1 Depreciation under the company law he Commerce course consists of many subjects. They are studied independently. But it is expected of the students to study all subjects as a unit to take correct decisions in business. It is an attempt to make commerce students to understand and apply the concepts that are studied under various subjects to take correct decisions. Module-I: Financial Accounting & Financial Applications: Financial Statements are Trading and Profit and Loss statements, Balance sheet statement and Cash Flow Statement. Most of the times they are prepared in accounting form or statement form i.e. horizontal or vertical form. Controlling cost is an important issue in costing. Some of the statistical tools are used for analysis of past information for future predictions. Financial management is used for how effectively and efficiently the funds are procured and used in the business. Operation research is used to convert business problems into mathematical problems and obtains mathematical solutions which help the business to take optimal solutions to business problems. Mathematics is used in every business decisions to narrow down the problems. Every business decisions have tax implications. Management accounting has various techniques and tools to collect information, which consists of Accounting, Costing, Statistics, Income tax, and corporate tax impact on decisions, Financial Management, Economic Applications. We have to study all subjects and the techniques available under various subjects can be used at an appropriate time in order to take a correct decision. First, let us understand the basics of Financial Statements: a) Balance Sheet Basics: Balance Sheet is the snap shot of financial strength of any company at any point of time. It gives the details of the assets and the liabilities of the company. Understanding balance sheet is very important because it gives an idea of the financial strength of the company at any given point of time. Following is the balance sheet of SAST Ltd. for the year ending on 31st Mar' 2008: As on 31-3-08 Assets Gross Block 3978.55 Net Block 2790.57 Capital WIP 66.72 T
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1
Depreciation under the company law
he Commerce course consists of many subjects. They are studied
independently. But it is expected of the students to study all subjects as a
unit to take correct decisions in business. It is an attempt to make
commerce students to understand and apply the concepts that are studied under
Consider the case of SAST Inc. manufacturer of scuba-diving equipment. After
the company switched to an inflation-sensitive method of accounting for inventory
costs in 2008, its cash flow increased on average by 10% annually. And the
higher inflation goes, the bigger the bang. Last year's cash-flow increase was close
to 25%.
Inflation wasn't always this painless for SAST. The company, founded back in
1954 by the late Sam -- an ex-marine who had invented an easy-breathing
regulator on his kitchen table -- grew to be one of the top names in its field, selling
nearly 5,000 items that range from masks and regulators to diving outfits. But
SAST remained small enough to be vulnerable to various types of inflation. By the
early 1980s its domestic labor costs were increasing at double-digit rates;
meanwhile, the costs of imports -- which added up to about 30% of its product line
-- had also been rising, although not as rapidly, thanks to the then-strong Rupee.
To David and chief financial officer Domnic inflation was just another cost of
doing business, albeit a painful and unpredictable one. But SAST's outside
accountants, Tim., had other ideas. "They came to me with a plan for us to switch
inventory accounting methods -- which some of their other clients had done -- and
said it would save taxes, therefore generating more cash," recalls Goldberg, an
accountant by training. "Frankly, I was worried that it would turn out to be a
gimmick," he confesses, "or an enormous paperwork headache for my staff."
Here's how the proposal worked: SAST, like most small to midsize businesses,
relied on FIFO (first in, first out) accounting for inventory expenses. Put simply,
every time SAST sold a piece of scuba-diving equipment -- which meant it could
write off the cost of producing the item against its profits -- the company would
look back in its records and write off the cost of producing the oldest item in
stock. In an inflationary environment, SAST's executives were in the worst
possible bind: their write-offs were artificially low, thanks to FIFO, but their
current expenses were quite high, because prices were rising.
SAST's outside accountants wanted to switch to the LIFO (last in, first out)
method. "That would bring their write-offs in line with current expenses," explains
Tim partner who now works most closely with the company. "Best of all, it would
accomplish the goal of increasing their write-offs -- always desirable, since this
would cut their tax bill."
The difference between FIFO and LIFO was clear. If it cost Rs.5 to produce the
oldest mask in stock and Rs.10 to produce the newest, SAST would be able to
write off Rs.10 each time it sold a mask under the LIFO method. Under FIFO,
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only Rs.5 could be written off. It sounded great. But there were plenty of
complications -- the kind that worry a financial officer with a small staff and a big
payroll to handle each week. "There were all these accounting decisions we would
have to make -- and it all sounded very, very complex," Tim says, shaking his
head.
So he took the proposal to his chief executive officer, whose response was
admirably straightforward. "He basically didn't understand it," Tim recalls, "but
said he didn't need to understand all those obscure accounting details. All he
wanted to know was whether it made financial sense for us. If I was convinced
that it did, he would do it."
After analyzing some of Tim initial projections, Tim was ready to make the leap.
His fear of hassles, though, was not out of line. LIFO does require more record
keeping than FIFO, especially in the early stages. For companies with large
inventories or limited computer capabilities, this can be a problem, and
unfortunately, SAST fit into both categories. But by the end of the first fiscal year,
the company found that financial rewards had outweighed the extra paperwork.
Analyse the above case with respect to method of valuation of inventory.
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Important adjustments in Final Accounts:
(a) Goods destroyed due to fire and goods are partly insured.
(b) Goods are destroyed due to fire and insurance company compensated-
Accounting treatment and tax implications.
(c) Plant and machinery destroyed due to fire and insurance company
compensated –accounting treatment and tax implications.
(d) Asset purchased enter into purchases account and Sale of building
entered into sales account- Accounting treatment and financial
implications
(e) Goods distributed as free sample for advertisement.
(f) Goods are sent on approval basis- Accounting and balance sheet effect.
(g) Wages paid to erect a machinery entered into wages account.
(h) Closing stock is given in the trial balance-treatment in final accounts.
(i) Outstanding expenses, prepaid expenses given in the trial balance-How
do you adjust?
(j) Provision for bad and doubtful debts, Reserves, provision for tax,
provision for dividend etc- tax treatment and accounting treatments.
(k) Tax paid by the owner -tax treatment and accounting treatment
(l) Advance payment of tax
(m) Prepaid expenses , outstanding expenses new provision for bad debts
and closing stock given in the trial balance.
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CHAPTER FIRST
DEPRECIATION Depreciation under Company Law, Accounting Standards
and the Income-Tax Act, Tax Planning and
Depreciation’s Impact on Finance such as lease/hire purchase/own.
epreciation is an allocation of past investment cash flows to expense
and has no impact on the statement of cash flows. Depreciation is a
significant operating expense and does not involve current cash
expenditure as cash flows are of the past; it is very important expenditure
like material and labour.
If an asset generates cash inflows over its life cannot be considered as
income until enough provision is made for its replacement. Depreciation is
the systematic allocation of the past cash flows over time.
The requirements of the Companies Act are applicable only to companies. In
the case of other entities, such as partnership firms, proprietary concerns and
so on, there is no law governing the charging of depreciation. The ICAI
made it mandatory for auditors to ensure compliance with the Accounting
Standards while carrying out attest functions. It is significant to note that
Accounting Standard (AS) 6 on depreciation does not suggest any rate of
depreciation.
Depreciation Amount: While company law requires 95 per cent of cost of an asset to be depreciated
over its life, the Income-Tax Act does not stipulate such a condition. But AS
6 requires that the historic cost of the asset less its estimated realizable value
to be depreciated over its useful life. The method of depreciation should be
followed consistently.
Deferment of Depreciation: Schedule XIV of the Companies Act lays down the schedule of the
depreciation rates to be charged by companies. It allows companies to
charge rates of depreciation independent of it. Section 205 suggests that a
company can postpone charging of depreciation until the company proposes
to pay dividends. (A note is, at times, appended to the balance sheet and the
auditor puts in his qualification under Section 211(3) a, b and c). But a
D
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dividend-paying company has to write off all previous years depreciation on
its assets and losses before declaring any dividends.
Thus, while there is a possibility that a company may postpone depreciation,
the I-T Act does not allow such a deviation. Following a recent amendment,
assessees will have to compulsorily provide for depreciation, there being a
loss notwithstanding.
Rigid Provisions: The depreciation rates mentioned in Schedule XIV are the minimum rates
and a company may choose to charge more than the rates specified therein.
If company uses higher rate, does it amount to non-compliance with AS 6?
Perhaps the company justifies increased rate of depreciation by providing a
basis for charging an increased rate of depreciation.
Methods of depreciation: While AS 6 does not suggest any method of
depreciation, company law provides an option between the straight-line and
written-down value (WDV) methods. But under income tax, one has to only
follow Block Asset method along with the WDV method.
Concept of Block of Assets: The I-T Act provides for charging of depreciation on a block of assets.
Under company law, each asset is considered independently. Any profit on
sale of assets is reduced from the block of assets, whereas for accounting
purposes, the profits are to be transferred to profit and loss (P&L) account.
Time Concept: Company law requires depreciation to be charged on time basis, say only
four months used during the current period, then depreciation for the current
year is only for four months. Under income tax, depreciation is allowed at
the normal rates for full year if the asset is used for more than 180 days
during the initial year. If it is used for less than 180 days, depreciation is
allowed at half the normal rates. If the same asset was purchased preceeding
to the current previous year but such asset is put into use for less than 180
days during the current previous year, then, full rate of depreciation is
allowed. Thus, if an asset is bought even on 31st March, half of the normal
rates can be claimed under income tax provided the the asset is put into use
during the previous year. Depreciation cannot be claimed for income-tax
deduction in the year of sale of the asset. Even if the asset is sold on 31st
March, the seller cannot claim depreciation. But the buyer can claim half of
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normal rate of depreciation. The date on which the asset is put to use is very
important, as depreciation can be claimed only for the period for which the
asset has been put to use.
Option of Depreciation Method:
Every Company can have its own accounting policy for depreciation.
Method should be Consistenly followed. If one chooses to claim
depreciation under the straight-line method for one class of assets and WDV
for other class of assets or under the same class of assets, too, the company
can claim one method for assets held by it and another method for assets
leased out. Well, income tax does not allow any method other than Block
Asset with WDV and that, too, only at the rates specified by it under Section
32.
Depreciation on Leased Assets:
AS 19 on leases permits the lessor to claim depreciation on assets under
operating lease and the lessee to claim on assets held under finance lease.
Under income tax, the lessor only can claim depreciation no matter whether
the lease is a finance or operating lease.
Assets Given on Lease:
It is now compulsory for companies to show assets given on lease separately
vis-a-vis the assets used by the company for itself. In respect of asset given
on lease, depending upon the internal rate of return (IRR), the company will
have to calculate lease equalisation reserve as per the guidance note on
accounting for leases issued by the ICAI. The system should be capable of
computing the lease-equalisation reserve automatically, given the various
parameters that are necessary for such computation.
Auditor and Depreciation:
AAS 20 requires the auditor to have knowledge of business. Such
knowledge of business would include the intricacies of the usage of assets
and estimated useful life of the asset. Depreciation in a routine simple
estimate (AAS 18) requires the auditor to prepare his estimate of the value
and compare it with the estimate made by the entity to satisfy him with the
value arrived at. An auditor should consider the implications of all these
factors while calculating depreciation on assets.
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Hire purchase or lease? The decision to go in for lease or hire purchase should depend on when the
asset will be put to use, the rate of depreciation available on the asset and the
cash flow position of the user, among others. In case an asset is purchased
under a hire-purchase scheme, the depreciation is available to the hirer (the
user of the asset). But if it is taken on lease, depreciation is allowed to the
lessor (the financer). Hence, acquiring an asset on hire purchase is a better
option than acquiring the same under lease, if the intention is to avail
deduction for depreciation.
However, in a lease, although a lessee (the user) loses the benefit of
depreciation, he can treat the lease rentals as an expense and reduce his
taxable income accordingly..
To claim or not to claim? Until 31 March 2001, a taxpayer had option whether or not to claim
depreciation. However, the claim of depreciation is no longer optional and
the amount of depreciation will be compulsorily treated as deduction,
irrespective of whether or not the claim has been made from 1 April 2001
onwards.
Unabsorbed depreciation: As per Income tax Act certain losses and unabsorbed depreciation can be
carried forward and set off from future profits from business. If, in a
particular year there are losses or inadequate profits, depreciation amount
may not be fully deductible. In such cases, the amount that cannot be
deducted wholly or partially can be set off against any other income. If such
‗unabsorbed depreciation‘ cannot be adjusted against the income of the same
year, it can be carried forward to next year and can be adjusted against any
income of the next year and so on. Unabsorbed depreciation can be carried
forward for any number of years without any limitation.
Special Provision for Free trade zone/Electronic hardware
technology park or Software technology park/Special economic
zone:
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Such assessee can claim 100% of their total income for a period of
10 consecutive assessment years under section 10A of the Income
tax Act
Depreciation and Financial Implications: Method of depreciation is not a method alone. It has financial impacts that
differ from method to method. Assets that are put into use or ready to use
during the previous year can be depreciated as per the rate prescribed by
Income tax Act. Companies Act prescribe different rate as per schedule XIV.
Depreciation is to be provided on all assets except land and goodwill as per
Accounting Standard Number 6.
Before calculating depreciation we have to keep in mind that the value of
the asset is to be properly calculated. All costs that are incurred before the
asset is put into use have to be capitalized. They include purchase cost,
import duty, installation charges etc.
As I have earlier said method of depreciation makes lots of difference to the
organization with respect to finance. Observe the following tables:
Table-1: - Assumed PBDT is Rs.50, 000 and rate of depreciation is 20%
Year Beginning
value
Rs.
Depreciation
SLM
Net
income
Rate of
return on
assets
1
2
3
4
5
1,00,000
80,000
60,000
40,000
20,000
20,000
20,000
20,000
20,000
20,000
30,000
30,000
30,000
30,000
30,000
30%
37.5%
50%
75%
150%
Rate of return on assets =Income/Beginning value of asset
Table-2: - Rate of Depreciation as per WDV is 1.5 times of SLM i.e. 30%
Particulars Beginning
value
Depreciation
WDV
Net
income
Rate of return on
assets
1 1,00,000 30,000 20,000 20%
20
2
3
4
5
70,000
49,000
34,300
24,010
21,000
14,700
10,290
7,203
29,000
35,300
39,710
42,797
41.42%
72.04%
115.7%
178.25%
Important observations from the above tables:
Particulars SLM WDV
Depreciation
Net Income
Asset
Equity
ROE
ROE
Turnover Ratio
Cash Flow
Lower
Higher
Higher
Higher
Higher
Higher
Lower
Same
Higher
Lower
Lower
Lower
Lower
Lower
Higher
Same
The above table to be read from early stage of asset. It is reversed at the
latter years of the asset‘s life.
1. Cash flows are not affected directly because depreciation is a non-
cash expense. But indirectly has some impact on cash flows if such
firm comes under tax. If there is tax holiday, it does not have any
impact on cash inflow or outflow.
2. If tax is considered, then the firm, which adopts WDV, recovers its
investments much faster as tax liability under WDV at early stage is
lower. Therefore Pay back period is low and NPV is higher than the
company, which follows SLM.
3. IRR is higher if firm follows WDV
4. Firm with stable or rising capital expenditures, the early year affect
will dominate and depreciation expense on the total firm basis will be
higher.
5. If firm invests in new assets out of the cash flows generated, in such
circumstances it provides less depreciation on old asset and more
depreciation on new asset under WDV, which compensate each other.
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6. There is a lower income under WDV, which causes a lower return on
Equity and return on Assets.
7. The turn over ratio (sales over Total Asset), the lower asset levels for
WDV method imply a higher ratio.
Depreciation and Tax PlanningU/S-32 of IT Act: In India Block Asset method is followed for tax purpose. The rate of
depreciation also prescribed as per Income Tax Act 1961. There is scope for
tax planning when an asset is sold which exceeds the block value. The
company can buy another the same nature asset having the same rate of
depreciation, which is at least equivalent to the extent of short-term capital
gain so that the block value will be zero.
When own funds used in plant and machinery -18.66% saving
When borrowed funds used –Tax savings through depreciation-
22.91%
Depreciation on intangible assets can be provided at 25% rate.
The eligible assets are: Know How, Patent Right, Copy Right,
Trade Mark, Licenses, Franchises, any other Commercial
Rights.
Carry forward and set of depreciation in the subsequent periods
Amalgamation, absorption, reconstruction and demerger-
Accumulated depreciation and set off against profits of new
company(Amalgamating company)
Purchase and put into use or ready to use a new asset at the end
of the financial year or 180 days before the end of the financial
year.
Sell old asset at the beginning of the previous year.
File your returns in the year of loss otherwise, the loss can not
be setoff.
In order to avoid Capital gain tax, the amalgamating company
should allot everything to the Amalgamated company
shareholders in shares. Cash should not be paid for settlement
of shareholders‘ claim.
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Can a New Company(Amalgamating) which absorbs an Old Company
(Amalgamated) carry forward and set off unabsorbed losses and
depreciation?
Conditons:
(a) Sec 72 of IT Act to be fulfilled.
(b) Accumulated losses remain unabsorbed for 3 or more years.
(c) 75% of book value to be held at least for 2 years before
amalgamation.
(d) The amalgamated Co. continues to hold 3/4th of book value at
least for 5 years.
(e) New Co. should continue for another 5 years.
(f) New Co. should achieve at least 50% of installed capacity
before the end of 5 years and should continue for 5 years.
(g) The Company which acquires should be an Indian Company.
CARRY FORWARD AND SET OFF OF BUSINESS LOSSES (SECTION 72 of the Income tax Act) Where the loss under the head ‘profits and gains of business or profession’ other than loss from speculation business, could not be set off in the same assessment year because either the assessee had no income under any other head or the income was less than the loss, such loss which could not be set off in the same assessment year, can be carried forward to the following assessment years, However it is subject to following conditions. I) Business losses can be adjusted only against business income: Business income may be from the same business in which the loss was incurred, or may be any other business. II) Business in respect of which a loss is incurred may or may not be continued. III) Losses can be set off only by the assessee who has incurred loss with a few exceptions like when a partnership firm is converted into a company, amalgamation of companies, etc. IV) Period of carry forward: Each year’s loss is a separate loss and no loss shall be carried forward for more than eight assessment years immediately succeeding the assessment year for which the loss was first computed. Therefore, a loss of previous year 2002-2003, i.e. assessment year 2003-2004 can be carried 161
forward till assessment year 2011-12. Besides the above, the following can also be carried forward indefinitely, as per income tax law: i) Unabsorbed depreciation ii) Unabsorbed capital expenditure on scientific research;
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iii) Unabsorbed expenditure on family planning.
SET OFF AND CARRY FORWARD OF SPECULATION LOSS (SECTION 73 of the Income tax). As stated earlier, the loss of a speculation business of any assessment year is allowed to be set off only against the profits and gains of another speculation business in the same assessment year. If a speculation loss could not be set off from the income of another speculation business in the same assessment year, it is allowed to be carried forward for 8 assessment years immediately succeeding the assessment year for which the loss was first computed. Also, it can only be set off against the income of only a speculation business. It may be observed that it is not necessary that the same speculation business must continue in the assessment year in which the loss is set off. Compulsory filing of loss of return (Section 80): Although the above losses are allowed to be carried forward, it is allowed only when such loss has been determined in pursuance of a return of loss submitted y the assessee on or before the due date for filing of the returns prescribed under section 139(1) .However loss under the head income from house property can be carried forward even if the return is not filed within the due date mentioned under section 139(1).
If the above conditions are fulfilled the unabsorbed depreciation and
accumulated losses can be set off against the profits of the absorbing
Company (New Company).
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Other Tax Benefits:
1. Expenditure on amalgamation or de-merger – allowed under
Sec.35DD both revenue and capital expenditure allowed.
2. Expenditure on scientific research can be carried forward and
set off.
3. Expenditure on acquisition of patent rights, copyrights –
depreciation can be provided.
4. Expenditure for obtaining license for telecommunication
service can be written off.
5. Preliminary expenses can be written off.
6. Capital expenditure on family planning can be set off against
profits.
7. Bad debts of the absorbed Company can be written off by the
absorbing company.
Illustration 1 From the following information submitted to you, compute the taxable income in the following situation. Situation I Situation II Rs. Rs. Long term capital gain/loss (+) 2, 80,000 50,000 Short term capital gain/loss (-) 50,000 (-) 1, 20,000
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Business income/loss (-) 1, 80,000 1, 40,000 Solution Situation I Situation II Rs. Rs. Capital gain Long term capital gain/loss (+) 2, 80,000 50,000 Short term capital gain/loss (-) 50,000 (-) 1, 20,000 Capital gain/loss after set off 2, 30,000 (-) 70,000 Set off of business income/loss (-) 1, 80,000 1, 40,000 Total income 1, 50,000 1, 40,000* *In situation II, capital loss of Rs. 70,000 will be carried forward and the total income shall be Rs.1, 40,000. Hence , we observe business loss can be set off against capital loss but vice-versa is not allowed. Illustration 2 From the following information submitted to you by Mr. X, calculate the gross total income for the A.Y 2006-07. I II Income from salary 2, 00,000 2, 00,000 Income from Bus/Prof (-) 50 ,000 (-) 50 ,000 Income from House Property _ 80,000 Solution In situation I his GTI would be 2, 00,000 and his loss from business and profession will be carried forward ( Any loss under the head Business & Profession cannot be set off against any income from Salary). In situation II business loss can be set off against income from House Property and his GTI would be Rs. 2, 30,000.
Exercise:1:Block Asset method of depreciation . Machine tools Ltd. Is considering the acquisition of a large equipment to set up its
factory in Siva Gangai District which is Mr.Chidambarm‘s constituency, the finance
Minister of India for Rs.20,00,000. The equipment is expected to have a expected useful
life of 4 years. The asset can be sold at the end of the fourth year for Rs.5,00,000. The
depreciation rate is 25% as per block asset method. The tax rate is 30%. Discounting rate
is 12% per annum.
There are two options available to you.
a) The equipment can be financed either with a 4 – year term loan at 14% interest,
repayable in equal annual instalments. or
b) Taking the property on lease paying Rs.5, 50,000 per annum.
Evaluate the method of acquiring the asset for the company
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Calculation of Depreciation :
Year Beginning
Value
Depreciation End Value Tax benefit on
Depreciation
1 20,00,000 5, 00,000 15,00,000 1,50,000
2 15,00,000 3,75,000 11, 25,000 1, 12,500
3 11,25,000 2,81,250 8,43,750 84,375
4 8,43,750 ------------ ------------
( In the year of sale no Depreciation )
Calculation of Capital loss ( Short term )
Book value = 8,43,750
Less: Sale = 5,00,000
Short term Capital Loss 3,43,750
3) Net Cash Inflow at the end of the 4th
year
Sale of Asset 5,00,000
Tax benefit on short term capital loss 1,03,125
Cash inflow at the end of the 4th
year 6,03,125
4) Calculation of Interest and Principal
a) PVIFA = 2.914, 14%, 4 years
Equated annual investment 20,00,000
2.914
= 6,86,342
b) Calculation of Principal and Interest
Year Principal Interest Total Cash Loan
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Repayment payment Inflow
1 4,06,342 2,80,000 6,86,342 20,00,000
2 4,63,230 2,23,112 6,86,342 15,93,658
3 5,28,032 1,58,260 6,86,342 11,30,428
4 6,02,014 84,328 6,86,342 6,02,346
c) Tax Benefit on Interest
Year Interest Tax Benefit
1 2,80,000 84,000
2 2,23,112 66,934
3 1,58,260 47,478
4 84,328 25,298
d) Cash outflows and Present Value
Year Annual
Installments
Tax Benefit
on
Depreciation
Tax
benefits on
Interest
PV factor
at
12%
Present
Value
1 6,86,342 1,50,000 84,000 0.893 4,03,941
2 6,86,342 1,12,500 66,934 0.797 4,04,006
3 6,86,342 84,375 47,478 0.712 3,94,796
4 6,86,342 ------------- 25,298 0.636 4,20,424
Total 16,23,167
Less: Net Cash Inflow on sale of asset at the end of 4
th 3,83,588
PV of Cash Outflows 12,39,580
Lease
a) Annual Lease Payment 5,50,000
Less: Tax benefit on Lease payment 1,65,000
3,85,000
Present Value of Lease Payment
3,85,000 X 3.037 = 11,69,245
Conclusion:
Select Lease
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Exercise-2
Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000
The rate of depreciation as per Companies Act is 20% whereas income tax rate
of depreciation is 25% . How do we calculate depreciation? Life is 3 years. By using calculator the value at the end of three years assuming the assets are
disposed of at the beginning of 4th
year =0.75*5,00,000= = =2,10,937.5-1,00,000
= 1,10,937(loss)
1,00,000+1,10937(.339)
=1,37,607(Inflow)
Suppose salvage value is 3,00,000
Short term capital gain= 3,00,000-2,10,937
=89,063
Tax on 89,063=89063*.339=30,192
Net cash inflow =3,00,000-30,192
=2,69,807.This should be discounted to today’s value
Example:3. Plant and machinery costs Rs.5,00,000 salvage value is Rs. 1,00,000
The rate of depreciation as per Companies Act is 20% whereas income tax rate of depreciation is
25% . Life is 3 years. Tax rate=30% surcharge 10% and 3% educational cess.
How do we calculate Capital loss? Cash Inflow at the end of the third year?.
Answer
Short term capital loss
Block value at the end of 2nd year- scrap at the end of three years
=Rs.2,81,750-Rs. 1,00,000
=Rs. 1,81,750
Cash Inflow at the end of third year
=Rs.1,00,000+(*33.90% *1,81,750)
= Rs.1,61,613
*Tax= 30%+10%(30%)+3%*33=33.99%
DDeepprreecciiaattiioonn aass ppeerr IInnccoommee ttaaxx aacctt Year
Cash flow from operations (CFO) + Cash flow from investing (CFI) + Cash flow from financing (CFF) = Net cash flow (the change in the cash account) + Beginning of period cash = Ending cash balance
Depreciation / 64
Net Income Rs.120
Decrease in accounts receivable +20
Depreciation +25
Increase in inventory - 10
Increase in accounts payable +7
Decrease in wages payable - 5
Increase in deferred taxes +15
Profit from the sale of fixed assets +2
A. Rs.142
B. Rs.158
C. Rs.170
D. Rs.185
Use the following information to answer 2 to 4
Net Income Rs.45
Depreciation +75
Taxes paid - 25
Dividends paid 10
Cash received from sale of company building 40
Sale of preferred stock 35
Re-purchase of common stock 30
Purchase of machinery 20
Issuance of Bonds 50
Debt retired through issuance of common stock 45
Paid of long term bank borrowings 15
Profit on sale of building 20
2. The cash flow from operations is
A. Rs.75
B. Rs.100
C. Rs.120
D. Rs.185
3. The cash flow from investing activities is
A. Rs.30
B. Rs.20
C. Rs.70
D. Rs.50
4. The cash flow from financing activities is
A. Rs.75
B. Rs.55
C. Rs.85
Depreciation / 65
D. Rs.30
5. Given the following
Sales Rs.1, 500
Increase in inventory Rs.100
Depreciation Rs.150
Increase in accounts receivable Rs.50
Decrease in accounts payable Rs.70
After tax profit margin 25%
Gain of sale of machinery Rs.30
The cash flow from operation is
A. Rs.25
B. Rs.115
C. Rs.275
D. Rs.375
CHAPTER -3
Different Approaches to Costing
Decision Making Approaches
Deals in details the following
Marginal Costing, Linear Programming, Learning Curve, Statistical
Investigation, Differentiation, Probability, Capital Budgeting and Economic
Applications for Decisions.
AApppplliiccaattiioonnss
1. Special Selling price decision
Depreciation / 66
2. Product –Mix decisions when capacity constraints exit
3. Decision on replacement of equipment
4. Outsourcing (make or buy)
5. Discontinuation decision
6. Export or local sales if local sales are affected/when local sales are not
affected
7. Relevance of variable cost and irrelevance of variable costs
8. Irrelevance of fixed cost and relevance of fixed cost
9. Cost–volume –Profit analysis in hospital, hotel industry
10. Changes in product
11. Graphical representation mix
12. Product abandonment
13. Limiting factor
14. BE chart and expected value
15. Changes in sales mix
16. Break even graph
17. P/V Ratio
18. Mathematical application of Break Even
19. Multi product Cost volume profit analysis
20. P/V Graph
21. Further processing
22. Investigation of variances
23. Determining Probabilities in Investigation of variances
24. Statistical control chart
25. Optimum selling prices using differential calculus
26. Cost volume profit analysis under conditions of uncertainty
Depreciation / 67
Find the difference between Absorption Costing and Variable/ Marginal
Costing.
ABSORPTION COSTING
LabourMaterial
Manufacturing
Cost
Cost
Non-
Manufacturing cost
Profit & Loss
A/C
Finished
goodsWIP
Overheads
The entire fixed manufacturing overheads are absorbed to manufacturing cost
which increases cost per unit.
VARIABLE COSTING
LabourMaterial
Manufacturing
cost
Cost
Non-
Manufacturing cost
Profit
and loss A/CFinished goodsWIP
Overheads
Variable
overheads
Fixed
Overheads
The fixed manufacturing overheads are transferred to profit and loss account
and treated as period cost.
Depreciation / 68
Example:
Absorption Costing vs. Variable
Costing Income Statements
Absorption Costing Variable /costing
Sales
Cost of Sales
Gross Profit
60,000
30,000
30,000
Sales 60,000
Operating Expenses
Variable
Fixed
Total Operating Expenses
6,000
20,000
26,000
Variable Costs
Cost of Sales
Operating Expenses
Total Variable Costs
30,000
6,000
36,000
Income 4,000 Contribution Margin
Fixed cost 24,000
20,000
44,000
Income 4,000
Depreciation / 69
Break Even Analysis
Costs/Revenue
Output/Sales
Initially a firm will incur fixed costs, these do not depend on output or sales.
FC
As output is generated, the firm will incur variable costs –these vary directly with the amount produced.
VC The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC
TC Total revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially.
TR The lower the price, the less steep the total revenue curve.
TR
Q1
The break even point occurs where total revenue equals total costs –the firm, in this example, would have to sell Q1 to generate sufficient revenue to cover its costs.
Break Even AnalysisCosts/Revenue
Output/Sales
FC
VCTCTR (p = £2)
Q1
If the firm chose to set price higher than £2 (say £3) the TR curve would be steeper –they would not have to sell as many units to break even
TR (p = £3)
Q2
Depreciation / 70
Break Even AnalysisCosts/Revenue
Output/Sales
FC
VCTC
TR (p = £2)
Q1
If the firm chose to set prices lower (say £1) it would need to sell more units before covering its costs.
TR (p = £1)
Q3
Break Even AnalysisCosts/Revenue
Output/Sales
FC
VC
TCTR (p = £2)
Q1
Loss
Profit
Costs/Revenue
Output/Sales
FC
VC
TR
High initial FC. Interest on debt rises each year – FC
rise therefore.
FC 1
Losses get bigger!
Depreciation / 71
Break Even Analysis
Remember:
A higher price or lower price does not mean that break even will
never be reached!
The break even point depends on the number of sales needed to
generate revenue to cover costs – the break even chart is NOT time
related!
Importance of Price Elasticity of Demand:
Higher prices might mean fewer sales to break even but those sales
may take a longer time to achieve.
Lower prices might encourage more customers but higher volume
needed before sufficient revenue generated to break even.
Break Even Analysis
Links of break even to pricing strategies and elasticity.
Penetration pricing – ‗high‘ volume, ‗low‘ price – more sales to
Margin of Safety = Expected sales – Breakeven Sales
Student’s Exercise on BEP and application of LP:
Depreciation / 74
Tim Enterprises promotes concerts in Bangalore. The Company wants to examine
the viability of concerts In Bangalore on 31st December 2007.
Estimated costs:
Stage Costs Rs. 2,00,000/- on the first day and Rs. 50,000/- extra for
the second day.
Music party fees Rs. 2,50,000/- for the first day and Rs.1,00,000/-
for the second day.
Audios and videos Rs.1,50,000/- for the first day and Rs.25,000/-
only for the second day.
The pre-packed buffet per head is Rs.300/- for the first day and
Rs.50/- per children on the second day.
The tickets are sold @ Rs.790/- per head for the first night show.
The Management of Tim Enterprises requested the following information:
(i). The number of tickets that must be sold to break even for the first day.
(ii). How many tickets should be sold to earn Rs.5,00,000/- as profit on the first
day?
(iii). What profit would result if 3000 tickets are sold on the first day?
(iv). If 3,200 tickets are sold, and the expected profit is Rs.6,00,000/- how much
price per ticket the company can charge minimum for the first day?
(v). They want to have a separate program on the second day for children which
is fully sponsored by the Fly king Freshers Ltd. This show is meant for
Children at free of cost, and the expected number of children is 1000.
Calculate the sponsorship amount.
Answer for the Problem: Tim Enterprises
1. Mathematical & Linear Programming Approach:
Answer to question no-(i):
NP = Px-(a+bx)
a + bx = Px- NP the break even point
Depreciation / 75
a = fixed cost = 6,00,000
b = 300
X =number of tickets
P = ticket price = 790
BE Tickets = 6,00,000 + 300x = 790x – 0
x = 6,00,000/490
x =1224.48
1225 tickets to be sold to break even.
Answer to question no-(ii):
Tickets to be sold to get profit of Rs.5,00,000/-
Np = Px - (a+bx)
5,00,000 = 790x-(6,00,000+300x)
490x = 11,00,000
x = 11,00,000/490
= 2244.89
= 2245 tickets
Using Contribution Approach:
Units sold at the required profit = FC+Target profit)/ contribution per unit
= 6,00,000+5,00,000)/490
= 2245 tickets
Answer to question no-(iii):
If 3000 tickets are sold profit will be
Np = Px - (a+bx) = 3000 x 790 - (6,00,000+3000 x 300)
= 8,70,000
Answer to question No (iv):
If 3200 tickets are sold and profit should be 6,00,000 the minimum selling price
will be
6,00,000 = 3200(x) – (6,00,000+3200 x 300)
X = 21,60,000/3200
= 675
Depreciation / 76
Answer to question No (iv):
1,75,000 + 1000 x 50 = 2,25,000 no of tickets
Practical Applications of Marginal Costing:
1. Evaluation of Performance:
Evaluation of performance of department or product or individual worker a
branch.
Criteria:
Use contribution generating capacity of the segments or individual worker
2. Profit Planning:
Planning of Profits:
Due to competition company would like to reduce selling price but to increase
volume and have to maintain the same profit as before.
Step-1: Calculate current profit
Step-2: Calculate new contribution and new P/V ratio.
Step-3: Break even at the required profit= (FC+ Required profit)/ P/V ratio.
Step-4: Fixation of Selling Price:
Fixed costs are stagnant; it can be ignored in the short run.
In the long run fixed costs can not be ignored.
Fixing price above variable cost brings some contribution, which can be used
to recover fixed cost.
During the phase of depression, serious competition in the market introduces a
new product fixing selling price below variable cost or to dispose of the
product which may deteriorate in quality.
Export price above variable cost will increase the contribution when inland
sales can take care of the fixed cost.
If local sales are disturbed for export the contribution lost should be recovered
or fixed costs, which are not recovered, should be recovered from export.
Therefore selling price for export
= (Variable cost+ fixed costs not recovered inland)/expected number of units sale.
Depreciation / 77
If fixed and variable costs are incurred exclusively for export has to be
recovered.
4. Make or Buy Decision:
Produced in house or out sourced.
Accounting operations to be done in the USA or out sourced to India or
Brazil or China or Philippines?
Criteria: View total cost without considering the classification of cost like
fixed or variable.
Decision Criteria:
If Purchase price < variable cost, go for purchase proposition.
If Purchase price > variable cost, go for manufacturing proposition.
If one production capacity used for same component or product may be diverted to
manufacture another component or product how do you take decisions?
Loss of contribution due to diversion of facility should be considered while fixed
price of alternative product.
Variable cost+ loss of contribution+ additional fixed cost to be considered.
5. Optimizing Product Mix:
Proportion in which various products of a company can be sold (Mix)
Criteria:
Study contributions generated by various products individually and by selecting
that mix generates the maximum contribution
6. Key factor/Scarce factor/Limiting factors:
Raw materials are constraints or Labour hours are constraints or machine
hours are constraints
Do not Use Maximum contribution or Maximum P/V Ratio are treated as
the maximum profitable products.
What criteria to be followed?
Limiting factor:
Criteria:
Contribution per limiting factor to be used
7. Multiplicity of the key Factors:
1. If there are two limiting factors- use graphical solution.
Depreciation / 78
2. If more than two limiting factors use Linear programming such as Simplex
method.
8.How the optimum output and selling price is determined? •Demand and costs can be estimated at each potential demand level.
•The Optimum output is determined where marginal cost equals to marginal revenue.
•The selling price at which the optimum output can be sold determines the optimum price
Example:
Different price levels
Price unit of demand total revenue Marginal Revenue.
•40 10 400 ---
•38 11 418 18
•36 12 432 14
•34 13 442 10
•32 14 448 06
•30 15 450 02
•28 16 448 -02
Estimated profit at different out put levels
•Price unit of demand Total Rev. total cost profit
•40 10 360 400 40
•38 11 364 364 54
•36 12 370 370 62
•34 13 378 378 64
•32 14 388 388 60
•30 15 400 400 50
•28 16 414 414 34
When price is Rs. 34 profit is maximum
9. Differential calculus to decide optimum selling price Marginal revenue is equal to Marginal cost to decide the optimum selling
price.
Tc= Rs.7,00,000+70 X where X is the annual level of demand and output
SP=Rs. 200-Rs.0.004X :
Total revenue(TR)= Rs.200X-Rs.0.004X
Marginal cost(MC) =dTC/dx =Rs.70
Marginal Revenue(MR)=dTR/dx=Rs.200-Rs..008X
Optimum output level dTC/dx=dTR/dx
X=16,250units; SP=Rs.135
Depreciation / 79
Target Costing approach to pricing
•
It is a reverse of cost plus pricing
•Decide the target selling price- customer is willing to pay for the product.
•Target profit margin is deducted to find target cost
•Predicted actual costs are compared with the target cost
•If predicted cost exceed target cost intensive effort made through value engineering
methods.
•
Cost-plus pricing •
Direct variable cost+total direct costs+Indirect costs+share of
organisational cost+% of Profit margin
Relevant cost and relevant benefit required for decision making:
Costs that are affected by the decision.
Costs and benefits that are independent of a decision are not relevant and need
not be considered.
Future cash inflows and future outflows are relevant.
Sunk costs are irrelevant.
Allocated common costs are irrelevant
Opportunity costs are relevant (shadow price)
Incremental costs and incremental benefits are relevant.
Avoidable costs are relevant and unavoidable costs are irrelevant for decision
making.
Problems related to relevant and irrelevant cost:
Five engineers are already employed on monthly salary basis but will not be sent
out if not employed in an another project.
(i). Are the salary paid to those engineers relevant or irrelevant to estimate the
price for a new project which will be completed within a month?
(ii). Two more engineers are selected exclusively to the new project. Are the costs
relevant to take decision for new project?
Depreciation / 80
(The students are expected to solve the above problem)
Example for Relevant Cost and relevant benefits:
Survey conducted by incurring Rs.10,00,000 product P can be produced and
marketed. If P is produced it was found that 1,00,000 units per annum can be
produced at a selling price of Rs.100/- per unit. It requires a machine costs Rs.1.5
crores .The material, manufacturing variable cost is Rs.65/- per unit.
What are the relevant costs to take decision whether to go for the project or not?
(The students are expected to solve the above problem)
Example-1:
Machine just purchased a few days ago by spending Rs.20,00,000/- Cost of
running this machine per hour is Rs 100/- It is about to be installed but we come
across an another efficient machine available in the market for Rs. 35,00,000/- The
cost of running this machine is Rs 70/- per hour. If new machine is purchased, the
machine just bought could be disposed for Rs 12,00,000/- Question-1: What are
relevant costs in this problem?
1. If so, how many hours should we run minimum so that it is beneficial to the
company.
2. If company wants to run maximum 60000 hours which machine is beneficial?
3. What is the Break even hours between these two machines?
Example - 2:
We have manufactured 20,000 units of shirts which are meant for export by
spending Rs.150/- per shirt. We can sell this product in the market for Rs.120/- per
shirt because of defects. We can further process them to rectify the defect by
spending Rs.30/- and we can export and sell for Rs.160/- Other good units are sold
for Rs.200 per shirt.
Questions:
1. What are the relevant cost and relevant benefits?
2. Should we rectify them or not?
3. How much gain or loss if not rectified?
4. How much gain or loss if rectified?
Example-3:
You have joined a course by spending Rs.50,000/- The course is for three years.
The cost of the course is Rs 50,000/- per year. In the mean time you come across a
Depreciation / 81
new innovative course which will be available for Rs.1,75,000/- Question-1: What
are relevant costs for current decision?
Example-4:
Mr.Kumar purchased a car for Rs.4,00,000/-; insurance Rs.15.000/- Registration
Rs.30,000/- After spending so much he heard that Metro Train will be ready with
in another two weeks.
Every kilometer if he uses the car the running cost per Kilometer = Rs.4/- The
season ticket available for metro is Rs 2000/- per month. His office is 15
kilometers away.
Questions:
(a) What are the relevant costs to take decision?
(b) What are the other factors to be considered before taking decision?
Example-5:
Examination fees had been paid for the final semester. This is the last semester.
The student has already been recruited by the IBM at the campus recruitment. It‘s
so happened that the exam falls on the 30th
day student‘s father‘s death.
What is relevant to take decision i.e. should he go for the exam or attend the death
ceremony? (Assume both are held in the same city and at the same time).
Example-5:
Component
“X”
Component
“Y”
Component
“Z”
Contribution per unit 12 10 6
Machine hour required per unit 6 hours 2 hours 1 hour
Estimated sales in demand 2000 units 2000 units 2000 units
Required machine hours for the
quarter
12,000
hours
4000 hours 2000 hours
One of the machines breakdown the total machine hours available =12000 hours
for the period.
Question-1: Advice the mix of the product.
Example-7:
Depreciation / 82
X Ltd has a Machine-001 produces product H. The selling price of H is Rs.100/-
and marginal cost is Rs.60/- It takes 20 hours to produce one H. The company has
alternative to produce product ‗S‘ which takes 3 hours per unit of S. The marginal
cost of S=5. S can be purchased from market at a price of Rs.10/-
Question: Should product ‘S’ be produced on the same Machine-001?
Answer-7:
Present contribution = 100 – 60 = 40
Contribution per hour = 40/20 = Rs.2 per hour
S requires 3 hours. The loss of contribution in place of H is 3 x 2 = 6
Full cost of producing component S=MC + loss contribution = 5+6 = 11.
As the supplier‘s price is cheaper buy from market.
Example-7:
A BPO Company based in Bangaloru had capacity to process 2,00,000 accounts in
a month. The Sales division reports that the following schedule of sales price is
possible.
Capacity Utilization Sales per account
(Rs.)
60% 90
70% 80
80% 75
90% 67
100% 61
The variable cost per account in Rs 15/-
Fixed cost is Rs 40,00,000/-
Questions:
(i). What capacity is the utilization most profitable proposition?
(ii). Which marginal costing technique do you follow?
Depreciation / 83
Answer-8• Technique is Incremental cost and incremental revenue
-
3
3
3
3
58
61
64
67
70
40
40
40
40
40
18
21
24
27
30
-
.04=4lak
8
.006
.014
1.08
1.12
1.2
1.206
1.22
1.2
1.4
1.6
1.8
2.0
60%
70%
80%
90%
100%
Differe
ntialco
st
(Rs.
Lakhs)
Total
cost
(Rs.
Lakhs)
Fixed
cost
(Rs.
Lakhs)
Variabl
e cost
(Rs.
Lakhs)
Increm
ental
revenu
e(In
Crores
)
Sales
Value(
Rs.in
crores)
Units(l
akhs)
Capac
ity
Incremental benefit/Incremental cost
Conclusion-8:
Incremental revenue is higher than differential cost up to the output level of
80% of capacity. Therefore operate at 80% level.
At 90% level of activity differential cost exceeds incremental revenue.
Is there any difference between differential cost and marginal cost?
Differential cost can include items of fixed cost if fixed cost is affected by
the decision.
Depreciation / 84
Example-9
Information-2008
Fixed costs increases by 6%
Direct material cost increases by 5%
Labour cost increases by 10%
Due to market pressure selling price
and quantity will remain unchanged
in 2008.
An enquiry for the supply of 10,000
dozens to a customer. What could
be the lowest quotation if business
wants to make a minimum profit of
Rs. 8,00,000?
If 80% learning effect what would be
the impact?
Information-2007
Product- fountain pen
Selling price 100 per dozen
Average net profit is 20% on sale of
50,000 dozen
Capacity-75,000 dozen
Cost sheet: cost per dozen
Direct materials- 36
Direct labour 30
Works over heads 10
(50% variable)
Sales overheads 4
(25% is variable)
Depreciation / 85
Answer -9
50,00,000
37.8(36*1.05)
33.0(30*1.1)
5.0
1.0
76.8
38,40,000
4,24,000
(4,00,000*1.06)
42,64,000
7,36,000.
50,00,000
36
30
5
1
72
36,00,000
5
3
8
4,00,000
40,00,000
10,00,000
Sales(50,000*100)other than special order (A)
Variable cost:
Direct material
Direct labour
Works Overheads
Selling overheads
Total variable overhead per unit
Total variable cost (B)
Fixed cost per unit at 50,000 dozens:
Works over heads
Selling over heads
Fixed overheads per unit at 50000 dozens
Total fixed cost (C)
Total cost D= B+C
Profit A-D
2008
Rs.
2007
Rs.
particulars
Answer:
Management wants to get minimum Rs.8,00,000/-
The profit from regular sales is Rs.7,36,000/-
There is a need for additional profit of Rs. 64,000/-
Minimum price per unit = Variable cost + Expected cost +
Additional fixed cost =76.80+(64,000/10,000)+0= Rs 83.20 per unit
Additional fixed costs are covered by the existing sale of 50,000
units.
If 80% learning effect then labour cost=Rs.30*.8*2*1.1=Rs.19.8
Exercise-10:
Bangaluru based BPO has the capacity to process 50,000 accounts per month.
Because of liquidation of one of the European clients the company has excess
capacity. For the next quarter current monthly accounts processed is expected to
be 35,000 accounts at a selling price of 4 pounds per account. The expected costs
Depreciation / 86
and revenues for the next month at an activity level of 35,000 accounts are as
follows:
Particulars Pounds
Pounds Per account
Direct labour Variable processing overheads Processing non-variable overheads Marketing costs Total cost Sales ( Collection) Profit
42,000 35,000 28,000 10,500
1,15,500 1,40,000
24,500
1.2 1.0 0.8 0.3 3.3 4.0 0.7
Questions:
(i). Another European client has asked his 3000 accounts to be processed each
month for three months at a price of 2.3 pounds per accounts. Do you
advise the company to go for this proposal?
(ii). If the existing labour force is not reduced but as per labour agreement
minimum three months notice to be given. The company feels that the jerk
is a temporary phenomenon. Do you advise the company to go for the
proposal for 2 pounds?
(iii). If upsurge is going to be permanent. The future sales will be 35,000
accounts for next one year. How much price is advisable to accept the
offer?
(iv). If demand will remain 35000 accounts for next one year and the permanent
employees will be sent out after three months what would be the best price
to accept?
(v). If the laborers are contract labourers and do you accept to process at 2
pounds per accounts?
Exercise-11:
A division of Shanthi Ltd. has received an enquiry from one of its major
customers for a special order for a component that will require 1000 skilled labour
hours and that will incur other variable costs of Rs.8000/- Skilled labour is in
short supply and if company accepts the order then it will be necessary to reduce
production of component P.
The details of the cost per unit and the selling price of component P are as follows:
Selling price=Rs.88; Direct labour(4 hours atRs.10 per hour) =40; other variable
costs =12.
Allocated fixed cost based on labour hours=8.
Question:
What is the minimum selling price the company should accept for the special
order?
Depreciation / 87
Relevant cost
Labour cost +contribution lost per labour hour= 10+9=19
19000+8000=27,000
27000/1000=Rs.27 per unit
Example-12: (EOQ Stock with probability)
A dress dealer specializing in seasonal fashion dresses has to decide on the
number of units of a particular dress type to order prior to Diwali. The order has to
be placed in advance only once. The cost of the dress is Rs. 6000, which can be
sold at a price of Rs.9000 per unit. Unsold units after Diwali will be sold at a price
of Rs. 3000 per unit. Demand that can not be fulfilled due to stock shortage incur a
goodwill loss estimated at Rs. 4000 per unit inventory carrying cost is 15% of the
cost incurred. The demand is subject to random fluctuation as per pattern indicated
below:
Determine the optimal number of units that the dealer should order in advance.
Demand units: 3 4 5 6 7 8
Probability: 0.1 0.2 0.3 0.2 0.1 0.1
Answer: 12
Selling Price=Rs.9000
Cost per unit=Rs.6000
Inventory carrying cost=.15* 6000/2=Rs.450
Stock out cost (loss of goodwill)=Rs.4000
Salvage per unit=RS.3000.
Unit cost of not stocking= 9000-6000-450+4000=Rs.6550.
Cost of over stocking=6000+450-3000=Rs.3450
Demand units: 3 4 5 6 7 8
Probability: 0.1 0.2 0.3 0.2 0.1 0.1
Cum.probability: 1.0 0.9 0.7 0.4 0.2 0.1
(Demand>)
P(D)>= 3450/6550+3450=0.345
From the above table it is clear that lowest cumulative probability >0.345 i.e. at
demand 6. Therefore optimal order is 6.
Depreciation / 88
Exercise 13(Transfer Price-
Marginal costing)• A company is organised into two divisions namely A and B produces
three products, K,L,M. Data per unit are:
• Division B has a demand for 600 units of product L for its use. If division A can not supply the requirement, Division B can buy a similar product from market at Rs.112 per unit.
• Question: What should be the transfer price of 600 units of L for Division B, if the total direct labour hours available in Division A are restricted to 15,000?
100
70
3
600
115
60
5
1000
120
84
4
1600
Market price
Variable costs
Direct labour hours
Maximum sales
potential(Units)
M
RS./unit
L
Rs./unit
K
Rs./unit
Answer-13• M
RS./unit
L
Rs./unit
K
Rs./unit
100
70
30
3
10
II
600 units
1800
hrs.
115
60
55
5
11
I
1000 units
5000 hrs.
120
84
36
4
9
III
1600 units
6400 hrs.
Market price
Variable costs
Contribution
Direct labour hours
Contribution per labour hour
Ranking
Maximum sales (Balance to K
6800/4=1700 units but limited to
1600 only)
Hours allotted based on ranking
Total hours = 15000
No of hours used = 13,200 (all three products)
Number of hours unutilized=1800 hours
Depreciation / 89
Number of units can be produced without disturbing any
product =1800/5= 360 units of L
Remaining number of units of L to be supplied by disturbing
product K=600-360=240
Number hours required to produce 240 units of
L=240*5=1200 hours.
We will disturb only product K. Product K contributes Rs.9 per
labour hour.
Therefore Price of 240 units of L per unit
Variable cost 60
Opportunity cost(9*5) 45
Total cost for 240 units of L 105
Price of 360 units per unit
Variable cost 60
Total cost=(240*105)+(360*60)= 25200+21600=46,800
Average cost per unit=Rs.78.
Depreciation / 90
Answer-14 make or buy
5625
6750
1350
1.5
1
2025
1350
900
2
3
1800
2700
900
2
3
1800
2700
Demand
Hours per unit in Dep.P
Hours per unit in Dep.Q
Total hours required in
Dep.P to produce compo
Total hours required in
Dep.Q to produce compo
TotalCBAparticulars
Statement showing number of hours required in Department P and Q to meet
The monthly demand of components
Department P is under utilised and department Q over utilised by 750 hours
Prob.14.Statement showing the units of
components to be purchased to minimise
the cost
50
70
20
1
20
114
-
-
-
-
99
129
30
3
10
Variable cost to make
Variable cost to buy
Extra cost to buy
Hours required to Dept.Q
Extra cost per hour
required on buying
CBAcomponents
Since the extra cost incurred per hour on buying component A is minimum, 250 units
Of component A(750 hrs/3 hours) should be purchased from outside.
Exercise-15: Optimum Selling Price Using Calculus
A company sells one of its products in the domestic market as well as in the export
market. The relationship between price and demand in the two different markets
are represented as under:
Depreciation / 91
Domestic Market: 136-8Q1
Export market : 228-20 Q2
Q1 and Q2 represent the quantity of demand in thousand units in the domestic and
export markets respectively.
The variable cost is represented by 38 Q where Q= Q1+ Q2
Calculate the optimum selling price and the total contribution for the sale in the
(i). Domestic market
(ii). Export market
Answer for 15:
Variable cost=38-Q
Total variable cost=38Q-Q2
Marginal cost(MC)= 38-2Q
Selling price= 136-8Q
Total sales=136Q-8Q2
Marginal revenue=136-16Q
We know that profit is maximum when MR=MC
136-16Q= 38-2Q
Q=7
Optimum selling price=136-8*7=Rs.80
Variable cost per unit=38-Q=38-7=31
Contribution per unit=80-31=49
Total contribution=7*49=343
Export:
Selling price=228-20Q
Total revenue 228Q-20Q2
Marginal revenue= 228-40Q
Marginal cost remains the same=38-2Q
Profit is maximized when MR=MC
228-40Q=38-2Q
Q=5
Optimum selling price=228-20*5=128
Variable cost per unit=38-Q=38-5=33
Contribution per unit=128-33=95
Total contribution=5*95=475. or 4,75,000.
Depreciation / 92
Exercise 16(Activity Based costing)• A company produces four products P,Q,R and S. The data
relating to production activity are as under:
3
3
12
9
0.50
0.50
1.00
1-1/5
1/2
1/2
2
1-1/5
5
5
16
17
500
5,000
600
7000
P
Q
R
S
Direct
labour
cost/unit
Machine
hours/unit
Direct
labour/unit
Material
cost/unit
Qty.of
production
Product
Production overheads are as under:
i) Overheads applicable to machine oriented activity-37,424
ii)Overhead relating to ordering materials-Rs.1920
iii) Setup Costs-Rs.4355
iV) Administration overheads for spare parts: Rs.8600
v) Materials handling costs-7580
• The following further information have been compiled:
2
5
1
4
2
10
3
12
1
4
1
4
1
6
2
8
P
Q
R
S
No.of
spareparts
No.of times
materials
handled
No. of
materials
order
No.of setupProduct
Required:1) Select a suitable cost driver for each item of overhead expenses and
calculate the cost per unit of cost driver
2.Using the concept of activity based costing , compute the factory cost per unit
Of each product.
These overhead costs are observed by products on a machine hour rate of
Rs.4.80 per hour having an overhead cost per product of:
A=Rs.1.20, B=Rs.1.20, C=4.8 D=Rs.7.2
Answer for 16:
Depreciation / 93
Factory overhead applicable to machine oriented activity = Rs.37,424/-
Total machine Hours = Volume x Machine hour required for each period
= (500 x 1/4)+(5,000 x 1/4)+(600 x 1)+(7,000 x 1.5)
= 12,475 hrs.
Machine overhead charged =37,424/12,475 hrs = Rs.3 per hour
Set up costs = 4355/17(i.e. total number of set ups) = Rs.256.18
Material ordering cost = 1920/10 operations = Rs.192
Material handling cost = 7580/27 operations = Rs.280.74
Spare parts = 8600/12 parts = 716.67
Answer-16….
3/2*3=4.5
8*256.18/7
000=0.29
4*192/
7000=0.11
12*280.74/
7000=0.48
4*716.67/
7000=0.41
1*.3=Rs.3
2*256.18/
600=0.85
1*92/600=
0.32
3*280.74/
600=1.40
1*716.67/
600=1.19
¼*3=0.75
6*256.18/
5000=0.31
4*192/5000
=0.15
10*280.7/
5000=0.56
5*716.67/
5000=0.72
¼*Rs.3=.0.75
1*256.18/500=
0.51
1*192/500=
0.38
2*280.74/
500=1.12
2*716.67/500=
2.87
Machine overhead
Setup cost
Material
Ordering cost
Material handling cost
Spare parts cost
DCBAOverhead items
Depreciation / 94
+4.43
+1.29
+1.96
-1.41
1.20
1.20
4.80
7.20
5.63
2.49
6.76
5.79
2.87
0.72
1.19
0.41
1.12
0.56
1.40
0.48
0.38
0.15
0.32
0.11
0.75
0.75
3.00
4.50
A
B
C
D
differenceTotal
(old
system)
Total
(ABC
syste
ms)
Spare
Parts
Mater
ial
handl
ing
Materia
l
orderin
g
Machine
overheads
product
s
traditional system does not make correct
assumptions that all overheads are
Related to volume and machine time.
Under traditional system products A and C are
under costed because it misallocates costs for small volume products.
Set ups
Rs.
0.51
0.31
0.85
0.29
Answer: Activity costing
The activity based costing recognizes the amount of input to each cost unit.
Product B previously avoided its full share of overhead because of its low machine
time and may still do so if part of Rs. 37,425 of machine oriented overhead should
be apportioned on some other basis.
Product D is over costed because the additional system loaded it with other
attributable to activities concerned with products A, B and C as result of using a
volume – based and machine oriented rate which failed to Pay proper attention to
activity costing.
Exercise-2: Activity Costing
A Company manufactures several products of varying levels of designs and
models. It uses a single overhead recovery rate based on direct labour hours. The
overheads incurred by the company in the first half of the year are as under.
Machine operating expenses 10,12,500
Machine maintenance expenses 1,87,500
Salaries to technical staff 6,37,500
Wages and salaries of stores staff 2,62,500
During the period, the company introduced activity based costing system and the
following significant activities were identified:
- receiving materials and components
Depreciation / 95
- setup of machines for production runs
- Quality inspection.
It is also determined that:
The machine operation and machine maintenance expenses should be
apportioned between stores and production activity in 20:80 ratio.
The technical staff salaries should be apportioned between machine
maintenance, set up and quality inspection in 30:40:30 ratio.
The consumption of activities during the period under review are furnished below:
Direct labour hours worked = 40,000
Direct wages @ Rs.6/- per hour
2040 Material and component consignments received from suppliers
1960
Number of quality inspections carried out = 1280
The data relating to two products manufactured by the company during the period
are as below:
Product P
(Rs)
Product Q
(Rs)
Direct material costs 6000 4000
Direct labour hours 960 100
Direct material consignment received 48 52
Production runs 36 24
Number of quality inspection done 30 10
Quantity produced 15,000 5,000
A potential customer has approached the company for the supply of 24,000 units
of a component K to be delivered in lots of 3,000 units per quarter. The job will
involve an initial design cost of Rs. 60,000 and the manufacture will involve the
following per quarter.
Direct material cost - Rs.12,000; Direct labour hours - 300; Production runs- 6;
Inspections- 24; Number of consignments of direct materials to be received -20
The company desires to mark up of 20% on cost.
Required:
(i). Calculate the cost of products P and Q based on the existing system of single
overhead recovery rate.
(ii). Determine the cost of products P and Q using activity based costing system.
(iii). Compute the sales value per quarter of component K using activity based
costing system.
Depreciation / 96
Answer:
Working notes:
1. Overhead rate=21,00,000/4000 hours=Rs.52.50
2. Apportionment of technical staff salaries:
Machine maintenance,
Set up and Quality Inspection respectively
= 6,37,500 x 30:40:30/100
= 1,91,250; 255,000 and 1,91,250.
3. Rate per Cost driver:
Store receiving = 275.89
Set-up production run = 670.59
Quality Inspection = 149.41
4. Single overhead recovery rate: Cost per Unit P= 4.144: Q=1.97
5. Store receiving = 5,40,750: set-up production run =13,68,000
6. Rate per activity 5,40,750/1960=275.89;
13,68,000/2040=670.59;
1,91,250/1280=149.41
for store receiving, setup and quality inspection respectively.
P and Q as per activity based costing system
Exercise-3(Activity Costing)
Depreciation / 97
• The data relating to two products manufactured by the company during the period are as under:
• Product P Product Q
• Direct material costs Rs.6000Rs.4000
• Direct labour hours 960 100
• Direct material consignment received 48 52
• Production runs 36 24
• Number of quality inspection done 30 10
• Quantity produced 15,000 5,000
A potential customer has approached the company for the supply of 24,000 units of a component K to be delivered in lots of 3,000 units per quarter. The job will involve an initial design cost of Rs. 60,000 and the manufacture will involve the following per quarter.
Direct material cost - Rs.12,000; Direct labour hours - 300; Production runs- 6; Inspections- 24; Number of consignments of direct materials to be received -20
5000
4000
600
14346
16094
1494
36534
7.31
15000
6000
5760
13243
24141
4482
53626
3.58
Units
Direct materials cost
Direct labour cost
Receiving /sores cost(48*275.89)
(52*275.89)
Production runs/set up cost (36* 670.59)
(24*670.59)
Inspection cost (30* 149.41)
(10* 149.41)
Total cost of products
Cost per unit
QPParticulars
Depreciation / 98
Computation of sales value per quarter of component K(Activitity
based costing)
3000
7500
12000
1800
5518
4024
3586
34428
8607
43035
14.34
Units
Components of initial design(Rs.60000/8)
Direct materials cost
Direct labour cost (300 hours 8 Rs.6)
Receiving /sores cost(20*275.89))
Production runs/set up cost (6* 670.59)
Inspection cost (24* 149.41)
Total cost of products
Add: Mark up( 25% of cost)
Sales value
Selling price per unit of K(43035/3000 units)
KParticulars
Exercise-17(Optimal safety
stock option)• The consumption pattern of component used in an assembly is
as under:
• The stock out cost is 18 per unit and the two monthly holding cost is also 18 per unit.
• Determine the optimal safety stock.
0.15
0.20
0.30
0.20
0.15
500
600
700
800
900
probabilityTwo monthly consumption
units
Depreciation / 99
5000
4000
600
14346
16094
1494
36534
7.31
15000
6000
5760
13243
24141
4482
53626
3.58
Units
Direct materials cost
Direct labour cost
Receiving /sores cost(48*275.89)
(52*275.89)
Production runs/set up cost (36* 670.59)
(24*670.59)
Inspection cost (30* 149.41)
(10* 149.41)
Total cost of products
Cost per unit
QPParticulars
Exercise 18(Break even sales)
• A newspaper presently sells 1,00,000 copies of its morning daily. It wants to publish evening daily. Particulars are :
• Sale of morning daily will come down by @1 copy of every 10 copies sold of evening daily.
• Calculate :Break even sales for evening daily week.
Rs.0.50 per paper
Rs.0.22 per paper
Rs.10,000 per week
Rs.2 per paper
Rs.1.20 per paper
Rs.2.4 lakhs per week
Sales price
Variable Cost
Fixed Cost
Estimates for eveningActual for morning
Depreciation / 100
Answer-18
• morning daily Evening Daily
• Sale price per paper Rs.2.00 Rs.0.50
• Variable cost Rs.1.20 Rs. 0.22
• Contribution per paper Rs.0.80 Rs.0.28
• The sale of ten evening daily will reduce one morning daily.
• Lost in contribution in morning daily=0.8/10=Rs.0.08
• Net contribution from evening daily= 0.28-0.08=0.20
• Breakeven sales of evening daily=Fixed cost/Net contribution
per copy
• =10000/0.20=50,000 copies
Exercise-19 (EOQ):
G limited produces a product which has a monthly demand of 4000 units. The
product requires a component X which is purchased at Rs.20. For every finished
product, one unit of component is required. The ordering cost is Rs.120 per order
and the holding cost is 10%p.a.
You are required to calculate:
(i). EOQ
(ii). If minimum lot size to be supplied is 4000 units, what is extra cost the
company has to incur?
(iii). What is the minimum carrying cost the company has to incur?
Answer-19:
1) EOQ=Root of 2AB/C
=Root of (2*12*4000*120)/(20*0.10)
=2400 UNITS
2) Extra costs if 4000 units are ordered instead of EOQ i.e. 2400 units.
Carrying cost + ordering cost
= 1/2(4000*Rs.20*0.10) + (48,000/4000)Rs.120
Depreciation / 101
= 5440
Cost at EOQ =1/2(2400*20*0.10)+(48000/2400)120
= 4800
Extra cost = 5440-4800=640
3) Minimum Carrying cost= 2400
Excercise-20 (Linear application):
The company has derived the following functions:
Total cost (Rs.)=1,00,000 +20q+0.005q2
Price per unit (Rs.)=76-0.002q
Where q=quantity
Determine the production level which will maximise profit.
AAnnsswweerr--2200 MR=MC to maximise profit
Revenue = Price*Quantity
= q (76-0.002q)
=76q-0.002q2
Marginal revenue=dR/dq=76-0.004q
Marginal cost=dc/dq=differentiate total cost=20+0.01q
Maximize profit 76-0.004q=20+0.01q
Q=4000 units.
Depreciation / 102
Exercise:21(Linear equations)
• The details of production department
involving two processes are as under:
2.5
2
100
3
2
200
2
3
Rs.400
Process I hours/unit
Process II hours/unit
Contribution per unit
Maximum capacity of process I is
1920 hours and of process II is
2200 hours.Maximum sales of A
will be 200 units.
Formulate LPP.
CBAProduct
Solution-21 :linear equation with learning curve effect)
Maximize Z=400A+200B+100C
Subject to:
2A+3B+2.5C<=1920
3A+2B+2C<= 2,200
A<=200
Where A,B,C>=0
Exercise-22:
A company manufactures specialized equipment. Direct labour required to make
the first equipment is 2000 hours. Learning curve is 80%. Direct labour cost is
Rs.40/- per hour. Direct material needed for one equipment is Rs.7200/- Fixed
overheads are Rs.32, 000/-
Required:
(i). Using the Learning curve concept calculate the expected average unit cost
of making an equipments b) 8 equipments.
(ii). After manufacturing 8 equipments, if a repeat order for manufacture of 8
equipments is received, what lowest price could be quoted for the repeat
order?
Depreciation / 103
23. Investigation to be done or not
Arbitrary Criteria: Investigating if the absolute size of a variance is greater than
a certain amount or if the variance exceeds the standard cost by a predetermined
percentage say 1%
Example: If standard usage for a particular component was 10 Kg if actual output
for a period is 1000 units the variance is with in 9,900 and 10,100.
This method is simple arbitrary rules are their simplicity and easy to
implementation. There are several disadvantages. Investigating all variances that
exceed the standard cost by fixed percentage can lead to investigating many
variances of small amounts.
Exercises on investigation:
A machine produces 1,00,000 standard components per day at a cost of 1.5 per
unit. If the process is in control, on an average 3% of the output is defective. If the
process is out of control the rate of defectives will be 5%. The entire cost of
defective unit is a loss.
The cost of carrying out an investigation is 600. If the process is found to be out of
control after an investigation then it costs another Rs.400 to rectify the error. The
probability of the process being in control is 0.7.
Required:
(i). Should an investigation be made or not?
(ii). What is the probability at which investigation is desirable?
Depreciation / 104
Answer-1
.7
.3
3%(1,50,000)
Out of control
under control
600+3000
Investigate
Do not investigate
Do not rectify
Rectify
5%(1,50,000)
3%(1,50,000)
Rectify
Do not rectify
3%(1,50,000)
5%(1,50,000)
Investigate600
1. If Investigation under taken
Process under control 600*0.7=420
Process out of control 1000*0.3=300
(600+400) 720
2. Cost of not to investigate:
Extra cost =1,00,000*1.5=1,50,000
Extra loss(5%-3%)=1,50,000*2%=3000
Probability = 0.3
Expected value= 3000*.03=900
Conclusion: the cost of investigation is less than the cost of non-investigation.
Hence it should be investigated.
Depreciation / 105
• 2. Probability at which investigation is
desirable:
3000*(1-x)
600x
1000-
1000x
1000-
400x
X
1-x
600
1000
Under control
Out of control
Net cost
Cost of
investigation
Eff.costProbcostProcess
Equating both sides we get: 1000-400x=3000-3000x
X=0.77
Probability of process in control=0.77
24. Problem• The relevant data of X Ltd. For its three
products A,B and C are as under.
930
250
260
180
3
1040
300
270
230
6
860
260
300
110
12
Selling price
Direct Material
Direct Labour
Variable Overheads
Machine hours required
C
Rs. Per unit
B
Rs. Per unit
A
Rs. Per unit
Products
The estimated fixed overheads at four different levels of 3,600; 6,000; 8400;and 10,800
machine hours are Rs.1,00,000,Rs.1,50,000,2,20,000 and Rs.3,00,000 respectively.
The maximum demand of A,B and C in a cost period are 500;300 and 1,800 units
Respectively.
Required:- Find out i) the most profitable product-mix at each level and ii) the level
Of activity where the profit would be maximum.
Solution Continues
Contributions at different levels of machine hours are
2,88,000; 456,000; 5,23,000; 561,000 respectively
Depreciation / 106
Less Fixed cost:
Net Profit: 1,88,000; 3,06,000; 303,000; 261,000
At 6000 units we get maximum profit.
Exercise-25:
An agriculturist has 480 hectares of land on which he grows potatoes, peas and
carrots. Out of the total area of land 340 hectares are suitable for all four
vegetables but the remaining 140 hectares of land are suitable only for growing
peas and carrots. Labour for all kinds of form works is available in plenty.
The market requirement is that all the four types of vegetables must be produced
with the minimum of 5000 boxes of any one variety. The former has decided that
the area devoted to any one crop should be in terms of complete hectares and not
in fractions of a hectare. The only other limitations is that not more than 1,13,750
boxes of any one vegetables should be produced.
• The relevant data concerning
production, market prices and costs are
as under:
180
Rs.
624
1056
10.40
19.20
44.55
70
Rs.
384
744
8.80
8.0
36.80
100
Rs.
432
1216
6.56
10.40
31.76
350
Rs.
952
1792
7.20
10.4
30.76
Annual yield :
Boxes per hectare
Cost:
Direct Material per hectare
Direct Labour:
Growing per hectare
Harvesting and packing per box
Transport per box
Market price per box
TomatoesCarrotsPeasPotatoesParticulars
It is possible to make the land presently suitable for peas and carrots, viable for
growing potatoes and tomatoes if certain land development work is
undertaken. This work will involve a capital expenditure of Rs.6,000/- per
hectare which a bank is prepared to finance at the rate of 15% per annum. If
such improvement is undertaken, harvesting cost of the entire crop of tomatoes
will decrease on an average by Rs.2.60 per box.
Depreciation / 107
Required:
(i). Calculate the area to be cultivated in respect of each crop with in the
constraints and profits before land development work is undertaken.
(ii). After development of land find the acres of land for each product and
maximum profits.
26.Replacement Problem
• A Super market is trying to determine the optimal replacement policy for its fleet of delivery vehicles. The total price of the fleet is Rs.2,20,000.
• The running costs and scrap values of the fleet at the end of each year are:
• The super market’s cost of capitial is 12% per annum.
• Ignore tax and inflation.
• Required: When to replace fleet of delivery vehicles ?
1,76,000
25,000
1,65,000
55,000
1,54,000
66,000
1,32,000
88,000
1,10,000
1,21,000
Running cost
Scrap value
Year 5Year 4Year 3Year 2Year 1
Depreciation / 108
Answer for replacement
-110
-132
-154
-165
-151(176-
25)
503.64
220
723.64
3.605
200.73
-110
-132
-154
-110(165-
55)
383.04
220
603.04
3.037
198.56
-110
-132
-88(154-66)
266.09
220
486.09
2.402
202.37
-110
-44(132-88)
133.30
220
353.30
1.690
209.05
+11(100-121)
9.83
220
210.17
o.893
235.35
Cash out flow at the
end of year
1
2
3
4
5
Present value of
outflows
Present cost
Present value
Annuity factor
Equivalent annual
cost
When to replace?
5
(000)
4
(000)
3
(000)
2
(000)
1
(000)
The lowest equivalent annual cost is Rs.198,560/- Therefore the fleet should be
replaced at the end of 4 years.
Exercise-27:
A company purchases 6000 components per annum at Rs.60/- each. The
management desires to install a machine to manufacture the components. The cost
of the machine is Rs.3,00,000/- It has a capacity to produce 10,000 components
per annum. The life of the machine is 5 years. The variable cost to manufacture
the components is Rs.48 per unit and a sum of Rs.20,000/- has been allocated to
this machine as a fair share of general factory overheads per annum.
(i). Should the company make or buy the components?
(ii). If an offer to buy 2500 components at Rs.50 each is received from another
company, should the company accept the offer to manufacture and supply?
Evaluation of make or buy decision:
Purchase price per component 60
Less: variable cost 48
Savings if component manufactured 12
Total savings (6000 x 12) 72,000
Less: Depreciation (3,00,000/5) 60,000
Net savings 12,000
Recommended to install special machine.
Depreciation / 109
Exercise-28: Special Order with Learning Curve
An electronic firm which has developed a new type of fire alarm system has been
asked to quote for a prospective customer. The customer requires separate price
quotations for each of the possible orders.
Order First Second Third
No. of fire and alarm system 100 60 40
The firm estimates the following cost per unit for the first order:
Materials Rs.500/-
Direct labour
Department A (Highly automated) 20 hours at Rs.10/- per hour
Department B (Skilled labour) 40 hours at Rs.15/- per hour
Variable overheads Rs.8/- per direct labour hour
Fixed overhead absorbed
Department A: Rs.8/- per hour
Department B: Rs.5/- per hour
Determine a price per unit for each of the three orders assuming the firm uses a
mark up of 25% on total costs and allows for 80% learning curve. Each from 80%
learning curve table
Learning Curve Table:
X 1.0 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0
Y% 100 91.7 89.5 87.6 86.1 84.4 83.0 81.5 80.0
Where X represents the cumulative total volume produced to date expressed as
a multiple of the initial order.
Y represents the learning curve factor, for a given X value, expressed as a
percentage of the cost of the initial order.
Answer:
First order:
Material = 500,
Direct Labour: A = 20 x 10 = 200, B= 40 x 15 = 600
Prime Cost = 1300,
Variable overheads = Rs.800(20/100) = 160
Fixed overheads: A = 20 x 8=160, B = 40 x 5=20
Total cost =1820, Profit=1850 x 0.25 = 455: Sales = 2275
Second order:
Cumulative out put = 100 + 60 = 160
Depreciation / 110
Total hours = 160units x 40 hrs x 0.861 = 5510.4 hrs
Hours for 60 units = 5510.4 – 4000 = 1510.4
Hours per unit = 1510.4/60 = 25.17 hrs
Sales per unit = Rs.1848.64
Third Order:
Labour hrs = 200 x 40 x 0.8 – 5510.4 = 889.6 hrs
Hours per unit = 889.6/40 units = 22.24
Sales =1764.40 per unit.
Exercise-29: Life Costing
A BPO Company has identified two places after spending Rs.20,00,000/- for
market study to set up its business operations. They request you to choose any one
of the places based on the following information.
Place I: Koramangala
80% of the employees are staying at 8 kilometers radius. 20% of the
employees are staying 12 kilometers radius.
Cabs are arranged for the employees both the ways.
10% of the total number of employees do not take the transport facilities
and are paid by Rs.3/- per k.m. for 10 kilometers basis per day trip
irrespective of the number of kilometers traveled by them.
A cab can bring 4 employees at a time.
The cabs while leaving the first shift employees in their houses pick up the
second shift employees. The cab is always full.
The cabs are taken on a daily rental of Rs.800/- irrespective of the
kilometers for 12 hours duration. For 18 hours duration Rs.1200/- is
charged per cab (both shifts and transport time) i.e. Rs.400/- is charged for
second shift employees to be dropped after second shift.
The rent of the building is Rs.25per month per square feet for the first year,
Rs.28/- p.m. for the second year and Rs.30/- p. m. for the third year.
Place II: Rajaji Nagar:
40% of the employees are staying in 10 kms radius and 60% of the
employees are staying at 14 kms radius. All employees prefer to take the
transport facilities.
A cab is taken on a daily rental of Rs.900/- per day irrespective of the kms
and Rs.400/- is charged per cab to drop the second shift employees in their
houses.
The rent of the building is Rs.15/- per month per square feet for the first
year, Rs.20/- p.m. for the second year and Rs.25/- p.m. for the third year.
Depreciation / 111
Other information:
The company has fixed order of 5,54,400 accounts per month. There are two shifts
in 24 hours a day. The working hours are 9 hours duration but effective working
hours are 8 hours per day. Each account is estimated to be processed in a five
minute duration.
On an average there are 22 working days in a month.
Irrespective of the place selected, the company makes a contract for three years
only. Each employee occupies on an average of 40 square feet including all other
facilities such as canteen, toilet etc.
Discounted rate is 12%.
Required:
(i). Choose the correct place to set up their business in Bangalore.
(ii). Having chosen the place, if the Company expects Rs.20,00,000/- p.m. as
profit and their variable and fixed over heads come to 70 per employee per
hour Calculate Break even employees per year and Margin of safety
employees to get a profit of Rs.20,00,00/- and also calculate break even
accounts per year and margin of safety accounts to be processed.
(iii). Should the company run in a single shift or double shift? Advice.
Answer:
Per day accounts processed = 5,54,400 /22=25200
Effective hours per day per employee = 8 hrs
Number of accounts processed per day per employee
= 8 x 60 mts/5 mts = 96 accounts
Number of employees = 25200 accounts/96 accounts per
employee
= 262.5=263employees.
Per shift = 263/2=132 employees per shift
The required space:
Per employee = 40 square feet
Total area in square feet = 40 x 132= 5840 square feet.
Rent in Koramangala in the first year = 5840 x 25 x 12 =
Rs.17,52,000
In the second year = 6000 x 28 x 12 = Rs.20,16,000
Third year = 6000 x 30 x 12 = Rs. 21,60,000/-
Depreciation / 112
Exercise-30:
Kings B&B IS A BED AND BREAKFAST ESTABLISHMENT
There are 10 rooms priced at £22 per night the B&B is open 7 nights per
week the following are typical costs:
Weekly costs
heat & light £42
Cleaning staff(basic) £100
admin £90
Breakfast staff £72
Other o/heads £60
Cost per guest night
Breakfast food £4
cleaning staff bonus £2
Laundry £3
The question asks to calculate the weekly Profit or loss if there were 42
guest nights in a week i.e.: an average of 6 guests on each of the 7 nights.
Answer:
If we start by saying that the
Weekly costs should be treated as not changing according to how many
people stay the night, so if there are 42 or 0 the cost is fixed
Cost per guest night is a variable cost and the total cost of breakfast food
etc will depend on how many people stay the night.
Total fixed cost is heat & light £42
Cleaning staff(basic) £100
admin £90
Breakfast staff £72
Other o/heads £60
£364
Total variable cost per guest night is:
breakfast food £4
cleaning staff bonus £2
Depreciation / 113
Laundry £3
Total variable cost £9
So the contribution per guest night is:-
Price - variable cost per night
£22 - £9 = £13
if there were 42 guest nights in a week
Then total contribution is
42 x £13 = £546
Fixed costs are £364
So the profit is £182
Exercise-31:
During ltd manufactures one product
no units manufactured 10000
number of units sold 8000
selling price £4 per unit
direct materials £8000
direct labour £16000
fixed production overheads £10000
There were no finished goods stock at start of month both direct materials and labour behave as
variable cost.
Produce a profit statement using marginal cost and absorption costing
On my profit statement for marginal costing I have:
sales @ £4 each = £32000
Variable cost
direct material @ £1 each = 8000
direct labour @ £2 each
less closing stock (marginal cost £6000)
2000 units x £3
fixed production o/heads £10000
profit £4000
Would really appreciate your help with this one. Trying to get through my
resubmits so I can concentrate on exam revision.
34. Special Sales Order:
Depreciation / 114
A. B. Fast is a manufacturer of automobile parts located in Texas.
Ordinarily A. B. Fast sells oil filters for $3.22 each.
R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or
$1.77 per filter.
Special Sales Order
A. B. Fast‘s manufacturing product cost is $2 per oil filter which includes variable
manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80.
Suppose that A. B. Fast made and sold 250,000 oil filters before considering the
special order.
Should A. B. Fast accept the special order?
Special Sales Order
The $1.77 offered price will not cover the $2 manufacturing cost.
However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit.
Accepting the order will increase A. B. Fast‘s contribution margin.
20,000 units × $.57 contribution margin per unit = $11,400
35. Dropping Products, Departments, and Territories:
Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil
filters and 20,000 air cleaners).
Suppose that the company is considering dropping the air cleaner product line.
Revenues for the air cleaner product line are $41,000.
Should A. B. Fast drop the air cleaner line?
Dropping Products, Departments, Territories
Variable selling and administrative expenses are $0.30 per unit.
Variable manufacturing expenses are $1.20 per unit.
Total fixed expenses are $335,000.
Total fixed expenses will continue even if the product line is dropped.
Sensitivity analysis is a technique for determining how much an expected payoff will
change in response to a given change in an input variable (all other things remaining
unchanged).
Steps in Sensitivity Analysis
Begin with consideration of a nominal base-case situation, using the expected values for
each input.
Calculate the base-case output.
Consider a series of "what-if" questions, to determine by how much the output would
deviate from this nominal level if input values deviated from their expected values.
Each input is changed by several percentage points above and below its expected value,
and the expected payoff is recalculated.
The set of expected payoff is plotted against the variable that was changed.
The steeper the slope (i.e., derivative) of the resulting line, the more sensitive the
expected payoff is to a change in the variable.
Scenario Analysis
Scenario analysis is a risk analysis technique that considers both the sensitivity of
expected payoff to changes in key variables and the likely range of variable values. The
worst and best "reasonable" sets of circumstances are considered and the expected payoff
for each is calculated, and compared to the expected, or base-case output.
Scenario analysis also includes the chance events, which could be rare or novel events
with potentially significant consequences for decision-making in some domain.
Integer Linear optimization Application:
Suppose you invest in project (i) by buying an integral number of shares in that project,
with each share costing Ci and returning Ri. If we let Xi denotes the number of shares of
project (i) that are purchased, then the decision problem is to find nonnegative integer
decision variables X1, X2,…, Xn --- when one can invest at most M in the n project --- is
to:
Integer Linear optimization Application
Maximize S Ri Xi
Subject to:
SXi Ci £ M
Application: Suppose you have 25 to invest among three projects whose estimated cost
per share and estimated return per share values are as follows:
Project Cost Return
1 5 7
2 9 12
3 15 22
Maximize 7X1 + 12X2 + 22X3
Subject to:
5X1 + 9X2 + 15X3 £ 25
Using any linear integer programming software package, the optimal strategy is X1 = 2,
X2 = 0, and X3 = 1 with $36 as its optimal return.
Depreciation / 182
Exercise-2
New Horizons Ltd wants to go in for the public share issue of Rs. 10 lakhs(1 lakhs
shares of Rs. 10 each) as a part of its effort to raise capital needed for its expansion
programme. The company is optimistic that if the issue were made now, it would be fully
taken up at a price or Rs. 30 per share.
However the company is facing situations both of which may influence the share prices
in the near future namely
a) An impending wage dispute with assembly workers which assembly workers which
could lead to strike in the whole factory could have an adverse effect on the share.
b) The possibility of a substantial business in the export market, which would increase
the share price.
The four possible events and their expected effect on the Company‘s share prices are
envisaged as:
E1: No strike and export business obtained-share price rises to Rs. 34
E2:strike and export business obtained-share price rises to Rs. 30
E3:No strike and export business lost-share price rises to Rs. 32
E4: strike and export business lost-share price drops to Rs. 16
And the management has identified three possible strategies that the company could
adopt:
S1-Issue 1,00,000 shares now.
S2- issue 1,00,000 shares only after the outcome of (a) & (b) are known.
S3- Issue 50,000 shares now and 50,000 shares after the outcome (a) & (b) are known.
Calculate 1. MINIMAX Regret 2. Maxmax 3. Expected value if probability of strike is
55% and chance of getting export business is 65% 4. Expected value of perfect
information.
Answer
Depreciation / 183
Pay off table (Rs. in lakhs)
30
16
23
30
32
31
30
32
30
30
34
32
S1
S2
S3
E4E3E2E1Event strategies
Calculations: see next page
Calculations
E1- 50,000*30+50,000*34 =32,00,000
E2- 1,00,000*30 = 30,00,000
E3- 50,000*30+ 50,000*32=31,00,000
E4- 50,000*30+ 50,000*16= 23,00,000
Depreciation / 184
Regret table
0 4
14 14
7 7
2
0
1
0
0
0
4
0
2
S1
S2
S3
E4 Max.reg
E3 E2E1Event strategies
Minimax regret solution is S1 ie 4. alternatively include Maxmin ie. Strategy
With highest minimum pay off to which is S1 i.e. 34
Joint probability
Probability of outcome are not given directly but can be easily calculated:
E1 0.45*0.65=0.2925
E2 0.55*0.65=0.3575
E3 0.45*0.35=0.1575
E4 0.55*0.35=0.1925
Depreciation / 185
Maximising expected pay off
30
28.79
29.40
30*.1975
16*.1975
23*.1975
30*.1575
32*.1575
31*.1575
30*.3575
30*.3575
30*.3575
30*.2925
34*.2925
32*.2925
S1
S2
S3
EXP.PAY OFF
E4E3E2E1Event strategies
S1 HAS THE HIGHEST EXPECTED PAYOFF I.E. 30(Rs. 30 lakhs)
Expected value of perfect information
9.94
10.72
5.04
5.78
31.48
0.2925
0.3575
0.1575
0.1925
34
30
32
30
E1
E2
E3
E4
TOTAL
EVPIJoint probability
Max.payoff
EXPECTED VALUE OF PERFECT
INFORMATION=31.48-30=1.48 OR RS.1,48,000
Example Engineering Ltd. Manufacture engines.They have been asked to bid on prospective contract for 90 engines for cars. They have completed an initial run of 30 of these mounting at the following costs:
Direct material Rs. 20,000; Direct labour(6000 hours at Rs.4 per hour)-24000; tooling cost (re-usable)- Rs.3000; variable overhead(Rs.0.50 per labour hour)-Rs.3000;Fixed overhead(Rs.0.50 per labour hour)-Rs.6000.
Depreciation / 186
If 80% learning curve is thought to be pertinent in this case. The Marketing Director believes that the quotation is unlikely to be accepted if it exceeds Rs. 1,10,000 and as the Company are short of work, he believes the contract to be vital.
You are required to comment whether it is worth accepting at Rs. 1,10,000.
No cumulative cumulative cumulative average
Qty.manufa. Hours hours per unit
1. 30 3000 200 ie 6000/30
2. 60 9600(160*60) 160 ie 80% of 200
3. 120 15,369(120*128) 128 ie.80%of 160
Additional hours for 90 additional engines= 15369-6000=9360 hours
Incremental costs for 90 engines:
direct material Rs.60,000
direct labour(9360*4) 37,440
Tooling cost nil
variable overheads(9360*0.5) 4,680
fixed overhead nil
total 1,02,120
Net saving=1,10,000-1,02,120=Rs.7880
3. Indian would like to have travelers cheques: GBP-
STERLING 72.70-73.25
A) explain the quote
B) compute the spread
C) How much would you pay for purchasing 250 pounds in
TCS?
D) If you have a balance of pounds 23 in travellers cheques ,
how many rupees would you receive if the bank in india
quotes 73.65-73.92?
4.Explain the sections 2(1B) and 72A of Income tax Act with
respect to amalgamation/absorption
1. Distinguish between Forwards and Futures
2. Distinguish between spread and swap points.
. Explain the following terms: a) Strike price b) forward price c)in
the money d)Bid and Ask e)holder and writer
4. The current market price is Rs. 50 has the following exercise
price and cal option premium. Compute intrinsic value and time
value
Exercise
price
premium
Depreciation / 187
45
48
50
52
55
5
6
4
5
7
1. consider the following Euro/USD direct quote 0.9345-0.9375