Anda di halaman 1dari 814


popr : 1


Management Accounting &

Production & Operation
Introduction to Management Accountancy

1.0 Learning Objectives

After studying this Chapter the student should be able to:

 Understand the meaning of Management Accounting, its and scope;
 Realize the role and functions of Management Accountant as well as his
qualifications and duties;
 Grasp tools and techniques of Management Accountant;
 Comprehend the relationship between Financial Accounting, Cost
Accounting and Management Accounting;
 Know the importance and limitations of Management Accounting.

1.1 Meaning, Nature, Scope and Significance of Management Accounting

1.1.1 Meaning of Management Accounting

Management is required to perform various functions like planning, organizing,
coordination, control, etc. Main it has to take decisions. Management cannot
afford to take chances. Though financial statements are of much value to
management, the principle objective of financial accounting is to serve the
needs of outsiders like debtors, employees, regulatory bodies, etc. who have
financial stake in the business.The information obtained by management from
financial accounts is not of much help to management in discharging its
functions efficiently and effectively. Thus, arises the need for Management

Management Accounting comprises of two words – ‘Management’ and

‘Accounting’. Management is concerned with panning, organizing, directing
and controlling the activities of an organization to achieve predetermined
objectives. Accounting involves collection, recording, classifying and
presenting financial data for the benefit to those who must make decisions or
form judgements.Management Accounting involves management employing
accounting information to discharge its functions, namely, panning, organizing,
directing and controlling more effectively.

Management Accounting or Managerial Accounting is concerned with the

provisions and use of accounting information to managers within organizations,
to provide them with the basis to make informed business decisions that will
allow them to be better equipped in their management and control
functions.Management Accounting information is the mechanism which can be

used by managers as a vehicle for the overview of the whole internal structure
of the organization to facilitate their control functions within an organization.

Definitions of Management Accounting

i) The Institute of Chartered Accountants of England and Wales:
Any form of accounting which enables a business to be conducted more
efficiently can be regarded as Management Accounting.

ii) J. Batty:
Management Accounting is the term used to describe the accounting
methods, systems and techniques which coupled with special knowledge
and ability assist management in its task of maximising profit and
minimising losses.

iii) Robert N. Anthony:

Management Accounting is concerned with accounting information which is
useful to management.

iv) Management Accounting Team of Anglo-American Council on

Management Accounting is the presentation of accounting information in
such a way as to assist management in the creation of policy and the day to
day operation of an undertaking.

v) Board and Carmichael:

Management Accounting covers all those services by which the accounting
department can assist the top management and other departments in
formulation of policy, control of execution and appreciation of

vi) Chartered Institute of Management Accountants (CIMA):

Management Accounting is "the process of identification, measurement,
accumulation, analysis, preparation, interpretation and communication of
information used by management to plan, evaluate and control within an
entity and to assure appropriate use of and accountability for its resources.
Management accounting also comprises the preparation of financial reports
for non-management groups such as shareholders, creditors, regulatory
agencies and tax authorities"(CIMA Official Terminology).

vii) The Institute of Management Accountants (IMA):

Management accounting is a profession that involves partnering in
management decision making, devising planning and performance
management systems,and providing expertise in financial reporting and

control to assist management in the formulation and implementation of an
organization’s strategy.

viii) The American Institute of Certified Public Accountants(AICPA):

states that
Management Accounting as practice extends to the following three areas:
 Strategic Management—Advancing the role of the management
accountant as a strategic partner in the organization.
 Performance Management—Developing the practice of business
decision-making and managing the performance of the organization.
 Risk Management—Contributing to frameworks and practices for
identifying, measuring, managing and reporting risks to the achievement
of the objectives of the organization.

xi) The Institute of Certified Management Accountants(ICMA) :

A management accountant applies his or her professional knowledge and
skill in the preparation and presentation of financial and other decision
oriented information in such a way as to assist management in the
formulation of policies and in the planning and control of the operation of
the undertaking.

From the above definitions it is clear that any form of accounting, quantitative
and other information, which enables the management to discharge its functions
efficiently to take decisions and frame policies is Management
Accounting.Management accounting knowledge and experience can therefore
be obtained from varied fields and functions within an organization, such as
information management, treasury, efficiency auditing, marketing, valuation,
pricing, logistics, etc.

1.1.2 Nature of Management Accounting

The distinctive features of Management Accounting are as follows:
i) Subjects: The purpose of Management Accounting is to help management
take useful decisions. Any tool which helps management is Management
Accounting.These tools are provided byvarious fields of study like financial
accounting, costing, statistics, operations research, statutory enactments,
economics, management information system, etc. Thus, Management
Accounting involves too many subjects.
ii) Tools: Since Management Accounting includes too many subjects, it
includes many techniques and tools which help management function more
iii) Selective: It is a technique of selective nature as it takes into consideration
only that data and information which is relevant and useful to the
management. Eg., Production Department is given data relating to

operating cost, standard costs, variances, production budget, etc. only as
they are concerned with such data.
iv) Use: This is mainly for use of management in efficient conduct of the
business. Management accounting focuses on internal reporting. It is
designed and intended for use by managers within the organization, instead
of being intended for use by shareholders, creditors, and public regulators.
v) Presentation:There is no unified structure. It can be presented in any form.
vi) Principles:It is not necessarily governed by generally accepted principles.
vii) Optional: Unlike financial accounting, management accounting is optional
rather than mandatory.
viii) Nature of information: Management Accounting includes non-monetary
information in addition to monetary information.Management accounting
measures and reports financial and non-financial information that helps
managers make decisions to fulfill the goals of an organization.
ix) Futuristic: Management Accounting is a means to assess the future and
thus there is more emphasis on future.It helps planning the future.
Management Accounting is thus, future oriented.
x) Focus: It focuses on parts as well as on the whole of a business.
xi) Precision: Management Accounting has less emphasis on precision.
xii) Confidentiality: Usually confidential and used by management, instead of
being publicly reported.
xiii) Computation: Computed by reference to the needs of managers, often
using management information systems, instead of by reference to general
financial accounting standards.
xiv) Usefulness: It is a means to an end, rather than end in itself.

1.1.3 Scope of Management Accounting

Internal Cost
Control Accounting

Law Management Accounting



The objective of Management Accounting is to aid management in discharging
its functions. Any information useful to achieve the above-said purpose comes
under its purview. Scope of Management Accounting is wide and broad based
that it encompasses within its fold a searching analysis of all the aspects and
branches of business operations. The areas covered by Management
Accounting are as under:
i) Financial Accounting or General Accounting: Financial or General
Accounting provides management with many useful financial data required
for better functioning of the business. Management Accountant gathers his
facts from Financial Accounting mainly. Management Accounting is
futuristic whereas Financial Accounting is based on historical information
and thus acts as a base for future financial forecasting and planning. Thus,
financial accounting is an intrinsic part of Management Accounting.
ii) Cost Accounting:Every management is concerned with keeping an eye on
costs involved in business. Control and reduction of costs is the key to
increasing profitability especially when it is not possible to increase prices.
Thus, in formulating policies Cost Accounting is an essential element for
management. Cost Accounting involves mainly cost sheets for
determination of cost per unit, standard costing for locating cost variances,
marginal costing to understand the impact on cost by increase in production
by one unit, budgetary control for overall control on costs involved under
various heads, etc., which play an important role in operation and control of
the business undertaking. All help management in improving efficiency.
iii) Statistical Methods:At times, for presenting results and information
revealed by cost and financial accounts and other books and records, charts,
graphs and other forms of pictorial presentation, index numbers, and other
statistical methods are used by the Management Accountant in his report to
the management authorities. This provides of presenting in an intelligent
manner and in non-technical language.
iv) Operations Research: This is a new discipline which makes use of
statistical methods/models for decision makers. Linear programming is a
mathematical model that helps in maximising profits or minimising costs in
typical situation where limited resources are a part of numerous uses. There
are also models which can be used for inventory control and transportation.
Critical Path Method (CPM) and Program Evaluation and Review
Technique (PERT) are popular forms which help management in decision
v) Management Information System: MIS involves continuous flow of
useful information and data to enable management to function more
effectively. This too comes under the preview of Management Accounting.
vi) Economics: Economics forms the base for commerce and management. A
branch of this Economics called Managerial Economics is of importance to
Management Accountant. Managerial Economics is the integration of

economic theory with business practice for the purpose of facilitating
decision making and forward planning by management. Economics
provides certain tools and techniques which help to analyse business
situation and enable management to exercise proper choices and therefore is
useful for optimization. Some areas where there is great scope of
application of knowledge of economics are project’s feasibility study
(location, profitability, financing and demand estimation), capital budgeting
(risk analysis), product mix, price fixation and determination of optimum
vii) Law (Statutory Enactments): Various laws and statutory provisions have a
bearing on functioning of management accountant. He must be familiar
with the provisions of Companies Act relating to issue of capital, accounts
and audit. He must be aware of relevant provisions of FEMA, Capital
Issues (Control) Act, Industries (Development and Regulation) Act, MRTP,
Income Tax Act, etc. All this information is useful for tax planning,
planning of scale of work, etc. Tax Accounting helps reducing tax burden
of the organization.
viii) Internal Audit: Management Accounting uses internal audit report as a
tool for gaining efficiency in functioning.

1.1.4 Significance of Management Accounting

i) Providing Information for Decision Making and Planning and
Proactively Participating As Part of the Management Team in the
Planning Processes:Planning is a very essential tool in every
manufacturing firm. An entity needs to plan the location of its plants,
introduction of new product lines and the strategies required to maintain the
assets of the firm. Management accounting assists the firm to make cost-
benefit analysis of each alternative and the best decision taken. For example,
a soap manufacturing firm before undertaking the manufacture of a new
type of soap will collect and analyze data on projected sales volumes, profit
margins and costs of inputs. Management accounting provides this data.
Any decision taken by the management team in the planning process has an
effect on costs, revenues, and management accounting data are essential in
estimating those effects. For example, management accounting
Management accounting would enable management to for example, budget
for the cost of establishing a new plant and alternatives evaluated for the
acquisition of the best plant. Budgets will also include targets to be met in
the manufacture of goods. Targets include production volume, sales volume,
profit, expenses, pilferage, losses and employee training. These data will be
collected, analyzed and summarized for management use in the form of
budgets prepared by the management accountant. Management accounting
data such as daily sales report is crucial in making decisions as to the
number of units to produce.

ii) Assisting Managers in Directing and Controlling Operational
Activities:Operational activities form an integral part of the manufacturing
process. The control function enables the operational managers ensure that
activities conform to set standards. Detailed reports of various kinds
prepared by the management accountant provide feedback as to whether the
set standards are being met. Controlling is very essential in inventory
control, total quality management and benchmarking in manufacturing
firms. A performance report compares budgeted to actual results. In a
manufacturing firm performance reports will indicate where some parts of
production activities are not proceeding as planned so that corrective
measures are instituted to reduce losses. E.g. measures of quality, including
internal and external failure rates, yields, and rework can be computed.
Measures of productivity efficiency, such as machine availability,
throughput and lead times, average inventory levels, and set-up times can be
iii) Motivating Managers and Other Employees toward Organizational
Goals:A well-motivated staff enhances performance and productivity.
Organizations are able to achieve their goals if employees are well
motivated. Management accounting through budgeting motivates managers
to direct their efforts toward achieving the organizational goals. In a
manufacturing firm a budget indicates how resources are to be allocated and
what activities are to be emphasized. Employee empowerment is the
concept of encouraging and authorizing workers to take the initiative to
improve operations, reduce costs, and improve product quality and customer
service. For example, employees can be given incentives to develop new
products for the organization.
iv) Measuring the Performance of Activities, Subunits, Managers, And
Other Employees within the Organization:Management accounting
assists management in measuring the performance of employees in
executing organizational objectives. Performance measurement is used as a
basis for rewarding performance through positive feedback, promotions and
pay rises. Performance measure may be productivity per worker on which
compensation may be based. Management accounting also provides data
about the performance of the various sub units product lines, geographical
units and divisions. These measures are important in determining whether a
particular process or subunit (e.g. Quality Control Unit) in the firm is an
economic viable unit.
v) Assessing the Organizations Competitive Position and Working with
Other Managers to Ensure the Organizations Long Run
Competitiveness in the Industry:Globalization has heightened competition
and among industries. Management accounting plays a crucial role in
ensuring that an organization competes effectively and survives the
competition. The financial strength of the organization must be prominent

on the agenda of management. Innovative measures must be instituted and
operations streamlined. Competitive prices must be adopted by the
organization. Data on other competing products must be collected and
carefully analysed before investment decisions are taken. Cost benefit
analysis is also important in the adoption of a particular method of
production (labour or machines), make or buy decisions, inventory
management and outsourcing. Management accounting provides the
necessary data for these very essential decisions to be made.

1.2 Role and Functions of Management Accountant

1.2.1 Role of Management Accountant

Management Accountant is also called as Corporate Accountants, Chief
Accountant, Controller of Finance and Accounts, Finance Manager, Chief Cost
and Works Accountant. The name indicated that a Management Accountanthas
a significant role to perform in modern business involving complexities,
intricacies and uncertainties due to economic and political factor. In complex
changing business environment the management has to carry out its basic
functions to increase profits and reduce costs for profit maximization. To carry
out its functions effectively the management needs not only financial data but
also varied information as and when required and not necessarily at the end of
financial year. Management wants someone to supply all the information as
and when needed that too in a form and language which will be readily
intelligible to management personnel. This somebody is Management
Accountant– eye and brain of management– having necessary knowledge to
wade through mass data and make requisite interpretation themselves.
Management Accountant not only submits information collected as it is but also
analyses and interprets it before submitting it to management. Though the work
of taking decisions rests on management, the Management Accountant has to
report his views and guide the management in decision making. He should also
suggest the means to be adopted to improve matters wherever such
improvement is necessary.

The role of the management accountant is to perform a series of tasks to ensure

their company's financial security, handling essentially all financial matters and
thus helping to drive the business's overall management and strategy.
Management Accountants are key figures in determining the status and success
of a company. His role in the organization is as follows:
i) To assist Management achieve the Goals:The aim of management is to
minimise cost and maximise profit by making best possible and economic
user of limited resources available. The Management Accountant’s role is
toassist the management in realizing this goal by furnishing necessary
economic, statistical and other data.

ii) To assist Managementin framing policy, coordination and control
functions: He gets periodic reports from various departments of the
organization. He coordinates them and throws a flood of light on the special
problems which emerge out of the reports. He helps management in its
basic function of decision-making by analysing the data collected and
suggesting various possible alternative courses of action together with their
impact on costs, prices and profits.
iii) To satisfy the requirements of each level of management:There are
usually there levels of managements (a) Top Management, (b) Middle
Management and (c) Lower Management. As the functions of these
Management differ, the information required by them also differs. The top
management is interested in knowing about the soundness of the plans,
proper structuring of the organization, proper delegation of authority and its
effectiveness. The middle management wants to know (i) What happened?
(ii) Where happened? and (iii) Who is responsible? The lower management
requires information regarding effectiveness of the operations. The reports
submitted by the Management Accountant must, therefore, meet the needs
of each level of management. The reports to top management have to show
whether the plans are sound, organization was properly established and
develop responsibility and those to lower management must indicate the
effectiveness of their operations, and should show planned performance.
iv) To keep close contacts with various units and activities:As the
Management Accountant occupies the unique position in the organization
and its required to assist all the levels of management in performing their
function, the areas of his functions include Financial Accounting, Cost
Accounting, Taxation, Organization and Methods, Production Control,
Inventory Control, Project Planning, Budgetary Control, Internal Audit and
Industrial Statistics. For all this he maintains close contracts virtually with
all phases of enterprise operations as well as opening units.
v) To assist Line Managers: Management Accountant is a Staff Officer, i.e.,
plays an advisory role. He assists the Line officers in their basic task of
decision making. Detailed information to the Line Officers in respect of
alternative plans and their profitability, which helps them in decision
making is supplied by him. As a result the question crops up whether the
Management Accountant is to be held responsible for a wrong or defective
decision taken by the manager. The answer depends upon the needs of each
individual case. If the wrong decision in the result of inaccurate data biased
and fabricated figures supplied by the Management Accountant. The
Management Accountant is responsible for the wrong decision; otherwise he
cannot be held responsible for any error of judgment.
vi) To coordinate:Management Accountants is in fact a coordinator of all
operative reports. He studies these reports carefully and brings to the notice
of the management the special problems with his remarks. He chooses the

date. Analysis them in detail and suggests various possible alternative
courses of action indicating their effect on costs, prices, and profits. By
submitting his reports to the managements from time to time, he ensures a
constant flow of information at each level of management at the appropriate
time and in adequate quantity.

Consistent with other roles in today's corporation, management accountants

have a dual reporting relationship. As a strategic partner and provider of
decision based financial and operational information, management accountants
are responsible for managing the business team and at the same time having to
report relationships and responsibilities to the corporation's finance

Management Accountants are seen as the "value-creators" amongst the

accountants. They are much more interested in forward looking and taking
decisions that will affect the future of the organization, than in the historical
recording and compliance (score keeping) aspects of the profession.

The Management Accountant thus, occupies a key position in the organization.

He is sometimes described as the Chief Intelligence Officer of the top
management. He is he only officer who is thoroughly acquainted with various
functions of the organization. His status has been aptly stated by Mr. P. L.
Tondon in the following words : The Managements Accountant is exactly like
the spokes in a wheel, connecting the rim of the wheel and the hub receiving the
information. He processes the information and then returns the processed
information back to where it came from.

1.2.2 Functions of Management Accountant

Management Accountant is often called upon to measure and report on
economic date to the management with a view to assist in the faming of policy
as well as the direction and control of duty to day operations. He thus helps the
management in its task of profit maximization.

A Management Accountant is an efficient accountant who is vigilant about

waste and inefficiency in the various departments and constantly strives to
create cost consciousness in the enterprise organization. He analyses every
organizational problem with accounting basic.

In U.S.A the Managements Accountant is designated “Controller”. The various

functions of Controllership have been stated by the Controllers’Institute
Committee. These functions are given below. The functions explain the matter
of Management Accountant job to large extant.

i) To establish,coordinate and administer as an integral part of management
and adequate plan for the control of operations. Such a plan would provide
to the extent required in the business cost standards, expense budgets, sales
forecasts, profit planning and programs for capital investment and financing,
together with the necessary products to effectuate the plan.
ii) To measure performance against approved opening plans and standards and
to report and interpret the results of operations to all level of management.
This function includes the design, installation and maintenance of
accounting and cost systems and records, the determination of accounting
policy, and the compilation of statistical records as required.
iii) To consult with all segments of managements responsible for policy or
action concerning any phase of the operations of the business as it relates to
the attainment of objectives and the effectiveness of policies, organization
structure and procedures.
iv) To administer tax policies and procedures.
v) To interpret and report on the effects of external influences on the
attainment of the objective of the business. This function includes the
continuous appraisal of economic and social forces and of Governmental
influences as they affect the operation of the business.
vi) To assure fiscal protection for the assets of the business through adequate
internal control and proper insurance coverage.

In general, the functions of Management Accountant can be stated as under:

i) To collect relevant quantitative and qualitative information.
ii) To analyze the data collected and interpret it as accurately as possible.
iii) To forecast the future with the help of data analyzed.
iv) To prepare budgets, funds flow and cash flow statements, charts, etc.
v) To provide the data for formulation of business plans.
vi) To evaluate the capability of the organization and methods employed in
executing the plan.
vii) To provide workable standards of performance.
viii) To coordinate by understanding the inter-link between departments, and
ix) To control by comparing actual performance with standards of performance
set and to compute and analyze the variances enabling management to
control easily through the technique of ‘Management by Exception’.
x) To communicate through reporting to management regarding results of plan
xi) To satisfy the needs of each level of management.

1.3 Tools and Techniques of Management Accountant

Management Accountant has to furnish information to the management. The
information furnished by him is varied in character. To start with he has to

provide diagnostic information which he has to call out from past records. Next,
he has to provide data for the formulation of business plan which considers
several alternatives. Planning also involves long-range planning and again it is
the Management Accountant who has to assist the management in Capital
Budgeting. Lastly, he has to provide information necessary for control. All this
is possible only by employing certain tools and techniques. The management
accountant has an array of tools and techniques which he can apply in the
discharge of his duties. Management Accounting is a wide and diverse subject.
It supplies both quantitative as well as qualitative information to management
derived from various subjects. The tools and techniques are from the various
subjects it encompasses.Important of them are discussed below.


Ratio Analysis

Cash Flow and

Funds Flow

Historical Cost

Tools and Techniques Standard Costing

of Management Cost Accounting

Accountant Budgetory Control

Marginal Costing

Charts, Graphs,

Law Tax Accounting

1. Tools and Techniques from Financial Accounting

i) Financial Statements: Profit and Loss Account and Balance Sheet gives
information of overall performance of the organization in terms of
profitability during a period and position of all assets and liabilities on a
particular date.
ii) Ratio Analysis: This technique is useful in performance appraisal, raising
short term and long term funds, budgeting, investment of funds etc.
iii) Cash Flow and Funds Flow Statements: These statements are useful in
the management and proper planning of cash and working capital funds

2. Tools and Techniques from Cost Accounting
i) Historical Cost Accounting: This provides past data to the management
relating to cost of each job, process and department so that comparison may
be used by management for future planning and cost control.
ii) Standard Costing:Standard Costing involves actual costs being compared
with standard costs. This technique is of great use in fixing responsibilities,
cost appraisal and control. It helps top management to concentrate their
attention on significant deviations from expected results and facilitate
management by exception.
iii) Budgetary Control:Budget is an estimate of future needs calculated for a
definite period. It is an important tool for planning and control. This
technique useful in profit planning and is invariably applied together with
standard costing to enable management to exercise control. It helps to
pinpoint responsibility and securing coordination.
iv) Marginal Costing: This technique is very useful in the area of decision
making. Price Fixation in special situations, make or buy decisions, key
factor contribution, determination of optimum level of production, profit
planning are some of the important areas in which this technique is made
use of.

3. Tools and Techniques from Statistics

Mathematical and Statistical Models: Techniques like Linear Programming,
Queuing Theory, Decision Theory, P.E.R.T. C.P.M. and other quantitative
techniques are being increasingly applied in the determination of product
mix, inventory control, project and product planning, transportation and
other areas.

Statistical techniques are also used in forecasting and presentation of

information. While techniques like analysis of time series and interpolation
are useful in demand estimation, histograms, frequency curves, charts and
diagrams are useful in the presentation of information to the management.

4. Tools and Techniques from Law

Taxation plays an important role in the profitability of a concern. The filing
of tax returns and the payment of tax thereon is to be ascertained as per the
provisions of tax. The filing of tax returns and the payment of tax in due
time is exclusively the responsibility of Management Accountant. Tax
Accounting is an important tool for the organization.

It is not possible list all the techniques that the Management Accountant
uses. He also uses break even charts inter period, inter-firm, comparisons,
cost data like unit costs, break-even analysis, EOQ, inflation accounting,

etc. An attempt is made to discuss only the most important techniques in
the arsenal of the management accountant.

1.4 Financial, Cost and Management Accounting and their Inter-

Relationship Accountancy Cycle

1.4.1 Financial Accounting and Management Accounting

Financial Accounting and Management Accounting both are the two branches
of the accounting. Financial Accounting is concerned with recording day to day
transactions of an enterprise whereas Management Accounting is using
accounting information for managing day to day activities of business more
effectively. Both are complimentary and necessary for running the concern
efficiently. Yet there are certain differences among them which are given as

S.N Subject Financial Accounting Management Accounting

1 Object To measure business To aid management to
income and statement of formulate policies and plans
affairs of the business. for more efficient
2 Users It confines itself to It uses financial accounts, etc.
preparation of accounts for internal management. It is
from the point of view of designed and intended for use
outside parties, i.e., by managers within the
shareholders, debenture organization, instead of being
holders, creditors, intended for use by
investors, etc. shareholders, creditors, and
public regulators.
3 Subjects Based only on It has too many aims and thus
Accountancy. It is based requires information from
only on accounts and various fields like financial
related records. accounting, costing, statistics,
operations research, statutory
enactments, economics,
management information
system. Since it involves too
many subjects, it includes
many techniques and tools.
4 Presentation The presentation must be There is no unified structure.
as per provisions of It can be presented in any
Companies Act and thus form.
has a unified structure.
5 Principles It is governed by various It is not necessarily governed
principles and by generally accepted
conventions which are principles.Computed by
universally accepted like reference to the needs of
principle of managers, often
conservatism, using management
consistency, matching information systems, instead
concept, etc. of by reference to general
financial accounting
standards. Management can
frame its own rules and
principles regarding form and
content of information for
internal use.
6 Compulsion It is mandatory Management Accounting is
(compulsory) for any optional rather than
organization as per mandatory. It is done at the
Companies Act, 1956 for discretion of the
companies and for other management.
concerns due to benefits
offered by financial
7 Information Includes only monetary Management Accounting
data which are historical, includes non-monetary
quantitative and (qualitative) information in
objective. addition to monetary
(quantitative) information. It
is descriptive, statistical,
subjective and relates to
8 Period It is based on past Management Accounting is a
historical data and means to assess the future and
records. thus there is more emphasis
on future. It has prospective
9 Focus It deals with whole of the It focuses on parts as well as
enterprise. on the whole of a business.
10 Precision It is more precise which Management Accounting has
is expected too from it as less emphasis on precision.
it deals with actual Reports and statements
expenses figures. There contain more approximate
is no scope for figures than the actual
approximate figures. figures.
11 Scope It is a part of It includes Financial
Management Accounting Accounting and hence has a
wider scope.
12 Characteristi It is objective in nature It has characteristics that
cs as it lays emphasis on enhance value of information
past activities and in its variety of uses like
represents historical flexibility (flexible budgets),
records. It thus has comparability.
universal confidence,
like objectivity, validity,
absoluteness, etc.
13 Period Financial Accounts are Management Accounting is
prepared at the end of the undertaken whenever
financial year. required. It is prepared more
frequently to enable
management to take proper
decisions. It is thus more
frequently prepared.
14 Audit They have to be audited. It does not require auditing.
15 Confidentiali It is a public document Usually confidential and used
ty and has to be published by management, instead of
for information of publicly reported.
general public.

1.4.2 Management Accounting and Cost Accounting

Cost Accounting and Management Accounting both have the objective of
assisting management in discharging its functions in a better way. Despite it
there are certain differences among them as follows:

S.N Subject Cost Accounting Management Accounting

1 Object To record the cost of To provide information to
producing a product or management for planning and
providing a service. It coordinating the activities of
deals with cost the business.
2 Scope It is a part of It includes Cost Accounting,
Management in addition to Financial
Accounting. Accounting, Tax Accounting,
etc. and hence has a wider
3 Period It is based on past Management Accounting is a
(historical) or present means to assess the future and
data and records. thus there is more emphasis
on future.
4 Area of It deals with It deals with effect and
Concern ascertainment, impact of cost on business.
allocation, appropriation
and accounting aspect of
5 Information Includes only monetary Management Accounting
data which are includes non-monetary
historical, quantitative (qualitative) information in
and objective. addition to monetary
(quantitative) information. It
is descriptive, statistical,
subjective and relates to
6 Status Status of Cost Management Accountant in
Accountant comes after senior in position to Cost
Management Accountant.
7 Tools and It provides techniques It employs techniques of Cost
Techniques for Management Accounting like standard
Accounting like costing, budgeting, marginal
standard costing, break- costing, break-even analysis,
even analysis, etc. etc.
8 Principles There are certain set It is not necessarily governed
rules, principles and by generally accepted
procedures on the basis principles or specific rules or
of which cost procedures.
accounting is prepared.
9 Qualification Prepared by CA or Cost Management Accounting
Accountant. could be prepared by cost
accountant, CA, management
consultant, etc. No specific
qualifications are mentioned.
10 Compulsion Compulsory when Cost It is not compulsory.
for Preparing Audit is compulsory as
per Companies Act,
1956 under certain

1.4.3 Inter-Relationship Accountancy Cycle of Financial, Cost and
Management Accounting
Financial accounting relates to the information presented based on past events
and records.
Cost and managerial accounting is the presentation of financial information to
the management to be used in decision making while in managerial accounting
projections are made based on past trends. Eg. projected cash flows, profit &
loss, balance sheet, cost sheets, break-even point, budgets.

Financial accounting reports are in standard formats which are worldwide

accepted, whereas ManagementAccounting reports are in the format as required
by the management. Financial Accounting records the transactions that has
already passed (history). Cost Accounting calculates the costs of manufacturing
products or provision of services (present) and Management Accounting uses
past accounting records and applies some method of calculation for preparation
of future undertakings (future). Management Accounting makes use of both
Financial as well as Cost Accounting.

1.5 Management Accountant – Qualifications, Duties and Rights

1.5.1 Qualifications of Management Accountant

Management accounting is an internal function that touches almost all of a
company's departments and divisions. Management accountants trace a
company's financial information from start to finish. Accountants record and
report this information to business owners for decision-making purposes.
Business owners or managers may request management accountants to provide
personal insight on financial reports and statements. Management accounting
requires individuals to have a few qualifications to help them understand and
prepare financial information.

There are several related professional qualifications and certifications in the

field of accountancy including:
i) Educational Qualifications:
• Management Accountancy Qualifications
 Chartered Institute of Management Accountant(CIMA) for Chartered
Management Accountant
 Institute of Certified Management Accountant (ICMA)
 Certified Management Accountant(CMA)
• Other Professional Accountancy Qualifications
 Chartered Institute of Public Finance and Accountancy (CIPFA)
 Chartered Certified Accountant, (CCA)
 Chartered Accountant (CA)
 Cost and Works Accountant

 Certified Public Accountant (CPA)
 American Institute of Certified Public Accountants
 Certified Practicing Accountant (CPA Australia)
 Chartered Global Management Accountant
At times, a very experienced person in production department, or Operation
and Methods personnel too could be employed.
ii) Quantitative Skills:
Quantitative management-accounting qualifications require the
understanding of basic mathematical or statistical formulas. Accountants
must be able to break down large amounts of information into the most
succinct numbers needed for reports or statements. This requires basic
mathematical skills as well as a formal education in management
accounting. Quantitative accounting skills represent technical knowledge for
preparing standard accounting reports and statements. Individuals may also
need to understand budgets, forecasts, cost-volume-profit analyses or cost-
allocation methods.
iii) Qualitative Skills:
Qualitative qualifications represent the "soft" skills of accounting. Soft
business skills represent are personal characteristics that help individuals
communicate, negotiate and solve problems. Experience helps individuals
develop their understanding of management accounting. Accountants often
must ask questions and negotiate with operational or other managers to
receive additional information.

The job of Management Accountant calls for greater qualities of head and heart.
He must have qualities of leadership. He must be gifted with some creative and
prophetic skill for having an integrated and perspective view of the entire
enterprise.To be a successful Management Accountant he must possess the
following qualities.
i) Pleasing Personality: Management Accountant is required to have a
personality acceptable to all types of individuals that may make up the
management group. Because of the pleasing personality he gets cooperation
from the managers and his view are valued and thought over.
ii) Knowledgeable:In addition to being a good financial and cost accountant,
be must also have to good working knowledge of economics, law, statistics,
management and a thorough understanding of budgetary control. He must
also be familiar with the political conditions of the country.
iii) Analytical Mind:His task invites greater amount of skill and exercise of
analytical faculty of mind. He should be able think logically and have high
intelligence level. He should have analytical and interpretive skills.
iv) Awareness of Organization Activities:He must get acquainted with
various activities and functions of his organization. He must know different
stages of production to avoid of minimize the idle hours of any machine.

He must know the different types of material required, the best sources and
the best times of their procurement, the kinds of labour required and the best
possible way of recruitment, the best territories and the best method of sale
of effect optimum sales. It is said that the Management Accountant it the
efficiency, accountant who is vigilant about waste and sufficiency in the
various departments.
v) Understanding of Needs of Management: Management Accountant has to
fulfill the needs of various levels of management. The ability to receive the
views of managements with comprehensions and to appreciate the type of
information management is required of him.
vi) Proper Judgments: Management Accountantshave sound judgement and
good business sense. They need to make inferences or judgments from a
company's financial information. They often review financial information
before owners to ensure no errors or flaws exist.The capacity to think and
confer with top managements about matters central to the profitability and
progress of the company.
vii) Communication Skills: He must have good communication skills to be
able toconvey recommendations clearly.
viii) Other Qualities: They include
• ability to work methodically
• interest and aptitude for Mathematics
• prepared to take responsibility for decisions made on recommendations
• ability to work under pressure
• ability to work accurately
• comply with high ethical and professional standards required
• dependability and integrity
• determination and perseverance

1.5.2 Duties of Management Accountant

As defined by the Controller’s Institute of America duties of Management
Accountant are:
i) The installation and supervision of all accounting records of the
ii) The preparation and interpretation of the financial statements and reports of
the corporation.
iii) The continuous audit of all accounts and records of the corporation
wherever located.
iv) The compilations of costs of distributors.
v) The compilation of production costs.
vi) The taking and costing of all physical inventories.
vii) The preparation and interpretation of all statistical records and reports.

viii) The preparation and filling of tax returns and the supervision of all
matters reating to taxes.
ix) The preparation as budget, director, in conjunction with other offers and
departmental heads, of an annual budget covering all activities of the
corporation for submission to the Board Directors prior to the beginning of
the fiscal year.
x) The ascertainment currently that the properties of the corporation are
properly and adequately insured.
xi) The initiation, preparation and issuance of standard practices, relating to all
accounting matters and procedures and the coordination of system
throughout the corporation including clerical and office methods, records,
reports and procedures.
xii) The maintenance of adequate records of authorized appropriations and the
determination that all sums expended pursuant thereto are properly
accounted for,
xiii) The ascertainment currently that financial transactions covered by the
minutes of the Board of Directors and or the Executive Committee are
properly executed and recorded.
xiv) The maintenance of adequate records of all contracts and leases.
xv) The approval for payment (and/or countersigning) of all cheques promissory
notes and other negotiable instruments of the corporation which have been
signed by the Treasurer or such other officers as shall have been authorized
by the by-laws of the corporation or from time to time designed by the
xvi) The examination of all warrants for the withdrawal of securities from the
values of the corporation and the determination that such withdrawals are
made in the conformity with the by-laws and/ or regulations established
from time to time by the Board.
xvii) The preparation or approval of the regulations or standard practices
required to assure compliance with orders or regulations issued by duly
constituted Governmental agencies.

1.5.3 Rights of Management Accountant

In recognition of the professional knowledge, judgement and skills in
Management Accounting that a Certified Management Accountant (CMA) has
demonstrated, the ICMA grants CMAs the following rights to represent that
a) Possess special knowledge, skills and judgement in Management
Accounting and have the required competence, integrity, credibility and
understanding of the need for confidentiality.
ii) Understand the management process as well as the technical accounting
knowledge needed to contribute to the success of an organization.

iii) Have the knowledge and ability to assist management and to be part of
management, particularly where financial and accounting matters are
iv) Continue to improve their professional knowledge.
v) Comply with IMA’s Statement of Ethical Professional Practice.
vi) Are Certified Management Accountants and can use the designation on
business cards, letterheads, and in other professional ways so long as it does
not violate local legislation.

1.6 Merits and Demerit of Management Accounting

1.6.1 Merits of Management Accounting

i) Helps Decision Making: Management Accounting supplies management
data required for decision making through the process of classification and
combination, so that it can be understood by the person in management very
ii) Efficiency: It increases the efficiency of various business functions.
iii) Interpretation: Absolute figures in the financial statement convey no
meaning to the management. Management Accounting involves analysis
and interpretation of figures in financial statements and establishes relations
between the various figures so that conclusions can be drawn by interpreting
the ratios.
iv) Facilitates Control: Management Accounting facilitates control. It enables
all accounting efforts to be directed towards control of the destiny of an
v) Eliminates Guesswork: Decisions can be based on the information supplies
by the Management Accountant and thus Management Accounting
eliminates the elements of intuition and guesswork.
vi) Objectivity: The different tools of Management Accounting have increased
validity, objectivity and reliability in business management. It provides
technique for useful interpretation of accounting data.
vii) Realistic Data: It helps in development of realistic data in respect future
viii) Diagnoses Data: It is one of the diagnostic techniques available to the
manager executives for improving economic performance by realization of
the accounting systems in use.
ix) Utilization of Resources: Management Accounting makes possible
maximum utilization of limited resources of production so that the losses are
minimized, cost of production is reduced and maximum profits are ensured.
x) Enables Forecasting: Management reporting helps management in future
planning and control of business operations. The reports enable to measure
the actual performance with the budgeted standards. It enables a firm to
make it free to a great extent from inherent jumps and jolts of seasonal

nature of business and normal trade cycles. The business activities are
regulated systematically with the help of efficient planning and
organization, thus avoiding over-working in busy periods and slackness in
slump periods.
xi) Increases Productivity: Management Accounting helps in coordinating
operations to attain increase in productivity.
xii) Increases Profitability: Management enables the business to get maximum
return on capital by helping it in planning, distribution and controlling
xiii) Improves Labour-Management Relations: It helps in improving
relations between management and labour by avoiding unreasonable
standards of work which are the chief cause of labour unrest.
Management Accounting thus helps management in planning for the future in
the light of past experience. It provides the data for the formulation of a plan
and helps in allocation of responsibilities and resources.

1.6.2 Demerits of Management Accounting

Despite the fact that the development of an effective discipline in managerial
accounting is one of the most significant steps to improve managerial
performances, the new discipline has to face conditions which limit the
effectiveness of management through accounting. Though Management
Accounting plays an important role in helping management in discharging its
functions effectively and efficiently, yet it suffers from the following
limitations. Such conditions are :
i) Basis Records: The Managements Accounting collects the data from
various sources like Financial Accounting Cost Accounting, Statistics and
other records. If such data is inaccurate or partial the decisions arrived at on
the basis of such data may be incorrect of misleading. It, in other words
means, that Management Accounting may suffer from the same defects or
drawbacks which the basic data have.
ii) Lack of Knowledge: Management Accounting is a combination of various
subjects like accounting, economics statistics, sociology, psychology,
taxation, production law etc. In order to take a sound decision the persons in
management are required to have comprehensive knowledge of all such
subjects. But this quality is rarely found in the managerial personnel. In the
absence of such knowledge the managers cannot understand the information
or problem properly. This may result either in drawing wrong conclusions
or solving the problem in the wrong way.
As the emergence of management accounting has been the result of fusion
of a number of subjects like statistics, accounting, management, theory,
economics engineering, etc., an inadequate grounding on the part of
management in any one or more of these subjects is bound to have an

unfavourable effect on the consideration and solution of problems relating to
management performance.
iii) Complexity: Wide scope of Management Accounting may result in
inexactness and subjectivity in the conclusions drawn. There is every
possibility that the Management Accountant may have biased view in
collecting and interpreting the collected data. The ambitious nature of the
objectives, which management accounting seeks to serve, and the extremely
wide scope of the subject matter dealt which by it create many difficulties.
Thus it is one thing to record, interpret and evaluate an objective historical
event converted into money figures while it something quite different to
perform the same function in respect of past possibilities, future
opportunities and unquantifiable situations.
iv) Costly: The installation of system of management accounting requires a
very elaborate organization and a very large number of rules and regulations
with the consequence that the entire propositions becomes quite costly and
can, therefore, be adopted only by very big concerns.
v) Time Factor: It takes time to prepare and convince management to
implement new plans. Situations keep changing and in changed situation the
information provided by management accountant does not serve the
vi) Persistent Efforts: The conclusions drawn byManagement Accountant may
not be readily and willingly implemented. For this the Management
Accountant has to strive to convince the staff members.Through the main
contribution of management of accounting has been the elimination of
intuitive management there is always a temptation to take an easy course of
arriving at decisions, by intuition rather than taking the tortuous path of
scientific decision making. Execution of the conclusions drawn by
Management Accountant will not occur automatically. In fact, management
must be ‘sold’ to efficiency and must participate in the program.
vii) Intuitive Decisions: In order to take scientific decisions the persons
responsible to take decisions have to study various factors and alternatives
and to evaluate the alternatives from all the points of view. But this a
torturous path. As a result, the managerial persons are tempted to follow the
simple and easy path of intuitive decisions.
viii) Opposition/Psychological Resistance:Management Accounting requires
re-arrangement of the personnel and their activities. Such radical change is
not liked by those who are involved therein and therefore, they oppose to
have such change.
Adoption of a system of management accounting brings about a radical
change in the established pattern of the activity of management personnel. It
calls for a rearrangement of personnel as well as their activities. This is
bound to encounter opposition from some quarter or the other.

ix) Staff Function: Management Accountant can only guide but not
implement and thus at times his valuable suggests may be disregarded by
management leading to frustration.
x) Not an Alternative to Management: Management Accounting is
concerned only with helping management to perform better but it cannot
replace management.
xi) Evolutionary Stage: Comparatively, management accounting is a new
discipline and is still very much in a state of evolution. Therefore, it comes
across the same impediments as a relatively new discipline has to face–
sharpening of analytical tools, improvement of techniques and fluidity of
concepts creating uncertainty about their applications. The Management
Accounting is in its initial stage. It will go on developing as the days pass
by. It, therefore, has the impediments which any new disciplines have, e.g.
fluidity of concepts, raw techniques and imperfect analytical tools.

1.7 Use of Computers in Managerial Accounting

Nearly every organisation needs the analytical, advisory and decision-making

skills of a trained management accountant. Management accountants are mainly
concerned with the collection, comparison and interpretation of a large variety
of information and advice with regard to costs and cost trends, levels of
performance and budgets.

By applying their skills to the decision-making process, management

accountants are vital members of any management team. They contribute to the
management of organisations by identifying, presenting and interpreting
financial and other information for strategy, decision-making and
control. Organisations in every field make use of the knowledge of the
management accountant in matters such as budget control, labour
compensation, expense calculation, price determination, management guidance
and many other fields where analysis and control of expenditure are
necessary.Management accountants determine the organisation’s development
and efficiency in a competitive market. They also assess the impact of change in
organisations. Facts provided by management accountants serve as a basis for
the determination of the feasibility of any enterprise. They calculate expenses
and costs to determine pricing structures for goods and services. They may also
give advice on matters such as labour compensation and remuneration.

With the growing complexities of business, an array of information is required

which the management accountant has to wade through. Manually, it becomes
an impossible task taking into account the time within which he is expected to
collect, analyse, interpret, forecast and give proper suggestions.

Computers give Management Accountants a helping hand. Management
accountants use computers to provide more in-depth information required by
management for better planning, development and control. Computer software
is available for most areas of Management Accounting, including cost systems,
activity-based accounting (ABC), forecasting, budgeting, planning, material
requirement appraisal, CPM, PERT, flow-charting, etc. There are stand along
packages, templates, and spread sheets. All this makes the job much easier for
Management Accountant.


I Objective Type:

1. Select the right answer.

(i) Financial Accounts contain:
(a) Actual Figures, (b) Budgeted Figures, (c) Standard Figures
(ii) Management Accounting includes:
(a) Financial Accounting, (b) Financial Accounting and Cost
Accounting, (c) Cost Accounting
(iii)The branch of accounting which primarily deals with processing and
presenting accounting data for internal use in a concern is:
(a) Inflation Accounting, (b) Responsibility Accounting, (c) Financial
Accounting, (d) Management Accounting
[Ans. (i) a, (ii) b, (iii) d]

2. State whether each of the following statements is ‘True’ or ‘False’.

(i) Management Accounting deals only with quantitative information.
(ii) Only a Chartered Accountant is qualified to perform Management
(iii)Management Accounting is useful for internal management.
[Ans. (i) False, (ii) False, (iii) True]

II Theory Questions:

1. Give the meaning of Management Accounting. Explain the scope of

Management Accounting.
2. How is Management Accounting different from Financial Accounting?
3. Explain the merits of Management Accounting.
4. Write short notes on:
(i) Nature of Management Accounting
(ii) Qualifications of Management Accountant
(iii)Demerits of Management Accounting

Management Audit

2.0 Learning Objectives

After studying this Chapter the student should be able to:

 Understand the meaning of Management Audit;
 Grasp the nature, objectives and scope of Management Audit;
 Differentiate between Management Audit and Statutory Audit;
 Know the the qualifications and functions of Management Audit;
 Learn drafting of effective Management Audit report.

2.1 Meaning, Nature, Objectives, Scope and Importance of Management


2.1.1 Meaning of Management Audit

Audit means examination and evaluation of financial statements. Such audit
refers to Financial Statements. The main object of Finanical Audit, also called
Statutory Audit it to systematically examine the books of accounts and related
records to confirm whether or not the financial statements, i.e., Profit and Loss
Account and Balance Sheet depict a ‘True and Fair View’. All are familiar with
financial auditing which is statutory as per Companies Act, 1956. Statutory
auditor never goes into :
• Questioning whether wisdom of management decisions– vouchers are
sufficient for him
• Questioning whether the policies laid down by the management are properly
carried out or not;
• Suggestingas to whether any improvement in running the businesscan be
made in order to to maximize profits or to eliminate wastes;
• Making any suggestion as to whether centralization or decentralisations is
advantageous or not;
• Being concerned whethera change in the system of running the business is
beneficial to the concern;

An argument is at times put forward that the Internal Auditor fulfills all these
furnction as stated above. But internal auditor confines his attention to the
financial aspect for the prevention and detection of errors, frauds and
manipulations, etc.He being an employer cannot see the organization from a
different angle. With the complexities of business growing and situations
changing, Internal Audit is not the solution. Management requires views of
experts with a new perspective and therefore arise the need for Management
Audit.Management audits are often necessitated by major changes in a business.
Some of the events that call for a management audit are top management
changes, mergers and acquisitions, and succession planning.

Management Audit is the method to evaluate the efficiency of management at

all levels throughout the organization in order to ascertain whether sound
management prevails throughout and to report as to its efficiency or otherwise,
with recommendations to ensure its effectiveness where such is not the case.

'Management Audit' involves analysis and assessment of competencies and

capabilities of a company's management in order to evaluate their effectiveness,
especially with regard to the strategic objectives and policies of the business.
The objective of a management audit is not only to appraise individual
executive performance, but to evaluate the management team’s overall
performance too.

Management Audit is the auditing of management performance of an enterprise.

It covers all the areas of management. It is an independent appraisal activity for
the review of control of managerial functions so as to ensure compliance with
the organizational objectives, policies and procedures and the management
methods and purposes.

Management audit implies periodic check of the functioning of the industry by

experts. It is “a systematic and dispassionate study, analysis and appraisal of
the management’s overall performance.” It is concerned with examination and
evalution of management process as a whole. It covers review and appraisal of
managerial policies and plans in cornparison to the determinedstandards. It is a
critical review of policies, processes, procedures and operation which from part
of the internal control system it is an to management and oprates within the
organization.Management audit is an examination, review and appraisal for the
various policies and actions of the management. It is a tool for the evaluation of
methods and performance in all the areas of the enterprise.

Management audit is a complex task closely linked with process of

management. It usually involves the following steps:
i) Identification of the objectives of the organization. Sometimes the
objectives are stated in specific terms but, in most cases, they remain
undefined. It is important that objectives are clearly perceived and
ii) The overall objectives of the organization are to be broken down into
detailed targest and plans for various segments.
iii) The organizational structure is to be reviewed to assess whether or not it can
effectively achieve the overall objectives and the detailed targets. If

possible, specific responsibility centers may be identified in the
iv) The performance of each functional area or responsibility center is to be
examined. In many cases, the performance can be expressed in quantitative
terms. Aslo, it should be compared with the objectives and targets.
v) On the basis of the above examination, a realistic course of action may be
suggested. A motivation system can be operated whereby incentives are
given to various personnel on the basis of results of management audit.

Definitions of Management Audit

i) T.G Rose:
Management audit is an advice of indenpedent who have made a study of
how to reach maximum effencienty in a certain field of activity.

ii) Taylor and Perry:

Management audit is a method to evaluate the efficieny of management at
all levels throughout the organization, or more specifically it comprises the
investigation of a business by an independent body from the highest
executive level downwards, in order to ascertain in order to ascertain,
whether sound management prevails throughout, and to report as to its
efficiency or otherwise with recommendations to ensure its effectiveness
where such is not the case.

iii) Willam P. Leonard:

Management audit is a comprehensive and constructive examination of an
orgaisational structure of company, institution or branch of Government and
components thereof such as a division or department and its plans and
objectives, its means of operation and its use of human and physical

iv) Lislie R. Howard:

Management audit is an investigation of business from the highest level
downward in order to ascertain, whether sound management prevails
throughout, thus facilitating the most effective relationship with the outside
world and the must efficient organization and smooth running interally.

v) John Crowhurst:
Management audit is the comprehensive examination of an enterprise to
appraise its organizational structure, policies and prcedures to determine
whether sound management exists at all levels, ensuring effective
relationship with the outside world (i.e., shareholders, suppliers, customers,
the community in general) and internal efficiency.

Another clear and practice definition of the term management audit is
“management auditing is a method to evalute the effenciency of management at
all levels throughout the organization, or more speectificully it companies the
investigation of a business by an independent body from the highest executive
level downwards, in order to ascertain whether sound management prevails
throughout and to report as to its efficiency or otherwise, with recommendations
to ensure its effectiveness where such is not the case”

2.1.2 Nature of Management Audit (Features/Characteristics of

Management Audit)
i) Management audit is the process of examination and evaluation of the
performance of managerial fuctions.
ii) It is an appraisal of both policies and actions.
iii) It ensures the sound and healthy growth of the business organization.
iv) It is both preventive and cruative. Besides detecting and diagnosing the
existing problems, it suggest measures to avoid probable dangers.
v) It is not a post mortem examination of the business activities. Its concept is
forward looking and therefore management audit is more concerned with
vi) It is dynamic and result oriented rather than simply procedure bound.
vii) It is a constructive method of assisting management to improve the
operations of the business. It indenifies areas of weakness in internal control
system in operation and suggests measures to improve performance.
viii) It is an extension of internal audit and is a development over it and is very
close to opernational audit.

2.1.3 Aims and Objectives of Management Audit

Management audit aims at achieving the efficiency of the management by
identifying areas of weakness in interla control system and suggest measures to
improve the performance. It is carried out for the following objectives.
i) Aparise the managerial performance at all levels and achieve efficiency of
management by helping them efficiently discharge their duties and
ii) Enhance operatinal profitability.
iii) Improve organizational effeciency.
iv) Spot light the decisions or activities that are not in conformity with
organisatioanl objectivies.
v) Ascertain that organizational objectives are properly understood at all levels.
vi) Discover weaknesses or irregularities in the interal control system and
suggest measures to get best possible results.
vii) Evaluate plans and policies and whether they have executed properly or not.
viii) Review the company’s organizational structure, i.e., assisgnment of
duties and responsibilities and delegation of authority.

ix) Facilitate performance evaluation of different resources.

2.1.4 Scope of Management Audit

The term "Scope of Audit" means the audit procedure which is considered
necessary for the achievement of desired objectives. The auditor should keep in
view the following points :
i) Legal Conditions: While determining the scope of audit and auditor should
follow the rules and regulations applicable on the audit work.
ii) Validity of Data: The auditor should use various methods to test the
validity of data. He should confirm that data provided in the financial
statement is reliable.
iii) Cover all the Aspects: The auditor should cover all the functions of
business, know all its working. Any aspect related to financial statement too
may not be ignored.
iv) Comparison: The auditor can compare the accounts record with the
financial statement to know the true picture. He determines whether the
relevant information is properly communicated or not.
v) Apply his Skill: While preparing the report, an auditor should apply his
professional skill and experience to prove that figures and facts.
vi) Sufficient Record: The auditor checks that record and relevant data is
sufficient. He also uses other tests and verification procedure.
vii) Judgement:The auditor also considers the judgement of the management
made in preparing the financial statements. The auditor must have the
quality of judgement when he fails to find the data in the books of account.
viii) Internal Check: It is not possible for the auditor to check each and every
voucher and transaction, so he should try to rely on internal check system.
He is also bond to make guess work on the basis of available data.
ix) Persuasive Evidence: The auditor his opinion as true fair instead of cent
percent correct because the available evidence is persuasive. The personal
judgement also affects the value of any items.
x) Misstatement Problem: Due to the limitations of audit sometimes some
material misstatements remain undiscovered. So statement does not show
the exact view of operations.
xi) Clear the Doubts: If the auditor smells any fraud, he should check cent
percent items and clear his doubts. He should extend the procedure to
confirm his doubts.
xii) Opinion of Auditor: If auditor is satisfied about financial information of
business then he can express the unqualified opinion otherwise he will
express qualified opinion.

Functional Areas for Management Audit

Management audit encompasses evaluation of all the functional areas of the
business, namely;

i) Purchase
Methods of purchase, quantities procured , problems on procurement and
discount earned etc;
ii) Production
Policy schedules of production, actual quantity produced at different levels ,
variances in production schedule, input-output ratios, ideal time etc;
iii) Distribution
Organisation of sales department, budgeted sales, actual performance,
incentives offered for sales, promotional offers, effectiveness of distribution
channels etc;
iv) Personnel
Personnel policy, method of recruiting and training, cost of man power,
promotion policy, appraisal policy, labour welfare activities.
v) Finance and Accounting
Financial structure followed, sources of raising funds, effectiveness of
raising finances, extent of working capital needs, financial controls
followed, systems of accounting, effectiveness of cost control devices;

2.1.5 Importance of Management Audit

The objectives of Management Audit are to pinpoint weaknesses or
irregularities at whichever level of management these may be existing so as to
attain maximum efficiency and effectiveness in every field, and to aid and assist
the management in accomplishment of this objective. Management audit,
though not compulsory for the organizations to undertake, but due to the
advantages it provides, it is advovated. The advantages are listed in section 2.2
A of the chapter.

2.2 Merits and Limitations of Management Audit

2.2.1 Merits (Advantages/Significance/Importance) of Management Audit

i) It detects deficiencies or irregularities in the interal control system and
suggests ways and means for best possible results.
ii) It assists all levels of management in effective discharge of their
iii) Probable managerial problems and related operational difficulties can be
spotted before the fact.
iv) It enhances operational productivity and promotes organizational efficiency.
v) It ensures optimum utilization of available resources by critically reviewing
all aspects of the management of an enterprise.
vi) It makes staff of the enterprise more responsible by fixing the
accountablility for poor performance.
vii) Management audit also assists in locating and diagnosing the conflicting
areas of responsibility.

2.2.2 Limitations (Demerits/Criticism) of Management Audit
Inspite of the various advantages of the management audit, it has been criticized
by the managers and accountants as a vague concept which serves no material
purpose. It is criticized on the following basis:
i) Instead of serving any useful purpose, it would discourge the intitative and
dynamism of the management.
ii) The management will not pay any attention to higher production because
they will always try to keep the books of account and other data up to
daterather than to pay attention to higher production and efficiency.
iii) The management will not take any risk because their decision may prove to
be wrong even through the instructions were for the good of the
iv) The critics also point out that the management auditor will always try to find
out some fault or another in order to justify his appointment and existence.
v) It is considered expensive as the fees paid to management consultant is an
handsome amount.

These criticisms are not convincing. The fear on the part of management is
uncalled for and is based on wrong notions. The role of the management auditor
is to point out the deficiencies in the actual performance and to what extent the
target laid down, has not been achieved. The cases contributing to the non
fulfillment of the targets must be highlighted. He shall make suggestions as how
to achieve the predetermined targets. Though management audit is a new
concept, it is an effective tool of management control in many sitructions to
improve the performance of the managers of the organization and in
accomplishing the desired objective. Such an audit is highly result oriented. As
stated ealier, these days quite a few companies invite experts from various fields
to undertake management audit periodically to asses the performance of their
managerial cadre officers and link a system of incentives with such assessment
for rewarding their efficient managersand other personnel.

2.3 Difference between Management Audit and Statutory Audit

Stautory Audit is an audit which is made compulsory by law for certain kind of
organizations like for per Companies Act, 1956, for banks as per Banking
Companies Act, 1949, for societies as per Societies Registered Act, 1860, for
Corporations, etc. It involves systematic and scientific examination of books of
accounts and related records of the organization by a qualified Chartered
Accountant. Management Audit on the other hand is concerned with evaluating
the efficiency of the management by analysis of various functions performed by
the management. It could be undertaken by an employee specially appointed
for this purpose or a qualified outsider. The differences between the two audits
are as under:

S.No. Basis of Statutory Audit Management Audit
1 Subject Review of financial Review of past
Matter aspects of business performance of the
transactions represented enterprise to examine the
through its Profit and Loss
efficiency of almost every
Account and the Balance area of operation within
Sheet for the period. the organization.
2 Object To ensure that the To achieve the efficiency
Financial Statement reflect
of management by areas
the true and fair view of of weakness in the
state of affairs of the internal control system
company. and suggest measures to
improve the performance.
3 Approach Exmination of accounting The approach of
records relating to a management audit is very
previous year, i.e., past dyanamic and forward
financial year. Financial looking and mainly
audit thus follows a focuses its attention to
backward approach. future planning and
performance after
reviewling the past
performance of the
4 Legal Compulsory under law for Not compulsory under the
Requirement every company registered law.
under the Companies Act,
5 Audit Vouching of business Management auditor
Techniques transactions and establishes the adequacy
verification and valuation and reliability of
of Balance Sheet items are procedures and internal
the primary techniques control system in
used by the financial operation.
auditor to form an opinion
on the financial statements
and accounts.
6 Concentration Detection and prevention Apparisal of management
of errors and frauds of policies and actions
financial nature.
7 Sequence Financial audit begins Management audit begins
where the work of where the financial
accountancy ends. auditing ends.
8 Qualification An independent Chartered There is no staturoty quail
of Auditor Accountant in practice or fications to be possessed
a firm of Chartered by a management auditor.
Accountants can resume It may be undertaken by
the responsibility of any independent expert
conducting financial audit. or consultant or
internal auditors.
9 Appointment Financial auditor in Management auditor may
of Auditor generally appointed by the be appointed by the board
shareholders in the general ofdirectors on their sole
meeting. discretion.
10 Reporting Financial auditor reports Management auditor
to shareholders in case of reports to the
a company within time management. No time
limit. frame as regards
submission of
management audit report.

2.4 Qualifications, Duties and Role of Management Auditor

2.4.1 Qualifications of Management Auditor

Due to keen competition in the business world today, the management of the
industrial organizations wants to minimise the cost of production which is
possible by eliminating wastes, avoid bottlenecks and to utilise fully the
manpoweras well as the plant and machinery management now-a-days recruit
auditors from the field other than accountancy. Such a person is called
management auditor.

Management audit is not legally required and therefore, there are no statutory
qualifications to be possessed by the Management Auditor. The Companies Act
does not contain any provision in relation to qualifications and mode of
appointment of management auditor. It is therefore up to the board of directors
or management of the enterprise as to who should be appointed as management
auditor. Management audit may be undertaken by any indenpedent expert or
management consultant. The management can also entrust these responsibility
to the interal auditor. The management audit in fact is an extention or expansion
of internal audit and thus, internal auditor are considered to be more competent
to conduct the management audit. In certain case management may also
appoint‘Organization and Methods Study’ (O&M) personnel as management
auditors. O & M department study both organizations and methods, and
therefore, personnel associated with the department are also deemed fit to
undertake this work. Thus, it differs from one case to another case and depends
upon the certain circumstances as who should be assigned the task of
management audit. But in this regard the management i.e. the appointing
authority of management auditor should take note of the fact that technical
profieiency is pre-requsite in any case to shoulder the responsibility of
management audit. Therefore, it is immarterial whether the management auditor
is O & M personnel or interal auditor or an independent expert or consultant.
First of all he must be technically proficient and fit for the job.

Thus, management auditor could either be an employee of the company or

independent consultant (an individual or a firm). Whatever qualification he
may have or irrespective of whether he is an employee or a consultant,
management audit should be conducted byexperienced and well-trained
interviewers. It isthe objective of the process not to assess theindividual
manager in isolation but in context totheir competitors and comparable roles
outsidethe company. This benchmark information is mostvaluable and delivers
conclusions as to theeffectiveness of the management team.

2.4.2 Duties and Role of Management Auditor

Major roles and responsibilities of management auditor are summarised as

• evaluates and provides reasonable assurance that risk management, control,

and governance systems are functioning as intended and will enable the
organisation's objectives and goals to be met
• reports risk management issues and internal controls deficiencies identified
directly to the audit committee and provides recommendations for improving
the organisation's operations, in terms of both efficient and effective
• evaluates information security and associated risk exposures
• evaluates regulatory compliance program with consultation from legal
• evaluates the organisation's readiness in case of business interruption
• maintains open communication with management and the audit committee
• teams with other internal and external resources as appropriate
• engages in continuous education and staff development
• provides support to the company's anti-fraud programs.

To fulfill his duties the management auditor uses the following techniques to
evaluate management fuctions.
i) Preliminary Survey: Before the commencement of a management audit,
the auditor should ascertain the following. Management auditor should
study the details of organization and its plans.

a) Objectives and goals of the enterprises with a view to assess the
possibilities of getting the desired results through them.
b) Suitability of policies, plans and procedures laid down by the
c) Effectiveness and credibility of the communication system including
management information system of the organization.
d) Adequacy of internal control system in operation.
e) Standards of performance set by the management.
f) Actual performance.
g) Effciency and economy of resources input.
ii) Enquiry: Management auditor gathers most of the information and seek
explanation by asking questions. For this he can make the use of standards
questionnaire specifically designed for the purpose. Inquiry A management
auditor collects most of the evidence required by him by asking relevant
questions and obtaining satisfactory answers to these questions. Proper
framing of questionaries is one of the first steps in conducting managements
audit. The main value of questionaries lies in the fact that a good question is
often a key to uncover a hidden problem. Some of the question that the
management auditor can ask in different areas are given later. It must be
emphasisted that these questions just illustrate the process of management
audit. Raising a proper question is often a matter of personal judgement in a
specific situation.
iii) Detailed Inspection of Relevant Documents: Management auditor may
have to examine documents or other information in writing to confirm the
information which he has already collected by asking questions. A
management auditor may resort to detailed inspection i.e. examinations of
relevant documents and records if his inquiry necessitates the examination
of original source of information for clarification of certain facts.
iv) Studying the Work Environment: Another productive source of collecting
pertinent information coupled with its examination is the direct observation
by the management auditor. Through studying the work environment the
auditor becomes aware of many problems that may not be recorded
elsewhere or the analysis thereof is not possible through data.
v) Review of Internal Auditor’s Report: Management audit in fact is more or
less extension of internal audit. Therefore, the reports submitted by the
internal auditor enable the management auditor to identify the problem areas
without much difficulty. Management auditor then forms his opinion on the
basis of evaluation of such reports. In particular, he should pay his attention
towards those reports which highlight significant problem areas where the
managements so far has not taken any action. Investigation into the reasons
and/or justification for inaction on part of the management in such cases
should be made by the management auditor. Such a review of internal

auditor’s report could throw light on weakness in internal control system
that may not have been referred to the top management previously.
vi) Physical Inspection: The management auditor sometimes conducts
physical inspection of activities of the enterprises. It proves to be very
useful tool to identify incompetency. Remedial measures can only be
suggested after identifying the areas of weakness or incompetency.
vii) Test Examination of Some Transactions: The management auditor selects
some transactions of varied nature on random basis and test the efficiency of
procedures by thoroughly studying the transactions so selected right from
their initiation to the final disposal.
viii) Personal Discussion with Officials and Employees: With a view to
have first hand information on problem areas warranting audit attention,
management auditor should hold discussion with the officials and
employees of the enterprise, who are concerned with the operations under
ix) Analysis and Suggestions for Improving the Performance of
Management: During the course of audit, the management auditor
identifies areas of problem or weakness in the system. He then investigates
into it and analyses the adequacy and efficacy of procedures, and suggests
remedial measures for further improvement in the performance of
management and the enterprise.

2.5 Drafting Reports for Managerial Effectiveness

“A good business report is a communication that contains factual information,
organised and presented in clear, correct and coherent language.” - Johnson and

A Management Auditor has to submit his report to the management of the

enterprise. There is no prescribed form of management audit report. Its form
and contents are to be decided by the auditor himself. The report should
normally contain the auditor’s opinion on the following matters.
i) Whether the internal control system in operation is adequate and foolproof.
ii) Whether the return on capital employed is satisfactory and reasonable
iii) Is the current rate of return is adequate in comparison to that of the last
iv) Position of the operating costs of the enterprise in comparison to that the
other concern engatged in similar business.
v) Whether the existing plant and equipment is suitable or otherwise to get the
optimum production.
vi) Whether the overall performance of the enterprise is satisfactory if not what
are the remedial measures to improve the performance.
vii) Are the relationships among the management and staff and workers cordial
and free from disagreement on material issues.

Besides a good management audit report should possess the following qualities:
i) Presentation
The report should be given proper title, headings, sub-headings and
paragraph divisions.
ii) Simplicity
The report should be presented in a simple, unambiguous and clear
iii) Promptness
Promptness in submitting a report is an essential element of a good report.
The reports should be sent at the earliest and should not be delayed.
iv) Frequency of reports
Along with promptness, the frequency of reporting is also significant. The
timing of reporting will depend upon the nature of information and its
purpose. These reports are prepared for appropriate persons.
v) Relevancy
The reports should be presented only to the persons who need them.
Sometimes the reports are sent to various departments and the secrecy will
not be maintained and expenditure will be more.
vi) Consistency
There should be a consistency in the preparation of reports. The
comparability of reports will be possible only if they are consistent.
vii) Comparability
This reporting system is meant to help management in taking correct
decisions and improving operational efficiency of organisation. This
information helps in finding out deviations or variances.
viii) Controllability
The report should be addressed to appropriate persons in respective
responsibility centres and its variance should be mentioned. It should be
drafted in such a manner so as to contribute to productivity of resources
input and act as controlling device to check inefficiency in the entire system
of management.
ix) Cost Consideration
The cost of preparing and presenting the report should also be considered
and it should not exceed the advantage derived from such reports.
x) Accuracy
The reports should be reasonably accurate. A report sometimes will be
approximated but approximation should not be done up to the level where
information loses its form and utility.The report should contain correct
information and statements based on facts collected by the auditor.
xi) Operational
It should be operational and suggestive. It should contain recommendations
which should be constructive and not condemning in nature.

xii) Clarity
It should be compact and concise, but at the same time clear, unambiguous
and comprehensive of pertinent and significant information.
xiii) Impartiality
It should contain impartial and correct assessment of operating efficiency of
the enterprise and potential of management.
xiv) Tone of Words
It should be critical but courteous, i.e., even it it has to critize management it
should be so worded as to avoid unnecessary sharpness or implication.


I Objective Type:

2. Select the right answer.

(iv) Financial Accounts contain:
(a) Actual Figures, (b) Budgeted Figures, (c) Standard Figures
(v) Management Accounting includes:
(b) Financial Accounting, (b) Financial Accounting and Cost
Accounting, (c) Cost Accounting
(vi) The branch of accounting which primarily deals with processing and
presenting accounting data for internal use in a concern is:
(b) Inflation Accounting, (b) Responsibility Accounting, (c) Financial
Accounting, (d) Management Accounting
[Ans. (i) a, (ii) b, (iii) d]

2. State whether each of the following statements is ‘True’ or ‘False’.

(iv) Management Accounting deals only with quantitative information.
(v) Only a Chartered Accountant is qualified to perform Management
(vi) Management Accounting is useful for internal management.
[Ans. (i) False, (ii) False, (iii) True]

II Theory Questions:

5. What do you understand by Management Audit? Explain its nature.

6. What are the limitations of Management Audit?
7. Give the differences between Management Audit and Statutory Audit.
8. Write short notes on:
(iv) Objectives of Management Audit
(v) Duties and role of Management Auditor
(vi) Qualities of a good Management Audit Report

Analysis and Interpretation of Financial Statements

3.0 Learning Objectives

After studying this Chapter the student should be able to:

 Understand the meaning of financial statements;
 Comprehend the importance as well as limitations of financial statements;
 Grasp appropriate formats for presentation of and items of Profit and Loss
Account and Balance Sheet;
 Know the different tools and techniques for analysisng and interpreting the
financial statements;
 Learn the technique of preparing comparative statements and undertaking
trend analysis;
 Recognize the requirements and limitations of inter-firm comparison.

3.1 Introduction, Significance, Advantages and Limitations of Financial


3.1.1 Introduction to Financial Statements

Every business is concerned with knowing its earnings at during a period and
financial position on a particular date. The purpose is to get a periodic review
or report on the progress of the organization. In order to ascertain the financial
status of the business every business prepares certain statements which are
called financial statements. The financial statements thus contain summarized
information of the firm’s financial affiars. These financial statements are
prepared not only for the management and owners but also for outsiders like
investors, creditors, lenders, etc.

The term Financial Statements in accounting are used to refer to two basic
statements,which the accountant prepares at the end of a given period of time
for business enterprise. They are :
i) Income Statement (Profit and Loss Account) : It is prepared by a business
to know the profit earned and loss sustained during a specified period.
ii) Statement of Financial Position (Balance Sheet): It is prepared on a
particular date to know its financial positions relating to assets and

To these statements are added the statement of retained earnings and mome
other staements like funds flow statement, cash flow statement, etc. and
schedule of fixed assets like investments, equipmens and debtors, etc. to give a
full view of financial afairs.

A financial statement is a collection of data and presenting it in a summarized
form to convey an understanding of some financial aspects of a business
i) John N. Myer:
The financial statements provide a summary of the accounts of a business
enterprise, the balance sheet reflecting the assets, liabilities and capital as on
a certain date and the income statement showing the results of operation
during a certain period.
ii) Smith and Asburne:
Financial statement is the end product of financial accounting in a set of
financial statements prepared by the accountant of a business, that purpose
to reveal the financial position of the enterprise, the result of its recent
activities, and an analysis of what has been done with earnings.
iii) Anthony:
Financial statement, essentially are interim reports, presented annually and
reflects a divison of the life of an enterprise into more or less arbitrary
accounting period, more frequently a year.

Forms of Presentation and Contents of Financial Statements

1. Income Statement (Profit and Loss Account)
Income Statement or Profit and Loss Account presents the summary of revenue
and expenses and net income (or net loss) of a firm for a period of time. It thus
serves as a measure of the firm’s profitability. It indicates the firm’s earning
capacity. As it shows operating results it is also called as Income Statement. It
is also a measure of company’s financial strength. It is thus a ‘scoreboard’ of
the firm’s performance during a particular period of time. Since the Profit and
Loss Account reflects the results of operations ‘for a period of time’, it is a
‘Flow’ Statement. This Account is prepared for one year’s duration, i.e., on an
annual basis.

The Profit and Loss Account can be presented in two forms:

i) Horizontal Form :
It is also called as Account form with Profit and Loss Account being divided
into two equal parts making ‘T’ shape account. On the left hand side are the
expenses and on the right hand side are the sources of income or revenue.

Format of Horizontal Form

Name of the Company

Profit and Loss Account
For the year ending 31st March ____

Particulars Amount Particulars Amount

(Rs.) (Rs.)
To Cost of Goods Sold --- By Sales ---
(Opening Stock +
Purchases – Closing
Stock) ---
To Gross Profit
Total --- Total ---
To General and ByGross Profit b/d ---
Administrative Expenses --- By Non Operating ---
To Selling and Income
Distribution Expenses ---
To Interest ---
To Depreciation ---
To Non Operating ---
Expenses ---
To Provision for Tax ---
To Net Profit
Total --- Total ---
To Provision for Dividend ByNet Profit
To Balance to be carried
forward to Balance Sheet
Total --- Total ---

ii) Vertical Form :

It is also called as Report Form or Step Form. The items of Profit and Loss
Account are displayed one after the other starting from Sales and there are
no right hand side and left hand side items. This too is represented in the
following two forms:
a) Single Step Form
In this form all revenue items (operating and non-operating) are
recorded first and then the items of expenses are shown. Total of
expenses are subtracted from total revenue to obtain net profit.

Format of Single Step Form
Name of the Company
Profit and Loss Account
For the year ending 31st March ____

Particulars Amount (in Rs.) Amount (in Rs.)

Sales ---
Non Operating Income ---
Total ---
Cost of Goods Sold ---
General and Administrative Expenses ---
Selling and Distribution Expenses ---
Interest ---
Depreciation ---
Non Operating Expenses ---
Provision for Tax ---
Total ---
Net Profit After Tax ---
Provision for Dividend ---
Balance to be carried forward to ---
Balance Sheet

b) Multiple Step Form

This form makes a distinction between operating and non-operating
revenue. It also reveals important information like gross profit, profit
before tax and profit after tax.

Format of Multiple Step Form

Name of the Company

Profit and Loss Account
For the year ending 31st March ____

Particulars Amount (in Amount (in

Rs.) Rs.)
Sales ---
Less: Cost of Goods Sold ---
Gross Profit ---
Less: Operating Expenses
General and Administrative Expenses ---

Selling and Distribution Expenses ---
Interest ---
Depreciation --- ---
Operating Income ---
Add: Non Operating Income ---
Less: Non Operating Expenses --- ---
Net Profit Before Tax ---
Less:Provision for Tax ---
Net Profit After Tax ---
Less: Provision for Dividend ---
Balance to be carried forward to Balance ---

2. Statement of Financial Position (Balance Sheet)

Statement of Financial Position is one of the most significant Financial
Statement. It indicates the financial condition or state of affairs of a business on
a particular moment of time. It is also called Balance Sheet or Position
Statement. More specifically, the Balance Sheet contains information about the
resources and obligations of a business entity and about its owner’s interests in
the business at a particular point of time. Thus a Balance Sheet of a firm
prepared on 31 st March reveals the firm’s financial position on that specific
date. It provides a snapshot of the financial position of the firm at the close of
firm’s accounting period. Balance Sheet is a ‘Stock’ or ‘Status’ Statement as it
shows assets, liabilities and owner’s equity ‘at a particular point of time’.

The Balance Sheet can be presented in two forms:

i) Horizontal Form : Balance Sheet as a Statement of Assets and Liabilities
In this kind of presentation the Balance Sheet is divided into two equal parts
making ‘T’ shape account. It is also called Account Form. On the left hand
side are the credit balances, i.e., share capital, long term liabilities, short
term liabilities, and provisions and on the right hand side are the assets. The
other terms used for such presentation are Horizontal Form, Position
Statement, or Statement of Financial Position.

Format of Horizontal Form
Name of the Company
Balance Sheet
as on 31st March ____

Liabilities Amount Assets Amount

(Rs.) (Rs.)
Share Capital Fixed Assets
(authorised, issued and Goodwill 11,500
paid up) Land and Building
Equity Share Capital Plant and Machinery
Preference Share Capital Furniture and Fixtures
Reserves and Surplus Investments
Capital Reserve (in bonds, shares, etc.)
Share Premium Current Assets, Loans
Surplus of Profit and Loss and Advances
A/c i) Current Assets
Loans Stock (of raw material,
i) Secured Loans work
Debentures in progress, finished
Loans from Bank goods,
ii) Unsecured Loans spare parts and loose
Fixed Deposits tools)
Current Liabilities and Sundry Debtors
Provisions Bills Receivable
i) Current Liabilities Cash in Hand
Bank Overdraft Bank Balance
Sundry Creditors i) Loans and Advances
Bills Payable Miscellaneous
Other Creditors Expenditure
ii) Provisions Prelimiary Expenses
Provision for Taxation Underwriting
Provision for Dividend Commission
Discount on
Profit and Loss A/c
(Debit Balance)
Total Total
Contingent Liability :

ii) Vertical Form : Balance Sheet as a Statement of Sources and Application

of Funds

It is also called as Report Form or Statement of Sources and Uses of Funds.
The items of Balance Sheet are displayed one after the other and there is no
right hand side and left hand side items.

Format of Vertical Form

Name of the Company
Statement of Sources and Application of Funds
as on 31 st March _____

I Sources of Funds Amount (Rs.) Amount (Rs.)

1 Shareholders’ Funds
i) Capital (Equity and Preference) ---
ii) Reserves and Surplus --- ---
2 Loan Funds
i) Secured Loans ---
ii) Unsecured Loans --- ---
Total ---
II Application of Funds
1 Fixed Assets
i) Gross Block ---
ii) Less: Depreciation ---
iii) Net Block ---
2 Investments ---
3 Current Assets, Loans and Advances
i) Stock ---
ii) Sundry Debtors ---
iii) Other Current Assets ---
iv) Cash and Bank Balance ---
v) Loans and Advances ---
Total ---
Less: Current Liabilities ---
and Provisions
Net Current Assets ---
(Net Working Capital)
Miscellaneous Expenditure ---
Total ---

3.1.2 Significance and Advantages of Financial Statements

Financial statements mean Profit and Loss Account and Balance Sheet of a
concern. Financial statements are basically for use of owners for knowing the
profitability and resources and obligations, management to understand the
efficiency of different cost centers, creditors, bankers and investors for
understanding the liquidity and solvency position of the enterprise while giving
loans, credit and sanctioning loans, government for assessing the tax liability,
employees to know that the bonus paid to them is proper or not, stock
exchanges for fixation of prices, etc.

To understand the benefits advantages of Financial Statements, the advantages

of each of them separately have to be understood.
1. Profit and Loss Account provides the following benefits:
i) It gives a concise summary of the firm’s revenue and expenses during a
period of time.
ii) It measures the profitability of the concern. Profit and Loss Account
matches revenue and expenses to determine net profit or net loss.
2. Benefits of Balance Sheet are as under:
i) It gives a concise summary of the firm’s resources (assets) and
obligations(liabilities and owner’s equity).
ii) It is a measureof firm’s liquidity. Liquidity refers to the firm’s ability to
pay debts as they mature. The net current assets or working capital is
the measure of liquidity.
iii) It is a measure of firm’s solvency. Solvency is measured by total assets
to toal liabilities. The high proportion of debt endangers solvency of the

3.1.3 Limitations of Financial Statements

The nature of figures which are reported and the way in which they are reported
tend to gve impression to the reader that financial statements are precise, extact
and final. But this is not the case in that these statements have certain
1. Limitations of Balance Sheet
i) Hisotrical Basis: The figures given in the balance sheet are on a
histrocal basis. The book value shown is based on the original cost after
deducting accumulated depereciation. The technological and economic
events since the date of acquision might hasve changed its replacement
while considerably. Therefore, a decision to replace the assets may
cause is severe financial drain affecting the liquidity of the company.
ii) Value of Liabilities in Case of Liquidation: Accounting is done on the
basis of certain conventions according to one of which the assets of the
company are valued on a ‘going concern’ basis. Since of the assets may
not realize the stated value if liquidation is forced on the company.
Assets shown in the balnce sheet reflect merely unexpired or
unamortised costs. However, the liablilities to the settled remain at the
same figure seriously affecting the solvency of the company.
iii) Not Much Help to Investor: As investor who wishes to anaylse the
balance sheet it more concerned with the present and future whereas the

balance sheet pertains to a point of time realting to past the therefore
may not be quite helpful.
iv) Exclusion of Certain Qualitative Assets: A balance sheet is described
as a statement of all assets and liabilities. But this is not true. Balance
sheet records only monetary facts. There are certain assets and liabilities
which it does not disclose. For example, the most tangible asset of a
company these days is its management force, which the balance sheet
does not disclose. Efforts are being made to quantify the human forces
but the technique is still not perfect. Likewise, balance sheet does not
disclose a dis-satisfied labour force which is a perennial liability to the
v) Exclusion of Certain Liabilities: Because of the fixibility of the
accounting principles certain liabilities are not provided for and to that
extent balance sheet will be give a misleading picture. To give one
example, most of the companies do not make any provision of payment
of graduity.
vi) Inadequate Information: Balance sheet does not disclosevital
information relating to changes in management, loss of market,
cessation of agreements which have a vital bearing on the earning of the
vii) Not Useful in Decision-Making: Companies present the financial
statements is accordance with the Schdule VI of the companies Act.
They are drawn up form the point view of the sharedholders and are
perfunctory in their presentation in that they merely reveal whether the
funds made availbe to the management have been satisfactorily
managed. If does not in any way help the dicision making of the
investors, creditors, and workers, That is why in recent years there has
demand for more and more information to the displaced in the published
accounts to serve the interests of others users as well.
viii) Time of Preparation of Balance Sheet: The balance sheet is
prepared at a point of item and the accounting year may be deliberately
chosen in such manner that is gives favourable picture. For example, in
the case of a highly seasonal industry like sugar a balance sheet prepared
during the off season may show good liability position. But the
accounting date coinsides with crushing season it will show the strain on
ix) Personal Judgement: Personal judgement plays a great part in
determining the figures for the balance sheet. Provision of depreciation,
stock valuation, amounts to the set apart for bad debts, etc. are based on
personal judgement and therefore not free from basis.
x) Problem of Manipulation: Very occasionally even audited balance
sheet have proved to the disastrously inaccuarate and misleading. Cases
in the High Courts have included deliberated mispulation of profit and

current assets on the part of highly placed company officials by inflating
closing stocks. One bank advanced about a quarter of million pounds on
the strength of such a balance sheet. The subsequent failure of the
company revealed the stock manipulations and the bank suffered huge
losses. Therefore, audit the accounts does not provide the complete seal
of accuracy.
xi) Variations in Accounting Policies: Financial statements are based are
accounting policies which very form enterprises both within a single
country and among countries. The users of the financial statements
require them as a part of information needed, among other purposes, for
making and evaluating financial dicisions. They cannot make a reliable
judgement on these matters unless the financial statements clearly
disclose the significant accounting policies which have been adopted in
preparing them
2. Limitations of Profit And Loss Account
i) Hisotrical Basis: Net profit is ascertained on the basis of histrocial
costs. In many companies if these profits are adjusted for inform there
may be no profit at all. According to a recent study made by Shri. N.
Mishra the continuous rise in prices had adverserly affected business
enterprises in the country. Their increases are not as good as they look.
They are paying taxes on capital and distributing dividend out of capital.
ii) Misleading Profits: Profit repeated by the profit and loss account is
only interm in nature. True profit can be ascertained only after the
concern has run its entire life.
iii) Calcuation of Cetain Costs and Revenue: The net income as disclosed
by the Profit and Loss Account is not absolute but relative in that this
statement is the outcome of (a) conventions and concepts (b) correct
calculations of expired costs and (c) correct recognition of revenue. The
concepts and conventions affecting the calculations of insurance are
many. The calculation of expired cost is a difficult process and
recognition of revenue is affected by various considerations.
iv) Exclusion of Non-Financial Items: Just the balance sheet does not
disclose non-financial items similarly the Profit and Loss Account does
not reveal factors like quality of management, loyalty of the working
force, quality of the working force, quality of the product, etc.
v) Personal Judgement: Again, as in the case of balance sheet, the net
income is the result of personel judgement. In such matters as
depreciation, stock valuation, allocation of expenditure between capital
and revnue. No doubt there are accepted principles of accoutnting
governing these, but bais of the accountants cannot be removed

3.2 Tools and Techniques of Financial Analysis

According to Harry Guthmann, “The first and most important function of

financial statement is, of course, to serve those who control and direct the
business, to the end of securing the profits and maintaining a sound financial
condition… questions as to how efficiently the capital of the business is being
utilized, how well credit standards are being observed and whether the financial
condition is being imporved my be answered in the financial statements.”

Financial Statements are indicators of the two significant factors – (i)

Profitablity and (ii) Financial Soundness. Financial Statements are prepared in
absolute manner are of very little significance to management. Figures standing
alone in Financial Statements convey no or little meaning to management.
Management wants to know financial strength of the business, its liquidity and
solvency position, its earning capacity, trends and future prospects. To serve
this purpose figures recorded in Financial Statements are to be rearranged and
analysed in such a manner that they become more intelligible to the
management who are not experts in accounting. Analysis of Profit and Loss
Account and Balance Sheet consists of breaking it down into various elements
like Gross Profit, Net Profit, Operating and Non-Operating Expenses, Net Profit
Before Tax and Net Profit After Tax, Owners’ Equity, Total Funds Employed,
Current Assets, Working Ccapital, etc.

Analysis and interpretation of Financial Statements refers to such a treatment of

the information contained in them so as to afford full diagnosis of the
profitability and financial soundness of the business. Analysis thus, means
evaluation, examination or breaking things into parts or elements to make it
easier to understand.Analysis means methodical classification of data given in
the Financial Statements. The figures given in the Financial Statements will not
help unless they are put in a simplified form. For example, all items relating to
‘Current Assets’ are put at one place while all items relating to ‘Current
Liabilites’ are put at another place. Interpretation means explaining the meaning
and significance of data so simplified. Analysis is useless without interpretation
and thus analysis covers both analysis and interpretation as analysis involves

Analysis of Financial Statement thus helps the management at self appraisal and
also helps sharehlolders to judge the performance of the management. There are
also outsiders like debenture holders, investors, bankers, legislators, creditors,
etc. who are interested in analysis and interpretation of financial statements.

Analysis of Financial Statements are of two types:
i) Trend Analysis or Dynamic Analysis which is made by analysing the
Financial Statements over a period of yerars. This indicates the trend of
variables like casles, cost of production, assets, liabilities, etc. They are also
called Horizontal Analysis.
ii) Structural Analysis or Static Analysis which is made by analysing a single
set of financial statements prepared on a particular date. It indicates
relationship between different accounting variables. For example, ratio of
gross profit to net sales, ratio of total outside debt to equity, etc. They are
also called Vertical Analysis.

The Financial Statements are made simpler to understand the operating results
and the financial health of the business by using the following tools:
i) Comparative Financial Statements i.e., Comparative Income Statements and
Balance Sheets
ii) Common Size Statements
iii) Trend Ratios
iv) Ratio Analysis
These tools aid the interested parties in interpreting the financial statements.

3.2 Comparative Financial Statements and Trend Ratio or Analysis

3.2.1 Comparative Financial Statements

Financial Statements of two or more firms may be compared for drawing
inferences. This is known as inter-firm comparison. Similarly, there may be
inter-period comparisons i.e. comparison of the financial statements of the same
firm over a period of years known as trend analysis. This is also known as
horizontal analysis since each accounting variable for two or more years is
analysed horizontally. Inter-firm or inter-period comparisons are very much
facilitated by the preparation of comparative statements. In preparing these
statements, the items are placed in the rows and the firms or years are shown in
the columns. Such arrangement facilitates highlighting the differences and
brings out the significance of such differences. The statement also provides for
columns to indicate the change from one year to another in absolute terms and
also in percertage form. In calculating percentages there is one difficulty,
namely, if the figure is netagive, percentage cannot be calculated. Likewise, if
the change is from or to a zero balance is account, it is not possible calculate the

Formula for finding out percentage decrease or increase is
Figures of Current Year – Figures of Previous Year of an Item X 100
Previous Year’s Figure of the Item

i.e., Difference between Amounts of Current Year and Previous Year of an Item
X 100
Previous Year’s Amount of the Item

i.e., Amount of Change X 100

Previous Year’s Amount

Principles to be followedor Precauctions to be undertakenwhile preparing

Comparative Statements:
Certain precautions to be taken while preparing Comparative Statements so that
the results will not be misleading:
i) Financial Statements should contain full disclosure of information by way
of foot-notes.
ii) Proper accounting procedures are to be followed every year while preparing
the accounts and financial statements.
iii) Items in Balance Sheet are to be properly classified and uniformity is to be
maintained in such classification.
iv) Concept of consistency and other relevant concepts and conventions are to
be followed.
v) Personal judgement is to be properly exercised as the accuracy of the
accounting statements depends to a large extent on the integrity, experience
and wisdom with which judegements are exercised.

Advantages of Comperative Financial Statements:

i) Easy Comparison: The comperative statements figures of two or more
periods are placed side by side, hence the comparison of various items
become easy. The inter period and inter firm comparision are also facilitated
from such arrangements. Comaprable to IndustryComparative statements
can also be used to compare the position of the firm with the average
performance of the industry or with other firms. Such comparaison facilities
the identification of weaknesses and remedying the situation.
ii) Indicates Trend of Progress: As the comperatives statements show sales
costs of good sold, grpss profit, net profit, and also the value of different
assets and liabilities in a particular form, the performance efficiency and
financial position can be easily evalued and their trend is easily value. The
common man can from an idea just by a glance on the trend is easily
visiable. Thus they indicate the direction of necessary with respect to the
financial position and operating results. These statements indicate trends in
sales, cost of production, profit, etc. helping the analyist to evaluate the

performance, effeciency and financial condition of the undertaking. For
example, if the sales are increasing coupled with the same or better profit
margin, it indicates healthy growth.
iii) Weakness Easily Diagnosed: When a comperative study of the two similar
firm of two periods is made through the comperative statements, the
weakness of any are diagnosed easily. The capable the management to take
corrective action at right time.

Disadvantages/Limitations of Comperative Financial Statements.

There are certain limitations of the comperative statements which should be
taken into consideration while interpreting the results. These limitations are:
i) Price Level Changes: The analyist should also keep in mind that
accounting data are revalued on the dates of occurances of the transactions
and therefore, the accounts usually reflect a great variation of price level.
Hence, in case the prices level has fluctuated substantially, the analyist must
exercise caution in interpreting the trend expressed by comperative
ii) Chage in Accounting Policies: The main subject of accounting statements
is to facilitate various comparisions which enable to know the real position
of business common. But the comparision can be made between similar
situations. Hence, if frequent changes are made, the comparisions become
iii) Similar Companies but Different Positions: The interfirm comparison
also between misleading if the two similar concerns compared are of
different standing different size and do not follow, uniform policies. There
may be also different accounting policies and practices adopted by different
concerns with regards to providing depreciation, creation of various
provisions, etc. which make the comparison difficult and misleading. Inter-
firm comparisons may be misleading if the firms are not of the same age and
size, follow different accounting policies in relation to depreciation,
valuation of stock, etc. and do not cater to the same market. Inter-period
comparisons will also be misleading if the period has witnessed frequent
changes in the accounting policies.

Illustration 1:
The following are the Income Statement and Balance Sheets as on 31st March
2009 and 31 st March 2010. You are required to prepare Comparaive Statements
for 31 st March 2010 and 2011.You are required to interpret them.

Income Statement

Particulars 2008- 2009-10 Particulars 2008- 2009-10

2009 Rs. 2009 Rs.
Rs. Rs.
To Stock 60,000 55,000 By Sales 4,00,000 3,75,000
To Purchases 2,40,000 2,15,000 By Stock 55,000 45,000
To Gross Profit 1,55,000 1,50,000
4,55,000 4,20,000 4,55,000 4,20,000

Balance Sheet

Liabiulities 2008-09 2009-10 Assets 2008-09 2009-10

Rs. Rs. Rs. Rs.
Creditors 32,000 25,000 Cash --- 1,600
Provision for 11,000 9,000 Debtors 55,000 40,000
Bank Overdraft 12,000 --- Stock 55,000 45,000
Paid up Capital 1,50,000 1,50,000 Prepaid 300 400
General Reserve 30,000 35,000 Plant 61,700 65,000
Profit and Loss 12,000 13,000 Building 75,000 80,000
2,47,000 2,32,000 2,47,000 2,32,000

Comparative Income Statement

Particulars 2008- 2009-10 Increase/Decrease Increase/Decrease

2009 Rs. Amount Percentage
Sales 4,00,000 3,75,000 – 25,000 – 6.25
Less Cost of 2,45,000 2,25,000 – 20,000 – 8.15
Goods Sold
Gross Profit 1,55,000 1,50,000 – 5,000 – 3.25

Comparative Statement of Sources and Application of Funds

Particulars 2008- 2009-10 Increase/Decrease Increase/Decrease

2009 Rs. Amount Percentage
Sources of

Paid up Capital 1,50,000 1,50,000 --- ---
General 30,000 35,000 5,000 16.65
Profit and Loss 12,000 13,000 1,000 8.35
Total 1,92,000 1,98,000 6,000 3.10
Application of
Fixed Assets
Building 75,000 80,000 5,000 6.65
Plant 61,700 65,000 3,300 0.05
1,36,700 1,45,000 8,300 6.05
Assets, Loans
and Advances
Stock 55,000 45,000 – 10,000 – 18.15
Debtors 55,000 40,000 – 15,000 – 27.25
Cash --- 1,600 1,600 ---
Prepaid 300 400 100 33.35
1,10,300 87,000 – 23,300 – 21.10
Less: Current
Liabilities and
Bank Overdraft 12,000 --- – 12,000 – 100.00
Creditors 32,000 25,000 – 7,000 – 21.85
Provision for 11,000 9,000 – 2,000 – 18.20
55,000 34,000 – 21,000 – 38.20
Net Current 55,300 53,000 – 2,300 – 4.15
Total 1,92,000 1,98,000 6,000 3.10

The Comparative Income Statement reveals that sales have decreased by around
6% but cost of goods sold too have decreased by approximately 8% leading to
gross profit decreasing by just 3.25%. The sales decreases is not considered
good but cost of goods decreasing by more percent could be a sign of relief.

The Comparative Balance Sheet shows that General Reserves have increased by
more than 16.5% from Rs. 35,000 to Rs. 30,000 and Profit and Loss Account

has increased by 8.35%. Overall soucres of funds has shown an increase of
3.10%. The funds have been utilized to increase fixed assets, which have
increased by 6.05%. All the current assets, excluding cash, show a negative
growth leadin to an overall decrease of 21.1%. But since the current liabilities
have decreased more drastically by overall 38.2%, the net working capital has
decreased only by 4.15%, which gives the organization a sign of relief.
Illustration 2:
(Please change year 2001 to 2011 and 2002 to 2012)

3.3.2 Trend Analysis/Trend Percentages/Trend Ratios (Horizontal
For the purpose of comparative study of financial statements over a number of
years trend percentages or ratios are very useful. This method involves the
calculation of percentage relationship that each statement item bears to the same
item in the ‘base year’. Out of the periods under study, any one year is taken as
base year and each item in this year is taken as 100. Percentage of the same
item in each of the remaining years is calculated. Trend percentages disclose
changes in the financial and accounting data between specific peiod and make
possible for the analyst to form on opinion as to whether favourable or
unfavourbale tendencies are reflected by the data.

As the large amounts are reduced to percentages, the management finds it easy
to compare and know the trends and their direction. However, the trend
percentages are calculated only for major items and not for each item.
Management is interested in knowing changes in important items only.

Trend ratios are calculated only for some important items which can be
logically connected which each other. Unless the figure is connected with other
figures, they are not as much meaningful. For example, trend ratio for sales,
though shows a clear cut increasing tendency, becomes meaningful in the real
sense when it is compared (i) with operating assets which might have increased
at a higher rate, (ii) with the cost of goods sold which might have increased at a
lower rate or (iii) with operating solid which might have increased at a lower
rate (iii) with operating expenses. As upward trend for inventories (stock in
trade), bills receivable snd debtors accompanied by a downward trend for sales

would reflect unfavourable condition. While reading trend percentrages it is
necessary to guard against the following types of weak links:

Formula for finding out percentage decrease or increase is

Items of Year to be Found Out X 100
Item Amount of Base Year

Principles to be followed or Precauctions to be undertaken while preparing

Trend Percentages:
While finding the trend percentages, the analyist must the ascertain that
i) The concept of consistency is adhered to. If the accounting principles and
practices have not been followed consistently the comparison is
ii) The base year selected is the normal year and is respresntative of the items
shown in the statement.
iii) Trend percentages are calculated only for some important items which can
be logically connected with each other.
iv) Absolute figures are taken into consideration. In the absence of absolute
figures, the conclusions drawn only from percentages can be misleading and
v) The figures for the current year are adjusted in the light of price level
changes as compared to the base year before calculating trend percentages.
If this is not done, the comparison will be meaningless.

Importance of Trend Anlysis

Trend analysis occupies in important place in the financial analysis of the
financial statement due to the following merits:
i) Comperative Study: The trend analysis of increases help in comperative of
different variables of the financial statement for several years. Such analysis
is very significant from the point of view of forcasting and budget.
ii) Surity and Responsibilitiy: The method of trend analysis a useful for the
management and also the common man since by satisfication of percentage
for large amounts the brevity and readability are achieved.
iii) Directions of Changes: The trend clarity reflect the increase or discrease on
various facts of business from the past of the present or from the year to
year The dirction of change can be more they by represented by graphs and
directions where change can be noted even with glimpse.
iv) Easy to Understand and Easy to Calculate: The method of aalaysis and
the result obtained can be easily understood by common man. Moreover the
calculations are not complex and trend percentage or ratio can be easily
calculated by directing the current year figures by the base years and
multiplied by 100. This is a method which is must appropriate in calculating
index members.

v) Fewer Chances of Errors: There is less chances of errors under the method
because remark obtained by percentage changes of data can be the corporate
with absolute changes.

Limitations/Disadvantages of Trend Analysis

While answering the financial statements through trend percentages and trend
ratio the following liabilities must be taken in to consideration.
i) No Significantlyof Single Percentage or Ratio: The trend ratio or
percentage items has no significance in itself. We can arrive of some
meaningful and useful calcuationsonly when the trend of items is conncted
with the trend ratio of othe calculation. To illustrate and increasing trend it
the value of stock is remaining less unless it is concern with a trend in sales.
There it will show the favourble or unfavourble position. Similarly and
upward trend in stock. Bills receivable and industry debtors accpated with
downward trend in sales monthly reflect unfavourable situation. Thus, it is
essential that ratio of locality related item should also be calculated and part
side by side for conspiration dnd for drawing come calculations.
ii) Illogical and Misleading Conclusions: The inferennce drawn on tha basis
of simply trend ratios without keeping in view the original absolute figures
may be sometimes illogical and misleading. Hence, it is essential to study
the original data alongwith trend ratiro. For example, one expense may
increase from Rs.400 to Rs. 800 while the other expense may increase from
Rs. 8,000 to Rs. 12,000.In the first case though the increase is 100% yet it is
insiginficiant, yet in the second though the increase is 50% yet it is
significiant in reals terms. Simiarly uneceassary doubts may raise when the
trend percentages show 100% increasesin debt while only 50% increase in
equity. This doubt can be removed when actual figures are also studied
alongwith trend ratios.
iii) Unscientific and Inconsistant: The comparison of trend ratio may be
unscientific and inconsistent if principles and practices were not kept
uniform and consistant throughout the period of analysis. Hence it is
necessary that the accounting policies and practices are not changed
throughout the period. Then and then comparison can be realistic.
iv) Update Weightages: Sometimes it may happen that updue weightages is
assigned to trend ratio. It is possible when the value in the base year is too
small. A small change in the base year’s value will lead to more change in
trend percentages. For example once news appeared in a daily nespapaer
that 33% of the lady lecturers of a college married 100% male lecturers of
the college. The news was astonishing, but when the actual figures were
looked into, the actual position became evident. There were 6 lady lecturers
and 2 male lecturers in that college. Hence, it is always desirable to have
information about relative and absolute figures.

v) Defective Selection of Base Year: The base year should be normal and be
representative of the items shown in the balance sheet. If the base year is an
abnormal year such as year of war, or of natural calamities, the comparison
with such a year will be misleading and farce.
vi) Price Level Changes: Comparability of data is also adversely affected
when the price level has changed materially during the year under review.
Hence the figures for the current year will be requiring adjustment in the
light of the price level changes as compared to the base year before
calculating trend ratios.

Illustration 3:
From the following information, interpret the results of operations of the
manufacturing concern using trend ratios:
Income Statements for the year ending 31st March

Particulars 2011 2012 2013

Rs. Rs. Rs.
Sales 1,50,000 1,30,000 1,00,000
Cost of Goods Sold 80,000 60,000 50,000
Gross Profit 70,000 70,000 50,000
Selling Expenses 20,000 10,000 10,000
Net Operating Profit 50,000 60,000 40,000

Trend Analysis
(2010-11 is the base year)

Particulars 2011 2012 2013

Rs. % %
Sales 100 87 67
Cost of Goods Sold 100 75 63
Gross Profit 100 100 71
Selling Expenses 100 50 50
Net Operating Profit 100 120 80

In comparion to 2010-11, the sales and cost of goods sold have decreased but
gross profit has remained the same in 2011-12 but in 2012-13 all of them have
decreased. On the other hand, in 2011-12 and 2012-13 operating expenses has
become 50% in comparison to the base year leading to increase of net operating
profit by 20% in relation to the base year in 2011-12 and decrease in net
operating profit by 20% in 2012-13, which is not a good sign.

Illustration 4:
(Please change year 1994, 1995 and 1996 to 2011, 2012 and 2013

3.4 Inter Firm Comparison – requirements, advantages and limitations
In the case of inter-firm comparions, the items in the financial statements of the
same firm over the periods are compared to know the trends and direction of
changes. But in the case of inter-firm comparison, comparison of the
performances, efficiencies, costs and profits of various firms in an industry is
made. Thus, it is a management technique by the use of which it is made
possible for an organization to compare its own achievements with those of
other units engaged in the same time of business.

3.4.1 Requirments for Interfirm Comaprison
i) Both the firms follow same accounting policies. If same accounting
principles and practices have not been followed by the firms then the
comparison is meaningless.
ii) Absolute figures are taken into consideration. In the absence of absolute
figures, the conclusions drawn only from percentages can be misleading and
iii) The figures for the current year are adjusted in the light of price level
changes as compared to the base year before calculating trend percentages.
If this is not done, the comparison will be meaningless.
iv) Items in Balance Sheet are properly classified and uniformity is to be
maintained in such classification.
v) Units should be of the same size.

3.4.2 Advantages of Interfirm Comaprison

Uniform accounting is ‘the basis of inter-firm comparison. Inter-firm
comparison is the technique of evaluating the relative performance, efficiency,
costs and profit of firms in a given industry. An inter-firm comparison is not
possible unless the ‘like’ is compared with the ‘like’. Therefore, uniform
accounting system is a pre-requisite to an inter-firm comparison. Apart from the
advantages of uniform costing, the following additional advantages are obtained
from inter-firm comparison :
i) Inter-firm comparison makes the management aware of its strength or
weakness in relation to others in the industry.
ii) It helps a concern in knowing its strengths or weaknesses in relation to
others so that remedial measures may be taken. Such a comparison gives an
overall view of the industry as a whole to its members– the present position
of the industry, progress made during the past and the future of the
iii) Improved method of production and technical knowledge of the superior
firm, become available to less efficient firms.
iv) Inter-firm comparison helps management to control the costs.
v) It ensures an unbiased specialized reporting on particular problems of the
vi) Production can be improved when the area of weaknesses or uneconomies is
vii) Efficient system of reporting can be developed and presented in
standardized forms.
viii) It eliminates unfair competitions among the firms.
ix) It facilitates fullest utilization of available resources.
x) Cost consciousness is created among the participant firms and they are
cautious at every level.

xi) It assists Government in industrial development and regulations through
appropriate policies.It helps Government in effecting price regulation.

3.4.3 Limitations or Drawbacks of Interfirm Comaprison

Comparison becomes difficult or meaningless due to divergence in nature and
size of the member-firms. It is, therefore, necessary to have a basic uniformity.
The financial statements of the members firms must be comparable. For this
purpose the accounts heads must be the same and the amount charged to such
account must be for the standing transactions. All the members firms must have
followed the same accounting principles, procedures and conventions, otherwise
the comparison of ratios has no meaning and the conclusions drawn therefrom
will be misleading. The practical difficulties in the implemenation of the
scheme are as under:
i) The top management may not be willing be disclose its trade secrets. The
firms are the competitors to one another.
ii) The efficient unit may be convinced of the ulility of the inter-firm
comparison. It may not like other units to come up to its level.
iii) The information given in the routine form will not be sufficiently
iv) The special staffs is not employed by the firm to collect and supply the
administration to the central organisationthis work to the neglected
profitunctorily executed and delayed by the staff members as this would be
the additional work. Information supplied in the hurry may be defective and/
or incompleted.
v) The term ‘capital’’ in not defined uniformely by all the firms and as such the
information supplied in respect of “capital” cannot be compared. Same
firms may make a confusion between fixed capital and working capital.
vi) To obtaine uniform information the Central Organisation may prescribe new
forms of ledger or account books and other books of record. The member-
firm may not like to change their routine method of accounting. Hence, the
Central Organisation has to see that the routine accounting procedure of the
firm is either not disturbed or if disturbed it’s disturbed as little as possible.
vii) Suitable basis may not be available for comparison.

Inspite of the above drawbacks, the inter-firm comparision is very helpful to the
management accountant to prepare useful information and member sound
advice to the management in many of their activities.


I Objective Type:

1. Select the right answer.

(i) Balance Sheet is prepared to know:
(a) Flow of Funds, (b) Efficiency, (c) Financial Position, (d) Profitability
(ii) Cost of Goods Sold means:
(a) Sales–Trade Discount, (b) Sales–Gross Profit, (c) Opening
Stock+Purchases+Direct Expenses – Closing Stock, (d) (a) and (c)
(iii)Comparative Statement is:
(a) Comparative Income Statement of two firms, (b) Comparing
Position of a firm Statement over a number of years, (c) Horizontal
Analysis, (d) (a) and (c)
[Ans. (i) c, (ii) d, (iii) d]

2. State whether each of the following statements is ‘True’ or ‘False’.

(i) Common Size Ratios and Ratio Analysis is a form of vertical analysis.
(ii) Comaprative Statement means Comparative Income Statement only.
(iii)Financial Analysis cannot be used for forecasting.
[Ans. (i) True, (ii) False, (iii) False]

II Theory Questions:

1. Explain the limitations of financial statements.

2. What are the different types of horizontal analysis? Explain with example.
3. Explain the limitations ofinter-firm comparison.
4. Write short notes on:
(i) Significance of financial statements
(ii) Trend Analysis
(iii)Advantages of inter-firm comparison

III Practical Problems:

1. The following is the Income Statement of Girija Limited as on 31st March

2010 and 31st March 2011. You are required to prepare Comparaive Income
Statement for 31st March 2010 and 2011 and also interpret it.

Particulars 2009- 10 2010-11 Particulars 2009-10 2010-11
Rs. Rs. Rs. Rs.
To Cost of Goods 1,08,000 1,16,800 By Sales 1,60,000 1,68,000
To Gross Profit 48,800 47,200 Less Returns 3,200 4,000
1,56,800 1,64,000 1,56,800 1,64,000
To Administrative To Gross Profit 48,800 47,200
Expenses 24,000 25,200
To Selling 12,000 14,000
To Net Profit 12,800 8,000
48,800 47,200 48,800 47,200

2. (Please change year 2003 to 2012 and 2004 to 2013)

3. (Please change year 1999, 2000, 2001 and 2002 to 2010, 2011, 2012 and
2013 respectively)

Ration Analysis

4.0 Learning Objectives

After studying this Chapter the student should be able to:

 Understand the meaning of ratios;
 Know the nature and interpretation of ratios;
 Understand the advantages, role and limitations of ratios;
 Grasp various types of ratios and the formulae of calculating them ;
 Be swift in calculating various ratios.

4.1 Nature, Interpretation and Classification of Ratios

Ratio analysis facilitates the presentation of information of financial statements

in simplified, concise and summarized form.

In simple words, "Ratio" is the numerical relationship between two variables

which are connected with each other in some way or the other. It means one
number expressed in terms of another. A ratio is said to be a statistical yardstick
by means of which relationship between two or various figures can be compared
or measured.It provides a measure of relationship between two accounting
figures. In fact,the relationship between the two figures expressed
mathematically is called a ratio.

The term "accounting ratios" is used to describe significant relationship between

figures shown on a balance sheet, in a profit and loss account, in a budgetary
control system or in any other part of accounting organization. Accounting
ratios thus shows the relationship between accounting data.

According to J. Batty, the term accounting ratios is used to describe significant

relationships which exist between figures shown in a balance sheet, in a profit
and loss account, in a budgetary control system or in any other part of the
accounting organization.

Ration Analysis of financial statements stands for the process of determining

and presenting the relationship of items and group of items in the statements. It
is a process of computing, determining and presenting the relationship betweem
items or group of items in the financial statements through accounting ratios.
An account ratio expresses the relationship between two numbers or figures or
two items or group of items which are contained in the financial statements, i.e.,
Profit and Loss Account and Balance Sheet.

Ratios are expressed in various forms:
i) Pure Ratios:As a proportional relationship between two numbers.Such
ratios are arrived by simple division of one number by another. The
relationship between 100 and 500 may be expressed as 1 : 5.
Example, Current assets to current liabilities ratio is 2:1, i.e.,
Current Assets = 2 = 2:1
Current Liabilities 1
ii) Rate (Turnover) Ratios: This signifies the ratio between two numerical
facts, usually over a period of time. Example, stock turnover ratio is 3 times
a year.
Sales = 2 times
Average Stock
iii) Percentage Ratios: It is a ratio which is a special type of rate expressing the
relation in hundredth. Example, gross profit in 25% of sales.
Gross Profit x 100 = 25%

Ratios can be used in

• Static/Structural analysis by taking a single year’s Balance Sheet or Profit
and Loss Account
• Dynamic/Trend analysis by taking a Balance Sheet or Profit and Loss
Account of several years.

Ratios involves two tpyes of comparisons

• Present ration with past or future ratio for same firm
• Ratios of one firm with that of a similar one or with the average of industry
at the same point of time. Ratio Analysis becomes complete only after
comparing the ratios of the firm with the average or standard ratios of the

4.1.1 Nature of Ratios

In financial analysis, ratio is used as an index of yardstick for evaluating the
financial position and performance of the firm. It is a technique of analysis and
interpretation of financial statements. It is not an end itself. Ratio analysis helps
in making decisions as it helps establishing relationship between various ratios
and interpret thereon. Ratio analysis helps analysts to make quantitative
judgement about the financial position and performance of the firm. Ratio
analysis involves following steps:
i) Relevant data selection from the financial statements related to the
objectives of the analysis.
ii) Calculation of required ratios from the data and presenting them either in
pure ratio form or in percentage.
iii) Comparison of derived different ratios with:
a) The ratio of the same concern over a period of years to know upward or
downward trend or static position to help in estimating the future, or
b) The ratios of another firm in same line, or
c) The ratios of projected financial statements, or
d) The ratios of industry average, or
e) The predetermined standards, or
f) The ratios between the departments of the same concern assessing either
the financial position or the profitability or both.
iv) Interpretation of the ratio

Ratios, by themselves, are not an end but only one of the means of
understanding the financial health of a business entity. Ratio analysis is not
capable of providing precise answers to all the problems faced by any business
unit. Ratio analysis is basically a technique of:
• Establishing meaningful relationship between significant variables of
financial statements and
• Interpreting the relationships to form judgment regarding the financial
affairs of the unit.

Ratio analysis uses financial report and data and summarizes the key
relationship in order to appraise financial performance. The effectiveness will
be greatly improved when trends are identified, comparative ratios are available
and inter-related ratios are prepared.
i) Though ratio analysis is ‘all the rage’ among the users of accounting
information, it is better to understand the nature of ratios so that they can be
employed judiciously under appropriate conditions.
The relation between two or more financial data brought out by an
accounting ratio is not an end in itself. They are means to get to know the
financial position of an organisation.
ii) An Individual ratio may not be capable of providing the answers required
for the various problems facing an executive.
iii) Industrial ratios may provide valuable information only when they are
studied and compared with several other related ratios.
iv) Ratio analysis will tend to be more meaningful when certain standards and
norms are laid down so that what the ratios indicate can be compared with
the said standards. This provides a base for decision-making and assists in
taking measures to rectify any drawback or deficiency.

It must be concluded that

• Ratio analysis consists of the calculation of ratios from financial statements
and is a foundation of financial analysis.
• A financial ratio, or accounting ratio, shows the relative magnitude of
selected numerical values taken from those financial statements.
• The numbers contained in financial statements need to be put into context so
that investors can better understand different aspects of the company's

4.1.2 Interpretation of Ratios

Accounting information is used to answer two key questions about a business:
• Is it making a profit?
• Are its assets sufficient to meet its liabilities?
In the earlier chapter the form in which different types of businesses prepare
their final accounts has been discussed. Now we need to examine in more detail
how these accounting statements can be used to assess a business’ performance
and progress. There are two stages in this process:
This is the detailed examination of various aspects of a business’ performance.
To make comparisons (with other businesses or for the same business over a
period of time) easier and more meaningful, the results are expressed as
percentages or ratios, e.g. the percentage of gross profit to sales, or the working
capital ratio.
Here the results of analysis are used to judge a business’ performance. This is
done by making comparisons a with other similar businesses, usually within the
same year, e.g. was the gross profit to sales percentage last year better or worse
than the average for the trade or industry?, for the same business over a number
of years, e.g. has the trend of the gross profit percentage to sales over the last
five years been up or down?

Ratio analysis and interpretation are useful tools for owners and others in
making and assessing business decisions.

Interpretation of ratios is an important factor. Though important, it must be

realized that calculation of ratios is easy but interpretation of ratios requires
skill, intelligence, and foresightedness. The limitations inherent in financial
statements and ratios must be borne in mind. Certain factors like inflation,
chances of window dressing, and differences of accounting policies should be
taken into account while interpreting ratios.

According to Robert Anthony ratio is “one number expressed in terms of

another”. However, the two figures must be interpreted to serve a useful

4.1.3 Classification of Ratios

Financial statements are generally insufficient to provide information to
investors on their own; the numbers contained in those documents need to be

put into context so that investors can better understand different aspects of the
company's operations. Ratio analysis is one of the methods an investor can use
to gain that understanding.

Financial statement analysis is the process of understanding the risk and

profitability of a firm through analysis of reported financial information. Ratio
analysis is a foundation for evaluating risk and for doing fundamental company
valuation. A financial ratio, or accounting ratio, is derived from a company’s
financial statements and is a calculation showing the relative magnitude of
selected numerical values taken from those financial statements.

There are various types of financial ratios, grouped by their relevance to

different aspects of a company’s business as well as to their interest to different
audiences. Financial ratios may be used internally by managers within a firm,
by current and potential shareholders and creditors of a firm, and other
audiences interested in understanding the strengths and weaknesses of a
company, especially compared to the company over time or compared to other

Calssification of

On the Basis of
On the Basis of Functions
Nature (Functional

Profit and Loss A/c Inter-Statement or

Balance Sheet Ratios Liquidity Ratios Activity Ratios Profitability Ratios Solvency Ratios
Ratios Composite Ratios

Ratios are classified on the basis of following:

i) According to Nature:
a) Profit and Loss Account Ratios – These are ratios when two items or
group of items in Profit and Loss Account are compared. Eg. Gross
Profit Ratio, Operating Ratio, etc.
b) Balance Sheet Ratios – When two items or group of items in Balance
Sheet are compared they are termed as Balance Sheet Ratios. Eg. Debt-
Equity Ratio, Current Ratio, etc.

c) Inter-Statement or Composite Ratios – When certain item or group of
items are from Profit and Loss Account and certain from Balance Sheet
and ratio is computed, they are called as Composite or Inter-Statement
Ratios. Example, Stock Turnover Ratio, Return on Investment, etc.
ii) Functional Classification:(explained in the preceeding paragraphs in 4.3)
a) Liquidity Ratios – These ratios measure the ability of a firm to meet its
short term obligations through the availability of cash and other current
assets to pay debt.Example, Current Ratio, Liquid Ratio, etc.
b) Activity Ratios – Also called efficiency ratios, they measure the
effectiveness of a firm’s use of resources, or assets. These ratios
evaluate efficiency with which the firm manages and utilizes its assets.
They indicate the speed at which assets are being converted over into
sales. Example, Stock Turnover Ratio, Debtors Turnover Ratio, etc.
c) Profitability Ratios – Profitability ratios measure the firm's use of its
assets and control of its expenses to generate an acceptable rate of
return.They measure the operational efficiency of a firm in terms of its
profits.Example, Net Profit Ratio, Operating Ratio, Return on
Investment, etc.
d) Solvency Ratios – These ratios measure the ability of a firm to meet its
long term obligations. Eg. Debt-Equity Ratio, Equity Ratio, etc.

4.2 Advantages, Role and Limitations of Ratio Analysis

4.2.1 Advantages (Merits)of Ratio Analysis

Ratio analysis is an important and age-old technique of financial analysis.
Financial ratio analysis is a useful tool for users of financial statement. The
following are some of the advantages/benefits of ratio analysis:
1. Simplifies Financial Statements: It simplifies the comprehension of
financial statements. Ratios tell the whole story of changes in the financial
condition of the business.It helps in trend analysis which involves
comparing a single company over a period.
2. Analyses Financial Statements:Ratio analysis is an important technique of
financial statement analysis. It highlights important information in simple
form quickly. A user can judge a company by just looking at few numbers
instead of reading the whole financial statements. Accounting ratios are
useful for understanding the financial position of the company. Different
users such as investors, management. bankers and creditors use the ratio to
analyze the financial situation of the company for their decision making
3. Facilitates Inter-Firm comparison:By providing data for inter firm
comparison, it helps in comparing companies of different size with each
other. They help compare a firm’s performance with similar competitors.
Ratios highlight the factors associated with successful and unsuccessful

firm. They also reveal strong firms and weak firms, overvalued and
undervalued firms.
4. HelpsIntra-firm Comparison: Ratios analysis also makes possible
comparison of the performance of different divisions of the firm. The ratios
are helpful in deciding about their efficiency or otherwise in the past and
likely performance in the future.
5. Judging Efficiency: Accounting ratios are important for judging the
company's efficiency in terms of its operations and management. They help
judge how well the company has been able to utilize its assets and earn
6. Help in Investment Decisions: It helps in investment decisions in the case
of investors and lending decisions in the case of bankers etc.
7. Locating Weakness:Ratios help monitor and identify issues that can be
highlighted and resolved. Accounting ratios can also be used in locating
weakness of the company's operations even though its overall performance
may be quite good. Management can then pay attention to the weakness and
take remedial measures to overcome them.
8. Helps in Formulation of Plans:Ratios are used to analyze the company's
past financial performance; they can also be used to establish future trends
of its financial performance. Ratios help compare current performance with
previous records which helps in planning and forecasting. Ratios can assist
management, in its basic functions of forecasting, planning, co-ordination,
control and communications.

4.2.2 Role of Ratio Analysis

The role of ratio analysis in accounting is to provide businesses with a way to
understand its financial position, find weaknesses and opportunities, and make
reasonable forecasts. Comparing numbers side-by-side does not always provide
businesses with a way of determining if their financial position has become
better or worse. Instead, ratio analysis in accounting allows businesses to place
data in manageable terms in order to better understand their position. This also
allows businesses to break data down so that they can recognize any weaknesses
or opportunities. While most ratio analysis in accounting is used to determine
the business’s current position, some ratios can be used to make financial

Ratio analysis in accounting involves using historical data in order to

understand the business’s past and current financial position. Data is often
retrieved from previous financial statements, such as the income
statement, balance sheet and statement of cash flows. It can also be collected
from competitors in order to do a competitor ratio analysis in accounting. These
ratios can be used to determine if the business is holding on to too
much inventory, has taken on too much debt, or is not using its cash effectively.

Business can use ratio analysis to try to tell us whether the business
i) is profitable
ii) has enough money to pay its bills
iii) could be paying its employees higher wages
iv) is paying its share of tax
v) is using its assets efficiently
vi) has a gearing problem
vii) is a candidate for being bought by another company or investor

And more, once the business has decided what they want to know then they can
decide which ratios they need to use to answer the question or solve the problem
facing us.

Ratio Analysis is the basic tool of financial analysis and Financial analysis itself
is an important part of any business planning process as SWOT (Strengths,
Weaknesses, Opportunities and Threats), being the basic tool of the strategic
analysis plays a vital role in a business planning process and no SWOT analysis
would be complete without an analysis of companies financial position. In this
way Ratio Analysis is very important part of whole business strategic planning.

4.2.3 Limitations (Demerits/Criticism) of Ratio Analysis

Financial ratio analysis is one of the most popular and powerful financial
analysis techniques for companies for financial management.

Though ratios are simple to calculate and easy to understand, they suffer from
serious limitations.Thus, despite usefulness, financial ratio analysis has some
disadvantages. Some key demerits of financial ratio analysis are:
1. Different Accounting Practices:Accounting information used in
computation of ratios is affected by the estimates, assumptions and different
accounting methods used by companies. Accounting standards allow
different accounting policies, which impairs comparability and hence ratio
analysis is less useful in such situations. Different companies may use
different methods to value their inventory (LIFO versus FIFO, etc.). If
companies are compared that use different inventory valuation methods, the
comparisons won't be accurate. Another issue is depreciation. The use of
different depreciation methods affects companies' financial statements
differently and won't lead to valid comparisons.
2. Historical Data: Ratio analysis information is historic – it is not current.
Ratio analysis explains relationships between past information while users
are more concerned about current and future information. Ratio analysis is
performed on historical data for the purpose of forecasting future
performance. The historical relationship may not continue because of

changes in the general state of the economy, management, general
environment in which the firm operates and policies established by
3. Problems of Price Level Changes: A balance sheet is a statement of a
firm's financial condition at a point in time. So, looking back on a balance
sheet, they show historical data. Inflation may have occurred since that data
was gathered and the figures may be distorted. Inflation may have badly
distorted a company's balance sheet. In this case, profits will also be
affected. Thus a ratio analysis of one company over time or a comparative
analysis of companies of different ages must be interpreted with
judgment.Failure to adjust for inflation or changes in fair value of the
historical cost used in computing the ratios may result in computations
providing misleading information on trend analysis.
4. Misleading Interpretations:Ratios alone are not adequate. Ratios are only
indicators, they cannot be taken as final regarding good or bad financial
position of the business. Other things have also to be seen. It is difficult to
generalize about whether a ratio is good or not. A high cash ratio in a
historically classified growth company may be interpreted as a good sign,
but could also be seen as a sign that the company is no longer a growth
company and should command lower valuations.A company may have
some good and some bad ratios, making it difficult to tell if it's a good or
weak company.

Deterioration is accounting ratios does not always indicate poor

management e.g. a decline in stock turnover ratio may seem unhealthy sign
for a business but a further investigation may reveal that reason is
accumulation of scarce raw material that enable a plant to continue working
when competitors are forced to suspend production. Too much significance
to individual ratio cannot result in good decision. eg. Sometimes higher
ROCE may be accompanied with low liquidity.

Understanding seasonal factors that affect a business can reduce the chance
of misinterpretation. For example, a retailer's inventory may be high in the
summer in preparation for the back-to-school season. As a result, the
company's accounts payable will be high and its ROA low.

At times along with ratios it is also proper to study the absolute figures. It
must be remembered that ratios are a means to an end and not an end itself.

5. Manipulationof Financial Statements: Ratio analysis is based entirely on
the data found in business firms' financial statements. If the financial
statements for a company are not quite as good as they should be and a
company would like better numbers to show up in an annual report, the
company may use window dressing to manipulate the data in the financial
statements. Bear in mind - this is completely against the concept of financial
and business ethics and flies in the face of corporate governance.
6. Limitations of Inter-firm comparison: Different companies operate in
different industries each having different environmental conditions such as
regulation, market structure, etc. Such factors are so significant that a
comparison of two companies from different industries might be
misleading. Many large firms operate different divisions in different
industries. For these companies it is difficult to find a meaningful set of
industry-average ratios.
7. Limitations of Financial Statements: Ratios are based only on the
information which has been recorded in the financial statements. Reliability
of ratios depend on reliability of data. Financial statements themselves are
subject to several limitations. Thus ratios derived, there from, are also
subject to those limitations. For example, non-financial changes though
important for the business are not relevant by the financial statements.
Financial statements are affected to a very great extent by accounting
conventions and concepts. Personal judgment plays a great part in
determining the figures for financial statements.Financial accounting
information is affected by estimates and assumptions.
8. Lack of Adequate Standard: No fixed standard can be laid down for ideal
ratios. There are no well accepted standards or rule of thumb for all ratios
which can be accepted as norm. It renders interpretation of the ratios
9. Comparative Study Required: Ratios are useful in judging the efficiency
of the business only when they are compared with past results of the
business. However, such a comparison only provide glimpse of the past
performance and forecasts for future may not prove correct since several
other factors like market conditions, management policies, etc. may affect
the future operations.
10. Limited Use of Single Ratios: A single ratio, usually, does not convey
much of a sense. To make a better interpretation, a number of ratios have to
be calculated which is likely to confuse the analyst than help him in making
any good decision.
11. Personal Bias: Ratios are only means of financial analysis and not an end in
itself. Ratios have to be interpreted and different people may interpret the
same ratio in different way.

If ratio analysis is used with knowledge and intelligence and not in a
mechanical and unthinking manner, it can be a very valuable tool for financial
analysis for the business owner.It can provide insightful information.Its
limitations have to be kept in mind but they should be more or less intuitive to a
savvy business owner.

Financial statement analysis is useful in anticipation of future conditions and

planning for actions that will improve the firm's future performance. Financial
ratios are designed to help you evaluate a financial statement. Users of financial
information such as creditors, investors, management and financial analyst use
ratio analysis for different purposes, such as analyzing liquidity and profitability
of the company. It is essential for users to understand the different environments
that companies operate in when using ratios to analyze the suitability of an

4.3 Liquidity Ratios, Activity Ratios, Profitability Ratios and Solvency

(Computation and Analysis of Ratios)

4.3.1 Liquidity Ratios

Liquidity Ratios are short term solvency ratios. They measure the firm’s ability
to meet its current obligations which is extremely essential for a firm. In fact,
analysis of liquidity needs the preparation of cash budgets and cash flow
statements, but liquidity ratios by establishing a relationship between cash and
other current assets to current obligations, provide a quick measure of liquidity.
A firm should ensure that it does not suffer from lack of liquidity (illiquidity)
and also it is not too much highly liquid. Failure of a company to meet its
obligations due to lack of sufficient liquidity will result in bad credit ratings,
loss of creditor’s confidence, or even in law suits resulting in the closure of the
firm. Very high degree of liquidity is too bad; idle assets earn nothing. The
firm’s fund will be unnecessarily tied up in current assets. Therefore, it is
necessary to strike a proper balance between liquidity and lack of liquidity.

Liquidity Ratios:
• They measure the firm’s ability to meet its current obligations.
• Liquidity ratios are Balance Sheet Ratios.
• They are pure ratios.

1. Current Ratio– Also called Working Capital Ratio.

Current Ratio is a measure of short term solvency. It indicates the availability

of current assets in rupees for every one rupee of current liability. If the ratio is

greater than one then it means that the firm has more current assets than current
liabilities or current claims against them.

A relatively high value of current ratio is considered as an indication that the

firm is liquid and has the ability to pay its bills. Ideal current ratio is 2:1 as it
means that in worst situation even if value of current assets becomes half, the
firm will be able to meet its obligations. Though more than one is considered
satisfactory. Current Ration thus represents ‘margin of safety’, i.e., a ‘cushion’
of protection of creditors. Liabilities are not subject to fall whereas current
assets can decline in value. Current ratio is a ‘crude and quick’ measure of
firm’s liquidity.

Current Ratio = Current Assets___

Current Liabilities
Current Assets = Cash and all those assets which can be converted into cash
within one year
= Marketable Securities + Stock (Inventories) + Debtors + Bills
+ Income Receivable + Cash + Bank + Prepaid Expenses
Current Liabilities = All obligations maturing within one year
= Bank Overdraft + Creditors + Bills Payable + Accrued
+ Income Tax Liability + Long Term Liability Maturing in
Current Year
+ Dividend Payable

2. Liquid Ratios– Also called as Acid Test Ratio or Quick Ratio or Quick
Asset Ratio or Near Money Ratio or Liquidity Ratio.

It is a more refined measure of firm’s liquidity. It establishes a relationship

between quick/liquid assets to current liabilities. An asset is liquid if it can be
converted into cash immediately or reasonably soon without a loss of value.
Cash is most liquid asset. The other assets which are considered relatively
liquid and included in quick assets are book debts (debtors and bills receivable)
and marketable securities (temporary investments). Stock are prepaid expenses
are considered less liquid. Inventories normally require some time for realizing
into cash; the value of stock also has a tendency to fluctuate. Prepaid expenses
are excluded as they can’t be converted into cash. Ideal quick ratio is 1:1 (some
say 1.33:1).

Liquid Ratio =Quick/Liquid Assets

Current Liabilities

Quick Assets = Marketable Securities + Debtors + Bills Receivable+ Income
+ Cash + Bank
= Current Assets – Stock – Prepaid Expenses

Liquid Ration is also calculated as

Liquid Ratio =Quick/Liquid Assets__
Quick/Liquid Liabilities
Liquid Liabilities = Current Liabilities – Bank Overdraft – Accrued Expenses

3. Absolute Ratio

Absolute Ratio =Cash + Marketable Securities

Current Liabilities

4.3.2 Activity Ratios–These ratios are also called as Turnover Ratios or

Performance Ratios.

Funds of the owners and creditors are invested in various kinds of assets to
generate profits and sales. Better the management of assets, the larger the
amount of sales. This ration is employed to evaluate efficiency with which the
firm manages and utilizes its assets. They indicate the speed at which assets are
being converted over into sales. They, therefore, involve a relationship between
sales and the various assets and presume that there exists an appropriate balance
between sales and various assets.
Activity Ratios:
• Evaluate efficiency with which the firm manages and utilizes its assets.
• They are composite ratios.
• They are turnover ratios, expressed as number of times/days (x times/x

1. Inventory Turnover Ratio–They are also called as Stock Turnover Ratio,

Merchandise Turnover Ratio, Inventory Velocity Ratio, Stock Velocity Ratio.

This ratio is expressed in number of times (x times). The higher, the better as it
shows how rapidly inventory is turning into receivable through sales.

Inventory Turnover Ratio= ___Cost of Goods Sold______

Average Inventory (Stock)

Average Inventory = Opening Stock + Closing Stock

• Stock means stock of finished goods.
• When Opening Stock is not given then only Closing Stock is taken for
• Stock means valuation done at cost.

At times the formula given under is used when closing stock is valued at selling
Inventory Turnover Ratio= __ Net Sales____
Average Stock

2. Debtors Turnover Ratio–They are also called as Receivables Turnover

Ratio, Debtors Velocity Ratio.

A firm sells goods on credit or cash. Due to credit sales book debts (debtors)
are created. Debtors are expected to be converted into cash over a short period
and hence are current assets. The liquidity of the firm depends on quality of
debtors to a great extent.
Expressed as number of times; the higher the better.

Debtors Turnover Ratio = _____Credit Sales____

Average Debtors
Average Debtors = Opening Balance of Debtors + Closing Balanceof

If information about Debtors or credit sales and opening balance of debtors is

not available then,
Debtors Turnover Ratio = ______Total Sales__________
Closing Balance ofDebtors

• Debtors = Sundry Debtors and Bills Receivable
• When Opening Balance is not given then only Closing Balance is taken for

3. Average Collection Period Ratio–They are also called Average Age of


The average collection period represents the average number of days for which
the firm must wait after making a sale before collecting cash from the customer.
Expressed as number of days, the lower the better. Too low indicates very strict

and restrictive collection policy and too high indicates very liberal and
inefficient credit policy.

Average Collection Period Ratio = Days in a Year =365 ____= 365 x Debtors
Debtors Turnover ___Sales__ Sales

In other way it could be said that,

Average Collection Period Ratio = __Sundry Debtors = Sundry Debtors =
365 x Debtors
Average Daily Sales Sales Sales

• Debtors = Sundry Debtors and Bills Receivable
• Sales may be credit sales or total sales and debtors may be average debtors
or closing balance of debtors as per information available.

4. Creditors Turnover Ratio

This ratio is expressed as number of times.

Creditors Turnover Ratio = Credit Purchases__

Average Creditors

Average Creditors = Opening Balance of Creditors + Closing Balance of


If information about Creditors or credit purchases and opening balance of

creditors is not available then,
Creditors Turnover Ratio = ____Total Purchases______
Closing Balance ofCreditors

• Creditors = Sundry Creditors and Bills Payable
• When Opening Balance is not given then only Closing Balance is taken for

5. Average Age of Creditors

Expressed as x days; the higher the better.

Average Age of Creditors = Days in a Year = 365______ = 365 x
Creditors Turnover Purchases

In other way it could be said that,

Average Collection Period Ratio = Sundry Creditors =Sundry Creditors =
365 x Creditors
Average Daily PurchasesPurchases Purchases
Note: Creditors = Sundry Creditors and Bills Payable

6. Total Assets Turnover Ratio

Expressed in x times, higher the better as it means assets are utilized efficiently.

Total Assets Turnover Ratio= ____Sales

Total Assets


Total Assets Turnover Ratio= Sales _________________

Total Assets – Intangible/Fictitious Assets

= _____Sales ____
Total Tangible Assets

Note: Intangible/Fictitious Assets are Goodwill, patents, items of miscellaneous


7. Capital Turnover Ratio–Also called Capital Employed Ratio.

Expressed in – times, higher the better.

Capital Turnover Ratio = Sales ______

Capital Employed


Capital Turnover Ratio = Cost of Sales __

Capital Employed

Capital Employed = Non Current Liabilities + Owners’ Equity
= Permanent Capital or long term funds entrusted to the
firm by creditors
and owners
= Non current assets + Working Capital

8. Fixed Assets Turnover Ratio

Expressed in x times;the higher the better.

Fixed Assets Turnover Ratio = ____Sales

Net Fixed Assets


Fixed Assets Turnover Ratio = Cost of Sales___

Net Fixed Assets

Note:Net Fixed Assets means fixed assets after charging depreciation.

9. Working Capital Turnover Ratio

Working CapitalTurnover Ratio= _____Sales ____

Working Capital


Working Capital Turnover Ratio= Cost of Sales

Working Capital

Note:Working Capital = Current Assets – Current Liabilities

4.3.3 Profitability Ratios

A business is run to earn profits. Profit is the ultimate output of a company. The
finance manager must evaluate the efficiency of the firm in terms of profit. It
must be calculated to measure operational efficiency of the firm. Such ration
which evaluates the operational efficiency of the firm are called Profitability
Ratios. Generally three major types of Profitability Ratios are calculated:
1. Profitability in Relation to Sales
2. Profitability in Relation to Investment – Such ratios calculate the returns
from investment in assets, in terms of capital employed by creditors and
3. Profitability based on Earnings on Shares

1. Profitability in Relation to Sales–
• They calculate the ability of the firm to produced adequate profits on each
Rupee of sales.
• Sales are the basis for calculation.
• These are Profit and Loss Ratios.
• They are percentage ratios, i.e., they are expressed as percentage.

i) Gross Profit Ratio – Also called Gross Profit Margin Ratio or Gross
Margin Ratio.

They reflect the efficiency with which management produces each unit of
product. This ratio indicates average spread between cost of goods sold and
sales revenue.

The higher the ratio; the better the efficiency.

Gross Profit Ratio =(Gross Sales – Sales Return) – Cost of Goods Sold x 100
Gross Sales – Sales Return

=Net Sales– Cost of Goods Sold x 100

Net Sales

=Sales– Cost of Goods Sold x 100

=Gross Profit x 100

Note: Cost of Goods Sold = Opening Stock of Finished Goods

+ Cost of Goods Produced
– Closing Stock of Finished Goods

ii) Net Profit Ratio – Also called Net Profit Margin Ratio or Net Margin

Generally, non-operating income and expenses are excluded when this ratio is
calculated. The ratio establishes relationship between net profit and slaes and
indicates management’s efficiency in manufacturing, administering and selling
the products. It is the overall measure of firm’s ability to turn each rupee of
sales into net profit.

The higher the ratio; the better the efficiency.

Net Profit Ratio =Gross Profit – Operating Expenses – Income Tax x 100
Net Sales

=Net Profit After Tax + Non -operating Expenses – Non-operating

Income x 100
Net Sales

= Net Operating Profit After Tax x 100



Net Profit Ratio =Net Profit After Tax x 100


• Sales means Net Sales
• Net Profit at times is also taken before tax

iii) Operating Ratio – Also called Operating Expenses Ratio.

This ratio excludes non-operating expenses. The ratio establishes relationship

between all operating expenses and slaes and indicates management’s efficiency
in manufacturing, administering and selling the products. It shows the percent
of sales being consumed by Cost of Goods Sold and Operating Expenses and
the remaining percent of sales is left to cover income tax, dividends and firm’s
need to retain profits for expansion.

The lower the ratio; the better the efficiency.

Operating Ratio =
Cost of Goods Sold+General and Administrative Expenses + Selling and
Distribution Expensesx 100

=Cost of Goods Sold + Operating Expensesx 100


Note:Sales means Net Sales

This ratio can be analysed further:

Materials Consumed Ratio = Materials Consumedx 100
a) Conversion Cost (or Manufacturing Expense) Ratio
= Manufacturing Expenses (Excluding Materials)x 100
b) Administrative Expenses Ratio
= Administrative Expensesx 100
c) Selling and Distribution Expenses Ratio
= Selling and Distribution Expensesx 100

2. Profitability in Relation to Investment –

Such ratios calculate the returns from investment in assets, in terms of capital
employed by creditors and owners.
• They calculate the ability of the firm to produced adequate profits on each
Rupee of investment.
• Investment is the basis for calculation. The investment may refer to total
assets, capital employed or owners’ equity.
• These are Composite Ratios.
• Expressed as Percentage and are thus percentage ratios.

i) Return on Assets(ROA) – Also called Net Profits to Assets or Return on

Total Assets.

They reflect the efficiency with which management produces each unit of
product. This ratio indicates average spread between cost of goods sold and
sales revenue.

The higher the ratio; the better the efficiency of firm in utilization of assets.

ROA = Net Profit After Tax + Interest x 100

Total Assets

Interest means interest on long term debt, i.e., debentures, long term loans, etc.
This is added back as total assets may be financed by funds supplied by
creditors and owners. Cost of debt, therefore, be considered to arrive at real
At times intangible assets are excluede from total assets. Thus,

ROA = Net Profit After Tax + Interest x 100

Total Tangible Assets

In certain cases it instead of using Net Profit After Tax, Net Profit Before Tax is
used. This is so as income tax keeps on changing as per government rules and
its incidence is not certain. Thus, it is also calculated as
ROA = Net Profit Before Tax + Interest x 100
Total Tangible Assets

ii) Return on Capital Employed (ROCE) –

The higher the ratio; the better the efficiency of the firm in utilization of funds.

There are three variations:

a) ROCE = Net Profit After Tax x 100

Capital Employed
b) ROCE = Net Profit After Tax + Interest x 100
Capital Employed
c) ROCE = Net Profit After Tax+ Interestx 100
Capital Employed – Intangible Assets

• Instead of Net Profit After Tax, Net Profit Before Tax is also used.
• Capital Employed = Shareholders’ Equity + Non Current Liabilities
(long term liabilities)
= Non Current Assets (Fixed Assets) + Working Capital

iii) Return on Shareholders’ Equity (ROSE) –

Also called Return on Shareholders’ Investemnt Ratio or Return on Proprietor’s

Shareholders comprise of ordinary (common/equity) shareholders and

preference shareholders.Dividendon preference shares are fixed and return on
common shareholders are not fixed. Earnings may be distributed or may not.
Nevertheless Net Profit After Tax and after preference share dividend represents
their return. ROSE is calculated to see the profitableness of owners’

The higher the ratio; the better it is for the firm.

ROSE= Net Profit After Tax x 100

Shareholders’ Equity

Shareholders’ Equity = Equity Share Capital + Preference Share Capital

+ Reserves and Surplus
– Accumulated Losses
Also called as Net Worth.

Since the equity shareholders are the real owners and risk takers, it is necessary
to calculate Return on Common Equity.
Return on Common Equity or Equity Capital = Net Profit After Tax –
Preference Dividend x 100
Common Shareholders’
Common Shareholders’ Equity = Equity Share Capital + Reserves and Surplus
– Accumulated Losses
= Shareholders’ Equity (Net Worth) – Preference
Share Capital
Return on Common Equity or Equity Capital = Net Profit After Tax –
Preference Dividendx 100
Shareholders’ Equity–
Preference Share Capital

3. Profitability Based on Earining on Shares

i) Earning Per Share (EPS)

It indicated the profitableness of common shareholders. It shows the
profitability of the firm on a per share basis. It does not reflect how much is
retained and how much is paid as dividend.

It is expressed in Rupees and the higher the better.

EPS = Net Profit After Tax – Preference Dividend

Number of Equity Shares

ii) Dividend Per Share (DPS)

Net Profit After Tax– Preference Dividend belongs to common sharesholders.
But the income which they really receive is the amount of earnings distributed
and paid as cash dividends. Therefore, large number of investors (present and
potential) are interested in Dividend Per Share rather than Earning Per Share.

It is expressed in Rupees. The higher the better.

DPS = Earnings Paid to Equity Shareholders

Number of Equity Shares
For example, if EPS is Rs. 3 and DPS is Rs. 1.80, that means Rs. 1.20 is
retained in the business.

iii) Dividend Payout Ratio/Payout Ratio
This is expressed in percentage. Higher ratio means more dividends than
retained earnings.

Dividend Payout Ratio = Dividend Per Sharex 100

Earning Per Share

iv) Dividend Yield Ratio

It is expressed in Rupees. The higher the better.

Dividend Yield Ratio = Dividend Per Share x 100

Market Value Per Share

v) Earning Yield/Earnings Price Ratio

It is expressed in Rupees. The higher the better.

Earning Yield Ratio = Earning Per Share x 100

Market Value Per Share
iv) and v) evaluate sharesholders returns in relation to market value of share.
Market value is collected from stock market.

vi) Price-Earnings Ratio

This is reciprocal to Earning Yield Ratio. It is used by security analysts to
evaluate firm’s performance as expected by investors. It also helps market
appraisal of firm’s performance.

It is expressed in Rupees. The higher the better.

Price-Earnings Ratio = Market Value Per Sharex 100

Earning Per Share

4.3.4 Solvency Ratios

• They indicate the ability of a firm to meet all outside liabilities out of all
• Liquidity ratios are Balance Sheet Ratios or Profit and Loss Account Ratios.
• Liquidity ratios are Balance Sheet Ratios are pure ratios and Profit and Loss
Account Ratios are turnover ratios.

1. Solvency Ratio which are calculated from Balance Sheet figures only

i) Solvency Ratio
Ideal Ratio is 2:1.

Solvency Ratio = Total Assets____

Total Outside Liabilities

Total Assets = Total Tangible Fixed Assets + Total Current Assets

(Miscellaneous Expenses are totally excluded)
= Fixed Assets (excluding goodwill) + Investments
+ Current Assets, Loans and Advances

Total Outside Liabilities = Long Term Liabilities + Short Term Liabilities

= Debentures + Bank long term Loans + Other Long Term
+ Fixed Deposits + Bank Overdraft + Creditors + Bills
+ Accrued Expenses + Income Tax Liability + Dividend

ii) Equity Ratio – Also called as Shareholders’ Fuynd to Total Assets Ratio.

Equity Ratio = Proprietor’s Fund___

Total Assets/Total Funds

Proprietor’s Fund/Shareholders’ Equity = Equity Share Capital + Preference

Share Capital
+ Reserves and Surplus – Accumulated Losses
Also called as Net Worth.

Total Assets = Total Assets excluding Fictitious/Intangible Assets

Total Funds = Long Term as well as Short Term Funds
= Shareholders Funds + Long Term Debt + Current Liabilities

iii) Debt Ratio

Debt Ratio = Total Liablities
Total Assets

Debt Ratio = Total Long Term Liablities

Total Assets

iv) Debt Equity Ratio

DebtEquity Ratio = Long Term Debt Funds

Equity means Shareholder’s Equity

v) Inventory to Working Capital Ratio

Inventory to Working Capital Ratio = Closing Stock_
Working Capital

2. Solvency Ratio calculated from Profit and Loss Account figures only

i) Net Income to Debt Service Ratio –

Also called Debt Service Ratio, Coverage Ratio, Interest/Fixed Coverage Ratio
or Times-Interest Earned

The ration is expressed as rate, i.e., number of times fixed charges earned. They
show how many times interest are covered by funds that are ordinarily available
to pay the interest charges. Income Tax should be included in the numerator
becasue it is calculated after paying the interest. This ratio indicate the extent to
which the earnings may fall without causing any embarrassment to the firm
regarding the payment of interest charges.

Debt Service Ratio = Net Income Before Charging Interest and Income Tax
Periodic Interest on Long Term Debt

Too high ration indicates conservativeness of shareholders in not using other

sources of finance.

ii) Fixed Charge Coverage Ratio

Interest/Fixed Coverage Ratio does not consider fixed obligations like
preference dividend and repayment of principal. It indicates how many times
fixed charges are covered by profits after tax, it measures margin of safety of
preference shareholders and long term creditors.
Expressed as turnover ratio, i.e., times. The higher the better.

Fixed Charge Coverage Ratio = Net Income Before Charging Interest and
Income Tax
Total Fixed Charges
Total Fixed Charges = Dividend on Preference Shares + Interest on Long Term

At times Net Profit After Tax is taken.

Ratios at a Glance

S.No. Ratios Formula

1. Liquidity Ratios
i) Current Ratio = Current Assets__
Current Liabilities
ii) Liquid Ratio = __Liquid Assets__
Current Liabilities
= Liquid Assets__
Liquid Liabilities
iii) Absolute Ratio = Cash + Marketable Securities
Current Liabilities
2. Activity Ratios
i) Inventor Turnover = Cost of Goods Sold
Ratio Average Stock
= Net Sales___
Average Stock
ii) Debtors Turnover = Credit Sales___
Ratio Average Debtors
= Total Sales_______
Closing Balance ofDebtors
iii) Average Age of = 365 x Debtors
Debtors Sales
iv) Creditors Turnover = Credit Purchases_
Ratio Average Creditors
= Total Purchases______
Closing Balance ofCreditors
v) Average Age of = 365 x Creditors
Creditors Purchases
vi) Total Assets = Sales _____
Turnover Ratio Total Tangible Assets
vii) Capital Turnover = _______Sales __
Ratio Capital Employed
= Cost of Sales__
Capital Employed
viii) Fixed Assets = Sales
Turnover Ratio Fixed Assets
= Cost of Sales
Fixed Assets
ix) Working Capital = ____Sales
Turnover Ratio Working Capital
= Cost of Sales
Working Capital
3. Profitability Ratios
i) In Relation to Sales
a) Gross Profit Ratio = Gross Profit x 100
b) Net Profit Ratio = Net Profit x 100
c) Operating Profit = Cost of Goods Sold + Operating
Expensesx 100
ii) In Relation to
a) Return on Assets = Net Profit After Tax + Interest x 100
(ROA) Total Tangible Assets
= Net Profit Before Tax + Interest x 100
Total Tangible Assets

b) Return on Capital = Net Profit After Tax + Interest x 100

Employed (ROCE) Capital Employed
c) Return on = Net Profit After Tax x 100
Shareholders’ Equity Shareholders’ Equity
d) Return on Equity = Net Profit After Tax – Preference
Capital Dividendx 100
Shareholders’ Equity– Preference Share
iii) Based on Earining
on Shares
a) Earning Per Share = Net Profit After Tax – Preference Dividend
(EPS) Number of Equity Shares
b) Dividend Per Share = Earnings Paid to Equity Shareholders
(DPS) Number of Equity Shares
c) Dividend Payout = Dividend Per Sharex 100
Ratio Earning Per Share
d) Dividend Yield Ratio = Dividend Per Share x 100

Market Value Per Share
e) Earnings Price Ratio = Earning Per Share x 100
Market Value Per Share
f) Price-Earnings Ratio = Market Value Per Sharex 100
Earning Per Share
4. Solvency Ratios
i) Calculated from
Balance Sheet
a) Solvency Ratio = Total Assets_____
Total Outside Liabilities
b) Equity Ratio = Proprietor’s Fund_____
Total Assets/Total Funds
c) Debt Ratio = Total Long Term Liablities
Total Assets
d) Debt Equity Ratio = Long Term Debt Funds__
Shareholder’s Equity

e) Inventory to = Closing Stock__

Working Capital Working Capital
ii) Calculated from
Profit and Loss
Account figures
a) Debt Service Ratio = Net Income Before Charging Interest and
Income Tax
Periodic Interest on Long Term Debt
b) Fixed Charge = Net Income Before Charging Interest and
Coverage Ratio Income Tax Total Fixed Charges

Illustration 1:
The following is the Profit and Loss Account for the year ending 31st March
2012 and Balance Sheet as on 31st March 2012. Find out various ratios.

Profit and Loss Account

For the year ending 31st March 2012

Particulars Amount Particulars Amount

(Rs.) (Rs.)
To Opening Stock 1,75,000 By Sales 15,00,000
Add: Maufacturing Cost 10,75,000
During the Year
Less: Closing Stock 1,50,000
Cost of Goods Sold 11,00,000
To Gross Profit 4,00,000
Total 15,00,000 Total 15,00,000
To General and 35,000 ByGross Profit b/d 4,00,000
Administrative Expenses By Non Operating 9,000
To Selling and 25,000 Income
Distribution Expenses
To Depreciation 50,000
To Interest 23,000
To Income Tax 1,26,000
To Net Profit 1,50,000
Total 4,09,000 Total 4,09,000
To Preference Dividend 16,000 ByNet Profit 1,50,000
To Ordinary Dividend 52,500 By Reserves, beginning 1,18,500
To Reserves, ending 2,00,000 balance
Total 2,68,500 Total 2,68,500

Balance Sheet
as on 31st March 2012

Liabilities Amount Assets Amount

(Rs.) (Rs.)
Share Capital: Plant and Machinery 10,00,000
Ordinary Share Capital Less: Accumulated
35,000 shares of Rs. 10 3,50,000 Depreciation 2,50,000
each 2,00,000 Net Plant and Machinery
8% Preference Share 2,00,000 Goodwill 7,50,000
Capital Stock 1,40,000
Reserves and Surplus 2,50,000 Debtors 1,50,000
Loans 1,00,000 Marketable Securities 75,000
7% Debentures Prepaid Expenses 25,000
Long Term Loans (@6%) 60,000 Cash 25,000
Current Liabilities and 20,000
Provisions 20,000
Creditors 65,000
Bills Payable
Accrued Expenses
Provision for Taxation
Total 12,65,000 Total 12,65,000


A. Liquidity Ratios
1. Current Ratio = Current Assets
Current Liabilities
= 1,50,000+1,00,000+75,000+25,000+25,000
= 3,75,000 = 2.27:1
2. Liquid Ratio = Liquid Assets
Liquid Liabilities
= Current Assets – Stock – Prepaid Expenses
Current Liabilities – Bank Overdraft – Accrued
= 3,75,000 – 1,50,000 – 25,000=2,00,000 = 1.38:1
1,65,000 – 20,000 1,45,000
3. Absolute = Cash + Marketable Securities
Ratio Current Liabilities
= 25,000+75,000 = 1,00,000= 0.60:1
B. Activity Ratios
1. Stock = Cost of Goods Sold
Turnover Stock
= 11,00,000= 7.33 times
2. Debtors = Total Sales
Turnover Closing Balance ofDebtors
= 15,00,000 = 15 times
3. Average Age = 365 x Debtors
of Debtors Sales
= 365 x 1,00,000 = 24.35 days
Creditors = Credit Purchases
Turnover Average Creditors
= Total Purchases
Closing Balance ofCreditors
Average Age = 365 x Creditors
of Creditors Purchases
Total Assets = Sales
Turnover Total Tangible Assets
= 15,00,000 = 15,00,000 = 1.33 times
12,65,000 – 1,40,000 11,25,000
Capital = Sales
Turnover Capital Employed
= 15,00,000
= 15,00,000 = 1.36 times
C. Profitability
Gross Profit = Gross Profit x 100
Ratio Sales
= 4,00,000 x 100 = 27%
Net Profit = Net Operating Profit x 100

Ratio Sales
= 1,50,000 – 9,000 x 100 = 9.40%
Operating = Cost of Goods Sold + Operating Expensesx 100
Profit Sales
= 11,00,000+35,000+25,000+50,000+23,000 x 100=
Return on = Net Profit After Tax + Interest x 100
Assets (ROA) Total Tangible Assets
= 1,50,000 + 23,000 x 100
12,65,000 – 1,40,000
= 1,73,000 x 100 = 15.38%
Return on = Net Profit After Tax + Interest x 100
Capital Capital Employed
= 1,50,000 + 23,000 x
= 1,73,000 x 100 = 15.73%
Return on = Net Profit After Tax x 100
Shareholders’ Shareholders’ Equity
= 1,50,000x 100
= 1,50,000 x 100 = 20%
Return on = Net Profit After Tax – Preference Dividendx 100
Common Shareholders’ Equity– Preference Share Capital
Equity or
= 1,50,000 – 16,000 x 100 = 1,34,000 x 100=
3,50,000 3,50,000
Earning Per = Net Profit After Tax – Preference Dividend
Share (EPS) Number of Equity Shares
= 1,50,000 – 16,000 = 1,34,000 = Rs. 3.83
35,000 35,000

Dividend Per = Earnings Paid to Equity Shareholders
Share (DPS) Number of Equity Shares
= 52,500 = Rs. 1.50
D. Solvency Ratios
1. Solvency = Total Tangible Assets
Ratio Total Outside Liabilities
= 12,65,000 – 1,40,000

= 11,25,000 = 2.18:1
2. Equity Ratio = Proprietor’s Fund
Total Assets/Total Funds
= 3,50,000+2,00,000+2,00,000 = 7,50,000= 0.67:1
12,65,000 – 1,40,000 11,25,000
3. Debt Ratio = Total Long Term Liablities
Total Assets
= 1,00,000+2,50,000 = 7,15,000 = 0.31:1
12,65,000 – 1,40,000 11,25,000
4. Debt Equity = Long Term Debt
Ratio Shareholder’s Equity

= 1,00,000+2,50,000 = 3,50,000 =
3,50,000+2,00,000+2,00,000 7,50,000
5. Debt Service = Net Income Before Charging Interest and Income
Ratio Tax
Periodic Interest on Long Term Debt
= 1,50,000+1,26,000+23,000 = 2,99,000 = 13 times
23,000 23,000
6. Fixed Charge = Net Income Before Charging Interest and Income
Coverage Tax Total Fixed Charges
= 1,50,000+1,26,000+23,000 = 2,99,000 = 7.65
23,000+16,000 39,000

Illustration 2:

Illustration 3:


I Objective Type:

2. Select the right answer.

(iv) Earning per Share comes under:
(a) Activity Ratio, (b) Solvency Ratio, (c) Profitability Ratio, (d)
Liquidity Ratio
(v) The following is not taken into consideration while calculating Current
(b) Marketable Securities, (b) Stock, (c) Bills Payable, (d) Creditors
(vi) When sales is Rs. 5,00,000, and debtors Rs. 1,00,000, the average
collection period is:
(b) 73 days, (b) 45 days, (c) 60 days, (d) 75 days
[Ans. (i) c, (ii) b, (iii) a]

2. State whether each of the following statements is ‘True’ or ‘False’.

(iv) Debt-Equity Ratio measures the liquidity of the firm.
(v) Ideal Quick Ratio is 2:1.
(vi) Quick Ratio is also called as Acid Test Ratio.
[Ans. (i) False, (ii) False, (iii) True]

II Theory Questions:

5. Describe the meaning and nature of ratios.

6. Explain the various classification of ratios.
7. What are the advantages and limitations of ratios.
8. Write short notes on:
(iv) Role of ratios
(v) Profitability Ratios
(vi) Solvency Ratios

III Practical Problems:

1. From the following Balance Sheet calculate various Solvency Ratios and
Liquidity Ratios:


3. With the help of the following information, complete the balance sheet of
Flex Ltd.
Equity Share Capital – Rs. 2,00,000
The relevant ratios of the company are as follows:
i) Current Debt to Total Debt – 0.40
ii) Total Debt to Owner’s Equity – 0.60
iii) Fixed Assets to Owner’s Equity – 0.60
iv) Total Assets Turnover – 2 times
v) Inventory Turnover – 8 times

Budget and Budetary Control

5.0 Learning Objectives

After studying this Chapter the student should be able to:

 Understand the meaning of budgets and budgetary control;
 Comprehend the scope, objectives, importance, advantages and limitations of
budgetary control ;
 Know the various types of budgets prepared in an organization;
 Prepare with ease the various buegets.

5.1 Meaning, Definition and Scope of Budget and Budgetary Control

5.1.1 Meaning and Definition of Budget and Budgetary Control

1. Meaning and Definition of Budget
The word ‘budget’ is derived from ‘bougette’, a French word denoting a leather
pouch in which funds are appropriated for meeting anticipated expenses. This in
reality is basic purpose of budgeting.

A budget is a quantitative expression of a plan for a defined period of time. It

may include planned sales volumes and revenues, resource quantities, costs and
expenses, assets, liabilities and cash flows. It expresses strategic plans of
business units, organizations, activities or events in measurable terms.A budget
is merely a plan relating to a period of time in future expressed in quantitative
or financial term. It is a quantitative expression of a plan of action preprared in
advance of the period to which it relates. In simple words, budget is a numerical
statement expressing the plans, policies and goals of enterprises for a definite
period in the future. It is plan laying down the target to be achieved, the target
may be expressed either in monetary or financial terms or may take the form of
statement of anticipated results, as reflected by the quantity produced, material,
number of hours worked, quantity sold, etc. Budget involves planning for all
functions of the business in advance. It covers not only payment and expenses,
but also receipts and income, both of capital and revenue character. It includes
not only financial transactions but also physical operations. It brings within its
fold every aspect of the business or industry viz, material, labour, plants and
equipments, production, sales, finance etc.

It covers all phases of the business enterprises and as such is usually identified
as the management instruments of planning, organizing, co-ordinating and
control. It lays down in advance the intentions of the management regarding the
business in concrete terms.

Definitions of Budget:
ix) The Institute of Chartered Accountants of England and Wales:
A financial and or quantative statement, prepared prior to a defined period
of time, of the policy to the persued during that period, for the purpose of
attaining a given objective.

x) Chartered Institute of Management Accountants, London:

A plan quantified in monetary terms prepared and approved prior to a
defined period of time, usually showing planned income to be generated and
or expenditure to be incurred during the period and the capital to be
employed to attain given objective.

xi) Clarance L. Van Sickle:

The budget is an estimate prepared in advance of the period to which it

The above definitions show that budgets are a blue print of a projected plan of
action of a business for a definite period of time. It is a comprehensive and co-
oridinated plan, expressed in financial terms, for the operations and resource of
an enterprise for some specific period in the future. It is pre-determined
statements of management policy during a given period which provides a
standard for comparison with the result actually achieved.

In short budget is an estimate of the future needs calculated for a definite period
(no specific period can be formulated as the best period, as it depends upon the
type of business).

A budget, therefore, is to be taken as a document which is closely related to

both the managerial and accounting functions of an organization.

An analysis of the above said definitions reveal the following essentials of a

i) It is prepared for a definite future period.
ii) It is a statement prepared prior to a defined period of time.
iii) The Budget is a monetary and / or quantitative statement of policy.
iv) The Budget is a predetermined statement and its purpose is to attain a given

2. Meaning and Definition of Budgetary Control

Budgetary Control is that type of control in which controller compares actual
result with budget data and identify the difference and correcting the cause of
difference.The terms budget and budgetary control are often used

interchangeably to refer to a system of managerial control. Budgetary control
implies the use of the comprehensive system of budgeting to aid management in
carrying out functions like planning, co-ordination and control. It is system
which uses budgets for planning and controlling different activities of business.
This system involves:
i) Division of organization on functional basis into different sections (section
is technically known as a budget centre)
ii) Preparations separate budget for each ‘budget centre’.
iii) Consolidation of all functional budgets to present overall organizational
objectives during the forth coming budget period.
iv) Comparison of actual level of performance against budgets. Comparison
process is stretched for enough to declare either attainment of objective or
basis for future course of action.
v) Reporting the variances which proper analysis to provide basis for future
courses of action.

Definitions ofBudgetary Control

i) The Chartered Institute of Management Accountants, London:
Budgetary control is the establishment of budgets relating to responsibilities
of executives to the requirement of a policy and the continuous comparison
of actual with budgeted results, either to secure by individual action the
objective of that policy or to provide a basis for revision”.

ii) Brown and Howard:

Budgetary control is a system of controlling cost, which includes the
preparation of budgets, co-ordinaring the departments and establishing
responsibilities, comparing actual performance with the budgeted and acting
upon results to achieve maximum ptofitability”.

iii) Rowland and William:

Budgetary control includes the science of planning the budgets themselves
and the utilization of such budgets to effect overall management tool for the
business planning and control.

iv) J. Batty:
Budgetary control is a system which uses budgets as a means of planning
and controlling all aspects of producing and/or selling commodities or

v) Wheldon:
Budgetary control is the planning in advance of the various functions of
business so that the business as a whole can be controlled.

Thus, the control exercised for execution of budgets is termed as budgetary
control.It is designed to evaluate the performance in terms of goals budgeted
through budget reports and to take corrective actions, if needed. Budget is
concerned with policy making,while budgetary control results from the
implementation of the policy.

The above definitions reveal the following essentials of budgetary control:

i) Establishment of objectives for each function and section of the
ii) Comparison of actual performance with budget.
iii) Ascertainment of the causes for such deviations of the actual from the
budgeted performance.
iv) Taking suitable corrective action from different available alternatives to
achieve the desired objectives.

The term budgeting is frequently used for preparing and other concerning
procedures in their use in planning, co-ordinating and control of the business
enterprises. Budgeting is a wide term and includes monthly budgetary control
but also budget preparations and using of budgets reports. Budgeting is done
mainly by the top management but while the budgetary control is exercised by
the middle management. However according to Rowland and Willman
Budgetary control is a wider term. According to them budgeting is the act the
building budgets, whereas budgetary control embraces budgets, budgeting and
in addition includes the science of planning the budgets themselves and the
utilization of such budgets to effect the overall managements tool for the
business plannings and control.

5.1.2 Scope of Budget and Budgetary Control

i) Budgets are prepared for different functions of business such as production,
sales etc. Actual results are compared with the budgets and control is
ii) Budgets have a wide range of coverage of the entire organization. Each
operation or process is divided into number or elements.
iii) Budgetary control is concerned with the origin of expenditure at functional
iv) Budget is the projection of financial accounts.

5.2 Objectives, Advantages, Limitations, Role andSignificance of
Budgetary Control

5.2.1 Objectives of Budgets and Budgetary Controls

The General goals of the plans or budgetary control might be expressed as, to
empower the administration to convey it essential capacities of arranging,
regulating, and co-organizing all the operations of the undertakings month to
month and productively. The targets of plans and budgetary control are in this
manner, abridged under their heads arranging co-appointment and control.
i) Planning: A plan is an arrangement of activity; a plan of action. The point
when plans are made ahead of time numerous issues that the firm might
confront in prospective could be foreseen. As an aftereffect of such foresight
they can be illuminated effortlessly without disturbing the arrangements of
the firm. Planning will compel administration whatsoever levels to arrange
in part all the exercises to be carried out in future, for example production,
sales, promotions, raw materials, labours, stock levels cost, research
programs capital necessities, and so on.
ii) Coordinating: In every concern different sections, areas and sub-segments
are created and each of them depended with a distinct work. In any case,
every last one of them are interlinked and they should work to accomplish
the regular objectives of the firm. For this reason, it is indispensible to have
co-appointment in the exercises through the expert plan. The expert plan is
dependent upon the different departmental plans. The budgetary control
strengths the executives to consider, and think as gathering. Co-appointment
of exertions requires correspondence of destinations and directions and plan
is a significant instrument of correspondence.
iii) Control:With a specific end goal to have coordination and to achieve the
fancied objectives, it is fundamental to have a control over the exercises of
the firm. Control comprises of the activity essential to guarantee that the
execution of the conglomerations adjusts of the arrangement, and targets.
This is not conceivable without predetermined standards. Budgetary control
makes control by analyzing the real results against what was planned. The
comparions demonstrate the variances, if any, from the targets, set out. The
explanations for such varieties could be followed out and the authority
regarding such variances might be settled. Preventive activities might be
taken to evade repeat of varieties in future.
iv) Other Uses: Budgeting guarantees that sufficient working capital is
accessible for the effective operation of the business. It additionally helps in
regulating money, and acquire, a more practical utilization of capital. It
smooths out regular varieties in creation by advancing new 'fill-in' item.

5.2.2 Advantages, Role and Significance of Budgetary Control
It is said that the budget is not only a money maker, but greatest money saver
ever discovered. S.W.Shibley says, “there is a secret gold mine in budgetary
control, which a select few have discovered and are mining profitably”. The
budgetary control system helps in fixing the goals for the organization as a
whole and concerted efforts made for its achievements. It enables economies in
the enterprise. Some of the advantages of budgetary control are:
i) Maximization of Profit: The budgetary control aims at the maximization of
profits of the enterprise. To achieve this aim, a proper planning and co-
ordination of different functions is undertaken. There is proper control over
various capital and revenue expenditures. The resources are put to the best
possible use.
ii) Co-ordination: The working of the diverse divisions and areas is fittingly
co-ordinated. The plans of diverse branches have a direction on each one in
turn. The coordination of different executives and subordinates is
indispensible for realizing planned targets.
iii) Control:It provides an effective means of controlling all activities. Budgets
lay down the goals in numerical terms with which the actual performance
can be compared and corrective steps can be taken, in case deviations from
the standards are noticed. Responsibilities for deviations can be fixed on
particular individuals.
iv) Communication: It forms a useful means of communicating company
policy. The plans, policies and goals are decided by the top management.
All efforts are put together to reach the common goal of the organization.
Every department is given a target to be achieved. The efforts are directed
towards achieving come specific aims. If there is no definite aim then the
efforts will be wasted in pursuing different aims.
v) Tool for Measuring Performance: By providing targets to various
departments, budgetary control provides a tool for measuring managerial
performance. The budgeted targets are compared to actual results and
deviations are determined. The performance of each department is reported
to the top management. This system enables the introduction of
management by exception.
vi) Economy: It directs to the full economic use of capital employed in the
business.The planning of expenditure will be systematic and there will be
economy in spending. The finances will be put to optimum use. The benefits
derived for the concern will ultimately extend to industry and then to
national economy. The national resources will be used economically and
wastage will be eliminated.
vii) Determining Weakness: The deviations in budgeted and actual
performance will enable the determination of weak spots. Efforts are
concentrated on those aspects where performance is less than the stipulated.

viii) Corrective Action: As the problem that are likely to be faced by the firm
are anticipated in the budget, the firm is saved from landing in trouble, when
such problems actually crop up. The management will be able to take
corrective measures whenever there is a discrepancy in performance. The
deviations will be regularly reported so that necessary action is taken at the
earliest. In the absence of a budgetary control system the deviation can
determined only at the end of the financial period.
ix) Consciousness: It creates budget consciousness among the employees. By
fixing targets for the employees, they are made conscious of their
responsibility. Everybody knows what he is expected to do and he continues
with his work uninterrupted.
x) Reduces Costs: In the present day competitive world budgetary control has
a significant role to play. Every businessman tries to reduce the cost of
production for increasing sales. He tries to have those combinations of
products where profitability is more.
xi) Introduction of Incentive Schemes: Budgetary control system also enables
the introduction of incentive schemes of remuneration. The comparison of
budgeted and actual performance will enable the use of such schemes.
xii) Other Benefits:
a) A budget provides management with useful basis upon which to build
their policy.
b) It reduces seasonal variations in productions, thereby reducing the cost
of production by increasing volume.
c) It provides a yardstick to measure efficiency of the execution of a
policy. Actual expenses can be compared with budgeted expenses.
d) It distributes production program according to plant capacities and
makes the most effective
e) Budgets form the basis for setting up of standard costing.
f) Cash budget enable the financial managements to forecast their need for
credit and arrange for it in advance. It ensures sufficient working capital
and other resources for the efficient operation of the business.
g) Advance planning inherent in budgets is looked upon with favour by
credit agencies as indicative of sound management.

5.2.2 Limitation of Budgetary Control

Though the budgeting has many advantages, it is not a foolproof tool in the
hands of management. It has its own limitations. Those who make use of
budgetary control, should be aware of these limitations:
i) Based on Estimates:The success or failure of budget depends to a large
extent upon the accuracy of basic estimates or forecasts. The budget plans
is based on estimates. However expert a person may be and whenever
techniques may be used in estimating, forecasting cannot be cent per cent
correct, as budget is not as exact science. As a result the strength or

weakness of budgetary control system depends, to a very large extent, on the
accuracy with which estimates are made.
ii) Lack of Flexibility: As budgets are prepared by qualifying or relevant data,
there is tendency to such more sort of finality to budget figures. But practice
the business conditions constantly cheque, and the budget must have
flexibility to adopt the changing conditions. A budget program must be
dynamic and continuously deal with changing conditions or else they will
lose their usefulness.
iii) Budget Execution Not Automatic: Execution of budgets will not occur
automatically. Introduction of Budget program alone is not sufficient to
ensure success. The persons responsible to ensure budget must participate
enthusiastically for the realization of budgetary goals. If they are
insufficient, the budgets, however good they may be, cannot be of any use.
iv) Expensive Technique: If the structure of the budgetary system becomes top
heavy, and costly, small concerns cannot afford to adopt it. The cost must be
commensurate with the benefit gained from the budgets.

5.3 Types of Budgets – Operating, Financial and Capital Budget

5.3.1 Operating Budget

An Operating Budget is the annual budget of an activity stated in terms of
Budget Classification Code, functional/subfunctional categories and cost
accounts. It contains estimates of the total value of resources required for
the performance of the operation including reimbursable work or services for
others. It also includes estimates of workload in terms of total work units
identified by cost accounts.

It contains detailed projection ofall estimated income and expenses based on

forecasted sales revenue during a given period (usually one year).

It generally consists of several sub-budgets, the most important one being

the sales budget, which is prepared first. Since an operating budget is a short-
term budget, capital outlays are excluded because they are long-term costs.

Operating Budget is thus a budget for current expenses as distinct from financial
transactions or permanent improvements.

5.3.2 Financial Budget

Also called as cash budget, it reveals the expected cash position of an enterprise
while proforma financial statements give information as to the future assets,
liabilities and income statement items. Financial budgets are financial plans
that are structured to detail projections on incomes and expenses on both a long-
term and a short-term basis. They are concerned with the financial implications

of the operating budgets – the expected cash inflows and cash outflows,
financial position and operating results, the balance sheet and income statement
and statement of changes in financial position.

It typically covers a period of at least one year, although it is not unusual for
some organizations to prepare this kind of budget to cover anywhere from two
to five years at a time.

5.3.3 Capital Budget

Capital budget involves the planning to acquire worthwhile projects together
with the timings of the estimated cost and cash flow of each project. Such
projects require large sum of funds and have long-term implications for the
firm. Capital budgets are difficult to prepare, because estimates of the cash flow
over a long period have to the made which involve a great degree of

The term capital budget can be applied to the budgets that lay down the
estimates in respect of the capital resources of the firm. The operating budget
helps to prepare the estimated income statements. The capital budgets facilitate
in the task of compiling of a projected balance sheets.

The actual budget usually precede the revenue or operating budget and are in
fact complimentary to it.

The Capital budget can be prepared for long-term as well as for the short term-

The capital budgets specify the capital intentions of the management and as
such often reflect the management policy in respect of investment, expression,
growth, contraction, productions and profits. Capital budgeting includes both
raising of long-term funds as well as their utilizations. It may defined as, “The
firm’s formal process for acquisition and investment of capital. It involves
firm’s decision to invest the current funds for addition disposition, modification
and replacement of long-term or fixed assets.

Capital Budgeting is many sided activity. It includes searching for new and
more probable investments proposals, investigations engineering and marketing
considerations to predict the consequences of accepting the investment and
making economic analysis to determine the profit potential of each investment
proposal. Its basic features can be summarized as under:
i) It has the potentiality of making large anticipated profits.
ii) It involves a high degree of risk.

iii) It involves a relatively long time period between initial outlay and the
anticipated return.

5.4 Prepration of Flexible Budgets, Production Budgets, Sales Budget

and Master Budget

5.4.1 Flexible Budget:

Flexible Budget is a budget designed to change in accordance with the level of
activity actually attained. Thus, this budget gives different budgeted cost for
different levels of activity from lowest to the highest level. This budget has a
distinct advantage over the fixed budget, where it is difficult to forecast sales,
costs and expenses with a great degree of accuracy. This budget is useful
especially in the business of which the sale cannot be predicted for one reason
or the other such as –
i) The typical nature of the business e.g., trade in luxury or fashionable good;
ii) The business is new one and the demand for its product cannot be foreseen;
iii) The business is subject to the vagaries of nature; and
iv) The business is suffering from shortage of the factor of production like
material, labour, etc. as the level of activity depends upon the supply of such
a factor.

In cases mentioned above, there is likely to be vast differences between the

actual level of activity and budgeted level of activity. In such a case fixed
budget is of no use, as it is based on one level of activity, to compare the actual
performance and the budgeted figure. For this purpose, it is necessary to prepare
a budget in way so as to provide for adjustment to make it comparable with the
actual performance. Such adjustments are possible in case of flexible budget. As
a matter of fact, a flexible budget is the series of fixed budgets providing for
estimates of revenues, and costs at different levels of activity.

For preparations of flexible budget, it is necessary to classify the overheads into

fixed, variable and semi-variable categories. Fixed overheads remain unchanged
as they are not related to level of activity. Variable expenses vary directly with
the level of activity whereas out of semi-variable expenses some amount remain
fixed in all levels of activity, whereas some part of the expenses vary directly
with the level of activity.

Illustration 1:
(write the year 1977 as 2012)

Illustration 2:

5.4.2 Production Budgets
The production budget calculates the number of units of products that must be
manufactured, and is derived from a combination of the sales forecast and the
planned amount of finished goods inventory to have on hand (usually as safety
stock to cover for unexpected increases in demand). The production budget is
typically prepared for a "push" manufacturing system, as is used in a material
requirements planning environment.

The production budget is typically presented in either a monthly or quarterly

format. The basic calculation used by the production budget is:
+ Forecasted unit sales
+ Planned finished goods ending inventory balance
= Total production required
– Beginning finished goods inventory
= Products to be manufactured

It can be very difficult to create a comprehensive production budget that

incorporates a forecast for every variation on a product that a company sells, so
it is customary to aggregate the forecast information into broad categories of
products that have similar characteristics.
The planned amount of ending finished goods inventory can be subject to a
considerable amount of debate, since having too much may lead
to obsolete inventory that must be disposed of at a loss, while having too little
inventory can result in lost sales when customers want immediate delivery.

Unless a company is planning to draw down its inventory quantities and
terminate a product, there is generally a need for some ending finished goods

Sample of Production Budget:

Zena Company plans to produce an array of plastic pails during the upcoming
budget year, all of which fall into the general Product A category. Its production
needs are outlined as follows:
Zena Company
Production Budget
For the Year Ended December 31, 20XX
Quarter 1Quarter 2Quarter 3Quarter 4
Forecasted unit sales 5,500 6,000 7,000 8,000
+ Planned ending inventory units 500 500 500 500
= Total production required 6,000 6,500 7,500 8,500
– Beginning,stock of finished goods 1,000 500 500 500
= Units to be manufactured 5,000 6,000 7,000 8,000

The planned ending finished goods inventory at the end of each quarter declines
from an initial 1,000 units to 500 units, since the materials manager believes
that the company is maintaining too much finished goods in stock.
Consequently, the plan calls for a decline from 1,000 units of ending finished
goods inventory at the end of the first quarter to 500 units by the end of the
second quarter, despite a projection for rising sales. This may be a risky
forecast, since the amount of safety stock on hand is being cut while production
volume increases by over 30 percent. Given the size of the projected inventory
decline, there is a fair chance that Zena will be forced to increase the amount of
ending finished goods inventory later in the year.

5.4.3 Sales Budget

A sales budget is a detailed schedule showing the expected sales for the budget
period; typically, it is expressed in both rupees and units of production. An
accurate sales budget is the key to the entire budgeting in some way. If the sales
budget is sloppily done then the rest of the budgeting process is largely a waste
of time. Sales Budget helps determine how many units will have to be
produced. Thus, the production budget is prepared after the sales budget. The
production budget in turn is used to determine the budgets for manufacturing
costs including the direct materials budget, thedirectlabor budget, and
the manufacturing overhead budget. These budgets are then combined with data
from the sales budget and the selling and administrative expensesbudget to
determine the cash budget. In essence, the sales budget triggers a chain reaction
that leads to the development of the other budgets. The selling and

administrative expenses budget is both dependent on and a determinant of the
sales budget. This reciprocal relationship arises because sales will in part be
determined by the funds committed foradvertising and sales promotion.
The sales budget is the starting point in preparing the master budget. All other
items in the master budget including production, purchase, inventories, and
expenses, depend on it in some way. The sales budget is constructed by
multiplying the budgeted sales in units by the selling price.

Sample of a Sales Budget:

Following is the sales budget of Gama Incorporates:

Gama Incorporates
Sales Budget
For the Year Ended 31st March 2013

1 2 3 4 Year
Budgeted Sales in 10,000 30,000 40,000 20,000 1,00,000
Selling Price per 20.00 20.00 20.00 20.00 20.00
unit (in Rs.)
------------ ------------ ------------ ------------ ------------
Total Sales (in Rs.) 2,00,000 6,00,000 8,00,000 4,00,000 20,00,000
======= ======= ======= ======= =======
Percentage of sales *70%
collected in the
period of the sales
Percentage of sales *30%
collected in the
period after the sales

Schedule of Expected Cash Collections (in Rs.)

1 Accounts 90,000 90,000
2 First quarter 1,40,000 60,000 2,00,000
3 Second 4,20,000 1,80,000 6,00,000
quarter sales
4 Third 5,60,000 2,40,000 8,00,000
quarter sales
5 Fourth 2,80,000 2,80,000

quarter sales
----------- ----------- ----------- ----------- -----------
6 Total 2,30,000 4,80,000 7,40,000 5,20,000 19,70,000
cash collections
======= ======= ======= ======= =======
1 *Cash collections from last years fourth-quarter sales.
2 Rs. 200,000 × 70%; Rs. 200,000 × 30%
3 Rs. 600,000 × 70%; Rs. 600,000 × 30%
4 Rs. 800,000 × 70%; Rs. 800,000 × 30%
5 Rs. 400,000 × 70%
6 Uncollected fourth quarter sales appear as accounts receivable on the
company's end of year balance sheet.

Illustration 3:
(write the year 2002 as 2012)

5.4.4 Master Budget

ThisBudgets combines all the functional budgets into one harmonious unit. On
completion of the functional budgets, the budget committee prepares this
budget. Rowland and William H. Harr define the budget as “a summary of the
budgets schedules in capsule form made for the purpose of presenting, in one
report the high light of the budgets forecast. The Institute of Cost and
Management Accountants, England, defines it as, “the summary budget
incorporating its component functional budget, which is finally approved,
adopted and employed. “It is in the form of a budgeted Profit and Loss Account
and a Budgeted Balance Sheet as the end of budget period.

Steps in the preparation of the master Budget

i) Preparation of sales budget.
ii) Preparation of the production budget.
iii) Preparation of cost of production budget.
iv) Preparation of Cash Budget.
With the help of above budgets, budgeted Profit and Loss A/cAs well as
Balance sheet can be prepared

Illustration 4:
A glass manufacturing company requires you to calculate and present the
budget for the next year from the following information:


I Objective Type:

3. Select the right answer.

(vii) Production Budget is prepared on the basis of:
(a) Capital Budget, (b) Sales Budget, (c) Master Budget, (d) Flexible
(viii) Master Budget is:
(c) Summary of all budgets, (b) Total of all budgets, (c) Expansion of
all budgets
(ix) Budget is prepared for:
(c) 1 year, (b) 3 years, (c) (a) and (b)
[Ans. (i) b, (ii) a, (iii) c]

2. State whether each of the following statements is ‘True’ or ‘False’.

(vii) Flexible budget is prepared for a particular level of activity.
(viii) Production budget is prepared in units.
(ix) Budget and Budgetary Control are the same.
[Ans. (i) False, (ii) True, (iii) False]

II Theory Questions:

9. Explain the meaning of Budget and Budgetary Control. What are their
10. What are the advantages of Budgetary Control?
11. Explain the role and limitations of Budgetary Control?
12. Write short notes on:
(vii) Financial Budget
(viii) Flexible Budget
(ix) Master Budget

III Practical Problems:

1. Draw up a flexible budget for overhead expenses on the basis of the

following data and determine the overhead rates at 70%, 80% and 90% plant

2. A company has a plan to prepare a production budget for the product A, B
and C. The sales forecasts for these products is 2,08,000 units, 1,82,000
units and 2,21,000 units. The estimated requirements of inventory both at
the beginning and at the end of the budget period are shown in the following

April 1 (units) 40,000 30,000 50,000
March 31 (units) 52,000 27,900 69,000

You are required to prepare the production budget for the company.

3. Singham Ltd. produces and sells two products in its plant. During the year
2013, it plans to sell the following quantity of each product:

Budgeted Sales
I Quarter II Quarter III Quarter IV Quarter Total
Product A 8,000 12,500 15,000 7,500 43,000
Product B 6,000 3,000 2,500 4,000 15,500

Selling Price per unit A Rs.10 and B Rs. 20.

It is revealed from the past experience that Singham has lost about 3% of
total revenue, each year because of returns 2% and for allowance and bad
debts 1%. Prepare a budget incorporating the above given information.

4. From the following information of a manufacturing company prepare the
master budgets.

Sales Rs. 4,00,000

Direct Material Cost 60% of sales
Direct Labour 20 workers @ Rs. 75 per month
Factory Overhead
Indirect Labour Rs. 250 p.m.
Works Manager Rs. 200 p.m.
Foreman Rs. 6,300
Stores and Spares 2 ½ % on sales
Depreciation on machine Rs. 1,800
Light and power Rs. 2,500
Repairs, etc. Rs. 4,000
Administrative, Selling and Rs. 7,000

Standard Costing AndClassification of Variances

6.0 Learning Objectives

After studying this Chapter the student should be able to:

 Know the meaning and scope of standard cost and standard costing;
 Understand the merits, importance, and limitations of standard costing;
 Learn the various types of standard costs and the difference between
standard costing and budgetary control;
 Under various varinace and calculate the various variances.

6.1 Meaning, Definition and Scope of Standard Cost and Standard


6.1.1 Meaning and Definition of Standard Cost and Standard Costing

3. Meaning of Standard Cost
Standard means ‘norm’. It is a predetermined estimate of quantities. A standard
may be defined as, “a pre-determined measurable quantity set in defined
conditions against which actual performance may be compared, usually for an
element of work, operation or activity”. While standards may be based on
unquestioned and immutable natural law or fact, they are finally set by human
judgement and consequently are subject to the same fallibility which attends all
human activity. Thus, a standard for a 100% machine output can be fixed by its
geared input/output speeds, but the effective realizable output standard is one of
judgement. “Standard is a thing serving as a basis for comparison”. It is a
relative term. In short, Standards are the desired level of performance pre-
determined for evaluating whether the actual performance is up to the mark, i.e.,
is it efficient are not.

Standards costs are “should be” costs per-determined for the product, process,
job, etc., and its various cost components, based on technical estimates for a
specified period and under prescribed set of conditions. Standard cost is a
planned cost for a unit of product or service rendered. An estimated or
predetermined cost of performing an operation or producing a good or service,
under normal conditions.They are highly detailed, scientifically predetermined
costs of material, labour, and overhead chargeable to a product or service.

Standard costs are used as target costs (or basis for comparison with the actual
costs), and are developed from historical data analysis or from time and motion
studies. They almost always vary from actual costs, because every situation has
its share of unpredictable factors. They are also called normal cost.

4. Definitions of Standard Cost
i) Eric L. Kolher:
Standard cost is a forecast or pre-determination of what actual cost should
be under projected conditions, serving as a measure of cost control and
production efficiency or standard of comparison when ultimately aligned
against actual cost. It furnishes a medium by which the effectiveness on
current results can be measure and the responsibility fordevitions can be

ii) Chartered Institute of Management Accountants (U.K.):

Standard Costs are pre-determined costs which is calculated form
management’s standards of efficient operation and the relevant necessary

iii) Blocker and Waltmer:

Standard of a product are “pre-determined” costs based upon engineering
specifications and representing a highly efficient production for quantity
standard and forecasts of future market trends for the price, standards with
fixed accounts expressed in rupees for material, labour and overheads for an
estimated quantity of production.

iv) I.C.M.A.:
Standard cost is a pre-determination education of how much costs should be
under specified working conditions. It is built from an assessment of the
value of cost eliments and correlates. It is built up from an assessment of the
value of the cost eliments other cost to the prices and/or wages rates
excepted to supply during the period in which the standard cost is indicated
to the used. It main purposes are the provide bases for control through
varains accounting, for the valuation of stock and work-in progress and, in
some cases, for fixing selling prices “

5. Meaning of Standard Costing

Historical costs are the actual costs that are ascertained after they are incurred.
During the initial stages of development of cost accounting, historical costing
systems like process costing, contract costing, service costing etc. were
available for ascertaining the costs. The historical costing methods are used to
determine the cost incurred for the production of a particular products or
completion of a particular job.
The historical costing systems suffer from several limitations; some of them are
as follows:
• No basis for cost control
• No yardstick for measuring efficiency
• Delay in availability of information
• Expensive
Although standard costing attempts to overcome the limitations of historical
costing system, it is not an alternative to the existing historical costing. Standard
costing is the most widely used technique of controlling costs.

Standard costing is a technique that establishes predetermined estimates of the

cost of products and services and compares these costs with the actual costs as
they incur. Standard costing can be considered as a yardstick to measure the
efficiency with the actual cost incurred. Hence, standard costing is system of
costing which makes a comparisonbetween the standard cost of each product or
service with its actual cost to determine the efficiency of the operation, with a
view to take corrective actions at the earliest possible time.

Thus, standard costing is the preparation and uses of standard costs, which
involves the following process:
i) Establishment of standard costs
ii) Ascertainment of actual costs
iii) Comparison of the above two and measurement of variances
iv) Analysis of variances
v) Reporting to responsibility centers to take appropriate and necessary
remedial actions.

Standard costing is one of the importants tools to control costs. In this system
all costs are pre-determined in advance of production. Such pre-determined
costs are then compared with the actual costs. The difference between the actual
costs and pre-determined costs are known as variances, and are analysed and
investigated on some scientific basis to know their reasons. Variances are
reported to management for taking remedial steps so that actual costs may not
exceed pre-determined costs.

6. Definitions of Standard Cost

The term “Standard costing “ has been define by different scholars are follows :
i) W.W.Bigg:
Standards costing disclose the cost of devitionsfrom standard and classifies
these as to their causes, so that management is immediately informed of the
sphere of operations in which remedial action is necessary.

ii) The Institute of Costs and Works Accounts, England:

Standards costing is the preparations and use of standards costs, their
comparison with actual costs and the analysis of variance to their causes and
points of incidence.

iii) M.C.Shukla and T.S. Greval:
Standards costing is a system which seeks to control the cost of each units
or batch through determination before hand of what should be the cost and
then its comparison with actual costs “

From the above definitions it could be summarised that standard costing is a

procedure under which pre-determined costs are used to measure the effeciency
of production. It refers to the determination of standard costs and their
application in managerial problems, particularly their problems relating to
products costs, and departmental cost control. Thus, under standard costing
system, pre-determined cost are carefully computed which are then compared
with actual cost to aid in cost control.

6.1.2 Scope of Standard Cost and Standard Costing

Standards are used for planning, control correction and motivations. Standard
Cost is pre-determined cost i.e., fixed for a specified period of time.It is always
product specific i.e. for a particular product process, job, etc., and is
scientifically determined. Standards are based on technical specifications.
Standards are built by correlating standards quantities of material, labour,
machine utilisation etc., to the excepted prices of materials, wage rates and cost
per machine hour etc..Standard cost is determined for each element for cost, i.e.
separately for direct material, direct labour and fixed and variable overheads, for
detail analysis.Standard costs are generally established by the cost and
management accountants in consultation with relevant technical expert and

6.2 Merits, Significance and Limitations of Standard Costing

6.2.1 Merits, Significance (Advantages / Benefits) of Standard Costing

Standard costing System has the following main advantages or benefits:
i) Evaluation of Performance: A standard costing is a rule of measurement
established by authority, which provides a yardstick for performance
evaluation, i.e., theyprovide a yardstick for measuring the efficiency or
inefficiency in performance.. The study enables management of identify
areas of weaknesses and take corrective measures in time.
ii) Management by Exception: The use of standard costs is a key element in
a management by exception approach that is, the management need not
trouble itself with respect to those activities which proceed according to
plans. It is only on the points of exceptions that they have to concentrate.If
costs remain within the standards, Managers can focus on other issues.
When costs fall significantly outside the standards, managers are alerted that
there may be problems requiring attention. This approach helps managers
focus on important issues.

iii) Variance Analysis: The standard costing system helps to draw
management's attention towards those items which are not proceeding
according to plan. Measurement and analysis of variances helps detecting
mistakes and inefficiencies, thereby enabling the management to investigate
into their causes. Thus, standard costing facilitates effective cost control and
provides the information required for cost reduction.
iv) Promotes Efficiency:Standards that are viewed as reasonable by employees
can promote economy and efficiency. Standard costing system minimizes
the wastage by detecting variance and suggesting for corrective actions.
They provide benchmarks that individuals can use to judge their own
v) Reduction of Work:Standard costs can greatly simplify clerical work and
bookkeeping. Only necessary information is recorded and other information
avoided. Instead of recording actual costs for each job, the standard costs for
materials, labour and overhead can be charged to jobs.
vi) Effective Delegation of Work:Standard costs fit naturally in an integrated
system of responsibility accounting. In standard costing, cost centre are
defined clearly thus showing who is responsible for which cost centre. As a
result, responsibilities are defined and executives are destined to be
responsible.It facilitates delegation of authority and fixation of
responsibility for each individual or department. Thus it helps to increase
the effective delegation of authority.
vii) Facilitates Budgetary Control:A proper laid down system of standard
costing facilitates the correct implementation of budgetary control
viii) Cost Control: It facilitates the basic management function of cost
control. It helps in the prompt preparation of the profit and loss account for
short periods, say, a week, a fortnight, a month, so as to apprise the
management of the business trends. Once the system is properly planned
and introduced, it leads to savings in costs as much of the costing work can
be avoided by simplifying the costing procedures. It provides means to
encourage actions to reduce cost. Standard costing system makes the whole
organization cost-conscious as it gives the focus to the standard cost and
variance analysis.
ix) Helps Planning:Standard costing acts as an effective tool for business
planning, budgeting, marginal costing , inventory valuation etc.
x) Aids Price Policies:Standard Costing provides a valuable guidance to
management in several management functions for example, formulating
policies and determining prices.It can be used as a basis for price fixation,
filing the tenders and offering the quotation.
xi) Provides Motivation: It sets a standard which needs greater effort and
motivation to work to achieve the same. A properly developed standard
costing system with full participation and involvement creates a positive,

cost effective attitude through all levels of management. Standard costing
system provides a basis for incentive scheme to workers and supervisors.

6.2.2 Limitations (Disadvantages/Problems) of Standard Costing

Besides all advantages derived from standard costing system, it has a number of
limitations. These limitations are discussed as follows :
i) Unrealistic Standards: For the success of standard costing system, realistic
standard should be set. Generally it is seen that standards are either too strict
or too libral. Both these put impediments in the successful operation of the
system. Too strict standardsdeomtivate workers, reduce their confidence in
the system and cuase frustration, whereas too libral standards would defeat
the objective cost control through standard costing.
ii) Frequent Revision of Standards: The frequent changes in prices and
ciricumstances require a frequent revision of standard also. It may create
some obsaches in the smooth operation of standard costing system.
Moreover, frequent revision of standard may prove costly. It may prompt
firms to avoid revision of standards, making them rigid. Such standard may
prove inaccurate, unreliable and also make standards setting difficult.
iii) Difficulity in Fixing Responsibility:Generally various factors contribute to
variation between actual and standards. Executives can only be held
responsible for variances if such variances arise from actions which can be
controlled by them. This means that for fixing responsibilities, the
controllable and non-controllable portion of the variances should be
separated. But the segregation of variances into controllable and non-
controllable portion may often become a difficult task.Indentification of
these factors and their segregation in to controllable and non-controllable
category variances are bound difficult. For example, adverse labour
efficiency variances may be due to either poor quality of materials are
defective tools are untrained workers are a combination of these factors.
iv) Lack of Co-operation: For successful operation of standard costing system
co-operation at all levels is essential. Generally due to defective
organization and inter-departmental rivalries, such co-operation might be
absent.If managers are insensitive and use variance reports as a club, morale
may suffer. Employees should receive positive reinforcement for work well
done. Management by exception, by its nature, tends to focus on the
negative. If variances are used as a club, subordinates may be tempted to
cover up unfavorable variances or take actions that are not in the best
interest of the company to make sure the variances are favorable. For
example, workers may put on a crash effort to increase output at the end of
the month to avoid an unfavorable labor efficiency variance. In the rush to
produce output quality may suffer.
v) Not Suitable for Small Firms:The ascertainment of standards requires a
high degree of technical skills is, therefore, costly. Therefore, small

organizations may find it difficult to establish standard costing owing to
their limited financial resources. Again, it is generally seen that in small
firms personal contact and supervision play a more dominate role in
controlling costs. The proprietor of the firm is generally aware of the causes
and effects of variances in costs. In such a situation, elaborate installation of
standard costing system may not be justified in standard costing or the small
firm.s. Further, this system is expensive and small concerns may not afford
to bear the cost.
vi) Not Applicable in Case of Non-standard Products: Standard costing
cannot be used in those concerns where non-standard products are produced.
If the production is undertaken according to the customer’s specification
then each job will involve different amount of expenditure. Under such
circumstances it is not possible to set up standards for every job. Standars
costing can be used only in those concerns where standardized products are
manufactured.Standard costing becomes ineffective in those industries also
which are subject to frequent changes in processes and technology, in the
quality of material and character of labour. In these industries, if the benefits
of standard costing are to be obtained, the standards have to be revised
frequently so as to render them comparable with actual results.
vii) Difficulty of Setting up Standards: The process of setting up standards is a
difficult task as it requires technical skills. The time and motion study is
required to be undertaken for these purposes. Therestudies require a lot of
time and money.In some cases, a "favorable" variance can be as bad or
worse than an "unfavorable" variance. For example, McDonald's has a
standard for the amount of hamburger meat that should be in a Big Mac. A
"favorable" variance would mean that less meat was used than standard
specifies. The result is a substandard Big Mac and possibly a dissatisfied
viii) Overemphasis on Standards:There may be a tendency with standard
cost reporting systems to emphasize meeting the standards to the exclusion
of other important objectives such as maintaining and improving quality,
on-time delivery, and customer satisfaction. This tendency can be reduced
by using supplemental performance measures that focus on these other
objectives. Just meeting standards may not be sufficient; continual
improvement may be necessary to survive in the current competitive
environment. For this reason, some companies focus on the trends in
the standard cost variances - aiming for continual improvement rather than
just meeting the standards. In other companies, engineered standards are
being replaced either by a rolling average of actual costs, which is expected
to decline, or by very challenging target costs.
ix) Improper Assumptions: Labour quantity standards and efficiency
variances make two important assumptions. First, they assume that the
production process is labour-paced; if labour works faster, output will go up.

However, output in many companies is no longer determined by how fast
labour works; rather, it is determined by the processing speed of machines.
Second, the computations assume that labor is a variable cost. However,
direct labor may be essentially fixed, then an undue emphasis on labor
efficiency variances creates pressure to build excess work in
process and finished goods inventories.
In sum, managers should exercise considerable care in their use of a standard
cost system. It is particularly important that managers go out of their way to
focus on the positive, rather than just on the negative, and to be aware of
possible unintended consequences.Nevertheless standard costs are still found in
the vast majority of manufacturing companies and in many service companies,
although their use is changing. For evaluating performance,standard
cost variances may be supplanted in the future by a particularly interesting
development known as the balanced scorecard.

6.3 Types and Concepts of Standard Cost and Difference between

Standard Costing and Budgetary Control

6.3.1 Types and Concepts of Standard Cost

Standard costs are also known as predetermined costs in terms of money,
quantity or time as the basis of standard costing. Standard costs are target costs,
which should be attained and can be considered as a measuring rod or norms for
performance evaluation.

There are various types of standards in use. Out of these, the suitable standards
should be selected for effective cot control. The following are the main types of
1. Basic Standards
2. Normal Standards
3. Current Standards
4. Attainable Standards / Expected Standards
5. Ideal Standards / Theoretical standards

1. Basic Standards: These are standards established considering those factors

that are basic in nature and remain unchanged over a long period of time and
are altered only when the business operations change significantly affecting
the very basic foundations of the entity and nature of busienss. These
standards help compare business operations over a longer period of time.
Basic standards are used not only to evaluate actual results but also current
expected results (current standards). We can say that basic standards work
as a standard for other standards. As basic standards are not updated
according to latest circumstances thus they are not used often as they cannot
help in short term period variance analysis.

2. Normal Standards: These are such standards which are expected if normal
circumstances prevail. Term normal represents the normal conditions of the
business in the absence of any unexpected fluctuations (either favourable or
unfavourable). Even through normal standards are more of a theoretical in
nature as reality cannot be sufficiently predicted with all its fluctuations in
advance. Also, circumstances may change in such a way that factors which
were expected to be controllable are not so controllable by the mangers.
Thus it has limited application in today’s business environment. However,
normal standards acts as a good yardstick that represents challenging yet
attainable results and can be used by management in such environment
which is simple in nature and is not prone to great fluctuations.
3. Current Standards:These standards are representative of current business
conditions. These are mostly short term in nature and are widely used as
they are the most relevant standards to be used for control purposes. These
standards represent the state that business currently achieving or must
4. Attainable Standards / Expected Standards: These standards are based
on current conditions and circumstances and represents what can be attained
with the present setup in place and if the current conditions prevail. Current
standards may be set lower or easier then expected standards but good
managers always try to achieve what is attainable so that no resource is left
unused. It means that attainable standards are representative of the potential
that business is capable to achieve. For example a machinery is expected to
run for 4,000 hours where it can run for 5,000. Thus current standard is
4,000 hours where attainable is 5,000 hours. These standards are useful as
they help management to analyze their performance and to use the unused
potential at the right time.
5. Ideal Standards / Theoretical Standards:These standards represents what
business operations would be under ideal set of circumstances where
everything is running at the optimum level with an ideal balance. These
standards are representative of long term goals rather than for short term
performance measurement. But with the advancement of technology and
inventions even the ideal standards become attainable over the period of
time but with every step taken forward and every question answered, more
questions and more complexities pop up and its in human nature that it
always extends the way forward with every milestone achieved. Therefore,
ideal standards are not meant to be achieved rather to act like a guiding star.

This is not like that one standard is always good and the other always bad. It’s
all relative. It is a matter of situation and involves judgment to decide which
standard is suitable for a particular situation and which can provide relevant and
reliable information which is also easily available and applicable. Therefore, it

depends on the requirements on the basis of which it is determined what type of
standard is suitable for use.

For example, in financial or environmental crisis it will be good if management

stick with current standards rather than using attainable standards as even
maintaining current standards is sometime difficult.

On the other hand, if management is of the opinion that circumstances are

favourable and also the resources available are capable of facing a challenge
then it may switch to attainable or even normal standards and a bit to the
extreme ideal standards where ideal standards may help to motivate staff to
perform at its peak.

6.3.2 Difference between Standard Costing and Budgetary Control

Standard costing and budgetary control have the common objective of cost
control by establishing pre-determined targets. The control performance are
measured and compared with the pre-determined targets. Both the techniques
are of importance in their respective fields and are complementary to each other.

Points of Similarly in Standard Costing and Budgetary Control: There are

certain basic points which are common to both Standard Costing and Budgetary
Control, which are:
i) The establishment of pre-determined targets of performance.
ii) The measurement of actual performance.
iii) The comparion of actual performance with pre-detarmined targets.
iv) The analysis of variances between the actual and the standard performance/
v) To take corrective measures, where necessary.

Inspite of the similarities there are various differences between Standard

Costing and Budgetary Control which are as follows:

S.No. Basis of Standard Costing Budgetary Control

1 Scope Standard costing techniqueBudgetary control is wider
is limited only toin scope as compared to
production and production standard costing.
cost. Budgetary controls covers
all aspect of the bueinss
e.g. production, purchase,
sales, finances, income,
expenditure, etc.,
2 Concept In standard costing the In Budgetary control the
standards are set for the budgets are prepare for the
producing the product, for concern as a whole. Thus
providing a service. In in budgetary control total
standard costing units concept is used.For
concept is used example, in case of
For example, in case of Governemnts, the budgets
Governemnts, the standard are fixed for the whole
cost is fixed for one country or the whole State,
product, are different,
standards are used for
different products.
3 Basis Standard costs are fixed on The budets are fixed on the
the basis of technical basis of past records and
information. Standards future exceptations.
costs are planned costs.
4. Objective The objective of standards The main objective of
cost is cost ascertainment budgetary control is to
and fixation of selling formulate business
prices and at the same policies.
times attempts to keep the
costs at minimum level.
5. Relationship Standard costing is related Budgetary is control is
to cost accounts. related to financial
6. Applications Standard costing control is Budgets are used for
used for forecasting forecasting purposes. The
purposes. forecast about income,
expenditure and cost are
based on historical figues
and expected changes in
7. Variances In standard costing Budgetary contro deals
Analysis variances are calculated for with total variances only.
different eliments of costs The variances may be
i.e. material, labour and calculated for different
overheads. deparments or for the
concern as a whole.
8. Elements Standard costing control be The Budgetary control
used partially. It will have system can be applied
to the used wholly. The party of wholly. Budget
standard will have to be set may be prepared for some
for all elements of costs. departments and may not
be prepared for ll the
departments. If a concern
is instered in preparing
production budget only, it
is free to do so.
9. Emphasis In standard costing the In budgetary control, the
standard costing the the targets of expenditure
standards are set and an are set and these targets
attempt is made to achieve cannot be exceed. In this
these standards. The system the emphasis is on
emphasis is on achieving keeping the expenditure
the standards. within the budgeted
10. Dependency Standard costing can not Budgetary control can be
exist without effecting operational without
budgeting system. standards costing system.
11. Analyais of Under standards costing This is not in case of
Variances system, the analysis of variance analysis in
variance is made according budgetary control.
to their originating causes.
12. Rigidity Standard costing system is The budgeting system is
more rigid than budgetary less rigid as compared to
control system. the system of standard
costing. Budget fix limits,
whereas targets are fixed
in standard costing.

6.4 Classification of Variance

In standard costing, great emphasis is laid on cost control and cost reduction by
means of variance analysis. The variances may be classified into following
1. Material Variances
2. Labour Variances
3. Fixed and Variable Overhead CostVariances

These variances may be classified into two groups –

1. Price Variance, eg.
i) Material Price Variance
ii) Wages Rate Variance
iii) Variable Overhead Expenditure Variance
Fixed Overhead Expenditure Variance
2. Volume Variance, eg.
i) Material Usage Variance
ii) Labour Efficiency Variance

iii) Sales Volume Variance

6.4.1 Material Variances

Also called as Direct Material Variances.


Quantity or
Material Cost Usage Variance
Price Variance

Mix Variance

Actual and Actual and

Standard Weight Standard Weight Yield Variance
Mix Do Not Differ Mix Differ

Actual and Actual and

Planned or Not planned,
Standard Weight Standard Weight
deliberate only fortuitous
Mix Do Not Differ Mix Differ

1. Material Cost Variances

Material Cost Variance is the difference between standard cost of material
specified and actual cost of material used. This variance arises due to changes
in price of materials and varions in the use of quantity of material. To calculate
material cost variance, it is necessary to know:
i) Actual cost of materials used.
ii) Actual price per unit
iii) Standard quantity of materials. Standard quantity means the quantity which
would have been required to produce the actual output (i.e., Actual Output x
Standard Quantity per Unit)
iv) Standard price per unit.

Material Cost Variance = Standard Cost of Material Specified – Actual Cost

of Material Used
= (Standard Price x Standard Quantity) – (Actual Price x
Actual Quantity)
= Material Price Variance + Material Usage Variance

2. Material Price Variance

It is the portion of Material Cost Variance which is due to the difference
between standard price specified and the actual price paid.

Price Variance = (Standard Unit Price – Actual Unit Price) x Actual Quantity of
Materials Used

3. Material Quantity or Usage Variance

It is that portion of Material Cost Variance which is due to the difference
between standard quantity speficited and the actual quantity used.

Usage Variance = (Standard Quantity – Actual Quantity) x Standard Price Per


Illustration 1:
It is estimated that for producing 1 unit of product Zee, 20 kgs of materials are
consumed. The standard price per kg.ofmateirl is Re. 1. During the month of
September 2012 60,000 kgs of material were used for producing 5,800 units of
Zee. The actual price of material was Re. 0.96 per kg. Calculate the variances.

Standard Quantity of Materials = Actual Quantity x Standard Quantity per unit
= 5,800 x 20 = 1,16,000
Standard Rate per kg. = Re. 1
Standard Cost = 58,000 x Rs. 1 = Rs. 58,000
Actual Cost = 60,000 x Rs. 0.96 = Rs. 57,600
Cost Variance (favourable) = Rs. 400

Price Variance = (Standard Unit Price – Actual Unit Price) x Actual

Quantity of Materials Used
= Price Difference x Actual Quantity
= (Re. 1 – Re. 0.96) x 60,000
= Rs. 2400 (favourable)

Usage Variance = (Standard Quantity – Actual Quantity) x Standard Rate

= (58,000 – 60,000) x Re. 1
= Rs. 2,000 (unfavourable)

Material Cost Variance = Material Price Variance + Material Usage Variance

= Rs. 2,400 (favourable) + Rs. 2,000 (unfavourable)
= Rs. 400 (favourable)

i) Mix Variance
It is the portion of Material Usage Variance which is due to the difference
between standard and actual composition of a mixture. Thus, if actual materials
used differ from the standard materials, there is material usage variance which

may be due to change in the composition of the mixture, called mix variance.
To simplify it is assumed that there will be no difference between standard and
actual output. There yet could be two situations:
a. Actual Weight Mix and the Standard Weight Mix Do Not Differ
Here, Mix Variance = Standard Price Per Unit x (Standard Quantity –
Actual Quantity)

Illustration 2:


b. Actual Weight of Mix and the Standard Weight Mix Differ

In this case, the changes taking place in composition of mixture
(i) Is planned or deliberate
(ii) Is not planned but only fortuitous

(i) Is planned or deliberate

In this case, the Mix Variance is in effect a Revision Variance, i.e., it
takes into account the amount by which the budget is revised. This
is due to circumstances prevailing subsequent to the establishment of
standards, eg., shortage of a particular type of materials. Under this

Mix Variance/Revised Usage Variance =

Standard Price Per Unit x (Standard Quantity – Revised Standard

Revised Standard Quantity =

Standard Quantity of Each Type of Material x Actual Total
Standard Total Quantity

Illustration 3:
Standard Mix Actual Mix
Material 120 @ Rs. = Rs. 600 88 kgs @ Rs. = Rs. 440
X kgs 5 5
Material 80 kgs @ Rs. = Rs. 800 124 @ Rs. = Rs.
Y 10 kgs 10 1,240
200 Rs. 200 Rs.
kgs 1,400 kgs 1,680

During a period due to shortage of Material X, it is decided to change the

standard mix from 3:2 to 2:3. Assuming that output is unchanged, find out the
Mix Variance.

In this case it is first necessary to prepare revised standard mix for production as

Revised Standard Mix

Material X 80 kgs @ Rs. 5 = Rs. 400
Material Y 120 kgs @ Rs. 10 = Rs. 1,200
200 kgs Rs. 1,600

Mix Variance = Standard Price Per Unit x (Standard Quantity – Revised

Standard Quantity)

Material X : 5 x (120 – 80) = Rs. 200 (favourable)
Material Y : 10 x (80 – 120) = Rs. 400 (unfavourable)
Rs. 200 (unfavourable)

(ii) Is not planned but only fortuitous

When the change in the composition of a mixture is not deliberate,
the Mix Variance is calculated as under:

Mix Variance =
Standard Price Per Unit x (Revised Standard Quantity – Actual

Illustration 4:
Standard Mix Actual Mix
Material 120 @ Rs. = Rs. 600 160kgs @ Rs. = Rs. 800
X kgs 5 5
Material 80 @ Rs. = Rs. 800 140kgs @ Rs. = Rs.
Y kgs 10 10 1,400
200 Rs. 300 Rs.
kgs 1,400 kgs 2,200

Assuming that output is unchanged, find out the Mix Variance.

Revised Standard Mix

Material X 120 x 300 = 180 kgs

Material Y 80 x 300 = 120 kgs

Mix Variance = Standard Price Per Unit x (Standard Quantity – Revised

Standard Quantity)
Material X : 5 x (180 – 160) = Rs. 100 (favourable)
Material Y : 10 x (120 – 140) = Rs. 200 (unfavourable)
Rs. 100 (unfavourable)

ii) Yield Variance

In process industries, loss isalmost inevitable. However, taking into
consideration the extent of normal loss, it is possible to fix a standard for
normal excepted yield on output. But quite often actual output may differ from
standard output and hence the difference can be expressed in Yield Variance.

Yield Variance is that portion of usage variance which is due to the difference
between the standard yield specified and the actual yield obtained. There is one
fundamental difference between yield variance and other material variances,
e.g. price, quantity and mixture, in that yield variance is an output variance
while others are input variance. Yield variance occurs under two possible
situations, viz.
a. When Standard and Actual Mix Do Not Differ
The ascertainment of yield variance in this case is relatively simple.
That is,

Yield Variance = Standard Rate x (Actual Yield – Standard Yield)

Standard Rate = Total Cost of Standard Mix

Net Standard Output

Illustration 5:
Standard Mix Actual Mix
Material 120 @ Rs. 5 = Rs. 600 112kgs @ Rs. 5 = Rs. 560
X kgs
Material 80 @ Rs. = Rs. 800 88kgs @ Rs. = Rs. 880
Y kgs 10 10
200 Rs. 300 Rs.
kgs 1,400 kgs 1,440
60 (30% 50 kgs (25%
kgs loss) loss)
140 Rs. 250 Rs.
kgs 1,400 kgs 1,440

Standard Cost per unit = Rs. 1,400 = Rs. 10
Yield Variance = Rs. 10 x (150 – 140) = Rs. 100 (favourable)

b. When Actual Mix Differs from Standard Mix

In this case also the formula for ascertaining yield variance does not
change. But since the weight of actual mix difers from that of the
standard, revised standard mix is to the calculated and from this revised
standard mix, the standard rate is to be calculated.

Illustration 6:
Standard Mix Actual Mix
Material 120 @ Rs. 5 = Rs. 600 160kgs @ Rs. 5 = Rs. 800
X kgs

Material 80 @ Rs. = Rs. 800 140kgs @ Rs. = Rs.
Y kgs 10 10 1,400
200 Rs. 300 Rs.
kgs 1,400 kgs 2,200
60 (30% 75 kgs (25%
kgs loss) loss)
140 Rs. 225 Rs.
kgs 1,400 kgs 2,200

Weight of actual mix differs from that standard. Therefore a revised stdnards
mix is to be prepared as follows :

Material X 120 x 300 = 180 kgs @ Rs. 5 = Rs. 900

Material Y 80 x 300 = 120 kgs @ Rs. 10 = Rs. 1,200
300 kgs Rs. 2,100
90 kgs (30% loss)
210 kgs Rs. 2,100

Standard Cost per unit = Rs. 2,100 = Rs. 10

Yield Variance = Rs. 10 x (225 – 210) = Rs. 150 (favourable)

6.4.1 Labour Variances

Like material labour variances can be analysed as follows :

Labour Cost or
Wage Variance

Rate of Pay Efficiency Idle Time Labour Mix

Variance Variance Variance Variances

Labour Cost or Wages Variance

It is the difference between standard cost of labours specified and actual cost of
labour employed.
Labour Cost Variance = Standard Cost of Labour – Actual Cost of Labour

= (Standard Hours x Standard Rate per hour)
– (Actual Hours x Actual Rate per hour)
= Rate of Pay Variance + Efficiency Variance
+ Idle Time Variance + Labour Mix Variance

1. Rate of Pay Variance

It is the portion Wages Variance which is due to the difference between
standard rate specified and actual rate paid. This variance is similar to Material
Price Variance. The Rate of Pay Variance may arise due to any one of the
following reasons :
i) Payment at a rate higher or lower than the standard rate.
ii) Grades of employees changed.
iii) Inclusion of new Workmen.
iv) Changes in the method of payemtn of remuneration, e.g., paying prices rate
instead of time rate etc.,

The Rate of Pay Variance is calculated as (Standard Rate – Actual Rate) x

Actual Hours/Production

2. EffciencyVariance
The Variance is that portion of Wages Variance which is due to the difference
between the standard labour hours specied and the actual labours hours
expended. Thus,

Labour Effciency Variance = (Actual Production – Standard Production) x

Standard Rate Per Unit

Note: Standard Production = Actual Hours Excluding Abnormal Time

Standard Time Per Unit

EffciencyVariance = (Standard Time for Actual Production – Actual Hours

ExcluingAbnornal Idle Time) x Standard Hourly Rate

If actual time is less than standard time or actual production is more than
standard production, the variance will be favourable and vice versa.

As a result of efficiency variance, their may be gain in production (due the

favourable variance) or loss production. The possible causes leading to such
gains or losses or noe listed below :

Illustration 7:


3. Idle Time Variance

Production may be affected due to causes like break down of machinery, power
failure etc., which cannot be controlled by workers. Therefore, the effect of such

abnormal causes should be shown separately. This is considered necessary
because of the fact that if abnormal idle time is concealed in efficiency variance
the workers will be blamed for inefficiency for reasons beyond their control.

Idle Time Variance is that portion of wages variance which is due to specified
of time of the workers. Idle Time Variance = Abnormal Idle Hoursx Standard
Hourly Rate

If should be noted that idle time variance will be always unfavourable and

Illustration 8:

4. Labour Mix Variances

At times due non-availability or shortage of labour a change in the grades of
labour employed has to be made. The effect of the change on the labour cost is
arrived at by finding out Labour Mix Variance. The Variance is akin to Material
Mix Variance. It is ascertained by the following formula:
Mix Varaince = Standard Cost of Standard Mix – Standard Cost of Actual Mix

Illustration 9:

6.4.3 Fixed and Variable Overhead Variance

1. Fixed Overhead Variance

The recovery of fixed overhead depends upon:
i) Amount of fixed overhead, and
ii) The outputs of products or standard hours during the period.

The standard recovery rate is found out by dividing total budgeted fixed
overhead by budgeted output during the period and this rate is applied for
evaluating the standard cost of production. Therefore, the amount recovered and
the amount incurred will not be equal. Thus, difference may be due to two main
factors, viz ----
i) A change in overhead costs, e.g., a price increase, and
ii) A change in output, e.g., loss of production due to break down of machinery
or any other reason.

The effect of the former can be shown in Expenditure Variance while Volume
Variance can reveal the effect of the second cause. Again, volume of production
may differ due to
a. Efficiency of workers
b. Actual capacity being different from budgted capacity
c. Actual working days/hours being different from budgeted working

Thus, on the basis of the foregoing discussion, it is now possible to list the
variances as follows:

Overhead Cost

Expenditure Volume
Variance Variance

Efficiency Capacity Calender

Variance Variance Variance

Cost Variances
It is different between standards overhead, and actual overhead. Thus,
Cost Variance= (Actual Production x Standard Recovery Rate) – Actual

i) Expenditure Variance
It is different between budgeted expenditure and actual expenditure. Thus,
Expenditure Variance =(Standard Recovery Ratex Budgeted Production) –
Actual Fixed Overhead

ii) Volume Variance

It is the portion ofthe overhead variance which is due to the difference
between the budgeted level of output and the actual level of output attained.
In other words,
Volume Variance = Standard Overhead – Budgeted Overhead
Since Volume Varinace is linked up with the question of recovery of
overhead, if standard overhead exceeds budgeted ovhead, there will be
over-recovery of overhead and hence favourable variance and vice versa.
Volume Variance may be due to a number of reasons. They include, inter-
alia – (i) Change of demands, (ii) Interpution or stoppage of work due to (a)
defective planning (b) shortage of materials (c) lack of proper tools (d)
absence, or faulty, instruction, etc. (iii) Ascertain of workers (iv) Breakdown
of machinery and failuter of power (v) Labours troubles.
Illustration 10:

a. Effciency Variance
It is the portion of Volume Variance which is due to difference between
the budgeted efficiency of the production and the actual efficiency
attained. The volume of production may differ due to efficiency of
workers. Therefore, the variance in concerned with labour efficiency
variances. The cuases leading to efficiency or inefficiency in labour
performance will also be applicable here. Effciency Variance is ascertains
as follows :-

Efficiency Variance= Standard Rate Per Unit x (Actual Production–

Standard Production)
Efficiency Variance=
Standard Hourly Rate x (Actual Hours Excluding Abnormal Idle Time–
Standard Hours)

In short, this variance is akin to labour efficiency variance.

b. Capacity Variance
This represents the portion of the volume variances which is due to
budgeted capacity specified and actual capacity attained. The variance
will reveal whether the capacity of the factory has been utilized so that
the production control department can be held responsibility.
Capacity Variance = Standard Rate x (Standard Production –

If standard production exccedsbudgetes production the variance will be

favourable and vice versa.

Illustration 11:
In the previous volume variance is Rs.4,000 (unfav). This may be further
brioken down into –
(a) EffciencyVariances
Rs,10 x (2,700 – 2,600)=Rs.1,000 (unfav)
(b) Capacity Variance
Rs. 10 x (2,700 – 3,000)= 3,000 (unfav)
Note: Standard Production = Hours works = 27,000 =2,700 Units
Standard Time per unit10

c. Calender Variance
When standard overhed recovery rate is computed for the budget period,
fixed number of working days is generally anticipated. That is, total
number of standard working days is divided by 12 so as to work out a

uniform number of days for all the calendar months. But all the calendar
months do not consist of equal number of days. Again, holidays may fall
in some months but not in others. As a result, the volume of production
will differ and this will lead to under- or over-recovery of fixed overhead.
That is why, Calendar Variance is to be computed which show the effect
of fixed overhead of changes in the number of working days. Calender
Variances, is therefore, defined is as the portion of volume variance
which is due to the difference between the number of working days in the
budget period and the number of working days in the period to which the
budget is applied. In other words ----

Calender Variance =
Standard No. of Working Days – Acutal No. of Working Days
xTotal Fixed Overhead in the Budget Period
Standard No. of Days in the Budget Period
If actual working days exceed standard days, of variance will be favourable and
vice versa. In this connection, it may be noted that the sum of monthly calendar
variances in a complete year will be zero.

Illustration 12:
The budgeted fixed overhead for the year 2011 amounted to Rs.14,400. It was
anticipated that 288 days would be worked during the year. During February
2011, only 20 days were worked. Find out Calender Variance.

Standard Working Days per Month = 288 =24 days


Calender Variance = (24 – 20) x Rs. 14,400 = 4 x Rs. 50 = Rs. 200 (unfav)

2. Variable Overhead Variance or Variable Overhead Expenditure

This is the difference between standard overhead allowed and actual overhead
incurred.It may be noted here that variable overhead cost variance is represented
by Expenditures Variance only. In this connection, the definition of the term
‘variable’ is important, namely, that which “tends to directly with variations in
volume of output”. Therefore, it will be assumed that variable overhead costs
will vary directly with production, so that only a change in expenditure can
affect costs.That is why only Expenditure Variance has been considered.

Illustration 13:
Standard variable overhead rate per unit Rs.10
Actual Production :900 Units

Overhead incurred :Rs. 10,000

Expenditure of Variance :
Standard Overhead – Actual Overhead
(900 x Rs.10) – Rs. 10,000 = Rs.1000 (unfav)

Since overhead is the aggregate of indirect material cost, indirect labour cost
and indirect expenses, it can be argued that in certain circumstances a variance
may arise due to efficiency or inefficiency and, therefore, the effect of such
variances should be shown separately from Expenditure Variance. But even in
such a case, the effect of and variance will be insignificiant and hence
considering the effort involved it may be left to be included in Expenditure
Variance for the sake of simplicity.


I Objective Type:

4. Select the right answer.

(x) The difference between actual cost and standard cost is known as:
(a) Differential Cost, (b) Profit, (c) Variance
(xi) Standard Cost involves:
(d) Determination of standard cost, (b) Estimation of costs, (c) Setting
of actual costs
(xii) Standard Cost helps in:
(d) Measuring Efficiency, (b) Controlling Prices, (c) Reducing Losses
[Ans. (i) c, (ii) a, (iii) a]

2. State whether each of the following statements is ‘True’ or ‘False’.

(x) Material Cost Variance = Material Price Variance + Material Usage
(xi) Idle Time Variance comes under Fixed Overhead Variance
(xii) Variable Overhead Variance includes Calender Variance
[Ans. (i) True, (ii) False, (iii) False]

II Theory Questions:

13. What do you understand by Standard Cost and Standard Costing?

14. Explian the advantages of Standard Costing.
15. State the difference between Standard Costing and Budgetary Control.
16. Write short notes on:
(x) Disadvantages of Standard Costing
(xi) Material Variance

(xii) Fixed Overhead Variance

III Practical Problems:

1. From the following dataCalcuate:

(i) Material Mix Variance (i) Revised Usage Variance (iii) Yield Variance

Standard Mix
Material X 130 units @ Rs. 5
Material Y 70 units @ Rs. 6
Total Standard Output 200 units

Actual Mix
Material X 110 units @ Rs. 4
Material Y 90 units @ Rs. 5
Total Standard Output 200 units

2. Calculate Labour Variance from the following information:

Standard Labour Force Rs.

60 skilled men @ Rs. 2 per hour for 60 hours 7,200
40 unskilled men @ Re. 1 per hour for 60 hours 2,400

ActualLabour Force Rs.

40 skilled men @ Rs. 1.50 per hour for 60 hours 3,600
60 unskilled men @ Rs. 1.25 per hour for 60 hours 4,500

3. From the following calculate:

(i) Fixed Overhead Cost Variance
(ii) Expenditure Variance
(iii) Volume Variance for the month of July 2012

Budgeted Production for the year 20,000 kgs

Fixed Overhead for the year Rs. 3,10,000
Actual Production for the month of July 1,400 kgs
Actual Fixed Overhead for the month of July Rs. 25,000

The factory works 340 days in a year and in a day 8 working hours. Actual
working days for the month of July 2012 are 28.

An Introduction to Production and Operations Management

7.1 Introdction and Meaning of Production and Operations Management

Production and Operations Managment refers to the application of
managment Principles to the production function in a factory. At times just
operation managment is used instead of production and operations managment.
It involves application of planning, organizing, directing and controlling in
production areas. Production and Operations Managment is thus an area of
managment concerned with overseeing, designing, controlling the process of
production and redisigning business operations in the production of goods
and/or services. It involves the responsibility of ensuring that business
operations are efficient in terms of using as few resources as needed, and
effective in terms of meeting customer requirements. It is concerned with
managing the process that converts inputs (in the forms of materials, labor and
energy) into outputs (in the form of goods and/or services).

The reationship of operation management to senior management in commercial

contexts can be compared to the relationship of line offcers to highest-level
seniour officers in military science. The highest-level officers shape the strategy
and rivise it over time, while the line officers make tactical decisions in support
of carrying out the strategy. In business as in military affairs, the boundaries
between levels are not always distinct; tactical information dynamically informs
strategy,and individual people often move between roles over time.

Accroding to the U.S. Department of Education, operations management

is the fild concerned with managing and directing the physical and/or technical
functions of a firm or organizati- on, particulary those relating to development,
production, and manufacturing. Operations management programs typically
include instuction in principles of general management, manufacturing and
production systems, plant management, equipement maintenance management,
production control, industrial labor relations and skilled trades supervision,
strategic manufacturing policy, systems analysis, productivity analysis and cost
control, and materials planning. Manageme- nt , including operations
management, is like engineering in that it blends art with applied science.
People skills, creativity, rational analysis, and knowledge of technology are all
required for success.

7.2 Scope of Operations Managment
Operations Managment deals with the design and managment of products,
processes, sevices and supply chains. It considers the acquistion, development,
and utilization of resources that firms need to deliver the goods and services
their clients want.

The survey of OM ranges from-stategic to tactical and operational levels.

Represenative strategic issues include determining the size and location of
manufacturing plants, deciding the structure of service or telecommunications
network, and designing technology supply chains.

Tactical issues include plant layout structure. project management

methods,and equipment selection and replacement. Operational issues inssues
production scheduling and control,inventory management, quality control and
inspection, traffic and materials handling, and equipment maintenance policies.

Basically this discipline has to decide about a production/operation

system to generate cusstomer satisfaction at optimum cost. As such, there are
certain long-term strategic decisions involved, influencing substantially the
whole system. Mostly these decisions are with respect to the Design and
Planning aspects.

1. Strategic or Long Tern Decisions;

(1) Product Selection and Design; The Product mix makes our system either
efficient or inefficient. Choosing the right products. keeping the mission and
overall objectives in mind is the key to success. Desingn of the product, which
gives it enough functional and aestheic value is of paramount importance.
It is the design of the product which makes us competitive or non- competitive.
Value engineeing does help us to retain enough of features, while eliminating
the unnecessary cost increasing feature
(2) Process Selection and Planning :
Selection of a process involves taking decisions about tech- nology,
machine and equipment. We have to optimise the output from a given process.
Process planning, detailing the stages of the process
give us an idea of optimum automation and mechanisation.
(3) Location Facilities :
Where can we locate our operations/production? it commits us at a
location for a long time, So, a worng decision may prove disastrous Location

should as far as possible cut down on production and distribution cost.
Therefore, from the alternatives open to us we have to evaluate and judge a
suitable location for us. While evaluating , there are diverse factors to be
(4) Layout and Materials Handling Facilities plant layout deals with the
arrangement of machines and plant facilities, The machines should be so
arranged that the flow of production remains smooth. there should not be
overlapping, duplication or interruption in production flow. Product layout.
where machines are arranged in a sequence required for the processing of a
particular product, and process layout-where machines performing similer
processes are grouped togehter- are two popular methods of layout . The
department are laid out in such a way that the cost of material handling is
reduced. There should be proper choice of materials handling equipme nt..These
days, computer software is available for planning the process layout (e.g.,
CORELAP etc.) Group Techology (G.T.) Celluar Manufacturing System
(CMS) and Flexible Manufacturing System (FMS) have made our concepts of
layout planning undergo a tremendous change.

(5) Capacity Planning : This deals with the procuerment of productive

resourcs.Capacity refers to a level of output of the conversion process over a
period of time. Full capacity indicates maximum level of output. Capacity is
planned for short-term as well as for lomg-term. Process industries pose
challenging problems in capicity planning, requiring in the long run, expansion
and contraction of major facilities in the conversion process. Some tools that
help us in capicity planning are marginal costing (BEA), learning curves, liner
programming , and decision trees.

Operational or Short-term Decisions: These deal with short-term planning

and control problems. Some illstrative decision are:
(1) Production Planning: Planning is a per-operation activity. It aims at
anticipating the probable difficulties so that they can be eliminated before they
materialise or be mitigated before they become grave. Production planning aims
at setting the golas or targets and allocating the existing resources, viz,
men,machine,matirials and plant services,among varied production operations
so that their best possible use can be mede in the light of the set goals or

According to Bethel, Atwater, Smith and Stackman, “Production planning
takes a given product or line of products and organizes in advance the
manpower, materials, machines and moneyrequired for a perdetermined output
in a given period of time.”

Thus, production planning is a management technique which attempts to

gain the best utilization of a firm’s manufacturing facillities. It is gained by the
integration and co-ordination of the manpower, machines, materials and plant
services employed in the manufacturing cycle.

(2) Production Control: Control is a management techinique which aims to

see that the activities are carried on in line with the predetermined standards, In
case of production activities, production control tries to see that the actual
manufacturing conforms to the perdetermined standards and scheduleles of
productions. Production control is considered to have a wider scope and thus it
includes production planning. In practice, a joint reference is made of
production planning and control and it is popularly ...... as PPC.
According to Soriegel and Lansburgh, “Production control is the
process of planning production in advance of operations; establishing the exact
route of each individual item, part or assembly; setting, starting and finishing
dates for each important item, assembly and the finished products; and releasing
the necessary orders as well as initiating the required follow-up to effect the
smooth functioning of the enterprise.”

Thus, production control involves the following stages:

(i) Planning- setting targets of production.

(ii) Routing - to decide the route or flow-of production activity.
(iii) Dispatching - to issue materials and authorizations for the use of machines
and plant services.
(iv) Follow-up - it compares the actual production with the targeted production.
Deviations are found out and corrected and reasons are investigated.

(3) Inventory Control: Inventory control deals with the control over raw
materials, work-in-progress, finished products, stores supplies, tools etc. The
managment of these items is closely related with the producation function and
so is included in production mangament.

The raw materials, supplies etc. should be purchased at right time, of
right quality, in right .......... from right source and at right price. These five ‘Rs’
consideration enables the scientific purchase.
Store-keeping is also an important aspect of inventory control. The raw
materials, work-in-progress, finished goods, supplies, tools etc. should be stored
efficiently. The different levels of inventory should be managed properly and
the issue of materials to departments should be made promplty and effectively.
Proper records should also be kept for various items of inventory control.

(4) Quality Control: The long-run success of the business largely depends on
its ability to maintain the quality standards as desided by the managment and
accepted by costomers. The quality stantdards are prescribed in terms of
specifications like size, colour, shape, tastes etc. The quality control is
maintained by testing the actual production and by ascertaining, whether they
conform to the set standards. The raw materials, work-in-progress, finished
products etc. are inspected at various stages of production. There may be 100%
quality control where each unit produced is inspected or there may be a policy
of testing the samples where the entire lot produced is either passed or rejected
on the basis of the tested samples. Various statistical techniques are used for the
effective quality.

(5) Method Study: Standard methods should be divised for performing the
repetitive functions efficiently. Unnecessary movements should be eliminated
and suitable positioning of the workers for different process should be
developed. Such methods should be devised with the help of time study and
motion study. The workers should be trained accordingly.

(6) Maintenance and Replacement: In this we cover preventive method to

avoid machine breakown, scheduled and breakdowns mainenance, policies
regarding repair replacement decisions. Maintenance manpower is to be
scheduled and repair jobs
are to be sequenced. There are some preventive replacement also.
Machine condition is to be constantly monitored. Effective maintenance is a
crciual problem for India which can help better capacity utilisation and make
operations systems productive enough.

(7) Cost Reduction and Control: Cost reduction ultimately improves

productivity. The industry becomes competitive. Essentially cost reduction and

cost elimation are productivity techniqes. Value engineering , budetary
control,standared costing, cost control
of labour materials etc. Helo us to keep our costs optimal.
All production decisions are subject to control measures, after receiving
proper feedback. Control function is exercised over the quantity to be produced,
quality expected, time needed, inventory consumed and carried and costs
incurred. Control ststem is designed after due cost benefit analysis. Controls
should be selective. A self-controlling sybernstic system though perferable is
not possible in all complex industries.
Environmental changes ultimately affect all the system of the
organization. A dynamic environment make it compulsory for us to adapt the
production system to changes in technology and other factors of the
environment. Product mix, composition of products, introduction of new
product, changing the layout system are some of the represenative decisions
which respond to environmental feedback.

5.3 Types of prodution Systems: When viewed from a different

context,theoperation/production system can be equated with the flow of
materials - flow into, flow through and flow out of the conversion process.
When we analyse the characteristics of this flow we find in some system it to be
very smooth, whereas in others it is we not only think in terms of producing
movies only, but also video-movies if the costomer demands them for his
entertainment needs.
Product mix is a selection of product we desire to produce, keeping our
business mission in mind. It is a strategic decision. While deciding our product
mix,we take into account our marketing and technological strenghs, the
potential demand, the history and traditions of our organization and the financial
capability we have. Competition also shapes our product mix decision. Product
selection is not a decision theat could be taken by the operations mangement
department alone, but requires interface with departments like marketing,
finance, research and developement, materials etc. It involves participation and
support of the top management.
Once a product mix is chosen, we have to pay attention to the economics of
producing each product, the design of the individual product the quality and
reliability of the product intended to be produced. We also consider
producibility which means the ease and speed with whichthe output can
generated. This is closely related to the plant and machinery and its
sophistication level, engineering operations necessary, and flexibility with
which we can adapt the facilities from producing one product to another
product. Of course it is easier alwaays to create a family of similar products.

Dissimilar product may need creation of either facilites de novo entitely or in
some sub prcesses.

* Main Factors to be Considered in Product Selection, Development and

Product Selection Product Development and Design
-Sales reports, forecasts
-Design sprcifications Marketing Product Economic
-Product characteristics Aspect Aspect Aspect Aspect
-Relation to other product/models
-Type of labour force available Functional Operational Durability &
-Financil resources Aspect Aspect Dependability
-Limitations of space
-Availability of raw materials
Availiable processes Profit consideration -Selection of ideal
Effect of standardisation, -Utilisation of
materials & components simplification and -Selection
of appropriate
Break-even analysis workmanship and

2 * Product Selection process

It is a part product planning process which is a continuous activity in
an organization involving marking out and supervising the search, screening,
development and commercialisation of new product; the modification of
existing lines and phasing out of the marginal or unprofitable lines. The most
important part in product selection
start with a number of ideas. Initial screening itself reduccces them by almost
half or even less than that. Business analysis us with some 3-4 ideas to be
worked out further into s prototype. Further development reduces them till
finally only a single product is left.
You will apprecitate that there is a time lag between the start of development
process and the final national launch of the product.The time lag depends upon
the type of industry and the product, and may vary from 1 to 8 years. If the time
lag is excessive, competitors may in the meantime launch their products or the
product may become irrelvant.when if finally sees the light of the day. Even
undue haste may result in product failures. The time therefore should be
optional under given conditions. Each developmental stage costs us in terms of
money and other resoures. So when the product is finally in the market, the

market has to bear this development cost. Many organizations work
simultaneously on different product propositions and may be at different stages
of development. Thus when some product ideas are generated and screened,
another set of ideas might have reached prototype stage, and yet another set of
ideas might have reached the commercialisation stage. This is a sign of an
innovative organization, where product develpoment is a continuous process.
The students may kindly note that the few successful product have to absorb
even the cost of their less fortunate brothers - the unsuccessful product.








Product development continues after commercial introduction of the

product throughout its life-cycle consisting of the stages of introduction,
growth, maturity, and declinf. modifications andextensions at the stage of
maturity in case of existing products lengthen the product life cycle, and prevent
its decline. Of course, an organization also modifies
the me-too product introduced by others as a part of development effort.On the
innovative scale, the exterme point is that of a major techological breakthrough
like indtroduction of nylon, transistor, micro-processor, radio-
transmission,laser, lithostripy for kidney and gall-stones,oral polio vaccine etc.
Such breakthroughs may bring about an altogether new industry. We await now
major brealthroughs in the field of genetic engineering and bio-
technology,super-conductivity,cancer therapy, AIDS therapy, organ transplants
etc.All this is a result of basic and applied research, and later on development on
commercial scale. There is a major thrust to techology advancement in recent
years, and we are all in for a future shock. What is more important? Research or
development Perhaps, the decision is a trade-off and is a strategic decision.

* Product Development and Design
An organization has to survive in the fast changing and turbulent
environment. The needs and expectations of the consumers must be met by
introducing the relevent and innovative products. Product development is a
continuous activity and is a link between the market and the production
department. A product emerges as an idea which is developed into a concept.
The concept is converted by suitable engineering into a prototype. The prototye
is further improved by interacting with the process. The pilot production is the
next step. The process is further and finlly commercially the product is
The development process is speeded by concurrent (CE) which takes
several steps simultaneosly rather than in sequential form.
Product development team has to take care of the design, management
and technical aspects.
Product design has to repond to the requirements of the customers. Many
products have features which are never used by the customers. The customer
and aesthetic-centrd design is called industrial desgin.
Costomer requirements can be ranked in order of importance.
Competitive product and the oranization’s product are compared. Techical
specifications are developed. These should be related to the customer
requirements. This approach to involve the customer into design specification is
called quality function deployment (QFD).

* Product Design
In the development of the product, the design stage is the crucil. Detailed
specifications are listed for a product at this stage. These specifications
ultimately result in product quality. The product’s design is translated in
quantitative ters hers. Compiling specification is not an easy task. It requires a
great deal of time. The profitability and competitiveness of the product depend
upon its design which in tuen depends upon bspecifications. And so
specifications should be carefully developed. Properly formulated specifications
have have the potential of controlling costs at the design stage. The task of
setting specificationd is done in the face of sometimes conflicting views of
different departments like sales,engineering and production. We cannot over-
specify as well as under specify. We have also to ensure smoothness of the
production line. Specifications aretherefore clear and explicit, and preferably
tions. A design should bestow a competitive edge to the product. As industrial
design must find solutions for the masses, they are evaluated in terms of the
imoact they have. A designer must have the abilityto mix and match to find
interesting solutions. A design must not only look good, but it must work well
too. A designer has to materials which go to make product.

Concept design is another hot area - a breakthrough concpet that can be
manufactured, can always, be a potential best-seller. A lot of time is spent on
streching on the rendering and visualising product. Indica has been indigenously
designed. Kinetic scooter is a two-wheeler designed in India. The design
objective was create a four-stroke gearless scooter with a target price of Rs
Though we are advised not to judge the book by its cover, yet most of us
are swayed by the packaging of a product. In the cluttered market, innovative
packaging is the only way to stand out. Packaging design is an important area.
Design should push the frontiers of technology, not follow it. It can
change the quality of life. Good design is good business. It becomes the
deciding factor for consumer choice. Before the product is developed, user
research is conducted by multi-disciplinary terms who observe and interpret the
everyday experience of target consuners from different vantage points. The
team then identifies core motivations and aspirations behind the use of product.
This understanding help define the userexperience dritea for design.
Participatory design (PD) is another approach that is receiving attention. Here
end-usera are involed in the design. Apart from PD, consumers are invited to
project future experiences they desire to have within the environment in which a
product is used, e.g., ideas of ideal cooking experinces of the future. They can
articulate their ideas through collage or blocks. Inernal manpower also
undertakes such studies. The ideas are later integrated. The design criteria of
consumer’s needs for desired experince around a product are spchronised with
the company’s vision and future profitability.

Standard is the word that denotes that there are only specific sizes made and
sold. Some people call process of cutting down on the number of sizes
‘simplification.’ Standardization, they say is the process of writing down two
concepts are closely reated.

Standardization (including simplification) means that non-standard items

will not be made except when the customer orders them specially, places a high
order, and pays extra for non-standard items.
Sometimes standards have been enacted into law for safety or for health
reasons. Mostly, though standardization is voluntary, industry wide
standardization requires industry-wide co-operation.
Standardization reduces the kinds, types and sizes of raw materials that
have to be bought. This lets you buy and so get lower prices per unit.
Standardization also cuts down on your manufacturing costa because you get
longer runs on the fewer kinds of product that you still make. You can cut set-
up costsa and use more specialised machines. You also need fewer patterns and
tools. We would always be reordering larger quantities of fewer thing and so
holding down manufacturing costs.

In the markets, there is a demand for low volumes, and high variety. In
such a situation, rigid standardisation is not the solution. The right approach
could be to designa range of products that share oarts, oeople and production

i) * Form and Functional Design

Product design deals withform and function. Form design deals with the
product’s shape and appearance. Functional design deals with how it works or
performs. The need for functional design is obvious - the product has to work or
it is useless. But how necessary is form design? When customers have no basis
of functions, the eye appeal wins. Even machinery makers pay attention to form
design, though fuctional utility is still uppermost. Inmost situations, it is a trade
off beyween form and function.

ii) Design and Production Costs

In designing products, we should keep in mind the production costs.

Sometimes initial designs cost more to produce than the market can bear. It
needs redesigning so that it costs less to produce. May be we will have
compromise quailty in order to get costs down. It means exploring the sales
possibilities of the low prices and lower quality product.

iii) Design for Volume Production

Mass-produced items need to be designed so that they can be made at low

cost. Products, subassemblies and parts are first designed so that they will
perform. Then the possibilities of cost reduction and elimination are examined
without affecting the functional utility.
Parts are so designed that they can be put on the machines for processing
quickly. The sequence of operations should be integrated, if possible. Quality
and speed is built into tools. Sub-assemblies are used for assembled products
wherever possible.
Precision of parts is of utmost importance for high volume products.

a) * Repairability

Easy repair is important in product design. Too much obsession with

appearance sometimes comes in the way easy repairs.
b) Redesign
Each proudct made can be improved by re-designing. Frequent redesigns
are however avoided. There is however no constant design. Changes in design
over a period of time are inevitable.

c) Miniaturization
More eloquently condeness the philosophy of miniaturization. An army
expression says: ‘If your product is room-size, make it desk-size; if it is desk-
size make it portable. When you can’t shrink it any more, pack twice as much
power into it.’ For industry in general we can say: “Make it smaller and lighter
in weight.”
Lap-top computers and palm pilot PCs are examples of miniaturization.
Palm V succeeds palm lll, the earlier model. It costs around $450. It uses a
rechargeable battery, which tasts about 21 hours between two charges.
Yet it is’t always so. Not everyone has to miniaturize. A half -size bed
isn’t much good to a full-sized person. And a desk has to stay desk-size and a
book, book-size. Typewriter and caculators cannot be made smaller beyond a
certain extent, or else we won’t be able to use them.
But even where you can’t miniaturize the whole product, it may be
paying to miniaturize the parts. Miniaturization is very important in electronics.
Miniaturization is partly design and partly research. No one could make a
finger nail-size hearing aid, for example, until germanium came out of research.
The miniature products using germanium had to be developed, and finally, they
had to be incorporated into the hearing aids.
Miniaturization a;ways results in using less material (but it may be more
expensive material). Saving space and weight is the main idea, particularly in
air planes, space rockets, automation components.
1.5 -----------------------------------------------------------------------------------------
-------------------- Innovation includes invention
Product innovation is the creation and subsequent introduction of a good or
servicethis in other ways. The firms were asked a more detailed uqestion,to
classify the innovations by type.
Yhey indicated whether their innovation was
(i) a modified version of an exiting product range
(ii) a new model in the exiting product rang
(iii) a new product outside the exiting range but in a similr field of technology
(iv) a totally new product in a new field of technology.

Evidently, as one moves up the scale from (i) to (iv), the degree of innovative
effort and risk-taking on the part of the firm is likely to increase significantly


Process innovations are critical. Innovation must focus on builiding a logistics
infrastructure, including manufacturing that is in accordance with the prevailing
conditions and can deliver solutions in a cost effctive manner.

No one should underestimate the importance of process innovation. By
investing in new plant and equipment, firms can gain in terms of productivity,
material utilization, quality or reliability. They can even gain the capacity to
manufacture new product which would otherwise have lain outside their reach.

It has often been pointed out that process innovation may be particulary helpful
or suitable for small firms, since by this means they can share in advanced
technology developed by larger firms. The adoption of a proven process
thchnology may also have the advantages of low risk and short-term
payback.The limitation of depending upon investments in process innovation,
however, is that any competitor can easily follow suit, removing the intial
advantage gained from the investment. Whereas new products tend to put a firm
ahead of its competitors, investment in available process technology merely
brings a firm up to standard. From the viewpoint of regional development,
nevertheless, it id important that the process technology used by local industry
should be up an adequate standard, since therwise the region will cease to be
competitive with regions where investment in up-to-date technology is higher.

Finally, it could be that investment in new production equipment goes hand-in-

hand with product development. This might take place simply because
innovative firms are likely to innovate in numerous ways. Or,similar technical
expertise may be needed both to introduce new equipment and to develop new
products: this could be particularly true where the same technology, such as that
of microelectronics, was involed in both. Or agai, firms diversifying their
product ranges may need new equipment to be able to make the different types
of products.

Operations strategy touches upon the decisions of the process design and
the infrastructure to
sustain the process.
Process design conisists of the choice of an appropriate technology,
measuring the process overtime, locating the process and logistical support of
the process. The infrastructure refers to the planning and control system, quality
assurance and control, comppensation methods and operations
Operationl objectives are correlated as the overall organizational
objectives. Since the overall
objectives change in responsse to the changing environment, so does the
operationl objectives.

Most of the US firs post-war were volume-driven to satisfy a large
demnd, whereas the japanese firms were quality-driven. As such, we can say,
priorities do chang in formulating the operations strategy from country to
country, and firm to firm. We have to appreciate the priorities and their
consequences and the trade-involved.
The priorities generally include cost, quality, reiability, delivery speed,
new product introduction speed and other criteria.
It should be appreciated that an operation could not excel at one the same
time on all perfomance measures, and hence the management changes the
perfomance criteria critical to the success of the organization and concentrates
its resources on these.

Conversion of inputs into outputs by adding value to them makes operations

management an imporant function. Though the conversuin process is taking
place internally, the value added by it to products and services is perceived
outside in the market by the consumers. Therefore the operations manger has to
be outward-oriented, conscious of consumer needs than inward-oriented,
placing emphasis on the production process only. To begin with, we talked of
products and services. But these product is used in a very comprehensive sense
and includes services also. In fact a product is considered as a bundle of benefits
that it offers to the customers. Thus a lipstick is not only a combination of a few
cemicals, but is something that imparts beauty to the customers. Similary,a tonic
is not a mix of some vitamins, but something that promises health to an
invalid,indisposed person. When product are thought of so broadly in terms of
customer benefits,several services also become a part of products. Thus, when a
computer is sold, we also sell a solution to custmer, to his problem of handling
data for information needs. Thus, is ivvolves system analysis and desion, the
hardware of adequate computing power, the software packages to help the
customer for his inforamation needs, the installation of the system and its
maintenance as an after sales services. Part of the product is tangible , and part
of it is in the form of intangible services Similary, a service centre like an
orthopaedic hospital sells medical care and tangible product like artificial
limps. Thus, to a customer, a product is a bundle of benefits, a solution to his
specific problems.
The above discussion points out the importance of deciding correct
definitiions of our products and organizational missions, which give a strategic
dimension to our output selection decision. Thus when we say we are in the
entertainment business,. We are also, of corse, particulary interested in how the
region differ in their use of new process technology. For example, does

Britain’s Northern region compensate for its lower emphasis on product
innovation through greater investment in equipment? Or does the Midlands
region,on the country, support its product innovation through superior attention
to new processes?

Need for Process Innovation Process innovationd increase bottom-line

profitability, reduce costs, improve efficiency, improve productivity, and
increase employee job satisfacion. They also deliver enhanced product or
service value to the customer.Focus Areas Process innovations foucua on
builiding an adaptive business process management system (BPMS). For
manufacturing companies, process innovation include such things as integrating
new production methods and technologics that lead to improved efficiency,
quality, or time-to-market, and services that are sold with those products. For
service companies, process innovations enable them to introduce “front office”
customer service improvements and add new srevices.

8.1 Meaning of Service
In economics a service is an intangible commodity. More specifically,
services are an intangible equivalent of economics goods.

Services are those economic activities which typically produce an

intangible product such as education, entertainment, hospitality,
government, financial, transportation, legal, agency services etc. The
service sector includes repair and maintenance, food and lodging,
tourism, transportation, telecommunication, banking and insurance,
trade, financial, real estate, education, legal, medical and health services,
entertainment, government and other professional occupations.

Service is when something is offered for sale that is not a product. For
example...massages, cleaning and walking dogs are all services. The
customer is not receiving a physical product.

Service is any work that is done by a person or a group of people that

provides a function for others. Service work can be paid or voluntary.
Waiters do service work. You provide a service rather than sell an object.

Philip Kotler : A service is any act or performance that one party can
offer to another that is essentially intangible and does not result in the
ownership of anything. Its production may or may not be tied to a
physical product.

Service definition
The generic clear-cut and complete, concise and consistent definition of
the services term reads as follows :
A service is a set of one time consumable and perishable benefits
* delivered from the accountable service provider, mostly in close a
coaction with his internal and external service suppliers.
* effectuated by distinct functions of technical systems and by distinct
activities of individuals respectively.
* commissioned according to the needs of his service consumers by the
service customer from the accountable service provider.
* rendered individually to an authorized service consumer at his/her
dedicated trigger.
* and, finally, consumed and utilized by the triggering service consumer for
executing his/her upcoming business activity or private activity.
8.2 Service characteristics

Services can be paraphrased in terms of their generic Key characteristics
1. Intangibility
Services are intangible and insubstantial : they cannot be touched,
gripped, handled, looked at, smelled, tasted or heard. Thus, there is
neither potential nor need for transport, storage or stocking of services.
Furthermore, a service cannot be (re)sold or owned by somebody, neither
can it be turned over from the service provider to the service consumer
not returned from the service consumer to the service provider. Solely,
the service can be commissioned to a service provider who must generate
and render the service at the distinct request of an authorized service

When in tourism you buy a tour package you are basically, a concept or
an idea. You cannot touch it, feel it, or smell it. When you buy a packages
or any tourism product you can only develop an imaginary picture about
what you are going to see at the destination, whereas when you buy a
bathing soap you can see it, touch it, feel it and use to check its
effectiveness in cleaning. In this product buying you can immediately
check its benefits whereas in case of tourism product there is no fixed
method to calculate. What would be the level of satisfaction or value for
money that a tourist will get in return. The continuum of Goods-Service
discussed in Fig. I, however suggest that most services in reality are a
combination of products and services having both tangible and intangible
aspects. For instance, when you sell a-hotel room, hotel room is tangible
since it’s location, physical amenities offered, etc. can be seen and felt by
a guest but services attached worth the room like room service, laundry,
food and beverages, back office, etc. are intangible aspects of tourism
services. Therefore, the intangible features of services are :1
a) A service cannot be touched;
b) Precise standardization is not possible ; ( difficulty in pricing )
c) There is no ownership transfers;
d) A service cannot be patented;
e) Production and consumption are inseparable;
f) There are no inventories of the service; ( lack of ability to be stored)
g) Middlemen roles are different; and
h) Consumer is part of production process so that delivery system must
go to the market or customer must come to the delivery system.
i) Cannot be stored on inventoried

2) Perishability
Services are perishable in two regards
* The service relevant resources, processes and systems are assigned
for service delivery during a definite period in time. An empty

seat on a plane never can be utilized and charged after
* When the service has been completely rendered to the requesting
service consumer, this particular service irreversibly vanishes as it
has been consumed by the service consumer. Example ; the
passenger has been transported to the destination and cannot be
transported again to this location at this point in time.

Products are produced in the factory today, stocked for the next
two, three or four months and sold when an order is procured,
However, services cannot be stored because they are perishable.
An unoccupied air seat, a vacant hotel room, an unsold seat in
cinema hall, or a car mechanic who has no cars to repair today is
irreparable loss because all these are perishable services. Besides, a
service not fully utilized represents a total loss or even a fluctuating
demand. For instance, there is peak demand time for buses in the
morning and evening or certain train routes are always more
heavily booked than others. This fluctuating demand pattern
aggravates the Perishability characteristics of services
3) Inseparability
The service provider is indispensable for service delivery as he
must promptly generate and render the service to the requesting
service consumer. In many cases the service delivery is executed
automatically but the service provider must preparatorily assign
resources and systems and actively keep up appropriate service
delivery readiness and capabilities. Additionally, the service
consumer is inseparable from service delivery because he is
involved in the from requesting it up to consuming the rendered
benefits, Examples; The service consumer must sit in the hair
dresser’s shop & chair or in the plane & seat ; correspondingly, the
hair dresser or the pilot must be in the same shop or plane,
respectively, for delivering the service.
In case of a consumer product, say body talk, is produced /
manufactured at Calcutta but is brought and sold at Delhi, whereas
in most cases a service cannot be separated from the person or firm
providing it. A service is provided by a person who possesses a
particular skill (chef or an escort) by using equipment to handle a
tangible product (dry cleaning) or by allowing access to or use of a
physical infrastructure (hotel, train). To put it in other words a
plumber has to be physically present to provide the services, a
guide has to go physically along with the group, a beautician has to
be available to perform the massage

4) Simultaneity (produced and consumed simultaneously)
services are rendered and consumed during the same period of
time. As soon as the service consumer has requested the service
(delivery), the particular service must be generated from scratch
without any delay and friction and the service consumer
instantaneously consumes the rendered benefits for executing his
upcoming activity or task.
5) Variability / Heterogeneity
Because of human element involved, service quality is variable.
Each service is unique. It is one-time generated, rendered and
consumed and can never be exactly repeated as the point in time,
location, circumstances, conditions, current configurations and /or
assigned resources are different for the next delivery, even if the
same service consumer requests the same service. Many services
are regarded as heterogeneous or lacking homogeneity and are
typically modified for each service consumer or each new situation
(consumerised). Example; The taxi service which transports the
service consumer from his home to the opera is different from the
taxi service which transports the service consumer from his home
to the opera is different from the taxi service which transports the
same service consumer from the opera to his home - another point
in time, the other direction, may be another route, probably another
taxi driver and cab.
In tourism related services humans serve humans. The human
element is very much involved in providing and rendering services
and this makes standardization a very difficult task to achieve. A
restaurant chef who cooks best cuisines in best possible manner
with full attention but every time same chef may behave differently
while preparing same cuisine or while presenting it. The new bank
clerk may not be as efficient as the previous one and you have to
spend more time for the same activity. In hotels, airlines,
restaurants, etc. there are standardized procedures to book a room,
seat or a corner, respectively. To minimize human contact,
Computerized Reservation System (CRS) is created but when you
reach the hotel there will be an important factor in your overall
assessment of the standard of services provided by the hotel. Thus,
it is the people interacting with you who will make all the
differences between a favorable and unfavorable perception of the
6) Ownership
When you buy a product, you become it’s owner - be a pencil,
book, shirt, refrigerator or a car. In case of a service you only pay

for its use but you never own it. You bock for yourself passage by
air from Delhi to Bombay, you have paid only for the use of air
seat but you don’t own it. By paying wages you can hire the
services of a baby sitter for some stipulated time but cannot own it.

Any given service will display a different combination of each of

five factors as is illustrated in Fig. I on Goods-Services Continuum.

This suggests a continuum for each of five characteristics, e.g. a

fast food service is high on intangibility, highly standardised,
generally performed near to the customer and is perishable. On the
other hand, financial services are less tangible, highly varied, can
often be performed away from the customer and are generally
required immediately. Tourism being the largest component of
service sector, its products share the same characteristics. It is
important for you to understand at length these characteristics and
their applications in tourism. Better understanding of these
characteristics would enable you to design, operate and sell these
services products effectively.

When we study the service sector it has very good future in India.
Service sector provide job opportunities and new types of
employment. We can easily find out service sector which can act as
a boon to improve our life style. So it is important to find out new
opportunities in service sector.

Each of these characteristics is retractable per se and their

inevitable coincidence complicates the consistent service
conception and make service delivery a challenge in each and
every case Proper service marketing requires creative visualization
to effectively evoke a concrete image in the service consumer’s
mind. From the service consumer’s point of view, these
characteristics make it difficult, or even impossible, to evaluate or
compare services prior to experiencing the service delivery.

Mass generation and delivery of services is very difficult. This can

be seen as a problem of inconsistent service quality. Both inputs
and outputs to the processes involved providing services are
highly variable, as are the relationships between these processes,
making it difficult to maintain consistent service quality. For many
services there is labor intensity as services usually involve
considerable human activity, rather than a precisely determined

process; exceptions include utilities. Human resource management
is important. The human factor is often the key success factor in
service economies. It is difficult to achieve economies of scale or
gain dominant market share. There are demand fluctuations and it
can be difficult to forecast demand. Demand can very by season,
time of day, business cycle, etc. There is consumer involvement as
most service provision requires a high degree of interaction
between service consumer and service provided. There is a
customer-based relationship based on creating long-term
relationships with their clients for decades. These repeat consumers
refer friends and family, helping to create a client-based

8.3 customer’s Views With Respect to Service

The rule, the customer is always right, has survived over a
century as a quick way to instill a strong sense of customer in all
Despite its detractors, it has breathed life into customer service
and sales and filled the gaps during uncertain moments.
As new graduates enter the workforce. many will be glad to
know that customers’ views breathe life into this old being right

Customer’s View Breathe Life into Always Right Rule & Our

The customer’s views about the following are always right-always

1. Urgency - Theirs not outs
2. Business or personal impact - To them before us.
3. Critical factors - From their perspective over ours when there
is disagreement.
4. What they expect of us. - Work hard and smart to achieve it.
5. How they want to be treated as people. - Completely right.
The key to living this old rule in today’s world is to
remember that may disagree or say no even when the
customer’s view is right for them.
Whether we say no for ethical reasons, legal restrictions,
limited capabilities, or strategic mission, we must still treat the
customer’s views with respect. They have insider insight we will
never have regardless of how well or how long we know them. The
decision of where to buy is theirs.

Their views are the lifeline for out success. Respecting their views
preserves that lifeline for the long term. Acting as if we always
know better, suffocates the customer’s view and could forever
sever our lifeline of
insider insight

Benefits if The Customer Is Always Right Rule

1. It helps establish a customer centric culture.
2. Guides all employees to sell to and serve the customer well
within the strategic mission of the business.
3. Increases our listening especially when our experience tries
to drown it out.
4. Keeps us in service mode even when business is booming
5. Fills the gaps during uncertain moments.
6. Shows constant gratitude and desire for future business.
7. Expresses respect for the customer’s insight and perspective.
8. Builds trust for current ad future business and often with
more openness for our views and expertise.

8.5 Difference between Goods and Services

Sr.No.Characteristics Goods Services
1. Output Tangible Intangible
It can be used repeatedly.
It indicates the ability to
touch,smell,taste and see
2. Product Uniformity Generally Uniform Output Varied output
Or Unique Need not be unique Often unique
Or Heterogeneity Homogeneous Investments and
On quality front, with goods policies of individual
it is homogeneous. Once customers
produced the quality is Heterogeneous
uniform across all line of Service is inseparable
products. They can be service provider and
separated from heterogeneous where
seller provider and not time the service is
offered dependent on the source
for it may vary in quality, output
and delivery. It cannot be
controlled and is dependent
on the human effort in

achieving that quality hence
is variable from producer, customer and
daily basis.
3. Facility Location Near Input Supply Close to Customer
4. Ownership Possible Not Possible
Ownership transferrable There is no ownership
from sellers to buyers involved
5. Customer Involvement Low or no Involvement High Involvement
6. Mechanization Generally High Generally Low
7. Producer Status Separable from Goods Inseparable from
8. Stock Inventorable Non-Inventorable
Frequently dispersed
9. Customer Rile Customer as only Customer Customer as Producer
10. Return/Resell/ Can be returned Cannot be returned
11. Perishability Non perishable Perishable
Have a long storage life Services are delivered
that moment and do not
have a long life or cannot be stored
for repeat use. They do not
bear an
advantage of shelf life as
in the case of goods like empty
seats in airlines.
12. Simultaneity Production and consumption Production and
does not take place consumption takes
simultaneously simultaneously in
13.Knowledge based Not necessary Often Knowledge
Educational, Medical,
Legal services.
14.Quality Some aspects of quality are Many aspects of
quality measurable are
difficult to measurable
15 Transportable Yes Service provider and
the service itself is often
16 Revenue Revenue is generated Revenue is generated

primarily from the tangible primarily from the
goods even if they are intangible services
accompanied by services though there are some
goods which are
associated with goods.
Goods and services at times are linked simultaneously Eg. on purchase of a car,
the good is the car but the processing, the provision of accessories,
after sales activities are all services. What we are talking of pure
goods and services. At times product is a mix of both - goods and
services. Eg. in a restaurant, food refers to goods while service is
the waiters offering, ambience, the setting of table etc.

8.5 Service Process Matrix

* Matrix means atmosphere, surrounding, medium, background

The Service Process Matrix is a classification matrix of service industry

based on the characteristics of the individual firm’s service processes. The
was derived by Roger Schmenner and first appeared in 1986, Although
different, the Service Process Matrix can be seen somewhat as a service
version of Wheelwright and Have’s Product-Process Matrix. The Service
Matrix can be useful when investigating the strategic changes in service
In addition, there are unique managerial challenges associated with each
of the matrix. By paying close attention to the challenges associated with
related classification, service firms may improve their performance.

The vertical axis on the matrix as shown in Figure I, is a continuum with high
degree of labor intensity on one end ( bottom ) and low degree of labor
on the other end (top). The horizontal axis is a continuum with high degree of
customer interaction and customization on one ends (right) and low degree of
customer interaction and customization on the other end (left). This results in
matrix with four quadrants, each with a unique combination of degrees of

intensity, customer interaction and customization.


On Wheelwright and Haye’s’ Product - Process Matrix processes appear on a
diagonal running from the upper left corner to the lower right corner. Firms
that position themselves directly on the diagonal are seen to be the most
efficient.Similarly, a national diagonal can be said to run from the upper left
corner to the lower right corner of the Service Process Matrix. Schmenner
states that many of the segmentation steps taken by service firms have been
toward the diagonal. The attraction seems to be better control. From the
perspective of the matrix, need for control would be greater for service
shops, which lie completely above the diagonal,and mass services, which lie
below the diagonal. The need for control is not as great for service factories
and professional services, as evidenced by the fact that the diagonal
transverses each of those quadrants.Schmenner also states that most services
that have changed their positions within the matrix over time have tended to
move up the diagonal. This, of course, implies a decrease in the degree of
interaction and customization and a decrease in labor intensity. Those firms
most affected by a move up the diagonal would be found in the professional
services where labor intensity and interaction / customization was high.
Obviously, any move up the diagonal, be it with professional services,mass
service, or service shops would be a movement toward the service factory.

The Legal field, a Professional Service, is prime example of up the diagonal

movement. Most have surely noticed the increase of television advertising on
the part of some in the legal profession. Other than personal injury, the most
prolific amount of advertising seems to come from lawyers seeking cases
involving bankruptcy and uncontested divorces. Obviously, these are the
cases that require the least amount of customizing. By handing this case in
bulk the attorney also lowers the labor intensity by handling multiple cases in
one trip to the court house and enjoys economies of scale just like a factory, a
Service Factory.

The traditional restaurant had a considerable degree of customization,

customer interaction putting it into the Service Shop category. The fast food
industry has taken restaurants into the Service Factory area through the
dramatic elimination of customization and lowering of labor intensity.
However, the degree of standardization may vary.

Witness Wendy’s’s where you can hold the pickles, “ hold the lettuce, special
orders don’t upset us !’’ Also, hospitals have seen movement within the

matrix. Consider Shouldice Hernia Centre in Canada, a hospital that
specializes in one type of surgery so that customization is at it lowest,
allowing them to run as a service factory rather than a service shop. Even
banking has made movement toward the Service Factory with the universal
use of ATMs.

Retailing has also seen changes within the Matrix. Warehouse stores such as
Sam’s Club and Internet sales have allowed retailers to move from Mass
Service to Service Factory by drastically cutting labor intensity. However,
some have gone in the opposite direction by becoming full-service boutiques
and specialty stores stressing customer interaction, customization and labor

8.6 Determinates or Domensions of Service Quality

Service Quality

Service Quality involves a comparison of expectations with performance.

According to Lewis and Booms (1983) service quality is a measure of how
well a delivered service matches the customers expectations.

Generally the customer is requesting a service at the service interface where

the service encounter is being realized, then the service is being provided by
the provider and in the same time delivered to or consumed by the customer.
The main reason to
focus on quality is to meet customer needs while remaining economically
competitive in the same time. This means satisfying customer needs is very
important for the enterprises to survive. The outcome of using quality
practices is :
* Understanding and improving of operational processes
* Identifying problems quickly and systematically
* Establishing valid and reliable service performance measures
* Measuring customer satisfaction and other performance outcomes

Service quality is business administration’s term and describes the degree of
achievement of an ordered service.
In this connection, objective and subjective service quality can be
Objective service quality is the concrete measurable conformity of a working
result with the previous defined benefit, since the measurability is remarkable
dependent on the definition’s accuracy, a measurable quality criterion easily
can turn out as a subjective one.

Subjective service quality is the customers perceived conformity of the
working result with the expected benefit, this perception is overlayed with
the customer’s original imagination of the service and the service providers
talent to present his performance as a good one.
Moreover, a defined result can turn out as unreachable. Then the best
possible achievable result would be the objective ideal result, but subjective
still be an unsatisfactory result of a service.
Service quality can be related to service potential, service process or service
result. In this way for example, potential quality can be understood as the co-
workers qualification, process quality as the speed of the generated service
and result quality as how much the performance matched the customers

Criteria of service quality

Word-of-mouth, personal needs and past experience create an expected
service ( expectation of the service ). The perceived service will be compared
with the expected service by the customer. And leads to the perceived service
quality as a result. Between the expected and the perceived service can
appear a gap if the perceived service does not match with the expected
service. Factors which influence the appearing of the gap were found by-
Parasuraman, Zeithaml and berry in 1985. They identified ten determinants
of service quality that may relate to any service.

1. Competence ( Possession of the required skills and knowledge to

perform the service : knowledge and skill of the contact personnel,
knowledge and skill of the operational support personnel, research
capability of the organization)Possession of skills and knowledge to
perform. Our management team benefitsfrom some of the most
knowledgeable resources in the business. Our cleaningexperience is
unsurpassed ! We are confident that there is no cleaning situationthat we
cannot manage!

2. Courtesy ( Politeness, respect, consideration and friendliness of the

contact personnel: consideration for the customer’s property, clean and
neat appearance of public contact personnel ) Friendliness of personnel
and ownership. We know how to handle complaints. We strive to be
“peacemakers not troublemakers”. We find answers, not excuses.
3. Credibility (Trustworthiness, believability and honesty. It involves
having the customer’s best interest at heart: company name, company
reputation, personal characteristics of the contact personnel )
Trust and personal characteristics of personnel. We have experienced
recruiters who ask pertinent questions, check references and conduct
background checks on all new hires.

4. Security ( Freedom from danger, risk or doubt: physical safety,
financial security, confidentiality ) Safety, financial security, and
5. Access ( Approachability and ease of contact: Service is easily
accessible, waiting time to receive service is not extensive, convenient
hours of operation, convenient location of service facility )
Approachability and ease of access to management. As owner managers
Bobby Blain and Scott Patterson interact daily with customers and
operations. We return phone calls.
6. Communication ( Informing the customers in a language they can
understand and listening to them. It may mean that the company has to
adjust its language for different consumers: explaining how much the
service will cost, explaining the trade-offs between service and cost,
assuring the consumer that the problem will be handled )
Providing the customer with effective information. We have a number
of effective means for passing this information on to our customers.
7. Understanding / knowing the customer ( Making the effort to
understand the customer’s needs: understanding customers’ specific
needs, providing individualized attention, recognizing the customer )
8. Tangibles ( Physical evidence of the service : appearance of physical
facilities, tools and equipments used to provide the service, appearance
of personnel and communication in the service facility )
Physical evidence of service. Reports, inspections. We want our
customers to know what we are doing for them, so we have a very
elaborate communications system that includes : a bar code inspection
program, a verbal report translatable into E-mail ( for an early morning
breakdown of evening activity), and a computerized schedule process,
so that our customers know when to expect specific work items.
9. Reliability ( The ability to perform the promised service dependably
and accurately service is performed right at the first time, the company
keeps its promises in accuracy in billing, in keeping records correctly
and in performing the services at the designated time)
10. Responsiveness ( The willingness and / or employees to help customers
and to provide prompt service, timeliness of service: mailing a
transaction slip immediately, setting up appointments quickly )
Willingness and readiness to perform services, Our
managers, supervisions and all personnel are encouraged to work under a spirit
of service. We understand that our personnel to understand and appreciate the
term “job security’’.



Industrial productivity is the key to economic dynamics. Raising of
industrial productivity has become the main slogan the world over.
Higher production, more consumption and greater comforts, are possible
only through raising the level of productivity, only through continued
improvement in productivity. We nerate more savings, increase our
investment and ensure steady improve the standard of living.
According to peter Drucker, Productivity is that balance between all
factors of production that will give the greatest output for the smallest
Fabricant defines Productivity as a measure of the efficiency with
which resources are convernted into commodities and services, that men
want Productivity is defined as ratio between Output and Input.
Symbolically P = 0
P - Productivity
O- Output
I - Input
(4) Productivity ,au ne defined as the rate of transformation of inputs
in output in the productive operation.
(5) Productivity is nothing but reduction in wastage of resources. The
arces may be men, machines, material, power , space, time and building
(6) Productivity may also be defined as human efforts to produce more
and more with less and less inputs of resources as a result of which the
benefits of production may be distributed more equally among maximum
number of people.
(7) According to V.K. Menon, Productivity implies development of
attitude of mind and a constant urge to find better cheaper, easier, quicker
and safer means of a doing a job, manufacturing a product and providing

(8) The I.L.O. defines Productivity as the ratio between the volume of
output as measured by production indices and the corresponding volume
of labour input as measured by employment indices.
The above definitions indicate that output is obtained by the
combined input of a number of factors such as men, material, money,
machine etc. The ratio between output and input of one these factors is
known as Productivity. reached India in 1950 through the efforts of the
I.L.O. and Asian Productivity Organisation.
The term Productivity is related to tangible aspects such as finance,
materials, labour etc.
In general, the term ‘ efficiency ’ relates to individual human
beings, factors of production, firm, whereas the term ‘ Productivity ’ is
applied to groups of human beings, factors of production, firms, industry
etc. which is wider. Two World Wars and the great depression created
Productivity consciousness amongst all i.e. individuals, firms, industry,
consumers, employees, government etc. The gains of Productivity are
shared by the individual firm, the workers, the consumers, the
government industry and the society. Due to this necessary efforts are
being made for improvement in Productivity, Production is a par of
Productivity and Productivity is also a par and reflection of the
Productivity of 3 firms.
Productivity helps the national economy in improving the standard
of living.
A general measure of it, is ------------ = Productivity
The concept of productivity according to Peter Drucker - Balance
between all factors of production that will give the general output for the
smallest efforts. In the words of Paul Mali - The organizational
productivity is the measure of how well resources are brought together in
organisation and how these are utilized for accomplishing a set of results.
Productivity is reaching the optimum level of performance with the
minimum expenditure of resources’’. As per International Labour

Organisation ‘ Productivity constitutes the ratio of all available goods and
services to the potential resources of the group, community or country ”
S. B. Karmarkar has defined productivity as, ratio between the production
of a given commodity measured by volume and one or more of the
corresponding input factors also measured by output.’’

(1) Highest production output, results or performance

(2) Minimum consumption of resources
(3) Relationship between results and resources or effectiveness and
(4) Resources are converted into goods and services
(5) Ratio of output ( expressed in value or units ) and input ( also
expressed in value or units ) of tangible factors
for accomplishing a set of results. Productivity is
reaching the highest level of performance with
the least expenditure of resources
Productivity implies the attainment of the highest results which is
the most important focus of attention. It also implies minimum
consumption of resources. It is therefore a relationship between results
and resources. One author equates productivity with effectiveness and
efficiency, effectiveness in obtaining maximum results and efficiency in
using minimum resources.
Productivity is therefore the efficiency production and distribution.
It is the efficiency with which resources are converted into goods and
services. It is the ratio between output measured in terms of units or value
of goods and services and inputs made up of Technical factors such as
physical capital, raw materials, power, and finance and Human factors
such as labour and management. There are other resources sidered a part
of physical capital. Some authors also detail such factors as research and
development, methods and procedures, and managerial expertise. These
could be part of management.

We can productivity in the from of a formula :-
Results Effectiveness
Productivity = ----------- ----------------
Resources Efficiency
= -----------------------------------------
Technical Factors + Human Factors
O Net Output
= --------------------- = ---------------------
C+M+P+F+L+Mn Net Output
The letters in the above formula represent :-
O = Output. C=Physical Capital. includes plant and equipment
machineries, land and space. M=Raw Materials. P= Power such as coal,
petroleum, electricity or even atomic energy. F=Finance. L= Labour.
This is known as Total Factor Productivity where all the factors of
Production are included in the input. Here output is considered to be
derived from a composite bundle of all resources.
In addition, it is also possible to consider each of the factors of
input independently and have ratios to find out their individual
productivities. If would then be called Individual Factor Productivity. The
individual factor approach may give us the following ratios.

Net Output Net Output

Labour Productivity = --------------- = -------------------
Labour Employed Number of Manhours

Net Output
Capital Productivity = --------------------
Net Capital Employed
Similarly one can find output per unit of power, per rupee of
investment, etc.
Although the above discussion would lead us to belive that
Productivity is a fairly simple concept to grasp, there is a great amount of
confusion and even controversy over what is Productivity, what it is that
should be measured and how.

(i) Productivity and Performance = Some mistake Productivity
for performance or results without relating them to the consumption of
resources. Results are only component of Productivity, the other
component being the input of resources.
Other mistake Productivity for production and for profitability Let
us see the distinctions.
(ii) Productivity and Production : Production is output.
Productivity is the efficiency or competence with which production or
output is produced. Productivity is the rate of production with given
inputs. Whenever production increases some amount of increase in the
inputs is inevitable. Additional machinery, raw materials, men power and
finance will be required to produce additional output. If this addition of
inputs is in proportion to the additional output, production increases
without affecting productivity. If this input-addition is more than in
proportion to the additional output, production increases but productivity
or efficiency falls. It is only when less than proportionate inputs are used
for additional outputs that productivity improves. For instance, if the
present output of 1000 units is produced at a total input cost of Rs.5000/-
the input cost per unit is Rs.5/- If every additional unit produced requires
an input worth Rs.5/- output increases without any increase or decrease of
productivity. If every additional unit produced requires a combined input
cost of Rs.5=05, production increases but productivity falls. If on the
other hand the input cost
productivity must be measured in such a way that it clearly reflects
the importance and there must not be any ambiguities about
measurement of inputs and outputs. As productivity is the ratio between
output and input it is possible to measure the productivity of each one of
the factors of production ( inputs ) or all the factors taken together.
(1) Productivity of labour : productivity of labour is the ratio
between the output and the member of man-hours worked. It may be
expressed as :
PL = ---------
PL = productivity of Labour
O = Output
MH = Man hours

To take an example, if 10 workers worked for 8 hours each and
produce 400 yards of cloth, the productivity of labour would be
400 Yards of Cloth 400
------------------------ = --------
10 ( Workers)X 8(hours) 80
= 5 Yards per man hour
(2) Productivity of Land : Productivity of land is expressed as
ratio between Output and Area of land used.
PL = ---------
PL = Productivity of Land
O = Output
AL = Area of land used
(3) Productivity of Machine : It is expressed as ratio between the total
production in weight length and total machine hours worked. It may be
expressed as
PM= ---------
PM = Productivity of Machine
O = Output
MH = Machine hours
(4) Productivity of Capital :
Capital Productivity is the ratio between Output and Capital invested.
PM= ---------
PC = Productivity of Capital
O = Output
CI = Capital invested

9.3 Multifactor Productivity

Multifactor productivity ( MFP) measures the changes in output per unit
of combined inputs. Multifactor productivity measures reflect output per
unit of some combined set of inputs. A change in multifactor productivity
reflects the change in output that cannot be accounted for by the change
in combined inputs. As a result, multifactor productivity measures reflect
the joint effects of many factors including new technologies, economies
of scale, managerial, skill, and change in the organization of production.

Whereas labour productivity measures the output per unit of labour input,
multifactor productivity looks at a combination of production inputs ( or
factors ): labour, materials, and capital. In theory, it’s a more
comprehensive measure than labour productivity, but it’s also more
difficult to calculate.
Labor Productivity ( output per hour ) = -------------------------
Labor Inputs
Multifactor Productivity = ---------------------
Multi-factor productivity is the same as total factor productivity, a
certain type of Solow residual.
d ( In f ) d ( In y ) Sl d ( In l ) sk-d ( In k )
MFP =--------- -------- - ------------ -- --------------
dt dt dt dt
Where :
* F is the global production function ;
* Y is output;
* I is time;
* SL is the share of input costs attributable to labor expenses;
* SK is the share of input costs attributable to capital expenses.
* L is a dollar quantity of labor
* K is a dollar quantity of capital
* M is a dollar quantity of materials
* S is a dollar quantity of ( business ) services
Efficiency and Productivity Measures
productivity is measure of the efficiency of production is a ratio of what
is produced to what is required to produce it. Usually this ratio is in the
form of an average, expressing the total output divided by the total input.
Productivity is a measure of output from a production process, per unit of

At the national level, productivity growth raises living standards because

more real income improves people’s ability to purchase goods and
services, enjoy leisure, improve housing and education and contribute to
social and environmental programs. Productivity growth is important to
the firm because it means that the firm can meet its ( perhaps growing)
obligations to customers, suppliers, workers, shareholders, and

governments ( taxes and regulation ) and still remain competitive or even
improve its competitiveness in the market place.
Productivity and Efficiency are not identical terms. Efficiency
connotes interent competence i.e. capacity of a given input or production
unit to produce under given conditions the result intended or studied.
Productivity on the other hand refers to the actual production result
shown by an input or production line under given conditions during a
given time ---------costs.
It is quite possible to increase the apparent productivity i.e. the
Productivity achieved in association with the other cooperant inputs, of a
given input without any improvement in its own efficiency. Conversely
speaking the individual efficiency of an input may increase without any
improvement in its apparent Productivity e.g. an input may be efficient
and yet the apparent Productivity may not improve because of
deficiencies of the inputs placed at its disposal.
Productivity invariably refers to individual factor productivity and
efficiency refers to all factor efficiency.
When the same output is produced with less inputs, are said to be
economically utilised.
When the same inputs produce more output, inputs are said to be
efficiently utilised.
Productivity includes economic and efficient utilisation of
resources i.e. to produce the most with the least efforts.
When we talk of efficiency, we generally refer to the qualitative
aspect of output and cost of inputs.

9.5 Business Process Reengineering ( BPR)

Business process re-engineering is a business management strategy,
originally pioneered in the early 1990s, focusing on the analysis and
design of workflows and processes within an organization. BPR aimed to
help organizations fundamentally rethink how they do their work in order
to dramatically improve customer service, cut operational costs, and
become world-class competitors, Business process re-engineering is also
known as business process, redesign, business transformation, or business
process change management.

BPR involves a fundamental rethinking and radical redesign of business
processes to achieve dramatic improvements in critical, contemporary
measures of performance such as cost, quality, speed and service to the
market. It involves basis question such as.
a) Why do we do it ?
b) Why is it done that way ?
BPR seeks to help companies radically restructure their organization by
focusing on the ground-up design of their business processes. According
to Davenport (1990) a business process is a set of logically related tasks
performed to achieve a defined business outcome. Re-engineering
emphasized a holistic focus on business objectives and how processes
related to them, encouraging full-scale recreation of processes rather than
iterative optimization of sub-processes.

Business Process Re-engineering (BPR) is basically rethinking and

radically redesigning an organizations existing resources. BPR, however,
is more than just business improvising, it is an approach for redesigning
the way work is done to better support the organization’s mission and
reduce costs. Reengineering starts with a high-level assessment of the
organization’s mission, strategic goals, and customer needs. Basic
questions are asked such as “ Does our mission need to be redefined ?
Are our strategic goals aligned with our mission ? Who are our customers
?” An organization may find that it is operating on questionable
assumptions, particularly in terms of the wants and needs of its
customers. Only after the organization rethinks what it should be doing,
does it go on to decide how best to do it.

Within the framework of this basic assessment of mission and goals, re-
engineering focuses on the organization’s business processess- the steps
and procedures that govern how resources are used to create products and
services that meet the needs of particular customers or markets. As a
structured ordering of work steps across time and place, a business
process can be decomposed into specific activities,
measured,modeled,and improved. It can also be completely redesigned or
eliminated altogether. Re-engineering identifies, analyzes, and re-designs
an organization’s core business processes with the aim of achieving
dramatic improvements in critical performance measures, such as cost,
quality, service, and speed.

Re-engineering recognizes that an organization’s business processes are

usually fragmented into subprocesses and tasks that are carried out by
several specialized functional areas within the organization Often, no one
is responsible for the overall performance of the entire process. Re-

engineering maintains that optimizing the performance of subprocesses
can result in some benefits, but cannot yield dramatic improvements if the
process itself is fundamentally inefficient and outmoded. For that reason,
re-engineering focuses on re-designing the process as a whole in order to
achieve the greatest possible benefits to the organization and their
customers. This drive for realizing dramatic improvements by
fundamentally re-thinking how the organization’s work should be done
distinguishes re-engineering from process improvement efforts that focus
on functional or incremental improvement.

BPR derives its existence from different disciplines, and four major areas
can be identified as being subjected to change in BPR - organization,
technology, strategy, and people - where a process view is used as
common framework for considering these dimensions.

Business process reengineering ( BPR ) is the analysis and redesign of

workflow within and between enterprises, BPR reached its heyday in the
early 1900’s when Michael Hammer and James Champy published their
best-selling book, “ Reengineering the Corporation ”. The authors
promoted the idea that sometimes radical redesign and reorganization of
an enterprise ( wiping he slate clean ) was necessary to lower costs and
increase quality of service and that information technology was the key
enable for that radical change.

Hammer and Champy felt that the design of workflow in most large
corporations was based on assumptions about technology, people, and
organizational goals that were no longer valid. They suggested seven
principles of reengineering to streamline the work process and thereby
achieve significant levels of improvement in quality, time management,
and cost :
1. Organize around outcomes, not tasks.
2. Identify all the processes in an organization and prioritize them in
order of redesign urgency.
3. Integrate information processing work into the real work that produces
the information
4. Treat geographically dispersed resources as though they were
5. Link parallel activities in the work flow instead of just integrating their
6. Put the decision point where the work is performed, and build control
into the process.
7. Capture information once and at the source.

9.6 Benchmrking
Benchmarking is the process of comparing one’s business
processes and performance mterics to industry bests or best practices
from other industries. Dimensions typically measured are quality, time
and cost. In the process of best practice benchmarking, management
identifies the best firms in their industry, or in another industry where
similar processes exist, and compares the results and processes of those
studied ( the “ targets”) to one’s own results and processes. In this way,
they learn how well the targets perform and, more importantly, the
business processes that explain why these firms are successful.

Benchmarking is used to measure performance using a specific indicator (

cost per unit of measure, productivity per unit of measure, cycle time of x
per unit of measure or defects per unit of measure ) resulting in a metric
of performance that is then compared to others.

Also referred to as “ best practice benchmarking ” or “ process is used in

management and particularly strategic management, in which
organizations evaluate various aspects of their processes in relation to
best practice companies’ processes, usually within a peer group defined
for the purpose of comparison. This then Haws organizations to develop
plans on how to make improvements or adapt specific best practices,
usually with the aim of increasing some aspect of performance,
Benchmarking may be a one-off event, but is often treated as a
continuous process in which organizations continually seek to improve
their practices.

The following is an example of a typical benchmarking methodology :
1. Identify problem areas : Because benchmarking can be applied to
any business process or function, a range of research techniques
may be required. They include informal conversations with
customers, employees, or suppliers, exploratory research
techniques such as focus groups; or in-depth marketing research,
quantitative research, surveys, questionnaires, re-engineering
analysis, process mapping, quality control variance reports,
financial ratio analysis, or simply reviewing cycle times or other
performance indicators. Before embarking on comparison with
other organizations it is essential to know the organization’s
function and processes, base lining performance provides a point
against which improvement effort can be measured.
2. Identify other industries that have similar processes : For
instance, if one were interested in improving hand-offs in addiction

treatment one would identify other fields that also have hand-off
challenges. These could include air traffic control, cell phone
switching between towers, transfer of patients from surgery to
recovery rooms.
3. Indemnity organizations that are leaders in these areas : Look
for the very best in any industry and in any country. Consult
customers, suppliers, financial analysts, trade associations, and
magazines to determine which companies are worthy of study.
4. Survey companies for measures and practices : Companies
target specific business processes using detailed surveys of
measures and practices used to identify business process
alternatives and leading companies. Surveys are typically masked
to protect confidential data by neutral associations and consultants.
5. Visit the “ best practice ” companies to identify leading edge
practices : Companies typically agree to mutually exchange
information beneficial to all parties in a benchmarking group and
share the results within the group.
6. Implement new and improved business practices : Take the
leading edge practices and develop implementation plans which
include identification of specific opportunities, funding the project
and selling the ideas to the organization for the purpose of gaining
demonstrated value from the process.

Costs in Banchmarking
The three main types of costs in benchmarking are :
1. Visit Costs - This includes hotel rooms, meals, a token gift, and
lost labor time.
2. Time Costs - Members of the benchmarking team will be investing
time in researching problems, finding exceptional companies to
study, visits, and implementation. This will take them away from
their regular tasks for part of each day so additional staff might be
3. Benchmarking Database Costs - Organizations that
institutionalize benchmarking into their daily procedures find it is
useful to create and maintain a database of best practices and the
companies associated with each best practice now.

The cost of benchmarking can substantially be reduced through utilizing

the many internet resources that have sprung up over the last few years.
These aim to capture benchmarks and best practices from organizations,
business sectors and countries to make the benchmarking process much
quicker and cheaper.

Types of Benchmarking
Benchmarking can be internal ( comparing performance between
different groups or teams within an organization ) or external ( comparing
performance with companies in a specific industry or across industries ).
Within these broader categories, there are three specific types of
benchmarking :1) Process benchmarking,2) Performance benchmarking
and 3 ) strategic benchmarking. These can be further detailed as follows :
1. Process benchmarking - The initiating firm focuses its
observation and investigation of business processes with a goal of
indentifying and observing the best practices from one or more
benchmark firms. Activity analysis will be required where the
objective is to benchmark cost and efficiency, increasingly applied
to back-office processes where outsourcing may be a consideration.
2. Financial benchmarking - performing a financial analysis and
comparing the results in an effort to assess your overall
competitiveness and productivity.
3. Benchmarking from an investor perspective - extending the
benchmrking universe to also compare to peer companies that can
be considered alternative investment opportunities from the
perspective of an investor.
4. Benchmarking in the public sector - functions as a tool for
improvement and innovation in public administration, where state
organizations invest efforts and resources to achieve quality,
efficiency and effectiveness of the services they provide.
5. Performance benchmarking - allows the initiator firm to assess
their competitive position by comparing products and services with
those of target firms.
6. Product benchmarking - the process of designing new products
or upgrades to current ones. This process can sometimes involve
reverse engineering which is taking apart competitors products to
find strengths and weaknesses.
7. Strategic benchmarking - involves observing how others
compete. This type is usually not industry specific, meaning it is
best to look at other industries.
8. Functional benchmarking - a company will focus its benchmarking
on a single function to improve the operation of that particular
function. Complex functions such as Human Resources, Finance
and Accounting and Information and Communication Technology
are unlikely to be directly comparable in cost and efficiency terms

and may need to be disaggregated into processes to make valid
9. Best-in-class benchmarking - involves studying the leading
competitor or the company that best carries out a specific function.
10 . Operational benchmarking - embraces everything from staffing
and productivity to office flow and analysis of procedures
11. Energy benchmarking - process of collecting, analysing and
relating energy performance data of comparable activities with the
purpose of evaluating and comparing performance between or
within entities. Entities can include processes, buildings or
companies. Benchmarking may be internal between entities within
a single organization. or - subject to confidentiality restrictions-
external between competing entities.


factors which influence productivity have to be used as measures
to improve productivity some of the internal measures are
1. Adopting simplification, standardisation, specialisation in
manufacturing activsities.
2. Time and motion and fatigue studies to lay down standard method
for doing work in standard time with timely adequate rest pauses.
3. Scientific plant layout to minimise material handling
4. Good comfortable working conditions like adequate lighting proper
ventilation, food noise control, right temperature.
5. Also good, congenial employer-employee relations to ensure
industrial peace.
6. Production planning and control.
7. Recognising collective bargaining, providing wage incentives.
8. Replacing outdated, worn-out machinery and equipment by
sophisticated one.
9. Scientific recruitment and selection to avoid the tragedy of misfits.
10. Flexible organisation structure with definite lines of authority and
responsibility and two-way communication.
11. Motivation ( financial and non-financial) schemes to induce labour
to put in better than the best.
12. A good control system to ensure timely feedback on the basis of
which corrective action is taken before it is too late.
13. Division of work must not entail any coordination problem
14. Automation and rationalisation

Also the external environment in which an industry operates should
be conducive to productivity improvement. Government plays a
very important role in the following ways.
1. It can set up technical institutes at local, regional and national
levels to conduct short-term courses on productivity improvement
and provide training to entrepreneurs
2. It can encourage productivity missions which can bring out
literature on productivity improvement and organise seminars,
discussions, symposia to create productivity consciousness in the
3. It can frame laws conducive to productivity improvement.
4. It can play a positive role in removing the fear from labour’s mind
that productivity improvement implies labour exploitation or
5. Radio and television can be used to educate the public on the
importance of productivity improvement.
6. It must itself set a good example by improving productivity in
public sector enterprise in which crores of rupees are invested
7 Government can help in collecting data for inter-firm and
interindustry comparisons.
8. It must institute awards to reward efficiency.
9. Adequate finance must be made available to enable purchase of the
right machines and materials.
10. Stable political atmosphere creates confidence among the business
community which is necessary for regular supply of goods and
9.8 In Pursuit of Excellence in Organizations
What exactly is excellence ?
Unless we define excellence and measure it, we would never know
if we achieved excellence.
Excellence is often touted in organizations, to exhort employees for
achieving higher quality and productivity. These two terms are
well defined and there are units of measure to measure them.
Therefore, can we equate excellence with productivity and quality
Excellence is not to be equated with mere higher productivity and
quality .It is something more.
Excellent Organizations are
1. They inspire trust in - Sections of the society
a) General Public
b) Customers
c) Vendors
d) Employees

e) Governments
f) Media
2. They keep a very low profile
a) Low key advertising
b) Never castigate a competitor
c) Minimal advertising
3. Quality
a. Their products and services normally exceed the required quality
b. They also usually in the forefront - in terms of design of
products or delivery of services.
c. They are frontrunners in using technology.

4. Reliability
a. Their products do what they are supposed to for the length of
time they are supposed to be operational
b. Their services are predictable
c. They respond to complaints - and resolve them -one doesn’t hear
of legal action on these organizations due to faulty product /
d. Their products / services are usually among the best- having
been subjected to rigorous in-house testing before release.
5. Productivity
a. Productivity is usually comparable with the best productivity in
their respective domains
b. Safety, quality and processes are never compromised for
attaining higher productivity.
6. Their people
a. One world describes them-integrity.
b. They are Knowledgeable in their respective domains
c. They are ready to acknowledge their own short-comings and are
willing to learn
d. Not necessarily from the best institutes but certainly are decent
persons in their own right.
7. Management
a. Committed to “ Excellence” and demonstrates their commitment
time and again.
b. Management Personnel always act with Integrity
c. Normally professionals manage these organizations - a person is
in management because he is a professional - not because he is
part of family or as a quid-pro-quo

d. It is a process-driven organization-never a person-driven
e. Organization has “ written-down processes” and implements
those processes in “letter and spirit”. Any permitted violations
of the process are approved / disapproved in adherence with the
process. There are processes right from granting leave to making
decisions by the Board of Directors.
f. Process itself facilitates deviations - but in a controlled manner.
g. Reward or punishments are decided based on measured data
than on subjective decisions.
h. They normally remain silent to provocative / unfair criticism
from media or activists - than enter into a controversy
8. Financial integrity
a. It is no news that they make profit
b. They always pay their vendors on time
c. They provide reasonable returns to their shareholders
d. They fulfill all their obligations to their employees - present or
e. They willingly accept loss than use their strength to inflict loss
in a disputed scenario
f. Their current assets always exceed current liabilities.

Summarizing all the above, we can say that Excellence is a multi-

adjective. If organizations desire to attach the tag of Excellence to
name, they need to match the above list. Summarizing the
attributes, we
may define thus -
Excellence is a continuously moving target that can be reached thru
actions of integrity, being front runner in terms of products /
provided that are reliable and safe for the intended users, meeting
obligations and continuously learning and improving in all spheres
meet the moving target.
The key words are -
1. Continuously moving target - what is excellent today would not
be excellent after some time.
2. That can be reached - Excellence is attainable - but as the target
moves, one needs to work to stay Excellent

3. Actions - the path to excellence is thru the specified actions /
deeds - not thru empty words. Rhetoric does not achieve
excellence - actions achieve excellence
4. Integrity - keeping far away from anything that can even
remotely be called “ dishonest”
5. Continuously learning - one needs to continuously upgrade - to
remain excellent
6. Improve - it is not enough to attain excellence, not enough to
continuously learn - but to improve continuously to remain
Journey of Excellence
It starts at the very top - Few things percolate from bottom to top -
Quality. All others follow gravity - they percolate from top to
The journey of Excellence starts at the very top of the organization
percolates towards the bottom. Therefore the first step is to be
taken by
- CEO - ( Chief Executive Officer ) who needs to -
1. Commit him / herself to excellence
2. Demonstrate this commitment in visible manner
3. Never compromise-even in the face of urgencies / emergencies /
probable losses.
4. Provide resources and funding for activities focused on
achieving excellence
5. Develop and document processes and set up a mechanism for
their continuous improvement
6. Implement the processes and demonstrate adherence to process
in visible manner
7. Educate the staff about the importance of adhering to such
process and monitor the adherence
8. Recognize and reward “ real” excellence - not like the rewards
given by the Government of India on Republic Day.
The Packing in the sandwich - a sandwich gets its name by the
packing used, even though it is not readily visible to outside view
sandwich is called vegetarian sandwich if the packing is vegetarian in
nature. The upper or the lower layers do not have any impact on the name
of the sandwich . Thus it is the Middle Management that determines the
organization. It is the Middle Management. Which is in physical and
continuous contact with top management and the people delivering product or
service. These are the people who develop processes,implement them, receive

feedback and improve them. Therefore, it is vital that this layer is filled
with people who believe in the Journey of Excellence and are continuously
motivated and upgraded to keep their faith burning bright.
Frontline - this is what is visible to outsiders, This layer of persons is
the one, which ultimately delivers. Excellence. This layer needs to be filled
with motivated people, qualified and trained people and the organization
implements mechanisms to keep this layer motivated to deliver Excellence.
Infrastructure - Infrastructure facilitates delivering excellence. Poor
infrastructure hinders otherwise excellent organization from delivering
Excellence. Setting up infrastructure is a strategic decision. More often than
not, it is simply not possible to replace the infrastructure. It is easier to replace
human beings - not so with infrastructure like buildings, machinery and so on.
Therefore, it is extremely important to provide excellent infrastructure in order
to achieve and retain organizational Excellence. Excellent infrastructure doe
not necessarily mean latest equipment - but it is robust like a workhorse and
delivers what is expected of it without any concerns.
Processes - a professional organization is one which is process driven -
it has processes for all facets of organizational functioning. Processes
empower people to act independently and sets limits of authority while
specifying the workflow. It is easy to make the processes too rigid or too
flexible. The art of having the “ right processes” that allow right amount of
flexibility as well as provide the right amount of checks and balances is
mastered by Excellent Organizations.
Quality - Quality assumes paramount importance in the organization.
Organization recognizes that quality has to be built - in and that it cannot be
appended by inspection and testing. Inspections and testing are carried out to
confirm that quality had been built-in. Variances -either chance or special are
seriously analyzed and findings are implemented. Quality issues are never
overruled owing to expediency of delivery pressures or target pressures.
Quality is seen as a friendly brake- not as an engine-jammer. In Excellent
organizations. Quality department is given the same importance as that of
revenue earning departments in the rank of its head as well as in decision-
Research & Development - this is the hallmark of an Excellent
Organization. R & D is continuously conducted - honestly - to ensure
continuous improvement in the products / services provided by the
organization. R & D is conducted usually in the areas of -
1. Product / Service innovation
2. Develop new technologies and new products / services
3. Methods of production and delivery of products / services
4. Customer perception of the product / service
5. Investor perception of the organization
6. Perception of the General Public

Customer Interface - Trust replaces suspicion. The interaction begins
with trusting the customer and the interactions ends with improvement in the
customer’s trust in the organization. When there is a conflicting situation, the
benefit of doubt is always given to the customer.
Employee Handling - This is a scenario of mutual-trust. Both treat each
other with trust and there is no place for suspicion. When there is conflict,
both parties are ready to give benefit of doubt to each other but it is usually the
organization that ensures that the employee benefits at the cost of the
organization and not the organization at the cost of the employee.

The following are the steps necessary to the journey of Excellence -

1. Carry out a Gap Analysis
a. Record present scenario
b. Contrast the present scenario with the desired / necessary
c. Record all the Gaps between existing and desired scenarios
2. Draw up action plans
a. Identification of alternative solutions for bridging the gaps
b. Critical Examination of alternative solutions and finalizing the
preferred solution
c. Draw up and allocate budgets
d. Finalize measures that indicate success of the endeavor
e. Finalize monitoring mechanisms
f. Develop schedule of implementation
g. Review and document the plans
3. Hire mentor / consultant it is usually the outsiders who can find out
faults. This is the philosophy behind independent Quality Control
Mechanisms is outsiders who can perceive the improvement better
than insiders.
4. Implement / execute plans and measure and monitor their success
5. Measure and determine the level of achievement in the journey of
6. Once the desired sate is achieved, start all over again - this to retain
excellence !

UNIT- 10

10.1 * Concept of Inventory

Inventry is defined as a usable resource which is physical and tangible
such as materials. In this sense, our stock is our inventory, but even then the
term inventory is comperehensive.Though inventory is a usable resource, it is
an idle resource, unless it is managed efficiently and effectively.
Inventory management boils down to maintaining an adequate supply of
something to meet the expected demand pattern subject to budgeting
considerations. Inventory could be raw materials, work-in-process (WIP),
finished product or the spare parts and other indirect materials. Effectiveness of
the materials and production functions depend to a large extent upon invetory
Annual Demand
Inventory turnover ratio Average Invento is an index of business performance.
Sound management give a higher inventory turnover ratio.
Inventories have to be procured, stored and carried for a production
system, since a situation when they can be instantaneously available is difficult
to assume in Indin setting. Inventories are, therefore, a necessary evil to stay.

10.2 * Importance of Inventory

Inventories constitute the largest component of currnet assets in mant

organizations. Poor managemant of inventories therefore may result in business
falures. A stock-out creates an unpleasant situation for the organization. In case
of a manufacturing organization, the inability to supply an item from inventory
could bring production process to a half. Conversely, if a firm carries excessive
inventories, the added carring cost may represent the difference between profit
and loss. Efficient inventory control, therefore, can significantly contribute to
the overall profit-position of the organization.

10.3 * What Function Does Inventory Perform?

* Functions that inventory performs

In any organization, invrntories add an operating flexibility that would
otherwise be lost. In production, work-in-process inventories are an absolute
necessity unless each individual part is to be carried from machine to machine
and those machines set up to produce that single part. The many functions
inventory performs can be summarized as follows:

(a) Regularising Demand and Supply
Harvest of tobacco is carried out during the concluding part of the
summer, but the manufacture of tobacco products such as cigarettes and cigare
continues throughout the entire year. In case like this sufficient raw materials
must be purchased during the tobacco-producing period to last the entire year. It
compels the manufacturer to carry inventory.
In a simple sense, because a commercial vehicle can be driven 100miles
without passing a petrol pump, its tanks must carry enough prtrol to avoid run-

(b) Economising Purchases or Productions by Lot Buying or Batch

If the product does not have the demand sufficint to sustain its continuous
production round the year, it is usually produced in batches or lots, on an
intermittent basis. During the time when the item is not being produced, sales
are made from inventory which is accumulated while the item is being
produced. Similarly, a super-bazar selling men’s clothing does not purchase a
new shirt from Double Bull each time they sell one. Rather they choose to carry
with them an inventory of these shirt so that purchasing can be done in larger
quantities,thereby allowing lower costs and less paper work.
(c) Allowing Organizations to cope with Perishable Materals
Organizations selling canned foods, particulary fruits and vegetable,
operate at peak production capacity only for a few monts each year. They must
store up inventory to supply sufficient to last them through a year’s anticipated
demand until the next season. They give thoughful consideration to the rate of
inventory accumulaion and depletion throughout the peak production and sales
periods each year.

(d) Inventory can Store Labour

Though it may sound abstract to talk of “Inventorying” labour, it has been
done as a matter of routine. Levin and Kirkpatrick illustrate this by a lively
example. “The peak demand for the installation of replacement heating units
comes in the fall, just after the old units have been operated for the first time.
The manufacturers of heating units store up excess labour by having their
workers produch at a designated rate all year long, then having converted lobour
into finished heating units,they hold them in inventory until the point when
demand increases rapidly. Even if demand exceeds current productive capacity,
a manufacturer can supply the difference out of inventory at that time”.


Inventory cost money. The cost factor must be considered while

taking any decision regarding inventories. Inventory cost includes ordering
cost, carrying cost, out of stock or shortage cost, and capacity cost. Each of
these comprises several elements as shown below:

1. Ordering Costs
A. Cost of placing an order with a vendor of materials:
1. Perparing a purchase order.
2. Processing payments.
3. Receiving and inspecting the material.
B. Ordering from the plant:
1. Machine set-up.
2. Start-up scrap generated from getting a production run started.
2. Carrying Costs
A. Costs connected directly with materials:
1. Obsolescence
2. Deterioration
3. Pilferage.
B. Financial Costs
1. Taxes
2. Insurance
3. Storage
4. Interest (as the cost of capital borrowed to acquire and
maintain the inventories).
Alijan elaborates the carrying costs in greater details as follows:

Capital Costs
Capital cost is the
loss of interest on Interest on money invested in inventory.
money invested in Interest on money invested in land and building to hold
inventory building inventory.
and inventory Interest on money invested in inventory holding and
con control equipment trol equipment.

Inventory Mangement____________________________________________

Storage Space Costs

Rent on building

Taxes and insurance on building.

Depreciation on warehouse installation.

Cost of maintenance and repairs.
Utility charges, including heat, light and water.
Salaries of security and maintenance personnel.

Inventory Service Costs

Taxes on inventory.
Labour costs in handing and maintaining stocks.
Clerical expenses in keeping records.
Employee benefits for warehose and administrative personnel

Handling-equipement Costs
Taxes and insrance equipment.
Depreciation on equipment.
Fuel expense.
Cost of maintenance and repairs.

Inventory Risk Costs

Obsolescence of inventory.
Insurance on inventory.
Physical deterioration of inventory.
Losses from pilferage.

3. Out-of-stock Costs
A. Back ordering.
B. Lost sales.

Capacity Costs
A. Overtime payments when capacity is too small.
B. Lay-off and idle time when capacity is too large.
Some of the components of inventory costs are conflicting,ordering costs
and carrying costs, for example. If ordering costs are more carrying costs are
less and vice versa.
Further, identifing and assessing some items of cost poses defficulty. Stock
out cost is one such example. In a seller’s market an unsatisfies customer will
not be lost as easily as in a buyer’s market, and who will say what the cost of
not satisfying this customer at this time will be in the long run?
Two approaches have been suggested to overcome the difficulty. It is
possible to trace and cumulate the individual costs attributable to individual
items and use these for decision making. For example, what is the cost of
issuing a purchase order for this item? Hopefully, such tracing would be

applicable to a class or a number of different items and might, therefore, have a
broader applicability.

10.5 Economic Order Qucntity

As was explained earlier, under the fixed order quantity system of
inventory management,an order for supplies is placed when the existing stock
reaches reorder point. The relevant question now is - What
should be the size of the order? Buying in large quantities has its virtues, but ,
one of the problems associated with bulk buying is the high carrying cost.
Similarly, buying in small quantities reduces holding cost but adds to oerdeing
cost. Consequently, the materials manager is torn between a desire to keep
inventories low by ordering in small quantities and a desire to reduce cost by
buying large quantities.
Economic order quantity (EOQ) is the technique which solves the problem
of the materials manger. EOQ or Q Opt (Optimum Quatity) is the order size at
which the total cost compriaing oedering cost and plus carrying cost, is the
Exhibit 23.4 illustrates the EOQ graphically.
Graphing the two costs,viz.,carrying costs and ordering costs show exactly,
where the total cost curve is at its lowest point. An examination of the two
curves reveals that the carrying cost curve is linear i.e., the more the inventory
held in any period, greater will be the cost of holding it. Ordering cost curve,on
the other hand, is dufferent. Ordering in small quantities means more
acquisition and higher ordering costs. The ordering costs decrease with increase
in order sezes.

Exhibit 23.4 : Graphic Presentation of EOQ

EOQ-is the level of T (Total Cost)
inventory order of (Carrying Cost) (Q/2)H
which inventory DS/Q (Ordering Cost)
cost is minimum. Cost (Rs.) EOQ
Order Quantity Size (Q)

A Point where thecarrying cost curve and the ordering cost curve meet
represent the least total cost which incidentally is the economic order quantity
or optimum quantity.

EOQ can be carrying with the help of a mathematical formula. Following
ions are and implied in the calculation:
1. Demand for the product is constant and uniform thoughout the period,
2. Lead time (time from ordering to receipt) constant,

3. Price per unit of product is constant,
4. Inventory holding cost is based on average inventory,
5. Ordering costs are constant, and
6. All demands for the product will be satisfied (no back orders are
In constructing any inventory model, the first step is to develop a
functional relationship between the variables of interest and the measure of
effectiveness. As we are concerned with cost here, the following equation
would pertain:

Inventory Mangement---------------------------------------------------------
Totel Annual = Annual Purchase + Annual Ordering + Annual Holding
Cost Cost Cost Cost
TC = DC + S+ H
Q 2
where, TC = Totel cost
D = Annual Demand
C = Purchase cost per unit
Q = Quantity to be ordered (the optimum amount is termed the
Annual demand is
EOQ or Q opt).
known and constant

for a year.
S = Cost of placing an order
H = Holding cost per unit of average inventory per annum.
[ C+ percent carrying]
I = Cost of carrying inventory as percentage.

On the right hand side of the equqtion, DC is the annual purchase cost for
the units, (D/Q)S is the annual ordering cost (the actual number of orders
placed, D/Q, times the cot of each order, S), and (Q/2) H is the annual holding
cost (the average inventory, Q/2, times the cost per unit for holding and storage,
H). Thaese cost relationships are shown graphically in Exhibit 23.4
The second step in the model development is to calculate order Q, for
which, the totel cost is the minimum. In the basic model, this may be done by
simple algebra if we recognise that DC is not a decision variable and hence not
a factor in the ordering decision. Then, with refernce to Exhibit 23.4 total cost is
minimum at the where, the cost of ordering is equal to the cost of carrying, or

S = H
Q 2

Which in turn is solved as follows :
DS = H or 2DS = QH or Q =
2 H
Q (optimum) or EOQ = 2DS
When more complex cost equations are involved, this single algebraic
approach will not suffice and different calcus must be employed.
EOQ technique is highly useful in as much it answers the question of how
much to order and in so doing establishes the frequency with which orders are
placed. EOQ is applicable to both single items and to any group of stock items
with similar holding and pfocurement costs. Its use causes the sum of the two
costs to be lower than under any other system of replenishment.
Weakness of EOQ Formula
1. Erratic Usages : The fomulae we have used assume that usage of
materials is both predictable and evenly distributed. When this is not the case,
the formulae are useless. Different and far more complex formulae can be
developed for wide swings in usage, so long as these swings can be predicted.
But if usage varies unpredicatably, as it often does, no formula will work well.
2. Faulty Basic Information : EOQ calcuations are only as accurate as
the order cost and carrying cost information in which they are based. It is no
easy job to calculate order cost. In practic, order cost varies from commodity to
commodity. Carrying cost can vary with the company’s opportunity cost of
3. Costly Calculations : It is not easy job to estimate cost of acquisition
and cost of possession accurately. This requires hours of work by skilled cost
accountants. Actual caculation of EOQ can be time-consuming even when the
simple formulae for steady usage are used More elaborate formulas are even
more expensive. In many cases, the cost of estimating cost of possession and
acquisition and calculating EOQ exceeds the saving made by buying that
4. No Formula is Substitute for Commonsense : It is therefore
desirable to inclide a number of modifiers. The formula may suggest that we
order six supply, based on the assumption that we will contitue to require the
item at the same rate for the next six years. The modifier is a ‘maximum’ limit,
not more than one year’s supply, or two year’s supply perhaps. It may suggest
that we order every week, for these volumes we would adopt a different
ordering method. It may suggest that we order very small quantities,
unacceptable to the supplier or penalised by small quantity extras. The modifier
here would be ‘minimum’ limits Some items are best ordered jointly from a
single source,if they are bought out, or ordered at the same time the works in the
case of made-in items to save on set-up time or for some other reason. ‘Order
with’ would be the modifier.

` 5. EOQ Ordering Must be Tempered with Judgement : Certain
corporate operating goals must be followed in managing an inventory.
Sometimes, the guidelines provide a conflict in ordering. Where an order
strategy conflicts with an operating goal, order strategy restrictions should be
developed to permit honouring the goal. EOQ restrictions might include the
* Items purched to order, and items subject to rapid product improvement
will be restricted from EOQ use.
* Shelf life items (those goods only for a spectific lengh of time ) should
be restricted to a quantity not greater than one fourth of their age limitation.
* Items with unusual sales will be identified, with annual sales reduced
by appropriate quantities, prior to calculating EOQ.
* Critical supply items (those having most effect on custmer’s service),
will be ordered in greater
than normal quantities. The time supply quantities selected will over-
ride EOQ.

Differentiating with respect to Q and setting the equation equal to zero,we

2SD p
EOQ = H (p-d)
Graphically this model is shown below:

Example: Optimal Lot Size

A componet of product * (let us call it *1) is produced in another department.
*1 is produced at the rate of 200 untis per day. The assembly line uses*1
component at the rate of 80 untis per day. Considering the following data, what
would be EOQ of component *?
Daily usage (d) = 80 untis
Annual demand (D) = 20000 (80 untis * 250 working days)
Daily productio ( P) = 200 untis
Cost for production set up (S) = Rs. 100
Annual Holding cost (H) = Rs. 1 per unit
Cost of component *1 (c) = Rs. 14 each
Lead time (L) = 7 days
The EOQ would be
2SD p
EOQ = H (p-d)
2(20000) 100 200

= 1 200-80
= 2581 untis
We can find the recoder point R by
R = DL = 80(7) = 560 untis
It means that an order for units of component * should be placed when
the stock drop
to 560 untis.
10.6 * Safty or Biffer Stock
We have assumed in the above discussion a certain demand at constant
rate. Mostly demand varies from day-to-day and is not constant. Safely stock
has to be maintained to protect against stockouts. Safely stock is defined as the
additional amount of stock carried to meet more than the expecte demand. But
if more and more additional stock is carried, it means holding of unnecessary
additional inventories. When less is carried, there are chances of a stock out.
Management then faces the risk or production hold ups. Such uncertainties
require precise treatment of safely stocks.
The following diagram illustrates the situation.
There are two caues of stockout. Stockout could be a result of the major
rate of usage or excess consumption. Stockout could be due to delayed delivery.
Stockouts could be the result of both of these two factors.
Sefely stocks provide the necessart cushion when consumption is at a
higher rate or the normal delivery period is exceeded.
Attaching inventory control to materials management activity is feasible
in irganisations where integrated materials management is in practice. There is a
strong justification for such an arrangement as inventory control is part of
materials activity and all materials functions must be integrated into group.
Assigning inventory control function to production planning and control,
however, has adventages. Production planning and control department will be in
a better position to plan its production schedule with the knowledge of
inventory under its control. Besides,the production planning and control
department will be able to issue timely requisitions for replenishment of stocks
used in the production operation. And logically speaking, it is the production
department which is the user of inventories and the same department must be
held responsible for controlling them.
Actually, the cature of firm’s production operation, its product, and the
type of market in which it operates determine the preference for assignig
inventory function to production. An engineering oriented company producing
specialised technical products on a job-shop basis might well choose to
emphasise production considerations as long as an analysis of totel costs
justifies such a decision. Hence, inventory may report to the production dision.
On the other hand, a mass producer of electric moters might well find itself in
just the opposible situation and be compelled by relative cost considerations to
integrate inventory control with purchassing.

Whatever the consideration, it may be pointed out that any inventory
control system is not ‘once set, goes automatic’ type but needs to be reset from
time to time as the conditions such as lead time, consumption pattern etc., keep


Inventory control techniques are employed be the inventory control
organisation within the framework of one of the basic inventory midels, viz.,
fixed order quantity system or fixed order period system. Inventory control
techniques represent the operational aspect of inventory management and help
realise the objectives of inventory managemant and control.
Several techniques of inventory control are in use and it depends on the
convenience of the firm to adopt any of the techniques. What should be
stressed, however, is the need to cover all items of inventory and all stages,i.e.,
from the stage of receipt from suppliers to the stage of their use. The techniques
most commonly used are the following:
Always better control (ABC) classification.
High, medium and low (HML) classification.
Vital, essential and desirable (VED) cassification.
Scarce, difficult and easy to obtain (SDE).
Fast moving, slow moving and non-moving (FSN).
Economic order quantity (EOQ).
Max-Minimum system.
Two bin system.

One of the widely used techniques for control of inventory is the ABC
(always better control) analysis. The objective of ABC control is to vary the
expenses asociated with maintaining appropriate control according to the
potential saving associated with a proper level of such control for example, an
items having an inventory cost of Rs. 1,00,000 such as sheet steel, has a much
greater potential for saving expenses related to maintaining inventories than an
item with a cost of Rs. 100. The ABC approach is a categorising iventory items
into three classes ‘A’, ‘B’ and ‘C’ accrding to the potential amount to be
Once inventory is classified, we have a firm base for decideing where we
will put our dffort. Logically, we expect to maintain strong controls over the ‘A’
item taking whatever special actions needed to maintain availability of these
items and hold stocks at the lowest possible levels consistent with meeting
demands. At the other end of the scale, we cannot afford the expense of rigid
controls, frequentc odering expediting, etc., because of the low amounts in this
area. Thus,with the ‘C’ group we may maintain somewhat higher safely stocks,
order more months of supply, expect lower levels of customer service, or all the

three. It is for this selective approach,ABC analysis is often called the Selective
Inventory Control Method (SIM).
The inspiration behind the ABC analysis has been drawn from
Vikfredo Pareto an ltalian economist and sociologist (1842-1923) who
generated some highly debatable concepta of economics and sociology. One
that is most interesting to astudent of inventory management is the concept
known as “Pareto’s Laws”. Pareto arrived at the general conclusion that income
distribution patterns were basically the same in different countries and in
different historical periods. Pareto’s studes showed that a very small percentage
of totel population always seemed to receive the bulk of the income. He
concluded that was a nutural economic law in exstence which would always
establish the shape of the income destribution and could not be overridden by
any political or sociological reforms.
Extending Pareto’s principle to inventory it is always possible and
necessary to separate “vital few” from “trivial many” of the stock items for their
effective control. Separaring vital few from trivial many is what us precisel
done in ABC analysis.
Pareto’s principle was brought to the attention of people conerned with
onventory management by H. Ford Diclie,who applied Pareto’s law to inventory
and developed the general concept of ABC analysis. Like so many ideas,
however it has been completely understood. Many people refer to the ABC
system or the ABC technique. The idea of distribution of value for inventory
stratification is neither a system nor a technique, it is a fundamental
management principle with universal application porential.

The following procedure is suggested for developing an ABC analysis:

1. List each item carried in inventory by number or some other designation.
2. Determine the annual volume of usage and rupee value of each item.
3. Multiply each item’s annual volume of usage by its rupee value.
4. Compute each item’s percectage of the total inventory in terms of annual
usage in rupwws.
5. Select the top 10 per cent of all items which have the highest rupee
percentages and cassify
them as ‘A’ items.
6. Select the next 20 per cent of all items with the next highest rupee percentage
and designate
them ‘B’ items.
7. The next 70 per cent of all items with the lowest rupee percentages are ‘C’

The SDE analysis is based upon the availability of items and is very useful
the context of scarcity of supply. In this analysis, ‘S’ refers to ‘scarce’ items,
generally imported, and those which are in short supply ‘D’ refers to diffcult
items which are available indigeniusly but are difficult items to procure. Items
which have to come from distant places or for which relible suppliers are
difficult to come by, fall into ‘D’ category. ‘E’ refers to items which are easy to
acquire and which are available in the local markets.
The SDE classification, based on problems faced in procurement, is vital
to lead time analysis and in deciding on purchasing strategies.

This classification runs like this.

S - Scarce items
D - Diffcult (to procure) items
E - Easy (not difficult to get) items

5. HML Classifications
The High, Medium and Low classification follows the same procedure as
is adopted in ABC classification. Only difference is that in HML classification
unit value is the criterion and not the annual consumption value. The items of
inventory should be listed in descending order of unit value and it is up to the
management to fix limits for three categories. For example, the management
may decide that all units with unit value of Rs. 2,000 and above will be H items,
Rs, 1,000 to 2,000 M items and less than Rs. 1,000, items.
The HML analysis is useful for keeping control over consumption at
departmental levels, for deciding frequency of physical verification, and for
controling purchases.

This analysis is based on the cost of the item.

H = High Cost Items
M = Medium Cost Items
L = Low Cost Items

It is also called zero-inventory operation, it is actually a philosophy which

can be installed after eliminating all unwanted operations and waste. It is a
continuous process, It seeks to eliminate raw material stock and finished stock.
It has to adhere to other norms of manufacturing excellence like right-time
delivery every time. perfect quality and right implemenation of plan. It pre-
supposes complete co-operation between management and workers.
JIT cannot be maintained if quality components are continuosly made
available. Rejections of substandard components or faulty production operation

leads to disrupted production. It consuquently leads to non-delivery of finished
In India, it is difficult to get specified materials at the right time and at
the right place. There is a factor of ancillarisation where ancillary industry feeds
the parent industry. In absebce of proper tooling and equipment, ancillaries face
rejections at their level or at the buyer’s level. The internal and external supliers
are the key to success in JIT system. Quality and timely supply schedule are
necessary for it. JIT has bee successfully employed in Taiwan,Korea and Japan.
On installing JIT,they have reduced inventory level of only 2 days in place of 8-
12 weeks inventory levels. Overseas supplies in a country like India also
impede the installation of JIT . JIT reduces inventory carrying costs. There is
scope to implement JIT in integrated companies where there is no reliance on
external sources.
JIT in our situation, therfore can be installed if suppliers carry stocks for
us, which make them participators in our JIT programme. Perhaps, this is easier
said than done in our situation. Even a slight trend towards JIT will be a big step
Companies often mistake JIT for inventory elimination, missing delivery
schedules and increasing manhing idle time.
* Just-In-Time Philosophy
The basic concept is not to make anything till it is needed. It further
extends to producing anything needed to the highest level of quality. JIT is not
restricted however to manufacturing, but can be extended to distribution,
seles,markting and finance. It is applicable to both manufacturing and service
industries. In JIT, we have to meet customer’s requirements of quality, cost and
delivery time. The factors which affect these requirements are wasteful, and so
must be eliminated. For instance, factors like interest, unnecessary equipment
and holding large inventories tend to increase costs, and so must be elimicated.
JIT teaches us an effective method of manufacturing. A working definitionof
just-in-time is that it is a structural approach in a manufacturing organization
focussed on improving timeliness, quality, productivity and flexilbility utiliding
various methids of work simplification and waste reduction. We shall be able to
appreciate JIT better if we compare it with traditional methods of

During the 1970s and 1980s, Japan beccame an international economic

power. Ite manufacturing companies, especially in the automotive and
electronics industries, became the leaders in world markets and they set the
standards for product quality and cost aganist which firms of other countries
were compared. This success is often attributed ot the Japanese development
and use of just-in time (JIT) production system.

After World War-ll, manufacturing organisations had faced the challenge
of increasing the quality fo their products while lowering product costs and
increasing the speed with which customer orders are fi lled. To meet these
challenfes, firms had to examine new approaches to their operations
management to streamline production of high quality goods and services. One
of the widely used operations phiosohipes was known as just-in Time
production system.
In this chapter, the just-in-time (JIT) philosophy of manufacturing will be
described along with its extension to service system. JIT is called a philosophy
because it goes far beyond inventory control and encomasses the entire system
of production. In a nutshell, “JIT is an approach that seeks to eliminate all
sources of waste in production activities by providing the right part at the right
place at the right time”. Parts are therefore produced just-in-time to meet
manufacturing requirements rather than by the traditional approach of
producing them in lot sizes, storing and using as and when needed in the
production stages or work centeres. The JIT system results in much less
inventory, lower costs and better quality than the traditional approach.


JIT is defined as “a philosophy of manufacturing based on planned
elimination of all waste and continuous improvement of productivity. It
encompasses the successful exection of all manufacturing activities required to
produce a final product, from design engineering to delivery and including all
stages of conversion from raw materials onward. The primary elements of JIT
are to have only the required inventory when needed, to improve quality to zero
defects,to reduce lead time by reducing set-up time, queue lenghts and lot sizes,
to incrementally revice the operations themselves and to accomplish these
things at minimum cost. In the broad sense, it applies to all forms of
manufacturing, job-shop, process as well as repetitive”.

(vi) Parallel Processing : Parallel processing or synchrononous

operations wherever possible is an important part of JIT operations which can
be performed in parallel and if performed in series, it takes more manufacturing
lead time. This concepts is similar to that of simultaneous engineering or
concurrent engineering. By carrying out product design and process design
simultaneously,the time to bring the new products to the market is
reduced. The same approach is adopted in companies that want to engage in
time-based competition through JIT. In many cases, lay-out redesign and
product design may be selected to achieve parllel processing. The additional
costs can usually be more than offset by significant reduction in manufacturing
lead times.

Benefits of JIT System
Some of the benefits claimed for JIT system are :
(i) Inventory levels are drastically reduced. Inventory turnovers as high as
50 to 100 times per year have been achieved. The raw materials
inventory, work-in-process inventory and finished goods inventories have
been reduced considerably.
(ii) The time taken for products to get through the factory (product
throughput time or production cycle time) is greatly reduced, thus
enabling manufactures to engage in time-based competitions,using
speed as a weapon t capture market share.
(iii) Product quality is improved and hence the cost of scrap is reduced.
Product quality improces because of worker involvement in solving the
causes of production problems.
(iv) Because the focus in manufacturing is on finding and correcting the
causes of production problems, manufacturing operations are streamlined
and problem free.
(v) With less-in-process inventory, less spac is taken up by inventory and
materials handling equipment
(vi) Multi-skilled, flexible workfore brought benefits like less worker idle
time, reduced overheads,fewer lay-offs due to demand fluctuations in
specific product lines and increased responsiveness.
Some additional benefits of JIT system are :
* Elmination of unpleasant suppliers such as those with late deliveries and
unacceptable quality.
* Reduction in customer-related problems.
* Significant improvements in quality (near to zero defects).
* Improvemants in communication.
* Reduction in floor space needs due to lesser work-in-process inventory and
smaller lot sizes.
* Shorter lead times of suppliers, allowing them to respond more quickly to
changing customer needs.
*Improvements in employee morale due to higher employee involvement and
emplyee empowerment.
*Reduced pressure on inwards goods receiving and incoming inspection areas.

Major Tools and Techniques of JIT Manufacturing

Just-in-time manufacturing works at two different levels. As a large
scale, organisation wide philosohpy, it directs everyone’s effrts at identifying
and eliminating waste in the firm. This broad-based, strategic orientation is
referred to as JIT or CORPORATE JIT or Big JIT. On the other hand,
practitioners can focus on various analytical tools and techniques that are
frrquently associated with just-in-time manufacturing.

Often this tactical orienation is referred to as jit or shop-floor JIT or Little
JIT. The tactical tools of little JIT are :
(i) Kanban system or pull scheduling
(ii) Set up reduction (SMED)
(iii) Lean production
(iv) Poka-Yoke (Fool proofing)
(v) Quality at the source
(vi) Standardisation and simplification
(vii) Supplier partnerships
(viii) Reduced transaction processing and
(ix) Kaizen (continuous improvement).
These techniques are descussed in the following sections.

10.9 Kanban System or Pull Scheduling

To build only what customers demand when they demand, JIT manufacturing
needs a scheduling system that can immediately and clearly communicate the
demands of the customer to the delivery system. The Kanban or pull scheduling
system does this “Kanban” is a Japanese world meaning “card” and these cards
are the menas of comminicating within to and from a work centre. Kanbans are
the heart of the JIT system. They effectively replace all written work orders,
move tickets and routing sheets. No parts can be moved, produced or used
without an appropriate Kanban. Parts and components are transferred from one
work area to another in rigid plastic containers. These containers are just large
enough to hold a small and fixed quantity of units of the same component
reference. Different parts are not put into the same container. There are two
kinds of Kanbans-production Kanban and withdrawal Kanban (or conveyance
Kanban). The information written on Kanban includes reference number,
storage areas and associated work centres.
The purpose of the Kanban system is to single the need for more parts
and to ensure that those parts are produced in time to support subsequent
fabrication or assembly. This is done by pulling parts through from the final
assembly line. Only the final assembly line receives a schedule from the
dispatching office and this schedule is nearly the same from day to day. All
other machine operators and suppliers receive production orders (Kanban cards)
from the subsequent (using) work centres. If production should stop for a time
in the using work centers, the supplying work centers will also soon stop, since
they will no longer receive Kanban orders for more materials.
The Kanban system is a physical control system consisting of cards and
containers. To control movement of the containers, the Kaban cards (production
cards and withdrawal or move cards) are used. These cardsare used to authorise
production and to identify parts in any container. The Kanban cards may be
made of paper, metal or plasitc and they generally contain the information
shown in Exhibit 24.2

Kanban cards take the place of shop paperwork used in traditional
repetitive manufacturing.
Working of the Kanban System : Exhibit 24.3 illustrates the working
of the Kanban system.
Assume that eight containers are used between work centre A and B (A
supplies B) and each container holds exactly 20 parts. The maximum inventory
that can exit bewteen these two work centres is then 160 units (i.e.,8 x 20) since
production work at work centre A will stop when all containers are filled.

In the normal course, the containers might be distributed as shown in Exhibit

24.3 Three containers are located at work centre A in the oupput area filled with
parts. One container is being moved from work centre A to B, two containers
are kept in the input area of work centre B and one container is being used at B.
These 8 containers are needed since work centre A also produces parts for other
work centres, machines at A may break down and time taken to move materials
from work centre A to B is not exactly predicable.
Here is now the kanban system works, assuming containers are moved one at
a time. When a container of parts is emptied at work centre B, the empty
container and associated withdrawal card are taken back to work centre A. The
production card a full container is removed from its container and replaced by
the withdrawal card. The production of another container of parts (20 numbers
in this case). The empty containe is left at workstation A.

The full container of parts and its withdrawal card are moved to work
centre B and placed in the input area. When this container of parts is
enventually used, its withdrawal card and the empty container are taken back to
work centre A and the cycle is repeated.
What is singnificant about Kanban system is that it is visual in nature. All
parts are neatly placed in containers of a fixed size. As empty containers
accumulate, it becomes evident that the producing work centre is lagging
behind. On the other hand, when all cintainer are full, production is stopped.
The production lot size is exactly to one container of parts.
Calculation of the number of containers needed : The number of
containers needed to operate a work centre is a function of the demand rate,
container size (capacity) and the circulating time for a container. The number of
containers required for an item is calculated as :
n = ----
where n = totel number of containers
D = demand rate of the using work centre

C = container size in number of parts, usually less than 10
percent of daily demand.
T = time for a container to complete an entire circuit; filled, wait,
moved, used and returned to be filled again (also known as lead
For exaple, if the demand at the next work centre is 2 parts per minute
and a standard container holds 15 parts, assuming that it takes 100 minutes for a
container to make a complete circuit from work centre A to work centre B and
back to A again, including a set-up, run,move and wait time, then the number of
containers needed is
n = ------- = 8 numbers
The maximum inventory is 8x25 = 200 units.
(Maximum inventory = container size x number of containers) (interms
of number of times to fill)
= Cn = DT [because n = ----]
Inventory can be reduced by reducing the size of the containers or the
number of containers used. This is done by reducing the time required to
circuired to circulate a contaicer, including its machine set-up time, run time,
wait time and move times. When any of these times has been rduced, certain
numbers of Kanban cards can be removed from the system along with an equal
number of containers. Hence, reducing lead time is the key to JIT production.
Exhibit 24.4 illustrates a complate Kanban system which links all work
centers in a production facilirty and the suppliers. All material is pulled through
by the final assembly schedule, based on a highly visible shop floor and
supplier control system.
Benefits of Kanban
Kanban system have resulted in significant benefits :
(i) Reduced inventory level
(ii) Less confusion over sequence of activities
(iii) Less obsolescence of inventory while in storage
(iv) Smaller floor space requirement for storing inventory
(v) Reduced lead times
(vi) Improved quality
(vii) Higher employee produtivity
(viii) creater system flexibility

10.10 Material Requirements Planning (MRP)
MRP is a production planning and inventory control system used to manage
manufacturing processes. Most MRP system are software-bases, while it is
possible to conduct MRP hand as well.

An MRP system is intended to simultaneously meet three objectives :

* Ensure materials are available for production and products are available for
delivery to customers.
* Maintain the lowest possible material and product levels in store
* Plan manufacturing activities, delivery schedules and purchasing activities.

The basic function of MRP system encludes inventory control, bill of material
processing and elementary scheduling. MRP help organizations to maintain low
in inventory levels. It is used to plan manufacturing, purchasing and delivering
MRP is a tool to deal with these problems. It procides answers for several
questions :
What items are required?
How many are required?
When are they required?

MRP will plan production so that the right materials are at the right place at the
right time. MRP determines the latest possible time to product goods, buy
materials and add manufacturing vaue. Proper Material Requirements Planning
can keep cash in the firm and still fulfill all production demands. It is the single
most powerful tool in guiding inventory planning. purchase management and
production control. MRP is easy to operate and adds dramatically to profits.
MRP calculates and maintains an optimum manufacturing plan based on master
production schedules, saled forecasts, inventory status, open orders and bills of
material. If properly implemented. it will reduce cash flow and increase
profitability. MRP will provide you with the ability to be pro-active rather than
re-active in the management of your inventory levels and material flow.

MRP is a planning tool geard specifically to assembly operation. The aim is to

allow each manufacturing unit to tell its supplier what parts it requires and when
it requires them. The supplier may be the upstream process within the plant or
an outside supplier. Together with MRP II it is probably the most widely used
planning and scheduling tool in the world. MRP was crated to tackle the
problem of ‘dependent demand’; determining how many of a particular
componet is required knowing the number of finished products. Asvances in
computer nardware made the calculation possible.

MRP is a planning tool geared specifically to assembly operations. The aim is to
allow each manufacturing unit tell its supplier what parts it requires and when it
requires them.The supplier may be the upstream process within the plant or an
outside supplier. Together with MRP II it is probably the most widely used
planning and scheduling tool in the world. MRP was created to tackle the
problem of ‘dependent demand ‘; determining how may of a particular
component is required knowing the number of finished products. Advances in
computer hardware made the calculation possible.


For a manufacturing company to produce end items to meet demand, the
availability of sufficient production capacity must be co-ordincted with the
availability of all raw materials and purchased items from which the end items
are to be produced. In other words,ther is a need to manage the availability of
dependent demand items from which the products are made. Dependent-demand
items are the components i.e., materials or purchased items, fabricated parts or
subassemblies that make up the end product.
One approach to manage the availability of dependent-demand item is to
keep a high stock of all the items that might be needed to produce the end items
and when the on-hand stock dropped below a present re-order level, the items
are produced or bought as the case may be to replenish the stock to the
maximum level. However this approach is costly due to the excessive inventory
of components, fabricated part and sub assemblies to ensure high service level
(i.e., availability of dependent demand items at short notic).
An alternative apprach to managing dependent-demand items is to plan
for procuremant or manufacture of the specific components that will be required
to produce the required quantities of end products as per the production
schedule indicated by the maste production schedule (MRP). The technique is
known as material requirements planning (MRP) technique.
MRP is a computer-based system in which the given MPS is exploded
into the required amounts of raw materials, parts and sub assemblies, needed to
produce the end items in each time periid (week or month) of the planning
horizon. The gross requirement of these materials is reduced to net requirements
by taking into account that materials that are in inventory or on order.
A schedule of orders is developed for purchased materials and in-house
manufactured items over the planning horizon on the knowledge of lead times
for procurement on in -house production.

Objectives of MRP
The objectives of material requirements planning in operations management are
1. To improve customer service by meeting delivery schedules promised
and shortening delivery lead times.
2. To reduce inventory costs by reducing inventory levels.
3. To improve plant operating efficiency by better use of productive
Three facets of MRP technique are :
1. The MRP technique as a requirements calculator
2. The MRP - A manufacturing, planning and control system
3. The MRP - A manufacturing resource planning system
The MRP technique as a requirements calculator was originally used as
an inventory control tool providing reports that specify how many components
should be ordered, when they should be ordered and when they should be
procured or produced in-house. Since MRP is a computer based system, it was
possible to expand the system into a manufacturing planning and control system
by providing information for planning and controlling both the material and the
capacity required to manufacture the products. Hence, MRP serves as a key
component in an information system for planning and controlling production
operations and procurement of materials. It is the basic foundation for
production activity control or shop floor control, for vender follow up system
and for detailed capacity requiremants planning. When both the MRP and CRP
are integrated within one system, the system is known as “Material
Requiremants Planning” abberviated as ‘mrp’ or MRP -1. When MRP is
expended to include feed back from and control of vendor orders and
production operations, it is called “closed-loop MRP” which helps managers
achieve effective manufacturing control.
Materials Requirements planning (MRP-1 or mrp) : Computer based
information system for ordering and scheduling of dependent demand

Purpose of MRP
The main purposes of a basic MRP system are to control inventory levels,
assign operating priorities for items and plan capacity to load the production
system. These are briefly discussed under three areas viz.,
(i) Inventory : Order the right item, order in the right quantity and order
at the right time in order to receive the supplies at the
right time.
(ii) Priorities : Order with the right due date and keep the due date valid.
(iii) Capacity : Plan for a complete load, plan an accurate load and
planfor an adequate time to view future load.

The theme of MRP is “ getting the right materials (whether bought-out
or in-house manufactured) to the right place at the right time in the right
Advantages and Disadvantages of MRP
Advantages : (i) Reduced inventory, (ii) Reduced idle time, (iii) Reduced set up
time, (iv) Ability to change the master production schedule, (v) Ability to price
more competitively, (vi) Better customer service, (vii) Better response to market
demands, (viii) Reduced sales price, In addition the MRP system enables the
following :
Disadvantages : Even though MRP system has many advantages, there
are some problems with MRP system which make them fail in many firms.
Three major causes for failures of an MRP system are :
(i) Lack of top managemant commitment. MRP must be accepted by top
management as a planning tool with specific reference to profit results. All
executives concerned with the implementaion of the MRP system must be
educated emphasizing the importance of MRP as a closed-loop, integrated
strategic planning tool.
(ii) MRP was presented and perceived as a complete and stand-alone
system to run a firm, rather than as part of the totel system.
(iii) The issue of how MRP can be made to function with just-in-time
production system.
MRP also needs a high degree of accurancy for operation, which often
requires (i) changing how the firm operates and (ii) updating files.
The major complaint by users of MRP is that MRP is too rigid because
when MRP develops schedule, it is quite difficult to deviate from the schedule it
need arises.


When the capabilities of closed-loop MRP are extended to integrate
financial, accounting, personnel, engineering and marketing information along
with the production planning and control activies of basic MRP system, the
resulting broad-based resource-coordination system is known as manufacturing
resource planning or MRP-II. MRP-II is the heart of corporate management
information system for many cpmpanies as it provides information about
inventory investment levels, plant expansion needs, and work-force
requirements that is rseful for co-ordinating marketing, financal, engineering
and manufacturing efforts to achieve the company’s overall business plants.
A master production schedule (MRP) is a plan for production, staffing,
inventory, etc. It is usually linked to manufacturing where the plan indicates
when and how much of each product will be demanded. This plan quantifies
significant processes, parts, and other resources in order to optimize production,
to identify bottenecks, and anticipate needs and completed goods. Since an

MRP drives much factory activity, its accuracy and viability dramatically affect
profitability. Typical MRP’s are created by software with user tweaking.
Master production schedules take into account important aspects and only key
elements of production that have proven their control effectivity, such as
forecast demand, production costs, inventory costs, lead time, working hours,
capacity, inventory levels, available storage, and parts supply. The MPS is a
statement of what the company expects to produce and purchase (i.e. quantity to
be produces, staffing levels, dates, available to promise, projected balance).
The MPS translates the business plan, including forecast demand, into a
production plan using planned orders in a multi-level optional component
scheduling environment. Using MPS helps avoid shortages, costly expediting,
last minute scheduling and inefficient allocation of resources. Working with
MPS allows businesses to consolidate planned parts, produce master scedules
and forecasts for any level of the Bill of Material (BOM) for any type of part.

An example of a master production schedule for “product A”.

Production Plan for Week 2,December 09
The master schedule (or master production schedule or MPS) sets the
quantity of end item (finished product) to be completed in each time period
(week or month or quantity of the short range planning horizon.
Master production schedules are developed by reviewing market
forecasts,customer orders, inventory levels, facility loading and capacity
information regularly.
The MPS is a plan for future production of end items over a short-range
planning horizon that usually spans from a few weeks to severl months. It is an
important link between marketing and production.

Objective of Master Production Scheduling

1. To schedule end items to be completed promptly and when promised to
2. To avoid overioading or underloading the production facility so that
production capacty is efficiently utilized and low production costs results.

Functions of Master Production Schedule

The MPS formalizes the production plan and converts it into specific
material and capacty requirements. This leads to the assessment of labour,
material and equipment needs for each job. Then the MPS derives the entire
production and inventory system by setting production target and responding to
feed back from all downstream operations. It is the beginning of a short-range
production planning. From the MPS, material requirement planning(MRP)
developed the production system. The MRP develops short-range plans for

puchasing the raw material and componets that are required to produce the
Some key functions of MPS are :
(a) Translating aggregate plans : The aggregate plan sets the level of
operations that rought balance market demands with the material, labour and
equipment capabilities of the firm. The aggregate is translated into specific
number of end products to be produced in specific time periods. Products are
grouped into economical lot sizes that can realistically load the firm’s facilities.
The MPS represents a manufacturing plan of what the firm intends to produce
and not the forecast of what the firm hopes to sell.
(b) Evaluating alternative master schedules : Master scheduling is done on
a trial and error basis. Trial-fitting of alternative MPS can be done by simulation
using computers. Detailed material and capacity required are then derived from
the firm MPS.
(c) Generating material requirements : The MPS id the prime input to the
MRP-1 system. The MRP-1 system provides for purchasing or manufacturing
the necessary items in sufficient time to meet the final assembly dates specified
based on the MPS for end products.
(d) Generating capacity requirements : Capacity needs arise for
manufacturing the components in the required time schedule to meets the
requirements of end products as per MPS. Capacity requirement planning is
based on the MPS which should reflect an economic usage of labour and
equipment capacities. Master schedules will have to be revised when capacity
requirements are inadequate.
(e) Facilitating information processing : By contolling the work load on work
centres, the MPS determines the delivery schedules for end products both for
make-to-stock and make-to-order items. It co-ordinated other management
information such as marketing capabilites, financial resources (for carrying
inventory) and personnel polices (for supplying labour)
(f) Maintaining valid priorities : The abosolute or relative priorities for
various jobs to be completed should reflect the true needs. This means that the
due date and the ranking of jobs should correspond with the time the order is
actually needed. When customers change their orders or materials get scrapped
sometimes, either the components are not actually needed or end items cannot
be produced because of shortage of some materials, it is necessary that the MPS
should be modified to reflect this change.
(g) Effective utilizing the capacity : By specifying the end item requirement
over a time period, the MPS establishes the load and utilization parameters for
labour and equipment (i.e., shifts worked or overtime or idle time)

10.11 Bill of Materials
A bill of materials (sometime bill of material or BOM) is a list of the raw
materials, sub-assemblies, intermedite assemblies, sub-components,
components, parts and the quantities of each needed to manufacture an end
product. No physical dimension is described in a BOM. It may be used for
communication between manucacturing parthers, or confined to a single
manufacturing plant.
A BOM can define products as they are designed (engineering bill of materials),
as they are ordered (sales bill of materials), as they are built (manufacturing bill
of materials), or as they are maintained (service bill of materials). The different
types of BOMs depend on the business need and use for which they are
intended. In process inndustries, the BOM is also known as the formula, recipe,
or ingredients list. In electronics, the BOM represents the list of components
used on the printed wiring board or printed circuit board. Once the design of the
circuit is completed, the BOM list is passed on to the PCB layout engineer as
well as component engineer who will procure the components required for the

BOMs are hierarchical in nature with the top level representing the finished
product which may be a sub-assembly or a completed item. BOms that describe
the sub-assemblies are referred to as modular BOMs.An example of this is the
NAAMS BOM that is used in oautomotive industry to list all the components in
an assembly line. The structure of the NAAM BOM is System, Line, Tool,Unit
and Detail.

The first hierarchical databases were developed for automating bills of materials
for manufaturing organizations in the early 1960s. At present this BOM is used
as a data base to identify the many parts and their codes in automobile
manufacturing companies.
A bill of materials “implosion” links component pieces to a major assembly,
while a bill of materials “explosion” breaks apart each assembly or sub-
assembly into its component parts.
A BOM can be displayed in the following formats :
* A single-level BOM that displays the assembly or sub-assembly with only
one level of children.
Thus it displays the components directly needed to make the assembly or
* An indented BOM that displays the highest-level item closest to the left
margin and the components used in that item indented more to the right.
* Modular (planning) BOM
A BOM can also be visually represented by a product structure tree, although
they are rarely used in the workplace.

A bill of materials (BOM) is a list of the parts or components that are required
to build a product. The B BoM provides the manufacturer’s part number
(MPN) and the quantity needed for each component.

At its most complex, a BoM is a multi-level document that provides build data
multiple sub-assemblies (products within products) and includes for each item:
part number , approved manufacturers list (AML) , mechanical characheristics
and a whole range of component descriptors. It may also include attached
reference files,such as part specifications,CAD files and schematics.

Originally used internally within a company, the BoM served as a way to track
product changes and maintain an accurate list of required components. As
manufacturing has become increasingly distributed, however, the BoM has
taken on even greater importance. It serves as the primary reference file for
product data when transferring product information from the original equipment
manufactuer (OEM) to the electronic manufacturing services.

popr : 1


Organization Behaviour
Unit 1 –


All organizations, be these business, educational or government, are social

systems. These are run by people. Take a business/industrial organization, for
example. It is a combination of men, money, machinery, material and
management, commonly known as five M’s. In fact, it is management, i.e. people
who actually take care of other four M’s. Then, it means that the functioning of an
organization depends upon how people work or behave in the organization.

Human behavior is caused and is highly unpredictable also. Why people behave
as they behave has, therefore, been a subject of much interest and concern since
our earliest years. Therefore, understanding human behavior has assumed great
significance for the managers for managing people effectively. In other words,
knowledge about why people behave as they behave helps managers extract
maximum results from people's efforts for accomplishing organizational goals in
an effective manner. For this, managers need to seek answers mainly to these two
questions: (i) why people behave as they behave or why people do what they do at
work in organizations? and (ii) What influences people's behaviour at work? The
same constitute the subject matter of organizational behaviour(often abbreviated
as OB).

OB is concerned with the study of human behaviour at work. In other words, OB
is the study and application of knowledge about how people as individuals and as
groups behave or act in organisations. Different behavioural scientists have
defined OB differently. A few important definitions on OB are given here.

According to Luthans"OB is directly concerned with the understanding,

prediction, and control of human behaviour in organisations."

Davis and Newstrom1 have defined OB as "the study and application of

knowledge how people act or behave within organisation. It is a human tool for
human benefit. It applies broadly to the behaviour of people in all types of
organisations such as business, government, schools and service organisations."

In the opinion of Robbins', "OB is a field of study that investigates the impact that
individuals, groups, and structure have on behaviour within organisations for the
purpose of applying such knowledge towards improving an organisation's

The above definitions are comprehensive ones as these contain all characteristics
of OB. In brief, what OB studies is three determinants of behaviour in
organizations: individuals, groups, and structure.

To sum up, OB is concerned with the study of how and what people act in
organisations and also how their acts affect the performance of the organisation. It
also applies the knowledge gained about individuals, groups and the effect of
structure on human behaviour in order to make organisations work more


Like all other disciplines/subjects, OB is also based on certain key elements also
called 'fundamental concepts or assumptions'. There are four key elements in OB.
These are: people, structure, technology, and the environment. Each of these four
elements of OB arenow discussed briefly.

As mentioned earlier, organisations are run by people. People consist of
individuals and groups. Though people have much in common (they become
happy by having gains and sad by losing something valuable), yet they differ
from each other. One can find glaring differences in people's trait, intelligence,
personality or any such trait. It is, in fact, individual differences the manager
cannot adopt one formula or standard across the board for dealing with
employees. Instead, manager has to treat employees with individual differences
differently. It is because of individual differences, the subject matter of OB begins
with individual.

An individual joins organisation along with his/her social background, likes and
dislikes, pride and prejudices. What is to say is that an individual's family life
cannot be separated from organisational life. Therefore, OB studies an individual
as a whole person.

Human behaviour is always caused; Behaviour is directed towards some goals.

There is always a cause behind every human behaviour or act. For example, when
a worker is absent from work, there is a cause behind. The manager must know
the cause to solve the problem. People are Jiving, thinking, feeling beings. The
manager, therefore, needs to treat them with human dignity, not just like an
economic tool.

Organisations are social systems. There are two types of social systems that exist
side by side in an organisation. One is the formal and other is the informalsocial
system. The formal relationship of people in organisations is called structure.
Different jobs are required to accomplish the organisational goals and objectives.
For example, there are managers and employees, accountants and assemblers.
These all people performing different jobs at different levels have to be related in
some structural way so that their work can be effectively coordinated.

That people need organisations and organisations also need people also comes
under the purview of OB. It means that OB is based on mutuality of interest. It is
mutual interest that unites people and organisation to go side by side for
accomplishing individual and organisational goals.

Technology provides the resources with which people work and also affects the
tasks that they perform. The great benefit of technology is that it allows people to
do more and better work. But, it also restricts people from doing things in various
ways. In fact, it has costs as well as benefits.


All organisations operate within a given internal and external environment.4 In

fact, no organisation exists alone. An organisation is a part of a larger system that
contains other factors or elements, such as a government, the family, and other
organisations. All of these mutually influence one another in a complex way.
Thus, organisations are influenced by the external environment. Environment,
thus, affects people by influencing their attitudes, working conditions, etc. It will
not be less than correct to mention that an organisation is the effect for which
environment is the cause. Hence, environment also becomes a key element in the
study of OB.


Organisational behaviour has emerged as a separate field of study. The nature it
has acquired by now is identified as follows:

1. Separate Field of Study and Not a Discipline only.

By definition, a discipline isan accepted science that is based on a theoretical
foundation. But, OB has a multi-interdisciplinary orientation and is, thus, not
based on a specific theoretical background. Therefore, it isbetter reasonable to
call OB as a separate field of study rather than a discipline only.

2. An Interdisciplinary Approach:
OB is essentially an interdisciplinary approach tostudy human behaviour at
work. It tries to integrate the relevant knowledge drawn from relateddisciplines
like psychology, sociology, and anthropology to make them applicable for
studyingand analysing organisational behaviour.

3. An Applied Science:
The very nature of OB is applied. What OB basically does is theapplication of
various researches to solve the organisational problems related to human
behaviour.The basic line of difference between pure science and OB is that
while the former concentrateson fundamental researches, the latter
concentrates on applied researches. As OB involves both
applied research and its application in organisational analysis, hence, OB can
be called both science as well as art.

4. A Normative Science:
OB is a normative science also, while the positive sciencediscusses only cause
effect relationship, OB prescribes how the findings of applied researches canbe
applied to socially accepted organisational goals. Thus, OB deals with what is
accepted byindividuals and society engaged in an organisation. Yes, it is not
that OB is not normative at all. In fact, OB is normative as well that is well
underscored by the proliferation of managementtheories

5. A Humanistic and Optimistic Approach:

OB applies humanistic approach towardspeople working in the organisation. It
treats people as thinking, feeling human beings. OB is based on the belief that
people have an innate desire to be independent, creative, and productive. It
also realizes that people working in the organisation can and will actualise
these potentials if they are given proper conditions and environment. As stated
earlier, environment affects performance of workers working in an

6. A Total System Approach:

The systems approach is one that integrates all the variablesaffecting
organisational functioning. The systems approach has been developed by the
behaviouralscientists to analyse human behaviour in view of his/her
socio-psychological framework. Man'ssocio-psychological
framework makes him a complex one and the systems approach tries to
studyhis/her complexity and find solution to it.

Scope of OB
As mentioned earlier, OB is the study of human behaviour at work in
organisations. Accordingly, the scope of OB includes the study of individuals,
groups and organisation/ structure. Let us briefly reflect on what aspects each of
these three cover.

Individuals:Organisations are the associations of individuals. Individuals differ

in many respects. The study of individuals, therefore, includes aspects such as

personality, perception, attitudes, values, job satisfaction, learning and
Groups of Individuals:Groups include aspects such as group dynamics, group
conflicts, communication, leadership, power and politics, and the like.

Organisation/Structure:The study of organisation/structure includes aspects

such as formation of organisational structure, culture and change and

In nutshell, OB studies how organisations influence people or how people

influence organisations.

The scope of OB is depicted in the following Figure


As mentioned earlier also, organisational behaviour is the study of people at work
in organisations. And we study organisations because we spend our lives
interacting with them. If the entire world is a stage, it is a stage filled with
organisations. Regardless of the part we play as a student, employee, manager or
customer, we play our roles/parts on an organisational stage. By acting our parts,
we influence organisations and organisations also influence us. The same
underlines the need for studying OB.

The study of OB benefits us in several ways.

Firstly, the study of OB helps us understand ourselves and others in a better way.
This helps greatly in improving our inter-personal relations in the organisations.
Friendly and cordial relations between employees and management and also
among the employees create a congenial work environment in organisations.

Secondly, the knowledge of OB helps the managers know individual employees

better and motivate employees to work for better results. It helps managers apply
appropriate motivational techniques in accordance to the nature of individual
employees who exhibit glaring differences many respects.

Thirdly, one of the basic characteristics of OB is that it is human in nature. So to

say, OB human problems humanly. It helps understand the cause of the problem
predicts its future of action and controls its evil consequences. Thus, treating
employees as human beings enables the managers to maintain cordial industrial
relations which, in turn, create peace andharmony in the organisations.

Fourthly, the most popular reason for studying OB is to learn how to predict
human behaviour and, then, apply it in some useful way to make the organisation
more effective. Thus, knowledge of OB becomes a pre-requirement for a person
like you the students of MBA who is going to assume a managerial job and
succeed as a manager.

Finally, all organisations are run by man. It is man working in the organisations
makes all thedifference. Then, it implies that effective utilization of people
working in the organisation guarantees success of the organisation. This is where
OB comes into the picture. OB helps managers how to efficiently manage human
resources in the organisation. It enables managers to inspire and motivate
employees towards higher productivity and better results.


As mentioned earlier, OB studies human behaviour at work. Thus, OB can be the
behaviour of the members of the organisation toward each other, toward the
organisation, toward the customers or clients, and towards the society at large.
Human behaviour is often caused. Psychologists have taken it as axiomatic that a
cause must precede its effect. For example, a Professor, who enters the classroom
after having a hot exchange and quarrel with his colleagues, may reveal bitterness
to his students in the class. Similarly when a manager comes to office after
quarrelling with his wife in the morning, may possibly exhibit unpleasant
behaviour like rebuking for pretty things to his subordinates. In sum and
substance, OB is the behaviour of people with each other in an organisational
framework. It follows cause-effect process and affects both inter-personal
relations and managerial effectiveness in the organisation.


OB process is now illustrated with an imaginary cause-effect model as shown in

Figure. The circle in the figure represents organisational framework. It contains
three levels of managers, viz., Top Level Managers (TM), Middle Level
Managers (MM), and Lower Level.

Managers (LM) and people denoted by P. The hierarchy of managers is indicated

by the triangle within the overall organisational framework. The bold line and
dotted line of triangle represent managerial effectiveness and human relations

The diagram exhibits that behaviour is caused, or say, behaviour has a cause-
effect relationship. In other words, the behaviour of one individual serves as
cause for another's behaviour. The behaviour of another individual, thus, becomes
effect. For example, B, behavior of top level management (TM) toward its people
(P) becomes cause for B3, behaviour (i.e. effect) of the people. Similarly, B2; is
the cause of B4 effect. This goes on and on in the whole organisational
framework. Finally, the diagram shows a positive relationship between
behaviour, human relations, and managerial effectiveness in the organisation. To
be precise, better the human relations maintained among the people, greater
would be the positive behaviour, and in turn, greater would be the managerial

effectiveness and vice versa. Thus, it becomes clear that OB follows a cause-
effect process.

OB is an applied behavioural science. It has drawn heavily from a number of
other applied interdisciplinary behavioural disciplines of psychology, sociology
and anthropology. A brief description of each is in order.

The discipline that has had the greatest influence on the field of OB is
psychology. It is a science that focuses directly on understanding and predicting
individual behaviour. It has greatly contributed to the intra-personal dynamics of
human behaviour. Topics such as personality, perception, attitude, opinion,
learning and motivation describe intra-personal aspects of OB.


Auguste Compte, a French philosopher of the nineteenth century, is generally

credited with coining the term sociologyas part of his attempt to reclassify and
rearrange the field of science. Sociology is the study of people in relation to their
fellow human beings. Whereas psychologists focus on the individuals,
sociologists study groups of individuals. The field of sociology has made valuable
contributions to our understanding of group dynamics within organisations. The
topics derived from sociology include group dynamics, formation of groups,
communication, formal and informal organisations and the like.

Anthropology is the study of societies to learn about human beings and their
activities. Anthropology helps us understand differences in fundamental values,
attitudes, and behaviour between people in different regions and organisations. In
sum and substance, anthropology studies culture. Culture dictates what people
learn and how they behave. Organisations create a unique culture that influences
the way organisational members think about the organisation and how they should
behave. Some important insights about organisational culture are derived from the
field of anthropology.

Other Social Sciences:

Besides psychology, sociology" and anthropology, three other disciplines also
contributed to our understanding of OB are economics, political science, and
history. Several economic models describe the behaviour of individuals when

they are confronted with a choice, and these economic models have made
valuable contributions to our understanding of both individual andorganisational
decision-making processes. Power, politics, and authority are popular topics
derived from the field of political science. They help explain certain influence
processes in OB; History has also greatly contributed to our understanding of OB
by describing the lives of great leaders and the successes and failures of
organisations they managed.


Although the field of OB has been around the past three decades, there are a few
dramatic challenges taking place as we have entered the twenty-first century. For
example, the typical employee is becoming older, his/her expectations are fast
changing, loyalties to the organisation have become a feature of the other day,
more and more women and nonwhites are joining the work force, and the ever
increasing global competition of business is requiring employees to become more
flexible and to learn to cope with rapid changes posing challenges. In sum, then
are a lot of challenges for OB to face in the twenty-first century. In fact, a time
has come to understand OB better and more than before. Here, we are discussing
some of the more critical issues/challenges confronting managers for which OB
offers solutions or at least some meaningful insights towards solutions.

Work-force Diversity

Work-force diversity can be defined as the situation that exists when members of
a group or organisation differ from each other in terms of age, gender, race,
ethnicity, and education. When workers join organisations, they come with their
differing cultural values and lifestyle preferences. Therefore, the challenge for
organisations is to make themselves accommodating to diverse groups of people
at work place by addressing their different lifestyles, cultural moorings, family
needs, and work styles. Managing people through melting pot assumption was a
fact till the other day. Now, it is being replaced by one that recognizes and values
differences among workers in organisations. If diversity is managed properly, it
can increase creativity and innovations. On the contrary, diversity, if not managed
properly, can result in higher turnover, heightened inter-personal conflict, and
ineffective communication.

Changing Demographics of Workforce

The demographic characteristics of workforce have undergone changes over the

years. Increasing number of women joining industrial workforce, higher
proportion of young workers, increasing share of aged people in work-force due
to increased life-expectancy, and increasing tendency of husband and wife as
working are the prominent changes occurred in workforce demographics

everywhere in the world including India. Employees with such changing demo-
graphics need to be handled with circumspection.

Changing Employee Expectations

Besides changes in workforce demographics, employee’s expectations and
aspirations have changed from traditional allurement such as job security, good
and attractive remunerations, housing facility to empowerment, equality and
quality of work life (QWL). Employee expectsequality with management.They
emphasis on leading by example.

That a new change in employees' expectation has been shifting them from factory
place to homeis illustrated by a Bangalore based VeriFone:

In this organisation, all the 100 employees used to work with computers at home.
They were linked to the office and customers. Thus, employees' homes turned
into surrogate offices. In the recent years, such paradigm shift has undergone
even in educational field. Under open/distance education system, the student does
not go to the educational institution for learning his/her subject. Instead, the
teacher in such case goes to the student's place through the study material, tele
conferencing, radio broadcast,etc.

That the average worker's expectations have now changed to better treatment,
challenging jobs and career advancements is well evidenced by the voices raised
for these by the workers' unions of Hindustan Lever, Tomco, Blue Star, and
Central Bank in the recent years. That is why monetary incentives alone are not
found sufficient to motivate workers all the times. The manager has, then, to
redraw new methods of motivation such as job design, for example, to motivate
workers to contribute toward accomplishment of organisational goals.

Ever Expanding Globalisation

By now, the whole world has become a global village. Business has crossed the
national boundaries and, thus, has become global, popularly known as 'multi-
national business'. This has made managing men more complex. Globalisation of
business poses at least two major challenges for managers:

First,in case of multi-national companies, the managers are frequently transferred

to other countries. In a new country, the managers have to manage a workforce
that is very different in needs, aspirations, and attitudes from the ones they were
used to back in the former country.

Second, even in their own country, the managers have to work with superiors,
subordinates, and peers who were born and brought up in a different culture, The
managers' problem, then, is whatmotivates them may not motivate others, i.e.,
superiors, subordinates, and peers. For example, the manager may like to adopt
an open and straightforward communication style, but the subordinates may find
the same style as threatening and uncomfortable. In order to manage these people
effectively, the managers need to understand their varying culture accurately and
know how it has shaped as such and then learn to adapt the management styles
accordingly. In sum, the managers need to modify their practices to face the
challenges before them.

Towards Improving Quality

Yet another major challenge before today's managers have to face is offering of
quality products and services to the customers. This is because the delivery of
quality products and services to the customers has a direct impact on the success
of organisations. The ever increasing concern for quality products and services
has given genesis to today's buzzword 'Total Quality Management' (TQM). TQM
is different things to different people and has been both "cussed" and discussed in
the management literature and the actual practice of management. TQM is a
philosophy of modern management that is driven by the constant attainment of
customer satisfaction through the continuous improvement of all organisational
processes. There is no denying of the fact that price, brand loyalty, attractive
design, and technical innovations are still important to consumers in developing
and developed countries, yet the quality of product has surged ahead in relative
importance. Similarly, the delivery of quality services in the ever exploding
service sector has become very critical. The challenge for managers across the
world is, therefore, have human resources to deliver quality to products and
services to the customers and clients.





There may be so many personalities as many persons. Hence, there is no
consensus what personality is. Personality means different things to different
people. To some,it means one'scharm, dress and attractiveness, to others; it
means a unitary mode ofresponse to life situations.

The English word 'personality' has been derived from the Latin word per
sonare.It means 'to speak through'.Originally, the term denoted the masks worn
by the actors in the ancient Greek dramas. In this way, personality is used in
terms of physical attractiveness. However, perceiving personality in terms of
external appearance is in narrow sense. Personality includes something more. Let
us go through some definitions on personality that will help us understand
personality in a proper and better sense.

According to Hilgard et at, "Personality may be understood as the characteristic

patterns of behaviour and modes of thinking that determine a person's adjustment
to the environment".

In the opinion of Ruch, "Personality can be described as how he understands and

views himself and his pattern of inner and outer measurable traits".

Allport has defined personality as:“the dynamic organisation within the

individual of those psycho-physical systems that determine his unique
adjustment to his environment."

Thus, it reflects from above definitions that personality includes both internal and
external aspects of a person. Here, external aspects relate to one's height, weight,
facial features, colour and ether physical aspects and traits. One's attitude, values,
learning etc. are the examples of internal aspects of personality. Of more
importance to organisational behaviour are internal aspects of personality.

Now, personality can be defined as the sum total of ways in which an individual
reacts and interacts with others and environment. In other words, personality is
an organised behaviour of an individual to react to a given stimulus in a set
manner. This is most often in the form of consistent response to environmental

An individual's personality is influenced by the personal life and where he/she is
working. We now, therefore, turn our attention to this aspect of personality.

What determines an individual's personality? Is the personality predetermined at
birth itself? Or is it the result of individual's interaction with one's environment?
Strictly speaking, there is no clear-cut answer to this question. Different thinkers
have listed different determinants of personality. For example, McClelland has
categorised them into four fundamental theories - (i) Traits, (ii) Schema, (iii)
Motives, and (iv) Self Schema. There are others--Scott and Mitchell, who have
classified personality determinants into heredity groups and cultural factors.
However, the various determinants of personality are broadly classified into three
groups, namely, (i) Heredity, (ii) Environment, and (iii) Situation.


Heredity refers to those factors that were determined at conception. Thus,

heredity refers to biological factors. Heredity is the transmission of the qualities
from the parents to the children through a biological mechanism lying in the
chromosomes of the germ cells. Physical stature, facial attractiveness,
temperament, sex, muscle composition and biological rhythms are the examples
of heredity characteristics that are generally influenced by who one's parents are.

Besides, studies on job satisfaction also lend credibility to the argument that
heredity surely plays a role in determining one's personality. Research has proved
that individual job satisfaction remains remarkably stable over time. Not only
that, job satisfaction tends to remain stable even when,employers or occupations

The environment, i.e., one's early conditioning, the family norms, friends and
social groups exerts pressures on one's personality formation. Culture establishes
the norms, attitudes and values that are passed along from generation to
generation. Thus, a cultural consistency is created over time Evidences are
available to believe that the cultural environment in which people are raised
plays major role in shaping personality. For example, in India, children learn
from an early age the values of hard work, frugality and family closeness. The
Indian culture expects different behaviours from males and females.

Home environment generated to a child also exerts important influence in shaping

his/her personality. For example, children reared in orphans or in unstimulating
homes are much more likely to socially and emotionally maladjusted than their
counterparts raised by parents in a warm, loving and stimulating environment.
Research studies have also revealed that parentshave more effect on the
personality development of their children as compared to other members of the
family. Besides parents, siblings (brothers and sisters) also influence shaping of
personality. Elders serve as models for younger’s.

The continuous impact of different social groups called, socialisation process, on

an individual also affects his/her personality development. The socialisation
process starts with the initial contactbetween a mother and her new infant. They
infact gradually come into contact with the social groups outside home/family
such as peers, school friends, and the members of the work group. The
socialisation process is, thus, not confined to early childhood; rather it takes place
throughout one's life. Organisation itself also contributes much to socialisation.
On the whole this socialisation process influences one's personality development.

No doubt, both heredity and environment are the primary determinants of
personality. But there is a third factor also, i.e., the situation, that influences the
effects of heredity environment on personality. In practice, an individual's
personality does change depending on the situation. This is because the different
demands of the different situations call forth different aspects of one's
personality. As an example, the same person while facing an employment
interview and while enjoying picnic with his/her friends in a public park behaves
quite differently depending on two different situations.

Situation, in fact, exerts an important pressure on the individual to behave in a

particular manner. In certain cases, how one will behave is not determined by
what kind of person is, but by in which kind of situation one is placed. There
may be, for example, a worker whose personality history suggests that he had
need for power and achievement. But, when the same worker is placed in a
highly bureaucratised work situation, may feel frustrated and behave
apathetically or aggressively. This clearly indicates that his personality changed
under changed situation.

However, it is difficult, if not impossible, to state the exact impact of various

type; situations exert on one's personality. Nonetheless, it can safely be
mentioned that certain situations are more relevant than others in influencing
personality. Hence, personality needs to be looked at situational context, not in

As stated earlier, there are so many personalities as many are persons.
Personalities differ in traits. A trait is any distinguishable, relatively enduring
way in which one individual differ from another. Though behavioural researchers

have attempted to identify the personality traits; the 16 traits reported by
Cattellare generally accepted ones. These are:

1 Reserved vs Outgoing
2 Less Intelligent VS More Intelligent
3 Affected by Feeling VS Emotionally Stable
4 Submissive VS Dominant
5 Serious VS Happy-Go-Lucky
6 Expedient vs Conscientious
7 Timid vs Venturesome
8 Tough-Minded vs Sensitive
9 Trusting vs Suspicious
10 Practical vs Imaginative
11 Forthright vs Shrewd
12 Self assured vs Apprehensive
13 Conservative vs Experimenting
14 Group dependent vs Self sufficient
15 Uncontrolled vs Controlled
16 Relaxed vs Tense
Sixteen Primary Traits of Personality

Groups of above traits serve as basis for classifying personalities in to types.

Based on these groups, following are the main types of personalities:

1. Introvert and Extrovert Personalities

2. Type A and Type B Personalities
3. Judging and Perceptive Personalities.

Let us discuss what each of these types means.

Introvert Personalities:Introvert is one of the two basic orientations of people

have. Persons with introvert orientation are primarily oriented to the subjective
world. Such peoplelook inward and experience and process their thoughts and
ideas within themselves. They also avoid social contacts and initiating interaction
with other group mates, withdrawn, quiet and enjoy solitude. People with
introvert personality are found more inclined to excel at tasks that require
thought and analytical skill.

Extrovert Personalities:Simply speaking, extroverts are just contrary to

introverts. Extroverts are friendly, sociable, lively, gregarious, aggressive and
expressing their feelings andideas openly. Accordingly, they are more suitable
and successful for the positions that require considerable interaction with others.
Sales activities, publicity departments, personal relational unit, etc. are the
examples of activities suitable for extroverts.

Look at following Table and see how introverts differ from extroverts.

Introverts:Like quiet for concentration

• Tend to be careful with details,dislike sweeping statements

• Have trouble remembering namesand faces.
• Like to think a lot before they act, sometimes without acting
• Work contentedly alone.
• Have some problems communicating
• Tend not to mind working on one projectfor a long time uninterruptedly.
• Dislike telephone intrusions andinterruptions.


• Like variety of action.

• Tend to work faster, dislike complicated procedure
• Are often good at greeting people.
• Often act quickly, sometimes without thinking.
• Like to have people around.
• Usually communicate freely.
• Are often impatient with long slow jobs
• Often do not mind interruptions of answering the telephone.
Validity of results has showed that introvert/extrovert is applicable to only the
rare extremes. The fact remains that most of the people really tend to be neither
introverts nor extroverts, but ambiverts. That is, they are in between introversion
and extroversion.

Type APersonality:Type A people are characterised by hard-working, highly

achievement-oriented, impatient, have sense of time urgency, aggressive, with
competitive drive, etc. Such people tend to be very productive and work very
hard. In fact, they are workaholics. Beingimpatient and aggressive, such people
are more prone to heart attack.

Type BPersonalities:Easy-going, sociable, free from urgency of time, laid-back

and noncompetitive are the characteristics of Type B personalities. Such people
do better on taskinvolving judgments, accuracy rather than speed and team work.

Judging Personalities: People with judging personality types like to follow a

plan, make decisions and need only that what is essential for their work.

Perceptive Personalities: These are the people who adapt well to change, want
to know about a job and at times may get overcommitted. Go through the

folllowing table, it will help you understand better about the two types of

Judging Type Perceptive Type

Work best when they can plan work

and follow the plan. Adapt well to changing situations.

Do not mind leaving things open for

Like to get things settled.

May decide things too quickly May have trouble making decisions.

May not notice new things that need to May start too many projects and have
be done difficulty in finishing them.

Want only essential things needed to

Want to know all about their work.
begin their work

Tend to be satisfied once they reach a Tend to be curious and welcome new
judgement on a thing or situation or information on a thing or a situation
person or a person.


By now, you have learnt various personality attributes and traits that help predict
one's behaviour. In this section, you will learn how some of the attributes
influence an individual's behaviour in organisations. Some of more important
personality attributes that determine how onewill behave are locus of control,
machiavellianism, self-esteem, self-monitoring, risk-takingpropensity and Type
A personality. These are discussed one by one.

Locus of Control:
Locus of control refers to one's belief that what happens is either within one’s
control or beyond one's control. The former is called internals and the latter is
called externals. Those who have internal locus of control believe that they are
masters of their own fate. On the contrary, those who have external locus of
control see themselves as pawns of fate and believe that what happens to them in
their lives is due to luck or factors beyond their control.

A large amount of research comparing internals with externals have proved that
externals are less satisfied with their jobs and have higher absenteeism rates than
internals. But, the dissatisfied internals are more likely to quit a dissatisfying job.


The personality characteristic of Machiavellianism (Mach) is named after

Niccolo Machiavelli who wrote in the sixteenth century about how to gain and
manipulate power. Thus, Machiavellianism refers to an individual's propensity to
manipultate people for solving his/her interest. An individual high in
Machiavellianism tends to be cool, logical and assessing the system around him,
pragmatic, maintains emotional distance, tries to control people, events and
situationby manipulating the system to his advantage. In sum, "if it works, use it"
is consistent with a highMachiavellianism. They manipulate more, win more, are
persuaded less and persuade others more than do individuals having low
Machiavellianism. However, these high outcomes are moderatedby situational

However, the Machiavellianism can be considered as good in jobs that need

bargainingskill(for example, labour negotiations) or in jobs offering substantial
rewards for winning (such ascommissioned sale). But, in jobs where ends cannot
justify the means i.e. in jobs ethical consideration isinvolved, the
Machiavellianism cannot perform better.

An individual's liking or disliking oneself is callled self-esteem. This trait is
bound to vary from individual to individual. Self-esteem is related to aspects
individuals regard themselves as capable to achieve success. The research on
self-esteem has revealed that individuals with high self esteem tend to take on
more challenging assignments and of unconventional nature. People with low
self-esteem, on the contrary, are characterised by their susceptibility to external
influences and approval seekers from others. They depend on the receipt of
positive evaluations from others. As regards job satisfaction, individuals with
high-self-esteem are found more satisfied with their jobs than those with low

Self-monitoring is a personality trait that has recently received increasing
attention. Simply speaking, self-monitoring is an individual's ability to adjust
his/her behaviour to external factors/situations. Individuals with high self-
monitoring trait show greater adaptability to adjust themselves with external
situations. They can behave differently in different situations. Hence, there is
very less behavioural consistency between who they are and what they do. It can
be hypothesised that individuals high in self-monitoring are likely to be more
successful managers who at times are required to play multiple, and even
contradicting roles to perform their managerial activities. In other words,
individuals with high self-monitors are capable of showing different faces for
different audiences as per the requirements of the situations.

Individuals differ in taking risks. The propensity to assume or avoid risks affects
a manager's behaviour in making decisions. Research has shown that managers
with high risk-taking make more rapid decisions and use less information in
making choices than do the low risk-taking managers. In practice, the propensity
to assume risks varies depending upon the nature of the job. For example, a high
risk-taking propensity may be good for a stock trader in a brokerage firm which
demands rapid decision-making. But, the same personality trait may not be
considered as good in auditing activities which require concentration and low
risk-taking propensity.

Type A Personality:
You have already learnt under title, Types of Personality who; type A
Personalities are? In brief, type A people are impatient and aggressive to achieve
more and more in less and less time. These characteristics result in some specific
behavioural outcomes. Working fast, emphasizing quantity over quality, working
for long hours, making quick decisions etc., are some of the behavioural
examples of Type A people.

In organisations, great salespersons are usually Type A's. The reason is,sales
occur in a competitive market which requires rigorous and aggressive efforts to
sell one's product. But senior executives are usually Type B's. The answer lies in
the fact that promotions in corporate organisations usually go to those who are
wise, tactful and creative rather than to those who are merely hasty and hostile in
doing things.

The Myers-Briggs Type Indicator

One of the most widely used personality frameworks is called the Myers-Briggs
Type Indicator (MBTI).It is essentially a 100-question personality test that asks
people how they usually feel or act in particular situations.

On the basis of the answers individuals give to the test, they are classified as
extroverted or introverted (E or I), sensing or intuitive (S or N), thinking or
feeling (Tor F), and perceiving or judging (P or J). These classifications are then
combined into 16 personality types. (These types are different from the 16
primary traits.) To illustrate, let's take several examples. INTJs are visionaries.
They usually have original minds and great drive for their own ideas and
purposes. They are characterized as skeptical, critical, independent, determined,
and often stubborn. ESTJs are organizers. They are realistic, logical, analytical,
decisive, and have a natural head for business or mechanics. They like to
organize and run activities. The ENTP type is a conceptualizer. He or she is
innovative, individualistic, versatile, and attracted to entrepreneurial ideas. This
person tends to be resourceful in solving challenging problems but may neglect
routine assignments. A recent book that profiled 13 contemporary businesspeople
who created super successful firms including Apple Computer, Federal Express,
Honda Motors, Microsoft, Price Club, and Sony found that all 13 are intuitive
thinkers (NTs).This result is particularly interesting because intuitive thinkers
represent only about 5 percent of the population.

More than 2 million people a year take the MBTI in the United States alone.
Organizations using the MBTI include Apple Computer, AT&T, Citicorp,
Exxon, GE, 3M Co., plus many hospitals, educational institutions, and even the
U.S. Armed Forces.

Ironically, there is no hard evidence that the MBTI is a valid measure of per-
sonality. But lack of evidence doesn't seem to deter its use in a wide range of or-

The Big Five Model

MBTI may lack valid supporting evidence, but that can't be said for the five-
factor model of personality—more typically called the Big Five. In recent years,
an impressive body of research supports that five basic dimensions underlie all
others and encompass most of the significant variation in human personality. The
Big Five factors are:

■ Extraversion.This dimension captures one's comfort level with relationships.

Extraverts tend to be gregarious, assertive, and sociable. Introverts tend to be
reserved, timid, and quiet.

■ Agreeableness.This dimension refers to an individual's propensity to defer to

others. Highly agreeable people are cooperative, warm, and trusting. People who
score low on agreeableness are cold, disagreeable, and antagonistic.

■ Conscientiousness.This dimension is a measure of reliability. A highly consci-

entious person is responsible, organized, dependable, and persistent. Those who
score low on this dimension are easily distracted, disorganized, and unreliable.

■ Emotional stability.This dimension taps a person's ability to withstand stress.

People with positive emotional stability tend to be calm, self-confident, and
secure. Those with highly negative scores tend to be nervous, anxious, depressed,
and insecure.

■ Openness to experience.The final dimension addresses an individual's range

of interests and fascination with novelty. Extremely open people are creative,
curious, and artistically sensitive. Those at the other end of the openness category
are conventional and find comfort in the familiar.

In addition to providing a unifying personality framework, research on the Big

Five also has found important relationships between these personality
dimensions and job performance. A broad spectrum of occupations was ex
amined: professionals (including engineers, architects, accountants, attorneys),:
police, managers, salespeople, and semiskilled and skilled employees. Job per-
formance was defined in terms of performance ratings, training proficiency
(performance during training programs), and personnel data such as salary level.
The results showed that conscientiousness predicted job performance for all
occupational groups. The preponderance of evidence shows that individuals who
are dependable, reliable, careful, thorough, able to plan, organized, hardworking,
persistent, and achievement-oriented tend to have higher job performance in
most if not all occupations." In addition, employees who score more highly in
conscientiousness develop higher levels of job knowledge, probably because
highly conscientious people exert greater levels of effort on their job. The higher
levels of job knowledge then contribute to higher levels of job performance.
Consistent with these findings, evidence also finds a relatively strong and
consistent relationship between conscientiousness and organizational citizenship

For the other personality dimensions, predictability depended upon both the
performance criterion and the occupational group. For instance, extraversion
predicted performance in managerial and sales positions. This finding makes
sense since these occupations involve high social interaction. Similarly, openness
to experience was found to be important in predicting training proficiency,
which, too, seems logical, What wasn't so clear was why positive emotional
stability wasn't related to job performance. Intuitively, it would seem that people
who are calm and secure would do better on almost all jobs than people who are
anxious and insecure. The researchers suggested that the answer might be that
only people who have fairly high scores on emotional stability retain their jobs.



Meaning of Attitudes
Attitudes are another type of individual differences that affects the behaviour of a
person. In a simple way attitudes can be referred to as evaluative statements
which may either be favourable or unfavourable regarding people, objects or
events.Attitudes are reflections about how one feel about someone or something.

Attitudes can be defined as relatively lasting feelings, beliefs and behavioural

tendency directed towards specific people, groups, ideas, issues or objects.

Usually attitudes reflect an individual's background and experiences. The attitude

is formed due to the strong influence of significant people in a person's life like
elders, parents, friend’s members of social and work groups.

Nature and Dimensions of Attitudes

Attitudes are often used to describe people and explain their behaviour. When
people m statements such as "I like her attitude" or say "Our sales persons are
able to meet their t because they have positive attitude" — they are clearly
referring to attitudes.

If one studies the following statements with reference to attitudes it will be easy
to understand its (attitudes) nature and dimensions.

• Attitude is a continuous tendency to feel and behave in a specific way towards

some object.
• Every person holds attitudes towards an object/person, irrespective of their
status intelligence.
• Attitudes tend to continue unless something is done to change them.
• Attitudes generally can fall anywhere along a continuum between extremely
favourable to extremely unfavourable.
• Attitudes are aimed at some object about which the person has some associated

Thus attitudes are unique to the individual and also affect their behaviour. When
one makes biased evaluative statements such as, "He is from a poor family and is
likely to have stolen the money which is lost". This statement is made in
prejudice and accusing a person without evidence can also be a prejudiced
attitude. Before one seeks the reasons for formation of attitudes it may be
understood that some evidence has pointed to genetic influences on the attitudes
that people develop.

Types of Job Attitudes

A person can have several attitudes but in Organisational Behaviour we are more
interested in understanding the job related attitudes. Such job related attitudes
will reveal about the positive or negative evaluations that employees possess
about the various aspects of their work environment.

In Organisational Behaviour there are three work related attitudes, namely — job
satisfaction, jobinvolvement and organisational commitment.

Job Satisfaction
Job satisfaction is all about how one feels about (or towards) one's job. An
employee who expresses satisfaction is said to have a positive attitude towards
the job, unlike a dissatisfied employee who has a negative attitude towards the
job. A person having negative attitude shows a personality disposition which is
inclined to experience nervousness, tension, worry, upset and distress, whereas
those with positive attitude will feel happy with themselves, others and their

Job Involvement
This refers to the extent to which an individual identifies psychologically with
his or her job and will try to perform the job to the best of his or her ability.A
higher level of job involvement results in a display of positive disposition
towards his/her job, subordinates, colleagues, superiors and derive a pleasurable
and positive attitudes from performing their job. Higher degree of job
involvement also ensures lesser rate of absenteeism and lower labour turnover.

Organisational Commitment
This can be visible in how the employee has identified (in thought and action)
with the organisation, its goals and vision and is also proud to be a part of the
organisation. An employee with a high degree of organisational commitment will
possess a sense of well-being towards the organisation and take pleasure and be
effectively engaged in his work and achieving the firms' goals.

Components of Attitudes
Attitudes can be broken down into three components — emotional, informational
and behavioural. It is said that these three components do not exist or function
separately. This is because 'an attitude' represents the interplay of an individual's
affective, cognitive and behavioural tendencies with regard to something which
could be — another person or group or event or even an issue.

(a)Emotional componentof attitude is with reference to a person's feelings or

affect about anobject which may be positive, negative or neutral. The emotional
component is givena lot of emphasis in Organisational Behaviour especially in
relation to job satisfaction. Whenwe talk of work related behaviour, the emotions
expressed by employees can be:Positive, Negative, and Neutral

(b) The informational componentof attitude will include all the beliefs the
person may have about the person or object. For instance, the sales manager may
believe that his sales team should be able to meet the monthly target of Rs. 4
lakhs worth of products, even though in reality, with the combined efforts of all
the members team may be able to meet a target of Rs. 2.75 — Rs. 3 lakhs only.
Thus it may be noted that the information which the sales manager has about his
teams, capability to perform, though not exact, is indicative of his attitude
towards achieving the target.

(c) The behavioural componentof attitude refers to the person's tendency to

behave in a particular manner towards the object or person. For instance, in the
above example, the sales manager may put pressure on his team members to
meet the target of Rs. 4 lakhs (per month).

Of the three components of attitudes, we are only able to observe and see the
behavioural component of an individual. One cannot see other people's feelings
(or emotions) nor the informational component. These two components can only
be derived at. Let us refer to the above example once again. We have presumed
that the sales manager pressurizes his team to meet the target of Rs. 4 lakhs (per
month), and then two conclusions can be drawn—

• Firstly, the sales manager feels very strongly about his team achieving the
monthly target.
• Secondly, the sales manager believes that achieving the sales target of Rs. 4
lakhs is necessary.

Thus taking a view of attitudes as comprising of the above three components will
be helpful in gaining an understanding of their complexity and the potential
relationship between attitudes and the individual's behaviour.

Functions of Attitudes
In organisational behaviour it is necessary to study the various functions of
attitudes mainly because:

• Attitudes are important predictors of work behaviour.

• Understanding of attitudes will help people to adapt to their working

For instance, if the firm's management tries to impose certain modified rules
related to their (employees) coming late to the factory premises and this is
followed by an increase in absence of the workers; the management may infer
that such occurrences are due to the workers' negative attitude towards the new
regulations. According to Katz (Daniel Katz, 'The Functional Approach to the
study of Attitudes, 1960) attitudes serve four significant functions, which are as

(a) The Adjustment Function
Attitudes help employees to adjust to their work environment. For instance,
Nagesh is a supervisor at the Garment factory. He is well liked by his
subordinates because he treats them well — they are free to discuss their work
related or personal problems with him and not only will he give them
(subordinates) a patient hearing but also try to solve them. The result is visible in
the form of the workers' positive attitude towards work. Conversely, if Nagesh
were not to treat his subordinates well, it is likely that they may develop a
negative attitudetowards work. Thus the adjustmentfunction of attitudes helps
employees to adjust,to their environment and form the basis for future behaviour.

(b) The Ego-defensive Function

Attitudes also help individuals in defending their self image. For instance,
Prakash is a manager (working since many years with the firm) who feels
threatened when Yash joins as an assistant manager. This is because Yash
continuously challenges the decisions of Prakash, who feels that Yash is
arrogant, immature and impolite. But the reality may be that Prakash is
ineffectivein his decision making. However, Prakash refuses to accept this and
will instead blame Yash. As a result Prakash develops a negative attitude towards
Yash and even Yash feels that his boss (Prakash) is not doing his job properly.

From the above example we can see that attitude formation helps people to
protect their own ego. For, were Yash to change his perception and believe that
Prakash is doing a good job then he will stop criticizing his boss. But since, he
was against doing this, his attitude helps him to justify the action and protect his

(c) The Value Expressive Function

Attitudes provide the basis for people to express their values. For instance, a
senior executive with a firm, who believes in work ethics, will be very vocal and
expressive about his upheld attitudes toward specific individuals or work
practices in order to emphasise these values. Similarly, the head of the HRD
department while addressing fresh recruits may say We (the company) have
reached this enviable position in the industry only through sheer hard work. And
as a company we firmly believe in this, so all of you who have joined us recently
must also be ready to put 'hard work' into practice." This example clearly serves
as a means to express one's (company's and senior executive's) core values.

d) The Knowledge Function

This function of attitudes provides standards and frames of reference by which
people are able to organise and make meaning or explanation of the world
around them. For instance, usually the trade union leaders of companies have a
negative attitude towards the company management. This attitude may not be
arrived at based on pure facts but it definitely enables the trade union leader to
relate to the management in a particular way. As a result, whatever the
management may have to communicate with the workers, the union leader may
not want to believe in it. This attitude may be seen as a manipulation or distortion
of facts by the management. But however, accurate or precise a person's view
may be of reality, it will be his or her attitude towards other persons, objects or
events which will help them to make sense of what is going on around them.


Is it possible to use attitudes to predict or cause behaviour? In the past,
behavioural scientists had contended that individuals' behaviour are consistent
with their attitudes. But now they have accepted that there frequently does not
exist a simple and direct link between attitudes and behaviour. This can be
explained with an example. Sandeep was thrilled when he received a call letter
for interview for the post of a technical trainee from the Nuclear Power
Corporation (say). When his turn for the interview came, he may recall that he
was against (has negative attitude) the use of nuclear power. So he suddenly,
might develop an intense dislike for the personnel manager interviewing him
based on his beliefs and opinions about the category of people who would work
for such a company. Yet, ultimately, he decides against displaying a negative
attitude and refusing the job offer.

The various reasons for Sandeep not acting on his original attitude may be:

• He was desperately seeking a job.

• His upbringing of desirous norms of courteous behaviour outweighs his desire
to display a negative attitude.
• Feels he may be looked up if he works for such a big and reputed company.
• He acknowledges (inwardly) the possibility of not having complete
• He decides not to make the interviewer the target for his negative attitude.

Even though it may be difficult, three principles have been suggested to improve
the accuracy of predicting behaviour from attitudes.
1. General attitudes best predict general behaviours.
2. Specific attitudes best predict specific behaviours.
3. Lesser the time that elapses between attitude measurement and behaviour,
there will bemore consistency between the relationship between attitude and


In organisational behaviour, job satisfaction is the most important and frequently
studied altitude. What is after all the meaning of job satisfaction? What
determines job satisfaction? How is job satisfaction measured? What are its
effects on employee productivity, absenteeism, and turnover rates?

Concept of Job Satisfaction

Job satisfaction is a positive attitude toward one's job. A few important
definitions on job satisfaction are produced here.

According to Feldman and Arnold, "Job satisfaction will be defined as the

amount of overall positive affect (or feelings) that individuals have towards their

Locke defined job satisfaction as "a pleasurable or positive emotional state

resulting from the appraisal of one's job or job experience."

In the opinion of Davis and Newstrom, "Job satisfaction is a set of favourable or

unfavourable feelings with which employees view their work."

Thus, job satisfaction means good or positive attitude or feeling toward one's job.
It is important to mention that an individual may hold different attitudes toward
various aspects of the job. For example, a university Professor may like his job
responsibilities but be dissatisfied with the opportunities for promotion.
Characteristics of individuals also influence, job satisfaction. Individuals with
high positive affectivity are more likely to be satisfied with their jobs. Reverse is
true for individuals with high negative affectivity.

There are three important dimensions to job satisfaction. These are:

First, job satisfaction being an emotional response to a job, cannot be seen. As

such, it can only be inferred.
Second, job satisfaction is often determined by how satisfactorily outcomes meet
or exceed one's expectations.
Third, job satisfaction represents an employee's attitudes towards five specific
dimensions of the job: pay, the work itself, promotion opportunities, supervision,
and co-workers.

Determinants of Job Satisfaction

What determines job satisfaction? The evidence from research studies indicates
that the more important elements that contribute to job satisfaction are:

Nature of Work:Most employees crave intellectual challenges on their jobs.

Therefore, they prefer to jobs that offer them challenges and an opportunity to
use their skills and abilities.However, while too much challenge in job creates

frustration and feelings of failure, too littlechallenge causes boredom. In fact, it is
the conditions of moderate challenge in which employees experience pleasure
and satisfaction.

Pay and Promotion:Employees want their pay systems and promotion policies
as unarmbiguous, and in line with their expectations. Accordingly, if they see
pay as fair, based on job demands and employees skill and as per community pay
standards, it results in job satisfaction.

Not surprisingly, employees consider promotions as their ultimate achievements

in their careers. When they achieve it, they feel satisfied with their jobs. Besides,
promotions made on a fair and just manner are also likely to create job
satisfaction for the employees.

Quality Supervision:Quality or supportive supervision establishes cordial and

supportive personal relationship with subordinates and takes interest in
subordinates well being. Such characteristics of supervision create satisfaction
for employees on their jobs.
Supportive Colleagues:Experience shows that employees get more out of work
than only money or tangible achievements. It happens so primarily by having
opportunities for interactionwith colleagues. Thus, work team fills the need for
social interaction. Thus, having supportive colleagues also leads to employees
job satisfaction.

Conducive Working Conditions:Employees are concerned with their work

environment for both personal comfort and facilitating doing a job. Therefore,
the physical surroundings that are safe, clean, comfortable and with a minimum
degree of distractions result in a good or positive feeling towards their jobs. The
good feeling toward one's job reflects his/her job satisfaction.

Measuring job satisfaction

Like attitudes, there are a number of ways of measuring job satisfaction. The
most common waysof measuring job satisfaction are: (1) Single Global Rating,
and (2) Summation Score.

Single Global Rating:

As implied from the terms, under single global rating, the employees are asked to
respond to one question. An example of single question may be : "Considering
all the dimensions of the job, how satisfied are you with your job?" Employees
need to respond reporting "a figure" based on rating scale. Rating scales are from
1 to 5 as follows:

1. Highly Dissatisfied
2. Dissatisfied
3. No comment
4. Satisfied
5. Highly Satisfied

Thus, the rating, based on above scale, to a question given by the employee is a
reflection of magnitude or measurement of employee's job attitude toward his/her

Summation Score:
The summation score considers employees attitudes towards the various aspects
of the job. The important aspects of the job that would be included for rating
score the nature of the work itself, supervision, pay, promotion opportunities, and
relationship with workers. The scores given to each of these aspects are then
added up to create an overall satisfaction score of an individual employee.

One may ask an obvious question: Which one of the two approaches discussed
above is better or superior? It can be said, at least intuitively, that the second, i.e.
summation score is likely to give a more accurate evaluation of job satisfaction
because it covers all important aspects of the job. But, given the broad and
inherent concept of job, the single-question global rating becomes a more
inclusive measure of job satisfaction. This may be one of those rare instances in
which simplicity (single rating) wins out over complexity (several ratings). The
following are some more ways of measuring job satisfaction:

Interviews:This is yet another method of measuring job satisfaction. Under this

method employees are interviewed personally. The responses given by them
reveal their satisfaction dissatisfaction towards their jobs.

Action Tendencies:Under this method, information is gathered about how the

employees were inclined to avoid or join certain things relating to their jobs. This
reflects their satisfaction or dissatisfaction.

Critical Incidents:This method is based on Herzberg'stwo-factor theory of

motivation. In this approach, employees are asked to identify the specific
incidents on their jobs in which they were particularly satisfied or dissatisfied.
These incidents are further analysed to ascertain the aspects which were closely
related to positive and negative attitudes of the employees towards incidents so

Effects of Job Satisfaction

What are the effects of job satisfaction on employees Productivity, absenteeism,
and turnover rates? The following sections examine the same.

On Productivity:
Are satisfied workers more productive than their less satisfied counterparts.
Though research evidence does not establish any consistent positive relationship
betweensatisfaction and performance, the general consensus is that, in the long
run if not in short-run, job satisfaction will lead to increasedproductivity.
Research evidence indicates that the satisfied work will not be necessarily be the
highest producers. In fact, the rewards employees receive results in greater
performance. There is also evidence to suggest that job performance leads tojob
satisfaction and not the other way around.

On Absenteeism:
There is a reverse relationship between satisfaction and absenteeism. When
satisfaction is high absenteeism tends to be low and vice versa. Ahigh degree of
job satisfaction will not necessarily result in low absenteeism, while a low level
of job satisfaction is likely to bring about high absenteeism.

On Turnover:
Like between satisfaction and absenteeism, an inverse relationship, though at a
moderate level, has been established between satisfaction and turnover. However
there are other moderating factors as well influencing the employee’s turnover
rates. Commitment to the organization is one such factor. There may be some
employees who cannot see themselves working anywhere else, so they remain in
the organization, regardless of how much dissatisfied they feel in the
organization. Similarly if the condition of economy is such that people find it
tough to get job, even the dissatisfied ones will stay where they are. If green
pastures are available,employees do not mind going in search of them, even
when they are satisfied with their existing jobs.

Other effects of job satisfaction:

1. Employees with high job satisfaction tend to have better mental and physical
2. They learn new job related tasks more easily and quickly.
3. They commit less mistakes including on the job accidents.
4. They have & file less grievances about the job and the management.
5. Last but not the least, the satisfied employees tend to show true social
attitude towards their co-workers & customers.




Perception is the selection and organization of environmental stimuli to provide
meaningful experiences for the perceiver. Perception implicates the search for,
obtaining and processing of the information in the mind. It can also be referred to
as a psychological process where people obtain (or take) information from the
environment and make sense of their worlds.

Very often two people who have seen the same thing end up interpreting it
differently. The reason for such an occurrence is because of the involvement of
an extremely complex cognitive process mentioned above — perception. Each
person has a unique perception resulting in individual differences in
processinginformation which is received.Perception plays a very important role
in shaping the personality of an individual. Since through the process of
perception individuals organise and interpret their sensory impressions so as to
provide meaning to their environment, it is possible that what is perceived by the
individual may be quite different from actual reality. Forexample.

The college lecturer, based on his perception that an intelligent, though naughty
student, will enjoy working on a challenging assignment will ask him to work on
a tricky assignment. On the other hand the student may not be feeling the same
way and would have preferred working on an easy assignment. So when he is
given the tough assignment, he may interpret that his lecturer is punishing him.
Whereas, the lecturer's perception and belief is that he is motivating his student
by asking him to work on a challenging assignment. Thus perception can very
often lead to complications and problems in real situations.

We will take another example. For instance, say the Corporation Bank may
decide to offer VRS (Voluntary Retirement Scheme) to some of its employees.
These employees may perceive this offer differently. They may believe this is an
attempt on the part of the management to get rid of them, whereas the
management and organisation is merely undertaking such an exercise for the
purpose of cost cutting and manpower reduction. Thus through the process of
perception the individual will organise and interpret his sensory impressions so
as to give meaning to his environment. In other words, the importance of
perception can be viewed from an individual's behaviour which emanates from
his or her perception of the reality.

The Basic Elements in the Perceptual Process

It has been noted that often different people perceive a situation differently, in
Terms of what is selectively perceived by them. In the figure below a summary
of the basic elements in the perceptual process starting from the initial
observation to final response is given.

Environmental Stimuli
Could be objects or people or events in Observation(Senses)
the immediate environment
• Taste
• Smell
• Hearing
• Sight
• Touch
Perceptual Selection
Perceptual Organisation
External Factors Internal Factors
Size Personality • Perceptual Grouping
Intensity Learning • Continuity
Contrast Motivation
• Proximity
Repetition • Closure
Novelty • Similarity


Perceptual errors Attribution Response

Perceptual defense Internal Vs
External Covert Overt
Stereotyping Causes for Attitudes Behaviour
success and Motivations Feelings
Halo Effect
Expentancy Effects


Individuals receive stimuli from the environment through their five senses
namely, taste/ smell/ hearing/ sight/ touch. There is a tendency to selectively pay
attention to certain aspects of the environment. In other words, a person’s
perceptual selection may be on account of the interplay of a complex setof
factors, some are internal factors while some form apart of external factors.
Say,for instance the personal secretary to the manager may ignore the sounds of
other employees talking but jumps or becomes alert as soon as the telephone
starts ringing.

The next step involves the perceptual organisation Since there will be variations
in how people interpret , what they perceive that is the person organises the
stimuli selected into meaningful pattern depending upon the circumstances and
the state of mind of those involved.

For instance, a firm handshake between the union leader and the personal
manager may be interpreted as friendly gesture from the manager to look into
their problems or that the union leader has joined hands with the management
against them (the workers). Thus while studying Organisational Behaviour
understanding of perception is important especially because perception of events
and behaviours:

•Will vary among employees (individually) and

•May be inaccurate also.

As shown in above figure an individual's interpretationof the sensory organs will

lead to a responsewhich may be overt (actions), covert (motivation, attitudes and
feelings) or both. Since each person selectively organises the sensory stimuli
received, there could be different interpretations and responses. Thus knowing of
perceptual differences can help explain why people behave differently in the
same situation.


It has been understood that each one of us may see the same person, object or
event and yet think of it differently. Supposing you visit an arts and craft
exhibition, took a look around and then ask your friend also to visit the exhibition.
Later on, when you exchange notes with your friend, you will be surprised to note
that your friend's views and expressions about the display differ significantly.
Why is this so? This occurs because of the influence of several factors on
perception. Usually individual's are involved in a process of perceptual selection
whereby people filter out most stimuli so that they can deal with the most
important ones. This process depends on several factors; let us have a look at
those factors which affect the perceptual process.

1. The Perceiver
• The understanding of what a person interprets when looking at the object or
target being perceived will be influenced by the personal traits of the individual
who perceives this.

For instance, we presume an individual is planning to purchase a car then it is

observed that he starts noticing other brands of cars (falling within his budget)
with more interest. Of course, this results in the purchase of a particular brand of
car which is influenced by his perception. And this is how factors associated with
the perceiver can greatly influence his or her perceptual process.

• Attitude influences a person's perception

We can take an example, Suma and Uma are two friends who have cleared their
bachelor's degree in management and are interested in pursuing further studies
and get into reputed Business Management institutes for obtaining a M.B.A.
degree. In order to improve their personality, both of them get enrolled; into a
well-known Personality Development Centre. Suma enjoys interacting in a small
group because of personal interaction between the lecturer and the student group.
However, Uma basically being an introvert preferred to be a part of a large group
so as to enjoy anonymity amidst the group. When both Suma and Uma sat down
for the first session on 'personality development', with a class of fifty students.
Suma seemed unhappy to be amidst a large class while Uma looked relieved to
be able to merge unnoticed into the large class. This example reveals that both
Suma and Uma saw the same thing but interpreted it differently.

• Unsatisfied needs or motives influence an individual's perception strongly

The particular aspect was highlighted in a study with hungry subjects. This
research study revealed that people who had been hungry for as long as 16 hours
saw more frequently images of food when they were shown blurred pictures in
comparison to those who had been hungry only for a short time.

• The perceptual process can also be influenced by one's interests

For instance, a fashion designer is more likely to notice a beautiful outfit worn by
a girl crossing the road rather than the traffic policeman. This can be because his
chosen profession has narrowed down his focus.

• One's experience in the past can also narrow down one's focus. And newness or
novelty also influences perception

An individual has the tendency to perceive those things (or objects) to which he
or she can relate. But very often one's past experience may reduce or nullify an
object's interest.

In India, the breaking away of the joint family set-up and making way to the
working couple nuclear family set up had not been easily accepted by the society
especially during the 70's and 80's of the 20th century. However, from the 90's
onwards with a significant increase in the number of women joining industries
and also occupying senior managerial positions, there is a gradual change and
people's negative perception/views/apprehensions about women executives is
slowing taking a back seat.

• Expectations also influence an individual's perception

At times expectations can also distort one's perception such that if we expect to
see something we may actually end up seeing that. For instance, if we expect
lawyers to be unscrupulous, politicians to be corrupt, youngsters to be rude and
so on, we will perceive them to be so, totally ignoring the individual's real traits.

2. The Target
Perception is impacted by the motion, sound, size and other such characteristics
of the target. This usually occurs because the target is not perceived in isolation
but along with its background. Moreover, we have a tendency to group close
things and similar things together.

• What one sees and perceives (observes) will generally depend on how one
separates the figure from its general background

For instance, when the lecturer uses the blackboard for teaching and for writing
uses white chalk pieces, the students are not seeing them as patches of white chalk
but will recognise each alphabet and see the words accordingly.

• At times even physical and time proximity makes one put together objects or
targets even when they are unrelated

For instance, recently we have been hearing of plane crashes, involving fighter
planes and domestic plane carriers. Suddenly many people may conclude that it is
dangerous to travel by air. Though the above incidents may be unrelated, their
proximity in time may have led people to develop such unrealistic perceptions
about flying.

• At times people have the tendency to perceive people, objects or events that
are similar to each other also as being grouped together

Greater is the similarity, more is the probability of perceiving them as a common

group. For instance, there is a tendency among people in India to perceive that all

foreign tourists (white coloured people) are rich. This perception is based on the
white skin ignoring all the other unrelated traits.

3. The Situation
The context in which we perceive events or objects is also important. There are
elements in our surrounding environment which influence our perception. For
instance, if the Managing Director of a company calls for a meeting with his
General Managers, and on that day a junior manager makes a small mistake, the
General Manager is more likely to register and notice that, which otherwise on
any other normal day would have been overlooked. If, say a person attired in a
dhoti-kurta were to enter the office premises, he is likely to draw more eyes
compared to if he were to be attired in the same dress when walking around in
the compound of his house.

This means that perception is influenced by various situational factors such as

time, location, light, heat etc. These may simultaneously impact the perception
process making it an extremely complex process.

Attribution refers to the tendency one develops to explain the ways in which one
judges other people’s behaviour. Very often we make attempts to understand the
more lasting causes behind others' actions by interpreting their traits, motives and
intentions through the attribution process. Simply stated

Attribution is the complex process in which we observe others' behaviour and try
to infer causes behind it from various areas.

With reference to social perception there are types of attributions which people
generally tend to make.

These are:

(a) Dispositional attributions(such as personality traits, motivation or ability) or

internal factors.
(b) Situational attribution(social influence of others, equipments etc.,) or
external factors.

The Attribution theory makes attempts to explain — how individuals when

observing behaviour attempt to determine whether it is (behaviour) internally or
externally caused, based on three factors: (1)Distinctiveness (2)Consensusand
(3)Consistency.There are significant contributions from attribution theories
especially in the areas involving psychological and personality processes like
motivation, performance appraisal and leadership.

Let us take an example in organisation setting. The production manager notices
the outstanding performance of his supervisor, but the assessment of his
performance will depend on the causes on which he attributes this performance.
If he believes that the performance of the supervisor is on virtue of his
competence and inner drive, he may praise him and also reward him. Whereas, if
the production manager believes that the performance is the result of using a
newer and superior technology, then he is likely to treat it in a different manner.
This means that perceptions and the subsequent behaviours change depending
upon whether internal or external situational attributes are made.

Problems in Perception
There are two common problems or errors which affect the social perception
process — Halo effect and Stereotyping.
Halo Effect Error
Evaluation of another person solely on the basis of one attribute, either favorable
or unfavorable is called the Halo Effect. This means the halo effect blinds the
perceiver to take notice of the other attributes which also are to be considered if
evaluation is to obtain a complete and accurate impression of the other person.
Managers have to make efforts to guard against the halo effect especially during a
preliminary interview with a prospective employee or rating an existing
employee's job performance. One trait may be singled out and used for passing
judgment on the performance of the individual/ For instance, the interviewer may
perceive a beautiful candidate to be suitable to be a personal secretary, though
actually she may be a poor typist and bad secretary. Or an excellent attendance
record may indicate perceptions of high productivity, quality work and
industriousness irrespective of whether this is an accurate or not judgmental.
Stereotyping refers to the tendency to assign attributes to a person solely on the
basis of a category of people of which his or she is a member. People have a
tendency to expect someone identified as a doctor, lawyer or politicians to posses
certain positive attributes even if they have met few others who did not have these
Stereotyping often results in attributing favorable or unfavorable traits to the
person being perceived. Very often the person may be aware of only the overall
category to which the person being perceived belongs and is thus put into a
Stereotype. (The perceiver fails to recognize the characteristics that will
distinguish the person as an individual and his unique traits and qualities). For
instance, common man may refer to a politician saying “He is a politician and
hence will be corrupt”. It can be inferred from this statement that what the
common man may want to say was that because he belongs to the class of
politicians he can safely be labeled as “corrupt”.

Stereotyping affects social perceptions in organizations where the most common
stereotyped groups are managers, blue collared workers, supervisors, and
administrative staff and trade union members.
The other common perception errors which affect the perceptual process are:

• Projection – The tendency for individuals to see their own traits in others.
• Expectancy effects—It is the extent to which prior expectations bias
perceptions of events, objects and other persons.

How to improve perception?

More accurate the perception, the better will be the behavior and vice versa.
Perceptions can be improved by making various efforts. The important ones are:

• Perceiving oneself accurately

• Improving one’s self concept
• Be empathetic
• Having Positive Attitudes
• Avoiding Perceptual Distortions
• Communicating Openly


The word 'organisation', among other things, implies where host of individuals
work together for achieving the organisational and individual goals. In this
process, they are always judging each other on a continuous basis. One tries to
evaluate how much effort his/her co-worker is putting into his/her job. Even when
a new worker joins a department, he/she is immediately sized up by the other
departmental workers. The perceptual process, as discussed earlier, suggests how
one judges/assesses others largely depend upon how he/she perceives/understands
them. In this way, perception tends to influence decision-making. Thus,
perceptions, in many cases, have important effect on organisations. Let us look at
a few of the more obvious applications of perception in organisations.

• Employment Interview
• Performance Appraisal
• Performance Expectation
• Employee Effort
• Employee Loyalty


A study on organisational behaviour will remain incomplete without studying

learning. It is for this obvious reason that almost all complex behaviour is learned.
If a manager wants to explain and predict behaviour, he/she needs to understand
how learning occurs or how people learn. Therefore, the purpose of this chapter is
to discuss the nature, theory, and principles of learning. Towards the end,
attempthas also been made to outline the managerial implications of learning.


What is learning? In simple words, learning is a change in behaviour as a result of

experience. Different psychologists and behavioural scientists have defined
learning differently. Given below are important definitions of learning.

According to Stephen P. Robbins, "Learning is any relatively permanent change

in behaviour thatoccurs as a result of experience."

Munn have defined learning as "The process of having one's behaviour modified,
more or less permanently, by what he does and the consequences of his action, or
by what he observes".

In the opinion of Steers and Porter, "Learning can be defined as relatively

permanent change in behaviour potentiality that results from reinforced practice
or experience."

Now, on an overall basis, learning can be defined as a change in behaviour

acquired through experience.

The above definitions of learning reveal several componentsthat deserve


First, Learning involves change,be it good or bad.

Second,the change in behaviour must be relatively permanent.For that matter, a

temporary change in behaviour as a result of fatigue or temporary adaptations are
not considered learning.

Third,only change in behaviour acquired through experienceis considered

learning. Therefore, a change in individual's thought process or attitudes, if
accompanied by no change in behaviour, would not be learning. For example, the
ability to work that is based on maturation, disease, or physical damages would
not be considered learning.

Fourth,some form of experience is necessary for learning.Experience may be

acquired directly through practice or observation or indirectly, as through

Finally,learning is not confined to our schooling only. As a matter of fact,

learning is a life-long process.


Now, let us understand what determines change in behaviour i.e., learning. The
important factors that determine learning are motive, stimuli, response,
reinforcement, and retention. A brief description of these follows:


Motives also called drives prompt people to action. They are the primary
energisers of behaviour. They are the ways of behaviour and mainsprings of
action. They are largely subjective and represent the mental feelings of human
beings. They are cognitive variables. They arise continuously and determine the
general direction of an individual's behaviour. Without motive, learning cannot
occur. Motive and motivation are discussed in detail in the following units.


Stimuli are objects that exist in the environment in which a person lives. Stimuli
increase the probability of eliciting a specific response from a person. Viewed
from this angle, stimuli may be of two types: generalisation and discrimination.


The principle of generalisation has important implications for human learning.

Generalisation takes place when the similar new stimuli repeat in the
environment. When two stimuli are exactly alike, they will have probability to
elicit a specific response. It makes possible for a manager to predict human
behaviour when stimuli are exactly alike.

However, the negative implication of generalisation is that the manager may

make false inferences and conclusions based on the principle of generalisation.

For example, halo effect in perception, as discussed earlier occurs mainly because
of generalisation.


What is not generalisation is discrimination. In case of discrimination, responses

vary to different stimuli. For example, an MBA student may learn to respond to
video teaching but not to the oral lecturing by his Professor.

Discrimination has wide applications in organisational behaviour in view of

individual differences in various aspects. For example, a supervisor may respond
to a high producing worker in a positive manner, but in a different manner to one
producing very less.


The stimulus results in responses-be these in the physical form or in terms of

attitudes or perception or in other phenomena. However, the responses need to be
operationally defined anc preferably physically observable.


Reinforcement is a fundamental conditioning of learning. Reinforcement can be

defined anything that both increases the strength of response and tends to induce
repetitions of the behavior that preceded the reinforcement. No measurable
modification of behaviour can take place without reinforcement. Reinforcement
is discussed in detail later in this chapter.


Retention means remembrance of learned behaviour over time. Converse is

forgetting. Learning which is forgotten over time is called 'extinction'. When the
response strength returns after extinction without any intervening reinforcement,
it is called 'spontaneous recovery'. Both extinction and spontaneous recovery are
discussed later.


The most important principles of learning are two-reinforcement and punishment.

A detailed description of these follows in turn.


Reinforcement may be defined as anything that both increases the strength of

response and tends to induce repetitions of the behaviour that preceded the
reinforcement. In other words, reinforcement is the attempt to develop or
strengthen desirable behaviour by either bestowing positive consequences or
withholding negative consequences. Positive reinforcement results from the
application of a positive consequence following a desirable behaviour. Bonuses
paid at the end of successful business years are an example of positive
reinforcement. Negative reinforcementresults from withholding a threatened
negative consequence when a desirable behavior occurs. For example, if the boss
imposes a penalty on an employee for coming late is an example of negative

Besides, a behaviour can be modified and strengthened by keeping the negative

consequence at bay. Take this example. An employee may be trying to avoid the
work place simply because he/she does not feel ease and comfort with the
colleagues he/she works in the office. In such case, merely a change in his/her
work place like change in seating place may help him her regain the enthusiasm.
Similarly, taking away a positive consequence can serve as a source of negative
reinforcement. A reduction in pay, i.e., a source of reward, would serve as a
negative reinforcer. Finally an interesting effect is noticed when 'good' behaviour
tends to continue to avoid negative consequence, or say, punishment. That is why
employees come on time to avoid being reprimanded i.e. punishment.

Schedules of Reinforcement:Any analysis of reinforcement shows that it is not

provided in a consistent manner. Following are some main types of reinforcement

(i) Continuous Reinforcement:In continuous reinforcement schedule, a desired

behaviour is reinforced each and every time. For example, let us take the example
of someone who always arrives at work late. Everytime he is not tardy. His
manager might compliment him on his desirableat work late. Every time he is not
tardy. His manager might compliment him on his desirable behaviour.

(ii) Intermittent Reinforcement:In case of intermittent reinforcement schedule,

a desired behaviour is reinforced often enough to make the behaviour worth
repeating but not every time it is demonstrated. In other words, in an intermittent
schedule, each response is not reinforced. In extreme cases of intermittent
scheduling, there is a little relationship between the occurrence of a response and
reinforcement. Gambling is an example often cited as an intermittent scheduling.
There is no relationship between the occurrence of Response and
Reinforcement. This kind of schedule leads to responses that hardly extinguish.

Intermittent or interval or ratio schedules can be of fixed or variable type.

Fixed-Ratio (FR):In a fixed-ratio schedule, rewards are initiated after a fixed or

constant number of responses. A typical example of fixed ratio schedule is
garment export industry. Each time a certain or fixed number of complete dresses
are handed over, then only the payment (reward) is made.

Variable-Ratio (VR):When the reward varies relative to the behaviour of the

person, it is called reinforcement on a variable-ratio schedule. Examples of such
reinforcement schedule are salesmen who are rewarded with commission.

Fixed-Interval:In fixed-interval, rewards are spaced at uniform time intervals.

The critical variable is time, and it is held fixed or constant. When your
Professor receives his fixed salary after every month, he is rewarded on a fixed-
interval schedule.

Variable-Interval: When rewards are distributed in time so that reinforcements

are unpredictable, the schedule is of the variable type. A series of randomly
timed unannounced visits to a company office by the corporateaudit staff is an
example of a variable-interval schedule.

Now, all the reinforcement schedules with their responses are juxtaposed in
the table below.

Schedule Description Effects responding

Continuous Reinforce follows 1. Steady high rate of performance as

long as reinforcement continues to
follow every response.
2. High frequency of reinforcement
may lead to early situation
3. Behaviour weakensrapidly
(undergoesextinction) when
reinforces are withheld.
4. Appropriate for newly emitted,
unstable or low frequency
Intermittent Reinforcer does not 1.Capable of producing high
follow every frequencies of responding
response 2.Low frequency of reinforcement
precludes early satiation.
3.Appropriate for stable or high
frequency responses.
Fixed ratio A fixed number of 1. A fixed ratio of 1:1reinforcement
responses must be occurs after every response) is the
emitted before same as a continuous schedule.
reinforcement 2. Tends to provide a high rate of
occurs response which is vigorous and
Variable ratio A varying or Capable of producing a high rate of
(VR) random number of response which is vigorous, steady,
responses must be & resistant to extinction
emitted before
Fixed The first response Produces, an uneven response pattern
interval(FI) after a specific varying from a very slow,
period of time has unenergetic response immediately
elapsed is following reinforce to a very fast,
reinforced. vigorous response immediately
preceding reinforcement.
Variable The first response Tends to produce a high rate of
interval (VI) after varying or response which is vigorous, steady &
random periods of resistant to extinction.
time have elapsed is


Learning Curve:Learning curve is a diagrammatic presentation of the amount

learned in relation to time. A learning curve will show on the Y-axis the

amount of learnt and on the X-axis the passage of time. Kolasa has suggested
the four types of learning curves as shown in the figure below.


Curve 1 is a negatively accelerated learning curve while curve 2 is a positively

accelerated one; Curve 3 is the combination of both 1 and 2 with an S shape.
Curve 4 is also a combination of both 1 and 2 but in the opposite direction. These
curves focus on individual differences.

Let us also know what these imply. Curve 1 indicates that initially there is a
spurt in the learning. Usually, the graph levels off at some stage indicating that
maximum performance has been achieved. This is because at the beginning of
the learning process, the learner is highly motivated to exhibit a significant surge
of effort. Curve 2 is just opposite of curve 1 indicating a rarer learning. It
continues till the learning is completely unfamiliar to the learner. But, after some
time learning starts taking better strides. Curve 3 represents the first both
situations. Curve 4 shows a levelling off in performance after an initial spurt.
This is called 'plateau.' Such type of curve is usually found in training
programmes in industry.

Extinction Principle: Extinction principle is related to reinforcement.

According to Pavlov in his operant conditioning theory of learning, if the
response is not reinforced by the consequence, the response will become extinct.
In other words, extinction may be defined as a loss memory. If response is not
reinforced repeatedly, it eventually tends to disappear. Extinction principle can
be practiced in organisations by not responding to the sarcasm (behaviour) of a
colleague. It might also be preferable in other cases of undesirable behaviour.

However, extinction may not always be the best strategy. Punishment might be
preferable in cases of seriously undesirable behaviour, such as employee
embezzlement or other unethical behaviour.

Spontaneous Recovery: The return of response strength after extinction, without

intending reinforcement, is called 'spontaneous recovery'. It may happen due to
the fact that theconditioned response may not totally disappear during extinction,
though it may get suppressed or inhibited. The spontaneous recovery may have
its origin from demonstration effect, egosatisfaction, or one's desire for equality
with the peers.

Generalisation: Generalisation is considered yet another determinant variable for

learning. Generally, a conditioned stimulus results in a conditioned behaviour.
Based on this, a newstimulus identical to the earlier conditioned stimulus is likely
to result in behaviour identical to the conditioned behaviour. The same is called
'generalisation’. The more the new stimulus is identical to the conditioned
stimulus, the more probable it is that the new stimulus will produce the alike
conditioned stimulus.

Discrimination: Discrimination is opposite to generalisation. The line of

distinction drawn between the two is that generalisation is a reaction to similar
stimuli, while discrimination is areaction to differences. Let it be clarified with an

There are two teachers equally competent, working in a University Department

of Business Administration. Among them, one is sincere, polite and
hardworking, and the other is rude and arrogant. Though, initially the response of
the Head of the Department may be equal or similar to both, the Head over the
period responds positively to the former and negatively to the latter. Thus, the
Head of the Department discriminates between the two. The rude and arrogant
teacher is not reinforced. Such discrimination enables the rude one to mend his
behaviour and the polite one to improve further.


Punishment is yet another way of changing human behaviour. It is inverse of the
reward. As punishment is related to penalising or causing harm to a person, it is
less talked of than reward. The purpose of punishment is to eliminate or weaken
undesirable behaviour. It is done in two ways. One way to punish a person is
through the application of a negative consequence following an undesirable
behaviour. For example, a professional athlete who is excessively offensive to the
referee on the football ground (undesirable behaviour) may be ejected from a
game (negative consequence). The second way to be used to punish the person is
through the withholdingof apositive consequence following an undesirable
behaviour, For example, a sales representative who makes few visits to
companies and, in turn, makes sales well below quotas ( undesirable behaviour) is
given less commission (positive consequence).

Punishment causes discomfort to the person being punished. Hence, it may have
ill-effects. It may result in negative psychological, emotional performance, or
behavioural consequences. For person punished may become angry, hostile,
depressed, or despondent. Experience suggests that work slowdowns, sabotage,
and subversive behaviour are usually the ill-effects of punishment.

Hence,efforts need to be made to minimize the ill-effects of punishment.

Research has shown that a hard punishment applied makes the person very
anxious, decreasing his potential to be a good worker. In order to avoid these ill-
effects, punishment needs to be followed by rewards to appropriatebehaviour. For
example, a worker who has been given a wage cut or forced to take casual leave
(punishment) for coming late could be given a small wage hike (reward) for
coming on time for a certain period like one month.

Solomon has suggested that punishment can become effective in changing

behaviour if it is (i) applied before the undesirable behaviour has become very
well learnt; (ii) fairly intense; (iii) followed immediately after the undesirable
behaviour; (iv) specific to a particular act; (v) consistent across persons; (vi)
applied everytime the act occurs; and (vii) accompanied by reward for the desired


By now we can conclude that almost all human behaviour is learned. Learning is,
therefore, considered vital for understanding human behaviour at work in
organizations.Let us try to understand in a more orderly manner how learning
helps managers change human behavior in different organisational situations,
such as reducing absenteeism, substituting well-sick-pay, improving employees'
discipline and developing training programme for the employees.These are
discussed one by one.

Reducing Absenteeism Through Learning:Learning can help managers evolve

programmes to reduce absenteeism. An example of such a programme may be
rewarding employees for their satisfactory attendance. The management of a
private software enterprise introduced lottery system to reward its employees with
attractive prizes. Only employees with perfect attendance were eligible to contest
for prizes. This lottery programme has a rousing success as it resulted in lower
absence rates (about 30 per cent) among the employees.

Substituting Well-Pay for Sick-Pay:Paid sick leave is one of the fringe benefits
provided to salaried employees by most of the organisations including
Universities. However, research studies indicate that paid sick leave programmes
reinforce the undesirable behaviour, i.e., absence from work. The reality is that
employees use sick leaves all up, regardless of whether they are sick. As a
consequence, organisations that provide paid sick leave experience quite more
absenteeism than organisations that do not provide paid sick leave.

As a matter of fact, organisations should reward attendance not absence. This

calls substituting well-pay for sick-pay. Hence, organisations should reward an
employee in the form of bonus for remaining no absent from work for a definite
period of time. There are researches that report that well-pay produced reduced
absenteeism, increased productivity, and improved employee satisfaction.

Improving Employee Discipline:Managers, at times, have to deal with

employees’ undesirable behaviour, such as drinking at work place,
insubordination, stealing company property, arriving continuously late, etc.
Usually managers respond to these with punishment oral reprimands, written
warnings, and even suspension. As mentioned earlier, punishment however,
provides only a short-term solution and has ill-effects on employee punished.

Evidences suggest that discipline produces results in short-run.. In this lies the
importance of fostering discipline in organisations. Learning helps the managers
how to more effectively implement disciplinary actions so as to promote
employee discipline. The managerial behaviour such as to respond immediately,
provide time, state the problem specifically, allow the employee to explain his/her
position, keep discussion impersonal, be consistent, take progressive action obtain

consensus agreement on change, if any, help the managers to more effectively
implement disciplinary actions.

Developing Training Programmes:Learning also helps managers develop

effective training programmes. Particularly, social-learning theory serves as a
guide for this purpose. It suggests the organiser-managers that the training
programme should offer a model to grab the trainee’s attention, provide required
motivational properties, provide adequate opportunities to practice the new
behaviours, and also offer due rewards to the employees for accomplishment of
tasks. In case of off-the-job training, the model should also allow the trainee some
opportunity to transfer what he/she has learned to the job.



Effectiveness of an individual will be judged on the basis of his ability to manage
people. Managers need to posses good interpersonal skills not only to motivate
employees to perform well but also to retain good employees. Present day
managers have to shoulder the responsibility of interacting and dealing with
varied employee profiles. The test before the managers is to understand the
aspirations of the employees, and learn how to motivate them, create effective
working environment and learn to manage their skills for the larger organizational
goals. Today’s managers have to –keep pace with changes, acknowledge
customer power ,build systems with inbuilt knowledge, reinvent companies,
prepare for tomorrow today, be appraised with various skills and adorn different
roles to suit the organizational setting. Developing interpersonal relations of a
manager are concerned with his interacting with other persons, both the
organizational members and outsiders.


You have already learnt that organisations are composed of individuals and their
groups. Human beings experience conflict in their everyday life. Hence
organisations are not free of it. Conflict has considerable influence on
organisational as well as individual performance. Conflict management has,
therefore, become a matter of great concern for the managers to make the
organization effectively run.


Like other behavioural terms, the term conflict has also acquired divergent
meanings. In sense, conflict is a tension or collision or disagreement. Here, are
someimportant definitions of conflict to make its meaning clearer.

Chung and Megginson have defined conflict as the struggle between incompatible
or opposing needs, wishes, ideas, interests, or people. Conflict arises when
individuals or groups encounter goals that both parties cannot obtain

Thomas has defined conflict as a process that begins when one party has
negatively affected or is about to negatively affects, something that the first party
cares about.

According to Kolb and Bartinek, conflict can be a disagreement, the presence of

tension, or some other difficulty within or between two or more parties. Conflict
can be public or private, formal or informal, or be approached rationally or

Now, conflict can simply be defined as disagreement, be it in violent or subtle

form between persons or parties.

Conflict can take on any of several different forms in an organisation. It can occur
within an employee, between individuals or groups, and across organizations.
Thus, the different types of conflicts are: intrapersonal, interpersonal, intergroup
and interorganisational conflicts. It is important to note that the prefix intra means
"within", whereas inter means "between". A brief description of each of these

Intrapersonal Conflict: When conflict occurs within an individual, it is called

intrapersonal conflict. It emerges as a result of conflicting role taken by the
individual. One such type of conflict many employees experience is work/home
conflict, in which their role as worker clashes with their role as spouse or parent.
For example, when a child gets sick at school, the parent often must leave work to
care for the child.

(Types of intrapersonal conflicts are discussed in the following unit under

Group structure)
Interpersonal Conflict: Conflict between two or more people is called
interpersonal conflict. Individual differences create interpersonal conflicts. Wide
differences are noticed between people in terms of personalities, perceptions,
values and attitudes which we have already discussed.

Intergroup Conflict: When conflict occurs between groups or teams, it is known
as intergroup conflict. Such conflict emerges when one group sets out to
undermine the other, gain power, and improve its image. Conflicts also arise from
such causes as different viewpoints, group loyalties, and competition for
resources. Such group conflicts have negative consequences like aggression,
hostile, and prejudice toward the other group. But, some group conflicts can be
constructive also. Conflicts can have predictable effects within each group, such
as increased group cohesiveness, increased focus on tasks, and increased loyalty
to the group.

Interorganisational Conflict: Conflict that occurs between two or more

organisations is called interorganisational conflict. Such conflict may include
conflict between organisations pursuing similar objectives, conflict between
government agency and organisation and conflict between head office and
manufacturing unit. Competition among organisations also can spur inter-
organisational conflict.

Analysing Interpersonal Conflict

Research studies have established beyond doubt that interpersonal conflict has
been major reason for organisational conflict. Hence, there is the need for
understanding the dynamics of interpersonal behaviour.


The Johari Window (named after its creators, (Joseph Luft and Harry Ingram) is a
popular model, used by training specialists, for evaluating communication styles.
The essence of the model is the belief that mutual understanding improves
perceptual accuracy and communication.

Joseph Luft and Harry Ingham (popularly known as Johari) developed a very
popular descriptive framework for analysing and understanding the dynamicsof
inter-personal behaviour and, for that matter, inter-personal conflict. The
name'Johari ‘is acombination of the first names of its originators, Joseph Luft and
Harry Ingham. The framework developed by Johari is termed as ''Johari Window'.

Information known to self Information not known to self

The model is made up of four quadrants that together represent a total person in
relation to others on the basis of awareness of behaviour, feeling, and motivation.
The awareness about the self is not static, rather, changes continuously. For self-
development, a manager is required to increase his open-self. For this purpose, he
can go through in the following manner:

1. There must be complete introspection of oneself so as to assess one's own

strengths and weaknesses.
2. There should be self-insight to identify patterns in emotional life and
recognising similar patterns in others.
3. On identification of one's patterns, there must be self-acceptance of the
mistakesand weaknesses which may be overcome through self-development
4. There must be right attitudes to develop a positive mind set or readiness to
change. Resistance to change blocks self-development.

The model classifies an individual’stendencies to facilitate or hinder interpersonal

communication along two dimensions: exposure and feedback. Exposure is
defined as extent to which an individual openly and candidly divulges feelings,
experiences and information when trying tocommunicate. Feedback is the extent
to which an individual successfully elicits exposure from others. As shown in the
figure these dimensions translate into four windows.

The model is based on four types of interactive forms of interpersonal

interaction/behavior as shown in the above figure. The term ‘self’ used in the
model refers to ‘me’ and ‘others’ to ‘you’. There are certain things that the
person/self knows about himself or herself and there are also certain things he/she
does not know.

Similarly, there are certain things the person knows about other and certain things
does notknow. Based on such knowledge about oneself and other, there can be
four types of interpersonal relationships, termed as 'cells', viz., open, hidden, blind
and unknown. What each of these cells means need to be explained.

1. Open Self:The open window is information known to you as well as others. In

this form of interactive cell, the person knows both about oneself and other. Since
there will be openness in interaction between the two, there would be less chances
forinterpersonal conflict.

2.HiddenSelf:The hidden window is informationknown by you and unknown by

others. It encompasses those feelings that we're aware of but don't share with
others for fear they'll think less of us or possibly use the information against us.
This is the situation in which person knows about oneself but does not know
about the other one. As such person remains hidden from the other with the fear
how the other might react. In other words, the person may hide his/her true
feelings from other. As such the situation becomes source for potential conflict.

3. BlindSelf:The blind window encompasses certain things about you that are
apparent to others but not to yourself. This is the result of no one ever telling you
or because you're defensive1y blocking them out. This situation is opposite of
hidden self. Person knows about other person but does not know about
himself/herself. The result is that the person might unintentionally may be
arguing and then irritating to others. As in the hidden self, here too lies potential
for interpersonal conflict.

4. Unknown Self:The unknown window includes feelings, experience, and in-

formation that neither you nor others are aware of. In this situation, the person
neither knows himself or herself nor the other person. Such situation creates
misunderstanding between the two and becomes the most explosive situation for
interpersonal conflict.

Although there is no substantive body of research to support the following

conclusion, the Johari Window model argues for more open communication on
the assumption that people understand each other better when the amount of
information in the open area increases.

If you accept this conclusion, how would you increase the open area?

According to Luft and Ingram, you do this through disclosure and feedback. By
increasing self-disclosure, you reveal your innerfeelings and experiences. In
addition, the evidence suggests that self-disclosure encourages others to, be
similarly forthcoming and open. So disclosure breeds more disclosure. When
others provide feedback on their insights into your behavior, you reduce your
blind window.

Although advocates of the Johari Window encourage a climate of openness,

where individuals self-disclose freely with each other, they recognize that there
are conditions where guarded communication may be appropriate. These include
transitory relationship where one party has violated trust in the past, in
competitive situations, or where the culture of the organization doesn't support
openness. Although critics might argue that one or more of those conditions just
about cover almost all communication situations in organizations, proponents of
the Johari Window are more optimistic. They see openness, authenticity, and
honesty to be valued qualities in interpersonal relationships. Although they don't
say so directly, they imply that it's in the self-interest of the individual to expand
the size of the open window by increasing self-disclosure and by being willing to
listen to feedback from others even if it's unflattering.

Sources of conflicts
Conflict can arise from a variety of sources. They can be classified into two broad
categories: structural factors, which stem from the nature of the organisation and
the way in which work is organized, and personal factors, which arise from
differences among individuals. Following figure summarizes the causes/sources
of conflict within each category.


Structural Factors Personal Factors

• Specification • Skills and Abilities

• Interdependence • Personalities
• Common Resources • Perceptions
• Goal Differences • Values and Ethics
• Authority • Emotions
Relationships • Communication
• Status Inconsistencies Barrier
• Juridictional • Cultural
Ambiguities Differences

Sources of Conflict in organizations

The structural factors and the personal factors are also called as the external
factors and the internal factors respectively. The most important of these are,
now, discussed here under.

1. Specialisation
When jobs are highly specialised, employees become experts at certain tasks.For
example, in case of a software company, while there is one specialist for data

bases, another for statistical packages, and yet another for expert systems. As the
highly specialised people have little awareness of the tasks that others perform,
such a case leads to conflict among the specialists.

2. Interdependence
Interdependence occurs when two or more groups depend on each other to
accomplish their tasks. Depending on other people to work done is good when the
process works smoothly. However, when problem arises, it becomes easy to
blame other party, and as such, conflict escalates. The potential of conflict
increases as the degree of interdependence increase.Three types of task
interdependence have been identified:

(i) Pooled Interdependence:A condition of pooled interdependence occurs with

additive when the performance of different groups is simply combined or added
together to achieve overall performance.

(ii) Sequential Interdependence:It occurs when the task of one group cannot be
completed unless the preceding group has completed its task. For example, in
case of assembly line manufacturing, the products must first pass through
department A before they can proceed to department B.

(iii) Reciprocal Interdependence:such interdependence also occurs with

conjunctive tasks when each group depends upon the performance of each of the
other group. While A group depends upon B and C, B and C groups depend upon
each other and as well as A. Reciprocal interdependence can be seen in hospitals
where various department like the X-ray unit, the blood laboratory, the nursing
unit, the emergency centre, and the anesthesiology staff all depend on each other
to provide skilled patient care.

3. Goal Differences
Sometimes different work groups having different goals have incompatible goals.
For example, in a cable television company, the salesperson's goal was to sell as
many new installations as possible. This created problem forthe service
department, because its goal was timely installations.

4. Jurisdictional Ambiguities
It refers to the presence of unclear lines of responsibility within an organisation.
Recall, you ever contacted your own University administration for some problem
and had you been to go to different people and departments? This happens
because of the juridictional ambiguities among the departments.

The sources or causes of conflict just discussed are external or structural in nature.
There other conflicts also that comes from differences among individuals, also
called personal/ internal sources or causes of conflict and

5. Skills and Abilities

Work force in an organisation/department is composed of people with varying
levels of skills and abilities. Such diversity in skills and abilities leads to conflict,
especially when jobs are interdependent. Workers may find it difficult to work
with a new boss, fresh from University knowing a lot about managing people but
unfamiliar with the technology they are working.

6. Personalities
We pointed out in that personality also causes individual differences. It is
differences in personality that neither the manager likes all of his co-managers
and subordinates nor all of them like the manager. This creates conflict among
them. Research studies report that usually an abrasive personality is rejected by
others. An abrasive person is one who ignores the interpersonal aspects of work
and feelings of colleagues.

7. Perception
Like personality, differences in perceptions can also lead to conflict. One area in
which perceptions can, for example, differ may be the perception of what
motivates employees. Managers, for example, usually provide what they think
employees want rather than what employees really want.

8. Values and Ethics

People also hold different beliefs and adhere to different value system. Older
workers, for example, value company loyalty and probably would not take a sick
day when they were not really sick/ill. But, the younger workers, valuing
mobility, may take a sick day to get away from work.

9. Emotion
The moods of the people can also be a source of conflict in the work place.
Problems at home often spill over into the work arena, and the related moods can
be hard for others to dealwith.

10. Communication Barriers

Communication barriers such as physical separation and language can create
distortions in messages, and these, in turn, can lead to conflict. Value judgment
also sometimes serves as barrier. Many other communication barriers also can
create conflict.

Transactional analysis (TA) offers a model of personality and dynamics of self
and its relationship to others that makes possible a clear and meaningful
discussion of behavior. TA refers to a method of analysing and understanding
interpersonal behaviour. When people interact, there is a social transaction in
which one person responds to another. The study of these transactions between
people is called transactional analysis. TA was originally developed by Eric
Berne, a psychotherapist, for psychotherapy in 1950. He observed patients that
often it was as if several different people were inside each person. He also
observed that these various 'selves' interacted with people in different ways. Later
on, its application to ordinary interactions was popularised by Harris and
Jongeward, besides Berne. To understand TA, structural analysis (ego states), life
position, and analysis of transactions should be understood.

Ego states
People interact with each other in terms of three psychological positions, or
behavioural patterns, known as ego states. Thus, ego states are a person's way of
thinking, feeling, and behaving at any time. These ego states are: parent, adult,
and child. These have nothing to do with the chronological age of the person;
rather, they are related with the behavioural aspects of age. Thus, person of any
age may have these ego states in varying degrees. A healthy person is able to
move from one ego state to another. Further, these three ego states are not
concepts like Freud's id, ego, and super ego. They are based on real world

1. Parent Ego. Parent ego state incorporates the attitudes and behaviour of all
emotionally significant people who serve as parent figure when an individual was
a child. The value and behaviour of these people are recorded in the mind of the
individual and these become the basic values of the personality. Characteristics of
a person acting with the parent ego include being overprotective, distant,
dogmatic, indispensable, and upright. Physical and verbal clues that someone
interacting with the parent ego includes the wagging finger to show displeasure,
reference to laws and rules, and reliance on ways that were successful in the past.

There can be two types of parent ego states—nurturing and critical. Nurturing
parent ego state reflects nurturing behaviour not only towards children but also to
other people in Interaction. Similarly, critical parent ego state reflects critical and
evaluative behaviour in Interaction with others. Each individual has his unique
parent ego state which is likely to a mixture of helpfulness and hurtfulness.
Awareness of this ego gives more choice over atone does.
2. Adult Ego.Adult ego state is based upon reasoning, seeking, and providing
information. Personinteracting with adult ego views people as equal, worthy, and
reasonable human beings. It is based on rationality. The adult is characterised by
logical thinking and reasoning. This ego state can be identified by verbal and
physical signs which include thoughtful concentration and factual discussion. The
process of adult ego state formation goes through one's own experience, and
continuously updating parental injunction by verifying.Though certain values
which are formed in the childhood are rarely erased, an individual at the later
stage of life may block his child and parent ego states and use his adult ego only
based on his experience. He updates the parent data to determine what is valid and
what is not. Similarly, he also updates child data to determine which feelings
should be expressed. Thus, he keeps and controls emotional expressions

3. Child Ego.Characteristics of child ego include creativity, conformity,

depression, anxiety, dependence, fear, and hate. Physical and verbal clues that
person is acting in the child ego are silent compliance, attention seeking, temper
tantrums, giggling, and coyness. The child ego is characterized by non-logical and
immediate actions which result in immediate satisfaction. Child ego state reflects
early childhood conditions and experiences perceived by individuals in their early
years of life, that is, before the social birth of an individual, say up to the age of
five years. The child has no self-direction, no ability to move out to face life. He
takes what comes in his way. There are three parts of child ego: natural, adaptive,
and rebellious. The natural child is affectionate, impulsive, sensuous, and does
what comes naturally. However, he is also fearful, self-indulgent, self-centered,
and aggressive, and may engage in many unpleasant roles. The adaptive child is
the trained one and he is likely to do what parents insist on, and sometimes learns
to feel non-O.K. The adapted child, when overtly inhibited, often becomes the
troubled part of the personality. The rebellious child experiences anger, fear, and

Each person may respond to specific stimulus in quite distinct ways from each
ego state. Sometimes, these ego states harmonise; sometimes, they are in conflict.
Some respond more with one ego state than with others.

Life Positions

The individual's behaviour towards others is largely based on specific

assumptions are made early in life. Very early in the childhood, a person develops
from expert dominant philosophy. Such philosophy is tied into their identity,
sense of worth, perceptions of other people. This tends to remain with the person
for lifetime unless experiences occur to change it. Such positions are called life-
positions or psychological positions, and fall into four categories as shown in
figure below.

You are O.K.

I am O.K. I am not O.K.

You are O.K. You are O.K.
I am O.K. I am O.K. I am not O.K. I am not O.K.
You are not O.K. You are not O.K.

You are not O.K.

Psychological positions

1.I am O.K., You are O.K.

This is a rationally chosen life position. It is made after individual has a large
number of O.K. experiences with others. People with this position about
themselves and others can solve their problems constructively. They accept
significance of other people and feel that life is worth living. This is based on
adult ego. When managers work from this position, they are likely to express a
more consistent pattern of confidence and competence. They display a much
higher level of mutual give and take. They are able to express freely what they
feel good about others because it offers littlethreat to them. They delegate
authority and feel comfortable with a spread of authority.

2.I am O.K., You are not O.K.

This position is taken by people who feel victimized or persecuted. They blame
others for their miseries. This is the case of aggrieved persons with an attitude that
whatever they do is right. This is a distrustful life position. It usually results when
a person was too much ignored when he was a child. These are the people with
rebellious child ego. In this life position, persons operate with parent ego.
Managers operating with this position are likely to give critical and oppressive
remarks. They tend to point out the flaws, the bad things, rarely giving any warm,
genuinely carrying feelings. They lack trust or confidence in the intelligence,
skills, and talents of others. They do believe in delegation of authority and feel
that decentralisation is a threat.

3.Iam not O.K., You are O.K.

This position is common to persons who feel powerfuless in comparison to others.

It is based on one's feelings about oneself. Individuals who feel aclear distinction
between themselves and the people around them who could do many things that
the individuals could not hold this life position. Persons with this life position
always grumble for one thing or the other. Managers operating from this position
tend to give and receive bad feelings. They often use their bad feelings as an
excuse to act against others, and then the whole thing comes full circle when they
feel guilty for their acts and turn their bad feelings against themselves. They tend
to vacillate in their behaviour and are often unpredictable and erratic.

4. I am O.K., You are not O.K. This is a desperate life position. This position is
taken by those PEOPLE who lose interest in living. They feel that life is not worth
living at all. In extreme cases, they commit suicide or homicide. This is the case
of individuals who are neglected seriously by their parents and are brought up by
servants. Managers operating from this position are likely to get put-down strokes
from others. They do not make decisions in time; make stupid mistakes or
otherwise provoke others to give them negative reactions. They lack personal
potency to look others for final decisions.

One of these positions dominates each person's life. The desirable position is one
that provides an adult-adult transaction, that is. "I am O.K., You are O.K." It
shows acceptance of self and others. The adults move into the O.K.-O.K. position
through psychological understanding and conscious choice. This position can be
learned through education. The other three positions are less psychologically
mature and less effective.
When people Interact, they involve in a transaction with others. Thus, when a
stimulus (verbal or non-verbal) from a person is being responded by another
person, a transaction is saidto occur. The transaction is routed from ego states.
Depending on the ego states of the persons involved in the transactions, there may
be three types of transaction— complementary, non-complementary, and ulterior:

1. Complementary Transactions.A transaction is complementary when the

stimulus and response patterns from one ego state to another are parallel. Thus,
message by a person gets the predicted response from other persons. The
transaction is complementary because both are acting in the perceived and
expected ego states. Usually in such a case, both persons are satisfied and
communication is complete. In all, there can be nine complementary transactions.
These are adult-adult, parent-child, adult-parent, adult-child, parent-parent,
parent-adult, child-parent, child-adult, and child-child transactions. However, out
of these, adult-adult and parent-child transactions are most desirable.

In adult-adult transaction, the manager in the adult ego tries to reason out issues,
clarifies and informs issues, and has concern for facts and figures and human
needs. His life position is "I am O.K., You are O.K." This is the ideal transaction.
Complementary transactions in these ego states are very effective because both
persons are acting in a rational manner. Data is processed, decisions are made,
and both parties are working for solutions. Satisfaction is achieved by both
persons from solution rather than one person(superior) treating other person
(subordinate) a dutiful employee, or the subordinate onlytrying to please his
superior. This transaction has been presented in the figure below.

Parent-child complementary transaction may be ideal if the manager is interacting

with parent ego and the employee is acting in his child ego. The employee finds
this transaction advantageous because it eliminates much responsibility and
pressure. The child prevents much conflict and provides for easy operation.
However, this situation may not be advantageous in the long run. This transaction
depends on the feeling that employees are not capable of doing anything. The
employee suffers from this interaction becausehe has to surrender his adult ego.
He may feel frustrated because he feels his personality isnot developed. This
transaction has been presented in the following figure

Parent-child transaction

4.Non-complementary Transactions.Non-complementary or crossed
transactions occur when stimulus-response lines are not parallel. This happens
when the person who initiates transaction expecting a certain response does not
get it. The position has been shown in the figure below.

Non-complementary transaction
In this case, the manager tries to deal with the employee on adult-to-adult basis
but the employee responds on child-to-parent basis and the communication is
blocked. Cross transaction is not a satisfactory one because the line of
communication is blocked and further transaction does not take place. In such a
case, the manager might refuse to play parent-child game and may try again for an
adult communication. Another alternative for the manager may be to move to
parent-child state in order to resume communication with the employee.
Benefits and uses of Transactional Analysis
TA is an approach towards understanding human behaviour. Thus, it can be
applied to any field of human interactions. This is more particularly related
when people come for interaction, and that too in inter personal relationships.
Following are some of the specific areas where TA can be applied

1. Developing Positive Thinking.TA Is applied to bring positive actions from

people because TA brings positive approach towards life and hence positive
actions. TA brings a clear change from negative feelings—confusion, defeat,
failure, fear, frustration, hesitation, loneliness, pessimism, and suppression to
positive feelings—clear thinking, victory, achievement, courage, gratification,
decision, friendship, optimism, and fulfillment. Such a change from negative
attitude to positive attitude is a source of psychic energy. Positive attitude makes
people stronger and negative attitude makes them exhausting. The whole
objective of TA training programme is directed towards positive thinking. Thus,
its application can enhance the trust and credibility felt towards the organisation
which is essential for good employee relations. Some of the specific areas for
developing positive thinking through TA are stroking, positive reinforcement,
inner dialogue as related to decision making, active listening, and time-

2. Interpersonal Effectiveness. TA improves interpersonal relationship by

providing understanding of ego states of persons Involved in interaction. It
emphasises complementary transactions which ensure complete communication
and problem-solving approach. Since complementary transactions can be learned
by individuals in the organisation, people can improve interpersonal relations
through TA. The effective managers may be able to analyse transactions with
employees in the organisation. TA provides them with a theoreticalframework
within which to examine the interactions with the employees. The managers may
be able to identify the ego states from which both parties are interacting. A better
understanding of themselves and of other persons will make them more
comfortable, confident, and effective. The improved interpersonal relations will
bring effectiveness to the organisation.

3. Motivation.TA can be applied in motivation where it helps in satisfying human

needs through complementary transactions and positive strokes. Managers can
enrich jobs for people by helping them to engage in kinds of activities that give
them more positive strokes. It emphasises strokes from the intrinsic value of the
work, rather than depending entirely on strokes from outside (extrinsic). The job
enrichment in this case means increasing the number of intrinsic strokes gained
from the work activity. TA helps in changing the managerial styles more suitably
to the emergent situation. In this context, TA may be compared with McGregor's
Theory X and Y. The theory X manager emphasises parent- child relationship and
uses terms like 'should be', ‘have to’, 'must' and so on. He adopts a life position of
"I am O.K., You are not O.K." which is not a healthy position either for
motivating the employees or for the organisation as a whole. On the other hand,
theory Y manager emphasises adult-adult interaction with life position "I am
O.K., You are O.K." which is motivating for employees and beneficial to the
organisation as a whole.

4. Organisation Development.Organisation development applies a humanistic

system to work behaviour and is orientation of man's thinking and behaviour
towards work organisation. The major goal of organisation development is to
fight the past in present in order to choose freely the future. TA can help in
organisation development process. Jongeward has identified the role of TA in six
areas of organisation development: to maintain adult-adult transactions, to give an
OK to the natural child, to identify and untangle crossed transactions, to minimise
destructive game playing, to maximise encounters (intimacy), and to develop
supportive systems, policies, and work environment. TA can compare with
managerial grid of Blake and Mouton, a technique for adopting appropriate
leadership styles and organisation development. Various leadership styles may be
described in terms of life positions, ego states, and transactions. For example, the
9-1 manager uses parent-child transaction, the 1-9 manager acts from child ego
state, and the 9-9 manager acts from adult ego and effectively makes use of parent
and child ego states. In the managerial grid, 9-9 style is the most desirable which
corresponds with adult-adult transaction, best according to TA. Besides TA,
organisation development, being a comprehensive educational strategy, uses
many other methods.

Besides these major areas, TA can be utilised anywhere the people come to
interact. Jongeward has suggested that transactional analysis is a practical and
useful interrelationship model for organisations because: (1) it is easy to learn,
(2) it gives a positive communication tool that is practical and almost
immediately usable, (3)it helps to increase a person's on-the-job effectiveness
because of better self-understanding and greater insight into personalities and
transactions. (4) it may help solve personal and family problems, it gives a
common language for people working together to attempt to solve their
communication problems, (6) it is a non-threatening approach to self-evaluation,
and (7) offers a method for analysing not only people but also organisational


We have already mentioned that conflict is inevitable in organisations. Hence, this

poses a question whether the conflict is good or bad for an organisation. In other
words, the management needs to know what are the good or bad aspects, if any, of
conflict in orgnaisation.Viewed from this angle, conflicts are characterised by
having two aspects, namely, functional and dysfunctional conflicts. These are
discussed one by one.

Functional Conflict
Conflicts that support the goals of the group and improve its performance are
known as functional conflicts. Studies have suggested that some conflicts not help
but may be a necessary condition for creativity/improvement. These are also
called 'constructive conflicts'.

Following are some of the positive or functional aspects of conflicts that

mayoccur in organisations:

• Conflictsbreed creativity among the members.

• Conflicts lead to innovation.
• Conflicts promote change.
• Conflicts lead to high quality decisions.
• Conflicts bring cohesiveness in groups
• Conflicts motivate group members to have concern for organizations.

As mentioned earlier, there is a close relationship between conflict and
organizational performance. Moderate or optimum level of conflict contributes to
high organisational performance. On the contrary, both extremely low and
extremely high level of conflicts adversely affectsorganisational performance. In
this context, Boulding also recognizes that some optimum level of conflict and
associated personal stress and tension are necessary for progress and productivity
but he portrays conflict primarily as a potential and social cost.

Dysfunctional Conflict
The destructive forms of conflict that hinder group performance are called
dysfunctional conflicts. Such conflicts hinder or destroy the achievement of
organisational or group goals. The performance of an organisation tends to
deteriorate when conflict becomes too great. InUniversities, for example, intense
conflict between employees and administration destroys the working
relationships between them and seriously reduces the level of organisational
efficiency and performance.




Level of Inter-group Conflict High

How to manage or resolve conflict?

Several styles or techniques have been suggested for managing conflict. Based on
styles assertiveness (the extent to which one wants one's goals met) and
cooperativeness (the extent to which one wants to see the other party's concerns
met), Thomashas classified conflict management styles into five styles: avoiding,
accommodating, competing, compromising, and collaborating. graphs these five
conflict management styles using these two dimensions.

Competing Collaborating

(Concern for self) Compromising

Avoiding Accomodating

Uncooperative Cooperative

Cooperativeness (Concern for others)

Each of these styles is discussed now.

Avoiding is a style low on both assertiveness and cooperativeness. Avoiding is a
deliberate decision to sidestep a conflictful issue, postpone addressing it till later
or withdraw from a conflicting situation. In certain situations, it may be
appropriate to avoid a conflict. For example, when parties are much angry and
need time to cool down, it may be best to avoidance. Avoiding conflict can be
very functional when the issue involved in the conflict is trivial. However,
research shows that overuse of this style results in negative evaluations from
others in the workplace. Here is an example of the avoiding style of conflict
management in use.

The head of a large MNC stayed regularly in a posh five star hotel in Delhi. On
one such trip, he forgot to remove the "Do Not Disturb" sign from his door when
he left for work in the morning. He came back late at night to find his room as he
had left it: the sheets unchanged, the breakfast tray still there, and the room
unswept. The sign on the door was intact.

His reaction? He charged down to the reception, sign in hand, and proceeded to
scream the hotel down. When the receptionist said that they were merely
following his instructions, hegot even more agitated, saying that he could have
died in his room, and nobody would’ve disturbed him.

The situation was rapidly spiralling out of control, when the hotel's General
Manager stepped in. Within minutes, he had pacified the charged executive,
apologising profusely instead of arguing with him. He then put him in a better
room till his room was made up, and sent him dinner. Suitably mollified, the guest
was soon tucking into his food all anger forgotten, and the staff heaved a sigh of

A style in which one is concerned that other party's goals be met but relatively
unconcerned with getting one's own way is called accommodating. In this style,
one party is willing to self-sacrifice in the interest of the other party. Overreliance
on accommodating has its dangers. If manager constantly defers to others, others
may lose respect for him. In addition, accommodating manager may become
frustrated as his/her own needs are never met. In turn, he/she may lose self-

This type of style is characterised by high assertion and low cooperation. In this
style, one tries to meet one's goals at the other party's expense. Much reliance on
competing strategy may be dangerous because one who does so may become
reluctant to admit even when he/she is wrong. He/she may find himself/herself
surrounded by people who are afraid to disagree with him/her.

The compromising style is intermediate on both the assertive and cooperative
dimensions. Each party tries to give up something to reach a solution to the
conflict. A typical give and take policy dominates the behaviour of the conflicting
parties. Compromises are often made in the final hours of union-management
negotiations, when time is of the essence. Compromising becomes an effective
style when efforts toward collaboration have failed.

Collaborating style is marked by both high assertiveness and
cooperativeness.Collaborating involves attempts to satisfy the needs of both the
parties. Thus, it is based on “win-win" style. In this style, a creative solution
usually emerges because of the joint efforts of both the parties who are keen on
both gaining from the situation without hurting the other.





A groupis defined as two or more individuals, interacting and interdependent,

who have come together to achieve particular objectives. Groups can be either
formal or informal. By formal groups, wemean those defined by the
organization's structure, with designatedwork assignments establishing tasks. In
formal groups, the behaviors that one should engage in are stipulated by and
directed toward organizational goals. The six members making up an airline
flightcrew are an example of a formal group. In contrast, informalgroupsare
alliances that are neither formally structured nor organizationally determined.
These groups are natural formations in the work environment that appear in
response to the need for socialcontact. Three employees from different
departments who regularly eat lunch together are an example of an informal
group. It's possible to sub classify groups as command, task, inter-or friendship
groups. Command and task groups are dictatedby the formal organization,
whereas interest and friendship groups are informalalliances.

A command groupis determined by the organization chart. It is composed of the

individuals who report directly to a given manager. An elementary school
principal and her 12 teachers form a command group, as do the director of postal
audits and his five inspectors.

Task groups,also organizationally determined, represent those working together

to complete a job task. However, atask group's boundaries are not limited to its
immediate hierarchical superior. It can cross command relationships. For
instance, if a college student is accused of a campus crime, it may require
communication and coordination among the dean of academic affairs, the dean of
students, the registrar, the director of security, and the student's advisor. Such a
formation would constitute a task group. It should be noted that all command
groups are also task groups, but because task groups can cut across the
organization, the reverse need not be true.

People who may or may not be aligned into common command or

groups may affiliate to attain a specific objective with which each is
concerned.This is an interest group. Employees who band together to have their
vacationschedules altered, to support a peer who has been fired, or to seek
improved working conditions represent the formation of a united body to further
their commoninterest.

Groups often develop because the individual members have one or more
common characteristics. We call these formations friendship groups. Social
alliances, which frequently extend outside the work situation, can be based on
similar age or ethnic heritage.

Informal groups provide a very important service by satisfying their member’s

social needs. Because of interactions that result from the close proximity of
workstations or task interactions, we find workers playing golf together,
commuting to work together, lunching together, and spending their breaks
around the water cooler together. We must recognize that these types of inter-
actions among individuals, even though informal, deeply affect their behaviour
andperformance.There is no single reason why individuals join groups. Because
most people belong to a number of groups, it's obvious that different groups
provide different benefits to their members

Why do people join groups?

Security.By joining a group, individuals can reduce the insecurity of "standing
alone." People feel stronger, have fewer self-doubts, and are more resistant to
threats when they are part of a group.

Status.Inclusion in a group that is viewed as important by others provides

recognition and status for its members.

Self-esteem.Groups can provide people with feelings of self-worth. That is, in

addition to conveying status to those outside the group, membership can also
give increased feelings of worth to the group members themselves.

Affiliation.Groups can fulfill social needs. People enjoy the regular interaction
that comes with group membership. For many people, these on-the-job
interactions are their primary source for fulfilling their needs for affiliation.

Power.What cannot be achieved individually often becomes possible through

group action. There is power in numbers.

Goal Achievement.There are times when it takes more than one person to ac-
complish a particular task—there is a need to pool talents, knowledge, or power
in order to complete a job. In such instances, management will rely on the use of
a formal group.


Groups generally pass through a standardized sequence in their evolution. We

call this sequence the five-stage model of group development. Recent studies,

however, indicate that temporary groups with task-specific deadlines follow a
very different pattern. In this section, we describe the five-stage general model
and an alternative model for temporary groups with deadlines.


Thefive-stage group-development model characterizes groups as proceeding
through five distinct stages: forming, storming, norming, performing, and
adjourning.The first stage, forming, is characterized by a great deal of
uncertainty about the group's purpose, structure, and leadership. Members are
"testing the waters" to determine what types of behavior are acceptable. This
stage is complete when members have begun to think of themselves as part of a

The stormingstage is one of intragroup conflict. Members accept the existence

of the group, but there is resistance to the constraints that the group imposes on
individuality. Furthermore, there is conflict over who will control the group.
When this stage is complete, there will be a relatively clear hierarchy of
leadership within the group.

The third stage is one in which close relationships develop and the group
demonstrates cohesiveness. There is now a strong sense of group identity and ca-
maraderie. This norming stage is complete when the group structure solidifies
and the group has assimilated a common set of expectations of what defines cor-
rect member behavior.

The fourth stage is performing. The structure at this point is fully functional and
accepted. Group energy has moved from getting to know and understand each
other to performing the task at hand.

For permanent work groups, performing is the last stage in their development.
However, for temporary committees, teams, task forces, and similar groups that
have a limited task to perform, there is an adjourning stage. In this stage, the
group prepares for its disbandment. High task performance is no longer the
group's top priority. Instead, attention is directed toward wrapping up activities.
Responses of group members vary in this stage. Some are upbeat, basking in the
group's accomplishments. Others may be depressed over the loss of camaraderie
and friendships gained during the work group's life.

Many interpreters of the five-stage model have assumed that a group becomes
more effective as it progresses through the first four stages. While thisassumption
may be generally true, what makes a group effective is more complex than this
model acknowledges. Under some conditions, high levels of conflict are
conducive to high group performance. So we might expect to find situations in
which groups in Stage II outperform those in Stages III or IV. Similarly, groups
do not always proceed clearly from one stage to the next. Sometimes, in fact,
several stages go on simultaneously, as when groups are storming and
performing at the same time. Groups even occasionally regress to previous
stages. Therefore, even the strongest proponents of this model do not assume that
all groups follow its five-stage process precisely or that Stage IV is always the
most preferable.

Another problem with the five-stage model, in terms of understanding work-

related behavior, is that it ignores organizational context. For instance, a study of
a cockpit crew in an airliner found that, within 10 minutes, three strangers as-
signed to fly together for the first time had become a high-performing group.
What allowed for this speedy group development was the strong organizational
context surrounding the tasks of the cockpit crew. This context provided the
rules, task definitions, information, and resources needed for the group to per-
form. They didn't need to develop plans, assign roles, determine and allocate re-
sources, resolve conflicts, and set norms the way the five-stage model predicts.


Part of a group's performance can be predicted by assessing the knowledge,
skills, and abilities of its individual members. It's true that we occasionally read
about the athletic team composed of mediocre players that, because of excellent
coaching, determination, and precision teamwork, beats a far more talented
group of players. But such cases make the news precisely because they represent
an aberration. As the old saying goes, "The race doesn't always go to the swiftest
nor the battle to the strongest, but that's the way to bet." A group's performance is
not merely the summation of its individual members' abilities. However, these
abilities set parameters for what members can do and how effectively they will
perform in a group.

A review of the evidence has found that interpersonal skills consistently emerge
as important for high work group performance. These include conflict
management and resolution, collaborative problem solving, and communication.
For instance, members need to be able to recognize the type and source of
conflict confronting the group and to implement an appropriate conflict resolu-
tion strategy; to identify situations requiring participative group problem solving
and to utilize the proper degree and type of participation; and to listen
nonevaluatively and to appropriately use active listening techniques.

There has been a great deal of research on the relationship between personality
traits and group attitudes and behavior. The general conclusion is that attributes
that tend to have a positive connotation in our culture tend to be positively re-
lated to group productivity, morale, and cohesiveness. These include traits such
as sociability, initiative, openness, and flexibility. In contrast, negatively evalu-
atedcharacteristics such as authoritarianism, dominance, and unconventionality
tend to be negatively related to the dependent variables. These personality traits
affect group performance by strongly influencing how the individual will interact
with other group members.

Is anyone personality characteristic a good predictor of group behavior? The

answer to that question is No. The magnitude of the effect of any single charac-
teristic is small, but taking personality characteristics together, the consequences
for group behavior are of major significance.

Work groups are not unorganized mobs. They have a structure that shapes the
behavior of members and makes it possible to explain and predict a large portion
of individual behavior within the group as well as the performance of the group
itself. What are some of these structural variables? They include formal leader-
ship, roles, norms, group status, group size, composition of the group, and the
degree of group cohesiveness.

Almost every work group has a formal leader. He or she is typically identified by
titles such as unit or department manager, supervisor, foreman, project leader,
task force head, or committee chair. This leader can play an important part in the
group's success—so much so much that, we review the research on leadership
and the effect that leaders have on individual and group performance variables.

Shakespeare said, "All the world's a stage, and all the men and women merely
players." Using the same metaphor, all group members are actors, each playing a
role.By this term, we mean a set of expected behavior patterns attributed to
someone occupying a given position in a social unit. The understanding of role
behavior would be dramatically simplified if each of us chose one role and
"played it out" regularly and consistently. Unfortunately, we are required to play
a number of diverse roles, both on and off our jobs. As we shall see, one of the
tasks in understanding behavior is grasping the role that a person is currently

For example, Bill Patterson is a plant manager with Electrical Industries, a large
electrical equipment manufacturer in Phoenix. He has a number of roles that he
fulfills on that job—for instance, Electrical Industries employee, member of
middle management, electrical engineer, and the primary company spokesperson
in the community. Off the job, Bill Patterson finds himself in still more roles:
husband, father, Catholic, Rotarian, tennis player, member of the Thunderbird
Country Club, and president of his homeowners' association. Many of these roles
are compatible; some create conflicts. For instance, how does his religious
involvement influence his managerial decisions regarding layoffs,
expenseaccount padding, and providing accurate information to government
agencies? A recent offer of promotion requires Bill to relocate, yet his family
very much wants to stay in Phoenix. Can the role demands of his job be
reconciled with the demands of his husband and father roles?

The issue should be clear: Like Bill Patterson, we all are required to play a
number of roles, and our behavior varies with the role we are playing. Bill's be-
havior when he attends church on Sunday morning is different from his behavior
on the golf course later that same day. So different groups impose different role
requirements on individuals.

Role IdentityThere are certain attitudes and actual behaviors consistent with a
role, and they create the role identity.People have the ability to shift roles
rapidly when they recognize that the situation and its demands clearly require
major changes. For instance, when union stewards were promoted to supervisory
positions, it was found that their attitudes changed from prounion to pro-
management within a few months of their promotion. When these promotions
had to be rescinded later because of economic difficulties in the firm, it was
found that the demoted supervisors had once again adopted their prounion

Role PerceptionOne's view of how one is supposed to act in a given situation is

a role perception.Based on an interpretation of how we believe we are supposed
to behave, we engage in certain types of behavior.

Where do we get these perceptions? We get them from stimuli all around us—
friends, books, movies, television. Many current law enforcement officers
learned their roles from reading Joseph Wambaugh novels, while many of to-
morrow's lawyers will be influenced by watching the actions of attorneys in Ally
McBeal or The Practice. Of course, the primary reason that apprenticeship
programs exist in many trades and professions is to allow beginners to watch an
"expert," so that they can learn to act as they are supposed to.

Role Expectations Role expectationsare defined as how others believe you

should act in a given situation. How you behave is determined to a large extent
by the role defined in the context in which you are acting. The role of a Professor
is believed as having sincerity and dignity, whereas a football coach is seen as
aggressive, dynamic, and inspiring to his players. In the same context, we might
be surprised to learn that the neighborhood priest, moonlights during the week as
a bartender because our role expectations of priests and bartenders tend to be
considerably different. When role expectations are concentrated into generalized
categories, we have role stereotypes.
In the workplace, it can be helpful to look at the topic of role expectations
through the perspective of the psychological contract.There is an unwritten
agreement that exists between employees and their employer. This psychological
contract sets out mutual expectations—what management expects from workers,
and vice versa. In effect, this contract defines the behavioral expectations that go
with every role. Management is expected to treat employees justly, provide
acceptable working conditions, clearly communicate what is a fair day's work,
and give feedback on how well the employee is doing. Employees are expected
to respond by demonstrating a good attitude, following directions, and showing
loyalty to the organization.

What happens when role expectations as implied in the psychological contract

are not met? If management is derelict in keeping up its part of the bargain, we
can expect negative repercussions on employee performance and satisfaction.
When employees fail to live up to expectations, the result is usually some form
of disciplinary action up to and including firing.
The psychological contract should be recognized as a "powerful determiner of
behavior in organizations." It points out the importance of accurately com-
municating role expectations.

Role ConflictWhen an individual is confronted by divergent role expectations,

the result is role conflict. It exists when an individual finds that compliance with
one role requirement may make more difficult the compliance with another. At
the extreme, it would include situations in which two or more role expectations
are mutually contradictory.

Our previous discussion of the many roles Bill Patterson had to deal with in
eluded several role conflicts—for instance, Bill's attempt to reconcile the expecta
tions placed on him as a husband and father with those placed on him as an ex
ecutive with Electrical Industries. The former, as you will remember, emphasizes
stability and concern for the desire of his wife and children to remain in Phoenix.
Electrical Industries, on the other hand, expects its employees to be responsive to
the needs and requirements of the company

All of us have faced and will continue to face role conflicts. The critical issue
from our standpoint is how conflicts imposed by divergent expectations within
the organization impact on behavior. Certainly, they increase internal tension and
frustration. There are a number of behavioural responses in which one may
engage. The conflict is then resolved by relying on the rules, regulations and
procedures that govern organizational activities. Other behavioural responses
may include withdrawal, stalling, negotiationor redefining the facts or situationto
make them appear congruent.


Did you ever notice that golfers don't speak while their partners are putting on
the green or that employees don't criticize their bosses in public? Why? The an-
swer is: 'Norms!'

All groups have established norms,that is, acceptable standards of behavior that
are shared by the group's members. Norms tell members what they ought and
ought not to do under certain circumstances. From an individual's standpoint,
they tell what is expected of you in certain situations. When agreed to and
accepted by the group, norms act as a means of influencing the behavior of group
members with a minimum of external controls. Norms differ among groups,
communities, and societies, but they all have them.

Common Classes of NormsA work group's norms are like an individual's

fingerprints—each is unique. Yet there are still some common classes of norms
that appear in most work groups.

Probably the most common class of norms is performance norms. Work groups
typically provide their members with explicit cues on how hard they should
work, how to get the job done, their level of output, appropriate levels of
tardiness, and the like. These norms are extremely powerful in affecting an indi-
vidual employee's performance—they are capable ofsignificantly modifying a
performance prediction that was based solely on the employee's ability and level
of personal motivation.

A second category encompasses appearance norms.These include things such as

appropriate dress, loyalty to the work group or organization, when to look busy,
and when it's acceptable to goof off. Some organizations have formal dress
codes. However, even in their absence, norms frequently develop to dictate the
kind of clothing that should be worn to work. Similarly, presenting the appear-
ance of loyalty is important, especially among professional employees and those
in the executive ranks. So it's often considered inappropriate to be openly looking
for another job.

Another category concerns social arrangement norms.These norms come from

informal work groups and primarily regulate social interactions within the group.
With whom group members eat lunch, friendships on and off the job, social
games, and the like are influenced by these norms.

A final category relates to allocation of resource norms.These norms can

originate in the group or in the organization and cover things such as pay,
assignment of difficult jobs, and allocation of new tools and equipment.
Some Norms Are More Important Than OthersGroups don't establish or enforce
norms for every conceivable situation. The norms that the group will enforce
tend to be those that are important to it. But what makes a norm important? (1)If
it facilitates the group's survival.Groups don't like to fail, so they look to enforce
those norms that increase their chances for success. This means that they'll try to
protect themselves from interference from other groups or individuals. (2)If it in-
creases the predictability of group members' behaviors.Norms that increase
predictability enable group members to anticipate each other's actions and to
prepare appropriate responses. (3)If it reduces embarrassing interpersonal
problems for group members.Norms are important if they ensure the satisfaction
of their members and prevent as much interpersonal discomfort as possible. (4)If
it allows members to express the central values of the group and clarify what is
distinctive about the group's identity.Norms that encourage expression of the
group's values and distinctive identity help to solidify and maintain the group.

As a member of a group, you desire acceptance by the group. Because of your
desire for acceptance, you are susceptible to conforming to the group's norms.
There is considerable evidence that groups can place strong pressures on
individual members to change their attitudes and behaviors to conform to the
group's standard.

Do individuals conform to the pressures of all the groups to which they belong?
Obviously not, because people belong to many groups and their norms vary. In
some cases, they may even have contradictory norms. So what do people do?
They conform to the important groups to which they belong or hope to belong.
The important groups have been referred to as reference groupsand are charac-
terized as ones in which the person is aware of the others; the person defines
himself or herself as a member, or would like to be a member; and the person
feels that the group members are significant to him or her. The implication, then,
is that all groups do not impose equal conformity pressures on their members.

The impact that group pressures for conformitycan have on an individual

member's judgment and attitudes was demonstrated in the now classic studies by
Solomon Asch. Asch made up groups of seven or eight people, who sat in a
classroom and were asked to compare two cards held by the experimenter. One
card had one line; the other had three lines of varying length. As shown in the
figure below, one of the lines on the three-line card was identical to the line on
the one-line card. Also as shown in exhibit the difference in line length was quite
obvious, under ordinary conditions, subjects made fewer than 1 percent errors.
The object was to announce aloud which of the three lines matched the single
line. But what happens if the members in the group begin to give incorrect
answers? Will the pressures to conform result in an unsuspecting subject (USS)
altering his or her answer to align with the others? That was what Asch wanted to
know. So he arranged the group so that only the USS was unaware that the
experiment was "fixed." The seating was prearranged: The USS was placed so as
to be the last to announce his or her decision.

The experiment began with several sets of matching exercises. All the subjects
gave the right answers. On the third set, however, the first subject gave an
obviously wrong answer—for example, saying "C" in exhibit . The next subject
gave the same wrong answer, and so did the others until it got to the unknowing
subject. He knew "B" was the same as "X," yet everyone has said "C." The
decision confronting the USS was this: Do you publicly state a perception that
differs from the preannounced position of the others in your group? Or do you
give an answer that you strongly believe is incorrect in order to have your re-
sponse agree with that of the other group members?

The results obtained by Asch demonstrated that over many experiments and many
trials, subjects conformed in about 35 percent of the trials; that is, the subjects
gave answers that they knew were wrong but that were consistent with the replies
of other group members. And what meaning can we draw from these results?
They suggest that there are group norms that press us toward conformity. That is,
we desire to be one of the group and avoid being visibly different.

The preceding conclusions are based on research that was conducted nearly 50
years ago. Has time altered their validity? And should we consider these findings
generalizable across cultures? The evidence indicates that there have been
changes in the level of conformity over time; and Asch's findings are culture
bound. Specifically, levels of conformity have steadily declined since Asch's
studies in the early 1950s. In addition, conformity to social norms is higher in
collectivist cultures than in individualistic cultures. Nevertheless, even in highly
individualistic countries such as the United States, you should consider confor-
mity to norms to still be a powerful force in groups.
Examples of Cards Used in Asch


Groups differ in their cohesiveness,that is, the degree to which members are at-
tracted to each other and are motivated to stay in the group. For instance, some
work groups are cohesive because the members have spent a great deal of time
together, or the group's small size facilitates high interaction, or the group has ex-
perienced external threats that have brought members close together. Cohesive-
ness is important because it has been found to be related to the group's

Studies consistently show that the relationship of cohesiveness and productivity

depends on the performance-related norms established by the group. If
performance-related norms are high (e.g., high output, quality work, cooperation
with individuals outside the group), a cohesive group will be more productive
than will a less cohesive group. But if cohesiveness is high and performance
norms are low, productivity will be low. If cohesiveness is low and performance
norms are high, productivity increases but less than in the high cohesiveness-high
norms situation. Where cohesiveness and performance-related norms are both
low, productivity will tend to fall into the low to moderate range. These
conclusions are summarized in the figure below.


High productivity Moderate

NORMS Low productivity Moderate to low


What can you do to encourage group cohesiveness? You might try one or more
of the following suggestions: (1) Make the group smaller. (2) Encourage
agreement with group goals. (3) Increase the time members spend together. (4)
Increase the status of the group and the perceived difficulty of attaining member-
ship in the group. (5) Stimulate competition with other groups. (6) Give rewards
to the group rather than to individual members. (7) Physically isolate the group.

Does the size of a group affect the group's overall behavior? The answer to this
question is a definite Yes, but the effect depends on what dependent variables
you consider.

The evidence indicates, for instance, that smaller groups are faster at completing
tasks than are larger ones. However, if the group is engaged in problem solving,
large groups consistently get better marks than their smaller counterparts.
Translating these results into specific numbers is a bit more hazardous, but we
can offer some parameters. Large groups—with a dozen or more members-are
good for gaining diverse input. So if the goal of the group is fact-finding, larger
groups should be more effective. On the other hand, smaller groups are better at
doing something productive with that input. Groups of approximately seven
members tend to be more effective for taking action.

One of the most important findings related to the size of a group has been labeled
social loafing.Social loafing is the tendency for individuals to expend less effort
when working collectively than when working individually.39 It directly
challenges the logic that the productivity of the group as a whole should at least
equal the sum of the productivity of each individual in that group.

A common stereotype about groups is that the sense of team spirit spurs in-
dividual effort and enhances the group's overall productivity. In the late 1920s, a
German psychologist named Max Ringelmann compared the results of individual
and group performance on a rope-pulling task. He expected that the group's effort
would be equal to the sum of the efforts of individuals within the group.

That is, three people pulling together should exert three times as much pull on
the rope as one person, and eight people should exert eight times as much pull.
Ringelmann's results, however, didn't confirm his expectations. Groups of three
people exerted a force only two-and-a-half times the average individual
performance. Groups of eight collectively achieved less than four times the solo

Replications of Ringelmann's research with similar tasks have generally sup-

ported his findings. Increases in group size are inversely related to individual
performance. More may be better in the sense that the total productivity of a
group of four is greater than that of one or two people, but the individual pro-
ductivity of each group member declines.

What causes this social loafing effect? It may be due to a belief that others in the
group are not carrying their fair share. If you see others as lazy or inept, you can
reestablish equity by reducing your effort. Another explanation is the dispersion
of responsibility. Because the results of the group cannot be attributed to any
single person, the relationship between an individual's input and the group's out-
put is clouded. In such situations, individuals may be tempted to become "free
riders" and coast on the group's efforts. In other words, there will be a reduction
in efficiency when individuals think that their contribution cannot be measured.

The implications for OB of this effect on work groups are significant. When
managers utilize collective work situations to enhance morale and teamwork,
they must also provide means by which individual efforts can be identified. If
this isn't done, management must weigh the potential losses in productivity from
using groups against any possible gains in worker satisfaction. However, this
conclusion has a Western bias. It's consistent with individualistic cultures, such
as the United States and Canada that are dominated by self-interest. It is not
consistent with collective societies in which individuals are motivated by in-
group goals. For instance, in studies comparing employees from the United
States with employees from the People's Republic of China and Israel (both
collectivist societies), the Chinese and Israelis showed no propensity to engage in
social loafing. In fact, the Chinese and Israelis actually performed better in a
group than when working alone.

The research on group size leads us to two additional conclusions: (1) Groups
with an odd number of members tend to be preferable to those with an even
number; and (2) groups made up of five or seven members do a pretty good job
of exercising the best elements of both small and large groups.44 Having an odd
number of members eliminates the possibility of ties when votes are taken. And
groups made up of five or seven members are large enough to form a majority
and allow for diverse input, yet small enough to avoid the negative outcomes
often associated with large groups, such as domination by afew members,
development of subgroups, inhibited participation by some members, and
excessive time taken to reach a decision.


Two by-products of group decision making have received a considerable amount
of attention by researchers in OB. As we'll show, these two phenomena have the
potential to affect the group's ability to appraise alternatives objectively and ar-
rive at quality decision solutions.

The first phenomenon, called groupthink,is related to norms. It describes

situations in which group pressures for conformity deter the group from critically
appraising unusual, minority, or unpopular views. Groupthink is a disease that
attacks many groups and can dramatically hinder their performance. The second
phenomenon we shall review is called group shift.It indicates that in discussing a
given set of alternatives and arriving at a solution, group members tend to ex-
aggerate the initial positions that they hold. In some situations, caution domi-
nates, and there is a conservative shift. More often, however, the evidence indi-
cates that groups tend toward a risky shift. Let's look at each of these phenomena
in more detail.

Have you ever felt like speaking up in a meeting, classroom, or informal group,
but decided against it? One reason may have been shyness. On the other hand,
you may have been a victim of groupthink, the phenomenon that occurs when
group members become so enamored of seeking concurrence that the norm for
consensus overrides the realistic appraisal of alternative courses of action and the
full expression of deviant, minority, or unpopular views. It describes
deterioration in an individual's mental efficiency, reality testing, and moral
judgment as a result of group pressures.

We have all seen the symptoms of the groupthink phenomenon:

1. Group members rationalize any resistance to the assumptions they have made.
No matter how strongly the evidence may contradict their basic assumptions,
members behave so as to reinforce those assumptions continually.

2. Members apply direct pressures on those who momentarily express doubts

about any of the group's shared views or who question the validity of arguments
supporting the alternative favored by the majority.

3. Those members who have doubts or hold differing points of view seek to
avoid deviating from what appears to be group consensus by keeping silent about
misgivings and even minimizing to themselves the importance of their doubts.

4. There appears to be an illusion of unanimity. If someone doesn't speak, it's

assumed that he or she is in full accord. In other words, abstention becomes
viewed as a "Yes" vote.

Groupthink appears to be closely aligned with the conclusions Asch drew in his
experiments with a lone dissenter. Individuals who hold a position that is dif-
ferent from that of the dominant majority are under pressure to suppress, with-
hold, or modify their true feelings and beliefs. As members of a group, we find it
more pleasant to be in agreement—to be a positive part of the group—than to bea
disruptive force, even if disruption is necessary to improve the effectiveness of
the group's decisions.

Doesgroupthink attack all groups? No. Itseems to occur most often where there is
a clear group identity, where members hold a positive image of their group that
they want to protect, and where the group perceives a collective threat to this
positive image. Sogroupthink is not a dissenter-suppression mechanism as much
as it's a means for a group to protect its positive image.

What can managers do to minimize groupthink? Onething they can do is
encourage group leaders to play an impartial role. Leadersshould actively seek
input from all members and avoid expressing their own opinions, especially in
the early stages of deliberation. Anotherthing is to appoint one group member to
play the role of devil's advocate. Thismember's role is to overtly challenge the
majority position and offer divergent perspectives. Stillanother suggestion is to
utilize exercises that stimulate active discussion of diverse alternatives without
threatening the group and intensifying identity protection. One such exercise is to
have group members talk about dangers or risks involved in a decision and de-
laying discussion of any potential gains. Byrequiring members to first focus on
the negatives of a decision alternative, the group is less likely to stifle dissenting
views and more likely to gain an objective evaluation.


Incomparing group decisions with the individual decisions of members within

the group, evidence suggests that there are differences. Insome cases, the group
decisions are more conservative than the individual decisions. Moreoften, the
shift is toward greater risk. Whatappears to happen in groups is that
thediscussion leads to a significant shift in the positions of members toward a
more extreme position in the direction in which they were already leaning before
the discussion. Soconservative types become more cautious and the more
aggressive types take on more risk. Thegroup discussion tends to exaggerate the
initial position of the group.

Thegroup shift can be viewed as actually a special case of groupthink. The

decision of the group reflects the dominant decision-making norm that develops
during the group's discussion. Whetherthe shift in the group's decision is toward
greater caution or more risk depends on the dominant prediscussion norm.

The greater occurrence of the shift toward risk has generated several expla-
nations for the phenomenon. It's been argued, for instance, that the discussion
creates familiarization among the members. Asthey become more comfortable
with each other, they also become more bold and daring. Another argument is
that most first-world society’s value risk, that we admire individuals who are
willing to take risks and that group discussion motivates members to show that
they are at least as willing as their peers to take risks. Themost plausible
explanation of the shift toward risk, however, seems to be that the group diffuses
responsibility. Group decisions free any single member from accountability for
the group's final choice. Greaterrisk can be taken because even if the decision
fails, no one member can be held wholly responsible.So how should you use the
findings on group shift? Youshould recognize that group decisions exaggerate
the initial position of the individual members that the shift has been shown more
often to be toward greater risk and that whether or not a group will shift toward
greater risk or caution is a function of the members' prediscussion inclinations.


Motivation represents those forces acting within a person which causes them to
behave in a specific, goal directed behaviour. Since work motives affect the
employee's productivity, one of management's jobs is to channelise their
motivations towards achieving organisational goals. The content theories and
process theories help to identify those specific factors which will motivate
individuals to behave in a particular way. The MBO approach involves
employees and managers in a participative style of management be jointly
involved in setting goals and evaluating the performance. We conclude the
chapter with emphasising that organisations have to make use of a combination
of non-financial and financial incentives to motivate a high level of performance
among employees.


Motivation can be said to be the consequence of an interaction between the
individual and the situation. Motivation is not an individual trait. Thus, it would
be improper to refer to an employee not performing his job as lazy. He may not
be performing well probably because he is not motivated enough. Every person
differs in this basic motivational drive. For example, there could be a college
student who very studious and another classmate of his who loves fun. The
studious student since he is highly motivated to study hard is always looking
forward to pore over many academic related books with a lot of enthusiasm.
While the other fun loving classmate of his may simply not be interested in even
touching those books unless forced to do so. But this same fun loving student is
seen, actively been involved in organising the college's 'Management Festival'
with unmatched enthusiasm. This once again reiterates the fact that each
individual has got a unique motivational drive.

Defining motivation is not easy. However, a simple and comprehensive

definition of motivation is attempted.Motivation is a process which begins with a
physiological or psychological need or deficiency which triggers behaviour or a
drive that is aimed at a goal or an incentive. A simple way of depicting a
motivational process will be:

A simple model of motivational process

Needs Drives Incentives

This raises the question as to what are needs, drives and incentives.A need is
created whenever there is a psychological imbalance. It can be defined as a
feeling of deficiency for something and the human being tries to get it removed.
A drive ora motive is set up to alleviate those needs. And anincentive is
something that will alleviate a need and reduce a drive. The incentive is
mentioned at the end of the motivation process because it restores the
physiological and psychological balance and reduces or offsets the drive.


Let us have a look at the different types of drives.

Primary Motives
Psychologists have believed that a motive in order to be a primary motive should
be unlearned and physiologically oriented. Such motives are also termed as
physiological, biological, unlearned orprimary motives. The most common
primary motives are hunger, thirst, clothing, sleep, sex and maternal concern.
Since human beings have a common physiological make-up, we all end up
having the same primary needs.

General Motives
There are various motives which can neither be classified as primary nor
secondary but can be referred to as general motives. In order to be included in
this category, a motive has to be unlearned but not physiologicallyoriented.
Thebasic difference is that primary needs try to reduce the tension orstimulation
whereas the general need induces the individual to enhance the amount of
stimulation. Sometimes these needs are also called "stimulus motives" such as
love, concern and affection which can help to resolve the problems to a
significant extent. Thus, it will be apt to say that general motives, if nurtured
well, can help in improving the organisational climate.

Secondary Motives
While general motives are important in understanding human behaviour, it
should be remembered that secondary motives are the most significant ones. It is
essentially the learned drives that become secondary motives. In other words,
social advancement, primary motives as well as general drives (to a certain
extent) give way to learned secondary motives. Examples ofsuch
general/stimulus motives are curiosity, manipulation, activity and affection. It is
to be remembered that general motives have a significant role to play in
organisational behaviour.

Research has recognised that if general drives such as curiosity, manipulation

and activity drives are intense, it will be beneficial. While if these are stifled or
inhibited they can make the entire society very stagnant. In the organisational set
up, a reasonable amount of curiosity, manipulation and activity motives is
necessary in order to keep the employees motivated. Take the case of small,
family run businesses, where it is expected of the clerk to sit at his seat for more
than eight hours on each working day. This is clearly an attempt to stifle his
general motives. With the liberalisation process and many multinationals having
set up business in India, a visible change is noticed from the above mentality.
Now organisations (especially many software companies) have introduced
flexible working hours, more activities involving healthy interactions among
employees etc., all with the intention of encouraging the employee's general
drives to be sufficiently motivated, resulting in a conducive working

Love and affection are again a complex general drive — which seems partly like
a primary drive and partly like a secondary drive. For instance, in the
organisational context, when interpersonal conflicts among employees result in
high individual stress, the manager uses the general motives drives which results
in motivating behaviour. There are a few important human motives which fall in
this category. They are power, achievement, affiliation, security and status. The
table below indicates few examples of key secondary needs.

Need for Achievement

• Doing better than competitors
• Attaining or surpassing a difficult goal.
• Solving a complex problem
• Carrying out a challenging assignment successfully.
• Developing a better way to do something

Need for Security

• Having a secure job
• Being protected against loss of income or economic disaster
• Having protection against physical harm or hazardous conditions
• Avoiding tasks or decisions with a risk of failure and blame

Need for Power

• Influencing people to change their attitudes or behaviour
• Controlling people and activities
• Being in position of authority over others
• Gaining control over information and resources
• Defeating an opponent or an enemy.

Need for Affiliation

• Being liked by many people.
• Being accepted as part of a group or team.
• Working with people who are friendly and co-operative.
• Maintaining harmonious relationships and avoiding conflicts.
• Participating in pleasant social activities.

Need for Status

• Having the right car and wearing the right clothes
• Working for the right company in the right job.
• Having a degree from Harvard or Stanford
• Living in the right neighbourhood and belonging to the country club.
• Having executive privileges

The achievement driveis one of the most intensively researched drives. The
achievement motive can be expressed as the desire of an individual to perform in
terms of a particular standard of excellence or the desire to be successful in
competitive situations. Refer to McClelland David C's Motivational Trends in
Society, 1971.
David McClelland's research has worked out the profile of a high achiever. The
specific characteristics of a high achiever can be given as follows:

Moderate risk taking

This is an important trait of a high achiever — he/she will accept an assignment
which carries moderate risk i.e., the assignment should satisfy two activities (a)It
should not be so easy that there seems no challenge is involved (b)Nor should the
assignment be so difficult that he would find it very difficult to accomplish it. So
the safe bet is to go for an assignment involving moderate risk because then the
chances of success are also high.

Preference for an immediate feedback

High achievers prefer to accept assignments where they can get immediate
feedback. This feedback is also an indicator of how they are progressing towards
a given goal.

Derive satisfaction on the accomplishment of a task

High achievers essentially get satisfaction and gratified on the completion of a
particular task and this is done without the expectation of material rewards. That
is, the individual may not be thinking of money for its material benefits but if he
receives money (after he completes an assignment) as a reward, a high achiever
will associate it as a measure or feedback on his performance.

Total concentration or preoccupation with the assigned task
A high achiever is totally immersed in his task till he completes it successfully
and is satisfied that he has given it his maximum effort. The dedication to his
work will also be visible in his personality, when others who come in touch with
such persons, terms such as "loners" and "unfriendly" are used while referring to
them. They are very pragmatic about their accomplishments and would not prefer
interference of anybody in the path of their achieving the goal.

Power Drive
The power motive was advocated by Alfred Adler, a leading behavioural
scientist, by developing the concepts of inferiority complexand compensationto
explain it. The power motive can be termed as the need to manipulate others or
the drive for superiority over others.

According to Adler, the feeling of inferiority is combined with an innate need for
superiority and it is these two which will rule all behaviour. He communicates
about how a person's life style is characterised by striving to compensate for
feeling of inferiority combined with the innate drive for power. In the
organisation, this motive can lead to employees striving for organisational
leadership and also the involvement of informal politics for this. This drive can
be illustrated by quoting the example of the politicians who adopt various tactics
to remain in power.

Affiliation Motive
Time and again the significance of affiliation motives in human behaviour has
been highlighted by research. Way back in 1920's when the Hawthorne studies
were carried out, this was confirmed. This motive has got a lot of relevance in
the organisational context. All employees and especially rank-and-file employees
always have a strong need and desire to belong to and to be accepted by the
group. Thus this affiliation motive can help in understanding group dynamics and
interpersonal relationships.

Security Motive
This is also a very intense motive, especially in today's fast moving world.
Security motive is generally based on the feeling of fear and the motive is
avoidance oriented. Good jobs are scarce and the feeling of job insecurity is
slowly seeping in among employees and thus impacting organisational
behaviour. This is because retrenchment and downsizing have come to stay, and
that is why the feeling of insecurity has assumed a serious dimension.

Thus, it can be said that people experience this security motive when they feel it
would protect them from the contingencies of life and are actively engaged in
trying to avoid situations which would prevent them from satisfying their
primary, general and secondary motives.

Status or Prestige Motive

This status motive is very much evident in our society today. People concerned
with the status want to "keep up with the Patels owning a car", in fact, if given
the opportunity they would like to forge ahead of the Patels. Gellerman
hasdescribed "Prestige as a sort of unwritten definition of the kinds of conduct
that other people are expected to show in one's presence, what degree of respect
or disrespect, formality or informality, reserve or frankness."

Prestige is an intangible "something" which is bestowed upon the person by the

society. Very often, at birth itself children inherit the status of their parents. And
in some cases, this status is enough to carry them through life on "a prestige
covered wave."

People are always seeking "status" throughout their lives in various ways. People
are usually seeking ways to display a high evaluation of themselves that is firmly
based in reality, based on the recognition and respect accorded to them by others
and the society at large. In the modern world a rich person is always looked upon
with awe and hence the rush of the average individual in search of status
symbols. Some try to satisfy this motive by seeking only the material symbols of
status, while others may strive for personal achievement or self actualisation
which may command respect, status and prestige in itself.

We have seen motivation as a psychological process consisting of different
drives. Now let us look into the theoretical streams for the study of work-



A well-known theory of motivation 'Hierarchy of Needs' theory is based on the
framework developed by Abraham Maslow, and works on the assumption that
the behaviour of individuals at a particular moment is usually determined by their
strongest need. According to Maslow, human needs arrange themselves in the
form of a hierarchy as shown in the figure below.

It is said that the behaviour of an individual at a particular moment, is usually

determined by his strongest need. The needs as per Maslow's theory are:

• Physiological Needs - The basic needs of hunger, thirst, shelter, sex and other
body needs.

• Safety Needs - The need to be free of the fear of physical danger and
deprivation of the basic physiological needs.

• Social Needs - Need to belong to and be accepted by various groups.

• Esteem Needs - Need for both self esteem (self respect, autonomy and
achievement) and external esteem (status, recognition and attention).

• Self-actualisation - The need to maximise one's potential whatever it may be.

According to the theory, depending upon the need which is to be satisfied, the
individual behaviour will be oriented towards satisfying that level of need. And
as each level of needs gets substantially satisfied, the individual will move up the
steps of the hierarchy.

While discussing the preponderance of one category of need over another,

Maslow has been careful to mention the assumption that "if one level needs has
been somewhat gratified, other needs emerge as dominant."This means that
Maslow didn't want to give the impression that one level of needs has to be
completely satisfied before the next level emerges as the most important. Simply
stated from the viewpoint of motivation, the theory suggests that although no
need is fully gratified, a substantially satisfied need will no longer motivate the
individual. Thus the focus will have shift to the higher level of needs.

The need hierarchy (model) by A.H. Maslow is based on other underlying

assumptions such as:

• As soon as a need has been satisfied, there is a decline in its motivational role
but gradually another need emerges in its place and so individuals will now strive
to satisfy this need.

• In general, the lower level needs have to be satisfied before higher level needs
are, activated sufficiently to drive behaviour.

• There are more ways of satisfying higher level needs as compared to lower
level needs.

Evaluation of the Theory
•To some extent Maslow's Hierarchy of needs has got sufficient support for the
hypothesis — human needs are in the form of a hierarchy and its assumption that
man's needs are never fully satisfied. This hierarchy theory also identifies the
type of behaviours which will help fulfill various needs of human beings.
According to Maslow, the three lowest level needs — physiological, safety and
social have to be fulfilled if the person is to develop into a healthy one (both
physiologically and physically). Whereas, the higher level needs i.e., esteem and
self actualisation needs have to be satisfied to help the person grow into a perfect
human being.

There is no complete information on the origin of these needs. But the theory
implies that usually the higher level needs exist within the individual, even
though they may not recognise or act on those needs. Also that most people get
motivated by these higher level needs so long as nothing comes in the way of
their emergence.

Even though the hierarchy of needs theory has been identified to have universal
application, it is based on U.S. cultural values, and so the sequence of the
hierarchy will vary from culture to culture. For instance: In cultures such as
Japan and Japan and Greece values such as uncertainty avoidance, job security
and lifelong employment act as strong motivators as compared to self
actualization. There are also countries such as Japan, China and Korea where
more importance is placed upon collectivism, and community practices over
individual growth needs.


The management's action of motivating human beings in the organisation,
according to McGregor, involves certain assumptions, generalisations, and
hypotheses relating to behaviour and human nature. These assumptions may be
neither consciously crystallised nor overtly stated; however, these serve the
purpose of predicting human behaviour, basic assumptions about human
behaviour may differ considerably because of the complexity of factors
influencing this behaviour. McGregor has characterised these assumptions two
opposite points—Theory X and Theory Y.

Theory X.
This is the traditional theory of human behaviour. In this theory, McGregor has
certain assumptions about human behaviour. In his own words, these
assumptions are as follows:

1. Management is responsible for organising the elements of productive

enterprises-- money, materials, equipment, people—in the interest of economic

2. With respect to people, this is a process of directing their efforts, motivating

controlling their actions, modifying their behaviour to fit the needs of

3. Without this active intervention by management, people would be passive-

even resistant—to organisational needs. They must be persuaded, rewarded,
punished controlled, and their activities must be directed. This is management's
task. We often sum it up by saying that management consists of getting things
done through other people.

4. The average man is by nature indolent—he works as little as possible.

5. He lacks ambition, dislikes responsibility, and prefers to be led.

6. He is inherently self-centered, indifferent to organisational needs.

7. He is, by nature, resistant to change.

8. He is gullible, not very bright, the ready dupe of charlatan and the demagogue.

Of these assumptions, last five deal with the human nature and first three
managerial actions. These assumptions about human nature are negative in their
approach; however, much organisational processes have developed on these
assumptions. Managers subscribing these views about human nature attempt to
structure, control, and supervise their employees. They feel that external control
is most appropriate for dealing with irresponsible and immature employees.
McGregor believes that these assumptions about human nature have not changed
drastically though there is a considerable change in behavioural pattern. He
argues that this change is not because of changes in the human nature, but
because of nature of industrial organisation, management philosophy, policy and

Theory Y:
The assumptions of Theory Y are described by McGregor in the following

1. The expenditure of physical and mental effort in work is as natural as play or

rest. The average human being does not inherently dislike work. Depending
upon controllable conditions, work may be a source of satisfaction or a source
of punishment.
2. External control and the threat of punishment are not the only means for
bringing about efforttowards organisational objectives. Man will exercise self-
direction and self-control in the service of objectives to which he is committed.
3. Commitment to objectives is a function of the reward associated with
theirachievement. The most significant of such awards, e.g., the satisfaction of
egoandself-actualisation needs, can be a direct product of effort directed
towardsorganisational objectives.
4. The average human being learns under proper conditions not only to accept, but
to seek responsibility. Avoidance of responsibility, lack of ambition, and
emphasis onsecurity are generally consequences of experience, not inherent
5. The capacity to exercise a relatively high degree of imagination, Ingenuity,
andcreativity in the solution of organisational problems Is widely, not
narrowly,distributed in the population.
6. Under the conditions of modern industrial life, the intellectual potentialities of
the average human beings are only partially utilised.
The assumptions of Theory Y suggest a new approach in management. It
emphasises on the cooperative endeavour of management and employees. The
attempt is to get maximum output with minimum amount of control and
direction. Generally, no conflict is visible between organisational goals and
Individual goals. Thus, the attempts of employees which are in their best
interests are also in the interests of organisation.

Comparison of Theories X and Y

Both these theories have certain assumptions about human nature. In fact they
are reverse sides of a coin, one representing head and the other representing
tail. Thus, these assumptions seem to be mutually exclusive. The difference
between two sets of assumptions can be visualised as follows:

1. Theory X assumes human beings to be inherently distasteful towards work.

Theory Y assumes that for human beings, work is as natural as play.
2. Theory X emphasises that people do not have ambitions and try to
avoidresponsibilities in jobs. The assumptions under Theory Y are just the
3. According to Theory X, most people have little capacity for creativity while
accordingto Theory Y; the capacity for creativity is widely distributed in the
4. In Theory X, motivating factors are the lower needs. In Theory Y, higher-order
needsare more important for motivation, though unsatisfied lower needs are
also important
5. In Theory X, people lack self-motivation and require to be externally controlled
andclosely supervised to get maximum output from them. In Theory Y, people
are self-directed and creative and prefer self-control.
6. Theory X emphasises scalar chain system and centralisation of authority in the
organisation while Theory Y emphasises decentralisation and greater
participation in the decision-making process.
7. Theory X emphasises autocratic leadership; Theory Y emphasises democratic
andsupportive leadership.


The psychologist Frederick Herzberg extended the work of Maslow and

proposed a new motivation theory popularly known as Herzberg's Motivation
Hygiene (Two-Factor) Theory. Herzberg conducted a widely reported
motivational study on 200 accountants and engineers employed by firms in and
around western Pennsylvania. He asked these people to describe two important
incidents at their jobs: (1) when did you feel particularly good about your job,
and when did you feel exceptionally bad about your job. He used the critical
incident method of obtaining data.

The responses when analysed were found quite interesting and fairly consistent.
The replies the respondents offered were consistent. The replies respondents
gave when they felt good about their jobs were significantly different from the
replies given when they felt bad. Reported good feelings were generally
associated with job satisfaction whereas bad feelings with job dissatisfaction.
Herzberg labeled the job satisfiers motivators,and he called job dissatisfiers
hygieneor maintenance factors. Taken together, the motivators and hygiene
factors have been known as Herzberg's two-factor theory of motivation.

Herzberg's motivational and hygiene factors have been shown in the Table

Hygiene: Job Dissatisfaction Hygiene: Job Dissatisfaction



Work itself




Company policy and administration


Intrepersonal relations

Working conditions

Salary *



* Because of its ubiquitous nature, salary commonly shows up as a motivator as

well as hygiene.

According to Herzberg, the opposite of satisfaction is not dissatisfaction. The
underlying reason, he says, is that removal of dissatisfying characteristics from a
job does not necessarily make the job satisfying. He believes in the existence of a
dual continuum. The opposite of satisfaction' is 'no satisfaction' and the opposite
of 'dissatisfaction' is 'no dissatisfaction'?

According to Herzberg, today's motivators are tomorrow's hygiene because the

latter stop influencing the behaviour of persons when they get them.
Accordingly, one's hygiene may be the motivator of another.

However, Herzberg's model is labeled with the following criticism:

1. People generally tend to take credit themselves when things go well. They
blame failure on the external environment.
2. The theory basically explains job satisfaction not motivation.
3. Even job satisfaction is not measured on an overall basis. It is not unlikely that
a person may dislike part of his/her job, still thinks the job acceptable.
4. This theory neglects situational variable to motivate an individual.

Regardless of criticisms, Herzberg's 'two-factor motivation theory' has been

widely read and a few managers seem unfamiliar with his recommendations. The
main use of his recommendations lies in planning and controlling of employees
Distinction between Maslow's and Herzberg's Theories

Both Maslow and Herzberg theories focus on motivational factors. However,

both differ from each other in their approaches. As discussed earlier, Maslow's
motivation theory is based on the hierarchy of needs. According to this theory,
only unsatisfied needs motivate individuals. Once a need is satisfied, it ceases to
be a motivating factor. But, Herzberg's motivation theory is based on
motivational and hygiene or maintenance factors. According to Herzberg,
hygiene or maintenance factors prevent job dissatisfaction but do not provide
motivation to workers. In his view, Maslow's lower order needs like
physiological, safety and social needs act as hygiene or maintenance factors.


One of the most widely accepted explanations of motivation is offered by Victor
Vroom in his Expectancy Theory. It is a cognitive process theory of motivation.
The theory is the basic notions that people will be motivated to exert a high level
of effort when they believe there are relationships between the effort they put
forth, the performance they achieve, and the outcomes/rewards they receive.

The relationships between notions of effort, performance, and rewards are

depicted in the figure below.
Effect Perform Reward

Will my effort Will performance Will rewards

improve my lead to rewards? satisfy my
performance? individual goals?


Thus, the key constructs in the Vroom's expectancy theory of motivation are:

1. Valence:Valence, according to Vroom, means the value or strength one

places on a particular outcome or reward.
2. Expectancy:It relates efforts to performance.
3. Instrumentality: By instrumentality, Vroom means, the belief that
performance is related to rewards.

Thus, Vroom's motivation can also be expressed in the form of an equation as


Motivation= Valence ൈExpectancy ൈ Instrumentality

Being the model multiplicative in nature, all the three variables must have high
positivevalues to imply motivated performance choices. If any one of the
variables approaches to zero level, the possibility of the so motivated
performance also touches zero level.

However, Vroom's expectancy theory has its critics. The important ones are:

1. Critics like Porter and Lawler labeled it as a theory of cognitive hedonism

which proposes that individual cognitively chooses the course of action that
leads to the greatest degree of pleasure or the smallest degree of pain.
2. The assumption that people are rational and calculating make the theory
3. The expectancy theory does not describe individual and situational differences.

But the valence or value people place on various rewards varies. For example,
one employee prefers salary to benefits, whereas another person prefers to just
the reverse. The valence for the same reward varies from situation to situation.

In spite of all these critics, the greatest point in the expectancy theory is that it
explains why a significant segment of workforce exerts low levels of efforts in
carrying out job responsibilities.

v) McCIelland's Need Theory

Another well-known need-based theory of motivation, as opposed to hierarchy of

needs of satisfaction-dissatisfaction, is the theory developed by McClelland and
his associates. McClelland developed his theory based on Henry Murray's
developed long list of motives and manifest needs used in his early studies of
personality. McClelland’s need theory is closely associated with learning theory,
because he believed that needs are learned or acquired by the kinds of events
people experienced in their environment and culture. He found that people who
acquire a particular need behave differently from those who do not have. His
theory focuses on Murray’s three needs: achievement, power and affiliation. In
the literature, these three needs are abbreviated "n Ach", "n Pow", and "n Aff"
respectively. They are defined as follows:

Need for achievement:

This is the drive to excel, to achieve in relation to a set of standard, and to strive
to succeed. In other words, need for achievement is a behavior directed toward
competition with a standard of excellence. McClelland found that people with a
high need for achievement perform better than those with a moderate or low need
for achievement, and noted regional/national differences in achievement
motivation. Through his research McClelland identified the following three
characteristics of high-needachievers:

1. High-need achievers have a strong desire to assume personal responsibility

performing a task or finding a solution to a problem.
2. High-need achievers tend to set moderately difficult goals and take calculated
3. High-need achievers have a strong desire for performance feedback.

Need for Power:

The need for power is concerned with making an impact on others, the desire to
influence others, the urge to change people, and the desire to make a difference
in life. People with a high need for power are people who like to be in control of
people and event results in ultimate satisfaction to man.

People who have a high need for power are characterized by:

1. A desire to influence and direct somebody else.

2. A desire to exercise control over others.
3. A concern for maintaining leader-follower relations.

Need for Affiliation:

The need for affiliation is defined as a desire to establish and maintain friendly
and warm relations with other people. The need for affiliation, in many ways, is
similar to Maslow's social needs. The people with high need for affiliation have
these characteristics:

1. They have a strong desire for acceptance and approval from others.
2. They tend to conform to the wishes of those people whose friendship and
companionship they value.
3. They value the feelings of others.

The figure below is a summary chart of the three need theories of motivation just
discussed. The chart shows the parallel relationship between the needs in each of
the theories. Maslow refers to higher-lower order needs, whereas Herzberg refers
to motivation and hygiene factors.

Maslow Herzberg McClelland

Self The work itself Need for

Motivational factors

actualisation Achievement
• Responsibility
• Advancement
• Growth
Need for power

Socialisation Quality of
Hygiene factors


Safety and Job security Need for

security affiliation
order Working
needs conditions



vi) Goal Setting Theory

Goals can be defined as future outcomes (results) that individuals and groups
desire and strive to achieve. Goal setting is the process through which efficiency
and effectiveness can be increased by specifying the desired outcomes towards
which individuals, teams, departments and organisations should work.


The importance of goal setting can be seen from the following statements:

• Setting of goals leads to role clarity and focussing attention on guiding and
directing behaviour.
• Goal setting can help in providing challenges and indication against which all
performances (of individuals, groups and organisations) can be evaluated and
• Goal setting facilitates optimum utilization of resources.
• Goal setting helps to work out a suitable organisational design.
• Goals serve as the basis for planning, organising and controlling functions of
Model of Goal setting and Performance
The goal setting process is one of the most important motivational tools

having an impact on the performance of employees in organisation. One such

model of individual goal setting and performance was developed by Ed Locke
and Gary Latham. This model, as a simplified version is illustrated in the figure

Challenge Mediators
Goal difficulty Direction
Goal clarity Effort Performance Rewards
Self efficacy Persistence

Moderators Consequences
Goal commitment
Task complexity

A simple model of goal setting

Goal setting is the process of developing, negotiating and establishing goals
which will be challenging enough to structure the individual's time and effort. The
key attributes of goals are:

Goal difficulty: A good goal should be challenging at the same time not too easy,
nor should h be too difficult.

Goal clarity: The goal should be clear and specific enough to direct the efforts of
the individual in the desired direction.

Self efficacy: The goal should be set such that the individual is able to perform
the task at the desired level.


There are certain factors which will moderate the strength of the relationship
between goals and performance. The first is ability — because this limits the
individual's capacity to respond to a challenge. An individual's goal orientation
can affect his ability to perform based on whether it is oriented towards learning
or performance. A person having a learning goal orientation will build up his
ability by acquiring new competencies and gain mastery over new situations.
Whereas, those having an inclination towards performance, will try to build up
their ability in order to continuously perform well by completing a task well in

Goal commitment in a simple way refers to an individual's determination to

perform. There are several factors which can affect a person's goal commitment.
These may be — employees' participation in goal commitment leading to a sense
of ownership, the employees' expectation of rewards for achieving goals, match
between expected rewards and actual rewards received and team work and peer

Feedback will provide the employee information about the outcomes and the
degree of employee performance. This can influence and bring about changes in
the degree of goal commitment.

Task complexity: Depending upon whether the task is simple or complex, the
employee will allocate his or her efforts to achieve the desired performance.


We presume that the individual may have challenging goals and the moderators to
support the achievement of these goals, now the model calls for the help of the
mediators who will be required to provide the necessary direction, effort,
persistence and task which will help him to perform the task well.

Direction: Refers to steer the individual to be involved in activities relevant to the


Effort: The amount the person exerts himself to reach the goal.

Persistence; It refers to the willingness of the individual to work at the task until
the results are reached.

Task strategy: The way in which the individual decides (usually through
instructions and experience) to tackle a task.

Performance of this individual should be high especially when challenging goals
are set, the noderators are present and the necessary mediators are operating. In
order to measure an employee'sperformance, organisations usually make use of
quantitative measures such as units of production, money in rupees and time.
When such measures are inappropriate, qualitative goals may be used. Over and
above, someorganisations also use a code of ethics to encourage employees to set
ethical goals and make ethical decisions.

When employees attain a high level of performance, rewards can be given to
them, and these will work as motivators and induce them to continue to perform
at that level. Rewards may be external (bonus, paid vacation etc.) or internal (a
sense of achievement or exuberance).

It is said that many factors such as challenging work, good colleagues, good pay
or salary, opportunity to learn and good working conditions can lead to
employee's satisfaction with his job. Thus attainment of goal can result in
individual satisfaction with performance associated with success.

Significance of the Theory

This goal setting theory or approach has a lot of practical implications for
employees, managers and groups.

(a) This can be used as a frame-work to analyse the potential problems with low
performing employees.

(b) It provides information to the management on how to create a high

performance work environment.

(c) It portrays the system of relationships and interplay among key factors such as
goal difficulty, goal commitment, feedback and rewards to achieve high

Let us take the example of the father of our nation Mahatma Gandhi who has
played a major role in India's fight forindependence. He had used the Path of
Non violence to motivate the masses (people) to fight against the British rule
over India, and march towards our struggle for an Independent India. Today,
when many people believe in getting whatever they desire for, through any
means, why cannot all of us be motivated by this great personality's thoughts
which conveyed the message "There is enough all over the world for every one's
need, but not for every one's greed?"


Having learned various theories or models of motivation in the previous unit now
a manager needs to see how to use them. This particular part will help to learn
how to apply motivational theories/models into practice.

As discussed earlier, motives are cognitive variables. They prompt people to
action. They arise on continuous basis and influence what people notice, how
they see and think, and whatthey learn from their environment. Such influence of
motivation on cognitive process is called motivational selectivity.For example, a
person who has an intense desire for having somethingwould be searching for
that particular thing, thus, forgetting or neglecting other things. In such
situations, the stimuli that are relevant to the active motive tend to stand out
focally, whereasthe irrelevant ones tend to fade into the background. The reason
being, people cannot assimilateall what they observe or receive from the
environment at a time. Hence, they selectively perceive objects/things which
interest to them most in a particular situation and avoid those for whichthey are
indifferent. Such selectivity involves the two psychological principles of (i)
figure grout* and (ii) relevancy. It means that people actively resist certain aspects
or objects while accepting the desirable ones. This is called perceptualdefence.
Perceptual errors are yet another type of motivational selectivity. If an employee
wants to seeher leader as an ideal or noble and a student wants to see his/her

Professor as a noble, it will be his/her tendency to neglect or resist evidences and
instances on the contrary.

Evidences suggest that when a particular motive-effort becomes fruitful, people

consider it as an incentive to direct their motive/effort in the same direction. In a
nutshell, the motivational selectivity aspects like attention and perception,
thinking and learning, remembering forgetting, fantasy and dreams, and levels of
awareness assume great importance in motivating people at work. Hence success
of motivation to a large extent depends upon selection of appropriate
motivational tools befitting the given situation and motivational selectivity.

Motivational tools are instruments that prompt people to action. Hence, while
using motivational tools, these should be adequate and capable enough to
motivate employees to make their maximum efforts to accomplish the set goals.
Various motivational tools used to motivate employees in business organisations
are broadlyclassified classified into monetory and non-monetory tools or
incentives. Here, we will focus on why motivational tools need to be appropriate
to activate people to action.

Man is a wanting animal. He works to satisfy his needs in a prepontency order.

Therefore motivational tools need to be effective enough to satisfy human needs.
As human needs vary between people and between different points of times in
case of the same person, motivation tools are, therefore, bound to vary
accordingly. For example, while increase in salary may satisfy one's physiological
needs, recognition may satisfy the esteem needs.

When needs are not satisfied, people become frustrated. Yes, there may be both
environmental and personal factors resulting in one's frustration. Apathy,
indifference, aggression, antagonism open conflict, physical violence, etc. are the
common responses to frustration observed in organisations. These are detrimental
to organisational efficiency.

It is true that reaction to frustration may vary from person to person, yet the
behaviour; pattern of individuals is likely to be identical in identical situations. As
such, it makes easier for the motivator/manager to apply the appropriate
motivational tools, if the behavioural pattern of the individuals is known to him.

Thus, it can be concluded that motivational tools are expected to be need

satisfying, and hence, need to be person-oriented. Better the motivational tools,
greater would be its effect on the individual behaviour. This would, in turn, lead
to organisational effectiveness. And in this lies the need for and significance of
motivational tools to be used to motivate employees in business organisations.

The term incentive means an inducement which rouses or stimulates one to
action ina desired direction. An incentive has a motivational power. A large
number of incentives the modern organisations use to motivate their employees
may be broadly grouped into (i) financial incentives, and (ii) non-financial
incentives. These are discussed one by one.

Financial Incentives

Money is an important motivator. Common uses of money as incentive are in the

form of wages and salaries, bonus, retirement benefits, medical reimbursement,
etc. Management needs to ease these financial incentives making wages and
salaries competitive between various organizations so as to attract and hold force.

Money plays a significant role in satisfying physiological and security/social

needs. As moneyis recognized as a basis of status, respect and power, it also
helps satisfy the social needs of the people. It is important to mention that once
the physiological and security needs are satisfied,money ceases to be motivator.
Money then becomes, what Herzberg termed, hygiene and maintenance factor.

The presence of hygiene factor, of course, prevents job dissatisfaction but do

not provide 'on the job satisfaction’ to the employees in the organisation. In such
case, money cannot be considered as motivator. Then, in order to motivate
employees, according to Herzberg, it is necessary to provide other incentives for
the satisfaction ofego, status and self actualization needs.

However, these needs are experienced generally by employees working at higher

levels inthe organisations. People in higher positions getting higher monetary
rewards are not motivatedbyincreased monetary rewards. Yes, they may be
motivated by money only when increase is large enough to raise their standard of
living and status in the society to which theybelong to.

What follows from above discussion is that money is not the only motivator and
also it is not always a motivator. In order to satisfy different kinds of human
needs, management needs to provide non-financial incentives such as job
enlargement, participative management, recognition, praise, etc. These also
motivate employees at their works.

Non-Financial Incentives
As mentioned earlier, man is a wanting animal. Once money satisfies his/her
physiology and security needs, it ceases to be a motivating force. Then, higher
order needs for status and recognition and ego in the society emerge. The
following non-financial incentives help management satisfy its employees' these
1. Appreciation of Work Done:Appreciation or praise for work done, be it
athome, at school/University or at work place, serves as an effective non-
financial incentive. Appreciation satisfies one's ego needs. However, managers
need to use this incentive with great degree of caution because praising an
incompetent employee may create resentment among competent employees.

2.Competition:If there exists a healthy competition among the employees both

at individual and group levels, it will prompt them to exert more to achieve their
personal or group goals. Thus, competition serves as a non-financial incentive for
employees to put in more efforts at their works.

3.Group Incentives:Some times, group incentives act as more effective than

individual incentives to motivate the employees. Particularly, when the prestige
or even existence of a group is at stake, the group members work with a team
spirit. This results in high morale and, in turn, increases in its productivity.

4.Knowledge of the Results:Knowledge of the results of work done leads to

employee satisfaction. An employee derives satisfaction when his/her boss
appreciates the work he/she has done just as an MBA student gets satisfaction
when his/her Professor appreciates the seminar he/ she presented in the class

5.Workers' Participation in Management:Inviting workers to participate in

organizational management gives worker'sa psychological satisfaction that their
voices are also heard. This imbibes a sense of importance among the workers.

6.Opportunity for Growth:Man is not only a wanting animal but an ambitious

creature also. People always need to grow in their career. So, if the employees
are provided proper opportunities for growth and career advancement and chance
to develop their personality, they feel much satisfied and become more
committed to the organisational goals.

7.Suggestion System:Suggestion system is yet another non-financial incentive to

be used to motivate employees. Following this, some organisations make use of
cash awards for givinguseful suggestions. They sometimes publish the worker's
name with his/her photograph in the company's magazine with a motive to
motivate other workers to search for useful suggestions for the company. Thus,
suggestion system acts as an incentive for the workers to be in search
ofsomething useful for the company.

8.Job Enrichment:Job enrichment simply means adding the contents to a job

leading toincreased responsibility, scope and challengein its performance.
Particularly, the executives working at higher levels often prefer to job
enrichmentbecause it makes job more challenging.

Theyderive higher satisfaction by performing more and more challenging jobs.

Thus job enrichment as an incentive motivates the executives to exert for
accomplishment of their goals. Job enrichment is a by-product of job design
which is discussed subsequently.

The job a worker does is a significant aspect of his/her life for more than one
reason: It provides worker not only a living, but also helps in achieving his/her
other goals such as economic, social, political and cultural. People who work for
living spend a significant period of their lives at work. Hence job needs to
provide them satisfaction to sustain their interest in jobs. This is done through job
design. While other incentives, as discussed in the preceding section, provide
extrinsic motivation job design provides intrinsic motivation to the workers.

A job can be defined as a grouping of tasks within a prescribed unit or units of

work. Job design is a deliberate attempt made to structure the tasks and social
relationships of a job to create optimal levels of variety, responsibility, autonomy
and interaction. In fact, the basic objective of job design is to maintain a fit
between a job and its performer so that the job is performed well and the job
performer derives satisfaction from doing job.

The important approaches or strategies a job design involves are job

enlargement, job enrichment, job simplification, job rotation, quality of work life
and goal-setting. The figure below summarizes the various approaches to job

Goal Job
setting enrichm

Quality Job
of simplific
worklife ation

Approaches to job design

Job Enlargement

Job enlargement consists of making a job larger in scope by combining additional

task activities into each job through expansion. This is called horizontal loading.
It, thus, focuses on enlarging jobs by increasing tasks and responsibilities.
Anexample of job enlargement in a University may be assigning a Professor the
task of looking after the NSS activities besides his/her teaching in his/her
Department. Similarly, a clerk in an office who is doing the typing work only may
also be assigned the task of drafting letters, sorting of incoming mails and filing
of letters.

Following are the advantages of job enlargement:

1. Job enlargement avoids monotony which is the result of high degree of

specialization and division of labour.
2. It improves workers satisfaction, decreased production costs, and increased
3. It also improves the worker's efficiency at work.

In spite of above advantages, certain disadvantages of job enlargement cannot be

lost sightof. These are:

1. Workers may require additional training for performing enlarged tasks. Thus,
the training costs tend to rise.
2. Moreover, productivity may fall during the introduction of new system based
on job redesigning.
3. Lastly, workers often argue for increased pay because of the increased work
load as a result of job enlargement.
Job Enrichment

Closely related to job enlargement is job enrichment. Job enrichment is a direct

outgrowth of Herzberg's two-factor theory of motivation. It refers to the vertical
enlargement of a job by adding responsibility and opportunity for personal
growth. In other words, job enrichment is concerned with designing jobs that
include a greater variety of work content, require a higher level of knowledge
and skill, give worker more autonomy and responsibility, and provide
opportunity for personal growth. Increase in job content vertically leads to
variety, making repetitive jobs less boring but more satisfying.

The term job enrichment is to be distinguished from the term job enlargement.
The difference between the two lies on the nature of additions to the job. While
job enlargement involves a horizontal loading, or expansion, or the adding of
more tasks of the same general nature, job enrichment involves vertical loading,
addition giving more challenge.

The advantagesof job enrichment are as follows:

1. It makes the job more interesting.

2. It discourages absenteeism and turnover of workers.
3. It motivates employees through opportunities for growth and advancement.
4. Workers derive higher job satisfaction from doing work.
5. The enterprise also gains through improvement of output both in quantity and

However, job enrichment is not an unmixed blessing. It suffers from the

followinglimitations or disadvantages also:

1. Technologically, it may not be easy to enrich all jobs.

2. Enrichment of jobs has proved to be a costly preposition in certain cases as
expenditure exceeds gains.
3. Adding challenges to highly skilled jobs may not necessarily bring
satisfaction forhighly professional ones.
4. All those who prefer to job enrichment may not have the requisite capability
to meet the newchallenges.

Go through the following short case of job enrichment applied in Dynamo

CorporationLimited, Rampur. It will help you understand how job enrichment
motivates workers to improve their jobperformance.

Job Enrichment in Dynamo Corporation Limited, Rampur

An interesting study in job enrichment was undertaken at the Rampur unit of
Dynamo Corporation Limited. The corporation was set up for 10 years and
produced items for the "core" sector (heavy engineering equipment). The study
was conducted on managers, supervisors, and workers of a unit producing
auxiliary equipment. An initial survey revealed that none of the workers was
emotionally committed to the product; there was forced idle time because of task
interdependence and uneven distribution of work load. Having worked for a long
time at the same job, workers did not find it sufficiently challenging.

These findings were placed before the total unit, which agreed on setting up a
rotating task force with representatives from each category and the introduction
of a new work system. The new work system consisted of having a group of
employees taking charge of a complete task and gradually taking on each other's
job after training. Thus a welder did the job of a fitter, and a fitter did that of a
welder or a gas cutter. Each worker became multiskilled. Three things were
noted: (1) Monotony was partially eliminated; (2) the traditional hierarchical
concept of trade was minimized, and (3) a positive attitude towards co-workers
and the work was developed.

Monthly data for targets set and percentages of fulfillment of targets were
plotted. From April 1975 to November 1975, rising trends were noticed both in
the fulfillment of targets and the overall efficiency against clocked time. There
was an increase of 6.9 per cent and 45.3 percent in relation to the targets and the
overall efficiency respectively. Thus, changes in jot content, greater variety, and
freedom contributed to the performance of the employees.

Job Simplification
In case of job simplification, a job is broken down, to the extent possible, into
smaller part as is done in assembly line operations. Doing so fragmented task
repetitively leads to increase i worker's productivity. However, the other side of
doing the repetitive task is that job may produce boredom and monotony to the
workers. This may, in turn, lead to a tendency of absenteeism among them.
Nonetheless, such type of job may be suitable for workers having low levels of
skill' and knowledge.

Job Rotation
Some people have suggested job rotation also as a motivational strategy. In job
rotation, worker moves from one job to another, at the same level,that has similar
skill requirements. Job rotation reduces boredom and monotony through
changing employee's activities. This has almost the similar effects as the job
enlargement has. However, job rotation has certain drawbacks also. The
important ones are(i)Work suffers from obvious disruption caused by change in
job; ( ii)Job rotation becomes less useful as specialisation proceeds, and (iii) It
may demotivate intelligent and ambitious employees who seek specific
responsibilities in their chosen speciality.

Quality of Work Life (QWL)

There have been divergent views as to what really is quality of work life (QWL).
According to Sangeeta Jain,QWL consists of a whole parcel of terms and notions
all of which really belong under the ‘Quality of working Life Umbrella'. Walton
viewed it as consisting of all those work conditions that give satisfaction to
workers while doing their jobs/tasks. In simple words, QWL refers to the
favourableness or unfavourableness of a total job environment for people. The
elements included in a QWL programme like open communication, equitable
reward system,employees' job security and satisfaction, participative
management, development of employee skill, etc. make job environment
Though one can catalogue a long list of factors that contribute to quality of work
life, following four are the broad and common ones:

1. Job Involvement
2. Job Satisfaction
3. Sense of Competence
4. Job Performance and Productivity

Now, in what follows is their brief description one by one.

1. Job Involvement:Job involvement indicates the extent a worker identifies

himself/herself with the work. Workers involved in their jobs spent more time on
their jobs. Challenging jobs make workers to get involved with their jobs.
Besides, people with high need for achievement and high work ethic are also
found to be involved with their jobs.

2. JobSatisfaction: Job satisfaction refers to one's good or positive feeling

toward his/her job. Job satisfaction improves work performance and reduces
employee absenteeism and turnover.

3. Sense of Competence:Job involvement ultimately results in sense of

competence. Sense of competence denotes the feelings of confidence that one has
in one's own ability, skill or competence. High sense of competence and job
involvement combinedly produce high levels of job satisfaction and productivity.

4.Job Performance and Productivity:The aforesaid three factors - job

involvement, job satisfaction, and sense of competence—boil down to improved
job performance and productivityof employees.

How to improve QWL? Suggestion and measures given by behavioural scientists

do not tally but vary. The simplest solution to improve QWL may be improving
the existing job environment. Some researchers consider two directions to
improve QWL. One direction concerns the alleviation or removal of negative
aspects of work and working conditions and the other direction concerns the
modification of aspects of work and working conditions. Measures to improve
QWL in India, as suggested by one researcher, include participative community
development projects, job sharing and creating part-time jobs, choice of
appropriate technology, involving unions, education and training and legislative
measures. Besides, the conditions that contribute to motivation (equitable
salaries, financial incentives, effective employee selection, etc.) also contribute
to improving the quality of work life (QWL).

Job Analysis
Closely related to job enlargement, enrichment, simplification, and rotation is job
analysis. Job analysis is a statement mentioning who will do what. Absence of
job analysis may adversely affect the performance of a task just as exemplified as

This is a story about four people named Everybody, Somebody, Anybody and
Nobody.There was an important job to be done and Everybody was sure that
Somebody would do it. Anybody could have done it, but Nobody did it.
Somebody got angry about that because it wasEverybody's job. Everybody
thought Anybody could do it, but Nobody realized that Everybody wouldn't do it.
It ended up that Everybody blamed Somebody when Nobody did what Anybody
could have done!

Goal setting

What is a goal? Goal is a target and objective for future performance. It helps
focus employee’s attention on items of greater importance to the organisation
and stimulates employee towards goal attainment. Goal setting refers to setting of
attainable goals for an organisation as well as for an employee.

It was Locke who did the seminal work on a theory of goal setting way back in
1968. His theory has generated a considerable research on goal setting. Goal
setting works as a motivation, tool because it creates adiscrepancy between
current and expected performance. Goal setting results in a feeling of tension
which is diminished through goal attainment. Individuals attain goals
successfully tend to set even higher goals in the future. Self-efficacy contributes
a lot success of goal setting. Self-efficacy is an internal belief regarding one's
job-related capability and competencies. It differs from self-esteem, which is a
broader feeling of like or dislike for oneself.

The presence of the following four elements in goal setting makes it more
effective improving job performance:

1. Goal Acceptance
2. Specific Goals
3. Challenging Goals
4. Performance Monitoring/Feedback. These are shown in the figure below.

Acceptance Specificity


Challenging Monitoring and


Elements Making Goal Setting Effective

A brief description of these follows:

Goal Acceptance: Effective goals need to be not only understood but also
accepted. Accepted goals arrived at through participation seem preferable to
assigned goals. There is a simple evidence to suggest that people who set their
goals through participation, and who own their own goals perform better than
those who are told what their goals are going to be.

Specific goals: Goals need to be specific, clear and measurable as possible.

Specific goals are always better than vague and general goalssuch as “do your
best”, “do better” or “work harder”. Giving a salesperson a specific quota or
worker an exact number of units to produce should be preferable to setting a goal
such as “try as hard as you can”, or “try to do better than last year”.

Challenging goals:Research shows that most employees work harder when they
nave difficult goals to attain rather than easy ones. Take the case of MBA students
itself, for example. They work harder in papers e.g. Financial Management,
Statistics for Managers, etc. which they treat/consider hard or difficult and their
surprise they perform better in these papers than in easy or simple ones, e.g.
Principles of Management, Marketing Management, etc. However, challenging
goals must be attainable/reachable and no so difficult that they would be

Monitoring and Feedback:Besides setting well-defined and challenging goals,

the two closely related elements, viz monitoring and feedback, are also important
to complete the process of goal-setting. Performance monitoring is observing
one's behaviour, inspecting output, etc. This heightens their awareness of the role
they play in contributing to organisational effectiveness.

Monitoring needs to be followed by performance feedback to enable employee to

have an idea how successful he/she is. Man, by nature, is hungry for information
about how well he/she is performing. Just as a football team needs to know the
score of the game, the woodchoper needs to see the chips fly and and pile of
firewood grow, and the student of MBA like you needs to know how he
performed in his assignment-seminar, the same is true of a worker working in an
organisation. In sum, performance feedback lends to increase better job
performance, and self generated feedback is an especially powerful motivational

A logical extension of goal setting is the traditionally used management-by-

objectives, or MBO, approach to planning, control, performance appraisal, and
overall system performance. The same is discussed next.


The, term 'management by objectives* (MBO) was first coined by Peter Drucker
in 1954, Basically, Drucker tried to attach MBO level to result-oriented
evaluations. He proposed MBO as a means of using goals to motivate people
rather than to control them. Management by objectives can simply be defined as a
programme that encompasses specific goals, paiticipatively set, for an explicit
time period, with feedback on goal progress.

According to Odiorne, "MBO is a process whereby the superior and subordinate

managers of an organisation jointly identify common. goals, define each
individual's major areas of responsibilities in terms of the results expected of him,
and use these measures as guides for operating the unit and assessing the
contribution of each of its members."

MBO provides specific objectives for each succeeding level (i.e., divisional,
departmental, individual in the organisation). In other words, MBO is a process
by which objectives cascade down through the organisation as depicted in the
figure below.

An MBO programme or process consists of four common ingredients. These are:

specificity, participative decision making, an explicit time period, and
performance feedback. A brief description of these follows.

1.Specificity:The objectives in MBO should be clear and precise that can be

measured andevaluated. To state a desire to cut costs, for example, may not be
enough. Instead, to cut costsby 5 per cent will be more clear, exact and
measurable objective.

2.Participative Decisions/Objectives:In MBO goals are not imposed on people.

Thesuperior and subordinate jointly set objectives to be attained.

3.Explicit Time:Each objective is to be completed within a specific time period,

be it threemonths, six months or a year.

4.Performance Feedback:The final ingredient in an MBO programme is

feedback onperformance. It includes continuous and systematic measurement and
review of performance.Based on these; corrective actions are taken to achieve the
planned objectives.

Advantages of MBO
Following are the advantages of MBO:

1. The need to clarify objectives is stressed and suggestions fo