1.

Absorption costing:

Absorption costing, also called full costing, includes anything that is a direct cost in producing a
good in its cost base. Absorption costing also includes fixed overhead charges as part of the product
costs. Some of the costs associated with manufacturing a product include wages for workers
physically working on the product; the raw materials used in producing the product; and all of the
overhead costs, such as all utility costs, used in production. In contrast to the variable costing
method, every expense is allocated to manufactured products, whether or not they are sold by the
end of the period.

Advantages and Disadvantages of Absorption Costing

Assets, such as inventory, remain on the entity’s balance sheet at the end of the period. Because
absorption costing allocates fixed overhead costs to both cost of goods sold and inventory, the costs
associated with items still in ending inventory will not be captured in the expenses on the current
period's income statement. Absorption costing reflects more fixed costs attributable to ending
inventory.

Absorption costing ensures more accurate accounting for ending inventory because the expenses
associated with that inventory are linked to the full cost of the inventory still on hand. In addition,
more expenses are accounted for in unsold products, which reduces actual expenses reported in the
current period on the income statement. This results in a higher net income calculation when
compared to variable costing calculations.

Because absorption costing includes fixed overhead costs in the cost of its products, it is
unfavorable when compared to variable costing when management is making internal incremental
pricing decisions. This is because variable costing will only include the extra costs of producing the
next incremental unit of a product.

In addition, the use of absorption costing generates a unique situation in which simply
manufacturing more items that go unsold by the end of the period will increase net income.
Because fixed costs are spread across all units manufactured, the unit fixed cost will decrease as
more items are produced. Therefore, as production increases, net income naturally rises because
the fixed cost portion of the cost of goods sold will decrease.

2. Variable costing:

Variable costing is also called as marginal costing or direct costing. It is that type of costing which
allocates only the variable portion of the manufacturing overheads to a product unit cost. Thus, the
cost of unit of a product under variable costing would include direct materials, direct labor and only
the variable portion of the manufacturing overhead. Fixed manufacturing overhead is treated as a
period cost.

Variable costing is a concept used in managerial and cost accounting in which the fixed
manufacturing overhead is excluded from the product-cost of production. The method is in contrast

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with absorption costing, in which the fixed manufacturing overhead is allocated to products
produced. In accounting frameworks such as GAAP and IFRS, variable costing is not allowed in
financial reporting.

3. Overhead absorption:

Overhead absorption is the amount of indirect costs assigned to cost objects. Indirect costs are
costs that are not directly traceable to an activity or product. Cost objects are items for which costs
are compiled, such as products, product lines, customers, retail stores, and distribution channels.
Overhead absorption is a necessary part of the requirement by both the GAAP and IFRS accounting
frameworks to include overhead costs in the recorded amount of inventory that is shown in a
company's financial statements. Overhead absorption is not needed for internal management
reporting, only for external financial reporting. Examples of indirect costs are: Selling and
marketing costs, Administrative costs, Production costs

Selling, marketing, and administrative costs are usually charged to expense in the period incurred.
However, indirect production costs are classified as overhead and then charged to products
through overhead absorption.

Overhead absorption involves the following steps:

1. Classify indirect costs: Depending on the type of allocation desired, some costs may be included
in overhead and others may not. For example, overhead absorption for a product would not
include marketing costs, but marketing costs might be included in an internal cost report for a
distribution channel.

2. Aggregate costs: Shift the identified costs into cost pools. Each cost pool should have a different
allocation base. Thus, the indirect costs related to a facility might be aggregated into a cost pool
that is allocated based on square footage used.

3. Determine allocation base: This is the basis upon which overhead is assigned to a cost object.
For example, facility costs may be assigned based on square footage used, while labor-related
indirect costs may be assigned based on direct labor used.

4. Assign overhead: Divide the allocation base into the total amount of overhead included in a cost
pool to arrive at the overhead rate.

Overhead absorption does not necessarily reflect the exact amount of overhead cost actually
incurred during an accounting period, since the overhead rate may be a long-term one that was
based on information derived at some point in the past. If so, the amount of overhead absorbed may
differ from the amount of overhead actually incurred.

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4. Activity based costing:

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related
products and services. This accounting method of costing recognizes the relationship between
costs, overhead activities, and manufactured products, assigning indirect costs to products less
arbitrarily than traditional costing methods. However, some indirect costs, such as management
and office staff salaries, are difficult to assign to a product.

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the
reliability of cost data, hence producing nearly true costs and better classifying the costs incurred
by the company during its production process.

This costing system is used in target costing, product costing, product line profitability analysis,
customer profitability analysis, and service pricing. Activity-based costing is used to get a better
grasp on costs, allowing companies to form a more appropriate pricing strategy.

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the
cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of
overhead and indirect costs related to a particular activity.

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the
number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs
in one company-wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items such that costs are allocated
based on the activities that generate costs instead of on volume measures, such as machine hours or
direct labor costs.

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect
—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC
transfers overhead costs from high-volume products to low-volume products, raising the unit cost
of low-volume products.

5. Target costing:

Target costing can be viewed as a proactive cost management tool used to reduce the total cost of
the product, over its complete lifecycle, through production, engineering, research and design. It
helps the firm in managing the business in reaping profits in the extremely competitive market.

Simply put, target costing is a process of ascertaining and attaining full stream cost, at which the
intended product with specific requirements, must be produced so as to realize the desired profits,
at an anticipated selling price over a specified period. It involves the discernment of maximum cost

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to be incurred on a new product, followed by the development of sample that can be profitably
created for that target cost figure.

In this technique, the costs are planned and managed out of the product or process early in the
introduction phase like development or designing, instead of performing it in the latter phase of
product development.

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

Formula of Target Costing:

Target Cost = Anticipated selling price – Desired profit

6. Life cycle costing:

Life cycle costing is the process of compiling all costs that the owner or producer of an asset will
incur over its lifespan. The concept applies to several decision areas. In capital budgeting, the total
cost of ownership is compiled and then reduced to its present value in order to determine the
expected return on investment (ROI) and net cash flows. This information is a key part of the
decision to acquire an asset. In the procurement area, the purchasing staff seeks to examine the
total cost of ownership of an asset in order to place orders for those items that are the least
expensive, in aggregate, to install, operate, maintain, and dispose of. In the engineering and
production areas, life cycle costing is used to develop and manufacture goods that will have the
least cost to the customer to install, operate, maintain, and dispose of. In the customer service and
field service areas, life cycle costing is focused on minimizing the amount of warranty, replacement,
and field service work that must be performed on products over their useful lives.

7. Throughput accounting:

Throughput accounting is a management accounting approach that focuses on the throughput of

cash from sales and the truly variable costs of producing an additional unit of a product or service.
It is designed to support management decision making. Throughput accounting is particularly
useful for identifying products that are generating the most cash flow for each incremental unit of
production.

The aim of throughput accounting is to maximize this measure of profitability, whilst

simultaneously reducing operating expenses and inventory (money is tied up in inventory). The
goal is achieved by determining what factors prevent the throughput from being higher. This
constraint is called a bottleneck, for example there may be a limited number of machine hours or
labor hours.

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In the short-term the best use should be made of this bottleneck. This may result in some idle time
in no bottleneck resources, and may result in a small amount of inventory being held so as not to
delay production through the bottleneck. In the long-term, the bottleneck should be eliminated. For
example a new, more efficient machine may be purchased. However, this will generally result in
another bottleneck, which must then be addressed.

8. Cost driver:

A cost driver is the unit of an activity that causes the change in activity's cost. Cost drivers are the
structural determinants of the cost of an activity, reflecting any linkages or interrelationships that
affect it. Therefore we could assume that the cost drivers determine the cost behavior within the
activities, reflecting the links that these have with other activities and relationships that affect
them.
In traditional costing the cost driver to allocate indirect cost to cost objects was volume of output.
With the change in business structures, technology and thereby cost structures it was found that
the volume of output was not the only cost driver. Activity Cost Driver is measure of frequency and
intensity of demand placed on activities by cost object. It is used to assign activity costs to cost
objects.

9. . Theory of constraints:

The Theory of Constraints is an organizational change method that is focused on profit

improvement. The essential concept of TOC is that every organization must have at least one
constraint. A constraint is any factor that limits the organization from getting more of whatever it
strives for, which is usually profit. The Goal focuses on constraints as bottleneck processes in a job-
shop manufacturing organization. However, many non-manufacturing constraints exist, such as
market demand, or a sales department’s ability to translate market demand into orders.

The Theory of Constraints defines a set of tools that change agents can use to manage constraints,
thereby increasing profits. Most businesses can be viewed as a linked set of processes that
transform inputs into saleable outputs. TOC conceptually models this system as a chain, and
advocates the familiar adage that a "chain is only as strong as its weakest link." Goldratt defines a
five-step process that a change agent can use to strengthen the weakest link, or links. In The Goal,
Goldratt proves that most organizations have very few true constraints. Since the focus only needs
to be on the constraints, implementing TOC can result in substantial improvement without tying up
a great deal of resources, with results after three months of effort.

 The Five Steps of the Theory of Constraints

1. Identify the System Constraint

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 2. Decide How to Exploit the Constraint
3. Subordinate Everything Else
4. Elevate the Constraint
5. Return to Step One, But Beware of "Inertia"

10. Throughput accounting ratio:

When there is a bottleneck resource, performance can be measured in terms of throughput for each
unit of bottleneck resource consumed. There are three interrelated ratios: Throughput Accounting
Ratio is a ratio of throughput and sum of labour and overheads. As the purpose of Throughput
Accounting is solely the short term. All the attention is put on the removal of bottleneck resources.

There are three interrelated ratios:

1. Throughput per factory hour = Throughput per unit / product’s time on the bottleneck
resource.
2. Cost per factory hour= Total factory cost/Total bottleneck resource time available
3. Throughput Accounting Ratio= Return per factory hour/cost per factory hour

11. Break-even point analysis:

Break Even Analysis in economics, business, and cost accounting refers to the point in which total
cost and total revenue are equal. A break even point analysis is used to determine the number of
units or dollars of revenue needed to cover total costs (fixed and variable costs).

The formula for break even analysis is as follows:

Break even in quantity = Fixed costs / (Sales price per unit – Variable cost per unit)

Where:

Fixed costs are costs that do not change with varying output (i.e. salary, rent, building machinery).

Sales price per unit is the selling price (unit selling price) per unit.

Variable cost per unit is the variable costs incurred to create a unit.

Break-even analysis is useful in the determination of the level of production or a targeted desired
sales mix. The study is for management’s use only, as the metric and calculations are not necessary
for external sources such as investors, regulators or financial institutions. This type of analysis
depends on a calculation of the break-even point (BEP). The break-even point is calculated by
dividing the total fixed costs of production by the price of a product per individual unit less the
variable costs of production. Fixed costs are those which remain the same regardless of how many
units are sold.

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12. C-V-P analysis:

Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at the impact that
varying levels of costs and volume have on operating profit. The cost-volume-profit analysis, also
commonly known as break-even analysis, looks to determine the break-even point for different
sales volumes and cost structures, which can be useful for managers making short-term economic
decisions.

The cost-volume-profit analysis makes several assumptions, including that the sales price, fixed
costs, and variable cost per unit are constant. Running this analysis involves using several
equations for price, cost and other variables, then plotting them out on an economic graph.

The objective of CVP analysis

CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a
business. The reason for the particular focus on sales volume is because, in the short-run, sales
price, and the cost of materials and labour, are usually known with a degree of accuracy. Sales
volume, however, is not usually so predictable and therefore, in the short-run, profitability often
hinges upon it. For example, Company A may know that the sales price for product X in a particular
year is going to be in the region of $50 and its variable costs are approximately $30.

It can, therefore, say with some degree of certainty that the contribution per unit (sales price less
variable costs) is $20. Company A may also have fixed costs of $200,000 per annum, which again,
are fairly easy to predict. However, when we ask the question, ‘Will the company make a profit in
that year?’ the answer is ‘We don’t know’. We don’t know because we don’t know the sales volume
for the year. However, we can work out how many sales the business needs to achieve in order to
make a profit and this is where CVP analysis begins.

Cost-Volume-Profit Analysis Formula Is

The CVP formula can be used to calculate the sales volume needed to cover costs and break even, in
the CVP breakeven sales volume formula, as follows:

Breakeven Sales Volume= FC/CM

where:

FC=Fixed costs CM=Contribution margin=Sales−Variable Costs

To use the above formula to find a company's target sales volume, simply add a target profit
amount per unit to the fixed-cost component of the formula. This allows you to solve for the target
volume based on the assumptions used in the model.

13. C-V-P analysis techniques:

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Cost Volume Profit Analysis (CVP Analysis) is an accounting technique which helps in identifying
the effect of sales volume and product cost on the operating profit of a business. Cost Volume Profit
analysis is also known as “Break Even Analysis”.

Cost Volume Profit Analysis includes the analysis of sales price, fixed costs, variable costs, the
number of goods sold and how it affects the profit of the business.

The aim of a company is to earn profit and profit depends upon a large number of factors, most
notable among them are the cost of manufacturing and the volume of sales. These factors are
largely interdependent.

The volume of sales is dependent upon production volume which in turn is related to costs which
are affected by Volume of production, product mix, internal efficiency of the business, production
method used etc.

CVP analysis helps management in finding out the relationship between cost and revenue to
generate profit.

CVP Analysis helps them to determine the break-even point for different sales volume and cost
structures.

With CVP Analysis information, the management can better understand the overall performance
and determine what units it should sell to break even or to reach a certain level of profit.

Importance of Cost Volume Profit Analysis

CVP analysis helps in determining the level at which all relevant cost is recovered and there is no
profit or loss which is also called the breakeven point. It is that point at which volume of sales equal
total expenses (both fixed and variable). Thus CVP analysis helps decision makers understand the
effect of a change in sales volume, price and variable cost on the profit of an entity while taking
fixed cost as unchangeable.

CVP Analysis helps in understanding the relationship between profits and costs on the one hand
and volume on the other. CVP Analysis useful for setting up flexible budgets which indicate costs at
various levels of activity. CVP Analysis also helpful when a business is trying to determine the level
of sales to reach a targeted income.

14. Margin of safety:

In break-even analysis, the term margin of safety indicates the amount of sales that are above the
break-even point. In other words, the margin of safety indicates the amount by which a company's
sales could decrease before the company will have no profit.

Example of Margin of Safety

Assume that a company currently sells 3,000 units of its only product. The company has estimated
that its break-even point is 2,800 units. Therefore, the company's margin of safety is 200 units.

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The margin of safety is the reduction in sales that can occur before the breakeven point of a
business is reached. This informs management of the risk of loss to which a business is subjected by
changes in sales. The concept is useful when a significant proportion of sales are at risk of decline or
elimination, as may be the case when a sales contract is coming to an end. A minimal margin of
safety might trigger action to reduce expenses. The opposite situation may also arise, where the
margin of safety is so large that a business is well-protected from sales variations.

To calculate the margin of safety, subtract the current breakeven point from sales, and divide by
sales. The formula is:

(Current Sales Level – Breakeven Point) ÷ Current Sales Level = Margin of safety

The amount of this buffer is expressed as a percentage.

15. Operating leverage:

Operating leverage is a cost-accounting formula that measures the degree to which a firm or project
can increase operating income by increasing revenue. A business that generates sales with a high
gross margin and low variable costs has high operating leverage.

The higher the degree of operating leverage, the greater the potential danger from forecasting risk,
where a relatively small error in forecasting sales can be magnified into large errors in cash flow
projections.

The Formula for Operating Leverage Is

Degree of operating leverage=Contribution margin/Profit

16. Limiting factor analysis:

In management accounting, limiting factors refer to the constraints in availability of production

resources (e.g. shortages in labor, machine hours or materials) that prevent a business from
maximizing its sales.

If an organization manufactures more than one product and faces a shortage in the supply of a
single resource (e.g. labor hours, machine hours or a material) that is required in the production of
its multiple products, what quantities of its various products should be produced to maximize
profits?

One option would be to determine production quantities on the basis of contribution per unit of the
different products (i.e. products with higher contribution per unit shall be given preference over
products with lower contribution per unit).

Prioritizing production on the basis of contribution per unit however would not maximize profits as
the approach fails to take into account the contribution of various products relative to their usage

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of the limiting resource which shall ultimately determine the overall profit. Therefore, when facing
a situation involving a single limiting factor, products should be prioritized in the production plan
according to their contribution per unit of the limiting resource.

17. Slack and surplus:

Slack is the amount by which a resource is underutilized, i.e. slack occurs when the maximum
availability of a resource is not used. Graphically speaking, it will occur when the optimum point
does not fall on a given resource line.

The optimal solution will typically occur where two ("critical") constraint lines cross. There will be
no slack for these constraints/resources as they will be fully utilized. For other constraint lines, the
fact that the optimal solution is not on these lines means that the resources are not fully utilized, so
there will be slack.
Slack is important for two reasons
1. For critical constraints (zero slack), then gaining additional units of these scarce resources
will allow the optimal solution to be improved (e.g. higher contribution earned). Similarly if
another department wants these resources then it will result in lower contribution.
2. For noncritical constraints, gaining or losing a small number of units of the scarce resource
will have no impact on the optimal solution.

18. Shadow prices;

Shadow price, or shadow pricing, is the real economic price of projects, activities, goods, and
services that have no market price. It also includes projects, etc. for which prices are difficult to
estimate. The shadow price is the opportunity cost, i.e., what somebody had to give up when they
made a choice.

The shadow price is the proxy value of a good or project. We often define it by what somebody has
to give up to gain an extra unit of that good.

However, the impact resulting from a project or the value of a good when measured using the
shadow price may differ from its value when measured using market prices.

This is because the market has not properly priced it in the first place.

The shadow price can also mean the highest price that a company would be willing to pay.
Specifically, the highest price it would pay for one extra unit of something.

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Shadow pricing involves determining whether doing something will bring in greater benefits than
the costs incurred. When we have estimated the shadow price, we subsequently decide whether to
go ahead with a plan. If we decide to go ahead, we also decide how much we are willing to spend on
it.

19. Price sensitivity:

The amount by which changes in a product's cost tend to affect consumer demand for that product.
The price sensitivity of a product within its target market is often used by a business when
determining its optimal pricing and marketing strategy for the product.

20. Price elasticity:

Price Elasticity is a measure of the relationship between a change in the quantity demanded of a
particular good and a change in its price. Price Elasticity of Demand (PED) is a term used in
economics when discussing price sensitivity. The formula for calculating price elasticity of demand
is:

Price Elasticity of Demand = % change in Quantity Demand / % Change in Price

If a small change in price is accompanied by a large change in quantity demanded, the product is
said to be elastic (or responsive to price changes). On the other hand, a product is deemed inelastic
if a large change in price is accompanied by a small amount of change in quantity demanded.

21. Profit-maximizing price:

Economic theory normally uses the profit maximization assumption in studying the firm just as it
uses the utility maximization assumption for the individual consumer. This approach is taken to
satisfy the need for a simple objective for the firm. This objective seems to be the most feasible. The
profit-maximizing firm chooses both inputs and outputs so as to maximize the difference between
total revenue and total cost. The firm will adjust variables under its control until it cannot increase
profit further. Thus, the firm looks at each additional unit of input and output with respect to its
effect on profit.

22. Cost-plus pricing:

Cost plus pricing involves adding a markup to the cost of goods and services to arrive at a selling
price. Under this approach, you add together the direct material cost, direct labor cost, and
overhead costs for a product, and add to it a markup percentage in order to derive the price of the
product. Cost plus pricing can also be used within a customer contract, where the customer
reimburses the seller for all costs incurred and also pays a negotiated profit in addition to the costs
incurred.

The following are advantages to using the cost plus pricing method:

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Simple. It is quite easy to derive a product price using this method, though you should define the
overhead allocation method in order to be consistent in calculating the prices of multiple products.

Assured contract profits. Any contractor is willing to accept this method for a contractual
agreement with a customer, since it is assured of having its costs reimbursed and of making a profit.
There is no risk of loss on such a contract.

Justifiable. In cases where the supplier must persuade its customers of the need for a price increase,
the supplier can point to an increase in its costs as the reason for the increase.

Disadvantages of Cost plus Pricing:

Ignores competition. A company may set a product price based on the cost plus formula and then be
surprised when it finds that competitors are charging substantially different prices. This has a huge
impact on the market share and profits that a company can expect to achieve. The company either
ends up pricing too low and giving away potential profits, or pricing too high and achieving minor
revenues.

Product cost overruns. Under this method, the engineering department has no incentive to
prudently design a product that has the appropriate feature set and design characteristics for its
target market. Instead, the department simply designs what it wants and launches the product.

Contract cost overruns. From the perspective of any government entity that hires a supplier under
a cost plus pricing arrangement, the supplier has no incentive to curtail its expenditures - on the
contrary, it will likely include as many costs as possible in the contract so that it can be reimbursed.
Thus, a contractual arrangement should include cost-reduction incentives for the supplier.

Ignores replacement costs. The method is based on historical costs, which may have subsequently
changed. The most immediate replacement cost is more representative of the costs incurred by the
entity.

23. Market skimming price:

Price skimming is a product pricing strategy by which a firm charges the highest initial price that
customers will pay and then lowers it over time. As the demand of the first customers is satisfied
and competition enters the market, the firm lowers the price to attract another, more price-
sensitive segment of the population. The skimming strategy gets its name from "skimming"
successive layers of cream, or customer segments, as prices are lowered over time.

Price Skimming Limits

Generally, the price skimming model is best used for a short period of time, allowing the early
adopter market to become saturated, but not alienating price-conscious buyers over the long term.
Additionally, buyers may turn to cheaper competitors if a price reduction comes about too late,
leading to lost sales and most likely lost revenue.

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Price skimming may also not be as effective for any competitor follow-up products. Since the initial
market of early adopters has been tapped, other buyers may not purchase a competing product at a
higher price without significant product improvements over the original.

24. Market penetration pricing:

Penetration pricing is a marketing strategy used by businesses to attract customers to a new

product or service by offering a lower price during its initial offering. The lower price helps a new
product or service penetrate the market and attract customers away from competitors. Market
penetration pricing relies on the strategy of using low prices initially to make a wide number of
customers aware of a new product.

The goal of a price penetration strategy is to entice customers to try a new product and build
market share with the hope of keeping the new customers once prices rise back to normal levels.
Penetration pricing examples include an online news website offering one month free for a
subscription-based service or a bank offering a free checking account for six months.

25. Product line pricing:

Product line pricing strategy A product line is a range of products that are related to one another.
Product line pricing occurs when setting the price steps between various products in a product
line, based on:

a. Cost differences between the products.

b. Customer evaluation of different features.
c. Competitor prices.

In other words, product line pricing occurs when a company must decide the price differences
between the upgrades of a product or service.

26. Price discrimination:

Price discrimination is a selling strategy that charges customers different prices for the same
product or service based on what the seller thinks they can get the customer to agree to. In pure
price discrimination, the seller charges each customer the maximum price he or she will pay. In
more common forms of price discrimination, the seller places customers in groups based on certain
attributes and charges each group a different price.

Price discrimination is practiced based on the seller's belief that customers in certain groups can be
asked to pay more or less based on certain demographics or on how they value the product or
service in question.

Price discrimination is most valuable when the profit that is earned as a result of separating the
markets is greater than the profit that is earned as a result of keeping the markets combined.
Whether price discrimination works and for how long the various groups are willing to pay
different prices for the same product depends on the relative elasticity’s of demand in the sub-

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markets. Consumers in a relatively inelastic submarket pay a higher price, while those in a
relatively elastic sub-market pay a lower price.

27. Relevant cost pricing:

Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only
when making specific business decisions. The concept of relevant cost is used to eliminate
unnecessary data that could complicate the decision-making process. As an example, relevant cost
is used to determine whether to sell or keep a business unit. The opposite of a relevant cost is a
sunk cost, which has already been incurred regardless of the outcome of the current decision.

28. Outsourcing:

Outsourcing is an increasingly popular method of achieving performance improvement. However,

the results have been mixed. Some organizations have not achieved the desired benefits associated
with outsourcing and experienced outsourcing failure instead. This research project examines the
issue of performance measurement in the outsourcing decision. Understanding current
performance and the degree to which sustainable superior performance can be maintained allows
the outsourcing process to be linked with the overall business strategy.

29. Maximin decision rule:

The ‘maximin’ decision rule looks at the worst possible outcome at each supply level and then
selects the highest one of these. It is used when the outcome cannot be assessed with any level of
certainty. The decision maker therefore chooses the outcome which is guaranteed to minimise his
losses. In the process, he loses out on the opportunity of making big profits. It is often seen as the
pessimistic approach to decision-making (assuming that the worst outcome will occur) and is used
by decision makers who are risk averse. It can be used for one-off or repeated decisions.

30. Maximax decision rule:

The decision maker who is risk seeking and optimistic will select the course of action with the
highest possible payoff. The decision maker seeks the highest return, assuming that events turns
out in the best possible way. The maximax decision rule is the decision rule for the risk seeker.

31. Decision trees:

A decision tree is a diagrammatic representation of a multi-decision problem, where all possible

courses of action are represented, and every possible outcome of each course of action is shown.

Decision trees should be used where a problem involves a series of decisions being made and
several outcomes arise during the decision-making process. Decision trees force the decision maker

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to consider the logical sequence of events. A complex problem is broken down into smaller, easier
to handle sections.

The financial outcomes and probabilities are shown separately, and the decision tree is 'rolled back'
by calculating expected values and making decisions.

32. The value of information:

In many questions the decision makers receive a forecast of a future outcome (for example a
market research group may predict the forthcoming demand for a product). This forecast may turn
out to be correct or incorrect. The question often requires the candidate to calculate the value of
the forecast. Perfect information the forecast of the future outcome is always a correct prediction.
If a firm can obtain a 100% accurate prediction they will always be able to undertake the most
beneficial course of action for that prediction. Imperfect information the forecast is usually correct,
but can be incorrect. Imperfect information is not as valuable as perfect information.

The value of information (either perfect or imperfect) may be calculated as follows:

Expected profit (outcome) WITH the information LESS Expected profit (outcome) WITHOUT the
information

33. Sensitivity analysis:

Sensitivity analysis is the use of multiple what-if scenarios to model a range of possible outcomes.
The technique is used to evaluate alternative business decisions, employing different assumptions
about variables. For example, a financial analyst could examine the potential profit levels that may
be achieved as a result of an investment in machinery by altering the expected demand level,
material costs, equipment downtime percentage, crewing costs, and residual value of the
equipment.

For example, an analyst is modeling the range of profit outcomes for a prospective equipment
purchase. A potential issue is that the equipment may be superseded by a new equipment model,
which may reduce its resale value. Accordingly, the analyst conducts a sensitivity analysis that
models the lifetime profitability of the investment, assuming a range of possible resale values at the
end of the projected usage period for the equipment.

A particularly useful aspect of sensitivity analysis is to locate those variables that can have an
unusually large impact on the outcome of the analysis. The decision maker can then evaluate the
probability of the variables experiencing significant changes. The outcome is a better
understanding of the risks associated with an investment.

One way to create a sensitivity analysis is to aggregate variables into three scenarios, which are the
worst case, most likely case, and best case. The probability of occurrence for the variables used in
these three cases clusters the highest probability variables in the most likely case.

34. Incremental budgeting:

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Incremental budgeting is budgeting based on slight changes from the preceding period's budgeted
results or actual results. This is a common approach in businesses where management does not
intend to spend a great deal of time formulating budgets, or where it does not perceive any great
need to conduct a thorough re-evaluation of the business. This mindset typically occurs when there
is not a great deal of competition in an industry, so that profits tend to be perpetuated from year to
year. There are several advantages to incremental budgeting, which are as follows:

Simplicity: The primary advantage is the simplicity of incremental budgeting, being based on either
recent financial results or a recent budget that can be readily verified.

Funding stability: If a program requires funding for multiple years in order to achieve a certain
outcome, incremental budgeting is structured to ensure that funds will keep flowing to the
program.

Operational stability: This approach ensures that departments are operated in a consistent and
stable manner for long periods of time.

There are several downsides of incremental budgeting that make it a less than ideal choice. The
issues are:

Incremental in nature: It assumes only minor changes from the preceding period, when in fact there
may be major structural changes in the business or its environment that call for much more
significant budget alterations.

Fosters overspending: It fosters an attitude of "use it or lose it" in regard to budgeted expenditures,
since a drop in expenditures in one period will be reflected in future periods, too.

Budgetary slack: Managers tend to build too little revenue growth and excessive expenses into
incremental budgets, so that they will always have favorable variances.

Budget review: When the budget is carried forward with minor changes, there tends to be little
incentive to conduct a comprehensive review of the budget, so that inefficiencies and budgetary
slack are automatically rolled into new budgets.

Variance from actual: When the incremental budget is based on a prior budget, there tends to be a
growing disconnect between the budget and actual results.

Perpetuates resource allocations: If a certain amount of funds were allocated to a specific business
area in a prior budget, then the incremental budget assures that funding will be allocated there in
the future, too - even if it no longer needs as much funding, or if other areas require more funding.

Risk taking: Since an incremental budget allocates most funds to the same uses every year, it is
difficult to obtain a large funding allocation to direct at a new activity. Thus, incremental budgeting
tends to foster a conservative maintenance of the status quo, and does not encourage risk taking.

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In short, incremental budgeting results in such a conservative mindset in a business that it may
actually be a noticeable driver in destroying a company over the long term. You should instead
engage in a thorough strategic re-assessment of a business when constructing a budget, as well as a
detailed investigation of expenditures. The result should be significant changes in the allocation of
funds from period to period, as well as targeted operational changes that are intended to improve
the competitive position of a business.

35. Activity based budgeting:

Activity-based budgeting is a planning system under which costs are associated with activities, and
budgeted expenditures are then compiled based on the expected activity level. This approach is
quite different from the more traditional budgeting system, where existing cost levels are adjusted
for inflation and major revenue changes in order to derive the annual budget.

An activity-based budgeting system allows for a high degree of refinement in cost planning, and
focuses attention on the volume and types of activities occurring within a business. A likely
outcome of using this system is management planning to reduce the activity levels required to
generate revenue, which in turn improves profits. It also means that managers are forced to have a
detailed knowledge of company processes if they want to enhance the cost structure of a business.

Another advantage of the system is the strong link between it and the goals of the parent company.
Ideally, management can use the system to see how much cost is associated with each part of a
business, and then decides whether funds need to be allocated to or away from each area. This
could result in a shift in funding to support parts of the business on which management wants to
place a greater emphasis, such as on the development of new products or a product rollout in a new
geographic region.

The downside of activity-based budgeting is the increased workload required to track activities, for
which there may be no traditional tracking systems. Also, costs need to be traced back to activities,
for which there may also be no systems in place. Consequently, setting up such a system can be
difficult. An organization may find that this type of budgeting can be more easily rolled out on a
pilot basis, perhaps by using it for a single department or profit center, and monitoring its impact
on the budgeting process.

36. Rolling budgets:

A rolling budget is continually updated to add a new budget period as the most recent budget
period is completed. Thus, the rolling budget involves the incremental extension of the existing
budget model. By doing so, a business always has a budget that extends one year into the future.

A rolling budget calls for considerably more management attention than is the case when a
company produces a one-year static budget, since some budget updating activities must now be
repeated every month. In addition, if a company uses participative budgeting to create its budgets
on a rolling basis, the total employee time used over the course of a year is substantial.

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Consequently, it is best to adopt a leaner approach to a rolling budget, with fewer people involved
in the process.

Advantages and Disadvantages of the Rolling Budget

This approach has the advantage of having someone constantly attend to the budget model and
revise budget assumptions for the last incremental period of the budget. The downside of this
approach is that it may not yield a budget that is more achievable than the traditional static budget,
since the budget periods prior to the incremental month just added are not revised.

Example of a Rolling Budget

ABC Company has adopted a 12-month planning horizon, and its initial budget is from January to
December. After a month passes, the January period is complete, so it now adds a budget for the
following January, so that it still has a 12-month planning horizon that extends from February of the
current year to January of the next year.

37. Learning curves:

In any environment if a person is assigned to do the same task, then after a period of time, there is
an improvement in his performance. If data points are collected over a period of time, the curve
constructed on the graph will show a decrease in effort per unit for repetitive operations. This
curve is very important in cost analysis, cost estimation and efficiency studies. This curve is called
the learning curve. The learning curve shows that if a task is performed over and over than less
time will be required at each iteration. Historically, it has been reported that whenever there has
been instanced of double production, the required labor time has decreased by 10 or 15 percent or
more.

Learning curves are also known as experience curve, cost curves, efficiency curves and productivity
curves. These curves help demonstrate the cost per unit of output decreases over time with the
increase in experience of the workforce. Learning curves and experience curves is extensively used
by organization in production planning, cost forecasting and setting delivery schedules.

Learning Curve on Graph

Learning curve demonstrates that over a period time, there is an increase in productivity but with
diminishing rate as production increases. Therefore, if the rate of reduction is 20% than the
learning curve is referred as 80% learning curve. Research has shown that as production quantities
double over a period of time, the average time decreases by 20% for immediate production unit.

Learning Curve from Single Unit Data

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The data for effort put into production of a single unit is available than that data can be used to plot
three useful curves; the unit curve, the cumulative total and cumulative average curve.

Unit curve is a curve which is plotted using a set of data available for the effort behind production of
a single unit. This curve is generally plotted on log-log paper and then best line can be drawn.

Cumulative total curve is a curve which is plotted using cumulative effort total. This produces curve
with positive slope.

Cumulative average curve is a curve which is plotted using the cumulative effort average for each
unit.

Assistance Score Learning Curve

As the name suggests an assistance score is the number of help, hint, wrong attempts recorded for a
given opportunity at the given task. From detailed research and analysis, it has been observed that
for the 1st opportunity at an average error of 1.3 times is made.

Error Learning Curve

Error learning curve depicts the percentage of assistance asked by the respondents on the 1st
opportunity.

Predicted Learning Curve

Predicted learning curve is derived from learning factor analysis, which has the capability in
measuring student proficiency, knowledge component difficulty and knowledge component
learning rates. This analysis helps in quantifying the learning process.

Criticisms of the Experience Curve

It has been observed that experience curve should not be viewed in isolation. Learning and
experience curve has a strong dependency on individuals under observation. If the attitude of the
individual is positive, the resulting curve will resemble learning curve but if the attitude of the
individual is negative, the resulting curve will not hold good.

38. The principle of controllability:

The principle of controllability is that managers of responsibility centers should only be held
accountable for costs over which they have some influence. They may become demotivated if they
are made responsible for non-controllable costs. Budgetary control is based around a system of
budget centers. Each budget center will have its own budget and a manager will be responsible for
managing the budget center and ensuring that the budget is met.

39. Material mix and yield variances:

That portion of the material usage variance that occurs due to the difference between the mixture’s
standard & actual composition is known as material mix variance. The variances in cost which

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arises because of change in the ratio in which the different materials are used as compared to the
standard which has been fixed for the purpose, is represented by material mix variance. It could
arise on account of temporary shortage or price rise of a particular type of material. Depending
upon the fact whether the total of actual mix of material & the standard mix of material are the
same or not, the formula which may be used for the calculation of the variance will be different.

The formula, in the case where total standard quantity & actual quantity are the same, is:

Standard price * (Standard quantity- Actual quantity)

The usage variance in such a case would be equal to the mix variance.

However, the formula, in the case where total standard quantity & actual quantity are not the same,
is:

Standard price * (Revised standard quantity-Actual quantity)

Revised standard is equal to actual quantity divided in the standard quantity ratio.

In such a case the usage variance shall be both due to mix as well as due to reasons which are other
than mix. Therefore, using the following formula, calculation can be done of another sub-variance
which is called revised usage (or sub usage) variance.

The formula is:

Standard price * (Standard quantity-Revised standard quantity)

Material Yield Variance:

That portion of the usage variance which arise as a result of the difference between the standard
yield which has been specified & the actual yield which has been obtained, is material yield
variance.

The formula is:

Standard cost per unit * (Standard yield for actual mix –Actual yield)

Due to abnormal contingencies like processing in wrong temperature, spoilage, chemical reactions
etc., this variance may arise.

On the basis of output or yield, calculation of yield variance may be done while on the basis of input,
calculation of revised usage variance may be done. Numerically, both will be equal. However,
revised variance is not that much popular & calculation of the same should be done only when due
to the lack of adequate information, the calculation of the yield variance is not possible.

Relationship between the variances:

Total material cost variance = Price variance+ Usage variance

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40. Sales mix and quantity variances:

In a multi-product business the sales volume variance can be separated into sales mix and quantity
variances. The purpose of the sales mix and quantity variances is to show how much of the sales
volume variance is due to a change in the mix of the products sold (sales mix variance) and how
much is due to a change in the quantity of the products sold (sales quantity variance).

Actual Sales Volume at Budgeted Sales Mix

Before discussing sales mix and quantity variances it is first necessary clarify what is meant by the
term ‘actual sales volume at budgeted sales mix’ and to understand how it is calculated.

Sales Mix Variance

The sales mix variance shows how much of the sales volume variance was due to a difference
between the actual sales mix and the budgeted sales mix.

The variance is calculated by taking the difference between the actual sales volume and the actual
sales volume at the budgeted mix and multiplying this by the budgeted price to give a monetary
amount.

Sales Quantity Variance

The sales quantity variance shows how much of the sales volume variance was due to a difference
between the actual volume sold at the budgeted mix and the budgeted volume.

The variance is calculated by taking the difference between the actual sales volume at the budgeted
mix and the budgeted sales volume and multiplying this by the budgeted price to give a monetary
amount.

41. Performance measurement and measures:

A performance measurement is a numeric outcome of an analysis that indicates how well an

organization is achieving its objectives. These measurements can be used to examine the
performance of all aspects of a business, including the accounting, engineering, finance, marketing,
materials management, production, research, and sales departments. Examples of performance
measurements are:

Tracking the ability of the accounting department to collect overdue accounts receivable

Tracking the speed with which the engineering department can design new products

Tracking the liquidity of funds administered by the finance department

Tracking the amount of inventory maintained by the materials management department

Tracking the amount of scrap produced in the production department

Tracking the ability of the sales staff to bring in new sales from existing customers

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Performance measurements are typically compiled into a summary sheet that is distributed to the
management team on a regular basis. Any measures falling below a trend line or not meeting a
standard will be subject to enhanced management attention.

Another form of performance measurement is the use of revenue centers, profit centers, and cost
centers to report the results of business segments. A revenue center is responsible solely for the
amount of revenue it generates, while a profit center is responsible for both the revenues it
generates and the costs it incurs. A cost center is only responsible for the costs it incurs. Nearly all
parts of a business can be broken down into one of these classifications.

42. The balanced scorecard:

A balanced scorecard is a strategic management performance metric used to identify and improve
various internal business functions and their resulting external outcomes. Balanced scorecards are
used to measure and provide feedback to organizations. Data collection is crucial to providing
quantitative results as managers and executives gather and interpret the information and use it to
make better decisions for the organization.

The balanced scorecard model reinforces good behavior in an organization by isolating four
separate areas that need to be analyzed. These four areas, also called legs, involve learning and
growth, business processes, customers, and finance.

The balanced scorecard is used to attain objectives, measurements, initiatives, and goals that result
from these four primary functions of a business. Companies can easily identify factors hindering
business performance and outline strategic changes tracked by future scorecards.

The balanced scorecard can provide information about the company as a whole when viewing
company objectives. An organization may use the balanced scorecard model to implement strategy
mapping to see where value is added within an organization. A company also uses a balanced
scorecard to develop strategic initiatives and strategic objectives.

Characteristics of the Balanced Scorecard Model

Information is collected and analyzed from four aspects of a business:

Learning and growth are analyzed through the investigation of training and knowledge resources.
This first leg handles how well information is captured and how effectively employees use the
information to convert it to a competitive advantage over the industry.

Business processes are evaluated by investigating how well products are manufactured.
Operational management is analyzed to track any gaps, delays, bottlenecks, shortages, or waste.

Customer perspectives are collected to gauge customer satisfaction with quality, price, and
availability of products or services. Customers provide feedback about their satisfaction with
current products.

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 Financial data, such as sales, expenditures, and income are used to understand financial
performance. These financial metrics may include dollar amounts, financial ratios, budget
variances, or income targets.

Balanced Scorecard provides an overview of the entire business, allowing monitoring the
performance of all the proposed strategic objectives, the measures taken to achieve them, the
degree of staff' involvement, involving all financial and non-financial aspects. Balanced Scorecard
concept involves grouping key performance indicators (KPIs), financial and nonfinancial, in four
perspectives. The four sizes cover financial success, market leadership, customer loyalty, capital
development, business process control and, in part, the consequences for the community.

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