Cma Final Scm

CMA FINAL SCM
STRATEGIC COST MANAGEMENT

Illustration 1
Ever Forward Ltd is manufacturing and selling two products: Splash and Flash, at selling
prices of ₹ 3/- and ₹ 4/- respectively. The following sales strategy has been outlined for the
year 2021.
(i) Sales planned for year will be ₹ 7.20 lakhs in the case of Splash and ₹ 3.50 lakhs in the
case of Flash
(ii) Break-even is planned at 60% of the total sales of each product.
(iii) Profit for the year to be achieved is planned at ₹ 69,120 in the case of Splash and ₹ 17,500
in the case of Flash. This would be possible by launching a cost reduction programme and
reducing the present annual fixed expenses of ₹ 1,35,000 allocated as ₹ 1,08,000 to Splash
and ₹ 27,000 to Flash.
The selling price of Splash and Flash will be reduced by 20% and 12.5% respectively to meet
the competition.
You are required to present the proposal in financial terms giving clearly the following
information.
(a) Number of units to be sold of Splash and Flash to break-even as well as the total number
of units of Splash and Flash to be sold during the year.
(b) Reduction in fixed expenses product-wise that is envisaged by the cost Reduction
Program.
Solution
Computation of Number of units to be Sold, Breakeven & envisaged Reduction in FC
Item Splash Flash Total
No. of units to be sold 3,00,000 1,00,000 4,00,000
Break even units 1,80,000 60,000
Cost Reduction envisaged in FC (₹) 4,320 750 5,070
Increase in profits during 2021-22 due to quality improvement = ₹ 230 lakhs

Illustration 2
The income statement of Ashok Gears Ltd. is summarized as below:
Net Revenue ₹ 80,00,000
Less: Expenses (including ₹40,00,000 of Fixed Cost) ₹ 88,00,000
Net Loss ₹ 8,00,000
The manager believes that an increase of ₹20,00,000 as fixed expenditure in advertising

outlays will increase the sales substantially. His plan was approved by the Board.
You are required to calculate:

(i) At what sales volume will the Company have break even?
What sales volume will result in a Net Profit of ₹ 4,00,000?
Solution:
(i) Computation of Break-Even Sales
Net Revenue = ₹ 80,00,000
Variable Expenses = ₹ (88,00,000 - 40,00,000) = ₹ 48,00,000
Contribution = (80,00,000 – 48,00,000) = ₹ 32,00,000
Contribution Margin Ratio (PV Ratio) = 32,00,000 ÷ 80,00,000 = 40%
Revised Fixed Cost = (Existing 40,00,000 +20,00,000 of Advertising) = ₹ 60,00,000
Break Even Sales = (Fixed Cost ÷ PV Ratio) = (60,00,000 ÷ 40%) = ₹ 1,50,00,000
(ii) Computation of sales level to earn a Net Profit of ₹ 4,00,000
Targeted Contribution = (Fixed Cost + Desired Profit) = (60,00,000 + 4,00,000)
= ₹ 64,00,000
Required Sales = (Targeted Contribution ÷ PV Ratio) = (64,00,000 ÷ 40%)
= ₹ 1,60,00,000
(Explanatory Comment: The problem brings forth the primary application of marginal
costing in manufacturing sector for the purposes of calculating the BEP and profit planning.)
Illustration 3
A manufacturing company currently operating at 80% capacity has received an export order
from Middle East, which will utilise 40% of the capacity of the factory. The order has to be
either taken in full and executed at 10% below the current domestic prices or rejected totally.
The current sales and cost data are given below-
Sales ₹ 16.00 lakhs
Direct Material ₹ 5.80 lakhs
Direct Labour ₹ 2.40 lakhs
Variable Overheads ₹ 0.60 lakhs
Fixed Overheads ₹ 5.20 lakhs
The following alternatives are available to the managem
A. Continue with domestic sales and reject the export order.
B. Accept the export order and allow the domestic market to starve to the extent of excess of
demand.
C. Increase capacity so as to accept the export order and maintain the domestic demand by:
(i) Purchasing additional plant and increasing 10% capacity and thereby increasing fixed
overheads by ₹ 65,000, and
(ii) Working overtime at one and half time the normal rate to meet balance of the required
capacity.
Required: Evaluate each of the above alternatives and suggest the best one
Solution
Alternative (A): Continue with domestic sales and reject the export order.
Serial Description Workings ₹ Lakhs
1 Capacity Given – 80%
2 Sales Given 16.00

Variable Costs
a. Direct Material 5.80
3 b. Direct Labour Given 2.40
c. Variable Overheads 0.60
d. Sub Total 8.80
4 Contribution (2 - 3) 7.20
5 Fixed Costs Given 5.20
6 Profit (4 – 5) 2.00
Alternative (B):
Accept the export order and allow the domestic market to starve to the extent of excess of
demand.
This alternative envisages utilization of 40% of the capacity for the export order and 60% of
the capacity for domestic market.
Further, the export order is to be executed at 10% below the current domestic prices i.e..,
(100- 10)% = 90% of the price.
Accordingly:
Sales at 100% Capacity = (16 ÷ 80%) = ₹20 Lakhs
Value of the export order = (40% of Capacity × 90% of the Price)
= (20 × 40% × 90%)
= ₹ 7.20 lakhs.
Value of the domestic sales = (20 × 60%)
= ₹ 12.00 lakhs.
1 Capacity Export 40% + Domestic 60%
2 Sales 7.20 + 12.00 19.20
Variable Costs
a. Direct Material
b. Direct Labour (5.80 / 80%) × 100% 7.25
c. Variable Overheads
3 d. Sub Total (2.40 / 80%) × 100% 3.00
(0.60 / 80%) × 100% 0.75
11.00
5 Fixed Costs Given 5.20
6 Profit (4 – 5) 3.00
Alternative (C): Increase capacity so as to accept the export order and maintain the domestic
demand by:
(i) Purchasing additional plant and increasing 10% capacity and thereby increasing fixed
overheads by ₹ 65,000, and
(ii) Working overtime at one and half time the normal rate to meet balance of the required
capacity.
1 Capacity Export 40% + Domestic 80%
2 Sales 7.20 + 16.00 23.20
Variable Costs
a. Direct Material (5.80 / 80%) × 120% 8.70
3 b. Direct Labour (2.40 / 80%) × 120% 3.60
c. Variable Overheads (0.60 / 80%) × 120% 0.90
d. Overtime Premium (2.40 / 80%) × 10% × 50% 0.15

[Balance capacity of
10%] 13.35
e. Sub Total
5 Fixed Costs [Including fixed O/H for (5.20 + 0.65) 5.85

capacity increased of 10 %]
6 Profit (4 – 5) 4.00
Suggestion: Alternative (C) with the highest profit of ₹4.00 lakhs works out to be the best.
(Explanatory Comment: The problem is a good example to understand the methodology for
evaluation of various alternatives with the help of marginal costing.)
Illustration 4
A manufacturer has three products A, B, and C. Current sales, cost and selling price details
and processing time
requirements are as follows
Product A Product B Product C
Annual sales (units) 6000 6000 750
Selling Price (₹) 20 31 39
Unit Cost (₹) 18 24 30
Processing time required per 1 1 2

unit (hour)
The firm is working at full capacity (13,500 processing hours per year). Fixed manufacturing
overheads are absorbed into unit costs by a charge of 200% of variable costs. This procedure
fully absorbs the fixed manufacturing overhead .
Assuming that:
(i) Processing time can be switched from one product line to another.
(ii) The demand at current selling price ( ₹) is:
Product A Product B Product C
11,000 8,000 2,000
(i) The selling prices are not be altered.

You are required to calculate the best production programme for the next operating period and
to indicate the increase in net profit that this programme should yield. In addition, identify the
shadow price of processing hour
Solution
Computation of Contribution per Labour Hour & Preference
Seria Description A B C
l
1 Selling price ₹ 20 31 39
2 Unit Cost ₹ 18 24 30
3 Variable cost (1/3rd of Unit Cost) ₹ 6 8 10
4 Contribution per unit (1 – 3) ₹ 14 23 29
5 Processing hours per unit 1 1 2
6 Contribution per hour (4 ÷ 5) ₹ 14 23 14.50
7 Preference III I II
Computation of Current Profit
Seria Description A B C TOTAL

l
1 No of units 6,000 6,000 750
2 Contribution per unit ₹ 14 23 29
3 Total contribution ₹ 84,000 1,38,00 21,750 2,43,750
4 Fixed cost per Unit (2/3rds of Unit ₹ 12 16 20

Cost)
5 Total Fixed cost ₹ 72,000 96,000 15,000 1,83,000
6 Profit (3-5) ₹ 60,750
Statement showing Optimum Mix & Profit at that Mix
Seria Description A B C Total

l
1 Order of Preference III I II

2 Process hours per unit 1 1 2
3 Demand (Units) 11,000 8,000 2,000
4 Hours Needed (2 × 3) 11,000 8,000 4,000 23,000
5 Hours Allocated 1,500 8,000 4,000 13,500
6 No of units 1,500 8,000 2,000
7 Contribution per unit ₹ 14 23 29
8 Total contribution ₹ 21,000 1,84,000 58,000 2,63,000
9 Fixed cost ₹ 1,83,000
10 Profit ₹ 80,000
Increase in Profit = (80,000 - 60,750) = ₹ 19,250
Shadow Price: Shadow price is the opportunity cost of one unit of resource relevant for the
decision maker. In the present case every extra processing hour will increase the production
of A by one unit and the contribution by ₹ 14. Therefore, the shadow price of processing hour
is ₹ 14.
Working Note for allocation of Hours
Total Hours Available = 13,500
Hours for B = 8000 × 1 = 8.000
Hours Available for C & A = (13,500 – 8,000) = 5,500
Hours for C = 2,000 × 2 = 4,000
Hours Available for A = (5,500 – 4,000) = 1,500
(Commentary: The problem serves as a good example for understanding the Limiting Factor
Analysis and Optimum Product Mix.)
Illustration 5
As a part of its rural upliftment programme, the Government has put under cultivation a farm
of 96 hectors to grow tomatoes of four varieties: Royal Red, Golden Yellow, Juicy Crimson
and Sunny Scarlet. Of the total 96 hectors, 68 hectors are suitable for all four varieties, but
the remaining 28 hectors are suitable for growing only Golden Yellow and Juicy Crimson.
Labour is available for all kinds of farm work and there is no constraint. The market
requirement is that all four varieties of tomatoes must be produced with a minimum of 1,000
boxes of any one variety. The farmers engaged have decided that the area devoted to any crop
should be in terms of complete hectors and not in fractions of a hector. The other limitation is
that not more than 22,750 boxes of any one variety should be produced. The following data
are given
Particulars Royal Golden Juicy Sunny

Red Yellow Crimson Scarlet
Annual Yield (Boxes per hector) 350 100 70 180
Direct Material Costs (₹ per hector) 4,760 2,160 1,960 3,120
Labour Costs (₹)
a. Growing per hector 8,960 6,080 3,710 5,280

b. Harvesting & packing per box
c. Transportation per box 36 32 44 52
52 52 40 96
Market price per box 153.80 158.70 183.80 222.70
Fixed Overheads per annum
Growing ₹ 1,12,000
Harvesting ₹ 74,000
Transportation ₹ 72,000 General Administration ₹ 1,02,000
Required
(i) Product Preference within the given constraints
(ii) Optimum Product Mix & Maximum Profit
(iii) A nationalized bank has come forward to help in an improvement programme for the
piece of 28 hectors in which only Golden Yellow and Juicy Crimson used to grow, with
a loan of ₹50,000 at a very nominal interest of 6% per annum. After this improvement is
carried out, there will be a saving of ₹12.50 per box in the harvesting cost of Golden
Yellow and the 28 hectors will become suitable for growing Royal Red in addition to the
existing Golden Yellow and Juicy Crimson varieties. Assuming that other constraints
continue, find the maximum total profit that would be achieved after the improvement
programme is carried out
Explanatory Comments
While seeking solutions in terms of product preference, optimum product mix, maximum
profit and evaluation
of alternatives, the problem sets certain constraints. The constraints are:
(i) 68 hectors are suitable for all four varieties, but the remaining 28 hectors are suitable for
growing only Golden Yellow and Juicy Crimson
(ii) All four varieties of tomato must be produced with a minimum of 1,000 boxes of any
one variety
(iii) The area devoted to any crop should be in terms of complete hectors
(iv) Not more than 22,750 boxes of any one variety should be produced
(v) After an improvement is carried out the 28 hectors will become suitable for growing
Royal Red in addition to the existing Golden Yellow and Juicy Crimson varieties
The problem can be solved by adopting five steps:
(i) Determination of Contribution per hector & product preference
(ii) Computation of Optimum Product Mix
(iii) Computation of Maximum Profit
(iv) Computation of Optimum Mix after the improvement programme
(v) Computation of Profit after the improvement programme
Here follows the stepwise solution. In order to assimilate the concepts, the students
are advised to go through the notes, furnished at relevant places, carefully
Solution
Step 1: Determination of Contribution per hector & product preference

Red Yellow Crimso Scarle
n t
Sales per hector

a. Boxes per hector 350 100 70 180
b. Market / Sales Price 153.80 158.70 183.80 222.7
per Box 53,830 15,870 12,866 0
c. Sales (a × b) 40,08
6
2 Variable costs
a. Direct material 4,760 2,160 1,960 3,120
b. Growing cost 8,960 6,080 3,710 5,280
c. Harvesting and
packing Per Box 36 32 44 52
Per hector 12,600 3,200 3,080 9,360
d. Transport Per Box
Per hector 52 52 40 96
18,200 5,200 2,800 17,28
0
e. Total Variable Cost 44,520 16,640 11,550 35,04
0
3 Contribution per hector 9,310 -770 1,316 5,046
(1 – 2)
4 Rank / Order of I IV III II
Preference
Note: Order of preference is decided on the basis of contribution per hector
Step 2: Computation of Optimum Product Mix
Golden Juicy Sunny

Particulars Royal Yellow Crimso n Scarlet Total
Red
(a) 1,000 1,000 1,000 1,000
Minimum
Boxes
Requirement
(b) Annual 350 100 70 180
Yield of Boxes
/ Hector
2.85 14.28 5.55
Required i.e..,3.0 i.e..15 i.e..6.0 34.00
Minimum Area 0 10.00 .0 0 0
(Hectors) [a ÷ b] Note Note Note
(i) (ii) (iii)
Balance Area (96 – 34) (Hectors) 62.00
Maximum
area for 22,750 22750 22750 22750 2275
boxes (Hectors) 0
(22750 / Annual 350 100 70
yield of Boxes) = 65 = 227.5 = 325 180
=
126.3
9
Allocation of area
68 hectors suitable
for all varieties 62.00 6.00
being distributed
for preferences 1
and 2
28 hectors suitable
for Golden yellow 10.00 18.00
&
Juicy Crimson
Total 62.00 10.00 18.00 6.00 96.
00
Notes
(i) In case of Royal Red, the minimum area of 2.85 hectors has been rounded off to the next
higher multiple 3.
(ii) In case of Juicy Crimson, the minimum area of 14.28 hectors has been rounded off to the
next higher multiple 15.
(iii) In case of Sunny Scarlet, the minimum area of 5.55 hectors has been rounded off to the
(iv) Of the 68 hectors suitable for all varieties, 62 acres have been apportioned to Royal Red
after allocating the minimum area of 6 to Sunny Scarlet.
Of the 28 hectors suitable for Golden yellow & Juicy Crimson, 18 acres have been
apportioned to Juicy Crimson after allocating the minimum area of 10 to Golden yellow
Step 3: Computation of Maximum Profit
Seri Particulars Royal Golden Juicy Sunny Total

al Red Yellow Crimson Scarlet
1 Area (Hectors) 62 10 18 6 96
2 Contribution per hector 9310 (770) 1316 5046
3 Total contribution 5,77,220 (7,700) 23,688 30,276 6,23,484
Fixed costs
a. Growing 1,12,000
4 b. Harvesting 74,000
c. Transport 72,000
d. General Administration 1,02,000
e. Sub Total (a + b + c + d)
3,60,000
5 Profit (3-4) 2,63,484
Step 4: Computation of Optimum Mix & Profit after the improvement programme
Particulars Royal Golden Juicy Sunny Total

Minimum Area (hectors) 3.00 10.00 15.00 6.00 34.00
Balance area being apportioned 62.00 62.00

on the basis of product
preference
Total area (hectors) 65.00 10.00 15.00 6.00 96.00
Note: Product-wise apportionment of the area has been done by following a similar process
as has been outlined in step2
Step 5: Computation of Profit after the improvement programme

1 Area (Hectors) 65 10 15 6 96
Existing
Savings after 1250
the improvement
Revised 9310 480 1316 5046
3 Total contribution 6,05,150 4,800 19,740 30,276 6,59,966
Fixed costs
a. Growing 1,12,000
b. Harvesting 74,000
c. Transport 72,000
4 d. General 1,02,000
Administration 3,000
e. Interest @ 6% 3,63,000
on
₹ 50,000/-
f. Sub Total (a..d)
5 Profit 2,96,966
(Commentary: Be it be manufacturing sector, service sector or agriculture sector, the

application of Marginal Costing is Universal.)
Illustration 6
MN Agarwal owns a Gift-Shop, a Restaurant and a Lodge in Shillong. Typically, he operates

these only during the season period of 4 months in a year. For the past season the occupancy
rate in the Lodge was 90% and level of activity in case of Gift-Shop and Restaurant was 80%.
The relevant data for the past season were as under-
Gift-Shop Restaurant Lodge
Amount (₹) % Amount (₹) % Amount (₹) %
1. Receipts/ Sales 48,000 100 64,000 100 1,80,000 100
2. Expenditure:
Cost of Sales 26,400 55 35,200 55 - -

Supplies 2,400 5 6,400 10 14,400 8
Insurance & Taxes 1,920 4 6,400 10 36,000 20
Depreciation 2,880 6 8,000 12.5 39,600 22
0
Salaries 4,800 10 4,800 7.50 25,200 14
Electricity Charges 960 2 3,200 5 13,500 7.50
Total 39,360 82 64,000 100 1,28,700 71.50
3. Profit 8,640 18 - - 51,300 28.50
Additional information
(a) Cost of Sales and Supplies vary directly with the occupancy rate in case of Lodge and
level of activity in case of Gift Shop and Restaurant.
(b) Insurances and Taxes and Depreciation are for the entire period of twelve months.
(c) Salaries paid are for the season period except a Chowkidar for the Lodge who is paid for
the full year at ₹400 per month.
(d) Electricity Charges include Fixed Charges of ₹640, ₹1,920 and ₹9,900 for Gift-shop,
Restaurant and Lodge respectively.
The balance amount varies directly with occupancy rate in case of Lodge and level of activity
in case of Gift- Shop and Restaurant. Fixed Electric Charges are for the season except in case
of Lodge where ₹6,900 is for the season and ₹3,000 for the entire period of twelve months.
Mr. Agarwal is interested in increasing his Net Income. The following options are under
consideration -
(a) To continue the operations during the season period only by inserting advertisement in
newspapers thereby occupancy rate to reach 100% in case of Lodge and 90% level of
activity in respect of Gift-Shop and Restaurant. The costs of advertisement are
estimated at ₹12,000.
(b) To continue operations throughout the entire period of twelve months comprising season
period of four months and off-season period of eight months. The occupancy rate is
expected at 90% and 40% during season period and off-season period respectively in case
of the Lodge. The room rents are bound to be reduced to 50% of the original rates during
off-season period. The level of activity of Gift-Shop and Restaurant is expected at 80% and
30% during season and off-season period respectively but 5% discount on the original rates
will have to be offered during off-season period.
Which option is profitable? As a Cost Accountant would you like to suggest him any other
alternative based upon the above figures, which can be adopted to earn more net profit? (Use
Incremental Revenue and Cost Approach.)
Solution
(a) Option 1: Operate during Season only
Incremental Revenues and Costs in (₹)
Particulars Gift- Shop Restaurant Lodge Total

Given ₹ 48,000 at Given ₹ 64,000 at Given ₹ 1,80,000 at
80%, Addl. 80%, Addl. 90%, Addl.
Incremental Revenue for extra Revenue for extra Revenue for extra
Revenue 10% 10% 10% 34,000
= 48,000 × (10/80) = 64,000 × (10/80) = 180,000 × (10/90)
= 6,000 = 8,000 = 20,000
Extra 10% Extra 10% Extra 10%
= (90-80)% = (90-80)% = (90-80)%
Incremental Costs
Cost of Sales 6,000 × 55% 8,000 × 55% Nil 7,700
= 3,300 = 4,400
Supplies 6,000 × 5% = 300 8,000 × 10% = 800 20,000 × 8% 2,700
=
1,600
Electricity (960 - 640) × (10/ (3,200 - 1,920) × (13,500 - 9,900) ×
Charges 80) (10/80) = 160 (10/90) = 400 600
(Excluding = 40
Fixed Charges)
Advertisement 12,000
Total of Incremental Costs 23,000
Incremental Profit 11,000
(b) Option 2: Operate during all 12 months
Incremental Revenues and Costs in (₹)
Incremental 48,000 × 2 × 64,000 × 2 × 1,80,000 × 1,59,800

Revenue (30% (30% 2 ×
/ 80%) × 95% / 80%) × 95% (40% / 90%) ×

50%
= 34,200 = 45,600
= 80,000
Incremental Costs
Cost of Sales 36,000 × 55% 48,000 × 55% Nil 46,200
=19,800 =26,400
Supplies 36,000 × 5% 48,000 × 10% = 1,60,000 × 8 = 19,400

=1,800 4,800 12,800 %
Electricity Charges 640 × 2 = 1,280 1,920 × 2 = 3,840 6,900 × 2 = 13,800 18,920

– Fixed
Electricity - (960-640) × (3,200 -1,920) × 2 (13500- 9900) × 2 4,400

Charges
Variable 2 × × (30%/80%) × (40%/90%)
= 960 = 3,200
(30%/80%) =240
Total of Incremental Costs 1,48,920
Incremental Profit 10,880
Suggestion
Both options are desirable since there is an Incremental Net Income. Option 1 is slightly
better than Option 2 by ₹120. However, it is suggested that the Firm should adopt a
combination of both options in which case, the Total Additional Profit will be ₹11,000 +
₹10,880 = ₹21,880
Illustration 7
AB Limited has two divisions Alpha & Beta. Alpha produces components, two units of
which are required for one unit of final product produced by Beta. Alpha has a capacity to
produce 20,000 units and entire quantity is supplied to Beta @ ₹ 200/unit. Variable cost
component at Alpha is ₹ 190 & fixed cost ₹ 20 per unit. For final product of Beta, per unit
variable cost excluding component is ₹ 700, fixed cost ₹ 200 and selling price is ₹ 1500.
Alpha has placed a proposal for increasing the transfer price to ₹ 220 i.e.. the market price.
Facility at Alpha can be rented out @ ₹ 3.00 Lakhs p.a. Manager at Alpha wants to opt for
this alternative. Beta can buy this component from outside market @ ₹ 210. If capacity of
Alpha is augmented to 40,000 units with an additional investment of ₹ 15 lakhs, it can sell
20,000 units to external market and balance to Beta @ ₹ 210 per unit. Fixed cost for Alpha
will be up by ₹ 1.00 lakh. Evaluate and give your opinion on:
a. Facility of Alpha is rented out and Beta buys from market @ ₹210 per unit
b. Alfa sells to outside market @ ₹220 and Beta buys @ 210 per unit from
market
c. Capacity enhancement at a cost of capital of 12% p.a.
Solution:
(i) Present position on transfer of Alpha @ ₹200 to Beta
Particulars Division Alpha Division Beta

Units sold 20,000 10,000
Selling price per unit (₹) 200 1,500
Variable cost per unit (₹) 190 700 + (2 × 200) = 1,100
Contribution per unit (₹) 10 400
Fixed cost per unit (₹) 20 200
Profit per unit (₹) (-) 10 200
Total Profit / Loss (₹) (–)2,00,000 20,00,000
Overall profit for the company = (-2,00,000 + 20,00,000)
= ₹ 18,00,000
Total Fixed Cost for Alpha = (20,000 × 20)
= ₹ 4,00,000
Total Fixed Cost for Beta = (10,000 × 200)
= ₹ 20,00,000
Alternative (a), i.e.. Facility of Alpha is rented out and Beta buys from market @ ₹ 210 per
unit
Units sold 0 10,000
Selling price per unit (₹) 1,500
Variable cost per unit (₹) 700 + (2 × 210) = 1,120
Contribution per unit (₹) 380
Total Contribution (₹) 38,00,000
Fixed Cost (₹) 20,00,000
Rental Income (₹) 3,00,000
Total Profit (₹) 3,00,000 18,00,000
Overall profit for the company = (3,00,000 + 18,00,000)

= ₹ 21,00,000
(i) Alternative (b), i.e.. Alpha sells to outside market @ ₹220 and Beta buys @ 210 per
unit from market

Units sold 20000 10000
Selling price per unit (₹) 220 1500
Variable cost per unit (₹) 190 700 + (2×210) = 1120
Contribution per unit (₹) 30 380
Total Contribution (₹) 6,00,000 38,00,000
Fixed Cost (₹) 4,00,000 20,00,000
Total Profit (₹) 2,00,000 18,00,000
Overall profit for the company = (2,00,000 + 18,00,000) = ₹ 20,00,000
(ii) Alternative (c), i.e.., Capacity enhancement of Alpha at a cost of capital of 12% p.a.
Division Division
Particulars Division Beta
Alpha Alpha
(Sale) (Transfer)
Units sold 20000 20000 10000
Selling price per unit (₹) 220 210 1500
700 + (2×210)
Variable cost per unit 190 190
(₹) = 1120
Contribution per unit (₹) 30 20 380
Total Contribution (₹) 6,00,000 4,00,000 38,00,000
Fixed Cost (₹) 4,00,000 1,00,000 20,00,000
12% of 15,00,000 =
Cost of Capital @ 12%
1,80,000
Total Profit (₹) 2,00,000 1,20,000 18,00,000
Overall profit for the company = (2,00,000 + 1,20,000 + 18,00,000) = ₹ 21,20,000
Evaluation
Serial Alternative Overall Profit (₹)

(i) Present position on transfer of Alpha @ ₹200 to Beta 18,00,000
(ii) Alternative (a), i.e.. Facility of Alpha is rented out and 21,00,000
Beta buys from market @ ₹210 per unit
(iii) Alternative (b), i.e.. Alpha sells to outside market @ ₹220 20,00,000
and Beta buys @ 210 per unit from market
(iv) Alternative (c), i.e.. Capacity enhancement of Alpha at a 21,20,000

cost of
capital of 12% p.a.
Opinion: Since overall profit is the highest, i.e.. ₹ 21,20,000 in alternative ‘c’, it can be
adopted.
Illustration 8
Forward and Foundry Ltd. is feeling the effects of a general recession in the industry. Its
budget for the coming half year is based on an output of only 500 tones of casting a month
which is less than half of its capacity. The prices of casting vary with the composition of the
metal and the shape of the mould, but they average ₹ 175 a tone. The following details are
from the Monthly Production Cost Budget at 500 tone levels:
Core Melting Cleaning

making and Moulding and
Pouring Grinding
₹ ₹ ₹ ₹
Labour 10,000 16,000 6,000 4,500
Variable overhead 3,000 1,000 1,000 1,000
Fixed overhead 5,000 9,000 2,000 1,000
18,000 26,000 9,000 6,500
Labour and O.H. rate per direct 9.00 6.50 6.00 5.2
labour hour
Operation at this level has brought the company to the brink of break-even. It is feared that if
the lack of work continues, the company may have to lay off some of the most highly skilled
workers whom it would be difficult to get back when the volume picks up later on. No
wonder, the work’s Manager at this Juncture, welcomes an order for 90,000 casting, each
weighing about 40 lbs., to be delivered on a regular schedule during the next six months. As
the immediate concern of the Works Manager is to keep his work force occupied, he does not
want to lose the order and is ready to recommended a quotation on a no-profit and no-loss
basis.
Materials required would cost ₹ 1 per casting after deducting scrap credits. The direct labour
hour per casting required for each department would be
Core Making 0.09
Melting and pouring 0.15
Moulding 0.06
Cleaning and grinding 0.06
Variable overheads would bear a normal relationship to labour cost in the melting and
pouring department and in the moulding department. In core making, cleaning and grinding
however, the extra labour requirements would not be accompanied by proportionate increases
in variable overhead. Variable overhead would increase by ₹1.20 for every additional labour
hour in core making and by 30 paise for every additional labour hour in cleaning and
grinding. Standard wage rates are in operation in each department and no labour variances are
anticipated. To handle an order as large as this, certain increases in factory overheads would
be necessary amounting to ₹ 1,000 a month for all departments put together. Production for
this order would be spread evenly over the
six months period. You are required to:
(a) Prepare a revised monthly labour and overhead cost budget, reflecting the addition of this
order.
Determine the lowest price at which quotation can be given for 90,000 castings without
incurring a loss
Solution
Computation of labour and overhead rate.
Core Melting & Cleaning

making pouring & grinding
Moulding
Labour & overheads (₹) 18,000.00 26,000.00 9,000.00 6,500.00
Labour & overheads per hour (₹) 9.00 6.50 6.00 5.20
No. of hours 2,000.00 4,000.00 1,500.00 1,250.00

Variable overhead per hour (₹) 1.50 0.25 0.67 0.80
Labour rate per hour (₹) 5.00 4.00 4.00 3.60
Hours required for new order 1,350.00 2,250.00 900.00 900.00
Labour cost required for order (₹) 6,750.00 9,000.00 3,600.00 3,240.00
Variable overhead cost for order (₹) 1,620.00 563.00 600.00 270.00
Revised monthly labour and overheads cost budget reflecting the additions of the order
Core Melting Cleaning

making & &
pouring Moulding grinding Total
₹ ₹ ₹ ₹ ₹
Labour 10,000.00 16,000.00 6,000.00 4,500.00
Labour for the order 6,750.00 9,000.00 3,600.00 3,240.00
16,750.00 25,000.00 9,600.00 7,740.00
Variable overheads 3,000.00 1,000.00 1,000.00 1,000.00
Variable overheads for 1,620.00 563.00 600.00 270.00

the order
4,620.00 1,563.00 1,600.00 1,270.00
Fixed cost 5,000.00 9,000.00 2,000.00 1,000.00
Total 26,370.00 35,563.00 13,200.00 10,010.00 85,143.00
Add : additional fixed cost 1,000.00
Total: 86,143.00
Computation of total price for the order
Material (15000 × 1) 15,000.00
Labour & overheads (86143 - 59500) 26,643.00

41,643.00
Total price for the order (41643 × 6) 249,858
Illustration 9
Transferor Ltd. has two processes, Preparing and Finishing. The normal output per week is
7,500 units (Completed) at a capacity of 75%. Transferee Ltd. had production problems in
preparing and requires 2,000 units per week of prepared material for their finishing processes.
The existing cost structure of one prepared unit of Transferor Ltd. at existing capacity is as
follows:
Material = ₹ 2.00 (variable 100%) Labour = ₹2.00 (Variable 50%) Overhead =

₹4.00 (variable 25%)
The sale price of a completed unit of Transferor Ltd is ₹16 with a profit of ₹4 per unit
Required:
Construct the effect on the profits of Transferor Ltd., for six months (25 weeks) of supplying
units to Transferee Ltd. with the following alternative transfer prices per unit:
i.Marginal Cost
ii.Marginal Cost + 25%
iii.Marginal Cost + 15% Return on capital (assume capital employed as ₹20 lakhs)
iv. Existing Cost
v. Existing Cost + a portion of profit on the basis of {(Preparing cost ÷ Total Cost) x
Unit Profit)
vi. At an agreed market price of ₹8.50. Assume no increase in fixed cost.
Solution
Working Note 1
Existing Cost Structure one Prepared Unit of Preparing Unit
Serial Element Workings (₹)

Variable (Marginal) Costs
(i) Material (100%) 2.00
1 (ii) Labour (50%) (2.00 × 50%) 1.00
(iii) Overheads (25%) (4.00 × 25%) 1.00
(iv) Total (i to iii) 4.00
Fixed Costs
2 (i) Labour (50%) (2.00 × 50%) 1.00
(ii) Overheads (75%) (4.00 × 75%) 3.00
(iii) Total (i to ii) 4.00
3 Total Preparing Cost (1 + 2) 8.00
Working Note 2
Units to be Transferred in 25 weeks = 25 × 2,000 = 50,000
Working Note 3
Capital Employed = ₹20,00,000
ROI per annum @ 15% = 20,00,000 × 15%
= ₹3,00,000
ROI for 6 months = {(3,00,000 ÷ 12) × 6}

= ₹1,50,000
ROI per Unit = (1,50,000 ÷ 50,000)
= ₹3.00
Working Note 4
Sale Price of the Completed Unit = ₹16.00
Profit per Unit – ₹4.00
Cost per Completed Unit = (16.00 – 4.00)
= 12.00
Proportionate Profit for Prepared Unit = {(Preparing cost ÷ Total Cost) × Unit Profit)
={(8 ÷ 12) × 4}
= ₹2.67
(Explanatory Comment: The problem highlights different methods of adopting the transfer
price within an organisation)
Illustration 10
SV Ltd. manufactures a product which is obtained basically from a series of mixing

operations. The finished product is packaged in the company made glass bottles and packed
in attractive cartons. The company is organized into two independent divisions viz. one for
the manufacture of the end product and the other for the manufacture of glass bottles. The
Product manufacturing division can buy all the bottle requirements from the bottle
manufacturing division.
The General Manager of the bottle manufacturing division has obtained the following
quotations from the outside manufacturers for the empty bottles.
Volume Purchase Value
Empty bottles Total (₹)
8,00,000 14,00,000
12,00,000 20,00,00
A cost analysis of the bottle manufacturing division for the manufacture of empty bottles
reveals the following production costs:
Volume Purchase Value
Empty bottles Total (₹)
8,00,000 10,40,000
12,00,000 14,40,000
The production cost and sales value of the end product marketed by the product
manufacturing division are as under.
Volume Total cost of end product* Sales Value
(Bottle of end product) (Packed in bottles)
8,00,000 ₹ 64,80,000 ₹ 91,20,000
12,00,000 ₹ 96,80,000 ₹ 1,27,80,000
There has been considerable discussion at the corporate level as to the use of proper price for
transfer of empty bottles from the bottle manufacturing division to product manufacturing
division. This interest is heightened because a significant portion of the Divisional General
Manager’s salary is in incentive bonus based on profit centre results. As the corporate
management accountant responsible for defining the proper transfer prices for the supply of
empty bottles by the bottle manufacturing division to the product manufacturing division, you
are required to show for the two levels of volume of 8,00,000 and 12,00,000 bottles, the
profitability by using
i. Market price and
ii. Shared profit relative to the cost involved basis for the determination of transfer prices.
The profitability position should be furnished separately for the two divisions and the
company as a whole under each method. Discuss also the effect of these methods on the
profitability of the two divisions.
* (Excluding cost of empty bottles)
Solution
(i) Profitability on the basis of Market Price
Description Amount (₹) Amount (₹)

Output (Units) 8,00,000 12,00,000
1. Bottle manufacturing division
Sale value to outside market 14,00,000 20,00,000
Cost 10,40,000 14,40,000
Profit of Bottle mfg. Div 3,60,000 5,60,000
2. Product manufacturing division
Sale value 91,20,000 1,27,80,000
Costs :–
Product manufacturing division 64,80,000 96,80,000
Bottle manufacturing division 14,00,000 20,00,000
Total cost of Product Mfg. Div. 78,80,000 1,16,80,000
Profit of Prod. Mfg. Div. 12,40,000 11,00,000
Total profit of Both Div. (1 + 2) 16,00,000 16,60,000
Transfer Price per Bottle based on Market 1.75 1.67
price
Statement showing Computation of Transfer Price on the basis of Profit shared on Cost
Basis:

Output (Units) 8,00,000 12,00,000
Sales of End Product 91,20,000 1,27,80,000
Production Costs:-
Total Cost 75,20,000 1,11,20,000
Profit 16,00,000 16,60.000
Apportionment of Profit in the ratio of Costs
Total Profit 16,00,000 16,60.000
Transfer Price of Bottle manufacturing
division
Costs of empty bottle mfg. 10,40,000 14,40,000
Share in Profit 2,21,276 2,14,964
Total Transfer price 12,61,276 16,54,964
Transfer price per bottle 1.5766 1.379
(i) Statement of Comparative Profits

Product manufacturing division
Market Price Basis 12,40,000 11,00,000
Profit shared on Cost Basis 13,78,724 14,45,036
Bottle manufacturing division
Market Price Basis 3,60,000 5,60,000
Profit shared on Cost Basis 2,21,276 2,14,964
Observations
(a) Share of Profit of Product manufacturing division is higher when Transfer Price is worked
out on Profit shared on Cost Basis.
(b) Share of Profit of Bottle manufacturing division is higher when Transfer Price is worked
out on Market Price Basis.
(c) Overall Profit of the Company remains the same under both the alternatives.
Illustration 11
The Officers’ Recreation Club of a large public sector undertaking has a cinema theater for
the exclusive use of themselves and their families. It is a bit difficult to get good motion
pictures for show and so pictures are booked as and when available.
The theater has been showing the picture ‘Blood Bath’ for the past two weeks. This picture,
which is strictly for adults only has been a great hit and the manager of the theater is
convinced that the attendance will continue to be above normal for another two weeks, if the
show of ‘Blood Bath’ is extended. However, another popular movie, eagerly looked forward
to by both adults and children alike, ‘Appu on the Airbus’ is booked for next two weeks.
Even if ‘Blood Bath’ is extended the theater has to pay the regular rental on ‘Appu on the
Airbus’ as well.
Normal attendance at theater is 2,000 patrons per week, approximately one fourth of whom
are children under the age of 12. Attendance of ‘Blood Bath’ has been 50% greater than the
normal total. The manager believes that this would taper off during the second two weeks,
25% below that of the first two weeks, during the third week and 331/3 % below that of the
first two weeks during the fourth week. Attendance for ‘Appu on the Airbus’ would be
expected to be normal throughout its run regardless of the duration
All runs at the theater are shown at a regular price of ₹2 for adults and ₹1.20 for children
lower than 12. The rental charge for ‘Blood Bath’ is ₹900 for one week or ₹1,500 for two
weeks. For ‘Appu on the Airbus’ it is ₹750 for one week or ₹1,200 for two weeks. All other
operating costs are fixed - ₹4,200 per week, except for the cost of potato wafers and cakes,
which average 60% of their selling price. Sales of potato wafers and cakes regularly average
₹1.20 per patron, regardless of age.
The Manager can arrange to show ‘Blood Bath’ for one week and ‘Appu on the Airbus’ for
the following week or he can extend the show of ‘Blood Bath’ for two weeks or else he can
show ‘Appu on the Airbus’ for two weeks as originally booked.
Show by computation, the most profitable course of action he has to pursu
Solution
Statement showing Evaluation of Alternatives for third and fourth week
Option 1 Option 2 Option 3

Blood Bath & Appu on the
Narration Blood Bath Appu on the Airbus
Airbus
(₹) (₹) (₹)
No. of spectators
Adults:
Third week 3,000 × 75% 2,250.00 2,250.00 1,500.00
Fourth week 3,000 × 2/3 2,000.00 1,500.00 1,500.00
4,250.00 3,750.00 3,000.00
Children:
Third week 500.00
Fourth week 500.00 500.00
500.00 1,000.00
Total spectators 4,250.00 4,250.00 4,000.00
Revenue
By sale of tickets
Adults (Total Spec. ×₹2) Children 8,500.00 7,500.00 6,000.00
(Total Spec. ×₹1.20) Sub Total - 600.00 1,200.00
8,500.00 8,100.00 7,200.00
Add: contribution from snacks @ 2,040.00 2,040.00 1,920.00
₹0.48 (40% of 1.20) per Patron
Total Revenue 10,540.00 10,140.00 9,120.00
Less: Incremental Costs (Rental 1,500.00 900.00
Charges)
9,040.00 9,240.00 9,120.00
It may be observed that the net revenue is more at the option of running ‘Blood Bath’ and
Appu on the Air bus a week each. It must be chosen.
Explanatory Notes:
(i) The problem specifies that even if ‘Blood Bath’ is extended the theater has to pay the
regular rental of ₹1,200 on ‘Appu on the Airbus’ for the two-week period under
consideration and hence they become irrelevant for the decision making.
(ii) In case of Option 1 rental of ₹1,500 on Blood Bath for two weeks is the incremental cost
(iii) In case of Option 2 rental of ₹900 on Blood Bath for one week is the incremental cost
Illustration 12
The accountant of XYZ Ltd. has prepared the following estimate on the basis of which he has
advised that a contract should not be accepted at the price offered. The estimate (₹) was as
follows:
Material X in stock at original cost 1,50,000
Material Y on order at contract price 1,80,000
Material Z to be ordered at current price 3,00,000
Skilled Labour 5,40,000
Unskilled Labour 3,00,000
Supervisory Cost 1,00,000
General Overheads 1,80,000
Total Cost 17,50,000

Price offered 14,00,000
Net Loss (Price offered – Total Cost) 3,50,000
The following details are available about the cost components listed above.
a. Material X is an obsolete material. It can be used on another product W, the material for
which is available at ₹1,35,000 (Material X requires some adaptation to be used which
costs ₹15,000). It may take some time before W’s order is confirmed. Until then storage
will cost ₹12,000.
b. Material Y is ordered for some other product which is no longer required. It now has a
residual value of ₹1,55,000.
Skilled labour can work on other contracts which are presently operated by semi-skilled
labour at a cost of ₹4,00,000
a. Unskilled labour are specifically employed for this contract
c. Supervisory staff will remain whether or not the contract is accepted. Only two them can
replace other positions where the salary is ₹50,000.
d. Overheads are charged at 331/3% of skilled labour. Only ₹1,25,000 would be avoidable
You are required to answer the following questions using relevant cost approach:
(a) Relevant costs of material X, Y and Z
(b) Relevant cost of labour-skilled and unskilled
(c) Relevant cost of Supervisory cost and General overheads
(d) If the contract is accepted, what would be the resulting financial impact on
XYZ’s profit
Solution
(a) Relevant costs of material X, Y and Z
Material X (Obsolete)
Material X in stock at original cost = ₹1,50,000
Reuse Value = ₹ 1,35,000
Adaptation Cost = ₹15,000

Storage Cost = ₹12,000
Relevant Cost of Material X= (1,35,000 – 15,000- 12,000) = ₹ 1,08,000
Material Y (No longer required)
Material Y on order at contract price = ₹ 1,50,000
Residual Value = ₹ 1,55,000
Relevant Cost of Material Y = ₹ 1,55,000
Material Z (To be ordered)
Material Z to be ordered at current price = ₹ 3,00,000
Relevant Cost of Material Z = ₹ 3,00,000
Material X is an obsolete material but can be used as substitute of some other material
available at ₹1,35,000 after incurring an adaptation cost of ₹15,000 and Storage cost of
₹12,000.
While using Material ‘X’ for current work, these costs can be saved, so relevant cost =
1,35,000 - 15000 -12,000 = 1,08,000
Relevant cost of labour-skilled and unskilled
Skilled Labour (Can replace unskilled labour)
Cost of skilled labour = ₹ 5,40,000

Replacement Cost (in place of unskilled labour) = ₹ 4,00,000
Relevant Cost of Skilled Labour = ₹ 4,00,000
Unskilled Labour (Specifically Employed) Cost of

unskilled labour = ₹ 3,00,000
Relevant Cost of Unskilled Labour = 3,00,000
(a) Relevant cost of Supervisory cost and General overheads
Supervisory cost= ₹ 1,00,000

Replacement Value for others= ₹50,000
Relevant Supervisory Cost= ₹50,000
Avoidable General Overheads= ₹ 1,25,000
Relevant Costs of General Overheads= ₹ 1,25,000
Computation of Financial Impact

Serial Element Amount (₹)
A Price Offered 14,00,000
Relevant Costs
1. Material X 1,08,000
B 2. Material Y 1,55,000
3. Material Z 3,00,000
4. Skilled Labour 4,00,000
5. Unskilled Labour 3,00,000
6. Supervisory Cost 50,000
7. General Overheads 1,25,000
8. Total (1...7) 14,38,000
Financial Impact (A-B) (38,000)
Observation: The loss is much less than what the accountant has worked out. However, if the
contract is accepted, XYZ’s profit will be reduced by ₹ 38,000/-.
Illustration 13
CELO Company has the capacity of production of 80,000 units and presently sells 20,000
units at ₹100 each. The demand is sensitive to selling price and it has been observed that for
every reduction of ₹10 in Selling Price, the demand is doubled.
Required:
a. What should be the Target Cost at full capacity, if Profit Margin on Sale is 25%?
b. What should be the Cost Reduction Scheme at full capacity if at the present level 40% of
the cost is variable and Total Fixed Cost is ₹36 lakhs?
c. If Rate of Return desired is 16%, what will be the maximum investment at full capacity?
Solution
a. Target Cost at Full Capacity Projected Demand
Selling Price (₹ Per

Unit) Demand (Units) Capacity Utilisation
100 20,000 25%
90 (20,000 × 2) = 40,000 50%
80 (40,000 × 2) = 80,000 100%
Selling Price at Full Capacity = ₹80.00 Target Profit = 25% on Sales = ₹20.00 Target Cost at
Full Capacity = (80 – 20) = ₹ 60.00 per unit
b. Cost Reduction Scheme
(i) Computation of Variable Cost per unit At the Present Capacity of 20,000 units Selling
Price = ₹100.00 per unit
Profit Margin = 25% on Sales = ₹25.00 Total Cost = (100 – 25) = ₹ 75.00 Variable Cost =
40% of total cost
= 40% of 75 = ₹30.00
(ii) Existing Projections of Total Cost at full capacity Total Variable Cost = (₹30 × 80000) =
₹24.00 lakhs Total Fixed Cost = ₹36.00 Lakhs
Total Cost = (24.00 + 36.00) = 60.00 lakhs
(i) Target Cost = (60 × 80000) = 48.00 lakhs
(ii) Cost Reduction Scheme
Cost Reduction Needed = (Existing Cost – Target Cost) = (60.00 – 48.00) = ₹ 12.00 lakhs
c. Maximum Investment at full capacity

(i) Target Profit at full Capacity
Sales = 80.00 × 80,000 units = ₹64.00
lakhs Target Cost = ₹48.00 lakhs
Target Profit = (64.00 – 48.00) = ₹16.00 lakhs
(ii) Rate of Return on Investment = 16%
(iii) Minimum Investment
Investment Needed = (Target Profit ÷ Target Return on Investment) = (16.00 ÷ 16%)
= ₹ 100.00 lakhs
Illustration 14
A manufacturing company “Bee” sells its product at ₹1,000 per unit. Due to competition, its
competitors are likely to reduce price by 15%. Bee wants to respond aggressively by cutting
price by 20% and expects that the present volume of 1,50,000 units p.a. will increase to
2,00,000. Bee wants to earn a 10% target profit on sales. Based on a detailed value
engineering the comparative position is given below:
Particulars Existing (₹) Target (₹)

Direct material cost per unit 400 385
Direct manufacturing labour per unit 55 50
Direct machinery costs per unit 70 60
Direct manufacturing costs per unit 525 495
Manufacturing overheads :
No. of orders (₹80 per order) 22,500 21,250
Testing hours (₹2 per hour) 4,500,000 3,000,000
Units reworked (₹100 per unit) 12,000 13,000

Manufacturing overheads are allocated using relevant cost drivers. Other operating costs per
unit for the expected volume are estimated as follows:
Research and Design ₹50
Marketing and customer service ₹130
Total ₹180
Required:
1. Calculate target costs per unit and target costs for the proposed volume showing break up
of different elements.
2. Prepare target product profitability statement

Solution
1. Calculation of target costs per unit and target costs for the proposed volume showing
break up of different elements
(a) Target Costs per Unit
Target selling price: ₹1,000 less 20% ₹800
Less: Target profit margin (10%) ₹80
Target costs per unit ₹720
(b) Elementwise break-up of ₹720 per unit
Serial Particulars ₹ Per Unit

1 Direct Manufacturing Costs
a Direct materials 385
b Direct manufacturing labour 50
c Direct machining costs 60
d Sub Total (a to c) 495
2 Manufacturing Overheads
a Ordering and receiving (21,250 × ₹80) ÷ 8.50

2,00,000
b Testing and inspection 30.00
(30,00,000 × ₹2) ÷ 2,00,000
c Rework 6.50
(13,000 × ₹100) ÷2,00,000
d Sub Total (a to c) 45
3 Total manufacturing costs (1+2) 540
4 Other operating costs
a Research and Design 50

b Marketing and Customer service 130
c Sub Total (a to b) 180
5 Total Cost (3+4) 720
2. Target Product Profitability
Serial Particulars Per unit (₹) 2,00,000 units

(₹)
1 Sales 800 16,00,00,000
2 Costs of goods sold:
a Direct materials 385 7,70,00,000
b Direct labour 50 1,00,00,000

c Direct machining costs 60 1,20,00,000
d Subtotal (a..c) 495 9,90,00,000
3 Manufacturing overheads 45 90,00,000
4 Total manufacturing costs (2+3) 540 10,80,00,000
5 Gross margin (1-4) 260 5,20,00,000
6 Other Operating costs
a Research and Design 50 1,00,00,000
b Marketing and customer service 130 2,60,00,000
b Sub Total (a..b) 180 3,60,00,000
7 Operating profit (5-6) 80 1,60,00,000
Illustration 15
Zenith Ltd. manufacturers tablet batteries. The company is preparing a product life cycle
budget for a new type of battery. Development on the new battery is to start shortly.
Estimates for the new battery are as follows
Life cycle units manufactured and sold 2,00,000
Selling price per battery ₹ 55

Life cycle costs:
R & D and design cost ₹ 8,00,000
Manufacturing:
Variable cost per battery ₹ 25
Variable cost per batch ₹ 300
Batteries per batch 250
Fixed costs ₹ 12,00,000
Marketing:
Variable cost per battery ₹ 3.50
Distribution:
Variable cost per batch ₹ 140
Batteries per batch 100
Customer service cost per battery (Variable) ₹ 1.70
Required:
(i) Calculate the budgeted life cycle operating income for the new battery.
(ii) What percentage of the budget total product life cycle costs will be incurred by the end of
the R&D and design stages?
(iii) Company’s market research department estimates that reducing price by ₹ 2.50 will
increase life cycle unit sales by 8%. If unit sale increases by 8%, the company plans to
increase manufacturing and distribution batch sizes by 8% as well. Assume that all
variable costs per battery, per batch and fixed costs will remain the same. Should the
company reduce battery price by ₹ 2.50?
Show your calculations.
Solution
(i) Statement of Budgeted Life Cycle Revenue and Costs
(a) Revenue (2,00,000 × ₹55) = ₹1,10,00,000
(b) Costs:
Element (₹)
Research and design 8,00,000
Manufacturing costs:
Variable costs ₹(25 × 200000) 50,00,000
Batch cost ₹{300 × (200000÷250)} 2,40,000
Fixed cost 12,00,000
Marketing costs:
Variable costs ₹(3.5 × 200000) 7,00,000
Fixed cost 8,00,000
Distribution costs:
Batch cost ₹{140 × (200000÷100)} 2,80,000
Fixed cost 4,60,000
Customer service [Variable] (1.7 × 200000) 3,40,000
Total cost 98,20,000
(c) Operating Income = 1,10,00,000 - 98,20,000 = ₹11,80,000
Total product life cycle costs by the end of the R&D and design stages
Budgeted product life cycle costs for R&D

₹ 8,00,000
and design
Total budgeted life cycle product costs ₹ 98,20,000
Percentage of budgeted product life cycle (8,00,000 ÷ 98,20,000) × 100 =
cost incurred till the R&D and design 8.15%
(i) Statement of Revised Budgeted Life Cycle Revenue and Costs

(a) Revenue (2,16,000 × ₹52.50) = ₹ 1,13,40,000
(b) Costs
Element (₹)
Research and design 8,00,000
Manufacturing costs:
Variable costs ₹(25 × 216000) 54,00,000
Batch cost ₹{300 × (216000 ÷ 270)) 2,40,000
Fixed cost 12,00,000
Marketing costs:
Variable costs ₹ (3.5 × 216000) 7,56,000
Fixed cost 8,00,000
Distribution costs:
Batch cost ₹{140 × (216000 ÷ 108)) 2,80,000
Fixed cost 4,60,000
Customer service [Variable](1.7 × 216000) 3,67,200
Total cost 1,03,03,200
Operating Income 10,36,800
(c) Operating Income = 1,13,40,000 – 1,03,03,200 = ₹ 10,36,800/-

Suggestion: Since profit is lower, price should not be reduced. (i.e.. ₹ 11,80,000 > ₹ 10,36,800
Illustration 16
(Computation of Equivalent Annual Cost and Identification of Year to Replace the Machine)
A & Co. is contemplating whether to replace an existing machine or to spend money on
overhauling it. A & Co. currently pays no taxes. The replacement machine costs ₹ 90,000
now and requires maintenance of ₹ 10,000 at the end of every year for eight years. At the end
of eight years, it would have a salvage value of ₹ 20,000 and would be sold. The existing
machine requires increasing amounts of maintenance each year and its salvage value falls
each year as follows:
Year Maintenance Salvage

Present % 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%. When should the company replace the
machine?
(Notes: Present value of an annuity of ₹1 per period for 8 years at interest rate of 15%:
4.4873; present value of ₹ 1 to be received after 8 years at interest rate of 15%: 0.3269)
Solution
Step1: Calculation of Equivalent Annual Cost of New Machine
Particulars Working Amount (₹)
Cost of New Machine 90,000
Add: Present value of annual maintenance cost (₹ 10,000 × 4.4873) 44,873

for 8 years
1,34,873
Deduct: Present value of salvage value at the end (₹ 20,000 × 0.3269) 6,538
of 8th year
Total present value of life cycle cost of new 1,28,335

machine
Equivalent annual cost of New Machine = ₹ 1,28,335 ÷ 4.4873 = ₹ 28,600
Step2: Calculation of Present Value of Maintenance & Salvage of Existing Machine
Maintenance (₹) Salvage Value (₹)
Year PVF @ 15% Annual Present Annual Present
Value Value Value Value
0 0 0 40,000 40,000
1 0.870 10,000 8,700 25,000 21,750
2 0.756 20,000 15,120 15,000 11,340
3 0.658 30,000 19,740 10,000 6,580
4 0.572 40,000 22,880 0 0
Step 3: Calculation of Equivalent Annual Cost of Existing Machine
PV of Opening Add: PV of Deduct: PV of Equivalent

Salvage Value Maintenance Closing Annual Cost
Year
Cost Salvage Value
1 40,000 8,700 21,750 26,950
2 21,750 15,120 11,340 25,530
3 11,340 19,740 6,580 24,500
4 6,580 22,880 0 29,460
Step 4: Comparison of Equivalent Annual Cost

Year New Machine (₹) Existing Machine (New – Existing)
(₹)
1 28,600 26950 1,650
2 28,600 25,530 3,070
3 28,600 24,500 4,100
4 28,600 29,460 (860)
Suggestion: Equivalent Annual Cost of New Machine is higher for the first 3 years and is
lower by ₹860/- in the 4th year. Therefore, it is desirable to replace the existing machine after
the third year.
Illustration17
A company has estimated the following demand level of its product:
Sales Volume (units) 10000 12000 14000 16000 18000
Probability 0.10 0.15 0.25 0.30 0.20
It has assumed that the sales price of ₹ 6 per unit, marginal cost of ₹ 3.50 per unit, and fixed
costs of ₹ 34,000. What is the probability that:
(a) The company will break-even in the period?
(b) The company will make a profit of at least ₹ 10,000?
Solution:
(a) Probability of Break-even for the period
In order to break-even, the company must earn enough total contribution to cover its fixed
costs.
The contribution is ₹ 2.50 per unit (i.e.. 6 - 3.5).
Break-even Sales = (Fixed Cost ÷ Contribution per Unit)
= (34,000 ÷ 2.50)
= 13,600 units
Contribution required/ Contribution per unit = ₹ 34,000/₹2.50
= 13600 units
The probability that sales will equal or exceed 13,600 units is the probability that sales will
be 14,000, 16,000 or 18,000 units which is (0.25 + 0.30 + 0.20) = 0.75 or 75%.
(b) Probability of earning Profit of ₹10,000
Contribution Needed = (Profit Needed + Fixed Cost)
= (10,000 + 34,000)
= ₹44,000
Desired Sales = (Contribution Needed ÷ Contribution per Unit)
= (44,000 ÷ 2.50) = 17,600 units
The probability that sales will equal or exceed 17,600 units is the probability that sales will
be 18,000 units which is 0.20 or 20%
Illustration 18
The Managing Director of Y Ltd. has evolved some decision making to the operating division
of the firm. He is anxious to extend this process but first wishes to be assured that decisions
are being taken properly in accordance with group policy. As a check on existing practice, he
has asked for an investigation to be made into a recent decision to increase the price of the
sole product of Z division to ₹ 14.50 per unit but to rising costs. The following information
and estimates were available for the management of Z division:
Last year 75,000 units were sold at ₹ 12 each with total units cost of ₹ 9 of which ₹ 6 were
variable costs. For the year ahead the following cost and demand estimates have been made:
Variable costs:
Pessimistic Probability 0.15 ₹ 7.00 per unit
Most likely Probability 0.65 ₹ 6.50 per unit
Optimistic Probability 0.20 ₹ 6.20 per unit
Total fixed costs:
Pessimistic Probability 0.3 Increase by 50%
Most likely Probability 0.5 Increase by 25%

Optimistic Probability 0.2 Increase by 10%
Demand estimates at various prices
Particulars Probability ₹ 13.50 per unit ₹ 14.50 unit

Pessimistic 0.30 45,000 35,000
Most likely 0.50 60,000 55,000
Optimistic 0.20 70,000 68,000
(Unit variable costs, fixed costs and demand estimates are statistically independent)
For this type of decision the group has decided that the option should be chosen which has
the highest expected outcome with at least an 80% chance of breaking even.
You are required
(a) to assess whether the decision was made in accordance with group guidelines,
(b) to obtain what is the group attitude to risk as evidenced by the guidelines
Solution
Contribut Total Joint Cumulat

Probabi ion per Probabil Contribut Probabil ive Joint
Situation Demand lity unit ity ion ity Probabil
ity
Selling Price ₹ 13.50
45,000 0.3 6.50 0.15 2,92,500 0.045 0.045
Pessimistic 7.00 0.65 3,15,000 0.195 0.240
7.30 0.20 3,28,500 0.060 0.300
Most Likely 60,000 0.5 6.50 0.15 3,90,000 0.075 0.375
7.00 0.65 4,20,000 0.325 0.700
7.30 0.20 4,38,000 0.100 0.800
70,000 0.2 6.50 0.15 4,55,000 0.030 0.830
Optimistic 7.00 0.65 4,90,000 0.130 0.960
7.30 0.20 5,11,000 0.040 1.000
35,000 0.3 7.50 0.15 2,62,500 0.045 0.045
Pessimistic 8.00 0.65 2,80,000 0.195 0.240
8.30 0.20 2,90,500 0.060 0.300
Most Likely 55,000 0.5 7.50 0.15 4,12,500 0.075 0.375
8.00 0.65 4,40,000 0.325 0.700
8.30 0.20 4,56,500 0.100 0.800
68,000 0.2 7.50 0.15 5,10,000 0.030 0.830
Optimistic 8.00 0.65 5,44,000 0.130 0.960
8.30 0.20 5,64,400 0.040 1.000
Last year’s fixed costs = 75,000 units × ₹ 3 = ₹ 2,25,000
Estimated Fixed Costs (₹)
₹ 2,25,000 × 1.10 × 0.2 49,500
₹ 2,25,000 × 1.25 × 0.5 1,40,625
₹ 2,25,000 × 1.50 × 0.3 1,01,250
To break-even the contribution must be equal to or greater than ₹ 2,91,375. It is noticed from
the above tables that at selling price of ₹ 13.50 there is 100% chance to break-even. However,
at selling price of ₹ 14.50 there is 70% (0.075 + 0.325 + 0.1 + 0.03 + 0.13 + 0.04) chance of
break-even. The selling price of ₹ 14.50, therefore, contravenes group guidelines.
Attitude to Risk: The group seeks to minimize the downside risk whilst maximizing its
return. It is to some extent risk averse, but it is prepared to take some risk i.e.., 20% risk of
loss. It is always sought maximize its returns, ignoring the probability of failure, it would be
risk neutral.
Illustration 19
A company produces four products, viz. P, Q, R and S. The data relating to production
activity are as under
Quantity of Material Direct Machine Direct Labour

Product production cost/ ₹. per labour hours/ unit cost/₹ per unit
unit hours/unit
P 4,500 12 2 1.50 8
Q 13,640 15 2 0.75 9
R 2,340 25 5 2.50 27
S 18,350 21 4 4.00 25
Production overheads are as under: ₹

(i) Overheads applicable to machine-oriented activity: 1,65,900
(ii) Overheads relating to ordering materials 8,760
(iii) Set up costs 21,400
(iv) Administration overheads for spare parts 44,690
(v) Material handling costs 25,545
The following further information have been compiled:
Product No. of set No. of materials No. of times No. of spare parts
up orders materials handled
P 3 3 6 6
Q 18 12 30 15
R 5 3 9 3
S 24 12 36 12
Total 50 30 81 36
Required:
(i) Select a suitable cost driver for each item of overhead expense and calculate the cost per
unit of cost driver.
(ii) Using the concept of activity-based costing, compute the factory cost per unit of each
product.
Solution
(i) Computation of Cost Driver Rates
(a) Overheads relating to Machinery oriented activity Cost Driver: Machine Hour Rate
Machine Oriented Overheads = ₹ 1,65,900
Total Machine hours = {(4500 × 1.5) + (13640 × 0.75) + (2340 × 2.5) + (18350 × 4)}
= 6750 + 10230 + 5850 + 73400
= 96230
Cost Driver Rate = (1,65,900 ÷ 96,230)
= ₹ 1.724 per hour
(ii) Computation of factory cost for each product
(a) Apportionment of Overheads on the basis of Cost Driver Rate
Sl Activity P Q R S
.
Number of Units of Production 4,500 13,640 2,340 18,350
1. Machinery oriented activity
Number of Machine Hours 6750 10230 5850 73400
Total Cost @ ₹ 1.724 per hour 11,637 17,637 10,085 1,26,542
Cost per Unit (₹) 2.586 1.293 4.31 6.896
2. Material Ordering
Number of Material Orders 3 12 3 12
Total Cost @ ₹ 292 per order 876 3,504 876 3,504
Cost per Unit (₹) 0.195 0.257 0.374 0.191
3. Set Up Cost
Number of Set Ups 3 18 5 24
Total Cost @ ₹ 428 per set up 1,284 7,704 2,140 10,272
Cost per Unit (₹) 0.285 0.565 0.915 0.56
4. Admn. Costs for Spare Parts
No. of spare parts 6 15 3 12
Total Cost @ ₹ 1241.39 per spare part 7,449 18,621 3,724 14,897
Cost per Unit (₹) 1.655 1.365 1.591 0.812
Material Handling Costs
No. of times materials are handled Total 6 30 9 36
5. Cost @ ₹315.37 per handling 1,892 9,461 2,838 11,353
Cost per Unit ( ₹) 0.42 0.694 1.213 0.619
6. Total Overheads 23,138 56,927 19,663 1,66,568
7. Overhead Cost per Unit ( ₹) 5.142 4.174 8.403 9.077
(a) Cost per Unit ( ₹)
Particulars P Q R S
Materials 12.00 15.00 25.00 21.00
Labour 8.00 9.00 27.00 25.00
Overheads
Machine oriented activity 2.586 1.293 4.310 6.896
Ordering of Materials 0.195 0.257 0.374 0.191
Set up costs 0.285 0.565 0.915 0.560
Administrative Spare Parts 1.655 1.365 1.591 0.812
Material handling 0.420 5.14 0.694 4.17 1.213 8.40 0.619 9.08
Factory Cost (₹) 25.14 28.17 60.40 55.08
Illustration 20
The budgeted overheads and cost driver volumes of XYZ are as follows.
Cost Pool Budgeted Cost Driver Budgeted

Overheads (₹ ) Volume
Material 5,80,000 No. of orders 1,100
procurement
Material handling 2,50,000 No. of movements 680
Set-up 4,15,000 No. of set ups 520
Maintenance 9,70,000 Maintenance 8,400
hours
Quality control 1,76,000 No. of inspections 900
Machinery 7,20,000 No. of machine 24,000
hours
The company has produced a batch of 2,600 components of AX-15; its material cost was ₹
1,30,000 and labour cost ₹ 2,45,000
The usage activities of the said batch are as follows:

Material orders – 26,
maintenance hours – 690,
material movements – 18,
inspections – 28,
set ups – 25,
machine hours – 1,800
Calculate – cost driver rates that are used for tracing appropriate amount of overheads to the
said batch and ascertain the cost of batch of components using Activity Based Costing.
Solution
Step1: Computation of Cost Driver Rates
Budgeted Budgeted Cost

Cost Pool (₹ ) Cost Driver Volume Workings Driver
Rate
Material 5,80,000 No. of orders 1,100 580000 ÷ 527.27
procurement 1100
Material 2,50,000 No. of 680 250000 ÷ 680 367.65
handling movements
Set-up 4,15,000 No. of set ups 520 415000 ÷ 520 798.07
Maintenance 9,70,000 Maintenance 8,400 970000 ÷ 115.48
hours 8400
Quality control 1,76,000 No. of 900 176000 ÷ 900 195.56
inspection
Machinery 7,20,000 No. of machine 24,000 720000 ÷ 30.00
hours 24000
Step 2: Apportionment of overheads to AX-15

Cost Pool Cost Driver Usage Cost Driver Workings Overheads
Volume Rate (₹)
Material No. of orders 26 527.27 26 × 527.27 13,709
procurement
Material No. of 18 367.65 18 × 367.65 6,618
handling movements
Set-up No. of set ups 25 798.07 25 × 798.07 19,952
Maintenance Maintenance 690 115.48 690 × 115.48 79,681
hours
Quality No. of 28 195.56 28 × 195.56 5,476
control inspections
Machinery No. of 1800 30.00 1800 × 30 54,000
machine hours
Total 1,79,436
Step 3: Computation of Batch Cost of 2600 units of AX-15
Sl Element (₹) (₹)

1 Material cost 1,30,000
2 Labour Cost 2,45,000
3 Prime Cost (1 + 2) 3,75,000
Overheads
4 a. Material orders 13,709
b. Material handling 6,618
c. Set-up 19,952
d. Maintenance 79,681
e. Quality Control 5,476
f. Machinery 54,000
g. Sub Total 1,79,436
5 Total Cost (3 + 4) 5,54,436
Illustration21
Precision Auto company Ltd. manufactures and sells two automobile components A and B.
Both are identical with slight variation in design. Although the market for both the products is
the same, the market share of the company for product A is very high and that of product B
very low. The company’s accountant has prepared the following profitability statement for
the two products (Cost of production: same for both the products)
Direct Material ₹ 125

Direct Labour ₹ 24
Direct Expenses (sub-contract charges) ₹ 36
Overheads (400% of direct labour) ₹ 96
Total Cost ₹ 281
Particulars Product A Product B Total
Quantity sold (in Unit) No. 1,24,000 23,150 1,47,150
Unit sale price ₹ 300 290
Total sales realization (Quantity Sold × ₹ 4,39,13,500
Unit S.P.)
Cost of sales as above ₹ 4,13,49,150
Margin ₹ 25,64,350
The company’s marketing manager, after attending a workshop on activity-based costing

challenges the accountant’s figures. The nearest competitor’s prices for the two products are
₹ 330 and ₹ 275 per unit respectively and, if the company can match the competitor’s prices,
it can sell 75,000 nos. each of the two products. The
Production Manager confirms that he can produce this product mix with the existing
facilities. The management engages you as consultant, and the following facts have been
identified by you:
a. Product A undergoes 5 operations and product B undergoes two operations by sub-

contractors, although the total subcontract charges are the same for both the products, and
b. 75% of the overheads is accounted for under three major heads relating to sub-contracting
operations, viz., ordering, inspection and movement of components, to and from the sub-
contractor’s works.
Prepare a revised profitability statement to find out if the marketing manager’s proposal is
viable.
Solution
Step (i): Segregation of Overheads
Total Overheads = (1,47,150 units × ₹ 96)
= ₹ 1,41,26,400
Overheads relating to sub-contracting operations = 75% of the total overheads
= (14126400 × 75/100)
= ₹ 1,05,94,800
Balance of 25% of the overheads, viz. other Overheads = (14126400 × 25/100)
= ₹ 35,31,600
Step (ii): Revision in apportionment of Overheads
Under the ABC refinement, Overheads relating to sub-contracting operations may be

apportioned on the basis of number of operations and Factory Overheads may be apportioned
on per unit basis. Considering the revised product mix of 75,000 units of A and 75,000 units
of B, and the total overheads remaining unchanged, the apportionment of overheads may be
reworked as follows
Sub-contacting overheads for A = (1,05,94,800 × 5/7) = ₹ 75,67,714 Or (75,67,714 ÷ 75,000)

= ₹ 100.90 per unit
Sub-contacting overheads for B = (1,05,94,800 × 2/7) = ₹ 30,27,086 Or (30,27,086 ÷ 75,000)

= ₹ 40.36 per unit
Factory Overheads = (35,31,600 ÷ 1,50,000) = ₹ 23.54 per unit
Step (iii): Computation of profit under Activity Based Costing
Particulars No. of A B
units 75000 75000 Total
Total P.U. Total P.U.
Materials 93,75,000 125 93,75,000 125 1,87,50,000
Labour 18,00,000 24 18,00,000 24 36,00,000
Direct expenses 27,00,000 36 27,00,000 36 54,00,000
Prime Cost 1,38,75,000 185 1,38,75,000 185 2,77,50,000
Particulars No. of A B
units 75000 75000 Total
Total P.U. Total P.U.
Sub-con 75,67,714 100.90 30,27,086 40.36 1,05,94,800
trading
Overheads
Factory Overheads 17,65,800 23.54 17,65,800 23.54 35,31,600
Total Cost 2,32,08,514 309.44 1,86,67,886 248.90 4,18,76,400
Profit 15,41,486 20.56 19,57,114 26.10 34,98,600
Sales 2,47,50,000 330 2,06,25,000 275 4,53,75,000
Step (iv): Viability Comparison
Profit as per Accountant = ₹ 25,64,350 Profit as per ABC Computation =₹

34,98,600
The profit as per the revised computation is higher by ₹ 9,34,250.
Explanatory Comments: Revision of computations under the ABC has thrown up the fact of
higher profit of ₹ 26.10 per unit of B in comparison to ₹ 20.56 per unit of A. As a strategic
consequence, quantity of A has been reduced from the level of 1,24,000 to 75,000 and
quantity of B has been increased from 23,150 to 75,000 and Thus, pushing up the total
volume from 1,47,150 units to 1,50,000 units. The sales realization has gone up from ₹
4,39,13,500 to ₹ 4,53,75,000. The ultimate result is increase in profit by ₹ 9,34,250.
Illustration22
Altra Video Company sells package of blank video tapes to its customers. It purchases video
tapes from Yash Tape Company at ₹ 150 per packet. Yash Tape Company pays all freight to
Altra Video Company. No incoming inspection is necessary because Yash Tape Company has
a superb reputation for delivery of quality merchandise. Annual demand of Altra Video
Company is 15,600 packages. Altra Video Company requires 10% annual return on its
investment. The purchase order Lead time is 2 weeks. The purchase order is passed through
internet and it costs ₹ 20 per order. The relevant insurance, material handling etc. is ₹ 10 per
package per year
Altra Video has to decide whether or not to shift to JIT purchasing. Yash Tape Company
agrees to deliver 100 packages of Video tapes 156 times per year (6 times every 2 weeks)
instead of existing delivery system of 1,200 packages 13 times a year, with additional amount
of ₹0.05 per package. Altra Video Company incurs no stock out under its current purchasing
policy. It is estimated that Altra Video Company will incur stock out cost on 50 video tape
packages under a JIT purchasing policy. In the event of stock out, Altra video company has to
rush order tape packages, which costs ₹ 8 per package. Comment whether Altra Video
Company should implement JIT purchasing system.
Ram Company also supplies video tapes. It agrees to supply at ₹ 145 per package under JIT
delivery system. If video tape is purchased from Ram Co. relevant carrying cost would be ₹ 9
per package against ₹ 10 in case of purchasing from Yash Tape Company. However, Ram
Company does not enjoy a sterling reputation for quality. Altra Video Company anticipates
the following negative aspects of purchasing tapes from Ram Company.
1. Incurring additional inspection cost of ₹ 0.05 per package.
2. Average stock out of 360 tape packages per year would occur, largely resulting from late
deliveries. Ram Company. cannot rush order at short notice. Altra Video Company
anticipates lost contribution margin per package of ₹ 10 from stock out.
3. Customers would likely return 2% of all packages due to poor quality of the tape and
to handle this return, an additional cost of ₹ 25 per package would be incurred.
Comment on whether Altra Video Company can place an order with Ram Company.
Solution
(i) Computation of Carrying Costs
Current JIT with JIT with

SL Particulars Policy Yash Tape Ram
Co. Co.
1 Interest ( ₹)
a. Cost per Package 150.00 150.05 145.00
b. Interest @ 10% on (a) 15.00 15.005 14.50
2 Insurance, Material Handling, etc. 10.00 10.00 9.00
3 Carrying Cost p.u. p.a. (1 + 2) 25.00 25.005 23.50
4 Average Inventory
a. Quantity per Order 1200 100 100
b. Average Inventory @ 50% of the 600 50 50
order
5 Annual Carrying Costs (₹) = 15,000 1250.25 1175
[3 × 4 (b)]
(ii) Comparative Statement of Total Relevant Costs
Current JIT with JIT with

SL Particulars Policy Yash Tape Ram Co.
Co.
1 Cost of Tapes
a. Cost per Tape ( ₹) 150.00 150.05 145.00
b. Cost per 15,600 (a × 15,600) 23,40,000 23,40,780 22,62,000
2 Ordering Costs
a. Ordering Cost per Order (₹) 20.00 20.00 20.00
b. Number order per annum 13 156 156
c. Ordering Costs per annum (₹) 260 3,120 3,120
(a × b)
3 Annual Carrying Costs (₹) 15,000 1250 1175
4 Stockout Costs
a. Number of Packages Nil 50 360
b. Loss per package - 8 10
c. Stockout Costs (₹) = (a × b) Nil 400 3600
5 Inspection Costs
a. Number of Packages Nil Nil 15600
b. Cost per package - - 0.05
c. Inspection Costs (₹) = (a × b) Nil Nil 780
6 Customer Return Costs
a. Number of Packages Nil Nil 15600
15600 x 2%
b. Number of Returns - - = 312
c. Cost per Return (₹) Nil Nil 25
d. Customer Return Costs (₹) = (b 7,800
× c)
7 Total Costs (₹ ) 23,55,260 23,45,550 22,78,475
Observations & Comments
a. Cost Saving of implementing JIT purchasing system with Yash Tape Co = ( ₹ 23,55,260 -
₹ 23,45,550) = ₹ 9,710
Hence, implementation of JIT system is recommended.
b. Amongst the three alternatives JIT with Ram Company results in the least total cost. Hence
order may be placed with Ram Company.
Illustration23
Cat Co makes a product using three machines – X, Y and Z. The product has to pass through
all the three machines.
The capacity of each machine is as follows:
X Y Z
Machine capacity per week (in units) 800 600 500
The demand for the product is 1,000 units per week. For every additional unit sold per week,
profit increases by ₹50,000. Cat Co is considering the following possible purchases (they are
not mutually exclusive hence combination of multiple Proposals are to be evaluated):
Proposal 1: Replace machine X with a newer model. This will increase capacity to 1,100
units per week and costs ₹60 Lakhs.
Proposal 2: Invest in a second machine Y, increasing capacity by 550 units per week. The
cost of this machine would be ₹68 Lakhs.
Proposal 3: Upgrade machine Z at a cost of ₹75 Lakhs, thereby increasing capacity to 1,050
units.
Required: Which is Cat Co’s best course of action under throughput accounting?
Solution
Since the product has to pass through all the machines, machine capacity is the bottleneck.
Bottleneck resource in order of preference is firstly machine ‘Z’, secondly machine ‘Y’ and
lastly machine ‘X’ because the no. of units is in that order in the existing capacity.
Particulars Proposal X Y Z Demand

Current capacity per week - 800 600 500* 1,000
Buy X 1 1,100 600 500* 1,000
Buy Y 2 800 1,150 500* 1,000
Buy Z 3 800 600* 1,050 1,000
Buy X & Z 1, 3 1,100 600* 1,050 1,000
Buy X & Y 1, 2 1,100 1,150 500* 1000
Buy Z & Y 2, 3 800* 1,150 1,050 1,000
Buy Z, Y & X 1, 2, 3 1,100 1,150 1,050 1,000*
* = bottleneck resource
Therefore, all the three machines are to be purchased in the above order to meet the existing
demand.
[Note: It can be seen that under Throughput Costing, decision is taken on the basis of
capacity and not on the basis of Capital Cost and Profit Amount]
Illustration24
A factory has a key resource (bottleneck) of Facility A which is available for 31,300 minutes
per week. Budgeted factory costs and data on two products, X and Y, are shown below:
Product Selling Price/Unit Material Time in Facility A

Cost/Unit
X ₹ 35 ₹ 20 5 minutes
Y ₹ 35 ₹ 17.50 10 minutes
Budgeted factory costs per week:
₹
Direct labour 25,000
Indirect labour 12,500
Power 1,750
Depreciation 22,500
Space cost 8,000
Engineering 3,500
Administration 5,000
Actual production during the last week is 4,750 units of product X and 650 units of product
Y. Actual factory cost was ₹ 78,250.
Calculate:
(i) Total factory costs (TFC)
(ii) Cost per factory minute
(iii) Return per Factory Minute for both products
(iv) TA ratios for both products
(v) Throughput cost per week
(vi) Efficiency ratio
Solution:
(i) Total Factory Costs = (Total of all costs except materials)
= ( ₹ 25,000 + ₹ 12,500 + ₹ 1,750 + ₹ 22,500 + ₹ 8,000 + ₹ 3,500 + ₹ 5,000)
= ₹ 78,250
(i) Cost per factory minute =
(ii) Return per bottleneck minute

(a) Return per bottleneck minute for Product X =
Explanatory Observations
(i) TA ratio of Product X is greater than 1 (1.20) and hence increasing the production of X
will be more profitable
(ii) TA ratio of Product Y is less than 1 (0.75) and hence decreasing the production of Y will
reduce the losses and be more profitable)
(iii) Standard minutes of throughput for the week:
= [4,750 × 5] + [650 × 10]

= 23,750 + 6,500
= 30,250 minutes
Throughput cost per week = 30,250 × ₹ 2.5 per minute
= ₹ 75,625
Explanatory Observations
The bottleneck resource of Facility A is available for 31,300 minutes per week but produced
only 30,250 standard minutes. This could be due to:
(i) The process of a ‘wandering’ bottleneck causing facility A to be

underutilized.
(ii) Inefficiency in facility A)
Note:
Wandering Bottleneck is a bottleneck emerging due to change in product mix
Illustration 25
T Ltd, produces a product which passes through two processes - cutting and finishing. The
following information is provided:
Cutting Finishing
Hours available per annum 50,000 60,000
Hours needed per unit of product 5 12
Fixed operating costs per annum excluding direct 10,00,000 10,00,000

material (`)
The selling price of the product is ` 1,000 per unit and the only variable cost per unit is direct
material, which costs ` 400 per unit. There is demand for all units produced.
Evaluate each of the following proposals independent of each other:
(i) An outside agency is willing to do the finishing operation of any number of units between
5,000 and 7,000 at ` 400 per unit.
(ii) Another outside agency is willing to do the cutting operation of 2,000 units at ` 200 per
unit
(iii) Additional equipment for cutting can be bought for ` 10,00,000 to increase the cutting
facility by 50,000 hours, with annual fixed costs increased by ` 2 lakhs.
Solution
Cutting process capacity = 50,000 hours ÷ 5 = 10,000 units
Finishing process capacity = 60,000 hours ÷ 12 = 5,000 units
Throughput contribution per unit = (Selling Price – Material Cost)
= ( ` 1,000 – ` 400) = ` 600 per unit
Observation: Finishing capacity (5,000 units) is less than the cutting capacity (10,000 units).
Therefore, Finishing Capacity is the bottleneck resource.
Alternative-I: If an outside agency is willing to do the finishing operation of any number of

units between 5,000 and 7,000
Increase in throughput contribution per unit
= (Throughput contribution - Subcontracting charges)
= ( ` 600 – ` 400) = ` 200
Throughput Contribution for 5,000 units = (5000 × 200) = ` 10,00,000

Throughput Contribution for 7,000 units = (7000 × 200) = ` 14,00,000
Observation:
Increase in throughput contribution is higher than the fixed operating costs of ` 10,00,000-
per annum beyond 5,000 level of subcontracting. Therefore, subcontracting above the 5,000
level is beneficial.
Alternative-II: If an outside agency is willing to do the cutting operation

The capacity of cutting process is 10,000 unis as against the finishing capacity of 5,000 units.
Cutting is not the bottleneck and hence outsourcing is not beneficial.
Alternative-III: Installation of additional equipment for cutting process.
The cutting process has surplus capacity. It is, therefore, suggested not to increase non-
bottleneck capacity.
Illustration 26
The manufacturing cost information for March for a division of XYZ Co. is as follows:
Cost incurred in March ` ‘000

Purchase of Raw Materials 4,250
Labour 2,800
Overheads 1,640
Activity in March Units (‘000)
Finished goods manufactured during the period 180
Sales 145
Standard cost per unit `
Materials 20
Labour 15
Overheads 9
Total 44
There were no opening stocks of raw materials, WIP or finished goods. It should be assumed
that there are no direct materials variance for the period. Show the relevant Journal entries
and ledger accounts in Variant 1 and Variant 2 of backflush system.
Solution
Variant 1 (Entries when there are two trigger points): The double entry would be as follows
Serial Particulars Dr. ` ‘000 Cr. ` ‘000

1 RIP account To, Creditor 4,250
4,250
Conversion Cost account To, Cash

2 To, Cash/creditor 4,440 2,800
1,640
FG account (180 × 44)

3 To, RIP account (180 × 20) 7,920 3,600
To, Conversion Cost account (180 × 24) 4,320
4 COGS (145 × 44) 6,380

To, FG account 6,380
The ledger would appear as follows
Raw and in process materials A/c
Particulars ` ‘000 Particulars ` ‘000

To, Creditor 4,250 By, FG 3,600
By, Bal c/d 650
4,250 4,250
Bal c/d 650
Conversion costs A/c

To, Cash/Creditor 4,440 By, FG 4,320
Bal c/d 120
4,440 4,440
To, Bal c/d 120
Finished goods A/c
To, RIP 3,600 By, COGS 6,380
To, Conversion Cost 4,320 By, Bal c/d 1,540
7,920 7,920
To, Bal c/d 1,540
Cost of goods sold A/c Cr.
To, FG 6,380 By, Sales 6,380
6,380 6,380
The stock balances at the end of March would be
` ‘000
Raw and in process material 650
Finished goods 1,540
2,190
The balance on the Conversion Cost (CC) Account will be carried forward and written off at
the end of the year.
Variant 2: Accounting entries where there is only one trigger point (i.e.,on completion of
units):
Dr. ` ‘000 Cr. ` ‘000

1 Conversion Cost account To, Cash Dr. 4,440
To, Cash/creditor 2,800
1,640
2 FG account (180 × 44) Dr. 7,920
To, RIP account (180 × 20)
3,600
To, Conversion Cost account (180 ×
24) 4,320
3 COGS Dr. 6,380

To, FG account 6,380
Variant 2 is, thus, suitable for JIT system with minimal raw materials stocks.
Illustration 27
The concepts of Sales Price Planning Variance and Sales Operating Variance are explained
by means of the following illustration
Budget Sale Revised Actual Sales Budget Sale Actual Sale

Product Price (₹) Sales Price Price (₹) Units Units
(₹)
P1 20 15 18 2000 1900
P2 25 30 25 2000 2300
P3 25 27 28 2000 2000
Sales Price Planning Variance
= Actual Sale Units (Revised Sale Price – Budget Sale Price)
Product Actual Sale Revised Sales Price Sales Price Planning Nature
Units - Budget Sale Price Variance
P1 1900 (15 -20) = -5 1900 × -5 = -9500 Adverse
P2 2300 (30 -25) = 5 2300 × 5 = 11500 Favourable
P3 2000 (27 -25) = 2 2000 × 2 = 4000 Favourable
Total 6000 Favourable
Sales Price Operating Variance
= Actual Sale Units (Actual Sale Price – Revised Sale Price)
Product Actual Sale Actual Sales Price - Sales Price Nature

Units Revised Sale Price Planning Variance
P1 1900 (18 - 15) = 3 1900 × 3 = 5700 Favourable
P2 2300 (25 - 30) = -5 2300 × - 5 = -11500 Adverse
P3 2000 (28 - 27) = 1 2000 × 1 = 2000 Favourable
Total -3800 Adverse
There are a number of factors causing a change in the product costs to change. These factors
can be planned or unplanned events. A change in the cost of any product will compel the
management to change the selling price. The budgeted or standard selling price will need to
be revised; the difference in the selling price for actual number of units sold will then give the
variance in the sale price planning.
There are a number of factors causing a change in the product costs to change. These factors
can be planned or unplanned events. A change in the cost of any product will compel the
management to change the selling price. The budgeted or standard selling price will need to
be revised; the difference in the selling price for actual number of units sold will then give the
variance in the sale price planning.
Causes for sales price planning variance include:
 Change in the raw materials prices, compelling management to revise sale prices
significantly
 Inefficient operations or unskilled labour, causes the product prices to rise or conversely
efficient production to control the costs
 Market competition, with fewer competitors likely to achieve favourable sale price
variance and intense competition to result in adverse
Planning and Operating Variances for Material and Labour Costs

In case of materials and labour, planning and operational variances can be calculated by
comparing original and revised budgets (planning) and revised budgets with actual results
(operational).
A material price planning variance is really useful to provide feedback on just how skilled
managers are in estimating future prices.
The operational variance is more meaningful as it measures the purchasing department’s

efficiency given the market conditions that prevailed at that time.
It ignores factors which cannot be controlled by purchasing department
Illustration 28
Green Chemicals produces agriculture fertilizers with following information provided. The
management analysed past data and set the budgeted rates as following:
Standard hours per unit of product = 1.1 Standard direct labour rate per hour = ₹ 18.50
Standard usage of material per unit = 1.2 kg per unit Standard price of material per unit = ₹
70
Revised price of material per unit = ₹ 71
Revised labour rate per hour = ₹ 20 per hour Revised hours per unit of product = 1.05
Revised usage of material per unit = 1.175 kg per unit
After the production period the company recorded the following actual results: Actual
Production = 15,400
Raw Material usage = 16,555 KGs
Actual cost of raw material = ₹ 11,91,960 or ₹ 72 per KG
Actual labour costs= 16,632 hours and ₹ 3,24,324 or ₹ 19.50 per hour.
Calculate the Raw Material and Direct labour Planning & Operational Variances.
Solution
(i) Calculation of Raw Material Price Variances
Raw Material Price Variance
= Actual Quantity (Standard Price - Actual Price)
=16555 (70 – 72)

= ₹ 33,110 Adverse
Raw Material Price Planning variance
= Actual Quantity (Standard Price - Revised Price)
= 16555 (70 - 71)
= ₹ 16,555 Adverse
Raw Material Price Operational variance
= Actual Quantity (Revised Price – Actual Price)
= 16555 (71 – 70)

= ₹ 16,555 Adverse
Check
Raw Material Price Variance
= Sum of Planning Variance and Operational Variance
= (₹ 16,555 Adverse + ₹ 16,555 Adverse)
= ₹ 33,110 Adverse
(ii) Calculation of Raw Material Usage Variances
Raw Material Usage Variance
= Standard Price (Standard Quantity – Actual Quantity)
=70 [(15400 × 1.2) - 16555]
= 70 (18480 - 16555)
= ₹ 1,34,750 Favourable
Raw Material Usage Planning Variance
= Standard Price (Standard Quantity - Revised Quantity)
=70 [(15400 × 1.2) - [(15400 × 1.175)]
= 70 (18480 - 18095)
= ₹ 26,950
Favourable Raw Material Usage
Operational Variance
= Standard Price (Revised Quantity - Actual Quantity)
=70 [(15400 × 1.175) -16555]
=70 (18095 -16555)
Check
Raw Material Usage Variance
= (₹ 26,950 Favourable + ₹ 1,07,800 Favourable)
= ₹ 1,34,750
Favourable Raw Material Variance
= Standard Cost – Actual Cost
= (15400 units × 1.2 kg × ₹ 70) – (11,91,960)
= (12,93,600 – 11,91,960)
Or
Raw Material Variance
= Sum of Price Variance and Usage Variance
= (₹ 33,110 Adverse + ₹ 1,34,750 Favourable)
(iii) Calculation of Labour Rate Variances

Direct Labour Rate Variance
= Actual Hours (Standard Rate - Actual Rate)
=16632 (18.50 – 19.50)
= ₹ 16,632
Adverse Direct Labour Rate Planning
variance
= Actual Hours (Standard Rate - Revised Rate)
= 16632 (18.50 - 20.00)
= ₹ 24,948
Adverse Direct Labour Rate
operational variance
= Actual Hours (Revised Rate – Actual Rate
= 16632 (20.00 – 19.50)
= ₹ 8,316 Favourable
Check
Direct Labour Rate Variance
= (₹ 24,948 Adverse + ₹ 8,316 Favourable)
= ₹ 16,632 Adverse
Calculation of Labour Efficiency Variances
Direct Labour Efficiency Variance
= Standard Rate (Standard Hours – Actual Hours)

=18.50 [(15400 × 1.1) - 16632]
= 18.50 (16940 - 16632)
= ₹ 5698 Favourable Direct labour Efficiency Planning Variance
= Standard Rate (Standard Hours - Revised Hours)
=18.50 [(15400 × 1.1) - [(15400 × .05)]
= 18.50 (16940 -16170)
= ₹ 14,245 Favourable Direct Labour Efficiency Operational Variance
= Standard Rate (Revised Hours - Actual Hours)
= 18.50 [(15400 × 1.05) -16632]
= 18.50 (16170 -16632)
= ₹ 8547 Adverse
Check
Direct Labour Efficiency Variance
= (₹ 14,245 Favourable + ₹ 8,547 Adverse)
= ₹ 5698 Favourable Direct Labour Variance
= Standard Cost – Actual Cost
= (15400 units × 1.1 hours × ₹ 18.50) – (16632 hours × 19.50)
= (3,13,390 – 3,24,324)
= ₹ 10,934 Adverse Or
Direct Labour Variance
= Sum of Rate Variance and Efficiency Variance

= (₹ 16,632 Adverse + ₹ 5698 Favourable)
= ₹ 10,934 Adverse
(i) Summary
The summary of variances may be presented in a tabular form as follows:
Serial Description Planning Operational Total

1 Raw Material
Raw Material Price
a 16,555 (A) 16,555 (A) 33,110 (A)
Variance
b Raw Material Usage 26,950 (F) 1,07,800 (F) 1,34,750 (F)
Variance
c Sub Total 10,395 (F) 91,245 (F) 1,01,640 (F)

2 Direct Labour
Direct Labour Rate
a 24,948 (A) 8,316 (F) 16,632 (A)
Variance
Direct Labour
b 14,245 (F) 8547 (A) 5,698 (F)
Efficiency
Variance
c Sub Total 10,703 (A) 231 (A) 10,934 (A)
3 Total 308 (A) 91,014 (F) 90,706 (F)
(i) Observations
(a) The planning variance consists of ₹ 10,395 (Favourable) with respect to Raw
Material and ₹ 10,703 (Adverse) in relation to Direct Labour, both together
aggregating to ₹ 308 (Adverse). Even though the variance looks smaller at the
aggregate level, it is substantial at the element level and hence needs further
probing as to the causes and effects.
(b) The operational variance consists of ₹ 91,245 (Favourable) with respect to Raw
Material and ₹ 231 (Adverse) in relation to Direct Labour, both together
aggregating to ₹ 91,014 (Favourable). Favourable Direct Labour Operational
Variance of ₹ 8,316 is neutralized by Adverse Direct Labour Efficiency Operational
Variance of ₹ 8,547. Therefore, all the elements of variance (material as also
labour) warrant further probing as to the causes and effects.
(ii) Revision of original proposition is the basic cause for the Planning and Operational
variances to occur. The analysis, as demonstrated in the earlier illustrations, can be
extended to each and every element of revenue and cost, both direct and indirect.
Competitive markets demand responsive actions to adjust to the market trends. A
careful interpretation of the planning variances can help the planners to identify the
reasoning for the change. Study of operating variances encourages operational
managers to achieve efficiency in production processes.
(iv) Controllable and Non-Controllable Variances

(v) The variance may be classified as Controllable and Uncontrollable., depending upon the
controllability of the factors causing variances.
controllable Variance uncontrollable variations

it is identified as the primary are due to the factors beyond the control
responsibility of
of a particular person or department. the concerned person or department
These factors are not within the
It refers to the deviation caused by such
control of the management and the
factors which could be influenced by the
responsibility of the variance cannot
managerial/ executive action.
be assigned to any
particular person or division
The rise in prices of materials,
For example, the excessive use of
increase in wage rates, Govt.
materials or labour hours than the
restrictions etc
standards can be
attributable to a particular person.
This revision variance is the difference between the standard cost originally set and the
revised standard cost.
The size of controllable variance reflects the degree of efficiency of the person/department. It
is the controllable variance with which the management is concerned because it needs
remedial measures.
Relevant Cost Approach to Variance Analysis
A relevant cost for a particular decision is the one that changes the result if an alternative
course of action is chosen. Studies have demonstrated that relevant costs will make a
difference in decision making. And, therefore, a similar approach is advocated in variance
analysis too
The fundamental principles of relevant costing are quite simple and managers can perhaps
relate the concept relevancy to variance analysis.
Costs are relevant, if they direct the executive towards the decision.
Variance Analysis under Marginal Costing and Absorption Costing
Absorption Marginal Costing
we use single overhead absorption rate to is a very important technique in solving

absorb overheads, because of the fact that managerial problems and contributing in
overheads are not segregated into variable various areas of decisions
and fixed
Variances will occur if the absorption rate is Marginal costing distinguishes between
incorrect (just as we will get over/under- fixed costs and variable costs which in turn
absorption) facilitates the analysis of variances to their
causes and points of incidence
In that it takes a leap forward, from the
absorption costing, and classifies overhead
we calculate the overhead
(indirect cost) variance into:
expenditure variance and the
overhead volume variance a. Variable Overhead Variance
b. Fixed Overhead Variance
Overhead volume variance can, further, be

split into a capacity variance and efficiency
variance
Variable Overhead Varianc

is the difference between the standard variable overhead cost allowed for the actual output
achieved and the actual variable overhead cost.
This variance is represented by expenditure variance only because variable overhead cost will
vary in proportion to production whereby only a change in expenditure can cause such
variance. The derivation may be expressed as:
Variable Overhead Variance = (Actual Output × Standard Variable Overhead

Rate) – (Actual Variable Overheads)
Overhead Efficiency Variance. The derivations may be expressed as
(Actual Units × Standard Variable Overhead Rate) –

Variable Overhead Expenditure (Actual Units × Actual Variable Overhead Rate)
Variance
Or
AU × (SR – AR)
Variable Overhead Efficiency Standard Variable Overhead Rate per unit ×

Variance (Standard Units for Actual Production - Actual
=
Units)
Variable overhead expenditure variance resembles the rate variance is calculated in a similar
manner:
Fixed Overhead Variance:

Fixed Overhead Variance is that portion of total overhead cost variance which is due to the
difference between the standard cost of fixed overhead allowed for the actual output achieved
and the actual fixed overhead cost incurred. The derivation may be expressed as:
Fixed Overheads Absorbed – Actual Fixed Overheads

Fixed Overhead Variance = Or
(SU × SR) – (AU × AR)
Fixed overhead variance can be sub divided into Fixed Overhead Expenditure Variance and
Fixed Overhead Volume Variance
Fixed Overhead Expenditure Variance:

Fixed Overhead Expenditure Variance is that portion of the fixed overhead variance which is
due to the difference between the budgeted fixed overheads and the actual fixed overheads
incurred during a particular period. The derivation may be expressed as:
Fixed Overhead Budgeted Fixed Overheads – Actual Fixed Overheads Or

Expenditure Variance = AU × (SR - AR)
Expenditure variance may arise on account of rise in general price level, changes in
production methods, ineffective control, etc
Fixed Overhead Volume Variance:
Fixed Overhead Volume Variance is that portion of the fixed overhead variance which arises
due to the difference between the standard cost of fixed overhead allowed for the actual
output and the budgeted fixed overheads for the period during which the actual output has
been achieved.
The derivation may be expressed as:
Fixed Overhead Volume Standard Rate (Actual Units - Budgeted Units) Or
Variance SR (AU – BU)
=
Capacity Variance:
Capacity Variance is that portion of the volume variance which is due to working at higher or
lower capacity than the budgeted capacity. In other words, this variance is related to the under
and over utilisation of plant and equipment and arises due to idle time, strikes and lock-out,
break-down of the machinery, power failure, shortage of materials and labour, absenteeism,
overtime, changes in number of shifts. In short, the variance arises due to more or less
working hours than the budgeted working hours.
Fixed Overhead Capacity = Standard Fixed Overhead Rate per Unit ×
Variance (Budgeted Units – Actual Units)
Calendar Variance:
Calendar Variance is that portion of the volume variance which is due to the difference
between the number of working days in the budget period and the number of actual working
days in the period to which the budget is applicable. If the actual working days are more than
the standard working days, the variance will be favourable and vice versa if the actual
working days are less than the standard days.
Fixed Overhead Calendar = Standard Rate Per Hour or Per Day ×
Variance Excess or Deficit Hours or Days Worked
Fixed Overhead Efficiency Variance:

Fixed Overhead Efficiency Variance is that portion of the volume variance which is due to
the difference between the budgeted efficiency of production and the actual efficiency
achieved. This variance is related to the efficiency of workers and plant.
Standard Rate per Unit × (Actual Production in Units –
Standard Production in Units)
Fixed Overhead Efficiency =
Variance or
SR × (AU – SU)
Activity Ratios
Absolute figures in themselves do not give the full picture and it is only by comparison of
one item with another that their correct relationship is obtained.
Variance Ratios serve this need and comparison of these ratios from one period to another
can be gainfully made.
Another advantage of Variance Ratio is in regard to its applicability in the dual plan of
standard cost accounting.
Capacity
Efficiency Activity Calendar Capacity Idle Time
Utilization
Ratio Ratio Ratio Usage Ratio Ratio
Ratio
Efficiency Ratio: Efficiency ratio reveals the input-output relationship. Input is available in
terms of hours worked. Output is converted into standard hours to determine the relationship
of input and output
Efficiency Ratio = Standard Hours

× 100
Actual Hours
1. Activity Ratio: Activity Ratio is the number of standard hours equivalent to the output
produced, expressed as a percentage of the budgeted standard hours.
Activity Ratio = Standard Hours for Actual Work

× 100
Budgeted Standard Hours
The following three steps are involved in determining this ratio:
a. Actual output should be expressed in terms of standard hours.
b. Budgeted output should be expressed in standard hours.
c. Percentage relationship of (a) and (b) should be expressed.
This ratio highlights the actual level of activity in comparison to budgeted activity level. This
ratio reveals how effectively or ineffectively actual efforts were made in comparison to
budgeted estimates.
2. Calendar Ratio: Calendar Ratio is the relationship between the number of working
days in a period and the number of working days in the relative budget period.
Calendar Ratio = Actual Working Days

× 100
Budgeted Working Days
Calendar ratio indicates whether all the budgeted working days in a budgeted period have
been available in actual practice. If the ratio is more than 100% actual working days are more
than the budgeted working days and vice versa
Calendar ratio indicates whether all the budgeted working days in a budgeted period have
been available in actual practice. If the ratio is more than 100% actual working days are more
than the budgeted working days and vice versa
Capacity Usage Ratio = Budgeted Hours
× 100
Maximum Possible Hours in Budget
Capacity usage ratio indicates the extent to which the budgeted hours have actually been
utilised.
(a) Capacity Utilisation Ratio: It is the relationship between actual hours in a budget
period and the budgeted working hours in the period.
Capacity Utilisation Ratio = Actual Hours

× 100
Budgeted Hours
Idle Time ratio: It is the ratio of idle time hours to the total hours budgeted
Idle Time ratio = Idle Time Hours

× 100
Budgeted Hours
Illustration 29
A company manufacturing a special type of fencing tile 12” × 8” × 1/2” used a system of
standard costing. The standard mix of the compound used for making the tiles is:
1,200 kg. of material A @ ₹ 0.30 per kg. 500 kg. of Material B @ ₹ 0.60 per kg 800 kg. of
Material C @ ₹ 0.70 per kg
The compound should produce 12,000 square feet of tiles of 1/2” thickness. During a period
in which 1,00,000 tiles of the standard size were produced, the material usage was:-
Kg ₹
7,000 Material A @ ₹ 0.32 per kg. 2,240
3,000 Material B @ ₹ 0.65 per kg. 1,950
5,000 Material C @ ₹ 0.75 per kg. 3,750
15,000 7,940
Present the cost figures for the period showing Material price, Mixture, Sub-usage Variance.
Solution
Step (i): Number of tiles for 12,000 sq ft.
Area of one tile =12” × 8”
= 96”
= (96÷144) sq ft
= 2/3 sq ft
Number of tiles that can be laid in 12000 sq ft is {12000 ÷ (2/3)} = 18000
Step (ii): Standard and Actual Material for 1,00,000 tiles
Standard Data Actual Data
Material Qty Price Value Qty Price Value
(1200 ÷
A 18,000) ×
0.30 2,000 7,000
1,00,000
= 6,666.67
2,240
0.32
(500 ÷ 18,000) ×
B 1,00,000 0.60 1,667 3,000 0.65 1,950
= 2,777.77
(800 ÷ 18,000) ×
C 1,00,000 0.70 3,111 5,000 0.75 3,750
= 4,444.44
Total 13,888.89 6,778 15,000 7,940
Step (iii): Revised Standard quantities (RSQ) for 1,00,000 tiles
RSQ for A = (15000÷13888.89) × 6666. 67 = 7200
RSQ for B = (15000÷13888.89) × 2777.77 = 3000
RSQ for C = (15000÷13888.89) × 4444.44 = 4800
Step (iv): Analysis of Computed Data

Material SQSP RSQSP AQSP AQAP
A 7,200 × 0.3 = 2,160 7,000 × 0.3 = 2,100
B 3,000 × 0.6 = 1,800 3,000 × 0.6 = 1,800
C 4,800 × 0.7 = 3,360 5,000 × 0.7 = 3,500
Total 6,778 7,320 7,400 7,940
Step (v): Computation of Variances
a. Material Sub-Usage Variance = (SQSP – RSQSP)
= (6778 - 7320) = ₹ 542(A)
b. Material Mix Variance = (RSQSP – AQSP)
= (7320 - 7400) = ₹ 80(A)
c. Material Usage Variance = (SQSP – AQSP)
= (6778 - 7400) = ₹ 622(A)
d. Material Price Variance = (AQSP-AQAP)
= (7400 - 7940) = ₹ 540(A)
e. Material Cost Variance = (SQSP – AQAP)
= (6778 – 7940) = ₹ 1162(A)
Check:
Material Usage Variance = (Material Sub-Usage Variance + Material Mix Variance) i.e.,
622(A) = 542(A)+ 80(A)
Material Cost Variance = (Material Usage Variance + Material Price Variance)
i.e., 1162(A) = 622(A) + 540(A)
Illustration 30
CELO Company has the capacity of production of 80,000 units and presently sells 20,000
units at ₹100 each. The demand is sensitive to selling price and it has been observed that for
every reduction of ₹10 in Selling Price, the demand is doubled.
Required:
a. What should be the Target Cost at full capacity, if Profit Margin on Sale is 25%?
b. What should be the Cost Reduction Scheme at full capacity if at the present level 40% of
the cost is variable and Total Fixed Cost is ₹36 lakhs?
c. If Rate of Return desired is 16%, what will be the maximum investment at full capacity?
Solution
a. Target Cost at Full Capacity Projected Demand
Selling Price (₹ Per
Unit) Demand (Units) Capacity Utilisation
100 20,000 25%
90 (20,000 × 2) = 40,000 50%
80 (40,000 × 2) = 80,000 100%
Selling Price at Full Capacity = ₹80.00 Target Profit = 25% on Sales = ₹20.00 Target Cost at
Full Capacity = (80 – 20) = ₹ 60.00 per unit
b. Cost Reduction Scheme
(i) Computation of Variable Cost per unit At the Present Capacity of 20,000 units Selling Price
= ₹100.00 per unit
Profit Margin = 25% on Sales = ₹25.00 Total Cost = (100 – 25) = ₹ 75.00 Variable Cost =
40% of total cost
= 40% of 75 = ₹30.00
(ii) Existing Projections of Total Cost at full capacity
Total Variable Cost = (₹30 × 80000) =
₹24.00 lakhs Total Fixed Cost = ₹36.00 Lakhs
Total Cost = (24.00 + 36.00) = 60.00 lakhs
(i) Target Cost = (60 × 80000) = 48.00 lakhs
(ii) Cost Reduction Scheme
Cost Reduction Needed = (Existing Cost – Target Cost) = (60.00 – 48.00) = ₹ 12.00 lakhs
c. Maximum Investment at full capacity

(i) Target Profit at full Capacity
Sales = 80.00 × 80,000 units = ₹64.00 lakhs Target Cost = ₹48.00 lakhs
Target Profit = (64.00 – 48.00) = ₹16.00 lakhs
(ii) Rate of Return on Investment = 16%
(iii) Minimum Investment
Investment Needed = (Target Profit ÷ Target Return on Investment) = (16.00 ÷ 16%)
= ₹ 100.00 lakhs
Illustration 31
A Company requires ₹ 85,00,000 in sales to meet its target net profit. Its contribution margin
is 30% and the fixed costs are ₹15,00,000. What is the target net profit?
Solution
Sales = ₹85,00,000
Contribution = 30% of Sales = (85,00,000 × 30%)
= ₹25,50,000
Fixed Costs = ₹15,00,000
Target Net Profit = (Contribution – Fixed Costs)
= (25,50,000 – 15,00,000)
= ₹10,50,000
Illustration 32
The assistant management accountant of your company has been preparing the profit and loss
account for the week ended 31st October. Unfortunately, he has had a traffic accident and is
now in a hospital. So, as senior cost analyst you have been asked to complete this statement.
The uncompleted statement and relevant data are shown below
Week ended 31st October
Sales ₹ ₹
50,000
Standard Cost: Direct Materials Direct Wages --- ---
Overheads Standard Profit Variances Fav. /(Adv.) Fav. /(Adv.)
₹ ₹
Direct Material:
Price Variance Usage Variance (400)
Total Direct Material Variance (300) (700)
Direct Labour:
Rate Variance Efficiency Variance
Total Direct Labour Variance
---
Overhead Expenditure Variance Overhead Volume

Variance Total
Overhead Variance ---
Total
Variance ---
Actual ---
Profit
Standard Data
The standard price of direct material used is ₹ 600 per ton. From each tone of material, it is
expected that 2,400 units will be produced. A forty-hour week is operated. Standard labour
rate per hour is ₹ 40. There are 60 employees working as direct labour. The standard
performance
is that each employee should produce one unit of product in 3 minutes. There are 4 working
weeks in October. The budgeted fixed overhead for October is ₹ 76,80
Actual data
Materials used during the week were 20 tones at ₹ 620 per ton. During the week 4 employees
were paid of ₹ 42 per hour and 6 were paid ₹ 38 per hour and remaining were paid at standard
rate. Overheads incurred was ₹ 18000.
You are required to complete the P & L Statement for the week ended 31st Oct.
Solution
₹
Actual Cost of Material 620 × 20 12400
(-) direct material:
price variance usage variance 400
300 (700)
11700
Production from one ton of direct material of ₹ 600 = 2400

units Proportionate production for direct material of ₹ 11700
= (2400 ÷600) × 11700
= 46800 units
Standard Labour Hours = (46800 units × 3 minutes) ÷ 60
= 2430 hours
Labour variances
(1) (2) (3)

SRSH SRAH ARAH
4 × 2340 4 × (40 × 60) [(4 × 4.20) + (6 × 3.80) + (50 × 4)] × 40 hrs
₹ 9360 ₹ 9600 ₹ 9584
Labour Rate Variance = (SRAH – ARAH)
= (9600-9584)
= 16(F)
Labour Efficiency Variance: (SRSH – SRAH)
= (9360 -9600)
= 240(A)
Overhead variances
Standard Hours per Week = 40 × 60
= 2400 hours Budgeted Overheads per Week = ₹ 76,800 ÷ 4 weeks
= ₹ 19,200
Standard Overhead Recovery Rate
= (19,200 ÷ 2400) ₹ 8 per hour
(1) (2) (3) (4)
SRSH SRAH SRBH ARAH
8 × 2340 8 × 2400
₹ 18720 ₹ 19200 ₹ 19200 ₹ 18000

OH Expenditure Variance = (SRBH – ARAH)
= (19200 – 18000)
= 1200(F)
OH Volume Variance = (SRSH – SRBH) = (18720 – 19200) 480(A)
P&L statement for the week ended 31st October:
₹ ₹
Sales 50000
Standard cost
Direct material 11700
Direct wages 9360
Overheads 18720 39780
Standard Profit 10220
Variance F/(A) F/(A)
Direct material:
Price (400)
Usage (300)
Total (700)
Direct Labour:
Rate 16
Efficiency (240)
Total (224)
Overheads: Expenditure
Volume 1200
Total (480)
720
Total variance (204)
Actual Profit 10016
Illustration 33
The following is a flexible budget of FB Co. Ltd. For a production department.
Level of Activity
Direct Labour Hours 4000 5000 6000
Number of Units 8000 10000 12000
Fixed Overhead (₹) 5000 5000 5000

Variable Overhead (₹) 800 1000 1200
Total Overheads (₹) 5800 6000 6200
Normal Level of activity was 5000 direct labour hours. Actual Results were:
Direct Labour hours – 4800 Variable Overhead – ₹ 900 Output in Units 10400
Fixed Overhead – ₹ 5100
Compute Fixed overhead cost, volume and expenditure variances, variable overhead cost,
efficiency and expenditure variances, efficiency, capacity and activity ratios.
Solution
Step 1: Initial Workings
Normal level of activity has been expressed in terms of direct labour hours.
Accordingly: Standard Labour Hours per unit of Output
= (10,000 ÷ 5,000)
= 2 hours per unit Standard Labour Hours for Actual Output = (10,400 ÷ 2)
= 5,200 hours Standard Rate of Recovery for FOH = (5,000 ÷ 5,000)
= ₹1 per labour hour Standard Rate of Recovery for VOH = (1,000 ÷ 5,000)
= ₹0.20 per labour hour
Step 2: FOH Variances
Description Formula Workings Variance

FOH Cost Variance SRSH – AOH (1 × 5200) – 5100 ₹ 100 (F)
= 100 (F)
FOH Volume Variance SR (SH – BH) 1 × (5200 – 5000) ₹ 200 (F)
= 200 (F)
FOH Expenditure Variance SRBH – AOH (1 × 5000) – 5100) ₹ 100 (A)
= 100 (A)
Step 3: VOH Variances
Description Formula Workings Variance

VOH Cost Variance SRSH – AOH (0.2 × 5200) – 900 ₹ 140 (F)
= 140 (F)
VOH Volume Variance SR (SH – BH) 0.2 × (5200 – 4800) ₹ 80 (F)
= 80 (F)
VOH Expenditure Variance SRAH – AOH (0.2 × 4800) - 900 ₹ 60 (F)
= 60 (F)
Step 4: Ratios
Description Formula Workings Ratio

Efficiency Ratio SH ÷ AH 5200 ÷ 4800 108.33%
Capacity Ratio AH ÷ BH 4800 ÷ 5000 96 %
Activity Ratio SH ÷ BH 5200 ÷ 5000 104%
Illustration 34
The operation costs of a product produced by ABC Ltd are ₹53. Presently, the company
produces only 600 units
p.a. to sell at ₹55 per unit due to hard competition in the market. But with existing facilities,
production can be increased to 1,000 units if additional production can be sold in the market.
The company accordingly introduced target costing on market research, new design for the
product and changes in the process so that costs are brought down substantially and market
share can be increased. The estimates for the next year are:
Target selling price ₹50 per unit
Target profit margin 10% on sales
Target volume 900 units
Required:
(a) Calculate target costs per unit and target costs for the expected volume; and
(b) Compare existing profit with target profit.
Solution
Statement of Target Costs

Particulars Per Unit (₹) For 900 units
(₹)
Target selling price 50 45,000
Less: Target profit margin (10% of sales) 5 4,500
Target costs 45 40,500
Comparative Profit Statement
Particulars Existing Position Proposed Position
Per unit (₹) 600 units (₹) Per unit (₹) 900 units (₹)
Sales 55 33,000 50 45,000
Less: Costs 53 31,800 45 40,500
Profit 2 1,200 5 4,500
Illustration 35
S Ltd. has sales of 2,00,000 units at a price of ₹100.00 per unit and profit of ₹70.00 Lakhs in
the current year. Due to stiff competition, next year the Company has to reduce its price of
product @ 3% to achieve same target volume of sales. The cost structure and profit for the
current year is given as below:
Particulars (₹ Lakhs)
Direct Material 50.00
Direct Wages 40.00
Variable Factory Overheads 15.00
Fixed Overheads including Sales & Admin Expenses 25.00
Total Cost 130.00
To achieve the Target Cost to maintain the same profit, the Company is evaluating the
proposal to reduce Labour Cost and Fixed Factory Overheads. A Vendor supplying the
Machine suitable for the Company’s operations has offered an advanced technology Semi-
Automatic Machine of ₹10 Lakhs as replacement of Old Machine worth ₹3 Lakhs. The
Vendor is agreeable to take back the Old Machine at ₹1 Lakh only. The Company’s policy is
to charge depreciation at 15% on WDV. The Maintenance Charge of the Existing Machine is
₹1 Lakh per annum whereas there will be warranty of services free of cost for the New
Machine first two years. There are 7 Supervisors whose Salary is ₹1.50 Lakhs per annum.
The New Machine having Conveyor Belt is expected to help in cost cutting measures in the
following ways -
(1) Improve Productivity of workers by 10%
(2) Cut-down Material Wastage by 5%
(3) Elimination of services of Supervisors because of automatic facilities of the

machine
(4) Saving in Packaging Cost by ₹1 Lakhs.
Assuming Cost of Capital to be 15%, calculate how many Supervisors should be removed
from the production activities to achieve the Target Cost.
Solution
A. Targeted Cost Reduction
Targeted price Reduction = 3% of 200 lakhs = ₹6 lakhs Targeted Cost Reduction =

₹6 lakhs
B. Net Savings on account of New Machine
1. Savings on account of the New Machine
a. Reduction in wages due to Improve Productivity of workers by 10%
= {40 lakhs – [(40 lakhs ÷110) ×100]
= (40.00 -36.36)
= ₹3.64 lakhs
b. Cut-down Material Wastage by 5% = 5% of 50 lakhs = ₹2.50 lakhs
c. Saving in Packaging Cost = ₹1.00 lakhs
d. Saving in Maintenance Cost = ₹1.00 lakhs
e. Total Savings = 3.64 + 2.50 +1.00 + 1.00 = ₹8.14 lakhs
2. Additional Costs on account of the New Machine

a. Loss in Disposal of Old Machine = (₹3 lakhs - ₹1 lakhs) = ₹2.00 lakhs
b. Difference in Depreciation = (₹10 lakhs - ₹3 lakhs) × 15% = ₹1.05 lakhs
c. Cost of Capital Investment = (₹10 lakhs × 15%) = ₹1.50 lakhs
d. Total Additional Costs = (2.00 + 1.05 + 1.50) = ₹4.55 lakhs
3. Net Savings = (8.14 – 4.55) = ₹3.59 lakhs
C. Supervisors to be Removed
Short Fall = (A-B) = (6.00 – 3.59) = ₹2.41lakhs Number of Supervisors to be removed
= (2.41 lakhs ÷ 1.50 lakhs per supervisors) = 1.61 i.e.. say 2 Supervisors
Illustration 36
Wipro is examining the profitability and pricing policies of its Software Division. The
Software Division develops Software Packages for Engineers. It has collected data on three
of its more recent packages –
(a) ECE Package for Electronics and Communication Engineers,
(b) CE Package for Computer Engineers, and
(c) IE Package for Industrial Engineers. Summary details on each package over their two-
year Life Cycle product lives are –
Package Selling Price Number of units sold
(₹) Year 1 Year 2
ECE 250 2,000 8,000
CE 300 2,000 3,000
IE 200 5,000 3,000
Assume that no inventory remains on hand at the end of year 2. Wipro is deciding which
product lines to emphasize in its software division. In the past two years, the profitability of
this division has been mediocre. Wipro is particularly concerned with the increase in R&D
costs in several of its divisions. An analyst at the Software Division pointed out that for one
of its most recent packages (IE) major efforts had been made to reduce R&D costs. Last
week, Amit, the Software Division Manager, decides to use Life Cycle Costing in his own
division. He collects the following Life Cycle Revenue and Cost information for the packages
-
Package ECE Package CE Package IE
Particulars Year 1 Year 2 Year 1 Year 2 Year 1 Year 2
Revenues 5,00,000 20,00,000 6,00,000 9,00,000 10,00,000 6,00,000
Costs
R&D 7,00,000 - 4,50,000 - 2,40,000 -
Design of Product 1,15,000 85,000 1,05,000 15,000 76,000 20,000
Manufacturing 25,000 2,75,000 1,10,000 1,00,000 1,65,000 43,000
Marketing 1,60,000 3,40,000 1,50,000 1,20,000 2,08,000 2,40,000
Distribution 15,000 60,000 24,000 36,000 60,000 36,000
Customer Service 50,000 3,25,000 45,000 1,05,000 2,20,000 3,88,000
Present a Product Life Cycle Income Statement for each Software Package. Which package is
most profitable and which is the least profitable? How do the three packages differ in their
cost structure (the percentage of total costs in each category)?
Solution
Life cycle Income Statement (in ₹ ‘000s)
Particulars Package ECE Package CE Package IE
Y1 Y2 Tota % Y1 Y2 Total % Y1 Y2 Total %

l
Revenues 500 2,00 2,50 100 600 900 1,500 100 1,000 600 1,600 100%
0 0 % %
Costs
R&D 700 - 700 28% 450 - 450 30% 240 - 240 15%
Design 115 85 200 8% 105 15 120 8% 76 20 96 6%
Manufacturi 25 275 300 12% 110 100 210 14% 165 43 208 13%
ng
Marketing 160 340 500 20% 150 120 270 18% 208 240 448 28%
Distribution 15 60 75 3% 24 36 60 4% 60 36 96 6%
Cust. 50 325 375 15% 45 105 150 10% 220 388 608 38%
Service
Total Costs 1065 1,08 2150 86% 884 376 1260 84% 969 727 1696 106%
5
Profit 350 240 (96)
Observations
(a) Package ECE with a Life Cycle Profit of ₹3,50,000 is most profitable; while package IE
with a Life Cycle Loss of ₹96,000 is least profitable.
(b) As may be observed from the tabulated data, the differences in comparative percentages
(of total costs to revenues) in each category of the three packages are apparent and self-
explanatory
Illustration 37
SRM Ltd. has developed a new product ‘Kent’ which is about to be launched into the market
and anticipates to sell 80,000 of these units at a sale price of ₹ 300 over the product’s life
cycle of four years. Data pertaining to product ‘Kent’ are as follows:
Costs of Design and Development of ₹ 10,25,000

Moulding Dies and Other tools
Manufacturing costs ₹ 125 per unit
Selling costs ₹ 12,500 per year + ₹ 100 per unit
Administration costs ₹ 50,000 per year
5 replacement parts per 25 units @ ₹ 10 per
Warranty expenses part, 1 visit per 500 units (cost ₹ 500 per
visit)
Required:
(i) Compute the product Kent’s Life Cycle Cost.
(ii) Suppose SRM Ltd. can increase sales volume by 25% through 15% decrease
in selling price, should SRM Ltd. choose the lower price?
Solution
(i) Statement showing Kent’s Life Cycle Cost (80,000 units)
Particulars Amount (₹ )
Costs of Design and Development of Moulding Dies and Other tools 10,25,000
Manufacturing costs (125 × 80,000 units) 1,00,00,000
Selling costs (₹ 100 × 80,000 units + ₹ 12,500 × 4 years) 80,50,000
Administration costs (₹ 50,000 × 4 years) 2,00,000
Warranty expenses
Replacement costs: {(80,000 units ÷ 25 units) × 5 parts × ₹ 10)} 1,60,000
Visit costs: {(80,000 units ÷ 500 units × 1 visit × ₹ 500)} 80,000
Total Cost 1,95,15,000
(i) Statement showing Kent’s Life Cycle Cost (1,00,000 units)
Particulars Amount (₹)
Manufacturing costs (125 × 1,00,000 units) 1,25,00,000
Selling costs (₹ 100 × 1,00,000 units + ₹ 12,500 × 4 years) 1,00,50,000
Warranty expenses
Replacement costs: {(1,00,000 units ÷ 25 units) × 5 parts × ₹ 10)) 2,00,000
Visit costs: {(1,00,000 units ÷ 500 units) × 1 visit × ₹ 500)) 1,00,000
(ii) Statement showing Kent’s Life Cycle Cost (1,00,000 units)
Particulars Amount (₹)
Manufacturing costs (125 × 1,00,000 units) 1,25,00,000

Selling costs (₹ 100 × 1,00,000 units + ₹ 12,500 × 4 years) 1,00,50,000
Warranty expenses
Replacement costs: {(1,00,000 units ÷ 25 units) × 5 parts × ₹ 10)) 2,00,000
Visit costs: {(1,00,000 units ÷ 500 units) × 1 visit × ₹ 500)) 1,00,000
Statement showing Kent’s Life Time Profit
Particulars ₹ at the level of 80,000 units ₹ at the level of 1,00,000 units
Sales (80,000 × 300) = 2,40,00,000 (1,00,000 × 255) = 2,55,00,000
Total cost 1,95,15,000 2,40,75,000
Profit 44,85,000 14,25,000
Observation: Reducing the, price by 15% will decrease profit by ₹ 30,60,000/-. Therefore,
SRM Ltd. should not cut the price.
Particulars ₹ at the level of 80,000 units ₹ at the level of 1,00,000 units
Sales (80,000 × 300) = 2,40,00,000 (1,00,000 × 255) = 2,55,00,000
Total cost 1,95,15,000 2,40,75,000
Profit 44,85,000 14,25,000
Observation: Reducing the, price by 15% will decrease profit by ₹ 30,60,000/-. Therefore,
SRM Ltd. should not cut the price.
Illustration 38
A company is considering the purchase of a machine for ₹ 3,50,000. It feels quite confident
that it can sell the goods produced by the machine as to yield an annual cash surplus of ₹
1,00,000. There is however uncertainly as to the machine working life. A recently published
Trade Association Survey shows that members of the Association have between them owned
250 of these machines and have found the lives of the machines vary as under:
No. of year of Machine life 3 4 5 6 7 Total
No. of machines having given 20 50 100 70 10 250
life
Assuming discount rate of 10% the net present value for each different machine life is
follows:
Machine life 3 4 5 6 7
NPV (₹) (1,01,000) (33,000) 29,000 86,000 1,37,000
You required to advice whether the company should purchase a machine or not.
Solution
Computation of Expected NPV of an asset considering the probability of life of machine.
Year Probability (a) (₹) NPV (b) (₹) Expected Value
(a × b)
3 20/250 = 0.08 (1,01,000) (8,080)
4 50/250 = 0.2 (33,000) (6,600)
5 100/250 = 0.4 29,000 11,600
6 70/250 = 0.28 86,000 24,080
7 10/250 = 0.04 1,37,000 5,480
Total = 1 26,480
Since, the Expected NPV is Positive.
Therefore, the advice, therefore, is for purchasing the machine.
Illustration 39
A company has a choice among three products A, B and C for which the following estimates
are available:
Estimated profits based on demand forecast (₹ ‘000)
Market X Market Y Market Z
Product A 380 100 30
Product B 300 280 220
Product C 220 400 320
Probabilities are: X = 0.60. Y = 0.20, Z = 0.20
Which project should be undertaken by the company?
Solution:
In order to answer the question, it is desirable to take the help of a pay-off matrix which in
turn demands the identification of the elements. e.g.; profits, events (demand), probabilities,
actions (products A, B or C), outcomes represented by Expected Values (EVs). (Profit ×
Probability)
Profit (₹ ‘000) Probability Expected Value

(₹ ‘000)
Product A X 380 0.6 228
Y 100 0.2 20
Z 30 0.2 6
Total 254
Product B X 300 0.6 180
Y 280 0.2 56
Z 220 0.2 44
Total 280
Product C X 220 0.6 132
Y 400 0.2 80
Z 320 0.2 64
Total 276
From the above matrix it is evident that Product B having the maximum EV of ₹ 2,80,000
should be selected.
Illustration 40
The Managing Director of Y Ltd. has evolved some decision making to the operating division
of the firm. He is anxious to extend this process but first wishes to be assured that decisions
are being taken properly in accordance with group policy. As a check on existing practice, he
has asked for an investigation to be made into a recent decision to increase the price of the
sole product of Z division to ₹ 14.50 per unit but to rising costs. The following information
and estimates were available for the management of Z division:
Last year 75,000 units were sold at ₹ 12 each with total units cost of ₹ 9 of which ₹ 6 were
variable costs. For the year ahead the following cost and demand estimates have been made:
Variable costs:
Pessimistic Probability 0.15 ₹ 7.00 per unit
Most likely Probability 0.65 ₹ 6.50 per unit
Optimistic Probability 0.20 ₹ 6.20 per unit
Total fixed costs:
Pessimistic Probability 0.3 Increase by 50%
Most likely Probability 0.5 Increase by 25%
Optimistic Probability 0.2 Increase by 10%
Demand estimates at various prices
Particulars Probability ₹ 13.50 per unit ₹ 14.50 unit
Pessimistic 0.30 45,000 35,000
Most likely 0.50 60,000 55,000

Optimistic
0.20 70,000 68,000
(Unit variable costs, fixed costs and demand estimates are statistically independent)
For this type of decision the group has decided that the option should be chosen which has
the highest expected outcome with at least an 80% chance of breaking even.
You are required
(a) to assess whether the decision was made in accordance with group guidelines,
(b) to obtain what is the group attitude to risk as evidenced by the guidelines
Solution
Contribut Total Joint Cumulat

Probabi ion per Probabil Contribut Probabil ive Joint
Situation Demand lity unit ity ion ity Probabil
ity
45,000 0.3 6.50 0.15 2,92,500 0.045 0.045
Pessimistic 7.00 0.65 3,15,000 0.195 0.240
7.30 0.20 3,28,500 0.060 0.300
Most Likely 60,000 0.5 6.50 0.15 3,90,000 0.075 0.375
7.00 0.65 4,20,000 0.325 0.700
7.30 0.20 4,38,000 0.100 0.800
70,000 0.2 6.50 0.15 4,55,000 0.030 0.830
Optimistic 7.00 0.65 4,90,000 0.130 0.960
7.30 0.20 5,11,000 0.040 1.000
35,000 0.3 7.50 0.15 2,62,500 0.045 0.045
Pessimistic 8.00 0.65 2,80,000 0.195 0.240
8.30 0.20 2,90,500 0.060 0.300
Most Likely 55,000 0.5 7.50 0.15 4,12,500 0.075 0.375
8.00 0.65 4,40,000 0.325 0.700
8.30 0.20 4,56,500 0.100 0.800
68,000 0.2 7.50 0.15 5,10,000 0.030 0.830
Optimistic 8.00 0.65 5,44,000 0.130 0.960
8.30 0.20 5,64,400 0.040 1.000
Last year’s fixed costs = 75,000 units × ₹ 3 = ₹ 2,25,000
Estimated Fixed Costs (₹)
₹ 2,25,000 × 1.10 × 0.2 49,500
₹ 2,25,000 × 1.25 × 0.5 1,40,625
₹ 2,25,000 × 1.50 × 0.3 1,01,250
2,91,375
To break-even the contribution must be equal to or greater than ₹ 2,91,375. It is noticed from
the above tables that at selling price of ₹ 13.50 there is 100% chance to break-even. However,
at selling price of ₹ 14.50 there is 70% (0.075 + 0.325 + 0.1 + 0.03 + 0.13 + 0.04) chance of
break-even. The selling price of ₹ 14.50, therefore, contravenes group guidelines
Attitude to Risk: The group seeks to minimize the downside risk whilst maximizing its
return. It is to some extent risk averse, but it is prepared to take some risk i.e.., 20% risk of
loss. It is always sought maximize its returns, ignoring the probability of failure, it would be
risk neutral.
Illustration 41
The budgeted overheads and cost driver volumes of XYZ are as follows.
Cost Pool Budgeted Cost Driver Budgeted

Overheads (₹ ) Volume
Material 5,80,000 No. of orders 1,100
procurement
Material handling 2,50,000 No. of movements 680
Set-up 4,15,000 No. of set ups 520
Maintenance 9,70,000 Maintenance 8,400
hours
Quality control 1,76,000 No. of inspections 900
Machinery 7,20,000 No. of machine 24,000
hours
The company has produced a batch of 2,600 components of AX-15; its material cost was ₹
1,30,000 and labour cost ₹ 2,45,000.
The usage activities of the said batch are as follows:
Material orders – 26,
maintenance hours – 690,
material movements – 18,
inspections – 28,
set ups – 25,
machine hours – 1,800
Calculate – cost driver rates that are used for tracing appropriate amount of overheads to the
said batch and ascertain the cost of batch of components using Activity Based Costing.
Solution
Step1: Computation of Cost Driver Rates
Budgeted Budgeted Cost

Cost Pool (₹ ) Cost Driver Volume Workings Driver
Rate
Material 5,80,000 No. of orders 1,100 580000 ÷ 527.27
procurement 1100
Material 2,50,000 No. of 680 250000 ÷ 680 367.65
handling movements
Set-up 4,15,000 No. of set ups 520 415000 ÷ 520 798.07
Maintenance 9,70,000 Maintenance 8,400 970000 ÷ 115.48
hours 8400
Quality control 1,76,000 No. of 900 176000 ÷ 900 195.56
inspection
Machinery 7,20,000 No. of machine 24,000 720000 ÷ 30.00
hours 24000
Step 2: Apportionment of overheads to AX-15
Cost Pool Cost Driver Usage Cost Driver Workings Overheads

Volume Rate (₹)
Material No. of orders 26 527.27 26 × 527.27 13,709
procurement
Material No. of 18 367.65 18 × 367.65 6,618
handling movements
Set-up No. of set ups 25 798.07 25 × 798.07 19,952
Maintenance Maintenance 690 115.48 690 × 115.48 79,681
hours
Quality No. of 28 195.56 28 × 195.56 5,476
control inspections
Machinery No. of 1800 30.00 1800 × 30 54,000
machine hours
Total 1,79,436
Step 3: Computation of Batch Cost of 2600 units of AX-15
Sl Element (₹) (₹)

1 Material cost 1,30,000
2 Labour Cost 2,45,000
3 Prime Cost (1 + 2) 3,75,000
Overheads
4 a. Material orders 13,709
b. Material handling 6,618
c. Set-up 19,952
d. Maintenance 79,681
e. Quality Control 5,476
f. Machinery 54,000
g. Sub Total 1,79,436
5 Total Cost (3 + 4) 5,54,436
Illustration 42
A Company manufactures a single product, which requires two components. The Company
purchases one of the components from two suppliers: X Ltd and Y Ltd. The price quoted by
X Ltd is ₹180 per 100 units of the component and it is found that on an average 3% of the
total receipt from this supplier is defective. The corresponding quotation from Y Ltd is ₹ 174
per 100 units, with defect rate of 5%. If the defectives are not detected, they are utilized in
production causing a damage of ₹180 per 100 units of the defective component.
The Company intends to introduce a system of inspection for the components on receipt. The
Inspection cost is estimated at ₹ 24 per 100 units of the component. Such an inspection will
be able to detect only 90% of the defective components received. No payment will be made
for components found to be defective in Inspection
Required:
(a) Please justify the Inspection at the point of receipt and give your working for
the same.
(b) Assuming a total requirement of 10,000 units, ascertain the lowest supplier
Solution
Recommendation:
(a) Inspection at the point of receipt is not advantageous, due to additional cost per 100 good
components,
i.e. (₹ 205.22 – ₹ 191.13) = ₹ 14.09 in case of X Ltd, and (₹ 200.07 - ₹ 192.63)
= ₹ 7.44 in case of Y Ltd.
(b) Purchase from X Ltd. without inspection is cheaper, as there is a cost saving of ₹ 1.50, i.e.
(192.63 -191.13) per 100 good components.
Illustration 43
The income statement of Ashok Gears Ltd. is summarized as below:

Net Revenue................................................................................................. ₹ 80,00,000
Less: Expenses (including ₹40,00,000 of Fixed Cost) ....................................₹ 88,00,000
Net Loss ......................................................................................................... ₹ 8,00,000
The manager believes that an increase of ₹20,00,000 as fixed expenditure in

advertising outlays will increase the sales substantially. His plan was approved by
the Board.
You are required to calculate:
(ii) At what sales volume will the Company have break even?
(iii) What sales volume will result in a Net Profit of ₹ 4,00,000?
Solution:
(i) Computation of Break-Even Sales

Net Revenue = ₹ 80,00,000
Variable Expenses = ₹ (88,00,000 - 40,00,000) = ₹ 48,00,000
Contribution = (80,00,000 – 48,00,000) = ₹ 32,00,000
Contribution Margin Ratio (PV Ratio) = 32,00,000 ÷ 80,00,000 = 40%
Revised Fixed Cost = (Existing 40,00,000 +20,00,000 of Advertising) = ₹ 60,00,000
Break Even Sales = (Fixed Cost ÷ PV Ratio) = (60,00,000 ÷ 40%) = ₹ 1,50,00,000
(ii) Computation of sales level to earn a Net Profit of ₹ 4,00,000

Targeted Contribution = (Fixed Cost + Desired Profit) = (60,00,000 + 4,00,000)
= ₹ 64,00,000
Required Sales = (Targeted Contribution ÷ PV Ratio) = (64,00,000 ÷ 40%)
= ₹ 1,60,00,000
(Explanatory Comment: The problem brings forth the primary application of marginal
costing in manufacturing sector for the purposes of calculating the BEP and profit
planning.)
Illustration 44
As a part of its rural upliftment programme, the Government has put under cultivation a farm
of 96 hectors to grow tomatoes of four varieties: Royal Red, Golden Yellow, Juicy Crimson
and Sunny Scarlet. Of the total 96 hectors, 68 hectors are suitable for all four varieties, but
the remaining 28 hectors are suitable for growing only Golden Yellow and Juicy Crimson.
Labour is available for all kinds of farm work and there is no constraint. The market
requirement is that all four varieties of tomatoes must be produced with a minimum of 1,000
boxes of any one variety. The farmers engaged have decided that the area devoted to any crop
should be in terms of complete hectors and not in fractions of a hector. The other limitation is
that not more than 22,750 boxes of any one variety should be produced. The following data
are given

Annual Yield (Boxes per hector) 350 100 70 180
Direct Material Costs (₹ per hector) 4,760 2,160 1,960 3,120

Labour Costs (₹)
a. Growing per hector 8,960 6,080 3,710 5,280
b. Harvesting & packing per box 36 32 44 52
c. Transportation per box 52 52 40 96
Market price per box 153.80 158.70 183.80 222.70
Fixed Overheads per annum
Growing ₹ 1,12,000
Harvesting ₹ 74,000
Transportation ₹ 72,000 General Administration ₹ 1,02,000
Required
(iv) Product Preference within the given constraints
(v) Optimum Product Mix & Maximum Profit
(vi) A nationalized bank has come forward to help in an improvement programme for the
piece of 28 hectors in which only Golden Yellow and Juicy Crimson used to grow,
with a loan of ₹50,000 at a very nominal interest of 6% per annum. After this
improvement is carried out, there will be a saving of ₹12.50 per box in the harvesting
cost of Golden Yellow and the 28 hectors will become suitable for growing Royal Red
in addition to the existing Golden Yellow and Juicy Crimson varieties. Assuming that
other constraints continue, find the maximum total profit that would be achieved after
the improvement programme is carried out
Explanatory Comments
While seeking solutions in terms of product preference, optimum product mix, maximum
profit and evaluation
of alternatives, the problem sets certain constraints. The constraints are:
(vi) 68 hectors are suitable for all four varieties, but the remaining 28 hectors are
suitable for growing only Golden Yellow and Juicy Crimson
(vii) All four varieties of tomato must be produced with a minimum of 1,000
boxes of any one variety
(viii) The area devoted to any crop should be in terms of complete hectors
(ix) Not more than 22,750 boxes of any one variety should be produced
(x) After an improvement is carried out the 28 hectors will become suitable for
growing Royal Red in addition to the existing Golden Yellow and Juicy
Crimson varieties
The problem can be solved by adopting five steps:
(vi) Determination of Contribution per hector & product preference
(vii) Computation of Optimum Product Mix
(viii) Computation of Maximum Profit
(ix) Computation of Optimum Mix after the improvement programme
Computation of Profit after the improvement programme
Here follows the stepwise solution. In order to assimilate the concepts, the
students are advised to go through the notes, furnished at relevant places,
carefully
Solution
Step 1: Determination of Contribution per hector & product preference

Gold Juicy Sun
Seria Particulars Royal
en Crims ny
l Red Yello Scar
on
w let
Sales per hector
a. Boxes per hector
350 100 70 180
1 b. Market / Sales Price
153.80 158.70 183.80 222.70
per Box
53,830 15,870 12,866 40,086
c. Sales (a × b)
2 Variable costs
a. Direct material 4,760 2,160 1,960 3,120
b. Growing cost 8,960 6,080 3,710 5,280
c. Harvesting and packing
Per Box 36 32 44 52
Per hector 12,600 3,200 3,080 9,360
d.
Transp 52 52 40 96
ort Per 18,200 5,200 2,800 17,280
Box
Per hector
e. Total Variable Cost 44,520 16,640 11,550 35,040
3 Contribution per hector (1 – 9,310 -770 1,316 5,046
2)
4 Rank / Order of Preference I IV III II
Note: Order of preference is decided on the basis of contribution per hector
Step 2: Computation of Optimum Product Mix

Gold Juicy Sunn
Particulars Royal Red en Crim y Total
Yello so n Scarl
w et
(a) Minimum 1,000 1,000 1,000 1,000
Boxes
Requirement
(b) Annual Yield of 350 100 70 180
2.85 14.28 5.55

Required Minimum i.e..,3.00 i.e..15. i.e..6.00
Area (Hectors) [a ÷ b] Note (i) 10.00 00 Note 34.00
N (iii)
ot
e
(ii
)
Balance Area (96 – 34) (Hectors) 62.00
Maximum area for
22,750 boxes (Hectors)
(22750 / Annual yield of 22750 22750 22750 22750
Boxes)
350 100 70 180

= 65 = 227.5 = 325 = 126.39
Allocation of area
68 hectors suitable for all
varieties being
distributed for 62.00 6.00
preferences 1 and 2
28 hectors suitable for

Golden yellow &
10.00 18.00
Juicy Crimson
Total 62.00 10.00 18.00 6.00 96.00
Notes:
(v) In case of Royal Red, the minimum area of 2.85 hectors has been rounded off to the
(vi) In case of Juicy Crimson, the minimum area of 14.28 hectors has been rounded off to
the next higher multiple 15.
(vii) In case of Sunny Scarlet, the minimum area of 5.55 hectors has been rounded off to the
(viii) Of the 68 hectors suitable for all varieties, 62 acres have been apportioned to Royal
Red after allocating the minimum area of 6 to Sunny Scarlet.
(ix) Of the 28 hectors suitable for Golden yellow & Juicy Crimson, 18 acres have been
apportioned to Juicy Crimson after allocating the minimum area of 10 to Golden
yellow.
Step 3: Computation of Maximum Profit

1 Area (Hectors) 62 10 18 6 96
3 Total contribution 5,77,220 (7,700) 23,688 30,276 6,23,484
Fixed costs
f. Growing 1,12,000
4 g. Harvesting 74,000
h. Transport 72,000
i. General Administration 1,02,000
j. Sub Total (a + b + c + d) 3,60,000
5 Profit (3-4) 2,63,484
Step 4: Computation of Optimum Mix & Profit after the improvement programme
Roy Gold Juicy Sunn

Particulars Total
al en Crims y
Red Yello on Scarl
w et
Minimum Area (hectors) 3.00 10.00 15.00 6.00 34.00
Balance area being
62.00 62.00
apportioned on the basis of
product preference
Total area (hectors) 65.00 10.00 15.00 6.00 96.00
Note: Product-wise apportionment of the area has been done by following a similar process
as has been outlined in step2
Step 5: Computation of Profit after the improvement programme

S Ro Gold Juicy Sun
Particulars Total
er yal en Crims ny
i Red Yello on Scar
al w let
1 Area (Hectors) 65 10 15 6 96
Contribution per
2 9310 (770) 1316 5046
hector Existing
Savings after 1250
the
improvement
Revised 9310 480 1316 5046
3 Total contribution 6,05,15 4,800 19,740 30,276 6,59,966
0
Fixed costs
a. Growing
b. Harvesting
1,12,000
74,000
c. Transport
d. General 72,000
4 1,02,000
Administrati
on 3,000
3,63,000
e. Interest @ 6%
on
₹ 50,000/-
f. Sub Total (a..d)
5 Profit 2,96,966
(Commentary: Be it be manufacturing sector, service sector or agriculture sector, the

application of Marginal Costing is Universal.)
Illustration 45
S.H.Ltd., a cycle manufacturing company, has drawn up a programme for the manufacture of
a new product for the purpose of fuller utilization of its capacity. The scheme envisages the
manufacture of baby tricycle fitted with a bell. The company estimates the sales of tricycles
at 10,000 during the first year and expects that from the second year onwards the sales
estimates will stabilize at 20,000 tricycles. Since the company has no provision for the
manufacture of the small bells specially required for the tricycles, the requirement of the bells
is initially proposed to be met by way of purchase from the market at ₹8 each. However, if
the company desires to manufacture the bell in its factory by installation of new equipment, it
has two alternative proposals as under:-
Installation of Super X Installation of

Machine Janta Machine
Initial Cost of Machine ₹ 3.00 Lakhs ₹ 2.00 Lakhs
Life 10 Years 10 Years
Fixed Overheads p.a. other than ₹ 54,000 ₹ 28,000
depreciation
Variable expenses per unit ₹ 4.00 ₹ 5.00

Required:
a. For each of the two levels of output namely 10,000 and 20,000 bells state with
suitable workings whether the company should purchase the bells from market
or install new equipment for manufacture of bells. If your decision is in favour
of the installation of new equipment, which of the two new machines should
be installed?
b. What would be your decision in case the forecast of requirement from the
second year onwards is estimated at 40,000 bells instead of 20,000 bells?
c. At what volume of bells will the installation of the two machines break even.
Solution
a. Cost-Benefit Analysis of two machines at Output Level of 10,000 and 20,000 units
Output 10000 units 20000 Units
Details Super X Janta Super X Janta
Cost of buying @ ₹ 8 80,000 80,000 1,60,000 1,60,000
Cost of Manufacturing
Variable cost 40,000 50,000 80,000 1,00,000
Depreciation on Machine Super X = 300000

10 𝑦𝑟𝑠
200000 30,000 20,000 30,000 20,000
Janta =
10𝑦𝑟𝑠
Fixed overheads 54,000 28,000 54,000 28,000

Total cost 1,24,000 98,000 1,64,00 1,48,00
0 0
Decision (Cost of Buying or Cost of M/g Buy from Install
Whichever is lower Market
(Super X or Janta Machine
Janta)
a. Buy / manufacture decision at level of 40,000 units in the Second year

Super X Janta
Cost of Buying @ ₹ 8 3,20,000 3,20,000
Cost of Manufacturing
Variable Cost 1,60,000 2,00,000
Depreciation on Machine 30,000 20,000
Fixed Overheads 54,000 28,000
Total Cost 2,44,000 2,48,000
Cost Saving on Manufacture 76,000 72,000
Decision – As Super X machine gives better saving, it should be installed at an estimated

volume of 40000 units
b. Break – even volume of installation of X two machines: It is that volume of production at
which a manufacturer is indifferent as to which machine he should install as total cost on both
machine is the same. This point is known as cost indifference point.
Let Break-even volume = x units
Cost on super-X Machine for x units = 54,000 + 30,000 + 4x = 84,000 + 4x …(1) Cost on
Janata Machine for x units = 20,000 + 28,000 + 5x = 48,000 + 5x …(2) At cost indifference
point total cost under two alternatives will be equal.
Therefore,
84,000 + 4x = 48,000 + 5x or x = 36,000 units.
So, at 36,000 units the installation of the two machines will break even.
Illustration 46
An agro-based farm is planning its production for next year. The following is relating to the
current year:
Product/Crop M N O P
Area Occupied (Acres) 125 100 150 125
Yield per acre (ton) 50 40 45 60
Selling Price per ton (₹) 100 125 150 135
Variable Cost per acre (₹)
Seeds 150 125 225 200
Pesticides 75 100 150 125
Fertilizers 62.50 37.50 50 62.50
Cultivation 62.50 37.50 50 62.50
Direct Wages 2000 2250 2500 2850
Fixed overhead per annum ₹13,44,000. The land that is being used for the production of O
and P can be used for either crop. But not for M and N; the land that is being used for the
production of M and N can be used for either crop, but not for O and P. In order to provide
adequate market service, the company must produce each year at least 1,000 tons of each of
M and N and 900 tons each of O and P.
Required:
(i) Determine the profit for the production mix fulfilling market commitment.
Assuming the land could be cultivated to produce any of the four products and there was no
market commitment, calculate the profit amount of most profitable crop and break-even point
of most profitable crop in terms of acres and sales value
Solution
(i) Determination of Profit for Production Mix fulfilling the market

commitment:
a. Statement of Recommended Product Mix
Sl. Product M N O P
1 Yield per acre (ton) 50 40 45 60
2 Selling Price per ton (₹) 100 125 150 135
3 Sales Revenue per acre (₹) 5000 5000 6750 8100
Variable Cost per acre (₹):
a. Seeds 150 125 225 200
b. Pesticides 75 100 150 125
4. c. Fertilizers 62.50 37.50 50 62.50
d. Cultivation 62.50 37.50 50 62.50
e. Direct Wages 2000 2250 2500 2850
f. Sub Total (a to e) 2350 2550 2975 3300
5. Contribution per acre (₹) 2650 2450 3775 4800
6. Rank III IV II I
Minimum Sales per
7. annum (tons) (Minimum 1000 1000 900 900
Market Commitment)
8. Minimum Area (acres) [7 (1000 ÷ 50) (1000 ÷ 40) (900 ÷ 40) (900 ÷ 60)
÷ 1] =20 = 25 =20 =15
9. Occupied Area (acres)** 125 100 150 125
10. Recommended Mix as per {(125+100) 25 20 {(150+125
Rank in 6 (acres) - (Minimum (Minimum )
25} = 200 ) ) -20} =255
**Area of M&N can be interchanged and area of O&P can be interchanged.
b. Statement of Profit
Serial Particulars Workings Rupees
Contribution for the
recommended product Mix
MNOP (200 × 2650) = 5,30,000 5,30,000
1 Sub Total (25 × 2450) = 61,250 61,250
(20 × 3775) = 75,500 75,500
(255 × 4800) = 12,24,000 12,24,000
18,90,750
2 Fixed Cost 13,44,000
3 Profit (1–2) 5,46,750
(ii) Most profitable crop
Product P gives highest contribution of ₹4,800 per acre and hence is the most profitable crop.
Statement of Profit if complete land is used for P:
Contribution = (500 × 4800) = ₹ 24,00,000
Fixed cost = ₹ 13,44,000
Profit = ₹ 10,56,000
Break-even point in acres for P = 13,44,000 ÷ 4,800 = 280 acres
Break-even point in sales value = 280 × 135 × 60 = ₹ 22,68,000
(Commentary: The problem reveals the utility of marginal costing with respect to
maximisation of crop income, i.e.. agriculture sector.)
Illustration 47
A Company manufacturing a highly successful line of cosmetics intends to diversify the

product line to achieve fuller utilization of its plant capacity. As a result of considerable
research made the company has been able to develop a new product called ‘EMO’. EMO is
packed in tubes of 50 grams capacity and is sold to the wholesalers in cartons of 24 tubes at
₹240 per carton. Since the company uses its spare capacity for the manufacture of EMO, no
additional fixed expenses will be incurred. However, the cost accountant has allocated a share
of ₹4,50,000 per month as fixed expenses to be absorbed by EMO as a fair share of the
company’s present fixed costs to the new production for costing purposes.
The company estimated the production and sale of EMO at 3,00,000 tubes per month and on
this basis the
following cost estimates have been developed.

₹ per carton
Direct Materials 108
Direct Wages 72
All overheads 54
Total costs 234
After a detailed market survey, the company is confident that the production and sales of
EMO can be increased to 3,50,000 tubes and the cost of empty tubes, purchased from outside
will result in a saving of 20% in material and 10% in direct wages and variable overhead
costs of EMO. The price at which the outside firm is willing to supply the empty tubes is
₹1.35 per empty tube. If the company desires to manufacture empty tubes in excess of
3,00,000 tubes,
new machine involving an additional fixed overheads ₹30,000 per month will have to be
installed
Required:
(i) State by showing your working whether company should make or buy the
empty tubes at each of the three volumes of production of EMO namely
3,00,000; 3,50,000 and 4,50,000 tubes.
(ii) At what volume of sales will it be economical for the company to install the
additional equipment for the manufacture of empty tubes?
Evaluate the profitability on the sale of EMO at each, of the aforesaid three levels of output
based on your decision and showing the cost of empty tubes as a separate element of cost
Solution
(i) Make or Buy
Total Cost per tube of EMO:
Per Tube
Direct Material = (108 ÷ 24) = ₹ 4.50
Direct Wages = (72 ÷ 24) = ₹ 3.00
Variable Overheads = {(54 ÷ 24) – (4,50,000 ÷ 3,00,000) = ₹ 0.75

Particulars Total Cost (₹) Tube Cost (₹) Product Cost (₹)
Material 4.50 20% of total cost = 0.90 3.60
Wages 3.00 10% of total cost = 0.30 2.70
Variable Overhead 0.75 10% of total cost = 0.675
0.075
Total 8.25 1.275 6.975
Cost of Making = (3,00,000 × 1.275) = ₹ 3,82,500 Cost of Buying = (3,00,000 ×

1.35) = ₹ 4,05,000
Therefore, It is better to make the tubes at 3,00,000 level of output, as it is cheaper than
Buying.
Computation of Cost for additional tubes at the level of 3,50,000 and 4,50,000:
Particulars 3,50,000 4,50,000

Additional tubes needed over 50,000 1,50,000
3,00,000
Cost of Making (₹) 93,750 2,21,750
[(50,000 × [(1,50,000 ×
1.275) + 1.275) +
30,000] 30,000]
Cost of Buying (₹) 67,500 2,02,500
(50,000 × 1.35) (1,50,000 × 1.35)
From the above, it is better to Buy the empty tubes at the level of 3,50,000 and 4,50,000, as it
is deeper than making at both levels.
The level at which it is beneficial to make the tubes over and above 300000 units
Additional Fixed Overheads = ₹ 30,000
Excess of buying cost over variable cost = (1.35 - 1.275) = ₹ 0.075
Indifference Point
Therefore, the Company will be justified to install the additional Equipment for the
manufacture of Empty tubes at a sales volume of 400000 units.
(ii) Evaluation of Profitability at the three levels of output
SL Particulars 3,00,000 3,50,000 4,50,000
I. Sales @ ₹ 10 p.u. 30,00,000 35,00,000 45,00,000
20,92,500 24,41,250 31,38,750
Product Cost @ ₹ 6.975 (3,00,000 × (3,50,000 × (4,50,000 ×
II.
p.u. 6.975) 6.975) 6.975)
3,82,500 4,72,500 6,07,500

Tube Cost (₹) (3,00,000 × (3,50,000 × (4,50,000 ×
III.
[As per (i)] 1.275) 1.35) 1.35)
IV. Fixed cost (₹) 4,50,000 4,50,000 4,50,000

V. Total Cost (₹) 29,25,000 33,63,750 41,96,250
VI. Profit (I–V) (₹) 75,000 1,36,250 3,03,750
Illustration 48
A review, made by the top management of Sweat and Struggle Ltd. which makes only one
product, of the result of the first quarter of the year revealed the following:
Sales in units 10,000
Loss ₹ 10,000
Fixed cost (for the year ₹1,20,000) ₹ 30,000
Variable cost per unit ₹ 8.00
The Finance Manager who feels perturbed suggests that the company should at least break-
even in the second quarter with a drive for increased sales. Towards this, the company should
introduce better packing which will increase the cost by ₹0.50 per unit.
The Sales Manager has an alternative proposal. For the second quarter additional sales
promotion expenses can be increased to the extent of ₹5,000 and a profit of ₹ 5,000 can be
aimed at during the period with increased sales.
The Production Manager feels otherwise. To improve the demand, the selling price
per unit has to be reduced by 3%. As a result the sales volume can be increased to attain a
profit level of ₹ 4,000 for the quarter.
The Manager Director asks you as a Cost Accountant to evaluate the three proposals and
calculate the additional sales volume that would be required in each case, in order to help him
to take a decision.
Solution
Calculation of selling price
(₹)
Variable cost (8 × 10,000) 80,000.00
Add : Fixed cost 30,000.00
Total cost 1,10,000.00
Profit (10,000.00)
Sales 1,00,000.00
Selling price (100000/10000) ₹ 10
Statement showing evaluation of alternatives and the number of units required to

attain the targets of respective managers.
Finance Sales Production

Manager Manager Manager
i) Selling price (₹) 10.00 10.00 9.70
ii) Variable cost (₹) 8.50 8.00 8.00
iii) Contribution per 1.50 2.00 1.70
unit (₹)
iv) Fixed cost (₹) 30,000.0 35,000.0 30,000.00
0 0
v)Target (₹) B.E.P Profit or Profit of ₹
₹ 5000 4000
(30000/1. (40000/2 (34000/1.7
5) ) )
20,000.0 20,000.0 20,000.00
0 0
Additional units 10,000.0 10,000.0 10,000.00
required 0 0
Illustration 49
Your company fixes the inter-divisional transfer prices for its products on the basis of cost,
plus a return on investment in the division. The Budget for Division A for 2021-22 appears as
under:
Particulars (₹)
Fixed Assets 5,00,000
Current assets 3,00,000
Debtors 2,00,000
Annual Fixed Cost of the Division 8,00,000
Variable Cost per unit of Product 10
Budgeted Volume 4,00,000 units per
year
Desired ROI 28%
Determine the transfer price for Division A.
Solution
Budgeted Volume = 4,00,000 units per year
Variable Cost per Unit = ₹10.00
Fixed Cost per Unit = (8,00,000 ÷ 4,00,000) = ₹2.00
Total Assets = 5,00,000 + 3,00,000 + 2,00,000
Desired ROI per Unit = {(10,00,000 × 28%) ÷ 4,00,000} = ₹0.70
Transfer Price per Unit = (VC + FC + ROI) = 10.00 + 2.00 + 0.70 = ₹12.70
(Explanatory Comment: The problem facilitates understanding the basic concept of transfer
pricing.)
Illustration 50
Division A is a profit centre which produces three products X, Y and Z. Each product has an
external market. The details are as follows:
X Y Z
External market price per unit (₹) 48 46 40
Variable cost of production in division A (₹) 33 24 28
Labour hours required per unit in division A 3 4 2
Product Y can be transferred to Division B, but the maximum quantity that might be required
for transfer is 300 units of Y.
X Y Z
The maximum external sales are: 800 500 300
units units units
Instead of receiving transfers of Product Y from Division A, Division B could buy similar
product in the open market at a slightly cheaper price of ₹45 per unit.
What should the transfer price be for each unit for 300 units of Y, if the total labour hours
available in Division A are?
(a) 3800 hours
(b) 5600 hours.
Solution
Computation of contribution per labour hour from external sales:
X Y Z
Market price (₹) 48 46 40
Variable cost (₹) 33 24 28
Contribution (₹) 15 22 12
Labour hours required 3 4 2
Contribution per labour hour (₹) 5 5.50 6
Ranking ΙΙΙ ΙΙ Ι
(a) Computation of transfer price when the capacity is 3800 hours:

Allocation of Hours if the capacity is 3800 labour hours
X Y Z
External Sales (Units) 800 500 300
Labour hours required per Unit 3 4 2
Hours needed for External Sales 2400 2000 600
Allocation of Hours if the capacity is 1200 2000 600

3800 hours as per ranking
(Bal. fig.)
The existing capacity is not sufficient, even, to produce the units to meet the external sales. In
order to transfer 300 units of Y, 1200 hours are required in which division A has to give up the
production of X [since lowest ranking] to the extent of 1200 hours (1200 hours ÷ 3 labour p.a.
= 400 units).
Transfer price for 300 units of Y will, therefore, work out to
Variable Cost of Y (₹ 24) + [{(Contribution loss for X (₹ 5 × 1200 hours = 6,000)} ÷300] = 24
+ 20 = ₹ 44
(b) Computation of transfer price when the capacity is 5600 labour hours:
Allocation of Hours if the capacity is 5600 hours
X Y Z
External Sales (Units) 800 500 300
Labour hours required per Unit 3 4 2
Hours needed for External Sales 2400 2000 600
Balance of hours (Surplus) 600
Labour Hours needed for 300 units of Y = 300 × 4

= 1200 Surplus Labour Hours Available = 5600 – 5000 = 600 Short
fall in Labour Hours = 1200 – 600 = 600
The short fall 600 hours may have to be diverted from X resulting in a contribution loss of
₹3,000 (600 × ₹5)
Transfer price for 300 units of Y will, therefore, work out to
Variable Cost of Y (₹24) + [{Contribution loss for X (₹5 × 600 hours = 3,000)} ÷ 300] = ₹24
+ ₹10 = ₹34
(Explanatory Comment: The problem is a good example to make use of transfer pricing for
optimum utilisation of limited resources.)

Cma Final Scm

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Cma Final Scm

Uploaded by

Copyright:

Available Formats

CMA FINAL SCM

STRATEGIC COST MANAGEMENT

(ii) Break-even is planned at 60% of the total sales of each product.

Computation of Number of units to be Sold, Breakeven & envisaged Reduction in FC

Item Splash Flash Total

No. of units to be sold 3,00,000 1,00,000 4,00,000

Break even units 1,80,000 60,000

Cost Reduction envisaged in FC (₹) 4,320 750 5,070

Increase in profits during 2021-22 due to quality improvement = ₹ 230 lakhs

Net Revenue ₹ 80,00,000

Less: Expenses (including ₹40,00,000 of Fixed Cost) ₹ 88,00,000

Net Loss ₹ 8,00,000

The manager believes that an increase of ₹20,00,000 as fixed expenditure in advertising

You are required to calculate:

What sales volume will result in a Net Profit of ₹ 4,00,000?

(i) Computation of Break-Even Sales

Net Revenue = ₹ 80,00,000

Variable Expenses = ₹ (88,00,000 - 40,00,000) = ₹ 48,00,000

Contribution = (80,00,000 – 48,00,000) = ₹ 32,00,000

Contribution Margin Ratio (PV Ratio) = 32,00,000 ÷ 80,00,000 = 40%

Revised Fixed Cost = (Existing 40,00,000 +20,00,000 of Advertising) = ₹ 60,00,000

Break Even Sales = (Fixed Cost ÷ PV Ratio) = (60,00,000 ÷ 40%) = ₹ 1,50,00,000

(ii) Computation of sales level to earn a Net Profit of ₹ 4,00,000

Targeted Contribution = (Fixed Cost + Desired Profit) = (60,00,000 + 4,00,000)

Required Sales = (Targeted Contribution ÷ PV Ratio) = (64,00,000 ÷ 40%)

Sales ₹ 16.00 lakhs

Direct Material ₹ 5.80 lakhs

Direct Labour ₹ 2.40 lakhs

Variable Overheads ₹ 0.60 lakhs

Fixed Overheads ₹ 5.20 lakhs

The following alternatives are available to the managem

A. Continue with domestic sales and reject the export order.

1 Capacity Given – 80%

2 Sales Given 16.00

a. Direct Material 5.80

3 b. Direct Labour Given 2.40

c. Variable Overheads 0.60

d. Sub Total 8.80

5 Fixed Costs Given 5.20

Sales at 100% Capacity = (16 ÷ 80%) = ₹20 Lakhs

Value of the export order = (40% of Capacity × 90% of the Price)

= (20 × 40% × 90%)

Value of the domestic sales = (20 × 60%)

Serial Description Workings ₹ Lakhs

1 Capacity Export 40% + Domestic 60%

2 Sales 7.20 + 12.00 19.20

(0.60 / 80%) × 100% 0.75

5 Fixed Costs Given 5.20

Serial Description Workings ₹ Lakhs

1 Capacity Export 40% + Domestic 80%

2 Sales 7.20 + 16.00 23.20

a. Direct Material (5.80 / 80%) × 120% 8.70

3 b. Direct Labour (2.40 / 80%) × 120% 3.60

c. Variable Overheads (0.60 / 80%) × 120% 0.90

d. Overtime Premium (2.40 / 80%) × 10% × 50% 0.15

5 Fixed Costs [Including fixed O/H for (5.20 + 0.65) 5.85

requirements are as follows

Product A Product B Product C

Annual sales (units) 6000 6000 750

Selling Price (₹) 20 31 39

Unit Cost (₹) 18 24 30

Processing time required per 1 1 2

(ii) The demand at current selling price ( ₹) is:

Product A Product B Product C