Part I covered cost concepts, break-even, budgets and variances. Part II is about strategic and control questions: how to cost products fairly when overhead is large, how to manage cost across the product’s life, how to price inside a company, how to judge divisions, and how to build a control system that drives the right behaviour.
1. Activity-based costing and management
Traditional costing spreads overhead on one base, such as direct labour hours. When overhead is large and products differ in complexity, this cross-subsidises: simple, high-volume products are over-costed and complex, low-volume ones are under-costed.
ABC works in steps: identify activities (set-ups, purchase orders, inspections), pool the cost of each activity, choose a cost driver for each, compute a rate per driver unit, and charge products by their usage.
Worked example. Overhead of ₹10,00,000 is made up of ₹6,00,000 for set-ups (200 set-ups) and ₹4,00,000 for inspections (400 inspections). Product A (high volume) uses 20 set-ups and 50 inspections; product B (low volume, complex) uses 80 set-ups and 150 inspections. Rates: set-up ₹3,000 each, inspection ₹1,000 each. A is charged 20 × 3,000 + 50 × 1,000 = ₹1,10,000; B is charged 80 × 3,000 + 150 × 1,000 = ₹3,90,000. A labour-hour method might have split the cost evenly by volume and hidden that B is far costlier.
Activity-based management (ABM) uses the same data to remove non-value-adding activities, redesign processes and price properly. Limits: ABC costs time and money to build, so it suits firms with high overhead and diverse products. Time-driven ABC simplifies it with a time equation per activity.
In the real world: ABC grew from manufacturers with many product variants (the Hewlett-Packard and John Deere cases are classic) and is now used in banking (cost per transaction by channel), hospitals and logistics. Cloud teams do a similar thing when they allocate shared platform cost by usage tags.
2. Strategic cost management
Most of a product’s cost is locked in at design, so managing cost only on the shop floor is too late.
| Technique | Idea |
|---|---|
| Target costing | Start with the market price, subtract the desired margin, and design to the allowable cost |
| Life-cycle costing | Count cost from design through use to disposal, not just manufacture; includes warranty and support |
| Value engineering | Reduce cost without reducing function the customer values |
| Kaizen costing | Small, continuous cost cuts after launch |
| Value-chain analysis | Look at the full chain from suppliers to customers; find where cost and value arise |
| Benchmarking | Compare cost and performance with best practice |
| Cost of quality | Prevention and appraisal costs vs internal and external failure costs; spending on prevention usually lowers total cost |
In the real world: Toyota uses target costing and Kaizen costing; the Japanese compact-car makers popularised designing to a cost. A lower-priced airline sets the ticket price first and then designs its operations to be profitable at that fare.
3. Throughput accounting and constraints
The theory of constraints (Goldratt) says the output of a system is limited by its bottleneck. Throughput accounting measures: throughput (sales minus truly variable costs), inventory (money tied up) and operating expense. The key ratio is throughput per bottleneck minute, which ranks products when capacity is the limit. Improving a non-bottleneck adds no output; improving the bottleneck raises the whole system’s output.
4. Transfer pricing
When one division sells to another inside the company, the transfer price is a revenue for the seller and a cost for the buyer. It affects divisional profit, motivation and, across countries, tax.
| Method | How | Issue |
|---|---|---|
| Market-based | Use the outside market price | Best when a competitive market exists |
| Cost-based | Variable or full cost, possibly plus a mark-up | Gives no incentive to be efficient |
| Negotiated | Divisions bargain | Time-consuming; depends on power |
| Dual pricing | Different prices for buyer and seller | Complex |
Goal congruence: the price should lead each division to act in the company’s best interest. A standard rule sets the minimum price at variable cost + opportunity cost to the seller. Example: if a division has spare capacity, the minimum price is its variable cost; if it is at full capacity and loses outside sales, the minimum is the outside price. For multinationals, arm’s-length pricing is required by tax authorities, and disputes are common.
In the real world: global technology and pharmaceutical groups have long faced tax-authority scrutiny over transfer prices for intellectual property, and many countries use advance pricing agreements to settle them in advance.
5. Divisional performance: ROI, RI and EVA
In investment centres, profit alone is not enough; it must be compared with the capital used.
- ROI = Operating profit ÷ Capital employed
- Residual income (RI) = Operating profit − (Capital employed × Required rate)
- EVA = NOPAT − (Capital × Cost of capital), with adjustments such as treating R&D as an investment
Worked example. Division X earns profit ₹30 lakh on capital ₹1 crore, ROI 30%. The required return is 20%. A new project offering 25% would lower the division’s ROI (average falls from 30% toward 25%), so the manager may reject it, though it clearly beats the 20% cost of capital. RI would rise by 25% − 20% = 5% of the investment, so RI encourages the right decision. This is why many firms prefer RI or EVA.
In the real world: Coca-Cola under Roberto Goizueta was an early, famous adopter of EVA, aligning managers with shareholder value. Several Indian companies also report EVA.
6. Management control systems
A management control system is the set of tools that steer people toward strategy. Anthony’s levels: strategic planning, management control and operational control. Simons’s levers of control:
| Lever | Purpose |
|---|---|
| Beliefs systems | Communicate core values |
| Boundary systems | Set limits (codes of conduct, forbidden actions) |
| Diagnostic control systems | Monitor against targets (budgets, KPIs) |
| Interactive control systems | Senior attention to strategic uncertainties; prompts debate |
Control types: feedback (after the event), feedforward (before) and concurrent. Design issues: goal congruence, motivation, budget slack, and dysfunctional behaviour. A badly chosen measure produces perverse results: if a call centre is rewarded on call length, agents end calls too quickly, and Goodhart’s law applies.
7. The balanced scorecard and non-financial measures
Kaplan and Norton’s balanced scorecard (BSC) translates strategy into measures across four perspectives:
| Perspective | Question | Example measures |
|---|---|---|
| Financial | How do we look to shareholders? | Revenue growth, EVA, margin |
| Customer | How do customers see us? | Satisfaction, retention, NPS |
| Internal process | What must we excel at? | Cycle time, defects, on-time delivery |
| Learning and growth | Can we keep improving? | Skills, employee satisfaction, IT readiness |
The perspectives are linked by cause and effect on a strategy map: skills lead to better processes, which lead to happier customers, which lead to financial results. Other modern ideas: sustainability and ESG reporting, triple bottom line, and beyond budgeting.
In the real world: tech teams use DORA metrics (deployment frequency, lead time, change failure rate, recovery time) as a balanced set, in the same spirit as a scorecard, so that speed is not chased at the expense of stability.
One-minute recap
| Topic | Key idea | Where you meet it |
|---|---|---|
| ABC and ABM | Costs follow activities and drivers | Banks, logistics, shared cloud cost |
| Strategic cost management | Target costing, life-cycle costing, Kaizen | Product design, pricing |
| Throughput accounting | The bottleneck sets output | Factories, pipelines |
| Transfer pricing | Market, cost-based, negotiated; goal congruence | Divisions, multinational tax |
| ROI, RI, EVA | Compare profit with capital cost | Divisional targets |
| Management control | Four levers; feedback and feedforward | KPIs and incentives |
| Balanced scorecard | Four linked perspectives | Strategy execution |
Next in MBA Revisited: Research Methods.
Written by Claude, Anthropic’s AI assistant, as part of MBA Revisited, a quick refresher of the PGDM subjects one at a time.