is performed, and build controls into the
process
Organisations can reduce non value-added management and flatten the organization

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structure if the organisations use information technology to capture and store data, and expert
systems to supply knowledge, to enable people tomake their own decisions.
This changes the role of manager from controller and supervisor to supporter and
facilitator. And, as organisations flatten, they can eliminate the middle managers who had
been summarizing and reporting information to upper management. To compensate,
executives must be directly lined to databases using executive information systems.
7. Capture information once and at the source
Collected and store data in online data-bases for all who need them. This principle is
facilitated by information technology, such as telecommunications, networking,
client/server architecture, EDI, image processing, relational database system, bare coding,
intelligent workflow software.

Main Stages Of BPR

Process Process Process Process

Identification Rationalisation Redesign Reassembly

• Each task • Process • Remainin • Reenginee

performed which are g red
being re- non value processes processes
engineere adding, to are are
d is be redesigned implement
broken discarded ed in the
down into most
a series of efficient
processes manner.

Porter’s Value Chain is commonly used in Business Process Re-engineering as a technique to

identify and analyse processes that are of strategic significance to the organization.

LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA

 [3. 27]

JUST – IN – TIME (JIT)

Que 1- SM
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 `110 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. KPL has determined that the cost of holding
inventory is `70 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 2018 as
follows:

Month Demand (Std. Hrs.)

Jan’18 3,150
Feb’18 3,760
Mar’18 4,060
Apr’18 3,350
May’18 3,650
Jun’18 4,830
Following other information is given:
(i) All other production costs are either fixed or are not driven by labour hours worked.
(ii) Production and sales occur evenly during each month and at present there is no stock at
the end of Dec’17.
(iii) The labour are to be paid for their minimum contracted hours in each month irrespective of
any purchase and production system.

Required
As a chief accountant you are requested to COMMENT on managing director’s view.

LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA

 [3. 28]

Solution
Workings
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 325 670 560 655 955 515
Inventory Holding Cost @ 22,750 46,900 39,200 45,850 66,850 36,050
70
(*) in terms of standard labour hours
Inventory Holding Cost for the six months = `2,57,600
(`22,750 + `46,900 + `39,200 + `45,850 +
`66,850 + `36,050)
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*) --- --- 260 ---- ---- 1,030
(C)
Actual Overtime Hours --- --- 273.68 ---- ---- 1,084.21
Overtime Payment @ --- --- 43,652 ---- ---- 1,72,931
159.50 [110+45%]
(*) 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 = `2,57,600 – `2,16,583
= `41,017
Comments
Though KPL is saving `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

LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA

 [3. 29]
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.

Que 2 - PM
United Video International Company (UVIC) sells package of blank video tapes to
its customer. It purchases video tapes from Indian Tape Company (ITC) @ ` 140 a
package. ITC pays all freight to UVIC. No incoming inspection is necessary because
ITC has a superb reputation for delivery of quality merchandise. Annual demand of
UVIC is 13,000 packages. UVIC requires 15% annual return on investment. The
purchase order lead time is two weeks. The purchase order is passed through Internet
and it costs ` 2 per order. The relevant insurance, material handling etc ` 3.10 per
package per year. UVIC has to decide whether or not to shift to JIT purchasing. ITC
agrees to deliver 100 packages of video tapes 130 times per year (5 times every two
weeks) instead of existing delivery system of 1,000 packages 13 times a year with
additional amount of ` 0.02 per package. UVIC incurs no stock out under its current
purchasing policy. It is estimated UVIC incurs stock out cost on 50 video tape
packages under a JIT purchasing policy. In the event of a stock out, UVIC has to
rush order tape packages which costs ` 4 per package. Comment whether UVIC
should implement JIT purchasing system.
Hindustan Tape Company (HTC) also supplies video tapes. It agrees to supply @ `
136 per package under JIT delivery system. If video tape purchased from HTC,
relevant carrying cost would be ` 3 per package against ` 3.10 in case of purchasing
from ITC. However HTC. doesn’t enjoy so sterling a reputation for quality. UVIC
anticipates following negative aspects of purchasing tapes from HTC.
— To incur additional inspection cost of 5 paisa per package.
Average stock out of 360 tapes packages per year would occur, largely resulting
from late deliveries. HTC cannot rush order at short notice. UVIC anticipates lost
contribution margin per package of ` 8 from stock out.
— Customer would likely return 2% of all packages due to poor quality of the tape
and to handle this return an additional cost of ` 25 per package.

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 [3. 30]
Required-
Comment whether UVIC places order to HTC.

Solution:

(i) Comparative ‘Statement of Cost’ for

Purchasing from ITC under ‘Current Policy’ & ‘JIT’

Particulars Current Policy JIT

(`) (`)
Purchasing Cost 18,20,000 18,20,260
(13,000 Packages × `140) (13,000 Packages ×
`140.02)
Ordering Cost 26.00 260.00
(`2 × 13 Orders) (`2 ×130 Orders)
Opportunity / 10,500.00 1,050
Carrying
(1/2 × 1,000 Packages × (1/2 × 100 Packages × `
Cost 140.02
`140 × 15%)
× 15%)
Other Carrying Cost 1,550.00 155.00
(Insurance, Material
(1/2 × 1,000 Packages × (1/2 × 100 Packages ×
Handling etc.)
`3.10)
`3.10)
Stock Out Cost --- 200
(50 Packages × `4.00)
Total Relevant Cost 18,32,076 18,21,925

Comments-
As may be seen from above, the relevant cost under the JIT purchasing policy is lower
than the cost incurred under the existing system. Hence, a JIT purchasing policy
should be adopted by the company.

Particulars JIT
(`)

Purchasing Cost 17,68,000

(13,000 Packages × `136)

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 [3. 31]
Ordering Cost 260.00
(`2 ×130 Orders)

Opportunity / Carrying Cost 1,020

(1/2 × 100 Packages × ` 136 × 15%)

Que 3 - PM
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 `110 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. KPL has determined that the cost of holding inventory is `70 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 2014 as
follows:

Month Demand (Std. Hrs.)

Jan’14 3,150
Feb’14 3,760
Mar’14 4,060
Apr’14 3,350
May’14 3,650
Jun’14 4,830
Following other information is given:
(i) All other production costs are either fixed or are not driven by labour hours
worked.
(ii) Production and sales occur evenly during each month and at present there is no
stock at the end of Dec’13.

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 [3. 32]
(iii) The labour are to be paid for their minimum contracted hours in each month
irrespective of any purchase and production system.

Required
As a chief accountant you are requested to comment on managing director’s view.
Solution:

Workings
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 @ `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 = `2,57,600

(`22,750 + `46,900 + `39,200 +
`45,850 + `66,850 + `36,050)
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 Availability* 3,800 3,800 3,800 3,800 3,800 3,800

Shortage (=Overtime*) --- --- 260 ---- ---- 1,030

(C)
Actual Overtime Hours --- --- 273.68 ---- ---- 1,084.21

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 [3. 33]
Overtime Payment --- --- 43,652 ---- ---- 1,72,931
[110+45%]
@ `159.50

(*) in terms of standard labour

hours
Total Overtime payment = `2,16,583
(`43,652 + `1,72,931)
Therefore, saving in JIT system = `2,57,600 – `2,16,583 =
`41,017
Comments
Though KPL is saving `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.

Que 4 - PM
Innovation Ltd. has entered into a contract to supply a component to a company which
manufactures electronic equipments.
Expected demand for the component will be 70,000 units totally for all the periods.
Expected sales and production cost will be

Period 1 2 3 4
Sales (units) 9,500 17,000 18,500 25,000
Variable cost per unit 30 30 32.50 35
Total fixed overheads are expected to be `14 lakhs for all the periods. The production
manager has to decide about the production plan.
The choices are:
Plan 1: Produce at a constant rate of 17,500 units per period. Inventory
LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA
 [3. 34]
holding costs will be Rs. 6.50 per unit of average inventory per period.
Plan 2: Use a just-in-Time (JIT) system
Maximum capacity per period normally ........... 18,000 units
It can produce further up to 10,000 units per period in overtime.
Each unit produced in overtime would incur additional cost equal to 30% of the
expected variable cost per unit of that period.
Assume zero opening inventory.
Required
(i) Calculate the incremental production cost and the savings in inventory holding
cost by JIT production system.
(ii) Advise the company on the choice of a plan
Solution
(i) Workings
Statement Showing ‘Inventory Holding Cost’ under Plan 1

Particulars Pd. 1 Pd. 2 Pd. 3 Pd.4

Opening Inventory …(A) --- 8,000 8,500 7,500
Add: Production 17,500 17,500 17,500 17,500
Less: Demand/ Sales 9,500 17,000 18,500 25,000
Closing Inventory …(B) 8,000 8,500 7,500 ---
Average Inventory 4,000 8,250 8,000 3,750

Inventory Holding Cost @ 26,000 53,625 52,000 24,375

`6.50

Inventory Holding Cost for the four periods = `1,56,000

(`26,000 + `53,625 + `52,000 + `24,375)
Statement Showing ‘Additional Cost-Overtime’ under Plan 2 (JIT System)
Particulars Pd. 1 Pd. 2 Pd. Pd.4
3
Demand/ Sales 9,500 17,000 18,500 25,000
Production in Normal Time 9,500 17,000 18,000 18,000
Production in Over Time …(A) --- --- 500 7,000
Variable Cost per unit 30.00 30.00 32.50 35.00
Additional Cost – Overtime per 9.00 9.00 9.75 10.50
unit…(B) (@ 30% of Variable Cost)

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 [3. 35]
Additional Cost – Overtime…(A) × --- --- 4,875 73,500
(B)
Total Additional Payment (Overtime) = `78,375
(`4,875 + `73,500)

Statement Showing ‘Additional Variable Cost*’ under Plan 2 (JIT System)

Particulars Pd. 1 Pd. 2 Pd. 3 Pd.4 Total

Production (Plan 1) 17,500 17,500 17,500 17,500 70,000

Variable Cost…(A) 5,25,000 5,25,000 5,68,750 6,12,500 22,31,250

Production (Plan 2, 9,500 17,000 18,500 25,000 70,000

JIT)
Variable Cost…(B) 2,85,000 5,10,000 6,01,250 8,75,000 22,71,250

Total …(B) – (A) 40,000

* excluding overtime cost

Incremental Production Cost in JIT System = `78,375 + `40,000
= `1,18,375
Therefore, Saving in JIT System (Net) = `1,56,000 – `1,18,375
= `37,625

(i) Advice
Though Innovation Ltd is saving `37,625 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:-
 Innovation Ltd 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.
 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.
 Innovation Ltd should also aim to improve quality at its process and design
levels with the purpose of achieving “Zero Defects” in the production process.
 Innovation Ltd should also keep in mind the efficiency of its work force.
Innovation Ltd 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

LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA

 [3. 36]
focused on a wide range of activities.

Que 5 - PM
Pearson Metal and Motor Works (PM2W) deals in manufacturing of the copper wired
electronic motor, which is specifically designed. PM2W is thinking to shift from
traditional system to JIT system as part of process innovation.
CEO among the other top bosses at PM2W are hopeful that implementation of JIT
will not only improve value in value chain for end consumer, but also improve overall
manufacturing cycle efficiency. JIT pre-implementation team was formed to evaluate
the probabilities, which collects following actual and estimated data about process;

Activity Traditional System JIT System

Category (Actual) (Estimated)
Inspection 40 30
Storage 80 20
Moving 20 10
Processing 60 40
# All data in minutes
Further, PM2W decided to practice single piece flow under JIT. PM2W received an
order which is due to manufacture and delivered for 10 such motors. Total available
production time to produce what customer demands is 480 minutes out of which it
normal practice that 30 minutes will be spent in shutdown and cleaning. CEO is also
considering JIT purchase apart from JIT production.
Required
(i) EXPLAIN just in time.
(ii) CALCULATE the ‘takt time’ and INTERPRET the results.
(iii) ADVISE whether company should shift to JIT

Solution
(i) Just-in-time (JIT) is a collection of ideas that streamline a company’s production
process activities to such an extent that wastage of all kind viz., of time, material and
labour systematically driven out of the process with single piece flow after considering
takt time.
In JIT, production facility is required to be integrated with vendor system for signal
(Kanban) based automatic supply which depends upon demand based consumption.
Under JIT system of inventory storage cost is at lowest level due to direct issue of
material to production department as and when required and resultantly less/no
material lying over in store or production floor.
Prerequisite of JIT system is integration with vendor, if vendor is not integrated
LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA
 [3. 37]
properly or less reliable, then situation of stock out can arise and which can result into
loss of contribution.
Multitasking by employee is another key feature of JIT, group of employees should be
made based upon product instead based upon function. Hence, functional allocations
of cost become less appropriate.
Overall, JIT enhance the quality into the product by eliminating the waste and
continuous improvement of productivity.
(ii) Takt Time is the maximum available time to meet the demands of the customer; this
will help to decide the speed of/ at manufacturing facility.
Takt time is the average time between the start of production of one unit and the start
of production of the next unit, when these production starts are set to match the rate of
customer demand.
Takt Time = Available Production Time
Total Quality Required
Here,
Available Production Time is ‘total available time for production’ – ‘planned downtime
i.e. spent in shutdown and cleaning’ i.e. 450 minutes = 480 minutes – 30 minutes.
Total Quantity Required is 10 units

Takt Time = 450minutes = 45 Minutes

10units
Note - Heijunka can be applied in order to reduce variation between ‘Takt times’ over
the production.
Interpretation
Customer’s demand is 10 units, to calculate the takt time, divide the available production
time (in minutes) by the total quantity required. The takt time would be 45 minutes. This
means that process must be set up to produce one unit for every 45 minutes throughout the
time available. As order volume increases or decreases, takt time may be adjusted so that
production and demand are synchronized.
(ii) Advise on Shifting to JIT
To evaluate how much of the old cycle time was spent in inventory, we need to know how
organizations assess the efficiency of their manufacturing processes. One commonly used
measure is process cycle efficiency and to calculate the same every process is breakdown
into combination of activities such as value added activities, non- value added activities
and non-value added activities but strategic activities. In order to generate highest value to
customer, only value added activities are included in process. But those non-value added
activities, which are strategic in nature, also need to be part of process. Therefore, it may be
possible that entire process is not efficient.
To measure efficiency of process, managers keep track of the relation between ‘times taken
by value added activities’ in comparison ‘total cycle time’. Such relation/ratio is processing
LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA
 [3. 38]
cycle efficiency.
Process Cycle Efficiency = Value Added Time
Cycle Time
Processing time is considered as value added time; whereas time spend on inspection,
storage and moving is non-value added time and included in cycle time. The higher the
percentage, less the time (and costs) needs to be spent on non- value added activities such
as moving and storing etc.
Computation of Processing Cycle Efficiency
Sr. Activity Category Traditional JIT System
No. System (Actual) (Estimated)

A. Inspection 40 30
B. Storage 80 20
C. Moving 20 10
D. Processing 60 40
E. Value Added Time 60 40
F. Cycle Time …(A)+(B)+(C)+(D) 200 100
Process Cycle Efficiency …(E)/ (F)×100 30% 40%

Of the 200 minutes required for manufacturing cycle under PM2W’s traditional system,
only 60 minutes were spent on actual processing. The other 140 minutes were spent on
non- value added activities, such as inspection, storage, and moving. The process cycle
efficiency formula shows that processing time equalled to 30% of total cycle time. The
cycle time is reduced substantially in the JIT system from 200 minutes to 100 minutes. In
addition to this, the amount of time that used up in inventory i.e. non-value-added activities
is also reduced. Therefore, process cycle efficiency has been increased from 30% to 40%.
This significant improvement in efficiency over the previous system comes from the
implementation of JIT system. Therefore, it is advantageous to shift to JIT system.

Que 6 - PM
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 production 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

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 [3. 39]
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 per year. Consequently, quality check and material handling cost for the
company would reduce by `1 crore per year. Similarly, insurance cost on raw
material inventory of `20 lakh per year need not be incurred any longer.
- Raw material is stored in a warehouse that costs the company rent of `3 crore
per annum. On changing to Just in time procurement, this warehouse space
would no longer be required.
Production is 1,50,000 per year. 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 000 units in a year.
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 per annum. 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 product 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

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 [3. 40]
Solution:
Implementing Just in time procurement system will benefit the company as explained
below:

Particulars Current JIT

Purchasing Procurement
Policy System
(`) (`)
Raw material procurement cost per year 12,00,00,000 15,60,00,000
Quality check and material handling cost (No 1,00,00,000 ---
longer required in JIT)
Insurance Cost on raw material inventory (No 20,00,000 ---
longer required in JIT)
Warehouse rental for storing raw material (No 3,00,00,000 ---
longer required in JIT)
Overtime Charges under JIT to reduce Stockouts --- 10,00,000
(note1)
Stockout Cost (note 2) --- 40,20,000
Total Relevant Cost 16,20,00,000 16,10,20,000
Therefore, moving to just in time procurement system results in savings of
`9,80,000 per year for the company. If reinvested, long term return on investment for the
company at 15% would yield a return of `1,47,000 per year.
In addition, by switching over to JIT system, company will also save working capital
requirement of `1 crore on account of average inventory of raw material held at present.
Company can earn further 15% on this amount i.e. `15,00,000 per year.
Therefore, total benefit for the company would be `26,27,000 per year.
Note 1: Should overtime cost be incurred to reduce Stockouts?
Contribution per unit = Sale price - Variable production cost - Variable selling, distribution
cost per unit;
Variable production cost under the just in time system =
`2,000+ `(1,040-800) = `2,240 per unit; Contribution per unit = `5,000 - `2,240-`750 per
unit = `2,010 per unit.
Overtime cost can reduce stockouts from 3,000 units to 2,000 units that is customers'
demand of 1,000 units more can be met.
Contribution earned from selling these 1,000 units = 1,000 × `2,010 per unit = `20,10,000.
Therefore, the contribution earned of `20,10,000 is more than the related overtime cost of
`10,00,000. Therefore, it is profitable to incur the overtime cost.

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 [3. 41]
Note 2: Stockout Costs
Out of the total shortfall of 3,000 units, by spending on overtime 1,000 units of demand can
be met. Therefore, actual stockout units is only 2,000 units. As explained above,
contribution per unit is `2,010 per unit.
Therefore, stockout cost = 2,000 units × `2,010 per unit = `40,20,000.
(ii) 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
whence 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

Que 7 SM
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 entity of few reputed foreign brands in the toy market and particularly
i n 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 per kg. and 5% of all materials supplied by the
suppliers are found to be substandard. Labour hour requirement fo r each toy is 0.4 hour at
`120 per hour.
Market research has determined that the 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

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 [3. 42]
year will be 50,000 toys. Sales and variable overhead per unit for the four quarters of the
year will be as follows-
Q1 Q2 Q3 Q4
(Festive (Festive
season) season)
Sales (units) 7,500 9,000 15,500 18,000

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
(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.
(iii) EXPLAIN, how implementation of JIT production method can be a major source
of competitive advantage and success of the company.

Solution:
Cost gap between Total Cost per toy as per the production plan and the Target Cost per toy
Target Cost per toy

Sr. Particulars ` per For Annual Sales of

No. unit 50,000 units

1 Selling Price per toy 240 1,20,00,000

2 Required Profit Margin 36 18,00,000
(15% of selling price =15% ×`240 per unit)
3 Target Cost per annum (Step 1 - 2) 1,02,00,000
4 Target Cost per toy (Step 3 / 50,000 units) 204.00
Therefore, Target Cost is `204 per toy.

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Total Cost as per production plan
Pixel Ltd. has an annual production requirement of 50,000 toys, which is also its annual
sales. Given that opening inventory for the first quarter is nil. The production manager
wants to produce 12,500 units per quarter irrespective of the sales demand for the quarter.
This implies that during some quarters, there might be unsold inventory, for which
inventory holding cost has to be borne. This type of production is called “produce to
stock”.
Production Schedule and Inventory Holding Cost for the year
Sr. Particulars Q1 Q2 Q3 Q4 Total for
No. the year

1 Opening Stock (units) - 5,000 8,500 5,500

2 Production (units) 12,500 12,500 12,500 12,500 50,000
3 Sales (units) 7,500 9,000 15,500 18,000 50,000
4 Closing Stock (units) (Step 1 5,000 8,500 5,500 -
+ 2 – 3)
5 Average Inventory 2,500 6,750 7,000 2,750
= (Step 1+ Step 4)/ 2
6 Inventory Holding Cost `45,000 `1,21,500 `1,26,000 `49,500 `3,42,000
(Average Inventory × `18 per
unit of Average Inventory)

Total Cost of Production per toy as per production plan

Sr. Particulars Q1 Q2 Q3 Q4 Total for
No 50,000 units
1 Direct Material Cost per `80 `80 `80 `80 `40,00,000
unit
(Note 1)
2 Direct Labour Cost per `48 `48 `48 `48 `24,00,000
unit
(Note 2)
3 Variable Overhead Cost `22 `22 `24 `25 `11,62,500
per unit
4 Total Variable Cost per `150 `150 `152 `153
unit for the quarter (other
than inventory holding
cost)
[Steps 1+ 2+3]
5 Production (units) for the 12,500 12,500 12,500 12,500 50,000

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 [3. 44]
quarter (refer production
schedule above)
6 Total Variable Cost for the `18,75,000 `18,75,000 `19,00,000 `19,12,500 `75,62,500
quarter (other than
inventory holding cost)
[Step 4 × Step 5]
7 Inventory Holding Cost for `45,000 `1,21,500 `1,26,000 `49,500 `3,42,000
the quarter (refer to the
production schedule above)
8 Fixed Overheads `6,25,000 `6,25,000 `6,25,000 `6,25,000 `25,00,000

9 Total Cost `25,45,000 `26,21,500 `26,51,000 `25,87,000 `1,04,04,500

[Step 6 + Step 7+Step 8]
10 Total Cost per toy as per `208.09
production schedule
(Step 9 / 50,000 units)

Note 1
Each toy requires 4kg of material, 5% of all materials is substandard. Therefore,
procurement should factor this substandard quality.
Material required per unit = 4 kg / 95% = 4.21 kg
Material Cost per toy produced = 4.21 kg ×`19 per kg = `80 per unit
Note 2
Each toy requires 0.40 hours. Rate per hour is `120 per hour.
Therefore, Cost per toy = 0.40 × `120 = `48 per unit
Cost Gap
= Total Cost per toy as per production schedule – Target Cost per toy
= `208.09 - `204.00 per toy
= `4.09 per toy
(ii) Just in Time Purchasing and Just in Time Production is aimed at eliminating
inventory holding of raw material and finished goods respectively. Components
are purchased only when there is a requirement in the production process.
Similarly, finished goods are produced only when there is a demand for them.
This type of production is called “produce to order”. Hence, there is neither any
opening inventory nor any closing inventory, thereby no inventory holding cost.
In the given problem, this savings is off-set by the extra payment to be made to labor for
overtime. Production capacity is 15,000 toys per quarter. This can be increased by 6,000
toys per quarter by incurring additional overtime cost.

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The Production Plan under the Just in Time System

Sr. Particulars Q1 Q2 Q3 Q4 Total
No. for the
year
1 Opening Stock (units) - - - -
2 Production (units) 7,500 9,000 15,500 18,000 50,000
3 Sales (units) 7,500 9,000 15,500 18,000 50,000
4 Closing (units) - - - -
5 Inventory Holding Cost - - - -
6 Production Beyond Capacity - - 500 3,000
of 15,000 Toys per quarter
(units)

Total Cost of Production under JIT System

Sr. Particulars Q1 Q2 Q3 Q4 Total for
No 50,000
units
1 Direct Material Cost per `76 `76 `76 `76 38,00,000
unit
(Note 1)
2 Direct Labour Cost per `48 `48 `48 `48 24,00,000
unit
3 Variable Overhead Cost `22 `22 `24 `25 11,85,000
per unit
4 Total Variable Cost per `146 `146 `148 `149
unit (Steps 1+ 2+3)
5 Production (units) for the 7,500 9,000 15,500 18,000 50,000
quarter (Refer JIT
production schedule
above)
6 Total Variable Cost for `10,95,000 `13,14,000 `22,94,000 `26,82,000 `73,85,000
the quarter (Step 4 × Step
5)

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 [3. 46]
7 Production (units) for the - - 500 3,000 3,500
quarter in excess of
capacity (Refer JIT
production schedule
above)
8 Overtime Labour Cost `0 `0 `12,000 `72,000 `84,000
for production in excess
of capacity (Note 2)
[Step 7 × 0.40 × 50%
×`120 per hour]
9 Fixed Overheads `6,25,000 `6,25,000 `6,25,000 `6,25,000 `25,00,000

10 Total Cost for production `17,20,000 `19,39,000 `29,31,000 `33,79,000 `99,69,000

under the JIT System
(Step 6
+ Step 8+ Step 9)
11 Total Cost per toy as per `199.38
production schedule
(Step 10
/ 50,000 units)

Note 1
Carefully selected suppliers of delivering high quality materials in a timely manner directly
at the shop floor, reducing the material receipt time and loss due to sub-standard material.
Note 2
Overtime wages are 150% of normal wage rate. Therefore, for every toy produced over the
quarterly production capacity of 15,000 toys, 50% extra wage over and above the hourly
rate has to be paid as overtime wages. Each toy needs 0.40 hours for production. Therefore,
overtime cost for excess production = excess production units × 0.40× 50% ×`120 per hour.
Cost Gap
The cost of production per toy under the JIT system is `199.38 per toy as compared to the
target cost of `204 per toy and save ` 4.62 per toy.
The savings primarily comes from eliminating the inventory holding cost of `3,42,000 per
annum and sub- standard material cost of `2,00,000 per annum under the previous
production system. This is slightly offset by the additional cost of `84,000 per annum that
has to be paid towards overtime labor charges and `22,500 towards additional variable
overheads. However, by switching to the JIT system, Pixel Ltd. could reduce its production
cost below the target cost per toy.

(ii) JIT system aims at:

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 [3. 47]
 Meeting customer demand in a timely manner.
 Providing high quality products and
 Providing products at the lowest possible price
The main features of the JIT production system are:
 Material handling cost is reduced – materials move from one machine to another in an
organized sequence. The production process is grouped into to manufacturing cells.
These can be managed with minimal labor. This reduces material handling costs as also
any pile up of inventory in the form of work-in- progress. In JIT procurement process,
the raw material is received only when needed. Due to significant reduction in
inventory, inventory holding costs, normal wastage cost and spoilage can be avoided.
Optimum arrangement of cells can lead to lesser floor space requirement, thereby
reducing factory rental and overhead cost.
 Multi-skilled labor: Hire and retain multi-skilled workers who are capable of
performing a variety in operations including repairs and maintenance. Therefore, a
worker is not confined to only one process in the production process. He can contribute
towards other processes as well. This reduces the workforce requirement and labor idle
time. The company can have a more efficient workforce, with lesser number of workers.
There is potential to reduce labor cost on account of this.
 Minimizing defects rework and scrap: Each stage of the production process is tightly
linked in a sequential manner. Defective output from one stage will stop the work at the
next stage. Due to this, workers can identify and correct errors or defects
instantaneously. JIT creates urgency for eliminating defects as quickly as possible since
the downstream work also stops due to error in any workstation. Production process
efficiency improves and reduces rework or scrap. The overall quality of production
improves. There are other benefits to streamlining production process: lesser need for
inspection of final output and lesser sales returns due to defects. This would contribute
to the product’s brand value .
 Reduced set-up time: Streamlined production process under JIT reduces set-up time at
the workstations. When the production process has to change to make the product per
the customers’ demands, set-up time is incurred at the workstation. By streamlining
operations, JIT system aims at reducing the set-up time, so that production can continue
with the least possible interruption. This brings flexibility in the operations since the
company can quickly change the production requirement, to make products to meet the
customer’s demand. Quick turnover improves productivity of the machine, thereby
increasing the production capacity. Lesser time is spent on set-up which is not a value
adding activity.
 Reduces lead time for receiving materials since the suppliers of raw material are
capable of delivering high quality materials in a timely manner directly at the shop.
Proper selection of such suppliers is imperative for the JIT system to be successful. If
this can be achieved, then it is beneficial for the company since inventory holding of
material is eliminated along with receiving better quality of raw material in a timely
manner
Eliminating inventory holding, scrap, material wastage, flexibility in operations by
reducing set-up time, better response time to customer’s demands, better skilled
LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA
 [3. 48]
workforce, better quality of production, lower workforce requirement, lower floor space
requirement all of these contribute towards lowering working capital requirements.
These contribute to a company’s competitive edge and success.

Que 8 - PM
Napier Company uses a backflush costing system with three trigger points:
(a) Purchase of Direct Materials
(b) Completion of Good Finished Units of Product
(c) Sales of Finished Goods
You are provided with the following information for July 2016.
Direct `2,64,000 Conversion `1,20,000
Materials Costs
Purchased Allocated
Direct `2,55,000 Costs `3,75,000
Materials Used Transferred to
Finished
Goods
Conversion `1,26,600 Cost of Goods `3,57,000
Costs Incurred Sold
Required
(i) Prepared journal entries for July (without disposing of under allocated/ over
allocated conversion costs).
(ii) Under an ideal JIT production system, how would the amounts in your journal
entries change from the journal entries in requirement (i)?

Solution

(i) Journal Entries for July are as follows

` `
E.1
Material and In-Process Inventory Control 2,64,000
Accounts Payable Control 2,64,000
(Direct Materials Purchased)

E.2
Conversion Costs Control 1,26,600
Various Accounts 1,26,600
(Conversion Cost Incurred)

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E.3
Finished Goods Control 3,75,000
Materials and In-Process Inventory Control 2,55,000
Conversion Costs Allocated 1,20,000
(Standard cost of finished goods completed)

E.4
Cost of Goods Sold 3,57,000
Finished Goods Control (Standard cost of finished goods 3,57,000
sold)

Zero inventory is the goal of an ideal JIT production system. Accordingly, entry (E.3)
would be `3,57,000 finished goods production, not `3,75,000. If the marketing division
could only sell goods costing `3,57,000, the JIT production system would call for direct
materials purchases and conversion costs lower than `2,64,000 and `1,26,600, respectively,
in entries (E.1) and (E.2).

KAIZEN COSTING

Que 9 PM
M. India Ltd. (MIL) is an automobile manufacturer in India and a subsidiary of
Japanese automobile and motorcycle manufacturer Leon. It manufactures and sells a
complete range of cars from the entry level to the hatchback to sedans and has a
present market share of 22% of the Indian passenger car markets. MIL uses a system
of standard costing to set its budgets. Budgets are set semiannually by the Finance
department after the approval of the Board of Directors at MIL. The Finance
department prepares variance reports each month for review in the Board of
Directors meeting, where actual performance is compared with the budgeted figures.
Mr. Suzuki, group CEO of the Leon is of the opinion that Kaizen costing method
should be implemented as a system of planning and control in the MIL.
Required
Recommend key changes vital to MIL’s planning and control system to support the
adoption of ‘Kaizen Costing Concepts’.

Solution:
Kaizen Costing emphasizes on small but continuous improvement. Targets once set at
the beginning of the year or activities are updated continuously to reflect the
improvement that has already been achieved and that are yet to be achieved.
The suggestive changes which are required to be adopted Kaizen Costing concepts in
MIL are as follows:
Standard Cost Control System to Cost Reduction System: Traditionally Standard
Costing system assumes stability in the current manufacturing process and standards
are set keeping the normal manufacturing process into account thus the whole effort is
on to meet performance cost standard. On the other hand Kaizen Costing believes in
continuous improvements in manufacturing processes and hence, the goal is to achieve
cost reduction target. The first change required is the standard setting methodology i.e.
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from earlier Cost Control System to Cost Reduction System.
Reduction in the periodicity of setting Standards and Variance Analysis: Under the
existing planning and control system followed by the MIL, standards are set semi-
annually and based on these standards monthly variance reports are generated for
analysis. But under Kaizen Costing system cost reduction targets are set for small
periods say for a week or a month. So the period covered under a standard should be
reduced from semi-annually to monthly and the current practice of generating variance
reports may be continued or may be reduced to a week Participation of Executives or
Workers in standard setting: Under the Kaizen Costing system participation of
workers or executives who are actually involved in the manufacturing process are
highly appreciated while setting standards. So the current system of setting budgets
and standards by the Finance department with the mere consent of Board of Directors
required to be changed.

Que 10 PM
ABC Ltd. is planning to introduce Kaizen Costing approach in its manufacturing plant.
State whether and why the following are Valid or Not in respect of Kaizen Costing.
(i) VP (Finance) is of the view that company has to make a huge initial investment
to bring a large scale modification in production process.
(ii) Head (Personnel) has made a point that introduction of Kaizen Costing does not
eliminate the training requirement of employees.
(iii) General Manager (Manufacturing) firmly believes that only shop floor
employees and workers’ involvement is prerequisite of Kaizen Costing
approach
(iv) Manager (Operations) has concerns about creation of confusion among
employees and workers regarding their roles and degradation in quality of
production.

Solution:

(i) Invalid: Kaizen Costing is the system of cost reduction procedures which
involves making small and continuous improvements to the production
processes rather than innovations or large-scale investment.
(ii) Valid: The training of employees is very much a long-term and ongoing
process in the Kaizen costing approach. Training enhances the abilities of
employees.
(iii) Invalid: Kaizen costing approach involves everyone from top management
level to the shop floor employees. Every employee’s active participation is a
must requirement.
(iv) Invalid: Though the aim of Kaizen Costing is to reduce the cost but at the
same time it also aims to maintain the quality. Kaizen costing also aims to
bring the clarity in roles and responsibilities for all employees.

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TOTAL PRODUCTIVE MAINTENANCE (TPM)

Que 11 SM
Gold Coast Company Ltd. manufactures spare parts. It works in two shifts of 8 hours for 6
days in a week. Lunch break is 45 mins and other miscellaneous breaks add up to 25
minutes. The following details are collected for the last 4 weeks by the TPM team for one
of their important equipment
Hours for Planned Preventive Maintenance = 15 minutes per shift For Breakdown
Maintenance = 6 hours total
Set up Changes = 15 hours total Power Failure = 4 hours total
Standard Cycle Time per piece = 3 minutes No of Parts Produced per shift = 120
Parts Accepted per shift = 115
Required
CALCULATE ‘OEE’.

Solution
Calculation of Shifts

Days per week …(A) 6

Shifts per week …(B) 2
Total Working Shifts per week …(C = A × B) 12
Total Weeks …(D) 4
Total Shifts …(E = C × D) 48
Calculation of Loss of Time per shift

Breakdown Maintenance ( in mins) 360

Set up Changes (in mins) 900
Power Failure (in mins) 240
Total …(A) 1,500
Loss of Minutes per shift …(A/ 48) 31.25
Add: Lunch Breaks per shift 45
Add: Other Breaks 25
Add: Preventive Maintenance 15
Total Time Loss (in Minutes) per shift 116.25

Availability Ratio = (480 mins – 116.35 mins) x 100%

480 mins

= 75.78%

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Actual Production = 120 units per shift

Standard time = 3 minutes
Standard Time Required = 120 units × 3 minutes
= 360 minutes
Actual Time Taken = 480 mins. – 116.25 mins.
= 363.75 minutes
Performance Ratio = (360 mins ) x 100 %
363.75 mins
= 98.96%

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Quality Ratio = 115h

115 parts x 100%
120 parts

= 95.83%

Thus, OEE = 0.7578 × .9896 × .9583 = 71.86%

Que 12 SM
KIWI Ltd. manufactures spare parts and can be called "high volume based"
manufacturing environment. The company is using the system of TPM 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 KIWI 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 NZ 10:

Cycle: 10 (seconds),
Spare parts Manufactured: 3,360, SCRAP: 75,
Unplanned Downtime: 36 minutes
Required
CALCULATE OEE (Overall Equipment Effectiveness) and comment on it.
Solution
Calculation of Planned Production Time
Total time (12 hrs. × 60 mins.) 720
Less: Planned downtime

break (3 × 15 mins.) 45
clean up time 10

Planned Production Time 665

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Comment
Since the OEE of KIWI Ltd 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 machine
NZ 10 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.

Que 13
Pacific Coast Company Ltd. manufactures spare parts. It works in two shifts of 9 hours for 6
days in a week. Lunch break is 30 mins and other miscellaneous breaks add up to 15 minutes.
The following details are collected for the last 4 weeks by the TPM team for one of their
important equipment
Hours for Planned Preventive Maintenance = 15 minutes per shift
For Breakdown Maintenance = 6 hours total
Set up Changes = 14 hours total
Power Failure = 4 hours total
Standard Cycle Time per piece = 3 minutes
No of Parts Produced per shift = 140
Parts Accepted per shift = 131
Required
CALCULATE ‘OEE’.

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Solution-

Calculation of Shifts
Days per week 6
Shifts per week 2
Total Working Shifts per week 12
Total Weeks 4
Total Shifts 48

Calculation of Un-Planned Downtime

Breakdown Maintenance ( in mins) 360
Set up Changes (in mins) 840
Power Failure (in mins) 240
Total 1,440
Loss of Minutes per shift 30

Calculation of Planned Production Time

Mins.
Total time (9 hrs. × 60 mins.) 540
Less: Planned downtime
Lunch break 30
Miscellaneous breaks 15
Preventive maintenance 15
Planned Production Time 480

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Que 13 SM

GVK Pharmaceuticals Ltd. is producing medication products (pills, balms etc.) and can be
called high volume based production environment. There are several different automated
production machines located in the plant, through which production of medicines is
accomplished and fulfilled the demands. Plant operates in double shift a day each consisting of 8
hours with 25 minutes’ lunch break and tea break of 10 minutes. Following data pertains to
automated machine ‘X-78’.
X-78
14 February 2020, Friday
Breakdown, repair and start up time
90 minutes
(unplanned)
Standard cycle time 2.5 minutes per tablet
Quality loss due to scrap, rework,
40 tablets
and rejection
Total quantity produced 280 tablets

Required
CALCULATE ‘OEE’

Solution

Calculation of Planned Production Time

Mins.
Total time 480
Less: Planned downtime
tea break 10
lunch break 25
Planned Production Time 445

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Que 14 SM

Hindustan Ltd. supplies the following information relating to a vital equipment used in its
production activity for April, 2020:

Total time worked during the month 210 hrs.

Total production during the month 2,800 units
No. of units accepted out of total production 2,520 units
Standard time for actual production of the month 180 hrs.
Time lost during the month 28 hrs.
Required
(i) STATE an appropriate approach to measure the total productive maintenance performance
of an equipment.
(ii) Quantify the total productive maintenance performance of the above-mentioned equipment
by using the approach stated in (i) above.
(iii) COMMENT on the effectiveness of maintenance of the equipment

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Solution
The most important approach to the measurement of TPM performance is known as Overall
Equipment Effectiveness (OEE) measure. The calculation of OEE measure requires the
identification of “six big losses”
1. Equipment Failure/ Breakdown
2. Set-up/ Adjustments
3. Idling and Minor Stoppages
4. Reduced Speed
5. Reduced Yield and
6. Quality Defects and Rework
The first two losses refer to time losses and are used to calculate the availability of equipment.
The third and fourth losses are speed losses that determine performance efficiency of equipment.
The last two losses are regarded as quality losses.
Performance × Availability × Quality = OEE %
OEE may be applied to any individual assets or to a process. It is unlikely that any
manufacturing process can run at 100% OEE.

(iii) Comment
World Class OEE is 85% or greater, Hindustan Ltd.’s OEE is somewhere around 68%. It just
means that company got some opportunities for improvement. Hindustan Ltd. may improve OEE
by collecting information related to all downtime and losses on equipment, analyzing such
information through graphs and charts, making improvement decisions thereon like autonomous
maintenance, preventive maintenance, reduction in set up time etc. and implementing the same.

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Ques 15 SM

History
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 contains 5,000 pairs when fully loaded.

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 [3. 60]
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
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.

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 [3. 61]
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 due to 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 562.904 BND (CNY28.00 × 110.10% × 18 + 8) and reduce the cost
saving to just 9.935% (62.096/ 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

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 [3. 62]
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.

-----

LEAN SYSTEM AND INNOVATION CA MANOJ SHARMA

CONTENTS.. 4. COST MANAGEMENT
TECHNIQUES

 Cost Control & Cost Reduction

 Target Costing
 Life Cycle Costing
 Pareto Analysis
 Environmental Management Accounting [EMA]
 [4 .2]

COST CONTROL & COST REDUCTION

Profit is feature of the gap between sales and cost, hence it can be enhanced either by
increasing the sale or reducing cost; & can also be maintained by controlling the cost. In the
competitive business environment, it not easy to increase the sales; hence cost reduction or
cost control, as the case may be; is available.

Cost Control
Cost control implies regulation of the cost of operation through the action of executives. It
involves setting up the targets (yardstick) for managers who are responsible for cost centres
and comparing their performance against such targets. Therefore, Cost Control involves
continuous comparisons of actual with the standards or budgets to regulate the former.

Types of Targets
Target used for purpose of cost control can be either
external or internal. Type of benchmarking (if applied Type of targets
by an
External Internal - Can be based on any
organisation) plays a crucial role in making this of following techniques;
decision. The prevailing techniques when target is
established in- house include standard costing and
Standard Costing Budgetary Control
budgetary control

Prerequisite of Cost Control

Crowningshield and Gorman in their book Cost Accounting - Principles and
Managerial Applications identified six prerequisites of cost control and these are
 Effective delegation of authority and assignment of responsibility for costs; simply
means cost centre must be designated against the name of the manager responsible for it.
 An agreed plan that sets up objectives and goals to be achieved with celerity; simply
means clearly defined targets.
 Motivation (may be finance linked or non-financial) to encourage individuals to reach
the goals established and agreed.
 Timely and efficient reporting.
 The recommendations must be followed by action.
 An effective system of follow-up to judge the effective implementation of
recommendation

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .3]

Cost Reduction
Cost reduction is the real and permanent reduction in the unit cost of goods manufactured or
service rendered without impairing the utility for the intended use. Therefore, cost reduction
is continuous effort to reduce cost through economics (standardization of product or
component) and savings in costs of manufacture, administration, selling and distribution. It
believes in reducing to cost till the optimal level rather any specified level such as standards
or budget.
Scope of Cost Reduction

Some of the important area where maximum efforts of the organization must concentrate to
reduce costs are discusses as under:
Product Design
Design of the product has a high possibility for cost reduction, because above 80% of
production cost is committed at design phase only. Since designing of the product is the
preliminary stage in the manufacturing of a product, hence the impact of any economy or
cost reduction will be felt throughout the manufacturing life of the product.

Efficient designing for a new product or improving the design for an existing product can
reduce the cost in the following manners:
 Cheaper substitute, higher yield and less quantity and varieties of materials, cause a
reduction in cost.
 Reduced time of operation and increased productivity reduce cost.
 Standardization and simplification in variety increases productivity and reduces costs.

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .4]

Organisation
It is not possible to measure the extent of the cost reduction resulting from an improvement
in organisation nevertheless, economies are bound to be achieved if the following
considerations are looked into:
 Definition of each function and responsibility.
 Proper assignment of task and delegation of responsibility to avoid overlapping
 A suitable channel of communication between various management levels.
 Co-operation and closed relationship between the various executives.
 Removal of doubts and fiction.
 Encouragement to employees for cost reduction suggestion.
Factory Lay Out Equipment
A cost reduction programme should study the factory layout and the utilisation of the existing
equipment to determine whether there is any scope of cost reduction by elimination of
wastage of men, materials and maximum utilisation of the facilities available.
The necessity for replacement of plants, introduction of new techniques or expansion of
facilities should be considered and various alternatives explored with a view to reducing
costs
Production Plan Programme and Method
Production control ensures proper planning of work by installing an efficient procedure and
programme ordering correct machine and proper utilisation of materials, manpower and
resources so that there is no waste of time and money due to waiting for components, men,
material etc. An efficient cost reduction programme should examine the following points
relating to production control.
 Whether wastage of manpower and material is kept to the minimum.
 Whether there is any scope for reducing idle capacity.
 Whether the procedures for the control of stores and maintenance services are efficient.
 Whether labour wastage may be reduced and productivity increased by eliminating faulty
production method, plant layout and designs or introducing incentive schemes.
 Whether there is scope for reduction of overhead, whether a budgetary control system is
in operation to ensure the control over overhead costs.
It may be extended to administrative, selling and distribution methods, personnel
management, purchase and material control, financial management and other services.
Tools and Techniques

For Cost Reduction the following tools and techniques can be applied
 Value Analysis
 Inventory Management (e.g. Just in Time, Backflush)
 Business Process Reengineering
 Target Costing
COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA
 [4 .5]

 Kaizen Costing
 Standarisation of product, components etc

Cost reduction v/s Cost Control

Cost Reduction Cost Control

Cost Reduction is the achievement of Cost Control involves a comparison of actual
real and permanent reduction in unit cost with the standards or budgets, to regulate the
of products manufactured. actual costs.
Realistic savings in cost. There could be temporary savings in cost.
Product’s Utility, Quality and Quality Maintenance is not a guarantee.
Characteristics are retained.
It is not concerned with maintenance of The process involves setting up a target,
performance according to standards investing variances and taking remedial
measures to correct them.
Continuous process of critical Control is achieved through compliance with
examination includes analysis and standards. Standards by themselves are not
challenge of standards. examined.
Fully dynamic approach. Less dynamic than Cost Reduction.
Universally applicable to all areas of Limited applicability to those items of cost
business. Does not depend upon for which standards can be set.
standards, though target amounts may be
set.
Emphasis here is partly on present costs Emphasis on present and past behaviour of
and largely on future costs. costs.
The function of Cost Reduction is to find Cost Control does competitive analysis of
out substitute ways and new means like actual results with established standards.
waste reduction, expense reduction and
increased production
Cost reduction is a corrective measure. Cost Control is a preventive measure.

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .6]

TARGET COSTING
Target costing is the DIFFERENCE between –

ESTIMATED SELLING PRICE

of a proposed product with specified functionality and quality
AND
The TARGET MARGIN
Cost Management Technique aims to produce and sell products that will ensure the target
margin.

Definition
“A structured approach to determining the cost at which a proposed product with specified
functionality and quality must be produced, to generate a desired level of profitability at its
anticipated selling price”

Components of Target Costing System

While designing the product, the company needs to understand what value target customers
will assign to different attributes and different aspects of quality. This requires use of
techniques like VALUE ENGINEERING AND VALUE ANALYSIS.
1) Value Engineering - Value Engineering involves searching for opportunities to
modify the design of each component or part of a product to reduce cost, but without
reducing functionality or quality of the product.
2) Value Analysis - Value Analysis is a systematic interdisciplinary examination of
factors affecting the cost of a product or service in order to devise means of achieving
the specified purpose at the required standard of quality and reliability at the target
cost

Ques 1 SM

Kowloon Toy Company (KTC) expects to successfully launch Toy “H” based on a Disney
character. KTC must may 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

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .7]

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-

Target Cost “H”

` / Toy
Target Selling Price 100.00
Less: Royalty @15% 15.00
Less: Profit @ 25% 25.00
Target Cost 60.00
Cost Structure “H”
` / 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% × 10.00
`16)
Total Cost of Manufacturing 63.00
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.
Step of Target Costing
Following are the steps to be performed while target costing applied. These steps will give
insight into the features of the target costing too.
Step 1– Re-orient culture of thinking and attitude, so that importance must be given to
market driven prices and need of customer can be prioritized rather a just technical
requirements whenever the product will be developed.
Step 2– Identify the market requirements as regards design, utility, and need for a new

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .8]

product or improvements in the existing products. (Be customer-oriented while determining

the requirements)
Note – If dealing the multiple products, perform this exercise for all product.
Step 3– Establish the market-driven target price based upon market share, the
competition, the price charged by competitors, the elasticity of demand, and strategy.
Step 3A– Determine the volume of product to be produced that will be produced at the
established market-driven target price.
Step 3B– Establish the target profit margin (for each product), based on the long-term
objectives and considering the financing aspects.
Step 4– Determine the target cost by reducing the desired/required margin from market-
driven target price. At this step, a work sheet needs to be prepared through which target cost
need to be allocated to different assemblies of the subsystem, which will be the responsibility
o f either team of or individual designer/s.
Step 4A– Establish a balance between target cost and requirement; target cost must be
seen in conjunction with requirements of customers which was identified at step two to lock
the target cost.
Step 5– Establish the target costing process (comprises the persons, their role &
responsibilities and tool & techniques to be involved in the process of target costing)
Step 6– Brainstorm and analyses the alternatives to identify the opportunity to reduce the
cost through consideration of the multiple concepts and design alternate for both the product
and its manufacturing process at each stage of the development cycle.
Step 6A– Establish product cost models (along with cost table) for each concept and design
alternate to support decision making. At early development stage model may be based upon
analogy technique and as product and process become a more defined model used must be
based upon industrial engineering or bottom-up estimating.
Step 7– Use the tools to closing down the gap between cost as determined by product cost
model in step 6A and target cost locked in step 4A. Analysis of cost reduction target can be
performed to identify cost reduction opportunities (both in design and layout of product and
processes) using Value Engineering/ Value Analysis.
Step 7A – Reduce the indirect cost applications – Re-engineer the indirect process by
eliminating the non-value-added function to minimize the cost. Use Activity Based Costing
(along- with knowledge of cost drivers) to understand how design decision impact these
indirect costs (to explore the scope of avoidance.
Step 8 – Measure the results and maintain management focus on further possibilities of
cost reduction as a continuous improvement program.

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .9]

Ques 2

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. 20,00,000

ft.

Direct Labour 90,000 hrs. 1,00,000 hrs. 10,00,000

Machine Setup 15,000 hrs. 15,000 hrs. 1,50,000

Mechanical 200,000 hrs. 200,000 hrs. 30,00,000

Assembly

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 per unit for a 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

Solution -

(i) The current cost and profit per unit are calculated as below:

Cost Component Units Actual Cost p.a. for Actual Cost per
10,000 racks (`) rack (`)

Revenue 10,000 racks 75,00,000 750

Direct Material 5,20,000 sq. ft. 20,00,000 200

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .10]

Direct Labour 1,00,000 hrs. 10,00,000 100

Machine Setup 15,000 hrs. 1,50,000 15

bx`Mechanical 200,000 hrs. 30,00,000 300

Assembly

Total Cost 61,50,000 615

Profit 13,50,000 135

Therefore, 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. In this case, 15,000
hours spent on setting up does not add value to the storage racks directly. Hence, it is a non-
value added activity.
(ii) 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) 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. = Actual cost / Actual material usage = `20,00,000 / 5,20,000
sq. ft. = `3.85 per sq. ft.
Therefore, inefficiencies resulted in extra cost = 20,000 sq. ft. × `3.85 per sq. ft. =
`77,000.
If corrective action is taken, for 10,000 racks this translates to a saving of `7.70 per
unit.
b. Inefficiencies resulted in extra 10,000 hrs. to be spent in production.
Labor cost per hr. = Actual cost / Actual labor hrs. = `10,00,000 / 10,000 hrs. = `10
per hr.
COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA
 [4 .11]

Therefore, inefficiencies resulted in extra cost = 10,000 hrs. × `10 per hour = `100,000.
If corrective action is taken, for 10,000 racks this translates to a saving of `10 per unit.
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, care 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 (process centering). 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.

Ques 3

UK Ltd. prepared a draft budget for the next year as follows:

Quantity – 10,000 units
`
Selling Price per unit 60
Variable Cost per unit
Direct Materials 16
Direct Labour (2 hrs × `6) 12
Variable Overheads (2 hrs × `1) 2
Contribution per unit 30
Total Budgeted Contribution 3,00,000
Total Budgeted Fixed Overheads 2,80,000
Total Budgeted Profit 20,000

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .12]

The board of directors are not satisfied with this draft budget and suggested the following
changes for the better profit:
(i) The budgeted profit is ` 50,000,
(ii) The company should spend ` 57,000 on advertisement and the target sales price up to
64 per unit.
(iii) It is expected that the sales volume will also rise, inspite of the price rise, to 12,000
units.
In order to achieve the extra production capacity, however, the work force must be able to
reduce the time taken to make each unit of the product. It is proposed to offer a pay and
productivity deal in which the wages rate per hour is increased to ` 8. The hourly rate for
variable overheads will be unaffected.
Required
Calculate the target labour time require to achieve the target profit.
Solution-

Statement Showing ‘Target Cost of Direct Labour & Variable Overheads’

Particulars Amount (`)
Expected Sales (` 64 × 12,000 units) 7,68,000
Less: Direct Material (` 16 × 12,000 units) 1,92,000
Advertisement Expenses 57,000
Fixed Overheads 2,80,000
Target Profit 50,000
Target Cost of Direct Labour and Variable Overheads 1,89,000

Target Labour Time Required to achieve Target Profit

Target Cost of Direct Labour and Variable Overheads
WagesRate + Variable OverheadRate
189000
8+1
= 21,000 hrs

Ques 4

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 ` 100.05 per unit.
Q : Annual production and sales of 50,000 units at a selling price of ` 150 per unit.
COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA
 [4 .13]

Direct and Indirect costs incurred on these two parts are as follows:
(` 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 700 550 1,250
Note)*
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 8.40 lakhs 14.10 lakhs
product
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 ` 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 ` 5 per unit.
 Labour cost is expected to decrease by ` 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 28 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
(i) 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.
(ii) What is the Mark-up on full cost per unit of P?
COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA
 [4 .14]

(iii) What is the Target Cost per unit for new design to maintain the same markup
percentage on full cost per unit as it had earlier? Assume cost per unit of cost drives
for the new design remains unchanged.
(iv) Will the new design achieve the cost reduction target?
(v) List four possible management actions that the NEC Ltd. should take regarding
new design.

Solution-

Working Notes
Particulars P Q
(a) Production / Sales Quantity (units) 1,00,000 50,000
(b) Batch Size (units) 1,000 500
(c) No. of Batches …(a ÷ b) 100 100
(d) Setup Time per Batch (hours) 30 36
(e) Total Setup Hours (hours) …(c × d) 3,000 3,600
(f) Machine Setup Cost ` 4,62,000
(g) 4,62,000
Cost Driver per Machine Setup Hour = = Rs.70
6,600hours

(h) Testing Time per Unit (hours) 5 9

(i) Total Testing Time (hours) …(a × h) 5,00,000 4,50,000
(j) Testing Cost `23,75,000
(k) 23,75,000
Cost Driver per Testing Hour = = Rs.2.5
9,50,000hours

(i) Statement Showing “Cost per unit- Activity Based Costing”

Particulars of Costs Basis P Q
Direct Material Direct 42,00,000 30,00,000
Direct Labour Direct 15,00,000 10,00,000
Direct Machine Cost Direct 7,00,000 5,50,000
Machine Setup Cost 3,000 hrs. @ `70 2,10,000 ----
3,600 hrs. @ `70 ---- 2,52,000
Testing Cost 5,00,000 hrs. @ `2.50 12,50,000 ----
4,50,000 hrs. @ `2.50 ---- 11,25,000
Engineering Cost Allocated 8,40,000 14,10,000
Total Cost (`) 87,00,000 73,37,000
Cost per unit (`) 87.00 146.74

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 [4 .15]

(ii) Statement Showing “Mark-up (full cost basis)- Product P”

Particulars Per unit
Selling Price 100.05
Less: Full Cost 87.00
Markup 13.05
13.05 15%
Percentage of Markup on Full Cost × 100
87

(iii) Statement Showing “Target Cost of Product P”

(After New Design is Implemented)
Particulars (`)
Target Price (given) 86.25
86.25 11.25
Mark-up × 15
115

Target Cost per unit 75.00

(iv) Statement Showing “Cost of P (New Design)”

Particulars of Basis of Costs Rate* Total Cost
Costs
Direct Material Decrease by ` 5 p.u. 37.00 37,00,000
Direct Labour Decrease by ` 2 p.u. 13.00 13,00,000
Direct Machining No Change as Machine is 7.00 7,00,000
Cost Dedicated
Machine Setup 100 Setup × 28 hrs. × ` 70 1.96 1,96,000
Cost
Testing Cost 1,00,000 units × ` 2.50 × 4 hrs. 10.00 10,00,000
Engineering Cost No Change 8.40 8,40,000
Total Cost 77.36 77,36,000
* Rate per unit
The target cost is ` 75 p.u. and estimated cost (new design) is ` 77.36 p.u. The new design
does not achieve the target cost set by NEC Ltd. Hence the target mark up shall not be
achieved.
(v) Possible Management Action
 Value engineering and value analysis to reduce the direct material costs.
 Time and motion study in order to redefine the direct labour time and related costs.
 Exploring possibility of cost reduction in direct machining cost by using appropriate
techniques.

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .16]

 Identification of non-value added activities and eliminating them in order to reduce

overheads.
 The expected selling price based on estimated cost of ` 77.36 per unit is (`77.36 +15%)
` 88.96. Introduce sensitivity analysis after implementation of new design to study the
sales quantity changes in the price range of ` 86.25 to ` 88.96.

Que 5

Ice-Cream Ltd. is engaged in production of three types of ice-cream products: Coco,

Strawberry and Vanilla. The company presently sells 50,000 units of Coco @ ` 25 per unit,
Strawberry 20,000 @ ` 20 per unit and Vanilla 60,000 units @ ` 15 per unit. The demand is
sensitive to selling price and it has been observed that every reduction of ` 1 per unit in
selling price, increases the demand for each product by 10% to the previous level. The
company has the production capacity of 60,500 units of Coco, 24,200 units of Strawberry
and 72,600 units of Vanilla. The company marks up 25% on cost of the product.
The Company management decides to apply ABC analysis. For this purpose it identifies four
activities and the rates as follows:
Activity Cost Rate
Ordering ` 800 per purchase order
Delivery ` 700 per delivery
Shelf stocking… ` 199 per hour
Customer support and assistance… ` 1.10 p.u. sold
The other relevant information for the products are as follows:
Particulars Coco Strawberry Vanilla
Direct Material p.u. (`) 8 6 5
Direct Labour p.u. (`) 5 4 3
No. of Purchase Orders 35 30 15
No. of Deliveries 112 66 48
Shelf Stocking Hours 130 150 160
Under the traditional costing system, store support costs are charged @ 30% of prime cost.
In ABC these costs are coming under customer support and assistance.
Required
(i) Calculate target cost for each product after a reduction of selling price required to
achieve the sales equal to the production capacity.
(ii) Calculate the total cost and unit cost of each product at the maximum level using
traditional costing.

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 [4 .17]

(iii) Calculate the total cost and unit cost of each product at the maximum level using
activity based costing.
(iv) Compare the cost of each product calculated in (i) and (ii) with (iii) and comment on
it.
Solution-

(i) Cost of Products Under ‘Target Costing’

Statement Showing “Demanded Unit and Selling Price”
Coco Strawberry Vanilla
Selling Demand Selling Demand Selling Demand
Price Price Price
25 50,000 20 20,000 15 60,000
24 55,000 19 22,000 14 66,000
23 60,500 18 24,200 13 72,600

Statement Showing “Cost per unit”

Particulars Coco Strawberr Vanilla
y
Selling Price after reduction 23.00 18.00 13.00

Profit Mark up 25% on Cost 4.60 3.60 2.60

(20 % on Selling Price)

Target Cost of Production (per unit) 18.40 14.40 10.40

(ii) Cost of Product Under ‘Traditional Costing’

Statement Showing “Cost per unit”
Particulars Coco (`) Strawberry Vanilla (`)
(`)
Units 60,500 24,200 72,600
Material Cost per unit 8.00 6.00 5.00
Labour Cost per unit 5.00 4.00 3.00
Prime Cost per unit 13.00 10.00 8.00
Store Support Costs (30% of Prime) 3.90 3.00 2.40
Cost per unit 16.90 13.00 10.40

(iii) Cost of Product Under ‘Activity Based Costing’

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 [4 .18]

Statement Showing “Cost per unit”

Particulars Coco (`) Strawberry (`) Vanilla (`)

Units 60,500 24,200 72,600

Material Cost 4,84,000 1,45,200 3,63,000
Labour Cost 3,02,500 96,800 2,17,800
Prime Cost 7,86,500 2,42,000 5,80,800
Ordering Cost @ ` 800 (35, 30, 15) 28,000 24,000 12,000
Delivery Cost @ ` 700 (112, 66, 48) 78,400 46,200 33,600
Shelf Stocking @ ` 199 25,870 29,850 31,840
(130,150,160)
Customer Support ` 1.10 66,550 26,620 79,860
Total Cost 9,85,320 3,68,670 7,38,100
Cost Per unit 16.29 15.23 10.17

(iv) Comparative Analysis of ‘Cost of Production’

Particulars Coco (`) Strawberry (`) Vanilla (`)

(a) As per Target Costing 18.40 14.40 10.40

(b) As per Traditional Costing 16.90 13.00 10.40
(c) As per Activity Based Costing 16.29 15.23 10.17
(a) – (c) 2.11 (-) 0.83 0.23
(b) – (c) 0.61 (-) 2.23 0.23

Comment
The cost of product of strawberry is higher in ABC method in comparison to target costing
and traditional methods. It indicated that actual profit under ABC is less than targeted. For
remaining two products, ABC is most suitable.

Ques 6

Transnet Ltd. is engaged in the production of four products: A, B, C and D. The price charged
for the four products are ` 180, ` 175, ` 130 and ` 180 respectively, Market research has
indicated that if Transnet Ltd can reduce the selling prices of its products by ` 5, it will be
successful in getting bulk orders and gain a significant share of market of those products.
The company’s profit markup is 25 per cent on cost of the product. The relevant information
of products are as follows:

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Products A B C D
Output in units 600 500 400 600
Cost per unit -
Direct material (in `) 40 50 30 60
Direct labour (in `) 28 21 14 21
Machine hours (per unit) 4 3 2 3
The four products are usually produced in production runs of 20 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 overheads for the period has been analysed as follows:
(`)
Machine department costs…………………………………… .. 52,130
Setup costs… 26,250
Stores receiving… 18,000
Inspection / Quality control… 10,500
Material handling and dispatch… 23,100

The cost drivers to be used for the overhead costs are as follows:
Cost.. Cost drivers
Setup costs… Number of production runs
Store receiving… Requisitions raised
Inspection / Quality control… Number of production runs
Materials handling and dispatch Order executed
The number of requisitions raised in the stores was 100 for each product and the number of
orders executed was 210, each order being for a batch of 10 units of a product.
Required
(i) To compute the target cost for each product.
(ii) To compute total cost of each product using activity based costing.
(iii) Compare target cost and activity based cost of each product and comment
whether the price reduction is profitable or not.

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Solution-

(i) Statement Showing “Target Cost of Product A, B, C, D”

Product Present Price Proposed Target Cost (`)
(`) Price (`) (with 25% Margin)
A 180 175 140
B 175 170 136
C 130 125 100
D 180 175 140

(ii) Statement Showing “Cost/unit of Driver- ABC’

Cost Amount Driver No. Cost / unit
of Driver (`)
Setups 26,250 Production 105 250.00
Runs
Stores Receiving 18,000 Requisition 400 45.00
Inspection / Quality 10,500 Production 105 100.00
Runs
Handling / Dispatch 23,100 Orders 210 110.00
Machine Department 52,130 Machine Hrs. 6,500 8.02

Production Runs = 105

600 𝑢𝑛𝑖𝑡𝑠 500 𝑢𝑛𝑖𝑡𝑠 400 𝑢𝑛𝑖𝑡𝑠 600 𝑢𝑛𝑖𝑡𝑠
+ + +
20 𝑢𝑛𝑖𝑡𝑠 20 𝑢𝑛𝑖𝑡𝑠 20 𝑢𝑛𝑖𝑡𝑠 20 𝑢𝑛𝑖𝑡𝑠

No. of Requisitions = 400

[100 for each product]
Machine Hours = 6,500 hours
[600 units x 4 hrs. + 500 units x 3 hrs. + 400 units
x 2 hrs. + 600 units x 3 hrs.]
No. of Orders = 210
600 𝑢𝑛𝑖𝑡𝑠 500 𝑢𝑛𝑖𝑡𝑠 400 𝑢𝑛𝑖𝑡𝑠 600 𝑢𝑛𝑖𝑡𝑠
+ + +
10 𝑢𝑛𝑖𝑡𝑠 10 𝑢𝑛𝑖𝑡𝑠 10 𝑢𝑛𝑖𝑡𝑠 10 𝑢𝑛𝑖𝑡𝑠

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Statement Showing “Total Cost & Cost per unit- ABC”

Particulars of A B C D
Costs (`) (`) (`) (`)
Direct Material 24,000 25,000 12,000 36,000
Direct Labour 16,800 10,500 5,600 12,600
7,500 6,250 5,000 7,500
Setup
[ 30Runsx`250] [ 25Runsx`250] [ 20Runsx`250] [ 30Runsx`250 ]
Stores 4,500 4,500 4,500 4,500
Receiving [ 100Req.x`45 ] [ 100Req.x`45 ] [100Req.x`45] [100Req.x`45]
Inspection / 3,000 2,500 2,000 3,000
Quality [ 30Runsx`100 ] [25Runsx`100] [20Runsx`100] [30Runsx`100]
6,600
Handling / 6,600 5,500 4,400
[60
Dispatch [60 Ordersx`110] [50 Ordersx`110] [40 Ordersx110]
Ordersx`110]
12,030 14,436
Machine Dept. 19,248 6,416
[1,500hrs.x`8.0 [1,800hrs.x`8.
Cost [2,400hrs.x`8.02] 2]
[800hrs.x`8.02]
02]
Total Cost 81,648 66,280 39,916 84,636
Output (Units) 600 500 400 600
Cost per unit 136.08 132.56 99.79 141.06

(iii) Statement Showing “Target Cost Vs Actual Cost”

Cost A B C D
(`) (`) (`) (`)
Actual 136.08 132.56 99.79 141.06
Target 140.00 136.00 100.00 140.00
Difference (-) 3.92 (-) 3.44 (-) 0.21 (+) 1.06

Comment
The total actual cost of A, B and C product is less than the target cost so there is no Que in
reducing the cost of these product by ` 5 from the present price. It will increase the
profitability of the company but the cost of D is slightly more than the target cost, it is
therefore, suggested that the company should either control it or redesign it.

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Ques 7

Speedo Limited is a specialist car manufacturer that produces various models of cars. The
organization is due to celebrate its 100th anniversary next year. To mark the occasion,
Speedo Limited intends to produce a sports car; the Model Royal. As this will be a special
edition, production will be limited to 1,000 numbers of Model Royal Cars.
Speedo Limited is considering using a target costing approach and has conducted market
research to determine the features that consumers require in a sports car. Based on this market
research and knowledge of competitor’s products, company has decided to price the Model
Royal at ` 9.75 Lacs. Company requires an operating profit margin of 25% of the selling
price of the car. Details for the forthcoming year are as follows:
Forecast of direct costs for a Model Royal Car-
Labour ` 2,50,000
Material ` 4,75,000

Forecast of annual overhead costs-

` in Lacs Cost Driver
Production Line Cost 2,310 See Note 1
Transportation Costs 900 See Note 2

Note 1
The production line that would be used for Model Royal has a capacity of 60,000 machine
hours per year. The production line time required for Model Royal is 6 machine hours per
car. This production line will also be used to make other cars and will be working at full
capacity.
Note 2
Some models of cars are delivered to showrooms using car transporters. 60% of the
transportation costs are related to the number of deliveries made. 40% of the transportation
costs are related to the distance travelled.
The car transporters have forecast to make a total of 640 deliveries in the year and carry 10
cars each time. The car transporter will always carry its maximum capacity of 10 cars.
The total annual distance travelled by car transporters is expected to be 2,25,000 kms. 50,000
kms of this is for the delivery of Model Royals car only. All 1,000 Model Royal cars that
will be produced will be delivered in the year using the car transporters.

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 [4 .23]

Required
(i) Calculate the forecast total cost of producing and delivering a Model Royal car using
Activity Based Costing principles to assign the overhead costs.
(ii) Calculate the cost gap that currently exists between the forecast total cost and the target
total cost of a Model Royal car
Solution:

Workings
Statement Showing “Cost Driver Rate”
Overhead Cost (`) - Lacs Cost Driver Cost Driver Rate (`)
Production Line Cost 2,310 60,000 Machine Hrs. 3,850 per hr.
2310 𝑙𝑎𝑐𝑠
( )
60000 ℎ𝑟𝑠
Transportation Cost
Delivery Related (60%) 540 640 Deliveries 84,375 per delivery
540 𝑙𝑎𝑐𝑠
( )
640 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑦

Distance Related (40%) 360 2,25,000 Kms. 160 per km

360 𝑙𝑎𝑐𝑠
( )
125000 𝑘𝑚𝑠

(i) Forecast Total Cost using Activity Based Costing Principles

Elements of Cost `
Material 4,75,000.00
Labour 2,50,000.00
Overhead
Production Line Cost (` 3,850 × 6 hrs.) 23,100.00
Transportation Cost -
𝑅𝑠 84375 8,437.50
Delivery Related
10 𝑐𝑎𝑟𝑠

𝑅𝑠 160 ×50000 𝑘𝑚𝑠 8,000.00

Distance Related
1000 𝑐𝑎𝑟𝑠

Total 7,64,537.50

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 [4 .24]

(ii) Calculation of Cost Gap Between Forecast Total Cost and the Target Total Cost
Particulars Amount (`)
Target Selling Price 9,75,000.00
Less: Operating Profit Margin (25%) 2,43,750.00
Target Cost (Target Selling Price – Operating Profit) 7,31,250.00
Forecast Total Cost 7,64,537.50
Cost Gap (` 7,64,537.50 – ` 7,31,250) 33,287.50

LIFE CYCLE COSTING

Life Cycle Costing involves identifying the costs and revenue over a product’s life i.e. from
inception to decline. Life cycle costing aims to maximize the profit generated from a product
over its total life cycle. Understanding this can be a useful analysis tool and can help to
suggest which strategies the organisation needs to adopt in order to compete successfully.

Product Life Cycle

Each product has a life cycle. The life cycle of a product varies from a few months to several
years. Product life cycle is thus a pattern of expenditure, sales level, revenue and profit over
the period from new idea generation to the deletion of product from product range.

Characteristics of Product Life Cycle

The major characteristics of the product life-cycle concept are as follows:
 The products have finite lives and pass through the cycle of development,
introduction, growth, maturity, decline, and deletion at varying speeds.

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 [4 .25]

 Product cost, revenue, and profit patterns tend to follow predictable courses through
the product life cycle. Profits first appear during the growth stage and after stabilizing
during the maturity stage, decline thereafter to the point of deletion.
 Average cost and Profit per unit varies as products move through their life cycles.
 Each stage of the product life-cycle poses different threats and opportunities that
give rise to different strategic actions.
 Products require different functional emphasis in each stage-such as an R&D
emphasis in the development stage and a cost control emphasis in the decline stage.
 Finding new uses (product extension) or new users (market extension) or getting
the present users to increase their consumption may extend the life of the product
Life Cycle Characteristics

Introduction Growth Maturity Decline

Objectives Create Maximise Maximise Reduce expenditures &
product market profits while milk the brand
awareness share defending
& trial market share
Sales Low sales Rapidly rising Peak sales Declining sales
Costs per High cost per Average cost Low cost per Low cost per
Customer customer per customer customer customer

Profits Negative Rising profits High profits Declining profits

Customers Innovators Early adopters Middle majority Laggards

Competitors Few Growing Steady number Declining number
number beginning to
decline
Product Offer basic Offer product Diversify Phase out weak items
product extensions, brands and
service & models
warranty
Price Cost plus Price to Price to match Price cutting
profit penetrate or beat
market competitors
Advertising Build product Build Stress on brand Reduce level to keep
awareness awareness & differences and hard core loyalty
amongst early interest in benefits
adopters &
mass market
Dealers

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Distribution Build selective Build Build more Go selective: Phase

distribution Intensive intensive out unprofitable
distribution distribution outlets
Sales Use heavy Reduce to Increase to Reduce to minimal
Promotion sales take encourage level
promotion to advantage brand
entice trial switching
of heavy
consumer
demand

Que 8

In WM Ltd. the ‘OB’ equipment is about to be replaced either by ‘CF’ system or by an ‘OF’
system. Finance costs 12% a year and the other estimated costs are as follows:

CF OF
(`) (`)
Initial Cost 28,000 40,000
Annual Operating Costs 24,000 p.a. 18,000 p.a.

Required
If the company expected the new system (either CF or OF) to last at least for 12 years, which
system should be chosen?
Solution:

Calculation of Life-cycle Costs

CF OF

Initial Cost 28,000 40,000

Add: Annual Operating Costs 1,48,656 1,11,492
(`24,000 × 6.194) (`18,000 × 6.194)
Total Life Cycle Costs 1,76,656 1,51,492
The annuity of 12% finance costs for 12 years is 6.194.
Analysis
When we compare only the initial cost, we will tend to purchase CF system, for its cheap
acquisition cost. But when we compare the total life-cycle costs, the OF system is most
preferable, for its lowest total life-cycle costs.

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 [4 .27]

Solution-

Calculation of Life-cycle Costs

CF OF
(`) (`)
Initial Cost 28,000 40,000
Add: Annual Operating Costs 1,48,656 1,11,492
(`24,000 × 6.194) (`18,000 × 6.194)
Total Life Cycle Costs 1,76,656 1,51,492
The annuity of 12% finance costs for 12 years is 6.194.
Analysis
When we compare only the initial cost, we will tend to purchase CF system, for its cheap
acquisition cost. But when we compare the total life-cycle costs, the OF system is most
preferable, for its lowest total life-cycle costs.
Que 9

A company is planning a new product. Market research information suggests that 40,000
units of the product can be sold at a maximum of ` 25 per unit. The company seeks a
minimum mark-up of 25% on product cost. It is estimated that the lifetime costs of the
product will be as follows:
(1) Research and development, design costs ` 1,50,000
(2) Manufacturing costs ` 16 per unit
(3) End of life costs ` 70,000
(4) Promotion and capacity cost ` 20,000

Should the product be manufactured?

Solution:
The new product can be sold into the market at a maximum of ` 25 per unit. The
company also seeks a minimum mark-up of 25% on product cost, which means the product
should have a target cost of ` 20 per unit. Calculation is as below:

Target Cost + 25% Mark-up on cost = ` 25

Or, Target Cost per unit = ` 20 per unit.

Statement Showing “Life Cycle Cost per unit”

Particulars of Cost `
Manufacturing Cost per unit 16.00
𝑅𝑠.1,50,000
Add: - Research and Development, Design Cost ( )
40000 𝑢𝑛𝑖𝑡𝑠 3.75

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 [4 .28]

70000
- End of Life Costs (40000 𝑢𝑛𝑖𝑡𝑠)
1.75
𝑅𝑠.20,000
- Promotion and Capacity Cost ( )
40000 𝑢𝑛𝑖𝑡𝑠 0.50
Total Life Cycle Cost per unit 22.00

The above life cycle cost of the proposed product is above the target cost of ` 20 per unit
hence, the product should not be manufactured.

Que 10

P & G International Ltd. (PGIL) has developed a new product “K” which is about to be
launched into the market and anticipates to sell 80,000 of these units at a sales price of `300
over the product’s life cycle of four years. Data pertaining to product “K” are as follows:

Costs of Design and Development `8,25,000

of Molds, Dies, and Other Tools

Manufacturing Costs `125 per unit

Selling Costs `12,500 per year + `100 per unit

Administration Costs `50,000 per year

Warranty Expenses 5 Replacement Parts per 25 units at

`10 per part ; 1 Visit per 500 units
(Cost ` 500 per visit)

Required
(i) Compute the product “K”’s ‘Life Cycle Cost’.
(ii) Suppose PGIL can increase sales volume by 25% through 10% reduction in selling
price. Should PGIL choose the lower price?

Solution:

(i) Statement Showing “K’s Life Cycle Cost (80,000 units)”

Particulars Amount
(`)
Costs of Design and Development of Molds, Dies, and 8,25,000
Other Tools
Manufacturing Costs (`125 × 80,000 units) 1,00,00,00
0
Selling Costs (`100 × 80,000 units + `12,500 × 4) 80,50,000
Administration Costs (`50,000 × 4) 2,00,000

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 [4 .29]

Warranty
(80,000 units / 25 units × 5 parts × `10) (80,000 units / 1,60,000
500 units × 1 visit × `500) 80,000

Total Cost 1,93,15,00

0

(ii) Statement Showing “K’s Life Cycle Cost (1,00,000 units)”

Particulars Amount
(`)
Costs of Design and Development of Molds, Dies, and 8,25,000
Other Tools
Manufacturing Costs (`125 × 1,00,000 units) 1,25,00,00
0
Selling Costs (`100 × 1,00,000 units + `12,500 × 4) 1,00,50,00
0
Administration Costs (`50,000 × 4) 2,00,000
Warranty
(1,00,000 units / 25 units × 5 parts × `10) (1,00,000 2,00,000
units / 500 units × 1 visit × `500) 1,00,000
Total Cost 2,38,75,00
0

Statement Showing “K’s Life Time Profit”

Particulars Amount Amount

80,000 units 100,000 units

Sales 2,40,00,000 2,70,00,000

(80,000 × `300) (1,00,000 × `270)

Less: Total Cost 1,93,15,000 2,38,75,000

Profit 46,85,000 31,25,000

Decision
Reducing the price by 10% will decrease profit by 33% (`15,60,000). Therefore, PGIL
should not cut the price.

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Ques 11

Great Eastern Appliances Ltd. (GEAL) manufactures consumer durable products in a very
highly competitive market. GEAL is considering launching a new product ‘Kitchen Care’
into the market and gathered the following data:

Expected Market Price… `5,000 per unit

Direct Material Cost `1,850 per unit

Direct Labour Cost `80 per hour

Variable Overhead Cost… `1,000 per unit

Packing Machine Cost (specially to be purchased for this product)…`5,00,000

GEAL expects the selling price for the new product will continue throughout the product’s
life and a total of 1,000 units can be sold over the entire lifetime of the product.

Direct labour costs are expected to reduce as the volume of output increases due to the
effects of 80% learning curve (index is -0.3219). The expected time to be taken for the first
unit is 30 hours and the learning effect is expected to end after 250 units have been
produced. Units produced after first 250 units will take the same time as the 250th unit.

Required

(i) Calculate the expected total labour hours over the life time of the product ‘Kitchen
Care’.

(ii) Profitability of product ‘Kitchen Care’ that GEAL will earn over the life time of the
product.

(iii) Average target labour cost per unit over the life time of the product if GEAL requires
average profit of ` 800 per unit, to achieve its long term objectives.

Note: 250 -0.3219 = 0.1691, 249 -0.3219 =0.1693

Solution:

(i) Calculation of ‘Total Labour Hours’ over the Life Time of the Product ‘Kitchen
Care’

The average time per unit for 250 units is

Yx = axb
Y250 = 30 × 250 -0.3219
Y250 = 30 × 0.1691
Y250 = 5.073 hours

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 [4 .31]

Total time for 250 units = 5.073 hours × 250 units

= 1,268.25 hours

The average time per unit for 249 units is

Y249 = 30 × 249–0.3219
Y249 = 30 × 0.1693
Y249 = 5.079 hours

Total time for 249 units = 5.079 hours × 249 units

= 1,264.67 hours

Time for 250th unit = 1,268.25 hours – 1,264.67 hours

= 3.58 hours

Total Time for 1,000 units = (750 units × 3.58 hours) + 1,268.25 hours
= 3,953.25 hours

(ii) Profitability of the Product ‘Kitchen Care’

Particulars Amount Amount
(`) (`)
Sales (1,000 units) 50,00,000
Less: Direct Material 18,50,000
Direct Labour (3,953.25 hours × ` 80) 3,16,260
Variable Overheads (1,000 units× `1,000) 10,00,000 31,66,260
Contribution 18,33,740
Less: Packing Machine Cost 5,00,000
Profit 13,33,740

(iii) Average ‘Target Labour Cost’ per unit

Particulars Amount (`)
Expected Sales Value 50,00,000
Less: Desired Profit (1,000 units × ` 800) 8,00,000
Target Cost 42,00,000
Less: Direct Material (1,000 units × ` 1,850) 18,50,000
Variable Cost (1,000 units × ` 1,000) 10,00,000
Packing Machine Cost 5,00,000
Target Labour Cost 8,50,000
Average Target Labour Cost per unit (` 8,50,000 ÷ 1,000 units) 850

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Que 12
P & G International Ltd. (PGIL) has developed a new product ‘ α3 ’which is about to be
launched into the market. Company has spent ` 30,00,000 on R&D of product ‘ α3 ’. It has
also bought a machine to produce the product ‘ α3 ’ costing ` 11,25,000 with a capacity of
producing 1,100 units per week. Machine has no residual value.
The company has decided to charge price that will change with the cumulative numbers of
units sold.

Cumulative Sales Selling Price ` per unit

(units)
0 to 2,200 750
2,201 to 7,700 600
7,701 to 15,950 525
15,951 to 59,950 450
59,951 and above 300
Based on these selling prices, it is expected that sales demand will be as shown below:

Weeks Sales Demand per

week (units)
1-10 220
11-20 550
21-30 825
31-70 1,100
71-80 880
81-90 660
91-100 440
101-110 220
Thereafter NIL

Unit variable costs are expected to be as follows:

` per unit
First 2,200 units 375
Next 13,750 units 300
Next 22,000 units 225
Next 22,000 units 188
Thereafter 225

PGIL uses just-in-time production system. Following is the total contribution statement of
the product ‘ α3 ’ for its Introduction and Growth phase:

Introduction Growth
Weeks 1 – 10 11 - 30

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Number of units Produced and 2,200 5,500 8,250

Sold
Selling Price per unit (`) 750 600 525
Variable Cost per unit (`) 375 300 300
Contribution per unit (`) 375 300 225
Total Contribution (`) 8,25,000 16,50,000 18,56,250

Required
(i) Prepare the total contribution statement for each of the remaining two phases of the
product’s life cycle.
(ii) Discuss Pricing Strategy of the product ‘ α3 ’.
(iii) Find possible reasons for the changes in cost during the life cycle of the product ‘ α3 ’.
Note: Ignore the time value of money.

Solution:

(i) Total Contribution Statement

Statement Showing “Total Contribution- for remaining two phases”

Particulars Maturity Decline
Weeks 31 – 50 51 - 70 71 - 110
Number of units Produced and 22,000 22,000 22,000
Sold
Selling Price per unit (`) 450 450 300
Less: Unit Variable Cost (`) 225 188 225
Unit Contribution (`) 225 262 75
Total Contribution (`) 49,50,000 57,64,00 16,50,00
0 0

(ii) Pricing Strategy for Product α3

- PGIL is following the skimming price strategy that’s why it has planned to launch
the product α3 initially with high price tag.
- A skimming strategy may be recommended when a firm has incurred large sums of
money on research and development for a new product.
- In the problem, PGIL has incurred a huge amount on research and development.
Also, it is very difficult to start with a low price and then raise the price. Raising a
low price may annoy potential customers.
- Price of the product α3 is decreasing gradually stage by stage. This is happening
- because PGIL wants to tap the mass market by lowering the price

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(iii)Possible Reasons for the changes in cost during the life cycle of the product ‘ α3 ’
Product life cycle costing involves tracing of costs and revenues of each product over several
calendar periods throughout their entire life cycle. Possible reasons for the changes in cost
during the life cycle of the product are as follows:

PGIL is expecting reduction in unit cost of the product α3 over the life of product as a
consequence of economies of scale and learning / experience curves.
Learning effect may be the possible reason for reduction in per unit cost if the process is
labour intensive. When a new product or process is started, performance of worker is not at
its best and learning phenomenon takes place. As the experience is gained, the performance
of worker improves, time taken per unit reduces and thus his productivity goes up. The
amount of improvement or experience gained is reflected in a decrease in cost.
Till the stage of maturity, PGIL is in the expansion mode. The PGIL may be able to take
advantages of quantity discount offered by suppliers or may negotiate the price with
suppliers.
Product α3 has the least variable cost `188 in last phase of maturity stage; this is
because a product which is in the mature stage may require less marketing support than a
product which is in the growth stage so, there is a saving of marketing cost per unit.
Again the cost per unit of the product α3 jumps to `225 in decline stage. As soon as the
product reaches its decline stage, the need or demand for the product disappear and quantity
discount may not be available. Even PGIL may have to incur heavy marketing expenses for
stock clearance.

Workings
Statement of Cumulative Sales along with Sales Price and Variable Cost

Weeks Demand Total Cumulat Selling Variable

per week Sales ive Sales Price per Cost per
unit (`) unit (`)
1 – 10 220 2,200 2,200 750 375
11 - 20 550 5,500 7,700 600 300
21 - 30 825 8,250 15,950 525 300
31 - 50 1,100 22,000 37,950 450 225
51 - 70 1,100 22,000 59,950 450 188
71 - 80 880 8,800 68,750 300 225
81 - 90 660 6,600 75,350 300 225
91 - 100 440 4,400 79,750 300 225
101 - 110 220 2,200 81,950 300 225

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PARETO ANALYSIS
Pareto Analysis is a rule that recommends focus on the most important aspects of the decision
making in order to simplify the process of decision making. It is based on the 80: 20 rule that
was a phenomenon first observed by Vilfredo Pareto
This phenomenon, or some kind of approximation of it say, (70: 30 etc.) can be observed in
many different business situations.

Usefulness of Pareto Analysis

− Prioritize problems, goals, and objectives to identify root causes.
− Select and define key quality improvement programs.
− Select key customer relations and service programs.
− Select key employee relations improvement programs.
− Select and define key performance improvement programs.
− Allocate physical, financial and human resource

Application of Pareto Analysis

1) Pricing of Product
2) Customer profitability analysis
3) Stock control
4) Activity based costing
5) Quality control

Ques 13

The following information is given about the type of defects during a production period and
the frequencies of their occurrence in a spectacle manufacturing company:
Defect No. of items
End Frame not equidistant from the centre 10
Non-uniform grinding of lenses 60
Power mismatches 20
Scratches on the surface 110
Spots / Stains on lenses 5
Rough edges of lenses 70
Frame colours-shade differences 25

Required

PREPARE a frequency table so that a Pareto Chart can be constructed for the defect type.
Also, IDENTIFY key areas of focus

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Solution

Statement Showing “Pareto Analysis of Defects”

Defect Type No. of Items % of Total Cumulative Total

Items

Scratches on the surface 110 36.67% 36.67%

Rough edges of lenses 70 23.33% 60.00%

Non-uniform grinding of lenses 60 20.00% 80.00%

Frame colours-shade differences 25 8.33% 88.33%

Power mismatches 20 6.67% 95.00%

End frame not equidistant from the 10 3.33% 98.33%

centre

Spots/ Strain on lenses 5 1.67% 100.00%

300 100.00%

The company should focus on eliminating scratches on the surface, rough edges of lenses
and grinding of lenses related defects which constitute 80% portion, according to Pareto
Theory

Ques 14

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 (`’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%

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Required
(i) Using the financial data, carry out a Pareto analysis (80/20 rule) of Sales and
Contribution.
(ii) Discuss your findings with appropriate recommendations.

Solution
Statement Showing “Pareto Analysis”

Model Sales % of Cumulativ Model Cont. % of Total Cumulativ

(`’000) Total e Total (`’000) Cont. e Total %
Sales
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%

(*) Rounding - off difference adjusted.

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Diagram Showing “Sales and Contribution”

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 business 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. Boths C003 and D004 are among the models giving 80% of total
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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.

ENVIRONMENTAL MANAGEMENT ACCOUNTING

[EMA]

 EMA is the process of collection and analysis of the information relating to

environmental cost for internal decision making.
 EMA identifies and estimates the costs of environment-related activities and seeks to
control these costs.
 The focus of EMA is not on financial costs but it also considers the environmental cost
or benefit of any decisions made.
 EMA is an attempt to integrate best management accounting thinking with best
environmental management practice.
 EMA aims to make a better use of or to modify sources of information and management
accounting techniques and to evaluate sustainability and/or environmental efficiency of
a company.
Areas for the application for EMA

 Product Pricing
 Budgeting
 Investment Appraisal
 Calculating Costs and
 Savings of Environmental Projects, or Setting Quantified Performance Targets

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Environmental Costs

The US Environmental Protection Agency in 1998 has categorized Environmental Costs in

four sections:
1) Conventional Costs: Raw material and energy costs having environmental
relevance.
2) Hidden Costs: Costs which have been accounted for but then lose their identity in
‘general overheads’.
3) Contingent Costs: Costs to be incurred at a future date – for example, clean- up
costs.
4) Relationship Costs: Intangible Costs, for example, the costs of preparing
environmental reports
The United Nations Division for Sustainable Development (UNDSD), on the other hand,
described Environmental Costs as comprising of:
− Costs incurred to protect the environment – for example, measures taken to
prevent pollution, and
− Costs of wasted material, capital and labor, i.e. inefficiencies in the production
process

Identification of Environmental Costs

1) Input-Output Analysis
This technique records material inflows and balances this with outflows on the basis that,
what comes in, must go out.

2) Flow Cost Accounting

This technique uses not only material flows but also the organizational structure.
Classic material flows are recorded as well as material losses incurred at various stages
of production.
Flow cost accounting makes material flows transparent by using various data, which are
quantities (physical data), costs (monetary data) and values (quantities x costs). The
material flows are divided into three categories, material, system, and delivery and
disposal.

3) Lifecycle costing
This considers the costs and revenues of a product over its whole life rather than one
accounting period. Therefore, the full environmental cost of producing a product will be
taken into account. In order to reduce lifecycle costs an organization may adopt a TQM
approach.

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4) Activity Based Costing

This allocates internal costs to cost centres and cost drivers on the basis of the activities
that give rise to the costs. In an environmental accounting context, it distinguishes
between environment-related costs, which can be attributed to joint cost centres, and
environment- driven costs, which tend to be hidden on general overheads.

Ques 15

A chemical company produces two chemicals SX and ZX. Environmental activities and
costs associated with the two chemicals are as follows;

SX ZX
Unit produced (kg.) 6,00,000 15,00,000
Packing Materials (kg.) 80,000 40,000
Energy Usage (KWH) 60,000 30,000
Toxin releases (Pounds into the air) 2,00,000 40,000
Pollution control machine hours 32,000 8,000

Cost of environmental activities:

Packing material Costs ₹ 3,60,000
Energy Costs ₹ 96,000
Fines for release of toxins into the air ₹ 48,000
Operating costs of pollution control equipment ₹ 1,12,000

Required
CALCULATE the environmental cost per kilogram for each chemical produced by the
company
Solution:

Environment costs can be allocated to Chemicals SX and ZX using Activity Based Costing.

Cost Allocation ₹
Sr. Type of Environment Allocation Basis Chemical Chemical Total
No. cost SX ZX
1. Packing Material Costs Packing Materials
(kg.) 2,40,000 1,20,000 3,60,000
SX 80,000 kg.
ZX 40,000 kg.

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2. Energy Cost Energy Usage

(KWH) SX 60,000 64,000 32,000 96,000
kwh
ZX 30,000 kwh
3. Fines for Release of Toxins Released
Toxins into Air (Pounds into air) SX 40,000 8,000 48,000
200,000 pounds
ZX 40,000 pounds
4. Operating Costs of Pollution Control
Pollution Control Machine Hours SX 89,600 22,400 1,12,000
Equipment 32,000 hrs.
ZX 8,000 hrs.
5. Total Cost Allocation Sum of Steps 1 to 4 4,33,600 1,82,400 6,16,000

6. Units Produced (kg.) 6,00,000 15,00,000 21,00,000

7. Environment Cost per

unit produced (Step 5 / ₹ 0.7227 ₹ 0.1216 ₹ 0.2933
Step 6)

The environment cost allocation per kilogram for Chemical SX is ₹0.7227 per kg and
Chemical ZX is ₹0.1216 per kg.
The average environment cost per kg for overall production is ₹0.2933 per kg.
Controlling Environmental Costs
After identification and allocation of environmental costs, the organisation needs to head
towards controlling these cost starts. The method applied to control environmental cost can
be oriented to individual cause or individual elements (such as water, energy) or uniform
wide across the organisation for all the causes.
Note- The techniques used for identification of environmental cost has implication in the
selection of method or tool for controlling the environmental cost. Moreover, the choice of
approach to control cost is highly impacted by the nature of industry, because the type of
environmental cost and their percentage to total cost will vary significantly across the
sectors.
For example, in order to reduce lifecycle costs (including full environmental cost) an
organization may adopt a TQM approach. It is arguable that TQM and environmental
management accounting are inextricably linked insofar as good environmental management
is increasingly recognized as an essential component of TQM. Such organizations pursue
objectives that may include zero complaints, zero spills, zero pollution, zero waste, and zero
accidents. Information systems need to be able to support such environmental objectives via

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the provision of feedback - on the success or otherwise - of the organizational efforts in

achieving such objectives
Let’s understand how environmental costs can be controlled by focusing on individual
elements (through-out the organisation).
Waste – ‘Mass balance’ approach can be used to determine how much material is wasted in
production, whereby the weight of materials bought is compared to the product yield. From
this process, potential cost savings may be identified. In addition to these monetary costs to
the organization, waste has environmental costs in terms of lost land resources (because
waste has been buried) and the generation of greenhouse gases in the form of methane. Costs
of unused raw materials and disposal; taxes for landfill; fines for compliance failures such
as pollution are considered as environmental cost associated with waste.
Practical Insight
EMA Practices
Xerox Limited, a subsidiary of Xerox Corporation, introduced the concept of lifecycle
costing for its logistic chain. Manufacturing photocopiers is the core business of Xerox. The
photocopiers are leased rather than sold. This means the machines are returned to Xerox
limited at the end of their lease. Previously, machines were shipped in a range of different
types of packaging, which could rarely be re-used by customers to return the old copiers.
The customer had to dispose of the original packaging and to provide new packaging to
return the machine at the end of its lease, which in turn could not be used to re-ship other
machines. So, Xerox ultimately lost the original costs and even had to bear the additional
costs of disposal of the new packaging.
A new system was invented which used a standard pack (tote). Two types of totes were
introduced to suit the entire range of products sold by Xerox. Totes can be used for both new
machine delivery and return carcasses. The whole-chain cost analysis showed the
considerably lower cost of the tote system, compared to the previously existing system and
the supply chain became more visible. The tote system resulted not only in cost savings but
also in reduced 'de-pack' times and improved customer relations.
Based upon life Cycle Costing and Packaging at Xerox Ltd, by M Bennett and P James, in
The Green Bottom line – Environmental Accounting for Management: Current Practice and
Future Trends (Greenleaf Publishing, Sheffield, 1998b)
Water - Businesses pay for water twice, firstly to buy it and secondly to dispose of it. If
savings are to be made in terms of reduced water bills, it is important for organizations to
identify where water is used and how the consumption can be reduced.
Energy - Often, energy costs can be reduced significantly that too at very little cost. EMA
may help to identify inefficiencies and wasteful practices therefore create opportunities for
cost savings.

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Transport and Travel - Again, EMA techniques may be used to identify savings in terms of
travel and transport of goods and materials. At a simple level, a business can invest in more
fuel -efficient vehicles.
Consumables and Raw Materials - These are directly attributable costs and discussions with
management can reduce such costs. For example, toner cartridges for printers could be
refilled rather than replaced. This should produce a saving both in terms of the financial cost
for the organization and a waste saving for the environment.

Que 16
Following three independent situations pertaining to environmental management and
sustainability are provided to you:
Situation I
Wasco Limited is a chemical company which uses chloro-fluorocarbons (CFC) in the
production of chemical. As awareness of the environmental damage caused by CFC spread,
Wasco Limited stopped using CFC in its production processes and analysed and redesigned
its product range much before the legislation controlling use of CFC introduced by the
Government.
Situation II
Energy drink manufacturer Cool Limited was ordered to submit a yearly report to the
Ministry of Environment and Forests on activities, which contains information concerning
collection, recovery and recycling of packaging waste, fulfilment of the targets, volume of
recovered and recycled packaging waste by type of material and declaration that all
compulsory contributions and taxes have been paid.
Situation III
KOA Limited has achieved a 25% reduction of energy consumption through its “Go
Renewable” initiative. For, the company a 25% reduction represents a cost saving of about
Rs. 30,00,000
Required
Read the above three situations and EXPLAIN:
(i) Why Wasco Limited stopped using CFC and redesigned its product range much before
legislation introduced by Government?
(ii) The risk exposure of Cool Limited.
(iii) How focusing on environmental sustainability provides opportunity to KOA Limited
for reducing costs?

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Solution:
(i) Ever increasing and demanding environmental regulation is forcing companies to change
their practices. In many countries, numerous pieces of legislation cover areas such as air
quality, climate change, hazardous substances, packaging, waste, and water quality.
The trend is very much in the direction of increased and more stringent legislation.
Environment sustainability is not an issue that can be avoided by any organisation.
Organisations need to consider how environmental regulation will impact thei r
operations and the cost of doing business.
By stopping the use of CFC much before the legislation, Wasco Limited gained
advantages over its rivals. Wasco’s actions were integral to its own strategic success, and
instrumental in driving through the subsequent legislation from which the company later
benefited. This will also help Wasco Limited to improve their brand image among the
stakeholder as corporate citizen.
(ii) Organizations increasingly have to demonstrate that they are managing all of their risks
systematically and responsibly. This includes environmental risks- risks that are a result
of impacts of the organization on the environment. By assessing the environmental risks
associated with their activities, processes, product, and services, organizations can
identify their potential legal and business exposure. Non-compliances can cause
enormous financial impacts, such as fines, penalties, legal costs, and damages.
Thus, Cool Ltd is exposed to environmental risks.
(iii) Focusing on environmental sustainability will often provide opportunities for reducing
costs. For example, reducing carbon impacts often also saves energy costs. Similarly,
programmes for reducing wastes improve environmental performance and reduce
operating costs.
Reducing environmental impacts can also reduce or eliminate associated fines, levies,
and other compliance costs.
Focusing on environmental sustainability thereby making investments in developing
clean technologies and more energy-efficient products and processes will not only save
the organization money, but could also be patented and/ or sold to other organizations,
providing an additional source of income. KOA Limited may have carbon credit for
efficiency in reducing energy and sell on the open market, thereby actually generating
revenue.

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Ques 17
“QR” Ltd. is the leading manufacturer and exporter of high quality leather products - Product
Q and Product R.
Selling price per unit of Product Q and Product R 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 Cost ` per 140 180 140 460
unit
Direct Labour Cost ` per unit 90 120 90 300
Cost allocation to Product Q 70% 50% 70%
Cost allocation to Product R 30% 50% 30%

General overheads per unit of leather products Q or R manufactured are ₹115. This blanket
absorption rate is derived after division of total general overhead with number of leather
product be it Q or R. 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 blanket rate per unit of leather products (be it Q or R) manufactured are
₹115 which includes–
Treatment cost of harmful gases….. ₹40
Wastewater treatment cost ₹50
Cost of planting of trees ₹10
Miscellaneous ₹15

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Process wise information related to generation of wastewater and harmful gases is given 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 Q 70% 50% 70%
Cost allocation to Product R 30% 50% 30%
The remaining overheads cost (miscellaneous) and cost of planting trees can be allocated
equally between Product Q and Product R.
Required
(i) CALCULATE the product wise profitability based on the original cost allocation.
(ii) RECALCULATE the product wise profitability based on activity-based costing
(Environment driven costs).
(iii) ANALYZE the difference in product profitability as per both the methods

Solution:

(i) Product Wise Profitability as per Original Allocation Methodology

(Figures in ` per unit of leather produced)
Particulars Product Q Product R Total
Selling Price 620 420 1,040
Direct Material (Refer Table 1) 286 174 460
Direct Labour (Refer Table 1) 186 114 300
Overheads 115 115 230
Total Expenses 587 403 990
Profit 33 17 50
Profitability (%) 5.32% 4.05% ×

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Workings
Table 1 Cost Allocation to the Products
(Figures in ` per unit of leather produced)
Particulars Tanning Dyeing Finishing Total
Q R Total Q R Total Q R Total Q R Grand
Total
Direct Material 98 42 140 90 90 180 98 42 140 286 174 460
Direct Labour 63 27 90 60 60 120 63 27 90 186 114 300

(ii) Product wise profitability based on activity-based costing using environment driven
costs requires the following steps:
 For convenience let presume only 2 units (1Q and 1R) are manufactured, currently
the total overhead of ₹230 (115×2) is equally divided between Q and R i.e. ₹115
per unit of Q and R. But this is blanket or convention approach of allocation and
misleading too. Hence the total overhead of ₹230 need to be divided such as ABC
as required in question
 Breakdown of total overhead cost of ₹230 per unit into treatment cost of harmful
gases, wastewater treatment cost, cost of planting trees and other overhead costs.
Refer Table 2 for the breakup.
 Treatment cost of harmful gases, wastewater treatment cost need to be individually
allocated to various processes based on relevant cost drivers. Refer Table 3 for cost
allocation to process.
 The overheads mentioned in point above thus allocated to the various processes,
will be reallocated to products based on the specific ratios given in the problem.
Refer Table 4 for cost allocation to products.
Product Wise Profitability Statement based on ABC using environment driven costs
(Figures in ` per unit of leather produced)
Particulars Product Q Product R Total
Selling Price 620 420 1,040
Direct Material (Refer Table 1) 286 174 460
Direct Labour (Refer Table 1) 186 114 300
Allocation of Overheads

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Treatment Cost of Harmful Gases 50 30 80

(Refer Table 4)
Wastewater Treatment Cost 62 38 100
(Refer Table 4)
Cost of Planting Trees (shared equally) 10 10 20
Other Overhead Cost (shared equally) 15 15 30
Total Expenses 609 381 990
Profit 11 39 50
Profitability % 1.77% 9.29% ×

Workings
Table 2: Breakdown of General Overheads (at total level of ₹ 230)
Overhead Amount Allocation basis between products
(`)
Treatment Cost of Harmful Gases 80 Emission of Harmful Gases
(cc per week)
Wastewater Treatment Cost 100 Wastewater Generated (litres per
week)
Cost of Planting Trees 20 Equally between Products Q and R
Miscellaneous 30 Equally between Products Q and R
Total General Overheads 230

Table 3: Allocation of Treatment Cost to various process

Process Wise Information (Basis of apportionment, Cost Driver and their volume)
Overhead Amount Allocation Basis Tanning Dyeing Finishing Total
(₹) Between Products
Treatment 80 Emission of Harmful 400cc 300cc 100cc 800cc
Cost of Gases
Harmful
(cc per week)
Gases

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .50]

Wastewater 100 Wastewater 900lt. 600lt. --- 1,500lt.

Treatment Generated
Cost
(ltr. per week)

Cost Allocation to Process

Overhead Amount Allocation Basis Tanning Dyeing Finishing Total
(₹) Between Products (₹) (₹) (₹) (₹)
Treatment 80 Emission of 40 30 10 80
Cost of Harmful Gases
Harmful
(cc per week)
Gases
Wastewater 100 Wastewater 60 40 0 100
Treatment Generated
Cost
(litres per week)

Table 4: Reapportionment of Treatment Cost to Product Q and R (`)

Overhead Tanning Dyeing Finishing Total
Treatment Cost of Harmful Gases `40 `30 `10 `80
Cost Allocation % to Product Q 70% 50% 70% ×
Cost Allocation % to Product R 30% 50% 30% ×
Cost Allocation to Product Q `28 `15 `7 `50
Cost Allocation to Product R `12 `15 `3 `30
Wastewater Treatment Cost `60 `40 --- `100
Cost Allocation % to Product Q 70% 50% 70% ×
Cost Allocation % to Product R 30% 50% 30% ×
Cost Allocation to Product Q `42 `20 --- `62
Cost Allocation to Product R `18 `20 --- `38

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 [4 .51]

(ii) Analysis of the difference in product profitability as per both the methods
In the first method, general overhead costs are allocated to the products Q and R, irrespective
of the environment costs that each product incurs. General overhead costs are to each product
equally. The resultant product profitability shows that Product Q yields 5.32% and Product
R yields 4.05% profitability. Therefore, the “QR” Ltd. would conclude that Product Q is
more profitable.
In the next method, general overhead costs are bifurcated to identify “hidden” environment
costs that are incurred on account of manufacturing these products. Environment costs are
first traced to the process that generates harmful gases and wastewater, for which treatment
is done. It can be seen that Tanning process, followed by Dyeing and Finishing process
generates the maximum amount of waste. Therefore, by proportioning the cost based on the
waste generated, more cost is allocated to Tanning the process. Similarly, Dyeing and
Finishing are allocated lesser cost since they do not generate as much waste. It is further
given that 70% of the cost of Tanning relates to Product Q. This is much higher than the 50%
that was allocated to the Product as per the first method.
Accordingly, the revised workings show that Product Q yields 1.77% and Product R yields
9.29% profitability. The reason being, Product Q generates more environment driven costs
as compared to Product R.
“QR” Ltd. would therefore increase the selling price of Product Q if it wants to maintain
profitability as per the original method. However, the more sustainable approach would be
find out ways of reducing wastewater and harmful gases the manufacturing process
produces. This would in turn result in reduction of environment driven costs such as
wastewater treatment and treatment of harmful gases. This would sustain profits in the long
run.

-----

COST MANAGEMENT TECHNIQUES CA MANOJ SHARMA

 6. DECISION MAKING

 CVP ANALYSIS
CONTENTS..

 Short Run Decision Making

 Out Sourcing Decision
 Sell or Further Process
 Minimum Pricing Decisions
 Keep or Drop Decisions
 Special Order Decisions
 Product Mix Decision
 [6. 2]

CVP ANALYSIS
Cost Volume Profit Analysis (CVP Analysis) analyses inter-relationships among revenues,
costs, levels of activity and profits. The information from this analysis is useful to management
because it indicates levels of production activity that is required to either (i) break-even (point
of no profit or no loss) or (ii) to earn a pre-determined target profit. The level of production
determines scale of operations, plant capacity, capital investments in fixed assets, procurement
of input resources, etc. This implies that volume is the key driver of many decisions and thereby
resultant costs / benefits in business operations. This is why volume is traditionally chosen as
the cost-driver in the CVP analysis framework.

𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
𝐵𝑟𝑒𝑎𝑘 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 (𝑖𝑛 𝑢𝑛𝑖𝑡𝑠) =
𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 – 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Conventional CVP analysis classifies costs of an organization as variable and fixed with
reference to volume. Volume based cost drivers are units of direct raw materials, direct labour
hours, machine hours etc. Costs such as direct material costs, labour costs, energy costs etc.
increase marginally each time a unit is produced (variable costs). On the other hand, fixed costs
(overheads) are incurred irrespective of volume of production. Examples would be rental,
administration expenses etc. Activities that have volume as their cost drivers are also called
unit- level activities.
Although CVP analysis is most useful for planning, it can also be used to assist with controlling
decisions and evaluating decisions. Consider a decision about choosing additional features of
an existing product i.e. product modification. Different choices can affect selling prices,
variable cost per unit, fixed costs, units sold, and operating income. CVP analysis helps
managers make product decisions by estimating the expected profitability of these choices.

CVP Analysis

CVP Analysis in Service

Activity Based CVP CVP Analysis in Just in
and Non-Profit
Analysis Time Environment
Organisations

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 [6. 3]

ACTIVITY BASED CVP ANALYSIS

CVP analysis would indicate how many units need to be sold, such that the contribution can
cover such fixed expenses (overheads) to arrive at the break- even point. This approach would
be accurate as long as majority of the activities have costs as the volume driver. In such cases,
the critical activity level for break-even can be clearly identified. However, there are certain
activities that are not related to volume of production at all. They occur irrespective of volume
of production. Such activities can be identified using the activity-based costing approach.
Analysis of an organization’s activities based on activity-based costing method can be broadly
classified into:
(i) Unit level (output) activities: Activities performed each time a product is
manufactured. As explained above, this varies in direct proportion to the volume
of production. The cost driver would be the production volume. Examples would
include direct material cost, direct labour cost, direct overhead costs (like repairs and
maintenance, energy consumption).
(ii) Batch-level activities: Certain activities are done for “a batch of production” rather than
for “a unit volume of output”. Examples are set-up activities or processing purchase
orders (material procurement). An example of setup in a manufacturing context is
changing machine specifications to meet product specifications. During this change, the
machine cannot produce any output. The same amount of resources would be required
during/for setup whether the next setup is after a batch size of 50 or 500 units. Resources
could be in terms of additional material or labour required to arrange for the machine
set-up. Here, instead of volume, it is the number of set-ups done that is the cost driver.
(iii) Total set-up costs per annum = Number of setups per annum × cost of each set-up

While set-up costs would variable (marginally incremental) in terms of the number of
set-ups (cost driver), they need to be charged equally to each unit produced within that
batch. Therefore, larger the batch size, lower the set-up cost that is assigned to each unit
within that batch. Hence, lower per unit costs require infrequent setups and large batch
sizes.
(iv) Product sustaining activities: These are activities performed to support production or
sale of a specific type of product. Examples of such activities would be designing a
product, designing production processes, drawing process charts, maintaining product
specifications, developing special testing routines or technical enhancements
(engineering change orders) or advertising for a particular product. The incurrence of
cost is not dependent on the volume of production. They depend on the additional
consumption of resources to enable performance of these activities. Example of
resources used could be additional engineering hours required to design / improve the
product or its production process would require overtime payment for labour, additional
materials needed for developing design, cost of testing etc.
(v) Facilities level activities: Activities performed for the general operations of business.
They cannot be traced to any particular product. Examples include depreciation of
factory building or the rent paid on it, insurance on the building, costs of training

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 [6. 4]

employees etc. Traditionally these costs have been part of fixed costs in the CVP
analysis.

How is CVP analysis with Activity Based Analysis relevant?

Conventional CVP analysis classifies cost behaviour as fixed and variable with respect to
volume alone. Therefore, any overhead that does not vary with respect to volume would be
pooled under a common cost pool “fixed cost”. However, as explained above, activities such
as production set -ups or product enhancements are not dependent on production volume.
Instead, they vary based on other cost drivers such as number of set-ups or engineering hours.
Following the Activity Based Costing system when activities are identified within the cost
hierarchy mentioned above, it provides management with more information on business
operat ions. CVP analysis using Activity Based Costing can now be formulated as below:
Break-even point (units) = [fixed cost# + (batch level cost driver × cost per batch driver) +
(product sustaining cost driver × cost per product sustaining cost driver)]/ (selling price per
unit – variable cost per unit)
# as identified under Activity Based Costing system
The numerator of the above formula is entire non-volume driven costs. The BEP will indicate
the sales volume required to recover these costs. This analysis can be done at an aggregate
level and at an individual cost category level for the product line.

Ques 1

A company manufactures cycles for both adults and children. Given below is information about
cycles made for children
Particulars Traditional Activity
Based
CVP Analysis
CVP
Analysis
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 ₹ 10,00,000 ₹ 8,00,000
system) p.m. p.m.

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 [6. 5]

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.
Required
(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 the number of set-ups and cost of each set-up impact flexibility of the milling
machine? Explain
Solution-

(i) Break-even point (units per month) and profit per month under traditional CVP analysis:

Selling Price per unit ₹8,000

Variable Cost per unit ₹7,500
Contribution per unit ₹500
Fixed Cost per month ₹10,00,000
Break-even Point (per month in units)
= Fixed Cost p.m. / Contribution p.u. 2,000 units
= ₹10,00,000 / ₹500 per unit
Monthly Demand (units) 10,000 units
Profit per month = {Monthly demand (units) × Contribution
per unit} – ₹40,00,000
Fixed Cost per month = (10,000 × ₹500 per unit) - ₹10,00,000

(b) Break-even point (units per month) and profit per month under Activity Based CVP method.
Number of units produced per batch is 25. Therefore, number of set-ups will be 10,000 units /
25 units = 400 per month.

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 [6. 6]

Selling Price per unit ₹8,000

Variable Cost per unit ₹7,500
Contribution per unit ₹500
Fixed Cost per month (per Activity Based method) ₹8,00,000
Break-even Point (per month in units)
= {Fixed Cost p.m. + (number of set-ups × cost per set-up)}/
Contribution p.u. 2,000 units
= {₹8,00,000 + (400 × ₹500 per set-up)}/ ₹500 per unit
= ₹10,00,000 / ₹500 per unit
Monthly Demand (units) 10,000 units
Profit per month = {Monthly demand (units) × Contribution per unit} –
(Fixed Cost per month + Set-up cost per month) = (10,000 × ₹500 per ₹40,00,000
unit) – (₹8,00,000+₹200,000) = ₹50,00,000 – ₹10,00,000
Although, the BEP units and the profit per month are the same under both methods, Activity
Based 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) Break-even point (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
Selling Price per unit ₹8,000
Variable Cost per unit ₹7,500
Contribution per unit ₹500
Fixed Cost per month (per Activity Based method)
₹8,50,000
Additional cost p.m. for inventory storage = ₹50,000
Break-even Point (per month in units)
= {Fixed Cost p.m. + (number of set-ups × cost per set-up)}/ Contribution
p.u. 1,900 units
= {₹8,50,000 + (200 × ₹500 per set-up)}/ ₹500 per unit
= ₹9,50,000 / ₹500 per unit
Monthly Demand (units) 10,000 units

Profit per month = {Monthly demand (units) × Contribution per unit} –

₹40,50,000
(Fixed Cost per month + Set-up cost per month)

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 [6. 7]

= (10,000 × ₹500 per unit) – (₹8,50,000+₹1,00,000) = ₹50,00,000 –

₹9,50,000

Analysis
It can be concluded 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:
(a) Cost of temporary labour hired for particular set-up or cost of outsourcing of set-up
activities would be included in set-up costs.
(b) 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.
(c) 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, and where no further overtime working is possible, the opportunity cost of labour
needs to be considered along with the hourly labour rate.
(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.

Ques 2

Catalyst Ltd. Makes a single product with the following details:

Current Proposed
Description
Situation Change
Selling Price (`/unit) 10
Direct Costs (`/unit) 5
Present number of setups per production
period, (before each production run, setup 42
is done)
Decrease by `
Cost per set up (`) 450
90
Production units per run 960 1,008

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 [6. 8]

Engineering hours for production period 500 422

Cost per engineering hour (`) 10
The company has begun Activity Based Costing of fixed costs and has presently identified two
cost drivers, viz. production runs and engineering hours. Of the total fixed costs presently at `
96,000, after the above, ` 72,100 remains to be analyzed. There are changes as proposed above
for the next production period for the same volume of output.
Required-
(i) How many units and in how many production runs should Catalyst Ltd. produce in the
changed scenario in order to break-even?
(ii) Should Catalyst Ltd. continue to break up the remaining fixed costs into activity based
costs? Why?

Solution:

Workings
Statement Showing ‘Non-unit Level Overhead Costs’

Particulars Current Situation Proposed Situation

40
No. of Production Runs/
Setups 42 960 𝑢𝑛𝑖𝑡𝑠 × 42 𝑠𝑒𝑡𝑢𝑝
( )
1008 𝑢𝑛𝑖𝑡𝑠
Cost per Setup ` 450 ` 360
Production Units per run 960 units 1,008 units
40,320
Production Units (960 units × 42) 40,320

Engineering Hrs. 500 422

Engineering Cost per hour ` 10 ` 10

Requirement of Question:
(i) Break Even Point (Changed Scenario)
Break Even Point =
Fixed Cost+ (Setup Cost × No. of Setups)+ (Engineering Costs × No. of Engineering Hrs.)
(Price - Unit Variable Cost)
72,100+ ( Rs. 360× 40 Setups)+ (`10 × 422 hrs.)
( 10 - 5 )
= 18,144 units

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 [6. 9]

Break Even Point (No of Production Runs) =

= Break Even (units)____
Production (units per run)
= 18,144
1008 units
= 18 runs
(ii) A company should adopt Activity Based Costing (ABC) system for accurate product
costing, as traditional volume based costing system does not take into account the Non-
unit Level Overhead Costs such as Setup Cost, Inspection Cost, and Material Handling
Cost etc. Cost Analysis under ABC system showed that while these costs are largely
fixed with respect to sales volume, but they are not fixed to other appropriate cost
drivers. If break up the remaining ` 72,100 fixed costs consist of only a small portion
of these costs, ABC need not be applied.
However, it may also be noted that the primary study has resulted in cost savings. If the savings
in cost are expected to exceed the cost of study and implementing ABC, it may be justified.
Further it is pertinent to mention that ABC offers no increase in product- costing accuracy for
single-product setting.
Ques 3

Linex Limited manufactures three products P, Q and R which are similar in nature and are
usually produced in production runs of 100 units. Product P and R require both machine hours
and assembly hours, whereas product Q requires only machine hours. The overheads incurred
by the company during the first quarter are as under:

Machine Department expenses…………………........................ 18,48,000

Assembly Department expenses…………………………………. 6,72,000
Setup costs…………………………………………………………. 90,000
Stores receiving cost………………………………………………. 1,20,000
Order processing and dispatch…………………………………… 1,80,000
Inspect and Quality control cost………………………………… 36,000
The date related to the three products during the period are as under:

P Q R
Units produced and sold 15,000 12,000 18,000
48,000 54,000
Machine hours worked 30,000 hrs.
hrs. hrs.
27,000
Assembly hours worked (direct labour hours) 15,000 hrs. -
hrs.
Customers orders executed (in numbers) 1,250 1,000 1,500
Number of requisitions raised on the stores 40 30 50

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 [6. 10]

Required
Prepare a statement showing details of overhead costs allocated to each product type using
activity based costing.
Solution:

Calculation of “Activity Rate”

Cost Driver Rate

Cost (`) Cost Driver
Cost Pool (`)
[A] [B]
[C] = [A]÷[B]

Machine Department Machine Hours

18,48,000 14.00
Expenses (1,32,000 hrs.)
Assembly Department Assembly Hours
6,72,000 16.00
Expenses (42,000 hrs.)
No. of Production Runs
Setup Cost 90,000 200.00
(450*)
No. of Requisitions
Stores Receiving Cost 1,20,000 Raised on the Stores 1,000.00
(120)
No. of Customers
Order Processing and
1,80,000 Orders Executed 48.00
Dispatch
(3,750)
Inspection and Quality No. of Production Runs
36,000 80.00
Control Cost (450*)
Total (`) 29,46,000
*Number of Production Run is 450 (150 + 120 + 180)

Statement Showing “Overheads Allocation”

Particulars of Cost Cost Driver P Q R Total

Machine 7,56,000
4,20,000 6,72,000
Department Machine Hours (54,000 × 18,48,000
(30,000 × `14) (48,000 × `14)
Expenses `14)
Assembly 4,32,000
2,40,000
Departmental Assembly Hours --- (27,000 × 6,72,000
(15,000 × `16)
Expenses `16)
No. of 30,000 24,000 36,000
Setup Cost 90,000
Production Runs (150 ×`200) (120 ×`200) (180 ×200)
No. of 50,000
40,000 30,000
Stores Receiving Requisitions (50 × 1,20,000
(40 × `1,000) (30 × `1,000)
Cost Raised on the `1,000)
Stores

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 [6. 11]

No. of 72,000
Order Processing 60,000 48,000
Customers (1,500 × 1,80,000
and Dispatch (1,250 × `48) (1,000 × `48)
Orders Executed `48)
Inspection and No. of
12,000 9,600 14,400
Quality Control Production 36,000
(150 × `80) (120 × `80) (180 × `80)
Cost Runs
Overhead (`) 8,02,000 7,83,600 13,60,400 29,46,000

Ques 4

G-2020 Ltd. is a manufacturer of a range of goods. The cost structure of its different products
is as follows:

Particulars A B C
Direct Materials 50 40 40 `/u
Direct Labour @ ` 10/ hour 30 40 50 `/u
Production Overheads 30 40 50 `/u
Total Cost 110 120 140 `/u
Quantity Produced 10,000 20,000 30,000 Units

G-2020 Ltd. was absorbing overheads on the basis of direct labour hours. A newly appointed
management accountant has suggested that the company should introduce ABC system and
has identified cost drivers and cost pools as follows:

Activity Cost Pool Cost Driver Associated Cost

Stores Receiving Purchase Requisitions 2,96,000
Number of Production
Inspection 8,94,000
Runs
Dispatch Orders Executed 2,10,000
Machine Setup Number of Setups 12,00,000
The following information is also supplied:

Details Product A Product B Product C

No. of Setups 360 390 450
No. of Orders Executed 180 270 300
No. of Production Runs 750 1,050 1,200
No. of Purchase Requisitions 300 450 500

Required
Calculate activity based production cost of all the three products.

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 [6. 12]

Solution-

The total production overheads are `26,00,000: Product A: 10,000 × ` 30 = ` 3,00,000

Product B: 20,000 × ` 40 = ` 8,00,000
Product C: 30,000 × ` 50 = ` 15,00,000
On the basis of ABC analysis this amount will be apportioned as follows:

Statement Showing “Activity Based Production Cost”

Activity Total A B C
Cost Driver Ratio
Cost Pool Amount (`) (`) (`) (`)
Stores Purchase
[Link] 2,96,000 71,040 1,06,560 1,18,400
Receiving Requisition
Production
Inspection [Link] 8,94,000 2,23,500 3,12,900 3,57,600
Runs
Orders
Dispatch [Link] 2,10,000 50,400 75,600 84,000
Executed
Machine
Setups [Link] 12,00,000 3,60,000 3,90,000 4,50,000
Setups
Total Activity Cost 7,04,940 8,85,060 10,10,000
Quantity Sold 10,000 20,000 30,000
Unit Cost (Overheads) 70.49 44.25 33.67
Add: Conversion Cost 80 80 90
Total 150.49 124.25 123.67

Ques 5

Chicago Manufacturing Co. (CMC) manufactures several product of varying levels of

designs and models. It uses a single overhead recovery rate based on direct labour hours. The
overheads incurred by the CMC in the half of the year are as under:
`Machine operation expenses………………………………… 10,12,500
Machine maintenance expenses……………………………… 1,87,500
Salaries of technical staff……………………………………… 6,37,500
Wages and salaries of stores staff…………………………… 2,62,500
During this period, CMC introduced activity based costing system and the following
significant activities were identified:
— receiving materials and components
— set up of machines for production runs
— quality inspection It is determined that:

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 [6. 13]

— The machine operation and machine maintenance expenses should be apportioned

between stores and production activity in 20:80 ratio.
— The technical staff salaries should be apportioned between machine maintenance ,
set up and quality inspection in [Link] ratio.
The consumption of activities during the period under review are as under:
— Direct labour hours worked 40,000
— Direct wage rate ` 6 per hour
— Production set-ups 2,040
— Material and component consignments from received from suppliers 1,960
— Number of quality inspections carried out 1,280
The data relating to two product manufactured by the CMC during the period are as under:

Product P Product Q
Direct material costs (`) 6,000 4,000
Direct labour hours 960 100
Direct material consignments received 48 52
Production runs 36 24
Number of quality inspections done 30 10
Quantity produced (units) 15,000 5,000

A potential customer has approached CMC for the supply of 24,000 units of a component K to
be delivered in lots of 3,000 units per quarter. The job will involve an initial design cost of`
60,000 and the manufacture will involve the following per quarter:
Direct material costs Rs. 12,000
Direct labour hours 300
Production runs 6
Inspections 24
Number of consignments of 20
Direct materials to be received CMC desires a mark up of 25% on cost.
Required
(i) Calculate the cost of product P and Q based on the existing system of single overhead
recovery rate.
(ii) Determine the cost of product P and Q using activity based costing system.
(iii) Compute the sales value per quarter of component K using activity based costing system.

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 [6. 14]

Solution-

(i) Statement Showing “Computation of Cost of Product P and Q”

(Based on the Existing System of ‘Single Overhead Recovery Rate’)
Product P Product Q
Units 15,000 5,000
Direct Materials Cost (`) 6,000 4,000
5,760 600
Direct Labour Cost (`)
(960 hours x `6) (100 hours x `6)
Overheads (`) 50,400 5,250
(Refer to W.N. 1) (960 hours x ` 52.50) (100 hours x `52.50)
Total Cost of Products (`) 62,160 9,850
4.144
1.97
Cost per unit (`) (` 62,160 / 15,000
(` 9,850 / 5,000 units)
units)

(ii) Statement Showing Computation of Cost of Products P and Q

(Using ‘Activity Based Costing System’)

Product P Product Q
Units 15,000 5,000
Direct Materials Cost (`) 6,000 4,000
Direct Labour Cost (`) 5,760 600

Receiving Cost 13,243 14,346

(Refer to W.N. 4) (48 x `275.89) (52 x `275.89)

Setup Cost 24,141 16,094

(Refer to W.N. 4) (36 x `670.59) (24 x 670.59)

Inspection Cost 4,482 1,494

(Refer to W.N. 4) (30 x `149.41) (10 x `149.41)

Total Cost of Products (`) 53,626 36,534

3.58 7.31
Cost per unit (`)
(`53,626 /15,000 units) (`36,534 /5,000 units)

(iii) Computation of Sales Value per Quarter ‘Component K’

(Using ‘Activity Based Costing System’)

3,000 units of ‘Component K’ to be delivered per quarter `

Initial Design Cost per quarter (`60,000 / 8 quarters) 7,500

Direct Material Cost 12,000

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Direct Labour Cost (300 hours x `6) 1,800

Receiving Cost (20 No. of Consignment x `275.89) 5,518

Setup Cost (6 Production Runs x `670.59) 4,024

Inspection Cost (24 Inspections x `149.41) 3,586

Total Cost 34,428

Add: Mark up (25%of cost) 8,607

Sales Value 43,035

Selling Price per unit ‘K’ (`43,035 / 3,000 units) 14.35

Working Notes:
1. Overhead Rate per Labour Hour
= Total Overhead Incurred by the Company in First Half
Year Total Direct Labour Hours Worked
= Rs. 21,00,000
40,000 Hours

= 52.50 per labour hour

2. Statement Showing Apportionment of ‘Technical Staff Salaries’ Over ‘Machine

Maintenance’, ‘Setup’ and ‘Quality Inspection’ in the Ratio [Link]
Total Machine Quality
Setup
Salaries Maintenance Inspection
(`)
(`) (`) (`)

Technical staff
6,37,500 1,91,250 2,55,000 1,91,250
salaries

3. Statement Showing Apportionment of ‘Machine Operation’ and ‘Machine

Maintenance’ Between ‘Stores’ and ‘Production Activity (Setup)’
Total Stores / Setup
Expenses Receiving
(`) (`) (`)
Machine Operation (20:80) 10,12,500 2,02,500 8,10,000

Machine Maintenance (20:80)

3,78,750 75,750 3,03,000
[`1,91,250 + `1,87,500]

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(Refer to W.N. 2)

Wages and Salaries of Stores

2,62,500 2,62,500 ----
Staff
Component of Setup Cost
2,55,000 ---- 2,55,000
(Refer to W.N. 2)
Total 19,08,750 5,40,750 13,68,000

4. Rate per ‘Activity Cost Driver’

Stores / Setup Quality
Receiving Inspection
(`) (`) (`)
Total Overheads (`) ...(A) 5,40,750 13,68,000 1,91,250
Units of Activities Carried out ...(B) 1,960 2,040 1,280
Rate per Activity Cost Driver (`)
275.89 670.59 149.41
...{(A) / (B)}

Ques 6

During the last 20 years, JPY Ltd’s manufacturing operation has become increasingly
automated with Computer-controlled robots replacing operators. JPY currently manufactures
over 100 products of varying levels of design complexity. A single plant wise overhead
absorption rate, based on direct labour hours, is used to absorb overhead costs.
In the quarter ended March, JPY’s manufacturing overhead costs were:
(`000)
Equipment Operation 125
Expenses…………………………………..
Equipment Maintenance 25
Expense………………………………..
Wages Paid to 85
Technicians………………………………………
Wages Paid to Store 35
Men…………………………………………
Wages Paid to Despatch 40
Staff…………………………………….
During the quarter, the company reviewed the Cost Accounting System and concluded that
absorbing overhead costs to individual products on a labour hour absorption basis is

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meaningless. Overhead costs should be attributed to products using an Activity Based Costing
(ABC) system and the following was identified as the most significant activities:
(i) Receiving component consignments from suppliers
(ii) Setting up equipment for production runs
(iii) Quality inspections
(iv) Despatching goods as per customer’s orders. During the quarter:
(i) a total of 2,000 direct labour hours were worked (paid at ` 12 per hr.)
(ii) 980 components consignments were received from suppliers
(iii) 1020 production runs were set up
(iv) 640 quality inspections were carried out
(v) 420 orders were dispatched to customers.
Equipment operation and maintenance expenses are apportioned as:
– Component stores 15% , manufacturing 70% and goods dispatch 15% Technician’s
wages are apportioned as:
– Equipment maintenance 30% , set up equipment for production runs 40% and
quality inspections 30%
JPY’s production during the quarter included components R, S and T. The following
information is available:

Component Component Component

R S T

Direct Material ` 1,200 ` 2,900 ` 1,800

Direct Labour Hrs worked 25 480 50
Component Consignments Recd. 42 24 28
Production Runs 16 18 12
Quality Inspections 10 8 18
Orders (goods) Despatched 22 85 46
Quantity Produced 560 12,800 2,400

Required
(i) Calculate the unit cost of R, S and T components, using JPY’s existing cost accounting
system.
(ii) Explain how an ABC system would be developed using the information given. Calculate
the unit cost of components R, S and T using ABC system

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Solution:
310000
Single Factory Direct Labour Hour Overhead Rate =
2000

= Rs. 155 per direct labour hour

Computation of Unit Cost (Existing System)

R S T

Direct Labour Cost @ ` 12 per Hour 300 5,760 600

Direct Material 1,200 2,900 1,800
Overheads (Direct Labour Hours x ` 155
3,875 74,400 7,750
per Hour)
Total Cost 5,375 83,060 10,150
Quantity Produced (No.s) 560 12,800 2,400
Cost per unit 9.60 6.49 4.23

(i) ABC system involves the following stages,

— Identifying the major activities that take place in an organisation.
— Creating a cost pool /cost centre for each activity.
— Determining the cost driver for each activity.
— Assigning the cost of activities to cost objects (e.g. products, components,
customers etc).
The most significant activities have been identified e.g. receiving components consignments
from suppliers, setting up equipment for production runs, quality inspections, and dispatching
orders to customers. The following shows the assignment of the costs to these activities.

Receiving Quality
Particulars Setups Dispatch Total
Supplies Inspection
Equipment Operation
18.75 87.50 ---- 18.75 125.00
Expenses
Maintenance 3.75 17.50 ---- 3.75 25.00
Technicians Wages [Initially
allocated to Maintenance
(30% of ` 85,000) and then 3.83 17.85 ---- 3.82 25.50
reallocated on same basis on
Maintenance]
Balance of Technicians
Wages (Allocated to Setups ---- 34.00 25.50 ---- 59.50
and Quality Inspections)

Stores Wages - Receiving 35.00 ---- ---- ---- 35.00

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Dispatch Wages - Dispatch ---- ---- ---- 40.00 40.00

Total 61.33 156.85 25.50 66.32 310.00

Equipment operation expenses and Maintenance allocated on the basis 15%,70% and 15% as
specified in the problem.
The next stage is to identify the cost drivers for each activity and establish cost driver rates by
dividing the activity costs by a measure of cost driver usage for the period. The calculations
are as follows:
61330
Receiving Supplies = [ ] = 62.58 per consignment
980 𝑐𝑜𝑛𝑠𝑖𝑔𝑛𝑚𝑒𝑛𝑡

156850
Performing setups = [ ] = 153.77 per setup
1020 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑟𝑢𝑛𝑠

66320
Dispatching Goods = [ ] = 157.90 per dispatch
420 𝑜𝑟𝑑𝑒𝑟𝑠

25500
Quality Inspection = [ ] = 39.84 per quality inspections
640 𝐼𝑛𝑠𝑝𝑒𝑐𝑡𝑖𝑜𝑛𝑠

Finally, costs are assigned to components based on their cost driver usage. The assignments
are as follows:

R S T
Particulars of Costs
(`) (`) (`)
Direct Labour 300.00 5,760.00 600.00
Direct Materials 1,200.00 2,900.00 1,800.00
Receiving Supplies 2,628.36 1,501.92 1,752.24
Performing Setups 2,460.32 2,767.86 1,845.24
Quality Inspections 398.40 318.72 717.12
Despatching Goods 3,473.80 13,421.50 7,263.40
Total Costs 10,460.88 26,670.00 13,978.00
No of Units Produced 560 12,800 2,400
Cost per unit 18.68 2.08 5.82

For components, the overhead costs have been assigned as follows:

Particulars Component R Component S Component T

Receiving `Rs. 2,628.36 Rs. 1,501.92 Rs.`1,752.24
Supplies (42 Receipts at Rs. (24 Receipts at Rs. (28 Receipts at Rs.

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62.58) 62.58) 62.58)

`Rs.2,460.32 Rs.`2,767.86 `Rs.1,845.24

Performing (16 Production (18 Production (12 Production
Setups Runs Runs Runs
at Rs.` 153.77) at `Rs. 153.77) at `Rs. 153.77)
`Rs.398.40 `Rs.318.72 `Rs.717.12
Quality
Inspections (10 Inspections at (8 Inspections at (18 Inspections at
Rs.` 39.84) Rs.` 39.84) Rs. `39.84)
Rs.`3,473.80 Rs.`13,421.50 `Rs.7,263.40
Dispatching
Goods (22 Orders at `Rs. (85 Orders at `Rs. (46 Orders at `Rs.
157.90) 157.90) 157.90)

Ques 7

Super Food Ltd. Manufactures 3 types of biscuits, A, B and C, in a fully mechanised factory.
The company has been following conventional method of costing and wishes to shift to
Activity Based Costing System and therefore wishes to have the following data presented under
both the systems for the month.
Inspection Cost ` p.m. 73,000
Machine – Repairs & Maintenance ` p.m. 1,42,000
Dye Cost ` p.m. 10,250
Selling Overheads ` p.m. 1,62,000

Product A Product B Product C

Prime Cost (` per unit) 12 9 8
Selling Price (` per unit) 18 14 12
Gross Production (units / production
2,520 2,810 3,010
run)
No. of Defective (units / production
20 10 10
run)
Product
Product A Product B
C
Inspection:
3 4 4
No. of Hours / Production Run
Dye Cost / Production Run (` ) 200 300 250
No. of Machine Hours / Production
20 12 30
Run
Sales – No. of Units / Month 25,000 56,000 27,000
The following additional information is given:

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(i) No accumulation of inventory is considered. All good units produced are sold.
(ii) All manufacturing and selling overheads are conventionally allocated on the basis of units
sold.
(iii) Product A needs no advertisement. Due to its nutritive value, it is readily consumed by
diabetic patients of a hospital. Advertisement costs included in the total selling overhead
is ` 83,000.
(iv) Product B needs to be specially packed before being sold, so that it meets competition.
` 54,000 was the amount spent for the month in specially packing B, and this has been included
in the total selling overhead cost given.
Required
Present product wise profitability of statements under the conventional system and the ABC
system and accordingly rank the products.
Solution:

Statement Showing “Gross Margin”

Particulars A B C Total
Sales Units 25,000 56,000 27,000 1,08,000
Selling Price per unit 18 14 12
Sales Value (`) …(A) 4,50,000 7,84,000 3,24,000 15,58,000
Prime Cost Overhead 12 9 8
No. of Units per run 2,520 2,810 3,010
Prime Cost (`) …(B) 3,02,400 5,05,800 2,16,720
Gross Margin …(A) - (B) 1,47,600 2,78,200 1,07,280 5,33,080

Statement Showing “Production & Selling Overheads”

Particulars A B C Total
Inspection Cost
73000 15,000 40,000 18,000 73,000
( × 30/80/60 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦)
146
Machine maintenance cost
142000 40,000 48,000 54,000 1,42,000
( × 200/240/270 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦)
710
Dye cost 2,000 6,000 2,250 10,250
Production overheads 57,000 94,000 74,250 2,25,250

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Advertisement
83000 ---- 56,000 27,000 83,000
( × 56/27 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦)
56000 + 27000
Packing ---- 54,000 ---- 54,000
Other overheads
25000 5,787 12,963 6,250 25,000
( × 25/56/27 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦)
108
Selling Overheads 5,787 1,22,963 33,250 1,62,000

Workings

No. Particulars A B C Total

(1) Gross Production (unit /run) 2,520 2,810 3,010
(2) Defectives / Run 20 10 10
(3) Good Units / Run 2,500 2,800 3,000
(4) Sales (goods units) 25,000 56,000 27,000
(5) No. of Runs 10 20 9
(6) Gross Production …(1 x 5) 25,200 56,200 27,090
(7) Prime Cost / Unit 12 9 8
(8) Prime Cost (`) 3,02,400 5,05,800 2,16,720 10,24,920
(9) Inspection Hours / Run 3 4 4
(10) Inspection Hours …(9 x 5) 30 80 36 146
(11) M/c Hours / Run 20 12 30
(12) M/c Hours …(11 x 5) 200 240 270 710
(13) Dye Cost / Run 200 300 250
(14) Dye Cost …(13 x 5) 2,000 6,000 2,250 10,250

“Statement Showing Rank - Conventional Accounting System”

Particulars A B C Total
Sales – Units / Production (good units) 25,000 56,000 27,000 1,08,000
Gross Margin (`) …(A) 1,47,600 2,78,200 1,07,280 5,33,080
Production Overheads (`) 52,141 1,16,797 56,313 2,25,250
Selling Overheads (`) 37,500 84,000 40,500 1,62,000
Sub-Total Overheads (`) …(B) 89,641 2,00,797 96,813 3,87,250
Net Profit (`) …(A) – (B) 57,959 77,403 10,467 1,45,830
Ranking II I III

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Statement Showing “Rank - Activity Based System”

Particulars A B C Total
Sales – Units / Production
25,000 56,000 27,000 1,08,000
(good units)
Gross Margin (`) …(A) 1,47,600 2,78,200 1,07,280 5,33,080
Production Overheads (`) 57,000 94,000 74,250 2,25,250
Selling Overheads (`) 5,787 1,22,963 33,250 1,62,000
Sub-Total Overheads (`) …(B) 62,787 2,16,963 1,07,500 3,87,250
Net Profit (`) …(A) – (B) 84,813 61,237 (220) 1,45,830
Ranking I II III

Ques 8

Humara - Apna’ bank offers three products, viz., deposits, Loans and Credit Cards. The bank
has selected 4 activities for a detailed budgeting exercise, following activity based costing
methods.
The bank wants to know the product wise total cost per unit for the selected activities, so that
prices may be fixed accordingly.
The following information is made available to formulate the budget:

Present
Activity Cost (`) Estimation for the budget period

ATM Services:
4,00,000 All fixed, no change.
Machine
(a) 2,00,000 Fully fixed, no change.
Maintenance Expected to double during budget
(b) Rents
1,00,000
period.
(c) Currency
Replenishment Cost 7,00,000 (This activity is driven by no. of ATM
transactions)
Half this amount is fixed and no change
is expected.
The variable portion is expected to
Computer Processing 5,00,000 increase to three times the current
level.
(This activity is driven by the number of
computer transactions)

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Presently, 3 lac statements are made. In

the budget period, 5 lac statements are
expected. For every increase of one lac
Issuing Statements 18,00,000 statement, one
lac rupees is the budgeted increase.
(This activity is driven by the number of
statements)
Estimated to increase by 80% during
the budget period.
Computer Inquiries 2,00,000
(This activity is driven by telephone
minutes)

The activity drivers and their budgeted quantifies are given below:

Credit
Activity Drivers Deposits Loans
Cards
No. of ATM Transactions 1,50,000 --- 50,000
No. of Computer Processing
15,00,000 2,00,000 3,00,000
Transactions
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000
The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and 14,000
Credit Card Accounts
Required
(i) Calculate the budgeted rate for each activity.
(ii) Prepare the budgeted cost statement activity wise.
(iii) Find the budgeted product cost per account for each product using (i) and (ii) above

Solution:

Statement Showing “Budgeted Cost per unit of the Product”

No. of
Activity
Units of Activity
Cost Activity Credit
Activity Activity Rate Deposits Loans
(Budgeted) Driver Cards
Driver (`)
(`)
(Budget)
No. of
ATM
8,00,000 ATM 2,00,000 4.00 6,00,000 --- 2,00,000
Services
Transaction
No. of
Computer
10,00,000 Computer 20,00,000 0.50 7,50,000 1,00,000 1,50,000
Processing
Transaction

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Issuing No. of
20,00,000 5,00,000 4.00 14,00,000 2,00,000 4,00,000
Statements Statements
Customer Telephone
3,60,000 7,20,000 0.50 1,80,000 90,000 90,000
Inquiries Minutes
Budgeted
41,60,000 29,30,000 3,90,000 8,40,000
Cost
Units of Product (as estimated in the budget period) 58,600 13,000 14,000
Budgeted Cost per unit of the product 50 30 60

Working Note
Budgeted
Activity Remark
Cost (`)
ATM Services:
(a) Machine Maintenance
4,00,000 − All fixed, no change.
(b) Rents
2,00,000 − Fully fixed, no change.
(c) Currency
Replenishment Cost 2,00,000 − Doubled during budget
period.
8,00,000
Total

Budgeted
Activity Remark
Cost (`)
Computer Processing 2,50,000 − `2,50,000 (half of `5,00,000) is
fixed and no change is expected.
7,50,000 − `2,50,000 (variable portion) is
expected to increase to three times
Total 10,00,000 the current level.
Issuing Statements − Existing.
18,00,000 − 2 lac statements are expected to
2,00,000 be increased in budgeted period.
For every increase of one lac
statement, one lac rupees is the
Total 20,00,000 budgeted increase.
Computer Inquiries − Estimated to increase by 80%
3,60,000
during the budget period.
Total 3,60,000 (`2,00,000 x 180%)

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Ques 9
Bank of HK operated for years under the assumption that profitability can be increased by
increasing Rupee volumes. But that has not been the case. Cost analysis has revealed the
following:

Activity Cost Activity

Activity Activity Driver
(`) Capacity
Providing ATM
1,00,000 No. of Transactions 2,00,000
Service
Computer Processing 10,00,000 No. of Transactions 25,00,000
Issuing Statements 8,00,000 No. of Statements 5,00,000
Customer Inquiries 3,60,000 Telephone Minutes 6,00,000
The following annual information on three products was also made available:

Checking Personal Gold

Activity Driver Loans Visa
Accounts
Units of Product 30,000 5,000 10,000
ATM Transactions 1,80,000 0 20,000
Computer Transactions 20,00,000 2,00,000 3,00,000
Number of Statements 3,00,000 50,000 1,50,000
Telephone Minutes 3,50,000 90,000 1,60,000
Required
(i) Calculate rates for each activity.
(ii) Using the rates computed in requirement (i), calculate the cost of each product

Solution:

No. of
Units of Activity
Activity Rate
Activity Activity Driver Activity
Cost [a] (`) [a] / [b]
Driver (`)
[b]
Providing ATM No. of ATM
1,00,000 2,00,000 0.50
Service Transactions
Computer No. of Computer
10,00,000 25,00,000 0.40
Processing Transactions
Issuing Statements 8,00,000 No. of Statements 5,00,000 1.60
Customer Inquiries 3,60,000 Telephone Minutes 6,00,000 0.60

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Statement Showing “Cost of Product”

Checking Accounts
Activity Personal Loans (`) Gold Visa (`)
(`)
Providing ATM 90,000 10,000
---
Service (1,80,000 tr.×` 0.50) (20,000 tr. × ` 0.50)
8,00,000 80,000 1,20,000
Computer
Processing (20,00,000 tr. × ` (2,00,000 tr. × ` (3,00,000 tr. × `
0.40) 0.40) 0.40)
4,80,000 80,000 2,40,000
Issuing Statements (3,00,000 st. × ` (50,000 st. × ` (1,50,000 st. × `
1.60) 1.60) 1.60)
2,10,000 54,000 96,000
Customer Inquiries (3,50,000 min. × ` (90,000 min. × ` (1,60,000 min. × `
0.60) 0.60) 0.60)
Total Cost [a] ` 15,80,000 ` 2,14,000 ` 4,66,000
Units of Product [b] 30,000 5,000 10,000
Cost of each
Product 52.67 42.80 46.60
[a] / [b]

Ques 10

DEO Limited sells two versions: Deluxe and Premium of its only product GoGo Juicer. The
GoGo Juicer uses patented technology to extract the last drop of juice from most fruits. The
'Premium' version can handle larger fruit and has more options relative to the 'Deluxe' version.
The following table provides the financial results of the most recent year of operations:

Deluxe Premium Total

Particulars 90,000 10,000 1,00,000
units units units
Revenue (`) 63,00,000 9,00,000 72,00,000
Material cost (`) 10,80,000 2,50,000 13,30,000
Direct labour cost (`) 14,40,000 1,60,000 16,00,000
Contribution margin (`) 37,80,000 4,90,000 42,70,000
Allocated fixed manufacturing overhead
34,20,000 3,80,000 38,00,000
(`)
Allocated fixed selling and
administrative overheads (`) 2,51,563 35,937 2,87,500
Profit margin (`) 1,08,437 74,063 1,82,500
Profit margin per unit (`) 1.2048 7.4063

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Labour cost is ` 16 per hour and each product requires one hour of labour. The company
currently allocates all fixed manufacturing overheads, using labour hours as the allocation
basis. It allocates fixed selling and administrative overheads, using revenue as the allocation
base.
Although the profit margin per unit of 'Deluxe' juicer is rather low, DEO Limited believes that
it is important to keep this model in the product mix. However, DEO can tailor its promotion
and sales strategies to improve the sales mix to 16:4 ratio from the current 9:1 ratio of 'Deluxe'
to 'Premium' juicers, with total volume staying at 1,00,000 units.
DEO Limited finds that ` 1.1 million of the ` 3.8 million of fixed manufacturing overheads
pertains to batch related activities such as scheduling production runs. Similarly, ` 1,15,000 is
the amount of administrative overheads out of the ` 2,87,500 of selling and administrative
overheads.
It is found that the 'premium' juicer is produced in smaller batches (250 units per batch) than
that of 'Deluxe' juicer (500 units per batch). Similarly, it takes 10 sales visits to sell 1,000 units
of the 'Deluxe' juicer, while it takes 25 visits to sell 1,000 units of 'Premium' juicer.

Required
(i) Prepare a profitability statement based on the proposed sales mix, using the most
appropriate basis of allocating fixed overheads. (In absence of an appropriate basis, do
not allocate overheads to products)
(ii) Advise the company on whether it should go ahead with the propose change in sales mix.

Solution:
(i) Profitability Statement New Mix - Most Appropriate Basis
Deluxe Premium
80,000 Units 20,000 Units
Particulars Total (`)
P.U. Amount P.U. Amount
(`) (`) (`) (`)
Revenue 70.00 56,00,000.00 90.00 18,00,000.00 74,00,000.00
Material Cost 12.00 9,60,000.00 25.00 5,00,000.00 14,60,000.00
Direct Labour Cost
[One hour per unit; 16.00 12,80,000.00 16.00 3,20,000.00 16,00,000.00
(80,000 hrs., 20,000
hrs.)]
Contribution Margin 42.00 33,60,000.00 49.00 9,80,000.00 43,40,000.00
Unit Related Fixed Mfg.
Overheads [Allocation on
the basis of direct labour
21,60,000.00 5,40,000.00 27,00,000.00
hours
(80,000:20,000);
(W.N.1)]

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Batch Related Fixed Mfg.

Overheads [Allocation on
7,33,333.33 3,66,666.67 11,00,000.00
the basis of no. of batches
(160:80); (W.N. 1 & 4)]
Fixed Selling Overheads
[Allocated on the basis of
sales 1,06,153.85 66,346.15 1,72,500.00
visits (800:500); (W.N. 2
& 3)]
Profit Margin Ex
Admin 3,60,512.82 6,987.18 3,67,500.00
Overheads
Admin Overheads [W.N. 2] 1,15,000.00
Profit Margin 2,52,500.00

Working
Note W.N.1

Fixed Mfg. Overheads 38,00,000.00

Less: Related to batch related activities 11,00,000.00
Fixed Mfg. Overheads – unit related 27,00,000.00

Note W.N.2

Selling & Admn. Overheads 2,87,500.00

Less: Admn. Overheads 1,15,000.00
Selling Overheads 1,72,500.00

Note W.N.3

10 Sales Visit 25 Sales Visit

No. of Visits for 1,000 Units for 1,000 Units Total
(Deluxe) (Premium)

For Proposed Mix - Sales Visit 800 500 1,300

Note W.N. 4

1 Batch for 1 Batch for

No. of Batches 500 Units 250 Units Total
(Deluxe) (Premium)
For Proposed Mix - Batches 160 80 240

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(ii) Change in product mix, yields profit of ` 70,000/- (` 2,52,500 - ` 1,82,500). Accordingly
company should go with proposed change mix.

Note -- This problem can be solved by assuming that some portion of the fixed cost as fixed
with respect to units of production, but variable with respect to certain activities. When the
production size is altered, these activities are increased and therefore, the activity cost varies
for the proposed production level. More batches of production and more sales visits will set off
the incremental contribution.

Que 11

Asian Mfg. Co. had decided to increase the size of the store. It wants the information about the
probability of the individual product lines : Lemon, Grapes and Papaya. It provides the
following data for the 2013 for each product line:

Particulars Lemon Grapes Papaya

Revenues (`) 79,350 2,10,060 1,20,990
Cost of goods sold (`) 60,000 1,50,000 90,000
Cost of bottles returned (`) 1,200 0 0
Number of purchase orders
36 84 36
placed
Number of deliveries
30 219 66
received
Hours of shelf stocking time 54 540 270
Items sold 12,600 1,10,400 30,600

Asian Mfg. Co. also provides the following information for the year 2013

Total Cost Allocation

Activity Description of Activity Costs
Basis
(`)
Bottle Returning of empty bottles to Direct tracing to
1,200
returns the store product line
156 purchase
Ordering Placing of orders of purchases 15,600
orders
Physical delivery and the
Delivery 25,200 315 deliveries
receipts of merchandise
Stocking of merchandise on
Self 864 hours of
store shelves and ongoing 17,280
stocking time
restocking
Assistance provided to
Customer 1,53,600 items
customers including bagging 30,720
support sold
and checkout

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Required
(i) Asian Mfg. Co. currently allocates store support costs (all costs other than the cost of
goods sold) to the product line on the basis of the cost of goods sold of each product line.
Calculate the operating income and operating income as the percentage of revenue of
each product line.
(ii) If Asian Mfg. Co. allocates store support costs (all costs other than the cost of goods sold)
to the product lines on the basis of ABC system, calculate the operating income and
operating income as the percentage of revenue of each product line
(iii) Compare both the systems
Solution:

(i) Traditional Costing

System Operating Income-

Particulars Lemon Grapes Papaya Total

Revenue 79,350 2,10,060 1,20,990 4,10,400

Less: Cost of Goods Sold 60,000 1,50,000 90,000 3,00,000

Less: Store Support Cost 18,000 45,000 27,000 90,000

Operating Income 1,350 15,060 3,990 20,400

Operating Income (%) 1.70 7.17 3.30 4.97

(ii)ABC System
Overhead Allocation Rate-

Total Costs Quantity of Cost Overhead

Activity
(`) Allocation Base Allocation Rate (`)

Ordering 15,600 156 Purchase Orders 100.00

Delivery 25,200 315 Delivering Orders 80.00

Shelf Stocking 17,280 864 Self Stocking Hours 20.00

Customer
30,720 1,53,600 Items Sold 0.20
Support

Store Support Cost-

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Particulars Cost Driver Lemon Grapes Papaya Total

Bottle Returns Direct 1,200 0 0 1,200
Ordering Purchase Orders 3,600 8,400 3,600 15,600
Delivery Deliveries 2,400 17,520 5,280 25,200
Self Stocking Hours of time 1,080 10,800 5,400 17,280
Customer Support Items Sold 2,520 22,080 6,120 30,720
Grand Total 10,800 58,800 20,400 90,000

Operating Income-

Particulars Lemon Grapes Papaya Total

Revenue 79,350 2,10,060 1,20,990 410,400
Less: Cost of Goods Sold 60,000 1,50,000 90,000 300,000
Less: Store Support Cost 10,800 58,800 20,400 90,000
Operating Income 8,550 1,260 10,590 20,400
Operating Income (%) 10.78 0.60 8.75 4.97

(iii) Comparison
Particulars Lemon Grapes Papaya Total
Under Traditional Costing System 1.70% 7.17% 3.30% 4.97%
Under ABC System 10.78% 0.60% 8.75% 4.97%

The grapes line drops sizeably when ABC is used. Although it constitutes 50 % of ‘Cost of
Goods Sold (COGS)’, it uses a higher percentage of total resources in each activity area,
especially the high cost of customer support area. In contrast, lemon line draws a much lower
percentage of total resources used in each activity area than its percentage of total COGS.
Hence under ABC, Lemon is most profitable. Fruitolay can explore ways to increase sales of
lemons and also explore price increases on grapes.
Operating Income Ranking is highest for Grapes under Traditional System because other
products bear its overhead cost, whereas under ABC a more accurate picture shows Grapes as
the lowest ranking product.

Ques 12
Golden North Ltd. manufactures four products, namely A, B, C and D using the same plant
and process. The following information relates to a production period:
Product A Product B Product C Product D
Output in units 720 600 480 504
Cost per unit: ` ` ` `
Direct Material 42 45 40 48

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Direct Labour 10 9 7 8
Machine hours per unit 4 hrs. 3 hrs. 2 hrs. 1 hr.
The four products are similar and are usually produced in production runs of 24 units and sold
in batches of 12 units. Using machine hour rate currently absorbs the production overheads.
The total overheads incurred by the company for the period is as follows:
Machine operation and maintenance cost (`) 63,000
Setup costs (`) 20,000
Store receiving (`) 15,000
Inspection (`) 10,000
Material handling and dispatch(`) 2,592
During the period the following cost drivers are to be used for the overhead cost:
Activity Cost Driver
Setup cost No. of production runs
Store receiving Requisition raised
Inspection No. of production runs
Material handling and dispatch Orders executed
It is also determined that:
— Machine operation and maintenance cost should be apportioned between setup cost,
store receiving and inspection activity in [Link].
— Number of requisition raised on store is 50 for each product and the no. of order
executed is 192, each order being for a batch of 12 of a product.
Required
(i) Calculate the total cost of each product, if all overhead costs are absorbed on machine
hour rate basis.
(ii) Calculate the total cost of each product using activity base costing.
(iii) Comment briefly on differences disclosed between overhead traced by present system
and those traced by activity based costing
Solution:

(i) Overhead Absorption on Machine Hour Basis

A B C D
Particulars
(`) (`) (`) (`)
Direct Material 42 45 40 48
Direct Labour 10 09 07 08
Overheads 72 54 36 18
Cost of Production per unit 124 108 83 74
Output in units 720 600 480 504
Total Cost 89,280 64,800 39,840 37,296

[[6,144 Machine Hours (720 units × 4 hrs. + 600 units × 3 hrs. + 480 units × 2 hrs. + 504
units × 1 hrs.)]

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1,10,592
Rate per hour = = 𝑅𝑠. 18/ℎ𝑜𝑢𝑟
6,144 ℎ𝑜𝑢𝑟𝑠

(ii) Activity Based Costing System

Statement Showing “Allocation of Machine Operation and Maintenance Cost”
Particulars Setup Receiving Inspection
Machine Operation and Maintenance Cost of
28,000 21,000 14,000
` 63,000 to be distributed in the ratio of 4: 3: 2

Statement Showing “Activities/ Drivers/ Cost”

Cost Cost per unit of
Activity Drivers Nos
(`) Driver (`)
Production
Setup 48,000 96 500.00
Runs
Requisitions
Store Receiving 36,000 200 180.00
Raised
Production
Inspection 24,000 96 250.00
Runs
Material Handling and
2,592 Orders 192 13.50
Disp.

Note:
Production Run for A (720/24) = 30
B (600/24) = 25
C (480/24) = 20
D (504/24) = 21

Statement Showing “Total Cost of Products”

Particulars of A B C D
Costs (`) (`) (`) (`)
Direct Material 30,240 27,000 19,200 24,192
Direct Labour 7,200 5,400 3,360 4,032
15000 12500 10000 10500
720 𝑢𝑛𝑖𝑡𝑠 600 𝑢𝑛𝑖𝑡𝑠 480 𝑢𝑛𝑖𝑡𝑠 504 𝑢𝑛𝑖𝑡𝑠
Setup [ [ [ [
24 𝑢𝑛𝑖𝑡𝑠 24 𝑢𝑛𝑖𝑡𝑠 24 𝑢𝑛𝑖𝑡𝑠 24 𝑢𝑛𝑖𝑡𝑠
× 𝑅𝑠. 500] × 𝑅𝑠. 500] × 𝑅𝑠. 500] × 𝑅𝑠. 500]
9000 9000 9000 9000
Store Receiving [50 𝑅𝑒𝑞 [50 𝑅𝑒𝑞 [50 𝑅𝑒𝑞 [50 𝑅𝑒𝑞
× 𝑅𝑠. 180] × 𝑅𝑠. 180] × 𝑅𝑠. 180] × 𝑅𝑠. 180]
7500 6250 5000 5250
720 𝑢𝑛𝑖𝑡𝑠 600 𝑢𝑛𝑖𝑡𝑠 480 𝑢𝑛𝑖𝑡𝑠 504 𝑢𝑛𝑖𝑡𝑠
Inspection [ [ [ [
24 𝑢𝑛𝑖𝑡𝑠 24 𝑢𝑛𝑖𝑡𝑠 24 𝑢𝑛𝑖𝑡𝑠 24 𝑢𝑛𝑖𝑡𝑠
× 𝑅𝑠. 250] × 𝑅𝑠. 250] × 𝑅𝑠. 250] × 𝑅𝑠. 250]

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810 675 540 567

Material 720 𝑢𝑛𝑖𝑡𝑠 600 𝑢𝑛𝑖𝑡𝑠 480 𝑢𝑛𝑖𝑡𝑠 504 𝑢𝑛𝑖𝑡𝑠
Handling and [ [ [ [
12 𝑢𝑛𝑖𝑡𝑠 12 𝑢𝑛𝑖𝑡𝑠 12 𝑢𝑛𝑖𝑡𝑠 12 𝑢𝑛𝑖𝑡𝑠
Dispatch
× 𝑅𝑠. 13.5] × 𝑅𝑠. 13.5] × 𝑅𝑠. 13.5] × 𝑅𝑠. 13.5]
Total Cost 69,750 60,825 47,100 53,541
Cost per unit 96.875 101.375 98.125 106.23

(iii)

A B C D
Particulars
(`) (`) (`) (`)
Cost per unit (Traditional)
124.00 108.00 83.00 74.00
…(a)
Cost per unit (ABC) …(b) 96.88 101.38 98.13 106.23
Difference …(b) – (a) (27.12) (6.62) 15.13 32.23

The total overheads which are spread over the four products have been apportioned on different
bases, causing the product cost to differ substantially: in respect of product A and D a change
from traditional machine hour rate to an activity system may have effect on price and profits
to the extent that pricing is based on cost plus approach.
Que 13

Woolmark Ltd. manufactures three types of products namely P, Q and R. The data relating to
a period are as under:

Particulars P Q R
Machine hours per unit 10 18 14
Direct Labour hours per unit @ ` 20 4 12 8
Direct Material per unit (`) 90 80 120
Production (units) 3,000 5,000 20,000
Currently the company uses traditional costing method and absorbs all production overheads
on the basis of machine hours. The machine hour rate of overheads is ` 6 per hour.
The company proposes to use activity based costing system and the activity analysis is as under:

Particulars P Q R
Batch size (units) 150 500 1,000
Number of purchase orders per
3 10 8
batch
Number of inspections per batch 5 4 3
The total production overheads are analysed as under:

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Machine set up costs……………………………………… 20%

Machine operation costs……………………………………. 30%
Inspection costs……………………………………………… 40%
Material procurement related costs……………………….. 10%
Required
(i) Calculate the cost per unit of each product using traditional method of absorbing all
production overheads on the basis of machine hours.
(ii) Calculate the cost per unit of each product using activity based costing principles.

Solution:

(i) Statement Showing “Cost per unit - Traditional Method”

P Q R
Particulars of Costs
(`) (`) (`)
Direct Materials 90 80 120
Direct Labour [(4, 12, 8 hours)  `20] 80 240 160
Production Overheads [(10, 18, 14 hours) 
60 108 84
`6]
Cost per unit 230 428 364

(ii) Statement Showing “Cost per unit - Activity Based Costing”

Products P Q R
Production (units) 3,000 5,000 20,000
(`) (`) (`)
Direct Materials (90, 80, 120) 2,70,000 4,00,000 24,00,000
Direct Labour (80, 240, 160) 2,40,000 12,00,000 32,00,000
Machine Related Costs @ `1.80 per hour
(30,000, 90,000, 2,80,000) 54,000 1,62,000 5,04,000

Setup Costs @ `9,600 per setup

(20, 10, 20) 1,92,000 96,000 1,92,000

Inspection Costs @ `4,800 per inspection

(100, 40, 60) 4,80,000 1,92,000 2,88,000

Purchase Related Costs @ `750 per

purchase
45,000 75,000 1,20,000
(60, 100, 160)
Total Costs 12,81,000 21,25,000 67,04,000

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Cost per unit (Total Cost  Units) 427.00 425.00 335.20

Workings
Number of Batches, Purchase Orders, and Inspections

Particulars P Q R Total
A
Production (units) 3,000 5,000 20,000
.
B. Batch Size (units) 150 500 1,000
C. Number of Batches [A  B] 20 10 20 50
D Number of Purchase Order per
3 10 8
. batch
E. Total Purchase Orders [C  D] 60 100 160 320
F. Number of Inspections per batch 5 4 3
G
Total Inspections [C  F] 100 40 60 200
.

Total Machine Hours-

Particulars P Q R
A. Machine Hours per unit 10 18 14
B. Production (units) 3,000 5,000 20,000
C. Total Machine Hours [A  B] 30,000 90,000 2,80,000

Total Machine Hours = 4,00,000

Total Production Overheads- = 4,00,000 hrs.  ` 6 = ` 24,00,000

Cost Driver Rates

Cost
Overheads Cost Driver Rate
Cost Pool % Driver
(`) (`)
(Units)
Setup 20% 4,80,000 50 9,600 per Setup
Inspection 40% 9,60,000 200 4,800 per Inspection
Purchases 10% 2,40,000 320 750 per Purchase
Machine 1.80 per Machine
30% 7,20,000 4,00,000
Hours Hour

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Ques 14

The following are Product Alpha's data for next year budget:
Cost Driver
Cost Pool
Activity Cost Driver Volume /
(`)
Year
Purchasing Purchase orders 1,500 75,000
Setting Batches produced 2,800 1,12,000
Materials handling Materials movements 8,000 96,000
Inspection Batches produced 2,800 70,000
Machining costs Machine hours 50,000 1,50,000

Purchase orders… 25
Output 15,000 units
Production batch size 100 units
Materials movements per batch 6
Machine hours per unit… 0.1
Required
(i) Calculate the budgeted overhead costs using activity based costing principles.
(ii) Calculate the budgeted overhead costs using absorption costing (absorb overhead using
machine hours).
(iii) How can the company reduce the ABC for Product Alpha?
Solution:

(i) ‘Budgeted Overhead Costs’ using ‘Activity Based Costing’

Computation of ‘Cost per unit of Cost Driver’

Cost
Driver
Cost Pool Cost / Unit of Cost Driver
Activity Cost Driver Volume /
[(a)] [(a) / (b)]
Year
[(b)]
Purchasing Purchase Orders ` 75,000 1,500 ` 50 per Purchase Order
Setting Batches Produced ` 112,000 2,800 ` 40 per Batch
Materials
Material Movements ` 96,000 8,000 ` 12 per Movement
Handling
Inspection Batches Produced ` 70,000 2,800 ` 25 per Batch
Machining Machine Hours ` 150,000 50,000 ` 3 per Machine Hour

Computation of the ‘Volume of Cost Drivers’ consumed by ‘Product Alpha’

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Purchase Orders (given) = 25

Batches (15,000 / 100) = 150
Materials Movement (150 batches × 6) = 900
Machine Hours (15,000 units × 0.1) = 1,500
Computation of the ‘Overheads Cost’ for ‘Product Alpha’

Costing Rate /
Overhead Cost
Activity Cost Driver Cost Driver Unit
(`)
(`)
`1,250
Purchasing Purchase Orders 50
(25 Order × `50)
`6,000
Setting Batches Produced 40
(150 Batches × ` 40)
Material Material `10,800
12
Handling Movements (900 Movement × `12)
` 3,750
Inspection Batches Produced 25
(150 Batches × ` 25)
` 4,500
Machining Machine Hours 3
(1,500 Hours × ` 3)
Total ` 26,300

(ii) ‘Budgeted Overheads Costs’ using ‘Absorption Costing’

Budgeted Overheads = ` 503,000
(` 75,000 + ` 96,000 + ` 112,000 + ` 70,000 + ` 150,000)
Budgeted Absorption Cost per Machine Hour = `10.06
(`503,000 / 50,000 Hours)
Budgeted Machining Hours for Product Alpha = 1,500 hrs.
Budgeted Absorbed Overhead (1,500 hrs. × ` 10.06) = `15,090

(iii) Ways in which the company can reduce the ABC for ‘Product Alpha’
― Reduce the number of batches by increasing the batch size which will then reduce
the setting up overhead, materials handling and inspection costs.
― Reduce the number of purchase orders.
― Innovate ways of speeding up production so that the machining hours are reduced

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CVP Analysis in Service and Non-Profit Organisations

In a firm has implemented Just in Time, the variable cost per unit sold is reduced, and fixed
costs are increased. Direct labor is considered as fixed instead of variable. On the other hand,
direct material, vary with production volume (unit- based variable cost) due to emphasis on
total quality and long-term purchasing. Waste, scrap, and quantity discounts are removed.
Other unit-based variable costs, such as power and sales commissions, also exist. Further, the
batch - level variable is absent as in Just in Time, the batch is equal to one unit. Therefore, the
cost equation for Just in Time can be expresses as follows:
Total Cost = Fixed Cost + (Unit variable Cost × Number of Units) + (Engineering Cost ×
Number of Engineering hours)
“Managers often use CVP analysis to guide other decisions, many of them are of strategic
nature due to tremendous potential of increase in the profitability and organisational
effectiveness”

Ques 15

Expert Roadways Services Pvt. Ltd. is planning to run a fleet of 15 buses in Birpur City on a
fixed route. Company has estimated a total of 2,51,85,000 passenger kilometers per annum. It
is estimated buses to have 100% load factor. Buses are purchased at a price of `44,00,000 per
unit whose scrape value at the end of 5 years life is `5,50,000. Seating capacity of a bus
excluding a Driver’s seat is 42. Each bus can give a mileage of 5 kmpl. Average cost of fuel is
`66 per liter. Cost of Lubricants & Sundries per 1,000 km would be `3,300. Company will
pay `27,500 per month to Driver and two attendants for each bus.
Other annual charges per bus: Insurance `55,000, Garage Charges `33,000, Repairs &
Maintenance `55,000. Route Permit Charges upto 20,000 km is `5,500 and `2,200 for every
additional 5,000 km or part thereof.
Required
(i) CALCULATE a suggested fare per passenger/km taking into account markup on cost
@20% to cover general overheads and sufficient profit.
(ii) The Transport Sector of Birpur is highly regulated. The Government has fixed the fare
@ `1.35 for next 2 years. COMMENT on the two year’s profitability taking into
consideration the inflation rate of 8%.
Note: Route permit charges is not subject to Inflation.
Solution

(i) Statement Suggesting “Fare per passenger – km (Each Bus)”

Particulars Cost per annum (`)
Fixed Expenses:

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Insurance 55,000.00
Garage Charges 33,000.00
Depreciation 7,70,000.00
Running Expenses:
Repair and Maintenance 55,000.00
Cost of Lubricants and Sundries 1,38,517.50
Fuel Cost 5,54,070.00

Salary of Driver and Two Attendants 3,30,000.00

Route Permit Charges 16,500.00
Total Cost per annum 19,52,087.50
Add: Markup @ 20% of Total Cost or 16.67% of Total
3,90,417.50
Revenue
Total Revenue 23,42,505.00

Rate per passenger- km equals to `1.395

Workings
Total Passenger Kms = 2,51,85,000
Total Buses = 15
Passenger Kms per bus = 16,79,000 (2,51,85,000 Kms /
15)
Total Passenger Capacity per bus = 42 – 2
= 40
Annual Distance Covered by a bus = 41,975 Kms.
(16,79,000Kms/ 40)

(ii) Regulated Fare per passenger km is `1.35

Profitability Statement for Each Bus

Particulars Year 1 (`) Year 2 (`)

Fixed Expenses:
Insurance 59,400.00 64,152.00
Garage Charges 35,640.00 38,491.20
Depreciation 7,70,000.00 7,70,000.00
Running Expenses:
Repair and Maintenance 59,400.00 64,152.00
Cost of Lubricants and Sundries 1,49,598.90 1,61,566.81
Fuel Cost 5,98,395.60 6,46,267.25
Salary of Driver and Two Attendants 3,56,400.00 3,84,912.00

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Route Permit Charges 16,500.00 16,500.00

Total Cost …[A] 20,45,334.50 21,46,041.26
Total Revenue (Regulated) …[B] 22,66,650.00 22,66,650.00
Profit …[B] – [A] 2,21,315.50 1,20,608.74
Profit to Total Revenue 9.76% 5.32%

The gross margin is showing a downward trend because the cost components have taken into
the effect of inflation hence increasing year by year but the total revenue has remained stagnant
due to Government regulations which resulted in reduction in gross margin per bus.
The company’s gross margin to total revenue ratio has come out to be 9.76% and 5.32% in
first and second year respectively but initially the company’s desired gross margin to total
revenue ratio is 16.67% to cover general overheads and sufficient profit. Though the amount
of general overheads is not given but we can safely assume that they may also subject to
inflation i.e. increase year by year then in such case the company needs to maintain or increase
its gross margin per bus to maintain its net profit after general overheads which is not possible
in regulated environment. The information about regulated fa re in the given case is regarding
first two years only but if this regulated fare scenario persists for further years then the project
may not be viable for the company.

Short Run Decision Making

Short-run decision making involves the act of choosing one course of action among various
feasible alternatives available. Short-term decisions sometimes are referred to as tactical, or
relevant, decisions because they involve choosing between alternatives with an immediate or
limited time frame. Strategic decisions, on the other hand, usually are long term in nature
because they involve choosing between different strategies that attempt to provide a
competitive advantage over a long time frame. Short run decisions involve evaluation of the
costs and benefits of short term actions, such as whether to make a product or outsource,
whether to accept a special order, whether to keep or drop an unprofitable segment, and whether
to sell a product as is or process it further. If resources are limited, managers may also have to
decide on the most appropriate product mix. While such decisions tend to be short run in nature,
it should be emphasized that they often have long-run consequences.
The tactical decision making approach just described emphasized the importance of identifying
and using relevant costs. But how do we identify and define the costs that affect the decision?
For a cost to be relevant to a decision it must be
1) A future cost, i.e. related to the future.
2) A differential Cost, i.e. its level must be different for each of the alternatives under
consideration.

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Accordingly, only future costs can be relevant to decisions. However, to be relevant, a cost
must not only be a future cost but must also differ from one alternative to another . If a future
cost is the same for more than one alternative, it has no effect on the decision. Such a cost is
irrelevant cost. The ability to identify relevant and irrelevant costs is a vital decision making
skill.
Non-Financial Considerations
With increase in competition, dynamic market changes and changing needs of customers, non-
financial information have gained relevance in the decision-making process. Information to
which monetary value can be attached is in the nature of financial information. Information of
an organization like number of employees, employee morale, customer sat isfaction that cannot
be expressed in monetary terms is termed non -financial in nature. Non- financial information
is long term focused and ensures profitability and sustainability in long term for an
organization thereby evaluating the internal performance of the company. Non- Financial
information which a company should focus that would turn out to be advantageous while
making decisions for a company are:
 Quality
 Employee Satisfaction
 Customer Satisfaction
 Corporate Social Responsibility
 Environmental Factors
 Intellectual Property
 Intangible Assets
 Competitor’s Movements
 Brand Name
Decisions made in a business rest on the balance between the perceived effects of financial and
non-financial information. Following are Limitations of Non- Financial Information-
 Time and Cost of the company involved.
 Subjective measurement – No proper of common denominator to measure performance.
 Improper measures will lead the companies to draw attention on wrong objectives.
 Lack of Statistical Reliability – Possible chances of error.
 Management Disintegration when excess of measures and indications used by the
company
Ethics
Ethics are moral principles that guide the conduct of individuals. By their behaviour and
attitude, managers set the company culture. Guideline for Ethical Conduct3:
 Identify an ethical decision by using personal ethical standards of honesty and fairness.

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 Identify the consequences of the decision and its effect on others.

 Consider obligations and responsibilities to those that will be affected by decision.
 Make a decision that is ethical and fair to those affected by it.
Some ethical problems can be avoided simply by using common sense and not focusing solely
on the short term at the expense of long term.
Firms with a strong code of ethics can create strong customer and employee loyalty.
Furthermore, a firm that values people more than profit and is viewed as operating with
integrity and honour is more likely to be a commercially successful business

Decision Making Model

A general approach to tactical decision making includes:
 Define the problem.
 Identify alternatives, eliminating unfeasible alternatives.
 Identify costs & benefits of each alternative.
 Examine total relevant costs, benefits of each alternative.
 Assess non-financial factors and ethical issues.
 Select alternative with greatest overall benefit

Application

Step 1: Define the Due to economic down turn, it is not feasible to operate
problem the plant at the normal capacity, at least during the quarter
Step 2: Identify  Shut down the plant
alternatives  Operate the plant
Step 3: Identify costs,
Alt 1: <Costs> + Benefits Alt 2: <Costs> + Benefits
benefits

Step 4: Total relevant Alt 1: Relevant <Costs> + Benefits Alt 2: Relevant

costs & benefits <Costs> + Benefits Differential Cost

Step 5: Assess non-  Interest of workers.

financial factors  Re-establishment of the market for the product.
 Plant may get rusted.
Step 6: Make decision Operate the plant

Ques 16 SM

Recently, Ministry of Health and Family Welfare along with Drug Control Department have
come hard on health care centres for charging exorbitant fees from their patients. Human

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Health Care Ltd. (HHCL), a leading integrated healthcare delivery provider company is
feeling pinch of measures taken by authorities and facing margin pressures due to this. HHCL
is operating in a competitive environment so; it’s difficult to increase patient numbers also.
Management Consultant of the company has come out with some plan for cost control and
reduction.
HHCL provides treatment under package system where fees is charged irrespective of days a
patient stays in the hospital. Consultant has estimated 2.50 patient days per patient. He wants
to reduce it to 2 days. By doing this, consultant has targeted the general variable cost of `500
per patient day. Annually 15,000 patients visit to the hospital for treatment.
Medical Superintendent has some concerns with that of Consultant’s plan. According to him,
reducing the patient stay would be detrimental to the full recovery of patient. They would
come again for admission thereby increasing current readmission rate from 3% to 5%; it means
readmitting 300 additional patients. Company has to spend `25,00,000 more to accommodate
this increase in readmission. But Consultant has found bless in disguise in this. He said every
readmission is treated as new admission so it would result in additional cash flow of `4,500 per
patient in the form of admission fees.
Required
(i) CALCULATE the impact of Management Consultant’s plan on profit of the company.
(ii) Also COMMENT on result and other factors that should be kept in mind before taking
any decision.
Solution:

(i) Impact of Management Consultant’s Plan on Profit of the HHCL

Human Health Care Ltd.
Statement Showing Cost Benefit Analysis

Particulars `
Cost:
Incremental Cost due to Increased Readmission 25,00,000
Benefit:
Saving in General Variable Cost due to Reduction in Patient
Days 37,50,000
[15,000 Patients × (2.5 Days – 2.0 Days) × `500)
Revenue from Increased Readmission (300 Patients × `4,500) 13,50,000
Incremental Benefit 26,00,000
(ii) Comment
Primary goal of investor-owned firms is shareholder wealth maximization, which
translates to stock price maximization. Management consultant’s plan is looking good
for the HHCL as there is a positive impact on the profitability of the company (refer
Cost Benefit Analysis).
Also HHCL operates in a competitive environment so for its survival, it has to work

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on plans like above.

But there is also the second side of a coin that cannot also be ignored i.e. humanity
values and business ethics. Discharging patients before their full recovery will add
discomfort and disruption in their lives which cannot be quantified into money. There
could be other severe consequences as well because of this practice. For gaining extra
benefits, HHCL cannot play with the life of patients. It would put a question mark
on the business ethics of the HHCL.
May be HHCL would able to earn incremental profit due to this practice in short run
but It will tarnish the image of the HHCL which would hurt profitability in the long
run.
So, before taking any decision on this plan, HHCL should analyze both quantitative as
well as qualitative factors.

Applications Of CVP Analysis And Cost Concepts

Minimum
Out Sourcing Sell or Further Keep or Drop Special Order Product Mix
Pricing
Decision Process Decisions Decisions Decision
Decisions

OUTSOURCING DECISION
Outsourcing decision is often called a ‘make or buy’ decision. It involves a decision of whether
to continue 'making' a product versus ‘buying’ it from an external firm. Outsourcing enables a
firm to
 reduce costs or
 benefit from supplier efficiencies
Outsourcing decision requires incremental analysis. The incremental amounts are based on the
difference in the cost of buying a product or service compared to the cost of producing the item
or providing the service in house.
Incremental costs are the additional costs incurred from outsourcing. The main cost is the
purchase price of the products or the cost of the services that are being provided by external
firms.
Incremental cost savings are reductions of costs that will no longer be incurred as a result of
outsourcing. They are often called avoidable costs because if a company outsources, it can
'avoid' certain costs. Variable product cost savings are always incremental. Because they reduce
total costs, they cause profits to increase. In some circumstances, a portion of fixed costs can
be saved such as equipment rental costs or supervisor salaries that can be avoided.

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Opportunity costs are the costs forgone as a result of selecting a different alternative. They are
always incremental. For example, if a company decides to outsource, it is able to lease its
factory space that the product being outsourced no longer will occupy.
Outsourcing Decisions- Accept or Reject?
If incremental cost savings + opportunity costs < incremental costs, reject the outsourcing,
unless qualitative factors fiercely impact the decision
If incremental cost savings + opportunity costs > incremental costs, accept the outsourcing
unless qualitative factors fiercely impact the decision.
If incremental cost savings + opportunity costs are = incremental costs, focus primarily on
qualitative factors to evaluate the decision.
Qualitative Factors
While considering the decision to Outsourcing the management should consider qualitative
aspects like quality of goods, reliability of suppliers, impact on the customers and suppliers etc

Ques 17

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 the making cost of the component is more than the buying cost, the Management asks
you to:
(i) ANALYSE the make or buy decision on unit basis and total basis.

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(ii) RECOMMEND the most profitable alternative.

Solution:

(i) 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 of manufacturing these components would
be as below:
Cost Structure Cost per component unit (`)
Direct Materials 80
Direct Labor 75
Variable Factory Overhead (70% of `40) 28
Total 183

Analysis
If DBA decides to manufacture the components in-house, the following would be the financial
impact:
(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) Current contribution considering a procurement price of `190 per component unit, is
`600 per fan. As calculated above, if produced in house, the variable cost would be
`183 per component unit. This would result in an increase in contribution by `7 per
fan (procurement price of `190 per component unit less variable cost of `183 per
component unit). In addition, there is an impact of `125 on account of reduction in
selling price. Therefore, the contribution if component produced in house would be
`482 per fan (`600+`7-`125).
To summarize the above figures

Procurement 25,000 Produce 30,000

Components Components
Particulars
Per Fan ` Total ` Per Fan ` Total `
Selling price per fan 2,500 6,25,00,000 2,375 7,12,50,000
Contribution per fan 600 1,50,00,000 482 1,44,60,000

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Therefore, incremental loss by switching to in house production (on a total basis) would be
`17,40,000 (incremental loss `5,40,000 – additional advertising expenses `12,00,000). On a per
unit basis, it would result in a loss of `58 per fan.
(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. In this situation, the contribution shall be increased by `1,75,000 (`7
×25,000 units).
Thus, DBA may choice the alternative after due and careful consideration of the facts
illustrated above.

SELL OR FURTHER PROCESS

Sell or process further refers to a decision-making situation where an executive has to decide
either to sell a component/ product/ raw material as it is or alternatively process it further by
incurring additional expenses. For instance, sometime, a redundant material lying in stores for
a long time may be sold as scrap at a small value or may be thrown away as waste. This material
may, however, be converted into a product of higher saleable value by carrying out some
further operations or processes. On further processing the component/product/raw material
may not only be improved or reconditioned but will mostly fetch a higher sale value as well.
Here if the differential sales value is more than the further processing cost , then it is beneficial
to process the product further otherwise sell it without further processing. Such type of decision
making problems usually arise in the case of joint products.
There are two rules to follow when ascertaining whether the further processing is worthwhile:
 Only the incremental costs and revenues of the further process are relevant.
 The joint process costs are irrelevant - they are already 'sunk' at the point of separation

Qualitative Factors
Qualitative factors related to processing further decisions include resource availability such as
the readiness of employees to work extra hours to further process the products and availabil ity
of materials required for the processing. In addition, the influence on customers that prefer the
original product should also be considered, as sales to these customers may be lost to
competitors.

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Example
A process industry unit manufactures three joint products: A, B and C. C has no realisable
value unless it undergoes further processing after the point of separation. The cost details of C
are as follows:
` / p.u.
Upto point of separation
Marginal cost 30
Fixed Cost 20
After point of separation
Marginal cost 15
Fixed cost 5
70
C can be sold at ` 37 per unit and no more.
Cost incurred on Product ‘C’ upto point of separation is irrelevant for decision making as
Product ‘C’ is a
Joint Product. Joint Products are the result of same raw material & same process Operations.
Cost incurred after point of separation will be considered for decision making as specifically
incurred for Product ‘C’.
After further processing Product ‘C’ will contribute `17 per unit toward ‘Joint Production
Cost’. Calculation is as follows
Particulars Amount (`)
Selling Price per unit 37.00
Less: Cost after separation:
Marginal Cost per unit 15.00
Fixed Cost per unit 5.00
Contribution toward ‘Joint 17.00
Production Cost’
Hence, further processing of Product ‘C’ is recommended.
If Product ‘C’ is not a joint product with same cost structure. In this case there will be negative
contribution on production of Product ‘C’. The calculation is as follows-
Particulars Amount (`)
Selling Price per unit 37.00

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Less: Marginal Cost (`30 + `15) 45.00

Contribution (8.00)
Hence, production of Product ‘C’ will not be recommended.

Ques 18

XL Polymers, located in Sahibabad Industrial Area, manufactures high quality industrial

products. AT Industries has asked XL Polymers for a special job that must be completed within
one week.
Raw material R1 (highly toxic) will be needed to complete the AT Industries’ special job. XL
Polymers purchased the R1 two weeks ago for `7,500 for a job ‘A’ that recently was
completed. The R1 currently in stock is the excess from that job and XL Polymers had been
plann ing to dispose of it. XL Polymers estimates that it would cost them `1,250 to dispose of
the R1. Current replacement cost of R1 is `6,000.
Special job will require 250 hours of labour G1 and 100 hours of labour G2. XL Polymers
pays their G1 and G2 employees `630 and `336 respectively for 42 hours of work per week.
XL Polymers anticipates having excess capacity of 150 [G1] and 200 [G2] labour hours in
the coming week. XL Polymers can also hire additional G1 and G2 labour on an hourly basis;
these part-time employees are paid an hourly wage based on the wages paid to current
employees.
Suppose that material and labour comprise XL Polymers’s only costs for completing the special
job.
Required
CALCULATE the ‘Minimum Price’ that XL Polymers should bid on this job?
Solution

Opportunity Cost of Labour - The G2 labour has zero opportunity cost as there is no other
use for the time already paid for and is available. However, XL Polymers needs to pay an
additional amount for G1 labour. This amount can be save if the special job were not there.
G1 labour:
Hours Required 250
Hours Available 150
Extra Hours Needed 100
Cost per hour (`630/42hrs) `15
Opportunity Cost `1,500
Thus, the ‘Opportunity Cost of Labour’ for completing the special job is `1,500.

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Opportunity Cost of Material – XL Polymers has no alternative use for the R1, they must
dispose of it at a cost of `1,250. Thus, XL Polymers actually saves `1,250 by using the materials
for the AT Industries’ special job. Consequently, the ‘Opportunity Cost of Material’ is - `1,250
(i.e., the opportunity cost of this resource is negative).
The minimum price is the price at which XL Polymers just recovers its ‘Opportunity Cost’. XL
Polymers’s ‘Total Opportunity Cost’ is `250 (`1,500 − `1,250). Accordingly, minimum Price
for the Special Job is `250.
Ques 19

Rabi Ltd. is considering the discontinuance of Division C. The following information is given:
Particulars Divisions A & B Division C Total
Sales (Maximum achievable) (`) 41,40,000 5,17,500 46,57,500
Less: Variable cost (`) 20,70,000 2,76,000 23,46,000
Contribution (`) 20,70,000 2,41,500 23,11,500
Less: Specific avoidable fixed cost (`) 14,49,000 4,14,000 18,63,000
Divisional Income (`) 6,21,000 (1,72,500) 4,48,500
The rates of variable costs are 90% of the normal rates due to the current volume of operation.
There is adequate market demand.
For any lower volume of operation, the rates would go back to the normal rates. Facilities
released by discontinuing Division C cannot be used for any other purpose.
Required
COMMENT on the decision to discontinue Division C using relevant cost approach.
Solution

As given in the problem Rabi Ltd. is considering to discontinue the Division C perhaps by
seeing the Division C‘s income as it is a loss of `1,72,500. Discontinuance of Division C might
be saving `4,14,000 on specific fixed costs to the company but due to this decision company
will not only be losing `2,41,500 contribution from the Division C but also an additional
burden of variable cost of `2,30,000 to Divisions A & B and Rabi Ltd. as a whole.
Let assess the decision of the Rabi Ltd. with the help of the Relevant Cost approach

Amount
Particulars
(`)
Savings Due to Discontinuance
Specific Fixed Cost 4,14,000
Total ...(A) 4,14,000
Loss/ Increase in Cost Due to Discontinuance

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Loss of Contribution 2,41,500

2070000
Increase in Variable Cost × 10 2,30,000
90

Total …(B) 4,71,500

Excess of Loss Over Savings …(B) – (A) 57,500

In a nutshell considering the above analysis we can conclude that the decision of discontinuing
Division C will not be beneficial for the Rabi Ltd and it should review its decision on the basis
of relevant cost approach to reach at right decision.

SPECIAL ORDER DECISIONS

Special order decisions focus on whether a special priced order should be accepted or rejected.
These orders often can be attractive, especially when the firm is operating below its maximum
productive capacity.
Price discrimination laws require that firms sell identical products at the same price to
competing customers in the same market. This law does not apply to
 Noncompeting customers from the same market.
 Potential customers in markets not ordinarily served.
Special order decisions are based on incremental analysis. Incremental analysis enables
managers to emphasis on the relevant areas of a decision.
 Incremental revenues are the additional revenues generated from accepting the special
order. The revenue can result from additional sales of products or from providing
services.
If the company is operating at less than capacity, revenue of regular customers will
not be affected.
If the company is operating at capacity, it will have to give up some regular sales in
order to provide the special order.
 Incremental costs are the additional costs incurred from accepting a special order.
Variable operating costs include special packing, commissions, and shipping costs.
Most often, a firm's recurring fixed costs will remain the same in total if a special
order is accepted
Decision - Accept or Reject?
 If incremental revenue < incremental cost, reject the special order, unless qualitative
characteristics fiercely impact the decision.
 If incremental revenue = incremental cost, qualitative effects must be used to make the
decision.
 If incremental revenue > incremental cost, accept the order, unless qualitative
characteristics fiercely impact the decision

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Ques 20

BNZ Ltd. is engaged in the manufacture of plastic bottles of a standard size and produced by
a joint process of machines. The factory has 5 machines and capable of producing 40 bottles
per hour. The variable cost per bottle is `0.32 and the selling price is `0.80 each. The company
has received an offer from another company for manufacture of 40,000 units of a plastic
moulded toy. The price per toy is `30 and the variable, cost is `24 each. In case of the company
takes up the job, it has to meet the expenses of making a special mould required for the
manufacture of the toy. The cost of the mould is `1,00,000. The company's time study analysis
shows that the machines can produce only 16 toys per hour. The company has a total capacity
of 10,000 hours during the period in which the toy is required to be manufactured. The fixed
costs excluding the cost of construction of the mould during the period will be `10 Lakh.
The company has an order for the supply of 3,00,000 bottles during the period.
Required
(i) Do you ADVISE the company to take up the order for manufacturing plastic moulded
toys during the time when it has an order in its book for the supply of 3,00,000 bottles.
(ii) If the order for the supply of bottles increases to 4,00,000 bottles, will you ADVISE
the company to accept the order for the supply of plastic moulded toys? State the
reasons.
(iii) An associate company of BNZ Ltd. has idle capacity and is willing to take up the whole
or partof the manufacturing of the plastic moulded toys on sub-contracting basis. The
subcontract price inclusive of the cost of construction of mould is `28 per toy.
DETERMINE the minimum expected excess machine hour capacity needed to justify
producing any portion of the toy order by the company itself rather than subcontracting.
Solution:

Workings
Statement Showing “Contribution / Machine
Hour”

‘Bottle’ ‘Toy’
Demand (units) 3,00,000 40,000
Sales (`/u) 0.80 30.00
Less: Variable Cost (`/u) 0.32 24.00
Less: Specific Fixed Cost (`/u) --- 2.50
Contribution (`/u) 0.48 3.50
Machine Hours Required per unit 0.025 0.0625
Contribution / Machine Hour 19.20 56.00

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Advice on Supply of 3,00,000/ 4,00,000 Bottles

(i) BNZ Ltd. can accept plastic moulded toy’s order as sufficient number of hrs. i.e. 2,500
hrs. (10,000 hrs.- 3,00,000 bottles × 0.025 hrs.) are available and would be able to
generate additional benefit of `3.50 per unit on 40,000 units of toys i.e. `1,40,000.
(ii) If the order for the supply of bottles increases to 4,00,000 bottles, then 2,500 more hrs.
will be required to produce the additional bottles. BNZ Ltd. has to decide whether to
utilize 2,500 hrs. for existing bottle order or for toy Order.
Machine time is limiting factor. Therefore, contribution per machine hour from both the
activities (i.e. bottles and toys) should be calculated to decide whether the order should
be accepted. Contribution per hour is more in case of toys (refer workings). Therefore,
BNZ Ltd. should utilize the remaining 2,500 hours for manufacturing toys rather than to
fulfil the order for supply of additional bottles.
Prioritizing production based on contribution per machine hour would maximize profits.
However, existing order fulfilment is necessary for building long term and sustainable
customer relationship. Developing and maintaining long term and intimate relationships
with the profitable customers provides valuable benefits to the company as the
relationships between company and customers grow, a customer who is satisfied with the
company’s products and services, tends to commit the relationship, and buy more over
time. Cost of keeping the existing customers is less expensive than the cost of acquiring
new customers.
Hence, BNZ Ltd. should be taken into consideration long term supplier relation before
accepting the toy order based on financial consideration as contribution per hour is more
in case of toys. Further, company may also explore outsourcing opportunities for
production of toys.
(iii) Minimum number of toys needed to be manufactured to justify the increase in fixed cost
of `1,00,000 to make the mould is 25,000 toys {1,00,000/ (`28 - `24}. Thus, as long as
company has excess capacity available to manufacture more than 25,000 toys it is
cheaper to produce than to buy from subcontractor.
Minimum Expected Excess Capacity hours to justify
25000 𝑡𝑜𝑦𝑠
= = 1562.5 𝑜𝑟 1563 ℎ𝑟𝑠
16 𝑡𝑜𝑦𝑠

Ques 21

A process industry unit manufactures three joint products: A, B and C. C has no realisable
value unless it undergoes further processing after the point of separation. The cost details of C
are as follows:
p.u.
`
Upto point of separation
Marginal cost 30

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Fixed Cost 20
After point of separation
Marginal cost 15
Fixed cost 5
70
C can be sold at ` 37 per unit and no more.
(i) Would you recommend production of C?
(ii) Would your recommendation be different if A, B and C are not joint products?

Solution

(i) Cost incurred on Product ‘C’ upto point of separation is irrelevant for decision making as
Product ‘C’ is a Joint Product. Joint Products are the result of same raw material & same
process Operations.
Cost incurred after point of separation will be considered for decision making as
specifically incurred for Product ‘C’.
After further processing Product ‘C’ will contribute `17 per unit toward ‘Joint Production
Cost’.
Calculation is as follows
Amount
Particulars
(`)
Selling Price per unit 37.00
Less: Cost after separation:
Marginal Cost per unit 15.00
Fixed Cost per unit 5.00
Contribution toward ‘Joint Production Cost’

Hence, further processing of Product ‘C’ is recommended.

(ii) If Product ‘C’ is not a joint product with same cost structure. In this case there will be
negative contribution on production of Product ‘C’.
The calculation is as follows→
Amount
Particulars
(`)
Selling Price per unit 37.00
Less: Marginal Cost (`30 + `15) 45.00
Contribution (8.00)

Hence, production of Product ‘C’ will not be recommended.

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Ques 22

A company processes different products from a certain raw material. The raw material is
processed in process I (where normal loss is 10% of input) to give products A and B in the
ratio 3 : 2. B is sold directly. A is processed further in process II (where normal loss is 12.5%
of output) to give products C and D in the ratio 5:3. At this point C and D have sale values ` 55
and ` 40 per kg respectively. C can be processed further in process III with processing cost `
3,95,600 and normal wastage 5% of input and then be sold at ` 66 per kg. D can be processed
further in process IV with processing cost ` 3,82,500 and normal wastage 12.5% of output and
then be sold at ` 55 per kg. The normal wastage of each process has no realizable value. During
the production period, 2,00,000 kgs of raw material is to be introduced into Process I.

Required
Using incremental cost-revenue approach, advise whether sale at split off or further processing
is better for each of the products C and D.
Solution:

Statement Showing “Decision on Sale at - Split-off Point or After Further

Processing”
Product Product - C Product - D

Quantity at Split off Point (Kg.) 60,000 36,000

Selling Price at Split off Point (`) 55 40

33,00,000 14,40,000
Sales Revenue (`)… [A]
(60,000 Kg. × `55) (36,000 Kg × `40)

32,000
57,000 36000 𝑘𝑔
Quantity if Processed Further (Kg.)
(60,000 Kg. × 95%) ( × 100)
112.5

Selling Price (`) per unit 66 55

37,62,000 17,60,000
Sales Revenue (`) …[B]
(57,000 Kg. × `66) (32,000 Kg. × `55)
Incremental Revenue
4,62,000 3,20,000
…[C] = [B] − [A]
Incremental Cost (`) …[D] 3,95,600 3,82,500
Profit / (Loss) …[C] − [D] 66,400 (62,500)
Sale at Split-off
Decision Process Further
Point

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Process I
Input - 2,00,000 kg

Normal Loss Product A Product B

20000 kgs 108000 kg 72000 Kg
(200000 kg x 10%) (180000 x 3/12) (180000 kg x 2/5)

Process II

Normal Loss Product C Product D

12000 kgs 60000 kg 36000 kg
(108000/112.5*12.5) (96000kg * 5/8) (96000 kg * 3/8)

PRODUCT MIX DECISION

Quest 23

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. `90 `80
Machine hrs. p.u.
Department A hrs. @ `40/ hr. 0.50 0.30
Department B hrs. @ `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 `5/ kg.

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Required
(i) FIND optimum product mix.
(ii) 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? FIND the number of units of that
product and relevant contribution.
Solution-

(i) Calculation of Optimum Production Mix

Statement Showing 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.
Statement of Rank
Particulars Product X Product Y
Sales 90 80
Less: Direct Material 10 10
Dept. A 20 12
Dept. B 24 27
Contribution p.u. 36 31
Contribution per kg. of Raw Material 18 15.5
Rank I II
Contribution /hr. of Dept. A 72 103.33
Rank II I
Contribution /hr. of Dept. B 90 68.89
Rank I II
To find the optimum mix of products that shall lead to maximum profits while taking into
consideration of shortage of resources (i.e. constraints), we have to use Linear Programming.
Let x1 and x2 donate quantities of product ‘x’ and product ‘y’ respectively.
The linear programming model for the given problem is:
Zmax = 36x1 + 31x2

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Subject to;
2x1 + 2x2 ≤ 17000 …. (for material)
0.5x1 + 0.3x2 ≤ 3400 ….(for dept. A)
0.4x1 + 0.45x2 ≤ 3640 ….(for dept. B)

X1 ≤ 7400 ….(demand constraint)

X2 ≤ 10,000 ….(demand constraint)

The graphical solution for the problem is given below:

So, different combinations of product mix include,

Total Contribution
Combination x1 x2 Rank
(in `)
P 6,800 0 2,44,800 IV
Q* 4,171 4,381 2,85,967 -
R 0 8,089 2,50,759 III
S 3,700 4,800 2,82,000 II
T 4,250 4,250 2,84,750 I
Note (*)
Combination Q (4,171, 4,381) is not possible as it is satisfying three conditions out of above
four conditions. To produce combination Q (4,171, 4,381), requirement of the material will be

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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.
Therefore, optimum product mix = X 4,250 units and Y 4,250 units
(ii) Statement Showing Product with Higher Contribution

Maximum Maximum Feasible

Maximum Maximum
Product

Demand Production Maximum Contribution

Production Production
with available Production
by Dept. A by Dept. B (`)
materials (lower of a, b, c
(a) (b) (c) and d)
(d)
X 7,400 6,800 9,100 8,500 6,800 2,44,800

Y 10,000 11,333 8,089 8,500 8,089 2,50,759

Therefore, Product Y should be produced at 8,089 units resulting in a contribution of Rs.
2,50,759.

Ques 24

‘S’ manages the school canteen (approximately 1,600 students) at Noida. The current cash
payment system requires three clerks (each 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)
Solution-

For each day, ‘S’ spends `360 per clerk (`90 per hr. × 4 hrs.). Therefore, ‘S’ spends `1,080 per
day to employ three clerks. Annually, this outlay amounts to `2,59,200 (`1,080 per day × 240
days).
Over five years, the outlay would be `12,96,000. If the WCMS is implemented, the initial cost
is `1,25,000. If we add the annual cost of `36,000, the total cost over five years amounts to
`3,05,000. Since one clerk will be needed as well, ‘S’ has to incur `4,32,000 over five years to
pay clerk (`4,32,000 = `90 × 4 hrs. × 1 clerk × 240 days × 5 years). Therefore, the total cost of
this option is `7,37,000.
Accordingly, there is cost saving of `5,59,000 from WCMS implementation.
Relevant Non-Financial Considerations

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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.
Conclusion
Obviously, WCMS option is more cost effective for ‘S’ because there is a cost saving of
`5,59,000. But, non- financial factors should also be taken into consideration

Ques 25

Aayla runs the Planetarium Station in New Delhi, India. The strength of the station lies in its
live interactions and programs for visitors, students and amateur astronomers. The station is
always active with programs for school and college students and for amateur astronomers. One
of the station’s key attractions is a big screen IMAX theatre. IMAX is a 70 mm motion picture
film format which shows images of far greater size and resolution than traditional film systems.
The IMAX cinema projection standards were developed in Canada in the late 1960s. Unlike
traditional projectors, the film is run horizontally so that the image width is greater than the
width of the film.
The average IMAX show at the station attracts 120 visitors (50 children and 70 adults) at a
ticket price of `160 for children and `200 for adults. Aayla estimates that the running costs per
IMAX show are `10,000. In addition, fixed costs of `7,500 are allocated to each show based on
annual estimate of the number of IMAX shows.
The Hobart School has approached Aayla about scheduling an extra show for its class VIII
students. One hundred students and five teachers are expected to join the special show on the
‘Planets & Solar System’, a feature that is currently showing. The school has asked Aayla for
a price quote. The special show will take place at 08:30 AM when the IMAX is not usually
open.
Required
RECOMMEND the minimum amount that Aayla should charge

Solution-

The incremental cost associated with the IMAX show appears to be `10,000 i.e. cost of running
the show. The allocated fixed cost per show is not relevant because the total amount of fixed
costs for the year will not change as a result of the special show. Further, the stated ticket prices
are not relevant because the show will take place at 08: 30 AM when the IMAX is not usually
open – thus, the students will not be displacing any regular visitors. Based on the financial data
provided, the minimum price quote appears to be `10,000.
Aayla should consider the following factors:
 Does the station have a souvenir shop and/or cafeteria?

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If so, many students are likely to buy food and/or souvenir items, thereby increasing
the station’s contribution. In turn, this would reduce the minimum price quote.
 What is the impact on future revenue?
After seeing the show, many students may return with their parents, thereby
increasing future revenue.
 Are there costs linked with the special showing that are not included in the `10,000
variable cost number?
For example, will the station have to pay an overtime premium.
Aayla should also consider the educational mission of the Planetarium Station. Such shows
directly contribute to this mission, the station, and, hopefully, the betterment of the students.
The special shows may be an excellent way to expose some students to earth science – these
students may have never gone through the Planetarium Station if it were not for the school
excursion.
Overall, the “best” price to charge is unclear and requires some judgment as Aayla needs to
balance an array of financial and non-financial factors.
Ques 26

The President of Automation Limited, a 150 persons engineering company, decided it was
time to fire the company's biggest client. Although the client provided close to 60% of the
company's annual revenue, Automation Limited decided that dropping this client was
necessary. The client was profitable.
The President of Automation Limited stated "We cannot be a great place to work without
employees, and this client was bullying my employees. Its demands for turnaround were
impossible to meet even with people working seven days a week. No client is worth losing
my valued employees".
The initial impact on revenues was significant. However, Automation Limited was able to cut
costs and obtain new customers to fill the void. Moreover, the dropped client later gave
Automation Limited two projects on more equitable terms.
Required
DISCUSS the reasons behind dropping of a profitable client by Automation Limited
Solution-

With increasing completion, dynamic market changes, changing needs of customers, non-
financial and ethical considerations have gained relevance in the decision- making process.
A company may face the dilemma of meeting customers’ needs while protecting employees’
rights. While there are no clear-cut parameters to measure the impact of such decisions, they
have a long-term impact on the company’s operations that ensures profitability and
sustainability of an organization.
In the given scenario, a customer who contributes close to 60% of Automation Ltd.’s profits
has been making turnaround demands that are unreasonable for the company employees to

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meet. Automation Ltd. has to decide whether to continue doing business with the customer
based on the current terms or protecting the work environment of its employees. In the
current scenario, it is in Automation’s long term interests to protect its employees’ rights (a
non-financial consideration). Keeping this approach in mind, Automation Ltd. decided to
terminate business with the profitable client. While this had a significant impact on revenues
in the short term, in the long run Automation Ltd. was able to get business from new clients.
Also, realizing the value of service provided, the dropped client came back with projects on
equitable terms. Therefore, even though it did not make financial sense in the short run,
decisions based on non-financial metrics played an important role in ensuring Automation
Ltd.’s long term sustainability

Ques 27

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
as follows –
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 following graph –

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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 hotel
closure would result in lost contribution of ZD16,20,000. This in turn would decrease annual
profits by ZD16,20,000. In addition, Nikko could lose guests at other quarters of the year,

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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. 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) 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.

Ques 28

Y-Connections, China based firm, has just developed ultra-thintablet S-5 with few features like
the ability to open two apps at the same time. This tablet cost ` 5,00,000 to develop; it has
undergone extensive research and is ready for production. Currently, the firm is deciding on
plant capacity, which could cost either ` 35,00,000 or ` 52,00,000. The additional outlay would
allow the plant to increase capacity from 500 units to 750 units. The relevant data for the life
cycle of the tablet at different capacity level are as under:
Expected Sales 500 units 750 units
Sale Price ` 79,600 per unit ` 69,600 per unit
Variable Selling Costs 10% of Selling Price 10% of Selling Price
Salvage Value - Plant ` 6,25,000 ` 9,00,000
Profit Volume Ratio 40%
Required
ADVISE Y-Connections, regarding the ‘Optimal Plant Capacity’ to install. The tablet’s life
cycle is two years.
Note: Ignore the time value of money

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Solution-

Advice
Based on the above ‘Expected Profit’ statement which is purely based on financial
considerations firm may go for high price – low volume i.e. 500 units level. However, non-
financial considerations are also given due importance as they account for actions that may not
contribute directly to profits in the short run but may contribute significantly to profits in long
run. Here, it is important to note that life cycle of product is two years and there is no significant
difference between the profits at both levels. In this scenario firm may opt the plant having
high capacity not only to increase its market share but also to establish a long term brand
image.
Workings
Statement Showing “Variable Manufacturing Cost per unit”
Particulars ` / unit
Sales 79,600
Less: Contribution (40%) 31,840
Variable Cost 47,760
Less: Variable Selling Costs (`79,600 × 0.1) 7,960
Variable Manufacturing Cost 39,800

Statement Showing “Expected Profit”

(‘000) ` / unit
Particulars
500 units 750 units
39,800 52,200
Sales
(`79,600 x 500) (`69,600 x 750)
19,900 29,850
Less: Variable Mfg. Cost
(`39,800 x 500) (`39,800 x 750)
3,980 5,220
Less: Variable Selling Cost
(`39,800 x 0.1) (`52,200 x 0.1)
Add: Salvage Value 625 900
Less: Cost of Plant 3,500 5,200
Net Profit 13,045 12,830

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Ques 29

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:

Total Units Book value of the Realizable Replacement

Material units already in units in inventory value cost
required 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
I) 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.
II) 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.
Required
ANALYSE the relevant costs of material while deciding whether to accept the order or not?
Solution-

Material A
The requirement of 2,000 units of Material A has to be purchased in entirety since there are no
units in stock. Therefore, the relevant cost will be the replacement cost at `8 per unit, which for
2,000 units is `16,000 (2,000 units × `8 per unit).
Material B
There is a requirement of 3,000 units of Material B, of which 1,200 units are in stock. Material
B 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, 3,000 units of Material B has to be procured if the special order is
undertaken. The relevant cost will be the replacement cost at `10 per unit, which for 3,000 units
is `30,000 (3,000 units × `10 per unit).
Material C

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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, which would be
`8,400 + `12,600 = `21,000.
Material 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) The realizable value of Material D is `6,000 (500 units × `12 per unit).
(ii) Material D can be used as a substitute for 700 units of Material Z. Since there is no
stock of Material Z currently, if the special order is accepted, the entire quantity
would have to be procured at `11 per unit. This would cost the company `7,700 (700
units × `11 per unit).
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.
Therefore, the relevant cost to accepting the special order would be the cumulative of the
relevant cost for Materials A, B, C, and D. This works out to `74,700

Ques 30

Diezel, is engaged in manufacturing many chemical products. It is using many chemicals some
of which are fast moving, some are slow moving and few are in non-moving category. The
firm has a stock of 10 units of one non-moving toxic chemical. Its book value is `2,400,
realizable value is `3,500 and replacement cost is `4,200.
One of the customers of the firm asks to supply 10 units of a product which needs all the 10
units of the non-moving chemical as an input. The other costs associated with the production
of the product are:
Allocated overhead expenses `16 per unit Out of pocket expenses `50 per unit
Labour cost `40 per hour. For each unit two hours are required. Other material cost `80 per unit.
The labour force required for the production of the product will be deployed from among the
permanent employees of the firm. This temporary deployment will not lead to any loss of
contribution.

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Required
(i) RECOMMEND the minimum unit price to be charged to the customer without any
loss to the firm.
(ii) ANALYSE with reasons for the inclusion or exclusion of each of the cost associated
with the production of the product.
(iii) ADVICE a pricing policy to be followed by Diezel in perfect competition.

Solution-

(i) Diezel has the opportunity to utilize 10 units of non-moving chemical as input to
produce 10 units of a product demanded by one of its customers. The minimum unit
price to be charged to the customer would be–
Cost Component Cost per unit of product (`)
Cost of Material
(Realizable value = `3,500 / 10 units of 350
chemical)
Out of Pocket Expenses 50
Other Material Cost 80
Minimum Unit Price that can be charged 480
Therefore, the minimum unit price that can be charged to the customer, without incurring any
loss is `480 per unit of product. As explained below in point (ii), allocated overhead expenses
and labor cost are sunk costs that have been ignored while calculat ing the minimum unit price
to be charged.
(ii) Analysis
(a) Cost of Material: Relevant and hence included at realizable value. Diezel has 10 units
of non-moving chemical input that has a book value of `2,400, realizable value of
`3,500 and replacement cost of `4,200. Realizable value of `3,500 would be the
salvage value of the chemical had it been sold by Diezel instead of using it to meet the
current order. This represents an opportunity cost for the firm and hence included
while pricing the product. Book value would represent the cost at which the inventory
has been recorded in the books, a sunk cost that has been ignored. Replacement cost
of `4,200 would be the current market price to procure 10 units of the input chemical.
This would be relevant only when the inventory has to be replenished after use. This
chemical is from the non-moving category, that means that it is not used regularly in
production process and hence need not be replenished after use. Therefore,
replacement cost is also ignored for pricing.
(b) Labour Cost: Not relevant and hence excluded from pricing. It is given in the problem
that this order would be met by permanent employees of the firm. Permanent
employee cost is a fixed cost that Diezel would incur irrespective of whether this order

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is produced or not. No additional labour is being employed to meet this order.

Therefore, this cost is a sunk cost, excluded from pricing.
(c) Allocated Overhead Expenses: These expenses have been incurred at another Cost
Centre, typical example would be office and administration costs. Such costs are fixed
in nature that would be incurred irrespective of whether th is order is produced or not.
Therefore, this cost is a sunk cost, excluded from pricing.
(d) Out of Pocket Expenses: These are expenses that are incurred to meet the production
requirement of this order. These are additional variable expenses, that need to be
included in pricing.
(e) Other Material Costs: These are expenses that are incurred to meet the production
requirement of this order. These are additional variable expenses, that need to be
included in pricing.

(iii) Advice on Pricing Policy

Under perfect competition conditions, Diezel can have no pricing policy of its own, here sellers
are price takers. It cannot increase its price beyond the current market price. The firm can only
decide on the quantity to sell and continue to produce as long as the marginal cost is recovered.
When marginal cost exceeds the selling price, the firm starts incurring a loss.
Since Diezel cannot control the selling price individually in the market, it can adopt the going
rate pricing method. Here it can keep its selling price at the average level charged by the
industry. This would yield a fair return to the firm. An average selling price would help the
firm attract a fair market share in competitive conditions.

Ques 31

Golden Pacific Airlines Ltd. operates its services under the brand ‘Golden Pacific’. The
‘Golden Pacific’ route network spans prominent business metropolis as well as key leisure
destinations across the Indian subcontinent. ‘Golden Pacific’, a low-fare carrier launched with
the objective of commoditizing air travel, offers airline seats at marginal premium to train fares
across India.
Profits of the ‘Golden Pacific’ have been decreasing for several years. In an effort to improve
the company’s performance, consideration is being given to dropping several flights that appear
to be unprofitable.
Income statement for one such flight from ‘New Delhi’ to ‘Leh’ ( GP - 022) is given below
(per flight):
` `
Ticket Revenue (175 seats x 60% Occupancy x `
7,35,000
7,000 ticket price)
Less: Variable Expenses (`1,400 per person) 1,47,000

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Contribution Margin 5,88,000

Less: Flight Expenses:
Salaries, Flight Crew 1,70,000

Salaries, Flight Assistants 31,500

Baggage Loading and Flight Preparation 63,000
Overnight Costs for Flight Crew and
12,600
Assistants at destination
Fuel for Aircraft 2,38,000
Depreciation on Aircraft 49,000*
Liability Insurance 1,47,000
Flight Promotion 28,000
Hanger Parking Fee for Aircraft at
7,000 7,46,100
destination
Net Gain / (Loss) (1,58,100)

The following additional information is available about flight GP-022.

1. Members of the flight crew are paid fixed annual salaries, whereas the flight
assistants are paid by the flight.
2. The baggage loading and flight preparation expense is an allocation of ground
crew’s salaries and depreciation of ground equipment.
3. One third of the liability insurance is a special charge assessed against flight GP-
022 because in the opinion of insurance company, the destination of the flight is in
a “high - risk” area.
4. The hanger parking fee is a standard fee charged for aircraft at all airports.
5. If flight GP-022 is dropped, ‘Golden Pacific’ Airlines has no authorization at present
to replace it with another flight.
Required
Using the data available, prepare an ANALYSIS showing what impact dropping flight GP-022
would have on the airline’s profit
Solution-

As per the statement given in the problem, FlightGP-022 incurs a net (loss) of `158,100. This
is the net result of revenue less costs. Revenue is entirely variable depending upon passenger
occupancy. Costs are both variable and fixed nature. To analyze the impact of dropping flight
GP-022, we need to re-compute net gain/ (loss) that Golden Pacific earns when it operates the
flight based on relevant costing principles.

Net Gain/ (Loss) = Revenue earned from flight operations less Variable costs of operation

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Revenue earned is the ticket revenue earned from flight operations of GP-022, this is entirely
variable. Variable costs of flight operations are those expenses that would be incurred only
when the flight is operated. These include variable expenses per passenger, salari es flight
assistants, overnight costs for flight crew and assistants, fuel for aircraft, a third portion of flight
insurance that is specifically related to this flight sector and flight promotion expense. These
are expenses that will not be incurred if the flight is not operated. Hence, relevant for decision
making.
Other expenses like salaries of flight crew and hanger parking fees for aircraft are fixed
expenses that will be incurred even if the flight does not operate. Loading and flight preparation
expense is an allocated cost that will continue to be incurred even if flight GP- 022 does not
operate. Depreciation of aircraft and liability insurance expense (2/3 rd portion not related to a
specific flight sector) are sunk costs. These expenses have already been incurred and hence are
irrelevant to decision making. Therefore, these fixed, allocated and sunk expenses are ignored
while analyzing the decision whether to continue operating flight GP-022.

Flight GP-022
Statement Showing Net Gain/ (Loss)
` `
Contribution Margin if the flight is continued 5,88,000
Less: Flight Costs
Flight Promotion 28,000
Fuel for Aircraft 2,38,000
Liability Insurance (1/3 × `1,47,000) 49,000
Salaries, Flight Assistants 31,500
Overnight Costs for Flight Crew and Assistants 12,600 3,59,100
Net Gain/ (Loss) 2,28,900
If Golden Pacific Airlines Ltd. discontinues flight GP-022, profits will reduce by `2,28,900.
The statement showing loss in operations of `158,100 is misleading for decision making
purpose because it accounts for costs that are fixed and irrelevant. However, since flight GP-
022 yields a net gain of `2,28,900, flight operations should continue
Ques 32

About Aditya Group

Aditya Group was established in 1975, manufactures and sells electronic personal grooming
and beauty products. The group has two 100% subsidiaries AUS Ltd. and ANZ Ltd. AUS Ltd.
manufactures luxury products that cater to niche customers who prefer specialized personal
grooming and beauty care. ANZ Ltd. caters to regular daily beauty and grooming requirements

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that has a wide reach within the market. Factories of both companies are located within India.
The products are sold to wholesalers, who supply these products to the retail market.
Aditya Group purchases its raw material requirements from both domestic and overseas
markets. Additionally, certain products manufactured by AUS Ltd. can be enhanced based on
the products manufactured by ANZ Ltd. Therefore, as per production requirements, AUS Ltd.
sources some product components from ANZ Ltd
Aditya Group has a centralized decision making set-up. Basic policy decisions for functions
such as production planning, sales and client relationship, finance and human resources are
handled at the group level. Individual units AUS Ltd. and ANZ Ltd. concentrate on the
manufacturing alone.
About You
You are an Assistant Manager in Finance and Accounts department of Aditya Group, headed
by Director- Finance Ms. Elsea. You assist and report to Ms. Fiona, Manager of your
department. Sometime you also assist Director Finance in analysing financial and non-
financial information, drafting reports for board meetings, preparation of presentation and staff
trainings.
Business Situation- 1
Yesterday, 5.15 P.M.
You got an email from Ms. Elsea, with Cc to Ms. Fiona. Ms. Elsea, asked you to prepare a cost
statement for making a quotation to a new customer. She has also informed you that the
customer can also maintain a long- term business relation with us. You have been requested to
gather information related to the specification from Sales Manager.
Yesterday, 5.25 P.M.
You have been called by Ms. Fiona, and provided the product specification received from
Sales- Manager for which quotation has to be quoted. Ms. Fiona has also requested you to
gather relevant information to prepare cost statement. Due to the expected long term business
relationship that AUS Ltd. wants to have with the customer, the sales manager wants to quote
the lowest possible price. AUS Ltd. currently has some spare capacity that can be utilized to
cater to this entire order. Therefore, only the relevant cost to AUS Ltd. has to be considered to
arrive at the quote.
After meeting with your reporting officer, you mailed to various concerned department and
requested for data.
The following information has been obtained in relation to the contract:
Today, 10.05 A.M.
You got an e-mail from Production Manager, it has been informed that 40 tonnes of material
Dx would be required. This material is in regular use by AUS and has a current purchase price
of `380 per tonne. Currently, there are 5 tonnes in inventory which cost `350 per tonne. The
resale value of the material in inventory is `240 per tonne.

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Further, with regards to components, it has been informed that 4,000 components would be
required. These could be bought externally for `15 each or alternatively they could be supplied
by ANZ Ltd. The variable cost of the component if it were manufactured by ANZ Ltd. would
be `8 per unit. ANZ Ltd. has sufficient capacity to produce 2,500 components without affecting
its ability to satisfy its own external customers. However, in order to make the extra 1,500
components required by AUS Ltd., ANZ Ltd. would have to forgo other external sales of
`50,000 which have a contribution to sales ratio of 40%. To have uniformity in the quality of
the component, it is assumed that AUS Ltd. would procure its entire requirement of 4,000
components either externally or from ANZ Ltd. The transfer pricing policy of Aditya Group
for sales between units aims at goal congruence. The unit selling the goods would be allowed
to charge any opportunity cost on account of catering to internal demand, while the purchasing
unit should ensure that the company is not at a loss.
Today, 10.45 A.M.
You got an e-mail from Personnel Manager, it has been informed that 2,000 high skilled labour
hours would be required. The grade of labour required is currently paid `5 per hour. Highly
skilled labour is in short supply and cannot be increased significantly in the short -term. This
labour is presently engaged in meeting the, demand for product ‘G’, which requires 4 hours of
highly skilled labour. The contribution from the sale of one unit of product L is `24.
It has also been informed that the contract would require a specialist machine. The machine
could be hired for `15,000 or it could be bought for `50,000. At the end of the contract if the
machine were bought, it could be sold for `30,000. Alternatively, it could be modified at a cost
of `5,000 and then used on other contracts instead of buying another essential machine that
would cost `45,000. The operating costs of the machine are payable by AUS whether it hires
or buys the machine. These costs would total `12,000 in respect of the new contract.
Supervisor
The contract would be supervised by an existing manager who is paid an annual salary of
`50,000 and has sufficient capacity to carry out this supervision. The manager would receive a
bonus of `5,000 for the additional work.
Development Time
15 hours of development time at a cost of `30,000 have already been worked in determining
the resource requirements of the contract.
Fixed Overhead Absorption Rate
AUS uses an absorption rate of `20 per direct labour hour to recover its general fixed overhead
costs. This includes `5 per hour for depreciation.
Today, 11.15 A.M: Ms. Fiona called you in her place as asked you the following:
Required
(i) CALCULATE the relevant cost of the contract to AUS. You must present your
answer in a schedule that clearly shows the relevant cost value for each of the items
identified above. You should also EXPLAIN each relevant cost value you have

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included in your schedule and why any values you have excluded are not relevant.
Ignore taxation and the time value of money.
(ii) DISCUSS two problems that can arise as a result of setting prices using relevant
costing.

Business Situation- 2
Today, 5.26 P.M: A memo from Managing Director of the group has been circulated to all
officers of the group which stated “My objective for the forthcoming year is to reduce our
quality costs in each of the primary activities in our value chain”. The company is keen to
build a reputation for quality and gives a five-year guarantee with all of its products.
Today, 5.37 P.M: Ms. Fiona, called you in her place and asked the following.
Required
EXPLAIN, by giving examples, how each of the four types of quality cost could be reduced.
You should also IDENTIFY in which primary activity each one of your examples would occur
in Aditya Group’s value chain.

Solution-

Statement Showing Relevant Cost

Type of Cost Explanation Amount (`)
Material Dx (40 tonnes × `380) 1 15,200
Components 2 52,000
Direct labour (2,000 hrs. × `11) 3 22,000
Specialist machine 4 10,000
Machine operating cost 5 12,000
Supervision 6 5,000
Development time 7 Nil
General fixed overhead 8 Nil
Total relevant cost 1,16,200
Explanation
1. Material Dx is in regular use by AUS Ltd. and must be replaced. Consequently, its relevant
value is its replacement cost. The historical cost is not relevant because it is a past cost and
the resale value is not relevant because AUS Ltd. is not going to sell it because the material
is in regular use.

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2. AUS Ltd. would like to procure 4,000 components either from ANZ Ltd. or external ly
from the market. At the current production level, ANZ Ltd. (seller) has available capacity
to accommodate part of AUS Ltd’s request to the extent of 2,500 components. At this
point, ANZ Ltd. would be operating at its maximum capacity.
To cater to the remaining demand of 1,500 units from AUS Ltd., ANZ Ltd. has to forego
external sales of `50,000 to its own customers. Given that the contribution to sales ratio is
40%. Therefore, ANZ Ltd. has to forego contribution of `20,000 (40% of external sales
foregone `50,000) in order to cater to AUS Ltd.’s request. Fixed cost at ANZ Ltd. is
irrelevant, since it would be incurred irrespective of whether AUS Ltd.’s order to catered
to or not.
Therefore, in spirit of goal congruence, the transfer price that ANZ Ltd. would charge
AUS Ltd. would be the variable cost of `8 per unit and `20,000 towards lost contribution
as explained above. Therefore, the transfer price
= (`8 per unit × 4,000 components) + `20,000
= `32,000 + `20,000
= `52,000 for 4,000 components
Therefore, per component, the price charged would be `52,000 / 4,000 = `13 per
component. This is lower than the external market price of `15 per unit. Therefore, in the
interest of goal congruence the cheaper option is preferred. AUS Ltd. should source its
components from ANZ Ltd, for a total procurement cost of `52,000.
3. Skilled labour is in short supply and can only be obtained by reducing the production of
product ‘G’, resulting in a loss of contribution of `24 (given) or `6 per hour of skilled
labour. Hence the relevant labour cost will be `6 (contribution lost per hour) + `5 (hourly
rate of skilled labour) i.e. `11 per hour.
4. AUS Ltd. has a number of options: (a) If the machine were to be hired it would have a cost
of `15,000; (b) if the machine were bought and then sold at the end of the work it would
have a net cost of `20,000; or (c) if the machine were bought and then modified to avoid
the need to buy the other machine it would have a net cost of `10,000 (`50,000 plus `5,000
modifications less `45,000 cost of another machine). Thus, the most economic approach
is buy the machine and then modify it so the relevant cost is `10,000.
5. The machine operating costs are future costs of doing the work and therefore are relevant.
6. The supervisor’s salary is irrelevant, but the bonus needs to be included because it is
dependent on this work and therefore is relevant.
7. The development time has already been incurred. Therefore, it is a past cost and not
relevant.
8. General fixed overhead costs and their absorption are not relevant because they will be
incurred whether the work goes ahead or not. Depreciation is also not relevant because it
is an accounting entry based on the historical purchase of assets. It is not affected by the
work being considered.

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(ii) Two main issues arise when pricing work based on relevant costs:

 Profit reporting; and

 Pricing of future work.
With regard to profit reporting, the decision as to whether to proceed with the work will
have been based on the use of relevant costs, but the routine reporting of the profit from the
work will be based on the company’s normal accounting system. Since thi s system will be
based on total cost, it is probable that the costs of the work reported will be greater than its
relevant cost. Consequently, the amount of profit reported to have been made on this order
will be lower than expected and may even be a loss. This may cause difficulties for the
manager who accepted the work as an explanation will be required of the reasons why there
is such a difference in profit.
With regard to the pricing of future work the difficulty lies in increasing the price for similar
items for the same customer in future. Once a price is set, customers tend to expect that any
future items will be priced similarly. However, where a special price has been offered based
on relevant cost because of the existence of spare capacity the supplier would not be able
to continue to price on that basis as it does not recover its long term total costs. There may
also be difficulties created by this method of pricing as other customers are being charged
on a full cost basis and if they were to discover that a lower price was offered to a new
customer they would feel that their loyalty was being penalised.
(iii) Prevention

Operations: Preventative maintenance and checking of the calibration of machinery. This

would reduce the number of potentially faulty products being produced and therefore
reduce guarantee claims.
Appraisal
Inbound Logistics: Reduce costs of incoming inspections by building close links with
suppliers and getting them to adopt TQM. If suppliers can guarantee their quality, then
inbound inspections could be eliminated.
Internal Failure
Operations: Reduce costs of re-works by training employees on a continual basis e.g.
quality circles. This would reduce failure costs and also improve quality.
External Failure
Service: Design quality into the product to try to prevent guarantee claims and therefore
the cost of servicing/repairing the product.

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Ques 32

N2 Co. is the manufacturer and supplier of firefighting and safety equipment for industrial use
and follows the international quality standards and uses the high grade raw material. It is a fast-
growing brand that protects millions of people across the India, every single day. N2 has been
offered a bid on a prospective export contract for 20,000 commercial fire extinguishers with
following specification from USA buyer and the delivery terms is FOB.
“two-gallon cylinder holding 10 pounds of multi-purpose dry chemical at 380 PSI”
N2 is exporting first time. The price computation per fire extinguisher is as follows:
` `
Direct Material
Circle Part Cost 620
Necking Part 30
Bottom Part 50
Fire Extinguisher Powder 590
Heat Process 50
Nozzle 60
Meter 20
Pipe 50
Nitrogen 30 1,500
Direct Labor (2 hrs. × `40) 80
Leakage Testing 50
Variable Overheads (including packing) 214
Export Clearance Charges on FOB term 36
Fixed Overhead 100
Total 1,980
Add: Markup @ 10% 198
Price 2,178
USD to INR 67
Price in USD 32.51
After quotation of USD 32.51, the buyer is negotiating the price and ready to pay only USD
28.50.

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Required
ADVISE whether it is worth accepting at USD 28.50 considering other factors.

Solution-

Workings
Statement Showing Benefit from Prospective Export Contract
`
Direct Material 1,500
Direct Labor (2 hrs. × `40) 80
Leakage Testing 50
Variable Overheads (including packing) 214
Export Clearance Charges on FOB term 36
Total Relevant Cost 1,880
USD to INR `67
Relevant Cost $28.06
Price Offered by Customer $28.50
Benefit per extinguisher $0.44
No. of Extinguishers 20,000
Total Benefit $8,800
Advise
From financial perspective, it will be profitable for N2 to accept the contract because of gain
of $8,800 (`5,89,600) along with export incentives of drawback. Besides this, following
consideration should also be taken into consideration while exporting fire extinguishers:
Statutory Compliances
Before exporting to a foreign country or even agreeing to sell to a new customer in a foreign
country, N2 should be aware of foreign laws that might affect the sale. Export documentation
is important as it plays a significant role in regulating the flow and movement of goods in
international markets. Each country has its own prescribed statutory documents to be complied
by exporters and importers. Thus, N2 should consider about the documentation and inspection
compliances part of new buyer. It may include third party audit, commercial invoice and
packaging list requirements, certificate requirements like- no child labour certificate,
inspection certificate, reach compliance certificate etc. If any compliance requirement is not
met, what will be the consequences? There may be stiff penalty has to be paid owing to non-
compliance or failure to accurately comply with the export obligation.

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Buyer Creditworthiness
It is necessary that before shipment the exporter to carry out its own credit check on the
importer to determine creditworthiness. Thus, N2 should make a proper assessment of the
creditworthiness of the foreign buyer and spend sufficient time in cross checking the credit
worthiness of his counterpart to avoid any kind of unforeseen situation in future. Such
information can be easily availed through contracts or through ECGC. Private agencies also
provide information on paid service basis. However, this risk can be covered by asking for LC
payment terms or 100% advance or opting for post shipment insurance for goods being
exported.
Industry Analysis
Industry analysis involves such things as assessing the competition in the industry; the interplay
of supply and demand in the industry; how the industry holds up against other industries that
are emerging and providing competitions; the likely future of the industry, especially in light
of technological developments; how credit works in the industry; and the exact extent of the
impact that external factors have on the industry.
For N2, it is worthwhile to know the current and future demand of fire extinguisher and factors
influencing the growth of global fire extinguisher market. N2 can perform industry analysis
through three main ways i.e. the Competitive Forces Model (also known as Porter’s 5 Forces);
the broad factors analysis, also known as PEST analysis; and SWOT Analysis. It may also
arrange industry report from trusted sources.
Additional Terms
Ensure that the all terms are clear and suit the business purpose. For instance, delivery terms
should provide date of shipment or means of determining the date. In some circumstances, a
late delivery penalty may be incurred where goods are not supplied by a specific delivery date.
Therefore, N2 should evaluate whether shipment date is attainable or not. If the target shipment
date could not be met, what will be the charges? Further, N2 must also check whether the
foreign bank charges are subject to beneficiary account. If yes, then the same must be
considered in the quotation.
Overall, N2 should accept the proposed contract only after due and careful consideration of
above factors.

Quest 34

Mount Sports Manufacturing Facilities (MSMF) deals in manufacturing of sports articles.

Although MSMF is major market player but can capture the market further. Currently MSMF
manufactures five types of badminton shuttle named as P-101, P-102, P103, P-104 and P-
105. Production facilities are limiting factor at MSMF. Production and marginal cost data of
these 5 products are specified in table below;
Particulars P-101 P-102 P-103 P-104 P-105

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Monthly production (in

1,000 1,200 2,000 3,000 1,500
units)
Direct Material Cost (₹per
6 4 7 3 6
unit)
Direct Labour Cost (₹per
4 9 5 8 5
unit)
Variable Production
Overhead 2 3 2 2 1
(₹per unit)
On drive to cost leadership strategy, MSMF is thinking to out-source some of the products.
Shuttles can be sourced from a well-established company ‘Protease’ at the following prices.
There is no tie-in between products, all products can outsources individually. These costs are
on CIF basis;

Particulars P-101 P-102 P-103 P-104 P-105

Outsourcing Cost/Buy in
17 18 18 11 15
Cost (₹per unit)
Company-wide fixed overheads are of ₹15 Lacs each year. Out of which ₹2,40,000 is directly
attributable to the production of these 5 products on annual basis. This fixed overhead of
₹2,40,000 is evenly split across such 5 products and entirely avoidable. Till date company does
not have experience to outsource any element of production.
Mr. Singh who is newly appointed management accountant, bring the huge experience to the
organization on cost control and reduction techniques. While discussing the possibility of
outsourcing with CFO, Mr. Singh explained the limitation of out-sourcing and also presents a
white paper on gain sharing arrangement; which can be entered with supplier to whom
outsourcing is considered.
CEO just entered into the office of CFO (where such discussion is ongoing) on verge of such
discussion, but he heard about gain sharing arrangement and curious to know further about the
same.
Required
CEO post presentation/ discussion seeks report from Mr. Singh to RECOMMEND, the
product/(s) which should be outsourced. Report should also EXPLAIN gain sharing
arrangement along with aspects that MSMF need to consider, ensuring success out of gain
sharing arrangement as a part of out-sourcing contract with Protease.
Solution-

Report to;
Office of CEO,

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 [6. 83]

Mount Sports Manufacturing Facilities (MSMF), Dated – 03rd Jan 2020

Report on Outsourcing of Products to Protease
(i) Recommendation on out-sourcing of the products – Product P-102 and P-104 can
be out-sourced. (see computations below)

Particulars P-101 P-102 P-103 P-104 P-105

a. Monthly production (in units) 1,000 1,200 2,000 3,000 1,500
b. Direct Material Cost (₹per unit) 6 4 7 3 6
c. Direct Labour Cost (₹per unit) 4 9 5 8 5

d. Variable Production Overhead (₹per unit) 2 3 2 2 1

e. Marginal Cost (₹per unit) (b)+(c)+(d) 12 16 14 13 12

f. Monthly Total Marginal Cost/Variable Cost
12,000 19,200 28,000 39,000 18,000
(e)×(a)

g. Monthly Allocable Fixed Overhead* 4,000 4,000 4,000 4,000 4,000

h. Total Monthly Cost Production-in- house 16,00
(f)+(g) 23,200 32,000 43,000 22,000
0
i. Outsourcing Cost/ Buy in Cost (₹per unit) 17 18 18 11 15
j. Total Monthly Cost Outsourcing/Buy in
(i)×(a) 17,000 21,600 36,000 33,000 22,500

Total monthly cost of in house production is ₹1,36,200 and Total comparable monthly cost of
outsourcing/Buy-in is ₹1,30,100. There is overall saving of ₹6,100, but since there is no tie-in
between products, hence decision on all products whether can be outsourced or produced in-
house can be taken individually.
The above calculation suggests that only P-102 and P-104 can be sourced through outsourcing
due to, whereas P-101, P-103 and P-105 can be produced more cheaply in- house.
(*)
Since avoidable in nature, hence relevant for decision making. ₹2,40,000 is annual cost, hence
monthly fixed overhead expenditure will be ₹20,000.
However, following aspects needs to be kept in mind, prior to entering to out- sourcing
arrangement of product P-102 and P-104
Issue 1
If products P-102 and P-104 are outsourced, the company would then have spare capacity.
Since the production function/capacity is a limiting factor and there is scope of selling the

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further units of P-101, P-103 and P-105; in order to acquire the market share. Hence, spare
capacity is of great importance and will be a powerful argument for outsourcing.
Issue 2
The reaction of the workforce at MSMF is also need to be considered because of two reasons;
a. If production of P-101, P-103 and P-105 cannot be expanded to take up the
spare capacity on account of out-sourcing of P-102 and P-104, then lay-off may
be required – Which may cause problem like strike by remain workforce or an
industrial dispute.
b. Facts also suggest that products P-102 and P-104 are labour intensive (due to
high comparative high labour cost). Hence, even the spare capacity on account
of out- sourcing of P-102 and P-104 is used, and then also the some of labour
forces need to be retrenched
Issue 3
Even if lay-off is accepted by workforce, then also cost associated with redundancies may be
critical. Such cost is relevant for decision-making, hence should be considered.
Issue 4
Since the MSMF has no experience in the outsourcing till now, hence while dealing with
Protease, MSMF need to ensure;
a. Timely delivery in right quantity
b. Quality of supplies
c. Penalties in case of default

(ii) Gain Sharing Arrangement by MSMF as part of outsourcing agreement with Protease
Gain Sharing Arrangement is a contractual arrangement where, entity (MSMF) & outsourcing
supplier (In this case protease) share the financial gain which result out of either productivity
gains or increased efficiency at end of outsourcing supplier from continuous improvement,
transformation, or innovation.
This arrangement in form of clause is usually included in Master Agreement of outsourcing.
Outsource supplier find it unique selling point and entity is also on for continuous improvement
apart this both will get share in cost saved.
Although gain sharing arrangement is largely useful in case of outsourcing services agreement,
but MSMF can also while entering out-sourcing contract with Protease for P- 102 and P-104;
but following aspects need to be considered;
Reason of failure of Gain Sharing Arrangement - Gain Sharing Arrangement sounds great
but in practice it is quite difficult to execute. Even after a considerable level of efforts due to
following reasons it may fail;
a. Unstructured/Poorly structured terms of arrangement, in outsourcing contracts.

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b. Error in implementation.
c. Relationship between outsource supplier and entity.
Precaution need to be taken - Action plan for executing gain share arrangement must contain;
a. Be specific in outsourcing agreement.
b. Predefined formula for sharing of benefits and period thereof.
c. Effort from entity, because innovation is not only responsibility of outsource
supplier.
d. Constitute innovation team to create an innovation structure, generate the idea
and execution of same
Overall
In consideration of above analysis, company should consider the outsourcing of P-102 and P-
104 by entering out-sourcing contract with Protease. At this point, it is important to note that
cost analysis emphasizes purely quantitative, financial considerations. However, outsourcing
decisions are often influenced by qualitative factors, which are not directly affected in
calculations. The impact of the same should also be taken into consideration. The issues
suggested above are not exhaustive. Further, before opting gain sharing arrangement, the same
should also be reviewed carefully from a business, legal, and tax perspective.
I hope this helps - if you need any further information, please let me know. Closure of Report

Mr. Singh,
Management Accountant
(For Management Accounting Division)
Mount Sports Manufacturing Facilities (MSMF

-----

DECISION MAKING CA MANOJ SHARMA

 7. PRICING DECISION
 Pricing Decision
 Theory of Price
 Profit Maximization Model
 Pricing Under Different Market Structures
 Pricing Policy
 Principles Of Product Pricing
 Pricing Methods
CONTENTS..

 Pricing In Periods Of Recession

 Pricing Below Marginal Cost
 Strategic Pricing Of New Products
 Pricing And Product Life CycleError! Reference
source not found.
 Price Adjustment Polices
 Structured Approach To Pricing Decisions
 Sensitivity Analysis In Pricing Decisions
 Pricing Of Services: Issues
 [7. 2]

PRICING DECISION
“A pricing decision is one of the most crucial & difficult decision that a firm has to make.
Such a decision affects the long- term survival of any profit-oriented enterprise.”
Accounting information is often an important input to pricing decisions. Most firms need to
make decision about setting or accepting selling prices for their products or services. In some
firms selling price is derived directly from cost information by estimating future product’s cost
& adding a suitable profit margin. In others, an established market price is accepted.
Generally, pricing decisions are influenced by the pricing policy followed by an organisation.
Pricing policies are made taking overall objectives of an organisation into account. Thus, before
fixing price of a product, objectives of the organisation must be understood first to achieve the
organisation’s goal. Objective of an organisation may be either to maximise the profit or
maximise the sales or maximise the output or optimal utilisation of resources etc.

THEORY OF PRICE
 The basic assumption of the pricing theory is that the firm’s main objective is to maximise
its profits.
 It also assumes that the firm takes into consideration the position of demand and cost
functions and that the firm produces one product.
 If a firm sells unlimited number of units, the total revenue line will be a straight line arrived
at by TR = mx.
Where,
TR = Total revenue line
m = quantity of units sold
x = price per unit.
 In most of the market situations, however, additional units can be sold by reducing the
price.
 This means that although the total sales revenue will increase as more and more units
are sold, the increase in total revenue will decline gradually as sales increases.

Example

A firm’s pricing of a product is as under:

20 units @ `4.00 per unit.
21 units @ `3.90 per unit.
22 units @ `3.80 per unit.
The sales figures can be summarised as under:

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 [7. 3]
Quantity Price Total Sales Addition to Total
Revenue Revenue

20 4.00 80.00 —
21 3.90 81.90 1.90
22 3.80 83.60 1.70

The reduction in the price of each additional unit reflects a gradual reduction in the steepness
of the total revenue curve as shown in the figure.
The total cost curve will however, register an increase in the steepness because as the volume
increases, the cost also increases because of the difficulty of expanding output with a given
productive resources.

At point Q, the gap between the total cost line and total revenue is the maximum, thus Q is the
point of optimum volume. Any attempt to increase the volume beyond this point will reduce
the profit because the incremental cost will be more than the incremental revenue.
These relations are expressed in terms of marginal revenue and marginal cost. Marginal
revenue is the increase in total revenue that results from the sale of one additional unit. In the
example given above, the marginal revenue of increasing one unit from 20 units to 21 units is
`1.90. Marginal cost is the increase in total cost that results from the production of one
additional unit.

PROFIT MAXIMIZATION MODEL

Pricing model is a mathematical model which uses economic theory of pricing.

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 [7. 4]
(i) As per economic theory of pricing, Profit is Maximum at a level of output where
Marginal Revenue (MR) is equal to Marginal Cost (MC) i.e.
Marginal Revenue (MR) = Marginal Cost (MC)
This model determines the level of production up to which production can be continued.
(ii) The Basic Price equation, which is used to determine the Price where Profit is
Maximum. The equation is written as:
P = a- bQ
Where, P= Price
b= Slope of the Demand Curve,
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
Calculated as 𝑏 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦

Q= Quantity Demanded
a= Price at Which Demand is Zero
(iii) The Marginal Revenue equation is written as

Marginal Revenue (MR) = P = a – 2bQ

Example

Aditya Heavy Engineering Ltd. (AHEL) produces its only product A7. To manufacture a unit
of A7, variable cost of `2,20,000 is incurred. Market research has indicated that at a selling
price of ` 5,10,000 no order will be received, but the demand for A7 will be increased by two
units with every `5,000 reduction in the unit selling price below `5,10,000.
To determine the unit selling price for A7 that will maximize the profit of AHEL. We assume
that: Selling Price per unit of A7 is ‘P’, and Quantity Demanded is ‘Q’
The Marginal Cost of a unit of A7 is `2,20,000 Price Equation for ‘A7’
P = a – bQ
P = 5,10,000 – (5,000 / 2) × Q
Revenue (R) = Q × [5,10,000 – 2,500 × Q]
= 5,10,000 Q – 2,500 Q2
Marginal Revenue (MR) = a – 2bQ
= 5,10,000 – 2 × (5,000 / 2) × Q
= 5,10,000 – 5,000 Q
Marginal Cost (MC) = 2,20,000

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 [7. 5]
Profit is Maximum where,
Marginal Revenue (MR) = Marginal Cost (MC)
5,10,000 – 5,000 Q = 2,20,000
Q = 58 units
By Putting the Value of ‘Q’ in Price Equation, Value of ‘P’ is Obtained
P = 5,10,000 – (5,000/ 2) × Q
= 5,10,000 – 2,500 × 58 units
= 3,65,000
At Selling Price of `3,65,000 AHEL’s Profit will be Maximum

Ques 1 SM

Baithway India Ltd. (BIL) is an ISO 9001:2008, 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 2019-20
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 quotation price below `3,20,000.

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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 quotation 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 for the financial year 2019-20.
(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-

(i) Assumed Quotation Price ‘P’, Quantity ‘Q’ The Marginal Cost of a ‘Wagon’ is `13,60,000
(`2,20,000 × 4 Bogies + `4,80,000)
Demand Function for a ‘Wagon’

P = `17,10,000 – (`50,000 / 2) × Q

Revenue (R) = Q × [17,10,000 – 25,000 × Q]

= 17,10,000 Q – 25,000 Q2

Marginal Revenue (MR) = 17,10,000 – 50,000 Q

Marginal Cost (MC) = 13,60,000

Profit is Maximum where Marginal Revenue (MR) equals to Marginal Cost (MC)
17,10,000 – 50,000 Q = 13,60,000
Q = 7.00 units
By putting the value of ‘Q’ in Demand Function, value of ‘P’ is obtained.
P = 17,10,000 – (50,000/ 2) × Q

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= 17,10,000 – 25,000 × 7.00
= `15,35,000
At `15,35,000 unit Quotation Price of a Wagon, the Baithway Company Ltd.’s Profit will be
Maximum.
(ii) At ‘BD’ the Divisional Manager would ensure that Divisional Marginal Revenue should
be equal to Division’s Marginal Cost so that Profit can be Maximum.

MR of a Bogies = MC of Manufacturing a Bogies

3,20,000 – 2(10,000/ 30) × Q = 2,20,000
Q = 150 units
Selling Price of a Bogie i.e ‘P’ is
P = 3,20,000 – (10,000/ 30) × 150
= `2,70,000
BD’ will earn Maximum Profit when it will Quote `2,70,000 to the Outside Market. Since,
Outside Market Quotation is Transfer Price as well, so Transfer Price to WD will be `2,70,000
and it forms part of WD’s Marginal Cost.
At ‘WD’, Division Manager would ensure that Divisional Marginal Revenue should be
equal to Division’s Marginal Cost so that Profit can be Maximum.

MR of a Wagon = MC of Manufacturing a Wagon

17,10,000 – 50,000 × Q = (2,70,000 × 4 Bogies) +
`4,80,000
Q = 3.00 units
Quotation Price of a Wagon ‘P’ should be:
P = `17,10,000 – 25,000 × 3.00
= `16,35,000
The unit Quotation Price of Wagon that emerges as a result of Market Based Transfer Pricing
is `16,35,000.
(iii) 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.

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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 appeared to be the more appropriate pricing strategy for Bogie
“E”.

PRICING UNDER DIFFERENT MARKET STRUCTURES

Perfect Competition
 Under perfect competitive market, there are large numbers of sellers selling a
homogeneous product using identical production process and all of them have perfect
information about the market and price.
 Perfect market allows free entry and exit of firms into and out of the industry.
 Under this type of market, firm has no pricing policy of its own as the sellers are price
takers (i.e. it has to accept the price determined by the market) and sell as much as they
are capable of selling at the prevailing market price.
 Since each firm produces and sells a homogeneous product, it cannot increase its price
beyond the market price. If it does so then it has to lose all of its market demand to the
competitors.

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Example

Aditya LLP produces a product X, the market for the product X is competitive and the
prevailing market price for a unit of product X is `40. The following table presents the marginal
cost and profit for the product X:
Units Total Total Cost (`) Marginal Profit (`)
Revenue (`) Cost (`)
0 0 20 - (20)
1 40 30 10 10
2 80 50 20 30
3 120 85 35 35
4 160 125 40 35
5 200 170 45 30
6 240 217 47 23
The marginal cost for producing 4th unit is equal to the price per unit. Thus, Aditya LLP can
maximize its profit at 4th unit level.

Monopoly
 Monopoly is a market condition where there is only one supplier or producer of a
homogeneous product for which there is no close substitute but has many buyers.
 Under the monopoly, a firm is a price setter i.e. it can fix any price but here also
the pricing is done taking elasticity of demand for the product into consideration.
 That means though the seller/ producer can fix any price but it will go for the price
where demand for the product and consequent profit will be maximum.

Monopolistic Competition
 The monopolistically competitive market is one in which there are large number of
firms producing similar but not identical products.
 Since there is limit to the growth of competitors the excess profits earned by
monopolistic situation attracts new competition.
 This will have a long - run effect on the excess profits which will tend to diminish
because of the price competition with close substitutes. The company will, however,
have to compare marginal cost and marginal revenue in maximising its profits.
 Under monopolistic condition, consumers may buy more at a lower price than at
higher price. The profit can be maximised by equating marginal revenue with
marginal cost.

Oligopoly

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 A market structure where there are few firms producing or selling homogenous or
identical product.
 In this type of market structure the firms are aware of the mutual interdependence of
investment, production process, advertising and sales plan of its rival firm.
 Hence, any change in any variable by a firm is likely to have an equal reaction on the
part of other competing firms.
 It is therefore, clear that the oligopolistic firm, while determining the price for its
product, consider not only the demand for the product but also the reactions of the
other firms in the industry to any action or decision it may take.

PRICING POLICY

 The pricing policy plays an important role in a business because the long run survival of a
business depends upon the firm’s ability to increase its sales and derive the maximum profit
from the existing and new capital investment.
 Although cost is an important aspect of pricing, consumer demand and competitive
environment are frequently far more significant in pricing decisions.
 These are also known as determinants of pricing or market powers.
 Thus, costs alone do not determine price.
 Cost is only one of the many complex factors which determine prices. There must however,
be some margin in prices over total cost if capital is to be unimpaired and production
maximised by the utilisation of internal surplus.

The pricing policy and the relative price structure should:

Ques 2

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Rapid Heal Tech Ltd. (RHTL) is a leading IT security solutions and ISO 9001 certified
company. The solutions are well integrated systems that simplify IT security management
across the length and depth of devices and on multiple platforms. RHTL has recently developed
an Antivirus Software and company expects to have life cycle of less than one year. It was
decided that it would be appropriate to adopt a market skimming pricing policy for the launch
of the product. This Software is currently in the Introduction stage of its life cycle and is
generating significant unit profits.

Required
(i) Explain, with reasons, the changes, if any, to the unit selling price that could occur when
the Software moves from the Introduction stage to Growth stage of its life cycle.
(ii) Also suggest necessary strategies at this stage

Solution-

Following acceptance by early innovators, conventional consumers start following their lead.
New competitors are likely to now enter the market attracted by the opportunities for large
scale production and profit. RHTL may wish to discourage competitors from entering the
market by lowering the price and thereby lowering the unit profitability. The price needs to be
lowered so that the product becomes attractive to different market segments thus increasing
demand to achieve the growth in sales volume.
Strategies at this stage may include the following
(i) Improving quality and adding new features such as Data Theft Protection, Parental
Control, Web Protection, Improved Scan Engine, Anti Spyware, Anti Malware etc.
(ii) Sourcing new market segments/ distribution channels.
(iii) Changing marketing strategy to increase demand.
(iv) Lowering price to attract price-sensitive buyers

PRINCIPLES OF PRODUCT PRICING

Price Customization
Pricing of a product is some time customised keeping taste, preference and perceived value of
a consumer into consideration. Price customisation is done in various ways:
 Based on product line: Based on the requirement of the consumer products can be
customized and accordingly the prices. For example, some may like to have a
smartphone with 16 GB over 32 GB. In this case pricing for the product can be based
on memory specification.

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 [7. 12]
 Based on customer’s past behaviour: A customer with good payment record may
be given more discounts then the others.
 Based on demographics: Different pricing may be adopted based on age or social
status. For example, railway fare concession for senior citizen and concessional price
tickets for military personnel.
 Based on time differential: Pricing for a product or service is also done on the basis
of time differential i.e. different price for different time period. For example,
discounted price for data usage provided by a broadband service provider if
subscription paid for six months at a time.
Apart from above pricing principles, other macro economic and legal factors should also be
given due importance while chalking out a pricing strategies.
Price Sensitivity
It measures the customer’s behaviour to the change in price of a product. Nagle1 has identified
nine factors that contribute to price sensitivity. These factors are:

Unique

Value Effect Substitute

Inventory
Awareness
Effect

Price Difficult

Quality Comparison
Price Sensitivity

Sunk Total
Investment Expenditure
Effect Effect
End-
Shared Cost
Benefit
Effect Effect

 Unique Value Effect- More unique the product, lower is the price sensitivity.
 Substitute Awareness Effect- If the buyers are aware of substitutes and these perform the
same function, then the buyer’s price sensitivity will be high.
 Difficult Comparison Effect- Price sensitivity will be low if the buyer has difficulty
comparing two alternatives.
 Total Expenditure Effect- If then expenditure on the product represents a low proportion
of the consumer income, the price sensitivity will be less visible for such a product.
 End- Benefit Effect- Buyers are less price sensitive where the expenditure on the product
is low compared to the total cost of the end product.
 Shared Cost Effect- If the cost of the product is shared by another party, the buyer will
have less prone to price sensitivity.

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 [7. 13]
 Sunk Investment Effect- Price sensitivity is low in products which are used along with
assets previously bought.
 Price Quality Effect- Higher the perceived quality of the product, lower the price
sensitivity
 Inventory Effect- If the product cannot be stored, the buyer will be less price sensitive

PRICING METHODS
Costs, Demand, and Competition define different pricing methods that a firm may adopt. Let
us understand these methods:

Ques 3 SM

The budgeted cost data of a product manufactured by Ayudhya Ltd. is furnished as below:
Budgeted units to be produced 2,00,000
Variable cost (`) 32 per unit
Fixed cost (`) 16 lacs
It is proposed to adopt cost plus pricing approach with a mark-up of 25% on full budgeted cost
basis.
However, research by the marketing department indicates that demand of the product in the
market is price sensitive. The likely market responses are as follows:
Selling Price (` per 44 48 50 56 60
unit)
Annual Demand 1,68,000 1,52,000 1,40,000 1,28,000 1,08,000
(units)
Required
ANALYSE the above situation and DETERMINE the best course of action

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Solution-

Analysis of Cost plus Pricing Approach

The company has a plan to produce 2,00,000 units and it proposed to adopt Cost plus Pricing
approach with a markup of 25% on full budgeted cost. To achieve this pricing policy, the
company has to sell its product at the price calculated below:
Qty. 2,00,000 units
Variable Cost (2,00,000 units × ` 32) 64,00,000
Add: Fixed Cost 16,00,000
Total Budgeted Cost 80,00,000
Add: Profit (25% of ` 80,00,000) 20,00,000
Revenue (need to earn) 1,00,00,000
Selling Price per unit ` 1,00,00,000
2,00,000 units 50 p.u.
However, at selling price `50 per unit, the company can sell 1,40,000 units only, which is
60,000 units less than the budgeted production units.
After analyzing the price-demand pattern in the market (which is price sensitive), it is perceived
that to sell all the budgeted units of 2,00,000 market price needs to be further lowered, which
might be lower than the total cost of production. This action does not seem to be in favor of
firm’s interest.
Statement Showing “Profit at Different Demand & Price Levels”
I II III IV Budgeted
Qty. (units) 1,68,000 1,52,000 1,40,000 1,28,000 1,08,000
` ` ` ` `
Sales 73,92,000 72,96,000 70,00,000 71,68,000 64,80,000
Less: Variable Cost 53,76,000 48,64,000 44,80,000 40,96,000 34,56,000
Total Contribution 20,16,000 24,32,000 25,20,000 30,72,000 30,24,000
Less: Fixed Cost 16,00,000 16,00,000 16,00,000 16,00,000 16,00,000
Profit (`) 4,16,000 8,32,000 9,20,000 14,72,000 14,24,000
Profit 5.96 12.87 15.13 25.84% 28.16%
(% on total cost)

Determination of the Best Course of Action

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 [7. 15]
(i) Taking the above calculation and analysis into account, the company should
produce and sell 1,28,000 units at `56. At this price company will not only be able
to achieve its desired mark up of 25% on the total cost but can earn maximum
contribution as compared to other even higher selling price.
(ii) If the company wants to uphold its proposed pricing approach with the budgeted
quantity, it should try to reduce its variable cost per unit for example by asking its
supplier to provide a quantity discount on the materials purchased. With reduction
in variable cost per unit, the selling price per unit (determined as a percentage of
full costs) will also reduce and suitably create demand for 2,00,000 units as
budgeted.

COST-BASED PRICING METHOD

In many businesses, the common method of price determining is to estimate the cost of product
& fix a margin of profit. The term ‘cost’ here means Full Cost at current output and wages
level since these are regarded as most relevant in price determination.
If a firm wants to survive and stay in business, it has to maintain its fixed capital intact so that
its fixed assets may be replaced at the end of their useful working life out of the funds generated
from profits retained in the business.
In a period of relatively stable price levels, depreciation based on historical cost of fixed assets
would perhaps be adequate for achieving this object.
In periods when the price level is continuously changing, the firm may not be left with adequate
funds generated out of accumulated depreciation at the end of the life of the plant to replace
the plant at a higher price. Hence depreciation should be properly included as a part of cost so
as to leave sufficient profits for asset replacement.
Pricing based on total costs is subjected to two limitations. They are:
 The allocation of inter-departmental overheads is based on an arbitrary basis; and
 The allocation overheads will require estimation of normal output which often cannot be
done precisely.
In order to avoid these complications, Variable Costs which are considered as relevant costs
are used for pricing, by adding a markup (to include fixed costs allocation also).
Sometimes, instead of arbitrarily adding a percentage on cost for profit, the firm determines an
average mark-up on cost necessary to produce a desired Rate of Return on Investment. The
rate of return to be earned by the firm or industry must depend on the risk involved.

Ques 4

Bosch Ltd. has developed a special product. Details are as follows: The product will have a life
cycle of 5,000 units. It is estimated that market can absorb first 4,500 units at ` 64 per unit and
then the product will enter the "decline" stage of its life cycle.

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The company estimates the following cost structure:
Direct Labour ` 6 per hour
Other variable costs ` 19 per unit
Fixed costs will be ` 40,000 over the life cycle of the product. The ‘labour rate’ and both of
these costs will not change throughout the product's life cycle.
The first batch of 100 units will take 1,000 labour hours to produce. There will be an 80%
learning curve that will continue until 2,500 units have been produced. Batches after this level
will each take the same amount of time as the 25th batch. The batch size will always be 100
units.
Required
CALCULATE average selling price of the final 500 units that will allow the company to earn
a total profit of ` 80,000 from the product if average time for 24 batches is 359.40 hours.
(Note: Learning coefficient is –0.322 for learning rate of 80%). The values of Logs have been
given for calculation purpose:
log 2 = 0.30103; log 3 = 0.47712; log 5 = 0.69897; antilog of 2.534678 = 342.51; antilog of
2.549863 = 354.70; antilog of 2.555572 = 359.40; antilog of 2.567698 = 369.57
Solution:

Average ‘Selling Price’ of the final 500 units

Particulars Amount (` )
Direct Labour [(8,867.50 hrs. + 241.90 hrs. × 25 batches) × `6] 89,490
Add: Other Variable Costs (5,000 units × `19) 95,000
Add: Fixed Costs 40,000
Total Life Cycle Cost 2,24,490
Add: Desired Profit 80,000
Expected Sales Value 3,04,490
Less: Sales Value (4,500 units × `64) 2,88,000
Sales Value (Decline Stage) …(A) 16,490
Sales Units (Decline Stage) …(B) 500
Average Sales Price per unit …(A)/ (B) 32.98

Workings
(i) The cumulative average time per batch for the first 25 batches
The usual learning curve model is

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Y = Axb
Where
Y = Average time per batch (hours) for x
batches
A = Time required for first batch (hours)
X = Cumulative number of batches produced
B = Learning coefficient
The Cumulative Average Time per batch for the first 25 batches
Y = 1,000 × (25) –0.322
log y = log 1,000 − 0.322 × log 25
log y = log 1,000 − 0.322 × log (5 × 5)
log y = log 1,000 − 0.322 × [2 × log 5]
log y = 3 − 0.322 × [2 × 0.69897]
log y = 2.549863
Y = antilog of 2.549863
Y = 354.70 hours
(ii) The time taken for the 25th
batch
Total Time for first 25 batches = 354.70 hours × 25 batches
= 8,867.50 hours
Total Time for first 24 batches = 359.40 hours × 24 batches
= 8,625.60 hours
Time taken for 25th batch = 8,867.50 hours − 8,625.60 hours
= 241.90 hours

Competition-Based Pricing Method

 When a company sets its price mainly on the consideration of what its competitors are
charging, its pricing policy under such a situation is called competitive pricing or
competition-oriented pricing.
 It is not necessary under competitive pricing to charge the same price as charged by the
concern’s competitors.

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 But under such a pricing the concern may keep its prices lower or higher than its
competitors by a certain percentage.
 It’s own costs or demand may change, but the concern maintains its price because its
competitors maintain their prices.
 Conversely, the concern will change its price when its competitors change their price, even
if its own costs or demand have not altered. Different types of competitive pricing in vogue
are as follows:

Going Rate Pricing

 It is a competitive pricing method under which a firm tries to keep its price at the average
level charged by the industry.
 The use of such a practice of pricing is especially useful where it is difficult to measure
costs. Adoption of going rate pricing will not only yield fair return but would be least
disruptive for industry’s harmony.
 Going rate pricing primarily characterises pricing practice in homogeneous product
markets, The concern selling a homogeneous product in a highly competitive market has
actually very little choice about the setting of its price.
 There is apt to be a market determined price for the product, which is not established by
any single firm or clique of firms but through the collective interaction of buyers and sellers.
 The concern which is going to charge more than the going rate would attract virtually no
customers. The concern should not charge less because it can dispose of its entire output at
the going rate.
Thus, under highly competitive conditions in a homogeneous product market (such as food,
raw materials and textiles) the concern really has no pricing decision to make. The major
challenge before such a concern is good cost control. Since promotion and personnel selling
are not in the picture, the major marketing costs arise in physical distribution.
In pure oligopoly, where a few large concerns dominate the industry, the concern also tends
to charge the same price as is being charged by its competitors. Since there are only a few
concerns, each firm is quite aware of other’s prices, and so are the buyers.
This does not mean that the going price in an oligopoly market will be in practice indefinitely.
It cannot, since industry costs and demand change over time.

Sealed Bid-Pricing
 Competitive pricing also dominates in those situations where firms compete on the basis of
bids, such as original equipment manufacturer and defense contract work.
 The bid is the firms offer price, and it is a prime example of pricing based on expectations
of how competitors will price rather than on a rigid relation based on the concern’s own
costs or demand.

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 The objective of the firm in the bidding situation is to get the contract, and this means that
it hopes to set its price lo wer than that set by any of the other bidding firms. But however,
the firm does not ordinarily set its price below a certain level.
 Even when it is anxious to get a contract in order to keep the plant busy, it cannot quote
price below marginal cost. On the other hand, if it raises its price above marginal cost, it
increases its potential profit but reduces its chance of getting the contract.

Value- Based Pricing Method

There is an increasing trend to price the product on the basis of customer’s perception of its
value. This method helps the firm in reducing the threat of price wars. Marketing research is
important for this method. It is based on:
Objective Value or True Economic Value (TEV)
This is a measure of benefits that a product is intended to deliver to the consumers relative to
the other products without giving any regard whether the consumer can recognize these
benefits or not.
True economic value for a consumer is calculated taking two differentials into consideration:
TEV = Cost of the Next Best Alternative + Value of Performance Differential
Cost of the next best alternative is the cost of a comparable product offered by some other
company. Value of performance differential is the value of additional features provided by the
seller of a product.
A firm’s product may be superior to the next best alternative in some dimensions but inferior
in others.

Example

A customer wants to buy a System for a single year (after which it will be scrapped) with plans
to use it for 2,500 hrs.
Cost Structure (similar products):
Particulars System-X System-X2
Operating Cost/ hour `5 ` 7.50
Probability of System Crash 10% 0.5%
Price ` 37,500 ?

Find the TEV for the System-X2 if the cost of a System Crash to the buyer is `1,00,000.
TEV=

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Particulars `
Operating Cost - `6,250
2,500 hrs. × (`5.00 - `7.50)
System Crash Savings `9,500
`1,00,000 × (10.00% - 0.50%)
Price of Next Best Alternative `37,500
TEV `40,750

Perceived Value
This is the value that consumer understands the product deliver to it. It is the price of a product
that a consumer is willing to spend to have that product.
At the time of fixing price, it is to be kept in the mind that any price which is set below the
perceived value but above the cost of goods sold give incentives to both buyers and the seller.
This can be understood with the help the diagram given below.

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PRICING IN PERIODS OF RECESSION

In periods of recession, a firm may sell its articles at a price less than the total cost but above
the marginal cost for a limited period.
The advantages of this practice are:
 The firm can continue to produce and use the services of skilled employees who are
well trained and will be difficult to re-employ later if discharged.
 Plant and machinery can be prevented from deterioration through idleness.
 The business would be ready to take advantage of improved business conditions
later.
 This avoids the competition of securing the business of the firm
One thing to remember here is that a situation like this should not lead to a drastic price cutting
and the orders accepted should not cover a long period extending over the production facilities
of a period when business conditions improve.

PRICING BELOW MARGINAL COST

Firm may also be justifiable to sell the product at a price below marginal cost for a limited
period provided the following conditions prevail:
 Where materials are of perishable nature.
 Where stocks have been accumulated in large quantities and the market prices have
fallen. This will save the carrying cost of stocks.
 To popularize a new product.
 Where such reduction enables the firm to boost the sales of other products having
larger profit margin.

STRATEGIC PRICING OF NEW PRODUCTS

The pricing of new product poses a bigger problem because of the uncertainty involved in the
estimation of their demand. In order to overcome this difficulty experimental sales are
conducted in different markets using different prices to see which price is suitable.
A company may, for example, choose three different markets and by using the same amount
of sales promotional activities, ascertain what the right price is.
In such circumstances, it may even prove that the highest price yielding the largest unit
contributory margin need not necessarily maximise the profits.
A lower price may well go to maximise the profits.

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 [7. 22]
But at the same time if a product is priced very low to attract more demand, it may be difficult
in the future to raise the price as it may not be acceptable to the consumers.
So, pricing of a new product is very crit ical issue which should be decided after a thorough
market study and consumer behavior analysis.
Situations-
Situation RP/EP/MP Pricing
Adjustable work table like a stool, has been Me-too Market Price that is
successfully capturing the market. Company X Product (MP) determined by competitive
makes a small variant of this product and is trying to forces for the successful
enter the market. product.
R & D has just been completed on an innovative Revolutionary Premium Pricing, it can
computer processor in the shape of a pen, with Product (RP) expect to make a tidy profit as
accompanying pen-like devices to act as keyboard a reward for innovation and
projector and monitor projector. This is expected to taking its first initiative.
get the laptops out of business due to extreme ease
of portability of just 3 pen-like light weight devices.
A successful mobile manufacturing company has Evolutionary Demand Based Pricing,
built into its latest mobile phone, an additional Product (EP) Price higher than the earlier
sliding screen and improved its processor version to justify its Costs and
capabilities so that the phone is almost a laptop. Benefits subject to what
amount can be stepped up in
the market.

While preparing to enter the market with a new product, management must decide whether to
adopt a skimming or penetration pricing strategy.

Skimming Pricing
It is a policy of high prices during the early period of a product’s existence. This can be
synchronised with high promotional expenditure and in the later years the prices can be
gradually reduced. The reasons for following such a policy are :
(i) The demand is likely to be inelastic in the earlier stages till the product is established in
the market.
(ii) The charge of high price in the initial periods serves to skim the cream of the market
that is relatively insensitive to price. The gradual reduction in price in the later year will
tend to increase the sales.
(iii) This method is preferred in the beginning because in the initial periods when the demand
for the product is not known the price covers the initial cost of production.
(iv) High initial capital outlays, needed for manufacture, results in high cost of production.
Added to this, the manufacturer has to incur huge promotional activities resulting in

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increased costs. High initial prices will be able to finance the cost of production
particularly when uncertainties block the usual sources of capital.

Penetration Pricing
This policy is in favour of using a low price as the principal instrument for penetrating mass
markets early. It is opposite to skimming price. The low price policy is introduced for the sake
of long-term survival and profitability and hence it has to receive careful consideration before
implementation. It needs an analysis of the scope for market expansion and hence considerable
amount of research and forecasting are necessary before determining the price.
Penetrating pricing, means a pricing suitable for penetrating mass market as quickly as possible
through lower price offers. This method is also used for pricing a new product. In order to
popularise a new product penetrating pricing policy is used initially. The company may not
earn profit by resorting to this policy during the initial stage. Later on, the price may be
increased as and when the demand picks up. Penetrating pricing policy can also be adopted at
any stage of the product life cycle for products whose market is approached with low initial
price. The use of this policy by the existing concerns will discourage the new concerns to enter
the market.
We must distinguish penetration pricing from Predatory Pricing. Predatory Pricing (loss
leading) is the practice of selling a product or service at a very low price, intending to drive
competitors out of the market or create barriers to entry for potential new competitors.
The three circumstances in which penetrating pricing policy can be adopted are as under:
(i) When demand of the product is elastic to price. In other words, the demand of the
product increases when price is low.
(ii) When there are substantial savings on large scale production. Here increase in demand
is sustained by the adoption of low pricing policy.
(iii) When there is threat of competition. The prices fixed at a low level act as an entry barrier
to the prospective competitors.
Situations-
Situation Appropriate Pricing Policy
‘A’ is a new product for the company and the market and meant for Penetration Pricing
large scale production and long term survival in the market. Demand
is expected to be elastic.
‘B’ is a new product for the company, but not for the market. B’s Market Price or Price Just
success is crucial for the company’s survival in the long term. Below Market Price
‘C’ is a new product to the company and the market. It has an Skimming Pricing
inelastic market. There needs to be an assured profit to cover high
initial costs and the unusual sources of capital have uncertainties
blocking them.
‘D’ is a perishable item, with more than 80% of its shelf life over. Any Cash Realizable Value*

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Ques 5 PM

State the appropriate pricing policy in each of the following independent situations:
1) 'A' is a new product for the company and the market and meant for large scale production
and long term survival in the market. Demand is expected to be elastic
2) 'B' is a new product for the company, but not for the market. B's success is crucial for the
company's survival in the long term.
3) 'C' is a new product to the company and the market. It has an inelastic market. There needs
to be an assured profit to cover high initial costs and the usual sources of capital have
uncertainties blocking them.
4) 'D' is a perishable item, with more than 80% of its shelf life over.

Solution-

Situation Appropriate Pricing

Policy
1) (‘A’ is a new product for the company and the market Penetration Pricing
iand meant for large scale production and long term
)survival in the market. Demand is expected to be
elastic.
2) (‘B’ is a new product for the company, but not for Market Price or Price
ithe Just Below Market Price
i
)market. B’s success is crucial for the company’s
survival in the long term.
3) (‘C’ is a new product to the company and the market. Skimming Pricing
iIt has an inelastic market. There needs to be an
iassured profit to cover high initial costs and the
iunusual sources
)
of capital have uncertainties blocking them.
4) (‘D’ is a perishable item, with more than 80% of its Any Cash Realizable
ishelf life over. Value*
v
)

Ques 6 PM

State the most appropriate pricing policy to be adopted in the following independent situations:
1) Modern patented drug entering the market.
2) The latest version of a mobile phone is being launched by an established, financially strong
company.

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 [7. 25]
3) An established company has recently entered the stationery market segment and launched
good quality paper for printing at home and office.
4) A car manufacturer is launching an innovative, technologically advanced car in the highly
priced segment
Solution-

Situation Appropriate Pricing

Policy
1) ( Modern patented drug entering the market. Skimming Pricing
i
)
2) ( The latest version of a mobile phone is being launched Penetration Pricing
i by an established, financially strong company.
i
)
3) ( An established company has recently entered the Market Price
i stationery market segment and launched good quality
i paper for printing at home and office.
i
)
4) ( A car manufacturer is launching an innovative, Skimming Pricing
i technologically advanced car in the highly priced
vsegment.
)

PRICING AND PRODUCT LIFE CYCLE

Introduction Stage Growth Stage Maturity Stage Decline Stage

▪ Skimming Policy with ▪ Reduce price to ▪ Price to match or ▪ Cut price if not
high prices, but low penetrate market beat competitor. repositioning.
profit margin due to high further.
fixed costs.
▪ Penetration Policy to ▪ Retain higher prices ▪ Some increases
enter the market and gain in some market in prices may
a high share quickly or to segments. occur in the late
prevent competitors decline stage.
from entering

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 [7. 26]
Ques 7 SM

Swift Tech Ltd. (STL) is a leading IT security solutions and ISO 9001 certified company. The
solutions are well integrated systems that simplify IT security management across the length
and depth of devices and on multiple platforms. STL has recently developed an Antivirus
Software and company expects to have life cycle of less than one year. It was decided that it
would be appropriate to adopt a market skimming pricing policy for the launch of the product.
This Software is currently in the Introduction stage of its life cycle and is generating significant
unit profits.
Required
(i) EXPLAIN, with reasons, the changes, if any, to the unit selling price that could occur
when the Software moves from the Introduction stage to Growth stage of its life cycle.
(ii) Also, IDENTIFY necessary strategies at this stage

Solution -

Following acceptance by early innovators, conventional consumers start following their lead.
New competitors are likely to now enter the market attracted by the opportunities for large
scale production and profit. STL may wish to discourage competitors from entering the market
by lowering the price and thereby lowering the unit profitability. The price needs to be lowered
so that the product becomes attractive to different market segments thus increasing demand to
achieve the growth in sales volume.
Strategies at this stage may include the following
(iii) Improving quality and adding new features such as Data Theft Protection, Parental
Control, Web Protection, Improved Scan Engine, Anti Spyware, Anti Malware etc.
(iv) Sourcing new market segments/ distribution channels.

(v) Changing marketing strategy to increase demand.

(vi) Lowering price to attract price-sensitive buyers.

Ques 8 SM

Angel 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 facility which has a 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.

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 [7. 27]
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 t here 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

Solution-

Selling Price for “Comfort” that would maximize its contribution at Maturity Stage
Contribution per unit of “Comfort” = Selling Price per unit – Variable Cost per unit Total
Contribution = Contribution per unit × Units sold

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 [7. 28]
All figures in Rupees
Sales (units) per week 550 725 1,000 1,150 1,200
Selling Price per unit 1,750 1,600 1,525 1,450 1,300
Less: Variable Cost per unit 750 750 750 750 750
Contribution per unit 1,000 850 775 700 550
Total Contribution 5,50,000 6,16,250 7,75,000 8,05,000 6,60,000
Total contribution is maximum when sales are 1,150 units. Therefore, the selling
price per unit of “Comfort” should be `1,450 per unit.
(ii) Production Number of “Sports” and Selling Price per unit
Angel Ltd. has a production capacity of 3,500 hours per week. As explained in (i) above, it
would manufacture 1,150 units of “Comfort” per week. Each unit of “Comfort” requires 2
hours of production. Therefore, total production hours for Comfort would be 1,150 units × 2
hours = 2,300 hours per week.
Production capacity remaining to manufacture “Sports” = 3,500 hours – 2,300 hours = 1,200
hours per week. Each unit of “Sports” requires 2.5 hours of production.
Therefore, the number of “Sports” units that can be produced = 1,200 hours / 2.5 hours = 480
units per week.
Linear relationship between Selling Price and Number of Units Demanded has been given to
be P= a – bx.
P = Selling Price per unit
a = Selling Price when demand will be zero
b (slope) = Change in Price / Change in Quantity x = Quantity Demanded
Given, at a Selling Price of `1,000 per unit, Quantity Demanded will be 1,000 units per week.
For every `100, per unit increase / decrease in Selling Price, the Quantity Demanded will
decrease / increase by 200 units per week respectively. A
`500 per unit increase in Selling Price will result in fall of 1,000 units of Sales per week. The
Selling Price at which Sales will be Zero i.e. a = `1,500 per unit.
b (slope) = Change in Price / Change in Quantity = `100 / 200 = 0.50
Penetration pricing is most commonly associated with a marketing objective of increasing
market share or sales volume, rather than short term profit maximization. Thus, substituting
the values in the equation to find the Selling Price of “Sports” when the Quantity Sold is 480
units:
P = a – bx
= 1,500 – 0.50 × (480)
= 1,500 – 240

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 [7. 29]
= `1,260
Sports should be sold at `1,260 per unit during the growth stage

Alternative- Hours after production of Product ‘Comfort’ (3,500-1,150×2) =1,200

hours to be utilized to produce product ‘Sports’.
1,200 hours/ 2.5 = 480 units
10% increase in selling price will lead to 20% decrease in demand of units of product “Sports”.
Here we can produce only 480 units which amounts to 52% decrease in units so the selling
price should be increased by 26% as per given price demand function. So, the selling price per
unit will be 1,260 for 480 units of product “Sports”.

(b) 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 Angel 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.

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 [7. 30]
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) Impact on Unit Selling Price and Average Cost of Production per unit at each stage
of “Ethnic” Product Lifecycle
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.
Growth Stage
This is the second phase of the Life-Cycle, 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 like to reverse engineer and offer similar products
in the market. Promotional activities and marketing activities need to continue to maintain and
gain market share.
Accordingly, the unit selling price would reduce from the introduction stage on account of the
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.
 Larger production batches due to increase in scale of operations will reduce the unit
variable overhead cost.
 Economies of scale would result due to fixed overhead cost being spread over larger
number of units.
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

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 [7. 31]
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.
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 at the decline stage.

PRICE ADJUSTMENT POLICES

Having set prices, often companies will need to adjust their basic prices to account for various
customer differences and changing situations. Companies, therefore, need to establish price
adjustment policies which are as follows-

Cash

Discounts
Quantity Price

Discounts Discrimination

Price
Distributor’s Geographic
Adjustment
Discounts Policies Pricing

Distributor’s Discounts
It means price deductions that systematically make the net price vary according to buyer’s
position in the chain of distribution. These discounts are given to various distributors in the

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 [7. 32]
trade channel e.g., wholesalers, dealers and retailers. As these discounts creates differential
prices for different customers on the basis of marketing functions performed by them, so these
are also called as functional discounts.

Quantity Discounts
Quantity discounts are price reductions related to the quantities purchased. It may take several
forms. It may be related to the size of the order which is being measured in terms of physical
units of a particular commodity. This is practicable where the commodities are homogeneous
or identical in nature, or where they may be measured in terms of truck-loads. However, this
method is not applicable in the case of heterogeneous commodities as it is difficult to add them
in terms of physical units or truck loads e.g. textile and drug industry. Quantity discounts are
useful in the marketing of materials and supplies but are rarely used for marketing equipment
and components.

Cash Discounts
Cash discounts are price reductions based on promptness of payment. It is a convenient device
to identify and overcome bad credit risks. In those trades where credit risk is high, the
percentage of cash discount given is also high. If a buyer decides to purchase goods on credit,
he has to pay a higher price by foregoing the cash discount.

Price Discrimination
Price discrimination means charging different prices and it takes various forms according to
whether the basis is customer, product, place or time. Price discrimination is possible if the
following conditions are satisfied:
 the maker must be capable of being segmented for price discrimination;
 the customers should not be able to resell the product of the segment paying higher
price; and
 the chance of competitors’ underselling in the segment of higher prices should not
be possible.
Under time differentials the objective of the seller is to take advantage of the fact that buyer’s
demand elasticity varies over time. Example, airline companies charge higher price if tickets
are booked near to travel dates rather than when booked based on pre-planned trips.

Geographic Pricing
In pricing, a seller must consider the costs of shipping goods to the buyer. These costs grow in
importance as freight becomes a larger part of total variable costs. Pricing policies may be
established whereby the buyer pays all the freight expense, the seller bears the entire cost, or
the seller and buyer share this expense. The strategy chosen can influence the geographic limits
of a firm’s market, locations of its production facilities, sources of its raw materials, and its
competitive strength in various geographic markets

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 [7. 33]

STRUCTURED APPROACH TO PRICING DECISIONS

Logical and acceptable way of structuring the process:

SENSITIVITY ANALYSIS IN PRICING DECISIONS

Sensitivity analysis is very significant in making pricing decisions, and striking the right
balance in which the price is good-looking enough to generate enough sales, yet is also
profitable for the firm. It is also important for determining how much can be spent on
development or marketing, etc. Simple analysis of past pricing decisions can inscribe poor
pricing controls, and sources of value leakage and more sophisticated price sensitivity analysis
can identify opportunities to increase or decrease prices to drive sales.
Product pricing decisions must be balanced against costs and competitive market conditions.
Sensitivity analysis is required to determine how sales and costs will respond to changes in the
market conditions.
Sensitivity analysis is performed by choosing the critical parameters upon which we based our
pro forma computations, and systematically changing them to assess how the changes will
affect the overall outcome. Some of these factors are external, and change according to the
market and economy. This analysis is important towards understanding how the company will
withstand external changes, for example:
 Market Demand
 Changes in Market Prices
 Exchange Rate Fluctuation
Other factors are typically internal, and in these cases sensitivity analysis is valuable in making
important decisions within the company. For example:
 Initial Outlay, R & D

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 [7. 34]
 Production Cost
 Marketing Costs
 Introduction Dates
 Product Prices

PRICING OF SERVICES: ISSUES

 When services are uniquely tailored to each customer’s needs, the pricing cannot be easy.
Each service transaction is likely to have distinct pricing structure.
 In certain services customer’s participation is essential. The customer may have to incur
certain intangible costs over and above monetary cost while making use of a service. The
pricing decision in such services should accommodate the intangible costs that a customer
may have to bear with.
 Some of the services like health care, education, communication, transport, etc. fall within
the larger domain of government. Therefore, price of those services tends to be regulated.
 Some services pricing is determined in a collective manner. Trade association, professional
bodies, or other institutions may impose broad guidelines for fixing the price

Cost – Plus / Mark-up Pricing

Quest 9 PM

Computer Tec a manufacturing firm, has entered into an agreement of strategic alliance with
Comp Inc. of United States of America for the manufacture of Super Computers in India.
Broadly, the terms of agreement are:
(i) Comp Inc. will provide Computer Tec with kits in a dismantled condition. These will be
used in the manufacture of the Super Computer in India. On a value basis, the supply, in
terms of the FOB price will be 50% thereof.
(ii) Computer Tec will procure the balance of materials in India.
(iii) Comp Inc will provide to Computer Tec with designs and drawings in regard to the
materials and supplies to be procured in India. For this, Computer Tec will pay Comp Inc.
a technology fee of ` 8 crores
(iv) Comp Inc. will also be entitled total royalty at 10% of the selling price of the computers
fixed for sales in India as reduced by the cost of standard items procured in India and also
the cost of imported kits from Comp Inc.
(v) Computer Tec will furnish to Comp Inc. detailed quarterly returns.
Other information available:

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 [7. 35]
a. FOB price agreed $2,040. Exchange rate to be adopted $1 = ` 55.00
b. Insurance and freight – ` 2,000 per imported kit;
c. Customs duty leviable is 200% of the CIF prices; but as a concession, the actual rate
leviable has been fixed at 40% of CIF.
d. The technology agreement expires with the production of 8,00,000 computers;
e. The quoted price on kits includes a 25% margin of profits on cost to Comp Inc.
f. The estimated cost of materials and supplies to be obtained in India will be 150% of the
cost of supplies made by Comp Inc.
g. 50% of the value in rupees of the locally procured goods represent cost of the standard
items.
h. Cost of assembly and other overheads in India will be ` 8,000 per Super Computer.
Required
Calculate the selling price, of a personal computer in India bearing in mind that Computer Tec
Ltd has targeted a profit of 20% to itself on the selling price.
Note: In making calculations, the final sum may be rounded to the next rupees.
Solution

Statement Showing “Selling Price of a Super Computer in India”

(`)
A. Landed Cost of a Dismantled Kit (Refer to Working Note: 81,340
4)
B. Cost of Local Procurement (Refer to Working Note: 3) 67,320
C. Cost of Assembly and Other Overheads per computer 8,000
D. Total Cost of Manufacture (A + B + C) 1,56,660
E. Technology Fee per computer (` 8,00,00,000 / 8,00,000 100
Computer)
F. Royalty Payment per unit (Refer to Working Note: 6) 9,251
G. Total Cost (D + E+ F) 166,011
H. Profit (20% on Selling Price of 25% of Total Cost) 41,503
I. Selling Price per computer 207,514

Working Notes
1. FOB Price of Dismantled Kit:
FOB Price of Dismantled Kit $2,040
FOB Price of dismantled Kit [$2,040 × `55] ` 1,12,200
2. Cost of a Dismantled Kit to Comp Inc.:
It is given that Quoted Price on Kits includes a 25% Margin on Profits.

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 [7. 36]
Cost of Dismantled Kit to Comp Inc. (100 / 125 × `1,12,200) `89,760
3. Cost of Local Procurements:
150% of the Supplies made by Comp Inc. (150% × `89,760 × 50%) `67,320
*Being 50% of Cost of a Dismantled Kit to Comp Inc.
4. Landed Cost of a Dismantled Kit:
(`)
FOB Price (50% × `1,12,200) (Refer to Working Note- 56,100
1)
Add: Insurance & Freight 2,000
CIF Price 58,100
Add: Customs Duty (40% × `58,100) 23,240
Landed Cost of a Dismantled Kit 81,340
5. Cost of the Standard Items Procured Locally:
50% of the Cost of locally procured Goods (50% × `67, 320) `33, 660
6. Royalty Payment per computer:
Let X = Selling Price per unit of Super Computer
Y= Royalty Paid per computer
Since 20% is the Margin of Profit on Selling Price. It means Margin of 25% on Cost Price.
Therefore we have
X = 1.25 × (`81,340 + `67,320 + `8,000 + `100 + Y)
Y = 10% × {X – (`33,660 + `81,340)}
On solving the above equations we get:
X = `2,07,514 (Approx)
Y = `9,251(Approx)

Quest 10 PM

RST Ltd. is specialists in the manufacture of sports goods. They manufacture croquet mallets
but purchase the wooden balls, iron arches and stakes required to complete a croquet set.
Mallets consist of a head and handle. Handles use 2.5 board feet per handle at ` 50 per board
foot. Spoilage loss is negligible for the manufacture of handles. Heads frequently split and
create considerable scrap.
A head requires 0.40 board feet of high quality lumber costing ` 60 per board foot. Spoilage
normally works out to 20% of the completed heads. 4% of the spoiled heads can be salvaged
and sold as scrap at ` 10 per spoiled head.

PRICING DECISION CA MANOJ SHARMA

 [7. 37]
In the department machining and assembling the mallets, 6 men work 8 hours per day for 25
days in a month. Each worker can machine and assemble 12 mallets per uninterrupted 40
minutes time frame. In each 8 hours working day, 15 minutes are allowed for coffee-break, 8
minutes on an average for training and 9 minutes for supervisory instructions. Besides 10% of
each day is booked as idle time to cover checking in and checking out changing operations,
getting materials and other miscellaneous matters. Workers are paid at a comprehensive rate of
` 6 per hour.
The department is geared to produce 20,000 mallets per month and the monthly expenses of
the department are as under:
(`) Finishing and painting of the mallets……………………… 20,000
Lubricating oil for cutting machines 600
Depreciation for cutting machine 1,400
Repairs and maintenance… 200
Power to run the machines 400
Plant Manager’s salary… 9,400
Other overheads allocated to the department… 60,000
Required
As the mallets are machined and assembled in lots of 250, prepare a total cost sheet for one lot
and advise the management on the selling price to be fixed per mallet in order to ensure a
minimum 33.33% margin on the selling price.
Solution:

RST Ltd.
Cost Sheet of One Lot of 250 Croquet Mallets
Computation of Total Cost:
(`)
Direct Material
Handles (2.5 feet × 250 units × `50) 31,250
Heads (1.20 × 250 × 0.40 × `60) [W.N.-1] 7,200
Less: Scrap Recovery (4% × 50 × `10) (20)
Direct Labour (8Hrs × `6 × 250 / 120) [W.N.-2] 100
Prime Cost 38,530
Factory & Other Overheads
Variable, Finishing & Painting (20,000 × 250 / 20,000) [W.N.- 250
3]
Fixed (`72,000 × 250 / 18,000) [W.N.-4] 1,000
Total Cost 39,780
Price Quotation:
(`)

PRICING DECISION CA MANOJ SHARMA

 [7. 38]
Cost per mallet (`39,780 / 250 Units) 159.12
Add: Profit (50% on Cost) 79.56
Selling Price 238.68

Working Notes
1. Since 20% of completed heads are spoiled, output of 1 unit requires input of 1.20 units
(1 + 0.20); so, total heads processed, 300 (1.20 × 250), of which spoiled heads are 50.

2. Total Time in a day (8 × 60) 480 minutes

Less: Idle Time 48 minutes
Coffee Break 15 minutes
Instructions 9 minutes
Training 8 minutes 80 minutes
Productive Time per day: 400 minutes
Therefore, mallets to be produced per man per day, 120 units (400/40 × 12).
Since mallets are produced at the rate of 120 mallets per man day, so total monthly production
will be18,000 mallets (120 units × 6 men × 25 days).
3. Finishing and painting overheads are assumed to be variable for the production of 20,000
mallets.
4. All the other expenses are fixed and are to be absorbed by 18,000 (120 units × 6 men
× 25 Days) mallets of monthly production.

Ques 11 PM

A manufacturing company has an installed capacity of 1,20,000 units per annum. The cost
structure of the product manufactured is as under:
(i) Variable cost per unit-
Materials… `8
Labour (subject to a minimum of ` 56,000 per month) `8
Overheads… `3
(ii) Fixed overheads… ` 1,68,750 per annum
(iii) Semi-variable overheads ` 48,000 per annum at 60% capacity, which increase by
` 6,000 per annum for increase of every 10% of the capacity utilisation or any
part thereof for the year as a whole.

PRICING DECISION CA MANOJ SHARMA

 [7. 39]
The capacity utilisation for the next year is estimated at 60% for two months, 75% for six
months and 80% for remaining part of the year.
Required
If the company is planning to have a profit of 25% on the selling price, calculate the selling
price per unit. Assume that there are no opening and closing stocks.

Solution-

Statement Showing “Selling Price and Profit

(`)
Material (89,000 units × `8) (W.N.-1) 7,12,000
Labour Cost (W.N.-2) 7,28,000
Variable Overhead (89,000 units × `3) 2,67,000
Semi Variable Overhead (W.N.-3) 60,000
Fixed Overheads 1,68,750
Total Cost 19,35,750
Add: Profit (25% of Selling Price or 33⅓ on Cost) 6,45,250
Total Sales Value 25,81,000
Selling Price per unit (`25,81,000 / 89,000 units) 29

Working Notes
W.N.-1
Computation of Capacity Utilisation (for the next year): (units)
60% of Capacity for first two months (2 months × 6,000 units) 12,000
75% of Capacity for next six months (6 months × 7,500 units) 45,000
80% of Capacity for the remaining four months (4 months × 8,000 units) 32,000
Total Capacity Utilization 89,000

W.N.-2
Computation of Labour Cost (Subject to a minimum of ` 56,000 p.m.):
(`)
Labour Cost of first two months (12,000 units × `8) 96,000

PRICING DECISION CA MANOJ SHARMA

 [7. 40]
However Minimum is (`56,000 × 2) 1,12,000
Labour Cost of next six months (45,000 units × `8) 3,60,000
Labour Cost of last four months (32,000 units × ` 8) 2,56,000
Total Labour Cost 7,28,000
W.N.-3
Computation of Semi-Variable Overheads per annum:
(`)
Semi-Variable Overheads (at 60% Capacity) 48,000
Semi-Variable Overheads for Additional 14.16%
(74.16% − 60.00%)
Capacity are the same as that for 20% of the Capacity Utilisation for the 12,000
entire year
60,000

Return on Investment Pricing

Ques 12 PM

A company produces a single product ‘lmpex’.

For an annual sales of 40,000 units of Impex, fixed overhead is ` 5,50,000. The variable cost
per unit is ` 60. Capital employed in fixed assets is ` 8,00,000 and in current assets is 50% of
net sales (i.e. sales less discount). The company sells goods at 20% discount on the maximum
retail price (M.R.P.), which is ` X per unit. The company wants to earn a return of 25% before
tax on capital employed in fixed and current assets.
Required
Calculate the value of X.

Solution:

Maximum Retail Price is ` X per unit.

Selling Price Net of Discount (i.e. 20%) = ` 0.80X
Statement Showing “Total Cost, Return on Capital Employed and Sales”
Amount (`)

PRICING DECISION CA MANOJ SHARMA

 [7. 41]
Variable Cost (`60 × 40,000 units) 24,00,000
Add: Fixed Overhead 5,50,000
Total Cost …(i) 29,50,000
Fixed Assets (25% of `8,00,000) 2,00,000
Current Assets {25% of (0.5 × 40,000 units × 0.80X)} 4,000 X
Return on Capital Employed …(ii) 2,00,000 + 4,000 X
Total Sales Net of Discount (`0.8X × 40,000 units) …(iii) 32,000 X

Hence, Total Sales = Total Cost + Return on Capital Employed

32000 = 29,50,000 + 2,00,000 + 4,000 X[From (i), (ii) and (iii)]
32,000 X – 4,000 X = 31,50,000
28,000 X = 31,50,000
3150000
X =
28000

X = 112.50
Ques 13 PM

Excel Ltd. specialises in the manufacture of Printers. They have recently developed a
technology to design a new Printer. They are quite confident of selling all of the 4,000 units
that they would be making in a year. The capital equipment that would be required will cost
`12.5 lakhs. It will have an economic life of 4 years and no significant terminal salvage value.
During each of the first four years promotional expenses are planned as under:
Year 1 Year 2 Year 3 Year 4
Advertisement (`) 50,000 50,000 30,000 15,000
Other expenses (`) 25,000 25,000 45,000 60,000
Variable costs of producing and selling the unit would be ` 125 per unit.
Additional fixed operating costs incurred because of this new product are budgeted at 37,500
per year.
The company’s profit goals call for a discounted rate of return of 15% after taxes on
investments on new products. The income tax rate on an average works out to 30%. You can
assume that the straight line method of depreciation will be used for tax and reporting.
Present value of annuity of ` 1 received or paid in a steady stream throughout 4 years in the
future at 15% is 2.854.
Required
Work out an initial selling price per unit of the product that may be fixed for obtaining the
desired rate of return on investment.
Solution:

PRICING DECISION CA MANOJ SHARMA

 [7. 42]
Let the Selling Price be `K Sales Value: `4,000K
Annual Cash Cost Amount
Variable Cost (4,000 units × `125) 5,00,000
Advertisement and Other Expenses 75,000
Additional Fixed Costs 37,500
Total Cash Cost 6,12,500

Depreciation per annum (`12,50,000 / 4) = `3,12,500

Profit for Taxation = 4,000 × `K − (`6,12,500 + `3,12,500)

= `4,000K − `9,25,000
Tax at 30% on Profit = 30% of {`4,000K − `9,25,000}
= `1,200K − `2,77,500
Total Annual Cash Outflow = `6,12,500 + (`1,200K − `2,77,500)
= `1,200K + `3,35,000
Net Annual Cash Inflow = `4,000K − (`1,200K + `3,35,000)
= `2,800K − `3,35,000
Now, Present Value of Initial = Present Value of Cash Inflow
Cash Outflow
Or, `12,50,000 = (`2,800K − `3,35,000) × 2.854
Or, K = `276.06
Hence Selling Price should be `276.06 per unit.

Pricing of New Product / Services

Ques 14 PM

Genie Carpets Associates have just developed a new carpet design with the brand name
‘Arabian Nights’. Sales demand is very difficult to predict but it very must depends upon the
selling price. At a price of ` 30 per square metre it is estimated that the annual sales demand
would be between 50,000 and 90,000 sq. Metres per annum. At a price of ` 40 per sq. metre,
sales demand would be between 34,000 and 44,000 sq. metres per annum. As regards cost, at
production volumes of 45,000 sq. metres or less per annum, attributable fixed costs would be
` 2,12,000 per annum and variable costs would be ` 32 per sq. metre. At higher production
volumes, attributable fixed costs would increase to ` 3,08,000 but variable costs per sq. metre
would be only ` 24.

PRICING DECISION CA MANOJ SHARMA

 [7. 43]
‘Arabian Nights’ has been developed at a cost of ` 80,000.
When the product is marketed, an amount of ` 70,000 per annum will be charged to the
operation towards Head Office Expenses.
The production of the new carpet will have to be supervised by a foreman. In order to find time
for supervision he has to give up work in another department, for which he is paid a salary of
` 1,000 per month.
The production of ‘Arabian Nights’ would be undertaken, of course, in a division of the factory
which is at present rented out to M/s S&R Ltd., Umbrella – makers for an amount of ` 10,000
per quarter.
Required
Calculate the margin of safety, as a percentage of expected sales volume at both the maximum
and minimum sales volume for the two price levels and decide on the selling price per sq.
metre.
Solution

Working Notes
(i) Relevant Total Fixed Costs
At a Price of At a Price of
` 30 per sq. mt. ` 40 per sq. mt.
(`) (`)
Attributed Fixed Costs 3,08,000 2,12,000
Foreman’s Salary 12,000 12,000
Rent Foregone (Opportunity Cost) 40,000 40,000
Total Fixed Cost 3,60,000 2,64,000

(ii) Contribution per sq. metre Rs. 6 Rs. 8

(iii) Profit or Loss at Minimum Sales Volume

Minimum Sales Volume (Sq. Metres) 50,000 34,000
Total Contribution at above volume (`) 3,00,000 2,72,000
Less: Total Fixed Costs (`) 3,60,000 2,64,000
Profit / (Loss) (60,000) 8,000

(iv) Profit or Loss at Maximum Sales Volume

Maximum Sales Volume (Sq. Metres) 90,000 44,000
Total Contribution (`) 5,40,000 3,52,000
Less: Total Fixed Costs (`) 3,60,000 2,64,000
Profit 1,80,000 88,000

PRICING DECISION CA MANOJ SHARMA

 [7. 44]
𝑅𝑠.360000 𝑅𝑠.264000
(v) Break-even Sq. Metres
𝑅𝑠.6 𝑅𝑠.8

= 60,000 sq mts = 33,000 sq mts

Margin of Safety
At Minimum 2.94%
Sales Nil (Loss) 34,000 𝑠𝑞 𝑚𝑡𝑟 − 33,000 𝑠𝑞 𝑚𝑡𝑟
Volume 34,000 𝑠𝑞 𝑚𝑡𝑟
× 100
At Maximum 33.33% 25.00%
Sales 90,000 𝑠𝑞 𝑚𝑡𝑟 − 60000 𝑠𝑞 𝑚𝑡𝑟 44,000 𝑠𝑞 𝑚𝑡𝑟 − 33,000 𝑠𝑞 𝑚𝑡𝑟
Volume 90000 𝑠𝑞 𝑚𝑡𝑟 44,000 𝑠𝑞 𝑚𝑡𝑟
× 100 × 100

Selling Price
At a price of `40 per sq. metre, there is possibility of earnings profit at both the minimum and
maximum level of sales. Hence, this price should be adopted. However at the maximum and
intermediate volumes (beyond 74,667 sq. mts.) profits will be higher at a price of `30 per sq.
mt. Therefore, the price of `30 per sq. mt. should be preferred, assuming that at this price sales
would be above 74,667 sq. mts. when the profit at `30 will be equal to the profit from maximum
sales volume at `40 per sq. mt.

Pricing – Different Scenario

Ques 15 PM

6,000 pen drives of 2 GB to be sold in a perfectly competitive market to earn ` 1,06,000 profit,
whereas in a monopoly market only 1,200 units are required to be sold to earn the same profit.
The fixed costs for the period are ` 74,000. The contribution per unit in the monopoly market
is as high as three fourths its variable cost.
Required
Determine the targets selling price per unit under each market condition.
Solution

Perfect Competition Monopoly

Units 6,000 1,200
Contribution (`1,06,000 + `74,000) 1,80,000 1,80,000
Contribution per unit 30 150

PRICING DECISION CA MANOJ SHARMA

 [7. 45]
4 --- 200
Variable Cost per (150 × )
3

Variable Cost per unit 200 ---

Selling Price per unit 230 350

Ques 16 PM

An organisation manufactures a product, particulars of which are detailed below:

Annual Production (Units) 20,000
Cost per annum (`)
Material 50,000
Other variable cost 60,000
Fixed cost 40,000
Apportioned Investment (`) 1,50,000
Required
Determine the unit selling price under two strategies mentioned below. Assume that the
organisation’s Tax rate is 40%―
(a) 20% return on investment.
(b) 6% profit on list sales, when trade discount is 40%.
Solution:

(a) Selling Price to Yield 20% Return on Investment

Investment (`) 1,50,000
After Tax Required ROI 20% (`) 30,000
Tax Rate 40%
After Tax Profit 60%
Pre Tax Profit - Return [(30,000 60) × 100] (`) 50,000
Sales (`1,50,000 + `50,000) (`) 2,00,000
Number of units Produced 20,000
Selling Price per unit (`2,00,000 ÷ 20,000 units) `10

(b) Selling Price to Yield 6% Profit on List Price

Let ‘K’ be the List Sales

PRICING DECISION CA MANOJ SHARMA

 [7. 46]
{ List Sales (1 − Trade Discount) − Cost} (1 − Tax Rate) = 0.06K
{K (1 − 0.40) − 1,50,000} (1− 0.40) = 0.06K
{0.60 K − 1,50,000} 0.6 = 0.06K
0.30 K = 90,000
K = `3,00,000

3,00,000
List Sales Price per unit Rs.15 = ( )
20,000 𝑢𝑛𝑖𝑡𝑠

Net Selling price per unit Rs. 9 = (𝑅𝑠. 15 − 40% 𝑜𝑓 15).

Ques 17 PM

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 (`) Department B
(`)
Direct Material per unit 30 25
Direct Labour per unit (` 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 ` 30, 000 per month. The product requires a
working capital of ` 4, 00,000 at the target volume of 1,500 units per month occupying 30 per
cent of practical capacity.
Required
To calculate the price of product Z to yield a contribution to cover 21 percent rate of return on
investment.
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-

(i) Statement Showing “Computation of Variable Cost”

(`) (`)
Direct Material Deptt. A--- 30

PRICING DECISION CA MANOJ SHARMA

 [7. 47]
Deptt. B--- 25 55
Direct Labour Deptt. A--- 30
Deptt. B--- 40 70
Variable Overhead Deptt. A (3 hrs × `6)--- 18
Deptt B (4 hrs × `3)--- 12 30
Variable Selling and Distribution Overhead (`30,000 / 1,500 units) 20
Total Variable Cost per unit 175

Total Hours Required for a Target of 1,500 units of Product Z:

Deptt. A (1,500 units × 3hrs) 4,500 hrs
Deptt. B (1,500 units × 4hrs) 6,000 hrs
10,500 hrs
10,500 hrs represent 30% Capacity
So Total Capacity per month (10,500 hrs. / 0.30) = 35,000 hrs
Yearly Capacity (35,000 hrs. × 12 months) = 4,20,000 hrs
Fixed Capital Employed in both departments = `40.00 Lakhs
(25 Lakhs + 15 Lakhs)
Expected Return (0.21 × `40,00,000) = `8,40,000
Contribution per hour (`8,40,000 / 4,20,000 hrs) = `2.00 per hour
Return on Working Capital (0.21 × `4,00,000) = `84,000
Contribution per unit (`84,000 / 18,000 units) = `4.67 per unit
Total Contribution Required
To Cover Fixed Cost (3 hrs of A and 4 hrs of B @ 2 per hr) = `14.00
To Working Capital = ` 4.67
`18.67
Fixed Charges Recovery is based on usage. Full Capacity is not being used by Product Z and
Departments are also producing other Products using same Plant and Machinery.
Price of Product is `193.67 per unit
[Variable Cost (`175) + Contribution Required (`18.67)].
(ii) Price of Product when product is well established in market:
Variable Cost `175
Fixed Cost (`24 + `16) `40

PRICING DECISION CA MANOJ SHARMA

 [7. 48]
Total price `215
The Product is first time launched in the market, and then Variable Cost `175 should form the
basis for Price Fixation.

Ques 18 PM

The Board of Directors XY Company Limited are considering a new type of handy sewing
machine which their R & D Department has developed. The expenditure so far on research has
been ` 95,000 and a consultant's report has been prepared at a cost of
` 22,500. The report provides the following information:
Cost of production per unit:
Rs.`
Material…………………………………………………………………… 45.00
Labour…………………………………………………………………….. 75.00
Fixed overheads (Based on Company’s normal allocation rates)………….. 20.00
Anticipated additional fixed costs:
Rent for additional space ………………………………… ` 1,25,000 per annum
Other additional fixed costs …………………………………. ` 70,000 per annum
A new machine will be built with the available facilities with a cost of ` 1,10,000 (material
`90,000 and labour ` 20,000). The materials are readily available in stores which are regularly
used. However, these are to be replenished immediately. The price of these materials have since
been increased by 50%. Scrap value of the machine at the end of the 10th year is estimated at
` 20,000. The product scraps generated can be disposed off at the end of year 10 for a price of
` 1,43,000.
Years 1-5 Years 6-10
Demand (Unit) Probability Demand Probability
40,000 0.15 24,000 0.30
20,000 0.60 16,000 0.50
12,000 0.25 4,000 0.20

It is estimated that the commercial life of the machine will be no longer than 10 years and the
after tax cost of capital is 10%. The full cost of the machine will be depreciated on straight line
basis, which is allowed for computing the taxable income, over a period of 10 years. Tax rate
is 30%.

DCF factors at 10%:

1 - 5 years (cumulative) 3.79
6 - 10 years (cumulative) 2.355

PRICING DECISION CA MANOJ SHARMA

 [7. 49]
10th year 0.386

Required
Compute minimum selling price for the handy sewing machine.
Solution-

(i) Expected Sales Volume

Years 1-5: (40,000 x 0.15 + 20,000 x 0.60 + 12,000 x 0.25) = 21,000 units
Years 6-10: (24,000 x 0.30 + 16,000 x 0.50 + 4,000 x 0.20) = 16,000 units
(ii) Capital Cost
Materials (` 90,000 x 1.50) 1,35,000
Labour (Replacement cost) 20,000
Overheads (Not Relevant) ---

1,55,000
(iii) Production Variable Cost
`
Materials 45
Labour 75
Overheads (Not relevant) ---

Total 120

(iv) Profitability
Details Years 1-5 Years 6-10

Sales Units 21,000 16,000

Selling Price(`) X X
Sales Value (`)…[A] 21,000X 16,000X
Material and Labour Cost @ `120 25,20,000 19,20,000
Incremental Fixed Cost (`) 1,95,000 1,95,000
Depreciation (1,55,000/10) 15,500 15,500
Total Cost (`) …[B] 27,30,500 21,30,500
Profit (`) …[A-B] 21,000X – 27,30,500 16,000X–
21,30,500
Less: Tax @ 30% 6,300X – 8,19,150 4,800X – 6,39,150
Profit After Tax 14,700X – 19,11,350 11,200X –
14,91,350

PRICING DECISION CA MANOJ SHARMA

 [7. 50]
Add: Depreciation 15,500 15,500
Cash Inflow 14,700X – 18,95,850 11,200X –
14,75,850

(v) Cash Inflow in the Terminal Year (year 10)

`
Sale Value of the Machine 20,000
Scrap Realization 143,000
Total 163,000
Tax @ 30% (48,900)
After Tax Cash Inflow 114,100

(vi) Present Value of Cash Flows

Details Year 0 Year 1-5 Year 6-10 Year 10
Capital Cost 1,55,000 – – –
Cash Flow from Operation – 14,700X – 11,200X – –
18,95,850 14,75,850
Cash Flow Terminal Year – – – 1,14,100
Discount Factor 1 3.79 2.355 0.386
Present Value of Cash Flows -1,55,000 55,713X – 26,376X – 44,042.6
71,85,271.5 34,75,626.7
0 0

(vii) Net Cash Inflows

= (-1,55,000) + (55,713X – 71,85,271.50) + (26,376X – 34,75,626.70) + (44,042.60)
= 82,089X – 1,07,71,855.60
(viii) Computation of Minimum Selling Price
For determining Minimum Selling Price, Net Cash Inflows should be equal to zero:
82,089X – 1,07,71,855.60 =0
Or X = 131.22
Minimum selling price is `131.22
Note
(a) R&D expenses of ` 95,000 is not relevant.
(b) Fee for consultant’s report of ` 22,500 is not relevant.
(c) Tax element on irrelevant costs not considered, since the benefit will arise even without
this product.

PRICING DECISION CA MANOJ SHARMA