Cost Academy

Advanced Management Accounting

Time Allowed: 1 hr. Attempt all questions Total Marks: 30

1.

A company manufacturing a consumer product and marketing through its net-work of 400 depots all over the country is considering closing down the depots and resorting to dealership arrangement. The total turnover of the company is Rs. 200 crores p.a. The average turnover, costs etc. in respect of a depot is given below: Annual Turnover Average Inventory Administrative expenses Staff salary Rs. Rs. Rs. Rs. 50 lakhs 5 lakhs 50,000 p.a. 80,000 p.a.

The inventory carrying cost is 16% p.a. which is the rate of working capital finance. Marketing through dealers would involve engaging dealers for each area. The dealres will assure a minimum sale for each area. This would result in increasing the capacity utilisation from 75% as at present to 90%. The Company P/V Ratio at present is 10% and the BEP is 50% of the capacity. The current profit is Rs. 150 lakhs. Marketing through dealers would involve payment of a commission of 5% on sales. But 50% of existing Depot staff will have to be absorbed in the company. The dealers will deposit Rs. 5 crores with the company on which interest at 12% p.a. will be paid. (1) You are required to work out the impact on profitability of the Company by accepting the proposal. (2) What will be your reaction if the commission to dealers is 4% on sales? Answer Comparative Profit Statements (Rs. in crores) Existing When marketing is done through dealers At 5% commission at 4% commission 240.00 216.00 24.00 240.00 216.00 24.00

Sales Cost of goods sold (90% of sales) Contribution (A) Expenses :

200.00 180.00 20.00

Administrative ex penses 2.00 (Rs. 50,000 400) Staff salaries (Rs. 80,000 400) 3.20 Inventory carrying cost 3.20 Other Fixed cost 10.10 Commission on sales

1.60* 10.10 12.00

1.60* 10.10 9.60

Final Evening

1st Session

12.02.11

Cost Academy

Total fixed Expenses (B) Profit (AB) Add Savings on account of Interest on Deposit Net profit 18.50 1.50 1.50

23.70 0.30 0.20 0.50

21.30 2.70 0.20 2.90

* When marketing is done through dealers 50% of the staff will be retained by the company. 1. It is obvious from the above profit statements that if the proposal is accepted, the existing profit of Rs. 150 lakhs will be reduced to Rs. 50 lakhs only. Hence the proposal should not be accepted. 2. If the commission to dealers on sales is 4%, the total net profit will be Rs. 2.90 crores, a net increase of Rs. 1.40 crores in the current profits. Hence the proposal to resort to dealership arrangement with 4% commission on sales should be accepted.

Working Notes : (i) When capacity utilisation increases from 75% to 90% the total turnover will be Rs. 240 90 crores, i.e. Rs. 200 = 240 75 (ii) Total fixed costs are Rs. 18.50 crores, i.e. Rs. 20 crores (less Rs. 1.50 crores profit). Hence other fixed costs will be Rs. 10.10 crores, i.e., Rs. 18.50 (2.00 + 3.20 + 3.20) crores. (iii) The difference between the two interest rates, i.e., for working capital finance and rate on deposits from dealers is 4%. Hence, the company will have a net savings of Rs. 20 lakhs, i.e., 4% on Rs. 5 crores, in interest costs in case of dealership arrangement. 2. Bengal Print Ltd. is considering launching a new monthly magazine at a selling price of Rs. 10 per copy. Sales of the magazine are expected to be 5,00,000 a copy per month, but it is possible that the actual sales could differ quite significantly from this estimate. The different methods of producing the magazine are being considered and neither would involve any additional capital expenditure. The estimated production cost for each of the two months of manufacture, together with the additional marketing and distribution costs of selling the new magazine, are given below: Method A (Rs) Method B (Rs) Variable costs 5.50 per copy 5.00 per copy Specific Fixed cost 8,00,000 per month 12,00,000 per month The following estimates of semi- variable costs have been available: Rs. Rs. 2,50,000 copies 5,50,000 per month 4,75,000 per month 4,50,000 copies 6,50,000 per month 5,25,000 per month It may be assumed that the fixed cost content of the semi variable cost will remain constant throughout the range of activity shown.

Final Evening

1st Session

12.02.11

Cost Academy

The company currently sells a magazine covering related topics to those that will be included in the new publication, and consequently, it is anticipated that sales of this existing magazine will be adversely affected. It is estimated that for every ten copies sold of the new publication, sales of the existing magazines will be reduced by one copy. Sales and cost data of the existing magazine are as shown below: Sales Selling price Variable costs Specified Fixed costs 2,20,000 copies per month Rs. 8.50 per copy 3.50 per copy 8,00,000 per month.

Required: (a) Calculate, for each production method the net increase in company profits which will result from the introduction of the new magazine, at each of the following levels of activity: 7,00,000 / 4,00,000 / 6,00,000 copies per month (b) Calculate for each production method, the amount by which sales volume of the new magazine could decline from the anticipated 7,00,000 copies per month before the co. makes no additional profit from the introduction of the new publication.

Answer (1)

Segregation of semi variable costs: Method A Increase in Cost Variable element = ---------------------------Increase in Activity RS. 1,00,000 = ------------------------------ = Re. 0.5 per copy 2,00,000 copies Fixed element (at 3,50,000 copies) = Total semi variable costs variable costs = Rs. 5,50,000 Rs. 1,25,000 = Rs. 4,50,000 Method B: Increase in Cost Variable Element = Increase in Activity -------------------------Rs. 50,000 = -------------------------- = Re. 0.25 per copy 2,00,000 copies Fixed element (at 3,50,000 copies) = Total semi variable costs = Rs. 4,75,000 62,500 = Rs. 4,12,500 Rs.

(2)

Total Fixed costs: Method A: Specific Fixed Costs Add: Fixed element in semi variable costs Total Method B: Specific fixed costs Add: Fixed element in semi variable Costs Total

8,00,000 __2,00,000 10,00,000 Rs. 12,00,000 __3,00,000 15,00,000 Method B (Rs.) __10.00 5.00 0.25

(3)

Contribution per copy from new magazine: Method A (Rs.) Selling price (i) __10.00 Variable costs (given) 5.50 Variable element in semi variable costs 0.5 Lost contribution from existing magazine

Final Evening

1st Session

12.02.11

Cost Academy

(on 10 new copies Rs. 5 will be lost) Total variable cost (ii) Contribution (i) (ii) (a)

0.50 __7.00 3.50

0.50 __6.00 4.25

COMPUTATION OF NET INCREASE IN COMPANYS PROFITS Levels of Activity 7,00,000 4,00,000 6,00,000 Rs. Rs. Rs. Contribution per copy (ii) 3.50 3.00 3.00 Total contribution (i) (ii) 21,00,000 12,00,000 18,00,000 Less: Total Fixed costs 10,00,000 10,00,000 10,00,000 Net increase in profits _5,00,000 __2,00,000 __8,00,000 Method A: Copies sold (i) Method B: Copies sold Total contribution Less: Total Fixed costs Net increase in profit Levels of Activity 7,00,000 4,00,000 Rs. Rs. (ii) _____4.25 ______4.25 (i) (ii) 20,00,000 16,00,000 15,00,000 15,00,000 5,00,000 1,00,000 Fixed costs =Contribution per unit -----------------------------------(i) Rs. 10,00,000 = ----------------------------------- = 3,33,333 copies Rs. 300 Rs. 15,00,000 = ---------------------------------- = 3,75,000 copies Rs. 4.00 6,00,000 Rs. ______4.00 24,00,000 15,00,000 9,00,000

(b)

Break even point Method A Method B

The Margin of safety (MS) or the amount by which sales volume of the new magazine could decline so as to incur no profit no loss is the difference between the anticipated sales and the break even sales. This has been computed below: Method A: Method B: (c) = 5,00,000 3,50,000 = 1,67,667 copies = 5,00,000 3,20,588 = 1,25,000 copies.

The working under (b) above indicates that Method B has a higher contribution per copy and higher break even point as compared to Method A. Hence, Method B is more vulnerable to decline in sales volume. Workings under (a) substantiate this observation. The profit under method B is lower than that under A when volume of sales falls down to 4,00,000 copies. However, the profit under Method B is higher (Rs. 9,00,000) as compared to profit under Method A (Rs. 8,00,000) When the volume of sales increases to 6,00,000 copies. The existing magazine gives a contribution of Rs. 5 per copy. The existing level of break even sales, therefore, amounts to 1,60,000 copies (i.e., 8,00,000/5). The present level of sales is 2,20,000 copies. Margin of safety is thus 60,000 copies (i.e., 2,20,000 1,60,000). In other words, sales can drop by 60,000 copies from the present level to reach no profit, no loss point. The problem states that for every additional sale of 10 copies of the new magazine, the sale of existing magazine will drop by one copy, consequently, at a level of sale of more than 6,00,000 copies of the new magazine, the existing magazine will start giving a loss. As such, the company will have to consider the question of continuance of the existing magazine after the sales volume of the new magazine exceeds 6,00,000 copies.

Final Evening

1st Session

12.02.11

Cost Academy

3.

The present output details of a manufacturing department are as follows:Average output per week 48,000 Units Saleable value of output Rs. 60,000 Contribution made by output to Wards fixed expenses and profit Rs. 24,000 The Directors plan to introduce more mechanization in the Department at a capital cost of Rs. 16,000. The effect of this will be to reduce the number of employees from the existing strength of 160 to 120, but to increase the output per individual employee by 60%. To provide the necessary incentive to achieve the increased output, the directors intend to offer a 1% increase on the existing piece work price of Re. 0.10 per article for every 2% increase in average individual output achieved. To sell the increased output, it will be necessary to decrease the selling price by 4%. Calculate the extra weekly contribution resulting from the proposed change and evaluate the worth of the proposal. (ICWA Final Dec. 83)

Answer

Rs. 60,000 48,000 24,000 Contribution per unit = -------------------- = 48,000

Selling price per Unit = -------------------- = i.e. variable cost per unit = 1.25 0.50 = Labour cost i.e. materials & variable overheads For every 2% increase in average Individual output For 60% increase

1.25 0.50 0.75 0.10 0.65 1% increase on the existing price rate ? = 30% increase on the Re. = 0.13 piece rate Per unit (Rs.) = 0.65 0.13 0.78 = 1.20 0.42 48,000 units (Existing strength 160) = = 48,000 x --------36,000 units 21,600 57,600 unit 9,600 units Rs. 24,000

60 ---- x 1 2
existing price rate i.e. 0.10 + 30% of 0.10 Materials & variable overheads Labour cost Variable cost New selling price 1.25 4% New contribution Average output per week Average output per week on reduced strength Add: 60% increase per individual employee Total output (proposed & expected) i.e., Increase in output per week 57,600 48,000 Contribution on present output per week 48,000 x 0.5 = =

Final Evening

1st Session

12.02.11

Cost Academy

Contribution on proposed output per week 57,600 x 0.42 Extra weekly contribution Extra Annual contribution 192 x 52 weeks Hence the proposal should be accepted

= =

24,192 __192 Rs. 9,984

Final Evening

1st Session

12.02.11