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337_resource_9. Profitability

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									Cost management-final course                                                                           1

9.     Profitability analysis: product /segment / customer wise
       Profitability measurement is an integral part of any Management control system. It is a
       part of strategic planning and control.

       There are different profitability performance measurement tools.
       1. Return on investment (ROI) (Refer chapter 3);
       2. Residual income method (RI) = Residual income = Income –Required rate of return
           into investment;

       3.     Economic value added (EVA);
              It is a specific type of Residual income. It is computed as follow: -
              Economic value added = After tax operating income – {Weighted average cost of
              capital× (Total assets –Current liability)}

       4.     Return on sale = Profit ÷sale ×100

       5.     Application of Balance Scorecard
       6.     Benchmark and performance evaluation

Problem 1
      A company has developed a new product. The sales volume of the new product was estimated
      to be between 15,000 and 20,000 units per month at a price of Rs. 20 per unit. Alternatively, if
      the selling price is reduced to Rs. 18 per unit, the sales volume will be between 24,000 and
      36,000 unit per month. If the production is maintained below 20,00 units per month, the 36,000
      units per month. If the production is maintained below 20,000 units per month, the variable
      manufacturing cost will be Rs. 16.50 per unit and the fixed costs Rs. 48,500 per month. If the
      production exceeds 20,000 units per month, the variable manufacturing cost will be reduced To
      Rs. 15.50 per unit, but the fixed costs will be increase to Rs. 64,500 per month. The company
      paid Rs. 40,000 ad fee for market survey and in addition incurred a cost of Rs. 60,000 in
      developing the new product.

       In the event of taking up this new line of business, it will be necessary to use the building space,
       which has been let out for a rental of Rs. 5,600 per month.

       You are required to analyse the potential Profitability of the proposal of the company at
       different levels of output and make suitable recommendations relating to the price and
       volume of output to be set.

Solution
      Basic data :
      1. (i) Contribution per unit
                                                  Estimate of                  Estimate of
                                              Sales lies between            sales lies between
                                              15,000 – 20,000 units         24,000 – 26,000 units
              Selling price per unit (Rs.)              20.00                         18.00
              Less; Variable costs per unit (Rs.)       16.50                         15.50
              Contribution per unit                      3.50                          2.50

       (ii)   Total contribution :

              Units sold                 15,000         20,000         24,000        36,000
              Total contribution (Rs.) (A)52,500        70,000         60,000        90,000
              (Refer to w. note 1 (i)) (15,000 units(20,000 units(24,000 units (36,000 units
                                     x Rs. 3.50)     x Rs. 3.50) x Rs. 2.50)     x Rs. 2.50)
Cost management-final course                                                                           2

      2.   Total Fixed costs :

           Units sold                     15,000            20,000         24,000             36,000
           Manufacturing fixed cost (Rs.) 48,500            48,500         64,500             64,500

           Opportunity cost (Rs.)               5,600        5,600          5,600              5,600
           Total fixed cost (Rs.) : (B)        54,100       54,100         70,100             70,100

      3.   Profit / (loss) at different levels :
           profit / (loss) Rs. : { (A) -- (B) } (1,600)     15,900        (10,100)            19,900

      4.   Break – even point (units)         15,457       15457           28,040        28,040
           [Fixed cost / contribution per unit] (Rs. 54,100 / Rs. 3.50)         (Rs. 70,100 / Rs. 2.50 )

      5.   Margin of safety (units)              (457)      (4,543)        (4,040)             7,960
           Sales above BEP


      Potential profitability of the proposal of the company at different levels of output and
      suitable recommendations relating to the price and volume of output to be set

      1.   An analysis of basic data at different levels of output clearly shows that the minimum
           quantity (in units) required for achieving the break-even –point is 15,457.

      2.   Profit is Rs. 15,900 and Rs. 19,900 when 20,000 and 36,000 units are sold respectively. At
           15,000 and 24,000 units of sales the proposal will result into losses to the extent of Rs.
           1,600 and Rs. 10,100 respectively.

      3.   At 24,000 units the company incurs a loss of Rs. 10,100.To earn the same profit viz Rs.
           15,900 ; the number of units required to be sold are : 34,400 units (28,040 units + 6,360
           units)

           (Breakeven point units viz. 28,040 and 6,360 more units required to earn a profit of Rs.
           15,900 / Rs. 2.50 = 6,360 units)

      4.   After 20,000 units the company will earn the same profit only at a sale of 34,400 units.

      5.   Selling price of Rs. 20 is less riskier than selling price of Rs. 18. At Rs. 20 loss is only Rs.
           1,600 whereas at Rs. 18 the loss is Rs. 10,100.

      6.   At selling price of Rs. 20, BEP is only 3% above the minimum sales, whereas at selling price
           of Rs. 18 BEP is 17% above the minimum sales.

      7.   Selling price of Rs. 18, will yield higher profit provided sales are at maximum.

      8.   If sales can be stabilized at more than 34,400 units, the selling price can be set at Rs. 18.

      9.   Market survey fee and development costs, being sunk costs and are thus not relevant.
Cost management-final course                                                                            3

      The Balanced Scorecard
      Before 1980, management accounting control systems focus es mainly on financial
      measures of performance. The inclusion of only those items that could be expressed in
      monetary terms motivated managers to focus excessively on cost reduction and ignore
      other important variables like product quality, delivery, relia bility, after-sales service and
      customer satisfaction. These became key competitive variables, but not of these were
      measured by the traditional management accounting performance measurement system.

      The Balanced scorecard helps top management evaluate whether lower – level managers have
      improved one area at the expense of others. For example, a manager at risk of not meeting
      operating profit goals may start to ship high – margin products and delay deliveries of low –
      margin products.      The balanced scorecard will recognize the improvement in financial
      performance but will also reveal that operating profit targets were achieved by sacrificing on –
      time performance. Four perspectives are typically integrated in a balanced scorecard :

      1.   Customer perspective: The balance scorecard builds on established competitive strategies,
           such as customer orientation, short response times, total quality and teamwork. Many
           organizations already see themselves as customer oriented. However, the customer
           perspective of the balanced scorecard requires customers themselves to identify a set of
           goals and measures on factors which really matter to them. Performance measures such
           as time, cost, quality, performance and service should be developed by groups of managers
           working with customers to understand their primary requirements.

      2.   Internal perspective: The organisation must excel at certain internal processes, decisions
           and actions if it is to meet these customer requirements. The internal perspective must
           reflect the organization’s core skills and the critical technology involved in adding value to
           the customer’s business. The organization’s overall goals have to be broken down into unit,
           departmental or workgroup measures which are influenced by employee actions. Clearly,
           this is a part of the same movement towards business processes which is being followed by
           activity – based costing and activity – based management.

      3.   Innovation & learning: So far, the customer and internal perspectives will have focused on
           the organization’s current competitive position. The innovation and learning perspective is
           required in order to recognize that this is constantly seek to learn, to innovate and to
           improve every aspect of the organisation and its business just to maintain their competitive
           situation, let alone to improve in the future.

      4.   Financial perspective: The financial perspective covers traditional measures such as growth,
           profitability and shareholder value but are set through talking to the shareholders(s) direct.
           The customer, internal and innovation and learning perspectives, if correctly implement4ed,
           will not automatically result in financial improvement if the overall corporate strategy is not a
           fundamentally profitable one. The financial perspective looks at whether is resulting in
           bottom line financial improvement.

      Only by combining, measuring and thinking in terms of all four perspectives can managers
      prevent improvements being made in one area at the expenses of another.   The    balanced
      scorecard forces managers to think in terms of those fundamental competitive issues which
      impact upon long – term, rather than short – term, profitability.
Cost management-final course                                                                   4

                                   The Balance Scorecard



                                       Financial perspective
                                      Goals      Measures



                                                                      Internal business
                                                 Vision                  prespective
         Customer perspective                     and
        Goals     Measures                      strategy            Goals      Measures




                                            Learning and
                                         growth perspective
                                         Goals    Measures




      Process of creating a Balance Score Card:

      The diagram given below shows a process to create a balance Score card. This diagram also
                                    Can create a balance score and
      depicts various steps involved to we continue to improve card:
                                            create values ?
      1. To identify a vision i.e. where an organization is going.
      2. To identify organization’s strategies i.e. how an organization is planning to go there.
      3. Define critical success factors and perspectives i.e. what we have to do well in each
         perspective.
      1. Identify measures which will ensure that everything is going in the expected way.
      2. Evaluation of Balance Score Card i.e. ensuring what we are measuring is right.
      3. Create action plans and plan reporting of the Balance Score Card.
      4. Following up and Manage i.e. which person should have reports and what reports should look
         like.
Cost management-final course                                                                        5
                                         Identify vision




                                          Identify Strategies




                            Identify Critical Success factors & perspectives




                                           Identify measures




                                                Evaluate




                                            Create action plan




                                           Follow up and manage


      Although the process to create balance Score cards is the same for all organization. However,
      each organization must decide what are its critical success factors and what are its performance
      measures. The choice will vary over time and should be linked to the strategy that organization is
      following.

      Consider the company is compute hardware business intend to create balance score card. The
      various steps involved will be as follows:

      1. To identify vision: The vision of Company is say to dominate the market.

      2. To identify the strategy: The strategy is to focus on cost efficiency, high quality and fresh
         investment in new technology.

      3. To identify the critical success factors and perspectives: A set of goals is known as critical
         success factor and performance measures for each perspective may be as follows:
Cost management-final course                                                                      6

      1. Customer Perspective

          Goals                          Performance Measures

          Price                          Competitive price

          Delivery                       Number of on time delivery, lead time from receipt of order
                                         to delivery to customers.

          Quality                        Own quality relative to industry standards, numbers of
                                         defects or defect level.

          Support                        Response time, customer satisfaction surveys.


      2. Internal business Perspective

          Goals                          Performance Measures

          Efficiency of
          Manufacturing process          manufacturing cycle time

          Sales penetration              Annual sales vs. plan sales, increases in number of
                                         customers in a unit of time.

          New product Introduction       Rate of new product introduction/quarter

      3. Innovation and learning perspective

          Goals                          Performance Measures

          Technology leadership          Product performance compared to competitors, number of
                                         new products with patented technology.

          Cost leadership                Manufacturing overhead per quarter as a percentage of
                                         sales rate of decrease in cost of quality per quarter.

          Market leadership              Market share in all major markets

          Research & development         Number of new products, numbers of patents.

      4. Financial Perspective

          Goals                          Performance Measures

          Sales                          Revenue and profit growth

          Cost of sales                  Extent it remain fixed or decreased each year.

          Profitability                  Return on capital employed

          Prosperity                     Cash flow

      Once the goals and measures for each perspective are established the next step is to create
      action plans for achieving defined targets.
Cost management-final course                                                                            7

       Implementation of Balance Score Card in the organization:

       Developing a balance score card involves a process as discussed above. Once the overall
       business process is identified, along with it goals it will be possible to identify the performance
       measures which are essential to compete successfully in today’s competitive environment.
       Although Balance Score Card relates to a set of measures for the business as a whole but it is
       also important that they are cascaded down the organization by creating lower level score card
       for individual units that make up the organization. Individual measures for the various functions
       and departments need to be established that they enhance the visibility of their contribution to
       higher level score card measures. Ideally, the linkage should be so established the employees at
       lower levels in the organization have clear targets for actions and decisions that will contribute to
       the company overall objectives.

BALANCE SCORECARD: Variance analysis

1.     Growth Component:

       (a) Revenue effect = (Actual Output sold – Budgeted Output sold) Bud. Price/ unit

       (b) Cost effect = (Budgeted Input –Budget Input for Actual Output) Budgeted rate

       Note : In case items of fixed cost nature , Budgeted Input for Actual Output = The Budget
       input.


2.     Price Recovery Component:

       (a) Rev. effect = (Actual Price –Budgeted Price) Actual Output sold

       (b) Cost effect = (Budgeted Rate –Actual Rate) Budgeted Input for Actual Output



3.     Productivity Component =(Bud. Input for Actual Output- Actual Input) Actual Rate

       Note: Actual profit = budgeted profit + adjustment of the above 3 items

Problem 2
      Following a strategy of product differentiation, Philis Corporation makes a chip product. The data
      for 2005 & 2006 are as follows:

                                                         2005                         2006
       1. Units produced & sold                         40,000                      42,000
       2. Selling price                                Rs. 100                     Rs. 110
       3. Direct Materials (Sq. feet)                 1,20,000                    1,23,000
       4. Direct material costs per Sq. foot            Rs. 10                       Rs. 11
       5. Manufacturing capacity for KE8 (units)        50,000                      50,000
       6. Conversion costs (Rs.)                    10,00,000                    11,00,000
       7. Conversion costs per unit of capacity (Rs.)       20                           22
       8. Selling and customer service capacity 30 customer                   29 customers
       9. Selling & customer service costs (Rs.)      7,20,000                    7,25,000
       10. Cost per customer of selling & customer
           Service capacity (Rs.)                       24,000                       25,000


       Philis Corporation produced no defective units and reduced direct material usage per unit in
       2006. Conversion costs in each year are tied to manufacturing capacity. Selling & customer-
Cost management-final course                                                                           8

      service costs are related to the number of customers that the selling & service functions are
      designed to support.

      Describe briefly the elements you would include in Balance Scorecard.

Solution
                            Operating income for each year

                                                                        2002               2003
                                                                         Rs.                Rs.
      Revenues (Rs. 100 per unit40,000 units;
      Rs. 110 per unit42,000 units)                                 40,00,000       46,20,000
      Costs
      Direct material costs (Rs. 10 per sq. ft 1,20,000 sq. ft.;
      Rs. 11 per sq. ft.1,23,000 sq. ft.)                           12,00,000       13,53,000
      Conversion costs (Rs. 20 per unit50,000 units;
      Rs. 22 per unit50,000 units)                                  10,00,000       11,00,000
      Selling & customer-service costs (Rs. 24,000 per
      Customer30 customers; Rs. 25,000 per customer
      29 customers)                                              ____7,20,000         7,25,000
      Total costs                                                ___29,20,000        31,78,000
      Operating income                                           Rs. 10,80,000   Rs. 14,42,000


      1. Growth Component:

      (a) Revenue effect = (Actual Output sold – Budgeted Output sold) Bud. Price/ unit
                     = (42,000 units – 40,000 units)  Rs. 100 per unit
                     = Rs. 2,00,000 F

      (b) Cost effect = (Budgeted Input –Budget Input for Actual Output) Budgeted rate
         Direct material cost   (1,20,000 sq. ft –1,26,000 sq. ft) Rs. 10 per sq. ft. = Rs. 60,000 U
         Conversion costs       (50,000 units –50,000 units)Rs. 20 per unit =                    0
         Selling & customer
         service cost           (30 customer–30 customer)Rs. 25,000 per customer =               0


      Revenue effect of the growth component                   Rs. 2,00,000 F
      Cost effect of the growth component                       Rs. 60,000 U
      Increase in operating income due to the growth component Rs. 1,40,000 F


   2. Price Recovery Component:

      (c)   Rev. effect = (Actual Price –Budgeted Price) Actual Output sold
                              = (Rs. 110 per unit –Rs. 100 per unit) 42,000 units
                              = Rs. 4,20,000 F

      (d) Cost effect = (Budgeted Rate –Actual Rate) Budgeted Input for Actual Output

      Direct material costs (Rs. 10 per sq. ft. –Rs. 11 per sq. ft.)1,26,000 sq. ft. = Rs. 1,26,000   U
      Conversion costs        (Rs. 20 per unit-Rs. 22 per unit)50,000 units =              1,00,000   U
      Selling &
      Customer-service cost (Rs. 23,000 per cust.-Rs. 24,000 per cust.)30 customers          30,000   U
      Total cost effect of the price-recovery component                                 Rs. 2,56,000   U
Cost management-final course                                                                       9

      Revenue effect of the price-recovery component                             Rs. 4,20,000 F
      Cost effect of the price-recovery component                                    2,56,000 U
      Increase in operating income due to the price-recovery component           Rs. 1,64,000 F


3.    Productivity Component =(Bud. Input for Actual Output- Actual Input) Actual Rate


      Direct material costs     (1,26,000 sq. ft. –1,23,000 sq. ft.)Rs. 11 per sq. ft = Rs. 33,000 F
      Conversion costs          (50,000 units –50,000 units)Rs. 20 per unit =                    0
      Selling & customer
      Service costs             (30 customer-29 per customer)Rs. 25,000 customer =          25,000 F
      Increase in operating income due to the productivity component                     Rs. 58,000 F



           Change in operating income = Rs. 3,62,000 F= the difference in operating income


      Benchmarking:
      Types of Benchmarking

      The Benchmarking is a versatile tool that can be applied in a variety of ways to meet a range of
      requirements. The distinct types of benchmarks have been evolved over a period of time. Each
      has its own benefits and shortcomings and therefore each one is appropriate in certain
      circumstances then others. The Benchmarking is of following types:

          1.   Competitive benchmarking
          2.   Strategic benchmarking
          3.   Global benchmarking
          4.   Process Benchmarking
          5.   Functional Benchmarking or Generic Benchmarking
          6.   Internal Benchmarking
          7.   External Benchmarking

      Now, we shall discuss each of these types of benchmarking.

1.    Competitive Benchmarking: it involves the comparison of competitors products, processes and
      business results with own. Benchmarking partners are drawn from the same sector. However, to
      protect confidentiality it is common for the companies to undertake this type of benchmarking
      through trade associations or third parties.


2.    Strategic Benchmarking: It is similar to the process benchmarking in nature but differs in its
      scope and depth. It involves a systematic process by which a company seeks to improve their
      overall performance by examining the long term strategies. It involves comparing high level
      aspects such as developing new products and services, core competences etc.

3.    Global benchmarking: It is benchmarking through which distinction in international culture,
      business processes and trade practices across companies are bridged and their ramification for
      business process improvement are understood and utilized. Globalization and advances in
      information technology leads to use this type of benchmarking.
Cost management-final course                                                                         10

4.    Process benchmarking: It involves the comparison of an organization critical business
      processes and operations against best practice organization that performs similar work on deliver
      similar services. For example, how do best practice organizations process customers orders.

5.    Functional benchmarking: This type of benchmarking is used when orgnaisational look to
      benchmark with partners drawn from different business sectors or areas of activity to find ways of
      improving similar functions or work processes. This sort of benchmarking can lead to innovation
      and dramatic improvements.

6.    Internal benchmarking: Involves seeking partners from within the same organization, for
      example, from business units located in different areas. The main advantages of internal
      benchmarking area that access to sensitive data and information are easier, standardized data is
      often readily available and usually less time and resources are needed. There may be fewer
      barriers to implementation as practices may be relatively easy to transfer across the same
      oraganisation. However, real innovation may be lacking and best in class performance is more
      likely to be found through external benchmarking.

7.    External Benchmarking: involves seeking help of outside organizations that are known to be
      best in class. External benchmarking provides opportunities of learning from those who are at the
      leading edge, although it must be remembered that not every best practice solution can be
      transferred to others. In addition, this type of benchmarking may take up more time and resource
      to ensure the comparability of data and information, the credibility of the findings and the
      development of sound recommendations.

      The benchmarking can be categorised into:

          i)   Intra-Group Benchmarking: In intra group benchmarking the groups of companies in
               the same industry agree that similar units within the co-operating companies will pool
               data on their process. The processes are benchmarked against each other at or
               operational level. ‘Improvement task forces’ are established to identify and transfer best
               practice to all members of the group.

          ii) Inter-industry benchmarking: In inter-industry benchmarking a non-competing business
              with similar process is identified and asked to participate in a benchmarking exercise. For
              example, a publisher of school book may approach a publisher of university level books
              to establish a benchmarking relationship. Although two publishers are not in direct
              competition but there are obviously many similarities in their business with respect to
              sources of supply, distribution channels. Each will be able to benefit from the experience
              of the other and establish ‘best practices’ in their common business processes.

      Goals of benchmarking: Benchmarking can deliver significant performance improvements and
      returns based on efficiency, cost savings and new revenues. Benchmarking projects typically
      target cycle times, productivity, customer service, quality and production costs, They also can be
      part of an effort to shift culture of a company to be more customer oriented and results focused.

      Process of benchmarking: The process of benchmarking requires a Company to identify the
      areas i.e. processes, activity etc. which are central to its business and then selects the top-
      performing companies in those areas. By analyzing how that excellence in achieved, the
      company learns lessons to apply to its own processes.

      The benchmarking process is comprised of following stages. These stages are:

1.    Planning:

      i) Determination of benchmarking goal statement: This requires identification of areas to be
      benchmarked. In practice, one should start with the identification of those areas which have to be
      really good to be really successful. One should start with the areas which account for most of the
Cost management-final course                                                                            11

      expenditure or which tie up the most of cash. One should remember that one cannot benchmark
      own performance until one have reliable and efficient systems of measurement in its own
      organization. This applies irrespective of whether our benchmarking partners are internal or
      external, in parallel or in totally different business sectors. For identification of areas to be
      benchmarked the following criterias are used:

      1. What would make the most significant improvements in our relationship with our customers.

      2. What would make the most significant improvements to our bottom-line.

      Benchmarks important for customer satisfaction may include:

          a)   Consistency of product or service
          b)   Process cycle time
          c)   Delivery performance
          d)   Responsiveness to customer requirements
          e)   Adaptability to special needs.

      Benchmarks important for direct impact on the bottom-line may include:
         a) Waste and reject levels.
         b) Inventory levels.
         c) Work-in-progress
         d) Cost of sales.
         e) Sales per employee.

      ii) Identification of best performance: Once the benchmarked goal statements are defined,
      the next step is seeking the best of the breed of the best. Since practically to arrive at the best is
      both expensive and time consuming therefore it is better to identify company which ahs recorded
      performance success in a similar area.

      iii) Establishment of the benchmarking or process improvement team: Ideally this should
      include the persons who are most knowledgeable about the internal operations and will be
      directly affected by changes due to benchmarking.

      iv) Defining the relevant benchmarking measurement: Relevant measures will not include
      the measures used by the organization today but they will be refined measures that comprehend
      the true performance differences. Developing good measurement is key to successful
      benchmarking.

2.    Collection of data & Information:

      The data gathering for benchmarking could be done through national/internal clearing houses,
      mail surveys, suppliers, company visits, telephone, interviews etc. In recent years national and
      international clearing houses have been set up.

      The collection of data and information involves following steps:

      1. Compile information and data on performance. They may include mapping processes.

      2. Select and contact partners.

      3. Develop with partners, a mutual understanding about the procedures to be followed and, if
         necessary, prepare a Benchmarking Protocol.

      4. Prepare questions & agree terminology & performance measures to be used.

      5. Distribute schedule of questions to each partner.
Cost management-final course                                                                       12


      6. Undertake information and data collection by chosen method for example, interviews, site-
         visits, telephone, fax and e-mail.
      7. Collect the findings to enable analysis.

3.    Analysing the findings:

      The analysing of finding of steps (2) requires following:
      1. Review the finds and produce tables, charts and graphs to support the analysis.

      2. Identify gaps in performance between our organisation and better performers.

      3. Seek explanations for the gaps in performance. The performance gaps can be positive,
         negative of zero.
      4. Ensure that comparisons are meaningful and credible.

      5. Communicate the findings to those who are affected.

      7. Identify realistic opportunities for improvements. The negative performance gap indicates an
         undesirable competitive position and provide a basis for performance improvement. If there is
         no gap it may indicate a neutral position relative to the performance being benchmarked. The
         zero position should be analyzed for identifying means to transform its performance to a level
         of superiority or positive gap.

4.    Recommendations:

      This involves: Making recommendation: This requires
      1. Deciding the feasibility of making the improvements in the light of the conditions that apply
         within own organisation.

      2. Agreement on the improvements that are likely to be feasible.

      3. Producing a report on the Benchmarking in which the recommendations are included.

      4. Obtaining the support of key stakeholder groups for making the changes needed.

      5. Developing action plan(s) for implementation.

      Implementing recommendations:
      1. Implement the action plans

      2. Monitor performance

      3. Reward and communicate successes.

      4. Keep key stakeholders informed of progress.

5.    Monitoring & reviewing:

      This involves:
      1. Evaluating the benchmarking process undertaken and the results of the improvements
         against objectives and success criteria plus overall efficiency and effectiveness.

      2. Documenting the lesions learnt and make them available to others.

      3. Periodically re-considering the benchmarks for continuous improvement.
Cost management-final course                                                                            13

      Pre-requisites for successful benchmarking:

      Irrespective of the type and scope of benchmarking, it will be important to ensure that:
      i)    Senior managers support benchmarking and are committed to continuous improvements;

      ii)     The objectives are clearly defined at the outset;

      iii)    The scope of the work is appropriate in the light of the objectives, resources, time available
              and the experience level of those involved;

      iv)     Sufficient resources are available to complete projects within the required time scale;

      v)      Benchmarking teams have clear picture of their organization’s performance before
              approaching others for comparisons;
      vi)     Benchmarking teams have the right skills and competencies;

      vii)    Stakeholders, particularly staff and their representatives, are kept informed of the reasons
              for benchmarking.

      Difficulties in implementation of Benchmarking:

      1.      Benchmarking is a time consuming and at time difficult. It has significant requirement of
              staff time and company resources.

      2.      Benchmarking implementation requires the direct involvement of the senior manager etc.
              The drive to be best in the industry or world cannot be delegated.

      3.      It is likely that there is resistance from employees.

      4.      Companies can become preoccupied with the measures. The goal becomes not to improve
              process but to match the best practices at any cost.

      5.      The key element in benchmarking is the adaptation of a best practice to tailor it to a
              company’s needs and culture. Without the step, a company merely adopts another
              company’s process. This approach condemns benchmarking to fail.

      6.      Companies often waste time in benchmarking non-critical functions.

      Benchmarking code of conduct:

      Benchmarking-the process of identifying and learning from the best practices anywhere in the
      world-is a powerful tool for continuous improvement. To contribute to efficient, effective, and
      ethical benchmarking, individuals agree for themselves and their organisation to be abide by the
      following principles for benchmarking with other organizations:

      The following is a suggested Benchmarking code of conduct:
         1. Principle of Legality: Avoid discussion or actions that might lead to or imply an interest
              in restraint of trade: market or customer allocation schemes, price fixing, dealing
              arrangements, bid rigging, bribery or misappropriation. Do not discuss costs with
              competitors if costs are an element of pricing.

             2. Principles of Exchange: Be willing to provide the same level of information that you
                request, in any benchmarking exchange.

             3. Principle of Confidentiality: Treat benchmarking interchange as something confidential
                to the individuals and organizations involved. Information obtained must not be
                communicated outside the partnering organizations without prior consist of participating
Cost management-final course                                                                         14

             benchmarking partners. An organization’s participation in a study should not be
             communicated externally without their permission.

          4. Principle of Use: Use information obtained through benchmarking partnering only for the
             purpose of improvement of operations within the partnering companies themselves.
             External use or communication of a benchmarking partner’s name with their data of
             observed practices requires permissions of that partner. Do not, as a consultant or client,
             extend one company’s benchmarking study findings to another without the first
             company’s permission.

          5. Principle of First party Contact: Initiate contacts, whenever possible, though a
             benchmarking contact designated by the partner company. Obtain mutual agreement with
             the contact of any hand off of communication or responsibility to other parties.

          6. Principle of Third party contact: Obtain an individual’s permission before providing their
             name in response to a contact request.

          7. Principle of Preparation: Demonstrate commitment to the efficiency and effectiveness
             of the benchmarking process with adequate preparation at each process step;
             particularly, at initial partnering contact.

      Key measures of theory of constraints: The theory of constraints focuses on revenue and cost
      management when faced with bottlenecks. It advocates the use of three key measures. These
      are:
      1. Throughput contribution: it is the rate at which the system generates profits through sales.
          It is defined as:

          Sales revenues less completely variable costs. This is usually sales revenue-Direct material
          cost (Labour costs tend to be partially fixed and are excluded normally. Direct material cost
          included purchased components and material handling costs.)

      2. Investments (Inventory): This is equal to the sum of material costs of direct materials
         inventory, WIP and Finished goods inventory; research and development costs and the costs
         of equipment and buildings.

      3. Other operating costs: The other operating costs equal to all operating costs (other than
         direct materials) incurred to earn throughput contribution. Other operating cost includes
         salaries and wages, rent utilities and depreciation.

      Steps in managing bottleneck resources: The theory of constraints describes the process of
      identifying and taking steps to remove the bottlenecks that restrict output. The theory of
      constraints considers short-run time horizons and assumes other current operating costing to be
      fixed costs. They key steps in managing bottleneck resources are as follows:

      1. Identifying the system bottlenecks: This step involves identification of constraints which
         restrict output from being expanded.

      2. Describe how to exploit the bottlenecks: Having identified the bottlenecks it becomes the
         focus of attention since only the bottleneck can restrict or enhance the flow of products. It is
         therefore essential to ensure that the bottleneck activity is fully utilized. Decision regarding
         the optimum-mix of products to be produced by the bottleneck activity must be made.

      3. Subordinate everything else to the decision in Step-2: This step requires that the
         optimum production of bottleneck activity should determine the production schedule of the
         non-bottleneck activities. Let us consider an organisation dealing with a product which
         requires multiple parts and processed on different machines. With multiple parts in a product,
Cost management-final course                                                                         15

          dependencies arise among operations; some operations cannot be started until parts from
          previous operations are available. Waiting time appear for two reasons:

          1. Parts that require processing at a bottleneck machine must wait in line until the bottleneck
             machine is free, and

          2. Parts made on non-bottleneck machines must wait until parts coming off the bottleneck
             machines arrive.

          Therefore, the workers of non-bottleneck machine should not be motivated to improve their
          productivity if the additional output cannot be processed by bottleneck machine. Producing
          more non-bottleneck output results in increase in WIP inventories and non increase in sales
          volume. Therefore, the preferred course of action is that bottleneck machine should setup
          pace for non-bottleneck machine.

      4. Elevate the system bottlenecks or increase bottleneck efficiency & capacity: This step
         involves either (i) taking action to remove (that is elevate) the bottleneck. This might involve
         replacing a bottleneck machine with a faster one. If the bottleneck activity has been replaced
         by a new bottleneck activity it is necessary to return to step 1 and repeat the process. Or (ii)
         take actions to increase bottleneck efficiency and capacity. The objective is to increase
         throughput contribution minus the incremental costs of taking such actions. This might involve
         providing additional training for a slow worker or changing of the design of the product to
         reduced the processing time required by a bottleneck activity.

          The main aim of performing all the aforesaid steps is to increase throughput contribution. The
          traditional technique such as linear programming for allocating the optimum use of bottleneck
          resources and the use of shadow prices for decision making and a various analysis can be
          viewed as an attempt to apply TOC ideas. Thus, theory of constraint attempts to do the
          following:

             Maximum throughput contribution (Sales revenue-Direct materials)

             Subject to:
             Production capacity (supply constraints)
             Production demand (demand constraints)

BENCH MARK : VARIANCE ANALYSIS :

Problem 3
      The performance of two companies in 2005:
                                                   X & Co.               Y & Co.
           Output (units)                             600                 1,000
           Material consume (Kg.)                   1,200                 2,100
           Rate per kg. (Rs.)                           8                   8.50

      The actual performance for 2005 were:
                                                  X & Co.                Y & Co.
           Output (units)                             680                    950
           Material consumed (Kg.)                  1,400                  1,860
           Rate per kg. (Rs.)                           9                      9

      Material price was increased by 12% due to International Shortage of material.
      (i) Identify the Benchmark for 2005
      (ii) Analyse the performance of 2005
      (iii) Find Benchmark for 2006.
Cost management-final course                                                                           16


Solution
       Analysis the performance of 2004 for Benchmark in 2005.

                                                          X & Co.                Y & Co.
      Material consumption ratio                     (1,200÷ 800)         (2,100 1,000)
                                                       = 2 kg./unit         =2.1 kg./unit
      Material price                                             8                   8.5

       Benchmark is 2 kg. per unit @ Rs 8/kg.as it is the best performance among the companies

      Material price increase due international effect.

      Revised Benchmark for 2005.
      2 kg./unit @ 8.96/kg. (due to external uncontrollable result)

      Analysis the performance of 2005
                                                          X & Co.                Y & Co.
      Material consumption                            (1,400680)            (1,860950)
                                                            = 2.06                 = 1.96

      Rate                                                       9                      9

      Revised the consumption Benchmark for 2 kg./unit to 1.96 kg./unit.
      However Benchmark for price will remain same i.e. 0.96 /kg.

General problems on Profitability

Problem 4
      Assog Ltd. manufactures two products, data for which for the year 2005 are as under :-

                                                Rs.
       Sales : Product ‘A’ 25,000 units @    300 each
           Product ‘B’ 50,000 units @        150 each
       Costs : Direct materials              36,00,000
           Direct Labour                     27,00,000
           Factory overheads                 54,00,000      (50% variable)
       Selling & Adm. Overheads              12,00,000      (50% fixed)

       While the direct labour content in Product ‘A’ and Product ‘B’ is 2 : 1, the direct material content
       in these two products respectively is 1 : 2.

       Due to waning off life cycle of Product ‘A’ the Company has developed Product C for marketing
       in the year 2006. The production of product A in the year 2006 will be restricted to half that of
       2005 and the labour time so spareb will be utilised for the manufacture of 20,000 units of Product
       ‘C’ whose particulars are as under .

                                               Rs.
       Direct materials                      45 per unit
       Direct labour                         45 per unit

       Variable factory overheads will according will according to the Company’s existing procedure, be
       charged as a percentage on direct wages.

       Variable selling and administration overheads Rs.12.50 per unit.

       Selling price Rs.250 per unit but an introductory discount of 5% is allowed on sales in 2006.
Cost management-final course                                                                                   17


       The fixed overheads both of factory and selling and administration will increase by 5% in2006.
       Research and Development expenditure allocable to 1982 costs is Rs.4,35,000. There is no
       change in the wage rates in 2006.

       You are required to :

       (.i) Prepare statements showing the profitability for 2005 and 2006; and
       (ii) Comment on the risk involved in the introduction of the new Product ‘C’ in 2006 as compared
               to the performance in 2005.


Solution
(i)                               Statement of Profitability for 2005
       Particulars                                     A                       B                       Total
       Sales units                                  25,000                50,000
       Selling price: Rs. Per unit                     300                   150
                                                                   (Rs. In lakhs)
       Sales value                                    75.00                 75.00                   150.00
       Direct materials 1:2                           12.00                 24.00                    36.00
       Direct Labour 2:1                              18.00                  9.00                    27.00
       Variable Factory overheads Rs. 27 lakhs
       Charged as a percentage on Direct wages        18.00                  9.00                     27.00

       Variable selling and Admn. Overheads
       Rs. 6,00,000 charged on the basis of
       Sales value                                        3.00                  3.00                   6.00
       Total variable cost                               51.00                 45.00                  96.00
       Contribution (S – V) =                            24.00                 30.00                  54.00
       Less: Fixed overheads: factory
       Rs. Lakhs + selling Admn. Overheads
       Rs. 6 lakhs                                                                                    33.00
       Profit                                                                                         21.00
                     C                  54
       P/V ratio = ------- x 100 = ---------- x 100 = 36%
                     S                 150
                     F            Rs. 33 lakhs
       BEP = ----------------- = ------------------------- = Rs. 91.67 lakhs and margin of safety Rs. 58.33 lakhs
              P/V ratio                 36%

                                  Statement of Profitability for 2006
       Particulars                                   A                 B                   C             Total
       Sales – units                              12,500          50,000               20,000
       Selling price – Rs. Per unit              ___300              150               237.50
                                                           (Rs. In lakhs)
       sales value                                 37.50            75.00               47.50         160.00
       Direct materials                             6.00            24.00                9.00          39.00
       Direct Labour                                9.00             9.00                9.00          27.00
       Variable Factory overheads                   9.00             9.00                9.00          27.00
       Variable selling and Admn. Overheads         1.50             3.00                2.50           7.00
       Total variable cost                         25.50            45.00               29.50         100.00
       Contribution                                12.00            30.00               18.00          60.00
       Fixed overheads:                                                                                33.00
       Increase 5%                                                                                      1.65
       R & D exp.                                                                                       4.35
                                                                                                       39.00
       Profit                                                                                          21.00
Cost management-final course                                                                            18


                     C                60.00
       P/V ratio = ------ x 100 = ---------------- x 100 = 37.5%
                     S                 160.00
                          F           39.00
       BEP = -------------------- = --------------- = Rs. 104 lakhs
                  P/V ratio             37.5%
       Margin of safety = 160 – 104 = Rs. 56 lakhs

(ii)   Risk:
       On introduction of Product C fixed expenditure ahs increased mainly on account of R & D
       expenses and this has increased Break – even point from Rs. 91.67 lakhs to Rs. 104 lakhs. At a
       later stage, sale of product ‘C’ may be affected by withdrawing the introductory discount and then
       profitability will improve from Rs. 21 lakhs, which is at present equivalent to the performance in
       2005. Hence the introduction of product ‘C’ is recommended.

Problem 5.

       A manufacturing unit is producing 15,000 containers per annum. There is good demand in local
       as well as export market. The unit is thinking of replacing the present production machine by an
       automatic machine. Due to this change, the production will be doubled. The present selling
       price of each container is Rs.20.

       The new machine will be operated by one labour while the present machine is operated by two
       operators. Value of the new machine is Rs.4,00,000 with no scrap value . The old machine has
       book value of Rs.1,60,000 and has scrap value of Rs.10,000. The unit is charging 10 per cent
       depreciation. The cost structure of containers is as follows :

       Direct Material                           6.00
       Direct Labour                             4.00
       Variable Overheads                        2.00
       Fixed Overheads
       (including Depreciation)                  2.00

       After the new machine is commissioned there will be an increase in fixed overheads (excluding
       depreciation) by Rs.15,000 p.a.

       (a) Calculate present and future profitability assuming no change in selling price.
       (b) (i)     In case the local market demand falls and the new machine is having 80 per cent idle
                   capacity, will it be feasible to offer the product in export market at a selling price of
                   Rs.10.50 per unit ?
           (ii)    Will your recommendation differ if the export price is Rs.9.50 per container as against
                   Rs.10.50 ?

Answer

(a)                                                     Profitability
       Product & sales – units                                 Present                       Future
                                                               15,000                         30,000
                                                                           (Rs, in lakhs)
       Sales value                                               3.00                          6.00
       Direct materials                                          0.90                          1.80
       Direct Labour                                             0.60                          0.60
                                                                                 (one operator only)
       Variable overheads                                        0.30                          0.60
       Fixed overheads excluding depreciation                    0.15                          0.15
       (see note below)
       Depreciation                                              0.15                           0.40
Cost management-final course                                                                                19

         Increase in fixed overheads                               ---                              0.15

         Total cost (15,000 x 14) =                              2.10                              3.70
         Profit                                                  0.90                              2.30
                                                                                                    Rs.
         Note: Fixed overheads including Dep. 15,000 x 2.00 =                                    30,000
         Less: Depreciation 1,60,000 – 10,000 Scrap
         = 1,50,000 x 10% =                                                                      15,000
         Fixed overheads excluding Dep.                                                          15,000

                                                          Rs. Per unit
(b)(i)   Direct Materials                                        6.00
         Direct Labour                                           2.00                    (one operator)
         Variable overhead                                       2.00
         Variable cost                                         10.00
         Export selling price                                  10.50
         Variable cost                                         10.00
         Contribution                                            0.50

         Hence it is feasible:
         Note: Profitability             Local Market                    Export                    Total
               Capacity                           20%                      80%                    100%
               Units                             6,000                   24,000                  30,000
                                                   Rs.                      Rs.                     Rs.
         Contribution per unit 20 – 10 =         10.00                     0.50
         Total Contribution                     60,000                   12,000                  72,000
         Fixed overheads
         (15,000 + 40,000 + 15,000)             70,000                       ---                 70,000
         Profit                             (-) 10,000                   12,000                   2,000

(ii)     If the export Price is Rs. 9.50 per container:

         This will not meet even the variable cost of Rs. 10 per unit. Export sale will cause a loss of Rs.
         12,000 in addition to the loss in the local market to the extent of Rs. 10,000. Then the total loss
         will be Rs. 22,000 hence it is not recommended to export at Rs. 9.50 container.

Problem 6

         Megatron Ltd. Had entered into a collaboration agreement with Kozuki of Japan for import of T.V.
         kits in completely knocked down (CKD) condition. The terms of agreement are as under:

         (a)   Megatron will import 40% items by value (in terms of FOB price of complete TV set) and
               balance 60% will be locally manufactured/purchased.

         (b)   For all non – standard items which are to be produced locally, Kozuki will provide drawings.

         (c)   Megatron will pay a lump sum of Rs. 30 lakhs for supply of technical know – how and
               drawings.

         (d)   Megatron will also pay a royalty at 10% of selling price fixed by it for sale in the local market
               less landed cost of imported kit, less cost of standard items purchased locally.

         (e)   Megatron will send a six monthly return to Kozuki showing No. of sets sold, sale value,
               standard components costs, landed cost of CKD etc.
Cost management-final course                                                                        20

      Considering the above terms and additional information given below, calculate the selling price
      that should be fixed for local sale so as to get 20% profit on selling price as part profitability
      improvement scheme.
.
      (i)    Agreement expires on production of 3 lakhs sets.
      (ii)   FOB price quoted is 1,20,000 yen.
      (iii)  Insurance and freight is Rs. 200 per CKD.
      (iv)   Customs duty at 140% of CIF price. However, effective rate of duty is only 40% as per
             Govt. notification.
      (v) Estimated cost of 60% items to be manufactured/ produced locally, will be 1.5 times as
             compared to cost of manufacture by Kozuki. The quoted by Kozuki contains 20% margin
             on cost.
      (vi) The ratio of standard and non – standard parts is 2:3 (in terms of rupee value).
      (vii) Assembling and other overhead costs will be Rs. 1,000 per set.
      (viii) Exchange rate is Rs. 5 per 100 yen.

Answer
     (1)      FOB price quoted in yen                                                 1,20,000
     (2)      FOB price in Rs.( @ 1 RE = 20 yen)                                         6,000
     (3)      Landed cost of CKD:                                                          Rs.
              FOB price of CKD – (40% of 6,000 as per (a))                               2,400
              Freight and insurance                                                    ___200
              CIF price of CKD                                                           2,600
              Customs duty at 40%                                                      __1,040
              Landed cost                                                              __3,640

      (4)  Cost of local purchase /manufacture:                                            Rs.
           60% of FOB price (i.e., 60% of 6,000 as per (b))                              3,600
           Less: profit of Kozuki of 20% on cost or 16.67% on sale                    ____600
           Cost of manufacture by Kozuki                                                 3,000
           Additional local cost 50% (i.e. 1.5 times to cost manufacturing of Kozuki)    1,500
           Cost of 60% items                                                             4,500
           (Standard parts 40% or 2/5th = Rs. 1,800)
           (Non – standard parts 60% or 3/5th = Rs. 2,700)
      (5) Assembly and overhead costs                                                  __1,000
      (6) Cost of manufacturer (3 + 4 + 5)                                               9,140
      (7) Technical know – how 30,00,000 /3,00,000                                      ___10
                                                                                         9,150
      (8) Royalty (as per working note)                                               ____685
           Total cost                                                                    9,835
      (9) Profit at 20% on sale or 25% on cost                                         __2,459
      (10) Selling price                                                              __12,294

      Working Note:
      Computation of Royalty
      Given: Royalty 10% on selling price less CKD price less standard parts
      Selling price = Cost + 25% on cost (or 20% on selling price)
      Let, selling price be X
      Let, Royalty be Y
      Selling price     X = 1.25  (9,150 + Y)                                     ………..(1)
      Royalty           Y = 0.10  [X – (3,640 + 1,800)].                          …………(2)

      On simplifying the equations (1) and (2)
      X = 11,437.5 + 1.25Y
      Y = 0.1 X – 544
      Or,
      X – 1.25 Y = 11,437.5.                                                       …………(3)
Cost management-final course                                                                          21

      - 0.1 X + Y = - 544.                                                           …………(4)

      Multiplying (4) by 1.25 and subtracting it from (3)
      X           = 11,437.5 + 1.25 Y
      0.125 X = 680           + 1.25 Y
      X           = 12,294.095 or 12,294
      Y           = 685.43 or 685

                                         _________________

Problem 7

      Cool Ltd. Sells a gadget and has estimated the market capacity as 50,000 units a year. The
      directors have set for the company a sales objective of between 50% and 80% of this potential.
      The sales force is divided into five equal areas and the objective is expected to be achieved by
      using the salesmen in the following manner:

      Number of salesmen used per area                      percentage Market potential expected
                     5                                                        50
                     6                                                        58
                     7                                                        65
                     8                                                        71
                     9                                                        76
                     10                                                       78
                     11                                                       80

      All the products are manufactured at one location at an ex – factory cost of Rs. 80 each and are
      sold the standardised price of Rs. 100 each. The transport and installation cost varies in relation
      to the distance from the factory as under:

      Sales Area                                                Variable distribution cost per unit
                                                                                (Rs.)
            1                                                                      10
            2                                                                       8
            3                                                                       6
            4                                                                       4
            5                                                                       2

      At present 35 salesmen are employed at an average cost of Rs. 8,000 each p.a. in 2006, they
      were divided evenly among the five areas. In 2007, the sales Manager decided to use 25
      salesmen to meet the basic 50% penetration in all areas and to concentrate the other ten
      salesmen equally in the two areas nearest the factory where the unit contribution is the highest.
      The calculation shown below indicates that this year the profit will be nearly 60% lower than in
      2006.
                                         2006                             2007
                                        Rs. (‘000)                     Rs. (‘000)
      Income from sales                                   3,250                          3,060
      Ex – factory cost                  2,600                            2,448
      Distribution cost                    195                              167
      Salesmen cost                   ____280           __3,075       ____280         ___2,895
      Total contribution                                ___175                        ____165

      You are required to:
      (a) Analyse the profitability by areas for both 2006 and 2007;
      (b) Explain briefly why concentrating on highest contribution areas has not increased profit; and
      (c) Calculate the highest total contribution possible using 35 salesmen.
Cost management-final course                                                                       22

Answer
(a)                                 Cool Ltd.
                             COMPUTATION OF TOTAL CONTRIBUTION
                          20060                                                    2007
Areas         1         2        3    4        5    1     2                      3       4          5
Sales        650      650      650   650      650  500   500                    500     780       780
Costs:
Ex - factory
Costs        520      520       520       520        520    400       400       400         624   624
Distribution
Cost          65       52        39        26         13     50        40        30         31    16
Salesmen
Cost          56       56        56        56         56     40        40        40         40    40
Total
Variable
Cost         641      628       615       602        589    490       480       470         735   720
Total
Contribution   9       22        35        48         61     10        20         0         45    60

      Working Note:
      In 2006 sales of Rs. 32,50,000 has been divided evenly over five sales areas. In 2007, sales of
      Rs. 25,00,000 (50% of market capacity) has been divided equally over five sales areas and the
      balance of Rs. 5,60,000 has been divided equally between areas 4 and 5 which have higher per
      unit contribution.

(b)   In 1985, the company wrongly concentrated on the highest contribution areas whereas it should
      have realised that the important thing is the highest marginal contribution per salesman. Table 3
      shows the marginal contribution per salesman when employing additional salesman. It will be
      seen that employing the tenth man in area 5 gives a marginal contribution of only Rs. 3,600
      which is much less than the additional salary cost of Rs. 8,000. similarly the company ought not
      to have employed the tenth salesman in area 4 as the total marginal contribution achieved was
      only Rs. 3,200 against an additional salary cost of Rs. 8,000.

(c)   Table 3 shows that it is possible to employ additional salesmen in an area only when the
      marginal contribution per salesman exceeds his salary cost of Rs. 8,000. it also depicts that it
      benefits the Company to employ a total of 12 salesmen over and above the five needed in each
      area to meet the basic 50% penetration. These extra 12 have marketed with an asterisk (*) in
      Table 3. However, if 12 extra salesmen are employed, this will bring the total number of
      salesmen to 37 in place of the stipulated 35. it is therefore advisable to exclude from the items
      marked (*) those which have the lowest marginal contribution per salesman, i.e., the second
      extra salesman in area 2 and the third extra salesman in area 3, as they have the lowest
      marginal contribution of Rs. 8,400. the highest contribution possible using 35 salesmen is Rs.
      1,81,000. this can be seen from Table 2 that the contribution per area marked (*) are as under:

      Area                            No. of salesmen             Contribution (Rs. ‘000)
      1                                        5                            50.00
      2                                        6                             69.6
      3                                        7                            91.00
      4                                        8                            113.6
      5                                    ___9                          _136.80
                                           __45                           461.00
      Less: Salaries (35  8)                                          __280.00
                                                                       __181.00

      Working Notes:
                                                Table 1
                                                                                  Area
Cost management-final course                                                                         23

                                                             1        2         3         4         5
      Gross contribution per unit (Rs.)                     20       20        20        20        20
      Distribution cost per unit (Rs.)                   ___10     ___8      ___6      ___4       __2
                                                            10       12        14        16        18

                                               Table 2
      No. of            Units                                    contribution in Rs. (‘000) per area
      Salesmen          (‘000)                               1        2          3          4         5
      5                    5.0                            50.0     60.0      70.0       80.0       90.0
      6                    5.8                            58.0     69.6      81.2       92.8     104.0
      7                    6.5                            65.0     78.0      91.0      104.0     117.0
      8                    7.1                            71.0     85.2      99.4      113.6     127.8
      9                    7.6                            76.0     91.2     106.4      121.6     136.8
      10                   7.8                            78.0     93.6     109.2      124.8     140.4
      11                   8.0                            80.0     96.0     112.0      128.0     144.0

      Note: The contribution in Table 2 has been obtained by multiplying the units in ‘000s by the
      contribution per unit shown in Table 1.

                                           Table 3
      No. of               Units                Marginal contribution per salesman Rs. (‘000)
      Salesmen          (‘000)                             1          2         3        4       5
      6                    0.8                           8.0        9.6      112    12.8      14.4
      7                    0.7                           7.0        8.6       9.8   11.2      12.6
      8                    0.6                           6.0        7.2       8.4     9.6     10.8
      9                    0.5                           5.0        6.0       7.0     8.0      9.0
      10                   0.2                           2.0        2.4       2.8     3.2      3.6
      11                   0.2                           2.0        2.4       2.8     3.2      3.6

      Note: The marginal contributions in Table 3 have been calculated by subtracting the total
      contribution shown in successive lines in Table 2.
                                ______________________________


Problem 8 ( On social cost Benefit Analysis)

      Traffic lights control the flow of traffic across and between two busy highways A and B. it is
      estimated that 50% of the traffic highway is delayed, the average loss of time per car delayed is
      minute on highways A and 1.2 minutes on highway B. The traffic on A average 5,000 cars a day
      and on B 4,000. 20% of the cars are trucks and commercial vehicles, the rest and private.
      Whether on business or pleasure, the occupants’ time has to be viewed as valuable. The cost of
      time for commercial vehicles is estimated at Rs. 5 an hour and private at Rs. 2. The cost of a
      stop and start is estimated to be 6 paise per commercial and 4 paise per private cars. Two fatal
      accidents due to failure to obey traffic signals occurred in last 4 years and the insurance
      settlements were Rs. 50,000 for each accident. Forty non – fatal accidents averaging a claim of
      Rs. 1,500 occurred in the same period. These accidents resulted from traffic light violations and
      will be eliminated by an overpass.

      The overpass is designed to replace the intersection and will add a quarter of mile to the distance
      of 15% of the total traffic. The overpass will cost Rs. 7,50,000 and the extra maintenance will be
      Rs. 2,500 a year. The incremental operating cost for commercial vehicles will be 25 paise a mile
      and for non – commercial 6 paise a mile.

      The cost of operating the traffic lights is Rs. 6,000 a year and a policeman spends 2 hours a day
      at the cross and the cost is apportioned at Rs. 3 per hour. No policeman will be needed at the
      overpass.
Cost management-final course                                                                          24

      The expected economic life of overpass is 25 years with a salvage value of zero. The cost of
      capital is 7% (The corresponding capital recovery factor is 0.0858). Compute the benefit cost
      ratio.

Answer
              COMPUTATION OF BENEFIT COST RATIO ON CONSTRUCTION OF OVERPASS
               Benefit to users                                                   Rs.
      1.       Annual savings on account of prevention of delays
               Highway A – (5,000  365  0.5  1/60) (0.2  5 + 0.8  2)      39.500
               Highway B – (4,000  365  0.5  1.2/60) (0.2  5 + 0.8  2) __38,000
                                                                               77,500
      2.       Cost of Added Distance:
               (5,000 + 4,000) (365) (0.25) (0.2  0.25 + 0.8  0.6)         (12,070)
      3.       Savings on account prevention of stops and starts
               (5,000 + 4,000) (365) (0.5) (2  0.06 + 1.8  0.4)              72,270
      4.       Savings in Accidents: (50,000  2/4) + (1,500  40/4)           40,000
               Total benefits (1 + 3 + 4 – 2)                               1,77,700

                Cost to the state:                                            Rs.
      1.        Investment cost Rs. 7,50,000  0.0858                      64,350
      2.        Maintenance cost                                            2,500
                                               2 x365 x6,000
      3.        Savings in operation 6,000 +                             __(8,190)
                                                   2,000
                Total cost (1 + 2 – 3)                                  ___58,660
                Benefit cost Ratio = Total benefits /Total costs
                                   = 1,77,700 /58,600 = 3 approx.


Problem 9

      Jai Textiles Ltd. has been having low profits. A special task force appointed for reviewing
      performance and prospects has the following to report:-

      The company has 1,200 looms working 2 shifts per day. There are 25 sections of 48 looms
      each. Each section has 24 weavers and a jobber. Thus there are 1,250 direct labourers, other
      than indirect labourers and service hands. The working time is between 7 a.m. and 12 mid –
      night, comprising 2 shifts of 8 hours each, with half hour interval between shifts. The production
      ;in 18 lakhs meters per month and the realisation is Rs. 3 per meter. The average wage of the
      direction laborer is Rs. 800 per month and the fixed costs amount to Rs. 1,75,000 per month.
      The production cost is Rs. 2.25 per metres in addition to direct wages.

      The following suggestions are to be considered:-

      (i) Labour productivity can be improved by changing the layout of the machines.

      (ii)       Given the space available, with the proposed change in layout, only 1,008 looms can be
              re – installed, with 48 looms in each section.

      (iii)      Technically, a section of 48 looms can be run with 12 weavers, a helper and a jobber. It
              will be necessary to increase the wage of direct labour, for such section’s by Rs. 110 per
              head per month. There will be some drop in production per loom. The company is not for
              retrenchment of labour.

      (iv)       The company can run a third shift between 12 mid – night and 7 a.m., with a half hour
              interval. However, for the six and half hours’ work, eight hours’ wage will have to be paid.
Cost management-final course                                                                             25

      (v)       Only 18 lakh metres can be sold at the present price of Rs. 3 per meter. There is an
              export offer for 4.5 lakh metres at Rs. 2.70 per meter.

      (vi)       As an initial step, the company can with to 3 shift working, with 12 sections having 25
              direct labourers each and 9 sections having 14 direct labourers retire or voluntarily leave the
              job. The production, with three shift working will be 22.5 lakh metres. Additions to fixed
              costs will amount to Rs. 50,000 per month.

      Examine the implications of the proposals for the company’s profitability and given your advice.


Answer
                      EVALUATION OF PRESENT & PROPOSED ALTERNATIVES
                                                       Present   Proposed
      Looms                                              1,200       1,008
      Shifts                                                 2            3
      Number of sections                                    25           21
      Number of sections with 25 hands in                       (1008 / 48)
      Each section at Rs. 800 per month                     25           12
      Number to sections with 14 hands in each section
      at Rs. 910 per head per month                          --           9
      Total number of direct labourers employed          1,250       1,278
      Expected production: Lakh metres p.m.                 18        22.5

                                                                Rs.                      Rs.
      1.     Sales revenue per month (A)                  54,00,000                66,15,000
      2.     Product cost per month @ Rs. 2.25 per metre  40,50,000                50,62,500
      3.     Direct wages per month                       10,00,000                10,63,980
      4.     Fixed costs per month                       __1,75,000              ___2,25,000
      5.     Total costs per month (B)                    52,25,000              __63,51,480
      6.     Profit per month (A – B)                      1,75,000                 2,63,520

      As a result of implementing the suggestions of the special Task Force, the profits of the
      company will increase by Rs. 88,520 (Rs. 2,63,520 – Rs. 1,75,000). Another implication of the
      proposal of change in layout is that 192 looms are rendered surplus which can be disposed of
      and the realised amount can be invested to fetch some returns. Hence, the company should
      implement the suggestions of the special Task Force.

      Working Notes:
      (1) With 1,000 looms in all, and 48 looms per section, there will be 21 sections after the change
          in layout.

      (2) Number of direct labourers employed:
          Present: 25 hands per section, for 25 sections
                   Working 2 shifts = 25 x 25 x 2 =                                     1,250
          Proposed: 25 hands per section for 12 sections and
                    14 hands per section for 9 sections all working 3 shifts
                     = (25 x 12 x 3) + (14 x 9 x 3) = 900 + 378 =                       1,278

      (3) Direct wages per month:
          Present : 1,250 x Rs. 800 =                                          Rs. 10,00,000
          Proposed : (900 x Rs. 800) + (378 x Rs. 910)                         Rs. 10,63,980

      (4) Sales Revenue per month:
          Present : 18,00,000 x Rs. 3 =                                        Rs. 54,00,000

             Proposed : (18,00,000 x Rs. 3) + (4,50,000 x Rs. 2.70) =          Rs. 66,15,000
Cost management-final course                                                                26

      Points to remember

                 1.     Always check the present profit situation.
                 2.     Apply standard to check the improve in profitability performance.

								
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