CHAPTER - 4 Cost Management Techniques ec it B: Stio) vit ins Question 1 Gokul Ltd. is a manufacturer of a range of goods. The cost structure of its different products is as follows: Particulars Product A Product B Product C Direct Materials 50 40 40 a7 Direct Labour — 300 40 50. | tu Quantity Produced 10,000 20,000 30,000 Units Anewly appointed management accountant has suggested that the company should introduce ABCsystem and has identified cost drivers and cost pools as follows: Adtivity Cost Driver Overheads (3) Stores Receiving Purchase Requisitions 2,96,000 Inspection “Inspection Hours: 8,94,000 Dispatch Orders Executed 2,10,000 Machine Setup ‘Number of Setups 12,00,000 Total 26,00,000 The following information is also supplied: Details Product A Product B Product € No. of Setups 360 390 450 No. of Orders Executed 180 270 300 Inspection Hours 75 105 120 No. of Purchase Requi 300 450 500 Required Calculate activity based cost of all the three products, Answer The total overheads are ¥26,00,000: On the basis of ABC, this amount will be apportioned as follows: Statement Showing “Activity Based Cost” Activity Cost | Cost | Ratio Total A B c Pool Driver Amount() | (%) o @ Stores Receiving | Purchase | 6:9:10 | 2,96000 | 71,040 | 106560 | 118400 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.1Cost Management Techniques Requisition [ Inspection Inspection | 5:78 | 894,000 | 2,23,500 | 3,12,900 | 357,600 Hours Dispatch Orders 69:10 | 210,000 | 50,400 | 75,600 | 84,000 Executed Machine Setups | Setups 12:13:15] 12,00,000 | 3,60,000 | 3,90,000 | 450,000 Total Activity Cost 7,04,940 | 885,060 | 10,10,000 Quantity Sold ‘| 10,000 | 20,000 | 30,000 Overhead Cost per unit 7049 | 4425 | 3367 Add: Direct Material & Direct Labour per unit 80 80 90 Total Cost per unit 150.49 | 124.25 | 123.67 Question 2 Bank of India operated for years under the assumption that profitability can be increased by increasing Rupee volumes. But that has not been the case. Cost analysis has revealed the following: Activity Activity Cost (9) Activity Driver | Activity Capacity Providing ATM Service 41,00,000 ‘ATM Transactions 200,000 Computer Processing 10,00,000 Computer Transactions | 25,00,000 Issuing Statements 8,00,000 No. of Statements 5,00,000 Customer Inquiries 3,60,000 Telephone Minutes 6,00,000 The following annual information on three products was also made available: Activity Driver Checking Accounts Personal Loans Gold Visa Units of Product 30,000 5,000 10,000 ATM Transactions 1,80,000 o 20,000 Computer Transactions 20,00,000 2,00,000 3,00,000 Number of Statements 3,00,000 — 50,000 150,000 Telephone Minutes 3,50,000 90,000 160,000 Required (i) Calculaterates for each activity. (ii) Using the rates computed in requirement (i), calculate the cost of each product. Statement Showing “Activity Rate” Activity Driver BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.2Cost Management Techniques er (b] ] fal/(b] @ Providing ATM Service 100,000. No. of ATM Transactions 2,00,000 | 0.50 Computer Processing 10,00,000 | No. of Computer Transactions | 25,00,000] 0.40 Issuing Statements 800,000 | No. of Statements 5,00000 | 1.60 Customer Inquiries 3,60,000 _| Telephone Minutes 6,00,000 | 0.60 ‘Statement Showing “Cost of Product” Activity [Checking Accounts (¥) | Personal Loans (%) | Gold Visa (®) Providing ATM 90,000 _ 10,000. Service (180,000 tr.x 20.50) (20,000 tr. x 20.50) Computer 8,00,000 80,000 1,20,000 Processing (20,00,000 tr. x 20.40) | (2,00,000 tr. 20.40) | —(3,00,000¢r. x 20.40) Issuing Statements 480,000 80,000 2,40,000 (3,00,000 st. x €1.60) | (50,000 st. x 1.60) | (1,50,000 st. x 81.60) Customer Inquiries 2,10,000 54,000 96,000 (350,000 min. « 80.60) |(90,000 min. x £0.60) | (1,60,000 min, x 20.60) Total Cost [a] % 15,80,000 %2,14,000 %4,66,000 Units of Product (b] 30,000 5,000 10,000 Cost of each 5267 42.80 46.60 Product (a]/{b) ‘Target Costing Question 3 Kowloon Toy Company (KTC) expects to successfully launch Toy “H" based on a Disney character. KTC must pay 15% royalty on the selling price to the Disneyland. KTC targets a selling price of 8100 per toy and profit of 25% on selling price. The following are the cost data forecast: ¥/toy Component Hi 850 Component H2 7.00 Labour: 040 hr. @ 260 per hr. 24.00 Product Specific Overheads - 13.50 {In addition, each toy requires 0.6 kg of other materials, which are supplied at a cost of 216 per kg. with anormal 4% substandard quality, which is not usablein the manufacture. Required Determine if the above cost structure is within the target cost. If not, what should be the extent of cost reduction? BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.3Cost Management Techniques Answer Target Cost “H” 3/Toy ‘Target Salling Price 100.00 Less: Royalty @15% 15.00 Less: Profit @ 25% 25.00 Target Cost 60.00 Cost Structure “H” ¥/Toy Component Hi a50 Component H2 7.00 Labour (0.40 hr. x ¥60perhr) 24.00 Product Specific Overheads 1350 Other Material (0.6 kg/96% x €16) 10.00 Total Cost of Manufacturing 63.00 Total Cost of Manufacturing is € 63 while Target Cost is ¢ 60. Company KTC should make efforts to reduce its manufacturing cost by £3 to achieve Target Selling Price of € 100. Question 4 X is a leading toy manufacturing firm. Having commenced its commercial operations in the year 1990, the firm has a state-of-the-art manufacturing facility in India. It sells toys through retail outlets and the firm’s website, X has been pioneering the concepts of quality and safety in toys and has been instrumental in raising the quality standards of toys in the Indian Market. X's mission is to influence parents to spend on toys that enable every child to grow with quality toys that contributes to his/her wholesome development. X procures the materials from a number of different suppliers. All of the purchased material are dispatched to its warehouse located at its factory and are held there unless they are moved to production, After production is completed, finished toys are moved to X's retail outlets by its own vehicles, Each week, the vehicles follow the same time schedule regardless of the ‘weight they are carrying. Finished toys that are sold through the X's website are dispatched to its distribution centre. X has recently got the contract to manufacture a new toy that is “Ty-Z’, amini cartoon based on a character from a famous international animated film. X has not been given any target price, hence is free to setthe selling price of “Ty-Z’, however, must pay a royalty of 10% of the selling pricetothefilm director. X is also planning to sell ‘Ty-Z' through its retail outlets X has decided to follow a target costing technique for “Ty-Z. Marketing manager has determined the selling price to be around €1,750 per “Ty-2'. X needs a margin of 26% of the selling price of ‘Ty-Z. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.4lanagement Techniques For the estimated costs per “Ty-Z' refer Annexure. Required DISCUSS three primary activities of value chain through which X can minimise gap if any. Annexure Estimated Costs per “Ty-2’ ® Material 150.50 Material D 122.50 Other Material seenote below Labour (0-4 hours at £1,050 per hour) 420.00 “Ty-Z- specific production overhead cost 132.30 “Ty-Z- specific selling and distribution cost 166.60 ‘Note- Each "Ty-2' requires 0.70 kg of ‘other materials’. These ‘other materials’ are procured from a supplier at a cost of 8280 per kg and around 5% of all purchased materials are found tobe downgraded. Answer In case of X, there is a cast gap of Rs. 78.22. Where a gap exists between the current estimated cost levels and the target cost, itis essential that this gap be closed. Cost gap can be removed by reducing the cost over all the Value Chain through the development of the spirit co-operation and understanding among all members of organizations associated with the product from suppliers, producers, customers, agents and service providers. In Xs Value Chain, three primary activities are:- Inbound logistics These are activities concerned with receiving, storing and distributing the inputs (raw material) to the production process, The relationship with supplier is a key component in this process. Currently, X procures materials from multiple suppliers and stores these materials in its store. Shifting to a just-in-time (JIT) system technique in procurement of materials could possibly save substantial storage costs provided the JIT supplier must agree to take the responsibility for the good quatity of materials supplied. This will also become a source of savings because downgraded items will be removed, However, X might have to pay additional payout toa supplier for JIT purchasing to work. Outbound logistics These activities involve collecting, storing and distributing the products to the customers. At X, scheduled transportation of toys to retail outlets is outbound logistics activity. Potentially, the scheduled transportation of toys to retail outlets every week is not an efficient way. Such deliveries do not consider whether toy is required at retail outlets or not, hence X may possibly deliver toys to retail outlets those do not need toys and suffer unnecessary transportation costs. X should plan to implement EDI system that will help it to improve warehousing and logistics BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.5OOOO by automatically tracking inbound shipments as well as outbound products. Adopting EDI, X can not only improve processes but also streamline inventory management across many channels. However, it wil require setup time and alearning curve toimplement the same. Marketing and sales Marketing and sales provide the means by which the customers are made aware of the Product. At X, the sales of toys via its retail outlets and website are marketing and sales activities. X Is planning to sell ‘Ty-Z' via retailers. If X sales “Ty-2’ through its website rather than through retail outlet, significant cost could easily be avoided. Simultaneously, X will be able to expose itself to attract international customers to buy "Ty-2' as product is based on character from a famous international animated film. Overall, X may create a cost advantage by reconfiguring the Value Chain. Reconfiguration means structural changes such a new production process, new distribution channels or a different sales approach as discussed above Workings Statement Showing Computation of Cost GAP x Sales Price 1,750.00 Less: Royalty @10% 175.00 Less: Profit @26% 455.00 ‘Target Cost "Ty-Z" 1,120.00 Material C 150.50 Material D 122.50 Labour (0.40 hours at %1,050 per hour) 420.00 Other Material (0.70kg x $280 per kg)/0.95 206.32 Production Overheads Cost 132.30 Distribution and Sales Cost 166.60 Estimated Cost Ty-Z' 1,198.22 Cost Gap 78.22 Question 5 Storewell Industries Ltd. manufactures standard heavy duty steel storage racks for industrial use. Each storage rack is sold for 750 each. The company produces 10,000 racks per annum. Relevant cost data per annum are as follows: ‘Cost Component Budget ‘Actual Actual Cost p.a. @ Direct Material 5,00,000sq.ft. | 5,20,000sq ft. 20,00,000 Direct Labour 90,000 hrs. 1,00,000 hrs. 10,00,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.6Cost lanagement Techniques 150,000 Machine Setup 15,000 hrs. 15,000 hrs. 30,00,000 Mechanical Assembly 200,000 hrs. 200,000hrs. | The actual and budgeted operating levels are the same, Actual and standard rates of material procurement and hourly labor rate are also the same, Any variance in costis solely on account of difference in the material usage and hours required to complete production. Aggressive pricing from competitors has driven down sales. A comparable rack is available in the market for 675 each. Vishal, the marketing manager has determined that in order to maintain the company’s existing market share of 10,000 racks, Storewell Industries must reduce the price of each rack to 8675, Required @ CALCULATE the current cost and profit per unit. IDENTIFY the non-value added activities in the production process. (ii) CALCULATE the new target cost per unit for a sales price of €675 if the profit per unit is maintained. (ill) RECOMMEND what strategy Storewell Industries should adopt to attain target cost calculated in (1i) above, Answer (The current cost and profit per unit are calculated as below: Cost Comp onent Units Actual Cost pa.for | Actual Cost per 10,000 racks (%) rack (2) Revenue 10,000 racks 75,00,000 750 Direct Material 5,20,0005q. ft 720,00,000 200 Direct Labour 1,00,000 hrs. 10,00,000 100 Machine Setup 15,000 hrs. 150,000 45 Mechanical Assembly | 200,000hrs. 30,00,000 300 Total Cost 61,50,000 ois Profit 13,50,000 135 Therefore, the current cost is 8615 p.t. while the profit is 135 p.. Machine setup is the time required to get the machines and the assembly lineready for production. In this case, 15,000 hours spent on setting up does not add value to the storage racks directly. Hence, it isa non-value add activity. (ii) New sale price per rack is 8675 per unit. The profit per unit needs to be maintained at 135 per unit. Hence, the new target cost per unit = new selling price per unit - required profit per unit = £675 - £135 = %540 per uni (iii) As explained above, current cost per unit is ¥615 while the target cost per unit is %540. Hence, the cost has to be reduced at least by €75 per unit. Analysis of the cost data shows the variances between the budget and actual material usage and labor hours. Itis given that the material procurement rate and labor hour rate is the same for budgets and actuals. Hence, the increment in cost of direct materials and labor is due to BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.7inefficient use of material and labor hours to complete the same level of production of 10,000 storage racks. Corrective actions to address these inefficiencies could resultin the following savings: (a) Inefficiencies resulted in use of extra 20,000 sq, ft. of material Material cost per sq. ft. = Actual cost/Actual material usage = °20,00,000/5,20,000 sq. ft. = £3.85 per sq. ft. Therefore, inefficiencies resulted in extra cost = 20,000 sq. ft. x 3.85 per sq.ft. = 877,000. If corrective action is taken, for 10,000 racks this translates to a saving of 87.70 per unit. (b) efficiencies resulted in extra 10,000 hrs. to be spent in production. Labor cost per hr, = Actual cost / Actual labor hrs. = 10,00,000/1,00,000 hrs, = {10 per hr. Therefore, inefficiencies resulted in extra cost = 10,000 hrs. x 810 per hour = %4,00,000. If corrective action is taken, for 10,000 racks this translates to a saving of 710 per unit. (Q) Machine setup cost is a non-value added cost. Value analysis can be done to determine if the setup time of 15,000 hrs. can be reduced, However, since these activities have been carried out for areason, care should be taken to ensure that this change should not adversely impact the production activity later down the stream. (4) Mechanical assembly cost is almost half of the total cost. These are costs incurred during the production process on the assembly line, Value analysis can be done to determine if the production process can be made more efficient, For example, the process can be streamlined, such that steps can be combined that can be handled by fewer people (process centering). Similarly, value analysis/value engineering can focus on the product design. Some questions to raise may be: ~ Can the product be designed better to make the production more efficient? + Can the design be minimized to include fewer parts and thus makeit easier and efficient to manufacture? + Can be substitute parts tomake it more efficient? Or ~ Is there simply a better way of producing the same product? While target costing is a dynamic and corrective approach, care must the taken the product quality, characteristics and utility are maintained. Question 6 NEC Furniture Ltd. is a leading manufacturer and supplier of furniture for students of pre- primary classes. The full cost of one set (comprising one Table and one chair) is ¥ 900 per set. The company has fixed its selling price so as to earn 30% return on investment of % 45,00,000. ‘The company produces and sells 6,000 sets per annum. Relevant cost data per annum are as follows: Cost Component Budget Actual Actual Cost pa. (®) BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.8‘Cost Man: ——aS—— Oeil" Direct Material 90,000 sq. ft. 1,00,000 sq.ft 1650,000 Direct Labour 35,000 hrs. 40,000hrs 10,32,000 Mechanical Assembly | 60,000 hrs. 60,000 hrs. 12,00,000 Machine Setup | 5,000hrs. - 5,000 hrs. 1,68,000 It has been revealed that the actual and budgeted operating levels are the same, Actual and standard rates of material purchase and labour rate per hour are also the same. Any variance in cost is solely on account of difference in the material usage and hours required to complete the production, A competitor has introduced a product very similar to product of the company at an aggressive price of & 820 per set which has resulted in downtrend in the sales volume the company. The management has called urgent meeting of the marketing team. After the ‘meeting, following recommendations of marketing team are approved by the management: @ (b) (9 ‘To maintain the company's existing sales volume and amount of present return on investment, reduce the selling price by 10%. ‘Tomake slight improvement in design to have edge over the competitors which will also reduce the direct material cost by % 30 per set. ‘Tomake the table and chair more attractive, print picture of Disney character on them, which will cost 5 per set. Required @ ai) (ai) (iv) CALCULATE the present selling price and profit per unit from the above. Also CALCULATE the mark-up % on the full cost per unit. IDENTIFY thenon-value-added activities in the production process. (a) CALCULATE the new target cost per unit and new revised cost per unit after implementation of above recommendations. (b) How much reduction in cost is required to achieve the new target cost? RECOMMEND what strategy the company should adopt to attain the target cost calculated above. Answer @ (i) Present selling price per unit (set) is {1,125 i.e. 900 (full cost per set) + €225 (desired return per set - refer working note below) Profit per unit (set) is €225 (refer working note below) Mark-up = (Profit per set/Full cost per set) x 100 i.e, (8225/%900) x 100 = 225/1,125=20% (on Sales) Working Note - Desired Return per set (30% of 845,00,000)/6,000 sets 13,50,000/6,000 sets 225 per set Machine setup is the time required to get the machines and the assembly line ready for production. NEC furniture limited spent 5,000 hours on setting up, which does not add BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.9—$— OOOO TT valueto the furniture set directly. Hence, itis a non-valueadd activity. (iii) (a) New Target Cost per unit (set) Particular ‘Amountin € Target Price (1,125 - 10% of 1,125) 101250 Less: Desired Return per set 225.00 ‘Target Cost per unit (set) 787.50 Revised Cost per unit (set) Particular Amountin € Present cost per unit (set) Less: Reduction in material cost Add: Incremental Cost to print picture Revised Cost per unit (set) (b) Cost Reduction Target Particular Revised C it (set Less: Target Cost per unit (set) Cost Reduction Target per unit (set) (iv) As calculated above, revised cost per unit (set) is $875.00 while the target cast per unit is %78750. Hence, the cost has to be reduced at least by 87.50 per unit. Critical aspects at which NEC furniture limited shall focus-wastage in term of productivity ie. usage of material and efficiency in labour; design of product in term of quality and function it renders, and material or components used as input; design of processes Including lay-out through which product will be manufactured i.e, machine set-up and mechanical assembly. Value analysis/value engineering shall be applied (by answering following questions) to focus on the above stated aspects in order to attain the target cost- = Can the product be designed better to make the production more efficient? = Isreduction of design (reduce features only, not functions) possible? = Can the design be minimized to include fewer parts and thus make it easier and efficient to manufacture? = Can any process eliminate or reduced? + Can be substitute parts to make it more efficient? Or = Istheresi iply abetter way of producing the same product? It is important to note that target costing is a dynamic and corrective approach, care must be taken for product quality, characteristics, and utility. Analysis of the cost data shows the variances between the budget and actual material usage and labour hours. It is given that the material procurement rate and labour hour rate is the same for budgets and actuals. Hence, the increment in cost of direct materials BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.10lanagement Techniques and labour is due to inefficient use of material and labour hours to complete the same level of production of 6,000 sets of furniture. Corrective actions to address these inefficiencies could result in the following savings: + Inefficiencies resulted in use of extra 10,000 sq. ft. of material. Material cost per sq. ft, = Actual cost (revised) /Adtual material usage = (216,50,000 ~ 830 « 6,000) 1,00,000 sq, ft. = €14.7 per sq.ft. Therefore, inefficiencies resulted in extra cost = 10,000 sq, ft. x 114.7 per sq. ft. = €1,47,000. If corrective action is taken, for 6,000 sets of furniture this translates to a saving of 24.50 per unit. + Inefficiencies resulted in extra 5,000 hours to be spent in production. Labour cost per hr, = Actual cost/Actual labour hrs. = %10,32,000/40,000 hrs, = 325.8 per hr. Therefore, inefficiencies resulted in extra cost = 5,000 hrs. « €25.8 per hour = %1,29,000. If corrective action is taken, for 6,000 sets of furniture this anslates toa saving of €21.5 per u = Machine setup cost is a non-value-added cost. Value analysis can be done to determine if the setup time of 5,000 hours/%1,68,000/- can be reduced. However, since these activities have been carried out for a reason, care should be taken to ensure that this change should not adversely impact the production activity later down the stream. = Mechanical assembly cost are costs incurred during the production process on the assembly line, Value analysis can be done to determine if the production process can be made more efficient. For example, process can be streamlined, such that steps can be combined that can be handled by fewer people (process centring), Question 7 Venice Light Works (VLW) manufactures multicolour glow bulb (MCG-10) used for lighting and decoration. MCG-10 considered as reliable product in market due to zero-defect. VLW sells MCG-10 through retail-chains and individual shopkeeper apart from factory outlet. MCG- 10 has demand throughout the year but there is high demand during festival seasons especially ahead of Diwali. Company follows the lot purchase system and manufacture the product ahead of peak season of festivals. Presently the VLW is working at 80% of capacity and manufacture 4,00,000 bulbs annually, at Following per unit cost: Particulars Behaviour Amount (In 8) Direct Material Variable 22 Direct Labour = Variable 6 Factory Overhead - - - 1. Engineering Cost Fixed 10 2. Machining Cost Fixed 5 3. Inspection Cost Variable 5 Administration Overheads Fixed 12 Selling and Distribution Overheads Fixed 12 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.11lanagement Techniques ‘Total Cost 72 Recently the competition in decorative lights & electronic markets has escalated, due to goods imported from Chinese manufactures at cheap rates, Such imported light bulbs are also sold through same shops at which MCG-10 is available for sale. Due cheaper in rate customer prefer imported light bulb rather MCG-10. To be competitive in market, the marketing department of VLW conducted applied research and suggested that price should be 12.5% lower than the current prices. VLW during last three financial years and during current year records the pre-tax profit @ 10% rate of sale, management of VLW wish to earn the same rate of profit (margin) in upcoming years too, Production and operation manger is of opinion that cost reduction, in order to be competitive in market may result in reduction in quality, whereas Manger - Quality control suggest, if number of inspection staff increased, then inspection can be performed at each stage and defect can be curtailed at the earliest stage to eliminate rework cost. Management accountant is of opinion that since MCG-10 is mature product, hence majority of cost associated in production of MCG- 10 are committed in nature, price cutting seems difficult; it may hit the top line and bottom line adversely. In response to him, Chief engineer suggest product (MCG-10) can be redesigned; but marketing manager shown his resistance on the suggestion of redesigning of product because according to him ‘existing product appearance and features are key reasons for popularity of product in market and leads to sale” Required (i) CALCULATE the price suggested by marketing department. (i) COMPUTE the target cost and new margin, appraise percentage decline in margin. (ii) If proportimate cost reduction plan is applied, then (@) CALCULATE planned cost reduction for each cost category. (0) EXPLAIN proportionate cost reduction plan, (iv) Based upon discussion taken place among the functional manger, EVALUATE the possibility of cost reduction in order to analyse the possibility of application of target costing, Also suggest course of action to adopt. Answer (Price suggested by marketing department (Target Price) Current cost per unit - &72 per unit Profit (Margin) @10% of sale price Sale Price = 272 + 10% of Sale Price So, let presume sale priceis ‘x’ X=372 + 10% of X X=972 401K X-O.1K=872 09x =372 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.12(i) Gi) lanagement Techniques X=872/0.9X =380 New price will be 125% less than currentprice 380- 12.5% of 80 380- 110= 870 Target cost and new margin ‘Target Price ~ Margin (Le, 10% of sale price) = Target Cost Target Cost = $70 - 10% of 70 370-27 = 863 New Margin (under target costing) is €7 Percentage decline in margin Existing Marg ‘Existing Margin _8-7 =o 100 =12.5% Note There is decline in margin in absolute term, whereas in relative term the margin remains sameie,, 10% of sale price Planned cost reduction for each cost category under proportionate reduction plan Amount in & Particulars ExistingCost | Target Cost Direct Material 22 19.25 | Direct Labour 6 «5.25 | Factory Overhead 1. Engineering Cost 10 8.75 2. Machining Cost 5 4.375 3. Inspection Cost 5 4.375 | Administration Overheads 12 105 Selling and Distribution Overheads 2 105 Total Cost 72 63 Under proportionate reduction plan cost for each category is proportionately reduced in proportion of existing weight. Here, a presumption is needed to be taken that all the cost are avoidable in nature, where as in case of every business; there are some of cost categories which are true sense unavoidable and committed in such a way that, these continue to occur even in shut down situation (eg. salary to guard, minimum rental for electricity and water meter etc); same is pointed by Management Accountant, that product is matured in nature (means not in designing or research phase) hence committed cost may be unavoidable in nature. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.13) Note - Student must note that fixed costs are not as same as unavoidable cost. Fixed cost may be avoidable in nature. Possibility of cost reduction & Suggested course of action for VLW Target costing comprises four stages. First being determining the product target price, quality, and functionality; second determine the target cost; thirdly designing the product and production process to achieve the target costing, and fourth use pilot project to evaluated feasibility. Based upon discussion taken place among the functional managers, itis evidential that VLW is presently moving towards third stage. As stated by management accountant that product MCG-10 is mature nature hence majority of cost are of committed nature, hence may be unavoidable in nature. Product MCG- 10 is material-oriented product and raw material cost is around 30% of total cost. So, if gain sharing arrangement can be entered with vendor then surely VLW can save ‘some portion of material cost. ‘As said by production and operation manager, cost reduction may lead to compromise with quality. He may be right, but he needs to look for scientific way to reduce the cost of operations like change in batch size (if required can shift to JIT) or outsource some part of operations; scientific management can also be applied in order to curtail motion time and reduction in labour cost. Quality Manager is of opinion with extra inspection staff, quality can be assured, but appointment of additional inspector and supervisor will also lead to increase in cost; hence effective way to ensure quality while reducing cost of application of practice of ‘TQM and Kaizen. Kaizen costing will be great help to management of VLW to cut the cost, with support and participation from worker. Chief engineer suggestion is appreciable, because target costing is most beneficial in those case where the product is in designing and planning phase. As per research around 70-80% of cost is committed at stage of designing of product. It is important to note that the word ‘committed! is used as ‘not incurred’; therefore, cost being committed (Le, not incurred cost) will be incurred when it became due in course of production, But redesigning is not feasible from the prospects of marketing of product as per the statement made by marketing manager. Marketing manager can conduct applied research in order to develop understanding the temperament of customer of MCG-10, whether they are price sensitive or conformance toneed is their priority. If customer found price sensitive (existing recommendation of marketing team shows high possibility of this, because marketing team feels customers can be retained is price is reduced by 12.5%) then product redesign may be opted. But if conformance to need is their (customers) priority, then value chain analysis can be used to identify the activities which creates value to customer and other than these activities (which are not creating the value) can be eliminated in order to reduce the cost. So, there are possibility to reduce the cost, even if not in all the cost category then surely in some of categories; so that target cost can be achieved. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.14Cost Management Techniques Question 8 UK Ltd. prepared a draft budget for the next year as follows: Quantity ~ 10,000 units x Selling Price per unit 60 Variable Cost per unit Direct Materials | 16 Direct Labour (2 hrs x 76) 2 Variable Overheads (2 hrs x 1) | 2 Contribution per unit 30 Total Budgeted Contribution 3,00,000 Total Budgeted Fixed Overheads 2,80,000 Total Budgeted Profit 20,000 The board of directors are not satisfied with this draft budget and suggested the following changes for the better profit: (i) The budgeted profit is 50,000, (ii) The company should spend & 57,000 on advertisement and the target sales price up to 64 per unit, (iii) I is expected that the sales volume will also rise, inspite of the price rise, to 12,000 units. In order to achieve the extra production capacity, however, the work force must be able to reduce the time taken to make each unit of the product. It is propased to offer a pay and productivity deal in which the wages rate per hour is increased to € 8, The hourly rate for variable overheads will be unaffected. Required Calculate the target labour time per unitrequire to achieve the target profit. Answer Statement Showing “Target Cost of Direct Labour & Variable Overheads’ Particulars ‘Amount (3) Expected Sales (8 64 12,000 units) 7,68,000 Less: Target Profit - 50,000 Less: Direct Material (¥ 16 x 12,000 units) 1,92,000 ‘Advertisement Expenses 57,000 Fixed Overheads 2,80,000 ‘Target Cost of Direct Labour and Variable Overheads (for 12,000 units) 1,89,000 ‘Target Labour Time per unit (88 +1) «hrs. x 12,000 units $189,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.15—_——— OOOO eee Hrs, = L7Shrs. Time tobe reduced per unit = 2hrs.- 1.75 hrs. = 02Shrs, Question 9 NEC Ltd,, forms a Committee consisting of its Production, Marketing, and Finance Directors to preparea budget for the next year. The Committee submits a draft budget as detailed below: Particulars z Selling Price per unit 50 Less: Direct Material Cost per unit 9 Direct Labour Cost per unit (3 hrs. @ %3) 9 Variable Overhead per unit (3 hrs. @ 2) 6 Contribution per unit 26 Budgeted Sales Quantity 25,000 units Budgeted Contribution (25,000 x 826) 650,000 Less: Budgeted Fixed Cost 5,00,000 Budgeted Profit 150,000 ‘The Management is not happy with the budgeted profit as it is almost equal to the previous year's profit, Therefore, it asks the Committee to prepare a budget to eam at least a profit of %3,00,000. To achieve the target profit, the Committee reports back with the following suggestions: The unit selling price should be raised to 255. The sales volume should be increased by 5,000 units, To attain the above said increase in sales, the company should spend %40,000 for advertising, ‘The production time per unit should be reduced. ‘Towin the acceptance of the workers in this regard the hourly rate should be increased by & 3 besides an annual group bonus of %30,000. There is no change in the amount and rates of other expenses. The company has sufficient production capacity. As the implementation of the above proposal needs the acceptance of the work force to increase the speed of work and to reduce the production time per unit, the Board wants to know the extent of reduction in per unit production time. Required (i) CALCULATE the target production time per unit and the time to be reduced per unit. i) IDENTIFY the other problems that may arise in production due to decrease in unit production time and also suggest the remedial measures to be taken. (iii) STATEthe most suitable situation for the adoption of Target Costing. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.16—— a Orel’ Answer (Target Production Time per unit (33 +83 + &2) xhrs.* 30,000 units = %5,10,000 Hrs, = 2125 ‘Time to be reduced per unit 3 hrs,- 2.125 hrs. = 0.875hrs. ‘Workings Statement Showing Target Cost (Direct Labour and Variable Overh ead) Particulars Amount (®) ‘Target Sales (755 = 30,000 units) 16,50,000 | Less: Target Profit — 3,00,000 | Less: Direct Material Cost (89x 30,000 units) — "270,000 | Less: Budgeted Fixed Costs — 5,00,000 Less: Proposed Advertising 40,000 Less: Proposed Annual Group Bonus 30,000 Target Cost (Variable Overhead and Direct Labour) for 30,000 units 5,10,000 (ii) Problem The target-costing method is applicable particularly for repetitive manufacturing, It should however be recognised that some products often bear a high degree of repetition and that there often are considerable repetitions where reduction targets could come into play as a framework for improving design. Working under pressure to finish new design assignments in a short time may take development resources away from efforts to optimise or re-engineer production processes. If approaching product design as an activity to be optimised independently there is a risk that target costing may not succeed to satisfactorily addressing overall performance, so in short decrease in unit production time may lead to unwanted pressure on design and its implementation stage. Remedial Measures As a remedial action organisation should retain strong control over the design teams headed by agood team leader. This person must have an exceptional knowledge of the design process, good interpersonal skills, and a commitment to staying within both time and cost budgets for a design project. If the time is too short even an organisation may reject a project for the time being. Later, it can be tried out with new cost reduction methods or less expensive materials to achieve target cost and control overall production activities. (iii) Target costing is most useful in situations where the majority of product costs are locked in during the product design phase. This is the case for most manufactured products, but few services, In the services area, such as consulting, the bulk of all activities can be reconfigured for cost reduction during the “production” phase, which is BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.17when services are being provided directly to the customer. In the services en vironment, the “design team" is still present but is more commonly concerned with streamlining the activities conducted by the employees providing the service, which can continue to be enhanced at any time, not just when the initial services process is being laid out. Question 10 JKL Ltd manufactures two parts "AXE" and "WYE" for Car Industry. Particulars AXE WYE ‘Annual Production & Sales 1,20,000 70,000 Selling price per unit 10380 150 Direct and indirect costsincurred on these two parts are as follows: Tin ‘000 Parti cular of cost AXE WYE Total Direct Material Cost 5,040 4,200 9,240 Labour Cost (variable) 1,800 1400 3,200 Direct Machining Cost (see note)* 900 750 1,650 Indirect Costs Machine set-up cost 516 Testing cost 2,910 Engineering cost, 2,340 Note: Direct machining costs represents the cost of machine capacity dedicated to the production of each product. These costs are fixed and are not expected to vary over the long- run horizon, Additional information is as follows: Particulars AXE WYE Production batch size 1,200 units 700 units Set-up time per batch 40 hours 46 hours ‘Testing time per unit +hours 7 hours Engineering cost incurred on each product 960,000 13,80,000 A foreign competitor has introduced a product very similar to "AXE". To maintain the company's share and profit, JKL Ltd. has to reduce the price to %90. The company calls for a meeting and comes up with proposal to change the design of the product "AXE". ‘The expected effects of new design areas falows: ~ Direct material costis expected to decreases by %4 per unit. Labour cost is expected to decrease by &3 per unit ~ Machine time is expected to decrease by 20 minutes; previously it took 4 hours to produce 1 unit of AXE. The machine will be dedicated to the production of new design. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.18‘Cost Man: —_— a errr ~ Set-up time will be 38 hours for each set-up. Time required for testing each unit will be reduced by 1 hour. = Engineering cost and batch size will rem ain unchanged, Required (i) Using activity based costing, CALCULATE the full cost for parts "AXE" and "WYE" and mark-up on full cost per unit for part “AXE” (1) @_ What is the target cost per unit for new design to maintain the same mark-up percentage on full cost per unit as it had earlier? Assume cost per unit of cost drivers for the new design remains unchanged. (b) Will the new design achieve the cost reduction target? (iil) LIST four possible management actions that the JKL Limited should take regarding new design, (iv) STATEthe most suitable situation for the adoption of target costing, Answer () Computation of “full cost per unit” using Activity Based Costing Particulars Basis ofallocation “AXE (8) WYE (3) a Direct material cost Traceable hence direct 50,40,000 42,00,000 1b. Direct labour cost Traceable hence direct 18,00,000 14,00,000 c. Direct machine cost Traceable hence direct 9,00,000 750,000 d. Machine set up cost _ ‘See working note 1 2,40,000 276,000 e Testing cost ‘See working note 2 14,40,000 | 14,70,000 f. Engineering cost Allocated 9,60,000 13,80,000 4g. Total cost in % (a) to (f) 1,03,80,000 | 94,76,000 1h, Production/Sales Quantity (units) 1,20,000 70,000 Full cost per unit in (g)/(h) 86.50 135.37 Mark up on full cost basis for Part AXE Particulars Amount per unit (in %) Selling price 103.80 ‘Less: Full cost computed above | 86.50 Mark-up 17.30 Percentage of mark up on full cost [(17.30/86.50) x 100] 20% Working Notes 1. Machine set-up cost per hour Particulars AXE WYE ‘a. Production /Sales quantity (units) 120,000 70,000 b, Batch size (units) 1,200 700 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.19(i) (a) (b) Cost Management Techniques ¢ Number of batches (a)/(b) 100 100 , Set-up time per batch (hours) 40 46 . Total set-up hours (¢)x(d) 4,000 4600 Machine set up cost =%5,16,000 up cost per hour = %5,16,000/8,600 hours ie, %60 Total set-up hours for both the products (4,000 + 4,600) = 8,600 hours Machine set- Particulars AXE WYE a. Total set-up hours 4/000 4600 b, Machine set-up cost per hour 7 60 260 ¢. Allocation based upon cost driver's activity %2,40,000 | %2,76,000 ‘Testing cost per hour Particulars AXE WYE a, Production /Sales Quantity (units) 120,000 70,000 b. Testing time per unit (hours) 4 7 € Total testing time in hours (a)*(b) 480,000 | 490,000 Testing cost = $29,10,000 Total testing time in hours for both the products (4,80,000 + 4,90,000) = 9,70,000 hours Testing cost per hour = %29, 10,000/9,70,000 hours ie., 83 Particulars AXE WYE a, Total testing time in hours 480,000 4,90,000 b. Testing cost per hour 3 3 ¢. Allocation based upon cost driver's activity 7%14,40,000 714,70,000 “Target Cost” of Part AXE after new design is implemented Particulars Amount per unit (in 3) ‘Target price 90.00 Mark-up [(90«20)/120] | 15.00 Target cost 75.00 Statement of per unit cost for new design of Part AXE Particulars | Effect of new design Cost per unit (in %) Direct Existing cost per units is €42 (50,40,000/1,20,000), 38 material cost | expected to reduce by %4 per unit Direct Existing cost per units is €15 (¥18,00,000/1,20,000), 2 labour cost _| expected to reduce by €3 per unit Direct Existing cost per units is 7.5 (¥9,00,000/1,20,000), 750 machine cost | but no change as machine is dedicated Machine Revised per unit cost will be %2,28,000((100 set-ups 1.90 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.20Git) (iv) Cost Management Techniques setup cost | 38 hours x %60)/1,20,000 = €1.9 Testing cost | Revised per unit cost will be &3 per hour x 3 hours (4 9 hours ~ Lhour) = 29 Engineering | Existing cost per units is €8 (29,60,000/1,20,000), 8 cost and same will remain unchanged Per unit cost for new design of Part AXE 764 Since the estimated cost per unit is %76.4, which is less than 875 i.e, target cost per unit, hence new design failed toa chieve the cost reduction target. Possible Management Action a Value analysis/engineering can be applied to reduce the costs, while enhancing the value. Detailed functional analysis can also/help in identification of scope of cost reduction while maintaining the quality. Standardisation of assembly or sub-parts can reduce material cost significantly. These activities might not be able to unlock entire value, hence Kaizen shall be practiced. b. Time and motion study can be performed in order toredefine the direct labour time ‘and related costs. Techniques like 5S, Cellular manufacturing shall be applied. © Exploring possibility of cost reduction in direct machining cost by using appropriate techniques. d. Identification of non-value added activities and eliminating them (or reduce them till residual level if elimination is not possible) in order to reduce overheads © The expected selling price based on estimated cost of $76.4 per unit is 791.68. (76.4 + 20%). Introduce sensitivity analysis after implementation of new design to study the sales quantity changes in the price range of £90 to %91.68. Most suitable situation for adopting target costing ‘Target costing is most useful in those situations where the substantial amount of Product costs are locked (committed) during the product design phase. This is a common feature of a product to be manufactured; but rare in case of services. In the services area, such as consulting, the bulk of all activities can be reconfigured for cost reduction when services are being provided directly to the customer. In the services environment, the “design team" is still present but is more commonly concerned with streamlining the activities conducted by the employees providing the service, which can continue to be enhanced at any time, not just when the initial services process is being laid out. Business organisations, with following features expected to gain maximum from target costing; a Assembly-oriented industries; b. Involved heavily with the diversification of the product lines; © Use technologies of factory automation, including computer-aided design, flexible manufacturing systems, office automation, and computer-aided manufacturing; BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.21— a Ore d. Have experienced shorter product life cycles where the pay-back for factory automation typically must be achieved in less than eight years; & Must develop systems for reducing costs during the planning, design, and development phases; f. Are in process of implementing managem value engineering. methods such as just-i Question 11 Pixel Limited is a toy manufacturing company. It sells toys through its own retail outlets. It purchases materials needed to manufacture toys from a number of different suppliers, Recently, due to the entry of few reputed foreign brands in the toy market and particularly in thesegment in which Pixel Ltd. is doing business, it is facing a threat to operate profitably. Each toy requires 4 kg. of materials at % 19 per kg. and 5% of all materials supplied by the suppliers are found to be substandard. Labour hour requirement for each toy is 0.4 hour at & 120 per hour. Market research has determined that the selling price will be < 240 per toy. The company requires a profit margin of 15% of the selling price. Expected demand for toy in the coming year will be 50,000 toys. Sales and variable overhead per unit for the four quarters of the year will beas follows: a | @ @ a (Festive season) | (Festive season) Sales (units) 7500 | 9,000 15,500 18,000- Variable overhead per unit (2) 22 2 24 25 Total fixed overheads are expected to be % 6,25,000 for each quarter. The production manager has decided to produce 12,500 units in each quarter. Inventory holding costs will be % 18 per unit of average inventory per quarter. Inventory holding costs arenot included in above. Normal production capacity per quarter is 15,000 toys. The company can produce further up to 6,000 units per quarter by resorting to overtime working. Overtime wages will be at 150% of normal wage rate, Assume zero opening inventory. Required (i) CALCULATE the cost gap that exists between the total cost per toy as per the production plan and the target cost per toy. (ii) _ DISCUSS how just-in-time purchasing and just-in-time production will remove the cost gap calculated in (i) above, Show calculations in support of your answer. (ili) EXPLAIN, how implementation of JIT production method can be a major source of competitive advantage and success of the company. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.22_————— OOO re Answer (Cost gap between Total Cost per toy as per the production plan and the Target Cost per toy ‘Target Cost per toy SN. | Particulars per unit | For Annual Sales of 50,000 units Selling Price per toy 240 1,20,00,000 2. | Required Profit Margin 36 18,00,000 (15% of selling price =15% x%240 per unit) 3_ | Tanget Cost per annum (Step 1- 2) 1,02,00,000 4 | Target Cost per toy (Step 3/50,000 units) 204.00 ‘Therefore, Target Cost is 204 per toy. ‘Total Costas per production plan Pixel Ltd. has an annual production requirement of 50,000 toys, which is also its annual sales. Given that opening inventory for the first quarter is nil. The production manager wants to produce 12,500 units per quarter irrespective of the sales demand for the quarter. This implies that during some quarters, there might be unsold inventory, for which inventory holding cost has tobe borne. This type of production is called “produce tostock’ Production Schedule and Inventory H olding Cost for the year S.] Particulars a @ @ Q4 | Total for IN, theyear 1 [Opening Stock (units) - 5,000 | 8500 | 5,500 2 | Production (units) 12500 | 12,500 | 12500 | 12500 | 50,000 3 [Sales (units) 7,500 | 9,000 | 15500 | 18,000 | 50,000 4 |Closing Stock (units) 5,000 | 8500 | 5500 (Step 1+ 2-3) 5 |Average Inventory 2,500 | 6750 | 7,000 | 2,750 = (Step 1+ Step 4)/2 6|Inventory Holding Cost] %45,000 | ¥1,21,500| %1,26,000 (Average Inventory * %18 per unit of Average Inventory) 49500 | 33,42,000 Total Cost of Production per toy as per production plan S.] Particulars a Q2 @ Q4 | Total for IN.| 50,000 units 1 [Direct Material Cost per] *80 380 380 80 | %40,00,000 junit (Note 1) BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.23Cost Management Techniques 2)Direct Labour Cost per] 48 | 48 48 48] %24,00,000 junit (Note 2) 3 |Variable Overhead Cost per! %22 | 22, 24 25 | ¥11,62,500 junit 4{Total Variable Cost per] > > = 6 | Production Beyond Capacity of - - | 500 | 3,000 15,000 Toys per quarter (units) Total Cost of Production under JIT System S.[Particulars a @ @ Qt | Total for IN. 50,000 units 1 Direct Material Cost per unit] %76 | &76 | 376 76 | 38,00,000 (Note 1) 2 [Direct Labour Cost per unit us [us | us 48 | 24,00,000 3|Variable Overhead Cost per] %22 wz | et 325 | 11,85,000 unit 4]Total Variable Cost per unit] t146 | e146 | e148 | e149 (Steps 1+ 2+3) 5|Production (units) for the! 7,500 | 9000 | 15,500 | 18000 | 50,000 quarter (Refer JIT Production schedule above) 6|Total Variable Cost for the|*1095.000/%13,14,000)%22,94,000)826,82,000] #73,85,000 quarter (Step 4 * Step 5) 7|Production (units) for the) - 500 | 3000 | 3,500 Jquarter in excess of capacity (Refer JIT Production schedule above) 8]Overtime Labour Cost for] 0 80 | 12,000 | 72,000 | %84,000 Iproduction in excess of! capacity (Note 2) [Step 7 x 10.40 x 50% * 2120 per hour] ‘9 [Fixed Overheads 625,000] &6,25,000 | €6,25,000 | €6.25,000 | ¥25,00,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.25(ii) Cost Management Techniques 10[Total Cost for production f817.20,000)819,39,000)%29,31,000)833,79,000) €99,69,000 under the JIT System (Step 6 + Step 8+ Step 9) 11/Total Cost per toy as per 3199.38 [production schedule (Step 10 |/50,000 units) Note 1 Carefully selected suppliers of delivering high quality materials in a timely manner directly at the shop floor, reducing the material receipt time and loss due to sub- standard material. Note2 ‘Overtime wages are 150% of normal wage rate. Therefore, for every toy produced over the quarterly production capacity of 15,000 toys, 50% extra wage over and above the hourly rate has to be paid as overtime wages. Each toy needs 0.40 hours for production. Therefore, overtime cost for excess production = excess production units * 0.40 * 50% « 3120 per hour. Cost Gap ‘The cost of production per toy under the JIT system is 199.38 per toy as compared to the target cost of %204 per toy and save % 4.62 per toy. The savings primarily comes from eliminating the inventory holding cost of %3,42,000 per annum and sub- standard material cost of €2,00,000 per annum under the previous production system. This is slightly offset by the additional cost of ¢84,000 per annum that has to be paid towards overtime labor charges and %22,500 towards additional variable overheads. However, by switching to the JIT system, Pixel Ltd. could reduce its production cost below the target cost per toy. JIT system aims at: + Meeting austomer demand in a timely manner. + Providing high quality products and + Providing products at the lowest possible price. The main features of the JI’ production system are: + Material handling cost is reduced ~ materials move from one machine to another in an organized sequence, The production process is grouped into to manufacturing calls. These can be managed with minimal labor. This reduces material handling costs as also any pile up of inventory in the form of work-in-progress. In JIT procurement process, the raw material is received only when needed. Due to significant reduction in inventory, inventory holding costs, normal wastage cost and spoilage can be avoided, Optimum arrangement of cells can lead to lesser floor space requirement, thereby reducing factory rental and overhead cost. * Multi-skilled labor: Hire and retain multi-skilled workers who are capable of performing a variety in operations including repairs and maintenance. Therefore, a BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.26lanagement Techniques worker is not confined to only one process in the production process. He can contribute towards other processes as well. This reduces workforce requirement and labor idle time. The company can have a more efficient workforce, with lesser number of workers. There is potential to reduce labor cost on account of this. Minimizing defects rework and scrap: Each stage of the production process is tightly linked in a sequential manner. Defective output from one stage will stop the work at the next stage. Due to this, workers can identify and correct errors or defects instantaneously, JIT creates urgency for eliminating defects as quickly as possible since the downstream work also stops due to error in any workstation, Production process efficiency improves and reduces rework or scrap. The overall quality of production improves. There are other benefits to streamlining production process: lesser need for inspection of final output and lesser sales returns due to defects, This would contributeto the product's brand value. Reduced set-up time: Streamlined production process under JIT reduces set-up time at the workstations. When the production process has to change to make the product per the customers’ demands, set-up time is incurred at the workstation, By streamlining operations, JIT system alms at reducing the set-up time, so that production can continue with the least possible interruption, This brings flexibility in the operations since the company can quickly change the production requirement, to make products to meet the customer's demand. Quick turnover Improves productivity of the machine, thereby increasing the production capacity, Lesser time is spent on set-up which is net a value adding activity. Reduces lead time for receiving materials since the suppliers of raw material are capable of delivering high quality materials in a timely manner directly at the shop. Proper selection of such suppliers is imperative for the JIT system to be successful. If this can be achieved, then it is beneficial for the company since inventory holding of material is eliminated along with receiving better quality of raw material in a timely manner. Himinating inventory holding, scrap, material wastage, flexibility in operations by reducing set-up time, better response time to customer's demands, better skilled workforce, better quality of production, lower workforce requirement, lower floor space requirement all of these contribute towards lowering working capital requirements. These contribute to a company’s competitive edge and success. Life Cycle Costing Question 12 A company is planning anew product. Market research information suggests that 40,000 units of the product can be sold at a maximum of % 25 per unit. The company seeks a minimum mark-up of 25% on product cost. Itis estimated that the lifetime costs of the product will be as Research and development, design costs € 150,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.27Cost Management Techniques (2) Manufacturing costs € 16 per unit (3) _ End of life costs ¥70,000 (4) Promotion and capacity cost & 20,000 Should the product be manufactured? Answer ‘The new product can be sold into the market at a maximum of & 25 per unit. The company also seeks a minimum mark-up of 25% on product cost, which means the product should have a target cost of € 20 per unit. Calculation is as below: ‘Target Cost + 25% Mark-up on cost = & 25 Or, Target Cost per unit = € 20 per unit. Statement Showing “Life Cyde Cost per unit” Particulars of Cost z Manufacturing Cost per unit 16.00 Add: - Research and Development, Design Cost (Gees) 375 ' 70,000 ~End of Life Costs ({72"-) us 20,000 Promotion and Capacity Cost (Soo) oso ‘Total Life Cycle Cost perunit 22.00 The above life cycle cost of the proposed product is above the target cost of € 20 per unit hence, the product should not be manufactured. Question 13 Mould & Dies (M&D) was established in 1980 and has enormous wealth of experience in the mould manufacturing industry and serves wide range of plastic moulds all over nation. Over the past decade, M&D has developed reputation for quality products & services for customer Focused approach. It deals in injection moulds, blow moulds, die sets, moulds base ete. With a state-of-the-art infrastructure facility, M&D is able to meet the qualitative and quantitative demands of its clients, Its vision & mission is to provide high class manufactured products by using best quality raw materials. M&D has developed a new product “M” which is about to be launched into the market and anticipates to sell 80,000 of these units at a sales price of 2300 over the product's life cycle of four years, Data pertaining to product “M’ are as follows: Costs of Design and Development of Molds, | 825,000 Dies, and Other Tools Manufacturing Costs 3125 per unit BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.28,—_—— a OOOO ere’ Selling Costs 312,500 per year + €100 per unit Administration Costs 350,000 per year Warranty Expenses 5 Replacement Parts per 25 units at €10 per part; 1 Visit per 500 units (Cost € 500 per visit) Required (Compute the product “M"’s ‘Life Cycle Cost’ (i) SUGGEST two ways to maximize "M’s lifecycle return. Note: Ignore time value of money Answer () Statement Showing “M’s Life Cycle Cost (80,000 units)” Particulars ‘Amount (2) Costs of Design and Development of Molds, Dies, and Other Tools 8,25,000 Manufacturing Costs (%125 » 80,000 units) 1,00,00,000 Selling Costs (7100 x 80,000 units + 12,500 x 4) 80,50,000 "Administration Costs (35 0,000 « 4) 2,00,000 Warranty (80,000 units/25 units x 5 parts x 10) 160,000 (80,000 units/500 units x 1 visit x 7500) 80,000 Total Cost 1,93,15,000 (ii) Following waysare suggested to maximize “M’ lifecycle return: R&D Costs Often significant part of cost (even above 80%) is committed at the R&D phase of new product, hence M&D should carefully plan and design its new product “M" as it will determine the number of parts, production process to be used ete, M&D can apply value engineering here. It involves improving product quality, reducing product costs, fostering innovation, eliminating unnecessary and costly design elements, ensuring efficient investment in product, and developing implementation procedures. Value engineering is most successful when it is performed early in product development stage. A value engineering study should be performed within the first 25-30% of the design effort prior to selecting the final design alternative. Here, it is also important that R&D team should work as a part of cross functional team ie. (participate in a group of people from different functional areas), to minimise lifecycle cost and the production cycle time in new development. Speed up the Product Launch In cut throat competitions; it is important for M&D to get new product 'M’ launch into the market as soon as possible since this will give “M" a long stay in the market place without competition in the market. Competitor always try to launch a rival product as quickly as possible in order to gain ‘competitive edge. M&D may lose overall profitability if it delays in launching of Product ‘M’. It is usually worthwhile incurring BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.29— Se OO errr’ extra costs to keep the launch on schedule or to speed up thelaunch. Question 14 Y-Con nections, China based firm, has just developed ultra-thin tablet S-5 with few features like the ability to open two apps at the same time. This tablet cost & 5,00,000 to develop; it has undergone extensive research and is ready for production. Currently, the firm is deciding on plant capacity, which could cost either X 35,00,000 or 52,00,000. The additional outlay would allow the plant to increase capacity from 500 units to 750 units, The relevant data for thelife cycle of the tablet at different capacity level are as under: Expected Sales 500 units 750 units Sale Price 379,600 per unit 369,600 per unit Variable Selling Costs 10% of Selling Price | 10% of Selling Price Salvage Value - Plant %6,25,000 9,00,000 Profit Volume Ratio 40% | Required Advise Y-Connections, regarding the ‘Optimal Plant Capacity’ to install. The tablet’ life cycle is twoyears Note: ignore the time value of money. Answer Advice Based on the above ‘Expected Profit’ statement which is purely based on financial considerations firm may go for high price - low volume i.e. 500 units level. However, non- financial considerations are also given due importance as they account for actions that may hot contribute directly to profits in the short run but may contribute significantly to profits in long run. Here, it is important to note that life cycle of product is two years and there is no significant difference between the profits at both levels. In this scenario firm may opt the plant having high capacity not only to increase its market share but also to establish a long term brand image. Workings Statement Showing “Variable Manufacturing Cost per unit” Particulars of Costs unit Sales 79,600 Less: Contribution (40%) 31840 Variable Cost 47,760 Less: Variable Selling Costs (79,600 0.1) 7,960 Variable Manufacturing Cost 39,800 ‘Statement Showing “Expected Profit” BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.30Cost Management Techniques Particulars of Costs (000) 500 units 750 units Sales 39,800 52,200 (579,600 500) (269,600 x 750) Less: Variable Mfg. Cost 19,900 29,850 (£39,800 500) (439,800 x 750) Less: Variable Selling Cost 3,980 5,220 (39,800 x 0.1) (852,200 x 0.1) ‘Ada: Salvage Value 625 900 Less: Cost of Plant 3,500 5,200 Net Profit 13,045 12,830 Development cost is sunk and is not relevant. Question 15 TtCo. Ltd. makes digital watches, The company is preparing a product life cycle budget for a new watch, Development on the new watch is to start shortly. Estimates for new watch are as under: Life Cycle Units 2,40,000 | Marketing Costs: Manufactured and Sold Selling Price Per Watch 3500 | Variable Cost Per Batch | R24 Life Cyde Costs: Watches Per Batch 96 R&D and Design Cost 280 Lakh | Fixed Costs %8.Lakh Manufacturing Costs: Distribution Costs: Variable Cost Per Watch 3120 | Variable Cost Per Watch 240 Variable Cost Per Batch 4,000 | Fixed Costs | 245 Lakh Watches Per Batch 300 | Customer Service Cost: Fixed Costs 8112 lakh | Variable Cost Per Watch 110 Required (i) CALCULATE the budgeted life cycle operating income for the new watch, (i) COMPUTE % of budgeted total product life-cycle costs incurred till the R&D and design stages. (iil) ADVISE the strategiesto be adopted by the Tt Co. Ltd. to develop a new watch. Answer (Statement Showing Budgeted Life-cycle Operating Income Particulars © Revenues (¥500 2,40,000 units) 12,00,00,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.31Cost Management Techniques Less: R&D and Design Casts £80,00,000 Manufacturing Costs: | __ Variable (120 * 2,40,000 units) - 2,88,00,000 | Batch. 32,00,000 Fixed 1,12,00,000 Marketing Costs: Batch (€24 * 2,500" batches) 60,000 *Assuming 1 Batch = 96 Pcs. Fixed 8,00,000 Distribution Costs | Variable (% 240 « 2,40,000) 5,76,00,000 Fixed 45,00,000 | Customer Service Cost (10 x 2,40,000) — 24,00,000 Total Costs 11,65,60,000 OperatingIncome 34,40,000 Gi) % of Budgeted Total Product Life-Cycle Costs incurred till R&D and Design Stages: 280,00,000 x 100 = 6.86% 3000 (iii) We can see from the below figure that approximately 80% of a product's cost are committed during the planning and design stage. At this stage product designers determine the product's design and the production process. In contrast, the majority of costs are incurred at the manufacturing stage, but they have already become locked in at the planning and design stage and are difficult to alter. ye af Set Product ect pen ‘The pattern of cost comm itment and incurrence will differ based on the industry and specific product introduced, For developing a watch, Tt Co. Ltd. needs to incur only 880 lacs for its R&D and design Cost. So, Cost Management of Tt Co. Ltd can be most effectively exercised during the planning and design stage of its new watch and net at the manufacturing stage when the product design and processes have already been BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.32Cost Management Techniques determined and costs have been committed. At manufacturing stage only cost containment is possiblerather than on cost management. An understanding of life-cycle costs and how they are committed and incurred at different stages throughout a product's life cycle of the watch will also led to the emergence of target costing, a technique that focuses on managing costs during a product's planning and design phase. Question 16 In WM Ltd. the ‘OB’ equipment is about to be replaced either by ‘CF system or by an ‘OF’ system, Finance costs 12% ayear and the other estimated costs are as follows: CFD OF (%) Initial Cost 28,000 40,000 Annual Operating Costs 24,000p.a 18,000 pa, Required If the company expected the new system (either CF or OF) to last at least for 12 years, which system should be chosen? COMMENT. Answer Calculation of Life-cycle Costs cr OF (%) Initial Cost 28,000 40,000 ‘Add: Present value of annual operating costs 148,656 111,492 over thelife-time (%24,000x6.194) | (¥ 18,000x 6.194) Total Life Cycle Costs 1,76,656 1,51,492 The annuity factor of 12% finance costs for 12 years Is 6,194. Analysis When we compare only the initial cost, we will tend to purchase CF system, for its cheap acquisition cost. But when we compare the total life-cycle costs, the OF system is most preferable, for its lowest total life-cyde costs. Question 17 Royal Bakers is famous for cakes and cookies. Mr. Das the owner at Royal Bakers is interested in offering affordable products to their customers, hence keen to capture the small scope of cost-effeectiveness, Royal Bakers located in the centre of the city where space has a huge cost and royal baker is running out of space during peak hour causing loss of sale. Most of the customer are regular to Royal Bakers. Royal Baker is known for fast service, Mr. Das wish to be true to the tagline ‘Close your eyes to wish and open them to find it cooked for you’. The hurdle rate is 12%. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.33_——— eer Non-availability of skilled worker and high attrition rate of worker including chef is the cause of worry for Mr. Das. In order to retain worker, Royal Baker is paying a higher salary than industry standards. The raw material is easily available as and when it is required. Royal Bakers Is considering two differ ent models of baking oven machine to replace its old oven. The baking capacity of both machines are the same and both will occupy asimilar amount of space. The first model is the automatic oven which will cost about €10,00,000. Another model is the semi-automatic oven which will cost at 75,60,000. The annual operating cost (including depreciation) is 40% of the acquisition cost and %4,20,000 in case of automatic and s automatic oven respectively. After 3 years of use, the automatic oven can be salvage at £70,000, whereas semi-automatic oven will fetch 20,000 only. The automatic oven is more advanced and equipped with latest technologies to speed up the baking, because only ingredients need to be inserted in right proportion and mix. Whereas in semi-automatic machine some part of the process needs to be performed manually by the workers. Required ADVISE which oven shall royal baker acquire: Note- You can ignore taxes but need to consider the time value of money; decimal accuracy up-to two digits is expected. Answer Statement of the Comparable Life Cycle Cost Particulars ‘Automatic Semi-Automatic Acquisition Cost 10,00,000 5,60,000 PV of Entire Life Cash Operating Cost (W.N.2) 2,16,000 5,76,000 PV of Salvage Value (W.N3) (49,700) (14,200) Total Cost of the Oven over the life cycle 11,66,300 11,21,800 Note — Hurdle rate of 12% (marginal cost of capital rate) is considered, for purpose of application of time value of money. Working Note 1 - Depreciation Particulars Automatic ‘Semi-Automatic ‘Acquisition Cost 10,00,000 5,60,000 Salvage Value 70,000 20,000 Depreciable Value 930,000 5,40,000 Useful life in anumber of years 3 3 Depreciation on SLM basis 3,10,000 180,000 Working Note 2 - Present Value of Entire Life Cash Operating Cost Particulars Automatic Semi-Automatic ‘Annual Operating Cost ,00,000 4,20,000 Depreciation (see W.N. 1) 3,10,000 1,80,000 ‘Annual Cash Operating Cost 90,000 240,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.34lanagement Techniques Cumulative PV factor @ 12% for 3 years 240 2.40 PV of Entire Life Cash Operating Cost 2,16,000 5,76,000 “Annual operating cost is 400,000 e., 40% of 10 Lakhs, in case of automatic machine. Working Note 3 - Present Value of salvage value Particulars Automatic Semi-Automatic Salvage Value 70,000 20,000 PV Factor @ 12% for 3rdyear 0.71 O71 PV of Salvage Value 49,700 14,200 | Advise Based upon life cycle cost, Royal Bakers are advised to acquire semi-automatic oven, because it causes a saving of %44,500. The cost has qualitative implications too, apart from quantitative or monetary implications. Similarly, a management decision is also impacted by qualitative and non-monetary quantitative factors, Hence, decision taken in part a above may differ if Royal Bakers consider- Finishing of bake products - the look and taste It is obvious the presence, which one important feature for bakery product in order look delicious and tempting; will be way different if cooked in the automatic and semi-automatic machine. The taste may also be different, which is more critical from prospective of customer retention because a large number of the customers are regular to the royal baker, hence maintaining the principal customer is maybe a key consideration. This factor may goin favour of any of version oven. If look goes in favour of automatic oven, then taste may be in semi- automatic due to corrections by worker during baking and relatively authentic preparation. Manpower Availability of skilled worker and retention of worker is the cause of worry presently. In order to operate an automatic oven obviously fewer workers are required; hence money can be saved by cutting down recruitment cost and excess salary paid tothe worker in order toretain them. On another hand, skilled workers are already in scarcity, automatic machine obviously Tequires a more technically competent operator. But largely this factor moves in favour of automatic machine despite is costlier. Space Royal Bakers located in the centre of the city where space has a huge cost and royal baker is running out of space during peaks hour causing loss of sale. Although the size of both the oven s are same, the number of worker and space required for them surely be less in case of the automatic oven, Hence this factor again moves in favour of automatic oven. Power consumption & availability Although the power consumption cost is presumed to already include in annual operating cost hence considered as a monetary factor but need and availability of power is a very important factor; in order to ensure uninterrupted baking. In absence of stand-by power back-up, power cut may lead to downtime. It will complete downtime for the automatic oven and to a certain extent in case of semi-automatic. Stand-by power back-up will also have an additional cost. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.35Cost Management Techniques Customisation In case of cookies, it may ok to produce the standard product; but the cake needs to base upon the order of the customer, who may seek customisation. Scope of customisation needs to evaluate, In the case of the semi-automatic oven, the scope of customisation and ethnicity will be relatively high Speed Royal Baker is known for fast service, and Mr. Das wish tobe true to tagline ‘Close your eyes to wish and open them to find it cooked for you’. The automatic oven is more advanced and equipped with latest technologies to speed up the production. Hence this factor moves in favour of automatic oven. Detection ofthe defect If speed thrills, then it kills too. In case of the bakery, rework and reprocessing is hardly possible, even if possible then at a huge cost; hence it is essential to keep vigil control over quality and detection of defect at the earliest stage, In the semi-automatic oven, there is the scope of reviewing the material after stage/s and improvisation can be done. Overall, Royal Bakers should take the decision only after due and careful consideration of above factors. Question 18 P &G International Ltd. (PGIL) has developed a new product ‘a2’ which is about to be launched into the market. Company has spent & 30,00,000 on R&D of product ‘a’. It has also bought a machine to produce the product ‘a costing € 11,25,000 with a capacity of producing 1,100 units per week. Machine has no residual value. ‘The company has decided to charge price that will change with the cumulative numbers of units sold: Cumulative Sales (units) Selling Price € per unit 0t02,200 750 2,201 t07,700 600 7,701 to 15,950 525 15,95 1 to 59,950 450 59,05 1 and above 300 Based on these selling prices, itis expected tht sales demand will be as shown below: Weeks Sales Demand per week (units) 1-10 220 11-20 550 21-30 a 825 31:70 1,100 71-80 880 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.36Cost Management Techniques 81-90 660 91-100 440 101-110 [ 220 Thereafter NIL Unit variable costs are expected to be as follows: per unit First 2,200 units 375 Next 13,750 units 300 Next 22,000 units 225 Next 22,000 units 188 ‘Thereafter 225 PGIL uses just-in-time production system. Following is the total contribution statement of the product ‘a’ for its Introduction and Growth phase: Introduction Growth Weeks 1-10 11-30 Number of units Produced and Sold 2,200 5,500 8250 Selling Price per unit (3) 750 600 525) Variable Cost per unit (%) 375 300 300 Contribution per unit (3 375 300 225 Total Contribution (3) 825,000 | 16,50,000 | 1856,250 Required (i)___ Prepare the total contribution statement for each of the remaining two phases of the product's life cycle. (ii) Discuss Pricing Strategy of the product ‘a’ Note: Ignore the time value of money. Answer (Total Contribution statement Find possible reasons for the changes in cost during the life cycle of the product ‘a, Statement Showing “Total Contribution- for remaining two phases” Particulars Maturity Decline Weeks 31-50 51-70 71-110 Number of units Produced and Sold 22,000 22,000 22,000 Selling Price per unit (%) 450 450 300 Less: Unit Variable Cost (2) 225 188 225 Unit Contribution () 225 262 75 Total Contribution (3) 49,50,000 | 57,64,000 | 1650,000 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.37Gi) Gi) Pricing Strategy for Product ‘a PGIL is following the skimming price strategy that’s why it has planned to launch the product o# initially with high price tag. A skimming strategy may be recomm ended when a firm has incurred large sums of money on research and development for anew product. In the problem, PGIL has incurred a huge amount on research and development. Also, it is very difficult to start with alow price and then raise the price. Raising alow price may annoy potential customers, Price of the product a? is decreasing gradually stage by stage. This is happening because PGIL wants to tap themass market by lowering the price. Possible Reasons for the changesin cost during the life cycle of the product ‘a Product life cycle costing involves tracing of costs and revenues of each product over several calendar periods throughout their entire life cycle. Possible reasons for the ‘changes in cost during the life cycle of the product are as follows: PGIL is expecting reduction in unit cost of the product « over the life of product as a consequence of economies of scale and learning /experience curves. Learning effect may be the possible reason for reduction in per unit cost if the process is labour intensive. When anew product or process is started, performance of worker is. not at its best and leaming phenomenon takes place. As the experience is gained, the performance of worker improves, time taken per unit reduces and thus his productivity goes up. The amount of improvement or experience gained is reflected in a decrease in cost. Till stage of maturity, PGIL is in expansion mode. PGIL may be able to take advantages of quantity discount offered by suppliers or may negotiate the price with suppliers. Product @? has the least variable cost $188 in last phase of maturity stage; this is because a product which is in the mature stage may require less marketing support than product which is in the growth stage so, there is a saving of marketing cost per unit. Again the cost per unit of the product a3 jumps to £225 in dedine stage. As soon as the product reaches its decline stage, the need or demand for the product disappear and quantity discount may not be available. Even PGIL may have to incur heavy marketing expenses for stock clearance: Workings Statement of Cumulative Sales along with Sales Price and Variable Cost Weeks |Demandper| Total | Cumulative | SellingPrice | Variable Cost week Sales Sales per unit (%) | _per unit (%) 1-10 20 2,200 2,200 750 375 11-20 550 5500 7,700 600 300 21-30 825 8250 15,950 525 300 31-50 1,100 22,000 37,950 450 225 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.38Cost Management Techniques 51-70 1,100 22,000 | 59,950 450 188 71-80 880 8800 68,750 300 225 81-90 660 6,600 75,350 300 225 91-100 440 4,400 79,750 300 225 101-110 20 2200 81,950 300 225 Pareto Analysis Question 19 ‘The following information is given about the type of defects during a production period and the frequencies of their occurrence in a spectacle manufacturing company: Defect No. ofitems End Frame not equidistant from the centre 10 Non-uniform grinding of lenses 60 Power mismatches 20 Scratches on the surface 110 Spots/Stains on lenses 5 Rough edges of lenses 70 Frame colours-shade differences 25 Required Answer Statement Showing “Pareto Analysis of Defects” PREPARE a frequency table so that a Pareto Chart can be constructed for the defect type. Also, IDENTIFY key areas of focus. Defect Type No.ofltems | %ofTotal | Cumulative Items Total Scratches on the surface 110 36.67% 36.67% Rough edges of lenses | 70 23.33% 60.00% Non-wniform grinding of lenses 60 20.00% 80.00% Frame colours-shade differences 25 833% 88.33% Power mismatches 20 667% 95.00% End frame not equidistant from the centre 10 3.33% 98.33% Spots/Strain on lenses 5 167% 100.00% 300 10.00% ‘The company should focus on eliminating scratches on the surface, rough edges of lenses and grinding of lenses related defects which constitute 80% portion, according to Pareto Theory. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.39Question 20 Generation 2050 Technologies Ltd. develops cutting-edge innovations that are powering the next revolution in mobility and has nine tablet smart phone models currently in the market whose previous year financial data is given below: Cost Management Techniques Model Sales (000) Profit-Volume (PV) Ratio Tab- A001 5,100 353% Tab - BOOZ 3,000 23.00% Tab - C03 2,100 14.29% Tab - DOO4 1,800 14.17% ‘Tab - E005 1,050 41.43% Tab - FOO6 750 26.00% Tab - G007 450 26.67% - Tab- HOOS 225 6.67% Tab - 1009 75 60.00% Required (i) Using the financial data carry out a Pareto ANALYSIS (80/20 rule) of Sales and Contribution. (ii) _ DISCUSS your findings with appropriate RECOMMENDATIONS. Answer “Pareto Analysis” Model | Sales | % of Total | Cumulative | Model| Cont. | % of Total | Cumulative (000) Sales Total (000) | Cont. Total % Pareto Analysis Sales Pareto Analysis Contribution A001 5,100 35.05% 35.05% B002 690 30.87% 30.87% BOO2 3,000 20.62% 55.67% E005 435 19.47%* 50.34% co03 2,100 14.43% 70.10% C003 300 13.42% 63.76% poos | 1800 | 12.37% | 8247% | O04 | 255 | 1141% | 75.17% ‘E005: 1,050 7.22% 89.69% F006 195 8.73%" 83.90% F006 750 5.15% 94.84% A001 180 8.05% 91.95% Goo7 | 450 | 3.09% | 97.93% | Go07 | 120 | 5.37% | 97.32% Hoos | 225 155% 99.48% | 1009 | 45 2.01% | 99.33% 1009 75 052% 100.00% O08 15 0.67% 100.00% 14,550 | 100.00% 2,235 | 100.00% BY CA ATUL AGARWAL ( (AIR-1) AIRICA Career Institute (ACI) Page 4.40Cost Management Techniques Diagram Showing “Sales and Contribution” = —— = — mae eS es aa . ‘SALES CONTRIBUTION Recommendations Pareto Analysis is a rule that recommends focus on most important aspects of the decision making in order to simplify the process of decision making. The very purpose of this analysis is to direct attention and efforts of management to the product or area where best returns can be achieved by taking appropriate actions. Pareto Analysis is based on the 80/20 rule which implies that 20% of products account for 80% of the revenue. But this is not the fixed percentage rule; in general business sense, it means that a few of the products, goods or customers may make up most of the value for firm. In present case, five models namely A001, B002, C003, DO04 account for 80% of total sales where as 80% of the company’s contribution is derived from models B002, E005, C003, D004 and F006, Models B002 and E005 together account for 50.34% of total contribution but having only 27.84% share in total sales. So, these two models are the key models and should be the top priority of management. Both C003 and D004 are among the models giving 80% of total contribution as well as 80% of total sales so; they can also be clubbed with BOO2 and £005 as key models. Management of the company should allocate maximum resources to these four models. Model F006 features among the models giving 80% of total contribution with relatively lower share in total sales. Management should focus on its promotional activities. Model A001 accounts for 35.05% of total sales with only 8.05% share in total contribution. Company should review its pricing structure to enhance its contribution. Models G007, HO08 and 1009 have lower share in both total sales as well as contribution. Company can delegate the pricing decision of these models to the lower levels of management, thus freeing themselves to focus on the pricing decisions for key models. BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.41Cost Management Techniques Question 21 The Information given below pertains to ABC Enterprises, a specialized car garage door installation company. ABC Enterprises use to get multiple service calls from the customers with variety of requirements. They may have to Install, Replace, Adjust or Lubricate some part or other to make the door functional. They work with § parts as given in the table, namely Door, Motor, Track, Trimmer and T -Lock. Parts Type of Service Total Install Replace | Adjust Lube 1 | Door 2 5 1 0 8 2 | Motor | 3 2 16 9 30 3 | Track 5 0 6 6 17 4 | Trimmer “uw | 6 0 0 20 5 | T-Lock | ) 1 Oo 6 6 | Miscellaneous _ 2 1 pd 4 Total 29 15 25 16 85 Required (Using the above data, carry out a Pareto Analysis (80/20 rule) of Total Parts. (i) _ Using the same data carry out the second level Pareto Analysis on the type of services ‘with respect to Motors only. (lil) Give your RECOMMENDATIONS on the basis of your calculations in (i) and (1i) above Answer (i) _ Statement Showing “Pareto Analysis of Total Parts” Parts No. of items %of Totalitems | Cumulative Total Motor 30 35.29 35.20% Trimmer 20 2353 58.82% ‘Track — 17 20.00 78.82% | Door 8 O41 88.23% T-Lock (6 7.06 95.29% Miscellaneous 4 471 10.00% 85 100 ‘Statement Showing “Pareto Analysis of Type of Services (Motor)” Type of Services No. ofitems % of Totalltems | Cumulative Total Adjust 16 5333 53.33% | Lube | 9 30.00 83.33% Install l 3 10.00 93.33% Replace 2 667 100.00% 30 100 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.42,(iii) Pareto Analysis is a rule that recommends focus on most important aspects of the decision making in order to simplify the process of decision making. The very purpose of this analysis is to direct attention and efforts of management to the product area where best returns can be achieved by taking appropriate actions, Pareto Analysisis based on the 80/20 rule which implies that 20% of the products account for 80% of the revenue. But this is not the fixed percentage rule. In general business sense, it means that afew of the products, goods or customers may make up most of the value for the firm. The present case stands in a difference to 80/20 rule. Because the company installs doors, they sometimes have multiple service calls to install each door piece by piece. ‘They may have to install, replace, adjust, or lubricate some part to get the door working properly. They work with five main parts: door, motor, track, trimmer and tock. The service calls with reference to motors are heavy and accounted for as much as 35.29% ‘of the number of calls attended, Motor together with trimmer accounted for 58.82%. So, these two parts are to be considered as key parts and ABC enterprises must be ever ready to cater to all provisional requirements for attending these classes without any inordinate delay. Any delay in service these calls is likely to damage its service rendering reputation within avery short span of time. Further, the second level Pareto Analysis on motors has revealed a particular reference to service problems related to motors, Adjustment and Lubrication issues cover up 83.33% of total service problem. exclusively connected to Motors. So, ABC Enterprise must direct its best efforts and develop specific expertise to solve these problems in best interest of customers, Environmental Management Accounting. Question 22 A chemical company produces two chemicals SX and ZX. Environmental activities and costs associated with the two chemicals are as follows: xx 7X Unit produced (kg.) 600,000 | 15,0000 Packing Materials (kg.) 80,000 40,000 Energy Usage (KWH) — 60,000 30,000 Toxin releases (Pounds into air) 2,00,000 40,000 Pollution control machine hours 32,000 8,000 Cost of environmental activities: Packing material Costs - %3,60,000 | Energy Costs $96,000 Fines for release of toxins into air | = 48,000 | Operating costs of pollution con rol equipments %1,12,000 Required BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.43Cost Management Techniques CALCULATE the environmental cost per kilogram for each chemical produced by the company. Answer Envir onment Cost Allocation Allocation of environment costs incurred by the company can be allocated to products using (i) Input-Out analysis (ii) Flow Cost Accounting (iii) Life cycle costing and (iv) Activity Based Costing Environment costs can be allocated to Chemicals SX and ZX using Activity Based Costing. S.| Type of Environment Cost Allocation = IN. cost Allocation Basis | Chemical SX [Chemical ZX] _ Total 1| Packing Material Packing Materials(kg) | 2,40,000 | 1,20,000 | 3,60,000 Costs $X 80,000 kg. 2X 40,000 kg. 2] Energy Cost Energy Usage (KWH) 64,000 32,000 | 96,000 SX 60,000 kwh 2X 30,000 kwh 3] Fines for Release of _ | Toxins Released 40,000 8.000 48,000 Toxins into Air (Pounds into air) $X 200,000 poun ds 2X 40,000 pounds 4| Operating Costs of Pollution Control 89,600 22,400, 1,12,000 Pollution Control —_| Machine Hours Equipment ‘SX 32,000 hrs 2X 8000hrs 5 | Total Cost Allocation | Sum of Steps 1 to 4 433,600 | 1,82,400 | 6,16,000 6 | Units Produced (kg.) 6,00,000 15,00,000 | 21,00,000 7 | Environment Cost 30.7227 %0.1216 20.2933 per unit produced (Step5 Step 6) The environment cost allocation per kilogram for Chemical SX is €0.72 per kg and Chemical ZX is £0.12 per kg, The average environment cost per kg for overall production is 0.2933 per kg. Question 23 A fertilizer company produces Grade A and Grade B fertilizers. One kilogram of Grade A fertilizer sells for €280 per kilogram and one kilogram of Grade B fertilizer sells for 2400 per kilogram, ‘The products pass through three cost centers CC1, CC2 and CC3 during the manufacturing process. Total direct material cost per kilogram of fertilizers produced (Both Grade A and Grade B) is €300 and direct labor cost per kilogram of fertilizers produced (Both Grade A and Grade B) is ¥200, Allocation between the cost centres is given below: BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.44Cost Management Techniques Particulars cci | oc2 | cc3 | Total Cost of Direct Material (per kg of fertilizers produced) x90 | t120 | 290 | 3300 Cost of Direct Labour (per kg of fertilizers produced) %60 | %80 | %60 | 2200 Cost Allocation to Grade A 30% | 50% | 30% Cost Allocation to Grade B 70% | 50% | 70% All of expenses (considered to be overheads) per kilogram of fertilizers produced (Both Grade A and Grade B) is 150. This is allocated equally between Grade A and Grade B fertilizer. Pricing decisions for the fertilizersis made based on the above cost allocation. The management accountant of the company has recently come across the concept of environmental management accounting. Pricing of products should also factor in the environmental cost generated by each product. An analysis of the overhead expenses revealed that the total cost of %150 per kilogram of fertilizers produced, includes incinerator costs of 290 per kilogram of fertilizers produced. The incinerator is used to dispose the solid waste produced during the manufacturing process. Below is the cost center and product wise information of solid waste produced: Waste produced (in tonnes p er annum) cet oc2 cc3 Total Grade A 2 3 1 6 Grade B 2 2 5 9 Based in the impact that each product has on the environment, the management would like to revise the cost allocation to products based taking Into account the incinerator cost that each product generates. The remaining overhead expenses of %60 per kilogram of fertilizers produced can be allocated equally. Required (i) CALCULATE product wise profitability based on the original cost allocation. RECALCULATE the product wise profitability based on activity based costing methodology (environmental management accounting) ANALYZE difference in product profitability as per both the methods. RECOMMEND key takeaways for the company to undertake the above analysis of overhead costs and pricing as per environmental management accounting. Answer (i) _ Product Wise Profitability as per Original Allocation Methodology (Figures in € per kilogram of fertilizer produced) Particulars GradeA | GradeB Total Selling Price 280 400 680 Direct Material (Refer Table 1) 14 186 300 Direct Labour (Refer Table 1) 76 124 200 Overheads (allocated equally) 75 75 150 Total Expenses 265) 385 650 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.45‘Cost Man: Profit 15 15, 30 Profitability 5.36% 3.75% x Table 1 Allocation of Direct Materials and Lab our as per Cost Centre and Product z cet cz ccs Total for company 3 A]B|ccTaal|A|[B] cc |A|B] cc |Gr.A]Gr.B|Grand = Total Total Total & Direct Material |27/63| 90 | 60|60| 120 |27|63| 90 | 114 | 186 | 300 Direct Labour | 18/42/60 | 40/40] 80 [18/42] 60 | 76 | 124 | 200 Accordingly, the Revised Product Profitability would be as follows: Product Wise Profitability (activity based costing using environmental management accounting) requires the following steps: 1. Overhead expenses of & 150 per kilogram of fertilizers produced be first bifurcated intoincinerator costs and other overhead costs. 2 _ Incinerator costs of % 90 per kilogram of fertilizers needs to be allocated first tothe cost centres. This is done based on the waste generated at each cost centre. The individual cost allocated to each cost centre is again allocated to products based on the waste generated at each cost centre by each product. Refer part a of table 2 for detailed calculations. 3. As mentioned in theproblem, other overhead costs are allocated to each product at each cost centre level equally. Refer part b of table 2 for detailed calculations. 4, The above allocations to each product at a cost centre level is then summed up to get the product wise overhead cost allocation. Refer part c of table 2 for detailed calculations. (Figures in € per kilogram of fertilizer produced) Particulars GradeA | GradeB | Total Selling Price 280 400 680 Less: Direct Material (refer table 1) 14 186 300 Less: Direct Labour (refer table 1) 76 wa | 200 Less: Overheads (refer table 2) 66 st | 150 Profit 24 6 30 Profitability 857% 1.50% x Table 2 Allocation of Overhead Expenses to each Cost Centre and Product (Figures in € per kilogram of fertilizer produced) Product Waste Produced (in tonnes per annum) cet | ccz | cca | Total Grade A 2 [3 [12 6 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.46Gi) Grade B 2[2 [s5][9 Total Waste (in tonnes) 4/5 | 6 | 1s Incinerator Cost Allocated to Cost Centres 24 | 30 [36 | 90 (based on waste generated) Other Overhead Expenses 20 | 20 | 20 | 60 Total Cost Centre Wise Overhead Cost 44 | so | 56 | 150 Part A: Allocation of Incinerator Cost from Cost Centre to each product (based on waste produced at each cost centre by each product) Product cet | cc2 | ccs Total Grade A 2 | wl 6 36 Grade B | 12 [30 | 54 Total Incinerator Cost 24 | 30 | 36 90 Part B: Allocation of Other Overhead Cost from Gost Centre to each product Product cet | cc2 | ccs Total Grade A 10 | 10 | 10 30 Grade B 10 | 10 | 10 30 ‘Total Other Overhead Cost 20 | 20 | 20 60 Part C: Total Overhead Cost (Cost Centre and Product Wise i.e. part a+b) Product cet | cc2 | ccs Total Grade A 22 | 28 | 16 66 Grade B 22 | 22 | 40 Bt ‘Total Overhead Cost 44 | 50 | 56 150 Summarizing Product Profitability as per both methods: Product] (Profitin € per kg of fertilizer Profit % produced) Original ABC. Original ABC Method | (asperEMA) Method | Method | (as per EMA) Method Grade A 15 24 536% 857% Grade B 15 6 3.75% 150% As summarized above, originally the profit generated from Grade A and Grade B Products, was 215 per Kilogram. Grade A was the more profitable product giving return of 5.36% compared to Grade B’s return of 3.75%. This has been calculated by allocating overheads equally to Grade A and B. During the year, 15 tons of waste is produced during the manufacturing process. Grade B fertilizer produces more waste that accounts for 60% of the waste. Therefore, Grade B should bear higher amount of the incinerator cost compared to Grade A. Allocation based on this premise, dramatically changes the profitability of the products. As calculated above, Grade A fertilizer, due to lower incinerator cost allocation, generates a profit of %24 per kilogram of fertilizer. Grade B's profits accordingly are BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.47lower, since the product generates more waste and has to bear a larger share of dean-up expenses. Profitability of Grade A increases to 8.57% while Grade B falls dramatically to1.50%. The company can draw a number of conclusions from this analysis of overhead costs as per environmental management accounting. This analysis has helped the company reach the conclusion that Grade B fertilizer produces more waste. The company could adopt either of the following approaches: (a) Tomaintain the same level of profitability, the company can increase the price of Grade B. Depending on the market for this grade of fertilizer, the company has to decide whether to increase the price of the product. While a price increase may be possible if the company has a strong market hold, it might be difficult if competition in the market is high. or (b) The other approach, a more sustainable approach that is the aim of environmental management accounting, would be to reduce the waste produced in the ‘manufacturing process. This analysis, has quantified the waste generated in the process. Better manufacturing techniques, could save the company incinerator costs, that would yield better profits for the company. Question 24 “QR” Ld. is the leacing manufacturer and exporter of high quality leather products - Product Qand Product R. Selling price per unit of Product Q and Product R is € 620 and % 420 respectively. Both the products pass through three processes - Tanning, Dyeing and Finishing during manufacturing process. Allocation of costs per unit of leather products manufactured among the processes are given below: Particulars Tanning Dyeing | Finishing | Total Direct Materials per unit 140 180) 140 460 Direct Labour per unit 90 120 Ce Cost allocation to Product Q 70% 50% 70% Cost allocation to Product R 30% 50% 30% General overheads per unit of leather products Q or R manufactured are 115. This blanket absorption rate is derived after division of total general overhead with number of leather product be it Q or R. Above cost allocation is the basis for the decisions regarding pricing of the products. In this Industry, all the major production processes have environmental impact at all stages of the process, including generation of waste, emission of harmful gases, noise pollution, water contamination etc. ‘The management of the company is worried about the above environmental impact and has taken initiative to preserve the environment like - research and development activities aimed at reducing pollution level, planting trees, treatment of harmful gases and airborne emissions, BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.48—————OOOOOOOOEEN Wastewater treatment ete. ‘The management of the company desires to adopt Environmental Management Accounting as @ part of strategic decision making process. Pricing of products should also factor in environmental cost generated by each product. General overheads blanket rate per unit of leather products (be it Q or R) manufactured are 3115 which includes- Treatment cost of harmful gases... Wastewater treatment cost... Cost of planting of treS een Miscellaneous Process wise information related to generation of wastewater and harmful gases is given as below: Particulars Tanning | Dyeing | Finishing | Total ‘Wastewater gener ated (litres per week) ‘900 600 0 1500 Emission of harmful gases (cc per week) 400 300 100 800 Cost allocation to Product Q 70% 50% 70% Cost allocation to Product R - 30% 50% 30% The remaining overheads cost (miscellaneous) and cost of planting trees can be allocated equally between Product Q and Product R. Required (a) CALCULATE the product wise profitability based on the original cost allocation. (b) RECALCULATE the product wise profitability based on activity based costing (Environment driven costs). (©) ANALYZE the difference in product profitability as per both the methods, (a) RECOMMEND and EXPLAIN the four management accounting techniques for the identification and allocation of environmental costs. (e) STATE why the management of environmental costs is becoming increasingly important in organizations. Givereasons. Answer (a) _ Product Wise Profitability as per Original Allocation Methodology (Figures in per unit of leather produced) Particulars Product Q ProductR | Total Selling Price 620 420 1,040 Direct Material (Refer Table 1) 286 174 460 Direct Labour (Refer Table 1) 186 14 300 Overheads us 115 230 Total Expenses 587 403 990 Profit 33 17 50 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 4.49Profitability (9%) 5.32% 4.05% x Workings Table 1 Cost Allocation to the Products (Figures in per unit of leather produced) Tanning Dyeing Finishing Total Q]R [Total] Q] R [Total] Q] R [Total] Q | R |Grand Total Direct Material |98|42] 140 [90 | 90 | 180 [98/42] 140 | 286/174] 460 Direct Labour [6327] 90 |60| 60 | 120 |63/27| 90 | 186 | 114] 300 (b) Product wise profitability based on activity based costing using environment driven ‘costs requires the following steps: + For convenience let presume only 2 units (1Q and 1R) are manufactured, currently the total overhead of €230 (1152) is equally divided between Q and R Le €115 per unit of Q and R. But this is blanket or convention approach of allocation and misleading too. Hence the total overhead of 8230 need to be divided such as ABC as required in question, + Breakdown of total overhead cost of € 230 per unit into treatment cost of harmful gases, wastewater treatment cost, cost of planting trees and other overhead costs. Refer Table 2 for the breakup. * Treatment cost of harmful gases, wastewater treatment cost need to be individually allocated to various processes based on relevant cost drivers. Refer Table 3 for cost allocation to process. + The overheads mentioned in point above thus allocated to the various processes, will be further allocated to products based on the specific ratios given in the problem, Refer Table 4 for cost allocation to products. Product Wise Profitability Statement based on ABC using environment driven costs (Figures in tper unit of leather produced) Particulars Product Q | ProductR | Total Selling Price 20 420 1,040 Direct Material (Refer Table 1) 286 174 460 Direct Labour (Refer Table 1) 186 14 300 Allocation of Overheads Treatment Cost of Harmful Gases (Refer Table 4) 50 30 80 "Wastewater Treatment Cost (Refer Table 4) 62 38 | 100 | Cost of Planting Trees (shared equally) 10 10 | (20 Other Overhead Cost (shared equally) 15 15 30 Total Expenses 609) 381 990 Profit Fry 39 50 Profitability % 1.77% | 9.2% x BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 450‘Cost Man: _j———— Orel’ Workings Table 2: Breakdown of General Overheads per unit ‘Overhead Amount (%) | Allocation basis between products Treatment Cost of Harmful 80 Emission of Harmful Gases (cc per Gases week) Wastewater Treatment Cost 100 Wastewater Generated (litres per week) Cost of Planting Trees 20 Equally between Products Q and R | Miscellaneous ~ 30 | Equally between Products QandR- Total General Overheads 230 Table 3: Allocation of Tr eatmer Process Wise Information Cost to various process Overhead [Amount | Allocation Basis | Tanning] Dyeing Finishing) Total @ Between Products Treatment Cost| 80 Emission of Harmful | 400ce | 300ce | 100ce | 800ce of Harmful Gas Gases (cc per week) Wastewater 100 Wastewater soar. | coor. | | 15o0r. ‘Treatment Generated (Itr. per Cost week) Cost Allocation toProcess Overhead [Amount] Allocation Basis |Tanning|Dyeing|Finishing] Total ()__| Between Products | (2) @ @ @ ‘Treatment Cost! 80 | Emission of Harmful | 40 30 10 80 of Harmful Gas Gases (cc per week) Wastewater 100 Wastewater 60 40 0 100 Treatment Generated (litres per Cost week) Table 4; Allocation of Treatment Cost to Product Qand R @ Overhead Tanning | Dyeing | Finishing | Total Treatment Cost of Harmful Gases 40 330 810 380 Cost Allocation % to Product Q 70% 50% 70% x Cost Allocation % to Product R 30% 50% 30% x Cost Allocation to Product Q 28 5 7 350 Cost Allocation to Product R %12 zs 3 330 Wastewater Treatment Cost 0 340 _ 2100 Cost Allocation % to Product Q 70% 50% 70% x Cost Allocation % to Product R 30% 50% 30% x Cost Allocation to Product Q a2 220 = 62 Cost Allocation to Product R 8 320 38 BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 451() (d@) Analysis of the difference in product profitab’ In the first method, general overhead costs are allocated to the products Q and R, rrespective of the environment costs that each product incurs. General overhead costs are to each product equally. The resultant product profitability shows that Product Q yields 5.32% and Product R yields 4.05% profitability. Therefore, the “QR" Ltd, would conclude that Product Qis more profitable. In the next method, general overhead costs are bifurcated to identify “hidden” environment costs that are incurred on account of manufacturing these products. Environment costs are first traced to the process that generates harmful gases and ‘wastewater, for which treatment is done. It can be seen that Tanning process, followed ‘by Dyeing and Finishing process generates the maximum amount of waste. Therefore, ‘by proportioning the cost based on the waste generated, more cost is allocated to ‘Tanning the process. Similarly, Dyeing and Finishing are allocated lesser cost since they do not generate as much waste. It is further given that 70% of the cost of Tanning Felates to Product Q. This is much higher than the 50% that was allocated to the Product as per the first method. Accordingly, the revised workings show that Product Q yields 1.77% and Product R yields 9.29% profitability. The reason being, Product Q generates more environment driven costs as compared to Produ ct R. “QR” Ltd. would therefore increase the selling price of Product Qif it wants tomaintain profitability as per the original method. However, the more sustainable approach would bbe find out ways of reducing wastewater and harmful gases the manufacturing process produces, This would in turn result in reduction of environment driven costs such as ‘wastewater treatment and treatment of harmful gases. This would sustain profits in the Jong run, Four Techniques for the identification and allocation of Environmental Costs Input-Output Analysis: This technique monitors the material input with the output that is produced. For example, if 100kg of material have been bought and input in the process resulting in 80kg output material, the 20kg must been accounted in some way. Some part of this may say 10% (2kgs) may have been sold as scrap while the remaining 90% (18kgs) of it may be waste. Possibly scrap can be reused therefore may have neutral environment impact. The company can then concentrate on minimizing waste generation. Flow Cost Accounting: This technique uses not only material flows but also the ‘organizational structure. Classic material flows are recorded as well as material losses incurred at various stages of production. Flow cost accounting makes material flows transparent. It tracks: @) quantities (physical data); (ii) costs (monetary data) and (iii) values = (quantities * costs). Material flows are divided into three categories: material, system, and delivery/disposal. (The material values and costs apply to the materials which are involved in the BY CA ATUL AGARWAL (AIR-1) AIRICA Career Institute (ACI) Page 452