Management control

Licence d’excellence CCA

Pr. Ilham RHAROUBI

Année universitaire: 2023/2024

Chapter 3 : managerial costing
• Strategic cost management: definition and practices
• The variable costing method
• Absorption costing
• Marginal costing
• Target costing method
• Activities Based Costing method
• Rational imputation of the fixed costs
• Responsibility centers and transfer pricing within organizations
Strategic cost management: definition and practices

Strategic Cost Management is an approach to cost accounting and

management that goes beyond traditional methods by aligning cost
management practices with an organization's strategic goals and
objectives.

It involves not only controlling costs but also using cost information
strategically to gain a competitive advantage and enhance overall
organizational performance.
Strategic cost management: definition and practices

Benefits of Strategic Cost Management

• Improved cost control.

• Enhanced competitiveness.
• Better alignment with organizational strategy.
• Informed decision-making based on comprehensive cost information.
• Ability to adapt to changing market conditions.
Strategic cost management: definition and practices
Practices of Strategic Cost Management
• Value Chain Analysis:
Involves analyzing the entire value chain – the sequence of activities that add value to a
product or service.
• Activity-Based Costing (ABC):
ABC is a cost allocation method that assigns costs to activities based on their
consumption of resources.
• Life-Cycle Costing:
Examines costs associated with a product or service throughout its entire life cycle,
from design to disposal.
• Strategic Costing Models:
Development of costing models that integrate with strategic planning and forecasting.
Strategic cost management: definition and practices

Practices of Strategic Cost Management

• Target Costing:
Establishing cost targets based on market conditions and desired profit margins.
• Cost Driver Analysis:
Identifying and understanding the factors (cost drivers) that significantly influence
costs.
• Performance Measurement:
Developing performance metrics that align with strategic goals and objectives.
• Integration with Strategic Planning:
Embedding cost management considerations into the strategic planning process.
 Conventional Management Accounting Versus Strategic Cost Management
Conventional Management Accounting Strategic Cost Management
Focus and Primarily historical and internal financial Future-oriented and strategic,
Scope information. Generally limited to cost emphasizing long-term goals. Expands
recording, budgeting, and financial beyond traditional cost accounting to
reporting include strategic decision-making and
value chain analysis
Time Short to medium term Long term
Horizon Historical performance and periodic Forward-looking, considering future
reporting costs and benefits.
Orientation Internal and financial External and internal, integrating
Often used for compliance and financial financial and non-financial
reporting information.
Emphasizes strategic decision-making,
cost control, and value creation.
 Conventional Management Accounting Versus Strategic Cost Management

Conventional Management Strategic Cost Management

Accounting
Cost Focus on historical cost data. Emphasizes analyzing costs in relation to
Analysis Primarily for cost control and strategic goals.
financial reporting. Aims to create a competitive advantage
through efficient cost management.
Decision- Typically focuses on short-term Focuses on strategic decisions affecting the
Making operational decisions organization's competitive position

Reporting Mainly financial reports Includes both financial and non-financial

performance indicators
Cost Management Perspective
Provide highest quality service / goods with lowest possible cost

Objectives:
• Determine cost of resources consumed in company’s activities
• Eliminate non-value added activities as much as possible
• Determine efficiency and effectiveness of all major activities
• Identify and evaluate new activities that can improve the
performance of the company
Strategic Cost Management
Value chain
• Get raw materials and other resources
• Research and development – including quality assessment
• Product design
• Production
• Marketing
• Distribution
• Customer service
Understanding the value chain
Cost drivers in activities

Managing the cost relationships within the value chain to a company’s

advantage
Strategic Cost Management

Understanding the value chain and strategically managing costs within

each activity is essential for companies aiming to operate efficiently,
create high-quality products, and remain competitive in the market. It's
a holistic approach that considers the entire process of bringing a
product to market.
Cost – Benefit Analysis (CBA)

• Cost- using resources to achieve a benefit

• Benefits- aspects of a decision that help the organization
• Analysis: the process of analyzing alternative decisions to determine
which decision has the greatest benefit relative to its cost

Cost-Benefit Analysis (CBA) is a structured approach to decision-making

that compares the total costs of a decision to the total benefits. The goal is
to determine whether the benefits outweigh the costs.
Basic Costs concept

Cost is any resource sacrificed or foregone to achieve a particular

objective

Cost object: anything for which you can measure or assign a cost
Exp: division, department or product

Costs can be direct or indirect

Direct cost: a cost that is directly Indirect cost: a cost that is not
traceable to the cost object directly traceable to a cost object
Cost
A cost is the value of money that has been used up to produce
something
Cost is a monetary value of:
• Effort
• Material
• Resources
• Time and utilities consumed
• Risk incurred
• Opportunity forgone in production and delivery of good or service
Cost object
Any product, any job order, any division, any anything to which we can assign a cost
Examples:
• Product lines
• Customers
• Departments

Why assign costs to cost objects?

- Track profitability
- Evaluate managerial performance
- Provide information for pricing decisions
- Control spending
Types of costs
• Fixed : cost does not vary with changing output
à even if you produce or don’t, this cost remains the same

• Variable : cost that depends on the output produced

à if you produce more cars, you must use more materials like metal

• Semi-variable cost: Half fixed cost, half variable

à if you produce more cars, you need to employ more workers; this is variable cost
à However, even if you didn’t produce any cars, you may still need some workers to
look after empty factory.
Types of costs

Opportunity cost and actual cost

• Opportunity Cost: The value of the next best alternative forgone when a decision is made.
• Example: Choosing to invest in stocks rather than bonds, where the opportunity cost is the
potential return from the bonds.
• Actual Cost: The direct monetary expense incurred for a particular decision or action.
• Example: Buying raw materials to produce a product, where the actual cost is the amount
spent on those materials.
Direct and indirect cost
• Direct Cost: Expenses that can be directly attributed to a specific product or department.
• Example: The cost of raw materials used in manufacturing a specific product.
• Indirect Cost: Costs not directly tied to a specific product, often related to overhead or shared
resources.
• Example: Rent for a factory building that produces multiple products.
Types of costs
Historical and replacement cost
• Historical Cost: The original cost of an asset when it was acquired.
• Example: Purchasing machinery for a factory at a specific cost.
• Replacement Cost: The cost to replace an asset with a new one at current market prices.
• Example: The current market cost of buying a similar piece of machinery to replace an old one.
Fixed cost and variable cost
• Fixed Cost: Remains constant irrespective of the level of production or output.
• Example: Monthly rent for a factory remains the same regardless of the number of units produced.
• Variable Cost: Fluctuates with changes in production or output.
• Example: The cost of raw materials, which increases with higher production levels.
Explicit and implicit cost
• Explicit Cost: Clearly identifiable, out-of-pocket expenses that involve a direct payment.
• Example: Wages paid to employees, as it involves a direct monetary outlay.
• Implicit Cost: Opportunity costs not involving a direct monetary payment.
• Example: Using owner's equity to fund a business instead of investing elsewhere, incurring an implicit cost.
Types of costs
Real and prime cost
• Real Cost: The total actual cost of production, including both explicit and implicit costs.
• Example: The total cost of manufacturing a car, considering all expenses.
• Prime Cost: The direct cost involved in the production of goods, typically including direct materials
and direct labor. DL+DM
• Example: The cost of raw materials and wages paid to workers assembling a product.
• Conversion cost: Conversion cost is the sum of direct labor and manufacturing overhead costs
incurred to turn raw materials into a finished product. DL+MOH
Total, average and marginal cost
• Total Cost: The sum of all costs incurred in producing a particular quantity of output.
• Example: The total cost of producing 1,000 units of a product.
• Average Cost: The cost per unit of output, calculated by dividing total cost by the quantity
produced.
• Example: Average cost per unit of producing 1,000 units of a product.
• Marginal Cost: The additional cost incurred by producing one more unit of output.
• Example: The cost of producing the 1,001st unit after producing 1,000 units.
Fixed costs

Break-even analysis provides valuable insights into the minimum level of sales or
production necessary for a business to cover its costs and avoid losses. Beyond the
break-even point, each additional unit sold contributes to profit.
 Costs
DH

This graph shows that the cost remains the same regardless of the volume of
output
 Examples of fixed costs

If you hire consultants Fixed, however

only when there's a Marketing costs can be
specific project, it's a variable, especially if
variable cost. they are campaign-
specific.

The costs associated with

Generally considered
research projects could be
fixed as they remain
considered variable, especially
constant regardless of
if they are conducted on a
the level of production
project basis. However, certain
or sales in the short
ongoing research activities
term.
might have fixed components.
Average fixed cost

output Total fixed AFC

cost
0 2000 -
50 2000 40
100 2000 20
150 2000 13.3
200 2000 10
250 2000 8
300 2000 6.6
Variable costs
 DH

This graph shows a proportionate increase in the cost by the increase in

the activity level
 Examples of variable costs
Can be variable if they are
directly tied to the number of
Variable, as the amount
hours worked or production
paid in commissions
output. If wage costs are fixed
would depend on the
salaries not dependent on
level of sales or
hours worked or production
performance.
output.

The cost of component Variable, as the cost of

parts can be variable if it raw materials is directly
changes with the related to the quantity
quantity produced. used in production.
Key concepts
Average cost à total cost per unit of output = total cost / output
= TC/Q
Average fixed cost à total fixed cost per unit of output = TFC/Q

Average variable cost à total variable cost per unit of output = TVC/Q
Fixed cost à Business expense that does not vary directly with the
level of output
Marginal cost à the change in total costs from increasing output by
one extra unit
Variable costs

• A variable cost is a corporate expense that varies with production.

• Variable costs differ from fixed costs such as rent, advertising,
insurance and office supplies, which tend to remain the same
regardless of production output.
• Fixed costs and variable costs comprise total cost.
• Variable costs vary depending on a company's production volume;
they rise as production increases and fall as production decreases.
Average total cost
output Total fixed Total Total cost Average
cost variable total cost
cost
0 2000 0 2000
50 2000 500 2500 50
100 2000 700 2700 27
150 2000 850 2850 19
200 2000 1000 3000 15
250 2000 1250 3250 13
300 2000 1900 3900 13
350 2000 2550 4550 13
400 2000 3600 5600 14
Marginal cost
• Marginal cost represents the additional cost incurred by producing
one more unit of a good or service.

Marginal Cost (MC) = Change in Total Cost / Change in Quantity

The concept of marginal cost is essential for decision-making, as it

helps determine the optimal level of production based on cost
considerations.
Calculating Marginal cost
Output Total cost Average Marginal
total cost cost
0 2000 - -
50 2500 50 10
100 2700 27 4
150 2850 19 3
200 3000 15 3
250 3250 13 5
300 3900 13 13
350 4550 13 13
400 5600 14 21
Marginal cost is the change in total cost from producing one extra unit of output
Manufacturing costs
• Direct Materials
Materials that go directly into the final product

• Direct labor
Labor that could be traced to individual unit of production

• Manufacturing overhead
All manufacturing costs that are not DM nor DL
 Manufacturing overhead
Manufacturing overhead includes various indirect costs associated with the production
process, such as factory rent, utilities, depreciation on manufacturing equipment, factory
management salaries, and maintenance expenses.

• Examples of components within manufacturing overhead include:

§ Factory utilities (electricity, water, etc.)
§ Depreciation on manufacturing machinery
§ Factory rent or lease costs
§ Indirect labor (supervisory salaries, janitorial staff, etc.)
§ Maintenance and repairs of manufacturing equipment

• Allocation of Manufacturing Overhead: Since manufacturing overhead cannot be directly

traced to products, it needs to be allocated to the units produced. This is typically done using
a predetermined overhead rate, which is calculated based on an estimated level of activity
(e.g., machine hours or direct labor hours).
Manufacturing overhead could be fixed or variable:
• Fixed Manufacturing Overhead: Fixed manufacturing overhead costs remain constant in total
despite changes in production volume or activity levels.
• Factory rent: The cost of leasing or renting the manufacturing facility remains the same
regardless of the number of units produced.
• Depreciation on machinery: The depreciation expense for manufacturing equipment is fixed
and does not change with the quantity of products manufactured.
• Supervisory salaries: Salaries of production supervisors and management personnel in the
manufacturing facility are typically fixed.
• Variable Manufacturing Overhead: Variable manufacturing overhead costs vary in direct
proportion to changes in production volume or activity levels.
• Indirect labor: Costs associated with additional workers hired for increased production, such
as overtime wages or temporary labor.
• Utilities: Costs of electricity, water, and other utilities that may increase with higher
production levels.
• Raw material handling: Costs related to the movement and handling of raw materials, which
may increase as production volume rises.
 What is Cost of Goods Sold (COGS)?

Cost of Goods Sold (COGS) measures the “direct cost” incurred in the
production of any goods or services. It includes material cost, direct labor
cost, and direct factory overheads, and is directly proportional to revenue.
As revenue increases, more resources are required to produce the goods
or service. COGS is often the second line item appearing on the income
statement, coming right after sales revenue. COGS is deducted from
revenue to find gross profit.
Gross margin

Gross margin is the portion of a company's revenue left over after direct costs are
subtracted. Gross margin is one of the most important indicators of a company's
financial performance. It's the portion of business revenue left over after you
subtract direct costs, such as labor and raw materials.
Gross margin, also known as gross profit margin, is a financial metric that
represents the percentage difference between revenue and the cost of goods sold
(COGS). It is a profitability ratio that indicates the proportion of revenue retained
by a company after covering the direct costs associated with producing or
purchasing the goods sold.
Income statement
An income statement shows a company's revenues, expenses and profitability
over a period of time. It is also sometimes called a profit-and-loss (P&L)
statement or an earnings statement. It shows your: revenue from selling
products or services. expenses to generate the revenue and manage your
business.
Variable costing
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 contrasts with absorption costing, in which the fixed

manufacturing overhead is allocated to products produced.
In accounting frameworks such as GAAP and IFRS, variable costing
cannot be used in financial reporting.
Example
HBC Electronics is a manufacturer of smartphones. In a quarter of year, the company manufactures
10,000 smartphones.
Cost Structure:
Variable Manufacturing Costs per Smartphone:
• Direct Materials: 100 dh per unit
• Direct Labor: 50 dh per unit
• Variable Manufacturing Overhead: 20 dh per unit
Fixed Manufacturing Costs for the Period:
• Total Fixed Manufacturing Costs: 500 000 dh

à Calculate the product cost under the method of variable costing

Pros and cons of variable costing
Absorption costing

Absorption costing is a costing system that is used in valuing inventory.

It not only includes the cost of materials and labor, but also both
variable and fixed manufacturing overhead costs. Absorption costing is
also referred to as full costing.
Variable Costing vs. Absorption Costing
Under variable costing, the following costs go into the product:
• Direct material (DM)
• Direct labor (DL)
• Variable manufacturing overhead (VMOH)

Under absorption costing, the following costs go into the product:

• Direct material (DM)
• Direct labor (DL)
• Variable manufacturing overhead (VMOH)
• Fixed manufacturing overhead (FMOH)
Note that product costs are costs that go into the product while period costs are costs that
are expensed in the period incurred.
Example
HBC Electronics is a manufacturer of smartphones. In a quarter of year, the company manufactures
10,000 smartphones.
Cost Structure:
Variable Manufacturing Costs per Smartphone:
• Direct Materials: 100 dh per unit
• Direct Labor: 50 dh per unit
• Variable Manufacturing Overhead: 20 dh per unit
Fixed Manufacturing Costs for the Period:
• Total Fixed Manufacturing Costs: 500,000 dh

à Calculate the product cost under the method of Absorption costing

Advantages of absorption costing

Absorption costing offers

advantages related to
comprehensive cost
consideration, suitability
for various business
scenarios, adherence to
accounting principles,
external reporting
requirements and
simplification of cost
allocation
Disadvantages of absorption costing

The disadvantages of absorption costing relate to its limitations in providing useful information
for managerial decision-making, challenges in preparing flexible budgets, and potential
misclassification of fixed costs as period costs. These limitations underscore the importance of
considering alternative costing methods in certain managerial contexts.
Example: absorption costing Vs variable costing
A firm that makes hot air balloons:
Production: First quarter: make 10 units, sell 10
Second quarter: make 20, Sell 10
Selling price per unit: 80 000
Expenses:
DM per unit: 25 000
DL per unit: 10 000
VOH per unit: 2000
FOH per quarter: 60 000

- Calculate the COGS under the two methods: variable and absorption costing
- Present the variable cost income statement and the absorption cost income statement
 Cost of Goods Sold (inventory accounting)
IFRS and US GAAP allow different policies for accounting for inventory and cost of goods
sold. Very briefly, there are four main valuation methods for inventory and cost of goods
sold.
• First-in-first-out (FIFO)
• Last-in-first-out (LIFO)
• Weighted average
Under FIFO, COGS consists of finished inventory units that were produced first and thus
consist of costs incurred first, whereas under LIFO, COGS consists of finished inventory units
that were produced last and therefore consists of later or most recent costs.
Under weighted average, the total cost of goods available for sale is divided by units
available for sale to find the unit cost of goods available for sale. This is multiplied by the
actual number of goods sold to find the cost of goods sold.
Cost of Goods Sold (inventory accounting)
For example, assume that a company purchased materials to produce four
units of their goods.
The first three units cost 5dh to produce. However, due to rising material
prices, the last unit costs 10dh to produce. In the subsequent period, the
company sold three units.
1. Under FIFO, COGS would consist of the first three units produced,
totaling 5dh x 3 = 15dh.
2. Under LIFO, COGS would consist of the last three units produced, totaling
10dh x 1 + 5dh x 2 = 20dh.
3. The weighted average per unit is 25dh/4 = 6.25dh. Thus, for the three
units sold, COGS is equal to 18.75dh.
 Target costing: Setting targets for costs according to market conditions
Target costing is not just a method of costing, but rather a management technique
wherein prices are determined by market conditions, taking into account several factors,
such as homogeneous products, level of competition, no/low switching costs for the end
customer, etc. When these factors come into the picture, management wants to control
the costs, as they have little or no control over the selling price.
Target costing is a pricing strategy where a company determines the desired profit margin
and sets a target cost for a product based on market conditions. The goal is to control
costs to meet the target cost while ensuring the product remains competitive in the
market.
Target Cost = Expected Selling Price - Desired Profit Margin
 Key Components of Target Costing

• Desired Profit Margin: The company determines the profit margin it

wishes to achieve on a product.
• Market Conditions: Understanding market conditions, including
competitors' prices and customer expectations, is crucial in setting a
competitive target cost.
• Cost Control and Design: To achieve the target cost, the company
focuses on cost control measures and often involves cross-functional
teams to work on product design, production processes, and cost
reduction initiatives.
 In industries such as FMCG (Fast Moving Consumer
Why Target Costing? Goods), construction, healthcare, and energy,
competition is so intense that prices are determined
by supply and demand in the market.
Producers can’t effectively control selling prices.
They can only control, to some extent, their costs, so
management’s focus is on influencing every
component of product, service, or operational costs.
The key objective of target costing is to enable
management to use proactive cost planning, cost
management, and cost reduction practices where
costs are planned and calculated early in the design
and development cycle, rather than during the later
stages of product development and production.

Target cost as “a product cost estimate derived from a competitive market price”
Example

Let's say a company wants to introduce a new smartphone and aims for a
20% profit margin. The expected selling price in the market is 5000 dh.

• Desired Profit Margin = 20% of 5000 dh = 1000 dh

• Target Cost = 5000 dh – 1000 dh = 4000 dh

The company must ensure that the cost of designing, manufacturing, and
distributing the smartphone does not exceed 4000 dh in order to meet its
profit margin target.
Target costing is customer-focused and encourages cost management
through collaboration across different functions. It helps companies align
their products with market expectations, promoting competitiveness and
profitability.
 Why target costing ?

• There is so much competition in sectors like FMCG (fast-moving

consumer goods), building, healthcare, and energy that market forces
decide prices. Thus, effective selling price management is unattainable
for producers. The management is focused on influencing each
component of product, service, or operational expenses because they
have little influence over their costs.
 Key Features of Target Costing
• The price of the product is determined by market conditions. The company is a price
taker rather than a price maker.
• The minimum required profit margin is already included in the target selling price.
• It is part of management’s strategy to focus on cost reduction and effective cost
management.
• Product design, specifications, and customer expectations are already built-in while
formulating the total selling price.
• The difference between the current cost and the target cost is the “cost
reduction,” which management wants to achieve.
• A team is formed to integrate activities such as designing, purchasing,
manufacturing, marketing, etc., to find and achieve the target cost.
Advantages of Target Costing
• It shows management’s commitment to process improvements and product
innovation to gain competitive advantages.
• The product is created from the expectation of the customer and, hence, the
cost is also based on similar lines. Thus, the customer feels more value is
delivered.
• With the passage of time, the company’s operations improve drastically,
creating economies of scale.
• The company’s approach to designing and manufacturing products becomes
market-driven.
• New market opportunities can be converted into real savings to achieve the
best value for money rather than to simply realize the lowest cost.
 Activity-Based Costing (ABC) Method
• Activity-based costing is a more specific way of allocating overhead costs based
on “activities” that actually contribute to overhead costs.
• Overhead costs are applied based on a specific cost driver such as labor hours or
machine hours.
• An activity is an event, task, or unit of work with a specific purpose, whether it be
designing products, setting up machines, operating machines, or distributing
products. Therefore, activity-based costing considers all the potential activities
instead of relying on just one variable (for example, labor hours or machine
hours).
• Generally, activity-based costing is used in the manufacturing industry, as it
produces more accurate cost data, generating values that are close to the true
cost and can be identified during the production phase.
Activity-Based Costing (ABC) Method

Definition :

Activity-Based Costing (ABC) is a cost allocation method that assigns

costs to products or services based on the actual activities and
processes involved in producing them. Unlike traditional methods that
use broad averages, ABC identifies specific activities that consume
resources and links costs directly to those activities.
Key Aspects of Activity-Based Costing:

1. Identifying Activities: ABC involves identifying all the activities in an organization

that contribute to the production of goods or services.
2. Determining Cost Drivers: Cost drivers are factors that cause the incurrence of costs
in various activities. ABC identifies these drivers for each activity.
3. Allocating Costs: Costs are allocated to products or services based on the actual
consumption of resources in specific activities. This provides a more accurate
reflection of the cost structure.
4. Enhanced Precision: ABC is particularly useful in situations where products or
services have diverse production processes, and traditional costing methods may
lead to distortions.
Activity-Based Costing (ABC) Method

Example:

Consider a manufacturing company that produces two products, X and Y. The

manager identifies the following activities:
• Material Handling: The activity of moving raw materials to the production
area.
• Machine Setup: The activity of setting up machines for production.
• Quality Inspection: The activity of inspecting finished products for quality.

The company allocates costs to each product based on the actual

consumption of resources in these activities. If Product X requires more
machine setup time, it will be assigned a higher share of the machine setup
costs.
Activity-Based Costing (ABC) Method

ABC provides a more accurate understanding of the costs associated

with each activity, allowing organizations to make informed decisions
about pricing, product mix, and process improvement. It is especially
valuable in complex production environments with diverse activities.
Rational Imputation of Fixed Costs

Rational imputation of fixed costs refers to a method of allocating fixed

costs to products or services based on a logical and justifiable rationale.
Unlike arbitrary methods, rational imputation involves a systematic
approach to distribute fixed costs in a way that reflects the actual
consumption of resources by each product or service.
 Rational Imputation of Fixed Costs

• Identifying Cost Drivers: Cost drivers are factors that influence the
incurrence of fixed costs. Rational imputation involves identifying these
drivers.
• Establishing Relationships: There is an effort to establish clear
relationships between the fixed costs and the activities or factors that
drive those costs.
• Allocation Basis: Rational imputation selects a reasonable and relevant
allocation basis to distribute fixed costs. This could be based on machine
hours, labor hours, production volume, or any other metric closely
related to cost incurrence.
Example of Rational Imputation of Fixed Costs

Consider a manufacturing company with two products, A and B. The fixed costs
include factory rent, which is driven by the area occupied by each product.

• Identify Cost Driver: Area occupied by products (square footage).

• Relationship: The more space a product occupies, the higher the portion of
fixed costs it should bear.
• Allocation Basis: Allocate fixed costs based on the square footage each
product uses.

This method ensures that products occupying more space contribute a larger
share of the fixed costs, aligning with the resources they consume.
Responsibility Centers and transfer pricing

Responsibility centers are organizational units or segments to which

management delegates authority and assigns responsibility for the
performance of specific tasks or activities.

• Types of Responsibility Centers:

• Cost Centers: Responsible for controlling costs.
• Revenue Centers: Responsible for generating revenues.
• Profit Centers: Responsible for both costs and revenues, aiming for profit.
• Investment Centers: Responsible for managing costs, revenues, and assets,
focusing on return on investment.
 Responsibility center

Relationship between inputs and outputs:

Management is responsible for ensuring the optimum relationship between inputs and
outputs. In some centers, the responsibility is casual and direct, as in the case of production
department
 Example

Inputs of raw materials become part of the finished goods. Hence, the control focus on
using the minimum input necessary to produce the required output according to the
correct specification and quality standards.
In many situations, inputs are not directly related to outputs e.g. advertising expenses
through an input to increase sales revenue but there are so many factors other than
advertising, the relationship between increased advertising and any subsequent
increase in revenue is not always demonstrable and the management’s decision to
increase advertising expenditure is based on judgement rather than data.
Similarly, the relationship between inputs and outputs is even more ambiguous in case
of R&D since the money spent on today’s R&D may not be known for several years and
hence the optimum sum any organization should spent for R&D is undeterminable.
 Transfer pricing

Transfer pricing is the process of determining the price at which goods are
transferred from one profit center (selling division) to another profit center
(buying division) within the same company.

Transfer pricing is the method used to set prices for goods, services, or assets
transferred between different divisions or entities within the same organization. It
is crucial in organizations with multiple divisions or subsidiaries.

Companies use transfer prices for internal purposes (to coordinate transfers
within the firm) and for external purposes (reporting to tax authorities).
 Transfer pricing

A transfer price is defined as “the price that is assumed to have been

charged by one part of a company for products and services it provides to
another part of the same company, in order to calculate each division's
profit and loss separately.” The main objective of transfer pricing is to aid in
the proper distribution of revenue between profit centers.

Proper transfer pricing ensures that each division is fairly compensated for
its contributions, encourages optimal performance, and supports accurate
financial reporting for the organization as a whole. It helps in evaluating the
profitability of individual units and aligning their goals with overall
organizational objectives.
 Transfer pricing

Methods of Transfer Pricing:

• Cost-Based Methods: Setting transfer prices based on the cost of production.
• Market-Based Methods: Using external market prices as a benchmark for internal
transfer prices.
• Negotiated Methods: Setting transfer prices through negotiation between the
involved parties.
Example: Consider a company with separate divisions for manufacturing and distribution.
The manufacturing division produces goods, and the distribution division sells those
goods to external customers. Transfer pricing determines the price at which goods are
transferred from manufacturing to distribution.
Objectives of Transfer Pricing
In particular, transfer price should be designed in such a way that it can
accomplish the following objectives:
1. It should provide each segment with the relevant information required to
determine the optimum trade-off between company costs and revenues.
2. It should induce goal congruence decisions i.e., the system should be so
designed that decision improves business unit (divisional) profits it will
also improve company profit.
3. It should help determine the economic performance of the individual
profit centers as accurately as possible.
4. The system should be simple to understand and easy to administer
To sum up
• Variable Costing: Considers only variable manufacturing costs as product
costs.
• Treatment of Fixed Costs: Fixed manufacturing overhead costs are treated as period
costs.
• Use: Often used for internal decision-making and managerial control.

• Absorption Costing: Allocates all manufacturing costs (variable and fixed)

to products.
• Treatment of Fixed Costs: Fixed manufacturing overhead costs are part of product
costs.
• Use: Commonly used for external financial reporting.
To sum up
• Marginal Costing: Emphasizes variable costs and contribution margin for decision-
making.
• Treatment of Fixed Costs: Fixed costs are treated as period costs and are not
assigned to products.
• Use: Valuable for short-term decision-making and assessing contribution to cover
fixed costs.
• Target Costing Method: Sets target costs based on market conditions and desired
profit margin.
• Treatment of Fixed Costs: Fixed costs are considered in the cost determination
process.
• Use: Strategic approach for pricing products to align with market expectations.
To sum up

• Activity-Based Costing (ABC) Method: Allocates costs based on

activities and resource consumption.

• Treatment of Fixed Costs: Both variable and fixed costs are linked to activities
and products.
• Use: Provides accurate product costs by considering diverse cost drivers and
activities.
To sum up
Application Areas:

• Variable Costing and Marginal Costing: Internal decision-making, short-term

planning.

• Absorption Costing: External financial reporting, inventory valuation.

• Target Costing: Strategic pricing to align with market demands.

• Activity-Based Costing (ABC): Accurate product costing by analyzing diverse

activities.