Strategic Cost Management-Complied-Course Presentation VHlJqezqMe

Strategic Cost Management
Session 1
Chapter No 1- Cost-Volume-Profit Analysis
Reshma Narang Bathija

Overview of the Course
Chapter Topic ( including sub-topics) Session
1 Cost-Volume-Profit Analysis 1
2 Strategic costing decisions 2
3 Activity-Based Costing and Target Costing 2
Budget and Budgetary Control System
4 3
Pricing Decisions and Strategies
5 4
Short term Decision Making
6 5
Balanced Scorecard and Performance
7 Evaluation 6
8 Responsibility Accounting and Transfer Pricing 7
Financial Statement Analysis
9 8
2
Before we start …
• This session is for YOU… so participate and
lets
make it interactive !
• I will keep my Chat window open – students
are requested to post queries on Chat
• I shall allocate time towards the end of
the session to respond to your queries
• Please point out in chat in case the
“recording” is
off at any time !!
3
Chapter 1. Cost-Volume-Profit Analysis
• Introduction to Cost Accounting, Management

accounting and Financial Accounting
• Profit
• Contribution
• Break Even Analysis
• Margin of Safety
• CVP Analysis
• Solved Problems
• Summary
4
Management Accounting
• What is Management ?
Management means administration of
an organization
• What is Accounting ?
Accounting means collecting,
categorizing, summarizing and
analyzing relevant financial data
5
Management Accounting contd…
What will Managers target ?
• How to increase sales ?

• Primarily driven by market factors
• How to reduce Costs ?

• Increase efficiency
• Negotiate lower costs
• Re-engineer
• Outsourcing / relocate to cheaper production centres
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Management Accounting contd…
Most of the times, these decisions involve trade-

offs
Management accounting assists Managers in

taking such decisions to:
• optimize the Revenues and
• minimize the Costs
Management
Accounting
Information and
Their Use
Monitoring and Facilitates decision-

Cost control making
measurement
Management Accounting Information & Use
1. Cost Measurement: It measures full cost including Direct and Indirect cost
Direct Costs – Those costs that are identifiable or traceable and can be
directly apportioned to the products or services.
Indirect costs – These costs are not allocated directly to the product or services.
The measurement of full costs serves different purposes and is used in

different decisions
2.Monitoring and Control: Another important use of management accounting

information is to monitor closely the cost aspect of a product or process and
implement important effective control measures to optimize the cost while not
compromising on quality.
This is done through the process of budget and budgetary control. The targeted
allocation of cost and actual is compared at different time intervals
Management Accounting Information & Use
3. Facilitates Decision Making: It generates appropriate and required information

for future decision making relative to various operations of a firm.
The decisions may involve :
• Make or Buy
• Further processing
• Shutting down operations
• Increasing production capacity
• Determining selling process
• And other related decisions
Management Accounting Tools and their Significance
Component Uses
Creating value for the customer through Proper planning
Strategy Formulation and implementation of the strategies. The ultimate target is
to reduce costs and improve efficiency
The flow of goods, services and information enhances the

Standard Costing and performance of the firm. Tools such as Standard costing and
Target Costing Target costing are effective for cost control and cost
reduction and thus ensure enhanced customer satisfaction
Techniques such as Marginal costing help generate
information that is useful for taking managerial decisions
Decision Making Science
such as Make or buy, drop a product line, additional Working
shift, Capital expenditure decisions etc
Several tools such as Budgets and budgetary control,
Analysis of Performance standard costing and marginal costing are used in
measuring actual performance
Fixing responsibility by creating different centres such as
Responsibility Centres
cost, profit, investment etc
Practical applications of Financial, Cost and Management
Accounting
Financial accounting:
• It presents the position of assets, liabilities, income and
expenditure of a firm for comparative periods.
• It only reflects the information as available in Books of
accounts. It represents past financial data and provides
consolidated information only.
Cost accounting:
• It helps in preparing product wise statement of cost, revenue
and profit or loss by allocating various costs according to the
existing policy of the firm.
• It also indicates which product is making profit and which ones
are in loss.
Practical applications of Financial, Cost and Management
Accounting
Management accounting:
• It analyses different cost elements by allocating them in a

very scientific manner to arrive at correct contribution from
different products.
• Based on an in-depth analysis of costs, revenue, capacity

utilization and contribution, it also decides whether to buy a
particular product from the market or produce on its own.
• It also suggests if various strategies can make a product

profitable and if not, whether it will be wise to shut down a
plant or product.
To Summarize :
Financial Accounting is Reporting
Cost accounting
is Implementation
Management accounting is
decision making
Cost
Classification
Classification of Costs – According to its Components
1. Material Cost:
It is the cost of acquiring raw materials to be used for a finished

product or the materials consumed in the process. This helps to
produce a product for sale.
It can be direct material that is consumed in the manufacturing

process and physically used for the finished product. It can be traced
out to the product.
It can also be indirect material cost . This is also required for the
production process, but cannot be directly attributed to the product.
The expenses on cotton waste, lubricating oil, etc., can be

classified as indirect materials. If the cost of materials is insignificant,
it can also be classified as indirect.
2. Labour Cost:
The amount paid to workers as wages and salaries are classified as

labor cost.
It also involves all the benefits passed on by the firm to the workers
when wages are paid to the workers who are directly involved in the
production process, that is, converting , materials into finished products
is called direct labor cost.
This involves all kinds of workers, skilled and unskilled.
There is another component which may include salary/wages being paid

to workers who do work directly on the product, but their services are
necessary for production process. This is termed as indirect labor cost.
Wages salaries paid to supervisors, security guards, purchase and store

staff etc., are indirect labor costs.
3. Expenses:
The amount spent for completion of manufacturing

process other than Materials and labour cost are
classified as expenses.
Direct expenses can be directly allocated to the specific

process, product or service.
The expenses that cannot be directly attributable to a

product or service are called indirect expenses.
Eg : Factory rent
Store expenses
Factory Manager’s salary
Classification of Costs – According to Behaviour
Fixed Vs Variable Costs

1.Fixed Costs:
• The costs that remain fixed up to a
particular level of Production irrespective of
changes in the production volume are
known as fixed costs.
• The peculiarity of fixed cost is that the total

costs remain same while per unit fixed
cost comes down with the increased
level of production.
• Examples of fixed costs are depreciation,

salaries, insurance, rent, etc.
2.Variable Costs:
• These costs change according to the volume of
production.
• If the production volume is higher, the variable cost will

be more and vice versa. This change occurs in
proportion.
• The features of variable costs are that per unit variable

cost remains the same whereas the total variable cost
will change with production.
• Some of the examples of variable costs are direct

materials, direct labor and direct expenses.
Cost-Volume-Profit Analysis: Introduction
CVP analysis is a managerial accounting technique, which is

particularly significant in establishing relationship among sales
volume, cost of a product and operating profit of a business
Profit
• Cost-Volume-Profit (CVP) Analysis is the relationship
between the cost structure to sales volume and profitability of
a firm
• The equation that is used in CVP analysis is derived as

follows:
o Profit= Sales – Expenses

And
o Profit= Sales – Total cost
(Here, Total cost= variable costs + fixed costs)

Profit
Therefore,
Profit + Fixed costs = Sales – Variable costs
Profit + Fixed costs = Units sold x (Selling Price – Variable

cost per unit)
This is the basic equation for profit which can be

expressed as:
P + FC = Q x (SP – VC)
Example
• You have started a business of designer clothing
• You intend to participate in an exhibition
• What information is required to process the decision ?
• Cost price Rs 12,000 per unit

• Exhibition charges Rs 50,000 fixed
• Expected Sale Price Rs 20,000 per unit
• Expected Sale Quantity 30 to 60 units
2 scenarios
(A) Sale of 5 units
(B) Sale of 40 units
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Cost per pc 12000
Sale per pc 20000
Exhibition Charges 50000
Sales 30-60 pcs
Range
Scenario Scenario
A B
Units sold 5 40
Total Cost 110000 530000

Total Sales 100000 800000
27
Net Profit -10000 270000
Scenarios Solved
The Cost price and Selling price per unit does not change
in both scenarios
However, significant change is seen in Profit / Loss
Why ?
Basically, every unit has a variable cost – which is to be
covered by the selling price
Apart from Variable cost, every unit needs to share the fixed
costs
In other words, every unit needs to contribute some amount
towards fixed costs
This is called “Contribution”
Contribution = Selling Price – Variable Cost
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29
Contribution
• Contribution (C) can be defined as the profit (P) before the

recovery of fixed costs (F)
• Thus, contribution goes toward the recovery of fixed cost and
profit and is equal to fixed cost plus profit
• Equation : Profit = Contribution - Fixed costs
• Marginal Cost Equation:

Total Sale = Total cost + Profit (or - Loss)
(where, Total Cost = Total Variable cost + Total Fixed cost)

Contribution
Hence,
Total sale= Total Variable cost + Total Fixed cost + Profit

And
Contribution = Total Sale - Total Variable cost
Contribution = Total Fixed cost + Profit
• From the above equation, it can be found that when the profit of a firm
is nil, then the contribution will be sufficient to cover the fixed cost, and
Total sale= Total cost

Watch Showroom Exercise
Purchase Cost 4905 per pc
Sale 9800 per pc
Expenses Per Month

Rent 100000
Staff 120000
Salary
Commission per pc 500
Ascertain Contribution per

piece
Ascertain Profit / Loss for sale of 40 pcs & 55
pcs
33
Ascertain Contribution as a %of Sales Price
Sale Price per pc 9800
Cost Price per pc 4905
Total Variable Costs per pc 5405
Contribution per pc 44.85% 4395

Fixed Costs per month 100000
per month 120000 220000
Contribution % Sale Pcs Variable Fixed Profit/Loss

44.85% 40 2,16,200 2,20,000 -44,200
55 2,97,275 2,20,000 21,725
Large and complex businesses have adopted “Contribution

Margin %” instead of a value
34
How many minimum units to be sold ?
• Depends !
• In watch showroom example, what is the number of units you
must sell per month to ensure no profit and no loss ?
or
• What should be the quantum of sales to ensure no profit and no
loss ?
• Quantity at which no profit and no loss is called

“Breakeven Point”
35
Computing Breakeven Point
• Breakeven point can be either
• No. of units to be sold (or)
• Value of sales to be reached
• BEP (No of units) = Fixed Costs

Contribution per piece
• BEP (Sales Value) = Fixed Costs

Contribution %
36
Let us ascertain the break-even for the
Watch Showroom in Units and in value
37
Sale Price per pc 9800
Cost Price per pc 4905
Total Variable per pc 5405
Costs
Contribution per pc 44.85% 4395

Fixed Costs per month 100000
per month 120000 220000
Contribution % Sale Pcs Variable Fixed Profit/Loss

44.85% 40 2,16,200 2,20,000 -44,200
55 2,97,275 2,20,000 21,725
BEP in units 50.056883

BEP in value 490557.45 38
Graphical presentation of watch showroom
1200,00
0
1100,00
0
1000,00 Profit
0
900,00 Total Revenue
0 Line
800,00
Revenu
0 Total Cost
700,00 Breakeven Line
Total Cost
0 Line
es
Point
600,00
0
500,00
0
400,00 Variable
0 Variable Costs
Costs
300,00
0
200,00
Fixed
0
100,00 Costs
0
1 2 3 40 50 60 7 8 90 100 110 120
0 0 0 0 0 130
Units
39
Sold
Break- Even (BE) Analysis
• The “break-even” point indicates the number of units that is
required to be sold in order to produce a profit of zero but at
the same time to recover all associated costs.
• In other words, it can also be said that the BE point is the
point to know if a firm intends to produce more to earn the
profit where increased sales beyond the BE level provide
profit to the firm.
• The BE Analysis can also be used to:
1. Set the selling price and its sensitivity
2. Target the most suitable values for the variable and fixed
costs and their different combinations
3. Determine various other combinations relating to CVP
Analysis
Margin of Safety (MOS)
MOS is the sales level beyond the BE point wherefrom the

firm starts generating profit, since the firm has already
recovered full fixed costs at the BE level.
MOS is that level of sales that exceeds BE sales
How close or far are you from Breakeven ??

• The basic sales that a business would like to achieve is the “Breakeven Sales”
• Beyond Breakeven Sales lies the region of “Safety”
• The Margin of Safety measures how much risk / adversity the business can absorb
• It is natural that you as a business person would like to know the “What If ?” scenario
• Let us see this with an example of 2 shops operating next to each other :
Shop A sells watches Shop B sells fastfood
Its Fixed Costs p.m. are Rs. Its Fixed Costs p.m. are Rs.
50,000 Sale price per watch is Rs. 30,000 Sale price per customer
10,000 Variable cost per watch is is Rs. 500 Variable cost per
Rs. 8,000 Current sales per customer is Rs. 250
month is Rs 500,000 Current Sales per month is Rs.
Contribution per watch is Contribution
130,000 per customer is
20% BE Sales = FC / 50% BE Sales = FC /
Contribution % Contribution %
= 50,000 / 20% = 30,000 / 50%
= month
Profit per 250,000
is Rs. = month
Profit per 60,000is Rs.
50,000 35,000
What happens if there is a downturn ?
• Suppose we assume a 50% fall in each shop’s sales

• What will be the fate of each shop-owner ?
Shop A sells watches Shop A sells fastfood
Its Fixed Costs p.m. are Rs. Its Fixed Costs p.m. are Rs.
50,000 Sale price per watch is 30,000 Sale price per customer
Rs. 10,000 Variable cost per is Rs. 500 Variable cost per
watch is Rs. 8,000 New Sales customer is Rs. 250 New Sales
per month is Rs. 250,000 per month is Rs. 65,000
Profit per month is Rs. Profit per month is Rs.
Nil 2,500
• What we have just analysed is “Margin of Safety”
• It is the quantum of adverse change that must occur for
the seller to fall to it’s Breakeven level
• In other words, how close or far are you from Breakeven ??
• Let us compute MOS
• MOS = Actual Sales – BE Sales x 100
Actual Sales
• Let us compute for MOS before the change in economy for each
500,000-250,000 x100 130,000 – 60,000 x 100

500,000 130,000
= 250,000 x 100 70,000 x 100
500,000 130,000
= 50% 53.84%
• How to read this ?
• If 50% sales decrease the shop will be at breakeven
• If ~54% sales decrease the shop will be at breakeven
Uses of CVP Analysis
The CVP Analysis can be used in the following decision situations:

1. To forecast profit fairly accurately as all the information and
calculations are known. If a firm wishes to increase or decrease the
future profits, it can be measured through the CVP Analysis in amore
logical manner
2. Forecast sales volume to achieve a particular profit level
3. To prepare flexible budgets where variable costs alone changes. The

flexible budget is a concept where fixed costs at different levels of
production remains the same and variable cost alone changes. The
firm can evaluate the sales revenue, costs and profit position by
changing the level of production at different capacities
CVP Analysis… Contd
4. The firm can also evaluate the impact of increased sales volume on
profits
5. Effect on profit if the fixed cost or variable cost changes
6.Required sales volume to cover additional fixed costs due to higher

investments
7.Assessment of contribution on account of changes in sales volume
8.To attain sales level on account of changes in contribution
9.As well as many other business operation-related decisions

Lets take a Break !
48
Problems and Solutions
Exercise
• Newage manufactures and sells mobile

covers
• We are giveprice
Selling the below
per information
Rs 80 :
unit Variable cost Rs 30
per unit Fixed Cost Rs
Capacity per year 50,000
2,000
units
Q 1 : Find the PV Ratio and BE point Selling Price 80
Variable 30
Cost
Contribution = Selling Price – Variable Cost Fixed Cost 50,000
= 80 – 30
= 50
PV Ratio = Contribution per unit (Rs) / Sale Price per unit

(Rs)
= 50 / 80
= 62.5%
BEP (in units) = Fixed Cost / Contribution per unit

(Rs)
= 50,000 / 50
= 1,000 units
BEP (in amount) = BEP units * Sale Price per unit (Rs)
= 1,000 * 80
= Rs. 80,000
Q 1 : Find the PV Ratio and BE point Selling Price 80
Variable 30
Cost
Contribution = Selling Price – Variable Fixed Cost 50,000
Cost
= 80 – 30
= 50
PV Ratio = Contribution per unit (Rs) / Sale Price per unit
(Rs)
= 50 / 80
= 62.5%
Alternatively, BEP can be ascertained as

follows :
BEP (in amount) = Fixed Cost / PV Ratio
= 50,000 / 62.5%
= Rs 80,000
Q 2 : What will be new PV Ratio and BE point
if selling price can be increased to Rs 100/- Selling Price 100
without changing other factors Variable Cost 30
Fixed Cost 50,000
New Selling Price = Rs 100
Hence , new Contribution will
be
New Contribution = Selling Price – Variable Cost
= 100 – 30
= 70
New PV Ratio = Contribution per unit (Rs) / Sale Price per unit
(Rs)
= 70 / 100
= 70%
BEP (in units) = Fixed Cost / New Contribution per unit (Rs)
= 50,000 / 70
= 714 units (appx)
BEP (in amount) = BEP units * Sale Price per unit (Rs)
= 714 * 100
Q 3 : Find the number of units to be Selling Price 80
sold to get a profit of Rs 30,000 Variable 30
Cost
Recall that at the BE point, profit is zero Fixed Cost 50,000
Therefore, units sold just recover full Fixed Cost
Beyond Breakeven units, profit = Contribution per
unit
Therefore, to find the number of units to be sold for a desired profit of Rs
30,000
The following formula can be used
Fixed Cost + Desired

Profit Contribution per
unit
= 50,000 + 30,000
50
= 80,000
50
Cost
unit
30,000
(Fixed Cost + Desired

Profit) Contribution per
unit
= 50,000 + 30,000
50
Sales =Volume
80,000
= 1600 * 80 = Rs
128,000 50
Cost
unit
30,000
Fixed Cost + Desired

= 50,000 + To verify :
Profit Contribution per
30,000 Profit = (Sale units * Contribution) – Fixed
unit
50 Cost
= 80,000 = (1600 *50) – 50,000
50 = 80,000 – 50,000
Sales =Volume
1600 units
= 1600 * 80 = Rs = 30,000
128,000
Q 4 : Find the MOS amount if the firm Selling Price 80
is able to sell 2,000 units Variable 30
Cost
MOS = Actual Sales – BE Sales Fixed Cost 50,000
x
100
Actual Sales
= (2000*80) -80,000 *
100
(2000*80)
Q 4 : Find the MOS amount if the firm Selling Price 80
is able to sell 2,000 units Variable 30
Cost
MOS = Actual Sales – BE Sales Fixed Cost 50,000
x
100
Actual Sales
(2000*80)
160,000 – -80,000 * * 100
= (2000*80)
80,000 100
160,000
= 80,000 * 100
160,000
= 50%
Q 5 : If the firm can manufacture 500 units
more per year with an additional fixed cost Selling Price 80
of Rs 2,000 what should be the selling price Variable Cost 30
to maintain the profit in Q3 above New Fixed 52,000
Cost
New Capacity 2,500
New Capacity = 2,500
New Fixed Cost =
52,000 New Selling
Price = ?
Let the new Sale Price
be x Therefore,
Units * new Sale price = (Units* VC) + Fixed Cost +
Desired Profit 2500*x = (2500*30) + 52,000 + 30,000
2500x = 75,000
157,000
+ 52,000 + 30,000
x = 157,000 /
2500
x
New = 62.80
Selling Price to maintain profit at Rs 30,000 is Rs 62.80
per unit
Quiz Time
Q1 . Which of the following are tools of management Accounting ?
a. Decision Making
b. Standard Costing
c. Budgetary Control
d. All of the Above

Quiz Time
Q1 . Which of the following are tools of management Accounting ?
a. Decision Making
b. Standard Costing
c. Budgetary Control
d. All of the Above

Quiz Time
Q2 . The angle where the Sales line intersects the total cost line in
the Break even chart
1. Angle of Margin of Safety
2. Right angle
3. Angle of Incidence
Quiz Time
Q2 . The angle where the Sales line intersects the total cost line in
the Break even chart
1. Angle of Margin of Safety
2. Right angle
3. Angle of Incidence
Quiz Time
Q3 . The P/V ratio increases if the:
1. There is a decrease in Fixed Cost
2. There is an increase in Fixed Cost
3. There is a decrease in Selling price per unit
4. There is a decrease in Variable cost per unit

Quiz Time
Q3 . The P/V ratio increases if the:
1. There is a decrease in Fixed Cost
2. There is an increase in Fixed Cost
3. There is a decrease in Selling price per unit
4. There is a decrease in Variable cost per unit

Do you feel you have a good understanding of the concepts of
• Contribution
• Cost Volume Profit analysis
• Break even point
• Margin of Safety etc
Do you feel you can calculate the Break even point and Margin of
Safety for a Business ?
…and similar such decisions ?

Key Words
Contribution: Sales minus Variable Cost

Profit: Sales - (Fixed cost + Variable costs).
Profit volume ratio: Percentage of contribution margin in relation to Sales
Volume
Break-even point: Sales level where the firm is able to recover all cost but no
profit
Desiredprofit:The targeted profit of a product
Margin of safety: Sales value above the Break Even level
Sales Mix: When sales revenue is received from more than one product
Break Even chart : A graph indicating BE point
Variable Cost volume ratio : A ratio of variable cost inTotal sale
Angle of Incidence: Where cost line intersects the sales line
Multi Break even analysis: BE analysis for more than one product
LET US SUM UP
• Contribution is defined as Sales Revenue minus Variable cost . It is
a very significant concept in Costing and useful for taking important
decisions in day to day business operations
• CVP analysis is a managerial accounting technique, which is

particularly significant in establishing relationship among sales
volume, cost of a product and operating profit of a business
• The cost of production, quantity of production and ultimately profit

are the main objectives of any business unit.
• The level of sales that just covers total cost (Variable plus fixed) is
called the Break even point
• BE analysis is used to assess the BE point of a product

LET US SUM UP
• BE analysis determines the point at which revenue equals the cost

associated with the units of production
• MOS is the sales level beyond the BE point wherefrom the firm starts
generating profit, since the firm has already recovered full fixed costs
at the BE level. MOS is that level of sales that exceeds BE sales
• At any MOS level fixed costs are zero and the profit is equal to
contribution as full fixed cost has already been recovered
• In practical business situations, we often come across the fact that

firms have more than one product. This is known as Sales Mix.
Strategic Cost Management Accounting
Session 2
Chapter No 2- Strategic Costing Decisions

+
Chapter No 3 – Activity Based Costing & Target
costing
Session Topic (including subtopics)
1. Cost-Volume-Profit Analysis
2. Strategic costing decisions
3. Activity-Based Costing and Target Costing
4. Budget and Budgetary Control System
5. Pricing Decisions and Strategies
6. Short term Decision Making
7. Balanced Scorecard and Performance Evaluation
8. Responsibility Accounting and Transfer Pricing
9. Financial Statement Analysis
7
1
Before we start …
lets
“recording” is
off at any time !!
7
2
Introduction
• Strategic Cost Management
• Life Cycle Costing
• Stages of LCC
• Product Life cycle stages
• Value Chain analysis
• Kaizen Costing
• Uses and Advantages
• Cost reduction through Kaizen
• Application of Kaizen costing
Strategic Cost Management (SCM)
Strategy : One of the definitions of Strategy is:
“ Art of skilfully using all available means to ensure

success in battle”
• To attain competitive advantage, a firm must ensure

cost advantage
• This requires choosing, distributing and organizing

man, Materials, machine and capital resources to
achieve the overall strategy
Focus of SCM :
Methods and techniques used by Managers in
• Planning,
• Implementing and
• Controlling
different decisions at different levels, both ,
short term and long term
Purpose of SCM :
Obtain maximum commercial value of products and
services at most economical costs
Life Cycle Costing
(LCC)
• “The mechanism of identifying and recording all the costs involved
over the life of a product is known as :
“LIFE CYCLE COSTING”(LCC)
• Life cycle costs are all the costs associated with a product during
its total life-span
• Costs included in LCC:
• Research and development (R & D) cost at planning stage
• Engineering and designing costs
• Infrastructure development cost
• Production costs
• Advertisement costs
• Logistics support cost ( distribution, customer service, replacement, repair
and maintenance on account of warranty, disposal cost)
• and all costs that maybe required to incur in the total life cycle
period of a product
Benefits of Life Cycle
•Costing
Assessing and Mobilizing Resource Requirements:
Helps in assessing future resource requirements over the life cycle of a
product The firm can plan well in advance for mobilization of resources
as per requirements
• Cost Comparison:
• Helps a firm in comparing the costs of a potential product in relation
to its rivals
• Product Costing :
• The firm can load all such costs to decide a price of the product in
advance covering all the costs
• Procurement :
Depending on the costs, the firm can decide between sources of
supply in a better way
• Risk Management :
• It also serves as an effective method of risk management
Benefits of Life Cycle
Costing
• Enhancing System design
• The firm can improve system design through better
understanding of input trends such as man power and utilities
over the expected life cycle of a product
• Optimize Operational support
• The firm can optimize operational and maintenance support as it
has understood input requirements over the life cycle of a
product
• Assess Financial viability of a project
• Helps to arrive at financial viability of a project in terms of cost-
benefit analysis, return-on-investment (ROI), savings-to-
investment ratio (SIR), etc.
• The firm can plan in advance for the alternative for the product at
the end of the economic life of a product
Stages of Life Cycle
Costing • A firm needs to understand customers demand regarding their
Research and preference and choices for the product, preparing technical
STAGE
Development specifications of the product to be launched and designing various

and processes for efficient production process.
1
engineering • The firm also assesses the technical requirements of the product to
process(R & D) arrange required machinery and other equipment
• The total cost involved in terms of arranging needed resources for the
STAGE
Manufacturing production process, and identifying relative materials, workers and

and sales other required inputs
2
• The relevant selling and distribution expenses are also assessed at this
stage
• In this case, all costs associated with post-sale services, replacements,
warranty, etc., including the disposal cost (i.e. when a product is
STAGE
Estimation of abandoned at the end of its life-cycle)are considered

post- sale • It is also observed at times that a product is found with technical faults
3
service costs and the all the units of the product that have been sold out have to be
replaced; thus, this is a very crucial stage.
Cost components of a Life cycle of a
product
• Can be categorized as follows:
1. R & D (Research and development) (initial
phase)
2. Engineering and design of the product

3. Resource requirements
4. Production process costs
5. Selling distribution (publicity measures)
6. Post-sale service, replacement and warranty
Product Life cycle
Stages
Primarily 4 stages in the Life cycle of a Product:
• Introduction
• Growth
• Maturity
• Decline
Important components of
LCC
The technique of LCC is very useful where capital investment
decisions for large projects are involved.
This is more suitable for evaluation of asset design alternatives

where a form needs to evaluate the most cost effective project in
terms of :
• Initial investments
• Operating and maintenance costs and
• All associated costs through the life cycle span
Used in Automobile, Engineering, Power projects, energy projects

etc
Measurement of Life Cycle
Costing
Cost Components Alternative 1 Alternative 2 Alternative 3
Rnd, Engineering and Designing
costs
Land acquisition and

Construction costs
Operations Cost
Repair and Maintenance
Replacement Costs
Warranty
Disposal Cost
Finance Costs
Total Life Cycle Cost

Kaizen Costing
Concept introduced in Japan and focuses on handling difficult situations

through different strategies at work
84
Kaizen Costing
• The ongoing process of continuous improvements
through successive and small measures
• The smaller measures turn to longer improvements in a

phased manner
• It enthuses and motivates people at work to think

innovatively
• Changes in the process and technology is the prime

focus
• The ultimate aim is to gain competitive advantage
85
Kaizen Costing – Steps involved
• All activities of operations are standardized
• Once the operations are standardized, various other related

activities are measured such as cycle time, in process inventory etc
• To match the measurements and requirements, the corrective

actions are taken
• Innovative steps are taken for increasing productivity
• Innovative and improved strategies are implemented for further

improvements
• Continuity of product cycle is ensured
86
Kaizen Costing – Uses
1. Helps in identifying non – value adding costs
2. Ensures Effective Supply chain
3. Costs are reduced and prices are lower
4. New technologies and innovations can be effectively

implemented
5. It facilitates Logistic management
87
Kaizen Costing – Advantages
1. Cost Reduction Methodology : Reduce cost without compromising
on quality
2. Additional investments not required : since it is a step by step

process of continuous improvements, improvements achieved at
lower costs.
3. Attitudinal change : It brings about a philosophical, attitudinal and

behavioural change in workers and managers as the underlying
principle is that everyone can contribute to the improvement of
products and services
4. Once Kaizen is entrenched in the system, Brings efficiency in all

the activities of the firm
5. Focus : Reducing wastage and efficient utilization of time

88
Cost reduction through Kaizen
Impact on cost reduction is very focused and specific .
Examples of some strategies for Automobile Sector based on their successin

Japanese firms:
1. Production, distribution and sales plan for expected margins from sales of
product.
2. Projected parts and material costs plan for purchasing department
3. Plant rationalization plan for Variable cost reduction in manufacturing

processes.
4. Personnel plan for labour cost reduction
5. Facility investment plan for Depreciation and purchase of assets
6. Fixed expense plan for non-manufacturing cost reduction

89
Kaizen - The secret behind Japanese
Application of Kaizen
productivity
https://www.youtube.com/watch
?v
=fcBXtwGexNc
90
Quiz
Quiz Time
Q1 . Kaizen Costing is a ------------------- device with

an effort to decrease the cost of a product lower
than the Standard cost while maintain the quality of
the product
Cost Reduction
Quiz Time
Q2 . Strategic Cost Management is concerned with costing

Aspects of the product. True or False
FALSE
Key
Words
• Strategic costing: The process of making costing decisions
based on various strategies
• Strategic cost management: Using cost data for making
effective cost strategies
• Life-cycle costing: The costing system that considers all costs
associated with the life-span of a product
• Disposal cost: The cost associated with disposing a product at
the end of its life cycle
• Post-sale service cost: The repair and maintenance cost after
sail
• Warranty cost: The cost incurred in the warranty period of a
product
• R & D cost: The initial cost in planning and designing of a product
Key
Words
• Net savings: The difference between operational savings and
capital investment costs
• Savings-to-investment ratio: The relation between savings
and investment cost
• Value chain: Creating a value to the product at different
stages.
• Kaizen costing: A process of continuous improvements
through small steps
• Throughput accounting: An accounting system that involves
throughput, inventory and operating expenses
• Throughput cost: The difference between revenue and
material costs
Chapter 3
Activity Based Costing
and
Target Costing
Introduction
• Activity Based Costing

• Difference between traditional Costing and ABC systems
• Rational allocation of costs under an ABC system
• Activities and cost drivers
• Steps in an ABC system
• Advantages and limitations in an ABC system
• Other concepts related to an ABC system
• Problems and Solutions
• Target Costing
• Objectives of Target costing
• Steps in Target costing
• Application of Target costing
Activity Based Costing (ABC)
• Evolution of Products / Companies

• In early days of management accounts, Companies
produced fewer products / variants, used limited
indirect resources
• Managers compiled Direct cost (major portion)

and reasonably averaged the Indirect cost
(minor portion) of the cost object
98
I n d i a Shoe Company Yr 2000
Shoes Sandals
Units 10,000 20,000
Variable cost - Direct 500 250

Fixed Cost - Direct 100 75
Variable cost - Indirect 75 75

Fixed Cost - indirect 30,00,000
Allocation of FC - indirect
on basis of number of 10,00,000 20,00,000
units
Per unit 100 100
Cost per unit 775 500
99
Later, Companies introduced multiple products / variants and
also
quantum of indirect costs increased manifold
I n d i a Shoe Company Yr 2018
Shoe 1 Shoe 2 Sandal 1 Sandal 2 Sports 1
Units 8000 15000 15000 10000 10000
Variable cost - Direct 500 750 250 350 1000

Fixed Cost - Direct 100 125 75 100 250
Variable cost - Indirect 75 150 75 100 100

Fixed Cost - indirect 75,00,000
Allocation of FC - indirect
on basis of number of 10,34,483 19,39,65 19,39,655 12,93,10 12,93,103
units 5 3
Per unit 129 129 129 129 129
Cost per unit 804 1154 529 679 1479

Allocated Fixed Indirect costs of Rs 75 lacs on same number of units basis
Major assumption is “utilization of common resources is proportionate to units
produced”
10
0
Applying ABC
Assuming we understand the break up of Indirect Fixed Cost of Rs 75 lacs
being
for setting up of R&D Department (Rs 20 lacs) - which has developed 2 new
products viz. Sports 1& Shoe 2
Further, Sandal 2 is being made by an outsourced vendor where indirect costs

only for HO (Rs 15 lacs) need to be
allocated
The Dies & Moulds Dept costs have increased significantly and are Rs 30 lacs
pa
Will allocation of Fixed Indirect costs Rs 75 lacs on number of units be

appropriate ?
Then the allocation of indirect cost will undergo change - wherein the products
presently bearing average cost will no longer bear costs which are irrelevant
10
1
ABC : Evolution
• Evolution of ABC
• Increase in product diversity
• Unequal utilization of common resources
• Indirect costs are significant in value
• Making pricing and product-mix decisions in competitive mkt
• Growth of information technology & systems
• Activity becomes the prime focus

• Firm identifies all major activities that involve overhead costs
• Activities may be related to production or service or both
• Cost of these activities is grouped into cost pools
• Cost pools are assigned to products based on magnitude of use of the
activity
10
2
ABC
• Activity Based Costing (ABC) is a system that
focuses on refining the assignment of indirect costs
to departments, processes, products or any Cost
Object
• It identifies individual “activities” as interim Cost Objects
• Compiles costs for each activity cost object and then
assigns the costs to final Cost Object – like a product
or service
Assign
Delivery
Compile Costs to
Department
all costs Products
(Activity
of Delivery Eg TVs
based
Departmen and
interim Cost
t Washing
Object)
Machines
• Thus, accuracy of arriving at “fair cost of a product” is
higher
ABC
• In absence of ABC, costs are allocated on “average
basis”
• This will lead to either product undercosting or
product overcosting
• Undercosting : Cost Object consumes more

resources but not allocated all costs ; hence
reflects a lower cost than actual
• Overcosting : Cost Object consumes less
resources but allocated more costs ; hence
reflects a higher cost than actual
10
4
Consequences of Under / Over costing
Decision driver Type of Effects
costing
Under costing • Underpricing of product
• Increase in sales / market share
• Result in greater losses
Cost based
Over costing • Overpricing of product
analysis
• Decrease in Sales / market share
• Result in greater losses
Under costing• Will show inflated profits
• Higher focus to push this product
• May eventually choose to focus only
Sale Price on this product – an adverse
based decision
analysis Over costing • Will show deflated profits
• Higher possibility to reduce this product
• May eventually choose to discontinue
• Traditional Costing may result
this in cross-
product – an adverse decision
subsidization 10
5
Difference between Traditional Costing and ABC Systems
Traditional Costing System ABC System
Different cost centres are identified as Activities of common nature are
production centre or service centre identified and aggregated like
activities relating to purchase of
materials
Manufacturing overheads are assigned to The cost is assigned to activity cost centre.
cost centres. The cost centre is treated as
a cost object.
There is often reallocation of costs Cost drivers are selected for allocation of
between the production and service costs to cost objects. The cost centre
departments on the basis of benefits becomes cost objects.
derived by one cost centre from the
other centre.
Overhead allocation rate is decided Total cost to a particular cost driver is
according to machine hours or direct measured to find out the cost driver
labour hours. rate.
The overhead cost is allocated Based on cost driver rates, the cost is
depending on machine / labour hours allocated to the activity depending on the
consumed by a cost centre. use by a particular activity. 10
6
Rational of allocation of costs under an ABC System
• ABC costing system works on two main
principles
• Identifying major activities and their costs
• Determining the cost drivers
Cost Object Cost Object
1 2
Cost Object 3
Cost Object
5
Cost Object 4
On the basis of COST DRIVERS
Activity : Material Costs related to Material e.g. Number of material
Handling Handling requisitions
10
7
Example of Activities and Drivers
• India Shoe Co. manufactures footwear

• It has the following activities identified :
• Processing orders for purchases
• Material Handling
• Inspection of materials and parts
• Setting up production processes
• Production of goods
• Supervising workers
• Finished goods inspection
• Dispatch of goods
10
8
Description of Activities, Costs and Cost Drivers
Major Activities Associated Costs Cost Drivers
Processing Orders for purchases Labour costs of employees Number of purchase

working in the purchase orders processed
department
Material Handling Labour costs of stores, Number of material and
depreciation on machines used parts requisitions
to move material
Inspection of materials and parts Labour costs of employees Number of receipts of
working in the inspection materials and parts
department, depreciation of
testing equipment
Setting up production processes Labour costs of employees Number of setups
working in the setup
department and depreciation of
setup equipment
Production of goods Depreciation of machines Number of machine hours
Supervising workers Salary of assembly supervisors Number of labour assembly

hours
Finished Goods inspection Salary of inspectors and Number of inspections
depreciation of test
equipment
Dispatched Goods Labour cost of packing and Number of boxes packed
cost of packing materials
Classification of Costs according to Cost Objects and Activity Driver
Activity Name Activity Description Activity Type Cost Objects Activity

Driver
Supervising Scheduling, Secondar Activities Percentage of time
Nurse Coordinating and y within the nurse spends on
performance Departments each activity
evaluation
Treating Administering Primar Patient Number of
Patients medicine and y types treatments
changing dressings
Providing Bathing, changing Primar Patient Labour

Hygienic Care bedding and clothes, y Types hours
walking patients
Responding Answering calls, Primar Patient Number of

to Patient counselling, y Types requests
request providing snacks,
etc.
Monitorin Checking vital signs Primar Patient Monitoring
g patients and posting patient y Types hours
information
Steps in an Activity Based Costing
system
• ABC is a re-engineering approach that is used to determine the cost
and benefits associated with different processes and systems.
• ABC system leads to cost and benefit analysis and thus becomes part
of the decision-making to choose the products and processes
• ABC system can be called as re-engineering process that helps in
allocating fairly accurate cost to a product and accordingly the selling
price.
• This approach considers activities, processes, frequency and cost of
activities prior to introducing and after implementation of the ABC
system to ascertain the difference in cost and arrive at a logical
decision.
• In this process a firm can also understand which process provides
value to the firm, which product should be produced more or less
and other such decisions
Steps in an Activity Based Costing
system
1. A firm needs to define the major business processes and key
activities, which is also known as process mapping
2. A detailed operating cost analysis including capital changes should

be undertaken.
3. The firm may examine other resources that can be modified or

eliminated in the process to optimize cost.
4.Various activities can be linked to processes to identify the cost

drives. This can be done by identifying activities to the process that
relates the cost to the activity
5. Once this is done, the total cost of each process can be arrived at
ABC Costing -
Advantages
The ABC system is expensive, time consuming and capital intensive .
However, once it is settled it results in many benefits in terms of
proper allocation of overheads and costs to the product, setting of
reasonable selling price etc.
1.Since cost is assigned to product and services based on cost

drivers, it results in fairly accurate allocation of overhead cost.
There remains a significant portion of overhead cost in total
cost, and once this is calculated properly, the firm will have fair cost
of the product.
2.Once cost allocation is fairly accurate, the product becomes

competitive in terms of selling price.
3.If the firm decides to allocate cost under the ABC system, it may
also choose which product to be continued or discontinued.
ABC Costing - Advantages
contd
4.It helps a firm to make more purposeful economic decisions
considering cause and effect relationship
5.The firm may also take many other decisions regarding

upgrading technology as it may find that the activities
involved with a particular process are more and it may find
technology/process with lesser number of activities to optimize
the cost.
ABC Costing -
Limitations
• It requires large amount of investment in implementation stage.
It is a very cumbersome process in the units where large number
of activities and processes are involved.
• Once the activities are identified and cost drivers are fixed, there
remains limited scope for further improvement as people
become used to it
• Certain accounting principles on allocation of cost are difficult to

follow under the ABC system
• The ABC system is more for internal purpose, and external

reporting is based on traditional costing
Other concepts related to an ABC
system
• ABC system allocates costs based on activities
• Management objective is to manage the activities – Activity
Based Management (ABM)
• Systematic method of planning, controlling
• Leading to improvements and efficiencies in overhead costs
• Continuous improvements by way of re-engineering
• Activity-based Budgeting : To target a cost of output to meet

strategic goals and planned improvements. Expression of
goals in quantitative terms
• Activity Accounting : defines and reports various activities. It
Provides inputs and outputs of each department and Cost
centres in a firm
Activity Based Costing (ABC) – Final
Analysis
• Despite its limitations, the ABC system is very helpful in proper allocation of
costs and thereby fixing reasonable selling price of a product.
• All the activities and steps associated with a product are identified alongwith
relevant cost drivers
• The total overheads are allocated into different activities depending on the
number of uses by the activity in proportion to overall usage
• In today's business environment, where automation and various activities are

involved in the process, it is necessary to implement the ABC system for
assessing fairly accurate costs.
• Also, when there are diverse products, the ABC system of cost allocation
becomes more effective than the traditional system
• It also helps in deciding if a product has to be phased out if it is not profitable

Exampl
e
• India Sporting Goods produces footballs and
basketballs in different lot sizes. Each time the setup is
to be changed while shifting the production to the next
size. Following is the data available for a month :
Particulars Football Basketball

Number of units produced 1,000 100
Machine Hours (per unit) 4 4
Machine setup (hours used per setup) 10 10
Budgeted Machine setup cost Rs 8,800
• Based on the information :

• Compute the overhead cost per unit under traditional
system
• Allocate overhead cost under the ABC system
Exampl
e
• Under traditional costing system, the overheads
are allocated based on machine hours used.
• To compute machine hour rate :
Budgeted setup
cost Total
machine hours
8800
(1000*4) + (100*4)
= 8800
4400
= Rs 2 per machine hour
Exampl
e
• Under traditional costing system, the overheads
are allocated based on machine hours.
Machine Hours (per unit) 4 4
Total Machine hours used 4,000 400
Machine setup cost absorbed @ Rs 2 per 8,000 800
hour
Overhead cost per unit 8 8
• Although machine hours used for “Football” is
much higher, the cost per unit is the same for
“Basketball”
• Let us see under ABC system
Exampl
e
• Under ABC system, the overheads are allocated
based on cost driver – machine setup hours
consumed for each product.
• To compute machine hour
rate : Budgeted setup cost Particulars Football Basketball
Total machine Setup hours Number of units produced 1,000 100
8800 Machine Hours (per unit) 4 4
10 + 10 Machine setup (hours used per 10 10
setup)
Budgeted Machine setup cost Rs
8,800
Exampl
e
• To compute machine hour
rate : Budgeted setup cost
Total machine Setup hours
8800
10 + 10
= 8800
20
= Rs 440 per machine setup hour
Exampl
e
Machine Setup Hours 10 10
Machine setup cost absorbed @ Rs 440 per 4,400 4,400
hour
Overhead cost per unit 4.40 44
• Based on ABC system, the correct cost of the

activity is included and hence, the cost price of
the product is more accurate
Target
Costing
Target Costing –
Introduction
• Target costing is a Price driven concept.
• When prices are set by a market forces or a price

leader, the cost has to be obviously lower than the
selling price to derive profit from a particular product.
• It is a reverse process of Fixing Selling Price
• Prices are determined by the interaction of market

demand
• It is an efficient took for Cost Management
• It is a comprehensive Cost planning process

Target Costing – Estimated Costs (Investments)
included in Target margin plus allowable Cost
• Target Costing Equation :
Price – Profit Margin = Cost
• Variable Product cost
Direct Material cost and conversion cost (Labour and Overheads)
• Unitized Product cost
• Development Cost
• Tool cost
• Depreciation
• Other Costs
General Manufacturing cost
Non manufacturing cost
• Investments :
• Inventories
• Plant and Equipment
Target Costing -
Objectives
1. It enables firms to manage business in a profitable manner in a
competitive environment
2. It is an efficient tool for cost management at different stages
3. The fundamental concepts of target costing such as market

based prices, price based costs and cross functional
participation and coordination can be achieved
4. Target costing is a comprehensive cost planning process.

Therefore firms are very conscious in fixing costs of various
components considering all the future consequences.
Target Costing -
Objectives
5.The product requirements are defined by market and customer
preference. Therefore target costing helps in meeting customer
needs according to their preference
6. It also helps in maintaining effective coordination amongst

various divisions
7.To achieve the targets of cost and price, a firm uses re-
engineering process and backward costing exercise.
8. It emphasizes understanding the markets and competition both
9. Ultimately, it helps in increasing the value of the firm

Target Costing –
Steps
• Following steps are required to establish the Target Costing
approach:
1.A firm needs to reorient culture and attitude of personnel according
to existing market requirement
2.The selling price is determined before launching a product keeping

in view the customer's preference and the product of competitors in
the market.
3.A firm needs to fix profit margin keeping in view all the allowable
cost for the product considering life cycle of the product.
4. A target costing process has to be established with the team-

building approach.
Target Costing – Steps
contd
5.The firm and managers have to work constantly in analysing
…. alternatives.
various
6.Product cost models should be developed to support

decision-making
7.Alternative strategies should be adapted choosing different

tools to bring down the cost within the targets.
8. There should be a focus on reducing indirect cost.
9.The firm may use tools and techniques such as value

engineering in the design process.
Application of Target
Costing
• The target costing system can be applied in the following
industries:
1. Industrial units having assembly orientation
2. Firms largely involved in diversified product lines
3. Firms using technologies for automation of production
process
4. Products that have shorter product life cycle where
payback should be achieved in very short time
5. Firms following modern techniques such as value
engineering, just-in time approach, total quality
management, etc.
Target Costing -A
synopsis
Under target costing, the Firm is a price taker rather than a
Price maker
1. The firm determines the required profit margin in the target
selling price
2. It focuses on Cost reduction and effective cost
management
3. In product design, specifications and customer
expectations are given due consideration while determining
selling price
4. Variation between the current cost and target cost is the
“cost reduction” which management targets to achieve.
5. A task force is formed to integrate activities such as
purchasing, mftg, marketing etc to assess and achieve the
target cost
Quiz
Quiz Time
Q1 . In ABC system, an activity / unit of work with

differentiated purposes will be classified :
a. A different Task
b. Purpose cost
c. An activity
d. Allocation Cost
Quiz Time
Q1 . In ABC system, an activity / unit of work with

differentiated purposes will be classified :
a. A different Task
b. Purpose cost
c. An activity
d. Allocation Cost
Quiz Time
Q2 . How among the following indicators, a firm would benefit

From switching to activity – based costing ?
a. When only one homogenous product is produced on a

continuous basis
b. If existing cost system is reliable and predictable
c. Overhead costs are high and showing an increasing trend
d. The costs of implementing ABC outweighs the benefits

Quiz Time
Q2 . How among the following indicators, a firm
would benefit from switching to activity – based
costing ?
a. When only one homogenous product is produced on a
continuous basis
b. If existing cost system is reliable and predictable
c. Overhead costs are high and showing an increasing

trend
d. The costs of implementing ABC outweighs the benefits

Keywords
• Activity-based costing: A process of allocating costs based on

activities involved in the process.
• Activity driver: Frequency of demand of particular activityleading to
cost allocation.
• Cost driver: Factors affecting the cost of an activity
• Cost object-S: Aims the product or services to beproduced.
• Setup cost: The cost involved when the setup of a machine is changed
to produce a different size.
• Order cost: Costs involved in placing an order forinventory.
• Traditional costing: A system where overhead costs are allocated
based on labor or machine hours.
• Activity-based management: A management tool that focuses on
monitoring and control of activities.
• Activity-based Budgeting: A mechanism for planning future
strategies and resource allocation based on activities.
• Target costing: A process of determining the cost first and then
designing the product to meet the pre-determined costs.
Summary – ABC system
• ABC system can be called as a re-engineering process that helps in

allocating fairly accurate cost to a product and accordingly
the selling price.
• This approach considers activities, processes, frequency

and cost of activities prior to introducing and after
implementation of the ABC systemto ascertain the
difference in cost and arrive at a logical decision.
• In this process, a firm can also understand which process

pro vides value to the firm, which product should be
produced more or less and other such decision s.
Summary – Target Costing
• The target costing can be explained as an effective cost management

tool for optimizing the overall cost of a product spread over to its life cycle.
• All the strategies are made to reduce the costs in the planning and
designing stage since the expected product cost is fixed at this stage.
• The concept of target costing is applied to new product planning where

good amount of investment by way of capital expenditure is needed.
• Therefore, the price so fixed includes both the costs and investments.
Another important aspect of target costing is that once the price is fixed, it
is difficult to change the price.
• The price fixation considers all the relevant costs at the initial stage itself.
The product design and development becomes more significant, which
should consider all the choices and alternatives in terms of materials
selection, product specifications, buy or make decisions, etc
1
7
t
h
O
c
t
’
Strategic Cost Management
2
Accounting
Session0 3
Chapter 3 - Activity Based Costing

and
Target Costing
+
Chapter No 5- Pricing decisions and Strategies
Reshma Narang Bathija

Chapter
Topic (including subtopics) Session
No
No
3 Activity-Based Costing and Target Costing 2&3
4 Budget and Budgetary Control System 4
5 Pricing Decisions and Strategies 3
6 Short term Decision Making 5
7 Balanced Scorecard and Performance Evaluation 6
9 Financial Statement Analysis 8
1
4
Before we start …
lets
“recording” is
off at any time !!
1
4
Introduction
• Objectives of Pricing
• Factors affecting pricing decisions
• Cost factors and pricing
• Pricing and Contribution
• Pricing Methods in practice
• Cost plus pricing
• Break even pricing
• Premium pricing
• Skimming pricing
• Backflush pricing


cost advantage
• This requires choosing, distributing and organizing man,

materials, machine and capital resources to achieve the
overall strategy
14
8
Pricing - Introduction
• Pricing is a strategy that provides sustainability to a
Firm
• In the competitive market, the firm is a price taker
• The firm that has cost efficiencies in the product gain

Leadership position
• Pricing decisions are affected by internal and external

reasons
• Pricing policy has a direct relationship with the revenue

of a firm
14
9
Objectives of Pricing
An appropriate pricing decision helps a firm in achieving the following
objectives:
1. To achieve the target and goals of a firm in the short term and the
long term
2. To achieve financial viability of a product
3. To ensure that the product is generating sufficient revenue
4. To achieve and sustain the market share in tune with the
corporate growth strategy and plans
5. To have consistency of the price for building the brand in the
market
6. To constantly maintain the difference between Total revenue and
total cost and ensuring target profit
7. To be more strategic to face competitive forces effectively and
efficiently
8. To create awareness amongst the marketing teams for better
pricing decisions
15
0
Factors affecting Pricing Decisions
• The Philosophy of Management and policy

decision techniques play an important role in
pricing decisions.
• Some firms believe that lower unit cost will lead to

higher profits in the long run while others are of the
opinion of fixing price with minimum profit margin
• Competition influences the pricing decisions to a

great extent
• A firm produces goods as long as Marginal revenue

equals
Marginal Cost
15
1
Pricing decisions may be influenced by internal factors and external factors
as well:
Internal Factors :
• Cost of the Product
• Profit objectives
• Health of the Organisation
• Inventory Holding period
• Nature of Goods
• Change in Sales Mix etc
External Factors:
• Competitors pricing actions
• Regulatory guidelines or Legal restraint on
price
• Demand and Supply conditions
• Marketing Mix variables
• Strength of competitors
• Recession
• Growth in market demand etc
15
2
Cost Factors and Pricing
Cost plays a very significant role in deciding the price as every
product is different and has a specific cost.
The technique of cost allocation to a product is also important.

For eg: Activity based costing system provides appropriate cost
allocation method
The cost components include :

• Material
• Labour
• Overheads
All the relevant costs, Direct and Indirect have to be appropriately

allocated to each product
A firm may also benchmark its cost against its competitors to

identify areas of advantage/ improvement
15
3
Pricing and Contribution
Contribution from a particular product is a very important criterion
in Pricing
Contribution has two components : Fixed Cost and Remaining

profit
The effort is to maximize the Contribution
Higher the contribution, higher will be the profits from a product
Management may decide maximization of Contribution for

Pricing decisions
The key consideration will be a thorough analysis of variable

costs and clearly identifiable Fixed costs
15
4
Pricing methods in practice
Pricing decisions are complex as several factors need to be
considered.
Pricing also depends on the business stage of a firm
For eg: In the initial stage, price may be low to push the product
even by sacrificing the profit component.
However, in the long run, PROFIT cannot be ignored.
Therefore, a firm evaluates several options before deciding on one: Initial stages of a
• Cost Plus Pricing Company
• Cost plus profit percentage
• Variable cost plus contribution
• Break Even Pricing
• Premium Pricing
• Skimming Pricing
15
5
Cost Plus Pricing
• Cost Plus Pricing is a common method
used for pricing decision.
• In this method the price is set by adding
pre-determined margin the cost of product.
• There are different cost – plus strategies
The main two types of Cost plus strategies

are:
 Cost plus profit percentage
 Variable cost plus contribution
15
6
Cost Plus Pricing
1. Cost plus profit percentage
• This is the traditional method where the profit is
added to the total cost at a certain percentage of
the cost
• The percentage is determined by trade practices
• Generally, a tailored percentage is determined
for a specific product
For e.g. : If the total cost of sales is Rs 10 lakhs and the

decision is to have a profit margin of 10%, then Rs 1
lakh will be added to the cost to decide the Selling
price.
15
7
Cost Plus Pricing
2. Variable cost plus contribution:
• In this method also a percentage is added to the
variable cost of the product.
• However, the percentage would be higher, as here it
should include both Profit and Fixed Cost.
• Variable cost plus percentage depends on the profit
margin requirement of the firm.
• If, the variable cost of the product is estimated to be Rs.
10 lakhs and fixed cost is Rs. 3 lakhs and the firm
decides to obtain Rs. 2 lakhs profit, the contribution
percentage will be
[(3,00,000 + 2,00,000) X 100]

= 50%
10,00,000 15
8
Cost Plus Pricing - Benefits
1. Firm can achieve required profit, if, budgeted sales
volume are achieved
2. Cost-plus pricing is more appropriate in contract costing,
like building, construction work, etc.
3. If, cost structure is well organized, cost-plus is easy to
implement
4. Justifies selling process to customers as customers are
aware of increase in cost
5. Its a transparent process
6. It provides premium to the producer due to assurance of
fixed contribution margin.
15
9
Cost Plus Pricing - Disadvantages
1. A suitable method has be selected, which is
difficult to decide
2. Selling price may vary to larger extent
depending on method chosen
3. In case the actual production is below the
normal capacity, cost-plus pricing method will
not yield the required profit
4. It lacks flexibility in different stages of a
product’s life
cycle
5. The buyer remains in suspense about the cost.
16
0
Break Even pricing (Done in detail in CVP analysis Chap 1)
Break even price per unit equals Variable cost plus
fixed cost per unit
It is used when the Fixed cost is identifiable
It involves different levels of production
The firm has a targeted profit and wants to ascertain

the price level at which the targeted profit can be
achieved.
The Sales level in this case is calculated as follows :
Sales = Total Fixed Costs + Targeted Profit

Profit Volume Ratio
16
1
Premium pricing
16
2
Premium pricing
This is a concept where pricing is above competition on a Regular basis
Firms charge Premium pricing when the product appears different

from the common products in the market and superior to competition
This is possible only if :

1. Product quality is excellent
2. Product has a unique image
3. Reliability of the product
4. Durability of the product
5. After sales service Facilities and convenience
6.Extended warranties than normal warranty on the
Product
Eg : Premium Real estate project/ Luxury vehicles
16
3
Skimming Pricing
16
4
Skimming Pricing
• In this the firm charges the maximum in the initial stage

of the product as customer is willing to pay the price
because of the liking and preference of the product.
• After satisfying the demand of first set of customers the

prices are lowered down to attract next set of customers
to attract more customers to buy the product and
demand rises further.
• This is also know as skimming layers of “cream” or

customer segment in initial stage to maximise profit and
recover cost of product development
16
5
Skimming Pricing – When is it useful ?
The strategy is more useful if:
1. Number of customers are sufficient who are willing to buy the
product at higher price.
2. Fixing higher price does not attract other competitors in the

market
3. On lowering the price, it will have only a limited effect on

increasing sales volume and reducing unit costs
4. High prices are taken by the customers for the high and
unique quality of the product
5. Demand for the product is relatively inelastic in initial stage
16
6
Skimming Pricing - Advantages
1. The Firm may have high profit margin in the initial stage
2. The firm, by virtue of higher prices, can recover the initial

development cost of the product. This strategy works well
when product life span is short and the market niche is also
limited.
3. The skimming pricing strategy provides an opportunity to the

dealers and distributors to earn higher profits. In the initial
stage as the prices are higher resulting in higher commission
4. A firm may continue to build its strong brand through

skimming pricing strategies. It is because the high quality
products only can provide a firm to adopt skimming price
strategy and organisations already having a strong brand
can utilise this strategy effectively
16
7
Skimming Pricing - Limitations
1. Increase in market competition as many firms will
enter the market by introducing new and more
innovative products, making difficult to charge higher
price for the same product
2. When market competition increases, the sales volume

decreases, it makes difficult to bring down the cost
of production as firm has already set certain standards
for the product
3. Firm cannot enjoy the same high preference for its

product from the customers for a longer period, as the
firm may lose acceptance of the product in the market
16
8
4.Since, the firm has already charged higher

price to the earlier group of customers, this may
have adverse impression of having the price
much lower at a later stage and affect
customer loyalty
5.Firm cannot maintain cost efficiency in the

long run as it has lower down the prices at a
later stage
16
9
Backflush Pricing
17
0
Backflush Pricing
Backflush accounting system is required backwords by
calculating the costs of the products after the products are sold,
rather than calculating the costs during the production process.
Following are the steps:

1. The firm needs to wait till the completion of the product
2. Trace out all records of inventory from stock required to
produce the product
3. The costs need not be assigned during the various
production stages
4. Process is completely automated
5. It eliminates large number of transactions which are
involved in traditional costing
17
1
Backflush Pricing
It relates to different types of inventory costs, process
cost and cost of goods sold.
Firms with lesser production cycle period, not holding

much inventory for storage and work in progress may
charge all manufacturing costs at the end of the period
rather than maintaining separate cost accounts.
This is a more streamlined method of accounting for the

costs to produce goods and services.
However this account system is not recognized under

generally accepted accounting principles (GAAP)
17
2
Exampl
e
• A Company has received an offer to supply 200 lakh cartons per month
for which an additional equipment of Rs 50,000 is required. The other
cost details are as follows :
Particulars
Duplex Board 50 tonnes at Rs. 5.50 per kg
Printing ink and gum Rs 2 per 1,000 cartons
Packing cost Rs 7.50 per 10 lakh cartons
Labour hours 1,600 hours of which 500 hours will be
overtime
Overheads Rs 16,300 per month
Selling & Distribution Expenses Rs 16,300 per month
The firm also needs additional working capital to the extent of 50% of the
sales value.
The Company expects a net return of 20% on the additional capital
required for accepting this order.
Prepare a cost estimate and indicate the price to be quoted to the
customer
Solutio
n
Statement of Cost for 200 Lakhs
cartons
Particulars Basis Rs. Rs.
Duplex Board 50 tonnes @ Rs 5.50 per 275,000
kg
Printing ink & gum Rs 2 per 1,000 cartons 40,000
Packing cost Rs 7.50 per 10 lakh cartons 1,500
Labour hours 1,600 hours @ Rs 4 6,400
Overtime 500 hours @ Rs 2,000 8,400
4
Overheads Given 16,300
Selling & Distribution Given 16,300
TOTAL 357,500
Solutio
n
Capital Employed :
Let us assume the Sales Value

is “X”
Additional Capital = Fixed Assets + Working
Employed Capital
= 50,000 + 50% of X
= 50,000 + 0.5X
Return Expected :
Return Expected is 20% on additional Capital

employed
= 20% * (50,000 + 0.5X)
= 10,000 + 0.1 X
Sales Value = Cost + Return
(X) Expected
XX-0.1X==357,500 + 10,000 +
367,5000.1X
0.9 X
=
367,500
Solutio
n
Capital Employed :
Let us assume the Sales Value

is “X”
Additional Capital = Fixed Assets + Working
Employed Capital
= 50,000 + 50% of X
= 50,000 + 0.5X
Return Expected :
Return Expected is 20% on additional Capital

employed
= 20% * (50,000 + 0.5X)
= 10,000 + 0.1 X
Sales Value = Cost + Return
(X) Expected
X X= -0.1X = + 10,000 +
357,500
0.1X0.9 X
367,500
=
367,500
Quiz
Quiz Time
Q1. When a firms introduces an innovative and a

high quality product , it can adopt :
• Cost plus Pricing
• Skimming pricing
• Super profit pricing policy

Quiz Time
Q1. When a firms introduces an innovative and a

high quality product , it can adopt :
Skimming
Pricing
Quiz Time
Q2 . Break Even price is a stage when :
• All Costs are covered
• Sales Revenue equals Total Cost
• Where price is broken into cost and

Profit
• Cost Plus Pricing

Quiz Time
Q2 . Break Even price is a stage when :
• Sales Revenue equals Total

Cost
Keywords
• Cost Plus Price: The price is determined based on total cost

plus some profit
• Break Even pricing: When the fixed cost is traceable and the
firm wants to achieve a target profit
• Premium pricing: When the price fixed by the firm is above the
market price or competitor’s price
• Skimming price: When higher prices are fixed in the initial

stage of a product launch
• Backflush Costing: A situation where inventory costs are

added at the end of the completion of a product
184

Session Topic (including subtopics)
1. Cost-Volume-Profit Analysis
2. Strategic costing decisions
3. Activity-Based Costing and Target Costing
4. Budget and Budgetary Control System
5. Pricing Decisions and Strategies
6. Short term Decision Making
7. Balanced Scorecard and Performance Evaluation
8. Responsibility Accounting and Transfer Pricing
9. Financial Statement Analysis

185
Before we start …
This session is for YOU… so participate and lets make it
interactive !
I will keep my Chat window open – students are requested to
post queries on Chat
I shall allocate time towards the end of the session to
respond to your queries
Please point out in chat in case the “recording” is off at any
time !!
Introduction
Factors affecting pricing decisions
Cost factors and pricing
Pricing and Contribution
Pricing Methods in practice
Cost plus pricing
Break even pricing
Premium pricing
Skimming pricing
Backflush pricing

To attain competitive advantage, a firm must ensure cost advantage
This requires choosing, distributing and organizing man, Materials,

machine and capital resources to achieve the overall strategy
188
Pricing - Introduction
• Pricing is a strategy that provides sustainability to a Firm
• In the competitive market, the firm is a price taker
• The firm that has cost efficiencies in the product gain

Leadership position
• Pricing decisions are affected by internal and external

reasons
• Pricing policy has a direct relationship with the revenue of a

firm
189
190
An appropriate pricing decision helps a firm in achieving the following
objectives:
1. To achieve the target and goals of a firm in the short term and the
long term
2. To achieve financial viability of a product
3. To ensure that the product is generating sufficient revenue
4. To achieve and sustain the market share in tune with the
corporate growth strategy and plans
5. To have consistency of the price for building the brand in the
market
6. To constantly maintain the difference between Total revenue and
total cost and ensuring target profit
7. To be more strategic to face competitive forces effectively and
efficiently
8. To create awareness amongst the marketing teams for better
pricing decisions
191
• The Philosophy of Management and policy decision

techniques play an important role in pricing decisions.
• Some firms believe that lower unit cost will lead to higher
profits in the long run while others are of the opinion of
fixing price with minimum profit margin
• Competition influences the pricing decisions to a great

extent
• A firm produces goods as long as Marginal revenue equals

Marginal Cost
192
Pricing decisions may be influenced by internal factors and external factors
as well:
Internal Factors :
• Cost of the Product
• Profit objectives
• Health of the Organisation
• Inventory Holding period
• Nature of Goods
• Change in Sales Mix etc
External Factors:
• Competitors pricing actions
• Regulatory guidelines or Legal restraint on
price
• Demand and Supply conditions
• Marketing Mix variables
• Strength of competitors
• Recession
• Growth in market demand etc
193
Cost Factors and Pricing

Cost plays a very significant role in deciding the price as every product is
different and has a specific cost.
The technique of cost allocation to a product is also important.

For eg: Activity based costing system provides appropriate cost
allocation method
The cost components include :

• Material
• Labour
• Overheads
All the relevant costs, Direct and Indirect have to be appropriately

allocated to each product
A firm may also benchmark its cost against its competitors to identify
areas of advantage/ improvement
194
Pricing methods in practice
Pricing decisions are complex as several factors need to be

considered.
Pricing also depends on the business stage of a firm
For eg: In the initial stage, price may be low to push the product
even by sacrificing the profit component.
However, in the long run, PROFIT cannot be ignored.
Therefore, a firm evaluates several options before deciding on one: Initial stages of a Company
• Cost Plus Pricing
• Cost plus profit percentage
• Variable cost plus contribution
• Premium Pricing
• Skimming Pricing
195
Cost Plus Pricing

• Cost Plus Pricing is a common method
used for pricing decision.
• In this method the price is set by adding
pre-determined margin the cost of product.
• There are different cost – plus strategies
The main two types of Cost plus strategies are:

 Cost plus profit percentage
 Variable cost plus contribution
196
Cost Plus Pricing

1. Cost plus profit percentage
• This is the traditional method where the profit is added
to the total cost at a certain percentage of the cost
• The percentage is determined by trade practices
• Generally, a tailored percentage is determined for a
specific product
For e.g. : If the total cost of sales is Rs 10 lakhs and the

decision is to have a profit margin of 10%, then Rs 1 lakh will
be added to the cost to decide the Selling price.
197
Cost Plus Pricing
2. Variable cost plus contribution:
• In this method also a percentage is added to the variable cost
of the product.
• However, the percentage would be higher, as here it should
include both Profit and Fixed Cost.
• Variable cost plus percentage depends on the profit margin
requirement of the firm.
• If, the variable cost of the product is estimated to be Rs. 10
lakhs and fixed cost is Rs. 3 lakhs and the firm decides to obtain
Rs. 2 lakhs profit, the contribution percentage will be
[(3,00,000 + 2,00,000) X 100]
-------------------------------------- = 50%
10,00,000
198
Cost Plus Pricing - Benefits
Following are the benefits of cost-plus pricing

1. Firm can achieve required profit, if, budgeted sales volume
are achieved
2. Cost-plus pricing is more appropriate in contract costing, like
building, construction work, etc.
3. If, cost structure is well organized, cost-plus is easy to
implement
4. Justifies selling process to customers as customers are
aware of increase in cost
5. Its a transparent process
6. It provides premium to the producer due to assurance of
fixed contribution margin.
199
Cost Plus Pricing - Disadvantages

Following are the disadvantages of cost-plus pricing:
1. A suitable method has be selected, which is difficult
to decide
2. Selling price may vary to larger extent depending on
method chosen
3. In case the actual production is below the normal
capacity, cost-plus pricing method will not yield the
required profit
4. It lacks flexibility in different stages of a product’s life
cycle
5. The buyer remains in suspense about the cost.
200
Break Even pricing
(Done in detail in CVP analysis Chap 1)
Break even price per unit equals Variable cost plus fixed cost per
unit
It is used when the Fixed cost is identifiable
It involves different levels of production
The firm has a targeted profit and wants to ascertain the price
level at which the targeted profit can be achieved.
The Sales level in this case is calculated as follows :
Sales = Total Fixed Costs + Targeted Profit

Profit Volume Ratio
201
Premium pricing
This is a concept where pricing is above competition on a Regular basis
Firms charge Premium pricing when the product appears different

from the common products in the market and superior to competition
This is possible only if :

1. Product quality is excellent
2. Product has a unique image
3. Reliability of the product
4. Durability of the product
5. After sales service Facilities and convenience
6. Extended warranties than normal warranty on the
Product
Eg : Apple Iphone
202
Skimming Pricing
In this the firm charges the maximum in the initial stage of the
product as customer is willing to pay the price because of the
liking and preference of the product.
After satisfying the demand of first set of customers the prices are
lowered down to attract next set of customers to attract more
customers to buy the product and demand rises further.
This is also know as skimming layers of “cream” or customer

segment in initial stage to maximise profit and recover cost of
product development
203
Skimming Pricing – When is it useful ?
The strategy is more useful if:

1. Number of customers are sufficient who are willing to buy the
product at higher price.
2. Fixing higher price does not attract other competitors in the

market
3. On lowering the price, it will have only a limited effect on

increasing sales volume and reducing unit costs
4. High prices are taken by the customers for the high and unique
quality of the product
5. Demand for the product is relatively inelastic in initial stage

204
Skimming Pricing - Advantages
1. The Firm may have high profit margin in the initial stage
2. The firm, by virtue of higher prices, can recover the initial

development cost of the product. This strategy works well when
product life span is short and the market niche is also limited.
3. The skimming pricing strategy provides an opportunity to the

dealers and distributors to earn higher profits. In the initial stage
as the prices are higher resulting in higher commission
4. A firm may continue to build its strong brand through skimming

pricing strategies. It is because the high quality products only
can provide a firm to adopt skimming price strategy and
organisations already having a strong brand can utilise this
strategy effectively
205
1. Increase in market competition as many firms will enter the market by
introducing new and more innovative products, making difficult to charge
higher price for the same product.
2. When market competition increases, the sales volume decreases, it makes
difficult to bring down the cost of production as firm has already set certain
standards for the product
3. Firm cannot enjoy the same high preference for its product from the
customers for a longer period, as the firm may lose acceptance of the
product in the market
4. Since, the firm has already charged higher price to the earlier group of
customers, this may have adverse impression of having the price much lower
at a later stage and affect customer loyalty
5. Firm cannot maintain cost efficiency in the long run as it has lower down the
prices at a later stage
206
Backflush Pricing
It relates to difference types of inventory costs, process
cost and cost of goods sold.
Firms with lesser production cycle period, not holding

much inventory for storage and work in progress may
charge all manufacturing costs at the end of the period
rather than maintaining separate cost accounts.
This is a more streamlined method of accounting for the

costs to produce goods and services.
However this account system is not recognized under

generally accepted accounting principles (GAAP)
207
Backflush Pricing
Backflush accounting system is required backwords by
calculating the costs of the products after the products are sold,
rather than calculating the costs during the production process.
Following are the steps:

1. The firm needs to wait till the completion of the product
2. Trace out all records of inventory from stock required to
produce the product
3. The costs need not be assigned during the various
production stages
4. Process is completely automated
5. It eliminates large number of transactions which are
involved in traditional costing
Quiz
Keywords
Cost Plus Price: The price is determined based on total cost
plus some profit
Break Even pricing: When the fixed cost is traceable and the
firm wants to achieve a target profit
Premium pricing: When the price fixed by the firm is above

the market price or competitor’s price
Skimming price: When higher prices are fixed in the initial

stage of a product launch
Backflush Costing: A situation where inventory costs are

added at the end of the completion of a product
Session 4
Chapter No 4- Budget and Budgetary Control

system
Oct’2
0
Chapter
No
No
2
1
Before we start …

lets
“recording” is
off at any time !!
2
1


cost advantage

man, materials, machine and capital resources to
Introduction
• Essentials of a Budget Document

• Budget Implementation process
• Different types of Budgets
• Advantages of Budgets and Budgeting exercise
• Limitations of Budgeting
• Budgetary Control Systems
• Essential requirements
• Features
• Objectives
• Advantages and limitations
• Difference between Budget and budgetary control
What is a Budget ?
Budget is :
• A document to achieve the goals of a firm
• It ensures optimum use of available resources
• It is an essential part of corporate planning
• Budgetary control helps in monitoring the resources,

income and expenditure
•The ultimate goal of a budget is to increase

profits and profitability
Budgets
• Why do we need budgets ?
• A numerical expression of common goals
• Ease of communication
• Maximize participation across departments
• Motivation to achieve
• Evaluate performances
•A Budget is a quantitative plan for a
future period
• Quantitative = Financial ?
Financial & Non-financial

21
7
Factors considered for preparing budgets
• Past performance
• Capacity & resources
• Economic & Market information (& Political, etc)
• Regulations, currencies
• Organization responsibilities; typical organized as :
• Cost centers responsible for all costs
• Revenue centers responsible for all revenues
• Profit centers responsible for all costs & revenues
• Investment centers responsible for all costs, revenues and
return on investments
21
8
Essentials of a Budget document
1. Specific Period: It is for a certain duration, it can be broken

down to monthly / quarterly / half yearly. There can be
seasonal budget for seasonal business activity. It can be for
long and medium term.
2. Goal: It contains an overall goal of the firm to be achieved in a
certain period of time.
3. Estimation: Estimates business unit’s profit potential by
showing how much business unit is expected to make.
4. Monetary and Non-monetary: It expresses budget in
monetary terms. It also supports non-monetary information
like quality produced, when to be sold, etc.
5. Variance analysis: It focuses on achieving or improving
profits and profitability of the firm. Performance is compared
with budget and gaps are ascertained, these are know as
variances. They are further analyzed to ascertain reasons.
21
9
Essentials of a Budget document
6. Commitment: Its is know as document of commitment; once

approved and implemented, it has to be taken up with complete
responsibility at all levels. Hence, it is linked to performance, each
responsibility center is liable for the gaps in the implementation
process.
7. No deviation: Once this document is approved, it does not get

changed in ordinary course. However, it can be altered with
approval of the budget management committee.
8.Periodic Monitoring: Progress is monitored periodically by an

appropriate authority and reported to the top level.
22
0
Budget implementation process - Steps
1. Preparation of functional budget: The corporate budget is
segregated into different function such as department
budget, cash budget, materials budget, etc.
2. Communication down the line:
• Communication of budget proposals down the line more so
to the responsibility centres is extremely important, without
objectives of budget clearly communicated, people’s
involvement in the task cannot be expected and it will
adversely affect the achievement of goals.
• It becomes important to communicate budgeted goals to
each responsibility centres for fixing up individual
responsibility based on actual performance.
3. Performance monitoring and follow-up: It is equally

important to have frequent follow-ups to take corrective action
in the budget.
22
1
Budget implementation process
4. Inter-division coordination:
For effective implementation and achievement of budgeted goals, well
organized co-ordination amount different departments and divisions is
very important.
For Eg : Production department wants to produce more but manpower
department does not provide the required workforce, the results cannot be
achieved. (SCB P loan example)
This is also true with other departments. Strong coordination and spirit of
co-operation among various division is essential.
5. Budget review:
Preparing periodic reports for the budget committee for forward submission to
the board is also an important part of the budget implementation process.
22
2
Budget implementation process
6.Awareness and participation: Unless a budget is adopted by the

people involved in the process, the goals cannot be achieved.
As the first step is to make people involved in the process by creating
awareness about the budgeted goals and their responsibility in
successful implementation to achieve budgeted goals, then only they will
become participative. It is only one’s awareness about business goals
that make one participate actively.
7.Adequate Flexibility: Budgeting process should have adequate

flexibility. Flexibility , depending on the changes in the business
environment, is required, but it should not be misused.
8.Budget Document: A firm is required to prepare a compressive

budgetary document containing organizational goals and future
expectations, This document may also be used as an effective tool for
monitoring and evaluation, which will help in better achievement of the
budgeted goals.
22
3
Different kinds of Budget
Types
of
Budget
Time s
Capacity Function
Perio
s
d
Long Term Fixed Operational
Budget Budget Budget
Short Term Flexible Master

Budget Budget Budget
Cash
Budge
t
22
4
Types of Budgets - Capacity
• Fixed budget
• Prepared before the start of the period
• Includes different operating / financial budgets
• Actuals are compared with budget to ascertain variances
• Flexible Budget
• Hypothetical budget prepared before the start of the
period
• Includes different operating / financial budgets
• Budget is recomputed at the end of the period using
“actual units”
22
5
Operating Budget
The budgets relating to various operational activities of a firm

are called operational or functional budgets.
They are functional budgets that can be broadly categorized

based on nature of functions:
1. Sales Budget
2. Production Budget
3. Material Budget
4. Purchase Budget
5. Manpower budget
6. Overhead budget
7. Selling and distribution cost budget
8. Research and Development budget
9. Capital Expenditure budget
22
6
Rolling Budget
This budget prepared time and again and rolled over to the next period, it is
updated on an ongoing basis.
The budget is reviewed for the past period and based on that the modified
detailed budged is prepared for the immediate next period followed by brief
budget prepared for subsequent period (monthly / quarterly / half yearly).
1. The budget prepared for the immediate next period based on the actual
performance for the immediate past period becomes more realistic.
2. It considers current market price for various components and evaluates
the recent market trend in terms of demand of the product and
accordingly modifies the budgets for the remaining periods.
3. It also considers the present external economic and other factors.
4. These budgets are prepared in details for short periods and revised
frequently.
22
8
Rolling Budget contd….
5. It provides more flexibility to the management
6.The periodicity of budget could be monthly or quarterly as convenient to

management.
7. Based on immediate past experience, the managers may fix targets that
are realistic and can be achieved. It motivates managers to achieve the
budgeted figures.
8. It helps to reduce risk and uncertainty as they are guided by recent trends.
9.These budgets are more realistic.
10. It is more useful when changes in business are frequent and involved
large uncertainty.
22
9
Cash Budget
• It is one of the most important budgets in a business, as cash is

crucial in managing day-to-day operations
• It is a statement that represents the inflows and outflows of cash
in a business in a particular given time period
• It is an effective tool to forecast short-term cash requirement
• It is also required to manage the surplus or shortage of funds
• It also helps to forecast net cash position and
accordingly plan for deficit or surplus cash
management
• It is prepared on month-by-month basis
23
0
Cash Budget – Sample format
23
1
Cash Budget - Features
1. It is prepared based on expected cash inflows and outflows in business in
the nearest future.
2. Considers more realistic estimates.
3. It helps firm for planning well in advance to arrange the deficit cash from
available various sources at the lowest cost, also plan for deployment of
excess cash in short-term instruments to yield optimum return on such
investments.
4. Firm can monitor the progress of collections from debtors as well as
creditors.
5. Firm can optimize its revenues and expenditure through cash budgets.
6. It help firms to predict payments in near future for non-operating activities
such as dividend payment, interest payment, etc.
7. Firm can also keep an active record on movements of cash expenditure.
8. Firm can plan suitable short-term investment strategies
23
2
Zero based Budget
ZERO BASED
BUDGETING
23
3
Zero based Budget
• As the name suggests, it has no base at the starting point.
• Every component of the expenditure starts from scratch.
• The previous year budget has no significance, as the budget for next
year is always ZERO.
• This means that all expenditure proposed in the budget has to be
justified by the divisional head in terms of their requirement, usefulness,
outcome, etc.
• It requires the division head undertakes the cost-benefit analysis of the
proposed expenditure. Here, the division unit head can also plan for
limited budget. Once it is consumed, further requirement can be placed
for additional resource giving justification.
• This is an operational planning and budgeting process where each
divisional manager is to provide justification to the budget proposal right
from scratch.
23
4
Performance Budget
23
5
Performance Budget
It is another concept emerged in recent past from the United States, it is related to
output.
It represents the purpose and objectives for which funds are required.
The total cost is estimated based on the objectives of the work to be performed.
Activity for which budgetary support is required should be identified and measurable. It
can be single or series of activities.
It should clearly indicate the work details to be performed for which budgetary support
is required. In India, it has started in government organizations and public sector
undertakings.
The features of performance budgets are:

1. Objectives are clearly defined and they are translated into specific functions.
2. Measurement parameters are also clearly defined.
3. It coordinates physical and financial aspects of the programs
23
6
Types of Budgets
• Operating
MASTE
Budgets
• Revenue
R
• Inventory BUDG
• Production ET
Quantities, unit costs, schedules,
• Sales values
• Distribution
Values – mapped with op.
budgets
• Financial Budgets
• Capital Expenditure Budget
• Income Statement
• Balance Sheet
• Cash Budget 23
7
Master Budget
• The Master budget represents the summary of the firm’s plan describing
sales, production, distribution and financing activities.
• It is a business strategy that documents expected future sales, productions

levels purchases, future expenses incurred, capital investments.
• In simple terms, it includes all other financial budgets as well as budgeted

income statement and balance sheet.
• It is also management’s strategic plan for the future growth of the firm.
• Every aspect of the organizational operations is charted and documented

for future predictions.
23
8
Master Budget
It can virtually be considered as a folder that includes all of the other budgets:
1. Sales Budget
2. Merchandise purchases budget
3. Production Budget
4. Manufacturing budget
5. Material Budget
6. Manpower budget
7. General and administrative expense budget
8. Selling and distribution cost budget
9. Research and Development budget
10. Capital Expenditure budget
11. Cash budget
12. Budgeted Financial statements
The Master Budget is used by the company management and officers

to make strategic “big picture” decisions about long term strategy as
well as current year forecasting.
23
9
Advantages of Budget and Budgeting exercise
1.An effective budgeting system enthuses and motivates management to
identify problems and hindrances in the organization for taking rational
decisions based on different kinds of analysis.
2. It is an effective tool for controlling income and expenditure of a firm as

there are definite plans designed and developed for both
3.It is also an effective tool in the hands of management to frame

appropriate plans and policies and review and monitor them periodically.
4. The management can establish suitable guidelines based

on the evaluation of performance against the budgeted goals in
the overall interest of the organization
5. It also helps in directing capital and other resources into the
most productive and profitable operations based on budget analysis
24
0
Limitations of the Budgeting exercise
1.The successful implementation of budget proposals calls for better coordination and
commitment of people down the line as well as cooperation of management.
2.The budget proposals are based on certain assumptions. Therefore, validity of such
estimates is an important issue. There is no well· developed mechanism to prove the
validity. There is more scope of subjectivity and individual perception.
3. When budgeted goals are not achieved, there is a tendency among managers to pass
on the blame and find excuses for non-achievement
4.An efficient budgeting system requires that all the managers of different
responsibility center should have more clarity and understanding about the whole
mechanism, objectives and essential requirements for effective implementation of the
budget proposals. This is not an easy task.
5.There are certain set principles based on which a budget is prepared and deviation
is very rare. In that case, innovativeness and new ideas have limitedscope.
24
1
Budgetary Control system
According to CIMA:
“ Budgetary control is the establishment of budgets relating the
responsibilities of executives to the requirements of a policy and
the continuous comparison of the actual with budgeted results
either to secure by individual action the objective of that policy, or
to provide a basis for its revision.”
It is a systematic approach of :
planning,
monitoring and
control of operational aspects of production, sales and other
business activities through budgets.
24
3
24
4
Budgetary Control system
The system involves the following processes for effective functioning:

1. Establishing a sound system of budgeting and planning
2. Ongoing monitoring and controlling through Variance analysis to find the

gap between actual and budget results for initiating required strategies.
3.Establishing decentralisation process by delegating powers down the line

and fixing accountability through different responsibility centres
4. Analyzing variances in detail to assess the reasons of differences.
5. Framing policies of performance evaluation of managers and staff based on

budgeted goals assigned.
6. Preparing future strategies based on results and achievements for bringing

necessary changes in the system.
24
5
Essential Requirements of a Budgetary Control system
For efficient functioning of a budgetary control system, following are the
essential requirements:
1.Management Support: To achieve pre-determined goals as envisaged in
the budgets, adequate resources and timely support is very much
essential. This support has to come from the management. Therefore, top
management needs to be convinced about the expected benefits in the
growth of business by implementing the budgeting and budgetary control
process.
2.Inter departmental coordination and HR policies : The management
say is also needed to establish better cooperation among the inter-
divisions . For this purpose, the HR policies and working environment has
to be very conducive.
3.Delegation of Authority: There should be a mechanism for taking
prompt decisions at various levels to avoid the delays. Thisrequires
proper delegation of powers.
24
6
Essential Requirements of a Budgetary Control system
contd….
4.Clear definition of Roles and Responsibilities: Each division's
responsibilities should be clearly defined and they should be aware and
cautious about their role.
5.Realistic goals:The goals and objectives have to be realistic in nature,
which are achievable, rather than fixing goals without proper planning
6.Competent Top Team: The group of managers at senior level involved
in overall budgeting exercise, setting goals and objectives, etc., should
necessarily have sufficient experience and competency to provide
effective guidance to the managers involved in actual implementation
7.Management Philosophy: Above all, the approach and philosophy of
top management play a crucial role. Their attitude and approach has to
be in strong favor of establishing a well organized mechanism of
budgeting and budgetary control in the overall growth of the firm.
24
7
Features of Budgetary Control system
1.Well defined objectives to be achieved over a period and pragmatic approach to

Achieve such objectives
2.Effective and efficient policies considering the practical operational aspects that will
help to achieve the goals and objectives
3.A detailed structure of various activities that should be undertaken and coordinated,
which may be helpful in achieving the goals and objectives conveniently.
4. Elaborative plans of operations to be developed and drawn in respect of each type

of activity, in physical as well as monetary terms, to be implemented during the
budget period in a phased manner
5. Adequate arrangements and supply of required resources

24
8
Features of Budgetary Control system
6.A well-designed performance evaluation system of analysis and

comparison of actual performance with the budgeted one, this should be
prepared in such a way that can evaluate and assess individual person's
involvement and fix responsibility to the individual, division or department.
7. An efficient monitoring system that facilitates online monitoring of various

activities.
8. Provision of adequate controls and corrective actions in case the

plans and activities are not working as desired.
24
9
Objectives of Budgetary Control system
1. The main objective of budgetary control is to evaluate the performance of different

units/divisions based on pre-determined targets
2. It is an effective process of short-term and long-term planning leading to various
business strategies.
3. This process facilitates a clear demarcation of responsibilities of the unit / division
managers as we have seen through a mechanism of responsibility accounting.
4. It ensures optimum utilization of available resources in terms of manpower,
infrastructure and other input resources to get the optimum output.
5.The process also enables coordinating the various activities of the business
operations among the divisions and units with a view to
achieve the desired goals.
The broad objectives of budgetary control system are planning,

coordination, communication and performance evaluation to achieve
overall goals of the organization.
25
0
Advantages of Budgetary Control system
There are many advantages of establishing an effective budgetary
control system in an organization in terms of bringing operational
efficiency in the system and thus bringing required improvements and
quality in products and services. Following are some of the major benefits:
1. Efficiency: It brings efficiency in the overall production process; this
ultimately results in bringing a qualitative product with lesser cost. The
firm can avail competitive advantage.
2. Optimum Utilization of resources: It utilizes all the resources effectively

with least wastage of time and resources.
3. Basis for Performance evaluation: It provides well-defined normsfor

performance evaluation based on performance. This motivated the
employees at different levels to be more participative.
25
1
Advantages of Budgetary Control system contd…
4. Pragmatic approach: It follows the approach of standard
costing and variance analysis that is supposed to be a more
pragmatic approach for performance evaluation
5. Clear definition of responsibility: Clearly assigns and

defines responsibilities to various functional managers.
6.Value addition to the organization: It also creates value

addition for the firm.
7.Competitive advantage: It helps firms to also enjoy the

gains of competitive advantage as their product quality and
pricing will be different from others.
25
2
Limitations of Budgetary Control system
The budgetary control system and mechanism is very

essential tool to achieve the goals of a firm in a planned
way.
However, practically, following are some of the limitations of
budgetary control process:
1. Not entirely accurate: The budget estimation process may
not be perfectly accurate as it is based on estimates.
Sometimes, there may be wide variations in actual and
budgeted output.
2.External Environment: The impact of external environment

and sudden changes in government policies are difficult to
capture in the budgetary control process.
25
3
Limitations of Budgetary Control system
3.Lacks flexibility: The norms are, sometimes, too rigid

and does not encourage innovations and dynamic
approach.
4.Expensive and Time consuming: Introducing and

implementing the budgetary control system in a systematic
way is a time-consuming process and expensive too.
5.Coordination is a challenge! : Though coordination among

different divisions/units is necessary, practically it is very
difficult to ensure this (collxns /ops example)
25
4
Difference between Budget and Budgetary Control
Sr No Budget Budgetarycontrol
Budget is a planning tool and an Budgetary control is a mechanism to

instrument for allocation of resources monitor and control various activities
and inputs among various operations and processes and also ensure
1 and activities of an organisation optimum utilisation of resources
We assign responsibilities to Unit In Budgetary control we evaluate
2 Managers/ Division managers Performance
Budget is a communication tool to
communicate Goals of the Budgetary control is a mechanism to
3 organisation ensure that the goals are achieved
Budget is a one time exercise for Budgetary control is a continuous
4 finalizing the goals and resources process
25
5
Difference between Budget and Budgetary Control
 Despite the differences, both are inter-

related and Budget is an integral part of
the Budgetary control system.
 The exercise of Budget formulation

becomes meaningful only if the Budgetary
Control system is efficient
25
6
Quiz
Quiz Time
1. A budgeting process which demands each manager to

justify his entire budget in details from beginning is
A. Functional budget B. Master budget
C. Zero base budgeting D. None of the above

Quiz Time
1. A budgeting process which demands each manager to

justify his entire budget in details from beginning is
C. Zero base budgeting

Quiz Time
2. A budget output is 8,000 units in the second quarter.
In the first quarter, Fixed overheads were Rs 40,000;
Variable overheads were Rs 5 per unit;
and semi-variable were Rs 20,000.
Determine the total manufacturing overhead budget for the second
quarter.
A. Rs 1,12,000 B. 1,12,000 units
C. Insufficient data D. None of the above

Answer
2. A budget output is 8,000 units in the second quarter.
In the first quarter, Fixed overheads were Rs 40,000;
Variable overheads were Rs 5 per unit;
and semi-variable were Rs 20,000.
Determine the total manufacturing overhead budget for the second
quarter.
A. Rs 1,12,000
Exampl
e
• Budget Information
available :
Particulars A4 Diary Notebook Spiral Bound
Sales (units) 8,750 12,500 5,000
Selling Price (per unit) 80 64 100
Variable Cost (per unit) 20 23 35
Fixed Costs 65,000 140,000 95,000
Allocation of General Fixed Costs 280,000 320,000 200,000
• You are required to

• Prepare a statement of budgeted profit for each product
• Prepare a budget if product Z is dropped out and sales of Product
X and Product Y remains the same. The general fixed costs fall
by 10%.
• Comment on the position revealed by your two statements
Solutio
n
Revenues -
workings
Sales (units) 8,750 12,500 5,000
Selling Price (per unit) 80 64 100
Revenues 700,000 800,000 500,000
Variable Costs -
workings
Sales (units) 8,750 12,500 5,000
Variable cost per unit 20 23 35
Variable costs 175,000 287,500 175,000
Solutio
n
Budgeted
Profit
Particulars A4 Diary Notebook Spiral Bound Total
Total revenue 7,00,000 8,00,000 5,00,000 20,00,000
Variable Costs 1,75,000 2,87,500 1,75,000 6,37,500
Contribution 5,25,000 5,12,500 3,25,000 13,62,500
Less : Fixed 65,000 1,40,000 95,000 3,00,000
Costs
Profit 4,60,000 3,72,500 2,30,000 10,62,500
Less : 2,80,000 3,20,000 2,00,000 8,00,000
General
Fixed Costs
Profit 1,80,000 52,500 30,000 2,62,500
Solutio
n
Scenario : Product Z is dropped, General Fixed Costs reduce
by 10%
Working for new General Fixed Costs = 800,000 * 90% =
X : 280 *
720,000 Y : 320 *
720
Allocation to Products X 720
& Y in same ratio as before
600 600
= 336,000
Particulars A4 Diary = Notebook Total
384,000
Total revenue 7,00,000 8,00,000 15,00,000
Variable Costs 1,75,000 2,87,500 462,500
Contribution 5,25,000 5,12,500 10,37,500
Less : Fixed 65,000 1,40,000 205,000
Costs
Profit 4,60,000 3,72,500 832,500
Less : 3,36,000 3,84,000 720,000
General
Fixed Costs
Solutio
n
Scenario : Product Z is dropped, General Fixed Costs reduce
by 10%
Working for new General Fixed Costs = 800,000 * 90% =
X : 280 *
720,000 Y : 320 *
720
Allocation to Products X 720
& Y in same ratio as before
600 600
= 336,000
Particulars A4 Diary = Notebook Total
384,000
Total revenue 7,00,000 8,00,000 15,00,000
Variable Costs 1,75,000 2,87,500 462,500
Contribution 5,25,000 5,12,500 10,37,500
Less : Fixed 65,000 1,40,000 205,000
Costs
Profit 4,60,000 3,72,500 832,500
Less : 3,36,000 3,84,000 720,000
General
Fixed Costs
Profit 1,24,000 (11,500) 112,500
Solutio
n
Findings
:
Particulars A4 Diary Notebook Spiral Bound Total
Profit 1,80,000 52,500 30,000 2,62,500
Profit 1,24,000 (11,500) dropped 1,12,500
1. While, Product Y sales are maximum as per number, Product X is

the most profitable under both scenarios while Product Z is the
least profitable in scenario 1
2. Product Y is viable only when all 3 products are made
3. If Product Z demand exists, it is advisable for firm to produce
all 3 products and make a total profit of Rs 262,500 instead
of dropping Product Z (wherein the total profit of the firm is
Rs 112,500)
Keywor
ds
• Budget : It is an instrument of planning and resource
allocation
• Forecasting : A process of prediction and estimation of
future happening
• Budgetary Control :A mechanism of monitoring and
controlling of operations to achieve goals
• Rolling Budget :A detailed budget that is prepared based on
the last period performance for immediate period followed
by brief budgets for the subsequent period
• Master Budget : A consolidated budgeted balance sheet
based on all budgets
• Zero based budget: A budget where all the expenditures are
justified right from the scratch
Keywor
ds
• Performance Budget : Here the budget is focused on achieving
goals through active participation
• Fixed Budget : A budget prepared at one activity level
• Flexible Budget : When budget is prepared for different levels of
activities
• Operational budget :Different types of budgets prepared for
different operations
• Capital Expenditure Budget: The budget is prepared for future
capital expenditure
• Production budget : A budget to forecast the expected production in
different periods
Summary - Budget and Budgetary Control
System
• The budget is an instrument which is implemented in all the organization having 6 components
i.e. goal, allocation of resources, planning, direction, monitoring and control.
• It is a systematic approach to achieve a desired goal. Budget can be prepared either fixed or
flexible budget.
• Budget related to various operational activity of a firm is called as operation / functional budget
such as sales, material budget, production budget, manpower budget, purchase budget, etc.
They can be further classified based on the nature of the functions like physical budget based
units of activities, which can be physically counted; cost budget based on cost relating to
various operations. Profit budget and financial budgets indicating the flow of financial resources
and resulting in preparation of master budget.
• Cash Budget is the most important budgets in a business firm, as it is the case that is crucial in
managing day-to-day operations. It represents the inflow and outflow of cash in a business in a
particular given time period. It is an effective tool in forecasting short-term cash requirements of
a firm, it is to manage surplus or shortage of funds. It helps management to forecast the net
cash position and plan for deficit or surplus.
• . 61
Summary Budget and Budgetary Control (contd)
System
• Zero-based budgeting or ZBB, it has no base at the starting point, every component of
the expenditure starts from scratch, the previous year budget has no significance.
• The concept here is the budget for next year is zero, all expenses have to be justified by
division head in term of requirements, usefulness, outcome, etc.
• No sanction of budget and no spending will be allowed, if, it is not justified.
• It also requires the division undertakes the cost-benefit analysis of the proposed
expenditure.
• It is an operating and budgeting process where each division head is to provide
justification to budget proposals right from scratch
• The Master budget represents the summary of the firm’s plan describing sales,
production, distribution and financing activities.
• It is a business strategy that documents expected future sales, productions levels
purchases, future expenses incurred, capital investments.
• In simple terms, it includes all other financial budgets as well as budgeted income
statement and balance sheet.
• It is also management’s strategic plan for the future growth of the firm. Every aspect of
the organizational operations is charted and documented for future predictions. It can
virtually be considered as a master budget as a folder that includes all of the other
budgets.
27
2
Summary
(contd)
• Budget provides overall framework and direction towards achieving the

set goals of the organization. It also provides needed resources and
guidance from time to time to achieve such goals.
• Once it is done, the next question is how to establish control mechanism

for effective monitoring and control and evaluate the performance by
evaluating actual results.
• This can be done through budgetary control. Hence, budgetary control is a

systematic and formalized approach for accomplishing the planning,
coordination and control.
• The main objective of the budgetary control is to find out the

variances/difference between actual and budgeted performance under
various parameters and components
27
3
27
4
Session 5
Chapter No 6- Short Term Decision Making

Strategies
Chapter
No
No
2
7
Before we start …
• This session is for YOU… so participate and lets

• I will keep my Chat window open – students are
requested to post queries on Chat
• I shall allocate time towards the end of the session to
respond to your queries
• Please point out in chat in case the “recording” is off
at any time !!
2
7
Introduction
• Essentials of the Decision Making Process

• Cost Benefit Analysis
• Relevant and Irrelevant Costs and benefits
• Key limiting factor
• Decision to accept or reject
• Outsourcing decisions
• Add or Drop a product
• Joint Products
• Product Mix decisions


cost advantage

Long term and Short term decisions
Organisations need to undertake various types of decisions to

manage their business. These are broadly classified as :
A. Long Term: Long term decisions require capital outlay and

hence the decisions need to consider :
• Time value of money
• Return on Investments
• Interest rates etc
Financial Management enables organisations to take long term
decisions
B. Short Term: Short term decisions are taken for a short period to
meet and measure the current requirements of a firm keeping in view
the overall profitability of a firm.
Managerial accounting plays a crucial role in making short term
decisions
28
1
Short Term Decision Making
Short term decision making is the process of selecting the best amongst various
alternatives considering the cost benefit factors and overall profitability of the
firm.
The type of situations may involve decisions relating to :
• Accepting or rejecting a special order
• Making or buying decisions
• Product Mix decisions
• Selling now or further process decisions
• Adding or Dropping a product line decision
These decisions require a different kind of analysis including:

• Contribution margin analysis
• Cost benefit analysis
• Relevant and Irrelevant Costs and benefits
• Key limiting factor etc
These decisions are very crucial in the short term aiming at an overall positive
impact on the financial performance of the firm
28
2
Essentials of the Decision Making Process
1. Define the decision problem:
In practical decision situations, we come across a variety of decision problems.

Some decisions are very simple, while others are very complicated.
When a firm a special order for supplying its products at a price lower than usual, the
decision problem is to accept or reject the order.
This is a very simple situation but the decision problem is not so simple in real
business situations.
We may presume that demand for a firm's popular product are declining.
• What exactly is causing the problem?
• Increasing competition?
• Declining quality control ?
• A new alternative product on the market?
Before a decision can be made, the problem needs to be clarified and defined in more
specific terms.
Considerable managerial skill is required to define a decision problem in terms that can
be focused effectively
28
3
2. Decision criteria:
Once a decision problem has been defined, it needs suitable criteria or
decision. Is the objective to:
• maximize profit,
• increase market share,
• minimize cost or
• improve customer service?
Sometimes the objectives are in conflict, as in a decision problem where
production cost is to be minimized but product quality must be maintained. The
objective should be clear such eg: cost minimization
3. Selection of alternative options:

A decision often involves selecting between two or more options. Suppose a
machine breaks downs.
The alternative courses of action have to be evaluated, such as:
• Whether machine can be repaired or replaced
• A replacement can leased
• What are the consequences of each option
• Whether repair will turn out to be more costly than replacement
28
4
4.A suitable decision model: A decision model is a simplified
representation of the choice problem. Incorporating unnecessary
details should be avoided and the most important elements of the
problem are highlighted. Thus, the decision model brings together the
elements such as the criteria, constraints and alternatives
5.Implementation of decision model : Once the decision model is

finalized, it is important to implement the same in a time bound
manner. The implementation process should be followed up according
to the strategies suggested in the model. Sufficient resources should
be made available for taking the right decision.
6.Monitoring and follow up : Once a decision has been

implemented, the results of the decision should be monitored and
evaluated with the objective of improving future decisions.
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5
Decision Making Process in a firm
In the decision-making process, the considerations have more relevance. There is
a need to evaluate the impact of a decision in future. Therefore, all analysis should
be undertaken keeping future effects in view. Following are the important
considerations in the decision-making process:
1. Impact on the future decisions: The cost or benefit must involve a future
event. For example, cost inform to Worldwide Airways' decision concerning its
Frankfurt Operations involves the costs that will be incurred in the future under
the airline’s two alternatives. Since relevant information involves future events,
the management should predict the amounts of the relevant costs and benefits.
This is important in understanding that information must involve costs and benefits
to be realized in the future.
2.Analysis of alternatives: The relevant information mt or benefits that differ
among the alternatives. Costs are the same across all the available alternatives do
decision. Therefore, a firm needs to consider costs and benefits under different
options and alternatives.
28
6
Decision Making Process in a firm contd…
3. Nature of decisions: Some decisions are unique in nature while others are
repetitive.
Unique decisions are required in taking certain major decisions, away from
routine decisions. They need more attention and focus. Such decisions
require a different kind of analysis and detailed information and data.
However, repetitive decisions are taken again and again with similar
situations. Cost predictions with respect to repetitive decisions can use
historical data.
Since the decisions are routine in nature, the data from those decisions
should be readily available.
The firm will have to focus attention on data that is more relevant.
28
7
Cost Benefit Analysis
28
8
There are certain costs that are significant and relevant for taking effective
decisions :
1. Sunk Costs: These are costs that have already been incurred. They do not
affect any future cost and cannot be changed by any current or future action.
Sunk costs are irrelevant to current decisions.
2. Book value of Machine:

Suppose following is the book value of a machine :
Particulars Amount (Rs)

Acquisition Cost 1,00,000.00
Less : Accumulated
Depreciation -75,000.00
Book Value 25,000.00
28
9
• Further, suppose that the machine has 1 year of useful life remaining, after which its
salvage value will be zero.
• However, it could be sold now for Rs 5,000/-.
• In addition to the annual depreciation of Rs 25,000/- the firm incurs Rs 80,000/- as
variable costs to operate the machine.
• Now, the firm faces a decision about replacement of the machine .
• A new machine is available that is much cheaper and efficient in production. It is
easy to operate also.
• The following data are available regarding this new machine :
• The firm may have different views on acquiring a new machine as the exist ng
machine has a book value of Rs. 25,000 and if it is disposedoff, it will bea lossof Rs.
20,000 (Rs.25,000- Rs.5,000) to thefirm.
In this case, Rs.25,000 is a sunk cost.
If thefirm continues with the machine, the depreciation of Rs. 25,000 will have to be
provided next year or Rs. 25,000 will be written off as machine’s book value.
Therefore, this sunk cost of Rs 25,000/- should NOT BE considered for taking a
further decision.
29
0
Cost of t w o alternatives
Particulars A m o u n t (Rs)
(A) (B) (C')
Do not Replace old Differential
replace machine Cost (A-B)
old m a c h i n e
Sun 1. Depreciation of old
machine 25,000.00
k
OR
Cost 2.Write off of old
s loader's 25,000.00 0.00
book value
Releva 3. Proceeds from

disposal of parts 0 -5000.00 5000.00
nt
4. Depreciation (cost) of
Data new loader - 15,000.00 -15,000.00
5. Operating Costs 80,000.00 45,000.00 35,000.00
Total Cost 1,05,000.00 80,000.00 25,000.00
29
1
When we analyse costs between the decision

alternatives, these are called as Differential costs.
The Chartered Institute of Management Accountants

(CIMA ) defines differential costing as a technique
used in preparation of information in which only costs
and benefits differences between alternative courses of
action are taken into consideration.
The differential costing is based on Absorption costing.
29
2
6.4 Relevant and Irrelevant costs and benefits
Relevant and Irrelevant costs are also an important technique for making
strategic decisions.
Relevant costs are crucial and significant for decision making
Fixed costs can be relevant if they can change due to Managerial

decision
An analysis of relevant and irrelevant cost is significant in taking the

following decisions:
1. Shutting down or carrying on a business
2. Accepting or rejecting special orders
3. Making a product in-house or buying it from outside
29
3
• Lets see an example of a bus-route operator

• He is taking a decision to add a stop at Talegaon in his Mumbai-Pune bus
service
• He has studied the preferences of customers and has shared that
• This would attract additional customers as well as cargo
• This would mean additional variable costs
29
4
• Solution
:
Description (per month) Old route New Route Difference Relevant
or
Irrelevan
t
Revenue – passenger 5,25,000 6,30,000 1,05,000 Relevant
Revenue – cargo 90,000 1,50,000 60,000 Relevant
Fuel Costs 1,00,000 1,20,000 -20,000 Relevant
Salaries 50,000 50,000 - Irrelevant
Parking & Cleaning charges 10,000 10,000 - Irrelevant
Bus life cost based on 3,00,000 3,60,000 -60,000 Relevant
Kms(Rs)
Relevant
Profit / Loss factors : will always have a value
1,55,000 in difference
2,40,000 85,000
column
29
5
6.5 Key limiting factor
• What could be the limiting

Factors ?
• Labour
• Materials
• Power
• Sales
• Capacity
• Machines
• ??
• ??
29
6
29
7
It is a concept according to which production stops at a level due to scarcity

of a factor of production and it becomes a limiting factor for continuing the
production.
It is also known as the “Scarce Factor” or governing factor.
It is simply a resource constraint of one of the factors of production such as

non-availability of raw materials, labor, machine, capital etc
In cases where the firm produces two or more products and if the Firm has a
key limiting factor, the decision has to be taken about the product that
should be produced more to make optimum utilization of the limiting factor.
The impact will be seen on overall profitability.
In such a situation the product that provides the highest contribution per unit
of the limiting factor should have the first preference in the production
process and the subsequent products in order of merit of contribution per
unit.
29
8
• Lets see an example of a farmer
• He has the below options for his farm that measures 10,000
sq mts:
Crop  Onions Lady-fingers Grapes
Sales – max 1,000 15,000 20,000
(Nos)
Contribution 20 30 50
/sqmt
Area for max 6,000 4,000 3,000
sales
• He will prioritise the crop that gives him maximum contribution i.e.
grapes
• He will allocate maximum area to that crop – i.e. 3,000 sq mts
• Then he will choose next best contribution crop (lady fingers) and
allot area
29
9
• Lets see an example of a farmer
• He has the below options for his farm that measures 10,000
sq mts:
Crop  Onions Lady-fingers Grapes
Sales – max (Nos) 1,000 15,000 20,000
Contribution /sqmt 20 30 50
Area for max sales 6,000 4,000 3,000
• He will prioritise the crop that gives him maximum contribution i.e.
grapes
• He will allocate maximum area to that crop – i.e. 3,000 sq mts
• Then he will choose next
Crop  best contribution
Onions Lady-fingerscrop (lady fingers) and
Grapes
allot
Areaarea
max 10,000 3,000 4,000 3,000
Sales (nos) 500 15,000 20,000
Contribution 10,000 4,50,000 10,00,000
Limiting factors : Sales size and 25

6.6 Decision to Accept or Reject contd…
The situation of accepting or rejecting decisions arises whenever there

us a special order for the product received either from abroad or the
home market.
These special offers are generally received to supply a product at a

price lower than the existing selling price.
In that situation, the main considerations are the production capacity and
contribution margin on the received special order.
A very important consideration here is that there should be NO long-run

or strategic implications to a one time or special – order situation.
For eg : If a Firm accepts an order at lower price for a particular
customer, other customers should not demand the same as well !
30
1
6.6 Decision to Accept or Reject contd…
The following points need to be evaluated:
1. If the firm has been operating on full capacity, there is no scope for
accepting the special order at lower price as the firm will suffer a loss on
the existing product.
For eg : If the Selling price of a Ladies wallet is Rs 250/- and a special order
is received for selling the product at a lower price of say, Rs 200/-.
If the firm agrees to supply the special order, it will have to forego Rs 50/- per
unit of wallet.
The firm has to sacrifice same number of units on the existing product order
to fulfil the additional requirements.
30
2
6.6 Decision to Accept or Reject
2.If the firm is not operating at full capacity and the special order so received is
within the existing capacity, the firm may accept it. However, it has to be ensured
that the firm recovers the full variable cost and also a certain margin on the order.
3.In case the above order (2) is accepted, the firm does not need to incur any
fixed cost. Only variable costs have to be incurred and some additional expenses
may be incurred on account of overtime payment to workers as they will be
working extra and there may be some other variable expenses that will increase
the total variable cost of the product.
In that case, the firm should accept the special order only if full variable cost is
recovered and a certain amount of margin is also made.
On the basis of the above, a firm may decide either to accept or reject the special
orders.
30
3
6.7 Outsourcing Decisions
Outsourcing is purchasing goods and services from outside vendors rather than
producing the same goods or providing the same services within the organisation.
Decisions about whether a producer of goods or services will insource or outsource

are called “make or buy” decisions.
Research indicates that companies consider the following

as most important factors in Make or buy decisions:
• Quality
• Dependability of Suppliers
• Costs
For Eg: Honda relies on Vendors for some component parts

(outsourcing) but chooses to manufacture other parts internally.
In contrast, to maintain the secrecy of its formula, Coca Cola

does not outsource the manufacture of its concentrate.
30
4
6.7 Outsourcing Decisions
1. Capacity Utilization - Low
If it is operating at the lower capacity, then whether the unutilized
productiion capacity is sufficient for producing the requirement of additional
component.
2. Capacity Utilization – Full

If it is working at the full capacity, then the opportunity loss has to be
measured.
The firm may have to reduce the production of the existing product to
the extent of new component.
In that case, the opportunity loss will be selling price of the existing
product.
If the buying cost of the additional component is lesser than the
selling price of the existing product, then it is better for the firm to buy it
from the market. If the buying cost is higher, then the firm can think of
producing it in-house.
30
5
6.7 Outsourcing Decisions contd…
3. Capacity Utilization : Low
If the firm is operating at the lower capacity, it may manufacture
the component in-house but in this case the firm may have to
look at variable costs of the particular component and certain fixed
cost associated with the component, if any.
The firm will need to evaluate between the two:
• The total additional cost for producing component in-house V/S
• Buying cost in the market.
If Market price < than the additional total costs of manufacturing
in-house, it will be preferred to buy from market and
If market price is > Totalcost of Manufacturing,it is betterto produceit in-
house.
The additional fixed cost may be required in terms of engaging
supervisor and using other fixed overheads.
The evaluation has to based on net savings on both the options.
30
6
6.7 Outsourcing Decisions - Takeaways
Outsourcing is Risky
As a company’s dependence on suppliers increases, suppliers could

increase prices and let performance and delivery slip.
To minimize these risks, companies generally enter into long term contracts
specifying costs, quality and delivery schedules etc with their suppliers
It is prudent to close partnerships or alliances with a few key suppliers.
For eg: Toyota sends it own engineers to improve processes of suppliers

“Toyota helped us dramatically improve our production system. We started by
making one component, and as we improved, [Toyota] rewarded us with orders for
more components. Toyota is our best customer.” —Senior executive, supplier to
Ford, GM, Chrysler, and Toyota, July 2001
Source: HBR Dec 2004 issue
30
7
6.8 Add or drop a product
30
8
At times, an organization needs to make certain decisions:

• Add or Drop a Product ?
• Continue an old product line or department or Start a new one ?
These decisions are called “ Add or Drop” decisions

An add-or-drop decision must be based only on relevant information.
Relevant information includes the revenues and costs which are directly related to a
product line or department.
Examples of relevant information are:
• Revenue projections .
• Costs for the launch of the new product or product line etc
• Variable overhead and
• Direct fixed overhead
Such decisions must not be based on irrelevant information such as allocated fixed
overhead because allocated fixed overhead will not be eliminated if the product line or
department is dropped
30
9
When adding or dropping a product, the following

considerations are evaluated:
1. Identify the expenses that are unavoidable even if the
product is dropped. They have to be incurred
2. Similarly identify the items that are avoidable.
3. Prepare the income statement considering both the

situations and arrive at the contribution margin and
profit/loss of the product or product line
4. Compare both the situations - the product is dropped or

continued to arrive at the cost-benefit analysis and evaluate
the difference
31
0
Steps for Add or Drop analysis :
1. First, the firm needs to make a comparison between the lost contribution
margin and reduction in fixed costs.
2.If the lost contribution margin is more than the reduction in fixed costs, the
product should be continued. Since it is a positive situation, add up of product
is suggested.
3.If the lost contribution margin is less than the reduction in fixed costs, the
product should be dropped out.
4.It is important to make appropriate treatment of common fixed cost and
allocated fixed cost.
5. Besides the product margin, other instrumental factors are :

• Future impact on overall efficiency of the firm
• Capacity Utilization
• Utilization of other available resources and infrastructure etc
31
1
6.9 Joint Products
6.9 Joint Products ( Decision to sell now or process
further)
When more than one product is produced from the inputs, they are
called “Joint products”.
For eg : From Crude oil, the following products are produced :
• Petrol
• Diesel
• Kerosene etc
These products are processed through a common process and then

separated
After Separation, there may be two situations :
• Either sell the product at that point OR
• Process it further to add further value
The point where products are separated to provide them individual

identity is called “Split off” point.
38
Joint Products
6.9 Joint Products ( Decision to sell now or process
further)
In such cases, an analysis is required – whether the product can be sold at the
split-off point or it should be further processed to make it saleable.
Such decisions are called “Sell now” or “Further process”.
If a product is further processed, it requires additional cost. Therefore, an

analysis should be made about the additional cost on the product and expected
revenue and contribution from the particular product.
We can understand some of the terms used in this process.

1. Split-off point: Point at which the product's identity is separated
2. Joint cost: All the common costs on product up to split-off point
3. The decision rule: The product should be further processed if the
incremental revenue is more than the incremental cost of processing the
product further.
4. Cost allocation: We have to be very cautious in allocating the common
costs.
31
5
6.10 Product Mix
31
6
6.10 Product Mix decisions
When a firm produces more than one product, i.e a combination of products, it is
called ‘Product Mix’.
In such a situation, the decision making is focused on deciding the proportion of the
mix of different products as resources are limited.
The decision about which product should be produced more and which less within
the limited resources available in the organization is called “Product Mix
Analysis”.
Considerations:
1. An analysis of the constraints in producing different products.
2. Analysis of the expected demand for different products.
3. Measurement of the contribution margin per unit for each product
4. Effect on fixed costs if the mix is changed
5. Effect on maximization of profits of the firm – an inter comparison of products.
6. Whether there is a change in fixed cost due to change in product mix
31
7
6.10 Product Mix decisions
The objective is to select the product with the

highest contribution margin per unit of the
limiting resource
These decisions usually have a short run focus because they typically arise in the
context of capacity constraints that can be relaxed in the long run.
For Eg : BMW , the German car manufacturer continually adapts the mix of its
different car models ( 3 series, 5 series,7 series to fluctuations in
selling prices and demand
To determine Product Mix, managers maximize

operating income, subject to constraints such
as capacity and Demand
31
8
Quiz
Quiz Time
Q1 . Which is an important factor to decide the

volume of production when products are more than
one?
a. Maximum Revenue from the product
b. Highest Contribution
c. Minimum Cost
d. Maximum demand
Quiz Time
Q1 . Which is an important factor to decide the

volume of production when products are more than
one?
b. Highest
Contribution
Quiz Time
Q2 . Opportunity Cost is :
a. Cost of new Business

Opportunities
b. Cost of next best alternative

option
c.Unplanned business cost
d. Opportunities lost in business

Quiz Time
Q2 . Opportunity Cost is :
b. Cost of next best alternative

option
Exampl
e
• Following is the budget information of Protect
Masks :
Particulars Guard-pro Guard Superior
Sales (units) 8750 12500 5000
Selling Price per unit (Rs) 80 64 100
Variable Cost per unit (Rs) 20 23 35
Fixed Costs (Rs) 65,000 1,40,000 95,000
Allocation of general fixed 2,80,000 3,20,000 2,00,000
costs (Rs)
You are required to

• Prepare a statement of budgeted profit for each product
• Prepare a budget if product “Superior” is dropped out and sales of
other two products remains the same. General fixed costs will fall by
10%.
• Comment on the position revealed by the above
Solutio
n
Working
s
Sales (units) 8,750 12,500 5,000
Revenue (Rs) 7,00,000 8,00,000 5,00,000
Variable Costs
Volume 8,750 12,500 5,000
Variable Cost per unit 20 23 35
Total Variable Cost 1,75,000 2,87,500 1,75,000
Solutio
1.n
Statement of Budgeted
Profit
Particulars Guard-pro Guard Superior Total
Total Revenue 7,00,000 8,00,000 5,00,000 20,00,000
Less : Total Variable Cost 1,75,000 2,87,500 1,75,000 6,37,500
Contribution 5,25,000 5,12,500 3,25,000 13,62,500
Less : Fixed Costs 65,000 1,40,000 95,000 3,00,000
Profit before general fixed costs 4,60,000 3,72,500 2,30,000 10,62,500
Less : General fixed costs 2,80,000 3,20,000 2,00,000 8,00,000
Profit 1,80,000 52,500 30,000 2,62,500
Solutio
1.n
Workings
Sales (units) 8,750 12,500 5,000
Revenue (Rs) 7,00,000 8,00,000 5,00,000
Variable Costs
Volume 8,750 12,500 5,000
Variable Cost per unit 20 23 35
Total Variable Cost 1,75,000 2,87,500 1,75,000
Solutio
n
2.Statement of Budgeted Profit – if “Superior” is
dropped
Particulars Guard-pro Guard Total
Total Revenue 7,00,000 8,00,000 15,00,000
Less : Total Variable Cost 1,75,000 2,87,500 4,62,500
Contribution 5,25,000 5,12,500 10,37,500
Less : Fixed Costs 65,000 1,40,000 2,05,000
Profit before general fixed costs 4,60,000 3,72,500 8,32,500
Solutio
n
Statement of Budgeted Profit – if “Superior” is
dropped
Total Revenue 7,00,000 8,00,000 15,00,000
Contribution 5,25,000 5,12,500 10,37,500
Less : Fixed Costs 65,000 1,40,000 2,05,000
Less : General fixed costs 3,36,000 3,84,000 7,20,000
Profit 1,24,000 (11,500) 1,12,500
General Fixed Cost will reduce by 10% in this
case Hence, General Fixed Cost = 800,000 *
0.90 = 720,000
Allocation between Guard-pro and Guard in same ratio as
Guard-pro
earlier : : 280 * 720 = 3,36,000 Guard : 320 * 720 = 3,84,00
0
600 600
Solutio
n
Statement of Budgeted Profit – if “Superior” is
dropped
Total Revenue 7,00,000 8,00,000 15,00,000
Contribution 5,25,000 5,12,500 10,37,500
Less : Fixed Costs 65,000 1,40,000 2,05,000
Less : General fixed costs 3,36,000 3,84,000 7,20,000
Profit 1,24,000 (11,500) 1,12,500
Solutio
n
Conclusion :
• With all 3 products, total Firm’s profit was Rs 262,500

• With Superior being dropped, Firm’s profit was Rs 112,500
• At product level, with Superior being made and sold,
all products were profit-making
• At product level, with Superior being dropped,
only Guard-pro is profit-making
• It is advisable not to drop product “Superior”
Exampl
e
• Accept or Reject
Order
Exampl
e
AB CD Ltd manufactures High density CDs for recording movies. It has a plant
capacity of
1,00,000 CDs per month. It is presently manufacturing 60,000 CDs per month.
Units 60,000
per piece Rs.
Sales 7 4,20,000
Variable manufacturing expenses 3.5 2,10,000
Fixed manufacturing expenses 1.5 90,000
Sub-total 5 3,00,000
Gross Margin 2 1,20,000
Variable Marketing expenses 0.65 39,000

Fixed Head Office expenses 0.25 15,000
Sub-total 0.9 54,000
Profit 1.1 66,000
It has received a one-time order direct enquiry to supply 30,000 CDs to a top
notch Film Production Company to be manufactured and delivered in November
2020.
The Film Production Co has offered a price of Rs 4.50 per CD.
Please help the company decide on taking this order or not.
Units 60,000 30,000 90,000
Rs. Rs. Rs.
Sales
(60,000 @ 7 & 30,000 @ 4.50) 4,20,000 1,35,000 5,55,000
Variable manufacturing expenses @ 3.50 per 2,10,000 1,05,000 3,15,000

pc
Fixed manufacturing expenses 90,000 0 90,000
Cost Sub-total 3,00,000 1,05,000 4,05,000
Per Piece 5.00 3.50
Gross Margin 1,20,000 30,000 1,50,000
Variable marketing costs are
Variable Marketing expenses 39,000 0 39,000 not applicable to “Direct”
Fixed Head Office expenses 15,000 0 15,000 orders Fixed HO Expenses –
no change
Units 60,000 30,000 90,000
Rs. Rs. Rs.
Sales
(60,000 @ 7 & 30,000 @ 4.50) 4,20,000 1,35,000 5,55,000

pc
Cost Sub-total 3,00,000 1,05,000 4,05,000
Per Piece 5.00 3.50
Gross Margin 1,20,000 30,000 1,50,000
Variable Marketing expenses 39,000 0 39,000

Fixed Head Office expenses 15,000 0 15,000
Total Cost 3,54,000 1,05,000 54,000
Per Piece 5.90 3.50
The price of Rs 4.50 per CD appears
Profitlower than the66,000
total cost of 30,000
production. 96,000
There are no variable marketing expenses, since this is a “direct” order.
Since, all fixed costs (factory and HO) are absorbed, this order is good for the
Company.
Units 60,000 30,000 90,000
Rs. Rs. Rs.
Sales
(60,000 @ 7 & 30,000 @ 4.50) 4,20,000 1,35,000 5,55,000

pc
Cost Sub-total 3,00,000 1,05,000 4,05,000
Per Piece 5.00 3.50
Gross Margin 1,20,000 30,000 1,50,000
Variable Marketing expenses 39,000 0 39,000

Fixed Head Office expenses 15,000 0 15,000
Total Cost 3,54,000 1,05,000 54,000
Per Piece 5.90 3.50
The price of Rs 4.50 per CD appears
Profitlower than the66,000
total cost of 30,000
production. 96,000
There are no variable marketing expenses, since this is a “direct” order.
Since, all fixed costs (factory and HO) are absorbed, this order is good for the
Company. With new order of 30,000 CDs to be manufactured and delivered in
November 2020, the Company will make additional profit of Rs 30,000/-
Keywor
• ds
Cost-benefit analysis: Analysis costs in relation to benefits of an order
• Contribution margin: Sales less variable costs
• Add or drop: Analysis of including or excluding a product line.
• Make or buy decision: The decision to make a product in-house or
buy from the market.
• Accept or reject decision: Accepting or rejecting a special order.
• Relevant and irrelevant costs: Decision based on relevance of cost
to the decision process
• Key limiting factor: The key limiting factor in terms of resources.
• Outsourcing: The decision to outsource a service
• Sell or furtherprocess: The decision to sell a product at split-off
point or further process it.
• Product mix: Combination of more than one product.
• Sunk cost: Cost incurred in the past and it is not relevant in future
decisions
64
Session 6
Chapter No 7- Balanced scorecard and

Performance Evaluation
Chapter
StratTopic (including subtopics) Session
No
No
3
4
Before we start …
lets
“recording” is
off at any time !!
3
4
Introduction
• Introduction – Concept of Balanced Scorecard
• Balanced Scorecard and Performance Evaluation
• Design of a Balanced Scorecard
• Variants of a Balanced Scorecard
• Decentralized Operations
• Performance Measurement Techniques
• Comparison of Balanced Scorecard and self
assessment for Business excellence
• Six Sigma Philosophy


cost advantage

Balanced Scorecard – The concept
It is about the identification of a small number of financial & non-financial

measures and attaching targets to them.
When reviewed, it becomes possible to determine whether current performance

‘meets expectation’.
Alerting the manager, if, performance deviates from expectation, they can be
encouraged to focus their attention within the part of the organization they lead.
It is to be focused on information relating to the implementation of a strategy and,

over time, there has bee a blurring of the boundaries between conventional
strategic planning and control activities and those required to design BSC.
This is illustrated by 4 steps required to design BSC including Kaplan and

Norton’s writing on the subject in the late 1990s
1. Translating the vision into operational goals.
2. Communicating the vision and link it to individual performances.
3. Planning business activities and setting index.
4. Providing feedback, and learning and adjusting the strategy accordingly.
34
6
Balanced Scorecard – The concept
• These steps goes beyond the simple task of identifying a small
number of financial and non-financial measures.
• It sets a:
• Direction,
• Design
• Suitable framework and
• Strategies
to achieve business goals.
• The process of BSC will integrate such strategies.
• It helps manager’s attention on strategic issues and

management of the implementation of strategy, it is important to
remember that the BSC itself has no role in the formation of
strategy, BSC can coexist with strategic planning system and
other tools
34
7
Balanced Scorecard (BSC) and performance evaluation
The BSC suggests that we view the organisation from 4 perspectives and
to develop metrics, collect data and analyse it relative to each of these
perspectives.
• Learning and Growth Perspective
• Business process perspective
• Customer Perspective
• Financial perspective
34
8
34
9
1. Learning and GrowthPerspective:
In a knowledge worker organization, people, the only repository of knowledge,

are the main resource.
In the current climate of rapid technological change, it is becoming necessary
for knowledge workers to be i.n a continuous learning mode.
Metrics can be put in place to guide managers to focus on training needs
where they can help the most. In any case, learning and growth constitute the
essential foundation for success of any knowledge-worker organization.
Kaplan and Norton emphasize that "learning" is more than "training"; it also
includes things like mentors and tutors within the organization, as well as
that ease of communication among workers that allows them to readily get
help on a problem when it is needed.
It also includes technological tools - what the Baldrige Criteria calls "high
performance work systems.“
Measures (examples):
• Employee Satisfaction
• Number of employees trained in managing bottleneck operations
35
0
2. Business Process Perspective:
This perspective refers to internal business processes.
Metrics based on this perspective allow the managers to know how well their
business is running and whether its products and services conform to
customer requirements ( the mission).
These metrics have to be carefully designed by those who know these

processes thoroughly well and are well acquainted with the mission of the
firm.
The expertise of business perspective obviously lies with Internal

management and they can contribute in a constructive manner to refine it
further.
35
1
2. Business Process Perspective contd :
Companies routinely use non financial measures to track the quality

improvements they are making.
Some of the non-financial measures are:
• Average Manufacturing time for key products

• Manufacturing cycle efficiency for key processes
• Defective units produced at bottleneck operations
• Percentage of re-worked products
• Average reduction in setup time and processing time at bottleneck
operations
• Number of design and process changes made to improve design
quality or reduce costs by maintaining quality
35
2
35
3
3. Customer Perspective :
Recent management philosophy has shown an increasing realization of the
importance of customer focus and customer satisfaction in any business.
These areleading indicators.
If customers are not satisfied, they will eventually find other suppliers that will
meet their needs.
Poor performance from this perspective is thus a leading indicator of future

decline, even though the current financial picture may not look good.
In developing metrics for satisfaction, customers should be analyzed in terms

of kinds of customers and the kind of processes for which we are providing a
product or service to these customer groups.
Examples of Measures:
• Customer response time (the time it takes to fulfill a customerorder)
• On-time performance (delivering a product or service by the
scheduled time)
35
4
4. Financial Perspective:
Kaplan and Norton do not disregard the traditional need for financial data.
Timely and accurate financial data will always priority and managers will do
whatever is necessary to provide it. In fact, often there is more than enough
handling and processing of financial data.
With the implementation of a corporate database, it is hoped that more of the
processing can be centralized and automated.
However, the emphasis on financials leads to an “unbalanced”

situation with regard to other perspectives.
It is imperative to include additional financial related data such

as Risk assessment and cost benefit data in this category.
Measures (Examples):
• Revenue gains or price increases from fewer delays
• Carrying cost of inventories
35
5
How focus on all
the
perspectives
impact the
Financial
perspective
35
6
35
7
Design of a Balanced Scorecard
Design of a BSC is about the identification of a small number of financial and non-
financial measures and attaching targets to them, so that when they are reviewed,
it is possible to determine whether current performance “meets expectations".
By alerting managers to areas where performance deviates from expectations,
they can be encouraged to focus their attention on these areas and hopefully, as a
result, trigger improved performance within the part of the organization they lead.
The original thinking behind a BSC was for it to be focused on information relating
to the implementation of a strategy and, over time, there has been a blurring of the
boundaries between conventional strategic planning and control activities and
those required to design a BSC. This is illustrated well by the four steps required to
design a BSC included in Kaplan writing on the subject in the late 1990s.
1. Translating the vision into operational goals
2. Communicating the vision and link it to individual performance
3. Planning business activities and setting index
4. Providing feedback, and learning and adjusting the strategy accordingly
35
8
35
9
• These steps go far beyond the simple task of identifying a small
number of financial and non-financial measures.
• These steps set a direct a suitable framework and strategies to
achieve business goals.
• The process of BSC will integrate such strategies.
• Although it helps focus manager’s attention on strategic issues and
the management of the implementation of strategy, it is important to
remember that the BSC itself has no role in the formation of
strategy.
• In fact, BSCs can coexist with strategic planning systems and other
tools.
36
0
36
1
Variants of a Balanced Scorecard
BSC was popularized in the early 1990s, a large number of alternatives to the
original "four box" BSC promoted by Kaplan and Norton in their articles and books
have emerged.
Most which have very limited application are typically proposed either by academics
as vehicles for promoting other as (such as green issues), for example, Brignell
(2002) or consultants, attempt at differentiation to promote sales of books and/or
consultancy.
Many of the structural variations proposed are broadly similar and a research paper
published in 2004 attempted to identify a pattern in these variations; noting there
are three distinct types of variation. The variations appeared to be part of an
evolution of the BSC concept and so the paper refers to these distinct types as
"generations."
36
2
Variants of a Balanced Scorecard
• Broadly, the original "measures in boxes" type design (as proposed by
Kaplan and Norton) constitutes the first generation design;
• BSC designs that include a "strategy map" or "strategic model" [for example,
the Performance Prism, later Kaplan and Norton designed the Performance
Driver Model of Olve, Roy and Wetter (English translation 1999, first
published in Swedish 1997)] constitute the second generation of BSC design;
• Designs that augment the strategy map/strategic model with a separate

document describing the long-term outcome from the strategy (the
"destination statement" idea) comprise the third generation BSC design.
• BSC is also often linked to quality management tools and activities. Although
there are clear areas of cross-over and association, the two sets of tools are
complementary rather than duplicative.
• A common use of BSC is to support the payments of incentives to

individuals even though it was not designed for this purpose and is not
particularly suited to it.
36
3
Decentralized Operations
Decentralization is the process of re-distributing or
dispersing functions, powers, people or things away
from a Central location or authority
Station
Lin
k
36
5
• Systems Approach
• Goals
• Participation
• Diversity
• Efficiency
• Conflict Resolution
• Processes
• Initiation
• Analysis of Operations
• Appropriate Size
• Inadvertent or Silent
• Asymmetry
• Measurement
36
6
• Systems Approach
• To study the goals and processes of implementation decentralization a system

theory approach is required. As per United Nation Development Program Report
“a whole system prospective, including levels, spheres, sectors and functions and
seeing the community level as the entry point.
• The holistic approach definitions of development goals gets emerged from people
themselves.
• It involves multi-level frameworks and continuous; synergistic processes of
interaction and iteration.
• Norman Johnson of Los Alamos National Laboratory wrote in 1999 – A
decentralized system is where some decisions by agents are made without
centralized control of processing.
• University of California, Irvine’s Institute for Software Research’s “PACE” project is
working on ‘architectural style for trust management in decentralized
applications.” adopting Rohit Khare’s definition “A decentralized system requires
multiple parties to make their own independent decisions” and applies it to peer-
to-peer software creation and other practical decision situations.
36
7
Decentralized Operations - GOALS
It has been used as a solution to problems like economic decline, government inability to
fund services and their general decline in performance and overloaded services
1. Participation
• The principle of subsidiary is often invoked, it holds the lowest centralized
authority capable of addressing an issue
• Thus, increasing the overall quality and effectiveness of the system of
governance, while increasing the authority and capability of sub-national
levels.
• It is linked to the concepts of participation in decision making, democracy,
equality and liberty from higher authority. It enhances the democratic
voice.
• Local authorities with discretionary powers can lead to local efficiency,
equity and development.
• It is described as “counterpoint to globalization”
• It brings decision-making to sub-national levels.
• It establishes interrelations of global, regional, national, sub-national and
local levels.
36
8
2. Diversity:
• According to Norman L. Johnson, diversity plays an important role in
decentralized systems, like ecosystems, social groups, large organizations
and political systems.
• According to him, "Diversity is defined to be unique properties of
entities, agents or individuals that are not shared by the larger group,
population, structure. Decentralized is defined as a property of a system
where the agent have some ability to operate 'locally'. Both
decentralization and diversity are necessary attributes to achieve the
self-organizing properties of interest."
• Advocates of political decentralization hold that greater participation by better

informed diverse interests in society will lead to more
relevant decisions than those made only by authorities
on the national level.
• Decentralization has been described as a response to

demands for diversity.
36
9
3. Efficiency :
37
0
3. Efficiency :
In business, decentralization leads to a “ Management by Results”
philosophy, which focuses on definite objectives to be achieved by
unit results.
Decentralization of government programs is said to increase efficiency
and effectiveness due to reduction of congestion in communications,
quicker reaction to unanticipated problems, improved ability to deliver
services, improved information about local conditions and more
support from beneficiaries of programs.
37
1
3. Efficiency :
Firms may prefer decentralization because it ensures efficiency by making sure:
• That managers closest to the local information make decisions in a more timely
fashion ;
• That their taking responsibility frees senior Management for long term
strategizing rather than day to day decision making:
• That managers have hands on training to move up the management heirarchy,
• That managers are motivated by having the freedom to exercise their own
initiative and creativity; and
• That managers and divisions are encouraged to prove that they are profitable
instead of allowing their failures to be masked by the overall profitability of the
company
37
2
Decentralized Operations - Goals
4. Conflict Resolution:
Economic and/or political decentralization can help prevent or reduce
conflict because they reduce actual or perceived inequities between
various regions or between a region and the central government.
Dawn Brancati finds that political decentralization reduces intrastate conflict
unless politicians create political parties that mobilize minority and even
extremist groups to demand more resources and power within national
governments.
However, the likelihood that this will be done depends on factors like how
democratic transitions happen and features like a regional party's proportion of
legislative seats, a country's number of regional legislatures, elector procedures
and the order in which national and regional elections occur.
Brancati holds that decentralization can promote peace if it encourages
statewide parties to incorporate regional demands and limit the power of
regional parties.
37
3
Decentralized Operations - Processes
• The process of decentralization redefines structures,

procedures and practices of governance to be closer to the
citizenry and make them more aware of the costs and benefits:
it is not merely a movement of power from the central to the
local government.
• According to the United Nations Development program, it is

"more than a process, it is a way of life and a state of mind”.
• The report provides a chart-formatted framework for defining

the application ofthe concept "decentralization," describing
and elaborating on the:
"who, what, when, where, why and how" factors
in any process of decentralization
37
4
Decentralized Operations - Initiation
Initiation :
The processes by which entities move from a more to a less centralized
state, vary.
They can be initiated from the centers of authority ("top-down") or from
individuals, localities or regions ("bottom-up"), or from a "mutually desired"
combination of authorities and localities working together.
Bottom-up decentralization usually stresses political values like local
responsiveness and increased participation and tends to increase political
stability.
Top-down decentralization may be motivated by the desire to "shift deficits
downwards” and find more resources to pay for services or pay off
government debt.
Some hold that decentralization should not be imposed but done in a
respectful manner.
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5
Decentralized Operations – Analysis of Operations
 One must access the lowest organizational level where

functions can be carried out efficiently and effectively
 Government deciding to privatize functions must decide where
best privatized, study existing types of decentralization and
centralization.
 Training of both national and local managers and officials is
necessary as well as technical assistance in the planning,
financing and management if decentralized functions.
37
6
Decentralized Operations – Appropriate Size
Gauging the appropriate size or scale of decentralized units has been studied in
relation to the size of sub-units of hospitals and schools, road networks,
administrative units in business and public administration and especially town
and city governmental areas and decision making bodies
In creating planned communities ("new towns"), it is important

mine the appropriate population and geographical size. While in earlier years,
small towns were considered appropriate, by the 1960s, 60,000 inhabitants were
considered the size necessary to support a diversified job market and an
adequate shopping center and array of services and entertainment.
Appropriate size of governmental units for raising revenue is also a consideration.
Even in bio-regionalism, which seeks to reorder many functions and even the
boundaries of governments according to physical and environmental features,
including watershed boundaries and soil and terrain characteristics, appropriate
size must be considered. The unit may be larger than many decentralist bio-
regionalists prefer.
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7
Decentralized Operations – Inadvertent or Silent
• It ideally happens as a careful, rational and orderly

process takes place during the times if economic
and political crisis, fall of a regime and resultant
power struggles.
• There is a need of experimentation, testing,

adjusting and replicating successful experiments in
other contexts.
• There is no blueprint for decentralization as it

depends on the initial state of a country, the power
and view of political interests and whether they
support or oppose decentralization.
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8
Decentralized Operations - Asymmetry
Decentralization may be uneven and “asymmetric” given any

one country’s population, political, ethnic and other forms of
diversity.
In many countries, political, economic and administrative

responsibilities may be decentralized to the larger urban areas
while rural areas are administered by the Central government.
Decentralization of responsibilities may be limited only to

those provinces or states which want or are capable of
handling responsibility.
Some privatization may be more appropriate to an urban than

a rural area while some types of privatization may be more
appropriate for some states and provinces but not others.
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9
Decentralized Operations - Measurement
Measuring the amount of decentralization , especially

politically, is difficult because studies of it use different
definitions and measurements.
An OECD study quotes Chanchal Kumar Sharma as stating :

“ A true assessment of the degree of decentralization in a
country can be made only if a comprehensive approach is
adopted and rather than trying to simplify the syndrome of
characteristics into the single dimension of autonomy, inter-
relationships of various dimensions of decentralization are
taken into account.”
38
0
Performance Measurement Techniques
Performance measurement under the BSC approach focuses on :

• Objective and Subjective measurement
• External and Internal measurement
• Financial and non Financial Measurement
• Individual and organizational measurement
38
1
BSC focuses on the measures that drive employee performance
The BSC provides a list of measures that balances the organisation’s internal
process and measures it with results, achievements and financial performance.
The 2 basic features of the BSC are as follows :
1. A balanced set of measures based on the 4 perspectives of BSC
2. Linking the measures to employee performance
38
2
1. A Balanced set of measures:
Instead of relying on just one instrument or measure, using a balanced set of
measures ensures that all the aspects of the employee’s performance are covered
and they provide relevant support for the decisions taken.
The 4 perspectives given by Kaplan and Norton are:
• The financial measures
• The Customer's perspective
• The internal business perspective
• The innovation and learning perspectives
For each perspective, BSC of the following things are measured:
1. Objectives: The goals and the targets to be achieved.
2. Measures: The standards which will be used to measure performance and the
progress
3. Action plans: The initiatives taken and the course of action to be followed to
achieve the objectives
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3
2. Tie in to Employee Performance

The BSC approach can be used and applied at both the levels, individual and the
organizational level.
It provides a balanced approach to evaluate the employees performance (for the
purpose of performance appraisal) in a comprehensive manner rather than a partial
view. In most of the organisations, the common pract.ise of measuring the
employee performance refers to only the comparison of their action plans and
behaviors with the standards set, that is, without actually measuring the actions, like
profits earned, increase in market share etc
This conventional practice can lead to the appraisal of most of the employees
without any or little progress towards achieving the goals and objectives of the
organization.
Thus, the BSC gives the complete view of the employee’s and organizational
performance and helps to align the employee performance / action plans with
organizational goals.
38
4
Comparison of BSC and self assessment for Biz
Excellence
Both methods aim at assessing the current state of the organisation or
parts of it.
BSC, is, however monitoring the organisation continuously while self –

assessment can be applied at certain intervals, for instance annually.
The improvement focus is more evident in self assessment than in BSC

as determining areas of improvement is a major part of self
improvement.
BSC is a continuous process as against self assessment that can be

utilized at certain intervals. The organisation should collect data and
analyse them to understand their own operations.
The data collecting in self assessment for business excellence consist of

both quantitative as well as qualitative data
In BSC, only quantitative data is collected.

38
5
Six Sigma Philosophy
38
6
Six Sigma is primarily a management philosophy that attempts to improve upon customer
satisfaction to near perfection. Six Sigma is a smarter way to manage a business or a
department by managing with facts, figures and data
The objective of Six Sigma is to drive process improvements by focusing on defect elimination
rather than creating and improving products/services that result in a very small number of
defects.
Six sigma is equal to 3.4 defect parts per million opportunities.
This suggests that a Six Sigma company has as few as 3.4 bad customer experiences for
every million opportunities/ interactions.
As per Pande (2002) and Ecke, Six sigma efforts target the main areas of improvement as
follows:
1. Improves customer satisfaction.

2. Reducing cycle time.
3. Reducing defects
38
7
It also has three critical success factors (CSFs):
• Strategic component
• Tactical component
• Cultural component
As per Ecke, the cultural component is most important as
“cultural acceptance of change” or
“resistance to change”
is the single most dominant factor which broadly confronts
all of us in the improvement process.
38
8
There are five main break through strategies of Six Sigma philosophy
(DMAIC) as follows :
1. D- Define the goals of the improvement activity
2. M- Measure the existing system
3.A – Analyse the system to identify ways to eliminate the gap between the
current performance or process
4. I- Improve the system
5. C – Control the new system
There are 3 more parameters like recognize, standardize and integration.
The improved system may be institutionalized by modifying compensation and

incentive system, policies , procedures, MRP, budgets, operating instructions etc
38
9
Quiz
Quiz Time
Q1 . Fundamental re-designing and re-thinking of

business processes to improve critical measures
such as quality, speed, cost and customer
satisfaction are called :
a. Differentiation
b. Re-engineering
c. Target performance
d. Six Sigma
Quiz Time
Q1 . Fundamental re-designing and re-thinking of

business processes to improve critical measures
such as quality, speed, cost and customer
satisfaction are called :
a. Re-engineering
Quiz Time
Q2 . The learning is fundamental to Balance scorecard design

True or False
TRUE
Putting the Balanced Scorecard to work
What looks like a giant spaceship in Cupertino, California is actually Tech Giant Apple’s new
Headquarters
Example
• Apple Computer developed a balanced scorecard to focus senior

management on a strategy that would expand discussions beyond
gross margin, return on equity, and market share.
• A small steering committee, intimately familiar with the deliberations
and strategic thinking of Apple’s Executive Management Team, chose
to concentrate on measurement categories within each of the four
perspectives and to select multiple measurements within each
category.
• For the financial perspective, Apple emphasized shareholder value;
• For the customer perspective, market share and customer satisfaction;
• For the internal process perspective, core competencies; and
• For the innovation and improvement perspective, employee attitudes.
Apple’s management stressed these categories in the following order

Example
1. Customer Satisfaction: Historically, Apple had been a technology-
and product-focused company that competed by designing better
computers.
Customer satisfaction metrics were introduced to orient

employees toward becoming a customer-driven company.
J.D. Power & Associates, a customer-survey company, now works for

the computer industry. However, because it recognized that its customer
base was not homogeneous, Apple felt that it had to go beyond J.D.
Power & Associates and develop its own independent surveys in order
to track its key market segments around the world.
2. Core Competencies:
Company executives wanted employees to be highly focused
on a few key competencies: for example,
• user-friendly interfaces,
• powerful software architectures and
• effective distribution systems
However, senior executives recognized that measuring
performance along these competency dimensions could be
difficult.
As a result, the company is currently experimenting with
obtaining quantitative measures of these hard-to-measure
competencies.
3. Employee Attitude : Commitment and Alignment:
• Apple conducts a comprehensive employee survey in each of
its organizations every two years; surveys of randomly selected
employees are performed more frequently.
• The survey questions are concerned with how well employees
understand the company’s strategy as well as whether or not
they are asked to deliver results that are consistent with that
strategy.
• The results of the survey are displayed in terms of both the
actual level of employee responses and the overall trend of
responses.
4. Market Share:
Achieving a critical threshold of market share was important to
senior management not only for the obvious sales growth
benefits but also to attract and retain software developers to
Apple platforms.
5. Shareholder Value:
Shareholder value is included as a performance indicator, even though this
measure is a result—not a driver—of performance.
The measure is included to offset the previous emphasis on gross margin

and sales growth, measures that ignored the investments required today to
generate growth for tomorrow.
In contrast, the shareholder value metric quantifies the impact of proposed

investments for business creation and development.
The majority of Apple’s business is organized on a functional basis—sales,

product design, and worldwide manufacturing and operations—so
shareholder value can be calculated only for the entire company instead of
at a decentralized level.
The measure, however, helps senior managers in each major organizational

unit assess the impact of their activities on the entire company’s valuation
and evaluate new business ventures.
While these five performance indicators have only recently
been developed, they have helped Apple’s senior managers
focus their strategy in a number of ways.
The Balanced Scorecard at Apple serves primarily as a

planning device, instead of as a control device.
To put it another way, Apple uses the measures to adjust the

“long wave” of corporate performance, not to drive operating
changes.
The metrics at Apple, with the exception of shareholder value, can be driven
both horizontally and vertically into each functional organization.
Considered vertically, each individual measure can be broken down into its
component parts in order to evaluate how each part contributes to the
functioning of the whole.
Thought of horizontally, the measures can identify how, for example, design
and manufacturing contribute to an area such as customer satisfaction.
In addition, Apple has found that its balanced scorecard has helped develop
a language of measurable outputs for how to launch and leverage programs.
• Apple uses the scorecard as a device to plan long-
term performance, not as a device to drive operating
changes.
• The five performance indicators at Apple are

benchmarked against best-in-class organizations.
• Today they are used to build business plans and are
incorporated into senior executives’ compensation
plans
Keywords
• Balanced Scorecard : A model for performance evaluationthat

balances the performance
• Six Sigma :A set of techniques and tools for process improvement.
Six Sigma strategies seek to improve the quality of the output of a
process by identifying and removing the causes of defects and
minimizing impact variability in manufacturing and business
processes.
• Conflict: Difference of opinion between the groups
• Diversity : Unique properties of an entity
• Decentralization: Transfer of processes by assigning powers
• Goals : Targets to be achieved
• Targets: Business goals for achievement
• Strategic Objective : Business objectives set with required strategies
Summary – Balanced Scorecard
• Balanced Score Card is a scientific approach for

performance evaluation of a firm from the angle of all stake
holders.
• It provides complete picture of the employee as well as the
organizational performance.
• It facilitates users in determining the critical success factors

and performance indicators.
• It supports strategic review or analysis of the firm's
capabilities and performance.
• Keeping in view the whole organization and focusing on thefew

keyparameters help to create breakthrough performance.
• It integrates anddirects the performance and efforts from the lowest levels
in the organization to achieve excellent overall performance.
66
Session 7
Chapter No 8- Responsibility Accounting and

Transfer Pricing
Reshma Narang
Bathija
Chapter
No
No
4
1
Before we start …

lets
“recording” is
off at any time !!
4
1


cost advantage

Introduction
• Responsibility Accounting and Responsibility Centre

• Investment Centre
• Profit Centre
• Revenue centre
• Cost Centre
• Focus on ROI
• ROI
• Residual Value
• Economic Value added
• Factors affecting Responsibility Center’s performance
• Transfer Pricing
• Methods of transfer pricing
Responsibility Accounting and Responsibility Centre
Responsibility accounting:
• It is a tool that assists managers to identify costs, revenues and
profits of a product or process so as to arrive at appropriate
decisions and strategies.
• Responsibility accounting also provides information about costing

components and their controllability mechanism so as
to manage responsibility centre more effectively and
efficiently.
• It helps the management to control costs more

systematically through budgeting and budgetary control
process
41
4
Responsibility Centre
• A Responsibility Centre is a unit or division in a firm that is managed and

headed by a manager who is directly responsible for achieving its goals and
objectives
• A Responsibility centre is generally a sub set of a business. Responsibility

centre fixes responsibility and goals to the heads of the centers.
• The center disseminates available information and data from various

responsibility centers and the managers who have been responsible for such
centers.
• This information is shared with the concerned responsibility managers and

managers can use the required information in the interest of the center.
• The information is also used as a tool for motivating, incentivizing and

controlling the actions of each Centre manager.
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5
They can be classified as follows :

1. Revenue Centre – Centres assigned the task of managing
revenue : Eg Regional Sales office of a MNC
2. Investment Centre – It is responsible for costs, revenue and

investments
3. Profit Centre – Profit centre focuses on targeted profits of

the firm
4. Expenditure / Cost Centre – The responsibility of Cost

Centre is to keep vigil on incurrence of certain costs
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6
Responsibility Accounting and Responsibility Centre
41
7
41
8
Investment Centre
• It is a firm, basically responsible for controlling sales revenue and
operating costs and other assets that generates profit to the business.
• Investment center manager has to acquire professional competencies

to appropriately assess and manage the size of the investment and
profit variables.
• This center, significantly contributes to financial efficiency and economic

performance of the firm.
• The prime responsibility of this center is to make an analysis of various

risk factors and take suitable investment decisions to augment the
return on investments and thereby contribute to the growth of profit.
• The ultimate goal of this center is to maximize profit, given the overall
amount of investment required to generate the profit.
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9
Investment Centre - Example
General Electric is an appropriate example of establishing the effective

functioning of an investment center.
Infrastructure includes the sub-businesses of :

• Energy, Techno/Infrastructure
• GE Capital
• Home & Business Solutions and
• NBC Universal
NBC Universal includes the sub-unit business of Network Film, Television

Stations, Entertainment Cable, Television Productions/Sports/Olympic
Games and Theme Parks.
All these are, in real sense diverse portfolios of businesses that must be
evaluated in terms of the return on investment each provides.
42
0
Investment Centre - Example
General Electric is an appropriate example of establishing the effective functioning
of an investment center.
Infrastructure includes the sub-businesses of :

• Energy, Techno/Infrastructure
• GE Capital
• Home & Business Solutions and
• NBC Universal
NBC Universal includes the sub-unit business of:

• Network Film
• Television Stations
• Entertainment Cable
• Television Productions/Sports/Olympic Games and
• Theme Parks.
All these are, in real sense diverse portfolios of businesses that must be evaluated
in terms of the return on investment each provides.
42
1
Investment Centre
42
2
Investment Centre
• The very objective of a firm is to achieve pre-determined returns on
investments, known as ROI.
• In that direction, all the important responsibility centers are assigned important
components such as cost quality, revenue, expenses and investments in required
quantity, but all these components have an important element of ROI.
• While allocating resources, the top management often views these resources
as investment and expects appropriate returns on it.
• In practice, all the performance measurement systems and financial

performance evaluation systems in a firm are designed and developed
following certain fundamental principles, focusing ROI.
• Therefore, individual responsibility centers should contribute to ROI as per the

expectations of top management
• However, the extent of contribution of each center depends on allocation of

resources to individual center and nature of responsibility
42
3
Profit Centres
• It is an important responsibility center which the team division and its
head are responsible to control both the revenues and the costs of
the products or services the center is also responsible to ensure
that pre-determined goals to these components are achieved.
• A profit center is also an independent business.
• The only difference is that investment activities of the center are

monitored and controlled by the top management.
• The responsibility center manager has no role in investment

decisions.
Example: In a firm, the manager of one store in a chain of stores has

the responsibility for pricing, product selection, purchasing and
promotion, but he does not decide the level of investment in the store.
This particular store is responsible only to meet the goals to be
evaluated as fixed for the profit center.
42
4
Profit Centres contd…
• Motivation: A profit center also acts positively in motivating managersto
perform to their best capacity in areas under their control.
• Encourages Initiative: The managers are also encouraged to take

initiatives and innovations for bringing more efficiency in the functioning
of the center.
• Market Data: The profit center also helps the firm to make optimum use of
specialized market knowledge of the divisional heads.
• Strategizing and Decision Making: The profit center manager can take
decisions and make strategies based on their own experiences and
expertise and in the overall interest of the center.
• Performance evaluation: In the profit earning targets and achievements,

contribution margin, direct earnings by the division, income before taxes
and net income, etc., play important role, and all these components are
evaluated while measuring the performance of the profit center.
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5
Revenue Centre
• Revenue is defined in terms of amount realized from sales proceeds in an

organization.
• This is also one of the major activities in a firm as this is the revenue that
yields income to a firm.
• Revenue centers are the centers that are assigned the task of managing and
controlling revenue only and they are involved in controlling other units such
as costs, investment or profit.
Examples
Revenue center may include:
• Regional sales office of a national or MNC
• A restaurant in a large chain of restaurants or
• A book store in a general department store.
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6
Cost Centre
Cost is also a very crucial component in deciding the firm's performance as it directly
contributes to profit augmentation. Therefore, firms pay greater attention to the cost
aspect.
The cost centers are established to control and optimize the cost of operations in an
organization.
The prime responsibility of a cost centre where managers and staff are employed is to
control costs.
The cost centre is not responsible for controlling the revenues, profit or investment
activities of an organization. Eg : Firms where services are processed such as a
cleaning plant in a dry cleaning business, front desk operations in a hotel etc are called
as cost centers.
A cost centre’s performance should not be measured only by its ability to control
and reduce costs but factors such as Quality, Response time, ability to meet
production schedules , employee motivation, employee safety and respect for the
organization’s ethical and environmental commitments should also be
considered
42
7
There are different Responsibility centers which function

independently but work in close coordination with each
other.
They perform different types of responsibilities
Their focus is also different but goals are common
42
8
8.2.1 Features of Responsibility Centres - Coordination
Revenue Investment
Sr No Factors Cost Center Center Profit Center Center
Areas of Costs, Costs,
control under revenues and Costs, revenues revenues and
1 the center investments and investments Costs, Revenue investments
Revenues
Areas not Costs relative relative to
covered by to standard budgeted
2 the center cost revenue Investments NA
Performance
Accounting on other factors Performance on Profits relative to ROI relative to
3 measurements except cost critical success targeted profit targeted ROI
Performance
Performance on on critical
Non- critical success success
accounting Factors other factors other factors other
4 measures NA than Revenue than profit than ROI
42
9
8.2.3 Set up of Responsibility Centre
• The setup and structure of responsibility center is an important
parameter to ensure smooth functioning and effective discharge of
responsibilities assigned to different centers.
• This will also help the management in measuring the performance of
responsibility centers.
• These responsibility centers work toward the achievement of the
organizational goals.
• Therefore, an appropriate setup of responsibility centers helps the top
management ensure that strategies and decisions taken across the
centers are and standard.
• An important element of responsibility structure is accounting system, which
has to be self-sufficient to provide the required information.
43
0
• An efficient and effective responsibility accounting system proves to be a
useful tool for responsibility center heads so as to record the plans
performances and prove their efficiency in responsibility areas that have
been assigned to them.
• Evaluation of performance of a responsibility center is taken up by
analyzing its performance profit, revenue, investment and quality goals
set by the top management
• The performance evaluation methods of responsibility centers can be

categorized in the following three categories:
1.Parameters that measure efficiency of a responsibility center.
2.Process as an evaluation criterion.
3.Parameters to measure the effectiveness of the responsibility centers
43
1
• The efficiency measurement parameters have been developed based on
inputs received by the responsibility center in a particular time period
and output derived from such inputs.
• Obviously, higher output than budgeted will indicate efficiency.

Accordingly, the performance measurement relating to process isbased
on production process.
• This can be explained in terms of process as compared to the pre-

determined standards.
• The responsibility of a responsibility centre can be measured in terms of

achievement of goals and objectives.
• If the goals are achieved as per the expectations as budgeted, a center

is treated as effective
43
2
8.3 Focus on ROI
1. Return on Investment
2. Residual Income
3. Economic Value Added
43
3
Return on Investment (ROI)
This is the commonly used parameter to know the ROI.
The 2 major components to calculate this are :

• Total investments made by the firm
• Expected income
ROI is calculated as the ratio of investment center income

to invested capital as follows :
ROI = Income
Invested Capital
ROI of a firm can also be expressed as a simple function of its margin and turnover:
ROI= Income = Income * Sales Revenue

Invested Capital Sales Revenue Invested Capital
43
4
Residual Income
Residual Income is directly related to the investment to find out the

minimum rate of return.
It is Net Operating income the Investment center could earn above

imputed interest charges on Capital investment
This is calculated in quantitative terms
The imputed interest can be calculated as minimum rate of return
Residual Income = Investment Center profit – ( Investment center

invested Capital* imputed interest rate)
Example
43
5
Residual Income
Exampl
e
43
6
Exampl
•AeFirm has 3 divisions : R, S & T whose positions with
reference to Investment, income and residual income are as
follows:
Particulars R S T
Total Net Assets (TNA) (Rs lacs) 20 100 200
Net Income (NI) (Rs lacs) 5 25 50
Rate Of Return (on TNA) (Rate) 25% 25% 25%
Target ROR (Rate) 15% 15% 15%
Target Income (TI) (Rs 3 15 30
Lacs)
Residual Income (RI) (Rs lacs) 2 10 20
(NI – TI)
Exampl
• eFirm has 3 divisions : R, S & T whose positions with
A
reference to
Investment,
Particulars income and residual income
R are as follows:
S T
Total Net Assets (TNA) (Rs 20 100 200
lacs)
Net Income (NI) (Rs 5 25 50
lacs)
Rate Of Return (on TNA) (Rate) 25% 25% 25%
Target ROR (Rate) 15% 15% 15%
Target Income (TI) (Rs 3 15 30
Lacs)
• Residual Incomeimpact
Above shows (RI) of(Rs 2
various components on10Residual Income
20
lacs)
• (NI
ROR and Target ROR is same across all divisions
– TI)
• Yet, Residual Income, of the 3 divisions are different
• Residual Income helps to identify the division with maximum monetary
profit
43
9
Economic Value Added
Economic value added (EVA) represents after tax operating profits minus
annual cost of capital of the investment center.
This is also expressed in quantitative terms as follows :
Economic Value added =
Investment centre’s after tax operating profit

Less: (IC's Total Assets – IC’s Total Liabilites )* Weighted average cost
of capital
*IC: Investment Centre
44
0
8.4 Factors affecting Responsibility Center’s performance
The following factors may contribute to the efficient performance of
responsibility centres:
1. Coordination: A good amount of coordination among various responsibility centers
is essential, which will lead to better performance in terms f goal achievements by
individual responsibility collectively.
2. Integration of various activities among the responsibility centers is also

important. This will encourage responsibility center managers to perform
collectively.
3. Performance Evaluation: The monitoring and control systems have to be perfect

to evaluate the performance of the individual responsibility centers to assess their
performance and accordingly guide them to take suitable strategies for better
performance.
4. Transfer Pricing mechanism: There has to be proper transfer price mechanism

for transferring business transactions among the divisions. This should be
encouraged while keeping in view the interests of both the divisions, that is,
transferor and transferee divisions.
44
1
8.4 Factors affecting Responsibility Center’s performance
5.MIS: A firm should establish a well-organized management information
system (MIS) to collect and analyze all the related information data. The MIS
system should be very perfect to provide required information by MIS should
be collected on both financial and non-financial parameters.
6.Financial Evaluation mechanism: For financial evaluation of

responsibility centers, information and data on various components, such as
sales, inventories, production levels at different periods, fund flow, cash flow,
profit margins, return on investments, etc., need to be built up.
7.Control systems: There should be proper controlling system designed for

individual responsibility centers such as marketing, finance, administration,
etc.
8.Value Analysis system: A firm should develop a system of value analysis

also. Value analysis primarily focuses on systematic analysis and evaluation
of various activities.
44
2
44
3
8.5 Transfer Pricing
44
4
In practical business scenario, it happens that product
of one division is used as supportive raw material by
another unit within the same organization.
Here the price has to be determined as the division

supplying the product needs to be compensated for its
costs and also the profit margin and division buying the
product should be charged as the cost of the product.
The interest of both the product should be kept in view.
This is known as transfer pricing or internal price or

charge back price.
44
5
Following are the objective of transfer pricing:
1. It provides equal opportunity for arriving cost and revenue of a product

to transferor and transferee divisions. It motivates both the division
managers.
2. It provides useful information for evaluating the managerial and

economic performance of the divisions.
3. Since transfer pricing is done at corporate level, it is a notional amount

that is considered.
4. The profit moves internally between the divisions
5.The divisions supplying the product are dually compensated
44
6
For example, assume entity A and entity B are two unique segmentsof
Company ABC.
• Entity A builds and sells wheels, and entity B assembles and sells
bicycles.
• Entity A may also sell wheels to entity B through anintracompany
transaction.
• If entity A offers entity B a rate lower than market value, entity B will
have a lower cost of goods sold (COGS) and higher earnings than it
otherwise would have.
• However, doing so would also hurt entity A's sales revenue.
If, on the other hand, entity A offers entity B a rate higher than market
value, then entity A would have higher sales revenue than it would have ifit
sold to an external customer.
Entity B would have higher COGS and lower profits. In either situation, one
entity benefits while the other is hurt by a transfer price that varies from
market value.
44
7
8.5 Transfer Pricing contd….
However, while deciding transfer pricing policy, a firm
should have the following consideration:
1. The policy should take care of the mutual interest of
both the divisional managers.
2. It should not be detrimental to any of the divisions
3. It should be framed in such a way that real performance
of the divisions could be measured
4. It should not have subjectivity and allow lesser
discretion to the divisional managers
5. It should be framed keeping overall objectives of the
organization
44
8
8.5 Methods of Transfer Pricing
The issue of transfer pricing is slightly complicated as it has many
complications.
For example, a firm may be operating on full capacity and in that
case if other divisions of the organization want inputs from this
division, the supplying firm will lose revenue that is being received by
way of selling price, On the contrary, the buying division will prefer to
buy at variable cost.
For Eg: A division producing1 lakh units at full capacity where
Variable cost = Rs. 12 per unit and
Selling price = Rs. 20 per unit.
In this situation, if another division wants to buy from this division, it
will pay only Rs.12 per unit, this being the variable cost.
However, the supplying division will lose Rs. 8 as a contribution,
which would have been received by selling outside in the market.
44
9
8.5 Methods of Transfer Pricing – Implications
There is always a there is always a conflict between divisional

managers on the issue of deciding transfer price
Often, the transferor division will prefer to charge as high as

possible as transfer price and on the other side the transferee
division would like to pay as low as possible
45
0
1. Market based transfer pricing
Sometimes, the selling division has no customer outside in the market and
the entire production is supplied to the sister division.
There may also be situations that a division may have intermediate market,
that is, the whole product could be sold immediately to outside customers. In
such a situation, the selling division will have option to either sell outside in the
market or supply it to sister division.
Suppose the variable cost of product produced by division A is Rs. 200.
The division has got two options:
a) Either sell in the market at market price of Rs.300 or
b) Supply to division B.
The question here is at what price division A should supply to division B.
Division B can buy from market at Rs. 300 and can do further value addition
at additional cost of Rs. 400 in the product and then sell in the market outside
at Rs. 1,000 per unit.
45
1
1. Market based transfer pricing… contd
In this situation, let us understand the net impact on the firm's revenue.
Given this, we also we also presume that division B should pay Rs. 300, the
market price to division A.
The net impact is shown in Table 8.2.
Total to firm
Particulars Division A Division B Amt (Rs)
Selling Price 300 1000 1000
Value addition Cost 200 400 600
Transfer Price - 300 -
Profit 100 300 400
In the above case, total profit to the firm is Rs. 400 as contributed Rs.100 by division
A and Rs. 300 by divisionB.
We have made the following assumptions inthis case:
• Both the divisions have agreed to buy and sell at a price of Rs 300/-
• We have assumed that DivisionA is producing at full capacity
• There is no loss to DivisionA as it gets the market price from Division B
45
2
2. Market price and Price difference in intermediate market
In the earlier case, it was assumed that both the divisions can buy and sell at market
price of Rs 300 but in real situation, it may not so happen that the selling unit may sell
at a higher price than the market price and buying unit may buy at a lower price than
Rs 300/-.
Let us suppose that Division B is able to get the product from the market at Rs 250/.
The question arises whether division B should buy it from division A at a transfer price
of Rs. 300 as against the market price of Rs. 250.
Whether division A should bring down the transfer price to Rs. 250 per unit.
In such a scenario. we need to understand at what capacity the selling division is

producing. If it is producing at full capacity, then it will lose the contribution margin on
account of supplying to internal division.
In this case, if division A is producing at 100% capacity and supplies in the market
at Rs. 300, then any concession in transfer price than the marketing selling price will
be a loss. If division A supplies to division B at Rs. 250, there will be a direct loss of
Rs. 50 per unit to division A.
45
3
2. Market price and Price difference in intermediate market
On the contrary, if selling division is “working below the capacity”, the division will
not lose anything as long as it is able to recover the variable cost.
Since the variable cost in the above case is Rs. 200, division A can supply at any price
up to Rs. 200 and that will be the transfer price for division A.
However, it should not supply below Rs. 200 under any circumstances.
Therefore, price difference can happen in any range between variable cost and market
price if the division is not operating on full capacity.
45
4
8.5 Methods of Transfer Pricing - 3
3. Modified Market price:
There is another concept of modified market price, which can be set as transfer
price.
This can be explained in terms of a price to be set up for supply within the
organization at a market price giving allowances for marketing efforts and
transportation cost.
The principle is simple as there is no publicity cost and transportation costs
involved in the internal transfers. Therefore,
Modified market price = Market price - Allowances granted
on account of selling cost
For example: The market price of a product is Rs 200 and includes Selling and distribution cost
of Rs 20/- and Carriage cost of Rs 5/-
The modified market price in this case could be Rs 175/-
The essence of modified market price is thar the benefits on account of reduced selling cost
should be passed on to the transferee division
45
5
Cost-based transfer price:
This is a concept where selling division of the product supplies the goods
to the buying division at cost price foregoing the profit. Now, here again we
need to understand different types of costs to be considered for the
purpose of transfer price.
This can be discussed as follows:
a)Transfer price based on variable cost where selling division transfers to

buying division only at the variable cost. This can happen only in case when
selling division is operating at lower capacity. The selling unit in this case
does not cover even the operating cost, which includes fixed cost
component also. The profit is totallyforegone.
b)Absorption cost is also known as full cost. In this case, the selling unit
transfers the product to the selling unit recovering both the costs, that is,
variable cost and fixed cost
45
6
c) Standard Cost :
Transfer price may also be fixed at standard cost. As we know, every division has its
own standard cost. This is the approach that motivates employees to work efficiently.
The assumption under this approach is that increased cost more than standard cost
occurs on account of inefficiencies in the production process.
The transferee division should not be burdened with the cost of inefficiency
It may also happen vice versa where the actual cost may be lower than the standard
cost but benefits of efficiency should not be passed on to the buying division.
The buying division is charged only the standard cost.

Therefore, incentives for operating efficiently are enjoyed by the selling unit.
d)Cost plus approach: In this method, the selling division adds some additional
cost in the overall cost and becomes standard transfer price.
This is often added to the cost in terms of certain percentage.
This approach provides certain incentives to the selling division.
45
7
e) Negotiated transfer price is basically a process of bargaining between
selling division and buying division.
Both the division heads have open discussion on the price to be fixed
keeping in view:
• The market price
• Savings in terms of selling cost and transportcost,
•Capacity utilization and other considerations
and thus arrive at a mutual transfer price.
Both the divisions are also free to deal in open market.
The effects of this approach are that it may lead to certain conflicts
between divisions, the division head who has better negotiation skills may
get better advantage.
45
8
Not in text
International Taxation and Transfer Pricing book
45
9
Not in text
Transfer prices are used when divisions sell goods in intracompany transactions
to divisions in other international jurisdictions.
A large part of international commerce is actually done within companies as

opposed to between unrelated companies. Intercompany transfers done
internationally have tax advantages, which has led regulatory authorities to frown
upon using transfer pricing for tax avoidance.
When transfer pricing occurs, companies can manipulate profits of goods and
services, in order to book higher profits in another country that may have a
lower tax rate.
In some cases, the transfer of goods and services from one country to another
within an intracompany transaction can also allow a company to avoid tariffs on
goods and services exchanged internationally.
The international tax laws are regulated by the Organisation for Economic
Cooperation and Development (OECD), and auditing firms within each
international location audit the financial statements accordingly.
46
0
Not in text
46
1
Not in text
In the previous example, let us assume entity A and entity B are two
unique segments of Company ABC which is a Multinational.
Entity A builds and sells wheels, and entity B assembles and sells
bicycles.
Assume entity A is in a high tax country, while entity B is in a low tax
country.
It would benefit the organization as a whole for more of the Company

ABC's profits to appear in entity B's division, where the company will
pay lower taxes.
In that case, the Company ABC may attempt to have entity A offer a
transfer price lower than market value to entity B when selling them the
wheels needed to build the bicycles. As explained above, entity B would
then have a lower cost of goods sold (COGS) and higher earnings, and
entity A would have reduced sales revenue and lower total earnings.
46
2
Not in text
• Companies will attempt to shift a major part of such economic activity to
low-cost destinations to save on taxes.
• This practice continues to be a major point of discord between the various

multinational companies and tax authorities.
• The various tax authorities each have the goal to increase taxes paid in
their region, while the company has the goal to reduce overall taxes.
• Hence, Transfer pricing requires strict documentation that is included in

the footnotes to the financial statements for review by auditors, regulators
and investors. This documentation is closely scrutinized.
• If inappropriately documented, it can burden the company with added

taxation or restatement fees.
• These prices are closely checked for accuracy to ensure that profits are
booked appropriately within arm's length pricing methods and associated
taxes are paid accordingly.
46
3
International Transfer Pricing - Synopsis
• Regulations on transfer pricing ensure the fairness and accuracy of

transfer pricing among related entities.
• Regulations enforce an arm’s length transaction rule that states that

companies must establish pricing based on similar transactions done
between unrelated parties. It is closely monitored within a company’s
financial reporting.
• Cross border transfer pricing impacts profits due to savings in

Customs duty
• Outsourcing decisions could be facilitated through transfer pricing
• Internationally, Transfer pricing has tax advantages
46
4
Quiz
Quiz Time
Q1 . ------------------- center is responsible not only

for profits, but also for the return on investments
Revenue Center
Investment
Center Profit
Center
Quiz Time
Q1 . ------------------- center is responsible not only

for profits, but also for the return on investments
Investment
Center
Quiz Time
Q2 . If a Subsidiary or affiliated company sells goods

or services to the -------------- company, the price charged for
such services is called as transfer price
Holdin
g
Exampl
•eXYZ Firm has different divisions.The divisionAhas been meeting its require-
ments of some components from Division B.
• Recently Division B increased the price of component to Rs. 3.
• The Division A had a second thought and decided to procure the
component requirements of 10,000 components per annum from outside
suppliers.
• The component can be purchased for Rs. 2.50 in the market. Division B
expressed its inability to supply the component at Rs. 2.50 per unit. This
will affect the profits of Division B.
• The following data and particulars are available in respect of Division B:
Installed capacity 50,000 units
Expected level of activity 45,000 units
Expected transfer to DivisionA 10,000 units
Exampl
e Level of Activity 45000 units 50000 units
Cost of Production: Amt (Rs) Amt (Rs)
Direct Materials and Overhead 67,500 75,000
Variable Production overheads
Supplies 9,000.0 10,000
Indirect Wages 13,500.0 15,000
Handling costs 4,500.0 5,000
Fixed Production Overheads 1,08,000.0 1,08,000
Total 2,02,500.0 2,13,000
1. If Division B has no other alternative to utilize the facilities, will it be

appropriate that Division A buys the component from the market @
Rs 2.50 per component?
2. Analyse the situation if the market price of the component falls to Rs
1.80 per component and Division B has no alternate to utilise the
facilities. Will it be in the interest of the organisation to buy the
component @ Rs 1.80 from the market ?
Solutio
n
Assessment of variable cost per unit Amt (Rs)
Direct Materials and Overhead 75,000
Supplies 10,000
Indirect Wages 15,000
Handling costs 5,000
Total Variable cost of 50000 units 1,05,000
Variable Cost per unit = 105,000 / 50,000
= Rs 2.10
Solutio
n
Assuming that the Division A procures the component from market @ Rs 2.50
Purchase Cost : Amt (Rs)

10000 units @ Rs 2.50 25000
Division B's savings in variable costs:
10000 units @ Rs 2.10 21000
Net Cost to the Firm 4000
The choice of buying the component from the

market @ Rs 2.50 will not be in favour of the
firm
Solutio
n
Assuming that the Division A procures the component from market @ Rs 1.80
Purchase Cost : Amt (Rs)

10000 units @ Rs 1.80 18,000
Division B's savings in variable
costs:
10000 units @ Rs 2.10 21,000
Net savings to the Firm -3,000
In this scenario, the firm will have an advantage of Rs

3,000/-
Keywor
ds
• Responsibility Accounting: Accounting systems
and procedures developed based on
responsibility concept.
• Responsibility center: The divisions/units set up
assigning different responsibilities for better
performance.
• Cost Center: A division responsible to manage cost
targets
• Revenue center : A unit responsible for managing
revenues
for the firm
• Profit center: A division exclusively responsible for
meeting targeted profits of the firm
• Investment center: A division responsible for
assessment of
investment in resources
• ROI : Return on investments
Keywor
ds
Weighted average cost of capital: Compounded cost of
capital based on proportion of different cost components
Performance evaluation: A mechanism for performance
assessment based on responsibilities assigned to each unit.
Residual Income : Net operating income
Transfer price : The price of a product charged on inter-
division
transfer of products in the same organisation
Cost Plus : Transfer price that includes total cost plus
certain percentage of profit
Absorption cost : The cost that includes total fixed and
variable
costs
Standard cost: A pre-determined cost based on certain
standards
Negotiated price: Transfer price decided through open
Summa
ry
• There is no foolproof method to decide the Transfer
price
• There are pros and cons of different approaches where

one is favorable to selling division but unfavorable to
buying decision.
• In practice, market-based transfer price

mechanism is considered to be an appropriate
approach.
70
Session 8
Chapter No 9- Financial Statement Analysis
Reshma Narang
Bathija
Chapter
No
No
4
8
Before we start …
lets
“recording” is
off at any time !!
4
8
Introduction
• Accounting Statements and Financial Analysis
• Important factors impacting communication of useful
information
• Information analysis
• Ratio analysis of financial statements
• Advantages of financial ratio analysis
• Limitations of financial ratio analysis
Numbers need not scare you …. They tell a lot !
Economic Times 18 Nov 2020 :

…. on a month-on-month basis, core inflation has gone down from an
annualized rate of 6% to about 3% in the last one month.
4
8
Accounting statements and Financial analysis
• “Accounting” records the various transactions in a period

• These are summarised into financial statements – viz:
• Profit and Loss A/c
• Balance Sheet and
• Cashflow
• Beyond the periodic presentation of the summary, different
stakeholders (based on their knowledge and requirement)
require to have better understanding of the Company
• Investors and analysts employ ratio analysis to evaluate

the financial health of companies by scrutinizing past
and current financial statements.
4
8
• Comparative data can demonstrate how a company is

performing over time.
• This data can also compare a company's financial standing

with industry averages while measuring how a company
stacks up against others within the same sector.
• Financial analysis is carried out to carry out to assess the

financial position of a firm based on accounting
statements.
• Different stakeholders analyse data in different ways

Important factors impacting communication of useful
information
• Accounting : Primary objective to provide useful
information for decision-making
• This can be achieved by knowing :
• Users
• Types of decisions that users will need to
make
• Users
• Banks and Financial institutions,
• Creditors,
• Stockholders,
• Potential investors and
• Regulatory agencies
9
Important factors impacting communication
of useful information
• Types of decisions that users will need to
make
Type of stakeholder Decision Parameters
Shareholder Value creation Profitability, P/E
Potential Investor Future gain Market share,
Industry averages,
profitability ratios
Supplier Getting payment Liquidity Ratio
New large customer Ensuring Company is Net Worth, Solvency
able to survive and ratios
complete
Management All of the above ++ All of the above
Ratio analysis of financial statements
Financial
Statement
s
Revenue Expense Assets Liabilities Capital
s s
Ratio analysis
Tools for Trend analysis
analysis
Common Size
statements
49
0
Ratio analysis of financial statements
1. Income Statement Ratios

• Operating Profit Ratio
• Profit margin percentage
• Gross profit percentage
2. Balance sheet ratios
• Current ratio
• Debt/equity (D/E) ratio
3. Inter-statement ratios
• Return on investment(assets)
• Return on investment(equity)
• Investment turnover ratio
• Inventory turnover
• Accounts receivable (NR) turnover
• Earnings per share(EPS)
• Price earnings (P/E) ratio
49
1
Areas of “Capital” Ratios Used
Management
ASSETS
Current Assets Current Ratio
Quick Ratio
Inventory
Ratio t written in
Fixed Assets Fixed Assets Turnover Ratio textbook
N
o
LIABILITIES
Current Liabilities Current Ratio
Long Term Liabilities Debt / Equity Ratio
CAPITAL
Contributed Capital EPS
Book Value per
shares P/E Ratio
Net Income Return on Investments
(assets) Return on 49
2
Important financial ratios and their interpretation
49
3
CURRENT RATIO
Current
Current Ratio Assets
Current
= Liabilities
•This ratio is of critical importance.
• It provides an indicator of the ability to pay short-term debt.
• If CL > CA, then, the company may be unable to pay its current debts.
•Inadequate working capital = one of the major reasons why businesses fail.
•Current Ratio > 1 : A general rule of thumb is that the ratio should be at
least 2:1 (can differ based on case to case)
49
4
CURRENT RATIO contd…
From a management point of view, the real issue is not the ratio itself but
the factors that create the ratio. ·
1. What are the decisions that directly affect current assets?
2. What are the decisions that affect current liabilities?
• Concerning current assets, the major elements are cash, Accounts
Receivables (A/R) and inventory. The decisions that affect current assets
most directly were discussed in earlier chapters. A/Rs are created by the
use of credit terms and inventory levels are largely determined by order
size and safety stock decisions.
• Quick Ratio (Cash + Receivables / Current Liabilities) is a better measure
of short-term liquidity than current ratio
49
5
DEBT EQUITY RATIO
Total
Debt Equity
Debt Equity
Total
Ratio
• The= D/E ratio is a measure of the risk assumed in a given

business.
• As the amount of debt capital increases relative to equity
capital, the greater is the risk.
• The term "risk" here refers either to the risk of not being able
to repay principal or the ability to pay interest.
• Studies have shown that a major factor for businesses failing or
going into bankruptcy is because these businesses assumed
too much debt and have yet to earn a satisfactory profit or no
profit at all
49
6
DEBT EQUITY RATIO
Total
Debt Equity Debt
Ratio Total
Equity
• A high=D/E ratio can mean that when a company issues debt
instruments, it may have to pay a much higher interest rate
(since higher risk = higher interest)
• It is in the interest of the company both in the short run and

in the long run to keep the relationship of debt to equity in balance,
consistent with current profit performance
49
7
Operating Ratio
Total
Operating Ratio Expenses
Sale
= s
• This ratio simply indicates what percentage of sales must be
used to pay the expenses
• The ratio standing alone is probably of little value. There are two
ways this ratio can be made useful.
• First, the company should compare the operating ratio to past

ratios. In this manner, a possible trend can be detected.
49
8
Operating Ratio
Total
Operating Ratio Expenses
Sale
= s
• If the operating expenses, as a percentage of sales, are
increasing from year to year, then reasons for the
increases should be found.
• Secondly the company should compare its operating ratio

to other companies in the same industry.
• If other similar companies have a lower ratio, then an

investigation into the causes of the company's higher
ratio should be undertaken.
49
9
Net Income
Profit Margin % =
Sales
Profit margin is simply another term for net
income.
The DuPont ROI formula makes use of the

ratio:
DU PONT ROI x
Investment Sales
Sales Earnings
=
• This ROI formula may be read as investment turnover times profit
margin percentage
50
0
Profit Margin Ratio
Net
Profit Margin % Income
Sale
= s
• In the past, many companies looked upon the profit margin
percentage as a measure of operating success.
• However, a company with the higher profit margin
percentage did not necessarily have the higher rate of
return.
• The weakness of the profit margin percentage standing
alone is that it fails to take into account the amount of
investment that is necessary to achieve a satisfactory rate of
return
50
1
• There are a number of important inventory decisions, as discussed
previously.
• The periodic analysis of inventory is important.
• One of the tools that is commonly used is the inventory turnover ratio
which may be defined as follows
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory
• This ratio may be applied to either finished goods or raw materials.

• One of the important questions is: what is the ideal turnover rate?
• Ingeneral, it is believed the higher the turnover rate the better has been
the control of inventory by management.
• A rapid turnover of inventory is thought to be generallydesirable.
• However, a higher turnover rate would need to be comparedwith purchasing
discount.
50
2
Inventory Turnover Ratio
Cost of Goods
Sold
Suppose a firm has : Average
Inventory
Annual Revenueof 20,00,000
Cost of Goods Sold 15,00,000
Average Inventory 5,00,000
the InventoryTurnoverRatio = 15,00,000 / 5,00,000 = 3 Error in Table 9.4 in text
InventoryTurnoverRatio can also be expressed in days as follows : book
Inventory Turnover Ratio Inventory Turnover in Days

(365/ITR)
1 365
2 182
3 122
5 73
6 61
50
3
Inventory Turnover Ratio
Cost of Goods
Sold
Suppose a trading firm has the belowAverage
Inventory
options : Annual Sales (nos) 20,000 @ Rs 20/- per
unit
Unit Purchase price (upto 10,000 units per
order) 10
Unit Purchase price (>10,001 units per 6
order) Particulars Small orders Large Orders
Units purchased / sold 20,000 20,000
Purchase orders in a year 5 2
Cost of Goods 2,00,000 1,20,000
Revenue 4,00,000 4,00,000
Gross Profit 2,00,000 2,80,000
Average Inventory 20,000 30,000
Inventory Turnover 10 4
Here, we see that lower Inventory Turnover Ratio is more profitable due to economy 50
4
in cost
Accounts Receivable (A/R) Turnover
Credit
Accounts Receivable Sales
Turnover Ratio Average Accounts
= Receivable
• This ratio is applied to Accounts Receivables (AR)
• As we know, AR assets are very liquid (firm is about to receive
cash from all of them)
• In general, AR Turnover Ratio is converted into days to make it
more objective to review and control
• Relating to budgeted days, a lower number of days
outstanding means the collections are being made earlier
than planned and vice versa
50
5
Accounts Receivable (A/R) Turnover
Credit Sales
Accounts Receivable Turnover Ratio =
Average Accounts
Suppose a firm has : Receivable
Annual Credit Sales of 20,00,000

AverageAccounts Receivables 4,00,000
the Accts Receivable Turnover Ratio = 20,00,000 / 4,00,000 = 5
InventoryTurnoverRatio can also be expressed in days as follows :
= 365 / ITR
= 365 / 5
= 73 days
If the credit policy of the firm is to collectbills in 60 days, the firm is not collecting the
receivables as per plan (it is worsethan planned)
50
6
Solvency Ratio
Shareholders
Solvency Funds x
Ratio Total 10
Assets 0
• Solvency
= Ratio measures liquidity for a long period of time
• It is a measure to absorb losses and unforeseen swings in

market
• Predicts ability of a firm to remain in business over a long

period
50
7
Interest Coverage Ratio
Net Income + Tax + Interest

expense
Interest Coverage Ratio =
Interest expense
• This ratio is applied by Lenders to ascertain ability to pay

interest in a particular year
• Interest expenses and tax on income, both are added back
to the
income to arrive at the net surplus
• This ratio is usually calculated by Banks and other lenders to
assess if the firm has adequate income to serve interest
payment obligations
• While desired Interest cover is 3x, cover more than 7 times
50
is considered very safe 8
• We just saw an important ratio from Lenders’

perspective
• Do you feel Lender is interested only in interest ?
The Lender also wants his principal back !
Debt Service Coverage Ratio provides the

answer !
50
9
Debt Service Coverage Ratio
PAT + Tax + Interest + Depreciation

Debt Service Coverage Ratio =
Principal and Interest
• This ratio is applied by Lenders to ascertain ability to pay

principal and interest in a particular year
• Desired cover is 2.0 x
• Higher the ratio, lower is the risk of bank not being repaid
51
0
Listed Company’s performance assessment
• In a listed company, 2 ratios are used to measure

performance
• EPS are :
(Earnings per share)
• P/E Ratio (Price to Earnings per share ratio)
• Earnings Per Share (EPS)
• Indicates higher profit per share / efficient capital productivity of a
company
• Computed as : PAT – Preference Shares
Earnings Per dividend
Share = Number of Equity
shares
• Impacts
• Ability of Company to pay dividend (or Dividend payout ratio)
• Market price of the stock (consequently valuation of the Company)
• Attracts potential investors
51
1
P/E Ratio (Price to Earnings per share ratio)
• Ratio of the market price to the EPS

• It demonstrates the sentiment / expectation in the market for the stock’s
value
Market Price of Stock

• Computed as : P/E
EPS
=
• P/E can be compared with other companies in the same
country /
sector
51
2
• P/E Ratio (Price to Earnings per share

ratio)
Screenshot
for Tech
Mahindra
price and
data
51
3
51
4
Advantages of financial ratio analysis
• Effective mechanism to compare financial

statements across years
• Numerous ratios can be computed from the
published accounts
• Firm can fix quantifiable objectives for growth
• Firm can identify areas to be strengthened
• Can help to measure operational efficiency,
liquidity, solvency, profitability trends
• Can be a guide for strategic decisions which will
impact future
51
5
Limitations of financial ratio analysis
• Effectiveness is dependent on the extent / accuracy of

data available
• A single ratio cannot be the basis for future course
of action – will need to be in conjunction with other
ratios and analytics
• It does not consider qualitative factors
• It may not be appropriate to use one ratio across
different industries
51
6
Quiz
Quiz Time
Q1 . An aircraft company would most likely have:
• A high inventory turnover
• Low profit margin
• High volume
• A low inventory turnover

Quiz Time
Q1 . An aircraft company would most likely have:
• A low inventory turnover

Quiz Time
Q2 . Which of the following is NOT a profitability

ratio?
a. Pay out Ratio
b. Profit Margin
c. Times interest earned
d. Return on ordinary shareholder’s equity

Quiz Time
Q2 . Which of the following is NOT a profitability

ratio?
c. Times interest earned

Financial Statements of Aryans Associates (Rs in
Profit and Loss Account Rs. Rs. Lacs)
Sales – Credit 12.00
Sales – Cash 3.00
Total Sales 15.00
Opening Stock 1.75

Add : Manufacturing Cost 10.75
Less : Closing Stock 1.50
Cost of Goods Sold 11.00
Gross Profit 4.00
Other Income 0.09
Administrative Expenses 0.35
Selling Expenses 0.25
Depreciation 0.50
Interest 0.47
Income Tax 1.26 2.83
Net Profit 1.26
Lacs)
LIABILITIES Rs. Rs. ASSETS Rs. Rs.
Equity Shares of Rs 10 each 3.50 Plant and Machinery 10.00
10% Preference Shares 2.00 Less : Depreciation 2.50
Reserves and Surplus 2.00 Net Plant and Machinery 7.50
Long Term Loan (12%) 1.00 Goodwill 1.40
Debentures (14%) 2.50 Stock 1.50
Creditors 0.60 Debtors 1.00
Bills Payable 0.20 Prepaid Expenses 0.25
Accrued Expenses 0.20 Marketable securities 0.75
Provision for Tax 0.65 Cash 0.25
TOTAL 12.65 TOTAL 12.65
Reserves working (Rs in
Lacs)
Reserves Rs. Rs.
Opening Reserves for the year 1.465
Add : Net Profit for the year 1.260
Sub-total 2.725
Less : Preference Dividends 0.200

Less : Equity Dividend 0.525 0.725
Closing Reserves for the year 2.000
We have been informed of the Share Price of the company on 31st

March as Rs 45
On the basis of the information, please compute the Financial Ratios

Lacs)
Balance Sheet - LIABILITIES Rs. Rs. Balance Sheet - Rs Rs
ASSETS
Equity Shares of Rs 10 each Plant and .
10.0 .
Share
10% Preference Shares 3.5 Machinery
Less : 02.5
-holders
0 2.0 Depreciation 0
Reserves and Surplus ’Fund Net Plant and 7.5
0 s
Long Term Loan (12%) 2.00
Long
Machinery
Goodwil 0
1.4
Debentures (14%) deb
term 1.0 lStoc 0
1.5
0 t 2.5 kDebtor 0
Creditors 1.0
0 0.6 sPrepaid 0
Bills Payable Curren 0.2 Curren
0 0.2 Expenses 5
Accrued Expenses tLia Marketable 0.7 t
0 b 0.2 securities 5 Assets
Provision for Tax 0.65 Cash 0.2
0 5
TOTAL 12.65 12.6
TOTAL 5
Working Notes :
Capital Employed = Equity + Preference Shs + Reserves + LT Loan +
Debentures
= 3.50 + 2.00 + 2.00 + 1.00 + 2.50
= 11.00
Shareholders’ Funds = Equity + Preference Shares + Reserves = 7.50
(Rs in
Profit and Loss Account Rs. Lacs)
Rs.
Sales – Credit 12.00
Sales – Cash 3.00
Total Sales 15.00 Working Notes :
Opening Stock 1.75 PBIT + 1.26 + 1.26 + 0.47 =

Add : Manufacturing Cost 10.75 2.99
Less : Closing Stock 1.50
PBIDT = 2.99 + 0.50 = 3.49
Cost of Goods Sold 11.00
Gross Profit 4.00 COGS = 11.00
Other Income 0.09
Operating Expenses =
Administrative Expenses 0.35 COGS + Admin + Selling +
Selling Expenses 0.25 Dep
= 11.00 + 0.35 + 0.25 + 0.50
Depreciation 0.50
= 12.10
Interest 0.47
Income Tax 1.26 2.83
Net Profit 1.26
Example
Current Current Assets = 375000= 2.27 : 1

Ratio
Current Liabilities 165000
Quick Ratio Current Assets - = 1.21 : 1

Inventories 20000
0
Current Liabilities - Bank
Overdraft 16500
Debt-Equity Long Term Debt = 350000=
0 0.467 : 1
Ratio Shareholders' Funds 750000
Example
Interest PBIT = 126000 + 47000 + = 6.36 times

126000
Coverage Interest 47000
Make this with dep add
back
Fixed Charge PBIDT = 349000 = 5.20 times

Coverage Interest + Preference Dividend 47000 + 20000
Example
Inventory Cost of Goods Sold = 1100000 = 6.8 times

Turnover
Average Inventory (175000 + 150000)/2
Debtors Credit Sales = 1200000 = 12 times

Turnover
Debtors 100000
Average 360 days = 360 = 30

Collection days
period Debtors Turnover 12
Example
Gross Sales - Cost of Goods Sold = 1500000 - 1100000 x = 26.67%

Profit x 100 100
Margin Sales 1500000
Net Profit PBIT x 100 = 126000 + 126000 + 47000 x = 19.93%

100
Margin Sales 1500000
Operating
Ratio :
Operating Expenses x = 1100000 + 35000 + 25000 + 50000 = 80.67%
100 x 100
Sales 1500000
Example
Return on Net Profit before Int and Tax x = 299000 x 100 = 27.18%
100
Capital Capital Employed 1100000
Employed
EPS Net Profit - Preference = 126000 - 20000 = 3.03

Dividend
No. of Equity Shares 35000
Return on Net Profit x 100 = 126000 x 100 = 16.8%

Shareholders' Shareholders' Funds 750000
Equity
Example
Price /
Earnings Market Price = 45 = 14.85
Ratio times
EPS 3.03
Earning Yield EPS x 100 = 3.03 x 100 = 6.73%

Market Price 45
Keywords
Accounting statements: The statements indicating the position of

income, expenditure, assets and liabilities are called accounting
statements.
Financial analysis: The analysis made based on accounting statements
to assess the performance of a firm is known as financial analysis
Current ratio: A ratio indicating relationship between current assets and
current liabilities
Cash flow statement: A statement indicating the cash outflows and
inflows in a particular time period
 Inventory turnover ratio: It indicates the number of times a firm’s
inventory has
been sold during the year
Keywords
 Debt-equity ratio: The extent of debt of a firm in comparison

to it’s
equity
Price earnings ratio: Number of times the current market
price of a share in comparison to EPS
 Earnings per share: The net profit earned per share
Interest coverage ratio: A ratio that indicated the interest
payment capacity of a firm on borrowings
 DSCR: The capacity of a firm to service it’s debt obligation
57
It’s the last session……
Thanks for being a super class !
Hope it has been a good learning ….
All the best for your future !

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Strategic Cost Management

Chapter No 1- Cost-Volume-Profit Analysis

Reshma Narang Bathija

• Introduction to Cost Accounting, Management

• How to increase sales ?

• How to reduce Costs ?

Most of the times, these decisions involve trade-

Management accounting assists Managers in

Monitoring and Facilitates decision-

The measurement of full costs serves different purposes and is used in

2.Monitoring and Control: Another important use of management accounting

3. Facilitates Decision Making: It generates appropriate and required information

The flow of goods, services and information enhances the

• It analyses different cost elements by allocating them in a

• Based on an in-depth analysis of costs, revenue, capacity

• It also suggests if various strategies can make a product

Financial Accounting is Reporting

It is the cost of acquiring raw materials to be used for a finished

It can be direct material that is consumed in the manufacturing

The expenses on cotton waste, lubricating oil, etc., can be

The amount paid to workers as wages and salaries are classified as

This involves all kinds of workers, skilled and unskilled.

There is another component which may include salary/wages being paid

Wages salaries paid to supervisors, security guards, purchase and store

The amount spent for completion of manufacturing

Direct expenses can be directly allocated to the specific

The expenses that cannot be directly attributable to a

Fixed Vs Variable Costs

• The peculiarity of fixed cost is that the total

• Examples of fixed costs are depreciation,

• If the production volume is higher, the variable cost will

• The features of variable costs are that per unit variable

• Some of the examples of variable costs are direct

CVP analysis is a managerial accounting technique, which is

• The equation that is used in CVP analysis is derived as

o Profit= Sales – Expenses

(Here, Total cost= variable costs + fixed costs)

Profit + Fixed costs = Sales – Variable costs

Profit + Fixed costs = Units sold x (Selling Price – Variable

This is the basic equation for profit which can be

• Cost price Rs 12,000 per unit

Total Cost 110000 530000

However, significant change is seen in Profit / Loss

• Contribution (C) can be defined as the profit (P) before the

• Equation : Profit = Contribution - Fixed costs

• Marginal Cost Equation:

(where, Total Cost = Total Variable cost + Total Fixed cost)

Total sale= Total Variable cost + Total Fixed cost + Profit

Contribution = Total Fixed cost + Profit

Total sale= Total cost

Expenses Per Month

Ascertain Contribution per

Contribution per pc 44.85% 4395

Contribution % Sale Pcs Variable Fixed Profit/Loss

Large and complex businesses have adopted “Contribution

• Quantity at which no profit and no loss is called

• BEP (No of units) = Fixed Costs

• BEP (Sales Value) = Fixed Costs

Contribution per pc 44.85% 4395

Contribution % Sale Pcs Variable Fixed Profit/Loss

BEP in units 50.056883

MOS is the sales level beyond the BE point wherefrom the