© The Institute of Chartered Accountants of India

VIRTUAL COACHING CLASSES ORGANISED BY BOS (ACADEMIC), ICAI

FACULTY - PANKAJ KAPOOR

DATE 4th and 7th June 2021

FINAL LEVEL

PAPER 5 – STRATEGIC COST MANAGEMENT

AND PERFORMANCE EVALUATION

Page | 1

Students are firmly advised to keep print-out of these lecture notes handy while attending class.

Do read this page prior to class.

Session – 4th June 2021 (Friday) and 7th June 2021 (Monday)

Coverage – Chapter 4 i.e. Cost Management Techniques

Cost Control/Waste Control and Cost Reduction Target Costing Pareto Analysis

Lecture’s learning objective – Post this lecture, students will able to answer

Cost Control Vs Cost Reduction LO1 – What is cost control and its prerequisites?

LO2 – What is cost reduction and its scope? (With Insight on avaible tools and techniques)

LO3 – How cost control is different from cost reduction?

Target Costing LO1 – What is target costing, its features, and scope?

LO2A – How target costing can be practiced? (Steps and Principles)

LO2B – How target costing can be practiced? (Tools)

LO3 – What impacts target costing can make on profitability?

LO4 – What are the uses case of target costing?

LO5 – What are pros and cons of target costing?

Pareto Analysis LO1 – What is Pareto Principle, Analysis and Chart?

LO2 – Performing Pareto Analysis and Preparing Pareto Chart?

LO3 – What are the use cases of Pareto Analysis?

See page 2 for the overview of question bank for chapter 4

Disclaimer – Views expressed in this document are of individual faculty, not necessary of the institute.

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Page | 3

Let’s start by acknowledging the fact that ‘anything which can be measure, can also be controlled and

managed’. Hence cost management is practiced reality for optimisation as extension of cost accounting (which

you already studied at intermediate level).

Lecture Notes

Note 1 - In the competitive business environment, it not easy to increase the sales; hence cost control or cost reduction are two preferable way to enhance the profit.

Note 2 - Cost control means regulation of the cost of operation by controlling the action of executives.

It involves setting up the targets (yardstick) for executives. (See note 2A)

Then continuous comparison of actual performance against such targets shall be made for executives (who are responsible for cost centres) to regulate the former.

Note 3 - Prerequisite of cost control (six)

Crowningshield and Gorman (Book Cost Accounting - Principles and Managerial Applications)

Effective delegation of authority (responsibility centre) clearly defined targets motivation to encourage timely and efficient reporting recommendations must be followed by action effective follow-up system

Check-Point LO1 What is cost control and its prerequisites? Yes No

Note 4 - Cost reduction is the real and permanent reduction (till the optimal level) in the unit cost of goods manufactured or service rendered without impairing the utility for the intended use.

Cost reduction team can be utilised to identify the scope of cost reduction. Cost/benefit approach is essential. Change management.

Note 5 - Scope of Cost Reduction

Product and Process Design - Design has a high possibility for cost reduction, because around or above 80% of life cycle cost is committed at design phase only.

Efficient designing for a new product or improving the design for an existing product can reduce the cost through cheaper substitute or/& less varieties of materials or/& reduced time of operation and increased productivity reduce cost or/& standardization and simplification

Organisation - #Definition of each function and responsibility, #Proper assignment of task and delegation of responsibility to avoid overlapping, #A suitable channel of communication between various management levels, #Co-operation and closed relationship between the various executives, #Removal of doubts and fiction, and #Encouragement to employees for cost reduction suggestion.

Note 2A - Type of targets

External Internal - Can be based on any of following techniques;

Standard Costing Budgetary Control

Page | 4

A cost reduction programme should study the factory layout and the utilisation of the equipment.

Production control ensures proper planning of work by installing an efficient procedures and production plan programme

Note 6 - Tools and Techniques

Value Analysis, Inventory Management (e.g. Just in Time, Backflush), Business Process Reengineering, Target Costing, Kaizen Costing, Standarisation of product, components etc.

Check-Point LO2 What is cost reduction and its scope? Yes No

Note 7 – Differentiate cost control and cost reduction

Cost Control Cost Reduction

Comparison of actual with the standards or budgets Real and permanent reduction in the unit cost

There could be temporary savings in cost. Realistic savings in cost, which are permanent too.

Quality maintenance is not guaranteed. Utility, quality and characteristics are retained.

Setting up a target, investing variances Not observing standard or budget as a yardstick

Relatively less dynamic. A fully dynamic approach.

Emphasis on present and past costs. Emphasis on present and future (largely) costs.

Preventive measure Corrective measure

Check-Point LO3 How cost control is different from cost reduction? Yes No

MCQ 1 - Which of following is not prerequisite of cost control

a. Effective delegation of authority (responsibility centre) b. Clearly defined targets c. Timely and efficient reporting d. Change management system

Correct Answer -

MCQ 2 – Identify the correct sequence (in term of increasing utility and benefits)

a. Cost Control Cost Ascertainment Cost Reduction b. Cost Control Cost Reduction Cost Ascertainment c. Cost Ascertainment Cost Control Cost Reduction d. Cost Reduction Cost Control Cost Ascertainment

Correct Answer -

MCQ 3 – Targets are determined and used in which of following

a. Cost Ascertainment b. Cost Control c. Cost Reduction d. None of these

Correct Answer -

Page | 5

MCQ 4 – Quality is guaranteed (assured) under

a. Cost Ascertainment b. Cost Control c. Cost Reduction d. All of these

Correct Answer –

MCQ 5 – Pick the correct statement

a. Cost control is corrective measure b. Cost reduction is periodical concept c. Cost reduction reduce the cost till the target established d. Cost control is also known as cost containment

Correct Answer -

MCQ 6 – Standardisation of component is technique of ___________, it _____________specifications, but

capable to _________ cost, due to economies of scale

a. Cost control, reduce, reduce b. Cost reduction, reduce, reduce c. Cost reduction, increase, reduce d. Cost reduction, reduce, increase

Correct Answer –

MCQ 7 – Which of the followings is correct statement (in trade parlance)

a. Around 50% cost is incurred till design phase b. Around or above 80% cost incurred till design phase c. Around or above 80% cost committed till design phase d. Design phase involves designing of product only

Correct Answer -

Page | 6

Target Costing

Note 1 - Target costing can be defined as “a structured approach to determining the cost at which a

product must be produced with specified functionality and quality, to generate a desired level of

profitability at its anticipated selling price”.

Note 2 - Target costing is almost the exact opposite of cost-plus margin modelling where a company produces

a product with no cost structure in mind. Once the product is built they add a p rofit margin on top to arrive at

the final price.

Limitation of traditional cost-plus pricing model, includes #the ignorance of the price charged by competitor,

#the ignorance to the price which customer ready to pay and #Cost control.

Study Material (Page 4.8)

KTC expects to successfully launch Toy “H” based on a Disney character.

KTC targets a selling price of ₹ 100 per toy and profit of 25% on selling price.

KTC must pay a 15% royalty on the selling price to Disneyland.

The cost data forecast are tabled below.

In addition to the above, each toy requires 0.6 kg of other materials, which are supplied at a cost of ₹ 16 per kg with a normal 4% substandard quality, which is not usable in the manufacture.

Determine target cost, and evaluate whether the forecasted cost is lower to target cost. If not, advice what should be the extent of cost reduction?

Check-Point LO1 What is target costing, its features, and scope? Yes No

Note 3 – Steps of Target Costing

Step 1 – Re-orient culture of thinking and attitude

Step 2 – Identify the requirements (market research)

Step 3 – Establish the market-driven target price

Step 3A – Determine the volume of product to be produced

Step 3B – Establish the target profit margin

Step 4 – Determine the target cost by reducing the desired/required margin from market-driven target price.

Step 4A – Establish a balance between target cost and requirement to finalize the target cost

Step 5 – Establish the target costing process

Step 6 – Brainstorm and analyses the alternatives

Particulars ₹ / toy

Component H1 8.50

Component H2 7.00

Labour: 0.40 hr. @ ₹ 60 per hr. 24.00

Product Specific Overheads 13.50

Page | 7

Step 6A – Establish product cost models

Step 7 – Use the tools to closing down the gap

Step 7A – Reduce the indirect cost applications

Step 8 – Measure the results and maintain management focus on further possibilities of cost reduction as a continuous improvement program.

The deductive approach discussed in step 4 above is not the only approach, Kobe University Management

Accounting Research Group found another inside-out approach ‘Additive Approach’. It suggests that

target cost can be calculated by adding up the costs function in a product for every product function. The

starting point under this approach is the supplier or suppliers’ supplier.

Note 4 - Principles of Target Costing

S Ansari, J Bell & Dan Swenson in the year 2006 in ‘A Template for Implementing Target Costing’

developed a model which includes following six main principles (as premise or dimension of target cost)

# Leadership of Target Selling Price, # Focusing on Customer, # Using and Developing a Team Work, #

Reduce the Cost of the Product Life Cycle, #Focus on the Stage of Product Design, #Attention to all Stages

of the Value Chain

Check-Point LO2A How target costing can be practiced? (Steps and Principles) Yes No

Note 5 - Pros (argument for) of Target Costing

Process and product innovation (to resolve issue and achieve competitive advantage)

Identify market opportunities that can be converted into real savings (best value rather than lowest cost)

Proactive approach (ahead of actual production and marketing)

Enhances the employee awareness and empowerment & fosters partnership with suppliers.

Encourages the adoption of value added activities with higher pay-off and elimination of non-value added activities to residual level

It enhances product life by reducing the time to market.

Target Costing takes a market-driven approach towards cost.

Note 6 - Cons (argument against) of Target Costing

Development process can be lengthened to a considerable extent only

Can result in finger-pointing in various parts of the company

Difficult to reach a consensus on the proper design

Require the development of detailed cost data

May reduce the quality of products

Involves the great amount of forecasting and estimation.

Market-led information is highly dynamic in nature.

For problems outlined above, there is one dominant solution and that is ‘retaining the strong control over the design teams, which calls for a good team leader. The team must be in the form matrix of cross-functional experts.

Page | 8

Case Scenario (Page 4.13 SM) Kaveri Ltd. (KL) is a manufacturer of bikes in India and it sells them in India and outside India. KL has just launched the World’s smallest and most affordable bike called ‘Zingaroo’.

The bike is mounted with all-aluminium, single cylinder, air cooled, and 99.2 cc engine. The engine makes just over 8 bhp power and 8 Nm of torque, but it stakes claim to be the fuel -efficient bike, with a claimed figure of 88 kmpl. It has been creating competition for two wheelers as none of the Indian companies as well as foreign companies, offer a bike for such a competitive price within the reach of middle class families

KL has adopted the target costing technique in manufacturing this bike. For KL, mai ntaining target-price was difficult. During the designing and production process of bike, input costs increased frequently. However, KL designed various components especially for bike to maintain the target price. Though, one curiosity about how this can be done in the future when input costs are bound to increase further.

Many environmentalists have opposed the manufacture of this bike, because they believe that mass production of the small bike (about 2.5 lakh bike every year) will create heavy pollution . Many people believe that this small bike is not up to the safety standards due to lightweight and use of aluminium and plastic frames. The design of this bike is entirely different from that of other bikes. This also causes a doubt that the existing bike mechanics would be able to repair or not. The durability of the bike is another issue in the Indian environment. Further, the performance of ‘Zingaroo’ more or less depends upon the condition of roads and traffic systems.

After the launch of ‘Zingaroo’, many other national and international automobile companies are also planning to manufacture small bike which will create tough competition in near future.

Now you being a strategic performance analyst of KL, required to answer the following questions:

Identify strategy which KL has adopted for ‘Zingaroo’ bike Low Cost Strategy (since it is the most affordable bike)

After adopting target costing, identify issues and challenges faced by KL and suggest the remedial action to be taken to solve these issues The issues and challenges faced by KL and their remedial action are #1.Maintaining of target price, #2.Environmental issues, #3.Safety issues, #4.Servicing/repairing facilities, #5.Durability, #6.Global competition.

Note 7 - Impact of Target Costing on Profitability. Target costing improves profitability in two major ways,

first being continuous emphasis on product costs throughout the life cycle and second being precise

targeting of the correct prices.

If any organisation constantly issues a stream of new products, or if its existing product lines is subject to severe pricing pressure, it must make target costing a central part of its strategy .

Note 8 - Target costing is most useful in those situations where the substantial amount of product costs are

locked (committed) during the product design phase. (Refer note 8A here). This is a common feature of a

product to be manufactured; but rare in case of services. In the services environment, the “design team” is

more commonly concerned with streamlining the activities conducted by the employees providing the service .

(Refer note 9 in further reference to this)

Note 8A - Companies, with following features (not exhaustive) expected to gain maximum from target costing;

Assembly-oriented industries; Involved heavily with the diversification of the product lines; Use technologies of factory automation, including computer-aided design, flexible manufacturing systems,

office automation, and computer-aided manufacturing; Are in process of implementing management methods such as just-in-time, value engineering.

Page | 9

Note 9 - Target costing may not be for everyone, the two cases illustrated below where the utility of target is not at the maximum level.

Fast-Food Restaurant - The design team can lay out the floor plan of a fast-food restaurant, with the objective of creating an arrangement that allows employees to cover the shortest possible distances while preparing food and serving customers; this is similar to the design of a new product.

However, unlike a product design, this layout can be readily altered at any time if the design team can arrive at a better layout, so that the restaurant staff can continue to experience high levels of productivity improvement even after the initial design and layout of the facility. In this situation, costs are not locked in during the desi gn phase, so there is less need for target costing.

Chemical Production Industry - Another situation where target costing results in less value is the production of raw materials, such as chemicals. In this case, there are no design features; instead, the industrial engineering staff tries to create the most efficient possible production process, which has little to do with cost reduction through the improvement of customer value.

Check-Point LO3 What impacts target costing can make on profitability? LO4 What are the uses case of target costing? LO5 What are pros and cons of target costing?

Yes No

Note – Lean System and Kaizen is already discussed in detail in chapter 3, hence will not be dealt with here.

Typically, under the target costing system the total target is broken down into its various components, and then each component is studied to identify the opportunities for cost reductions.

Note 10A – Value Engineering is a systematic approach to analyzing functional requirements of products or services for the purposes of achieving the essential functions at the lowest total lifecycle cost. It can be seen as a problem solving technique.

Note 10B – Value Analysis is a scientific technique which improves value by sustaining or improving performance attributes of the product and/or service while at the same time reducing the overall cost

Value analysis is focused upon value perceived by customer hence customer oriented and useful for both new and existing products, whereas value engineering is focused on features of products due to which value is being perceived by customer hence product oriented and largely useful for a new product.

Note 11 – Questions that must be answered during a Value Analysis/Value Engineering review:

Can we eliminate functions from the production process? (Determines the non- value added activities) Can we eliminate some durability or reliability? Can we minimize the design? (Uses fewer parts or has fewer features) Can we design the product, in the way in which it is better for the manufacturing process? Can we substitute parts? (Search for less expensive components) Can we combine steps? (Process centering) Can we take the supplier’s assistance? Is there a better way?

Note 10 - Tools of Target Costing

Value Engineering /

Value AnalysisKaizen Lean Manufacturing DFMA

Page | 10

Note 12 – The initial value engineering may not uncover all possible cost savings Then What Kaizen Costing is designed to repeat many of the value engineering steps for as long as a product is produced, constantly refining the process and thereby stripping out extra costs. The cost reductions resulting from kaizen costing are much smaller than those achieved with value engineering but are still worth.

Case Scenario (Additional Case Study, Page 4.19 SM) Queenstown Wood Co. (QWC) began 20 years ago, as a small family-run business supplying custom-made school furniture. Now QWC has grown into a thriving hub of experts specializing in either custom-made, locally sourced or quality imported commercial grade furniture. The newly appointed CFO is concerned

due to declining trends in sales volumes and profits for last three years, cost is also increasing. He observed that the reason of these trends is increased cut-throat competition that has emerged over the last three years. For many years, QWC has been known for high quality but now this quality is being matched by the competitors. QWC’s market share is declining due to equivalent products being sold by competitors at relatively lower prices. It is considered that, to offer such low prices, the furniture’s production costs of t he competitors must be lower than QWC’s.

You are required to advice how QWC can improve its sales volumes, costs and profits using Value Analysis and Functional Analysis.

Solution

Value Analysis is viewed as a reduction in cost and problem solving technique. Such technique analyses an existing product to identify and cutback or eliminate any cost which does not give any contribution to performance or value. It is a planned, scientific approach to cost reduction which reviews the material composition of a product and production design so that modifications and improvements can be made which do not reduce the value of the product to the customer or to the user (i.e. quality for the purpose should no t be compromised).

Functional analysis is applied to the design of new products and breaks the product down into functional parts. For example, a new chair may have the moveable feature. The value that the customer places on each feature is considered and added to give a target cost. Thus, functional analysis aims to increase profits by reducing costs through elimination of unnecessary features and/or by adding cost -effective new features that are so attractive to customers that the product becomes more lucrative.

The result of the above analysis is to improve the value of the furniture while maintaining costs and/or cutback the costs of the furniture without compromising with value. It is clear from the scenario that QWC needs to cut back its selling prices to compete in the market. This selling price reduction can only be possible by a reduction in QWC’s unit costs; however, such reduction must not be accomplished by compromising with quality. Both value analysis and functional cost analysis may be used for QWC; however, value analysis is likely to be a more useful technique because office tables and chairs are such items which are demanded more on the basis of their use value rather than their esteem value.

Note 13 – Designed for Manufacturing Assembly – This tool is used throughout the product designing but

before the first pilot product is built. This tool is used to evaluate the effectiveness of design with regard to

assembly operations. One benchmark is to reduce the number of products components and to simplify the

assembly processes that will result in fewer errors and improved reliability.

Check-Point LO2B How target costing can be practiced? (Application of tools) Yes No

Page | 11

MCQ 1 – Target cost can be computed using

a. Deductive method

b. Additive approach

c. None of a and b

d. Both a and b

Correct Answer -

MCQ 2 – For minimising the cost of new products (which is in development phase) which of following is

most useful

a. Value Engineering

b. Value Analysis

c. Kaizen

Correct Answer -

MCQ 3 – Which of the following statements is correct

a. Functional analysis is wider than value engineering

b. Value engineering can be followed by kaizen

c. Value engineering and value analysis both are the same thing

d. None of these

Correct Answer –

MCQ 4 – Which of the following are techniques to attain the target costing

a. Value engineering

b. Kaizen

c. DFMA

d. All of the above

Correct Answer –

MCQ 5 (Adopted from Nov 2018) – Target costing is not useful in case of

a. Assembly-oriented industries; b. Involved heavily with the diversification of the product lines; c. Where high end and costly technology is used during design phase

d. None of these

Correct Answer -

MCQ 6 – Which of the following is not a positive outcome of target costing

a. Process and product innovation (to resolve issue and achieve competitive advantage) b. Identify market opportunities that can be converted into real savings (best value rather than lowest

cost) c. Encourages the adoption of value added activities with higher pay-off and elimination of non-value

added activities to residual level d. None of these

Correct Answer –

Page | 12

MCQ 7 - Which one is not limitation of traditional cost-plus pricing model?

a. The ignorance of the price charged by competitor,

b. The ignorance to the price which customer ready to pay

c. Hardly focus on cost control and reduction

d. Determining the price is difficult

Correct Answer –

MCQ 8 – Identify the correct sequence

a. Identify the requirements Establish the market-driven target price Establish the target profit

margin Establish the target cost

b. Establish the market-driven target price Establish the target profit margin Establish the target

cost Identify the requirements

c. Establish the target profit margin Establish the target cost Identify the requirements

Establish the market-driven target price

d. Identify the requirements Establish the market-driven target price Establish the target cost

Establish the target profit margin

Correct Answer –

MCQ 9 (Adapted from Nov 2020) (All amounts in INRs) – NEC Furniture Ltd. is a leading manufacturer and

supplier of furniture for students of pre-primary classes. The full cost of one set (comprising one Table and

one chair) is 900 per set. The company has fixed its selling price so as to earn 30% return on investment of

45 lacs. The company produces and sells 6,000 sets per annum. Competition in market forces the company

to reduce the price by 10% and the company willing earn the same amount of profit. Target cost will be;

a. 1012.50

b. 787.50

c. 675.00

d. None of these

Correct Answer –

MCQ 10 – Target costing is (in comparison to manufacturing)

a. Equally useful in service industry

b. Less useful in service industry

c. More useful in service industry

d. Not at all useful in service industry

Correct Answer -

MCQ 11 – Value has ______relation with function and _______relation with cost

a. Direct, Direct

b. Direct, Inverse

c. Inverse, Direct

d. Inverse, Inverse

Correct Answer -

Page | 13

Questions for Practice (RTP, MTP, Past Exams & others)

Storewell Industries Ltd. manufactures standard heavy duty steel storage racks for

industrial use. Each storage rack is sold for ₹750 each. The company produces 10,000

racks per annum. Relevant cost data per annum are as follows:

Cost Component Budget Actual Actual Cost p.a. (₹)

Direct Material 500,000 sq. ft. 520,000 sq. ft. 20,00,000

Direct Labour 90,000 hrs. 100,000 hrs. 10,00,000

Machine Setup 15,000 hrs. 15,000 hrs. 1,50,000

Mechanical Assembly 200,000 hrs. 200,000 hrs. 30,00,000

The actual and budgeted operating levels are the same. Actual and standard rates of material procurement

and hourly labour rate are also the same. Any variance in cost is solely on account of difference in the material

usage and hours required to complete production. Aggressive pricing from competitors has driven down sales.

A comparable rack is available in the market for ₹675 each. Vishal, the marketing manager has determined

that in order to maintain the company’s existing market share of 10,000 racks, S torewell Industries must

reduce the price of each rack to ₹675.

Required

i. Calculate the current cost and profit per unit. Identify the non-value added activities in the production

process.

ii. Calculate the new target cost per unit for a sales price of ₹675 if the profit per unit is maintained.

iii. Recommend what strategy Storewell Industries should adopt to attain target cost calculated in (ii) above.

Zen Ltd., forms a Committee consisting of its Production, Marketing, and Finance Directors to

prepare a budget for the next year. The Committee submits a draft budget as detailed below:

Particulars ₹

Selling Price per unit 50

Less: Direct Material Cost per unit 9

Direct Labour Cost per unit 9

Variable Overhead per unit (3 hrs. @ 2) 6

Contribution per unit 26

Budgeted Sales Quantity 25,000 units

Budgeted Contribution (25,000 x 26) 6,50,000

Less: Budgeted Fixed Cost 5,00,000

Budgeted Profit 1,50,000

The Management is not happy with the budgeted profit as it is almost equal to the previous year’s profit.

Therefore, it asks the Committee to prepare a budget to earn at least a profit of ₹300,000. To achieve the

target profit, the Committee reports back with the following suggestions:

The unit selling price should be raised to ₹55.

The sales volume should be increased by 5,000 units.

Question

1

Originally Placed Repeat 1 Repeat 2 Repeat 3

RTP May 2018 (Q9) SM – Page 4.53 MTP May 20 (Q2) Nov 2020 (Q2)

Question 2 Originally Placed Repeat 1 (with name NEC Ltd.)

Nov 2018 (Q2) (20M) SM back problem 2 (removed in Nov 2020 edition)

Page | 14

To attain the above said increase in sales, the company should spend ₹40,000 for advertising.

The production time per unit should be reduced.

To win the acceptance of the workers in this regard the hourly rate should be increased by ₹3 besides an

annual group bonus of ₹30,000

There is no change in the amount and rates of other expenses. The company has sufficient production

capacity.

As the implementation of the above proposal needs the acceptance of the work force to increase the speed

of work and to reduce the production time per unit, the Board wants to know the extent of reduction in per

unit production time.

Required

i. Calculate the target production time per unit and the time to be reduced per unit.

ii. Identify the other problems that may arise in production due to decrease in unit production time and also suggest

the remedial measures to be taken.

iii. State the most suitable situation for the adoption of Target Costing.

Pixel Limited is a toy manufacturing

company. It sells toys through its own retail

outlets. It purchases materials needed to

manufacture toys from a number of different suppliers. Recently, due to the entry of few

reputed foreign brands in the toy market and particularly in the segment in which Pixel Ltd. is doing business,

it is facing a threat to operate profitably.

Each toy requires 4 kg of materials at ₹19 per kg and 5% of all materials supplied by the suppliers are found

to be substandard. Labour hour requirement for each toy is 0.4 hour at ₹120 per hour.

Market research has determined that the selling price will be 240 per toy.

The company requires a profit margin of 15% of the selling price. Expected demand for toy in the coming

year will be 50,000 toys. Sales and variable overhead per unit for the four quarters of the year will be as

follows:

Particulars Q1 Q2 Q3 Festive season Q4 Festive season

Sales (units) 7,500 9,000 15,500 18,000

Variable overhead Per units (₹) 22 22 24 25

Total fixed overheads are expected to be ₹625,000 for each quarter.

The production manager has decided to produce 12,500 units in each quarter.

Inventory holding costs will be 18 per unit of average inventory per quarter. Inventory holding costs are not

included in above mentioned costs.

Assume zero opening inventory.

You are required to calculate the cost gap that exists between the total cost per toy as per the production

plan and the target cost per toy.

Question 3 Originally Placed

Nov 2019 (Q2 (a) (i) (9M)

Page | 15

Pareto Analysis

Strategy is all about achieving the objectives with a scarce set of resources. Hence it is important to prioritise the application of the resources (efforts) to those causes (reasons) which has higher significance.

(On page 4.30 of Study material) Note 1 - Italian economist Vilfredo

Pareto in 1896 noticed approximately 80% of the land in Italy was

owned by 20% of the population

This phenomenon gain popularity as ‘80:20 rule’. Pareto’s 80:20 rule

simply states that 80 percent of the results come from only 20 percent

of efforts (vital few), while the remaining 20 percent of results are

achieved by 80 percent of efforts (trivial many). Or alternatively 20

percent of the reasons cause 80 percent of the problems.

Note 2 - Is such an 80:20 rule applicable to cost management?

Joseph M. Juran, found that this phenomenon of the ‘vital few and the trivial many’ applied to many areas

of cost management. He coined the concept of Pareto analysis (as application tool) and Pareto Chart (as a

presentation tool) in the context of quality control and improvement. Juran suggested the bulk of the quality

problems are due to a few of the possible sources.

Note 3 - The management can use Pareto Analysis in different circumstances to focus on a key areas as a

control mechanisms. Pareto Analysis ranks the causes (reasons) in descending order of effect. Hence help

to identify pay-off. It’s obvious that focus is on items at the top (vital few) of the list because these have a

higher probability of payoff. Law of diminishing returns (pick the low hanging fruits first)

Some Examples

20% Customer – 80% Revenue | 20% Supplier – 80% Value of supplies

20% Product – 80% of Production cost / 80% of Profits | 20% Defects – 80% Wastage

Study Material (Page 4.31)

The tabled information is about the type of defects during a production period

and the frequencies of their occurrence in a spectacle manufacturing company:

You are required to prepare a frequency

table to construct Pareto Chart for the defect

type. Identify key areas (vital few) of focus

and highlight them in the graph too.

Solution

Statement Showing “Pareto Analysis of Defects”

Defect Type No. of Instances % to total Defects Cumulative Defects

Scratches on the surface 110 36.67% 36.67%

Rough edges of lenses 70 23.33% 60.00%

Non-uniform grinding of lenses 60 20.00% 80.00%

Frame colours-shade differences 25 8.33% 88.33%

Power mismatches 20 6.67% 95.00%

End frame not equidistant from the center 10 3.33% 98.33%

Spots/ Strain on lenses 5 1.67% 100.00%

300 100.00%

Defect No. of Instances

End Frame not equidistant from the center 10

Non-uniform grinding of lenses 60

Power mismatches 20

Scratches on the surface 110

Spots / Stains on lenses 5

Rough edges of lenses 70

Frame colours-shade differences 25

1 Mark

Page | 16

The company should focus on the elimination of scratches on the surface, rough edges of lenses, and non -uniform grinding of lenses (in priority order), because they constitute 80% of instances when defect found in any item.

In the above Pareto Chart, till the point where the line (cumulative defects) is dotted, the causes are Vital (but Few) and remaining causes falls thereafter shall be categories as trivial many.

Check-Point LO1 – What is Pareto Principle, Analysis and Chart? LO2 – Performing Pareto Analysis and Preparing Pareto Chart?

Yes No

Note 4 - Pros and Cons of Pareto Analysis

One can advocate the use of Pareto analysis due to the following benefits -

Breakdown big problem into smaller pieces by looking at different sort of root causes. Identification of significance of each cause/factor. Prioritise where to focus and apply efforts. Ensure optimal use of scare resources. Act as a control mechanism.

Pareto Analysis involves data and its classification, presentation, and analysis; these factors itself become

the sources of shortcoming. Major limitations are-

Possibility of exclusion of important problems which may be small initially (now), but may grow with time.

Lack of understanding of how it should be best applied to particular problems, simply the wrong identification of causes.

Effectiveness of Pareto Analysis is purely based upon the data/information.

Note 5 - Use Cases of Pareto Analysis

Pricing of a Product - In the case, where a firm dealing with multi products, it would not be possible for it to

analyse cost-profit-price-volume relationships for all of them. Pareto Analysis is used for analyse the

estimated sales revenues from various products and it may indicate that approximately 20% of products

contribute about 80% of total sales revenue

Customer Profitability Analysis - It is often found that approximately 20% (vital few) of customers helps to

generate 80% of the profit and vice-versa.

0.00%20.00%40.00%60.00%80.00%100.00%120.00%

020406080

100120

% a

ge d

efec

ts

No.

of I

nsta

nces

Pareto Chart

No. of Instance % to total Defects Cumulative Defects

Page | 17

Inventory Control - Another application of Pareto analysis is in stock control where it may be found that only

a few of the goods in stock make up most of the value. The outcome of such analysis is that by concentrating

on a small proportion of stock items that jointly accounts for 80% of the total value, a firm may well be able

to control most of the monetary investment in stocks.

Activity Based Costing - In Activity Based costing it is often said that 20% of an organisation cost drivers

are responsible for 80% of the total cost pool. By analysing, monitoring, and controlling those cost drivers

that cause the most cost, better control and understanding of overheads will be obtained.

Quality Control - Often, 80% of reported problems can usually be traced to 20% of the var ious underlying

causes. By concentrating once efforts on rectifying the vital 20%, one can have the greatest immediate impact

on product quality.

Space for practical notes – Industry Practices and Knowledge (To be discussed in class)

______________________________________________________________________________________

______________________________________________________________________________________

______________________________________________________________________________________

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______________________________________________________________________________ ________

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Check-Point LO3 What are the use cases of Pareto Analysis? Yes No

MCQ 1 – Pareto principle based upon the law of

a. Diminishing returns

b. Variable returns

c. Increasing returns

d. Stable returns

Correct Answer -

MCQ 2 – Pareto principle can’t be applied to

a. Inventory control

b. Quality control

c. Customer profitability analysis

d. None of the above

Correct Answer -

MCQ 3 – Pareto analysis shall be performed

a. Periodically

b. Continuously

c. Occasionally

Correct Answer -

MCQ 4 – Which one need to be responded first

a. Trivial many

b. Vital few

c. Both

Correct Answer -

Page | 18

Questions for practice

Generation 2050 Technologies Limited develops

cutting-edge innovations that are powering the

next revolution in mobility and has nine tablet smart

phone models currently in the market whose

previous year financial data is given below:

You are required to carry out a Pareto Analysis (80/20 rule) of Sales and Contribution.

Discuss your findings with appropriate Recommendations.

Table for solution

Model Sales (₹’000) % of Total

Sales

Cumulative

% Model

Contribution

(₹’000)

% of Total

Contribution

Cumulative

%

Pareto Analysis Sales Pareto Analysis Contribution

A001 5,100 35.05% 35.05% B002 690 30.87% 30.87%

B002 3,000 20.62% 55.67% E005 435 19.47% 50.34%

C003 2,100 14.43% 70.10% C003 300 13.42% 63.76%

D004 1,800 12.37% 82.47% D004 255 11.41% 75.17%

E005 1,050 7.22% 89.69% F006 195 8.73% 83.90%

F006 750 5.15% 94.84% A001 180 8.05% 91.95%

G007 450 3.09% 97.93% G007 120 5.37% 97.32%

H008 225 1.55% 99.48% I009 45 2.01% 99.33%

I009 75 0.52% 100.00% H008 15 0.67% 100.00%

14,550 100.00% 2,235 100.00%

Question 1 Originally Placed Repeat 1

SM – Page 4.53 MTP Nov 2020 (Q2) (20)

Model Sales (₹’000) Profit-Volume Ratio

Tab - A001 5,100 3.53%

Tab - B002 3,000 23.00%

Tab - C003 2,100 14.29%

Tab - D004 1,800 14.17%

Tab - E005 1,050 41.43%

Tab - F006 750 26.00%

Tab - G007 450 26.67%

Tab - H008 225 6.67%

Tab - I009 75 60.00%

Page | 19

The information given below pertains to ABC Enterprises, a specialized car garage door

installation company. ABC Enterprises use to get multiple service calls from the customers with variety of requirements. They may have to install, replace, adjust, or lubricate some part or other to make the door functional. They work with 5 major parts as given in the table, namely Door, Motor, Tra ck, Trimmer and T-Lock.

Sr. No. Parts Type of Service

Total Install Replace Adjust Lubricate

1 Door 2 5 1 0 8

2 Motor 3 2 16 9 30

3 Track 5 0 6 6 17

4 Trimmer 14 6 0 0 20

5 T-Lock 5 0 1 0 6

6 Miscellaneous 0 2 1 1 4

Total 29 15 25 16 85

Required (Do calculations up-to two decimals only) i. Using the above data, carry out a Pareto Analysis (80/20 rule) of total parts (3) ii. Using the same data carry out the second level Pareto Analysis on the type of services with respect to Motors

only (2) iii. Give your recommendations on the basis of your calculations in (i) and (ii) above Or State the business

situation in which you recommend to apply Pareto analysis (5)

Table for solution to part (i)

Parts No. of Items % of Total Items Cumulative Total

Motor 30 35.29 35.29%

Trimmer 20 23.53 58.82%

Track 17 20.00 78.82%

Door 8 9.41 88.23%

T-Lock 6 7.06 95.29%

Miscellaneous 4 4.71 100.00%

Total 85 100

Table for solution to part (ii)

Type of

Services

No. of Items % of Total Items Cumulative Total

Adjust 16 53.33 53.33%

Lubricate 9 30.00 83.33%

Install 3 10.00 93.33%

Replace 2 6.67 100.00%

Total 30 100

Question 2 Originally Placed Repeat 1

May 2019 (Q6B) (10 Marks) SM – Page 4.54