International School of Business & Media

Post Graduate Diploma in Business Management (2012-14)Course Outline – Trimester I

Management Accounting

(Prof. S.B.Subramaniam)

Introduction

Organizations are driven by long term strategy defining the road map for the way going forward and the targets to be achieved. Managers at all levels within the organization need to plan, control through timely decisions, their respective area of operation in order to achieve the goals set. In the process, they have to take a variety of quick and timely decisions relating to cost and revenue involving their areas of responsibility. The Management Accountant (also commonly referred to as the Controller) is the key person who facilitates the process of providing the appropriate and timely information to the managers across the organization.

Objectives To familiarize the students about the structure and set up of an organization,

information requirement at each managerial level in the organization, To acquaint them with the type of information that each managers would require

and how they would understand and interpret these, To develop an appreciation about the utility of timely information as a vital input

for management information and decision making process. In the process, the students would become familiar with how Controllership

function within an organization could serve as a very crucial resource tool towards achieving the desired plan.

In order to achieve the objective as above, the course will be divided into 6 parts: Introduction to Management Accounting - the relevance and purpose, Understanding the key cost elements, the cost behavior, and how costs get

classified for better understanding, Marginal costing – cost volume relationship and break-even levels,

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Introduction to some important concepts managerial decisions – pricing decisions using concepts of Cost plus (full cost), Marginal cost, Target costing. Decisions on make or buy, invest or outsource, etc, import vs localization etc.

The preparation of budgets and plan – monitoring actual results through performance reports and interpretation of variances in taking decisions,

Evaluation:

Assignment / Surprise quiz

15%

Midterm 25%Presentation 20%End term 40%

There will be no makeup for missed tests. If an examination / test is missed without a valid excuse, students will receive a Zero for that component.

Required Readings:

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Sr. No.

Title Author Edition Publication

1. Managerial Accounting James Jiambalvo Second John Wiley & Sons Inc

2. Management Accounting

Horngren Sundem Stratton

Fourteenth Pearson Education

3. Management Accounting

Anthony A. AtkinsonRobert S. KaplanS Mark Young

Fifth Pearson Education

3. Cases in Management Accounting and Control Systems

Bandt R AllenE. Richard Brownlee Mark E. HaskinsLuan J Lynch

Fourth Pearson Education

Journals & websites

THE JOURNAL OF APPLIED MANAGEMENT ACCOUNTING

RESEARCH(JAMAR)

Management accounting research (Elsevier)

www.journals.elsevier.com/management-accounting-research

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Management Accounting - Introduction

What is Accounting? The basic purpose of Accounting is to help capture correct information on the business proceedings of any organization. In a way, it resembles the lens in the camera which captures and records the business proceedings.

The information captured is reproduced and presented in a manner to make it meaningful to the users.

Users of information generally fall into two categories:o External Parties – investors, government and tax authorities, lenders and

creditors,o Internal parties – Managers at all levels of any organization,

Each of above users would require information which would help in taking decisions from their own perspective,

Source of Information for External users is generally from Financial Accounting records - comprises of the Audited Financial Statements viz. Balance sheet, Profit & Loss, and Cash flow Statement,

Source of information for internal users –

o not restricted to the financial statements from Financial Accounting

records,o any information that helps the concerned managers plan, control, decide

and take corrective actions.

Management Accounting deals with the portion of information which involves all managers within the organization to generate the right type of information required and use them for timely decisions.

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Distinctions - Management Accounting vs Financial Accounting:Management Accounting Financial Accounting

1. Primary Users Organization managers at all levels

Outside parties,

2. Flexibility / freedom of choice of information

No constraints ; highly flexible; the only constraint could be governed by cost-benefit considerations in making available the information,

Information should comply with the framework as governed by Generally Accepted Accounting Practices (GAAP)

3. Behavior implications in selecting accounting measures

Choice depends on how measurements would influence managers in taking the right decisions and actions to adhere to the targets set,

The designing of the accounting format is governed by standards to generally suit the use of the external users, but is not the primary consideration

4. Time focus of reports Future orientation – generally use of budgets as well as historical data from financial accounting information, Example: Budget vs actual

Historical data: Actual PY vs CY

5. Time span of reports Highly flexible: varying from hourly to span of 10 to 15 years.

Usually one year; for listed companies quarterly extracts,

6. Types of reports Reports can be relating to company as a whole, on specific business segment, departments, products, territories, etc.

Reports are in a summarized form for the entity as a whole

7. Use of cost accounting

Embraces and includes areas of cost analysis, cost management, and cost accounting techniques,

No detailed information on cost except for comparative information on major expenses heads – PY vs CY

8. Information source Could be financial ,non-financial data from transactions level, or from the data from the accounting records

Is built on financial transactions as captured

9. Establishing credibility factor

Onus is primarily on the controller or the source from where information is originated to ensure acceptability is established,

Generally audited statements are accepted on face value

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A Brief Case study (Case Study 1)

Mr. Braganza is the CEO of Bright Star Limited, which manufactures and sells consumer electronics and durables. The company manufactures and sells a wide range of consumer electronic products viz. televisions, washing machines, refrigerators, & audio appliances. The products enjoy a fairly good reputation for its quality and brand in the market. The company has a build a good network for distribution of its products all over India.

Braganza has a Board meeting scheduled in about two weeks’ time. The main item in the agenda is to discuss and approve the audited annual results for the year ending March.

Mr.Jacob, the CFO, has just finished the audit of accounts for the year ending 31st

March 2012. He looks very relieved after a very hectic schedule of very long working hours without any week-end breaks.

Branganza picks up the inter-com and asks Jacob “Are you through with the final audited figures?” A relieved Jacob replies” Yes, we are finally through. I am just mailing you the summarized results in a few minutes”. In the next ten minutes Braganza receives the mail from Jacob giving the summary results for the company for the year ending March 2012.

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Following are the excerpts from the summarized results:(Rs Million)

Current Year - 31st March

2012

Previous Year - 31st March 2011

Rs RsSales 6250 5000

Les:Cost of Goods Sold 4563 3350Salary and other manufacturing cost 563 300Selling & distribution exp 438 250Administrative expense 563 400Financial cost (Interest exp.) 313 200Total Expenditure 6438 4500Net Profit/ (Loss) -188 500

Financ ial Results of Bright Star L td

Braganza is shocked to see the company has reported a loss figure of Rs 188 million as against profit of Rs 500 Million in the previous year. He immediately calls .Jacob to his room.

A worried CEO asks Jacob “I cannot understand how the results can show a loss especially when we have done extremely well in the sales front. We had planned an overall turnover target of 20% increase over the last year. We have had regular reviews on the sales achievement vis-à-vis target with our marketing team in all business groups. Except for the appliances segment where we managed to hold on to our last year figures (which is incidentally a very small and negligible portion of our overall business portfolio), in all the other main business segments, and we had right through done better compared to both the last year as well as our plan. In fact, we achieved a record 25% increase in the sales over the previous year which is the highest ever since the inception of the company. I think you need to recheck the numbers thoroughly once again and get back to me latest by tomorrow morning. We have to discuss this once again tomorrow first thing in the morning. I am very hopeful you would get to me back with some better bottom line figures.”

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Jacob gets back to his room and calls his two able accounts assistants. “Guys, we need to recheck the audited numbers finalized and I have to get back to the CEO latest by tomorrow morning. Since we have very limited time, let’s quickly carry out overall control checks and look if there are any major incorrect major wrong bookings in any of the cost heads. We would have long day ahead and I do not see an option but to burn the midnight oil tonight as well.”

The Accounts of the company are maintained on SAP, one of the best internationally acclaimed ERP tool available in accounting. The accounts assistants have been trained well and have a good expertise in the financial accounting module of SAP. Periodic checks and confirmations from the suppliers and customers account are obtained to ensure there are no discrepancies with the records maintained by the company. As at end March 2012, for the first time Jacob has ensured that there has been a 100% check and confirmation on all the balances from suppliers and customers obtained. .

He has a discussion with the Company’s auditor to find out if the auditor has any specific observation which could have an impact in improving the bottom lines figures. The auditor replies” We have carried out all necessary checks including system compliance checks on SAP. We have not come across any instance of wrong booking. We had some observations regarding the provisioning of some marketing expenditure, which was not done earlier but all these have already been corrected and incorporated”.

Next day first thing in the morning, Jacob hurries up to Branganza’s room. He starts the discussion” Sorry Chief, we have spent the entire yesterday afternoon and night.I am unable to give you any better information. We have rechecked the figures and have no found there are no glaring mistakes. So the figure as given earlier stands. As you may be aware, our accounting systems are fairly good and maintained in SAP and we have carried out all possible checks and do not find any changes in the figures as reported. Both me and the auditor are ready to certify the correctness of the figures.”

Is there anything the CEO and his team could have done better?

How do you think CEO and his team should prepare themselves for the forthcoming Board Meeting given the short time?

What steps and actions could CEO and his team take in the current financial year.

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Suggested Model Answer

Point 1: Could the CEO and his team done anything better?

CFO seems primarily involved in financial accounting, annual book closure and audit activity.

He should have also involved himself in controllership function by supporting the CEO in generating timely management information reports and holding regular reviews with the respective functional heads viz. Purchase, production, Marketing etc. This would have helped the organization in monitoring the costs much better..

CEO’s focus has been top line driven and has primarily focused on the turnover. He does not seem to have given much attention in understanding and analysis of cost at the various functional managerial levels,

In the absence of timely information and review, the company failed to control some of the major cost elements resulting in losses for the financial year last ended,

Point 2: How should be CEO and his team prepare for the forthcoming Board meeting?

It is clear from the data that the company failed to control costs and almost all cost components show major increase over the previous year, (comparative data analysis – CY vs PY)

CFO should analyze data further – look at data in the individual business segments and check whether one or more is /are responsible for the losses,

Check within the product segments which are the specific products contributing to the overall losses;

Analyze major cost components and check for increases in cost or any decrease offered in the product selling prices,

Having identified the reasons for the cost over-runs, there must be a list of corrective action plan.

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Point 3: What steps should the CEO and his team take in the current financial year?

Controllership function should be in put in place; Maximum use of the SAP tool should be made in trying to get the

best out of the available resource, This would facilitate the process of establishing a good reporting

system, A detailed budget and plan should be worked out for the year which

should be broken down to the individual functions, Managers in all functions should have timely information about their

areas of performance and cost implications Action points should be identified and pursued regularly in each

review till closure,

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Managing Costs

Points to be remembered:

1. Revenue – Cost = Profit,

2. In competitive situation, Revenues are not fully in control due to extraneous factors viz. government policies, competition around, etc; it is the Costs which have to be managed very carefully,

3. Companies are run by managers; Managers cannot control costs unless they have a very good understanding about the cost,

Understanding Costs

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1. What influences the creation of cost? Example comparing a large organization using large amount of

resources vis a vis small organization using lesser resources,

2. Resources results in costs; Resource comprises of people, machines and equipment, land building, etc.

Example comparing a large organization using large amount of resources viz a viz small organization using lesser resources,

3. Resources can results in costs – By their mere existence – salary of people, machines, On their usage by performing an activity,

4. Crux lies in how smartly resources are deployed and managed, Examples and impact of unproductive resources – people not

productive and contributing, idle machines, etc.

Understanding cost behavior

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1. How do costs behave?a. Example of human behavior depending on specific situation,

2. Costs that change directly in proportion to change in the volume of output –Variable costs

a. In general, these costs should result in increase of output and revenue,

3. Costs that do not immediately change with change in volume of output – Fixed cost,

4. Total Costs =Variable + Fixed; in other words, Sales- Variable Cost – Fixed Cost = Profit

a. Illustrative Example of Variable and fixed cost and demonstrate,(refer to prescribed books)

5. With change of volume of output; (present in matrix form)

a. Fixed cost – In Absolute terms - no increase / decrease, Cost per unit – increases / decreases

b. Variable cost – In Absolute terms - increases / decreases, Cost per unit – no increase / decrease

Significance of the “Relevant” Range in Cost Behaviour

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Behavior of cost as fixed or variable generally holds so long as activity is within a certain relevant” range,

Fixed Cost - likely to remain within a certain band width, Variable cost – Unit cost is likely to remain within a certain band so long

as operating activity remain within the bandwidth,

Break-Even Levels

The level at which the Sales = Cost; in other words Profits = 0, Sales = Variable cost + Fixed Cost, Sales – Variable Cost = Fixed Cost, Contribution = Fixed cost, Break Even sales (expressed in terms of value) = Contribution Margin Ratio (i.e

Total Contribution / Total Sales Value) Break even ( expressed in terms of number of units ):

Fixed Cost/ Contribution per unit,

Key Factors influencing Break-Even Levels Selling price of the product (or sales value) Variable Cost per unit (or variable cost) Fixed Cost,

Any change in any of the above would have an impact in the break-even levels. If an organization is able to reduce the variable cost or fixed cost, or increase the selling price, it will result in the break-even levels coming down. Conversely, if the cost goes up or the selling price comes down, the break-even level would go up.

In a multi-product environment, any variation in the product mix can also have an effect in the overall cost, contribution and consequently the break-even. For example, if there an organization sells more of product A which has a higher material cost content compared to product B, it would result in the break-even levels going up.

Case Study 2

Short Case Study - Stay Healthy (Part A)

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Mr.Joseph is keen on starting a restaurant business in Pune.He would like the restaurant to cater to multiple choice of food dishes which will include Indian, Chinese, as well as Continental items.

“I would not like to restrict my customers by providing limited choice of food. My restaurant should be open for all categories of people, cast and religion should be no bar”.

Joseph has identified a suitable place in Central Pune for a monthly rental of Rs 75,000/-.

He has worked intensely on this project and also identified the entire list of equipment required. Based on the final quotations received from the various vendors, the cost of all the equipment put together is estimated as Rs 25 lacs.

He has also got in touch with a professional interior designer to help him out with exquisite interiors for the restaurant including central air conditioning systems. “The ambience should be exquisite and should automatically attract customers to visit again”, he tells his interior designer. After two rounds of negotiations, the designer has given his final estimate of Rs 15 lacs for the entire work to be carried out. He feels the life span of the equipment and the interiors should be good enough to last for 5 years.

Based on a survey done by him in the neighborhood area for similar restaurants, he discovers that that the average price per plate for a customer charged is at Rs 400/-. He strongly feels Stay Healthy should be able to get the same price per plate especially considering that he should be able to provide good quality food, better variety in dishes coupled with exquisite ambience.

Joseph has made a detailed cost estimate of all items of vegetable and ingredient required. The estimated cost of the vegetable and ingredient per plate works out to Rs 280/- per plate. Apart from this, he has estimated the cost of power, fuel, etc. which would be required to run the kitchen and serve the food for customers. He has estimated this as around Rs 50/- per plate.

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He intends to engage 8 employees including experienced chefs, helpers and a manager. Their monthly salary bill is estimated as Rs 4,40,000/-. Apart from this, he also estimates other establishment cost which are expected to be incurred at an average monthly Rs 2,00,000/- per month. The restaurant would have no holiday and would be open on all the days.

Mr.Joseph feels with the initial investment and infrastructure planned, he should be easily able to cater upto 400 customers a day. To start with, he is confident of billing minimum 200 plates a day.

You are Joseph’s Financial Advisor. As his financial advisor, he now seeks your opinion on the following:

How much profits can he make in the first year on selling 200 plates in a day?

How much should be the minimum number of plates he should sell in a day as to ensure he does not make any losses?

He is also keen to know what could be his incremental earnings if he is able increase the sale from 200 to 300 plates per day?

Please advise Mr.Joseph with your computation and findings.

Case Study 3

Short Case Study - Stay Healthy (Part B)

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After 3 months of running the business, Mr.Joseph discovers that he is not in a position to bill more than 225 plates per day and he does expect the situation to improve by end of the first year.

He is of course very concerned about the losses that he would suffer since he is unable to reach the break- even levels.

He is now in desperately in negotiation with some corporate clients. One of the clients is keen to offer him a contract for a period of 9 months (working for 20 days a month) to supply 200 plates a day. They have quoted a price of Rs 360/- per plate. He is aware he may have to drop the price from his normal price of Rs 400/- per plate to other customers. He is confident of fulfilling the order with the existing infrastructure and equipment available except that he may require to employ 2 additional people at Rs 50,000 per month and there would be some additional packing and logistics cost of Rs 25,000/- per month.

Joseph once again approaches you and seeks your advice as to:1. Whether he should accept the order at the offer quoted by the

company?2. What should be the price he should accept in order to ensure he

does not make any losses in the first year of operations.

Case Study 4

Short Case Study - Stay Healthy (Part C)

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After 3 months of running the business, Mr.Joseph discovers that he is not in a position to bill more than 210 plates per day and he does not expect the situation to improve by end of the first year.

He is of course very concerned about the losses that he would suffer since he is unable to reach the break- even levels.

He is now in desperately in negotiation with some corporate clients. One of the clients is keen to offer him a contract for a period of 9 months (working for 20 days a month) to supply 175 plates a day. They have quoted a price of Rs 325/- per plate. He is aware he may have to drop the price from his normal price of Rs 400/- per plate to other customers. He is confident of fulfilling the order with the existing infrastructure and equipment available except that he may require to employ 2 additional people at Rs 50,000 per month and there would be some additional packing and logistics cost of Rs 25,000/- per month.

Joseph once again approaches you and seeks your advice as to:1. Whether he should accept the order at the offer quoted by the

company?2. What should be the price he should accept in order to ensure he

does not make any losses in the first year of operation.

Learning from the case study: Stay Healthy

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1. Based on understanding of the behavior pattern of cost, it should be possible to forecast the cost, revenue and profit at different activity levels within a given capacity,

2. Variable cost and contribution – a. per unit of sale normally remains the same for different activity

levelsb. in value terms varies with the change in activity or level of

output,

3. Fixed Cost –a. Per unit of sale varies and comes down with higher activity level

through better utilization of resources.b. In value terms remains constant with the change in level of

activity of output,

4. Based on understanding of the behavior, it is possible to predict the Break-even level ( No profit no loss levels),

a. Lower the break-even levels in relation to capacity, the better the chances of achieving higher profits through higher utilization of resources,

b. Higher the break-even levels, greater the threat of viability and lesser the chances of improving profits through higher activity levels,

5. The important triggers that influence break-even:a. Selling priceb. Variable cost per unit,c. Fixed cost,d. Product mix,

6. Break-even levels vary with the change of any one or more of the above,

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7. Cost at different levels can be predicted based on the incremental or marginal cost and incremental or marginal revenue,

8. Can be helpful in the context of pricing decisions especially in instances of accepting or rejecting a special order,

Understanding cost:

1, According to its behavior – Variable or Fixed,

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The distinction between whether anexpenditure should be categorized as variable or fixed would depend largely on the behavior of the expenditure in the specific situation. For example: Expenditure on Repair and Maintenance – Expenditure on repairs of a machine could be categorized as variable; whereas the annual maintenance contract could be categorized as fixed. Salary of employees – monthly salary shall be categorized as fixed, whereas payments linked to productivity or performance of an improvement activity could be categorized as variable,

While it is to be understood that variable cost per unit or fixed cost remains constant with changes in activity levels within a given capacity, from a practical perspective it needs to be understood that these would remain constant within a given range; it does not usually remain an arithmetically constant figure. It is therefore important to understand the relevant range within which the variable cost per unit or fixed cost remains constant.

2. According to its function –

In any organization, cost depends largely on the following factors: How the activities in the organization are aligned according to its

primary functions The organization structure – the resources in terms of people,

machines and equipment deployed. Deployment of resources triggers cost. Higher the resources, higher the likelihood of costs. This depends on the size and complexity of the organization structure.

. What are the primary functions typically in any organization?- Production – buy materials, store, produce, - Research & Development – working on products for the future

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- Selling and distribution, - distribute and sell,- Administration (Support services)

3. Booking and classification of costs:- Cost centre,- Cost centres are mapped to a primary functional area,- Within each cost centre expenses get booked with specific expense

head which are the Cost elements,

4. What are cost centres?- these are individual centres within the organization headed by a

functional head who would be responsible for the costs in his cost centre, - Organizations have the flexibility to choose the name the cost

centres and the numbers – this would largely depend on the size of the organization, and, the availability of tool for ease of handling for reporting,

5. Cost Elements:- Organizations have the flexibility to choose the name the cost

element and the numbers – this would largely depend on the size of the organization, and,

- Availability of tool and the ease of handling for reporting,

9. Cost Pool:- Cost elements are pooled into generic category for convenience of

reporting,

International School Of Business & Media Management Accounting 2012-14 (Section A)

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Case Study 5Over the last twelve years, Bright Star Ltd enjoys the status of being one of the leading manufacturers of consumer appliances in the country. The company manufactures and sells a wide range of consumer electronic products viz. televisions, washing machines, refrigerators, & audio appliances. The products are marketed under the brand name “BSL”. Brand BSL has been ranked among the top five brands in the country. The products have a fairly good reputation for its quality and after-sales service in the domestic market. The company has successfully built a wide distribution and service network for its products all over India.

During the last year’s annual conference of all senior managers of the company, one of the items in the agenda was to review its overall marketing strategy and invite suggestions from the managers on new marketing initiatives. After due deliberations and intensive brain-storming session, one of the significant points that came up was that the company had virtually no presence in the global market. While the company had done well in establishing its brand and presence in the domestic market, it had not succeeded in making its presence felt in any of the overseas market. There was consensus among all managers that the company should now also work towards becoming global and gradually making its foot-hold overseas.

In pursuance of this strategy, the Company appointed Mr. Rajeev Bhatia as the General Manager Exports for the group covering all the product segments. Rajeev was well experienced with good dealership contacts in the overseas market. His last assignment was an overseas posting in Thailand with one of the leading MNC consumer durables. Rajeev assumed charge of BSL export business around four months back and had been working intensely in trying to get some initial break-through. He found that trying to get entry into any of the overseas market was quiet tough with some of the reputed multi-national brands already well entrenched in these markets. After a great deal of persuasion, he finally managed to get an order from one of the dealers in Thailand.

Rajeev was highly relieved in getting this initial break-through. Since his joining, over the last three months during the performance reviews with his CEO, Mr.Branganza, he had nothing concrete to share in terms of his

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achievement except his assurance that he was working hard in trying to get some initial break-through.

The next morning a very excited Rajeev is eager to share the piece of good news with his CEO. He walks in straight to the CEO’s office and to his pleasant surprise finds him alone. He immediately shares the news about the break-through on the export order. “Good job, Rajeev; so how much do we have to supply and what is the price? I hope you are able to get better prices compared to what we are selling in the domestic market.” Rajeev presented in brief the gist of the order which covers annual supply of:Televisions – 50,000 sets @ $360/- set,(Domestic price-Rs 25,995/-)Washing Machines – 30,000@ $220/- set,(Domestic Price-Rs15,493/-)Refrigerators – 25,000 sets @ $290/- set,(Domestic price – Rs 19,220/-)Audio set - 75,000 sets @ $125/- per set.(Domestic price – Rs 9006/-)Mr.Braganza is not too impressed looking at the prices. “The volumes are good to start with but prices not attractive enough. Even considering that the current $ to Re exchange rate is hovering at a high of Rs 55/- to a dollar, the prices for all the products would still work out lower than what we sell in the domestic market. You are aware that we struggle to maintain reasonable margins in the domestic market. Please discuss with Finance and get their views before we can take a final decision on accepting these prices”.

Rajeev walks out of the CEO’s office and gets in touch with the colleagues in Finance. He meets the CFO, Jacob along with his junior assistant, Mr.Sunil, who looks after the company’s Management information Reporting systems. Sunil is entrusted with the task of working out the implications on accepting the price for the export contract.

After around two hours, Sunil gets in touch with Rajeev and informs him that he is through with his workings.

For the purpose of his workings, he has used the actual historical data for the recent year ended March. He felt this would be the closest representation of the current level of cost incurred by the company.The following are the details he shares with Rajeev:The financial results for the recent year ended March -

Rs Crores

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Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Company

Sales 3,400 1,650 1,970 725 7,745

Cost of goods produced & sold 2448 1238 1478 537 5700Gross margin 952 413 493 189 2,046 Gross Margin% 28 25 25 26 26Research & Development Cost 133 69 83 41 326

Selling & distribution exp 306 149 143 120 717Marketing cost 187 83 108 61 439

Distribution Cost 119 66 34 59 279

Administration expense 209 101 121 81 512

Financial cost 68 33 39 21 161Total Cost 3164 1590 1864 799 7416Net Profit/ (Loss) 236 60 106 -74 329

Financ ial Results of Bright Star Ltd Rs Crores

In addition to the above, he has used the data on the number of units sold during the last year. Based on these data, he has worked out the per unit cost for each of the product as below:Installed Capacity (Number of Units) 1,500,000 1,200,000 1,500,000 1,200,000 Number of units sold 1,308,000 1,065,000 1,025,000 805000Average Selling price per unit 25,994 15,493 19,220 9,006 Cost of production per unit 18,716 11,620 14,415 6,665 Research & development cost Per unit 1,014 651 807 509 Selling and distribution cost 2,339 1394 1393 1491Administration cost 1,599 953 1182 1003Financial cost 519.88 310 384 259Total cost per unit 24,187 14927 18182 9926Net margin per unit 1,807 565 1038 -920

The computation of the incremental cost and revenue for the export order is as follows:Additional Export Order TV W/M Refrigerators Audio

Number of units to be sold annually 50,000 30,000 25,000 75000Average Selling price per unit 360 220 290 125 Average Selling price per unit 19,800 12,100 15,950 6,875

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Incremental Revenue & cost for Additional Export Orders(Rs Crores)

Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Compa

ny

Incremental Sales (Sales price per unit X Number of units) 99 36 40 52 227

Incremental Cost (Cost per unit X Number of units) 121 45 45 74 286Net margin (22) (8) (6) (23) (59) Net Margin% (22) (23) (14) (44) (26)

The conclusions summarized by Sunil were: In view of the fact that the incremental costs exceed the incremental

revenue in all the product segments, it would not be advisable to go ahead with the export order at these prices.

We could consider accepting the order if the customer is agreeable to revise the prices upward for each of the product segments.

o Televisions – additional $80 per set (revised price should be

$440/-)o Washing M/c – additional $51 per set (revised price should be

$271/-)o Refrigerators – additional $41 per set (revised price should be

$331/-)o Audio – additional $ 55 per set (revised price should be $180/-)

Rajeev is obviously extremely disappointed looking at the workings and the conclusion as summarized. He looks into the workings and makes one observation. “I think you should exclude the administration cost. I strongly feel this should be excluded from the incremental cost that you have considered. Your conclusions could possibly be different then”

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Sunil reluctantly agrees and makes some quick alterations in his workings. His revised results are as follows:

Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Company

Incremental Sales (Sales price per unit X Number of units) 99 36 40 52 227

Incremental Cost (cost of goods per unit Less Admin cost Per unit X Number of units) 113 42 42 67 264

Net margin (14) (6) (3) (15) (38)

Net Margin% (14) (15) (7) (30) (17)

He now summarizes his results and concludes as follows: In view of the fact that the incremental costs even excluding the

administration cost still exceed the incremental revenue in all the product segments, the conclusion does not change and it would not be advisable to go ahead with the export order at these prices.

We could consider accepting the order if the customer is agreeable to revise the prices upward for each of the product segments.

o Televisions – additional $51 per set (revised price should be

$411/-)o Washing M/c – additional $34 per set (revised price should be

$254/-)o Refrigerators – additional $41 per set (revised price should be

$309/-)o Audio – additional $ 55 per set (revised price should be $162/-).

Not fully convinced and highly disappointed with the outcome, Rajeev now approaches the CFO and seeks his guidance and views. Rajeev informs the CFO” We cannot afford to lose this annual contract. This is likely to set the foundation for future bigger contracts. We have negotiated hard in

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getting the best prices considering the intense competition. Anything beyond this would be impossible to pursue, and we would end up losing the contract to our competitor”.

Case Study 6 (contd from 5)

CFO has a look at the workings done by Sunil. While he is convinced about the bright future business prospect of BSL having a good overseas

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presence on execution of this contract, he is clear that the company should not lose money in the process. He asks Sunil to do the following:

1. Get into the break-up and details of the major expense head under each of these functional areas of cost.

2. Based on each major head of expenditure, identify the costs which would be relevant to the export contract and the ones which would not have any relevance or impact on the export contract. Please rework the proposal on these lines”.

Sunil gets back to his desk, and starts reworking on the data. 1. Against each functional area viz. cost of production, selling &

distribution, Administration cost, he gets the major head of expenditure incurred.

2. Next, against each of the expense head, he carries out a validity test as to whether these are relevant to the export contract.

3. Based on the above working, he has now been able to regroup the historic information from the financial results classifying between what would be relevant to the export contract and what would not be relevant.

The figures after regrouping and recasting looks as follows:

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Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Company

Cost classificatio

nSales 3,400 1,650 1,970 725 7,745 Net sales of products 3,100 1,450 1,695 650 6,895 Other income 300 200 275 75 850

Cost of goods produced & sold 2448 1238 1478 537 5700Cost of Materials Consumed 2040 1073 1221 450 4783 Relevant

Direct Personnel Cost - contract labour 68 33 39 7 148

Relevant

Salary - workers and production supervisors 102 50 49 22 223

Not relevant

Depreciation on production machines 102 33 79 29 243

Not relevant

Plant maintenance & related cost 68 16.5 30 7 121 Relevant

Cost of Power 68 33 59 22 182 Relevant

Gross margin 952 413 493 189 2,046 Gross Margin% 28 25 25 26 26

Research & Development Cost 133 69 83 41 326

Personnel Cost R&D 51 25 30 25 130Not

relevant

Lab testing cost 17 8 10 4 39Not

relevant

Deprecation on R&D equipment 26 11 13 5 54Not

relevant

Electricity cost 22 9 11 4 46Not

relevant

Other cost 17 17 20 4 57Not

relevant

Financ ial Results of Bright Star Ltd Rs Crores

Contd..

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Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Company

Cost classificatio

nSelling & distribution exp 306 149 143 120 717

Marketing cost 187 83 108 61 439Personnel cost - salary (marketing

staff) 17 8 10 21 56

Not relevant

Personnel cost - incentive 9 4 5 2 19 Relevant

Electricity cost 9 4 5 2 19Not

relevant

Branding and publicity 85 33 49 18 185Not

relevantCommission to dealers 68 33 39 18 159 Relevant

Distribution Cost 119 66 34 59 279Personnel cost - salary (logistics

staff) 34 33 10 31 108

Not relevant

Rent - warehouse 51 17 10 10 87Not

relevantTransportation cost 34 17 15 18 83 Relevant

Administration expense 209 101 121 81 512

Personnel cost - Support services 102 50 59 51 262

Not relevant

Rental office building 85 41 49 25 201Not

relevant

Electricity cost 9 4 5 2 19Not

relevant

Travel 9 4 5 2 19Not

relevant

Communication 5 2 3 1 12Not

relevant

Financial cost 68 33 39 21 161Interest on working capital 17 8 10 10 45 Relevant

Interest on long term loans 51 25 30 11 116Not

relevantTotal Cost 3164 1590 1864 799 7416Net Profit/ (Loss) 236 60 106 -74 329

Based on the above analysis, CFO asked Sunil to recast the results which looked as under:

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Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Compan

y

Sales 3,400 1,650 1,970 725 7,745 Net sales of products 3,100 1,450 1,695 650 6,895 Other income 300 200 275 75 850

Variable Cost 2372 1217 1418 534 5541Variable Cost Per unit 18,131 11,426 13,838 6,631 Cost of goods produced & sold 2040 1073 1221 450 4783Direct Personnel Cost - contract labour68 33 39.4 7 148Plant maintenance & related cost 68 17 30 7 121Cost of power 68 33 59 22 182Personnel cost - incentive 9 4 5 2 19Commission to dealers 68 33 39 18 159Transportation cost 34 17 15 18 83Interest on working capital 17 8 10 10 45Contribution 1,029 433 552 191 2,204 Contribution Per unit 7,863 4,067 5,381 2,375

Contd…

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Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Compan

y

Fixed Cost 792 373 445 265 1,876 Salary - workers and production supervisors102 50 49 22 223 Depreciation on production machines102 33 79 29 243 Personnel Cost R&D 51 25 30 25 130 Lab testing cost 17 8 10 4 39 Deprecation on R&D equipment 26 11 13 5 54 Electricity cost 22 9 11 4 46 Other cost 17 17 20 4 57 Personnel cost - salary (marketing staff)17 8 10 21 56

Electricity cost 9 4 5 2 19 Branding and publicity 85 33 49 18 185

Personnel cost - salary (logistics staff) 34 33 10 31 108Rent - warehouse 51 17 10 10 87

Personnel cost - Support services 102 50 59 51 262Rental office building 85 41 49 25 201Electricity cost 9 4 5 2 19Travel 9 4 5 2 19Communication 5 2 3 1 12Interest on long term loans 51 25 30 11 116Net Profit/ (Loss) 236 60 106 -74 329

Based on the above data, he reworks the incremental cost and revenue for the export order which now looks as under:

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Additional Export Order

Number of units as per annual export contract 75,000 45,000 50,000 100000Average Selling price per unit ($) 360 220 290 125 Average Selling price per unit (Rs) 19,800 12,100 15,950 6,875

Televisions

Washing M/c

Refrigerators

Audio & other

appliances

Total Compan

y

Incremental Sales (Sales price per unit X Number of units) 149 54 80 69 351

Incremental Cost (Relevant Cost per unit X Number of units) 136 51 69 66 323Net margin 13 3 11 2 29 Net Margin% 8 6 13 4 8

Based on the revised workings, the following were the conclusions as summarized:

1. Financial Perspective: In view of the fact that the incremental costs are lower than the incremental revenue, the company should be in a position to earn additional profits of Rs 8 crores annually on executing the above order.

2. Risk Perspective: The exchange rate of the dollar to the rupee could result in dilution of the margins in the event of the dollar weakening vis-à-vis the rupee. However, this risk could be mitigated by taking suitable covers of the dollar to the rupee.

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3. Other qualitative factors – The Company should be in a position to make a strong entry in the overseas market. The execution of the contract would help building up its global presence which has been one of the primary objectives.

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Learning Outcome from the Case Study

1. Accounting or historical information must be very carefully used in the context of any decision having a bearing on the future. If not properly used, decisions blindly based on historical data can be completely misleading.

2. Only Costs and revenue which are relevant to the decision should be identified and analyzed while taking decisions,

3. In the context of pricing in a competitive scenario it could consider pricing based on marginal cost basis especially where the organization has spare capacity available, rather than adopting full cost basis may not be the appropriate method,

4. While taking any decision, it is always prudent to Identify risk and qualitative factors associated with the decision. Evaluate range or extent of possible risk considering the best case, worst case, and most likely.

5. Final conclusion / decision should be based after considering all the following factors:

a. Financial consideration / viabilityb. Risk factors and implications to the organization,

Other qualitative factors and implications to the organization

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Product Cost and Pricing

Basic Principles in Pricing decisions:

How to price a product?

One of major decisions managers face is how do you price a product. Pricing can take many forms and can be looked upon from different perspectives. In addition to pricing special orders, managers often have to make pricing decisions in various situations;viz.1. In the context of accepting additional volumes within the relevant range,2. Special orders,3. Pricing a new product,

Organizations normally adopt certain principles and guidelines in the context of pricing. The objective behind these principles and guidelines would be to primarily ensure that the organization does not suffer any loss in view of wrong pricing decisions.

Most organizations have a well defined framework within which the Manager can take any decisions relating to pricing. Any decision beyond his framework goes through an escalation process before a final decision to decision to accept or reject the price is taken.

A typical example of a price escalation model:At full cost plus 15% or more

Level 1: The concerned sales manager dealing directly with the customer

At full cost plus upto 5% Level 2: The Marketing Manager Below full cost but exceeding a certain percentage over cost of goods sold

Level 3: Zonal / Country Manager with CFO/Finance Head

Below full cost and even below the threshold percentage but exceeding cost of goods sold

Level 3: CEO / Business Head with CFO/Finance Head

Below cost of goods sold Level 4: Director /Board level as recommended by CEO and CFO

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What is cost plus pricing?

COST + DESIRED MARKUP = PRICE

Typically the model for pricing a product pricing shall be cost plus pricing. Cost is computed on full cost basis - bifurcation between variable and fixed would not be so relevant in the context of pricing based on full cost, (it could still be useful in predicting cost at different levels or understanding Break-even levels),

This pricing model would normally include all the components of cost involved upto the point of selling the product to the customer. - Cost of production- Selling and distribution cost,- Administration cost- Finance cost,

What influences cost?

Full cost is a direct reflection of the efficient or inefficient manner in which the company manages its costs in the entire value chain,

Higher the productivity and efficiency of the value chain, lower the costs; lower the productivity or efficiency higher the costs,

What influences Mark-up?

The mark-up to a great extent depends on the demand of the customers for the product,

Higher the demand of the customers for the product, higher can be the mark-up; on the other hand lower the demand of customers, companies may have little choice but to compromise on the mark-up;

“Mark-up” cannot be merely based on the wishful thinking of any organization,

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What Influences Price?

Price an organization can get is a combination of:- how efficiently a company manages its costs in its entire value chain, &- The demand of the customers for the product, Higher the efficiency of the company in managing costs lower, the higher can command on the “mark-up” and vice-versa,

ULTIMATELY, PRICES TO END CUSTOMERS ARE MOSTLY DRIVEN BY MARKET

Why Cost Plus pricing?

In the long run, the company must be in a position to recover its full cost (even if some costs are fixed in nature in the short run),

Full cost could provide the bench mark of how efficient the company is in managing its costs as compared to its competitors (of course, assuming competitors also price based on cost plus mark up),

Full cost provides the platform for improving cost efficiency keeping in view a targeted cost,

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Target Costing

Working Back to the desired Cost

PRICE – DESIRED MARK-UP = TARGET COST

Price and mark-up are pre-determined, and costs worked back to meet the targeted levels,

Target costing is a team effort and is normally worked jointly between various functionaries involved in building up the value chain for the product,

Chain could involve right from R&D stage to end distribution and service to the customer.

Target cost helps reviewing and reinventing each activity in the chain resulting in cost efficiency /reduction,Success in cost reduction or efficiency through target costing efforts can only be achieved if the organization is able to strike a very fine balance –

- keeping in view the interest of the stake holders; and above all, - without making any compromise on the customer requirement,

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Case study no.7 on Target Costing – “The Launch Of Nano”

(Students should download the case study covering the invention and launch of Nano by the Tata Group).

Brief discussion points and learning outcome emerging out of the case study:

Excerpts from Ratan Tata’s speech on the launch of the Nano...“ Today, we indeed have a people’s car, which is affordable, and yet built to meet safety requirements and emission norms, to be fuel efficient and low on emissions. We are happy to present the people’s car to India and we hope it brings the joy, pride, and utility of owing a car to many families who need personal mobility…”a

Based on the study of the case, students may note some pertinent facts:

What did Ratan Tata do?

He announced in 2008 that he would launch the product with a price tag of Rs 1,00,000 (around $2000),

He looked at creating a new customer segment in the passenger car market which could potentially generate huge demand and consequently high volumes,

HE PRE-DEFINED THE PRICE TO CUSTOMER; ALSO AIMED AT RE-DEFINING CUSTOMER MARKET SEGMENT

He settled for a low margin and was well prepared that the project would take a long time to break-even,

HE PRE-DEFINED MARGINS AT A VERY LOW LEVEL ON THE ASSUMPTION THAT PROJECT WOULD BREAK-EVEN ON REACHING HIGH VOLUMES,

How they worked towards the Target Cost and Price?

The project to build Nano was started in 2003.

Girish Wagh was selected as the leader of 500-member team which was chosen to develop the Nano,

Right from beginning the team members were asked to maintain the low price target without compromising on the quality, fuel efficiency, and safety features.

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From the engine, steering, wheels, and tyres to the windshield washing system, gear shifter, central console, every component was given special emphasis in an effort to cut down cost.

Every component was redesigned and looked at innovatively. It was a complete revolutionary change in the approach and mind set,

Vendors were allowed to set-up their facilities in the proximity of the main plant,

Sourcing prices with vendors underwent radical changes; Negotiations demanded high level of cost efficiency from the vendors with low margins and high volumes,

Cost effective and innovative use of media as part of the marketing strategy,

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Case Study 8 - Filters India Pvt Ltd

Filters India Limited is a reputed global MNC. The company has an established global presence in making various kinds of specialized filters catering to Automobile and various other Industrial applications. Filters India Pvt Ltd had set up its production facilities in India around four years back for marketing its products to the customers in India. The company had already started getting orders from some of the reputed automobile majors and other companies requiring filters for specialized industrial application.Monday Morning:Mr.Sudeesh, the Head Marketing (Automotive Business) of the Company has convened an emergency meeting. Apart from Mr.Sudeesh, the other participants in the meeting were: Head - Design and development, Head – Tooling, Head – Procurement and sourcing, Head - Production, Head –Logistics, Head – Finance along with his costing in-charge. “We are close to getting an order from Maruti for supply of filters for their new launch of the D Zire models. The program will be over a period of five years. We would have to supply annually 300,000 filters annually with the housing for these models. We have a very good chance to win the order provided we can offer them a competitive price. In fact, Maruti is happy with our technical credentials and could even award 80% of their requirement for this model to us. Of course, we have our competitor also in the race and they are likely to quote a very aggressive price”.After discussions and deliberations, the actions points going forward were listed out.

Outcome of the Meeting: Action points identified1. Head– Design: to work out the design and material specification and

requirement,2. Head – Tooling: to work out the tooling specification and investment

requirement for the tool,3. Head – Production: to work out the productivity and cycle time 4. Head – Procurement: to work on the sourcing and price negotiations

for the material and tooling requirement,5. Head – Logistics: work on the transportation cost involved in moving

the product to the customer,

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6. Costing in-charge: to coordinate closely with all the agencies and work out the cost of the product,

7. Next meeting scheduled on Friday: Objective to discuss the price of the product,

Friday Morning:

Each functional head have worked out their input data. The costing-in-charge has worked out the cost sheet and the desired selling price with the mark up of 15%.The finance department presents the cost sheet with the proposed pricing and gets the final confirmation on the inputs from all the other participants.

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Model Solution to the Case study

Cost Sheet Summary Product: Filter 1234 (Maruti) Cost per unit Material Cost

Cost of Materials 457.19

Direct Materials 438

.44

Indirect Materials 1

8.75

Material overhead @ 3% of Direct Material cost 13.72

A Total Material Cost 470.90 Production Cost 102 Direct production cost Machining cost 52.5 Welding Cost 47 Assembly Cost 2.5 Indirect Production cost

Production Overhead @ 5% on total direct production cost 5.10

Tooling cost 13.57 Depreciation cost 11.29

B Total production cost 107.10

A+B =C Total Cost of Production 578.00

D Selling an Distribution cost 156

Cost of servicing the customer by marketing 25

Tranportation Cost 75 Warehoiusing cost 56

E Administration cost 55

F Finance Cost 15

C+D+E+F=G Total Cost per unit 804.00

H Desired Mark-up @15% on total cost 120.60I Desired Selling Price 924.60

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Back-up details to the Summary Cost Sheet

Materials Cost break-up

Unit

Qty (per unit) Currency

Rate per unit Cost (INR)

Direct materials Imported

Raw Material 1 Kg 0.65 $ 4.50 201.09

Equivalent INR INR 247.50 Cutoms and clearing

charges@25% INR 61.875 Landed cost INR 309.38

Raw Material 2 0.75 $ 2.30 118.59

Equivalent INR INR 126.50 Cutoms and clearing

charges@25% INR 31.625 Landed cost INR 158.13

Local

Raw Material 3 Kg 0.95 125 118.75

Total Direct Materials 438.44

Indirect Materials

Consumales Ltrs 0.25 75 18.75

Total Material Cost 457.19

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Production Cost break-up Units NoCycle time Machining Cost Number of cyles per hour Nos 20No. of hours per unit of production Machine Hours 0.05Machining cost Rate/hour 1050Machining cost per unit Nos 52.5 Welding Cost Number of cyles per hour Nos 50No. of hours per unit of production Machine Hours 0.02Welding cost Rate/hour 2350Welding cost per unit Nos 47 Assembly Number of cyles per hour Nos 30No. of hours per unit of production Man Hours 0.033Assembly cost Rate/hour 75Assembly cost per unit Nos 2.5

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Machine & equipment cost Units Rate INR Machining equipment

Sourcing: from India 2 INR 1,250,000

Total Landed cost 2,500,

000 Welding equipment

Sourcing: import from Germany 2 Euro 125,000 Cost of imported equipment 250,000

Equivalent INR @Rs 70 INR 8,750,000 Customs and clearing

charges@15% INR 1,312,500

Total Landed cost 10,437,

500 Assembly equipment

Sourcing: From India 2 Euro 2,000,000

Total Landed cost 4,000,

000

Total Machine & Equipment Cost 16,937,

500 Tool life 5 years

Depreciation cost per year INR 3,387,500

Number of units to be supplied annually INR

300,000

Depreciation cost per unit INR/Unit 11.29

Tooling Cost break-up Units Rate INR

48

Tooling Upper Casing

Sourcing: Import from China No 200,000 Equivalent INR No 11,000,000

Customs duty and clearing charges @15% 1,650,000

Total cost 12,850,000

Lower Casing Sourcing: Local from India No 7,500,000

Total cost 7,500,000

Total Tooling cost 20,350,000

Tool life 5 years

Cost amortised per year INR 4,070,000

Number of units to be supplied INR 300,000

Cost of tool per unit INR/Unit 14

Fundamentals in Budgeting

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The Planning Process: Business Strategies and Budgets

- Business Strategy (Long range plan covering 10 to 15 years horizon)- Annual Plan and Budgets - define resource requirement; sub-set of the Business

Strategy,- Define specific targets at operational levels, KPIs, based on annual plan, - Periodic reviews and forecast, validate operational decisions for day to day

actions and execution,

Budgets and Strategy

Budget is a formalized financial plan for operations of an organization for a specified period,

Budget is a powerful supporting tool which helps in the navigation of the road map towards the strategic destination,

Budget in other words is a sub-set and part of the process in achieving the long term goals,

Why do we Need Budgets?

Helps in communicating organizational strategies and goals to the entire organization, and within each organization for each segment, division, or department,

Assigning decision rights (authority to spend and responsibility for decision outcomes),

Source of Motivating managers to plan their activities in advance,

Coordinating and creating a strong bonding of all operational activities right from the top to the bottom-most level,

Planning and allocation of resources required to carry out the activities across all levels,

Monitoring actual performance with budgets, analyzing variances, and ensure timely corrective actions taken,Motivating managers through suitable performance linked incentive pay on budget achievement in their respective areas,

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Revaluating and revisiting strategies and operating plans as conditions may keep changing,

Process of Developing a Budgeting for an Organization

Issuance of policy guidelines for each operational areas conforming to the organization strategy – these are generally approved by the Managing Board,

Budget can either be “top-driven” or “bottom-up “ depending on the type and size of the organization – bigger the organization structure, greater the complexity in coordinating the activities across all functions ,

Key objective and success factor would be to ensure that budgets in each functions are “owned” by the respective functional managers in the organization, it should not be viewed as “thrust upon”,

If organization has different profit centers or divisions, separate budgeted financial statement shall have to be prepared for each profit centre or division and consolidated for the entity as a whole,

Each profit center or division would typically have to prepare the following inputs at each micro level:- Revenue or Sales budget,- Capacity and Investment planning,- Inventory holding plan and Production budget,- Material requirement budget,- Direct manpower and production cost budget,- Department budgets and individual cost centers,

All the above would inputs culminate into “Budgeted Financial Statements”

Inputs for Budget Preparation

Historic data or recent past actual could serve as a useful benchmark or starting point,

Input information should be compiled at the micro level so that monitoring and analyzing variances for quick corrective actions become easier,Likely situational changes in future (external as well as internal) that could have an impact on the budget going forward,

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Articulating the key budget assumptions visualizing likely situational and environmental changes, and the likely impact on budget going forward,

Analyzing “Risk implications” in the event of any key assumption that may go wrong,

Establish standard price and costs for products,

What comprises the budgeted financial statement for any organization?

Based on the inputs and assumptions, the budgeted financial statement for an organization gets summarized and would normally comprise the following:

Investment Budget – is the total additional amount the company plans to invest on its expansion, infrastructure improvement etc.

Budgeted Income statement – Summary of the total revenue and the cost for each profit center/ Division/ Company as a whole – is the revenue growth and profit as projected in line with the desired long term strategy,

Budgeted cash flow statements – defines the resources in terms of funds requirement based on the investment planned, how this is proposed to be raised, how funds are proposed to be allocated in each segment or department,

Budgeted Statement of sources and utilization of funds (statement of Assets and Liabilities)

Monitoring Budgets vs Actual

Actual performance data shall be compiled with the budget for each level of input, and the budgeted financial statements,

Comparison of actual data with the budget inputs and highlighting all major variances, (use flexible budget for variations in activity),

Analyzing root causes of variance against input assumptions in the budget, Identify corrective actions with defined time frame and monitor these periodically till closure

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