A to Z Costing Knowledge Glossary — Letter T
Investopedia-style costing concepts explained with formulas, practical examples, comparisons, and exam-focused teaching tips.
1 Target Costing
| Category | Contemporary Costing / Pricing |
|---|---|
| Best Used In | New product development, pricing under competition |
| Key Formula | Target Cost = Target Selling Price − Desired Profit Margin |
| Exam Importance | High |
Target Costing is a cost management technique that determines the allowable cost for a product or service, given a market-based selling price and a desired profit margin.
It starts with the price customers are willing to pay, subtracts the required profit, and arrives at the target cost that must be achieved through design, engineering, and process improvement.
- New product development
- Competitive pricing in consumer markets
- Cost reduction through design changes
A company plans to launch a new smartphone. Market research shows customers will pay ₹20,000. Desired profit margin is 20% (₹4,000). Target cost = 20,000 − 4,000 = ₹16,000. The design team must ensure the product can be made within ₹16,000.
Target selling price ₹500; desired profit 25% on selling price = ₹125. Target cost = 500 − 125 = ₹375. If current estimated cost is ₹410, the company must reduce cost by ₹35 through value engineering.
- Determine target selling price based on market research.
- Determine desired profit margin (either % of sales or absolute).
- Subtract profit from price to get target cost.
- Compare current cost estimate with target cost.
- Implement cost reduction strategies to close the gap.
| Target Costing vs. Cost-Plus Pricing | Cost-plus adds margin to cost; target costing subtracts margin from price. |
|---|---|
| Target Costing vs. Standard Costing | Standard costing is internal; target costing is market-driven. |
2 Target Profit
| Category | CVP Analysis / Planning |
|---|---|
| Best Used In | Determining required sales for desired profit |
| Key Formula | Required Sales (units) = (Fixed Costs + Target Profit) / Contribution per Unit |
| Exam Importance | High |
Target Profit is the amount of profit a company aims to achieve in a period, used in CVP analysis to determine the required sales volume or revenue to reach that goal.
It goes beyond break-even by adding the desired profit to fixed costs, then dividing by contribution margin to find the necessary sales level.
- Setting sales targets
- Profit planning
- Evaluating feasibility of business plans
A company wants to earn ₹1,00,000 profit. Fixed costs ₹2,00,000, contribution per unit ₹20. Required sales = (2,00,000 + 1,00,000) / 20 = 15,000 units.
Fixed costs ₹1,50,000, desired profit ₹50,000, contribution per unit ₹25. Required units = (1,50,000+50,000)/25 = 8,000 units. If selling price ₹60, required sales value = 8,000 × 60 = ₹4,80,000.
Required Sales (₹) = Fixed Costs + Target ProfitP/V Ratio
- Compute fixed costs and contribution per unit (or P/V ratio).
- Add target profit to fixed costs.
- Divide by contribution per unit to get required units.
- Alternatively, divide by P/V ratio for sales value.
- Assess achievability based on market demand.
| Target Profit vs. Break-Even Point | Break-even is zero profit; target profit adds desired profit to fixed costs. |
|---|---|
| Target Profit vs. Actual Profit | Actual profit is after the fact; target profit is a goal. |
3 Taylor Differential Piece Rate System
| Category | Labour Incentive Scheme |
|---|---|
| Best Used In | Motivating workers, productivity-based pay |
| Key Formula | Higher piece rate for above standard, lower for below standard |
| Exam Importance | Medium |
Taylor’s Differential Piece Rate System is an incentive scheme where a worker is paid a higher piece rate for output above standard and a lower piece rate for output below standard, encouraging higher productivity.
It sets two piece rates: a high rate (e.g., 120% of ordinary rate) for workers who meet or exceed standard output, and a low rate (e.g., 80% of ordinary rate) for those who produce below standard.
- Manufacturing with measurable output per worker
- Labour cost control
- Encouraging high productivity
Standard output per day = 20 units. Ordinary piece rate ₹10/unit. High rate = ₹12/unit (120%), low rate = ₹8/unit (80%). If worker produces 25 units, earnings = 25 × 12 = ₹300. If produces 15 units, earnings = 15 × 8 = ₹120, significantly penalizing low output.
Standard output 50 units/day. High piece rate ₹5/unit (above standard), low rate ₹3/unit (below standard). Worker A produces 60 units → 60×5 = ₹300. Worker B produces 40 units → 40×3 = ₹120. Big difference rewards efficiency.
- Set standard output per day.
- Determine ordinary piece rate.
- Set high and low differential rates (e.g., 120% and 80%).
- Compare worker’s actual output with standard.
- Multiply output by appropriate rate to get earnings.
| Taylor vs. Halsey Plan | Taylor is piece-rate based, no guaranteed time wage; Halsey guarantees time wage plus bonus for time saved. |
|---|---|
| Taylor vs. Rowan Plan | Rowan gives bonus based on time saved; Taylor pays entirely by output with differential rates. |
4 Theory of Constraints (TOC)
| Category | Management Philosophy / Throughput Accounting |
|---|---|
| Best Used In | Improving throughput by managing bottlenecks |
| Key Formula | Throughput = Sales Revenue − Direct Material Cost |
| Exam Importance | Medium |
Theory of Constraints (TOC) is a management philosophy that focuses on identifying and managing the bottleneck (constraint) that limits a system’s throughput, and optimizing the system around that constraint.
TOC emphasizes that every system has at least one constraint; improving non-constraints does not improve overall throughput. The five focusing steps guide continuous improvement.
- Production scheduling and capacity planning
- Throughput accounting and profitability analysis
- Process improvement in manufacturing and services
A factory identifies a bottleneck machine that can process only 100 units/hour while other machines can do 150. TOC focuses on maximizing the bottleneck’s output, scheduling to its capacity, and ensuring no idle time on it.
Bottleneck operation has capacity 80 units/day; other operations 100+ units/day. Throughput is limited to 80/day. TOC improves bottleneck by adding a second shift or reducing setup time, increasing overall output.
- Identify the constraint (bottleneck).
- Exploit the constraint (maximize its throughput).
- Subordinate other processes to the constraint.
- Elevate the constraint (add capacity).
- Repeat if a new constraint emerges.
| TOC vs. Lean Manufacturing | Lean focuses on waste elimination; TOC focuses on bottleneck management. |
|---|---|
| TOC vs. Traditional Costing | Traditional allocates all costs; TOC uses throughput accounting, focusing on throughput and minimizing inventory. |
5 Throughput Accounting
| Category | Contemporary Costing / Decision Making |
|---|---|
| Best Used In | Profitability analysis under constraints |
| Key Formula | Throughput = Sales Revenue − Direct Material Cost |
| Exam Importance | Medium |
Throughput Accounting is a management accounting approach based on the Theory of Constraints, focusing on throughput (sales minus direct materials), investment (inventory), and operating expenses.
It treats only direct materials as variable costs; all other costs are considered fixed operating expenses. Profitability is measured by throughput per unit of the constrained resource.
- Product mix decisions under capacity constraints
- Profitability analysis in bottleneck environments
- Replacing traditional absorption costing in lean/JIT contexts
A company with a bottleneck machine evaluates two products. Product A: throughput ₹500/unit, uses 5 machine hours; Product B: ₹800/unit, uses 10 hours. Throughput per hour: A = ₹100, B = ₹80. Prioritize A.
Sales ₹1,000/unit, direct material ₹400/unit, labour and overhead (fixed) ₹300/unit. Throughput = 600/unit. If bottleneck time is 2 hours/unit, throughput per hour = ₹300. Decisions rank products by this measure.
Profit = Throughput − Operating Expenses
- Compute throughput per unit = selling price − direct material.
- Identify the bottleneck resource.
- Calculate throughput per unit of bottleneck (e.g., per hour).
- Rank products by throughput per bottleneck unit.
- Allocate bottleneck capacity to maximize total throughput.
| Throughput Accounting vs. Absorption Costing | Absorption treats all manufacturing costs as product cost; throughput treats only direct material as variable. |
|---|---|
| Throughput Accounting vs. Marginal Costing | Marginal costing includes all variable costs; throughput only includes direct material. |
6 Throughput Contribution
| Category | Throughput Accounting |
|---|---|
| Best Used In | Measuring product profitability in TOC |
| Key Formula | Throughput Contribution = Sales Revenue − Direct Material Cost |
| Exam Importance | Low |
Throughput Contribution is the amount remaining after deducting direct material cost from sales revenue, representing the cash generated by a product that contributes to covering operating expenses and profit.
It is a core measure in throughput accounting; all other costs are treated as fixed and not allocated to products, simplifying decisions to focus on material cost only.
- Product mix decisions under constraints
- Profitability analysis in bottleneck environments
- Throughput accounting reports
A product sells for ₹500, direct material cost ₹200, so throughput contribution = ₹300. This ₹300 is what the product contributes to paying fixed operating expenses.
Product X: selling price ₹800, direct material ₹350 → throughput contribution ₹450. Product Y: selling price ₹600, direct material ₹300 → throughput contribution ₹300. X is preferred if bottleneck capacity is limited.
- Determine selling price per unit.
- Determine direct material cost per unit.
- Subtract material cost from sales to get throughput contribution.
- Use as basis for ranking products when a constraint exists.
- Deduct total operating expenses from total throughput to get profit.
| Throughput Contribution vs. Contribution Margin | Contribution margin = sales − all variable costs; throughput contribution = sales − direct material only. |
|---|---|
| Throughput Contribution vs. Gross Profit | Gross profit = sales − cost of goods sold (includes labour and overhead); throughput contribution excludes all but material. |
7 Time and Motion Study
| Category | Industrial Engineering / Labour Costing |
|---|---|
| Best Used In | Setting standard times, improving work methods |
| Key Formula | Standard Time = Basic Time + Allowances |
| Exam Importance | Medium |
Time and Motion Study is a technique used to determine the standard time required to perform a job by analyzing its component motions and adding allowances for rest and contingencies.
It combines time study (measuring time required) and motion study (analyzing body movements) to improve efficiency and set performance standards for labour.
- Setting labour standard times
- Improving work methods and ergonomics
- Determining labour rates and incentive schemes
A time and motion study of assembling a product determines the basic time as 5 minutes. After adding 15% allowance for fatigue and personal needs, standard time = 5 + 0.75 = 5.75 minutes per unit.
Basic time for a task 10 minutes. Allowances: personal 5%, fatigue 5%, contingency 5% → total 15%. Standard time = 10 × 1.15 = 11.5 minutes. Used to set piece rates or efficiency standards.
- Break the job into basic motions.
- Measure basic time using stopwatch or predetermined motion time systems.
- Determine allowance factors (personal, fatigue, delay).
- Apply allowances to basic time to get standard time.
- Use standard time for labour cost, budgeting, and incentive calculations.
| Time Study vs. Motion Study | Time study measures how long; motion study analyzes how movements can be improved. |
|---|---|
| Time and Motion Study vs. Work Measurement | Work measurement is broader, including time study and other techniques. |
8 Time Sheet
| Category | Labour Time Record |
|---|---|
| Best Used In | Recording time spent on jobs or tasks |
| Key Formula | No formula; document listing jobs, times, and worker |
| Exam Importance | Low |
A Time Sheet is a document used to record the amount of time a worker spends on different jobs or activities during a period, supporting labour cost allocation and payroll.
It summarizes hours worked per job for each worker, often used in professional services and where workers move between multiple tasks.
- Professional services (audit, consulting)
- Job costing and labour cost allocation
- Payroll processing and billing clients
An accountant fills a timesheet showing 3 hours on Client A, 2 hours on Client B, and 1 hour on internal training. The 3 hours on Client A are billed accordingly.
Timesheet for Worker X: Job 1 – 4 hrs, Job 2 – 3 hrs, Job 3 – 1 hr. Total 8 hrs. Labour cost allocated to jobs based on these hours at the worker’s rate.
- Prepare timesheet with employee name and date.
- Record time spent on each job or task.
- Verify total hours with attendance records.
- Use to allocate labour cost to jobs or bill clients.
- Summarize for payroll and costing.
| Time Sheet vs. Job Card | Job card is typically per job; timesheet lists multiple jobs for a worker in a period. |
|---|---|
| Time Sheet vs. Clock Card | Clock card records attendance; timesheet records job-wise time. |
9 Time Value of Money
| Category | Financial Concept / Capital Budgeting |
|---|---|
| Best Used In | Discounting cash flows, investment appraisal |
| Key Formula | PV = FV / (1 + r)^n |
| Exam Importance | High |
Time Value of Money (TVM) is the principle that a rupee today is worth more than a rupee in the future due to its earning potential (interest) and inflation.
TVM underlies all discounted cash flow techniques; it requires adjusting future cash flows to their present value using a discount rate that reflects the required return.
- Net Present Value and Internal Rate of Return
- Valuing bonds, leases, and annuities
- Comparing cash flows at different times
If you receive ₹1,10,000 after one year and the required return is 10%, the present value is 1,10,000 / 1.1 = ₹1,00,000. So ₹1,00,000 today is equivalent to ₹1,10,000 in a year.
Future cash inflow ₹2,00,000 after 3 years; discount rate 8%. PV = 2,00,000 / (1.08)^3 ≈ ₹1,58,766. This is used in NPV calculations.
Future Value = Present Value × (1 + r)^n
- Identify future cash flow and timing.
- Determine discount rate (cost of capital or required return).
- Apply formula to compute present value.
- Use present values to compare projects or investments.
- Understand that higher discount rate reduces present value.
| Time Value of Money vs. Inflation | Inflation is a general rise in prices; TVM encompasses opportunity cost and inflation. |
|---|---|
| Present Value vs. Future Value | PV is today’s worth of future money; FV is future worth of today’s money. |
10 Total Cost
| Category | Cost Concept |
|---|---|
| Best Used In | Cost sheet, pricing, decision making |
| Key Formula | Total Cost = Direct Material + Direct Labour + Direct Expenses + Overheads |
| Exam Importance | Very High |
Total Cost is the sum of all costs incurred to produce and sell a product or service, including direct costs and all overheads.
It represents the complete monetary sacrifice for a cost object, used for pricing, profitability analysis, and external reporting under absorption costing.
- Cost sheet preparation
- Pricing decisions (cost-plus)
- Profitability analysis
A company calculates total cost per unit by adding prime cost (direct material + labour + expenses) and all production, admin, selling, and distribution overheads.
Direct material ₹50, direct labour ₹30, direct expenses ₹5, production overhead ₹15, admin overhead ₹10, selling overhead ₹5. Total cost = ₹115 per unit.
- Compute prime cost (direct material + labour + expenses).
- Add production overheads to get works cost.
- Add administrative overheads to get cost of production.
- Add selling and distribution overheads to get total cost.
- Use for pricing, valuation, and decision making.
| Total Cost vs. Marginal Cost | Marginal cost includes only variable costs; total cost includes fixed and variable. |
|---|---|
| Total Cost vs. Cost of Goods Sold | COGS is cost of units sold; total cost includes unsold inventory too. |
11 Total Fixed Cost
| Category | Cost Behaviour |
|---|---|
| Best Used In | Break-even analysis, budgeting |
| Key Formula | Total Fixed Cost = Sum of all fixed expenses |
| Exam Importance | High |
Total Fixed Cost is the sum of all costs that remain constant in total regardless of changes in activity level within the relevant range.
Examples include rent, insurance, salaries of permanent staff, and depreciation. Total fixed cost does not change with production volume, though fixed cost per unit changes inversely.
- Break-even and CVP analysis
- Budgeting and cost control
- Determining cost structure and operating leverage
A company has monthly rent ₹50,000, salaries ₹1,00,000, insurance ₹10,000, depreciation ₹20,000. Total fixed cost = ₹1,80,000 per month, regardless of production volume.
Fixed costs: rent ₹30,000, salaries ₹60,000, utilities ₹10,000 (fixed portion), depreciation ₹15,000. Total fixed cost ₹1,15,000. Used in BEP: if contribution per unit ₹50, BEP units = 1,15,000/50 = 2,300 units.
- Identify all costs that do not vary with production.
- Sum them to get total fixed cost.
- Use in break-even formula: BEP units = Total Fixed Cost / Contribution per unit.
- Compute fixed cost per unit at different activity levels for decision making.
- Analyze fixed cost changes when capacity changes.
| Total Fixed Cost vs. Fixed Cost per Unit | Total fixed cost is constant; fixed cost per unit decreases as volume increases. |
|---|---|
| Total Fixed Cost vs. Total Variable Cost | Variable cost changes with volume; fixed cost remains constant. |
12 Total Variable Cost
| Category | Cost Behaviour |
|---|---|
| Best Used In | Contribution calculation, CVP analysis |
| Key Formula | Total Variable Cost = Variable Cost per Unit × Number of Units |
| Exam Importance | High |
Total Variable Cost is the total cost that changes in direct proportion to the level of activity or output, such as raw materials, direct labour (if hourly), and variable overheads.
It is calculated by multiplying variable cost per unit by the number of units produced or sold. It increases or decreases with volume.
- Contribution margin calculation
- Break-even and target profit analysis
- Flexible budgeting
Variable cost per unit ₹25; production 5,000 units. Total variable cost = 25 × 5,000 = ₹1,25,000. If production increases to 6,000, total variable cost becomes ₹1,50,000.
Direct material ₹10/unit, direct labour ₹5/unit, variable overhead ₹3/unit. Total variable cost per unit = ₹18. For 4,000 units, total variable cost = ₹72,000.
- Identify all variable cost elements per unit.
- Sum to get variable cost per unit.
- Multiply by actual activity level.
- Use in contribution formula: Contribution = Sales − Total Variable Cost.
- Use for flexible budgeting and variance analysis.
| Total Variable Cost vs. Variable Cost per Unit | Per unit is constant; total changes with volume. |
|---|---|
| Total Variable Cost vs. Total Fixed Cost | Fixed cost remains constant; variable cost changes with volume. |
13 Total Quality Management (TQM)
| Category | Quality Management Philosophy |
|---|---|
| Best Used In | Improving quality and reducing quality costs |
| Key Formula | No formula; continuous improvement philosophy |
| Exam Importance | Medium |
Total Quality Management (TQM) is a management approach that focuses on continuous improvement, customer satisfaction, and involvement of all employees to achieve high quality and reduce costs.
TQM integrates quality into all processes, aiming for zero defects and reducing prevention, appraisal, and failure costs. It is a long-term commitment to quality.
- Quality cost reduction
- Improving customer satisfaction
- Creating a quality culture
A company implements TQM by training employees in quality tools, encouraging suggestions for process improvement, and focusing on defect prevention rather than inspection. This reduces rework and warranty costs over time.
Before TQM, external failure costs ₹5,00,000. After TQM, prevention costs increase by ₹1,00,000, but external failure drops to ₹1,00,000, saving ₹3,00,000 net.
- Train employees on quality principles and tools.
- Empower workers to identify and solve quality problems.
- Focus on prevention rather than inspection.
- Measure and report quality costs regularly.
- Continuously improve processes to reduce total quality cost.
| TQM vs. Six Sigma | Six Sigma uses statistical methods to reduce defects; TQM is broader and more cultural. |
|---|---|
| TQM vs. Quality Control | Quality control is inspection-based; TQM is prevention-based and organization-wide. |
14 Total Quality Costs
| Category | Cost of Quality |
|---|---|
| Best Used In | Quality cost reporting, improvement analysis |
| Key Formula | Total Quality Costs = Prevention + Appraisal + Internal Failure + External Failure |
| Exam Importance | Medium |
Total Quality Costs are the sum of all costs associated with preventing, detecting, and correcting defects, including both the cost of good quality (prevention, appraisal) and poor quality (internal and external failure).
Managing total quality costs involves balancing prevention and appraisal against failure costs; often, investing in prevention reduces total quality costs significantly.
- Quality cost reporting
- Justifying investment in quality programs
- Identifying areas for cost reduction
A company calculates its total quality costs and finds high failure costs. By increasing prevention (training), it reduces internal and external failure, lowering total quality costs overall.
Prevention ₹50,000; appraisal ₹30,000; internal failure ₹40,000; external failure ₹80,000. Total quality costs = ₹2,00,000. Analysis shows external failure is highest; more prevention can reduce it.
- Collect data on each quality cost category.
- Classify costs into prevention, appraisal, internal failure, external failure.
- Sum each category.
- Compute total quality costs.
- Analyze trends and implement improvements.
| Prevention vs. Appraisal Costs | Prevention avoids defects; appraisal detects defects. |
|---|---|
| Internal vs. External Failure Costs | Internal found before delivery; external after delivery. |
15 Traceable Cost
| Category | Cost Classification |
|---|---|
| Best Used In | Segment profitability, responsibility accounting |
| Key Formula | Traceable cost = Cost directly identifiable to a specific cost object |
| Exam Importance | Low |
A Traceable Cost is a cost that can be directly identified with a specific cost object (product, department, segment) using objective tracing methods, without allocation.
Similar to direct cost, but in segment reporting, traceable fixed costs are those that can be traced to a segment and would disappear if the segment were eliminated.
- Segment profitability analysis
- Discontinuation decisions
- Responsibility accounting
A retail chain traces store manager salaries and store rent to each store. These are traceable costs for the store. Head office costs are not traceable to individual stores and are treated as common.
Segment A has traceable sales ₹10,00,000, traceable variable costs ₹6,00,000, and traceable fixed costs ₹1,00,000. Segment margin = 10,00,000 − 6,00,000 − 1,00,000 = ₹3,00,000. This margin is used to assess segment performance.
- Identify the cost object (product, department, segment).
- Determine if the cost can be directly traced to it.
- Classify as traceable if yes.
- Use for segment margin calculation.
- Exclude common costs from segment performance.
| Traceable Cost vs. Common Cost | Common cost benefits multiple objects and cannot be traced; traceable can be directly identified. |
|---|---|
| Traceable Fixed vs. Direct Fixed Cost | Traceable fixed cost may be avoidable if segment eliminated; direct fixed is traceable but may not be avoidable. |
16 Traditional Costing
| Category | Costing Methodology |
|---|---|
| Best Used In | Simple overhead allocation, absorption costing |
| Key Formula | Overhead rate = Total overheads / Total volume-based driver (e.g., labour hours) |
| Exam Importance | Medium |
Traditional Costing is a costing method that allocates manufacturing overhead to products using a single volume-based cost driver, such as direct labour hours, machine hours, or units produced.
It assumes that overheads are driven by volume, which may be inaccurate for complex products with varying overhead consumption. It is still widely used due to simplicity.
- Absorption costing for external reporting
- Small or homogeneous product lines
- Where overhead is a small proportion of total cost
A simple factory with one product line uses a plant-wide overhead rate based on direct labour hours to allocate all overhead to products. This works fine when overheads are low and homogeneous.
Total overhead ₹1,00,000; total direct labour hours 20,000. Overhead rate = ₹5 per labour hour. Product using 10 hours absorbs ₹50 overhead, regardless of actual overhead consumption.
- Estimate total manufacturing overhead.
- Select a single volume-based driver.
- Estimate total driver units for the period.
- Compute overhead rate.
- Apply rate to products based on actual driver usage.
| Traditional Costing vs. Activity-Based Costing | ABC uses multiple cost drivers; traditional uses one volume-based rate, leading to less accurate costing in complex environments. |
|---|---|
| Traditional Costing vs. Throughput Accounting | Throughput accounting treats only direct material as variable; traditional allocates all overheads. |
17 Transfer Price
| Category | Responsibility Accounting / Performance Measurement |
|---|---|
| Best Used In | Internal transactions between divisions |
| Key Formula | Transfer Price = Price charged for goods/services between divisions |
| Exam Importance | High |
Transfer Price is the price at which goods or services are transferred between divisions or departments within the same organization, affecting each division’s reported performance.
It serves as an internal price mechanism, influencing divisional profits, resource allocation, and decision making. Transfer prices can be based on market prices, cost, or negotiated amounts.
- Divisional performance evaluation
- Resource allocation and coordination
- Tax planning (in multinationals)
Division A produces a component used by Division B. The transfer price set at market price ₹100 ensures both divisions are evaluated fairly, as if transacting externally.
Division A capacity 1,000 units, market price ₹80, variable cost ₹60. Division B needs 500 units and can buy externally at ₹80. Minimum transfer price for A = variable cost ₹60; maximum B willing to pay = ₹80. Negotiated range ₹60-80.
Maximum Transfer Price (for buyer) = External Market Price
- Identify the transfer situation and whether seller has excess capacity.
- If excess capacity: minimum transfer = variable cost.
- If full capacity: minimum transfer = variable cost + lost contribution (opportunity cost).
- Compare with external market price buyer would pay.
- Set transfer price within this range, considering divisional autonomy and goal congruence.
| Transfer Price vs. Market Price | Transfer price is internal; market price is external. |
|---|---|
| Transfer Price vs. Cost-Plus Price | Cost-plus adds markup; transfer price may be cost-based or market-based. |
18 Transfer Pricing
| Category | Performance Measurement / Tax Planning |
|---|---|
| Best Used In | Setting internal transaction prices |
| Key Formula | Methods: market-based, cost-based, negotiated |
| Exam Importance | Medium |
Transfer Pricing is the process of setting transfer prices for goods and services exchanged between divisions, affecting divisional profits, performance evaluation, and tax liabilities in multinational companies.
It involves selecting an appropriate method (market, cost-plus, negotiated) that aligns divisional goals with overall corporate objectives and complies with tax regulations (arm’s length principle).
- Multinational corporations managing tax
- Divisional performance measurement
- Resource allocation decisions
A multinational sets transfer prices for inter-company sales using the arm’s length principle (market price). This ensures each entity’s profit reflects its economic contribution and complies with tax authorities.
Subsidiary A in low-tax country manufactures and transfers to Subsidiary B in high-tax country. By setting high transfer price, profits shift to A, reducing overall tax. Tax authorities require arm’s length pricing to prevent abuse.
- Identify the transaction between related parties.
- Select appropriate transfer pricing method (market, cost-plus, etc.).
- Determine the transfer price using chosen method.
- Ensure compliance with tax regulations (arm’s length).
- Review and document for audit purposes.
| Transfer Pricing vs. Transfer Price | Transfer pricing is the process; transfer price is the amount. |
|---|---|
| Market-based vs. Cost-based Transfer Pricing | Market-based uses external market; cost-based uses cost plus markup. |
19 Two-bin System
| Category | Inventory Control |
|---|---|
| Best Used In | Simple replenishment of small items |
| Key Formula | Re-order when first bin is empty; second bin contains re-order quantity |
| Exam Importance | Low |
The Two-bin System is an inventory control method where each item is stored in two bins; when the first bin is empty, it triggers a re-order, and the second bin contains enough stock to cover demand during lead time.
It is a visual, simple replenishment system used for low-value, frequently used items; it reduces the need for detailed perpetual records.
- Maintenance and repair supplies
- Low-value, high-usage items (nuts, bolts)
- Simplify inventory management
A storekeeper keeps two bins of screws. When Bin 1 is empty, a purchase order is placed. Bin 2 holds enough screws (re-order quantity) to cover usage during the supplier’s lead time.
Bin 1 contains stock for immediate use; Bin 2 contains 200 units (re-order quantity). When Bin 1 empty, order 200 units. During lead time, Bin 2 supply used. When new stock arrives, Bin 2 is replenished, and remainder goes to Bin 1.
- Determine re-order quantity based on demand and lead time.
- Place that quantity in Bin 2.
- Place remaining stock in Bin 1.
- When Bin 1 empty, issue purchase order for re-order quantity.
- Use Bin 2 stock during lead time; replenish both bins upon receipt.
| Two-bin vs. Perpetual Inventory System | Perpetual uses continuous records; two-bin is visual and simple. |
|---|---|
| Two-bin vs. Kanban | Kanban is similar pull system but used in JIT; two-bin is simpler. |
20 Turnover
| Category | Performance Measurement / Financial Term |
|---|---|
| Best Used In | Sales revenue, asset efficiency |
| Key Formula | Turnover = Total Sales Revenue or Asset Turnover = Sales / Average Total Assets |
| Exam Importance | Medium |
Turnover generally refers to the total sales revenue generated by a business over a period. In ratio analysis, asset turnover measures how efficiently assets generate sales.
In costing and management, turnover often means total sales. Asset turnover ratio is used in profitability analysis (ROI = Net Profit Margin × Asset Turnover).
- Income statement reporting
- Asset efficiency analysis
- ROI decomposition
A company has total sales ₹50,00,000 and average total assets ₹25,00,000. Asset turnover = 50,00,000/25,00,000 = 2 times, indicating each rupee of assets generates ₹2 of sales.
Sales ₹10,00,000; average assets ₹5,00,000. Asset turnover = 2. If net profit margin is 10%, ROI = 10% × 2 = 20%.
Turnover (Sales) = Total revenue from operations
- Determine total sales revenue.
- Determine average total assets (opening + closing /2).
- Divide sales by assets to get turnover ratio.
- Interpret efficiency of asset use.
- Combine with net profit margin for ROI analysis.
| Turnover vs. Profit | Turnover is sales; profit is after expenses. |
|---|---|
| Asset Turnover vs. Inventory Turnover | Inventory turnover = COGS / Average Inventory; asset turnover includes all assets. |
21 Total Absorption Costing
| Category | Costing Methodology |
|---|---|
| Best Used In | External reporting, inventory valuation |
| Key Formula | Total absorption cost = All manufacturing costs (fixed + variable) absorbed into product |
| Exam Importance | High |
Total Absorption Costing is an absorption costing method where both fixed and variable manufacturing overheads are included in the cost of products, ensuring full cost recovery.
It treats all manufacturing costs as product costs, contrasting with marginal costing where fixed overheads are period costs. It is required for external financial reporting.
- Inventory valuation under financial reporting
- Long-term pricing decisions
- Cost audit and regulatory filings
A company values closing stock at full absorption cost, including fixed factory overhead. This affects profit when inventory levels change, reconciling to financial accounting.
Direct material ₹50, direct labour ₹30, variable overhead ₹20, fixed overhead ₹10 (absorbed). Total absorption cost per unit = ₹110. Under marginal costing, cost would be ₹100 (excluding fixed).
- Compute direct material and labour costs.
- Compute variable manufacturing overhead.
- Compute fixed manufacturing overhead absorption rate based on normal capacity.
- Add all to get total absorption cost.
- Use for inventory valuation and external reporting.
| Total Absorption vs. Marginal Costing | Marginal excludes fixed production overhead from product cost. |
|---|---|
| Total Absorption vs. Activity-Based Costing | ABC is a refined absorption method using multiple drivers. |
22 Target Rate of Return
| Category | Pricing / Investment Decision |
|---|---|
| Best Used In | Setting prices to achieve desired ROI |
| Key Formula | Selling Price = Cost per Unit + (Desired ROI × Investment) / Expected Sales |
| Exam Importance | Low |
Target Rate of Return is a pricing method where the selling price is set to achieve a predetermined return on investment (ROI), by adding a margin based on the required return on capital employed.
It is a cost-plus approach that explicitly considers the desired return on investment, ensuring that prices cover costs and provide the targeted profit.
- Pricing products with high capital investment
- Setting long-term pricing policies
- Evaluating product profitability against ROI targets
Company invests ₹10,00,000 in a product line; desired ROI 20% = ₹2,00,000. Expected sales 10,000 units. Required profit per unit = 2,00,000/10,000 = ₹20. If cost per unit ₹50, selling price = ₹70.
Investment ₹5,00,000; target ROI 15% → required profit ₹75,000. Expected sales 5,000 units → profit ₹15/unit. Cost per unit ₹30 → selling price ₹45.
- Determine total investment and target ROI.
- Compute total required profit = Investment × ROI.
- Divide by expected unit sales to get required profit per unit.
- Add to cost per unit to set selling price.
- Adjust for market competition.
| Target Rate of Return vs. Cost-Plus Pricing | Cost-plus uses arbitrary markup; target rate uses ROI-based profit. |
|---|---|
| Target Rate of Return vs. Target Costing | Target costing starts with price; target rate of return starts with cost and desired ROI. |
23 Total Revenue
| Category | CVP / Financial Performance |
|---|---|
| Best Used In | Break-even analysis, profitability |
| Key Formula | Total Revenue = Selling Price per Unit × Number of Units Sold |
| Exam Importance | High |
Total Revenue is the total income generated from sales of goods or services, calculated as the selling price per unit multiplied by the quantity sold.
It is the top line of the income statement, used in break-even analysis and CVP to compare with total cost and determine profit or loss.
- Break-even analysis
- Target profit and revenue forecasting
- Income statement reporting
If a company sells 1,000 units at ₹50 each, total revenue = ₹50,000. This is plotted on a break-even chart to find the intersection with total cost.
Selling price ₹80, units sold 5,000. Total revenue = 80 × 5,000 = ₹4,00,000. If total cost ₹3,50,000, profit = ₹50,000.
- Determine selling price per unit.
- Determine number of units sold.
- Multiply to get total revenue.
- Compare with total cost to find profit/loss.
- Use in break-even and target profit calculations.
| Total Revenue vs. Total Cost | Profit = Total Revenue − Total Cost. |
|---|---|
| Total Revenue vs. Net Revenue | Net revenue deducts returns, discounts; total revenue is gross. |
24 Total Productive Maintenance (TPM)
| Category | Maintenance Management / Lean |
|---|---|
| Best Used In | Improving equipment reliability, reducing downtime |
| Key Formula | No formula; focus on Overall Equipment Effectiveness (OEE) |
| Exam Importance | Low |
Total Productive Maintenance (TPM) is a maintenance program where all employees are involved in maintaining equipment, aiming for zero breakdowns, zero defects, and maximum equipment effectiveness.
TPM combines preventive maintenance, autonomous maintenance by operators, and continuous improvement to reduce downtime, increase productivity, and improve quality.
- Manufacturing companies with heavy machinery
- Reducing machine breakdowns and idle time
- Improving OEE and production efficiency
A factory implements TPM by training operators to perform routine maintenance (cleaning, lubrication) and involving maintenance staff in proactive repairs, reducing unexpected breakdowns and increasing machine availability.
Before TPM, machine downtime 100 hours/month. After TPM, downtime reduced to 40 hours/month, increasing production capacity and reducing cost of idle time.
- Train operators in basic maintenance tasks.
- Implement preventive maintenance schedules.
- Monitor equipment performance and downtime.
- Continuously improve through root cause analysis.
- Measure OEE and reduce losses.
| TPM vs. Preventive Maintenance | Preventive is scheduled maintenance; TPM includes autonomous and company-wide involvement. |
|---|---|
| TPM vs. Lean Manufacturing | Lean focuses on waste; TPM focuses on equipment reliability and effectiveness. |
