areas of applications-bep final

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


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


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.

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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.

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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 labour cost (300 hours 8 Rs.6)

Receiving /sores cost(20*275.89))




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 labour cost

Receiving /sores cost(48*275.89)

(52*275.89)


(24*670.59)


(10* 149.41)


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


A. B. Fast has the following costs for


Part no. 4 costs: Total


Direct labor 20,000



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.


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?


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


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.


B. Fast has the following costs for


Part no. 4 costs:

Total


Direct labor 20,000



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

areas of applications-bep final

Economy & Finance