Management Accounting for Decision Making

.
Professor Narasimhan M S
CASE 1.
RK Forging Company
Introduction
RK Forging is a forging company based in Coimbatore serving several sectors including power,
automotive, oil and gas, construction, mining, locomotive, marine and aerospace. The growth is more
of cyclical in nature and currently it is operating at 62% capacity utilization. The company has few
regular customers and the customer base is expanding. Normally, the company gets order for the year
with definite delivery schedule. Under the current costing system, the cost of the product is computed
by adding material cost, direct labour cost, and production overhead. Currently, the production
overhead rate is Rs. 20000 per machine hour1.
The Marketing Department is approached by Rinki Automotive, an overseas automobile company, which
requires 1000 units of the front axle beams to be supplied by June 30th 2014. The production
department estimates the order requires 72 hours of machine shop time and material plus labour cost
of Rs. 500 per unit. The customer also informed that they may order the same quantities for the next
two quarters (September 30th and December 31st) but these orders are uncertain. The order requires
significant investment on product level cost which includes design approval, supply of sample, mold, etc.
Initial estimates show an investment of Rs. 1500000. The issue before the management is how to treat
these product level costs load it completely on the first order or spread over three orders.
The Executive Committee Discussion
The following is an edited transcript of the discussion of the executive committee regarding the pricing
of the product.
Rahul: So, how do you think we should quote our price for the product required by our new customer
Rinki Automotive? Maybe, we had better start with Tanya [Tanya Sharma; the Chief Accountant], since
she has cost data.
Tanya: In this order, I am of the opinion that we need to discuss about how the mold cost and other
product related costs are to be loaded. Since the subsequent two orders are uncertain, I think that it
would be appropriate to load the entire mold cost on the first order.

Professor Narasimhan M S prepared this case with the assistance of Yogitha C as the basis for classroom discussion
rather than to illustrate either the effective or ineffective handling of administrative situation.
.

The estimated production overhead for the year is Rs. 29.76 million and total available machine hour is 2400
hours. Production overhead rate is equal to 29760000/(2400*62%)

Management Accounting for Decision Making

.
Professor Narasimhan M S

Siddharth: This is the sure way of losing the customer. We worked hard to get this customer and had
to do considerable amount of spending both time and cost to include our name in the vendor list.
Loading the entire mold cost on the first order would lead to a substantial increase in the price of the
product. This would make our product less competitive in the market. Our price will be definitely higher
by 40% than what Rinki is currently buying the item from their regular vendor. We are also at the risk
of losing a large customer. I think it would be more appropriate to charge one-third of the cost on each
order on the assumption that we will get the remaining two orders. If we are serious to add new
customers, we need to be very careful in our pricing.
Tanya: It is true that such liberal pricing will bring customer and keep us busy but profit need not
increase. Our operating profit margin is declining over the years because we are too liberal in pricing
our products and every time we get one reason or other saying if we dont do this, we will not get the
order. In this case, if the customer has not placed the two subsequent orders, we will end up incurring
huge loss if we charge only 1/3 of product related cost. She feels a loss of Rs. 1 million is significant and
not to worth to take such risk.
Rahul: So, why dont we load the entire mold price on the first order and give discounts on the
subsequent orders?
Siddharth: Of course, we talked about this option. However, the customer is not willing to give any
formal commitment for the next two orders. They also dont want to evaluate our order with such
conditional pricing. Our price is valid for the first as well as subsequent two orders if materialized.
Rahul: Both of you are right. If it is a small order, I would have gone with Siddharth and take a chance.
We dont lose much if subsequent two orders fail. The product cost is really large and hence Tanyas
concern is valid. I will think about the issue and get back. Siddharth, can you get me some more details
of the customer? We should not end up losing money on false promise. Any other issue on the order?
Siddharth: I wanted to raise another issue related to production overhead. Currently, we are charging
Rs. 20000 per machine hour irrespective of machines that we use. In our machine shop, we have
different kinds of machine, old and new, low cost and high cost, automated and semi-automated, etc.
We dont differentiate our orders and we charge a flat overhead rate. This particular order doesnt
require any of the hi-tech machines and I dont see the rationale of such high overhead cost.
Tanya: We compute budgeted overhead and machine hours of the production department to derive the
overhead rate. This is the methodology we have been following for the last 15 years and it is the same
methodology that some of our competitors also follow, which I came to know through our consultant
who works for different companies. If you want us to develop rates for different machines, then we
need additional manpower.
Siddharth: Our Accounting department has an answer for every problem that we face. Instead of
getting support, we get justification. I dont understand whether we need to lose business and turn
totally uncompetitive just because we dont want to hire two more persons for our Accounting

Management Accounting for Decision Making

.
Professor Narasimhan M S

department. In my view, our operating profit is not showing up any improvement because we lose all
profitable orders because of our wrong pricing. Unlike our competitors, the marketing department has
limited power in pricing the product and we always have to use the pricing model prescribed by the
Accounting department.
Rahul: Well Siddharth, you need elaborate your concerns with specific data. If this is really an issue and
we lose profitable orders, I dont mind in hiring two more staff and establish full-fledged costing
department. Tanya, you also need to think on the issue of production overhead and get some shortterm solution.
Required: Do you agree with Tanya or Siddharth on charging the product related cost of the new order?
Do you see any need for changing the production overhead rates?

Management Accounting for Decision Making

.
Professor Narasimhan M S

Table 1: Income statement summary

(Rs. in millions)

Year

Net Sales

Operating Profit

Operating profit Margin

2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

24
30
48
64
71
90
130
159
129
137

4
6
9
13
12
15
23
26
20
19

17%
21%
19%
21%
17%
17%
18%
17%
16%
14%

180
160

Net Sales
Operating Profit

140
120
100
80
60
40
20
0
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014