CA FINAL - Advanced Management Accounting

A. Rajagopalan

Cost concepts in decision making

1. Estimated direct material requirements of a business concern ABC Ltd for the
year 2008-09 are 100000 units. Unit cost for orders below 120000 units is Rs. 10. When
size of order equals 120000 units are more, the concern can receive a discount of 2% on
the above quoted price. Keeping in view the following two alternatives:

i) Buy 120000 units at the start of the year.

ii) Buy 10000 units per month.

Calculate the opportunity cost, if the concern has the facility of investing the surplus
funds in Government bonds at 10% interest.

2. Company Z Ltd. owns and operates a chain of 25 stores. Budgeted data for store
No: 5 are as follows:

Annual sales ………………………… Rs. 425000

Annual cost of goods sold and other
Operating expenses …………….. 382000
Annual building ownership cost not
Included in above …………………….. 20000

The company can lease out the building for Rs. 4000 month.

Decide whether to continue operations or to lease out store No:5 using:

i) Total project cost approach.

ii) Incremental cost approach.
iii) Opportunity cost approach.

3. A manufacturing company sells one of its products under the brand name
‘Utility’ at Rs. 3.50 each. After further processing which entails additional material and
labour costs of Rs. 2.50 and Rs. 2 per unit respectively, Utility is converted in to another
product ‘Ace’. Ace can be sold at Rs. 8 each. The concern at present produces per day
600 numbers of each of the two products, for which 2500 labour hours are used. The
factory overheads have been budgeted as under:-
Labour hours 2000 2500 3000 3500

Factory overheads (Rs.) 700 800 900 1000

The following alternative proposals have been put forth for varying the sales mix.

a) To process the entire quantity of Utility by converting 600 Nos into Ace. This will
need additional 500 labour hours.

b) To continue the present level of output of Utility but double the production of Ace
which will also require additional 500 labour hours.

You are required to work out the incremental profit / loss involved in each of the
proposals and to offer your suggestion.

4. Noval Accessories have been manufacturing tiny alloy model of Ashok pillar
with lion capital to be fitted on car bonnets. Due to a ban by the Government for use of
that model in public cars, the company is now left with an inventory of 8000 units as not
saleable.

The manufacturing cost per unit were as follows:

Material Rs. 1.20
Labour 0.80
Fixed overheads 0.50
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Total cost 2.50
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Prior to being banned the selling price of that design was Rs. 3 per unit. A mould for this
was originally acquired at Rs. 1000. Now three courses of action are available:

1. Sell the units as scrap material for Rs. 6500.

2. Re-work them to change the design and sell at Rs. 3.20 each, incurring additional
labour cost of Rs. 2 per unit. A fixed overhead charge of Re. 1 each will get added in
terms of company’s absorption costing system.
3. Melt them down and use the metal as a substitute in a strong selling line, where the
metal currently used costs 50% more than the metal used in Ashoka pillar with lion
capital model. Melting down will result in a material loss of 3/8 of the original metal.

Examine the alternatives and arrive at the maximum beneficial course of action.

5. A company has been making a machine for a customer. But the customer
has closed down his business and is now absconded. Cost incurred to date in
manufacturing the machine is Rs. 50000.

There is another company willing to buy the machine for Rs. 34000, if it is completed
and delivered.

To complete the machine the following costs would be incurred:

a) Materials: These have been bought at a cost of Rs. 6000. They have no other use. If the
machine is not finished, they would be sold for Rs. 2000.

b) Further labour cost would be Rs. 8000. Labour is in short supply and if the machine is
not finished, the work force can be used for another job which would earn Rs. 30000
revenue, with other direct costs of Rs. 12000 and fixed overheads Rs. 8000.

c) Consultancy fees Rs. 4000. If the work is not completed, the consultant contract would
be cancelled at a cost of Rs. 1500.

d) General overheads of Rs. 8000 would be apportioned to the cost of additional work.

Should the new company’s offer be accepted? Prepare a statement showing the
economics of the proposition.

CVP Analysis and decision making

6. Titan Engineering is operating at 70% capacity and presents the following

information:

BEP …… Rs. 200 crores

P/V Ratio ….. 40%
Margin of safety … Rs. 50 crores
The management has decided to increase production to 95% capacity with the following
modifications:

i) The selling price would be reduced by 8%

ii) The variable cost would be reduced by 5% on sales
iii) The fixed cost will increase by Rs. 20 crores including depreciation on additions but
excluding interest on additional capital.
iv) Additional capital of Rs. 50 crores will be needed for capital expenditure and working
capital.

Required:
a) Indicate the sales that will be needed to earn Rs. 10 crores over and above the present
profit and also meet 20% interest on the additional capital.

b) What will be the revised 1. BEP

2. P/V Ratio
And 3. Margin of safety

7. Find the cost Break even points between each pair of plants whose cost
functions are:

Plant A Rs. 600000 + 12x

Plant B 900000 + 10x
Plant C 1500000 + 8x where x is the number of units produced.

8. The parts of Indian Automobile vehicle are produced to rigorous standards of

accuracy. Every batch of 1000 units is tested to know whether the units are defective, at a
cost of Rs. 12.50 per unit. The defective units are then rectified and put in good order at a
cost of Rs. 50 per unit. If the units are not tested, any defect would become apparent later
when they are fitted in the vehicle. At that stage it would cost Rs. 100 per unit to put the
parts in good working order.

Find out the minimum percentage of defective units in a batch such that it would be
cheaper to test all the units in the batch instead of none of them.
9. The transport department of a very large company, maintains a fleet of 60 cars
for use by authorized company personnel.

The department budget allows 10 paise per k.m of operation plus Rs. 75000 per year for
general maintenance.

During last year 60 cars were operated on an average 60000 k.ms each. Total cost in the
Transport department was Rs. 475000. The hiring cost of similar cars would be 15 paise
per k.m

You are required to evaluate operation of the department if it is regarded

1. as a cost centre
2. as a profit centre.

At what volume of operation would it be more profitable to hire cars?

10. A company manufacturing a consumer product and marketing through its net
work of 400 depots all over the country is considering closing down the depots and
resorting to dealership arrangement. The total turn over of the company is Rs. 200crores
p.a. The average turnover cost etc in respect of a depot is given below.

Annual turn over Rs. 50 lakhs

Average inventory Rs. 5 lakhs
Administrative expenses Rs. 50000 p.a.
Staff salary rs. 80000 p.a.
The inventory carrying cost is 16% p.a. which is the rate for working capital finance.

Marketing through dealers would involve engaging dealers for each area. The dealers will
assure a minimum sale for each area. This would result in increasing the capacity
utilization from 75% at present to 90%. The company’s P.V. Ratio at present is 10% and
total fixed expenses Rs. 18.50 crores. The current profit is Rs. 150 lakhs.

Marketing through dealers would involve payment by a commission of 5% on sales. But

50% of the existing depot staff will have to be absorbed in the company. The dealers will
deposit Rs. 5 crores with the company on which interest at 12% p.a. will be paid.
1. Work out the impact on profitability, by accepting the proposal.
2. What will be your conclusion if the commission to dealers is 4% on sales.

11. Solo products limited manufactures manually a product under the brand
name DISTINCT. The current variable cost of producing each unit is Rs. 4 and the
selling price per unit is Rs. 10. The annual fixed cost is Rs. 120000.

There is a proposal to acquire a semi automatic machine costing Rs. 60000 to

manufacture DISTINCT. As a result, the variable cost will decline to Rs. 2 per unit. But
there will be increase in annual cash outlays Of Rs. 30000 and the new annual fixed cost
will be Rs. 150000.

The new equipment will have a useful life of 4 years (independent of annual production
volume). Solo products Ltd have a cost of capital of 10%.

You are required to find out:

i) What level of annual sales is necessary in order for this investment in semi automatic
machine to break-even – That will generate enough annual profit to repay the initial
capital cost and the required rate of return on this capital?

ii) What level of annual sales will be necessary to switch over profitably from manual to
semi automatic production?

Note: The annuity factor representing the present value at an interest rate of 10% of
receiving Re 1 at the end of each of the next 4 years is 3.17. Ignore taxation.

12. A paint manufacturing company manufactures 200000 per annum medium

sized tins of ‘Spray lac’ paints, when working at normal capacity. It incurs the following
manufacturing cost per unit:

Direct material Rs. 7.80

Direct labour 2.10
Variable overhead 2.50
Fixed overheads 4.00
---------
Total cost per tin Rs. 16.40
---------
Each tin is sold for Rs. 21 with variable selling and administrative expenses of 60 paise
per tin.

During the next quarter only 10000 tins can be produced and sold. Management plans to
shut down the plant, estimating that the fixed manufacturing cost can be reduced to Rs.
74000 for the quarter. When the plant is operating, fixed overhead are incurred at a
uniform rate through out the year. Additional cost of plant shut down for the quarter are
estimated at Rs. 14000

You are required to:

1) Express your opinion as to whether the plant should be shut down during the quarter.
2) Calculate the shut down point in terms of number of tins.

13. Sellaway limited manufactures and markets two products A and B. The
demand in the market fluctuates with the prices quoted. As `a result of the delibrations of
its recent sales conference, the following data were agreed up on as a working basis:

Product A B_____________
Selling price per unit (Rs) 32 30 28 22 20 18
Expected demand
Per month in Nos. 900 1000 1500 1600 2000 3000

8 labour hours are required to produce product A and 4 labour hours are required to
produce product B. The maximum capacity of the factory is restricted to 20000 labour
hours per month.

Cost structure of production per unit is as under:

Product A B____________
Direct material Rs. 4 Rs. 3
Direct labour 6 5
Variable overheads 10 6
----- -----
20 14
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Fixed overheads are Rs. 32400 per quarter. You are required to compute the possible
combinations and arrive at proper price mix to earn maximum profit.
Pricing decisions

14. Perfect pistons limited produce 60000 pistons per annum for its parent
company Perfect Motors Ltd. The pistons are sold to Perfect Motors at Rs. 200 per unit.
The variable cost per piston is Rs. 180. The Annual fixed cost of Perfect pistons Ltd is
Rs. 1500000. It is currently operating at 60% capacity.

The company desires to respond to an export enquiry for 30000 pistons of the type of it is
currently manufacturing. The company’s aim is to improve capacity utilization and avoid
loss.

You have to take note of the following benefits that will accrue to the export transactions
while determining the FOB price to be quoted.

i) Export incentive by way of cash assistance at 10% FOB value of exports.

ii) Reimbursement of excise duty on manufacturing inputs by way of 5% of draw back of
duty on FOB value of exports.

iii) Entitlement of import license to the extent of 10% on FOB value of exports. The
import license can either be sold at a premium of 100% or it can be utilized to import
certain critical auto components that will yield a 30% profit on cost.

Recommend the bare minimum price that the company should quote, in order to break
even, assuming,

a) It sells the import license in the market

b) It imports components against the license and sells them for profit.

15. The cost profile of a company manufacturing only one product is as under:

Direct material Rs. 5.60

Direct labour 1.50
Variable factory overhead 0.40
--------
7.50
--------
Fixed factory overhead is budgeted at Rs. 330000 for an annual sales of 400000 units.
Selling, distribution and administration cost are budgeted at Rs. 180000. Capital
employed is, Rs. 450000 in fixed assets and 50% of sales in working capital.

Determine a selling price for the product to yield a 20% return on capital employed.

16. XYZ Limted has received an enquiry for the supply of 10000 units of steel
chairs. Capacity exists for manufacture of chairs in company’s unit No:3. A fixed
investment of Rs. 25000 and working capital to the extent of 25% of sale value will be
required if the job is under taken. The costs are estimated as follows:

Raw materials : 100000 kgs at Re. 1 per kg.

Direct wages: 10000 hours at Rs. 4 per hour.
Variable overheads:-
Factory: Rs. 2.40 per labour hour.
Selling and distribution: Rs. 16000
Fixed overheads:
Factory: Rs. 6000
Selling and distribution: Rs. 14000

Prepare a statement showing the price to be fixed as under:

a) Total cost method with 30% profit on total cost.
b) Conversion cost method with 100% conversion cost as profit.
c) Marginal cost assuming a P.V Ratio of 40%.
d) Return on investment method with an expected net return of 80% on capital
employed.

17. Prompt printers Limited use a scheme of pricing based on cost plus. All the
overheads are charged based on direct labour. Base on the total cost arrived at, the selling
price is fixed.

The following figures are taken from the annual budget for 2008 prepared by the
company:
Sales Rs. 1000000
Direct material 180000
Direct labour 320000
Factory Supervisor’s salary 30000
Commission on sales @ 5% 50000
Foreman’s salary 60000
Insurance 10000
Advertisement 20000
Depreciation on assets 30000
Administration expenses 90000
Variable factory cost:
Repairs and maintenance 60000
Tools consumed 40000
Miscellaneous stores consumed 10000

The company has submitted a tender quoting Rs. 10000 on a large order with a cost of
Rs. 1800 direct materials and Rs. 3200 direct labour. The customer strikes the business at
Rs. 8900 on a ‘take it or leave it’ basis. If the company accepts the order, the total sales
for 2008 would be Rs. 1008900. The company is reluctant to accept the order, as it would
be against its policy, accepting an order below cost.

Is the price offered by the customer really below cost? If not explain with supporting
figures. Also comment on the pricing policy of the company.

18. Sriram painters under take painting jobs of cars, scooters, buses etc. The paint
materials of desired shades are purchased from market and then painted by spray guns by
skilled painters. The budget for next year is given below:

Paint materials 100 kilo litres Rs. 1500000

Direct labour 25000 hours 500000
Variable overheads for 25000 hours 1000000
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Total variable cost 3000000
Fixed overheads 2000000
--------------
Total expected cost 5000000
Profit @ 25% on total cost 1250000
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Expected job work revenue 6250000
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The firm always faces problems in getting paint materials from the markets as the
customer needs only a particular shade. The skilled labour is also some times not
available due to rush of jobs.

A customer wants to get his moped painted urgently. It is estimated that one litre paint is
sufficient for painting the moped. 4 labour hours will be required to complete the job.

1) What should be the painting charges if fixed costs are absorbed on the basis of variable
cost and profit at 25% on total cost?
2) What should be the charges in case the paint material is a limiting factor?
3) What should be the charges, in case, the skilled labour is a limiting factor?
4) What price out of the above three would you recommend to the customer? Why?