UNIT 15: RELEVANT COSTS FOR

DECISION MAKING
Structure
15.0 Objectives
15.1 Introduction
15.2 Relevant Costs for Decision Making
15.2.1 Concept of Relevant Costs
15.2.2 Concept of Differential Costs
15.2.2 Decision-Making Process
15.2.3 Selling Price Decisions
15.2.4 Exploring New Markets
15.2.5 Make or Buy Decisions
15.2.6 Expand and Contract
15.2.7 Sales Mix Decisions
15.2.8 Alternative Methods of Production
15.2.9 Plant Shut Down Decisions
15.2.10 Acceptance of Special Order
15.2.11 Adding or Dropping a Product Line
15.2.12 Replacement of Machinery
15.2 Let Us Sum Up
15.3 Key Words
15.4 Answers to Check Your Progress
15.5 Terminal Questions

15.1 OBJECTIVES
After studying this unit, you should be able to:
●● distinguish between the different types of costs;
●● distinguish between the nature of costs;
●● present different alternatives before the decision making; and
●● selection out of different alternatives.

15.1 INTRODUCTION
The analysis of costs plays a vital role in selecting the alternatives available
before the management. Costs could shape alternative opportunities and
therefore, it influences and shapes future profits. Management is not only
interested in the historical cost analysis but it is also interested to study
those costs, which are influencing the future operations. After analyzing
different types of costs according to their nature, one can be able to select
one out of the various optimal alternatives. When costs are future oriented
then only they remain important for the decision maker. In this unit you will
study the importance of relevant costs for decision making.
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Decision Making
15.2 RELEVANT COSTS FOR DECISION
MAKING
With different objectives the different costs concept is always there. It is
pertinent to use the word relevant while providing the information about
costs. When the costs are not changing with the different alternatives and
remain fixed in nature then they become irrelevant or sunk costs. When
management wants to select any of the alternatives available before them
and take decision then the relevant costs become very important.
15.2.1 Concept of Relevant Costs
Relevant cost is a cost of decision. You may call it decision cost, as it is
always relevant with the selection of one out of different alternatives. If
decision is being taken and any cost is increased because of the change in
decision, that particular cost becomes relevant cost. Relevant cost is always
for future and not for the analysis of the past decisions. These costs are
‘Future Costs’ and they differ to different alternatives. We focus on the
future whether it may be 10 seconds after or it may be 10 years later.
Relevant costs are also known as differential costs. Relevant costs differ
among the different alternatives. For example, if an engineering graduate
wants to start his own work shop and he has a choice to complete his
post–graduation. Relevant costs to continue his studies are fees and books.
Irrelevant costs are clothes and his residential arrangements, which will
incur under both the circumstances.
15.2.2 Concept of Differential Costs
Differential cost is the difference between the costs of alternatives. Difference
in total cost between the two alternatives available. It is also known as net
relevant cost. Differential cost is not calculated per unit. It is calculated
as total cost and then the difference is being calculated between the two
levels of production or is being calculated between the two alternatives.
Both variable costs and fixed costs may be differential cost when there is
a change in both these costs in response to alternative course of action.
When a decision does not affect either the variable or fixed costs then there
is no differential costs. It is a technique of costing and not a method. Only
relevant costs of the option are being considered. It is normally calculated
on sales basis, which gives revenue. Decision cannot be taken only on the
basis of differential cost analysis as other factors like government policies,
social and financial causes, investment and the behaviour of the workers
are also the influential part of the decision-making process. Conditions and
costs of different alternatives always differ, so the differential costs once
calculated cannot be used without adjustments for the other decisions. As
differential costs are relevant costs for future, so irrelevant costs should be
known. The costs which do not change as a result of decision are irrelevant
costs. Fixed costs are irrelevant costs as they do not change if production is
expanded upto certain level.

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15.2.3 Decision-Making Process Relevant Costs for Decision
Making
Decision-making is a process of selecting any of the alternatives available
after evaluation of all the options. Selection of one alternative out of two or
more should maximize the profits of the concern. Decision-making is very
much related with future planning with a particular goal. In this process,
available information regarding the options should be analyzed properly
to make a beneficial decision for the benefit of the organization. Before
taking decision firstly one should recognise the problem, secondly identify
the various alternatives, thirdly evaluate different alternatives with helps of
cost benefit analysis and finally adopt the most profitable course of action.
Differential cost analysis is a very useful technique to the management in
formulating policies and making the following decisions:
1) Selling Price Decisions
2) Exploring New Markets
3) Make or Buy Decisions
4) Expand and Contract
5) Sales Mix Decisions
6) Alternative Methods of Production
7) Plant Shut Down Decisions
8) Acceptance of Special Order
9) Adding or Dropping a Product Line
10. Replacement of Machinery
Let us study each one of these in detail.
15.2.4 Selling Price Decisions
Pricing process is different in different industries. It differs according to
the nature, cost and demand of the product. Every producer accepts the
different criterion for pricing his product. Effect of changes in selling price
can easily be understood with the help of the following illustration.
Illustration 1
X Ltd. produces and markets ballpoint pens. Due to competition, the
company proposes to reduce the selling price. From the following
information, examine the effects of reduction in selling price by (a) 5%, (b)
10% and (c) 15%
Rs. Rs.
Present Sales 3,000 units — 3,00,000
Variable Costs 1,80,000
Fixed Costs 70,000 2,50,000
Net Profit 50,000
Indicate the number of units to be sold if the company wants to maintain the
same profits in each of the above cases.

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Decision Making Solution
Statement of Cost and Profit
Particulars Present Price Price Price
price Reduction Reduction Reduction
by 5% by 10% by 15%

Selling price per unit (Rs.) 100 95 90 85

Less: Variable cost (Rs.) 60 60 60 60
Contribution (Rs.) 40 35 30 25
Contribution for 3,000 units (Rs.) 1,20,000 — — —
Contribution required to maintain — 1,20,000 1,20,000 1,20,000
same profit (Rs.)
Required units to be sold — 3,429 4,000 4,800
Less: Units sold at present price — 3,000 3,000 3,000
Additional Units required to be
sold to earn the same amount of — 429 1,000 1,800
Profit
Decision: If company reduces the selling price by 5% then it requires 429
pens more to sell to earn the same amount of profit. If it accepts the second
option to reduce the price by 10% then it requires 1,000 pens more to sell to
earn the same amount, and if it accepts the third alternate to reduce the price
by 15% then it require 1,800 pens more to sell to earn the same amount.
Working Notes:
1) It has been assumed that in all the options, fixed costs remain
unchanged and to earn the same amount of profit the contribution
should remain the same.
2) Calculation of Required Units to be sold to earn the same amount has
been mentioned with the use of the following formulae:
Required Contribution Rs. 1,20,000
Required Sales = =
Contribution Per Unit Rs. 35
= 3,249 units required to be sold if selling price is being
reduced by 5%
15.2.5 Exploring New Markets
Decisions regarding new market can be taken if the home market is not
affected. If we sell the commodity to the foreign market at lower price and
they re-export to our existing customers at lesser price what we charge to
our customers, then there cannot be a decision in favour of new market
even if profit or contribution is increased. It is advisable only when other
things being remain same in the home or present market. To make use of
the existing capacity, export and new market is the best alternate. With the
following illustration, one can understand about the new market decision.
Illustration 2
X Ltd. manufactures 1,000 units p.a. at a cost of Rs. 40 per unit and there is
a demand of the whole production at a price of Rs. 42.5 per unit in the home
market. There is a fall in the demand in the home market in the year 2003

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and the whole production can be sold in the home market at a selling price Relevant Costs for Decision
of Rs. 37.2 per unit. The cost analysis for 1,000 units is as follows: Making

Rs.
Materials 15,000
Wages 11,000
Variable Expenses 6,000
Fixed Expenses 10,000
2,000 Units can be sold in the foreign market at a explored price of Rs. 35.5
per unit. It is also estimated that for additional 1,000 units of the product the
fixed cost will increase by 10%. Advise the management.
Solution
Statement showing the Effects of Selling Goods in the Foreign Market
Rs. Year 2002 Year 2003
Home Home Foreign Total
market market market 3,000
1,000 units 1,000 units 2,000 units units
Rs. Rs. Rs. Rs.
Materials 15,000 15,000 30,000 45,000
Wages 11,000 11,000 22,000 33,000
Variable expenses 6,000 6,000 12,000 18,000
Marginal cost 32,000 32,000 64,000 96,000
Sales 42,500 37,200 71,000 1,08,200
Contribution
(Sales – Marginal Cost) 10,500 5,200 7,000 12,200
Less : Fixed cost 10,000 10,000 2,000 12,000
Profit / (Loss) 500 (4,800) Loss 5,000 200
It is advisable to accept the proposal for sale in the foreign market as it
converts loss of Rs. 4,800 of home market into a net profit of Rs. 200.
15.2.6 Make or Buy Decisions
Decisions about, whether a manufacturer of goods or services should
produce goods or services within the factory or purchase them from the
market. This type of decision is needed when the concern organization is
producing the item, which is also available in the market at cheaper rate.
If, purchased from the open market, retrenchment of workers becomes
inevitable or may not be able to reduce the fixed costs of the factory. During
the processing of the alternatives available other than cost factor should
also be considered. Some of these are quality of the product available in
the market, regularity of the supply, expected fluctuations in the demand
and reliability of the supplier. The processing and designing of the item of
a product should be kept as a secret, then this cannot be purchased from the
market and it should be produced at the floor of the factory. The following
example makes this concept easy to understand:
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Decision Making Illustration 3
With the help of the following data, a manufacturer seeks your advice
whether to buy an item from the market or to produce it at the floor of the
factory:

Particulars Present Proposed

(Buy) (Make)
Rs. Rs.
Sales 16,00,000 16,00,000
Costs: Variable 11,20,000 10,24,000
   Fixed 3,60,000 4,00,000
Capital required 8,00,000 9,00,000
Advise the management.
Solution
Statement of Cost and Profitability

Particulars Buy Make

Rs. Rs.
Sales ( S ) 16,00,000 16,00,000
Less : Variable Costs 11,20,000 10,24,000
Contribution ( C ) 4,80,000 5,76,000
Less : Fixed Costs 3,60,000 4,00,000
Profit ( P ) 1,20,000 1,76,000
P/V Ratio (C/ S multiplied by 100) 30% 36%
Percentage of profit on sales (P/S multiplied 7.5% 11%
by 100)
Return on capital employed (P/Capital multiplied 15% 19.6%
by 100)
Decision: By describing the above statement making of the item at the floor
is better than to buy.
Working Note: Total costs would be reduced by Rs. 56,000 and by the
same amount the profit would also increase. P/V Ratio and profit on sale
increase by 6 % and 3.5% respectively. Return on capital employed will
also increase by 4.6 %.
15.2.7 Expand and Contract
In any factory, if there is scope of expansion and there is a possibility to
purchase the same item on contract basis from the market then we would
look at the total cost of both the alternate. It can be understood easily with
the following example:

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Illustration 4 Relevant Costs for Decision
Making
X Ltd. has two factories – A and B. A is running at 70% of installed capacity
(Installed capacity is 12,000 units) and B Factory supplies its requirements
by working at 80% of its installed capacity. The cost structure of the B
factory is given below:
Materials Rs. 16,800
Labour Rs. 6,000
Apportioned Fixed Overheads Rs. 7,500
Variable Overheads Rs. 4,200
Total Rs. 34,500
The production of A factory is to be increased to 80% capacity. The
component produced in B factory can be purchased from the market at Rs.
4.00 per unit. As the cost of B factory exceeds Rs. 4 per unit, it is proposed
to obtain the additional requirement from the market instead of getting it
from B factory. Advise the management.
Solution
A factory can produce 12,000 units at 100% capacity and is working at
70% capacity means it is producing 8,400 units. B factory is working at
80% capacity to fulfill the needs of A factory. B factory when working at
100% capacity can produce 84,000 / 80% = 10,500 units, so if A factory
is working at 100% capacity B factory cannot fulfill the requirement of A
factory. If A factory is working at 80% capacity that is 9,600 units (80%of
12,000). B factory will be required to produce 1,200 units more (9,600 –
8,400). For this analysis, the following statement is required:
Statement showing costs of buying and manufacturing for 1200 units
Cost of Cost of
Component Manufacturing Buying
1,200 units 1,200 units
Rs. Rs.
Material (16,800 / 8,400) 1,200 2,400 —
Labour (1,200 multiplied by 0.50) 600 —
Variable overhead (4,200 / 8,400) 1,200 600 —
Costs of buying @ Rs. 4.00 per unit — 4,800
Total Costs (Rs.) 3600 4,800
Decision: B factory will continue supply to A factory as manufacturing
cost of Rs. 1,200 (Rs. 4800 - Rs. 3600) less than the cost of buying. So it is
advisable to expand B factory. It is presumed that fixed cost will not change
after the expansion.
15.2.8 Sales Mix Decisions
The relative contribution of quantities of products or services constitutes
total revenues. It becomes difficult to analyze the profitability of the product
when more than one product is produced. To establish most profitable sales
mix it becomes necessary to get the most profitable sales mix by considering
all the alternatives. Look at following example.
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Decision Making Illustration 5
X Ltd. produces and sells four products A, B, C and D. The analysis of
income from each product has been shown in the following statement.
Which of these product lines would you like to continue and which would
you like to drop?
Income
Statement
Particulars Products Total Rs.
A B C D
Rs. Rs. Rs. Rs.
Sales 6,80,000 29,20,000 8,00,000 6,00,000 50,00,000
Less Variable Cost Gross 4,00,000 5,70,000 5,50,000 5,80,000 21,00,000
Contribution 2,80,000 23,50,000 2,50,000 20,000 29,00,000
Less :
50,000 7,00,000 70,000 20,000 8,40,000
Variable Selling Costs:
Salesmen 40,000 7,00,000 60,000 10,000 8,10,000
Warehouse Packing 30,000 2,00,000 50,000 2,000 2,82,000
Delivery 30,000 3,00,000 40,000 8,000 3,78,000
Total Variable Selling 1,50,000 19,00,000 2,20,000 40,000 23,10,000
Costs:
Net Contribution 1,30,000 4,50,000 30,000 - 20,000 5,90,000
Less: Fixed Selling Cost — — — — 1,10,000
Contribution for Fixed
Administrative Cost &
4,80,000
Profit
Less: Fixed
Administration Costs 1,88,000
Net Profit 2,92,000
Solution:
By looking at the above statement it is concluded that selling price of the
product D is not able to recover its variable costs even, so, the production of
product D should be stopped immediately. It shows the loss of Rs. 20,000
in net contribution.
Gross contribution of product Y is also not satisfactory so management can
reconsider about the use of resources engaged in the production of Y.
15.2.9 Alternative Methods of Production
The decision to be taken is of the nature of selecting one machine out
of one or more available in the market for production or to purchase the
ready goods for further processing from the market. In these cases, cost is
considered and the decision is taken in favour of the lowest cost occurring
sector. Look at illustration 6 and see how a decision will be taken out of
alternative methods of production.
Illustration 6
X Ltd. has to install a machine for the production of a part of a new product
to be launched by them. Two machines B and C are being considered. Their
details are given below:
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 Relevant Costs for Decision
Details Machine B Machine C
Making
Cost in Rs. 2,00,000 4,40,000
Annual Capacity in units 4,000 10,000
Life in Years 10 10
Salvage value in Rs. Nil 40,000
Material per unit in Rs. 30.00 30.00
Production cost per unit (other than depreciation) 45.00 45.00
Apportioned overheads 2,000 2,000

Interest is @ 10% per annum. The part is available in the market @ Rs.
90 per unit and can be sold at a net price of Rs. 85 per unit. The company
requires 6,000 units per annum. Advise the management.
Solution:
Statement of cost of Depreciation and Interest per annum
Particulars Cost of Machine Cost of
B Machine C
Rs. Rs.
Initial Investment needed 2,00,000 4,40,000
Less Salvage Value Nil 40,000
Net Value of Machine to be depreciated 2,00,000 4,00,000
Depreciation p.a. for 10 years 20,000 40,000
Interest on initial investment @10% p.a. 20,000 44,000

Statement showing Comparative Costs in Different Alternatives

Particulars Cost, if Cost of Cost of
purchased Machine B Machine C
Rs. Rs. Rs.
Units purchased 6,000 2,000 —
Units produced — 4,000 10,000
Surplus units to be sold in the open
market — — 4,000

Annual requirement (units) 6,000 6,000 6,000

Rs. Rs. Rs.

Cost of material @ Rs. 30 per unit — 1,20,000 3,00,000
Production cost @ Rs. 45 per unit — 1,80,000 4,50,000
Cost of Depreciation p.a. — 20,000 40,000
Cost of interest @ 10% per annum — 20,000 44,000

Total Cost of production Add : 3,40,000 8,34,000

Cost of purchases @ Rs. 90 per unit 5,40,000 1,80,000 —
Less : Sale proceeds of surplus — 3,40,000
production @ Rs. 85 per unit
Net Cost of 6,000 units Rs. 5,40,000 Rs. 5,20,000 Rs. 4,94,000
Decision: In all the above three alternatives the last alternate that is to
purchase machine C is the cheapest and so company should purchase in the
machine C and install it.
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Decision Making 15.2.10 Plant Shut Down Decisions
This type of decision is being taken when the nature of business is seasonal,
cut-throat competition and other un-favourable conditions of the market are
there. While taking the decision of ‘Shut Down’ of the going concern the
behaviour of costs should be considered.
When one shuts down his plant, there are some avoidable, traceable or
escapable fixed costs such as salaries of temporary workers and salary of
sales man, which can be stopped by this decision. Some unavoidable or un-
escapable cost are : depreciation on fixed assets, rent of office and factory,
insurance, interest and salaries of permanent staff. These can not be stopped
by shutting down the plant temporarily.
Some additional cost of Shut Down or Reopening Costs should be considered
as the part of the unavoidable costs. Normal decisions are for maximizing
the profits; but Shut Down decision is for reducing the loss as it always
considers the savings under loss. Calculation of net avoidable costs can be
made through the following formulae:
Net Avoidable FC = Total FC – (Un-avoidable FC + Re-opening Costs)
If the loss by taking the decision of ‘Shut Down’ is less than the continuity
of the business then the decision of ‘Shut Down’ may be considered as
favourable in short term. Some aspects other than costs should also be
considered, such as utility of the goods by the consumers, benefits of the
employees, obsolescence of machinery, goodwill of the concern, objection
by the labour unions and the government interference. ‘Shut Down Point’
can be calculated by marginal cost method by the following formulae:
Net Avoidable Fixed Cost
Shut Down Point (in Units) =
Contribution Per Unit

Net Avoidable Fixed Cost

Shut Down Point (in Units) =
P/V Ratio

There is a great difference between the ‘Shut Down’ of a business and

stopping the production of one type of product. If production of any type of
product is stopped then the fixed cost of that product can be allocated to the
remaining products; but when the plant is being ‘Shut Down’, the remaining
fixed costs are the loss for the concern.
15.2.11 Acceptance of Special Order
If any producer is not utilizing plant’s full installed capacity and he receives
special order for the product and that will not make any adverse impact on
our present sale then the offer will be accepted if it increases contribution.
This can be illustrated by the following illustration:
Illustration 7
Y Ltd. is working on 80% capacity and its Flexible Budget is as follows:
Output 60,000 units, sales value Rs. 12,00,000, material cost Rs. 30,000,
wages Rs. 2,10,000, variable expenses Rs. 1,20,000, Semi-variable expenses
Rs. 70,000 and fixed costs Rs. 2,00,000.

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A proposal for additional sale of 7,500 units is available, if it is accepted Relevant Costs for Decision
and supplied at Rs. 14.00 each. The semi-variable overheads increases by Making
Rs. 2,500 for the additional production. Advise the management.
Solution
Statement of Marginal Cost and Profitability
Particulars Production Production Total
of 60,000 of Additional Units:
units 7,500 units 67,500
Rs. Rs. Rs.
Material @ Rs. 0.50 30,000 3,750 33,750
Wages @ Rs. 3.5 2,10,000 26,250 2,36,250
Variable Expenses @ Rs. 2 1,20,000 15,000 1,35,000
Semi-variable expenses 70,000 2,500 72,500
Marginal cost 4,30,000 47,500 4,77,500
Sales 12,00,000 1,05,000 13,05,000
Contribution = (S-V) 7,70,000 57,500 8,27,500
Less Fixed Costs 70,000 — 70,000
Profit 7,00,000 57,500 7,57,500

Decision: If the proposal for additional supply of 7,500 units is accepted

then contribution increases by Rs. 57,500 and profit also increases by the
same amount. So it is advisable to accept the offer for additional supply. It
is assumed that this supply will not affect the present market for its product.
15.2.12 Adding or Dropping a Product Line
It is obvious to add or drop a product line to increase the profitability of the
business. For this purpose it is needed to analyze all the details available.
Profitability should be assessed in the existing framework and then the
profitability of all the alternatives should be compared and then the decision
should be taken.
Look at the following illustration :
Illustration 8
A factory manager seeks your advice whether he should drop one item from
his product line and replace it with another. Present cost and production data
per unit are as follows:
Product Price Variable Costs % Sales in
(Rs.) (Rs.) Total Sales
Tables 60 40 50
Chairs 100 60 10
Book Stands 200 120 40
Total Fixed cost per annum Rs. 7,500
Current Sales of the year Rs. 25,000

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Decision Making The change under consideration consists in dropping the line of chairs and
replacing it with a line of Sofa. If this drop and add change is made the
manager forecasts the following data regarding cost and output:
Product Price Variable Costs % Sales in
(Rs.) (Rs.) Total Sales
Tables 60 40 30
Sofa 160 60 20
Book Stands 200 120 50
Total Fixed cost per annum Rs. 7,500
Projected Sales of the year Rs. 26,500
Is this proposal feasible? Advise the management.
Solution
Statement of profitability for current production
Particulars Tables Chairs Book Stands Total
Rs. Rs. Rs. Rs.
Selling Price 60 100 200 —
Less Variable Cost % 40 60 120 —
Contribution 20 40 80 —
P/V Ratio 33.33% 40% 40% —
Sales of Rs. 25,000 in the
ratio of 50%, 10% & 40% 12,500 2,500 10,000 25,000
Contribution (P/V
multiplied by Sales) 4,167 1,000 4,000 9,167
Less Fixed Costs — — — 7,500
Profit — — — 1,667
Statement of profitability for projected production
Particulars Tables Sofa Book Stands Total
Rs. Rs. Rs. Rs.
Selling Price 60 160 200 —
Less Variable Cost 40 60 120 —
Contribution 20 100 80 —
P/V Ratio 33.33% or 1/3 62 ½% 40 % —
Sales of Rs. 26,500
in the ratio of 30%,
20% & 50% 7950 5300 13250 26,500
Contribution (P/V
multiplied by Sales) 2650 3313 5300 11,263
Less Fixed Costs — — — 7,500
Profit — — — 3,763

Decision: After analyzing the above statements it is observed that if the

proposal is accepted then the profit will increase by Rs. 2,096 (i.e., Rs.
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3,763 – Rs. 1,667). It is presumed that the demand of the proposed products Relevant Costs for Decision
will remain in the market. Therefore the proposed is to be accepted. Making

15.2.13 Replacement of Machinery

It becomes necessary to replace the old machinery by a new because of
the obsolescence of the old one or the renovation of the old one. Objective
of replacing the old machinery by a new machine is to reduce the cost of
production and to increase the revenue. While deciding the replacement
of machinery factors like operating cost, technological development,
return on capital, demand for the product, opportunity cost of the capital,
availability of raw material, labour etc, should be taken into consideration.
The replacement of machinery is assessed either by marginal cost analysis
or differential cost analysis but the later is more appropriate and is much in
use. Let us study in brief the factors to be considered for the replacement of
machinery
i) Operating Cost: Comparative study of the operating cost of the old
and the new machinery should be done. Per unit cost of production by
old machinery and the new one can be analyzed by the comparative
statement.
ii) Technological Development: New inventions are taking place every
day. The chances of new inventions should be taken into consideration
before the decision of replacement.
iii) Return On Capital: Return on capital on the new investment should
be feasible. What will be the amount of loss while selling the old?
iv) Demand for the Product: Production will be increased by the use
of the new machine and the demand for the increased production
should be estimated. If the production at full capacity cannot be sold,
then what percentage of the capacity can be sold and at this point
of utilization of the capacity would it be possible to keep the price
competitive. Market trend of the product should also be analyzed. If
the nature of the product is not going to last for a greater period then
the decision regarding change of machinery is not required.
v) Assessment of the Opportunity Cost of the Capital: If the capital
needed for the replacement is being used for any other alternative
would the capital yield more. If it is so then the decision of replacement
should be dropped.
vi) Availability of Raw Material and Skilled Labour: Availability of
raw material and skilled labour to run the machinery should be studied
before replacing the machine.
Illustration 9
The following facts relate to two machines:
Existing Machine New Machine
Capital cost (Rs.) 10,00,000 40,00,000
Marginal cost per unit (Rs.) 60 52
Selling price per unit (Rs.) 120 120

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Decision Making
Fixed expenses (Rs.) 1,00,000 4,00,000
Annual output (units) 20,000 40,000
Life of machines (years) 10 10
The existing machine has worked for 5 years. Its present resale value is
Rs. 4,00,000. The scrap value of the machine may be taken as nil, Advise
whether new machine should be installed if rate of interest is 10 %.
Solution
Statement of Differential Cost And Incremental Revenue
Particulars Existing Machine New Machine Incremental
Cost Revenue Cost Revenue Cost Revenue
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 24,00,000 48,00,000 24,00,000
Total 12,00,000 20,80,000
Marginal Cost
Total Fixed 1,00,000 4,00,000
Cost
Interest on
additional
capital outlay
on 36,00,000
@ 10 % (Rs.
40,00,000 Rs.
4,00,000) 3,60,000
Depreciation 1,00,000 4,00,000
on original
cost
Loss on sale 14,00,000 1,00,000 33,40,000 19,40,000
of machinery
Profit 10,00,000 14,60,000 4,60,000

Decision: It is clear from the above statement that installation of new

machinery is beneficial as incremental revenue is Rs 24,00,000 where as
the differential cost is Rs. 19,40,000. After installing the new machine the
total increase in the revenue will be Rs. 4,60,000.
Working Note:
1) Total cost of the machine is Rs. 10,00,000 and life is for 10 years
and it has been used for 5 years. The present book value of existing
machine is Rs. 5,00,000. So, the loss on sale of old machine is = Rs.
1,00,000. (Rs. 5,00,000- 4,00,000)
2) The net amount required to install new machine is Rs. 3,60,000 i.e.,
after deducting the amount of Rs. 4,00,000 received on sale of existing
machinery.
3) Loss on sale of existing machinery is to be included in the total cost
of new machinery for evaluation of new proposal.
4) Opportunity cost of the capital has not been considered.
Check Your Progress
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1) What do you understand about relevant cost and irrelevant costs ? Relevant Costs for Decision
Give one example. Making

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2) Explain the concept of differential cost.
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3) What is decision making process ?
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4) List out four managerial applications of differential cost analysis .
1 ................................................................
2 ................................................................
3 ................................................................
4 ................................................................
5) State whether the following statements are True or False:
Relevant cost analysis is used for future decision making and
i) 
not for past decisions.
ii) Relevant costs are also known as differential costs.
Differential cost is always calculated per unit and not on total
iii) 
cost of two alternatives.
iv) Differential costs and marginal costs are the same.
Fixed costs are not taken into account for differential cost
v) 
analysis.
6) X Ltd. produces 1,000 articles at the following costs:
Components Rs. Rs.
Materials Wages — 4,00,000
Factory Overheads: — 3,60,000
Fixed Variable 1,20,000
Fixed Administrative Overhead 2,00,000 3,20,000
Selling Overheads: — 1,80,000
Fixed Variable 1,00,000
Total 1,60,000 2,60,000
— 15,20,000
1,000 units @ Rs. 1,550 can be consumed in home market. Foreign

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Decision Making market can consume 4,000 articles of this product if rate can be
reduced to Rs. 1,250 per article. Is the foreign market worth trying?
7) The present volume of sales in a factory is 30,000 units and the
management has installed modern machinery to increase the
production to 6 times. The present selling price is Rs. 24 per unit. Six
successive levels with equal increments reaching up to 1,80,000 units
are contemplated sales. The reduction in selling price is expected to
be Rs. 2 at each higher level of sales. Fixed cost of
Rs. 1,32,000 will not change Other costs at different levels are given
below:
Production 30 60 90 120 150 180
(units in 000)
Variable cost 4.18 8.18 12.78 15.78 17.78 19.02
(in Rs. ‘000)
Semi Variable Cost 1.50 1.50 1.70 1.70 2.00 2.00
(in Rs. ‘000)
Prepare a statement of differential cost and incremental revenue and
give your advice as to which level of production should be adopted to
gain maximum.

15.3 LET US SUM UP

Before taking a decision, one must analyze the alternatives available
before him and then one should take a decision, which is beneficial to the
management. The decision should be in such a way that it increases the
profit of the company. When we take a decision for a short period, normally
we look at the contribution we receive in all the available alternatives and
compare them and one should accept the alternate, which provides more
contribution, as in shorter period it is presumed that fixed costs will not
change. If a decision is to be taken for a long period when the fixed costs
will also change then one should take the decision through differential cost
system. So, costs become relevant when decisions are being taken. In long-
run variable and fixed costs normally change. Total differential cost and
incremental revenue is considered in this method of analyzing for longer
period.

15.4 KEY WORDS

Alternative: Options.
Administrative Cost : A cost which relates to the enterprise as a whole.
Book Value : The amount shown in books of account for an asset
Contribution Margin : Excess of sales revenue over all variable expenses.
Differential analysis : Process of estimating the consequence of alternative
actions while taking a decision by decision-makers.
Differential cost : The costs which will change in response to a particular
course of action.

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Interest : The cost for using money. Relevant Costs for Decision
Making
Make or buy decision : A managerial decision about whether the firm
should produce internally or purchase it from outside.
Opportunity Cost : The present value of income/costs that could be earned
from using an asset in its best alternative uses.
Residual value : The estimated realisable value of an asset after use.
Relevant costs : Costs that are different under different alternatives.
Short run : Period of time over which capacity will not be changed.
Decision: Deciding one out of the many options.
Differential Cost: Change in the cost.
Incremental revenue: Increase in the revenue.
Semi variable costs: A cost, which has both variable and fixed elements.
Sunk Costs: Past costs which are unavoidable because they cannot be
changed.

15.5 ANSWERS TO CHECK YOUR PROGRESS

5) i) True ii) True iii) False iv) False v) False
6) Statement Showing Differential Cost and Incremental Revenue
Components Rs. Rs.
Sales of 4,000 units @ Rs.1250 — 50,00,000
(incremental revenue)
Differential costs:
Materials (4,00,000/1,000)4,000 16,00,000 —
Labour (3,60,000/1,000)4,000 14,40,000 —
Factory O.H. (2,00,000/1,000)4,000 8,00,000 —
Selling O.H. (1,60,000/1,000)4,000 6,40,000 44,80,000
Net profit or incremental profit 5,20,000
Decision: It is better to accept the foreign proposal, as it will increase
the profit by Rs. 5,20,000. It is assumed that this acceptance will not
affect the home market and the fixed cost will remain same.
7) Statement of Differential Cost And Incremental Revenue
Production Selling Sales Variable Semi- Fixed Total Differential Incremental
in Units Price Revenue Cost Variable Cost Cost Cost Revenue
(’000) per (Rs. (Rs. Cost (Rs. (Rs. (Rs. (Rs. ’000)
(Rs. ’000)
Unit ’000) ’000) ’000) ’000) ’000)
o 24 720 4.18 1.50 132 137.68 — —
60 22 1320 8.18 1.50 132 141.68 4.00 600
90 20 1800 12.78 1.70 132 146.48 4.80 480
120 18 2160 15.78 1.70 132 149.48 3.00 360
150 16 2400 17.78 2.00 132 151.78 2.30 240
180 14 2520 19.02 2.00 132 153.02 1.24 120

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Decision Making Decision: Production level can be increased up to the equalization of
incremental revenue and the differential cost. In this case both of these are
equal at the level of 90,000 units but the incremental revenue increases
till the production level is achieved at 1,50,000 units. After this level
incremental revenue is decreases so the production fixed at 1,50,000 units
will provide the optimum level of profit.

15.6 TERMINAL QUESTIONS

Questions
1) What do you understand by differential costing ? How does it differ
from managerial costing?
2) Explain the practical applications of differential costing.
3) X Company Ltd. manufactures a product. You are required to prepare
a statement showing differential cost and incremental revenue. At
what volume the company should set its level of production ?
Output Selling Total semi-fixed Total Total fixed
(in ’000 price Per cost per unit variable Cost cost per unit
units) unit per unit
30 24 1.50 4.18 1.32
60 22 1.50 8.18 1.32
90 20 1.70 12.78 1.32
120 18 1.70 15.78 1.32
150 16 2.00 17.78 1.32
180 14 2.00 19.02 1.32
(Ans : Production at 1,50,000 units will provide optimum level of profit)
4) What considerations are involved in taking decision of the following:
i) Make or buy decisions
ii) Dropping a product or adding a new product
iii) Shut-down of plant
5) Golden company Ltd produces a product which is yielding a profit of
Rs. 14,00,000 after charging fixed costs of Rs. 10,00,000 per annum.
The selling price of the product is Rs. 50 per unit and has a variable
cost of Rs. 20 per unit. The management wants to make changes in
the selling price of the product. The following options are open to the
management.
Alternatives Reduction in Selling Increase in quantity
Price to be sold
1 5% 10%
2 7% 20%
3 10% 25%
Evaluate the above alternatives and advise the management which
alternative yields maximum profit ?
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 (Ans: Contribution : 
1. Rs. 24,20,000   2. Rs. 25,44,000 and Relevant Costs for Decision
3. Rs. 25,00,000 Making

Decision : Alternative 2 gives maximum profit.

6) X Company Ltd is producing 10,000 articles and its cost data is given
below :
Variable Cost per unit : Rs. 26
Fixed overheads : Rs. 10
Total Cost : Rs. 36
A manufacturer offers the same commodity for Rs. 32 per unit. The
analysis of the cost data shows that Rs. 60,000 of fixed overheads will
be incurred regardless of production.
You are requested to suggest that should company X make or buy the
article ?
(Ans : Cost of making product Rs. 30, Difference of Rs. 2. is in
favour of making the product)
7) The total fixed cost of a company for producing a product price is Rs.
15 lakhs, the selling price per unit is Rs. 50 and the variable cost per
unit is Rs. 40. The company is incurring losses for the past several
years due to lack of demand. The company wants to shut down the
plant till the demand picks up. The avoidable costs are estimated at
Rs. 4,00,000. Should the company discontinue production till the
demand picks up? Advise the management.
(Ans. If the company’s sales are at least Rs. 55,00,000, it should
not be shut down )
 Fixed Cost – Available Cost
Hint: Shut down Sales = P/V Ratio 
 
8) A firm manufactures and sells three products – X, Y and Z. Their cost
data is given below:
Product : A B C
Production (Units): 5,000 12,500 17,500
Selling Price (Rs.) 9 5 15
Variable Cost (Rs.) 8 3 11
Fixed Cost Rs. 1,05,000
There is no under utilisation of production capacity. Fixed costs are
allocated on the basis of units produced. There is no difference in the
manufacturing time of each product. The management proposes to
drop product A as it contributes a loss of Rs. 2 per unit as calculated
below :
Selling price Rs. 9
Variable cost Rs. 8
Fixed cost Rs. 3 Rs. 11
(Rs. 105000 ÷ 35000 units)
Loss per unit Rs. 2
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Decision Making The management proposes to add product S in place of product A
as more units of product S can be produced and sold in the market
whose selling price and variable cost per units is Rs. 8 and Rs. 7.75
respectively. It is estimated that
12,000 units of product S can be sold if product A is dropped. You are
requested to advise the management.
(Ans : Contribution : Product A : Rs. 1. Profit would decrease by
Rs. 5000 if the product A is dropped.
Product S : Rs. 0.25 p. If product S is added in place of product A
profit will decrease by
Rs. 2000)
Note : These questions will help you to understand the unit better. Try to
write answers for them but do not submit your answers to the University.
These are for your practice.

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Unit 16: Pricing Decisions
Structure
16.0 Objectives
16.1 Introduction
16.2 Objectives of Pricing
16.3 Need for Pricing Decisions
16.4 Factors Influencing Pricing Decisions
16.4.1 Internal Factors
16.4.2 External Factors
16.5 Methods of Pricing
16.5.1 Cost-oriented Methods
16.5.2 Market-oriented Methods
16.6 Let Us Sum Up
16.7 Key Words
16.8 Answers to Check Your Progress
16.9 Terminal Questions

16.0 OBJECTIVES
After studying this unit, you should be able to
●● understand the need for pricing decisions;
●● state the objectives of pricing;
●● identify the factors influencing pricing decisions; and
●● explain various methods of pricing.

16.1 INTRODUCTION
Pricing is the process whereby a business sets the price at which it will
sell its products and services. In setting prices, the business will take into
account the price at which it could acquire the goods, the manufacturing
cost, the market place, competition, market condition, brand, and quality of
product. Pricing can be defined as a process of determining the value that
is received by an organization in exchange of its products or services. An
organization, while setting the prices of its products, needs to ensure that
prices must cover costs incurred for producing products and profit margins.
Pricing is a process to determine what manufacturer receive in exchange
of the product. Pricing depends on various factors like manufacturing cost,
raw material cost, profit margin, etc.
Pricing decisions are the choices businesses make when setting prices for
their products or services. Companies that make simple pricing decisions
often try to increase sales by making small, competitive adjustments such as
purchase discounts, volume discounts and purchase allowances.

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Decision Making
16.2 OBJECTIVES OF PRICING
Pricing objective is to price the product in such a way that maximum profit
can be extracted from it. Let us now discuss the main objectives of pricing.
The main objectives of pricing are as follow:
●● Maximization of profit in the short run
●● Optimization of profit in the long run
●● Maximum return on investment
●● Decreasing sales turnover
●● Fulfil sales target value
●● Obtain target market share
●● Penetration in market
●● Introduction in new markets
●● Obtain profit in whole product line irrespective of individual product
profit targets
●● Tackle competition
●● Recover investments faster
●● Stable product price
●● Affordable pricing to target larger consumer group
●● Pricing product or services that simulate economic development

16.3 NEED FOR PRICING DECISIONS

Pricing decisions may have significant consequences for the organization. It
is one of the first considerations for customers and it determines the amount
of profit margin on the products. Pricing is one of the significant elements
of the marketing mix. Pricing is an important decision making aspect after
the product is manufactured. Price determines the future of the product,
acceptability of the product by the customers and return and profitability
from the product.
The importance of pricing can be studied under the following points:
A. Most Flexible Marketing Mix Variable: Price is the most adjustable
aspect of the marketing mix. Prices can be changed rapidly, as
compared to other elements like product, place or promotion.
Changes in product design or distribution system take a long time to
be implemented.
Bringing about changes in advertisements or promotional activities
is also a time consuming task. But price is very flexible and can be
changed according to the needs of the situation. Therefore it is a very
important component of marketing mix.
B. Setting the Right Price: The wrong price decision can bring about the
downfall of a company. It is extremely significant to fix prices at the
right level after sufficient market research and evaluation of factors
like competitors’ strategies, market conditions, cost of production, etc.
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 Low prices may attract customers in the initial stages, but it would be Pricing Decisions
very hard for the company to raise prices on a future date. Similarly, a
very high price will ensure more profit margins, but lesser sales. So in
order to maintain balance between profitability and volume of sales,
it is important to fix the right price.
C. Trigger of First Impression: Often price is the first factor a customer
notices about a product. While the customer may base his final buying
decision on the overall benefits offered by the product, he is likely to
compare the price with the perceived value of the product to evaluate
it. After learning about the price, the customers try to learn more about
the product qualities.
If a product is priced too high, then the customer may lose interest
in knowing more. But if he thinks that a product is affordable, then
he would try to get more information about it. Therefore price is a
critical factor that influences a buyer’s decision.
D. Important Part of Sales Promotion: Being the most flexible
component of marketing mix, price is the most important part of the
sales promotion. In order to encourage more sales, the marketing
manager may reduce the price. In case of goods whose demand is
price sensitive, even a small reduction in price will lead to higher
sales volume. However prices should not be fluctuated too frequently
to stimulate sales.
Check Your Progress A
State whether the following statements are True or False:
a) Pricing does not depend on various factors like manufacturing cost,
raw material cost, profit margin, etc.
b) Pricing is defined as a process of determining the value that is received
by an organization in exchange of its products or services.
c) Optimization of profit in the long run is not the objective of pricing
d) Very high price will ensure more profit margins, but lesser sales.
e) In case of goods whose demand is not price sensitive, a small reduction
in price will lead to higher sales volume.

16.4 FACTORS INFLUENCING PRICING

DECISIONS
Large number of factors affects pricing decisions. The organisation should
identify and study the relevant factors affecting the pricing decisions. Factors
may be internal to organisation and known as controllable factors while
other factors are external or environmental and are known as uncontrollable
factors.
Factors are also classified in terms of competition-related factors, market-
related factors, product- related factors, and so forth. However, we will
consider internal and external factors affecting pricing decisions. Figure
2 depicts internal and external factors. Let us analyze some of the main
factors influencing pricing decisions.
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Decision Making
Internal Factors
1. Top Level Management
2. Elements of Marketing Mix
3. Degree of Product Differentiation
4. Costs
5. Objectives
6. Stage of Product Life Cycle
7. Product Quality
8. Brand Image
9. Category or Class of Product
10. Market Share
Factors Affecting
Pricing Decisions External Factors
1. Demand for the Product
2 Competition
3. Price of Raw Materials and Other Inputs
4. Buyers Behaviour
5. Government Rules and Regulations
6. Ethical Considerations or Code of Conduct
7. Seasonal Effect
8. Economic Condition

Figures 17.1: Factors affecting Pricing Decisions

16.4.1 Internal Factors

Internal factors are controllable. These factors play vital role in pricing
decisions. They are also known as organizational factors. Manager, who is
responsible to set price and formulate pricing policies and strategies, must
be acquainted and must have thorough knowledge about these factors. Let
us discuss these factors in detail.
1. Top Level Management
Top-level management has full authority over the issues related to
pricing. Marketing manager’s role is administrative. The philosophy
of top-level management is reflected in forms of pricing also. How
does top management perceive the price?
How far is pricing considered as a tool for earning profits, and what is
the importance of price for the overall performance? In short, overall
management philosophy and practice have a direct impact on pricing
decision. Price of the product may be high or low; may be fixed or
variable; or may be equal or discriminative, it depends on the top-
level management.
2. Elements of Marketing Mix
Price is one of the important elements of marketing mix. Therefore,
it must be integrated to other elements (promotion, product, and
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 distribution) of marketing mix. So, pricing decisions must be linked Pricing Decisions
with these elements so as to consider the effect of price on promotion,
product and distribution, and effect of these three elements on price.
For example, high quality product should be sold at a high price. When
a company spends heavily on advertising, sales promotion, personal
selling and publicity, the selling costs will go up, and consequently,
price of the product will be high. In the same way, high distribution
costs are also reflected in forms of high selling price.
3. Degree of Product Differentiation
Product differentiation is an important guideline in pricing decisions.
Product differentiation can be defined as the degree to which company’s
product is perceived different as against the products offered by the
close competitors, or to what extent the product is superior to that of
the competitors’ in terms of competitive advantages. The theory is,
the higher the product differentiation, the more will be the freedom to
set the price, and higher the price will be.
4. Costs
Costs and profits are two dominant factors having direct impact
on selling price. Here, costs include product development costs,
production costs, and marketing costs. It is very simple that costs
and price have direct positive correlation. However, production and
marketing costs are more important in determining price.
5. Objectives of Company
Company’s objectives affect price of the product. Price is set in
accordance with general and marketing objectives. Pricing policies
must the company’s objectives. There are many objectives, and price
is set to achieve them.
6. Stages of Product Life Cycle
Each stage of product life cycle needs different marketing strategies,
including pricing strategies. Pricing depends upon the stage in which
company’s product is passing through. Price is kept high or low,
allowances or discounts are allowed or not, etc., depend on the stage
of product life cycle.
7. Product Quality
Quality affects price level. Mostly, a high-quality-product is sold at a
high price and vice-versa. Customers are also ready to pay high price
for a quality product.
8. Brand Image and Reputation in Market
Price does not include only costs and profits. Brand image and
reputation of the company are also added in the value of product.
Generally, the company with reputed and established brand charges
high price for its products.
9. Category of Product
Over and above costs, profits, brand image, objectives and other
variables, the product category must be considered. Product may
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Decision Making be imitative, luxury, novel, perishable, fashionable, consumable,
durable, etc. Similarly, product may be reflective of status, position,
and prestige. Buyers pay price not only for the basic contents, but also
for psychological and social implications.
10. Market Share
Market share is the desired proportion of sales a company wants
to achieve from the total sales in an industry. Market share may be
absolute or relative. Relative market share can be calculated with
reference to close competitors. If company is not satisfied with the
current market share, price may be reduced, discounts may be offered,
or credit facility may be provided to attract more buyers.
16.4.2 External Factors
External factors are also known as environmental or uncontrollable factors.
External factors are more powerful than the internal factors. Pricing
decisions should be taken after analyzing following external factors
1. Demand for the Product
Demand is the single most important factor affecting price of the
product and pricing policies. Demand creation or demand management
is the prime task of the marketing management. So, price is set at a
level at which there is the desired impact on the product demand.
Company must set price according to the purchase capacity of its
buyers.
Here, there is reciprocal effect between demand and price, i.e., price
affects demand and demand affects price level. However, demand is
more powerful than price. So, marketer takes decision as per demand.
Price is kept high when demand is high, and price is kept low when
demand of the product is low. Price is constantly adjusted to create
and/or maintain the expected level of demand.
2. Competition
A marketer has to work in a competitive situation. To face competitors,
defeat them, or prevent their entry by effective marketing strategies
is one of the basic objective of the organisations. Therefore, pricing
decision is taken accordingly.
A marketer formulates pricing policies and strategies to respond
competitors, or, sometimes, to misguide competitors. When all the
marketing decisions are taken with reference to competition, how can
price be an exception?
Sometimes, a company follows a strong competitor’s pricing policies
assuming that the leader is right. Price level, allowances, discount,
credit facility, and other related decisions are largely imitated.
3. Price of Raw Materials and other Inputs
The price of raw materials and other inputs affects pricing decisions.
Change in the price of the needed inputs has direct positive effect
on the price of the finished product. For example, if price of raw
materials increases, company has to raise its selling price to offset
increased costs.
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4. Buyers’ Behaviour Pricing Decisions

It is essential to consider buyers’ behaviour while taking pricing

decision. Marketer should analyze consumer behaviour to set effective
pricing policies. Consumer behaviour includes the study of social,
cultural, personal, and economic factors related to the consumers. The
key characteristics of consumers provide a clue to set an appropriate
price for the product.
5. Government Rules and Restrictions
A company cannot set its pricing policies against rules and regulations
prescribed by the governments. Governments have formulated at least
30 Acts to protect the interest of the customers. Out of them, certain
Acts are directly related to pricing aspects. Marketing manager must
set pricing within limit of the legal framework to avoid unnecessary
interference from outside. Adequate knowledge of these legal
provisions is considered to be very important for the manager.
6. Ethical Consideration or Codes of Conduct
Ethics play vital role in price determination. Ethics may be said as
moral values or ethical code that governs managerial actions. If a
company wants to fulfil its social obligations and when it believes
to work within limits of the ethics prescribed, it always charges
reasonable price for its products. Moral values restrict managerial
behaviour.
7. Seasonal Effect
Certain products have seasonal demand. In peak season, demand
is high, while in slack season, demand is reduced considerably. To
balance the demand or to minimize the seasonal-demand fluctuations,
the company changes its price level and pricing policies. For example,
during a peak season, price may be kept high and vice-versa. Discount,
credit sales, and price allowances are important issues related to the
seasonal factor.
8. Economic Condition
This is an important factor affecting pricing decisions. Inflationary
or deflationary condition, depression, recovery or prosperity
condition influence the demand to a great extent. The overall health
of the economy has tremendous impact on price level and degree
of variation in price of the product. For example, price is kept high
during inflationary conditions. A manager should keep in mind the
macro picture of the economy while setting price for the product.

16.5 METHODS OF PRICING

There are many methods of pricing a product. While selecting the method
of pricing a product, a marketer must consider the factors that affect the
price of a product. The pricing methods can be broadly classified into two
groups—cost-oriented method and market-oriented method.

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Decision Making 16.5.1 Cost-oriented Methods
Cost provides the base for a possible price range; some firms may consider
cost-oriented methods to price a product. Let us discuss these methods in
detail
1. Cost plus pricing
Cost plus pricing involves adding a certain percentage to cost in order
to fix the price. For instance, if the cost of a product is Rs. 200 per
unit and the marketer expects 10 per cent profit on costs, then the
selling price will be Rs. 220. The difference between the selling price
and the cost is the profit. This method is simpler as marketers can
easily determine the costs and add a certain percentage to arrive at the
selling price.
2. Mark-up pricing
Mark-up pricing is a variation of cost pricing. In this case, mark-
ups are calculated as a percentage of the selling price and not as a
percentage of the cost price. Firms that use cost-oriented methods
use mark-up pricing. Since only the cost and the desired percentage
markup on the selling price are known, the following formula is used
to determine the selling price:
Average unit cost/Selling price
3. Break-even pricing
In this case, the firm determines the level of sales needed to cover all
the relevant fixed and variable costs. The break-even price is the price
at which the sales revenue is equal to the cost of the goods sold. In
other words, there is neither profit nor loss.
For instance, if the fixed cost is Rs. 2, 00,000, the variable cost per
unit is Rs. 10, and the selling price is Rs. 15, then the firm needs to sell
40,000 units to break even. Therefore, the firm will plan to sell more
than 40,000 units to make a profit. If the firm is not in a position to sell
40,000 units, then it has to increase the selling price. The following
formula is used to calculate the break-even point:
Contribution = Selling price – Variable cost per unit
4. Target return pricing
In this case, the firm sets prices in order to achieve a particular level
of return on investment (ROI).
The target return price can be calculated by the following formula:
Desired % ROI investment
Target return price = Total costs +
Total sales in units
For instance, if the total investment is Rs. 10,000, the desired ROI
is 20 per cent, the total cost is Rs.5000, and total sales expected are
1,000 units, then the target return price will be Rs. 7 per unit as shown
below:
20% 10,000
5000 +
7000

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 The limitation of this method (like other cost-oriented methods) is that Pricing Decisions
prices are derived from costs without considering market factors such
as competition, demand and consumers’ perceived value. However,
this method helps to ensure that prices exceed all costs and therefore
contribute to profit.
5. Early cash recovery pricing
Some firms may fix a price to realize early recovery of the investment
involved, when market forecasts suggest that the life of the market is
likely to be short, such as in the case of fashion-related products or
technology-sensitive products. Such pricing can also be used when
a firm anticipates that a large firm may enter the market in the near
future with its lower prices, forcing existing firms to exit. In such
situations, firms may fix a price level, which would maximize short-
term revenues and reduce the firm’s medium-term risk.
16.5.2 Market-oriented Methods
1. Perceived value pricing
A good number of firms fix the price of their goods and services on
the basis of customers’ perceived value. They consider customers’
perceived value as the primary factor for fixing prices, and the firm’s
costs as the secondary.
The customers’ perception can be influenced by several factors, such
as advertising, sales on techniques, effective sales force and after-sale-
service staff. If customers perceive a higher value, then the price fixed
will be high and vice-versa. Market research is needed to establish the
customers’ perceived value as a guide to the effective pricing.
2. Going-rate pricing
In this case, the benchmark for setting prices is the price set by major
competitors. If a major competitor changes its price, then the smaller
firms may also change their price irrespective of their costs or demand.
The going-rate pricing can be further classified into three sub-
methods:
a. Competitors’ parity method: A firm may set the same price as
that of the major competitor.
b. Premium Pricing: A firm may charge a little higher if its
products have some additional special features as compared to
the major competitors.
c. Discount Pricing: A firm may charge a little lower price if
its products lack certain features as compared to the major
competitors.
The going-rate method is very popular because it tends to reduce the
likelihood of price wars emerging in the market. It also reflects the
industry’s co-active wisdom relating to the price that would generate
a fair return.

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Decision Making 3. Sealed-bid Pricing
This pricing is adopted in the case of large orders or contracts,
especially those of industrial buyers or government departments. The
firms submit sealed bids for jobs in response to an advertisement. In
this case, the buyer expects the lowest possible price and the seller
is expected to provide the best possible quotation or tender. If a
firm wants to win a contract, then it has to submit a lower price bid.
For this purpose, the firm has to anticipate the pricing policy of the
competitors and decide the price offer.
4. Differentiated Pricing
Firms may charge different prices for the same product or service and
hence there may be different types of differentiated pricing. Let us
discuss these types in detail.
1. Customer Segment Pricing :Here different customer groups
are charged different prices for the same product or service
depending on the size of the order, payment terms, and so on.
2. Time Pricing : Here different prices are charged for the same
product or service at different timings or season. It includes off-
peak pricing, where low prices are charged during low-demand
tunings or season.
3. Area Pricing : Here different prices are charged for the same
product in different market areas. For instance, a firm may
charge a lower price in a new market to attract customers.
4. Product form Pricing :Here different versions of the product
are priced differently but not proportionately to their respective
costs. For instance, soft drinks of 200,300, 500 ml. etc. are
priced according to this strategy.
Check Your Progress B
Fill in the blanks:
a) Different prices charged for the same product in different market
areas is called…………….
b) ………is adopted in the case of large orders or contracts, especially
those of industrial buyers or government departments.
c) The pricing wherein a firm may charges a little higher price if its
products have some additional special features as compared to the
major competitors is called……….
d) The pricing wherein a firm sets prices in order to achieve a particular
level of return on investment is called…………..
e) Firms that use cost-oriented methods use ………. pricing..

16.6 LET US SUM UP

Pricing is the process whereby a business sets the price at which it will
sell its products and services. In setting prices, the business will take into
account the price at which it could acquire the goods, the manufacturing
cost, the market place, competition, market condition, brand, and quality of
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product. Pricing can be defined as a process of determining the value that is Pricing Decisions
received by an organization in exchange of its products or services. Pricing
objective is to price the product in such a way that maximum profit can be
obtained from it. Some of the objectives of pricing are: Obtain target market
share, Penetration in market, Introduction in new markets, Obtain profit in
whole product line irrespective of individual product profit targets, Tackle
competition, Recover investments faster, Stable product price.
Pricing decisions may have significant consequences for the organization. It
is one of the first considerations for customers and it determines the amount
of profit margin on products. Need of the pricing can be studied under the
points: Most Flexible Marketing Mix Variable, Setting the Right Price,
Trigger of First Impression, Important Part of Sales Promotion. Pricing
decisions are affected by a large number of factors which are classified as
internal and external factors:
Internal Factors are: Top level management, Elements of Marketing Mix,
Costs, Objectives of the company, Degree of Product Differentiation, and
External factors are:
Demand for the product, competition, Price of Raw Materials and other
Inputs, Buyer behaviour, Govt rules and regulations, Ethical Consideration
or Codes of Conduct, seasonal effect, and economic condition.
There are many methods of pricing a product. While selecting the method
of pricing a product, a marketer must consider the factors that affect the
price of a product. The pricing methods can be broadly classified into two
groups—cost-oriented method and market-oriented method.
Cost-oriented methods are: cost-plus pricing, Mark-up pricing, Break-even
pricing, Target return pricing, Early cash recovery pricing.
Market-oriented methods are: perceived value pricing, going rate pricing,
Sealed-bid pricing and differentiated pricing.

16.7 KEY WORDS

Cost-plus Pricing: It is a method in which the selling price is set by
evaluating all variable costs a company incurs and adding a markup
percentage to establish the price.
Time Pricing: It is a situation where different prices are charged from the
customers for the same product or service at different timings or season.
Perceived-Value Pricing: It is a method in which a firm sets the price of
a product by considering what product image a customer carries in his
mind and how much he is willing to pay for it.

16.8 ANSWER TO CHECK YOUR PROGRESS

A a) False, b) True c) False d) True e) False
B a) Area Pricing, b) Sealed-bid pricing,
c) Premium Pricing, d) Target return pricing, e) Mark-up

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Decision Making
16.9 TERMINAL QUESTIONS
1. What is meant by pricing? State the objectives of pricing.
2. What is the need for pricing decisions? Explain
3. Describe the factors influencing pricing decisions.
4. What are the various methods of pricing? Explain with suitable
examples.
5. Write short note on the followings:
● Break-even pricing
● Differentiated pricing

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UNIT 17: RESPONSIBILITY ACCOUNTING
Structure
17.0 Objectives
17.1 Introduction
17.2 The Concept of Responsibility Accounting
17.3 Profit Planning and Control
17.4 Design of the System
17.5 Uses of Responsibility Accounting
17.6 Essentials of Success of Responsibility Accounting
17.7 Segment Performance
17.7 Measuring Segment Performance
17.7.1 Return on Investment
17.7.2 Residual Income
17.9 Transfer Pricing
17.10 Methods of Transfer Pricing
17.10.1 Market Price Based
17.10.2 Cost Price Based
17.11 Let Us Sum Up
17.12 Key Words
17.13 Answers to Check Your Progress
17.14 Terminal Questions
17.15 Further Readings

17.0 OBJECTIVES
After studying this unit, you should be able to:
●● know how cost and management accounting will be used for
managerial planning and control.
●● appreciate the structure and process in designing responsibility
accounting system;
●● understand the concept of responsibility centres;
●● familiar with different methods of evaluating the performance of
different segments of an organisation; and
●● identify the benefits, and essentials of success of measuring and
reporting of costs by managerial levels of responsibility.

17.1 INTRODUCTION
Responsibility accounting has been very much a part of cost and management
accounting for a while now. It has emerged as a widely accepted practice
within budgeting. But mind that responsibility accounting is not a separate
system of management accounting. It does not involve any significant change
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Decision Making in accounting theory or generally accepted accounting principles. Else, it
represents one of the three sets of management accounting information. The
two other sets are full cost information and differential cost information.
In this unit you will study about the concept of responsibility accounting,
design of the system and uses of responsibility accounting. In addition
to this you will also learn performance evaluation of different segments
besides transfer pricing.

17.2 THE CONCEPT OF RESPONSIBILITY

ACCOUNTING
The framework of responsibility accounting was developed by Professor
A.J.E. Sorgdrager titled “Particularisation of Indirect Costs”. As the
title suggests, responsibility accounting is a cost accounting system
established on a responsibility basis. A basis is said to be responsible
where actual results are as close to planned results as possible. As such,
the variances are minimal. Planned results could be stated in budgets and
standards. Properly speaking, responsibility accounting is a method of
budgeting and performance reporting created around the structure of the
organization. Individual managers are hold accountable for the costs within
their jurisdiction. The purpose, obviously, is to exercise control over the
operations. Hence, in simple words, it could be described as a system of
collecting and reporting accounting data on the basis of managerial level.
It may be defined as the approach to accountability- identification of cost,
with the persons responsible for their incurrence. Performance is evaluated
by assigned responsibilities. Reporting on performance is on the lines of
organizational structure. There is a separate report for each box of the
organization chart.
The concept emphasizes “personalization of costs” by putting questions
as to where the cost was incurred and who were responsible for it. The
technique seeks to control costs at the starting point. Broadly speaking,
responsibility accounting is designing the accounting system according to
answerability of the manager. The accumulation classification, measurement
and reporting of financial data is so arranged that it promotes the fixing
of precise responsibility on the concerned manager. Horngreen rightly
says, “Responsibility accounting focuses on people and not on things. It is
designed to present managers with information relating to their individual
fields of responsibility’’. The message is that since all items of income,
operating costs, other expenses and capital expenditure are the responsibility
of some manager, none should be left unassigned. Responsibility accounting
considers both historical and future costs. For some purposes, the activity of
responsibility centers is expressed in historical amounts. For others, these
are expressed in estimated future amounts.

17.3 PROFIT PLANNING AND CONTROL (PPC)

As mentioned earlier responsibility accounting is an important piece of
the budgetary system. It provides for the reporting of operating data and
budget comparisons to the individuals and groups who have organizational
responsibility. Responsibility accounting, measures plans by budgets, and
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actions by actual results of each responsibility centre. If fully developed, it Responsibility Accounting
has a built-in budgetary system which perfectly fits the organizational chart.
Budgeting provides the measuring stick by which the actual performance
can be judged. Budgets, along with responsibility accounting provides
systematic help to the managers if they interpret the feedback carefully.
When an integrated and comprehensive view is taken of budgeting, it
becomes Profit Planning and Control (PPC). Desired or target profit figures
are planned and controlled through a set of budgets. Here, responsibility
accounting is the dominant concept as control is its crux. Performance is
measured by using actual results. Traditional cost accounting had been
focused on determinining the cost of products and services. In responsibility
accounting, this is reversed. Costs are no longer associated with products and
services. Else, the focus is on planning and control needs of management.
Costs initially accumulated for control purposes are then recast for product
costing purposes. The control aspect is emphasized by summarizing and
reporting costs on the basis of individual responsibility before those costs
are merged for product cost purposes.

17.4 DESIGN OF THE SYSTEM

In designing a system, one has to decide upon its structure and the process.
So is the responsibility accounting. Its structure rests on the responsibility
centres. The process consists of bifurcating costs into controllable and non-
controllable groups, flexible budgeting, and performance reporting. These
three dimensions of the process and, then, the structural reorganization
could be called the principles or fundamentals of responsibility accounting.
These are being discussed below:
1) Establishing Responsibility Centers : A responsibility centre (RC)
is an organizational unit. It exists because of some functional activity
for which each specific manager is made responsible. Setting up
of responsibility centres, therefore, becomes the first step. A large
decentralized organization has to be restructured in terms of areas of
influence. In ascending (i.e., rising) order of autonomy, these are cost
centres, revenue centres, profit centres, and investment centres. The
depth of use of responsibility accounting in the enterprise depends
on the delegation of authority and assignment of responsibility. In a
cost centre the manager is responsible only for the costs (expenses)
incurred in his sub-unit. When actual costs of his sub-unit differ
from budgeted costs then the manager must explain the significant
variances. In a revenue centre, the manager is responsible for
generating revenues too upto the budgeted levels. In a profit centre, the
manager goes beyond, and is responsible also for profit performance.
For instance, the manager of a furniture department of a departmental
store is responsible for earning a profit on the furniture sold. He is
expected to earn the budgeted amount of profit during the period. In
an investment centre, the manager has the responsibility and control
over the assets that are used to carry on its activities. For example,
individual departments of a departmental store, and individual
branches of a chain stores are investment centres. The manager of
the concerned department is expected to achieve some target rate of
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Decision Making return on investment. It should be noted that investment centre differs
from a profit centre as investment centre is evaluated on the basis
of the rate of return earned on the assets invested in the sub-unit or
segment while a profit centre is evaluated on the basis of excess of
revenue over the revenue for the period. Control can be exercised
only though managers who are responsible for what the organization
does. It is based on the principle that a manager’s performance, should
be assessed only on the factors that are within his span of control.
Each managers’s budget contains costs and revenues within his span
of control. Generally costs are accumulated by departments.
Subsidiary revenue and expense accounts are created for each centre.
These enable accounting transactions to be recorded not only by
revenue and expense category, but also by the responsibility centre
incurring the transaction. The accounting system can then summarize
transactions by descriptive category for public reporting purposes,
and by responsibility centre for purposes of performance evaluation.
These accounts indicate how, at the lowest reporting level in an
organization, performance reports show costs incurred in a division
by descriptive category. At higher reporting levels, summaries reflect
total costs incurred in subordinate responsibility centres.
2) Limits to Controllable Costs: Once the responsibility centres have
been established in a company, costs and revenues under the control
of each therein need be indicated. In responsibility accounting, the
basis of classifying costs is controllability---the capability of the
manager of a responsibility centre to influence (i.e., increase or
decrease) them. As such, costs are accumulated and reported in the
two groups of controllable and noncontrollable costs. The former
are those which can be changed by the head of the responsibility
centre. He has the ability to regulate the quantity or price or both
of an item by his managerial action. Uncontrollable costs, obviously,
are the costs which cannot be increased or decreased within a given
time span at the discreation of the manager. But these can be changed
at higher levels of management authority. Generally, costs of raw
materials, direct labour and operating supplies are controllable. Fixed
costs are non-controllable such as rentals, depreciation, and insurance
on equipment. In this setup, no allocation of common or joint costs
takes place, which by their very nature are quite indirect. Allocation
is always an arbitrary process.
3) Flexible Budgeting: Responsibility accounting starts with the
assumption that budgets are flexible. They have to be prepared for
several levels of activity, instead of one static level. When actual output
has been obtained, a fresh budget is prepared thereof. Comparison
of actual results is made against the budget targets freshly prepared
for that level. It would be a weak analysis to use a budget based
on a level of activity that differs from the actual level of activity.
A performance budget is the flexible budget adjusted to the actual
level attained. Flexible budgeting permits comparison of actual costs
352
 with budgeted costs that have been recast to changes in production Responsibility Accounting
volume. It would be recalled that flexible budgets are prepared either
by the mathematical function or formula method, or the multi-activity
method.
4) Performance Reporting: Each responsibility centre has to
periodically report about its performance, the feedback. A report has
both financial and statistical parts. It shows income, expenses and
capital expenditures. Statistics such as volume of production, cost per
unit, and manpower data are also provided. Typically, performance
reports will disclose the actual costs incurred, the budgeted costs,
and a variance, which is the difference between the actual and
budgeted amounts. Normally these amounts will be summarized by
the responsibility centre for the month being reported and also for
the current year-to-date. The purpose is to take timely and corrective
action. Performance reports could be monthly, weekly, or even daily
depending on the size of the organization and significance of the
item. In addition, the report must be given to the manager while the
information is still useful. Reports received weeks after the period are
of little value. Further, once the performance reports are prepared,
management need only to consider the significant variances from the
budget. This is what is being referred to as management by exception.
Difficulties
Responsibility accounting is a conceptually appealing tool for motivation and
control. But many organizations in practice do not achieve these objectives.
Two major difficulties in implementing a successful responsibility accounting
system are: Accumulation of mass of dats, and Development of appropriate
performance measures. However, cost accumulation at such a detailed level
throughout an organization is made practicable by the use of computer-
based cost accounting systems. Computer programs can quickly summarize
costs for each descriptive category for purposes of product costing and
producing a traditional income statement. Similar programs can summarize
costs by responsibility centres and generate the associated performance
reports. Thus, the problem of data accumulation, although a substantial one
can now be overcome through the use of computer technology. As a result,
the problem of developing appropriate performance measures has become
the more difficult one to resolve.
For a budgetary system to serve as an effective means of control, cost
and revenues goals must be adopted by each manager and accepted as
individual objectives. This is most likely to occur when budgeted goals
are reasonable and realistically attainable and yet challenging. The cost
accountant is in a position to identify these performance measure and to
isolate the costs incurred in each responsibility centre. These costs must
then be categorized as controllable and uncontrollable before the reporting
structure is developed. These decisions will have a sound impact on the
effectiveness of the system. Generally, responsibility accounting systems
are used in conjunction with standard costs. A major task then of the cost
accountant is of the development and then interpretation
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Decision Making
17.5 USES OF RESPONSIBILITY ACCOUNTING
Responsibility accounting which focuses on managerial levels is an
important aid in the management control process. It has several uses and
confers many benefits. These are listed below:
i) Performance Evaluation : This is perhaps the biggest benefit. With
responsibility localized, it is possible to rate individual managers on a
cost basis. When a manager is held responsible for whatever he does,
he become extra vigilant. Responsibility accounting system provides
the manager with information that helps controlling operations and
evaluating the performance of subordinates.
ii) Delegating Authority : Large business firms can hardly survive
without proper delegation of authority. By its very nature, responsibility
accounting makes it happen. Decentralisation of power is its keypoint
and; hence, delegation of authority follows.
iii) Motivation : Responsibility accounting is the use of accounting
information for planning and control. When the managers know that
they are being evaluated, they are prompted to put their heart and soul
in meeting the targets set for them. It acts as a great stimulus. As a
matter of fact, responsibility accounting is based on the motivating
individual managers to maximum performance. The targets provide
goals for achievement and serve to motivate managers to increase
revenues or decrease costs.
iv) Corrective Action : If performance is unsatisfactory, the person
responsible must be identified. It is only after identification of the
erring subordinate that the corrective action can be taken. Under
responsibility accounting, as areas of authority are clearly laid down,
such corrective action becomes easier. The control action to be
effective must occur immediately after identification of the causes of
the problem. The longer control action is deferred, the greater the
unfavourable financial effect.
i) Management by Objectives : The heads of divisions and departments
are assigned definite objectives before the commencement of the
period. They are held answerable for the attainment of these targets.
Shortfalls are punished and excesses rewarded. Such a system helps
in establishing the principle of management by objectives (MBO).
vi) Management by Exception : Performance reporting here, is on
exceptions or deviations from the plan. The idea runs throughout
the responsibility accounting. It helps managers by spending their
time on major variances with greatest potential improvements. The
concentration of managerial attention on exceptional or unusual items
of deviation rather than on all is the key to success of the system.
vii) High Morale and Efficiency: Once it is clear that rewards are
linked to the performance, it acts as a great morale booster. Great
disappointment will be caused if an operating foreman is evaluated on
the decisions in which he was not a party
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 Responsibility Accounting
17.6 ESSENTIALS OF SUCCESS OF
RESPONSIBILITY ACCOUNTING
Responsibility accounting by itself, does not give any benefits. Its success
is dependent on certain conditions. These are:
1) Support of all levels of management through “Participative budgeting”.
Budgeted performance is basic to responsibility accounting. Most
managers will be responsive to a budget which they have helped to
develop. If the budget of the responsibility centre is produced by a
process of negotiation between its manager and immediate supervisor,
he will work to attain it. He will more actively pursue the goals and
accept the resulting performance measures as equitable. Effective
motivations and control based on appropriate performance measures
does not occur by accident. They must be carefully considered during
the design of the system.
2) The system is based on individual manager’s responsibility. It is the
manager who incur costs and should be held accountable for each
expenditure.
3) Separation of costs into controllable and non-controllable categories.
4) Restructuring the organization along the decision-making lines of
authority.
5) An organization plan which establishes objectives and goals to be
achieved.
6) The delegation of authority and responsibility for cost incurrence
through a system of policies and procedures.
7) Motivation of the individual by developing standards of performance
together with incentives.
8) Timely reporting and analysis of difference between goals and
performance by means of a system of records and reports.
9) A system of appraisal or internal auditing to ensure that unfavourable
variances are clearly shown. Then, follow-up and corrective action
need be applied. ·
In responsibility accounting revenues and expenses are accumulated and
reported by levels of responsibility with a view to comparing the actual
costs with the budgeted performance data by the responsible manager. The
whole effort is towards satisfying the ‘data requirements for responsive
control’.
Check Your Progress A
1) What do you understand about Responsibility Accounting?
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………

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Decision Making 2) What are the stages that are involved in the process of Responsibility
Accounting?
1) .…………………………………………………………………
2) .…………………………………………………………………
3) .…………………………………………………………………
4) .…………………………………………………………………
3) Specify any four essential conditions for the success of Responsibility
Accounting.
1) .…………………………………………………………………
2) .…………………………………………………………………
3) .…………………………………………………………………
4) .…………………………………………………………………
4) State whether the following statements are ‘True’ or ‘False’:
i) Responsibility accounting emphasises on personalisation of
costs.
ii) Responsibility accounting is based on historical costing only.
iii) The degree of responsibility of a cost centre, in a responsibility
accounting, depends upon the level of delegation of authority.
iv) Responsibility accounting is not based on the assumption that
budgets are flexible.
v) Setting up of responsibility centres is the first step in the process
of responsibility accounting.

17.7 SEGMENT PERFORMANCE

A segment or division may be either a profit centre having responsibility
for both revenues and operating costs, or an investment centre, having
responsibility for assets in addition to revenues and operating costs.
The manager of each segment are free to take decisions regarding the
performance of their centres. When an orgainzation grows it is inevitable
to create divisions or segments to control operations of different divisions.
This requires accounting information which discloses not only the objectives
and performances of divisions but also whether or not each division is
performing in the interest of the organization as a whole. This section
illustrates how segment data should be presented so that meaningful decisions
regarding segment performance can be taken. A manager’s performance
is evaluated generally on the basis of comparison of costs incurred with
costs budgeted. It is therefore, important to allocate appropriate costs to
the respective segments. While allocating the costs, the costs relating to
general administration or head office should not be charged to any segment
as these costs remain constant irrespective of the volume of sales by each
department. Let us see the following illustration:

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Illustration 1 Responsibility Accounting

A simplified representation of organization of Digital Co. Ltd. is presented

below:

President

Vice President Vice President

Marketing Manufacturing

Sales Advertising Credit Production Production

Manager Manager Manager Manager Engineer

Sewing Cutting
Department Department

The company manufacturers cloth potholders in a simple process of cutting

the potholders in various shapes and then sewing the contrasting pieces
together to form the finished potholder.
The accounting system reports the following data for the year 2020-2021:
Budgeted Actual
Rs. Rs.
Bad debt losses 500 300
Cloth used 3,100 3,400
Advertising 400 400
Credit reports 120 105
Sales representatives travel exp. 900 1,020
Sales commissions 700 700
Cutting labour 600 600
Thread 50 45
Sewing labour 1,700 1,840
Cutting utilites 80 70
Credit department salaries 800 800
Sewing utilities 90 95
Vice-President, Marketing office exp. 2,000 2,145
Production engineering expense 1,300 1,220
Sales management office expenses 1,600 1,570
Production manager’s office exp. 1,800 1,700
Vice-President, manufacturing office expenses 2,100 2,010
Using the data given, prepare responsibility accounting reports for the two
vice-presidents.
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Decision Making Solution:
Responsibility accounting tailors reports to each level of management to
include those items which they can control and for which they are responsible.
The items for which they are responsible are generally determined by the
organization structure as reflected in the organization-chart. Responsibility
report highlights variances to assist in the process of management by
exception. Reports for higher-level managers are in summary form in order
to avoid flooding them with more detail than is needed.
With these general ideas in mind, one can turn to the responsibility
reports required by the problem. Each report is assumed to contain a one-
line summary of the expenses of the subordinate departments. From the
organization chart, the contents of the reports will, therefore, be as follows:
Vice-president, Sales expense + advertising expense + credit expense
marketing :
Sales expense : Sales representatives’ travel expense + sales
commissions + sales management office
Advertising Advertising
expense :
Credit expense : Credit reports + credit department salaries + bad debt
losses
Vice-president, Production expense + production engineering expense
manufacturing : + production manager’s office expenses
Production Sewing department + cutting department, i.e. thread.+
Manager : sewing labour + sewing utilities + cloth used + cutting
labour + cutting utilities
Notice that these reports do not contain the expenses of the vice-president’s
offices. Although sometimes included, they are not here on the ground that
the vice presidents cannot control their own salaries, the major component
of these categories. If they are excluded on these reports, they would be
included as an item on the president’s report, where they are controllable..
Since the lower level reports are summarized in the higher-level reports, it
is usually easier to begin with the lower-level reports.
Budgeted Actual Variance
1) Production Manager
Controllable expense report: Rs. Rs. Rs.
Sewing department 1,840 1,980 140U
Cutting department 3,780 4,130 350U
Total 5,620 6,110 490U

Vice-President,
2) 
Manufacturing
Controllable expense report:

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 Responsibility Accounting
Production departments 5,620 6,110 490U
Production manager’s
expenses 1,800 1,700 100F
Production engineer’s
expenses 1,300 1,220 80F
Total 8,720 9,030 310U

Vice-President,
3) 
Manufacturing
Controllable expenses summary
Sales manager’s expense 3,200 3,290 90U
Advertising expense 400 400 —
Credit expense 1,420 1,205 215F
Total 5,020 4,895 125F
Probably the most significant variances are in the production departments,
 490 × 100 
with an average unfavourable variance of 8.7 percent   of the
 5620 
budgeted amount and the credit department, with a favourable variance of
 215 × 100 
15.1 percent   of the budgeted amount. The credit department
 1420 
variance results primarily from a better than normal bad debt loss experience.
The production department’s variance should be investigated if 8.7 percent
appears large relative to past experience.
Illustration 2
Kelly Services Ltd. has five plants, A,B,C,D and E. Each plant has a
forming, cleaning and packing department. Each level of management at
the company has responsibility over costs incurred at its level. The budget
for the year ended March, 2021 has been set up as follows:
Plant Budgeted Cost (Rs.)
A 1,35,000
B 1,22,500
C 1,08,400
D 1,35,000
E 1,35,000
Budgeted information for Plant C is as follows:
Rs.
Plant manager’s office 2,350
Forming department 30,000
Cleaning department 55,450
Packing department 20,600

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Decision Making Budgeted information for Plant C forming department is as follows:
Rs.
Direct material 8,333
Direct labour 15,000
Factory overhead 6,667
The following additional budgeted costs available:
Rs.
President’s Office 16,250
Vice President-Marketing 20,000
Vice President-Manufacturing office 4,167
The following actual costs were incurred during the year:
Plant Budgeted Cost Rs.
A 1,27,650
B 1,24,300
C 1,08,475
D 1,31,100
E 1,36,800
Actual costs for Plant C Forming department were as follows:
Rs.
Direct materials 333 Under budget
Direct labour 4,000 Under budget
Factory overhead 333 Over budget
Actual cost for Plant C plant manager were:
Rs.
Plant manager’s office 2,475
Cleaning department 57,500
Packing department 22,500
Forming department ?
Actual costs for the president’s level were:
Rs.
President’s Office 16,375
Vice president-marketing 29,800
Vice-president-manufacturing 6,33,315
Prepare a responsibility report for the year showing the details of the
budgeted, actual and variance amounts for levels 1 through 4 for the
following areas:
Level 1-Forming department-Plant C
Level 2-Plant manager-Plant C
Level 3-Vice president-manufacturing
Level 4- President.

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Solution Responsibility Accounting

Kelly Services
Responsibility Report for the Year ended March 2021
Budgeted Actual Variance
Level 4- President Rs. Rs. Rs.
President’s Office 16,250 16,375 125
Vice-president---marketing 20,000 29,800 9,800
Vice-president-manufacturing 6,40,000 6,33,315 (6,752)
Total Controllable costs 6,76,250 6,79,490 3,173

Budgeted Actual Variance

Level 3-Vice President— 4,167 4,990* 823
Manufacturing
vice president manufacturing
office:
Plant A 1,35,000 1,27,650 (7,350)
Plant B 1,22,500 1,24,300 1,800
Plant C 1,08,400 1,08,475 75
Plant D 1,35,000 1,31,100 (3,900)
Plant E 1,35,000 1,36,800 1,800
Total Controllable costs 6,40,067 6,33,315 (6752)

Budgeted Actual Variance

Level 2 - Plant Manager—
Plant C:
Plant manager’s office 2,350 2,475 125
Forming department 30,000 26,000 (4,000)
Cleaning department 55,450 57,500 2,050
Packing department 20,600 22,500 1,900
Total Controllable costs 1,08,400 1,08,475 75

Budgeted Actual Variance

Level 1-Forming
Department-Plant C:
Direct material 8,333 8,000 (333)
Direct labour 15,000 11,000 (4,000)
Factory overhead 6,667 7,000 333
Total Controllable costs 30,000 26,000 4,000
* The difference in the actual total controllable cost arrived and the
figure as given in the illustration is to be treated as the actual cost of
manufacturing office of vice president.
c) Variance favourable (Figures within parentheses indicate favourable
variances)
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Decision Making
17.8 MEASURING SEGMENT PERFORMANCE
The primary purpose of a responsibility accounting is to determine the
individual segment performance of an organization. The managers of
different cost centres of the organisation are responsible to earn acceptable
profit measured in terms of segment margin, or rate of return on sales for
the profit centre. Segment margin represents the amount of income that has
been earned by the particular segment. The manager of an investment centre
is responsible for earning a rate of return on the segment’s investment in
assets. There are various criteria to measure divisional performance such
as profit on turnover, sales per employee and sales growth, etc. The most
popular criteria are:
1) Return on Investment (ROI)
2) Residual Income (RI)
17.7.1 Return on Investment
Divisional operating profit is generally, used as a common measure of
performance. But divisional profit by itself does not provide a basis for
measuring a divisions performance in generating a return on the funds
invested in the division. For example, Division A and Division B had
an operating profit of Rs.1,00,000 and Rs.80,000 respectively does not
necessarily mean that Division A was more successful than Division B.
The difference in profit levels may be due to the difference in the size of
the divisions. Therefore, a suitable measure may be used to scale the profit
for the amount of capital invested in the division. One common method is
Return on Investment (ROI) which will be calculated as follows capital
invested in the division. One common method is Return on Investment
(ROI) which will be calculated as follows:
Profit
Return on Investment = × 100
Capital Employed
or
Profit Profit
ROI = ×
Sales Capital Employed

If the investment in the Division A and Division B, in the above example

was Rs. 10,00,000 and Rs.5,00,000 respectively,
then ROI would be 10%
 Rs. 1,00,000 
 i.e., × 100
 Rs. 10,00,000 
and 16% If investment in respective divisions is considered, Division B is
more profitable than division A.
 Rs. 80,000 
 i.e., × 100 
 Rs. 5,00,000 

The ROI of partial segment must be high enough to provide adequate rate of
return for the firm as a whole. It is always better to require a segment to earn
362
a higher minimum rate of return on their investment. To improve this rate Responsibility Accounting
of return, a segment can increase its return on sales, increase its investment
turnover or do both. The other way of increasing ROI is to reduce expanses
and investment. If a segment reduces its investment without reducing sales,
its ROI will increase. The ROI for the firm as a whole must not fail to meet
the goals of top management. Though ROI is used widely to measure the
segment performance, it has many limitations. One of the most limitations is
that it can motivate managers to act contrary to the aims of goal congruence.
If managers are encouraged to have a high ROI, they may turn down
investment opportunities that are above the minimum acceptable rate, but
below the current ROI of the divisional performance. For example, where a
division earns a profit of Rs.1,00,000 for an investment of Rs.4,00,000, the
 1,00,000 
ROI is 25%  × 100
 4,00,000 
Suppose there is an opportunity to make an additional investment of
Rs.2,00,000 which would earn a profit of Rs.40,000 per annum. The ROI
 Rs. 40,000 
for additional investment is investment is 20%  i.e., × 100 
 Rs. 2,00,000 
Assume that the company requires a minimum requires a minimum return
of 15 per cent on its investment, the additional investment clearly qualifies,
but it would reduce the investment centre ROI from 25% to 23.3%
 Rs. 1,00,000 + Rs. 40,000 
 i.e., × 100
 Rs. 4,00,000 + Rs. 2,00,000 
Consequently the manager of the division might decide not to make such an
investment because the comparison of old and new returns would imply that
performance had worsened. The centres manager might hesitate to make
such investment, even though the investment would have positive benefit
for the company as a whole. To over come this drawback, Residual Income
Method is used to evaluate the acceptability of a project proposal.
Illustration 3
Peacock Company Ltd. has six segments for which the following information
is available for the year 31st March, 2021:
I II III IV V VI
(Rs. in (Rs. in (Rs. in (Rs. in (Rs. in (Rs. in
Lakhs) Lakhs) Lakhs) Lakhs) Lakhs) Lakhs)

Capital 1500 1200 3000 2400 4500 6000

employed

Sales 3000 3000 6000 3600 18000 12000

Net profit 150 300 150 720 450 1200

You are required to measure the performance of different segments.

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Decision Making Solution
The return on investment can be analysed as follows:
Segments
I II III IV V VI
Profit/ Sales (Profit ÷ Sales 5% 10% 2.5% 20% 2.5% 10%
× 100)
Turnover of capital (Sales ÷ 2 2.5 2 1.5 4 2
Capital Employed)
ROI (Profit ÷ Capital 10% 25% 5% 30% 10% 20%
Employed × 100)
The above analysis gives the following conclusions regarding the
performance of different segments:
1) The manager of segment I is not showing a satisfactory level of
ROI even though his turnover of capital is not too bad. He must be
motivated to increase his profit sales ratio.
2) Segment II is performing well as profit, sales ratio and turnover of
capital, are relatively good.
3) The performance of segment III is not satisfactory as its profit margin
and capital turnover is Poor.
4) The performance of segment IV is good as its profit margin is high
with a reasonable capital turnover.
5) In respect of segment VI, the manager should be motivated to increase
its profit margin but maintains a very good turnover of capital.
6) The manger of segment VI is performing well comparing to other
segments, as it maintains a good ROI, fairly good capital turnover and
reasonably good profit margin.
The segments which show a low capital turnover should be investigated and
remedial action should be initiated particularly in segments IV, I and III.
17.7.2 Residual Income
Residual income is the profit remaining after deduction of the cost of capital
on investment. It is the excess of net earnings over the cost of capital. Any
income earned above the cost of capital is profit to the firm. The cost of
capital charged to each division will be the same rate that is applicable to
the organization as a whole. The more the income earned above the cost of
capital, the better off the firm will be.
The Residual Income may be calculated as follows:
RI = Profit – (Capital Charge × Investment Centre Asset)
Where, capital is the minimum acceptable rate of return on investment.
This method is used as a substitute for or along with ROI as means of
evaluating managerial performance and motivates the managers to act to the
aims of goal congruence. The firm is interested to maximise its income above
the cost of capital. If the divisional managers are measured only through
ROI, they will not necessarily maximise RI. If managers are encouraged to
maximise RI, they will accept all projects above the minimum acceptable
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rate of return. That is why most managers recognise the weakness of ROI Responsibility Accounting
and take into account when ROI is lowered by a new investment.
Illustration 4
A division of a company earns a profit of Rs.1,00,000 for an investment of
Rs.4,00,000. There is an opportunity to make an additional investment of
Rs.2,00,000 which earns an annual income of Rs.40,000. You are required
to calculate residual income if the company requires a minimum return of
15 per cent on its investment and comment.
Solution
Before the additional Investment:
RI = Rs.1,00,000 - (15% of Rs.4,00,000).
= Rs.1,00,000 - Rs.60,000
= Rs.40,000
RI from additional Investment
RI = Rs.40,000 - (15% of 2,00,000)
= Rs.40,000 - Rs.30,000
= Rs. 10,000
Total Residual Income on an investment of Rs.6,00,000 is Rs.50,000.
The additional investment increases residual income and is improving the
measure of merformance.
Illustration 5
Sunrise Company has three divisions A, B and C. The investment in
these divisions amounted to Rs.2,00,000, Rs.6,00,000 and Rs.4,00,000
respectively. The profits in these divisions were Rs.50,000, Rs.60,000 and
Rs.80,000 respectively. The cost of capital is 10 per cent. From the above
data, comment the performance of the three divisions.
Solution
Divisions
A B C
Profit Rs. 50,000 Rs. 60,000 Rs.80,000
Investment Rs. 200,000 Rs. 600,000 Rs. 400,000
ROI 25% 10% 20%
 Profit   50,000   60,000   80,000 
  ×100   ×100   ×100   ×100
Investment 2,00,000 6,00,000 4,00,000

RI = Profit – Cost Rs. 30,000 NIL Rs. 40,000

of capital: (50,000– (60,000–10% of (80,000–10% of
20,000) 6,00,000) 4,00,000)

In terms of profit division C has done best performance. If evaluation is

done on the basis of ROI criteria division A is the best performer. If residual
income is the criterian, division C is the best.

365
Decision Making Check Your Progress B
1) What do you mean by ROI.
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………
2) Why do RI method is used to performance evaluation ?
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………
3) ABC Company has assets worth Rs.2,40,000, operating profit of Rs.
60,000 and cost of capital 20%. Compute Return on Investment and
Residual income
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………
4) Under what conditions would the use of ROI measure inhibit goal
congruent decision making by a division manager?
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………
5) What are the advantages of using Residual Income Method?
………………………………………………………………………
………………………………………………………………………
………………………………………………………………………
6) State which of the following statements is ‘True’ or ‘False’.
i) Administration and overhead costs should not be changed to
any segment in evaluating segment performance.
ii) Segment margin represents the amount of income that has been
earned by the organisation. 
iii) It is always better to have a minimum rate of return on investment
in the evaluation of segment performance.
iv) ROl and RI both the methods are to be used in performance
evaluation.

17.9 TRANSFER PRICING

Large businesses are organized into different divisions for effective
management control. When the business is organized into divisions and if
one division supplies its finished output as input to another division, there
arise the question of transfer pricing. Transfer price is the price at which the
supplying division prices its transfer of output to the user division. The price
assigned to the interdivisional transfer of output represents a revenue of the
366
selling division and a cost of the buying division. It should be noted that Responsibility Accounting
there is only an internal transfer and not a ‘sale’. Transfer prices are set at
the time of the transfer rather than waiting until the manufacturing process
is completed and the goods are sold to someone outside the company. As
the pricing of these goods or services is likely to have an impact on the
performance evaluation of divisions, setting an appropriate transfer pricing
is a problem. Questions like what should be the transfer price? Whether it
should be equal to manufacturing cost of selling division or the amount at
which the selling division could sell its output externally? Or should the
transfer price be negotiated amount between the selling division’s cost of
manufacturing and the external market price? etc. would arise. Selection of
transfer price to some extent depends upon the nature of the product, type
of the product and policy of the organization. Transfer would like to obtain
the highest possible price while the transferee would require the lowest
possible price. Goal congruence should be taken into account while fixing
the transfer price because the actions of one division should not have a
detrimental effect on the group as a whole.

17.10 METHODS OF TRANSFER PRICING

There are different methods for pricing the output of one division to another.
The selection of an appropriate transfer price will have significant impact on
decision mąking, product costing and performance evaluation of different
divisions in the organization.
Generally transfer pricing methods can be classified into two broad
categories. They
Market Price Based and (2) Cost-based. There are a number of alternative
methods within each of the above two methods and these are discussed
below.
17.10.1 Market Price Based
This method consist of the following methods:
a) Market Price
b) Adjusted Market Price, and
c) Negotiated Price
a) Market Price: When a market price is available or when there is a
comparable product on the market and its price is available, this price
can be used as a transfer price. Both the selling and buying divisions
can sell and buy as much as they can at this market price. Managers
of both the selling and buying divisions are indifferent trading with
each other or with outsiders. From the company’s perspective this is
fine as long as the supplying unit is operating at capacity. The market
price is useful for fixing transfer price when there is a competitive
external market for the transferred product. An advantage of this
method is that it can be regarded as the opportunity cost to a division
in so far as there is choice whether or not to purchase from external
market. Additionally managers have control over their transfer price
so performance measurement is facilitated. Another advantage of this
method is that it helps to assure profit independence of the divisions.
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Decision Making Any gain of the selling division do not get passed on to the buying
division.
b) Adjusted Market Price: This price is based on the above market
price, but it is adjusted to allow for the fact that such cost as sales
commission and bad debts should not be incurred within the divisions.
c) Negotiated Price: This price can occur when there is some basis on
which to negotiate between the divisional managers. The negotiated
price, normally, may be a market price or a cost price. For example, one
basis may be the contribution margin on the product being transferred
divided between the transferor and the transferee or it may be the total
cost which the transferer could suggest or the market price which the
transferee could suggest. Both the divisions could negotiate between
these two figures. Sometimes the negotiated price may be based on
manufacturing cost plus an extra percentage added to approximate
market price.
Whatever the basis chosen, the company should be careful in avoiding
arbitrary price between the divisions. The arbitrary price may be rewarding
to one division and prevailing to another division. Some times negotiated
prices are imposed by company top level, but this could not hamper the
autonomy of divisional managers and distorting the financial performance
of any division.
17.10.2 Cost Price Based
Another method to be followed for charging transfer price for the transfer
of output from one division to another division is Cost Price. When external
markets do not exist or when the information about external market prices
is not readily available, companies may elect to use some of cost based
transfer pricing methods as stated below:
a) Absorption Cost
b) Cost Plus Profit Margin
c) Marginal Cost
d) Standard Cost
e) Opportunity Cost
Let us study about these methods in brief.
a) Absorption Cost: Absorption or full cost is based on the total cost
incurred in manufacturing a product. When cost alone is used for
transfer pricing, the selling division cannot realise any profit on the
goods transferred. This method has a disadvantage that any excess cost
on account of inefficiency may be passed on to the other divisions.
b) Cost Plus Profit Margin: Under absorption costing when cost alone
is used for transfer pricing, the selling division cannot make any profit
on the goods transferred. This is disincentive to selling division. To
overcome this problem, some companies set transfer price on cost
plus profit margin. This includes the cost of the item plus a mark up
or other profit allowance. Under this method, the selling division
obtains a profit contribution on the units transferred. It also benefits
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 the transferring division if performance is measured on the basis Responsibility Accounting
of divisional operating profits. At the same time, it has also similar
drawback of absorption costing that the inefficiencies if any, may also
creep into the other divisions.
c) Marginal Cost: Another method to be followed for transfer pricing
is the marginal cost. All costs that change in response to the change in
the level of activity should be taken into account for the transfer price
while transferring output from one division to another division. But
this method fails to motivate divisional managers because it makes no
contribution towards fixed overheads and profit.
d) Standard Cost: If actual costs are used as the basis for the transfer,
any variances or inefficiencies in the selling division are passed
along to the buying division. To promote responsibility in the selling
division and to isolate variances within divisions, standard costs are
usually used as a basis for transfer pricing in cost based systems. Use
of standard costs reduces risk to the buyer. The buyer knows that the
standard costs will be transferred and avoids being charged with the
seller’s cost overruns.
e) Opportunity Cost: It represents the opportunity which has been
foregone by following one course of action rather than another.
Thus, if goods are transferred internally the organization could lose a
contribution to profit which could have been obtained from an external
sale. Generally, an opportunity cost approach will be used to establish
a range of transfer prices in situations where the market is imperfect.
If the selling division has sufficient sales in the intermediate market such
that it would have had to forgo those sales to transfer internally, the transfer
price should be equal to differential cost to the selling division plus implicit
opportunity cost to company if goods are transferred internally. The
formulae is:
Transfer Price= Differential cost to the selling division + Implicit opportunity
cost to company if goods are transferred internally.
Differencial costs are those costs that change in response to alternative
course of action. In estimating differential cost, the manager concerned unit
has to determine which costs will be effected by an action and how much
they will change. As long as the transfer price is greater than the opportunity
cost of the selling division and less than the opportunity cost of the buying
division, a transfer will be encouraged. A transfer is in the best interest of
the company if the opportunity cost for the selling division is less than the
opportunity cost for the buying division.
Transfer Prices are an important factor in the measurement of divisional
performance. Whatever the method of transfer pricing is adopted it should
be not only fair to each division concerned but it should also be in the best
interest of the company as a whole. Use of bad transfer price may lead to
conflict among the different divisions of the organisation and hamper the
ultimate objective of the enterprise.

369
Decision Making
17.11 LET US SUM UP
Responsibility cost information is one of the three types of management and
cost accounting information. The two others are full cost, and differential
cost information. Responsibility accounting, also called “Responsibility
reporting” is a system of responsibility reporting and control at each
managerial level. It is built around functional activity for which specific
managers are accountable. In designing a system; one has to look into its
structure and the process. The four fundamental principles or techniques of
responsibility accounting are: (i) Restructuring the organization in terms
of responsibility centres viz. cost revenue, profit or investment centres,
(ii) Bifurcating costs into controllable and uncontrollable categories, (iii)
Flexible budgeting, and (iv) Performance reporting. The first technique
gives the structure; and the other three the process of implementing
responsibility accounting. Since the focus is on responsibility centres,
it has several uses and gives many benefits. It is an important aid in the
management control process. A responsibility accounting system provides
information that helps control operations, and evaluate the performance of
subordinates. It facilitates corrective action, management by objectives, and
delegation of authority. It is a morale booster too as rewards are linked to
the accomplishment. The success of the system depends, apart from other
things, on active cooperation amongst the managers. Further, it is adopted
by large decentralized organizations where departments and divisions could
be treated as managerial levels of responsibility.
The primary purpose of responsibility accounting is to measure the
performance of individual divisions. The most popular criteria to be used in
measuring the divisional performance is Return on Investment and Residual
Income.
Transfer price is the price at which the supplying division prices its transfer
of output to the user division. The selection of an appropriate transfer price
will have significant impact on decision making and performance evaluation
of different divisions of the company. There are different methods at which
transfer price can be set. These methods can be classified as Market Price
based and Cost based. The market price based consists of (a) market price,
(b) adjusted market price, and (c) negotiated price methods. Cost based
method may again be sub-divided into (a) absorption cost (b) Cost plus
profit margin, (c) Marginal Cost, (d) Standard cost and (e) Opportunity cost
methods. Whatever the method of transfer price followed, the divisional
managers should not forget goal congruence of the organisation because the
action of one division should not have a detrimental effect on the group as
a whole.

17.12 KEY WORDS
Cost Centre: A responsibility level where employees are concerned only
with cost management.
Controllable Cost: A cost for which the departmental supervisor is able to
exert influence over the amount spent.

370
Flexible Budget: A budget prepared using the actual sales volume realized Responsibility Accounting
by a segment. It is used for computing the effects of differences between
actual sales prices and costs, and budgeted sales prices and costs on the
profit goals of the segment.
Investment Centre: A responsibility level whose manager is concerned not
only with cost management but also with revenue generation and investment
decisions. -
Management by Exception: A management principle by which managers
concentrate their attention on exceptional or unusual items in the performance
reports.
Non-controllable Cost: A cost assigned to a department or responsibility
centre that is not incurred or controlled by the department head.
Negotiated Price: Either the market price or cost price which is negotiated
between divisional managers.
Performance Report: A report produced by each decision centre which
discloses budgeted and performance measures, and variances from the
budget.
Profit Center: A responsibility level in which performance is measured
in terms of budgeted profits and has responsibility for both income and
expenses.
Responsibility Centre (RC): A unit or segment of the organization in which
a specific manager has the authority and responsibility to make decisions.
Transfer Price: The price at which the supplying division prices its transfer
of output to the user division.
17.13 ANSWERS TO CHECK YOU PROGRESS
A) 4) i) True ii) False iii) True
   iv) False v) True
B) 3) ROI : 25% and RI : Rs. 1200
6) i) True, ii) True, iii) False, iv) True
17.14 TERMINAL QUESTIONS
1) “Responsibility accounting is a responsibility set-up of management
accounting”. Comment.
2) Define Responsibility Accounting. How does it differ from
conventional cost accounting?
3) Is it fair to opine that responsibility accounting is a method of
budgeting and performance reporting created around the structure?
4) Explain ‘how the choice’ of the responsibility center type (cost
revenue, profit or investment) affects budgeting and performance
reporting.
5) Explain clearly the terms cost centre, revenue centre, profit centre,
and investment centre, and their utility to management.
7) a) 
Why should non-controllable costs be excluded from
performance reports prepared in accordance with responsibility
accounting?
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Decision Making b) Why is a flexible budget rather than a stable budget used to
evaluate production departments?
8) How may controllable and uncontrollable costs be handled in a
responsibility accounting system?
9) Give the pre-requisites for the success of a responsibility accounting
system.
10) The following information related to the operating performance of
three divisions of a company for the year 2021.
Division
A B C
Contribution (Rs.) 50,000 50,000 50,000
Investment (Rs.) 4,00,000 5,00,000 6,00,000
Sales (Rs.) 24,00,000 20,00,000 16,00,000
No. of employees 22,500 12,000 10,500
You are required to evaluate the performance using rate of Return on
Investment (ROI) and Residual Income (RI) criteria.
11) The operating performance of the three divisions of Excel Company
Ltd. for 2021 is as follows:
Division
A (Rs.) B (Rs.) C (Rs.)
Sales 3,80,000 17,00,000 20,00,000
Operating Profit 20,000 50,000 1,00,000
Investment 2,00,000 6,25,000 8,00,000
a) Using the rate of return on investment and residual income as
the criteria which is the most profitable division?
b) Which of the two measures in your opinion gives the better
indication of over all performance.
13) The managers of Divisions X and Y in Beta Company Ltd. are
considering the possibility of investment in a project. The estimated
cost of the proposed project to be Rs. 2,00,000. The present ROI of
X and Y divisions are 10 per cent and 25 per cent respectively. The
Company uses a cost of capital of 15% in evaluating the projects. The
details of the project are as follows:
Division
X (Rs. ’000) Y (Rs. ’000)
Investment Rs.400 Rs.400
Life in years 10 10
Estimated costs and revenues:
Revenue 420 440
Costs:
Direct materials 200 160
Direct wages 40 80
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 Responsibility Accounting
Power 20 20
Consumable stores 12 12
Maintenance 20 8
Depreciation 80 80
Total Cost 372 360
Surplus 48 40
You are required to evaluate the proposals on the basis of ROI and RI and
also comment.

17.15 FURTHER READINGS

J. Lewis Brown, Leslie R. Howard, Managerial Accounting and Finance,
Machonald & Evans Ltd., London.
Davidson, Maher, Stickney, Weil, Managerial Accounting, Holt-Sounders
International Editions, New York.
Nigam and Sharma, Advanced Cost Accounting, Himalaya Publishing
House, Bombay.
Arora, M.N., Cost Accounting, Vikas Publishing House Pvt. Ltd., New
Delhi.

Note : These questions will help you to understand the unit better. Try to
write answers for them. But do not submit your answers to the University.
These are for your practice only.

373
 UNIT 18 CONTEMPORARY ISSUES IN
MANAGEMENT ACCOUNTING - I
Structure
18.0 Objectives
18.1 Introduction
18.2 Scope and Limitation of Conventional Financial Accounting
18.3 Inflation Accounting
18.4 Human Resources Accounting
18.5 Social Accounting
18.6 Environmental Accounting
18.7 International Accounting
18.8 Strategic Cost Management
18.9 Activity Based Costing
18.10 IT Developments in Accounting
18.11 Let Us Sum Up
18.12 Terminal Questions
18.13 Further Readings

18.0 OBJECTIVES
The objectives of this unit are to:
●● explain some of the recent developments in financial and management
accounting;
●● give an overview on special accounting issues like inflation
accounting, human resources accounting, environmental accounting
and international accounting;
●● give an overview on activity based costing and cost reduction
methods; and
●● review developments of information technology that are related to
accounting.

18.1 INTRODUCTION
The primary role of accounting is to record financial transaction and
summarise the same in a useful format. Financial accountants prepare three
principal financial statements by summarising huge volume of financial
transactions namely Profit and Loss Account, Balance Sheet and Cash
Flow Statement. While these three are reported in annual reports, they also
prepare a number of statements for internal purpose. Cost Accountants
prepare a number of statements mainly for internal purpose and the primary
objective of the exercise is to find out the cost of production. However, the
world of accounting or accountant is fast changing. Modern accountants are
expected to be more intelligent than doing a mere compiling job. You might
374
have seen that even smaller companies are started using computer software Contemporary Issues in
for accounting. With simplification in tax laws, the role of accountant in Management Accounting - I
tax administration is also diminishing. Accountants are also expected to
provide more information about the non-conventional information. When
machines dominate industrial world, accountants are asked to provide
more information about material things of the firm. Today, in many firms,
knowledge is asset. Since financial reports stated above are not geared
to provide such information, accountants are asked to provide additional
information. There is also lot of concerns about the social behaviour of
corporate sector. Hence many are interested in knowing the firms’ effort on
social responsibility and environment. Special reports are devised to address
some of these issues. In this unit, we will briefly discuss some of these
reports and recent developments. Each item discussed here are full subject
on its own and depending on your interest, you can specialise in one or more
of the subjects either taking up some specific issue and mastering them by
reading some specialised books or attending some courses on these topics.
It is to be noted that accountants today, are expected to be more intelligent
since computers replaced conventional accountants in many firms.
Activity 1
1) It is the time for you to interact with some of your friends who are in
accounting profession. Have a general chat with them and note down
what they have observed as recent trends in accounting profession.
..............................................................................................................
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) Take any annual report of some well known companies and find out
how much of space they spend in providing non-financial information?
..............................................................................................................
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.2 SCOPE AND LIMITATION OF

CONVENTIONAL FINANCIAL
ACCOUNTING
It is interesting to know why companies are suddenly focussing on some
of the reports, which we mentioned in the introduction. Alternatively, what
is the wrong with the conventional accounting reports? Accounting reports
such as profit and loss account, balance sheet and cash flow statements
provide wealth of information but the question is whether it is adequate to
know about the current or future performance of the companies. Secondly,
not all stakeholders are interested only in knowing the profit or income
details. Future of companies depends on current strength and such strength

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Decision Making is not reflected in the accounting reports. This is particularly true for new
economy or knowledge based companies, which is seeing phenomenal
growth in recent times. Also, many stakeholders would be interested to
corporate social behaviour. Some of the prominent limitations are listed
below:
a) The balance sheet is often based on historical value. It fails to show
the true value of the firm in that context. Suppose a company owns
10 acres land in Delhi or Mumbai, which was purchased some 40
years back at the rate of Rs. 10000 per acre. Is it right on the part of
the company to show the value of the land at the same price in 2003
when the cost of land is several 100 times more than the purchase
value? The above applies to many industrial machines which are used
in the firm but are efficiently managed beyond their normal life. How
to reflect true and fair value of such assets?
b) Is human resource of a firm not an asset? Today, every company is
proudly stating that they have so many engineers, doctors, etc. in their
company. If so, what is the value of such intangible pool of expertise
inside the company? Conventional accounting treat salaries and
wages paid to such employees as an expense but fails to recognise the
value of human resources.
c) Can a company be focussed narrowly and always aiming to maximise
profit? Is it not fair to provide something to society particularly
when they spoil natural resources in their normal operation? Many
developed nations are shifting their high-pollution industries to the
third world countries to have a clean air in their countries. When
these countries shift their base to third world nations, it is legitimate
expectation of the citizens of these countries that these companies
spend sufficient amount to control pollution and other side effects.
d) Companies have changed the way in which it is operating business.
Many concepts such as just in time (JIT), Total Quality Management
(TQM), Flexible Manufacturing System, etc. are common today.
But only very few companies have changed their costing system.
For instance, salaries and wages of many manufacturing companies
constitute an insignificant portion of the total cost but our costing
system not only report the labour cost but also uses the same as cost
allocation basis in some cases. Is it not desirable to change our costing
system to get some reliable cost data?
e) Traditionally, firms use IT only for accounting purpose and such
accounting was standalone without any linkages to mainstream
business operation. Today, accounting information is extensively
used and also IT is extensively used throughout the organisation. Is it
right or economical or efficient to have standalone IT system for each
functional area? Is it not desirable to have an integrated accounting
system or more specifically enterprise wide resource planning (ERP),
which performs not only accounting but several other business
operations in a total integrative manner?

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Activity 2 Contemporary Issues in
Management Accounting - I
1) We listed few reasons why accounting or accountants need to change
from conventional outlook. Can you apply these ideas into anyone of
the companies or to your own company and list out your findings?
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) Find out from your IT friend how ERP is different from that of
accounting pages like Tally.
..............................................................................................................
..............................................................................................................
..............................................................................................................
3) Do you feel that spending money on social and environment is wastage
of corporate resources? What do these firms get in return by spending
such amount?
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.3 INFLATION ACCOUNTING

Inflation rate is the percentage change in the price level from the previous
period. The primary objective of inflation accounting is to correct
conventional historical cost accounts for the understatement of inventory
and plant used in production, i.e. the cost of goods sold and depreciation,
in order to prevent erosion of capital during inflation. That is, inflation
accounting is used to provide information that is useful to present and
potential investors and creditors and other users in making decisions (and) in
assessing the amounts, timing, and uncertainty of prospective cash receipts
from dividends or interest and the proceeds from the sale, redemption, or
maturities of securities or loans. Inflation accounting was of interest when
many developing economies were suffering inflation rates of 25% or more.
Now that rates are in single figures, the debate on the need of inflation
accounting is subdued. Some of the related objectives are:
a) To show the real profit and loss for the period under consideration as
against the profit or loss on the basis of historical cost;
b) To show the real value of the assets and liabilities instead of historical
cost; and
c) To ensure that sufficient funds will be available to replace the various
assets when the replacement becomes due.
This objective is generally achieved by the current cost method, which is
also much more responsive to the general objectives of financial reporting.
There are alternative methods like Current Purchasing Power Method,
Constant Dollar Accounting Method, etc. Under the current cost accounting
method, fixed assets, stocks, stocks consumed, etc. are shown in the financial
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Decision Making statements at their value to the business and not at the depreciated value or
original cost. Depreciation for the year is calculated on the current value
of the fixed assets. All these things normally leads to reduction in profit
worked out under this method compared to normal historical based profit.
Since the discussion beyond this input is out of the scope of the subject,
interested students are advised to refer to Statement of Standard Accounting
Practice (SSAP) 16.
There are limitations to inflation accounting and the failure to recognize them
has led to unnecessary complexity in some methods. Inflation accounting
cannot isolate or condense into one earnings number all of the effects of
inflation on a company. It is simply an improved system of measurement
which brings financial statements into harmony with current costs and
values. Such improved statements provide a foundation for analysis of
a company’s economic earnings and financial position in an inflationary
environment, including any special effects of inflation.
Activity 3
1) What is the purpose of using inflation index in the preparation of
accounting?
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) Suppose a company provides inflation-adjusted accounting. In your
opinion, who gains most by using such accounting statement?
..............................................................................................................
..............................................................................................................
..............................................................................................................
3) Identify a few old cement or fertiliser companies, which have been
established some 20 years back. Compare their book value and market
value of the company or price per share. Do you feel that the book
value is not representative of current market value? If so, do you feel
that use of inflation accounting resolve such inconsistency?
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.4 HUMAN RESOURCES ACCOUNTING

In the case of manufacturing firms, most of the assets are in physical form.
These could be easily traced and valued. Hence it’s not much difficult to
find the value of the firm. Other than the physical assets, manufacturing
firms also have assets like intangible assets like goodwill, brand value, etc.
are to a greater extent possible to give an approximate value. The most
important is human capital, the ability of employees to do the things that
ultimately make the company work and succeed, particularly in the case of
software firms, the main asset is human being. Is it possible to value human
being? Can we assign a value every individual in the firm? Should we have
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to value the human beings, just because they form the main asset in the IT Contemporary Issues in
firms? Yes it is utmost necessary. As in most software companies though the Management Accounting - I
projects are completed on a team basis, the skills of each individual and his
contribution is utmost important. Further, its not only important only for IT
firms it could also be more helpful if such value is given to employees in
manufacturing firm also, so that human beings get to know what is the value
they are contributing to the organisation and how much are they able to
improve in providing the value addition. Hence human resource accounting
became important. But not every company understands their contribution to
the bottom line or knows how to manage them to drive even better financial
results, even though they account for as much as 80 per cent of the worth
of a corporation.
What is needed is measurement of abilities of all employees in a company,
at every level, to produce value from their knowledge and capability.
Human Resource Accounting (HRA) is basically an information system
that tells management what changes are occurring over time to the human
resources of the business. HRA also involves accounting for investment in
people and their replacement costs, and also the economic value of people
in an organization. The current accounting system is not able to provide the
actual value of employee capabilities and knowledge. This indirectly affects
future investments of a company, as each year the cost on human resource
development and recruitment increases.
The information generated by HRA systems can be put to use for taking
a variety of managerial decisions like recruitment planning, turnover
analysis, personnel advancement analysis and capital budgeting, which
can help companies save a lot of trouble in the future. In India, there are
very few companies like BHEL, Infosys and Reliance Industries, which
have implemented HRA and some are working on it. Infosys, which started
showing human resource as an asset in its balance sheet, has been reaping
high market valuations.
Companies can derive many benefits by going in for HRA. Not only
can they measure the return on capital employed on total organisational
assets (including the human assets), but the resources can also be planned
accordingly. Once organisations realise the actual benefit and take it as a
growth process, it will only help them in increasing their shareholders’
value. When a company is able to assess an individual’s worth, it helps
in increasing its own worth. Basically HRA can be tracked through two
methods: cost-based analysis and value-based analysis. The cost-based
approach focuses on the cost parameters, which may relate to historical
cost, replacement cost, or opportunity cost. The value-based approach
suggests that the value of human resources depends upon their capacity to
generate revenue. This approach can be further sub-divided into two broad
categories: non-monetary and monetary.
The disposition of resources can also be examined by allocating relative
human asset values to different job grades. HRA also helps in examining
expenditure on personnel and in re-appraisal of expenditure on services and
training. It can also serve as a key factor in case of mergers and takeover
decisions, where the human asset value becomes a relevant factor. Another
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Decision Making very significant role, which HRA can help in creating, is goodwill for a
company. The company can project itself in having best practices with
superior policies in place. Experts believe that this may help the organisation
attract more investments.
Infosys in its balance sheets shows Human Resources value at Rs. 9539.15
cr. as on March 31, 2002. The HRA section of Infosys Annual Report states
the following:
The dichotomy in accounting between human and non-human capital is
fundamental. The latter is recognized as an asset and is therefore recorded
in the books and reported in the financial statements, whereas the former
is totally ignored by accountants. The definition of wealth as a source
of income inevitably leads to the recognition of human capital as one of
several forms of wealth such as money, securities and physical capital.
The Lev & Schwartz model has been used by Infosys to compute the value
of the human resources as on March 31, 2002. The evaluation is based
on the present value of the future earnings of the employees and on the
following assumptions:
1. Employee compensation includes all direct and indirect benefits
earned both in India and abroad.
2. The incremental earnings based on group/age have been considered.
3. The future earnings have been discounted at 17.17% (previous year
– 21.08%), this rate being the cost of capital for Infosys. Beta has
been assumed at 1.41 based on the average beta for software stocks
in US.
While HRA as a concept has been present in India for more than a decade,
with BHEL taking a lead, it is only now that the awareness is being translated
into application. However, in terms of awareness and acceptance, the level
is still low as many companies take little initiative to make the numbers
public to shareholders, despite having the data. And there is a lack of an
industry standard. This means that every company has to evolve its own
standard, which can become a tedious process, considering that most of
them are still involved in improving their business. Industry bodies like
Nasscom can help set a standard.
Activity 4
1) What is HRA? How different is it from Human Resource Management.
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) How wide is the application in the area of human resources valuation
in India? Name few companies that are implementing HR valuation.
..............................................................................................................
..............................................................................................................
..............................................................................................................

380
3) What are the benefits of human resource accounting for the companies Contemporary Issues in
and also for the employees? Management Accounting - I

..............................................................................................................
..............................................................................................................
..............................................................................................................

18.5 SOCIAL ACCOUNTING

Social accountability is about being answerable to the people affected by your
actions. Leading organizations now engage relevant stakeholders, including
employees, suppliers, consumers, regulators, NGOs and communities, in
open, consequential dialogue at all levels of business decision-making
and activity. They also volunteer information to these stakeholders on
their social performance, thereby making themselves accountable to these
interest groups. Social and ethical accounting, auditing and reporting
is still relatively new in many developing or third world nations, but is
gaining acceptance internationally as the primary demonstration of social
accountability. A social report is the result of a thorough evaluative process
focused on the social impact of a business on all its various stakeholders.
Social accounting and audit is a framework which allows an organisation
to build on existing documentation and reporting and develop a process
whereby it can account for its social performance, report on that
performance and draw up an action plan to improve on that performance,
and through which it can understand its impact on the community and be
accountable to its key stakeholders. The social accounting process should
be driven by a rigorous methodology that involves the collection, analysis
and interpretation of quantitative and qualitative data. The accounting
systems should be standardized to facilitate verification by a third party. A
social report represents the disclosure of the company’s social performance
in the same way that the annual report discloses financial performance.
Social accounting is not just a public relation exercise but a strategic
intervention that, in addition to disclosing social performance, serves to steer
the company in a transformation process. This strategic effect is achieved
by adhering to the principle of full disclosure. Both negative and positive
performances are declared in the final report. Consequently the corporation
is compelled to perform and the social report has a level of legitimacy that
run-of-the-mill PR efforts do not have.
Effective reputational risk management contributes significantly to gaining
and maintaining a competitive advantage. Today’s informed consumers are
increasingly concerned with the ethical characteristics of a business. And
companies that have values closely aligned with wider societal demands are
better placed to recruit and retain talented employees. A brand associated
with ethical business conduct is better protected in the global market
because it enjoys hardier loyalty. Engaging in a social accounting process,
thoroughly and transparently, will enhance your company’s competitive
edge. Some of the social indicators are as follows:
1) Quality of Management
2) Human Rights
381
Decision Making 3) Environmental Performance
4) Health and Safety
5) Stakeholder Relationships
6) Corporate Social Investment
7) Employment Equity
8) Products and Services
Through dialogue with stakeholders, an organization identifies social and
ethical indicators that will objectively reflect its performance in relation to
corporate values and objectives. The choice of indicators is based on the
organization’s statement of values and the standards, codes and guidelines
to which the organization subscribes; on stakeholders’ perception of the
organization’s performance against its values, and in respect of their specific
needs and concerns; and on best practices established in societies that are
part of the social accounting scope, weighed against the societal needs of
the South African context.
Decision-makers must consequently determine which parts of the
organization, such as divisions, departments or sites, are to be measured.
The process of improving social and ethical performance takes time and
an organization may choose to limit disclosure while setting performance
targets and goals for more comprehensive reporting over time. These
decisions should be declared in the social report if credibility is to be
maintained. Once indicators have been established and the parts of the
organization to be evaluated identified, relevant data must be collected.
Initially this may prove challenging because there is seldom a system in
place for deliberately measuring social impacts. Producing the first social
performance report will educate the organization as to the nature of Social
Impact Accounting Systems (SIAS) needed for rigorously and objectively
measuring performance.
Collected data is analysed and a social performance report is produced.
The manner in which publication and distribution is addressed may be
taken as indicative of the organization’s commitment to ethical and socially
responsible business practice. Consequently, the report should be afforded
the care and status devoted to the traditional annual report on financial
performance. And in the same way that a company’s financial performance
is audited for assurance, social performance should be submitted to the
same intense scrutiny.
The core business of community and social enterprises and of community
organisations is to achieve some form of social, community or environmental
benefit. Financial sustainability or profitability is essential to achieving that
benefit, but subsidiary to it. The organisation and all the people associated
with it or affected by it need to know if it is achieving its objectives, if it is
living up to its values and if those objectives and values are relevant and
appropriate. That is what the social accounting process aims to facilitate.
A full set of Social Accounts is likely to include the following:
1) A report on performance against the stated objectives (How well have
we done what we said we would do?)
2) An assessment of the impact on the community (Can this be measured?
382
 What do people think?) Contemporary Issues in
Management Accounting - I
3) The views of stakeholders on our Objectives and Values (Are we
doing the “right” things? Are we “walking our talk”?)
4) A report on environmental performance (Are we “living lightly” and
minimizing resource consumption?)
5) A report on how we implement equal opportunities (Do we effectively
encourage social inclusion?)
6) A report on our compliance with statutory and voluntary quality and
procedural standards (Do we do what is expected of us, and more?)
Keeping social accounts gives us the information we need qualitative and
quantitative to tell us how we are performing and what people think about
what we do, and how we do it. This is a social balance sheet so that all
stakeholders can decide for themselves whether to use, work for, support,
or invest in the organisation. Through the production of audited social
accounts the organisation can fulfil its accountability to its stakeholders.
The overarching principle of social accounting and audit is to achieve
continuously improved performance relative to the chosen social objectives
and to the stated values. Six specific key principles have been identified from
recent theory and practice as underpinning the concept and good practice.

18.6 ENVIRONMENTAL ACCOUNTING

Environmental accounting is defined as the accountants’ contribution
towards environmental sensitivity in organizations. It gained prominence
in the 1990s. The emphasis on the social responsibilities of the accountancy
profession is not new, having been led to prominence by the social accounting
debate of the 1970s. The social consciousness of the accountancy profession
was started to receive its attention. It focused on extending accountability
to numerous stakeholders by necessitating disclosure of social information
in corporate annual reports. The accountability function of accounting was
believed to be fulfilled by reporting (financial and social) information that
stakeholders would find useful in their decision making process.
This led to the appearance of environmental, employee and ethical
information on a voluntary basis in modern day corporate annual reports.
Unfortunately, social accounting as discussed in the earlier section, failed
to make its way into the mainstream accounting agenda, largely due to lack
of mandatory standards to guide it and value judgments associated with
determination of social responsibilities of an organization. In spite of this,
there has been renewed interest in social accounting in the 1990s, triggered
by the urgency associated with reducing environmental problems that exist
today.
Practical developments of environmental accounting saw tremendous
growth in research, with various initiatives and proposals being put
forward by accountancy bodies and related international organizations.
In essence, environmental accounting now plays a vital role in daily
commercial undertakings, attempting to ensure that development is not
at odds with environmental protection. The potential for accountants to
make a significant contribution towards environmental consciousness

383
Decision Making in organizations has been envisaged through their managerial, auditing
and reporting skills. Increasingly, the emphasis has shifted from social
accounting in general to a more specific environmental accounting. These
days, social accounting has become synonymous with the term social and
environmental accounting (SEA), a linkage that places due emphasis on the
importance of environmental issues.
The fundamental premise behind environmental accounting is that
organizations should internalize environmental costs. Currently, these
costs are externalized, which means that the society bears the impact of
an organization’s adverse activities on the environment, largely due to the
fact that is a “public good”. Internal environmental accounting mechanisms
such as life cycle costing or even full cost accounting attempt to trace
costs of the organization’s activities on the environment. It is believed that
once organizations are made accountable for these costs, they would be
compelled to minimize the potentially harmful effects of such activities.
Further, environmental accounting requires organizations to forecast the
potential environmental impact of their activities and accordingly estimate
contingent liabilities and create provisions for environmental risk.
Accountants’ role in environmental issues extends beyond management of
the internal mechanisms (environmental management accounting). They
could be responsible for the disclosure of environmental information,
primarily in corporate annual reports, but also through some other
communication media. Environmental reporting provides accountability
to the wider society of the organization’s commitment to environmental
consciousness. Disclosure could constitute monetary information such
as environmental costs, liabilities, provisions and contingencies, coupled
with quantitative and descriptive information such as ecological data (for
example, physical measurement of environmental impacts), environmental
policies, targets and achievements.
The Environmental Accounting was first considered a new field in accounting
in during 1998 by the intergovernmental work group ISAR (United
Nations Inter governmental Working Group of Experts on International
Standards of Accounting and Reporting). Jointly with this work, ISAR
has been coordinating efforts with IAPC (International Auditing Practices
Committee) to formalize a group of audit standards for verification of
the environmental performance reported on accounting statements. This
work group basically emphasised the need for environmental accounting
to cover the following basic objectives: (a) assistance of professionals in
other fields of knowledge; (b) give the status of the information system of
the analyzed company, as regards the preparation of its internal controls to
provide its financial accounting with relevant information on environmental
aspects; and (c) effective contribution of various external intervenors, as the
consulting specialists, certification companies and independent auditors, to
grant an independent opinion on specific aspects of the report.
The concept of sustainable development catching on rapidly, corporate
and industrial houses across the world are increasingly incorporating the
environmental element in their day-to-day business operations. They are
clear in their perception that along with quality, safety of the environment,
too, is an important factor in making a business successful.
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Activity 5 Contemporary Issues in
Management Accounting - I
1) Take the annual report of top 5 companies in the Petrochemicals
industry and find out which part of the report covers the environmental
accounting if given?
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) How efficiently companies follow the environmental accounting
requirements? Do you find any deviance from what they actually
practice and what they report in their financial reports? If so, given an
instance of any company violating the same.
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.7 INTERNATIONAL ACCOUNTING

Many Indian companies, particularly in pharmaceutical and software
industry have overseas operations. With trade liberalisation in place, many
Indian companies would be future multinationals. When firms operations
move international, not only on manufacturing and marketing but also
investors, accounting of different business operations located at different
countries under one roof becomes difficult. There are two potential problems
that an accountant faces in dealing with such consolidation.
Accounting standards differ in several countries and investors of those
countries require the financial statements using their countries accounting
standards to enable them to compare the company with other company.
For instance, if you are a shareholder of Hindustan Lever Ltd., or Castrol
India Ltd. you would like to have the financial statements under Indian
GAAP. Think about an investor of Unilever located either in Netherlands
or UK, who has majority stake in Hindustan Lever. While consolidating
the Hindustan Levers Ltd. financial statements with Unilever statements,
the investors of Unilever expects Hindustan Levers Ltd., financial data
also reflects their countries GAAP. The task turns complex further if the
shareholders are located in different countries. For instance, Infosys or
many other top rated Indian companies shares are held by several FIIs
whose investors are located across the globe and investors of ADR of these
companies are also located in different parts of globe. If Infosys prepares
financial statements only on the basis of Indian GAAP, they will not be
happy. By virtue of agreement with overseas stock exchanges, Infosys may
be required to present a separate statement following the US GAAP. But
what about the investors in Japan, who has also purchased shares of infosys
either directly or indirectly through FII. Today, many companies started
giving separate financial statement using major countries GAAP to satisfy
the investors of those countries. While it adds cost of compiling financial
reports, it brings lot of goodwill.
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Decision Making Firms operating in different countries also have certain peculiar problem.
For instance, your company’s overseas venture would have posted increased
profit during a period but when you convert the profit in your currency,
you might be alarmed to see that profit has actually come down from the
previous year if there is a currency depreciation in the country. On the other
hand, the performance of overseas country might have actually come down
but when we convert the same to our currency, the performance might have
improved if our currency appreciates during the period. Handling multi-
currency business operations in consolidation is another complex task in
international accounting.
Activity 6
1) Collect or download from the company’s website the annual report
of Infosys or Wipro or Asian Paints. Read the statement of significant
accounting policies of consolidated financial statements. List down
your observation/understanding?
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) Visit http://www.icai.org and locate Accounting Standard page.
Download AS 21 and AS 27. Write a one page note on each accounting
standard after reading the same.
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.8 STRATEGIC COST MANAGEMENT

The field of management accounting has also seen considerable changes in
recent times. When industrialisation was limited and economies were closed
for external competition and also having restricted internal competition,
managers decision making scope was normally restricted to few operational
decision making such as production optimisation, product mix, setting
discount policies, etc. Conventional cost and financial accounting provide
adequate information for such decisions. However, over a period of time,
business environment has completely changed and internal and external
competitions have become the order of the day. Top management of any
firm, small, medium, large or multinational, are increasingly spending
time on strategic decision and cost and financial data are extensively used
along with input drawn from the environment, which includes competitors’
financial and non-financial information. A new discipline called ‘strategic
cost management’ or ‘strategic management accounting’ addresses these
issues. The following issues are typically addressed using cost input from
strategic perspective:
a) Value Chain Analysis : Let us take an example of a product say
television which we use daily in our life to understand the concept. The
television set which you are using is giving you some value - educative
or entertainment value. There are so many organisations, which are
386
 involved in the whole process of manufacturing and delivering the Contemporary Issues in
television to you. All these organisations are adding value at each Management Accounting - I
stage to the product and what you get finally the collective amount
of all value addition. The value chain analysis looks into how much
of value addition has taken place at each stage of the whole process.
It helps the organisations to identify the place where they need to
be there to maximise the reward and at the same time using their
expertise. If all organisations try to reduce the total cost of the value
chain, then customers get benefit out of such exercise. For instance, if
you are manufacturing PET bottles, which are used by many mineral
water manufacturing companies you have two options in setting up
your plant. One, you can put up a centralised huge plant to achieve
economies of scale but force your customers to hold more inventory
since without bottles, it is difficult to run the plant. Alternatively, you
can put up smaller plants near manufacturer. While this will add cost
of manufacturing, but it will bring down inventory level. As PET
bottle manufacturer, you need to look beyond your costing and see
the value chain.
b) Activity-based-costing (ABC) : ABC looks into a firm as a bunch of
activities and hence focuses more on activity analysis, cost associated
in performing such activities and then finally ways to perform the
activities better while reducing the cost. ABC provides more accurate
cost data than conventional costing system and such reliable costing
is often required for strategic decision. ABC is also useful to identify
value added and non-valued activities.
c) Customer cost analysis : Do you feel all your customers are
equally important to you? If you ask this question to MD of a large
company, the answer will be most probably ‘Yes’ since today every
company wants to be customer focussed and it is immaterial whether
the customer is small customer or large customer. Suppose you ask
another question to the same MD - are all your customers equally
profitable? The answer need not be ‘Yes’ and often the answer is
‘No’. Customers are increasingly demanding and hence the cost of
providing services to customers significantly differ from customers
to customers. How many companies trace the cost up to the customer
level? They normally stop costing exercise upto the product level and
that too with some ad hoc overhead allocation. You need reliable cost
data to measure customer profitability.
d) Competitor cost analysis: Can you run a company without
understanding competitor? The answer would be probably ‘yes’ in
some 15 years back and today it is a strong ‘NO’. What do you want
know about the competitor ? Apart from several other things, you
would like to know their cost structure. An understanding of their
cost structure is helpful in several ways. For instance, if the material
cost of the competitors is lower than your company, you can start
looking for alternative source of buying or changing material quality
or change.
e) Target costing: Here, costing of product starts before the product
gets into the production stage. Many experts find that the best way to reduce
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Decision Making the cost is spend time while products are under development. Because, once
a product design is completed, about 80% of the costs are pre-determined.
For instance, imagine you want to construct a hotel and run profitably. The
operating cost of running a hotel is relatively small compared to fixed cost.
So the best way to reduce the cost is to spend more time and energy in
drawing the construction plans and economically using the space, material
and other items. This applies to many manufactured products like watch or
television or air-conditioner. Target costing is done with the help of set of
employees drawn from several functional areas, who together participate in
the development exercise with a single goal of designing a product whose
cost is less than target cost.
In addition to the above, there are several other strategic cost management
techniques like life-cycle costing, capacity costing, etc. For all these
techniques, activity based costing is used as a principle cost information.
we will discuss briefly the activity based costing. Under 19.9 of this Unit.
Activity 7
1) How value chain analysis is different from value analysis?
..............................................................................................................
..............................................................................................................
..............................................................................................................
2) Indian Railways moves passengers and goods from one place to other
place. Can you perform value chain analysis for Indian Railways
and find out how they can add value to passengers and business
communities, which use the freight service?
..............................................................................................................
..............................................................................................................
..............................................................................................................
3) Compare whether the profit changes are in line with the changes in
cash flow from operating activities.
..............................................................................................................
..............................................................................................................
..............................................................................................................
4) Suppose one of the co-operative banks want to consult you in helping
customer cost analysis. Can you briefly tell how you can go about in
helping the bank?
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.9 ACTIVITY BASED COSTING

Accurate and relevant cost information is critical to any organisation that
hopes to maintain, or improve, its competitive position. For years, firms
operated under the assumption that their cost information actually reflected
388
the costs of their products and services when, in reality, it did nothing of Contemporary Issues in
the kind. Over-generalised cost systems were actually misleading decision Management Accounting - I
makers, causing them to make decisions inconsistent with their organisations’
needs and goals, principally because of misallocated costs.
Activity-based costing (ABC) is a valuable concept that can be used
to correct the shortcomings in the cost systems of the past. It is a means
of creating a system that ultimately directs an organisation’s costs to the
products and services that require those costs to be incurred. ABC can be
used this way because it provides a cross-functional, integrated view of the
firm, its activities and its business processes.
As a result, in many organisations, ABC has evolved beyond the point of
simply developing more accurate and relevant product, process, service
and activity costs. These organisations use ABC as a means of improving
operations by managing the drivers of the activities that cause costs to be
incurred. They are using ABC to support major decisions on product lines,
market segments and customer relationships, as well as to simulate the
impact of process improvements. Organisations involved in Total Quality
Management processes are using both the financial and non-financial
information of ABC as a measurement system.
The basic distinction between traditional cost accounting and ABC is as
follows: traditional cost accounting techniques allocate costs to products
based on attributes of a single unit. Typical attributes include the number
of direct labour hours required to manufacture a unit, purchase cost of
merchandise resold, or number of days occupied. Allocations, therefore,
vary directly with the volume of units produced, cost of merchandise sold,
or days occupied by the customer. In contrast, ABC systems focus on
activities required to produce each product or provide each service based on
each product’s or service’s consumption of the activities.
Using ABC, overhead costs are traced to products and services by identifying
the resources, activities and their costs and quantities to produce output. A
unit of output (a driver) is used to calculate the cost of each activity. Cost
is traced to the product or service by determining how many units of output
each activity consumed during any given period of time. An ABC system
can be viewed in two different ways. The cost assignment view provides
information about resources, activities and cost objects. The process view
provides operational (often non-financial) information about cost drivers,
activities and performance.
ABC does not only apply to manufacturing organisations, it is also
appropriate for service organisations such as financial institutions, and
medical care providers and government units. In fact, some banking firms
have been applying the concept for years under another name - unit costing.
Unit costing is used to calculate the cost of banking services by determining
the cost and consumption of each unit of output of functions required to
deliver the service.
Activity 8
1) How ABC is different from that of conventional costing?
..............................................................................................................
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Decision Making ..............................................................................................................
..............................................................................................................
2) Can you list at least three examples where ABC gives different cost
value compared to conventional costing?
..............................................................................................................
..............................................................................................................
..............................................................................................................
3) List down any three uses of ABC in strategic cost application?
..............................................................................................................
..............................................................................................................
..............................................................................................................

18.10 IT DEVELOPMENTS IN ACCOUNTING

Accounting is one of the earliest operation that has seen computerisation
in the commercial world. Today, we have reached a stage in which almost
all accounting operations are done through computers. What is the use of
computers in accounting? Book-keeping is monotonous job and it is best
done by machine than men. Further, accuracy and speed of the operation
improves considerably. Most importantly, transactions are entered only
once and all further operations are done by the machine. Compare this
with manual operations in which someone keep basic day books, someone
posts it to ledger and prepares trial balance and someone prepares financial
reports. When the level of computerisation expands and includes several
other business operations, the task improves considerably.
Today, many companies are using Enterprise Resource Planning (ERP)
software like SAP, Peoplesoft, etc. ERP attempts to integrate all departments
and functions across a company to create a single software program that
runs off one database. For instance, if your planning is very good, the ERP
system operates like this. Suppose, the inventory level has come down
below certain level. Your ERP system immediately generates purchase order
and electronically placed the same to the pre-defined vendor. When the
vendor supplies the material, you are making two entries - one at the stores
level for the receipt of the material and one at the accounts department for
invoice data. The machine compares the two and pass the bill for payment.
On the due date, cheques are printed and accounting of payment is done
electronically.
What is the use of such integration? It avoids duplication of systems and
data entry or data transport from system to another. Major benefit of ERP
is better planning and control. Suppose, you have made a plan for the next
year sometime around January 2003 (for the period of April 2003 to March
2004). Sometime around July you have found that the performance of the
first quarter is better than what you have expected and hence you want to
increase your target and reset the budget. While it may be easier to change
overall budget values, no one knows what will be changes required at
various stages unless there is an integration. Planning doesn’t end with the
390
boardroom. To translate the planning into action, changes are required every Contemporary Issues in
stages and people should realise what kind of problems it may pose when Management Accounting - I
we change the plan. For instance, such an upward revision may require
additional working capital or identifying new supplier for the material or
booking of additional railway wagon. ERP software typically identifies all
such problems and helps you to optimise using simple to advance modelling.

18.11 LET US SUM UP
Accounting primarily complies monetary transactions taken place between
the company and others and prepares financial statements. Accounting
information is used by several users. A significant part of the accounting
system is today handled by computers and hence requires accountants to
upgrade the skills. Top management as well as other stakeholders expect
accountant to provide useful information in addition to traditional income
statement and balance sheet. For instance, the profit shown under profit
and loss account is unreliable in a situation of high inflation or when the
assets are very old. The company may not have adequate funds to meet the
expenditure.
Accountants are expected to provide insight on the future growth prospects
of companies in an inflationary condition. Similarly, stakeholders,
particularly those other than shareholders, would be interested to know the
contribution of company to social causes and how it respects environmental
and other issues. Though in a narrow sense, shareholders are not concerned
on this issue, their interest is also affected if the firm fails to consider the
interest of society. Shareholders interest of automobile companies, textile
companies, tobacco companies, etc. is affected if these companies fail to
comply environmental issues. Accountants are also expected to provide
information of intangibles, which are particularly relevant for knowledge-
based companies and other service organisations. Human Resources
Accounting, Brand Valuation, etc. are important pieces of information that
stakeholders expect to be incorporated in the balance sheet. In addition
to these inputs, accountants are expected to provide lot of inputs that are
used for strategic decision making process. For instance, accountants have
to collect the details on product-wise, geographic-wise, customer-wise,
etc. and also information pertaining to competitors. Accountant inputs
are extensively used for bench marking exercises and also decision such
as out-sourcing. Since the stakeholders are geographically spread all over
the world, many companies are showing accounting results under several
accounting standards to satisfy the needs of investors, employees, suppliers,
customers and government authorities of several countries. Modern
accountants are also expected to be computer-savvy and be familiar to work
in a computerised networking environment. Companies spend substantial
money in IT and integrate all their operations. While on the one hand,
accountants role is declining on account of computerisation, accountant
contribution and involvement at high-end are increasing. For instance,
today accounting processes are centralised and concepts like shared service
operation are emerging. In this, the shared service operation provider
maintains the accounts of several companies and general many value added

391
Decision Making reports for the management. In other words, accounting profession is as
challenging as any other professions and also highly rewarding.
Interested students can refer the Shareholders Information section of the
Annual Report of Infosys Technologies Limited (page numbers (page
number 137 to 162). It covers intangible assets score sheet, human resources
accounting and value-added statement, brand valuation, balance sheet
(including intangible assets), current-cost- adjusted financial statements,
economic value-added (EVA) statement, ratio analysis, statutory
obligations, value reporting and management structure. It gives you a real
life perspective on current trends in accounting. You can download the
report from the company’s website http://infosys.com/investor/reports/
annual/Infosys_AR03.pdf).

18.12 TERMINAL QUESTIONS

1) When conducting a social audit, what are the things must a company
do?
2) What is the benefit of companies being socially responsible?
3) For what type of industries, Human Resource Accounting is most
suitable? Is it relevant to countries like India? Explain.
4) Inflation rates have come down in the last few years in many countries
including India. Do you feel inflation accounting has a role? Discuss
your answer.
5) Is environmental accounting PR exercise? How do you perform
environmental accounting and auditing of fertiliser company?
6) How does activity based costing differ from traditional costing
approach?
7) What is the role of cost accounting/cost data in strategic management?
8) Suppose your company wants to pursue product differentiation
strategy. How as an accountant you will be useful for this exercise?
9) List down some of the major benefits to a company on account of
computerised accounting system.
10) How implementation of ERP is different from computerisation of
accounting function?

18.13 FURTHER READINGS

Bowman, E. H. and M. Haire. 1976. Social Impact Disclosure and Corporate
Annual Reports. Accounting, Organizations and Society 1(1): 11-21.
Brandon, C. H. and J. P. Matoney, Jr. 1975. Social Responsibility Financial
Statement. Management Accounting (November): 31-34.
Cowen, S. S., L.. B. Ferreri and L. D. Parker. 1987. The Impact of Corporate
Characteristics on Social Responsibility Disclosure: A Typology and
Frequency-based Analysis. Accounting, Organizations and Society 12(2):
111-122.
Elias, N. and M. Epstein. 1975. Dimensions of corporate social reporting.
392
Management Accounting (March): 36-40. Contemporary Issues in
Management Accounting - I
Geoffrey Whittington (1983), Inflation Accounting: An Introduction to the
Debate, Cambridge University Press.
Gray, R. 2002. The Social Accounting Project and Accounting Organizations
and Society Privileging Engagement, Imaginings, New Accountings and
Pragmatism Over Critique? Accounting, Organizations and Society 27(7):
687-708.
Jack Quarter, Laurie Mook, Betty Jane Richmond (2002),What Counts:
Social Accounting for Non Profits and Cooperatives, Prentice -Hall.
Lehman, G. 1999. Disclosing new worlds: A Role for Social and
Environmental Accounting and Auditing. Accounting, Organizations and
Society 24(3): 217-241
Lyn M Fraser and Aileen Ormiston, Understanding Financial Statements
(Sixth Edition), Prentice-Hall of India Private Ltd. New Delhi
Pramanik, Kumar A. (2002) Environmental Accounting and Reporting,
New Delhi, Deep & Deep, 2002.
Robert Bloom Araya Bebessay, Inflation Accounting: Reporting of General
and Specific Price Changes, Greenwood Publishing Group.
Roberts, R. W. 1992. Determinants of Corporate Social Responsibility
Disclosure: An application of stakeholder theory. Accounting, Organizations
and Society 17(6): 595-612.

Note : These questions will help you to understand the unit better. Try to
write answers for them. But do not submit your answers to the University.
These are for your practice only.

393
 UNIT 19: CONTEMPORARY ISSUES IN
MANAGEMENT ACCOUNTING – II
Structure
19.0 Objectives
19.1 Introduction
19.2 Activity Based Costing
19.2.1 Steps in Activity-Based Costing
19.2.2 Advantages of Activity-Based Costing
19.2.3 Disadvantages of Activity-Based Costing
19.3 Target Costing
19.3.1 Definitions
19.3.2 Steps in Target Costing
19.3.3 Example
19.3.4 Features of Target Costing
19.4. Life Cycle Costing
19.4.1 Stages in Cost Life Cycle
19.4.2 Categories of costs to calculate Life Cycle Costing
19.4.3 Example
19.4.4 Features of Life Cycle Costing
19.5 Kaizen Costing
19.5.1 Waste
19.5.2 Approaches to Kaizen Costing
19.5.3 Stages in Kaizen Costing
19.5.4 Features of Kaizen Costing
19.6 Throughput Costing
19.6.1 Throughput (T)
19.6.2 Inventory (or Investment) (I)
19.6.3 Operating Expenses (OE)
19.6.4 Example
19.6.5 Features of Throughput Costing
19.7 Back flush Costing
19.7.1 Example
19.7.2 Calculation
19.7.3 Features of Backflush Costing
19.8 Let us Sum Up
19.9 Key Words
19.10 Answers to Check your Progress
19.11 Terminal Questions

394
 Contemporary Issues in
19.0 Objectives Management Accounting - II
After study this unit, you should be able to :
●● understand the concept of Activity-based costing;
●● identify the steps involved in Activity-based costing;
●● understand the advantages and disadvantages of Activity-based
costing;
●● comprehend the concept of Target costing;
●● know about Life cycle costing and its various stages;
●● identify the various categories of costs involved in Life cycle costing.
●● understand Kaizen costing and waste;
●● classify the various stages in Kaizen costing and discuss its features;
●● comprehend the concept of Throughput costing and its various
components and
●● understand Backflush costing and its features.

19.1 Introduction
This unit presents an introduction to the contemporary issues in Management
accounting. With the advent of new processes and complexities involved,
traditional methods can no longer accommodate the needs of a business.
This need gives rise to the development of new techniques catering to the
requirements of the organization. Some of the prevalent methods developed
and used in the organizations are provided for an understanding of the
concepts.

19.2 Activity Based Costing

Activity based costing (ABC) is an ‘approach to the costing and monitoring
of activities which involves tracing resource consumption and costing final
outputs. Resources are assigned to activities, and activities to cost objects
based on consumption estimates. The latter utilise cost drivers to attach
activity costs to outputs.’ CIMA Official Terminology
It refers to a methodology that measures the cost and performance of
activities, resources and cost objects. It assigns costs to activities based on
their consumption of resources and then allocates costs to cost objects based
on their required activities. (Turney, 1996)
The concept of Activity Based Costing (ABC) was initially outlined by
Robert Kaplan and William Burns in the late 1980s. The focus was on the
manufacturing industry where technological developments had decreased
the proportion of direct labour and material costs but increased the
proportion of indirect or overhead costs. The concept has gained popularity
as it is realistic assigning manufacturing overhead costs to products more
logically than the traditional approach of allocating costs based on labour
hours or machine hours.
In the past, companies were producing limited products. Direct labour costs
and direct material costs were considered the most significant proportion of
395
Decision Making total costs. As they constitute the maximum share in the overall cost, these
variable costs were required to be controlled. There was a small fraction of
overhead cost in the total costs.
As technology has been advancing, the overhead costs are constituting the
significant portion in the overall costs. In the new age production systems,
support activities such as setting-up, production scheduling, material
handling, inspection and data processing are the major contributors to
the costs. These overhead costs are hidden costs difficult to attribute to
individual units. In the today’s context, when there is a lack of relationship
to attribute the plant-wide predetermined overhead rates, it is not advisable
to use traditional costing methods. This is the reason why activity-based
costing is gaining popularity over the traditional costing methods.
An activity is any event, action or a transaction that incurs a cost while
making a product or rendering a service.
In this costing, multiple activities that are associated with costs in the
production process are identified. The events that are identified in the
activities that generate work (costs) are known as cost drivers. It is a factor
influencing the level of cost.
19.1.2 Steps in Activity-Based Costing
The following steps are followed to assign costs to activities:
Step 1: Identify the activities that are required to create a product.
Step 2: Classify each activity into its cost’s own pool. This group is of
individual costs associated with an activity. Define the total overhead of
each cost pool.
Example: Inspection could be its own cost pool.
Step 3: Assign activity cost drivers to each cost pool. These cost drivers are
things (could be units, hours, parts, etc.) that control the changes in costs.
Example: Inspection costs are driven by the number of parts inspected.
Step 4: Distribute the total overhead in each cost pool by the total cost
drivers to get your cost driver rate.
Step 5: Calculate the hours, parts, units, etc. that the activity used and
multiply it by the cost driver rate.
19.2.2 Example
Rose Ltd. produces three products X, Y and Z and the details are as follows:
Products
X Y Z
Output (Units) 5,000 10,000 15,000
Direct Material (per unit) Rs. 40 Rs. 45 Rs. 35
Direct Labour (per unit) Rs. 30 Rs.45 Rs. 40
Labour hours per unit 10hrs 7hrs 4hrs
Machine hours per unit 8hrs 15hrs 15hrs
Number of Purchase and Inspection
orders 600 500 900
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 Contemporary Issues in
Number of Machine arrangements 150 250 100 Management Accounting - II
Production Overheads of Departments
Department A Rs.12,00,000
Department B Rs.18,00,000
Total Rs.30,00,000
Department A is labour intensive while Department B is machine intensive.
Total labour hours in Department A 2,00,000
Total Machine hours in Department B 5,00,000
Production overhead split by activity
Purchase and Inspection orders Rs.14,00,000
Machine arrangements Rs.16,00,000
Total Rs.30,00,000
Number of batches received and
inspected 2,000
Number of batches scheduled 500
Compare the cost statements under the traditional absorption costing and
activity-based costing methods.
Solution
Products
X Y Z
Output (Units) 5,000 10,000 15,000
Direct Material (per unit) Rs. 40 Rs. 45 Rs.35
Direct Labour (per unit) Rs. 30 Rs.45 Rs. 40
Labour hours per unit 10hrs 7hrs 4hrs
Machine hours per unit 8hrs 15hrs 15hrs
Number of Purchase and Inspection orders 600 500 900
Number of Machine arrangements 150 250 100

A. Traditional Costing:
Department wise costing:
Department A (for 2,00,000 labour hours) Rs.12,00,000
= Rs. 6 per hr (Rs. 12,00,000 / 2,00,000 labour hours)
Department B (for 5,00,000 machine hours) Rs. 18,00,000
= Rs. 3.6 per hr (Rs. 18,00,000 / 5,00,000 machine hours)
Total Rs. 30,00,000
B. Activity wise costing:
Purchase and Inspection orders
Purchase and Inspection orders (for 2,000 batches) Rs. 14,00,000
= Rs. 700 per batch (Rs. 14,00,000 / 2,000 batches)
Per unit and Product wise cost:
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Decision Making 700
a) X (5,000 units) = Rs.
5,000
Number of purchase and inspection orders for Product X
= 600
600
Per unit corresponding cost Rs. (700 × )
5,000
= `84
700
b) Y (10,000 units) = Rs.
10,000
Number of purchase and inspection orders for Product Y
= 500
500
Per unit corresponding cost Rs.(700 × )
10,000
= `35
700
c) Z (15,000 units) = Rs.
15,000
Number of purchase and inspection orders for Product Z
= 900
900
Per unit corresponding cost Rs. (700 × )
15,000
= `42
Machine arrangements
Machine arrangements (for 500 batches) Rs. 16,00,000
Rs. 16,00,000
= Rs. 3,000 per batch ( batches)
500
Per unit and Product wise cost:
3,000
a) X (5,000 units) = Rs.
5,000
Number of Machine arrangementsfor Product X
= 150
150
Per unit corresponding cost Rs. (3,000 × )
5,000
= Rs.90
3,000
b) Y (10,000 units) = Rs.
10,000
Number of Machine arrangementsfor Product Y
= 250
250
Per unit corresponding cost Rs. (3,000 × )
10,000
= Rs.75
3,000
c) Z (15,000 units) = Rs.
15,000
Number of Machine arrangementsfor Product Z
= 100
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 100 Contemporary Issues in
Per unit corresponding cost Rs. (3,000 × ) = Rs.20 Management Accounting - II
15,000
Cost Statement
Products
Traditional Method X Y Z
Direct Material Rs. 40 Rs. 45 Rs. 35
Direct Labour Rs. 30 Rs. 45 Rs. 40
Department A (Labour hour Rs.
Rs. 60 Rs. 42 Rs. 24
6 per hr)
Department B (Machine hour Rs.
Rs. 28.80 Rs. 54 Rs. 54
3.6 per hr)
Total (Cost per unit) Rs. 58.80 Rs. 186 Rs. 153

Activity Based Costing Method X Y Z

Direct Material Rs. 40 Rs. 45 Rs. 35
Direct Labour Rs. 30 Rs. 45 Rs. 40
Purchase and Inspection orders
Rs. 84 Rs. 35 Rs. 42
(activity)
Machine arrangements (activity) Rs. 90 Rs. 75 Rs. 20
Total (Cost per unit) Rs. 244 Rs. 200 Rs. 137

19.2.3 Advantages of Activity-Based Costing

a) Accurate cost estimates: It provides realistic, accurate and reliable
product cost determination. It recognises the principle that activities
generate costs, not products.
b) Knowledge about cost behaviour: Activity Based costing
distinguishes the real nature of cost behaviour and aids in reducing
costs by classifying activities that do not add value to the product.
c) Tracing of activities for the cost object: It applies multiple cost
drivers, many of which are transaction based rather than product
volume.
d) Identification of inefficiency in the process: It is helpful in identifying
inefficient processes and aims for improvement in the system.
e) Profitable to service industry: This type of costing is very beneficial
for service industry and organizations including hospitals, hotels and
banks which are very different from manufacturing organizations.
Service organizations have limited scope for direct costs; almost all
the costs are overheads.
f) Determination of profit margins: It helps to ascertain the profit
margins more accurately for products.
g) Tracing the overhead costs: This technique helps in tracing the
costs to various activities involved in processes, departments, support
services, customers, etc. besides the product costs.
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Decision Making h) Helpful in identification of wasteful activities: This helps in
discovering the processes having unnecessary and wasteful costs.
19.2.4 Disadvantages of Activity-Based Costing
a) Time consuming: This method takes quite some time for collection
and preparation of data.
b) Selection of drivers: It is challenging in implementation while
selection of cost drivers, distribution of common costs, varying cost
driver rates, etc.
c) Costly and complex: The method requires accumulating and
analysing data making it costlier and complex.
d) Difficult to allocate source: In this method, data source is not easily
available in comparison to the normal accounting methods.
e) Non-conformance to accepted principles: The reports do not always
adhere to the generally accepted accounting principles. This makes it
difficult for the external reporting.
f) Not suitable to all organizations: This type of costing may not
be helpful for organizations where overhead is meagre in the total
operating costs and for small organizations.

19.3 Target Costing

The term Target costing was coined in Japan by Toyota Motors in the
1960s in response to complicated market conditions. Target costing is the
cost management technique to reduce the total cost of the product, over
its complete lifecycle. It could be reducing the production, raw material,
labour, engineering, research and design cost.
In this technique the prices are decided by the market conditions after
considering the factors like type of product, level of competition, switching
cost, etc.
19.3.1 Definitions
Target costing is a part of wide product/service cost management process
which is concerned with achieving target costing together with the planning
and new product development.  Tani et al. (1994)
Target costing is a systematic process for product costs reduction which
starts in the product planning stage. Fisher (1995)
CIMA defines target cost as “a product cost estimate derived from a
competitive market price.”
Target Costing = Anticipated selling price – Desired profit
19.3.2 Steps in Target Costing
Step 1: Identify the customer needs.
Step 2: Then after the market analysis, plan the selling price for the new
product.
Step 3: Identify the target cost after considering the profit from the selling
price.

400
Step 4: Analyse the functional cost for the various components and processes. Contemporary Issues in
Management Accounting - II
Step 5: Determine the estimated product cost.
Step 6: Compare and match the estimated cost and target cost.
Step 7: Manage cost during the production.
19.3.3 Example
XYZ Ltd. is one of the major FMCG player operating in a highly competing
market. It is planning to introduce a new product to its existing customers.
The company after the survey gets to know that it can charge only Rs. 100
per unit. The company also intends a margin of 12% on the selling price.
Please determine the target cost per unit.
Answer
Target Profit Margin = 12% of Rs. 100 = Rs. 12 per unit
Target Cost = Selling Price – Profit Margin (Rs. 100 – `12)
Target Cost = Rs. 88 per unit
19.3.4 Features of Target Costing
●● In this technique, product price is fixed by the market conditions. The
company is a price taker instead of deciding the price.
●● The technique is suitable for complex and competitive market
conditions.
●● Target Costing is considered as an integral part where the team tries to
achieve target cost after considering activities ranged from designing
to marketing.
●● The management wishes to achieve a reduction in cost, i.e. the
difference between the current cost and the target cost.
●● This is a strategic cost management tool applied to manage future
products costs.
●● This technique is not for controlling the cost but to reduce the cost.
●● This is an integral part of management’s strategy concentrating on
efficient cost management and reduction.
●● This technique employs many techniques like value engineering,
quality function deployment, etc. for reducing the cost.

19.4 Life Cycle Costing

Life cycle costing is a system that follows and accumulates the actual costs
and revenues attributable to the cost object from the conception to its end. It
includes following cost and revenues on a product by product base over the
lifetime that could span to years.
In simple term, it can be defined as estimating the money that will be spent
on a product over the course of its useful life.
The aim of this technique is to evaluate the available investment opportunities;
estimate the life cycle cost of the project (as against the initial cost) and to
ensure sufficient management of the product over its life.

401
Decision Making There are two aspects of the Product Life Cycle: Cost life cycle and Sales
life cycle.
The cost life cycle is the chain of activities within the organization, indicating
the life cycle of the product from the viewpoint of costs incurred.
19.4.1 Stages in Cost Life Cycle
The stages in Cost Life Cycle can be divided into three major categories:
Planning and Design; Production and Sales and Service and Abandonment
stage. These three stages can be further subdivided into seven stages. The
details are as follows:
Step 1: Planning: First step is to research the market regarding the
preference of the customer. This will include the costs related to the market
research activities.
Step 2: Concept definition and other details: Based on the research, a
concept of the product will be developed. This includes the estimate the
price the customer is ready to pay and the quantity he is ready to buy. The
cost pertaining to all the activities will be estimated to calculate the total
cost.
Step 3: Design specifications: This includes ascertaining the design
specifications including the details like the required life, costs i.e.
manufacturing, maintenance and other costs, anticipated delivery date,
proposed performance of the product.
Step 4: Prototyping or Purchase: After designing, prototypes of the product
will be manufactured for developing the product if the organisation wishes
to manufacture. The alternative could be to buy instead of manufacturing.
Based on the option selected, the respective cost will be the cost pertaining
to this stage.
Step 5: Production or Buy: Depending upon the option chosen by the
organization, the product will be manufactured or bought by the organization.
It will involve purchase of raw materials and components, labour and other
manufacturing expenses.
Step 6: Marketing, Selling and Distribution: The next step is to market,
sell and distribute the product. The costs of all the activities will be calculated
for the estimation of Life Cycle Costing.
Step 7: Decommissioning: This is the final step when the product comes
to an end. Costs incurred on abandonment of the product like disposal and
retreat at the end of the asset’s useful life will be calculated.
19.4.2 Categories of costs to calculate Life Cycle Costing
The total expenditure during the life of a project will be considered for
Life Cycle Costing. The following types of costs are covered primarily for
calculating the Life Cycle Costing:
1. Capital Costs: This includes the assets like land, building, equipment
and other material.
2. Operating Costs: All the operational costs including rent, energy,
staffing, etc. are included as operational costs.

402
3. Maintenance Costs: Costs incurred on maintenance while Contemporary Issues in
manufacturing the product. Management Accounting - II

4. Residual Values and Disposal Costs:Salvage is the worth obtained

after disposing the plant and machinery at the end of life cycle period.
This is the resale worth of the building, land, plant, etc. and the
expenditure of disposing the plant, building after the completion of
the lifecycle of the product.
The Sales Life Cycle is the chain of activities in the product life cycle. It
includes Introduction, Growth, Maturity and Decline stage.
19.4.3 Example
ABC Ltd. is planning to introduce a new product in the market. During the
market research it is suggested that 1,00,000 units of the product could be
sold at the rate of `50 per unit.
It is also estimated that the present value of the lifetime costs of the product
is as follows:
1. Design and development cost: Rs. 5,00,000.
2. Capital cost: Rs. 15,00,000.
3. Manufacturing cost: Rs. 12 per unit.
4. Disposal cost: Rs. 1,00,000.
5. Salvage value of machinery not included in Disposal cost: Rs. 20,000.
Life Cycle Costing
Design and development cost: Rs. 5,00,000 (+)
Capital cost: Rs. 15,00,000 (+)
Manufacturing cost: Rs. 12 per unit 1,00,000 units (+)
Disposal cost: Rs. 1,00,000 (–)
Salvage value of machinery: Rs. 20,000
= Rs. (5,00,000+ 15,00,000 + 12,00,000+1,00,000-20,000)
= Rs. 32,80,000
Life Cycle Costing per unit= Rs. 32,80,000/1,00,000 units
= Rs. 32.80 per unit
19.4.4 Features of Life Cycle Costing
●● It provides a long-term horizon as it treats the entire life cycle of the
product.
●● It takes into account a more comprehensive perspective of the product
cost spanning throughout the lifetime of the product.
●● The technique is also considered as a mechanism to control the
manufacturing cost of the product by tracking the cost at each stage
of life cycle.
●● The life cycle can be extended by finding innovative uses or different
users. The consumption can also be increased by enhancing the
consumption of the present users.

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Decision Making
19.5 Kaizen Costing
Kaizen costing is a technique of continuous incremental change for reducing
waste and costs. In this technique, endeavours are made for incremental
changes in the product, reducing the production cost and constant
advancement in designing and developing the product.
The aim is to challenge the status quo and introduce continuous improvement
in the organisation by reducing the waste.
19.5.1 Waste
It is any activity which does not add any value. There are seven types of
waste:
1. Over Production: Stocking more than the demand is a waste.
2. Inventory: Inventory is the waste produced by unprocessed inventory.
Example: Excess raw material for production.
3. Waiting time: Any waiting time is a waste. Example: Machine
downtime while the worker is waiting.
4. Defective: Defects mean the deviation of a product from the standards
of its design or the customer’s expectation.
5. Motion: Motion of any person or machine which is not adding any
value is a waste.
6. Transportation: Moving material within the factory or office
premises without adding value.
7. Over Processing: Any unnecessary activity which is not required is
over processing. Example: Painting any area which is not exposed
and will never be seen.
19.5.2 Approaches to Kaizen Costing
There can be two approaches to Kaizen costing:
1. Asset specific - The incremental improvement activities will relate to
reduction of cost in a particular asset or business unit.
2. Product specific - The activities pertain to a project or product aimed
at value analysis.
19.5.3 Stages in Kaizen Costing
Step 1: Form a team: Form a small group of 10-12 employees. The selected
employees should be involved and motivated.
Step 2: Identify a problem: Recognize a problem in the process which
requires a solution or has an opportunity to reduce waste.
Step 3: Arrange discussions: Arrange meetings to brainstorm and find
solutions. Allow the employees to speak, discuss and express their views.
Time is a critical factor.
Step 4: Identify solutions: Involve employees to find creative solutions for
the identified problem/s. Classify solutions for the issues in hand.

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Step 5: Implement: Incremental change is an excellent way to test out Contemporary Issues in
new theories. This is true for all organizations. The implementation must be Management Accounting - II
planned and controlled.
Step 6: Check: The people at the decision-making level must ensure that
the suggested changes are implemented at ground level for proper results.
Step 7: Standardize: The outcome of the change should be evaluated in
terms of success or failure. If successful, standardize the process across all
departments and locations. If not, restart from step 3.
Step 8: Repeat: Challenge the status quo and repeat the complete procedure
for the next incremental change.
19.5.4 Features of Kaizen Costing
●● Kaizen costing encourages and empowers the employees to identify
problems and wastes for cost reduction.
●● It challenges the status quo and explores opportunities for improvement.
●● It is a never-ending process involved in continuous improvement.
●● This technique promotes collective decision-making.
●● It helps to reduce cost and save organizational resources.
●● This technique does not aim for perfection. Instead, it looks for
incremental improvements in the existing system at an affordable
cost.

19.6 Throughput Costing

Eliyahu M. Goldratt proposed this technique as an alternative to traditional
cost accounting. Throughput costing is the technique of costing a product
where only the direct costs (unit-wise) are allocated to the product. It
assigns only the direct material to the product as other costs are considered
as period costs.
It is also described as super-variable costing. It is applicable for the
organizations where labour and overheads are fixed costs. Organizations,
where assembly-line or highly automated machines are employed, are likely
to meet this criterion. This includes the organizations where the employees
are well educated and employed permanently. Throughput costing considers
all costs as period costs except the direct materials.
This technique enhances profit performance with more meticulous
management decisions by using measures that indicate the impact of
decisions on three significant monetary variables (throughput, investment
(i.e. inventory), and operating expense).
19.6.1 Throughput (T)
●● This is defined as the rate at which the organization produces goal
units.
●● It can also be referred as the value an organization generates.
●● Mathematically it can be described as:
Throughput (T)= Revenue + Totally Variable Costs(TVCs)

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Decision Making 19.6.2 Inventory (or Investment) (I)
●● Initially the definition only included inventory, but over a period of
time, investment is also included.
●● It is the money the organization invests in purchasing items the
organization expects to sell.
●● Inventory can be defined as basic categories of Raw Materials, Work-
in-Process, and Finished Goods.
●● The difference is the value given to inventories.
●● In this technique, inventories are carried at their TVC value i.e.
Material cost and freight in.
19.6.3 Operating Expenses (OE)
●● It is the money spent by an organization turning inventory into
Throughput.
●● These are the total expenses other than TVCs.
●● This includes, wages, salaries, interest, depreciation, etc. Labour cost
is not included if it is paid on piece rate basis.
The change with Throughput Costing is in the understanding of the
reprioritization of T, I, and OE. Earlier, it was prioritized as: OE, I and then
T. This technique has changed the priorities to T, then I, and lastly OE. The
main focus is to know these three variables in all the alternatives. Delta
Throughput, Inventory or Investment, and Operating Expenses is used for
decision making. This is considered as a robust, easily understood, and
quickly implemented technique.
This technique considers the concept of ‘bottleneck’ very diligently. The
resource which limits the throughput is referred as ‘bottleneck resource.’
Bottleneck is also termed as ‘constraint’ in the Theory of Constraints in
various manufacturing or servicing organizations.
19.6.4 Example
Direct materials: Rs. 10 per unit
Direct labour: Rs. 22 per unit
Overhead: Rs. 31 per unit
Fixed costs: Rs. 55,000 for 5000 units
Total cost per unit: Rs. 10 per unit
The total cost is Rs. 10 per unit because throughput costing only considers
direct materials. All the other costs, as mentioned earlier, are considered as
period costs.
19.6.5 Features of Throughput Costing
●● Supports incremental analysis: Throughput costing supports
incremental analysis for achieving special orders when there is excess
capacity.
●● New technique: This technique is comparatively new in management
accounting.

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●● Performance Measure: It is used as a performance measure in the Contemporary Issues in
Theory of Constraints. Management Accounting - II

●● Business Intelligence Tool: This technique is a business intelligence

tool for optimizing profits.
●● Dynamic: This technique is a dynamic, integrated, principle-based.
●● Support Decision-Making: It provides managers with decision-
support information for optimization of resources.

19.7 Backflush Costing

It is a technique whereby the costs linked to producing a product is recorded
after it is actually produced, completed or sold. It is system that uses just-in-
time (JIT) inventory environment.
Back flush costing describes a costing system that delays recording some
or all of the journal entries relating to the cycle from purchase of direct
materials to the sale of finished goods.
 Horngren, Datar and Foster (2007)
Standard costs are calculated backwards through the system to assign costs
to products. In this technique, detailed tracking of costs is waived. This
technique is suitable for organizations having low inventories. Work-in-
process is also customarily excluded.
It is also referred as Delayed or Post Deduct Costing.
19.7.1 Example
ABC Ltd. is into assembling of medical kits. Each kit should contain the
following:
●● Gloves
●● CPR Pocket Mask
●● Gauze Pads
●● Medical Tape
●● Bandages
●● Antiseptic wipes
●● Antibiotic ointment
●● Antiseptic solution
This is referred to as a bill of materials of the kit or BOM. The workers take
various constituents of the kit from the stores and pack them in a kit. Once
the kit is assembled, the inventory is deducted based on the BOM.
In the traditional costing, the inventory is deducted while the constituents are
issued. This saves time and efforts are made for recording and maintaining
quantum of transactions.
19.7.2 Calculation
Number of material units removed from stock = Number of units produced
Units listed in the BOM for each component

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Decision Making 19.7.3 Features of Backflush Costing
●● Shorter production cycles: This technique applies to organizations
where the product takes a shorter time to manufacture. This helps to
assign the cost accurately.
●● Accurate costing: Organizations can assess the accurate and complete
costs of a product as the consideration of all the costs are done at the
end of the process.
●● Suitable for JIT manufacturing: This technique is developed while
considering the requirements of Just in Time manufacturing.
●● Not suitable for commoditized products: The technique is not fit for
the manufacturing of customized products as it needs the formulation
of different bills of materials for each customized product.
●● Demands accurate production count: In this costing the quantity of
finished product manufactured is the multiplier. If that quantity is not
accurate, the results provide an incorrect estimate.
●● Difficult to audit: Backflush accounting generally does not adhere to
generally accepted accounting principles. This makes it difficult for
organizations to audit.
●● Saves time and efforts: This technique requires less time and
efforts and help the organization to concentrate on other things. In
contrast, traditional costing methods require a lot of time and efforts
in recording and maintaining transactions when the organization is
involved in manufacturing multiple products.
Check Your Progress
1. Define Activity based costing.
2. Which costing technique is not suitable for the commoditized products
?
3. State whether each of the following statements is True or False
i. Activity based costing is a methodology that measures the cost
and performance of resources and cost objects only.
ii. Activity based costing helps in tracing the costs to various
activities involved in processes, departments, support services,
customers, etc. besides the product costs.
iii. Target costing is the technique to reduce the total cost of the
product over its complete lifecycle.
iv. Life cycle costing is a system that follows and accumulates the
actual costs and revenues attributable to cost object for the first
5 years.
v. Salvage is the worth obtained after disposing the plant and
machinery at the end of the life cycle period.
vi. Kaizen costing is a technique of radical change for reducing
waste and costs.
vii. Backflush costing is also known as super-variable costing.

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 Contemporary Issues in
19.8 Let us Sum Up Management Accounting - II
As business organizations are changing the way they work, traditional
methods of recording and analysing are no longer relevant. New ways of
costing have emerged catering to the needs of the new business issues.
Activity Based Costing focusses on reducing the proportion of direct labour
and material costs but increasing the proportion of indirect or overhead costs.
Target costing is the technique to reduce the total cost of the product, over
its lifecycle by reducing the production, raw material, labour, engineering,
research and design cost.
Life cycle costing is a way that follows and accumulates the actual costs
and revenues attributable to cost object from the conception to its end, while
Kaizen costing strives for continuous change to reduce the waste and costs.
In Throughput costing, the cost is calculated based on unit wise direct cost. It
treats all costs as period costs except the direct materials. Backflush costing
considers recording the transactions after the manufacturing of the product.

19.9 Key Words

Activity based costing: A technique for measuring the cost and performance
of activities.
Backflush costing: It is a technique where the recording of the cost is done
after the completion of the production process.
Capital cost: The cost that is spent in the production of goods or providing
services.
Kaizen costing: It is a technique for continuous incremental improvement
for reducing and controlling cost.
Life cycle costing: It is assessing the expenditure that is incurred on a
product over its life cycle.
Maintenance cost: The cost that is incurred in keeping an asset in working
condition.
Operating cost: The amount that is spent on normal business operations.
Product life cycle: It is the stages through which every product goes
through from introduction to abandonment.
Salvage value: It is the expected resale value of a product at the end of its
useful life.
Target costing: It is a technique for estimating the cost from the market
price.
Throughput costing: It views only the direct materials as the true variable
cost.
Throughput: This can be defined as the number of units produced in a
given amount of time.
Waste: Any non-value adding activity or unwanted material.

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Decision Making
19.10 Answers to Check your Progress
3 i) False ii) True iii) True iv) False v) True
vi) False vii) False

19.11 Terminal Questions

1) What are the drawbacks of the Traditional costing system?
2) Under what circumstances Activity Based costing method be used in
the organisation? Justify your answer with suitable example?
3) Explain the levels involved in Activity-Based costing.
4) Elucidate the steps followed in Target Costing.
5) Discuss the two aspects of the Product life cycle.
6) What are the various approaches to Kaizen Costing? Explain with the
help of examples.
7) Explain the features of Throughput costing.
8) What features of Backflush costing differentiates it from other
techniques.

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