PRACTICE MANUAL

F INAL C OURSE
P APER 5
A DVANCED
M ANAGEMENT
A CCOUNTING
V OL . II

The Institute of Chartered Accountants of India

(Set up by an Act of Parliament )
New Delhi
 PRACTICE MANUAL
Final Course

PAPER : 5
ADVANCED MANAGEMENT
ACCOUNTING

BOARD OF STUDIES THE INSTITUTE OF

CHARTERED ACCOUNTANTS OF INDIA
This practice manual has been prepared by the faculty of the Board of Studies.
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 December/ 2010/ 20,000 Copies (Updated)

A WORD ABOUT PRACTICE MANUAL

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Happy Reading and Best Wishes!

 CONTENTS

CHAPTER 1 – DEVELOPMENTS IN THE BUSINESS

ENVIORNMENT ...........1.1 – 1.62
CHAPTER 2 – COSTS CONCEPTS IN DECISION MAKING............................2.1
– 2.24
CHAPTER 3 – CVP ANALYSIS & DECISION MAKING...................................3.1
– 3.72
CHAPTER 4 – PRICING DECISION ...............................................................4.1
– 4.23
CHAPTER 5 – BUDGET & BUDGETARY CONTROL......................................5.1
– 5.25
CHAPTER 6 – STANDARD COSTING............................................................6.1
– 6.66
CHAPTER 7 – COSTING OF SERVICE SECTOR ...........................................7.1
– 7.12
CHAPTER 8 – TRANSFER PRICING .............................................................8.1
– 8.38
CHAPTER 9 – UNIFORM COSTING & INTER FIRM COMPARISON ................
9.1 – 9.3
CHAPTER 10 – COST SHEETS, PROFITABILITY ANALYSIS AND
REPORTING ......................................................................10.1 –

10.15 CHAPTER 11 – LINEAR

PROGRAMMING...................................................11.1 – 11.33 CHAPTER 12 –

THE TRANSPORTATION PROBLEM ..................................12.1 – 12.35

CHAPTER 13 – THE ASSIGNMENT PROBLEM ...........................................13.1

– 13.27 CHAPTER 14– CRITICAL PATH

ANALYSIS...............................................14.1 – 14.17 CHAPTER 15 –

PROGRAM EVALUATION AND REVIEW TECHNIQUE........15.1 – 15.26

CHAPTER 16 – SIMULATION .....................................................................16.1 –

16.20 CHAPTER 17 – LEARNING CURVE

THEIRY .................................................17.1 – 17.9 CHAPTER 18 – TESTING OF

HYPOTHESIS................................................18.1 – 18.13

CHAPTER 19 – TIME SERIES ANALYSSIS & FORECASTING.....................19.1

– 19.10

CHAPTER 1

DEVELOPMENTS IN THE BUSINESS

ENVIRONMENT

BASIC CONCEPTS AND FORMULAE

1. TOTAL QUALITY MANAGEMENT
TQM is a systematic process for identifying and implementing solution &
prioritized opportunities for improvement.
The TQM approach highlights the need for a customer oriented approach
to management reporting, eliminating some of our more traditional
reporting practices. Performance measurement and quality improvement
are not the sole domain of manufacturing industry, but detailed
applications of the new management accounting practices to the
professional service environment. 1.1 Six C’s Of TQM
i) Commitment ii) Culture iii)
Continuous improvement.
iv) Co-operation
v) Customer focus vi)
Control
2. ACTIVITY BASED COST MANAGEMENT (ABM)
The use of ABC as a costing tool to manage costs at activity level is known
as Activity Based Cost Management (ABM). ABM is a discipline that
focuses on the efficient and effective management of activities as the route
to continuously improving the value received by customers. ABM utilizes
cost information gathered through ABC. It determines what drives the
activities of the organization and how these activities can be improved to
increase the profitability.
2.1 Core Areas In Activity Based Cost Management
• Cost Object–It is an item for which cost measurement is required
e.g. a product or a customer.
Advanced Management Accounting

• Cost Driver–It is a factor that causes a change in the cost of

an activity. There are two categories of cost driver:
• Resource Cost Driver–It is a measure of the quantity of
resources consumed by an activity. It is used to assign the
cost of a resource to an activity or cost pool.
• Activity Cost Driver–It is a measure of the frequency and
intensity of demand, placed on activities by cost objects. It is
used to assign activity costs to cost objects.

2.2 Stages In Activity Based Costing

These stages are:
i) Identification of the activities that have taken place in the
organisation. ii) Assigning costs to cost pool for each activity.
iii) Spreading of support activities across the primary activities.
iv) Determining cost driver for each activity.
v) Assigning the costs of activities to products according to product
demand for activities.

2.3 Value-added activities (VA): The value-added activities are those

activities which are necessary for the performance of the process.
Such activities represents work that is valued by the external or
internal customer. The customers are usually willing to pay (in some
way) for the service. For example polishing a furniture by a
manufacturer dealing in furniture is value added activity.

2.4 Non-value-added activities (NVA) : The NVA activity represents

work that is not valued by the external or internal customer. NVA
activities do not improve the quality or function of a product or
service, but they can adversely affect costs and prices. Non-value
added activities create waste, result in delay of some sort, add costs
to the products or services and for which the customer is not willing
to pay. Moving materials and machine set up for a production run are
examples of NVA activities.
2.5 Business Application of ABM
(i) Cost reduction
(ii) Activity Based Budgeting

1.2
 Developments in the Business Environment

(iii) Business process re-engineering

(iv) Benchmarking
(v) Performance measurement

3. ACTIVITY BASED BUDGETING (ABB)

Activity-based budgeting is a process of planning and controlling the
expected activities for the organisation to derive a cost-effective budget
that meets forecast workload and agreed strategic goals. An activity-based
budget is a quantitative expression of the expected activities of the firm,
reflecting management’s forecast of workload and financial and non-
financial requirements to meet agreed strategic goals and planned
changes to improve performance.
3.1 Key Elements of ABB
(i) type of work/activity to be performed;
(ii) quantity of work/activity to be performed; and (ii)
cost of work/activity to be performed.

4. TARGET COSTING
It can be defined as “a structured approach to determining the cost at
which a proposed product with specified functionality and quality must be
produced, to generate a desired level of profitability at its anticipated
selling price”. It is an important part of a comprehensive management
process aimed at helping an organization to survive in an increasingly
competitive environment. In this sense the term “target costing” is a
misnomer:
4.1 Features of Target Costing System
1. Target costing is viewed as an integral part of the design and
introduction of new products
2. For any given product, a target selling price is determined
using various sales forecasting techniques.
3. Integral to setting the target selling price is the establishment
of target production volumes, given the relationship between
price and volume.
4. The next stage of the target costing process is to determine
cost reduction targets.
5. It should be noted that a fair degree of judgement is needed
where the allowable cost and the target cost differ.

1.3
Advanced Management Accounting

6. The total target is broken down into its various components, each
component is studied and opportunities for cost reductions are
identified. These activities are often referred to as value
engineering (VE) and value analysis (VA).

4.2 Problems with Target Costing

1. The development process can be lengthened to a
considerable extent since the design team may require a
number of design iterations before it can devise a sufficiently
low-cost product that meets the target cost and margin criteria.
2. A large amount of mandatory cost cutting can result in finger-
pointing in various parts of the company, especially if
employees in one area feel they are being called on to provide
a disproportionately large part of the savings.
3. Representatives from number of departments on the design
team can
sometimes make it more difficult to reach a consensus on the
proper design
4.3 Most Useful Situations for Target Costing
Target costing is most useful in situations where the majority of
product costs are locked in during the product design phase. This is
the case for most manufactured products, but few services.
4.4 Impact of Target Costing on Profitability
Target costing improves profitability in two
ways.
1. It places such a detailed continuing emphasis on product costs
throughout the life cycle of every product that it is unlikely that
a company will experience runaway costs;
2. It improves profitability through precise targeting of the correct
prices at which the company feels it can field a profitable
product in the marketplace that will sell in a robust manner.

1.4
 Developments in the Business Environment

5. LIFE CYCLE COSTING

CIMA defines life cycle costing as the practice of obtaining over their life
time, the best use of physical asset at the lowest cost of entity.
Life cycle costing is different to traditional cost accounting system which
report cost object profitability on a calendar basis i.e. monthly, quarterly
and annually. In contrast life cycle costing involves tracing cost and
revenues on a product by product bases over several calendar periods.

5.1 Phases in the Life Cycle of a Product

The life cycle of a product consists of four phases viz.,
Introduction;
1. Growth
2. Maturity
3. Saturation
4. Decline

5.2 Characteristics of Product Life Cycle

The major characteristics of product life-cycle concept are as follows
:
(i) The products have finite lives and pass through the cycle of
development, introduction, growth, maturity, decline and
deletion at varying speeds.
(ii) Product cost, revenue and profit patterns tend to follow
predictable courses through the product life cycle.
(iii) Profit per unit varies as products move through their life cycles.
(iv) Each phase of the product life-cycle poses different threats
and opportunities that give rise to different strategic actions.
(v) Products require different functional emphasis in each phase-
such as an R&D emphasis in the development phase and a
cost control emphasis in the decline phase.
(vi) Finding new uses or new users or getting the present users to
increase their consumption may extend the life of the product.

1.5
Advanced Management Accounting

6. VALUE CHAIN ANALYSIS

Value chain analysis requires a strategic framework or focus for organising
internal and external information, for analysing information, and for
summarising findings and recommendations. Because value chain
analysis is still evolving, no uniform practices have yet been established.
However, borrowing recent concepts from strategists and organisation
experts, three useful strategic frameworks for value chain analysis are
6.1 Steps in the Value Chain Analysis
The way the value chain approach helps these organisations to
assess competitive advantage includes the use of following steps of
analysis :
(i) Internal cost analysis :rganisations use the value chain
approach to identify sources of profitability and to understand
the cost of their internal processes or activities. The principal
steps of internal cost analysis are:
1. Identify the firm’s value-creating processes.
2. Determine the portion of the total cost of the product or
services attributable to each value-creating process.
3. Identify the cost drivers for each process.
4. Identify the links between processes.
5. Evaluate the opportunities for achieving
relative cost advantage.
(ii) Internal differentiation analysis — to understand the
sources of differentiation (including the cost) within internal
value-creating processes; and
(iii) Vertical linkage analysis — to understand the relationships
and associated costs among external suppliers and customers
in order to maximise the value delivered to customers and to
minimise cost.
(iv) Core Competencies Analysis — Core competencies should
tie together the portfolio of end products and help a firm excel
in dominating its industry. Core competencies need to be
continually validated. In the early 1970s, Timex held half of the
global market for watches with its core competence in low-cost
management of precision manufacturing. By the mid-1970, the
watch industry moved to digital technology, making Timex’s
core competence irrelevant.

1.6
 Developments in the Business Environment

7. COST CONTROL AND COST REDUCTION

7.1 Cost Control
Cost Control involves continuous comparisons of actual with the
standards or budgets to regulate the former. Standards or budgets
once set up are not attended during the period or until some
mistakes are discovered in standards.
7.2 Cost reduction
Cost reduction is the achievement of real and permanent reduction
in unit cost of products manufactured. It, therefore, continuously
attempts to achieve genuine savings in cost of production
distributing, selling and
administration. It does not accept a standard or budget as or fined. It
rather challenges the standards/budgets continuously to make
improvement in them. It attempts to excavate, the potential savings
buried in the standards by continuous and planned efforts. Cost
control relax that dynamic approach, it usually dealt with variances
leaving the standards intact.
8. COMPUTER -AIDED MANUFACTURING
Computer-aided manufacturing process is carried out by a range of
machinery together with its concomitant software. Maximum elements of
CAM are computer numerical control (CNC) and robotics.
CNC machines are programmable machine tools. These are capable of
performing a number of machining tasks, e.g. cutting, grinding, moulding,
bending etc. Human operators will tire and are error prone. CNC machines
are able to repeat the same operation continuously in identical manner,
with high accuracy level.

1.7
Advanced Management Accounting

9. JUST IN TIME
A complete JIT system begins with production, includes deliveries to a
company’s production facilities, continues through the manufacturing plant,
and even includes the types of transactions processed by the accounting
system. Most important in JIT system is to ensure receiving of
products/spare parts/materials from its suppliers on the exact date and at
the exact time when they are needed in order to reduce excessive
inventory in stock.
9.1 Steps in JIT
• Evaluation of supplier by purchase staff in regards to quality of
supply and reliability.
• Visit of supplier site and inspection of supply quality there to
ensure quality and time etc
• A small cluster of machines are operated who can monitor
each output part from machine to machine within the cell and
can immediately identify defective output
• Empowered workforce are allowed to stop their machines
when they see a problem and take all action for immediate
resolution of the bulk of performance problems.
9.2 Reduction of following inventory costs though JIT :
• Interest cost related to the debt that funds the inventory
investment
• Cost of inventory that becomes obsolete over time

1.8
 Developments in the Business Environment

• Cost of rent for inventory storage facilities

• Cost of all equipment used in the warehouse
• Cost of warehouse utilities
• Cost of warehouse employees
• Cost of insurance needed to cover the possible loss of
inventory
9.3 Backflushing in a JIT System
Backflushing requires no data entry of any kind until a finished
product is completed. At that time the total amount finished is
entered into the computer system, which multiples it by all the
components listed in the bill of materials for each item produced.
This yields a lengthy list of components that should have been used
in the production process and which is subtracted from the beginning
inventory balance to arrive at the amount of inventory that should
now be left of hand. Back the entire production process. Given the
large transaction volumes associated with JIT, this is an ideal
solution to the problem.
10. MANUFACTURING RESOURCES PLANNING
It is a part of production operation system. In early 1960’s a material
acquisition plan was first introduced known as Material Requirement Plan (
MRP-I ). MRP-2 is latest all-round development of that plan.
10.1 Objective of material requirement planning:
i) Determine for final products namely, what should be produced
and at what time.
ii) Ascertaining the required units of production of sub-
assemblies.
iii) Determining the requirement for materials based on an up-to-
date bill of materials file (BOM). iv) Computing inventories,
WIP, batch sizes and manufacturing and packaging lead times.
v) Controlling inventory by ordering bought-in components and raw
materials in relation to the orders received or forecast rather
than the more usual practice of ordering from stock-level
indicators.

11. SYNCHRONOUS MANUFACTURING

It has been defined as: an all-encompassing manufacturing management
philosophy that includes a consistent set of principles, procedures, and

1.9
Advanced Management Accounting

techniques where every action is evaluated in terms of the common global

goal of the organization.
11.1 Principles Associated With Synchronous Manufacturing
1. Do not focus on balance idle capacities; focus on
synchronizing the production flow.
2. The marginal value of time at a bottleneck resource is equal to
the throughput rate of the products processed by the
bottleneck.
3. The marginal value of time at a non-bottleneck resource is
negligible.
4. The level of tilization of a non-bottleneck resource is controlled
by other constraints within the system.
5. Resources must be utilized, not simply activated.
6. A transfer batch may not, and many times should not, be equal
to the process batch.
7. A process batch should be variable both along its route and
over time.
12. BUSINESS PROCESS RE-ENGINEERING
Business process re-engineering involves examining business processes
and making substantial changes in the day to day operation of the
organization. It involves the redesign of work by changing the activities.
12.1 Aim of Business Process Re-Engineering
The aim of business process re-engineering is to improve the key
business process in an organization by focusing on
(a. simplification,
(b) cost reduction,
(c) improved quality and
(d) enhanced customer satisfaction

14. THROUGHPUT ACCOUNTING

Throughput Accounting (TA) is a method of performance measurement
which relates production and other costs to throughput. Throughput
accounting product costs relate to usage of key resources by various
products. It assumes that a manager has a given set of resources
available and these have been efficiently used to process purchased
materials and components to generate sales revenue.

1.10
 Developments in the Business Environment

The cost of all other is deemed at least time related rather than fixed.
Throughput is influenced by:
• Selling price
• Direct purchase price
• Usage of direct materials
• Volume of throughput.
14.1 Constraints on Throughput
• the existence of an uncompetitive selling price
• the need to deliver on time to particular customers
• the lack of product quality and reliability
• the lack of reliable materials suppliers
• the existence of shortage of production resources.

15. THEORY OF CONSTRAINTS

The theory of constraint focuses its attention on constraints and
bottlenecks within the organization which hinder speedy production. The
main concept is to maximize the rate of manufacturing output i.e. the
throughput of the organisation. This requires to examine the bottlenecks
and constraints.
15.1 Bottlenecks
A bottleneck is an activity within the organisation where the demand
for that resource is more than its capacity to supply. A constraint is a
situational factor which makes the achievement of
objectives/throughput more difficult then it would otherwise be.
15.2 Constraints
Constraints may take several forms such as lack of skilled
employees, lack of customers orders or the need to achieve a high
level of quality product output. Using above definition, therefore, a
bottleneck is always a constraint but a constraints need not be a
bottleneck.
15.3 Idea of theory of constraints (TOC)
The theory of constraints (TOC) describes methods to maximize
operating income under bottleneck situation. The objective of TOC is
to increase throughput contribution while decreasing investments
and operating costs. TOC considers a short run time and assumes

1.11
Advanced Management Accounting

that operating costs are fixed costs.

The three measurements:

1. Calculate Throughput contribution = sale - direct materials cost
of the goods sold.
2. Investments = Sum of materials costs in direct materials, work
– in – process, and finished goods inventories; R & D costs;
and costs of equipment and buildings.
3. Operating costs equal all costs of operations (other than direct
materials) incurred to earn throughput contribution. Operating
costs include salaries and wages, rent utilities, and
depreciation.
The important concept behind TOC is that the production rate of the
entire factory is set at the pace of the bottleneck resource. Hence, in
order to achieve the best result TOC emphasises the importance of
removing bottlenecks or limiting factor.

THE IMPACT OF CHANGING ENVIRONMENT ON COST AND MANAGEMENT

ACCOUNTING

1.12
 Developments in the Business Environment

Question 1
How has the composition of manufacturing costs changed during recent years?
How has this change affected the design of cost accounting systems?
Answer
Traditionally, manufacturing companies classified the manufacturing costs to be
allocated to the products into (a) direct materials. (b) direct labour and (c) indirect
manufacturing costs. In the present day context, characterised by intensive
global competition, large scale automation of manufacturing process,
computerization and product diversification to cater to the changing consumer
tastes and preferences has forced companies to refine their costing systems to
provide better measurement of the overhead costs used by different cost objects.
Accordingly, manufacturing costs are classified in to three broad categories as
under:
1. Direct cost: As many total costs relating to cost objects as feasible are
classified into direct cost. The objective is to trace as many costs as
possible in to direct and to reduce the amount of costs classified into
indirect because the greater the proportion of direct costs the greater the
accuracy of the cost system.
2. Indirect cost pools: Increase the number of indirect cost pools so that each
of these pools is more homogeneous. In a homogeneous cost pool, all the
costs will have the same cause-and-effect relationship with the cost
allocation base.
3. Use cost-and-effect criterion for identifying the cost allocation base for
each indirect cost pool.
The change in the classification of manufacturing costs as above has lead to the
development of Activity Based Costing (ABC). Activity Based Costing refines a
costing system by focusing on individual activities as the fundamental cost
objects. An activity is an event, task or unit of work with a specified purpose as
for example, designing, set up, etc. ABC system calculates the costs of individual
activities and assigns costs to cost objects such as products or services on the
basis of the activities consumed to produce the product or provide the service.
TOTAL QUALITY MANAGEMENT
Question 2
Carlon Ltd. makes and sells a single product; the unit specifications are as
follows:
Direct Materials X : 8 sq. metre at Rs 40 per square metre
Machine Time : 0.6 Running hours
Machine cost per gross hour : Rs. 400

1.13
Advanced Management Accounting

Selling price : Rs. 1,000

Carlon Ltd. requires to fulfil orders for 5,000 product units per period. There are
no stock of product units at the beginning or end of the period under review. The
stock level of material X remains unchanged throughout the period.
Carlon Ltd. is planning to implement a Quality Management Programme (QPM).
The following additional information regarding costs and revenues are given as
of now and after implementation of Quality Management Programme.
Before the implementation of QMP After the implementation
1. 5% of incoming material from suppliers 1. Reduced to 3%.
scrapped due to poor receipt and storage
organisation.
2. 4% of material X input to the machine 2. Reduced to 2.5% process is
wasted due to processing problems.
3. Inspection and storage of Material X costs 3. No change in the unit rate Re.
1 per square metre purchased.
4. Inspection during the production cycle, 4. Reduction of 40% of the existing
calibration checks on inspection equipment cost. vendor rating and other
checks cost Rs.
2,50,000 per period
5. Production Qty. is increased to allow for 5. Reduction to 7.5% the
downgrading of 12.5% of the production units at the final inspection stage.
Down graded units are sold as seconds at a discount of 30% of the
standard selling price.
6. Production Quantity is increased to allow 6. Reduction to 2.5% for return
from customers (these are replaced free of charge) due
to specification failure and account for 5% of units actually delivered to
customer.
7. Product liability and other claims by 7. Reduction to 1%.
customers is estimated at 3% of sales
revenue from standard product sale.
8. Machine idle time is 20% of Gross machine 8. Reduction to 12.5%.
hrs used (i.e. running hour = 80% of gross/hrs.).
9. Sundry costs of Administration, Selling and 9. Reduction by 10% of the
Distribution total – Rs. 6,00,000 per period. existing.
10. Prevention programme costs Rs. 2,00,000 10. Increase to Rs. 6,00,000.
The Total Quality Management Programme will have a reduction in Machine Run
Time required per product unit to 0.5 hr.
Required:

1.14
 Developments in the Business Environment

(a) Prepare summaries showing the calculation of (i) Total production units
(pre inspection), (ii) Purchase of Materials X (square metres), (iii) Gross
Machine Hours.
(b) `In each case, the figures are required for the situation both before and
after the implementation of the Quality Management Programme so that
orders for 5,000 product units can be fulfilled.
Prepare Profit and Loss Account for Carlon Ltd. for the period showing the profit
earned both before and after the implementation of the Total Quality Programme.
Answer
(a)
Existing After TQM
Programme
i. Total production units
(Preinspection)
Total sales 5,000 5,000
requirements
Specification losses 250 2.5% 125
5%
5,250 5,125
Downgrading at inspection 750 416

×
5,250 × 5,125

Total units before inspection 6,000 5,541

ii Purchase of material ‘X’(Sq Mtr)
Material required to meet pre 48,000 SqMtr 5,541×8 SqMtr 44 ,328
inspection production requirement SqMtr
6,000 × 8 SqMtr

Processing loss × 48,000 2,000 1,137

44,328
×
Input to the process 50,000 45,465

Scrapped material × 50,000 2,632 1,406

× 45,465
Total purchases 52,632 46,871

1.15
Advanced Management Accounting

iii Gross Machine Hours

Initial requirements 6,000 × 0.6 3,600 5,541 × 0.5 2,771

12 . 5
Idle time × 3,600 900 87 . 5 × 2,771 396
Gross time 4,500 3,167 (b) Profit and loss
statement
Rs Rs
Sales revenue 5,000 Units× Rs 50,00,000 50 ,
1,000 00,000
Sales downgraded 750 5,25,000 416 Units × Rs 700 2,
Units×Rs 700 91,200
55,25,000 52 ,
91,200
Costs:
Material 52,632 Sq Mtr ×Rs 40 21,05,280 46,871Sq Mtr × Rs 40 18 ,
74,840
Inspection and storage costs
52,632 Sq Mtr ×Re 1 52,632 46,871Sq Mtr × Re 1 46,871
Machine cost 4,500 Hrs × Rs 400 18,00,000 3,167 Hrs× Rs 400 12 ,
66,800
Inspection and other cost 2,50,000 2,50,000 × 60% 1,
50,000
Product liability (3% × 50,00,000 1,50,000 1% × 50,00,000 50,000
Sundry cost of selling, distribution
5,
and administration. 6,00,000 6,00,000 × 90% 40,000
Preventive programme cost 2,00,000 6,
00,000
51,57,912 45 ,
28,511
Net profit 3,67,088 7,
62,689
Question 3
What are the essential requirements for successful implementation of TQM?
Answer
Commitment: Quality improvement must be everyone’s job. Clear commitment
from the top management, steps necessary to provide an environment for
changing attitudes and breaking down barriers to quality improvement must be
provided. Support and training for this must be extended.

1.16
 Developments in the Business Environment

Culture: Proper training must be given to effect changes in culture and attitude.
Continuous Improvement: Recognition of room for improvement continually as
a process, and not merely a one-off programme.
Cooperation: Must be ensured by involving employees by resorting to mutually
agreeable improvement strategies and associated performance measures.
Customer Focus: Perfect service with zero defectives with satisfaction to end
user whether external customer or internal customer.
Control: Documentation, procedures and awareness of current practices ensure
checking deviation from the intended course of implementation.
Question 4
Discuss the benefits accruing from the implementation of a Total Quality
Management programme in an organization.
Answer
The benefits accruing from the implementation of a Total Quality Management
programme in an organisation are:
(i) There will be increased awareness of quality culture in the organization.
(ii) It will lead to commitment to continuous improvement.
(iii) It will focus on customer satisfaction.
(iv) A greater emphasis on team work will be achieved.
Question 5
TQ Ltd. implemented a quality improvement programme and had the following
results:
2007 2008
(Figures in Rs. ’000)
Sales 6,000 6,000
Scrap 600 300
Rework 500 400
Production inspection 200 240
Product warranty 300 150
Quality training 75 150
Materials inspection 80 60
You are required to:
(i) Classify the quality costs as prevention, appraisal, internal failure and
external failure and express each class as a percentage of sales.
(ii) Compute the amount of increase in profits due to quality improvement.

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Advanced Management Accounting

Answer
(i) Classification of Quality Costs
Figures Rs. ’000
2007 % of sales 2008 % of
sales

Sales 6,000 6,000

Prevention
Quality training 75 1.25 150 2.5
Appraisal
Product Inspection 200 240
Materials Inspection 80 60
280 4.67 300 5
Internal Failure
Scrap 600 300
Rework 500 400
1100 18.33 700 11.67
External Failure
Product warranty 300 5 150 2.5
1755 29.25 1300 21.67
(ii) Cost reduction was effected by 7.58% (29.25 – 21.67) of sales, which is an
increase in profit by Rs.4,55,000.
Question 6
What are the critical success factors for the implementation of a “Total Quality
Management” programme?
Answer
Critical success factors of TQM:
• Focus on customer needs.
• Everyone in the organisation should be involved.
• Focus on continuous improvement.
• Design quality in product and production process.
• Effective performance measurement system.

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 Developments in the Business Environment

• Rewards and performance measurements should be renewed.

• Appropriate training and education to everyone to understand the aim of
TQM.
Question 7
Explain four P’s of quality improvement principles.
Answer
The Four P’s quality improvement principles are as below:
1. People: It will quickly become apparent that some individuals are not
ideally suited to the participatory process. Lack of enthusiasm will be
apparent from a generally negative approach and a tendency to have
prearranged meeting which coincide with the meetings of TOM teams.
2. Process: The rhetoric and inflexibility of a strict Deming approach will often
have a demotivating effect on group activity.
3. Problem: Experience suggests that the least successful groups are those
approaching problems that are deemed to be too large provide meaningful
solutions within a finite time period.
4. Preparation: A training in the workings of Deming- like processes is an
inadequate preparation for the efficient implementation of a quality
improvement process.
ACTIVITY BASED COST MANAGEMENT
Question 8
ABC electronics makes audio player model ‘AB 100’. It has 80 components. ABC
sells 10,000 units each month at Rs.3,000 per unit. The cost of manufacturing is
Rs.2,000 per unit or Rs.200 lakhs per month for the production of 10,000 units.
Monthly manufacturing costs incurred are as follows:
(Rs. Lakhs)
Direct material costs 100.00
Direct manufacturing labour 20.00
costs
Machining costs 20.00
Testing costs 25.00
Rework costs 15.00
Ordering costs 0.20
Engineering costs 19.80
200.00

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Advanced Management Accounting

Labour is paid on piece rate basis. Therefore, ABC considers direct

manufacturing labour cost as variable cost.
The following additional information is available for ‘AB
100’ (i) Testing and inspection time per unit is 2
hours.
(ii) 10 per cent of ‘AB 100’ manufactured are reworked.
(iii) It currently takes 1 hour to manufacture each unit of ‘AB 100’
(iv) ABC places two orders per month for each component. A different supplier
supplies each component.
ABC has identified activity cost pools and cost drivers for each activity. The cost
per unit of the cost driver for each activity cost pool is follows:
Manufacturing Description of activity Cost driver Cost per unit of cost
Activity driver
1. Machine costs Machining components Machine hours of
Rs.200 capacity
2. Testing costs Testing components Testing hours Rs.125 and finished products.
(Each unit of ‘AB 100’ is tested individually)
3. Rework costs Correcting and fixing Units of ‘AB 100’ Rs.1,500 per
unit errors and defects reworked
4. Ordering costs Ordering of components Number of orders Rs.125 per
order
5. Engineering Designing and Engineering hours Rs.1,980 per
costs managing of products engineering hour
and processes
Over a long-run horizon, each of the overhead costs described above vary with
chosen cost drivers. In response to competitive pressure ABC must reduce the
price of its product to Rs.600 and to reduce the cost by at least Rs.400 per unit.
ABC does not anticipate increase in sales due to price reduction. However, if it
does not reduce price it will not be able to maintain the current sales level.
Cost reduction on the existing model is almost impossible. Therefore, ABC has
decided to replace ‘AB 100’ by a new model ‘AB 200’, which is a modified
versions of ‘AB 100’. The expected effect of design modifications are as follows:
(i) The member of components will be reduced to 50.
(ii) Direct material costs to be lower by Rs.200 per unit.
(iii) Direct manufacturing labour costs to be lower by Rs.20 per unit.

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 Developments in the Business Environment

(iv) Machining time required to be lower by 20 per unit.

(v) Testing time required to be lower by 20 per cent.
(vi) Rework to decline to 5 per cent.
(vii) Machining capacity and engineering hours capacity to remain the same.
ABC currently out sources the rework on defective units.
Required:
(i) Compare the manufacturing cost per unit of ‘AB 100’ and ‘AB 200’.
(ii) Determine the immediate effect of design change and pricing decision on
the operating to apply to ‘AB 200’.
Ignore income tax, Assume that the cost per unit of each cost driver for ‘AB 100’
continues to apply to ‘AB 200’.
Answer
(i) Comparison of manufacturing cost per unit.
Audio Player Model
‘AB 100’ ‘AB
200’
Rs. Rs.
Direct material cost 1,000.00 800.00
Direct manufacturing labour cost 200.00 180.00
Machining costs 200.00 160.00
Testing costs 250.00 200.00
Rework costs 150.00 75.00
Ordering costs 2.00 1.25
Engineering costs 198.00 198.00
Total manufacturing cost per unit 2,000.00 1,614.25
Working notes for audio player model ‘AB 200’
(i)Machining hours and cost: Machining hours = (1 hour–0.20 hours) or
0.80 hours)
Machining cost is 0.80 hours ×
Rs.200 or Rs.160
(ii) Testing hours and cost: Testing hours = 2 hours × (1 hour – 0.20) or
1.60 hours.
Testing cost is 1.60 hours × Rs.125
or Rs.200

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Advanced Management Accounting

(iii) Rework cost per unit:

Rework units = 5% × 10,000 units or 500 units. Rework cost = 500
units × Rs.1,500 or Rs.7,50,000. Rework cost per unit Rs.7,50,000 /
10,000 units or Rs.75 per unit.
(iv) Ordering cost:
No. of orders per month 50 components × 2 orders = 100
Ordering cost per month 100 orders × Rs.125 per order =
Rs.12,500 Ordering cost per unit = Rs.12,500 / 10,000 units =
Rs.1.25 per unit.
(v) It is assumed that total available engineering hours will be used for
manufacturing ‘AB 200’ model of audio player.
(ii) Effect of design change and pricing decision on operating income of
ABC.
(Rs. Lakhs)
Revenue loss on 10,000 units (40)
(Rs.10,000 units × Rs.400)
Saving in cost:
Direct material costs 20.00
(Rs.200 × 10,000 units)
Direct manufacturing labour costs 2.00
(Rs.20 × 10,000 units)
Rework costs 7.50 29.50
(5% × 10,000 units × Rs.1,500)
Net effect on operating income (10.50)

Conclusion:
Operating income per month will be reduced by Rs. 10.50 Lakhs.
Effects of reduction in components, machining time, and testing time will not
have any immediate effect, because it is difficult to adjust the available facilities
in ordering department, machining department and testing department.
Question 9
XYZ Ltd. manufactures four products, namely A, B, C and D using the same
plant and process. The following information relates to a production period:
(11 Marks)

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 Developments in the Business Environment

Product A B C D
Output in units 720 600 480 504
Cost per unit: Rs. Rs. Rs. Rs.
Direct Material 42 45 40 48
Direct labour 10 9 7 8
Machine hours per unit 4 hrs. 3 hrs. 2 hrs. 1
hr.
The four products are similar and are usually produced in production runs of 24
units and sold in batches of 12 units. Using machine hour rate currently absorbs
the production overheads. The total overheads incurred by the company for the
period is as follows:
Rs.
Machine operation and Maintenance cost 63,00
0
Setup costs 20,00
0
Store receiving 15,00
0
Inspection 10,00
0
Material handling and dispatch 2,59
2
During the period the following cost drivers are to be used for the overhead cost:
Cost Cost driver
Setup cost No. of production runs
Store receiving Requisition raised
Inspection No. of production runs
Material handling and dispatch Orders executed

It is also determined that:

• Machine operation and maintenance cost should be apportioned between
setup cost, store receiving and inspection activity in 4:3:2.
• Number of requisition raised on store is 50 for each product and the no. of
order executed is 192, each order being for a batch of 12 of a product.
Required:
(a) Calculate the total cost of each product, if all overhead costs are absorbed
on machine hour rate basis.

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Advanced Management Accounting

(b) Calculate the total cost of each product using activity base costing.
(c) Comment briefly on differences disclosed between overhead traced by
present system and those traced by activity based costing.
Answer
(a) Total cost of different products (overhead absorption on Machine
hour basis)
A B C D
Rs. Rs. Rs. Rs.
Direct material 42 45 40 48 Direct labour 10 09 07 08 Overhead 72 54 36
18
Cost of production per unit 124 108 83 74
Out put in unit 720 600 480 504
Total cost 89,280 64,800 39,840 37,296
Machine hours (720 × 4 + 600 × 3 + 480 × 2 + 504 × 1) = 6,144
Rs 1,10,592
hours. Rate per hour = = Rs18 per hour.
6,144 hours
(b) Activity based costing system
Set up Store
Inspection
receiving
Machine operation and maintenance cost of 28,000 21,000 14,000
Rs 63,000 to be distributed in the ratio of 4: 3: 2.

Cost Rs Drivers No Cost per

unit of
driver (Rs)
Set up 48,00 Production runs 96 500
0
Store receiving 36,00 Requisitions raised 200 180
0
Inspection 24,00 Production runs 96 250
0
Material handling and disp 2,59 Orders 192 13.50
2
Production Run for A (720/24) = 30 ; B (600/24) = 25 ; C (480/24) = 20 ; D
(504/24) = 21.
A (Rs) B(Rs0 C(Rs) D(R

1.24
 Developments in the Business Environment

s)
Direct material 30,240 27,000 19,200 24,19
2
Direct labour 7,200 5,400 3,360 4,03
2
Setup 15,000 12,500 10,000 10,50
0
Store receiving 9,000 9,000 9,000 9,00
0
Inspection 7,500 6,250 5,000 5,25
0
Material handling and dispatch 810 675 540 567
Total cost 69,750 60,825 47,100 53,54
1
Per unit cost 96.875 101.375 98.125 106.2
3
(c)

A B C D
Cost per unit (a) 124 108 83 74
Cost per unit (b) 96.88 101.38 98.13 106.2
3
Difference (27.12) (6.62) 15.13 32.2
3
The total overheads which are spread over the four products have been
apportioned on different bases, causing the product cost to differ
substantially: in respect of product A and D a change from traditional
machine hour rate to an activity system may have effect on price and
profits to the extent that pricing is based on cost plus approach.
Question 10
During the last 20 years, KL Ltd’s manufacturing operation has become
increasingly automated with Computer-controlled robots replacing operators. KL
currently manufactures over 100 products of varying levels of design complexity.
A single plant wise overhead absorption rate, based on direct labour hours, is
used to absorb overhead costs.
In the quarter ended March, KL’s manufacturing overhead costs were:
( Rs. ‘
000)
Equipment operation expenses 125
Equipment maintenance expense 25
Wages paid to technicians 85
Wages paid to Store men 35
1.25
Wages paid to despatch staff 40
Advanced Management Accounting

310

During the quarter, the company reviewed the Cost Accounting System and
concluded that absorbing overhead costs to individual products on a labour hour
absorption basis is meaningless. Overhead costs should be attributed to
products using an Activity Based Costing (ABC) system and the following was
identified as the most significant activities:
(i) Receiving component consignments from suppliers
(ii) Setting up equipment for production runs
(iii) Quality inspections
(iv) Despatching goods as per customer’s orders.
It was further observed that in the short-term KL’s overheads are 40% fixed and
60% variable. Approximately, half the variable overheads vary in relating to direct
labour hours worked and half vary in relation to the number of quality
inspections. Equipment operation and maintenance expenses are apportioned
as:
• Component stores 15% , manufacturing 70% and goods dispatch 15%
Technician’s wages are apportioned as:
• Equipment maintenance 30% , set up equipment for production runs 40%
and quality inspections 30% During the quarter:
(i) a total of 2000 direct labour hours were worked (paid at Rs. 12 per hr.)
(ii) 980 components consignments were received from suppliers
(iii) 1020 production runs were set up
(iv) 640 quality inspections were carried out
(v) 420 orders were dispatched to customers.
KL’s production during the quarter included components R, S and T. The
following information is available:
Component Component Compone
nt
R S T
Direct labour Hrs worked 25 480 50
Direct Material Rs. 1,200 Rs. 2,900 Rs.
1,800
Component Consignments Recd. 42 24 28
Production runs 16 18 12

1.26
 Developments in the Business Environment

Quality Inspections 10 8 18
Orders (goods) despatched 22 85 46
Quantity produced 560 12,800 2,400
Required:
(1) Calculate the unit cost of R, S and T components, using KL’s existing cost
accounting system.
(2) Explain how an ABC system would be developed using the information
given. Calculate the unit cost of components R, S and T using ABC
system.
Answer

Rs 3,10,000
(1) Single factory direct labour hour overhead rate = = Rs 155 per
direct labour 2,000
hour
Computation of unit cost (existing system)
R (Rs) S(Rs) T(Rs
)
Direct labour cost @ Rs 12 per hour 300 5,760 600
Direct material 1,200 2,900
1,80
0
Overheads(direct labour hours × Rs 155 per hour 3,875 74,400 7,75
0
5,375 83,060 10,15
0
Quantity Produced (No) 560 12,800 2,40
0
Cost per unit 9.60 6.49 4.23

(2) ABC system involves the following stages,

1. Identifying the major activities that take place in an organisation.
2. Creating a cost pool /cost centre for each activity
3. Determining the cost driver for each activity
4. Assigning the cost of activities to cost objects (e.g. products,
components, customers etc)
The most significant activities have been identified e.g. receiving
components consignments from suppliers, setting up equipment for

1.27
Advanced Management Accounting

production runs, quality inspections, and despatching orders to customers.

The following shows the assignment of the costs to these activities,
(Rs ,000)
Receiving Set ups Quality Despatch Total
supplies inspection
Equipment operation 18.75 87.50 18.75 125.00
expenses

Maintenance 3.75 17.50 3.75 25.00

Technicians wages initially 3.83 17.85 3.82 25.50

allocated to
Maintenance(30% of Rs
85,000= Rs 25,500 and
then reallocated on same
basis on maintenance)

Balance of technicians 34.00 25.50 59.50

wages allocated to set
ups and quality
inspections
Stores wages - Receiving 35.00 35.00

Despatch wages - 40.00 40.00

Despatch
61.33 156.85 25.50 66.32 310.00
Note: Equipment operation expenses and Maintenance allocated on the
basis 15%,70% and 15% as specified in the question.
The next stage is to identify the cost drivers for each activity and establish cost
driver rates by dividing the activity costs by a measure of cost driver usage for
the period. The calculations are as follows:-
Rs 61,330
Receiving supplies ( ) = Rs 62.58 per component.
980

Performing set ups ( ) = Rs 153.77 per set up

Despatching goods ( ) = Rs 157.93 per despatch

1.28
 Developments in the Business Environment

Quality inspection ( ) = Rs 39.84 per quality inspection

Finally, costs are assigned to components based on their cost driver usage. The
assignments are as follows,
R (Rs) S(Rs) T(Rs)
Direct labour 300 5,760 600
Direct materials 1,200 2,900 1,800
Receiving supplies 2,628.36 1,501.92 1,752.2
4
Performing set ups 2,460.32 2,767.86 1,845.2
4
Quality inspections 398.40 318.72 717.12
Despatching goods 3,474.46 13,424.05 7,264.7
8
Total costs 10,461.54 26,672.55 13,979.3
8
No of units produced 560 12,800 2,400
Cost per unit 18.682 2.08 5.82
For components, the overhead costs have been assigned as follows,
(Component R)
Receiving supplies (42 receipts at Rs 62.58)
Performing set ups (16 production runs at Rs 153.77)
Quality inspections (10 at Rs 39.84)
Despatching goods ( 22 at Rs 157.93).
Question 11
Give two examples for each of the following categories in activity based
costing: (i) Unit level activities
(ii) Batch level
activities (iii) Product
level activities (iv)
Facility level
activities.
Answer
Examples:

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Advanced Management Accounting

(i) Unit level activities (i) Use of indirect materials

(ii) Inspection or testing of every item produced

or say every 100th item produced
(iii) Indirect consumables

(ii) Batch level activities (i) Material ordering

(ii) Machine set up costs

(iii) Inspection of products–like first item of every

batch
(iii) Product level (i) Designing the product
(ii) Producing parts to a certain specification

(iii) Advertising costs, if advertisement is for

individual products
(iv) Facility level (i) Maintenance of buildings

(ii) Plant security

(iii) Production manager’s salaries

(iv) Advertising campaigns promoting the

company
Question 12
“Cost can be managed only at the point of commitment and not at the point of
incidence. Therefore, it is necessary to manage cost drivers to manage cost.”
Explain the statement with reference to structural and executional cost drivers.
Answer
A firm commits costs at the time of designing the product and deciding the
method of production. It also commits cost at the time of deciding the delivery
channel (e.g. delivery through dealers or own retail stores). Costs are incurred at
the time of actual production and delivery. Therefore, no significant cost
reduction can be achieved at the time when the costs are incurred. Therefore, it
is said that costs can be managed at the point of commitment. Cost drivers are
factors that drive consumption of resources. Therefore, management of cost
drivers is essential to manage costs. Structural cost drivers are those which can
be managed by effecting structural changes. Examples of structural cost drivers
are scale of operation, scope of operation (i.e. degree of vertical integration),

1.30
 Developments in the Business Environment

complexity, technology and experience or learning. Thus, structural cost drivers

arise from the business model adopted by the company. Executional cost drivers
can be managed by executive decisions, examples of executional cost drivers
are capacity utilization, plant layout efficiency, product configuration and linkages
with suppliers and customers. It is obvious that cost drivers can be managed
only at the point of structural and operating decisions, which commit resources to
various activities.
Question 13
What is the fundamental difference between Activity Based Costing System
(ABC) and Traditional Costing System? Why more and more organisations in
both the manufacturing and non-manufacturing industries are adopting ABC?
Answer
In the traditional system of assigning manufacturing overheads, overheads are
first allocated and apportioned to cost centres (production and support service
cost centres) and then absorbed to cost objects (e.g. products). Under ABC,
overheads are first assigned to activities or activity pools (group of activities) and
then they are assigned to cost objects. Thus, ABC is a refinement over the
traditional costing system. Usually cost centres include a series of different
activities. If different products create different demands on those activities, the
traditional costing system fails to determine the product cost accurately. In that
situation, it becomes necessary to use different rates for different activities or
activity pools.
The following are the reasons for adoption of ABC by manufacturing and
nonmanufacturing industries:
(i) Fierce competitive pressure has resulted in shrinking profit margin. ABC
helps to estimate cost of individual product or service more accurately. This
helps to formulate appropriate marketing / corporate strategy.
(ii) There is product and customer proliferation. Demand on resources by
products / customers differ among product / customers. Therefore,
product / customer profitability can be measured reasonably accurately,
only if consumption of resources can be traced to each individual product /
customer.
(iii) New production techniques have resulted in the increase of the proportion
of support service costs in the total cost of delivering value to customers.
ABC improves the accuracy of accounting for support service costs.
(iv) The costs associated with bad decisions have increased substantially.
(v) Reduction in the cost of data processing has reduced the cost of tracking
resources consumption to large number of activities.
Question 14

1.31
Advanced Management Accounting

Biscuit Ltd. Manufactures 3 types of biscuits, A, B and C, in a fully mechanised

factory. The company has been following conventional method of costing and
wishes to shift to Activity Based Costing System and therefore wishes to have
the following data presented under both the systems for the month.
Inspection cost Rs. p.m. 73,00
0
Machine – Repairs & Maintenance Rs. p.m. 1 ,
42,000
Dye cost Rs. p.m. 10,25
0
Selling Rs. p.m. 1 ,
overheads 62,000

Product A B C
Prime cost (Rs. per unit) 12 9 8
Selling price (Rs. per unit) 18 14 12
Gross production (units/production run) 2,520 2,810 3,010
No. of defective units / production run 20 10 10
Inspection: C
No. of hours / production run 3 4 4
Dye cost / production run (Rs.) 200 300 250
No. of machine hours / production run 20 12 30
Sales – No. of units / month 25,000 56,000 27,00
0
The following additional information is given:
(i) No accumulation of inventory is considered. All good units produced are
sold.
(ii) All manufacturing and selling overheads are conventionally allocated on
the basis of units sold.
(iii) Product A needs no advertisement. Due to its nutritive value, it is readily
consumed by diabetic patients of a hospital. Advertisement costs included
in the total selling overhead is Rs. 83,000.
(iv) Product B needs to be specially packed before being sold, so that it meets
competition. Rs. 54,000 was the amount spent for the month in specially
packing B, and this has been included in the total selling overhead cost
given.
You are required to present productwise profitability of statements under the
conventional system and the ABC system and accordingly rank the products.

1.32
 Developments in the Business Environment

Answer
Sales A B C Total
(i) Units Rs. 25,000 56,000 27,000 1 , 08,000 Selling price/unit 18 14 12
(ii) Sales Value (Rs.) 4,50,000 7,84,000 3,24,000 15 ,
58,000
(iii) Prime Cost Overhead 12 9 8 (iv) No. of units/run 2,520
2,810 3,010 (v) Prime Cost Rs. 3,02,400 5,05,800
2,16,720
(vi) Gross Margin (ii − v) 1,47,600 2,78,200 1,07,280 5 ,
33,080

Total A B C
Inspection Cost 73,000 15,000 40,000 18,000
 7,3000 
 × 30/80/36 respectively 
 146 
Machine Maintenance 1,42,000 40,000 48,000 54,000
 1,42,000 
 × 200/240/270 respectively 
 710 
Dye Cost 10,250 2,000 6,000 2,250 Sub Total 2,25,250 57,000 94,000 74,250
Selling Overhead Advertisement 83,000 − 56,000 27,000
 83,000 
 × 56/27 respectively 

 56,000+ 27,000 

Other Overheads 25,000 5,787 12,963 6,250

 25,000 
× 25/56/27 respectively



 108 
Packing _______ _____ 54,000
_______

1.33
Advanced Management Accounting

Sub Total Selling Overhead 1,62,000 5,787 1,22,963

Workings: 33,250

A B C Total
Gross Production/unit /run (1) 2,520 2,810 3,010
Defectives/run (2) 20 10 10
Good units / run (3) 2,500 2,800 3,000
Sales (Goods units)(4) 25,000 56,000 27,000
No. of runs (5) 10 20 9
Gross Production (6) = (1) × (5) 25,200 56,200 27,090
Prime Cost / unit (7) 12 9 8
Prime Cost (8) Rs. 3,02,400 5,05,800 2,16,720 10 , 24,920
Inspection hours/run (9) 3 4 4
Inspection hours (10) = (9) × (5) 30 80 36 146
M/c hours / run (11) 20 12 30
M/c hours (12) = (1) × (5) 200 240 270 710
Dye Cost/run (13) 200 300 250
Dye cost (14) (13) × (5) 2,000 6,000 2,250 10,250
Conventional Accounting System

Total A B C
Sales – units / Production (good units) 1,08,000 25,000 56,000 27,000 Gross
Margin (Rs.) 5,33,080 1,47,600 2,78,200 1 , 07,280 Production overheads
(Rs.) 2,25,250 52,141 1,16,797 56,313

Selling Overhead (Rs.) 1,62,000 37,500 84,000 40,50

0
Sub-Total Overhead (Rs.) 3,87,250 89,641 2,00,797 96,81
3
Net profit (Rs.) 1,45,830 57,959 77,403 10,46
7

1.34
 Developments in the Business Environment

Ranking II I III
Activity Based System

A B C
Sales – units / Production (good units) 25,000 56,000 27,00
0
Gross Margin (Rs.) 1,47,600 2,78,200 1 ,
07,280
Production overheads (Rs.) 57,000 94,000 74,25
0
Selling Overhead (Rs.) 5,787 1,22,963 33,25
0
Sub-Total Overhead (Rs.) 62,787 2,16,963 1 ,
07,500
Net profit (Rs.) 84,813 61,237 (220)
Ranking I II III
Question 15
A company manufactures three types of products namely P, Q and R. The data
relating to a period are as under:
P Q R
Machine hours per unit 10 18 14
Direct labour hours per unit @ Rs. 20 4 12 8
Direct Material per unit (Rs.) 90 80 120
Production (units) 3,000 5,000
20,00
0
Currently the company uses traditional costing method and absorbs all
production overheads on the basis of machine hours. The machine hour rate of
overheads is Rs. 6 per hour.
The company proposes to use activity based costing system and the activity
analysis is as under:
P Q R
Batch size (units) 150 500 1,000
Number of purchase orders per batch 3 10 8 Number of
inspections per batch 5 4 3 The total production overheads are
analysed as under:
Machine set up costs 20
%

1.35
Advanced Management Accounting

Machine operation costs 30

%
Inspection costs 40
%
Material procurement related costs 10
%
Required:
(i) Calculate the cost per unit of each product using traditional method of
absorbing all production overheads on the basis of machine hours.
(ii)Calculate the cost per unit of each product using activity based costing
principles.
Answer
(i) Cost per unit using traditional method of absorbing all production
overheads on the basis of machine hours:
Products P Q R Rs. Rs. Rs.

Direct materials 90 80 120

Direct labour (4:12:8 hours) × Rs. 20 80 240 160 Production

Overheads (10:18:14 hours) × Rs. 6 60 108 84

Cost per unit 230 428 364

(ii) 1. Cost per unit of each product using activity based costing:
Products P Q R Total
A. Production (units) 3,000 5,000 20,000 B. Batch size (units)
150 500 1000

C. Number of batches [A ÷ B] 20 10 20 50
D. Number of purchase order per batch 3 10 8
E. Total purchase orders [C × D] 60 100 160 320 F. Number of
inspections per batch 5 4 3

G. Total inspections [C × F] 100 40 60 200

2. Total Production overhead

A. Machine hours per unit 10 18 14
B. Production units 3,000 5,000 20,000

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 Developments in the Business Environment

C. Total machine hours [A × B] 30,000 90,000

2,80,000
Total machine hours = 4,00,000
Total production overheads = 4,00,000 × Rs. 6 = Rs. 24,00,000.
3. Cost driver rates:
Cost Pool % Overheads Cost Driver Cost Driver Rate
Rs. Units Rs.
Set up 20% 4,80,000 50 9,600 per set up
Inspection 40% 9,60,000 200 4,800 per
inspection
Purchases 10% 2,40,000 320 750 per purchase
Machine hours 30% 7,20,000 1.80 per Machine
4,00,000 Hour
4. Cost per unit of P, Q and R:
Products P Q R
Production (units) 3,000 5,000 20,000
Rs. Rs. Rs.
Direct Materials (90:80:120) 2,70,000 4,00,000 24 ,
00,000
Direct Labour (80:240:160) 2,40,000 12,00,000 32 ,
00,000
Overheads:
Machine related costs @ Rs.
5,
1.80/hour (30,000:90,000:2,80,000) 1,62,000 04,000
54,000
Set-up costs @ Rs. 9600 / set up
1,
(20 : 10 : 20) 96,000
1,92,000 92,000
Inspection costs @ Rs.
4800 / 1,92,000 2 ,
inspection (100 :40 : 60) 4,80,000 88,000
Purchase related costs @ Rs. 750 /
1,20,00
purchase (60 : 100 : 160) 75,000
45,000 0
Total costs 12,81,000 21,25,000 67 ,
04,000
Cost per unit (Total cost ÷ units) 427.00 425.00 335.20
Question 16

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Advanced Management Accounting

A bank offers three products, viz., deposits, Loans and Credit Cards. The bank
has selected 4 activities for a detailed budgeting exercise, following activity
based costing methods.
The bank wants to know the product wise total cost per unit for the selected
activities, so that prices may be fixed accordingly.
The following information is made available to formulate the budget:
Activity Present Cost Estimation for the budget period
(Rs.)
(i) ATM Services:
(a) Machine maintenance 4,00,000 (all fixed, no change)
(b) Rents 2,00,000 (fully fixed; no change)
(c) Currency Replenishment 1,00,000 (expected to double during budget
Cost period)
7,00,000 (This activity is driven by no. of
ATM transactions)
(ii) Computer Processing 5,00,000 (Half this amount is fixed and no change is
expected)
(The variable portion is
expected to increase to three
times the current level).
This activity is driven by the number of
computer transactions.
(iii) Issuing Statements 18,00,000 Presently, 3 lac statements are
made. In the budget period, 5
lac statements are expected;
For every increase of one lac
statement, one lac rupees is the
budgeted increase (this activity is
driven by the number
of
statements)
(iv) Computer Inquiries 2,00,000 Estimated to increase by 80% during the
budget period. (This activity is driven by telephone minutes).
The activity drivers and their budgeted quantifies are given below:
Deposits Loans Credit Cards
No. of ATM Transactions 1,50,000 - 50,000

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 Developments in the Business Environment

No. of Computer Processing 15,00,000 2,00,000 3,00,000

Transactions
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000
The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts,
and 14,000 Credit Card Accounts.
You are required to:
(i) Calculate the budgeted rate for each activity.
(ii) Prepare the budgeted cost statement activity wise.
(iii)Find the budgeted product cost per account for each product using (i) and
(ii) above.
Answer
Budget Cost Statement
Activity Activity Activity No. of Activit Deposits Loans Credit
Cost Driver Units of y Cards
(Rs.) Activity Rate
(Budgeted Driver (Rs.)
) (Budget)

1.ATM 8,00,000 ATM 2,00,00 4 6,00,00 - 2 ,

Services Transactio 0 0 00,000
n
2. 10,00,00 Computer 20,00,00 0.50 7,50,00 1,00,00 1 ,
Computer 0 Transactio 0 0 0 50,000
Processing n
3. Issuing 20,00,00 No. of 5,00,00 4.00 14,00,00 2,00,00 4 ,
Statements 0 Statement 0 0 0 00,000
s
4. 3,60,000 Telephone 7,20,00 0.50 1,80,00 90,000 90,000
Customer Minutes 0 0
Inquiries
Budgeted 41,60,00 29,30,00 3,90,00 8 ,
0 0 0 40,000
Cost
Units of product as estimated in the budget period 58,600 13,000 14,000
Budgeted Cost per unit of the product 50 30 60
Working Notes:

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Advanced Management Accounting

(i) ATM 4,00,000 + 2,00,000 + 2 × 1,00,000 = 8,

00,000
(ii) Computer 5,00,000 (Fixed = 2,50,000) Variable = 10,
2,50,000 increase to 3 times = 7,50,000 00,000
(iii) Issuing Statements 2,00,000 + 80% × 2,00,000 = 2 + 1.6 =
3,60,000.
Question 17
The following are Product Nova Shaft's data for next year budget:
Activity Cost Driver Cost Driver Cost Pool
volume/year
Purchasing Purchase orders 1,500 Rs.75,000
Setting Batches produced 2,800 Rs.1,12,000
Materials handling Materials movements 8,000 Rs.96,000
Inspection Batches produced 2,800 Rs.70,000
Machining costs Machine hours "50,000' Rs.1,50,000
Purchase orders 25
Output 15,000 units
Production batch size 100 units
Materials movements per batch 6
Machine hours per unit 0.1
Required:
(i) Calculate the budgeted overhead costs using activity based costing
principles.
(ii) Calculate the budgeted overhead costs using absorption costing (absorb
overhead using machine hours).
(iii) How can the company reduce the ABC for Product Nova Shaft?
Answer
(i) Computation of the activity based overheads
Step 1: Compute cost per unit of cost driver = Cost pool / cost driver
volume
Activity Cost Driver Cost Cost driver Cost/Unit of
Pool volume/yr cost driver (a)/
(a) (b) (b)

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 Developments in the Business Environment

Purchasing Purchase orders Rs.75,000 1,500 Rs.50/pruchse

order
Setting Batches Rs.112,00 2,800 Rs.40/batch
produced 0
Materials Material
handling movements Rs.12/movemen
Rs. 96,000 8,000 t
Inspection Batches Rs.70,000 2,800 Rs.25/batch
produced
Machining Machine hours Rs.150,0 50,000 Rs.3/machine
00 hour
Step 2: Compute the volume of cost drivers consumed by Product Nova Shaft

Purchase orders (given) = 25

Batches = 15,000/100 = 150
Materials movement = 150 batches × 6 = 900
Machine hours = 15,000 units × 0.1 = 1,500
Step 3: Compute the Activity Based Overheads Cost for Product Nova
Shaft
Activity Cost Driver Costing
Rate
/ Cost
Driver Unit
Rs.
Purchasin Purchase orders 50 25 order × Rs.50 Rs.1,250
g
Setting Batches produced 40 150 batches × Rs.6,000
Rs.40
Material Material 12 900 movement × Rs.10,80
handling movements Rs.12 0
Inspection Batches produced 25 150 batches × Rs.3,750
Rs.25
Machining Machine hours 3 1,500 hours × Rs.3 Rs.4,50
0
Rs.26,30
0
(ii) Computation of budgeted overheads costs for Product Nova Shaft
using absorption costing

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Advanced Management Accounting

Budgeted overheads = (Rs.75,000 + Rs.96,000 + Rs.112,000 + Rs.70,000

+ Rs.150,000) = Rs.503,000
Budgeted absorption cost/machine hour = Rs.503,000 / 50,000 =
Rs.10.06 Budgeted machining hours for Product Nova Shaft = 1,500
Budgeted absorbed overhead = 1,500 × Rs.10.06 = Rs.15,090
(iii) Ways in which the company can reduce the ABC for product Nova
Shaft:
• Reduce the number of batches by increasing the batch size which
will then reduce the setting up overhead, materials handling and
inspection costs.
• Reduce the number of purchase orders
• Innovate ways of speeding up production so that the machining hours
are reduced Question 18
X Ltd. is engaged in the production of four products: A, B, C and D. The price
charged for the four products are Rs.180, Rs.175, Rs.130 and Rs.180
respectively, Market research has indicated that if X Ltd can reduce the selling
prices of its products by Rs.5, it will be successful in getting bulk orders and gain
a significant share of market of those products. The company’s profit markup is
25 per cent on cost of the product. The relevant information of products are as
follows:
Products A B C D
Output in units 600 500 400 600
Cost per unit:

Direct material (in Rs.) 40 50 30 60

Direct labour (in Rs.) 28 21 14 21
Machine hours (per unit) 4 3 2 3
The four products are usually produced in production runs of 20 units and sold in
batches of 10 units. The production overhead is currently absorbed by using a
machine hour rate, and the total of the production overheads for the period has
been analysed as follows:
(Rs.)
Machine department costs 52,130
Setup costs 26,250

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Advanced Management Accounting

Stores receiving 18,00

0
Inspection/Quality Control 10,50
0
Material handling and dispatch 23,10
0
The cost drivers to be used for the overhead costs are as follows:
Cost Cost drivers
Setup costs Number of production
runs
Store receiving Requisitions raised
Inspection/Quality control Number of production
runs
Materials handling and dispatch Order executed
The number of requisitions raised in the stores was 100 for each product and the
number of orders executed was 210, each order being for a batch of 10 units of
a product.
You are required:
(i) To compute the target cost for each product.
(ii) To compute total cost of each product using activity based costing.
(iii)
Compare target cost and activity based cost of each product and comment
whether the price reduction is profitable or not.
Answer
(i) The target cost of each product after reduction is computed as follows:
Product Present Price Proposed Target Cost (Rs)
(Rs) Price (Rs) (with 25% Margin)
A 180 175 140
B 175 170 136
C 130 125 100
D 180 175 140
(ii) Statement showing cost/unit of Driver as per ABC
Cost Amount Driver No. Cost/unit
of
Driver
Set-ups 26,250 Production runs 105* Rs.250.0
0
Stores receiving 18,000 Requisition 400** Rs.45.00

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Advanced Management Accounting

Inspection/Quality 10,500 Production runs 105 Rs.100.0

0
Handling/Dispatch 23,100 Orders 210 Rs.110.00
Machine Department 52,130 Machine Hrs. 6,500 Rs.8.02
* Production runs = (600/20) + (500/20) + (400/20) + (600/20) = 105
** Requisitions = 100 for each product or 400 total
Machine hours = 2,400 + 1,500 + 800 + 1,800 = 6,500 hours.
Statement showing Total Cost and Cost Per Unit as per ABC
Item A B C D
Rs. Rs. Rs. Rs.
Direct Material 24,000 25,000 12,000 36,000
Direct Labour 16,800 10,500 5,600 12,600
Set-up 7,500 6,250 5,000 7,500
Stores receiving 4,500 4,500 4,500 4,500
Inspection/Quality 3,000 2,500 2,000 3,000
Handling/Dispatch 6,600 5,500 4,400 6,600
Machine Dept. Cost 19,248 12,030 6,416 14,436
Total Cost 81,648 66,280 39,916 84,636
Output (Units) 600 500 400 600
Cost per unit 136.08 132.56 99.79 141.06
Comparison of Actual Cost and Target Cost
(iii)
Cost A B C D
Rs. Rs. Rs. Rs.
Actual 136.08 132.56 99.79 141.06
Target 140.00 136.00 100.00 140.00
Difference (-) 3.92 (-) 3.44 (-) 0.21 (+) 1.06

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 Developments in the Business Environment

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

VALUE CHAIN ANALYSIS

Question 19
What is the concept of ‘Value-chain’ and why is it important for Cost
Management?
Answer
Value chain is the linked set of value creating activities from the basic raw
materials and components sources to the ultimate end use of the product or
service delivered to the customer.
The six business functions contained in the value chain are (i) Research and
Development, (ii) Design (iii) Production (iv) Marketing (v) Distribution and (vi)
Customer service.
The objective of value chain is to serve as means of increasing the customer
satisfaction and managing costs effectively. Coordination of the individual parts
of the value chain activities creates conditions to improve customer satisfaction
in terms of cost efficiency, quality and delivery. A firm which performs value chain
activities more efficiently and at a lower cost than its competitors will be able to
gain competitive advantage. The following methodology should be adopted.
1. The firm should identify the industry value chain and then assign costs,
revenues and assets to value activities.
2. Diagnose the cost drivers regulating each value activity.
3. Develop sustainable cost advantage either by controlling cost drivers better
than competitors or by reconfiguring the chain value.
By analyzing costs, revenues and assets in each activity systematically a
company can achieve low cost. Thus value chain helps managers in deciding
how to apply the organization’s valuable physical and human resources to each
linked process so as to achieve cost effectiveness.
Question 20
Explain with a diagram the value chain activities within the firm with suitable
classifications under primary and support activities and also the industry value
chain indicating what the end use consumer pays for.

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Advanced Management Accounting

Answer
Industry Value Chain Value Chain Activities within the firm
Primary Activities Support Activities
End use consumer pays for profit margin throughout

Supplier
value ROD
chain

Procur
ement
Design
Firm Z
x y value
chain
Technology
Produc Development
tion
Distribut
ion
value Market
chain ing Human
Resource
Management
Buyer
value
Distribu
chain
tion
Firm
infrastructure

Disposal Service
Recycle
value
chain

Question 21
How can value analysis achieve cost reduction?
Value analysis can do cost reduction in the following manner:

1.46
 Developments in the Business Environment

Answer
• By identifying and removing unnecessary components in a product which
had utility earlier.
• By introducing component substitution at a lesser cost without affecting the
quality of the product.
• By simplifying the product design.
• By introducing alternative methods with less cost but improved efficiency.
Question 22
Define the term 'value-chain’. Mention three 'useful strategic frameworks of the
valuechain analysis. Answer
Value chain is the linked set of value-creating activities all the way from basic raw
material sources for component suppliers through to the ultimate end-use
product or service delivered to the customer. Proter’s described the value chain
as the internal processes or activities a company performs “to design, produce,
market, deliver and support its product”. He further stated that “a firm’s value
chain and the way it performs individual activities are a reflection of its history, its
strategy, its approach of implementing its strategy, and the underlying economics
of the activities themselves”. The business activities are classified in to primary
activities and support activities.
Primary activities are those activities which are involved in transforming the
inputs in to outputs, delivery and after sales service. Support activities are
intended to support the primary activities like for example procurement, human
resources management, etc. Three useful strategic frameworks for value chain
analysis are:
• Industry structure analysis;
• Core competencies; and
• Segmentation analysis.
TARGET COSTING LIFE CYCLE COSTING
Question 23
List the steps involved in target costing process with the help of a block diagram.
Target Costing Process

Set target selling price based on customer

expectations and sales forecast

1.47
Advanced Management Accounting

Answer
Establish profit margin based on long-
term profit objectives and projected
volumes

Determine target (or allowable) cost per unit

(target selling price less required profit

Compare with Estimate the current cost of new product

Establish cost reduct

ion targets for each
component and
production activity, using value
engineering and value
analysis

Question 24

What is Target Costing? It is said that implementation of the target costing

technique requires intensive marketing research. Explain why intensive
marketing research is required to implement target costing technique.
Answer
Target cost is the difference between estimated selling price of a proposed
product with specified functionality and quality and the target margin. This is a
cost management technique that aims to produce and sell products that will
ensure the target margin. It is an integral part of the product design. While
designing the product, the company needs to understand what value target
customers will assign to different attributes and different aspects of quality. This
requires use of techniques like value engineering and value analysis. Intensive
marketing research is required to understand customer preferences and the
value they assign to each attribute and quality parameter. This insight is required
to be developed must before the product is introduced. The company plays
within the space between the maximum attributes and quality that the company
can offer and the

1.48
 Developments in the Business Environment

minimum acceptable to target customers. Therefore in absence of intensive

marketing research, the target costing technique cannot be used effectively.
Question 25
Discuss, how target costing may assist a company in controlling costs and
pricing of products.
Answer
Target costing may assist control of costs and pricing of product as under:
(i) Target costing considers the price that ought to be charged by a company
to achieve a given market share.
(ii) Target costing should take life cycle costs in to consideration.
(iii) If there is a gap between the target cost and expected cost, ways and
means of reducing or eliminating it can be explored.
(iv) The target cost may be used for controlling costs by comparison.
Question 26

What is total-life-cycle costing approach? What is it important?

Answer

Total life cycle costing approach:

Life cycle costing estimates, tracks and accumulates the costs over a product’s
entire life cycle from its inception to abandonment or from the initial R & D stage
till the final customer servicing and support of the product. It aims at tracing of
costs and revenues on product by product basis over several calendar periods
throughout their life cycle. Costs are incurred along the product’s life cycle
starting from product’s design, development, manufacture, marketing, servicing
and final disposal. The objective is to accumulate all the costs over a product life
cycle to determine whether the profits earned during the manufacturing phase
will cover the costs incurred during the pre and post manufacturing stages of
product life cycle.
Importance:
Product life cycle costing is important for the following reasons:
(i) When non-production costs like costs associated with R & D, design,
marketing, distribution and customer service are significant, it is essential
to identify them for target pricing, value engineering and cost management.
For example, a poorly designed software package may involve higher
costs on marketing, distribution and after sales service.
(ii) There may be instances where the pre-manufacturing costs like R & D and
design are expected to constitute a sizeable portion of life cycle costs.

1.49
Advanced Management Accounting

When a high percentage of total life cycle costs are likely to be so incurred
before the commencement of production, the firm needs an accurate
prediction of costs and revenues during the manufacturing stage to decide
whether the costly R & D and design activities should be undertaken.
(iii) Many costs are locked in at R & D and design stages. Locked in or
Committed costs are those costs that have not been incurred at the initial
stages of R & D and design but that will be incurred in the future on the
basis of the decisions that have already been taken. For example, the
adoption of a certain design will determine the product’s material and
labour inputs to be incurred during the manufacturing stage. A complicated
design may lead to greater expenditure on material and labour costs every
time the product is produced. Life cycle budgeting highlights costs
throughout the product life cycle and facilitates value engineering at the
design stage before costs are locked in.
Total life-cycle costing approach accumulates product costs over the value
chain. It is a process of managing all costs along the value chain starting
from product’s design, development, manufacturing, marketing, service
and finally disposal.
Question 27
Explain the essential features of Life-cycle costing.
Answer
Essential features of Life Cycle Costing:
Product Life Cycle costing involves:
• Tracing of costs and revenue of product over several calendar period-
throughout their entire life cycle.
• Emphasis is on Cost and revenue accumulation over the entire life cycle of
the product.
• Life cycle costing traces research and design.
• It focuses on development costs, incurred to individual products over their
entire life cycles.
• Total magnitude of research and development costs are reported and
compared with product revenues generated in later periods.
Question 28
Meena is a news reporter and feature writer for an economic daily. Her
assignment is to. develop a feature article on 'Product Life-cycle Costing',
including interviews with the' Chief Financial Officers (CFO) and operating,
managers. Meena has been given a liberal budget for travel so as to research

1.50
 Developments in the Business Environment

into company's history, operations, and market analysis for the firm she selects
for the article.
Required:
(i) Meena has asked you to recommend industries and firms that would be good
candidates for the article. What would you advice? Explain your
recommendations. (June 2009, 3 Marks)
Answer
The product life cycle span the time from the initial R & D on a product to when
customer service and support is no longer offered for that product.
Life Cycle Costing technique is particularly important when:
(a) High percentage of total life-cycle costs are incurred before production
begins and revenue are earned over several years and
(b) High fraction of the life cycle costs are locked in at the R & D and design
stages.
Meena should identify those industries and then companies belonging to those
industries where above mentioned feature are prevalent. For example,
Automobile and Pharmaceutical Industries companies like Tata Automobile,
M&M, Ranbexy and Dabur will be good candidates for study on product life cycle
costing. JUST IN TIME
Question 29
X Video Company sells package of blank video tapes to its customer. It
purchases video tapes from Y Tape Company @ Rs140 a packet. Y Tape
Company pays all freight to X Video Company. No incoming inspection is
necessary because Y Tape Company has a superb reputation for delivery of
quality merchandise. Annual demand of X Video Company is 13,000 packages.
X Video Co. requires 15% annual return on investment. The purchase order lead
time is two weeks. The purchase order is passed through Internet and it costs
Rs2 per order. The relevant insurance, material handling etc Rs3.10 per package
per year. X Video Company has to decide whether or not to shift to JIT
purchasing. Y Tape Company agrees to deliver 100 packages of video tapes 130
times per year (5 times every two weeks) instead of existing delivery system of
1,000 packages
13 times a year with additional amount of Rs0.02 per package. X Video Co.
incurs no stock out under its current purchasing policy. It is estimated X Video
Co. incurs stock out cost on 50 video tape packages under a JIT purchasing
policy. In the event of a stock out, X Video Co. has to rush order tape packages
which costs Rs4 per package. Comment whether X Video Company should
implement JIT purchasing system.

1.51
Advanced Management Accounting

Z Co. also supplies video tapes. It agrees to supply @ Rs13.60 per package
under JIT delivery system. If video tape purchased from Z Co., relevant carrying
cost would be Rs3 per package against Rs3.10 in case of purchasing from Y
Tape Co. However Z Co. doesn’t enjoy so sterling a reputation for quality. X
Video Co. anticipates following negative aspects of purchasing tapes from Z Co.
• To incur additional inspection cost of 5 paisa per package.
Average stock out of 360 tapes packages per year would occur, largely resulting
form late deliveries. Z Co. cannot rush order at short notice. X Video Co.
anticipates lost contribution margin per package of Rs8 from stock out.
• Customer would likely return 2% of all packages due to poor quality of the
tape and to handle this return an additional cost of Rs25 per package.
Comment whether X Video Co places order to Z Co
Answer
(i) Comparative Statement of cost for purchasing from Y Co Ltd under
current policy & JIT
Particulars Current JIT
Policy
Rs Rs
Purchasing cost 18,20,000 18 , 20,260
(13,000 × (13,000 × 140.02)
140)
Ordering cost 26.00(2×13 260.00(2×130
orders) orders )
Opportunity carrying cost 10,500.00 1,050.15
(1/2×1000×140×15%) (1/2×100×140.02×1
5%)
Other carrying cost 1,550.00(1/2×1000×3. 155.00
(Insurance, material handling 10)
etc)
Stock out cost 200(4 × 50)
Total relevant cost 18,32,076 18,21,925.15
Comments: As may be seen from above, the relevant cost under the JIT
purchasing policy is lower than the cost incurred under the existing system.
Hence, a JIT purchasing policy should be adopted by the company.
(ii) Statement of cost for purchasing from Z Co Ltd.
Particulars Rs.
Purchasing cost 1,76,800 (13,000x13.60) Ordering Cost 260.00 (2x130
orders )

1.52
 Developments in the Business Environment

Opportunity Carrying 102.00

Cost (1 /2×100×13.60× 15% )
Other Carrying Cost 150.00 (1/2×100×3.00)
Stock out Cost 2,880 (8x360)
Inspection Cost 650.00 (13,000 x . 05)
Customer Return Cost 6,500.00 ( 13,000 x 2% x 25)

Total Relevant Cost 1 , 87,342

Comments : The comparative costs are as follows,
Under current policy Rs
18,32,076.00 Under purchase under JIT Rs
18,21,925.10
Under purchase from Z Co Ltd Rs 1,87,342.00
Packages should be bought from Z Co as it is the cheapest.
Question 30
How does the JIT approach help in improving an organisation’s profitability?
Answer

JIT approach helps in the reduction of costs/increase in prices as follows:

(i) Immediate detection of defective goods being manufactured so that early
correction is ensured with least scrapping.
(ii) Eliminates/reduces WIP between machines within working cell.
(iii) OH costs in the form of rentals for inventory, insurance, maintenance costs
etc. are reduced.
(iv) Higher product quality ensured by the JIT approach leads to higher
premium in the selling price.
(v) Detection of problem areas due to better pdn/scrap reporting/labour tracing
and inventory accuracy lead to reduction in costs by improvement.
Question 31
Explain, how the implementation of JIT approach to manufacturing can be a
major source of competitive advantage.
Answer
JIT provides competitive advantage in the following ways:
(i) Stocks of raw materials and finished goods are eliminated, stock holding
costs are avoided.

1.53
Advanced Management Accounting

(ii) JIT aims at elimination of non-value added activities and elimination of cost
in this direction will improve competitive advantage.
(iii) It affords flexibility to customer requirements where the company can
manufacture customized products and the competitive advantage is
thereby improved.
(iv) It focuses the direction of performance based production of high quality
product.
(v) It minimize waiting times and transportation costs.
Question 32
Differentiate between ‘Traditional Management Accounting’ and ‘Value Chain
Analysis in the strategic framework’.
Answer
Traditional management accounting focuses on internal information. It often
places excessive emphasis on manufacturing costs. It also assumes that cost
reduction must be found in the “value-added” process i.e. selling price less the
cost of raw material. The value chain analysis approach encompasses external
and internal data, uses appropriate cost drivers for all major value-creating
processes, exploits linkages throughout the value chain, and provides
continuous monitoring of a firm’s strategic competitive advantages. Value Chain
vs. Traditional Management Accounting
Traditional Management Value Chain Analysis in the
Accounting strategic framework
1. If focuses on internal information Focuses on external informations.
2. Application of single cost driver at Application of multiple cost drivers i.e.
the overall firm level is taken. structural and executional are taken for
each value activity.
3. It assume that cost reduction must Exploits linkages throughout the value
be found in the value added chain i.e. within firm, with suppliers and
process customers.
4. Insights for strategic decision Identity cost driver at the individual
somewhat limited in s activity level and develop cost /
management traditiona differentiation advantage either by
accounting l controlling those drivers better than
competitors by reconfiguring the value
chain.
Question 33
Describe the Just-in-time systems.

1.54
 Developments in the Business Environment

Answer
A complete JIT system begins with production, includes deliveries to a
company’s production facilities, continues through the manufacturing plant and
even includes the types of transactions processed by the accounting system.
(i) The company must ensure that it receives it supplies on time, preferably
directly at the production facility that needs them. The company engineers
must assist suppliers at their premises and ensure defect free supplies.
Thus raw material inventory is reduced if correct quantities are delivered as
per production schedules.
(ii) Long set-up times are reduced into short ones by eliminating inefficiency.
Thus the WIP is reduced and so is the number of products before defects
are identified.
(iii) A ‘Kanban’ card, which authorizes production of the right quantity by its
feeder machine ensures ‘pulling’ the production process and elimination of
inventory. Another method is the introduction of a working cell, which is a
cluster of machines run by a single trained operator. This also identifies
defects quickly and reduces maintenance costs. Both methods are used
together.
(iv) Work force is trained to be empowered to halt operations understand more
about the system, product flow, different machines and thus, elaborate
reporting of a past variance is eliminated.
(v) Suppliers may be paid based on production units adjusted for defects.
Question 34
What do you mean by back-flushing in JIT system? What are the problems that
must be corrected before it will work properly?
Answer
Backflushing requires no data entry of any kind until a finished product is
completed. At that time the total amount finished is entered into the computer
system, which multiples it by all the components listed in the bill of materials for
each item produced. This yields a lengthy list of components that should have
been used in the production process and which is subtracted from the beginning
inventory balance to arrive at the amount of inventory that should now be left of
hand. Back the entire production process. Given the large transaction volumes
associated with JIT, this is an ideal solution to the problem. The following
problems must be corrected before it will work properly:
(i) Production reporting
(ii) Scrap reporting
(iii) Lot tracing

1.55
Advanced Management Accounting

(iv) Inventory accuracy.

THROUGHPUT ACCOUNTING
Question 35
Vikram Ltd. produces 4 products using 3 different machines. Machine capacity is
limited to 3,000 hours for each machine. The following information is available for
February,
2009:
Products A B C D
Contribution (Sales-direct material) Rs. 1,500 1,200 1,000 600
Machine Hours Required/Unit :
Machine 1 10 6 2 1
Machine 2 10 9 3 1.5
Machine 3 10 3 1 0.5
Estimated Demand (units) 200 200 200 200
From the above information you are required to identify the bottleneck activity
and allocate the machine time.
Answer
Time required for products Total Time Machine
Machine A B C D Time Available utilization
1 2000 1200 400 200 3800 3000 126.67%
2 2000 1800 600 300 4700 3000 156.67%
3 2000 600 200 100 2900 3000 96.67%
Since Machine 2 has the highest machine Utilization it represents the bottleneck
activity hence product, ranking & resource allocation should be based on
contribution/machine hour of Machine 2.

Allocation of Resources
A B C D Machine Spare
Utilizatio Capacit
n y
Contribution per 1500 1200 1000 600
unit (Rs.)
Time required in 10 9 3 1.5
Machine 2

1.56
 Developments in the Business Environment

Contribution per 150 133.33 333.33 400

Machine – hour
(Rs.)
Rank as per 3rd 4th 2nd 1st
contribution /
mach.
Hour
Allocation of 200×10 = 100 200×3 200×1.5 3000
Machine 2 time 2000 (balancing = 600 = 300
figure)
Production 200 100/9=11.1 200 200
Quantity 1
Allocation 2000 11.11×6 = 400 200 2666.66 333.34
Machine 1 time 66.66
Allocation of 2000 11.11×3 = 200 100 2333.33 666.67
Machine 3 time 33.33
Question 36
A company produces three products A, B and C. The following information is
available for a period:
A B C
Contribution 30 25 15
(Rupees per unit)
(Sales – Direct materials)

Machine hours required per unit of production:

Hours
A B C Throughout accounting
ratio
Machine 1 10 2 4 133.33 %
Machine 2 15 3 6 200 %
Machine 3 5 1 2 66.67 %
Estimated sales demand for A, B and C are 500 units each and machine
capacity is limited to 6,000 hours for each machine.
You are required to analyse the above information and apply theory of
constraints process to remove the constraints.
How many units of each product will be made?

1.57
Advanced Management Accounting

Answer
Throughout Accounting ratio is highest for ‘Machine 2’.
∴ ‘Machine 2’ is the bottleneck
Contribution per unit of bottleneck machine
hour: Total ‘Machine 2’ hours available = 6,000
A B C
A. Contribution per unit (Rs.) 30 25 15
B. ‘Machine 2’ hours 15 3 6
C. Contribution per ‘Machine 2’ hours (A / B) 2 8.33 2.50
D. Ranking 3 1 2
E. Maximum Demand 500 500 500
‘Machine 2’ hours required (B × E) 7,500 1,500 3,00
0
‘Machine 2’ hours available 1,500 1,500 3,00
0
Units 100 500 500
Shut Down & Divestment
Question 37
What is divestment strategy? Highlight the main reasons for divestments.

Answer
Divestment Strategy:
Divestment involves a strategy of selling off or shedding business operations to
divert the resources, so released, for other purposes. Selling off a business
segment or product division is one of the frequent forms of divestment strategy. It
may also include selling off or giving up the control over subsidiary where by the
wholly owned subsidiaries may be floated as independently quoted companies.
Reason for Divestment Strategy
1. In case of a firm having an opportunity to get more profitable product or
segment but have resource constraint, it may selling off it’s unprofitable or
less profitable division and utilized the recourse so released. Cost Benefit
analysis & Capita Budgeting Method are the useful tool for analyzing this
type of situation.
2. In case of purchase of new business, it may be found that some of the part
of the acquired business is not upto the mark. In such type of situation

1.58
 Developments in the Business Environment

disposal of the unwanted part of the business is more desirable than hold
it.
3. In case where any business segment or product or subsidiary is pull down
the profit of the whole organization, it is better to cut down of that operation
of the product or business segment.

EXERCISE
TOTAL QUALITY MANAGEMENT
Question 1
Define Total Quality Management? What are the six Cs for successful
implementation of TQM?
Answer
Refer to Chapter 1: Paragraph 1.2.2 & 1.2.5
ACTIVITY BASED COST MANAGEMENT
Question 2
Explain the concept of cost drivers indicate what you will consider as cost drivers
for the following business function:
Research & development; and Customer service.
Answer
Refer to Chapter 1: Paragraph : 1.3.3
Question 3
What is activity based costing?
Answer
Refer to Chapter 1: Paragraph: 1.3.2 & 1.3.4
Question 4
What are the areas in which activity based information is used for decision
making?
Answer
Refer to Chapter 1: Paragraph: 1.3.9
Question 5
Explain the concept of activity based costing. How ABC system supports
corporate strategy?
Answer
Refer to Chapter 1: Paragraph: 1.3.7.3
Question 6

1.59
Advanced Management Accounting

Computo Ltd. manufactures two parts ‘P’ and ‘Q’ for Computer Industry.
P : annual production and sales of 1, 00,000 units at a selling price of Rs.
100.05per unit.
Q : annual production and sales of 50,000 units at a selling price of Rs. 150 per
unit. Direct and Indirect costs incurred on these two parts are as follows:
(Rs. in thousand)
P Q Tot
al
Direct Material cost (variable) 4,200 3,000 7,20
0
Labour cost (variable) 1,500 1,000 2,50
0
Direct Machining cost (See Note)* 700 550 1,25
0
Indirect Costs:
Machine set up cost
462
Testing cost 2,37
5
Engineering cost 2,25
0
16,03
7
Note: Direct machining costs represent the cost of machine capacity dedicated
to the production of each product. These costs are fixed and are not expected to
vary over the long-run horizon.
Additional information is as follows:
P Q
Production Batch Size 1,000 units 500
units
Set up time per batch 30 hours 36
hours
Testing time per unit 5 hours 9 hours
Engineering cost incurred on each 8.40 lacs 14.10
product lacs
A foreign competitor has introduced product very similar to ‘P’. To maintain the
company’s share and profit, Computo Ltd. has to reduce the price to Rs. 86.25.
The company calls for a meeting and comes up with a proposal to change
design of product ‘P’. The expected effect of new design is as follows:
• Direct Material cost is expected to decrease by Rs. 5 per unit.

1.60
 Developments in the Business Environment

• Labour cost is expected to decrease by Rs. 2 per unit.

• Machine time is expected to decrease by 15 minutes; previously it took 3
hours to produce 1 unit of ‘P’. The machine will be dedicated to the
production of new design.
• Set up time will be 28 hours for each set up.
• Time required for testing each unit will be reduced by 1 hour.
• Engineering cost and batch size will be unchanged.
Required:
(a) Company management identifies that cost driver for Machine set-up costs
is ‘set up hours used in batch setting’ and for testing costs is ‘testing time’.
Engineering costs are assigned to products by special study. Calculate the
full cost per unit for ‘P’ and ‘Q’ using Activity-based costing.
(b) What is the Mark-up on full cost per unit of P?
(c) What is the Target cost per unit for new design to maintain the same mark
up percentage on full cost per unit as it had earlier? Assume cost per unit
of cost drivers for the new design remains unchanged.
(d) Will the new design achieve the cost reduction target?
(e) List four possible management actions that the Computo Ltd. should take
regarding new design.
Answer
(a) Cost driver per machine set up hour = Rs. 70
(b) Cost driver per testing hour = Rs. 2.50
P Q
(c) Total cost (Rs.) 87,00,000 73,37,000 (d) Cost per unit (Rs.) 87.00 146.74

(e) Percentage of mark up on full cost = 15%

(f) Target cost per unit (Rs.) = 75.00
Cost P.U Total Cost
(g) Total Cost (Rs.) 77.36 77,36,000
The target cost is Rs. 75 p.u. and estimated cost of new design is Rs. 77.36 p.u.
The new design does not achieve the target cost set by Computo Ltd. Hence the
target mark up shall not be achieved. Question 7
Why are conventional product costing systems more likely to distort product
costs in highly automated plants? How do activity-based costing systems deal
with such a situation?
Answer

1.61
Advanced Management Accounting

Refer to Chapter 1: Paragraph: 1.1

Question 8
Differentiate between ‘Value-added’ and ‘Non-value-added’ activities in the
context of Activity-based costing.
Give examples of Value-added and Non-value-added activities.
Answer
Refer to Chapter 1: Paragraph: 1.6.6
Question 9
Traditional Ltd. is a manufacturer of a range of goods. The cost structure of its
different products is as follows:

Particulars Product Product Product

A B C
Direct materials 50 40 40 Rs./
u
Direct labour @ 10 Rs./hour 30 40 50 Rs./
u
Production overheads 30 40 50 Rs./
u
Total Cost 110 120 140 Rs./
u
Quantity produced 10,000 20,000 30,000 Unit
s
Traditional Ltd. was absorbing overheads on the basis of direct labour hours. A
newly appointed management accountant has suggested that the company
should introduce ABC system and has identified cost drivers and cost pools as
follows:
Activity Cost Pool Cost Driver Associated Cost
Stores Receiving Purchase Requisitions 2,96,000
Inspection Number of Production 8,94,000
runs
Dispatch Orders Executed 2,10,000
Machine Setup Number of setups 12,00,000
The following information is also supplied:

Details Product A Product B Product C

No. of Setups 360 390 450
No. of Orders Executed 180 270 300

1.62
 Developments in the Business Environment

No. of Production runs 750 1,050 1,200

No. of Purchase Requisitions 300 450 500
You are required to calculate activity based production cost of all the three
products.
Answer
A B C
Unit Cost 70.49 44.25 33.67
Add: Conversion Cost 80 80 90
Total 150.49 124.25 123.67

VALUE CHAIN ANALYSIS

Question 10
What steps are involved in value chain analysis approach for assessing
competitive advantages?
Answer
Refer to Chapter 1: Paragraph: 1.6.6
TARGET COSTING LIFE CYCLE COSTING
Question 11
What is Target Costing and what are the stages to the methodology?
Answer
Refer to Chapter 1: Paragraph: 1.4.3.2 & 1.4.12
Question 12
What is Product Life-cycle Costing ? Describe its characteristics and benefits.
Answer
Refer to Chapter 1: Paragraph: 1.5.5 & 1.5.7
JUST IN TIME
Question 13
What do you mean by ‘Back flushing’ in JIT system? Explain briefly the problems
with back flushing that must be corrected before it will work properly. (4 Marks)
Answer
Refer to Chapter 1: Paragraph: 1.9.4

1.63
 CHAPTER 2

COST CONCEPTS IN DECISION MAKING

BASIC CONCEPTS & FORMULAE

Basic Concepts
1. Relevant cost in decision making process: Costs which are relevant for
a particular business option, which are not historical cost but future costs to
be associated with different inputs and activities related a business
process. Actual, current or historical costs may be used for estimating the
future costs of each alternative. The contribution approach, coupled with
the ability to distinguish between relevant and irrelevant costs will prove to
be a boon for the managers in arriving at correct conclusions in the
challenging area of decision making.
2. Differential cost, Incremental cost and Incremental revenue:
Differential cost (which may be incremental or decremental cost) is the
difference in total cost that will arise from the selection of one alternative
instead of another. It involves the estimation of the impact of decision
alternatives on costs and revenues. The two basic concepts which go
together with this type of cost analysis are incremental revenue and
incremental costs. Incremental revenue is the change in the total income
resulting from a decision. Incremental costs represent a change in the total
costs resulting from a decision. Such a change in cost is not necessarily
variable in nature.
3. Opportunity cost concept: The opportunity cost of the value of
opportunity foregone is taken into consideration when alternatives are
compared. Opportunity Cost is the value of the next best alternative. In
other words, it is the opportunity cost lost by diversion of an input factor
from one use to another. It is the measure of the benefit of opportunity
foregone.
The opportunity cost is helpful to managers in evaluating the various
alternatives available when multiple inputs can be employed for multiple
uses. These inputs may nevertheless have a cost and this is measured by
the sacrifice made by the alternative action in course of choosing another
alternatives.
Advanced Management Accounting

4. Sunk costs: Costs which do not change under given circumstance and do
not play any role in decision making process are known as sunk costs.
They are historical costs incurred in the past. In other words, these are the
costs which
have been incurred by a decision made in past and cannot be changed by
any decision made in the future.
5. Application of Incremental/Differential Cost Techniques In Managerial
Decisions:
The areas in which the above techniques of cost analysis can be used for
making managerial decisions are:
(i) Whether to process a product further or not.
(ii) Dropping or adding a product line.
(iii) Making the best use of the investment made.
(iv) Acceptance of an additional order from a special customer at lower
than existing price.
(v) Opening of new sales territory and branch.
(vii) Make or Buy decisions.
(viii) Submitting tenders
(ix) Lease or buy decisions
(x) Equipment replacement decision.
Question 1
Explain briefly the concepts of Opportunity costs and Relevant costs.
Answer
Opportunity cost is a measure of the benefit of opportunity forgone when various
alternatives are considered. In other words, it is the cost of sacrifice made by
alternative action chosen. For example, opportunity cost of funds invested in
business is the interest that could have been earned by investing the funds in
bank deposit.
Relevant Cost: Expected future costs which differ for alternative course. It is not
essential that all variable costs are relevant and all fixed costs are irrelevant.
Fixed, or variable costs that differ for various alternatives are relevant costs.
Relevant costs draw our alternation to those elements of cost which are relevant
for the decision.

2.2
 Cost Concepts in Decision Making

E.g. Direct labour under alternative I – Rs.10/ hour

Direct labour under alternative II – Rs.20/hour
Then, direct labour is relevant cost.
Question 2
X is a multiple product manufacturer. One product line consists of motors and the
company produces three different models. X is currently considering a proposal
from a supplier who wants to sell the company blades for the motors line.
The company currently produces all the blades it requires. In order to meet
customer's needs, X currently produces three different blades for each motor
model (nine different blades).
The supplier would charge Rs.25 per blade, regardless of blade type. For the
next year X has projected the costs of its own blade production as follows (based
on projected volume of 10,000 units):
Direct materials Rs.75,00
0
Direct labour Rs.65,00
0
Variable overhead Rs.55,00
0
Fixed overhead:
Factory supervision Rs.35,00
0
Other fixed cost Rs.65,00
0
Total production costs Rs.2,95,00
0
Assume (1) the equipment utilized to produce the blades has no alternative use
and no market value, (2) the space occupied by blade production will remain idle
if the company purchases rather than makes the blades, and (3) factory
supervision costs reflect the salary of a production supervisor who would be
dismissed from the firm if blade production ceased.
(i) Determine the net profit or loss of purchasing (rather than manufacturing),
the blades required for motor production in the next year.
(ii) Determine the level of motor production where X would be indifferent
between buying and producing the blades. If the future volume level were
predicted to decrease, would that influence the decision?

2.3
Advanced Management Accounting

(iii)
For this part only, assume that the space presently occupied by blade
production could be leased to another firm for Rs.45,000 per year. How
would this affect the make or buy decision?
Answer
(a) This is a make or buy decision so compare the incremental cost to make
with the incremental cost buy.
Incremental Costs Per Unit Make the
Blades
Direct materials (Rs.75,000 ÷ 10,000 units) Rs.7.50
Direct labour (Rs.65,000 ÷ 10,000 units) Rs.6.50
Variable overhead (Rs.55,000 ÷ 10,000) Rs.5.50
Supervision (Rs.35,000 ÷ 10,000) Rs.3.50
Total cost Rs.23.00
Compare the cost to make the blades for 10,000 motors. Rs.23.00, with the
cost to buy, Rs.25.00 There is a net loss of Rs.2.00 if ‘X’ chooses to buy
the blades.
(b) ‘X’ will be indifferent between buying and making the blades when the total
costs for making and buying will be equal at the volume level where the
variable costs per unit times the volume plus the fixed avoidable costs are
equal to the supplier’s offered cost of Rs.25.00 per unit times the volume.
(Direct materials + Direct labour + Variable overhead) × Volume +
Supervision =,
Cost to buy × Volume. Let volume in units = x
(7.50 + 6.50 + 5.50) × x + 35,000 = 25.00x
19.50 x + 35,000 = 25.00 x
35,000 = 25.00 × x – 19.50 × x
35,000 = 5.50 × x
x = 6,364 units of blades
As volume of production decreases, the average per unit cost of in house
production increases. If the volume falls below 6,364 motors, then ‘X’ would
prefer to buy the blades from the supplier.
(c) If the space presently occupied by blade production could be leased to
another firm for Rs.45,000 per year, ‘X’ would face an opportunity cost
associated with in house blade production for the 10,000 units of Rs.4.50
per unit.

2.4
 Cost Concepts in Decision Making

New cost to make = 23.00 + 4.50 = 27.50

Now ‘X’ should buy because the cost to make, 27.50, is higher than the
cost to buy,
25.00.
Question 3
Why is meant by incremental Revenue?
Answer
Incremental Revenue: Incremental revenue is the additional revenue that arise
from the production or sale of a group of additional units. It is one of the two
basic concepts the other being incremental cost which go together with
differential cost analysis. Incremental cost in fact is the added cost due to change
either in the level of activity of in the nature of activity.
Question 4
Distinguish between “Marginal cost” and ‘Differential Cost”.
Answer
Marginal cost represents the increase or decrease in total cost which occurs with
a small change in output say, a unit of output. In Cost Accounting variable costs
represent marginal cost.
Differential cost is the change (increase or decrease) in the total cost (variable as
well as fixed) due to change in the level of activity, technology or production
process or method of production.
In other words, it can be defined as the cost of one unit of product or service
which would be avoided if that unit was not produced or provided.
The main point which distinguishes marginal cost and differential as that change
in fixed cost when volume of production increases or decreases by a unit of
production. In the case of differential cost variable as well as fixed cost. i.e. both
costs change due to change in the level of activity, whereas under marginal
costing only variable cost changes due to change in the level of activity.
Question 5
What are the applications of incremental cost techniques in making managerial
decisions?
Answer
Incremental cost technique: It is a technique used in the preparation of ad-hoc
information in which only cost and income differences between alternative
courses of action are taken into consideration. This technique is applicable to
situations where fixed costs alter.

2.5
Advanced Management Accounting

The essential pre-requisite for making managerial decisions by using incremental

cost technique, is to compare the incremental costs with incremental revenues.
So long as the incremental revenue is greater than incremental costs, the
decision should be in favour of the proposal.
Applications of incremental cost techniques in making managerial
decisions
The important areas in which incremental cost analysis could be used for
managerial decision making are as under: (i) Introduction of a new product
(ii) Discontinuing a product, suspending or closing down a segment of the
business
(iii) Whether to process a product further or not
(iv) Acceptance of an additional order form a special customer at lower than
existing price
(v) Opening of new sales territory and branch.
(vi) Optimizing investment plan out of multiple alternatives.
(vii) Make or buy decisions
(viii) Submitting tenders
(ix) Lease or buy decisions
(x) Equipment replacement decisions
Question 6
Ranka Builders has been offered a contract by Excel Ltd. to build for it five
special Guest Houses for use by top management. Each Guest House will be an
independent one. The contract will be for a period of one year and the offer price
is Rs. One crore. In addition Excel Ltd. will also provide 2 grounds of land free of
cost for the purpose of construction. The Chief Accountant of Ranka Builders has
prepared an estimate o the basis of which he has advised that the contract
should not be accepted at the price offered. His estimate was as follows:
Rs. in Lacs
Land (3 Grounds at Rs.20 lacs each) 60
Drawings and design 7 Registration 10
Materials:
Cement and Sand 6
Bricks and Tiles 4
Steel 10

2.6
 Cost Concepts in Decision Making

Others (including interior decoration) 10

Labour – Skilled 12
- Unskilled 8
- Supervisor’s Salary 5
Overheads General 12
Depreciation 00
6
Total Cost 15
0
The Accountant also provides the following information:
Land: The total requirement of land is 3 grounds costing Rs.20 lacs per ground
Excel Ltd. will provide 2 grounds free of cost.
Drawing and Design: These have already been prepared and 50% of the cost
has already been incurred.
Materials:
(i) Cement and sand are already in stock and are in regular use. If used for
this contract, they have to be replaced at a cost of Rs.8 lacs.
(ii) Bricks and tiles represent purchases made several months before for a
different contract, they have to be sold readily for a net Rs.5 lacs after
meeting all further expensed.
(iii)Others: Material worthRs.2 lacs relating to interior decoration are in stock
for which no alternative use is expected in the near future. However they
can be sold for Rs.1 lac.
Labour:
(i) Skilled workers will be transferred to this project from another project. The
Project Manager claimed that if the men were returned to him, he could
have earned the company an additional Ps.2 lacs in terms of profits.
(ii) The supervisor undertakes various tasks in the sites and his pay and
continuity of employment will not be affected by the new contract if the
contract is taken, he will devote half of his time.
Overheads:
(i) The equipment that would be used on the contract was bought one year
before for Rs.30 lacs and is expected to last for five years. It can also be
used on other contracts and the current replacement price will be Rs.32
lacs and in a year’s time it will be Rs.25 lacs.

2.7
Advanced Management Accounting

(ii) The general overheads includes both specific and absorbed overheads. If
the contract is not undertaken, Rs.4 lacks of the same can be avoided.
Ranka Builders has also on hand another project, which would not be executed if
the contract from Excel Ltd. were to be accepted. The estimated profit on that
project is Rs.10 lacs.
In the light of information given above, you are required to indicate with reasons
whether the contract from Excel Ltd. should be accepted or not.
Answer
M/s Ranka Builder’s Statement
of relevant costs on the
Acceptance of contract form Excel Ltd.
(Figure in laksh of Rs.)

S. Particulars Basis for the Relevant cost if Irrelevant cost

No. cost to be contract is if the contract
relevant accepted Rs. is accepted
Rs.
1. Land cost 20
(Refer to working note 1)
2. Drawings and design - 7 (Sunk cost)
3. Registration Incremental 10 -
4. Materials:
Cement and sand Replacement 8
Bricks and Tiles Opportunity 5
Steel Incremental 10
Others (Refer to working note 9
2)
5. Labour:
Skilled Opportunity 2
Unskilled Incremental 8
Supervisor’s Salary 5 (Sunk Cost)
6. Overheads:

2.8
 Cost Concepts in Decision Making

General Relevant 4
(avoidable)
Depreciation - 6 (Sunk Cost)
Replacement cost of machine 7
7. Estimated profit foregone on Opportunity 10 other
project foregone
Total 93
Decision: Since the offer price of contract is Rs.1 crore and its total relevant cost
is Rs.93 lacs; these figures clearly shows that the offer should be accepted.
Working notes:
1. Rs.
(Lacs)
Total cost of 3 grounds of land 60
Cost of ground of land will be borne by Excel Ltd. 40
Cost of 1 ground of land will be borne by M/s Ranka Builders 20
2. Others
material
cost is
Rs.10
lacs, it
includes
material
worth
Rs.2
lacs,
relating
to
interior
decorati
on,
which is
a sunk
cost, this
material
can be
sold for
Rs.1 lac,

2.9
Advanced Management Accounting

(which is
a
relevant
opportun
ity cost)
and Rs.8
lacs,
material
is an
increme
ntal cost.
Hence
total
relevant
cost of
others
material
is Rs.9
lacs.
(Rs.8
lacs,
increme
ntal +
Rs.1 lac,
opportun
ity cost).
3. Since
the
equipme
nt can
also be
used on
ths
contract.
Its
current
replace
ment
price is

2.10
 Cost Concepts in Decision Making

Rs.32
lacs, and
after one
year its
cost will
be Rs.25
lacs.
Therefor
e the
relevant
opportun
ity cost
of
machine
is:
(Rs.32
lacs –
Rs.25
lacs).
Question 7
AB Ltd. manufactures product ‘X’. the company operates single shift of 8 hours
for 300 days in a year. The capital employed in the business is Rs.18 crores.
The manufacturing operations of the company comprise of four production
departments. The company at present produces 9,000 units of product ‘X’ at
maimum capacity. However, the capacity utilization of all the four departments
are not equal and the present individual capacity utilizations are as under:
Departme
nt
Capacity Utilisation % A 75
B 100
C 70
D 50
The present return on capital of the company has gone down to 10% from the
earlier cutoff rate of 15% due to increased cost of production.

2.11
Advanced Management Accounting

As the company cannot operate more than one shift, the management is
considering two alternative proposals to increase the return on capital employed.
Alternative I
To hire out the surplus capacity of departments A, C and D. The cost and
revenue projections are as under:
Department Hire Charges per Incremental Cost per Hour
Hour
A 2,500 2,000
C 1,800 1,500
D 1,600 1,200
Alternative II
To increase the installed capacity of the factory to 12,000 units by adding plant
and machinery in department B at a capita cost of Rs.4 crore. Any Balance
surplus capacity in other departments after meeting the increased volume to be
hired out as per alternative I. The additional units would fetch incremental
revenue of Rs.1,600 per unit.
You are required to evaluate the two proposals and suggest to the management,
which of the two proposals is to be accepted.
Answer
Working notes:
1. Statement of total available, utilized and surplus capacity hours when 9,000
units of product ‘X’ are produced.
Departments Available Capacity utilized Surplus
Capacity Capacity
hours hours
(in % (in hours)
(1) (2) (3) (4) = (2)×(3) (5)=(2)-(4)
A 2,400 (300 days 75 1,800 600
× 8 hours)
B 2,400 100 2,400 NIL
C 2,400 70 1,680 720
D 2,400 50 1,200 1,200
2. Statement of total available, utilized and surplus capacity hours when
12,000 units of product ‘X’ are produced.

2.12
 Cost Concepts in Decision Making

Production Available Capacity Balance Unit per hour Hours Surplus

Department capacity utilization on capacity required capacity
hours 9,000 units hours for 3,000 hours
Hours additional
units
(1) (2) (3) (4)=(2)× (5) (6) (7) (8)=(
(3) 5)-
(7)
A 2,400 75 1,800 600 5 600 Nil
 9,000
units 
 
 1,800
hrs. 
B 2,400 10 2,400 Nil 3.75 800 Nil
0  9,000
units 
 
 2,400
hrs. 
C 2,400 70 1,680 720 5.36 560 160
 9,000
units 
 
 1,680
hrs. 
D 2,400 50 1,200 1,200 7.5 400 800
 9,000
units 
 
 1,200 hrs. 
Alternative I
Statement of net Revenue (Under Alternative I)

2.13
Advanced Management Accounting

Production Surplus Hire Total Incremental Total cost Net capacity charges
revenue in costs per in (Rs. revenue
hours per hour (Rs. Lacs) hour Rs. Lacs) in (Rs.)
(Refer to
W.N.-1
(a) (b) (c)=(a)×(b) (d) (e)=(a)×(d) ( f)=(c)-(e )
A 600 2,500 15.00 2,000 12.00 3.00
B 720 1,800 12.96 1,500 10.80 2.16
D 1,200 1,600 19.20 1,200 14.40 4.90
Total 47.16 37.20 9.96
Add: present income (10% of Rs.1,800 180.0
lacs) 0
Total return 189.9
6
Return on investment
= Total return × 100 = 189.96 × 100 = 10.553%
Total investment 1,800
Alternative II
Statement of Net Revenue when 12,000 units of product ‘X’ are produced
and surplus plant capacity (hours) in departments C and D hired out.
Production Surplus Hire Total Incremental Total cost Net
capacity charges revenue in costs per in (Rs. revenu
hours per hour (Rs.Lacs) hour Rs. Lacs) e in
(Refer to (Rs.
W.N.-2) Lacs)
(1) (2) (3)=(1)×(2) (4) (5)=(1)×(4) (6)=(3)-
(5)
C 160 1,800 2.88 1,500 2.40 0.48
D 800 1,600 12.80 1,200 9.60 3.20
Total 15.68 12.00 3.68
Add: Revenue (in lacs) earned on 3,000 additional units sale (3,000 units is
× Rs.1,600) 48.00
Add: Present income on investment (10% × Rs.1,800 lacs) 180.00
Total Return (in lacs) 231.69

2.14
 Cost Concepts in Decision Making

231.68 lacs
Return on investment = × 100 = 10.53%
2,200 lacs
Evaluation of two alternative proposals:
Since the return on investment under alternative I is more than that under
alternative II; therefore it should be accepted.
Question 8
B Ltd. is a company that has, in stock, materials of type XY that cost Rs.75,000,
but that are now obsolete and have a scrap value of only Rs.21,000. Other than
selling the material for scrap, there are only two alternative uses for them.
Alternative 1 – Converting the obsolete materials into a specialized product,
which would require the following additional work and materials:
Material A 600 units
Material B 1,000 units
Direct Labour
5,000 hours unskilled
5,000 hours semi skilled
5,000 hours highly skilled
Extra selling and delivery expenses Rs.27,000
Extra advertising Rs.18,000
The conversion would produce 900 units of saleable product and these could be
sold for Rs.300 per unit.
Material A is already in stock and is widely used within the firm. Although present
stocks together with orders already planned, will be sufficient to facilitate normal
activity and extra material used by adopting this alternative will necessitate such
materials being replaced immediately. Material B is also in stock, stock, but is
unlikely that any additional supplies can be obtained for some considerable time,
because of an industrial dispute. At the present time material B is normally used
in the production of product Z, which sells at Rs.390 per unit and incurs total
variable cost (excluding Material B) of Rs.210 per unit. Each unit of product Z
uses four units of Material B. The details of Materials A and B are as follows:
Material A Material B
(Rs.) (Rs.)
Acquisition cost at the time of purchase 100 per unit Rs.10 per
unit

2.15
Advanced Management Accounting

Net realizable value 85 per unit Rs.18 per

unit
Replacement cost 90 per unit -
Alternative 2 – Adopting the obsolete materials for use as a substitute for a sub-
assembly that is regularly used within the firm. Details of the extra work and
materials required are as follows:
Material C 1,000 units
Direct Labour:
4,000 hours unskilled
1,000 hours semi-skilled
4,000 hours highly skilled
1,200 units of the sub-assembly are regularly used per quarter at a cost of
Rs.900 per unit. The adaptation of material XY would reduce the quantity of the
sub-assembly purchased from outside the firm to 900 units for the next quarter
only. However, since the volume purchased would be reduced, some discount
would be lost and the price of those purchased from outside would increase to
Rs.1,050 per unit for that quarter.
Material C is not available externally thought 1,000 units required would be
available from stocks, it would be produced as extra production. The standard
cost per unit of Material C would be as follows:
Rs.
Direct labour, 6 hour unskilled 18
labour
Raw materials 13
Variable overhead: 6 hours at Re.1 06
Fixed overhead: 6 hours at Rs.3 18

55
The wage rate and overhead recover rates for B Ltd. are:
Variable overhead Re.1 per direct labour hour
Fixed overhead Re.2 per direct labour hour
Unskilled labour Re.3 per direct labour hour
Semi-skilled labour Re.4 per direct labour hour Highly skilled labour Re.5 per
direct labour hour

2.16
 Cost Concepts in Decision Making

The unskilled labour is employed on a casual basis and sufficient labour can be
acquired to exactly meet the production requirements. Semi-skilled labour is part
of the permanent labour force, but the company has temporary excess supply of
this type of labour at the present time. Highly skilled labour is in short supply and
cannot be increased significantly in the short-term, this labour is presently
engaged in meeting the, demand for product L, which requires 4 hours of highly
skilled labour. The contribution from the sale of one unit of product L is Rs.24.
Given the above information, you are required to present cost information
advising whether the stocks of Material XY should be sold, converted into a
specialized product (Alternative 1)) or adopted for use as a substitute for a sub-
assembly (Alternative 2).
Answer
Alternative 1 – (Conversion versus immediate sale)
Rs. Rs. Rs.
Sales revenue 900 units at Rs.300 per unit (Refer to 2 ,
working note 1) 70,000
Less: Relevant costs
Material XY opportunity cost (Refer to working note 2) 21,000
Material A – units @ Rs.90 per unit (Refer to working 54,000
note 3
Material B – 1,000 units @ Rs.45 per unit (Refer to 45,000
working note 4)
Direct Labour:
Unskilled – 5,000 hours @ Rs.3 per hour 15,000
Semi-skilled Nil
Highly skilled – 5,000 hours @ Rs.11 (Refer to 55,000 70,000
working note 5)
Variable overheads 15,000 hours @ Re.1 (Refer to 15,000
working note 6)
Extra selling and delivery expenses 27,000
Extra advertising 18,000 45,000 2 ,
50,000
Fixed advertising Nil

2.17
Advanced Management Accounting

(To remain same, not relevant) .

Excess of relevant revenues 20,00
0
Alternative 2 – (Adaptation versus Immediate
Sale)
Saving on purchase of sub-assembly
Normal spending – 1,200 units @ Rs.900 per unit 10,80,000
Less: Revised spending – 900 units @ Rs.1,050 per 9,45,000 1 ,
unit (Refer to working note 7) 35,000
Less: Relevant costs:
Material XY opportunity cost (Refer to working note 2) 21,000
Material C – 1,000 units @ Rs.37 (Refer to working 37,000
note 8)
Direct labour
Unskilled – 4,000 hours @ Rs.3 per hour 12,000
Semi-skilled Nil
Highly skilled – 4,000 hours @Rs.11 per hour (Refer to 44,000 56,000 working
note 5, 6)
Variable Overheads – 9,000 hours @ Re.1/- per hour 9,000 1 , 23,000
(Refer to working note 6)
Fixed overheads Nil .
Net relevant savings 12,000
Evaluation:
The evaluation of two alternatives clearly shows that Alternative 1, yields higher
net revenue of Rs.8,000 (Rs.20,000 – Rs.12,000). Hence because of higher net
revenue of Alternative 1, it is advisable to convert material XY into a specialized
product.
Working notes:
1. There will be a additional sales revenue of Rs.2,70,000 if Alternative 1 is
chosen.
2. Acceptance of either Alternative 1 or 2 will mean a loss of revenue of
Rs.21,000 from the sale of the obsolete material XY and hence it is an
opportunity cost for both of the alternatives. The original purchase cost of
Rs.75,000 is a sunk cost and thus not relevant.

2.18
 Cost Concepts in Decision Making

3. Acceptance of Alternative 1 will mean that material A must be replaced at

an additional cost of Rs.54,000.
4. Acceptance of Alternative 1 will mean diversion of material B from the
production of product Z. The excess of relevant revenues over relevant
cost for product Z is Rs.180 (Rs.390 – Rs.210) and each unit of product Z
uses four units of material B. The lost contribution (excluding the cost of
material B which is incurred for both alternatives) will therefore be Rs.45 for
each unit of material B that is used for converting the obsolete materials
into a specialised product.
5. Unskilled labour can be matched exactly to the company’s production
requirements. Hence acceptance of either alternative 1 or 2 will cause the
company to incur additional unskilled labour cost at Rs.3 for each hours. It
is assumed that the semi-skilled labour will be able to meet the extra
requirements of either alternatives at no extra cost to the company. Hence,
cost of semi-skilled labour will not be relevant. Skilled labour is in short
supply and can only be obtained by reducing the production of product L,
resulting in a loss of contribution of Rs.24 (given) or Rs.6 per hour of skilled
labour. Hence the relevant labour cost will be Rs.6 (contribution lost per
hour) + Rs.5 (hourly rate of skilled labour) i.e. Rs.11 per hour.
6. It is assumed that for each direct labour of input, variable overhead will
increase by Re.1 hence for each alternative using additional direct labour
hours, variable overheads will increase.
7. The cost of purchasing the sub-assembly will be reduced by Rs.1,35,000 if
the second alternative is chosen and so these savings are relevant to the
decision.
8. The company will incur additional variable costs, of Rs.37 for each unit of
material C that is manufactured, so the fixed overheads for material C viz.
Rs.18/- per unit is not a relevant cost.
Question 9
Comment on the use of opportunity cost for the purpose of decision-making
Answer
Decision making: Opportunity costs apply to the use of scarce resources, where
resources are not secure, there is no sacrifice from the use of these resources.
Where a course of action requires the use of scarce resources, it is necessary to
incorporate the lost profit which will be foregone from using scarce resources.
If resources have no alternative use only the additional cash flow resulting from
the course of action should be included in decision making as relevant cost.

2.19
Advanced Management Accounting

Question 10
Explain with one example each that sun cost is irrelevant in making decisions,
but irrelevant costs are not sunk costs. (May 2001)
Answer
Sunk cost is a historical cost incurred in the past. In other words it is a cost of a
resource already acquired. Future decisions in respect of this resource will not be
affected by it. For example, book value of machinery. Hence sunk costs are
irrelevant in decision making.
Irrelevant costs are not necessary sunk costs. For example, when a comparison
of two alternative production methods using the same material quantity is made,
then direct material cost is not affected by the decision but this material cost is
not sunk cost.
Question 11
The following are cost data for three alternative ways of processing the clerical
work for cases brought before the LC Court System:
A B Semi C Fully
Manual Automatic (Rs.) Automatic
(Rs.) (Rs.)
Monthly fixed costs
Occupancy 15,000 15,000 15,000
Maintenance contract 0 3,000 10,000
Equipment lease 0 25.000 1 , 00,000
15,000 45,000 1 , 25,000
Unit variable costs (per report):
Supplies 40 80 20
Labour 5 hrs × 40 1 hr × 60 0.25 hr ×
80
or 200 or 60 or 20
240 140 40
Required:
(i) Calculate cost indifference points. Interpret your results.
(ii) If the present case load is 600 cases and it is expected to go up to 850
cases in near future, which method is most appropriate on cost
considerations

2.20
 Cost Concepts in Decision Making

Answer
(i) Statement of cost indifference points between ways of processing the
clerical work for cases.
A and B A and C B and C
(Rs.) (Rs.) ( Rs. )
Differential fixed costs: (I) 30,000 1,10,000 80,000
(Rs.45,000 (Rs.1,25,000 (Rs.1,25,00
– – Rs.15,000) 0
Rs.15,000) –
Rs.45,000)
Differential variable costs per 100 200 100
case: (II)
(Rs.240 – (Rs.240 – ( Rs.140 –
Rs.140) Rs.40) Rs.40)
Cost indifference point (I/II) 300 550 800
(Differential fixed costs / Cases Cases Case
s
Differential variable costs per case)
Interpretation of results:
At activity level below the indifference points, the alternative with lower
fixed costs and higher variable costs should be used. At activity level above
the indifference point alternative with higher fixed costs and lower variable
costs should be used.
Thus, it expected number of cases is below 300, alternative A should be
used. If expected number of cases are between 301 and 800 use
alternative B. If expected number of cases is above 800, use alternative C.
(ii) Present case load is 600. Therefore, alternative B is suitable. As the
number of cases is expected to go upto 850 cases, alternative C is
most appropriate.
Question 12
“Sunk cost is irrelevant in decision-making, but irrelevant costs are not sunk
costs”. Explain with example.
Answer
Sunk costs are costs that have been created by a decision made in the past and
that cannot be changed by any decision that will be made in the future. For

2.21
Advanced Management Accounting

example, the written down value of assets previously purchased are sunk costs.
Sunk costs are not relevant for decision making because they are past costs.
But not all irrelevant costs are sunk costs. For example, a comparison of two
alternative production methods may result in identical direct material costs for
both the alternatives. In this case, the direct material cost will remain the same
whichever alternative is chosen. In this situation, though direct material cost is
the future cost to be incurred in accordance with the production, it is irrelevant,
but, it is not a sunk cost.
Question 13
Explain the concept of relevancy of cost by citing three examples each of
relevant costs and non-relevant costs.
Answer
Relevant costs are those costs which are pertinent to a decision. In other words,
these are the costs which are influenced by a decision. Those costs which are
not affected by the decision are not relevant costs.
Examples of relevant costs are:
(1) All variable costs are relevant costs.
(2) Fixed Costs which vary with the decision are relevant costs.
(3) Incremental costs are relevant costs. Examples of non-relevant costs:

(1) All fixed costs are generally non-relevant.

(2) Variable costs which do not vary with the decision are not relevant costs.
(3) Book value of the asset is not relevant.

2.22
 Cost Concepts in Decision Making

EXERCISE
Question 1
ZED Ltd. operates two shops. Product A is manufactured in Shop – 1 and
customer’s job against specific orders are being carried out in Shop 2. Its annual
statement of income is:
Shop-1 (Product-A) Shop-2 (Job Total
Works) Rs.
Rs. Rs.
Sales/Income 1,25,000 2,50,000 3 ,
75,000
Material 40,000 50,000 90,000
Wages 45,000 1,00,000 1 ,
45,000
Depreciation 18,000 31,500 49,500
Power 2,000 3,500 5,500
Rent 5,000 30,000 35,000
Heat and Light 500 3,000 3,500
Other Expenses 4,500 2,000 6,500
Total 1,15,000 2,20,000 3 ,
35,000
Net Income 10,000 30,000 40,000
The depreciation charges are for machines used in the shops. The rent and heat
and light are apportioned between the shops on the basis of floor area occupied.
All other cots are current expenses identified with the output in a particular shop.
A valued customer has given a job to manufacture 5,000 units of X for shop-2. As
the company is already working at its full capacity, it will have to reduce the
output of productA by 50%, to accept the said job. The customer is willing to pay
Rs.25 per unit of X. The material and labour will cost Rs.10 and Rs.18
respectively per units. Power will be consumed on the job just equal to the power
saved on account of reduction of output of A. In addition the company will have to
incur additional overheads of Rs.10,000. You are required to compute the
following in respect of this job.
(a) Differential cost;
(b) Full costs;
(c) Opportunity costs; and (d) Sunk cost.

2.23
Advanced Management Accounting

Advise whether the company should accept the job.

Answer
ZED Ltd. should not accept the job as there will be a chase disadvantage of
Rs.42,750/- as computed below:
Rs. Rs.
Incremental revenue
5,000 units @ Rs.25 1,25,000
Less: Sale of product A 62,500
62,500
Differential costs (a) 1,05,25
0
Cash disadvantage
42,750
Question 2
Indicate the major areas of short-term decisions in which differential cost analysis
is useful.
Answer
1. Accept – or – reject special order decisions.
2. Make – or – buy decisions.
3. Sell – or – process decisions.
4. Reduce – or – maintain price decisions.
5. Add – or – drop product decisions.
6. Operate – or shut down decisions.
Question 3
“Relevant cost analysis helps in drawing the attention of managers to those
elements of cost which are relevant for the decision.”
Answer
Refer Chapter 2: Paragraph: 2.1
Question 4
Briefly explain the concept of ‘Opportunity Costs’.
Answer
Refer to Chapter 2: Paragraph: 2.13

Question 5

2.24
 Cost Concepts in Decision Making

Mahila Griha Udyog Industries is considering to supply its products – a special

range of namkeens – to a departmental store. The contract will last for 50 weeks,
and the details are given below:
Material: Rs.
X (in stock – at original cost) 1,50,00
0
Y (on order – on contract) 1,80,00
0
Z (to be ordered) 3,00,00
Labour 0

Skilled 5,40,00
0
Non-skilled 3,00,00
0
Supervisory 1,00,00
0
General overheads 10,80,00
0
Total cost 26,50,00
0
Price offered by department store 18,00,00
0
Net Loss 8,50,00
0
Should the contract be accepted if the following additional information is
considered? (i) Material X is an obsolete material. It can only be used on
another product, the material for which is available at Rs.1,35,000 (Material X
requires some adaptation to be used and cost Rs.27,000).
(ii) Material Y is ordered for some other product which is no longer required. It
now has residual value of Rs.27,000).
(iii) Skilled labour can work on other contracts which are presently operated by
semiskilled labour at a cost of Rs.5,70,000.
(iv) Non-skilled labour are specifically employed for this contract.
(v) Supervisor staff will remain whether or not the contract is accepted. Only
two of them can replace other positions where the salary is Rs.35,000.
Overheads are charged at 200% of skilled labour. Only Rs.1,25,000 would be
avoidable, if the contract is not accepted.

2.25
Advanced Management Accounting

Answer
Decision Relevant costs (if Relevant costs
contract is (if contract is
accepted) Rs. rejected) Rs.
Total cash outflows: (B) 14,65,000 27,000
Net cash inflows: (A) – (B) 3,35,000 1,83,000
The net benefit on accepting the contract is: Rs.3,35,000 – Rs.1,83,000 =
Rs.1,52,000.
The contract should be accepted as it yields a net incremental cash inflow of
Rs.1,52,000.

2.26
 CHAPTER 3

CVP ANALYSIS & DECISION MAKING

BASIC CONCEPTS & FORMULAE

1. Marginal Costing
According to CIMA, Marginal costing is the system in which variable costs
are charged to cost units and fixed costs of the period are written off in full
against the aggregate contribution.
Marginal costing is not a distinct method of costing like job costing, process
costing, operating costing, etc. but a special technique used for marginal
decision making. Marginal costing is used to provide a basis for the
interpretation of cost data to measure the profitability of different products,
processes and cost centre in the course of decision making.
2. Cost-volume-profit analysis
Cost-volume-profit analysis (as the name suggests) is the analysis of three
variable viz., cost, volume and profit. Such an analysis explores the
relationship existing amongst costs, revenue, activity levels and the
resulting profit. It aims at measuring variations of cost with volume. In the
profit planning of a business, cost-volume-profit (C-V-P) relationship is the
most significant factor.
3. Important Factors in Marginal Costing Decisions
In all recommendations of marginal costing decisions, the following factors
are to be considered:
(i) Whether the product or production line in question makes a
contribution.
(ii) Where a choice is to be made between two courses of action, the
additional fixed overhead, if any, should be taken into account.
(iii) The continuity of demand after expansion or renovation or installation
of the sophisticated machine and its impact on the selling price
should also be considered.
(iv) Cost is not the only criterion for decision making. Non-cost factors
like the necessity to retain the experienced employees, etc. should
also be considered.
Advanced Management Accounting

4. Pricing Decisions under Special Circumstances

If goods were sold in the normal circumstances under normal business
conditions, the price would cover the total cost plus a margin of profit.
Selling prices are not always determined by the cost of production. They
may be determined by market conditions but in the long run they tend to
become equal to the cost of production of marginal firm. Therefore, a
business cannot continue to sell below the total cost for a long period.
Occasionally, a firm may have to sell below the total cost.
The problem of pricing can be summarised under three heads:
(i) Pricing in periods of recession,
(ii) Differential selling prices, and
(iii) Acceptance of an offer and submission of a tender.
5. Make or Buy Decision
Very often management is faced with the problem as to whether a part
should be manufactured or it should be purchased from outside market.
Under such circumstances two factors are to be considered: (a) whether
surplus capacity is available, and (b) the marginal cost.

6. Shut Down or Continue Decision

Very often it becomes necessary for a firm to temporarily close down the
factory due to trade recession with a view to reopening it in the future. In
such cases, the decision should be based on the marginal cost analysis. If
the products are making a contribution towards fixed expenses or in other
words if selling price is above the marginal cost, it is preferable to continue
because the losses are minimised. By suspending the manufacture,
certain fixed expenses can be avoided and certain extra fixed expenses
may be incurred depending upon the nature of the industry, say, for
example, extra cost incurred in protecting the machinery. So the decision
is based on as to whether the contribution is more than the difference
between the fixed expenses incurred in normal operation and the fixed
expenses incurred when the plant is shut down.

3.2
 CVP Analysis & Decision Making

7. Export V/S Local Sale Decision

When the firm is catering to the needs of the local market and surplus
capacity is still available, it may think of utilising the same to meet export
orders at price lower than that prevailing in the local market. This decision
is made only when the local sale is earning a profit, i.e., where its fixed
expenses have already been
recovered by the local sales. In such cases, if the export price is more than
the marginal cost, it is preferable to enter the export market. Any reduction
in the price prevailing in the local market to fulfil surplus capacity may have
adverse effect on the normal local sales. Dumping in the export market at a
lower price will not, however, have any such adverse effect on local sales.
8. Expand or Contract Decision
Whenever a decision is to be taken as to whether the capacity is to be
expanded or not, consideration should be given to the following points:
(a) Additional fixed expenses to be incurred.
(b) Possible decrease in selling price due to increase in production.
(c) Whether the demand is sufficient to absorb the increased production.
9. Product Mix Decision
Many times the management has to take a decision whether to produce
one product or another instead. Generally decision is made on the basis of
contribution of each product. Other things being the same the product
which yields the highest contribution is best one to produce. But, if there is
shortage or limited supply of certain other resources which may act as a
key factor like for example, the machine hours, then the contribution is
linked with such a key factor for taking a decision.
10. Price-Mix Decision
When a firm can produce two or more products from the same production
facilities and the demand of each product is affected by the change in their
prices, the management may have to choose price mix which will give the
maximum profit, particularly when the production capacity is limited. In such
a situation, the firm should compute all the possible combinations and
select a price-mix which yields the maximum profitability.
BASIC FORMULAS
1. Sales-Variable Cost = Contribution = Fixed Cost + Profit
2. P/V ratio (or C/S ratio) = Contribution ÷ Sales
= Contribution per unit ÷ Selling price per unit

3.3
Advanced Management Accounting

= Change in Contribution ÷ Change in Sales

3. Break-even Point: Point where there is no profit or no loss.
(i) at BEP, Contribution = Fixed Cost
Thus, Break Even Sales (in sales value) = Fixed Cost ÷ P/V ratio
4. Margin of safety = Sales – BEP sales
= Contribution / PV ratio - Fixed cost / PV ratio
= Profit / PV ratio
5. BEP Calculation in different scenario:
(i) With out limiting factor (non- attributable to a single product)
BEP in units = Fixed cost ÷ Average contribution p.u.
(when sales mix in units are given)
BEP in Rs. = Fixed cost ÷ composite p\v ratio
(when sales mix in rupee are given )
where composite p\v ratio = ∑ [ Sales Mix P\V
Ratio ]
(ii) With limiting factor (attributable to a single product)
Find contribution per limiting factor & give rank. Find total
contribution from 1st rank product. Calculate the amount of fixed
cost still to recover. Whether it can be recovered by 2nd rank
product or not ?
(iii) For Perishable product apply the same concept in case of opening stock
with different variable cost.
e. BEP in case of process costing is expressed in terms of total
raw material input
f. In capital budgeting, BEP is that sales volume where
Σdiscounted Cash in flow = Σdiscounted Cash out flow. In
case of perpetuity, the financing charge p.a.= CIF pa
g. Potential BE: On the basis of sales out of current period
production only.
h. Multiple BE: Different BE due to change in sales price,
variable costs & fixed costs for different production level.
i. Cash BEP = Cash fixed cost ¸ contribution p.u. So do not
consider the sunk cost.

3.4
 CVP Analysis & Decision Making

j. BEP for decision making purpose: Accept that proposal where

BEP is lowest provided the profit can not be calculated. Total
fixed cost – Shut down costs
6. Shut down point = Contribution per unit
Question 1
Enumerate the limitations of using the marginal costing technique.
Answer
Marginal costing is defined as the ascertainment of marginal cost and of the
effect on profit of changes in volume or type of output by differentiating between
fixed costs and variable costs. Limitations of Marginal Costing Techniques:
The limitations of using the marginal costing technique are as follows:
1. It is difficult to classify exactly the expenses into fixed and variable
category. Most of the expenses are neither totally variable nor wholly fixed.
2. Contribution itself is not a guide unless it is linked with the key factor.
3. Sales staff may mistake marginal cost for total cost and sell at a price;
which will result in loss or low profits. Hence, sales staff should be
cautioned while giving marginal cost.
4. Overheads of fixed nature cannot altogether be excluded particularly in
large contracts, while valuing the work-in-progress. In order to show the
correct position fixed overheads have to be included in work-in-progress.
5. Some of the assumptions regarding the behaviour of various costs are not
necessarily true in a realistic situation. For example, the assumption that
fixed cost will remain static throughout is not correct.
Question 2
Briefly discuss on curvilinear CVP analysis.
Answer
In CVP analysis, the usual assumption is that the total sales line and variable
cost line will have linear relationship, that is, these lines will be straight lines.
However, in actual practice it is unlikely to have a linear relationship for two
reasons, namely:
• after the saturation point of existing demand, the sales value may show a
downward trend.
• the average unit variable cost declines initially, reflecting the fact that, as
output increase the firm will be able to obtain bulk discounts on the
purchase of raw materials and can also benefit from division of labour.
When the plant is operated at further higher levels of output, due to

3.5
Advanced Management Accounting

bottlenecks and breakdowns the variable cost per unit will tend to increase.
Thus the law of increasing costs may operate
and the variable cost per unit may increase after reaching a particular level
of output.
In such cases, the contribution will not increase in linear proportion i.e.
based on the phenomenon of diminishing marginal productivity; the total
cost lie will not be straight, as assumed but will be of curvilinear shape.
This situation will give rise to
two break even points. The optimumearned
profit is
at the point where the distance
between sales and total cost is the greatest.

Los
s
A2
.

Profi A1 and 2 are

t A
break-even
t

points

Los A1
s

Quantity
Question 3
A company manufactures two types of herbal product, A and B. Its budget shows
profit figures after apportioning the fixed joint cost of Rs.15 lacs in the proportion
of the numbers of units sold. The budget for 2002, indicates:
A B
Profit (Rs.) 1,50,000 30,00
0
Selling price / unit (Rs.) 200 120
P/V ratio (%) 40 50
You are required to advise on the best option among the following, if the
company expects that the number of units to be sold would be equal.
(i) Due to exchange in a manufacturing process, the joint fixed cost would be
reduced by 15% and the variables would be increased by 7½ %.
(ii) Price of A could be increased by 20% as it is expected that the price
elasticity of demand would be unity over the range of price.

3.6
 CVP Analysis & Decision Making

(iii) Simultaneous introduction of both the option, viz, (i) and (ii) above.
Answer
1. Contribution per unit of each
product:

Product
A B
Rs. Rs.
Contribution per unit 80 60
(Sales × P/V ratio) (Rs.20 × 40%) (Rs.12 ×
50%)
2. Number of units to be sold:
We know that:
Total contribution – Fixed cost = Profit
Let x be the number of units of each product sold, therefore:
(80x + 60x) – Rs.15,00,000 = Rs.1,50,000 + Rs.30,000
or x = 12,000 units
(i) Option: Increase in profit when due to change in a manufacturing
process there is reduction in joint fixed cost and increase in variable
costs.
Rs.
Revised contribution from 12,000 units of A due 8 ,
to 52,000
7.5% increase in variable cost
(12,000 units (Rs.200 – Rs.129)
Revised contribution from 12,000 units of B due 6 ,
to 66,000
7.5% increase in variable cost
12,000 units (Rs.120 – Rs.64.50)
Total revised contribution 15,18,000
Less: Fixed cost 12,75,000
(Rs.15,00,000 – 15% × Rs.15,00,000)
Revised Profit 2,43,000

3.7
Advanced Management Accounting

Less: Existing profit 1,80,000

Increase in profit 63,000
(ii) Option: Increase in profit when the price of product A increased by
20% and the price elasticity of its demand would be unity over the
range of price.
Rs.
Budgeted revenue from Product A (12,000 24 ,
units × Rs.200) 00,000

Revised demand (in units) 10,000

(Rs.24,00,000 / Rs.240)

Revised contribution (in Rs.) 12 ,

[10,000 units × (Rs.240 – Rs.120)] 00,000

Less: Existing contribution (12,000 9,

units × Rs.80) 60,000

Increase in profit (contribution) 2,

40,000
*Note: Since price elasticity of demand is 1, therefore the revenue in
respect of products will remain same.
(iii) Option: Increase in profit on the simultaneous introduction of above
two options
Rs.
Revised contribution from Product A [10,000 11 ,
units (Rs.240 – Rs.129)] 10,000

Revised contribution from Product B [12,000 6,

units (Rs.120 – Rs.64.50)] 66,000

Total revised contribution 17 ,

76,000
Less: Revised fixed cost 12 ,
75,000
Revised profit 5,
01,000
Less: Existing profit 1,
80,000
Increase in profit 3,
21,000

3.8
 CVP Analysis & Decision Making

Advise: A comparison of increase in profit figures under above three

options clearly indicates that the option (iii) is the best as it increases
the profit of the concern by Rs.3,21,000.
Note: The budgeted profit/(loss) for 2002 in respect of products A and
B should be Rs.2,10,000 and (Rs.30,000) respectively instead of
Rs.1,50,000 and Rs.30,000.
Question 4
“Use of absorption costing method for the valuation of finished goods inventory
provides incentive for over-production.” Elucidate the statement.
Answer
When absorption costing method is used, production fixed overheads are
charged to products and are included in product costs. Consequently, the closing
stocks are valued on total cost (including fixed overheads) basis. The net effect is
that the charge of fixed overheads to P/L account gets reduced, if the closing
stock is greater than the opening stock. This situation has the effect of inflating
the profit for the period.
Where stock levels are likely to fluctuate significantly, profits may be distorted if
calculated on absorption costing basis. If marginal costing is used, since the fixed
costs are charged off to P/L account as period cost, such a situation will not
arise. The impact of using absorption costing on profits can be summerised as
under:
• When sales are equal to production, profits will be the same under
absorption costing and marginal costing.
• If production is higher than sales, the absorption costing will post higher
profits that marginal costing.
• If sales are in excess of production, absorption costing will show lower
profits than marginal costing.
Since profit calculation in absorption costing can produce strange result, the
managers may deliberately alter the stock levels to influence the profits if
absorption costing is used. Hence, it is true to say that if absorption costing
method is used managers have the incentive to over produce to show better
result.
Question 5
A Pharmaceutical company produces formulations having a shelf life of one year.
The company has an opening stock of 30,000 boxes on 1st January, 2005 and
expected to produce 1, 30,000 boxes as was in the just ended year of 2004.
Expected sale would be 1,50,000 boxes. Costing department has worked out
escalation in cost by 25% on variable cost and 10% on fixed cost. Fixed cost for

3.9
Advanced Management Accounting

the year 2004 is Rs40 per unit. New price announced for 2005 is Rs100 per box.
Variable cost on opening stock is Rs40 per box.
You are required to compute breakeven volume for the year 2005.
Answer
Shelf life is one year hence opening stock of 30,000 boxes is to be sold first.
Contribution on these boxes is 30,000(100 – 40) = Rs18,00,000.
In the question production of 2004 is same as in 2005. Hence fixed cost for the
year 2004 is Rs52, 00,000 (1, 30,000×40). Therefore fixed cost for the year 2005
is Rs57, 20,000 (52, 00,000 + 10% of 52, 00,000).
Variable Cost for the year 2005 (Rs40 + 25% of Rs40) = Rs50 per
Unit Hence Contribution per unit during 2005 is Rs50 (100 – 50)
Break even volume is the volume to meet the fixed cost i.e. fixed cost equals to
contribution. Therefore, remaining fixed cost of Rs39, 20,000 (57, 20,000 – 18,
00,000) to be recovered from production during 2005.
Production in 2005 to reach BEP = 3920000 / 50 = 78,400 units
Therefore BEP for the year 2005 is 1, 08,400 boxes (30000 + 78400)
Question 6
Jay Kay Limited is a single product manufacturing company. The following
information relates to the months of May and June, 2003:
May June Rs. Rs.
(i) Budgeted Costs and Selling prices:
Variable manufacturing cost per unit 2.00 2.20
Total fixed manufacturing cost
(based on budgeted output of 25,000 units per month) 40,000
44,000
Total fixed marketing cost 14,000 15,400 Selling price
per unit 5.00 5.50 (ii) Actual production and sales:
Units Units
Production 24,000 24,000
Sales 21,000 26,500
(iii) There was no stock of finished goods at the beginning of May, 2003. There
was no wastage or loss of finished goods during May or June, 2003.
(iv) Actual costs incurred corresponded to those budgeted for each month.

3.10
 CVP Analysis & Decision Making

You are required to calculate the relative effects on the monthly operating profits
of applying: (i) Absorption costing and (ii) Marginal costing.
Answer
(a) Quantity tally:
May 2003 June
2003
Opening Stock units − 3,000
Production units 24,000 24,000
Total units 24,000 27,000
Sales units 21,000 26,500
Closing Stock units 3,000 500
Fixed manufacturing overheads Rs. 40,000 44,000
Budgeted output units 25,000 25,000
Fixed overheads absorption rate per Rs. 1.60 1.76
unit

(i) Profitability based on absorption costing:

May 2003 June
2003
Rs. Rs.

Sales:
May: 21,000 units @ Rs. 5.00 1 , 05,000
June: 26,500 units @ Rs. 5.50 1,
Production Costs: 45,750

Variable: May 24,000 units @ Rs. 2.00 48,000

June 24,000 units @ Rs. 2.20 52,800
Fixed: May 24,000 units @ Rs. 1.60 38,400
June 24,000 units @ Rs. 1.76 42,240
Total production costs 86,400 95,040
Add: Opening stock
May Nil

June 3,000 units @ Res. 3.60* 10,800

3.11
Advanced Management Accounting

Total 86,400
1,05,84
0
Less: Closing stock
May 3,000 units @ Rs. 3.60* 10,800
June 500 units @ Rs. 3.96* 1,980
Production cost of goods sold 75,600 1,03,86
0
Marketing fixed costs 14,000
15,40
0
Total cost of goods sold 89,600 1 ,
19,260
Profit (Sales – COGS) 15,400 26,490
Budgeted output 25,000 units
Actual output 24,000 units
Shortfall 1,000 units
Under recovery of fixed overheads

May 1,000 units @ Rs. 1.60 1,600

June 1,000 units @ Rs. 1.76 1,760
Net profit 13,800 24,730
*Total cost = VC + FC
May 2.00 + 1.60 = 3.60
June 2.20 + 1.76 = 3.96
(ii) Profitability based on marginal costing:
May 2003 June 2003
Rs. Rs.
Sales 1,05,000 1,
45,750
Production cost – variable 48,000 52,800
Add: Opening stock
May Nil
June 3,000 units @ Rs. 2.00 6,000

3.12
 CVP Analysis & Decision Making

Total 48,000 58,800

Less: Closing stock
May 3,000 units @ Rs. 2.00 6,000
June 500 units @ Rs. 2.20 1,100
Variable cost of goods sold 42,000 57,700
Contribution 63,000 88,050
Fixed costs: May June
Production 40,000 44,000
Marketing 14,000 15,400 54,000 59,400
Net profit 9,000 28,650
Question 7
X Ltd. manufactures a semiconductor for which the cost and price structure is
given below:
Rs. per
unit
Selling price 500
Direct material 150
Direct labour 100
Variable overhead 50
Fixed cost = Rs. 2 lakhs.
The product is manufactured by a machine, whose spare part costing Rs. 2,000
needs replacement after every 100 pieces of output. This is in addition to the
above costs. Assume that no defectives are produced and that the spare part is
readily available in the market at all times at Rs. 2,000.
(i) Prepare the profitability statement for production levels of 2,000 units and
3,000 units, when fixed cost = Rs. 1 lakhs.
(ii) What is the break-even point (BEP) for the above data?
(iii)
Comment on the BEP, if the fixed cost can be reduced to Rs. 1,80,000 from
the existing level of 2 lakhs.
Answer
(i) X Ltd. Profitability Statement:
Volume Level

3.13
Advanced Management Accounting

Particulars 2000 units 3000 units

Rs.’000
Sales 1,000 1,500
Variable costs
Direct Material 300
450
Direct Labour 200
300
Variable overhead 100
150
Part costs* 40 60
Fixed cost 100
100
Total cost 740 1,06
0
Profit 260
440
*Part cost: 2,000 ×2,000 = 40,000 3,000 ×60,000 = 2,000
100 100
(ii) For computing the BEP: Parts cost although a step fixed cost can be
considered as variable for the limited purpose of computing the range in
which BEP occurs. The variable parts cost per unit is Rs. 20  2,000 
.
 100 
Range in which the BEP occur 1,00,000 = 555.55 2,00,000 =
(200 −20) 1,111.11 (200
−20)
Range 501−600 1,101−1,200
General Fixed Cost 1,00,000* 2 , 00,000
Parts cost (6 × 2,000) = (12 × 2,000) =
12,000 24,000
Total Fixed Cost 1,12,000 2 , 24,000
Gross Contribution/unit** 200 200
BEP 560 units 1 ,120 units
**Gross Contribution per unit

3.14
 CVP Analysis & Decision Making

Sales –Direct Material – Direct Labour – Variable Overheads

Rs. 500 – Rs. 150 – Rs. 100 –Rs. 50 = Rs. 200
1,80,000
(iii) When fixed cost is Rs. 1,80,000. Range of BEP will be = 1,000
(901 − 1,000)
180
Since the BEP of 1,000 falls on the upper most limits in the range 901 –
1,000 there will be one more BEP in the subsequent range in 1,001 –
1,100.
Range 901 – 1,000 1 ,001 –
1,100
Rs. Rs.
Gross fixed cost 1,80,000 1 , 80,000
Parts cost 20,000 22,000
10 × 2,000 11 × 2,000
Total fixed cost 2,00,000 2 , 02,000
Gross contribution/unit 200 200
BEP 1,000 units 1 ,010 units
Question 8
A company has produced 1,500 units against a budgeted quantity of 2,000 units.
Actual sales were 1,300 units. The company’s policy is to value stocks at
standard absorption cost.
Other data are:
Direct material Rs. 100 per unit
Direct labour Rs. 100 per unit at normal
efficiency
Variable OH Rs. 50 per unit
Fixed OH at budgeted capacity Rs. 1,00,000
Variable selling OH Rs. 26,000
Budgeted fixed selling OH Rs. 30,000
Actual fixed selling OH Rs. 25,000
Selling price Rs. 400 per unit
There was no opening stock.
(i) Present the profitability statement under absorption costing system.

3.15
Advanced Management Accounting

(ii) Assuming actual labour was 25% below normal efficiency and that 100
units of production had to be scrapped after complete manufacture,
compute the actual profit or loss.
(iii) Reconcile the profits under (i) and (ii) above.
Answer
(i & ii) Profitability under absorption costing system Actual profit and loss account
Particulars Rs. 000’s Particulars Rs.
000’s
Sales (1,300×400) 520 Sales (1,300×400) 520
Absorption costs Closing Stock (100×300) 30
Opening Stock Nil Total 550
Cost of production Cost
1,500 units × 300 450 Direct materials 150
(1,500×100)
Less: Closing stock 60 Direct labour 200
(200×300) (1,500×100/75%)
Net Absorption costs 390 Variable overhead 75
(1,500×50)
Add: Under-absorption 25 Fixed manufacturing 100
(500×50) overhead
Total absorption costs 415 Fixed Selling overhead 25
Gross profit 105 Variable selling overhead 26
Less: Selling overhead 26 Total costs 576
variable
Selling overhead fixed 25
Profit/(loss) 54 Profit / (Loss) (26)
Working Notes:

Rs. Units
Absorption cost per unit Budgeted capacity 2,000
Direct materials 100 Production 1,500
Direct labour 100 Under-absorption 500
Variable overhead 50 Sales 1,300
Fixed Overhead (1,00,000 / 50 Closing stock 200
2,000)

3.16
 CVP Analysis & Decision Making

Total 300
(iii) Reconciliation
Rs. 000’s
Profit under absorption costing 54
Less: Labour inefficiency** (50)
Less: Value of units scrapped (30)
Actual profit / (loss) (26)
** (1,500× (133 1/3−100)
Note: In case budgeted fixed selling overheads are considered while
arriving at absorption profit a saving of Rs. 5,000 shall need to be identified
as part of reconciliation.
Question 9
The following information of a company is available for the year 2006:
Rs.
Sales 40,000
Raw materials 20,000
Direct wages 6,000
Variable and fixed OH 10,000
Profit 4,000
Units sold 200
Nos.
In the year 2007, wages rate will increase by 50% and fixed cost will decrease by
Rs. 600. If 300 units are sold in 2007, the total fixed and variable OH will be
11,400. How many units should be sold in 2007, so that the same amount of
profit per unit as in year 2006 may be earned? Answer
Particulars (Data per unit) 2006 2007
Rs. Rs.
Selling price (40,000 /200) 200 Raw materials (20,000 /200) 100
Direct wages (6,000 /200) 30 (30 ×150%) 45
Variable overhead 20 Total variable cost 165
Contribution 35
Profit per unit (4,000 /200) 20
Net contribution per unit to cover fixed overheads 15

3.17
Advanced Management Accounting

Fixed overheads 6,000 5,400

No. of units 5 ,400/15 = 360 units Working Notes:
No. of units sold 200 300
Total variable and fixed overheads 10,000 11 ,400 + 600 =
12,000
Differential cost in 2007 100 units Rs.
2,000
Variable overhead per unit 2 ,000 / 100 = 20
Total variable cost 4,000 6,000
Total fixed cost 6,000 (6 ,000 – 600)
5,400
Question 10
A company makes 1,500 units of a product for which the profitability statement is
given below:
Rs.
Sales 1 , 20,000
Direct materials 30,000 Direct labour 36,000
Variable OH 15,000
Subtotal variable cost 81,000
Fixed cost 16,800
Total cost 97,800
Profit 22,200
After the first 500 units of production, the company has to pay a premium of Rs.
6 per unit towards overtime labour. The premium so paid has been included in
the direct labour cost of Rs. 36,000 given above.
You are required to compute the Break-even point.
Answer
Data / Unit 1 – 500 501 – 1,500
Rs. Rs.
Sales (1,20,000 / 1,500) 80 80
Direct material (20,000 / 1,000) 20 20
Direct labour 20 26
Variable overheads 15,000 / 1,500 10 10
Contribution 30 24

3.18
 CVP Analysis & Decision Making

No. of units 500

Total contribution 15,000
Fixed costs 16,800
Shortfall 1,800
No. of units required above 500 to recover 1,800 / 24 = 75
shortfall
Break even point (500 + 75) = 575
units
Let X be the Direct Labour per unit upto 500 units.
Total Direct Labour 500X + 1,000 (X + 6) = 36,000
1,500X + 6,000 = 36,000
X = 20.
Therefore, up to 500 units the Direct Labour is Rs. 20. After 500 units it is Rs. 26.
Question 11
A Ltd. Makes and sells a single product. The company’s trading results for the
year are:
Figs. – Rs. ’000 (Year 2007)
Sales 3,000
Direct materials 900 Direct labour 600
Overheads 900 2,400
Profits 600
For the year 2008, the following are expected:
(i) Reduction in the selling price by
10%. (ii) Increase in the quantity
sold by 50%.
(iii) Inflation of direct material cost by 8%.
(iv) Price inflation in variable overhead by 6%.
(v) Reduction of fixed overhead expenses by 25%.
It is also known that:
(a) In 2006, overhead expenditure totalled to Rs. 8,00,000.
(b) Total overhead cost inflation for 2007 has been 5% more than 2006.
(c) Production and sales volumes have been 25% higher in 2007 than in 2006.
The high-low method is being used by the company to estimate overhead
expenditure.

3.19
Advanced Management Accounting

You are required to:

(i) Prepare a statement showing the estimated trading results for 2008.
(ii) Calculate the Break-even point for 2007 and 2008.
(iii) Comment on the BEP and profits of the years 2007 and 2008.
Answer
(a) (i) Trading Results
Figures Rs. ’000
2006 2007 2008 Workings
Sales: 3,000 4,050 (3,000 × 1.5 × .9)
( Refer to Note 1)
Direct Material 900 1,458 (900 × 1.5 × 1.08) Direct Labour 600 900 (600
× 1.5 × 1)

Variable 300* 477 (300 × 1.06 × 1.5)

Overhead ( Refer Note 2)
Total Variable 1,800 2,835 Total variable cost
Cost
Contribution 1,200 1,215
Fixed Overhead 600 450 (600 × .75)
( Refer to Note 3)

Total Overhead 800 900 927

Total Cost 2,400 3,285

Profits 600 765

(ii) P/V Ratio Contribution/ Sales 40% 30%
600 450
BEP Fixed Cost/PV Ratio = 1,500 = 1,500
40% 30 %
(Note 1) 3,000 × 1.5 × 0.9
(Note 2) Overhead Cost in 2006 = 800
Increase in price = 5%
∴ Overhead cost for same production 800 × 5% + 800 = 840.

3.20
 CVP Analysis & Decision Making

Overhead increase due to quantity = 900 – 840 = Rs. 60

Rs. 60 represents increase in variable Overhead in 2007 due to
increase in quantity by 25%.

∴ Variable Overhead amount in 2007 = 1 times

 1 
i.e. = 5 times  th quantity  = 5 × 60 = 300
4 
(Note 3)
In 2007 Total Overhead 900
Variable Overhead (Refer to Note 2) 300
Fixed Overhead 600

(iii)
2007 2008 Difference %
BEP 1,500 1,500 0
Fixed Overhead 600 450 150 25 %

PV Ratio 40% 30% 10% 25%

Profit 600 765 165 27.5 %
BEP = Fixed Cost
P/V ratio
Both Fixed Cost and P/V ratio have declined by 25% equally. So BEP sales
remains the same.
The contribution is only Rs. 1,215 in 2008 though quantity is increased by
50%. This is due to increase in production cost and decrease in selling
price. This is more than made up by decrease in fixed cost so that overall
profit has increased by 27.5%.
Alternative Solution (for identifying variability and fixedness of overheads):
V1q1 = Variable Overhead / unit in 2007 × quantity in 2007
V2q2 = Variable Overhead / unit in 2008 × quantity in 2008
V2q2 = V1(1.06) (1.5)q1 = 1.59 v1q1

3.21
Advanced Management Accounting

V0 q0 + F0 = 800
V1 q0 + F0 = 840 where q0 × 1.25 = q1

V1 q0 − V0 q0 = 40
V0q0 = V1 q0 − 40

V1 q0 + F1 – (V0 q0 + F0) = × 800 =

40 i.e. V1 q0 + F1 =

840 V1 q1 + F1 = 900

V1 (q0 − q1) = −60

V1 (q1 − 1.25q) = −60 × 1.25
V1 (−.25)q1 = −75

− 75
V1q1 = = 300
−.25
Variable Overhead 300
Year 2007

Fixed Overhead 600

900
Question 12
Draw and explain the angle of incidence in a break-even chart. What is its
significance to the management?
Answer

3.22
 CVP Analysis & Decision Making

(c)

C
Cost & Revenue (Rs.)

A D

0
Units (Nos.)

Angle of incidence (0)angle

is thebetween the total cost line and the total sales
line.
If the angle is large, the firm is said to make profits at a high rate and vice-versa.
A high angle of incidence and a high margin of safety indicate sound business
conditions.
Question 13
A single product manufacturing company has an installed capacity of 3,00,000
units per annum. The normal capacity utilization of the company is 90%. The
company has prepared the following budget for a year:
Variable costs:
Factory costs Rs. 33 per unit

Selling and Administration Rs. 9 per unit

costs
Fixed costs:

Factory costs Rs. 21,60,000

Selling and Administration Rs. 7,56,000

costs
Selling Price

Selling price per unit Rs. 60

3.23
Advanced Management Accounting

The actual production, sales, price and cost data relating to the year under
review are as given below:
Production 2,40,000
units
Sales 2,25,000
units
Finished goods stock in the beginning of the year: 15,000 units
Actual factory variable costs exceeded the budget by Rs. 1,20,000
Required:
(i) Calculate the budgeted profit and break-even point in units.
(ii) What increase in selling price was necessary during the year under review
to maintain the budgeted profit?
(iii) Prepare statements showing the actual profit during the year under review
by using
(1) absorption costing method and (2) marginal costing method.
Answer
(i) Contribution per unit:
Rs. Rs.
Selling price per unit 60
Variable costs per unit:
Factory 33
Selling & Administration 9 42
Contribution per unit (Selling price – Variable cost) 18
Budgeted Profit:

Units Rs. Rs.

Installed capacity 3,00,000
Normal capacity utilization (3,00,000 × 90%) 2,70,000

Total contribution (A) (Contribution per unit ×

Normal capacity utilization) (2,70,000 × 18) 48 ,
60,000
Fixed Costs (B)

3.24
 CVP Analysis & Decision Making

Factory Costs 21,60,000

Selling and Administration costs 7,56,000 29 , 16,000
Profit (A – B) 19 , 44,000
Fixed costs
Break-even point (in units) =
Contribution per unit

= 29,16,000 = 1,62,000.
18
(ii) 1. Actual variable costs per unit Rs. Rs.
Budgeted factory costs 33
Increase in Factory costs per unit

 1,20,000  

 2,40,000  0.50 33.50

Selling and Administration costs 9.00
42.50
2. Selling price required to maintain the budgeted profit:
A. Total contribution required (Rs.) 48 , 60,000 B. Actual production
(units) 2 , 40,000

C.Contribution desired per unit (A ÷ B) (Rs.) 20.25

D. Variable cost per unit (Rs.) 42.50
E.Selling price required to maintain budgeted profit
(C + D) (Rs.) 62.75
F. Increase in selling price necessary Rs. (62.75 – 60) 2.75
(iii) Fixed overhead recovery rate:
Fixed factory overheads Rs. 21,60,000 Normal Production 2 ,70,000 units
Absorption Rate per unit : 21,60,000 / 2,70,000 = Rs. 8
Stock analysis:
Units
Opening stocks 15,000 Add: Production 2 , 40,000
Total 2 , 55,000
Less: Sales 2 , 25,000 Closing stocks 30,000
1. Profitability based on Absorption Costing Method:

3.25
Advanced Management Accounting

Rs. Rs.
A. Sales (2,25,000 units @ Rs. 60) 1 ,35,
00,000
B. Production costs:
Variable factory cost:(2,40,000 units × 79,20,000
Rs. 33)
Increase in cost 1,20,000
Fixed factory costs (2,40,000 units × 19,20,000
Rs. 8)
Total production costs 99,60,000
Less: Closing stock
(30,000 units × 99,60,000) / 2,40,000 12,45,000
87,15,000
Add: Opening stock 15,000 units × Rs. 41* 6,15,000
Production cost of goods sold 93 ,
30,000
C. Selling and Administration Costs:
Variable costs: 2,25,000 units × Rs. 9 20,25,000
Fixed Costs 7,56,000
27,81,00
0
D. Less: Total cost of goods sold (B + C) 1 ,21,
11,000
13 ,
89,000
Less: Under absorption of factory fixed
overheads
(2,40,000 – 2,70,000 units) × Rs. 8 2,40,000
Profit 11 ,
49,000
Cost of opening stock (per unit) = Variable Factory cost + Fixed overhead
recovery rate
= Rs. 33 per unit + Rs. 8
per unit = Rs. 41
per unit.
Profitability based on Marginal Costing Method:

3.26
 CVP Analysis & Decision Making

Rs. Rs. A Sales (2,25,000 units @ Rs. 60)

1 ,35, 00,000 Production variable costs:

Variable cost (2,40,000 units × Rs. 33) 79,20,000

Increase in cost 1,20,000
Total 80,40,000
Less: Closing stock:
(30,000 × 80,40,000) / 2,40,000 10,05,000
70,35,000
Add: Opening Stock (15,000 units × Rs. 33) 4,95,000
B Production variable cost of goods sold 75,30,000
C Variable Selling & Administrative Expenses20,25,000
(2,25,000 × Rs. 9)
D Total variable costs (B + C) 95 ,
55,000
E Contribution (A − D) 39 ,
45,000
F Less: Fixed overheads: Factory 21,60,000
Selling & Administration 7,56,000 29 ,
16,000
G Profit (E − F) 10 ,
29,000
Question 14
Bloom Ltd. makes 3 products, A, B and C. The following information is available:
(Figures in Rupees per unit)
A B C
Selling price (peak-season) 550 630 690
Selling price (off-season) 550 604 690
Material cost 230 260 290
Labour (peak-season) 110 120 150
Labour (off-season) 100 99 149
Variable production overhead 100 120 130

3.27
Advanced Management Accounting

Variable selling overhead

(only for peak-season) 10 20 15
Labour hours required for one unit of 7
production 8 11 (hours)
Material cost and variable production overheads are the same for the peak-
season and off-season. Variable selling overheads are not incurred in the off-
season. Fixed costs amount to Rs. 26,780 for each season, of which Rs. 2,000 is
towards salary for special technician, incurred only for product B, and Rs. 4,780
is the amount that will be incurred on after-sales warranty and free maintenance
of only product C, to match competition.
Labour force can be interchangeably used for all the products. During peak-
season, there is labour shortage and the maximum labour hours available are
1,617 hours. During offseason, labour is freely available, but demand is limited to
100 units of A, 115 units of B and 135 units of C, with production facility being
limited to 215 units for A, B and C put together.
You are required to:
(i) Advise the company about the best product mix during peak-
season for maximum
profit.
(ii) What will be the maximum profit for the off-season?
Answer

(a) Bloom Ltd.

Peak Season.
Statement of Contribution and BEP (in units)
Figures Rs.
Product A B C
A. Selling Price per unit 550 630 690

Variable Costs per unit:

Direct Material 230 260 290
Direct Labour 110 120 150
Variable Overhead – Production 100 120 130
Variable Overhead-Selling 10 20 15

3.28
 CVP Analysis & Decision Making

B. Total Variable Cost 450 520 585

C. Contribution / unit (A – B) 100 110 105
D. Direct Labour hours / required per 8 11 7
unit
E. Contribution per Labour Hour (C / D) 12.5 10 15
F. Ranking 2 3 1
General Fixed Overhead 20,000
Specific Fixed overhead 2,000 4,780 6,780
G. Total Fixed Overhead 26,780
H. time) (G/C) BEP (units) (for only 1 Product at a 20,000100 = 20

= 20 = 23

Maximum units that can be produced of product C with limited labour hours
1,617.

= = 231.
231 < Break Even units.
Hence, Bloom Ltd. cannot produce C.
Next rank = A
Break Even units of A = 200
∴Profit if only A is produced
Rs.
Contribution = Rs. 202 × 100 20,200
Fixed Cost 20,000
Profit 200
Off Season
Bloom Ltd.
Off Season
Statement of Contribution and demand

Figures Rs. per

unit

3.29
Advanced Management Accounting

Product A B C

A Selling Price 550 604 690

Direct Material 230 260 290
Direct Labour 100 99 149
Production-Variable Overhead 100 120 130

Maximum units of A that can be produced with limited labour hours = = 202
units.

3.30
 CVP Analysis & Decision Making

B Total Variable Cost 430 479 569

C Contribution per unit (A − B) 120 125 121
Ranking 3 1 2
Maximum demand 100 115 135
Overall limit of production 215
units
Statement of profitability under different options
(limit of production = 215 units)
A B C Total Fixed Cost Profit
( loss )
Contribution per unit 120 125 121 -
Option 1: Units - 115 100 215
Contribution (Rs.) - 14,375 12,100 26,475 26,780 (305)
Option 2: Units 100 115 - 215
Contribution (Rs.) 12,000 14,375 - 26,375 22,000 4,375
Option 3: Units 80 - 135 215
Contribution (Rs.) 9,600 - 16,335 25,935 24,780 1,155
Best strategy is to produce 100 units of product A and 115 units of product B
during offseason.
Maximum profit = Rs. 4,375.
(i) Best strategy for peak-season is to produce 202 units of A.
(ii) Maximum profit for off-season Rs. 4,375.
Question 15
A company has prepared the following budget for the forthcoming year:
Rs. lakhs
Sales 20.00
Direct materials 3.60
Direct labour 6.40
Factory overheads:
Variable 2.20
Fixed 2.60
Administration overheads 1.80

3.31
Advanced Management Accounting

Sales commission 1.00

Fixed selling overheads 0.40
Total costs 18.00
Profit 2.00
The policy of the company in fixing selling prices is to charge all overheads other
than the prime costs on the basis of percentage of direct wages and to add a
mark up of one-ninth of total costs for profit.
While the company is confident of achieving the budget drawn up as above, a
new customer approached the company directly for execution of a special order.
The direct materials and direct labour costs of the special order are estimated
respectively at Rs. 36,000 and Rs. 64,000. This special order is in excess of the
budgeted sales as envisaged above. The company submitted a quotation of Rs.
2,00,000 for the special order based on its policy. The new customer is willing to
pay a price of Rs. 1,50,000 for the special order. The company is hesitant to
accept the order below total cost as, according to the company management, it
will lead to a loss.
You are required to state your arguments and advise the management on the
acceptance of the special order.
Answer
Analysis of Cost and profit:
Rs. (lakhs) Rs. (lakhs)
Direct material 3.60
Direct labour 6.40
Prime cost 10.00
Overhead:
Variable factory overhead 2.20
Fixed factory overhead 2.60
Administration overheads 1.80
Selling commission 1.00
Fixed selling overheads 0.40 8.00
Total cost 18.00
Profit 2.00
Rate of profit on costs (2/18) = 1/9

3.32
 CVP Analysis & Decision Making

Overhead absorption rate based on direct wages = (8.00 / 6.40) × 100 = 125% of
direct wages
Break up of new order: Rs.
Direct Materials 36,000
Direct Labour 64,000
Overheads 125% of direct wages 80,000
Total costs 1 , 80,000
Profit 1/9 20,000
Selling Price 2 , 00,000
The following points emerge:
(i) Factory overheads only are to be recovered on the basis of direct wages.
(ii) The special order is a direct order. Hence commission is not payable.
(iii) The budgeted sales are achieved. Hence all fixed overheads are
recovered. Hence, no fixed overheads will be chargeable to the special
order.
Based on the above, the factory variable overheads recovery rate may be
calculated as under:
Total variable factory overheads Rs. 2.20 lakhs
Direct wages Rs. 6.40 lakhs
Factory overhead rate = (2.20 / 6.40) × 100 = 34.375%
Applying this rate the cost of the special order will be as under:
Rs.
Direct materials 36,000
Direct labour 64,000
Overheads 34.375% of direct wages 22,000
Total costs 1 , 22,000
Price offered 1 , 50,000
Margin 28 ,000 (more than
1/ 9)
Hence, the order is acceptable at the price of Rs. 1,50,000.
Question 16
Paints Ltd. manufactures 2,00,000 tins of paint at normal capacity. It incurs the
following manufacturing costs per unit:

3.33
Advanced Management Accounting

Rs.
Direct material 7.80
Direct labour 2.10
Variable overhead 2.50
Fixed overhead 4.00
Production cost / unit 16.40
Each unit is sold for Rs. 21, with an additional variable selling overhead incurred
at Rs. 0.60 per unit.
During the next quarter, only 10,000 units can be produced and sold.
Management plans to shut down the plant estimating that the fixed
manufacturing cost can be reduced to Rs. 74,000 for the quarter.
When the plant is operating, the fixed overheads are incurred at a uniform rate
throughout the year. Additional costs of plant shut down for the quarter are
estimated at Rs. 14,000.
You are required:
(i) To advise whether it is more economical to shut down the plant during
the quarter rather than operate the plant.
(ii) Calculate the shut down point for the quarter in terms of numbering units.
Answer

Contribution per tin = Selling Price – Variable cost

= 21 – (7.8 + 2.1+ 2.5 + 0.6) =
Rs. 8 per tin.
Loss on operation:
Fixed cost per annum = 2,00,000 units × 4 per unit = 8 lakhs.

∴ Fixed cost for 1 quarter = = 2 lakhs

Rs.
Fixed cost for the quarter 2,
00,000
Less: Contribution on operation (8 × 10,000) 80,000

3.34
 CVP Analysis & Decision Making

Expected loss on operation (1,20,00

Loss on shut down: 0)

Rs.
Unavoidable Fixed Cost 74,000
Additional shut down cost 14,000
Loss on shut-down (88,00
0)
Conclusion: Better to shut down and save Rs. 32,000.
Shut-down point (number of units) = Avoidable Fixed Cost
Contribution per unit

= 2,00,000 − 88,000
8

= = 14,000 units.
Question 17
XYZ Ltd. has two divisions, A and B. Division A makes and sells product A, which
can be sold outside as well as be used by B. A has a limitation on production
capacity, that only 1,200 units can pass through its machining operations in one
month. On an average, about 10% of the units that A produces are defective. It
may be assumed that out of each lot that A supplies, 10% are defectives. (12
Marks)
When A sells in the outside market, the defectives are not returned, since the
transportation costs make it uneconomical for the customer. Instead, A's
customers sell the defectives in the outside market at a discount.
But, when B buys product A, it has to fix it into its product, which is reputed for its
quality. Therefore, B returns all the defective units to A. A can manually rework
the defectives, incurring only variable labour cost and sell them outside at
Rs.150 and not having to incur any selling costs on reworked units. If A chooses
not to rework, it can only scrap the material at Rs.30 per unit. B can buy product
A from outside at Rs.200 per unit, but has to incur Rs.10 per unit as variable
transport cost. B can insist to its outside suppliers also that it will accept only
good units.
A incurs a variable selling overhead only on units (other than reworked units)
sold outside. The following figures are given for the month:
Variable cost of production – Dept. A (Rs./unit) 120

3.35
Advanced Management Accounting

Variable selling overhead (Rs./u) 20

Selling price per unit in the outside market (Rs./u) 200
Current selling price to B (Rs./u) 190
Additional variable labour cost of reworking defectives (Rs./u) 100
Selling price of reworked defectives (Rs./u) 150
Fixed costs for the month (Rs.) 36,00
0
Maximum demand from B at present (no. of units) 630
The outside demand can be freely had upto 900units.
Given the demand and supply conditions, you are required to present
appropriate calculations for the following:
(i) Evaluation of the best strategy for A in the present condition.
(ii) If B can buy only upto 540 units and the outside demand is only 600 units,
how much should A charge B to maintain the same level of profit as in (i)
above? Answer
(i) Contribution per unit against sale to outside = Rs ( 200-120-20) = Rs 60
In case of transfer, good units and rejected units are in proportion
of 9:1 In case of transfer, contribution per good unit = Rs ( 190 –
120) = Rs 70
In case of transfer, contribution per rejected unit = Rs ( 150 – 120-100) =
Rs -70
Thus, effective contribution per unit of transfer = Rs ( 70 x 0.9 – 70x 0.1) =
Rs 56 As contribution per unit aginst outside sale is higher, the best
strategy should be to sell maximum number of unit to outside marker.
Contribution from outside market from sale of 900 units = Rs
54,000
Rs.(900 x 60)
Contribution from transfer of 300 units to B = Rs
16,800
Rs (300 x 56)
Total Contribution from best strategy = Rs 70,800
(ii) If B’s demand is 540 unit, total production required = 600
units. (540 /0.9)

3.36
 CVP Analysis & Decision Making

Taking outside market demand of 600, it is within production capacity of

1200 units. Now contribution from 600 units of outside sale =
Rs 36,000
Rs ( 600 x 60 )
Contribution from rejected 60 units = Rs
(4,200)
Rs ( 60 x – 70)
= Rs 31,800
To keep same level of contribution as in (i), the contribution required from
transfer of 540 unit to B = Rs 39,000
(Rs 70,800 – 31,800)
Thus, contribution required per unit = Rs 72.22
Rs 39,000 /540
Hence price to be charged per unit against transfer to B = Rs 192.2
Rs ( 120 + 72.22)
Alternative Solution:
Let x be the number of units sold outside and y be the number of units sold to B,
before B returns 10% as defectives.
Then, x + y = 1,200, is the limitation on production capacity of A.
Department A
Outside to B
Rs. Rs.
Selling Prices 200 190
Variable Cost – Production 120 120
Variable Cost – Sale 20 --
Total Variable Cost 140 120
Contribution 60 70
Contribution on x units sold outside = 60x

Out of y units to B, 10% = y = .1y is returned to A. If A scraps, amount got = 30

per unit.

If A reworks and sells, it gets 150 – 100 = 50 / unit.

3.37
Advanced Management Accounting

∴Decision to reworks all defectives. i.e. (.1) (y)

Contribution on good units of B = 0.9y × 70 = 63y
Contribution on reworked units of B = (.1) (y) × 50 = 5y
Amount of material lost on manufacture of defectives to B =
12y (.1) (y) × 120
∴Contribution on y gross units transferred to B = 56y
63y + 5Y – 12y
Total contribution earned by A = 60x + 56y
where x + y = 1200
To maximize contribution, maximize units sold outside.
∴900 units – sell outside.

Balance units (gross transfer to B, of which B gives back 30 defectives)

Contribution : Rs.60 (900) + Rs.56 (300)
= Rs.54,000 + Rs.16,800
Contribution = Rs.70,800
Fixed Cost = Rs.36,000
(i) Profit = Rs.34,800
(ii) Outside demand = 600 units
Contribution = 600 × Rs.60 = Rs.36,000
Balance to be got = Rs.34,800
= Rs.70,800
Out of Rs.34,800, defectives of B will give
Rs. 3,000 60 × 50
Rs. 31,800 charge to B for 540 units
Contribution to be obtained from 540 units of B = Rs. 31,800
Add: Production cost of 600 units @ 120/- = Rs. 72,000
Amount changed for 540 units = Rs.1,03,800

∴Price to be charged to B = = 192.22

Per good unit transferred, to maintain the same level of profit as in (a).
Question 18

3.38
 CVP Analysis & Decision Making

Ret Ltd., a retail store buys computers from Comp Ltd. and sells them in retail.
Comp Ltd. pays Ret Ltd. a commission of 10% on the _selling price at which Ret
sells to the outside market. This commission is paid at the end of the month in
which Ret Ltd. submits a bill for the commission. Ret Ltd. sells the computers to
its customers at its store at Rs.30,000 per piece Comp Ltd. has a policy of not
taking back computers once dispatched from its factory. Comp Ltd. sells a
minimum of 100 computers to its customers.
Comp Ltd. charges prices to Ret Ltd. as follows:
Rs.29,000 per unit, for order quantity 100 units to 140 units.
Rs.26,000 per unit, for the entire order, if the quantity is 141 to 200 units. Ret Ltd.
cannot order less than 100 or more than 200 units from Comp Ltd.
Due to the economic recession, Ret Ltd. will be forced to offer as a free gift, a
digital camera costing it Rs.4,500 per piece, which is compatible with the
computer. These cameras are sold by another Co., Photo Ltd. only in boxes,
where each box contains 50 units. Ret Ltd. can order the cameras only in boxes
and these cameras cannot be sold without the computer.
In its own store, Ret Ltd. can sell 110 units of the computer. At another far of
location, Ret Ltd. can sell upto 80 units of the computer (along with its free
camera), provided it is willing to spend Rs.5,000 per unit on shipping costs. In
this market also, the selling price that each unit will fetch is Rs.30,000 per unit.
You are required to:
(i) State what is Ret's best strategy along with supporting calculations.
(ii) Compute the break-even point in units, considering only the above costs.
Answer
Order Qty Order Qty
100-140 Rs.)
( 141-200 Rs.)
(
Selling Price Rs./u 30,000 30,000
Commission @ 10% 3,000 3,000
Sales revenue p. u. 33,000 33,000
Less: Variable purchase cost
Contribution / unit (before shipping)
Less: Shipping cost > 110 units
Contribution/ units after Shipping
(i) Upto 110 units, Reference will earn a contribution of Rs.4,000/u.

3.39
 29,000 26,000
4,000 7,000
Advanced Management Accounting 5,000
2,000

(ii) Between 110 & 140 units, contribution of 4,000 will be wiped out by 5,000
on shipping costs. Hence we should not consider 110 – 140 range.
(iii) 101 – 110 not to be considered since additional fixed costs 2,25,000 will not
be covered by 10 units.
(iv) Valid consideration, 100 units or 141 to 190 units.
Fixed cost of box of 50 cameras is Rs. 2,25,000
Units 100 141 150 190 No. of Camera Boxes A 2 3 3 4
Cost of Cameras (Rs.) B 4,50,000 6,75,000 6,75,000
9 , 00,000 Contribution (Rs/u) Rs. 4,000 C 400,000
Contribution (Rs.) first 110 units D 7,70,000 7,70,000 7 ,
70,000
@ 7,000/u
Contribution (Rs.) Balance units E 62,000 80,000 1 , 60,000
@ 2,000/u
Total Contribution (F = C + D + F 4,00,000 8,32,000
8,50,000 9 , 30,000
E) (Rs.)
Profit (F) – (B) (Rs.) G - 50,000 1,57,000 1,75,000 30,000
Best strategy buy 150 units from Comp. sell 110 at store and 40 outside.
BEP should be between 151 – 191 units
Extra Camera box cost beyond 150 units = 2,25,000 Less:
Profit for 150 units = 1,75,000
Extra profit acquired = 50,000
No. of units to cover this additional costs at contribution 2000 Rs./u =

= 25
∴BEP = 150 + 25 = 175 units

Alternative Solution to (ii)

The problem involves fixed cost of 50 Computers i.e Rs 2,25,000 for incremental
sale of 50.
Units sold
110 140 150 190

3.40
 CVP Analysis & Decision Making

Margin per unit = Sales price – 4000 4000 7000

buying price + commission ( Rs) 7000
Margin ( Excluding shipping cost) 4,40,000 5,60,000 10,50,000 13 ,
30,000
Shipping cost ( Rs) 30 x 5000 40 x 5000 80 x
For sale beyond 110 units = 1,50,00 = 2,00.000 5000
= 4,
00,000
Contribution ( Rs) 4,40,000 4,10,000 8,50,000 9,
30,000
Fixed cost ( Cost of Computers) 6,75,000 6,75,000 6,75,000 9,
00,000
Profit -2,75,000 -2,65,000 1,75,000 30,000
Best strategy is sales level at 150 units.
The variations of profit is due to incremental fixed cost.
From the profits at different levels, it is seen that the BEP lies between 151 and
190. Let BEP = X Units
Margin = 7000 X
Shipping Cost = ( X -110)x 5000
Cost of Computers = Rs 9,00,000
We have, 7000 X = ( X -110) x 5000 + 900000
Or 7X = 5X – 550 +900
Or 2X = 350 or X = 175
Thus, BEP = 175 units.
Question 19
Lee Electronic manufactures four types of electronic products, A,B,C and D. All
these products have a good demand in the market. The following figures are
given to you:
A B C D
Material cost (Rs./u) 64 72 45 56
Machining Cost (Rs/u @ Rs. 8 per hour) 48 32 64 24
Other variable costs (Rs/u) 32 36 44 20
Selling Price (Rs/u) 162 156 173 118
Market Demand (Units) 52,000 48,500 26,500 30,000
Fixed overhead at different levels of operation are :

3.41
Advanced Management Accounting

Level of operation (in production hours) Total fixed cost (Rs.)

Upto 1,50,000 10,00,000
1,50,000 – 30,00,000 10,50,000
3,00,000 – 4,50,000 11,00,000
4,50,000- 6,00,000 11,50,000
Demand 52,000 48,500 26,500 30,00
0
A B C D
Direct Material 64 72 45 56
M/c 48 32 64 24
Other Variable Cost 32 36 44 20
Total Variable Cost 144 140 153 100
Selling Price 162 156 173 118
Contribution (Rs./u) 18 16 20 18
M/s Hours per unit 6 4 8 3
Contribution (Rs./ M/c hr.) 3 4 2.5 6
Ranking III II IV I
At present, the available production capacity in the company is 4,98,000 machine
hours. This capacity is not enough to meet the entire market demand and hence
the production manager wants to increase the capacity. The company wants to
retain the customers by meeting their demands through alternative ways. One
alternative is to sub-contract a part of its production. The sub-contract offer
received as under :
A B C D
Sub-contract Price (Rs./u) 146 126 155 108
The company seeks your advice in terms of products and quantities to be
produced and/or sub-contracted, so as to achieve the maximum possible profit.
You are required to also compute the profit expected from your suggestion.
Answer

Sub-Contract Cost Rs./u) 146 126 155 108

3.42
 CVP Analysis & Decision Making

Contribution (Rs./u) on (Sub- 16 30 18 8

Contract)
I Division: It is more profitable to sub-contract B, since contribution is higher sub-
contract.
1st Level of Operations: 1,50,000 hours, Produce D as much as
possible. Hours required = 30,000 units × 3 = 90,000 hours
Balance hours available: 60,000 hours.
Produce the next best (i.e. A, Since B is better outsourced)
60,000 hrs
= 10,000 units of A.
6 hrs/u
st
1 Level of Operation:
Contribution (units) Contribution (Rs.)
A Produce 10,000 units 18 1 , 80,000
A Outsource 42,000 units 16 6 , 72,000
B 48,500 units
Outsource fully 30 14 , 55,000
C 26,500 units
Outsource fully 18
D 30,000 units
Fully produce 18 5 , 40,000
Total Contribution: 33 , 24,000
Less: Fixed cost 10 , 00,000
Net Gain 23 , 24,000
nd
2 Level of Operation:
Both A and C increase contribution by own manufacture only by Rs.2/- per unit.
1,50,000 hrs can produce 25,000 units of A.
∴Contribution increases by 25,000 × 2 = 50,000
(Difference in Contribution sub-contract and own manufacturing)
= 2 But increase in fixed Cost = 50,000

3.43
Advanced Management Accounting

At the 2nd level of operation, the increase in contribution by own manufacturing is

exactly set up by increase in fixed costs by Rs.50,000/-. It is a point of financial
indifference, but other conditions like reliability or possibility of the sub-contractor
increasing his price may be considered and decision may them but towards own
manufacture.
3rd Level Additional: 1,50,000 hrs available
Unit of A that are needed = [52,000 – 25,000 (2nd Level) – 10,000 (1st
Level)] = 17,000 units × 6 hrs/u = 1,02,000 hrs.

Balance 48,000 hrs are available for C to produce 6,000 units.

Increase in Contribution over Level 1st or 2nd:
A: 17,000 × 2 = Rs.34,000
C: 6,000 × 2 = Rs.12,000
= Rs.46,000
Increase in fixed costs = Rs.50,000
Additional Loss = Rs. 4,000

4th Level Additional: 1,50,000 hrs can give = 18,750 unit of C.

Increase in Contribution 18,750 × 2 = Rs. 37,500
Increase in Cost = (Rs. 50,000) Level 3rd loss c/fd = (Rs.
4,000)
Level 1st profit will order by =(Rs. 16,500)
Advice: Do not expand capacities; sell maximum
No. of units by operating at 1,50,000 hrs. capacity (level 1 st ) and gain
Rs.23,24,000.
Summary:
Product Produce Sub-Contract Contribution Contribution Total
(Units) (Units) (Production) (Sub-Contract) Contribution
A 10,000 42,000 1,80,000 6,72,000 8 , 52,000
B - 48,500 - 14,55,000 14 , 55,000
C - 26,500 - 4,77,000 4 , 77,000
D 30,000 - 5,40,000 - 5 , 40,000
33 , 24,000
Fixed Cost 10 , 00,000

3.44
 CVP Analysis & Decision Making

Profit 23 , 24,000
Question 20
TQM Limited makes engines for motor cars for its parent company and for two
other motor car manufacturers.
On 31st December, the company has sufficient work order for January and one
further order for 21,000 engines. Due to recession in the economy, no further
order are expected until May when it is hoped economic prospect for the motor
car industry will have improved. Recently factory has been working at only 75%
of full capacity and the order for 21,000 engines represents about one month
production at this level of activity.
The board of directors are currently considering following two options:
(i) Complete the order in February and close the factory in March and
April. OR
(ii) Operate at 25 per cent of full capacity for each of three months of
February, March and April.
The costs per month at different levels of activities are as. follows:
At 75% (Rs.) At 25% (Rs.) Idle (Rs.)
Direct Material 5,25,000 1,75,000 --
Direct Labour 5,23,600 1,73,250 --
Factory overhead:
Indirect material 8,400 4,900 4,900
Indirect labour 1,01,500 59,500 --
Indirect expenses:
Repairs and maintenance 28,000 28,000 --
Others expenses 52,500 34,300 26,600
Office overheads:

Staff salaries 1,48,400 98,000 67,550

Other overheads 28,000 19,950 11,200

Other information is as follows:

• Material cost and labour cost will not be incurred where there is no
production.

3.45
Advanced Management Accounting

• On the reopening of the factory, one time cost of training and

engagement of new personnel would be Rs.65,800 and overhauling
cost of plant would be Rs.14,000.
• Parent company can purchase engines from open market at
reasonable
price.
Required:
(i) To express your opinion, along with calculations, as to whether the
plant should be shut down during the month of March and April or
operate 25% of full capacity for three months.
(ii) To list and comment on cost and non-costs factors which might to
relevant to the discussion.
Answer
(i)
Option I Option II
At 75% in Feb and close in At
25% each from Feb March and April
(Rs.) – April (Rs.)
Direct Material 5,25,000 5 , 25,000 Direct Labour 5,23,600 5 , 19,750
10,48,600 10 , 44,750
Factory Overhead :
Indirect Material 8,400 14,700 Two months idle 9,800
Indirect Labour 1,01,500 1 , 78,500
Training cost 65,800
Indirect Exp. :
Repairs & Maintenance 28,000 84,000 Over hauling cost 14,000
Others Expenses 52,500 1 , 02,900
Idle × 2 53,200
Office overhead:
Staff Salaries 1,48,400 2 , 94,000 Idle 67,550 × 2 1 , 35,100
Other overheads 28,000 59,850
Idle 22,400
Total overhead cost 6,67,100 7 , 33,950
Total cost 17,15,700 17 , 78,700

3.46
 CVP Analysis & Decision Making

The more economic course of action is to operate at 75% capacity for a

month only, and close the plant for March and April. This option will save
(Rs.17,78,700 – Rs.17,15,700) = Rs.63,000.
(ii) Cost Factors and Non Cost Factors
In regard to the decision on close down of operations or continuing with
operations, the factors to be considered are:
(a) Cost factors:
(1) The proposal which involves the lower total costs will be
selected.
(2) If the company has contracted the purchases from high qulaity
and high price suppliers, a change in the procurement policy to
‘shop around’ may be considered to obtain economics in
purchases.
(3) The services of unskilled labour, if any, who do not require re-
training may be dispensed with. They may be recruited and put
on work without incurring training cost on re-opening of the
factory. This will save training and idle time cost.
(4) The possibility of wage freeze may reluctantly be considered as
an extreme measure.
Question 21
Fairbilt Furniture Ltd. manufactures three products: Tables, Chairs and Cabinets.
The company is in the process of finalizing the plans for the coming year; hence
the executives thought it would be prudent to have a look at the product-wise
performance during the current year. The following information is furnished:
Tables Chairs Cabinets
Unit selling price 80 60 36
Direct material 28 24 16
Direct labour 20 12 12

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Advanced Management Accounting

Factory overheads:
Variable 8 6 4
Fixed 8 6 1.28
Cost of production 64 48 33.28
Selling, distribution and general
administration expenses :
Variable 4 2 2
Fixed 4 6 1.52
Unit cost (I) 72 56 36.80
Unit profit (loss) (II) 8 4 (0.80)
Sales volume (units) 10,000 15,000 15,000
Profit (loss) 80,000 60,000 (12,000)

For the coming period, theng

selli
prices and the cost of
reethproducts are expected to
remain unchanged. There will be an increase in the sales of tables by 1,000 units
and the increase in sales of cabinets is expected to be 8,000 units. The sales of
chairs will remain to be unchanged. Sufficient additional capacity exists to enable
the increased demands to be met without incurring additional fixed costs. Some
among the executives contend that it will be unwise to go for additional
production and sale of cabinets, since it is already making losses at Rs.0.80 per
unit. The suggestion is that cabinets should be eliminated altogether.
Do you agree? Substantiate with necessary analysis and determine the product
wise and overall profits for the coming year.
Answer
Note: Reconciliation of the figures given for ‘cabinets’ reveals the fact that the
selling price is 36(36.80 – .80)
Fairbilt Furniture Ltd.
Statement showing Product-wise Contribution and Total Profit
Tables Chairs Cabinets Total
Per Unit Total Per unit Total Per unit Total
Sales volume 10,000 15,000 15,000
(units
Selling price 80 800,000 60 900,000 36 540,00022,40,000
(Rs.)

3.48
 CVP Analysis & Decision Making

Direct Material 28 280,000 24 360,000 16 240,000 880,000 Direct Labour 20

200,000 12 180,000 12 180,000 560,000
Variable factory 8 80,000 6 90,000 4 60,000 230,000 overheads
Variable selling, 4 40,000 2 30,000 2 30,000 100,000 distribution and
administration overhead
Total variable 60 600,000 44 660,000 34 510,000 1,770,000 cost
Contribution 20 200,000 16 240,000 2 30,000
470,000 Fixed factory 80,000 90,000 19,200
189,200 overheads
Fixed selling, 40,000 90,000 22,800 152,800 distribution
and administration overheads
Total fixed 342,000 overheads
Total Profit 128,000
The above analysis shows the cabinets make a contribution of Rs.2 per unit. The
loss sustained in the previous year is because of the falling sales volume below
breakeven level. Fairbilt Furniture Ltd.
Budgeted Performance for the Coming Year
Tables Chairs Cabinets
Unit Contribution (Rs.) 20 16 2
Sales Volume (Units) 11,000 15,000 23,000
Total Contribution (Rs.) 220,000 240,000 40,000
Less: Fixed Cost (Rs.) 120,000 180,000 42,000
Profit (Rs.) 100,000 60,000 4,000
The company makes a total profit of Rs.164,000 if all the products are continued.
However, if the production of cabinets is discontinued, there will be an adverse
effect on the overall profit of the company. This is because cabinets also
contribute toward meeting the fixed costs of the company.
Question 22
An agro-products producer company is planning its production for next year. The
following information is relating to the current year:
Products/Corps A1 A2 B1 B2
Area occupied (acres) 250 200 300 250
Yield per acre (ton) 50 40 45 60

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Advanced Management Accounting

Selling price per ton (Rs.) 200 250 300 270

Variable cost per acre (Rs.)
Seeds 300 250 450 400
Pesticides 150 200 300 250
Fertilizers 125 75 100 125
Cultivations 125 75 100 125
Direct wages 4,000 4,500 5,000 5,700
Fixed overhead per annum (Rs.) 53,76,000.
The land that is being used for the production of B1 and B2 can be used for
either crop, but not for A1 and A2. The land that is being used for A1 and A2 can
be used for either crop, but not for B1 and B2. In order to provide adequate
market service, the company must produce each year t least 2,000 tons each of
A1 and A2 and 1,800 tons each of B1 and B2.
You are required to:
(i) Prepare a statement of the profit for the current year.
(ii) Profit for the production mix by fulfilling market commitment.
(iii)
Assuming that the land could be cultivated to produce any of the four
products and there was no market commitment, calculate: Profit amount of
most profitable crop and break-even point of most profitable crop in terms
of acres and sales value.
Answer
(i) Calculation of selling price and contribution per acre:
Products A1 A2 B1 B2 Total
Yield per acre in (tones) 50 40 45 60 Selling price per tones (Rs.) 200
250 300 270 Sales revenue per acre (Rs.) 10,000 10,000 13,500 16,200
Variable cost per acre (Rs.) 4,700 5,100 5,950 6,600 Contribution per
acre (Rs.) 5,300 4,900 7,550 9,600
Area (acres) 2,50 200 300 250
Total contribution (Rs.) 13,25,000 9,80,000 22,65,000
24,00,000 69,70,000
Less: Fixed Cost 53,76,000
Profit (Rs.) 15,94,000
(ii) Profit Statement for recommended mix
Products A1 A2 B1 B2 Total

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 CVP Analysis & Decision Making

Contribution per acre 5300 4900 7550 9600

Rank 1 2 2 1
Minimum Sales 2000/40 1800/45
Requirement in = 50 = 40
acres
Recommended Mix 400 50 40 510
(in Acres)
Total Contribution 21,20,00 2,45,000 3,02,000 48,96,00 75 ,
(Rs.) 0 0 63,000
Less: Fixed Cost 53 ,
76,000
Profit 21 ,
87,000
(iii) Most profitable crop: Production should be concentrated on B2 which gives
highest contribution per acres Rs.9,600.
Overall contribution if complete land is used for B2 (1,000 × 9,600) =
Rs.96,00,000
Less: Fixed Cost = Rs.53,76,000
Profit: = Rs.42,24,000
Break even point in acres for B2 = 5376000 ÷ 9600 = 560 acres
Break even point in sales value = 560 × (270 × 60) = Rs.90, 72,000
Question 23
LMV Limited manufactures product Z in departments A and B which also
manufacture other products using same plant and machinery. The information of
product Z is as follows:
Items Department A (Rs.) Department B
(Rs.)
Direct material per unit 30 25
Direct labour per unit (Rs.10 per 30 40
hour) Overhead rates:

Fixed 8 per hour 4 per hour

Variable 6 per hour 3 per hour
Value of Plant and Machinery 25 lakhs 15 lakhs
Overheads are recovered on the basis of direct labour hours. Variable selling
and distribution overheads relating to product Z are amounting to Rs.30, 000 per

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Advanced Management Accounting

month. The product requires a working capital of Rs.4, 00,000 at the target
volume of 1,500 units per month occupying 30 per cent of practical capacity.
You are required:
(i) To calculate the price of product Z to yield a contribution to cover 21
percent rate of return on investment.
(ii) Set the minimum selling price of the product if (1) the product is well
established in the market; (2) the product is first time launched in the
market.
Answer
(i) Statement showing price of Product Z
Direct Material Deptt. A 30
Deptt. B 25 55
Direct Labour Deptt. A 30
Deptt. B 40 70
Variable overhead Deptt. A 3×6 18
Deptt B 4×3 12 30
Variable selling and distribution overhead 20
30,000/1,500
Total Variable Cost per unit 175
Total hours required for a target of 1,500 units of
product Z
Deptt. A1500 × 3 4500
hours
Deptt. B1500 × 4 6000
hours
10500
hours
10500 hours represent 30% capacity
So total capacity per month 10500 / 0.30 = 35000 hours.
Yearly capacity is 35000 × 12 = 420000 hours.
Fixed capital employed in both department = 40.00 Lakhs
(25 lakhs + 15 Lakhs)
Expected return = 0.21 × 40,00,000 = 840000
Contribution per hour = 840000 / 4200000 = 2.00 per hour

3.52
 CVP Analysis & Decision Making

Working Capital = 0.21 × 400000 = 84000

Contribution per unit 84000 / 18000 unit = 4.67 per unit

Total contribution required Rs.

To cover fixed cost 3 hours of A and 4 of B = 7 × 2 = 14.00
To working capital = 4.67
18.67
Fixed charges recovery is based on usage. Full capacity is not being used
by product Z and departments are also producing other products using
same plant and machinery. Price of Product = Variable cost + contribution
required = 175 + 18.67 = 193.67 per unit.
(ii) Price of product when product is well established in market:
Variable Cost 175
Fixed Cost (24 + 16) 40
Total price 215
The product is first time launched in the market, and then variable cost Rs.175
should form the basis for price fixation.

EXERCISE
Question 1
AB Ltd. Manufacture foam, carpets and upholstery in its there divisions. Its
operating statement for 1995-96 showing the performance of these divisions
drawn for the use of management is reproduced below:
(Rupees in ‘000)
Manufacturing Divisions Total
Foam Carpets Upholstery
Sales revenue 1,600 (A) 1,200 1,200 4,000
Manufacturing Costs 1,200 700 680 2,580
Variable
Fixed (Traceable) - 100 20 120
1,200 800 700 2,700
Gross Profit 400 400 500 1,300

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Advanced Management Accounting

Expenses: Administration 134 116 172 422

Selling 202 210 232 644
336 326 404 ( B)
1,066
Net Income 64 74 96 234
Division’s Ranking 3rd 2nd 1st -
(A) Sales include foam transferred to the Upholstery division at its
manufacturing cost Rs.2,00,000.
(B) Common expenses of Rs.1,30,000 and Rs.1,00,000 on account of
administration and selling respectively stand apportioned to these divisions
at 10% of Gross Profit in case of administration and 2.5 % of Sales in case
of selling expense. Rest of Rs.8,36,000 of the expense are traceable to
respective divisions.
The manager of the foam division is not satisfied with the above approach
of presenting operating performance. In his opinion his division is best
among all the divisions. He requests the management for preparation of
revised operating statement using contribution approach and showing
internal transfer at market price.
You are required to:
(a) Draw the revised operating Statement using contribution approach
and pricing the internal transfer at market price.
(b) Compute relevant rations to show comparative profitability of these
division and rank them in the light of your answer at (a) above.
Further, other your comments on the contention of the manager of
foam division.
(c) State why the contribution approach and pricing of internal transfer at
market price are more appropriate in realistic assessment of the
performance of various divisions. Answer
(Rs.’000)
Divisions Foam Carpets Upholstery Total (a) Contribution: 480 500 440 1,420 (b)
Fixed Cost 256 356 344 956 (c) Net Income of the company 234

Question 2
K. Ltd. Manufactures and sells a range of sport goods. Management is
considering a proposal for an advertising campaign, which would cost the
company Rs.3,00,000. The marketing department has put forward the following
two alternative sales budgets for the following year.

3.54
 CVP Analysis & Decision Making

Product (‘000)
A B C D
Budget 1 – Without Advertising 216 336 312 18
0
Budget – 2 With Advertising 240 372 342 19
8
Selling prices and variable production costs are budgeted as follow:
Product (Rs. Per unit)

A B C D
Selling prices 11.94 14.34 27.54 Variable Production Costs: 23.9
4

Direct Material 5.04 6.60 15.24 12.4

8
Direct Labour 2.04 2.04 3.36 3.1
8
Variable overheads 0.72 0.72 1.20 1.0
8

Other Data:
(1) The variable overheads are absorbed on a machine hour basis at a rate of
Rs.1.20 per machine hour.
(2) Fixed overheads total Rs.30,84,000 per annum.
(3) Production capacity during the budget period 8,15,000 machine hours.
(4) Products A and C could be bought in at Rs.10.68 per unit and Rs.24 per
unit respectively.
Required:
(i) Determine whether investment in the advertising campaign would be
worthwhile and how production facilities would be best utilised.
(ii) Explain the assumptions and reasoning behind your advise.
Answer
Statement of production facilities utilisation
Product Machine hours utilised
A 1,44,000
B 2,23,200
C

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Advanced Management Accounting

2,69,600
D 1,78,000
Total 8,15,000
Question 3
You have been approached by a friend who is seeking your advice as to whether
he should give up his job as an engineer, with a current salary of Rs.14,800 per
month and go into business on his own, assembling and selling a component
which he has invented. He can procure the parts required to manufacture the
component from a supplier.
It is very difficult to forecast the sales potential of the component, but after some
research, your friend has estimated the sales as follows:
(i) Between 600 to 900 components per month at a selling price of Rs.250 per
component.
(ii) Between 901 to 1,250 components per month at a selling price of Rs.220
component for the entire lot.
The cost of the parts required would be Rs.140 for each completed component.
However if more than 1,000 components are produced in each month, a discount
of 5% would be received from the supplier of parts on all purchases.
Assembly costs would be Rs.60,000 per month upto 750 components. Beyond
this level of activity assembly costs would increase to Rs.70,000 per month.
Your friend has already spent Rs.30,000 on development, which he would write-
off over the first five years of the venture.
Required:
(i) Calculate for each of the possible sales levels at which your friend could
expect to benefit by going into the venture on his own.
(ii) Calculate the break-even point of the venture for each of the selling price.
(iii) Advise your friend as to the viability of the venture. Answer

It is not worthwhile to sell between 900 and 1,000 units when no discount is
available. Also, it is worthwhile selling at Rs.220 if sales units are in excess of
1,000 units and a discount of 5% is available on the purchase of all components
– parts.
Profit on the sale of 1,250 units = 1,250 units × Rs.87 – Rs.84,800 = Rs.23,950
Question 4

3.56
 CVP Analysis & Decision Making

SWEET DREAMS LTD. Manufactures and markets three products A, Band C in

the State of Haryana and Rajasthan. At the end of first half of 1996-97 the
following absorption based profit statement has been drawn by the accountant:
(Rs. in ‘000)
Haryana Rajasthan Total
Sales 3,000 900 3,900
Manufacturing Costs of Sales 2,331 699 3,030
Gross Profit 699 201 870
Administration Expenses (A) 120 36 156
Selling Expenses (B) 184 169 353
Total Expenses 304 205 509
Net Profit 365 (-) 4 361
(A) The expenses are constant and common to both the States. They stand
allocated on the basis of Sales.
(B) The expenses are semi-fixed but specifically relate to the respective State.
The management is worried to note that the decision taken to market the
products in Rajasthan to utilise idle capacity has proved wrong and wish to
cover only Haryana State. The incharge marketing division is not satisfied
with the above way of profit presentation. He is of the firm opinion that
sales effected in the State of Rajasthan is contributing profits. For the next
half year he expects no increase in demand in Haryana while for Rajasthan
he anticipates to sell B or C more by 50% of existing sales. This will utilise
the idle capacity in full.
The product-wise relevant details for the first half of 1996-97 are:
A B C
Sales (in Rs.’000):
Haryana 1,200 900 900 Rajasthan 300 300 300
Variable Costs (as a % on sales) :
Manufacturing 40 35 30
Selling 3 2 2
Specific fixed manufacturing expenses
(in Rs.’000) 570 470 610
You are required to:

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Advanced Management Accounting

(a) Prepare s State-wise profit statement for the first half of 1996-97
using contribution approach. Also offer your views on the contention
of the management and opinion expressed by incharge marketing
division.
(b) Prepare a product wise profit statement for the same period using
contribution approach.
(c) Submit your well thought out recommendation as to which product
should be produced to utilise idle capacity.
Answer
A B C Total
P/V ratio (Contribution/Sales) × 100 57% 63% 68% 62.23 %

Recommendation for utilising idle capacity:

A review of the above P/V ratio’s shows that the increase of output of product C
in Rajasthan is the best. The increase of production after utilising the idle
capacity in Rajasthan to the extent of Rs.1,50,000 (i.e. 50% of Rs.3,00,000)
would increase the contribution of the company in the state of Rajasthan by
Rs.1,02,000 (68% × Rs.1,50,000).
Question 5
The relevant data of X Ltd. For its three products A, B and C are as under:
A B C
Direct Material (Rs./Unit) 260 300 250
Direct Labour (Rs./Unit) 130 270 260
Variable Overheads (Rs./Unit) 110 230 180
Selling Price (Rs./Unit) 860 1040 930
Machine Hours Required (per Unit) 12 6 3
The estimated fixed overheads at four different levels of 3,600; 6,000; 8,400 and
10,800 machine hours are Rs.1,00,000; Rs.1,50,000; Rs.2,20,000 and
Rs.3,00,000 respectively. The maximum demand of A, B and C in a cost period
are 500; 300 and 1,800 units respectively.
You are required to find out (i) the most profitable product-mix at each level and
(ii) the level of activity where the profit would be maximum.
Answer
Product A B C
Maximum demand in units 500 300 1,800

3.58
 CVP Analysis & Decision Making

Recommendation:
At 8,400 machine hour level of capacity the company would earn maximum profit
i.e. Rs.3,20,000.
* Refer to working note.
Question 6
Navbharat Commerce College, Bombay has six sections of B.Com, and two
section of M.Com with 40 and 30 students per section respectively. The college
plans one-day pleasure trip around the city for the students once in an academic
session during winter break to visit park Zoo, planetarium and aquarium.
A transporter used to provide the required number of buses at a flat rate of
Rs.700 per bus for the aforesaid purpose. In addition, a special permit fee of
Rs.50 per bus is required to the deposited with city Municipal Corporation. Each
bus is 52 seater. Two seats are reserved for teachers who accompany in each
bus. Each teacher is paid daily allowance of Rs.100 for the day. No other costs in
respect of teachers are relevant to the trip.
The approved caterers of the college supply breakfast, lunch and afternoon tea
respectively at Rs.7; Rs.30 and Rs.3 per student.
No entrance fee is charged at the park. Entrance fees come to Rs.5 per the zoo
and the aquarium. As regards planetarium the authorities charge block entrance
fee as under for group of students of educational institutions depending upon the
number of students in a group:
No. of students in a Group Block Entrance Fee
Upto 100 200
101-200 300
201 & above 450
Cost of prizes to be awarded to the winner in different games being arranged in
the park depend upon the strength of students in a trip. Cost of prizes to be
distributed are:
No. of students in a Trip Cost of
Prizes
Rs.
Upto 50 900
51-125 1,050
126-150 1,200

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Advanced Management Accounting

151-200 1,300
201-250 1,400
251 & above 1,500
To meet the above costs the college collects Rs.65 from each student who wish
to join the trip. The college release subsidy of Rs.10 per student in the trip
towards it.
You are required to:
(a) Prepare a tabulated statement showing total costs at eth levels of 60, 120,
180, 240 and 300 students indicating each item of cost.
(b) Compute average cost per student at each of the above levels.
(c) Calculate the number of students to break even for the trip as the college
suffered loss during the previous year despite 72% of the students having
joined the trip. Answer (a)
No. of students 60 120 180 240 300
Total costs 5,850 9,600 13,500 17,400 21,150
(b)

No. of students: 60 120 180 240 300

Average cost (Rs.) 97.50 80 75 72.50 70.50
(c)

No. of students in 51-100 101- 126-150 151-200 201-250 251-300

the trip 125
No. of students to 105 140 145 180 220 255
break even:
Question 7
A Company produces three products from an imported material. The Cost
Structure per unit of the products are as under:
Product
A B C
Rs. Rs. Rs.
Sales Value 200 300 25
0
Direct Material 50 80 60

3.60
 CVP Analysis & Decision Making

Direct Wages Rs.6 per hour 60 120 10

8
Variable Overheads 30 60 54
Out of Direct Material 80% is of the imported material @ Rs.10 per kg.
Prepare a statement showing comparative Profitability of the three products
under the following scenarios.
(i) Imported Material is in restricted supply.
(ii) Production Capacity is limiting factor.
(iii) When maximum sales potential of products A and B are 1,000 units each
and that of product ‘C’ is 500 units for specific requirement, availability of
imported material is restricted 10,000 kgs per month, how the profit could
be maximised? Answer
Products A B C
Contribution per kg (Rs.) 15 6.25 5.8
3
4,000 3,600 2,40
0
No. of units 1,000 562 50
0
Question 8
Elegant Hotel has a capacity of 100 single rooms and 20 double rooms. It has a
sports centre with a swimming pool, which is also used by persons other than
residents of the hotel. The hotel has a shopping arcade at the basement and a
specialty restaurant at the roof top.
The following information is available:
(i) Average occupancy: 75% for 365 days of the
year. (ii) Current costs are:
Variable cost Fixed cost
Rs./per day Rs./per day
Single Room 400 200
Double Room 500 250
(iii) Average sales per day of restaurant Rs.1,00,000; contribution is at 30%.
Fixed cost Rs.10,00,000.
(iv) The sports centre/swimming pool is likely to be used by 50 non-residents
daily; average contribution per day per non-resident is estimated at Rs.50;
fixed cost is Rs.5,00,000 per annum.

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Advanced Management Accounting

(v) Average contribution per month from the shopping arcade is Rs.50,000;
fixed cost is Rs.6,00,000 per annum.
You are required to find out:
(a) Rent chargeable for singe and double room per day, so that there is a
margin of safety of 20% on hire of rooms and that the rent for a double
room should be kept at 120% of a single room.
(b) Evaluate the profitability of restaurant, sports centre and shopping arcade
separately. Answer
Rent per day of single room (in Rs.) 756 (approx.) Rent per day
of double room (in Rs.) 907 (approx.) (b) Profitability of
restaurant: Rs. 99,50,000
Profitability of sports centre:
Rs.
Contribution of sports centre per day: 4,12,500
Profitability of shopping arcade: Nil
Question 9
ACE Office Supplies Corporation retails two products – a standard and a deluxe
version of a designer ball point pen. The budgeted income statement is as
under :
Standard Deluxe Total
Sales (in units) 1,50,000 50,000 2,
00,000
Rs. Rs. Rs.
Sales:
@ Rs.20 per unit 30,00,000 - -
At Rs.30 per unit - 15,00,000 45 ,
00,000
Variable Costs:
At Rs.14 per unit 21,00,000 - -
At Rs.18 per unit - 9,00,000 30 ,
00,000
Contribution 9,00,000 6,00,000 15 ,
00,000
Fixed Costs 12 ,

3.62
 CVP Analysis & Decision Making

00,000
Profit 3,00,0
00
Required:
(i) Calculate the breakeven point in units assuming that the planned sales mix
is maintained.
(ii) Calculate the breakeven point in units:
(a) if only standard version is sold, and
(b) if only deluxe version is sold.
(iii) Suppose 2,00,000 units are sold, but only 20,000 units are of deluxe
quality. Calculate the profit. Calculate the breakeven points if these
relationships persist in the next accounting period. Compare your answer
with the original plan and the answer in requirement (b). what is your major
finding? Answer
(a) Break even point in units (if only Standard version is sold)
= 2,00,000 units
(b) Break even point in units (if only Deluxe version is sold)
= 1,00,000 units
Major findings on comparing budgeted sales plan and original sales plan
Sales mix ratio of Standard Unites to be sold at Total units Profit
on the sale and Deluxe breakdown sold of 2,00,000 unit
Standard Deluxe
3 : 1 1,20,000 40,000 1,60,000 3 , 00,000
Question 10
The details of the output presently available from a manufacturing department of
Hitech Industries Ltd. Are as follows:
Average output per week 48,000 units from 160 employees
Saleable value of output Rs.6,00,000
Contribution made by the output towards fixed
Expenses and profit Rs.2,40,000
The Board of Directors plans to introduce more automation in the department at
a capital cost of Rs.1,60,000. The effect of this will be to reduce the number of
employees to 120, but to increase the output per individual employee by 60%. To
provide the necessary incentive to achieve the increased output the Board
intends to offer a 1% increase in the piecework rate of one rupee per article for

3.63
Advanced Management Accounting

every 2% increase in average individual output achieved. To sell the increased

output, it will be necessary to decrease the selling price by 4%. Required:
Calculate the extra weekly contribution resulting from the proposed change and
evaluate, for the Board’s information, the worth of the project.
Answer
(a) Proposed piece work rate = Rs.130 per unit (b) Proposed sale
price per unit = Rs.12
(c) Present marginal cost (excluding wages) per unit. = Rs.6.50 p.u.
Question 11
Satish Enterprises are leading exporters of Kid’s Toys. J Ltd. of U.S.A. have
approached Satish Enterprises for Exporting a special toy named “Jumping
Monkey”. The order will be valid for next three years at 3,000 toys per month.
The export price of the toy will be 84. Cost data per toy is as follows:
Rs
.
Materials 60
Labour 25
Variable overheads 20
Primary packing of the toy 15
The toys will be packed in lots of 50 each. For this purpose a special box, which
will contain the 50 toys will have to be purchased, cost being Rs.400 per box.
Satish Enterprises will also have to import a special machine for making the toys.
The cost of the machine is Rs.24,00,000 and duty thereon will be at 12%. The
machine will have an effective life of 3 years and depreciation is to be charged
on straight-line method. Apart from depreciation, annual fixed overheads is
estimated at Rs.4,00,000 for the first year with 6% increase in the second year.
Fixed overheads are incurred uniformly over the year.
Assuming the average conversion rate to be Rs.50 per $, you are required to:
(i) Prepare a monthly and yearly profitability statements for the first year and
second year assuming the production at 3,000 today per month.
(ii) Compute a monthly and yearly break even units in respect of the first year.
(iii) In what contingency can there be a second break-even point for the month
and for the year as a whole?
(iv) Have you any comments to offer on the above? Answer

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 CVP Analysis & Decision Making

(b) (i) Profit Statement of M/s Satish Enterprises for first and second year on
monthly and yearly basis.
First year Second Year
Monthly Rs. Yearly Rs. Monthly Rs. Yearly Rs.
Profit 108 1,296 106 1,272
Question 12
“Cost is not the only criterion for deciding in favour of shut down” – Briefly
explain. Answer

Refer to Chapter 3: Paragraph 3.5

Question 13
M Company’s Central Services Department is evaluating new coping machines
to replace the firm’s current copier, which is worn out. The analysis of alternative
machines has been narrowed to three and the estimated costs of operating them
are shown below:
Cost per 100 copies
Machine A Machine B Machine
C
Rs. Rs. Rs.
Materials Cost 60 40 20
Labour Cost 80 30 20
Annual Lease Cost 30,000 58,000 1,00,000
Required:
(i) Compute the cost indifference points for the three alternatives.
(ii) What do the cost indifference points suggest as a course of action in this
regard?
(iii) If the management expects to need 87,000 copies next year which copier
would be most economical?
Answer
Cost indifference point for two machines viz.,
(a) A&B = 400 Nos. (Multiple of 100 copies)
(b) B & C =1,400 Nos. (Multiple of 100 copies)
(c) C&A = 700 Nos. (Multiple of 100 copies) (d) Hence from
the above we conclude as follows:

3.65
Advanced Management Accounting

From 0 to 400 Nos. (Multiple of 100 copies) use Machine A

From 400 to 1,400 Nos. (Multiple of 100 copies) use Machine
B Above 1,400 Nos. (Multiple of 100 copies) use Machine C.
(e) machine B would be most economical.
Question 14
Somesh of Agra presently operates its plant at 80% of the normal capacity to
manufacture a product only to meet the demand of Government of Tamil Nadu
under a rate contract.
He supplies the product for Rs.4,00,000 and earns a profit margin of 20% on
sales realisations Direct cost per unit is constant.
The indirect costs as per his budget projections are:
Indirect costs 20,000 units (80% 22,500 units (90% 25,000 units
capacity) Rs. capacity) Rs. (100%
capacity) Rs.
Variable 80,000 90,000 1,00,000
Semi-variable 40,000 42,500 45,000
Fixed 80,000 80,000 80,000
He has received an export order for the product equal to 20% of its present
operations. Additional packing charges on this order will be Rs.1,000.
Arrive at the price to be quoted for the export order to give him a profit margin of
10% on the export price.
Answer
Price to be quoted Rs. 50,000
Export price per unit Rs. 12.50
Question 15
ACE Ltd. has an inventory of 5,000 units of a product left over from last years’
production. This model is no longer in demand. It is possible to sell these at
reduced prices through the normal distribution channels. The other alternative is
to ask someone to take them on “as is where is” basis. The latter alternative will
cost the company Rs.5,000.
The company produced 2,40,000 units of the product, last year, when the unit
costs were as under:
Manufacturing Costs:
Variable 6.00

3.66
 CVP Analysis & Decision Making

Fixed 1.00 7.0

0
Selling & Distribution Cost:
Variable 3.00
Fixed 1.50 4.5
0
Total Cost 11.5
0
Selling Price per Unit 14.0
0
Required:
Should the company scrap the items or sell them at a reduced price? If you
suggest the latter, what minimum price would you recommend? Answer
If the company can get anything more than Rs.2/- per unit, then it is worthwhile to
sell the stock of 5,000 units and earn an additional contribution.

3.67
 CHAPTER 4

PRICING DECISION

BASIC CONCEPTS & FORMULAE

4.1 Role of Pricing Policy
The pricing policy plays an important role in a business because the long
run survival of a business depends upon the firm’s ability to increase its
sales and device the maximum profit from the existing and new capital
investment. Although cost is an important aspect of pricing, consumer
demand and competitive environment are frequently far more significant in
pricing decisions. Thus costs alone do not determine prices. Cost is only
one of the many complex factors which determine prices. There must
however, be some margin in prices over total cost if capital is to be
unimpaired and production maximised by the utilisation of internal surplus.
4.2 Principles of Product Pricing
As already stated cost should not be considered as an important
determinant of price. The tendency should be to lower the price in such a
way so as to choose a right combination of price and output to maximise
profits. The important determinants of price, therefore, are competitive
situations prevailing in the market and elasticities. Taking the standard
products into consideration, the pricing principles are much the same
whether the product is a new one or the one already well established in
the market. However the environmental situation and information base are
different.
4.3 Pricing of Finished Product
4.3.1 Cost plus pricing: In many business the common method of price
determining is to estimate the cost of product & fix a margin of profit..
The term ‘cost’ here means full cost at current output and wage
levels since these are regarded as most relevant in price
determination .In arriving at cost of production, it is necessary to
determine the size of the unit whose products are to be costed and
priced. In order to frame a price policy, one of the element that
should receive consideration is the determination of normal capacity.
Advanced Management Accounting

Advantages:
1. Fair method
2. Assured Profit
3. Reduced risks and uncertainties 4. Considers market factors
Disadvantages:
1. Ignores demand
2. Ignores competition
3. Arbitrary cost allocation
4. Ignores opportunity cost
5. Price-Volume relationships
4.3.2 Rate of Return Pricing: Determination of return on capital employed is one
of the most crucial aspect of price fixation process. In this process instead
of arbitrarily adding a percentage on cost for profit, the firm determines an
average mark up on cost necessary to produce a desired rate of return on
its investment.
4.3.3 Variable costs pricing: variable costs which are considered as relevant
costs are used for pricing, by adding a mark up to include fixed costs
allocation also.
4.3.4 Competitive pricing: When a company sets its price mainly on the
consideration of what its competitors are charging, its pricing policy under
such a situation is called competitive pricing or competition-oriented pricing.
Different type of competitive pricing in vogue are as follows:
(i) Going rate pricing
(ii) Sealed bid pricing
(i) Going rate pricing: It is a competitive pricing method under which a
firm tries to keep its price at the average level charged by the
industry.
(ii) Sealed bid-pricing The bid is the firms offer price, and it is a prime
example of pricing based on expectations of how competitors will
price rather than on a rigid relation based on the concern’s own
costs or demand.
4.3.5 Incremental pricing: Incremental pricing is used because it involves
comparison of the impact of decisions on revenues and cost. If a
pricing decision results in a greater increase in revenue than in
costs, it is favourable.

4.2
 Pricing Decision

4.4 Meaning of Pricing Strategies

Pricing strategy is defined as a broad plan of action by which an
organisation intends to reach its goal. Some illustrative strategies are:-
• Expanding product lines that enjoy substantial brand equity
• Offer quantity discounts to achieve increase in sales volume.
4.5 Market-Entry strategies
While preparing to enter the market with a new product, management
must decide whether to adopt a skimming or penetration pricing strategy.
4.5.1 Skimming pricing: It is a policy of high prices during the early
period of a product’s existence. This can be synchronised with high
promotional expenditure and in the later years the prices can be
gradually reduced.
4.5.2 Penetration pricing: This policy is in favour of using a low price as
the principal instrument for penetrating mass markets early. It is
opposite to skimming price. The low price policy is introduced for the
sake of long-term survival and profitability and hence it has to
receive careful consideration before implementation Penetrating
pricing, means a pricing suitable for penetrating mass market as
quickly as possible through lower price offers.
This method is also used for pricing a new product.
4.6 Price discounts and differentials
4.6.1 Distributors’ discounts: It means price deductions that
systematically make the net price vary according to buyer’s position
in the chain of distribution. These discounts are given to various
distributors in the trade channel e.g., wholesalers, dealers and
retailers.
4.6.2 Quantity discounts: Quantity discounts are price reductions related
to the quantities purchased. It may take several forms. It may be
related to the size of the order which is being measured in terms of
physical units of a particular commodity.
4.6.3 Cash Discounts: Cash discounts are price reductions based on
promptness of payment. It is a convenient device to identify and
overcome

4.3
Advanced Management Accounting

bad credit risks.

4.6.4 Time differentials: Charging different prices on the basis of time is
another kind of price discrimination.
Time differentials can be classified under the following heads.
(i) Clock-time differentials: The price differentials are known as
clocktime differentials when different prices are charged for the
same service or commodity at different times within a 24 hour
period.
(ii) Calendar-time differentials: Here price differences are based
on a period longer than 24 hours.
iii) Geographical price differentials: It refers to price
differentials based on buyers location.
(iv) Consumer category price differentials: Price discriminations
is frequently practised according to consumer categories in the
case of public utilities,
4.7 Price Discrimination: Price discrimination means charging different
prices and it takes various forms according to whether the basis is
customer, product, place or time. These are illustrated as under:
4.7.1 Price discrimination on the basis of customer: In this case, the
same product is charged at different prices to different customers. It
is, however, potentially disruptive of customer relations.
4.7.2 Price discrimination based on product version: In this case, a
slightly different product is charged at a different price regardless of
its cost-price relationship. If, for example, a table with wooden top
can be sold at Rs. 400, a table with sunmica top costing Rs. 175
extra is sold at Rs. 575. The higher premium in the latter case does
not necessarily reflect the higher production cost.
4.7.3 Price discrimination based on place: An example of this method is
the seats in cinema theatre where the front seats are charged at
lower rates than the back seats.
4.7.4 Price discrimination based on time: An example of this method is
the practice of giving off-season concession in sale of fans or
refrigerators just after the summer season.

4.8 Geographic Pricing Strategies:

In pricing, a seller must consider the costs of shipping goods to the buyer.

4.4
 Pricing Decision

These

costs grow in importance as freight becomes a larger part of total variable

costs. It includes:
4.8.1 Point-of-Production Pricing: In a widely used geographic pricing
strategy, the seller quotes the selling price at the point of production
and the buyer selects the mode of transportation and pays all freight
costs.
4.8.2 Uniform Delivered Pricing: Under uniform delivered pricing, the
same delivered price is quoted to all buyers regardless of their
locations.
4.8.3 Zone-Delivered Pricing: Zone-delivered pricing divides a seller’s
market into a limited number of broad geographic zones and then
sets a uniform delivered price for each zone.
4.8.4 Freight-Absorption Pricing: Under freight-absorption pricing, a
manufacturer will quote to the customer a delivered price equal to its
factory price plus the freight costs that would be charged by a
competitive seller located near that customer.

4.5
Advanced Management Accounting

4.9 Pareto Analysis

Pareto Analysis is a rule that recommends focus on the most important
aspects of the decision making in order to simplify the process of decision
making. It is based on the 80: 20 rule that was a phenomenon first
observed by Vilfredo Pareto, a nineteenth century Italian economist. He
noticed that 80% of the wealth of Milan was owned by 20% of its citizens.
The management can use it in a number of different circumstances to
direct management attention to the key control mechanism or planning
aspects.
4.9.1 Usefulness of Pareto Analysis: Pareto analysis is useful to:
• Prioritize problems, goals, and objectives Identify root causes .
• Select and define key quality improvement programs Select
key customer relations and service programs Select key
employee relations improvement programs.
• Select and define key performance improvement programs
Maximize research and product development time.
• Verify operating procedures and manufacturing processes.
• Product or services sales and distribution.
• Allocate physical, financial and human resources.

Question 1
What is Penetration pricing? What are the circumstances in which this policy can
be adopted? Answer
Penetration pricing: This pricing policy is in favour of using a low price as the
principal instrument for penetrating mass markets early. It is opposite to
skimming pricing. The low pricing policy is introduced for the sake of long-term
survival and profitability and hence it has to receive careful consideration before
implementation. It needs an analysis of the scope for market expansion and
hence considerable amount of research and forecasting are necessary before
determining the price.
Penetration pricing means a price suitable for penetrating mass market as
quickly as possible through lower price offers. This method is also used for
pricing a new product. In order to popularize a new product penetrating pricing
policy is used initially. The company may not earn profit by resorting to this policy
during the initial stage. Later on, the price may be increased as and when the
demand picks up. Penetrating pricing policy can also be adopted at any stage of

4.6
 Pricing Decision

the product life cycle for products whose market is approached with low initial
price. The use of this policy by the existing concerns will discourage the new
concerns to enter the market. This pricing policy is also known as “stay-out-
pricing”.
Circumstances for adoption:
The three circumstances in which penetrating pricing policy can be adopted are
as under:
(i) When demand of the product is elastic to price. In other words, the demand
of the product increases when price is low.
(ii) When there are substantial savings on large-scale production, here
increase in demand is sustained by the adoption of low pricing policy.
(iii) When there is threat of competition. The prices fixed at a low level act as
an entry barrier to the prospective competitions.
Question 2
C Ltd. and Indian company, ahs entered into an agreement of strategic alliance
with Z Inc. of United States of America for the manufacture of personal
computers in India. Broadly, the terms of agreement are:
(i) Z will provide C with kits in a dismantled condition. These will be used in
the manufacture of the personal computer in India. On a value basis, the
supply, in terms of the FOB price will be 50% thereof.
(ii) C will procure the balance of materials in India.
(iii) Z will provide to C with designs and drawings in regard to the materials and
supplies to be procured in India. For this, C will pay Z a technology fee of
Rs.3 crores.
(iv) Z will also be entitled total royalty at 10% of the selling price of the
computers fixed for sales in India as reduced by the cost of standard items
procured in India and also the cost of imported kits from Z.
(v) C will furnish to Z detailed quarterly returns.
Other information available:
(i) FOB price agreed $510.
Exchange rate to be adopted $1 = Rs.47.059
[Note: In making calculations, the final sum may be rounded to the next
rupees)
(ii) Insurance and freight – Rs.500 per imported kit;
(iii) Customs duty leviable is 150% of the CIF prices; but as a concession, the
actual rate leviable has been fixed at 30% of CIF.

4.7
Advanced Management Accounting

(iv) The technology agreement expires with the production of 2,00,000

computers; (v) The quoted price on kits includes a 20% margin of profits
on cost to Z.

(vi) The estimated cost of materials and supplies to be obtained in India will be
140% of the cost of supplies made by Z.
(vii) 48% of the value in rupees of the locally procured goods represent cost of
the standard items.
(viii) Cost of assembly and other overheads in India will be Rs.2,000 per
personal computer.
Required: Calculate the selling price, of a personal computer in India bearing in
mind that
C has targeted a profit of 20% to itself on the selling price. Answer

Working Notes:
1. FOB price of dismantled kit:
FOB price of dismantled kit (in$) 510
FOB price of dismantled kit (in Rs.) 24,000
($510 × Rs.47.059)
2. Cost of a dismantled kit to Z Inc.
If Rs.120 is the S. P. of kit to Z Inc. then its C Rs.100
Rs.100
Re 1 =
Rs.120

If Rs.24,000 is the S. P.
then C. P. is =
Rs.100
× Rs.24,000
Rs.120
= Rs.20,000
3. Cost of local procurements:
140% of the supplies made by Z Inc. or 140% × Rs.10,000* =
Rs.14,000 *Being 50% of cost of a dismantled kit to Z Inc.
4. Landed cost of a dismantled kit:
Rs.

4.8
 Pricing Decision

FOB price 12,000

(50% × Rs.24,000) (Refer to working note 1)
Add: Insurance & freight 500
CIF price 12,500 Add: Customs duty 3,750
(30% × Rs.12,500)
Landed cost of a dismantled kit 16,250
5. Cost of the standard items procured locally:
48% of the cost of locally procured goods
= 48% × Rs.14,000
= Rs.6,720
6. Royalty payment per computer:
Let x = Selling price per unit of personal computer
y = Royalty paid per computer
Since 20% is the margin of profit on S.P. it main a margin of 25% on C.P.
Therefore we have
X = 1.25 (Rs. 32,250+ Rs. 150 + y)
Y = 10% {x – (Rs. 6,720 + Rs. 16,250)}
On solving the above equations we get:
X = Rs. 43,000
Y = Rs. 2003.43 or Rs. 2,000 (Approx)
Statement showing the selling price of a personal computer in India Rs.
A. Landed cost of a dismantled kit
(Refer to working note 4) 16,250
B. Cost of local procurement
(Refer to working note 3) 4,000
C. Cost of assembly and other overheads per computer 2,000
D. Total cost of manufacture: (A+ B + C) 33,250
E. Technology fee per computer 150
(Rs. 3,00,00,000 / 2,00,000 computer)
F. Royalty payment per unit
(Refer to working note 6)

4.9
Advanced Management Accounting

G. Total cost (D + E+ F) 34,400

H. Profit (20% on selling price of 25% o total cost) 8,600
I. Selling price (per computer) 43,000
Question 3
Explain Skimming pricing strategy.
Answer
Skimming pricing
It is a policy where the prices are kept high during the early period of a product’s
existence. This can be synchronised with high promotional expenditure and in
the latter years the prices can be gradually reduced. The reasons for following
such a policy are as follows:
(1) The demand is likely to be inelastic in the earlier stages till the product is
established in the market.
(2) The gradual reduction in price in the latter years will tend to increase the
sales.
(3) This method is preferred in the beginning because in the initial periods
when the demand for the product is not known the price covers the initial
cost of production.
(4) High initial capital outlays needed for manufacture, results in high cost of
production. In addition to this, the producer has to incur huge promotional
activities resulting in increased costs. High initial prices will be able to
finance the cost of production particularly when uncertainties block the
usual sources of capital.
Question 4
How Pareto analysis is helpful in pricing of product in the case of firm dealing
with multiproducts? Answer
In the case of firm dealing with multi products, it would not be possible for it to
analyse price-volume relationship for all of them. Pareto Analysis is used for
analysing the firm’s estimated sales revenue from various products and it might
indicate that approximately 80% of its total sales revenue is earned from about
20% of its products. Such analysis helps the top management to delegate the
pricing decision for approximately 80% of its product to the lower level of
management, thus freeing them to concentrate on the pricing decisions for
products approximately 20% of which is essential for the company’s survival.
Thus, a firm can adopt more sophisticated pricing methods for small proportion
of products that jointly account for 80% of total sales revenue. For the remaining

4.10
 Pricing Decision

80% products, which account for 20% of the total sales value the firm may use
cost based pricing method.
Question 5
An organisation manufactures a product, particulars of which are detailed below:
Annual Production (Units) 20,0
Cost per annum (Rs.) 00

Material 50,0
00
Other variable cost 60,0
00
Fixed cost
40,0
00
Apportioned Investment (Rs.) 1 , 50,000
Determine the unit selling price under two strategies mentioned below. Assume
that the organisation’s Tax rate is 40%― (a) 20% return on investment.
(b) 6% profit on list sales, when trade discount is 40%.
Answer
(i) Selling price to yield 20% return on investment:
Rs.
Investment 1 , 50,000
After tax required ROI 20% 30,000
Tax 40%
After tax profit 100 – 40 = 60%
Pre tax profit (return) (30,000 ÷ 60) × 100 50,000 Sales = cost + return
or 1,50,000 + 50,000 2 , 00,000
Number of units produced 20,000
Selling price Rs. 2,00,000 ÷ 20,000 = Rs. 10 per unit
Alternative solution
(Sales – cost) (1 – Tax) = ROI
(Sales – 1, 50,000) (1 – 0.40) = 1, 50,000 × 20%
(0.60 Sales – 90,000) = 30,000
0.60 Sales = 1, 20,000
Sales = 1, 20,000 ÷ 0.60 = Rs. 2, 00,000

4.11
Advanced Management Accounting

Number of units 20,000

Selling price Rs. 2, 00,000 ÷ 20,000 = Rs. 10.
(ii) Selling price to yield 6% profit on list price.
Rs. Rs.
Investment 1 , 50,000
Let the list price be 100
Desired after tax profit of 6% 6
Pre-tax profit (1– 0.40) = 0.60 = (6÷0.60) = 10
List price 100 Discount 40 Net price 60
Profit desired 10
Cost 50
Cost of 50% = Rs. 1,50,000
Sales = (Rs.1,50,000 ÷ 50) × 100 = Rs. 3,00,000
Number of units 20,000
List selling price (3,00,000 ÷ 20,000) = Rs. 15
Discount 40%
Net price (15 × 60%) Rs. 9 per unit
Alternative solution
Let s be the list sales
[List Sales (1 – tax discount) – cost] (1 – Tax rate) = 0.60s
[s (1– .40) – 1, 50,000] (1– 0.40) = .06s s
= Rs. 3, 00,000 List sales price per unit

 3,00,000
is Rs. 15  

 20,000 
Net selling price per unit is Rs. 9 (Rs. 15 – 40% of 15%).
Question 6
Outline the features of penetration pricing strategy
Answer
(i) Penetration Pricing: It is a policy of using a low price as the principal
instrument for penetrating mass markets early.

4.12
 Pricing Decision

(ii) This method is used for pricing a new product and to popularize it initially.
(iii) Profits may not be earned in the initial stages. However, prices may be
increased as and when the product is established and its demand picks up.
(iv) The low price policy is introduced for the sake of long term survival and
profitability and hence it has to receive careful consideration before
implementation. It needs an analysis of the scope for market expansion
and hence considerable amount of research and forecasting are necessary
before determining the price.
(v) The circumstances in which penetrating pricing can be adopted are:

Elastic demand: The demand of the product is high when price is low. Hence,
lower prices mean large volumes and hence more profits.
Mass Production: When there are substantial savings in large-scale production,
increase in demand is sustained by the adoption of low pricing policy.
Frighten off competition: The prices fixed at a low-level acts as an entry barrier
to the prospective competitors. The use of this policy by existing concerns will
discourage the new concerns to enter the market. This pricing policy is also
known as “stay-out-pricing”.
Question 7
S Limited is engaged in manufacturing activities. It has received a request from
one of its important customers to supply a product which will require conversion
of material ‘M’, which is a non-moving item. The following details are available:
Book value of material M Rs. 60
Realisable value of material M Rs. 80
Replacement cost of material M Rs. 100
It is estimated that conversion of one unit of ‘M’ into one unit of the finished
product will require one labour hour. At present, labour is paid at the rate of Rs.
20 per hour. Other costs are as follows:
Out-of-pocket expenses Rs. 30 per unit
Allocated overheads Rs. 10 per unit
The labour will be re-deployed from other activities. It is estimated that the
temporary redeployment will not result in loss of contribution. The employees to
be re-deployed are permanent employees of the company.
Required:
Estimate the minimum price to be charged from the customer so that the
company is not worse off by executing the order.

4.13
Advanced Management Accounting

Answer
Relevant costs of producing one unit of the finished product
R
s.
Cost of material ‘M’ (realisable value) 8
0
Cost of labour (Being sunk cost) 0
Out-of-pocket expenses 3
0
11
0
Allocated overhead is not relevant for the decision. The customer should be
charged Rs. 110 per unit.
Question 8
What is Pareto Analysis? Name some applications.
Answer
Vilfredo Pareto, an Italian economist, observed that about 70 – 80% of value was
represented by 30 – 20% of volume. This observation was found to exist in many
business solutions.
Analysing and focusing on the 80% value relating to 20% volume helps business
in the following areas.
(i) Pricing of a product (in a multi-product
company) (ii) Customer profitability.
(iii) Stock control.
(iv) Activity Based Costing (20% cost drivers are responsible for 80% of
total cost) (v) Quality Control. Question 9
State the general guidelines to be used in adopting a pricing policy in a
manufacturing organization.
Answer
The general guidelines to be used in adopting a pricing policy are as under:
(i) The pricing policy should encourage optimum utilization of resources.
(ii) The pricing policy should work towards a better balance between demand
and supply.
(iii) The pricing policy should promote exports.

4.14
 Pricing Decision

(iv) The pricing policy should serve as an incentive to the manufacturers to

maximize production by adopting improved technology.
(v) The pricing policy should avoid adverse effects on the rest of the economy.
Question 10
Enumerate the uses of Pareto Analysis.
Answer
Pareto analysis is useful to:
(i) Prioritize problems, goals and objectives.
(ii) Identify the root causes.
(iii) Select and define the key quality improvement programs, key employee
relations improvement programs etc.
(iv) Verify the operating procedures and manufacturing processes.
(v) Allocate physical, financial and human resources effectively.
(vi) Maximise research and product development time.
Question 11
Briefly explain skimming pricing and penetration pricing policies.
Answer
Skimming prices: Policy of highly pricing a product at the entry level into the
market and reducing it later.
For example: Electronic goods, mobile phone, Flat, TVs, etc.
It is used when market is price insensitive, demand inelastic or to recover high
promotional costs.
Penetration Pricing: Policy of entering the market with a low price, then
establishing the product and then increasing the price.
This is also used by companies with established markets, when products are in
any stage of their life cycle, to avoid competition. This is also known as “stay-out
pricing”. For example, entry of a new model small segment car into the market.
Question 12
Hind Metals Manufactures an alloy product ‘Incop’ by using iron and Copper. The
metals pass through two plants, X and Y. The company gives you the following
details for the manufacture of one unit of Incop:
Materials Iron: 10 kgs @ Rs.5 per kg.
Cooper: 5 kg @ Rs.8 per kg.

4.15
Advanced Management Accounting

Wages 3 hours @ Rs.15 per hour in Plant X

5 hours @ Rs.12 per hour in Plant Y
Overhead recovery On the basis of direct labour
hours
Fixed overhead Rs.8 per hour in Plant X
Rs.5 per hour in Plant Y
Variable overhead Rs.8 per hour in Plant X
Rs.5 per hour in Plant Y
Selling overhead: (fully variable) – Rs.20 per unit
(i) Find out the minimum price to be fixed for the alloy, when the alloy is
new to the market. Briefly explain this pricing strategy.
(ii) After the alloy is well established in the market. What should be the
minimum selling price? Why?
Answer
Rs./u of alloy

Materials:
Iron 10kg @ Rs.5/- 50
Copper 5 kg @ Rs.8/- 40 90
Wages
X: 3 hrs @ 15 Rs./Hr. 45

4.16
Y: 5 hrs @ 12 Rs./Hr 60 105
Variable OH (Production)
X: 8 hrs × 3 hrs 24 Pricing Decision
Y: 5 hrs × 5 hrs 25 49
Variable OH – Selling 20
Total Variable Cost 264
Fixed Off:

X: 8/hrs × 3 hrs. 24
Y: 5/hrs × 5 hrs 25 49
Total Cost 313

(i) If pricing strategy is to penetrate the market, the minimum price for a new
product should be the variable cost i.e. Rs.264/-. In some circumstances, it
can also be sold below the variable cost, if it is expected to quickly
penetrate the market and later absorb a price increase. Total Variable Cost
is the penetration price.
(ii) When the alloy is well established, the minimum selling price will be the
total cost – including the fixed cost i.e. Rs.313 per unit. Long run costs
should cover at least the total cost. Question 13
What is penetrating pricing? What are the circumstances in which this policy can
be adopted? Answer
The penetration pricing policy implies charging a low price to deter entry of
competitors and to expand market share. Circumstances of penetration policy:
• The short run price elasticity of demand is high. By charging a low price,
the first entrant is able to establish a market.
• Economies of scale are significant. By entering at a large scale the first firm
can both enjoy low average cost and impose a cost penalty on any small
scale subsequent entrant.
• Exploitation of established reputation / sales, marketing, distribution
strengths. Create platform form for continued sale of related products.
• When there is a threat of competition. It depicted at maturity stage of a
product in its life-cycle.
Question 14
A company had nearly completed a job relating to construction of a specialised
equipment, when it discovered that the customer had gone out of business. At
this stage, the position if the job was as under:
Rs.
Original cost estimate 1,75,20
0

4.17
Advanced Management Accounting

Costs incurred so far 1,48,50

0
Costs to be incurred 29,70
0
Progress payment received from original customer 1,00,00
0
After searches, a new customer for the equipment has been found. He is
interested to take the equipment, if certain modifications are carried out.
The new customer wanted the equipment in its original condition, but
without its control device and with certain other modifications. The costs of
these additions and modifications are estimated as under:
Direct materials (at cost) Rs.1,050
Direct Wages Dept.: A 15 man days
Dept.: B 25 man days
Variable overheads 25% of direct wages in each
dept.
Delivery costs Rs.1,350
Fixed overheads will be absorbed at 50% of direct wages in each
department.
The following additional information is available:
(1) The direct materials required for the modification are in stock and if
not used for modification of this order, they will be used in another
job in place of materials that will now cost Rs.2,250.
(2) Department A is working normally and hence any engagement of
labour will have to be paid at the direct wage rate of Rs.120 per man
day.
(3) Department B is extremely busy. Its direct wages rate is Rs.100 per
man day and it is currently yielding a contribution of Rs.3.20 per
rupee of direct wages.
(4) Supervisory overtime payable for the modification is Rs.1,050.
(5) The cost of the control device that the new customer does not
require is Rs.13,500. If it is taken out, it can be used in another job in
place of a different mechanism. The latter mechanism has otherwise
to be bought for Rs.10,500. The dismantling and removal of the
control mechanism will take one man day in department A.
(6) If the convention is not carried out, some of the materials in the
original equipment can be used in another contract in place of
materials that would have cost Rs.12,000. It would have taken 2 man

4.18
 Pricing Decision

days of work in department A to make them suitable for this purpose.

The remaining materials will realize Rs.11,400 as scrap. The
drawings, which are included as part for the job can he sold for
Rs.1,500.
You are required to calculate the minimum price, which the company can afford
to quote for the new customer as staled above.
Answer
Statement of minimum price which the company can afford
to quote for the new customer

(based on relevant cost)

Rs.
Cost to be incurred to bring the equipment in its original condition. 29,700
Opportunity cost of the direct material 2,250
Direct wages:

Dept. A: 15 man days × Rs.120 1,800

Dept. B: 25 man days × Rs.100 2,500
Opportunity cost of contribution lost by department B (Rs.2,500 × 8,000
Rs.2.30)
Variable overheads 1,075
25% × (Rs.1,800 + Rs.2,500)
Delivery costs 1,350
Supervisory overtime payable for modification 1,050
Control device to be used in another job (Refer to working note 1) (10,350)
Net loss on material cost savings, in the original equipment (Refer to 11,700
working note)
Opportunity cost of remaining materials which can be sold as scrap 11,400
Opportunity cost of sale drawings 1,500
Total minimum price which may be quoted 61,975
Working notes:
1. Cost of control device to be used in another job:
Rs.

4.19
Advanced Management Accounting

Cost of control device 10,500

Less: Dismantling & removal cost of control 120
mechanism (1 man day × Rs.120)

Less: Variable cost )25% × Rs.120) 30

Balance cost of control device 10,350
2. Net loss on material cost saving of equipment:
Loss on material cost saving of equipment Less: 12,00
Conversion cost 0

(2 man days × Rs.120) 240

Less: Variable overheads (25% × Rs.240) 60
Net loss on material cost saving of equipment 11,70
0
Question 15
Determine the selling price per unit to earn a return of 12% net on capital
employed (net of Tax @ 40%).
The cost of production and sales of 80,000 units per annum are:
Material Rs. 4,80,000 Labour Rs. 1,60,000
Variable overhead Rs. 3,20,000 Fixed overhead Rs. 5,00,000
The fixed portion of capital employed is Rs. 12 lacs and the varying portion is
50% of sales turnover. .
Answer
Return of 12% net (after tax of 40%) on capital employed is equivalent to 12% ÷
(1 – 0.4) = 20% (gross) on capital employed
Let selling price per unit to be
‘x’ Since Total sales = Total cost +
profit

i.e. 80,000 x = 14,60,000 + 20% (12,00,000 + 0.5 ×

80,000x) or, 80,000 x = 14,60,00 + 2,40,000 + 8,000x
or, 72,000 x = 17,00,000

or, ‘x’ = = Rs. 23.61

Hence selling price per unit will be Rs. 23.61

4.20
 Pricing Decision

EXERCISE
Question 1
Name the pricing policy which aims at high selling price in the beginning of a
product’s, life cycle?
Answer
Refer to Chapter 4: Paragraph:4.7.1
Question 2
What is meant by Cost-plus pricing?
Answer

Refer to Chapter 4: Paragraph: 4.6.1

Question 3
Enumerate the circumstances which are favourable for the adoption of a
penetrating pricing policy
Answer
Refer to Chapter 4: Paragraph: 4.7.1
Question 4
Chum-Chum Ltd. is about to introduce a new product with the following
estimates:
Price per unit (in rupees) Demand (in thousand units)
30-00 400
31-50 380
33-00 360
34.50 340 36-00 315
37-50 280
39-00 240
Costs:
Direct material Rs.12 per unit
Direct labour Rs.3 per unit Variable
overhead Rs.3 per unit Selling expenses 10% on
sales Fixed production overheads Rs.14,40,000 Administration expenses
Rs.10,80,000

4.21
Advanced Management Accounting

Judging from the estimates, determine the tentative price of the new product to
earn maximum profits.
Answer
Maximum profit = Rs.20,16,000
Question 5
Explain the concept of cost plus pricing. What are its advantages and
disadvantages?
Answer
Refer to Chapter 4: Paragraph: 4.6.1
Question 6
P. W. Perfume Company manufactures various qualities of perfumes and
colognes. One popular line of colognes includes three products that result from a
joint production process. Below are data from the most recent month of
production:
Product Sales Price Quantity Joint cost Cost after Total
split off cost
Evergreen Rs.40 10,000 Rs.28 Rs.20 Rs.48
Morning Flower Rs.100 6,000 Rs.28 Rs.40 Rs.68
Evening Flower Rs.150 4,000 Rs.28 Rs.50 Rs.78
As the Controller, you are called into the Presidents Office with the Director of
Marketing. The President says, “I don’t understand your product cost report.
Either, we are selling our largest-volume product at a loss or the product cost
data are all wrong. Now what is it?”
Required:
(i) Respond to the Presidents question.
(ii) Another company has just introduced a product that competes directly with
Morning Flower to compete successfully with the other company’s product,
the price of Morning Flower cologne must be reduced to Rs.60. Should the
company do so and sell below cost?
(iii) If P. W. Perfume Company has a policy of maintaining a gross margin of 20
per cent on sales, what would your answer be in response to the price
reduction in part
(ii)?
(iv)What is the minimum price for which Morning Flower can self and still meet
the 20 per cent product gross margin for the group of products?
Answer

4.22
 Pricing Decision

Evergreen Morning Flower Evening Flower Total

Profit 83,333 1,50,000 1,66,667 4,00,00
0

Evergreen Morning Flower Evening Flower

Rs. Rs. Rs.
Joint cost per unit 11,666 35 58.33
If the company sell Morning Flower Cologne below cost, it will still contribute
Rs.20 per unit (Rs.60 – Rs.40) towards joint cost and profit. On a volume of
6,000 units it will contribute Rs.1,20,000 in total. Hence the company should do
so and go ahead to sell Morning Flower below cost.
Minimum price per unit: Rs. 83.33

4.23
 BUDGET &
CHAPTER 5

BUDGETARY CONTROL

BASIC CONCEPTS AND FORMULAE

Basic Concepts
5.1 Strategic Planning: Strategic planning is concerned with preparing long-
term action plans to attain the organization’s objectives by considering the
changes at horizon.
5.2 Budgetary Planning: Budgetary planning is mainly concerned with
preparing the short to medium term plan of the organisation. It will be
carried out within the framework of the strategic plan as already set. An
organization’s annual budget is considered as an intermediary step
towards achieving the strategic plan.
5.3 Operational Planning: It concerns with the short-term or day-to-day
planning process. It plans the utilisation of resources and will be carried
out within the framework of the budget. Each step in the operational
planning process is an interim step towards achieving the budget.
5.4 Preparation of Budgets : The process of preparing and using budgets will
differ from organisation to organisation. However, there are a number of
key requirements in the design of a budgetary planning and control
process.
5.4.1 Co-ordination: The budget committee:
Budgets provide a means of co-ordination of the business as a
whole. In the process of establishing budgets, the various factors like
production capacity, sales possibilities, and procurement of material,
labour, etc. are balanced and co-ordinates so that all the activities
proceed according to the objective.
5.4.2 Participative budgeting:
CIMA defines participative budgeting as: A budgeting system in
which all budget committee members are given the opportunity to
apply their own budgets in practice.
5.4.3 Budget Manual:
A budget manual is a collection of documents that contains key
information for those involved in the planning process.
Advanced Management Accounting

5.2
 Budget & Budgetary Control

5.5 5.4.4 Identification of the principal budget factor:

The principal budget factor is the factor that limits the activities of
functional budgets of the organization. The early identification of this
factor is important in the budgetary planni ng process because it
indicates which budget should be prepared first. Zero Base Budgeting
5.6 (ZBB)
ZBB is defined as ‘a method of budgeting which requires each cost
element to be specifically justified, as though the activities to which the
budget relates were being undertaken for the first time. ZBB is prepared
and justified from zero, instead of simple using last year’s budget as a
base. Traditional Budgeting vs Zero- based budgeting.
Traditional budgeting Zero Based Budgeting
Accounting Oriented Responsibility Accounting oriented Reference is
5.7 past budget. Some Fresh approach without any previous managers only
inflate them. reference. Nothing is taken into account
without justification.
Routine Approach Investigative approach
Performance Budgeting (PB)
Performance Budgeting provide a meaningful relationship between
estimated inputs and expected outputs as an integral part of the
5.8 budgeting system. ‘A performance budget is one which presents the
purposes and obj ectives for which funds are required, the costs of the
programmes proposed for achieving those objectives, and quantities data
measuring the accomplishments and work performed under each
programme.
Traditional budgeting vs. Performance budgeting
1. The traditional budgeting (TB) give s more emphasis on the
financial aspect than the physical aspects or performance. PB aims
at establishing a relationship between the inputs and the outputs.
2. Traditional budgets are generally prepared with the main basis
towards the objects or items of expenditure i.e. it highlights the
items of expenditure, namely , salaries, stores and materials, rates
rents and taxes and so on. In the PB latter the emphasis is more on
the functions of the org anisation, the programmes to discharge
these function and the activities which will be involved in
undertaking these programmes.

5.3
Advanced Management Accounting

5.9 Budget Ratio

These ratios provide information about the performance level, i.e., the
extent of deviation of actual performance from the budgeted performance
and whether the actual performance is favourable or unfavorable. If the
ratio is 100% or more, the performance is considered as favourable and if
ratios is less than 100% the performance is considered as unfavourable.
Basic Formulas
i) Efficiency Ratio = (Standard hours ÷ Actual hours)
× 100 ii). Activity Ratio = (Standard hours ÷
Budgeted hours) × 100

iii) Calendar Ratio = (Available working days ÷ budgeted working days) × 100
iv) Standard Capacity Usage Ratio = (Budgeted hours ÷ Max. possible hours
in the budgeted period) × 100
v). Actual Capacity Usage Ratio = (Actual hours worked ÷ Maximum possible
working hours in a period) × 100
vi). Actual Usage of Budgeted Capacity Ratio=(Actual working
hours÷Budgeted hours) × 100
Question 1
A company manufactures two products X and Y. Product X requires 8 hours to
produce while Y requires 12 hours. In April, 2004, of 22 effective working days of
8 hours a day, 1,200 units of X and 800 units of Y were produced. The company
employs 100 workers in production department to produce X and Y. The
budgeted hours are 1,86,000 for the year. Calculate Capacity, Activity and
Efficiency ratio and establish their relationship.
Answer
Standard hours produced
Product X Product Y Total
Out put (units) 1,200 800
Hours per unit 8 12
Standard hours 9,600 9,600
19,20
Actual hours worked 0

100 workers ×8 hours × 22 days = 17,60

5.4
 Budget & Budgetary Control

0
Budgeted hours per month
1,86,000/12 = 15,50
0
Capacity Ratio = actual hours ×100 = 17,600
= 113.55 %
Budgeted hours 15,500
Efficiency Ratio = Standard Hours Produced×100 =
19,200 ×100 109.09%
Actual hours 17,600

Activity Ratio = Standard Hours Produced×100 = 19,200

×100 123.87%
Budget hours 15,500
Relationship : Activity Ratio = Efficiency Ratio × Capacity Ratio
or 123.87 = 109.09×113.55
100
Question 2
Kitchen King Company makes a high-end kitchen range hood ‘Maharaja’. The
company presents the data for the year 2003 and 2004:
2003 2004
1. Units or maharaja produced and sold 40,000 42,000
2. Selling Price per unit in Rs. 1,000 1,100
3. Total Direct Material (Square feet) 1,20,000 1 , 23,000
4. Direct material cost per square feet in Rs. 100 110
5. Manufacturing Capacity (in units) 50,000 50,000
6. Total Conversion cost in Rs. 1,00,00,000 1 ,10,
00,000
7. Conversion cost per unit of capacity (6)/(5) 200 220
8. Selling and customer service capacity 300 customer 290
customer
9. Total selling and customer service cost in Rs. 72,00,000 72 , 50,000
10. Cost per customer of selling and customer 24,000 25,000
service capacity (9)/(8)

5.5
Advanced Management Accounting

Kitchen King produces no defective units, but it reduces direct material used per
unit in 2004. Conversion cost in each year depends on production capacity
defined in terms of Maharaja units that can be produced. Selling and Customer
service cost depends on the number of customers that the selling and service
functions are designed to support.
Kitchen King has 230 customers in 2003 and 250 customers in 2004.
You are required
1. Describe briefly key elements that would include in Kitchen King’s Balance
Score Card.
2. Calculate the Growth, Price-recovery and productivity component that
explain the change in operating income from 2003 to 2004.
Answer
Kitchen King’s Score card should describe its product differentiation strategy. The
key points that should be included in its balance score card are
• Financial Perspective – Increase in operating income by charging higher
margins on Maharaja.
• Customer Perspective – Market share in high-end kitchen range market
and customer satisfaction.
• Internal business Perspectives: Manufacturing quality, order delivery time,
on time delivery and new product feature added.
• Learning and Growth Perspective: Development time for designing new
end product and improvement in manufacturing process. Operative
Income:
(Amount in 000 Rs.)
2003 200
4
Revenue (40000×1000: 42000×1100) 40000 4620
0
Direct Material 12000 1353
0
Conversion cost 10000 1100
0
Selling and Customer service 7200 725
0
Total cost 29200 3178
0
Operative Income 10800 1442
0

5.6
 Budget & Budgetary Control

Change in operating Income 36, 20,000 (F)

A. Growth Component
(a) Revenue effect = Output Price in 2003{Actual units sold in 04 –
Actual units sold in 03}
= Rs1, 000 (42,000 units – 40,000 units) = Rs20, 00,000 (F)
(b) The cost effect = Input price in 2003{Actual units of input to produce
2003
output less Actual units of input which would have been used to
produce year 2004 output on the basis of 2003}
42,000 units
(i) Direct Material = Rs100 [1, 20,000sqft – 1, 20,000sqft × ]
40,000 units
= Rs6, 00,000 (A)
(ii) Conversion cost and selling and customer service will not change
since adequate capacity exists in 2003 to support 2004 output and
customers. Hence variance
Conversion cost = 200(50000 – 50000)
=0 S & Customer Service = 25000 (300 –
300) =0
Increase in operating effect of Growth component is Rs14, 00,000 (F)
B Price recovery Component:

(i) Revenue effect = Actual output in 2004 [Selling price per unit in 2004
less Selling price per unit in 2003]
= 42,000units (Rs1, 100 – Rs1, 000) = Rs42, 00,000 (F)
(ii) Cost effect = Unit of input based on 2003 actual that would have
been used to produce 2004 output {Input prices per unit in 2003 less
Input prices per unit in 2004}
(a) Direct material = 1, 26,000sqft (Rs100/sqft –
Rs110/sqft)=Rs12, 60,000 (A)
(b) Conversion Cost = 50,000 units (Rs200/unit –Rs220/unit)
= Rs10, 00,000(A)
(c) S & Custr Service = 300 customers (Rs24, 000 –Rs25,000)
= Rs3,00,000 (A) = Rs 25, 60,000 (A)

5.7
Advanced Management Accounting

Increase in Operating income due to Price Recovery is Rs16, 40,000

(F) {Rs42, 00,000 – Rs25, 60,000}
C Productivity Component
Productivity component = Input Prices in 04{Actual units of input which
would have been used to produce year 2004 output on the basis of 2003
actual less Actual
Input
(i) Direct Material: Rs110/sqft (1, 26,000 units – 1, 23,000 units) = Rs3,
30,000(F)
(ii) Conversion Cost: Rs200/unit (50,000 units – 50,000 units) =0
(iii) Selling & Customer = Rs25, 000 (300 customers–290 customers)=
Rs2,50,000 (F)
= Rs 5,80,000
(F) The change in operating income from 2003 to 2004 is analysed as
follows:
(Amount in 000 Rs.)
2003 Growth Price Cost effect of 2004
component recovery productivity
component
Revenue 40000 2000 (F) 4200 (F) ------------
4620
0
Cost 29200 600 (A) 2560 (A) 580 (F) 3178
0
Operating 10800 1400(F) 1640 (F) 580 (F) 1442
0
Income
Question 3

Explain briefly the major components of a balanced score card.

Answer
An ideal Balanced score card combines financial measures of past performance
with measures of the firm’s drivers of future performance. The following
perspectives are evaluated:
(i) Customer perspective − Measures of price / delivery / quality / support.
(ii) Internal perspective – Measures of efficiency / sales penetration and new
product introduction.

5.8
 Budget & Budgetary Control

(iii) Innovation and learning perspective − Measures of technology / cost

leadership.
(iv) Financial perspective − Sales / Cost of sales / Return on capital employed
etc.
Question 4
Describe the process of zero-base budgeting.
Answer
The zero Base Budgeting involves the following steps:
(i) Corporate objectives should be established and laid down in details.
(ii) Decide about the techniques of ZBB to be applied.
(iii) Identify those areas where decisions are required to be taken.
(iv) Develop decision programmes and rank them in order of preferences.
(v) Preparation of budget, that is translating decision packages into practicable
units/items and allocating financial resources.
Question 5
“In many organisations, initiatives to introduce balanced score card failed
because efforts were made to negotiate targets rather than to build consensus.”
Required:
Elucidate the above statement.
Answer
Balanced score card is a set of financial and non-financial measures relating to a
company’s critical success factors. It is an approach which provides information
to management to assist in strategy implementation. Therefore, the components
to be included in the balanced score card must flow from strategy. The targets
should be measurable and must flow from strategy and corporate plan of the
company. It is necessary that managers should agree to the components and
targets because in absence of a consensus, managers may not commit to the
targets established by the top management / the board of directors. Moreover,
the functions are interdependent and results in one functional area/perspective
(e.g. innovation and learning) have direct bearing on the results in other
functional area / perspective (e.g. customer perspective). Therefore, it is not
sufficient that individual managers agree to their targets. Successful
implementation requires that the top management builds an overall consensus
on the components and targets of the balanced score card. Negotiation
undermines the fundamental principle that the components and targets should

5.9
Advanced Management Accounting

flow from strategy. As a result, an approach to establish targets through

negotiation defeats the very purpose of balanced score card.
Question 6
What do you mean by a flexible budget? Give an example of an industry where
this type of budget is typically needed?
Answer
A flexible budget is a budget which, by recognizing the difference between fixed,
semi-variable and variable costs, is designed to change in relation to the level of
activity attained. E.g. seasonal products – e.g. soft drink industry industries in
make to order business like ship building industries influenced by change in
fashion.
Industries which keep on introducing new products / new designs.
Question 7
Describe the four types of bench marking of critical success factors.
Answer

The Benchmarking is of following types:

(i) Competitive benchmarking: It involves the comparison of competitors
products, processes and business results with own.
(ii) Strategic benchmarking: It is similar to the process benchmarking in
nature but differs in its scope and depth.
(iii) Global benchmarking: It is a benchmarking through which distinction in
international culture, business processes and trade practices across
companies are bridged and their ramification for business process
improvement are understood and utilized.
(iv) Process benchmarking: It involves the comparison of an organisation
critical business processes and operations against best practice
organization that performs similar work or deliver similar services.
(v) Functional Benchmarking or Generic Benchmarking: This type of
benchmarking is used when organisations look to benchmark with partners
drawn from different business sectors or areas of activity to find ways of
improving similar functions or work processes.
(vi) Internal Benchmarking: It involves seeking partners from within the same
organization, for example, from business units located in different areas.
(vii) External Benchmarking: It involves seeking help of outside organisations
that are known to be best in class. External benchmarking provides

5.10
 Budget & Budgetary Control

opportunities of learning from those who are at the leading edge, although
it must be remembered that not every best practice solution can be
transferred to others.
Question 8
(a) What are the advantages and limitations of Zero base Budgeting?
(b) What are benchmarking code of conduct?
(c) A Company manufactures two Products A and B by making use of two
types of materials, viz., X and Y. Product A requires 10 units of X and 3
units of Y. Product B requires 5 units of X and 2 units of Y. The price of X is
Rs. 2 per unit and that of Y is Rs. 3 per unit. Standard hours allowed per
product are 4 and 3, respectively. Budgeted wages rate is Rs. 8 per hour.
Overtime premium is 50% and is payable, if a worker works for more than
40 hours a week. There are 150 workers.
The Sales Manager has estimated the sales of Product A to be 5,000 units
and Product B 10,000 units. The target productivity ratio (or efficiency ratio)
for the productive hours worked by the direct worker in actually
manufacturing the product is 80%, in addition, the non-productive
downtime is budgeted at 20% of the productive hours worked. There are
twelve 5-day weeks in the budget period and it is anticipated that sales and
production will occur evenly throughout the whole period.
It is anticipated that stock at the beginning of the period will be:
Product A 800 units; Product B 1,680 units. The targeted closing stock
expressed in terms of anticipated activity during the budget period are
Product A 12 days sales; Product B 18 days sales. The opening and
closing stock of raw material of X and Y will be maintained according to
requirement of stock position for Product A and B.
You are required to prepare the following for the next period:
(i) Material usage and Material purchase budget in terms of quantities
and values.
(ii) Production budget.
(iii) Wages budget for the direct workers.
Answer
(a) Advantage of ZBB
(i) It provides a systematic approach for evaluation of different activities
and ranks them in order of preference for allocation of scare
resource.

5.11
Advanced Management Accounting

(ii) It ensures that the various functions undertaken by the organisation

are critical for the achievement of its objectives and are being
performed in the best way.
(iii) It provides an opportunity to the management to allocate resources
for various activities only after having a thorough cost-benefit
analysis.
(iv) The area of wasteful expenditure can be easily identified and
eliminated.
(v) Departmental budgets are closely linked with corporate objectives.
(vi) The technique can also be used for the introduction and
implementation of the system of ‘management by objective’.
Limitations of ZBB
(i) Various operational problems are likely to be faced in implementing
the technique.
(ii) The full support of top management is required.
(iii) It is time consuming as well as costly.
(iv) It requires proper trained managerial staff.
(b) Benchmarking code of conduct
Bench marking is the process of identifying and learning from the best
practices anywhere in the world. It is a powerful tool for continuous
improvement. To contribute to efficient, effective and ethical bench
marking, individuals agree for themselves and their organisation to be
abided by the following principles for the
benchmarking with other organisations.
Suggested benchmarking code of conduct:
(i) Principle of legality
(ii) Principle of exchange
(iii) Principle of confidentiality
(iv) Principle of use
(v) Principle of first party contact
(vi) Principle of third party contact
(vii) Principle of preparation
(c) (i) Material usage budget
Products Products Total Cost Total cost A (units) B
(units) material per of

5.12
 Budget & Budgetary Control

usage units unit materials

(Rs) (Rs)
Estimated sales 5,000 10,000
Material X : 10 units 50,000 50,000 1,00,000 2 2 ,
per product A and 5 00,000
units per product B
Material Y : 3 units 15,000 20,000 35,000 3 1 ,
per product A and 2 05,000
units per product B
Total 65,000 70,00 1,35,000 3 ,
0 05,000
Material Purchase Budget
X Units Y Units Total
Required for sales 1,00,000 35,000
Add: desired closing stock
Product A:
1,000 units (A)× 10 units (X) =10,000
units of X
3,000 units (B) × 5 units (X) =15,000
units of X. 25,000
Product B: 9,000
1,000 units (A) × 3 units (Y) = 3000
units of Y
3,000 units (B) × 2 units (Y) = 6,000
units of Y.
1,25,000 44,000
Less: Opening stock
Product A:
800 units (A) × 10 units (X) = 8,000
units of X
1,680 units (B) × 5 units (X) = 8,400
units of X 16,400

5.13
Advanced Management Accounting

Product B
800 units (A) × 3 units (Y) = 2,400
units of Y 5,760
1,680 units (B) × 2 units (Y) = 3,360
units of Y.
Units to be purchased 1,08,600 38,240 1 ,
46,840
Cost per unit Rs.2 Rs.3
Cost of purchase (Rs.) 2,17,200 1,14,720 3 ,
31,920

(ii) Production Budget

Product A Product B
Units Units
Sales 5,000 10,000
Add: Closing stock** 1,000 3,000
6,000 13,000
Less: Opening stock 800 1,680
Production 5,200 11,320
**Calculation of closing stock:
Budgeted period is 12 weeks of 5 days each =60 days.

Product A = 5,000 × 12 =1,000

units 60

10,000 × 18
Product B = =3,000 units
60
(iii) Wages budget for direct workers
Product Product Total
A B ( hrs. )
(hrs) (hrs)
Standard hours (budgeted)
5,200 units (A) × 4 hours per unit and 20,800 33,960 54,760
11,320 units (B) × 3 hours per unit.

5.14
 Budget & Budgetary Control

Standard hours at 80% efficiency ratio 68,450 Add: non

productive time (20% of 68,450) 13,690
82,140
Labour hours required (150 workers × 8 72,000 hours per day × 60
days)
Overtime 10,140
Wages for normal hours(72,000 × 8) = Rs 5,76,000
Wages for overtime (10,140 × 8 × 1.5) = Rs
1,21,680 Total wages = Rs 6,97,680
Question 9
The budgeted and actual cost data of M Ltd. for 6 months from April to
September, 2008 are as under:
Budget Actual
Production units 16,000 14,000
Material cost Rs. 25,60,000 Rs. 41,60,000
(1,600 MT @ Rs. 1,600) ( at Rs. 1,650)
Labour cost Rs. 16,00,000 Rs. 15,99,840
(at Rs. 40 per hour) ( @ Rs. 44 per
hour )
Variable overhead Rs. 3,00,000 Rs. 2,76,000
Fixed overhead Rs. 4,60,000 Rs. 5,80,000
In the first half of financial year 2009-10, production is budgeted for 30,000 units,
material cost per tonne will increase from last year’s actual by Rs. 150, but it is
proposed to maintain the consumption efficiency of 2008 as budgeted. Labour
efficiency will be lower by 1% and labour rate will be Rs. 44 per hour. Variable
and fixed overheads will go up by 20% over 2008 actuals.
Prepare the Production Cost budget for the period April-September, 2009 giving
all the workings.
Answer
Production Cost Budget
(for 6 months ending 30th September, 2009)
30 ,000 units

5.15
Advanced Management Accounting

Cost per unit Total

Rs. Rs.
Material cost 180 54 , 00,000
Labour cost 115.21 34 , 56,420
Variable overhead 23.65 7 , 09,500
Fixed overhead 23.2 6,96,000
342.06 1 ,02,
61,920
Assumption: Here, difference in actual and standard time is also considered for
calculating the lower efficiency i.e. 3.74% + 1% = 4.74%
Working Notes:
I. Material cost
1,600 MT
Material consumption per unit = = 0.10 MT
16,000
Consumption for 30,000 units = 3,000 MT.
Cost of 3,000 MT @ Rs. 1,800 per MT = Rs. 54,00,000.
II. Labour cost can be calculated as follows:
Time required for 30,000 units = 75,000
hours
Add: *(3.74% + 1%) = 4.74% for lower efficiency = 3,555 hours
= 78,555
hours
*3.74% = Difference in actual and standard hours × 100 = 1,360 hours
Actual hours 36,360
hours
Labour cost = 78,555 hours × 44 per hour = 34,56,420.
III. Variable overhead
Actual rate = Rs. 2,76,000 = 19.71 per
14,000 units unit
Add: 20 = 3.94
New rate 23.65
Total variable overhead = 30,000 × 23.65 = Rs.
7,09,500

5.16
 Budget & Budgetary Control

IV. Fixed overhead

Actual = Rs. 5,80,000
Add:20% = Rs. 1,16,000
= Rs. 6,96,000
According to above the production cost budget will be as follows:
Alternative
Production Cost Budget
(for 6 months ending 30th September, 2009)
30,000 units
Cost per unit Total
Rs. Rs.
Material cost 180 54,00,000
Labour cost 111.1 33,33,000
Variable overhead 23.65 7,09,500
Fixed overhead 23.2 6,96,000
337.95 1,01,38,500
Working Notes:
I. Material cost
1,600 MT
Material consumption per unit = = 0.10 MT
16,000
Consumption for 30,000 units = 3,000 MT.

Cost of 3,000 MT @ Rs. 1,800 per MT = Rs. 54,00,000.

II. Labour Cost:

2008 – Total Budgeted Hour = = 40,000 hours Labour

hour budget for each unit = = 2.5

5.17
Advanced Management Accounting

Actual time paid = = = 36,360 hours

Less: Standard labour hours for 14,000 units (i.e. 14,000 × 2.5) = 35,000 hours
Difference in actual and standard hours = 1,360
Time required for 30,000 units (30,000 × 2.5) = 75,000, hours
Add: 1% for lower efficiency = 750 hours
= 75,750 hours
Labour cost = 75,750 hours × 44 per hour = 33,33,000
III. Variable overhead
Rs. 2,76,000
Actual rate = = 19.71 per unit
14,000 units
Add: 20 = 3.94
New rate 23.65
Total variable overhead = 30,000 × 23.65 = Rs.
7,09,500
IV. Fixed overhead
Actual = Rs.
5,80,000
Add: 20% = Rs.
1,16,000
= Rs.
6,96,000
Question 10
What are the various formulae used in calculating budget ratios?
Answer
Type of budgeted ratio used are:
1. Efficiency Ratio = (Standard hours + Actual hours) × 100
2. Activity Ratio = (Standard hours + Budgeted hours) × 100
3. Calendar Ratio = (Available working days ÷ budgeted working days) × 100
4. Standard Capacity Usage Ratio (Budgeted hours ÷ Max. possible hours in
the budgeted period) × 100
5. Actual Capacity Usage Ratio = (Actual hours worked + Maximum possible
working hours in a period) × 100

5.18
 Budget & Budgetary Control

6. Actual usage of Budgeted Capacity Ratio = (Actual working hours ÷

Budgeted hours) × 100. Question 11
Explain goals and performance measure for each perspective of Balance Score
Card.
Answer
Goals and performance measures for each perspective of balance
scorecard. Customer Perspective
Goals Performance Measures
Price Competitive price
Delivery Number of on time delivery, lead time from receipt of order to
delivery to customer.

Quality Own quality relative to industry standards, number of defects or

defect level.
Support Response time, customer satisfaction survey.
Internal Business Perspective
Goals Performance Measures
Efficiency of Manufacturing cycle time
manufacturing process
Sales penetration Sales plan, Increase in number of customer in a
unit of time.
New Product introduction Rate of new product introduction.
Innovation and Learning Perspective
Goals Performance Measures
Technology leadership Performance of product, use of technology
Cost leadership Manufacture overhead per quarter
Market leadership Market share in all major markets
Research and development Number of new products, Patents
Financial Perspective
Goals Performance Measures

5.19
Advanced Management Accounting

Sales Revenue and profit growth

Cost of Sales Extent in remain fixed or decreased each year
Profitability Return on capital employed
Prosperity Cash flows
Question 12
JBC Limited, a manufacturing company having a capacity of 60,000 units has
prepared a following cost sheet:
Direct material (per unit) Rs.12.50
Direct wages (per unit) Rs.5.00
Semi-variable cost Rs.30,000 fixed plus 0.50 per unit
Factory overhead (per unit) Rs.10.00 (50% fixed)
Selling and administration overhead (per unit) Rs.8.00 (25%
variable)
Selling price (per unit) Rs.40
During the year 2008, the sales volume achieved by the company was 50,000
units.
The company has launched an expansion program as
under (a) The capacity will be increased to
1,00,000 units.

(b) The cost of investment on expansion is Rs.5 lakhs which is proposed

to be financed through financial institution at 12 per cent per annum.
(c) The depreciation rate on new investment is 10 per cent based on
straight line.
(d) The additional fixed overheads will amount to Rs.2.00 lakhs up to
80,000 units and will increase by Rs.80,000 more beyond 80,000
units.
After the expansion, the company has two alternatives for operating the
expanded plant as under:
(i) Sales can be increased up to 80,000 units by spending Rs. 50,000
on special advertisement campaign to explore new market.
(ii) Sales can be increased up to 1,00,000 units subject to the following:
(a) Reduction of selling price by Rs.4 per unit on all the units sold.
(b) The direct material cost would go down by 4 per cent due to
discount on bulk buying.

5.20
 Budget & Budgetary Control

(c) By increasing the variable selling and administration expenses

by 4 per cent.
Required.
(i) Construct a flexible budget at the level 50,000 units, 80,000 units and
1,00,000 units of production and select best profitable level of
operation.
(ii) Calculate break even point both before and after expansion.
Answer
Flexible Budget
Output level (units) 50,000 80,000 1 , 00,000 (Rs. in lakhs) (Rs. in
lakhs) ( Rs. in lakhs )
Sales 20.00 32.00 36.00
Direct Material 12.5 per unit (reduction 6.25 10.00 12.00 for 1,00,000
units by Rs.0.50)
Direct wages (5.00 per unit) 2.50 4.00 5.00 Semi variable cost (variable) 0.25
0.40 0.50 Factory overhead (V) Rs.5 per unit) 2.50 4.00 5.00 Selling and Adm.
(25% variable) 1.00 1.60 2.08
Total variable cost 12.50 20.00 24.58
Contribution 7.50 12.00 11.42
Fixed factory overheads (5×60,000) 3.00 3.00 3.00 Selling and adm. (6 ×
60,000) 3.60 3.60 3.60 Semi variable fixed part .30 .30 .30 Increase due to
expansion 2.00 2.80
Interest .60 .60 Depreciation .50 .50
Special Advertisement exp. . .50 .
Total fixed costs 6.90 10.50 10.80
0.60 1.50 0.62
Therefore activity level 80,000 units is most profitable level.
Calculation of Break even point
P/V ratio
7.5/20.00 × 100 = 37.5%, 12.00/32.00 × 100 = 37.5%, 11.42/36.00 × 100 =
31.72%BEP (value) = 6.90/37.5% = Rs.18,40,000, 10.50/37.5% = Rs.28,00,000,
10.80/31.72% = 34,04,792 BEP (Units)

5.21
Advanced Management Accounting

6.90 lakhs 10.50 lakhs 10.80 lakhs

Rs.15 Rs.15 Rs.15
= 46,000 units = 70,000 units = 94,571 units
Alternative Solution (BEP in Sales)
Break Even Point in value of sales: (F x S) / (S – V)
At 50000 units’ level : (6,90,000 x 20,00,000)/7,50,000 = Rs. 18,40,000
At 80000 units’ level : (10,50,000 x 32,00,000)/12,00,000 = Rs.
28,00,000 At 100000 units’ level : (10,80,000 x 36,00,000)/11,42,000
= Rs. 34,04,553
Question 13
Explain briefly stages involved in the process of Bench marking.
Answer

Process of Benchmarking: The process of benchmarking requires a Company

to identify the areas i.e. processes, activity etc. which are central to its business
and then selects the top-performing companies in those areas.
The benchmarking process is comprised of following stages. These stages are:
1. Planning:
(i) Determination of benchmarking goal statement: This requires
identification of areas to be benchmarked. In practice, one should
start with the identification of those areas which have to be really
good to be really successful.
(ii) Identification of best performance: Once the benchmarked goal
statement are defined, the step is seeking the best of the breed of
best of the best.
(iii) Establishment of the benchmarking or process improvement
team: Ideally this should include the persons who are most
knowledgeable about the internal operations and will be directly
affected by changes due to benchmarking.
(iv) Defining the relevant benchmarking measurement: Relevant
measures will not include the measures used by the organisation
today but they will be refined measures that comprehend the true
performance differences.
2. Collection of data and information:
The data gathering for benchmarking could be done through
national/international clearing houses, mail surveys, suppliers, company

5.22
 Budget & Budgetary Control

visits, telephone, interviews etc. In recent years national and international

clearing houses have been set up.
3. Analysing the findings: The analysing of finding of step (2) requires
following:
(i) Review the findings and produce tables, charts and graphs to
support the analysts.
(ii) Identify gaps in performance between our organisation and better
performers.
(iii) Seek explanations for the gaps in performance. The performance
gaps can be positive, negative or zero.
(iv) Ensure that comparisons are meaningful and credible.
(v) Communicate the findings to those who are affected. (vi) Identify
realistic opportunities for improvements.
4. Recommendations: This involves:
Making recommendation: This requires:
(i) Deciding the feasibility of making the improvements in the light of the
conditions that apply within own organisation.
(ii) Agreement of the improvements that are likely to be feasible.
(iii) Producing a report on the Benchmarking in which the
recommendations are included.
(iv) Obtaining the support of key stakeholder groups for making the
changes needed.
(v) Developing action plan(s) for implementation.
5. Monitoring and reviewing: This involves:
(i) Evaluating the benchmarking process undertaken and the results of
the improvements against objectives and success criteria plus overall
efficiency and effectiveness.
(ii) Documenting the lessons learnt and make them available to others.
(iii) Periodically re-considering the benchmarks

EXERCISE
Question 1
A company manufactures two products X and Y Product X requires 5 hours to
produce while Y requires 10 hours. In July, 1996, of 25 effective working days of
8 hours a day, 1,000 units of X and 600 units of Y were produced. The company

5.23
Advanced Management Accounting

employees 50 workers in the production department to produce X and Y. The

budgeted hours are 1,02,000 for the year.
Calculate capacity ratio, activity ratio and efficiency ratio. Also establish their
interrelationship.
Answer
Inter-relationship:
Capacity ratio ÷ Efficiency ratio = Activity ratio
117.65% × 110% = 129.41%
Question 2
The Financial controller of ACE Ltd. has prepared the following estimates of
working results for the year ending 31st March, 1999:
Year ending 31.3.1999
Direct Material Rs. / unit 16.00
Direct wages Rs. / unit 40.00
Variable Overheads Rs. / unit 12.00
Selling Price Rs. / unit 125.00
Fixed Expenses Rs. 6,75,000 per annum
Sales Rs 25,00,000 per annum
During the 1999-2000, it is expected that the material prices and variable
overheads will go up by 10% and 5 % respectively. As a result of re-engineering
of business processes, the overall direct labour efficiency will increase by 12%,
but the wage rate will go up by 5%. The fixed overheads are also expected to
increase by Rs.1,25,000.
The Vice-President-Manufacturing states that the same level of output as
obtained in 1998-1999 should be maintained in 1999-2000 also and efforts
should be make to maintain the same level of profit by suitably increasing the
selling price.
The Vice President-Marketing states that the market will not absorb any increase
in the selling price. On the other hand, he proposes that publicity involving
advertisement expenses as given below will increase the quantity of sales as
under:
Advertisement Expenses (Rs.) 80,000 1,94,000 3,20,000
4,60,000 Additional units of Sales 2,000 4,000 6,000 8,000
Required:
Present an Income Statement for 1999-2000.

5.24
 Budget & Budgetary Control

Find the revised price and the percentage of increase in the price for 1999-2000,
if the views of the Vice-President. Manufacturing are accepted.
Evaluate the four alternative proposals put forth by the Vice-President –
Marketing Determine the best output level to the budgeted and prepare an
overall Income Statement for 1999-2000 at that level of output.
Answer
Additional units of sales 2,000 4,000 6,000 8,000
Rs. Rs. Rs. Rs.
Additional Profit/ (Loss) 34,600 35,200 23,800 (1,600)
Evaluation of four alternatives: Since the additional profit is maximum at the
additional sales of 4,000 units, therefore the second alternative is adjudged as
the best out of the four alternatives proposed by the Vice President of Marketing.
Hence the concern should produce and sell 24,000 units during the year 1999-
2000.
Question 3
A Company is engaged in manufacturing two products ‘X’ and ‘Y’. Product X
uses one unit of component ‘P’ and two units of component ‘Q’. Product ‘Y’ uses
two units of component ‘P’, one unit of component ‘Q’ and two units of
component ‘R’. Component ‘R’ which is assembled in the factory uses one unit of
component ‘Q’.
Component ‘P’ and ‘Q’ are purchased from the market. The company has
prepared the following forecast of sales and inventory for the next year:
Product ‘X’ Product
‘Y’
Sales (in units) 80,000 1,50,000
At the end of the year 10,000 20,000
At the beginning of the year 30,000 50,000
The production of both the products and the assembling of the component ‘R’ will
be spread out uniformly throughout the year. The company at present orders its
inventory of ‘P’ and ‘Q’ in quantities equivalent to 3 months production. The
company has compiled the following data related to two components:
P Q
Price per unit (Rs.) 20 8
Order placing cost per order (Rs.) 1,500 1,50
0
Carrying cost per annum 20% 20
%

5.25
Advanced Management Accounting

Required:
(a) Prepare a Budget of production and requirements of
components during next year.
(b) Suggest the optimal order quantity of components ‘P’ and ‘Q’.
Answer

(a) Budgeted requirements of components P, Q and R are 3,00,000, 4,80,000

and 24,000 respectively.
(b) EOQ: P = 15,000 components and Q = 30,000 components

5.26
 CHAPTER 6

STANDARD COSTING

BASIC CONCEPTS AND FORMULAE

Ba c Concepts
si
6.1 Meaning of Variance Analysis
Variance analysis is the analysis of the co st variances into its component
parts with appropriate justification of such variances, so that we can
approach for corrective measures
6.2 Variances of Efficiency
Variances due to the effective or ineffective use of materials quantities,
labour hours, once actual quantities are compared with the predetermined
standards.
6.3 Variances of Price Rates
Variances arising due to chang e in unit material prices, standard labour
hour rates and standard allowances for indirect costs.

6.4 Variances Due to Volume

Variance due to the effect of difference between actual activity and the
level of activity assumed when the standard was set.

6.5 Purpose of Standard Costing

Standard Costing main purpose is to
• Investigate the reasons
• Identify the problems
• Take corrective action.

6.6 Reasons for Each Type Of Variances And The Suggested Course Of
Action
Type of Reasons of Variance Suggestive Course of Action
Variance
MATERIAL
Advanced Management Accounting

Material • Change in Basic • Departmental head

Price should take
necessary action to

6.2
 Standard Costing

• Overtime
Administrat • Over expenditure • Comparison of budgets
Price
ive • with
purchase at right point of
• time Cash discount or
actuals
Fail to purchase the • Introduction interest rateof for payment
Operating
anticipated standard of purchase should be
costing
quantities at appropriate • consider at the
Introduction time of
of cost
price such
ratios payment
SALES • Price check on the
purchase of standard
Sales • Change in Price • Better
qualityPrice Decision
materials
Value
Material • UseChange in Market Size • Improved
of sub-standard Regular Strategic
Inspection of
Usage • Change
material in Market Planning
quality of materials
Ineffective
Share use of Proper training of
B c Formulas materials operators
a Pilferage Ensure best
si Non standardised mix utilisation of
1. Material Variance resources
1. LABOUR
Material costs variance = (Standard quantity x Standard Pric e) –
1 (Actual
Labourquantity xChange
Actual in design and price)
Proper planning
MCV = (SQ × SP)quality
Efficiency – (AQstandard
× AP) Proper training
Poor working conditions Healthy working
1. Material price variance
Improper = Actual quantity × (Standard
scheduling price – Actual
environment
2 price) Timelines for achieving set
MPV = AQ × (SP – AP) targets
1. Material
Labour usage variance = Standard
Improper placement of price (Standard
Time quantity
Scheduling – Actualfor
3 quantity)
Rate labour work performance
MUV = SP × (SQ –AQ)
Increments / high labour Proper job allocation
Check: wages Overtime according to capabilities of
1. Material cost variance = Material usage variance + Material price
workers
4 variance
MCV = MUV + MPV
OVERHEADS
Classification of Material Usage Variance
Material usage• variance
Manufacturi Improper planning
is further sub- Efficient planning for
ng Under or over better
divided into: i) Material mix variance Capacity utilization
absorption of fixed
ii) overheads
Material yield variance.Reduction Check on
of sub-usage
(Or Material expenditure
variance)
sales
Breakdowns
Power failure
Labour Trouble
Selling and Increase in delivery Sales quotas
Distribution cost 6.3 Sale Targets
Increase in stock
holding period
Advanced Management Accounting

1. Material mix variance = (Revised standard quantity – Actual quantity) ×

5 Standard price
MMV = (RSQ – AQ) × SP
Where
Revised standard quantity =
Standard quantity of one material ×Total of actual quantities of all materials
Total of standard quantitiets of all materials
1.6 Material revised usage variance=(Standard quantity–Revised standard
quantity)×Standard
price
MRUV = (SQ – RSQ) × SP
1.7 Material yield variance = (Actual yield – Standard yield) × Standard
output price
MYV = (AY – SY) × SOP
Check:
Material usage variance = Material mix variance + Material yield
variance
MUV = MMV + MYV

Or
1.8 Material usage variance = Material mix variance + Material revised
usage variance
MUV = MMV + MRUV
Note: Material revised usage variance is also known as material sub –
usage variance.
In each case there will be only one variance either material yield or material
revised usage variance.
2. Labour Variance
2.1 Labour Cost variance = (Std. hours for actual output x Std. rate
per hour) – (Actual hours
x Actual rate per hour)
LCV = (SH x SR) – (AH x AR)
2.2 Labour rate variance = Actual time (Std. rate – Actual rate)
LRV = AH x (SR – AR)
2.3 Labour efficiency (or time) variance=Std. rate (Std. hours for
actual output–Actual hours)

6.4
 Standard Costing

LEV = SR x (SH – AH)

Check:
Labour cost variance = Labour efficiency variance + Labour rate variance
LCV = LEV + LRV
2.4 Classification of Labour Efficiency Variance
Labour efficiency variance is further divided into the following variances:
(i) Idle time variance
(ii) Labour mix variance
(iii) Labour yield variance (or Labour revised-efficiency variance)
2.5 Idle time variance = Idle hours x Standard rate
ITV = IH x SR
2.6 Labour mix variance = (Revised std. hours – Actual hours) x
Standard rate
LMV = (RSH – AH) x SR
2.7 Labour revised efficiency variance = (Std. hours for actual
output–Revised std. hours) x Standard rate LREV = (SH –
RSH) x SR
2.8 Labour yield variance = (Actual yield–Std. yield from actual input)
x Std. labour cost per
unit of output
LYV = (AY – SY) x SLC
Check:
Labour efficiency variance=Idle time variance+Labour mix
variance+Labour yield variance
(or lobour revised efficiency variance)
LEV = ITV + LMV + LYV (or LREV)
3. Overhead Variance
Basic terms used in the computation of overhead
variance Standard overhead rate (per hour) = Budgeted
overhead
Budgeted hours
Or
Standard overhead rate (per unit) = Budgeted Overhead

6.5
Advanced Management Accounting

Budgeted output in units

Note: Separate overhead rates will be computed for fixed and variable
overheads.
Basic calculations before the computation of overhead variances:
The following basic calculation should be made before computing
variances.
(i) When overhead rate per hour is used:
(a) Standard hours for actual output (SHAO)
SHAO = Budgeted hours × Actual output
Budgeted output
(b) Absorbed (or Recovered) overhead = Std. hours for actual
output × Std.
overhead rate
per hour
(c) Standard overhead = Actual hours × Std. overhead rate per
hour
(d) Budgeted overhead = Budgeted hours × Std. overhead rate
per hour
(e) Actual overhead = Actual hours × Actual overhead rate per
hour
(ii) When overhead rate per unit is used
(a) Standard output for actual hours (SOAH)
SOAH = Budgeted output (in units) × Actual hours
Budgeted hours
(b) Absorbed overhead = Actual output × Std. overhead rate per unit
(c) Standard overhead = Std. output for actual time × Std. overhead
rate per unit
(d) Budgeted overhead = Budgeted output × Std. overhead rate per
unit
(e) Actual overhead = Actual output × Actual overhead rate per unit
Overhead cost variance = Absorbed overhead – Actual overhead
OCV = (Std. hours for actual output × Std. overhead rate) – Actual
overhead Overhead cost variance is divided into two categories:
(i) Variable overhead (VO) variances
(ii) Fixed overhead (FO) variances

6.6
 Standard Costing

3.1 Variable Overhead (VO) Variances

V. O. cost variance = (Absorbed variable overhead – Actual variable
overhead)
= (Std. hours for actual output × Std. variable overhead
Rate) – Actual overhead cost
This variance is sub-divided into the following two variances:
(a) Variable overhead expenditure variance or spending variance or
budget variance (b) Variable overhead efficiency variance
3.2 V. O. expenditure variance = (Standard variable overhead – Actual
variable overhead) = (Actual hours × Std. variable overhead
rate) – Actual overhead cost
3.3 V.O. efficiency variance = (Absorbed variable overhead – Standard
variable overhead) = (Std. hours for actual output – Actual hours) × Std.
variable overhead rate
Check:
V. O. cost variance = V.O. expenditure variance + V. O. efficiency
variance
Fixed Overhead (FO) Variances
3.4 F.O cost variance = (Absorbed overhead – Actual overhead)
= (Std. hours for actual output × Std. fixed overhead rate) – Actual fixed
overhead Fixed overhead cost variance is further divided into the
following two variances:
(a) Fixed overhead expenditure variance
(b) Fixed overhead volume variance
3.5 F.O. expenditure variance = (Budgeted fixed overhead – Actual fixed
overhead)
= (Budgeted hours × Std. fixed overhead rate) – Actual
fixed overhead

6.7
Advanced Management Accounting

3.6 F.O volume variance = (Absorbed overhead – Budgeted overhead)

= (Std. hours for actual output – Budgeted hours) × Std. fixed
overhead rate Check:
F.O. cost variance = F.O. expenditure variance + F.O. volume variance
Fixed overhead volume variance is further divided into the
following variances: (a) Efficiency variance
(b) Capacity variance
(c) Calendar variance
3.7 Efficiency variance = (Absorbed fixed overhead – Standard fixed
overhead)
= (Std. hours for actual output – Actual hours) × Std. fixed
overhead rate
3.8 Capacity variance = (Standard fixed overhead –
Budgeted overhead) = (Actual hours – Budgeted hours)
× Std. fixed overhead rate
3.9 Calendar variance = (Actual No. of working days – Std. No. of working
days) × Std. fixed rate per day
Or = (Revised budgeted hours – Budgeted hours) × Std.fixed rate
per hour Where,
Revised budgeted hours = Budgeted hours × Actual days
Budgeted days

Note: When calendar variance is computed, there will be a modification in

the capacity variance. In that case revised capacity variance will be
calculated and the formula is: Revised capacity variance = (Actual hours –
Revised budgeted hours) × Std. fixed rate per hour
Check: F. O. volume variance = Efficiency Variance + Capacity variance +
Calendar variance

6.8
 Standard Costing

4. Sales Variance
The sales variances can be computed in two ways. They are:
(a) Sales turnover or value method.
(b) Profit or sales margin method.
(a) Sales turnover or sales value method: It includes the following:

4.1 Sales value variance: (Budgeted sales - Actual sales)

The variance can be bifurcated into sales price variance and sales volume
variance.
4.2 Sales price variance:
Actual quantity of Sales (Actual price –
Budgeted
price) or
(Actual sales - Actual quantity at budgeted prices)
4.3 Sales volume variances:
Budgeted price (Actual quantity – Budgeted
quantity) or
(Actual quantity at budgeted price - budgeted sales)
Check: Sales value variance = Sales price variance + Sales volume
variances Sales volume variance can be sub-divided into two parts:
(i) Sales mix variance
(ii) Sales quantity variance

4.4 Sales mix variance

Total actual sales quantity (Budgeted price per unit of actual mix –
Budgeted price per unit of budgeted mix)

4.5 Sales quantity variance:

Budgeted price per unit of budgeted mix (Actual total sales qty. –
Budgeted total sales qty.)
Check: Sales volume variance = Sales mix variance + Sales
quantity variance (b) Profit or sales margin method

4.6 Total Sales Margin Variance (TSMV):

(Budgeted margin - Actual margin)

6.9
Advanced Management Accounting

4.7 Sales Margin Price Variance (SMPV):

SMPV = Actual quantity (Actual margin per unit – Budgeted margin per
unit).
4.8 Sales Margin Volume Variance (SMVV):
SMVV = Budgeted margin per unit (Actual units –
Budgeted units) This can be further sub-divided into the
following two variances:
4.9 Sales Margin Quantity Variance (SMQV):
(Budgeted total quantity - Actual total quantity) Budgeted margin per unit of
budgeted mix.
4.10 Sales Margin Mix Variance (SMMV):
SMMV = Total actual quantity sold × (Budgeted margin per unit of actual
mix -Budgeted margin per unit of budgeted mix).
Check: Sales Margin Volume Variance = Sales Margin Quantity Variance +
Sales Margin Mix Variance

Question 1
(a) State the features of Partial plan of Standard Cost Accounting procedure.
(b) The following is the Operating Statement of a company for April 2001:
Rs.
Budgeted Profit 1 ,
00,000
Variances: Favourabl Advers
e Rs. e Rs.
Sales Volume 4,000
Price 9,600
Direct Material Price 4,960
Usage 6,400
Direct Labour Rate 3,600
Efficiency 3,600
Fixed Efficiency 2,400
Overheads
Capacity 4,000
Expense 1,400

6.10
 Standard Costing

17,000 22,960 5 ,960 (A )

Actual profit 94,040
Additional information is as under:
Budget for the year 1,20,000 units
Budgeted fixed overheads Rs.4,80,000 per annum
Standard cost of one unit of product is:
Direct Materials 5 kg.@ Rs.4 per kg.
Direct Labour 2 hours @ Rs.3 per hour
Fixed overheads are absorbed on direct labour hour basis.
Profit 25% on sales
You are required to prepare the Annual Financial Profit / Loss Statemetn for
April, 2001 in the following format:
Account Qty./ Hours Rate / Price Actual Value Rs.
Sales
Direct Materials Direct Labour
Fixed Overheads Total Costs

Profit
Answer
(a) Features of Partial Plan of Standard Cost Accounting procedure:
Standard cost operations can be recorded in the books of account by using
partial plan, Features of partial plan of standard costing procedure are as
follows:
(i) Partial plan system uses current standards in which the inventory will
be valued at current standard cost figure.
(ii) Under this method WIP account is charged at the actual cost of
production for the month and is credited with the standard cost of the
month’s
production of finished product.
(iii) The closing balance of WIP is also shown at standard cost. The
balance after making the credit entries represent the variance from
standard for the month.
(iv) The analysis of variance is done after the end of the month.

6.11
Advanced Management Accounting

(b) Working notes:

1. (a) Budgeted fixed overhead per unit:
= (Budgeted fixed overheads p.a / Budgeted output for the year)
= Rs.4,80,000 p.a. / 1,20,000 units = Rs.4 per unit.
(b) Budgeted fixed overhead hour:
= Budgeted fixed overhead per unit / Standard labour hours per
unit = Rs.4 / 2 hours = Rs.2 per hour 2. (a) Standard
cost per unit:
Rs.
Direct material 20
(5 kg × Rs.4/- per kg)
Direct labour 6
(2 hours × Rs.3/- per hour)
Fixed overhead 4 (2 hours × Rs.2)
Total standard cost (per unit) 30
(b) Budgeted selling price per unit
Standard cost per unit 30 Standard profit per unit
10
(25% on slaes or 33 – 1/3% of standard cost)
Budgeted selling price per unit 40
3 (a) Actual output units for April, 2001:
Fixed overhead volume Variance
= Efficiency variance + Capacity variance
or (Budgeted output units – Actual output units) Budgeted fixed
overhead p.u.
Rs.2,400 (Favourable) + Rs.4,000 (Adverse) = Rs.1,600
(Adverse) or (10,000 units – x units) Rs.4 – Rs.1,600 (Adverse)
or (10,000 units – 400 units) = x (Actual output units) or Actual
output units = 9,600 units (b) Actual fixed overhead expenses:
(budgeted fixed overhead – Actual fixed overhead) = Fixed
overhead expenses variance

6.12
 Standard Costing

or (Rs.40,000 – x) = Rs.1,400 (Favourable)

or x = Rs.40,000 – Rs.1,400
= Rs.38,600
4. (a) Actual sales quantity units: Sales volume variance

= Budgeted margin per unit quantity Actual salesunits −

Budgetedquantity units 

= Rs.4,000 (Adverse) = Rs.10 (x – 10,000 units)
or 400 units = x – 10,000 units
or x (Actual sales quantity) = 9,600 units
(b) Actual selling price per units

Sales price variance = priceActual per Selling unit

−Budgetedprice per unitselling SalesActual units

or Rs.9,600 (Fav.) = (x – Rs.40) × 9,600
units or Actual selling price per unit = Rs.41/- 5.
(a) Actual quantity of material consumed:

Material usage variance =  Standardquantity −

quantityActual Standardper unit price

or 6,400 (Adv.) = (9,600 units × 5 kgs.) Rs.4

or x kgs. = 49,600 kgs.
(actual quantity of material consumed)
(b) Actual price per kg:
Actual price per kg.:
Material price variance = (Standard price per kg – Actual price per
kg) Actual quantity of material consumed

6.13
Advanced Management Accounting

-Rs.4,960 = (Rs.4 –Rs. y per kg.) 49,600 kg.

-0.1 = (Rs.4 – Rs. y per kg) or y
= Rs.4.10 per kg.
6. (a) Actual direct labour hour used:
Labour efficiency variance = (Standard hours – Actual hours)
Standard rate per hour
Rs.3,600 (Favourable) = (9,600 units × 2 hours – p hours)
Rs.3
Rs.3,600 (Favourable) = (19,200 hours – p hours) Rs.3
P hours = (19,200 hours – 1,200 hours) – 18,000 hours (Actual
direct labour hours)
(b) Actual direct labour hour rate:

 Standardrate per hour −

Labour rate variance =
perActual hour rate labourActual Direct hours

Rs.3,600 (Adverse) = (Rs.3 per hour – t per hour) 18,000 hours

or t = Rs.3 + Rs.0.20 – Rs.3.20 per hour
(actual direct labour hour rate)
7. Actual fixed overheads:
Fixed overhead expense variance = Budgeted fixed overhead –
Actual fixed overhead
or Rs.1,400 (Favourable) = 10,000 units×Rs.4 p.u.–
Actual fixed overhead
or Actual fixed overhead = Rs.40,000 –
Rs.1,400 or Actual fixed overhead = Rs.38,600
Annual financial Profit /Loss
Statement (for April, 2001)
Account Qty./ Hours Rate/Price Actual/ Value
(a) (b) (c) ( d)=(b)×
(c )
Sales: (A) 9,600 units 41 3,
93,600
(Refer to working note 4)

6.14
 Standard Costing

Direct Materials 49,600 kgs. 4.10 per kg. 2,

03,360
(Refer to working note 5)
Direct labour 18,000 hours 3,20 per hour 57,600
(Refer to working note 6)
Fixed Overheads 18,000 hours 2.14444 per hour 38,600
(Refer to working note 6 (a) and 7)
(Rs.38,600/18,000 hours)
(absorbed on direct labour hour basis)
Total costs: (B) 2,
99,560
Profit: [(A) – (B)] 94,040
Question 2
C Preserves produces Jams, Marmalade and Preserves. All the products are
produced in a similar fashion; the fruits are cooked at low temperature in a
vacuum process and then blended with glucose syrup with added citric acid and
pectin to help setting.
Margins are tight and the firm operates, a system of standard costing for each
batch of Jam.
The standard cost data for a batch of raspberry jam are
Fruits extract 400 kgs @ Rs. 16 per kg.
Glucose syrup 700 kgs @ Rs. 10 per kg.
Pectin 99 kgs. @ 33.2 per kg.
Citric acid 1 kg at Rs. 200 per kg.
Labour 18 hours @ Rs. 32.50 per
hour.
Standard processing loss 3%.

The climate conditions proved disastrous for the raspberry crop. As a

consequence, normal prices in the trade were Rs. 19 per kg for fruits abstract
although good buying could achieve some savings. The impact of exchange
rates for imported sugar plus the minimum price fixed for sugarcane, caused the
price of syrup to increase by 20%. The retail results for the batch were –
Fruit extract 428 kgs at Rs. 18 per kg. Glucose syrup 742 kgs at Rs.
12 per kg.

6.15
Advanced Management Accounting

Pectin 125 kgs at Rs 32.8 per kg. Citric acid 1 kg at Rs. 95 per kg.
Labour 20 hrs. at Rs. 30 per hour.
Actual output was 1,164 kgs of raspberry jam.
You are required to:
(i) Calculate the ingredients planning variances that are deemed uncontrollable.
(ii) Calculate the ingredients operating variances that are deemed controllable.
(iii) Calculate the mixture and yield variances.
(iv) Calculate the total variances for the batch.
Answer
Details of original and revised standards and actual achieved
Original standards Revised standards Actual
Fruit 400 Kgs × Rs6,400 400 Kgs ×Rs Rs7,600
428 Kgs× Rs7,7
Rs16 19 Rs 18 04
Glucose 700 Kgs × Rs7,000 700 Kgs × Rs 8,400 742 Kgs × Rs
Rs10 Rs12 Rs 12 8,904
Pectin 99 Kgs × Rs Rs 3286.8 99 Kgs × Rs Rs 125Kgs×Rs Rs
33.2 33.2 3286.8 32.8 4,100
Citric 1 Kg× Rs 200 Rs 200 1 Kg× Rs 200 Rs 200 1 Kg× Rs 95 Rs
acid 95
1,200 kgs 1,200 kgs Rs19,48 1,296 kgs Rs20,
Rs16,886. 8 6.8 8 03
Labour Rs 585.0 Rs 585.0 Rs
600
1,200 kgs 17,471.8 1,200 kgs 20,071.8 1,296 kgs 21,40
3
Loss 36 kgs 36kgs 132
1,164kgs Rs 1,164kgs Rs 1,164 Kgs Rs
17,471.8 20,071.8 21,403
(i) Planning variances
*
Fruit extract (6,400 less 7,600) Rs 1,200(Adverse)
Glucose syrup (7,000 less 8,400) Rs1,400(Adverse)
Total Rs 2,600(Adverse)
*
(Std qty × Std price less Std qty × Revised Std price)

6.16
 Standard Costing

(ii) Ingredients operating variances

Total (19,486.8 less 20,803) = Rs 1,316.2(Adverse)
Ingredients Price variance
(Revised Material Price – Actual Material Price)×( Actual Qty Consumed)
Variance in
Rs
Fruit extract (19 – 18) × 428 428(F)
Glucose syrup Nil
Pectin (33.2 – 32.8) × 125 50(F)
Citric acid (200 – 95) × 1 105(F)
583(F)

Usage variance
(Std Qty on Actual Production less Actual Qty on Actual Production)×Revised
Std Price/Unit
Rs Variance in
Rs
Fruit extract (400 – 428) × 19 532(A)
Glucose syrup (700 – 742) ×12 504(A)
Pectin (99 – 125) ×33.2 863.2(A)
Citric acid Nil
1 ,899.2(A )
(iii) Mix Variance
(Actual usage in std mix less Actual usage in actual mix) ×std price
Variance in
Rs
Fruit extract (432 – 428) ×19 76(F)
Glucose syrup (756 – 742) × 12 168 (F)
Pectin (106.92 – 125) ×33.2 600.3(A)
Citric acid (1.08 – 1) ×200 16(F)
340.3 (A)
Yield variance
(Actual yield – Std yield from actual output) × Std cost per unit of output

6.17
Advanced Management Accounting

= (1,164 – 1,296 × 0.97) × = 1,558.9(A)

Labour operating variance
585 – 600 = 15(A)
(iv) Total variance = Planning variance + Usage Variance + Price Variance +
labour operating Variance.
Or Total Variance = (2,600) + (1,899.2) + 583 + (15) = 3931.2 (A).
Question 3
Rainbow Ltd. manufactures paint in batches. The company uses standard costing
system and the variances are reported weekly. You have taken the account sheet
for study for variance analysis discussion. While working coffee was spilled on
these sheets and only following could have been retrieved:
Dr. Cr.
Raw Material -1
Beg. Balance 0 18,00
0
Closing Balance 6,00
Raw Material -2 0

Beg. Balance 18,000

Closing Balance 41,40
Work in Progress 0

Beg. Balance 0
Raw Material -2 72,000 Closing Balance 0
Sundry Creditors
1 ,
Wages outstanding 27,200

51,750
Quantity Variance-Material-1

1,200
Price Variance-Material-2

6,600
Efficiency Variance-Labour

6.18
 Standard Costing

7,200
Other information’s are: standard cost of Material – 2 is Rs180 per litre and
standard quantity is 5 litres. Standard wages rate is Rs24 per hour and a total
2,300 hours were worked during the week. 1,000 kg of Material -1and 550 litres
of Material-2 were purchased. Sundry creditors are for material acquisition, and
wages outstanding pertain to direct labour.
You are required to compute Material-1 Rate Variance, Material-2 Quantity
Variance & Labour Spending Variance, Standard hours allowed for production
and purchase value of Material-1 for variance analysis discussion.
Answer
Material – 1 Rate Variance = Standard cost of material purchased – Actual
cost
= Rs24, 000 – Rs21, 600 = Rs2, 400 (F)
Material – 2 Quantity Variance = SR × SQ – SR × AQ
= Rs900 × 80 units – Rs75, 600
= Rs3, 600 (A)
Labour Spending Variance = SR × AH – AR × AH
= Rs24/per hour × 2300 hours – Rs51, 750
= Rs3, 450 (A)
Labour Efficiency Variance = SR × (SH – AH)
– 7200 = 24 (SH – 2300)
SH = 2000 Hrs.

Rs
Total Cost of material purchased 1 ,
27,200
Less Purchase Value of Material – 2 1 ,
05,600
Cost of material –1 21,60
0
Working Notes:
(1) Standard Cost of Material – 2 actually consumed in production = Rs72,
000 (Given)

6.19
Advanced Management Accounting

Standard cost of Material – 2 per unit: 5 litres × Rs180 = Rs900

∴No of units produced = Rs72, 000 / Rs900 = 80
units Total material – 1 used in production = Rs18, 000 (Given)
Add Closing Inventory = Rs6, 000 (Given)
Less Opening Inventory = 0
Hence Standard Cost of Material – 1 purchased = Rs24, 000
(2) Standard Rate of Material -1 = Rs24, 000 / 1,000kg
= Rs24 per kg
Standard Cost of Material – 1 = Rs18, 000
Add favourable Quantity Variance = Rs1, 200
Material – 1 allowed = Rs19, 200
Standard quantity of Material – 1 allowed = Rs19, 200/Rs24=
800 Kg. Standard quantity per unit =
800kg/80units = 10 kg
Standard purchase price for Material – 2 = (550liters × Rs180)= Rs99, 000
Add unfavourable Rate Variance = Rs6, 600 Actual
cost Price of Material – 2 = Rs1, 05, 600 (3)
Opening balance of Material – 2 = Rs18, 000
Add Standard Cost of Purchase (550 litres × Rs180) = Rs99, 000
Less Closing Balance = Rs41, 400
Material-2 Consumed at Standard cost = Rs75, 600
Question 4
“Overhead variances should be viewed as interdependent rather than
independent”. Explain.
Answer
The operations of a firm are so inter linked that the level of performance in one
area of operation will affect the performance in other areas. Improvements in one
area may lead to improvements in other areas. A sub-standard performance in
one area may be compensated by a favourable performance in another area.
Because of such interdependency among activities in the firm, the managers
should not jump to conclusions merely based on the label of variances namely
favourable or unfavourable. They should remember that there is a room for trade

6.20
 Standard Costing

off amongst variances. Hence, variances need to be viewed as ‘attention

directors’ rather than problem solvers. Thus, a better picture will be captured
when overhead variance are not viewed in isolation but in an integrated manner.
Question 5
A company following standard marginal costing system has the following interim
trading statement for the quarter ending 30th June, 2005, which reveals a loss of
Rs. 17,000, detailed below:
Rs.
Sales 4,
99,200
Closing stock (at prime cost) 18,000
5,
17,200
Costs:
Direct material 1,68,000
Direct labour 1,05,000
Variable overhead 42,000
3,15,000
Fixed overhead 1,20,000
Fixed Admn. Overhead 40,000
Variable distribution Overhead 19,200
Fixed selling Overhead 40,000
2,19,200
Total costs 5 ,
34,000
Loss
17,00
0
Additional information is as follows:
(i) Sales for the quarter were 1,200 units. Production was 1,400 units, of
which 100 units were scrapped after complete manufacture. The factory
capacity is estimated at 2,000 units.
(ii) Because of low production, labour efficiency during the quarter is estimated
to be 20% below normal level.
You are required to analyse the above and report to the management giving the
reasons for the loss.

6.21
Advanced Management Accounting

Answer
(i)
Details Working Amount (Rs.)

(1) Selling price at cost 416

(2) Raw materials 120

Labour 60
[Equivalent units (1,400/80%)]

Factory overhead 30

Total manufacturing cost 210 Distribution overheads 16

Total cost 226
Contribution 190
Total fixed cost: factory 1,20,000
Administration 40,000
Selling 40,000 2 , 00,000
(ii) Standard Profit for 1,200 units sold:
Rs.
Contribution 1,200 × 190 2 , 28,000 Less: Fixed costs 2 , 00,000

Profit 28,000
(iii) Reconciliation
Rs.
Budgeted profit (2,000 × 190 – 2,00,000) 1 , 80,000
Less: Volume variance 800 × 190 1 , 62,000
Standard profit 28,000
Factors causing loss:
Units scrapped 100 × 210 21,000
Labour inefficiency 350 × 60 21,000
Undervaluation of closing stock 100 × (210 – 180) 3,000

6.22
 Standard Costing

Actual profit – 17,000

Question 6
The following figures are available. Find out the missing figures, giving
appropriate formulae:
Rs.
Budgeted profit 15,000
Less: Adverse variances:
Contribution price variance 10,600
Direct materials variance 1,000
Fixed overhead variance 600 (12,200)
2,800
Add: Favourable variances
Contribution quantity variance 1,800
Direct wages variance 600
Variable overhead variance 1,800 4,200
Actual profit 7,000
There is no inventory
Production units = Sales units for both actual and budget.
Standard selling price Rs. 18/unit Standard variable cost Rs. 15/unit
Standard contribution Rs. 3/unit Actual selling price Rs. 17/unit

Budgeted sales 10 ,000 units

Standard material cost p.u. = Re. 1 (which is 5 kg. @ Rs. 20 Paise/kg.).
Material usage variance = 400 (Adv.)
Actual labour hours @ actual rate = Rs. 63,000
Actual labour hours @ standard rate = Rs. 61,950
Variable overhead standard rate = Rs. 2
Standard hours of production = 4 per unit
Variable overhead at standard rate = Rs.
84,800.
Variable overhead expenditure variance = 400 (A).

6.23
Advanced Management Accounting

Budgeted fixed overhead = Rs. 15,000.

Find out the following:
(i) Actual sales units
(ii) Actual sales rupees
(iii) Actual quantity of raw materials used
(iv) Labour efficiency variance
(v) Actual variable overhead in rupees
(vi) Variable overhead efficiency variance (vii) Actual fixed overheads

(viii) Operating profit variance.

Answer
Rs.
(1) Budgeted contribution = Budgeted Profit + Budgeted Fixed 15,000 +
15,000
Cost = 30,000
Plus Contribution quantity variance 1,800 Total Standard
contribution 31,800 Standard Contribution per unit 3
Actual Sales Volume 10 ,600 units
(2) Actual Sales Volume 10,600 × 17 1,80,200
(3) Actual quantity of Raw Materials used
Standard consumption 10,600 × 5 2 ,000 Kgs. Add: Material Usage

2 ,000 kgs.
Variance
Actual consumption 55 ,000 Kgs.
(4) Labour Efficiency variance
Standard labour cost for Standard hours (63,000 + 600) 63,600
Standard labour cost for actual hours 61,950
Labour efficiency variance 1 ,650 F
(5) Actual variable overhead
Selling Overhead variance – Variable Rs. 84,800 − Rs. 1,800 = Rs. overhead
83,000
(6) Variable Overhead efficiency variance

6.24
 Standard Costing

Actual hours (AH) 61950/15 41 ,300 hours Standard

hours (SH) 60,600 × 4 42 ,400 hours Standard rate per hour (SR)
63600/(10600x4) Rs. 1.5
Efficiency variance SR (SH– AH) = 2 (42,400 – 41,300) = 2,200F
(7) Actual fixed overheads: Budgeted Overhead + Fixed Overhead variance
= 15,000 + 600 = Rs. 15,600.
(8) Operating profit variance
If budgeted profit is considered (15,000 – 7,000) = Rs. 8,000 adverse
If standard profit is considered (16,800 – 7,000) = Rs. 9,800 adverse
Question 7
Under the single plan, record the journal entries giving appropriate narration, with
indication of amounts of debits or credits alongside the entries, for the following
transactions using the respective control A/c.
(i) Material price variance (on purchase of
materials) (ii) Material usage variance (on
consumption) (iii) Labour rate variance.
Answer
(i) Dr. Material Control A/c
Dr. or Cr. Material Price Variance A/c
Cr. Creditors A/c
(Being price variance during purchase of materials)
(ii) Dr. WIP Control A/c
Dr. or Cr. Material Usage Variance A/c
Cr. Material Control A/c
(Being recording of usage variance at Standard cost
of excess/under utilized quantity)
(iii) Dr. Wages Control A/c
Dr. or Cr. Labour Rate Variance A/c
Cr. Cash
(Being entry to record wages at standard rate)
Question 8
A company produces a product X, using raw materials A and B. The standard mix
of A and B is 1: 1 and the standard loss is 10% of input.

6.25
Advanced Management Accounting

You are required to compute the missing information indicated by “?” based on
the data given below:
A B Total
Standard price of raw material (Rs./kg.) 24 30
Actual input (kg.) ? 70
Actual output (kg.) ?
Actual price Rs./kg. 30 ?
Standard input quantity (kg.) ? ?
Yield variance (sub usage) ? ? 270(
A)
Mix variance ? ? ?
Usage variance ? ? ?
Price variance ? ? ?
Cost variance 0 ? 1300(
A)
Answer
Computation of Yield Variance for ‘A’ and ‘B’
DM yield variance for ‘A’ =
DM yield = [ Std qty of - Actual ] × Std × Std price of ‘A’
variance all DM total qty of Mix for ‘A’ allowed all
DM %age
for actual used of ‘A’ output
= [SQ A - RSQ A ] × Std price of ‘A’
Where RSQ A = Revised Standard Quantity of ‘A’ = (Actual total qty of all DM
used) × Std Mix %age of ‘A’ and
SQ A = Standard Quantity of DM ‘A’ for Actual Production = Standard quantity of
all DM allowed for actual output × Std Mix %age of ‘A’
DM yield = [ Std qty of - Actual ] × Std × Std price of ‘B’
variance all DM total qty of Mix for ‘B’ allowed all
DM %age
for actual used of ‘B’ output
= [SQ B - RSQ B ] × Std price of ‘B’
Where RSQ B = Revised Standard Quantity of ‘B’ = (Actual total qty of all DM
used) × Standard Mix %age of ‘B’ and
SQ B = Standard quantity of DM ‘B’ for Actual Production = Standard quantity of
all DM allowed for actual output × Standard Mix %age of ‘B’

6.26
 Standard Costing

Since Standard Mix %age is the same for both ‘A’ and ‘B’ (1:1) we have,
Total Yield variance for ‘A’ and ‘B’= T × (Std price of ‘A’ + Std price of ‘B’)
Where T = (Std qty of all DM allowed for actual output - Actual total qty of all DM
used) ×
0.5
As Total Yield variance for ‘A’ and ‘B’ is given as – Rs 270, we have
- Rs 270 = T × Rs 24 + T × Rs 30
Or T = - 5
Hence Yield Variance for ‘A’ = - 5 × 24 = - Rs 120 and
Yield variance for ‘B’ = - 5 × 30 = - Rs 150.
Also
(SQ A - RSQ A ) × 24 = - 120 or SQ A - RSQ A = - 5
Similarly
(SQ B - RSQ B ) × 30 = - 150 or SQ B - RSQ B = - 5
Alternative 1
Let total actual quantity consumed; X kg.
Then, Quantity of A = X – 70

X X
RSQ = of A & of B.(Since the Mix ratio is 1:1)
2 2
The Standard input for both ‘A’ and ‘B’ will be 0.5X – 5
Since Cost Variance for ‘A’ is given to be nil, we have,
(SPA × SQA) − (AQA × APA) = 0
i.e. 24 × (0.5 X – 5) – (X − 70) × 30 = 0
or X = 110 Kgs
Therefore Actual Input for ‘A’ = 110 – 70 = 40 Kgs Also, Standard Input for ‘A’ and
 110 
‘B’ will be  − 5  = 50 Kgs. Using this quantity in the

2 
Cost Variance of ‘B’ , the actual price per kg of ‘B’ (APB)
will be , 50 × 30 – 70 × AP B = -1,300 Or AP B = Rs 40.
Alternative 2

6.27
Advanced Management Accounting

Let the standard input of ‘A’ = X kg. Therefore, the total standard input for ‘A’ +
‘B’= 2X Actual input = (2X + 10) Kgs.∴ Actual input for ‘A’ = (2X +10 – 70)= (2X –
60)Kgs Forming the equation for nil cost variance of ‘A’.
Rs. 24 × X – Rs. 30 × (2X – 60) = 0
Or X = 50 Kgs. Using this quantity in the Cost Variance of ‘B’, the actual price per
kg. of ‘B’ (APB) will be ,
50 × 30 – 70 × APB =
−1,300 Or APB = Rs. 40.

Alternative 3
Let the actual input of ‘A’ = X
Then the total actual input = (X + 70). Therefore, RSQ of ‘A’ and ‘B’ each = 0.5X +
35 and Standard Input of ‘A’ and ‘B’ each = 0.5X +30.
Forming the equation for nil cost variance of ‘A’, we
have, 24 × (0.5X + 30) – 30 × X = 0 Or X = 40 Kgs.

∴Standard Input will be 50 Kgs. Using this, quantity in the Cost Variance of ‘B’,
the actual price per kg. of ‘B’ (APB) will be,
50 × 30 – 70 × APB =
−1,300 Or APB = Rs. 40.

Substituting various values for quantity and price, we get the following table.
(1) (2) (3) (4)
Std. Price × SQ Std. Price × Std. Price × Actual Actual Price × Actual
RSQ Qty. Qty.
A 24 × 50 = 1200 24 × 55 = 1320 24 × 40 = 960 30 × 40 = 1200
B 30 × 50 = 1500 30 × 55 = 1650 30 × 70 = 2100 40 × 70 = 2800
2700 2970 3060 4000

(1) – (2) (2) – (3) (1) – (3) (3) – (4) (1) – (4)
Yld variance Mix variance Usage variance Price Cost variance
variance
A 1200 − 1320 = 1320 − 960 = 1200 − 960 = 960 − 1200 = 1200
120(A) 360(F) − 1200
240(F) 240(A) =0

6.28
 Standard Costing

B 1500 − 1650 = 1650 − 2100 = 1500 − 2100 = 2100 −

2800 1500 − 2800
150(A) 450(A) 600(A) = 700(A) = 1300(A)
270A) 90A) 360A) 940A) 1300A)
Actual Output = 90 Kgs.
(Actual output and standard output are always equal numerically in any material
variance analysis)
Standard output = Standard input – Standard loss or 100 – 10 = 90 Kgs.
Question 9
The working results of a Software Company for two corresponding years are
shown below:
Amount (Rs. in lakhs)
Year 2005 Year
2006
Sales (A) 600 770
Cost of Sales:
Direct materials 300 324
Direct wages and variable 180 206
overheads
Fixed overheads 80 150
Total (B) 560 680
Profit (A – B) 40 90
In year 2006, there has been an increase in the selling price by 10 per cent.
Following are the details of material consumption and utilization off direct labour
hours during the two years:
Year 2005 Year
2006
Direct material consumption (M. tons) 5,00,000 5,40,000
Direct labour hours 75,00,000 80,00,00
0
Required:
(i) Taking year 2005 as base year, analyse the variances of year 2006 and
also workout the amount which each variance has contributed to change in
profit.
(ii) Find out the breakeven sales for both years.

6.29
Advanced Management Accounting

(iii) Calculate the percentage increase in selling price in the year 2006 that
would be needed over the sale value of year 2006 to earn margin of safety
of 45 per cent. Answer
Working Notes:
(i) Budgeted sales in year 2006 = (100/110) × 770 = Rs. 700
lakhs
(ii) Budgeted direct material cost = (300/600) × 700 = Rs. 350
lakhs
(iii) Budgeted direct wages and variable overheads = (180/600) ×
700 = Rs. 210 lakhs
(iv) Rate per M. ton of direct material: Year 2005 = (300/5) = Rs. 60
: Year 2006 = (324/5.40)= Rs.
60
(v) Material usage budget for the year 2006 = (5/600) × 700 =
5.83333 lakhs
(vi) Direct labour hours budget for the year 2006 = (75/600) × 700
= 87.50 lakhs
(vii) Direct labour and variable overheads rate per hour: Year 2005
= (180/75) = Rs. 2.40
Year 2006 = (206/80) = Rs.
2.575
(viii) Material price variance = (Rs. 60 – Rs. 60) × 5,40,000 = zero
(ix) Material usage variance = (5.83333 – 5.40) × Rs. 60 = Rs. 26
lakhs (F)
(x) Labour and variable overheads rate variance =(2.40 – 2.575) ×
80 = Rs.14 lakhs (A)
(xi) Labour and variable overheads efficiency variance = (87.50 –
80.00) × Rs. 2.40
= Rs. 18 lakhs (F)
(xii) Fixed overheads expenditure variance = (150 – 80) = Rs. 70
lakhs (A)

(xiii) Statement of working results of the company

Amount Rs. in

6.30
 Standard Costing

lakhs
Actuals Budget Varianc
e
2006 2006
Sales 770 700 70(F)
Less: Direct material 324 350 26(F)
Direct wages and variable overheads 206 210 4( F )
Contribution 240 140 100(F)
Less: Fixed overheads 150 80 70(A)
Profit 90 60 30(F)
I Reconciliation statement showing variances contribution to
change in
profit (Rs. in lakhs)
Favourable Advers
e
Increase in contribution due to volume 20 −
Sales price variance 70 −
Material usage variance 26 −
Material price variance − −
Direct labour and variable overheads rate − 14
variance
Direct labour and variable overheads 18 −
efficiency variance
Fixed overheads expenditure variance − 70
134 84
Total change in profit (increase) 50
II Break-even point
Year 2005: (80/120) × 600 = Rs. 400 lakhs
Year 2006: (150/240) × 770 = Rs. 481.25 lakhs
III Required percentage increase in selling price in the year 2006 to
earn a margin of safety of 45%.
Break-even sales = (1 – 0.45) or 55 per cent of total sales.

6.31
Advanced Management Accounting

Contribution at 55% sales = Fixed overheads = Rs. 150 lakhs.

Required contribution at total sales = Rs. 150/.55 = Rs. 272.73
lakhs Additional contribution required = (272.73 – 240) = Rs. 32.73
lakhs Percentage increase in selling price required = (32.73/770) ×
100 = 4.25%.
Question 10
The following information has been extracted from the books of Goru Enterprises
which is using standard costing system:
Actual output = 9,000 units
Direct wages paid = 1,10,000 hours at Rs.22 per hour, of which 5,000
hours, being idle time, were not recorded in production
Standard hours = 10 hours per
unit
Labour efficiency variance = Rs. 3,75,000
(A)
Standard variable = Rs. 150 per
Overhead unit
Actual variable Overhead = Rs. 16,00,000
You are required to calculate:
(i) Idle time variance
(ii) Total variable overhead variance
(iii) Variable overhead expenditure variance
(iv) Variable overhead efficiency variance.
Answer
Actual output = 9,000 units
Idle time = 5,000 hours
Production time (Actual) = 1,05,000 hours
Standard hours for actual production = 10 hours / unit × 9,000 units = 90,000
hours.
Labour efficiency variance = 3,75,000 (A)
i.e. Standard rate × (Standard Production time – Actual production time) =
3,75,000(A). SR (90,000 – 1,05,000) = – 3,75,000

SR = − 3,75,000 = Rs. 25

6.32
 Standard Costing

−15,000
(i) Idle time variance = 5,000 hours × 25 Rs. / hour = 1,25,000. (A)
(ii) Standard Variable Overhead = Rs. 150 / unit
Standard hours = 10 hours / unit
Standard Variable Overhead rate / hour = 150 / 10 = Rs. 15 / hour
Total Variable Overhead variance = Standard Variable Overhead – Actual
Variable Overhead
= Standard Rate × Standard hours –
Actual rate × Actual hours
= (15) × (10 × 9,000) – 16,00,000
= 13,50,000 – 16,00,000
Total Variable Overhead Variance = 2,50,000 (A)
(iii) Variable Overhead Expenditure Variance = (Standard Rate × Actual Hours)
–
(Actual Rate × Actual Hours)
= (15 × 1,05,000) –
16,00,000
= 15,75,000 – 16,00,000
= 25,000 (A)
(iv) Variable Overhead Efficiency Variance = Standard Rate × (Standard Hours
for actual output–Actual hours for Actual
output)
= 15 (90,000 – 1,05,000)
= 15 (–15,000)
= 2,25,000 (A)
Alternative Solution
Actual Output = 9,000 Units
Idle time = 5,000 hrs
Direct Wages Paid = 1,10,000 hours @ Rs. 22 out of which 5,000 hours being
idle, were not recorded in production. Standard hours = 10 per unit.
Labour efficiency variance = Rs. 3,75,000
(A) or
Standard Rate (Standard Time – Actual Time) = – 3,75,000

6.33
Advanced Management Accounting

−3,75,000
Or (90,000 –
1,05,000) =
Standard Rate
Or Standard Rate = Rs 25/-
(i) Idle time variance = Standard Rate × Idle time
25 × 5,000 = Rs 1,25,000 (A)

(ii) Standard Variable Overhead / unit = 150 Standard Rate = = Rs.15/hour

Standard Quantity = 10 hours

Actual Variable Overhead = 16,00,000
Standard Variable Overhead = 150 × 9,000 = 13,50,000
Actual Variable Overhead = 16,00,000
Total Variable Overhead Variance = 2,50,000 (A)
(iii) Variable Overhead expenditure Variance = Standard Variable Overhead for
actual hours – Actual Variable Overhead
= (150 × 1,05,000) –
16,00,000
= 15,75,000 – 16,00,000
= 25,000 (A)
(iv) Variable overhead efficiency variance = Standard Variable Overhead for
actual output–Standard Variable Overhead for Actual
hours)
= 15 (10 hours × 90,000 units – 1,05,000)
= 15 (90,000 – 1,05,000)
= 15 (–15,000)
= 2,25,000 (A)
Question 11
A manufacturing company has furnished the following financial data relating to
the actual output of 9,600 units produced in the last quarter:
Rs.
Sales 4 ,
Costs: 45,500

Direct Materials 59,400

6.34
 Standard Costing

Direct Wages 89,400

Variable Overheads 1 , 45,500
Fixed Overheads 78,000 3 ,
72,300
Profit
73,20
0
The standard wage rate is Rs. 4.50 per hour and the standard variable overhead
rate is Rs. 7.50 per hour. The company uses a JIT system and the budgeted
production and sales quantity is 10,000 units.
The following are the variances from standard costs recorded during the last
quarter:
Rs.
Direct materials Price V 600 A
Usage V 1 ,200
A
Direct Wages Rate V 1 ,500
F
Efficiency V 4 ,500
A
Variable Overheads Expense V 6 ,000
F
Efficiency V 7 ,500
A
Fixed Overheads Expense V 3 ,000
A
Sales Price V 13 ,500
F
You are required to:
(i) Prepare the Original budget and Standard cost sheet per unit of
output; (ii) Produce a statement reconciling the budgeted profit with
actual profit. Usage variance Price variance
1200 A 600 A
Answer
AQ × SP = 58,8001
Direct Materials: 2
SQ × SP = 57,600
SQ AQ SP SQ × SP AQ × SP AP
Standard × AP
AQcost of materials for actual output of 9,600 units = Rs.
57,600. Hence, standard cost per unit is 57,600 / 9,600 = Rs. 6.
59,400
Direct Labour:
SH AH SR SH × SR AH × SR AR AH
6.35
× AR

89,400
Advanced Management Accounting

Efficiency variance Rate variance

4500 A 1500 F
AH × SR = 90,9003
SH × SR = 86,4004
Standard wage cost per unit is 86,400 / 9,600 = Rs. 9.
Standard wage rate is Rs. 4.50.
Standard time per unit is 9/4.5 = 2 hours.
Variable Overheads:
Standard rate is Rs. 7.50 per hour
Standard cost per unit is 2 hours × Rs. 7.50 = Rs. 15.
Fixed Overheads:
Actual units 9,600
Standard time / unit 2 hours
Standard hours produced 9,600 × 2 = 19,200 hours
Actual overheads 78,000
Expense variance 3,000 A
Budgeted overheads 75,000 Budgeted units 10,000
Fixed overheads per unit Rs. 7.50.
Charged to Production: 9,600 × 7.50 = Rs. 72,000

6.36
 Standard Costing

Budgeted overheads Rs. 75,000

Volume variance Rs.
3,000 (A)
Sales:
SQ AQ SP SQ × SP AQ × SP AP AQ × AP
4,45,500

Price variance 13,500 F

AQ × SP = 4,32,000 5

Actual units = 9,600

Standard price is 4,32,000 / 9,600 = Rs. 45 per unit.
Original Budget and Standard Cost Sheet:
Budget Standard
Cost
Units budgeted 10,000
Sales 4,50,000 45.00
Direct materials @ Rs. 6 per unit 60,000 6.00
Direct Wages 90,000 9.00
Variable Overheads @ Rs. 15 per unit 1,50,000 15.00
Fixed overheads @ Rs. 7.50 per unit 75,000
Total costs 3,75,000 7.50
37.5
Profit 75,000 07.50

Sales volume variance is (9,600 – 10,000) × 7.50 = Rs.

3,000 A
Reconciliation Statement:
Budgeted Profit 75,000
Sales volume variance 3 ,000 A
Standard profit 72,000
Sales price variance 13 ,500 F
Total 85,500
Cost variances:

6.37
Advanced Management Accounting

F A
Materials: Price 600
Usage 1,200
Direct Labour: Rate 1,500
Efficiency 4,500
Variable Overhead: Efficiency 7,500
Expense 6,000
Fixed Overhead: Volume 3,000
Expense _____ 3,000
Total variances 7,500 19,800 12 ,300 A
Actual profit 73,200
Working Notes:
(1) Price Variance = [SP – AP] AQ
600 (A) = [SP × AQ –
59,400] SP × AQ = 58,800.

(2) Usage Variance = [SQ × SP] –

[AQ × SP] 1200 (A) = SQ × SP
– 58,800 SQ × SP = 57,600.

(3) Rate Variance = [SR – AR] AH

1500 (F) = SR × AH –
89,400 SR × AH = 90,900.

(4) Efficiency Variance = [SH – AH] ×

SR 4500 (A) = SH × SR –
90,900 SH × SR = 86,400.

(5) Price Variance = (AP – SP) × AQ

13500 (F) = SP × AQ –
4,45,500 SP × AQ = 4,59,000.

6.38
 Standard Costing

Question 12
The following profit reconciliation statement has been prepared by the Cost
Accountant of RSQ Ltd. for March, 2008:
Rs.
Budget profit 2,40,000
Sales price variance 51,000 (
F
)
Sales volume profit variance 42,000 (
A
)
2,49,000
Material price variance 15,880 (
A
)
Material usage variance 3,200 (
F
)
Labour rate variance 78,400 (
F
)
Labour efficiency variance 32,000 (
A
)
Variable overhead expenditure variance 8,000 (
F
)
Variable overhead efficiency variance 12,000 (
A
)
Fixed overhead volume variance 1,96,000 (
A
)
Fixed overhead expenditure variance 4,000 (
F
)
Actual profit 86,720
Budgeted production and sales volumes for Mach, 2008 were equal and the level
of finished goods stock was unchanged, but the stock of raw materials decreased

6.39
Advanced Management Accounting

by 6,400 kg (valued at standard price) during the month. The standard cost card
is as under:
Material 4 kg @ Rs. 2.00 8.00 Labour 4 hours @ Rs. 32.00 128.00
Variable overhead
4 hours @ Rs. 12.00 48.00
Fixed overheads
4 hours @ Rs. 28.00 112.00
296.00
Standard profit 24.00
Standard selling price 320.00
The actual labour rate was Rs. 2.24 lower than the standard hourly rate.
You are required to calculate:
(i) Actual quantity of material purchased
(ii) Actual production and sales volume
(iii) Actual number of hours worked
(iv) Actual variable and fixed overhead cost incurred. Answer

(i) Budgeted volume = Budgeted profit

Budgeted profit per unit

=
= 10,000 units
Difference between actual and budgeted volume = Fixed overhead volume
variance
Standard fixed overhead rate

=
= 1,750 units
Actual Production = Budgeted volume – Difference between actual and budget
volume
= 10,000 – 1,750
= 8,250 units
(ii) Actual production = 8,250 units

6.40
 Standard Costing

Material quantity = 4 kg. × 8,250 = 33,000 kg. Less:

Difference in material use

Material = Usage variance = 3,200 = 1,600 kg.

Standard price 2.00

Actual usages 31,400 kg.

Less: Decrease in stock 6,400 kg.
Actual purchases 25,000 kg.
(iii) Actual hours
8,250 units × 4 hours = 33,000 hours
Difference in actual and standard
Efficiency variance = 32,000 (A) = 1,000 (A) hours
Standard rate 32.00
Actual hours 34,000 hours
(iv) Actual variable overhead incurred:
Standard cost of variable overhead = 8,250 × 48 = Rs.
3,96,000
Total variable overhead cost variance [8,000 (F) + 12,000 (A)] = Rs.
4,000 (A)
Actual variable overhead = Rs.
4,00,000
(v) Actual fixed overhead:
Budgeted fixed overhead =
Budgeted units × Budgeted rate

= 10,000 × 112 = Rs. 11,20,000 Expenditure variance = Rs. 4,000

(F) Actual fixed overhead = Rs. 11,16,000
It can also be calculated as below:
Actual fixed overhead:
Standard fixed overhead = (Actual output × Standard fixed = Rs. 9,24,000
overhead rate per unit) 8,250 × 112
Total fixed overhead variance [1,96,000 (A) + 4,000 (F)] = Rs. 1,92,000
(A)

6.41
Advanced Management Accounting

Actual fixed overhead = Rs. 11,16,000

(vi) Actual sales volume:
Sales volume variance = Standard profit per unit (Actual quantity of sales –
Standard quantity of sales)
42,000 (A) = 24 (Actual Quantity of sales – 10,000)
Actual quantity of sales = 8,250 units
Alternative for (iv) and (v) points
(1) Variable overhead cost variance = (Standard hours for actual output ×
Standard variable overhead rate per hour) – Actual
variable overhead cost
4,000 (A) = (4 × 8,250 × 12) – Actual variable
overhead Actual variable overhead = Rs. 4,00,000.

(2) Fixed overhead cost variance = (Standard hours for actual output ×
Standard fixed overhead rate
per hour) – Actual fixed overheads

1,92,000 (A) = (4 × 8,250 × 28) – Actual fixed overheads.

Actual fixed overhead = Rs. 11,16,000.
Question 13
The CEO of your company has been given the following statement showing the
results for a recent month:
Particulars Master Budget Actual
Units produced & sold 10,000 9,000
Rs. Rs.
Sales 8,00,000 7,00,000
Direct material 2,00,000 1,84,000 Direct Wages 3,00,000
2,62,000
Variable overhead 1,00,000 94,000 Fixed overhead 1,00,000
98,000
Total Cost 7,00,000 6,38,000 Net Surplus 1,00,000 62,000
The standard cost of the product is as follows:

6.42
 Standard Costing

Direct material (1 kg @ Rs. 20/kg) Rs. 20.00 per unit Direct

Wages (1 hour @ Rs. 30/hour) Rs. 30.00 per unit
Variable overhead (1 hour @ Rs. I0/hour) Rs. 10.00 per unit
Actual results for the month revealed that 9,800 kg. of material was used and
8,800 labour hours were recorded.
(i) Prepare a flexible budget for the month and compare with the actual
results.
(ii) Calculate material volume and variable overhead efficiency variances.
Answer

(i)
Particular Master Budget Flexible Actual
Variance

Budget
Units 10,000 9,000 9,000
(Rs.)Total (Rs.) (Rs.) (Rs.)
Per Unit
Sales 8,00,000 80 7,20,000 7,00,000 20,000 ( A ) Direct Material
2,00,000 20 1,80,000 1,84,000 4,000 ( A ) Direct Wages 3,00,000 30
2,70,000 2,62,000 8,000 ( F ) Variable Overhead 1,00,000 10 90,000
94,000 4,000 ( A ) Total Variable Cost 6,00,000 60 5,40,000 5,40,000 -
Contribution 2,00,000 20 1,80,000 1,60,000 20,000 ( A ) Fixed Overhead
1,00,000 10 1,00,000 98,000 2,000 ( F )
Net Profit 1,00,000 10 80,000 62,000 18,000
(A)

(ii) Calculation of Variances:

Material Volume Variance: SP (SQ – AQ) = 20 (9,000 – 9,800) = 16,000 (A)
Variable Overhead efficiency variance SR (SH – AR) = 10 (9,000 – 8,800) =
2,000 (F Question 14
The following information relates to labour of x Ltd.

6.43
Advanced Management Accounting

Type of Labour Skilled Semi Skilled Unskille Total

d
No. of workers in standard 4 3 2 9
gang
Standard rate per hour (Rs) 6 3 1 -
Number of workers in actual
gang
Actual rate per hour (Rs.) 7 2 2 -
In a 40 hours week, the gang produced 270 standard hours.
The actual number of semi-skilled workers is two times the actual number of
unskilled workers. The rate variance of semi-skilled workers is Rs.160 (F).
Find the following:
(i) The number of workers in each category
(ii) Total gang variance
(iii) Total Sub-efficiency variance
(iv) Total labour rate variance
(v) Total labour cost variance
Answer

SR SH SR RSH SR AH AR AH
Skill 6× 120 720 6× 960 160 6× 120 120 7× 120
840
Semi-Skill 3× 90 270 3× 360 120 3× 160 480 2× 160
320
Unskilled 1× 60 60 1× 80 80 1× 80 80 2× 80 160
1050 1400 1280 1320
Sub-efficiency Variance Gang Variance Rate Variance
350 (A) 120 (F) 40 (A)
Cost Variance = 270 (A)

Workings Note:
Standard hours produced = 270
Standard Mix: 270 ÷ 9 = 30
Skill Semi-Skill Unskilled
Ratio 4: 3: 2:

6.44
 Standard Costing

Hrs. 120 90 60
Actual hrs = 40 × 9 = 360 hrs.

Actual hrs in Standard Ratio = 360

4: 3: 2:
360 360 360
4 160 3 120 2 80
9 × = 9 × = 9 × =
[(Standard Rate = Actual Rate) Actual hrs.]= Rate Variance
Semi-skilled = 160
(3 – 2) Actual hrs = 160
Actual hrs = 160 (for semi-skilled)
Actual Semi-skilled = 2 (Unskilled
actual) 160 = 2 (Unskilled)

Unskilled hrs (actual) = =180

Total Actual = 360
∴ Actual hrs – skilled = 360 – (160 + 80)
= 360 – 240 = 120
Actual Hrs. Skilled Semi-skilled Unskilled
120 160 80 40 hr week

∴
=3 =4 =2
No. of Workers
(i) 3 4 2

(ii) Gang Variance:

= (Actual Hrs in Standard Ratio – Actual Hrs in Actual Ratio) × Standard
Rate
= 1400 – 1280 = 120 (F)
(iii) Sub-efficiency Variance:
= Standard Rate (Standard Hrs – Actual Hrs in Standard Ratio)
= 1050 – 1400 = 350 (A)
(iv) Total Labour Rate Variance:

6.45
Advanced Management Accounting

= Actual Hrs (Standard Rate – Actual

Rate) = 1280 – 1320 = 40 (A) (v) Labour
Cost Variance:
= (Standard Rate × Standard Hrs – Actual Rate × Actual Hrs.)
= 1050 – 1320 = 270 (A)
Question 15
Global Limited uses standard and marginal costing system. It provides the
following details for the year 2007-08 relating to its production, cost and sales:

Particulars Budget Actual

Sales units 24,000 25,60
0
Sales value 6,000 6,78
Materials 4
960 1,08
0
Labour 1,440 1,66
4
Variable overheads 2,400 2,59
Total variable cost 2
4,800 5,33
6
The sales budget is based on the expectation of the company's estimate of
market share of 12%. The entire industry's sales of the same product for the year
2007-08 is 2,40,000 units. Further details are as follows:
(In Rs. )
Particulars Standard Actu
al
Material price per kg. 8.00 7.50
Labour rate per hour 6.00 6.40

You are required to:

(a) Prepare a statement reconciling the budgeted contribution
with actual contribution on the basis of important material
variances, labour variances, variable overhead variances
and sales variances.

6.46
 Standard Costing

(b) Compute market size variance and market share variance.

Answer

Sales variances
Budgeted Sales Rs.6000
Budgeted sales quantity 24000
Budgeted selling price 6000/24000 = Rs.0.25
Actual industry sales in units 240000
Budgeted market share 12%
Hence market share required: 240000 × 12% = 28800 units
SQ RSQ AQ SP SQ × SP RSQ × SP AQ × SP AQ×AP 24000 28800
25600 0.25 6000 7200 6400 6784
Sales Market Size variance 6000-7200 = Rs.1200 F
Sales Market Share Variance: 7200-6400 = Rs. 800 A
Sales Volume Variance: 6000-6400 = Rs. 400 F
Sales Price variance 6400-6784 = Rs. 384 F
Budgeted contribution:
Sales Rs.6000
Variable costs Rs.4800
Contribution Rs.1200
Units 24000
Contribution/unit: Rs.0.05
(1200/24000)
SQ RSQ AQ SP SQ × SP RSQ × SP AQ ×
SP
24000 28800 2560 0.05 1200 1440 1280
0

Sales Market Size variance: 1200 – 1440 = Rs.240

F
Sales Market Share Variance: 1440 – 1280 = Rs.160
A

6.47
Advanced Management Accounting

Sales Volume Variance 1200 – 1280 = Rs 80

F
As per the requirement of the question (b)
Sales Market Size variance is Rs.1200
F Sales Market Share variance is Rs.800
A Sales Variances:
Sales Gross Margin Market Size Rs.240 F
variance
Sales Gross Margin Market Share Rs.160 A
variance
Sales Gross Margin Volume Variance: Rs. 80 F
Sales Price Variance Rs.384 F
Direct materials:

Budgeted Material costs Rs.960

Budgeted units 24000

Budgeted material cost per 100 units: = Rs.4.00

(960/24000) × 100
Standard price of Material/ kg = Rs.8
Standard requirement of materials per 100 units of output: 4/8 = 0.50
kg
Actual output: = 25600
Standard requirement for actual output =128kg
(25600 × 0.50)/100
Actual material cost: = Rs.1080
Actual price/kg = Rs.7.50
Actual quantity of materials consumed: = 144 kg
(1080/7.50)
SQ AQ SP SQ × SP AQ × SP AP AQ x
AP
128 144 8 1024 1152 7.50 1080
Usage Variance 1024-1152 = Rs.128 A
Price Variance 1152-1080 = Rs. 72 F

6.48
 Standard Costing

Direct Labour:
Budgeted Labour costs Rs.1440
Budgeted units 24000
Budgeted Labour cost per 100 units: = Rs.6.00
(1440/24000) ×100
Standard Labour hour rate/hour = Rs.6
Standard requirement of labour hours per 100 units of output:6/6 = 1.00
hour
Actual output = 25600
Standard hours required for actual output: (25600 × 1)/100 = 256 hours
Actual labour cost: = Rs.1664
Actual direct labour hour rate = Rs.6.40
Actual hours worked (1664/6.40) = 260 hours
Budgeted direct labour (1440/6) = 240 hours
SH AH SR SH×SR AH×SR AR AH×AR
256 260 6 1536 1560 6.40 1664
Efficiency Variance 1536 – 1560 = Rs. 24 A
Labour Rate Variance 1560 – 1664 = Rs.104
A Variable Overheads:
Budgeted variable overheads Rs. 2400 Budgeted direct labour hours
240
Budgeted variable overhead rate per direct labour hour: 2400/240 = Rs.10
A. Charged to production: 256 hours ×10 Rs.256
0
B. Standard cost of actual hours: 260 × 10 Rs.260
0
C. Actual overheads Rs.259
2
Efficiency Variance 2560 – 2600 Rs. 40
A
Expense variance 2600 – 2592 Rs. 8 F
Contribution analysis:

Budget Actual

6.49
 Rs
Budgeted Contribution 1200
Gross
Advanced Margin SalesAccounting
Management Volume Variance 80 F
Standard Contribution 1280
Sales Rs.
Price Variance Rs384 F
Total contribution
Sales 6000 1664
6784
Variable costs
Cost Variances: 4800 5336
Contribution 1200 F A 1448
Material Usage Variance 128
Material Price Variance 72
Labour Efficiency Variance 24
Labour Rate Variance 104
Variable OH Efficiency 40
Variance
Variable OH Expense 8 216 A
Variance
Statement of Reconciliation between Budgeted and Actual
Contribution

Actual Contribution 1448

Question 16

The following information relates to a manufacturing concern:

Standard Rs.
Material A 24,000 kgs @ Rs.3 per kg. 72,000 Material B 12,000 kgs @ Rs.4 per
kg 48,000 Wages 60,000 hours @ Rs.4 per hour 2 , 40,000
Variable overheads 60,000 hours @ Re.1 per hour 60,000 Fixed overheads
60,000 hours @ Rs.2 per hour 1 , 20,000
Total Cost 5 , 40,000 Budgeted profit 60,000

6.50
 Standard Costing

Budgeted sales 6,00,000

Budgeted production (units) 12,000
Actual Rs.
Sales (9,000 units) 4,57,500
Material A consumed 22,275 kgs. 62,370
Material B consumed 10,890 kgs. 44,649
Wages paid (48,000 hours) 1,91,250
Fixed Overhead 1,20,900
Variable overhead 45,000
Labour hours worked 47,700
Closing work in progress 900 units
Degree of completion:
Material A and B 100%
Wage and overheads 50%

You are required to:

(i) Calculate all the material and labour variances.

(ii)Calculate variable overhead expenditure and efficiency variances, fixed
overhead expenditure and volume variances and sales price and sales
volume variances.
Answer
(i) Statement of Equivalent Production in Units

Particulars Materials Wages & Overheads

% age Units % age Units
Units Completed 100% 9000 100% 9000
Closing W.I.P. 100% 900 50% 450
Equivalent Units 9900 9450

Material Variances
Standard qty for actual output ** Actual
qty x std price X actual price

6.51
Advanced Management Accounting

Material A 19,800 @ 3 = 59,400 22,[email protected]* = 62,370

Material B 9,900 @ 4 = 39,600 10,889 @4.1* = 44,649
29,700 99,000 33,165 1 , 07,019
*Actual Cost / Actual Quantity
** Standard Quantity for actual output = ( std qty/ budgeted prod) x actual
output
MCV = TSC – TAC
= 99,000 – 1,07,019 = 8,019 (A)
MPV = AQ (SP – AP)
A = 22,275 (3 – 2.80) = 4,455 (F)
B = 10,890 (4 – 4.10) = 1,089 (A)
3,366 (F)
MUV = SP (SQ – AQ)
A = 3 (19,800 – 22,275) =
7,425 (A) B = 4 (9,900 – 10,890) =
3,960 (A)
11,385
(A)
MMV = SP (RSQ – AQ)
A = 3 {19,800 ÷ 29,700 × 33,165 – = 495
22,275} (A)
B = 4 {9,900 ÷ 29,700 × 3,165 – 10,890} = 660
(F)
165
(F)
MYV = S. C Per Unit (S. O. For Actual Mix – A. O.)
= 99,000 ÷ 9,900 {9,900 ÷ 29,700 × 33,165 – 9,900}
= 10 (11.055 – 9,900) = 11,550 (A)
Labour Variances:
LCV = TSC – TAC
= 2,40,000 ÷ 12,000 × 9,450 – 1,91,250 = 2,250 (A)
LRV = AH (SR – AR)
= 48,000 {4 – (1,91,250 ÷ 48,000)} = 750 (F)
LITV = No. of Idle hours × SR

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 Standard Costing

= 48,000 – (47,500 ÷ 4) = 1,200 (A)

LEV = SR (SH – AH)
= 4 {(60,000 ÷ 12,000) × 9,450 – 47,700} = 1,800 (A)
(ii) Variable Overhead Variances
VOC = Recovered Overheads – Actual Overheads
= 9,450 × 5 – 45,000 = 2,250 (F)
V.O (Exp.) V = Standard V.O. – Actual V.O.
= 47,700 × 1 – 45,000 = 2,700 (F)
V.O. (Eff.) V = Recovered Overheads – Standard Overheads
= 9,450 × 5 – 47,700 = 450 (A)
Fixed Overheads Variances
FOCV = Recovered Overheads – Actual Overheads
= (1,20,000 ÷ 12,000) × 9,450 – 1,20,900 =
94,500 – 1,20,900
= 26,400 (A)
F.O.(Exp.) V = Budgeted Overheads – Actual Overheads
= 1,20,000 – 1,20,900 = 900 (A)
FOVV = Recovered Overheads – Budgeted Overheads
= 95,500 – 1,20,000 = 25,500 (A)
Sales Variances
Sales Price Variance = Actual Unit Sold (SP – AP)
= 9,000 {50 – (4,57,500 ÷ 9,000)} = 7,500
(F)
Sales Volume Variance (Contribution Loss)
= S. R. of Profit (Budgeted Qty. – Actual
Qty.)
= (60,000 ÷ 12,000) (12,000 – 9,000) =
15,000 (A)
Question 17
How are cost variances disposed off in a standard costing system? Explain.
Answer

There is no unanimity of opinion among Cost Accountants regarding the

disposition of variances. The following are commonly used methods for their
disposition.

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Advanced Management Accounting

1. Transfer all variances to Profit and Loss Account. Under this method, stock
of workin-progress, finished stock and cost of sales are maintained at
standard cost and variances arising are transferred to profit and loss
account.
2. Distributing variances on pro-rata basis over the cost of sales, work-in-
progress and finished goods stocks by using suitable basis.
3. Write off quantity variance to profit and loss account and spread price
variance over to cost of sales, work in progress and finished goods. The
reason behind apportioning variance to inventories and cost of sales is that
they represent costs although they are derived as variances.
Question 18
“Calculation of variances in standard costing is not an end in itself, but a means
to an end.” Discuss.
Answer
The crux of standard costing lies in variance analysis. Standard costing is the
technique whereby standard costs are predetermined and subsequently
compared with the recorded actual costs. It is a technique of cost ascertainment
and cost control. It establishes predetermined estimates of the cost of products
and services based on management’s standards of efficient operation. It thus lays
emphasis on “what the cost should be”. These should be costs are when
compared with the actual costs. The difference between standard cost and actual
cost of actual output is defined as the variance.
The variance in other words in the difference between the actual performance
and the standard performance. The calculations of variances are simple. A
variance may be favourable or unfavourable. If the actual cost is less than the
standard cost, the variance is favourarable but if the actual cost is more than the
standard cost, the variance will be unfavourable. They are easily expressible and
do not provide detailed analysis to enable management of exercise control over
them. It is not enough to know the figures of these variances from month to
month. We infact are required to trace their origin and causes of occurrence for
taking necessary remedial steps to reduce / eliminate them.
A detailed probe into the variance particularly the controllable variances helps the
management to ascertain: (i) the amount of variance
(ii) the factors or causes of their occurrence
(iii) the responsibility to be laid on executives and departments and
(iv) corrective actions which should be taken to obviate or reduce the
variances.

6.54
 Standard Costing

Mere calculation and analysis of variances is of no use. The success of variance

analysis depends upon how quickly and effectively the corrective actions can be
taken on the analysed variances. In fact variance gives information. The manager
needs to act on the information provided for taking corrective action. Information
is the means and action taken on it is the end. In other words, the calculation of
variances in standard costing is not an end in itself, but a means to an end.
Question 19
Describe three distinct groups of variances that arise in standard costing.
Answer
The three distinct groups of variances that arise in standard costing are:
The three distinct groups of variances that arise in standard costing are:
(i) Variances of efficiency. These are the variance, which arise due to
efficiency or inefficiency in use of material, labour etc.
(ii) Variances of prices and rates: These are the variances, which arise due to
changes in procurement price and standard price.
(iii) Variances due to volume: These represent the effect of difference between
actual activity and standard level of activity. These can be summarized as
under:
Element of cost Variance of Variance of price Variance of volume
Efficiency
Material Usage, Mixture, Price Revision
Yield
Labour Efficiency, idle time Rate of pay - - Variable
Efficiency Expenditure Revision
- Fixed Efficiency Expenditure Revision
Capacity
Calendar
Question 20
“Standard costing variances centre around comparison of actual Performance
with the standard and the standards or plans are normally based on the
environment anticipated when the targets are set and if the current environment
is different from that anticipated, such analysis cannot measure managerial
performance”. Comment on the statement and how will you deal with the
situation with reference to material, labour and sales variances.

Answer

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Advanced Management Accounting

(a) The statement give in the question highlights practical difficulties faced by our
industries today.
When the current environmental conditions are different from the anticipated
environmental conditions (prevailing at the time of setting standard or plans)
the use of routine analysis of variance for measuring managerial
performance is not desirable / suitable.
The variance analysis can be useful for measuring managerial performance if the
variances computed are determined on the basis of revised targets /
standards based on current actual environmental conditions. In order to
deal with the above situation i.e. to measure managerial performance with
reference to material, labour and sales variances, it is necessary to proceed
and compute the following variances.
Material variances:
In the case of material purchase price variance, suppose the standard price of
raw material determined was Rs.5 per unit, the general market price per
unit at the time of purchase was Rs.5.20 and actual price paid per unit was
Rs.5.18 on the purchase of say 10,000 units of raw material.
In this case the variances to be computed should be:
Uncontrollable material purchase price planning variance:
= (Standard price p.u. – General market price p.u.) Actual
quantity purchased = (Rs.5 – Rs.5.20) 10,000 units = Rs.2,000
(Adverse) Controllable material purchase price efficiency variance:
= (General market price p.u. – Actual price paid p.u.) Actual quantity
purchased
= (Rs.5.20 – 5.18) 10,000 units
= Rs.200 (Fav.)
In the case of material usage variance, suppose the standard quantity per unit be
5 kgs, actual production units be 250 and actual quantity of material used is
1,450 kgs. Standard cost of material per kg. was Re.1. Because of shortage
of skilled labour it was felt necessary to use unskilled labour and that
increased material usage by 20%. The variances to be computed to deal
with the current environmental conditions will be: Uncontrollable material
usage planning variances: = (Original std. quantity in kgs. – Revised
std. quantity in kgs.) Standard price per kg.
= (1,250 kgs. – 1,500 kgs) Re.1
= Rs.250 (Adverse)
Controllable material usage efficiency variance:

6.56
 Standard Costing

= (Revised standard quantity in kgs. Actual quantity used in kgs.)

Standard price per kg.
= (1,500 kgs. – 1,450 kgs.) Re.1
= Rs.50 (Favourable) Labour
variances:
Like material variances, here also labour efficiency and wage rate variances
should also be adjusted to reflect changes in environmental conditions that
prevailed during the period. The labour efficiency variances would be equivalent
to the following two variances. (a) Uncontrollable labour efficiency planning
variance
(b) Controllable labour efficiency variance
The above variances would arise when unskilled labour is substituted for skilled
labour.
Similarly, one uncontrollable and other controllable variance would arise in the
case of wage rate variance as well under current environmental conditions.
Sales variances:
The conventional sales volume variance reports the difference between actual
and budgeted sales, priced at the budgeted contribution per unit. The variance
merely indicates whether sales volume is greater or less than expected. It does
not indicate how well sales management actual sales volume should be
compared with an expert estimate that reflects the market conditions prevailing
during that period.
Total sales margin variance (planning element):
= {Expert’s budgeted sales volume × (Expert’s selling price – Standard cost) –
Original budgeted sales volume × (Budgeted selling price – Standard cost)} Total
sales margin variance (appraisal element):
= {Actual sales volume × (Actual selling price – Standard cost)}
= Expert’s budgeted sales volume × (Expert’s selling price – Standard cost)}
The figure of “Expert’s budgeted sales volume” for a particular product can be
determined by estimating the total market sales volume for the period and then
multiplying the estimate by the target percentage of market share.

EXERCISE
Question 1
Super Computers manufactures and sells three related PC models:
(1) PC = Sold mostly to college students.

6.57
Advanced Management Accounting

(2) Portable PC = Smaller version of PC positioned as home

computer (3) Super PC = Sold mostly to business
executives.
Budgeted and actual data for 1995 is as follows:
Budget for 1995
Selling Price Variable Contribution Sales Volume in
per Unit Cost per margin per Unit Units
Unit
Rs. Rs. Rs. Rs.
PC 24,000 14,000 10,000 7,000
Portable PC 16,000 10,000 6,000 1,000
Super PC 1,00,000 60,000 40,000 2,000
10,000
Actual for 1995

Selling Price Variable Contribution Sales Volume in

per Unit Cost per margin per Unit Units
Unit
Rs. Rs. Rs. Rs.
PC 22,000 10,000 12,000 8,250
Portable PC 13,000 8,000 5,000 1,650
Super PC 70,000 50,000 20,000 1,100
11,000
Super computers derived its total unit sales budget for 1995 from the internal
management estimate of a 20% market share and an industry sales forecast by
computer manufactures association of 50,000 units. At the end of the year the
association reported actual industry sales of 68,750 units.
Required:
(i) Compute the individual product and total sales volume variance.
(ii) Compute total sales quantity variance.
(iii) Compute the market size and market share variance.
(iv) Compute individual product and total sales mix variances.
(v) Comment on your results.

6.58
 Standard Costing

Answer
(i) Total Sales Volume Variance = Rs.1,96,00,000 (Adv.)
(ii) Total sales quantity variance = Rs.1,56,00,000 (Fav.)
(iii) Market size variance = Rs.5,85,00,000 (Fav.)
(iv) Market share variance = Rs.4,29,00,000 (Adv.)
(iv) Computation of individual product and total sales mix
variances 1. Individual product and total sales mix variance:
Sales mix variance:
PC = Rs.30,80,000 (Adv.)
Super PC = Rs.2,68,40,000 (Adv.)
2. Total sales mix variance = Rs.3,52,00,000 (Adv.)
Question 2
GLOBAL LTD. is engaged in marketing of wide range of consumer goods. A, B, C
and D are the zonal sales officers for four zones. The company fixes annual
sales target for them individually. You are furnished with the following:
(1) The standard costs of sales target in respect of A, B, C and D are
Rs.5,00,000, Rs.3,75,000, Rs.4,00,000 and Rs.4,25,000 respectively.
(2) A, B, C and D respectively earned Rs.29,900, Rs.23,500, Rs.24,500 and
Rs.25,800 as commission at 5% on actual sales effected by them during
the previous year.
(3) The relevant variances as computed by a qualified cost accountant are as
follows:
A B C D
Rs. Rs. Rs. Rs.
Sales price variance 4,000 (F) 6,000 (A) 5,000 (A) 2 ,000
(A ) Sales volume variance 6,000 (A) 26,000 (F) 15,000 (F)
8 ,000 (F )
Sales margin mix variance 14,000 (A) 8,000 (F) 17,000 (F)
3 ,000 (A ) (A) = Adverse variance and (F) = Fabourable variance.

You are required to:

(1) Compute the amount of sales target fixed and the actual amount of
contribution earned in case of each of the zonal sales officer.

6.59
Advanced Management Accounting

(2) Evaluate the overall performance of these zonal sales officers taking three
relevant base factors and then recommend whose performance is the best.
Answer
(Rs.’000)
Zonal Sales Officers A B C D
Sales target / Budgeted sales 600 450 480 510
Standard cost of sales target 500 375 400 425
Standard margin/ Budgeted margin 100 75 80 85
Sales margin mix variance 14 (A) 8 (F) 17 (F) 3 (A)
Sales price variance 4 (F) 6 (A) 5 (A) 2 (A)
Actual margin 90 77 92 80
Question 3
The following information is available in respect of Y Ltd. for a week:
(a) 400 kg of raw material were actually used in producing product ‘EXE’. The
purchase cost thereof being Rs.24,800. The standard price per kg of raw
material is Rs.60. The expected output is 12 units of product ‘EXE’ from
each kg of raw material. Raw material price variance and usage variance
as computed by cost accountant are Rs.800 (adverse) and Rs.600
(adverse) respectively.
(b) The week is of 40 hours. The standard time to produce one unit of ‘EXE’ is
30 minutes. The standard wage rate is Rs.5 per labour hour. The company
employs 60 workers who have been paid hourly wage rate as under:
Number of workers 6 8 46
Hourly Wage Rate (Rs.) 4.80 5.20 5.00
(c) Budgeted overheads for a four-weekly period is Rs.81,600. The actual fixed
overheads spent during the said week are Rs.19,800.
(d) Entire output of ‘EXE’ has been sold at its standard selling price of Rs.15
per unit.
You are required to:
(i) Compute the variances relating to labour and overheads.
(ii) Prepare a statement showing total standard costs, standard profit, and
actual profit for the week.
Answer
Labour cost variance = Rs. 316 (Adverse)

6.60
 Standard Costing

Labour Rate Variance = Rs.16 (Adv.)

Labour efficiency variance = Rs.300 (Adv.)
Total fixed overhead cost variance = Rs.90 (Fav.)
Fixed overhead volume variance = Rs.510 (Adv.)
Fixed overhead expenditure variance = Rs.600 (Fav.)
Actual Profit = Rs. 13,584
Question 4
The Standard Cost of producing one unit of Item ‘Q’ is as under:
Direct Material -- A – 12 Kg. @ Rs.10/- =
Rs.120
B – 5 kg. @ Rs.6/- = Rs.30
Direct Wages -- 5 hrs. @ Rs.3/- = Rs.15
Fixed Production Overheads = Rs.35
Total Standard Cost: =
Rs.200
Standard Gross Profit = Rs.50
Standard Sale Price =
Rs.250
Fixed Production overhead is absorbed on expected annual output of 13,200
units.
Actual result for the month of September, 1997 are under:
Actual Production: 1,000 units
Rs.
Sales 1,000 Units @ Rs.250 =
2,50,000
Direct Material -- A – 11,000 kg. =
1,21,000
B – 5,200 kg. = 28,600
Direct wages 5,500 hrs. = 17,500
Fixed Overheads = 39,000
=
2,06,100
Gross profit = 43,900
You are required to calculate all variances. Material price variance is taken out at
the time of receipt of Material. Material purchases were:
12,000 kg. ‘A’ @ Rs.11 & 5,000 kg. of ‘B’ @ Rs.5.50

6.61
Advanced Management Accounting

Answer
Material cost variance = Rs.400 (Fav.)

Material price variance = Rs.8,400 (Adv.)

Material usage variance = Rs.8,800 (Fav.)

Material mix variance = Rs.1,741.18

(Fav.)
Material yield variance = Rs.7058.82
(Fav.)
Material purchase price variance = Rs.9,500 (Adv.)
Labour cost variance = Rs.2,500 (Adv.)
Labour rate variance = Rs.1,000 (Adv.)
Labour efficiency variance = Rs.1,500 (Adv.)
Total fixed overhead variance = Rs.4,000 (Adv.)

Fixed overhead expenditure = Rs.500 (Adv.)

variance
Fixed overhead volume variance = Rs.3,500 (Adv.)
Efficiency variance = Rs.3,500 (Adv.)
Question 5
On 1st April, 1998, ZED Company began the manufacture of a new electronic
gadget. The company installed a standard costing system to account for
manufacturing costs.
The standard costs for a unit of the product are as under:
Rs.
Direct Material (3 kg at Rs.5 per kg.) 15.0
0
Direct Labour (0.5 hour at Rs.20 per hour) 10.0
0
Manufacturing Overhead (75% of direct labour 7.5
cost) 0
Total Cost 32.5
0
The following data was obtained from ZED Company’s records for April 1998:
Debit Credit

6.62
 Standard Costing

Rs. Rs.
Sales -- 1 ,
25,000
Sundry Creditors (for purchase of direct materials in April 68,250 --
1998)
Direct Material Price Variance 3,250 --
Direct Labour Rate Variance 2,500 --
Direct Labour Rate Variance 1,900 --
Direct Labour Efficiency Variance -- 2,000
The Actual Production in April 1998 was 4,000 units of the gadget and the actual
sales for the month was 2,500 units.
The amount shown above for direct materials price variance applies to materials
purchase during April, 1998. There was no opening stock of raw materials on 1 st
April, 1998.
Required:
Calculate for April, 1998 the following:
(i) Standard direct labour hours allowed for the actual output achieved.
(ii) Actual direct labour hours worked.
(iii) Actual direct labour rate.
(iv) Standard quantity of direct materials allowed (in kgs.) (v) Actual quantity
of direct materials used (in kgs.) (vi) Actual quantity of direct materials
purchased (in kgs.) (vii) Actual direct materials price per kg.

Answer
(i) Standard direct labour hours allowed for the actual output achieved = 2,000
hous.
(ii) Actual direct labour hour worked = 1,900 hours.
(iii) Actual direct labour rate = Rs.21
(iv) Standard quantity of direct materials allowed (in kgs.) = 12,000 Kgs.
(v) Actual quantity of direct materials used (in Kgs.) or Actual qty. of direct
materials used for actual output = 12,500 Kgs.
(vi) Actual quantity of direct materials purchased (in Kgs.) = Rs.13,000 Kgs.
(vii) Actual direct materials price per Kg.= Rs.5.25

6.63
Advanced Management Accounting

Question 6
Despite the increase in the Sales price of its sole product to the extent of 20%, a
company finds that it has incurred a loss during the year 1998-99 to the extent of
Rs.4 lakhs as against a profit of Rs.5 lakhs made in 1997-98. This adverse
situation is attributed mainly to the increase in prices of materials and overheads,
the increase over the previous year being, on the average, 15% and 10%
respectively.
The following figures are extracted from the books of the company.
31..03.98 31.03.99
Rs. Rs.
Sales 1,20,00,000 1 ,29,
Cost of Sales: 60,000

Material 80,00,000 91 ,
10,000
Variable Overhead 20,00,000 24 ,
00,000
Fixed Overhead 15,00,000 18 ,
50,000
Required:
Analyse the variances over the year in order to bring out the reasons for the fail in
profit
Answer
Sales price variance = Rs.21.60 (Lakhs)
(Fav.)
Material price variance = 11.88 (Lakhs) (Adv.)
Variable overhead expenditure variance = Rs.2.18 (Lakhs)
(Adv.)
Variable overhead efficiency variance = Rs.3.62 (Lakhs)
(Adv.)
Fixed overhead expenditure variance = Rs.1.68 (Lakhs)
(Adv.)
Fixed overhead volume variance = Rs.1.82 (Lakhs)
(Adv.)
Question 7
Following the standard cost card of a component:
Materials 2 units at Rs.15 Rs.3
0

6.64
 Standard Costing

Labour 3 Hours at Rs.20 Rs.6

0
Total overheads 3 Hours at Rs.10 Rs.3
0
During a particular month 10,000 units of the component were produced and the
same was found to be at 60% capacity of the budget. In preparing the variance
report for the month, the cost accountant gathered the following information:
Labour Rs.6,50,000
Variable overheads Rs.2,00,000 Fixed overheads
Rs.3,00,000
Material price variance Rs.70,000 (A) Material
cost variance Rs.50,000 (A)
Labour rate variance Rs.50,000 (F)
Fixed overhead expenditure variance Rs.50,000 (A)
You are required to prepare from the above details:
(1) Actual material cost incurred
(2) Standard cost of materials actually consumed
(3) Labour efficiency variance
(4) Variable OH efficiency variance
(5) Variance OH expenditure variance
(6) Fixed OH efficiency variance
(7) Fixed OH capacity variance
(8) Fixed OH volume variance
Answer
(1) Actual material cost incurred = Rs. 3,50,000
(2) Standard cost of materials actually consumed = Rs.2,80,000
(3) Labour efficiency variance = Rs.1,00,000 (Adv.)
(4) Variable OH efficiency variance = Rs.25,000 (Adv.)
(5) Variable OH expenditure variance = Rs.25,000 (Adv.)
(6) Fixed OH efficiency variance = Rs.25,000 (Adv.)
(7) Fixed OH capacity variance = Rs.75,000 (Adv.)
(8) Fixed OH volume variance = Rs.1,00,000 (Adv.)
Question 8

6.65
Advanced Management Accounting

F Manufacturing Ltd., uses the three variances method to analyse the

manufacturing overhead variances for the fiscal year just ended were computed
as follows:
Spending Rs.86,000 Adverse
Efficiency Rs.36,000 Favourable
Volume Rs.80,000 Favourable
The manufacturing overhead application rate for the year was Rs.160 per
machine hours of which Rs.60 per machine hour was the variable component.
The year end balance the manufacturing overhead control account was
Rs.16,50,000 and the standard machine hours for the year were 11,300. From
the above data compute:
(i) Budgeted Machine Hours
(ii) Actual Machine Hours
(iii) Applied Manufacturing Overhead
(iv) Total Amount of Fixed Overhead Cost Answer

(i) Budgeted Machine Hours = 10,500

hours (ii) Actual machine Hours
= 10,700 hours.
(iii) Applied Manufacturing Overhead = Rs.16,80,000
(iv) Total Amount of Fixed Overhead Cost = Rs.9,22,000

6.66
 CHAPTER 7

COSTING OF SERVICE SECTOR

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Meaning of Costing of Service Sector
This is a method of ascertaining costs of providing or operating a service.
This method of costing is applied by those undertakings which provide
services rather than production of commodities.
2. Cost Units
(A) To External Customers Cost Unit
(i) Hotel Bed nights available, Bed night occupied
(ii) School Student hours, Full time students
(iii) Hospital Patient per day, Room per day
(iv) Accounting firm Charged out client hours
(v) Transport Passenger km., quintal km.
(B) Internal services Cost Unit
(i) Staff canteen Meals provided, No. of staff
(ii) Machine maintenance Maintenance hours provided to user
department
(iii) Computer department Computer time provided to user
department
3. Costing Methods Used In Service Sector
(i) Job costing method
(ii) Process costing method
(iii) Hybrid costing method
4. Job costing method in service sector
The two significant costs which are incurred in service sectors are :
(i) Direct labour

(ii) Service overheads

Advanced Management Accounting

5. Process costing method in service sector :

In this method the cost of service is obtained by assigning costs to masses
of units and then computing unit costs on an average basis.
6. Customer costing in service sector
The central theme of this approach is customer satisfaction. For customer
costing purpose, the costs are divided into following categories. These are:
(i) Customer Specific costs
(ii) Customer-line categories
(iii) Company costs

Question 1
Discuss with examples, the basic costing methods to assign costs to services.
Answer
(i) Job costing method: The cost of a particular service is obtained by
assigning costs to a distinct identifiable service.
e.g. Job Costing method is used in service sectors – like Accounting Firm,
Advertisement campaign.
(ii) Process Costing method: Cost of a service is obtained by assigning
costs to masses of similar unit and then computing cost / unit on an
average basis. e.g. Retail banking, postal delivery, credit card etc.
(iii) Hybrid method: Combination of both (i) & (ii) above.
Question 2
A city health centre provides health and other related services to the citizens who
are covered under insurance plan. The health centre receives a payment from
the insurance company each time any patient attends the centre for consultation
as under:
Consultations involving Payment from Insurance
company
Rs.
No treatment 60
Minor treatment 250
Major treatment 500
In addition, the adult patients will have to make a co-payment which is equivalent
to the amount of payment for the respective category of treatment made by the

7.2
 Costing of Service Sector

insurance company. However, children and senior citizens are not required to
make any such copayment.
The health centre will remain open for 6 days in a week for 52 weeks in a year.
Each physician treated 20 patients per day although the maximum number of
patients that could have been treated by a physician on any working day is 24
patients.
The health centre received a fixed income of Rs. 2,25,280 per annum for
promotion of health products from the manufacturers.
The annual expenditure of the health centre is estimated as under:
Materials and consumable (100% variable) Rs. 22,32,000 Staff
salaries per annum per employee (fixed):
Physician Rs. 4,50,000 Assistants Rs. 1,50,000
Administrative staff Rs. 90,000
Establishment and other operating costs (fixed) Rs. 16,00,000
The non-financial information is as under:

(i) Staff:
Number of physicians employed 6
Assistants 7 Administrative
staff 2 (ii) Patient Mix:
Adults 50% Children 40%
Senior Citizens 10%
(iii) Mix of patient appointments (%)
Consultation requiring no treatment 70%
Minor treatment 20%
Major treatment 10%
Required:
(i) Calculate the Net income of the city health centre for the next year;
(ii)Determine the percentage of maximum capacity required to be utilized
next year in order to break even.
Answer
1. (1) Total number of patients attended
Number of patients attended per day by a physician: 20

7.3
Advanced Management Accounting

Number of physicians employed 6 Number of days in

week 6
Number of weeks in a year 52
Total number of patients attended = 20 × 6 × 6 × 52 = 37,440.
(2) Patient Mix:
Adults (50%) 37,440 × 50/100 = 18,720
Children (40%) 37,440 × 40/100 = 14,976
Senior Citizens (10%) 37,440 × 10/100 = 3,744
37,440
(3) Patient Appointments:
No treatment required (70%) 37,440 × 70/100 = 26,208
Minor treatment (20%) 37,440 × 20/100 = 7,488 Major
treatment (10%) 37,440 × 10/100 = 3,744
37,440
(4) Income from Insurance Companies:
Number of Rs. Rs.
patients
(A) (B) (A × B)
No treatment patients 26,208 60 15,72,480 Minor treatment
patients 7,488 250 18,72,000 Major treatment patients 3,744
500 18,72,000
Total 53,16,480

(5) Co-payment from adult patients:

Number of Payment Total payment
patients (Rs.) (Rs.)
Total number of adult patients 18,720
No treatment patients (70%) 13,104 60 7,86,240 Minor
treatment (20%) 3,744 250 9,36,000 Major treatment (10%)
1,872 500 9,36,000

7.4
 Costing of Service Sector

Total 26,58,240
(6) Net income:
Rs. Rs.
Payment from Insurance companies 53,16,480 Co-payment
from adult patients 26,58,240
Total 79,74,720
Other Income (fixed) 2,25,280
Total Income (A) 82,00,000
Less: Expenditure Variable expenses:
Material and consumables 22,32,000
Fixed expenses:
Physician’s salary (6 × 4,50,000) 27,00,000
Assistants salary (7 × 1,50,000) 10,50,000
Administrative staff’s salary (2 × 90,000) 1,80,000
Establishment and other operating costs 16,00,000
55,30,000
Total Expenditure (B) 77,62,000 Net Income (A – B)
4,38,000
(ii) 1. Contribution Analysis:
(Rs.)
Total Fees from Insurance Companies and adult 79,74,720
patients
Less: Variable costs 22,32,000
Contribution 57,42,720

Average contribution per patient = 153.38

2. Break-even patients:
(Rs.)
Fixed costs 55,30,00
0
Less: Fixed income 2,25,28
0

7.5
Advanced Management Accounting

Net Fixed costs 53,04,72

0
Break-even patients = Net fixed costs 53,04,720 =
34,585
Contribution per patient 153.38
3. Percentage of maximum capacity required to be utilized in order to
breakeven
Present utilization = 20 patients = 83.33% = 37,440
24 patients

100% patient capacity is = 44,930 patients

Percentage of maximum capacity required to be utilized in order to
breakeven
= Break - even patients × 100
100% patient capacity

= × 100 = 76.98% say 77%.

Assumption: Patient mix and mix of patient appointments will be
same in the next year.
Question 3
Give an appropriate cost unit for each of the following service
sectors: (i) Hotel
(ii) School
(iii) Hospital
(iv) Accounting firm
(v) Transport
(vi) Staff Canteen
(vii) Machine maintenance
(viii) Computer
Department
Answer
Service Sector Cost Unit
Hotel Bednights available or occupied
School Student hours or no. of full time students

7.6
 Costing of Service Sector

Hospital Patient-day / Room-day

Accounting firm Client hours
Transport Passenger-Kms, or Quintal km or tonne-km
Staff Canteen No. of meals provided or no. of staff
Machine maintenance Maintenance hours to user departments
Computer Department Computer time to user departments.

Question 4
Explain the main characteristics of Service sector costing.
Answer
Main characteristics of service sector are as below:
(a) Activities are labour intensive: The activities of service sector generally
are labour intensive. The direct material cost is either small or non-existent.
(b) Cost-unit is usually difficult to define: The selection of cost units usually,
for service sector is difficult to ascertain as compared to the selection of
cost unit for manufacturing sector. The following table provides some
examples of the cost units for service sector.
• Hospital – Patient per day, Room per day • Accounting firm –
Charged out client hours
• Transport – passenger km., quintal km.
• Machine maintenance – Maintenance hours provided to user
department • Computer department – Computer time provided
to user department.
(c) Product costs in service sector: Costs are classified as product or period
costs in manufacturing sector for various reasons.
Question 5
B Ltd. makes industrial power drills, which is made by the use of two
components A (electrical and mechanical components and B (plastic housing).
The following table shows the cost of plastic housing separately from the cost of
the electrical and mechanical components:
A B A&B
Electrical and Plastic Industrial
Mechanical Housing Drills
Components

7.7
Advanced Management Accounting

Rs. Rs. Rs.

Sales 1,00,000 units @ Rs.100 1 ,00,
Variable Costs: 00,000

Direct materials 44,00,000 5,00,000 49 , 00,000

Direct Labour 4,00,000 3,00,000 7 , 00,000
Variable factory overhead 1,00,000 2,00,000 3 , 00,000
Other Variable Costs 1,00,000 - 1 , 00,000
Sales commission @10% of sales 10,00,000 - 10 , 00,000
Total variable costs 60,00,000 10,00,000 70 , 00,000
Contribution - - 30 , 00,000
Total fixed costs 22,20,000 4,80,000 27 , 00,000
Operating income 3 , 00,000
Answer the following questions independently:
(i) During the year, a prospective customer offered Rs.82, 000 for 1,000 drills.
The drills would be manufactured in addition to the 1,00,000 units sold. B
Ltd. would pay the regular sales commission rate on the 1,000 drills. The
Chairman rejected the order because “it was below our costs”. Calculate
operating income if B Ltd. accepts the offer.
(ii) A supplier offers to manufacture the yearly supply of 1,00,000 units plastic
housing components for Rs.13.50 each. Assume that B Ltd. would avoid
Rs.3,50,000 of the costs assigned to plastic housing if it purchases.
Calculate operating income if B Ltd. decides to purchase the plastic
housing from the supplier.

7.8
 Costing of Service Sector

(iii)
Rs.
Direct Materials 49,00
0
Direct Labour 7,00
0
Variable Factory Overhead 3,00
0
Other Variable Cost 1,00
0
Sales commission @ 10% of Rs.82,000 8,20
0
Total Variable Costs 68,20
0
Selling Price 82,00
0
Contribution 13,80
0
Assuming that B Ltd. could purchase 1,20,000 units (plastic housing
components) for Rs.13.50 each and use the vacated plant capacity for the
manufacture of deluxe version of drill of 20,000 units (and sell them for
Rs.130 each in addition to the sales of the 1,00,000 regular units) at a
variable cost of Rs.90 each, exclusive of housings and exclusive of the
10% sales commission. All the fixed costs pertaining to the plastic housing
would continue, because these costs are related to the manufacturing
facilities primarily used. Calculate operating income of B Ltd. purchases
the plastic housings and manufacture the deluxe version of drills.
Answer
(i) The costs of filling the special order of 1000 drills:

Operating income would have been Rs.3,00,000 + Rs.13,800 = Rs.3,13,800, if B

Ltd had accepted the order.
(ii) Assuming that B Ltd. could have avoided Rs.3,50,000 of the fixed costs by
not making the housings and that the other fixed costs would have
continued, we can summarize the alternatives as follows:
Make Buy
Purchase Cost Rs.13,50,00
0

7.9
Advanced Management Accounting

Variable Costs Rs.10,00,000

Avoidable fixed Costs Rs.3,50,000 .
Total relevant Costs Rs.13,50,000 Rs.13,50,00
0
If the facilities used for plastic housings became idle, the B Ltd. would be
indifferent whether to make or buy. The present operating income would be
unaffected.

(iii) The effect of purchasing the plastic housings and using the vacated
facilities for the manufacture of a deluxe version of its drill is as follows:

Increase in sales 20,000 units @ Rs.130 26 ,

Increase in Variables cost 20,000 units, @Rs.90 18,00,000 00,000

Plus: Sales commission, 10% of Rs.26,00,000 2,60,000 20 ,

60,000
Contribution on 20,000 units 5,
Housings: 1,20,000 rather than 1,00,000 would be 16,20,000 40,000
needed Buy 1,20,000 @ Rs.13.50
Less: Make 1,00,000 @ Rs.10 (only the variable costs 10,00,000
are relevant)

Excess cost of outside purchase 6,20,00

0
Loss on making deluxe units Rs.80,000
Conclusion: Operating income would decline to Rs.2, 20,000 (3, 00,000 –
80,000).

7.10
 Costing of Service Sector

EXERCISE
Question 1
A Multinational company runs a Public Medical Health Centre. For this purpose,
it has hired a building at a rent of Rs. 10,000 per month with 5% of total taking.
Health centre has three types of wards for its patients namely. General ward,
Cottage ward and Deluxe ward. State the rent to be charged to each bed-day for
different type of ward on the basis of the following informations:
(i) The number of beds of each type are General ward 100, Cottage ward 50,
Deluxe ward 30.
(ii) The rent of Cottage ward bed is to be fixed at 2.5 times of the General
ward bed and that of Deluxe ward bed as twice of the Cottage ward bed.
(iii) The occupancy of each type of ward is as follows:
General ward 100%, Cottage ward 80% and Deluxe ward 60%. But, in general
ward there were occasions when beds are full, extra beds were hired at a
charges of Rs. 20 per bed. The total hire charges for the extra beds
incurred for the whole year amount to Rs. 12,000.
(iv) The Health Centre engaged a heart specialist from outside and on an
average fees paid to him was Rs. 15,000 per trip. He makes three trips in
the whole year. (v) The other expenses for the year were as under:
Rs.
Salary of Supervisors, Nurses, Ward boys 4 , 25,000
Repairs and maintenance 90,000 Salary of doctors 13 , 50,000
Food supplied to patients 40,000
Laundry charges for their bed linens 80,500
Medicines supplied 74,000
Cost of oxygen, X-ray etc. other than directly borne for
Treatment of patients 49,500
General administration charges 63,000
(vi) Provide profit @ 20% on total taking.
(vii) The Health Centre imposes 8% service tax on rent received.
(viii) 360 days may be taken in a year.

Answer
Rent to be charged

7.11
Advanced Management Accounting

Particulars Basic Service tax Total

General ward 30.65 2.45 33.10
Cottage ward 76.63 6.13 82.76
Deluxe ward 153.25 12.26 165.51

7.12
 CHAPTER 8

TRANSFER PRICING

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Transfer Price
Transfer price is the price which one division of an organisation charges for
a product or service supplied to another division of the same organisation.
2. Objectives of Transfer Pricing System
The main-objectives of intra-company transfer pricing are as
below: i) Emphasis on Profits ii) Maximum
Utilisation of plant capacity
iii) Optimise allocation of financial resources
3. Pricing at Cost
In this method the goods and services are transferred at the following
costs: a. Actual manufacturing cost:
b. Standard cost
c. Full cost:
d. Full cost plus mark up
4. Pricing at market price
Under this method, the transfer prices of goods/services transferred to
other units/divisions are based on market prices. Since market prices will,
by and large be determined by demand and supply in the long run, it is
claimed that profits which results under this method, will provide a good
indicator of the overall efficiency of the various units.
5. Bargained or Negotiated Prices
Under this method each decentralised unit is considered as an independent
unit and such units decide the transfer price by negotiations or bargaining.
Divisional managers have full freedom to purchase their requirement from
outside if the
Advanced Management Accounting

prices quoted by their sister unit are lower.

6. Multinational Transfer Pricing
Multinational companies use transfer prices to minimize worldwide income
taxes, import duties, and tariffs. By setting a low transfer price, the
company can recognize most of the profit from the production in the low-
income-tax-rate country, thereby minimizing taxes. Likewise, items
produced by divisions in a lowincome-tax-rate country and transferred to a
division in a high-income-tax-rate country should have a high transfer price
to minimize taxes. Sometimes import duties offset income tax effects
Question 1
A company is engaged in the manufacture of edible oil. It has three divisions as
under:
(i) Harvesting oil seeds and transportation thereof to the oil mill.
(ii) Oil Mill, which processes oil seeds and manufactures edible oil.
(iii) Marketing Division, which packs the edible oil in 2 kg. containers for sale at
Rs.150 each container.
The Oil Mill has a yield of 1,000 kgs of oil from 2,000 kg of oil seeds during a
period. The Marketing Division has a yield of 5,000 cans of edible oil of 2 kg
each from every 1,000 kg of oil. The net weight per can is 2 kgs of oil.
The cost data for each division four the period are as under:
Harvesting division
Variable cost per kg of oil seed Rs.2.50 Fixed cost per kg of oil seed
Rs.5.00
Oil Mill Division:
Variable cost of processed edible oil Rs.10.00 per kg Fixed cost of processed
edible oil Rs.7.50 per kg
Marketing Division:
Variable cost per can of 2 kg of oil Rs.3.75 Fixed cost per can of 2 kg of oil
Rs.8.75
The fixed costs are calculated on the basis of the estimated quantity of 2,000 kg
of oil seeds harvested, 1,000 kg of processed oil and 500 can s of edible oil
packed by the aforesaid divisions respectively during the period under review.

8.2
 Transfer Pricing

The other oil mills buy the oil seeds of same quality at Rs.12.50 per kg in the
market. The market price of edible oil processed by the oil mill, if sold without
being packed in the marketing division is Rs.62.50 per kg of oil.
Required:
(i) Compute the overall profit of the company of harvesting 2,000 kg of oil
seeds, processing it into edible oil and selling the same in 2 kg cans as
estimated for the period under review.
(ii) Compute the transfer prices that will be used for internal transfers from (1)
Harvesting Division to Oil Mill Division and (2) from Oil Mill Division to
Marketing Division under the following pricing methods:
(1) Shared contribution in relation to variable costs; and
(2) Market price.
(iii) Which transfer pricing method will each divisional manager prefer to use?

Answer
(i) Statement of the overall profit of the company

(By harvesting 2,000 kgs of oil seeds, processing it

into edible oil & selling the same in 2 kg cans)
Harvesting Oil Mill Marketing Total
Division Division Division Rs.
Output of 2,000 kgs of 1,000 kgs. of 500 cans of 2
each oil seed oil produced kg each
department
Total costs
Variable cost (Rs.) : (A) 5,000 10,000 1,875 16,875
(2,000 kgs × (1,000 kgs × (500 ×
Rs.2.50) Rs.10) Rs.3.75)
Fixed cost (Rs.): (B) 10,000 7,500 4,375 21,875
(2,000 kgs × (1,000 kgs × (500 ×
Rs.5) Rs.7.50) Rs.8.75)
Total cost (Rs.): (C) = 15,000 17,500 6,250 38,750
[(A)+(B)]
Sales revenue (Rs.): (D) 75,000

8.3
Advanced Management Accounting

(500 cans × Rs.150)

Profit (Rs.) [(D) – (C)] 36,250
(ii) Working note:
(a) Total Contribution = (Sales revenue – total variable cost)
= Rs.75,000 – Rs.16,875 =
Rs.58,125
(b) Amount of shared contribution in relation to variable costs:
Rs.5,000
Harvesting Division = Rs.58,125 × = Rs.17,222
Rs.16,875

Rs.10,000
Oil Mill Division = Rs.58,125 × =
Rs.34,445
Rs.16,875

Rs.1,875
Marketing Division = Rs.58,125 × = Rs.6,458
Rs.16,875
Computation of Transfer Price (for internal transfers) under the following pricing
methods:
(1) Shared contribution in relation to variable costs:
Transfer price from harvesting Division to Oil Mill Division
= Variable cost of Harvesting Division + Shared contribution of
Harvesting Division in relation to variable costs
= Rs.5,000 + Rs.17,222 (Refer to working note 2) =
Rs.22,222
Transfer price from Oil Mill Division to Marketing Division
= Transfer price from Harvesting Division to Oil Mill Division +
Variable cost of Oil Mill
Division + Shared contribution of Oil Mill Division in relation to variable costs
(Refer to working note 2)
= Rs.22,222 + Rs.10,000 + 34,445
= Rs.66,667
(2) Market price:
Transfer price from Harvesting Division to Oil Mill Division

8.4
 Transfer Pricing

= Market price of 2,000 kgs of Oil seeds transferred to Oil

Mill Division
= 2,000 kgs. × Rs.12.50 = Rs.25,000
Transfer price from Oil Mill Division to Marketing Division
= Market price of 1,000 kgs of edible oil
= 1,000 of kgs × Rs.62.50 – Rs.62,500
(iii) Statement of profitability (under different transfer prices method)
From From Oil Mil to From Marketing
Harvesting Marketing Division to
Division to Oil Division market (500
Mill Division cans
of 2 Kgs.)
Rs. Rs. Rs.
Shared
contribution
method
Transfer price: 22,222 66,667 75,000
(Refer to (1) above)
Less: Transfer price __ 22,222 66,667
(Refer to (ii) above)
Less: Variable cost 5,000 10,000 1,875
Less: Fixed cost 10,000 7,500 4,375
(Refer to (i) above)
Profit 7.222 26,945 2,083
Market price method
Transfer price 25,000 62,500 75,000
(Refer to (2) above)
Less: Transfer in price __ 25,000 62,500
(Refer to (ii) above)
Less: Variable cost 5,000 10,000 1,875
(Refer to (ii) above)
Less: Fixed cost 10,000 7,500 4,375

8.5
Advanced Management Accounting

(Refer to (i) above)

Profit 10,000 20,000 6,250
Decision: Divisional Manager of Harvesting Division would prefer the use
of market price method for transferring 2,000 kgs of oil seeds to Oil Mill
Division because its usage increases the profit by Rs.2,778 (Rs.7,222)
over the shared contribution method.
Whereas Oil Mill Division manager would prefer the use of shared
contribution method over the market price method because its use would
increase its profit by Rs.6,945 (Rs.26,945 – Rs.20,000). Similarly
Marketing Divisional Manager would be benefited to the extent of Rs.4,167
(Rs.6,250 – Rs.2,083) by using market price method. Question 2
Indicate the possible disadvantages of treating divisions as profit centres.
Answer
The Possible disadvantages of treating divisions as profit centres are as follows:
1. Divisions may compete with each other and may take decisions to increase
profits at the expense of other divisions thereby overemphasizing short
term results.
2. It may adversely affect co-operation between the divisions and lead to lack
of harmony in achieving organizational goals of the company. Thus it is
hard to achieve the objective of goal congruence.
3. It may lead to reduction I the company’s overall total profits.
4. The cost of activities, which are common to all divisions, may be greater for
decentralized structure than centralized structure. It may thus result in
duplication of staff activities.
5. Top management looses control by delegating decision making to
divisional managers. There are risks of mistakes committed by the
divisional managers, which the top management, may avoid.
6. Series of control reports prepared for several departments may not be
effective from the point of view of top management.
7. It may under utilize corporate competence.
8. It leads to complications associated with transfer pricing problems.
9. It becomes difficult to identity and defines precisely suitable profit centres.
10. It confuses division’s results with manager’s performance.
Question 3

8.6
 Transfer Pricing

The two manufacturing divisions of a company is organized on profit centre

basis. Division X is the only source of a component required by Division Y for
their product ‘P’. Each unit of P requires one unit of the said component. As the
demand of the product is not steady, orders for increased quantities can be
obtained by manipulating prices.
The manager of Division Y has given the following forecast:
Sales per day (Unit) Average price per unit of P (Rs.)
5,000 393.75
10,000 298.5
0
15,000 247.5
0
20,000 208.5
0
25,000 180.0
0
30,000 150.7
5
The manufacturing cost (excluding the cost of the component from Division X) of
P in Division Y is Rs.14,06,250 on first 5,000 units and Rs.56.25 per unit in
excess of 5,000 units.
Division X incurs a total cost of Rs.5,62,500 per day for an output upto 5,000
components and the total costs will increase by Rs.3,37,500 per day for every
additional 5,000 components manufactured. The Manager of Division X has set
the transfer price for the component at Rs.90 per unit to optimize the
performance of his Division.
Required:
(i) Prepare a divisional profitability statement at each level of output, for
division X and Y separately;
(ii) Find out the profitability of the company as a whole at the output level
where: (a) Division X’s net profit is maximum;
(b) Division Y’s net profit is maximum.
(iii)
Find out at what level of output, the company will earn maximum profit, if
the company is not organized on profit centre basis.
Answer
(i) Statement of profitability of Division X

8.7
Advanced Management Accounting

No. of components Transfer price for the Total cost of Profit / (Loss)
component to components (Rs.)
Department Y @ Rs.90 (Rs.)
per unit
(a) (b) (c) ( d) = {(b) –
(c )}
5,000 4,50,000 5,62,500 (1,12,500)
10,000 9,000 9,00,000 __
15,000 13,50,000 12,37,500 1 , 12,500
20,000 18,00,000 15,75,000 1 , 25,000
25,000 22,50,000 19,12,500 3 , 37,500
30,000 27,00,000 22,50,000 4 , 50,000
Statement of profitability of Division Y
No. of Sale Component Manufacturing Total cost Profit/(Loss)
Components revenue cost cost in
on (Transfer division Y
average price) to
price basis Dept. Y
Rs. Rs. Rs. Rs. Rs.
(a) (b) (c) (d) (e)={(c)+(d)} ( f)={(b)-(e )}
5,000 19,68,750 4,50,000 14,06,250 18,56,250 1 ,
12,500
10,000 29,85,000 9,00,000 16,87,500 25,87,500 3 ,
97,500
15,000 37,12,500 13,50,000 19,68,750 33,18,750 3 ,
93,750
20,000 41,70,000 18,00,000 22,50,000 40,50,000 1 , 20,000 25,000
45,00,000 22,50,000 25,31,250 47,81,250 (2,81,250)
30,000 45,00,000 27,00,000 28,12,500 55,12,500
(9,90,000)
(ii) Profitability of the company as a whole
(a) At 30,000 units level, at which Division X’s net profit is
maximum Rs.

8.8
 Transfer Pricing

Profit of Division X 4,50,000

Profit of division Y (9,00,000)
Operating profitability / (Loss) of the company (5,40,000)
(b) At 10,000 units level, at which Division Y’s net profit is
maximum Rs.
Profit of division X NIL Profit
of division Y 3,97,500
Operating profitability of the company 3,97,500
(iii) Profitability of the company, if it is not organised on profit centre
basis
No. of Sales Cost of Manufacturing Total cost Profit/ components
revenue on component cost in (Loss)
average to division X division
Y basis
(Rs.) (Rs.) (Rs.) (Rs.) ( Rs. )
(a) (b) (c) (d) (e)={(c) + ( f)={(b)–(e )}
(d)}
5,000 19,68,750 5,62,500 14,06,250 19,68,750 -
10,000 29,85,000 9,00,000 16,87,500 25,87,500 3 ,
97,500
15,000 37,12,500 12,37,500 19,68,750 32,06,250 5 ,
06,250
20,000 4170,000 15,75,000 22,50,000 38,25,000 3 ,
45,000
25,000 45,00,000 19,12,500 25,31,250 44,43,750 56,250
30,000 45,22,500 22,50,000 28,12,500 50,62,500 (5,40,00
0)
The level of output, the company will earn maximum profit, if the company
is not organized on profit centre basis is 15,000 components.
Question 4
Tycon Ltd. has two manufacturing departments organized into separate profit
centres known as Textile unit and Process House. The Textile unit has a
production capacity of 5 lacs metres cloth per month, but at present its sales is
limited to 50% to outside market and 30% to process house.

8.9
Advanced Management Accounting

The transfer price for the year 2004 was agreed at Rs. 6 per metre. This price
has been fixed in line with the external wholesale trade price on 1 st January,
2004. However, the price of yarn declined, which was the raw material of textile
unit, with effect, that wholesale trade price reduced to Rs. 5.60 per metre with
effect from 1st June, 2004. This price was however not made applicable to the
sales made to the processing house of the company. The textile unit turned down
the processing house request for revision of price.
The Process house refines the cloth and packs the output known as brand
Rayon in bundles of 100 metres each. The selling price of the Rayon is Rs. 825
per bundle. The process house has a potential of selling a further quantity of
1,000 bundles of Rayon provided the overall prices is reduced to Rs. 725 per
bundle. In that event it can buy the additional 1,00,000 metres of cloth from
textile unit, whose capacity can be fully utilised. The outside market has no
further scope.
The cost data relevant to the operations are:
Textile unit Process
Rs. house Rs.
Raw material (per metre) on 1st June, 2004 3.00 Transfer
price
Variable cost 1.20 (per metre) 80 (per
bundle )
Fixed cost (per month) 4,12,000 1 , 00,000
You are required to:
(i) Prepare statement showing the estimated profitability for June, 2004 for
Textile unit and Process house and company as a whole on the following
basis:
(a) At 80% and 100% capacity utilisation of the Textile unit at the market
price and the transfer price to the Processing house of Rs. 6 per
metre.
(b) At 80% capacity utilisation of the Textile unit at the market price of
Rs. 5.60 per metre and the transfer price to the Processing house of
Rs. 6 per metre.
(c) At 100% capacity utilisation of the Textile unit at the market price of
Rs. 5.60 per metre and the transfer price to the Processing house of
Rs. 5.60 per metre.
(ii) Comment on the effect of the company’s transfer pricing policy on the
profitability of Processing house.

8.10
 Transfer Pricing

Answer
(i) (a) At 80% level (in Rs)
-Textile unit -Process house
Sales (4,00,000 × 6) 24,00,000 Sales(1,50,000/100) ×825 12 ,
37,500
Less Less

Raw material (4,00,000 × 3) 12,00,000 Transfer Price (1,50,000 × 6) 9 ,

00,000
Variable cost (4,00,000 ×1.2) 4,80,000 Variable cost (1,500 × 80) 1,
20,000
Fixed cost 4,12,000 Fixed cost 1,
00,000
Profit 3,08,000 Profit 1,
17,500
Overall profit = 3,08,000 + 1,17,500 = Rs
4,25,500 At 100% level

Sales (5,00,000 × 6) 30,00,000 Sales (2,50,000/100) ×725 18 ,

12,500
Less Less

Raw material (5,00,000 × 3) 15,00,000 Transfer Price (2,50,000 × 6) 15 ,

00,000
Variable cost (5,00,000 × 1.2) 6,00,000 Variable cost 2,
00,000
Fixed cost 4,12,000 Fixed cost 1,
00,000
Profit 4,88,000 Profit 12,500
Overall profit = 4,88,000+12,500 = Rs 5,00,500
(b) At 80% level (market price 5.60 and transfer price 6/-) (in Rs)
Textile unit Process house
Sale (2,50,000 ×5.6) 1400000
(1,50,000 ×6.0) 900000
23,00,000
Less
Raw material (4,00,000 ×3) 12,00,000 Variable cost

(4,00,000 ×1.2) 4,80,000

Fixed cost 4,12,000

8.11
Advanced Management Accounting

Profit 2,08,000 Profit 1 , 17,500

Overall profit = 2,08,000+1,17,500 =Rs
3,25,500 (c) Sales 100% level at (5.60) (in
Rs)

Sale (5,00,000 × 5.6) 28,00,000 Sales(2,50,000 ×725) 18 ,

12,500
Less Less

Raw material (5,00,000 ×3) 15,00,000 Transfer Profit (2,50,000 14 ,

00,000
×5.6)
Variable cost (5,00,000 ×1.20) 6,00,000 Variable cost (2,500 × 80) 2 , 00,000
Fixed cost 4,12,000 Fixed cost 1 , 00,000
Profit 2,88,000 Profit 1 , 12,500
Overall profit = 2,88,000 + 1,12,500 =4,00,500
(ii) Comments on the profitability of processing units:-

Transfer price (Rs) Profit

(Rs)
(a) 80% capacity 6.00 1,
17,500
100% capacity 6.00 12,500
(b) 80% capacity 6.00 1,
17,500
(c) 100% capacity 5.60 1,
12,500
Processing house will not be interested to buy more than 1,50,000 meters
from textile units. Question 5
AB Cycles Ltd. has 2 divisions, A and B which manufacture bicycle. Division A
produces bicycle frame and Division B assembles rest of the bicycle on the
frame. There is a market for sub-assembly and the final product. Each division
has been treated as a profit centre. The transfer price has been set at the long-
run average market price. The following data are available to each division:
Estimated selling price of final product Rs. 3,000 p.u.

8.12
 Transfer Pricing

Long run average market price of sub-assembly Rs. 2,000 p.u.

Incremental cost of completing sub-assembly in Rs. 1,500 p.u.
division B
Incremental cost in Division A Rs. 1,200 p.u.
Required:
(i) If Division A’s maximum capacity is 1,000 p.m. and sales to the
intermediate are now 800 units, should 200 units be transferred to B on
long-term average price basis.
(ii) What would be the transfer price, if manager of Division B should be kept
motivated?
(iii) If outside market increases to 1,000 units, should Division A continue to
transfer 200 units to Division B or sell entire production to outside market?
Answer
(i) In this case there are two options available –
(a) Sell at the sub assembly stage (after completion of Div. A) @
Rs. 2000/-
Incremental cost in Div. A Rs 1,200/-
Contribution Rs 800/-
(b) Sell at the final product stage Rs. 3,000
Cost at Div. A and Div. B Rs(1200+1500) Rs 2,700
Contribution Rs 300
Therefore it is profitable to sell at the subassembly stage because of higher
contribution, provided there is a market.
Hence, if there is market at intermediate stage, first priority is to sell
intermediary (sub assembly).Therefore, 800 units should be sold as sale of
intermediary.
The balance capacity available of (1000 – 800) = 200 units should be
transferred to B and B should complete the assembly and sell as final
product, since the company can earn Rs. 300 per unit for each unit of such
sale.
(ii) If B Div. receives the subassembly at market price of Rs. 2,000, plus its
own incremental cost of Rs. 1,500 will give total cost of Rs. 3,500, thereby
yielding a
loss of Rs. 3500 – Rs. 3000 = Rs. 500 per unit, whereas the company
makes a profit of Rs. 300 per unit.

8.13
Advanced Management Accounting

In order to keep the manager of Div. B motivated, the profit earned of Rs. 300
per unit should be shared between A and B. Hence transfer price will be
variable cost of Div. A + 50% of profit earned in the final product = 1200 +
150 = Rs. 1,350
(iii)Both Div. A and the Company make higher contribution by selling to
intermediate market. If the market demand increases to 1,000 units, the full
quantity should be sold outside as intermediary and nothing should be
transferred to Div. B.
Question 6
What are some goals of a ‘transfer-pricing’ system in an organization?
Answer

The goals of transfer pricing are that it should:

1. provide information that motivates divisional managers to take good
economic decisions which will improve the divisional profits and ultimately
the profits of the company as a whole.
2. provide information which will be useful for evaluating the divisional
performance.
3. seek to achieve goal congruence.
4. ensure that divisional autonomy is not undermined.
Question 7
Division Z is a profit center which produces four products A, B, C and D. Each
product is sold in the external market also. Data for the period is:
A B C D
Market price per unit (Rs.) 150 146 140 13
0
Variable cost of pdn. Per unit (Rs.) 130 100 90 85
Labour hours required per unit 3 4 2 3
Product D can be transferred to division Y, but the maximum quantity that may be
required for transfer is 2,500 units of D. The maximum sales in the external
market are:
A 2,800 units
B 2,500 units
C

8.14
 Transfer Pricing

2,300 units
D 1,600 units
Division Y can purchase the same product at a price of Rs. 125 per unit from
outside instead of receiving transfer of product D from Division Z.
What should be the transfer price for each unit for 2,500 units of D, if the total
labour hours available in division Z are 20,000 hours?
Answer
Ranking of products when availability of time is the key factor
Contribution p.u. (Rs.)
Products 20
A 46
B 50
C 45
D
Labour hours p.u.
Market price 3
150 4
146 2
140 3
130
Contribution/labour
Less: Variable cost hour 6.66
130 11.5
100 25
90 15
85
Ranking IV III I II
Maximum demand (units) 2,800 2,500 2,300 1,60
0
Total No of hours 8,400 10,000 4,600 4,80
0
Allocation of 20,000 hours on the basis of 600* 10,000 4,600 4,80
ranking 0
*Balancing figure
Note: Time required meeting the demand of 2,500 units of product D for division
Y is 7,500 hours. This requirement of time viz, 7,500 hours for providing 2,500
units of product D for division Y can be met by sacrificing 600 hours of Product A
(200 units) and 6,900 hours of Product B (1,725 units)
Transfer Price = Variable cost + Opportunity cost
)
Or Rs85 + (Rs6,900×11.5 + 600×6.66 = Rs.85+(79350+ 4000)
2,500 2500
= Rs (85 + 33.34) = Rs 118.34
Question 8
X Ltd. has two divisions, A and B, which manufacture products A and B
respectively. A and B are profit centres with the respective Divisional Managers
being given full responsibility and credit for their performance.
The following figures are presented:
Division A Division B

8.15
Advanced Management Accounting

Rs. Per Unit Rs. Per Unit

Direct material cost 50 24* *(other than
A)
Material A, if transferred from Division ─ 144
A
Material A, if purchased from outside ─ 160
Direct labour 25 14
Variable production overhead 20 2
Variable selling overhead 13 26
Selling price in outside market 160 300
Selling price to B 144 ─
Selling price to S Ltd. ─ 250
Other Information:
To make one unit of B, one unit of component A is needed. If transferred from A,
B presently takes product A at Rs.144 per unit, with A not incurring variable
selling overheads on units transferred to B.
Product A is available in the outside market at Rs. 160 per unit from competitors.
B can sell its product B in the external market at Rs. 300 per unit, whereas, if it
supplied to X Ltd.’s subsidiary, S Ltd., it supplies at Rs. 250 per unit, and need
not incur variable selling overhead on units transferred to S Ltd. S Ltd. requires
6,000 units and stipulates a condition that either all 6,000 units be taken from B
or none at all.
A(units) B(units)
Manufacturing capacity 20,000 28,000 Demand in
external market 18,000 26,000
S Ltd.’s demand ─ 6,000 or zero
Assume that Divisions A and B will have to operate during the
year. What is the best strategy for:
(i) Department A?
(ii) Department B, given that A will use its best strategy?
(iii) For X Ltd. As a whole?
Answer

8.16
 Transfer Pricing

Div A B B
Rs. / unit Rs. / unit Rs. /
unit
Direct Material (Other than A) 50 24
Direct Labour 25 14
Variable Overhead (Production) 20 2
Variable Production Cost (excl. A) 95 40 40
From A 144
From Outside ____ 160
Variable production Cost / unit 184 200
Selling Price
From outside 160 300
Less: Selling Overhead 13 26
Net Selling Price (outside) 147 274
Net Selling Price to B 144
Net Selling Price to S 250
Net Selling Price (outside) 147 274 274
Variable Production Cost − 95 − 184 −200
Contribution / unit (outside) 52 90 74
(Sale to B & S respectively) 144 250 250
Variable Production Cost −95 −184 −200
Contribution / 49 66 50
unit

Best strategy
A = Maximise Production; Sell maximum no. of units @ 18,000 × 52 = 9,36,000
52 / unit (outside)
(To B) remaining units 2,000 × 49 = 98,000 Total Contribution for A
10,34,000
Best strategy for B:

8.17
Advanced Management Accounting

Maximise contribution / unit by selling outside and procuring from A 90 / unit

Contribution × 2,000 units
Balance units can yield contribution of either 74/ unit for outside or Rs. 50 / unit
to S Ltd. Production Capacity = 28,000.
Option I Option II
Outside Sales Sales to S Outside Sales ×
contribution / unit
20,000 × 74 = 14,80,000 6,000 × 50 = 3,00,000 24,000 × 74 =
17,76,000
2,000 × 90 = 1,80,000 2,000 × 90 = 1,80,000
16,60,000
3,00,000
Total Contribution (16,60,000 + 19,56,000
3,00,000)19,60,000
(B) Choose Option I i.e. get 2,000 units from A, sell 6,000 units to S and 20,000
to outside. Make 28,000 units @ full capacity. Total Contribution
Rs19,60,000. If A and B are allowed to act independent of the group
synergy,
Rs.
Total contribution A – 10,34,000
B – 19,60,000
Total contribution for X Ltd. 29,94,000

Cost from X Ltd.’s Perspective

Variable Cost of production Div A Rs.
95
Div B
Variable cost of production other than A 40 40
A supplied by Division 95
A – Variable Cost
A purchased ____ 160
135 200
Option I Outside 26,000 units Option
II

8.18
 Transfer Pricing

Outside 20,000 × (274 – 135) 27,80,000 20,000 (274 – 135) 27 ,

80,000 2,000 × (274 – 200) 1,48,000 6,000 (274 – 200)
4,44,000
22,000
S Ltd. 6,000 units (250 – 200) 3,00,000 _______
__
32,28,000 32 ,
24,000
Choose Option I
Contribution = Rs. 32,28,000 for X Ltd. as a whole
Transfer (2,000 units)
Make A transfer all output to B. Sell 6,000 units of B to S and 22,000 units to
outside market. This will make X Ltd. better off by 32,28,000 – 29,94,000 = Rs
2,34,000
(i.e. 18,000 units of A sold to outside increases contribution to A by 3 Rs. / unit
and decreases contribution to B by 16 Rs. / unit Net negative effect = 13 ×
18,000 = Rs.2,34,000).
Question 9
A large business consultancy firm is organized in to several divisions. One of the
divisions is the Information Technology (IT) division which provides consultancy
services to its clients as well as to the other divisions of the firm. The consultants
in the IT divisions always work in a team of three professional consultants on
each day of consulting assignment. The external clients are charged a fee at the
rate of Rs. 4,500 for each consulting day. The fee represents the cost plus 150%
profit mark up. The break up of cost involved in the consultancy fee is estimated
at 80% as being variable and the balance is fixed.
The textiles division of the consultancy firm which has undertaken a big
assignment requires the services of two teams of IT consultants to work five
days in a week for a period of 48 weeks. While the director of the textiles division
intends to negotiate the transfer price for the consultancy work, the director of IT
division proposes to charge the textiles division at Rs. 4,500 per consulting day.
In respect of the consulting work of the textiles division, IT division will be able to
reduce the variable costs by Rs. 200 per consulting day. This is possible in all
cases of internal consultations because of the use of specialized equipment.
You are required to explain the implications and set transfer prices per consulting
day at which the IT division can provide consultancy services to the textiles

8.19
Advanced Management Accounting

division such that the profit of the business consultancy firm as a whole is
maximized in each of the following scenarios:
(i) Every team of the IT division is fully engaged during the 48 week period in
providing consultancy services to external clients and that the IT division
has no spare capacity of consultancy teams to take up the textiles division
assignment.
(ii) IT division will be able to spare only one team of consultants to provide
services to the textiles division during the 48 week period and all other
teams are fully engaged in providing services to external clients.
(iii) A new external client has come forward to pay IT division a total fee of Rs.
15,84,000 for engaging the services of two teams of consultants during the
aforesaid period of 48 weeks.
Answer
Transfer Price is Rs. 4,500 for each consulting day.
Profit mark-up = 150%
Let cost =x

Profit = x ×
= 1.5x
Cost + profit = Transfer price
⇒ x + 1.5x = 4,500
⇒ 2.5x = 4,500

⇒ x = = 1,800
∴ Cost = Rs. 1,800
and profit = 1.5x = 1.5 ×
1,800
= Rs. 2,700
Variable cost (80%) = Rs. 1,800 × 80%
= Rs. 1,440
Fixed cost (20%) = Rs. 1,800 × 20%
= Rs. 360.

8.20
 Transfer Pricing

Scenario (i):
Every consultancy team is fully engaged. There is no idle time or spare capacity.
Hence, transfer price = Marginal cost plus opportunity cost
Marginal cost = Rs. 1,440
Saving for internal work = Rs. 200
Net Marginal Cost = Rs. 1,240
Opportunity cost is the lost contribution.
Lost contribution = Contribution from external client
= Fee charged from external client –
Variable cost
= Rs. (4,500 – 1,440)
= Rs. 3,060.
∴ Transfer price = Rs. 1,240 + 3,060
= Rs. 4,300 per consulting day per team.
Scenario (ii):
One team is idle. Idle time has no opportunity cost. Variable cost for internal work
is Rs. 1,240 per consulting day. Second team is busy. Hence opportunity cost is
relevant in case of second team. Hence charge of second team is Rs. 4,300 per
consulting day per team.
Average of charge of two teams = Rs. (1,240 + 4,300) / 2
= Rs. 2,770 per consulting day per team.
Scenario (iii):
New client offers a fee of Rs. 15,84,000
Duration: 5 days of 48 weeks × 2 teams = 480 days
Fee per day 15,84,000 / 480 = Rs. 3,300

Variable cost = Rs. 1,440

Contribution Rs. (3,300 – 1,440) = Rs. 1,860
Fee for consulting day for internal
work:
Variable cost = Rs. 1,240
Contribution lost = Rs. 1,860

8.21
Advanced Management Accounting

Fee to be charged = Rs. 3,100 per consulting day per

team.
Question 10
Tripod Ltd. has three divisions − X, Y and Z, which make products X, Y and Z
respectively. For division Y, the only direct material is product X and for Z, the
only direct material is product Y. Division X purchases all its raw material from
outside. Direct selling overhead, representing commission to external sales
agents are avoided on all internal transfers.
Division Y additionally incurs Rs. 10 per unit and Rs. 8 per unit on units delivered
to external customers and Z respectively. Y also incurs Rs. 6 per unit picked up
from X, whereas external suppliers supply at Y’s factory at the stated price of Rs.
85 per unit. Additional information is given below:
Figures Rs./unit
X Y Z
Direct materials (external supplier rate) 40 85 135
Direct labour 30 50 45
Sales Agent’s commission 15 15 10
Selling price in external market 110 170 240
Production capacity 20,000 30,000 40,000
units
External demand 14,000 26,000 42,000
units
You are required to discuss the range of negotiation for Managers X, Y and Z, for
the number of units and the transfer price for internal transfers.
Answer

Analysis of range of negotiation for Manager of Division X

(Figures in Rs.)
(a) Division X

Outside sales Sales to Y (Range)

Selling Price 110 70 − 79
(−) Commission 15 − −

8.22
 Transfer Pricing

Net Selling Price 95 70 − 79

Variable Cost 70 70 − 70
Contribution per unit 25 0 9
Units 14,000 6,000 6,000
Total contribution
(Units × Contribution per 3,50,000 0 54,00
unit) 0

Analysis of Range of negotiation for Manager of Division Y

(Figures in Rs.)
Division Y

8.23
 Outside Sales Sale to Z
From A From outside From A From
Advanced Management Accounting outside
Price range 70 79 85 70 79 85
Add: Transport 6 6 − 6 6 −
76 85 85 76 85 85
Add: Direct Labour 50 50 50 50 50 50
126 135 135 126 135 13
5

Add: Delivery cost 10 10 10 8 8 8

136 145 145 134 143 14
3
Add: Sales 15 15 15 − − −
Commission

Total Cost 151 160 160 134 134 143 14

3
Selling Price 170 170 170 134 135 135 13
5
Contribution 19 10 10 0 +1 (−) 8 (−)
8
Range of Negotiations:
Manager of division X will sell 14,000 units outside at 110 Rs. per unit and earn
contribution of Rs. 3.50 lakhs.
Excess capacity of 6,000 units can be offered to Y at a price between 70 (the
variable manufacturing cost at X) and Rs. 95 (the maximum amount to equal

8.24
 Transfer Pricing

outside contribution). But Y can get the material outside @ 85. So, y will not pay
to X anything above (Rs.85 – 6) = Rs. 79 to match external available price.
X will be attracted to sell to Y only in the range of 71 – 79 Rs. per unit at a
volume of 6,000 units.
At Rs. 70, X will be indifferent, but may offer to sell to Y to use idle capacity.
Z will not buy from Y at anything above 135. If X sells to Y at 70 per unit, Y can
sell to Z at 134 and earn no contribution, only for surplus capacity and if
units transferred by X to Y at Rs. 70 per unit.
Y Z
Sell 4,000 units to Z at 134 Buy 4,000 units from y
Provided X sells (Indifferent) at 134 (attracted)
to
Sell 4,000 units to Z at 135 Indifferent, since
Y at Rs. 70 per
(willingly for a contribution of market price is also
unit Re. 135
1)
For buying from X at 71 – 79 price range, Y will be interested in selling to Z only
at prices 136 – 143, which will not interest Z.
Thus Y will sell to Z only if X sells to Y at Rs. 70 per unit and Y will supply to Z
maximum 4,000 units.
Question 11
Bearings Ltd. makes three products, A, B and C in Divisions A, Band C
respectively. The following information is given:
A B C
Direct Materials (excluding material A for 4 15 20 Rs./u
Divisions B and C)
Direct Labour 2 3 4 Rs./u
Variable overhead 1 1 1 Rs./u
Selling price to outside customers 15 40 50 Rs./u
Existing Capacity 5,000 2,500 2,500 (No. of
units)
Maximum External demand 3,750 5,000 4,000 (No. of
units)
Additional fixed costs that 24,000 6,000 18,700 Rs.
would be incurred to install
additional capacity

8.25
Advanced Management Accounting

Maximum Additional units that can be 5,000 1,250 2,250 (No. of

units)
produced by additional capacity
B and C need material A as their input. Material A is available outside at Rs.15
per unit. Division A supplies the material free from defects. Each unit of B and C
requires one unit of A as the input material.
If B purchases from outside, it has to pay Rs.15 per unit. If B purchases from A, it
has to incur in addition to the transfer price, Rs.2 per unit as variable cost to
modify it.
B has sufficient idle capacity to inspect its inputs without additional costs.
If C gets material from A, it can use it directly, but if it gets material from outside,
which is at Rs.15, it has to do one of the following:
(i) Inspect it at its own shop floor at Rs.3 per unit Or

(ii) Get the supplier to supply inspected products and pay the supplier Rs.2 p.
u. as inspection charges.
Or
(iii) A has enough idle labour, which it can lend to C to inspect at Re 1 p.u.
even though C purchases from outside.
A has to fix a uniform transfer price for both B and C. The transfer price will not
be known to outsiders and is at the discretion of the Divisional Managers.
What is the best strategy for each division and the company as a whole?
Answer

8.26
 Transfer Pricing

Exiting capacity 5,000 2,500 2,500 6,000 18,700

Maximum capacity that can be 5,000 1,250 2,250
6 added 6
Total maximum that can be 10,000 3,750 4,750
produced
Additional fixed cost on expansion 24,000 6,000 18,700 Units that must be
24,000
sold/transfer to = 4,000 =1,000 =1,558.33 get this amount as contribution
6
External demand not covered by - 2,500 1,500 existing capacity
Decision Expand make Expand make Do not expand 10,000 units 2,500 + 1,250
make only 2,500 3,750 – outside = 3,750 units
units.
3,750 – B 2,500
–C

A B C
Outside Transfer to
sale B & C
Units 3,750 3,750 + 3,750 2,500

8.27
Advanced Management Accounting

2,500 =
6,250
Contribution / unit 8 6 6 12
Contribution (Rs.) 30,000 37,500 22,500 30,000
67,500 22,500 30,000
Additional Fixed Cost 24,000 6,000 - Net revenue addition 43,500 16,500
30,000
Individual strategy is the Company’s best strategy.
Question 12
Optically Ltd. makes two kinds of products, P (lenses) and Q (swimming goggles)
in divisions P and Q respectively. P is an input for Q and two units of P are
needed to make one unit of Q.
The following data is given to you for a period :
P Rs./u Q
of P Rs./u of Q
Direct Materials 20 25 (excluding P)
Direct Labour 30 35
Variable Overhead 10 20
External Demand (units) 3,000 3,000
Capacity (units) 7,000 2,500
Selling Price Rs./u (outside market) 100 410
If Q buys P from outside, it has the following costs:
For order quantity 2,499 or less Rs.90 per unit for the entire quantity ordered.
For order quantity 2,500 – 5,000 Rs.80 per unit for the entire quantity ordered.
For order quantity more than 5,000 Rs.70 per unit for the entire quantity ordered.
You are required to:
(i) Evaluate the best strategies for Division P and Q.
(ii) Briefly explain the concept of goal congruence.
Answer
Opticals Ltd manufactures P( lenses) and Q ( swimming goggles ).
Division P has option to supply to Division Q or sell to outside market.

8.28
 Transfer Pricing

Division Q has option to buy from Division P or purchase from outside market.
However, both divisions have to work within their individual capacity.
Variable Cost for product P in Division P = Rs 60.
Variable cost for product Q in Division Q ( excluding 2 Nos P's) = Rs 80.
Division P has better market price of its product P than the market price offered
to Q division.
For maximizing profit of the organization : Rs
P division should optimise its profit by selling maximum units to outside
market.
Contribution per unit for sale to outside for division P 40
Contribution per unit for Div Q as follows :
Sale price - Variable cost ( excluding lenses) 330 Max Contribution per unit ( if
procured from P div at its variable cost i.e Rs 60) 210 Min Contribution per unit
( if procured at Rs 90 per unit from outside) 150 Contribution per unit at transfer
price of Rs 70 i.e minimum market price 190
Option 1 : Division Q buys 5001 units from market @ Rs 70 and meets its
capacity.
Division P sells 3000 units to outside market @ Rs 100
Sale / Transfer Contrib. /unit thousand rupees
Contribution in
Rs P Div Q Div Total
DivP :Sale of 3000 units to outside market @ Rs 100 40 120 120
DivQ: Sale of 2500 units with P from market @ Rs 70 190 475 475
Less : cost of rejection of one unit of product P -0.07 -0.07
Total 120 474.93 594.93
Option 2 : Division P sells 3000 units to outside market, transfer 4000 units
to div Q and Division Q buys 1000 units from outside market to work within
the capacity P Division agrees to a transfer price so that profitability of Q is not
affected. To maintain the same profitability of Q, contribution required from 2000
units for Div Q is Rs 400,000 i.e contribution per unit Rs 200 i.e transfer price per
unit of P is Rs 65 per unit to make cost of lences Rs 130
Sale / Transfer Contrib /unit thousand rupees Contribution in
Rs P Div Q Div Total

8.29
Advanced Management Accounting

Div P : Sale of 3000 units to outside market 40 120 120 Div P : Transfer
of 4000 units to div Q at Rs 65 5 20 20 Div Q :Sale of 2000 units
with P from P div @ Rs 65 200 400 400 Div Q : Sale of 500 units with P
from market @ Rs 90 150 75 75
Total 140 475 615
Under Option 1, both divisions worked dis-jointly without caring for capacity
utilization resulting lower profitability of the organization.
Under Option 2, both divisions worked with mutual advantages for optimizing
their individual profits and overall profit for the organization has gone up by
effective utilization of capacity.
Product P from Division P fetches higher price from open market indicating good
quality of product. Moreover, supply from P division is well assured in the long
run which is the justification of establishment of two parallel divisions.
Hence, Option 2 is suggested.
(ii) Division functioning as profit centers strive to achieve maximum divisional
profits, either by internal transfers or from outside purchase. This may not
match with the organisation’s objective of maximum overall profits.
Divisions may be commercial to advice overall objects objectives, where
divisional decisions are in line with the overall best for the company, and
this is goal congruence. Divisions at a disadvantage may be given due
weightage while appraising their performance. Goal incongruence defeats
the purpose of divisional profit centre system.
Question 13
A company is organized on decentralized lines, .with each manufacturing division
operating as a separate profit centre. Each division manager has full authority to
decide on sale of division's output to outsiders or to other divisions. Division AB
manufactures a single standardized product. Some output is sold externally and
remaining is transferred to division XY where it is a subassembly in the
manufacture of the division product. The unit cost of division AB product and
division XY is as follows:
Division AB (Rs.) Division XY (Rs.)
Transfer from division AB to XY -- 42.00
Direct Material 6.00 35.00
Direct Labour 3.00 4.50
Direct expenses 3.00 --

8.30
 Transfer Pricing

Variable manufacturing overheads 3.00 18.00

Fixed manufacturing overheads 6.00 18.00
Variable selling and packing expenses 3.00 2.50
24.00 120.00
Division AB sold 40,000 units annually at the standard price of Rs.45 in external
market. In additions to the external sales, 10,000 units are transferred annually
to division XY at internal price of Rupees 42 per unit. Variable selling and
packing expenses are not incurred by supplying division- for the internal transfer
of the product. Division XY incorporates the transferred goods into more advance
product. The manager of division XY disagrees with the basis used to set the
transfer price. He argues that transfer price should be made at variable cost
since he claims that his division is taking output that division AB should be
unable to sell at price Rs.45.
He also submitted a report of the relationship between selling price and demand
to support of his disagreement. The report of customer demand at various selling
prices for division AB and for division XY is as follows: Division AB
Selling price per unit (Rs.) 30 45 60
Demand (Units) 60,000 40,000 20,00
0
Division XY
Selling price per unit (Rs.) 120 135 150
Demand (Units) 15,000 10,000 5,00
0
The company has sufficient capacity to meet demand at various selling prices.
Internal transfer demanded units will be decided by XY division.
Required:
(i) To calculate divisional profitability and overall profitability of company if
division AB transfers demanded units to XY at price of Rs. 42.
(ii) To calculate divisional profitability and overall profitability of company if
division AB transfers demanded units to XY at variable cost.
(iii) In place of internal transfers, AB division can sell 10,000 units of their
product in new external market without effecting existing market, at price
Rs. 32 per unit arid XY division can 'purchase these units at the rate of Rs.
31 in open market. Calculate company's profit by following above
strategies.
Answer

8.31
Advanced Management Accounting

(i) AB sells product at external market

Selling price (Rs.) 30 45 60 Less Variable cost 18 18 18 Contribution (per
unit) 12 27 42 Demands (units) 60,000 40,000 20,000
Total contribution 7,20,000 10,80,000 8 , 40,000
Optimal output is 40,000 units at a selling price of Rs.45
AB transfer at Rs.42 to XY division then contribution
of XY
Selling price (Rs.) 120 135 150 Less Variable cost V+TP
102 102 102 (42+60)
Contribution (per unit) 18 33 48 Demands (units) 15,000 10,000 5,000
Total contribution 2,70,000 3,30,000 2 , 40,000
Manager will choose out put level 10,000 units at a selling price of Rs.135.
Overall profit when transfer made at Rs.42
Division AB contribution on 10,000 units [42 – (18 -3)] =
2,70,000 Division XY contribution 10,000 (135 – 102)
= 3,30,000
Total contribution =
6,00,000
Division AB contribution from external market sale =
10,80,000
Total profit
16,80,000
(ii) AB transfer at variable cost
Selling price (Rs.) 120 135 150 Less Variable cost (15+60) 75 75 75
Contribution (per unit) 45 60 75 Demands (units) 15,000 10,000 5,000
Total contribution 6,75,000 6,00,000 3 , 75,000
Optimal is 15,000 units at the rate of 120 per unit.
If AB transfer at Variable cost (Rs.15) then no contribution will be generated
by AB division

8.32
 Transfer Pricing

XY division choose 15,000 units level gives contribution 15,000 × 45

= 6,75,000
Division AB contribution from external market sale
=10,80,000
Total contribution
=17,55,000
(iii) Contribution AB division by selling 10,000 units to new external market
at Rs.32 and XY division purchasing at Rs.31.
Contribution (32 – 18) × 10,000 = 1,40,000 XY contribution
[135 – (31 + 60)] = 4,40,000
Division AB contribution from external market sale = 10,80,000
Total contribution = 16,60,000
Question 14
What should be the basis of transfer pricing, if unit variable cost and unit selling
price are not constant?
Answer
If unit variable cost and unit selling price were not constant then the main
problem that would arise while fixing the transfer price of a product would be as
follows:
There is an optimum level of output for a firm as a whole. This is so because
there is a certain level of output beyond which its net revenue will not rise. The
ideal transfer price under these circumstances will be that which will motivate
these managers to produce at this level of output.
Essentially, it means that some division in a business house might have to
produce its output at a level less than its full capacity and in all such cases a
transfer price may be imposed centrally. Question 15
(a) What will be the marketable transfer pricing procedure regarding the goods
transferred under the following conditions (each condition is independent of
the other)?
(i) When division are not captives of internal divisions and the divisions
are free to do business both internally and externally and when there
are reasonably competitive external markets for the transferred
products.
(ii) If the external market for the transferred good is not reasonably
competitive.

8.33
Advanced Management Accounting

(b) Discuss the potential for maximization of income by a multinational through

the use of transfer pricing mechanism.
Answer
(a) Marketable Transfer Pricing Procedure
(i) When division are not captives of internal divisions and the divisions
are free to do business both internally and externally and when there
are reasonably competitive external markets for the transferred
products, then the most suitable transfer price would be, the market
price, as it generally leads to optimal decisions.
(ii) In case, the external market for the transferred good is not
reasonable competitive, following two situations may arise in this
case.
(a) If there is idle capacity: Under this situation opportunity cost will
be zero hence minimum transfer price should be equal to the
additional
outlay costs incurred upto the point of transfer (sometimes
approximated by variable costs).
(b) If there is no idle capacity: Under this situation opportunity cost
should be added to outlay costs for determining minimum
transfer price.
(b) The potential for maximization of income by a multinational through the use
of transfer pricing mechanism is based on the successful implementation of
the following steps:
(i) Transfer pricing may be set relatively higher for affiliates in relatively
hightax countries that purchase inputs from affiliates located in
relatively low-tax countries.
(ii) Transfer prices to affiliates in countries which are subject to import
duties for goods or services purchase may be set low so as to avoid
host country taxes.
(iii) Transfer prices to an affiliate in a country that is encountering
relatively high inflation may be set relatively high to avoid some of the
adverse effects of local currency devaluation that are related to the
high inflation.
(iv) Transfer prices may be set high for goods and services purchased by
an affiliate operating in a country that has imposed restriction on the
repatriation of income to foreign companies.

8.34
 Transfer Pricing

(v) Transfer prices may be set low for an affiliate that is trying to
establish a competitive advantage over a local company either to
break into a market or to establish a higher share of the company’s
business.

EXERCISE
Question 1
In transfer pricing what is common conflict between a division and the company
as a whole.
Answer
Refer Chapter 8: Paragraph: 8.4
Question 2
A Company has two Division, Division ‘A’ and Division ‘B’. Division ‘A’ has a
budget of selling 2,00,000 nos. of a particular component ‘x’ to fetch a return of
20% on the average assets employed. The following particulars of Division ‘A’
are also known:
Fixed Overhead Rs.5 lakhs
Variable Cost Re.1 per
unit
Average Assets
Sundry Debtors Rs.2 lakhs
Inventories Rs.5 lakhs
Plant & Equipments Rs.5 lakhs
However, there is constraint in Marketing and only 1,50,000 units of the
component ‘x’ be directly sold to the proposed price.
It has been gathered that the balance 50,000 units of component ‘x’ can be taken
up by Division ‘B’ Division ‘A’ wants a price of Rs.4 per unit of ‘x’ but Division ‘B’
is prepared to pay Rs.2 per unit of ‘x’.
Division ‘A’ has another option in hand, which is to produce only 1,50,000 units of
component ‘x’. This will reduce the holding of assets by Rs.2 lakhs and fixed
overhead by Rs.25,000. You are required to advise the most profitable course of
action for Division ‘A”. Answer
Most Profitable Course of Action: Sale to market and transfer to division B.
Question 3

8.35
Advanced Management Accounting

Enumerate and briefly explain any three methods of determining transfer price.
Answer
Refer Chapter 8: Paragraph: 8.3.1
Question 4
A company is organized on decentralized lines, with each manufacturing division
operating as a separate profit centre. Each division manager has full authority to
decide on sale of the division’s output to outsiders and to other divisions.
Division C has always purchased its requirements of a component from Division
A. But when informed that Division A was increasing its selling price to Rs.150,
the manger of Division C decided to look at outside suppliers.
Division C can buy the component from an outside supplier for Rs.135. But
Division A refuses to lower its price in view of its need to maintain its return on
the investment.
The top management has the following information:
C’s annual purchase of the component 1,000 units A’s variable costs per unit
Rs.120 A’s fixed cost per unit Rs.20
Required:
(i) Will the company as a whole benefit, if Division C bought the component at
Rs.135 from an outside supplier?
(ii) If A did not produce the material for C, it could use the facilities for other
activities resulting in a cash operating savings of Rs.18,000. Should C then
purchase form outside sources?
(iii)
Suppose there is no alternative use of A’s facilities and the market price
per unit for the component drops by Rs.20. Should C now buy from
outside?
Answer
(i) Net cost (benefit) to the company as a whole Rs.
15,000
(ii) Net cost (benefit) to the company as a whole Rs.
(3,000) (iii) Net cost (benefit) to the company
Rs. (5,000)
Question 5
Division Z is a profit centre, which produces four products A, B, C and D. Each
product is sold in the external market also. Data for the period is as follows:

8.36
 Transfer Pricing

A B C D
Market Price per unit Rs.150 Rs.146 Rs.140 Rs.130
Variable cost of Production per Unit Rs.130 Rs.100 Rs.90 Rs.85
Labour Hours required per Unit 3 4 2 3
Product D can be transferred to division Y but the maximum quantity that might
be required for transfer is 2,500 units of D. The maximum sales in the external
market are:
A 2,800
units
B 2,500
units
C

2,300
units
D 1,600 units
Division Y can purchase the same product at a slightly cheaper price of Rs.125
per unit instead of receiving transfers of product D from division Z.
What should be transfer price for each unit for 2,500 units of D, if the total labour
hours available in division Z are:
(i) 20,000 hours? (ii)
30,000 hours?
Answer (i)
2,500 units of Per unit of
product D Product D
Transfer price 2,95,850 118.34
(ii)

2,500 units of Per unit of

product D Product D
Transfer price 2,47,833.20 99.13

8.37
Advanced Management Accounting

Question 6
City Instrument Company (CIC) consists of the Semi-conductor Division and the
Minicomputer Division, each of which operates as an independent profit centre.
Semiconductor Division employs craftsmen, who produce two different electronic
components, the new – high performance Super chip and an older product called
Okay-chip. These two products have the following cost characteristics:
Super-chip Okay-chip
Material Parts Rs.20 Parts Rs.10
Labour 2 hours × Rs.140 280 ½ hours × Rs.140 70
Annual Overhead in Semi-conductor Division is Rs.40,00,000 all fixed. Owing to
high skill level necessary for the craftsmen, the Semi-conductor Divisions
capacity is set at 50,000 hours per year.
To date, only one customer has developed a product utilizing super-chip, and this
customer orders a maximum of 15,000 super-chips per year at a price of Rs.600
per chip. If CIC cannot meet his entire demand, the customer curtails his own
production. The rest of the semi-conductor’s capacity is devoted to Okay-chips,
for which there is unlimited demand at Rs.120 per chip.
The Mini-computer Division produces only one product, a process control unit,
which requires a complex circuit board imported at a price of Rs.600. The control
units costs are:
Control Unit
Material Circuit board Rs.600
Other parts 80
Labour 5 hours @ Rs.100 500
The Mini-computer Division is composed of only a small assembly plant and all
overhead is fixed at a total of Rs.8,00,000 per year. The current market price for
the control unit is Rs.1,400 per unit.
A joint research project has just revealed that with minor modifications, a single
supership could be substituted for the circuit board currently used by the Mini-
computer Division. The modification would require an extra one-hour of labour by
Mini-computer’s staff, for a total of 6 hours per control unit. Mini-Computer has
therefore asked Semiconductor division to declare a transfer price at which
Semi-conductor division would sell super-chip internally.
Required:

8.38
 Transfer Pricing

(i) Mini-computer expects to sell 5,000 control units this year .From the overall
view point of CIC, how many super-chips should be transferred to Mini-
computer Division to replace circuit boards?
(ii) If the demand for the control units is sure to be 5,000 units, but its price is
uncertain, what should be the transfer price of super-chip to ensure proper
decisions? (All other data unchanged)
(iii) If demand for the control unit rises to 12,000 units at a price of Rs.1,400
per unit, how many of 12,000 units should be built using super-chip? (All
other data unchanged.)
Answer
1. Contribution per hour of Super-chips and Okay-chips:
Super-chips Okay-chips
Contribution per hour 150 80
2. hours utilized in meting the demand of 15,000 units of Super-chips and
utilizing the remaining hours for Okay-chips out of available hours of
50,000 per annum:
50000 Hours
3. Contribution of a process control unit (using an imported complex circuit
board):
Contribution per unit (Rs.) : 220
4. Contribution of process control unit (using a Super-chips):
Contribution per unit (Rs.) : 420
Question 7
A Company is organised into two divisions. Division X produces a component,
which is used by division Y in making of a final product. The final product is sold
for Rs540 each. Division X has capacity to produce 2,500 units and division Y
can purchase the entire production. The variable cost of division X in
manufacturing each component is Rs256.50. Division X informed that due to
installation of new machines, its depreciation cost had gone up and hence
wanted to increase the price of component to be supplied to division Y to Rs297 ,
however division Y can buy the component from out side the market at Rs270
each. The variable cost of division Y in manufacturing the final product by using
the component is Rs202.50 (excluding component cost).
Present the statement indicating the position of each Division and the company
as whole taking each of the following situations separately:

8.39
Advanced Management Accounting

(i) If there is no alternative use for the production facility of X, will the
company benefit, if division Y buys from out side suppliers at Rs270 per
component.
(ii) If internal facilities of X are not otherwise idle and the alternative use of the
facilities will bring an annual cash saving of Rs50,625 to division X, should
division Y purchase the component from outside suppliers ?
(iii) If there is no alternative use for the production facilities of division X and
the selling price for the component in the outside market drops by Rs20.25,
should division Y purchase from outside supplier?
(iv)What transfer price would be fixed for the component in each of the above
circumstances?
Answer
(i) When component is purchased by division Y from outside
Total contribution Rs. 1,68,750
When component is purchased from division X
Total contribution Rs. 2,02,500
(ii) When there is alternative use of Division X with given cash saving
Company’s total contribution Rs. 2,19,375
(iii) When there is no alternative use of Division X & selling price of
component reduces in the market
Total contribution Rs. 2,19,375
(iv) Transfer price
(a) Where there is no alternative use of capacity of division X, then
variable cost
i.e. Rs256.50 per component will be charged.
(b) If facilities of division X can be put to alternative use then variable
cost Rs256.50+ opportunity cost Rs20.25 =Rs276.75 will be transfer
price.
(c) If market price gets reduced to Rs. 249.75 and there is no alternative
use of facilities of Division X the variable cost Rs256.50 per
component should be charged.

8.40
 CHAPTER 9

UNIFORM COSTING AND INTER FIRM

COMPARISON

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Uniform Costing
When several undertakings start using the same costing principles and/or
practices they are said to be following uniform costing. The basic idea
behind uniform costing is that the different concerns in an industry should
adopt a common method of costing and apply uniformly the same
principles and techniques for better cost comparison and common good.
2. Objectives of Uniform Costing
i. Facilitates Comparison ii. Eliminates Unhealthy Competition iii.
Improves Efficiency iv. Provides Relevant Data
v. Ensures Standardisation vi.
Reduces Cost
3. Inter-Firm Comparison
It is technique of evaluating the performance, efficiency, costs and profits
of firms in an industry. It consists of voluntary exchange of infor-
mation/data concerning costs, prices, profits, productivity and overall
efficiency among firms engaged in similar type of operations for the
purpose of bringing improvement in efficiency and indicating the
weaknesses.
4. Requisites of inter-firm comparison system
i. Centre for Inter-Comparison
ii. Membership
iii. Nature of information to be collected
iv. Method of Collection and presentation of information
Question 1
What are the requisites for the installation of a uniform costing system ?
Answer
Requisites for the installation of uniform costing: Essential requisites for the
installation of uniform costing are as under:
Advanced Management Accounting

(i) The firm’s in the industry should be willing to share / furnish relevant data
or information.
(ii) A spirit of cooperation and mutual trust should prevail among the
participating firms.
(iii) Mutual exchange of ideas, methods used, special achievement made,
research and know how etc. should be frequent.
(iv) Bigger firms should take the lead towards sharing their experience and
know how with the smaller firm to enable the latter to improve their
performance.
(v) In case of accounting methods, principles, procedure and production
method uniformity must be established.
Question 2
What is uniform costing? Why is it recommended?
Answer
Uniform Costing: It is not a distinct method of costing when several
undertakings start using the same costing principles or practices, they are said to
be following uniform costing. Different concerns in an industry should adopt a
common method of costing and apply uniformly the same principles and
techniques for better cost comparison and common good and helps in mutual
cost control and cost reduction. Hence, it is recommended that a uniform method
of costing should be adopted by the member units of an industry.

9.2
Uniform Costing & Inter Firm Comparison

EXERCISE
Question 1
What is inter-firm comparison and requisites of inter-firm comparison system?
Answer
Refer Chapter: 9 Paragraph: 9.2

Question 2
State the limitations of uniform costing.
Answer
Refer Chapter: 9 Paragraph: 9.1.4
Question 3
What are the advantages of inter firm comparison.
Answer
Refer Chapter: 9 Paragraph: 9.2.2

9.3
 CHAPTER 10

COST SHEET, PROFITABILITY ANALYSIS

AND COMPARISON

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Cost Sheet
A Cost Sheet or Cost Statement is “a document which provides for the
assembly of the detailed.
2. Cost of a Cost Centre
Cost of a Cost Centre or Cost Unit”. It is a detailed statement depicting the
subdivision of cost arranged in a logical order under different heads.
3. Market driven standard costs
The allowable or target cost per unit is a market driven standard cost that
has to be met if the desired profit are to be achieved.
4. Direct product profitability (DPP)
This is a new way of spreading overheads in retail organisations, which is
used in the grocery trade in particular. DPP has become much more
sophisticated and is now very similar to activity-based costing.
5. Categorisation of Indirect Costs for DPP
i. Overhead cost ii.
Volume related cost iii.
Product batch cost iv.
Inventory financing costs
6. Customer profitability analysis
This is a relatively new technique that ABC makes possible because it
creates cost pools for activities. Customers use some activities but not all,
and different groups of customers have different ‘activity profiles’.Different
customers or
Advanced Management Accounting

categories of customers will each use different amounts of these activities

and so customer profitability profiles can be built up, and customers can
be charged according to the cost to serve them.
7. The Balanced Scorecard
The Balanced Scorecard can be defined as ‘an approach to the provision
of information to management to assist strategic policy formulation and
achievement’. It emphasizes the need to provide the user with a set of
information, which addresses all relevant areas of performance in an
objective and unbiased fashion.
Question 1
“Costs may be classified in a variety of ways according to their nature and the
information needs of the management” Explain.

Answer
Cost classification is the process of grouping costs according to their
characteristics. Costs are classified or grouped according to their common
characteristics. Costs may be classified according to elements, according to
functions or operations, according to their behaviour, according to controllability
or according to normality.
The break up of the aggregate costs into relevant types, is an essential pre-
requisite of decision making as well as of controlling costs. Classification of costs
on different bases is thus necessary for various purposes. For the purpose of
decision-making and control, costs are distinguished on the basis of their
relevance to different type of decisions and control functions. The importance of
distinguishing cost as direct or indirect lies in the fact that direct costs of a
product or an activity can be accurately allocated while indirect costs have to be
apportioned o the basis of certain assumptions. This is so because direct costs
are controllable at the operational level whereas indirect costs are not amenable
to such control.
Question 2
A company produces and sells four types of dolls for children. It also produces
and sells a set of dress kit for the dolls.
The company has worked out the following estimates fort the next year:
Doll Estimated Standard Standard Estimated
Demand Material Cost Labour Cost Sales Per
Unit
(Rs.) Rs. ( Rs. )

10.2
 Cost Sheets, Profitability Analysis and Comparison

A 50,000 20 15 60
B 40,000 25 15 80
C 35,000 32 18 100
D 30,000 50 20 120
Dress Kit 2,00,000 15 5 50
To encourage the sale of dress kits, a discount of 20% in its price is offered if it
were to be purchased along with the doll. It is expected that all the customer,
buying dolls will also buy the dress kit.
The company’s factory has effective capacity of 2,00,000 labour hours per
annum on a single-shift basis and it produces all the products on that basis. The
labour hour rate is Rs.15 Overtime of labour has to be paid at double the normal
rate.
Variable cost works out to 50% of direct labour cost. Fixed costs are Rs.30 lakhs
per annum.
There will be no inventory at the end of the year.
You are to draw a conservative estimate of the year’s profitability.
Answer
Working notes:
1. Total labour hours required to meet estimated demand of four types of dolls
and their dress kit:
Doll Estimated *Std labour Total labour
Demand (units) time per doll hours
(a) (b) (c) (d) = (b) ×
(c)
A 50,000 1 hr 50,000.00
B 40,000 1 hr 40,000.00
C 35,000 1.2 hrs 42,000.00
D 30,000 1.33 hrs 40,000.00
Dress Kit 2,00,000 0.33 hrs 66,666,66
Total labour hours to meet estimated demand 2,38,666,66
*Standard labour time per doll has been calculated by dividing standard
labour cost (per doll) by Rs.15.
Since the total available hours are only 2,00,000 therefore 38,666.66 hours
will be utilised by employing the labour on overtime basis.
2. Total discount on the sale of dress kit.

10.3
Advanced Management Accounting

Out of 2,00,000 dress kits, 1,55,000 were sold along with four type of dolls.
Each unit of sale of dress kit along with a unit of doll is entitled for a
discount of 20% of Rs.50 i.e. Rs.10. The total discount amount on the sale
of 1,55,000 dress kit comes to Rs.15,50,000.
Statement of Conservative Estimate of the Year’s Profitability

Doll A Doll B Doll C Doll D Dress Kit

Estimated demand 40,000 35,000 30,000 2 , 00,000
50,000
(units)
Rs. Rs. Rs. Rs. Rs.
Selling price per unit: (A) 60 80 100 120 50
Material cost per unit 20 25 32 50 15
Labour cost 15 15 18 20 5
Variable cost 6 6 7.20 8 2
*40% of labour cost ___ ___ ___ ___ ___
Total marginal cost: (B) 41 46 57.20 78 22
Contribution p.u. (C):{(A) 19 34 42.80 42 28
– (B)}
Total contribution 9,50,000 13,60,000 4,98,000 12,60,00 56 ,
0 00,000
On estimated demand (40000× (35000× (30000× (200000×
(50,000× Rs.34 Rs.42.80 Rs.42) Rs.28)
Rs.19)
Less: Discount on dress kits (15,50,00
0)
(Refer to working note 2)
Net contribution 9,50,000 13,60,000 4,98,000 12,60,00 40 ,
0 50,000
Total net contribution (Rs.) 91,18,000
Less: Overtime premium (Rs.) 5,80,000

(38,666,66 hrs × Rs.)15)

(Refer to working note 1)
Less: Fixed cost (Rs.) 30,00,000

10.4
 Cost Sheets, Profitability Analysis and Comparison

Profit (Rs.) 55,38,000

Question 3
What do you understand by a Balanced Scorecard? Give reasons why Balanced
Scorecards sometimes fail to provide for the desired results. Do you think that
such a scorecard is useful for external reporting purposes?
Answer
The Balanced Scorecard can be defined as ‘an approach to the provision of
information to management to assist strategic policy formulation and
achievement. It emphasises the need to provide the user with a set of
information, which addresses all relevant areas of performance in an objective
and unbiased fashion. The information provided may include both financial and
non financial elements, and cover areas such as profitability, customer
satisfaction, internal efficiency and innovation’.
It is clear from the above definition that the central idea of the Balanced
Scorecard is that managers should develop the measures on which they manage
the business from four different perspectives:
1. customer satisfaction
2. internal business process e.g., operating cycle time.
3. kaizen approach (can we continue to improve and create value)
4. financial e.g., operating income by segments.

10.5
Advanced Management Accounting

The following figure summarises the ideas of a Balanced Scorecard:

FINANCIAL PERSPECTIVE

Goals and Measures

(How do we look to our
shareholders?)

CUSTOMER INTERNAL BUSINESS

PERSPECTIVE PERSPECTIVE
VISION &
Goals and Measures
(How are we looked upon Goals and Measures
STRATEGY
by customers?) (What should we excel at?)

INNOVATION & LEARNING

PERSPECTIVE

Goals and Measures

(Is it possible for us to continuously
improve and create values?)

According to Kaplan and Norton, the ultimate result of using the Balanced
Scorecard approach should be an improved long-term financial performance.
Since the scorecard gives equal importance to the relevant non – financial
measures, it should discourage the short termism that leads to cuts in spending
on new product development, human resource development etc which are
ultimately detrimental for the future prospects of the company.
The responsibility to devise and implement a Balanced Scorecard should be that
of the managers working with the business. Since every company is different, it
shall need to work out for itself the various financial and non – financial
measures, which need to be focussed upon for its own development. Since the
Balanced Scorecard is recommended as a management tool used both for
internal and external reporting purposes, it is again the manager’s responsibility
to decide as to what information needs to be disclosed and how any problems of
confidentiality can best be overcome.
The following are some reasons why Balanced Scorecards sometimes fail to
provide for the desired results;
• The use of non financial measures leads managers to think that they have
a Balanced Scorecard already working for strategic purposes.
• Senior executives misguidedly delegate the responsibility of the Scorecard
implementation to middle level managers.

10.6
 Cost Sheets, Profitability Analysis and Comparison

• Company’s try to copy measures and strategies used by the best

companies rather than developing their own measures suited for the
environment under which they function.
• There are times when Balanced Scorecards are thought to be meant for
reporting purposes only. This notion does not allow a Business to use the
Scorecard to manage Business in a new and more effective way.
It may be noted that the above-mentioned difficulties refer to the internal use of
the Scorecard. It remains a matter of debate whether a Balanced Scorecard is
applicable to external reporting. Critics argue that if the Scorecard is indeed a
relevant driver of long term performance, shouldn’t the information generated be
of interest to the investment community? However, it has been noticed that the
Scorecard does not translate easily to the investment community for the simple
reason that it makes sense for individual business units and different individual
projects rather than the company as a whole. Most companies have different
divisions with their own mission and strategy and hence these individual
scorecards cannot be aggregated into an overall corporate scorecard. However,
in case the company somehow manages to overcome such a problem and
indeed use its Scorecard for external reporting, it may end up passing sensitive
information to its competitors which may end up being detrimental to the
company in the long run. However, with changes in the thinking process of the
investment community, such strategic reporting could well be accepted in the
near future.
For a further understanding of the concept, please refer to chapter 14 of the
Institute’s Cost Management book.
Question 4
Kitchen King company makes a high-end kitchen range hood ‘Maharaja’. The
company presents the data for the year 2007 and 2008:
2007 2008
1. Units or maharaja produced and sold 40,000 42,000
2. Selling Price per unit in Rs. 1,000 1,100
3. Total Direct Material (Square feet) 1,20,000 1 , 23,000
4. Direct material cost per square feet in Rs. 100 110
5. Manufacturing Capacity (in units) 50,000 50,000
6. Total Conversion cost in Rs. 1,00,00,000 1 ,10,
00,000
7. Conversion cost per unit of capacity (6)/(5) 200 220
8. Selling and customer service capacity 300 customer 290

10.7
Advanced Management Accounting

customer
9. Total selling and customer service cost in Rs. 72,00,000 72 , 50,000
10. Cost per customer of selling and customer service 24,000 25,000
capacity (9)/(8)
Kitchen King produces no defective units, but it reduces direct material used per
unit in 2008. Conversion cost in each year depends on production capacity
defined in terms of Maharaja units that can be produced. Selling and Customer
service cost depends on the number of customers that the selling and service
functions are designed to support. Kitchen King has 230 customers in 2007 and
250 customers in 2008.
You are required
1. Describe briefly key elements that would include in Kitchen King’s Balance
Score Card.
2. Calculate the Growth, Price-recovery and productivity component that
explain the change in operating income from 2007 to 2008.
Answer
Kitchen King’s Score card should describe its product differentiation strategy. The
key points that should be included in its balance score card are:
• Financial Perspective – Increase in operating income by charging higher
margins on Maharaja.
• Customer Perspective – Market share in high-end kitchen range market
and customer satisfaction.
• Internal business Perspectives: Manufacturing quality, order delivery time,
on time delivery and new product feature added.
• Learning and Growth Perspective: Development time for designing new
end product and improvement in manufacturing process.
Operative Income:
(Amount in 000’ Rs.)
2007 2008
Revenue (40,000 ×1,000: 42,000 × 1,100) 40,000 46,20
0
Direct Material 12,000 13,53
0
Conversion cost 10,000 11,00
0
Selling and Customer service 7,200 7,250

10.8
 Cost Sheets, Profitability Analysis and Comparison

Total cost 29,200 31,78

0
Operative Income 10,800 14,42
0
Change in operating Income is Rs. 36,20,000 (F)
A. Growth Component
(a) Revenue effect = Output Price in 2007 {Actual units sold in 08 –
Actual units sold in 07}
= Rs. 1, 000 (42,000 units – 40,000 units)
= Rs. 20, 00,000 (F)
(b) The cost effect = Input price in 2007 {Actual units of input to produce
2007 output less Actual units of input which would have been used to
produce year 2008 output on the basis of 2007}
(i) Direct Material = Rs. 100 [1, 20,000 sq.ft. – 1, 20,000 sq.ft.
× 42,000 units ]
40,000 units
= Rs. 6,00,000 (A)
(ii) Conversion cost and selling and customer service will not
change since adequate capacity exists in 2007 to support 2008
output and customers. Hence variance
Conversion cost = 200 (50,000 – 50,000)
= 0 S & Customer Service = 25,000 (300 – 300)
=0
Increase in operating effect of Growth component is Rs.
14,00,000 (F) B. Price recovery Component:

(i) Revenue effect = Actual output in 2008 [Selling price per unit in 2008
less Selling price per unit in 2007] = 42,000 units (Rs. 1,100 – Rs.
1,000)
= Rs. 42,00,000 (F)
(ii) Cost effect = Unit of input based on 2007 actual that would have
been used to produce 2008 output {Input prices per unit in 2007 less
Input prices per unit in 2008}
(a) Direct material = 1,26,000 sq. ft. (Rs. 100/sq. ft. – Rs.
110/sq. ft.)
= Rs. 12, 60,000 (A)

10.9
Advanced Management Accounting

(b) Conversion Cost = 50,000 units (Rs. 200/unit – Rs. 220/unit)

= Rs. 10,00,000 (A)
(c) S & Customer Service = 300 customers (Rs. 24,000 – Rs.
25,000)
= Rs. 3,00,000 (A)
= Rs. 25,60,000 (A)
Increase in Operating income due to Price Recovery is Rs. 16,40,000
(F) {Rs. 42,00,000 – Rs. 25,60,000}
(C) Productivity Component
Productivity component = Input Prices in 08{Actual units of input which
would have been used to produce year 2008 output on the basis of 2007
actual less Actual
Input}
(i) Direct Material: Rs. 110/sqft
(1,26,000 units – 1,23,000 units) = Rs. 3,30,000 (F)
(ii) Conversion Cost: Rs. 200/unit
(50,000 units – 50,000 units) =0
(iii) Selling & Customer = Rs. 25,000
(300 customers – 290 customers) = Rs. 2,50,000 (F)
= Rs.
5,80,000 (F)
The change in operating income from 2007 to 2008 is analysed as follows:
(Amount in 000’ Rs.)
2007 Growth Price Cost effect of 2008
component recovery productivity
component
Revenue 40,000 2,000 (F) 4,200 (F) ─ 46,200
Cost 29,200 600 (A) 2,560 (A) 580 (F) 31,780
Operating Income 10,800 1,400(F) 1,640 (F) 580 (F) 14,420
Question 5
EXE Wood Company is a metal and woodcutting manufacturer, selling products
to the home construction market. Consider the following data for 2008:
Rs.

10.10
 Cost Sheets, Profitability Analysis and Comparison

Sandpaper 1,000
Materials-handling costs 35,000
Lubricants and coolants 2,500
Miscellaneous indirect manufacturing labour 20,000
Direct manufacturing labour 1 , 50,000
Direct materials inventory, Jan. 1, 2008 20,000
Direct materials inventory, Dec. 31, 2008 25,000
Finished goods inventory, Jan. 1, 2008 50,000
Finished goods inventory, Dec. 31, 2008 75,000
Work in process inventory, Jan. 1, 2008 5,000
Work in process inventory, Dec. 31, 2008 7,000
Plant-leasing costs 27,000
Depreciation – plant equipment 18,000
Property taxes on plant equipment 2,000
Fire insurance on plant equipment 1,500
Direct materials purchased 2 , 30,000
Revenues 6 , 80,000
Marketing promotions 30,000
Marketing salaries 50,000
Distribution costs 35,000
Customer-service costs 50,000
Required:
1. Prepare an income statement with a separate supporting schedule of cost
of goods manufactured. For all manufacturing items, classify costs as direct
costs or indirect costs and indicate by V or F whether each is basically a
variable cost or a fixed cost (when the cost object is a product unit). If in
doubt, decide on the basis of whether the total cost will change
substantially over a wide range of units produced.
2. Suppose that both the direct material costs and the plant-leasing costs are
for the production of 4,50,000 units. What is the direct material cost of each
unit produced ? What is the plant-leasing cost per unit ? Assume the plant-
leasing cost is a fixed cost.

10.11
Advanced Management Accounting

3. Suppose EXE Wood Company manufactures 5,00,000 units next year.

Repeat the computation in requirement 2 for direct materials and plant-
leasing costs. Assume the implied cost-behaviour patterns persist.
Answer
1. EXE Wood Company
Income Statement
For the year ended December 31, 2008
Rs. Rs.
Revenues 6 , 80,000
Cost of goods sold:
Beginning finished goods, January 1, 50,000
2008
Cost of goods manufactured (see 4,80,000
schedule below)
Cost of goods available for sale 5,30,000
Deduct ending finished goods, December 75,000 4 , 55,000
31, 2008
Gross margin (or gross profit) 2,
Operating costs 25,000
Marketing promotions 30,000 Marketing salaries
50,000 Distribution costs 35,000

Customer-service costs 50,000 1,

65,000
Operating income 60,000

EXE Wood Company

Schedule of Cost of Goods
Manufactured For the year ended
December 31, 2008
Rs. Rs.
Direct materials:
Beginning inventory, January 1, 2008 20,000
Purchases of direct materials 2,
30,000

10.12
 Cost Sheets, Profitability Analysis and Comparison

Cost of direct materials available for use 2,

50,000
Ending inventory, December 31, 2008 25,000
Direct materials used 2 ,25,000
(v )
Direct manufacturing labour 1 ,50,000
(v )
Manufacturing overhead costs:
Sandpaper 1,000 (v)
Materials-handling costs 35,000 (v)
Lubricants and coolants 2,500 (v)
Miscellaneous indirect manufacturing 20,000 (v)
labour
Plant-leasing costs 27,000 (F)
Depreciation – plant equipment 18,000 (F)
Property taxes on plant equipment 2,000 (F)
Fire insurance on plant equipment 1,500 (F) 1,
07,000
Manufacturing costs incurred during 2007 4,
82,000
Beginning work in process, January 1, 2007 5,000
Total manufacturing costs to account for 4 , 87,000
Ending work in process, December 31, 2007 7,000
Cost of goods manufactured (to income statement) 4 , 80,000
2. Direct material unit cost = direct
materials used ÷ Units produced
= Rs. 2,25,000 ÷ 4,50,000 units = Re. 0.50
per unit
Plant-leasing unit cost = Plant-leasing costs ÷ Units produced
= Rs. 27,000 ÷ 4,50,000 units = Re. 0.06
per unit
3. The direct material costs are variable, so
they would increase in total from Rs.
2,25,000 to Rs. 2,50,000 (5,00,000 units ×
Re. 0.50 per unit). However, their unit cost
would be unaffected: Rs. 2,50,000 ÷

10.13
Advanced Management Accounting

5,00,000 units = Re. 0.50 per unit. In

contrast, the plant-leasing costs of Rs.
27,000 are fixed, so they would not increase
in total. However, the plant leasing cost per
unit would decline from Re. 0.060 to Re.
0.054: Rs. 27,000 ÷ 5,00,000 units = Re.
0.054 per unit.
Note: All the Questions are arranged in a sequence as per the syllabus of
‘Advanced Management Accounting’ (AMA) [Paper 5 of Final (New)
Course]. This RTP contains chapter name followed by the topic against
each theory/practical question

EXERCISE
Question 1
The trading results of ZED Ltd. for 1995-96 and 1996-97 are as follows:
1995-96 1996-
Rs. 97 Rs.
Material 1,60,000 2 ,
05,200
Wages 96,000 1 ,
32,000
Variable Overheads 40,000 46,00
0
Fixed Overheads 50,000 54,80
0
Total Costs 3,46,000 4 ,
38,000
Profit 54,000 90,00
0
Sales 4,00,000 5 ,
28,000
Selling price was enhanced by 10% 1996-97. Material prices and wage rates too
have increased by 8% respectively.
Prepare a statement showing how much each factor has contributed to the
variation in profit.
Answer
2. Rise in the figure of sales volume in 1996-97 =Rs.80,000
3. Percentage rise in the figure of sales volume in 1996-97 = 20%

10.14
 Cost Sheets, Profitability Analysis and Comparison

4. Increase in material prices in 1996-97 due to 8% price increase =

Rs.15,200
5. Increase in wages due to 10% increase in wage rates = Rs.12,000
Question 2
“Balanced score card and performance measurement system endeavours to
create a blend of strategic measures, outcomes and drive measures and internal
and external measures”. Discuss the statement and explain the major
components of a balanced score card.
Answer
Refer to Chapter 10: Paragraph 10.4
Question 3
What are the elements of a Balanced Score card? Also explain how it can be
used as a Financial Planning model.
Answer
Refer to Chapter 10: Paragraph: 10.4

10.15
 CHAPTER 11

LINEAR PROGRAMMING

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Linear Programming
Linear programming is a mathematical technique for determining the
optimal allocation of re- sources nd achieving the specified objective when
there are alternative uses of the resources like money, manpower,
materials, machines and other facilities.
2. Categories of the Linear Programming Problems
i. General Linear Programming Problems.
ii. Transportation Problems.
iii. Assignment Problems.
3. Methods of Linear Programming
i. Graphical Method ii. Simplex Method
4. Graphical Method
It involves the following:
i. Formulating the linear programming problem ii. Plotting the capacity
constraints on the graph paper.
iii. Identifying feasible region and coordinates of corner points.
iv. Testing the corner point which gives maximum profit.
v. For decision – making purpose, sometimes, it is required to know
whether optimal point leaves some resources unutilized.
5. Extreme Point Theorem
It states that an optimal solution to a LPP occurs at one of the vertices of
the feasible region.
6. Basis theorem
It states that for a system of m equations in n variables (where n > m) has
a solution in which at least (n-m) of the variables have value of zero as a
vertex. This solution is called a basic solution.
Advanced Management Accounting

7. The Simplex Method

The simplex method is a computational procedure - an algorithm - for
solving linear programming problems. It is an iterative optimizing
technique.
8. The Simplex Method for Minimization and Maximization Problems
The simplex algorithm applies to both maximization and minimization
problems. The only difference in the algorithm involves the selection of the
incoming variable.In the maximization problem the incoming variable is the
one with highest +ve net evaluation row (NER) element. Conversely, it is
the most – ve variable that is selected as the incoming variable in a
minimization problem. And if all elements in the NER are either positive or
zero, it is the indication for the optimal solution.
9. Practical Application of Linear Programming
1. Industrial Application: To derive the optimal production and
procurement plan for specific time period.
2. Administrative Application: in both academic circles and the area of
business operations.

Question 1
A farm is engaged in breeding pigs. The pigs are fed on various products grown
in the farm. In view of the need to ensure certain nutrient constituents (call them
X, Y and Z), it becomes necessary to buy two additional products say, A and B.
One unit of product A contains 36 units of X, 3 units of Y and 20 units of Z. One
unit of product B contains 6 units of X, 12 units of Y and 10 units of Z. The
minimum requirement of X, Y and Z is 108 units, 36 units and 100 units
respectively. Product A costs Rs.20 per unit and product B Rs.40 per unit.
Formulate the above as a linear programming problem to minimize the total cost
and solve this problem by suing graphic method.
Answer
The data of the given problem can be summarized as under:
Nutrient constituents Nutrient content in product Minimum
requirement
of nutrient
A B
X 36 06 108

11.2
 Linear Programming

Y 03 12 36
Z 20 10 100
Cost of product Rs.20 Rs.40
Let x1 units of product A and x2 units of product B are purchased. Making use of
the above table, the required mathematical formulation of L.P. problem is as
given below:

Minimize Z = 20x1 + 40x2 subject to the constraints

36x1 + 6x2 ≥ 108
3x1 + 12x2 ≥ 36
20x1 + 10x2 ≥ 100
and x1, x2 ≥ 0
For solving the above problem graphically, consider a set of rectangular axis
x1ox2 in the plane. As each point has the coordinates of type (x 1, x2), any point
satisfying the conditions x1 ≥ 0 and x2 ≥ 0 lies in the first quadrant only.
The constraints of the given problem as described earlier are plotted by treating
them as equations:
36x1 + 6x2 = 108
3x1 + 12x2 = 36
20x1 + 10x2 = 100

11.3
Advanced Management Accounting

Or

x 1 + x2 = 1

2 18

x 1 + x2 = 1

12 3

x 1 + x2 = 1

5 10
The area beyond these lines represents the feasible region in respect of these
constraints, any point on the straight lines or in the region above these lines
would satisfy the constraints. The coordinates of the extreme points of the
feasible region are given by
A = (0,18), B = (2,6), C = (4,2) and D = (12,0)
The value of the objective function at each of these points can be evaluated as
follows:
Extreme Point (x1, x2) Z = 20x1 + 40x2
A (0,18) 720
B (2,6) 280
C (4,2) 160 Minimum
←
D (12,0) 240
The value of the objective function is minimum at the point C (4,2).
Hence, the optimum solution in to purchase 4 units of product A and 2 units of
product B in order to have minimum cost of Rs.160.
Question 2
A Computer Company produces three types of models, which are first required to
be machined and then assembled. The time (in hours) for these operations for
each model is give below:

Model Machine Time Assembly Time

11.4
 Linear Programming

P III 20 5
P II 15 4

Celeron 12 3
The total available machine time and assembly time are 1,000 hours and 1,500
hours respectively. The selling price and other variable costs for three models
are:
P III P II Celeron
Selling Price (Rs.) 3,000 5,000 15,000
Labour, Material and
other Variable Costs (Rs.) 2,000 4,000 8,000
The company has taken a loan of Rs.50,000 from a Nationalised Bank, which is
required to be repaid on 1.4.2001. In addition, the company has borrowed
Rs.1,00,000 from XYZ Cooperative Bank. However, this bank has given its
consent to renew the loan. The balance sheet of the company as on 31.3.2001 is
as follows:

Liabilities Rs. Assets Rs.

Equity Share Capital 1,00,000 Land 80,00
0
Capital reserve 20,000 Buildings 50,00
0
Profit & Loss Account 30,000 Plant & Machinery 1 ,
00,000
Long-term Loan 2,00,000 Furniture etc. 20,00
0
Loan from XYZ Cooperative 1,00,000 Cash 2 ,
10,000
Bank
Loan from Nationalized Bank 50,000
Total 5,00,000 Total 5,00,000

The company is required to pay a sum of Rs.15,000 towards the salary. Interest
on longterm loan is to be paid every month@ 18% per annum. Interest on loan
from XYZ Cooperative and Nationalised Banks may be taken as Rs.1,500 per
month. The company has already promised to deliver three P III, Two P II and

11.5
Advanced Management Accounting

five Celeron type of computers to M/s. ABC Ltd. next month. The level of
operation I the company is subject to the availability of cash next month.
The Company Manager is willing to know that how many units of each model
must be manufactured next month, so as to maximize the profit.
Formulate a linear programming problem for the above.
Answer
Let X1, X2 and X3 denote the number of P III, P II and Celeron computers
respectively to be manufactured in the company. The following data is given:
P III P II Celeron
Selling price per unit (Rs.) 3,000 5,000 15,000
Labour Material & other 2,000 4,000 8,000
Variable cost per unit (Rs.)
Profit per unit (Rs.) 1,000 1,000 7,000
Since the company wants to maximize the profit, hence the objective function is
given by:
Maximize Z = 1,000X1 + 1,000X2 + 7,000X3 –
(Rs.15,000+3,000+Rs.1,500)
From the data given for time required for various models and the total number of
hours available for machine time and assembly time, we get the following
constraints:
20X1 + 15X2 + 12X3 ≤ 1,000 (Machine Time Restriction)
5X1 + 4X2 + 3X3 ≤ 1,500 (Assembly Time Restriction)
The level of operations in the company is subject to availability of cash next
month i.e.; the cash required for manufacturing various models should not
exceed the cash available for the next month.
The cash requirements for X1 units of P III, X2 units of P II and X3 units of Celeron
computers are:
2,000 X1 + 4,000 X2 + 8,000 X3
……(1)
The cash availability for the next month from the balance sheet is as below:
Cash availability (Rs.) = Cash balance (Rs.2,10,000)
- Loan to repay to Nationalized Bank
(Rs.50,000)

11.6
 Linear Programming

- Interest on loan from XYZ Cooperative bank and Nationalized bank

(Rs.1,500)
- Interest on long term loans
 0.18×2,00,000  
 12 
- Salary to staff (Rs.15,000)
or, Cash availability = Rs.2,10,000 –
(Rs.50,000 + Rs.1,500 + Rs.3,000 +15,000)
= Rs.1,40,500 ……(2)
Thus, from (1) and (2),
2,000 X1 + 4,000 X2 + 8,000 X3 ≤ Rs.1,40,500
The company has also promised to deliver 3 P III, 2 P II and 5 Celeron
computers to M/s Kingspen Ltd.
Hence, X1 ≥ 3, X2 ≥ 2, X3 ≥ 5
The LP formulation of the given problem is as follows:
Maximize Z – 1,000 X1 + 1,000 X2 + 7,000 X3 – (Rs.15,000 + Rs.3,000 +
Rs.1,500) Subject to the constraints:
20 X1 + 15 X2 + 12X3 ≤ 1,000
5 X1 + 4 X2 + 3 X3 ≤ 1,500
2,000 X1 + 4,000 X2 + 8,000 X3 ≤ Rs.1,40,500
X1 ≥3, X2 ≥ 2, X3 ≥ 5
X1, X2 and X3 can take only positive integral values.
Question 3
Computer Company produces three types of models, which are first required to
be machined and then assembled. The time (in hours) for these operations for
each model is given below:

Model Machine Time Assembly Time

P III 20 5
P II 15 4

Celeron 12 3

11.7
Advanced Management Accounting

The total available machine time and assembly time are 1,000 hours and 1,500
hours respectively. The selling price and other variable costs for three models
are:
P III P II Celeron
Selling Price (Rs.) 3,000 5,000 15,000
Labour, Material and other Variable Costs 2,000 4,000 8,000

(Rs.) The company has taken a loan of Rs.50,000 from a Nationalised Bank,
which is required to be repaid on 1.4.2001. In addition, the company has
borrowed Rs.1,00,000 from XYZ Cooperative Bank. However, this bank has
given its consent to renew the loan. The balance sheet of the company as on
31.3.2001 is as follows:
Liabilities Rs. Assets Rs.
Equity share Capital 1,00,000 Land 80,000
Capital reserve 20,000 Buildings 50,000
Profit & Loss Account 30,000 Plant & Machinery 1,00,000
Long-term Loan 2,00,000 Furniture etc. 20,000
Loan from XYZ Cooperative 1,00,000 Vehicles 40,000
Bank
Loan from National Bank 50,000

Total 5,00,000 Total 5,00,000

The company is required to pay a sum of Rs.15,000 towards the salary. Interest
on longterm loan is to be paid every month @ 18% per annum. Interest on loan
from XYZ Cooperative Bank and Nationalised Bank may be taken as Rs.1,500
per month. The company has already promised to deliver thr ee P III. Two P II
and five Celeron Type of Computer of M/s ABC Ltd. next month. The leve l of
operation in the company is subject to the availability of cash next month.
The Company Manager is willing to know that how many units of each model
must be manufactured next month, so as to maximize the profit. Formulate the
linear programming problem for the above. Answer
Let x1, X2 and X3 denote the number of P III, P II and Celeron Computers
respectively to the manufactured in the company. The following data is given:

11.8
 Linear Programming

P III P II Celeron
Selling Price per unit (Rs.) 3,000 5,000 15,000
Labour, Material and other Variable Costs p.u. 2,000 4,000 8,000
(Rs.)
Profit per unit (Rs.) 1,000 1,000 7,000
From the data given for time required for various models and the total number of
hours available for machine time and assembly time, we get the following
constraints:
20x1 + 15x2 + 12x3 ≤ 1,000 (Machine Time Restriction)
5x1 + 4x2 + 3x3 ≤ 1,500 (Assembly Time Restriction)
The level of operations in the company is subject to availability of cash next
month i.e.; the cash required for manufacturing various models should not
exceed the cash available for the next month.
The cash requirements for x1 units of P III, x2 units of P II and x3 units of Celeron
computers are:
2,000x1 + 4,000 x2 + 8,000x3
…… (1)
The cash availability for the next month from the balance sheet is as below:
Cash availability (Rs.) Cash balance (Rs. 2,10,000)
Loan to repay to Nationalized bank (Rs. 50,000)
Interest on loan from XYZ cooperative bank and Nationalized bank (Rs.

1500) Interest on long term loans  0.18×122,00,000

Salary to staff (Rs. 15,000)

Or, Cash availability = Rs. 2,10,000-(Rs. 50,000 + Rs. 1,500+Rs. 3,000+Rs.
15,000)
= Rs. 1,40,500 ..…. (2)
Thus, from (1) and (2),
2000 X1 + 4000 X2 + X3 < Rs. 1,40,500
The company has also promised to deliver 3 P III, 2 P II and 5 Celeron
computers to M/s. Kingspen Ltd.

11.9
Advanced Management Accounting

Hence, X1 > 3, X2 > 2, X3 > 5

Since the company wants to maximize the profit, hence the objective function is
given by: Maximize Z = 1000X1 + 1000X2 + 7000X3- (Rs. 15000 + Rs. 3000 +
Rs. 1500) The LP formulation of the given problem is as follow:
Maximize Z=1000 X1+1000X2+7000 X3–(Rs. 15000+Rs.15000) Subject to the
constraints: 20X1 + 15X2 + 12X3 < 1000
5X1 + 4X2 + 3X3 < 1500
2000 X1 + 4000 x2 + 8000 X3 < Rs. 1,40,500
X1 > 3, X2 > 2, X3 > 5
X1, X2 and X3 can take only positive integral values.
Question 4
A manufacturing company produces two types of product the SUPER and
REGULAR. Resource requirements for production are given below in the table.
There are 1,600 hours of assembly worker hours available per week. 700 hours
of paint time and 300 hours of inspection time. Regular customers bill demand at
least 150 units of the REGULAR type and 90 units of the SUPER type. (8
Marks)
Table
Product Profit/contribution Rs. Assembly time Paint time Inspection time
Hrs. Hrs. Hrs.
REGULAR 50 1.2 0.8 0.2
SUPER 75 1.6 0.9 0.2
Formulate and solve the given Linear programming problem to determine
product mix on a weekly basis. Answer
Let x1 and x2 denote the number of units produced per week of the product
‘REGULAR’ and ‘SUPER’ respectively. Maximise Z =50 x1 + 75 x2
Subject to
1.2x1 + 1.6x2 ≤ 1,600 or 12x1 + 16x2 ≤ 16,000 -(i)
0.8 x1 +0.9 x2 ≤ 700 or 8 x1 + 9 x2 ≤ 7,000 -(ii)
0.2 x1 + 0.2 x2 ≤ 300 or 2 x1 + 2 x2 ≤ 3,000 -(iii)
X1 ≥ 150 -(iv)
x2 ≥ 90 -(v)

11.10
 Linear Programming

Let x1 = y1 + 150 x2 =y2 +

90 where y1 , y2 ≥ 0
Maximize Z = 50(y1+ 150) + 75 (y2 + 90) or , Z = 50y1 + 75y2 + 14,250
Subject to:
12(y1 + 150) + 16(y2 + 90) ≤
16,000 8(y1 + 150) + 9(y2 + 90) ≤
7,000 2(y1 + 150) + 2(y2 + 90) ≤
3,000
and y1 , y2 ≥ 0
Adding slack variables s1 , s2 , s3 , we get
Maximize Z= 50y1+75y2 +14,250 subject to
12y1+ 16y2 + s1 = 12,760
8y1 + 9y2 + s2 = 4,990
2y1 + 2y2 + s3 = 2,520
Table I
Cj 50 75 0 0 0
Cb y1 y2 s1 s2 s3
0 s1 12,760 12 16 1 0 0 12760/16
0 s2 4,990 8 9 0 1 0 4990/9
0 s3 2,520 2 2 0 0 1 2520/2
∆j -50 - 0 0 0
Table II 75

Cj 50 75 0 0 0
Cb y1 y2 s1 s2 s3
0 s1 3889 -20/9 0 1 -16/9 0
75 y2 554.44 8/9 1 0 1/9 0
0 s3 1411 2/9 0 0 -2/9 1

11.11
Advanced Management Accounting

∆j 50/3 0 0 75/9 0
Since all the elements in the index row are either positive or equal to zero, table II
gives an optimum solution which is y1 = 0 and y2 = 554.44
Substituting these values we get
x1 = 0+150 =150 x 2 = 90+554.44 =644.44 and the value
of objective function is
Z = 50 x 150 + 75 x 644.44
= Rs. 55,833
Question 5
A company manufactures two products A and B, involving three departments –
Machining, Fabrication and Assembly. The process time, profit/unit and total
capacity of each department is given in the following table:
Machining (Hours) Fabrication (Hours) Assembly (Hours) Profit
(Rs).

A 15 3 80

B 24 1 100

Capacity 720 1,800 900

Set up Linear Programming Problem to maximise profit. What will be the product
Mix at Maximum profit level ?
Answer
Maximize z = 80x + 100y subject to x + 2y ≤ 720
5x
+ 4y ≤ 1800
3x + y ≤ 900
x≥0y≥0

where x = No.
of units of A
y = No. of units of B

11.12
 Linear Programming

By the addition of slack variables s1, s2 and s3 the inequalities can be converted
into equations. The problems thus become
z = 80x + 100y subject to x + 2y + s1 = 720
5x + 4y +
s2 = 1800 3x
+ y +s3 = 900
80 100 0 0 0
Profit/unit Qty. X Y S1 S2 S3 and x
≥ 0, y ≥ 0, 720 Ι 2 1 0 0 s1 ≥ 0, s2 ≥
0, s3 ≥ 0
Table I: 1800 5 4 0 1 0
900 3 Ι 0 0 1
S1 0 720 = 360
2
S2 0 1800/4 = 450
S3 0 900/1 = 900
Net evaluation row 80 100 0 0 0
1800 – 720 ×4/2 = 360 900 - 720×1/2 = 540
5 – I×2 = 3 3 - 1× ½ = 5/2
4 – 2 × 2 =0 I – 2 ×1/2 = 0
0 - I×2 = - 2 0 – I ×1/2 =- 1/2
I - 0×2 = I 0 – 0 ×1/2 = 0
0 - 0×2 = 0 I- 0×1/2 = I
Table 2:
80 100 0 0 0
Program Profit/unit Qty. X Y S 1 S2 S3 Y 100 360 ½ I ½ 0 0 360÷1/2=720 S2 0

360 3 0 −2 1 0 360÷3=120 S3 0 540 5/2 0 −1/2 0 I 540÷5/2=216

Net evaluation row 30 0 −50 0 0

360 – 360 × 1/6 = 300 540 – 360 × 5/6 = 240

11.13
Advanced Management Accounting

½ - 3 ×1/6 = 0 5/2 –3 × 5/6 = 0

1- 0× 1/6=1 0 – 0 × 5/6 = 0
½ - -2 × 1/6 = 5/6 -1/2 - -2 ×5/6 = 7/6
0 – 1 ×1/6 = - 1/6 0 – 1 × 5/6 = -5/6
0 – 0 ×1/6 = 0 1-0 × 5/6 = 1
Table 3:
80 100 0 0 0
Program Profit/unit Qty. X Y S1 S2 S
3
Y 100 300 0 I 5/6 -1/6 0

X 80 120 I 0 −2/3 1/3 0

S3 0 240 0 0 7/6 -5/6 I

Net evaluation row 0 0 -500/6 +100/6

+160/3 -80/3
0

= =−
All the values of the net evaluation row of Table 3 are either zero or negative, the
optimal program has been obtained.
Here X = 120, y = 300 and the
maximum profit = 80×120 +
100× 300 = 9600 + 30,000

= Rs. 39,600.
Question 6
Three grades of coal A, B and C contains phosphorus and ash as impurities. In a
particular industrial process, fuel up to 100 ton (maximum) is required which
could contain ash not more than 3% and phosphorus not more than .03%. It is
desired to maximize the profit while satisfying these conditions. There is an
unlimited supply of each grade. The percentage of impurities and the profits of
each grade are as follows:
Coal Phosphorus (%) Ash (%) Profit in Rs. (per ton)

11.14
 Linear Programming

A .02 3.0 12.00

B .04 2.0 15.00
C .03 5.0 14.00
You are required to formulate the Linear-programming (LP) model to solve it by
using simplex method to determine optimal product mix and profit.
Answer
Let X1, X2 and X3 respectively be the amounts in tons of grades A, B, and C used.
The constraints are:
(i) Phosphorus content must not exceed 0.03%
.02 X1+ .04X2 + 0.3 X3 ≤ .03 (X1 + X2 + X3)
2X1 + 4 X2 + 3X3 ≤ 3 (X1 + X2 + X3) or – X1 + X2 ≤ 0
(ii) Ash content must not exceed 3%
3X1 + 2 X2 + 5 X3 ≤ 3 (X1 + X2 + X3) or – X2 + 2X3 ≤ 0
(iii) Total quantity of fuel required is not more than 100 tons. X1 + X2 + X3 ≤ 100
The Mathematical formulation of the
problem is Maximize Z = 12 X1 + 15X2 + 14
X3 Subject to the constraints:

- X1 + X2 ≤ 0
- X2 + X3 ≤ 0
X1 + X2 + X3 ≤ 100
X1, X2, X3 > 0
Introducing slack variable X4 >0, X5>0, X6>0
12 15 14 0 0 0
Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
0 Y4 0 -1 1* 0 1 0 0
0 Y5 0 0 -1 2 0 1 00
Y6 100 1 1 1 0 0 1 Z
-12 -15 -14 0 0 0
Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
15 Y2 0 -1 1 0 1 0 0

11.15
Advanced Management Accounting

0 Y5 0 -1 0 2 1 1 0 0 Y6 100 2* 0 1 -1 0 1 Z -27 -14 15 0 0

Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
15 Y2 50 0 1 1/2 1/2 0 1/2
0 Y5 50 0 0 5/2* 1/2 1 1/2 12 Y1 50 1 0 1/2 -1/2 0 1/2
Z 0 0 -1/2 3/2 0 27/2
Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
15 Y2 40 0 1 0 2/5 -1/5 2/5 14 Y3 20
0 0 1 1/5 2/5 1/5 12 Y1 40 1 0
0 -3/5 -1/5 2/5
Z 0 0 0 8/5 1/5 68/5
The optimum solution is X1 = 40, X2 = 40 and X3 = 20 with maximum Z = 1360.
Question 7
What are the practical applications of Linear programming?
Answer
Linear programming can be used to find optional solutions under constraints.
In production:
• pdt. mix under capacity constraints to minimise costs/maximise profits
along with marginal costing.
• Inventory management to minimise holding cost, warehousing /
transporting from factories to warehouses etc.
Sensitivity Analysis: By providing a range of feasible solutions to decide on
discounts on selling price, decisions to make or buy.
Blending: Optional blending of raw materials under supply constraints.
Finance: Portfolio management, interest/receivables management.
Advertisement mix: In advertising campaign – analogous to pdn. management
and pdt. mix.
Assignment of personnel to jobs and resource allocation problems.
However, the validity will depend on the manager’s ability to establish a proper
linear relationship among variables considered.
Question 8
Transport Ltd. Provides tourist vehicles of 3 types – 20-seater vans, 8-seater big
cars and 5-seater small cars. These seating capacities are excluding the drivers.
The company has 4 vehicles of the 20-seater van type, 10 vehicles of the 8-

11.16
 Linear Programming

seater big car types and 20 vehicles of the 5-seater small car types. These
vehicles have to be used to transport employees of their client company from
their residences to their offices and back. All the residences are in the same
housing colony. The offices are at two different places, one is the Head Office
and the other is the Branch. Each vehicle plies only one round trip per day, if
residence to office in the morning and office to residence in the evening. Each
day, 180 officials need to be transported in Route I (from residence to Head
Office and back) and 40 officials need to be transported in Route II (from
Residence to Branch office and back). The cost per round trip for each type of
vehicle along each route is given below.
You are required to formulate the information as a linear programming problem,
with the objective of minimising the total cost of hiring vehicles for the client
company, subject to the constraints mentioned above. (only formulation is
required. Solution is not needed).
Figs. – Rs. /round trip
20-seater 8-seater big 5-seater small
vans cars cars
Route I ─
Residence ─ Head Office and Back 400
600 300
Route II ─ 500 200
Residence ─ Branch Office and Back 300
Answer

Type I II III Total no. of

20 – Seater 8 – Seater 5 – Seater passenger
vans Big cars Small cars s

Route I Residence H.O. 600 400 300 180

Residence
Route II Residence 500 Br. 300 200 40
Residence
No. of vehicles 4 10 20 220
Max. capacity 80 80 100 No. of passengers 260
Let i be the ith route,
and j be the type of vehicle, so that
S11 = no. of vans (vehicles on Route I, Type I)

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Advanced Management Accounting

S12 = no. of 8 seater cars on Route I

S13 = no. of 5 seater cars on Route I
S21 = no. of vans ─ on Route II
S22 = no. of 8 seater cars on Route II
S23 = no. of 5 seater cars on Route II
Objective:
Minimise
Cost Z = 600 S11 + 400 S12 + 300 S13 + 500 S21 + 300 S22 + 200S23
Subject to
20 S11 + 8 S12 + 5 S13 = 180
20 S21 + 8 S22 + 5 S23 = 40
S11 + S21 ≤ 4
S21 + S22 ≤ 10
S31 + S32 ≤ 20
All sij ≥ 0
Question 9
Explain the concept and aim of theory of constraints. What are the key measures
of theory of constraints?
Answer
The theory of constraints focuses its attention on constraints and bottlenecks
within organisation which hinder speedy production. The main concept is to
maximize the rate of manufacturing output is the throughput of the organisation.
This requires to examine the bottlenecks and constraints. A bottleneck is an
activity within the organization where the demand for that resource is more than
its capacity to supply.
A constraint is a situational factor which makes the achievement of objectives /
throughput more difficult than it would otherwise, for example of constraint may
be lack of skilled labour, lack of customer orders, or the need to achieve high
quality in product output.
For example let meeting the customers’ delivery schedule be a major constraint
in an organisation. The bottleneck may be a certain machine in the factory. Thus
bottlenecks and constraints are closely examined to increase throughput.
Key measures of theory of constraints:

11.18
 Linear Programming

(i) Throughput contribution: It is the rate at which the system generates

profits through sales. It is defined as, sales less completely variable cost,
sales – direct are excluded. Labour costs tend to be partially fixed and
conferred are excluded normally.
(ii) Investments: This is the sum of material costs of direct materials,
inventory, WIP, finished goods inventory, R & D costs and costs of
equipment and buildings.
(iii)Other operating costs: This equals all operating costs (other than direct
materials) incurred to earn throughput contribution. Other operating costs
include salaries and wages, rent, utilities and depreciation.
Question 10
The costs and selling prices per unit of two products manufacturing by a
company are as under:
Product A (Rs.) B (Rs.)
Selling Price 500 450
Variable costs:
Direct Materials @ Rs. 25 per kg. 100 100
Direct Labour @ Rs. 20 per hour 80 40
Painting @ Rs. 30 per hour 30 60
Variable overheads 190 175
Fixed costs @ Rs. 17.50/D.L.Hr. 70 35
Total costs 470 410
Profit 30 40
In any month the maximum availability of inputs is limited to the
following:
Direct Materials 480 kg.
Direct Labour hours 400
hours
Painting hours 200
hours

Required:
(i) Formulate a linear programme to determine the production plan which
maximizes the profits by using graphical approach.

11.19
Advanced Management Accounting

(ii) State the optimal product mix and the monthly profit derived from your
solution in (i) above.
(iii) If the company can sell the painting time at Rs. 40 per hour as a separate
service, show what modification will be required in the formulation of the
linear programming problem. You are required to re-formulate the problem
but not to solve.
Answer
Contribution analysis:
Products A B
(Rs.) (Rs.)
Selling price (A) 500 450
Variable costs:
Direct Materials 100 100
Direct Labour 80 40
Painting 30 60
Variable Overheads 190 175
Total variable costs (B) 400 375
Contribution (A – B) 100 75
Direct Material per unit 100/25 = 4 kg. 100/25 = 4
kg.
Direct Labour hour per unit 80/20 = 4 hours 40/20 = 2
hours
Painting hour per unit 30/30 = 1 hour 60/30 = 2
hours
Let A be the units to be produced of product A and B be the units to be produced
of product B.

LP Problem formulation:
Z Max 100A + 75B Maximisation of
contribution
Subject to:
4A + 4B ≤ 480 Raw material constraint

11.20
 Linear Programming

4A + 2B ≤ 400 Direct Labour hour constraint

A + 2B ≤ 200 Painting hour constraint
A, B ≥ 0 Non negativity constraint
Raw Material Constraint : Put B = 0, A = 120
Put A = 0, B = 120

Direct Labour Constraint : Put B = 0, A = 100

Put A = 0, B = 200

Painting Constraint : Put B = 0, A = 200

Put A = 0, B = 100

The graphical representation will be as under:

Q Intersects 4A + 2B = 400 (1) and 4A + 4B = 480 (2)

Subtracting (2) from (1), we get −2B = −80

⇒ B = 80/2 = 40
Putting value of B in (1), we get 4A + 2 × 40 = 400

11.21
Advanced Management Accounting

⇒ A = 400 − 80 =
80 4
R Intersects 4A + 4B = 480 (3) and A + 2B = 200 (4)

Multiplying (4) by (2) and then subtracting from (3), we

get 2A = 80

⇒ A = 40
Putting the value of A in (4), we get 2B = 200 –
40 ⇒ B = 80.

Evaluation of corner points:

Point Products Contribution Total
Contribution
A B A (Rs.) B (Rs.) Rs.
100 per unit 75 per unit
P 0 100 0 7,500 7,500
Q 80 40 8,000 3,000 11,000
R 40 80 4,000 6,000 10,000
S 100 0 10,000 0 10,000
Optimal product mix is Q

Product Units Contribution

Rs.
A 80 8,000
B 40 3,000
Total contribution 11,000
Less: Fixed costs 400 D.L. Hrs. × Rs. 17.50 7,000
Optimal Profit 4,000
(iii) If the painting time can be sold at Rs. 40 per hour the opportunity cost is
calculated as under:
A B
(Rs.) (Rs.)

11.22
 Linear Programming

Income from sale per hour 40 40

Painting variable cost per hour 30 30
Opportunity cost 10 10
Painting hours per unit 1 2
Opportunity cost 10 20
Revised contribution 100 – 10 = 90 75 – 20 =
55
Hence, modification is required in the objective function.

Re-formulated problem will be:

Z Max. 90A + 55B Maximisation of contribution
Subject to:
4A + 4B ≤ 480 Raw Material constraint
4A + 2B ≤ 400 Direct Labour hour constraint
A + 2B ≤ 200 Painting hour constraint
A, B ≥ 0 Non-negativity constraint
Question 11
The following matrix gives the unit cost of transporting a product from production
plants P1, P2 and P3 to destinations. D1, D2 and D3. Plants P1, P2 and P3 have a
maximum production of 65, 24 and 111 units respectively and destinations D 1, D2
and D3 must receive at least 60, 65 and 75 units respectively:
To D1 D2 D3 Supply
From
P1 400 600 800 65
P2 1,000 1,200 1,400 24
P3 500 900 700 111
Demand 60 65 75 200
You are required to formulate the above as a linear programming problem. (Only
formulation is needed. Please do not solve). Answer
Let pidj be the variable to denote the number of units of product from the ith plant
to the jth destination, so that
P1d1 = transport from plant P1 to D1

11.23
Advanced Management Accounting

P2d2 = transport from plant P2 to D2 etc.

Objective function
Minimize z = 400 p1d1 + 600 p1d2 + 800 p1d3 + 1000 p2d1 + 1200 p2d2 + 1400 p2d3
+ 500 p3d1 + 900 p3d2 + 700 p3d3. Subject to:
p1d1 + p1d2 + p1d3 ≤ 65 
 p2d1 + p2d2
+ p2d3 ≤ 24  (Plant constraints)

p3d1 + p3d2 + p3d3 ≤
111

and
p1d1 + p2d1 + p3d1 ≥ 60
 p1d2 + p2d2 +
p3d2 ≥ 65 (destination constraints)

p1d3 + p2d3 + p3d3 ≥ 75


all pidj ≥ 0
Question 12
Formulate the dual for the following linear program: (6 Marks)
Maximise: 100x1 + 90x2 + 40x3 + 60x4

Subject to
6x1+ 4x2 + 8x3 + 4x4 ≤ 140
10x1 + 10x2 + 2x3 + 6x4 ≤ 120
10x1 + 12x2 + 6x3 + 2x4 ≤ 50
x1, x2, x3, x4, ≥ 0
(Only formulation is required. Please do not solve.)
Answer

11.24
 Linear Programming

Dual:
Minimise 140u1 + 120u2 + 50u3
S.T. 6u1 + 10u2 + 10u3 ≥ 100
4u1 + 10u2 + 12u3 ≥ 90
8u1 + 2u2 + 6u3 ≥ 40
4u1 + 6u2 + 2u3 ≥ 60
u1, u2 u3 u4 ≥ 0
Question 13
The following is a linear programming problem. You are required to set up the
initial simplex tableau. (Please do not attempt further iterations or solution):
Maximise
100x1 = 80x2
Subject to

3x1 + 5x2 ≤ 150

x2 ≤ 20

8x1 + 5x2 ≤ 300

x1
+ x2 ≥ 25
x1, x2 ≥ 0
Answer
Under the usual notations where
S1, S2, S3 are stock Variables,
A4 = the artificial variable
S4 = Surplus Variable
We have,
Max. Z = 100x1 + 80x2 + 0S1 + 0S2 + 0S3 + 0S4 – M A4.
S.t.

11.25
Advanced Management Accounting

3x1 + 5x2 + S1 =
150 x2 + S2 =
20
8x1 + 5x2 + S3 = 300
x1 + x2 + - S4 + A4 = 25
x1 x2 S1 S2 S3 S4 A4
C
Basis j CB 100 80 0 0 0 0 -M

S1 0 3 5 1 0 0 0 0 150 √
S2 0 0 1 0 1 0 0 0 20 √
S3 0 8 5 0 0 1 0 0 300 √
A4 -M 1 1 0 0 0 -1 1 25 √
Zj -M -M 0 0 0 M -M -25M √
Cj-Zj 100+ 80+M 0 0 0 -M 0 √
M
Question 14
An oil refinery can blend three grades of crude oil to produce quality A and
quality B petrol. Two possible blending processes are available. For each
production run, the older process uses 5 units of crude Q, 7 units of crude P and
2 units of crude R and produces 9 units of A and 7 units of B. The newer process
uses 3 units of crude Q, 9 unit of crude P and 4 units of crude R to produce 5
units of A and 9 units of B.
Because of prior contract commitments, the refinery must produce at least 500
units of A and at lease 300 units of B for the next month. It has ,1,500 units of
crude Q, 1,900 units of crude P and 1,000 of crude R. For each unit of A, refinery
receives Rs.60 while for each unit of B, it receives Rs.90
Formulate the problem as linear programming model so as to maximize the
revenue. Answer

Maximize Z = 60 (9x1 + 5x2) + 90 (7x1 + 9x2)

= 1170x1 + 1110x2

11.26
 Linear Programming

Subject to 9x1 + 5x2 ≥ 500 commitment for

A 7x1 + 9x2 ≥ 300 commitment for
B
5x1 + 3x2 ≤ 1500 availability of Q
7x1 + 9x2 ≤ 1900 availability of
P 2x1 + 4x2 ≤ 1000 availability of
R and x1 ≥ 0, x2 ≥ 0.
Question 15
Write short notes on the characteristics of the dual problem.
Answer
Characteristics of the dual problem:
1. For any linear programming model called primal model, there exists a
companion model called the dual model.
2. The number of constraints in the primal model equals the number of
variables in the dual model.
3. The number of variables in the primal problem equals the number of
constraints in the dual model.
4. If the primal model is a maximization problem then the dual model will be of
the form less than or equal to, “≤” while the restrictions in the dual problem
will be of the form-greater than or equal to, “≥”.
5. The solution of the prima; model yields the solution of the dual model. Also,
an optimal simplex table for the dual model yields the optimal solution to
the primal model. Further, the objective functions of the two optimal tables
will have identical values.
6. Dual of the prima’s dual problem is the primal problem itself.
7. Feasible solutions to a primal and dual problem are both optimal if the
complementary slackness conditions hold, that is, (value of a primal
variable) x (value of the corresponding dual surplus variable) = 0 or (value
of a primal slack variable) x (value of the corresponding dual variable) = 0.
If this relationship does not hold, than either the primal solution or the dual
solution or both are no optimal.
8. If the primal problem has no optimal solution because of infeasibility, then
the dual problem will have no optimal solution because of unboundedness.

11.27
Advanced Management Accounting

9. If the primal has no optimal solution because of unboundedness, then the

dual will have no optimal solution because of infeasibility.
EXERCISE
Question 1
A Sports Club is engaged in the development of their players by feeding them
certain minimum amount of Vitamins (say A, B and C), in addition to their normal
diet. In view of this, two types of products X and Y are purchased from the
market. The contents of Vitamin constituents per unit, are shown in the following
table:
Vitamin Vitamin contents in products Minimum
Constituents requirement
for each player
X Y
A 36 06 108
B 03 12 36
C 20 10 100
The cost of product X is Rs.20 and that of Y is Rs.40.
Formulate the linear programming problem for the above and minimize the total
cost, and solve problem by using graphic method.
Answer
The optimal solution is to purchase 4 units of product X and 2 units of product Y
in order to maintain a minimum cost of Rs.160/-.
Question 2
A manufacturer produces three products Y1, Y2, Y3 from three raw materials X1,
X2, X3. The cost of raw materials X1, X2 and X3 is Rs.30, Rs.50 and Rs.120 per kg
respectively and they are available in a limited quantity viz 20 kg of X 1, 15 kg of
X2 and 10 kg of X3. The selling price of Y1, Y2 and Y3 is Rs.90, Rs.100 and
Rs.120 per kg respectively. In order to produce 1 kg of Y1, ½ kg of X1, ¼ kg of X2
and ¼ kg of X3 are required. Similarly to produce 1 kg of Y 2, 3/7 kg of X1, 2/7 kg
of X2 and 2/7 kg of X3 and to produce 1 kg Y3, 2/3 kg of X2 and 1/3 kg of X3 will be
required.
Formulate the linear programming problem to maximize the profit.
Answer
Maximise Z = 32.50 y1 + 38.57 y2 + 46.67 y3
½ y1 + 3/7 y2 ≤ 20 or 7 y1 + 6 y2 ≤ 280

11.28
 Linear Programming

¼ y1 + 2/7 y2 + 2/3 y3 ≤ 15 or 21 y1 + 24 y2 + 56 y3 ≤ 1,260

¼ y1 + 2/7 y2 + 1/3 y3 ≤ 10 or 21 y1 + 24 y2 + 28 y3 ≤ 840
where Y1, Y2 and Y3 ≥ 0
Question 3

Write short notes on applications and limitation of Linear Programming

Techniques. Answer

Refer to Chapter 11: Paragraph: 11.9

Question 4
In a chemical industry two products A and B are made involving two operations.
The production of B also results in a by-product C. The product A can be sold at
a profit of Rs.3 per unit and B at a profit of Rs.8 per unit. The by-product C has a
profit of Rs.2 per unit. Forecast show that upto 5 units of C can be sold. The
company gets 3 units of C for each unit of B produced. The manufacturing times
are 3 h per unit and on each of the operation one and two and 4 h and 5 h per
unit for B on operation one and two respectively. Because the product C results
from producing B, no time is used in producing C. The available times are 18 h
and 21 h of operation one and two respectively. The company desires to know
that how much A and B should be produced keeping c in mind to make the
highest profit. Formulate LP model for this problem.
Answer
Maximise Z = 3x1 + 8x2 + 2x3
Subject to the constraints
3x1 + 4x2 ≤
18 3 x1 + 5x2 ≤
21 x3 ≤ 5, x3 =
3x2 x1, x2, x3 = 0
Question 5
An advertising firm desires to reach two types of audiences – customers with
annual income of more than Rs.40,000 (target audience A) and customers with
annual income of less than Rs.40,000 (target audience B). The total advertising
budget is Rs.2,00,000. One programme of T.V. advertising costs Rs.50,000 and
one programme of Radio advertising costs Rs.20,000. Contract conditions
ordinarily require that there should be at least 3 programmes on T.V. and the
number of programmes on Radio must not exceed 5. Survey indicates that a

11.29
Advanced Management Accounting

single T.V. programme reaches 7,50,000 customers in target audience A and

1,50,000 in target audience B. One Radio programme reaches 40,000 customers
in target audience A and 2,60,000 in target audience B.
Formulate this as a linear programming problem and determine the media mix to
maximize the total reach using graphic method.
Answer
the advertising firm should give 4 programmes on TV and no programme on
Radio in order to achieve a maximum reach of 36,00,000 customers.
Question 6
Let us assume that you have inherited Rs.1,00,000 from your father-in-law that
can be invested in a combination of only two stock portfolios, with the maximum
investment allowed in either portfolio set at Rs.75,000. The first portfolio has an
average rate of return of 10%, whereas the second has 20%. In terms of risk
factors associated with these portfolios, the first has a risk rating of 4 (on a scale
from 0 to 10), and the second has 9. Since you wish to maximize your return,
you will not accept an average rate of return below 12% or a risk factor above 6.
Hence, you then face the important question. How much should you invest in
each portfolio?
Formulate this as a Linear Programming Problem and solve it by Graphic
Method. Answer

the company should invest Rs.60,000 in first portfolio and Rs.40,000 in second
portfolio to achieve the maximum average rate of return of Rs.14,000.
Question 7
A firm buys casting of P and Q type of parts and sells them as finished product
after machining, boring and polishing. The purchasing cost for casting are Rs.3
and Rs.4 each for parts P and Q and selling costs are Rs.8 and Rs.10
respectively. The per hour capacity of machines used for machining, boring and
polishing for two products is given below:
Parts
Capacity (per hour) P C
Machining 30 50
Boring 30 45
Polishing 45 30

11.30
 Linear Programming

The running costs for machining, boring and polishing are Rs.30, Rs.22.5 and
Rs.22.5 per hour respectively.
Formulate the linear programming problem to find out the product mix to
maximize the profit.

Answer
Maximise Z = 2.75x + 4.15y
Subject to the constraints
50x + 30y ≤ 1,500
45x + 30y ≤ 1,350
30x + 45y ≤ 1,350
where x, y ≥ 0
Question 8
A Mutual Fund Company has Rs.20 lakhs available for investment in
Government Bonds, blue chip stocks, speculative stocks and short-term bank
deposits. The annual expected return and risk factor are given below:

Type of investment Annual Expected return (%) Risk Factor (0 to 100)

Government Bonds 14 12 Blue Chip Stocks 19 24 Speculative
Stocks 23 48 Short term deposits 12 6
Mutual fund is required to keep at least Rs.2 lakhs in short-term deposits and not
to exceed an average risk factor of 42. Speculative stocks must be at most 20
percent of the total amount invested. How should mutual fund invest the funds so
as to maximize its total expected annual return? Formulate this as a Linear
Programming Problem. Do not solve it.
Answer
Objective function:
Maximise Z = 0.14x1 + 0.19x2 + 0.23x3 + 0.12x4
Subject to the constraints:
x1+x2+x3+x4 ≤
20,00,000 x4 ≥
2,00,000

11.31
Advanced Management Accounting

- 30x1 – 18x2 + 6x3 – 36x4 ≤ 0

- 0.2x1 – 0.2x2 + 0.8x3 +0.2x4 ≤ 0
Where x1 ≥ 0, x2 ≥ 0, x3 ≥ 0 and x4 ≥ 0
Question 9
The owner of Fancy Goods Shop is interested to determine, how many
advertisements to release in the selected three magazines A, B and C. His main
purpose is to advertise in such a way that total exposure to principal buyers of
his gods is maximized. Percentages of readers for each magazine are known.
Exposure in any particular magazine is the number of advertisements released
multiplied by the number of principal buyers. The following data are available:
Magazines
Particulars A B C
Readers 1.0 Lakhs 0.6 Lakhs 0.4 Lakhs
Principal buyers 20% 15% 8%
Cost per advertisement 8,000 6,000 5,000
The budgeted amount is at the most Rs.1.0 lakh for the advertisements. The
owner has already decided that magazine A should have no more than 15
advertisements and that B and C each gets at least 8 advertisements. Formulate
a Linear Programming model for this problem.
Answer
Maximise Z = 20,000 x1 + 9,000 x2 + 3,200 x3
subject to 8,000 x1 + 6,000 x2 + 5,000 x3 ≤
1,00,000 x1 ≤ 15, x2 ≥ 8, where x1, x2
and x3 ≥ 0
Question 10
An agriculturist has a farm with 125 acres. He produces Radish, Mutter and
Potato. Whatever he raises is fully sold in the market. He gets Rs.5 for Radish
per kg Rs.4 for Mutter per kg and Rs. for Potato per kg. The average yield is
1,500 kg of Radish per acre, 1,800 kg of Mutter per acre and 1,200 kg of Potato
per acre. To produce each 100 kg of Radish and Mutter and to produce each 80
kg of Potato, a sum of Rs.12.50 has to be used for manure. Labour required for
each acre to raise the crop is 6 man days for Radish and Potato each and 5 man
days for Mutter. A total of 500 man days of labour at a rate of Rs.40 per man day
are available.

11.32
 Linear Programming

Formulate this as a Linear Programming model to maximize the Agriculturist’s

total profit. Answer

Maximise Z = 7,072.5x1 + 6,775x2 + 5572.5x3

Subject to following constraints:
x1 + X2 + X3 ≤ 125
6x1 + 5x2 + 6x3 ≤ 500
Where x1, x2 and x3 ≥ 0
Question 11
A firm produces three products A, B and C. It uses two types of raw materials I
and II of which 5,000 and 7,500 units respectively are available. The raw material
requirements per unit of the products are given below:
Raw Material Requirement per unit of Product
A B C
I 3 4 5
II 5 3 5
The labour time for each unit of product A is twice that of product B and three
times that of product C. The entire labour force of the firm can produce the
equivalent of 3,000 units. The minimum demand of the three products is 600,
650 and 500 units respectively. Also the ratios of the number of units produced
must be equal to 2: 3: 4. Assuming the profits per unit of A, B and C as Rs.50, 50
and 80 respectively.
Formulate the problem as a linear programming model in order to determine the
number of units of each product, which will maximize the profit. Answer
Maximise Z = 50x1 + 50x2 + 80x3
Subject to the constraints
3x1 + 4x2 + 5x3 ≤ 5,000
5x1 + 3x2 + 5x3 ≤ 7,500
6x1 + 3x3 + 2x3 ≤ 18,000
3x1 = 2x2 and 4x2 = 3x3 x1 ≥
600, x2 ≥ 650 and x3 ≥ 500

11.33
 CHAPTER 12

THE TRANSPORTATION PROBLEM

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Transportation Problem:
This type of problem deals with optimization of transportation cost in a
distribution scenario involving m factories (sources) to n warehouses
(destination) where cost of shipping from ith factory to jth warehouse is
given and goods produced at different factories and requirement at different
warehouses are given.
2. Northwest corner Rule:
The idea is to find an initial basic feasible solution i.e., a set of allocations
that satisfied the row and column totals. This method simply consists of
making allocations to each row in turn, apportioning as much as possible to
its first cell and proceeding in this manner to its following cells until the row
total in exhausted.
3. Algorithm Involved Under North-West Corner Rule Steps:

1. Before allocation ensure that the total on demand & supply of

availability and requirement are equal. If not then make same equal.
2. The first allocation is made in the cell occupying the upper left hand
corner of the matrix.
The assignment is made in such a way that either the resource
availability is exhausted or the demand at the first destination is
satisfied.
3. (a) If the resource availability of the row one is exhausted first, we
move down the second row and first column to make another
allocation which either exhausts the resource availability of row two
or satisfies the remaining destination demand of column one.
(b) If the first allocation completely satisfies the destination demand of
column one, we move to column two in row one, and make a
second allocation which either exhausts the remaining resource
availability
Advanced Management Accounting

of row one or satisfies the destination requirement under column two.

4. The Least Cost Method:
i) Before starting the process of allocation ensure that the total of
availability and demand is equal. The least cost method starts by
making the first allocation in the cell whose shipping cost (or
transportation cost) per unit is lowest.
ii) This lowest cost cell is loaded or filled as much as possible in view of
the origin capacity of its row and the destination requirements of its
column. iii) We move to the next lowest cost cell and make an
allocation in view of the remaining capacity and requirement of its
row and column. In case there is a tie for the lowest cost cell during
any allocation, we can exercise our judgment and we arbitrarily
choose cell for allocation. iv) The above procedure is repeated till all
row requirements are satisfied.
5. Vogel’s Approximation Method (VAM)
VAM entails the following steps:
Step 1: For each row of the transportation table identify the smallest and
next smallest costs. Find the difference between the two costs and display
it to the right of that row as “Difference” (Diff.). Likewise, find such a
difference for each column and display it below that column. In case two
cells contain the same least cost then the difference will be taken as zero.
Step 2: From amongst these row and column differences, select the one
with the largest difference. Allocate the maximum possible to the least cost
cell in the selected column or row. If there occurs a tie amongst the largest
differences, the choice may be made for a row or column which has least
cost. In case there is a tie in cost cell also, choice may be made for a row
or column by which maximum requirement is exhausted. Match that
column or row containing this cell whose totals have been exhausted so
that this column or row is ignored in further consideration.
Step 3: Recompute the column and row differences for the reduced
transportation table and go to step 2. Repeat the procedure until all the
column and row totals are exhausted.

12.2
 The Transportation Problem

6. Optimality Test
Once the initial allocation is done, we have to do the optimality test if it
satisfy the condition that number of allocation is equal to (m+n-1) where
m= number of rows, n= number of columns. If allocation is less than
( m+n-1), then the problem shows
degenerate situation. In that case we have to allocate an infitely small
quanity (e) in least cost and independent cell.
7. Cell Evaluations
The allocations are m+n-1 in number and independent.
For each allocated cell, cell value = cij = uij +vij where uij = row value +
column value.
One row where maximum allocation is made, U value is made zero and ui
and vj for all rows and columns are calculated.
For each unallocated cell, cell value = [ cost of cell –(u+ v) ]

Question 1
A product is manufactured by four factories A, B, C and D. The Unit production
costs are Rs.2, Rs.3, Re.1 and Rs.5 respectively. Their daily production
capacities are 50, 70, 30 and 50 units respectively. These factories supply the
product to four P, Q, R and S. The demand made by these stores are 25, 35, 105
and 20 Units transportation cost in rupees from each factory to each store is
given in the following table;
Stores
P Q R S
A 2 4 6 11
Factory B
10 8 7 5
C
13 3 9 12
D
4 6 8 3
Determine the extent of
deliveries from each of the factories to each of the stores so that the total cost
(production and transportation together) is minimum.
Answer
The new transportation costs table, which consists of both production and
transportation costs, is given in following table.
Store

12.3
Advanced Management Accounting

P
Q R 2+2=4 4+2=6 6+2=8 11+2=1 50
S 3
Supply 10+3=1 8+3=11 7+3=10 5+3=8 70
A 3
B 13+1=1 3+1=4 9+1=10 12+1=1 30
Factories C 4 3
4+5=9 6+5=11 8+5=13 3+5=8 50
D
Demand 25 35 105 20 200
185

Since the total supply of 200 units exceeds the total demand of 185 units by 200-
185 =15 units of product, there fore a dummy destination (store) is added to
absorb the excess supply. The associated cost coefficients in dummy store are
taken as zero as the surplus quantity remains lying in the respective factories
and is, in fact, not shipped at all. The modified table is given below. The problem
now becomes a balanced transportation one and it is a minimization problem.
We shall now apply Vogel’s Approximation method to fine an initial solution.
P Q R S Dummy Supply Differenc
e
A 25 5 20 13 0 50/25/20/0 4 2 2 2 5
8

4
6
B 13 11 70 8 0 70/0 8 2 2 2 2
10 2

C 14 30 10 13 0 30/0 4 6 _ _ _
4 _

D 9 11 15 20 15 50/35/15/0 8 1 1 3 3
0 5
13
8
Demand 25/0 35/5/0 105/85/15/0 20/0 15/0 200
Difference 5 2 2 0 0
5 2 2 0 -
5 5 2 0 -

12.4
 The Transportation Problem

- 5 2 0 -
- - 2 0 -
The initial solution is shown in above table. It can be seen that 15 units are
allocated to dummy store from factory D. This means that the company may cut
down the production by 15 units at the factory where it is uneconomical. We will
now test the optimality of the solution. The total number of allocations is 8 which
is equal to the required m+n-1 (=8) allocation. Introduce u i’s, vj’ s, i= (1,2,- - - - -4)
and j =(1,2,- - - -5) ∆ij=cij-(ui+vj) for allocated cells. We assume that u4 =0 and
remaining uj’s, vj’s and ∆ij’s are calculated below.”

P Q R S Dummy Supply Ui
A 25 5 20 13 0 50 U1= -5
4 6 8 +1 +
0 5
B 70 U2 =
13 11 70 8 0
+7 +3 10 +3 +3
C 30 U3 = -7
14 30 10 13 0
+ 4 +4 +1 +7
D 1 2 50 U4 = 0
9 11 15 20 15
0 35 0 13 8 0
Demand 25 105 20 15
Vj V1=9 2 2 0 0
Please not that figures in top left hand corners of the cell represent the cost and
the one in the bottom right hand corner of the non basic cell are the values of
∆ij=cij-[(ui+vj)].
Since opportunity cost in all the unoccupied cells is positive, therefore initial
solution is an optimal solution also. The total cost (transportation and production
together) associated with this solution is
Total cost = 4×25+6×5+8×20+10×70+4×30+13×15+8×20+0×15
= 100+30+160+700+120+195+160
= Rs.1,465/- Question 2

A compressed Natural Gas (CNG) company has three plants producing gas and
four outlets. The cost of transporting gas from different production plants to the
outlets, production capacity of each plant and requirement at different outlets is
shown in the following cost-matrix table:

12.5
Advanced Management Accounting

Plants A B Outlet C D Capacity

s of
Productio
n
X 4 6 8 6 700
Y 3 5 2 5 400
Z 3 9 6 5 600
Requirement 400 450 350 500 1,700
Determine a transportation schedule so that the cost is
minimized. The cost in the cost-matrix is given in thousand of
rupees.
Answer
The given problem is a balanced minimization transportation problem. The
objective of the company is to minimize the cost. Let us find the initial feasible
solution using Vogel’s Approximation method (VAM)
Outlets
Plants A B C D Capacity Difference
X 400 300 700/300/0 2200
4 6 8 6
Y 50 350 400/50/0 1200
3 5 2 5
Z 600/200/0 2240
400 3 200
9 6
Requirement 400/0 450/400/0 350/0 500/300/0
Difference 0 1 4 0
0 1 - 0
- 1 - 0
The initial feasible solution obtained by VAM is given below:
Outlets
Plants A B C D Capacity
X 400 300 700
4 6 8 6

50 350
3 5 2 5
12.6
400 3 200
9 6
5
 The Transportation Problem

Y 400

Z 600

Requirement 400 450 350 500

Since the number of allocations = 6= (m+n-1), let us test the above solution for
optimality. Introduce ui (i=1,2,3) and vj (1,2,3,4) such that ∆ij= Cij –(ui+vj) for
allocated cells. We assume u1=0, and rest of the ui’s, vj’s and ∆ij’s are calculated
as below: Outlets
Plants A B C D Ui
X 0 400 5 300 0
4 6 8 6
Y 0 50 350 0 -1
3 5 2 5
Z -1
400 3 4 4 200
9 6
5
Vj 4 6 3 6

On calculating ∆ij’s for non-allocated cells, we found that all the ∆ij≥0, hence the
initial solution obtained above is optimal.
The optimal allocations are given below.
Plants Outlet Units Cost Total
Cost
X →B 400 × 6 = 2,400
X →D 300 × 6 = 1,800
Y →B 50 × 5 = 250
Y →C 350 × 2 = 700
Z →A 400 × 3 = 1,200
Z →D 200 × 5 = 1,000
7,350

The minimum cost = 7,350 thousand rupees.

12.7
Advanced Management Accounting

Since some of the ∆ij’s = 0, the above solution is not unique. Alternative solutions
exist.
Question 3
Consider the following data
the transportation
for problem:
Factory Destination Supply to be
(1 (2 (3 exhausted

A )5 )1 )7 1
B 6 4 6 0
8
C 3 2 5 0
1
Demand 7 2 5 5
5 0 0
Since there is not enough supply,thesome
demands
of at the three destinations may not
be satisfied. For the unsatisfied demands,
the penalty
let costs be rupees 1, 2 and 3 for
destinations (1), (2) and (3) respectively.
Answer
The initial solution is obtained below by vogel’s method.
Since demand (=75+20+50=145) is greater than supply (=10+80+15=105) by 40
units, the given problem is an unbalanced one. We introduce a dummy factory
with a supply of 40
units. It is given that for the unsatisfieds,demand
the penalty cost is rupees 1, 2, and 3
for destinations (1), (2) and (3) respective
ly. Hence, the transport
ation problem becomes
Factory Destination Supply to be
(1) (2) (3) exhausted

A 5 1 7 1
B 6 4 6 0
8
C 3 2 5 0
1
Dummy 1 2 3 5
4
Demand 7 2 5 0
14
5 0 0 5
Destination

(1) (2) (3) Supply Difference

A 100 4 _ _ 10
5 1

7
20 1012.8 50
6 4 6
 Demand 75/35/20/0 20/10/0 50/0
The Transportation Problem
Difference 2 1 2
2 0 2
3 2 1
15
The initial solution is given in the table below.
3 2
Destination

(1) (2) 5 (3) Supply

40
Factory B 10 80/70/50/0 222
1 2
C 15/0 1 1 1 5 1 7

20 10 50 3
Dummy 40/0 6 4 6 11_

15
A 10
3 2 5

Factory B 80 40
1 2 3

C 15

Dummy 40

Demand 75 20 50
We now apply the optimality test to find whether the initial solution found above is
optimal or not.
The number of allocations is 6 which is equal to the required m+n -1 (=6)
allocations. Also, these allocations are in dependent. Hence, both the conditions
are satisfied.
Let us now introduce ui , and vj’ I = (1,2,3,4) and j = (1,2,3) such that ∆ ij = Cij –
(ui+vj) for allocated cells. We assume that u 2 =0 and remaining ui’s, vj’s and ∆ij’s
are calculated as below:-
(1) (2) (3) ui’s
A -3 2 1 4
Factory B0 20 10
0 1 50
6 4 6
C -3 5 7
15 1 2
3 2 5
Dummy -5
40 3 2
1 2 3
12.9
Advanced Management Accounting

vj’s 6 4 6
Since all ∆ij’s for non basic cells are positive, therefore, the solution obtained
above is an optimal one. The allocation of factories to destinations and their cost
is given
Factory Destination Units Cost Total Cost
below:-
A (2) 10 Re 1 Rs,10
B (1) 20 Rs.6
Rs.120
B (2) 10 Rs.4 Rs.40 Transportation
Cost
B (3) 50 Rs.6 Rs.300
C (1) 15 Rs.3 Rs.45

Dummy (1) 40 Re 1 Rs.40 Penalty Cost

Rs.555
Question 4
A manufacturing company produces two types of product the SUPER and
REGULAR. Resource requirements for production are given below in the table.
There are 1,600 hours of assembly worker hours available per week. 700 hours
of paint time and 300 hours of inspection time. Regular customers bill demand at
least 150 units of the REGULAR type and 90 units of the SUPER type. (8
Marks)
Table
Product Profit/contribution Assembly Paint Inspection
Rs. time Hrs. time time Hrs.
Hrs.
REGULA 50 1.2 0.8 0.2
R
SUPER 75 1.6 0.9 0.2
Formulate and solve the given Linear programming problem to determine
product mix on a weekly basis.
Answer
Let x1 and x2 denote the number of units produced per week of the product
‘REGULAR’ and ‘SUPER’ respectively. Maximise Z =50 x1 + 75 x2
Subject to
1.2x1 + 1.6x2 ≤ 1,600 or 12x1 + 16x2 ≤ 16,000 -(i)
0.8 x1 +0.9 x2 ≤ 700 or 8 x1 + 9 x2 ≤ 7,000 -(ii)
0.2 x1 + 0.2 x2 ≤ 300 or 2 x1 + 2 x2 ≤ 3,000 -(iii)

12.10
 The Transportation Problem

X1 ≥ 150 -(iv)
x2 ≥ 90 -(v)

Let x1 = y1 + 150 x2 =y2 +

90 where y1 , y2 ≥ 0
Maximize Z = 50(y1+ 150) + 75 (y2 + 90) or , Z = 50y1 + 75y2 + 14,250
Subject to:

12(y1 + 150) + 16(y2 + 90) ≤ 16,000

8(y1 + 150) + 9(y2 + 90) ≤ 7,000
2(y1 + 150) + 2(y2 + 90) ≤ 3,000
and y1 , y2 ≥ 0
Adding slack variables s1, s2, s3, we get
Maximize Z = 50y1+75y2 +14,250 subject to
12y1+ 16y2 + s1 = 12,760
8y1 + 9y2 + s2 = 4,990
2y1 + 2y2 + s3 = 2,520
Table -1
Cj 50 75 0 0 0
Cb y1 y2 s1 s2 s3
0 s1 12,760 12 16 1 0 0 12760/16
0 s2 4,990 8 9 0 1 0 4990/9
0 s3 2,520 2 2 0 0 1 2520/2
∆j -50 -75 0 0 0
Table II

Cj 50 75 0 0 0
Cb y1 y2 s1 s2 s3

0 s1 3889 -20/9 0 1 -16/9 0

75 y2 554.44 8/9 1 0 1/9 0
0 s3 1411 2/9 0 0 -2/9 1

12.11
Advanced Management Accounting

∆j 50/3 0 0 75/9 0
Since all the elements in the index row are either positive or equal to zero, table
II gives an optimum solution which is y1 = 0 and y2 = 554.44
Substituting these values we get x1 = 0+150 =150 x 2
=90+554.44 =644.44 and the value of objective function
is
Z = 50 x 150 + 75 x 644.44
=Rs. 55,833
Question 5
A company manufactures two products A and B, involving three departments –
Machining, Fabrication and Assembly. The process time, profit/unit and total
capacity of each department is given in the following table:
Machining Fabrication Assembly Profit
(Hours) (Hours) (Hours) (Rs).
A 1 5 3 80
B 2 4 1 100
Capacity 720 1,800 900
Set up Linear Programming Problem to maximise profit. What will be the product
Mix at Maximum profit level ?
Answer
Maximize z = 80x + 100y subject to x + 2y ≤ 720
5x
+ 4y ≤ 1800
3x + y ≤ 900
x≥0y≥0
where x = No.
of units of A
y = No. of units of B

12.12
 5x + 4y + s2 = 1800

3x + y +sThe Transportation Problem

3 = 900

and x ≥ 0, y ≥ 0, s1 ≥ 0, s2 ≥ 0, s3 ≥ 0
Table I: By the
addition of
80 100 0 0
slack
0
Profit/unit 720
Qty. ΙX 2Y 1 S10 0
S3 variables
S2 s1, s2 and
s3 the inequalities can be 1800 5 4 0 1 0 converted
into equations. The problems 900 3 Ι 0 0 1 thus
become z = 80x + 100y subject to x
+ 2y + s1 = 720

S1 0 720 = 360
2
S2 0 1800/4 = 450
S3 0 900/1 = 900
Net evaluation row 80 100 0 0 0
1800 – 720 ×4/2 = 360 900 - 720×1/2 = 540
5 – I×2 = 3 3 - 1× ½ = 5/2
4 – 2 × 2 =0 I – 2 ×1/2 = 0
0 - I×2 = - 2 0 – I ×1/2 =- 1/2
I - 0×2 = I 0 – 0 ×1/2 = 0
0 - 0×2 = 0 I- 0×1/2 = I
Table 2:
80 100 0 0 0
Program Profit/unit Qty. X Y S1 S2 S3
Y 100 360 ½ I ½ 0 0 360÷1/2=72
0
S2 0 360 3 0 −2 1 0 360÷3=120
S3 0 540 5/2 0 −1/2 0 I 540÷5/2=21
6
Net evaluation row 30 0 −50 0 0

360 – 360 × 1/6 = 300 540 – 360 × 5/6 =

240

12.13
Advanced Management Accounting

½ - 3 ×1/6 = 0 5/2 –3 × 5/6 = 0

1- 0× 1/6=1 0 – 0 × 5/6 = 0
½ - -2 × 1/6 = 5/6 -1/2 - -2 ×5/6 = 7/6
0 – 1 ×1/6 = - 1/6 0 – 1 × 5/6 = -5/6
0 – 0 ×1/6 = 0 1-0 × 5/6 = 1
Table 3:

80 100 0 0 0
Program Profit/unit Qty. X Y S1 S2 S3
Y 100 300 0 I 5/6 -1/6 0
X 80 120 I 0 1/3 0
−2/3
S3 0 240 0 0 7/6 -5/6 I
Net evaluation row 0 0 -500/6 +100/6
+160/3 -80/3 0

= =−
All the values of the net evaluation row of Table 3 are either zero or negative, the
optimal program has been obtained.
Here X = 120, y = 300 and the
maximum profit = 80×120 +
100× 300 = 9600 + 30,000

= Rs. 39,600.
Question 6
Three grades of coal A, B and C contains phosphorus and ash as impurities. In a
particular industrial process, fuel up to 100 ton (maximum) is required which
could contain ash not more than 3% and phosphorus not more than .03%. It is
desired to maximize the profit while satisfying these conditions. There is an
unlimited supply of each grade. The percentage of impurities and the profits of
each grade are as follows:
Coal Phosphorus Ash (%) Profit in Rs. (per ton)
(%)
A .02 3.0 12.00

12.14
 The Transportation Problem

B .04 2.0 15.00

C .03 5.0 14.00
You are required to formulate the Linear-programming (LP) model to solve it by
using simplex method to determine optimal product mix and profit. Answer
Let X1, X2 and X3 respectively be the amounts in tons of grades A, B, and C used.
The constraints are
(i) Phosphorus content must not exceed 0.03%
.02 X1+ .04X2 + 0.3 X3 ≤ .03 (X1 + X2 + X3)
2X1 + 4 X2 + 3X3 ≤ 3 (X1 + X2 + X3) or – X1 + X2 ≤ 0
(ii) Ash content must not exceed 3%
3X1 + 2 X2 + 5 X3 ≤ 3 (X1 + X2 + X3) or – X2 + 2X3 ≤ 0
(iii) Total quantity of fuel required is not more than 100 tons. X1 + X2 + X3 ≤ 100
The Mathematical formulation of the problem is
Maximize Z = 12 X1 + 15X2 + 14 X3
Subject to the constraints:

- X1 + X2 ≤ 0
- X2 + X3 ≤ 0
X1 + X2 + X3 ≤ 100
X1, X2, X3 > 0
Introducing slack variable X4 >0, X5>0, X6>0
12 15 14 0 0 0
Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
0 Y4 0 -1 1* 0 1 0 0
0 Y5 0 0 -1 2 0 1 00 Y6
100 1 1 1 0 0 1 Z -12
-15 -14 0 0 0
Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
15 Y2 0 -1 1 0 1 0 0
0 Y5 0 -1 0 2 1 1 0 0 Y6 100 2* 0 1 -1 0 1 Z -27 -14 15 0 0

Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
15 Y2 50 0 1 1/2 1/2 0 1/2

12.15
Advanced Management Accounting

0 Y5 50 0 0 5/2* 1/2 1 1/2

12 Y1 50 1 0 1/2 -1/2 0 1/2
Z 0 0 -1/2 3/2 0 27/2
Cb Yb Xb Y1 Y2 Y3 Y4 Y5 Y6
15 Y2 40 0 1 0 2/5 -1/5 2/5 14 Y3 20
0 0 1 1/5 2/5 1/5

12 Y1 40 1 0 0 -3/5 -1/5 2/5

Z 0 0 0 8/5 1/5 68/5
The optimum solution is X1 = 40, X2 = 40 and X3 = 20 with maximum Z = 1360.
Question 7
The initial allocation of a transportation problem, alongwith the unit cost of
transportation from each origin to destination is given below. You are required to
arrive at the minimum transportation cost by the Vogel’s Approximation method
and check for optimality. (Hint: Candidates may consider u 1 = 0 at Row 1 for
8 6 4 initial cell
11 evaluation)
2 8 6 2 Requirement
10
18 9 9 12 9 6

8
10
7 6 7 7
3
8 2 2
3 11
4 9 5 6
Availability
12 8 8 8 4 40
Answer
The concept tested in this problem is Degeneracy with respect to the
transportation problem. Total of rows and columns = (4 + 5) = 9. Hence, the
number of allocations = 9 – 1 = 8. As the actual number of allocation is 7, a ‘zero’
allocation is called for. To resolve this, an independent cell with least cost should
be chosen. R4C2 has the least cost (cost = 3), but this is not independent. The
next least cost cell R4C3 (cost = 5) is independent.

12.16
 The Transportation Problem

9 2 5 6 2
C1 C2 C3 C4 C5 Total
8 6 4
0R1 18
11 2 8 6 2
1
0R2 0 10
9 9 12 9 6
8
−2R3 8
7 6 3 7 7
2
0R4 0 2 4
9 3 5 6 11
Total 12 8 8 8 4 40

Forming Equations through allocated cells

Basic equation Setting R1 = 0 other
values
R1 + C2 = 2 Setting R1 = 0, C2 = 2
R1 + C4 = 6 C4 = 6
R1 + C5 = 2 C5 = 2
R2 + C1 = 9 R2 = 0
R3 + C3 = 3 R3 = −2
R4 + C1 = 9 C1 = 9
R4 + C3 = 5 C3 = 5
R4 + C4 = 6 R4 = 0
Evaluate unallocated cells

R1C1 = 11 − 0 − 9 R3C1 = 7 + 2 − 9 = 0
=2
R1C3 = 8 − 0 − 5 = R3C2 = 6 + 2 − 2 = 6
3

12.17
Advanced Management Accounting

R2C2 = 9 − 0 − 2 = R3C4 = 7 + 2 − 6 = 7
7
R2C3 = 12 − 0 − 5 R3C5 = 7 + 2 − 2 = 7
=7
R2C4 = 9 − 0 − 6 = R4C2 = 3 − 0 − 2 = 1
3
R2C5 = 6 − 0 − 2 = R4C5 = 11 − 0 − 2 = 9
4
Since all the evaluation is 0 or +ve, the optimal solution is obtained.
Optimal cost = (8 × 2) + (6 × 6) + (4 × 2) + (10 × 9) + (8 × 3) + (2 × 9) + (0 × 5)
+ (2 × 6) = 16 + 36 + 8 + 90 + 24 + 18 + 10 + 12 = Rs. 204.
Note: As regards allocation of the zero values, the solution to the above problem
is also obtained by allocating the zero value in other independent cells such as
R1C3, R2C2, R2C3, R3C1, R3C2, R3C4, R3C5. In such situation there will be
one more iteration.
Question 8
Goods manufactured at 3 plants, A, B and C are required to be transported to
sales outlets X, Y and Z. The unit costs of transporting the goods from the plants
to the outlets are given below:
Plants A B C Total Sales outlets
Demand

X 3 9 6 20
Y 4 4 6 40
Z 8 3 5 60
Total supply 40 50 30 120
You are required to:
(i) Compute the initial allocation by North-West Corner Rule.
(ii) Compute the initial allocation by Vogel’s approximation method and check
whether it is optional.
(iii)
State your analysis on the optionality of allocation under North-West corner
Rule and Vogel’s Approximation method.
Answer

12.18
 The Transportation Problem

20 − − 20
3 9 6
20 20 − 40
4 4 6

− 30 30 60
8 3 5
40 50 30
120

(i) Initial allocation under NW corner rule is as above.

Initial cost: 20 × 3 = 60
20 × 4 = 80
20 × 4 = 80
30 × 3 = 90
30 × 5 = 150
460
(ii) Initial solution by VAM:
20 3 20 − −
3 9 6
40 0 0 2
20 − 20
60 2 2 4 4 6 2
50 10
40 50 30
8 3 5

1 1 1
4 1 1

1 1
Initial 20 × 3 = 60
solution:

12.19
Advanced Management Accounting

20 × 4 = 80
50 × 3 = 150
20 × 6 = 120
10 × 5 = 100
460

Checking for optimality

u1 = 0 3 u2 = 1

4 6
u3 = 0 3 5
V1 = 3 V2 =3 V3 =5
3 5
ui + vj
01 4

0 3
3 3 5
∆ij = cij – ( ui + vj)
6 1
0
5
∆ij ≥ 0 ∴ Solution is optimal
Conclusion:

The solution under VAM is optimal with a zero in R 2C2 which means that the cell
C2R2 which means that the cell C2R2 can come into solution, which will be
another optimal solution. Under NWC rule the initial allocation had C 2R2 and the
total cost was the same Rs. 460 as the total cost under optimal VAM solution.
Thus, in this problem, both methods have yielded the optimal solution under the
1st allocation. If we do an optimality test for the solution, we will get a zero for ∆ij
in C3R2 indicating the other optimal solution which was obtained under VAM.
Question 9
State the methods in which initial feasible solution can be arrived at in a
transportation problem Answer

12.20
 The Transportation Problem

The methods by which initial feasible solution can be arrived at in a

transportation model are as under:
(i) North West Corner Method.
(ii) Least Cost Method
(iii) Vogel’s Approximation Method (VAM)
Question 10
The cost per unit of transporting goods from the factories X, Y, Z to destinations.
A, B and C, and the quantities demanded and supplied are tabulated below. As
the company is working out the optimum logistics, the Govt.; has announced a
fall in oil prices. The revised unit costs are exactly half the costs given in the
table. You are required to evaluate the minimum transportation cost.
Destinatio A B C Supply
ns Factories
X 15 9 6 10
Y 21 12 6 10
Z 6 18 9 10
Demand 10 10 10 30
Answer
The problem may be treated as an assignment problem. The solution will be the
same even if prices are halved. Only at the last stage, calculate the minimum
cost and divide it by 2 to account for fall in oil prices.
A B C
X 15
9 6 Y
21 12 6
Z 6 18 9
Subtracting Row minimum, we get
A B C
X 9 3 0 Y 15 6 0
Z 0 12 3
Subtracting Column minimum,
A B C

12.21
Advanced Management Accounting

No of lines required to cut Zeros = 3

Cost / u Units Cost Revis
ed
Cost
Allocation: X B 9 10 90 45
Y C 6 10 60 30 Z A 6 10 60 30
210 105
Minimum cost = 105 Rs.
Alternative Solution I
Least Cost Method

X–B
Y–C
Z –A
Test for optimality
No. of allocation = 3

12.22
 The Transportation Problem

No. of rows m =3, no. of

column = 3 m+n–1=3+
3–1=5
2 very small allocation are done to of
2 cells
minimum costs, so that , the following
table is got:
A B C

1 e
X 1 9 6
5

Y 2 1 1 6
1 2

Z 1 6 18 e 9

m+n–1=5
Now testing for optimality

12.23
Advanced Management Accounting

All ∆ij > 0, Hence this is the optimal solution.

Original Reduced Qty. Cost
Costs Costs due
to Oil Price
X–B 9 4.5 10 45
Y–C 6 3 10 30

12.24
 The Transportation Problem

Z–A 6 3 10 30
105
Total cost of transportation is minimum at Rs.105
Alternative Solution II

No. of rows + no. of column –

1 m+n–1=5
No. of allocation = 3
Hence add ‘e’ to 2 least cost cells so that

12.25
Advanced Management Accounting

Now m + n – 1 = 5
Testing for
optimality, ui, vj table

12.26
 The Transportation Problem

ui + vj for unoccupied cells

3 - -
3 4.5 -
- 4.5 -

Cij ui+vj
7.5 - - 3 - -
11.5 6 - 3 4.5 -
- 9 - - 4.5 -

∆ij = Cij – (ui + vj)

4.5 - -
11.5 1.5 -
8.5 4.5 -

All ∆ij > 0. Hence the solution is optimal.

Qty. Cost/u Total Cost

X–B 10 4.5 45
Y–C 10 3 30
Z–A 10 3 30
Total 105
minimum
cost at
revised oil
prices
Question 11
How do you know whether an alternative solution exists for a transportation
problem?

12.27
Advanced Management Accounting

Answer
The ∆ ij matrix = ∆ ij = Cij – (ui + vj)
Where ci is the cost matrix and (ui + vj) is the cell evaluation matrix for allocated
cell.
The ∆ ij matrix has one or more ‘Zero’ elements, indicating that, if that cell is
brought into the solution, the optional cost will not change though the allocation
changes.
Thus, a ‘Zero’ element in the ∆ ij matrix reveals the possibility of an alternative
solution.
Question 12
Explain the term degeneracy in a transportation problem.
Answer
If a basic feasible solution of transportation problem with m origins and n
destinations has fewer than m + n – 1 positive xij (occupied cells) the problem is
said to be a degenerate transportation problem. Such a situation may be handled
by introducing an infinitesimally small allocation e in the least cost and
independent cell.
While in the simple computation degeneracy does not cause any serious
difficulty, it can cause computational problem in transportation problem. If we
apply modified distribution method, then the dual variable ui and vj are obtained
from the Cij value to locate one or more Cij value which should be equated to
corresponding Cij + Vij.

12.28
 The Transportation Problem

EXERCISE
Question 1
A particular product is manufactured in factories A, B, and D: and is sold at
centers 1, 2 and 3. The cost in Rs. of product per unit and capacity in kgms per
unit time of each plant is given below:
Factory Coast (Rs.) per unit Capacity (kgms) per unit
A 12 100
B 15 20
C 11 60
D 13 80
The sale price in Rs. Per unit and the demand is kgms per unit time are as
follows:
Sale Centre Sale price (Rs.) per unit Demand (Kgms) per unit
1 15 120
2 14 140
3 16 60
Find the optimal sales distribution.
Answer
Total Profit = Rs. 660
Question 2

A Company has four factories F1, F2, F3 and F4, manufacturing the same product.
Production and raw material costs differ from factory to factory and are given in
the first two rows of the following table. The Transportation costs from the
factories to sales depots S1, S2 and S3 are given in the next three rows of the
table. The production capacity of each factory is given in the last row.
The last two columns in the table given the sales price and the total requirement
at each depot:
Item Factory Sales priceRequirement
Per unit F1 F2 F3 F4 Per unit
Production cost 15 18 14 13 - -
Raw material cost 10 9 12 9 - -

12.29
Advanced Management Accounting

Transportation cost 3 9 5 4 34 80
1 7 4 5 32 120
5 8 3 6 31 150
Production capacity 10 150 50 100 - -

Determine the most profitable production and distribution schedule and the
corresponding profit. The surplus should be taken to yield zero profit.
Answer
Profit associated with the optimum Program is Rs. 480.
Question 3
A company has 3 plants and 3 warehouses. The cost of sending a unit from
different plants to the warehouses, production at different plants and demand at
different warehouses are shown in the following cost matrix table:
Plants Warehouses Production
ABC
X 8 16 16 152
Y 32 48 32 164
Z 16 32 48 154

Demand 144 204 82

Determine a transportation schedule, so that the cost is minimized. Assume that
the cost in the cost matrix is given in thousand of rupees.
Answer
On calculating ∆ij’s=0, the solution is not unique.
Question 4
Following is the profit matrix based on four factories and three sales depots of
the company:
S1 S2 S3
Availability 6 6 1
F1 10
-2 -2 -4
Towns F2 150
F3 50 3 2 2
F4 100 8 5 3
Requirement 80 120
150

12.30
 The Transportation Problem

Determine the most profitable distribution schedule and the corresponding profit,
assuming no profit in case of surplus production. Answer
Total Profit = Rs. 480
Question 5
A company produces a small component for all industrial products and
distributes it to five wholesalers at a fixed prices of Rs.2.50 per unit. Sales
forecasts indicate that monthly deliveries will be 3,000, 3,000, 10,000, 5,000 and
4,000 units to wholesalers 1,2,3,4 and 5 respectively. The monthly production
capabilities are 5,000, 10,000, 12,500 at plants 1, 2 and 3 respectively. The
direct costs of production of each unit are Rs.1.00 and Rs.0.80 at plants 1, 2 and
3 respectively. The transportation costs of shipping a unit from a plant to a
wholesaler are given below:
1 2 3 4 5
1 0.05 0.07 0.10 0.15 0.15
Plant 2 0.08 0.06 0.09 0.12 0.14
3 0.10 0.09 0.08 0.10 0.15
Find how many components each plant supplies to each wholesaler in order to
maximize profit.
Answer
Profit = Rs.32,520
Question 6
The following table shows all the necessary information on the available supply
to each warehouse, the requirement of each market and the unit transportation
cost from each warehouse to each market:
Market
I II III IV Supply
A 22 5 2 4 3
Warehouse B 15 4 8 1 6
C
8
4 6 7 5
Requirement 7 12 17 9
The shipping clerk has worked out the following schedule from his experience:
12 Units from A to II
1 Unit from A to III

12.31
Advanced Management Accounting

9 Units fro A to IV
15 Units from B to III
7 Units from C to I and
1 Unit from C to III
You are required to answer the following:
(i) Check and see if the clerk has the optimal schedule;
(ii) Find the optimal schedule and minimum total shipping cost; and
(iii) If the clerk is approached by a carrier of route C to II, who offers to reduce
his rate in the hope of getting some business, by how much should the rate
be reduced before the clerk should consider giving him an order?
Answer
Total Shipping Cost = Rs.103.
Question 7
A company has three warehouses W1, W2 and W3. It is required to deliver a
product from these warehouses to three customers A, B and C. There
warehouses have the following units in stock.

Warehouse: W1 W2 W3
No. of units: 65 42 43
and customer requirements are:

Customer: A B C

No. of units: 70 30 50

The table below shows the costs of transporting one unit from warehouse to the
customer:
Warehouse
W1 W2 W3
A 5 7 8
Customer B 4 4 6
C 6 7 7
Find the optimal transportation route.

12.32
 The Transportation Problem

Answer Total Cost = Rs. 830

Question 8
A company has four factories situated in four different locations in the country
and four sales agencies located in four other locations in the country. The cost of

Investment made at Net Return Data (in Paise) of Selected Amount

the Beginning of year Investment available
P Q R S (Lacs)

1 95 80 70 60 70
2 75 65 60 50 40
3 70 45 50 40 90
4 60 40 40 30 30
Maximum Investment 40 30 60 60
(Lacs)
The following additional information are also provided
production (Rs.
Answer
Since one of the ∆ij’s is Zero, the optimal solution obtained above is not unique.
Alternate solution also exists. Question 9
XYZ and Co. has provided the following data seeking your advice on optimum
investment strategy.
• P, Q, R and S represent the selected investments,
• The company has decided to have four years investment plan.
• The policy of the company is that amount invested in any year will remain
so until the end of the fourth year.

12.33
Advanced Management Accounting

• The values (Paise) in the table represent net return on investment of one
Rupee till he end of the planning horizon (for example, a Rupee investment
in Investment P at the beginning of year 1 will grow to Rs.1.95 by the end
of the fourth year, yielding a return of 95 paise)
Using the above determine the optimum investment strategy.
Answer
The optimal allocations are given below:
Year Invest in Net Return

1 Invest Rs 40 lacs in investment P 0.95xRs.40 lacs = Rs.

38,00,000
Rs 30 lacs in investment Q 0.80xRs.30 lacs = Rs.
24,00,000
2 Invest Rs 20 lacs in investment Q 0.65xRs.20 lacs = Rs.
13,00,000
Rs 20 lacs in investment R 0.60xRs.20 lacs = Rs.
12,00,000
3 Invest Rs 40 lacs in investment R 0.50xRs.40 lacs = Rs.
20,00,000
Rs 50 lacs in investment S 0.40xRs.50 lacs = Rs.
20,00,000
4 Invest Rs.10 lacs in investment S 0.30xRs.10 lacs = Rs.
3,00,000
Total Rs.130,00,000
Question 10
A company has four terminals U, V, W and X. At the start of a particular day 10,
4, 6 and 5 trailers respectively are available at these terminals. During the
previous night 13, 10 , 6 and 6 trailers respectively were loaded at plants A, B, C
and D. The company dispatcher has come up with the costs between the
terminals and plants as follows: Plants
A B C D
Terminals U 20 36 10 28
V 40 20 45 20
W 75 35 45 50
X 30 35 40 25
Find the allocation of loaded trailers from plants to terminals in order to minimize
transportation cost.

12.34
 The Transportation Problem

Answer Terminal Plant Cost = Rs. 555

12.35
 CHAPTER 13

THE ASSIGNMENT PROBLEM

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. The Assignment Algorithm
The Assignment Problem is another special case of LPP. It occurs when n
jobs are to be assigned to n facilities on a one-to-one basis with a view to
optimising the resource required.
2. Steps for Solving the Assignment Problem
Assignment problem can be solved by applying the following steps:
Step 1: Subtract the minimum element of each row from all the elements
in that row. From each column of the matrix so obtained, subtract its
minimum element. The resulting matrix is the starting matrix for the
following procedure.
Step 2: Draw the minimum number of horizontal and vertical lines that
cover all the zeros. If this number of lines is n, order of the matrix, optimal
assignment can be made by skipping steps 3 and 4 and proceeding with
step 5. If, however, this number is less than n, go to the next step.
Step 3: Here, we try to increase the number of zeros in the matrix. We
select the smallest element out of these which do not lie on any line.
Subtract this element from all such (uncovered) elements and add it to the
elements which are placed at the intersections of the horizontal and
vertical lines. Do not alter the elements through which only one line
passes.
Step 4: Repeat steps 1, 2 and 3 until we get the minimum number of lines
equal to n.
Step 5: (A) Starting with first row, examine all rows of matrix in step 2 or 4
in turn until a row containing exactly one zero is found. Surround this zero
by, indication of an assignment there. Draw a vertical line through the
column containing this zero. This eliminates any confusion of making any
further assignments in that column. Process all the rows in this way.
(B) Apply the same treatment to columns also. Starting with the first
Advanced Management Accounting

column, examine all columns until a column containing exactly one zero is
found. Mark and
draw a horizontal line through the row containing this marked zero. Repeat
steps 5A and B, until one of the following situations arises:
(i) No unmarked ( ) or uncovered (by a line) zero is left,
(ii) There may be more than one unmarked zero in one column or row. In
this case, put around one of the unmarked zero arbitrarily and pass 2
lines in the cells of the remaining zeros in its row and column. Repeat
the process until no unmarked zero is left in the matrix.
3. Unbalanced Assignment Problems
Like the unbalanced transportation problems there could arise unbalanced
assignment problems too. They are to be handled exactly in the same
manner i.e., by introducing dummy jobs or dummy men, etc.
Question 1
An Electronic Data Processing (ED) centre has three expert Software
professionals. The Centre wants three application software programs to be
developed. The head of EDP Centre estimates the computer time in minutes
required by the experts for development of Application Software Programs as
follows:
Software programs Computer time (in minutes)
required by software
Professionals
1 100 85 70
2 50 70 110
3 110 120 130
Assign the software professionals to the application software programs to ensure
minimum usage of computer time.
Answer
The given problem is a balanced minimization assignment problem.
Step 1 & II: The minimum time elements in row 1, 2 and 3are 70, 50 and 110
respectively. We subtract these elements from all elements in their respective row.
The reduced matrix is shown in Table 1.

Table 1
Software A B C
Programs

13.2
 The Assignment Problem

1 30 15 0
2 0 20 60
3 0 10 20
The minimum time elements in columns A, B and C are 0, 10, and 0 respectively.
Subtract these elements from all the elements in their respective columns to get
the reduced time matrix as shown in table 2.

Table 2
Software A B C
Programs
1 30 5 0
2 0 10 60
3 20
0 0
Step 3(a): The minimum number of horizontal and vertical lines to cover all zeros
is 3, which is equal to the order of the matrix. Examine all rows one by one
starting from row 1 until a row containing only single zero element is located.
Assign this zero. All zero in the assigned column are crossed off as shown in table
3. Table 3
Software A B C
Programs
1 30 5 0
2 0 10 60
3 0 0 20
Step 3(b): Now examine each column starting from A. There is only one zero in
column. B Assign this cell as shown in table 4

Table 4
Software Programs A B C
1 30 15 0
2 0 20 60
3 0 0 20
Step 3(c): Since the number of assignments (=3) equals the number of rows, the
optimal solution is obtained. This Pattern of assignments among software
professionals and programs with their respective time (in minutes) is given below:

13.3
Advanced Management Accounting

Program Software Professionals Time (in Minutes)

1 C 70
2 A 50
3 B 120
Total 240
Question 2
A Production supervisor is considering, how he should assign five jobs that are to
be performed, to five mechanists working under him. He wants to assign the jobs
to the mechanists in such a manner that the aggregate cost to perform the jobs is
the least. He has following information about the wages paid to the mechanists
for performing these jobs: Jobs
Mechanist 1 2 3 4 5
A 10 3 3 2 8
B 9 7 8 2 7
C 7 5 6 2 4
D 3 5 8 2 4
E 9 10 9 6 10
Assign the jobs to the mechanists so that the aggregate cost is the least.
Answer
The given problem is a standard minimization problem.
Subtracting minimum element of each row from all the elements of that row, the
given problem reduces to
Jobs
Mechanist 1 2 3 4 5
A 8 1 1 0 6
B 7 5 6 0 5
C 5 3 4 0 2
D 1 3 6 0 2
E 3 4 3 0 4
Subtract the minimum element of each column from all the elements of that
column. Draw the minimum number of lines horizontal or vertical so as to cover all
zeros.

13.4
 The Assignment Problem

Jobs
Mechanist 1 2 3 4 5
A 7 0 0 0 4
B 6 4 5 0 3
C 4 2 3 0 0
D 0 2 5 0 0
E 2 3 2 0 2
Since the minimum number of lines covering all zeros is equal to 4 which is less
than the number of columns/rows (=5), the above table will not provide optimal
solution. Subtract the minimum uncovered element (=2) from all uncovered
elements and add to the elements lying on the intersection of two lines, we get
the following matrix. Jobs

Mechanist 1 2 3 4 5
A 7 0 0 2 6
B 4 2 3 3
C 2 0 1 0
D
0 2 5 2
E
0 1 0 2
0
0
2
0

Since the minimum number of horizontal and vertical lines to cover all zeros is
equal to five which is equal to the order of the matrix, the above table will give the
optimal solution. The optimal assignment is made below:

13.5
Advanced Management Accounting

Jobs
Mechanist 1 2 3 4 5
A 7 0 0 2 6
B 4 2 3 0 3
C 2 0 1 0 0
D 0 2 5 2 2
E 0 1 0 0 2

The optimal assignment is given below:

Mechanist Job Wages

A 2 3
B 4 2
C 5 4
D 1 3
E 3 9
21

The total least cost associated with the optimal mechanist-job assignment = 21
Question 3
A project consists of four (4) major jobs, for which four (4) contractors have
submitted tenders. The tender amounts, in thousands of rupees, are given below.
Jobs
Contractors A B C D
1 120 100 80 90
2 80 90 110 70
3 110 140 120 100
4 90 90 80 90
Find the assignment, which minimizes the total cost of the project. Each
contractor has to be assigned one job.
Answer
The given problem is a standard minimization problem. Subtracting the minimum
element

13.6
 The Assignment Problem

of each row from all its elements in turn, the given problem reduces
to Jobs
Contractors A B C D
1 40 20 0 10
2 10 20 40 0
3 10 40 20 0
4 10 10 0 10
Now subtract the minimum element of each column from all its elements in turn.
Draw the minimum number of lines horizontal or vertical so as to cover all zeros.
Jobs
Contractors A B C D
1 30 10 0 10
2 0 10 40 0
3 0 30 20 0
4 1
0 0 0 0

Since the minimum number of lines to cover all zeros is equal to 4(=order of the
matrix), this matrix will give optimal solution. The optimal assignment is made in
the matrix below:

13.7
Advanced Management Accounting

Jobs
Contractors A B C D
1 30 10 0 10
2 0 10 40 0
3 0 30 20 0
4 0 0 0 10

The optimal assignment is

Contractor Job Cost (in thousands of

rupees)
1 C 80
2 A 80
3 D 100
4 B 90
Hence, total minimum cost of the project will be Rs.3,50,000.
Question 4
A project consists of four (4) major jobs, for which four (4) contractors have
submitted tenders. The tender amounts, in thousands of rupees, area given
below: Jobs
Contractors A B C D
1 120 100 80 90
2 80 90 110 70
3 110 140 120 100
4 90 90 80 90
Final the assignment, which minimizes the total cost of the project. Each
contractor has to be assigned one job.
Answer
The given problem is a standard minimization problem. Subtracting the minimum
element of each row from all its elements in turn, the given problem reduces to
Jobs
Contractors A B C D
1 40 20 0 10

13.8
 The Assignment Problem

2 10 40 20 0
3 10 40 20 0
4 10 10 0 0
Now subtract the minimum element of each column from all it elements in turn.
Draw the minimum number of lines horizontal or vertical so as to cover all zeros.
Jobs
Contractors A B C D
1
30 40 0 10
2 0 10 40 0
3 0 30 20 0
4 1
0 0 0 0
Since the minimum number of lines to cover ros is all
equal
ze to 4 ( = order of the matrix),
this matrix will give optimal solution.imal
Theassignment
opt is made in the matrix below.
Contractors A B C D
1 3 4 0 1
2 00 0
1 4 00

3 0 0
3 0
2 0
4 0 00 00 1
0
The optimal assignment is:

Contractor Job Cost (in thousands of

rupees)
1 C 80
2 A 80
3 D 100
4 B 90
Hence, total minimum cost of the project will be Rs. 3,50,000.
Question 5

13.9
Advanced Management Accounting

A Marketing Manager has 4 subordinates and 4 tasks. The subordinates differ in

efficiency. The tasks also differ in their intrinsic difficulty. His estimates of the time
each subordinate would take to perform each task is given in the matrix below.
How should the task be allocated one to one man so that the total man-hours are
I II III IV
16 52 34 22
26 56 8 52
76 38 36 30
38 52 48 20
minimised ?

1
2
3
4
Answer
I II III IV
1 16 52 34 22
2 26 56 8 52
3 76 38 36 30
4 38 52 48 20
Step 1:
Subtract the smallest element of each row from every element of the
corresponding row
I II III IV
1 0 36 18 6
2 18 48 0 44
3 46 8 6 0
4 18 32 28 0
Step 2: Subtract the smallest element of each column from every element in that
column

13.10
 The Assignment Problem

I II III IV
1 0 28 18 6
2 18 40 0 44
3 46 0 6 0
4 18 24 28 0
Step 3: Drew minimum number of horizontal and vertical lines to cover all the
zeros
I II III IV
1 0 28 18 6
2 18 40 0 44
3 0
46 0 6
4 18 24 28 0
The optimal assignment is
1 ─ I = 16
2 ─ III = 8
3 ─ II = 38
4 ─ IV = 20
82
hours
Minimum time taken = 82 hours
Question 6
A BPO company is taking bids for 4 routes in the city to ply pick-up and drop
cabs. Four companies have made bids as detailed below:

Bids for Routes (Rs.)

Company/Routes R1 R2 R3 R4

C1 4,000 5,000 − −

C2 − 4,000 − 4,000

13.11
Advanced Management Accounting

C3 3,000 − 2,000 −

C4 − − 4,000 5,000
Each bidder can be assigned only one route. Determine the minimum cost that
the BPO should incur.
Answer
Reducing minimum from each column element (figure in ’000s)

Step 1 Step 2
R1 R2 R3 R4 R1 R2 R3 R4
C1 1 1 − − C1 0 0 − −
C2 − 0 − 0 C2 − 0 − 0
C3 0 − 0 − C3 0 − 0 −

C4 − − 2 1 C4 − − 1 0
Number of lines to connect all zeros nos. is 4 which is optional.
Alternatively you may also reduce the minimum from each row.

Step 1 Step 2
R1 R2 R3 R4
0 1 R1 R2 R3 R4
− −
C1 0 0 C1 0 1 − − C2 C2
− −
1 − 0 − − 0 − 0 C3 C3 0

− − 0 1 − 0 −

C4 C4 − − 0 0
Number of lines to connect all zeros nos. is 4 which is optional.
All diagonal elements are zeros and are chosen. The minimum cost is Rs.15,000
C1 – R1 4,000; C2 – R2 4,000; C3 – R3 2,000; C4 – R4 5,000; (Total) = 15,000.
Question 7
A gear manufacturing company makes two types of gears – A and B. Both gears
are processed on 3 machines, Hobbing M/c, Shaping M/c and Grinding M/c. The
time required by each gear and total time available per week on each M/c is as
follows:

13.12
 The Assignment Problem

Gear (A) Gear (B) Availabl

Machin (Hours) (Hours) e
e Hours
Hobbing M/c 3 3 36
Shaping M/c 5 2 60
Grinding M/c 2 6 60
Other data:
Selling price (Rs.) 820 960
Variable cost (Rs.) 780 900
Determine the optimum production plan and the maximum contribution for the
next week by simplex method. The initial table is given below:
Cj 40 60 0 0 0
Qty.

Cj Variable X1 X2 X3 X4 X5
0 X3 36 3 3 1 0 0
0 X4 60 5 2 0 1 0
0
X5 60 2 6 0 0 1
Answer
Table 1
Cj 40 60 0 0 0 Ratio
Qty
cj Variable X1 X2 X3 X4 X5
0 X3 36 3 3 1 0 0 12
0 X4 60 5 2 0 1 0 30
0 X5 60 2 6 0 0 1 10

Zj 0 0 0 0 0 0
Zj – Cj −40 −60 0 0 0
Table 2

13.13
Advanced Management Accounting

Cj 40 60 0 0 0 Ratio
Qty

cj Variable X1 X2 X3 X4 X5
0 X3 6 2 0 1 0 −½ 3
0 X4 40 13/3 0 0 1 −⅓ 120/1
3
60 X2 10 ⅓ 1 0 0 1/6 30
Zj 600 20 60 0 0 10
Zj – Cj −20 0 0 0 10
Table 3
Cj 40 60 0 0 0
Qty
cj Variable X1 X2 X3 X4 X5
40 X1 3 1 0 ½ 0 −1/4
0 X4 27 0 0 −13/6 1 ¾
60 X2 9 0 1 −1/6 0 ¼
Zj 660 40 60 10 0 5
Zj – Cj 0 0 10 0 5
Since all Z
j – Cj are positive or zero, this is the optimum solution with.
1 = 40X and X
2 = 60

and optimum Z = 660.

Note: Alternatively, Cj – Zj may be used whereby maximum positive value may be
considered.
Question 8
A company has four zones open and four marketing managers available for
assignment. The zones are not equal in sales potentials. It is estimated that a
typical marketing manager operating in each zone would bring in the following
Annual sales:
Zones Rs.
East 2 , 40,000 West 1 ,
92,000 North 1 , 44,000

13.14
 The Assignment Problem

South 1 , 20,000
The four marketing manages are also different in ability. It is estimated that
working under the same conditions, their yearly sales would be proportionately as
under:
Manager M : 8 Manager N : 7
Manager O : 5
Manager P : 4
Required:
If the criterion is maximum expected total sales, find the optimum assignment and
the maximum sales.
Answer
Sum of the proportion = (8 + 7 + 5 + 4) = 24
Assuming Rs. 1,000 as one unit, the effective matrix is as follows:

13.15
Advanced Management Accounting

Effective Matrix
Managers Zones
East West North South
M (8/24) × 240 = 80 (8/24) × 192 = 64 (8/24) × 144 (8/24) × 120 =
= 48 40
N (7/24) × 240 = 70 (7/24) × 192 = 56 (7/24) × 144 (7/24) × 120 =
= 42 35
O (5/24) × 240 = 50 (5/24) × 192 = 40 (5/24) × 144 (5/24) × 120 =
= 30 25
P (4/24) × 240 = 40 (4/24) × 192 = 32 (4/24) × 144 = 24 (4/24) × 120 =
Convert the maximization problem to minimization problem 20

The resultant loss matrix is as follows:

Loss Matrix
Managers East West North South
M 0 16 32 40
N 10 24 38 45
O 30 40 50 55
P 40 48 56 60
Row operation
Managers East West North South
M 0 16 32 40
N 0 14 28 35
O 0 10 20 25
P 0 8 16 20
Column
operation
Managers East West North South
0 8 16 20
M
0 6 12 15
N
O 0 2 4 5
P 0 0 0 0
Managers East West North South

13.16
 The Assignment Problem

M 0
6 0 4 10 13
14
18 0 0 2 3
N
O
P 2 0 0 0

Managers East West North South

M 0 2 10 14
N 0 0 6 9
O
4 0 2 3
P 6
0 0 0

Managers East West North South

M 0 2 8 12
N 0 0 4 7
O
4 0 0 1
P 8
2 0 0

Assignment Sales
Rs.

M – East 80,000

N – West 56,000

O – North 30,000

P – South 20,000

1,86,00
0
Question 9

13.17
Advanced Management Accounting

The cost matrix giving selling costs per unit of a product by salesman A, B, C and
D in regions R1, R2, R3 and R4 is given below:
A B C D
R1 4 12 16 8
R2 20 28 32 24
R3 36 44 48 40
R4 52 60 64 56
(i) Assign one salesman to one region to minimise the selling cost.
(ii) If the selling p[rice of the product is Rs. 200 per unit and variable cost
excluding the selling cost given in the table is Rs. 100 per unit, find the
assignment that would maximise the contribution.
(iii) What other conclusion can you make from the above?
Answer
(i)
4 12 16 8
20 28 32 24
36 44 48 40
52 60 64 56
Subtracting minimum element – each row.
0 8 12 4
0 8 12 4
0 8 12 4
0 8 12 4
Subtracting minimum element – each column,
0
0 0 0
0 0 0 0

0
0 0 0
0 0 0 0

13.18
 The Assignment Problem

Minimum no. of lines to cover all zeros = 4 = order of matrix. Hence optional
assignment is possible.
Minimum cost = 4 + 28 + 48 + 56 = 136.
= AR1 + BR2 + CR3 + DR4
Since all are zeros, there are 24 solutions to this assignment problem.
Viz. A B C D
R1 R2 R3 R4
R2 R3 R4 R1
R3 R4 R1 R2
R4 R1 R2 R3
R1 R3 R4 R2 etc.
A can be assigned in 4 ways, B in 3 ways for each of A’s 4
ways. (ii) SP – VC = 100 Rs.
A B C D
R1 96 88 84 92
R2 80 72 68 76
R3 64 56 52 60
R4 48 40 36 44
Subtracting the highest term

08 12 4
16 24 28 20
32 40 44 36
48 56 60 52
Subtracting minimum term of each
row.
08 12 4
08 12 4
08 12 4
08 12 4
Which is the same as the earlier matrix

13.19
Advanced Management Accounting

Maximum contribution = Rs. (96 + 72 + 52 + 44) = Rs. 264.

Alternative Solution:
Maximisation of contribution is same as minimizing cost. Hence, same
assignments as in (i) will be the optional solution.
Maximum Contribution Rs. (400 – 136) = Rs. 264
(iii) (a) The relative cost of assigning person i to region r does not change by
addition or subtraction of a constant from either a row, or column or all
elements of the matrix.
(b) Minimising cost is the same as maximizing contribution. Hence, the
assignment solution will be the same, applying point (i) above.
(c) Many zero’s represent many feasible least cost assignment. Here, all zeros
mean maximum permutation of a 4 × 4 matrix, viz. 4 × 3 × 2 × 1 = 24
solutions are possible.
Question 10
In an assignment problem to assign jobs to men to minimize the time taken,
suppose that one man does not know how to do a particular job, how will you
eliminate this allocation from the solution? Answer
In an assignment minimization problem, if one task cannot be assigned to one
person, introduce a prohibitively large cost for that allocation, say M, where M has
a high the value. Then, while doing the row minimum and column minimum
operations, automatically this allocation will get eliminated.
Question 11
A factory is going to modify of a plant layout to install four new machines Ml, M2,
M3 and M4. There are 5 vacant places J, K, L, M and N available. Because of
limited space machine M2 cannot be placed at L and M3 cannot be placed at J.
The cost of locating machine to place in Rupees is shown below:
(Rs.
)
J K L M N
M1 18 22 30 20 22
M2 24 18 -- 20 18
M3 -- 22 28 22 14
M4 28 16 24 14 16

Required:

13.20
 The Assignment Problem

Determine the optimal assignment schedule in such a manner that the total costs
are kept at a minimum.
Answer
Dummy machine (M5) is inserted to make it a balanced cost matrix and assume
its installation cost to be zero. Cost of install at cell M3 (J) and M2 (L) is very high
marked as é.
J K L M N
M1 18 22 30 20 22
M2 24 18 é 20 18
M3 é 22 28 22 14
M4 28 16 24 14 16
M5 (Dummy) 0 0 0 0 0
Step 1
Subtract the minimum element of each row from each element of that row
J K L M N
M1 0 4 12 2 4
M2 6 0 é 2 0
M3 é 8 14 8 0
M4 14 2 10 0 2
M5 (Dummy) 0 0 0 0 0
Step 2
Subtract the minimum element of each column from each element of that column
J K L M N
M1 0 4 12 2 4
M2 6 0 é 2 0
M3 é 8 14 8 0
M4 14 2 10 0 2
M5 (Dummy) 0 0 0 0 0

Step 3
Draw lines to connect the zeros as under:

13.21
Advanced Management Accounting

J K L M N
M1 12 2 4
M2 é 2 0
M3 14 8 0
M4 10 0 2
M5 0 0 0
(Dummy) 0 4
6 0
é 8
14 2
0 0
There are five lines which are equal to the order of the matrix. Hence the solution
is optimal. We may proceed to make the assignment as under:
J K L M N
M1 0 4 12 2 4

M2 0 e 2 0
6
M3 8
8 0
e 14
2 2
M4 10 0
14 0
0
M5 (Dummy) 0 0
0

The following is the assignment which keeps the total cost at minimum:
Machines Location Costs Rs.
M1 J 18
M2 K 18
M3 N 14
M4 M 14
M5 (Dummy) L 0
Total 64

13.22
 The Assignment Problem

EXERCISE
Question 1
A Car hiring company has one car at each of the five depots A,B,C,D and E. A
customer in each of the five towns V,W,X,Y and requires a car. The distance in
kms, between depots (origin) and the towns (destination) are given in the
following table:
Depots
A B C D E
V 3 5 10 15 8
W 4 7 15 18 8
Towns X 8 12 20 20 12
Y
5 5 8 10 6
Z
10 10 15 25 10
Find out as to which
car should be assigned to which customer so that the total distance traveled is a
minimum. How much is the total traveled distance?
Answer
The optimal assignment is
Town Depot Distance (in kms)
V C 10
W B 7
X A 8
Y D 10
Z E 10
Total 45
Hence the minimum total traveled distance = 45 kms.
Question 2
ABC airline operating 7 days a week has given the following time-table. Crews
must have minimum layover of 5 hours between flights. Obtain the pairing flights
that minimize the layover time away from home. For any given pairing the crew
will be based at the city that results in the smaller layover.

Hyderabad-Del hi Delhi-Hyderaba d

13.23
Advanced Management Accounting

Flight No. Depart. Arrive Flight No. Depart. Arrive

A1 6 AM 8 AM B1 8 AM 10 AM
A2 8 AM 10 AM B2 9 AM 11 AM
A3 2 PM 4 PM B3 2 PM 4 PM
A4 8 PM 10 PM B4 7 PM 9 PM
Answer
The optimal assignment is
From Flight No. To Flight No. Layover time
A1 B3 6
A2 B4 9
A3 B1 16
A4 B2* 9 40
hours

Question 3
Solve the assignment problem represented by the following effective matrix:
a b c d e f
AB 9 22 58 11 19 27
C 43 78 72 50 63 48
D 41 28 91 37 45 33
E 74 42 27 49 39 32
F 26 11 57 22 25 18
Answer 3 56 53 31 17 28

The assignment is
(i) A→d, B→f, C→b, D→c, E→e, F→a
And total effect = 11+48+28+27+25+3=142
Alternate solutions exist. One of the alternate solutions is given by
(ii) A→d, B→a, C→f, D→c, E→b and F→e with total effect = 142
Question 4

13.24
 The Assignment Problem

To stimulate interest and provide an atmosphere for intellectual discussion, a

finance faculty in a management school decides to hold special seminars on four
contemporary topics: leasing, portfolio management, private mutual funds, swaps
and options. Such seminars should be held once in a week in the afternoons.
However, scheduling these seminars (one for each topic, and not more than one
seminar per afternoon) has to be done carefully so that the number of students
unable to attend is kept to a minimum. A careful study indicates that the number
of students who cannot attend a particular seminar on a specific day is as follows:
Leasing Portfolio Private Swaps &
Management Mutual Fund Options
Monday 50 40 60 20
Tuesday 40 30 40 30
Wednesday 60 20 30 20
Thursday 30 30 20 30
Friday 10 20 10 30
Find an optimal schedule of the seminars. Also find out the total number of
students who will be missing at least one seminar.
Answer
And the optimal schedule is
No. of Students Missing
Monday : Swaps and options 20
Tuesday : No Seminar 0
Wednesday : Portfolio Management 20
Thursday : Pvt. Mutual funds 20
Friday : Leasing 10
70
Thus, the total number of students who will be missing at least one seminar = 70
Question 5
A manufacturing company has four zones A, B, C, D and four sales engineers P,
Q, R, S respectively for assignment. Since the zones are not equally rich in sales
potential, therefore it is estimated that a particular engineer operating in a
particular zone will bring the following sales;
Zone A : 4,20,000

13.25
Advanced Management Accounting

Zone B : 3,36,000 Zone C

: 2,94,000

Zone D : 4,62,000
The engineers are having different sales ability. Working under the same
conditions, their yearly sales are proportional to 14, 9, 11 and 8 respectively. The
criteria of maximum expected total sales is to be met by assigning the best
engineer to the richest zone, the next best to the second richest zone and so on.
Find the optimum assignment and the maximum sales.
Answer
The optimum assignments are as follows:
Zones (Loss in thousands of rupees)
Sales A B C D
Engineer
P 3 13 19 0
Q 0 0 1 2
R 0 4 7 0
S 2 0 0 5

Engineers Zones Sales (in Rs.)

P D 1 , 54,000
Q B 72,000
R A 1 , 10,000
S C 56,000
3 , 92,000
It can be seen from the above assignments that the best engineer P is assigned
to the richest Zone D, the next best engineer R is assigned to second richest zone
A, the next best engineer Q is assigned to zone B and so on. Hence, the optimum
assignment matches the company’s criteria of achieving the maximum expected
total sales.
Question 6
An organization is producing 4 different products viz. A, B, C, and D having 4
operators viz. P, Q, R and S, who are capable of producing any of the four
products, works

13.26
 The Assignment Problem

effectively 7 hours a day. The time (in)minutes

required for each operator for producing
each of the product are given
the cells
in of the following matrix
along profit (Rs. per unit):
Operator Product
A B C D
P 6 1 1 1
Q 7 05 43 24

R 6 7 1 1
S 2 1 0
1 0
1
Profit (Rs./Units) 03 02 54 51

Find out the assignment of operators

products
to which will maximize the profit.

Answer
Specific assignments in this case are as below:
Operato Product Profit (Rs.)
r
P A 210
Q C 560
R B 120
S D 28
Total Profit 918
(Rs.)
Question 7
A private firm employs typists on hourly piece rate basis for their daily work. Five
typists are working in that firm and their charges and speeds are different. On the
basis of some earlier understanding, only one job is given to one typist is paid for
full hours even when he or she works for a fraction of an hour. Find the least cost
allocation for the following when he or she works for a fraction of an hour. Find
the least cost allocation for the following data:

Typist Rate per Number of Job No. of pages

hour (Rs.) pages typed
hour
A 5 12 P 199

13.27
Advanced Management Accounting

B 6 14 Q 175
C 3 8 R 143
D 4 10 S 298
E 4 11 T 178
(Nov 1996)
Answer
Cost ( Rs.)
Thus typist A is given job T 75
Thus typist B is given job R 66
Thus typist C is given job Q 66
Thus typist D is given job P 80
Thus typist E is given job S 112
Total Rs.39
9
Note: In case the above solution is not unique. Alternate solution also exists.
Question 8
XYZ airline operating 7 days a week has given the following time-table. Crews
must have a minimum layover of 5 hours between flights. Obtain the paining
flights and minimizes layover time away from home. For any given pairing the
crew will be based at the city that results in the smaller layover:
Chennai ai M umbai - ai
Mumb Chenn
Flight Depart. Arrive Flight Depart. Arrive
Number Number
A1 6 AM 8 AM B1 8 AM 10 AM
A2 8 AM 10 AM B2 9 AM 11 AM
A3 2 PM 4 PM B3 2 PM 4 PM
A4 8 PM 10 PM B4 7 PM 9 PM

Answer
The optimal assignment is

13.28
 The Assignment Problem

From Flight No. To Flight No. Layover

A1 B3 6
A2 B4 9
A3 B1 16
A4 B2* 9 40
hours

Question 9
A firm produces four products.. There are four operators who are capable of
producing any of these four products. The processing time various from operator
to operator. The
firm records 8 hours a day and allows 30 minutes for lunch. The processingtime in
minutes and the profit for eachthe
of products are given below:
Operators Products
A B C D
1 15 9 10 6
2 10 6 9 6
3 25 15 15 9
4 15 9 10 10
Profit (Rs.) p. u. 8 6 5 4
Find the optimal assignmentproducts
of to operators.

Answer
The optimal assignment is as shown below:
Operator Product Profit (Rs.)
1 D 300
2 B 450
3 C 150
4 A 240
Rs. 1140

13.29
 CHAPTER 14

CRITICAL PATH ANALYSIS

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Framework of Pert/Cpm
The PERT and CPM models are extremely useful for the purpose of
planning, scheduling and controlling the progress and completion of large
and complex projects or for carrying out the analysis of these three
managerial functions. A network is a graphical representation of a project,
depicting the flow as well as the sequence of well-defined activities and
events. Both CPM (Critical Path Method) and PERT (Programme
Evaluation and Review Technique) are network techniques/ models.
2. Network
A network is, then, a graphical representation of a project plan, showing
the interrelation- ship of the various activities. Networks are also called
arrow diagrams (see figure-6). When the results of time estimates and
computations have been added to a network, it may be used as a project
schedule.
3. Steps in PERT/CPM Model
PERT/CPM model building consists of following five steps:
1. Analyse and break down the project in terms of specific activities
and/ or events.
2. Determine the interdependence and sequence of specific activities
and prepare a net- work.
3. Assign estimates of time, cost or both to all the activities of the
network.
4. Identify the longest or critical path through the network.
5. Monitor, evaluate and control the progress of the project by
replanning, rescheduling and reassignment of resources.
4. Critical Path
The longest path is the critical path because it equals the minimum time
required to complete the project. All other paths other than the critical path
Advanced Management Accounting

(i.e. non-critical
or slack paths) offer flexibility in scheduling and transferring resources,
because they take less time to complete than the critical path.
5. Activity
An activity is a distinct operation or an element of a project which
consumes time or resources and has a definable beginning and ending.
Commonly used terms synonymous with "activity" are "task" and "job".

6. Conventions Adopted In Drawing Networks

There are two conventions normally adopted while drawing networks:
(a) Time flows from left to right.
(b) Head events always have a number higher than that of the tail
events.
7. Graphical Representation of Events and Activities
Events are represented by numbers within circles. Activities are
represented by arrows; the arrow-heads represent the completion of the
activities. The length and orientation of the arrow are of no significance.
8. Fundamental Properties Governing the Representation of Events and
Activities The representation of events and activities is governed by one
simple dependency rule which requires that an activity which depends
upon another activity is shown to emerge from the head event of the
activity upon which it depends and that only dependent activities are drawn
in this way. An event cannot occur until all activities leading to it are
complete. No activity can start until its tail event is reached.
9. Logical Sequencing and Connection of Activities
A project entails several activities. The arrows are arranged to show the
plan of logical sequence in which the activities of the project are to be
accomplished. The sequence is ascertained for each activity tby three
queries viz:
(i) Which activity or activities must be completed before the start of a
particular activity?
(ii) Which activity or activities should follow this?
(iii) Which activities can be accomplished simultaneously?
10. Errors in logical sequencing

14.2
 Critical Path Analysis

Two types of errors in logic may arise while drawing a network, particularly
when it is a complicated one. These are known as looping and dangling.
11. Dummy activity
It is a hypothetical activity which consumes no resource and time. It is
represented by dotted lines and is inserted in the network to clarify activity
pattern under the following situations:
(i) It is created to make activities with common starting and finishing
events distin- guishable.
(ii) to identify and maintain the proper precedence relationship between
activities that are not connected by events.
(iii) to bring all "loose ends" to a single initial and a single terminal event
in each network using dummies, if necessary.

Question 1
Explain the following in the context of a
network: (i) Critical path (ii)
Dummy activity.
Answer
(i) Critical Path:
Critical Path is a chain of activities that begin with the starting event and
ends with ending event of a particular project. It is that path that runs
through a network with the maximum length of time or it indicates the
maximum possible time required for completion of a project. Critical path
indicates the minimum time that will be required to complete a project. It is
determined after identifying critical events. Critical path goes through
critical events.
(ii) Dummy Activities:
Dummy Activity is that activity which does not consume time or resources.
It is used when two or more activities have same initial and terminal
events. As a result of using dummy activities, other activities can be
identified by unique end events.
These are usually shown by arrows with dashed lines.

14.3
Advanced Management Accounting

A 2

Dummy 1

3
B
Question 2
The following network gives the duration in days for each activity:

8
2
2 5
5
7
3
1 6
3
4 1 6

(i) You are required to list the critical paths.

(ii) Given that each activity can be crashed by a maximum of one day, choose
to crash any four activities so that the project duration is reduced by 2
days.
Answer
Critical Paths:
All are critical paths:
(i) 1–2–5–6 2+8+5 = 15 (ii) 1
–3–5–6 3+7+5 = 15 (iii) 1–4–5
–6 4+6+5 = 15
(iv) 1–3–4–5–6 3 + 1 + 6 + 5 = 15
(i) Choose 5 – 6, common path;
Crash by 1 day
(ii) Choose: 1 – 2, 1 – 3, 1 – 4
Or
(iii) Choose: 1 – 2, 3 – 5, 4 – 5

14.4
 Critical Path Analysis

Or
(iv) Choose: 2 - 5 , 3 – 5, 4 – 5 Or
(v) Choose: 1 – 3, 1 – 4, 2 - 5
Question 3
A company is launching a new product and has made estimates of the time for
the various activities associated with the launch as follows:
Times (Days)
Activity Predecessor Optimistic Most likely Pessimistic
A None 1 3 5
B None 3 4 5
C A, B 1 3 11
D B 3 3 9
E A 1 2 3
F C 2 5 14
G E, F 2 3 4
H D, F 2 2 2
I G, H 10 10 10
Required:
(i) Draw the network diagram.
(ii) Calculate the expected time and variance of each activity.
(iii) Find out the expected length of critical path and its standard deviation.
(iv) Find the probability that the launching will be completed in 27 days.
(v) Find the duration, which has 95% probability of completion.
Answer
Critical Path B C  F  G  Z

14.5
Advanced Management Accounting

(i) Network Diagram

(ii) Calculation of Expected Time, Standard Deviation and Variance of
Activities

Activity Expected Time Standard Deviation Variance

t 0 + 4tm + tp tp −t o σ²

t =
e
6 6

S=
A ( 1-2) 5 5−1 = 0.67 0.44
1+12+ = 3
6
6
B ( 1-3) 0.11
3+16+5 = 4 5−3 = 0.33
6 6
C (3-4) 11−1 =1.67 2.78
1+12+11 = 4
6
6
D (3-5) 1.00
3+12+9 = 4 9−3 =1.00
6 6
E ( (2-6) 0.11
1+8+3 = 2 3−1 = 0.33
6 6
F ( 4-7) 14−2 = 2.00 4.00
2+20+14 = 6
6
6
G ( 6-8) 0.11
2+12+ 4 = 3 4−2 = 0.33
6 6
H( (5-9) 0
2+8+2 = 2 2−2 = 0
6 6

14.6
 Critical Path Analysis

I ( 8-10) 10+ 40+10 10−10 0

6 =10 6 =
0

S.D. of Critical Path

= Totalof varianceof CriticalActivities

= 0.11+2.78+ 4 +0.11+0
= 7
= 2.645
(iii)

(iv) Probabilities of completion of job in 27 days.

X = 27 Days
Z = 27−27 = 0
2 .645
For Z = 0 the probability is 0.5 from the table of area under normal curve
or 50%. (v) For 95% of area the corresponding Z value is 1.64 (from the
table).
Therefore,
X −27
1.64 =
2.645
X = 27 + 4.33 = 31.33 Days
Question 4
Consider the schedule of activities and related information as given below, for the
construction of a Plant:

Activity Expected Time Variance Expected Cost

(Months) (Millions of Rs.)
1-2 4 1 5
2-3 2 1 3

14.7
Advanced Management Accounting

3-6 3 1 4
2-4 6 2 9
1-5 2 1 2
5-6 5 1 12
4-6 9 5 20
5-7 7 8 7
7-8 10 16 14
6-8 1 1 4
Assuming that the cost and time required for one activity is independent of the
time and cost of any other activity and variations are expected to follow normal
distribution. Draw a network based on the above data and calculate:
(i) Critical path
(ii) Expected cost of construction of the plant
(iii) Expected time required to build the plant
(iv) The standard deviation of the expected time.
Answer
The required network is drawn below:

(i) From the above network, it can be noted that the critical path is 1 – 2 – 4 –
6 – 8.

14.8
 Critical Path Analysis

(ii) Expected cost of construction of the plant = (5 + 3 + 4 + 9 + 2 + 12 + 20 + 7

+ 14 + 4) millions of Rs. = Rs.80 million
(iii) Expected time required to build the plant = 4 + 6 + 9 + 1 = 20 months.
(iv) It is given that the time required for one activity is independent of the time
and cost of any other activity and variations are expected to follow normal
distribution, the S.D.
Hence, the variance of the expected time is determined by summing the
variance of critical activities and is = 1 + 2 + 5 + 1 = 9.
Standard Deviation of the expected time = √9 = 3 months.
Question 5
A product comprised of 10 activities whose normal time and cost are given as
follows:
Activity Normal Time (days) Normal cost
1-2 3 50
2-3 3 5
2-4 7 70
2-5 9 120
3-5 5 42
4-5 0 0
5-6 6 54
6-7 4 67
6-8 13 13
0
7-8 10 16
6
Indirect cost Rs. 9 per day.
(i) Draw the network and identify the critical path.
(ii) What are the project duration and associated cost ?
(iii) Find out the total float associated with each activity. Answer

14.9
Advanced Management Accounting

Critical path A D GHJ

1------2-------5-------6---------7---------8
(ii) A D G H J is the critical path having normal project duration
3 + 9 + 6 + 4 +10 = 32 days
Normal project cost:- Direct cost = Rs. 704
Indirect cost (32×9) = 288
992
(iii) Calculation of total float
Activity Nt(days) EF LF Float (LF–EF)
1-2 3 3 3 0
2.3 3 6 7 1
2.4 7 10 12 2
2-5 9 12 12 0
3-5 5 11 12 1
4-5 0 10 12 2
5-6 6 18 18 0
6-7 4 22 22 0
6-8 13 31 32 1
7-8 10 32 32 0
Question 6
A network is given below:
(i) Name the paths and give their total duration.
(ii) Give three different ways of reducing the project above duration by four
days.

14.10
 Critical Path Analysis

2 5
8 9
1
6

3
4 7

Answer
(i) Assuming that the duration of activity 3 – 5 is 4
weeks. The various critical paths are:
1-2-5-8-9 15 weeks 1-3-4-7-8-9
15 weeks 1-3-4-6-7-8-9 15
weeks
1-3-5-8-9 15 weeks
(ii) Note: Since the duration for activity 3-5 is not
specified it is open for you to assume the duration.
Depending upon the duration assume three
possibilities emerge.
1. If the duration assumed is more than 4 weeks then that path (13, 35, 58,
89) alone will be critical. In that case you can choose any of the activity in
the critical path.
2. If the duration assumed is exactly 4 weeks then it will be one of the 4
critical paths and the various possibilities are given below.
3. If the duration assumed is less than 4 weeks then the solution should be
based on 3 of the critical paths namely 12,589, 1346789 and 134789. This
has 16 combinations.
Reduce in the following ways, the project duration is. Since all the paths
are critical, reduction is possible by combining activities. The activities can
be independent, common to few paths and common to all the paths. The
various categories are as follows:
1. Common to all the paths. 8-9
2. Independent: Combination 1. 1-2,3-5,4-6 and 4-
7.
Combination 2. 2-5,3-5,4-6 and 4-

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Advanced Management Accounting

7.
Combination 3. 1-2,3-5,4-7, 6-7.
Combination 4. 2-5,3-5,4-7, 6-7.
3. Activities common to two of the paths.
Combination 1. 1-2,1-3.
Combination 2. 1-3,2-5.
Combination 3. 3-4,5-8.
Combination 4. 5-8,7-8.
4. Activities common to two of the paths and two independent activities.
Combination 1. 1-2,3-4,3-5.
Combination 2. 1-2,3-5,7-8.
Combination 3. 2-5,3-4,3-5.
Combination 4. 2-5,3-5,7-8.
Combination 5. 4-6,4-7,5-8.
Combination 6. 4-7,5-8,6-7.
(Any three of the above combination.)
Question 7
A company had planned its operations as follows:
Activity Duration (days)
1−2 7
2−4 8
1−3 8
3−4 6
1−4 6
2−5 16
4−7 19
3−6 24
5−7 9
6−8 7
7−8 8

14.12
 Critical Path Analysis

(i) Draw the network and find the critical paths.

(ii) After 15 days of working, the following progress is noted:
(a) Activities 1−2, 1−3 and 1−4 completed as per original schedule.
(b) Activity 2−4 is in progress and will be completed in 4 more days.
(c) Activity 3−6 is in progress and will need 17 more days to complete.
(d) The staff at activity 3−6 are specialised. They are directed to
complete 3−6 and undertake an activity 6−7, which will require
7days. This rearrangement arose due to a modification in a
specialisation.
(e) Activity 6−8 will be completed in 4 days instead of the originally
planned 7 days. (f) There is no change in the other activities.
Update the network diagram after 15 days of start of work based on the
assumption given above. Indicate the revised critical paths alongwith their
duration.
Answer
(i)

Paths Duration
1–2–5–7–8 7 + 16 + 9 + 8 = 40 1 – 2 – 4 – 7 – 8
7 + 8 + 19 + 8 = 42 1 – 4 – 7 – 8 6 + 19 + 8 = 33
1–3–4–7–8 8 + 6 + 19 + 8 = 41
1–3–6–8 8 + 24 + 7 = 39
Critical path 1 – 2 – 4 – 7 – 8 = 42 days.

14.13
Advanced Management Accounting

Revised Duration of activities 2 – 4 and 3 – 6 after 15 days for updation.

Activity Preceding Activity Date of completion Revised Duration
2–4 1 – 2 15 + 4 = 19 days 19 – 7 = 12 days 3 – 6
1–3 15 + 17 = 32 days 32 – 8 = 24 days
6 – 7 (new activity) 3–6 7 days
6–8 3–6 4 days
(ii)

Paths Duration
1–2–5–7–8 7 + 16 + 9 + 8 =
40
1–2–4–7–8 7 + 12 + 19 + 8 =
46
1–4–7–8 6 + 19 + 8 = 33
1–3–4–7–8 8 + 6 + 19 + 8 =
41
1 – 3 – 6 – 7– 8 8 + 24 + 7 + 8 =
47
1–3–6–8 8 + 24 + 4 = 36
Critical path = 1 – 3 – 6 – 7 – 8 = 47 days.
Question 8
The following table gives the activities in a construction project and the time
duration of each activity:
Activity Preceding activity Normal Time (Days)
A − 16

14.14
 Critical Path Analysis

B − 20
C A 8
D A 10
E B, C 6
F D, E 12
Required:
(i) Draw the activity network of the project.
(ii) Find critical path.
(iii) Find the total float and free-float for each activity.
Answer
(i)

A → D → F = 16 + 10 + 12 =
38 B → E → F = 20 + 6 + 12 =
38
(ii) A − C − E − F = 16 + 8 + 6 + 12 = 42 Critical path
(iii) Total float and free float for each
activity
Activity Normal time Earliest Time Latest Time finish Float Fre
finish start total e
(Days) start
A 16 0 16 0 16 0 0
B 20 0 20 4 24 4 4
C 8 16 24 16 24 0 0
D 10 16 26 20 30 4 4
E 6 24 30 24 30 0 0
F 12 30 42 30 42 0 0
Question 9

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Advanced Management Accounting

What do you mean by a dummy activity? Why is it used in networking?

Answer

Dummty activity is a hypothetical activity which consumes no resource or time. It

is represented by dotted lines and is inserted in the network to clarify an activity
pattern under the following situations.
(i) To make activities with common starting and finishing events
distinguishable.
(ii) To identify and maintain the proper precedence relationship between
activities that are not connected by events.
(iii) To bring all “loose ends” to a single initial and single terminal event. e.g.

1 3 4 5

Dummy (2) – (3) is used to convey that can start only after events
numbered (2) and (3) are over:

EXERCISE
Question 1
The time schedule for different activities of a project is given below:
Activity (i – j) Time in days

14.16
 1-2 8
1-3 10
1-4 8 Critical Path Analysis
2-3 10
2-6 16
3-5 17
4-5 18
4-6 14
5-6 9

Construct the PERT network and compute.

(i) Critical path and its duration.
(ii) Total and free float for each activity.
Answer

The critical path is given by 1 – 2 – 3 – 5 – 6. The path represents the minimum

possible time to complete the project.
The project duration = 8 + 10 + 17 + 9 = 44 days.
Question 2
A project has the following time schedule:
Activity Time in weeks Activity Time in weeks
1-2 4 5-7 8
1-3 1 6-8 1
2-4 1 7-8 2
3-4 1 8-9 1
3-5 6 8-10 8
4-9 5 9-10 7
5-6 4
Construct a PERT network and compute:
(i) TE and TL for each
event; (ii) Float for each
activity; and (iii) Critical
path and its duration.
Answer
Critical path is given by all those activities which have zero floats. Along the zero
float activities, there are two such critical paths:
(i) 1 → 3 → 5 → 7 → 8 → 9 → 10

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Advanced Management Accounting

(ii) 1 → 3 → 5 → 7 → 8 → 10
The project duration is 25 weeks.
Question 3
Given the following information:

Activity: 0-1 1-2 1-3 2-4 2-5 3-4 3-6 4-7 5-7
6-7
Duration: 2 8 10 6 3 3 7 5 2
8 (in days)
(i) Draw the arrow diagram.
(ii) Identify critical path and find the total project duration.
(iii) Determine total, free and independent floats. Answer

The critical path is - 0→1→3→6→7

Total project duration = 27 days.

14.18
 CHAPTER 15

PROGRAM EVALUATION AND REVIEW

TECHNIQUE

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Program Evaluation and Review Technique
PERT is more relevant for handing such projects which have a great deal
of uncertainity associated with the activity durations.
2. Types of Times Estimates
To take these uncertainity into account, three kinds of times estimates are
generally obtained. These are: 2.1 The Optimistic Time Estimate
This is the estimate of the shortest possible time in which an activity
can be completed under ideal conditions. For this estimate, no
provisions for delays or setbacks are made. We shall denote this
estimate by to.
2.2 The Pessimistic Time Estimate
This is the maximum possible time which an activity could take to
accomplish the job. If everything went wrong and abnormal
situations prevailed, this would be the time estimate. It is denoted by
tp.
2.3 The Most Likely Time Estimate
This is a time estimate of an activity which lies between the
optimistic and the pessimistic time estimates.

The variance is St2 = tp 6 - to  2

3. Exppected time
The expected time (te) is the average time taken for the completion of the
job. By using beta-distribution, the expcetion time can be obtianed by
following formula.
Advanced Management Accounting

te = to +4tm +tp 6
4. Probability estimate in PERT
The probability of completing the project by scheduled time is assessed
with normal variate Z given by
T1–Tcp
Z=
S.D.
Where T1 denotes the duration in which we wish to complete the project
and Tcp represents the duration on the critical path, S.D. stands for
standard deviation of the earliest finish of a network.

5. Project Crashing
It means reduction in project duration. Reduction in duration involves
application of additional resources which involves additional cost and at
the same time reduction in indirect cost per day. We identify the activities
which can be crashed and compare the activity cost slope with indirect
cost per day so as to arrive at project duration at optimum cost.
Activity cost slope = (Crash cost – Normal Cost) / (Normal time – Crash
time)
6. Resource smoothing
It is used for smoothening the peak resource requirement during different
periods of project duration. It is a time scaled diagram of various activities
and their float along with resource requirement. Float gives the option of
balancing the resources over longer period so that resource requirement is
smoothened without much affecting the project duration.
Question 1
The normal time, crash time and crashing
per day
cost
are given for the following network:
2

1
4 5

15.2
 Program Evaluation and Review Technique

Activity Normal time Crash time (days) Crashing cost

(days) (Rs./day)
1−2 18 14 40
1−3 23 22 20
2−3 8 5 60
2−4 10 6 40
3−4 3 2 80
4−5 8 6 50
(i) Crash the project duration in steps and arrive at the minimum duration. What
will be the critical path and the cost of crashing?
(ii) If there is an indirect cost of Rs. 70 per day, what will be the optimal project
duration and the cost of crashing?
Answer
(i) Critical path
1–2–3–4–5 37 days
Paths:
Normal Crash

1 – 2 – 4 – 5 36 26
1 – 2 – 3 – 4 – 5 37 27
1 – 3 – 4 – 5 34 30
Crash Activity Days, Cost
Step I 1 – 2 1 40
II 1–2 1 40
III 4–5 1 50
IV 4–5 1 50
V 2–3 1 60
VI 1–2&1– 1 60 (40 + 20)
3
6 300

1−2−4−5

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Advanced Management Accounting

1 − 2 − 3 − 4 − 5
Revised critical paths : 1 − 3 − 4 − 5  31
days

VII 1–2&3–4 (40 + 80) 30 days

But VII is not done if indirect cost = 70, which is < 120.
(ii) Project duration is 31 days and cost of crashing is 300.

15.4
Program Evaluation and Review Technique

15.5
Advanced Management Accounting

Critical Path : 1 − 2 − 3 − 4 − 5 (37 days) Crashing cost

(1) 1−2 1 day 40
(2) 1−2 1 day 40
(3) 4−5 2 days 100
(4) 2−3 1 day 60
(5) 1 − 2 & 1 − 3 1 day (40 + 20) 60
300
Revised critical Path: 1−2−4−5

1−2−3−4−5
1−3−4−5
Duration 31 days
(Note: After each crashing a networking diagram has to be drawn and
critical path has to be decided). Alternative Solution:

15.6
 Program Evaluation and Review Technique

(i) Network Diagram:

1 18 2 10 4 8 5
0 0 18 8 29 29 37 37

8 3

23

3
26 26

Project duration = 37 days.

Critical Paths :
(i) 1 3 4 5
(ii) 1−2−3−4−5
Crashing by Steps
Step : 1 Crash Crashing Crash cost per Crashing
activity No. of days day (Rs.) cost
(Rs.)
1−2 3 40 120
Step : 2 1−2 1 40 40
1−3 1 20 20
Step : 3 4−5 2 50 100
Step : 4 3−4 1 80 80
360

15.7
Advanced Management Accounting

Revised Network

1 14 2 10 4 6 5
0 0 14 14 24 24 30 30

8
2
22

3
22 22

Effective crashing days = 7

Critical Paths:
(i) 1−2−4−
5 (ii) 1−3−4−
5

(iii) 1−2−3−4−5
Project duration = 30 days
Crashing cost = Rs. 360
(ii) For optimal project duration, we have to consider indirect cost per day i.e., Rs.
70. The crashing cost of activity 3–4 is Rs. 80 which is higher than indirect
cost per day. Hence, we may opt it out (Step 4).
In that case, project duration = 31 days.
Crashing cost = Rs. 280.
Saving in indirect cost = 6 × Rs. 70 = Rs. 420.
Question 2
A project with normal duration and cost along with crash duration and cost for each
activity is given below:
Activity Normal Time Normal Cost Crash Time Crash Cost
(Hrs.) (Rs.) (Hrs.) (Rs.)
1-2 5 200 4 300
2-3 5 30 5 30
2-4 9 320 7 480
2-5 12 620 10 710

15.8
 Program Evaluation and Review Technique

3-5 6 150 5 200

4-5 0 0 0 0
5-6 8 220 6 310
6-7 6 300 5 370
Required:
(i) Draw network diagram and identify the critical path.
(ii) Find out the total float associated with each activity.
(iii)
Crash the relevant activities systematically and determine the optimum project
completion time and corresponding cost.
Answer
(i) Net work diagram
E3 = 10
L3 = 11
3
E2 = 5 E6 = 25
E1 = 0 L2 = 5 5 6 L6 = 25
L1 = 0
5 12 8 6 12
567

9 E5 = 17 E7 = 31
4 0 L5 = 17 L7 = 31

E4 = 14
L5 = 17
Path are 1-2-5-6-7 = 31 hours, this is critical path
1-2-3-5-6-7 = 30 hours
1-2-4-5-6-7 = 28 hours
(ii) Total floats
Activity Duratio Early Latest Early Latest Total
n start start finish finish float
hours
1-2 5 0 0 5 5 0
2-3 5 5 6 10 11 1
2-4 9 5 8 14 17 3
2-5 12 5 5 17 17 0
3-5 6 10 11 16 17 1
4-5 0 14 17 14 17 3
5-6 8 17 17 25 25 0

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Advanced Management Accounting

6-7 6 25 25 31 31 0
(iii) Calculation of crashing
Activity Nt Nc Ct Cc Slop = (Cc-
Nc) / (Nt-Ct)
1-2 5 200 4 300 100
2-3 5 30 5 30 0
2-4 9 320 7 480 80
2-5 12 620 10 710 45
3-5 6 150 5 200 50
4-5 0 0 0 0 0
5-6 8 220 6 310 45
6-7 6 300 5 370 70
The critical path activities are 1-2 2-5 5-6 6-7
Slope 100 45 45 70
Two activities cost slope cost is minimum (2-5 and 5-6) but activity 5-6 is
common and critical, it also continuing so reduce by 2 hours, then reduce
activity 2-5 by one hour.
From-to Project Cost
durations
Activity
I 5-6 8-6 hours 31-2 = 29 1840 + (2×45) + (29×50) =
3380
II 2-5 12-11 29-1 = 28 1840+90+(1×45)+28×50) =
3375
After this reduction now two paths are critical 1-2-3-5-6-7 = 28 and 1-2-5-6-7 =
28
So 1-2 3-5 6-7
2-5
Slope cost 100 50+45=95 70
As cost per hour for every alternative is greater than Rs.50 (overhead cost
per hour). Therefore, any reduction in the duration of project will increase the cost
of project completion. Therefore, time for projects is 28 weeks, minimum cost is
Rs.3375. Question 3
An Engineering Project has the following activities, whose time estimates are listed
below:

15.10
 Program Evaluation and Review Technique

Activity Estimated duration (in months)

(i – j) Optimistic Most likely Pessimistic
1-2 2 2 14
1-3 2 8 14
1-4 4 4 16
2-5 2 2 2
3-5 4 10 28
4-6 4 10 16
5-6 6 12 30
(i) Draw the project network and find the critical path.
(ii) Find the expected duration and variance for each activity. What is the expected
project length?
(iii) Calculate the variance and standard deviation of the project length.
(iv) What is the probability that the project will be completed at least eight months
earlier than expected time?
(v) If the project due date is 38 months, what is the probability of not meeting the
due date? Given:

Z: 0.50 0.67 1.00 1.33 2.00

Prob. : 0.3085 0.2514 0.1587 0.0918 0.0228
Answer
The earliest and latest expected time for each event is calculated by considering the
expected time of each activity as shown in the table below:

Activity (i – j) t0 tm tp te = (t0 + 4tm + tp) / 6 σ2 =  tp 6−

t0 2

1.2 2 2 14 4 4
1.3 2 8 14 8 4
1.4 4 4 16 6 4
2-5 2 2 2 2 0
3-5 4 10 28 12 16

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Advanced Management Accounting

4-6 4 10 16 10 4
5-6 6 12 30 14 16
(a) The project network is drawn below:

(i) Critical Path is : 1 – 3- 5 – 6

(ii) The expected duration and variance of each activity is shown in the table
above.
The expected project length is the sum of the duration of critical activities.
Hence,
Expected project Length = 8 + 12 + 14 = 34 months
(iii) Variance of the project length is the sum of the variances of critical
activities.
Variance of project length = σ² = 4 + 16 + 16 = 36 months
Therefore, Standard Deviation = σ = √36 = 6
(iv) Probability that the project will be completed at lest 8 months earlier than
the expected time of 34 months is given by
Prob. Z ≤ T s − Te = (34 − 8) − 34 = Prob.[Z ≤ - 1.33]
σ
 e 6 
But Z = -1.33 from the normal distribution table is 0.0918.
Students may please note that the values for the Prob. For a Z value
correspond tot e shaded area as shown in the diagram below:

15.12
 Program Evaluation and Review Technique

Thus, the probability of completing the project within 26 months is 9.18%.

(v) If the project due date is 38 months, then the probability of not meeting
the due date is given by

s e (38 − 34)
 T −T =  = Prob.[Z > 0.67]

Prob. Z >
σ
 e 6 
But Z = 0.67 from the normal distribution is 0.2514.
Thus, the probability of not meeting the due date is 25.14%.
Question 4
A small project consists of jobs as give in the table below. Each job is listed with
tits normal time and a minimum or crash time (in days). The cost (in Rs. per day)
of each job is also given:
Job (i – j) Normal duration Minimum (crash) Cost of Crashing
(in days) Duration (in (Rs. per day)
days)
1-2 9 6 20
1-3 8 5 25
1-4 15 10 30
2-4 5 3 10
3-4 10 6 15
4-5 2 1 40
(i) What is the normal project length and the minimum project length?
(ii) Determine the minimum crashing cost of schedules ranging from normal
length down to, and including the minimum length schedule. That is, if L =

15.13
Advanced Management Accounting

Length of the schedule, find the costs of schedules which are L, L – 1, L –

2 and so on.
(iii)
Overhead costs total Rs.60 per day. What is the optimum length schedule
in terms of both crashing and overhead cost? List the schedule duration of
each job for your solution.
Answer
(i) The required network is given below:

The various paths in the network are:

1 – 2 – 4 – 5 with project duration = 16 days

1 – 4 – 5 with project duration = 17 days
1 – 3 – 4 – 5 with project duration = 20 days
The critical path is 1 → 3 → 4 → 5. The normal length of the project is 20 days and
minimum project length is 12 days.
(ii) Since the present schedule consumers more time than the minimum project
length, the duration can be reduced by crashing some of the activities. Also,
since the project duration is controlled by the activities lying on the critical
path, the duration of some of the activities lying on critical path can be
reduced. It is given that overhead cost is Rs.60 per day.
Step I: First, the crashing cost of activity (3, 4) being minimum, the duration
of this activity can be compressed from 10 days to 9 days. The total cost for
19 day’s schedule = Rs.15 + Rs.19 × 60 = Rs.1,155
Step II: Since the critical path remains unchanged, the duration of activity
(3, 4) can be further reduced from 9 days to 8 days resulting in an
additional cost of Rs.15 so that total cost for 18 days schedule = Rs.30 +
Rs.60 × 18 = Rs.30 + Rs.1,080 = Rs.1,110.

15.14
 Program Evaluation and Review Technique

Step III: Continue this procedure till the minimum project length schedule. The
calculations are given below:
Normal Job crashed Crashing Cost (Rs.) Overhead Total
Project cost @ Cost.
length Rs.60 / (Rs.)
(days) day
20 -- -- 20×60 1,200
19 3–4 1 × 15 = 15 19×60 1,155
18 3–4 2 × 15 = 30 18×60 1,110
17 3–4 3 × 15 = 45 17×60 1,065
16 4–5 3×15+1×40 = 85 16×60 1,045
15 3–4, 1–4 4×15+1×40+1×30= 130 15×60 1,030
14 1–3, 1–4, 2– 130+1×30+1×25+1×10= 15×60 1,035
4 195
13 1–3, 1–4, 2– 195+1×25+1×30+1×10= 13×60 1,040
4 260
12 1–3, 1–4, 1– 260+25+30+20=335 12×60 1,055
2
(iii) Since the total cost starts increasing from 14 days duration onwards, the
minimum total cost of Rs.1,030 for the optimum project duration of 15 days
occurs for optimum duration of each job as given below:

Job: (1,2) (1,3) (1,4) (2,4) (3,4) (4,5)

Optimum: 9 8 14 5 6 1
Duration (day)

Path 1→ 2 → 4 → 5 = 9 + 5 + 1= 15 days

Path 1 → 4 → 5 = 14 + 1 = 15 days
Path 1 → 3 → 4 → 5 = 8 + 6 + 1 = 15 days.
Hence, the optimum duration of the project is 15 days.

15.15
Advanced Management Accounting

Question 5
Write short notes on Distinction between PERT and CPM.
Answer
Distinction between PERT and CPM: The PERT and CPM models are similar in
terms of their basic structure, rationale and mode of analysis. However, there are
certain distinctions between PERT and CPM networks which are enumerated
below:
(1) CPM is activity oriented i.e. CPM network is built on the basis of activities.
Also results of various calculations are considered in terms of activities of
the project. On the other hand, PERT is even oriented.
(2) CPM is a deterministic model i.e. it does not take into account the
uncertainties involved in the estimation of time for execution of a job or an
activity. It completely ignores the probabilistic element of the problem.
PERT, however, is a probabilistic model. It uses three estimates of the
activity time; optimistic, pessimistic and most likely, with a view to take into
account time uncertainty. Thus, the expected duration for each activity is
probabilistic and expected duration indicates that there is fifty per probability
of getting the job done within that time.
(3) CPM laces dual emphasis on time and cost and evaluates the trade-off
between project cost and project item. By deploying additional resources, it
allows the critical path project manager to manipulate project duration within
certain limits so that project duration can be shortened at an optimal cost.
On the other hand, PERT is primarily concerned with time. It helps the
manger to schedule and coordinate various activities so that the project can
be completed on scheduled time.
(4) CPM is commonly used for those projects which are repetitive in nature and
where one has prior experience of handling similar projects. PERT is
generally used for those projects where time required to complete various
activities are not known as prior. Thus, PERT is widely used for planning
and scheduling research and development project.
Question 6
A small project is composed of seven activities, whose time estimates are listed
below. Activities are identified by their beginning (i) and ending (j) node numbers.
Activity Estimated durations (in days)
(I-j) Optimistic Most likely Pessimistic
1-2 2 2 14
1-3 2 8 14
1-4 4 4 16

15.16
 Program Evaluation and Review Technique

2-5 2 2 2
3-5 4 10 28
4-6 4 10 16
5-6 6 12 30
(a) Draw the project network.
(b) Find the expected duration and variance for each activity. What is the expected
project length?
(c) If the project due date is 38 days, what is the probability of meeting the due
date ?
Given: z 0.50 0.67 1.00 1.33 2.00
P 0.3085 0.2514 0.1587 0.0918
0.0228
Answer

Activity Estimated durations (in days) = a + 4m + b σ 2 = b − a

2
6 6
(I – j) a m b
1.2 2 2 14 4 4
1.3 2 8 14 8 4
1.4 4 4 16 6 4 2-5 2 2 2 2
0
3-5 4 10 28 12 16 4-6 4 10 16 10
4 5-6 6 12 30 14 16

The critical path is 1-----3----5----6

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Advanced Management Accounting

(b
The expected duration of the project 8+12+14 = 34 days
(c) Variance of project length is σ 2 = 4 +16 +16 = 36 The standard
normal deviate is:

Z = due date - expected date of completion

variance

26 − 34
Z = = =−1.33 probability of meeting the due date is
0.0918 or 9.18% 6
(d) When due date is 38 days

38 − 34
Z = = = 0.67 Probability
meeting the date is 0.2514 or 25.14%. 6
Question 7
The following information is available:
Activity No. of days No. of men required per day
A 1─2 4 2B 1─3 2 3C 1─4 8
5D 2─6 6 3
E 3─5 4 2
F 5─6 1 3
G 4─6 1 8
(i) Draw the network and find the critical path.
(ii) What is the peak requirement of Manpower? On which day(s) will this occur?
(iii)
If the maximum labour available on any day is only 10, when can the project be
completed?
Answer
2

1 2
4 1 6
3 5

G
4

15.18
 Program Evaluation and Review Technique

Path Days
AD 10 CP
BEF 7 CG 9
Critical Path = 1– 2 – 6
i.e. AD = 10 days.
Peak requirement is 11 men, required on days 7 and 9.
If only 10 men are available on any day, shift F,G to days 10 and 11 and the
project can be completed in 11 days.
Day 1 2 3 4 5 6 7 8 9 1 11 1 1 1
0 2 3 4
A2 A2 A2 A2
D D D D D D
3 3 3 3 3 3
B3 B3 E2 E2 E2 E2
F3

C5 C C C C C5 C5 C
5 5 5 5 5
G8
1 1 9 9 1 1 11 8 11 3
0 0 0 0

If s/o shift F3 G
8
New 1 1 9 9 1 1 8 8 3 6 8
0 0 0 0
Question 8
A project consists of seven activities and the time estimates of the activities are
furnished as under:
Activity Optimistic Days Most likely Days Pessimistic Days
1−2 4 10 16
1−3 3 6 9
1−4 4 7 16
2−5 5 5 5
3−5 8 11 32

15.19
Advanced Management Accounting

4−6 4 10 16
5−6 2 5 8
Required:
(i) Draw the network diagram.
(ii) Identify the critical path and its duration.
(iii) What is the probability that the project will be completed in 5 days earlier than
the critical path duration?
(iv) What project duration will provide 95% confidence level of completion (Z 0.95
=1.65)?
Given Z 1.00 1.09 1.18
1.25 1.33
Probability 0.1587 0.1379 0.1190 0.1056 0.0918
Answer
Calculation of expected time and variance of each activity:
Activity Optimistic Most likely Pessimistic Expected Variance
Days Days Days Duration
1−2 4 10 16 10 4
1−3 3 6 9 6 1
1−4 4 7 16 8 4 2−5 5 5 5 5 0
3−5 8 11 32 14 16 4−6 4 10 16 10 4
5−6 2 5 8 5 1
The network diagram is as under:

Critical Path: 1−3 3−5 5−6

15.20
 Program Evaluation and Review Technique

Duration (days) 6 14 5 = 25 days

Standard deviation: 1 + 16 + 1 = 18
18 = 4.24
Probability that the project will be completed five days earlier:

20 − 25
Z= = −1.18.
4.24
According to probability values given in the question probability is
11.9% To obtain 95% confidence level:

1.65 = X − 25
4.24
X – 25 = 6.996
X = 32 days

15.21
Advanced Management Accounting

EXERCISE
Question 1
A small maintenance project consists of the following twelve jobs whose precedence
relations are identified with their node numbers.

Job (i, j) (1, 2) (1, 3) (1, 4) (2, 3) (2, 5) (2,

6)
(i) Dra
Duration (in days) 10 4 6 5 12 9
w an
Job (i, j) (3, 7) (4, 5) (5, 6) (6, 7) (6, 8) (7,
8)
Duration (in days) 12 15 6 5 4 7
arrow diagram representing the project.
(ii) Calculate earliest start, earliest finish, la test start and latest finish time for al
the jobs.
(iii) Find the critical path and project duration.
(iv) Tabulate total float, free float and independent float. Answer

(iii) The critical path s 1 → 2 → 5 → 6 → 7 → 8 and the project is 40 days.

(iv) Total float, free float and independent fl oat for various activities are calculated
in the above table.
Question 2
A project has the following time schedule:
Time in Weeks Activity Time in Weeks
1-2 2 4-6 3
1-3 2 5-8 1
1-4 1 6-9 5
2-5 4 7-9 4
3-6 8 8-9 3
4-7
5
Construct PERT network and
compute: (i) total float for each
activity; and (ii) critical path
and its duration.

15.22
 Program Evaluation and Review Technique

Answer
The critical path is given by 1-3-6-9 and the project duration is 15 weeks.
Question 3
The following information is given:
Activity (1-2) (2-3) (2-4) (3-5) (4-6) (5-6) (5-7) (6-7)
Pessimistic time 3 9 6 8 8 0 5 8
(in weeks)
Most likely time 3 6 4 6 6 0 4 5
(in weeks)
Optimistic time 3 3 2 4 4 0 3 2
(in weeks)
Draw the Network diagram for the above. Calculate:
Variance to each activity.
(ii) Critical path and expected project length.
(iii) The probability that the project will be completed in 23 weeks. Given
that:

Z value : 1.90 1.91 1.92 1.93 1.94

Probability : 0.9713 0.9719 0.9726 0.9732 0.9738
Answer
(i) Critical path is given by 1 – 2 – 3 – 5 – 6 – 7 and the expected
project length is 20 weeks.
(ii) Variance of the critical path = σ² = 0 + 1 + 4/9 + 0 + 1 = 22/9 =
2.444 Thus, the probability that the project will be completed in 23
weeks is 97.26%.

Question 9
A project consists of eight activities with the following relevant information:
Activity Immediate Predecessor Estimated Duration (Days)
Optimistic Most Likely Pessimistic
A __ 1 1 7
B __ 1 4 7

15.23
Advanced Management Accounting

C __ 2 2 8
D A 1 1 1
E B 2 5 14
F C 2 5 8
G D, E 3 6 15
H F, G 1 2 3
(i) Draw the PERT network and findthe
outexpected project completion time.

(ii) What duration will have 95% confidence for project completion?
(iii) If the average duration for activity F increases to 14 days, what will be its
effect on the expected project completion time which will have 95%
confidence?
(For standard normal Z = 1.645, area under the standard normal curve from 0 to Z =
0.45) Answer

(i) The required network is drawn below:

15.24
 Program Evaluation and Review Technique

The expectedtime for each activity shown in the network above is calculatedin the
following table:
Activity Estimated Duration (Days Expected Variance┌
Optimistic a Most likely m Pessimistic b duration┌
A 1-2 1 1 7 2 1
B 1-3 1 4 7 4 1
C 1-4 2 2 8 3 1
D 2-5 1 1 1 1 0
E 3-5 2 5 14 6 4
F 4-6 2 5 8 5 1
G 5-6 3 6 15 7 4
H 6-7 1 2 3 2 1/9
The critical path is given by 1 – 3 – 5 – 6 – 7 or B – E – G – H and the expected
project completion time is 19 days.
(ii) The variance for critical path is 1 + 4 + 4 + 1/9 = 82/9
Standard deviation of critical path = = σ1┌ = 3.02 (approx.).
To calculate the project duration which will have 95% chances of its
completion, we utilse the given value of Z corresponding to 95% confidence
which is 1.645. Thus, ┌ = 1,645 or X = 1,645 × 3.02 + 19 = 23.97 days = 24
days
Hence, 24 days of project completion time will have 95% probability of its
completion.
(iii)If the average duration for activity F increases to 14 days, then the path 1 – 4 –
6 – 7 i.e. C –F – H will also become critical path with expected project
completion time of 19 days. Now, activities C and F are also critical activities.
Since we are given only the average duration for activity F, It is assumed that
the variance for this activity is zero. Further, since PERT analysis is based on
the assumption that the activities are independent in terms of their variance,
therefore, standard deviation of critical paths can be computed as:
σ=┌
We now wish to calculate the expected project completion time that will have 95%
confidence level,
P 9Z < 1.645) = 0.95 or
X = 19 + 1.645 × 3.18 = 24.23 days.

15.25
Advanced Management Accounting

Hence the project duration of 24.23 days will have 95% confidence of
completion.
Question 10
A small project consists of seven activities for which the relevant data are given
below:
Activity Preceding activities Activity Duration (Days)
A -- 4
B -- 7
C -- 6

D A, B 5
E A, B 7
F C, D, E 6
G C, D, E 5

(i) Draw the network and find the project completion time.
(ii) Calculate total float for each of the activities.
(iii) Draw the time scaled diagram. Answer

15.26
Program Evaluation and Review Technique

15.27
Advanced Management Accounting

(iii) The required time scale diagram is drawn below:

Question 13

Define a project and briefly explain the four common implications which characterize
a project, and state the five steps of the working methodology of critical path
analysis. (May 1997 Answer
A project can be defined as a set of activities or jobs that are performed in a
certain sequence determined logically or technologically and it has to be
completed within (i) a specified time, (ii) a specified cost and (iii) meeting the
performance standards. Examples of a project from fairly diverse fields could be
cited. Some of them are given below:
1. Introducing a new product in the market.
2. Construction of a new bridge over a river or construction of a 25 – storied
building.
3. Executing a large and complex order on jobbing production.
4. Sending a spacecraft to the mars.
All these projects are characterized by the following set of common implications,
although they pertain to widely different fields.
(i) The Large-scale characteristic: These projects are generally unusually large
and complex. Thousands of suppliers, workers and other categories of
persons are involved and their efforts have to be coordinated for completion
of the project.
(ii) The non-recurring characteristic: These projects are generally of a one-time
nature. Neither in the past, nor in the future they are likely to undertaken
substantially in the same form.
(iii) Uncertain and critical dates: During of the various activities involved in such
projects are usually uncertain. Further in such type of projects, many critical

15.28
 Program Evaluation and Review Technique

dates exits by which operations must be completed in order to complete the

entire project on schedule.
(iv) Completion dead line: The fourth distinct feature of these projects is that
there is dead line for the completion of the entire project. In case of any
delay in the completion of the project, some penalty is levied for such delay
beyond the dead line.
The working methodology of Critical Path Analysis (CPA) which includes both CPM
and PERT, consists of following five steps:
1. Analyse and breakdown the project in terms of specific activities and / or
events.
2. Determine the interdependence and sequence of specific activities and prepare
a network,
3. Assign estimates of time, cost or both to all the activities of the network.
4. Identify the longest or critical path through the network.
5. Monitor, evaluate and control the progress of the project by re-planning,
rescheduling and reassignment of resources.

15.29
 CHAPTER 16

SIMULATION

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Simulation
Simulation is a quantitative procedure which describes a process by
developing a model of that process and then conducting a series of
organised trial and error experiments to predict the behaviour of the
process over time.
2. Steps In The Simulation Process
1. Define the problem or system you intend to simulate.
2. Formulate the model you intend to use.
3. Test the model; compare its behaviour with the behaviour of the
actual problem environment.
4. Identify and collect the data needed to test the model.
5. Run the simulation.
6. Analyze the results of the simulation and, if desired, change the
solution you are evaluating.
7. Rerun the simulation to test the new solution.
8. Validate the simulation, that is, increase the chances that any
inferences you draw about the real situation from running the
simulation will be valid.
3. Monte Carlo Simulation
The Monte Carlo method employs random numbers and is used to solve
problems that depend upon probability, where physical experimentation is
impracticable and the creation of a mathematical formula impossible. In
other words, it is method of Simulation by the sampling technique.
First of all, the probability distribution of the variable under consideration is
determined; then a set of random numbers is used to generate a set of
values that have the same distributional characteristics as the actual
experience it is devised to simulate.
Advanced Management Accounting

4. Steps in Monte Carlo Simulation

The steps involved in carrying out Monte Carlo Simulation are:
(i) Select the measure of effectiveness of the problem.
(ii) Identify the variables which influence the measure of effectiveness
significantly.
(iii) Determine the proper cumulative probability distribution of each
variable selected under step (ii). Plot these, with the probability on
the vertical axis and the values of variables on horizontal axis.
(iv) Get a set of random numbers.
(v) Consider each random number as a decimal value of the cumulative
probability distribution. With the decimal, enter the cumulative
distribution plot from the vertical axis. Project this point horizontally,
until it intersects cumulative probability distribution curve. Then
project the point of intersection down into the vertical axis.
(vi) Record the value (or values if several variables are being simulated)
generated in step (v) into the formula derived from the chosen
measure of effectiveness. Solve and record the value. This value is
the measure of effectiveness for that simulated value.
(vii) Repeat steps (v) and (vi) until sample is large enough for the
satisfaction of the decision maker.

Question 1
A Car Manufacturing Company manufactures 40 cars per day. The sale of cars
depends upon demand which has the following distribution:
Sales of Cars Probability
37 0.10
38 0.15
39 0.20
40 0.35
41 0.15
42 0.05
The production cost and sale price of each car are Rs.4 lakh and Rs.5 lakh
respectively. Any unsold car is to be disposed off at a loss of Rs.2 lakh per car.

16.2
 Simulation

There is a penalty of Re.1 lakh per car, if the demand is not met. Using the
following random numbers, estimate total profit/ loss for the company for the next
ten days:
9, 98, 64, 98, 94, 01, 78, 10, 15, 19
If the company decides to produce 39 cars per day, what will be its impact on
profitability?
Answer
First of all random numbers 00-99 are allocated in proportion to the probabilities
associated with the sales of cars as given below: Table 1
Sales of Car Probability Cumulative Range for
probability random numbers
37 0.10 0.10 00-99
38 0.15 0.25 10-24
39 0.20 0.45 25-44
40 0.35 0.80 45-79
41 0.15 0.95 80-94
42 0.05 1.00 95-98
Based on the given random numbers, we simulate the estimated sales and
calculate the profit / loss on the basis of specified units of production. Table 2
Day Random Estimat Profit (Production 40 Profit (Production 39
Numbers ed Sale cars / day) (Rs. cars / day) (Rs.
Lakh) Lakhs)
1 9 37 37×1-3×2=31 37×1-2×2=33
2 98 42 40×1-2×1=38 39×1-3×1=36
3 64 40 40×1=40 39×1-1×1=38
4 98 42 40×1-2×1=38 39×1-3×1=36
5 94 41 40×1-1×1=39 39×1-2×1=37
6 01 37 37×1-3×2=31 37×1-2×2=33
7 78 40 40×1=40 39×1-1×1=38
8 10 38 38×1-2×2=34 38×1-1×2=36
9 15 38 38×1-2×2=34 38×1-1×2=36
10 19 38 38×1-2×2=34 36×1-1×2=36

16.3
Advanced Management Accounting

There is no additional profit or loss if the company decides to reduce production

to 39 cars per day. Question 2
An investment company wants to study the investment projects based on market
demand, profit and the investment required, which are independent of each
other. Following probability distributions are estimated for each of these three
factors:
Annual Demand
(Units in thousands) 25 30 35 40 45 50 55
Probability 0.05 0.10 0.20 0.30 0.20 0.10 0.05
Profit per Unit: 3.00 5.00 7.00 9.00 10.00
Probability: 0.10 0.20 0.40 0.20 0.10
Investment required
(in thousands of 2,750 3,000 3,500
Rupees):
Probability: 0.25 0.50 0.25

Using simulation process, repeat the trial 10 times, compute the investment on
each trail taking these factors into trail. What is the most likely ret Use the
following random numbers:urn?
(30, 12, 16); (59, 09, 69); (63, 94, 26); (27, 08,
74); (64, 60, 61); (28, 28, 72); (31, 23, 57); (54,
85, 20); (64, 68, 18); (32, 31, 87).
In the bracket above, the first random number is for annual demand, the second
one is for profit and the last one is for the investment required.
Answer
The yearly return can be determined by the formula:

Return (%) Pr ofit×Number of units demanded×100

Investment
First of all, random number 00-99 are allocated in proportion tot eh probabilities
associated with each of the three variables as given under:
Annual Demand

16.4
 Simulation

Units in Probability Cum. Random Number

thousands Probability assigned
25 0.05 0.05 00-04
30 0.10 0.15 05-14
35 0.20 0.35 15-34
40 0.30 0.65 35-64
45 0.20 0.85 65-84
50 0.10 0.95 85-94
55 0.05 1.00 95-99
Profit per unit
Profit Probability Cum. Random Number
Probability assigned
3.00 0.10 0.10 00-09
5.00 0.20 0.30 10-29
7.00 0.40 0.70 30-69
9.00 0.20 0.90 70-89
10.00 0.10 1.00 90-99
Investment required (in thousands of Rupees)
Units Probability Cum. Random Number
Probability assigned
2,750 0.25 0.25 00-24
3,000 0.50 0.75 25-74
3,500 0.25 1.00 75-99
Let us now simulate the process for 10 trails. The results of the simulation are
shown in the tables given below:
Trails Random Simulated Random Simulated Random
Simulated Simulated
Number demand No for profit per Number for investment return (%) of
(‘000) profit per unit investment (‘000) Rs. (Demand
Demand units unit × profit
per unit ×
100) +
investment

16.5
Advanced Management Accounting

1 30 35 12 5.00 16 2,750 6.36

the annual demand of 40,000 units resulting a profit of Rs.10/- per unit and the
required investment will be Rs.30,00,000.
Question 3
A Publishing house has bought out a new monthly magazine, which sells at Rs.
37.5 per copy. The cost of producing it is Rs. 30 per copy. A Newsstand
estimates the sales pattern of the magazine as follows:
Demand Copies Probabilit
y
0 < 300 0.18
300 < 600 0.32
600 < 900 0.25
900 < 1200 0.15
1200 < 1500 0.06
1500 < 1800 0.04
The newsstand has contracted for 750 copies of the magazine per month from
the publisher.
The unsold copies are returnable to the publisher who will take them back at cost
less Rs. 4 per copy for handling charges.
The newsstand manager wants to simulate of the demand and profitability. The
of following random number may be used for simulation:
27, 15, 56, 17, 98, 71, 51, 32, 62, 83, 96, 69.

16.6
 Simulation

You are required to-

(i) Allocate random numbers to the demand patter forecast by the newsstand.
(ii) Simulate twelve months sales and calculate the monthly and annual
profit/loss.
(iii) Calculate the loss on lost sales.
Answer
(i) Allocation of random numbers
Demand Probability Cumulative probability Allocated RN
0<300 0.18 0.18 00 — 17 300 < 600 0.32 0.50 18 — 49
600 < 900 0.25 0.75 50 — 74 900 < 1200 0.15 0.90 75 — 89 1200 <1500
0.06 0.96 90 — 95
1500 < 1800 0.04 1.00 96 — 99
(ii) Simulation: twelve months sales, monthly and annual profit/loss
Month RN Demand Sold Return Profit on Loss on Net
Loss on
sales (Rs.)
return (Rs.) lost
(Rs.) units
1 27 450 450 300 3375 12000 2175 2 15 150 150 600 1125 2400
-1275 3 56 750 750 -- 5625 -- 5625 4 17 150 150 600 1125 2400
-1275
5 98 1650 750 -- 5625 --- 5625 900
6 71 750 750 -- 5625 -- 5625
7 51 750 750 -- 5625 -- 2175 8 32 450 450 300 3375 1200 5625
9 62 750 750 -- 5625 -- 5625 300 10 83 1050 750 -- 5625 -- 5625 900
11 96 1650 750 -- 5625 -- 5625 12 69 750 750 -- 5625 5625 54000
7200 46800 2100
(iii) Loss on lost sale 2100×7.5 = Rs15750.
Question 4
(i) What is simulation?
(ii) What are the steps in simulation?
Answer

16.7
Advanced Management Accounting

(i) Simulation is a quantitative procedure which describes a process by

developing a model of that process and then conducting a series of
organized trial and error experiments to product the behaviour of the
process over time.
(ii) Steps in the simulation process:
(i) Define the problem and system you intend to simulate.
(ii) Formulate the model you intend to use.
(iii) Test the model, compare with behaviour of the actual problem
environment.
(iv) Identify and collect data to test the model.
(v) Run the simulation.
(vi) Analyse the results of the simulation and, if desired, change the
solution you are evaluating.
(vii) Rerun the simulation to tests the new solution.
(viii) Validate the simulation i.e., increase the chances of valid inferences.
Question 5
How would you use the Monte Carlo Simulation method in inventory control?
Answer
The Monte Carlo Simulation:
It is the earliest mathematical Model of real situations in inventory control:
Steps involved in carrying out Monte Carlo simulation are:
• Define the problem and select the measure of effectiveness of the problem
that might be inventory shortages per period.
• Identify the variables which influence the measure of effectiveness
significantly for example, number of units in inventory.
• Determine the proper cumulative probability distribution of each variable
selected with the probability on vertical axis and the values of variables on
horizontal axis.
• Get a set of random numbers.
• Consider each random number as a decimal value of the cumulative
probability distribution with the decimal enter the cumulative distribution
plot from the vertical axis. Project this point horizontally, until it intersects
cumulative probability distribution curve. Then project the point of
intersection down into the vertical axis.

16.8
 Simulation

• Then record the value generated into the formula derived from the chosen
measure of effectiveness. Solve and record the value. This value is the
measure of effectiveness for that simulated value. Repeat above steps until
sample is large enough for the satisfaction of the decision maker.
Question 6
A single counter ticket booking centre employs one booking clerk. A passenger
on arrival immediately goes to the booking counter for being served if the counter
is free. If, on the other hand, the counter is engaged, the passenger will have to
wait. The passengers are served on first come first served basis. The time of
arrival and the time of service varies from one minute to six minutes. The
distribution of arrival and service time is as under:
Arrival / Service Arrival Service
Time (Minutes) (Probability) (Probability)
1 0.05 0.10
2 0.20 0.20

3 0.35 0.40

4 0.25 0.20

5 0.10 0.10

6 0.05 −
Required:
(i) Simulate the arrival and service
of 10 passengers starting from 9
A.M. by using the following
random numbers in pairs
respectively for arrival and
service. Random numbers 60 09
16 12 08 18 36 65 38 25 07 11
08 79 59 61 53 77 03 10.
(ii) Determine the total duration of
(1) Idle time of booking
clerk and
(2) Waiting time of passengers.

16.9
Advanced Management Accounting

Answer
Random allocation tables are as under:
Probabil

Probabil

Probabil
Random

Random
Cumula

Cumula
Probab

alloca

alloca
Servi

Servi
Arriv

Arriv
(Mts)

(Mts)
Time

Time
als

ted

ted
tive

tive
ility

ce

ce

No.
No.
ity)

ity)

ity)
al

(
1 0.05 0.05 00-04 1 0.10 0.10 00-09
2 0.20 0.25 05-24 2 0.20 0.30 10-29
3 0.35 0.60 25-59 3 0.40 0.70 30-69
4 0.25 0.85 60-84 4 0.20 0.90 70-89
5 0.10 0.95 85-94 5 0.10 1.00 90-99
6 0.05 1.00 95-99
Simulation of ten trails:
R. No. Arrival Mts. Time Start R. No. Time Mts. Finish Time
Waiting Time
Clerk Passenger
60 4 9.04 9.04 09 1 9.05 4
16 2 9.06 9.06 12 2 9.08 1 08 2 9.08 9.08 18 2 9.10 − 36 3 9.11 9.11 65 3
9.14 1 38 3 9.14 9.14 25 2 9.16 − 07 2 9.16 9.16 11 2 9.18 − 08 2 9.18
9.18 79 4 9.22 − 59 3 9.21 9.22 61 3 9.25 − 1 53 3 9.24 9.25 77 4 9.29 1
03 1 9.25 9.29 10 2 9.31 _ 4
Total 6 6
In half an hour trial, the clerk was idle for 6 minutes and the passengers had to
wait for 6 minutes.
Question 7
State major reasons for using simulation technique to solve a problem and also
describe basic steps in a general simulation process.
Answer
Reasons:

(i) It is not possible to develop a mathematical model and solutions with out
some basic assumptions.

16.10
 Simulation

(ii) It may be too costly to actually observe a system.

(iii) Sufficient time may not be available to allow the system to operate for a
very long time.
(iv) Actual operation and observation of a real system may be too disruptive.

Steps:
(i) Define the problem or system which we want to simulate.
(ii) Formulate an appropriate model of the given problem.
(iii) Ensure that model represents the real situation/ test the model, compare its
behaviour with the behaviour of actual problem environment.
(iv) Identify and collect the data needed to list the model.
(v) Run the simulation
(vi) Analysis the results of the simulation and if desired, change the solution.
(vii) Return and validate the simulation.
Question 8
At a small store of readymade garments, there is one clerk at the counter who is
to check bills, receive payments and place the packed garments into fancy bags.
The arrival of customer at the store is random and service time varies from one
minute to six minutes,
the frequency distributionrfo
which is given below:
Time between Frequency Service Time (in Frequency
arrivals (minutes) minutes)
1 5 1 1
2 20 2 2
3 35 3 4
4 25 4 2

5 10 5 1
6 5 6 0

The store starts work at 11 a.m. and closes at 12 noon for lunch and the
customers are served on the “first came first served basis”.

16.11
Advanced Management Accounting

Using Monte Carlo simulation technique, find average length of waiting line,
average waiting time, average service time and total time spent by a customer in
system.
You are given the following set of random numbers, first twenty for arrivals and
last twenty for service:
64 04 02 70 03 60 16 18 36 38
07 08 59 53 01 62 36 27 97 86
30 75 38 24 57 09 12 18 65 25
11 79 61 77 10 16 55 52 59 63
Answer
From the frequency distribution of arrivals and service times, probabilities and
cumulative probabilities are first worked out as shown in the following table:
Time
between Frequenc Probabilit Cum. Service Frequenc
Prob.
Cum.
arrivals y y Prob. Time y Prob.

1 5 0.05 0.05 1 1 0.10 0.10

2 20 0.20 0.25 2 2 0.20 0.30
3 35 0.35 0.60 3 4 0.40 0.70
4 25 0.25 0.85 4 2 0.20 0.90
5 10 0.10 0.95 5 1 0.10 1.00
6 5 0.05 1.00 6 0 0.00 1.00
Total 100 10
The random numbers to various intervals have been allotted in the following
table:
Time Probability Random Service Time Probability Random between
numbers numbers arrivals allotted allotted
1 0.05 00-04 1 0.10 00-09
2 0.20 05-24 2 0.20 10-29
3 0.35 25-59 3 0.40 30-69
4 0.25 60-84 4 0.20 70-89
5 0.10 85-94 5 0.10 90-99
6 0.05 95-99 6 0.00 -

Simulation Work Sheet

16.12
 Simulation

Rando Time Arriva Servic Rando Servic Servic Clerk Custom Lengt
m till l e m e e Waitin er h of
Numbe next Time begins number time Ends g waiting waitin
r arrival a.m. a.m. a.m. time Time g
line
64 4 11.04 11.04 30 3 11.07 04 - -
04 1 11.05 11.07 75 4 11.11 - 2 1
02 1 11.06 11.11 38 3 11.14 - 5 2
70 4 11.10 11.14 24 2 11.16 - 4 2
03 1 11.11 11.16 57 3 11.19 - 5 2
60 4 11.15 11.19 09 1 11.20 - 4 2
16 2 11.17 11.20 12 2 11.22 - 3 2
18 2 11.19 11.22 18 2 11.24 - 3 2
36 3 11.22 11.24 65 3 11.27 - 2 1
38 3 11.25 11.27 25 2 11.29 - 2 1
07 2 11.27 11.29 11 2 11.31 - 2 1
08 2 11.29 11.31 79 4 11.35 - 2 1
59 3 11.32 11.35 61 3 11.38 - 3 1
53 3 11.35 11.38 77 4 11.42 - 3 1
01 1 11.36 11.42 10 2 11.44 - 6 2
62 4 11.40 11.44 16 2 11.46 - 4 2
36 3 11.43 11.46 55 3 11.49 - 3 2
27 3 11.46 11.49 52 3 11.52 - 3 1
97 6 11.52 11.52 59 3 11.55 - - -
86 5 11.57 11.57 63 3 12.00 2 - -
20 57 54 6 56 26
Average queue length = Number of customers in waiting line = 26 =1.3
Number of arrivals 20

Average waiting time per customer = = 2.8 minutes

Average service time = = 2.7 minutes

Time a customer spends in system = 2.8 + 2.7 = 5.5 minutes.

16.13
Advanced Management Accounting

Question 9
Write a short note on the advantages of simulation.
Answer
Advantages of simulation are enumerated below:
1. Simulation techniques allow experimentation with a model of the system
rather than the actual operating system. Sometimes experimenting with the
actual system itself could prove to be too costly and, in many cases too
disruptive. For example, if you are comparing two ways of providing food
service in a hospital, the confusion that would result from operating two
different systems long enough to get valid observations might be too great.
Similarly, the operation of a large computer central under a number of
different operating alternatives might be too expensive to be feasible.
2. The non-technical manage can comprehend simulation more easily than a
complex mathematical model. Simulation does not require simplifications
and assumptions to the extent required in analytical solutions. A simulation
model is easier to explain to management personnel since it is a
description of the behaviour of some system or process.
3. Sometimes there is not sufficient time to allow the actual system to operate
extensively. For example, if we were studying long-term trends in world
population, we simply could not wait the required number of years to see
results. Simulation allows the manger to incorporate time into an analysis.
In a computer simulation of business operation the manager can compress
the result of several years or periods into a few minutes of running time.
4. Simulation allows a user to analyze these large complex problems for
which analytical results are not available. For example, in an inventory
problem if the distribution for demand and lead time for an item follow a
standard distribution, such as the poison distribution, then a mathematical
or analytical solution can be found. However, when mathematically
convenient distributions are not applicable to the problem, an analytical
analysis of the problem may be impossible. A simulation model is a useful
solution procedure for such problems.

EXERCISE
Question 1
An investment company wants to study the investment projects based on market
demand profit and the investment required, which are independent of each other.

16.14
 Simulation

Following probability distributions are estimated for each of these three factors.
Annual demand

(units in thousands) 25 30 35 40 45 50 55

Probability 0.05 0.10 0.20 0.30 0.20 0.10 0.05

Profit per unit 3.00 5.00 7.00 9.00 10.00

Probability 0.10 0.20 0.40 0.20 0.10

Investment Required

(In thousand of rupees) 2,750 3,000 3,500

Probability 0.25 0.50 0.25

Using simulation process, repeat the time 10 times, compute the investment on
each that taking these factors into trial. What is the most likely return? Use the
following random numbers:

(30, 12, 16) (50, 09, 69) (63, 94, 26) (27, 08,
74)
(54, 85,
(64, 60, 61) (28, 28, 72) (31, 23, 57)
20)
(64, 68, 18) (32, 31, 87)
In the bracket above, the first random number is for annual demand, the second
one is for profit and the last one is for the investment required. Answer
Highest likely return is 13.33% which is corresponding to the annual demand of
40,000 units resulting a profit of Rs.10/- per unit and the required investment will
be Rs.30,00,000.
Question 2
A retailer deals in a perishable commodity. The daily demand and supply are
variables. The data for the past 500 days show the following demand and supply:
Supply Demand
Availability (kg.) No. of days Demand (kg.) No. of days
10 40 10 50
20 50 20 110

16.15
Advanced Management Accounting

30 190 30 200
40 150 40 100
50 70 50 40
The retailer buys the commodity at Rs.20 per kg and sells it at Rs.30 per kg. Any
commodity remains at the end of the day, has no saleable value. Moreover, the
loss (unearned profit) on any unsatisfied demand is Rs.8 per kg. Given the
following pair of random numbers, simulate 6 days sales, demand and profit.
(31, 18); (63, 84); (15, 79); (07, 32) (43, 75); (81,
27)
The first random number in the pair is for supply and the second random number
is for demand viz. in the first pair (31, 18), use 31 to simulate supply and 18 to
simulate demand. Answer
net profit of the retailer = Rs.400
Question 3
A book-store wishes to carry Systems Analysis and Design in stock. Demand is
probabilistic and replenishment of stock takes 2 days (i.e., if an order is placed in
March 1, it will be delivered at the end of the day on March 3). The probabilities
of demand are given below:
Demand (daily): 0 1 2 3 4
Probability: 0.05 0.10 0.30 0.45 0.10
Each time an order is placed, the store incurs an ordering cost of Rs.10 per
order. The store also incurs a carrying cost of Rs.0.50 per book per day. The
inventory carrying cost is calculated on the basis of stock at the end of each day.
The manger of the book-store wishes to compare two options for his inventory
decision:
A. Order 5 books, when the inventory at the beginning of the day plus orders
outstanding is less than 8 books.
B. Order 8 books, when the inventory at the beginning of the day plus orders
outstanding is less than 8 books.
Currently (beginning of the 1st day) the store has stock of 8 books plus 6
books plus 6 books ordered 2 days ago and expected to arrive next day.
Using Monte-Carlo simulation for 10 cycles, recommend which option the
manager should choose?
The two digits random numbers are given below:
89, 34, 78, 63, 81, 39, 16, 13, 73

16.16
 Simulation

Answer
Option A: Carrying Cost = 39 × 0.50 = Rs.19.50
Ordering Cost = 4 × 10 = Rs.40.00
Total Cost = Rs.59.50
Option B: Carrying Cost = 45 × 0.50 = Rs.22.50
Ordering Cost = 2 × 10 = Rs.20.00
Total Cost = Rs.42.50
Since Option B has lower cost, Manager should order 8 books.
Question 4
A bakery shop keeps stock of a popular brand of cake. Previous experience
indicates the daily demand as given here:
Daily demand: 0 10 20 30 40 50
Probability: 0.01 0.20 0.15 0.50 0.12 0.02
Consider the following sequence of random numbers;
R. No. 48, 78, 19, 51, 56, 77, 15, 14, 68, 09
Using this sequence, simulate the demand for the next 10 days. Find out the
stock situation if the owner of the bakery decides to make 30 cakes every day.
Also, estimate the daily average demand for the cakes on the basis of simulated
data. Answer
Daily average demand of the basis of simulated data = 220

Question 5
A company trading in motor vehicle spares wishes to determine the level of stock
it should carry for the item in its range. Demand is not certain and replenishment
of stock takes 3 days. For one item X, the following information is obtained: (7
Marks)
Demand (unit per day) Probabilit
y
1 .1
2 .2
3 .3
4 .3
5 .1

16.17
Advanced Management Accounting

Each time an order is placed, the company incurs an ordering cost of Rs. 20 per
order. The company also incurs carrying cost of Rs. 2.50 per unit per day. The
inventory carrying cost is calculated on the basis of average stock.
The manager of the company wishes to compare two options for his inventory
decision.
(A) Order 12 units when the inventory at the beginning of the day plus order
outstanding is less than 12 units.
(B) Order 10 units when the inventory at the beginning of the day plus order
outstanding is less than 10 units.
Currently (on first day) the company has a stock of 17 units. The sequence of
random number to be used is 08, 91, 25, 18,40, 27, 85, 75, 32, 52 using first
number for day one.
You are required to carry out a simulation run over a period of 10 days,
recommended which option the manager should chose.
Answer
Option I
Carrying cost (94.5 × 2.50) =Rs.236.25
Ordering cost (2 × 20) =Rs.40.00
Rs.276.25
Option 11
Day Random Opening Demand Closing Order Order in Averag
no. Stock Stock placed e stock
1 08 17 1 16 - - 16.5
2 91 16 5 11 - - 13.5
3 25 11 2 09 10 - 10.0 4 18 09 2
07 - - 8.00
5 40 07 3 04 - 5.50 6 27 04 2 02 - 10 3.00 7 85 12 4 08 10 - 10.00
8 75 08 4 04 - - 6.00
9 32 04 3 01 - - 2.50
10 52 01 3 - - 10 0.50
75.5
Carrying cost (75.5 × 2.50) = Rs.118.75
Ordering cost (2 × 20) = Rs. 40.00

16.18
 Simulation

Rs.228.75
Option II is better.
(ii) Assuming Karam must wait until Param completes the first item before
starting work. Will he have to wait to process any of the other eight items?
Explain your answer, based upon your simulation.
Answer
Cumulative frequency distribution for Param is derived below. Also fitted against
it are the eight given random numbers. In parentheses are shown the serial
numbers of random numbers.
10 4 01 (2) 00 (7) 03 (8)
20 10
30 20 14 (1)
40 40
50 80 44 (4) 61 (5)
60 91 82 (6)
70 96 95 (3)
80 100
Thus the eight times are: 30, 10, 70, 50, 60, 10 and 10 respectively.
Like wise we can derive eight times for Karam also.
Col-1 Col-2 Col-3 (2× Col-2)
10 4 8
20 9 18 13 (7) 30 15 30 25 (4)
40 22 44 36 (1) 34 (8) 41 (6)
50 32 64 55 (3)
60 40 80 76 (2)
70 46 92
80 50 100 97 (5)
(Note that cumulative frequency has been multiplied by 2 in column 3 so that all
the given random numbers are utilized).
Thus, Karam’s times are: 40, 60, 50, 30, 80 40, 20 and 40 seconds respectively.
Param’s and Karam’s times are shown below to observe for waiting time, if any.
1 2 3 4

16.19
Advanced Management Accounting

Param Cum. Times Karam Initial Karam’s cumulative time with 30

seconds included
30 30 40 70
10 40 60 130
70 110 50 180
50 160 30 210
50 210 80 290
60 270 40 330
10 280 20 350
10 290 40 390
Since col. 4 is consistently greater than Co.2, no subsequent waiting is involved.

16.20
 CHAPTER 17

LEARNING CURVE THEORY

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Learning Curve
Learning curve is a geometrical progression, which reveals that there is
steadily decreasing cost for the accomplishment of a given repetitive
operation, as the identical operation is increasingly repeated. The amount
of decrease will be less and less with each successive unit produced. The
slope of the decision curve is expressed as a percentage. The other
names given to learning curve are Experience curve, Improvement curve
and Progress curve.
2. The Learning Curve Ratio
In the initial stage of a new product or a new process, the learning effect
pattern is so regular that the rate of decline established at the outset can
be used to predict labour cost well in advance. The effect of experience on
cost is summaries in the learning ratio or improvement ratio:
Average labour cost of first 2N units
Average labour cost of first N units
3. Learning Curve Equation
Mathematicians have been able to express relationship in equations. The
basic equation
Yx = KXs

...(1)
where,
X is the cumulative number of units or lots produced
Y is the cumulative average unit cost of those units X or lots. K is the
average cost of the first unit or lots is the improvement exponent or the
learning coefficient or the index of learning which is calculated as
follows: s = log of learning ratio / log 2
Advanced Management Accounting

Question 1
Discuss the application of the learning curve.
Answer
Application of Learning curve: Learning curve helps to analyse cost-volume
profit relationships during familiarisation phase of product or process to arrive at
cost estimates.
It helps in budgeting and profit planning.
It helps in pricing and consequent decision making – e.g. acceptance of an order,
negotiations in establishing contract prices etc. with the advantage of the
knowledge of decreasing unit cost.
It helps in setting standards in the learning phase.
Question 2
What are the distinctive features of learning curve theory in manufacturing
environment? Explain the learning curve ratio.
Answer
As the production quantity of a given item is doubled, the cost of the item
decreases at a fixed rate. This phenomenon is the basic premise on which the
theory of learning curve has been formulated. As the quantity produced doubles,
the absolute amount of cost increase will be successively smaller but the rate of
decrease will remain fixed. It occurs due to the following distinctive features of
manufacturing environment:
(i) Better tooling methods are developed and used.
(ii) More productive equipments are designed and used to make the product.
(iii) Design bugs are detected and corrected.
(iv) Engineering changes decrease over time.
(v) Earlier teething problems are overcome.
(vi) Rejections and rework tend to diminish over time.
In the initial stage of a new product or a new process, the learning effect pattern
is so regular that the rate of decline established at the outset can be used to
predict labour cost well in advance. The effect of experience on cost is
summarized in the learning curve ratio or improvement ratio.
Learning curve ratio = Average labour cost of first 2N
units Average labour cost of first N
units

17.2
 Learning Curve Theory

For example, if the average labour cost for the first 500 units is Rs. 25 and the
average labour cost for the first 1,000 units is Rs. 20, the learning curve ratio is
(Rs. 20/25) or 80%. Since the average cost per unit of 1,000 units is Rs. 20, the
average cost per unit of first 2,000 units is likely to be 80% of Rs. 20 or Rs. 16.
Question 3
M Ltd. Manufactures a special product purely carried out by manual labour. It has
a capacity of 20,000 units. It estimates the following cost structure:
Direct material 30 Rs. / unit
Direct labour (1 hour / unit) 20 Rs. / unit
Variable overhead 10 Rs. / unit
Fixed overheads at maximum capacity is Rs. 1,50,000.
It is estimated that at the current level of efficiency, each unit requires one hour
for the first 5,000 units. Subsequently it is possible to achieve 80% learning rate.
The market can absort the first 5,000 units at Rs.100 per unit. What should be
the minimum selling price acceptable for an order of 15,000 units for a
prospective client?
Answer
5,000 units 20 ,000 units
Material 1,50,000 6 , 00,000
Direct Labour 1,00,000 2 , 56,000
Refer to W Note i

Variable Overhead 50,000

Total Variable Cost 3,00,000 10 , 56,000
Fixed Cost 1,50,000
Total Cost 4,50,000 12 , 06,000
Total cost / unit 90 60.3
Sales 100 × 5,000 5,00,000 5 , 00,000
15,000 × x(assumed selling price) 15,000 x
(Total Sales less Total Cost) = Profit 50,000 15 ,000 x – 7,
06,000
Or minimum selling price = 50.4(refer to Working Note ii)

17.3
Advanced Management Accounting

Working Note: I
Units Hours
5,000 5,000
10,000 10,000 × 1 × .8 = 8,000 hours
20,000 20,000 × 1 × .8 × .8 = 12,800 hours
Working Note: II
15,000 x – 7,06,000 > 50,000
15,000 x > 7,56,000
or x > 50.4
Alternative Solution:
Total cost / unit of capacity 20,000 = 60.3
Weighted average selling price > 80.4
i.e. 5,000 × 100 + 15,000 x > 60.3
20,000
= 5,00,000 + 15,000 x > 60.3 × 20,000
= 15,000 x > 12,06,000 – 5,00,000
Or
15,000 x > 7,06,000
x > 47.06
Minimum price to cover production Cost = 47.06
Minimum price to cover same amount of profit = 50.40 (refer to Working Note 1)
Working Note 1
(− 47.06 + 50.04) × 15,000 units
= Rs. 50,000
Question 4
A company which has developed a new machine has observed that the time
taken to manufacture the first machine is 600 hours. Calculate the time which the
company will take to manufacture the second machine if the actual learning
curve rate is (i) 80% and (ii) 90%. Explain which of the two learning rates will
show faster learning.
Answer
(i) Actual learning curve rate is 80%.
Time taken to produce the first machine = 600 hours

17.4
 Learning Curve Theory

Average time taken to produce two machines = 600 × 80% hours

= 480 hours.
Cumulative time taken to produce two = 480 × 2 hours
machines
= 960 hours.
Time taken to produce the second machine = (960 − 600)hours
= 360 hours.
(ii) Actual learning curve rate is 90%.
Time taken to produce the first machine = 600 hours
Average time taken to produce two machines = 600 × 90% hours
= 540 hours.
Cumulative time taken to produce two = 540 × 2 hours
machines
= 1080 hours.
Time taken to produce the second machine = (1080 − 600)
hours
= 480 hours.
The time taken to produce the second machine is lower at 80% learning
rate and hence 80% learning rate shows faster learning rate.
Question 5
The Gifts Company makes mementos for offering chief guests and other
dignitaries at functions. A customer wants 4 identical pieces of hand-crafted gifts
for 4 dignitaries invited to its function.
For this product, the Gifts Company estimates the following costs for the 1 st unit
of the product
Rs./unit
Direct variable costs (excluding 2,000
labour)
Direct labour (20 hours @ Rs. 50 1,000
hour)
90 % learning curve ratio is applicable and one labourer works for one
customer’s order.
(i) What is the price per piece to be quoted for this customer if the targeted
contribution is Rs.1,500 per unit?

17.5
Advanced Management Accounting

(ii) If 4 different labourers made the 4 products simultaneously to ensure faster

delivery to the customer, can the price at (i) above be quoted? Why?
Answer
(i)
Rs/u
st th
1 unit Avg/u after 4 at
Variable Cost 2000 2000
Labour 1000 810
Target 1500
Contribution Price 4310 (Rs./u)
to be quoted
(ii) No, the company cannot quote this price for varying products because the
learning curve Ratio does not apply to non-repeated jobs. Each product will
carry a different price according to its direct labour hours.
Question 6
The following information is provided by a firm. The factory manager wants to
use appropriate average learning rate on activities, so that he may forecast costs
and prices for certain levels of activity.
(i) A set of very experienced people feed data into the computer for
processing inventory records in the factory. The manager wishes to apply
80% learning rate on data entry and calculation of inventory.
(ii) A new type of machinery is to be installed in the factory. This is patented
process and the output may take a year for full fledged production. The
factory manager wants to use a learning rate on the workers at the new
machine.
(iii) An operation uses contract labour. The contractor shifts people among
various jobs once in two days. The labour force performs one task in 3
days. The manager wants to apply an average learning rate for these
workers.
You are required to advise to the manager with reasons on the applicability of the
learning curve theory on the above information.
Answer
The learning curve does not apply to very experienced people for the same job,
since time taken can never tend to become zero or reduce very considerably
after a certain range of output. This is the limitation of the learning curve.

17.6
 Learning Curve Theory

(i) Data entry is a manual job so learning rate theory may be applied.
Calculation of inventory is a computerized job. Learning rate applies only to
manual labour.
(ii) Learning rate should not be applied to a new process which the firm has
never tried before.
(iii) The workers are shifted even before completion of one unit of work. Hence
learning rate will not apply.
Question 7
PQ Ltd. makes and sells a labour-intensive product. Its labour force has a
learning rate of 80%, applicable only to direct labour and not to variable
overhead. The cost per unit of the first product is as follows:
Direct materials 10,000
Direct labour 8,000 (@Rs.4 per hour)
Variable overhead 2,000
Total variable cost 20,000
PQ Ltd. has received an order from X Ltd. for 4 units of the product. Another
customer, Y Ltd. is also interested in purchasing 4 units of the product. PQ Ltd.
has the capacity to fulfill both the orders. Y Ltd. presently purchases this product
in the market for Rs.17,200 and is willing to pay this price per unit of PQ's
product. But X Ltd. lets PQ choose one of the following options:
(i) A price of Rs.16,500 per unit for the 4 units it proposes to take from
PQ. Or
(ii) Supply X Ltd.'s idle labour force to PQ, for only 4 units of
production, with PQ having to pay only Re. 1 per labour hour to X
Ltd.'s workers. X Ltd.'s workers will be withdrawn after the first 4
units are produced. In this case, PQ need not use its labour for
producing X Ltd.'s requirement. X Ltd. assures PQ that its labour
force also has a learning rate of 80%. In this option, X Ltd. offers to
buy the product from PQ at only Rs.14,000 per unit.
X and Y shall not know of each other's offer.
If both orders came before any work started, what is the best option that
PQ may choose?
Present suitable calculations in favour of your argument.
Answer
Units Average/ hrs/u.

17.7
Advanced Management Accounting

1 2,000
2 1,600
4 1,280
8 1,024
Material Cost / u = 10,000
Variable cost = 2,000
Variable Cost = 12,000
Option I
If both the orders came together, learning rate 80% applies and 8 units can be
made, with average time of 1,024 hours per unit. Cost to PQ:
Variable cost excl. labour = Rs.12,000
Labour cost 1,024 hrs × 4 Rs./hr = Rs. 4,096
= Rs.16,096

In this case,
Y X
Selling Price p. u. Rs.17,200 Rs.16,500 → (under option
I)
Variable Cost p. u. Rs.16,096 Rs.16,096
Contribution p. u. Rs.1,104 Rs.404
No. of units 4 4
Contribution (Rs.) 4416 1616 6032
Option II
If X Ltd supplies its labour. 80% learning curve will apply to 4 units each of PQ &
X. Hence: hrs/ u = 1280
Y X
Selling Price Rs.17,200 Rs.14,000
Variable Cost (excl. labour) Rs.12,000 Rs.12,000
Labour cost:

1280 × 4 Rs.5,120
1280 × 1 . Rs.1280

17.8
 Learning Curve Theory

Total Variable Cost Rs.17,120 Rs.13,280

Contribution Rs.80 Rs.720
Units 4 4
Contribution (Rs.) 320 2,880 3,20
0
PQ should not take labour from X Ltd. It should choose option I.

17.9
Advanced Management Accounting

EXERCISE
Question 1
An electronics firm which has developed a new type of fire-alarm system has
been asked to quote for a prospective contract. The customer requires separate
price quotations for each of the following possible orders:
Order Number of fire-alarm systems
First 100
Second 60
Third 40
The firm estimates the following cost per unit for the first order:
Direct materials Rs. 500
Direct labour
Deptt. A (Highly automatic) 20 hours at Rs. 10 per hour
Deptt. B (Skilled labour) 40 hours at Rs. 15 per hour
Variable overheads 20% of direct labour Fixed overheads
absorbed:
Deptt. A Rs. 8 per hour
Deptt. B Rs. 5 per hour
Determine a price per unit for each of the three orders, assuming the firm uses a
mark up of 25% on total costs and allows for an 80% learning curve. Extract from
80% Learning curve table:
X 1.0 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0
Y% 100.0 91.7 89.5 87.6 86.1 84.4 83.0 81.5 80.0
X represents the cumulative total volume produced to date expressed as a
multiple of the initial order.
Y is the learning curve factor, for a given X value, expressed as a
percentage of the cost of the initial order.
Answer
(i) Price per unit for first order of 100 units
Selling price per unit = Rs. 2,275.00
(ii) Price per unit for second order of 60 units
Selling price per unit = Rs. 1,848.64

17.10
 Learning Curve Theory

(iii) Price per unit for third order of 40 units

Selling price per unit = Rs. 1,764.40

Question 2
Explain the concept ‘Learning curve’. How can it be applied for Cost
management?
Answer
Chapter 17: Paragraph 17.5

17.11
 CHAPTER 18

TESTING OF HYPOTHESIS

BASIC CONCEPTS AND FORMULA

Bas Concepts
ic
1. Testing Of Hypothesis Or Test Of Significance
It is a statistical procedure to asses the significance of
(i) Difference between a statistic and corresponding population
parameter.
(ii) Difference between two independent statistics, know as test of
significance.
2. Null Hypothesis (HO)
It asserts that there is no real difference between the sample statistic and
sample parameter or between two independent sample statistics.

3. Alternative Hypothesis (H1)

Any hypothesis Complementary to null hypothesis.

4. Possible Errors in Test of Significance

Four possible errors in test of significance:

Type of error Actual Decision from Probability of

sample error
1 Ho is true Reject Ho α
2 Ho is false Accept Ho β
5.
One-tailed Test
A hypothesis test in which rejection of the null hypothesis occurs for
values of test statistic in one time of the sampling distribution.
6. Two-way Test
A hypothesis test is which rejection of the null hypothesis occurs for
values for test statistic in either tail of its sampling distribution.
Advanced Management Accounting

7. Critical Value
A value that is compared with the test statistic to determine whether Ho
stated be rejected.

18.2
 Testing of Hypothesis

SSE
Mean of square due to error MSE =
8. Procedure for Large Sample nTest t - k
(t-
test)
Step
Test 1: Set upfor
Statistic Null hypothesis
equality Ho and alternative
of k population mean hypothesis
1 +1.
= MSTR t - E (t)
Step2: FCompute Z
= MSESE(t)
ANOVA StepTable
3: Testing significance at desired level, usually 5%
& 1%
At 1% At 5%
Source of Variation Sum of Squarely Degree of freedom Mean Square
Level Level
Significant values
Z 2.5 1.9 Two tailed
Treatment SSTR k–1 SSTR
of 8 6 test MSTR = k-1
Significant values
Z 2.3 1.64 One tailed
Errorof SSE3 5 nt - k test SSE
9. Analysis of Variance Test Analysis of MSE for
variance can be used = testing
nT-k
(ANOVA):
of k population equality
means.
TotalHo: 1 2 - - - - - SST nT - 1 F = MSTR MSE
µ =µ = - - - - - - =µk
H1: Not all population means are
equel.
Where mj = mean t
h
of j population
Let xi = value of observation I for
j treatment j
nj = No. of observation for
treatment j
x j = sample mean for
treatment j
s2j = sample variance for
treatment j
x= overall samplet = Total Sample
man n Size
Sum of Square due to
treatment k
SSTR = nj (xj - x)2
∑
j =1

Mean Square due to

treatment
SSTR
MSTR
= k −1
Sum of Square due to
error k
SSE = (n j -1)s2j
∑
j =1

18.3
Advanced Management Accounting

9.1 ANOVA For Randomized Block Design ( 2- ways

classification) k = No. of treatments b = No. of blocks n T = Total
sample size = kb r = replications
xij = Value of observation responding to treatment j in block j
j = sample mean of jth treatment
= sample means of ith stock x=
overall sample mean

Total Sum of Square

b k

SST = ∑∑(x ij - x)2

i= 1 j=1

Sum of Square due to treatments

k

SSTR = b ∑(x j - x)2

j= 1

Sum of Square due to blocks

b

SSBL = k ∑(x - x) i
2

i=1
Sum of Square due to error SSE = SST –SSTR –SSBL
ANOVA TABLE
Source of Sum of Degree of Mean Square F
Variation Squarel freedom
Treatment (TR) SSTR K–1 SSTR MSTR MSE
MSTR =
K −1
Block (BL) SSBL b-1 SSBL MSBL MSE
MSBL = b
-1

18.4
 Testing of Hypothesis

TR x BL SSTB (k-1) (b-1) MSTB = MSTB

SSTB MSE
(k-1)(b-1)
Error SSE Kb (r – 1) MSE =

SSE

kb (r - 1)
Total SST nT - 1
Basic Formulas
1. Test Statistic for Hypothesis Test, about a Population Mean is known
x - µ0
Z = µ = population mean α/ n
n = sample size
2. Test Statistic for Hypothesis Test, about a population Mean; is unknown

x - µ0
t= s = sample mean
s/ n

3. Test Statistic for Hypothesis Tests about a Population Proportion

Z = p - po
po (1 - po)
n

Question 1
Write a short note on the procedure in hypothesis testing.
Answer
Procedure in Hypothesis Testing: Following procedure is followed in
hypothesis testing:
1. Formulate the hypotheses: Set up a null hypothesis stating, for e.g. H0: θ=
θ0and an alternative hypothesis H1, which contradicts H0. H0 and H1 cannot
be done simultaneously. If one is true, the other is false.
2. Choose a level of significance, i.e. degree of confidence. This determines
the acceptance rejection region. For example, Z.05 in a 2 tailed ‘Z’ test is.

18.5
Advanced Management Accounting

3. Select test statistic: For n > 30, Z statistic is used, implying normal
distribution for large samples. For small samples, we use t 1, F1 and x 2
distribution.
4. Compute the sample values according to the test statistic.
5. Compare with the table value of the statistic and conclude.
Question 2
A factory manager contends that the mean operating life of light bulbs of his
factory is 4,200 hours. A customer disagrees and says it is less. The mean
operating life for a random sample of 9 bulbs is 4,000 hours, with a sample
standard deviation of 201 hours. Test the hypothesis of the factory manager,
given that the critical value of the test statistic as per the table is (-) 2.896.
Answer
Manager’s Hypothesis H0 µ0 = 4,200
x −µ0
H1 µ < 4,200 (Left Tail test) t= ,

where σ = s = 201 = 201 = 67

n 9 3

t = 4,000−4,200 =−200 = -2.985

67 67
Calculated t = 2.985, < table value of t .01 (sdf) which is
-2.896 Hence reject the null hypothesis H0. i.e. Accept H1
The customer’s claim is correct. Question 3
In the past, a machine has produced pipes of diameter 50 mm. To determine
whether the machine is in proper working order, a sample of 10 pipes is chosen,
for which mean diameter is 53 mm and the standard deviation is 3 mm. Test the
hypothesis that the machine is in proper working order, given that the critical
value of the test statistic from the table is 2.26.
Answer
Null Hypothesis H0 : µ = 50 mm i.e. the M/c works
properly. H1 : µ ≠ 50 mm. i.e. the M/c does not
work properly Sample Size = 10, small. use
‘t’ statistic

18.6
 Testing of Hypothesis

x −µ
t= x = 53
S/ n−1
µ = 50
n = 10;

n−1 = 9 = 3 S =
std dev = 3

53−50
T= = =3
3/ 3
Table Value = 2.26
Calculated t > table value
Reject Ho
i.e. The M/c is not working properly.
Question 4
A manufacturer claimed that at least 95% of the equipment which he supplied to
a factory conformed to specifications. An examination of a sample of 200 pieces
of equipment revealed that 18 were faulty. Test this claim at a significance level of
(i) 0.05 (ii) 0.01.
Answer
In the usual notations, we are given n = 200. x = No. of pieces conforming to
specifications in the sample = 200 – 18 = 182.

∴P = Proportion of pieces conforming to specifications in the sample = =

0.91.
Null hypothesis. H0 : P≥ 0.95, i.e., the proportion of pieces conforming to
specifications in the lot is at least 95%.
Alternative Hypothesis. H1 ; P < 0.95 (Left-tailed alternative).
It will suffice to test H0 : P = 0.95 ⇒ Q = 1 – P = 0.05
Level of significance (i) ∝ = 0.05, (ii) ∝ = 0.01

P − E(P) P−P
Test statistic. Under H0, the test statistic is Z = = ∼N (0,1),
SE (P) PQI n
Since sample is large

18.7
Advanced Management Accounting

= 0.91 − 0.95 = − 0.04 = − 0.04 = − 2.6.

0.95 × 0.05/200 0.00237 0.0154
(i) Significance at 5% level of significance.
Since the alternative hypothesis is one-sided (left-tailed), we shall apply
left-tailed test for testing significance of Z. The significant value of Z at 5%
level significance for lefttail test is—1.645.
Since computed value of Z = – 2.6 is less than – 1.645 (or since |z| >
1.645), we say Z is significant (as it lies in the critical region) and we reject
the null hypothesis at 5% level of significances. Hence, the manufacturer’s
claim is rejected at 5% level of significance.
(ii) Significance at 1% level of significance. The critical value of Z at 1% level
of significance for single-tailed (left-tailed) test is – 2.33. Since the
computed value Z = –
2.6 is less than – 2.33 (is |z| > 2.33),
∴H0 is rejected at 1% level of significance also.

Question 5
For the following data representing the number of units of production per day
turned out by five workers using from machines, set-up the ANOVA table
(Assumed Origin at 20).
Workers Machine Type
A B C D
1. 4 -2 7 -4
2. 6 0 12 3
3. -6 -4 4 -8
4. 3 -2 6 -7
5. -2 2 9 -1
Answer
Null Hypothesis
(a) The machines are homogenous
i.e., µ A =µ B=µC=µ D
(b) The workers are homogeneous

18.8
 Testing of Hypothesis

i.e., µ1 = µ 2 =µ3=µ 4=µ5

Alternative Hypothesis

(a) At least two of the machines differ

significantly
(b) At least two of the workers differ
significantly In the usual notation,
we have:
K = 5, H = 4, N = KH = 5 × 4 = 20
G = Σ Σ Xij = 20;
Calculation for Various S.S
Workers Machine Type Total
A B C D
I 4 -2 7 -4 R1 = 5
II 6 0 12 3 R 2 = 21
III -6 -4 4 -8 R 3 = -14
IV 3 -2 6 -7 R 4= 0
V -2 2 9 -1 R5=8
Total C1= 5 C2 = -6 C3 = 38 C4 = -17 G = 20
Corrector Factor (CF) = G 2 = 202 = 20
n20
Raw S.S (RSS) = Σ Σ Xij2
= [(16+4+49+16)+(36+0+144+9) + (36+16+16+64) + (9+4+36+49) +
(4+4+81+1)]
= 594
Total S.S = RSS-CF = 594-20 = 574
R2
S.S Rows (Workers) = 1 +R22 +R32 +R42 +R52 CF

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Advanced Management Accounting

= 52 + 212 +(−14)2 + 0+ 82 20

= 25+441+196+64−80 = =161.5
4

S.S Columns (Machine Type) = C12 +C22 +C3 2 +C42 − CF

5

= 52 +(-6)2 + 382 +(-17)2 − 20

5

= 25 + 36 +1,444 + 289 −100

5

= = 338.8
: SSE = Error S.S = TSS SSR SSC

= 574 161.5 338.8

= 73.7
Since the various sum of the squares are not affected by change of origin,
the ANOVA table for the original data and the given data obtained on
changing the origin to 20 will be same and in given in following table.
Degrees of Freedom for various S.S
d.f for TSS = n -1= 20 -1=19

d.f for Rows (Workers) = 5-1= 4

d.f for Column (Machines ) = 4-1= 3
d.f for SSE = 19-(4 + 3) =12
OR d.f for SSE = (d.f for Rows) × (d.f for columns)
= (3 × 4) = 12
ANOVA TABLE

18.10
 Testing of Hypothesis

Sources of d.f S.S S.S Variance Radio (F)

MSS =
variation
d.f
Rows (Workmen) 4 161.5 40.38 40.38
= 6.58 ~F(4,12)
6.14
Columns 3 33.8 112.93 112.93
= 18.39~F(3,12)
(Machine)
6.14
Errors 12 73.7 6.14
Total 19 574
Question 6
Given below in the contingency table for production is three shifts and the
number of defective good turn out- Find the value of C. It is possible that the
number defective goods depends on the shifts then by them, No of Shifts:
Shift I Week II Week III Week Total
I 15 5 20 40
II 20 10 20 50
III 25 15 20 60
60 30 60 150
Answer
Let Ho: Defective is good does not depend upon the shift run by the factory the
first Expected value is

= E = 40×60 = 16
150
0 E 0-E (0-E)² (0-E)²/E
15 16 -1 1 0.063
20 20 0 0 0
25 24 1 1 0.042
5 8 -3 9 1.125
10 10 0 0 0
15 12 3 9 0.750
20 16 4 16 1.0

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Advanced Management Accounting

20 20 0 0 0
20 24 -4 16 0.667
3.647
D: F = V= (r -1) (c -1) = (3-1)(3-1) = 4

: Ψ 2 (4, 0.05) = 9.488

Here, the calculated value of Ψ 2 is less then of table value.

Hence, the hypothesis is accepted.
i.e., the number of defective does not depend m shift run by the factory.

18.12
 Testing of Hypothesis

EXERCISE
Question 1
The contingency table below summarize the results obtained in a study
conducted by a research organization with respect to the performance of four
competing brands of tooth paste among the users
Brand A Brand B Brand C Brand D Tota
l
No. of Cavities 9 13 17 11 50
One of five 63 70 85 82 300
More than five 28 37 48 37 150
Total 100 120 150 130 500
Test the hypothesis that incidence of cavities is independent of the brand of the
tooth paste used. Use level of significance 1% and 5%. Answer
Incidence of cavities is independent of the brand of the tooth paste
used. Question 2

Below are given the yield (in kg.) per acre for 5 trial plots of 4 varieties of
treatment. Carry out an analysis of variance and state conclusion
Treatment
Plot no. 1 2 3 4
1 42 48 68 80
2 50 66 52 94
3 62 68 76 78
4 34 78 64 82
5 52 70 70 66
Answer
∴The null hypotheses is rejected
∴The treatment does not have same effect.
Question 3
The sales data of an item in six shops before and after a special promotional
campaign are as under
Shops A B C D E F
Before Compaign 53 28 31 48 50 42

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Advanced Management Accounting

After Compaign 58 29 30 55 56 45
Can the compaign be judged to be a success?
Test at 5% level of significance using t-test.
Answer
H0 is rejected at 5% level of significance and we conclude that the special
promotional campaign has been effective in increasing the sales.

18.14
 CHAPTER 19

TIME SERIES ANALYSIS &

FORECASTING

BASIC CONCEPTS AND FORMULA

Basic Concepts
1. Time Series Analysis
The term ‘Time Series’ means a set of observations concurring any activity
against different periods of time. In order to describe this flow of economic
activity, the statistician uses a time series.
2. Examples of Time Series Data
Following are few examples of time series data:
a) Profits earned by a company for each of the past five years.
b) Workers employed by a company for each of the past 15 years.
c) Number of students registered for CA examination in the institute for
the past five years.
d) The weekly wholesale price index for each of the past 30 week.
e) Number of fatal road accidents in Delhi for each day for the past two
months.
3. Components of a Time Series:
A time series may contain one or more of the following four components:
1. Secular trend (T): (Long term trend) It is relatively consistent
movement of a variable over a long period.
2. Seasonal variation (S): Variability of data due to seasonal influence.
3. Cyclical variation (C): Recurring sequence of points above and
below the trend line lasting over more than one year.
4. Irregular variation (I): (random movements) Variations due residual
factors that accounts for deviations of the actual time series values
from those expected, given the effect of trend, seasonal and
seasonal components. Example, erratic movements that do not have
any pattern and are usually caused by unpredictable reason like
Advanced Management Accounting

earthquake, fire etc.

4. Approaches for the Relationship amongst Components of a Time

Series There are two approaches for the relationship amongst these
components.
(a) Y = T×S×C×I (multiplicative model)
(b) Y = T+S+C+I (additive model)
Note: In multiplicative models S,C and I indexes are expressed as decimal
percents Where Y is the result of the four components.
5. Trend
The trend is the long-term movement of a time series. Any increase or
decrease in the values of a variable occurring over a period of several
years gives a trend. If the values of a variables remain statutory over
several years, then no trend can be observed in the time series.
6. Methods of Fitting a Straight Line to a Time Series
i. Free hand method, ii.
The method of semi-averages,
iii. The method of moving
averages iv. The method of
least squares.
7. Methods of Finding Short Period Variations Other Methods of finding
short period variations 7.1 Simple Average:
Simple Average: The method is very simple: average the data by
months or quarters or years and them calculate the average for the
period. Then find out, what percentage it is to the grand average.
Seasonal Index = MonthlyorQuaterlyAverage x100
GrandAverageofthemonthsorthequaters
Same results are obtained if the totals of each month or each quarter
are obtained instead of the average of each month or each quarter.
7.2 Ratio-to-Trend Method
This method is an improvement over the previous method because
this assumes that seasonal variation for a given month is a constant

19.2
 Time Series Analysis & Forecasting

fraction of trend. This method presumably isolates the seasonal

factor in the following manner:
S × C × I= T × S × C × I
T
Random elements (I) are supposed to disappear when the ratios are
averaged. Further, a carefully selected period of years used in
computation is expected to eliminate the influence of cyclical
fluctuations (C).
8. Deseasonalization
The process of eliminating seasonal fluctuations or deseasonalization of
data consists of dividing each value in the original series by the
corresponding value of the seasonal index.
9. Forecasting
Time series forecasting methods involve the projection of future values of
a variable based entirely on the past and present observation of that
variable.
10. Various Forecasting Methods Using Time Series.
10.1 Mean Forecast
The simplest forecasting method in which for the time period t. we
forecast the value of the series to be equal to the mean of the series.
This method is not adequate as trend effects and the cyclical effects
are not taken into account in this.
10.2 Naïve forecast
In this method, by taking advantage of the fact that there may be
high correlation between successive pairs of values in a time series,
we forecast the value, for the time period t, to-be equal to the actual
value observed in the previous period t that is, time period (t – 1):

yt = yt−1
10.3 Linear Trend Forecast
In this method, a linear relationship between the time and the
response value has been found from the linear relationship. yt
=a+bX where X will be found from the value of t and a and b are
constants.
10.4 Non-linear Trend Forecast

19.3
Advanced Management Accounting

In this method, a non-linear relationship between the time and the

response value has been found again by least-squares method.
Then the value, for the
time period t , will be calculated from the non-linear
equation . i.e., yt =a+bX +cX2 where X-value will be
calculated from the value of t.

10.5 Forecasting will Exponential Smoothing

In this method, the forecast value for the time period t is found using
exponential smoothing of time series. Specifically, at the time period
t.
yt = yt−1 +α(yt −yt−1)
where the forecasted value for time period
t + 1 ; yt-1= the forecasted value for time
period t.: yt=the observed value for time
period t.
Question 1
What is trend? What are the various methods of fitting a straight line to a time
series?
Answer
Trend is the long term movement of a time series. Any increase or decrease in
the values of a variable occurring over a period of several years gives a trend.
The various methods of fitting a straight line to a time series are:
(i) Free hand method.
(ii) The method of semi-averages.
(iii) The method of moving averages.
(iv) The method of least squares.
Question 2
Name the various methods of fitting a straight line to a time series and briefly
explain any two of them.
Answer
The various methods of fitting a straight line are:
(i) Free hand method
(ii) Semi-average
(iii) Moving average

19.4
 Time Series Analysis & Forecasting

(iv) Least square

Freehand method:
First the time series figures are plotted on a graph. The points are joined by
straight lines. We get fluctuating straight lines, through which an average straight
line is drawn. This method is however, inaccurate, since different persons may fit
different trend lines for the same set of data.
Method of Semi Averages:
The given time series is divided into two parts, preferably with the same number
of years. The average of each part is calculated and then a trend line through
these averages is filled.
Moving Average Method:
A regular periodic cycle is identified in the time series. The moving average of n
years is got by dividing the moving total by n. The method is also used for
seasonal and cyclical variation.
Method of Least Squares:
The equation of a straight line is Y = A + b X, where X is the time period, say year
and Y is the value of the item measured against time, a is the Y intercept and b,
the co-efficient of X, indicating the slope of the line. To find a and b, the following
‘normal’ equations are solved.
∑ Y = an + b ∑ X
∑ XY = a ∑ X + b ∑ X²
Where n is the no. of observation in the series or n = no. of data
items. Question 3

Apply the method of link relatives to the following data and calculate seasonal
indices.
Quarterly Figures
Quarter 1995 1996 1997 1998 199
9
I 6.0 5.4 6.8 7.2 6.6
II 6.5 7.9 6.5 5.8 7.3
III 7.8 8.4 9.3 7.5 8.0
IV 8.7 7.3 6.4 8.5 7.1
Answer
Calculation of seasonal indices by the method of link relatives.

19.5
Advanced Management Accounting

Arithmetic average = = 86.35 = 108.28

= 121.66 = 93.86

Chain relatives 100 100 × 108.28 =

108.28 100
121.66 × 108.28 =
131.73 100
93.86 × 131.73 =
123.65 100
Corrected chain relatives 100 108 – 1.675 = 106.605
131.73 – 3.35 = 128.38

123.64 – 5.025 =
118.615

Seasonal indices 100 × 100 ×

100 × 100
113.4

× 100

19.6
 Time Series Analysis & Forecasting

= 88.18 = 94.01 = 113.21

= 104.60
The calculation in the above table are explained below:
Chain relative of the first quarter (on the basis of first quarter = 100)
Chain relative of the first quarter (on the basis of the last quarter)
= 86.35 × 123.64 =
106.7
100
The difference between these chain relatives = 106.7 – 100 = 6.7
6.7
Difference per quarter = = 1.675
4
Adjusted chain relatives are obtained by subtracting 1 × 1.675, 2 × 1.675, 3 ×
1.675 from the chain relatives of the 2nd, 3rd and 4th quarters respectively.
Average of corrected chain relatives

= 100 + 106.605 + 128.38 + 118.615 =

= 113.4
4

Seasonal variation index = Correct chain relatives ×100

113.4
Question 4
The following table relates to the tourist arrivals during 1990 to 1996 in India:
Years : 1990 1991 1992 1993 1994 1995 1996
Tourists arrivals: 18 20 23 25 24 28 30
(in millions)
Fit a straight line trend by the method of least squares and estimates the number
of tourists that would arrives in the year 2000.
Answer
Fitting straight line Trend by the Method of Least squire

19.7
Advanced Management Accounting

N = 7 Σy = 168 Σx = 0 Σxy = 53 Σx2 = 28

The equation of the straight line trend is:
Y = a + bx

∑y 168
Since ∑x = 0, a = = = 24
N 7

∑xy 53
And b= 2 = 28 = 1.893

∑x
Hence Y = 24 + 1.893x
Estimated Number of tourists that would arrive
in 2000 Y = 24 + 1.893 (7) = 24 + 13.251 =
37.251 million.

19.8
 Time Series Analysis & Forecasting

EXERCISE
Question 1
Below are given the figures of production (in thousand quintals) of a sugar
factory.
Year Production
(thousand quintals)
1993 77
1995 88
1996 94
1997 85
1998 91
1999 98
2002 90
(i) Fit a straight line by the 'least squares' method and tabulate the trend
values.
(ii) Eliminate the trend. What components of the series are thus left over?
(iii) What is monthly increase in the production of sugar?
Answer
(i) equation of straight line trend is Y = 88.803 + 1.38 X
(ii) After eliminating the trend we are left with cyclical and irregular variations.
(iii) The monthly increase in the production of sugar is b/12, i.e. 1.38 / 12 =
0.115 thousand quintal.
Question 2
Calculate 5 yearly and 7 yearly moving averages for the following data of the
numbers of commercial and industrial failure in a country during 1987 to 2002.
Year No. of failures
1987 23
1988 26
1989 28
1990 32
1991 20
1992 12
1993 12

19.9
Advanced Management Accounting

1994 10
1995 9
1996 13
1997 11
1998 14
1999 12
2000 9
2001 3
2002 1
Also plot the actual and trend values on a graph.
Answer
Calculation of 5 – yearly and 7 – yearly moving Averages
Year 5 – yearly moving 7 – yearly moving
average average
1987 – –
1988 – –
1989 25.8 –
1990 23.6 21.9
1991 20.8 20.0
1992 17.2 17.6
1993 12.6 15.4
1994 11.2 12.4
1995 11.0 11.6
1996 11.4 11.6
1997 11.8 11.1
1998 11.8 10.1
1999 13.8 9.0
2000 7.8 –
2001 – –
2002 – –

19.10