Management Accounting

Sandeep Gokhale
Jamnalal Bajaj Institute
University of Mumbai

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 Syllabus
• Relevance & Scope • Balance Score card
• C-V-P Analysis • Learning Curves
• Cost Classification • Profit Center Mgmt
• Marginal Costing • Transfer Pricing
• Standard Costing • Over Head Allocations
• Budgeting • Cost Sheet Analysis
• Inventory Valuation

2
 References

• Charles Hongren
• Khan & Jain
• S.C.Maheshwari
• Banerjee
• Robert Kaplan

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 FINANCIAL MANAGEMENT
Objective: Create share holder value
Methodology: Capturing of value at all Levels.
Scalability of Operations
Business Process restructuring
Enterprise resource management.
Vertically integrated operations.
Customer relationship Management
Effectiveness: Proximity of gross profit to net profit
Maximisation of EVA
4
EV / EBIDTA multiple
 Financial Management – an overview

Business environment

Planning Policies&Decisions
(Management Accounting)

Restructuring
Financial Investor Wish
Markets Resource mobilisation List
Treasury

Control&Information
( Audit & Taxation)

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Valuation Technique
 Financial Decision Areas
• Investment analysis
• Working capital management
• Sources and cost of funds
• Determination of capital structure
• Dividend policy
• Analysis of risks & returns
• Treasury - interest / exchange rate swaps
• Restructuring of operations / term debt profile

• To result in shareholder wealth maximisation

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 PROFIT AND LOSS ACCOUNT

For the Period 1st April to March 31st

Income: Gross sales from Goods & Services

Less: Excise Duty
Net Sales
Other Income
Non operating Income
Total Income

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Expenditure: Raw materials consumed
Manufacturing expenses
Administrative expenses
Selling expenses
WIP +FG adjustment
PBIDT (Gross Profit)
Less: Interest
Less Depreciation
PBT (Operating Profit)
Less: Tax
PAT (net profit)
Gross cash accruals : PAT + Depn
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Net cash accruals : GCA - Dividend
 THE BALANCE SHEET
For the year ended March 31st 200...

Liabilities: Equity share capital

Reserves & Surplus
Term loan
Debentures
Fixed deposits
Other unsecured loans
Commercial bank borrowings
Creditors
Other current liabilities 9
Assets: Gross fixed assets
Less: Acc. Depn
Net Block
Investments
Currents Assets: RM Stock
WIP
F.G.Stock
Debtors
Cash in bank
Loans & Advances
Misc.. expenditure
Deferred expenditure 10
 MANAGEMENT ACCOUNTING
It is the process of Identification, Measurement,
Accumulation, Analysis, Preparation, Interpretation and
Communication of financial information used by management
to plan, evaluate and control an organisation and to ensure
appropriate use of and accountability for its resources.

It is thus the process of :

 Identification
 Measurement
 Accumulation
 Analysis
 Preparation and interpretation
 Communication
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Management accounting is for exercising internal control by the
management and hence companies follow different techniques,
methodologies to enable them to utilise the results obtained for
optimal benefit.

Management accounting is used to:

 Plan
 Evaluate
 Control
 Establish Accountability
 Short Term Business Decisions
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1. Financial accounting serves the interest of external users
while management accounting caters to the needs of internal
users.

2. Financial accounting is governed by the generally accepted

accounting principles while management accounting has no set
principles.

3. Financial accounting presents historical information while

management accounting represents predetermined as well as past
information.

4. Financial accounting is statutory while management

accounting is optional.

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5. Financial accounting presents annual reports while management
accounting reports are of both shorter and longer duration.

6. Financial accounting reports cover the entire organization while

management accounting reports are prepared for the organization as
will as its segments.

7. Financial accounting emphasises accuracy of facts while

management accounting requires prompt and timely
reporting of facts even if they are less precise.

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 DISTINCTION BETWEEN MANAGEMENT
ACCOUNTING AND FINANCIAL ACCOUNTING
MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING

1. PRIMARY USERS ORGANISATIONAL OUTSIDE AGENCIES

MANAGERS AT INVESTORS, GOVT.,
VARIOUS LEVELS. CLB, SEB ETC.

2. FREEDOM OF NO CONSTRAINTS CONSTRAINED BY

CHOICE OTHER THAN COSTS STATUTES
IN RELATION TO - TAX
BENEFITS OF - CLB
IMPROVED - SEB
MANAGEMENT
DECISIONS

3. BEHAVIOURAL CONCERN ABOUT BEHAVIOURAL

IMPLICATIONS HOW ASPECT IS
MEASUREMENTS SECONDARY.
AND REPORTS WILL PRIMARY OBJECTIVE
INFLUENCE IS COMMUNICATION.
DECISION MAKING.
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4. TIME FOCUS FUTURE PAST ORIENTATION
ORIENTATION

5. TIME SPAN FLEXIBLE / NEED LESS FLEXIBLE

BASED DAILY, YEARLY.
WEEKLY, MONTHLY,
YEARLY.

6. REPORTS DETAILED CONCERN SUMMARY REPORTS

ABOUT DETAILS OF - CONCERN WITH
DIVISIONS OF THE COMPANY AS A
ENTITY, PRODUCTS, WHOLE.
DEPARTMENTS.

7. INPUTS PREDETERMINED ACTUAL EVENTS

EVENTS

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 EXTRACT OF FACTORY COST SHEET

A. Direct materials consumed

= Opening Stock + Purchases - Closing Stock =________

B. Direct labour = ________

A+B = ________
(prime cost)
C. Factory overheads:
1. Indirect materials
2. Indirect labour
3. Factory rent, insurance etc
4. Depreciation for factory
5. Salaries & wages of supervisory staff
=_______ 17
D. = Opening WIP

E . = A+B+C+D = Factory cost of goods available for

manufacturing.

F. = Closing WIP

G. = E -F Factory cost of goods manufactured.

H. = Finished goods opening stock.
I. = G + H = cost of goods available for sale.
J. = Closing finished goods.
K. = I - J = factory cost of goods sold.

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 INCOME STATEMENT

Gross sales .........................

Less : Excise duty
Net sales ....................
Less : Factory cost of goods sold .............................
Gross manufacturing profit .........................................
Less : Selling & distribution expenses.
Add : Income other than sales.
PBIDT
Less : Depreciation
Less : Interest
Less : Tax
Profit after tax

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 METHODS OF COSTING

1. Job costing
- Batch costing
- Contract costing

2. Process costing

3 .Multiple costing

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 TECHNIQUES OF COSTING

 Marginal costing

 Absorption costing

 Standard costing

 Joint product costing

 By-product costing

 Activity based costing

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 CLASSIFICATION OF COSTS

Elements

Functional

Behavioural

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CLASSIFICATION OF COSTS BY ELEMENTS

 Direct materials
 Indirect materials
 Direct labour
 Indirect labour
 Factory overheads (variable)
 Factory overheads (fixed)
 Selling and distribution
 General administration
 Interest
 Depreciation

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CLASSIFICATION OF COSTS BY FUNCTIONS

 Sales
 Marketing

 Production

 Research & development

 Personnel

 Administration

 Staff welfare

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 CLASSIFICATION OF COSTS BEHAVIOURALLY

Variable costs : When costs change in direct proportion to

changes in volume, it is called variable costs. Variable cost vary in
proportionate with volume. Mathematically, a linear relationship could
exist between variable costs and volume.

Fixed costs : When costs remain non-variable (fixed) to changes

in volume, it is called a fixed cost. Fixed costs remain at the same
level irrespective of changes in volume.

Semi fixed /semi-variable costs : Costs which are partially fixed

and partially variable.

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 BREAK EVEN ANALYSIS

Cost-volume-profit (CVP) analysis :

The technique to study the behaviour of profit in response to
the changes in volume, costs and prices is called CVP analysis.
Break even analysis is the most widely known form of CVP analysis.

Break even point :

It is that point of sales at which total revenue is equal to total
costs. It is a no-profit, no-loss point.

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 BREAK EVEN FORMULA

F = Total fixed cost

V = Total variable cost
T = Total cost
S = Total sales

Total fixed cost

BEP(Units) = ---------------------
Unit contribution
where unit contribution = Unit sales - Unit variable cost.

Total fixed cost

BEP(Rs) = ---------------------- x Unit selling price.
Unit contribution

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•Margin of safety : The excess of actual or budgeted
sales over break even sales is called
margin of safety.

Budgeted sales - Break even sales

•Margin of safety ratio = ------------------------------------------
Budgeted sales
•Break even point is a function of fixed cost, unit selling price
and unit variable cost.

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 PROFIT VOLUME RATIO (P/V RATIO)

It represents the rate at which the company is

generating surplus in the financial system.

Contribution
P/V = -----------------
Sales

Break even analysis:

Scenario 1 : Company having a high P/V ratio but

also having high BEP.
Reason : Fixed cost is high.

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Scenario 2 : Company having high selling prices but
low P/V ratio, high BEP and a low M.O.S.
Reason : High variable cost.

Scenario 3 : Company having high selling price,

low variable cost, low M.O.S.
Reason : Low volumes.

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 PROFIT ANALYSIS

Impact of changing factors

Profits may be affected by the changes in the following

factors.

1. Selling price
2. Volume
3. Variable costs
4. Fixed costs
5. A combination of all or any of the above factors.

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UTILITY OF CVP ANALYSIS

1. Understanding accounting data.

2. Diagnostic tool

3. Provides basic information for profit improvement

4. Risk implications for alternative action.

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LIMITATIONS OF CVP - ANALYSIS

1. Difficulty in segregation of fixed and variable costs.

2. The assumption that total fixed costs would remain
unchanged over the entire range of volume is not valid.
3. The assumption of constant selling prices and variable
costs is not valid.
4. Difficult to use in a multi-product company.
5. It is a short run concept with a limited use in long
range planning.
6. It is a static tool.

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 MARGINAL COSTING

Marginal costing is also called as direct costing.

It is a system of segregating costs between fixed and

variable components and charging the product only the variable
cost. It comprises of the prime cost and variable overheads. It
highlights the concept of contribution margin, which is the
excess of sales over variable costs.

Contribution = U.S.P - U.V.C

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 ABSORPTION COSTING

Generally accepted conventional system of product costing and

external reporting. The basic premise on which this system
rests is that all costs, direct and indirect, should be charged to
the cost of goods in a given period.

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DIRECT COSTING VS. ABSORPTION COSTING

1. Sales equals production

PA = PD

2. Production exceeds sales

PA > PD

3. Sales exceeds production, 36

RECONCILIATION

Fixed cost Fixed cost

PD + allocable to - allocable = PA
closing to opening
inventory inventory

VALUATION OF INVENTORY

Direct costing : Only variable cost.

Absorption costing : Full cost

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APPLICATIONS OF MARGINAL COSTING

1. Segregation of fixed and variable costs

2. Emphasis on c-v-p relationship

3. Highlights contribution

4. Avoids allocation of fixed cost

5. Profit planning

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6. Decision making

Pricing special orders

Product mix decision

Make or buy

Sell or process further

Closing of operations

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SHORT RUN DECISION MAKING PROCESS USING
MARGINAL COSTING

The following steps/ elements need to be analysed :

1. Identify and define the problem

2. Identify alternatives as possible solutions to the problem

3. Eliminate alternatives that are clearly not feasible

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LIMITATIONS OF MARGINAL COSTING

1. Difficulty in segregation of fixed and variable costs

2. Improper to exclude fixed manufacturing overheads

from inventories

3. Wide fluctuations in profits

4. Only a short run profit planning and decision making

technique

5. Non-acceptable for external reporting

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 STANDARD COSTING

Standard costs are “scientifically predetermined costs”.

They are an estimate prepared in advance, co-relating to a

technical specification of materials and labour.

VARIANCE ANALYSIS :

It is the difference between standard costs and actual costs.

Variances are of two types :

a. Favourable variance

b. Unfavourable variance 42
 STEPS IN STANDARD COSTING &
VARIANCE ANALYSIS

1. Establish scientific standards for each element of cost.

2. Communicate these standards through budgets.

3. Cost comparison.

4. Variance analysis.

5. Corrective action.

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 BENEFITS OF STANDARD COSTING

- Performance evaluation.

- Management by exception.

- Cost reduction.

- Planning and decision making.

- Optimal resource utilisation.

- Pricing decisions.

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 ANALYSIS OF COST VARIANCES BY CAUSES

MATERIALS PRICE VARIANCE

1. Recent changes in purchase of materials.

2. Failure to purchase anticipated quantities when standards

were established resulting in higher prices owing to non-
availability of quantity purchase discounts.

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3. Not obtaining cash discounts anticipated at the time of
setting standards resulting in higher prices.

4. Substituting raw material differing from original

material specifications.

5. Freight cost changes and changes in purchasing and

storekeeping costs if these are debited to the materials
cost. 46
MATERIALS QUANTITY VARIANCE

1. Poor material handling

2. Inferior workmanship by machine operators.

3. Faulty equipment

4. Cheaper, defective raw material causing excessive

scrap

5. Inferior quality control inspection

6. Pilferage

7. Wastage due to inefficient production method

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LABOUR RATE VARIANCE

1.Recent labour rate changes within industry

2. Employing a worker of a grade different from the one
laid down in the standard
3. Labour strike leading to utilisation of unskilled help
4. Retaining skilled labour at higher rates, so as to
prevent resignations and job switching
5. Employee absenteeism
6. Paying a higher overtime allowance than provided for
in the standard

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LABOUR EFFICIENCY VARIANCE

1. Machine breakdown, use of defective machinery and

equipment.

2. Inferior raw materials.

3. Poor supervision.

4. Lack of timely material handling.

5. Poor employee performance.

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6. Inefficient production scheduling – delays in routing

work, materials, tools and instructions.

7. Inferior engineering specifications.

8. New inexperienced employees.

9. Insufficient training of workers.

10. Poor working conditions – inadequate or excessive

heating, lighting, ventilation etc.

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OVERHEAD VOLUME VARIANCE

1. Failure to utilise normal capacity

2. Lack of orders
3. Excess installed capacity
4. Inefficient utilisation of existing capacity
5. Machine breakdown
6. Defective materials
7. Labour inefficiencies

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 BUDGETING

Definition : A budget is a quantified expression of the intentions of

the management and operates in a fashion that enables attainment of
orgainsational goals.

Elements of a budget are :

1. It is a comprehensive and co-ordinated plan.

2. It is expressed in financial terms.

3. It is a plan for the company’s operations and resources.

4. It is a future plan for a specified period.

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THE MAJOR PURPOSES OF BUDGETING ARE

1. To state the company’s goals.

2. To communicate expectations to all concerned.

3. To provide detailed plan of action for reducing

uncertainty.

4. To co-ordinate activities and efforts in such a way so

as to maximise resources.

5. Measure for controlling performance.

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 TYPES OF BUDGETS

Comprehensive budgeting involves the preparation of a master

budget. The three important components of master budget are :
i) Operational / functional budgets.
ii) Financial budgets
iii) Capital budgets

Budgeting concepts :
- Budget period
- Fixed time / rolling
- A-priori Vs. Posteriori budgeting
- Key factors.

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 Facets of budgets
Name of What it shows Prepared by Based upon Classification
budget

Sales Estimated Sales Historical analysis Product-wise,

sales department of sales. Business territory or
condition market client wise
analysis monthwise

Production Quantity of Production Sales budget, Product-wise,

production to production department-
be capacity, stock wise monthly.
manufactured requirements.

Materials Quantity & Production Production budget Item-wise

value of & costing & stocks on hand.
materials
needed for
production.
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 Name of What it shows Prepared by Based upon Classification
budget

Labour Labour hours production Production budget Category skill-

and cost. costing. wise

Production Estimated Production Production budget Expense item-

overhead overhead costing & fixed expenses. wise
expenses for department-
the production wise.
department.

Selling & Estimated Sales Marketing Item-wise,

distribution costs. information, past territorywise,
experience client-wise
Admin + Estimated Finance Past data. Item-wise
finance costs

Master Summary of Finance All operational

budget p & l, budgets
balance sheet -
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& cash flow.
 ESSENTIALS OF BUDGETING

The following are the important essentials for a successful

budgeting exercise
1. Senior management support
2. Clear and realistic goals
3. Assignment of authority and responsibility
4. Creation of responsibility centres
5. Adaptation of accounting system
6. Full participation
7. Effective communication
8. Budget education
9. Flexibility
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 PROCESS OF BUDGETARY CONTROL
Specification of organisational objectives
and identification of key factors

Sales Budget

Production Budget for prime Budget for

Budget cost & overhead sell & dist. cost

Cap. Expend Cash Administrative

Budget Budget Cash Budget

Master Budget

Acc. Var analysis & Rep. Managerial action

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 FUNCTIONAL / OPERATIONAL BUDGETS

1. Sales budget
2. Production
3. Material consumption
4. Purchase
5. Labour
6. Overheads
7. Marketing and selling
8. Administration and finance

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 SALES BUDGET

The forecast of goods to be sold is the starting point in

budgeting. The forecast is prepared after consideration of
the following factors:
a) The quantity and value of past sales;
b) Competition and conditions within the particular
industry;
c) General economic conditions;
d) Market research and salesmen’s estimates;
e) Sales mix – which is dependent on the relative product
profitability
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 STEPS

a) Sales forecast by product

b) Product mix : taking into consideration the manufacturing

capacity and profitability of product lines.

c) By product type; area and mix which management

believes it could sell to achieve company objectives.

d) Customer profile

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 PRODUCTION BUDGET

The production budget is expressed in terms of physical units

of products. The basic information required is:

Sales budget Units

Add: Closing stock requirements of Units
finished goods
Less: Opening stock of finished units
goods

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 The production budget assists in making provision
for the following:

a) The stock budget

b) Production planning – what, when and in what quantities
shall it be produced?
c) The productive capacity required
d) The plant utilisation
e) In the light of production capacity and plant utilisation,
an estimate of additional facilities required
f) Labour and material requirements
g) Cash requirements

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 COST OF PRODUCTION BUDGET

a) Direct materials cost/usage budget

Basic information required:

i) Production budget

ii) Raw materials per unit of product by type and quantity

iii) Allowance for waste and scrap

iv) Rate per unit of raw material

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b) Direct labor cost budget

c) Basic information required:

i) The production budget

ii) Hours per unit in various producing departments.

iii) Rates per direct labor hour.

iv) Labor related costs and their treatment.

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c) Production overhead budget

Basic information required:

i) The behaviour of manufacturing overhead items of

expenditure. A cost classification according to the
behaviour of each element of cost.

ii) The classification of overhead departmentally (both

producing and service departments) to meet the
production target.

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 PURCHASES BUDGET
Basic information required:

a) Production budget: raw materials by type and quantity

required for production during the budget period.
b) Planned opening and closing stock requirements.
c) Materials allocated for incomplete order or special jobs.
d) Orders for materials already placed.
e) Economic size of the order – the actual quantity
purchased at one time.
f) Availability of finance.

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 PLANT UTILISATION BUDGET
The plant utlisation budget is a forecast of the plant capacity
required (expressed in machine hours, direct labour hours, weight,
number of products) to carry out the production programe as per
the production budget. It is essential that the aim should be the
most effective utilisation of capacity.

The plant utilisation budget determines for the budget period :

a) The machine load on individual machines within a cost
center (or group of machines if they are identical) and the
machine load on departments
b) The bottlenecks created by over-loading
c) Idle facilities
d) Use of sub-contractors
e) Purchase of additional plant and equipment
f) Changes necessary to the sales and production budgets, to
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increase manufacturing capacity
 STEPS IN BUDGETING

1. Preparation of budget
a. Decide objectives
b. SWOT analysis
c. Preparation of statement
d. Anticipate performance indicators for evaluation.
2. Record actuals.
3. Comparison between actuals and budgets.
4. Variance analysis - controllable / uncontrollable.
5. Responsibility accounting.
6. Revision in budgets.
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 FLEXIBLE BUDGETING

It is a budget which by recognizing the difference between

fixed, semi fixed and variable costs, is designed to change in
relation to the level of activity attained. It is a budget prepared for
a range and is also known as variable budget or a sliding scale
budget.

Steps in flexible budgeting:

1. Deciding the range of activity
2. Determine cost behaviour patterns
3. Selecting the activity levels to prepare budgets at those
levels
4. Prepare budget at each activity level

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 CASH BUDGET

It contains detailed estimates of cash receipts (cash

inflows) and disbursements (cash outflows) for the period under
review. It fulfills the following objectives:
1. It indicates the effect on the cash position of seasonal
requirements, large inventories, unusual receipts
and delays in collection of receivables.
2. Indicates cash requirements for working capital and
fixed capital
3. Indicates availability of cash for taking advantage of
discounts
4. Fund flow planning
5. Asset liability planning
6. Establishes/ determines external fund requirement
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 ZERO BASE BUDGETING

ZBB is a method of budgeting whereby all activities are

revalued each time a budget is formulated and every item of
expenditure in the budget is fully justified. That is, ZBB involves
starting from scratch or zero.

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Implementation of ZBB involves the following :

1. Each activity of the organisation is identified and

called a decision package
2. Each decision package must be justified
3. If justified the minimum cost to sustain each decision
package is determined
4. Alternatives for decision packages are evaluated
5. Managers rank their decision package in order of
priority for resource allocation
6. Resources are allocated to the package

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 ADVANTAGES OF ZBB

1. Allocation of resources by need and benefit.

2. Identifies and eliminates wastage's and obsolete
operations .
3. Best possible methods of performing jobs is ensured.
4. Increased staff involvement which may lead to
improved motivation and greater interest in job.
5. It increases communication and co-ordination within
the organisation.
6. Managers become more aware of cost inputs which
help in identifying priorities.

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 DISADVANTAGES OF ZBB

1. Substantial Cost & time involved in preparing a large number

of decision packages.

2. Managers could develop fear and feel threatened by

ZBB.

3. Ranking of packages could result in departmental

conflict.

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 ADVANTAGES OF BUDGETING

1. Forced planning.
2. Co-ordinated operations.
3. Performance evaluation & control.
4. Effective communication.
5. Optimum resource utilisation.
6. Productivity improvement.
7. Profit mindedness.
8. Efficiency.
9. Cost control.

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 LIMITATION IN USING THE BUDGETING
SYSTEM

1. Management judgement.
2. Continuous adaptation.
3. Implementation.
4. Management complacency.
5. Unnecessary detailing.
6. Goal conflict.
7. Evaluation system.
8. Unrealistic targets.
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 ALLOCATION OF OVERHEADS

Indirect, or overhead costs are difficult to be traced to

products. However, these costs will have to be allocated to
production departments and products for the purposes of

1. Valuation of inventory.

2. Controlling costs.

3. Decision making.

4. Product pricing.

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 DEPARTMENTALISATION

For the purpose of accumulating costs, a company divides

itself into departments or smaller units.

There are two broad categories of departments or cost centres.

Production cost centres.

Service cost centres.

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 ALLOCATION PROCESS

i) Assignment of direct costs.

ii) Allocation of indirect costs (primary allocation).

iii) Allocation of service department costs (secondary

allocation).

iv) Absorption of costs by products.

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 ALLOCATION BASIS

1. Space related.

2. Value related.

3. Activity related.

4. Material related.

5. Utility related.

6. Labour related.

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 METHODS OF ALLOCATION

1. Step ladder method.

2. Repeated distribution.

3. Matrix algebra.

82
LEARNING CURVES AND NON LINEAR COSTS

The learning curve phenomena is based on the concept that

cost,s tend to be non linear.

It is found that the cost of doing most tasks of a repetitive

nature decrease as experience at doing these tasks accumulate.

Most experience curves, estimated on actual process, indicate

that costs decline 20 to 30 percent each time accumulated experience
doubles.

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 Factors that lead to this long-run decline in costs
include:

1. Labour efficiency.

2. New process and improved methods.

3. Product stadardisation.

4. Scale effect.

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 In competitive scenarios this effect should net of inflation.

The learning curve phenomena is represented by the equation:

Y=A X -b

Y= average number of direct labour hours per unit

A= number of direct labour hours for the first unit

X= cumulative number of units produced

b= index of learning rate (o<b<1)

The direct labour hours (DLH) decreases exponentially

with cumulative output.
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 ACTIVITY BASED COSTING

In Activity based costing (ABC) costs are first traced to activities

and then to products. It is a system which focuses on activities
performed to produce products . Activities become the focal point
of cost accumulation

ABC involves two primary stages

-Tracing costs to activities

-Tracing activities to products

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 COSTS DRIVERS IN ABC
1. Number of receiving orders.
2. Number of purchase orders.
3. Number of dispatch orders.
4. Number of units.
5. Amount of labour cost involved.
6. Number of material handling man hours.
7. Number of direct labour hours.
8. Number of vendors/ suppliers.
9. Number of set up hours.
10. Number of employees.
11. Number of labour transaction.
87
 CLASSIFICATION OF ACTIVITIES

Activities are classified into one of the four activity

categories:

1. Unit level activities

2. Batch level activities

3. Product level activities

4. Facility level activities

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 ADVANTAGES OF ABC

1. ABC brings accuracy and reliability in product cost

determination by focusing on cause and effect
relationship in the cost incurrance.

2. More systematised/ logical way of tracing/

allocating fixed overheads.

3. Better mechanism for managing cost.

4. Better control over activities which generate fixed

overheads.

5. Controlling activities which drive costs.

89
 PROFIT CENTRE MANAGEMENT

A profit centre is a responsibility centre where the

manager is responsible for both costs and revenues and thus for
profits.

A profit centre provides more effective assessment of

performance as both costs and revenues are measured in financial
terms.

90
 Organisation will be divided into:

- Profit center

- Cost center

- Service centre

Cost and service centres will at mutually agreed transfer

price will pass on the cost to the profit centre.

Cost centres and service centres should not show any

surplus.

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 ADVANTAGES OF PROFIT CENTRES

1. Speed of operating decisions may be increased.

2. Quality of decisions tend to improve.
3. Corporate management may be relieved of day to
day decisions.
4. Profit consciousness is enhanced.
5. Better measurement of performance.
6. Organisation becomes profit conscious.
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 DISADVANTAGES OF PROFIT CENTRES

1. Top management may lose control.

2. Competent managers may not exist to take decision in profit

centres.

3. Friction among centres.

4. Too much emphasis on short term profitability.

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 TRANSFER PRICING

The fundamental principle is that the transfer price should

be similar to the price that would be charged if the product

would sold to outside customers or purchased from outside

vendors.

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Pricing mechanism used for inter divisional transfer of goods/
services in divisionalised/ profit centre managed companies.
While determining transfer prices a number of criteria should be
carefully followed:

1. Should help in accurate measurement of divisional

performance.
2. Should motivate divisional management into
maximising their divisions profitability and making
decisions that are in the interest of the organisation as a whole.
3. Should ensure divisional autonomy and authority.
4. Goal congruent objectives.

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IDEAL SITUATION TO IMPLEMENT TRANSFER
PRICING

1. Competent people.

2. Good atmosphere.

3. Market price.

4. Freedom to source.

5. Full flow to information.

6. Negotiations.

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 TYPES OF TRANSFER PRICING

1. Market price based

2. Cost based price

3.Variable cost
a. Actual full cost
b. Cost plus approach
c. Standard cost
d. Opportunity cost
e. Administered price based

4. Negotiated price based

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 FACTORS INFLUENCING PRICING DECISIONS

Product pricing decisions are influenced by internal and

external factors which are as follows:

1. Cost data of the product which could be based upon

replacement, actual, standard or any other cost base.

2. Firms profit and other objectives.

3. Demand for the product and its elasticity.

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4. Nature of product and its life expectancy.

5. Pricing decision as a long run decision or a one time

spare capacity decision.

6. Type of competition and availability of “me too”

products.

7. Economic/ fiscal trends.

8. Seasonal or continual demand.

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INVENTORY MANAGEMENT AND VALUATION

Inventory comprises :

 Raw material stock

 Work in progress
 Finished good stock

Inventory holding is depended upon:

- Nature of business
 Through put time
 Competitiveness in raw-material market
 Market for finished product
 Seasonality in demand

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Inventory management :

 Optimise inventory levels to reduce inventory

carrying / holding costs.

Objectives :

 Reduce inventory to the lowest acceptable limit.

 Minimise inventory carrying cost.
 Minimise losses to price / exchange fluctuations.
 Identify slow moving items.
 Prevent stock out costs.

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 INVENTORY VALUATION METHODS

1. LIFO (last in first out)

2. FIFO (first in first out)

3. Weighted average.

Choice of valuation system is important since it,

- Influences book profits there by affecting the tax
liability.

- Once adopted cannot be changed (prior approval of it

department essential).
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