21521sm Final Vol2 Cp2 CHAPTER 2

8/11/2019 21521sm Final Vol2 Cp2 CHAPTER 2

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CHAPTER 2

Decision Making using Cost Conceptsand CVP Analysis

Basic Concepts

Absorption Cos ting *

Assigns direct costs and all or part of overhead to cost units using one or more overheadabsorption rates.

Absorbed Overhead*

Overhead attached to products or services by means of an absorption rate, or rates.

Al locate*

To assign a whole item of cost, or of revenue, to a single cost unit, centre, account or timeperiod.

Apport ion*

To spread indirect revenues or costs over two or more cost units, centres, accounts or timeperiods. This may also be referred to as indirect allocation.

Ap pl icati on of Incremental / Di ff erenti al Cost Techn iq ues in Managerial Dec isi on s

The areas in which the above techniques of cost analysis can be used for makingmanagerial decisions are:

(i) Whether to process a product further or not.

(ii) Dropping or adding a product line.

(iii) Making the best use of the investment made.

(iv) Acceptance of an additional order from a special customer at lower than existing

price.(v) Opening of new sales territory and branch.

(vi) Make or Buy decisions.

(vii) Submitting tenders

(viii) Lease or buy decisions

(ix) Equipment replacement decision.

The Institute of Chartered Accountants of India


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2.2 Advanced Management Accoun ting

Avoidable Cost*

Specific cost of an activity or sector of a business that would be avoided if the activity or

sector did not exist.

Bottleneck*

Facility that has lower capacity than prior or subsequent facilities and restricts output

based on current capacity.

Breakeven po int*

Level of activity at which there is neither profit nor loss.

Cost*

As a noun The amount of cash or cash equivalent paid or the fair value of other

consideration given to acquire an asset at the time of its acquisition or construction.

Cost-Benefit Analysi s*

Comparison between the costs of the resources used plus any other costs imposed by an

activity.

Cost Centre*

Production or service location, function, activity or item of equipment for which costs are

accumulated.

Common Cost*

Cost relating to more than one product or service.

Committed Cost*

Cost arising from prior decisions, which cannot, in the short run, be changed. Committed

cost incurrence often stems from strategic decisions concerning capacity with resulting

expenditure on plant and facilities. Initial control of committed costs at the decision point

is through investment appraisal techniques.

Conversion Cost *

Cost of converting material into finished product, typically including direct labour, direct

expense and production overhead.

Cost Classification*

Arrangement of elements of cost into logical groups with respect to their nature (fixed,

variable, value adding), function (production, selling) or use in the business of the entity.

Cost Elements*

Constituent parts of costs according to the factors upon which expenditure is incurred, namely

material, labour and expenses.



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Decision Making using Cost Concepts and CVP Analysis 2.3

Cost Management*

Application of management accounting concepts, methods of data collection, analysis andpresentation in order to provide the information needed to plan, monitor and control costs.

Cost Object*

For example a product, service, centre, activity, customer or distribution channel in relation towhich costs are ascertained.

Cost Pool*

Grouping of costs relating to a particular activity in an activity-based costing system.

Cost-Volume-Profit Analysis

Cost-Volume-Profit Analysis (as the name suggests) is the analysis of three variable viz.,cost, volume and profit. Such an analysis explores the relationship existing amongstcosts, revenue, activity levels and the resulting profit. It aims at measuring variations ofcost with volume. In the profit planning of a business, cost-volume-profit (C-V-P)relationship is the most significant factor.

Differential / Incremental Cost *

Difference in total cost between alternatives. This is calculated to assist decision making.

Direct Cost*

Expenditure that can be attributed to a specific cost unit, for example material that forms partof the product.

Distribution costsCost of warehousing saleable products and delivering them to customers. These costs arereported in the income of statement.

Discretionary Cost*

Cost whose amount within a time period is determined by a decision taken by the appropriatebudget holder. Marketing, research and training are generally regarded as discretionary costs.Also known as managed or policy costs.

Efficiency*

Achievement of either maximum useful output from the resources devoted to an activity or therequired output from the minimum resource input.

Expand or Contract Decision

Whenever a decision is to be taken as to whether the capacity is to be expanded or not,consideration should be given to the following points:

(i) Additional fixed expenses to be incurred.

(ii) Possible decrease in selling price due to increase in production.

(iii) Whether the demand is sufficient to absorb the increased production.



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Export v/s Lo cal Sale Decision

When the firm is catering to the needs of the local market and surplus capacity is stillavailable, it may think of utilising the same to meet export orders at price lower than thatprevailing in the local market. This decision is made only when the local sale is earning aprofit, i.e., where its fixed expenses have already been recovered by the local sales. Insuch cases, if the export price is more than the marginal cost, it is preferable to enter theexport market. Any reduction in the price prevailing in the local market to fulfil surpluscapacity may have adverse effect on the normal local sales. Dumping in the export marketat a lower price will not, however, have any such adverse effect on local sales.

Features of CVP Analysi s

Features of CVP Analysis are as follows:

(i)

It is a technique for studying the relationship between cost volume and profit.

(ii) Profit of an undertaking depends upon a large number of factors. But the mostimportant of these factors are the cost of manufacture, volume of sales and sellingprice of products.

(iii)

In words of Herman C. Heiser, the most significant single factor in profit planning ofthe average business is the relationship between volume of business, cost andprofits.

(iv)

The CVP relationship is an important tool used for profit planning of a business.

Fixed Cost*

Cost incurred for an accounting period, that, within certain output or turnover limits, tends tobe unaffected by fluctuations in the levels of activity (output or turnover).

Joint Cost*

Cost of a process which results in more than one main product.

Long-term Variable Cost*

All costs are variable in the long run. Full unit costs may be surrogates for long-term variablecosts if calculated in a manner which utilises long-term cost drivers, for example activity-basedcosting.

Make or Buy Decisio n

Very often management is faced with the problem as to whether a part should bemanufactured or it should be purchased from outside market. Under such circumstancestwo factors are to be considered:

(i) Whether surplus capacity is available, and

(ii) The marginal cost.



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Marginal Cost*

Part of the cost of one unit of product or service that would be avoided if the unit were notproduced, or that would increase if one extra unit were produced.

Marginal Costing

According to CIMA, Marginal costing is the system in which variable costs are charged tocost units and fixed costs of the period are written off in full against the aggregatecontribution.

Marginal costing is not a distinct method of costing like job costing, process costing,operating costing, etc. but a special technique used for managerial decision making.Marginal costing is used to provide a basis for the interpretation of cost data to measure

the profitability of different products, processes and cost centre in the course of decisionmaking. It can, therefore, be used in conjunction with the different methods of costingsuch as job costing, process costing, etc., or even with other technique such as standardcosting or budgetary control.

Marginal Revenue*

Additional revenue generated from the sale of one additional unit of output.

Normal Loss*

Expected loss, allowed for in the budget, and normally calculated as a percentage of the goodoutput from a process during a period of time. Normal losses are generally either valued atzero or at their disposal values.

Notional Cost*

Cost used in product evaluation, decision making and performance measurement to reflectthe use of resources that have no actual (observable) cost. For example, notional interest forinternally generated funds or notional rent for use of space.

Opportunity Cost*

The value of the benefit sacrificed when one course of action is chosen in preference to analternative. The opportunity cost is represented by the foregone potential benefit from the bestrejected course of action.

Outsourcing*

Use of external suppliers as a source of finished products, components or services. This is

also known as contract manufacturing or subcontracting.

Overhead/Indirect Cost,*

Expenditure on labour, materials or services that cannot be economically identified with aspecific saleable cost unit.

Period Cost*

Cost relating to a time period rather than to the output of products or services.



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Post-Purchase Cost*

Cost incurred after a capital expenditure decision has been implemented and facilitiesacquired. May include training, maintenance and the cost of upgrades.

Pricing Decisions - Special Circumstances

If goods were sold in the normal circumstances under normal business conditions, theprice would cover the total cost plus a margin of profit. Selling prices are not alwaysdetermined by the cost of production. They may be determined by market conditions butin the long run they tend to become equal to the cost of production of marginal firm.Therefore, a business cannot continue to sell below the total cost for a long period.Occasionally, a firm may have to sell below the total cost.

Theproblem of pricing can be summarised under three heads:

(i) Pricing in periods of recession,

(ii) Differential selling prices and

(iii) Acceptance of an offer and submission of a tender.

Prime Cost*

Total cost of direct material, direct labour and direct expenses.

Product Cost*

Cost of a finished product built up from its cost elements.

Production Cost*

Prime cost plus absorbed production overhead.

Product Mix Decision

Many times the management has to take a decision whether to produce one product oranother instead. Generally decision is made on the basis of contribution of each product.Other things being the same the product which yields the highest contribution is best oneto produce. But, if there is shortage or limited supply of certain other resources which mayact as a key factor like for example, the machine hours, then the contribution is linked withsuch a key factor for taking a decision.

Price-Mix Decision

When a firm can produce two or more products from the same production facilities andthe demand of each product is affected by the change in their prices, the managementmay have to choose price mix which will give the maximum profit, particularly when theproduction capacity is limited. In such a situation, the firm should compute all the possiblecombinations and select a price-mix which yields the maximum profitability.

Re-apportion *

The re-spread of costs apportioned to service departments to production departments.



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Relevant Costs / Revenues*

Costs and revenues appropriate to a specific management decision. These are representedby future cash flows whose magnitude will vary depending upon the outcome of themanagement decision made. If stock is used, the relevant cost, used in the determination ofthe profitability of the transaction, would be the cost of replacing the stock, not its originalpurchase price, which is a sunk cost. Abandonment analysis, based on relevant cost andrevenues, is the process of determining whether or not it is more profitable to discontinue aproduct or service than to continue it.

Replacement Cost*

Cost of replacing an asset. This is important in relevant costing because if, for example,material that is in constant use is needed for a product or service, the relevant cost of thatmaterial will be its replacement cost. Replacement cost has also been proposed as analternate to historic cost accounting and it can, therefore, be an important concept withrelevance to accounting for inflation or measuring performance where the value of assets isimportant.

Semi-Variable Cos t*

Cost containing both fixed and variable components and thus partly affected by a change inthe level of activity.

Shut Down or Continue Decision

Very often it becomes necessary for a firm to temporarily close down the factory due totrade recession with a view to reopening it in the future. In such cases, the decisionshould be based on the marginal cost analysis. If the products are making a contributiontowards fixed expenses or in other words if selling price is above the marginal cost, it ispreferable to continue because the losses are minimised. By suspending the manufacture,certain fixed expenses can be avoided and certain extra fixedexpenses may be incurreddepending upon the nature of the industry, say, for example, extra cost incurred inprotecting the machinery. So the decision is based on as to whether the contribution ismore than the difference between the fixed expenses incurred in normal operation and thefixed expenses incurred when the plant is shut down.

Standard Cost*

Planned unit cost of a product, component or service. The standard cost may be determinedon a number of bases. The main uses of standard costs are in performance measurement,control, stock valuation and in the establishment of selling prices.

Sunk Cost*

Cost that has been irreversibly incurred or committed and cannot therefore be consideredrelevant to a decision. Sunk costs may also be termed irrecoverable costs.



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Under / Over Absorbed Overhead*

The difference between overhead incurred and overhead absorbed, using an estimatedrate, in a given period. If overhead absorbed is less than that incurred there is under-absorption, if overhead absorbed is more than that incurred there is over-absorption.Over- and under-absorptions are treated as period cost adjustments.

Unit Cost *

Unit of product or service in relation to which costs are ascertained.

Variable Cost*

Cost that varies with a measure of activity.

(*) Source- CIMAs Official Terminology



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Basic FormulaeProfit Statement under Marginal Costing

Revenue / Sales xxx

Less:

Material xxx

Labour xxx

Direct Expenses xxx

Variable Overheads xxx

Variable Cost of Production xxx

Add:Opening Stock of Finished goods (at Marginal Cost) xxx

Less:Closing Stock of Finished goods (at Marginal Cost) xxx

Variable Cost of Goods Sold

Add: Variable Selling Overheads

Variable Cost of Sales

xxx

xxx

xxx

Contribution xxx

Less:All types of Fixed Cost (Committed, Discretionary costs) xxx

Profit xxx

Contribution = Sales Variable Cost

= Fixed Cost Profit/ (loss)

Profit Volume (P/V) Ratio

Or

Contribution to Sales (C/S) Ratio

Or

Contribution Margin Ratio = Contribution Sales

= Contribution per unitSelling Price per unit

= Change in Contribution Change in Sales

Breakeven Point (BEP) = Point where there is No Profit or No Loss

At BEP, Contribution = Fixed Cost



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2.10 Advanced Management Accou nting

Thus, Break Even Sales (in sales value) = Fixed Cost P/V Ratio

Margin of Safety = Sales BEP Sales

= Contribution / P/V Ratio Fixed Cost / P/VRatio

= Profit / P/V Ratio

Profit = Sales P/V Ratio Fixed Cost

= Margin of Safety Sales P/V Ratio



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Solution:Marginal cost represents the increase or decrease in total cost which occurs with a smallchange in output say, a unit of output. In Cost Accounting variable costs represent marginalcost.

Differential cost is the change (increase or decrease) in the total cost (variable as well asfixed) due to change in the level of activity, technology or production process or method ofproduction.

In other words, it can be defined as the cost of one unit of product or service which would be

avoided if that unit was not produced or provided.

The main point which distinguishes marginal cost and differential as that change in fixed costwhen volume of production increases or decreases by a unit of production. In the case ofdifferential cost variable as well as fixed cost. i.e. both costs change due to change in the levelof activity, whereas under marginal costing only variable cost changes due to change in thelevel of activity.

Question-4

What are the applications of incremental cost techniques in making managerial decisions?

Solution:Incremental Cost Technique:It is a technique used in the preparation of ad-hoc informationin which only cost and income differences between alternative courses of action are taken intoconsideration.

The essential pre-requisite for making managerial decisions by using incremental costtechnique, is to compare the incremental costs with incremental revenues. So long as theincremental revenue is greater than incremental costs, the decision should be in favour of the

proposal.Ap pl ication s of Increment al Cost Techn iqu es in maki ng Managerial Dec isi ons :

The important areas in which incremental cost analysis could be used for managerial decisionmaking are as under:

(i) Introduction of a new product.

(ii) Discontinuing a product, suspending or closing down a segment of the business.



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(iii) Whether to process a product further or not.

(iv) Acceptance of an additional order from a special customer at lower than existing price.

(v) Opening of new sales territory and branch.

(vi) Optimizing investment plan out of multiple alternatives.

(vii) Make or buy decisions.

(viii) Submitting tenders.

(ix) Lease or buy decisions.

(x) Equipment replacement decisions.

Question-5

Sunk cost is irrelevant in decision-making, but irrelevant costs are not sunk costs. Explainwith example.

Solution:Sunk costs are costs that have been created by a decision made in the past and that cannotbe changed by any decision that will be made in the future. For example, the written downvalue of assets previously purchased are sunk costs. Sunk costs are not relevant for decisionmaking because they are past costs.

But not all irrelevant costs are sunk costs. For example, a comparison of two alternativeproduction methods may result in identical direct material costs for both the alternatives. Inthis case, the direct material cost will remain the same whichever alternative is chosen. In thissituation, though direct material cost is the future cost to be incurred in accordance with theproduction, it is irrelevant, but, it is not a sunk cost.

Question-6

Explain the concept of relevancy of cost by citing three examples each of relevant costs andnon-relevant costs.



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Solution:Relevant costs are those costs which are pertinent to a decision. In other words, these are thecosts which are influenced by a decision. Those costs which are not affected by the decisionare not relevant costs.

Examples of Relevant Costs :

(i) All variable costs are relevant costs.

(ii) Fixed Costs which vary with the decision are relevant costs.

(iii) Incremental costs are relevant costs.

Examples of Non-Relevant Costs :

(i) All fixed costs are generally non-relevant.

(ii) Variable costs which do not vary with the decision are not relevant costs.

(iii) Book value of the asset is not relevant.

Question-7

Pick out from each of the following items, costs that can be classified under committed fixedcosts or discretionary fixed costs.

(i) Annual increase of salary and wages of administrative staff by 5% as per agreement

(ii) New advertisement for existing products is recommended by the Marketing Departmentfor achieving sales quantities that were budgeted for at the beginning of the year.

(iii) Rents paid for the factory premises for the past 6 months and the rents payable for thenext six months. Production is going on in the factory.

(iv) Research costs on a product that has reached maturity phase in its life cycle and theresearch costs which may be needed on introducing a cheaper substitute into the marketfor facing competition.

(v) Legal consultancy fees payable for patent rights on a new product Patenting rights havebeen applied for.



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Solution:

Committed Fixed Cost Discretionary Fixed Cost

(i) Salary and Wage increase. (ii) New Advertisement Cost.

(iii) Rents payable for the next 6 months. (iv) Research Cost for substitutes.

(v) Legal Fees for filing for patent rights.

Question-8

Enumerate the limitations of using the marginal costing technique.

Solution:Marginal costing is defined as the ascertainment of marginal cost and of the effect on profit ofchanges in volume or type of output by differentiating between fixed costs and variable costs.Limitations of Marginal Costing Techniques:

The limitations of using the marginal costing technique are as follows:

(i) It is difficult to classify exactly the expenses into fixed and variable category. Most ofthe expenses are neither totally variable nor wholly fixed.

(ii) Contribution itself is not a guide unless it is linked with the key factor.

(iii) Sales staff may mistake marginal cost for total cost and sell at a price; which will resultin loss or low profits. Hence, sales staff should be cautioned while giving marginal cost.

(iv) Overheads of fixed nature cannot altogether be excluded particularly in large contracts,while valuing the work-in-progress. In order to show the correct position fixedoverheads have to be included in work-in-progress.

(v) Some of the assumptions regarding the behaviour of various costs are not necessarilytrue in a realistic situation. For example, the assumption that fixed cost will remainstatic throughout is not correct.

Question-9

Briefly discuss on curvilinear CVP analysis.



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Solution:In CVP analysis, the usual assumption is that the total sales line and variable cost line willhave linear relationship, that is, these lines will be straight lines. However, in actual practice itis unlikely to have a linear relationship for two reasons, namely:

(i) After the saturation point of existing demand, the sales value may show a downwardtrend.

(ii)

The average unit variable cost declines initially, reflecting the fact that, as outputincrease the firm will be able to obtain bulk discounts on the purchase of raw materials

and can also benefit from division of labour. When the plant is operated at furtherhigher levels of output, due to bottlenecks and breakdowns the variable cost per unitwill tend to increase. Thus the law of increasing costs may operate and the variablecost per unit may increase after reaching a particular level of output.

In such cases, the contribution will not increase in linear proportion i.e. based on thephenomenon of diminishing marginal productivity; the total cost lie will not be straight,as assumed but will be of curvilinear shape. This situation will give rise to two breakeven points. The optimum profit is earned at the point where the distance betweensales and total cost is the greatest.



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Question-10

Use of absorption costing method for the valuation of finished goods inventory provides

incentive for over-production. Elucidate the statement.

Solution:

When absorption costing method is used, production fixed overheads are charged to products

and are included in product costs. Consequently, the closing stocks are valued on total cost

(including fixed overheads) basis. The net effect is that the charge of fixed overheads to P/L

account gets reduced, if the closing stock is greater than the opening stock. This situation hasthe effect of inflating the profit for the period.

Where stock levels are likely to fluctuate significantly, profits may be distorted if calculated on

absorption costing basis. If marginal costing is used, since the fixed costs are charged off to

P/L account as period cost, such a situation will not arise. The impact of using absorption

costing on profits can be summerised as under:

(i)

When sales are equal to production, profits will be the same under absorption costing

and marginal costing.

(ii)

If production is higher than sales, the absorption costing will post higher profits than

marginal costing.(iii)

If sales are in excess of production, absorption costing will show lower profits than

marginal costing.

Since profit calculation in absorption costing can produce strange result, the managers may

deliberately alter the stock levels to influence the profits if absorption costing is used. Hence, it

is true to say that if absorption costing method is used managers have the incentive to over

produce to show better result.

Question-11

Draw and explain the angle of incidence in a break-even chart. What is its significance to the

management?



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Solution:

Angle of incidence (Q) is the angle between the total cost line and the total sales line. If theangle is large, the firm is said to make profits at a high rate and vice-versa. A high angle ofincidence and a high margin of safety indicate sound business conditions.

Question-12

Explain the concept of discretionary costs. Give three examples.

Solution:

Discretionary costs can be explained with the help of following two important features-

(i) They arise from periodic (usually yearly) decisions regarding the maximum outlay to beincurred.

(ii) They are not tied to a clear cause and effect relationship between inputs and outputs.



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Examples of Discretionary Costs includes: advertising, public relations, executive training,teaching, research, health care and management consulting services. The note worthy featureof discretionary costs is that managers are seldom confident that the correct amounts arebeing spent.

Question-13

Discuss how control may be exercised over discretionary costs.

Solution:

Control Over Discretionary Costs:To control discretionary costs control points/parametersmay be established. But these points need to be devised individually. For research anddevelopment function to control discretionary costs, data may be established for submittingmajor reports to management. For advertising and sales promotion, such costs may becontrolled by pre-setting targets. In the case of employees benefits, discretionary costs maybe controlled by calling a meeting of employees union and making them aware that thecompany would meet only the fixed costs and the variable costs should be met by them.

Question-14

Comment on the use of opportunity cost for the purpose of:

(i) decision-making and

(ii) cost control

Solution:(i) Decision Making: Opportunity costs apply to the use of scarce resources, where

resources are not scarce; there is no sacrifice from the use of these resources. Where a

course of action requires the use of scarce resources, it is necessary to incorporate thelost profit which will be foregone from using scarce resources. If resources have noalternative use only the additional cash flow resulting from the course of action shouldbe included in decision making as relevant cost.

(ii)

Cost Control: The conventional variance analysis will report an adverse usagevariance and adverse sales volume variance. However, the failure to achieve thebudgeted optimum level of output may be due to inefficient usage of scarce resources.



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The foregone contribution should therefore be charged to the manager responsible forcontrolling the usage of scarce resources and not to the sales manager because thefailure to achieve the budgeted sales is due to the failure to use scarce resourcesefficiently. Thus if resources are scarce, the usage variance should reflect theacquisition cost plus budgeted contribution per unit of the scarce resources. If the lostsales are made good in subsequent periods, the real opportunity cost will consists oflost interest arising from delay in receiving the net cash-flows and not the foregonecontribution.

Question-15Mention any four important factors to be considered in Marginal Costing Decisions.

Solution:Important factors to be considered in Marginal Costing Decisions are as follows:

(i) Whether the product or production makes a contribution,

(ii) In the selection of alternatives, additional fixed costs if any should be considered.

(iii) The continuity of demand after expression and its impact on selling price are to be

considered.(iv) Non-cost factors such as the need to keep labour force intact and governmental attitude

are also to be taken into account.

Question-16

Cost is not the only criterion for deciding in favour of shut down Briefly explain.

Solution:Cost is not only criterion for deciding in the favour of shut down. Non-cost factors worthy ofconsideration in this regard are as follows:

(i)

Interest of workers, if the workers are discharged, it may become difficult to get skilledworkers later, on reopening of the factory. Also shut-down may create problems.

(ii) In the face of competition it may difficult to re-establish the market for the product.



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(iii)

Plant may become obsolete or depreciate at a faster rate or get rusted. Thus, heavycapital expenditure may have to be incurred on re-opening.

Question-17

Explain, how Cost Volume Profit (CVP) - based sensitivity analysis can help managers copewith uncertainty.

Solution:Sensitivity analysis focuses on how a result will be changed if the original estimates or theunderlying assumptions change.

Cost Volume Profit (CVP) based sensitivity analysis can help managers to provide answersto the following questions to cope with uncertainty.

(i) What will be the profit if the sales mix changes from that originally predicted?

(ii) What will be the profit if fixed costs increase by 10% and variable costs decline by 5%.

The use of spreadsheet packages has enabled managers to develop CVP computerisedmodels which can answer the above questions. Managers can now consider alternative plansby keying the information into a computer, which can quickly show changes both graphicallyand numerically. Thus managers can study various combinations of changes in selling prices,fixed costs, variable costs and product mix, and can react quickly without waiting for formalreports from the accountant. In this manner the use of CVP based sensitivity analysis can helpmanagers to cope up with uncertainty.

Question-18

State the non-cost factors to be considered in make/buy decisions.

Solution:

Non-Cost Factors i n Make / Buy Decisions :

(i) Possible use of released production capacity and facility as a result of buying instead ofmaking.

(ii) Sources of supply should be reliable and they are capable of meeting un-interruptedlythe requirement of the concern.



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(iii) Assurance about the quality of goods supplied by outside supplier.

(iv) Reasonable certainty, from the side of supplier about, meeting the delivery dates.

(v) The decision of buying the product / component from outside suppliers should bediscouraged, if the technical know- how used is highly secretive.

(vi) The decision of buying from outside sources should not result in the laying off ofworkers and create industrial relation problems. In fact, on buying from outside theresources freed should be better utilised elsewhere in the concern.

(vii) The decision of manufacturing product / component should not adversely affect theconcerns relationship with suppliers.

(viii) Ensure that more than one supplier of product/component is available to reduce the riskof outside buying.

(ix) In case the necessary technical expertise is not available internally then it is better tobuy the requirements from outside.

Question-19

Enumerate the factors involved in decisions relating to expansion of capacity

Solution:The factors involved in decisions relating to expansion of capacity are enumerated as below:

(i) Additional fixed overheads involved should be considered.

(ii) Possible decrease in selling price due to increased production capacity.

(iii) Whether the demand is sufficient to absorb the increased production.

Question-20

Discuss the role of costs in product-mix decisions.

Solution:Role of Costs in Product Mix Decisions: All types of cost involved in cost accountingsystem are useful in decision making. The cost which plays a major role in product mixdecision is the relevant cost. Costs to be relevant should meet the following criteria:



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(i) The costs should be expected as future costs.

(ii) The costs differ among the alternatives course of action.

While making decision about product mix using the facilities and other available resources, theend results should always aim at profit maximisation. Variable costs are relevant costs inproduct mix decisions and consequently contribution plays a major role in maximisation ofprofit. In addition to the relevancy of costs, the other factors and costs that should be takeninto account at the time of deciding the products mix are:

(i) The available production capacity

(ii) The limiting factor (s)

(iii) Contribution per unit of the limiting factor

(iv) Market demand for the products.

(v) Opportunity costs

Question-21

State the relative economics of the makes vs. buy decision in management control.

Solution:

The relative economics of the Make vs. Buy decision in management control:

Generally for taking a make vs. buy decision comparison is made between the suppliers priceand the marginal cost of making plus the opportunity cost. Make vs. buy decision is a strategicdecision, and, therefore, both short-term as well as well as long-term thinking about variouscost and other aspects needs to be done.

A company generally buy a component instead of making it under following situations:

(i) If it costs less to buy rather than to manufacture it internally;

(ii) If the return on the necessary investment to be made to manufacture is not attractive

enough;(iii) If the company does not have the requisite skilled manpower to make;

(iv) If the concern feels that manufacturing internally will mean additional labour problem;

(v) If adequate managerial manpower is not available to take charge of the extra work of

manufacturing;



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(vi) If the component shows much seasonal demand resulting in a considerable risk ofmaintaining inventories;

(vii) If transport and other infrastructure facilities are adequately available;

(viii) If the process of making is confidential or patented;

(ix) If there is risk of technological obsolescence for the component such that it does not

encourage capital investment in the component.

Question- 22

The use of Absorption costing method in decision-making process leads to anomalies.

Discuss.

Solution:

In absorption costing, fixed overheads are assigned to products by establishing overhead

absorption rates based on budgeted or normal output. By using absorption costing principles,

it is possible for profit to decline when sales volume increases. If the stock levels fluctuate

significantly, profits may be distorted because stock changes will significantly affect the

amount of fixed overheads allocated to a period. If profits are measured on monthly or

quarterly or on periodical basis, seasonal variations in sales may cause significant fluctuations

in profits. Internal profit statements on monthly or quarterly basis are used for measuring the

managerial performance. In the circumstances, managers may deliberately alter inventory

levels to influence profit, if absorption costing is used. When sales are less and the closing

inventory increases, a part of the fixed overheads contained in the value of the closing stock is

reduced from the fixed costs allocated to production for the period. Thus, if sales are reduced,

inventories will increase and absorption cost will post higher profits. Similarly, if sales are

increased as compared to production, inventories will be reduced and absorption costing will

return lower profits.

Question- 23

What are the major areas of decision-making in which differential costing is used?



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Solution:Differential costing can be used for all short, medium and long term decisions. When twolevels of activities are being considered, or while choosing between competing alternativesdifferential cost analysis is essential. The differential cost is useful for decision making in thefollowing areas:

(i)

Capital Expenditure Decisions.

(ii)

Make or Buy Decision

(iii)

Production Planning(iv)

Sales Mix Decision

(v)

Production or Product Decision

(vi)

Change in Level or Nature of an Activity.



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Break-even Point / CVP Analysis / Profit Loss ForecastQuestion-1

A company has an opening stock of 6,000 units of output. The production planned for thecurrent period is 24,000 units and expected sales for the current period amount to 28,000units. The selling price per unit of output is `10. Variable cost per unit is expected to be `6per unit while it was only ` 5 per unit during the previous period. What is the break-evenvolume for the current period if the total fixed cost for the current period is `86,000?

Assume that the First InFirst Out System is followed.

Solution:Since the First in First Out (FIFO) system is being presumed, units available for sale are 6,000units from opening stock and 22,000 units from current year's production. Thus, making a totalof 28,000 units. Units from opening stock give a contribution of `5 (i.e., `10`5) per unitwhereas units from current production, give a contribution of only `4 (i.e. `10`6)

Break-even Volume (in units) = Units from Op. Stock

Total Fixed Costs-Total Contribution from Op. Stock+

Current Contribution per unit

=86,000 - (6,000units 5)

6,000units4

+

` `

`

= 20,000 units

Question-2

The following information is given by Z Ltd.:

Margin of Safety `1,87,500

Total Cost `1,93,750

Margin of Safety 7,500 units

Break-even Sales 2,500 units

Required:

Calculate Profit, P/V Ratio, BEP Sales (in`) and Fixed Cost.



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Solution:Margin of Safety (%) =

=7,500units

7,500units 2,500units+

= 75%

Total Sales =1,87,500

0.75

`

= `2,50,000

Profit = Total Sales Total Cost

= `2,50,000 `1,93,750

= `56,250

P/V Ratio =Profit

100MarginofSafety( )

`

= 56,250

1001,87,500

`

`

= 30%

Break-even Sales = Total Sales [100 Margin of Safety %]

= `2,50,000 0.25

= ` 62,500

Fixed Cost = Sales x P/V Ratio Profit

= `2,50,000 0.30 `56,250

= `18,750

Question-3

A Pharmaceutical company produces formulations having a shelf life of one year. Thecompany has an opening stock of 30,000 boxes on 1st January, 2005 and expected toproduce 1,30,000 boxes as was in the just ended year of 2004. Expected sale would be1,50,000 boxes. Costing department has worked out escalation in cost by 25% on variablecost and 10% on fixed cost. Fixed cost for the year 2004 is `40 per unit. New price announced



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for 2005 is `100 per box. Variable cost on opening stock is `40 per box. You are required tocompute breakeven volume for the year 2005.

Solution:Shelf life is one year hence opening stock of 30,000 boxes is to be sold first. Contribution onthese boxes is `18,00,000 [30,000 boxes (`100 `40)].

In the question production of 2004 is same as in 2005. Hence fixed cost for the year 2004 is`52,00,000 (1,30,000 boxes `40). Therefore fixed cost for the year 2005 is `57, 20,000 (`52,00,000 + 10% of `52,00,000).

Variable Cost for the year 2005, `50 per unit (`40 + 25% of`40).

Hence Contribution per unit during 2005 is `50 (`100 `50).

Break even volume is the volume to meet the fixed cost i.e. fixed cost equals to contribution.Therefore, remaining fixed cost of `39,20,000 (`57, 20,000 `18, 00,000)to be recovered fromproduction during 2005.

Production in 2005 to reach BEP, 78,400 units (`39,20,000 / `50).

Therefore BEP for the year 2005 is 1,08,400 boxes (30,000 boxes + 78,400 boxes)

Question-4

A company makes 1,500 units of a product for which the profitabil ity statement is given below:

`)

Sales 1,20,000

Direct Materials 30,000

Direct Labour 36,000

Variable Overheads 15,000

Fixed Cost 16,800

Profit 22,200

After the first 500 units of production, the company has to pay a premium of ` 6 per unittowards overtime labour. The premium so paid has been included in the direct labour cost of `36,000 given above.

You are required to compute the Break-even point.



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Solution:

Data / Unit 1 500 501 1,500

`) `)

Sales (`1,20,000 / 1,500 units) 80 80

Direct Material (`30,000 / 1,500 units) 20 20

Direct Labour* 20 26

Variable Overheads (`15,000 / 1,500 units) 10 10

Contribution 30 24

Contribution at 500 units = `15,000

Fixed Cost = `16,800

Shortfall = `1,800

No. of units to recover shortfall = 75 units (`1,800 / `24)

Break Even Point = 575 units (500 units + 75 units)

(*)

Let X be the Direct Labour per unit up to 500 units. Total Direct Labour-

500X + 1,000 (X + 6) = 36,000

1,500X + 6,000 = 36,000

X = 20

Therefore, up to 500 units the Direct Labour is `20. After 500 units it is `26.

Question-5

A Ltd. Makes and sells a single product. The companys trading results for the year are:

Figs. `000 (Year 2007)Sales 3,000

Direct materials 900

Direct labour 600

Overheads 900

Profits 600



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For the year 2008, the following are expected:

(i) Reduction in the selling price by 10%.

(ii) Increase in the quantity sold by 50%.

(iii) Inflation of direct material cost by 8%.

(iv) Price inflation in variable overhead by 6%.

(v) Reduction of fixed overhead expenses by 25%.

It is also known that:

(a) In 2006, overhead expenditure totalled to `8,00,000.

(b) Total overhead cost inflation for 2007 has been 5% more than 2006.(c) Production and sales volumes have been 25% higher in 2007 than in 2006.

The high-low method is being used by the company to estimate overhead expenditure.

You are required to:

(i) Prepare a statement showing the estimated trading results for 2008.

(ii) Calculate the Break-even point for 2007 and 2008.

(iii) Comment on the BEP and profits of the years 2007 and 2008.

Solution:

(i)

Trading Results

Figures `000

2007 2008

Sales 3,000 4,050(`3,000 1.5 .9)

Less:Direct Material 900 1,458(`900 1.5 1.08)

Less: Direct Labour 600 900(`600 1.5 1)

Less: Variable Overhead 300(W.N.-1)

477(`300 1.06 1.5)

Contribution 1,200 1,215

Less: Fixed Overhead 600(W.N.-2)

450(`600 .75)

Profits 600 765



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(ii)

Figures `000

2007 2008

P/V Ratio (Contribution / Sales) 40% 30%

BEP (Fixed Cost / PV Ratio) 1,500

600

40%

`

1,500

450

30%

`

Working Note (Figures `000)

W.N.-1

Overhead Cost in 2006 = `800

Increase in Price = 5%

Overhead Cost for Same Production = `840 (`800 5% + 800)

Overhead Increase Due to Quantity = `60( 900 `840)

` 60 represent increase in Variable Overhead in 2007 due to increase in Quantity by 25%

Variable Overhead Amount in 2007 =1

1 times4

i.e.5

4

= 15 times th quantity4

= 5 `60

= `300

W.N.-2

In 2007 Total Overhead = `900

Variable Overhead (W.N.-1) = `300

Fixed Overhead = `600

(iii)Particul ars 2007 2008 Difference (%)

BEP 1,500 1,500 0 ---

Fixed Overhead 600 450 150 25%

PV Ratio 40% 30% 10% 25%

Profit 600 765 165 27.50%



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Both Fixed Cost and P/V ratio have declined by 25% equally. So BEP Sales remains the same.

The Contribution is only `1,215 in 2008 though Quantity is increased by 50%. This is due to

increase in Production Cost and decrease in Selling Price. This is more than made up by

decrease in Fixed Cost so that Overall Profit has increased by 27.5%.

Question-6

Titan Engineering is operating at 70 per cent capacity and presents the following information:-

Break even Point ` 200 Crores

P/V Ratio 40 per cent

Margin of Safety ` 50 Crores

Titans management has decided to increase production to 95 per cent capacity level with the

following modifications:-

(i)

The selling price will be reduced by 8 per cent.

(ii) The variable cost will be reduced by 5 per cent on sales.

(iii)

The fixed cost will increase by ` 20 Crores, including depreciation on additions, but

excluding interest on additional capital.

(iv)

Additional capi tal of ` 50 Crores will be needed for capital expenditure and workingcapital.

Required:

(a) Indicate the sales figure, with the working, that will be needed to earn ` 10 Crores over

and above the present profit and also meet 20 per cent interest on the additional

capital.

(b) What will be the revised?

(i)

Break even Point

(ii)

P/V Ratio(iii)

Margin of Safety



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Solution:Working Note

Present Sales and Profit

Total Sales = Break even Sales + Margin of Safety

= `200 Crores + `50 Crores

= `250 Crores

P/V Ratio = 40%

Variable Cost = 60% of Sales

= `250 Crores 60%

= `150 Crores

Fixed Cost = Break even Sales P/V Ratio

= `200 Crores 40%

= `80 Crores

Total Cost = `150 Crores + `80 Crores

= `230 Crores

Profit = Total Sales Total Cost

= `250 Crores `230 Crores

= `20 Cores

(a) Revised Sales (` in Crores)

Present Fixed Cost 80.00

Increase in Fixed Cost 20.00

Interest at 20 per centon Additional Capital( 50Crores 20%) 10.00

Total Revised Fixed Cost 110.00

Assuming that the Present Selling Price is`100

Revised Selling Price will be (8% Less) 92.00

New Variable Cost (Reduced from 60% to 55%)of Sales (`92 55%) 50.60

Contribution (`92.00 `50.60) 41.40



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New P / V Ratio =41.40

x 10092.00

`

`

= 45%

Revised Required Sale =RevisedFixedCost + ExpectedProfit

P / VRatio

=110Crore+ 30Crore

45%

` `

= `311.11Crores

(b) (i) Revised Break even Point =FixedCost

P/ VRatio

=110crore

45%

`

= `244.44 Crores

(ii)

P / V Ratio = 45%

(ii i)

Revised Margin of Safety = Revised Sales Revised Breakeven Sales

= `311.11Crores `244.44Crores

= `66.67 Crores.

Question-7

The budgeted results of A Ltd. as under:

Product Sales Values () P / V Ratio (%)

X 2,50,000 50

Y 4,00,000 40

Z 6,00,000 30

Fixed overheads for the period is ` 5,02,200.

The management is worried about the results. You are required to prepare a statementshowing the amount of loss, if any, being incurred at present and recommend a change in thesale value of each product as well as in the total sales value maintaining the same sales mix,which will eliminate the said loss.



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Solution:Statement of Profitability

Product Sales Value (`) P / V Ratio (%) Contri buti on (`)

X 2,50,000 50 1,25,000

Y 4,00,000 40 1,60,000

Z 6,00,000 30 1,80,000

Total 12,50,000 4,65,000

Less: Fixed Overheads 5,02,200

Profit / (Loss) (37,200)

Ad di ti onal Sale Valu e o f each Produ ct

Produc t Sales Value (`)

X `74,400 (`37,200 0.5)

Y `93,000 (` 37,200 0.4)

Z `1,24,000 (`37,200 0.3)

Additional Total Sales Value maintaining the same Sale Mix = `37,200 0.372*

= `1,00,000

* Combined P / V Ratio =TotalContribution

100TotalSales

=4,65,000

10012,50,000

`

`

= 37.2%

Question-8

Details about the single product marketed by a company are as under:

Per unit (`)

Selling Price 100

Direct Material 60

Direct Labour 10

Variable Overheads 10



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No. of units sold in the year are 5,035. Pursuant to an agreement reached with the EmployeesUnion, there would be next year a 10% increase in wages across the board for all thosedirectly engaged in production.

Work Out:

(i) How many more units have to be sold next year to maintain the same quantum ofprofit.

(ii) Or else, by what percentage the Selling Price has to be raised to maintain the sameP / V ratio.

Solution:

(i) The same quantum of Profit means the same quantum of Contribution as Fixed Costremains unchanged.

Present Contribution = 5,035 units `20

= `1,00,700

Net unit Contribution after 10% increase in Wages = `19

No. of units to be sold =1,00,700

19

`

`

= 5,300 units

More units to be sold next year for the same Profit = 5,300 units 5,035 units

= 265 units

(ii) Existing P/V Ratio20

x100100

`

` = 20%

Therefore, Marginal Cost = 80% of Sales

New Marginal Cost (`60 +`11 + `10) = `81

Increase in Selling Price:When Marginal Cost is `80, Selling Price = `100

When Marginal Cost is `81, Price100

x 8180

``

` = `101.25

Thus, Selling Price has to be raised by = 1.25%(`101.25 `100)



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Question-9

Aditya Ltd., manufactures and markets a single product. The following data (per unit) areavailable:

Materials(` ) 16 Fixed Cost (` ) 5,00,000

Conversion Costs (Variable) (` ) 12 Present Sales (units) 90,000

Dealers Margin (10% of Sale) (` ) 4 Capacity Utilization 60 %

Selling Price(` ) 40

There is acute competition, Extra efforts are necessary to sell. Suggestions have been made

for increasing sales:(a) By reducing sales price by 5 per cent.

(b) By increasing dealer's margin by 25 per cent over the existing rate.

Which of these two suggestions you would recommend, if the company desires to maintain thepresent profit? Give reasons.

Solution:Statement Showi ng Profi t on Sale of 90,000 unit s

(`)

Material 16

Add: Conversion Cost 12

Add: Dealers Margin 4

Total Variable Cost 32

Selling Price 40

Less: Variable Cost 32

Contribution 8

Total Contribution on Sales (90,000 units `8) 7,20,000

Less: Fixed Cost 5,00,000

Profit 2,20,000

In both the suggested courses, the Fixed Costs remain unchanged. Therefore, the PresentProfit of `2,20,000 can be maintained by maintaining the Total Contribution at the PresentLevel i.e. `7,20,000.



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(a) Reducing Selling Price by 5 %.

New Sales Price (`40 `2) = `38

New Dealer's Margin (10% of `38) = `3.80

New Variable Cost (`16 + `12 +`3.80) = `31.80

New Contribution per unit(`38 `31.80) = `6.20

Sales (in units) required for Present Level of Profits =Total Contribution Required

New Contribution per unit

=7,20,000

6.20

`

`

= 1,16,129 units

(b) Increasing Dealers Margin by 25%.

Present Rate of Dealer's Margin4

10040

`

` = 10%

New Dealers Margin after increasing it by 25% = `5

Or 12 % of Sales Price

New Variable Cost (`16 + `12 +`5) = `33

Contribution (`40 33) = `7

Level of, Sales required for Present Level of Profits =Total Contribution Required

New Contribution per unit

=7,20,000

7.00

`

`

= 1,02,857 units

Conclusion:

The Second Proposal, i.e., increasing the Dealer's Margin, is recommended because:

(i) The Contribution per unit is higher. It is `7.00 in comparison to `6.20 in the FirstProposal; and

(ii) The Sales (in units) required to earn the same Level of Profit are lower. They are at1,02,857 as against 1,16,129 units in the First Proposal. This means a lower Saleseffort and less Finance would be required for implementing Proposal (b) as againstProposal (a). Of course, under Proposal (b) the company can earn higher Profits thanat Present Level if it can increase its Sales beyond 1,02,857 units.



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Question-10

A company has three factories situated in North, East and South with its Head Office inMumbai. The Management has received the following summary report on the operations ofeach factory for a period:

(in 000)

Particulars Sales Profit

Actual Over / Under Budget Actual Over/(Under) Budget

North 1,100 (400) 135 (180)

East 1,450 150 210 90

South 1,200 (200) 330 (110)

Calculate for each factory and for the company as a whole for the period:

(i) Fixed Cost

(ii) Break-even Sales

Solution:Computation of Profit Volume Ratio

(`in 000)

Particulars

Sales Profit P/V Ratio

Change in Prof it

Change inSales

Ac tu al Over / (Under)

Budget

Budgeted

Sales

Ac tu al Over /(Un der )

Budget

Budget

Profit

North 1,100 (400) 1,500 135 (180) 315 45%

East 1,450 150 1,300 210 90 120 60%

South 1,200 (200) 1,400 330 (110) 440 55%

(i) Computation of Fixed Costs

(`in 000)

Particulars Actual Sales P/V Ratio Contribution Actual Profit Fixed Cost

(1) (2) (3) = (1) (2) (4) (5) = (3) - (4)

North 1,100 45% 495 135 360

East 1,450 60% 870 210 660

South 1,200 55% 660 330 330

Total 3,750 2,025 675 1,350



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(ii) Computation of Break-Even Sales

Particular

s

Fixed Cost

(a)

P/V Ratio

(b)

Break-even Sales

(a) / (b)

North 360 45 800

East 660 60 1,100

South 330 55 600

2,500

Break-even Sales (Company as Whole) =Fixed Cost

Composite P/ V Ratio

=

13,50,000

54%

`

= `25,00,000

Question-11

From the following data, you are required to calculate the break-even point and sales value atthis point:

Selling Price per unit `25 Fixed Overheads `24,000

Direct Material Cost per unit `8 Variable Overheads @ 60% onDirect Labour

`3

Direct Labour Cost per unit `5 Trade Discount 4%

If sales are 15% and 20% above the break-even volume, determine the net profits.

Solution:

(Amount in `)

Selling Price per unit 25

Less: Trade Discount @ 4% 1

Net Realisation per unit 24

Less:Variable Costs per unit

Direct Material 8



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Direct Labour 5

Variable Overheads 3

Contributionper unit 8

(i)

Break -even Point (units) =Fixed Costs

Contribution per unit

=24,000

8

`

`

= 3,000 units

(ii)

Break-even Point of SalesSales at Break-even Point (3,000 units `25) = `75,000

Less: Trade Discount @ 4% = `3,000

Net Sales Value = `72,000

Statement Show ing Net Profit When Sales Are 15% Above The Break-Even Volume

Statement Show ing Net Profit When Sales Are 20% Above The Break-Even Volume

Units

Sales at Break-even Point 3,000

Add: 15% over Break-even Point 450

Sales 15% above Break-even Point 3,450

(`)Contribution on 3,450 units (3,450 units `8) 27,600

Less:Fixed Costs 24,000

Profit 3,600

Units

Sales at Break-even Point 3,000

Add: 20% over Break-even Point 600

Sales 20% above Break-even Point 3,600

(`)

Contribution on 3,650 units (3,600 units `8) 28,800

Less:Fixed Costs 24,000

Profit 4,800



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Question-12

X Ltd. manufactures a semiconductor for which the cost and price structure is given below:

(`per unit)

Selling Price 500

Direct Material 150

Direct Labour 100

Variable Overhead 50

Fixed Cost = `2 lakhs.

The product is manufactured by a machine, whose spare part costing ` 2,000 needsreplacement after every 100 pieces of output. This is in addition to the above costs. Assumethat no defectives are produced and that the spare part is readily available in the market at alltimes at `2,000.

(i) Prepare the profitabili ty statement for production levels of 2,000 units and 3,000 units,when fixed cost = `1 lakhs.

(ii) What is the break-even point (BEP) for the above data?

(iii) Comment on the BEP, if the fixed cost can be reduced to `1,80,000 from the existinglevel of 2 lakhs.

Solution:(i) X Ltd. Profitabil ity Statement

Particulars

Volume Level

2,000 uni ts 3,000 uni ts

( 000)

Sales 1,000 1,500

Direct Material 300 450

Direct Labour 200 300

Variable Overhead 100 150

Part Costs* 40 60

Fixed Cost 100 100

Profit 260 440



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*Part Cost: 2,000 2,000 = 40,000100

` `

3,000 2,000 = 60,000

100

` `

(ii) For Computi ng the BEP: Parts cost although a step fixed cost can be considered asvariable for the limited purpose of computing the range in which BEP occurs. The

variable parts cost per unit is `202,000

100

`.

Range 501600$ 1,1011,200@

General Fixed Cost 1,00,000 2,00,000

Parts Cost 12,000

(6 2,000)

24,000

(12 2,000)

Total Fixed Cost 1,12,000 2,24,000

Gross Contribution / unit* 200 200

Break-even Point (BEP) 560 units 1,120 units

($) =1,00,000

( 200 20)

`

` `

= 555.55 units

(@) =2,00,000

( 200 20)

`

` `

= 1,111.11 units

(*) Gross Contribution per unit = Sales Direct Material Direct Labour

Variable Overheads

= `500 `150 `100 `50

= `200

(iii) When fixed cost is `1,80,000. Range of BEP will be 901 10001,80,000

( 200 20)

`

` `

Since the BEP of 1,000 falls on the upper most limits in the range 901 1,000 therewill be one more BEP in the subsequent range in 1,001 1,100.



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901 1,000 1,001 1,100

`) `)

Gross Fixed Cost 1,80,000 1,80,000

Parts Cost 20,000 22,000

(10 2,000) (11 2,000)

Total Fixed Cost 2,00,000 2,02,000

Gross Contribution per unit 200 200

BEP 1,000 units 1,010 units

Question-13

The following information of a company is available for the year 2006:

`)

Sales 40,000

Raw Materials 20,000

Direct Wages 6,000

Variable and Fixed Overheads 10,000

Profit 4,000

Units Sold 200 Nos.

In the year 2007, wages rate will increase by 50% and fixed cost will decrease by `600. If 300units are sold in 2007, the total fixed and variable overheads will be 11,400. How many unitsshould be sold in 2007, so that the same amount of profit per unit as in year 2006 may beearned?

Solution:

Particul ars (Data per unit ) 2007

`)

Selling Price (`40,000 / 200 units) 200

Raw Materials (`20,000 / 200 units) 100

Direct Wages (`6,000 / 200 units 150%) 45



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Variable Overhead (Refer W.N.) 20

Contribution 35

Profit per unit (`4,000 / 200 units) 20

Net Contribution per unitto cover Fixed Overheads 15

Fixed Overheads (`11,400300 units `20) 5,400

No. of Units( 5,400 / `15) 360

Working Note

2006

`)

2007

`)

No. of units Sold 200 300

Total Variable and Fixed Overheads 10,000 12,000

(`11,400 + `600)

Variable Overhead per unit `20

(`2,000 / 100 units)

Question-14

M.K. Ltd. manufactures and sells a single product X whose selling price is ` 40 per unit andthe variable cost is ` 16 per unit.

(a) If the Fixed Costs for this year are ` 4,80,000 and the annual sales are at 60% marginof safety, calculate the rate of net return on sales, assuming an income tax level of40%

(b) For the next year, it is proposed to add another product line Y whose selling pricewould be ` 50 per unit and the variable cost ` 10 per unit. The total fixed costs areestimated at ` 6,66,600. The sales mix of X : Y would be 7 : 3. At what level of salesnext year, would M.K. Ltd. break even? Give separately for both X and Y the breakeven sales in rupee and quantities.

Solution:(a) Contribution per unit = Selling price Variable cost

= `40 `16

= `24



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Break-even Point = 4,80,00024

`

`

= 20,000 units

Percentage Margin of Safety =ActualSalesBreak- evenSales

ActualSales

Or,60% =ActualSales20,000

ActualSales

units

Actual Sales = 50,000 units

`)

Sales Value (50,000 units `40) 20,00,000

Less:Variable Cost (50,000 units `16) 8,00,000

Contribution 12,00,000

Less:Fixed Cost 4,80,000

Profit 7,20,000

Less:Income Tax @ 40% 2,88,000

Net Return 4,32,000

Rate of Net Return on Sales = 21.6%4,32,000

10020,00,000

`

`

(b) Products

X (`) Y (`)

Selling Price per unit 40 50

Variable Cost per unit 16 10

Contribution per unit 24 40

Individual Products Contribution Margin 60%

24

x10040

`

`

80%

40

x10050

`

`

Contribution Margin (X & Y)

60% 7

10+ 80 %

3

10 = 66%

Break-even Sales = `10,10,0006,66,600

66%

`



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Break-even Sales Mix

X - 70% of 10,10,000 = `7,07,000 i.e.17,675 units.

Y - 30% of 10,10,000 = `3,03,000 i.e. 6,060 units.

Alternative, if it is assumed that sales mix is based on quantity, the following will be thecomputations:

(`)

Sales Price :

X : `7

40 x10

28.00

Y : `3

50 x10

15.00

Variable Cost:

X : `7

16x10

11.20

Y : `3

10 x10

3.00

Contribution 28.80

Break-even Sale = 23,146 units 6,66,60028.80 ``

Break-even Sales Mix:

X (23,146 units 70%) = 16,202 units

Or = `6,48,080

Y (23,146 units 30%) = 6,944 units

Or = `3,47,200

Question-15

X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of X Ltd.facilitates production of any one spare part for a particular period of time. The following arethe cost and other information for the production of the two different spare parts A and B:

Per unit Part A Part B

Alloy usage 1.6 kgs. 1.6 kgs.



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Machine Time : Machine A 0.6 hrs. 0.25 hrs.

Machine Time : Machine B 0.5 hrs. 0.55 hrs.

Target Price (` ) 145 115

Total hours available : Machine A 4,000 hours

Machine B 4,500 hours

Alloy available is 13,000 kgs. @ ` 12.50 per kg.

Variable overheads per machine hours:

Machine A : ` 80

Machine B : ` 100

You are required to identify the spare part which will optimize contribution at the offered price.

If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized machine hour,what will be the total contribution from the spare part identified above?

Solution:(i)

Number of Parts to be Manufactured Part A Part B

Machine A (4,000 hrs) 6,666 16,000

Machine B (4,500 hrs) 9,000 8,181

Alloy Available (13,000 kg.) 8,125 8,125

Maximum Number of Parts to be manufactured 6,666 8,125

Cost per unit `) `)

Material (`12.5 1.6 kg.) 20.00 20.00

Variable Overhead: Machine A 48.00 20.00

Variable Overhead: Machine B 50.00 55.00

Total Variable Cost per unit 118.00 95.00

Price Offered 145.00 115.00

Contribution per unit 27.00 20.00

Total Contribution for units produced (I) 1,79,982 1,62,500

Spare Part A will optimize the contribution.



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(ii)

Part A

Parts to be manufactured numbers 6,666

Machine A : to be used 4,000

Machine B : to be used 3,333

Underutilized Machine Hours (4,500 hrs. 3,333 hrs.) 1,167

Compensation for unutilized machine hours (1,167hrs. `60) (II) 70,020

Reduction in Price by 10%, Causing fall in Contribution of `14.50 perunit (6,666 units `14.5) (III) 96,657

Total Contribution (I + IIIII) 1,53,345

Question-16

The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the relevantfigures are as under:

Sales ` 5,00,000

Direct Materials ` 2,50,000Direct Labour ` 1,00,000

Variable Overheads ` 40,000

Capital Employed ` 4,00,000

The new Sales Manager who has joined the company recently estimates for next year a profitof about 23% on capital employed, provided the volume of sales is increased by 10% andsimultaneously there is an increase in Selling Price of 4% and an overall cost reduction in allthe elements of cost by 2%.

Find out by computing in detail the cost and profit for next year, whether the proposal of Sales

Manager can be adopted.



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Solution:Statement Showi ng Cost and Profit fo r the Next Year

Particulars Existing

Volume, etc.

Volume, Costs, etc.

after 10% Increase

Estimated Sale,

Cost, Profit, etc.*

(`) (`) (`)

Sale 5,00,000 5,50,000 5,72,000

Less:Direct Materials 2,50,000 2,75,000 2,69,500

Direct Labour 1,00,000 1,10,000 1,07,800Variable Overheads 40,000 44,000 43,120

Contribution 1,10,000 1,21,000 1,51,580

Less:Fixed Cost# 60,000 60,000 58,800

Profit 50,000 61,000 92,780

(*)for the next year after increase in selling price @ 4% and overall cost reduction by 2%.

(#)

Fixed Cost = Existing Sales Existing Marginal Cost 12.5% on `4,00,000

= `5,00,000 `3,90,000 `50,000

= `60,000

Percentage Profit on Capital Employed equals to 23.19%92,780

x1004,00,000

`

`

Since the Profit of `92,780 is more than 23% of capital employed, the proposal of the SalesManager can be adopted.

Question-17

A company manufactures two types of herbal product, A and B. Its budget shows profi t f igures

after apportioning the fixed joint cost of `15 lacs in the proportion of the numbers of units sold.The budget for 2012, indicates:

A B

Profit (`) 1,50,000 30,000

Selling price / unit (`) 200 120

P/V ratio (%) 40 50



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You are required to advise on the best option among the following, if the company expectsthat the number of units to be sold would be equal.

(i) Due to exchange in a manufacturing process, the joint fixed cost would be reduced by15% and the variables would be increased by 7 %.

(ii) Price of A could be increased by 20% as it is expected that the price elasticity ofdemand would be unity over the range of price.

(iii) Simultaneous introduction of both the option, viz, (i) and (ii) above.

Solution:1. Contribution per unit of each product:

Product

A (`) B (`)

Contributionper unit 80 60

(Sales P/V Ratio) (`200 40%) (`120 50%)

2. Number of units to be sold:

Total Contribution Fixed Cost = Profit

Let x be the number of units of each product sold, therefore:(80x + 60x) `15,00,000 = `1,50,000 + `30,000

Or x = 12,000 units

(i) Option: Increase in profit when due to change in a manufacturing process there isreduction in joint fixed cost and increase in variable costs.

`)

Revised Contribution from 12,000 units of A due to 7.5% increase inVariable Cost {12,000 units (`200 `129)}

8,52,000

Revised Contribution from 12,000 units of B due to 7.5% increase in

Variable Cost {12,000 units (`120 `64.50)}

6,66,000

Total Revised Contribution 15,18,000

Less: Fixed Cost (`15,00,000 15% `15,00,000) 12,75,000

Revised Profit 2,43,000

Less:Existing Profit 1,80,000

Increase in Profit 63,000



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(ii) Option: Increase in profit when the price of product A increased by 20% and the priceelasticity of its demand would be unity over the range of price.

`)

Budgeted Revenue from Product A (12,000 units `200) 24,00,000

Revised Demand (in units) (`24,00,000 / `240) 10,000

Revised Contribution (in `) [10,000 units (`240 `120)] 12,00,000

Less: Existing Contribution (12,000 units `80) 9,60,000

Increase in Profit (Contribution) 2,40,000

*Note:Since Price Elasticity of Demand is 1, therefore the Revenue in respect of Products willremain same.

(iii) Option: Increase in profit on the simultaneous introduction of above two options.

`)

Revised Contribution from Product A [10,000 units (`240 `129)] 11,10,000

Revised contribution from Product B [12,000 units (`120 `64.50)] 6,66,000

Total Revised Contribution 17,76,000

Less: Revised Fixed Cost 12,75,000

Revised Profit 5,01,000

Less: Existing Profit 1,80,000

Increase in Profit 3,21,000

Ad vi se

A comparison of increase in profit figures under above three options clearly indicates that theoption (iii) is the best as it increases the profit of the concern by `3,21,000.

Note

The budgeted profit / (loss) for 2012 in respect of products A and B should be `2,10,000 and(`30,000) respectively instead of `1,50,000 and `30,000.

Question-18

You have been approached by a friend who is seeking your advice as to whether he shouldgive up his job as an engineer, with a current salary of ` 14,800 per month and go intobusiness on his own assembling and selling a component which he has invented. He canprocure the parts required to manufacture the component from a supplier.



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It is very difficult to forecast the sales potential of the component, but after some research,your friend has estimated the sales as follows:

(i)

Between 600 to 900 components per month at a selling price of ` 250 per component.

(ii)

Between 901 to 1,250 components per month at a selling price of ` 220 percomponent for the entire lot.

The costs of the parts required would be ` 140 for each completed component. However ifmore than 1,000 components are produced in each month, a discount of 5% would bereceived from the supplier of parts on all purchases.

Assembly costs would be ` 60,000 per month upto 750 components. Beyond this level of

activity assembly costs would increases to ` 70,000 per month.Your friend has already spent ` 30,000 on development, which he would write off over thefirst five years of the venture.

Required:

(i)

Calculate for each of the possible sales levels at which your friend could expect tobenefit by going into the venture on his own.

(ii) Calculate the break even point of the venture for each of the selling price.

(iii) Advice your f riend as to the viabi lity of the venture.

Solution:(i) & (ii)

The salary of `14,800 per month is a benefit foregone by going into business. It shouldtherefore be considered as a minimum profit which must be earned p.m. from the new venturein order to be not worse off than before.

Sum of `30,000 spent on the development work of the new venture cannot be recoveredirrespective of the decision and thus it should be ignored.

At a Selling Price of `250

Contribution per unit(`250 `140) `110Minimum Sales (units) to recover assembly costsof `60,000 p.m. and earn a profitof `14,800p.m. (Break even Sales Level)

FixedCosts+Profit

Contribution perunit



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60,000 14,800

110

+` `

`= 680 units

Notethat at 600 units and up to 679 units i.e. units below the break-even level the loss wouldbe `110/- per unit. The total loss would be `8,800/- (80 units `110). From 680 units up to 750units i.e. on additional 70 units the total profit would be `7,700 (70 units `110).

Minimum Sales (units) to recover assembly costof `70,000 p.m. and earn a profit of `14,800p.m. (Break even Sales Level)

70,000 14,800770.909 units

110

+=

` `

`

If the sales units are more than 770.909 units and up to 900 units, profit would be made. Thetotal amount of profit comes to `14,200 [(900 units 770.909 units) `110]

It is not worthwhile to proceed if the demand of components is less than 680 units or between750 to 770.909 units.

At a Selling Price of `220

Minimum Sales (units) to recover assembly costof `70,000 p.m. and earn a profitof `14,800p.m. (Break even Sales Level)

FixedCosts Profit

Contributionperunit

+

70,000 14,800

220 140

+

` `

` `= 1,060 units

Minimum Sales (units) to recover assembly costof `70,000 p.m. and earn a profit of `14,800p.m.; after availing a discount of 5% on the purchases of all parts.

5140 x 140

100

70,000 14,800

220

+

` `

` `

`= 974.712 units Or975 units

Conclusion:It is not worthwhile to sell between 900 and 1,000 units when no discount is available. Also, itis worthwhile selling at ` 220 if sales units are in excess of 1,000 units and a discount of 5% isavailable on the purchase of all componentsparts.

Profit on the Sale (1,250 units) `23,950 (1,250 units `87 `84,800)



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(iii)

Advise on the viability of the venture:

At a selling price of `250 he will not be at a loss if the demand of the component exceeds 680units to 749 units and 770.909 units to 900 units.

At a selling price of `220, it is not worthwhile to sell if the demand is less than 1,000components without availing a discount of 5%.

Question-19

Mr. Rajesh is quite displeased and frustrated as despite his and his staffs best efforts,although the sales are increasing, the profits are declining over the last three years. Hesupplies you with the following information and asks your help to clear the picture:

(`in 000s)

2011 12 2012 13 2013 14

Sales (At ` 20 per unit) 1,000 1,100 1,200

Cost of Production:

Variable 260 240 160

Fixed (Applied) 390 360 240

Opening Inventory (Added) 50 200 250

Closing Inventory (Deducted) 200 250 50

500 550 600

Adjustment for Overheads Applied (30) --- 120

Actual Cost of Goods Sold 470 550 720

Gross Profit 530 550 480

Less: Selling Expense (Semi Variable) 490 530 570

Net Profit / (Loss) 40 20 (90)

Actual productions for the last three years were 65,000, 60,000 and 40,000 units respectively.5,000 units were in stock at the beginning of 2011 12. Fixed manufacturing overheads areapplied to production based on planned activity of 60,000 units every year. Actual overheadswere `10,80,000 for past three year period and were evenly incurred.



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Solution:Working Notes:

2011 12 2012 13 2013 14

1. Units Sold

Sales

20

`

50,000

10,00,000

20

`

`

55,000

11,00,000

20

`

`

60,000

12,00,000

20

`

`

2. Variable Expenses per unit

VariableCost

Output

`4

2,60,000

65,000

`

`4

2,40,000

60,000

`

`4

1,60,000

40,000

`

3. Variable Selling Expenses per unit

(High Low method)=

5,30,000 4,90,000

55,000units 50,000units

` `

= `8 per unit

4. Fixed Manufacturing Expenses = `10,80,000 / 3 years

= `3,60,000 p.a.

Fixed Selling Expenses = `4,90,000 (50,000 units `8)

= `90,000 p.a.

Total Fixed Costs = `3,60,000 +`90,000

= `4,50,000 p.a.

5. Contribution per unit = `20 `4 `8

= `8

Statement of Profit fo r Three Years(Under Variable Costing)

(` in 000)

201112 201213 201314

Units Sold (in units) (W.N.-1) 50,000 55,000 60,000

Sales 1,000 1,100 1,200

Less: Variable Costs:

Manufacturing,`4 per unit (W.N.-2) 200 220 240

Selling Expenses, `8 per unit 400 440 480



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Contribution 400 440 480

Less:Fixed Costs (W.N.-4) 450 450 450

Net Profit / (Loss) (50) (10) 30

Break even Sales =4,50,000

8

`

`

= 56,250 units

The above statement shows that in 2011 2012 and 2012 13 sales were below the breakeven point. Due to which loss occurred during this period. It is only in 2013 14 that sales

exceeded breakeven point resulting in profit. The increasing sales trend really supports Mr.Rajeshs efforts. He need not feel frustrated but should continue the present sales trend.

Production during 201112 was of 65,000 units. This fell down to 60,000 units in 2012 13and to 40,000 units in 2013 14. The opening and closing inventories were valued by him at `10 per unit (including fixed cost of production) for arriving at the results shown under the givenstatement. This valuation of Mr. Rajesh was based on absorption costing method due to whichbook profits emerged during 201112 and 201213.

Mr. Rajesh should adjust his production in such a manner so that the net sales exceed thebreak even point of 56,250 units per annum to increase his profits.

Question-20

Gourmet Food Products is a new entrant in the market for chocolates. It has introduced a newproductSweetee. This is a small rectangular chocolate bar. The bars are wrapped inaluminium foil and packed in attractive cartons containing 50 bars. A carton, is therefore,considered the basic sales unit. Although management had made detailed estimates of costsand volumes prior to undertaking this venture, new projections based on actual costexperience are now required.

Income Statements for the last two quarters are each thought to be representative of t

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