ADVANCED MANAGEMENT

ACCOUNTING
M.Com., (Accountancy)
Semester – IV, Paper-I

Lesson Writers

Prof. V. Chandra Sekhara Rao Prof. David Raju Gollapudi

Dept. of Commerce & Business Admin. Dept. of Commerce & Business Admin.
Acharya Nagarjuna University Acharya Nagarjuna University
.

Lesson Writer & Editor

Prof. G. Prasad
Dept. of Commerce & Business Admin.,
Acharya Nagarjuna University

Director
Dr. NAGARAJU BATTU
MBA., MHRM., LLM., M.Sc. (Psy).,MA (Soc)., M.Ed., M.Phil., Ph.D

CENTRE FOR DISTANCE EDUCATION

ACHARAYANAGARJUNAUNIVERSITY
NAGARJUNANAGAR – 522510
Ph:0863-2346222,2346208,
0863-2346259(Study Material)
Website: www.anucde.info
e-mail:anucdedirector@gmail.com
M.Com. (Accountancy) - ADVANCED MANAGEMENT ACCOUNTING

First Edition 2023

No. of Copies :

©Acharya Nagarjuna University

This book is exclusively prepared for the use of students of M.Com.(Accountancy) Centre for
Distance Education, Acharya Nagarjuna University and this book is meant for limited
Circulation only.

Published by:
Dr. NAGARAJU BATTU,
Director
Centre for Distance Education,
Acharya Nagarjuna University

Printed at:
 FOREWORD

Since its establishment in 1976, Acharya Nagarjuna University has been forging a
head in the path of progress and dynamism, offering a variety of courses and research
contributions. I am extremely happy that by gaining ‘A’ grade from the NAAC in the year
2016, Acharya Nagarjuna University is offering educational opportunities at the UG, PG
levels apart from research degrees to students from over 443 affiliated colleges spread over
the two districts of Guntur and Prakasam.

The University has also started the Centre for Distance Education in 2003-04 with
the aim of taking higher education to the door step of all the sectors of the society. The
centre will be a great help to those who cannot join in colleges, those who cannot afford
the exorbitant fees as regular students, and even to housewives desirous of pursuing
higher studies. Acharya Nagarjuna University has started offering B.A., and B.Com
courses at the Degree level and M.A., M.Com., M.Sc., M.B.A., and L.L.M., courses at the
PG level from the academic year 2003-2004onwards.

To facilitate easier understanding by students studying through the distance mode,

these self-instruction materials have been prepared by eminent and experienced teachers.
The lessons have been drafted with great care and expertise in the stipulated time by these
teachers. Constructive ideas and scholarly suggestions are welcome from students and
teachers involved respectively. Such ideas will be incorporated for the greater efficacy of
this distance mode of education. For clarification of doubts and feedback, weekly classes
and contact classes will be arranged at the UG and PG levels respectively.

It is my aim that students getting higher education through the Centre for Distance
Education should improve their qualification, have better employment opportunities and
in turn be part of country’s progress. It is my fond desire that in the years to come, the
Centre for Distance Education will go from strength to strength in the form of new courses
and by catering to larger number of people. My congratulations to all the Directors,
Academic Coordinators, Editors and Lesson-writers of the Centre who have helped in
these endeavors.

Prof. P. RajaSekhar
Vice-Chancellor
Acharya Nagarjuna University
 Semester – IV
401CO21: INTERNATIONAL BUSINESS
Paper-I
SYLLABUS

1. Management Accounting: Management Accounting, Nature – Scope - Functions –

Differences between Management Accounting and Financial and Cost Accounting –
Emerging Trends in Management Accounting.
2. Cost Management: Techniques for profit improvement, cost reduction and value analysis;
Activity based costing. Target costing; cost as certainment and pricing of products and
services
3. Cost Volume Profit Analysis: Relevant cost, Product sales price in gand mix, Limiting
factors
4. Pricing Decisions: Theory of price, Product pricing, New product pricing, Pricing strategies,
Pricing of services
5. Budgets and Budgetary Control: Budget manual, Preparation and monitoring procedures,
Budget variances, Flexible budgets, preparation of functional budget operating and non-
operating functions, cash budgets, Capital expenditure budget, Master budget, Principal
budget factors.

FURTHER READINGS:

1. Shasi K. Gupta & R.K. Sharma, Accounting for Managerial Decisions, Kalyani
Publishers, New Delhi
2. RSN Pillai, Bagarathi & S. Uma, Fundamentals for Advanced Accounting, Vol I & II S,
Chand, New Delhi, 2006.
3. Bhattacharya S.K. Accounting for Management, Vikas Publication, New Delhi.
4. Ramachandran T. Accounting for Management, Sci Tech Publications, Hyderabad 2009.
5. Madigovda, Accounting for Managers, Himalaya Publishing House New Delhi 2010
 CONTENTS

S.NO. LESSON PAGES

1. Management Accounting 1.1 – 1.16

2. Cost Reduction Profit Improvement and Value Analysis 2.1 – 2.12

3. Activity Based Costing & Absorption Costing 3.1 – 3.13

4. Cost Ascertainment and Pricing of Products and Services 4.1 – 4.13

5. Marginal Costing 5.1 – 5.13

6. Marginal Costing – CVP Analysis 6.1 – 6.34

7. Marginal Costing – Managerial Decisions 7.1 – 7.24

8. Pricing Decisions 8.1 – 8.12

9. Pricing Strategies 9.1 – 9.14

10. Budgets – Budgetary Control 10.1 – 10.10

11. Classification of Budgets 11.1 – 11.18

 LESSON -1
MANAGEMENT ACCOUNTING
OBJECTIVES

After reading this unit you should be able to

 understand the concept of management accounting
 distinguish between financial and management accounting
 discuss the functions, scope and limitations of management accounting
 go through organization for management accounting in addition to the role of a
management accountant.

STRUCTURE

1.1 Concept of Management Accounting

1.2 Limitations of Financial Accounting
1.3 Distinction between Financial and Management Accounting
1.4 Importance of Management Accounting
1.5 Functions of Management Accounting
1.6 Scope of Management Accounting
1.7 Limitations of Management Accounting
1.8 Tools of Management Accounting
1.9 Organization for Management Accounting
1.10 Role of Management Accountant
1.11 Self Assessment Questions
1.12 Reference Books

1.1 CONCEPT OF MANAGEMENT ACCOUNTING

Management Accounting is one of the branches of accounting. It provides the relevant

information to the management for decision making. It provides necessary information to the
management for discharging its functions. These functions are : planning, organizing,
staffing, directing and controlling. Further, it provides necessary data for management for
effective and efficient control of the business.

Management Accounting is not mere recording and compiling of income and

expenditure but also an effective tool of forecasting, planning and regulating business or
economic activity of a concern. It helps the management in budgeting and budgetary control,
production planning and control. Till recently very few people looked upon Management
Accounting as a subject distinct from accounting. Management Accounting is comparatively
new field in the area of accounting. Data process by high speed computers has left traditional
accounting far behind in the task of serving the decisional needs of management.

Management Accounting is highly sensitive to management needs. However, it assists

the management and does not replace it. It represents a service the phase of management
rather than service to management from an outsider.
Advanced Management Accounting 1.2 Management Accounting

The Management accounting covers all those services by which the accounting
department can assist the management in the formation of policy, taking a decision, control
of its execution and the appreciation of effectiveness. It eliminates intuition which is not at al
dependable fromthe field of business management and attempts at broadening the services of
accounting to management. It has opened new lines of thought on work measurement and has
indicated the advantages still to be obtained from more precise form of control. It not only
provides meaningful accounting information to various levels of managers but also equips
them with analytical and measurable tools.

Management Accounting – Definitions:

Many experts have defined the term management accounting. They are given below:

Charles T. Horngren: “Management Accounting is the process of identification,

measurement, accumulation, analysis, preparation, interpretation and communication of
information that assists executives in fulfilling organisations objectives.”

Robert N. Anthony: “Management Accounting is concerned with accounting information

that are useful to management.”

Batty: “Management Accountancy is the term used to describe the accounting methods,
systems and techniques which , coupled with special knowledge and ability, assist
management in its task of maximizing profits or minimizing losses”.

Management Accounting Practices Committee (MAPC) of U.S.A.: “Management

Accounting is the process of identification, measurement, accumulation, analysis,
preparation, interpretation and communication of financial information used by the
management to plan, evaluate and control.”

1.2 LIMITATIONS OF FINANCIAL ACCOUNTING

Financial Accounting is concerned with recording, classifying and summarising

financial transactions pertaining to an accounting period. The basic objective is to provide a
commentary to the shareholders and outside parties on the financial status of an enterprise in
the form of a profit and loss account and balance sheet. The profit or loss of business
operations is revealed through these statements year after year, observing the statutory
requirements of the Companies Act, 1956.

Cost Accounting, on the other hand, aims at providing cost data for managerial
planning, controlling and decision-making. It provides a complete explanations as to how
the scarce inputs are put to use in business. The sources of efficiency or inefficiency are
revealed through periodical reports. The profit or loss relating to each job, department or
product can also be found out easily.

Financial Accounting provides a post-mortem examination of past events and, hence,

not amenable for exercising control measures. It does not offer a running commentary on the
profitability of various jobs, departments or processes in an organization. These serious
limitations have ultimately paved the way for the emergence of cost accounting. Let us now
examine the limitations of financial accounting in greater detail:
Centre for Distance Education 1.3 Acharya Nagarjuna University

Financial accounting discloses only the net result of the collective activities of the
business as a whole. It does not indicate the profit or loss of each department, job, process
or contract.

Expenditure is not split up according to departments, process and products

and, hence, prices of articles manufactured cannot be fixed accurately.

Financial accounting does not indicate the remunerative prices which may be
quoted in times of depression.

It does not ensure proper control over materials and supplies, wages, labour and
overheads.

Expenses are not classified as direct and indirect items and are not assigned to the product
at each stage of production to show the controllable and uncontrollable items of overhead
cost.

It does not provide any measure to judge the efficiency of the concern.

Financial Accounting is purely historical, since the data is summarised at the end of
the accounting period. Prompt cost information on a day-to-day basis is not available.

It does not provide a complete analysis of losses due to idle time, idle plant and equipment.

It does not offer cost data for comparison with previous periods.

Despite these limitations, financial statements remain the basic documents from out of
which out information is obtained.

As we are aware, the trading and profit and loss accounts portray overall results of
working of an enterprise during a specified period. Whereas costing, with its objective and
analytical approach, discloses the detailed information relating to profit or loss. The
information contained in financial statements is digged, analysed and presented in a
convenient form, facilitating management planning and control.

1.3 FINANCIAL ACCOUNTING – MANAGEMENT ACCOUNTING –COST

ACCOUNTING

Financial Accounting: The purpose of Accounting is to ascertain the financial results i.e.,
profit or loss in the operations during a specific period. It is also aimed at knowing the
financial positions, i.e., assets, liabilities and equity position at the end of the period.

Cost Accounting: The purpose of cost accounting is to analyse the expenditure so as to

ascertain the cost of various products manufactured by the firm and fix the prices. It also
helps in controlling the costs and providing necessary costing information to management for
decision making.

Management Accounting: The purpose of management accounting is to assist the

management in taking rational policy decisions. This branch of accounting is primarily
concerned with providing the necessary accounting information about funds, costs, profits,
Advanced Management Accounting 1.4 Management Accounting

etc., to the management.

Now let us go through the differences between Financial Accounting and Management
Accounting.

Differences between Financial Accounting and Management Accounting

Basis for Difference Financial Accounting Management Accounting

1. Objective The primary objective of The primary objective of
financial accounting is to management accounting is to
ascertain profit and to find out provide accounting informatic to
financial status of a concern. the management in day to day
It provides financial data of operations for taking proper
the organisation to the decisions.
shareholders and creditors.
2. Nature Financial Accounting is Management accounting is
concerned almost exclusively concerned with future plans and
with historical records and policies.
past performance.
3. Dependency Financial accounting is not Management accounting
dependent on management depends on financial accounting
accounting. for vital information.
4. Application ofIt adheres to Generally Such accounting principles are
Accounting Principles Accepted Accounting not considered.
Principles.
5. Approach Financial accounting is Management accounting is
historical in approach. Financial predictive in approach. It is
accounts are the results of past concerned more with future.
events, only past expenses and Thus, all information are in the
incomes form estimates and Budgets for
are recorded. future.
6. Presentation These accounts are presented He no such form is prescribed.
in a specific form either The information can be presented
prescribed by law or by in any way suitable
convention. to the management needs.
7. Control It does not lay emphasis on Management accounting
control. controls the performance of the
organisation by preparing
performance reports for each
responsibility centre.
8. Valuation of Stock Stocks are valued on the No such principle is followed for
principle of “cost or market valuation of stocks.
price whichever is lower”.
9. Statutory obligation Financial accounting is Management accounting is not
guided by statutes statutory
10 Audit Audit of financial accounts is Audit of management accounts is
compulsory not compulsory.
Centre for Distance Education 1.5 Acharya Nagarjuna University

Differences between Cost Accounting and Management Accounting:

Basis for Difference Cost Accounting Management Accounting

1. Objective The primary objective of cost The primary objective of
accounting is to set routine, management accounting is to
budgets and standards. It is mainly measure actual performance
aimed at knowing the per unit measure actual performance and
cost of output. report to the management for
taking corrective actions by
detecting the mistakes.
2. Scope It is primarily concerned with Its scope is wider. It covers
cost allocation. financial accounting an tax
accounting.
3. Applicability It is generally applicable to Management accounting
manufacturing concerns. methods and techniques are
applicable to all concerns.
4. Data used Here quantitative figures are Here both quantitative and
used. qualitative costs are used.
5. Transactions Cost accounting embraces Management accounting is
internal as well as external concerned with internal
transactions. transactions.
6. Future Activities Cost accounting does not attachFuture activities are primarily
importance to future activities. considered.

1.4 IMPORTANCE OF MANAGEMENT ACCOUNTING

Management accounting assists the management in achieving better results by making

a clear shift in emphasis from mere recording of transactions to their analysis and
interpretation. It concerns with the tools and techniques of formulation of budgets and
presetting of standards as well as evaluation of deviations in actual performance and also
implementation of prompt remedial measures. In fact, management accounting broadens the
services of accounting to management. The importance of management accounting can be
learned from the following.

1. Helps in maximising profits: Management Accounting helps in maximising the

profits. The constant effort of the Management accountant is to suggest the ways and
means of cost reduction. It increases the efficiency of various business functions.
Further, the management aims to control the cost of production and this will help to
increase the profits. Increase in profits will benefit different persons as follows:
i. Customers can be charged a lower price.
ii. Workers can be paid higher wages and the service conditions of the working staff
can be improved.
iii. The owners may be given a higher rate of return on the capital employed.
iv. The Government may get higher income in the form of taxes.
v. The reputation of the company will increase.
Advanced Management Accounting 1.6 Management Accounting

2. Helps in planning: The Management accounting helps to plan the business activity in
a systematic manner. It involves forecasting, and planning of future operations of the
business in the light of the past as well as present achievements.

3. Helps in analysis and interpretation of data: Management accounting is

concerned with analysis and interpretation of financial data. Thus, data becomes more
useful and reliable. For this purpose engineering records, case studies, minutes of
meeting productivity reports, special service and other business documents are
greatly reliedupon.

4. Helps in preparing budgets: The techniques of management accounting are

widely used and accepted for preparing budgets. These budgets are compared with
actual results and thus an effort is made to find out and correct the variances, if any.

5. Helps in decision making: Management accounting furnishes accounting data and

statistical information required for the decision making process in management
which vitally affects the survival and the success of the business. There are always
many courses open for management and selection of the best alternate is decided by
the techniques of the Management Accounting. Thus, it is useful for selection of the
best alternative.

6. Helps in control: Management Accounting is an useful technique for control on

wastes. This is done by using techniques of standards and budgeting which is a vital
part of management accounting. Different techniques of management accounting will
help in the effective control of the business operations.

1.5 FUNCTIONS OF MANAGMENT ACCOUNTING

The management accounting function is to assist and advise management in taking

appropriate decisions. As such, it is vitally important that the information is presented in
the most comprehensive and effective manner. It is, therefore, the duty of the management
accountant to evolve an efficient and suitable system of reporting and presentation of cost of
other financial information to the management. The reporting system should be designed to
meet the needs of individual concerns and should be frequently reviewed and adjusted in
accordance with the requirements. The main functions of Management Accounting are given
below:

1. Planning function: Management accounting is very useful in planning. Before planning

management has to evaluate past and future strategy. The Management Accounting provides
past data on the basis of which future line of action can be chosen. Management accounting
provides costing and statistical data to the utilized in setting goals and framing policies.
Management accounting assists in planning for a specific purpose as well as overall planning
for the organization.

2. Decision making function: Accounting data required for decision making purpose is
supplied by management accounting through resort to a process of classification and
combination of data. In fact, before taking up any scheme, management has to study various
alternatives. The selection of best alternative is recommended.
Centre for Distance Education 1.7 Acharya Nagarjuna University

3. Formulation of business budgets: Management ‘accounting is very useful in planning

which involves the setting up of objectives, a search for optional strategies for achieving
business objectives and helpful in selection of the most appropriate alternative course of
action.

4. Organisation function: Management accounting helps in establishing sound

organisation by dividing the whole organisation into different cost centres. Fixing and
controlling of responsibilities and costs at each of these centres leads to efficient business
structure. A sound system of internal control and internal audit for each of these centres and
the constant review of the procedures helps the people concerned to be alert and makes
possible improvements.

5. Co-ordination Function: Management Accounting involves establishing sound

leadership in order to maintain high standard and co-operation among the employees.
The superiors should be able to identify the needs and gaps in the satisfaction among the
employees. This is made possible through periodical departmental profit and loss accounts,
budgets and reports prepared by each department.

6. Control function: Management accounting facilitates management in controlling the

destiny of the organisation. The standards for performance are maintained and any deviation
from them is measured and estimated. Measuring actual performance against approved
operating plans, standards and budgets are interpreted and reported to the heads of the
departments at higher levels. All these help the management in controlling the overall
performance of the organisation. Cost control techniques and functional control enables
the management to delegate the authority easily and successfully.

7. Protection of business interests: Management accounting is useful to interpret and report

the effects of external influences on the achievement of business goals. This function lays
stress on the continuous appraisal of economic and social forces and government which are
directly associated with the operation of the business. Further, the management accounting
provides internal check and control for the protection of thebusiness assets.

8. Provision of data: Management accounting provides concise information covering entire

field of business activities at relatively for long interval to the top management.

1.6 SCOPE OF MANAGEMENT ACCOUNTING

The scope of Management Accounting is very wide and broad based and it include within
its fold, a variety of aspects of business operations. The following are some of the areas of
specialization included within the ambit of management accounting.
Advanced Management Accounting 1.8 Management Accounting

ACCOUNTING

Financial Managerial

External Interested Internal Interested

Reporting Parties Reporting Parties
or Users

1. Income 1.Shareholders 1.Planning Management

2.Statement 2.Investors 2.Decision- making (or managers)
3.Balance Sheet 3.Creditors 3.Performance - Top
4.Cash Flow 4.Govt. authorities Evaluation - Middle
5.Statement 5.Managers 4.Control - Lower
6.Employees 5.Management of Cost
7.Stock Exchange 6.Cost Determination
8.Investors’
Association
9.Industry
10. Association

1. Financial Accounting: Historical data presented in financial accounting is the basis for
planning the future course of action.
2. Cost Accounting: Cost Accounting provides various techniques such as marginal costing,
standard costing etc., which help the management in a number of ways.
3. Tax Accounting: Tax planning with different departments, filing of tax returns and
keeping the management informed of its tax burden falls within the scope of Management
Accounting.
4. Internal Audit: Internal audit undertaken for performance appraisal, strengtheningof
internal control procedures as an aid to the final statutory audit, also comes within the
purview of Management Accounting.
5. Forecasting: Management Accounting covers forecasting the future in all possible states
of nature and evaluation of available alternatives that backdrop.
6. Budgetary Control: Formulation of budgets, their comparison with actuals and analysis
of variances is a part of Management Accounting.
7. Reporting: Reporting to management of the various activities of the organisation isan
integral part of Management Accounting. Reports are made in uniform intervalsof time,
the length of the time interval being dependent on the nature of information.
8. Office Services: Management Accounting might also be expected to deal with data
processing, filing, copying, duplicating, communication etc., and report about the utility of
different office machines.

The Scope of Management Accounting and Financial Accounting can be observed

fromthe following figure. Through this one can exactly find out the role of the Management
Accountant and Financial Accountant.
Centre for Distance Education 1.9 Acharya Nagarjuna University

1.7 LIMITATIONS OF MANAGEMENT ACCOUNTING

The following are the limitations of management accounting.

1. Accuracy of information: The management accounting depends upon the cost and
financial accounting records for information. Therefore, the accuracy of information
furnished by management accounting and the reliability of conclusions derive
therefrom depends upon the accuracy of these information.

2. Use by management: Management accounting is only a tool. It cannot replace

management. The usefulness of the management accountancy depends upon the
extent to which the data provided by it are used by the management in taking
decisions. The whole utility will go waste if management accountant lacks capability.

3. Misleading conclusions: Management accounting requires a blending of knowledge

of different fields – accountancy, statistics, economics and law. Improper or
insufficient knowledge of all these aspects may lead to misleading conclusions.

4. High cost: The installation of management accounting requires a blending of

knowledge of different fields – accountancy, statistics, economics and law. Improper
or insufficient knowledge of all these aspects may lead to misleading conclusions.

5. Management accounting is at initial stage: Management accounting is a new

technique and is still in evolutionary stage. New ideas and techniques are being
introduced now and then. Therefore, it is essential to keep a continuous track of
latest theories and developments in the field.

6. Opposition to change: The old techniques of accounting are in use since long. Thus,
change for new approach is opposed by many. The accounting staff will hesitate to
new approach, thus, introduction of management accounting will need more efforts to
motivate employees for accepting new approach.

7. Lack of statutory recognition: In our country, the results shown by management

accounting do not get legal recognition. The income tax department does not
consider the profits shown by management accounting techniques.

8. No set of rules: There is hardly any prescribed set rule of management accountants,
some one may prepare funds flow statement in vertical form, while others may follow
horizontal form.

9. Limited use: The management accounting is a new technique. Its use is limited to
big business houses and it may be of little use to small undertakings.

10. Intuitive decision making: Though the main contribution of management

accounting has been the elimination of intuitive management, there is always a
temptation to take an easy course of arriving at decisions by intuition rather than
following the path of scientific decision making.

1.8 TOOLS OF MANAGEMENT ACCOUNTING

Advanced Management Accounting 1.10 Management Accounting

Management accounting helps the management in solving the operational problems

of the concern. It aims at presenting the accounting information to help management in
formulation of policies and increasing the operational efficiency so as to maximise profits or
minimise losses of the undertaking. In order to fulfil its task of helping the management in
the managerial functions – planning, coordinating, controlling and appraisal of activities,
management accounting uses the following tools and techniques.

1.8.1 Financial Planning:

The success of a business enterprise depends upon the careful preparation of a prudent
financial plan for the business. By estimating in detail the current and future requirements of
funds for operations and capital expenditure purposes, the management gets the information
and, thereby the ability, to utilise the resources to the optimal level and avoid wastage.
Financial plan also helps to determine the optimal capital structure of the firm.

It is the function of the management accountant to prepare the financial plan taking
into accountant t’—company policy and the forecasts of his production and marketing
colleagues. It is his responsibility to coordinate the plans of each area. Once the financial
forecasts are ready, the management has an opportunity to review the projected plans and
modify them to match the resources of the firm. Thus, the maximum utilisation of available
funds can be ensured. The advantages of financial planning are:

1. It points out to management what funds are needed, and when, and for what duration,
if the specific plans and programmes of the company are to be implemented.

2. It highlights to management what resources are needed, and enables management to

consider suitable alterations to plans before commitments are made.

3. It also serves as a basis for review and control whereby deviations from the expected
performance can be promptly identified and necessary corrective actions taken
without delay.

1.8.2 Financial Analysis:

Financial Analysis is the process of identifying the financial strengths and weaknesses
of the firm by properly establishing relationships between the items of financial statements
viz., Balance Sheet and Profit and Loss Account. The analysis and interpretation of financial
statements is an important tool of management accounting. Proper analysis and
interpretationof financial data makes it more meaningful and places it in proper perspective.

The data becomes more meaningful by proper analysis in relation to other data. For
this purpose important technique that is used is preparation of comparative financial
statements, trend analysis, funds flow techniques and ratio analysis etc. This analysis and
interpretation of various financial statements provide information to take decisions and
forming policies.

1.8.3 Budgetary Control:

Budgetary control is an important managerial tool. The basic purpose of budgetary

control is to improve the efficiency and the profitability of the concern. Budgetary control
Centre for Distance Education 1.11 Acharya Nagarjuna University

serves as invaluable aid to management through planning, coordination and control.

Budget presents the plans, objectives and policies of an enterprise in numerical

terms. It is a short-term operational plan used as a tool by management for planning as well
as controlling the activities of the organisation and also ensure the coordination among the
different departments in the organisation to achieve its predetermined goals. The use of
budget to monitor and regulate the operational activity of the organisation in a systematic
manner is called “budgetary control”. A budgetary control system secures control over costs
and performances in various parts of an enterprise by:

1. Establishing budgets;
2. Comparing actual results with budgeted ones; and
3. Taking corrective action or revising the budget if necessary.

1.8.4 Standard Costing:

Another important tool of Management Accountant is Standard costing. Standard

costing is a system in which cost of each unit of batch or job is predetermined on the basis of
normal levels of activity and efficiency. In this way, standards, are set with which actual
expenditure when incurred are compared. Differences between actual expenditures and the
predetermined standards are technically known as ‘Variances.’ Standard costing is designed
to give costs of operation or process rather than products so that variances may be traced to
their source.

1.8.5 Marginal Costing:

Marginal costing is comparatively a new area in the field of accounting. It is a useful

technique which guides management in pricing, decision making and assessment of
profitability. It is the cost which arises from the production of additional output. It classifies
costsinto fixed and variable ones. This distinction forms the basis of marginal costing.

Marginal costing regards as product costs only those manufacturing cost which have a
tendency to vary directly with the volume of output. It is an important tool in the hands of
management to take decisions. Marginal costing includes the discussion of cost-volume-
profit analysis and break even analysis. It helps the management in taking sound and
scientificdecisions regarding production and distribution.

1.8.6 Funds Flow Statement and Cash Flow Statements:

The effectiveness of the financial management can be understood by statement of

changes in the financial position. Our business activities generate income which is used
again in generating more income. In other words, we can say that the additional funds
generated during a particular year as compared to its previous year is applied in various uses.

The effectiveness of the management lies in the fact that the income is generated
without sacrificing the financial health of the business concern. Statement of changes in the
financial position, therefore, supply us information concerning financing and investing
activities of the business. These statements also show the changes in the financial position of
the business for a period. It summarises the sources from which funds have been obtained
and the uses to which they have been applied.
Advanced Management Accounting 1.12 Management Accounting

Funds flow Statement: The funds flow statement deals with the presentation of a statement
which summarises for the period the resources made available to finance the activities of an
enterprise and the uses the which such resources have been put. The statements of sources
and application of funds is a useful tool in the financial manager’s analytical kit. It gives an
insight into the most detailed analysis and understanding of changes in the distribution of
resources between balance sheet dates. Funds flow statements help a lot in financial analysis
and control, future guidance and comparative studies.

Cash Flow Statement: Cash flow statement shows the movement of cash between two
periods. This statement shows various causes of variances in cash balance. Like funds flow
statement this statement also shows inflow and outflow of cash between two time periods.
Cash flow statement is unlike funds flow statement, highlights only total cash inflow and
closing cash at the end. It speaks about short term financial positions of a company. It
speaks about the speed of cash being collected from debtors, stock and other current assets,
on the other hand, the use of cash in paying current liabilities.

1.8.7 Human Resources Accounting:

Human Resource Accounting means accounting of people as organisational resources. It

means the measurement of the cost and value of people in organisations. More formally
human resource accounting can be defined as the process of identifying, measuring and
communicating information about human resources and it ought to be viewed as a metaphor.

Human resource accounting is not only a system of accounting for the cost and
value of people to organisations, it is also a way of thinking about the management of people
in formal organisations.

1.8.8 Responsibility Accounting:

Responsibility Accounting represents a method of appraising the performance of

various divisions of organisation. It is a system of accounting that recognises various
responsibility centres and reflects the plan and action of each of these centers by assigning
particular revenues and cost to these plans. It is also known as Profitability Accounting and
Active Accounting. The Responsibility Accounting collects and reports planned and actual
accounting information about the input and output of responsibility centres.

1.8.9 Revaluation Accounting:

This tool is also of a recent origin. It ensures the maintenance and presentation of the
capital of enterprise. It is an important tool of management accounting. It involves more
extended estimation and prediction of things to come requiring a high order of intellectual
ability for their economic analysis.

1.8.10 Statistical and Graphical Techniques:

A large number of statistical and graphical techniques has been evolved to be used in
management accounting. Examples of some of these techniques generally used are:
Investment chart, Current assets chart, Master chart, Chart of sales. Statistical techniques are
also increasingly used in management accounting. Method of least squares, Regression lines,
Linear programming and Statistical quality control etc., are usually used for the purpose.
Centre for Distance Education 1.13 Acharya Nagarjuna University

1.8.11 Financial Reporting:

Finally, the Management Accountant has to provide management at all levels with
necessary factual data and information so as to enable them to carry out the various functions
most efficiently. The ability of accounting to translate activities involving people, things and
even abstract relationship into monetary terms facilitates the communication process.

Proper planning, controlling and decision making etc., all depend upon effective
communication for financial reporting. Various charts and graphs are also used in financial
reporting.

1.9 ORGANISATION FOR MANAGEMENT ACCOUNTING

The organisation of the Management Accounting System should provide relevant

information for all levels of management to achieve maximum efficiency. The organisation
chartshould be adopted keeping adequae provisions for modifications, if any, required for
years to come, particularly so when a firm expands or shrinks on account of financial
booms or stringencies. The following is the typical organisation chart of a manufacturing
company. From this chart we can observe the place and the role of the Management
Accountant.

Shareholders

Board of Directors

Managing Director

Marketing Production Personnel Finance Research &

Directors Director Manager Director Development
Dierotr

Chief
Management
Accountant

Financial Cost Budget Chief Head of Credit

Accountant Accountant Officer Internal Computer Controller
Officer Accounting
Division
Advanced Management Accounting 1.14 Management Accounting

1.10 ROLE OF MANAGEMENT ACCOUNTANT

1.10.1 Role of Management Accountant:

The person who is entrusted with management accounting function in an organisation

is known as Management Accountant. The position of the management accountant varies
from organisation to organisation. He may be considered as head of the accounting
department or as a member of the Board of Director or Controller. Whatever may be his
designation and placement, his functions and duties will be the same.

The designation of the person who is entrusted with the management accounting
functions in an organisation vary from company to company. In some large concerns, he is
called Controller or Management Accountant. In some other concerns he is designated a
Chief Accountant or Chief Accounts Officer, Controller of Accounts, Finance Controller or
FinanceDirector.

Whatever may be the organisational setup and intra-organisational relationships, the

practitioner of management accounting must be so placed that he is in a position to exercise
effective independent judgement on business problems. He must be involved as an active
participant in the management. As remarked by Anderson and Schmidt “the Management
Accountant will be specially concerned about the problem of cooperation with all other
organisation units. In some organisations he may be member of the board of directors, in
otherhe may be subordinate to the managing director.”

1.10.2 Functions of Management Accountant:

The functions of the Management Accountant have been exhaustively spelt out by the
Management Accountant Institute as well as National Industrial Conference Board of the
United States, in a greater detail. But all the same, they devolve mainly on the seven-point
concept of modern accountant. But with the passage of time, the functions of the
management accountant have been vastly expanded. The following are the functions of a
management accountant.

1. Planning function: It includes profit planning, programmes, investing and

financing, sales forecast, expense budgets and cost standards. The plan as such should
involve the necessary procedures to implement the plan effectively.

2. Reporting and Interpreting: Another important function of management

accountant is to compare performance with operating plans and standards and to
report and interpret the results of operations to all levels of management. This
function includes the designing, installation and maintenance of accounting and
cost systems and records, the determination of accounting policy and preparation of
other reports as required.

3. Advise to Management: The Management Accountant has to evaluate the

effectiveness of the policies, organisational structure and procedures in attaining the
business objectives. He has to measure and report on the validity of the various
business policies and objectives. For this purpose he keeps in touch and consults
all segments of management responsible for policy or operations of business related
to the attainment of objectives. On the basis of this evaluation, he advises the top
Centre for Distance Education 1.15 Acharya Nagarjuna University

management with a view to improve efficiency and performance of his accounting

function.

4. Administration of tax matters: The Management Accountant will supervise all

matters relating to tax accounting. This requires preparation of returns on the basis
of taxable income of the enterprise. All the papers duly filled in have to be submitted
to the income tax authorities in time.

5. Government Reporting: He will see that all the statements that have to be
submitted periodically to the Government agencies are prepared correctly in time. It
is also his duty to explain any complexity that may arise.

6. Protection of Firm’s Assets: Another important function of the management

accountant is to protect physically the assets of the business. This function requires
adequate internal control and auditing and assuring proper insurance coverage.

7. Constant vigil on environmental changes: Last but not the least, the function of
management accountant is to continuously appraise economic and social forces and
government influences and interpret their effect on business. The Management
accountant has to see that as far as feasible the organisation conforms to
management’s plans and policies. He has, therefore, to make thorough study of all
the external influence that may exert their effect on the business and interpret them
and report to the top management.

1.10.3 Responsibilities of a Management Accountant:

The role of Management Accounting is largely advisory in nature. His authority of

restricted to his own department. His function is to bring to the notice of the management the
various aspects related to a particular division and explain the consequences of selecting a
particular alternative. The Management Accountant tenders sound advise for improving the
efficiency of all the phases of the management, he cannot be considered to be an expert in
solving the problems of production or marketing. At best, he can discuss with different levels
of management such problems in detail and the financial implication of the alternative
solutions suggested.

Thus, the modern management accountant place a dual role in organisations. In the
first place, he acts as a watchdog for top management. In this role, he is responsible to the
tope management for the integrity and reliability of the performance reports he submits.
Secondly, he assumes a helper’s role in which he is responsible for helping departmental
managers in planning and control operations.

1.11 SELF ASSESSMENT QUESTIONS

1. Define Management Accounting.

2. Discuss the concept of Management Accounting.
3. Explain the limitations of Financial Accounting.
4. Explain the importance of Management Accounting.
5. “The Managerial objectives of accounting are to provide us data to help management
to plan and control operations” Discuss and mention the main objectives of
managerial Accountancy.
Advanced Management Accounting 1.16 Management Accounting

6. Distinguish between Financial Accounting and Management Accounting.

7. Distinguish between Cost Accounting and Management Accounting.
8. Explain the functions of the Management Accounting.
9. What is Management Accounting? Discuss the scope and limitations of the
management accounting.
10. Explain briefly the tools and techniques of Management Accounting.
11. Draw an organisation chart showing the role of Management Accountant in a
manufacturing company.
12. Discuss the role of the Management Accountant in an organisation. Briefly state his
functions.
13. Discuss the principal functions of management accounting and show how it helps in
solving managerial problems in key areas of the business.
14. “Management Accounting is nothing more than the use of cost and financial
information for management purpose.” Explain the statement and clearly distinguish
between Financial Accounting and Management Accounting.
15. “Management Accounting is the presentation of accounting information in such a
way so as to assist the management in the creation of policy and in the day to day
operation ofthe undertaking” Elucidate.
16. “Any form of Accounting which enables a business to be conducted more
efficiently canbe regarded as Management Accounting.” Elucidate.
17. Describe how management accounting satisfies the various needs of management for
arriving at appropriate business decisions.

1.12 REFERENCE BOOKS :

1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting – Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting –
5. N. Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V. Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain & KL Narang, Advanced Cost and Management Accounting
 LESSON 2
COST REDUCTION, PROFIT IMPROVEMENT AND
VALUE ANALYSIS
OBJECTIVES

After careful understanding of the lesson, student will be in a position to

1. Understand the profit improvement process through control of costs and its
reduction
2. Understand the evaluate the differences between the cost control and cost reduction
mechanism
3. How the cost reduction, cost control and value analysis are interlinked and knows
how to apply practically in the industry.

STRUCTURE

2.0 Profit Improvement

2.1 Cost Control
2.2 Cost Reduction
2.3 Characteristics of cost reduction
2.4 Essentials for success of Cost Reduction Programme
2.5 Cost Control Vs Cost Reduction.
2.6 Scope of Cost reduction (Areas or fields of cost reduction)
2.7 Tools and techniques of cost reduction
2.8 Advantages of Cost Reduction
2.9 Value Analysis
2.10 Process of Value Analysis and Value Engineering (VAVE)
2.11 Summary of the Lesson
2.12 Key Terms
2.13 Review Questions
2.14 Suggested Readings

2.0 PROFIT IMPROVEMENT

Cost control and cost reduction are the two very efficient tools used to reduce the cost
of production and maximise profit. In simple words, Cost control is a technique used to
provide the management with all the necessary information regarding the actual costs and
also align them properly with the budgeted costs. On the other hand, the term cost reduction
is used to save the unit cost of the product, without causing any compromise to its quality.

The companies use a wide variety of techniques of cost control and cost reduction in
order to carry out the process effectively.
Advanced Management Accounting 2.2 Cost Reduction, Profit Impro…

2.1 COST CONTROL

Business firms aim at producing the product at the minimum cost. It is necessary in
order to achieve the goal of profit maximization. Profit is the difference between selling price
and cost of production. Generally, selling price is not within the control of a firm but it can
minimize the cost. In fact, the success of a business firm is judged in controlling its costs.
Cost control by management means a search for better and more economical ways of
completing each operation. Cost control is simply the prevention of waste within the existing
environment.

It aims at reducing costs and increasing the profitability of the firm. This is done by
reduction in specific expenses of the firm and making a better use of the money spent. If a
firm is producing a certain quantity of product, it should ensure that it is produced at the
minimum cost and gives more profit.

Management should follow three rules in cost control activities

(i) It is easier to keep costs down than to bring costs down.
(ii) The amount of effort put into cost control tends to increase when business
is bad and decrease when business is good.
(iii) Cost control is more profitable when business is good than when it is bad.

2.2 COST REDUCTION

Profit is the result of two varying factors, viz., sales and cost. The wider the gap
between these two factors, the larger is the profit. Thus, profit can be maximised either by
increasing sales or by reducing cost. In a competition loss market or in case of monopoly
products, it may perhaps be possible increase price to earn more profits and the need for
reducing costs may not be felt. Such conditions cannot, however, exist paramount and when
competition comes into play, it may not be possible to increase the sale price without having
its adverse effect on the ale volume, which, in turn, reduces profit. Besides, increase in price
of products has the ultimate effect of pushing up the raw material prices, wages of employees
and other expenses all of which tend to increase costs. In the long run, substitute products
may come up in the market, resulting in loss of business. Avenues have, therefore, to be
explored and method devised to cut down expenditure and thereby reduce the cost of
products. In short, cost reduction would mean maximization of profits by reducing cost
through economics and savings in costs of manufacture, administration, selling and
distribution.

Cost reduction may be defined as the real and permanent reduction in the unit costs of
goods manufactured or services rendered without impairing their suitability for the use
intended. As will be seen from the definition, the reduction in costs should be real and
permanent. Reductions due to windfalls, fortuities receipts, changes in government policy
like reduction in taxes or duties, or due t6 temporary measures taken for tiding over the
financial difficulties do not strictly come under the purview of cost reduction. At the same
time a programmer of cost reduction should in no way affect the quality of the products nor
should it lower the standards of performance of the business.
Centre for Distance Education 2.3 Acharya Nagarjuna University

Broadly speaking reduction in cost per unit of production may be affected in two
ways viz.,

1. By reducing expenditure, the volume of output remaining constant, and

2. By increasing productivity, i.e., by increasing volume of output and the level of
expenditure remains unchanged.

These aspects of cost reduction are closely linked and they act together - there may be
a reduction in the expenditure and the same time, an increase in productivity.

Cost reduction is a planned positive approach to reduce expenditure. It is a corrective

function for reducing cost in various operations.

The Chartered Institute of Management Accountants, London defines cost reduction

as “Cost reduction is to be understood as the achievement of real and permanent reduction in
the unit cost of goods manufactured without impairing the quality of the product”.

Cost reduction is the process of eliminating wasteful elements in the method of

production. Cost reduction is a continuous process of critically examining various elements
of cost to improve the efficiency for reducing cost.

Cost reduction means maximization of profit by reducing cost through economies and
savings in cost of manufacture, administration, selling and distribution.

2.3 CHARACTERISTICS OF COST REDUCTION

Reduction must be a real one. It may be done through

1. Large volume of production
2. Use of lower priced material
3. Reducing cost through process substitution
4. By simplifying the manufacturing process
5. By changing the features of product
6. Reduction must be a permanent one. It would be a permanent one if it is through
improvements in methods of production.
7. Reduction should not be at the cost of quality of the product

2.4 ESSENTIALS FOR SUCCESS OF COST REDUCTION PROGRAMME

1. Cost reduction programme must be appropriate to the organisation

2. It should be a continuous activity
3. It should be real and permanent cost reduction
4. It should start from top executives. Then only cooperation of all can be achieved
5. Persons giving innovative ideas for cost reduction should be rewarded
6. It should consider all other factors like social and legal factors too

2.5 COST CONTROL VS COST REDUCTION

Cost Control VS Cost Reduction: Both cost reduction and cost control are efficient tools of
management but their concepts and procedure are widely different. The differences are
summarised below:
Advanced Management Accounting 2.4 Cost Reduction, Profit Impro…

Cost Control Cost Reduction Cost Control Cost Reduction

(a) Cost Control represents efforts made (a) Cost reduction represents the
towards achieving target or goal. achievement in reduction of cost
(b) The process of cost control is to set up (b) Cost reduction is not concern with
a target, ascertain the actual performance maintenance of performance according to
and compare it with the target, standard
Investigate the variances, and take
remedial measures.
(c) Cost control assumes the existence of (c) Cost reduction assumes the existence
standards or norms which are not of concealed potential savings in
challenged standards or norms which are therefore
subjected to a constant challenge with a
view to improvement by bringing out
savings
(d) Cost Control is a preventive function. (d) Cost reduction is a corrective
Costs are optimized before they are function. It operates even when an
incurred efficient cost control system exists. There
is room for reduction in the achieved
costs under controlled conditions
(e) Cost control lacks dynamic approach (e) Cost reduction is a continuous
process of analysis by various methods of
all the factors affecting costs, efforts and
functions in an organization. The main
stress is upon the why of a thing and the
aim is to have continual economy in costs

2.6 SCOPE OF COST REDUCTION (AREAS OR FIELDS OF COST

REDUCTION)

1. Product design: Possibilities of cost reduction should be checked when designing the
product itself. Different alternatives and substitutes must be checked before finalizing the
product design. Efficient designing of a product reduce cost in the following ways

 By finding cheaper substitutes of material or by using less quantity of materials

 By ensuring minimum time of operation to reduce labour cost
 Reduction in after sales service cost

2. Organisation: Proper care should be taken while setting the type of organisation. Cost
reduction can be achieved if the following considerations are looked into

 Define cash function and responsibility

 Proper assignment of tasks and delegation of responsibility
 Fix a suitable channel of communication
 Encourage employees for cost reduction suggestions
 Avoid overlapping of duties

3. Factory layout and equipment: A cost reduction programme should study the factory
layout to determine whether there is any scope for cost reduction by elimination of wastage
of men, material and maximize utilization of the facilities available. Replacement of plant,
Centre for Distance Education 2.5 Acharya Nagarjuna University

introduction of new technology, expansion of plant, changing the arrangements of equipment

etc. should be considered with a view to reduction in cost. Any hidden difficulties in the plant
should be probed into. Factory layout and position of equipment must be in such a way to
minimize related costs and maximize utilization.

4. Production plan, Programme and methods: There must be proper planning for material
ordering, material movement, machine loading and proper utilization of men and other
resources to avoid waste of time and resources.

5. Administration: Use of unnecessary forms should be avoided to save the cost of stationary
and labour. Reduce the cost of lighting, telephone and travelling as much as possible.
Through computerization cost can be reduced to an extent.

6. Marketing: Another area where cost reduction can be brought is marketing, which
includes market research, advertisement, packing, warehouses, distribution, after sales
services etc. Proper care should be taken in the following areas to ensure minimum cost

 Channel of distribution must be efficient and economical

 Sales promotion system must be effective
 Check the chance to reduce selling and distribution expenses

7. Personnel management: Personnel management is another prominent area where cost

reduction programmes can be applied. Recruitment, selection, training and placement stages
of employees must be critically examined. Take measures to improve labour relations,
welfare measures to improve operational efficiency.

8. Material control: By taking the following steps a company can keep material cost at
minimum.

 Economical purchase of material

 Stick on EOQ
 Keep low inventory
 Proper check on goods received
 Proper control on material storage and issues

9. Financial management: Cost reduction programme must care about over and
undercapitalization. Capital should be procured at minimum cost and it should be utilised so
as to maximize return. Due consideration should be given in the following areas

 Ensure fair capitalization

 Procure capital at minimum cost
 Make investment for maximum return

10. Utility services: Utility services include power, water, steam, repair, maintenance,
transport and clerical services. Proper system of control must be there to avoid wastage and
other losses related to these utilities.
Advanced Management Accounting 2.6 Cost Reduction, Profit Impro…

2.7 TOOLS AND TECHNIQUES OF COST REDUCTION

It includes
1. Budgetary control
2. Standard costing
3. Standardization of products, tools and equipments
4. Simplification and variety reduction
5. Improvement in design
6. Material control
7. Labour control
8. Overhead control
9. Production planning and control
10. Automation
11. Operation research
12. Market research
13. Financial planning and control
14. Value analysis
15. Cost benefit analysis
16. Contribution analysis
17. PERT
18. Job evaluation and merit rating

2.8 ADVANTAGES OF COST REDUCTION

1. It increases profit
2. Improve men – management relationship
3. Make goods available at cheaper price
4. Help to meet competition effectively
5. Higher profit leads to more revenue to the government
6. Increase export
7. Increase productivity
8. Improved method of production

2.9 VALUE ANALYSIS

Concept

The current business scenario is very demanding with a continuous demand from the
market forces to reduce the product price. The pricing as demanded by the market, forces the
businesses to reduce product development and manufacturing costs to remain competitive.
Manufacturing costs of a product can be broadly categorized in the following heads:

• Raw material
• Labor
• Process that is technology driven

Product engineers are constantly faced with the following challenges:

• Reduce production cost

• Reduce the material cost
Centre for Distance Education 2.7 Acharya Nagarjuna University

Value Analysis & Value Engineering (VAVE) methods are very important and useful
in driving down the product cost which helps companies retain market share and sustain their
profitability

Important to distinguish between four types of value

Cost value - the cost of producing and selling an item.

Exchange value – the market value of the product or service.

Use value – the value an item has because of the uses to which it can be put, e.g. using a car
to go from A to B.

Esteem value - the value put on an item because of its beauty, craftsmanship etc, e.g. the
colour, image or top speed of a car.

Meaning

Value analysis (VA) is a tool to enhance cost efficiency by evaluating the

functionality of a product or a process about its cost. It helps identify and eliminate
unnecessary costs incurred while making a product or conducting a business function.

Typically, the total target is broken down into its various components, each
component is studied and opportunities for cost reductions are identified. These activities are
often referred to as Value Analysis (VA) and Value Engineering (VE).

Value Analysis is a planned, scientific approach to cost reduction which reviews the
material composition of a product and production design so that modifications and
improvements can be made which do not reduce the value of the product to the customer or
to the user. Value Engineering is the application of value analysis to new products. Value
engineering relates closely to target costing as it is cost avoidance or cost reduction before
production. Value analysis is cost avoidance or cost reduction of a product already in
production; both adopt the same approach i.e. a complete audit of the product.

Here are some of the issues that are dealt with during a Value Analysis/ Value
Engineering review:
Advanced Management Accounting 2.8 Cost Reduction, Profit Impro…

Can we eliminate
functions from the
production process?

Can we eliminate
some durability or
reliability?

Can we minimize the

design?

Can we design the

product better for
Value Analysis the manufacturing
Value Engineering process?

Can we substitute
parts?

Can we combine
steps?

Can we take
supplier’s
assistance?

Is there a better
way?

2.10 PROCESS OF VALUE ANALYSIS AND VALUE ENGINEERING (VAVE)

Cost reduction helps a business spend less on expenses leaving it with more profit at
the end of a year. As such, businesses devise innovative ways to reduce costs while ensuring
that the quality of their products, services, or processes is not compromised.

Value Analysis is a method to achieve cost reduction by analyzing the utility or value
of a product, service, or process about the cost incurred on it. In the process, the value
analysis team conducts a thorough examination of different segments or components of a
product/service/process and identifies areas of avoidable costs. It then comes up with
innovative ways to enable cost reduction. The solutions are then implemented to enhance
profits by reducing costs.

For example, value analysis of a wall clock will involve applying different methods to
break down a wall clock’s functions and the cost involved at various stages to bring in those
functions. Finally, the team will analyze the functions of the wall clock for customers, which
will be to see the time and add to the beauty of their homes.
Centre for Distance Education 2.9 Acharya Nagarjuna University

A classification between necessary

and unnecessary functions will become
possible based on function analysis. As a
result, the business can achieve cost-
reduction by eliminating unnecessary
functions that add to the cost but are neither
improving quality nor enhancing customer
satisfaction. Not only does it help in cost-
saving, but it will make the product available
to the customer at a lower price.

The analysis involves more complex steps, which we will study under the steps of
value analysis.

1 – Familiarization to gain information

The first step involves the team familiarizing itself with the process, product, or
service that requires value analysis. Then, each component is studied in detail, keeping in
mind the department’s goals and the organization. Other details could be how much loss it
incurred or profit it attained in the last quarter, people employed to carry out the process, etc.

The team also takes down all the costs involved at all levels. It is like the research
stage in which the team also documents competitor-related information regarding cost and
function to favor comparisons.

2 – Analysis to identify problem areas

Once the team has all the relevant information, it gets into the analysis. The analysis
is focused on breaking down the functions of the subject in question. Usually, a product or a
process serves two functions, primary and secondary. For example, the primary function of
the wall clock was to see the time. Its secondary function was adding to the beauty of the
house. There could be several functions that all need to be studied from the point of view of
customer satisfaction.

Functions have a weight age and a cost. A detailed analysis is done regarding how a
particular function meets customer requirements and the cost of that function. In this process,
the value analysis team compiles a list of all the functions in descending order of their utility.
The cost incurred on these functions is mentioned alongside. Some formulas like cost-benefit
ratios are applied to give weight to the study. The most unnecessary function which will have
the least utility can be removed.

3 – Innovation

In this stage, the team searches for alternative ways that allow reduction, change, or
modifications in the existing components and functions. This stage thus emphasizes
producing new ideas and finding alternative ways of accomplishing the basic and secondary
functions.
Advanced Management Accounting 2.10 Cost Reduction, Profit Impro…

The underlying idea behind innovation focuses on delivering the said process or
product at a reduced cost without compromising its quality. In other cases, it focuses on
bringing in some investment like automation while suggesting lay off for cost-cutting.

Sometimes, the team suggests enhancing the quality for greater profits at a lower cost
by replacing a component. For example, replacing the clock’s wooden digits with cheaper but
similar-looking ceramic ones could make the product available at a cheaper rate. As a result,
it could increase its sales and help the business make greater profits at a lesser cost.

4 – Evaluation and Selection

The evaluation phase estimates the value of each idea generated during the innovation
phase and selects the best. Evaluation involves checking the feasibility and cost of various
ideas presented. It also measures the value of the best alternative. Cash flow analysis or
break-even point is some of the techniques which may be used for this.

The evaluation phase may be carried out via qualitative analysis or quantitative
analysis. The overall process involves computing the cost and picking the most feasible idea
based on quantitative or qualitative analysis.

The alternative that reduces cost without compromising the quality will be selected.
Many additional details include organizational goals, constraints, customer preference,
competitor analysis, impact on the pollution, law abidance, etc.

5 – Implementation, Monitoring and Corrective Actions

The next step involves implementing the selected alternative. Over months or as
defined in the report, the performance of the alternative implemented will be constantly
monitored and documented. Any deviations from plans will need to be rectified to ensure
high performance. Companies usually monitor the performance very carefully and make it a
permanent practice upon the initial implementation’s success.

Over the years, value analysis and value engineering have come to be understood as
similar terms as both involve an in-depth analysis to help reduce costs. However, one salient
feature of value engineering compared to value analysis is that the former is usually
undertaken at the design stage of new or old projects and products.

Now that we have understood the steps to conduct value analysis, let us look at some
examples to understand the process better.

Example 1
The production process of a lead pencil was analyzed using the value analysis
technique to reduce cost. Wood and paint were the two most expensive elements in producing
the pencil, which shared 37.5% of the pencil’s total cost.

A round-shaped design for the pencil was suggested instead of the hexagonal-shaped
design to reduce the manufacturing time and manufacturing cost. In addition, normal paints
were suggested instead of expensive glitter paints, and additional care was required while
applying them to wood.
Centre for Distance Education 2.11 Acharya Nagarjuna University

With the suggested design changes, the production cost of each pencil was reduced by 25%.

Example2
A bank is incurring extra costs at a particular branch. At the same time, it is getting
complaints from customers about not adding a self-help desk. So the value analysis team
evaluated all the bank processes, such as banking services, technology maintenance, staff
duties and roles, and relative costs.

It was discovered that the bank had employed two extra people than the required
capacity and yet could not address customer problems due to confusion in roles. The team
suggested introducing a help desk and employing the two extra employees at the desk to
guide and help the customers. In a year, the branch’s profit grew by 30% at the same cost
while receiving a positive response from its customers

2.11 SUMMARY OF THE LESSON

In competitive environment, companies have to make continuous efforts to find out

ways and means to control and reduce costs.

Cost Control is exercised by comparing actual costs with pre determined standard costs so
that the difference between the two can be measured and then analysed according to reasons
for taking corrective action. Cost control is thus simply the function of keeping costs within
the prescribed limits

Cost Reduction is the achievement of real and permanent reduction in the per unit cost of
goods manufacture or services rendered without impairing their suitability for use intended,
say, through increase in productivity, change in product design, improvement in technology,
etc.
Cost reduction is much wider in scope than cost control and consists of effecting
savings in cost by continuous research for improvement in products, methods, procedures and
organizational practices.

Value analysis is a systematic method to enhance an item’s value and utility. The item
could be a product or a process.

It carries techniques to systematically identify areas of avoidable costs in a product or

service. The analysis is also applied to the various components and functions of the subject in
question.

Another part of this tool involves removing these unnecessary costs without
compromising the quality and efficiency of a product, service, or process.

The value analysis team undertakes extensive research, identifies problem areas,
devises innovative ways to do away with extra cost, or enhances the product/processes’
functionality at the same cost.

2.12 KEY TERMS

1. Continuous Improvement (KAIZEN)

2. Cost Reduction & Control
Advanced Management Accounting 2.12 Cost Reduction, Profit Impro…

3. Cost Optimization
4. Value Analysis and Value Engineering
5. Just-in-time JIT
6. PERT (Program Evaluation and Review Technique)

2.13 REVIEW QUESTIONS

1. Cost Measure is What Kind of Control?

a) Corrective b) Preventive c) Both d) None of the above
Ans: (b) Preventive
2. Which Type of Control Process Does Not Affect the Quality of the Products?
a) Cost control b) Cost reduction c) Cost-cutting d) None of the above
Ans: (b) Cost reduction
3. Distinguish between Cost Control and Cost Reduction
4. Define cost reduction and illustrate with industry examples

2.14 SUGGESTED READINGS

1. A Text Book of Cost and Management Accounting by MN Arora, 9 th Edition, Vikas

Publications
2. Strategic Cost Management by ICMAI Material

Dr. David Raju Gollapudi

 LESSON 3
ACTIVITY BASED COSTING & ABSORPTION
COSTING
OBJECTIVES

After going through this lesson, one should be able to–

 Understand about basic concepts of Activity Based Costing (ABC) and its evolution
its objectives.
 Know about difference between Traditional Absorption Costing and Activity Based
Costing.
 Understand about Cost drivers, its types.
 Understand about practical uses of Activity Based costing.

STRUCTURE

3.1 Introduction
3.2 Meaning and Definition Activity Based Costing
3.3 The features of ABC are as under:
3.4 Objectives of ABC
3.5 The Traditional Costing System
3.6 Terminology of Activity Based Costing
3.7 Stages in Developing ABC System
3.8. Uses of Activity Based Costing
3.9 Limitations of Activity Based Costing
3.10 Distinction between Traditional Absorption Costing and ABC
3.11 Definition of Target Costing
3.12 Features of Target Costing
3.13 Objectives of Target Costing
3.14 Difference between Traditional Costing and Target Costing
3.15 Principles of Target Costing
3.16 Process of Target Costing
3.17 Summary of the Lesson
3.18 Self-Assessment Questions
3.19 Key Terms
3.20 Further Readings

3.1 INTRODUCTION

Wrong cost analysis leads to wrong decision making. Traditional cost accounting can
be used appropriately where the organisation has only few products but when organisation
expand their products offering and these products use different amount of resources , it
become difficult to determine accurate cost of products by using Traditional Absorption
Costing and use of Activity Based Costing (ABC) is inevitable in such situations. Activity-
based cost-management systems trace indirect and support expenses accurately to individual
products, services and customers.
Advanced Management Accounting 3.2 Activity Based Costing & Abso…

The Activity Based Costing (ABC) is a method of costing, which focuses on activities
performed to produce products. Under this system costs are first traced to activities and then
to products. This costing system assumes that activities are responsible for the incurrence of
costs and create the demands for activities. E.g. an accounting firm prepares tax returns; a
University teaches students. Costs are charged to products based on individual product's use
of each activity.

ABC aims at identifying as many costs possible to be subsequently accounted as

direct costs of production. Any cost that is traced to a particular product via its consumption
of activity becomes direct cost of the product. For instance, in conventional costing system,
cost of setup and adjustment time is considered as factory overhead and subsequently
assigned to different products on the basis of direct labour hours. But in ABC, setup and
adjustment time is determined for each product and its costs are directly charged to each
product. ABC is generally used as a tool for understanding product and customer cost and
profitability.

As global competition intensifies, companies are producing an increasing variety of

products and services. They are finding that producing different products and services places
varying demands on their resources. The need to measure more accurately how different
products and services use resources has led companies such as American Express, Boeing,
General Motors, and Exxon Mobil to refine their costing systems. One of the main ways
companies around the globe have refined their costing systems is through activity based
costing.

The Evolution: The concepts of ABC were developed in the manufacturing sector of the
United States during the 1970’s and 1980’s.During this time, the consortium for advanced
manufacturing – International , now known simply as CAM-I , provided a formative role for
studying and formalizing the principles that have become more formally known as Activity
Based Costing. ABC is developed due to many deficiencies of Traditional Cost systems,
which lead to the discovery of the ABC System.

3.2 MEANING AND DEFINITION

The ABC system assigns costs to each activity that goes into production, such as
workers testing a product, setting up of machines, orders passed for purchase of raw materials
etc.
Activity-Based costing is allocating costs to the activities involved in the production.
It can be defined as a system of costing that recognizes activities involved in producing a
product and then traces the cost incurred in performing each activity.

"ABC is the cost attribution to cost units based on benefits received from indirect
activities, e.g., ordering, setting up, assuring quality, etc."
- Chartered Institute of Management Accountants (CIMA)

Cost pool: It is an aggregate of all the costs associated with performing a particular business
activity.

Cost driver: It is an activity that is the root cause of why a cost occurs. It must be applicable
and relevant to the event that is incurring a cost. A cost driver assists with allocation expenses
Centre for Distance Education 3.3 Acharya Nagarjuna university

in a systematic manner that results in more accurate calculations of the true costs of
producing specific products.

From the above definition, ABC is the costing system in which cost is attributed to
each activity, and then it is summed up to the product.

3.3 THE FEATURES OF ABC ARE AS UNDER

 Two Stage Costing: Activity-based costing (ABC) is a two-stage product costing

method that first assigns costs to activities and then allocates them to products based
on the each product’s consumption of activities.
 The cost pools in the two-stage approach now accumulate activity-related costs.
 An activity is any discrete task that an organization undertakes to make or deliver a
product or service.
 Activity-based costing is based on the concept that products consume activities and
activities consume resources.
 Activity-based costing can be used by any organization that wants a better
understanding of the costs of the goods and services it provides, including
manufacturing, service, and even nonprofit organizations.

3.4 OBJECTIVES OF ABC

The objectives of Activity Based Costing are as under:

1. To improve product costing
2. To identify non-value adding activities in the production process which might be a
suitable focus for attention or elimination?
3. To provide required information for decision making
4. To reduce the frivolous (nonessential) use of common resources
5. To encourage managers to evaluate the efficiency of internally provided services
6. To calculate the full cost of products for financial reporting purposes and for
determining cost-based prices

3.5 THE TRADITIONAL COSTING SYSTEM

Absorption costing technique is also termed as Traditional or Full Cost Method.

Under this method, the cost of a product is determined, after considering both fixed and
variable costs. The variable costs, such as direct materials, direct labour, etc. are, directly,
charged to the products. The fixed costs are apportioned on a suitable basis over different
products, manufactured during a period. Under absorption costing, all costs, both variable
and fixed, are charged to the products for cost determination. Thus, in case of absorption
costing, all costs are identified with the products manufactured. Both Fixed costs and
Variable costs are also treated as product costs. The cost unit is made to bear the burden of
full cost, irrespective of the current level of operations.

Absorption costing is a costing system that is used in valuing inventory. It not only
includes the cost of materials and labor, but also both variable and fixed manufacturing
overhead costs. Absorption costing is also referred to as full costing. Under the absorption
method of costing (aka “full costing”), the following costs go into the product:
Advanced Management Accounting 3.4 Activity Based Costing & Abso…

 Direct material (DM)

 Direct labor (DL)
 Variable manufacturing overhead (VMOH)
 Fixed manufacturing overhead (FMOH)

Under absorption costing, the costs below are considered period costs and do not go into the
cost of a product. They are, instead, expensed in the period occurred:

 Variable selling and administrative

 Fixed selling and administrative

We can summarise the main difference between ABC and traditional costing by following
picture:

Traditional allocation method

Costs Products

Activities
Costs Products

Activity-based allocation method

3.6 TERMINOLOGY OF ACTIVITY BASED COSTING

Function Cost Drivers

Research and  Number of Research Projects
Development  Personal Hours on a project
 Technical Complexities of Project

Customer Service  No. of service calls

 No. of products serviced
 Hours spent on serving products
Production  No. of Machine set ups
 No. of units
 No. of machine hours
Purchase of Materials  No. of orders placed
 No. of receipts of materials
 No. of inspections
Centre for Distance Education 3.5 Acharya Nagarjuna university

1. A Cost Object: It is an item for which cost measurement is required e.g. Product, job or a
customer.

2. A Cost Driver: In an ABC system, the allocation basis that are used for applying costs to
services or procedures are called cost drivers. It is a factor that causes a change in the cost of
an activity. Few examples of cost driver as under:

3. Unit level cost: Traditionally, cost drivers were viewed only at the unit level. These
drivers create unit-level costs meaning that they are caused by the production or acquisition
of a single unit of product or the delivery of a single unit or service.

4. Batch level cost: Costs are caused by a group of things being made, handled or processed
at a single time are referred to as batch level costs.

5. Product-level cost: A cost caused by the development, production or acquisition of

different items is called a product level or process level cost. These include engineering
change orders, equipment maintenance, product development and scrap, if related to product
design.

6. Facility-level cost: Some costs cannot be related to a particular product line. These are
instead related to providing a facility. For e.g. Cost of maintaining a building or plant security
or advertisement promoting the organization.

7. Organizational-level cost: Certain costs are incurred at organizational level for the single
purpose of supporting continuing facility operations. These organizational level costs
common to many different activities and products and services can be prorated among
services and products on an arbitrary basis only. These costs are not product related .thus they
should be subtracted from net product revenues instead of an arbitrary and illogical
apportionment.

8. Cost Pool: Costs are grouped into pools according to the activities, which drive them. In
this al costs associated with procurement i.e. ordering, inspection, storing etc would be
included in this cost pool and cost driver identified.

3.7 STAGES IN DEVELOPING ABC SYSTEM

Identify Identify Identify Cost

Resources Activities Objects

Define Define
Activity Resource
Drivers Drivers

Enter Enter Enter Calculate

Resource Resource Activity Costs
Costs Driver Qty Driver Qty
Advanced Management Accounting 3.6 Activity Based Costing & Abso…

Step 1. Identify Resources

Resources represent the expenditure of an organization. These are the same costs that
are represented in a traditional accounting, ABC links these cost to products, customers or
services.

Step 2. Identify Activities

Activities represent the work performed in an organization. ABC accounts for the
costs based on what activities caused them to occur. By determining the actual activities that
occur in various departments it is then possible to more accurately relate these costs to
customers, products and services.

Step 3. Identify Cost

Objects ABC provides profitability by one or more cost object. Cost object
profitability is utilized to identify money losing customers to validate separate divisions or
business units. Defining outputs to be reviewed is an important step in a successful ABC
implement action.

Step 4. Determine Resource Drivers

Resource drivers provide the link between the expenditure of an Organisation and
activities performed within the Organisation.

Step 5. Determine Cost (Activity) Drivers

Determination of cost drivers completes the last stage of the model. Cost drivers trace
or link the cost of performing certain activities to cost objects.
Activity Cost Driver Rate = Activity Cost Driver/Total Cost of Activity(Cost pool)

Step 6. Assign Costs To The Cost Objects

We can use following formula for assigning costs to the cost objects
Costs = Resources Consumed × Activity Cost Driver Rate

3.8. USES OF ACTIVITY BASED COSTING

The areas in which activity based information is used for decision making are as under: -

1. Activity costs: ABC is designed to track the cost of activities, so we can use it to see if
activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for
measuring the ongoing cost of specific services as management focuses on cost reduction.

2. Customer profitability: Though most of the costs incurred for individual customers are
simply product costs, there is also an overhead component, such as unusually high customer
service levels, product return handling, and cooperative marketing agreements. An ABC
system can sort through these additional overhead costs and determine which customers are
actually providing a reasonable profit. This analysis may result in some unprofitable
customers being turned away, or more emphasis being placed on those customers who are
contributing more in profits.

3. Distribution cost: Organisation uses a variety of distribution channels to sell its products,
such as retail, Internet, distributors, and mail order catalogs. Most of the structural cost of
maintaining a distribution channel is overhead, so if we can make a reasonable determination
Centre for Distance Education 3.7 Acharya Nagarjuna university

of which distribution channels are using overhead, we can make decisions to alter how
distribution channels are used, or even to drop unprofitable channels.

4. Make or buy: ABC enables the manager to decide whether he should get the activity done
within the firm or outsource the same. Outsourcing may be done if the firm is incurring
higher overhead costs as compared to the outsourcer or vice-versa.

5. Margins: With proper overhead allocation from an ABC system, we can determine the
margins of various products, product lines, and entire subsidiaries. This can be quite useful
for determining where to position company resources to earn the largest margins.

6. Minimum price: Product pricing is really based on the price that the market will bear, but
the marketing manager should know what the cost of the product is, in order to avoid selling
a product that will lose company money on every sale. ABC is very good for determining
which overhead costs should be included in this minimum cost, depending upon the
circumstances under which products are being sold.

7. Production facility cost: It is usually quite easy to segregate overhead costs at the plant-
wide level, so we can compare the costs of production between different facilities.

3.9 LIMITATIONS OF ACTIVITY BASED COSTING

Activity based costing help managers in decision making. However activity based costing has
certain limitations or disadvantages which as are under:

1. Implementing an ABC system requires substantial resources, which is costly to maintain.

2. Activity Based Costing is a complex system which need lot of record for calculations.

3. In small organisation mangers are accustomed to use traditional costing systems to run
their operations and traditional costing systems are often used in performance evaluations.

4. Activity based costing data can be easily misinterpreted and must be used with care when
used in decision making. Managers must identify which costs are really relevant for the
decisions at hand.

5. Reports generated by this systems do not conform to generally accepted accounting

principles (GAAP). Consequently, an organization involved in activity based costing should
have two cost systems - one for internal use and one for preparing external reports.

3.10 DISTINCTION BETWEEN TRADITIONAL ABSORPTION COSTING AND

ACTIVITY BASED COSTING

Traditional Absorption Costing Activity Based Costing

Overheads are first related to Overheads are first related to activities
departments cost centers (Production or grouped into Cost Pools.
and Service Cost Centres)
Only two types of activities viz. Unit All levels of activities in the
Level Activities and Facility Level manufacturing cost hierarchy viz. Unit
Activities are identified. Level, Batch Level, Product Level and
Advanced Management Accounting 3.8 Activity Based Costing & Abso…

Facility Level are identified.

This method relates overheads to cost This method relates overheads to the
centres i.e. locations. It is not realistic causal factor i.e. driver. Thus, it is more
of the behavior of costs. realistic of cost behavior.
Overhead Rates can be used to Activity Cost Driver Rates can be used
ascertain cost of products only. Activity to ascertain cost of products and also
Cost Driver Rates can be used to cost of other cost objects such as
ascertain cost of products and also cost customer segments, distribution
of other cost objects such as customer channels. etc.
segments, distribution channels. etc.

TARGET COSTING

Generally, in traditional method, price decisions were based on standard. Competitors

are emerging and the business for competition inflows other areas as cycle time, quality,
reliability. The traditional method standard costing is not effective in longer period for cost
reduction. In order to remove the drawback of traditional method, the New Method of
Costing is introduced.

In the modern days, fast growing industries use target costing approach moves the
decision perspective from book keeper’s office to the market. So growing companies are
turning equation around and setting cost id prices.

Target costing has been derived from a Japanese term “Gena Kikaku.” Concept of
target costing was developed in Japan around 1970.

Determination of the price at which they can sell the new product or service and then
design a product or service which can be produced a low to provide an adequate profit is
called target costing.

In other words, Target Costing is a cost management tool for producing overall cost
of product over its entire life cycle with the help of the function engineering and research and
development. Target cost is called estimated cost of the product that helps a manufacturing
unit to remain. Target Costing is a result of team-work that provides a way to link
profit planning, market surveys, value analysis, budgetary control and effective
financial management.

3.11 DEFINITION OF TARGET COSTING

CIMA defines Target Cost as “a product cost estimate derived from a competitive
market price”.

“a disciplined process for determining and achieving a full-stream cost at which a

proposed product with specified functionality, performance and quality must be produced in
order to generate the desired profitability at the product’s anticipated selling price over a
specified period of time in the future”.
Centre for Distance Education 3.9 Acharya Nagarjuna university

3.12 FEATURES OF TARGET COSTING

The main features of target costing are as follows:

1. Price Taker: The price of the product is determined by market conditions. The company
is a price taker rather than a price maker.
2. Profit includes in SP: The minimum required profit margin is already included in the
target selling price.
3. Management tool: It is part of management’s strategy to focus on cost reduction and
effective cost management.
4. Built-in Selling Price: Product design, specifications, and customer expectations are
already built-in while formulating the total selling price.
5. Goal Attainment: The difference between the current cost and the target cost is the “cost
reduction,” which management wants to achieve.
6. Team Work: A team is formed to integrate activities such as designing, purchasing,
manufacturing, marketing, etc., to find and achieve the target cost.

3.13 OBJECTIVES OF TARGET COSTING

1. The fundamental objective of target costing is to enable management to use proactive

cost planning, cost management and cost reduction practices whereby, costs are planned
and managed out of a product and business, early in the design and development cycle,
rather to a during the later stages of product development and production. Broadly
speaking, a target costing system has three objectives:

2. To lower the costs of new products so that the required profit level can be ensured.

3. Just-in-Time: The new products meet the levels of quality, delivery timing and price
required by the market.

4. Collective Activity: To motivate all company employees to achieve the target profit
during new product development by making target costing a companywide profit
management activity.

3.14 DIFFERENCE BETWEEN TRADITIONAL COSTING AND TARGET

COSTING

S.No. Target Costing Traditional Costing

1 Market price is not considered as a Competitive price is considered as a
part of prime cost planning. part of prime cost planning.
2 Costs determine sales price. It is sales price that determine costs.
3 Losses and inefficiency are taken into Design is an important factor in
consideration in order to reduce costs. reducing costs.
4 Customers are not involved in cost Customer data is considered as a
reduction. guide for cost reduction.
5 Teamwork and multiple skills are not Teamwork and multiple skills are
taken into account. taken into account.
6 Prime cost and some proportion of It is an open system and takes into
profit stem from closed system. consideration the interactive function
or the external effect of variables on
the system
Advanced Management Accounting 3.10 Activity Based Costing & Abso…

7 Suppliers of material and equipment Suppliers of material and equipment

are involved after designing the are involved before designing the
product. product.
8 It does not use value engineering. Value engineering is used as a
prerequisite in this system.

3.15 PRINCIPLES OF TARGET COSTING

According to Hilton, target costing involves seven key principles listed as follows:
1. Price-Led Costing
2. Focus on the Customer
3. Focus on Product Design
4. Focus on Process Design
5. Cross-Functional Teams
6. Life-Cycle Costs
7. Value-Chain Orientation

a) Price-Led Costing
Target costing sets the target cost by first determining the price at which a product can be
sold in the marketplace. Subtracting the target profit margin from this target price yields the
target cost, that is, the cost at which the product must be manufactured.

Notice that in a target costing approach, the price is set first, and then the target product
cost is determined. This is opposite from the order in which the product cost and selling price
are determined under traditional cost-plus pricing.

b) Focus on the Customer

To be successful at target costing, management must listen to the company’s customers.
What products do they want? What features are important? How much are they willing to pay
for a certain level of product quality?

Management needs to aggressively seek customer feedback, and then products must be
designed to satisfy customer demand and be sold at a price they are willing to pay. In short,
the target costing approach is market driven.

c) Focus on Product Design

Design engineering is a key element in target costing. Engineers must design a product
from the ground up so that it can be produced at its target cost. This design activity includes
specifying the raw materials and components to be used as well as the labour, machinery, and
other elements of the production process. In short, a product must be designed for
manufacturability.

d) Focus on Process Design

Every aspect of the production process must be examined to make sure that the product is
produced as efficiently as possible. The use of touch labour, technology, global sourcing in
procurement and every aspect of the production process must be designed with the product’s
target cost in mind.
Centre for Distance Education 3.11 Acharya Nagarjuna university

e) Cross-Functional Teams
Manufacturing a product at or below its target cost requires the involvement of people
from many different functions in an organisation: market research, sales, design engineering,
procurement, production engineering, production scheduling, material handling and cost
management.

Individuals from all these diverse areas of expertise can make key contributions to the
target costing process. Moreover, a cross-functional team is not a set of specialists who
contribute their expertise and then leave; they are responsible for the entire product.

f) Life-Cycle Costs
In specifying a product’s target cost, analysts must be careful to incorporate all of the
product’s life-cycle costs. These include the costs of product planning and concept design,
preliminary design, detailed design and testing, production, distribution and customer service.

Traditional cost-accounting systems have tended to focus only on the production phase
and have not paid enough attention to the product’s other life-cycle costs.

g) Value-Chain Orientation
Sometimes the projected cost of a new product is above the target cost. Then efforts are
made to eliminate non-value-added costs to bring the projected cost down. In some cases, a
close look at the company’s entire value chain can help managers identify opportunities for
cost reduction.

3.16 PROCESS OF TARGET COSTING

Target Costing applies to new products and succeeding generations of a product. It begins
with understanding the market thoroughly and an intention to satisfy customer needs,
concerning product quality, features, timeline and price:

1. Identifying customer needs.

2. Planning of selling price as per the needs.
3. Identifying the target cost.
4. Keep the price in consideration after identifying suppliers and fixing the
manufacturing process.
5. Compare sample product with the target and start production for product launch.

Target costing is an excellent tool for planning a suite of products that have high levels of
profitability. This is opposed to the much more common approach of creating a product that
is based on the engineering department’s view of what the product should be like, and then
struggling with costs that are too high in comparison to the market price.

Target costing is a tool for Cost Management which helps in reducing the cost of a
product over its entire life-cycle. Target costing induces those actions which management
must take for establishing reasonable target costs, developing methods to achieve these
targets and developing the mechanisms to test the cost effectiveness of various reduction
efforts.
Advanced Management Accounting 3.12 Activity Based Costing & Abso…

3.17 SUMMARY OF THE LESSON

 The Activity-Based Costing (ABC) is a costing system, which focuses on activities

performed to produce products. ABC is that costing in which costs are first traced to
activities and then to products.
 ABC is developed due to many deficiencies of Traditional Cost systems.
 In traditional product costing system, costs are first traced not to activities but to an
organizational unit, such as department or plant and then to products.
 Cost driver is an activity which generates cost. Costs are grouped according to what
drives them or causes them to be incurred.
 A Cost Object: It is an item for which cost measurement is required e.g. Product , job or a
customer.
 Cost drivers type of Pure Volume, Weighted Volume, Situational, Motivational.
 Cost pool is created for each activity and such activities are related with each type of
product to determine the cost of such product.
 Stages in developed ABC system as under:
• Identify resources
• Identify activities
• Identify cost objects
• Determine resource drivers
• Determine cost (activity) drivers
• Assign costs to the cost objects

Target costing is not just a method of costing, but rather a management technique
wherein prices are determined by market conditions, taking into account several factors, such
as homogeneous products, level of competition, no/low switching costs for the end customer,
etc. When these factors come into the picture, management wants to control the costs, as they
have little or no control over the selling price.

Target cost is the difference between the competitive market price and required profit.
In order to achieve target cost, companies redesign the products, achieve higher productivity
and use advanced technology.

3.18 SELF-ASSESSMENT QUESTIONS

1. What is Activity Based Costing? Why is it needed?

2. What is a ‘Cost Driver’? What is the role of cost driver in tracing cost to products?
3. Discuss the steps in applying Activity Based Costing?
4. How are activities grouped in a manufacturing company?
5. Distinguish between traditional costing system and activity based costing.
6. What are the benefits of activity based costing?
7. What is target costing? Explain its objectives
8. Illustrate the process of target costing with suitable market conditions prevailing at
present
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3.19 KEY TERMS

1. Cost Drivers
2. Cost Allocation
3. Target Costing
4. Absorption Costing

3.20 FURTHER READINGS

1. A text book cost and management accounting by M.N.Arora, 9 th edition 2010, Vikas
publications.
2. Accounting for managers by Prof. G Prasad, and Prof. V. Chandra sekhara Rao, 8th Edition
2012 Jayabharat Publishers

Dr. David Raju Gollapudi

 LESSON 4
COST ASCERTAINMENT AND PRICING OF PRODUCTS
AND SERVICES
OBJECTIVES

After studying this Unit, student will be able to:

1. State the meaning and scope of cost accounting.
2. Explain the objectives of cost accounting.
3. Understand how to ascertain the cost for products or services.
4. Explain limitations of cost accounting.
5. Explain the Cost Accounting Systems
6. Ex plain the requirements and limitations to installation of cost accounting systems
Explain the methods and techniques of costing

STRUCTURE

4.1 Meaning of Cost Ascertainment

4.2 Meaning of Costing
4.3 Scope of Cost Accounting
4.4 Objectives of cost accounting
4.5 Importance of Cost accounting
4.6 Cost Ascertainment – Elements of Cost
4.7 Elements of Cost
4.8 Methods of Costing
4.9 Techniques of Costing
4.10 Limitations of Cost Accounting
4.11 Summary of the Lesson
4.12 Key Terms
4.13 Self-Assessment Questions
4.14 Further Reading

4.1 MEANING OF COST ASCERTAINMENT

Cost ascertainment is the process of determining costs on the basis of actual data. Hence,
the computation of historical cost is cost ascertainment while the computation of future costs
is cost estimation. Both cost estimation and cost ascertainment are interrelated and are of
immense use to the management.

If an entrepreneur wants to set up a small business unit, say manufacturing of juice selling
business, a problem will arise what price of each box you should quote to the buyer. Many
factors are considered while fixing the price of a product/item such as competitors’ price etc.

One of the basic factors is the cost of its production. Cost is essential not only to fix price
but also to ascertain the margin of profit. Knowledge of the cost determination is also
necessary to keep a check on the cost of product/control on wastages, etc. The accounting
Advanced Management Accounting 4.2 Cost Ascertainment & Price…

used to study the various aspects of cost is known as cost accounting. In this lesson, you will
learn about meaning, importance, limitations etc. of cost accounting.

4.2 MEANING OF COSTING

Cost accounting is the process of determining and accumulating the costof product or
activity. It is a process of accounting for the incurrence andthe control of cost. It also covers
classification, analysis, and interpretationof cost. In other words, it is a system of accounting,
which provides theinformation about the ascertainment, and control of costs of products,
orservices. It measures the operating efficiency of the enterprise. It is aninternal aspect of the
organisation. Cost Accounting is accounting for cost aimed at providing cost data, statement
and reports for the purpose of managerial decision making. The Institute of Cost and
ManagementAccounting, London defines “Cost accounting is the process of accountingfrom
the point at which expenditure is incurred or committed to theestablishment of its ultimate
relationship with cost centres and cost units.In the widest usage, it embraces the preparation
of statistical data,application of cost control methods and the ascertainment of profitabilityof
activities carried out or planned”.

Costing includes “the techniques and processes of ascertaining costs.”

The‘Technique’ refers to principles which are applied for ascertaining costs of products, jobs,
processes and services. The `process’ refers to day to dayroutine of determining costs within
the method of costing adopted by abusiness enterprise.

Costing involves “the classifying, recording and appropriate allocation of expenditure

for the determination of costs of products or services; therelation of these costs to sales value;
and the ascertainment of profitability”.

4.3 SCOPE OF COST ACCOUNTING

The terms ‘costing’ and ‘cost accounting’ are many times usedinterchangeably.
However, the scope of cost accounting is broader than thatof costing. Following functional
activities are included in the scope of costaccounting:

1. Cost book-keeping:
It involves maintaining complete record of all costsincurred from their incurrence to
their charge to departments, productsand services. Such recording is preferably done on the
basis of doubleentry system.

2.Cost system:
Systems and procedures are devised for proper accountingfor costs.

3.Cost ascertainment:
Ascertaining cost of products, processes, jobs,services, etc., is the important function
of cost accounting. Costascertainment becomes the basis of managerial decision making
suchas pricing, planning and control.

4.Cost Analysis:
It involves the process of finding out the causal factorsof actual costs varying from the
budgeted costs and fixation of responsibility for cost increases.
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5.Cost comparisons:
Cost accounting also includes comparisons betweencost from alternative courses of
action such as use of technology forproduction, cost of making different products and
activities, and costof same product/ service over a period of time.

6.Cost Control:
Cost accounting is the utilisation of cost information forexercising control. It involves
a detailed examination of each cost inthe light of benefit derived from the incurrence of the
cost. Thus, wecan state that cost is analysed to know whether the current level of costsis
satisfactory in the light of standards set in advance.

7.Cost Reports:
Presentation of cost is the ultimate function of costaccounting. These reports are
primarily for use by the management atdifferent levels. Cost Reports form the basis for
planning and control, performance appraisal and managerial decision making.

4.4 OBJECTIVES OF COST ACCOUNTING

There is a relationship among information needs of management, costaccounting

objectives, and techniques and tools used for analysis in costaccounting. Cost accounting has
the following main objectives to serve:

1. Determining selling price,

2. Controlling cost
3. Providing information for decision-making
4. Ascertaining costing profit
5. Facilitating preparation of financial and other statements.

1. Determining selling price

The objective of determining the cost of products is of main importancein cost

accounting. The total product cost and cost per unit of productare important in deciding
selling price of product. Cost accountingprovides information regarding the cost to make and
sell product orservices. Other factors such as the quality of product, the condition of the
market, the area of distribution, the quantity which can be suppliedetc., are also to be given
consideration by the management beforedeciding the selling price, but the cost of product
plays a major role.

2. Controlling cost

Cost accounting helps in attaining aim of controlling cost by usingvarious techniques

such as Budgetary Control, Standard costing, andinventory control. Each item of cost [viz.
material, labour, and expense]is budgeted at the beginning of the period and actual expenses
incurredare compared with the budget. This increases the efficiency of theenterprise.

3. Providing information for decision-making

Cost accounting helps the management in providing information formanagerial

decisions for formulating operative policies. These policiesrelate to the following matters:
Advanced Management Accounting 4.4 Cost Ascertainment & Price…

(i) Determination of cost-volume-profit relationship.

(ii)Make or buy a component
(iii)Shut down or continue operation at a loss
(iv)Continuing with the existing machinery or replacing them by improved and
economical machines.

4. Ascertaining costing profit

Cost accounting helps in ascertaining the costing profit or loss of anyactivity on an

objective basis by matching cost with the revenue of theactivity.

5. Facilitating preparation of financial and other statements

Cost accounting helps to produce statements at short intervals as the management may
require. The financial statements are prepared generally once a year or half year to meet the
needs of the management. In orderto operate the business at high efficiency; it is essential for
management to have a review of production, sales and operating results. Cost accounting
provides daily, weekly or monthly statements of units produced, accumulated cost with
analysis. Cost accounting system provides immediate information regarding stock of raw
material, semi-finished and finished goods. This helps in preparation of financial statements.

4.5 IMPORTANCE OF COST ACCOUNTING

The limitation of financial accounting has made the management to realize the
importance of cost accounting. The importance of cost accounting areas follows:

1. Importance to Management

Cost accounting provides invaluable help to management. It is difficult to indicate

where the work of cost accountant ends and managerial control begins. The advantages are as
follows:

Helps in ascertainment of cost

Cost accounting helps the management in the ascertainment of cost of process,
product, Job, contract, activity, etc., by using different techniques such as Job costing and
Process costing.

Aids in Price fixation

By using demand and supply, activities of competitors, market condition to a great
extent, also determine the price of product and cost to theproducer does play an important
role. The producer can take necessary help from his costing records.

Helps in Cost reduction

Cost can be reduced in the long-run when cost reduction programme and improved
methods are tried to reduce costs.

Elimination of wastage
As it is possible to know the cost of product at every stage, it becomes possible to
check the forms of waste, such as time and expenses etc.,are in the use of machine equipment
and material.
Centre for Distance Education 4.5 Acharya Nagarjuna University

Helps in identifying unprofitable activities

With the help of cost accounting the unprofitable activities are identified, so that the
necessary correct action may be taken.

Helps in checking the accuracy of financial account

Cost accounting helps in checking the accuracy of financial account with the help of
reconciliation of the profit as per financial accounts with the profit as per cost account.

Helps in fixing selling Prices

It helps the management in fixing selling prices of product by providing detailed cost
information.

Helps in Inventory Control

Cost furnishes control which management requires in respect of stock of material,
work in progress and finished goods.

Helps in estimate
Costing records provide a reliable basis upon which tender and estimates may be
prepared.

2. Importance to Employees

Worker and employees have an interest in which they are employed. An efficient
costing system benefits employees through incentives plan intheir enterprise, etc. As a result
both the productivity and earning capacity increases.

3. Cost accounting and creditors

Suppliers, investor’s financial institution and other money lenders have a stake in the
success of the business concern and therefore are benefited by installation of an efficient
costing system. They can base their judgment about the profitability and prospects of the
enterprise uponthe studies and reports submitted by the cost accountant.

4. Importance to National Economy

An efficient costing system benefits national economy by stepping up the government

revenue by achieving higher production. The overall economic developments of a country
take place due to efficiency of production.

5. Data Base for operating policy

Cost Accounting offers a thoroughly analysed cost data which forms the basis of
formulating policy regarding day to day business, such as:
(a)Whether to make or buy decisions from outside?
(b)Whether to shut down or continue producing and selling at belowcost?
(c)Whether to repair an old plant or to replace it?
Advanced Management Accounting 4.6 Cost Ascertainment & Price…

4.6 COST ASCERTAINMENT – ELEMENTS OF COST

Cost is referred to ―the amount of expenditure (actual ornotional) incurred on, or

attributable to, a given thing. However, an exact definition of the term cost is difficult as its
interpretation depends upon the nature of the business, or industry, and the context in which it
is used.

For example, the cost of a product can be calculated excluding packaging expenses if
the sameare nominal in amount (eg. soap bar) while this treatment of exclusion of cost will
not be feasiblein case the nature ofthe product requires heavy packaging cost (eg. perfumes).

Cost can also be considered as monetary valuation of effort, risk involved,

opportunity forgonein production and delivery of a good or service and most importantly,
resources like time,material and utilities. It is also imperative to remember that all expenses
are costs, but not allcosts,especially the ones incurred in acquisition of an income-generating
asset, are expenses.

Before proceeding with the elements and components of cost, a basic understanding
of costobject and cost driver is necessary.

4.6.1 Cost Object

Cost object may be defined as anything for which a separate measurement of cost is
desired. Thefollowing examples will further enhance the understanding:

Cost Object Example

Product Laptop
Service Airfare from Mumbai to Delhi
Project Construction of Two Storied Building
Department HR Dept. of a company

4.6.2 Cost driver

Chartered Institute of Management Accountants defines cost driver as ―an activity

which generates cost. A cost driver triggers a change in the cost of an activity and is
generallyused to assign overhead costs to the number of produced units.

An activity can have more than one cost driver attached to it. For example, a
production activity may have a machine, machine operator(s), floor space occupied, power
consumed as the associated cost-drivers.

Examples of Cost Drivers

Machine Set-ups; Purchase Orders; Quality Inspections; Production Orders;
Shipments; Maintenance Requests; Power Consumed; Kilometers Driven; Projects or
Working Hours; Advertisements or Sales Volume; Product Hours
Centre for Distance Education 4.7 Acharya Nagarjuna University

4.6.3 Cost Unit, Cost Centre & Profit Centre

Cost Unit

The Chartered Institute of Management Accountants (CIMA), London, defines a unit of cost
as-a unit of quantity of product, service or time in relation to which costs may be ascertained
or expressed.

The preparation of cost accounts requires selection of a unit for identification of expenditure.
The quantity upon which cost can be conveniently allocated is known as cost unit.

For example: in case of electricity companies cost unit will be per unit of electricity
generated and in case of transport companies, it will be per passenger-km. or per tone-km.

Cost Centre

According to the Chartered Institute of Management Accountants, England, cost centre

means - a location, person or item of equipment or group of these for which costs may be
ascertained and used for the purpose ofcost control. It can be a department or a sub-
department or an item ofequipment or machinery or a group of persons.

Profit Centre
A profit center is a business unit or department within an organization that generates revenues
and profits or losses. Here, both the inputs and outputs are measured in monetary terms, and
accounting for both costs and revenues results in automatic computation of profit with respect
tothis centre, termed as profit centre.

4.7 ELEMENTS OF COST

The basic elements of cost can be illustrated as follows:

The broad elements of cost are categorized as Material, Labour and Expenses, which are
further classified as direct and indirect. The indirect material, labour and expenses together
are termed asoverheads.

A brief explanation of the elements has been given below:

Material: The basic substance used for producing the product is referred to as material.
Material can be direct or indirect in nature.

a. Direct Material: The materials which directly contribute to the production of the product
andare easily identifiable in the finished product are called direct materials. Cloth in shirt,
paper in books, wood in furniture are examples of direct materials.

b. Indirect Material: Other material which is ancillary in the production of any finished
productand cannot be conveniently assigned to specific physical units is called indirect
material. Forexample, printing in stationery, scissors used in cutting cloth for shirt, nails in
shoes or furniture.

Labour: Labour refers to the human effort needed for conversion of materials into finished
goods. Labour can be direct or indirect.
Advanced Management Accounting 4.8 Cost Ascertainment & Price…

a. Direct Labour: Labour which takes an active and direct part in the production of a
particular commodity and can be directly co-related to any specific activity of production is
termed asdirect labour.
Process labour, productive
labour, operating labour,
manufacturing labour,
direct wages etc are used
synonymously with direct
labour.

b. Indirect Labour:
Employees who do not
directly take part in the
manufacturing process and
whose cost cannot be
identified with the
individual cost centre are
included under indirect
labour. Such labour does
not alter the construction,
composition or condition of
the product. Salary of foreman, sales men and director are some examples of indirect labour.

Expenses: Costs incurred in the production process but not included under material or labour
are generally expenses. They can be direct or indirect.

a. Direct Expenses: These are expenses which can be directly, conveniently and wholly
allocated to specific cost centres or cost units. Direct expenses are sometimes also described
as - chargeable expenses.

b. Indirect Expenses: All expenses other than direct expenses are indirect in nature.

Overheads
People generally use the terms overheads and indirect expenses synonymously. But, it needs
to be understood that – over heads has a wider meaning than the term ―indirect expenses.

Overheads include the cost of indirect material, indirect labour besides indirect expenses.

Indirect expenses may be classified under the following three categories:

Factory (Manufacturing, works or production) Overheads: All expenses incurred in the

factory for its smooth functioning including production management expenses are included
here. Examples: Rent, rates, insurance, power etc. of factory.

Office and Administrative Overheads: include expenses pertaining to the management and
administration of business. Example: Rent of office, lighting, heating, printing, stationery, etc

Selling and Distribution Overheads: These are expenses incurred for marketing of
acommodity, for securing orders for the articles, despatching goods sold, and for making
efforts to find and retain customers
Centre for Distance Education 4.9 Acharya Nagarjuna University

4.8 METHODS OF COSTING

The fundamental principles of cost ascertainment remain the same but the methods of
analysing and presenting theses costs differ from industry to industry. Broadly, there are two
main methods used to determine costs viz. Job Cost Method and Process Cost Method.
However, the different methods of costing can be further bifurcated and can be explained
indetail as follows:

4.8.1 Job Costing

This method is used for tracing specific costs to individual jobs especially where
production is not highly repetitive. The cost ascertainment is for specific jobs or orders which
are not comparable with each other. Job costing is commonly used in printing press,
automobile garage, repair shops, etc.

4.8.2 Contract Costing

Principally, there is no difference between job and contract costing but it is

convenient to prepare and maintain separate contract accounts when large scale contracts are
carried out at differentsites like in the case of building construction, ship builders, etc. A
contract is a big job while ajob is asmall contract.

4.8.3 Cost Plus Costing

In some contracts, an agreed sum or percentage besides – cost‘to cover overheads and
profit ispaid tothe contractor. This system of costing is termed as cost plus costing. The
system is used generally where Government is the contractee.

4.8.4 Batch Costing

In this method of costing, a batch of similar products is considered as one job and the
cost of the complete batch is ascertained. Thereafter, the cost of each unit is determined.
Pharmaceutical industries, brick manufacturing companies generally use this method.

4.8.5 Process Costing

If a product passes through different stages, each distinct and well-defined, with the
output ofone process becoming the input for the other, it is desirable to know the cost of
production at each stage. Process costing is employed to ascertain the same. The system of
costing is suitable for the extractive industries, e.g., chemical manufacture, paints, foods,
explosives, soap making etc.

4.8.6 Operation Costing

The procedure of operation costing is broadly the same as for process costing except
that cost unit is an operation instead of a process. For large undertakings involving a number
of operations, it isimportant to compute the cost of each operation. For example, the
manufacturing of handles for bicycles will make use of operation costing as it involves many
Advanced Management Accounting 4.10 Cost Ascertainment & Price…

operations like cutting steelsheets into proper strips, moulding, machining and finally
polishing.

4.8.7 Unit Costing (Output Costing or Single Costing)

Under this method of costing, cost of a single product produced by a continuous

manufacturing process is computed in addition to amount of each element of cost.The method
is suitable in industries such as flour mills, paper mills, cement manufacturing etc.

4.8.8 Operating Costing

Also known as service costing, thismethod is employed to ascertain the cost of

services rendered like transport companies, electricity companies, or railway companies. The
total expenses regarding operation are divided by the units as may be appropriate (e.g., total
number of passenger-kms. in case of bus company) and cost perunit of service is calculated.

4.8.9 Departmental Costing

Departmental Costing aims to ascertain the cost of output of each department of the
company separately.

4.8.10 Multiple Costing (Composite Costing)

Application of more than one method of costing for the same product is done under
multiple costing. Herein, the costs of different sections of production are combined after
finding out thecost ofevery part manufactured. It is applicable where a product comprises of
many assembled parts, e.g., motor cars, engines, machine tools, typewriters, radios, cyclesetc.

4.9 TECHNIQUES OF COSTING

In addition to the above stated methods, the following techniques of costing are used
by management for the purpose of managerial decision making and controlling costs.

4.9.1 Marginal Costing

Marginal costing has been defined as the accounting system in which variable costs
are chargedto cost units and the fixed costs of the period are written-off in full against the
aggregate contribution. ‘Fixed overheads are excluded on the ground that in cases where
production varies, the inclusion of fixed overheads may give misleading results.

4.9.2 Direct Costing

The practice of charging all direct costs to operation, process or products, excluding
all indirect costs to be written off against profits in the period in which they arise, is referred
to as directcosting. Direct costing the technique considers some fixed costs as direct costs in
appropriate circumstances, thus differentiating it from marginal costing.
Centre for Distance Education 4.11 Acharya Nagarjuna University

4.9.3 Absorption Costing

The Institute of Cost and Management Accountant of India defines absorption costing
as – a method of costing by which all direct costs and applicable overheads are charged in
products or cost centers for finding out thetotal cost of production. Absorbed cost includes
production cost aswell as administrative and other costs Absorption costing does not make
any difference between variable and fixed cost in the calculation of profits. It charges all
costs, both variable and fixed, to operations, products or processes.

4.9.4 Uniform Costing

Uniform costing refers to a technique of costing wherein standardised principles and

methods of cost accounting are employed by a numberof different companies and firms, thus,
facilitating inter-firm comparisons, establishment of realistic pricing policies etc.

4.9.5 Activity Based Costing

The Chartered Institute of Management Accountants (CIMA), London, defines it as a

technique of ―cost attribution to cost units on the basis of benefits received from indirect
activities e.g. ordering, setting up, assuring quality. In other words, it is a method of assigning
organizations’ resource costs through activities (called cost drivers) to the products and
services. It is generally used by a company having products that differ in volume and
complexity of production for the purpose of apportionment of overhead costs.

4.10 LIMITATIONS OF COST ACCOUNTING

Like other branches of accounting, cost accounting is not an exact science but is an art
which has developed through theories and accounting practices based on reasoning and
common sense. These practices are not static but changing with time. Cost accounting lacks a
uniform procedure. There isno stereotyped system of cost accounting applicable to all
industries. There are widely recognised cost concepts but understood and applied differently
by different industries. Cost accounting can be used only by big enterprises.The limitations of
cost accounting are as follows:

 It is expensive because analysis, allocation and absorption of overheads require

considerable amount of additional work.
 The results shown by cost accounts differ from those shown by financial accounts.
Preparation of reconciliation statements frequently is necessaryto verify their
accuracy. This leads to unnecessary increase in workload.
 It is unnecessary because it involves duplication of work. Some industrial units are
functioning efficiently without any costing system.
 Costing system itself does not control costs. If the management is alert and efficient, it
can control cost without the help of the cost accounting.Therefore it is unnecessary.

4.11 SUMMARY OF THE LESSON

Cost accounting facilitates overcoming drawbacks of financial accounting like cost

ascertainment, tracing costs to individual products, cost reduction, cost control, etc.Although,
the terms costing, cost accounting and cost accountancy are generally used inter changeably
but they differ from each other.Cost accounting
Advanced Management Accounting 4.12 Cost Ascertainment & Price…

Cost accounting and financial accounting are different from each other on the basis of their
meaning, objective, information recorded, type of cost recorded, mode of presentation, time
period of Reporting, users, basis of valuation of stock and such other reasons.

Cost accounting, being voluntary with no specific uniform systems of cost accounting
applicable to all industries, makes comparisons difficult due to difference in understanding
and application of concepts, methods and techniques of cost accounting by different
industries.

Elements of cost include cost of material, labour and expenses. Overheads are
different from indirect expenses as the term includes indirect material and indirect labour in
addition to indirect expenses.There are two main methods of determination of costs, Job
costing and process costing.

4.12 KEY TERMS

Cost
Costing
Cost Reduction
Cost Control
Cost Audit
Cost object
Cost driver
Cost unit
Cost centre
Profit center
Direct Material
Direct Labour
Cost Sheet

4.13 SELF-ASSESSMENT QUESTIONS

Fill in the blanks with correct word/words.

1. .......................... Process of accounting for the incurrence of cost and the control of cost.
2. The objective of determining the.......................... of products is of main importance in
cost accounting.
3. Cost accounting provides information regarding the cost to make and
..........................product or services.
4. Cost accounting helps the management in providing information for..........................
decisions for formulating operative policies.
5. A .......................... system provides immediate information regarding stock of raw
material, semi-finished and finished goods
6. State the meaning and scope of cost accounting.
7. Explain the objectives of cost accounting.
8. Differentiate between cost accounting and financial accounting
9. What is the importance of cost accounting in a production unit?
10. Define costing, cost accounting and cost accountancy.
11. Write a short note on objectives of cost accounting.
12. What is a cost unit and a cost centre.
13. How is a cost centre different from profit centre?
Centre for Distance Education 4.13 Acharya Nagarjuna University

14. Differentiate between product cost and period cost.

15. Enumerate the different basis for classifying costs.
16. Write a short note on the elements of cost.
17. What are the different systems of costing?
18. Briefly explain the techniques of costing.

4.14 FURTHER READING

1. Cost Accounting - Theory and Practice by Banerjee Bhabatosh, 12th Edition, Prentice-
Hall India
2. A text book cost and management accounting by M.N.Arora, 9th edition 2010, Vikas
publications.
3. Accounting for managers by Prof. G Prasd, and Prof. V. Chandra sekhara Rao, 8th Edition
2012 Jayabharat Publishers

Dr. David Raju Gollapudi

 LESSON 5
MARGINAL COSTING

OBJECTIVES

After studying this unit you should be able to:

• Know the meaning and importance of marginal costing
• Distinguish between absorption costing and marginal costing
• Determine the margin of safety
• Understand the benefits and limitations of marginal costing

STRUCTURE

5.1 Introduction
5.2 Marginal Costing
5.3 Absorption Costing and Marginal Costing
5.4 Benefits of Marginal Costing
5.5 Limitations of Marginal Costing.
5.6 Self Assessment Questions
5.7 Exercises
5.8 Reference Books

5.1 INTRODUCTION

Marginal Costing is a useful technique which guides management in pricing,

decision making and assessment of profitability. It classifies costs into fixed and
variable ones. The expenses which vary directly in proportion to the volume of
production are termed as ‘variable expenses’. The expenses which remain constant or
unaffected by the change in output are called ‘fixed expenses’. This distinction forms
the basis of marginal costing.

Profit is influenced by the changes in fixed expenses and these expenses will
remain static and do not affect decision–making. Moreover they are largely
uncontrollable. The theory of marginal costing, therefore, argues that only variable
expenses should be taken into account for purposes of product pricing, inventory
valuation and other important management decisions.

5.1.1 Marginal Cost

The Institute of Cost and Works Accountants, London, defined marginal costs
as “the amount at any given volume of output by which aggregate costs are changed,
if the volume of Output is increased or decreased by one unit of output”. It is the
additional cost of producing one additional unit. It arises from the production of
additional increments of output.
Advanced Management Accounting 5.2 Marginal Costing

IIIu.1: A factory produces plastic cans. The variable cost of the can is
Rs.5.The fixed costs are Rs.5,000 per annum. Presently 200 cans are produced
annually. The cost sheet of 200 cans would be:

Rs.
Variable cost(200 x Rs.5) 1,000
Fixed cost 5,000
Total cost 6,000

If production is increased by one plastic can, the cost sheet of 201can would be:

Rs.
Variable Cost(201 x 5) 1,005
Fixed Cost 5,000
Total Cost 6,005

Marginal cost per unit is Rs.5(i.e., the cost of producing one additional
unit).Marginal cost ,thus consists of prime cost plus total variable over heads. It
should also be remembered that marginal cost takes into account only variable cost
and excludes the fixed cost. Within the capacity of an organisation, an increase of one
unit in production, obviously, will cause an increase in variable costs only. The
following illustration will make this clear.

Illu.2: Following information relates to a factory, manufacturing good

quality fountain pens:

Total cost Production Direct Labour Other variable Fixed costs

Rs. (units) material Rs. Costs Rs.
Rs. Rs.
3,250 500 1,000 750 500 1,000
5,500 1,000 2,000 1,500 1,000 1,000
7,750 1,500 3,000 2,250 1,500 1,000
10,000 2,000 4,000 3,000 2,000 1,000
12,250 2,500 5,000 3,750 2,500 1,000
Calculate marginal cost of production.
Centre for Distance Education 5.3 Acharya Nagarjuna University

Solution:
Marginal Cost of Production

Production Total Costs Fixed Costs Marginal Cost

Units (a) (b) (c)=(a)–(b)
Total Per Unit Total Per Unit Total Per Unit
Rs. Rs. Rs. Rs. Rs. Rs.
500 3,250 6.50 1,000 2.00 2,250 4.50
1,000 5,500 5.50 1,000 1.00 4,450 4.50
1,500 7,750 5.17 1,000 0.67 6,750 4.50
2,000 10,000 5.00 1,000 0.50 9,000 4.50
2,500 12,250 4.90 1,000 0.40 11,250 4.50

The above table shows that with an increase in production the total cost per unit
is decreasing. This happens because the fixed overheads which are constant at all
levels of output are apportioned over larger outputs. Hence, cost of output per unit
goes on declining with every increase in volume of output. It will be seen that while
the marginal cost of production per unit remains constant (atRs.4.50), the fixed cost
per unit decreases from Rs.2 to Rs.0.40. Marginal cost has been calculated thus:

Marginal Cost = Direct Material Cost + Direct Labour Cost +

Direct expenses + Variable overheads
OR
Marginal Cost=Total Cost–Fixed Cost

5.2 MARGINAL COSTING

Marginal Costing is a technique where only the variable costs are taken into
account while calculating the cost of product. The fixed costs are met against the total
fund arising out of excess of selling price over total variable cost. This fund is called
Contribution. Let us now go through various definitions given for Marginal Costing.

1. ICMA London: According to ICMA London, Marginal Costing is a

technique where only the variable costs are charged to cost units, the fixed
cost attributable being written off in full against the contribution for the
period.

2. D. Joseph: Marginal Costing is a technique of determining the amount of

change in the aggregate cost due to an increase of one unit over the
existing level of production.

3. Horold J. Wheldon: Other things being equal, the fixed over head will,
in total remain fixed during changes in production achieved and the rate
per unit will consequently vary, where as that variable overhead will
remain constant per unit of production and vary in total.
Advanced Management Accounting 5.4 Marginal Costing

5.2.1 Characteristics of Marginal Costing:

1. It is a technique of analysis and presentation of cost rather than an independent

method of costing. It can be applied with any method of costing.
2. Basically it involves differentiation of variable costs from fixed costs. It
considers only variable costs in its analysis.
3. It guides pricing and other managerial decisions on the basis of contribution.
4. The stock of finished goods and work-in-progress are valued at marginal cost.
5. Fixed costs are charged against the contribution earned during a period. No
portion of fixed cost is carried forward to next period.
6. The difference between the contribution and fixed cost represents either profit
or loss, excess of contribution and fixed cost is the profit and the deficiency of
contribution to fixed cost is the loss.

5.3 ABSORPTION COSTING AND MARGINAL COSTING

Absorption Costing technique is also known as Traditional or Full Cost

Method. In this method, both fixed and variable costs are recovered from production.
The variable costs, such as those of direct materials, direct labour etc., are directly
charged to the products, while fixed costs are apportioned on a suitable basis over
various products manufactured during a period. All costs are, thus, identified with
manufactured products.

Illu.3: A Company is manufacturing 3 products A, B and C. The costs of

their manufacture are as follows:

A B C
Rs. Rs. Rs.
Direct material pre Unit 3 4 5
Direct labour 2 3 4
Selling price 10 15 20
Output (Units) 1,000 1,000 1,000

The total overheads are Rs.12,000 out of which Rs.9,000 are fixed and rest
are variable. It is decided to apportion these costs over different products in the
ratio of output. You are required to prepare:

(a) A statement showing cost of each product and profit according to

absorption costing and
(b) A statement of cost and profit according to the Marginal costing
technique.
Centre for Distance Education 5.5 Acharya Nagarjuna University

Solution: (A)
Statement Showing Cost and Profit
(According to Absorption Costing Technique)

Particulars A=1,000 B=1,000 C=1,000

Per Total Per Total Per Total
Unit Rs. Unit Rs. Unit Rs.
Direct Material 3 3,000 4 4,000 5 5,000
Direct labour 2 2,000 3 3,000 4 4,000
Prime Cost 5 5,000 7 7,000 9 9,000
Add: Overheads:
Fixed 3 3,000 3 3,000 3 3,000
Variable 1 1,000 1 1,000 1 1,000
Total Cost 9 9,000 11 11,000 13 13,000
Profit 1 1,000 4 4,000 7 7,000
Sales 10 10,000 15 15,000 20 20,000
Total Profit=Rs.1,000+Rs.4,000+Rs.7,000=Rs.12,000

The system of absorption costing has a number of limitations. It assumes that

prices are simply a function of costs. The demand side of the product is thoroughly
discounted. Only past costs are considered which arriving at pricing decisions.
Further, it does not offer information which helps decision making in a changing
environment.

More importantly charging of fixed costs to different products on a suitable

basis poses innumerable problems. These costs have to be incurred whether there is
production or not. In other words, the cost of a product not only depends on expenses
which have been incurred directly but also on the volume of output. For example, if
the cost of direct material and direct labour for a product is Rs.2 and Rs.4
respectively and the volume of output is 500 units the total cost of production will be
as under:

Rs.
Costs of Direct material and labour 3,000
Fixed Overheads 1,000
Total Cost 4,000

The cost per unit comes to Rs.8. In case the output is only 400 units the cost of
production (400 x 6+10,000) would beRs.3,400 and cost per unit would increases not
because prices of materials or labour have gone up, but because lower level of
production. Obviously, the whole exercise seems to be illogical. The technique of
marginal costing is employed to overcome this deficiency, by charging, fixed costs
against the total fund arising out of excess of selling price over variable cost.
Advanced Management Accounting 5.6 Marginal Costing

(b)Marginal Cost Statement

Particulars A=1,000 B=1,000 C=1,000
Per Total Per Total Per Total
Unit Rs. Unit Rs. Unit Rs.
Sales (S) 10 10,000 15 15,000 20 20,000
Less: Marginal Cost:
Direct Material 3 3,000 4 4,000 5 5,000
Direct Labour 2 2,000 3 3,000 4 4,000
Prime Cost 5 5,000 7 7,000 9 9,000
Variable Overheads 1 1,000 1 1,000 1 1,000
Total Marginal Cost (V) 6 6,000 8 8,000 10 10,000
Contribution (S-V) (C)
4 4,000 7 7,000 10 10,000
Selling Price
10 10,000 15 15,000 20 20,000
Thus, the total contribution from the three products, A, B and C is
Rs.21,000.The profit will now be computed as follows:

Rs.
Total Contribution 21,000
Fixed costs 9,000
Profit 12,000

5.3.3 Differences between Marginal Costing and Absorption Costing:

The difference between absorption costing and marginal costing, as the above
illustrations show, is based on the recovery to fixed overheads. In absorption costing
both fixed and variable overheads are charged to production. As a result, work in
progress and finished goods are valued at ‘works cost’ and ‘total cost of production’
respectively, giving effect to fixed overheads. In marginal costing only variable over
heads are charged to production, there by leading to under-recovery of overheads.

This obviously leads to undervaluation of closing stock. But this does not result
in carrying over of fixed overheads of one period to another, as it happens in
absorption costing. The main points of difference between absorption costing and
marginal costing are given below:

Differences between Marginal and Absorption Costing

Basis of Difference Absorption Costing Marginal Costing

1.FixedCosts Fixed overheads are Fixed costs are not
Charged to the product to Included while computing
Be subsequently released Cost per unit.
As a part of cost of goods
Sold i.e., it is included in
Cost per unit.
Centre for Distance Education 5.7 Acharya Nagarjuna University

Basis of Difference Absorption Costing Marginal Costing

2.Profit Profit is the difference Profit in marginal costing
between sales and cost of is ascertained by
goods sold. establishing the total
contribution and then
deducting there from the
total fixed expenses.
Contribution is the excess
of sales over variable
cost.
3.ClassificationofCosts Costs are rarely classified Cost – Volume – Profit
into variable and fixed. relationship is an
Although such a essential part of marginal
classification is possible, it costing. Costs have to be
fails to establish a cost– classified into fixed costs
Volume profit relationship. And variable costs.
4. Valuation of If inventories increase If inventories increase
Inventories during a period, this during a period, this
method will reveal more method generally reports
profit than marginal less income than
costing. When absorption costing, but
inventorie when
s decrease, less profits are inventorie
reported because in this s decrease this method
method closing stock is reports more net income.
Valued at higher figures.
5. Recovery of Apportionment of fixed There is no arbitrary
Over heads costs is arbitrary and this apportionment of fixed
may result in under overheads, as fixed costs
Recovery of overheads. Are excluded.

5.3.4 Contribution:

Contribution represents the difference between sales and variable costs. It may
be considered as some sort of fund from out of which all fixed costs are to be met.
The difference between contribution and fixed costs represents either profit or loss, as
the case may be. Contribution is also called ‘Gross Margin’. Contribution can be
expressed thus:

Contribution = Selling Price – Variable cost

Or
Fixed Cost + Profit or Loss
Profit/Los = Contribution–Fixed Cost
Advanced Management Accounting 5.8 Marginal Costing

5.3.5 Marginal Cost Equation:

ThealgebraicexpressionofcontributionisknownasMarginalCostEquation.Itcanbe
expressed as follows:

S– V=F+P

Where
S = Selling Price
V=Variable Cost F = Fixed
Cost
P=Profit

IIIu.4:From the following information find out the amount of profit earned
during the year using marginal cost technique.
Fixed cost Rs.5,00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 1,50,000 units.

Solution:
Sales = 1,50,000 units 15 = Rs.22, 50,000
Variable cost = Rs.1,50,000 10 = Rs.15,00,000
Fixed cost = Rs.5,00,000
S– V=F+P
Rs.22,50,000 – Rs.15,00,000 = 5,00,000 + P
Rs.7,50,000 – 5,00,000 = P
Rs.2,50,000=P
P=Rs.2,50,000

5.4. BENEFITS OF MARGINAL COSTING

The technique of marginal costing is of immense use to the management in taking

various decisions. It helps the management in taking the following decisions:

1. Helps in determining level of output: Marginal costing helps in finding

out the output which is most profitable for running a concern. This, in
turn, helps in utilising plant capacity in full, and realize maximum profits.
By determining the most profitable relationships between cost, price and
volume, marginal costing helps a business to determine most competitive
prices for its product.

2. Help in selection of most suitable product mix: By applying marginal

costing techniques, the most suitable production line could be determined.
Centre for Distance Education 5.9 Acharya Nagarjuna University

The profitability of various products can be compared and the most

products which languish behind and which do not seem to be feasible (in
view of their inability to recover marginal cost) may be eliminated from
the production line by keeping the capacity and resources constrains in
mind. It will also serve as a guide in arriving at the price for new products.

3. Helps in determining Make or Buy decisions: The marginal cost of

producing an article inside the factory serves as a useful guide while
arriving at make or buy decisions. The costs of manufacturing can be
compared with the costs of buying outside and a suitable decision can be
arrived at easily.

4. Helps in the selection of method of production – Manual or Machine

Based: In case a particular product can be produced by two or more
methods, as curtaining the marginal cost of producing the product by each
method will help in deciding as to which method should be followed. The
same is true in case of decisions to use machine power in place of manual
labour.

5. Helps in decision making during Recessionary period: In periods of

trade depression, marginal costing helps in deciding whether production
in the plant should be suspended temporarily or continued in spite of low
demand for the firm’s product.

6. Help in product planning: Marginal costing helps in determining the no-

profit no- loss point. The efficiency and economy of various products,
plants, departments can also be determined. This helps in profit planning
as well as cost control.

5.5 LIMITATIONS OF MARGINAL COSTING

Marginal costing has the following limitations:

1. Difficulty in Classifications: In marginal costing, costs are segregated

into fixed and variable. In actual practice, this classification scheme proves to be
super fluous in that certain costs maybe partly fixed and partly variable and certain
other costs may have no relation to volume of output or even with the time. In short,
the categorization of costs into fixed and variable elements is a difficult and tedious
job.

2. Difficulty in Application: The marginal costing technique cannot be

applied in industries where large stocks in the form of work in progress (job and
contracting firms)

3. Defective Inventory Valuation : Under marginal costing, fixed costs are

Advanced Management Accounting 5.10 Marginal Costing

not included in the value of stock of finished goods and work in progress. As fixed
costs are also incurred, these should form part of the cost of the product. By
eliminating fixed costs from finished stock and work in progress, marginal cost is
objectionable because of other reasons also:
i. In case of loss by fire, full loss cannot be recovered from the insurance
company.
ii. Profits will be lower, than that shown under absorption costing and
hence maybe objected by taxation authorities.
iii. Circulating assets will be estimated in the balance sheet.

4. Objectionable basis of Pricing: In marginal costing, sale prices are

arrived at on the basis of contribution alone. This is an objectionable practice. For
example, in the long run, the selling price should not be fixed on the basis of
contribution alone as it may result in losses or low profits. Other important factors
such as fixed costs, capital employed should also be taken into account while fixing
selling prices. Further, it is also not correct to lay more stress in selling function, as is
done in marginal costing and relegate production function to the background.

5. Limited scope: The utility of marginal costing is limited to short run

profit planning and decision making. For decisions of far reaching importance, one is
interested in special purpose cost rather than variable cost. Important decisions on
several occasions, depend on non-cost considerations also, which are thoroughly
discounted in marginal costing.

In view of these limitations marginal costing needs to be applied with necessary

care and caution. Fruitful results will emerge only when management tries to apply
the technique in combination with other useful techniques such as budgetary control
and standard costing.

5.6 QUESTIONS

I. Short Questions:

1. Defined the term ‘marginal costing’.

2. How can the cost be classified on the basis of variability?
3. What is contribution?

II. Essay type questions:

1. Explain the advantages and disadvantages of marginal costing.

2. Discuss the applications of the marginal costing technique.
3. DefineMarginalCosting.ExplaintheadvantagesandlimitationsofMarginalCosting.
4. DefineMarginalCosting.ExplainthedifferencesbetweenMarginalCostingand
absorption costing.
Centre for Distance Education 5.11 Acharya Nagarjuna University

5. What is marginal costing? Explain the advantages and disadvantages of marginal

costing.

5.7 EXERCISES

1. What is the amount of Fixed Costs when sales in Rs.2,40,000; Direct Material is
Rs.80,000; Direct Labour is Rs.50,000, Variable overheads are Rs.20,000 and profit
is Rs.50,000?

[Ans.: Fixed Costs: Rs.40,000]

2. From the following information, calculate margin of safety.

Rs.
Sales(4,000units@Rs.25each) 1,00,000
Variable cost 72,000
Fixed expenses 16,800

[Ans.: Margin of Safety Rs.40,000]

3. Given, fixed cost of Rs.5,00,000; variable cost as Rs.10 per unit; selling price of
Rs.15 per unit and output as 1,50,000 units, find the profit earned.

[Ans.: Profit Rs.2,50,000]

4. Using the information given below, prepare operating statements for the
months of June and July, 2007 using.

(i) Marginal costing technique and (ii) Absorption costing

Per unit
Rs.
Selling price 50
Direct material cost 18
Direct labour cost 4
Variable production overhead 3

Monthly costs:

Fixed production overheads 99,000

Fixed selling expenses 15,000
Fixed administration expenses 25,000
Advanced Management Accounting 5.12 Marginal Costing

Variable selling costs are 10% of sales revenue and normal production capacity
is 11,000units per month. The other details are:

Sales Production
(units) (units)
June 10,000 12,000
July 12,000 10,000
[Ans.: Profits: (i)Rs.61,000; Rs.1,01,000; (ii) Rs.81,670; 80,330]

5. The following data are obtained from the records of a factory:

Rs. Rs.
Sales4,000unitsatRs.25each 1,00,000
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
72,000
Fixed overheads 18,000 90,000
Profit 10,000

It is proposed to reduce the selling price by 20%. What extra units

should be sold to obtain the same amount of profit as above?

[Ans.: Units sold:(a)14,000 units; Extra units to be sold:14,000 4,000 =

10,000 units]

6. On the basis of the following data prepare a Marginal cost statement:

Variable Cost Rs. Rs.

Direct Material 4,500
Direct Wages 2,500
Factory overhead 1,050
Administration, selling and distribution overhead 1,600 9,650
Fixed Cost
Factory overhead 400
Administration, selling and distribution overhead 670 1,070
Total Cost 10,720
Profit 4,280
Sales 15,000

[Ans.: Profit Rs.4,280]

Centre for Distance Education 5.13 Acharya Nagarjuna University

7. Takur Ltd., produces 1 standard type of article. The results oflast4 months of
2007 are as follows.

September October November December

Output in Units 200 300 400 600

Prime Cost is Rs.10 per unit Variable

expenses are Rs.2 per unit Fixed
expenses are Rs.36,000 p.a. Find out
cost per unit of each month.
[Ans.: Cost per unit:Oct.Rs.10;Nov.Rs.7.50;Dec.Rs.5]

8. Calculate the fixed cost from the following information:

2006 2007
Sales(Rs.) 4,00,000 6,00,000
Profit(Rs.) 80,000 2,00,000
[Ans.:Rs.1,60,000]

5.8 REFERENCE BOOKS

1. R.S.N.Pillai,& Bagavathi, Management Accounting ,S. Chand & Company

Ltd., New Delhi
2. M.A.Sahaf, Management Accounting–Principles & Practice, Vikas
Publishing House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K.Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting–
5. N.Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V.Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP.Jain & KL Narang, Advanced Cost and Management Accounting
 LESSON 6
MARGINAL COSTING – CVP ANALYSIS
OBJECTIVES:

After reading this lesson you should be able to:

 Understand the break even analysis and profit/volume ratio
 Know the meaning and importance of margin of safety
 Prepare break even chart of an organization

STRUCTURE:

6.1 Break Even Analysis

6.2 Profit/ Volume Ratio
6.3 Margin of Safety
6.4 Break Even chart
6.5 Advantages of Break-Even Analysis
6.6 Limitations of Break-Even Analysis
6.7 Self Assessment Questions
6.8 Exercises
6.9 Reference Books

6.1 BREAK-EVENANALYSIS

Break even analysis is a specific method of presenting and studying the inter
relationship between costs, volume and profits. (Hence, it also known as Cost – volume
– Profit Analysis – C.V.P Analysis). It is an important tool of financial analysis whereby
the impact on profit of the changes in volume, price, costs and mix can be found out
with a certain amount of accuracy. A business is said to break even when its total sales
are equal to its total costs. Breakeven point is a point of no profit or no loss. At this
point contribution is just sufficient to recover the fixed costs. Breakeven point can be
calculated in units or sales. It can be calculated with the help of any of the following
formulae.
Advanced Management Accounting 6.2 Marginal Costing – CVP Analysis

At break-even point the desired profit will be zero. Where the volume of output
sales is to be calculated so as to earn a desired amount of profit, the amount of desired
profit has to be added to the fixed cost.
Illu.1: From the following particulars calculate the Break-even point in terms of
both quantity and value:

Production in units 10,000

Sales price Rs.5.00perunit
Variable costs Rs.20,000
Fixed costs Rs.12,000

Solution: Calculation of Break-even Point

6.2 PROFIT/VOLUME RATIO

The profitability of business operations could be found outby calculating the

profit – volume ratio (P/V Ratio). It is the ratio of contribution to sales. It is also
known as marginal – income ratio, contribution – Sales ratio or variable – profit
ratio. The ratio can be shown in the form of a percentage also.

The ratio can also be shown by comparing the change in contribution to change
in sales, or change in profit to change in sales. Any increase in contribution, obviously,
Centre for Distance Education 6.3 Acharya Nagarjuna University

would mean increase in profit, as fixed expenses are assumed to be constant at all levels of
production.

The importance of P/V Ratio lies in its use for evaluating the profitability of
alternative products or proposals. A higher ratio shows grater profitability.
Management should, there force, try to increase P/V Ratio by widening the gap
between the selling price and the variable costs. This can be achieved by increasing
sale price, reducing variable costs or switching over to more profitable products.

IIIu.2: A Company producing a single article sells at Rs.20 each. The

marginal costs of production is Rs.12 each and fixed cost is Rs.8,000 p.a.
calculate I) the P/V ratio, ii)sales required to break – even.

Solution:

Illu.3: Calculate margin of safety and the amount of actual sales from the following:

Rs.
(i) Profit 10,000
(ii) PV Ratio 50%
(iii) BEP Sales 20,000
Advanced Management Accounting 6.4 Marginal Costing – CVP Analysis

Solution:
Centre for Distance Education 6.5 Acharya Nagarjuna University
6.3 MARGIN OF SAFETY

Total sales minus the sales at breakeven point is known as the margin of safety.
Lower break–even point means a higher margin of safety. Margin of safety can also
be expressed as a percentage of total sales. The formula is:
Margin of Safety = Total Sales–Sales at BEP

Higher margin on safety shows that the business is sound. Even when sales
substantially come down the business may earn profit. Lower margin of safety, means
that when sales come down slightly profit position may affect adversely. Thus,
margin of safety can be used to test the soundness of a business. In order to improve
the margin of safety, a business can increase selling prices (without affecting demand,
of course)reducing fixed or variable costs and replacing unprofitable products with
profitable ones.

Illu.5: From the following information calculate:

(a) P/V Ratio.
(b) Break Even Point
(c) Margin of Safety.

Rs.
Total Sales 3,60,000
Selling price per unit 100
Variable Cost per unit 50
Fixed Costs 1,00,000

(d) If selling prices is reduced to Rs.90, by how much is the margin of safety is
reduced?

Solution:
Advanced Management Accounting 6.6 Marginal Costing – CVP Analysis

Illu.6:A manufacture has supplied the following information relating to one of

his product.

Total variable costs Rs.30,000

Total sales Rs.60,000
Units sold 20,000
Total Fixed Costs Rs.18,000

Calculate:
a. Contribution per unit
b. Break-even point
c. Margin of Safety
d. Profit
e. Volume of sales to earn a profit of Rs.24,000

Solution:
Centre for Distance Education 6.7 Acharya Nagarjuna University

IIIu.7: In 2006, Srikanth Ltd., sold its products worth Rs.40 lakhs and made a
profit of Rs.4 lakhs. But in 2002, the sales dipped to Rs.30 lakhs due to competition in
the market and the profit is reduced to 3 lakhs. Calculate Break – even points and
profit volume rations in 2006 and 2007.
Advanced Management Accounting 6.8 Marginal Costing – CVP Analysis

Illu.8: The sales and profits during two periods are as under:
Period I : Sales Rs.20 lakhs; profit Rs.2 lakhs
Period II: Sales Rs.30 lakhs; Profit Rs.4 lakhs.

Calculate: (a) P/V Ratio (b) Breakeven point (c) Sales required to earn a
profit of Rs.5 lakhs (d) Profit when sales are Rs.50 lakhs, and (e) Margin of
safety at a profit of Rs.2.5 lakhs.
Centre for Distance Education 6.9 Acharya Nagarjuna University

Illu.9: The following information was extracted from the books of Giridhar Mft. Co.Ltd.

Rs.
Sales 1,80,000
Less: Variable Costs 1,44,000
Contribution 36,000
Less: Fixed costs 24,000
Net Profit 12,000

Calculate the following (a) P/V ratio (b) Break-even point (c) Net profit
earned at sales of Rs.2,70,000 (d) Sales required to earn a profit of Rs.24,000.

Illu.10: The price structure of a cycle made by the Cycle Company Ltd., is as follows.

Per Cycle
Rs.
Materials 60
Labour 20
Variable Over head 20
100
Fixed Over heads 50
Profit 50
Selling Price 200
This is based on the manufacture of one lakh cycles per annum.
Advanced Management Accounting 6.10 Marginal Costing – CVP Analysis

The company excepts that due to competition they will have to reduce selling
prices, but they want to keep the total profits intact. What level of production will have
to be reduced i.e., how many cycles will have to be made to get the same amount of
profit if:
a. TheSellingpriceisreducedby10%
b. The selling price is reduced by 20%
Solution:

(a) If Selling price is reduced by 10% Rs.

Selling Price 200
Less: Price 20
Present Selling Price 180

If Selling Price is reduced by 20% Rs.

Selling Price 200
Less: 20% reduction 40
Present Selling Price 160
Centre for Distance Education 6.11 Acharya Nagarjuna University

Ilu.11: Find P/V Ratio and Margin of Safety –when sales, variable cost, fixed
costs are Rs. Ten lakhs, Four lakhs, Four lakhs respectively.

Illu.12: Fixed expenses Rs.1,50,000 percentage of variable expenses on sales is

66 2/3 %. Normal sales at 100% capacity is Rs.9,00,000. Calculate,
a. P/V Ratio
b. Breakeven point at what percentage of sales
c. Profitat80% of sales capacity.

Illu.13: Sri Sai Ram Limited furnishes you the following information relating to
the half year ended 30th June 1996:

Rs.
Fixed expenses 45,000
Sales value 1,50,000
Profit 30,000

During the second half of the year, the company has projected a loss of
Rs.10,000.
Advanced Management Accounting 6.12 Marginal Costing – CVP Analysis

Calculate:
(a) The Break-even point and Margin of safety for six months ending 30th June 1996.
(b) Expected sales volume for second half of the year assuming that P/V ratio and
fixed expenses remain constant in the second half year also.
(c) The Break –even point and Margin of safety for the whole year 1996.

Alternatively:
Margin of Safety = Actual Sales–Break Even Sales
= (Rs.1,50,000+70,000)Rs.1,80,000=Rs.40,000
Centre for Distance Education 6.13 Acharya Nagarjuna University

Illu.14: The following figures relate to a company manufacturing a varied range of

products.

Total Sales Total Cost

Rs. Rs.
Year ended 31st March, 2001 22,23,000 19,83,600
Year ended 31st March, 2002 24,51,000 21,43,200
Assuming stability in prices, with variable costs carefully controlled to reflect
predetermined relationships, and an unvarying figure for fixed costs, calculate:

a. The profit / volume ratio, to reflect the rates of growth for profit and sales; and
b. Any other cost figures to be deduced from the data.

Solution:
Sales Cost
Rs. Rs.
2001 22,23,000 19,83,600
2002 24,51,000 21,43,200
Difference 2,28,000 1,59,600
Advanced Management Accounting 6.14 Marginal Costing – CVP Analysis

Illu.15: From the following data calculate:

i) P/V ratio
ii) Profit when sale are Rs.20,000
iii) New Break-even point if selling price is reduced
by 20%. Fixed expenses Rs.4,000
Break-even point Rs.10,000

Solution:

6.4 BREAK-EVEN CHART

The breakeven point can also be shown graphically through the break even chart. The
break even chart shows the profitability or otherwise of an under taking at various levels of
activity and as a result indicate the point at which neither profit nor loss is made. It shows
the relationship, through a graph between cost, volume and profit. The breakeven point lies at
the point of intersection between the total cost line and the total sales line in the chart.

In a nut shell break–even charts are often used to depict the following.

1. Cost volume profit relationships and break-even point.

2. Profit volume ratio and margin of safety
3. The impact of change in the level of sales on likely costs and profit.
4. Profit appropriations and expense analysis.
Centre for Distance Education 6.15 Acharya Nagarjuna University

5. For controlling profits and level of activity by comparing the budgeted with
actual sales and profit.
6. For deriving the figures of optimum output
6.4.1 Preparation of break–even Charts:

These charts are shown on the graph paper by drawing lines at the point which are to
be plotted. The sales in units are depicted on the horizontal line i.e., X-X’ and costs and
revenue on the vertical line i.e., Y-Y’. Both are expressed in monetary values.

First of all a line is drawn parallel to X-axis showing the fixed costs. Then the total
cost line is drawn and inserted upon the fixe cost line. There after the sales line is drawn
diagonally touching the zero at the orgin point and the highest point on the vertical scale.
The point at which this sales line interests the total cost line, is the breakeven point. The right
sector of this point shows the profits and the left sector shows the loss. This is a simple break
even chart. Suitable description regarding variable costs, fixed costs, profit or loss and break-
even point are usually written on this chart.

6.4.2 Angle of Incidence:

It is an angle at which sales line cuts the total costs line. A high angle denotes high
rate of profit while a low angle reflects poor rate of return. Obviously management must plan
for high angle of incidence which can only be when variable costs bear a low proportion of
cost of sales.

If the angle is large, the firm is said to be making profits at a high rate or vice versa.
A large angle of incidence together with a high margin of safety indicate sound business
conditions. Therefore, the management’s aim will be to have as large an angle as possible;
because this shows a high rate of profit once the fixed costs are met. A narrow angle, on the
other hand would show that even after absorbing the fixed costs the rate of profit is
comparatively low. In other words, it indicates that the variable costs form a large part of the
total costs.
Advanced Management Accounting 6.16 Marginal Costing – CVP Analysis

Illu.16:From the following information draw up a chart to show break-even points.

Rs.
Fixed costs(Total) 40,000
Variable costs(per unit) 2
Selling price(pe runit) 3

Solution:

40,000 units x selling price per unit i.e., Rs.3 = Rs.1,20,000 when output is 40,000 units.
Total cost and Total sales will be Rs.1,20,000.

In the graph given below the horizontal scale OX shows volume of production expressed
in units. The vertical scale OY shows sales and cost in Rs.10,000. In the chart three lines are
drawn. The first line shows fixed cost which is parallel to the base scale and has not relation
with the output.

Output in Units

The sales line (total sales) is drawn from the point where there are no sales (zero
intersection of horizontal and vertical scales).
The total cost line (variable costs + fixed costs) is drawn from the point of fixed costs.
The total costs and total sales lines intersect each other at point “P” which is a B.E.P. from
Centre for Distance Education 6.17 Acharya Nagarjuna University

this point perpendicular is drawn which touches output at R (40,000 units) and Revenue at Q
(Rs.1,20,000). If the output is below 40,000 units there will be a loss. If output exceeds
40,000 units there will be a profit. Output in excess of 40,000 units i.e., RX shows margin of
safety.

Illu.17:The following figures relate to one year’s working at 100% capacity level in a
manufacturing business.

Rs.
Fixed Over heads 30,000
Variable Overheads 50,000
Direct Wages 40,000
Direct Materials 1,00,000
Sales 2,50,000

Represent that above figures on a break-even chart and determine from the chart
the break-even point. Verify your result by calculations.
Advanced Management Accounting 6.18 Marginal Costing – CVP Analysis

Cash Break-Even Chart:

This chart is prepared to show the cash needs of a concern. Fixed expenses are to be
classified as those involving cash payments and those not involving cash payments like
depreciation. As the cash break even chart is designed to include only actual payments and not
expenses incurred, any time lag in the payment of items included under variable cost must be
taken into account. Equal care must be shown on the period of credit allowed to the debtor for
the purpose of calculating the amount of cash to be received from them, during a particular
period. Cash break-even point is used to assess the liquidity position of the firm. It can be
calculated as under:

6.4.3 Assumptions of Break even Analysis:

Break even analysis is based on the following assumptions.

i Fixed cost remains constant at all levels of output.

ii Variable costs fluctuate indirect proportion to volume of output.
iii Selling prices do not change as volume changes.
iv There is only one product and in the case of multiple products, the sales mix
remains constant.
v There will be no change in general price level.
vi Productivity per worker will remain unchanged.
vii There is synchronization between productions and sales, i.e., whatever is
produced is sold out.

6.5. ADVANTAGES OF BREAK EVEN ANALYSIS

The break even analysis is a simple tool employed to graphically represent

accounting data. The data revealed by financial statements and reports are difficult to
understand and interpret. But when the same are presented through break even charts, it
becomes easy to understand them. Break even charts help in:

1. Determining total cost, variable cost and fixed cost at a given level of activity;
2. Finding outbreak even output or sales;
3. Understanding the cost, volume, profit relationship;
4. Making inter-firm comparisons;
5. Fore casting profits;
6. Selecting the best product mix;and
7. Enforcing cost control.
Centre for Distance Education 6.19 Acharya Nagarjuna University

Thus, the break even analysis can be used to find out the effect of all these changes
which influence total revenue and total cost and thereby the profitability of a business. The
marginal cost approach, which is better termed as relevant cost approach, is vital for making
a choice out of various alternatives. But to make all decision on the basis of marginal cost
would be wrong. Normal prices for example are based on full costs and not marginal cost.

6.6. LIMITATIONSOFBREAKEVENANALYSIS

On the negative side, break even analysis suffers from the following limitations.

1. Difficulty in segregation of Costs: It is very difficult, if not impossible, to

segregate costs into fixed and variable components. Further, fixed costs to not
always remain constant. They have a tendency to rise to some extent after
production reaches certain level. Likewise, variable costs do not always vary
proportionately.

2. Complicated Calculations: The application of break even analysis to a multi-

product firm is very difficult. A lot of complications are involved.

3. Limited Importance: The breakeven point has limited importance. At best it

would help management to indulge in cost reduction in times of dull business.
Normally, it is not the objective of business to break even, because no business
is carried on in order to break even. Thus, the BEP ‘Provides neither a standard
of performance nor a guide for executive decisions.

4. Limitations application in long-range planning: Break even analysis is a short

run concept, and it has a limited application in the long range planning.

Despite these limitations, break even analysis has some practical utility in that it helps
management in profit planning. According to Wheldon, “if the limitations are accepted, and
the chart is considered as being an instantaneous photograph of the present position and
possible trends, there are some very importance conclusions to be drawn from such a chart”.

Illu.18: A factory engaged in manufacturing plastic buckets is working at 40% capacity

and produces 10,000 buckets for annum.
The present cost break- up for one bucket is as under:

Rs.
Material 10
Labour Cost 3
Overheads 5(60%fixed)
ThesellingpriceisRs.20per
bucket.
Advanced Management Accounting 6.20 Marginal Costing – CVP Analysis

If it is decided to work the factory at 50% capacity, the selling price falls by 3%.
At 90% capacity the selling price falls by 5% accompanied by a similar fall in the prices
of material.

You are required to calculate the profit at 50% and 90% capacities and also the
break-even points for the same capacity productions.

Solution:

Statement showing profit and break-even point at different capacity levels

50% 90%
Capacity level Production 12,500 22,500
(Units) Per Unit Total Per Unit Total
Rs. Rs. Rs. Rs.
a) Sales 19.40 2,42,500 19.00 4,27,500
Variable cost material 10.00 1,25,000 9.50 2,13,750
Wages 3.00 37,500 3.00 67,500
Variable overhead 2.00 25,000 2.00 45,000
b) Total varibale cost 15.00 1,87,500 14.50 3,26,250
Contribution(S-V)
c)
Or(a-b)
4.40 55,000 4.50 1,01,250
Less: Fixed cost
Net profit 30,000 30,000
Break-even point at 25,000 71,250
50% 90%

Illu.19:From the following data calculate:

i) P/V ratio
ii) Profit when sales are Rs.20,000

iii) New Break – even point if selling price is reduced by 20%.

Fixed expenses Rs.4,000

Break-even point Rs.10,000
Centre for Distance Education 6.21 Acharya Nagarjuna University

Solution:

Illu.20: The sales and profit during the years were as follows.

Sales Profit
Rs. Rs.
2001 1,50,000 20,000
2002 1,70,000 25,000

You are required to calculate

a. P/V Ratio
b. Breakeven level
c. Sales required to earn a profit of Rs.40,000
d. Margin of Safety at a profit of Rs.2,50,000
e. Profit made when sales are Rs.50,000
f. Variable Cost in the two periods.
Advanced Management Accounting 6.22 Marginal Costing – CVP Analysis

Solution:

Illu.21: Assuming that the cost structure and selling prices remain the same
in periods I and II find out:

(a) Profit volume ratio,(b) Profit when sales are Rs.1,00,000.

Periods Sales Profit

Rs. Rs.
I 1,20,000 9,000
II 1,40,000 13,000
Centre for Distance Education 6.23 Acharya Nagarjuna University

6.7 SELF ASSESSMENT QUESTIONS

I. Short Questions:

1. What is break- even point?

2. What is margin of safety?
3. What is profit-volume ratio?
4. What is contribution?
5. What is angle of incidence?
6. What is Cash break-even point?

II. Essay type questions:

1. Explain cost-volume profit analysis.

2. Explain the ways by which profit-volume ratio can be improved.
3. Explain the uses of break-even analysis in profit planning.
4. What assumptions are made to construct a simple Break-even Chart?
5. Explain the utility of Break-even Analysis in Managerial Decisions
6. What do you meant by Break-even level of output?
7. What are the limitations of the break-even charts?
8. What are the managerial uses of break-even analysis?
9. What is Profit volume ratio and Profit Volume graph? How is Profit-
volume graph technique helpful to management?
10. What is C.V.P.? Analyse and state its uses and applications.
11. Explain ‘Break-Even Analysis’. Discuss the assumptions that underline the
technique and the practical usefulness of Break-even analysis.
12. Define Break-even-Point and explain its advantage and limitations.
13. What do you mean by P/V Ratio? What are its uses?
14. What are the assumptions of Break-even-Analysis?
15. Explain the concepts of marginal costing and Break-even analysis.
16. Explain about Break-even Analysis. What are its applications?
6.8 EXERCISES

1. From the following particulars calculate the Break-even point interms of

both quantity and value:
Production in units 10,000
Sales price Rs.5,00 per
unit
Variable costs Rs.20,000
Fixed costs Rs.12,000

[Ans.: (a) 4,000 units; (b Rs.20,000]

Advanced Management Accounting 6.24 Marginal Costing – CVP Analysis

3. What is the break-even-point when sales is Rs.6.0 lakhs; Fixed expenses are
Rs.1.5 lakhs and Variable costs are Rs.4.0 lakhs?

[Ans.:Rs.4.5lakhs]

4. Find P/V Ratio and Margin of Safety –when sales, variable cost, fixed costs are
Rs. Ten lakhs, Four lakhs, Four lakhs respectively.

[Ans.: P.V. Ratio=60%; MOS=Rs.3,33,333]

5. The following information is extracted from the books of Harish Ltd.

Year Sales Cost

Rs. Rs.
2006 2,00,000 1,40,000
2007 2,40,000 1,60,000
Calculate B.E.P.

[Ans.: BEP Rs.80,000; P.V.Ratio=50%;Fixed Cost Rs.40,000]

6. A company estimates that next year it will earn a profitofRs.50,000.The budgeted

fixed costs and sales are Rs.2,50,000 and Rs.9,93,000 respectively. Find out Break-
Even point.

[Ans.: Rs.8,27,500]
7. From the following information, calculate margin of safety.

Rs.
Sales(4,000units@Rs.25each) 1,00,000
Variable cost 72,000
Fixed expenses 16,800

[Ans.: Margin of SafetyRs.40,000]

8. From the following details calculate BEP, Margin of safety:

Rs.
Sales 4,20,000
Fixed cost 90,000
Variable cost ratio 55% of sales

[Ans.: BEP Rs.2,00,000;Margin of Safety Rs.2,20,000]

Centre for Distance Education 6.25 Acharya Nagarjuna University

9. From the following particulars calculate the margin of safety Sales units:
15,000; Fixed costs Rs.34,000; Selling price per unit Rs.10; Variable cost
per unit Rs.6.

[Ans.: Margin of Safety Rs.65,000]

10. From the following information calculate:

(a) Break-even point
(b) TurnoverrequiredtoearnaprofitofRs.36,000.
(c) Margin of safety for Rs.36,000 profit. Fixed overhead Rs.1,80,000
Variable cost per unit Rs.2 Selling price per unit Rs.20.

[Ans.: (a)Rs.10,000 units; ValueRs.2,00,000; (b) 12,000 units; Value

Rs.2,40,000; (c) Rs.40,000]

11. Sri Sai Ram Limited furnishes you the following information relating to the half
year ended 30th June 2007:

Rs.
Fixed expenses 45,000
Sales value 1,50,000
Profit 30,000

During the second half of the year, the company has projected a loss of
Rs.10,000. Calculate:
(a) The Break-even point and Margin of safety for six months ending 30th June
2007.
(b) Expected sales volume for second half of the year assuming that P/V ratio
and fixed expenses remain constant in the second half year also.
(c) The Break-even point and Margin of safety for the whole year 2007.

[Ans.:(a)BEPRs.90,000;MOSRs.60,000;(c)BEPRs.1,80,000;MOSRs.40,000]

12. You are given the following data for the year of a company.

Rs. %
Variable costs 6,00,000 60
Fixed costs 3,00,000 30
Net profit 1,00,000 10
10,00,000 100
Advanced Management Accounting 6.26 Marginal Costing – CVP Analysis
Find out
(a) Breakeven point
(b) P/V Ratio.
(c) Margin of safety.

[Ans.: (a) Rs.7,50,000;(b) 40%;(c) Rs.2,50,000]

13. The following information relates to an article produced by EMEM Ltd:

Rs.
Total fixed costs 18,000
Total variable costs 30,000
Total sales 60,000
Units sold 20,000

From the above information find out (a)Per unit contribution (b) Break-even-point
(b) Safety margin and (d) Sales required to earn a profit of Rs.24,000.

[Ans.: (a) Rs.1.50 (b)12,000 unitsRs.36,000;(c) 8,000 units–Rs.24,000;(d)

28,000 units value Rs.84,000]

14. From the following figures, calculate P/V ratio, BEP, profit on estimated sales
of Rs.1,25,000 and sales required to earn a profit of Rs.20,000:

Sales Profit
Rs. Rs.
Period I 1,00,000 15,000
Period II 1,20,000 23,000

[Ans.: P.V. Ratio=40%;BEP Rs.62,500; Profit Rs.25,000; Sales required

Rs.1,12,500]

15. The following data are obtained from the records of a factory:

Rs. Rs.
Sales 4,000 units at Rs.25 each 1,00,000
Materials consumed 40,000
Labour charges 20,000
Variable overheads 12,000
72,000
Fixed overheads 18,000 90,000
Profit 10,000
Centre for Distance Education 6.27 Acharya Nagarjuna University
It is proposed to reduce the selling price by 20%. What extra units should be sold to
obtain the same amount of profit as above?

[Ans.: Units sold:(a)14,000 units; Extra units to be sold:14,000 4,000= 10,000 units]

16. From the following particulars calculate:

(a) Contribution
(b) P/V Ratio
(c) Break-even in units and in Rupees
(d) Whatwillbethesellingpriceperunitifthebreak-evenisbroughtdownto25,000
units?

Rs.
Fixed Expenses: 1,50,000
Variable cost per unit 10
Selling price per unit 15

17. Bhargavi Ltd. incurred a total cost of Rs.40,000 on a sales of Rs.45,000 in the 1st half
year and Rs.43,000 cost on sales of Rs.50,000 in the 2nd half year.
Assuming that costs and prices remained the same, calculate for the entire year:
(i) P.V. Ratio (ii) Fixed Expenses
(iii) Break-even sales (iv) % of margin of safety.

[Ans.: (i) 40%;(ii) Rs.26,000;(iii) Rs.65,000;(iv) Rs.30,000 and 31.58%]

18. The sales and profit during two years are as follows:

Year Sales Profit

Rs. Rs.
2006 3,00,000 30,000
2007 4,00,000 50,000
You are required to calculate (i) p/v ratio (ii) Break even sales (iii) Margin of Safety at a
Profits of Rs.40,000.

19. From the following data, determine the net profits, if actual sales are 10% and
15% above the Break-Even volume:
Selling Price per unit : Rs.10
Trade discount : 5%
Fixed over heads : Rs.10,000
Variable cost per unit : Rs.7
Advanced Management Accounting 6.28 Marginal Costing – CVP Analysis
[Ans.: B.E.P=4,000 Units; Net Profit=Rs.1,000; Rs.1,500]

20. The following figures are available from the records of Sindhu enterprises as at
31stDecember:

2006 2007
Rs. in lakhs Rs. in lakhs
Sales 150 200
Profit 30 50

Calculate:
(a) The p/v ratio and total fixed expenses.
(b) The break-even level of sales.
(c) Sales required to earn a profit of Rs.90 lakhs.
(d) Profit or loss that would arise If the sales were Rs.280 lakhs.

[Ans.:(a) 40% & Rs.30,00,000;(b) Rs.75,00,000 (c) Rs.3,00,00,000 (d) 82,00,000]

21. Calculate the Break-even point from the following particulars:
Budgeted output 70,000 units
Fixed cost (Rs.) 4,00,000
Variable cost per unit (Rs.) 12
Selling price per unit (Rs.) 22
If the selling price is reduced to (Rs.) 20 per unit what will be the revised Break-even
point?

[Ans.: BEP = 40,000 units Value Rs.8,80,000; Revised BEP = 50,000 units Value
Rs.10,00,000]

22. From the following data, determine the net profits, if actual sales are 10% and
15% above the Break-Even Volume:-

Selling price per unit: Rs.10

Trade discount: 5%
Fixed over heads: Rs.10,000
Variable cost per unit Rs.7

[Ans.: BEP=400 Units: Profits Rs.(i) Rs.1,000;(ii) Rs.1,500]

23. Sales of a product amount to 200 units per month at Rs.10 per unit. Fixed
overhead is Rs.400 per month and variable cost Rs.6 per unit. There is a
proposal to reduce prices by 10%. Calculate present and future P/V ratio, how
many units must be sold to maintain total profit.
Centre for Distance Education 6.29 Acharya Nagarjuna University

24. From the following particulars calculate the P/V ratio Break-even sales and
Fixed Costs. Profit Rs.2,000 which represents 10% of sales Margin of safety =
Rs.10,000.

25. From the following particulars calculate (a) Fixed costs (b) Break Eve Sales
(c)Total Sales and (d) Profit.
Margin of Safety=Rs.10,000 (which represents 40% of sales) P/V Ratio=50%.

[Ans.:(a)Rs.7,500;(b)15,000;(c)Rs.25,000;(d)Rs.5,000.]
26. Given:
Sales 10,000 units
Variable cost Rs.1,00,000
Sales value Rs.2,00,000
Fixed cost Rs.40,000
Selling Price per unit Rs.20

You are required to calculate:

(a) P/V Ratio (b) Break-even point (c) Margin of safety (d) Sales to earn a profit of
Rs.30,000.

[Ans.:(a)50%(b)Rs.80,000(c)Rs.1,20,000(d)Rs.1,40,000]

27. Assuming that the cost structure and selling prices remain the same in Periods I and
II, find out:

(a) Profit Volume Ratio;

(b) Fixed Cost;
(c) Break Even Point for Sales;
(d) Profit when Sales are of Rs.1,00,000;
(e) Sales required to earn a Profit of Rs.20,000; and
(f) MarginofSafetyataprofitofRs.15,000;
(g) Variable cost in Period II

Period Sales Rs. Profit Rs.

I 1,20,000 9,000
II 1,40,000 13,000

[Ans.: (a) 20% (b) Rs.15,000 (c) Rs.75,000 (d) Rs.5,000 (e) Rs.1,75,000 (f)
Rs.75,000 (g) Rs.1,12,000]
Advanced Management Accounting 6.30 Marginal Costing – CVP Analysis

28. The sales turnover and profit of M/s Sreenivasa & Co. Ltd. during the two years
2006 and 2007 were as follows:

Sales Profit
(Rs.) (Rs.)
2006 4,50,000 60,000
2007 5,10,000 75,000

You are required to calculate:

1. Profit-volume ratio.
2. Break-even point.
3. The sales required to earn a profit of Rs.1,20,000.
4. The profit made when sales are Rs.7,50,000.
5. Margin of safety at a profit of Rs.1,50,000.
6. Variable costs of the two periods.

[Ans.:(1)25% (2) Rs.2,10,000 (3) Rs.6,90,000 (4) Rs.1,35,000 (5)Rs.6,00,000

(6)1989 =Rs.3,37,500;1990=Rs.3,82,500]

29. Following are the particulars of Pennar Tubes Ltd:

Sales Rs.30,00,000; Fixed costs Rs.9,00,000; Variable costs Rs.15,00,000. Calculate
(a)P/V ratio, (b) Break-even point (c) Margins of safety and (d) Margin of safety
ratio.
[Ans.:(a)50%(b)Rs.18,00,000(c)Rs.12,00,000(d)40%]

30. M Ltd., manufacturing and selling industrial boxes. It is proposed to decrease the
prices due to heavy competition. By decreasing the selling prices by 10% and 15%,
how many units to be sold to maintain the current level of profit. The additional
information is given:

Currentsales30,000units Rs.3,00,000
Variablecost30,000units 1,80,000
Fixed cost 70,000 2,50,000
Net profit 50,000

[Ans.: Sale of Units at 10% reduction in selling price 40,000; Sale of Units at
15% reduction in selling price 48,000]

31. From the following details calculate:

(a) P/V Ratio
(b) BE Point
(c) Margin of safety
(d) Effect of 10% increase in SP on BEP.
Centre for Distance Education 6.31 Acharya Nagarjuna University

(e) Effect of 10% decrease in SP on BEP.

Rs.
Sales 60,000
Variable Cost 30,000
Fixed Cost 15,000

[Ans.: (a)50, (b)Rs.30,000;(c) Rs.30,000;(d)BEP Rs.27,500;(e)Rs.33,750

32. From the following particulars find

(i) Contribution, (ii) P/V Ratio:
Variable cost per unit Rs.20; Selling price per unit Rs.40; Fixed expenses
Rs.1,00,000; Output 5,000 units.

[Ans.: Contribution per unit Rs.20;P.V.Ratio: 50%]

33. Ramachandra sells a line of Men’s foot wears for Rs.18 a pair. Each pair that is
sold contributes Rs.6 to the recovery of fixed costs and to profits. His fixed costs
amounts to Rs.84,000 a year.

You are asked to (a) show how many pairs must be sold in a year to Break
Even. (b) Break Even sales revenue at the Break Even Point. (c) Desired sales to
earn a profit of Rs.54,000.

[Ans.: (a)14,000 units (b) Rs.2,52,000 (c) Rs.4,14,000]

34. From the following details, compute: (i) P.V. Ratio (ii) Profit
Fixed Costs Rs.50,000
SalesRs.3,00,000

35. From the following details compute: (a) Variable Costs; (b) P/V Ratio.

Rs.
Sales 3,00,000
Fixed Costs 70,000
Profit 80,000

[Ans.: (a)Rs.1,50,000 (b) Rs.50%]

Advanced Management Accounting 6.32 Marginal Costing – CVP Analysis

36. From the following data, you are required to calculate

a. P/V Ratio
b. Break even sales with the help of P/Vratio
c. Sales required to earn a profit of Rs.4,50,000
Fixed expenses Rs.90,000
Variable cost per unit:
Direct material = Rs.5
Direct Labour = Rs.2
Direct overheads = 100 per cent of direct labour
Selling price per unit = Rs.12

[Ans.: (a) 25% (b) 3,60,000 (c) Rs.21,60,000]

37. From the following information pertaining to the years, calculate:

a. P/V ratio
b. Amount of sales to earn profit of Rs.40,000
c. Profit on sales Rs.1,20,000

Years Sales Rs. Profit Rs.

2006 1,40,000 15,000
2007 1,60,000 20,000

[Ans.:(a) 25% (b) Rs.2,40,000 (c) Rs.10,000]

38. From the following data relating to a company, calculate:

i. The break-even sales; and
ii. Sales required to earn a profit of Rs.6,000 per period.

Period Rs. Total Sales Rs. Total Cost

1. 42,500 38,700
2. 39,200 36,852

[Ans.: (i) Rs.33,863.64 (ii) Rs.47,500]

39. The following information was extracted from the books of Giridhar Mft.Co.Ltd.

Rs.
Sales 1,80,000
Less: Variable Costs 1,44,000
Contribution 36,000
Less: Fixed costs 24,000
Net Profit 12,000
Centre for Distance Education 6.33 Acharya Nagarjuna University

Calculate the following (a) P/V ratio (b) Break-even point (c) Net profit
earned at sales of Rs.2,70,000 (d) Sales required to earn a profit of Rs.24,000.

[Ans.:(a) 20% (b)Rs.1,20,000 (c)Rs.30,000 (d)Rs.2,40,000]

40. By making and selling 7,000 units of its product, accompany would lose Rs.10,000;
whereas in the case of 9,000 units it would make a profit of Rs.10,000 instead.
Calculate:
(a) The amount of fixed expenses.
(b) Number of units of Break-Even.
(c) Profit or Loss for10,000 units.
(d) Number of units to earn a profit of Rs.40,000.

[Ans.: P.V.Ratio=10%;(a) 80,000 (b)8,000 units (c)Rs.20,000 (d)12,000 units]

41. M/s Haripriya Ltd., sold its products worth Rs.180 lakhs and made a profit of rS.18
lakhs in 2006. But in 2007, the sales cam down to Rs.140 lakhs due to serve
competition in the market. The fall in profit was Rs.4 lakhs. Calculate break-even
points and profit volume ratios in 2006 and 2007.

[Ans.: BEP=0;P.V.Ratio: 2001–10%;2002–10%]

42. Two competing companies P Ltd. and Q Ltd. produce and sell the same type of
product in the same market. For the year ended March 2008, their forecasted profit
and loss accounts are as follows:

Rs. P.Ltd. Rs. Rs. Q.Ltd. Rs.

Sales 3,00,000 3,00,000
Selling Price Expenses 2,00,000 2,25,000
Fixed Cost 50,000 2,50,000 25,000 2,50,000
50,000 50,000

You are required to calculate the following:

(a) Profit volume ratio, Break-even Point and Margin of Safety of each business.
(b) Sales volume at which each business will earn a profit of Rs.30,000.
(c) Explain, giving reasons which business is likely to earn greater profits in
conditions of (i) heavy demand for the product, (ii) low demand for the product.

[Ans.: (a) P.V. Ratio : P Ltd.33.33%; QLtd.25%; BEP Sales : P Ltd.,

Rs.1,50,015; Q Ltd., Rs.1,00,000; Margin of safety : P Ltd. Rs.1,50,015; Q
Ltd., Rs.2,00,000; (b) P Ltd. Rs.2,40, 024; Q Ltd. Rs.3,00,000 (c) (i) In case of
heavy demandtheproductofPLtd.,ismoreprofitable,becauseP.V.ratioofPLtd.,
is greater than Q Ltd. (ii) In case of low demand, the product Q Ltd., is more
Advanced Management Accounting 6.34 Marginal Costing – CVP Analysis

preferable since it provides more profit. It is because BEP of Q Ltd., is lower

than the BEP of P Ltd.]

43. FollowinginformationhasbeenobtainedfromtherevenueaccountofBalajiLtd.forthe
year ended 31st December, 2007:

Rs. Rs.
Sales 6,00,000
Direct materials 1,80,000
Direct wages 1,20,000
Variable overheads 48,000
Fixed overheads 1,72,000 5,20,000
Profit 80,000

It is proposed to reduce the selling price by 5%.What would be the sales volume if the
present level of Profit is to be maintained. Assume no change in cost structure.

[Ans.: Old P.V. Ratio: 42%; New P.V. Ratio : 38.95%;Sales Volume at
present level of profit Rs.6,46,938]

6.9 REFERENCEBOOKS:

1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting–Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K.Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting–
5. N.Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Man mohan & Goyal, Management Accounting
8. V.Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain &KL Narang, Advanced Cost and Management Accounting
Centre for Distance Education 7.1 Acharya Nagarjuna University

LESSON 7
MARGINAL COSTING – MANAGERIALDECISIONS
OBJECTIVES

After studying this chapter you should be able to

• Understand the uses of marginal costing and taking various managerial decisions
• Explain the problems relating to profit planning, introduction of new product,
planning the level of activity. Key factor, suitable product mix, pricing decisions etc.

STRUCTURE

7.1 Marginal Costing and Decision making

7.2 Buy or Make Decisions
7.2 Self Assessment Questions
7.4 Exercises
7.5 Reference Books

7.1 MARGINAL COSTING AND DECISION MAKING

Marginal costing techniques may be applied in various fields to aid management

in arriving at many important policy decisions. These include:

1. Profit planning
2. Introduction of new product
3. Planning of level of activity
4. Key factor
5. Determination of suitable product–mix
6. Pricing Decisions
7. Foreign Market offer
8. Make or buy decisions

7.1.1 Profit Planning:

Profit planning is the planning of future operations so as to attain maximum profit.

The contribution ratio shows the relative profitability of various sectors of the business
whenever there is a change in selling price, variable costs or product mix. There are four
important ways to improve the profit performance of a business.
Advanced Management Accounting 7.2 Marginal Costing – Manag…

By increasing volume
(i) By increasing selling price
(ii) By reducing variable costs, and
(iii) By reducing fixed costs.

Illu.1:The following are the budgeted data relating to AB Ltd., and CD Ltd.,
producing identical products.

Rs. Rs. Rs. Rs.

Sales 1,50,000 1,50,000
Less: Variable cost 1,20,000 1,00,000
Fixed Cost 15,000 1,35,000 35,000 1,35,000
Net Profit 15,000 15,000

a. Calculate break-even points, P/V ratio and margin of safety of each

company:
b. State which company is likely to earn greater profits in conditions of
(i) heavy demand and (ii) low demand of the product.

Solution:

(b) In case of heavy demand, CD Ltd., will earn higher profit since the P/V Ratio is
higher for the company. In case of low demand, AB Ltd., may earn higher profit
since its breakeven point is low and margin of safety is higher.
7.1.2 Introduction of New Product:

Sometime, a product may be added to the existing lines of products with a view to
utilise idle facilities to capture new market or for any other purpose. The profitability of this
Centre for Distance Education 7.3 Acharya Nagarjuna University

new product has to be found out initially. Usually, the new product will be manufactured if it
is capable of contributing something towards fixed costs and profit after meeting its variable
costs.

Illu.2: A firm manufacturing Product X has provided the following information.

Rs.
Sales 75,000
Direct materials 30,000
Direct labour 10,000
Variable over head 10,000
Fixed overhead 15,000

In order to increase its sales by Rs.25,000,the firm wants to introduce the

Product Y, and estimates the costs in connection therewith as under:

Rs.
Direct materials 10,000
Direct labour 8,000
Variable overhead 5,000
Fixed overhead Nil

Advise whether the Product Y will be profitable or not.

Solution:
Marginal Cost Statement
X Y Total
Rs. Rs. Rs.
Sales 75,000 25,000 1,00,000
Less: Material cost:
Direct materials 30,000 10,000 40,000
Direct labour 10,000 8,000 18,000
Variable overhead 10,000 5,000 15,000
50,000 23,000 73,000
Contribution 25,000 2,000 27,000
Fixed Costs 15,000
Profit 12,000
Commentary: If product Y is introduced, the profitability of product X is not affected
in any manner. On the other hand, product Y provides a contribution of Rs.2,000 towards
fixed cost and profit. Therefore, Product Y should be introduced.
Advanced Management Accounting 7.4 Marginal Costing – Manag…

7.1.3 Planning the Level of Activity:

Marginal costing is of great help while planning the level of activity. Maximum
contribution at a particular the level of activity will show the position of maximum
profitability.

IIIu.3: Excellent company is currently working at 50% capacity and produces

10,000 units.

At 60% capacity, raw material cost increases by 2% and selling price falls by 2%.
At 80% working, raw material cost increase by 5% and selling price falls by 5%. At
50% capacity working, the product costs Rs.180 per unit and is sold at Rs.2.00 per unit.
The unit cost of Rs.180 is made up as follows.

Materials Rs.100
Wages Rs.30
Factory overheads Rs.30 (40% fixed)
Administrative overheads Rs.20 (50% fixed)

You are required to work out the material cost, fixed cost, total cost and
profit for three capacity levels.

Solution:
Statement Showing Material Cost, Fixed Cost, Total
cost and Profit at three Capacity Levels
Output Capacity 50% 60% 70%
Sales (A) 20,00,000 23,52,000 30,40,000
Marginal Cost:
Material Cost 10,00,000 12,24,000 16,80,000
Wages 3,00,000 3,60,000 4,80,000
Factory Overheads 1,80,000 2,16,000 2,88,000
Administrative Overheads 1,00,000 1,20,000 1,60,000
Total Marginal Cost (B) 15,80,000 19,20,000 26,08,000
Contribution (A-B) (C) 4,20,000 4,32,000 4,32,000
Less: Fixed Expenses:
Factory Overheads 1,20,000 1,20,000 1,20,000
Administrative Overheads 1,00,000 1,00,000 1,00,000
Total Fixed Expenses (D) 2,20,000 2,20,000 2,20,000
Total Cost (B+D) (E) 18,00,000 21,40,000 28,28,000
Profit / Loss (C-D) (F) 2,00,000 2,12,000 2,12,000

Note: Statement showing material cost, fixed cost, total cost; and profit per unit at three
capacity levels.
Centre for Distance Education 7.5 Acharya Nagarjuna University

Output Capacity 50% 60% 70%

Selling Price (A) 200 196 190
Marginal Cost:
Materials 100 102 105
Wages 30 30 30
Factory Overheads 18 18 18
Administrative Overheads 10 10 10
Total Marginal Cost (B) 158 160 163
Contribution (A-B) (C) 42 36 27
Less: Fixed Expenses:
Factory Overheads 12 10 7.50
Administrative Overheads 10 8.33 6.25
Total Fixed Expenses (D) 22 18.33 13.75
Profit/Loss (C-D) (E) 20 17.67 13.25

Illu.4:Two companies which have the following operating details decide to merge:
Company I Company II
Capacity utilisation 90% 60%
Sales (Rs. Lakhs) 540 300
Variables cost (Rs. Lakhs) 396 225
Fixed cost (Rs. Lakhs) 80 50

Assuming proposal is implemented, calculate:

(a) Break-even sales of the merged plant and the capacity
utilisation at that stage.
(b) Profitabilityofthemergedplantat80%capacityutilisation.
(c) SalesturnoverofthemergedplanttoearnaprofitofRs.75lakhs.

Solution:
Statementofthemergedcompanyat100%and80%Capacity

Capacity Company A Company B Merged

Company
90% 100% 90% 100% 100% 80%
Sales 540 600 300 500 1,100 880
Variable Cost 396 440 225 375 815 652
Contribution(S-V) 144 160 75 125 285 228
Fixed Cost 80 80 50 50 130 130
Profit 64 80 25 75 155 98
Advanced Management Accounting 7.6 Marginal Costing – Manag…

7.1.4 Key Factor:

A concern would produce and sell only those products which offer maximum profit.
This is based on the assumption that it is possible to produce any quantity without any
difficulty and sell likewise. However, in actual practice, this seems to be unrealistic as
several constraints come in the way of manufacturing as well as selling. Such constraints that
come in the way of management’s efforts to produce and sell in unlimited quantities are
called ‘Key factors’ or ‘limiting factors’.

The limiting factors may be materials, labour, plant capacity, or demand.

Management must as certain the extent of influence of the key factor for ensuring
maximisation of profit. Normally, when contribution and key factors are known, the relative
profitability of different products or processes can be measured with the help of the following
formula.

Illu.5: From the following data, which product would you recommend to be
manufactured in a factory, time being the key factor?

Per unit of Per unit of

product X product Y
Rs. Rs.
Direct material 24 14
Direct labour at Rs.1 per hour 2 3
Variable over head at Rs.2 per hour 4 6
Selling price 100 110
Standard time to produce 2hours 3hours
Centre for Distance Education 7.7 Acharya Nagarjuna University

Solution:

Product X Product Y
Per unit Per unit
Rs. Rs. Rs. Rs.
Selling price 100 110
Less: Marginal cost:
Direct materials 24 14
Direct labour 2 3
Variable overhead 4 30 6 23
Contribution 70 87
Standard time to produce 2hours 3hours
70= 87 =
Contribution per hour 2 3
Rs.35 Rs.29

Contribution per hour of product X is more than that of product Y by Rs.6. Therefore,
product X is more profitable and is recommended for manufacturing.

7.1.5 Suitable Product Mix:

Normally, a business concern will select the product mix which gives maximum profit.
Product mix is the ratio in which various products are produced and sold. The marginal
costing technique helps management in taking appropriate decisions regarding the produce
mix, i.e., in changing the ratio of product mix so as to maximise profits. The technique not
only helps in dropping unprofitable products from the mix but also helps in dropping
unprofitable departments, activities etc.,

IIIu.6: Present the following information to show to them management: a) the

marginal product cost and the contribution per unit; b) the total contribution and
profits resulting from each of the following sales mixtures:

Product Per Unit

Rs.
Direct materials A 10
B 9
Direct wages A 3
B 2
Fixed expenses Rs. 800

Variable expenses are allocated to products as 100% of direct wages.

Rs.
Sales Price A 20
B 15
Advanced Management Accounting 7.8 Marginal Costing – Manag…

Sales mixtures:
i) 1000 units of product and 2000 units of B
ii) 1500 units of product and 1500 units of B
iii) 2000 units of product A and 1000 units of B

Solution:

a) Marginal Cost Statement A B

Rs. Rs.
Direct materials 10 9
Direct wages 3 2
Variable overheads (100%) 3 2
Marginal Cost 16 13
Sales Price 20 15
Contribution 4 2

(b) Product mix choice 1000A+2000B 1500A+1500B 2000A+1000B

(i) (ii) (iii)
Rs. Rs. Rs.
Total Sales (1000 x 20+2000x15) (1500 x 20+1500 (2000 x 20+1000 x
= 50,000 x 15) =52,500 15) =55,000
(1000 x 16+2000x13) (1500 x16+1500 (2000 x16+1000 x
= 42,000 x13) =43,500 13) =45,000
Less: Marginal Cost
Contribution 8,000 9,000 10,000
Less: Fixed Costs 800 800 800
Profit 7,200 8,200 9,200

Therefore, sales mixture (iii) will give the highest profit; and as such mixture (iii) can
be adopted.

7.1.6 Pricing Decisions:

Marginal costing techniques helps a firm to decide about the prices of various
products in a fairly easy manner. Let’s examine the following cases.

(i) Fixation of Selling Price.

Illu.7: P/V ratio is 60% and the marginal cost of the product is Rs.50. What will
be the selling price?
Centre for Distance Education 7.9 Acharya Nagarjuna University

(ii.) Pricing during Recession:

Illu.8: Hindustan Engineering Company is working well below normal capacity

due to recession. The directors of the company have been approached with an enquiry
for special job. The costing department estimated the following in respect of the job.

Direct materials–Rs.10,000
Direct labour – 500 Hours @ Rs.2 per hour.
Overhead costs : Normal recovery rates.
Variable – Re. 0.50 per hour
Fixed – Rs.1.00 per hour.
The directors ask you to adise them on the minimum price to be charged. Assume
that there are no production difficulties regarding the job.

Solution:
Calculation of Marginal Cost:

Rs.
Direct materials 10,000
Direct labour 1,000
Variable overhead @ Rs.0.50per 250
hour
Marginal cost Rs.11,250
Commentary: Here the minimum price to be quoted is Rs.11,250, which is the
marginal cost. By quoting o, the company is sacrificing the recovery of the profit and the
fixed costs. The fixed costs will continue to be incurred even if the company does not accept
the offer. So any price above Rs.11,250 is welcome.

(iii) Selling below marginal cost:

Selling below marginal cost, normally, is not feasible. However, under the following
circumstances this can be practised.

1. When a new product is introduced.

2. When competitors have to be edged out of the market.
Advanced Management Accounting 7.10 Marginal Costing – Manag…
3. When company deals with perishable products.,

4. When the product is used as a loss leader.

5. When labour engaged cannot be retrenched.
6. When foreign market is to be explored to earn foreign exchange.
7. When there is cut-throat competition.
8. When the plant has to be kept in a running condition.

7.1.7 Foreign Market Offer:

The acceptance or rejection of an offer from a foreign market depends upon the
incremental cost and incremental revenue.

Illu.9: Chola Pen Co. Ltd. Produces and markets Micro tipped pens. The selling
price per pen is Rs.5.50 made up as follows:

Rs.
Direct materials 2.00
Direct labour 1.50
Variable overheads 0.50
Fixed over heads (Rs.90,000÷1,20,000)
0.75
Total cost
Profit 4.75
Selling price 0.75
5.50
The installed capacity is 1,50,000 pens per month. At present, it is producing and
selling, on an average, 1,20,000 pens per month. The company has received an export
order for 30,000 pens per month for two years but at a price of Rs.4.50.the management
is hesitant to accept this order because it does not cover the total cost. There are no
government subsidies to meet the deficit. It is unlikely that the domestic market will
expand in the next two years. Advise them with necessary supporting data.
Solution:

Marginal Cost per unit:

Rs.
Direct material 2.00
Direct labour 1.50
Variable over heads 0.50
Total Variable Cost 4.00

Selling price of the export order Rs.4.50

If the foreign order is accepted for each unit the firm gets a profit. of Rs.0.50
(Rs.4.50 – 4.00). The total profit if the foreign order is accepted = Rs.15,000 (30,000 x 0.50).
Centre for Distance Education 7.11 Acharya Nagarjuna University

So it is better to accept foreign order.

7.2 MAKE OR BUY DECISIONS

A company might be having unused capacity which may be utilised for making
component parts or similar items instead of buying them from the market. In arriving at such
a ‘make or buy’ decision, the cost of manufacturing component parts should be compared
with price quoted in the market. If the variable costs are lower than the purchase price, the
component parts should be manufactured in the factory itself.

Fixed costs are excluded on the assumption that they have been already incurred, and
the manufacturing of components involves only variable cost. However, I there is an increase
in fixed costs and any limiting factor is operating they should also be taken into account.
Consider the following illustration, throwing light on these aspects.

Illu.10: A manufacturing company finds that while the cost of making a

component part is Rs.10, the same is available in the market at Rs.9 with an assurance
of continuous supply. Give your suggestion whether to make or buy this part. Give also
your views in case the supplier reduces price from Rs.9 to Rs.8.

The cost information is as follows:

Particulars Rs.
1. Material 3.50
2. Direct Labour 4.00
3. Other Variable expenses 1.00
4. Fixed expenses 1.50
10.00
Solution:
Make or Buy Decision Statement
Purchasing Price (A) 9
Manufacturing Cost:
Material 3.50
Direct Labour 4.00
Variable Expenses 1.00
Total Manufacturing Cost (B) 8.50
Saving in Manufacturing (A-B) (C) 0.50
Advise:
1. It is better to manufacture rather than buying from outside Market.
2. If the component is supplied at Rs.8 it is better to purchase it rather than
manufacturing it. By purchasing, the profit will increase by Rs.0.50 (Rs.8.50 – 8.00)
per unit.

Illu.11:AcompanyengagedinthemanufacturingradiosincursRs.6.25perpiece for
producing part A. But the same part is available for at Rs.5.75 only per piece in the
Advanced Management Accounting 7.12 Marginal Costing – Manag…
market. Its supply will also be alright. Particulars of expenses are as follows:

Rs.
Material per piece 2.75
Labour per piece 1.75
Other variable expenses per piece 0.50
Depreciation and fixed overheads per piece 1.25
6.25

(a) Do you manufacture that part or purchase it in the market?

(b) In case the supplier offers the same at Rs.4.85 only per piece,
what is your decision?

Solution:
Make or Buy Statement for Part A

Rs.
Buying Price (A) 5.75
Manufacturing Cost:
Material 2.75
Labour 1.75
Variable Expenses 0.50
Total Manufacturing Cost (B) 5.00
Saving in Manufacture (A-B) (C) 0.75
Advise:
a. It is better to manufacture rather than buying this. It is because the buying
price per unit is Rs.5.75 and manufacturing price is Rs.5.00. In
manufacturing the product the firm has a saving of Rs.0.75 per product.

b. If the computer supply price is Rs.4.85 then it is better to purchase it

rather than manufacturing it due to a saving of Rs.0.15 per unit.

Illu.12: ABC company has just been formed. A company has a special process
which will enable it to produce a unique product, the demand for which is uncertain.
Their estimated costs are:

Material per unit Rs.2

Labour per unit Rs.6
Variable manufacturing expenses per unit Rs.3
Variable selling expenses per unit Re.1
FixedmanufacturingexpensesRs.24,000
FixedAdministrativeandsellingexpensesRs.72,000.
Centre for Distance Education 7.13 Acharya Nagarjuna University

(a) If the selling price is Rs.20, how many units they have to sell to (i) break even ( ii)
make a profit of Rs.32,000 (iii) make a profit of 20 percent of sale?
(b) If the demand for the product is 10,000 units, what price must they charge in order
to (i) break-even (ii) make a profit of Rs.24,000 (iii) make a profit of 20 per cent of
sales?

Illu.13: A firm is selling X product, whose variable cost per unit is Rs.10 and fixed cost
is Rs.6,000. It has sold 1,000 articles during one month at Rs.20 per unit. Market
research shows that there is a great demand for the product if the price can be reduced.
If the price can be reduced to Rs.12.50 per unit, it is expected that 5,000 articles can be
sold in the expanded market. The firm has to take a decision whether to produce and
sell 1,000 units at the rate of Rs.20 or to produce and sell for the growing demand of
5,000 units at the rate of Rs.12.50. Give your advice to the management in taking the
Advanced Management Accounting 7.14 Marginal Costing – Manag…
decision.

Solution:

1,000 5,000
units units
Selling Price (A) 20 12.50
Less: Variable cost (B) 10 10.00
Contribution per unit A-B) (C) 10 2.50
Total Contribution 10,000 12,500
Less: Fixed Cost 6,000 6,000
Profit 4,000 6,500

The management may be advised to reduce the selling price to Rs.12.50.It is also
advised to produce and sell, 5,000 units because it gives an additional profit of Rs.2,500
(Rs.6,500- 4,000)

Illu.14: A Toy manufacturer earns an average net profit of Rs.3 per piece in a
selling price of Rs.15 by producing and selling 60,000 pieces at 60% of the potential
capacity. Composition of cost of sales is as follows:

Rs.
Direct Materials 4.00
Direct Wages 1.00
Factory overhead 6.00
(50% Fixed)
Sales overhead 1.00
(25% varying)

During the current year, he intends to produce the same number of toys but
anticipates that:

(a) His fixed charges will go up by 10%.

(b) Rates of Direct labour will increase by 20%
(c) Rates of Direct Material will increase by 5%
(d) Selling price cannot be increased.

Under these circumstances, he obtains an order for a further 20% of his

capacity. What minimum price will you recommend for accepting the order to
ensure the manufacturer an overall profit of Rs.1,80,500.
Centre for Distance Education 7.15 Acharya Nagarjuna University

Solution:
Calculation of Current year Marginal Cost Statement:

Calculation of Total Fixed Cost:

Rs.
Fixed factory overheads per unit 3.00
Fixed sales overheads per unit 0.75
Total fixed cost per unit 3.75

Calculation of New Selling Price for 20% Capacity:

Rs.
Given required Profit 1,80,500
Less: Profit earned for 60,000 units 1,33,500
Profit to be acquired for 20% capacity 47,000
When the firm is at 60% capacity the output is 60,000 units.
For additional 20% capacity the required units 20,000
New Selling Price is assumed at ‘S’ per unit.
For 20,000 units sales amount = 20,000 units x S = 20,000 S
Variable Cost per unit = 8 – 65
Total Variable Cost = 20,000 units x Rs.8-65 = Rs.1,73,000
Advanced Management Accounting 7.16 Marginal Costing – Manag…

The minimum recommended Selling Price to the company to accept the order is Rs.11.

Illu.15: Budgeted Results to X Ltd. Include the following.

Sales Amount Variable cost as

(Rs. Lakhs) % of sales value
A 5.0 60%
4.0 50%
B 8.0 65%
C
3.0 80%
D 6.0 75%
26.0 65.17%
E

Fixed cost for the period are Rs.9.1 lakhs. You are required to (a) Produce a
statement showing the amount of loss expected and (b) Recommend a change in sales
volume of each product which will eliminate the expected loss that sales of only one
product can be increased at a time.

Solution:
(a) Statement of Profit / Loss Expected
(Amount in lakhs)
Product Sales Variable Variable P.V. Ratio Contribution
Cost Ratio Cost (or)C%
A 5 60 3.0 40 2.0
4 50 2.0 50 2.0
B 8 65 5.2 35 2.8
C 3 80 2.4 20 0.6
D 6 75 4.5 25 1.5
E 17.1 8.9

Calculation of Expected loss:

Total Contribution 8.9

Less: Fixed Expenses 9.1
Centre for Distance Education 7.17 Acharya Nagarjuna University

Expected loss 0.2

b. Assumeonlyoneproductcanbeincreasedatatime.Theamountofsalesofeachproduct
to be increased as follows.

Note: For (a)

Note: For (b)

Under recovery of fixed expenses=Expected loss = Rs.20,000

Illu.16: The following figures are extracted from there cords of a company.

Departments
A B C D Total
Rs. Rs. Rs. Rs. Rs.
Sales 200 400 600 800 2,000
Costs:
Direct Material 80 200 360 580 1,220
Direct Labour 40 150 180 140 510
Direct Expenses 4 6 8 10 28
Prime Cost 124 356 548 730 1,758
Overheads:
Variable 20 30 24 20 94
Fixed 10 20 10 8 48
Advanced Management Accounting 7.18 Marginal Costing – Manag…
30 50 34 28 142
Total cost 154 406 582 758 1,900
Profit/Loss 46 (-)6 18 42 100

On the basis of the above information, the management is inclined to dis

continue department B. What will be your advice to management?

Solution:
Comparative Statement of Profitability

With Dept. B Without Dept. B

Total Rs. Total Rs.
Sales 2,000 1,600
Less: Variable cost 1,852 1,466
Contribution 148 134
Less: Fixed expenses 48 48
Profit 100 86

Advise: If Department B is discontinued we have a total profit of Rs.86.Ifitiscontinuedthe

total profit is Rs.100. Hence it is better to continue will be Department B.

Note: It is assumed that the total fixed costs remains the same.

Illu.17: Hindustan Limited is engaged in manufacturing and selling industrial

boxes. It is proposed to reduce the prices due to heavy competition. By decreasing the
selling price by 10% and 15%, how many units are to be sold to maintain the current
level of profit?

Rs. Rs.
Current Sales(15,000units) 1,50,000
Variable Cost(15,000units) 90,000
Fixed Costs 35,000 1,25,000
Net Profit 25,000

Solution:
Calculation of Selling Price per unit, Variable Cost per unit
and Contribution Per unit

Total Per unit

Current Sales (15,000 units) 1,50,000 Rs.10
Variable Cost (15,000 units) 90,000 Rs.6
Contribution per unit 60,000 Rs.4
Centre for Distance Education 7.19 Acharya Nagarjuna University

Calculation of required sales in units to earn a profit of Rs.25,000 when selling priceis
reduced by 10% and 15%.

Illu.18: Assume you are the Management Consultant of XYZ Co. Ltd. The
Managing Director of the company seeks your advice on the following problem:

The XYZ Ltd., produces a variety of products each having a number of

component parts. Product “B” takes 5 hours to produce on machine No.99 working at
full capacity.“B” has a selling price of Rs.50 and a marginal costs of Rs.30 per unit. “A-
10” a component part could be made on the same machine in 2 hrs. for marginal cost of
Rs.5 per unit. The supplier’s price is Rs.12.50 per unit. Should the company make or
buy “A- 10”?
Assume that machine hour is the limiting factor.

Solution:
In this problem the cost of new product plus contribution lost during the time for
manufacturing “A-10” should be compared with the supplier’s price to arrive at a decision.

Rs.
B - Selling Price 50.00
Less: Marginal Cost 30.00
Contribution 20.00
It takes 5 hours to produce one unit of “B”
Contribution earned per hour on Machine No.99 is Rs. 20/5 = Rs 4

“A-10” takes two hours to be manufactured on machine which is producing “B”.

If “A-10” is produced, contribution lost will be = 2 hours x Rs.4 = Rs.8
Real cost of“A-10”to the company = Marginal cost of “A-10 ”plus contribution
lost for using the machine for “A-10”.

Rs.5+Rs.8 = Rs.13
Advanced Management Accounting 7.20 Marginal Costing – Manag…

This is more than the seller’s price of Rs.12.50 and so it is advisable for the company to
buy the product from outside.

7.3 SELF ASSESSMENT QUESTIONS

1. Explain the specific decision-making areas where the principles of marginal

costing could be applied.
2. What is the signification of Contribution of marginal costing? State its uses in
managerial decision making.
3. What is Marginal Costing ? How is it useful to the manufacturing organization?
4. Bring out the significance of imputed costs and out pocket costs for managerial
decision making.

7.3 EXERCISES

1. A company is considering expansion. Fixed costs amount to Rs.4,20,000 and are

expected to increase by Rs.1,25,000 when plant expansion is completed. The present
plant capacity is 80,000 units a year. Capacity will increase by 50 per cent with the
expansion. Variable costs are currently Rs.6.80 per unit and are expected to go down by
Rs.0.40 per unit with the expansion. The current selling price is Rs.16perunitand is
expected to remain same under either alternative. What are the break-even points under
either alternative? Which alternative is better and why?
[Ans.: It is better to go for expansion because the profit will double]

2. Arjun Electronic decided to effect a 10% reduction in the price of its product because it is
felt that such a step may lead to a greater volume of sales. It is anticipated that there are
no prospects of a change in total fixed costs and variable cost per unit. The director wish
to maintain net profits at the present level.

The following information has been obtained from its books.

Sales : 10,000 units Rs.2,00,000
Variable Costs: Rs.15
per unit Fixed Costs
Rs.40,000
How would management proceed to implement this decision?

[Ans.: Sales Rs.3,00,000]

3. Vimala Company produced and sold 10,000 units under the following Cost structure
during the year 2006:

(a) Prime Cost Rs.80 per unit.

Centre for Distance Education 7.21 Acharya Nagarjuna University

(b) Variable Over heads Rs.10 per unit.

(c) Fixed expenses Rs.1,50,000.
(d) Advertising Rs.25,000.
(e) Selling Price Rs.150 per unit.
For the year 2007 the following changes are proposed to be made:
(i) Advertising to be discontinued.
(ii) Reduction indirect labour cost by Rs.3per unit.
(iii) Reduction invariable administration expenses byRs.3per unit.
(iv) New selling price: Rs.120 per unit.
(v) Increase in production and sales by100%.

You are required to find out (1) The P/V ratio (2) The Break-even point and (3) The
amount of profit for the year 2007, taking into account the proposed changes.

[Ans.:(1) 30% (2) Rs.5,00,000 (3) Rs.5,70,000]

4. The costofmanufacturingof8,000unitsof‘X’productisgivenbelow:
Direct materials Rs.8,000; labour Rs.64,000; Variable overheads Rs.32,000; Fixed
overheadsRs.40,000;FixedoverheadisincludedRs.24,000,thatcontinues regardless of the
decision. The same product is available in the market for Rs.16 per unit. Should the
company make or buy the product?
[Ans.: Manufacturing is more profitable than purchase because due to manufacture
the profit is more by Rs.32,000]

5. The management of Pioneer Products Corporation Limited requests assistance from you
in arriving at a decision whether to continue manufacturing a certain part of an assembly
or to buy it from an outside supplier who had been quoting a price of Rs.8 per unit.

The Corporation’s annual requirements is 5,000 units and the costs accumulated
for their special manufacture are:

Rs.
Direct Materials 17,500
Direct labour 28,000
Indirect Labour 6,000
Power(Electricity) 300
Others 640

If the parts are purchased from outside, the present machinery used to make the parts
could be sold and its value would be realised. This step would reduce the total machinery
depreciation by Rs.2,000 and property taxes and insurance by Rs.1,000.
If the parts are purchased from the outside supplier, the following additional costs
would be incurred:
FreightRs.0.50perunitandmaterialreceivedcharges@Rs.1perunit.
From the above information you are required to prepare a statement comparing the
Advanced Management Accounting 7.22 Marginal Costing – Manag…
costs of manufacturing the parts, with the costs of purchasing them from the outside supplier
and guide management for a make or buy decision.

[Ans.: It is better to purchase 5,000 units instead of manufacturing it due to the saving
of Rs.7,440]

6. A company produces variety of products and components. Following components with

relevant manufacturing costs are under consideration for purchase outside:

Component Direct Material Direct Labour Variable Fixed Bought out

Rs. Rs. overheads Costs price
Rs. Rs. Rs.
XY 600 200 100 300 800
PR 200 800 200 1,000 2,300
MN 100 300 200 500 1,200

Select the components which should be bought from outside, indicating the reasons for
choice.
[Ans.: (a) It is better to purchase XY Product (b) It is better to manufacture PR
product (c) It is better to manufacture MN Product.]

7. A manufacturer has planned his level of operation at 50% of his plant capacity of
30,000 units. His expenses are estimated as follows, if 50% of the plant capacity is
utilised.
Rs.
(i) Director materials 8,280
(ii)Direct wages 11,160
(iii)Variable and other manufacturing expenses 3,960
(iv)Total fixed expenses irrespective of capacity 6,000
utilisation

The expected selling price in the domestic market is Rs.2 per unit. Recently the
manufacturer has received a trade enquiry from an overseas organisation interested in
purchasing 6,000 units at a price of Rs.1.45 per unit.
As a professional management accountant, what would be your suggestion regarding
acceptance or rejection of the offer? Support your suggestion with suitable quantitative
information.
[Ans.:15,000 units: Profit Rs.600;6,000 units: Loss Rs.660;Total 21,000 units
:Loss Rs.60; It is not profitable to accept the foreign offer.]

8. A company currently operating at 80% capacity has the following particulars.

Rs.
Sales 32,00,000
Direct materials 10,00,000
Centre for Distance Education 7.23 Acharya Nagarjuna University

Direct labour 4,00,000

Variable overheads 2,00,000
Fixed overheads 13,00,000

An export order has received that would utilize half the capacity of the factory. The
order cannot be split, i.e., it has either to be taken in full and executed at 10% below the
normal domestic prices are rejected totally.
The alternative available to the management are:

1. Reject the order and continue with the domestic sales only; (at as present); or
2. Accept the order, split capacity between overseas and domestic sales and turn away
excess domestic demand; or
3. Increase capacity to accept the export order and maintain the present domestic sales by:
(a) Buying an equipment that will increase capacity by 10%.This will result in an
crease of Rs.1,00,000 in fixed costs; and
(b) Work over time to met balance of required capacity. In that case, labour will be paid
at one and half times the normal wage rate.

Prepare a comparative statement of profitability and suggest the best alternative.

[Ans.: Profit I Rs.3,00,000; II Rs.5,00,000; III Rs.9,50,000. Alternative III is the
best because it results in the highest amount of profit.]

9. Prestige company private limited, manufacturing pressure cookers has drawn up the
following budget for the year 2006-07.

Rs.
Raw materials 20,00,000
Labour, stores, power and other variable 6,00,000
costs
Manufacturing overheads 7,00,000
Variable distribution costs 4,00,000
General overheads including selling 3,00,000
Total 40,00,000
Income from sales 50,00,000
Budgeted profits 10,00,000

The General Manager suggests to reduce selling price by 5% and expects to achieve
an additional volume of 50%. There is sufficient manufacturing capacity. More intensive
manufacturing programme will involve additional costs of Rs.50,000 for production
planning. It will also be necessary to open an additional sales office at the cost of Rs.1,00,000
per annum.

The Sales Manager, on the other hand, suggests to increase selling price by 10%,
which it is estimated will reduce sales volume by 10%. At the same time saving in
Advanced Management Accounting 7.24 Marginal Costing – Manag…
manufacturing overheads and general over heads at Rs.50,000 and Rs.1,00,000 per annum
respectively is expected on this reduced volume.
Which of these two proposals would you accept and why?

[Ans.: Proposal I:Profit Rs.14,75,000; Proposal II Rs.14,00,000;Proposal I is

acceptable as it gives higher profit.]

10. The following production / sales mix are capable of achievement in a factory.

i. 2,000 units of Product A and 2,000 units of product C.

ii. 4,000 units of product B.
iii. 1,000 units of product A, 2,000 units of product B and1,600 units of product C.
Cost per unit is as follows.

A B C
Rs. Rs. Rs.
Direct material 20 16 40
Direct wages 8 10 20

Fixed cost is Rs.20,000 and variable overheads per unit of A, B and C are Rs.2, Rs.4
and Rs.4 and Rs.8 respectively. Selling prices of A, B and C are Rs.36, Rs.40 and Rs.100 per
unit respectively. Determine the marginal contribution per unit of A, Band C and the profits
resulting from product mixed (i), (ii) and (iii).

[Ans.: Marginal Contribution per unit; A Rs.6; B Rs.10; C Rs.32; Sales mix (iii)
is profitable as it is yields the highest amount of contribution and profit.]

7.5 REFERENCE BOOKS:

1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company

Ltd., New Delhi
2. M.A. Sahaf, Management Accounting–Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers,
4. Charlesthorn Gaxy Sundem, Introduction to Management Accounting
5. N. Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V.Krishna Kumar, Management Accounting
9. Dr. Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain & KL Narang, Advanced Cost and Management Accounting
 LESSON 8
PRICING DECISIONS
OBJECTIVES

1. Discuss the three major influences on prices

2. Understand the factors that influence on price
3. Will be known the objectives behind the pricing of the products/services
4. Understand and implement practically the theory of price
5. Able to know how pricing decisions influence the various areas of the business

STRUCTURE

8.1 Meaning
8.2 Definitions of Price
8.3 Objectives of Pricing:
8.3.1. Survival
8.3.2. Expansion of current profits
8.3.3. Ruling the market
4.3.4. A market for an innovative idea
8.4 Importance of Pricing
8.5 Theory of Price
8.6 Determination of Prices
8.6.1. Product Cost
8.6.2. The Utility and Demand
8.6.3. The extent of Competition in the Market
8.6.4. Government and Legal Regulations
8.6.5. Pricing Objectives
8.6.6. Marketing Methods Used
8.7 Summery of the Lesson
8.8 Key Terms
8.9 Self-Assessment Questions
8.10 Further Readings

8.1 MEANING

Pricing decisions have strategic importance in any enterprise. Pricing governs the very
feasibility of any marketing program because it is the only element in a marketing
mix accounting for demand and sales revenue. Other elements are cost factors.

Price is the only variable factor determining the revenues or income. A variety of
economic and social objectives came in to prominence in many pricing decision.

Pricing is a process of fixing the value that a manufacturer will receive in the
exchange of services and goods. Pricing method is exercised to adjust the cost of the
producer’s offerings suitable to both the manufacturer and the customer. The pricing depends
on the company’s average prices, and the buyer’s perceived value of an item, as compared to
the perceived value of competitors’ product.
Advanced Management Accounting 8.2 Pricing Decisions

8.2 DEFINITIONS OF PRICE

Economist defines price as the exchange value of a product or services always

expressed in money.

To the consumer the price is an agreement between seller and buyer concerning what
each is to receive.

Price is the mechanism or device for translating into quantitative terms(Rupees) the
perceived value of the product to the customer at a point of time. The buyer is interested in
the price of the whole package consisting of the physical product plus bundle of expectations
or satisfactions. The consumer has numerous expectations such as accessories, after–sales–
service, replacement parts, technical guidance, extra service, credit and many other benefits.

Thus price must be equal to the total amount of benefits (physical, economic, social
and psychological benefits).

Pricing is equivalent to the total product offering. This offering includes a brand
name, a package, and benefits, service after sale, delivery, and credit and so on. From the
marketers point of view, the price also covers the total market offering, i.e., the consumer is
also purchasing the information through advertising, sales promotion and personal selling and
distribution method that has been adopted. The consumer gets these values and also covers
their costs. We can now define price as the money value of a product or service agreed upon
in a market transaction. We have a kind of price equation where:

Money (price) = Bundle of Expectations

“Price is the amount of money and/or other items with utility needed to acquire a
product.- Prof. William J. Stanton

“Price is the only element in the marketing mix that produces revenue, the other elements
produce cost. - Prof. Philip Kotler

“Price is the exchanged value of the product or service expressed in terms of money”
-David J. Schwartz

8.3 OBJECTIVES OF PRICING

8.3.1. Profits-related Objectives:

Profit has remained a dominant objective of business activities.

Company’s pricing policies and strategies are aimed at following profits-related objectives:
i. Maximum Current Profit:
 One of the objectives of pricing is to maximize current profits.
 This objective is aimed at making as much money as possible.
 Company tries to set its price in a way that more current profits can be earned.
However, company cannot set its price beyond the limit.
 But, it concentrates on maximum profits.
ii. Target Return on Investment:
Centre for Distance Education 8.3 Acharya Nagarjuna University

Most companies want to earn reasonable rate of return on investment.Target return may be:
 fixed percentage of sales,
 return on investment, or
 A fixed rupee amount.

Company sets its pricing policies and strategies in a way that sales revenue ultimately
yields average return on total investment. For example, company decides to earn 20% return
on total investment of 3 crore rupees. It must set price of product in a way that it can earn 60
lakh rupees.

8.3.2. Sales-related Objectives:

i. Sales Growth:
 Company’s objective is to increase sales volume.
 It sets its price in such a way that more and more sales can be achieved.
 It is assumed that sales growth has direct positive impact on the profits.
 So, pricing decisions are taken in way that sales volume can be raised.
 Setting price, altering in price, and modifying pricing policies are targeted to
improve sales.

ii. Target Market Share:

 A company aims its pricing policies at achieving or maintaining the target market
share.
 Pricing decisions are taken in such a manner that enables the company to achieve
targeted market share.
 Market share is a specific volume of sales determined in light of total sales in an
industry. For example, company may try to achieve 25% market shares in the
relevant industry.

iii. Increase in Market Share:

Sometimes, price and pricing are taken as the tool to increase its market share.
When company assumes that its market share is below than expected, it can raise it by
appropriate pricing; pricing is aimed at improving market share.

8.3.3. Competition-related Objectives:

 Competition is a powerful factor affecting marketing performance.
 Every company tries to react to the competitors by appropriate business strategies.
With reference to price, following competition-related objectives may be priorized:

i. To Face Competition:
 Pricing is primarily concerns with facing competition.
 Today‟s market is characterized by the severe competition.
 Company sets and modifies its pricing policies so as to respond the competitors
strongly.
 Many companies use price as a powerful means to react to level and intensity of
competition.

ii. To Keep Competitors Away:

 To prevent the entry of competitors can be one of the main objectives of pricing.
Advanced Management Accounting 8.4 Pricing Decisions

 The phase „prevention is better than cure‟ is equally applicable here. If competitors
are kept away, no needto fight with them.
 To achieve the objective, a company keeps its price as low as possible to minimize
profit attractiveness ofproducts.
 In some cases, a company reacts offensively to prevent entry of competitors by selling
product even at aloss.

iii. To Achieve Quality Leadership by Pricing:

 Pricing is also aimed at achieving the quality leadership.
 The quality leadership is the image in mind of buyers that high price is related to high
quality product.
 In order to create a positive image that company’s product is standard or superior than
offered by the closecompetitors; the company designs its pricing policies accordingly.

iv. To Remove Competitors from the Market:

 The pricing policies and practices are directed to remove the competitors away from the
market.
 This can be done by forgoing the current profits – by keeping price as low as possible – in
order tomaximize the future profits by charging a high price after removing competitors
from the market.
 Price competition can remove weak competitors.

8.3.4. Customer-related Objectives:

Customers are in center of every marketing decision.

Company wants to achieve following objectives by the suitable pricing policies and practices:

i. To Win Confidence of Customers:

 Customers are the target to serve.
 Company sets and practices its pricing policies to win the confidence of the target
market. Company, byappropriate pricing policies, can establish, maintain or even
strengthen the confidence of customers thatprice charged for the product is reasonable
one.
 Customers are made feel that they are not being cheated.

ii. To Satisfy Customers:

 To satisfy customers is the prime objective of the entire range of marketing efforts.
And, pricing is noexception.
 Company sets, adjusts, and readjusts its pricing to satisfy its target customers.
 In short, a company should design pricing in such a way that results into maximum
consumer satisfaction.

8.3.5. Other Objectives:

Over and above the objectives discussed so far, there are certain objectives that company
wants to achieve bypricing.
They are as under:
Centre for Distance Education 8.5 Acharya Nagarjuna University

i. Market Penetration:
 This objective concerns with entering the deep into the market to attract maximum
number of customers.
 This objective calls for charging the lowest possible price to win price-sensitive
buyers.

ii. Promoting a New Product:

 To promote a new product successfully, the company sets low price for its products in
the initial stage toencourage for trial and repeat buying.
 The sound pricing can help the company introduce a new product successfully.

iii. Maintaining Image and Reputation in the Market:

 Company‟s effective pricing policies have positive impact on its image and
reputation in the market.
 Company, by charging reasonable price, stabilizing price, or keeping fixed price can
create a good imageand reputation in the mind of the target customers.

iv. To Skim the Cream from the Market:

 This objective concerns with skimming maximum profit in initial stage of product life
cycle. Because aproduct is new, offering new and superior advantages, the company
can charge relatively high price.
 Some segments will buy product even at a premium price.

v. Price Stability:
 Company with stable price is ranked high in the market.
 Company formulates pricing policies and strategies to eliminate seasonal and cyclical
fluctuations.
 Stability in price has a good impression on the buyers. Frequent changes in pricing
affect adversely theprestige of company.

vi. Survival and Growth:

 Finally, pricing is aimed at survival and growth of company‟s business activities and
operations. It is afundamental pricing objective.
 Pricing policies are set in a way that company‟s existence is not threatened

8.3.1. Survival

The objective of pricing for any company is to fix a price that is reasonable for the
consumers and also for the producer to survive in the market. Every company is in danger of
getting ruled out from the market because of rigorous competition, change in customer’s
preferences and taste. Therefore, while determining the cost of a product all the variables and
fixed cost should be taken intoconsideration. Once the survival phase is over the company
can strive for extra profits.

8.3.2. Expansion of Current Profits

Most of the company tries to enlarge their profit margin by evaluating the demand and
supply of services and goods in the market. So the pricing is fixed according to the product’s
demand and the substitute for that product. If the demand is high, the price will also be high.
Advanced Management Accounting 8.6 Pricing Decisions

8.3.3. Ruling the Market

Firms’ impose low figure for the goods and services to get hold of large market size.
The technique helps to increase the sale by increasing the demand and leading to low
production cost.

8.3.4. A Market for an Innovative Idea

Here, the company charge a high price for their product and services that are highly
innovative and use cutting-edge technology. The price is high because of high production
cost. Mobile phone, electronic gadgets are a few examples.

8.4 IMPORTANCE OF PRICING

Price is a matter of vital importance to both the seller and the buyer in the market
place.In money economy, without prices there cannot be marketing. Price denotes the value
of aproduct or service expressed in money. Only when a buyer and a seller agree on price, we
canhave exchange of goods and services leading to transfer of ownership.

In a competitive market economy, priceis determined by free play of demand

andsupply. The price will move forward or backward with changing supply and demand
conditions.

The going market price acts as basis for fixing the sale price. Rarely an individual
seller candishonour the current market price. In a free market economy, we have freedom of
contract,freedom of enterprise, free competition and right to private property. Price regulates
businessprofits, allocates the economic resources for optimum production and distribution.

Thus price isthe prime regulator of production, distribution and consumption of

goods. Economics revolvesaround pricing of resources. Price influences consumer purchase
decisions. It reflects purchasingpower of currency. It can determine the general living
standards. In essence, by and large, everyfacet of our economic life is directly or indirectly
governed by pricing. This is literally true in ourmoney and credit economy.

Pricing decisions inter-connectmarketing actionswith the financial objectives of

theenterprise.Among the most important marketing variables influenced by pricing decisions
are:
1. Sales volume,
2. Profit margins,
3. Rate of return on investment,
4. Trade margins,
5. Advertising and sales promotion,
6. Product image,
7. New product development.

Therefore, pricing decisions play a very important role in the design of the
marketingmix. Pricing strategy determines the firms’ position in the market vis-a-vis its
rivals.
Centre for Distance Education 8.7 Acharya Nagarjuna University

Marketingeffectiveness of pricing policy and strategy should not suffer merely on

account of cost andfinancial criteria.

8.5 THEORY OF PRICE

The theory of price is an economic theory that states that the price for a specific good
or service is determined by the relationship between its supply and demand at any given
point. Prices should rise if demand exceeds supply and fall if supply exceeds demand.

The theory of price—also referred to as "price theory"—is a microeconomic principle

that says the market forces of supply and demand will determine the logical price point for a
particular good or service at any given time.

Relationship of Supply and Demand to Price Theory

Supply denotes the number of products or services that the market can provide. This
includes both tangible goods, such as automobiles, and intangible ones, such as the ability to
make an appointment with a skilled service provider. In each instance, the available supply is
finite in nature. There are only a certain number of automobiles available and only a certain
number of appointments available at any given time.

Supply may be affected by forces that are beyond a producer's control, such as the
availability of raw materials.

Demand applies to the market's desire for tangible or intangible goods. At any time,
there is also only a finite number of potential consumers available. Demand may fluctuate
depending on a variety of factors, such as whether an improved version of a product is
available or if a service is no longer needed. Demand can also be affected by an item's
perceived value by the consumer market.

As mentioned earlier, equilibrium occurs when the total number of items available—
the supply—can be consumed by potential customers. If a price is too high, customers may
avoid the goods or services or find other alternatives. This would result in excess supply and
possibly cause producers to lower prices.

In contrast, if a price is too low, demand may significantly outpace the available
supply, causing prices to rise again

The traditional theory of pricing that of supply versus demand is developed from
economics. As such, it offers a useful intellectual framework for the consideration of pricing
issues. Unfortunately, most of the parameters needed to apply this theory have been
extremely difficult to measure in practice. Customer needs and market factors tend to
dominate the more “practical” marketing theory.New product pricing, whether to “skim”
profits or to “penetrate” the market, is a particular form of pricing and poses rather different
challenges. However, much of this chapter describes the various practical pricing policies
adapted from cost-plus and market-based strategies to selective ones. Discounts and
competitive pricing are also investigated.Although fundamentals of pricing remain the same,
the proliferation of e-commerce on the internet is also revolutionizing the relationships
between buyers and sellers in the market. Both parties have clearer pictures of the cost and
price structures in their market exchange. As presented in the vignette at the beginning of this
Advanced Management Accounting 8.8 Pricing Decisions

chapter, in the age of the internet, buyers will probably benefit from lower prices, and sellers
will also benefit from more fluid pricing to meet the consumer demand more accurately.

In a free market economy, producers typically want to charge as much as they

reasonably can for their goods and services, while consumers want to pay as little as they can
to obtain them. Market forces will cause the two sides to meet somewhere in the middle, at
price consumers are willing to pay and that producer are willing to accept.

Companies often differentiate their product lines vertically, rather than horizontally,
considering consumers' differential willingness to pay for quality. As noted by Michaela
Draganska of Drexel University and Dipak C. Jain of INSEAD in the journal Marketing
Science, many firms offer products that vary in characteristics like colour or flavour, but that
do not vary in quality. Their study found that using uniform prices for all products in a
particular product line tends to be the best pricing policy for producers.

For example, Apple Inc. offers several different MacBook Pro laptop computer
models, with varying screen sizes, capabilities, and prices. The customer has a choice of two
colours: silver and space gray. If Apple charged a higher price for a 13-inch silver MacBook
Pro versus an otherwise identical space gray one, demand for the silver model might fall, and
the available supply of the silver model would increase. At that point, Apple might be forced
to reduce the price of that model.

When the quantity of a good or service that's available matches the demand of
potential consumers for it, the market is said to achieve equilibrium. The concept of price
theory allows for price adjustments as market conditions change.

Every businessperson starts a business with a motive and intention of earning profits. This
ambition can be acquired by the pricing method of a firm. While fixing the cost of a product
and services the following point should be considered:

 The identity of the goods and services

 The cost of similar goods and services in the market
 The target audience for whom the goods and services are produces
 The total cost of production (raw material, labour cost, machinery cost, transit,
inventory cost etc).
 External elements like government rules and regulations, policies, economy, etc.,

8.6 DETERMINING FACTORS OF PRICES

Determination of Prices means to determine the cost of goods sold and services
rendered in the free market. In a free market, the forces of demand and supply determine the
prices.The Government does not interfere in the determination of the prices. However, in
some cases, the Government may intervene in determining the prices. For example, the
Government has fixed the minimum selling price for the wheat.

Factors Influencing Pricing

Pricing of a product is influenced by various factors as price involves many variables.
Factorscan be categorized into two, depending on the variables influencing the price.
Centre for Distance Education 8.9 Acharya Nagarjuna University

Internal Factors

The following are the factors that influence the increase and decrease in the price of a product
internally −
• Marketing objectives of company
• Consumer’s expectation from company by past pricing
• Product features
• Position of product in product cycle
• Rate of product using pattern of demand
• Production and advertisement cost
• Uniqueness of the product
• Production line composition of the company
• Price elasticity as per sales of product

Internal factors that influence pricing depend on the cost of manufacturing of the
product, whichincludes fixed cost like labor charges, rent price, etc., and variable costs like
overhead, electriccharges, etc.

The factors which affect the price determination of the product are:

External Factors

The following are the external factors that have an impact on the increase and decrease in
theprice of a product −

• Open or closed market

• Consumer behavior for given product
• Major customer negotiation
• Variation in the price of supplies
• Market opponent product pricing
• Consideration of social condition
• Price restricted as per any governing authority

External factors that influence price depend on elements like competition in market,
consumerflexibility to purchase, government rules and regulation, etc.

Let’s discuss some of the important factors having influence on price determination discuss
below:

8.6.1. Product Cost:

Product cost is one of the most important factors which affect the price. It includes the
total of fixed costs, variable costs and semi-variable costs incurred through the production,
distribution, and selling of the product. Fixed costs refer to those costs which remain fixed at
all the levels of production or sales. For instance, rent, salary, etc.

Variable costs attribute to the costs which are directly related to the levels of
production or sales. For example, the costs of basic material, apprentice costs, etc. Semi-
variable costs take into account those costs which change with the level of activity but not in
direct proportion.
Advanced Management Accounting 8.10 Pricing Decisions

8.6.2. The Utility and Demand:

Habitually, end user demands more units of a product when its price is low and vice
versa. On the other hand, when the demand for a product is elastic, little variation in the price
may result in large changes in quantity demanded.

While, when it is inelastic a change in the prices does not affect the demand
significantly. In addition, the buyer is ready to pay up to that point where he perceives utility
from the product to be at least equal to the price paid.

8.6.3. The extent of Competition in the Market:

The next consistent factor affecting the price of manufactured goods is the nature and
degree of competition in the market. A firm can fix any price for its product if the degree of
competition is low. However, when there is competition in the market, the price is fixed after
keeping in mind the price of the substitute goods.

8.6.4. Government and Legal Regulations:

The firms which have a monopoly in the market, habitually charge a high price for
their products. In order to protect the interest of the public, the government intervenes and
regulates the prices of the commodities. For this purpose, it declares some products as
indispensable products. For example, Life-saving drugs, etc.

8.6.5. Pricing Objectives:

Another consistent factor, affecting the price of an item for consumption or service is
the pricing objectives. Profit Maximization, Obtaining Market Share Leadership, Surviving in
a Competitive Market and Attaining Product Quality Leadership are the pricing objectives of
an enterprise. By and large, firm charges higher prices to cover high quality and high cost if
it’s backed by the above objective.

8.6.6. Marketing Methods Used:

A range of marketing methods such as circulation system, quality of salesmen,

marketing, type of wrapping, patron services, etc. also affects the price of manufactured
goods. For instance, an organization will charge sky-scraping revenue if it is using the classy
material for wrapping its product

The price that makes demand equivalent to

supply is called the equilibrium price. Graphically,
Price

Demand

it can be said that the equilibrium price is the point Supply

where the demand curve and supply curve intersect.

E

It is the price at which there is no unsold P

stock left neither is any demand unfulfilled. Thus, it
is also known as the market clearing price. D

Qty

Q
Centre for Distance Education 8.11 Acharya Nagarjuna University

Once the Equilibrium price and quantity are reached, we attain Stable Equilibrium.
Stable equilibrium adjusts any disturbance in the demand and supply and restores the original
equilibrium.

Other things remaining the same, when the price falls below the equilibrium price, the
demand increases and supply decreases. There arises a shortage of goods which in turn
increases the price to equilibrium price.

Similarly, when the price rises above the equilibrium price, the demand decreases and
supply increases. There arises a surplus of goods which in turn decreases the price to
equilibrium price. Thus, the market restores the equilibrium price on its own.
However, the prices are not determined only by the forces of demand and supply.

Other factors such as the price of substitute goods, price of related goods, government
policies, competition in the market, etc. also play an important role in the determination of
the prices.

Price Elasticity of Demand: The degree to which demand is sensitive to price is called
price elasticity of demand. This expression is often shortened to elasticity of demand,
although strictly it is difficult to analyze and predict the actual elasticity of demand
because economists recognize that demand may also depend on other factors, such as
income. The price elasticity of demand refers to the percentage change in the quantity of a
good demanded as a result of the percentage change in its price, orPrice elasticity of demand
= Percentagechangeindemand/Percentagechangeinprice

8.7 SUMMARY OF THE LESSON

Much of pricing theory is derived from economics, especially from supply and
demand theory. This information is encapsulated in the famous demand and supply curves.

The price is set by the point where the curves intersect. The degree to which demand
is susceptible to price changes (price elasticity of demand) is another concept borrowed from
economics but very useful to marketers.

Again in theory, but rarely in practice, these curves can be obtained from statistical
analysis of historical data, survey research, and experimentation. Rather less theoretically,
factors affecting the pricing policies of a specific organization include organization factors,
product life cycle, product portfolio, product line pricing, segmentation and positioning, and
branding. Factors derived from customers are demand, benefits, value, and distribution
channels. Of these, perceived value is especially important because it defines what the
customer should be prepared to pay

8.8 KEY TERMS

1. Pricing Decision
2. Perceived Value
3. Competition
4. Bundle of benefits
5. Bundle of expectations
6. Marketing mix
Advanced Management Accounting 8.12 Pricing Decisions

8.9 SELF-ASSESSMENT QUESTIONS

1. How does the equilibrium price come about? What is the price elasticity of demand?
2. How may supply and demand curves be established in practice?
3.What organizational factors, derived from related marketing theory, might influence
price? How may positioning or branding be used to raise prices?
4. What customer-related factors might, in theory, affect price? Why may perceived value be
important?

8.10 FURTHER READINGS

1. Marketing Management by Michael Czinkota and Masaaki Kotabe, Feb, 2022 Chapter 10
2. A Text Book of Cost and Management Accounting by MN Arora, 9th Edition, Vikas
Publications, 2010

Dr. David Raju Gollapudi

 LESSON 9
PRICING STRATEGIES
OBJECTIVES

1. To provide students with an integrative frame work for making pricing decisions.
2. To provide students with a systematic overview of the factors to be considered
when setting price.
3. To facilitate students’ understanding of how pricing strategy alternatives can be
developed and analyzed
4. Understand how pricing strategies would implement in service industry

STRUCTURE

9.1 Product Pricing

9.3 Pricing Strategies
9.3.1 Product Pricing Strategies
9.3.1.1. Cost-Oriented Pricing
9.3.1.2. Demand-Oriented Pricing
9.3.1.3. Competition-Oriented Pricing
9.3.2 Pricing New Products
9.3.2.1 Skimming Pricing
9.3.2.2 Penetration Pricing
9.3.3 Pricing of Services
9.3.3.1 Category Pricing
9.3.3.2 Customer Group Pricing
9.3.3.3 Peak Pricing
9.3.3.4 Yield Pricing
9.3.3.5 Service-Level Pricing
9.4 Summery of the Lesson
9.5 Self-Assessment Questions
9.6 Key Terms
9.7 Further Readings

9.1 PRODUCT PRICING

Sometimes established companies need not adjust their prices at all in response to
entrants and their lower prices, because customers frequently are willing to pay more
for the products or services of an established company to avoid perceived risks
associated with switching products or services.

However, when established companies do not have this advantage, they

must implement other pricing strategies to preserve their market share and
profits. When entrants are involved, established companies sometimes attempt to
hide their actual prices by embedding them in complex prices. This tactic
makes it difficult for customers to compare prices, which is advantageous
to established companies competing with entrants that have lower prices. In addition,
established companies also may use a more complex pricing plan, such as a two-part
pricing tactic. This tactic especially benefits companies with significant market
power. Local telephone companies, for example, use this strategy, charging both
fixed and per-minute charges.

The next step is to determine the base price of products or services.

Usually, the steps in setting price involve the following procedure:

1. Estimate the demand for the product.
2. Anticipate the competitive reaction.
3. Establish the expected share of the market.
4. Select the price strategy to be used to reach the market target.
5. Consider company policies regarding products, channels and promotion.
6. Select the specific price.

Step 1: Estimate the Demand for the Product

The demand for an established product is easier to be known than for an

entirely new product. However, two steps are available for demand estimation.

First: to determine whether there is a price which the customers think the
product is worth, i.e., the expected price may range between, say Rs.10 and 20. The
seller may determine the expected price by submitting the product to an experienced
retailer or wholesaler for appraisal. Producers of industrial products may know the
expected price by seeking advice of the technical persons working for the customers.

By showing models or blue prints, necessary information may be gathered as

to what theprice would be or he may observe prices or competitive prices, or the
potential customers maybe surveyed. The most effective approach is to market the
product in a few limited test areas. By quoting different prices under controlled
subject, a reasonable range of price may be determined.

Second: to estimate the sales volume at different prices. A product with elastic
market demand is usually priced lower than the product with an inelastic demand.

Step 2: Anticipate the Competitive Reaction

Present and potential competition also influences price determination.

Competition may come from three existing sources.

First: from directly similar products such as the producer such as the producer
may have to compete his vegetable oil product under the name of Dalda with that of
Madhuram or Malti or any other new brand or different types of nylon saris.

Second: the competition may be from available substitutes, e.g., butter and
ghee, fluid milk and powdered milk.

Third: competition may be from unrelated items seeking the same consumer
rupee. The shrewd marketing manager tries to discourage the potential
competition, in case of new products, by keeping the prices low so that the
competitors may not dare to enter the market.
Step 3: Establish Expected Share of the Market

A firm which wants to win a large share of the market, will price its products
differently from a firm which is content with its present share in the market. Attempts
towards capturing a large market are manifested in heavy advertisements and other
forms of non-price competition. What the share of a particular firm in the market
should be, would be influenced by such factors as present production capacity, cost of
plant extension and ease of competition

Step 4: Select Pricing Strategy to Reach Market Target

Broadly speaking two alternatives are available for pricing of new

products. First, Skimming Pricing and penetrating pricing

Step 5: Consider company marketing policies

This is concerned with the consideration of the product policies, distribution

system; and the promotional programs. Product policies involve knowing the
economic characteristics of the products so that pricing may be done suitably.
Whether a product is of permanent nature or is of perishable nature, influence the
pricing policy.

Perishable products have to be disposed of within a limited time to save them

from spoilage. Hence, throw-away prices may be set for fruits, vegetables, milk etc.
after the days close. But so far as motor-cars, radios, cloth or such other durable
products are concerned, their price need not be reduced, for demand exists for these,
though it may be postponed for the time being, Change in fashion also compels the
seller to dispose of his stock, before the fashion goes old.

Channels of Distribution: The nature of the channels used, and the

gross-margin requirements of the middlemen influence the pricing decisions. Pricing
discretion differ with the length and complexity of the chain of distribution. A firm
selling through wholesalers and also directly to retailers often sets a different factory
price for each of these two classes of customers.

Promotional programmers: The larger the promotional methods used, the

higher will be the pricing, for expenses incurred will have to be covered from the
price set.

Step 6: Select the specific price

After taking all the above facts into consideration, the last stage would be of
selecting the specific price for the products by the producer. This will depend upon
the cost of the product
9.2 PRICING STRATEGIES

9.2.1 Product Pricing Strategies

Pricing policies are more specific than the objectives and deal with situations
in the foreseeable future that generally recurs. Pricing policies provide the framework
and consistency needed by the firm to make reasonable, practicable and
effective pricing decisions. The correctness of any pricing policy depends on
such variables as managerial philosophy, competitive conditions, and the firms
marketing and pricing objectives. The following are, however, the policies
recognized for pricing.

1. Cost-oriented pricing,
2. Demand-oriented pricing
3. Competition-oriented pricing
4. Selective Pricing

9.2.1.1. Cost-oriented pricing

It is also referred to as cost-plus pricing. This pricing method assures that no

product is sold at a loss, since the price covers the full cost incurred. Definitely, costs
furnish a good point from which the computation of price could begin. Fixing a
tentative price is easier under this method. But the criticism against this policy is that
it ignores completely the influences of competition and market demand.

Cost-plus policies are often used by retail traders and in manufacturing

industries where the production is non-standardized. The method of pricing here is
based on simple arithmetic, adding a fixed percentage to the unit cost. Thus the retail
price of a particular item might be the manufacturers cost plus his gross margin plus
the wholesalers gross margin, plus the retailers gross margin. This method is known
as sum of margins method.

The starting point for most pricing exercises is an examination of the cost of
the product or service. In practice, such “cost-plus pricing” is probably the most
common approach and may be understandable when the price list contains
hundreds of items, although, under those circumstances, it is highly debatable
whether the “cost” for each item represents anything more than an estimate.

Paradoxically, cost-plus pricing seems to suggest that inefficiency (which

would lead to a higher unit cost) should be rewarded.

The one area in which cost-plus pricing is possibly justifiable is where the
supplier has a long-term relationship, almost a partnership, with a customer (often the
government and perhaps in the case of industrial buyer). In these circumstances it is
sometimes agreed that a certain level of profit, as a percentage of cost, is accept-able.
But even here a question has to be asked as to the efficiency of such a pricing policy,
for the customer as well as for the supplier, because profit is supposed to be the main
incentive. The legal actions taken by government to recover unwarranted profits
made by some defense contractors operating under these pricing policies seem
to argue for some dissatisfaction.

The most critical element

in this process is often the most All Overheads
arbitrary—that of the allocation of
overheads. The process of
“absorption” of overheads,
whereby indirect overheads are
allocated on the basis of
“judgment” to production
departments and then, combined
Service
with direct overheads, “absorbed” Production
into the individual product costs, Department Department
is often made on the basis of labor Overheads Overheads
content (see the Fig.)

Another common method

used under cost-oriented pricing is
known as Target Pricing.This is Production
invariably adopted by
manufacturers who fix a target
return on its total cost.

Target Pricing: In target pricing, the intention is not just to obtain a

“profit” over costs but is to obtain a reasonable return on investment (ROI).

Therefore, the price has to be based on both the variable costs (as in cost-plus)
and the fixed costs. Fixed costs generally include facility, capital equipment and
investment, and other over-head, including top management’s salaries. The process
of trying to consider investment decisions and pricing decisions simultaneously is
a complex one, requiring accurate information. General Motors extensively used
target pricing in the 1980s. Facing intense Japanese competition, General Motors was
losing customers. To achieve its targeted ROI, the company had to raise prices
frequently to compensate for revenues lost to the Japanese automakers and further
aggravated its customer losses as a result. Thus, it is not surprising that target
pricing is one of the less popular policies, except where it is used often in a theoretical
rather than practical context, as part of a justification for a large capital investment
program.

Manufacturers these days use Break-Even Analysis for deciding cost-plus

pricing. As mentioned earlier one defect of this pricing policy is that it ignores the
demand factor. This analysis helps to calculate in advance the likely relationship
between the cost, volume and profit over various time periods. It has also proved to
be a highly useful technique for the broad planning of manufacturing facilities.

The break-even analysis helps a firm to determine at what level of output the
revenues will equal the costs, assuming a certain selling price. For this purpose the
cost of manufacture is also divided into two: Fixed and Variable costs. Fixed costs
(Rent, Rates, Insurance etc.) theoretically remain constant over all levels of output.
 Variable costs (Labour and Material) vary with changes in output level. Fixed
costs naturally decrease per unit when production increases.Variable costs, on the
other hand, change as production varies i.e., no production, no variable cost.

The break-even point, therefore, is a point where there is neither loss nor
profit. This is found out by using the following equation.

BEP = Total fixed costs / Margin of contribution.

Margin of contribution = Unit selling price – Unit variable costs.

Historical Pricing: The normal extension of cost-plus pricing is to base today’s prices
on yesterday’s—thus, “historical” pricing. The annual round of price increases,
for example, is based on last year’s price raised by something approximating the
increase in the cost of living or the true increase in costs—whichever is
higher. Also, any adjustment of the historical price should consider market
environmental changes such as changes in buying power, competitors’ price,
regulatory issues, and so forth.

Product Line Pricing: The pricing for a given product may be decided by the
range within which it fits. There may thus appear to be an inevitable logic, derived
from the rest of the product line. A 12-ounce pack, for example, is expected to
have a price somewhere close to the median of the 8-ounce and 16-ounce packs. A
premium price on a member of a budget-price product line would pose questions, and,
at the other extreme, a budget-price entry into a luxury product line might do severe
damage to the quality image of that product line.

A more specific example of product line pricing comes from retailing, where it is
often called price lining. In this case there are a limited number of predetermined
price points, and all items in a given price category are given a specific price, say
$9.99. This type of pricing also illustrates the “psychological” aspect of choosing
certain price points on the basis that customers will read $9.99 as $9 rather than the
$10 it nearly is! However, there is debate about the effectiveness of such psycho-
logical pricing strategies.

9.2.1.2. Demand-Oriented Pricing

As the name suggests, under this method of pricing, the demand is the pivotal
factor. Price is fixed by simply adjusting it to the market conditions. A high price is
charged when orwhere the demand is intense, and a low price is charged when
the demand is low, Price discrimination is usually adopted under such market
situations.

“Demand and Supply,” market-based pricing is sometimes called “perceived

value pricing” because the price charged matches the value that the customer
perceives the product or service offers. Clearly, this strategy is nearly ideal because it
is likely to be optimal in terms of obtaining the maximum premium on the commodity
price. This is also the ideal price in that it matches the “position” of the product
to the customer’s perceptions. Particularly in the luxury goods markets, the price is an
element of the overall “description” of the product and one that is seen as
reflecting its quality. There are many examples of luxury products, such as
Harley-Davidson motorcycles, that have performed badly until the price is
increased in line with the quality expected.

9.2.1.3. Competition-Oriented Pricing

Most companies set prices after a careful consideration of the competitive

price structure. Deliberate policies may be formulated to sell above, below, or
generally in line, with competition. One important feature of this method is that there
cannot be any rigid relation between the price of a product and the firms own cost or
demand. Its own cost or demand may change but the firm maintains its price.
Conversely, the same firm will change its price when the competitors change theirs,
even if its own cost or demand has not altered. KINDS OF PRICING

Adopting basic principle explained above, firms may choose various kinds of
pricing for their products. These are discussed below.

1. Odd pricing: The term odd price is used in two ways. It may be a price
ending in an odd number or a price just under a round number. The seller of specialty
or convenience goods adopts such a pricing generally; for example, a shoe
manufacturer pricing one of his products, at say, Rs. 49.92.

2. Psychological pricing: The price under this method is fixed at a full

number. The price-setters feel that such a price has an apparent psychological
significance from the view point of buyers. For example, it is stated that there are
certain critical points at prices such as 1, 5 and 10. The experiments conducted proved
that change of price over a certain range, has little effect until some critical point is
reached.

3. Customary prices: Such prices are fixed by custom. For example, sweets
manufacturers price their products in such a way that a particular variety of sweets are
sold at approximately the same price. Soft drinks are also priced in the same manner.
Such a pricing is usually adopted by chain stores

9.2.2 Pricing New Products

An organization is most free to determine the price of its products or services

when they are launched. After the price has been set, so has a precedent. In the event
of any future changes, consumers will have not only the competitive prices as a
comparison, but they will also have the previous prices as a very direct point of
reference.

Therefore, making substantial changes to the prices of existing products or

services is very difficult. Consumer reactions may be severe if they think the
organization is taking advantage of them.

If the new product is entering an existing market, price will be just one of the
positioning variables. On this basis, the price will be carefully calculated to position
the brand exactly where it will make the most impact—and profit. At a less
sophisticated level, the producer of a new brand will decide which of the existing
price ranges-cheap or expensive-the product or service should address. A
supplier entering a mass consumer market can simply go to the local super market or
specialty store and see what prices are already accepted for similar products.

In industrial markets, obtaining competitive prices may be much more

difficult, even where published price lists are available, because these prices
are often only the starting point for negotiations that result in heavy discounts.

In the case of a totally new product or service, the pricing exercise will be that
much more difficult because no precedents indicate how the consumer might
behave, and market research is notoriously inaccurate in this area. In the end, what
“perceived value” the consumer will put on the offering will have to be a judgmental
decision.

Pricing a new product is an art. It is one of the most important and puzzling
marketing problems faced by a firm. Pricing is important in two ways, as far as a new
product is concerned.

(a) It affects the quantity of the product to be sold

(b) It determines the amount of the revenue of affirm

New products, when introduced, appeal too many as novel items. But this
distinctiveness created by novelty is only temporary. The price factor which may be
ignored initially would become important when the product becomes an ordinary one
because of being constantly used. Furthermore, competitors may also appear in the
market. Therefore, the new products are hard to be priced, especially with a right
price. Incorrect pricing will definitely lead to product failure. For setting a price on a
new product, three guidelines are to be adopted.

1. Making the product accepted

2. Maintaining the market
3. Retaining the profits

There are two options available for pricing a new product: Skimming and
Penetration pricing. If product is entirely new in all respects, skimming method could
be used. A strategy of high prices coupled with large promotional expenditure in
the initial stages has proved successful in a number of cases. Skimming pricing is
recommended on account of the following reasons:

1) Initial sales would be-less,

2) Helps to take the cream of market through high prices,
3) As pointed out people may like to own a new product even at a higher cost,
4) Helps to develop demand as the price is gradually reduced
5) High sales volume on account of higher price.

However, it should be noted that high initial prices may also prevent quick
sales. The second option is to adopt penetration pricing. A comparative analysis of
these two pricing systems reveals that both these methods are not free from errors.
 “Pricing New Products,” however, two main approaches are possible for a
new product’s pricing strategy and to a lesser extent for an existing one: skimming
and penetration pricing.

9.2.2.1 Skimming Pricing

One pricing approach is to set the initial price high, to “skim” as much profit
as possible, even in the early stages of the product life cycle. This approach is
particularly applicable to new products that, at least for some time, have a monopoly
of the market because the competitors have not yet emerged or at least the quality of
the newly launched product is much better than the existing alternative products and
is a pattern often seen in the introduction of new technology. For example, when
telephone companies entered Russia with cellular phones, they were priced very high
at $2500 for sign-up because they had no competition and appealed to just a handful
of wealthy people. Within 2 years, however, the average price of those cellular
phones returned to $200 for sign-up due to a demand much larger than expected and
threats of eventual competition. Similarly, the price of a mobile phone was
much higher when it was first launched in the mid-1990s, in comparison to
the price of mobile phones today.

The price is usually reduced, possibly in stages, by the first entrants to

gradually expand demand, until it reaches a competitive level just before the
competitors enter the market. However, it is interesting to note that in the case of
video recorders, latecomers such as Panasonic and Toshiba, with improved
technology and competitive prices, actually swept the market originally created
by Philips and Sony.

A skimming pricing strategy is highly market-dependent, and before applying

it, a company must ensure the following:

1. Many customers are willing to pay a high price.

2. Competitors cannot disrupt the market.
3. The costs of producing a smaller volume are not high.

The rationale behind skimming (sometimes called rapid payback) is

normally quite simply that of maximizing profit. But there may occasionally
be another motive—that of maximizing the image of “quality.” This is a policy that
holds in consumer markets such as the upper end of the perfume trade; for example,
sales of Chanel No. 5 would probably not increase dramatically if the price were
reduced. But this policy can just as easily apply in industrial markets. It is the foolish
consultant who asks for a low price; because the client will probably think that the
quality is comparably low.

As just indicated, the danger of a skimming policy is that a high price

encourages other competitors to enter the market because they see that sales revenue
can quickly cover the expense of developing a rival product. Even if your prices are
not exorbitant, you may still need, therefore, to plan for a steady reduction in
price as competitors appear and you recover some of your launch costs. Such a price
reduction will normally be helped by economies of scale. For example, Dell began
selling sub-$1000 home PCs and plans to have much more presence and
aggressiveness in the lower-priced product segment. Although hardly ground-
breaking in an era of $599 machines, Dell’s most recent embrace of under-$1000
PCs continues the balancing act of avoiding first-time PC buyers without alienating
them from its own line of PCs in its strategy of “skimming the cream” in the low end
of the market.

Zara pricing strategy: Zara is a well-known fashion retailer that has outlets all
over the world. Zara offers fashion clothing to the masses at affordable prices. Zara's
primary strategy is value-based pricing. Zara considers customers' perceptions of
prices and offers clothes with up-to-date fashion trends. It promotes fast fashion and
charges lower rates than high-end brands like Gucci, Louis Vuitton, etc. Zara analyses
sales every day and offers discounts on unsold clothing lines. Apart from these
strategies, Zara uses promotional strategies. As a result, you may see long queues in
front of Zara outlets on Black Friday or during a summer sale.

Tesco pricing strategy: Tesco, one of the largest grocery retailers in Europe,
tries to serve customers at low prices. Tesco follows a cost-based pricing strategy.
Tesco works to reduce production and transportation costs by implementing
economies of scale. Tesco also uses dynamic pricing via its membership program.
Members get some items at a reduced price and collect points while shopping. Tesco
claims to be a cost leader because of these strategies.

9.2.2.2 Penetration Pricing

A manufacturer could choose the opposite tactic by adopting a penetration

pricing policy. Indeed, this has been the very successful policy behind the
move of Japanese corporations into a number of existing markets. Here, an
initial low price might make imitating innovations less attractive for would-be
competitors, particularly when the technology is expensive; and it encourages
more customers to buy the product soon after its introduction, which hastens the
growth of demand and earlier economies of scale. The main value of this policy is
that it helps to secure a relatively large market share and increase turnover
while reducing unit costs; consequently, the price domination can be
maintained and extended. Its major disadvantage lies in lost opportunities for higher
profit margins.

In recent decades, many software companies have been literally giving

away their product in order to build market share and to entice buyers to buy other
products. Giving away the product to consumers is common in consumer
goods companies. Companies such as Gillette often give away razors to later make
huge profits on the blades. Under this broad category, however, there are a number of
more specific policies:

Maximizing brand/product share- This justification is sometimes made in

terms of maximizing sales growth, particularly in new markets where competitive
activity is less evident.
Maximizing current revenue- The assumption is that higher sales
automatically lead to higher profits, although in practice most products are more
sensitive, in terms of profit, to price than to volume.
 Survival- For some organizations, maximizing revenue by price-cutting may
be seen as the only way to survive. This is the philosophy of despair.

The circumstances generally favoring the skimming and penetration

pricing are summarized in the following table.

Conditions for skimming versus penetration pricing strategy

Skimming Pricing Penetration Pricing
Prices are likely to be inelastic Prices are likely to be elastic
The product or service is new and unique Competitors are likely to enter the market
quickly
There are distinct segments There are no distinct segments
Quality is important Products will be undifferentiated
Competitive costs are unknown Economies of scale apply

9.2.3 Pricing of Services

Some suppliers apply different prices for the same product or service. Marketing in
Action 10.1 shows how the internet is facilitating this strategy for natural gas
suppliers.

9.2.3.1 Category pricing: The supplier aims to cover the range of price
categories (possibly all the way from cheap to expensive) with a “range” of “brands”
based on the same “product” (repackaged and possibly with some minor
changes). This strategy was particularly obvious when Bausch + Lomb marketed
Sensitive Eyes 1 oz. eye drops for $5.65 and Sensitive Eyes 12 oz. contact lens
solution for $2.79. It may be less obvious when suppliers run high-priced
brands while at the same time offering low-priced store brands.

9.2.3.2 Customer group pricing: The ability of various groups to pay prices
may be met by having different categories of prices: Entrance fees and fares are
often lower for students and senior citizens.

9.2.3.3 Peak pricing: The price is matched to the demand: High prices are demanded
at peak times (the rush hours for transport, the evening performances for theaters, or
resort hotel rates for off-season months), but lower prices at off-peak times (to
redistribute the resource demands by offering incentives to those who can make use
of the services off-peak)

9.2.3.4 Yield pricing: A variant of peak pricing known as yield management was
originally used by airlines to price each seat differently depending on the
hourly fluctuating demand conditions. At the Washington National Opera
(formerly Washington Opera Co.), located in the nation’s capital, the ticket-services
man-ager knew—and his computer system confirmed—that the company routinely
turned away people for Friday and Saturday night performances, particularly for
prime seats. Meanwhile, midweek tickets went begging. He also knew that not all
seats were equal in terms of the view and the acoustics, even in the sought
after orchestra section. So the ticket manager and his staff played with ticket prices
until he arrived at nine levels, up from five. In the end, the opera raised prices for its
most coveted seats by as much as 50% but also dropped the prices of some 600 seats.
The gamble paid off in a 9% revenue increase during the next season.

Yield management emphasizes an aggressive micro market approach to

maximizing sales. It assures that companies will sell the right product to the right
consumer at the right time for the right price.

4.2.3.5 Service-level pricing: The level of service chosen may determine the price. At
its simplest, the buyer may pay for immediate availability rather than having to wait
(or may pay more for the guarantee of a seat). This may be extended to levels of
“delivery”; the product may be available immediately, and gift wrapped, in an
expensive store, or it may arrive some weeks later by mail from a cheaper mail order
house. There may also be levels of “quality” in delivery; for instance, seats in
different parts of a theater may have differing levels of access to the
performance, although the basic “product” may be identical. In addition to the
confirmed service (e.g., guaranteed seats in stadium as the seasonal ticket
scheme), many service providers (i.e., immigration departments in many countries)
offer quicker service with additional price.

The last four of these selective pricing strategies are particularly prevalent in
the service industries, where the supplier is in direct contact with the customer.Above
all, the main temptation to avoid is the assumption that price is the most important
variable in the marketing mix. Sometimes it may be, and you will obviously need to
recognize that. In most situations, however, it is not, and in many it may be a very
minor consideration. Under these “typical” circumstances, it is important to attend to
the other elements of the marketing mix first and then deal with price in this context.

9.3 SUMMERY OF THE LESSON

Pricing new products offers a different set of challenges. In general, the two main
opposing strategies are:

Skimming—High price, to skim off the short-term profit

Penetration—Low price, to maximize long-term market share

Practical pricing policies for existing brands may include cost-plus pricing, target
pricing, historical pricing, product line pricing, competitive pricing, market-based
pricing, and selective pricing. The price can also be a major factor in determining a
product’s or service’s image, ranging from quality price to budget price.

A wide range of discounts may be offered: trade, quantity, cash, allowances,

seasonal, promotional, and individual.

Prices may also be set at levels that are judged to be “psychologically”

appropriate ($9.95, for instance). Other ways of achieving a price effect may lie
with other parts of the offer, such as product bundling, at one extreme, and charging
separately for “options,” at the other. Alternatively, price may be negotiated, as
it often is in capital goods markets.
 Organizations may resort to price competition for several reasons, including
volume sales, other stimuli, and minor brands. On the other hand, the dangers of
initiating a price war include low-quality image, temporary advantage, and profit loss.

9.4 SELF-ASSESSMENT QUESTIONS

1. The most important decision in marketing is _____.

(a) Price (b) Product (c) Place (d) Promotion

2. What is a major problem posed by the traditional economic approach to pricing?

(a) Supply is difficult to determine. (b) Demand is difficult to determine.
(c) Supply is inelastic to price. (d) Demand is inelastic to price.

3. Inelastic demand is characterized by

(a) Demand sensitive to price change (b) Demand insensitive to supply change
(c) Demand sensitive to supply change (d) Demand insensitive to price change

4. All the following are theoretical ways to measure the demand curve EXCEPT
(a) Regression analysis (b) Survey research
(c) Experiment (d) Product life cycle analysis

5. All the following are factors that affect prices and are under direct control of the
organization EXCEPT
(a) Product life cycle (b) Product portfolio
(c) Product line pricing (d) Product competition

6. If price competition is severe, the firm should undertake which of the following to
offer a degree of protection?
(a) Segmentation (b) Differentiation (c) Penetration (d) Collaboration

7. Which of the following is NOT a strategy to cope with geographical pricing?

(a) Uniform (b) FOB (c) Zone d) Peak

8. Which of the following is NOT a benefit of penetration pricing?

(a) Growth of demand (b) Earlier economies of scale
(c) Increased market share (d) Higher profit margins

9. Market-based pricing is also called _____.

(a) Quality pricing (b) Customer group pricing (c) Perceived value pricing
(d) Competitive pricing

10. All the following are dangers of initiating a price war EXCEPT
(a) Low-quality image (b) Temporary advantage
(c) Decreased profitability (d) Excess capacity

11. Many firms enter a market as price leaders, but their strategy changes as they
dominate the lower end of the market. What are some of the challenges these firms
face? What strategies have and have not been successful?
12. What opposing pricing policies may be applied to new products, and how do they
work?

13. List the pricing policies used in practice. What are the drawbacks of cost-plus
pricing?

14. How is competitive pricing different from market-based pricing? What selective
pricing policies may be employed?

15. What discounts may be offered? What is psychological pricing? What are the
differences between product bundling and charging for options?

9.5 KEY TERMS

1. Category pricing
2. Customer group pricing
3. Equilibrium price
4. Free on board (FOB) pricing
5. Peak pricing
6. Price elasticity of demand
7. Service-level pricing
8. Skimming& Penetrating Pricing
9. Uniform pricing
10. Yield pricing
11. Zone pricing

9.6 FURTHER READINGS

1. Wyner, G. A. (2002). Get serious about pricing. Marketing Research, 14, 4–6.
2. Lee, W. A. (2003). Visa, MC offer advice to Amex: Lower interchange. American
Banker, p. 11

Dr. David Raju Gollapudi

 LESSON 10
BUDGETS – BUDGETARY CONTROL

OBJECTIVES

After reading this unit you should be able to:

 understand the meaning of budget and budgetary control
 find out the essentials of a budgetary control system
 understand the budgetary control organization of a company.
 know the advantages and limitations of budgetary control.

STRUCTURE

10.1 Introduction
10.2 Budgetary Control
10.3 Essentials of a Good Budgetary Control System
10.4 Budgetary Control Organization
10.5 Advantages of Budgetary Control
10.6 Limitations of Budgetary Control
10.7 Self Assessment Questions
10.8 Reference Books

10.1 INTRODUCTION

Cost accounting aims at ascertaining costs accurately. Additionally, it seeks to

control costs through careful planning. To this end, management tries to fix targets for
all important activities in advance. A comparison of actual performance with these pre-
determined targets is then made and reasons for variance are looked into with a view to
reduce costs and thereby improve performance continuously. Budgetary control is an
important managerial tool that helps to achieve these objectives.

10.1.1 Meaning of Budget:

The Institute of Cost and Management Accountants, London, defines budget as a

financial and/or quantitative statement prepared to a definite period of time, of the policy
to be pursed during that period for the purpose of attaining a given objective.

George R. Terry: “A budget is an estimate of future needs arranged according to at an

orderly basis covering some or all the activities of an enterprise for a definite period of time.

H.J.Weldon: A budget is thus, a standard with which to measure the actual achievement of
people, department etc.

Hemass C. Heiser: Budget is an overall blue print of a comprehensive plan of operations

and actions expressed in financial terms.
Advanced Management Accounting 10.2 Budgets- Budgetary Control

Thus, the essential features of a budget are:

1. It is statement in terms of money or quantity or both.
2. It is prepared for a definite future period.
3. It is prepared in advance.
4. Its purpose is to attain a given objective.

Budget presents the plans, objectives and policies of an enterprise in numerical

terms. It isa short-term operational plan used as a tool by management for planning as well
as controlling the activities of the organisation and also ensure the coordination among the
different departments in the organisation to achieve its predetermined goals. In a broad sense,
a budget constitutes a statement of planned or expected results (of any proposed course of
action) in quantitative terms for a specified future period. It may be expressed either in
financial or physical terms like machine hours, man hours, units or products, or in any other
numerically measurable terms.

10.1.2 Budgetary Control

The use of budget to monitor and regulate the operational activity of the organisation
in a systematic manner is called ‘budgetary control’.

The Institute of Cost and Management Accountants, London, defines budgetary

control as ‘the establishment of budgets, relating the responsibilities of executive to the
requirements ofa policy and the continuous comparison of actual with budgeted results either
to secure by individual action or to provide a firm basis for its revision.

A budgetary control system secures control over costs and performances in various
parts of an enterprise by:

1. establishing budgets;
2. comparing actual results with budgeted ones; and
3. taking corrective action or revising the budget if necessary.

As stated above, Budgeting means the process of preparing budgets. It is an act of

planning the activities of a firm and expressing the same in numerical terms. Budgetary
controlis the act of adhering to the plan.

Rowland and Harry have stated the difference between budgets, budgeting and
budgetary control. According to them, budgets are the individual objectives of a
department, etc., whereas Budgeting may be said to be the act of building budgets.

Budgetary control embraces all and in addition includes the science of planning the
budgets themselves and the utilisation of such budgets to effect an overall management tool
for the business planning and control. In the words of Van Sickle, “the budget is the
financial plan. Budgetary control results from the administration of the financial plan.”
Centre for Distance Education 10.3 Acharya Nagarjuna University

10.1.3 Forecast and Budget

Forecast is a statement of probable events. Budget is an operating and financial plan

of a firm. At planning stage, it is essential to prepare forecasts of probable courses of
action for the business in future. Plans or budgets are prepared on the basis of these
forecasts. A forecast is, therefore, the basis for the budget. The following are the
differences between ‘forecast’ and ‘budget’.

Differences between a Forecast and Budget

Forecast Budget
1. It is concerned with probable events It is concerned with planned events
2. It is prepared for a long period It is usually prepared for each accounting
period.
3. It deals with only a limited activity It deals with the entire unit.
of business, e.g., sales forecast
purchase forecast
4. Forecasting may not be very precise It is definite and precise and is an important
and it may lack control orientation control tool.
5. It is a preliminary step in budgeting It begins when forecasting ends Forecasts
are converted into budgets.

10.2 BUDGETARY CONTROL

Budgetary control could be described as ‘forward costing’ establishment of budgets

and then their application with a view to ensure control over the activities of concern. The
basic purpose is to improve the efficiency and profitability of the concern.

10.2.1 Objectives of Budgetary Control:

The following are the objectives of budgetary control.

1. To provide a detailed plan of action for a business over a period of time;
2. To coordinate the different units and activities of the organization with a view to
utilizeresources judiciously;
3. To motivate organizational members to perform well; and
4. To exercise control on cost through comparison of actual results with budgeted ones
and initiating rectificational steps promptly.

10.2.2 Distinction between Budgeting and Budgetary Control:

Budgeting and Budgetary control are accounting exercises which act as a tool
ofmanagement at all level. Budgeting differs from budgetary control in the following
respect.
Advanced Management Accounting 10.4 Budgets- Budgetary Control

Budgeting Budgetary Control

1. Budgeting is the preparation in advance Budgetary Control is a system by which
of the quantitative as well as financial budgets are used as a means of planning
statements to indicate the intention of and controlling all the aspects of a
the management in respect of the business.
various aspects of the business.
2. Budget is a statement showing the Budgetary control is a means of control
probable items of work to be carried out by which the actual position is compared
by the various departments specifying with that planned for to enable the
the quantities and monetary values. management to take appropriate action
if there are any deviations.
3. Budget is a plan of operations Budgetary control is the very essence
expressed in monetary terms offinancial control.
4. It is an overall statement in financial Its main objective is to control all aspects
terms of the plan of operations. It of production and selling. The results
includes the sales to be made, the revealed by the budgets if found
expenses to be incurred and the unsatisfactory indicates a need for
income change
to be received during the budget period. in policy itself.
5. Budget should be prepared by the Budgetary control in employed by a
department to which it relates. budget committee or controller.

10.3 ESSENTIALS OF A GOOD BUDGETARY CONTROL SYSTEM

The following are the essentials of good budgetary control system.

1. Management Support: Top management’s support and cooperation is essential

for successful implementation of the budgets. It should take interest in setting the
targets and finalising the budgets. It should also in constantly monitor the actual
performance to find out the deviations, if any and take curative steps. Then the top
management should motivate the personnel and reward the good performers.

2. Determination of Organisational Objectives: The organisational goal should

be quantified and clearly stated. These goals should be set within the framework
of corporate objectives and strategies. A well defined corporate policies and
strategies arepre-requisites to budgeting.

3. Creation of Effective Organisation Structure: There should be a well-planned

organisational structure with clearly defined authority and responsibility of different
levels of management. Role and responsibilities of Budget Committee and its
president must be made known to the people in the organisation.

4. Existence of accurate and reliable accounting system: The organisation should

have good accounting system so as to generate precise, accurate, reliable and
prompt information which is essential for successful implementation of budget
system.
5. Participation of all level of staff: This is the fundamental requirement. If the
Centre for Distance Education 10.5 Acharya Nagarjuna University

budgets are prepared from “the bottom up,” they will in general work as they were
intended to be. The top management must understand and give enthusiastic support
to the system. In fact, it requires education and participation at all levels.

6. Need for flexibility in budgeting: If conditions change from those prevailing at

the time of making the budget, the budget must be recast. If the budget is subject to
annual review, it can deal with several conditions as they may arise. The flexible
budget, also called variable or sliding scale budget, takes both fixed and variable
manufacturing costs into account.

7. Budget period: The usual budget period is the normal financial year, but not
necessary so. In most of the business, operations from month to month are not
uniform. They have seasonal periods during which purpose, quarterly or even
monthly as regards time coverage, budgets can be divided into two types: (a) period
budgets covering a fixed period of time generally one year, and (b) continuous
budgets where monthly or quarterly budgets are continuously extended.

8. Codes and headings: For budgeting, accounting and costing to be meaningful, it is

important that an ideal scheme of classifying codes and headings is adopted. Code
numbers or symbols avoid the use of long and complex account titles. The data
feeding, tabulation and analysis becomes easier with this process of budgeting.

9. Integration of budgets: The various budgets must be integrated so that they reflect
the operating plans for the specified future period. A budgetary control system, to
be successful, must develop this attribute.

10. Control Statements: For implementing the system of budgetary control, it is

necessary that control statements are to be submitted periodically. These serve as
feedb ack reports on whose basis further planning could be made. Reports will be
rendered as necessary – daily, weekly and monthly. Generally the daily reports
will be for the lower levels of management and they will be followed by
summaries at longer intervals – weekly and monthly for the higher levels of
management.

11. Communication of Results: Finally, the communication systems should be

established for management reporting and information service so that information
pertaining to actual performance is presented to the concerned manager timely and
accurately so that remedial action is taken wherever necessary.

10.4 BUDGETARY CONTROL ORGANISATION

The following steps should be considered in detail for sound be considered in detail
for sound budgets and for successful implementation of the budgetary control system.

10.4.1 Organisation for Budgeting

(i) Budget Centre: The organisation must have a clear perspective of the objectives
that are sought to be achieved through budgetary control. After outlining such objectives,
budget centres must be established. A budget centre is a section of an undertaking
Advanced Management Accounting 10.6 Budgets- Budgetary Control

defined for the purpose of budgetary control. A budget centre must be clearly demarcated
to facilitate the formulation of various budgets with the help of the heads of the
departments concerned. For example, the production manager must be consulted for the
preparation of the production budget. The responsibility of each executive must also be
clearly defined.

(ii) Budget Manual: It is a written document or booklet containing standing

instructions regarding the procedures to be followed and the time schedules to be
observed. It is usually maintained in a loose-leaf form so as to facilitate easy alterations
from time to time. The main purpose behind the Budget Manual is to inform line
executives beforehand about the procedures to be followed rather than issuing frequent
instructions from the controller’s office, and thereby avoid friction between line and staff
officials.

The budget manual clearly states the functions of various officials connected with
the formulation of budgets. It sets out steps in the preparation of various budgets including
submission, review, approval and final adoption. It also indicates the time table for budget
operations and the records, reports and forms to be maintained for the purpose.

10.4.2 Responsibility for Budgeting

Budget Controller: The budgetary control organisation is usually headed by a top

executive known as Budget Controller. He should be a man of wide experience and should
posses through knowledge regarding budget matters, since he is expected to command the
respect of all members in the organisation. The budget controller is a staff man providing
advice to management on various important issues (i.e., preparation of budgets, informing
management of the need to revise budgets, collecting information as to how the
budgets could be operated more efficiently etc.), and is answerable to the Chairman of the
companydirectly.

Budget Committees: The Budget Controller may have a budget committee

under him to help in his work. It will have the representatives from various departments
like production, finance, marketing, administration and accounts. The members of the
committee discuss the budget figures thoroughly before coming out with a mutually
agreed programme for the organisation.

10.4.3 Fixation of the Budget Period

Budget Period: It refers to the period of time covered by a budget. The length of
budget period depends on the nature of business, the production period, the control aspect
etc. Industries experiencing a high rate of change generally go for annual budgets (Ex.:
electronics, consumer goods industries), whereas in industries like ship-building, the
period of budget may vary between 5 to 10 years.

10.4.4 Determination of the Key Factors

Budget Key Factor: Key factor is also known as limiting factor or governing
factor. It has been defined as the factor the extent of whose influence must first be
assessed in order to ensure that the functional budgets are reasonably capable of
Centre for Distance Education 10.7 Acharya Nagarjuna University

fulfillment. It proves to be an obstacle in the achievement of the targeted figures

constrained in the functional budgets. Stated otherwise, it is a factor of such importance
that it influences all other budgets so that the coordination must be centered round it. The
following are the examples of key factors:

(a) Materials: Non-availability of supply in terms of quality as well as quantity.

(b) Labour: Shortage of skilled labour; problems of high turnover.
(c) Working Capital: Shortage due to lack of funds, inefficient use of working
capital.
(d) Plant: Constraints of finance, space etc., shortage of plant capacity due to
import restrictions.
(e) Management: Limited availability of expertise, technical and managerial.

10.4.5 Reporting on results

Budget report: Establishing budgets is in itself of no use unless a comparison is

made regularly between actual performance and budgeted performance, and the results
brought to the notice of management through reports. The budget reports should be
prepared in such a way that will reveal the responsibility of a department or an
executive and give full reasons for the variances so that proper corrective action may be
taken.

10.5 ADVANTAGES OF BUDGETARY CONTROL

Budgetary control makes all the difference between drifting in an uncharted sea
and following a well planned course towards predetermined destination. It serves as
invaluable aidto management through planning, coordination and control.

10.5.1 As an Aid in Planning

i. Habit of thinking ahead: Budgetary control forces management to follow the

principle of ‘look before you leap’. It compels management to make an early study
of problems and outline ways of tackling the same.

ii. Pooled Judgement and experience: It reflects the combined efforts of best brains
in the organisation. The combined judgement, experience of executives can be
used to determine the most profitable course of action for future use.

iii. Realistic goals and policies: It gives planning a reality and sense. It helps the
enterprise to clarify the goals and policies to be pursued in operational and realistic
terms.

iv. Planned way to secure economy: This is a planned approach to expenditure and
financing of the business so that economy is achieved in the use of resources. The
resources are used to the best advantage. It directs enterprise activity towards
maximisation of efficiency, productivity and profitability.

v. Reduces uncertainty: Uncertainty is reduced to minimum. It forces executives to

 Advanced Management Accounting 10.8 Budgets- Budgetary Control

map out future courses of action clearly. These are periodically examined,
restated and reformulated in the light of changed circumstances. This helps an
organisation to face future challenges with confidence.

10.5.2 As an aid in Co-ordination:

i. Establishes co-ordination: Budgetary control forces executives to think as a

group. All the departments in an organisation tend to move in a well-coordinated
manner, trying to implement the planned courses of action in a systematic way.
There is very little room for internal friction.

ii. Relates business activity with general economic trend: Budgetary control helps
management to coordinate the activities of the business to the signals of high and
low economic trends. The danger signals in the economy are promptly taken care
of. The entire organisational machinery is kept ready to overcome environmental
and competitive challenges.
10.5.3 As an Aid in Control

i. Indicates weaknesses: It establishes divisional and departmental responsibility. As

a result executives cannot seek shelter behind a mountain of rules and regulations for
their inefficiency. They cannot indullge in buck-passing when budget figures are not
met. By pin-pointing responsibility for inefficient performance, budgeting helps
management trace weak spots early and take remedial steps.

ii. Prevents waste: Budgeting wages a continuous war against wastages of all kinds. It
conducts a searching analysis of all items of expenditure and keeps them under check.
There is a conscious attempt to channel activities through profitable channels.
Capital isput to profitable use.

iii. Facilitates standard costing: The use of performance standards especially in

operational activities and financial matters help the adoption of standard costing
technique.

iv. Management by exception: Budgetary control helps in finding out deviations from
pre- planned courses of action. Management can probe into the causes and
concentrate on important factors causing the trouble.

v. Motivates people: The method of evaluating performance against standards set in

advance, enables employees to find out their strengths and weaknesses It makes them
work for assigned goals show performance and obtain the rewards. In other
words, theyare made to earn their rewards by showing superior performance.

10.6 LIMITATIONS OF BUDGETARY CONTROL

Budgetary control is not always on the credit side of the ledger. It has its own
limitations. These include:

1. Accuracy is open to doubt: Budgetary control begins with formulation of budgets

which are more estimates. The adequacy of budgetary control, therefore, depends
Centre for Distance Education 10.9 Acharya Nagarjuna University

upon the accuracy with which these estimates are made. Budgeting based on
inaccurate forecasts is useless as a yardstick for measuring performance.

2. Constant review needed: Budgeting should be a flexible exercise. When

conditions change, budget estimates loose their usefulness. The effectiveness of a
budget, thus, depends on how the budget revisions are made in the light of changed
circumstances. Usually budget makers do not show much interest in reviewing the
budgets. In that case budget becomes a self-defeating exercise.

3. Cost may be prohibitive: The cost involved in installation and maintenance of the
budgetary control system is somewhat prohibitive. Small concerns may find it to
be a luxury. Again, revising budget becomes a strenuous and demanding job and
smallconcerns may find these revisions too taxing and troublesome.

4. Impersonal approach: Budgetary control does not guarantee success

automatically. There is, however, an erroneous impression that budgeting brings
about success. There is no doubt that budgeting direct enterprise activities along
right routes. But this impersonal approach needs to be supported by proper
administration. Top management must be willing to cooperate and extend its
continued blessings to budget planners and administrators. Sufficient training and
education must be imparted to employees before budgets are translated into
meaningful action. This would not only help in overcoming employee resistance to
changes but also enable the organisation to bring about cost consciousness among
employees.

10.7 SELF ASSESSMENT QUESTIONS

1. What purpose is served by instituting a Budgetary Control System to any organization

having both manufacturing and selling activities? Discuss the main factors to be
considered in framing the Purchase Budget in such an organization.
2. Distinguish between a Forecast and Budget
3. What are the objectives of Budgetary Control?
4. Describe briefly the purpose and uses of a system of budgetary control and explain its
relation to the financial accounts of a company.
5. What additional advantages do you consider likely to follow the adoption of
Budgetary Control by a manufacturing business in which standard costing technique
is already employed?
6. Distinguish between budget and budgeting.
7. State the difference between Budget and Budgetary Control.
8. “Budgets are not merely accounting documents, they are blue prints for managerial
action during a budget period.” Examine this statement.
9 State the essentials of a good budgetary control ystem.
10 State the essentials of a good budgetary control system.
11 What is Budget Centre?
12 What is Budget Manual?
13 What are budget committees?
14 “A budget is an aid to management and not a substitute for management.” Explain.
Advanced Management Accounting 10.10 Budgets- Budgetary Control

15 How does budgetary control serve as a planning and control device? Point out its
limitations and the requisites for successful operation.
16 “For the success of a system of budgetary control it is essential that there should be a
sound organisation for budget preparation, budget maintenance, and budget
administration.” Discuss.
17 What are the essentials of an effective system of budgetary control?
18 What is Zero based Budgeting?
19 What is Performance Budgeting?
20 What is Flexible Budget? Explain
21 Write short notes on the following:
a. Capital Expenditure budget
b. Zero based budget
c. Performance budget
22 Explain the latest developments in the field of budgeting and budgetary control.

10.8 REFERENCE BOOKS

1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting – Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers,
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting –
5. N. Vinayakam, Tools & Techniques of Management Accounting
6. SP Gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V. Krishna Kumar, Management Accounting
9. Dr.Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP. Jain & KL Narang, Advanced Cost and Management Accounting
 LESSON 11
CLASSIFICATION OF BUDGETS

OBJECTIVES

After reading this unit you should be able to

 explain the type of budget in an organization
 know the differences between fixed and flexible budgets
 analyse the current developments in budgeting

STRUCTURE

11.1 Types of Budgets

11.2 Fixed and Flexible Budgets
11.3 Current Developments in Budgeting
11.4 Self Assessment Questions
11,5 Exercises
11.6 Reference Books

11.1 TYPES OF BUDGET

Budgets may be classified on the basis of scope, the capacity or efficiency to

which they are related, the condition on which they are based and the periods they
cover.

Though budgets can be classified according to various points of view, the

following basis of classification are generally followed in practice.

a. Functional classification
b. Classification on the basis of time factor.
c. Classification on the basis of flexibility.

11.1.1 Functional Classification:

A master budget is the summary budget for the entire enterprise and embodies the
summarised figures for various activities. It is the consolidation of all functional budgets.
A functional budget is a budget which relates to any of the functions of an undertaking;
e.g., production, sales, finance etc.

Functional Budgets: The following are the principal functional budgets:

(a) Sales Budget: The sales budget is a forecast of total sales expressed in terms of
money and quantity. In practice, quantitative budget is prepared first, then it is
translated into monetary terms.
Advanced Management Accounting 11.2 Classification of Budgets

(b) Production Budget: It is a forecast of the production for the budget period. It may
be expressed in units or standard hours. A standard hour is the quantity of output or
amount of work which should be performed in one hour. While preparing the
production budget, the production budget, the production executive will take into
account the physical facilities like plant, power, factory space, materials, labour
availability for the period.

(c) Materials Budget: It shows the details of raw materials to be consumed. It is

expressed in terms of physical quantities and values of materials to be issued from
the stores for production purpose. This budget provides that right materials of right
quantity and quality are procured.

(d) Labour Budget: It shows the details of labour requirements in quantity, with
estimated costs. This budget gives detailed information relating to the number of
employees, rates of wages and cost of labour hours to be employed.

(e) Manufacturing Overhead Budget: It shows the estimated costs of indirect

materials, indirect labour and indirect manufacturing expenses during the budget
period to achievethe predetermined targets.

(f) Administration Cost Budget: This comprises the salaries and expenses of
administrative office and management for a specified period. It is prepared with the
help of past experience and expected changes in future.

(g) Selling Expenses Budget: All expenses concerned with sale of products to
customers are included in this budget. It is generally prepared territory-wise by the
sales manager of each territory, on the basis of past records.

(h) Research and Development Budget: This budget lists all the research and
development activities together with their likely costs.

(i) Cash Budget: It is prepared after all the functional budgets are prepared by the
chief accountant either on a monthly or weekly basis. It shows the sum total of the
requirements of cash in respect of various functional budgets and of estimated cash
receipts for a stipulated period.

(j) Capital Expenditure Budget: This budget shows the estimated expenditure on
fixed assets like plant, land, machinery, building etc. It is a long-term budget,
usually set for three to five years. The budget requires frequent revision because of
changes in cost of land, buildings, machinery and equipment. It gives an indication
of the cash requirements. If financial resources are not available with the company,
arrangements have to be made to raise them from outside. The following are the
advantages of capital expenditure budget.

i. It estimates the capital expenditure requirements and accordingly provides or

arranges for it.
ii. The priority of procuring assets can be determined. Those assets which are
very important and unavoidable is given first preference and others are
postponed to a later period.
Centre for Distance Education 11.3 Acharya Nagarjuna University

iii. It serves as a tool of controlling capital expenditure.

Illu.1: From the following information prepare a monthly cash budget for the
threemonths ending 31st December, 2002.

Overheads
Month Sales Materials Wages Production Admn.
Selling
etc.
2002 Rs. Rs. Rs. Rs. Rs.
June 3,000 1,800 650 225 160
July 3,250 2,000 750 225 160
Aug. 3,500 2,400 750 250 175
Sept. 3,750 2,250 750 300 175
Oct. 4,000 2,300 800 300 200
Nov. 4,250 2,500 900 350 200
Dec. 4,500 2,600 1,000 350 225

i. Credit terms are: (a) Sales – 3 months to debtors. 10% of sales are on cash.
On an average, 50% of credit sales are paid on the due dates while the
other 50% are paid in the month following (b) Creditors for material – 2
months.

ii. Lag in payment: Wages ¼ months, overheads – ½ months.

iii. Cash and Bank Balance on 31st October expected Rs.1,500

iv. Other information (a) Plant and Machinery to be installed in August at a

cost of Rs.24,000. It will be paid for by monthly instalments of Rs.5,000
each from 1st October; (b) Preference share dividend @ 5% on Rs.50,000
are to be paid on 1 st December; (c) Calls on 250 equity shares @ Rs.2 per
share expected on 1st November; (d) Dividends from investments
amounting to Rs.250 are expected on 31st December; (e) Income tax
(advance) to be paid in December Rs.500

Solution:
Cash Budget
Period: 3 months ending 31st December, 2002

Details October November December

Rs. Rs. Rs.
Balance b/d 1,500.00 537.50 350.00
Receipts (Estimated)
Sales 3,212.50 3,462.50 3,712.50
Capital - 500.00 -
Dividends - - 250.00
Advanced Management Accounting 11.4 Classification of Budgets

Total (A) 4,712.50 4,500.00 4,312.50

Payments:
Creditors 2,400.00 2,250.00 2,300.00
Wages
787.50 875.00 975.00
Overheads:
Production
300.00 325.00 350.00
Adm., Selling and Distribution
187.50 200.00 212.50
Pref. Dividend - - 2,500.00
Income tax
- - 500.00
Plant and Machinery Rs.500 each 500.00 500.00 500.00
Total (B)
Balance c/d (A-B) 4,175.00 4,150.00 7,337.50
537.50 350.00 (-) 3,025

Calculation of Amount of Sales:

2002 Sale October November December

Month Rs. Rs. Rs. Rs.
June 3,000 1,350.00 - -
July 3,250 1,462.50 1,462.50 -
Aug. 3,500 - 1,575.00 1,575.00
Sep. 3,750 - - 1,687.50
Oct. 4,000 400.00 - -
Nov. 4,250 - 425.00 -
Dec. 4,500 - - 450.00
Total - 3,212.50 3,462.50 3,712.50

Wages Calculation:
¼ Wages of September and ¾ wages of October
Thus (¼ × 750) = 187.50 + (¾ × 800) Rs.600 = Rs.787.50
The wages of other months will be calculated on the same
pattern.
Illu.2: The following are the details regarding the budgeted and actual
production forsix months ending 31st December, 2001.

Unit 40,000 50,000

Budgeted Actual Units
Rs. Rs.
Material consumed 45,000 units 1,35,000 55,000 = 1,90,000
Wages at 3 hours per unit
Rs.1.50 per hour 1,80,000 2,45,000
Variable Overhead at Rs.2 80,000 1,25,000
PUFixed overheads 75,000 1,00,000
Total 4,70,000 6,60,000
 Centre for Distance Education 11.5 Acharya Nagarjuna University

During the budgeted period:

i. Production is expected to go up to 60,000 units
ii. The prices of materials are expected to increase further in the same
manner as they had increased over the budgeted price.
iii. Labour charges are expected to increase by 50 paise per hour above the
actualrate shown above through efficiency is expected to decline by 20%
iv. Fixed overheads are expected to increase by 20%
v. Loss of materials is expected to be uneffected.
vi. Variable overheads are expected to increase by 10%
Prepare a production budget for the six months ending 30th June, 2002

Solution:
Production Cost Budget
Budget - 6 months Actual - 6 months Budget - 6 months
Ending Ending Ending
December 2001 December, 2001 June, 2002
Production 40,000 50,000 60,000
Level
Material 45,000 × 3 1,35,000 45,000 × 3 1,90,000 65,000 × 2,58,570
3.978
Wages 3 hr × 1.50 1,80,000 3 hr × 1.633 2,45,000 3 hr – 36 4,60,728
mts. 2.133
Variable
Overheads 2 × 4,000 80,000 2.5 × 500 1,25,000 2.75 × 1,65,000
60,000
Fixed
Overheads 75,000 1,00,000 1,20,000
4,70,000 6,60,000 10,04,298
Working Notes:
1. Material cost increase is 15% over Budget figures. For six months ending June,2002
an increase of 15% over Rs.3,455 is assumed.
2. Efficiency decrease by 20% leads to 20% more time i.e., 36 minutes. Total time
required i.e. 2,16,000 hours. Per hour rate increases by 50 paise to Rs.2,133.

Illu.3: The sales director of Navabharat Manufacturing Company reports that

next year he expects to sell 54,000 units of a certain product. The production
manager consults his store keeper and casts his figures as follows:

Two kinds of raw materials A and B are required for manufacturing the
product. Each unit of the product required 2 units of A and 3 units of B. The
estimated opening balances at the commencement of the next year are:
Finished product – 10,000 units; A – 12,000 units; B – 15,000 units.
The desirable closing balances at the end of next year are: Finished product –
14,000 units; A – 13,000 units; B – 16,000 units.
Prepare the Materials Budget for the next year.
Advanced Management Accounting 11.6 Classification of Budgets

Solution:
Materials Budget for the year ending……

Finished Raw Materials

Products A B
Units Units Units
Desired Production @ 2 units for
A and 3 units for B 54,000 1,08,000 1,62,000
Add: Opening Balance 10,000 12,000 15,000
64,000 1,20,000 1,77,000
Less: Closing Balance 14,000 13,000 16,000
Estimated Sales 50,000 - -
Materials to be purchased - 1,07,000 1,61,000

11.1.2 Preparation of Master Budget:

The Master budgets combine all functional budgets into one harmonious unit. It is
a summary plan of overall proposed operations developed by management for the
company, covering a specific period. It is a summary budget incorporating its functional
budgets which is finally approved, adopted and employed. This budgeting contains the
details of sales budget, production budget, cash budget etc. When it is complete, the
budget committee will review all the details and if approved, it will be submitted to the
board of directors. Once it is accepted and approved it becomes the target for the company
during a specific period to achieve the desired targeted results.

Illu.4: A Glass Manufacturing Company requires you to calculate and present

the budget for the next year from the following information:

Rs.
Sales:
Product A 3,00,000
Product B 5,00,000
Direct materials Cost 60% of Sales
Direct Wages 20 Workers @
Rs.150 per month
Factory Overheads:
Indirect labour i.e.,
Works Manager Rs.500 per month
Foreman Rs.400 per month
Stores and Spares 2½% on sales
Depreciation on machinery Rs.12,600
Light and Power Rs.5,000
Repairs and Maintenance Rs.8,000
Other Sundries 10% on direct wages
Administration, selling and distribution expenses Rs.14,000 per year
Centre for Distance Education 11.7 Acharya Nagarjuna University

Solution:
Master Budget
Rs. Rs.
A. Sales Budget:
Budgeted Sales:
Product A 3,00,000
Product B 5,00,000
8,00,000
Less: Administrative, selling and distribution expenses 14,000
Net sales value 7,86,000
B. Product Cost Budget 4,80,000
Direct materials 60% of sales 36,000
Direct wages (20 × 150 × 12)
Prime Cost 5,16,000
Factory overhead
Variable : Stores & spares (2 ½ % of sales) 20,000
Light & power 5,000
Repairs & maintenance 8,000 33,000
5,49,000
Fixed : Indirect labour:
Works manager 6,000
Foreman 4,800
Depreciation 12,600
Sundries 3,600 27,000
5,76,000
C. Expected Profit (A-B) 2,10,000

11.1.3 Classification according to time factor:

In terms of time factor, budgets are broadly of the following three types.

1. Long-term Budgets: They are concerned with planning the operations

of a firmover a perspective of five to ten years. They are usually in terms of
physical quantities.

2. Short-term Budgets: They are usually for a period of a year or two and are
in the nature of production plan in monetary terms.

3. Current Budgets: They cover a period of month or so and they will be

adjusted to current conditions or prevailing circumstances.

11.1.4 Budgets based on Flexibility:

On the basis of flexibility budgets may be classified into a) fixed and b) flexible
budgets.
Advanced Management Accounting 11.8 Classification of Budgets

Fixed Budget: Fixed budget is a budget in which targets are rigidly fixed. Such
budgets are usually prepared from one to three months in advance of the fiscal year to
which they are applicable. Thus, twelve months or more may elapse before figures
forecast for the December budget are used to measure actual performance. Many things
may happen during this intervening period and they may make the figures go widely
out of line with the actual figures. Though it is true that a fixed, or static budget as it is
sometimes called, can be revised whenever the necessity arises, it smacks of rigidity
and artificially so far as control over costs and expenses are concerned.

Flexible Budget: Flexible budget or variable budget is one which provides

estimates for different levels of activities. It is a budget which, by recognising the
difference in behaviour between fixed and variable costs in relation to fluctuations in
output or turnover, is designed to change appropriately with such fluctuations. A
flexible budget may, for example, provide estimates for 50%, 60%, 70% and 80%
production capacities. The actual production can be compared with the appropriate
estimate in the budget.

11.2 FLEXIBLE BUDGET

As stated above budget may be established, either as a fixed budget or a flexible
budget. A fixed budget is a budget designed to remain unchanged irrespective of the level
of activity actually attained. It does not change with the change in the level of activity
actually attained and does not conform with the budgeted one. As a result, fixed budgets
can be established only for a small period of time when the actual output is not anticipated
to differ much from the budgeted output. Obviously, fixed budgets have only limited
application and are ineffective as managerial tools.

11.2.1 Need for Flexible Budget

A flexible budget is a budget designed to change in accordance with the level of

activity actually attained. It is also known as variable or sliding scale budget. It is
prepared in such a way as to present the budgeted cost for different levels of activity. It is
more realistic and practical in that the changes expected at various levels of activity are
given due weightage. Flexible Budgeting is desirable in the following cases:

(i) Where sales are not predictable and certain because of the peculiar nature of
thebusiness e.g. business dealing in luxury or semi-luxury goods.
(ii) Where the venture is a new and accurate demand forecasting is a tedious task,
particularly when there is a question of specific customers’ tastes and fashions.
(iii) Where the business is subject to the vagaries of nature such as soft drinks etc.
(iv) Where the production cannot be estimated because of uncertainties as regards
availability of material or labour.

11.2.2 Features of flexible budgets

1. They are prepared for a range of activity instead of a single level.
2. They provide a sound basis for comparison because they are automatically
geared to changes in volume.
3. They provide a ready-made budget for a particular volume.
Centre for Distance Education 11.9 Acharya Nagarjuna University

4. These are based upon adequate knowledge of cost behaviour pattern.

Illu.5: Prepare a flexible budget for the production of 80% and 100% activity
on the basis of the following information.

Production at 50% capacity 5,000 units

Raw Material Rs.80 per unit
Direct Labour Rs.50 per unit
Direct Expenses Rs.15 per unit
Factory Expenses Rs.50,000 (50%) fixed
Administration expenses Rs.60,000 (variable)
Solution:
Flexible budget
Capacity of Output units 50% 80% 100%
5,000 8,000 10,000
Rs. Rs. Rs.
Raw material 4,00,000 6,40,000 8,00,000
Labour 2,50,000 4,00,000 5,00,000
Direct expenses 75,000 1,20,000 1,50,000
Prime Cost 7,25,000 11,60,000 14,50,000
Factory expenses
Variable 25,000 25,000 25,000
50% fixed (50,000) 25,000 40,000 50,000
Factory cost 7,75,000 12,25,000 15,25,000
Administration expenses
Fixed 40% (60,000) 24,000 24,000 24,000
Variable (60%) 36,000 57,600 72,000
Total cost 8,35,000 13,06,600 16,21,000
Illu.6: With the following data at 60% activity prepare a budget at 80% and
100% activity.
Production at 60% capacity, 600 units
Materials Rs.100 per unit
Labour Rs.40 per unit
Expenses Rs.10 per unit
Factory expenses Rs.40,000 (40% fixed)
Administrative expenses RS.30,000 (60% fixed)
Solution:
Flexible budget
Level of Activity 60% 80% 100%
Output (Units) 600 800 1,000
Variable Expenses: Rs. Rs. Rs.
Material 60,000 80,000 1,00,000
Labour 24,000 32,000 40,000
Expenses 6,000 8,000 10,000
Factory expenses 24,000 32,000 40,000
Advanced Management Accounting 11.10 Classification of Budgets

Administrative expenses 12,000 16,000 20,000

Total Variable cost 1,26,000 1,68,000 2,10,000
Fixed Expenses:
Factory expenses 16,000 16,000 16,000
Administrative expenses 18,000 18,000 18,000
Total cost 1,60,000 2,02,000 2,44,000

Illu.7: Prepare a flexible budget at 60%, 80% and 100% capacities from the
following information.

a. Fixed expenses Rs.1,49,500

b. Semi-variable expenses of 50% capacity – Rs.89,500
c. Variable expenses at 50% capacity – Rs.2,67,000

Semi variable expenses remained constant between 40% and 70% capacity,
increase by 10% between 70% and 85% capacity and 15% between 85% and 100%
capacity. Sales at 60% are Rs.5,10,000, at 80% capacity Rs.6,80,000 and at 100%
capacity Rs.8,50,000. Assume that all products are sold.

Solution:
Flexible budget
60% 80% 100%
capacity capacity capacity
Sales (A) 5,10,000 6,80,000 8,50,000
Variable expenses 3,20,400 4,27,200 5,34,000
Semi-variable expenses 89,500 98,450 1,02,925
Fixed expenses 1,49,500 1,49,500 1,49,500
Total expenses (B) 5,59,400 6,75,150 7,86,425
Profit/Loss (-) 49,400 4,850 63,575

Illu.8: The following data are available in a manufacturing company for a

yearlyperiod.
Rs. (lakhs)
Fixed Expenses
Wages and Salaries 9.5
Rent, Rates and taxes 6.6
Depreciation 7.4
Sundry administration expenses 6.5
Semi-variable expenses (at 50% of capacity)
Maintenance and repairs 3.5
Indirect labour 7.9
Sales department salaries 3.8
Sundry administrative expenses 2.8
Variable expenses (at 50% of capacity)
Material 21.7
Labour 20.4
Other expenses 7.9
Centre for Distance Education 11.11 Acharya Nagarjuna University

Assume that the fixed expenses remain constant for all levels of production, semi-
variable expenses remain constant between 45% and 65% of capacity, increased by
10% between 65% and 80% capacity and by 20% between 80% and 100% capacity.
Sales at various levels are:
Rs. (lakhs)
50% capacity 100
60% capacity 120
75% capacity 150
90% capacity 180
100% capacity 200

Prepare a flexible budget for the year and forecast the profit at 60%, 75%,
90% and100% of capacity.
Solution:
Flexible Budget
50% 60% 75% 90% 100%
Rs Rs. Rs. Rs. Rs.
(Lakhs) (Lakhs) (Lakhs) (Lakhs) (Lakhs)
(A) Sales 120 150 180 200
100
Variable expenses
Material 21.70 26.04 32.55 39.06 43.40
Labour 20.40 24.48 30.60 36.72 40.80
Other expenses 7.90 9.48 11.85 14.22 15.80
Semi-variable expenses:
Maintenance and
Repairs 3.50 3.50 3.85 4.20 4.20
Indirect labour
7.90 7.90 8.69 9.48 9.48
Sales dept. salaries
3.80 3.80 4.18 4.56 4.56
Sundry administrative
Expenses
Fixed Expenses: 2.80 2.80 3.08 3.36 3.36
Wages and salaries
Rent rate and taxes 9.50 9.50 9.50 9.50 9.50
Depreciation 6.60 6.60 6.60 6.60 6.60
Sundry 7.40 7.40 7.40 7.40 7.40
administrativeExpenses
(B) Total cost 6.50 6.50 6.50 6.50 6.50
Profit (A-B) 98.00 108.00 124.80 141.60 151.60
2.00 12.00 25.20 38.40 48.40
Illu.9: A factory is currently working to 50% capacity and produces 10,000
units. Estimate the profits of the company when it works to 60% and 80% capacity
and offeryour critical comments. At 60% working material cost increases by 2% and
selling price falls by 2%. At 80% raw material cost increases by 5% and selling price
falls by 5%.

At 50% capacity working the product costs Rs.180 per unit and is sold at
Rs.200 perunit. The unit cost is Rs.180 is made up as follows:
Advanced Management Accounting 11.12 Classification of Budgets

Rs.
Material 100
Labour 30
Factory overhead 30 (40%
fixed)

Solution:
Flexible Budget
50% 60% 80%
10,000 Units 12,000 Units 16,000 Units
Per Amount Per Unit Amount Per Unit Amount
Unit
Rs. Rs. Rs. Rs. Rs. Rs.
Material 100 10,00,000 102 12,24,000 105 16,80,000
Labour 30 3,00,000 30 3,60,000 30 4,80,000
Factory overheads
Fixed 12 1,20,000 10 1,20,000 7.50 1,20,000
Variable 18 1,80,000 18 2,16,000 18 2,88,000
Administrative
overheads
Fixed 10 1,00,000 8.33 1,00,000 6.25 1,00,000
Variable 10 1,00,000 10 1,20,000 10 1,60,000
Total cost 180 18,00,000 178.33 21,40,000 176.75 28,28,000
Sales 200 20,00,000 196.00 23,52,000 190.00 30,40,000
Profit 20 2,00,000 17.67 2,12,000 13.25 2,12,000

11.3 CURRENT DEVELOPMENTS IN BUDGETING

11.3.1 Zero Based Budgeting (ZBB):

Zero Based Budgeting is a relatively new approach to budgeting. This is increasingly

employed in the budget preparation of such items as the administrative costs, special
programmes, and other clearly identifiable projects. The key element in ZBB is future
objective orientation of past objectives Instead of taking the last year’s budget and the
adjusting them for finding out the future level of activity and preparation of budgets
there from. ZBB forces managers to review the current, ongoing objectives and operations.

ZBB is, therefore, a type of budget that requires managers to rejustify the past
objectives, projects, and budgets and to set priorities for the future. The essential idea of
ZBB that differentiates from traditional budgeting is that it requires managers to justify
their budget request in detail from scratch without any reference to the level of previous

appropriations. It tantamount to recalculations of all organisational activities to see which

should be eliminated founded at reduced level, founded at the current level of increased
finances must be provided.
Centre for Distance Education 11.13 Acharya Nagarjuna University

11.3.2 Performance Budgeting:

The basic aim of performance budgeting (also known as programme budgeting) is

to focus attention on the work to be carried out, services to be rendered rather than
things to be spent for or acquired. It concentrates attention on physical aspects of
achievement. Here, there is not only a financial plan but also a work plan in terms of
work done. It takes a systems view of activities by trying to associate the inputs of the
expenditure with the output of accomplishment in terms of services, benefits etc.

11.3.3 Responsibility Accounting:

It is method of accounting in which costs are identified with persons assigned to

their control rather than with products of functions. In this system devision of units of
an organisation under specified authority of a person are developed as a responsibility
centre and evaluated individually for their performance.

11.4 SELF ASSESSMENT QUESTIONS

1. What do you consider to be the purposes and special features of a flexible budget?
2. “A budget is an aid to management and not a substitute for management.” Explain.
3. How does budgetary control serve as a planning and control device? Point out its
limitations and the requisites for successful operation.
4. “For the success of a system of budgetary control it is essential that there should
be a sound organisation for budget preparation, budget maintenance, and budget
administration.” Discuss.
5. What is Zero based Budgeting?
6. What is Performance Budgeting?
7. What is Flexible Budget? Explain
8. Write short notes on the following:
a. Capital Expenditure budget
b. Zero based budget
c. Performance budget
9. Explain the latest developments in the field of budgeting and budgetary control.

11.5 EXERCISES

1. A company manufacturers two products A and B. The sales manager forecasts the
sales in units as follows:

Jan. Feb. March April May June July

Product A 28 28 24 20 16 16 18
Product B 10 12 16 20 24 24 20

It is assumed that there will be no work-in-progress at the end of any month and
finished units equal to half the sales for the following month will be kept in stock.
Prepare a production budget for each month.
[Ans.: Jan. 1,100; Feb. 1,400; Mar. 1,800; April 2,200; May 2,400; June 2,200]
Advanced Management Accounting 11.14 Classification of Budgets

2. The sales director of a manufacturing company reports that next year he expects to
sell 54,000 units of a certain product. Production manager consults his store keeper
and castshis figures as follows:

Two kinds of raw materials A and B are required for manufacturing of the
product. Each unit of the product required 2 units of A and 3 units of B. The
estimated opening balances at the commencement of the next year are:

Finished Product – 10,000 units; A – 12,000 units; B –

15,000 units. The desirable closing balances at the end of the
next year are: Finished Product – 14,000 units; A – 13,000
units; B – 16,000 units. Prepare the material budget for the
next year.
[Ans.: Materials to be purchased A – 1,17,000 units; B – 1,75,000 units]

3. You are required to prepare a selling overhead budget from the estimates given
below:
Rs.
Advertisement 1,000
Salaries of the Sales Department 1,000
Expenses of the Sales Department (fixed) 750
Salesmen’s Remuneration:
Salaries and Dearness Allowance 3,000
Commission @ 1% on sales affected
Carriage outwards: Estimated @ 5% on sales
Agent’s commission: 6¼ % on sales
The sales during the period were estimated as follows:
Rs.80,000 including Agent’s sales Rs.8,000
Rs.90,000 including Agent’s sales Rs.10,000
Rs.1,00,000 including Agent’s Sales Rs.10,000
[Ans.: Rs.7,450; Rs.7,775; Rs.7,875]

4. From the following information, prepare cash budget for the month of January to April.

Expected Sales Expected Purchase

Rs. Rs.
January 60,000 January 48,000
February 40,000 February 80,000
March 45,000 March 81,000
April April
40,000 90,000

Wages to be paid to workers Rs.5,000 each month. Balance at bank

on 1stJanuary Rs.8,000. It has been decided by the Management that:
i. In case of deficit fund within the limit of Rs.10,000 arrangements can be made with
bank.
ii. In case of deficit fund exceeding Rs.10,000 but within the limits of Rs.42,000 issue
of debentures is to be preferred.
Centre for Distance Education 11.15 Acharya Nagarjuna University

iii. In case of deficit fund exceeding Rs.42,000, issue of shares is preferred (considering
thefact that it is within the limit of authorised capital)
[Ans.: Cash Closing Balance : January Rs.15,000; February – Nil; March
– Nil; April – Nil]

Comment: It is presumed that Shares/Debentures are issued by the company

precisely to meet the deficit arising in each month.

5. Prepare Cash budget of a company for April, May, June 2002 in a columnar form
usingthe following information.

Month Sales Purchases Wages Exp

Rs. Rs. Rs. .
Rs.
January (Actual) 80,000 45,000 20,000 5,000
February (Actual) 80,000 40,000 18,000 6,000
March (Actual) 75,000 42,000 22,000 6,000
April Budget 90,000 50,000 24,000 6,000
May Budget 85,000 45,000 20,000 6,000
June Budget 80,000 35,000 18,000 5,000

You are further informed that:

a. 10% of purchase and 20% of Sales are for cash.
b. The average collection period of the Company is ½ month and credit
purchases are paid off regularly after one month.
c. Wages are paid half monthly and the rent of Rs.500 excluded in expense
is paid monthly.
d. Cash and Bank balance on April 1, was Rs.15,000 and the company wants
to keep it on end of every month below this figure, the excess cash being put in
fixed deposits.
[Ans.: Cash Closing Balance: April Rs.21,700; May Rs.12,700; June
Rs.13,200]

6. The Delta Ltd., manufacturers two brands of pen one sold under the name of
‘Bright’ and one under the name of ‘Hans’. The sales department of the company has
three departments in different areas of country.

The sales budgets for the year ending 31st December, 2002 were:

Bright – Department I – 3,00,000; Department II – 5,62,500; Department III – 1,80,000;

and
Hans – Department I – 4,00,000; Department II – 6,00,000; and Department III – 20,000.
Sales prices are Rs.3 and Rs.1.20 for Bright and Hans respectively, in all departments.

It is estimated that by forced sales promotion the sale of ‘Hans’ in Department I will
increase by 1,75,000. It is also expected that by increasing Production and arranging
extensive advertisement. Department III will be enable to increase the sale of ‘Hans’ to
50,000.
It is recognised that the estimated sales by Department II represent an unsatisfactory
Advanced Management Accounting 11.16 Classification of Budgets

target. It is agreed to increase both estimates by 20%.

Prepare a Sales Budget for the year to 31st December, 2002.

[Ans.: Quantity : Bright 11,55,000; Hans 13,65,000; Amount : Bright Rs.34,65,000;
Hans Rs.16,38,000]

7. The following information has been made available from the accounting records of
payment of Precision Tools Ltd., for the last six months of 2001 (and of only sales for
January, 2002)in respect of fishplates X produced by it.

i. The units to be sold in different months are:

July 2,200 November 5,000
August 2,200 December 4,600
September 3,400 January, 2002 4,000
October 3,800
ii. There will be no work-in-progress at the end of any month.
iii. Finished units equal of half the sales for the next month will be in stock
at the endof every month (including June, 2001)
iv. Budgeted production and production costs for the year ending
December, 2001are as thus:
Production 44,000
Direct materials per unit Rs.10.00
Direct wages per unit Rs.4.00
Total factory overheads apportioned to Rs.88,000
product

It is required to prepare: Production budget for the last six months of 2001; and
a. Production cost budget for the same period.

[Ans.: Production required total for 6 months 22,100 units; Product cost
budget total for 6 months Rs.3,53,600; Factory Overhead per unit Rs.2]

8. Binaka Ltd., have prepared the budget for the production of a lakh units of the
only commodity manufactured by them for a costing period as under:
Rs.
Raw material 2.52 per unit
Direct labour 0.75 per unit
Direct xpenses 0.10 per unit
Works overhead (60% fixed) 2.50 per unit
Administration overheads (80%fixed) 0.40 per unit
Selling overheads (50% fixed) 0.20 per unit
The actual production during the period was only 60,000 units. Calculate the revised
budgeted cost per unit.
[Ans.: Cost per unit Rs.7.75]
Centre for Distance Education 11.17 Acharya Nagarjuna University

9. The expenses budgeted for production of 10,000 units in a factory are furnished below:

Per unit
Rs.
Materials 70
Labour 25
Variable overheads 20
Fixed overheads (Rs.1,00,000) 10
Variable expenses (Direct) 5
Selling expenses (10% fixed) 13
Distribution expenses (20% fixed) 7
Administrative expenses (Rs.50,000) 5
Total cost of sales per unit (to make and sell) 155

Prepare a Budget for production of (a) 8,000 units and (b) 6,000 units. Assume that
administration expenses are rigid for all levels of production.

[Ans.: Total cost at 10,000 units Rs.15,50,000; at 8,000 units Rs.12,75,400; at

6,000 units Rs.10,00,800]
10. A factory is currently working to 50% capacity and the product cost is Rs.180 per
unit as follows:

Material Rs.100
Labour Rs.30
Factory overhead Rs.30 (40% fixed)
Administration overhead Rs.20 (50% fixed)

The product is sold at Rs.200 per unit and the factory produces 10,000 units at 50%
capacity.

You are required to estimate profit if the factory works at capacity of 60%. At the
working level of 60% the raw cost increases by 20% and the selling price falls by 20%.

[Ans.: At 60% Total Cost: Rs.23,56,000; per unit Rs.196.33; Loss Rs.4,36,000; per
unit Rs.(-) 36.33; Sales Rs.19,20,000; per unit Rs.160]

11. The monthly budget for a producing unit for two levels were as follows:

Capacity 60% 100%

Units 300 500
Indirect wages 600 1,000
Consumable Stores 450 750
Depreciation 2,000 2,000
Insurance 1,000 1,000
Maintenance 800 1,000
Power and Fuel 1,450 1,750
Advanced Management Accounting 11.18 Classification of Budgets

Prepare a budget of 80% activity segragating fixed and variable cost in total and per
unit. At80% activity indirect wages will rise by 5%.

[Ans.: At 60%: Total Cost Rs.6,300; per unit Rs.21; At 80%: Total Cost
Rs.6,940;per unit Rs.17.35; At 100%: Total Cost Rs.7,500; per unit Rs.15]

11.6 REFERENCE BOOKS

1. R.S.N. Pillai, & Bagavathi, Management Accounting, S. Chand & Company Ltd.,
New Delhi
2. M.A. Sahaf, Management Accounting – Principles & Practice, Vikas Publishing
House Pvt. Ltd., New Delhi.
3. Shashi K. Gupta & R.K. Sharma, Management Accounting, Kalyani Publishers
4. Charles thorn Gaxy Sundem, Introduction to Management Accounting
5. N. Vinayakam, Tools & techniques of Management Accounting
6. SP gupta, Management Accounting
7. Manmohan & Goyal, Management Accounting
8. V. Krishna Kumar, Management Accounting
9. Dr. Kulsreshtha and Gupta, Practical Problems in Management Accounting
10. SP Jain & KL Narang. Advanced Cost and Management Accounting
 (401CO21)
Model Question Paper
M.Com. (Accountancy).
Semester –1V
Paper 1 - Advanced Management Accounting

Time : Three hours Maximum : 70 marks

SECTION A — (4 × 5 = 20 marks)
Answer any FOUR of the following.

1. (a) Concept of Management Accounting

(b) Cost Control
(c) Uses of Activity Based Costing
(d) Differentiate between product cost and period cost
(e) What is Cash break-even point
(f) Pricing decisions
(g) Meaning and essential features of a budget
(h) Zero Based Budgeting

SECTION B — (5 × 10 = 50 marks)
Answer the following questions.

2. (a) Explain briefly the tools and techniques of Management Accounting?

Or
(b) From the following information find out the amount of profit earned
during the year using marginal cost technique.
Fixed cost Rs.5,00,000
Variable cost Rs.10 per unit
Selling price Rs.15 per unit
Output level 1,50,000 units.

3. (a) Briefly explain the concept of Cost Reduction & Control.

Or
(b) A manufacturer has supplied the following information relating to one of
his product.
Total variable costs Rs.30,000 Total sales Rs.60,000
Units sold 20,000 Total Fixed Costs Rs.18,000
Calculate: a. Contribution per unit b. Break-even point
c. Margin of Safety d. Profit
e. Volume of sales to earn a profit of Rs.24,000

4. (a) Discuss the steps in applying Activity Based Costing?

Or
(b) Hindustan Engineering Company is working well below normal capacity
due to recession. The directors of the company have been approached
with an enquiry for special job.
The costing department estimated the following in respect of the job.
 Direct materials : Rs.10,000
Direct labour : 500 Hours @ Rs.2 per hour.
Overhead costs : Normal recovery rates.
Variable - Rs. 0.50 per hour
Fixed - Rs.1.00 per hour.
The directors ask you to advise them on the minimum price to be charged.
Assume that there are no production difficulties regarding the job.

5. (a) explain the Pricing of Services.

Or
(b) The monthly budget for a producing unit for two levels were as follows:

Prepare a budget of 80% activity segregating fixed and variable cost in total and per
unit. At 80% activity indirect wages will rise by 5%.

6. (a) Briefly write about types of Budgets.

Or
(b) You are required to prepare a selling overhead budget from the estimates
given below:

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