Cost,Volume,Profit Analysis-Problem 1

Cost, volume, profit analysis-Problem 1


Q. A company has the following budget on orders from home market


                                   



At this level of output the company has spare capacity and it is therefore planning to develop export market. It believes that it will be able to sell an additional 750 units – the limit of its production due to shortage of raw materials. No additional fixed costs would be incurred and selling price and variable costs per unit would be same as for the home market.

Before launching its export campaign, however , the company is approached by a home buyer who wishes to purchase 200 deluxe models which twice as much materials as the standard model. What is the minimum price which should be charged if this order is accepted?




Ans.  From  the data given above for 2000 units we can find the contribution per unit:-

        


The company has spare capacity to manufacture 750 additional units which it can sell in the export.     -------------------(Given)

The contribution which the company can obtain from the sale of these 750 units
                                                                                                               = 750 * 2 = $1,500

The company’s capacity is limited by the availability of raw materials.
So the total cost of raw materials available = 2750 * .5 = $1,375

The new deluxe product which the home buyer needs requires twice the raw material.

So if the company manufactures 200 units of the deluxe product it will have spare capacity to manufacture only 350 additional units of the standard product.

Contribution from the 350 units of standard product = 350 * 2 = $700

The company can only take the order if the contribution from the 200 units of deluxe product and 350 units of standard product equals to the 750 units of the normal  product.

Contribution needed from the 200 units of deluxe product = 1500 - 350 * 2 = $800.
Contribution/unit of deluxe product = $4

The cost of the deluxe product is



So in order to take the order for 200 units of deluxe product the company must charge a minimum price of 3.5 + 4= $7.5

Cost Accounting-Breakeven problem

Question

Universal Airlines is considering a proposal to initiate air service between Phoenix, Arizona and Las Vegas, Nevada. The route would be designed primarily to serve the recreation and tourist travelers that frequently travel between the two cities. By offering low-cost tourist fares, the airline hopes to persuade persons who now travel by other modes of transportation to switch and fly Universal on this route.

In addition, the airline expects to attract business travelers during the hours of 7 AM. to 6 PM. on Mondays through Fridays. The fare price schedule or tariff would be designed to charge a higher fare during business-travel hours so that tourist demand would be reduced during those hours. The company believes that a business fare of $100 one way during business hours and a fare of $60 for all other hours would result in the passenger load being equal during business-travel and tourist-travel hours.

To operate the route, the airline would need two 200-passenger jet aircraft. The aircraft would be leased at an annual cost of $10,000,000 each. Other fixed costs for ground service would amount to $ 500,000 per year. Operation of each aircraft requires a flight crew whose salaries are based primarily on the hours of flying time. The costs of the flight crew are approximately $800 per hour of flying time. Fuel costs are also a function of flying time. These costs are estimated at $1000 per hour of flying time. Flying time between Phoenix and Las Vegas is estimated at 45 minutes each way.

The costs associated with processing each passenger amount to $5. This includes ticket processing, agent commissions, and variable costs of baggage handling. Food and beverage service cost $10 per passenger and will be offered at no charge on flights during business hours. The cost of this service on non-business hour flights is expected to be recovered through charges levied for alcoholic beverages.



Required:

1 If six business flights and four tourist flights are offered each way every weekday, and twelve tourist flights are offered each way every Saturday and Sunday, what is the average number of passengers that must be carried on each flight to break even? What is the breakeven load factor or percentage of available seats occupied on a route?

2. If Universal Airlines operates the Phoenix—Las Vegas route, its aircraft on that route will be idle between midnight and 6 A.M. The airline is considering offering a “Red Die” special, which would leave Phoenix daily at midnight and return by 6 A.M. The marketing division estimates that if the fare were no more than $40, the load factor will be 50% for each “Red Die” flight. Operating costs would be at the same rate for this flight, but advertising costs of $10000 per week would be required for promotion of the service. No food or beverage costs would be borne by the company. Management wishes to know the minimum fare that would be required to break even on the “Red Die” special assuming the marketing division’s passenger estimates are correct.

Answer

Part 1.
Flying Time - Weekdays
Business - 6 flights x 2 way x 5 days x 45 minutes = 2700 minutes
Tourist - 4 flights x 2 way x 5 days x 45 minutes = 1800 minutes

Flying Time - Weekends
Tourist - 12 flights x 2 way x 2 days x 45 minutes = 2160 minutes
---------------
Total : 6660 minutes

6660 minutes/60 = 111 hours per week or 5772 hours per year (111 hours x 52 weeks)


FIXED COST
Lease : 10,000,000 x 2 flights 20,000,000
+ Ground Service : 5,000,000
Total 25,000,000

VARIABLE COST
Salaries $ 800 x 5772 hours = $4617600
Fuel Cost $ 1000 x 5772 hours = $5772000
Total : $ 10389600

Ticket Processing cost
12 flights x 5 days x 52 weeks x $5 = $15600
8 flights x 5 days x 52 weeks x $5 = $10400
24 flights x 2 days x 52 weeks x $5 = $12480
Total $38480

Food and beverages service
12 flights x 5 days x 52 weeks x $10 = $31200


SALES
12 business flights x 5 days x Y number of passengers x 52 weeks x $100 = 312000 Y
8 business flights x 5 days x Y number of passengers x 52 weeks x $60 = 124800 Y
24 business flights x 5 days x Y number of passengers x 52 weeks x $60 = 149760 Y
Total = 586560 Y

At Break Even Point
Sales = Fixed Cost + Variable Cost

586560 Y = 25000000 + 10389600 + 38480Y + 31200Y
or Y = 69 Passengers to Breakeven

Part 2
Breakeven Load Factor : 69/200 x 100 = 34.5%

Part 3
Load Factor 50% i.e. 100 passengers per flight

Time - 2 flights x 7 days x 45 minutes = 630 minutes/60 = 10.5 hours

Sales = 2 flights x 7 days x 45 minutes x $Y fare = 1400Y

1400Y = 35900 Hours

Y = 35900/1400 = $ 25.64

Limiting Factor - Problem 1

Limiting factor


Q. In a factory producing two different kinds of articles,the limiting factor is availability of material but the same material is used in both articles:



The demand during each period for the two products is 10,000units of A and 8,000 units of B. It is also considered desirable that, should demand be there, the firm should be willing to meet at least half the demand stated above in all circumstances. The total availability of materials for sometime will be restricted to the quantity available for $120,000 only.

State how the available raw material would be utilized.


Ans. In all these problems it is necessary to understand the limiting factor and find the contribution for each product based on the limiting factor.

And then analyze any additional constraints which are given.

Here the limiting factor is the availability of raw materials so we need to find the contribution for each product per unit of material used which is as given below:


Its mentioned that the firm needs to meet at least half the demand for product A and product B at all times.
Demand for A = 10000
Demand for B = 8000
So the firm needs to produce at least 5000 units of Product A and 4000 units of product B.

Raw material consumed = 5000*15 + 4000*10 = $115,000

Total available raw material is worth $120,000

So the remaining 120000 – 115000 = $5000 worth of raw material should be used by the firm to manufacture the product which gives maximum contribution which is product B.

The number of units of product B that can be produced in$5000 are = 5000/10 = 500 units.

Ans. So the firm should use the raw materials such that they produce 5000 units of product A and 4500 units of product B.

Variance Analysis - Problem 2

Q. A Company selling consumer durables prepared its budget for 2008-09 anticipating a profit of $ 40 Million. But the actual results for the year disclosed a net loss of $2 Million. The managing director of the company wanted to prepare a statement explaining the reasons for the loss. Details of the budget with actual are given below:-



During investigation you found that there was an overall increase of 10% in cost of material. The labourers were given 15% increase in wages as a result of agreement with trade unions. The selling prices increase by 10%. Prepare a report listing the various factors responsible for the loss of $2 mill. as against the anticipated profit of $40 mill.


Ans.
The increase in selling price = 10%(Given)

As we know that sales is a function of volume and selling price.
Sales = F(Volume,SP)
The actual volume in 2008-2009 without the increase in selling price would be = (968*100)/(100+10) = 880

The increase in SP by 10% contributes purely to increase in profit = 968 - 880 = 88 ---(I)
There is also an actual increase in volume from what was budgeted = 880 - 800 = 80 ----------(i)


Material variances

The material price increased by 10%. (Given)
The material price variance = 506 - (506*100)/(100+10) = 506 - 460 = 46 ---------------(II)

The volume increased by 80 from what was budgeted.
For a volume of 800 the material required = 400
Hence for a volume of 880 , material required would be = (880 * 400)/800 = 440
Thus the material volume variance = 440 - 400 = 40 ------------------------------------------(ii)

The difference 460 - 440 = 20 in material is due to the reduction in efficiency.
Thus the material usage variance = 20 -----------------------------------------------------------(III)


Labour Variances

The labour cost increased by 15% (Given)
The labour price variance = 230 - ((230 * 100)/(100+15)) = 230 - 200 = 30 -----------------(IV)

The volume increased by 80 from what was budgeted.
For a volume of 800 the labour cost = 160
For a volume of 880 the labour cost would be = (880*160)/800 = 176
Thus the labour cost volume variance = 176 - 160 = 16 ------------------------------------------(iii)

The difference 200 - 176 = 24 in labour is due to the reduction in efficiency.
Thus the labour efficiency variance = 24 -------------------------------------------------------------(V)


Variable Overheads

The volume increased by 80 from what was budgeted.
For a volume of 800 the variable overhead = 80
For a volume of 880 the variable overheads would be = (880*80)/800 = 88
Thus the variable overhead volume variance = 88 - 80 = 8 --------------------------------------(iv)

The difference 96 - 88 = 8 in variable overhead is the expenditure variance.
The the variable overhead expenditure variance = 8 -----------------------------------------------(VI)

Fixed Overheads

The fixed overhead variance = 138 - 120 = 18 ------------------------------------------------------(VII)

The increase in volume contributes positively to profit but it also leads to increase in material, labour and variable overhead costs.

Thus from (i), (ii), (iii) & (iv) we see that the increase in profit due to increase in volume is
= 80 – 40 – 16 – 8 = 16

Variance Analysis - Problem 1

Q. A company finds that it has incurred loss during the year 2010 to the extent of $3.40 million as against a profit of $5 Million in 2009, despite increase inselling price of its sole product to the extent of 20%.

The adverse situation is mainly attributable to the increase invariable costs and fixed costs, the increase over the previous years being onaverage 15% to 20% respectively. The following figures are extracted from the books of the company:




You are requested to analyse the variances relating to sales,fixed and variable overheads over the year in order to bring out thereason for the fall in profit.



Ans.

The increase in selling price = 20% ( Given )

Sales volume in 2010 = 129.6 (mill. $ )
Sales volume in 2009 = 120 (mill. $ )

Sales volume is a function of volume and selling price.
Sales volume = F(volume,selling price)

The sales volume in 2010 without increase in selling price would be = (129.6 * 100)/(100 + 20) = 108
Thus there is an actual reduction in sales volume from 2009 to 2010 = 120 - 108 = 12 ---------- (i)

The increase of 20% in selling price contributes purely to profit = 129.6 - 108 = 21.6 -----> (I)

Variable cost in 2009 for sales volume of 120 = 100
Variable cost in 2010 for sales volume of 108 = (108 * 100)/ 120 = 90 ----------- (ii)
The variable cost volume variance = 100 - 90 = 10 -------------------------------- (iii)

The increase in variable costs in 2010 = 15% (Given)
The variable costs without the increase of 15% =(115*100)/(100+15) = 100 ----- (iv)
The increase of $ 15 mill. due to increase of 15% in variable costs is the variable cost price variance.

Variable cost price variance = 115 - 100 = 15 (mill. $) ------------------------------------> (II)

From (ii) and (iv) we observe there is a difference of 10 (mill $)in the variable costs which is due to loss in efficiency and which contributes adversely to profit.
Thus Variable cost efficiency variance = 10 (mill. $) --------------------------------------> (III)

Also the reduction in sales volume would contribute adversely to profit, however as it also leads to decrease in material usage it would affect profit only to the extent of
12 – 10 = 2 (mill. $) (From (i) & (iii) ) ---------------------------------------------->(IV)

There has been an increase in fixed costs from 2009 - 2010 for an amount of 3 (mill. $) . This would again affect profit in an adverse manner.

The Fixed overhead expenditure variance = 18 -15 = 3------------------------------> (V)


           

Some Perceptual errors

What are the different types of Perceptual errors that you have encountered in your workplace? As a manager, how will you correct these errors?

I work for an Export House, involved in the business of manufacturing and exporting readymade garments to Europe and the US. I have worked with this organization for more than 15 years and have been involved in different departments over the years – these are Accounts, Finance, Export Documentation and Merchandising. I currently head the Export Documentation & Shipping department. With my experience in various departments, I can list below the common Perceptual errors that I have encountered at my workplace.

# STEREOTYPING

Documentation department

My sub-ordinate, Ranjan K in the documentation department, is a Keralite and he is stereotyped as a stubborn person, as that is the perception for all Keralites in our country. Though he displays typical traits of the Malayali community, and is extremely stubborn and argumentative at times, he also has immense positive characteristics like being methodical; is extremely hard working and is a perfectionist. He does not get along with anyone in the organization because of his ill-tempered & stubborn nature. He was always getting a negative evaluation from other managers.

Also, due to the stereotyping of Ranjan K, fresh applicants who were Keralites, and who wanted to join my organization, were being rejected as they were all perceived to possess the same negative characteristics as that of Ranjan K.

Correcting the error

As a manager, I had to do something about the situation. I had an informal chat with Ranjan K and explained to him how his attitude of being hard-headed and not accepting change was detrimental to his growth in the organization. I valued his positive attributes and did not want to lose a good employee. He gave me a positive response and promised me he will try to implement the behavioral changes I had suggested. At the same time, I also spoke to the HR department head and urged him not to stereotype all prospective employees belonging to a particular community, as we could be missing the opportunity to hire good and valuable employees.

Production department

Our manufacturing units are in a town called Tirupur, which is located in Tamil Nadu. Tirupur is a major hub for knitted garment manufacturers and is known for it’s resources of skilled and semi-skilled labour essential for the manufacturing of knitted garments. The staff and the labour force, comprising of local Tamilians, are stereotyped as gossip-mongers and rhetorical. They would never say no to any task assigned to them or a deadline given to them, but would work at their own pace. Also, politics at workplace is a major problem.

Correcting the error

I have personally identified many merchandisers in Tirupur who are hard working, efficient & free from the stereotypical error mentioned above. I believe in identifying such individuals and empowering them with additional responsibility to choose their task force, and motivate them with performance based incentives.

# THE HALO EFFECT

I would like to cite the example of Mr. Sameer Mehta, who in the Finance department of our organization, and has excellent communication skills. He has not been very effective in his work, and we had lost a considerable amount of money in Forex dealings in the last financial year due to wrong decision-making on his part. His single attribute of good communicating skills, fuelled by his good relations with the Managing Director, has earned him the current position that he enjoys.

Correcting the error

I would highlight Mr. Mehta’s poor decision-making and his condescending manner to the directors and explain how his bad judgement in forex deals have resulted in financial losses to the organization.

# ATTRIBUTION

Mr. Manoj Sareen, who was heading the Production department in our manufacturing units in Tirupur, was a hard-working, efficient, honest and dedicated individual. Under his control, we had seen several years of successful & timely despatches of our export orders, without any quality claims or late shipment penalties from our overseas buyers. He had been instrumental in running efficiently, our five manufacturing units involved in finishing of goods, quality control, technical assistance to printing, embroidery, stitching and special processes in garment washing. It also involved sacrifice of family life on his part as Tirupur is a small town with limited educational or recreational facilities. After ten years of successfully running the manufacturing process of our organization, Mr. Sareen had a disagreement with the management over certain issues. He was also not getting certain perks that were due to someone in his capacity. When he confronted the management citing his contributions and sacrifices over the years, the management appreciated him for his good work but attributed the successful & timely despatch of orders to good decision-making by Administrative managers sitting in Mumbai. Mr. Sareen was shocked and argued as to how his contribution and efforts could be compared to the inputs given by people in Mumbai office, but his role was played down by the management and he had to leave the organization.

# SELF-FULFILLING PROPHECY

I have a classic example of the above perceptual error in my organization and it is none other than the Managing Director, Mr. Rajesh Kapoor. Mr. Kapoor is a pessimist by nature and always has negative thoughts about the future. Though he had been instrumental in establishing the business, we have not seen much growth in the last 2-3 years, as he has been against expansion of any kind. Since the garment export industry has seen a tough phase in the last few years and never really recovered after the global recession, Mr. Kapoor would advise us in the board meetings that the next 2 years are crucial, and if we survive this phase, we will grow substantially and the sky would be the limit. A lot of time has passed, but those “2 years” have never really gone by, and we are still given the same advice by Mr. Kapoor. This has deteriorated the situation to an extent that he is consulting several fortune-tellers. Though he claims that his pessimistic nature enables him to foresee problems and find solutions before they occur, the fact is that he visualizes a dark future and has convinced himself that there is no way out. As a result, there are no efforts taken to get the business back on track, or to expand customer base, even though we enjoy tremendous goodwill in the market & are getting several enquiries from prospective customers. Therefore, there is a severe negative impact on the business, and Mr. Kapoor’s self-fulfilling prophecy of doomsday is actually coming true and we are facing the risk of a possible closure.

Correcting the error

Despite several attempts by managing partners to convince him, Mr. Kapoor has been adamant about not entertaining new business enquiries. As Self-fulfilling prophecy works the same for both positive and negative thoughts, we need to convince Mr. Kapoor to think and act in a positive manner and manufacture ways to achieve those positive outcomes.

# CONTRAST EFFECT

Mr. Arun Goyal, who was heading the Accounts department in my organization, resigned 2 months back. He was extremely organized, orderly and meticulous in his work. Because of his systematic way of working, any kind of data / financial reports required by the departmental heads would be presented by him almost immediately on demand. Stepping into his department would give a complex to most of the other employees.

After he left, his position has been taken by Ms. Seema Dhar, who is not as organized as him, but is a good worker, nevertheless. Ms. Dhar is a victim of bias as the Finance Head is used to getting all sorts of reports within minutes of his asking for them, thanks to the efficiency that Mr. Goyal had displayed while he was working with the company. Ms. Dhar always seems to be falling short of the high expectations of the Finance Head, Mr. Mishra, even though she is a hard worker. This is an example of Contrast effect which is having a negative impact on Ms. Dhar’s career due to high standards set by Mr. Goyal.

Correcting the error

If I were in the Finance Head’s position, I would give more time to Ms. Dhar to settle down and to understand the responsibilities allotted to her. She is new to the organization, it is unfair to immediately compare her performance to that of Mr. Goyal’s. But I would certainly talk to her about the precedent that Mr. Goyal had set and the fact that I would expect similar dedication and efficiency in the near future.