SCHOOL OF OPEN LEARNING UNIVERSITY OF DELHI 5, CAVALRY LANE DELHI

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1 Graduate Course B.Com. (Hons.) III Year Paper XVI : Management Accounting Contents : UNIT : 5 1. Management Decision Making 2. Marginal Costing and Decision Making 3. Differential Cost Analysis UNIT : 6 1. Responsibility Accounting 2. Divisional Performance Measurement : Financial Measures: Editor : Dr. N.K. Aggarwal SCHOOL OF OPEN LEARNING UNIVERSITY OF DELHI 5, CAVALRY LANE DELHI

2 SESSION ( Copies) School of Open Leaning Published by the Executive Director, School of Open Learning, University of Delhi, 5 Cavalry Lane, Delhi Laser typeset : S.O.L. Computer Centre Printed at

3 UNIT 5 1 MANAGEMENT DECISION MAKING Smriti Chawla Shri Ram College of Commerce University of Delhi CHAPTER OBJECTIVES Meaning of decision making Steps involved in Decision making Costs for Decision Making Decision making and Marginal Costing o Fixation of Selling Prices o Effect of change in price o Maintaining a desired level of profit (with Illustrations) Meaning of Decision Making Decision-making is the process of choosing the best course of action from among available alternative courses of action. Choice between alternative courses is an all pervading managerial function. Managers of business concern discharge their functions only by making decisions. Every manager regardless of level in which he operates is a decision maker. For example cost of product is Rs.45 per unit. An export order is received at Rs. 40 per unit. Should this order be accepted or not? The decision to be taken will be affected by cost and other factors and cost accountant must use all information at his disposal to help management make right decision. Here, we are concerned with short term operating decisions such as whether to make a component or buy it from outside supplier or whether or not to sell product at below cost. For this marginal costing and differential cost analysis are two valuable techniques which are used for short-term business decisions. Steps Involved in Decision Making The various steps involved in decision making process are: Identify the problem or subject matter of decision: A problem may be defined as a gap between existing or forecast condition and desired condition. It may arise either because of an external event or an event purely internal to business. Once the problem is known it becomes necessary to classify the same and ascertain the relevant facts in order to make the right decision. 1

4 Identify alternative courses of action There are various ways of achieving organisational objectives. Each of these is an alternative. If for instance, profit is considered to be margin between sale price and cost, the decision maker should not jump to conclusion that only way of increasing profitability is to cut down costs. He must think of other alternatives to increase profits such as change in product mix or make or buy a product or exploring new market etc. The decision maker must make exhaustive list of all alternatives available. Evaluation of alternatives Identify the cost and benefit of each available alternative and make comparison between them. Selecting the best alternative and making it effective Select the alternative which generates net maximum benefit. Moreover, people in the organisation must be informed about the decision in order to make it effective. Costs for Decision Making The following are the important cost concepts used in decision-making: (1) Relevant Costs: A relevant cost is a cost that is affected by a managerial decision. Relevance means pertinent to decision in hand. Relevant costs for decision-making are expected future costs that will differ under various alternatives. For example, if a decision is to be taken whether idle capacity should be utilized or not. The costs that are relevant in this decision are the additional cost that will be incurred for utilizing idle capacity. The costs that are already incurred will be irrelevant costs and will be ignored for taking decisions. Examples of relevant cost are marginal or variable cost, specific cost, incremental costs, opportunity cost, out of pocket costs etc. (2) Irrelevant Costs: Costs that are not affected by managerial decisions and hence are ignored while taking decisions. Examples of irrelevant costs are general or absorbed fixed cost, committed costs, sunk costs etc. (3) Sunk Costs: Sunk Cost are historical costs incurred in past that cannot be changed and over which management has no control. These costs are not relevant for decision making about the future but they are frequently analysed in detail before decisions about future courses of action are made. For example, in case of decision relating to replacement of a machine, the written down value of existing machine is a sunk cost and therefore not considered. (4) Differential (Incremental and Decremental) Cost: It refers to the change (increase or decrease) in total cost that occurs due to change in activity level, technology, process or method of production etc. This cost is regarded as the difference in total cost resulting from contemplated change. (5) Marginal Cost: It is the additional cost of producing one additional unit and it is the same thing as variable cost. Marginal costing is a technique of charging only variable 2

5 costs to products and helps in decisions like make or buy pricing of products, selection of sales mix etc. Hence, this cost concept is of great relevance in managerial decisionmaking. (6) Imputed Costs: These are hypothetical costs which are specially computed outside the accounting system for the purpose of decision-making. Interest on capital, rent of premises payment for which is not actually made are examples of imputed cost. (7) Opportunity costs: It is cost that measures the benefit that is lost or sacrificed when the choice of one course of action requires that other alternative course of action be given up. It is pure decision-making cost. For example, a company deposited Rs.1 lakh in bank at 10% p.a interest. Now it considers to invest this amount in debentures where yields is 17%. If company decides to invest in debentures it will have to forego bank interest of Rs p.a which is an opportunity cost. (8) Replacement Cost: It is current market cost of replacing assets. For example: a machinery purchased in 1990 at Rs is discarded in 1998 and new machinery of same type is purchased for Rs So, the replacement cost of machinery is Rs (9) Out of pocket costs: out of pocket costs ate those costs that involve cash outlays which may be either fixed or variable. It is frequently used as an aid in make or buy decisions, price fixation during depression. Examples are wages, material cost, and insurance. Depreciation on plant and machinery does not involve any cash outlay. Decision Making and Marginal Costing Marginal costing technique is used in providing assistance to the management in vital decision making, especially in dealing with the problems requiring short-term decisions where fixed costs are excluded. The following are important areas where managerial problems are simplified by the use of the marginal costing. Fixation of selling price Effect of change in price Maintaining desired level of profit Key or Limiting Factor Make or Buy Decision Selection of Suitable product mix Closing down or suspending activities Alternative methods of production Fixation of Selling Price Although prices are more controlled by market conditions and other economic factors than by decisions of management yet fixation of selling prices is one of the most important functions of management. This function is to be performed: a) Under normal circumstances b) In times of competition c) In times of trade depression 3

6 d) In accepting additional orders for utilizing idle capacity e) In exporting and exploring new markets In normal circumstances the price fixed must cover total cost, as otherwise profits cannot be earned but under other circumstances, products may have to be sold at a price below total cost, if such a step is necessary to meet the situation arising due to competition, trade depression, additional orders for utilising spare capacity, exploring new markets etc. Thus, in special circumstances, price may be below total cost and it should be equal to marginal cost plus certain amount (if possible). Pricing in Depression: Prices fall during depression and product may be sold below total cost. In case there is serious but temporary fall in the demand on account of depression leading to the need for a drastic reduction in prices temporarily, the minimum selling price should be equal to marginal cost. If the selling price at which the goods can be sold is equal to marginal cost or more than marginal cost the product should be continued. Fixed expenses will be incurred even if product is discontinued during depression for a short period. If the product can be sold at a price which is little more than marginal cost, loss on account of fixed expenses will reduce because price will recover fixed expenses to some extent. If the selling price is below the marginal cost, loss will be more than the fixed costs because variable expenses will not be recovered fully. Hence, efforts should be made to sell the product at a price which is equal to marginal cost or more than marginal cost. Production should be discontinued if the price obtained is below the marginal cost so that loss may not be more than the fixed costs. Selling Price Below the Marginal Cost In the following circumstances production may be continued even if the selling price is below the marginal cost. 1. When a new product is introduced in the market. 2. When foreign market is to be explored to earn foreign exchange. 3. When concern has already purchased large quantities of materials. 4. When sales of one product at a price below the marginal cost will push up the sales of other profitable products. 5. When employees cannot be retrenched. 6. When competitors are to be eliminated from the market. 7. When the goods are of perishable nature. Accepting Additional Orders, Exploring Additional Markets and Exporting When additional orders are accepted or additional markets explored at a price below normal price to utilise idle capacity, it should be very carefully seen that they will not affect the normal market and goodwill of the company. The order from local merchant should not be accepted at a price below normal price because it will affect relationship of concern with other customers purchasing the goods at normal price. In case of foreign markets, goods may be sold at a price below normal price keeping in view the direct and indirect benefits of exporting such as import quotas, subsidies of government. Factors to be considered before Launching a Product in the New Market (1) Whether the firm has surplus capacity to meet the new demand. (2) The price offered by the new market or expected to be realised should fully recover variable cost plus additional expenditure to be incurred in launching product in the new 4

7 market. Over and above this price should earn a profit margin considered appropriate by the producer depending on market conditions and marketing strategy. (3) Lower price charged in the new market, domestic or foreign, should not adversely affect price or demand in existing market. Goods sold at lower price in the new market should not be dumped back in the existing market. Illustration 1: MM Company Limited produces a single product. Its selling price and production cost per unit as under: Output 40,000 units Rs. Material cost 4.00 Labour cost 4.00 Variable overhead 2.00 Fixed expense 4.00 Total Cost Due to depression, the company is not able to sell at the existing selling price of Rs.16 per unit. However, it is possible to sell the total output of 40,000 units at Rs.12 per unit. You are required to advise whether the company should sell at Rs.12 per unit or close the factory. Solution: Profit Statement if output is sold at Rs. 12 per unit Sales : Rs. 12 per unit 4,80,000 Less : Variable Rs.10 per unit (Rs.4 + Rs. 4 + Rs.2) 4,00,000 Contribution 80,000 Less : Fixed cost (40,000 x Rs.4) 1,60,000 Loss (80000) If company sells at Rs.12 per unit it will suffer a loss of Rs.80,000. However, if the company discontinues the production it will suffer a loss of Rs.160,000 on account of fixed costs which cannot be avoided during the period of closure of factory. It is therefore advantageous to sell at Rs.12 per unit even though it is below the total cost of Rs.14 per unit Any price above the marginal cost will reduce loss and therefore should be acceptable. Illustration 2: The Everest Snow Company manufacturers and sells direct to customers 10,000 jars of Everest Snow per month at Rs per jar. The company s normal production capacity is 20,000 jars and snow per month. Analysis is of cost for 10,000 jars show: Direct Material 1,000 Direct Labour 2,475 Power 140 Misc. Expense 430 Jars 600 Fixed expenses of manufacturing, Selling and administration 7,955 Total Rs. 12,600 5

8 The company has received an offer for export under a different brand name of 10,000 jars per month at 75 paise a jar. Write a short note on the advisability of accepting the offer? Solution: Particulars Present position Position after export order receipt Sales price Less Variable cost Direct material Direct labour Power Misc. Supplies Jars Contribution Less Fixed cost Profit (loss) 12,500 1,000 2, ,645 7,855 7,955 (100) (12,500+7,500) 20,000 2,000 4, ,200 9,290 10,710 7,955 2,755 Note: From the above statement it is clear that the offer for export should be accepted as it converts the loss of Rs.100 into net profit of Rs.2,755. Illustration 3: (Selling Price Decision) Prestige Company Private Limited, manufacturing pressure cookers has drawn up the following budget for the year Raw materials 20,00,000 Labour, stores, power and other variable costs 6,00,000 Manufacturing overheads 7,00,000 Variable distribution costs 4,00,000 General overheads including selling 3,00,000 Total 40,00,000 Income from sales 50,00,000 Budgeted profit 10,00,000 The General Manager suggests to reduce selling prices by 5% and expects to achieve an additional volume of 50%. There is sufficient manufacturing capacity. More intensive manufacturing programme will involve additional costs of Rs.50,000 for production planning it will also be necessary to open an additional sales office at a cost of Rs.1,00,000 per annum. The Sales Manager, on the other hand, suggests to increase selling price by 10% which is estimated to reduce sales volume by 10%. At the same time, saving in manufacturing overheads and general overheads at Rs.50,000 and Rs.1,00,000 per annum respectively is expected on this reduced volume. Which of these two proposal would you accept and why? 6

9 Solution: Comparative Statement of Budgeted Profit Proposal I Rs. Proposal II Rs. Sales 71,25,000 49,50,000 Cost of Sales: Raw materials 30,00,000 18,00,000 Labour, stores, power and other variable costs Manufacturing overheads Variable distribution cost General overheads including selling 9,00,000 5,40,000 7,50,000 6,50,000 6,00,000 3,60,000 4,00,000 2,00,000 Total 56,50,000 35,50,000 Profit (Sales Cost of sales) 14,75,000 14,00,000 Conclusion: Proposal I gives a larger profit of Rs.14,75,000 and thus should be accepted. Working Notes Sales: Proposal I Rs. 50,00,000 x x Rs.71,25, II Rs. 50,00,000 x x Rs.49,50, Raw material: Proposal I Rs. 20,00, % = Rs. 30,00,000 II Rs. 20,00,000-10% = Rs. 18,00,000 Labour etc.: Proposal I Rs.6,00, % = Rs. 9,00,000 Effect of Change in Sales Price II Rs. 6,00,000-10% = Rs. 5,40,000 Management is confronted with the problem of cut in prices of products from time to time on account of competition, expansion programmes or government regulations. It is therefore necessary to know the effect of a cut in selling price per unit will be that contribution per unit will reduce. Illustration 4: The selling price of a product was Rs. 200 per unit, as against its variable cost of Rs.100 per unit. Total fixed costs were Rs.2,00,000. Calculate the effect of a reduction in price by Rs. 40 on the P/V ratio, break-even point and margin of safety, if 4000 units were produced and sold. 7

10 Solution: Particulars Results before price reduction Results after price reduction Selling Price (S) Less Variable cost per unit Contribution per unit Fixed Cost (F) P/V ratio = C/S BEP = F/ P/V ratio Total Sales Margin of safety Rs Rs.2,00, /200 = 0.5 or 50% 2,00,000/5 = Rs.4,00,000 4,000 x 200= 8,00,000 8,00,000 4,00,000 = Rs.4,00,000 Rs Rs.2,00,000 60/160=0.375or37.5% 2,00,000/.375 = Rs 5,33,333 4,000 x160=6,40,000 6,40,000 5,33,333 = Rs.1,06,667 Illustration 5: XYZ Ltd. has the following budget for the year Sales (1,00,000 Rs.20) Rs.20,00,000 Variable cost 10,00,000 Contribution 10,00,000 Fixed Cost 4,00,000 Net Profit 6,00,000 From the above set of information find out: (a) The adjusted profit for if the following two sets of changes are introduced and also suggest which plan should be implemented. Plan A Increase in price Decrease in volume Increase in variable cost Increase in fixed cost 20% 25% 10% 5% Plan B Decrease in price Increase in volume Decrease in variable cost Decrease in fixed cost 20% 25% 10% 5% (b) The P/V ratio and breakeven point under the two plans referred above. 8

11 Solution: Comparative Profit, P/V ratio and BEP Sales Original budget Plan A Plan B volume 1,00,000 75,000 1,25,000 Per unit Total Per unit Total Per unit Total Sales (S) less variable cost Contribution 20 20,00, ,00, ,00,000 Less cost Profit P/V ratio fixed 10 10,00, ,00,000 4,00,000 6,00,000 10/20=0.5 or 50% 11 8,25, ,75,000 4,20,000 5,55,000 13/24 = or 54.16% 9 11,25, ,75,000 3,80,000 4,95,000 7/16 = or 43.75% BEP units= F/Contribut ion per unit 4,00,000/10=40,000 4,20,000/13= ,80,000/7= BEP = F/P/V ratio 4,00,000/0.5 = Rs. 8,00,000 4,20,000/ = Rs.7,75, ,80,000/ = Rs. 8,68, Maintaining a Desired Level of Profits Management may be interested in maintaining a desired level of profits. The volume of sales needed to have a desired level of profits can be ascertained by the marginal costing technique. Illustration 6: The profit of P Ltd. for the year works out to 12.5% of the capital employed and the relevant figures are as under: Sales 5,00,000 Variable overheads 40,000 Direct materials 2,50,000 Capital employed 4,00,000 Direct labour 1,00,000 The new sales manager who has joined the company recently estimated for the next year a profit of about 23% on capital employed provided the volume is increased by 10% and simultaneously there is an increase in selling price of 4% and an overall cost reduction in all the elements of cost of 2%. Find out by computing in detail the cost and profit for the next year. Whether the proposal of sales manager can be adopted? 9

12 Solution: Old Fixed Cost = Sale Total Variable Cost Profit = 5,00,000 (2,50, ,00,000+40,000)- (4,00,000 x 12.5/100) = Rs. 60,000 Particulars Sales (a) Direct Material Direct labour Variable overheads Total Variable cost (b) Contribution (a) (b) Fixed Cost Profit Profit on capital employed Budgeted Cost and Profit for the next year Existing Results 5,00,000 2,50,000 1,00,000 40,000 3,90,000 1,10,000 60,000 50, % Budgeted sales, cost and profit for the next year 5,00,000 x110/100 x104/100 = 5,72,000 2,50,000 x 110/100 x 98/100 = 2,69,500 1,00,000 x 110/100 x 98/100 = 1,07,800 40,000 x 110/100 x 98/100 = 43,120 = 4,20,420 1,51,580 60,000 x 98/100 58,800 92,780 Profit/capital employed x 100 = 92,780/4,00,000 x 100 = % The proposal by the sales manager yields the desired profit on capital employed. Hence, the proposal can be accepted. 10

13 2 MARGINAL COSTING AND DECISION-MAKING Smriti Chawla Shri Ram College of Commerce University of Delhi CHAPTER OBJECTIVES Marginal costing and Decision making Key or Limiting Factor Make or Buy Decisions Selection of Suitable Product Mix Closing down or Suspending Activities Alternative factors of Production (with Illustrations) Key or Limiting Factor A key factor is that factor which puts a limit on production and profit of a business. Usually the limiting factor is sales. A concern may not be able to sell as much as it can produce. But sometimes a concern can sell all it produces but production is limited due to shortage of materials, labour, plant capacity or capital. In such a case, a decision has to be taken regarding the choice of the product whose production is to be increased, reduced or stopped. When there is no limiting factor the choice of the product will be on the basis of the highest P/V ratio. But when there are scarce or limited resources, selection of the product will be on the basis of contribution per unit of scarce factor of production. Illustration 1: A company manufactures and markets three products A, B and C. All the three products are made from the same set of machines. Production is limited by machine capacity. From data given below indicate priorities for products A, B and C with a view to maximizing profits. Product A Product B Product C Raw Material Cost per unit Rs.2.25 Rs.3.25 Rs Direct Labour cost per unit Re.0.50 Re.0.50 Re 0.50 Other variable cost per unit Re Re.0.45 Re.0.71 Selling price per unit Rs.5.00 Rs.6.00 Rs.7.00 Standard machine time required per unit 39 minutes 20 minutes 28 minutes 11

14 In the following year the company faces extreme shortage of raw materials. It is noted that 3kg, 4kg and 5 kg of raw materials are required to produce one unit of A, B and C respectively. How would products priorities change? Solution: Current Year Selling price per unit Less Marginal cost per unit Raw materials cost Direct labour cost Other variable cost Contribution per unit Standard machine time required per unit (minutes) Contribution per machine minute Priorities for products Following year Raw materials required to produce one unit Contribution per kg of raw material Priorities for products Make or Buy Decisions A paise III 3 kg 65 paise I Products B paise I 45 paise II 20 4 kg C /2 paise II 5 kg 30.8 paise III A concern can utilize its idle capacity by making component parts instead of buying them from market. In arriving at such a make or buy decision, the price asked by the outside suppliers should be compared with the marginal cost of producing the component parts. If the marginal cost is lower than the price demanded by the outside suppliers, the component parts should be manufactured in the factory itself to utilize unused capacity. Fixed expenses are not taken in the cost of manufacturing component parts on the assumption that have been already incurred, the additional cost involved is only variable cost. Factors that influence Make or Buy Decision Cost Factors: In make or buy decision the following cost and non-cost factors must be considered: (1) Availability of plant facility (2) The space required for production of item. (3) Any special machinery or equipment required. (4) Cost of acquiring special know how required for the item (5) Any transportation involved due to location of production. 12

15 (6) As to labour factors like availability of required labour, sheet required and other must be kept in view. (7) As to overhead expenses, adoption of lease for apportioning them must be taken into consideration including other factors. Non-Cost Factors: (1) In favour of making, the factors like: Secrecy of company production Ideal facility available Tax considerations Quality and stability of market supply (2) In favour of buying factors: Lack of capital required Wide selection Passing know how to suppliers or not Uneven production of end product. (3) The outside supplier should not be competitor. (4) In case there are large fluctuation in demand, it is better to purchase from outside, but if demand is likely to increase substantially own production may lead to lower cost latter. Illustration 2: A radio manufacturing company finds that while it costs Rs to make component X 273 Q, the same is available in market at Rs each with an assurance of continued supply. The break down of the cost is: Cost per unit Material Labour Variable overhead 5.00 Depreciation and other fixed costs (a) Should the company make or buy the component? (b) What would be your decision, if supplier offered the component at Rs each? Solution: Compare the marginal cost of making the component with the cost of buying. It is done below: The marginal cost of manufacturing the component: Material Labour Variable overhead Cost of buying the component Disadvantage in buying: Rs Rs.50 = Rs.7.50 per unit. Hence, the company should make the component instead of buying. Here fixed cost are sunk cost and irrelevant for decision. 13

16 (b) If the component is available at Rs each then the option to buy will be profitable as it will result in the saving of Rs per unit (Rs. 50 marginal cost of manufacture less Rs purchase price) Illustration 3: (Make or Buy Decision) Auto Parts Ltd. has an annual production of 90,000 units for a motor component. The component cost structure is as below: Materials Rs. 270 per unit Labour (25% fixed) Expenses: Variable Fixed Total 180 per unit 90 per unit 135 per unit 675 per unit (a) The purchase manager has an offer from a supplier who is willing to supply the component at Rs.540. Should the component be purchased and production stopped? (b) Assume the resources now used for this component's manufacture are to be used to produce another new product for which the selling price is Rs.485.In the latter case the material price will be Rs.200 per unit. 90,000 units of this product can be produced at the same cost basis as above for labour and expenses. Discuss whether it would be advisable to divert the resources to manufacture that new product, on the footing that the component presently being produced would, instead of being produced, be purchased form the market. Solution Rs. Material 270 Labour (75% of Rs.180) 135 Variable expenses 90 Total variable cost when component is produced 495 Suppliers price 540 Excess of purchase price over variable cost = = Rs.45 (a) Fixed expenses are not affected whether the component is made or purchased. Thus company should make the component itself because if purchased from outside it will have to pay Rs.45 per unit more and on 90,000 Rs.45 it comes to Rs.40,50,000. (b) Cost implications of proposal to divert available production facilities for a new product: 14

17 Rs. Selling price of per unit of new product 485 Less: Variable costs - Material 200 Labour 135 Expenses Contribution per unit 60 Loss if present component is purchased = = Rs.45. If company diverts the resources for the production of a new product, it will benefit by Rs.15 (i.e. Rs.60 45) per unit. On 90,000 units it will Rs.15 i.e. Rs.13,50,000. Thus, it is advisable to divert the production facilities in the manufacture of the new product and the component presently being manufactured should be bought from outside. This will result in additional profit of Rs.13,50,000. Selection of Suitable product mix When a factory manufactures more than one product, a problem is faced by management as to which product mix will give maximum profits. The best product mix is that which yields the maximum contribution. The products which give the maximum contribution are to be retained and their production should be increased. The products, which give comparatively less contribution, should be reduced or closed down altogether. The effect of sales mix can also be seen by comparing the P/V ratio and break even point. The new sales mix will be favourable if it increases P/V ratio and reduced the break even point. Illustration 4: A manufacturer with an overall capacity of one lakh machine hours (interchangeable among products) has so far been producing a standard mix of 15,000 units of product A, 10,000 units of Product B and C each. The total expenditure exclusive of fixed charges is Rs lakhs and variable cost ratio among the products approximates 1:1.5:1.75respectively per unit. The fixed charges came to Rs per unit. When the unit selling prices are Rs for A, Rs 7.50 for B and Rs for C, he incurs a loss. He desires to change the product mix as under: A B C Mix 1 Mix 2 Mix 3 18,000 15,000 22,000 12,000 6,000 8,000 7,000 13,000 8,000 As an accountant what mix will you recommend? 15

18 Solution: (i) Computation of variable cost per unit Total variable cost of Rs. 2,09,000 will be apportioned among the three products in the following ratio: A 15,000 x 1= Rs.15000: B 10,000 x 1.5 = Rs C 10,000 x 1.75 = Rs. 17,500 6:6:7 Hence, total variable cost of each product will be A : 2,09,000 x 6/19 = Rs.66,000 B : 2,09,000 x 6/19 = Rs.66,000 C : 2,09,000 x 7/19 = Rs.77,000 And per unit variable cost of each product: A : 66,000/15000= Rs per unit B : 66,000/10,000 = Rs.6.60 per unit C : 77,000/ 10,000 = Rs per unit or (ii) Computation of contribution per unit of each product: Product A Product B Product C Selling price Variable cost Contribution (iii) It is assumed that the fixed cost of Rs. 70,000 (35,000 unit of present mix at Rs. 2) remains constant for all proposed mixes. Comparative profitability statement to evaluate here product mixes. Product A B C Contribution Less fixed charges Profit(loss) Contribution rate per unit Mix 1 Mix 2 Mix 3 Units Total contribution 18,000 33,300 12,000 10,800 7,000 19,600 63,700 70,000 (6300) Units Total contribution 15,000 27,750 6,000 5,400 13,000 36,400 69,550 70,000 (450) Units Total contribution 22,000 40,700 8,000 7,200 8,000 22,400 70,300 70,

19 Note : It is evident from the above statement that Mix 3 gives the maximum total contribution and gives a net profit of Rs.300 after recovering fixed cost hence Mix 3 is recommended. Closing Down or Suspending Activities: Sometimes, it become necessary for firm to temporarily suspend or close the activities of the particular product, factory or department as a whole due to trade recession. The decision to close down or suspend it activities will depend on whether product are making contribution towards fixed cost or not. If products are making contribution towards fixed cost it is preferable not to close business or suspend its activities to minimise the losses. If business is closed down there may be certain fixed cost which could be avoided but there will be certain expenses which will have to be incurred at the time of closing the operation like redundancy payments, maintenance of plant etc. Such cost are associated with closing down of the business and must be taken into consideration before taking any decision. Fixed cost may be general or specific. General fixed cost may or may not remain constant while specific cost will be directly affected by closing down of operation. In addition to cost consideration, there may be some non-cost considerations which may weigh in taking the decision to close down or suspend its activities or not. The following noncost considerations are relevant in this respect: Once business is closed down, competitors may establish their products and our business may be lost. It may be difficult to recapture the lost market again. Fear of retrenchment of workers. If workers are discharged it may be difficult to get experienced and skilled workers again at the restart of business. Plant may become obsolete with the closure of business and heavy capital expenditure may have to be incurred on restart of the business. Reputation of the firm may suffer if some activities are closed down or suspended. Temporary closing down or suspending activities may not be desirable if the relationship with the suppliers is adversely affected. Alternative Methods of Production: Marginal costing is helpful in comparing alternative method of production, i.e., machine work or handwork. The method which gives the greatest contribution (assuming fixed expense remaining same) is to be adopted keeping, of course the limiting factor in view. Where, however, fixed expenses change, the decision will betaken on the basis of profit contributed by each. Illustration 5: Product X can be produced either by machine A or machine B. Machine A can produce 100 units of X per hour and machine B 150 units per hour. Total machine hours available during the year are 2,500. Taking into account the following data determine the profitable method of manufacture. Per unit of product X Machine A (Rs) Machine B(Rs) Marginal cost 5 6 Selling price 9 9 Fixed cost

20 Solution: Profitability Statement Machine A (Rs.) Machine B (Rs.) Selling price per unit 9 9 Less marginal cost 5 6 Contribution per unit 4 3 Output per hour 100 units 150 units Contribution per hour Machine hours per year Annual contribution 10,00,000 11,25,000 Hence, production by machine B is more profitable. Illustration 6: (Sales Mix Decision). A multi-product company provides the following costs and output data for the last year. Products X Y S Sales mix 40% 35% 25% Rs. Rs. Rs. Selling price Variable cost per unit Total fixed cost 1,50,000 Total sales 5,00,000 The company proposes to replace Product Z by Product S. Estimated cost and output data are: Products X Y Z Sales mix 50% 30% 20% Rs. Rs. Rs. Selling price Variable cost per unit Total fixed cost 1,50,000 Total sales 5,00,000 Analyses the proposed change and suggest what decision the Company should take. 18

21 Solution: Present Position Products Total X Y Z Selling price Rs Less : Variable cost Rs Contribution Rs P/V ratio 50% 40% 40% Sales mix 40% 35% 25% 100% Sales Rs. 2,00,000 1,75,000 1,25,000 5,00,000 Contribution (Sales x P/V ratio) Rs. 1,00,000 70,000 50,000 2,20,000 Less: Fixed cost Rs. 1,50,000 Profit Rs. 70,000 B.E. Point (Rs.1,50,000 44%*) Rs.3,40,909 *Overall P/V ratio = 2,20,000 5,00,000 x 100 = 44% Proposed Position Products Total X Y S Selling price Rs Less : Variable cost Rs Contribution Rs P/V ratio 50% 40% 50% Sales mix 50% 30% 20% 100% Sales Rs. 2,50,000 1,50,000 1,00,000 5,00,000 Contribution (Sales x P/V ratio) Rs. 1,25,000 60,000 50,000 2,35,000 Fixed cost Rs. 1,50,000 Profit Rs. 85,000 B.E. Point (Rs.1,50,000 47%*) Rs.3,19,149 *Overall P/V ratio = 2,35,000 5,00,000 x 100 = 47% 19

22 Conclusion: It may thus, be concluded that the proposed change should be acceptable because replacement of Product Z by Product S will: (a) increase profit by Rs.15,000 (i.e., 85,000 70,000); (b) bring down B.E. point from Rs.3,40,909 to Rs.3,19,149. Illustration 7: (Changes in Price and Volume) Reliable Product Co. manufactures product MK. The company is expected to show a profit of Rs.14,00,000 from the production of this product MK in the year 1999, after charging fixed cost of Rs.10,00,000. Product MK is sold for Rs.50 per unit and has a variable cost of Rs.20 per unit. Market research suggest the following responses to price charges: Alternative Selling price reduced by Quantity sold increased by A 5% 10% B 7% 20% C 10% 25% Evaluate these alternatives and suggest on profitability considerations, which alternative should be adopted for the forthcoming year 2000, assuming there is no change in the cost structure. Solution: Total Contribution = F + P = 14,00, ,00,000 = Rs.24,00,000. Contribution per unit = S V = = Rs.30 Quantity produced = Rs.24,00,000 Rs.30 = 80,000 units. PROFITABILITY STATEMENT Alternatives A B C Rs. Rs. Rs. Selling price Less: Price reduction New price Less: Variable cost (A) New contribution Sales (units) 80,000 80,000 80,000 Add: Increase 8,000 16,000 20,000 (B) New sales (units) 88,000 96,000 1,00,000 Total Contribution (A x B) Rs. 24,20,000 25,44,000 25,00,00 Less: Fixed cost 10,00,000 10,00,000 10,00,000 Profit 14,20,000 15,44,000 15,00,000 Conclusion: Alternative B should be adopted as it results in the highest of contribution and profit. 20

23 Illustration 8: (Discontinuance of a Product Line) Pee Kay Ltd. is engaged in 3 distinct lines of production. Their production cost per unit and selling prices are as under : A B C Production (units) 3,000 2,000 5,000 Rs. Rs. Rs. Material cost Wages Variable overheads Fixed overheads Total cost Selling price Profit The management wants to discontinue one line and gives you the assurance that production in two other lines shall rise by 50%. They intend to discontinue the line which produces Article A as it is less profitable.(a) Do you agree to the scheme in principle? If so, do you think that the line which produces 'A' should be discontinued? (b) Offer your comments and show the necessary statements to support your decision. Solution: Total Fixed Overheads: A (3,000 Rs.5) 15,000 B (2,00 Rs.8) 16,000 C (5,000 Rs.9) 45,000 Total fixed overheads 76,000 Contribution = Selling price Variable cost Article A = = Rs. 13 per unit B = = Rs.22 per unit C = = Rs.18 per unit The decision should be taken on relative profitability of various alternative as ascertained below: Profits from different production arrangements are shown below: (a) If 'A' is given up, sale of B and C will increase by 50%. Then the sales would be, B -3,000 units are Article C 7,500 units. Contribution on B = 3,000 x 22 = Rs. 66,000 Contribution on C = 7,500 x 18 = Rs. 1,35,000 21

24 Total contribution 2,01,000 Less: Fixed overheads 76,000 Profit Rs. 1,25,000 (b) If 'B' is discontinued, production of A and C will increase by 50%, i.e. A 4,500 units and C 7,500 units. Contribution on A = 4,500 x 13 = Rs. 58,000 Contribution on C = 7,500 x 18 = Rs. 1,35,000 Total contribution 1,93,500 Less: Fixed overheads Rs. 76,000 Profit Rs. 1,17,500 (c) If 'C' is discontinued, production of A will be 4,500 units and that of B will be 3,000 units. Contribution on A = (4,500 x 18) Contribution on B = (3,000 x 22) Total contribution Rs.58,500 Rs.66,000 Rs.1,24,500 Less: Fixed overheads Rs. 76,000 Profit Rs. 48,500 Conclusion: Of the three alternatives, the highest amount of profit (Rs.1,25,000) is earned when A line of production is discontinued. Thus, the management decision to discontinue A line is correct. 22

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26 3 DIFFERENTIAL COST ANALYSIS Smriti Chawla Shri Ram College of Commerce University of Delhi CHAPTER OBJECTIVES Meaning Characteristics of Differential Cost Difference between Differential Cost Analysis and Marginal Costing Practical Applications of Differential Cost Analysis Determination of Optimum level of production Accept or Reject Decision Adding or Dropping a Product line Make or buy decisions Sell or process decisions Introduction of Additional shift (with Illustrations) Meaning Differential cost is the change in the costs which may take place due to increase or decrease in output, change in sales volume, alternate method of production, make or buy decisions, change in product mix etc. So, differential cost is the result of an alternative course of action. For example, difference in costs may arise because of replacement of labour by machinery and difference in costs of two alternative courses of action will be the differential cost. If change in cost occurs due to change in level of activity, differential cost is referred to as incremental cost in case of increase in output and decremental cost in case of decrease in output. In differential cost analysis costs are calculated on the basis of absorption or total costing technique, but in marginal costing technique, costs are calculated on the basis of variable costs only and fixed costs are not taken. But if the alternate course of action does not 23

27 involve any extra fixed costs change in variable costs will become differential costs and there will be no difference between marginal costs and differential costs. Differential cost is the change in cost which may result from the adoption of an alternate course of action or change in the level of activity. Change in cost may take place due to change in fixed costs and variable costs, so differential cost is the aggregate of changes in fixed costs and variable costs which take place due to the adoption of an alternate course of action or change in the level of output. Characteristics of Differential Cost The following are the essential characteristics of differential costs: 1. Differential cost analysis is not made within the accounting records rather it is made outside the accounting records. Differential costs may, however, be incorporated in the flexible budgets because they budget costs at various levels of activity. 2. Total differential costs are considered in differential cost analysis. Cost per unit is not taken into consideration. 3. Total differential revenues are compared with total differential costs before advocating an alternate course of action. A change in course of action is recommended only if differential revenues exceed differential costs. 4. The items of cost which do not change for the alternatives under consideration are ignored, only the difference in items of costs are considered because differential costs analysis is concerned with changes in costs. 5. The changes in costs are measured from a common base point which may be a present course of action or present level of production. 6. Differential cost analysis is related to the future course of action or future level of output, so it deals with future costs. Historical costs or standard cots may be used but they should be suitably adjusted to future conditions. 7. For making a choice among the various alternatives, the alternative which gives the maximum difference between the incremental revenue and incremental cost is recommended to be adopted. Difference Between Differential Cost Analysis and Marginal Costing Differential costs are often confused with marginal costs; so it is better to compare the two to remove the confusion. The points of similarity and difference between the two are summarized as follows: 24

28 Similarity 1. Both are techniques of cost analysis and cost presentation. 2. Both are used for taking managerial decisions such as effect on profits by following changes in sales volume, product mix, price or method of production. 3. Marginal costs and differential costs are the same when there is no change in fixed costs on account of increase or decrease in output. Difference 1. Under marginal costing technique, fixed costs are not added to get the marginal cost of a product whereas differential cost analysis takes into consideration changes in fixed costs due to change in output. 2. Differential cost analysis is helpful in taking the managerial decisions and is not incorporated in accounting records. In other words, differential costs are calculated separately as analysis statements. On the other hand, marginal costs may be incorporated in the accounting records. 3. Marginal costs are calculated on the basis of contribution approach whereas differential costs may be ascertained on the basis of both absorption costing as well as marginal costing. 4. In marginal costing, margin of contribution, contribution per unit of limiting factor and profit-volume ratio are the main yardsticks for evaluating the managerial decisions whereas in differential cost analysis, differential costs are compared with the differential revenues of determine whether alternate course of action should be followed or not. Practical Applications of Differential Costs Many managerial decisions involving problems of alternative choices are made with the help of differential cost analysis. Such decisions include the following: (1) Determination of the Optimum Level of Production The optimum level is that level of production where profit is the maximum. In order to arrive at a decision of this type, the differential costs are compared with incremental revenue at various levels of output. So long as the incremental revenue exceeds differential costs, it is profitable to increase the output. But as soon as the differential cost equals or exceeds increments revenue, it is no more profitable to increase the volume of output. Illustration 1: A company has a capacity of producing 1,00,000 units of a certain product in a month. The sales department reports that the following schedule of sale prices is possible: 25

29 Volume of production Selling price per unit Re. At 60% capacity 60,000 units 0.90 At 70% capacity 70,000 units 0.80 At 80% capacity 80,000 units 0.75 At 90% capacity 90,000 units 0.67 At 100% capacity 1,00,000 units 0.61 Variable cost of manufacture is 15 paise per unit and total fixed cost Rs.40,000. Prepare a statement showing incremental revenue and differential cost of each stage. At which volume of production will the profit be maximum? Solution: Statement of Differential Cost and Incremental Revenue Capacity Units output of Variable Re.0.15 Rs. Fixed cost Rs. Total cost Rs. Differential cost Rs. Sales Rs. Incremental revenue Rs. 60% 60,000 9,000 40,000 49, , % 70,000 10,500 40,000 50,500 1,500 56,000 2,000 80% 80,000 12,000 40,000 52,000 1,500 60,000 4,000 90% 90,000 13,500 40,000 53,500 1,500 60, % 1,00,000 15,000 40,000 55,000 1,500 61, At 80% volume of production, profit is maximum. This is because at this level, incremental revenue is Rs.4,000 whereas, differential cost is Rs.1,500, resulting in additional profit of Rs.2,500 (i.e. Rs.4,000 1,500). After 80% level, differential cost exceeds incremental revenue thereby resulting in a loss. 26

30 (2) Accept or Reject Decision Sometimes a concern may receive special offers from its regular customers to sell its regular products. Special offers may be received from the home customers for one time quantity sales or sales to foreign customers. Such offers generally are received at lesser prices than the usual customary prices. The decision to accept or reject special offers is based entirely on differential cost and the contribution margin approach. The point to be considered is whether incremental revenue is more than the differential costs to be incurred. The use of absorption costing is not preferred as it may show misleading results. While deciding about special offers rejection or acceptance the following factors should be taken into consideration: (i) (ii) (iii) (iv) (v) The impact on future earnings of temporarily reduction in he selling price. The effect of reducing selling prices on the existing customers when it comes to their knowledge. The possibility of selling additional units to the new customers beyond the special offer. The reliability of cost estimates associated with the offer. The effect on current and future capacity in terms of an expansion of plant, personnel, financial requirements and other capacity constraints. Illustration 1(Continued): If there is a bulk offer for export at 50 paise per unit for the balance capacity over the maximum profit volume and the price quoted will not affect the internal sales, will you advise accepting this bid and why? Solution: Internal Market (80,000 units) Special Order for export (20,000 units) Total (1,00,000 units) Rs. Rs. Rs. 12,000 3,000 15,000 Variable 15 paise per unit Fixed cost 40, ,000 Total Cost 52,000 3,000 55,000 Sales 60,000 10,000 70,000 Profit 8,000 7,000 15,000 It is advisable to accept the bulk Re.0.50 per unit for the balance capacity of 20,00 units (i.e. 1,00,000 80,000) for export as it will result in an increase of profit by Rs.7,

31 (3) Adding or Dropping a Product Line In a multi-product company, the management may have to decide on adding or dropping a product line. When a new product line is added, its sales and certain costs will also be increased and reverse will happen when a product line is dropped. In order to arrive at such a decision, the management should compare the differential cost and incremental revenue and study its effect on the overall profit position of the company. Illustration 2: The management of a company is thinking whether it should drop one item from the product line and replace it with another. Given below are present cost and output data: Product Price Variable costs per Percentage of sales Rs. unit Rs. Book shelf % Table % Bed % Total fixed costs per year Rs. 7,50,000 Sales Rs. 25,00,000 The change under consideration consists in dropping the line of Tables and adding the line of Cabinets. If this change is made, the manufacturer forecasts the following cost and output data: Product Price Variable costs per Percentage of sales Rs. unit Rs. Book shelf % Cabinet % Bed % Total fixed cost per year Rs. 7,50,000 Sales Rs.26,00,000 Should this proposal to be accepted? Comment. 28

32 Solution: Comparative Profit Statement Existing situation Proposed situation Book Shelf Table Bed Total Book Shelf Cabin et Bed Total Sales 7,50,0 00 5,00, ,50, ,00, ,00,0 00 2,60, ,40, ,00,0 00 Less: V.C. 5,00,0 00 3,00,0 00 7,50, ,50,0 00 8,66, ,50 0 6,24, ,88,1 67 Contributio n 2,50,0 00 2,00,0 00 5,0,000 9,50,00 0 4,33,33 3 1,62,5 00 4,16, ,11,8 33 Less: Fixed cost 7,50,00 0 7,50,00 0 Profit 2,00,00 0 2,61,83 3 2,61,83 3 Incremental revenue Differential cost Additional profit = Rs.26,00,000 Rs.25,00,000 = Rs.1,00,000 = Rs.15,88,167 15,50,000 = Rs.38,167 = Incremental revenue Differential cost = Rs.1,00,000 38,167 Rs.61,833 Total profit has increased by Rs.61,833 from Rs.2,00,000 to Rs.2,61,833 by accepting the proposal. Thus, the proposal to drop the line of Tables and add the line of Cabinets should be accepted. Working notes: Variable cost is calculated as under: Book shelf (Present situation). Sales = 25,00,000 x 30% = Rs. 7,50,00 When selling price of book shelf is Rs.60, its variable cost is Rs.40. Thus: Rs.40 Variable cost 7,50,000 x Rs.5,00,000 Rs.60 Book shelf (Proposed situation) 29