Q Girish Engineering (MCS-2004) Numerical Responsibility budgeting was introduced in a medium sized organization Girish Engineering. Monthly report (in part) for an expense centre in factory is: All figures in Rs. Lacs Actual Variance Direct Labour 100.13 0.21 (Favourable) Indirect Labour 66.34 8.10 (Unfavourable) Total Controllable Costs 168.47 8.50 (Unfavourable) Department Fixed Costs 38.82 -------- Allocated Costs 53.62 -------- Questions: 1. Why no variance is shown in two items? Is this correct approach in performance reporting? 2. Should overhead expenses mentioned above be included in Controllable Costs? Why? Why not? Solution (a): Variances between actual and budgeted departmental fixed costs are obtained simply by subtraction, since these costs are not affected by either the volume of sales or the volume of production. That’s why no variance is shown for departmental fixed costs. Allocated costs are a share of the costs of a resource used by a project, where the same resource is also used by other activities. These are different to the Incurred costs because these costs are not exclusively related to any individual project. However, the cost of the resource still
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Q Girish Engineering (MCS-2004) Numerical
Responsibility budgeting was introduced in a medium sized organization Girish Engineering.
Monthly report (in part) for an expense centre in factory is: All figures in Rs. Lacs
Actual VarianceDirect Labour 100.13 0.21 (Favourable)Indirect Labour 66.34 8.10 (Unfavourable)Total Controllable Costs 168.47 8.50 (Unfavourable)Department Fixed Costs 38.82 --------Allocated Costs 53.62 --------
Questions:1. Why no variance is shown in two items? Is this correct approach in performance
reporting?2. Should overhead expenses mentioned above be included in Controllable Costs?
Why? Why not?
Solution (a):
Variances between actual and budgeted departmental fixed costs are obtained simply
by subtraction, since these costs are not affected by either the volume of sales or the
volume of production. That’s why no variance is shown for departmental fixed costs.
Allocated costs are a share of the costs of a resource used by a project, where the same
resource is also used by other activities. These are different to the Incurred costs
because these costs are not exclusively related to any individual project. However, the
cost of the resource still needs to be recovered, and making a fair and reasonable charge
to all projects using the resource does this.
The key difference between costs and Allocated costs is that the latter will be charged
based upon an estimate, rather than actual cash values. Thus as it is charged based upon
an estimate the budgeted figure is the same as the actual figure and hence no variances.
Solution (b):
Overhead Expenses mentioned above should not be included in controllable costs
because some costs are uncontrollable like fixed costs. . They don't vary with the change
in short run managerial decisions and output. And some costs are controllable i.e. they
can be managed and changed with the managerial decisions and output.
As the above overhead expenses would have certain portion of fixed expenses this is
hard to control. So, these should not be a part of controllable cost.
Kiran Company (MCS-2004) Numerical
Budget versus Actual comparison for div Z of Kirancompany is as follows:
Budget Actual Actual better
(worse) than budget
Sales and other income 800 740 (60)
Variable expenses 480 436 44
Fixed expenses 120 120 0
Sales promotional expenses 40 28 12
Operating profit 160 156 4
Net working capital 400 412 12
Fixed assets 160 148 (12)
(a) Carry out and overall performance analysis to decide areas needing investigation.
From the given data, we see that there is a certain amount of variance between the
budgeted operating profit and actual operating profit. In order to analyze the variances, we
need to understand the key causal factors that affect profit, namely, revenues and cost
structure. The profit budget has embedded in it certain expectations about the state of total
industry, company’s market share, selling prices and cost structure. Results from variance
computation are actionable if changes in actual results are analyzed against each of this
expectation.
Revenue variances, that is a negative Rs 60 lakhs, could be a result of selling price variance,
mixed variance and/or volume variance. A combination of above three factors must have
been unfavorable that is either the volume of sales must have been below the budgeted
volumes ( this must be particularly true since actual variable expenses are less than
budgeted) and/or the selling price must have been below expectation and/or the proportion
of products sold with a higher contribution must have been less than budgeted.
One more factor could have been the overall industry volume. However, this factor is
beyond the managements control and largely dependent on the state of economy.
Variable expenses are directly proportional to volumes and hence as is evident are less than
budgeted.
Sales promotional expenses also show a negative variance which could be a cause of lower
sales volumes.
A cause of concern is that despite lower sales, the net working capital is more than
budgeted which indicates capital block in higher inventory.
Another issue is that the fixed assets are lower than the budget by Rs 12 lakhs which may
indicate slower capacity expansion then expected or distressed sale of assets to tide over
cash flow.
(b) What are the remedial measures if any would you suggest based on analysis?
The budgeted estimates may be too optimistic and far from reality, one needs to ensure
that estimates the as realistic as possible. Given the estimates are correct, in that case
depending upon the above analysis, the management needs to take corrective action areas
needing improvement, sales volume could be improved by better marketing, quality
standards and promotional efforts, product mix could be improved by selling more of higher
contribution products. Better sales will ensure a higher inventory turnover. Better credit
management to recover receivables, will ensure improve cash flow situation since less
capital will be tied up in working capital.
Q.5ABC ltd. (MCS-2008) Numerical
Particulars Division X (Rs.) Division Y (Rs.)
ROI 28% 26%
Sales 100 Lacs 500 lacs
Investment 25 lacs 100 Lacs
EBIT 7 Lacs 26 lacs
Analyze and comment upon performances of both the divisions
Solution:
Division X
ROI = (Profit / investment)* 100
Profit = (28/100)*25lacs
= 7lacs
Profit margin = (Profit/sales)*100
= (7/100)*100
= 7lacs
Turnover of investments = (Sales/investment)*100
= (100/25)*100
= 4 times
Division Y
ROI = (Profit / investment)* 100
Profit = (26/100)*100lacs
= 26lacs
Profit margin = (Profit/sales)*100
= (26/500)*100
= 5.2lacs
Turnover of investments = (Sales/investment)*100
= (500/100)*100
= 5 times
Profit margin of X is better than profit margin of division Y. Turnover of investment of division Y is better than
Division X.
Hence cost management of Division X is better than Division Y.
MCS 2006 (SUM NO 7)
Q) Soniya Company has two Divisions: A & B. Return on Investment for both divisions is 20%.
Details are given below:-
Particulars Div A Div B
Divisional sales 4000000 9600000
Divisional Investment 2000000 3200000
Profit 400000 640000
Analyse and comment on divisional performance of each.
ANSWER
As Profit Margin = Profit *100
Sales
Profit Margin for Division ‘A’= 4,00,000 /40,00,000 *100 = 10%
Q 2)Suresh Ltd. (Numerical) (MCS-2007) and same as Ananya Ltd (MCS 2009)
(a) Define profit in this case and prepare a statement for both divisions and overall company.
Solution:
i) Profitability statement of Division A:-
Particulars Amount(Rs.)
Selling price p.u. 35
Variable Cost p.u. 11
Contribution p.u. 24
Contribution p.u. Expected sales
(no. of units)
Total contribution Total Fixed cost
(Rs.)
Net profit (Rs.)
24 2000 48000 60000 (12000)
24 3000 72000 60000 12000
24 6000 144000 60000 84000
ii) Profitability statement of Division B:-
Selling p.u. Total
variable
cost p.u.
Contribution
p.u.
Expected
sales (no. of
units)
Total
contribution
Total Fixed
cost (Rs.)
Net profit
(Rs.)
90 42 48 2000 96000 90000 6000
80 42 38 3000 114000 90000 24000
50 42 8 6000 48000 90000 (42000)
[Note: Total Variable cost p.u. = Variable cost p.u. (Rs.7) + Transfer price of intermediate product
(Rs.35)]
iii) Profitability statement of Company as a whole:-
Expected sales Net profit of division A
(Rs.)
Net profit of Division
B (Rs.)
Total Net profit
2000 (12000) 6000 (6000)
3000 12000 24000 36000
6000 84000 (42000) 42000
(b) State the selling price which maximizes profits for division B and company as a whole.
Comment on why the latter price is unlikely to be selected by division B.
Solution:
As per the calculation in part (a), selling price p.u. of Rs.80 maximizes profit for division B
whereas selling price p.u. of Rs.50 maximizes profit for the Company as a whole. However, if
Division B opts for selling price p.u. of Rs.50 in order to maximize Company’s profit, it would
suffer a loss of Rs.42000. Therefore, Division B would not select Selling price p.u. of Rs.50.
MCS – 2007
Two Divisions A and B of Satyam Enterprises operate as Profit centers. Division A normally
purchases annually 10,000 nos. of required components from Div. B; which has recently
informed Div. A that it will increase selling price per unit to Rs.1,100. Div.A decided to
purchase the components from open market available at Rs. 1000 per unit. Naturally, Div. B is
not happy and justified its decision to increase price due to inflation and added that overall
company profitability will reduce and the decision will lead to excess capacity in Div. B, whose
variable and fixed costs per unit are respectively Rs. 950 and Rs. 1,100.
Assuming that no alternate use exists for excess capacity in Div. B, will company as a whole
benefit if div A buys from the market.
If the market price reduces by Rs. 80 per unit. What would be the effect on the company
(assuming Div. B still has excess capacity) if A buys from the market
If excess capacity of Div. B could be used for alternative sales at yearly cost savings of Rs. 14.5
lacs, should Div. A purchase from outside?
Justify your answers with figures.
Solution
Option A ( Div A buys from outside)
Total Purchase Cost = 10,000 Units * Rs. 1000 = Rs. 1,00,00,000
Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000
Since total outlay if transferred inside is lesser than total purchase cost if bought from outside, relevant cost is the lesser one i.e. Rs. 95,00,000 and overall benefit for the company would be Rs. 5,00,000
a) Option B ( if the market price is reduced by Rs. 80 per unit and A buys from the market)Total Purchase Cost = 10,000 Units * Rs. 920 = Rs. 92,00,000Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000Since total purchase cost is lesser than the total outlay if transferred inside, relevant cost is the lesser one i.e. 92,00,000 and overall benefit for the company would be Rs. 3,00,000
b) Option C ( if excess capacity of Div B could be used for alternative sales at yearly cost savings of Rs 14.5 lacs, should Div A purchase from outside)Total Purchase Cost = 10,000 Units * Rs. 1,000 = Rs. 1,00,00,000Total outlay if transferred inside = 10,000 Units * Rs. 950 = Rs. 95,00,000Total opportunity cost if transferred inside = Rs. 14,50,000Total relevant cost becomes Rs. 1,00,00,000If Div A purchase from outside, overall benefit for the company would be Rs. 9,50,000. Therefore, Div A should purchase from outside.
Particulars Option A
Amount
Option B
Amount
Option C
Amount Total Purchase Cost 1,00,00,000 92,00,000 1,00,00,000
Total outlay if transferred inside 95,00,000 95,00,000 95,00,000Total opportunity cost if transferred inside - - 14,50,000Total relevant cost 95,00,000 92,00,000 1,00,00,000Net advantage/disadvantage to company as a
whole if it buys from inside
5,00,000 (3,00,000) (9,50,000)
For 20,000 Units For 19,600 Units
(Numerical) MCS – 2004
Division B of Shayanacompany contracted to buy from Div. A, 20,000 units of a
components which goes into the final product made by Div. B. The transfer price for this
internal transaction was set at Rs. 120 per unit by mutual agreement. This comprises of
(per unit) Direct and Variable labour cost of Rs. 20; Material Cost of Rs.60; Fixed
overheads of Rs.20 (lumpsum Rs.4 lacs) and Rs.20 lacs that Div. A would require for this
additional activity. During the year, actual off take of Div. B from Div. A was 19,600
units. Div. A was able to reduce material consumption by 5% but its budgeted
investment overshot by 10%.
a) As Financial controller of Div. A, compare Actual VsBudgetred Performance
b) Its implications for Management Control?
Solution:
a)
Particulars Budgeted
(Rs. Per
Unit)
Budgeted
(Total in Rs.)
Actual
(Rs. Per Unit)
Actual
(Total in Rs.)
Direct and
Variable Labour
Cost
20 4,00,000 20 3,92,000
Material Cost 60 12,00,000 57 11,17,200
Fixed Overheads 20 4,00,000 4,00,000
Total Cost 100 20,00,000 19,09,200
Transfer Price 120 24,00,000 119.86 23,49,200
Profit 20 4,00,000 4,40,000
Investment 20 20,00,000 22,00,000
ROI =
Profit/Investment
20% 20%
Despite of increase in investment by 10%, there is negligible difference in transfer price. Also the
sales have decreased by 400 units. Therefore we can say that additional investment has not achieved
any positive results.
Q) Division of Aparna Company manufactures Product A, which is sold to another division as a component of its product B; which then is sold to third division to be used as part of its Product C (sold to outside market). Intra company transactions rule: standard cost plus a 10 percent return on fixed assets and inventory, to be paid by the buying division.
Standard Cost per Unit Product A Product B Product C
*Purchase of outside material (Rs.) 40 60 20Direct. Labour (Rs.) 20 20 40Variable overhead (Rs.) 20 20 40*Fixed overhead per unit. (Rs.) 60 60 20Average Inventory (Rs.) 14 lacs 3 lacs6 lacsNet Fixed Assets (Rs.) 6 lacs 9 lacs 3.2 lacsStandard Production (Units) 2 lacs 2 lacs 2 lacs
(a) Determine from above data, transfer prices for Products A, B and Standard Cost of Product C.
(b) Product C could become uncompetitive since upstream margins are added. Comment.
Answer(a):Standard Cost of Product A
Outside material (40 * 2 lac units) 80,00,000
Direct Labour (20 * 2 lac units) 40,00,000
Variable O.H. (20 * 2 lac units) 40,00,000
1,60,00,000
+ 10% on (FA + Inventory)
i.e. 10% on 20 lacs 2,00,000
1,62,00,000
Transfer Price for Product A = 1,62,00,000 = 81
2,00,000
Standard Cost of Product B
Outside material (60 * 2 lac units) 1,20,00,000
Direct Labour (20 * 2 lac units) 40,00,000
Variable O.H. (20 * 2 lac units) 40,00,000
2,00,00,000
+ 10% on (FA + Inventory)
i.e. 10% on 12 lacs 1,20,000
2,01,20,000
Transfer Price for Product A = 2,01,20,000 = 100.6
2,00,000
Standard Cost of Product C
Outside material (20 * 2 lac units) 40,00,000
Direct Labour (40 * 2 lac units) 80,00,000
Variable O.H. (40 * 2 lac units) 80,00,000
Fixed O.H. (20 * 2 lac units) 20,00,000
2,20,00,000
(b): While arriving at the cost of Product C, margins of Product A, which become an input to Product
B, and Product B, which in turn become an input to Product C, are added. So when it is sold to outside
market, it suffers a disadvantage from its competitors as far as pricing is concerned, as its price will
normally be high compared to products of similar category. So it might become uncompetitive.
But in the long run, customers will distinguish between a good product and a bad product and the one
with the best quality will survive. So if the quality of product C is better than its competitors than only
it can survive in this competitive market.
Another strategy for the company is to cut the margins added by Products A and B, and then come out
with Product C with a lower price tag on it. This may do well to the product by making higher
revenues and capturing the market share.
Q) Ananaya& Company comprises of five divisions A, B, C, D and E and the present performance.
metricis return on assets. However, the controller has suggested management to switch over to
economic value added(EVA) as the criterion rather than return on assets. Compute and tabulate
both return on assets and EVA on the basis of following information (Rs. lakhs) and comment on
divisional performance.
Division Profit Fixed Assets Current Assets
--
A 300 800 160
- - ----
B 220 400 1600
C 100 600 1000
________
D 110 400 800
-
E 180 200 800
Controller feels corporate finance rates on current assets and.fixed assets should be 5% and 10%
respectively.
Solution:
Working Note:
Return on Assets = Profit * 100
Total Assets
A = 300/960*100 = 31.25%
B = 220/2000*100 = 11%
C = 100/1600*100 = 6.25%
D = 110/1200*100 = 9.17%
E = 180/1000*100 = 18%
Economic Value Added (EVA) = Profit – (W.A.C.C.* Capital Employed)
In this case,
EVA = Profit – (W.A.C.C. on Fixed Assets * Total Fixed Assets) + (W.A.C.C. on Current Assets * Total
Current Assets)
A = 300 – (0.10*800) + (0.05*160) = 212 lakhs
B = 220 – (0.10*400) + (0.05*1600) = 100 lakhs
C = 100 – (0.10*600) + (0.05*1000) = -10 lakhs
D = 110 – (0.10*400) + (0.05*800) = 30 lakhs
E = 180 – (0.10*200) + (0.05*800) = 120 lakhs
Summary
Division Return on Assets (R.O.A.) Economic Value Added (E.V.A.) (Rs.
lakhs)
A 31.25% 212
B 11.00% 100
C 6.25% -10
D 9.17% 30
E 18.00% 120
Comments:
1. It appears from the above analysis that division A has performed the best among the five divisions.
2. Also, it can be clearly noticed that divisions C and D seem to be in trouble.
3. Division A has performed the best when seen in terms of return on assets and economic value
added.
4. The reason why division A has performed the best is that it has the best working capital
management that can be reflected in the total amount invested in current assets and which is the
least among the five divisions.
5. The above reason holds true for the poor performance of divisions C and D as can be seen that
they have a huge amount invested in current assets which does not indicate good signs about their
operational efficiency.
6. A company which is into an expansion and overall growth mode primarily invests into fixed assets
and this is also one of the major reasons why the performance of division A is the best amongst all.
7. Though division C has also invested a huge amount in fixed assets the advantage is offset due to
the fact that it perhaps has a larger investment in current assets.
8. Division E is the second best both in terms of R.O.A. as well as E.V.A.
9. Though division E has the same amount invested in current assets as that of division D and
perhaps a lesser amount invested in fixed assets its profitability is much better and hence it has
delivered a better performance.
10. Division B is a better performer than divisions C and D in terms of R.O.A. as well as E.V.A. but the
major problem with this division is that it has a terrible working capital management. Its current
assets are the highest and this reflects that it has huge sums of money held up either in debtors or
inventory or rather it is holding a large amount of cash which is not a good sign.
Pritam Engineering manufacturing variety of metal product at many factories.Currently. It is
experiencing crisis, Management has, therefore, decided to detailed expense control system
including responsibility budgets for overhead expense items at each factory. From historical data,
Controller developed a standard for each overhead expense item (relating expense to volume of
activity). Summarized expenses for November,2005 given to concerned Production Supervisor for
comments is tabulated. All figures are in Rs. 000.
Item Standard at nominal volume Budgeted at actual volume actual
Management Supervision
720 720 582
Indirect labour 12706 11322 12552Idle time 420 361 711Materials, Tools 3600 3096 3114Maintenance, scrap 14840 13909 17329Allocated expenses 21040 21040 21218Total per ton (Rs.) 2133.04 2103.39 2413.3
(A) Explain with justification which of the two (1) or (2) is more meaningful for expense control.
(B) Can the supervisor be held responsible for all overhead expenses included? Why/why not?
Ans. (A) There is two general types of expense centers: engineered
and discretionary. This label relate to two types of cost. Engineered
costs are those for which the “right” or “proper” amount can be
estimated with reasonable reliability for example, a factory’s costs for
direct labor, direct material, components, supplies, and utilities.
Discretionary costs (also called managed costs) are those for which
not such engineered estimate is feasible. In discretionary expense
centers, the costs incurred depend on managements judgment as to
the appropriate amount under the circumstances.
Engineered expense centers
Engineered expense centers are usually found a manufacturing
operations. Warehousing, distribution, trucking, and similar units
within the marketing organization may also be engineered expense
centers, as may certain responsibility centers within administrative
and support department for instance, accounts receivable,
accounts payable, and payroll sections in the controller
department; personnel records and the cafeteria in the human
resources department; shareholder records in the corporate
secretary department; and the company motor pool. Such units
perform repetitive tasks for which standard costs can be
developed. These engineered expense centers are usually located
within departments that are discretionary expense centers.
In an engineered expense center, output multiplied by the standard
cost of each unit produced measures what the finished product
should have cost. The difference between the theoretical and the
actual cost represents the efficiency of the expense center being
measure.
We emphasize that engineered expense centers have other
important tasks not measured by cost alone; their supervisors are
responsible for the quality of the products and volume of
production as well as for efficiency. Therefore, the type and level
of production are prescribed, and specific quality standards are set.
So that manufacturing costs are not minimized at the expense of
quality. Moreover, managers of engineered expense centers may be
responsible for activities such as training and employee
development that are not related to current production; their
performance reviews should include an appraisal of how well they
carry out these responsibilities.
There are few, if any, responsibility centers in which all cost items
are engineered. Even in highly automated production departments,
the use of indirect labor and various services can vary with
management’s discretion. Thus the term engineered expense
center refers to responsibility centers in which engineered costs
predominate. But it does not imply that valid engineered estimates
can be made for each and every cost item.
Discretionary expense centers
Discretionary expense centers include administrative and support
units (e.g. accounting, legal, industrial relations, public relations,
human resources), research and development operations, and most
marketing activities. The output of these centers cannot be
measured in monetary terms.
The term discretionary does into imply that managements
judgment as to optimum cost is capricious or haphazard. Rather it
reflects management’s decisions regarding certain policies:
whether to match or exceed the marketing efforts of competitors;
the level of services the company should provide to its customers;
and the appropriate amounts to spend for R&D, financial planning,
public relations, and a host of other activities.
One company may have a small headquarters staff, while another
company of similar size and in the same industry may have a staff
10 times as large. The senior managers of each company may each
be convinced that their respective decisions on staff size are
correct, but there is no objective way to judge which (if either) is
right; both decisions may be equally good under the circumstances,
with the differences’ in size reflecting other underlying deference’s
in the two companies.
As far as above stated over heads are concern, we can easily
estimate “proper” or “right” amount with responsible reliability.
There for standard (1) is more meaningful for expenses control.
Ans. (B) A responsibility center is an organization unit that is
headed by a manager who is responsible for its activities. In a
sense, a company is a collection of responsibility centers, each of
which is represented by a box on the organization chart. These
responsibility centers form a hierarchy. At the lowest level are the
centers of the sections, work shift, and other small organization
units. Departments or business units comprising several of these
smaller units are higher in the hierarchy. From the standpoint of
senior management and and the board of directors, the entire
company is a responsibility center, though the term is usually used
to refer to units within the company and there for Supervisor is
responsible for the uses of the Above stated Resources (over heads)
like Indirect labor, idle time, Materials, tools, maintenance, scrape
and Management supervision by proper supervising supervisor can
control the listed overhead expenses.
Q:2005 )A TV dealership Veena Television (VT) is organized into four profit centers.
colour TV, Black and White, spare parts(SP) and servicing (SG) each headed by
manager BTV in addition to BVTV sales; also sells old TV exchanged (under scheme)
by customer while purchasing new TV . in one particular instance a new TV was sold
for 14150(financed by cash rs2000, Bank loan 7350and Rs 4800;exchange price for old
TV agreed by CTV manager )cost of new TV was Rs 11420.Shivangi Manager of BTV,
examined the old TV (valued at Rs 3500 by TV trade magazine) and felt that she could
get Rs 5000 for that TV offer repairing cabinet, resulting and servicing for which she
would use services of SP and SG price chargeable to BTV by SP and SG are at market
rates Rs235 for parts by SP and Rs 470 for services by SG. Market price are arrived at
after marking up cost by 3.5 times SG and 1.4 times SP. BTV pays a service
commission of Rs 250 per TV sold .overhead fixed per sale are CTV Rs 835;BTV Rs
665;SP RS 32 ;SG Rs 114.
Compute the profitability of the transaction assuming sales commission of $250 for the trade in on a selling price of $5000
Compute at market price At cost price Gross and net profit each
SOLUTION:
SP of New TV by CTV = $14150.
Original cost= $11420 ($14150= $2000 cash down payment + $4800
trade in allowance + $7350 bank loan)
Guide Book Value =$3500
Ms. Shivangi of BTV Dept, believed that she could sell the trade in at $5000
Other Cost: Rs235 for parts by SP and Rs 470 for services by SG
When trade-in is recorded @ $4800 4800+470+235=5505; 5000-5505= (-505)
Particulars New TV OLD TV Service PartsSales 14150 5000 470 235
Selling commission 0 250 0 0
Gross profit 2730 -505 470 235
Overhead 835 665 114 32
Servicing 0 470 0 0 Net profit before common exp 1895 -1640 591 123
If the trade-in is recorded @ $3500
Particulars New TV OLD TV Service Parts
Sales 14150 5000 470 235
Selling commission 0 250 0 0
Gross profit 2730 1045 470 235
Overhead 835 665 114 32
Servicing 0 470 0 0
Net profit before common exp 1895 -340 356 123
2006: sum(11)
Two divisions A and B of sonali enterprises operate Profit centers. Div A normally purchases annually 10000 nos. of required components from Div B, which has recently informed Div A that it will increase selling price p.u to Rs. 1100. Div A decided to purchase the components from open market available at Rs.1000 p.uDiv B is not happy and justified its decision to increase price due to inflation and added that the overall company profitability will reduce and decision will lead to excess capacity in Div B, whose V.C and Fixed cost p.u. are Rs. 950 and Rs.1100.
1. Assuming that no alternate use exists for excess capacity in Div B, will company benefit as a whole if Div A buys from the market.
2. If the market price reduces by Rs.80 p.u. What would be the effect on the company (assuming Div B has still excess capacity) if A buys from market.
3. If excess capacity of Div B could be use for alternative sales at yearly costs savings of Rs. 14.5 lacs, should Div A purchase from outside?
Justify your answers with figures
ANSWER
1) Division ‘A’ action
BUY OUTSIDE (Rs.) (Rs.) BUY INSIDE
Total Purchase Cost 10,00,000 Nil
Total Outlay Cost Nil 9,50,000
Net Cash Outflow To The Company As A Whole
10,00,000 9,50,000
The Company as a whole will benefit if Division ‘A’ buys inside from Division ‘B’.
2) If the market price reduces by Rs.80 p.uDivision ‘A’ action
BUY OUTSIDE (Rs.) (Rs.) BUY INSIDE
Total Purchase Cost 9,20,000 Nil
Total Outlay Cost Nil 9,50,000
Net Cash Outflow To The Company As A Whole
9,20,000 9,50,000
The Company as a whole benefit if ‘A’ buys from outside supplier at Rs. (1000-80) = 920
3) If excess capacity of Div B could be use for alternative sales at yearly costs savings of Rs. 14.5 lakhs
Division ‘A’ action
BUY OUTSIDE (Rs.) (Rs.) BUY INSIDE
Total Purchase Cost 10,00,000 Nil
Total Outlay Cost Nil 9,50,000
Revenue From Using These Facilities
1,45,000
Net Cash Outflow To The Company As A Whole
8,55,000 9,50,000
1 Girish Engineering Ltd. (Numerical) (MCS-2006)
(1) On the basis of costing, will the manager be interested in accepting the market offer?
Solution:
Particulars Amount (Rs./unit) Amount (Rs./unit)
Cost of critical component for division X
220
Cost of other material 500
Fixed & processing costs 290
Total cost for division X 1010
Selling price of final product 1000
Net loss for division X 10
Desired profit for division X 60
Thus on the basis of full actual cost incurred by division X, it would suffer a loss of Rs.10/unit if it accepts the market offer whereas its target profit margin is Rs.60/unit. So, division X would not accept the market offer.
(2) Is this offer beneficial to the company as a whole? Justify with figures.
Solution:
Particulars Amount (Rs. Lakh) Amount (Rs. Lakh)
Cash inflow (a) 50 (5000 units * Rs.1000/unit)
Cash outlay:
Variable cost for division Y 5 (Working note)
Material bought by division X from outside
25 (5000 units * Rs.500/unit)
Total cash outlay (b) 30
Net cash inflow to Company as a whole [(a)- (b)]
20
Thus, the Company as an entity would receive cash inflow of Rs.20 lakh. So, the offer is beneficial to the company as a whole.
Working notes:-
Variable cost for division Y:
Desired RoI =10% of Rs.2.4 Cr. p.a. = Rs.24 lakh p.a. i.e. Rs.2 lakh per month
Fixed cost assigned to division X = Rs.4 lakh per month
Fixed cost p.u. = 400000/5000 = Rs.80
Contribution per month = Rs.6 lakh
Total sales value for division Y = 220 * 5000 = Rs.11 lakh per month
So, total Variable cost per month for division Y = 11 lakh – 6 lakh = Rs.5 lakh
Variable cost p.u. for division Y = 500000/5000 = Rs.100
An annual investment of Rs2.4 Cr. is assigned by division Y to division X but it does not imply that a special investment of Rs.2.4 Cr. is made by division Y exclusively to produce the component required by division X. Therefore, cash outflow associated with this investment is not relevant for the above concerned decision regarding accept the market offer.
(3) If yes, how should the company organize its transfer pricing mechanism? Illustrate.
Solution:
Currently, Girish Engineering Ltd. is following 2 step transfer pricing method wherein the selling division charges actual variable cost along with profit mark-up & separately allocates a particular amount of fixed costs per month to the buying division. However, in the case of division X (buying division) & division Y (selling division), this method of transfer pricing is not feasible as division X would suffer loss if it accepts the market offer under this scenario. So, divisions X & Y can negotiate a transfer price by taking into account full actual variable cost (Rs.100 p.u.) & half of fixed costs incurred by division Y that is assigned to division X (Rs.40 p.u.) & add a mark-up of say Rs.10/unit. Taking into consideration only half of the fixed costs of selling division i.e. division Y prevents shifting of any operational inefficiencies from selling division to buying division i.e. division X, which would unnecessarily increase the costs for division X and thereby eat up its profit margin. In this case, division X’s total costs would turn out to Rs.940 (500 + 290 + 150) & would earn a profit margin of Rs.60 p.u. (desired profit margin). Also, contribution p.u. for division Y would be Rs.50 (150 – 100). Thus, total contribution for division Y would be Rs.250000 resulting in RoI of 12.5% (250000/2000000) which is more than the desired RoI of 10%.