1
CHAPTER -
Different Approaches to Costing
Decision Making Approaches
Deals in details the following
Marginal Costing, Linear Programming, Learning Curve, Statistical
Investigation, Differentiation, Probability, Capital Budgeting and Economic
Applications for Decisions.
Applications
1. Special Selling price decision
2. Product –Mix decisions when capacity constraints exit
3. Decision on replacement of equipment
4. Outsourcing (make or buy)
5. Discontinuation decision
6. Export or local sales if local sales are affected/when local sales are not
affected
7. Relevance of variable cost and irrelevance of variable costs
8. Irrelevance of fixed cost and relevance of fixed cost
9. Cost–volume –Profit analysis in hospital, hotel industry
10. Changes in product
11. Graphical representation mix
12. Product abandonment
13. Limiting factor
14. BE chart and expected value
15. Changes in sales mix
16. Break even graph
17. P/V Ratio
18. Mathematical application of Break Even
2
19. Multi product Cost volume profit analysis
20. P/V Graph
21. Further processing
22. Investigation of variances
23. Determining Probabilities in Investigation of variances
24. Statistical control chart
25. Optimum selling prices using differential calculus
26. Cost volume profit analysis under conditions of uncertainty
3
Find the difference between Absorption Costing and Variable/ Marginal
Costing.
ABSORPTION COSTING
LabourMaterial
Manufacturing
Cost
Cost
Non-
Manufacturing cost
Profit & Loss
A/C
Finished
goodsWIP
Overheads
The entire fixed manufacturing overheads are absorbed to manufacturing cost
which increases cost per unit.
VARIABLE COSTING
LabourMaterial
Manufacturing
cost
Cost
Non-
Manufacturing cost
Profit
and loss A/CFinished goodsWIP
Overheads
Variable
overheads
Fixed
Overheads
The fixed manufacturing overheads are transferred to profit and loss account
and treated as period cost.
4
Example:
Absorption Costing vs. Variable
Costing Income Statements
Absorption Costing Variable /costing
Sales
Cost of Sales
Gross Profit
60,000
30,000
30,000
Sales 60,000
Operating Expenses
Variable
Fixed
Total Operating Expenses
6,000
20,000
26,000
Variable Costs
Cost of Sales
Operating Expenses
Total Variable Costs
30,000
6,000
36,000
Income 4,000 Contribution Margin
Fixed cost 24,000
20,000
44,000
Income 4,000
5
Break Even Analysis
Costs/Revenue
Output/Sales
Initially a firm will incur fixed costs, these do not depend on output or sales.
FC
As output is generated, the firm will incur variable costs –these vary directly with the amount produced.
VC The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC
TC Total revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially.
TR The lower the price, the less steep the total revenue curve.
TR
Q1
The break even point occurs where total revenue equals total costs –the firm, in this example, would have to sell Q1 to generate sufficient revenue to cover its costs.
Break Even AnalysisCosts/Revenue
Output/Sales
FC
VCTCTR (p = £2)
Q1
If the firm chose to set price higher than £2 (say £3) the TR curve would be steeper –they would not have to sell as many units to break even
TR (p = £3)
Q2
6
Break Even AnalysisCosts/Revenue
Output/Sales
FC
VCTC
TR (p = £2)
Q1
If the firm chose to set prices lower (say £1) it would need to sell more units before covering its costs.
TR (p = £1)
Q3
Break Even AnalysisCosts/Revenue
Output/Sales
FC
VC
TCTR (p = £2)
Q1
Loss
Profit
Costs/Revenue
Output/Sales
FC
VC
TR
High initial FC. Interest on debt rises each year – FC
rise therefore.
FC 1
Losses get bigger!
7
Break Even Analysis
Remember:
A higher price or lower price does not mean that break even will
never be reached!
The break even point depends on the number of sales needed to
generate revenue to cover costs – the break even chart is NOT time
related!
Importance of Price Elasticity of Demand:
Higher prices might mean fewer sales to break even but those sales
may take a longer time to achieve.
Lower prices might encourage more customers but higher volume
needed before sufficient revenue generated to break even.
Break Even Analysis
Links of break even to pricing strategies and elasticity.
Penetration pricing – ‘high’ volume, ‘low’ price – more sales to
break even.
Market Skimming – ‘high’ price ‘low’ volumes – fewer sales to
break even.
Elasticity – what is likely to happen to sales when prices are
increased
or decreased?
Objective of CVP Analysis:
The objective of CVP analysis is to establish what will happen to the
financial results if a specified level of activity or volume fluctuate.
Volume plays a vital role in management decision because
management is interested in critical output level ie Break even point
where there is no loss or no profit.
CVP -Short Run:
CVP is based on the relationship between volume and sales revenue,
costs and profit in the short run.
Short run-one year or less.
In short run some input can be increased but others not.
8
Example:
Additional supply of materials or unskilled labour can be obtained in the short run
but it takes time to expand the capacity of plant and machinery.
Out put is limited in the short run
Major constraints is sales which is uncertain
Short run profitabilities are sensitivity to sales volume.
CVP- Long Run:
Expansion of output beyond certain points may requirements of fixed costs,
such as additional supervision and machinery, appointment of additional
sales persons and expansion of distribution facilities.
In the long run other factors besides volume are likely to be important.
CVP analysis is only appropriate if all variables other than volume, remain
unchanged.
Increase in fixed cost and
Break Even Analysis
Costs/Revenue
Output/Sales
TC
TR
Q1
Profit
Q2 Q3
C
A Mathematical Approach to CVP
It is more flexible and quicker method with financial calculators.
9
Assumptions:
a. Selling price and costs remain constant per unit of output.
b. In the short run fixed costs are constant total amount whereas unit cost
changes with output level.
Mathematical formula-CVP:
Net profit = (Units sold x Unit selling price) –
[(Unit sold x Unit variable cost) + Total
fixed cost]
NP = Px - (a+bx)
Where NP=Net Profit
x= Units sold
P=selling price
b=unit variable cost
a=total cost
BE Point
A + bx = Px - NP
BEP = Fixed Cost/Contribution per unit
(FC + target profit)
Units sold for target profit = -------------------------------
Contribution per unit
Contribution x 100
Profit volume ratio(P/V ratio) = --------------------------
Sales
or
NP = Sales revenue x P/V ratio – Fixed Costs
BEP = FC / P / V Ratio
Margin of Safety = Expected sales – Breakeven Sales
Student’s Exercise on BEP and application of LP:
10
Tim Enterprises promotes concerts in Bangalore. The Company wants to examine
the viability of concerts In Bangalore on 31st December 2007.
Estimated costs:
Stage Costs Rs. 2,00,000/- on the first day and Rs. 50,000/- extra for
the second day.
Music party fees Rs. 2,50,000/- for the first day and Rs.1,00,000/-
for the second day.
Audios and videos Rs.1,50,000/- for the first day and Rs.25,000/-
only for the second day.
The pre-packed buffet per head is Rs.300/- for the first day and
Rs.50/- per children on the second day.
The tickets are sold @ Rs.790/- per head for the first night show.
The Management of Tim Enterprises requested the following information:
(i). The number of tickets that must be sold to break even for the first day.
(ii). How many tickets should be sold to earn Rs.5,00,000/- as profit on the first
day?
(iii). What profit would result if 3000 tickets are sold on the first day?
(iv). If 3,200 tickets are sold, and the expected profit is Rs.6,00,000/- how much
price per ticket the company can charge minimum for the first day?
(v). They want to have a separate program on the second day for children which
is fully sponsored by the Fly king Freshers Ltd. This show is meant for
Children at free of cost, and the expected number of children is 1000.
Calculate the sponsorship amount.
Answer for the Problem: Tim Enterprises
1. Mathematical & Linear Programming Approach:
Answer to question no-(i):
NP = Px-(a+bx)
a + bx = Px- NP the break even point
11
a = fixed cost = 6,00,000
b = 300
X =number of tickets
P = ticket price = 790
BE Tickets = 6,00,000 + 300x = 790x – 0
x = 6,00,000/490
x =1224.48
1225 tickets to be sold to break even.
Answer to question no-(ii):
Tickets to be sold to get profit of Rs.5,00,000/-
Np = Px - (a+bx)
5,00,000 = 790x-(6,00,000+300x)
490x = 11,00,000
x = 11,00,000/490
= 2244.89
= 2245 tickets
Using Contribution Approach:
Units sold at the required profit = FC+Target profit)/ contribution per unit
= 6,00,000+5,00,000)/490
= 2245 tickets
Answer to question no-(iii):
If 3000 tickets are sold profit will be
Np = Px - (a+bx) = 3000 x 790 - (6,00,000+3000 x 300)
= 8,70,000
Answer to question No (iv):
If 3200 tickets are sold and profit should be 6,00,000 the minimum selling price
will be
6,00,000 = 3200(x) – (6,00,000+3200 x 300)
X = 21,60,000/3200
= 675
12
Answer to question No (iv):
1,75,000 + 1000 x 50 = 2,25,000 no of tickets
Practical Applications of Marginal Costing:
1. Evaluation of Performance:
Evaluation of performance of department or product or individual worker a
branch.
Criteria:
Use contribution generating capacity of the segments or individual worker
2. Profit Planning:
Planning of Profits:
Due to competition company would like to reduce selling price but to increase
volume and have to maintain the same profit as before.
Step-1: Calculate current profit
Step-2: Calculate new contribution and new P/V ratio.
Step-3: Break even at the required profit= (FC+ Required profit)/ P/V ratio.
Step-4: Fixation of Selling Price:
Fixed costs are stagnant; it can be ignored in the short run.
In the long run fixed costs can not be ignored.
Fixing price above variable cost brings some contribution, which can be used
to recover fixed cost.
During the phase of depression, serious competition in the market introduces a
new product fixing selling price below variable cost or to dispose of the
product which may deteriorate in quality.
Export price above variable cost will increase the contribution when inland
sales can take care of the fixed cost.
If local sales are disturbed for export the contribution lost should be recovered
or fixed costs, which are not recovered, should be recovered from export.
Therefore selling price for export
= (Variable cost+ fixed costs not recovered inland)/expected number of units sale.
13
If fixed and variable costs are incurred exclusively for export has to be
recovered.
4. Make or Buy Decision:
Produced in house or out sourced.
Accounting operations to be done in the USA or out sourced to India or
Brazil or China or Philippines?
Criteria: View total cost without considering the classification of cost like
fixed or variable.
Decision Criteria:
If Purchase price < variable cost, go for purchase proposition.
If Purchase price > variable cost, go for manufacturing proposition.
If one production capacity used for same component or product may be diverted to
manufacture another component or product how do you take decisions?
Loss of contribution due to diversion of facility should be considered while fixed
price of alternative product.
Variable cost+ loss of contribution+ additional fixed cost to be considered.
5. Optimizing Product Mix:
Proportion in which various products of a company can be sold (Mix)
Criteria:
Study contributions generated by various products individually and by selecting
that mix generates the maximum contribution
6. Key factor/Scarce factor/Limiting factors:
Raw materials are constraints or Labour hours are constraints or machine
hours are constraints
Do not Use Maximum contribution or Maximum P/V Ratio are treated as
the maximum profitable products.
What criteria to be followed?
Limiting factor:
Criteria:
Contribution per limiting factor to be used
7. Multiplicity of the key Factors:
1. If there are two limiting factors- use graphical solution.
14
2. If more than two limiting factors use Linear programming such as Simplex
method.
8.How the optimum output and selling price is determined? •Demand and costs can be estimated at each potential demand level.
•The Optimum output is determined where marginal cost equals to marginal revenue.
•The selling price at which the optimum output can be sold determines the optimum price
Example:
Different price levels
Price unit of demand total revenue Marginal Revenue.
•40 10 400 ---
•38 11 418 18
•36 12 432 14
•34 13 442 10
•32 14 448 06
•30 15 450 02
•28 16 448 -02
Estimated profit at different out put levels
•Price unit of demand Total Rev. total cost profit
•40 10 360 400 40
•38 11 364 364 54
•36 12 370 370 62
•34 13 378 378 64
•32 14 388 388 60
•30 15 400 400 50
•28 16 414 414 34
When price is Rs. 34 profit is maximum
9. Differential calculus to decide optimum selling price Marginal revenue is equal to Marginal cost to decide the optimum selling
price.
Tc= Rs.7,00,000+70 X where X is the annual level of demand and output
SP=Rs. 200-Rs.0.004X :
Total revenue(TR)= Rs.200X-Rs.0.004X
Marginal cost(MC) =dTC/dx =Rs.70
Marginal Revenue(MR)=dTR/dx=Rs.200-Rs..008X
Optimum output level dTC/dx=dTR/dx
X=16,250units; SP=Rs.135
15
Target Costing approach to pricing
•
It is a reverse of cost plus pricing
•Decide the target selling price- customer is willing to pay for the product.
•Target profit margin is deducted to find target cost
•Predicted actual costs are compared with the target cost
•If predicted cost exceed target cost intensive effort made through value engineering
methods.
•
Cost-plus pricing •
Direct variable cost+total direct costs+Indirect costs+share of
organisational cost+% of Profit margin
Relevant cost and relevant benefit required for decision making:
Costs that are affected by the decision.
Costs and benefits that are independent of a decision are not relevant and need
not be considered.
Future cash inflows and future outflows are relevant.
Sunk costs are irrelevant.
Allocated common costs are irrelevant
Opportunity costs are relevant (shadow price)
Incremental costs and incremental benefits are relevant.
Avoidable costs are relevant and unavoidable costs are irrelevant for decision
making.
Problems related to relevant and irrelevant cost:
Five engineers are already employed on monthly salary basis but will not be sent
out if not employed in an another project.
(i). Are the salary paid to those engineers relevant or irrelevant to estimate the
price for a new project which will be completed within a month?
(ii). Two more engineers are selected exclusively to the new project. Are the costs
relevant to take decision for new project?
16
(The students are expected to solve the above problem)
Example for Relevant Cost and relevant benefits:
Survey conducted by incurring Rs.10,00,000 product P can be produced and
marketed. If P is produced it was found that 1,00,000 units per annum can be
produced at a selling price of Rs.100/- per unit. It requires a machine costs Rs.1.5
crores .The material, manufacturing variable cost is Rs.65/- per unit.
What are the relevant costs to take decision whether to go for the project or not?
(The students are expected to solve the above problem)
Example-1:
Machine just purchased a few days ago by spending Rs.20,00,000/- Cost of
running this machine per hour is Rs 100/- It is about to be installed but we come
across an another efficient machine available in the market for Rs. 35,00,000/- The
cost of running this machine is Rs 70/- per hour. If new machine is purchased, the
machine just bought could be disposed for Rs 12,00,000/- Question-1: What are
relevant costs in this problem?
1. If so, how many hours should we run minimum so that it is beneficial to the
company.
2. If company wants to run maximum 60000 hours which machine is beneficial?
3. What is the Break even hours between these two machines?
Example - 2:
We have manufactured 20,000 units of shirts which are meant for export by
spending Rs.150/- per shirt. We can sell this product in the market for Rs.120/- per
shirt because of defects. We can further process them to rectify the defect by
spending Rs.30/- and we can export and sell for Rs.160/- Other good units are sold
for Rs.200 per shirt.
Questions:
1. What are the relevant cost and relevant benefits?
2. Should we rectify them or not?
3. How much gain or loss if not rectified?
4. How much gain or loss if rectified?
Example-3:
You have joined a course by spending Rs.50,000/- The course is for three years.
The cost of the course is Rs 50,000/- per year. In the mean time you come across a
17
new innovative course which will be available for Rs.1,75,000/- Question-1: What
are relevant costs for current decision?
Example-4:
Mr.Kumar purchased a car for Rs.4,00,000/-; insurance Rs.15.000/- Registration
Rs.30,000/- After spending so much he heard that Metro Train will be ready with
in another two weeks.
Every kilometer if he uses the car the running cost per Kilometer = Rs.4/- The
season ticket available for metro is Rs 2000/- per month. His office is 15
kilometers away.
Questions:
(a) What are the relevant costs to take decision?
(b) What are the other factors to be considered before taking decision?
Example-5:
Examination fees had been paid for the final semester. This is the last semester.
The student has already been recruited by the IBM at the campus recruitment. It’s
so happened that the exam falls on the 30th
day student’s father’s death.
What is relevant to take decision i.e. should he go for the exam or attend the death
ceremony? (Assume both are held in the same city and at the same time).
Example-5:
Component
“X”
Component
“Y”
Component
“Z”
Contribution per unit 12 10 6
Machine hour required per unit 6 hours 2 hours 1 hour
Estimated sales in demand 2000 units 2000 units 2000 units
Required machine hours for the
quarter
12,000
hours
4000 hours 2000 hours
One of the machines breakdown the total machine hours available =12000 hours
for the period.
Question-1: Advice the mix of the product.
Example-7:
18
X Ltd has a Machine-001 produces product H. The selling price of H is Rs.100/-
and marginal cost is Rs.60/- It takes 20 hours to produce one H. The company has
alternative to produce product ‘S’ which takes 3 hours per unit of S. The marginal
cost of S=5. S can be purchased from market at a price of Rs.10/-
Question: Should product ‘S’ be produced on the same Machine-001?
Answer-7:
Present contribution = 100 – 60 = 40
Contribution per hour = 40/20 = Rs.2 per hour
S requires 3 hours. The loss of contribution in place of H is 3 x 2 = 6
Full cost of producing component S=MC + loss contribution = 5+6 = 11.
As the supplier’s price is cheaper buy from market.
Example-7:
A BPO Company based in Bangaloru had capacity to process 2,00,000 accounts in
a month. The Sales division reports that the following schedule of sales price is
possible.
Capacity Utilization Sales per account
(Rs.)
60% 90
70% 80
80% 75
90% 67
100% 61
The variable cost per account in Rs 15/-
Fixed cost is Rs 40,00,000/-
Questions:
(i). What capacity is the utilization most profitable proposition?
(ii). Which marginal costing technique do you follow?
19
Answer-8• Technique is Incremental cost and incremental revenue
-
3
3
3
3
58
61
64
67
70
40
40
40
40
40
18
21
24
27
30
-
.04=4lak
8
.006
.014
1.08
1.12
1.2
1.206
1.22
1.2
1.4
1.6
1.8
2.0
60%
70%
80%
90%
100%
Differe
ntialco
st
(Rs.
Lakhs)
Total
cost
(Rs.
Lakhs)
Fixed
cost
(Rs.
Lakhs)
Variabl
e cost
(Rs.
Lakhs)
Increm
ental
revenu
e(In
Crores
)
Sales
Value(
Rs.in
crores)
Units(l
akhs)
Capac
ity
Incremental benefit/Incremental cost
Conclusion-8:
Incremental revenue is higher than differential cost up to the output level of
80% of capacity. Therefore operate at 80% level.
At 90% level of activity differential cost exceeds incremental revenue.
Is there any difference between differential cost and marginal cost?
Differential cost can include items of fixed cost if fixed cost is affected by
the decision.
20
Example-9
Information-2008
Fixed costs increases by 6%
Direct material cost increases by 5%
Labour cost increases by 10%
Due to market pressure selling price
and quantity will remain unchanged
in 2008.
An enquiry for the supply of 10,000
dozens to a customer. What could
be the lowest quotation if business
wants to make a minimum profit of
Rs. 8,00,000?
If 80% learning effect what would be
the impact?
Information-2007
Product- fountain pen
Selling price 100 per dozen
Average net profit is 20% on sale of
50,000 dozen
Capacity-75,000 dozen
Cost sheet: cost per dozen
Direct materials- 36
Direct labour 30
Works over heads 10
(50% variable)
Sales overheads 4
(25% is variable)
21
Answer -9
50,00,000
37.8(36*1.05)
33.0(30*1.1)
5.0
1.0
76.8
38,40,000
4,24,000
(4,00,000*1.06)
42,64,000
7,36,000.
50,00,000
36
30
5
1
72
36,00,000
5
3
8
4,00,000
40,00,000
10,00,000
Sales(50,000*100)other than special order (A)
Variable cost:
Direct material
Direct labour
Works Overheads
Selling overheads
Total variable overhead per unit
Total variable cost (B)
Fixed cost per unit at 50,000 dozens:
Works over heads
Selling over heads
Fixed overheads per unit at 50000 dozens
Total fixed cost (C)
Total cost D= B+C
Profit A-D
2008
Rs.
2007
Rs.
particulars
Answer:
Management wants to get minimum Rs.8,00,000/-
The profit from regular sales is Rs.7,36,000/-
There is a need for additional profit of Rs. 64,000/-
Minimum price per unit = Variable cost + Expected cost +
Additional fixed cost =76.80+(64,000/10,000)+0= Rs 83.20 per unit
Additional fixed costs are covered by the existing sale of 50,000
units.
If 80% learning effect then labour cost=Rs.30*.8*2*1.1=Rs.19.8
Exercise-10:
Bangaluru based BPO has the capacity to process 50,000 accounts per month.
Because of liquidation of one of the European clients the company has excess
capacity. For the next quarter current monthly accounts processed is expected to
be 35,000 accounts at a selling price of 4 pounds per account. The expected costs
22
and revenues for the next month at an activity level of 35,000 accounts are as
follows:
Particulars Pounds
Pounds Per account
Direct labour Variable processing overheads Processing non-variable overheads Marketing costs Total cost Sales ( Collection) Profit
42,000 35,000 28,000 10,500
1,15,500 1,40,000
24,500
1.2 1.0 0.8 0.3 3.3 4.0 0.7
Questions:
(i). Another European client has asked his 3000 accounts to be processed each
month for three months at a price of 2.3 pounds per accounts. Do you
advise the company to go for this proposal?
(ii). If the existing labour force is not reduced but as per labour agreement
minimum three months notice to be given. The company feels that the jerk
is a temporary phenomenon. Do you advise the company to go for the
proposal for 2 pounds?
(iii). If upsurge is going to be permanent. The future sales will be 35,000
accounts for next one year. How much price is advisable to accept the
offer?
(iv). If demand will remain 35000 accounts for next one year and the permanent
employees will be sent out after three months what would be the best price
to accept?
(v). If the laborers are contract labourers and do you accept to process at 2
pounds per accounts?
Exercise-11:
A division of Shanthi Ltd. has received an enquiry from one of its major
customers for a special order for a component that will require 1000 skilled labour
hours and that will incur other variable costs of Rs.8000/- Skilled labour is in
short supply and if company accepts the order then it will be necessary to reduce
production of component P.
The details of the cost per unit and the selling price of component P are as follows:
Selling price=Rs.88; Direct labour(4 hours atRs.10 per hour) =40; other variable
costs =12.
Allocated fixed cost based on labour hours=8.
Question:
What is the minimum selling price the company should accept for the special
order?
23
Relevant cost
Labour cost +contribution lost per labour hour= 10+9=19
19000+8000=27,000
27000/1000=Rs.27 per unit
Example-12: (EOQ Stock with probability)
A dress dealer specializing in seasonal fashion dresses has to decide on the
number of units of a particular dress type to order prior to Diwali. The order has to
be placed in advance only once. The cost of the dress is Rs. 6000, which can be
sold at a price of Rs.9000 per unit. Unsold units after Diwali will be sold at a price
of Rs. 3000 per unit. Demand that can not be fulfilled due to stock shortage incur a
goodwill loss estimated at Rs. 4000 per unit inventory carrying cost is 15% of the
cost incurred. The demand is subject to random fluctuation as per pattern indicated
below:
Determine the optimal number of units that the dealer should order in advance.
Demand units: 3 4 5 6 7 8
Probability: 0.1 0.2 0.3 0.2 0.1 0.1
Answer: 12
Selling Price=Rs.9000
Cost per unit=Rs.6000
Inventory carrying cost=.15* 6000/2=Rs.450
Stock out cost (loss of goodwill)=Rs.4000
Salvage per unit=RS.3000.
Unit cost of not stocking= 9000-6000-450+4000=Rs.6550.
Cost of over stocking=6000+450-3000=Rs.3450
Demand units: 3 4 5 6 7 8
Probability: 0.1 0.2 0.3 0.2 0.1 0.1
Cum.probability: 1.0 0.9 0.7 0.4 0.2 0.1
(Demand>)
P(D)>= 3450/6550+3450=0.345
From the above table it is clear that lowest cumulative probability >0.345 i.e. at
demand 6. Therefore optimal order is 6.
24
Exercise 13(Transfer Price-
Marginal costing)• A company is organised into two divisions namely A and B produces
three products, K,L,M. Data per unit are:
• Division B has a demand for 600 units of product L for its use. If division A can not supply the requirement, Division B can buy a similar product from market at Rs.112 per unit.
• Question: What should be the transfer price of 600 units of L for Division B, if the total direct labour hours available in Division A are restricted to 15,000?
100
70
3
600
115
60
5
1000
120
84
4
1600
Market price
Variable costs
Direct labour hours
Maximum sales
potential(Units)
M
RS./unit
L
Rs./unit
K
Rs./unit
Answer-13• M
RS./unit
L
Rs./unit
K
Rs./unit
100
70
30
3
10
II
600 units
1800
hrs.
115
60
55
5
11
I
1000 units
5000 hrs.
120
84
36
4
9
III
1600 units
6400 hrs.
Market price
Variable costs
Contribution
Direct labour hours
Contribution per labour hour
Ranking
Maximum sales (Balance to K
6800/4=1700 units but limited to
1600 only)
Hours allotted based on ranking
Total hours = 15000
No of hours used = 13,200 (all three products)
Number of hours unutilized=1800 hours
25
Number of units can be produced without disturbing any
product =1800/5= 360 units of L
Remaining number of units of L to be supplied by disturbing
product K=600-360=240
Number hours required to produce 240 units of
L=240*5=1200 hours.
We will disturb only product K. Product K contributes Rs.9 per
labour hour.
Therefore Price of 240 units of L per unit
Variable cost 60
Opportunity cost(9*5) 45
Total cost for 240 units of L 105
Price of 360 units per unit
Variable cost 60
Total cost=(240*105)+(360*60)= 25200+21600=46,800
Average cost per unit=Rs.78.
26
Answer-14 make or buy
5625
6750
1350
1.5
1
2025
1350
900
2
3
1800
2700
900
2
3
1800
2700
Demand
Hours per unit in Dep.P
Hours per unit in Dep.Q
Total hours required in
Dep.P to produce compo
Total hours required in
Dep.Q to produce compo
TotalCBAparticulars
Statement showing number of hours required in Department P and Q to meet
The monthly demand of components
Department P is under utilised and department Q over utilised by 750 hours
Prob.14.Statement showing the units of
components to be purchased to minimise
the cost
50
70
20
1
20
114
-
-
-
-
99
129
30
3
10
Variable cost to make
Variable cost to buy
Extra cost to buy
Hours required to Dept.Q
Extra cost per hour
required on buying
CBAcomponents
Since the extra cost incurred per hour on buying component A is minimum, 250 units
Of component A(750 hrs/3 hours) should be purchased from outside.
Exercise-15: Optimum Selling Price Using Calculus
A company sells one of its products in the domestic market as well as in the export
market. The relationship between price and demand in the two different markets
are represented as under:
27
Domestic Market: 136-8Q1
Export market : 228-20 Q2
Q1 and Q2 represent the quantity of demand in thousand units in the domestic and
export markets respectively.
The variable cost is represented by 38 Q where Q= Q1+ Q2
Calculate the optimum selling price and the total contribution for the sale in the
(i). Domestic market
(ii). Export market
Answer for 15:
Variable cost=38-Q
Total variable cost=38Q-Q2
Marginal cost(MC)= 38-2Q
Selling price= 136-8Q
Total sales=136Q-8Q2
Marginal revenue=136-16Q
We know that profit is maximum when MR=MC
136-16Q= 38-2Q
Q=7
Optimum selling price=136-8*7=Rs.80
Variable cost per unit=38-Q=38-7=31
Contribution per unit=80-31=49
Total contribution=7*49=343
Export:
Selling price=228-20Q
Total revenue 228Q-20Q2
Marginal revenue= 228-40Q
Marginal cost remains the same=38-2Q
Profit is maximized when MR=MC
228-40Q=38-2Q
Q=5
Optimum selling price=228-20*5=128
Variable cost per unit=38-Q=38-5=33
Contribution per unit=128-33=95
Total contribution=5*95=475. or 4,75,000.
28
Exercise 16(Activity Based costing)• A company produces four products P,Q,R and S. The data
relating to production activity are as under:
3
3
12
9
0.50
0.50
1.00
1-1/5
1/2
1/2
2
1-1/5
5
5
16
17
500
5,000
600
7000
P
Q
R
S
Direct
labour
cost/unit
Machine
hours/unit
Direct
labour/unit
Material
cost/unit
Qty.of
production
Product
Production overheads are as under:
i) Overheads applicable to machine oriented activity-37,424
ii)Overhead relating to ordering materials-Rs.1920
iii) Setup Costs-Rs.4355
iV) Administration overheads for spare parts: Rs.8600
v) Materials handling costs-7580
• The following further information have been compiled:
2
5
1
4
2
10
3
12
1
4
1
4
1
6
2
8
P
Q
R
S
No.of
spareparts
No.of times
materials
handled
No. of
materials
order
No.of setupProduct
Required:1) Select a suitable cost driver for each item of overhead expenses and
calculate the cost per unit of cost driver
2.Using the concept of activity based costing , compute the factory cost per unit
Of each product.
These overhead costs are observed by products on a machine hour rate of
Rs.4.80 per hour having an overhead cost per product of:
A=Rs.1.20, B=Rs.1.20, C=4.8 D=Rs.7.2
Answer for 16:
29
Factory overhead applicable to machine oriented activity = Rs.37,424/-
Total machine Hours = Volume x Machine hour required for each period
= (500 x 1/4)+(5,000 x 1/4)+(600 x 1)+(7,000 x 1.5)
= 12,475 hrs.
Machine overhead charged =37,424/12,475 hrs = Rs.3 per hour
Set up costs = 4355/17(i.e. total number of set ups) = Rs.256.18
Material ordering cost = 1920/10 operations = Rs.192
Material handling cost = 7580/27 operations = Rs.280.74
Spare parts = 8600/12 parts = 716.67
Answer-16….
3/2*3=4.5
8*256.18/7
000=0.29
4*192/
7000=0.11
12*280.74/
7000=0.48
4*716.67/
7000=0.41
1*.3=Rs.3
2*256.18/
600=0.85
1*92/600=
0.32
3*280.74/
600=1.40
1*716.67/
600=1.19
¼*3=0.75
6*256.18/
5000=0.31
4*192/5000
=0.15
10*280.7/
5000=0.56
5*716.67/
5000=0.72
¼*Rs.3=.0.75
1*256.18/500=
0.51
1*192/500=
0.38
2*280.74/
500=1.12
2*716.67/500=
2.87
Machine overhead
Setup cost
Material
Ordering cost
Material handling cost
Spare parts cost
DCBAOverhead items
30
+4.43
+1.29
+1.96
-1.41
1.20
1.20
4.80
7.20
5.63
2.49
6.76
5.79
2.87
0.72
1.19
0.41
1.12
0.56
1.40
0.48
0.38
0.15
0.32
0.11
0.75
0.75
3.00
4.50
A
B
C
D
differenceTotal
(old
system)
Total
(ABC
syste
ms)
Spare
Parts
Mater
ial
handl
ing
Materia
l
orderin
g
Machine
overheads
product
s
traditional system does not make correct
assumptions that all overheads are
Related to volume and machine time.
Under traditional system products A and C are
under costed because it misallocates costs for small volume products.
Set ups
Rs.
0.51
0.31
0.85
0.29
Answer: Activity costing
The activity based costing recognizes the amount of input to each cost unit.
Product B previously avoided its full share of overhead because of its low machine
time and may still do so if part of Rs. 37,425 of machine oriented overhead should
be apportioned on some other basis.
Product D is over costed because the additional system loaded it with other
attributable to activities concerned with products A, B and C as result of using a
volume – based and machine oriented rate which failed to Pay proper attention to
activity costing.
Exercise-2: Activity Costing
A Company manufactures several products of varying levels of designs and
models. It uses a single overhead recovery rate based on direct labour hours. The
overheads incurred by the company in the first half of the year are as under.
Machine operating expenses 10,12,500
Machine maintenance expenses 1,87,500
Salaries to technical staff 6,37,500
Wages and salaries of stores staff 2,62,500
During the period, the company introduced activity based costing system and the
following significant activities were identified:
- receiving materials and components
31
- setup of machines for production runs
- Quality inspection.
It is also determined that:
The machine operation and machine maintenance expenses should be
apportioned between stores and production activity in 20:80 ratio.
The technical staff salaries should be apportioned between machine
maintenance, set up and quality inspection in 30:40:30 ratio.
The consumption of activities during the period under review are furnished below:
Direct labour hours worked = 40,000
Direct wages @ Rs.6/- per hour
2040 Material and component consignments received from suppliers
1960
Number of quality inspections carried out = 1280
The data relating to two products manufactured by the company during the period
are as below:
Product P
(Rs)
Product Q
(Rs)
Direct material costs 6000 4000
Direct labour hours 960 100
Direct material consignment received 48 52
Production runs 36 24
Number of quality inspection done 30 10
Quantity produced 15,000 5,000
A potential customer has approached the company for the supply of 24,000 units
of a component K to be delivered in lots of 3,000 units per quarter. The job will
involve an initial design cost of Rs. 60,000 and the manufacture will involve the
following per quarter.
Direct material cost - Rs.12,000; Direct labour hours - 300; Production runs- 6;
Inspections- 24; Number of consignments of direct materials to be received -20
The company desires to mark up of 20% on cost.
Required:
(i). Calculate the cost of products P and Q based on the existing system of single
overhead recovery rate.
(ii). Determine the cost of products P and Q using activity based costing system.
(iii). Compute the sales value per quarter of component K using activity based
costing system.
32
Answer:
Working notes:
1. Overhead rate=21,00,000/4000 hours=Rs.52.50
2. Apportionment of technical staff salaries:
Machine maintenance,
Set up and Quality Inspection respectively
= 6,37,500 x 30:40:30/100
= 1,91,250; 255,000 and 1,91,250.
3. Rate per Cost driver:
Store receiving = 275.89
Set-up production run = 670.59
Quality Inspection = 149.41
4. Single overhead recovery rate: Cost per Unit P= 4.144: Q=1.97
5. Store receiving = 5,40,750: set-up production run =13,68,000
6. Rate per activity 5,40,750/1960=275.89;
13,68,000/2040=670.59;
1,91,250/1280=149.41
for store receiving, setup and quality inspection respectively.
P and Q as per activity based costing system
Exercise-3(Activity Costing)
33
• The data relating to two products manufactured by the company during the period are as under:
• Product P Product Q
• Direct material costs Rs.6000Rs.4000
• Direct labour hours 960 100
• Direct material consignment received 48 52
• Production runs 36 24
• Number of quality inspection done 30 10
• Quantity produced 15,000 5,000
A potential customer has approached the company for the supply of 24,000 units of a component K to be delivered in lots of 3,000 units per quarter. The job will involve an initial design cost of Rs. 60,000 and the manufacture will involve the following per quarter.
Direct material cost - Rs.12,000; Direct labour hours - 300; Production runs- 6; Inspections- 24; Number of consignments of direct materials to be received -20
5000
4000
600
14346
16094
1494
36534
7.31
15000
6000
5760
13243
24141
4482
53626
3.58
Units
Direct materials cost
Direct labour cost
Receiving /sores cost(48*275.89)
(52*275.89)
Production runs/set up cost (36* 670.59)
(24*670.59)
Inspection cost (30* 149.41)
(10* 149.41)
Total cost of products
Cost per unit
QPParticulars
34
Computation of sales value per quarter of component K(Activitity
based costing)
3000
7500
12000
1800
5518
4024
3586
34428
8607
43035
14.34
Units
Components of initial design(Rs.60000/8)
Direct materials cost
Direct labour cost (300 hours 8 Rs.6)
Receiving /sores cost(20*275.89))
Production runs/set up cost (6* 670.59)
Inspection cost (24* 149.41)
Total cost of products
Add: Mark up( 25% of cost)
Sales value
Selling price per unit of K(43035/3000 units)
KParticulars
Exercise-17(Optimal safety
stock option)• The consumption pattern of component used in an assembly is
as under:
• The stock out cost is 18 per unit and the two monthly holding cost is also 18 per unit.
• Determine the optimal safety stock.
0.15
0.20
0.30
0.20
0.15
500
600
700
800
900
probabilityTwo monthly consumption
units
35
5000
4000
600
14346
16094
1494
36534
7.31
15000
6000
5760
13243
24141
4482
53626
3.58
Units
Direct materials cost
Direct labour cost
Receiving /sores cost(48*275.89)
(52*275.89)
Production runs/set up cost (36* 670.59)
(24*670.59)
Inspection cost (30* 149.41)
(10* 149.41)
Total cost of products
Cost per unit
QPParticulars
Exercise 18(Break even sales)
• A newspaper presently sells 1,00,000 copies of its morning daily. It wants to publish evening daily. Particulars are :
• Sale of morning daily will come down by @1 copy of every 10 copies sold of evening daily.
• Calculate :Break even sales for evening daily week.
Rs.0.50 per paper
Rs.0.22 per paper
Rs.10,000 per week
Rs.2 per paper
Rs.1.20 per paper
Rs.2.4 lakhs per week
Sales price
Variable Cost
Fixed Cost
Estimates for eveningActual for morning
36
Answer-18
• morning daily Evening Daily
• Sale price per paper Rs.2.00 Rs.0.50
• Variable cost Rs.1.20 Rs. 0.22
• Contribution per paper Rs.0.80 Rs.0.28
• The sale of ten evening daily will reduce one morning daily.
• Lost in contribution in morning daily=0.8/10=Rs.0.08
• Net contribution from evening daily= 0.28-0.08=0.20
• Breakeven sales of evening daily=Fixed cost/Net contribution
per copy
• =10000/0.20=50,000 copies
Exercise-19 (EOQ):
G limited produces a product which has a monthly demand of 4000 units. The
product requires a component X which is purchased at Rs.20. For every finished
product, one unit of component is required. The ordering cost is Rs.120 per order
and the holding cost is 10%p.a.
You are required to calculate:
(i). EOQ
(ii). If minimum lot size to be supplied is 4000 units, what is extra cost the
company has to incur?
(iii). What is the minimum carrying cost the company has to incur?
Answer-19:
1) EOQ=Root of 2AB/C
=Root of (2*12*4000*120)/(20*0.10)
=2400 UNITS
2) Extra costs if 4000 units are ordered instead of EOQ i.e. 2400 units.
Carrying cost + ordering cost
= 1/2(4000*Rs.20*0.10) + (48,000/4000)Rs.120
37
= 5440
Cost at EOQ =1/2(2400*20*0.10)+(48000/2400)120
= 4800
Extra cost = 5440-4800=640
3) Minimum Carrying cost= 2400
Excercise-20 (Linear application):
The company has derived the following functions:
Total cost (Rs.)=1,00,000 +20q+0.005q2
Price per unit (Rs.)=76-0.002q
Where q=quantity
Determine the production level which will maximise profit.
Answer-20
MR=MC to maximise profit
Revenue = Price*Quantity
= q (76-0.002q)
=76q-0.002q2
Marginal revenue=dR/dq=76-0.004q
Marginal cost=dc/dq=differentiate total cost=20+0.01q
Maximize profit 76-0.004q=20+0.01q
Q=4000 units.
38
Exercise:21(Linear equations)
• The details of production department
involving two processes are as under:
2.5
2
100
3
2
200
2
3
Rs.400
Process I hours/unit
Process II hours/unit
Contribution per unit
Maximum capacity of process I is
1920 hours and of process II is
2200 hours.Maximum sales of A
will be 200 units.
Formulate LPP.
CBAProduct
Solution-21 :linear equation with learning curve effect)
Maximize Z=400A+200B+100C
Subject to:
2A+3B+2.5C<=1920
3A+2B+2C<= 2,200
A<=200
Where A,B,C>=0
Exercise-22:
A company manufactures specialized equipment. Direct labour required to make
the first equipment is 2000 hours. Learning curve is 80%. Direct labour cost is
Rs.40/- per hour. Direct material needed for one equipment is Rs.7200/- Fixed
overheads are Rs.32, 000/-
Required:
(i). Using the Learning curve concept calculate the expected average unit cost
of making an equipments b) 8 equipments.
(ii). After manufacturing 8 equipments, if a repeat order for manufacture of 8
equipments is received, what lowest price could be quoted for the repeat
order?
39
23. Investigation to be done or not
Arbitrary Criteria: Investigating if the absolute size of a variance is greater than
a certain amount or if the variance exceeds the standard cost by a predetermined
percentage say 1%
Example: If standard usage for a particular component was 10 Kg if actual output
for a period is 1000 units the variance is with in 9,900 and 10,100.
This method is simple arbitrary rules are their simplicity and easy to
implementation. There are several disadvantages. Investigating all variances that
exceed the standard cost by fixed percentage can lead to investigating many
variances of small amounts.
Exercises on investigation:
A machine produces 1,00,000 standard components per day at a cost of 1.5 per
unit. If the process is in control, on an average 3% of the output is defective. If the
process is out of control the rate of defectives will be 5%. The entire cost of
defective unit is a loss.
The cost of carrying out an investigation is 600. If the process is found to be out of
control after an investigation then it costs another Rs.400 to rectify the error. The
probability of the process being in control is 0.7.
Required:
(i). Should an investigation be made or not?
(ii). What is the probability at which investigation is desirable?
40
Answer-1
.7
.3
3%(1,50,000)
Out of control
under control
600+3000
Investigate
Do not investigate
Do not rectify
Rectify
5%(1,50,000)
3%(1,50,000)
Rectify
Do not rectify
3%(1,50,000)
5%(1,50,000)
Investigate600
1. If Investigation under taken
Process under control 600*0.7=420
Process out of control 1000*0.3=300
(600+400) 720
2. Cost of not to investigate:
Extra cost =1,00,000*1.5=1,50,000
Extra loss(5%-3%)=1,50,000*2%=3000
Probability = 0.3
Expected value= 3000*.03=900
Conclusion: the cost of investigation is less than the cost of non-investigation.
Hence it should be investigated.
41
• 2. Probability at which investigation is
desirable:
3000*(1-x)
600x
1000-
1000x
1000-
400x
X
1-x
600
1000
Under control
Out of control
Net cost
Cost of
investigation
Eff.costProbcostProcess
Equating both sides we get: 1000-400x=3000-3000x
X=0.77
Probability of process in control=0.77
24. Problem• The relevant data of X Ltd. For its three
products A,B and C are as under.
930
250
260
180
3
1040
300
270
230
6
860
260
300
110
12
Selling price
Direct Material
Direct Labour
Variable Overheads
Machine hours required
C
Rs. Per unit
B
Rs. Per unit
A
Rs. Per unit
Products
The estimated fixed overheads at four different levels of 3,600; 6,000; 8400;and 10,800
machine hours are Rs.1,00,000,Rs.1,50,000,2,20,000 and Rs.3,00,000 respectively.
The maximum demand of A,B and C in a cost period are 500;300 and 1,800 units
Respectively.
Required:- Find out i) the most profitable product-mix at each level and ii) the level
Of activity where the profit would be maximum.
Solution Continues
Contributions at different levels of machine hours are
2,88,000; 456,000; 5,23,000; 561,000 respectively
42
Less Fixed cost:
Net Profit: 1,88,000; 3,06,000; 303,000; 261,000
At 6000 units we get maximum profit.
Exercise-25:
An agriculturist has 480 hectares of land on which he grows potatoes, peas and
carrots. Out of the total area of land 340 hectares are suitable for all four
vegetables but the remaining 140 hectares of land are suitable only for growing
peas and carrots. Labour for all kinds of form works is available in plenty.
The market requirement is that all the four types of vegetables must be produced
with the minimum of 5000 boxes of any one variety. The former has decided that
the area devoted to any one crop should be in terms of complete hectares and not
in fractions of a hectare. The only other limitations is that not more than 1,13,750
boxes of any one vegetables should be produced.
• The relevant data concerning
production, market prices and costs are
as under:
180
Rs.
624
1056
10.40
19.20
44.55
70
Rs.
384
744
8.80
8.0
36.80
100
Rs.
432
1216
6.56
10.40
31.76
350
Rs.
952
1792
7.20
10.4
30.76
Annual yield :
Boxes per hectare
Cost:
Direct Material per hectare
Direct Labour:
Growing per hectare
Harvesting and packing per box
Transport per box
Market price per box
TomatoesCarrotsPeasPotatoesParticulars
It is possible to make the land presently suitable for peas and carrots, viable for
growing potatoes and tomatoes if certain land development work is
undertaken. This work will involve a capital expenditure of Rs.6,000/- per
hectare which a bank is prepared to finance at the rate of 15% per annum. If
such improvement is undertaken, harvesting cost of the entire crop of tomatoes
will decrease on an average by Rs.2.60 per box.
43
Required:
(i). Calculate the area to be cultivated in respect of each crop with in the
constraints and profits before land development work is undertaken.
(ii). After development of land find the acres of land for each product and
maximum profits.
26.Replacement Problem
• A Super market is trying to determine the optimal replacement policy for its fleet of delivery vehicles. The total price of the fleet is Rs.2,20,000.
• The running costs and scrap values of the fleet at the end of each year are:
• The super market’s cost of capitial is 12% per annum.
• Ignore tax and inflation.
• Required: When to replace fleet of delivery vehicles ?
1,76,000
25,000
1,65,000
55,000
1,54,000
66,000
1,32,000
88,000
1,10,000
1,21,000
Running cost
Scrap value
Year 5Year 4Year 3Year 2Year 1
44
Answer for replacement
-110
-132
-154
-165
-151(176-
25)
503.64
220
723.64
3.605
200.73
-110
-132
-154
-110(165-
55)
383.04
220
603.04
3.037
198.56
-110
-132
-88(154-66)
266.09
220
486.09
2.402
202.37
-110
-44(132-88)
133.30
220
353.30
1.690
209.05
+11(100-121)
9.83
220
210.17
o.893
235.35
Cash out flow at the
end of year
1
2
3
4
5
Present value of
outflows
Present cost
Present value
Annuity factor
Equivalent annual
cost
When to replace?
5
(000)
4
(000)
3
(000)
2
(000)
1
(000)
The lowest equivalent annual cost is Rs.198,560/- Therefore the fleet should be
replaced at the end of 4 years.
Exercise-27:
A company purchases 6000 components per annum at Rs.60/- each. The
management desires to install a machine to manufacture the components. The cost
of the machine is Rs.3,00,000/- It has a capacity to produce 10,000 components
per annum. The life of the machine is 5 years. The variable cost to manufacture
the components is Rs.48 per unit and a sum of Rs.20,000/- has been allocated to
this machine as a fair share of general factory overheads per annum.
(i). Should the company make or buy the components?
(ii). If an offer to buy 2500 components at Rs.50 each is received from another
company, should the company accept the offer to manufacture and supply?
Evaluation of make or buy decision:
Purchase price per component 60
Less: variable cost 48
Savings if component manufactured 12
Total savings (6000 x 12) 72,000
Less: Depreciation (3,00,000/5) 60,000
Net savings 12,000
Recommended to install special machine.
45
Exercise-28: Special Order with Learning Curve
An electronic firm which has developed a new type of fire alarm system has been
asked to quote for a prospective customer. The customer requires separate price
quotations for each of the possible orders.
Order First Second Third
No. of fire and alarm system 100 60 40
The firm estimates the following cost per unit for the first order:
Materials Rs.500/-
Direct labour
Department A (Highly automated) 20 hours at Rs.10/- per hour
Department B (Skilled labour) 40 hours at Rs.15/- per hour
Variable overheads Rs.8/- per direct labour hour
Fixed overhead absorbed
Department A: Rs.8/- per hour
Department B: Rs.5/- per hour
Determine a price per unit for each of the three orders assuming the firm uses a
mark up of 25% on total costs and allows for 80% learning curve. Each from 80%
learning curve table
Learning Curve Table:
X 1.0 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0
Y% 100 91.7 89.5 87.6 86.1 84.4 83.0 81.5 80.0
Where X represents the cumulative total volume produced to date expressed as
a multiple of the initial order.
Y represents the learning curve factor, for a given X value, expressed as a
percentage of the cost of the initial order.
Answer:
First order:
Material = 500,
Direct Labour: A = 20 x 10 = 200, B= 40 x 15 = 600
Prime Cost = 1300,
Variable overheads = Rs.800(20/100) = 160
Fixed overheads: A = 20 x 8=160, B = 40 x 5=20
Total cost =1820, Profit=1850 x 0.25 = 455: Sales = 2275
Second order:
Cumulative out put = 100 + 60 = 160
46
Total hours = 160units x 40 hrs x 0.861 = 5510.4 hrs
Hours for 60 units = 5510.4 – 4000 = 1510.4
Hours per unit = 1510.4/60 = 25.17 hrs
Sales per unit = Rs.1848.64
Third Order:
Labour hrs = 200 x 40 x 0.8 – 5510.4 = 889.6 hrs
Hours per unit = 889.6/40 units = 22.24
Sales =1764.40 per unit.
Exercise-29: Life Costing
A BPO Company has identified two places after spending Rs.20,00,000/- for
market study to set up its business operations. They request you to choose any one
of the places based on the following information.
Place I: Koramangala
80% of the employees are staying at 8 kilometers radius. 20% of the
employees are staying 12 kilometers radius.
Cabs are arranged for the employees both the ways.
10% of the total number of employees do not take the transport facilities
and are paid by Rs.3/- per k.m. for 10 kilometers basis per day trip
irrespective of the number of kilometers traveled by them.
A cab can bring 4 employees at a time.
The cabs while leaving the first shift employees in their houses pick up the
second shift employees. The cab is always full.
The cabs are taken on a daily rental of Rs.800/- irrespective of the
kilometers for 12 hours duration. For 18 hours duration Rs.1200/- is
charged per cab (both shifts and transport time) i.e. Rs.400/- is charged for
second shift employees to be dropped after second shift.
The rent of the building is Rs.25per month per square feet for the first year,
Rs.28/- p.m. for the second year and Rs.30/- p. m. for the third year.
Place II: Rajaji Nagar:
40% of the employees are staying in 10 kms radius and 60% of the
employees are staying at 14 kms radius. All employees prefer to take the
transport facilities.
A cab is taken on a daily rental of Rs.900/- per day irrespective of the kms
and Rs.400/- is charged per cab to drop the second shift employees in their
houses.
The rent of the building is Rs.15/- per month per square feet for the first
year, Rs.20/- p.m. for the second year and Rs.25/- p.m. for the third year.
47
Other information:
The company has fixed order of 5,54,400 accounts per month. There are two shifts
in 24 hours a day. The working hours are 9 hours duration but effective working
hours are 8 hours per day. Each account is estimated to be processed in a five
minute duration.
On an average there are 22 working days in a month.
Irrespective of the place selected, the company makes a contract for three years
only. Each employee occupies on an average of 40 square feet including all other
facilities such as canteen, toilet etc.
Discounted rate is 12%.
Required:
(i). Choose the correct place to set up their business in Bangalore.
(ii). Having chosen the place, if the Company expects Rs.20,00,000/- p.m. as
profit and their variable and fixed over heads come to 70 per employee per
hour Calculate Break even employees per year and Margin of safety
employees to get a profit of Rs.20,00,00/- and also calculate break even
accounts per year and margin of safety accounts to be processed.
(iii). Should the company run in a single shift or double shift? Advice.
Answer:
Per day accounts processed = 5,54,400 /22=25200
Effective hours per day per employee = 8 hrs
Number of accounts processed per day per employee
= 8 x 60 mts/5 mts = 96 accounts
Number of employees = 25200 accounts/96 accounts per
employee
= 262.5=263employees.
Per shift = 263/2=132 employees per shift
The required space:
Per employee = 40 square feet
Total area in square feet = 40 x 132= 5840 square feet.
Rent in Koramangala in the first year = 5840 x 25 x 12 =
Rs.17,52,000
In the second year = 6000 x 28 x 12 = Rs.20,16,000
Third year = 6000 x 30 x 12 = Rs. 21,60,000/-
48
Exercise-30:
Kings B&B IS A BED AND BREAKFAST ESTABLISHMENT
There are 10 rooms priced at £22 per night the B&B is open 7 nights per
week the following are typical costs:
Weekly costs
heat & light £42
Cleaning staff(basic) £100
admin £90
Breakfast staff £72
Other o/heads £60
Cost per guest night
Breakfast food £4
cleaning staff bonus £2
Laundry £3
The question asks to calculate the weekly Profit or loss if there were 42
guest nights in a week i.e.: an average of 6 guests on each of the 7 nights.
Answer:
If we start by saying that the
Weekly costs should be treated as not changing according to how many
people stay the night, so if there are 42 or 0 the cost is fixed
Cost per guest night is a variable cost and the total cost of breakfast food
etc will depend on how many people stay the night.
Total fixed cost is heat & light £42
Cleaning staff(basic) £100
admin £90
Breakfast staff £72
Other o/heads £60
£364
Total variable cost per guest night is:
breakfast food £4
cleaning staff bonus £2
49
Laundry £3
Total variable cost £9
So the contribution per guest night is:-
Price - variable cost per night
£22 - £9 = £13
if there were 42 guest nights in a week
Then total contribution is
42 x £13 = £546
Fixed costs are £364
So the profit is £182
Exercise-31:
During ltd manufactures one product
no units manufactured 10000
number of units sold 8000
selling price £4 per unit
direct materials £8000
direct labour £16000
fixed production overheads £10000
There were no finished goods stock at start of month both direct materials
and labour behave as variable cost.
Produce a profit statement using marginal cost and absorption costing
On my profit statement for marginal costing I have:
sales @ £4 each = £32000
Variable cost
direct material @ £1 each = 8000
direct labour @ £2 each
less closing stock (marginal cost £6000)
2000 units x £3
fixed production o/heads £10000
profit £4000
Would really appreciate your help with this one. Trying to get through my
resubmits so I can concentrate on exam revision.
34. Special Sales Order:
50
A. B. Fast is a manufacturer of automobile parts located in Texas.
Ordinarily A. B. Fast sells oil filters for $3.22 each.
R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or
$1.77 per filter.
Special Sales Order
A. B. Fast’s manufacturing product cost is $2 per oil filter which includes variable
manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80.
Suppose that A. B. Fast made and sold 250,000 oil filters before considering the
special order.
Should A. B. Fast accept the special order?
Special Sales Order
The $1.77 offered price will not cover the $2 manufacturing cost.
However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit.
Accepting the order will increase A. B. Fast’s contribution margin.
20,000 units × $.57 contribution margin per unit = $11,400
35. Dropping Products, Departments, and Territories:
Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil
filters and 20,000 air cleaners).
Suppose that the company is considering dropping the air cleaner product line.
Revenues for the air cleaner product line are $41,000.
Should A. B. Fast drop the air cleaner line?
Dropping Products, Departments, Territories
Variable selling and administrative expenses are $0.30 per unit.
Variable manufacturing expenses are $1.20 per unit.
Total fixed expenses are $335,000.
Total fixed expenses will continue even if the product line is dropped.
51
Product Line
Oil Filters Air Cleaners Total
Units 250,000 20,000 270,000
Sales $805,000 $ 41,000 $846,000
Variable expenses 375,000 30,000 405,000
Contribution margin $430,000 $ 11,000 $441,000
Fixed expenses 310,185 24,815 335,000
Operating income/(loss) $119,815 ($13,815) $106,000
36.Dropping Products,
Departments, Territories
36. Dropping Products, Departments, Territories:
To measure product-line operating income, A. B. Fast allocates fixed expenses in
proportion to the number of units sold.
Total fixed expenses are $335,000 ÷ 270,000 units, or $1.24 fixed unit cost.
Fixed expenses allocated to the air cleaner product line are 20,000 units × $1.24
per unit, or $24,815.
Dropping Products, Departments, Territories
Oil Filters Alone
Units 250,000
Sales $805,000
Variable expenses 375,000
Contribution margin 430,000
Fixed expenses 335,000
Operating income $ 95,000
37. Dropping Products, Departments, Territories:
Suppose that the company employs a supervisor for $25,000.This cost can be
avoided if the company stops producing air cleaners. Should the company stop
producing air cleaners?
Yes!
$11,000 – $25,000 = ($14,000)
52
38. Product Mix:
Companies must decide which products to emphasize if certain constraints prevent
unlimited production or sales.
Assume that A. B. Fast produces oil filters and windshield wipers.
The company has 2,000 machine hours available to produce these products.
Product Mix
A. B. Fast can produce 5 oil filters in one hour
or 8 windshield wipers.
ProductOil Windshield
Per Unit Filters Wipers
Sales price $3.22 $13.50
Variable expenses 1.50 12.00
Contribution margin $1.72 $ 1.50
Contribution margin ratio 53% 11%
Product Mix
Which product should A. B. Fast emphasize?
Oil filters:
$1.72 contribution margin per unit × 5 units per hour
= $8.60 per machine hour
Windshield wipers:
$1.50 contribution margin per unit × 8 units per hour
= $12.00 per machine hour
53
39. Outsourcing (Make or Buy):
A. B. Fast is considering the production of a part it needs, or using a model
produced by C. D. Enterprise.
C. D. Enterprise offers to sell the part for $0.37.
Should A. B. Fast manufacture the part or buy it?
Outsourcing (Make or Buy)
A. B. Fast has the following costs for
250,000 units of Part no. 4:
Part no. 4 costs: Total
Direct materials $ 40,000
Direct labor 20,000
Variable overhead 15,000
Fixed overhead 50,000
Total $125,000
$125,000 ÷ 250,000 units = $0.50/unit
Outsourcing (Make or Buy)
A. B. Fast has the following costs for
250,000 units of Part no. 4:
Part no. 4 costs: Total
Direct materials $ 40,000
Direct labor 20,000
Variable overhead 15,000
Fixed overhead 50,000
Total $125,000
$125,000 ÷ 250,000 units = $0.50/unit
54
Assume that by purchasing the part, A. B. Fast can avoid all variable
manufacturing costs and reduce fixed costs by $15,000 (fixed costs will decrease
to $35,000).
B. Fast should continue to manufacture the part.
Why?
Purchase cost (250,000 × $0.37) $ 92,500
Fixed costs that will continue 35,000
Total $127,500
The unit cost is then $0.51
($127,500 ÷ 250,000).
$127,500 – $125,000 = $2,500, which is the
difference in favor of manufacturing the part.
Outsourcing (Make or Buy)
Expected cost of obtaining 250,000 parts:
Make part $125,000
Buy part and leave facilities idle $127,500
Buy part and use facilities for gas filters $110,500*
*Cost of buying part: $127,500 less
$17,000 contribution from gasoline filters.
Best Use of Facilities
55
41. Best Use of Facilities:
Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the
facilities previously used to manufacture Part no. 4 to produce gasoline filters.
The expected annual profit contribution of the gasoline filters is $17,000.
What should A. B. Fast do?
Expected cost of obtaining 250,000 parts:
Make part $125,000
Buy part and leave facilities idle $127,500
Buy part and use facilities for gas filters $110,500*
*Cost of buying part: $127,500 less
$17,000 contribution from gasoline filters.
42.Best Use of Facilities
42. Sell As-Is Or Process Further:
The sell as-is or process further is a decision whether to incur additional
manufacturing costs and sell the inventory at a higher price, or sell the inventory
as-is at a lower price.
Suppose that A. B. Fast spends $500,000 to produce 250,000 oil filters.
A. B. Fast can sell these filters for $3.22 per filter, for a total of $805,000.
Sell As-Is Or Process Further
Alternatively, A. B. Fast can further process these filters into super filters at an
additional cost of $25,000, which is $0.10 per unit ($25,000 ÷ 250,000 = $0.10).
Super filters will sell for $3.52 per filter for a total of $880,000.
Should A. B. Fast process the filters into super filters?
Sell As-Is Or Process Further
A. B. Fast should process further, because the $75,000 extra revenue ($880,000 –
$805,000) outweighs the $25,000 cost of extra processing.
Extra sales revenue is $0.30 per filter.
Extra cost of additional processing is $0.10 per filter.
56
Sell As-Is Or Process Further
Cost to produce 250,000 parts: $500,000
Sell these parts for $3.22 each: $805,000
Cost to process original parts further: $ 25,000
Sell these parts for $3.52 each: $880,000
Sales increase ($880,000 – $805,000) $ 75,000
Less processing cost 25,000
Net gain by processing further $ 50,000
Explain the difference between correct analysis and incorrect analysis of a
particular business decision.
Correct Analysis
A correct analysis of a business decision focuses on differences in revenues and
expenses.
The contribution margin approach, which is based on variable costing, often is
more useful for decision analysis.
It highlights how expenses and income are affected by sales volume.
Incorrect Analysis
The conventional approach to decision making, which is based on absorption
costing, may mislead managers into treating a fixed cost as a variable cost.
Absorption costing treats fixed manufacturing overhead as part of the unit cost.
43. Opportunity Cost (with Average rate of return, NPV)
Is the benefit that can be obtained from the next best course of action.
Opportunity cost is not an outlay cost, so it is not recorded in the accounting
records.
Suppose that A. B. Fast is approached by a customer that needs 250,000 regular
oil filters.
Opportunity Cost is equal to the customer is willing to pay more than $3.22 per
57
filter
.
A. B. Fast’s managers can use the $855,000 ($880,000 – $25,000) opportunity
cost of not further processing the oil filters to determine the sales price that will
provide an equivalent income i.e. $855,000 ÷ 250,000 units = $3.42
Use four capital budgeting
Models to make longer-term
Investment decisions
Accounting Rate of Return Example
Assume that a machine costs $200,000, has no residual value, and has a useful life
of 8 years.
How much is the straight-line depreciation per year?
$25,000
Management expects the machine to generate annual net cash inflows of $40,000.
Accounting Rate of Return Example
How much is the average operating income?
$40,000 – $25,000 = $15,000
How much is the average investment?
$200,000 ÷ 2 = $100,000
What is the accounting rate of return?
$15,000 ÷ $100,000 = 15%
Net Present Value
The (NPV) method computes the expected net monetary gain or loss from a
project by discounting all expected cash flows to the present.The amount of
interest deducted is determined by the desired rate of return.This rate of return is
called the discount rate, hurdle rate, required rate of return, or cost of capital.
Net Present Value Example
A. B. Fast is considering an investment of $450,000.
This proposed investment will yield periodic net cash inflows of $225,000,
$230,000, and $210,000 over its life.
A. B. Fast expects a return of 16%.
Should the investment be made?
58
Net Present Value Example
Periods Amount PV Factor Present Value
0 ($450,000) 1.000 ($450,000)
1 225,000 0.862 193,950
2 230,000 0.743 170,890
3 210,000 0.641 134,610
Total PV of net cash inflows $499,450
Net present value of project $ 49,450
Internal Rate of Return is another model using discounted cash flows.The
internal rate of return (IRR) is the rate of return that a company can expect to earn
by investing in a project.The higher the IRR, the more desirable the
investment.The IRR is the rate of return at which the net present value equals zero.
Investment = Expected annual net cash inflow × PV annuity factor
Investment ÷ Expected annual net cash inflow = PV annuity factor
Internal Rate of Return Example
Assume that A. B. Fast is considering investing $500,000 in a project that will
yield net cash inflows of $152,725 per year over its 5-year life. What is the IRR of
this project?
$500,000 ÷ $152,725 = 3.274 (PV annuity factor)
The annuity table shows that 3.274 is in the 16% column for a 5-period row in this
example.
Therefore, 16% is the internal rate of return of this project.
If the minimum desired rate of return is 16% or less, A.B. Fast should undertake
this project.
59
The discounted cash-flow models, net present value, and internal rate of return are
conceptually superior to the payback and accounting rate of return models. It is
easy to calculate, highlights risks, and is based on cash flows. Its weaknesses are
that it ignores cash flows beyond the payback, the time value of money, and
profitability. The strength of the accounting rate of return is that it is based on
profitability. Its weakness is that it ignores the time value of money.
Outsourcing (Make or Buy)
B. Fast has the following costs for
250,000 units of Part no. 4:
Part no. 4 costs:
Total
Direct materials $ 40,000
Direct labor 20,000
Variable overhead 15,000
Fixed overhead 50,000
Total $125,000
$125,000 ÷ 250,000 units = $0.50/unit
176
Exercise A2
Customer per month 8000 Music & Entertainment $100
Check Average $6,5 Marketing $1.250
% of Food Sales 85,0% Utilities $1.250
Other Income $0 Repair & Maintenance $500
Food Cost 25% Administration $500
Beverage Cost 20% Rent $2.800
Employee wages 15,0% Interest $1.000
Management salaries 5,0% KDV taxes 18%
Employee Benefit 2,0% Refund $4.500
Direct Operating Expenses $2.000
1) Calculate the Cash Balance $4.690
2) Calculate the guest needed monthly (break even) 5.982
3) Calculate the guest needed daily to reach a profit of 10,0% 277
4) Calculate the guest needed daily to reach a profit of $6.500 293
60
178
Exercise A2 (&
result)Total Labor Cost 22,0% $11.440
Operating Expenses
Direct Operating Expenses 3,8% $2.000
Music & Entertainment 0,2% $100
Marketing 2,4% $1.250
Utilities 2,4% $1.250
Repair & Maintenance 1,0% $500
Administration 1,0% $500
Rent 5,4% $2.800
Interest 1,9% $1.000
Total Operating expenses 18,1% $9.400
Restaurant Profit before taxes & refund $18.550
KDV taxes 18% of Total Sales $9.360
Refund $4.500
Cash Balance 9,0% $4.690
177
Exercise A2 (&
result)F&B Sales
Food 85,0% $44.200
Beverage 15,0% $7.800
Total F&B Sales 100,0% $52.000
Cost of Sales
Food: 25% of Food Sales 21,3% $11.050
Beverage: 20% of Beverage Sales 3,0% $1.560
Total Cost of Sales 24,3% $12.610
Gross Profit $39.390
Other Income $0
Total Income $39.390
Labor Cost
Employee wages 15,0% $7.800
Management salaries 5,0% $2.600
Employee Benefit 2,0% $1.040
Total Labor Cost 22,0% $11.440
61
178
Exercise A2 (&
result)Total Labor Cost 22,0% $11.440
Operating Expenses
Direct Operating Expenses 3,8% $2.000
Music & Entertainment 0,2% $100
Marketing 2,4% $1.250
Utilities 2,4% $1.250
Repair & Maintenance 1,0% $500
Administration 1,0% $500
Rent 5,4% $2.800
Interest 1,9% $1.000
Total Operating expenses 18,1% $9.400
Restaurant Profit before taxes & refund $18.550
KDV taxes 18% of Total Sales $9.360
Refund $4.500
Cash Balance 9,0% $4.690
62
180
Exercise A1 (&
result)
Total Operating Expenses $11.900
Principle on note (refund) $3.000
Total Fixed Cost $14.900
Other Income (without KDV) $0
Total $14.900
1-(%Total Variable Cost / 100) 0,3300
% of Total Cost of Sales0,2900
% of Total Labor Cost 0,2000
% KDV 0,1800
% of Total Variable Cost0,6700
Check Average $7
Customer needed monthly to break even: 6.450
Number of days in one month 30
Customers needed daily to break even: 215
Calculate the breakeven for the exercise A-2
Total Operating Expenses $9.400
+ Principle on note (refund) $4.500
Total Fixed Cost $13.900
- Other Income (without KDV) $0
Total $13.900
./. 1-(%Total Variable Cost / 100) 0,3575
% of Total Cost of Sales 0,2425
% of Total Labor Cost 0,2200
% KDV 0,1800
% of Total Variable Cost 0,6425
./. Check Average $7
Customer needed monthly to break even: 5.982
./. Number of days in one month 30
Customers needed daily to break even: 199