Vol 1.

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CA Nimeet Piti
 Decision Making using Cost Concepts and CVP Analysis.

CVP Analysis.
CVP analysis stands for Cost Volume Profit analysis. The tool is also called a, what if analysis tool as it
studies the impact or cost (either fixed or variable) and volumes, on profit. Some of the very common
answers it helps to arrive are:
What if the volume falls?
What if the volume increases, should we incur further fixed costs and reduce the variable costs?
What is the level where the organisation won’t at least make a loss? And so on.
The answer to all the questions is the impact on profit.
Let’s try and understand the above with an example.
Let’s say, you have qualified as a Chartered Accountant and now you set up your own practice. It is
obvious, a practicing CA cannot really work in isolation in his office with his laptop. He has to visit to the
respective taxation authorities, clients etc. Being a new start up, you want to keep your travelling costs
low. You think of purchasing a motorcycle to travel around.
A motorcycle would cost you, let’s say around INR 200,000/-. The life of the motorcycle is around 100,000
kms. The per km cost of running the motorcycle including gen, repairs and maintenance would cost you,
INR 4/-, as against the taxi fare of Rs. 14/-.
In the above scenario, the decision to be taken is whether to buy the motorcycle or not. There are two
kinds of cost which are involved in taking such a decision.
The first cost, is the cost of buying the motorcycle, which is 200,000/- Now, once the asset is purchased,
there is no cost increase or decrease, no matter how may kms you clock.
On the other hand, you have the per km running cost, which is 4/-. This cost would keep increasing as the
kms increase.
The kms here are known as level of activity. As the level of activity would increase, so does the running
cost. Any cost, which increases in DIRECT PROPORTION. To the level of activity, is known as variable costs.
The purchase cost of the bike would not increase or decrease, no matter the kms clocked. The costs which
do not respond to the level of activity, is known as FIXED COSTS.
In the current situation, there is a saving in running costs (difference between taxi per km cost and
motorcycle per km cost) of Rs.10/-. However, to save that Rs 10/- a one-time cost of 200,000 has to be
paid.
When will the cost of the bike be recovered? The savings of Rs. 10 per km would be directed towards
repayment of the initial outlay and at 20,000 kms, the savings would be 20,000kms* 10 which is 200,000.
exactly the purchase price of the motorcycle. This point, the point at which the fixed cost is fully recovered
is known as the break- even point.
Question 8
The profit for the year of R. J. Ltd. works out to 12.5% of the capital employed and the relevant figures are
as under:

Particulars (Amount in
Rs.)
Sales 500000
Direct Materials 250000
Direct Labour 100000
Variable Overheads 40000
Capital Employed 400000

The new Sales Manager who has joined the company recently estimates for next year a profit of about
23% on capital employed, provided the volume of sales is increased by 10% and simultaneously there is
an increase in Selling Price of 4% and an overall cost reduction in all the elements of cost by 2%.

Required
Find out by computing in detail the cost and profit for next year, whether the proposal of Sales Manager
can be adopted.

Explanation: The question provides the current cost structure along with profit detail 12..5% of capital
employed). However, the question doesn’t specify the fixed costs. However, that can be calculated.
Also, the question further states that, a reduction of 2% in ALL ELEMENTS of cost. This would mean,
reduction in fixed costs as well. Thus, fixed costs have to be calculated first.
Let’s say, if the proposal couldn’t achieve a 23% return on the capital employed, but achieved less than
that, let’s say 18%. In my opinion, it should still be chosen since it is more than the current return of
12.5%.
However, the question specifically states that the proposal to earn 23% return and thus, it is considered
that as a minimum hurdle.

Solution:
Note.
Calculation of current fixed costs
Sales 5,00,000
Less: Variable Cost (3,90,000)
(Direct Material + Direct Labour + Variable
Overhead)
Contribution 1,10,000
(–) Fixed Cost 60,000
Profit (12.5% of 400,000) 50,000
As per the new sales manager,

Particulars Amount

Sales (current + 10% volume + 4% rise in Selling Price) 572,000

(500,000 + 10% × 1.04)
Variable Cost (Current + 10% volume – 2% Reduction) 420,420
[(390,000 + 10%) – 2%]
Contribution 151,580
(–) Fixed Cost (current – 2%) 58,800
Profit 92,780
92, 780
Return = ×100 = 23.195%
400, 000

Since, the proposal brings in 28% return, it should be adopted.

Question 34
A company had nearly completed a job relating to construction of a specialised equipment. When it
discovered that the customer had gone out of business. At this stage, the position of the job was as
under:

(Rs.)
Original cost estimate 1,75,200
Costs incurred so far 1,48,500
Cost to be incurred 29,700
Progress payment received from original customer 1,00,000

After searches, a new customer for the equipment has been found. He is interested to take the
equipment, if certain modifications are carried out. The new customer wanted the equipment in its
original condition, but without its control device and with certain other modifications. The costs of these
additions and modifications are estimated as under:

Direct Materials (at cost) Rs. 1,050

Direct Wages Dept.: A 15 men days
Dept.: B 25 men days
Variable Overheads 25% of Direct Wages in each
Dept.
Delivery Costs Rs. 1,350
Fixed overheads will be absorbed at 50% of direct wages in each department.

The following additional information is available:

(1) The direct materials required for the modification are in stock and if not used for modification of this
order, they will be used in another job in place of materials that will now cost Rs. 2,250.
(2) Department A is working normally and hence any engagement of labour will have to be paid at the
direct wage rate of Rs. 120 per man day.
(3) Department B is extremely busy. Its direct wages rate is Rs. 100 per man day and it is currently
yielding a contribution of Rs. 3.20 per rupee of direct wages.
(4) Supervisory overtime payable for the modification is Rs. 1,050.
(5) The cost of the control device that the new customer does not require is Rs. 13,500. If it is taken out, it
can be used in another job in place of a different mechanism. The latter mechanism has otherwise to
be bought for Rs. 10,500. The dismantling and removal of the control mechanism will take one-man
day in department A.
(6) If the conversion is not carried out, some of the materials in the original equipment can be used in
another contract in place of materials that would have cost Rs. 12,000. It would have taken 2 men
days of work in department A to make them suitable for this purpose. The remaining materials will
realise Rs. 11,400 as scrap. The drawings, which are included as part for the job can be sold for Rs.
1,500.

Required:
Calculate the minimum price, which the company can afford to quote for the new customer as stated
above.

Solution:
WN 1:Calculation of point (5)

Savings in cost if this control device is used 10,500

elsewhere
(–) Removal Cost:
One-man day in Dept. A. 120
(+) 25% Variable Overhead on above 30 (150)
Net savings from removal of control 10,350
device

WN 2:Calculation of point (6).

The statement reads “If the conversion is not carried out”, meaning any revenue would be considered as
opportunity cost, since, the benefit would be foregone due to the acceptance of this order.
Saving in material foregone 12,000
(–) Removal Cost:
Two men days in Dept A = 120× 2 =240
(+) 25% Variable Overhead on above = 25% of 240 =60 300
Net savings foregone 11,700
(A)
Scrap Value of other materials foregone (Given) 11,400
(B)
Opportunity costs of drawings (Given) 1,500
(C)
Total opportunity costs (A) + (B) + (C) 24,600

Relevant cost for the new order:

Original cost to be incurred 29,700

Direct Material (Opportunity Cost) 2,250
Department A labour:
15 men days – 15× 120 = 1,800
(+) Variable Overhead – 25% of 1800 = 450 2,250
Department B labour
25 men days – 25 × 100 = 2,500
(+) Variable Overhead 25% of 2500 = 625
(+) Opportunity Cost [3.2 × 2500] (refer note) = 8,000 11,125
Delivery Costs 1,350
Supervisory overtime 1,050
Savings in cost (Point 5 WN 1) (10,350)
Opp. Cost (Point 6 WN2) 24,600
Net relevant cost/min cost to be quoted 61,975

 Opportunity Cost of Department B Labour

Dept B is earning a contribution of Rs. 320 for every rupee of Direct labour Cost. This would mean that
for every Rs. 100 spent on Direct labour an opportunity cost of Rs. 320 (3.20 × 100) would be
chargeable to the job.
In the above case labour cost is Rs. 2500 & therefore opportunity Cost chargeable would be
2,500 × 3.2 = 8000
Question 63
A company manufactures a single product in its factory utilising 60% of its capacity. The selling price and
cost details are given below:

Particulars Rs.
Sales (6,000 units) 5,40,000
Direct materials 96,000
Direct labour 1,20,000
Direct expenses 18,000
Fixed overheads:
Factory 2,00,000
Administration 21,000
Selling and distribution 25,000

An analysis of fixed factory and selling & distribution overheads reveals that 12.5% of factory overheads
and 20% of selling and distribution overheads are variable with production and sales. Administration
overheads are wholly fixed.
Since existing product could not achieve budgeted level for two consecutive years, the company decides
to introduce a new product with marginal investment but largely using present plant and machinery.
The cost estimates of the new products are as follows:

Cost elements: Rs. per unit

Direct materials 16.00
Direct labour 15.00
Direct expenses 1.50
Variable factory overheads 2.00
Variable selling and distribution 1.50
overheads

It is expected that 2,000 units of the new products can be sold at a price of Rs. 60 per unit. The fixed
factory overheads are expected to increase by 10% while fixed selling and distribution expenses will go up
by Rs. 12,500 annually. Administration overheads remain unchanged. However, there will be an increase of
working capital to the extent of Rs. 75,000, which would take the total project cost to Rs. 8.75 lakhs.
The company considers that 20% pre-tax and interest return on investment is the minimum acceptable to
justify and new investment.
Required:
(1) Should the new product be introduced?
(2) Give the data above and making any assumptions that you consider appropriate, are there any further
observations or recommendation you wish to make?

Explanation: As soon as you might have read that the firm is working at 60% capacity and is
manufacturing, 6,000 units, you might have assumed that the total capacity of the firm is 10,000 units.
This statement, however, is true, only on one condition i.e. the firm being a single product manufacturing
firm. Capacities are generally expressed in hours and not units.
Consider this. You have a capacity of 10,000 Hrs. Currently, you were manufacturing a product which took
an hour. So, the capacity, is then of 10,000 units, Now, if at all you start manufacturing a product which
only takes half an hour, your capacity will be of 20,000 units. But has the capacity actually doubled? No. It
hasn’t changed as such. The only thing happened has the units can now be manufactured 2x because they
take only 0.5 x time. Thus, as a thumb rule for questions henceforth, always keep that in mind,
capacities are always and will always be expressed in Hours first. If at all there are no details as to the
hours and only units are provided, then you can consider products as a measure to express capacities,
otherwise, never do that.

Solution:
Calculation of Contribution per unit of the existing & new product
Particulars Existing
Sales 5,40,000
(–) Variable Cost:
Direct Material 96,000
Direct Labour 120,000
Direct Expenses 18,000
Variable Fixed Overhead [2,00,000× 12.5%] 25,000
Variable S & D [25,000×20%] 5,000
Contribution 276,000
(–) Fixed costs
Factory [200,000 – 25,000] 175,000
Administration 21,000
Selling [25,000– 5,000] 20,000
Profit 60,000

60, 000
Current return on Capital Employed = = 7.5%
875, 000 – 75, 000

Cost structure of the new product: -

SP 60
(–) Variable Cost
Direct Material 16
 Direct Labour 15
Direct Expenses 1.5
Variable Factory Overhead 2.0
Variable S & D Overhead 1.5
Contribution per unit 24
(x) no. of units 2,000
Total Contribution 48,000
(–) Fixed Cost (Only relevant)
Factory Overhead [200,000 – 25,000] 10% 17,500
Administration —
Selling 12,500
Profit 18,000

18, 000
Return on new product = = 24%
75, 000

60, 000 + 18, 000

Total return of both products = = 8.9%
8, 00, 000 + 75, 000

Question 69
A Co. Ltd. manufactures several different styles of jewellery cases. Management estimates that during the
third quarter, the company will be operating at 80 percent of the normal capacity. Because the company
desires a higher utilisation of plant capacity, the company will consider a special order.
The company has received special order inquiries from two companies. The first order is from JCP Co. Ltd.
which would like to market a jewellery case similar to one of A Co. Ltd.’s jewellery cases. JCP jewellery case
would be marketed under JCP’s own label. JCP Co. Ltd. has offered A Co. Ltd. Rs. 57.50 per jewellery case
for 20,000 cases to be shipped by the last date of the quarter. The cost data for A Co. Ltd. jewellery case
that would be similar to the specifications of JCP special order are as follows:

Particulars Rs.
Regular selling price per unit 90
Cost per unit
Raw Materials 25
Direct Labour 0.5 hour @ Rs. 60 30
Overhead 9.25 machine hour @ Rs. 40 10
Total Cost 65

According to the specifications provide by JCP Co. the special-order case requires less expensive raw
materials. Consequently, the raw materials will only cost Rs. 22.50 per case, Management has estimated
that the remaining costs, labour time and machine time will be the same as for A Co. Ltd. jewellery Case.
The second special order was submitted by K Co. Ltd. for 7,500 jewellery cases at Rs. 75 per case. These
jewellery cases, like the JCP cases, would be marketed under K label and have to be shipped by the last
date of the quarter. However, the K Jewellery case is different from any jewellery case in the A. Co Ltd. line.
The estimated per unit cost of this case are as follows.

Particulars Rs.
Raw Materials 32.50
Direct Labour 0.5 hour @ Rs. 60 30.00
Overhead 0.5 machine hour @ Rs. 40 20
Total Costs 82.50

In addition, A Co. Ltd. will incur Rs. 15,000 in additional setup costs and will have to purchase a Rs. 25,000
special devices to manufacture these cases, these devices will be discarded once the special order is
completed.
The A Co. Ltd.’s manufacturing capabilities are limited to the total machine hours available. The plant
capacity under normal operations is 90,000 machine hours per year or 7,500 machine hours per month.
The budgeted fixed overhead for the current year amounts to Rs. 21,60,000. All manufacturing overhead
costs are applied to production on the basis of machine hours at Rs.40 per hour.
A Co. Ltd. will have the entire quarter to work on the special orders. Management does not expect any
repeat sales to be generated from either special order. Company practice precludes from subcontracting
any portion of an order, when special orders are not expected to generate repeat sales.

Required:
Should A Co. Ltd. accept either special order? Justify your answer and show the calculations.

Explanation: The overheads are charged at Rs. 40/- hour. However, it is not mentioned whether these are
fixed overheads or variable overheads. This is important to know, because, if the overheads are variable,
they are certainly relevant and will have an impact on contributions and PV ratios. Also, if the overheads
are fixed and specific to a particular order, then they might also be relevant. So, to iron out that, we need
to have a break up of overheads as fixed and variable.

Whenever, the question used JUST THE TERM OVERHEADS, they refer to both fixed and variable together.
If at all the question uses the term overheads, the first thing you need to do is to bifurcate them. The
question will always hint you towards the bifurcation. Be careful in picking up the figures. Your first
working note in such cases, should be the bifurcation, since unless the variable overheads are not known.
The contribution won’t arrive anyways.

Solution:
WN-1
Hours available for the quarter: -
Hours available for the year 90,000 hours
Hours available for the quarter 22,500 hours
Capacity Utilized 80% 18,000 hours
Hours available 4,500 hours
WN-2
Segregation of Fixed & Variable Overheads:

Total Fixed Overheads 21,60,000

Total Hours per year 90,000 hours
 Fixed overheads per hour Rs. 24/hour
(21,60,000/90,000)
Total Overheads recovery rate Rs. 40/hour
 Balance, will be variable overheads Rs. 16/hour
recovery rate

Max units that can be manufactured.

Particulars Order from Order from

JCP Co. Ltd. K. Ltd. Co.
Hours required per box 0.25 hours 0.5 hours
Hours, available 4,500 4,500
Units that can be manufactured 18,000 units 9,000 units
(4500/0.25hours) (4,500/0.5 hours)
Order size 20,000 units 7,500 units
 Maximum units that can be 18,000 units 7,500 unit
manufactured

Cost sheet for the two orders.

Particulars JCP Co. Ltd. K. Co. Ltd.

Selling Price 57.50 75
(–) Variable Cost
Raw materials 22.50 32.50
Direct Labour 30.00 30.00
Variable overhead 4.00 8.00
Contribution 1.00 4.5
(x) no of units 18,000 7500 units
Total contribution 18,000 33,750
(–) Additional Fixed Cost – 40,000
Net Gain 18,000 (6250)

If an order of 18,000 units can be processed, then the order from JCP Co. Ltd. can be processed or
else both the order should be rejected.
 Total cost @ present i.e. 4000 units [4000×34] 136,000
Total cost @ proposed i.e. 6000 units [6000× 31] 186,000
Incremental Cost of 2000 units 50,000
Incremental revenue [2000 units × 28] 56,000
This, net revenue 6,000

Since, the net revenue is positive, the offer should be taken.

Question 72
E Ltd. is engaged in the manufacturing of three products in its factory. The following budget estimates are
prepared for 2014-15.

Products
A B C
Sales (units) 10,000 25,000 20,000
Selling Price per unit (Rs.) 40 75 85
Less : Direct Materials per unit (Rs.) 10 14 18
Direct Wages per unit @ Rs. 2 per hour 8 12 10
Variable Overhead per unit (Rs.) 8 9 10
Fixed Overhead per unit (Rs.) 16 18 20
Profit / Loss (2) 22 27

After the finalisation of the above manufacturing schedule, it is observed that presently only 80% capacity
being utilised by these products. The production activities are made at the same platform and it may be
interchangeable among products according to requirement. In order to improve the profitability of the
company the following three proposals are put for consideration.

(a) Discontinue product A and capacity released may be used for either product B or C or equally shared.
The fixed cost of product A is avoidable. Expected changes in material cost and selling price subject to
the utilisation of product A’s capacity are as under:
Product B: Material cost increased by 10% and selling price reduced by 2%.
Product C: Material cost increased by 5% and selling price reduced by 5%.

(b) Discontinue product A and divert the capacity so released and the idle capacity to produce a new
product D for meeting export demand whose per unit cost data are as follows:
 (Rs.)
Selling Price 60
Direct Material 28
Direct Wages @ Rs. 3 per hour 12
Variable Overheads 6
Fixed Cost (Total) 1,05,500

(c) Product A, Band C are continuously run and hire out the idle capacity fixing a price in such a way that
the same rate of profit per direct labour hour is obtained in the original budget estimates.

Required:
(i) Prepare a statement of profitability of products A, B and C in existing situation.
(ii) Evaluate the above proposals independently and calculate the overall profitability of the company
under each proposal.
(iii) What proposal should be accepted, if the company wants to maximise its profit?

Solution:
Statement showing capacities &contribution per unit
A B C
Wages per unit 8 12 10
(÷) Wages per hour 2 2 2
 hours per unit 4 6 5
(x) no. of units 10,000 25,000 20,000
Total hours 40,000 150,000 100,000
This is 80% capacity 290,000
hrs
290, 000×100
 100% capacity = = 362,500 hrs
80

 Spare hrs (362,500 – 290,000) =72,500 hours

Statement showing contribution per unit& total Fixed costs for each product
A B C
Selling Price 40 75 85
(–) Direct Material 10 14 18
(–) Direct Wages 8 12 10
(–) Variable Overhead 8 9 10
Contribution per unit 14 40 47
 Fixed Cost per unit 16 18 20
(×) no. of units 10,000 25,000 20,000
Total Fixed Cost 160,000 450,000 400,000

(i) Profitability under existing situation.

A B C Total
Sales units 10,000 25,000 20,000
(x) Contribution per unit 14 40 47
Total contribution 140,000 10,00,000 940,000 2080,000
(–)Fixed Cost 160,000 450,000 400,000 10,10,000
Profit/loss (20,000) 550,000 540,000 10,70,000

(ii) (a) Discontinue A & use released capacity for either B or C or both.

Produce only B  units possible  6666 units

Released capacity -40,000 hrs.
Produce only C  units possible  8000 units

3333 units of A
Share equally <
4000 units of B

It is assumed that the changes are applicable to all units and not just incremental units

B C
Current contribution per unit 40 47
(–) Increase in Material Cost 1.4 0.9
[14×10%] [18×5%]
(–) Decrease in Selling Price 1.5 4.25
[75×2%] [85×5%]
Revised contribution 37.1 41.85
(÷) No of hours 6 5
Contribution per/hour 6.18 8.37

 Manufacture C since the contribution p/hr is higher for product C

Profitability, if A’s capacity is used by C.

Sales volume [20,000 (current) +18,000 (additional)] 28,000 units

(x) Contribution per unit 41.85
Total contribution 11,71,800
(–) Fixed costs 4,00,000
7,71,800
 (+) Profit of B 550,000
Total Profit 1321800

Proposal (b)
Capacity released + idle =40,000 hours+72,500 hours = 112500 hours
Hours required per unit of D = 12/3 = 4 hours

Possible production = 112500/4 = 28,125 units

Calculation of Contribution per unit of D

Selling Price 60
(–) Direct Material 28
(–)Direct Wages 12
(–) Variable Overhead 6 46
Contribution 14 per unit
(x) no. of units 28,125 units
Total contribution 393,750
(–) Fixed Cost 105,500
288,250
(+) Profit of ‘B’ 550,000
(+) Profit of ‘C’ 540,000
Total Profit 13,78,250

Proposal (c) : Hire out idle capacity

Profit per hour = (10,70,000/290,000 hours) 3.69
(x) idle hours 72,500 hours
Revenue 267,500
(+) Existing profit 1070,000
Total Profit 13,37,500

Summary
Existing Proposal A Proposal B Proposal C
10,70,000 13,21,800 13,78,250 13,37,500
Question 85
ABC Ltd. manufactures three prototype toy furniture products – chairs, benches and tables. The budgeted
unit cost and resource requirements of each item is detailed below.

Particulars Chair Bench Table

(Rs.) (Rs.) (Rs.)
Timber cost 5.00 15.00 10.00
Direct labour cost 4.00 10.00 8.00
Variable overhead cost 3.00 7.50 6.00
Fixed overhead cost 4.50 11.25 9.00
Total Cost 16.50 43.75 33.00
Budgeted volumes per annum 4,000 2,000 1,500

These volumes are believed to equal the market demand for these products. The fixed overhead costs are
attributed to three products on the basis of direct labour hours.
The labour rate is Rs 4.00 per hour
The cost of the timber is Rs 2.00 per square metre.

The products are made from a specialist timber. A memo from the purchasing manager advises you that
because of a problem with the supplier, it is to be assumed that this specialist timber is limited in supply
to 20,000 square metres per annum.

The sales manager has already accepted an order for 500 chairs, 100 benches and 150 tables which if not
supplied would incur a financial penalty of Rs 2,000. These quantities are included in the market demand
estimates above.

The selling prices of the three products are:

Product Rs
Chair 20.00
Bench 50.00
Table 40.00
Required:
Determine the optimum production plan and state the net profit that this should yield per annum.
Solution:
(a) Calculation of Total Fixed Overheads, Contribution per unit & Total Timber requirement
Particulars Chair Bench Table
Fixed Overhead cost per unit 4.5 11.25 9.00
(x) volumes 4000 2000 1500
Fixed Overhead 18,000 22,500 13,500
Total Fixed Overhead 54,000

Particulars Chair Bench Table

Selling Price 20 50 40
(–) Variable Cost:
Timber Cost 5 15 10
Direct labour 4 10 8
Variable overhead 3 7.5 6
Contribution 8 17.5 16

Timber requirement
Chair Bench Bench
Timber required per unit 2.5 sq. mt. 7.5 sq. mt. 5 sq. mt.
[Timber cost ÷ 2] [5/2] [15/2] [10/2]
(x) Production 4,000 2,000 1,500
Total timber required 10,000 15,000 7,500
32,500 sq. mtr.
Total Timber available 20,000 sq. mtr.

Ranking: Chair Bench Table

Contribution 8 17.5 16
(÷) Timber required 2.5 sq.mt. 7.5 sq. mt. 5 sq. mt.
Contribution per sq. mt. 3.2 2.33 3.20
Ranking I II I

Allocation:
Timber available Allotted to Balance
20,000 sq. mt. 4000 chairs 10,000 sq. mt.
 [4,000 × 2.5 = 10,000 sq. mt.]

10,000 sq. mt. 1,500 tables 2,500 sq. mt.

[1,500 × 5 sq. mt. = 7,500 sq. mt.]
2,500 sq. mt. Balance to manufacture benches 2.5 sq. mt.
[2,500/7.5 sq. mt. = 333 benches]

Profit
Particulars Chairs Benches Tables
Units produced 4000 333 1500
(x) Contribution per 8 17.5 16
unit
Total Contribution 32,000 58,275 24,000
61827.5
(–) Fixed Cost 54,000
Profit 7827.5

Question 89
A manufacturer of industrial pump buys 30,000 components annually from a supplier @ 300 per set.
Purchase Department has received request from vendor for an upward revision of price per set of
components by 5% from the next financial year. Production manager is in favour of manufacturing the
40,000 components in the factory itself so that the same may be used to match its enhanced capacity of
manufacturing pumps. He has submitted the following cost estimates.

For 40,000
units
Direct Material Rs 80.00 lakh
Direct wages Rs 30.00 lakh
Factory overheads Rs 12.00 lakh

The Manager has proposed for procurement of required machines the cost estimate for which Rs 20 lakh
and life of the same is 10 years. Additional Maintenance cost per annum will be Rs 1.00 lakhs which is not
included in variable factory overheads. Loan arrangement with the bank of Rs 25.00 lakhs against additional
working capital requirement @ 12% per annum has been finalized. On critical analysis, it has been seen that
30% of the factory overheads included in the cost of component are fixed in nature.
You are required to place your views.

Solution:
Cost to manufacture 40,000 components: -
(Rs In Lakhs)
Direct material 80
Direct wages 30
Factory Overhead (Only variable i.e. 70% of 12) 8.4
Additional Dep. (20 lakhs /10 year) 2
Additional Maintenance 1
Interest on loan (25 lakhs × 12%) 3
Total Cost 124.4

 Cost per unit 124.4 lakhs /40,000 units Rs 311

Cost to buy (300 + 5% increase) Rs 315

Thus, there is a saving of Rs 4 per unit resulting in total savings of 40,000 × 4 = Rs 160,000.
Therefore, component should be manufactured.

Question 90
A manufacturer of household Pressure Cooker buys 20,000 components annually from a supplier @ Rs 45.
Production manager has given a proposal of manufacturing the component in the own factory, the
detailed cost estimates are given a below:

For 20,000 units Per unit (Rs.)

Direct Material Rs 4.00 lakh 20.00
Direct wages Rs 3.50 lakh 17.50
Factory overheads (60% Rs 1.75 lakh 8.75
Variable)
Total Cost Rs 9.25 lakh 46.25

Moreover, production manager argument is that in-house facilities will provide better flexibility to
enhance the production to the extent of 25,000 units of Pressure cooker. It has been indicated that for
enhancing the production the banker of the company has in principle agreed to arrange additional
working capital requirement of Rs 20.00 lakhs at a cost of 12% annum. However, marketing department
has indicated that price of Pressure cooker may require reduction in price by at least 4% to take care of
additional sale. Existing per unit sales price of Pressure Cooker Rs 1,300 and Contribution is Rs 250.
As the production cost is more than the procurement price from the market, management of the
company seek your views as Management Accountant on Make or Buy decision.

Solution:
Relevant Cost to manufacture the component
Direct Material 20
Direct wages 17.5
Factory Overhead (Variable only – 8.75 5.25
×.6)
Cost to manufacture 42.75

Manufacturing would bring reduction in cost by Rs 2.25 per unit (45-42.75)

If 25,000 cookers are to be sold:

Existing contribution 250
(+) Reduction in Variable Cost of component 2.25
(–) Decrease in Selling Price (1,300 × 4%) (52)
Revised Contribution 200.25
(x) no. of units 25,000
units
Total Contribution 50,06,250
(–) Working capital interest 240,000
(20,00,000 × 12%)
Net Contribution 47,66,250

Original Contribution = 250 per unit × 20,000 units = 50,00,000

Since, there is a decline in contribution, the project should not be carried forward.

Question 92
X is a multiple product manufacturer. One product line consists of motors and the company produces
three different models. X is currently considering a proposal from a supplier who wants to sell the
company blades for the motors line.

The company currently produces all the blades it requires. In order to meet customer’s needs. X currently
produces three different blades for each motor model (nine different blades).
The supplier would charge Rs 25 per blade, regardless of blade type. For the next year X has projected the
costs of its own blade production as follows (based on projected volume of 10,000 units).

Direct materials Rs 75,000

Direct labour Rs 65,000
Variable overhead Rs 55,000
Fixed overhead:
Factory supervision Rs 35,000
Other fixed cost Rs 65,000
Total production costs Rs 2,95,000

Assume:
(1) the equipment utilized to produce the blades has no alternative use and no market value
(2) the space occupied by blade production will remain idle if the company purchases rather than makes
the blades, and
(3) factory supervision costs reflect the salary of a production supervisor who would be dismissed from
the firm if blade production ceased.

Required:
(i) Determine the net profit or loss of purchasing (rather than manufacturing), the blades required for
motor production in the next year.
(ii) Determine the level of motor production where X would be indifferent between buying and
producing the blades. If the future volume level were predicted to decrease, would that influence the
decision?
(iii) For this part only, assume that the space presently occupied by blade production could be leased to
another firm for Rs 45,000 per year. How would this affect the make or buy decision?

Explanation:
The company in question i.e. X ltd manufactures many products along with some kind of blades for their
motors. An outside vendor is willing to sell those blades to us at a flat rate of Rs 25 per blade. Now, X Ltd
has given us their cost structure for 10,000 blades.
Now, the cost structure is made up of variable costs and fixed costs. Now, the supervisor costs, even
though fixed in nature, is still relevant for decision making, as this cost will not be incurred if we
discontinue.

i.e. Continue operations = Hire the supervisor

Discontinue operations = Do no hire the supervisor.
Thus, the cost even though fixed, changes between alternatives and thus relevant to decision in hand.

Also, a close attention should be towards the assumptions made in the question.
Assumption 1: The equipment utilized to produce the blades has no alternative use and no market value:
-
It means that machine will not generate any contribution by producing something else or no salvage
value. If there were any of it, it would have been reduced the cost of buying!
Assumption 2: The space occupied by blade production will remain idle if the company purchases rather
than makes the blades: –
This means that the space cannot be rented out and no rental income can be earned. If there was any
rental income, it would have reduced the cost of buying!
Assumption 3: Factory supervision costs reflect the salary of a production supervisor who would be
dismissed from the firm if blade production ceased. This means that the salary of the supervisor can be
saved if production is not taking place. This means, that the salary, even though fixed, is relevant for
decision making.

Solution:
Calculate of cost of production (WN1)

(i) Direct Material 75,000

Direct Labour 65,000
Variable Overhead 55,000
Factory Supervisor 35,000
Total Cost 230,000
(÷) no of blades 10,000
Cost per blade Rs 23

The vendor is offering the blades at a cost of Rs 25. Thus, X ltd. should continue production as
loss form purchasing is Rs 2 per blade.
 35,000 
Variable cost without supervisor cost =  230, 000 – = 19.5
 10, 000 

(ii) Indifference point between buying & manufacturing

Saving in variable cost 25– 19.5 = Rs. 5.5 per unit
Indifference Point (35,000 ÷ 5.5) = 6,364 blades

(iii) The lease rent can either be added as opportunity cost to cost of manufacture or can be reduced from
cost of buying as savings.
 We will add to cost of manufacture as opportunity cost.

Cost to manufacture 23
(+) Opportunity Cost 4.5
(45,000/10,000)
27.5

It is now viable to buy the product as the cost to manufacture in house is higher by Rs 2.5 per blade

Question 97
Aditya Ltd. manufactures four products A-1, B-2 C-3 and D-4 in Gurgaon and one product F-1 in
Faridabad. Aditya Ltd. operates under Just-in-time (JIT) principle and does not hold any inventory of either
finished goods or raw materials.
Company has entered into an agreement with M Ltd. to supply 10,000 units per month each product
produced from Gurgaon unit at a contracted price Aditya Ltd. is bound to supply these contracted units to
M ltd. without any fail. Following are details related with non-contracted units of Gurgaon unit.

(Amount in Rs)
Particulars A-1 B-2 C-3 D-4
Selling Price per unit 360 285 290 210
Direct Labour @ Rs 45 per hour 112.5 67.5 135 67.5
Direct Material M-1 @ Rs 50 per kg. 50 100 — 75
Direct Material M-2 @ Rs 30 per litre. 90 45 60 —
Variable Overhead (varies with labour 12.5 7.5 15 7.5
hours)
Variable Overhead (varies with machine 9 12 9 15
hours)
Total Variable Cost 274 232 219 165
Machine Hours per unit 3 hours 4 hours 3 hours 5 hours
Maximum Demand per month (units) 90,000 95,000 80,000 75,000

The products manufactured in Gurgaon unit use direct material M-1 and M-2 but product F-1 produced in
Faridabad unit is made by a distinct raw material Z. Material Z is purchased from the outside market at Rs
200.000 per unit. One unit of F-1 requires one unit of material Z.
Material Z can also be manufactured at Gurgaon unit but for the 2 hours of direct labour, 3 hours of
machine time and 2.5 litres of material M-2 will be required.
The Purchase manager has reported to the production manager that material M-1 and M-2 are in short
supply in the market and only 6,50,00 kg. of M-1 and 6,00,000 litres of M-2 can be purchased in a month.

Required:
(i) Calculate whether Aditya Ltd. should manufacture material Z in Gurgaon unit or continue to purchase
it from the market and manufacture it in Faridabad unit.
(ii) Calculate the optimum monthly usage of Gurgaon unit’s resources and make decision accordingly.
(iii) Calculate the purchase price of material Z at which your decision in (i) can be sustained.

Explanation:
Aditya Ltd. has two plants, one in Gurgaon and the other one in Faridabad. Different products are
manufactured at both the plants. Aditya Ltd. has got into a contract to sell 10,000 units A1, B2, C3, D4 (all
of which are manufactured in Gurgaon) and these units have to be delivered without fail.
One of the products that are made in Faridabad, requires a raw material Z, which can either be sourced
from market @ Rs. 200 per unit or can be manufactured at Gurgaon. However, Gurgaon has constraints in
their raw materials. However, it is pertinent to note that short term decision making can solve situations
with one constraint. If there is more than one constraint, the solution will be arrived using Linear
Programming. So, we will have to identify that one material which is actually the constraint.
One important area that I would like to bring to your attention is the calculation of variable overheads
which varies with labour hours. Now the key term is that it varies with labour HOURS and not labour
COST. Even though, it will not make a difference, it is always a good habit to follow the question to the
letter. Thus, the nexus has to be drawn with labour hours. For example, Direct labour cost is Rs 112.5 paid
at the rate of Rs. 45 per hour, which means labour hours are 2.5 hours. For 2.5 hours, variable overheads
are Rs 12.5, which means, variable overheads are Rs 5 per hours. The same relation can be drawn for other
products as well.
Part 1 of the question is asking whether material Z, which is raw material from product manufactured in
Faridabad, should be manufactured in Gurgaon or should be purchased from the market. You will have to
understand that there is a shortage of material in Gurgaon. So, if material Z is manufactured, some of the
products will not be manufactured, meaning, there will be contribution foregone. This would mean that
material Z will have variable cost + opportunity cost. Now, if that is lesser than the purchase price, it is
worthwhile to manufacture or else, it should be purchased from the market.
One should also bear in mind that Aditya Ltd. has already contracted for sale of 10,000 units. Those units
have to be manufactured no matter what. So, for deciding the sale units for the outside market, resources
for those 10,000 units should be kept aside and then, the balance should be utilized.
Part 2 of the question is asking for a basic production plan that will be carried out at the Gurgaon plant.
Part 3 of the question is asking for that minimum market rate of product Z., where manufacturing it would
be feasible. For example, if the manufacturing cost along with the opportunity cost works out to Rs 300
per unit, it would mean that if product Z, is not sold at the outside market for a minimum of Rs 300, it is
just not worthwhile for it to be manufactured. The question is asking for that rate (in out example which is
Rs 300)
Solution:
Calculation of requirement of material M1& M2.

Particulars A1 B2 C3 D4
Material requirement M1 1 kg. 2 kg. — 1.5 kg.
(Material Cost/50)
Material required M2 per 3 litres 1.5 2 litres —
unit litres
(Material Cost/30)

Particulars A1 B2 C3 D4 Total
Total M1 required
For contracted sale 10,000 kg. 20,000 kg. — 15,000 kg. 45,000 kg.
Non-contracted Sale 90,000 kg. 190,000 kg. — 112,500 kg. 392,500 kg.
(90,000 × 1) (95,000 × 2) (75,000 × 1)
437,500
kgs.

Total requirement of M2
Particulars A1 B2 C3 D4 Total
For contracted sale 30,000 litres 15,000 litres 2000 litres – 65,000 litres
Non-contracted sale 2,70,000 litres 142500 litres 16000 litres – 572,500
(90,000×3) (95,000 ×1.5) (80,000 ×2) litres

637,500
litres

M1 is in supply, but M2 is not in supply. Thus, optimization should be done as per M2 being the constraint.

Optimization plan.

Particulars A1 B2 C3 D4
Contribution (Sales-Variable 86 53 71 45
Cost) (360–274) (285–232) (290–219) (210-165)
(÷) Units of M2 required 3 1.5 2 –
 Contribution per litre of M2 28.67 35.33 35.5
Ranks III II I

Litres Issued for Balance

Available
600,000 litres 10,000 units A1, B2 535,000 litres
C3, D4
65,000 litres (Refer
WN)
535,000 litres 80,000 units of C3 375,000 litres
160,000 litres
375,000 litres 95,000 units of B2 232,500 litres
142,500 litres
232,500 litres Balance units of A1 -
232,500/3 = 77,500
units

(i) If product Z is to be manufactured & since M2 is in short supply. A1 unit will have to be sacrificed so as
to Manufacture Z. Opportunity cost of 28.67 Litre will be charged to product Z.

Manufacturing cost of Z. (Rs.)

Direct labour (2 hours × 45) 90
Direct Material [2.54 litres × (30+28.67)] 146.68
Variable Overhead (2 hours × 5) * 10
Variable Overhead (3 hours × 3) 9
255.68

Thus, it is better to purchase, than to manufacture

(ii) If the market quotes a minimum of Rs. 255.68 unit of Material Z. it is only then worthwhile to
manufacture or else it is better to buy the product.

* refer question analyses.

Question 105
Apex Limited manufactures two products, P and Q, using the same production facility. The following
information is available for a production period:

Particulars Product P Product Q

Demand (units) 2,20,000 1,75,000
Contribution (Rs / unit) 10 12
Machine hours required per 100 units 15 25

P and Q can be produced only in batches of 100 units and whatever is produced has to be sold or
discarded. Inventory build-up is not possible from one production period to another. The total fixed costs
for each level of production and directly attributable to P and Q are given below:

Total Fixed Cost (Rs)

Level of output
Product P Product Q
Upto 1,00,000 units 6,00,000 5,50,000
1,00,001 to 2,00,000 units 13,50,000 12,20,000
2,00,001 to 3,00,000 units (maximum possible level) 18,70,000 15,50,000

75,000 machine hours are available in the production period.

Required:
(i) Calculate the quantities of P and Q in the best product mix to achieve the maximum profit and
compute the maximum profit.
(ii) What will be opportunity cost of meeting P’s demand fully?

Explanation:
The term opportunity cost here would mean the amount that should be totally recovered from the units
of product P not manufactured, i.e. 20,000 units.
The additional fixed costs for units above 200,000 for product P is 520,000/- Also, since production of P
will be taken up, we will have to sacrifice the contribution that will be made from 70 batches of Q, which is
70*120= Rs 84,000/-

Therefore,
Total amount to be recovered
(additional Fixed costs + Opportunity Costs) 604,000/-
Less : Contribution that will be generated from production of 20,000 units of P (200,000/-)
 (20,000 ×10)
Opportunity Cost 404,000

The question here means that WHAT WAS THE MINIMUM AMOUT TO BE RECOVERED IF PRODUCTION
OF 20,000 UNITS OF PRODUCT P WAS TO BE MANUFACTURED. Thus, it would be the total amount it
NEEDS to be recovered towards the ADDITIONAL FIXED COSTS AND THE CONTRIBUTION that would be
lost if production of product P was taken up.

Solution: (1) Calculation of contribution per machine hour.

P Q
Contribution per batch of 100 units 1000 1200
(10×100) (12×100)
(÷) no. of hours 15 25
Contribution per hour. 66.67/- 48/-
Rank I II
Demand (batches) 220,000 units 175,000 units
100 100
2,200 batches 1,750 batches

Produce P as much as possible and balance allocate to Q.

Hours for 2200 batches of P — 2200 ×15 33,000 hours

Balance hours for Q 75, 000 – 33, 000 1,680 batches
25hrs.

Statement showing incremental cost

P Q
First 100,000 units 600,000 550,000
Next 100,000 units 750,000 670,000
Next 100,000 units 520,000 330,000

For units above 200,000 units of P, i.e. 20,000 units contribution would be 20,000 × 10 i.e. 200,000 but an
additional fixed cost of 520,000 would have to be incurred. Thus, these 20,000 units or 200 batches would
not be manufactured. However, time saved on these 200 batches i.e. 200 × 15 = 3,000 hours would be
used to manufacture Q, 3000/25, 120 batches of
Q. But the demand for Q remains to 1750 batches. Therefore only 70 more batches (1750 – 1680) would
be manufactured. Thus, ideal production profit will be as follow 2000 batches of P & (1680 + 70) = 1750
batches of Q.

Profit Calculation 20,00,000

Contribution from P (2000 × 1000)
Contribution from Q (1750 ×1200) 21,00,000
Total Contribution 41,00,000
 (–) Fixed Costs
Product P 1350,000
Product Q 1220,000 24,70,000
Profit 15,30,000

Transfer Pricing
Consider this, the TATA Group is one of the biggest conglomerate of the world, having a piece of every
industry, be it, automobiles, technology, hospitality, FMCG and so on. Or let’s just say, they have direct or
indirect connections in every industry except Tobacco and Alcohol.

Now, let’s say, the Hospitality division of TATA, i.e. the Taj Group of Hotels wants to serve green tea in
their hotels which is manufactured by Tetley, which is also owned by the TATA Group.

The procurement manager of Taj can simply order the green tea from the market and pay what generally
the market pays for that green tea, OR can call up the sales team of Tetley
and ask for a quotation. He can bargain with Tetley, on probably these few points:

1. We are sister concerns and I do deserve some benefit

2. Selling to me means, you don’t have to pay commission to anyone, so at least give me that
amount as discount.
3. Selling to me means, you don’t have to pack it the way you do it for retail customers, just give me
a bulk packing, save on your packing costs and give me that amount as discount.

So, if you see, a transfer between two known entities, can be done at a reduced price, since there are costs
which can be reduced and eliminated. In this case, what price needs to be set, is the agenda of this
particular study.

There are two parties to this pricing decision:

1. Tetley: who is the transferor of the goods

2. Taj Group: who is the transferee of the goods.

The price that will be set between the two parties, is called the Transfer Price. The transfer price is
generally set keeping the transferor in focus, i.e. the transferor looks in and checks what is the best price
that it can offer.

Now, understand this, Tetley is a separate entity and it is Tetley’s responsibility to generate its own profits.
Thus, when the departments, companies are SEPARATE RESPONSIBILITY CENTRES OR PROFIT CENTRES, in
no case, Tetley will sell at a loss.

The basic, line of thinking is dependent on the following: -

The minimum transfer price that would be charged is the extra cost incurred to manufacture the
product which is the variable cost.
However, the manufacturing capacities also have to be kept in mind. Only if there is spare capacity
available with the transferor, the minimum transfer price, will be the variable cost.

Question 6
Hardware Ltd. manufactures computer hardware products in different divisions which operate
as profit centers. Printer Division makes and sells printers. The Printer Division’s budgeted
income statement, based on a sales volume of 15,000 units is given below. The Printer
Division’s Manager believes that sales can be increased by 2,400 units, if the selling price is
reduced by Rs 20 per unit from the present price of Rs 400 per unit, and that, for this additional
volume, no additional fixed costs will be incurred.
Printer Division presently uses a component purchased from an outside supplier at Rs 70 per
unit. A similar component is being produced by the Components Division of Hardware Ltd.
and sold outside at a price of Rs 100 per unit. Components Division can make this
component for the Printer Division with a small modification in the specification, which would
mean areduction in the Direct Material cost for the Components Division by Rs 1.5 per unit.
Further, theComponent Division will not incur variable selling cost on units transferred to the
Printer Division. The Printer Division’s Manager has offered the Component Division’s
Manager a price of Rs 50 per unit of thecomponent.
Component Division has the capacity to produce 75,000 units, of which only 64,000 units can
be absorbed by the outside market.

The current budgeted income statement for Components Division is based on a volume of
64,000 units considering all of it as sold outside.

Printer Component
Division Division
(Rs in ‘000) (Rs in ‘000)
Sales Revenue 6,000 6,400
Manufacturing Cost
Component 1,050 -
Other Direct Materials, Direct Labour & 1,680 1,920
Variable Overhead
Fixed Overhead 480 704
Variable Marketing Costs 270 384
Fixed Marketing and Administration Overhead 855 704
Operating Profit 1,665 2,688

Required
 (i) Should the Printer Division reduce the price by Rs 20 per unit even if it is not able to
procure the components from the Component Division at Rs 50 perunit?
(ii) Without prejudice to your answer to part (i) above, assume that Printer Division needs
17,400 units and that, either it takes all its requirements from Component Division or all
of it from outside source. Should the Component Division be willing to supply the
Printer Division at Rs 50 perunit?
(iii) Without prejudice to your answer to part (i) above, assume that Printer Division needs
17,400 units. Would it be in the best interest of Hardware Ltd. for the Components
Division to supply the components to the Printer Division at Rs50?
Solution:
(i) Should Printed Division reduce price by Rs20/unit even if it procures component from
market?

Computation of Profitability of Printer Division on reduction of selling price

Particulars Amount
Selling Price 400-20 = 380
Less: Component Cost 1050/15 = (70)
Less: Other DM/DL/VOH 1680/15 = (112)
Less: Variable Marketing Costs 270/15 = (18)
Contribution(per unit) 180
Contribution (total) 180*(15000+2400) = 31,32,000
Fixed Costs (all) 480000+855000 = (13,35,000)
PROFIT 17,97,000

Since the profit is increasing by Rs1,32,000 (1797000-1665000), the Printer Division should reduce its
selling price, irrespective of the fact that it procures the component from Component Division or open
market.

(ii) Should Component division be willing to supply all 17,400 units at Rs50/unit to Printer Division?

Computation of Net Contribution on transfer of 17400 units

Particulars Amount
Transfer Price 50
Less: Variable Production Cost {(1920/64)-1.5} (28.5)
Contribution 21.5
Total Contribution from 17400 units 374100
Less: Opportunity Cost (Note 1) 409600
Net Contribution (35500)

Therefore, if Component division transfers all 17400 units to Printer division at a transfer price of
Rs50/unit, the contribution of Component division will reduce by Rs35,500

[Note 1: Since there is an excess capacity of 11000 units (75000-64000), opportunity cost will be
calculated only for 17400-11000 = 6400 units.
Calculation of Opportunity Cost (not selling 6400 units in the market)
Particulars Amount
Selling Price 100
Less: Variable Production Cost (1920/64) (30)
Less: Variable Marketing Cost (384/6) (6)
Contribution 64
Opportunity Cost (6400units*Rs64/unit) 409600

(iii) Is it beneficial for Hardware Ltd, as a whole, if Components Division supplies all components to
Printer Division at Rs50/unit?

The component produced at the Components Division can be sold at two stages: -
 Sold directly from Components Division at contribution of Rs64/unit, OR
 Transferred to Printers division and sold from there as part of Finished Goods

Analysis of benefit to Hardware Ltd if Component Division transfers 17400units to Printers Division
Particulars Printers Division Component Division Component Division
(transfer) (sold in market)
Selling Price 380 50 100
Less: Variable Costs 180 28.5 36
Contribution 200 21.5 64
Units sold 17400 0 64000
Total Contribution 34,80,000 40,96,000

a) Contribution on Transfer of Component = Contribution earned by Printers Division + Contribution

earned by Component Division
= Rs34,80,000 + Rs.37,41,000 (from answer ii) = Rs7, 221 ,000

b) Contribution on Sale from Component Division = Rs4, 096, 000

c) Incremental Contribution on transfer to Hardware Ltd = Rs3, 125, 000

Therefore, it will be in the best interest of Hardware Ltd if Component Division sells the units to Printers
Division @ Rs50/unit.

Question 12
A Company is organized into two divisions. Division X produces a component, which is used by
division Y in making of a final product. The final product is sold for Rs.540 each. Division X has
capacity to produce 2,500 units and division Y can purchase the entire production. The variable cost of
division X in manufacturing each component is Rs.256.50.
Division X informed that due to installation of new machines, its depreciation cost had gone up and
hence wanted to increase the price of component to be supplied to division Y to Rs.297, however
division Y can buy the component from outside the market at Rs.270 each. The variable cost of
division Y in manufacturing the final product by using the component is Rs.202.50 (excluding
component cost).
Present the statement indicating the position of each Division and the company as
whole taking each of the following situations separately:

(i) If there is no alternative use for the production facility of X, will the company benefit, if division
Y buys from outside suppliers at Rs.270 per component.
(ii) If internal facilities of X are not otherwise idle and the alternative use of the facilities will bring
annual cash saving of Rs.50,625 to division X, should division Y purchase the component from
outside suppliers?
(iii) If there is no alternative use for the production facilities of division X and the selling price for the
component in the outside market drops by Rs.20.25, should division Y purchase from outside
supplier?

What transfer price would be fixed for the component in each of the above circumstances?

Solution:
(i) If Division Y purchases the component from outside market the cost to buy is Rs.270 per
component whereas if the same is bought internally the cost is Rs.256.50. Thus in this case there is a
net saving of Rs.13.50 per unit.
Therefore, the total benefit to the company is Rs.33,750 (13.50 x 2,500) making it beneficial for the
company as a whole to transfer component from Division X

(ii) If there are alternative facilities available for Division X then in this case there will be an opportunity
cost. The opportunity cost per unit will be Rs.20.25 (50,625/2,500). Thus the transfer price in this case
will be Rs.276.75 (256.50+20.25) whereas the same if bought from outside supplier costs Rs.270.
Thus in this case there is a net saving of Rs.6.75 per unit on purchase.
Therefore, the total benefit to the company is Rs.16,875 (6.75 x 2,500) making it beneficial for the
company to buy component from outside supplier.
(iii) If the market price for the component falls by Rs.20.25, then the cost to buy from the outside
supplier will be Rs.249.75 whereas if the same is bought from division X will cost Rs.256.50. Thus in
this case there is a net saving of Rs.6.75 per unit on purchase.
Therefore, the total benefit to the company is Rs.16,875 (6.75 x 2,500) making it beneficial for the
company to buy component from outside supplier.
(iv) Transfer Price:
a. Where there is no alternative use of capacity of division X, then variable cost i.e. Rs.256.50 per
component will be charged.
b. If facilities of division X can be put to alternative use then variable cost Rs.256.50+ opportunity
costRs.20.25 =Rs.276.75 will be transfer price.
c. If market price gets reduced to Rs.249.75 and there is no alternative use of facilities of Division
X the variable cost Rs.256.50 per component should be charged.
 Question 23

Bearings Ltd. makes three products, A, B and C in Divisions A, Band C respectively. The following
information is given:

Particulars A B C
Direct Materials (excluding material A for 4 15 20 Rs. per unit
Divisions B and C)
Direct Labour 2 3 4 Rs. per unit
Variable overhead 1 1 1 Rs. per unit
Selling price to outside customers 15 40 50 Rs. per unit
Existing Capacity 5,000 2,500 2,500 (Number of units)
Maximum External demand 3,750 5,000 4,000 (Number of units)
Additional fixed costs that would be 24,000 6,000 18,700 Rs.
incurred to install additional capacity

Maximum Additional units that can be 5,000 1,250 2,250 (Number of units)
produced by additional capacity

B and C need material A as their input. Material A is available outside at Rs.15 per unit. Division A
supplies the material free from defects. Each unit of B and C requires one unit of A as the input
material.
If B purchases from outside, it has to payRs.15 per unit. If B purchases from A, it has to incur in
addition to the transfer priceRs.2 per unit as variable cost to modify it.
B has sufficient idle capacity to inspect its inputs without additional costs.
If C gets material from A, it can use it directly, but if it gets material from outside, which is at
Rs.15, it has to do one of the following:
(i) Inspect it at its own shop floor at Rs.3 per unit
Or
(ii) Get the supplier to supply inspected products and pay the supplier Rs.2 p. u. as inspection
charges.
Or
(iii) A has enough idle labour, which it can lend to C to inspect at Rs.1 per unit even though C
purchases from outside.
A has to fix a uniform transfer price for both B and C. The transfer price will not be known to outsiders
and is at the discretion of the Divisional Managers.
What is the best strategy for each division and the company as a whole?

Solution:
Working Note:
1) The question beautifully states that there will be a uniform transfer price to be fixed for both the
departments. Transfer price acceptable to Division B will be Rs.13 per unit as the department gets the
same material at Rs.15 per unit from outside and the department spends Rs.2 per unit as modification
cost if it receives transfer from Division A.

Division C has options available with it when it purchases from the market, which are analyzed as
follows:-
(i) It will purchase from market at Rs.15 per unit and incur an inspection cost of Rs.3 per unit at
its own shop floor. The total cost under this option will be Rs.18 per unit (Rs.15+Rs.3).
(ii) Here the division will get the product inspected from the vendor and pay him Rs.2 per unit as
inspection charges. The total cost under this option will be Rs.17 per unit (Rs.15+Rs.2).
(iii) In this case Division A will lend its idle labour to Division C for Rs.1 per unit. Thus in this case
the total cost will be Rs.16 per unit (Rs.15+Rs.1)

But the question clearly specifies that the Division A has to follow a uniform transfer pricing policy, so the
transfer price to Division C will be the same as transfer price to Division A i.e. Rs.13 per unit, which will be
acceptable to both the division.

2) Statement showing Contribution per unit; considering transfer price to Division B & C as Rs.13 per
unit.

Particulars Division A Division B Division C

Market Transfer
Selling Price 15 13 40 50
Less: Direct Material (4) (4) (15) (20)
Less: Material A - - (13) (13)
Less: Modification Cost - - (2) -
Less: Direct Labour (2) (2) (3) (4)
Less: Variable Overhead (1) (1) (1) (1)
Contribution Per Unit 8 6 6 12

3) Costs benefit analysis with respect to quantities to be supplied.

Division A’s demand is dependent on demand from Division B & C. Therefore, demand of Division B & C
have to be crystallized first to estimate A’s demand.

Particulars Division A Division B Division C

Demand 3,750 5,000 4,000
Normal Production Capacity 5,000 2,500 2,500
Balance Demand to be fulfilled - 2,500 1,500
Extra demand that can be supplied by enhancing 5,000 1,250 2,250
capacity
Further units will be lower of balance demand/supply - 1,250 1,500
from enhanced capacity
Extra Contribution earned 30,000 7,500 18,000
(5,000 x 6) (1,250 x 6) (1,500 x 12)
Fixed Cost (Given) 24,000 6,000 18,700
Whether to enhance capacity Yes Yes No

Division A’s requirement (Market + B’s Demand + C’s Demand) = 3,750+3,750+2,500 = 10,000
units.
Particulars Division A Division B Division C
Sale to Transfer to B &
Market C
Units 3,750 6,250 3,750 2,500
(3,750+2,500)
Total Contribution 30,000 37,500 22,500 30,000
(3,750 x 8) (6,250 x 6) (3,750 x 6) (2,500 x 12)
67,500 22,500 30,000
Additional Fixed Cost 24,000 6,000 -
Profit 43,500 16,500 30,000

Question 29
Tripod Ltd. has three divisions  X, Y and Z, which make products X, Y and Z respectively.For
Division Y, the only direct material is product X and for Z, the only direct material isproduct Y.
Division X purchases all its raw material from outside. Direct selling overhead, representing
commission to external sales agents are avoided on all internal transfers. Division Y
additionally incurs Rs. 10 per unit and Rs. 8 per unit on units delivered to external customers
and Z respectively. Y also incurs Rs. 6 per unit picked up from X, whereas external suppliers
supply at Y’s factory at the stated price of Rs. 85 perunit.
Additional information is given below:

Figures
(Rs.)/unit
X Y Z
Direct Materials (external supplier rate) 40 85 135
Direct Labour 30 50 45
Sales Agent’s Commission 15 15 10
Selling Price (in external market) 110 170 240
 Production Capacity (units) 20,00 30,000 40,00
0 0
External Demand (units) 14,00 26,000 42,00
0 0

Required

Discuss the range of negotiation for Managers X, Y and Z, for the number of units and the
transfer price for internal transfers.

Solution:
Since this is a pure strategy and negotiation oriented question, we need to analyze the best option for
each division individually
Tripod Ltd has three divisions X, Y and Z
X can:
(i) either sell in the open market or
(ii) transfer its production to Y
Y can:
(i) either sell open market or
(ii) transfer its production to Z
Z can:
(i) only sell in the open market

DIVISION X
The least price Division X will quote is the sum of variable costs incurred on transfer to Division Y
Minimum Price = Direct Material + Direct Labour+ Sales Agent's Commission
= 40+30 = Rs70/unit

The maximum price Division Y will accept is the market price less additional charges it will have to pay
on internal transfer
Maximum Price = Market Price - Additional Charges
=85 - 6 = Rs79 per unit

Therefore, RANGE ON TRANSFER FROM DIVISION X TO DIVISION Y = Rs70 per unit to Rs79 per
unit

DIVISION Y

There are four situations arising in case of Division Y. We will have to calculate the range of contribution in
all four situations to identify the best strategy for Division Y.
The least price that will be charged by Division Y from Division Z will be its variable cost = Direct Material
+ Direct Labour + Cost of delivery to Division Z= Rs70 + Rs6 + Rs50 + Rs8 = Rs134 per unit
Since the maximum amount that Division Z will pay to Division Y is its Market Price = Rs135 per unit

Buy from X Buy from Buy from Buy from Buy from Buy
Particulars
(Rs70) X (Rs79) X (Rs70) X (Rs79) Market from
 Market
Sell to Z Sell to Z Sell to Sell to Sell to Z Sell to
Market Market Market
Market Price 135 135 170 170 135 170
Less: Direct (70) (79) (70) (79) (85) (85)
Material
Less: Additional (6) (6) (6) (6) - -
Handling cost
(from Division X)
Less: Additional (8) (8) (10) (10) (8) (10)
delivery cost (to
Division Z)
Less: Direct (50) (50) (50) (50) (50) (50)
Labour
Less: Sales Agent - - (15) (15) - (15)
Commission
Contribution 1 (8) 19 10 (8) 10

We can clearly see that the range of contribution which Division Y will earn on transfer to Division Z will
be Rs1 to Rs(8).

Institute's Answer
Therefore, the strategy for Division Y will be to buy from Division X at Rs70 and sell 26000 units in the
market.
If Division Y receives product x from Division X at Rs70/unit, then it may transfer balance 4000 units
(excess capacity) to Division Z and earn a contribution of Re1/unit.

Deviation from Institute's Answer

Since Division X can earn a contribution of Rs25/unit when selling in the open market, it will obviously
want to satisfy the market demand first. In doing so, only 6000 units of Product X are available for transfer
to Division Y.
Since, only 6000 units of product X can be transferred to Division Y, Division Y will not transfer ANY
PRODUCT to Division Z because, for Division Y - the priority will be to sell in the open market.

Therefore, in the given solution, there will be no internal transfers taking place from Division Y to
Division Z

Question 33
AB Cycles Ltd. has two Divisions, A and B which manufacture bicycle. Division A produces
bicycle frame and Division B assembles rest of the bicycle on the frame. There is a market for
sub-assembly and the final product. Each Division has been treated as a profit centre. The
transfer price has been set at the long-run average market price. The following data are
available to each Division:
Estimated Selling Price of Final Product Rs. 3000 per
unit

Long Run Average Market Price of Sub-Assembly Rs. 2000 per

unit

Incremental Cost of Completing Sub-Assembly in Rs. 1500 per

Division B unit

Incremental Cost in Division A Rs. 1200 perunit

Required

(i) If Division A’s maximum capacity is 1,000 units p.m. and sales to the intermediate are
now 800 units, should 200 units be transferred to B on long-term average pricebasis.
(ii) What would be the transfer price, if manager of Division B should be keptmotivated?
(iii) If outside market increases to 1,000 units, should Division A continue to transfer 200
units to Division B or sell entire production to outsidemarket?

Solution:

(i) Should Division 'A' transfer 200 units to Division B on long-term average price basis?

The maximum capacity of Division A is 1000 units and the market can absorb only 800 units. Therefore,
there is a surplus capacity of 200 units on which no opportunity cost will be incurred.
Therefore, if Division 'A' has the option of transferring bicycle frame to Division B at its variable cost which
is Rs1200/unit, the company can earn an extra Rs300 (Rs3000-(1500+1200)).
Division A should transfer 200 units to Division B at its incremental cost and NOT on long-term average
price basis.

(ii)Transfer Price to keep the manager of Division B motivated

Profit Analysis of Division B if transfer price is Long Term Average Price Basis(i.e. Rs2000)
Particulars Amount (Rs/unit)
Selling Price 3000
Less: Incremental Cost of completing Sub- (1500)
assembly
Less: Transfer Price (2000)
Profit/(Loss) (500)

Profit Analysis of Division A if transfer price is Long Term Average Price Basis(i.e. Rs2000)
Particulars Amount (Rs/unit)
Selling Price/Transfer Price 2000
Less: Incremental Cost of completing Sub- (1200)
assembly
Profit/(Loss) 800 Net
Prof
it for the enterprise = 800-500 = 300
Therefore, to keep the manager of Division B motivated, a part of the profit will have to be allocated to his
division.
This allocation can be on any reasonable basis. Some common reasonable allocation bases are-
 Equal share to both divisions
 Profit share divided based on marginal cost (i.e. incremental cost of production)
 Profit share based on an agreement between the two divisions or as per company policy

If we take equal share as the base, then 50% share of Rs300 i.e. Rs150 will have to be allocated to Division
A and Division B each.
Therefore, transfer price will be Rs1200+Rs150 (profit share of Division A) = Rs1350

(iii)If outside market demand increases to 1000 units

Profit to Company when Division A sells entire production to Market

Particulars Amount
Selling Price 2000
Less: Incremental Cost in Division (1200)
A
Profit 800

Profit to Company when Division A sells part of the production to Division B

Particulars Amount
Selling Price 3000
Less: Incremental Cost in Division (1500)
B
Less: Incremental Cost in Division (1200)
A
Profit 300

Therefore, the company will want to sell to the market as much as possible and only when the market
demand is completely satisfied will it want Division A to turn to Division B to absorb excess production.
Since, in the given case, Division A is producing only 1000 units, all of which can be absorbed by the
market, the Company will not want Division A to transfer any units to Division B, as profit on sale at sub-
assembly level is greater than profit on sale of final output.
About the Author
The faculty is qualified Chartered Accountant and
Company Secretary and has experience of 10 years
in Textile Industry and has around 3 years of experience
of teaching.The family has its own Textile Business and
he has been managing the same since last 10 years and
as the textile business is a lot related to production
planning, he from the very start found a great inclination
towards the subject. He has been teaching in several
classes in Mumbai like PDLC, Pinnacle and is a faculty
at WIRC, Rajkot and Mumbai. He has also started
teaching at Yasha’s, Bangalore.