Chapter 7 Relevant Costs for Decision Making

Relevant Costs for Decision Making

I n this chapter we are going to focus on measuring costs and benefits for non-routine decisions.
The term 'special studies' is sometimes used to refer to decisions that are not routinely made at
frequent intervals. In other words, special studies are undertaken whenever a decision needs to
be taken; such as discontinuing a product or a channel of distribution, making a component within
the company or buying from an outside supplier, introducing a new product and replacing existing
equipment.

Managers usually follow a decision model for choosing among different courses of action. A decision
model is a method of making a choice, and it often involves both quantitative and qualitative
analysis. Management accountants work with managers by analyzing and presenting relevant data
to guide decisions. Decision making should normally follow a five step process. The process is (a)
identify the problem and uncertainties, (b) obtain information, (c) make predictions about the
future, (d) make decisions by choosing among alternatives, and (e) implement the decision, evaluate
performance, and learn.

In the above process of decision making, we need relevant information for the decision making. To
be relevant for a particular decision, a revenue or cost item must meet two criteria: (a) it must be an
expected future revenue or expected future cost, and (b) it must differ among alternative courses of
action. The outcomes of alternative actions can be quantitative and qualitative. Quantitative
outcomes are measured in numerical terms. Some quantitative outcome can be expressed in
financial terms, others cannot. Qualitative factors are difficult to measure accurately in numerical
terms. Consideration must be given to relevant quantitative and qualitative factors in making
decisions

We begin by introducing the concept of relevant cost and applying this principle to special studies
relating to the following situations:

1. Disposal of Assets
2. Product-mix decisions;
3. Special selling price decisions;
4. Decisions on replacement of equipment;
5. Outsourcing (make or buy) decisions;
6. Discontinuation decisions.

Disposal of Assets

In case of disposal of assets or material we have to ignore the sunk cost, which is irrelevant today.
We have to see the future benefits and additional cost to be incurred for the alternatives available
before us. If the future benefits are more than the future costs then we should go for disposal of
asset, otherwise not. But there are many qualitative decisions that affects management decision
making. A policy of management to go for modernisation of plant may ignore the above financial
viability. In this chapter, the qualitative aspects of decision making is ignored to make student

understand the basic skills of decision making using cost information.

Q.No.1. A company has an inventory of 100 assorted parts for a line of missiles that has been
discontinued. The inventory cost is ₹80,000. The parts can be either (a) remachined (reworked) at

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total additional costs of ₹30,000 and then sold for ₹35,000 or (b) sold as scrap for ₹2,000. Which
action is more profitable? Show your calculations.

Sol: In the above situation we have two alternatives, (i) these parts can be remachined or (ii) it
can be sold as scrap. The cost of inventory is irrelevant for decision making because it is a sunk
cost(past cost).

If we go for remachining, we get additional profit of ₹5,000(i.e., ₹35,000- 30,000) and if we sell as
scrap, we get ₹2,000. Hence we should go for remachining the parts as it gives us an incremental
profit of ₹3,000.

Q.No.2. A motor, costing ₹1,00,000 and uninsured, is wrecked its first day in use. It can be either (a)
disposed of for ₹10,000 cash and replaced with a similar motor costing ₹1,02,000 or (b) built for
₹85,000 and thus become brand new as far as operating characteristics and looks are concerned.
Which action is less costly? Show your calculations.

Product mix decisions when capacity constraints exist

An organisation tries to manufacture as many number of units as it is having a demand in the

market. But this is not always possible because the production capacity of any organisation will be
limited due to limited machine capacity, material availability, skilled labour availability, capacity
constraint in other processes, etc. These scarce resources are known as limiting factors(constraint
resources). Within a short-term time period it is unlikely that production constraints can be removed
and additional resources acquired. Where limiting factors apply, managers must decide how the
constraint resource should be used.

In such situations, the first job as a manager of the department or business unit is to identify the
limiting factor(s). The contribution of each product is to be ascertained for every limiting factor.
Decision to manufacture a particular product over the other, is based on the contribution
generated by the product for the limiting factors. Fixed costs are ignored for these decisions, they
are usually unaffected by such choices, so the course of action that will maximize the company's
contribution margin should ordinarily be selected. But, if there is any future fixed cost which is
attached with the product, then it should be considered for decision making.

Q.1. Benoit Company produces three products, A,B and C. Data concerning the three products
follow(per unit):

Products
A B C
Demand for the
Selling price............................................. ₹80 ₹56 ₹70
company's
Less: Variable expenses.......................... products is very
Direct materials......................................
24 15 9 strong, with far
more Other variable expenses.........................
24 27 40 orders each
Total variable expenses..........................
48 42 49 month than the
Contribution margin...............................
32 ₹14 ₹21
company has raw
Contribution margin ratio.......................
40% 25% 30%
materials
available to
produce. The same material is used in each product costing ₹ 3 per kg with a maximum of 5,500 kgs
available each month.

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Required:

Which orders would you advise the company to accept first, those for A, for B, or for C? Which
orders second? Third? Also find out the estimated profit with the proposed quantity of output.

Sol: Contribution Format Income Statement

A B C
Selling price............................................. ₹80 ₹56 ₹70
Less: Variable expenses..........................
Direct materials...................................... 24 15 9
Other variable expenses......................... 24 27 40
Total variable expenses.......................... 48 42 49
Contribution margin............................... 32 ₹14 ₹21
Material cons. Per unit(kg) 8 5 3
Contribution per kg of material……………………. 4(IInd) 2.8(IIIrd) 7(Ist)
Contribution margin ratio....................... 40% 25% 30%

As in the above situation we see that availability of material is limited, we would like to utilise the
material where our contribution per kg of material will be maximum. Thus we see that product C
gives us maximum contribution per kg of material i.e., 4, second is Product C ( ₹ 7 per kg) and then
product C with lowest contribution per kg.

If there is no other limiting factor, then we would like to produce only Product C. We will have a
contribution of ₹ 38500 (i.e.,5500 x 7).

Q.No.2. Super India Ltd is producing three products X, Y and Z. A minimum of 1000 units of each
product is to be produced by the company for keeping a product mix to compete with other
companies' products. The manager of the company is asked to come out with a product mix in the
following constraint resource situations. The following data has been provided by the accounting
department regarding the three products:

X Y Z
Maximum Capacity 5000 units 2000 units 3000 units
Direct material @ Rs 10 per kg Rs. 40 Rs 10 Rs 30
Other variable costs 36 25 10
Selling price 100 50 60
Fixed costs (unavoidable) 20,000 15,000 10,000

Calculate the best product mix in each of the following three independent cases:
a. Total availability of raw materials is limited to 18,000 kgs.
b. Under a trade agreement the firm cannot produce more than 7500 units of the three
products taken together.
c. Total sales value of the three products cannot exceed Rs 6, 50,000.

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Sol: Contribution Format Income Statement

X(₹) Y(₹) Z(₹)

Selling price 100 50 60
Less: Variable cost per unit
Direct material @ Rs 10 per kg 40 10 30
Other variable costs 36 25 10
Variable cost per unit 76 35 40
Contribution per unit(Rank) 24(Ist) 15(3rd) 20(2nd)
Material consumed per unit(kg) 4 1 3
Contribution per kg of material(₹) 6(3rd) 15(1st) 6.67(2nd)
Contribution margin ratio(%) 24%(3rd) 30%(2nd) 33.33%(1st)
a) If material availability is the limiting factor(only 18000kgs of Material available), then the
product mix will be decided as follows:
First we will manufacture 1000 units of each of the product.
That will consume= (1000 x 4 + 1000 x 1 + 1000 x 3) = 8000 kgs of material
Remaining amount of material = 18000 – 8000 =10000 kgs

Product Units Material Remaining

consumed(kgs) material(kgs)
Y 1000 1000 (i.e.,1000 x 1) 9000(i.e.,10000-1000)
Z 2000 6000 (i.e.,2000 x 3) 3000 (i.e,9000-6000)
X 750(i.e.,3000/4) 3000 Nil

Profit estimation with the above product mix

X Y Z Total
Units sold 1750 2000 3000
Contribution per unit 24 15 20
Total Contribution 42000 30000 60000 132000
Less: Fixed cost (-)45000
Profit ₹87,000

b. Under a trade agreement the firm cannot produce more than 7500 units of the three
products taken together.

If you see per unit contribution then Product X is most profitable( ₹24 p.u.), Product Z is second
best(₹20 p.u) and Product Y is least profitable( ₹15).

First we have to manufacture 1000 each of X, Y and Z. Then rest of 4500(i.e.,7500 -3000) units will be
produced as follows:

X all 4000 units(i.e.,5000 – 1000) as this is the most profitable per unit. The remaining 500 units
(4500 – 4000) of product Z.

So the product mix will be

X – 5000 units, Y- 1000 units and Z- 1500 units

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Profit estimation with the above product mix

X Y Z Total
Units sold 5000 1000 1500
Contribution per unit 24 15 20
Total Contribution 120000 15000 30000 165000
Less: Fixed cost (-)45000
Profit ₹1,20,000

c. Third condition is, total sales value of the three products cannot exceed Rs 6, 50,000.

When sales value is the limiting factor, then on the basis of contribution margin ratio we see the
profitability of the product. Referring the contribution format income statement, we find that
Product Z is most profitable(33.3%), then product Y (30%) and Product X is least profitable(24%).

Sales value of compulsory production:

X = 100 x 1000 = ₹1,00,000, Y= 50 x 1000 = ₹50000 and Z = 60 x 1000 = ₹60,000.

Remaining Sales value = 6,50,000 – (100000 + 50000 + 60000) = ₹ 4,40,000

First we will produce product Z, then Product Y and at last product X if sales value will be left.

Product Units Sales value Remaining sales value

Z 2000 1,20,000 (i.e.,2000 x 60) 3,20,000(i.e.,4,40,000-1,20,000)
Y 1000 50,000 (i.e.,1000 x 50) 2,70,000 (i.e,3,20,000-50,000)
X 2700(i.e.,270000/100) 2,70,000 Nil

Profit estimation with the above product mix

X Y Z Total
Units sold 3700 2000 3000
Contribution per unit 24 15 20
Total Contribution 88800 30000 60000 1,78,800
Less: Fixed cost (-)45000
Profit ₹1,33,800

Q.No.3. A company produces three products. The cost data are as under:

Products A B C

Direct Materials Rs 64 Rs 152 Rs 117

Direct Labour:
Deptt. Rate per hr. Hrs Hrs Hrs
1 Rs 5 18 10 20
2 Rs 6 5 4 7
3 Rs 4 10 5 20
Variable overheads Rs 16 Rs 9 Rs 21
Fixed overheads Rs 4,00,000 per month

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A B C

The budget was prepared at a time when the market was sluggish. Keeping the market
condition into consideration the budgeted quantities and selling prices were decided, which
is given below:

Product Budgeted Quantity Selling Price/Unit

A 9750 270
B 7800 280
C 7800 400

Later the market improved and the sales team suggested that the sales quantities could be
increased by 20% for the product A and 25% each for products B and C. The sales manager
confirmed that the increased quantities could be achieved at the prices originally budgeted.
But the production manager stated that the output cannot be increased beyond the
budgeted level due to limitation of direct labour hours in Dept-2.
Required:
a. Present a statement of budgeted profitability
b. Set optimal product mix and calculate the optimal profit.

Sol: In the question it is given that there is limited direct labour hours in Dept-2. That means
availability of labour hours in Dept-2 is the constraint. The total labour hours available in Dept-2 is
equal to the labour hours required for the production of budgeted quantity.

Labour hours available in Dept-2

Products Budgeted Labour hour per Labour hours in

Quantity unit in Dept-2 Dept-2
A 9750 5 48750
B 7800 4 31200
C 7800 7 54600
134550
Although the market condition has increased and we can sell more number of units than the
budgeted quantity, still we can not manufacture upto the market demand as we have limited labour
hours available in Dept-2. Hence we will manufacture that product to the maximum demand which
is having higher contribution per labour hour in Dept-2.

Contribution format income statement

A B C
Sales 270 280 400
Less: Variable Cost:
Direct Material 64 152 117
Labour- Dept-1 90 50 100
Dept-2 30 24 42
Dept-3 40 20 80
Variable overhead 16 9 21
Variable cost per unit 240 255 360
Contribution per unit 30 25 40
Labour hour in Dept-2 per unit 5 4 7

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Contribution per labour hour(₹) 6(3rd) 6.25(1st) 5.71(2nd)

Hence we should manufacture Product B first, then Product A and at the end Product C if labour
hour will be available.

Q.No.4. Children Toy Company produces two models of toy Car, Deluxe and Super. Pertinent data
are as follows:

Deluxe Super
Selling price per unit ₹100.00 ₹70.00
Costs:
Direct Material 28.00 13.00
Direct Manufacturing labour 15.00 25.00
Variable Manufacturing overhead* 25.00 12.50
Fixed manufacturing overhead* 10.00 5.00
Market cost (all variable) 14.00 10.00
Total Cost 92.00 65.50
Operating income 8.00 4.50

*Allocated on the basis of machine-hours.

The car craze is such that enough of either Deluxe or Super can be sold to keep the plant operating
at full capacity. Both products are processed through the same production departments.
Which products should be produced? Briefly explain your answer.

Sol: Here in this case, both the products are having demand in the market but the capacity of the
plant is limited. Hence the product which gives more contribution per unit is profitable and we
should produce that product.

Note: Fixed manufacturing overhead is assumed to be a common cost divided on the basis of
machine hours. Therefore, this is unavoidable fixed cost and irrelevant for the decision.

Contribution Format Income Statement

Delux Super

Selling price per unit ₹100.00 ₹70.00

Costs:
Direct Material 28.00 13.00
Direct Manufacturing labour 15.00 25.00
Variable Manufacturing overhead* 25.00 12.50
Market cost (all variable) 14.00 10.00
Total Cost 82.00 60.50
Contribution per unit 18.00 9.50

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As Deluxe consumes double the machine hours consumed by Super. Therefore, if we double the
contribution of Super, it becomes 19 (i.e.,9.50 x2). This is more than the contribution of Deluxe.
Hence we should manufacture Super.
Q.No.5. A company manufactures three products. The budgeted quantity, selling prices and unit
costs are as under:

Products A B C
Raw materials (@ Rs 20 per kg) Rs.80 Rs.40 Rs.20
Direct wages (@ Rs 5 per hr) 5 15 10
Variable overheads (Rs) 10 30 20
Fixed overheads (Rs) 9 22 18
Budgeted production (units) 6400 3200 2400
Selling price per unit (Rs) 140 120 90
Required:
a.
b. Present a statement of budgeted profit
c. Set optimal product mix and determine the profit if the supply of raw material is
restricted to 18,400 kg.

Adding or Dropping Product Lines and Other Segments:

Decisions relating to dropping a product line or closing a department, is the most difficult
decision for a manager. Apart from emotional aspects there are many qualitative and
quantitative aspects to be considered for the decision making. Ultimately, however, any final
decision to drop an old segment or to add a new one is going to hinge primarily on the impact,
the decision will have on net operating income. To assess this impact, costs must be carefully
analyzed.
In such situations, we should carefully see the cost which continues even after dropping the
product or closing the department. Such costs become irrelevant for our decision making, as
these costs remain there in both the alternatives of continuing or discontinuing. Some time it
happens that such costs does not remain same in amount, then those costs become relevant for
the decision.

Q.No.6. Vanjanagar, sports shoe company is considering dropping one line of product, whose
information is given below.
Revenue ₹ 950,700
Cost of goods sold 861,840
Gross Margin 88,920
Selling and administrative expenses 136,800
Net Loss ₹ (47,880)

Factory overhead accounts for 35% of the cost of the goods sold and is one-third fixed. These
data are believed to reflect conditions in the immediate future.

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Required:
Should the line dropped?
Sol: Factory overhead is 35% of the cost of goods sold i.e., 861840 x 35% = ₹301644
Fixed Factory overhead = 310644 x 1/3= 103548
So, variable cost of goods sold = 861840 – 103548 = ₹ 758292

Revenue ₹ 950,700
Variable Cost of goods sold 758,292
Contribution before S&Adm exp. 192,408
Selling and administrative expenses 136,800
Net Contribution ₹ 55,608

As the product line is giving positive contribution, hence it should not be dropped, otherwise
the company will suffer a loss of ₹55,608.
Q.No.7. The Discount Drug Company has three major product lines-- drugs, cosmetics, and
housewares. Sales and cost information for the preceding month for each separate product line
and for the store in total are given below:

Product line
Total Drugs Cosmetics Housewares
Sales ₹250,000 ₹125,000 ₹75,000 ₹50,000
Less: Variable expenses 105,000 50,000 25,000 30,000
Contribution margin 145,000 75,000 50,000 20,000
Less- fixed expenses:
Salaries 50,000 29,500 12,500 8,000
Advertising 15,000 1,000 7,500 6,500
Utilities 2,000 500 500 1,000
Depreciation-fixtures 5,000 1,000 2,000 2,000
Rent 20,000 10,000 6,000 4,000
Insurance 3,000 2,000 500 500
General Administrative 30,000 15,000 9,000 6,000
Total fixed expenses 125,000 59,000 38,000 28,000
Net operating income(loss) ₹20,000 ₹16,000 ₹12,000 ₹(8,000)

What can be done to improve the company's overall performance? One product line--
housewares --shows a net operating loss for the month. Should this be dropped or continued?
Sol: Although product Housewares is looking loss making. But we have to see whether this
product is giving any positive saving(net contribution) to the organization or not. Therefore, we
have to deduct the avoidable fixed costs which can be avoided if we drop the product line. But
if we continue, we incur these avoidable fixed expenses specific for the product.

Product line
Total Drugs Cosmetics Housewares
Sales ₹250,000 ₹125,000 ₹75,000 ₹50,000
Less: Variable expenses 105,000 50,000 25,000 30,000
Contribution margin 145,000 75,000 50,000 20,000
Less-Avoidable/Traceable
fixed expenses:

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Salaries 50,000 29,500 12,500 8,000

Advertising 15,000 1,000 7,500 6,500
Utilities 2,000 500 500 1,000
Insurance 3,000 2,000 500 500
Total Traceable fixed exp. 70,000 33000 21000 16000
Product Line income ₹75,000 ₹42,000 ₹29,000 ₹4,000
Less: Untraceable or
Common Fixed Exp.
Depreciation 5000 1000 2000 2000
Rent 20000 10000 6000 4000
General Administration 30000 15000 9000 6000
Total Untraceable F. Cost 55000 26000 17000 12000
Net Income 20000 16000 12000 (8000)

Conclusion: If we see the product line income we find that all the products are contributing
positively. We should take the decision based on product line income. The other common fixed
costs are the costs which will remain there even if we drop one product line.
Q.No.8. The Regal Cycle company manufactures three types of bicycles-- a dirt bike, a mountain
bike, and a racing bike. Data on sales and expenses for the past quarter follow:

Total Dirt Bikes Mountain Racing

Bikes Bikes
Sales ₹300,000 ₹90,000 ₹150,000 ₹60,000
Less variable expenses 120,000 27,000 60,000 33,000
Contribution margin 180,000 63,000 90,000 27,000
Less: Fixed expenses:
Advertising, traceable 30,000 10,000 14,000 6,000
Depreciation of special equipment 23,000 6,000 9,000 8,000
Salaries of product-line managers 35,000 12,000 13,000 10,000
Allocated common fixed expenses* 60,000 18,000 30,000 12,000
Total fixed expenses 148,000 46,000 66,000 36,000
Net operating income(loss) ₹32,000 17,000 ₹24,000 ₹(9,000)
*Allocated on the basis of sales dollars.
Management is concerned about the continued losses shown by the racing bikes and wants a
recommendation as to whether or not the line should be discontinued. The special equipment
used to produce racing bikes has no resale value and does not wear out.

Required:
1. Should production and sale of the racing bikes be discontinued? Explain. Show computations
to support your answer.
2. Recast the above data in a format that would be more usable to management in assessing
the long-run profitability of various product line.
Sol:

Total Dirt Bikes Mountain Racing

Bikes Bikes
Sales ₹300,000 ₹90,000 ₹150,000 ₹60,000

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Less variable expenses 120,000 27,000 60,000 33,000

Contribution margin 180,000 63,000 90,000 27,000
Less: Traceable fixed expenses:
Advertising, traceable 30,000 10,000 14,000 6,000
Depreciation of special equipment 15,000 6,000 9,000 8000
Salaries of product-line managers 35,000 12,000 13,000 10,000
Total traceable fixed expenses 80,000 28,000 36,000 16,000
Product line segment income ₹ 100,000 35,000 ₹ 54,000 ₹ 3,000
Less: untraceable fixed cost ₹ 60,000 18,000 30,000 12,000
Net Income 40,000 17,000 24,000 (9,000)
Every product is contributing positive income towards recovering the common fixed cost.
Therefore, Racing Bike should not be dropped. If racing bike is dropped then instead of ₹1,000,
the firm will suffer a loss of ₹12,000, as this common cost now to be recovered from other two
products.

Make or Buy decisions

Some time we get offers from some suppliers to supply the parts or services, we would be
otherwise manufacturing or having our own service departments to take care of. They come
with many lucrative offers. Decisions on whether to produce components or avail services
within the organization or to acquire them from outside suppliers are called outsourcing or
make or buy decisions. Such decisions are to be taken very carefully after considering the
financial merits as well as the qualitative aspects. The long term impact of such decisions over
ride on short term impact. Even though it looks profitable in short term, we need to see long
term horizon for continuity of service, quality of products and services, availability of
alternatives, reliability of the supplier, etc. Here we are going to consider the financial aspects
only for our decision making, although the qualitative aspects will also be discussed in the class.

Q.No.9. Auto Parts Ltd has an annual production of 90,000 units for a motor component. The
company’s cost structure per unit is given below:

Materials Rs.270
Labour (25% fixed) 180
Other Manufacturing Exp:
Fixed exp. 90
Variable exp. 135
Total Rs.675
a. The purchase manager has an offer from a supplier who is willing to supply the
component at Rs 540. Should the component be purchased and production stopped?
b. There is one other alternative available, that is the resources now used for this
component’s manufacturing are to be used to produce another new product for which
the selling price is Rs 485.

In the latter case, the material price will be Rs 200 per unit. 90,000 units of this product can
be produced on the same cost basis as above for labour and expenses. Discuss whether it
would be advisable to divert the resources to manufacture the new products, on the
footing that the component presently being produced would, instead of being produced, be
purchased from the market.

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Sol.a) Variable cost per unit

Items ₹
Material 270
Labour(75% variable) 135
Var. Manuf. exp 135
540
In the first instance the offer is looking lucrative, when we are seeing the cost of our
product i.e.,₹ 675. But when we see the variable cost we find that we are also incurring the
variable cost of ₹ 540 and rest of the cost are fixed cost which will be there even if we buy it
from outside. If the fixed cost is avoidable then we can think of buying it from outside
supplier. Hence at this price we will not buy it.

b) If a new product is manufactured then the contribution from that product will be

Items ₹
Selling price per unit 485
Less: Variable cost per unit
Material 200
Labour(75% variable) 135
Var. Manuf. Exp 135
470
Contribution per unit 15
So we should buy the original product from outside and can manufacture another product in
its place which will give us a contribution of ₹15 per unit.
Total contribution will be = 90000 x 15 = ₹13,50,000
Note: we have only considered the quantitative aspects into consideration. The points like
quality, regular supply and reliability we have not taken into consideration.

Special order/one time order

some time as a manufacturer or service provider we get special orders at either a special
price or we get an opportunity to enter a new market. We have to decide the price of the
product or to decide on the offered price. Now many a cases you may not be having
sufficient capacity or resources to meet the order, then either you have to drop your
existing order/client to fulfil the special order. The loss of benefit(opportunity cost) from
the loss of existing order should be considered for the decision making.

These decisions are to be taken very carefully because sometime you have to trade off
between long term and short term benefits. It also depends on the strategy of the firm. A
firm can suffer loss or not to make any profit initially to have a foothold in a new
promising market.

Q.No.10. A company currently operating at 80% capacity has the following particulars:

Sales ...................................... Rs.32 lakhs

Direct Materials...................... 10 lakhs

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Direct Labour.......................... 4 lakhs

Variable Overheads................ 2 lakhs
Fixed overheads..................... 13 lakhs

An export order has been received that would utilize half the capacity of the factory. The
order cannot be split, that is, it has to be taken in full and executed at 10% below the
normal domestic prices, or rejected totally. The alternatives available to the management
are:
i. Reject the order and continue with the domestic sales only (as at present); or
ii. Accept the order, split capacity between overseas and domestic sales and turn
away excess domestic demand.

Prepare a comprehensive statement of profitability and suggest the best alternative.

Sol: We have two alternatives,

a) Reject the order and manufacture at 80% capacity and sell in the domestic market only,
b) Accept the order and manufacture at 100% capacity and sell half of it in export and rest
half in domestic market.

Sol:a) In the first alternative, the profit will be

Items At 80% At 100%

capacity(₹) capacity (₹)
Sales 32,00,000 40,00,000
Less: Variable cost
Material 10,00,000 12,50,000
Labour 4,00,000 5,00,000
Var. Manuf. Exp 2,00,000 2,50,000
16,00,000 20,00,000
Contribution 16,00,000 20,00,000
Less: Fixed cost 13,00,000 13,00,000
Profit 3,00,000 7,00,000
b)Half of its sales(50%) = 4000000 x 50% = 20,00,000

Domestic sales will be 50% at same selling price and export sales will be 50% at 10%
discount.

Items Domestic Export 100%

sales sales(50%) capacity(₹)
(50%) (₹)
Sales 20,00,000 18,00,000 38,00,000
Less: Variable cost
Material 12,50,000
Labour 5,00,000
Var. Manuf. Exp 2,50,000
20,00,000
Contribution 18,00,000
Less: Fixed cost 13,00,000
Profit 5,00,000
If we go for export sales then our profit increases by ₹2,00,000. Hence we should accept
export sales.

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Q.No.11. Following data are in respect of a firm manufacturing a single product for a particular
period:
Sales (20,000 units) : Rs 2,00,000
Cost of production (20,000 units) : Rs 1,20,000
Selling and distribution expenses : Rs 30,000
Maximum capacity is 25,000 units
Fixed costs included in cost of production are Rs 40,000 and only variable cost included in
selling and distribution expenses are commission @ 10% on sales and packing expenses @
20p. per unit.
a. An offer for purchase of 4000 units is received from outside India. No sales commission
is payable on such foreign order but packing costs will be 80p. per unit.
What minimum price may be quoted for the foreign offer?
b. What should be the minimum price had the offer size been 8000 units instead of 4000
units?

Sol: Maximum capacity =25,000 units

Currently the firm is producing 20000 units, if we go for another 4000 units, still it will be within the
capacity. Hence the fixed cost will not increase, only change will be in variable cost.

For pricing the product to get into a foreign market, sometime companies can sell their product
without making any profit i.e., at marginal cost. Here the marginal cost for 4000 units is calculated as
follows:

Variable cost of production = 120000 – 40000 = 80000

Variable cost of production per unit = 80000/20000 = ₹ 4

Packing cost = ₹0.80 per unit

Hence, we can sell the product at ₹4.80 per unit. This strategy we adopt to get into the new market.
By doing this we don’t sacrifice anything as we are well within the capacity.

b) But if we get an offer of 8000 units then in that case, we have to leave the domestic
sales to accept the full export order.

Our capacity is 25000 units but if we accept the order, we have to produce 28000 units,
which is not possible within our production capacity. So we have to give up 3000 units of
domestic sales to accept the export order. Therefore the price for the export order will be
the marginal cost plus Contribution sacrificed from loss sale of domestic order.

Current contribution format income statement(domestic sales)

20000 units
Sales ₹ 200000
Less: Variable cost
Cost of production(₹4.00 p.u) 80000
Selling commission(₹ 1.00p.u) 20000

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Packing expenses(0.20) 4000

Total variable cost 104000
Contribution 96,000
Contribution per unit = 96000/20000= ₹4.80

Contribution sacrificed on 3000 units =3000 x 4.80 = ₹ 14400

The price of the export order will be = Variable cost of export order + opportunity cost of
loosing the domestic sales

= 8000 x 4.80 + 14400 =₹ 52,800

S.P per unit = 52,800/8000 =₹ 6.6 p.u.

Case-1 (Make or Buy)

The management of an engineering company manufacturing a range of products, is considering next
year’s production, purchase and sales budgets. Shown below are the budgeted total unit costs of
two of the components and two of the products manufactured by the company.

Comp. 12 comp. 14 product VW product XY

Per unit(Rs.) per unit(Rs.) per unit(Rs.) per unit(Rs.)
Direct material 18 26 12 28
Direct Labour 16 4 12 24
Variable overhead 8 2 6 12
Fixed overhead 20 5 15 30
62 37 45 94

Components 12 and 14 are incorporated into other products manufactured and sold by the
company, but not the two products shown above. It is possible to purchase components 12 and 14
from another company for Rs.60 per unit and Rs.30 per unit respectively.
The anticipated selling prices of products VW and XY are Rs.33 and Rs.85 respectively.
Required:
(a) Advise the management of the company whether it would be profitable to :
(i) Purchase either of the above components,
(ii) Sell either of the above products.

(b) State clearly, and where appropriate comment upon, the assumptions you have made in
answering (a) above

(c) Consider how the following additional information would affect your advice in (a) above.
(i) Next year’s budgeted production requirements for the two components are 7000
units of component 12 and 6000 units of Components 14. Next year’s budgeted
sales for the two products are Product VW 5,000 units and Product XY 4,000 units.

(ii) A special machine is used exclusively by the above two components and two
products and technical reasons the machine can only be allowed to operate for
80,000 machine hours next year.
The budgeted usage of the machine is:

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Component 12- 8 machine hours Product VW- 6 machine hours

Component 14- 2 machine hours Product XY- 12 machine hours

The operating costs of the machine have been included in the unit costs shown in (a)
above.

Sol: a)

Comp. 12 comp. 14 product VW product XY

Per unit(Rs.) per unit(Rs.) per unit(Rs.) per unit(Rs.)
Direct material 18 26 12 28
Direct Labour 16 4 12 24
Variable overhead 8 2 6 12
Variable cost per unit 42 32 30 64

It is possible to purchase components 12 and 14 from another company for Rs.60 per unit and Rs.30
per unit respectively.
At the given price we should buy component 14 from outside, whereas component 12 should be
manufactured on our own.
The anticipated selling prices of products VW and XY are Rs.33 and Rs.85 respectively. Hence both
product is having a selling price more than the variable cost, that means both the product is having
positive contribution. Hence we should sell both the product.
b)It is assumed that fixed cost is unavoidable. Hence fixed cost is irrelevant for decision making.

c) Next year’s budgeted production requirements for the two components are 7000 units of
component 12 and 6000 units of Components 14. Next year’s budgeted sales for the two products
are Product VW 5,000 units and Product XY 4,000 units.
The budgeted usage of the machine is:
Component 12- 8 machine hours Product VW- 6 machine hours
Component 14- 2 machine hours Product XY- 12 machine hours

Total machine hours required:

Budgeted Machine Total Machine

units hour per unit hour required
Comp-12 7000 8 56000
Comp-14 6000 2 12000
Product VW 5000 6 30000
Product XY 4000 12 48000
146000
Total machine hour available is 80000, hence all the products can not be manufactured in full
capacity.
Component 14 should be bought from outside because purchase price is less than variable cost per
unit.
So for the other products contribution per unit is to be calculated to find out which product to be
manufactured using the machine hour available.
Comp. 12 product VW product XY
Per unit(Rs.) per unit(Rs.) per unit(Rs.)

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Selling price 60 33 85
Variable cost per unit 42 30 64

Contribution per unit 18 3 21

Machine hour per unit 8 6 12

Contribution per m.hour 2.25 0.5 1.75

So component 12, all 7000 units should be manufactured and that will consume 56000 machine
hours. Remaining machine hour will be 24000, which will be used to manufacture Product XY 2000
units(i.e.,24000/12). We have to purchase 2000 units product XY and 6000 units of component 14.
Quiz-4/Practice set-1
1. Activity based costing is a method of charging:
a. Direct expenses to cost unit
b. Overhead to production department
c. Overhead to cost units
d. None of the above 0.5 mark
2. Activity-based costing is suitable for product costing when:
a. One product is manufactured by the organization
b. Many products of different types are manufactured by the organization
c. Products are similar and consume same resources
d. None of the above 0.5 mark
3. In activity based costing, costs are accumulated by:
a. Cost objects
b. Cost benefit analysis
c. Cost pool
d. None of the above 0.5 mark
4. In activity-based costing, a facility(organization)-sustaining activity is:
a. Related to any particular product or service
b. Related to only particular batch of product
c. Not related to any particular product or service or batch of product
d. None of the above 0.5 mark
5. In activity-based costing, a product sustaining activity supports:
a. The production of a specific product or service
b. The efficient operation of organization
c. The production of a batch of product
d. None of the above. 0.5 mark
6. The three products manufactured by DEL Co. and further information is given below:

A(Rs.) B(Rs.) C(Rs.)

S.P 400 350 600
Variable Cost per unit:
Material 100 75 150
Labour 80 40 90
Variable manufacturing Overhead 60 50 100
Fixed overhead per unit 40 50 40
Material consumed per unit 4 kgs 3 kgs 6 kgs
Labour hour per unit 8 hours 4 hours 9 hours

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a. Which product is most profitable, if material availability is limited?

b. Which product is most profitable, if no. of units to be sold is limited?
c. Which product is most profitable, if sales value(Rs.) is the limiting factor?
d. Which product is most profitable, labour hour is limited? 2 marks
7. If the average cost of the product is Rs.100, marginal(Variable cost) cost per unit is Rs.60 and
fixed cost is Rs.60,000(unavoidable), then what will be minimum price for export sale?
0.5mark
Ans.

Quiz-4/Practice set-2
1. Activity-based costing is suitable for product costing when:
e. One product is manufactured by the organization
f. Many products of different types are manufactured by the organization
g. Products are similar and consume same resources
h. None of the above 0.5 mark
2. Activity based costing is a method of charging:
e. Direct expenses to cost unit
f. Overhead to production department
g. Overhead to cost units
h. None of the above 0.5 mark
3. In activity-based costing, a product sustaining activity supports:
e. The production of a specific product or service
f. The efficient operation of organization
g. The production of a batch of product
h. None of the above. 0.5 mark
4. In activity based costing, costs are accumulated by:
e. Cost objects
f. Cost benefit analysis
g. Cost pool
h. None of the above 0.5 mark
5. In activity-based costing, a facility(organization)-sustaining activity is:
e. Related to any particular product or service
f. Related to only particular batch of product
g. Not related to any particular product or service or batch of product
h. None of the above 0.5 mark
6. The three products manufactured by DEL Co. and further information is given below:

A(Rs.) B(Rs.) C(Rs.)

S.P 400 350 600
Variable Cost per unit:
Material 100 60 150
Labour 80 40 120
Variable manufacturing Overhead 60 50 100
Fixed overhead per unit 40 50 40
Material consumed per unit 5 kgs 3 kgs 7.5 kgs
Labour hour per unit 6 hours 3 hours 9 hours
e. Which product is most profitable, if material availability is limited?

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f. Which product is most profitable, if no. of units to be sold is limited?

g. Which product is most profitable, if sales value(Rs.) is the limiting factor?
h. Which product is most profitable, labour hour is limited? 2
marks
7. If the average cost of the product is Rs.100, marginal(Variable cost) cost per unit is Rs.60 and
fixed cost is Rs.60,000(unavoidable), then what will be minimum price for export sale?
0.5mark
Ans:

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