# 249 resource 04 JUNE 1996 by 33iLhq

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```									Tax Shield Education Pvt. Ltd.                                                                        Page - 1
FINAL EXMANIATION – STAGE IV
SUGGESTED ANSWERS TO QUESTIONS - JUNE 1996
TECHNIQUES AND APPLICATIONS
Question 1. 06-96
N.R.I Ltd. produces an unique product, the potential demand for which would diminish with any
prolonged period of business recession. A review of the price product over the past six months
has become necessary in order to determine future market strategy. A cost and profit statement
has been prepared for this purpose.

You are required to calculate the Break even point for total sales, actual and potential.

Why should the above procedure be adopted instead of the usual way of finding the Break Even
Point ?

Cost and Profit statement for the six months January - June 1996

Rs.              Rs.
Net Sales                                                            24,50,000
Stock 1st January 1996                               4,00,000
Direct Labour                                        8,95,000
Direct Material                                      7,45,800
Indirect expenses:
Variable                                     2,38,700
Fixed                                        3,58,000
26,37,500
Less stock 30th June 1996                            8,00,000
Cost of Sales                                                        18,37,500
Gross profit                                                          6,12,500
Selling & Distribution Expenses :
Variable                                     1,00,000
Fixed                                        2,00,000         3,00,000
Profit before Tax                                                     3,12,500
Tax provision                                                         1,26,200
Net Profit for 6 months                                               1,86,300

Increase in stock should be assumed as potential sales within the period.

Part 1
N.R.I. Ltd.
It is assumed that the ‘stocks’ were of finished goods valued at production cost and that the fixed
overhead rate per unit is unchanged over the stock t 1st January 1996 and the stock at 30th 1996.

Gross profit rate is 6,12,500 / 24,50,000 = 25% of sales or 331/3% of production cost of sales. So,
sales equivalent to increased stock of Rs. (80,00,000 – 4,00,000) is Rs. 5,33,333.

Total sales (actual + potential) = (24,50,000 + 5,33,333) = Rs. 29,83,333 which is the sales
equivalent of all production is the six months, January – June 1996.
29,83,333
Variable selling and distribution expenses on total sales = Rs. 1,00,000 x                /   24,50,000   = Rs.
1,21,769
Tax Shield Education Pvt. Ltd.                                                           Page - 2
Total variable cost of total sales
DL                       DM        Production                  S&D
= Rs. (8,95,000 + 7,45,800 + 2,38,700 + 1,21,769) = Rs. 20,01,0269, which is 67.08165% of total
sales.

 Profit / Volume ratio is 32.91835%
Production + S & D expenses

Break – even point for total sales (six months basis) =
P / V ratio
= Rs. 5,58,000 / 32.91835%
= Rs. 16,95,103

Part II
Reason s for inclusion of potential sales:

The usual BE sales is found, though erroneously, by dividing the fixed costs by the marginal
contribution percentage on ‘actual’ sales ignoring the adjustment for the variation in beginning
and ending inventories. For managerial decision, the true contribution margin, in a case of
inventory build up a depletion, shall be worked out on the sales value of all production, whether
sold or not.

The inventory represents potential sales and the BEP will be realistic only when these sales
potential is taken into account. As this analysis is meant for management action, correct position
has to be portrayed.

_________

Question 2.

O.B.C Ltd. is evaluating its research and Development programme for the year 1996. The five
projects under consideration all appear to offer favorable profitability if they can be carried out
successfully to completion. But Rs.10 lakhs only has been provided against R&D in the Budget
for 1996.

The following information is relevant :

Project       Expenditure (Rs. Lakhs)            Probability of success       .
To date           To complete         Commercially       Technically
1             15                   1                   0.7              0.4
2             12                   3                   0.8              0.5
3             11                   3                   0.5              0.9
4               6                  7                   0.4              0.5
5               4                  10                  0.3              0.9
Which projects should be completed in 1996 and why?

OBC Ltd.
R & D expenses, as sanctioned are limited to Rs. 10 lakhs. ‘Expenditure to date’ is sunk cost
and not relevant for decision making.

Decision on the projects to be completed should be based on the associated joint probabilities of
success, keeping the available funds constraint in mind.
Tax Shield Education Pvt. Ltd.                                                                   Page - 3

Project          Joint probability of         Expenditure to               Weighted expenditure
Success                  complete Rs lakhs              for success
1                 0.28                          1                            0.28
2                 0.40                          3                            1.20
3                 0.45                          3                            1.35
4                 0.20                          7                            1.40
5                 0.27                          10                           2.70

Projects 3 and 4 together have the greatest weight for success, 2.75. They just cost the
budgeted provision of Rs. 10 lakhs to complete. So projects 3 and 4 should be completed in the
year 1996.

___________

Question 3.

S.R. Ltd. manufactures 3 products A, B & C. The details are as under :

Product                         A               B               C
Per Unit                        Rs.             Rs.             Rs.
Direct Materials                15              19              25
Direct labour                    7               5              11
Selling Price                   30              38              50
Output per day (units)          110    or       60    or        50

If sale of product A exceeds 50 units a day, the selling price is expected to fall to Rs.29 a unit for
each additional unit; if sale of C exceeds 20 units a day, the selling price is expected to fall to
Rs.49 a unit; and if sales of B exceeds 15 units a day, the price is expected to fall to Rs.37 a unit.

The company works an eight-hour day and on an average 40 minutes daily are taken up by
machine setting up time. The constraint is the machine capacity.

Work out the optimum level of production that would maximum profits for the company.

S.R. Ltd.
Product                                                     A               B                C
I. At initial demand prices:

Output (unit)                                            50                 15              20
Contribution / unit (Rs.)                                 5                  8              10
Total Contribution (Rs.)                                250                120             200

II. At further demand prices:

Output (unit)                                            60                 45              30
Contribution / unit (Rs.)                                 4                  7               9
Total contribution (Rs.)                                240                315             270

Total contribution
I + II (Rs.)                                            490                435             470
Tax Shield Education Pvt. Ltd.                                                                     Page - 4

If withdrawal of B and / or C from the market will not affect the sale of A and the customer
satisfaction, then S.R. Ltd. should produce only A.
If all of A, B and C must needs be marketed, then produce them in the ratio of B – 15 units, C –
20 units and use the balance time for A. Assuming the company works 24 days a month in the
average, monthly production will be B – 360 units = 6 days’ operation; c – 500 units = 10 days’
operation; A – 880 units = 8 days’ operation. Total contribution will then be:
Rs.
B                                    2,880
C                                    4,980
A                                    4,400
--------------
Rs. 12,260
--------------
Working:
a. Time taken per unit. After initial set up, available time for one day’s operation is 440 minutes.

Minutes         Output per day       Time per unit minutes
A                   440                110                          4
B                   440                 60                         7 1/3
C                   440                 50                         8 4/5

In view of the above, it will not be prudent to restrict the production of C to 480 units to sell at
initial higher price only and use the available surplus time of 176 minutes for a second set up and
production of A ( 34 units), s 34 units of A @ Rs. 5 contribution per unit is lesser than 20 units
of C @ Rs. 9 contribution per unit.

b. it is assumed that none of A, B, and C is a perishable item. Hence suitable production
schedule will be made for production and sales effected ex – stock.

_________

Question 4.

(a)       List out the accounting and financing areas where linear Programming can be used.
(b)       What are the uses of the learning curve concept?

Accounting and financing areas where Linear Programming can be used:
Allocation problems are concerned with the utilisation of limited resources to best advantage.

Linear Programming (LP) is a mathematical technique to optimise the value of some objective
e.g., maximum profit or minimum cost, when the factors involved, say labour or machine hours,
are subject to some constraints:

LP can be used in solving resource allocation problems in any area, including accounting and
finance, provided that the problem meets the following requirements:

i)     The problem must be capable of being stated in numeric terms.
ii)    All factors involved in the problem must have linear relationship.
iii)   The problem must permit a choice or choices between alternative courses of action.
iv)    There must be one or more restrictions on the factors involved.

Specific examples in the accounting and finance areas include:

i)     Capital investment and project appraisal particularly relating to capital rationing problems.
Tax Shield Education Pvt. Ltd.                                                              Page - 5
ii) Maximising contribution or minimization cost decisions involving production planning, product
mix and similar problems.
iii) Transfer pricing problems and elements of corporate strategy formulation.

For any labour intensive job, as the worker retreats the job be gains experience, time taken per
unit reduces and his performance improves. This improvement in productivity is due to learning
effect. A diagram depicting the effect of learning is known as learning / experience /
improvement / progress curve. As the quantity produced of a given item doubles, the cost of that
item decrease at a fixed rate.

Knowledge of learning curve helps in cost predictions. Its main uses include:

i)     L.C. helps in analysing cost – volume- profit relationship and is useful for cost estimates and
forecasting.
ii)    L.C. helps in budgeting and profit planning.
iii)   L.C. helps in pricing, particularly in a tender when it is known that the tender consists of
several repetitive jobs.
iv)    L.C. helps design engineers in making decision, based upon expected rates of improvement.
v)     L.C. helps in setting standards in learning phase.
vi)    L.C. knowledge helps in manpower planning for contract of long duration or for repetitive
clerical work.

________

Question 5.

Write short notes on any two of the following:

(a)       Decision Making Process.
(b)       Transfer Pricing.
(c)       Simulation.
(d)       Economic order quantity.

Decision-making is an all-pervasive activity taking place at every level in the organisation
covering both long and the short term.

Plans are activated by decisions and the decision process includes consideration of political,
psychological and social factors as well as quantitative and financial ones.

A decision is a choice between future, uncertain alternatives in pursuit of an objective(s), for
which correct information of relevant costs and revenues are needed.

The decision process consists of: (i) the definition of objectives, (ii) the consideration of
alternatives, (iii) the evaluation of alternatives, and (iv) the selection of the course of action.

(i) The definition of objectives will inevitably cause initial consideration to be given to the
constraints or limitation of the problem.
(ii) Alternatives have to be continuously and actively sought out. For this, effective information
systems have to be developed.
(iii) Evaluation of alternatives rests or quantitative comparisons between them. Techniques used
include
Tax Shield Education Pvt. Ltd.                                                                  Page - 6

--Determination of economically relevant costs (= opportunity costs = avoidable costs) and
revenues
--Use of various formal decision rules or models
--Use of probabilities in decision analysis
--Construction of decision trees
--Use of Cost – Volume – Profit analysis
--Resource allocation using linear programming
--Use of investment appraisal techniques such as ROI, payback, DCF, PI, expected value,
maximin, maximax, and the minimax regret criterion.

(iv) Risk and uncertainty are ever present in business situation and so the information
personated by the management accountant must clearly show the effects of uncertainty.
Acceptance of an alternative course of action depends much on the decision – maker’s attitude
to risk.

Transfer pricing is the pricing of internal transfer of goods or services between profit centres of
an organisation. Ideally the transfer prices should promote goal congruence (i.e. a profit center’s
goal should be consistent with the corporate objective), enable effective performance appraisal
and maintain divisional autonomy. It should also motivate internal transfers rather than buying
from outside. Transfer prices should always be based on the outlay costs of the supplying
division plus an opportunity cost to the organisation as a whole.

Because of information deficiencies, transfer pricing in practice does not follow theoretical
guidelines. Typically prices are market based, cost based or negotiated.

For some transferred goods there may not be any market, or the market may be imperfect or the
prices considered unreprestative. If cost based systems are used, them it is preferable to use
standard costs to avoid transfer division’s inefficiency. Full cost or cost plus transfer pricing may
be equally inefficient: it may cause sub – optimal decision making, the price is only valid at our
output level, it makes genuine performance appraisal difficult.

Providing that variable cost equates with economic marginal cost then transfers at variable cost
will avoid gross sub – optimality but performance appraisal becomes meaningless.

Negotiated transfer prices will only be appropriate if there is equal bargaining power and if
negotiations are not protracted.

Imposed transfer prices and / or lack of buying and selling options (lack of motivation) severely
limit the significance of any form of divisional performance appraisal.

To simulate is to imitate. In general terms, simulation involves developing a model of some real
phenomenon, performing experiments on the model and examining the results of each
experiment. Business models can take the forms of flowcharts, formula, equations, etc. the
model must reflect reality and reality inevitably involves variable or probabilistic elements.
Practical simulations should include only those variations which are relevant and objective
oriented. Practical simulation, so formed, is sometimes known as Monte Carlo simulation. The
best model will be simple and at the same time it should have predictive qualities.

To carry out a realistic simulation involving probabilistic elements, it is necessary to avoid bias in
the selection of the values, which vary. This is done by selecting randomly using one of the
following methods:
Tax Shield Education Pvt. Ltd.                                                                Page - 7
(i) Random number tables.
(ii) Random number generation by computer.
(iii) Lottery selection.
(iv) Roulette wheel
(v) Dice or cards

By logging the resultant outputs an understanding is gained of the likely pattern of results so that

Because of the iterative nature of simulation the use of a computer is a necessity for all practical
problems.

Stocks are held to satisfy demands quickly to allow unimpeded production, to take advantage of
bulk purchasing, as a necessary part of the production process, and to absorb seasonal and
other fluctuations. However, stocks accumulate unnecessarily through poor control methods,
obsolescence, poor liaison and sub – optimal decision making. The costs associated with stock
are all marginal costs: they are (i) holding costs (interest, storage, handling, audit, insurance,
deteriorate, obsolescence, pilferage, etc.); (ii) Costs of obtaining stock (placing order, receiving
goods, purchasing, inspection, transport; production planning set up and tooling costs as when
manufactured internally); and (iii) stock out costs (contribution lost, loss of customer goodwill,
cost of production stoppages, extra costs associated with urgent, replenishment purchases)

One basic inventory control system is called the re – order level under which the usual
replenishment orders quantity is the EOQ (economic order quantity). This ordering quantity
minimises the balance of cost between inventory holding costs and re – order costs.

The EOQ is based on certain assumptions:

(i) That there is a known, constant stockholding cost,
(ii) That there is a known, constant ordering cost,
(iii) That rates of demand are known,
(iv) That there is a known, constant price per unit,
(v) That replenishment is made instantaneously, i.e., the whole batch is delivered at once.

Because of the above sweeping assumptions any EOQ calculation shall be treated with caution.
Of course, the basic EOQ formula.

2. Co. D
EOQ = ----------------------           Where Co = ordering per order
Cc                                D = Demand per annum
Cc = Carrying cost per item annum
Can be modified to fit into the circumstances in which some of these assumptions do not hold.
The rationale of EOQ ignores buffer stocks which are maintained to cater for variations in lead
time and demand. The EOQ is an operational research technique that includes risk and
uncertainty as a part of the study and thus assists management decision making and control.

___________
Tax Shield Education Pvt. Ltd.                                                               Page - 8
Question 6.

PRIYA GADGETS LTD. specialising in household gadgets, has just perfected and test marketed
a modified version of a popular gadget. It has three components X, Y and Z one of each is
required per gadget. All these components are made and assembled in its own factory and
capacity utilisation of the machines is full.

The modification essentially involves a special machining and fixing a new attachment for which
the company has proved for double the existing production capacity to take care of possible
increased demand.

The cost structure of the modified gadget is an under :

Component      Machine       Variable          Fixed Cost         Total Cost
Hours             Cost            Allocated
Per Unit           per Unit           Per Unit
Hours                Rs.               Rs.                 Rs.
X              16                 50                 15                   65
Y              24                 56                 20                   76
Z              32                 54                 30                   84
Special machining & assembly --   60                 45                 105
220                110                 330
Selling Price                                                           500

Since the response to the modified gadget is very good the Company would like to capture the
market in the ensuing year itself by increasing sales. While all the existing machines in the
factory are capable of making all the components X, Y and Z increase of machine capacity
cannot be achieved /made during the budget year. However the special machining process and
capacity permits one of the components, either X, Y or Z to be bought from outside. The

Component                       Price per Unit
X                                Rs.66
Y                                Rs.78
Z                                Rs.94

The Marketing Manager feels that sales can be increased at least by 50% during the year and

You are required to give your recommendations as to which component should be bought from
outside if production is to be increased by 50% and 75% respectively.

The constraint in this case is the availability of machine hours. The component which results in
the least extra cost per hour released may have to be brought out.

Component                 Excess of price        M/C hours             Extra cost
Over variable cost     released              per M/C hour
Rs. / Unit             Hrs.                   Rs.
X                           16                16                     1.00
Y                           22                24                     0.92
Z                           40                32                     1.25
Tax Shield Education Pvt. Ltd.                                                               Page - 9
The order of preference for outside purchase X, Y, Z.

Since only one of the components can bought out, the M / C hours released in each has to be
ensured to be sufficient to manufacture 50% or 75% more of the remaining components.
Tabulating

Component                 M/C hours released               Total M/C hours required by
When bought out                  other two components for
50% increase 75% increase
X                           16                           281              42
Y                           24                          24                362
Z                           32                          20                30

Note: (1) 24 + 32 = 56          50% = 28
(2) 16 + 32 = 48          75% = 36

Similarly in all other cases.

RECOMMENDATION:

50% increase             75% increase
Make                                                 X&X                       X&Z

____________

Question 7.

NA FABRICATORS LTD. have procured an order from the railways for supply of 2,40,000 pieces
of metal case-bonds of a special design. The supply is to be completed is not more than 12
months at the rate of 20,000 to 25,000 pieces per month at a price of Rs.75 per piece with a
bonus/penalty of Rs.2.75 per piece for supplies in excess/short of 20,000 pieces per month.

It has promptly purchased a special purpose machine with capacity to produce 20,000 + 5%
pieces per month. The machine which has cost Rs.2 lakhs is expected to fetch a residual value
of Rs.50,000 on completion of the contract job. The cost details of the piece is estimated as
follows:

Material                                            (Rs./Unit)            50.00
Labour                                              (Rs./Unit)              5.00
Variable production overheads – 40% of labour       (Rs./Unit)              2.00
Fixed production and selling/delivery expenses      (Total)           Rs.3 lakhs.

A week before starting the job the suppliers of machine offer an advanced version of the same
capable of 20% more output per hour. There will however be a material loss of 0.5%. This new
machine costs Rs.3 lakhs with no residual value. The supplier has agreed to take back the
original machine for Rs.1.50 lakhs. Fixed cost, by way of maintenance, will increase by Rs.1,000
per month. Entire job can be completed in 10 months.

Advise whether they should go in for the improved model of the special purpose machine.

NA FABRICATORS LTD.
This involves calculation of differential costs by reckoning those costs which undergo change.

Existing M/C            Proposed M/C
Material cost / unit                        Rs. 50.00                Rs. 50.25
Tax Shield Education Pvt. Ltd.                                                                   Page - 10
Labour cost / unit                              Rs. 5.00                     Rs. 4.17
Variable production overhead / unit             Rs. 2.00                     Rs. 1.67
------------------            -----------------
Rs. 57.00                    Rs. 56.00
-----------------             ----------------

For 2,40,000 Units                   Rs. 136.80 Lakhs               Rs. 134.62 Lakhs
Increase in Fixed cost                         --                         0.10
Cost of new M/C less trade of Value            --                         1.50
Residual Vallue of existing M/C Cost       (0.50)                           ---
Bonus earned on 40,000 Units @ 2.75
Per unit                                        ---                        (1.10)
--------------                 ---------------
Total                   136.30                          135.12
--------------                  --------------

By going in for new machine there will be a net gain of Rs. 1.18 lakhs. Hence the offer should be
accepted.

Notes:

1.     There is a 20% increase in output. Hence labour cost per unit will be 5 = Rs. 4.17
1.2
2.     The job will be completed is 10 months @ 24,000 units per month. Hence total increase in
fixed cost will be 1,000 x 10 or Rs. 10,000.
3.     Output per month will be 24,000 instead of 20,000 thereby getting bonus on 4,000 units per
month i.e., Rs. 11,000. total for 10 months = 11,000 x 10 = Rs. 1.10 lakhs.

__________

Question 8.

(a)    Define “Sales Mix Variance”.
(b)    From the details given below reconcile the budgeted sales with the actual sales and budgeted
profit with actual profit bringing out the important variances :

Budget         Actual
Sales Quantity –
Product M                  2000           1800
Product N                  3000           3500

Sales price Unit
Product M                  Rs.12          Rs.14
Product N                  Rs.8           Rs.7

Cost per Unit
Product M                   Rs.9           Rs.10
Product N                   Rs.6           Rs.5

A sales mix variance arises when two or more lines of production are sold and their proportion in
the actual sales varies from the budget. This may affect both the total sales turnover and the
profit. If a larger than standard proportion of a more profitable line is sold, a larger profit will
result and vice – versa.
Tax Shield Education Pvt. Ltd.                                                          Page - 11
The other variance usually considered along with sales mix variance and inter – dependent on
one another are:
Sales Price Variance
Sales Volume Variance
Profit Variance.

Actual Sales at standard mix is computed below:

M          5,300 x 40% =          2,120
M          5,300 x 60% =          3,180
5,300

---------------------------------------------------------------------------------------------------------------------------------
Product                  Actual Price                                               Standard Price_______________
Actual Qnty             Actual Qnty                      Actual Qnty                    Std. Qnty
Actual Mix               Actual Mix                      Std. Mix                        Std. Mix
---------------------------------------------------------------------------------------------------------------------------------
(a)                   (b)                               (c)                           (d)
M                          14 x 1,800             12 x 1,800                      12 x 2,120                   12 x 2,000
= 25,200               = 21,600                        = 25,440                      = 24,000

N                            7 x3,500               8 x 3,500                        8 x 3180                     8 x 3,000
= 24,500                = 28,000                        = 25,440                      = 24,000
---------------------------------------- ---------------------------------------------------------------
Total                     Rs. 49,700              Rs. 49,600                       Rs. 50,880                   Rs. 48,000
---------------------------------------------------------------------------------------------------------------------------------

Sales Variance
Rs.
Price Variance               (a) – (b) = 49,700 – 49,600 = 100 (F)
Mix Variance                 (b) – (c) = 49,600 – 50,880 = 1,280 (A)
Volume Variance              (c) – (b) = 50,880 – 48,000 = 2,880 (F)

Net Variance                 Rs. 1,700 (F)

Alternatively, according to some school of accounts:
(i)   Price variance        (a) – (b)              100 (F)
(ii) Volume variance        (b) – (d)            1,600 (F)
(iii) Mix variance          (b) – (c)           1,280 (A)
(iv) Quantity variance      (c) – (d)            2,880 (F)

Note: (iii) & (iv) are sub – variances of (ii)
---------------------------------------------------------------------------------------------------------------------------------
Product                                    Standard Profit_______________________                             Actual Qnty
Actual Qnty                  Actual Qnty                       Std. Qnty                 x (Std. Cost -
Actual Mix                    Std. Mix                         Std. Mix                  Actual Cost)
_____________________________________________________________________________
(a)                         (b)                                 (c)                       (d)
M                     3 x 1,800                     3 x 2,120                         3 x 2,000                1,800 x – 1
= 5,400                      = 6,360                            = 6,000               = (-) 1,800
N                     2 x 3,500                     2 x 3,180                         2 x 3,000                  1 x 3,500
= 7,000                       = 6,360                            = 6,000                   = 3,500
---------------------------------------------------------------------------------------------------------------------------------
Total                    12,400                       12,720                              12,000                 (+) 1,700
Tax Shield Education Pvt. Ltd.                                                                                          Page - 12
---------------------------------------------------------------------------------------------------------------------------------

Profit Variance:
Mix Variance     =          (a) – (b) = 12,400 – 12,720          = Rs. 320 (A)
Volume Variance =           (b) – (C) = 12,700 – 12,000          =      Rs. 729 (F)
Cost Variance =             (d)                                  = Rs. 1,700 (F)
Price Variance =            As per first tabulation              =      Rs. 100 (F)
---------------------
NET               = Rs. 2,200 (F)
-------------------

Reconciliation

Sales                            Profit
Rs.                              Rs.
Budget M               24,000                                                    6,000
N               24,000                                                    6,000
48,000                           12,000
Volume Variance                                      2,880                               720
Cost Variance                                             ---                         1,700
------------                   --------------
50,980                           14,520
Less:      Mix Variance                                       (1,280)                             (320)
-----------                   --------------
Actuals                                                        49,700                           14,200
-----------                     ------------
Comprising - M                                                 25,200                            7,200
N                                                 24,500                            7,000
-----------                   --------------

____________

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