INDIAN CONTRACT ACT 1872

INDIAN CONTRACT ACT 1872

INTRODUCTION
• The Law of Contract deals with the law relating to the general principles of contract. It is the most important part of Mercantile Law. It affects every person in one way or the other, as all of us enter into some kind of contract everyday.
• Since this law was not happily worded, two subsequent legislations namely Indian Sale of Goods Act – Sections 76 to 123 of the Indian Contract Act 1872 were repealed; and Partnership Act was also enacted and Sections 239 to 266 of the Contract Act were also repealed.
What is ‘Contract‘
• The term ‘Contract‘ is defined in Section 2(h) of the Indian Contract Act, which reads as under
“An agreement enforceable by law is a contracts.”
• The analysis of this definition shows that a contract must have the following two elements:
1. An agreement, and
2. The agreement must be enforceable by law.
• In other words:
Contract = An Agreement + Enforceability (by law)
Agreement (Section 2(e)
Every promise and every set of promises forming the consideration for each other is an agreement.
Promise (Section 2(b))
A proposal when accepted becomes a promise.
• Every agreement is not a contract. When an agreement creates some legal obligations and is enforceable by law, it is regarded as a contract.
2.1 ESSENTIAL ELEMENTS OF CONTRACT
1. Agreement
2. Intention to create legal relationship
3. Free and genuine consent.
4. Parties competent to contract.
5. Lawful consideration.
6. Lawful object.
7. Must be in writing. (Generally, oral contract is not enforceable)
8. Agreement not declared void or illegal.
9. Certainty of meaning.
10. Possibility of performance.
11. Necessary legal formalities.
Ex –
Where ‘A’ who owns 2 cars x and y wishes to sell car ‘x’ for Rs. 30,000. ‘B’, an acquaintance of ‘A’ does not know that’ A’ owns car ‘x’ also. He thinks that’ A’ owns only car ‘y’ and is offering to sell the same for the stated price. He gives his acceptance to buy the same. There is no contract because the contracting parties have not agreed on the same thing at the same time, ‘A’ offering to sell his car ‘x’ and ‘B’ agreeing to buy car or’. There is no consensus-ad-idem.
LAW OF CONTRACT CREATES jus in personam
• The term jus in personam means a “right against or in respect of a specific person.” Thus, law of contract creates jus in personam and not jus in rem. A jus in rem means a right against or a thing.
CLASSIFICATION OF CONTRACTS
1. Classification according to validity or enforceability.
a) Valid
b) Voidable
c) Void contracts or agreements
d) Illegal.
e) Unenforce¬able
2. Classification according to Mode of formation
(i) Express contract
(ii) Implied contract
2. Classification according to Performance
(i) Executed contract
(ii) Executory contract.
(iii) Unilateral Contract
(iv) Bilateral Contract
2.2 OFFER AND ACCEPTANCE
[Sections 3-9]
OFFER
What is ‘Offer/Proposal‘
• A Proposal is defined as “when one person signifies to another his willingness to do or to abstain from doing anything, with a view to obtaining the assent of that other to such act or abstinence, he is said to make a proposal.” [Section 2(a)].
How an Offer is made?
• An offer can be made by
(a) any act or
(b) omission of the party proposing by which he intends to com¬municate such proposal or which has the effect of communicating it to the other (Section 3).
CASE EXAMPLE
In Carbolic Smoke Ball Co. ‘s case, the patent-medicine company advertised that it would give a reward of £100 to anyone who contracted influenza after using the smoke balls of the company for a certain period according to the printed directions. Mrs. Carlill purchased the advertised smoke ball and contracted influenza in spite of using the smoke ball according to the printed instructions. She claimed the reward of £100. The claim was resisted by the company on the ground that offer was not made to her and that in any case she had not com¬municated her acceptance of the offer. She filed a suit for the recovery of the reward. Held: She could recover the reward as she had accepted the offer by complying with the terms of the offer.)
ESSENTIAL REQUIREMENTS OF A VALID OFFER
• An offer must have certain essentials in order to constitute it a valid offer. These are:
I. The offer must be made with a view to obtain acceptance.
2. The offer must be made with the intention of creating legal relations. [Balfour v. Balfour (1919) 2 K.B.57Il
2. The terms of offer must be definite, unambiguous and certain or capable of being made certain. The terms of the offer must not be loose, vague or ambiguous.
4. An offer must be distinguished from (a) a mere declaration of intention or (b) an invitation to offer or to treat.
An auctioneer, at the time of auction, invites offers from the would-be-bidders. He is not making a proposal.
A display of goods with a price on them in a shop window is construed an invitation to offer and not an offer to sell.
Offer vis-a-vis Invitation to offer
 An offer must be distinguished from invitation to offer.
 A prospectus issued by a company for subscription of its shares by the members of the public, is an invitation to offer. The Letter of Offer issued by a company to its existing shareholders is an offer.
5. The offer must be communicated to the offeree. An offer must be communicated to the offeree before it can be accepted. This is true of specific as sell as general offer.
6. The offer must not contain a term the non-compliance of which may be assumed to amount to acceptance.
Cross Offers
• Where two parties make identical offers to each other, in ignorance of each other’s offer, the offers are known as cross-offers and neither of the two can be called an acceptance of the other and, therefore, there is no contract.
TERMINATION OR LAPSE OF AN OFFER
• An offer is made with a view to obtain assent thereto. As soon as the offer is accepted it becomes a con¬tract. But before it is accepted, it may lapse, or may be revoked. Also, the offeree may reject the offer. In these cases, the offer will come to an end.
1) The offer lapses after stipulated or reasonable time
2) An offer lapses by the death or insanity of the offeror or the offeree before acceptance.
3) An offer terminates when rejected by the offeree.
4) An offer terminates when revoked by the offeror before acceptance.
5) An offer terminates by not being accepted in the mode prescribed, or if no mode is prescribed, in some usual and reasonable manner.
A conditional offer terminates when the condition is not accepted by the offeree.
(7) Counter Offer
TERMINATION OF AN OFFER
1. An offer lapses after stipulated or reasonable time.
2. An offer lapses by the death or insanity of the offeror or the offeree before acceptance. 2. An offer lapses on rejection.
4. An offer terminates when revoked.
5. It terminates by counter-offer.
6. It terminates by not being accepted in the mode prescribed or in usual and reasonable manner.
7. A conditional offer terminates when condition is not accepted.
ACCEPTANCE
• Acceptance has been defined as “When the person to whom the proposal is made signifies his assent thereto, the proposal is said to be accepted”.
Acceptance how made
• The offeree is deemed to have given his acceptance when he gives his assent to the proposal. The assent may be express or implied. It is express when the acceptance has been signified either in writing, or by word of mouth, or by performance of some required act.
Ex- A enters into a bus for going to his destination and takes a seat. From the very nature, of the circumstance, the law will imply acceptance on the part of A.]
• In the case of a general offer, it can be accepted by anyone by complying with the terms of the offer.
ESSENTIALS OF A VALID ACCEPTANCE
1) Acceptance must be absolute and unqualified.
2) Acceptance must be communicated to the offeror.
3) Acceptance must be according to the mode prescribed.
Ex- A sends an offer to B through post in the usual course. B should make the acceptance in the “usual and reasonable manner” as no mode of acceptance is prescribed. He may ac¬cept the offer by sending a letter, through post, in the ordinary course, within a reasonable time.
COMMUNICATION OF OFFER, ACCEPTANCE AND REVOCATION
• As mentioned earlier that in order to be a valid offer and acceptance.
(i) the offer must be communicated to the offeree, and
(ii) the acceptance must be communicated to the offeror.
The communication of acceptance is complete:
(i) as against the proposer, when it is put into a course of transmission to him, so as to be out of the power of the acceptor;
(ii) as against the acceptor, when it comes to the knowledge of the proposer.
Ex-
A proposes, by letter, to sell a house to B at a certain price. B accepts A’s proposal by a letter sent by post. The communication of acceptance is complete: (i) as against A, when the letter is posted by B; (ii) as against B, when the letter is received by A.
The communication of a revocation (of an offer or an acceptance) is complete:
(1) as against the person who makes it, when it is put into a course of transmission to the person to whom it is made, so as to be out of the power of the person who makes it.
(2) as against the person to whom it is made when it comes to his knowledge.
Ex-
A revokes his proposal by telegram. The revocation is complete as against A, when the tele¬gram is dispatched. It is complete as against B, when B receives it.
Revocation of proposal and acceptance:
• A proposal may be revoked at any time before the communication of its acceptance is complete as against the proposer, but not afterwards.
Ex-
A proposes, by a letter sent by post, to sell his house to B. B accepts the proposal by a letter sent by post. A may revoke his proposal at any time before or at the moment when B posts his letter of ac¬ceptance, but not afterwards. B may revoke his acceptance at any time before or at the moment when the letter communi¬cating it reaches A, but not afterwards.

2.3 CAPACITY TO CONTRACT
(Sections 10-12)
WHO ARE NOT COMPETENT TO CONTRACT
• The following are considered as incompetent to contract, in the eye of law: -
(1) Minor: -
(i) A contract with or by a minor is void and a minor, therefore, cannot, bind himself by a contract.
(ii) A minor’s agreement cannot be ratified by the minor on his attaining majority.
(iii) If a minor has received any benefit under a void contract, he cannot be asked to refund the same.
(iv) A minor cannot be a partner in a partnership firm.
(v) A minor’s estate is liable to a person who supplies necessaries of life to a minor.
CASE EXAMPLE
In 1903 the Privy Council in the leading case of Mohiri Bibi v. Dharmodas Ghose (190,30 Ca. 539) held that in India minor’s contracts are absolutely void and not merely voidable.
The facts of the case were:
Dharmodas Ghose, a minor, entered into a contract for borrowing a sum of Rs. 20,000 out of which the lender paid the minor a sum of Rs. 8,000. The minor executed mortgage of property in favour of the lender. Subsequently, the minor sued for setting aside the mortgage. The Privy Council had to ascertain the validity of the mortgage. Under Section 7 of the Transfer of Property Act, every person competent to contract is competent to mortgage. The Privy Coun¬cil decided that Sections 10 and 11 of the Indian Contract Act make the minor’s contract void. The mortgagee prayed for refund of Rs. 8,000 by the minor. The Privy Council further held that as a minor’s contract is void, any money advanced to a minor cannot be recovered.
(2) Mental Incompetence
 A person is said to be of unsound mind for the purpose of making a contract, if at the time when he makes it, he is incapable of understanding it, and of forming a rational judgement as to its effect upon his interests.
 A person, who is usually of unsound mind, but occasionally of sound mind, may make a contract when he is of sound mind.
Ex- A patient, in a lunatic asylum, who is at intervals, of sound mind; may contract during those intervals.
A sane man, who is delirious from fever or who is so drunk that he cannot understand the terms of a contract or form a rational judgement as to its effect on his interest, cannot contract whilst such delirium or drunkenness lasts.
(3) Incompetence through Status
(i) Alien Enemy (Political Status)
(ii) Foreign Sovereigns and Ambassadors
(iii) Company under the Companies Act or Statutory Corporation by passing Special Act of Parliament (Corporate status)
(iv) Insolvent Persons
2.4 FREE CONSENT
(Sections 10; 13-22)
What is the meaning of ‘CONSENT‘ (SECTION 13)
• When two or more persons agree upon the same thing in the same sense, they are said to consent.

Ex-
A agrees to sell his Fiat Car 1983 model for Rs. 80,000. B agrees to buy the same. There is a valid contract since A and B have consented to the same subject matter.
What is meant by ‘Free Consent‘
• Consent is said to be free when it is not caused by¬
Causes affecting contract Consequences
1. Coercion
2. Undue influence
2. Fraud
4. Misrepresentation
5. Mistake –
(i) of fact
(a) Bilateral
(b) Unilateral
(ii) of Fact Contract voidable
Contract voidable
Contract voidable
Contract voidable


Void
Generally not invalid
Void
Ex -
(i) A railway company refuses to deliver certain goods to the consignee, except upon the pay¬ment of an illegal charge for carriage. The consignee pays the sum charged in order to obtain the goods. He is entitled to recover so much of the charge as was illegally excessive.
(ii) The directors of a Tramway Co. issued a prospectus stating that they had the right to run tramcars with steam power instead of with horses as before. In fact, the Act incorporating the company provided that such power might be used with the sanction of the Board of Trade. But, the Board of Trade refused to give permission and the company had to be wound up. P, a shareholder sued the directors for dam¬ages for fraud. The House of Lords held that the directors were not liable in fraud because they honestly believed what they said in the prospectus to be true. [Derry v. Peek (1889) 14 A.C. 337].
2.5 CONSIDERATION
[Sections 2(d), 10,23-25, 148, 185]
Definition
• Consideration is what a promisor demands as the price for his promise. In simple words, it means ‘something in return.’
• Consideration has been defined as
“When at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or promises to abstain from doing some¬thing, such act or abstinence or promise is called a consideration for the promise.”
IMPORTANCE OF CONSIDERATION
• A promise without consideration is purely gratuitous and, however sacred and binding in honour it may be, cannot create a legal obligation.
• A person who makes a prom¬ise to do or abstain from doing something usually does so as a return or equivalent of some loss, damage, or inconvenience that may have been occasioned to the other party in respect of the promise. The benefit so received and the loss, damage or inconvenience so caused is regarded in law as the consideration for the promise.
KINDS OF CONSIDERATION
• A consideration may be:
1. Executed or Present
2. Executory or Future
2. Past
2.6 LEGALITY OF OBJECT
(Sections 23, 24)
• An agreement will not be enforceable if its object or the consideration is unlawful. According to Section 23 of the Act, the consideration and the object of an agreement are unlawful in the following cases:
What consideration and objects are unlawful – agreement VOID
1. If it is forbidden by law
2. If it is of such a nature that if permitted, it would defeat the provisions of any law.
2. If it is fraudulent. An agreement with a view to defraud other is void.
4. If it involves or implies injury to the person or property of another. If the object of an agree¬ment is to injure the person or property of another it is void.
5. If the Court regards it as immoral or opposed to public policy. An agreement, whose object or consideration is immoral or is opposed to the public policy, is void.
Ex-
A partnership entered into for the purpose of doing business in arrack (local alcoholic drink) on a licence granted only to one of the partners, is void ab-initio whether the partnership was entered into before the licence was granted or afterwards as it involved a transfer of licence, which is forbidden and penalised by the Akbari Act and the rules thereunder [Velu Payaychi v. Siva Sooriam, AIR (1950) Mad. 987].
2.7 VOID and VOIDABLE Agreements
(Sections 26-30)
Void agreement
1. The following are the additional grounds declaring agreements as void: -
(i) Agreements by person who are not competent to contract.
(ii) Agreements under a mutual mistake of fact material to the agreement.
(iii) Agreement with unlawful consideration.
(iv) Agreement without consideration. (Exception – if such an agreement is in writing and registered or for a past consideration)
(v) Agreement in restraint of marriage.
(vi) Agreement in restraint of trade
(vii) Agreements in restrain of legal proceedings,
(viii) Agreements void for uncertainty (Agreements, the meaning of which is not certain, or capable of being made certain)
(ix) Agreements by way of wager (a promise to give money or money’s worth upon the determination or ascertainment of an uncertain event)
(x) Agreements against Public Policy
(xi) Agreements to do impossible act.
Voidable agreements
• An agreement, which has been entered into by misrepresentation, fraud, coercion is voidable, at the option of the aggrieved party.
2.8 CONTINGENT CONTRACTS
(SECTIONS 31-36)
• A contingent contract is a contract to do or not to do something, if some event, collateral to such con¬tract does or does not happen.
When a contingent contract may be enforced
• Contingent contracts may be enforced when that uncertain future event has happened. If the event becomes impossible, such contracts become void.
ESSENTIAL ELEMENTS OF A CONTINGENT CONTACT
1. There must be a valid contract.
2. The performance of the contract must be conditional.
3. The even must be uncertain.
4. The event must be collateral to the contact.
5. The event must be an act of the party.
6. The event should not be the discretion of the promisor.
2.9 QUASI CONTRACTS
[SECTIONS 68- 72]
• The term ‘quasi contract‘ may be defined as a ‘ contract which resembles that created by a contract.‘ as a matter of fact, ‘quasi contract‘ is not a contract in the strict sense of the term, because there is no real contract in existence. Moreover, there is no intention of the parties to enter into a contract. It is an obligation, which the law creates in the absence of any agreement.
CIRCUMSTANCES OF QUASI CONTRACTS
• Following are to be deemed Quasi-contracts.
(i) Claim for Necessaries Supplied to a person incapable of Contracting or on his account.
(ii) Reimbursement of person paying money due by another in payment of which he is inter¬ested. Obligation of a person enjoying benefits of non-gratuitous act.
(iii) Responsibility of Finder of Goods
(iv) Liability of person to whom money is paid, or thing delivered by mistake or under coercion
Ex-
A, who supplies the wife and children of B, a lunatic, with necessaries suitable to their con¬ditions in life, is entitled to be reimbursed from B’s property.
2.10 PERFORMANCE OF CONTRACTS
[SECTIONS 37-67]
Offer to perform or tender of performance
• According to Section 38, if a valid offer/tender is made and is not accepted by the promisee, the promisor shall not be responsible for non-performance nor shall he lose his rights under the contract. A tender or offer of performance to be valid must satisfy the following conditions:
1. It must be unconditional.
2. It must be made at proper time and place, and performed in the agreed manner.
WHO MUST PERFORM
• Promisor - The promise may be performed by promisor himself, or his agent or by his legal representative.
• Agent - the promisor may employ a competent person to perform it.
• Legal Representative - In case of death of the promisor, the Legal representative must perform the promise unless a contrary intention appears from the contract.

CONTRACTS, WHICH NEED NOT BE PERFORMED
I. If the parties mutually agree to substitute the original contract by a new one or to rescind or alter it
2. If the promisee dispenses with or remits, wholly or in part the performance of the promise made to him or extends the time for such performance or accepts any satisfaction for it.
2. If the person, at whose option the contract is voidable, rescinds it.
4. If the promisee neglects or refuses to afford the promisor reasonable facilities for the performance of his promise.
2.11 DISCHARGE OF CONTRACTS
[Sections 73-75]
• The cases in which a contract is discharged may be classified as follows:
A. By performance or tender
B. By mutual consent
 A contract may terminate by mutual consent in any of the following ways: -
a. Novation (substitution)
b. Recession (cancellation)
c. Alteration
C. By subsequent impossibility
D. By operation of law
E. By breach
2.12 REMEDIES FOR BREACH OF CONTRACT
(SECTIONS 73-75)
• As soon as either party commits a breach of the contract, the other party becomes entitled to any of the following reliefs: -
a) Recession of the contract
b) Damages (monetary compensation)
c) Specific performance
d) Injunction
e) Quantum meruit
Ex –
A, a singer contracts with B, the manager of a theatre, to sing at his theatre for two nights in every week during the next two months, and B engages to pay her Rs. 100 for each night’s performance. On the sixth night, A wilfully absents herself from the theatre and B in consequence, rescinds the contract. B is entitled to claim compensation for the damages for which he has sustained through the non-fulfilment of the contract.
2.13 CONTRACTS OF INDEMNITY
[SECTIONS 124-125]
What is contract of indemnity
• A contract of indemnity is a contract whereby one party promises to save the other from loss caused to him by the conduct of the promisor himself or by the conduct of any other party.
• A contract of indemnity may arise either (1) by an express promise or (2) by operation of law i.e. the duty of a principal to indemnify an agent from consequences of all lawful acts done by him as an agent.
RIGHTS OF INDEMNIFIED (THE INDEMNITY HOLDER)
• The indemnity holder is entitled to recover from the promisor
a) All the damages which may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies
b) All costs of suit which he may have to pay to such third party provided in bringing or defending the suit (i) he acted under the authority of the indemnifier or (ii) he did not act in contravention of the orders of the indemnifier and in such a such as a prudent man would act in his own case.
c) All sums which he may have paid under the terms of any compromise of any such suit, if the compromise was not contrary to the orders of the indemnifier, and was one which it would have been prudent for the promisee to make.
RIGHTS OF INDEMNIFIER
• The Contract Act makes no mention of the rights of the indemnifier. It has been held in Jaswant Singh Vs. Section of State 14 Bom 299 that the indemnifier becomes entitled to the benefit of all the securities, which the creditor has against the principal debtor whether he was aware of them, or not.
2.14 CONTRACT OF GUARANTEE
[SECTION 126]
What is Contract of Guarantee
• A contract of guarantee is defined as a contract to perform the promise or discharge the liability or a third person in case of his default.
• The person who gives the guarantee is called the “Surety”, the person from whom the guarantee is given is called the “Principal Debtor” and the person to whom the guarantee I given is called the “Creditor”.
Requirement of two contracts
• It must be noted that in a contract of guarantee there must, in effect be two contracts, a principal contract - the principal debtor and the creditor ; and
(i) a secondary contract - the creditor and the surety.
Ex –
When A requests B to lend Rs. 10,000 to C and guarantees that C will repay the amount within the agreed time and that on C failing to do so, he will himself pay to B, there is a contract of guarantee.
Essential and legal rules for a valid contract of guarantee
(i) The contract of guarantee must satisfy the requirements of a valid contract
(ii) There must be someone primarily liable
(iii) The promise to pay must be conditional
Kinds of guarantee
(i) Specific Guarantee
(ii) Continuing Guarantee
RIGHTS AND OBLIGATIONS OF THE CREDITOR
Rights
• The creditor is entitled to demand payment from the surety as soon as the principal debtor refuses to pay or makes default in payment.
Obligations
• The obligations of a creditor are:
1) Not to change any terms of the Original Contract.
2) Not to compound, or give time to, or agree not to sue the Principal Debtor
3) Not to do any act inconsistent with the rights of the surety
RIGHTS OF SURETY
• Rights of a surety may be classified under three heads:
1. Rights against the Creditor
In case of fidelity guarantee, the surety can direct creditor to dismiss the employee whose honesty he has guaranteed, in the event of proved dishonesty of the employee.
2. Rights against the Principal Debtor
(a) Right of Subrogation (stepping into the shoes of the original)
Where a surety has paid the guaranteed debt on its becoming due or has performed the guaranteed duty on the default of the principal debtor, he is invested with all the rights, which the creditor has against the debtor.
(b) Right to be indemnified
The surety has the right to recover from the principal debtor, the amounts which he has rightfully paid under the contract of guarantee.
2. Rights of Contribution
Where a debt has been guaranteed by more than one person, they are called as co-sureties. When a surety has paid more than his share, he has a right of contribution from the other sureties who are equally bound to pay with him.
LIABILITIES OF SURETY
• The liability of a surety is called as secondary or contingent, as his liability arises only on default by the principal debtor.
• But as soon as the principal debtor defaults, the liability of the surety begins and runs co-extensive with the liability of the principal debtor, in the sense that the surety will be liable for all those sums for which the principal debtor is liable. The creditor may file a suit against the surety without suing the principal debtor.
• Where the creditor holds securities from the principal debtor for his debt, the creditor need not first exhaust his remedies against the securities before suing the surety, unless the contract specifically so provides.
DISCHARGE OF SURETY
1. By notice of revocation
2. By death of surety
2. By variance in terms of contract
4. By release or discharge of Principal Debtor
5. By compounding with, or giving time to, or agreeing not to sue, Principal Debtor
6. By creditor’s act or omission impairing Surety’s eventual remedy
7. Loss of Security
2.15 CONTRACT OF BAILMENT AND PLEDGE BAILMENT
[SECTIONS 148 –181]
What is ‘Bailment‘
• When one person delivers some goods to another person under a contract for a specified purpose and when that specified purposes is accomplished the goods shall be delivered to the first person, it is known as Bailment
• The person delivering the goods is called the “Bailor”, and the person to whom goods are delivered is called the “Bailee”.
CHARACTERISTICS OF BAILMENT
1. Delivery of Goods - it may be express or constructive (implied).
2. Contract.
2. Return of goods in specie.
KINDS OF BAILMENTS
• Bailment may be classified as follows: -
1. Deposit - Delivery of goods by one man to another to keep for the use of the bailor.
2. Commodatum - Goods lent to friend gratis (free of charge) to be used by him.
2. Hire - Goods lent to the bailee for hire, i.e., in return for payment of money.
4. Pawn or Pledge - Deposit of goods with another by way of security for money borrowed.
5. Delivery of goods for being transported by the bailee - for reward.
DUTIES OF BAILOR
1. To disclose faults in the goods
2. Liability for breach of warranty as to title.
2. To bear expenses in case of Gratuitous bailments
4. In case of non-gratuitous bailments, the bailor is held responsible to bear only extra-ordinary expenses.
Ex-
A horse is lent for a journey. The ordinary expenses like feeding the horse etc., shall be borne by the bailee but in case horse falls ill, the money spent in his treatment will be regarded as an extra-ordinary expenditure and borne by the bailor.
DUTIES OF THE BAILEE
1. To take care of the goods bailed
2. Not to make unauthorised use of goods
2. Not to Mix Bailor’s goods with his own
4. To return the goods bailed
5. To return any accretion to the goods bailed
RIGHTS OF BAILEE
1. The bailee can sue bailor for
(a) claiming compensation for damage resulting from non-disdosure of faults in the goods;
(b) for breach of warranty as to title and the damage resulting therefrom; and
(c) for extraordinary expenses.
2. Lien
2. Rights against wrongful deprivation of injury to goods
RIGHTS OF THE BAILOR
1. The bailor can enforce by suit all duties or liabilities of the bailee.
2. In case of gratuitous bailment (i.e., bailment without reward), the bailor can demand their return whenever he pleases, even though he lent it for a specified time or purpose.
TERMINATION OF BAILMENT
1. On the expiry of the stipulated period.
2. On the accomplishment of the specified purpose.
2. By bailee’s act inconsistent with conditions.

FINDER OF LOST GOODS
• Finding is not keeping. A finder of lost goods is treated as the bailee of the goods found as such and is charged with the responsibilities of a bailee, besides the responsibility of exercising reasonable efforts in finding the real owner.
• However, he enjoys certain rights also. His rights are summed up hereunder¬
1. Right to retain the goods
2. Right to Sell -the finder may sell it:
(1) when the thing is in danger of perishing or of losing the greater part of its value;
(2) when the lawful charges of the finder in respect of the thing found, amount to 2/3rd of its value.
2.16 PLEDGE
• A pledge is the bailment of goods as security for payment of debt or performance of a promise. The person who delivers the goods, as security is called the ‘pledgor’ and the person to whom the goods are so delivered is called the ‘pledgee’. The ownership remains with the pledgor. It is only a qualified property that passes to the pledgee.
• Delivery Essential - A pledge is created only when the goods are delivered by the borrower to the lender or to someone on his behalf with the intention of their being treated as security against the advance. Delivery of goods may, however, be actual or constructive.
2.17 CONTRACT OF AGENCY
[SECTION 182 – 238]
Who is an ‘Agent‘
• An agent is defined as a “person employed to do any act for another or to represent another in dealings with third person”. In other words, an agent is a person who acts in place of another. The person for whom or on whose behalf he acts is called the Principal.
• Agency is therefore, a relation based upon an express or implied agreement whereby one person, the agent, is authorised to act for another, his principal, in transactions with third person.
• The function of an agent is to bring about contractual relations between the principal and third par¬ties.
WHO CAN EMPLOY AN AGENT
• Any person, who is capable to contract may appoint as agent. Thus, a minor or lunatic cannot contract through an agent since they cannot contract themselves personally either.
WHO MAY BE AN AGENT
• In considering the contract of agency itself (i.e., the relation between principal and agent), the contractual capacity of the agent becomes important.
HOW AGENCY IS CREATED
• A contract of agency may be created by in any of the following three ways: -
(1) Express Agency
(2) Implied Agency
(3) Agency by Estoppel
(4) Agency by Holding Out
(5) Agency of Necessity
(6) Agency By Ratification
DUTIES OF AGENT
1. To conduct the business of agency according to the principal’s directions
2. The agent should conduct the business with the skill and diligence that is generally possessed by persons engaged in similar business, except where the principal knows that the agent is wanting in skill.
3. To render proper accounts.
4. To use all reasonable diligence, in communicating with his principal, and in seeking to obtain his instructions.
5. Not to make any secret profits
6. Not to deal on his own account
7. Agent not entitled to remuneration for business misconducted.
8. An agent should not disclose confidential information supplied to him by the principal [Weld Blundell v. Stephens (1920) AC. 1956].
9. When an agency is terminated by the principal dying or becoming of unsound mind, the agent is bound to take on behalf of the representatives of his late principal, all reasonable steps for the protection and preservation of the interests entrusted to him.
RIGHTS OF AN AGENT
1. Right to remuneration
2. Right Of Retainer
2. Right of Lien
4. Right of Indemnification
5. Right to compensation for injury caused by principal’s neglect
PRINCIPAL’S DUTIES TO AGENT
• A principal is:
(i) bound to indemnify the agent against the consequences of all lawful acts done by such agent in exercise of the authority conferred upon him;
(ii) liable to indemnify an agent against the consequences of an act done in good faith.
(iii) The principal must make compensation to his agent in respect of injury caused to such agent by the principal’s neglect or want of skill.
TERMINATION OF AGENCY
1. By revocation by the Principal.
2. On the expiry of fixed period of time.
2. On the performance of the specific purpose.
4. Insanity or Death of the principal or Agent.
5. An agency shall also terminate in case subject matter is either destroyed or rendered unlawful.
6. Insolvency of the Principal. Insolvency of the principal, not of the agent, terminates the agency.
7. By renunciation of agency by the Agent.

Break Even Analysis

Learning Objectives

• To describe as to how the concepts of fixed and variable costs are used in C-V-P analysis
• To segregate semi-variable expenses in C-V-P analysis
• To identify the limiting assumptions of C-V-P analysis
• To work out the breakeven analysis, contribution analysis and margin of safety
• To understand how to draw a breakeven chart
• To compute breakeven point

Introduction

In this lesson, we will discuss in detail the highlights associated with cost function and cost relations with the production and distribution system of an economic entity.
To assist planning and decision making, management should know not only the budgeted profit, but also:
• the output and sales level at which there would neither profit nor loss (break-even point)
• the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety)
MARGINAL COSTS, CONTRIBUTION AND PROFIT
A marginal cost is another term for a variable cost. The term ‘marginal cost’ is usually applied to the variable cost of a unit of product or service, whereas the term ‘variable cost’ is more commonly applied to resource costs, such as the cost of materials and labour hours.
Marginal costing is a form of management accounting based on the distinction between:
a. the marginal costs of making selling goods or services, and
b. fixed costs, which should be the same for a given period of time, regardless of the level of activity in the period.
Suppose that a firm makes and sells a single product that has a marginal cost of £5 per unit and that sells for £9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of £5 and receive income of £9. The net gain will be £4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called contribution.
Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’. Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
C-V-P analysis is broadly known as cost-volume-profit analysis. Specifically speaking, we all are concerned with in-depth analysis and application of CVP in practical world of industry management.
Cost-Volume-Profit (C-V-P) Relationship
We have observed that in marginal costing, marginal cost varies directly with the volume of production or output. On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management. In case if cost behavior is related to sales income, it shows cost-volume-profit relationship. In net effect, if volume is changed, variable cost varies as per the change in volume. In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.
Being a manager, you constantly strive to relate these elements in order to achieve the maximum profit. Apart from profit projection, the concept of Cost-Volume-Profit (CVP) is relevant to virtually all decision-making areas, particularly in the short run.
The relationship among cost, revenue and profit at different levels may be expressed in graphs such as breakeven charts, profit volume graphs, or in various statement forms.
Profit depends on a large number of factors, most important of which are the cost of manufacturing and the volume of sales. Both these factors are interdependent. Volume of sales depends upon the volume of production and market forces which in turn is related to costs. Management has no control over market. In order to achieve certain level of profitability, it has to exercise control and management of costs, mainly variable cost. This is because fixed cost is a non-controllable cost. But then, cost is based on the following factors:
• Volume of production
• Product mix
• Internal efficiency and the productivity of the factors of production
• Methods of production and technology
• Size of batches
• Size of plant
Thus, one can say that cost-volume-profit analysis furnishes the complete picture of the profit structure. This enables management to distinguish among the effect of sales, fluctuations in volume and the results of changes in price of product/services.
In other words, CVP is a management accounting tool that expresses relationship among sale volume, cost and profit. CVP can be used in the form of a graph or an equation. Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:
1. What is the breakeven revenue of an organization?
2. How much revenue does an organization need to achieve a budgeted profit?
3. What level of price change affects the achievement of budgeted profit?
4. What is the effect of cost changes on the profitability of an operation?
Cost-volume-profit analysis can also answer many other “what if” type of questions. Cost-volume-profit analysis is one of the important techniques of cost and management accounting. Although it is a simple yet a powerful tool for planning of profits and therefore, of commercial operations. It provides an answer to “what if” theme by telling the volume required to produce.
Following are the three approaches to a CVP analysis:
• Cost and revenue equations
• Contribution margin
• Profit graph
Objectives of Cost-Volume-Profit Analysis
1. In order to forecast profits accurately, it is essential to ascertain the relationship between cost and profit on one hand and volume on the other.
2. Cost-volume-profit analysis is helpful in setting up flexible budget which indicates cost at various levels of activities.
3. Cost-volume-profit analysis assist in evaluating performance for the purpose of control.
4. Such analysis may assist management in formulating pricing policies by projecting the effect of different price structures on cost and profit.
Assumptions and Terminology
Following are the assumptions on which the theory of CVP is based:
1. The changes in the level of various revenue and costs arise only because of the changes in the number of product (or service) units produced and sold, e.g., the number of television sets produced and sold by Sigma Corporation. The number of output (units) to be sold is the only revenue and cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is any factor that affects revenue.
2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output. Variable costs include the following:
o Direct materials
o Direct labor
o Direct chargeable expenses
Variable overheads include the following:
o Variable part of factory overheads
o Administration overheads
o Selling and distribution overheads
3. There is linear relationship between revenue and cost.
4. When put in a graph, the behavior of total revenue and cost is linear (straight line), i.e. Y = mx + C holds good which is the equation of a straight line.
5. The unit selling price, unit variable costs and fixed costs are constant.
6. The theory of CVP is based upon the production of a single product. However, of late, management accountants are functioning to give a theoretical and a practical approach to multi-product CVP analysis.
7. The analysis either covers a single product or assumes that the sales mix sold in case of multiple products will remain constant as the level of total units sold changes.
8. All revenue and cost can be added and compared without taking into account the time value of money.
9. The theory of CVP is based on the technology that remains constant.
10. The theory of price elasticity is not taken into consideration.
Many companies, and divisions and sub-divisions of companies in industries such as airlines, automobiles, chemicals, plastics and semiconductors have found the simple CVP relationships to be helpful in the following areas:
• Strategic and long-range planning decisions
• Decisions about product features and pricing
In real world, simple assumptions described above may not hold good. The theory of CVP can be tailored for individual industries depending upon the nature and peculiarities of the same.
For example, predicting total revenue and total cost may require multiple revenue drivers and multiple cost drivers. Some of the multiple revenue drivers are as follows:
• Number of output units
• Number of customer visits made for sales
• Number of advertisements placed
Some of the multiple cost drivers are as follows:
• Number of units produced
• Number of batches in which units are produced
Managers and management accountants, however, should always assess whether the simplified CVP relationships generate sufficiently accurate information for predictions of how total revenue and total cost would behave. However, one may come across different complex situations to which the theory of CVP would rightly be applicable in order to help managers to take appropriate decisions under different situations.
Limitations of Cost-Volume Profit Analysis
The CVP analysis is generally made under certain limitations and with certain assumed conditions, some of which may not occur in practice. Following are the main limitations and assumptions in the cost-volume-profit analysis:
1. It is assumed that the production facilities anticipated for the purpose of cost-volume-profit analysis do not undergo any change. Such analysis gives misleading results if expansion or reduction of capacity takes place.
2. In case where a variety of products with varying margins of profit are manufactured, it is difficult to forecast with reasonable accuracy the volume of sales mix which would optimize the profit.
3. The analysis will be correct only if input price and selling price remain fairly constant which in reality is difficulty to find. Thus, if a cost reduction program is undertaken or selling price is changed, the relationship between cost and profit will not be accurately depicted.
4. In cost-volume-profit analysis, it is assumed that variable costs are perfectly and completely variable at all levels of activity and fixed cost remains constant throughout the range of volume being considered. However, such situations may not arise in practical situations.
5. It is assumed that the changes in opening and closing inventories are not significant, though sometimes they may be significant.
6. Inventories are valued at variable cost and fixed cost is treated as period cost. Therefore, closing stock carried over to the next financial year does not contain any component of fixed cost. Inventory should be valued at full cost in reality.
Sensitivity Analysis or What If Analysis and Uncertainty
Sensitivity analysis is relatively a new term in management accounting. It is a “what if” technique that managers use to examine how a result will change if the original predicted data are not achieved or if an underlying assumption changes.
In the context of CVP analysis, sensitivity analysis answers the following questions:
a. What will be the operating income if units sold decrease by 15% from original prediction?
b. What will be the operating income if variable cost per unit increases by 20%?
The sensitivity of operating income to various possible outcomes broadens the perspective of management regarding what might actually occur before making cost commitments.
A spreadsheet can be used to conduct CVP-based sensitivity analysis in a systematic and efficient way. With the help of a spreadsheet, this analysis can be easily conducted to examine the effect and interaction of changes in selling prices, variable cost per unit, fixed costs and target operating incomes.
Example
Following is the spreadsheet of ABC Ltd.,
Statement showing CVP Analysis for Dolphy Software Ltd.
Revenue required at $. 200 Selling Price per unit to earn Operating Income of
Fixed cost Variable cost
per unit 0 1,000 1,500 2,000
2,000 100 4,000 6,000 7,000 8,000
120 5,000 7,500 8,750 10,000
140 6,667 10,000 11,667 13,333
2,500 100 5,000 7,000 8,000 9,000
120 6,250 8,750 10,000 11,250
140 8,333 11,667 13,333 15,000
3,000 100 6,000 8,000 9,000 10,000
120 7,500 10,000 11,250 12,500
140 10,000 13,333 15,000 16,667
From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit. For example, revenue of $. 6,000 (30 units @ $. 200 each) is required to earn an operating income of $. 1,000 if fixed cost is $. 2,000 and variable cost per unit is $. 100. You can also use exhibit 3-4 to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place:
• The booth rental at the ABC convention raises to $. 3,000 (thus increasing fixed cost to $. 3,000)
• The software suppliers raise their price to $. 140 per unit (thus increasing variable costs to $. 140)
An aspect of sensitivity analysis is the margin of safety which is the amount of budgeted revenue over and above breakeven revenue. The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the “what if” questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitor’s better product, poorly executed marketing programs and so on.
Assume you have fixed cost of $. 2,000, selling price of $. 200 and variable cost per unit of $. 120. For 40 units sold, the budgeted point from this set of assumptions is 25 units ($. 2,000 ÷ $. 80) or $. 5,000 ($. 200 x 25). Hence, the margin of safety is $. 3,000 ($. 8,000 – 5,000) or 15 (40 –25) units.
Sensitivity analysis is an approach to recognizing uncertainty, i.e. the possibility that an actual amount will deviate from an expected amount.
Marginal Cost Equations and Breakeven Analysis
From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)
Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal cost equation as follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.
The sales and marginal costs vary directly with the number of units sold or produced. So, the difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,
P/V Ratio (or C/S Ratio) = Contribution (c) ......(4)
Sales (s)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)
Or, Sales = Contribution ......(6)
P/V ratio
The above-mentioned marginal cost equations can be applied to the following heads:
1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:
• Selecting product mix or sales mix for profit maximization
• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and Application
The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows:
P/V ratio = Sales – Marginal cost of sales = Contribution = Changes in contribution = Change in profit
Sales Sales Changes in sales Change in sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:
• Breakeven point
• Profit at any volume of sales
• Sales volume required to earn a desired quantum of profit
• Profitability of products
• Processes or departments
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
• Increasing selling price
• Reducing marginal costs by effectively utilizing men, machines, materials and other services
• Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point
Breakeven point is the volume of sales or production where there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal cost equation, P/V ratio or contribution per unit.
a. Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following equation:
S BEP = F.S/S-V
b. Using P/V Ratio
Sales S BEP = Contribution at BEP = Fixed cost
P/ V ratio P/ V ratio
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:
Breakeven point = 400 x 2000 = $. 1000
2000 - 1200
Similarly, P/V ratio = 2000 – 1200 = 0.4 or 40%
800
So, breakeven sales = $. 400 / .4 = $. 1000
c. Using Contribution per unit
Breakeven point = Fixed cost = 100 units or $. 1000
Contribution per unit
4. Margin of Safety (MOS)
Every enterprise tries to know how much above they are from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.
Margin of safety = Sales at selected activity – Sales at BEP = Profit at selected activity
P/V ratio
Margin of safety is also presented in ratio or percentage as follows: Margin of safety (sales) x 100 %
Sales at selected activity
The size of margin of safety is an extremely valuable guide to the strength of a business. If it is large, there can be substantial falling of sales and yet a profit can be made. On the other hand, if margin is small, any loss of sales may be a serious matter. If margin of safety is unsatisfactory, possible steps to rectify the causes of mismanagement of commercial activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin of safety in order to strengthen the financial health of the business. It should be able to influence price, provided the demand is elastic. Otherwise, the same quantity will not be sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume of output
e. Modernization of production facilities and the introduction of the most cost effective technology
Problem 1
A company earned a profit of $. 30,000 during the year 2000-01. Marginal cost and selling price of a product are $. 8 and $. 10 per unit respectively. Find out the margin of safety.
Solution
Margin of safety = Profit
P/V ratio
P/V ratio = Contribution x 100
Sales
Problem 2
A company producing a single article sells it at $. 10 each. The marginal cost of production is $. 6 each and fixed cost is $. 400 per annum. You are required to calculate the following:
• Profits for annual sales of 1 unit, 50 units, 100 units and 400 units
• P/V ratio
• Breakeven sales
• Sales to earn a profit of $. 500
• Profit at sales of $. 3,000
• New breakeven point if sales price is reduced by 10%
• Margin of safety at sales of 400 units
Solution Marginal Cost Statement
Particulars Amount Amount Amount Amount
Units produced 1 50 100 400
Sales (units * 10) 10 500 1000 4000
Variable cost 6 300 600 2400
Contribution (sales- VC) 4 200 400 1600
Fixed cost 400 400 400 400
Profit (Contribution – FC) -396 -200 0 1200
Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%
Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000
Sales at BEP = Contribution at BEP/ PVR = 100 units
Sales at profit $. 500
Contribution at profit $. 500 = Fixed cost + Profit = $. 900
Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)
Profit at sales $. 3,000
Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200
Profit = Contribution – Fixed cost = $. 1200 – $. 400 = $. 800
New P/V ratio = $. 9 – $. 6/$. 9 = 1/3
Sales at BEP = Fixed cost/PV ratio = $. 400 = $. 1,200
1/3
Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %
(Actual sales – BEP sales/Actual sales * 100)
Breakeven Analysis-- Graphical Presentation
Apart from marginal cost equations, it is found that breakeven chart and profit graphs are useful graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume, marginal costs and fixed costs, and profit or loss at different levels of activity. Such a chart also shows the effect of change of one factor on other factors and exhibits the rate of profit and margin of safety at different levels. A breakeven chart contains, inter alia, total sales line, total cost line and the point of intersection called breakeven point. It is popularly called breakeven chart because it shows clearly breakeven point (a point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at different volumes of sales.
Construction of a Breakeven Chart
The construction of a breakeven chart involves the drawing of fixed cost line, total cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join these points. This will give total cost line. Alternatively, obtain total cost at different levels, plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and the point so obtained.
Uses of Breakeven Chart
A breakeven chart can be used to show the effect of changes in any of the following profit factors:
• Volume of sales
• Variable expenses
• Fixed expenses
• Selling price
Problem
A company produces a single article and sells it at $. 10 each. The marginal cost of production is $. 6 each and total fixed cost of the concern is $. 400 per annum.
Construct a breakeven chart and show the following:
• Breakeven point
• Margin of safety at sale of $. 1,500
• Angle of incidence
• Increase in selling price if breakeven point is reduced to 80 units
Solution
A breakeven chart can be prepared by obtaining the information at these levels:
Output units 40 80 120 200
Sales $. $. $. $.
400 800 1,200 2,000
Fixed cost 400 400 400 400
Variable cost 240 480 400 720
Total cost 640 880 1,120 1,600
Fixed cost line, total cost line and sales line are drawn one after another following the usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and angle of incidence.
a. Breakeven point-- Breakeven point is the point at which sales line and total cost line intersect. Here, B is breakeven point equivalent to sale of $. 1,000 or 100 units.
b. Margin of safety-- Margin of safety is the difference between sales or units of production and breakeven point. Thus, margin of safety at M is sales of ($. 1,500 - $. 1,000), i.e. $. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total cost line at breakeven point. A large angle of incidence shows a high rate of profit being made. It should be noted that the angle of incidence is universally denoted by data. Larger the angle, higher the profitability indicated by the angel of incidence.
d. At 80 units, total cost (from the table) = $. 880. Hence, selling price for breakeven at 80 units = $. 880/80 = $. 11 per unit. Increase in selling price is Re. 1 or 10% over the original selling price of $. 10 per unit.
Limitations and Uses of Breakeven Charts
A simple breakeven chart gives correct result as long as variable cost per unit, total fixed cost and sales price remain constant. In practice, all these facto$ may change and the original breakeven chart may give misleading results.
But then, if a company sells different products having different percentages of profit to turnover, the original combined breakeven chart fails to give a clear picture when the sales mix changes. In this case, it may be necessary to draw up a breakeven chart for each product or a group of products. A breakeven chart does not take into account capital employed which is a very important factor to measure the overall efficiency of business. Fixed costs may increase at some level whereas variable costs may sometimes start to decline. For example, with the help of quantity discount on materials purchased, the sales price may be reduced to sell the additional units produced etc. These changes may result in more than one breakeven point, or may indicate higher profit at lower volumes or lower profit at still higher levels of sales.
Nevertheless, a breakeven chart is used by management as an efficient tool in marginal costing, i.e. in forecasting, decision-making, long term profit planning and maintaining profitability. The margin of safety shows the soundness of business whereas the fixed cost line shows the degree of mechanization. The angle of incidence is an indicator of plant efficiency and profitability of the product or division under consideration. It also helps a monopolist to make price discrimination for maximization of profit.
Multiple Product Situations
In real life, most of the firms turn out many products. Here also, there is no problem with regard to the calculation of BE point. However, the assumption has to be made that the sales mix remains constant. This is defined as the relative proportion of each product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as in a single product firm. While the numerator will be the same fixed costs, the denominator now will be weighted average contribution margin. The modified formula is as follows:
Breakeven point (in units) = Fixed costs
________________________________________
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion to the relative sales of all products. Here, it will be the contribution margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now will be weighted average contribution margin ratio which is also called weighted average P/V ratio. The modified formula is as follows:
B.E. point (in revenue) = Fixed cost
________________________________________
Weighted average P/V ratio
Problem Ahmedabad Company Ltd. manufactures and sells four types of products under the brand name Ambience, Luxury, Comfort and Lavish. The sales mix in value comprises the following:
Brand name Percentage


Ambience 33 1/3
Luxury 41 2/3
Comfort 16 2/3
Lavish 8 1/3
------
100

The total budgeted sales (100%) are $. 6,00,000 per month.
The operating costs are:
Ambience 60% of selling price Luxury
Luxury 68% of selling price Comfort
Comfort 80% of selling price Lavish
Lavish 40% of selling price
The fixed costs are $. 1,59,000 per month.
a. Calculate the breakeven point for the products on an overall basis.
b. It has been proposed to change the sales mix as follows, with the sales per month remaining at $. 6,00,000:
Brand Name Percentage

Ambience 25
Luxury 40
Comfort 30
Lavish 05
---
100

Assuming that this proposal is implemented, calculate the new breakeven point.
Solution
a. Computation of the Breakeven Point on Overall Basis
b. Computation of the New Breakeven Point
Profit Graph
Profit graph is an improvement of a simple breakeven chart. It clearly exhibits the relationship of profit to volume of sales. The construction of a profit graph is relatively easy and the procedure involves the following:
1. Selecting a scale for the sales on horizontal axis and another scale for profit and fixed costs or loss on vertical axis. The area above horizontal axis is called profit area and the one below it is called loss area.
2. Plotting the profits of corresponding sales and joining them. This is profit line.
Summary
1. Fixed and variable cost classification helps in CVP analysis. Marginal cost is also useful for such analysis.
2. Breakeven point is the incidental study of CVP. It is the point of no profit and no loss. At this specific level of operation, it covers total costs, including variable and fixed overheads.
3. Breakeven chart is the graphical representation of cost structure of business.
4. Profit/Volume (P/V) ratio shows the relationship between contribution and value/volume of sales. It is usually expressed as terms of percentage and is a valuable tool for the profitability of business.
5. Margin of safety is the difference between sales or units of production and breakeven point. The size of margin of safety is an extremely valuable guide to the financial strength of a business.
Questions
1. Discuss the concept of fixed and variable cost.
2. CVP analysis is a useful technique for managerial decision-making. Discuss.
3. CVP analysis has no limitation. Discuss.
4. What is a breakeven chart?
5. What questions can a breakeven chart answer to?
6. Provide a formula to determine the breakeven point of a single product, multi-product and different divisions and subdivisions of an organization.
7. What are the disadvantages of using breakeven analysis?
8. Define contribution margin.
9. Explain-- Margin of safety shows the financial strength of a business.
Quick quiz
1. What is the formula for calculating the breakeven point in terms of the number of units required to break even?
2. Give the formula which uses the C/S ratio to calculate the breakeven point.
3. What is the margin of safety?
4. What do the axes of a breakeven chart represent?
5. Give three uses of breakeven charts.
6. What is a profit/volume chart?
7. What does the horizontal axis of the PN chart represent?
8. What are the limitations of breakeven charts and CVP analysis?
Answers to quick quiz
1. Breakeven point (units) = Total fixed costs/Contribution per unit
2. Sales value at breakeven point = .Total Fixed Cost divide by C/S ratio
3. The margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume.
4. The vertical axis represents money (costs and revenue) and the horizontal axis represents the level of activity (production and sales).
5. Breakeven charts are used as follows.
o To plan the production of a company’s products
o To market a company’s products
o To given a visual display of breakeven arithmetic
6. The profit/volume chart is a variation of the breakeven chart which provides a simple illustration of the relationship of costs and profit to sales.
7. ‘V on the horizontal axis is volume or value of sales.
8.
o A breakeven chart can only apply to a single product or a single mix of a group of products.
o A breakeven chart may be time-consuming to prepare.
o It assumes fixed costs are constant at all levels of output.
o It assumes that variable costs are the same per unit at all levels of output.
o It assumes that sales prices are constant at all levels of output.
o It assumes production and sales are the same (stock levels are ignored).
o It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

Bench Marking

What is benchmarking?
Benchmarking is a way to go backstage and watch another company’s performance from the wings, where all stage tricks and hurried realignments are visible.
In Joseph Juran’s 1964 book Managerial Breakthrough, he asked the question:
What is that organizations do that gets result so much better than ours?
The answer to this question opens door to benchmarking, an approach that is accelerating among many firms that have adopted the total quality management (TQM) philosophy.

The Essence of Benchmarking
The essence of benchmarking is the continuous process of comparing a company’s strategy, products, processes with those of the world leaders and best-in-class organizations.
The purpose is to learn how the achieved excellence, and then setting out to match and even surpass it.The justification lies partly in the question: “Why reinvent the wheel if I can learn from someone who has already done it?” However, Benchmarking is not a panacea that can replace all other quality efforts or management processes.
The Evolution of Benchmarking
The method may have evolved in the early 1950s, when W. Edward Deming taught the Japanese the idea of quality control. Other American management innovations followed.
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The best example is Toyota Motor Corporation’s following the footsteps of Ford Motor Corporation albeit with the adaptation of the Ford’s Just-in-case System into Toyota’s Just-in-Time System. The term “benchmarking” whoever, was not coined by that time yet.
The term “benchmarking” emerged when the idea took ground in US during 1980s when Xerox, Ford and Motorola became the pioneers of benchmarking in USA. Robert Camp, the logistics engineer who initiated Xerox’s benchmarking program and who is generally regarded as the guru of the benchmarking movement, defines it: “Benchmarking is the search for industry best practices that lead to superior performance”.
The Xerox Case
The company invented the photocopier in 1959 and maintained a virtual monopoly for many years thereafter. “Xerox” became a generic name for all photocopiers. By 1981, however, the companies market shrunk to 35% as IBM and Kodak developed high-end machines and Canon, Richo and Savin dominated the low-end segment of market.
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The company instituted the quality improvement plan, which resulted in tremendous progress and survival of the organization. This quality improvement plan was later known to the world as Benchmarking Program. Xerox’s approach focused on key processes, rather than simply on finished products, and highlighted distinctive elements of those processes that accounted for product superiority.
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Xerox’s benchmarking strategy recognized that many processes are not unique to a single industry and that comparisons need not be confined strictly to one’s competitors. Xerox and other benchmarkers now believe that breakthrough advances are more likely to occur by adapting lessons learned from leaders operating in entirely different industries.
Xerox benchmarked companies both, in and outside the industry. The particular example is L.L.Bean, catalog seller of outside equipment for improving distribution system based on the same. The benchmarking process resulted in: Quality problems cut by two-thirds, manufacturing costs cut in half, development task cut by two-thirds, direct labor cut by 50% and corporate staff cut by 35% while increase in volume.

It should be noted that all these improvements were not direct result of benchmarking rather it became the cause climate for change and continuous improvement followed as a natural result.
Levels of Benchmarking

There are three levels of benchmarking:

1. Internal benchmarking (within the company)
2. Competitive or strategic benchmarking (Industry and competitors)
3. Benchmarking outside the industry.

What benefits have been achieved by the organizations that have successfully completed their benchmarking programs?
There are three sets of benefits:
1. Cultural Change
2. Performance Improvement
3. Human Resources
1. Cultural Change: Benchmarking allows organizations to set realistic, rigorous new performance targets, and this process helps convince people of the credibility of these targets. It helps people to understand that there are other organizations who know and do job better than their own organization.
2. Performance Improvement: Benchmarking allows the organization to define specific gaps in performance and to select the processes to improve. These gaps provide objectives and action plans for improvement at all levels of organization and promote improved performance for individual and group participants.
3. Human Resources: Benchmarking provides basis for training. Employees begin to see gap between what they are doing and what best-in-class are doing. Closing the gap points out the need of personnel to be trained to learn techniques of problem solving and process improvement.
What theoretical model would you suggest to implement a benchmarking program?
Organizations that benchmark, adapt the process to best fit their own needs and culture. Although number of steps in the process may vary from organization to organization, the following six steps contain the core techniques:
1. Decide what to benchmark.
2. Understand the current performance of your organization.
3. Do proper planning of what, how and when of benchmarking endeavor.
4. Study others well (the practices or system you wish to benchmark)
5. Gather data and learn from it.
6. Use the findings.
Some prominent beneficiaries of Benchmarking
Within a decade following its introduction, benchmarking had distinguished itself as an important tool for performance improvement in corporate America.

In several highly publicized cases, benchmarking corporations were learning and benefiting from what would have seemed unlikely partnerships in the pre-benchmarking era.
• Xerox learned from L.L. Bean, a clothing store catalogue retailer
• Motorola from Domino’s Pizza
• Digital Equipment Corporation (DEC) from a seemingly illogical set of partners that included Scott Paper, Campbell Soup, Whirlpool, Boeing, Hewlett-Packard, and Apple.

Quality Guru's

The Quality Gurus—
1. Dr. W. Edwards Deming,
2. Dr. Joseph Juran,
3. Philip Crosby,
4. Armand V. Feigenbaum,
5. Dr. H. James Harrington,
6. Dr. Kaoru Ishikawa,
7. Dr. Walter A. Shewhart,
8. Shigeo Shingo,
9. Frederick Taylor, and
10. Dr. Genichi Taguchi
—have made a significant impact on the world through their contributions to improving not only businesses, but all organizations including state and national governments, military organizations, educational institutions, healthcare organizations, and many other establishments and organizations.
DR. W. EDWARDS DEMING (1900–1993)
Dr. W. Edward Deming is best known for reminding management that most problems are systemic and that it is management’s responsibility to improve the systems so that workers (management and non-management) can do their jobs more effectively. Deming argued that higher quality leads to higher productivity, which, in turn, leads to long-term competitive strength. The theory is that improvements in quality lead to lower costs and higher productivity because they result in less rework, fewer mistakes, fewer delays, and better use of time and materials. With better quality and lower prices, a firm can achieve a greater market share and thus stay in business, providing more and more jobs.
When he died in December 1993 at the age of ninety-three, Deming had taught quality and productivity improvement for more than fifty years. His Fourteen Points, System of Profound Knowledge, and teachings on statistical control and process variability are studied by people all over the world. His books include: Out of the Crisis (1986), The New Economics (1993), and Statistical Adjustment of Data (1943).
In emphasizing management’s responsibility, Deming noted that workers are responsible for 10 to 20 percent of the quality problems in a factory, and that the remaining 80 to 90 percent is under management’s control. Workers are responsible for communicating to management the information they possess regarding the system. Deming’s approach requires an organization-wide cultural transformation.
Deming’s philosophy is summarized in his famous fourteen points, and it serves as a framework for quality and productivity improvement. Instead of relying on inspection at the end of the process to find flaws, Deming advocated a statistical analysis of the manufacturing process and emphasized cooperation of workers and management to achieve high-quality products.
Deming’s quality methods centered on systematically tallying product defects, analyzing their causes, correcting the causes, and recording the effects of the corrections on subsequent product quality as defects were prevented. He taught that it is less costly in the long-run to get things done right the first time then fix them later.
THE RISE OF DEMING’S INFLUENCE
The son of a small-town lawyer, Deming (a teacher and consultant in statistical studies) attended the University of Wyoming, University of Colorado, and Yale University, where he earned his Ph.D. in mathematical physics. He then taught physics at several universities, worked as a mathematical physicist at the U.S. Department of Agriculture and was a statistical adviser for the U.S. Census Bureau.
From 1946 to 1993 he was a professor of statistics at New York University’s graduate school of business administration, and he taught at Columbia University. Deming became interested in the use of statistical analysis to achieve better quality control in industry in the 1930s.
In 1950 Deming began teaching and consulting with Japanese industrialists through the Union of Japanese Scientists and Engineers (JUSE). In 1960, he received the Second Order Medal of the Sacred Treasure from the Emperor of Japan for improvement of quality and the Japanese economy. In 1987 he received the National Medal of Technology from U. S. President Ronald Reagan because of his impact on quality in the United States.
From 1946 to 1993, he was an international teacher and consultant in the area of quality improvement based on statistics, leadership, and customer satisfaction. The Deming Prize for quality was established in 1951 in Japan by JUSE and in 1980 in the United States by the Metropolitan Section of the American Society for Quality.
American companies ignored Deming’s teachings for years. In 1980, NBC aired the program “If Japan Can, Why Can’t We?,” highlighting Deming’s contributions in Japan and American companies began to discover Deming. His ideas were used by major U.S. corporations as they sought to compete more effectively against foreign manufacturers.
As a consultant, Deming continued to conduct Quality Management seminars until just days before his death in 1993.
DEMING’S SYSTEM OF PROFOUND KNOWLEDGE
One of Deming’s essential theories is his System of Profound Knowledge, which includes appreciation for a system, knowledge about variation (statistics), theory of knowledge, and psychology (of individuals, groups, society, and change). Although the Fourteen Points are probably the most widely known of Dr. Deming’s theories, he actually taught them as a part of his System of Profound Knowledge. His knowledge system consists of four interrelated parts: (1) Theory of Optimization; (2) Theory of Variation; (3) Theory of Knowledge; and (4) Theory of Psychology.
THEORY OF OPTIMIZATION.
The objective of an organization is the optimization of the total system and not the optimization of the individual subsystems. The total system consists of all constituents—customers, employees, suppliers, shareholders, the community, and the environment. A company’s long-term objective is to create a win-win situation for all of its constituents.
Subsystem optimization works against this objective and can lead to a suboptimal total system. According to Deming, it is poor management, for example, to purchase materials or service at the lowest price or to minimize the cost of manufacturing if it is at the expense of the system. Inexpensive materials may be of such inferior quality that they will cause excessive costs in adjustment and repair during manufacturing and assembly.
THEORY OF VARIATION.
Deming’s philosophy focuses on improving the product and service uncertainty and variability in design and manufacturing processes. Deming believed that variation is a major cause of poor quality. In mechanical assemblies, for example, variations from specifications for part dimensions lead to inconsistent performance and premature wear and failure. Likewise, inconsistencies in service frustrate customers and hurt companies’ reputations. Deming taught Statistical Process Control and used control charts to demonstrate variation in processes and how to determine if a process is in statistical control.
There is a variation in every process. Even with the same inputs, a production process can produce different results because it contains many sources of variation, for example the materials may not be always be exactly the same; the tools wear out over time and they are subjected to vibration heat or cold; or the operators may make mistakes. Variation due to any of these individual sources appears at random; however, their combined effect is stable and usually can be predicted statistically. These factors that are present as a natural part of a process are referred to as common (or system) causes of variation.
Common causes are due to the inherent design and structure of the system. It is management’s responsibility to reduce or eliminate common causes. Special causes are external to the system, and it is the responsibility of operating personnel to eliminate such causes. Common causes of variation generally account for about 80 to 90 percent of the observed variation in a production process. The remaining 10 to 20 percent are the result of special causes of variation, often called assignable causes. Factors such as bad material from a supplier, a poorly trained operator or excessive tool wear are examples of special causes. If no operators are trained, that is system problem, not a special cause. The system has to be changed.
THEORY OF KNOWLEDGE.
Deming emphasized that knowledge is not possible without theory, and experience alone does not establish a theory. Experience only describes—it cannot be tested or validated—and alone is no help for management. Theory, on the other hand, shows a cause-and-effect relationship that can be used for prediction. There is a lesson here for the widespread benchmarking practices: copying only an example of success, without understanding it in theory, may not lead to success, but could lead to disaster.
THEORY OF PSYCHOLOGY.
Psychology helps to understand people, interactions between people and circumstances, interactions between leaders and employees, and any system of management. Consequently, managing people requires knowledge of psychology. Also required is knowledge of what motivates people. Job satisfaction and the motivation to excel are intrinsic. Reward and recognition are extrinsic. Management needs to create the right mix of intrinsic and extrinsic factors to motivate employees.
DEMING’S SEVEN DEADLY DISEASES
Deming believed that traditional management practices, such as the Seven Deadly Diseases listed below, significantly contributed to the American quality crisis.
Lack of constancy of purpose to plan and deliver products and services that will help a company survive in the long term.
Emphasis on short-term profits caused by short-term thinking (which is just the opposite of constancy of purpose), fear of takeovers, worry about quarterly dividends, and other types of reactive management.
Performance appraisals (i.e., annual reviews, merit ratings) that promote fear and stimulate unnecessary competition among employees.
Mobility of management (i.e., job hopping), which promotes short-term thinking.
Management by use of visible figures without concern about other data, such as the effect of happy and unhappy customers on sales, and the increase in overall quality and productivity that comes from quality improvement upstream.
Excessive medical costs, which now have been acknowledged as excessive by federal and state governments, as well as industries themselves.
Excessive costs of liability further increased by lawyers working on contingency fees.
DEMING’S FOURTEEN POINTS
Deming formulated the following Fourteen Points to cure (eliminate) the Seven Deadly Diseases and help organizations to survive and flourish in the long term:
1. Create constancy of purpose toward improvement of product and service. Develop a plan to be competitive and stay in business. Everyone in the organization, from top management to shop floor workers, should learn the new philosophy.
2. Adopt the new philosophy. Commonly accepted levels of delays, mistakes, defective materials, and defective workmanship are now intolerable. We must prevent mistakes.
3. Cease dependence on mass inspection. Instead, design and build in quality. The purpose of inspection is not to send the product for rework because it does not add value. Instead of leaving the problems for someone else down the production line, workers must take responsibility for their work. Quality has to be designed and built into the product; it cannot be inspected into it. Inspection should be used as an information-gathering device, not as a means of “assuring” quality or blaming workers.
4. Don’t award business on price tag alone (but also on quality, value, speed and long term relationship). Minimize total cost. Many companies and organizations award contracts to the lowest bidder as long as they meet certain requirements. However, low bids do not guarantee quality; and unless the quality aspect is considered, the effective price per unit that a company pays its vendors may be understated and, in some cases, unknown. Deming urged businesses to move toward single-sourcing, to establish long-term relationships with a few suppliers (one supplier per purchased part, for example) leading to loyalty and opportunities for mutual improvement. Using multiple suppliers has been long justified for reasons such as providing protection against strikes or natural disasters or making the suppliers compete against each other on cost. However, this approach has ignored “hidden” costs such as increased travel to visit suppliers, loss of volume discounts, increased set-up charges resulting in higher unit costs, and increased inventory and administrative expenses. Also constantly changing suppliers solely on the base of price increases the variation in the material supplied to production, since each supplier’s process is different.
5. Continuously improve the system of production and service. Management’s job is to continuously improve the system with input from workers and management. Deming was a disciple of Walter A. Shewhart, the developer of control charts and the continuous cycle of process improvement known as the Shewhart cycle. Deming popularized the Shewhart Cycle as the Plan-Do-Check-Act (PDCA) or Plan-Do-Study-Act (PDSA) cycle; therefore, it is also often referred to as the Deming cycle. In the planning stage, opportunities for improvement are recognized and operationally defined. In the doing stage, the theory and course of action developed in the previous stage is tested on a small scale through conducting trial runs in a laboratory or prototype setting. The results of the testing phase are analyzed in the check/study stage using statistical methods. In the action stage, a decision is made regarding the implementation of the proposed plan. If the results were positive in the pilot stage, then the plan will be implemented. Otherwise alternative plans are developed. After full scale implementation, customer and process feedback will again be obtained and the process of continuous improvement continues.
6. Institute training on the job. When training is an integral part of the system, operators are better able to prevent defects. Deming understood that employees are the fundamental asset of every company, and they must know and buy into a company’s goals. Training enables employees to understand their responsibilities in meeting customers’ needs.
7. Institute leadership (modern methods of supervision). The best supervisors are leaders and coaches, not dictators. Deming high-lighted the key role of supervisors who serve as a vital link between managers and workers. Supervisors first have to be trained in the quality management before they can communicate management’s commitment to quality improvement and serve as role models and leaders.
8. Drive out fear. Create a fear-free environment where everyone can contribute and work effectively. There is an economic loss associated with fear in an organization. Employees try to please their superiors. Also, because they feel that they might lose their jobs, they are hesitant to ask questions about their jobs, production methods, and process parameters. If a supervisor or manager gives the impression that asking such questions is a waste of time, then employees will be more concerned about pleasing their supervisors than meeting long-term goals of the organization. Therefore, creating an environment of trust is a key task of management.
9. Break down barriers between areas. People should work cooperatively with mutual trust, respect, and appreciation for the needs of others in their work. Internal and external organizational barriers impede the flow of information, prevent entities from perceiving organizational goals, and foster the pursuit of subunit goals that are not necessarily consistent with the organizational goals. Barriers between organizational levels and departments are internal barriers. External barriers are between the company and its suppliers, customers, investors, and community. Barriers can be eliminated through better communication, cross-functional teams, and changing attitudes and cultures.
10. Eliminate slogans aimed solely at the work force. Most problems are system-related and require managerial involvement to rectify or change. Slogans don’t help. Deming believed that people want to do work right the first time. It is the system that 80 to 90 percent of the time prevents people from doing their work right the first time.
11. Eliminate numerical goals, work standards, and quotas. Objectives set for others can force sub-optimization or defective output in order to achieve them. Instead, learn the capabilities of processes and how to improve them. Numerical goals set arbitrarily by management, especially if they are not accompanied by feasible courses of action, have a demoralizing effect. Goals should be set in a participative style together with methods for accomplishment. Deming argued that the quota or work standard system is a short-term solution and that quotas emphasize quantity over quality. They do not provide data about the process that can be used to meet the quota, and they fail to distinguish between special and common causes when seeking improvements to the process.
12. Remove barriers that hinder workers (and hinder pride in workmanship). The direct effect of pride in workmanship is increased motivation and a greater ability for employees to see themselves as part of the same team. This pride can be diminished by several factors: (1) management may be insensitive to workers’ problems; (2) they may not communicate the company’s goals to all levels; and (3) they may blame employees for failing to meet company goals when the real fault lies with the management.
13. Institute a vigorous program of education and self improvement. Deming’s philosophy is based on long-term, continuous process improvement that cannot be carried out without properly trained and motivated employees. This point addresses the need for ongoing and continuous education and self-improvement for the entire organization. This educational investment serves the following objectives: (1) it leads to better motivated employees; (2) it communicates the company goals to the employees; (3) it keeps the employees up-to-date on the latest techniques and promotes teamwork; (4) training and retraining provides a mechanism to ensure adequate performance as the job responsibilities change; and (5) through increasing job loyalty, it reduces the number of people who “job-hop.”
14. Take action to accomplish the transformation. Create a structure in top management that will promote the previous thirteen points. It is the top management’s responsibility to create and maintain a structure for the dissemination of the concepts outlined in the first thirteen points. Deming felt that people at all levels in the organization should learn and apply his Fourteen Points if statistical process control is to be a successful approach to process improvement and if organizations are to be transformed. However, he encouraged top management to learn them first. He believed that these points represent an all-or-nothing commitment and that they cannot be implemented selectively.
THE DEMING CYCLE
Known as the Deming Plan-Do-Check-Act (PDCA) Cycle, this concept was invented by Shewhart and popularized by Deming. This approach is a cyclic process for planning and testing improvement activities prior to full-scale implementation and/or prior to formalizing the improvement. When an improvement idea is identified, it is often wise to test it on a small scale prior to full implementation to validate its benefit. Additionally, by introducing a change on a small scale, employees have time to accept it and are more likely to support it. The Deming PDCA Cycle provides opportunities for continuous evaluation and improvement.
The steps in the Deming PDCA or PDSA Cycle as shown in Figure 1 are as follows:
Plan a change or test (P).
Do it (D). Carry out the change or test, preferably on a small scale.
Check it ©. Observe the effects of the change or test. Study it (S).
Act on what was learned (A).
Repeat Step 1, with new knowledge.
Repeat Step 2, and onward. Continuously evaluate and improve.
Deming was trained as a mathematical physicist, and he utilized mathematical concepts and tools (Statistical Process Control) to reduce variation and prevent defects. However, one of his greatest contributions might have been in recognizing the importance of organizational culture and employee attitudes in creating a successful organization. In many ways, his philosophies paralleled the development of the resource-based view of organizations that emphasized that employee knowledge and skills and organizational culture are very difficult to imitate or replicate, and they can serve as a basis of sustainable competitive advantage.
DR. JOSEPH JURAN (B. 1904)
Dr. Juran was born on December 24, 1904 in Braila, Romania. He moved to the United States in 1912 at the age of 8. Juran’s teaching and consulting career spanned more than seventy years, known as one of the foremost experts on quality in the world.
A quality professional from the beginning of his career, Juran joined the inspection branch of the Hawthorne Co. of Western Electric (a Bell manufacturing company) in 1924, after completing his B.S. in Electrical Engineering. In 1934, he became a quality manager. He worked with the U. S. government during World War II and afterward became a quality consultant. In 1952, Dr. Juran was invited to Japan. Dr. Edward Deming helped arrange the meeting that led to this invitation and his many years of work with Japanese companies.
Juran founded the Juran Center for Quality Improvement at the University of Minnesota and the Juran Institute. His third book, Juran’s Quality Control Handbook, published in 1951, was translated into Japanese. Other books include Juran on Planning for Quality (1988), Juran on Leadership for Quality (1989), Juran on Quality by Design (1992), Quality Planning and Analysis (1993), and A History of Managing for Quality (1995). Architect of Quality (2004) is his autobiography.
SELECTED JURAN QUALITY THEORIES
Juran’s concepts can be used to establish a traditional quality system, as well as to support Strategic Quality Management. Among other things, Juran’s philosophy includes the Quality Trilogy and the Quality Planning Roadmap.
JURAN’S QUALITY TRILOGY.
The Quality Trilogy emphasizes the roles of quality planning, quality control, and quality improvement. Quality planning’s purpose is to provide operators with the ability to produce goods and services that can meet customers’ needs. In the quality planning stage, an organization must determine who the customers are and what they need, develop the product or service features that meet customers’ needs, develop processes which are able to deliver those products and services, and transfer the plans to the operating forces. If quality planning is deficient, then chronic waste occurs.
Quality control is used to prevent things from getting worse. Quality control is the inspection part of the Quality Trilogy where operators compare actual performance with plans and resolve the differences. Chronic waste should be considered an opportunity for quality improvement, the third element of the Trilogy. Quality improvement encompasses improvement of fitness-for-use and error reduction, seeks a new level of performance that is superior to any previous level, and is attained by applying breakthrough thinking.
While up-front quality planning is what organizations should be doing, it is normal for organizations to focus their first quality efforts on quality control. In this aspect of the Quality Trilogy, activities include inspection to determine percent defective (or first pass yield) and deviations from quality standards. Activities can then focus on another part of the trilogy, quality improvement, and make it an integral part of daily work for individuals and teams.
Quality planning must be integrated into every aspect of the organization’s work, such as strategic plans; product, service and process designs; operations; and delivery to the customer. The Quality Trilogy is depicted below in Figure 2.
JURAN’S QUALITY PLANNING ROAD MAP.
Juran’s Quality Planning Road Map can be used by individuals and teams throughout the world as a checklist for understanding customer requirements, establishing measurements based on customer needs, optimizing product design, and developing a process that is capable of meeting customer requirements. The Quality Planning Roadmap is used for Product and Process Development and is shown in Figure 3.
Juran’s Quality Trilogy and Quality Roadmap are not enough. An infrastructure for Quality must be developed, and teams must work on improvement projects. The infrastructure should include a quality steering team with top management leading the effort, quality should become an integral part of the strategic plan, and all people should be involved. As people identify areas with improvement potential, they should team together to improve processes and produce quality products and services.
Under the “Big Q” concept, all people and departments are responsible for quality. In the old era under the concept of “little q,” the quality department was responsible for quality. Big “Q” allows workers to regain pride in workmanship by assuming responsibility for quality.
PHILIP CROSBY (1926–2001)
Philip Bayard Crosby was born in Wheeling, West Virginia, in 1926. After Crosby graduated from high school, he joined the Navy and became a hospital corpsman. In 1946 Crosby entered the Ohio College of Podiatric Medicine in Cleveland. After graduation he returned to Wheeling and practiced podiatry with his father. He was recalled to military service during the Korean conflict, this time he served as a Marine Medical Corpsman.
In 1952 Crosby went to work for the Crosley Corp. in Richmond, Indiana, as a junior electronic test technician. He joined the American Society for Quality, where his early concepts concerning Quality began to form. In 1955, he went to work for Bendix Corp. as a reliability technician and quality engineer. He investigated defects found by the test people and inspectors.
In 1957 he became a senior quality engineer with Martin Marietta Co. in Orlando, Florida. During his eight years with Martin Marietta, Crosby developed his “Zero Defects” concepts, began writing articles for various journals, and started his speaking career.
In 1965 International Telephone and Telegraph (ITT) hired Crosby as vice president in charge of corporate quality. During his fourteen years with ITT, Crosby worked with many of the world’s largest industrial and service companies, implementing his pragmatic management philosophy, and found that it worked.
After a number of years in industry, Crosby established the Crosby Quality College in Winter Park, Florida. He is well known as an author and consultant and has written many articles and books. He is probably best known for his book Quality is Free (1979) and concepts such as his Absolutes of Quality Management, Zero Defects, Quality Management Maturity Grid, 14 Quality Improvement Steps, Cost of Quality, and Cost of Nonconformance. Other books he has written include Quality Without Tears (1984) and Completeness (1994).
Attention to customer requirements and preventing defects is evident in Crosby’s definitions of quality and “non-quality” as follows: “Quality is conformance to requirements; non-quality is nonconformance.”
CROSBY’S COST OF QUALITY.
In his book Quality Is Free, Crosby makes the point that it costs money to achieve quality, but it costs more money when quality is not achieved. When an organization designs and builds an item right the first time (or provides a service without errors), quality is free. It does not cost anything above what would have already been spent. When an organization has to rework or scrap an item because of poor quality, it costs more. Crosby discusses Cost of Quality and Cost of Nonconformance or Cost of Nonquality. The intention is spend more money on preventing defects and less on inspection and rework.
CROSBY’S FOUR ABSOLUTES OF QUALITY.
Crosby espoused his basic theories about quality in four Absolutes of Quality Management as follows:
Quality means conformance to requirements, not goodness.
The system for causing quality is prevention, not appraisal.
The performance standard must be zero defects, not “that’s close enough.”
The measurement of quality is the price of nonconformance, not indexes.
To support his Four Absolutes of Quality Management, Crosby developed the Quality Management Maturity Grid and Fourteen Steps of Quality Improvement. Crosby sees the Quality Management Maturity Grid as a first step in moving an organization towards quality management. After a company has located its position on the grid, it implements a quality improvement system based on Crosby’s Fourteen Steps of Quality Improvement as shown in Figure 4.
Crosby’s Absolutes of Quality Management are further delineated in his Fourteen Steps of Quality Improvement as shown below:
Step 1. Management Commitment
Step 2. Quality Improvement Teams
Step 3. Quality Measurement
Step 4. Cost of Quality Evaluation
Step 5. Quality Awareness
Step 6. Corrective Action
Step 7. Zero-Defects Planning
Step 8. Supervisory Training
Step 9. Zero Defects
Step 10. Goal Setting
Step 11. Error Cause Removal
Step 12. Recognition
Step 13. Quality Councils
Step 14. Do It All Over Again
ARMAND V. FEIGENBAUM
Feigenbaum was still a doctoral student at the Massachusetts Institute of Technology when he completed the first edition of Total Quality Control (1951). An engineer at General Electric during World War II, Feigenbaum used statistical techniques to determine what was wrong with early jet airplane engines. For ten years he served as manager of worldwide manufacturing operations and quality control at GE. Feigenbaum serves as president of General Systems Company, Inc., Pittsfield, Massachusetts, an international engineering firm that designs and installs integrated operational systems for major corporations in the United States and abroad.
Feigenbaum was the founding chairman of the International Academy for Quality and is a past president of the American Society for Quality Control, which presented him its Edwards Medal and Lancaster Award for his contributions to quality and productivity. His Total Quality Control concepts have had a very positive impact on quality and productivity for many organizations throughout the industrialized world.
DR. H. JAMES HARRINGTON
An author and consultant in the area of process improvement, Harrington spent forty years with IBM. His career included serving as Senior Engineer and Project Manager of Quality Assurance for IBM, San Jose, California. He was President of Harrington, Hurd and Reicker, a well-known performance improvement consulting firm until Ernst & Young bought the organization. He is the international quality advisor for Ernst and Young and on the board of directors of various national and international companies.
Harrington served as president and chairman of the American Society for Quality and the International Academy for Quality. In addition, he has been elected as an honorary member of six quality associations outside of North America and was selected for the Singapore Hall of Fame. His books include The Improvement Process, Business Process Improvement, Total Improvement Management, ISO 9000 and Beyond, Area Activity Analysis, The Creativity Toolkit, Statistical Analysis Simplified, The Quality/Profit Connection, and High Performance Benchmarking.
DR. KAORU ISHIKAWA (1915–1989)
A professor of engineering at the University of Tokyo and a student of Dr. W. Edwards Deming, Ishikawa was active in the quality movement in Japan, and was a member of the Union of Japanese Scientists and Engineers. He was awarded the Deming Prize, the Nihon Keizai Press Prize, and the Industrial Standardization Prize for his writings on quality control, and the Grant Award from the American Society for Quality Control for his educational program on quality control.
Ishikawa’s book, Guide to Quality Control (1982), is considered a classic because of its in-depth explanations of quality tools and related statistics. The tool for which he is best known is the cause and effect diagram. Ishikawa is considered the Father of the Quality Circle Movement. Letters of praise from representatives of companies for which he was a consultant were published in his book What Is Total Quality Control? (1985). Those companies include IBM, Ford, Bridgestone, Komatsu Manufacturing, and Cummins Engine Co.
Ishikawa believed that quality improvement initiatives must be organization-wide in order to be successful and sustainable over the long term. He promoted the use of Quality Circles to: (1) Support improvement; (2) Respect human relations in the workplace; (3) Increase job satisfaction; and (4) More fully recognize employee capabilities and utilize their ideas. Quality Circles are effective when management understands statistical techniques and act on recommendations from members of the Quality Circles.
DR. WALTER A. SHEWHART (1891–1967)
A statistician who worked at Western Electric, Bell Laboratories, Dr. Walter A. Shewhart used statistics to explain process variability. It was Dr. W. Edward Deming who publicized the usefulness of control charts, as well as the Shewhart Cycle. However, Deming rightfully credited Shewhart with the development of theories of process control as well as the Shewhart transformation process on which the Deming PDCA (Plan-Do-Check or Study-Act) Cycle is based. Shewhart’s theories were first published in his book Economic Control of Quality of Manufactured Product (1931).
SHIGEO SHINGO (1919–1990)
One of the world’s leading experts on improving the manufacturing process, Shigeo Shingo created, with Taiichi Ohno, many of the features of just-in-time (JIT) manufacturing methods, systems, and processes, which constitute the Toyota Production System. He has written many books including A Study of the Toyota Production System From An Industrial Engineering Viewpoint (1989), Revolution in Manufacturing: The SMED (Single Minute Exchange of Die) System (1985), and Zero Quality Control: Source Inspection and the Poka Yoke System (1986).
Shingo’s greatness seems to be based on his ability to understand exactly why products are manufactured the way they are, and then transform that understanding into a workable system for low-cost, high quality production. Established in 1988, the Shingo Prize is the premier manufacturing award in the United States, Canada, and Mexico. In partnership with the National Association of Manufacturers, Utah State University administers the Shingo Prize for Excellence in Manufacturing, which promotes world class manufacturing and recognizes companies that excel in productivity and process improvement, quality enhancement, and customer satisfaction.
Rather than focusing on theory, Shingo focused on practical concepts that made an immediate difference. Specific concepts attributed to Shingo are:
Poka Yoke requires stopping processes as soon as a defect occurs, identifying the source of the defect, and preventing it from happening again.
Mistake Proofing is a component of Poka Yoke. Literally, this means making it impossible to make mistakes (i.e., preventing errors at the source).
SMED (Single Minute Exchange of Die) is a system for quick changeovers between products. The intent is to simplify materials, machinery, processes and skills in order to dramatically reduce changeover times from hours to minutes. As a result products could be produced in small batches or even single units with minimal disruption.
Just-in-Time (JIT) Production is about supplying customers with what they want when they want it. The aim of JIT is to minimize inventories by producing only what is required when it is required. Orders are “pulled” through the system when triggered by customer orders, not pushed through the system in order to achieve economies of scale with the production of larger batches.
FREDERICK TAYLOR (1856–1915)
An industrial (efficiency) engineer, manager, and consultant, Frederick Taylor is known as the Father of Scientific Management. In 1911, he published The Principles of Scientific Management. Taylor believed in task specialization and is noted for his time and motion studies. Some of his ideas are the predecessors for modern industrial engineering tools and concepts that are used in cycle time reduction.
While quality experts would agree that Taylor’s concepts increase productivity, some argue that his concepts are focused on productivity, not process improvement and as a result could cause less emphasis on quality. Dr. Joseph Juran said that Taylor’s concepts made the United States the world leader in productivity. However, the Taylor system required separation of planning work from executing the work. This separation was based on the idea that engineers should do the planning because supervisors and workers were not educated. Today, the emphasis is on transferring planning to the people doing the work.
DR. GENICHI TAGUCHI (B. 1924)
Dr. Genichi Taguchi was a Japanese engineer and statistician who defined what product specification means and how this can be translated into cost effective production. He worked in the Japanese Ministry of Public Health and Welfare, Institute of Statistical Mathematics, Ministry of Education. He also worked with the Electrical Communications Laboratory of the Nippon Telephone and Telegraph Co. to increase the productivity of the R&D activities.
In the mid 1950s Taguchi was Indian Statistical Institute visiting professor, where he met Walter Shewhart. He was a Visiting Research Associate at Princeton University in 1962, the same year he received his Ph.D. from Kyushu University. He was a Professor at Tokyo’s Aoyama Gakuin University and Director of the Japanese Academy of Quality.
Taguchi was awarded the Deming Application prize (1960), Deming awards for literature on quality (1951, 1953, and 1984), Willard F. Rockwell Medal by the International Technologies Institute (1986).
Taguchi’s contributions are in robust design in the area of product development. The Taguchi Loss Function, The Taguchi Method (Design of Experiments), and other methodologies have made major contributions in the reduction of variation and greatly improved engineering quality and productivity. By consciously considering the noise factors (environmental variation during the product’s usage, manufacturing variation, and component deterioration) and the cost of failure in the field, Taguchi methodologies help ensure customer satisfaction.
Robust Design focuses on improving the fundamental function of the product or process, thus facilitating flexible designs and concurrent engineering. Taguchi product development includes three stages: (1) system design (the non-statistical stage for engineering, marketing, customer and other knowledge); (2) parameter stage (determining how the product should perform against defined parameters; and (3) tolerance design (finding the balance between manufacturing cost and loss).