Q Girish

Engineering (MCS-2004) Numerical

Monthly report (in part) for an expense centre in factory is: All figures in Rs. Lacs Actual Variance Direct Labour Indirect Labour Total Controllable Costs Department Fixed Costs Allocated Costs

66.34

100.13 0.21 (Favourable) 8.10 (Unfavourable) 168.47 8.50 (Unfavourable) 38.82 -------53.62 --------

Questions: 1. Why no variance is shown in two items? Is this correct approach in performance reporting? 2. Should overhead expenses mentioned above be included in Controllable Costs? Why? Why not?
Solution (a):

Variances between actual and budgeted departmental fixed costs are obtained simply by subtraction, since these costs are not affected by either the volume of sales or the volume of production. Thats why no variance is shown for departmental fixed costs.

Allocated costs are a share of the costs of a resource used by a project, where the same resource is also used by other activities. These are different to the Incurred costs because these costs are not exclusively related to any individual project. However, the cost of the resource still needs to be recovered, and making a fair and reasonable charge to all projects using the resource does this. The key difference between costs and Allocated costs is that the latter will be charged based upon an estimate, rather than actual cash values. Thus as it is charged based upon an estimate the budgeted figure is the same as the actual figure and hence no variances.

Solution (b): Overhead Expenses mentioned above should not be included in controllable costs because some costs are uncontrollable like fixed costs. . They don't vary with the change in short run managerial decisions and output. And some costs are controllable i.e. they can be managed and changed with the managerial decisions and output. As the above overhead expenses would have certain portion of fixed expenses this is hard to control. So, these should not be a part of controllable cost. Kiran Company (MCS-2004) Numerical

Budget versus Actual comparison for div Z of Kirancompany is as follows: Budget Actual Actual better (worse) than budget Sales and other income Variable expenses Fixed expenses Sales promotional expenses Operating profit Net working capital Fixed assets 800 480 120 40 160 400 160 740 436 120 28 156 412 148 (60) 44 0 12 4 12 (12)

(a)

Carry out and overall performance analysis to decide areas needing investigation.

From the given data, we see that there is a certain amount of variance between the budgeted operating profit and actual operating profit. In order to analyze the variances, we need to understand the key causal factors that affect profit, namely, revenues and cost structure. The profit budget has embedded in it certain expectations about the state of total industry, companys market share, selling prices and cost structure. Results from variance computation are actionable if changes in actual results are analyzed against each of this expectation. Revenue variances, that is a negative Rs 60 lakhs, could be a result of selling price variance, mixed variance and/or volume variance. A combination of above three factors must have been unfavorable that is either the volume of sales must have been below the budgeted volumes ( this must be particularly true since actual variable expenses are less than budgeted) and/or the selling price must have been below expectation and/or the proportion of products sold with a higher contribution must have been less than budgeted. One more factor could have been the overall industry volume. However, this factor is beyond the managements control and largely dependent on the state of economy.

Variable expenses are directly proportional to volumes and hence as is evident are less than budgeted. Sales promotional expenses also show a negative variance which could be a cause of lower sales volumes. A cause of concern is that despite lower sales, the net working capital is more than budgeted which indicates capital block in higher inventory. Another issue is that the fixed assets are lower than the budget by Rs 12 lakhs which may indicate slower capacity expansion then expected or distressed sale of assets to tide over cash flow.

(b) What are the remedial measures if any would you suggest based on analysis? The budgeted estimates may be too optimistic and far from reality, one needs to ensure that estimates the as realistic as possible. Given the estimates are correct, in that case depending upon the above analysis, the management needs to take corrective action areas needing improvement, sales volume could be improved by better marketing, quality standards and promotional efforts, product mix could be improved by selling more of higher contribution products. Better sales will ensure a higher inventory turnover. Better credit management to recover receivables, will ensure improve cash flow situation since less capital will be tied up in working capital.

Q.5ABC ltd. (MCS-2008) Numerical

Particulars ROI Sales Investment EBIT Division X (Rs.) 28% 100 Lacs 25 lacs 7 Lacs Division Y (Rs.) 26% 500 lacs 100 Lacs 26 lacs

Analyze and comment upon performances of both the divisions Solution:

Division X ROI Profit = = = (Profit / investment)* 100 (28/100)*25lacs 7lacs

Profit margin

= = = 7lacs

(Profit/sales)*100 (7/100)*100

Turnover of investments

= = =

(Sales/investment)*100 (100/25)*100 4 times

Division Y ROI Profit = = = (Profit / investment)* 100 (26/100)*100lacs 26lacs

Profit margin = =

(Profit/sales)*100

(26/500)*100 5.2lacs

Turnover of investments

= = =

(Sales/investment)*100 (500/100)*100 5 times

Profit margin of X is better than profit margin of division Y. Turnover of investment of division Y is better than Division X.

Hence cost management of Division X is better than Division Y.

MCS 2006

(SUM NO 7)

Q) Soniya Company has two Divisions: A & B. Return on Investment for both divisions is 20%. Details are given below:Particulars Divisional sales Divisional Investment Profit Div A 4000000 2000000 400000 Div B 9600000 3200000 640000

Analyse and comment on divisional performance of each. ANSWER As Profit Margin = Profit *100 Sales Profit Margin for Division A= 4,00,000 /40,00,000 *100 = 10% Profit Margin for Division B = 6,40,000/ 96,00,000 *100 = 6.6% Turnover of Investment = Sales * 100 Investment Turnover of Investment for Division A = 40,00,000/20,00,000 = 2 times Turnover of Investment for Division B = 96,00,000/32,00,000 = 3 times As Return on investment for both Divisions A and B is 20%. COMMENTS:Division A Although A has more profit margin than Division B that is 10% as compared to 6.6% of B, so it has more profitability but inspite of it, division A has lower turnover of investment that its assets management is bad than Division B, it can be improved by increased sales or reducing investment. Division B Needs to improve profit margin by increasing sales and reduce variable cost and sales at same price or by reducing salesprice and increase the volume of sales so that its profit would improve. As it has good assets management shown by its turnoverof Division B that is 3 times which is better than Division A. So it can become profitable organisation by improving Profit Margin

Q5: Shandilya Ltd. (MCS-2008) Numerical

Shandilya Ltd. has adopted Economic Value Added (EVA) technique for the appraisal of performance of its three divisions A,B and C. Company charges 6% for current assets and 8 % for Fixed Assets, while computing EVA relevant data are given below :Particulars Div A Budgeted Profit Current Assets Fixed Assets 360 400 1600 Actual 320 360 1600 Div B Budgeted 220 800 1600 Actual 240 760 1800 Div C Budgeted 200 1200 2000 Actual 200 1400 2200 Total Budgeted 780 2400 5200 Actual 760 2520 5600

Solution: Particulars Div A Budgeted ROA EVA 18% 208 Actual 16% 170.4 Div B Budgeted 9% 44 Actual 9% 50.4 Div C Budgeted 6% -32 Actual 6% -60 Total Budgeted 10% 220 Actual 9% 160.8

Q 2)Suresh Ltd. (Numerical) (MCS-2007) and same as Ananya Ltd (MCS 2009)
(a) Define profit in this case and prepare a statement for both divisions and overall company.

Solution:

i) Profitability statement of Division A:-

Particulars Selling price p.u. Variable Cost p.u. Contribution p.u.

Amount(Rs.) 35 11 24

Contribution p.u.

Expected (no. of units)

sales Total contribution

Total Fixed cost Net profit (Rs.) (Rs.)

24 24 24

2000 3000 6000

48000 72000 144000

60000 60000 60000

(12000) 12000 84000

ii) Profitability statement of Division B:-

Selling p.u.

Total variable cost p.u.

Contribution p.u.

Expected

Total

Total Fixed Net cost (Rs.) (Rs.)

profit

sales (no. of contribution units)

90 80 50

42 42 42

48 38 8

2000 3000 6000

96000 114000 48000

90000 90000 90000

6000 24000 (42000)

[Note: Total Variable cost p.u. = Variable cost p.u. (Rs.7) + Transfer price of intermediate product (Rs.35)]

iii) Profitability statement of Company as a whole:-

Expected sales

Net profit of division A Net profit of Division Total Net profit (Rs.) B (Rs.) 6000 24000 (42000) (6000) 36000 42000

2000 3000 6000

(12000) 12000 84000

(b) State the selling price which maximizes profits for division B and company as a whole. Comment on why the latter price is unlikely to be selected by division B.

Solution: As per the calculation in part (a), selling price p.u. of Rs.80 maximizes profit for division B whereas selling price p.u. of Rs.50 maximizes profit for the Company as a whole. However, if Division B opts for selling price p.u. of Rs.50 in order to maximize Companys profit, it would suffer a loss of Rs.42000. Therefore, Division B would not select Selling price p.u. of Rs.50.

MCS 2007
Two Divisions A and B of Satyam Enterprises operate as Profit centers. Division A normally purchases annually 10,000 nos. of required components from Div. B; which has recently informed Div. A that it will increase selling price per unit to Rs.1,100. Div.A decided to purchase the components from open market available at Rs. 1000 per unit. Naturally, Div. B is not happy and justified its decision to increase price due to inflation and added that overall company profitability will reduce and the decision will lead to excess capacity in Div. B, whose variable and fixed costs per unit are respectively Rs. 950 and Rs. 1,100. Assuming that no alternate use exists for excess capacity in Div. B, will company as a whole benefit if div A buys from the market. If the market price reduces by Rs. 80 per unit. What would be the effect on the company (assuming Div. B still has excess capacity) if A buys from the market If excess capacity of Div. B could be used for alternative sales at yearly cost savings of Rs. 14.5 lacs, should Div. A purchase from outside? Justify your answers with figures. Solution Option A ( Div A buys from outside) Total Purchase Cost = 10,000 Units * Rs. 1000 = Rs. 1,00,00,000 Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000 Since total outlay if transferred inside is lesser than total purchase cost if bought from outside, relevant cost is the lesser one i.e. Rs. 95,00,000 and overall benefit for the company would be Rs. 5,00,000 a) Option B ( if the market price is reduced by Rs. 80 per unit and A buys from the market) Total Purchase Cost = 10,000 Units * Rs. 920 = Rs. 92,00,000 Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000 Since total purchase cost is lesser than the total outlay if transferred inside, relevant cost is the lesser one i.e. 92,00,000 and overall benefit for the company would be Rs. 3,00,000 b) Option C ( if excess capacity of Div B could be used for alternative sales at yearly cost savings of Rs 14.5 lacs, should Div A purchase from outside) Total Purchase Cost = 10,000 Units * Rs. 1,000 = Rs. 1,00,00,000 Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000 Total opportunity cost if transferred inside = Rs. 14,50,000 Total relevant cost becomes Rs. 1,00,00,000 If Div A purchase from outside, overall benefit for the company would be Rs. 9,50,000. Therefore, Div A should purchase from outside. Particulars Total Purchase Cost Total outlay if transferred inside Total opportunity cost if transferred inside Total relevant cost Net advantage/disadvantage to company as a whole if it buys from inside Option A Amount (Rs.) 1,00,00,000 95,00,000 95,00,000 5,00,000 Option B Amount (Rs.) 92,00,000 95,00,000 92,00,000 (3,00,000) Option C Amount (Rs.) 1,00,00,000 95,00,000 14,50,000 1,00,00,000 (9,50,000)

(Numerical) MCS 2004

Division B of Shayanacompany contracted to buy from Div. A, 20,000 units of a components which goes into the final product made by Div. B. The transfer price for this internal transaction was set at Rs. 120 per unit by mutual agreement. This comprises of (per unit) Direct and Variable labour cost of Rs. 20; Material Cost of Rs.60; Fixed overheads of Rs.20 (lumpsum Rs.4 lacs) and Rs.20 lacs that Div. A would require for this additional activity. During the year, actual off take of Div. B from Div. A was 19,600 units. Div. A was able to reduce material consumption by 5% but its budgeted investment overshot by 10%. a) As Financial controller of Div. A, compare Actual VsBudgetred Performance b) Its implications for Management Control?

Solution: a) Particulars Budgeted (Rs. Per Unit) 20 Budgeted (Total in Rs.) 4,00,000 Actual (Rs. Per Unit) 20 Actual (Total in Rs.) 3,92,000

For 20,000 Units

For 19,600 Units

Direct and Variable Labour Cost Material Cost Fixed Overheads Total Cost Transfer Price Profit Investment ROI = Profit/Investment

60 20 100 120 20 20

12,00,000 4,00,000 20,00,000 24,00,000 4,00,000 20,00,000 20%

57

11,17,200 4,00,000 19,09,200

119.86

23,49,200 4,40,000 22,00,000 20%

Despite of increase in investment by 10%, there is negligible difference in transfer price. Also the sales have decreased by 400 units. Therefore we can say that additional investment has not achieved any positive results.

Q) Division of Aparna Company manufactures Product A, which is sold to another division as a component of its product B; which then is sold to third division to be used as part of its Product C (sold to outside market). Intra company transactions rule: standard cost plus a 10 percent return on fixed assets and inventory, to be paid by the buying division. Standard Cost per Unit *Purchase of outside material Direct. Labour Variable overhead *Fixed overhead per unit. Average Inventory Net Fixed Assets Standard Production (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Units) Product A 40 20 20 60 14 lacs 6 lacs 2 lacs Product B 60 20 20 60 3 lacs6 lacs 9 lacs 2 lacs Product C 20 40 40 20 3.2 lacs 2 lacs

(a) Determine from above data, transfer prices for Products A, B and Standard Cost of Product C. (b) Product C could become uncompetitive since upstream margins are added. Comment. Answer (a):Standard Cost of Product A Outside material (40 * 2 lac units) Direct Labour (20 * 2 lac units) Variable O.H. (20 * 2 lac units) 80,00,000 40,00,000 40,00,000

1,60,00,000 + 10% on (FA + Inventory) i.e. 10% on 20 lacs 2,00,000

1,62,00,000

Transfer Price for Product A = 1,62,00,000 = 81 2,00,000

Standard Cost of Product B Outside material (60 * 2 lac units) Direct Labour (20 * 2 lac units) Variable O.H. (20 * 2 lac units) 1,20,00,000 40,00,000 40,00,000

2,00,00,000 + 10% on (FA + Inventory) i.e. 10% on 12 lacs 1,20,000

2,01,20,000

Transfer Price for Product A = 2,01,20,000 = 100.6 2,00,000

Standard Cost of Product C Outside material (20 * 2 lac units) Direct Labour (40 * 2 lac units) Variable O.H. (40 * 2 lac units) Fixed O.H. (20 * 2 lac units) 40,00,000 80,00,000 80,00,000 20,00,000 2,20,00,000

(b): While arriving at the cost of Product C, margins of Product A, which become an input to Product B, and Product B, which in turn become an input to Product C, are added. So when it is sold to outside market, it suffers a disadvantage from its competitors as far as pricing is concerned, as its price will normally be high compared to products of similar category. So it might become uncompetitive. But in the long run, customers will distinguish between a good product and a bad product and the one with the best quality will survive. So if the quality of product C is better than its competitors than only it can survive in this competitive market. Another strategy for the company is to cut the margins added by Products A and B, and then come out with Product C with a lower price tag on it. This may do well to the product by making higher revenues and capturing the market share.

Q) Ananaya& Company comprises of five divisions A, B, C, D and E and the present performance. metricis return on assets. However, the controller has suggested management to switch over to economic value added(EVA) as the criterion rather than return on assets. Compute and tabulate both return on assets and EVA on the basis of following information (Rs. lakhs) and comment on divisional performance. Division Profit Fixed Assets Current Assets -A B 220 400 300 800 1600 160 ----

C ________ D E

100

600

1000

110

400

800

180

200

800

Controller feels corporate finance rates on current assets and.fixed assets should be 5% and 10% respectively. Solution: Working Note: Return on Assets = Profit * 100 Total Assets

A = 300/960*100 = 31.25% B = 220/2000*100 = 11% C = 100/1600*100 = 6.25% D = 110/1200*100 = 9.17% E = 180/1000*100 = 18% Economic Value Added (EVA) = Profit (W.A.C.C.* Capital Employed)

In this case, EVA = Profit (W.A.C.C. on Fixed Assets * Total Fixed Assets) + (W.A.C.C. on Current Assets * Total Current Assets) A = 300 (0.10*800) + (0.05*160) = 212 lakhs B = 220 (0.10*400) + (0.05*1600) = 100 lakhs C = 100 (0.10*600) + (0.05*1000) = -10 lakhs D = 110 (0.10*400) + (0.05*800) = 30 lakhs E = 180 (0.10*200) + (0.05*800) = 120 lakhs

Summary Division Return on Assets (R.O.A.) Economic Value Added (E.V.A.) (Rs. lakhs) A B C D E 31.25% 11.00% 6.25% 9.17% 18.00% 212 100 -10 30 120

Comments: 1. It appears from the above analysis that division A has performed the best among the five divisions. 2. Also, it can be clearly noticed that divisions C and D seem to be in trouble. 3. Division A has performed the best when seen in terms of return on assets and economic value added. 4. The reason why division A has performed the best is that it has the best working capital management that can be reflected in the total amount invested in current assets and which is the least among the five divisions. 5. The above reason holds true for the poor performance of divisions C and D as can be seen that they have a huge amount invested in current assets which does not indicate good signs about their operational efficiency. 6. A company which is into an expansion and overall growth mode primarily invests into fixed assets and this is also one of the major reasons why the performance of division A is the best amongst all. 7. Though division C has also invested a huge amount in fixed assets the advantage is offset due to the fact that it perhaps has a larger investment in current assets. 8. Division E is the second best both in terms of R.O.A. as well as E.V.A. 9. Though division E has the same amount invested in current assets as that of division D and perhaps a lesser amount invested in fixed assets its profitability is much better and hence it has delivered a better performance. 10. Division B is a better performer than divisions C and D in terms of R.O.A. as well as E.V.A. but the major problem with this division is that it has a terrible working capital management. Its current assets are the highest and this reflects that it has huge sums of money held up either in debtors or inventory or rather it is holding a large amount of cash which is not a good sign.

Q: 32 Pritam Engineering manufacturers (MCS-2005) Numerical

Pritam Engineering manufacturing variety of metal product at many factories.Currently. It is experiencing crisis, Management has, therefore, decided to detailed expense control system including responsibility budgets for overhead expense items at each factory. From historical data, Controller developed a standard for each overhead expense item (relating expense to volume of activity). Summarized expenses for November,2005 given to concerned Production Supervisor for comments is tabulated. All figures are in Rs. 000. Item Management Supervision Indirect labour Idle time Materials, Tools Maintenance, scrap Allocated expenses Total per ton (Rs.) Standard at nominal volume 720 12706 420 3600 14840 21040 2133.04 Budgeted at actual volume 720 11322 361 3096 13909 21040 2103.39 actual 582 12552 711 3114 17329 21218 2413.3

(A) Explain with justification which of the two (1) or (2) is more meaningful for expense control. (B) Can the supervisor be held responsible for all overhead expenses included? Why/why not?

Ans. (A) There is two general types of expense centers: engineered and discretionary. This label relate to two types of cost. Engineered costs are those for which the right or proper amount can be estimated with reasonable reliability for example, a factorys costs for direct labor, direct material, components, supplies, and utilities. Discretionary costs (also called managed costs) are those for which not such engineered estimate is feasible. In discretionary expense centers, the costs incurred depend on managements judgment as to the appropriate amount under the circumstances. Engineered expense centers Engineered expense centers are usually found a manufacturing operations. Warehousing, distribution, trucking, and similar units within the marketing organization may also be engineered expense centers, as may certain responsibility centers within administrative and support department for instance, accounts receivable, accounts payable, and payroll sections in the controller department; personnel records and the cafeteria in the human resources department; shareholder records in the corporate secretary department; and the company motor pool. Such units perform repetitive tasks for which standard costs can

be developed. These engineered expense centers are usually located within departments that are discretionary expense centers. In an engineered expense center, output multiplied by the standard cost of each unit produced measures what the finished product should have cost. The difference between the theoretical and the actual cost represents the efficiency of the expense center being measure. We emphasize that engineered expense centers have other important tasks not measured by cost alone; their supervisors are responsible for the quality of the products and volume of production as well as for efficiency. Therefore, the type and level of production are prescribed, and specific quality standards are set. So that manufacturing costs are not minimized at the expense of quality. Moreover, managers of engineered expense centers may be responsible for activities such as training and employee development that are not related to current production; their performance reviews should include an appraisal of how well they carry out these responsibilities. There are few, if any, responsibility centers in which all cost items are engineered. Even in highly automated production departments, the use of indirect labor and various services can vary with managements discretion. Thus the term engineered expense center refers to responsibility centers in which engineered costs predominate. But it does not imply that valid engineered estimates can be made for each and every cost item. Discretionary expense centers Discretionary expense centers include administrative and support units (e.g. accounting, legal, industrial relations, public relations, human resources), research and development operations, and most marketing activities. The output of these centers cannot be measured in monetary terms. The term discretionary does into imply that managements judgment as to optimum cost is capricious or haphazard. Rather it reflects managements decisions regarding certain policies: whether to match or exceed the marketing efforts of competitors; the level of services the company should provide to its customers; and the appropriate amounts to spend for R&D, financial planning, public relations, and a host of other activities. One company may have a small headquarters staff, while another company of similar size and in the same industry may have a staff 10 times as large. The senior managers of each company may each be convinced that their respective decisions on staff size are correct, but there is no objective way to judge which (if either) is right; both decisions may be equally good under the circumstances, with the differences in size reflecting other underlying deferences in the two companies.

As far as above stated over heads are concern, we can easily estimate proper or right amount with responsible reliability. There for standard (1) is more meaningful for expenses control. Ans. (B) A responsibility center is an organization unit that is headed by a manager

who is responsible for its activities. In a sense, a company is a collection of responsibility centers, each of which is represented by a box on the organization chart. These responsibility centers form a hierarchy. At the lowest level are the centers of the sections, work shift, and other small organization units. Departments or business units comprising several of these smaller units are higher in the hierarchy. From the standpoint of senior management and and the board of directors, the entire company is a responsibility center, though the term is usually used to refer to units within the company and there for Supervisor is responsible for the uses of the Above stated Resources (over heads) like Indirect labor, idle time, Materials, tools, maintenance, scrape and Management supervision by proper supervising supervisor can control the listed overhead expenses.

Q:2005 )A TV dealership Veena Television (VT) is organized into four profit centers.
colour TV, Black and White, spare parts(SP) and servicing (SG) each headed by manager BTV in addition to BVTV sales; also sells old TV exchanged (under scheme) by customer while purchasing new TV . in one particular instance a new TV was sold for 14150(financed by cash rs2000, Bank loan 7350and Rs 4800;exchange price for old TV agreed by CTV manager )cost of new TV was Rs 11420.Shivangi Manager of BTV, examined the old TV (valued at Rs 3500 by TV trade magazine) and felt that she could get Rs 5000 for that TV offer repairing cabinet, resulting and servicing for which she would use services of SP and SG price chargeable to BTV by SP and SG are at market rates Rs235 for parts by SP and Rs 470 for services by SG. Market price are arrived at after marking up cost by 3.5 times SG and 1.4 times SP. BTV pays a service

commission of Rs 250 per TV sold .overhead fixed per sale are CTV Rs 835;BTV Rs 665;SP RS 32 ;SG Rs 114. Compute the profitability of the transaction assuming sales commission of $250 for the trade in on a selling price of $5000 Compute at market price At cost price Gross and net profit each SOLUTION: SP of New TV by CTV = $14150. Original cost= $11420 ($14150= $2000 cash down payment + $4800 trade in allowance + $7350 bank loan) Guide Book Value =$3500 Ms. Shivangi of BTV Dept, believed that she could sell the trade in at $5000 Other Cost: Rs235 for parts by SP and Rs 470 for services by SG When trade-in is recorded @ $4800 4800+470+235=5505; 5000-5505= (-505)

Particulars Sales Selling commission Gross profit Overhead Servicing Net profit before common exp

New TV 14150 0 2730 835 0 1895

OLD TV 5000 250 -505 665 470 -1640

Service 470 0 470 114 0 591

Parts 235 0 235 32 0 123

If the trade-in is recorded @ $3500

Particulars Sales Selling commission Gross profit Overhead Servicing Net profit before common exp

New TV 14150 0 2730 835 0 1895

OLD TV 5000 250 1045 665 470 -340

Service 470 0 470 114 0 356

Parts 235 0 235 32 0 123

2006: sum(11)
Two divisions A and B of sonali enterprises operate Profit centers. Div A normally purchases annually 10000 nos. of required components from Div B, which has recently informed Div A that it will increase selling price p.u to Rs. 1100. Div A decided to purchase the components from open market available at Rs.1000 p.uDiv B is not happy and justified its decision to increase price due to inflation and added that the overall company profitability will reduce and decision will lead to excess capacity in Div B, whose V.C and Fixed cost p.u. are Rs. 950 and Rs.1100. 1. Assuming that no alternate use exists for excess capacity in Div B, will company benefit as a whole if Div A buys from the market. 2. If the market price reduces by Rs.80 p.u. What would be the effect on the company (assuming Div B has still excess capacity) if A buys from market. 3. If excess capacity of Div B could be use for alternative sales at yearly costs savings of Rs. 14.5 lacs, should Div A purchase from outside? Justify your answers with figures ANSWER 1) Division A action BUY OUTSIDE (Rs.) Total Purchase Cost Total Outlay Cost (Rs.) BUY INSIDE 10,00,000 Nil Nil 9,50,000

Net Cash Outflow To The 10,00,000 9,50,000 Company As A Whole The Company as a whole will benefit if Division A buys inside from Division B.

2) If the market price reduces by Rs.80 p.u Division A action BUY OUTSIDE (Rs.) Total Purchase Cost Total Outlay Cost Net Cash Outflow To The Company As A Whole 9,20,000 Nil 9,20,000 (Rs.) BUY INSIDE Nil 9,50,000 9,50,000

The Company as a whole benefit if A buys from outside supplier at Rs. (1000-80) = 920

3) If excess capacity of Div B could be use for alternative sales at yearly costs savings of Rs. 14.5 lakhs Division A action BUY OUTSIDE (Rs.) Total Purchase Cost Total Outlay Cost Revenue From Using These Facilities Net Cash Outflow To The Company As A Whole 10,00,000 Nil 1,45,000 (Rs.) BUY INSIDE Nil 9,50,000

8,55,000

9,50,000

1 Girish Engineering Ltd. (Numerical) (MCS-2006)

(1) On the basis of costing, will the manager be interested in accepting the market offer? Solution: Particulars Amount (Rs./unit) Amount (Rs./unit)

Cost of critical component 220 for division X Cost of other material Fixed & processing costs Total cost for division X Selling price of final product Net loss for division X Desired profit for division X 500 290 1010 1000 10 60

Thus on the basis of full actual cost incurred by division X, it would suffer a loss of Rs.10/unit if it accepts the market offer whereas its target profit margin is Rs.60/unit. So, division X would not accept the market offer.

(2) Is this offer beneficial to the company as a whole? Justify with figures. Solution: Particulars Cash inflow (a) Amount (Rs. Lakh) Amount (Rs. Lakh) 50 (5000 Rs.1000/unit) units *

Cash outlay: Variable cost for division Y 5 (Working note)

Material bought by division 25 (5000 units * Rs.500/unit) X from outside Total cash outlay (b) Net cash inflow to Company as a whole [(a)- (b)] 30 20

Thus, the Company as an entity would receive cash inflow of Rs.20 lakh. So, the offer is beneficial to the company as a whole. Working notes: Variable cost for division Y:

Desired RoI =10% of Rs.2.4 Cr. p.a. = Rs.24 lakh p.a. i.e. Rs.2 lakh per month Fixed cost assigned to division X = Rs.4 lakh per month Fixed cost p.u. = 400000/5000 = Rs.80 Contribution per month = Rs.6 lakh Total sales value for division Y = 220 * 5000 = Rs.11 lakh per month So, total Variable cost per month for division Y = 11 lakh 6 lakh = Rs.5 lakh Variable cost p.u. for division Y = 500000/5000 = Rs.100 An annual investment of Rs2.4 Cr. is assigned by division Y to division X but it does not imply that a special investment of Rs.2.4 Cr. is made by division Y exclusively to produce the component required by division X. Therefore, cash outflow associated with this investment is not relevant for the above concerned decision regarding accept the market offer.

(3) If yes, how should the company organize its transfer pricing mechanism? Illustrate. Solution: Currently, Girish Engineering Ltd. is following 2 step transfer pricing method wherein the selling division charges actual variable cost along with profit mark-up & separately allocates a particular amount of fixed costs per month to the buying division. However, in the case of division X (buying division) & division Y (selling division), this method of transfer pricing is not feasible as division X would suffer loss if it accepts the market offer under this scenario. So, divisions X & Y can negotiate a transfer price by taking into account full actual variable cost (Rs.100 p.u.) & half of fixed costs incurred by division Y that is assigned to division X (Rs.40 p.u.) & add a mark-up of say Rs.10/unit. Taking into consideration only half of the fixed costs of selling division i.e. division Y prevents shifting of any operational inefficiencies from selling division to buying division i.e. division X, which would unnecessarily increase the costs for division X and thereby eat up its profit margin. In this case, division Xs total costs would turn out to Rs.940 (500 + 290 + 150) & would earn a profit margin of Rs.60 p.u. (desired profit margin). Also, contribution p.u. for division Y would be Rs.50 (150 100). Thus, total contribution for division Y would be Rs.250000 resulting in RoI of 12.5% (250000/2000000) which is more than the desired RoI of 10%.