The Hindu Business Line : Surviving labour shortage and acute competition

MODERN Electronics produces two standard components `P' and `Q' widely used by the electronic industry. The prices of these products are not steady and competition is acute.

`P' requires two hours of skilled labour per unit while `Q' requires only one hour of the same labour. The total availability of skilled labour is currently limited to 66,000 hours per annum and the company is trying to augment this capacity.

The cost dept of the firm has prepared the budget estimates shown in Table 1 for two possible levels of production/sales of these products for the year 2002. The marketing department has made the forecast of probable sale of the two products for 2002 (see Table 2).

Required: i) Assuming that the constraint on labour availability can be overcome, how many of the two products should be manufactured and sold for maximum profit? What is the profit likely to be earned by the firm?

ii) If the availability of skilled labour cannot be augmented, what will be your recommendation and the corresponding profit earned by the firm?

Working note (WN) 1: Segregation of cost:

Product P: 25,000 units cost Rs 7,00,000, therefore, 20,000 units would cost Rs 6,20,000

The difference is 5,000 units and Rs 80,000

Variable cost = Rs 80,000 / 5,000 units = Rs 16 per unit.

Fixed cost = SV - V

7,00,000 - (25,000 x 16) = Rs 3,00,000

Product Q: 40,000 units cost Rs 6,50,000, therefore, 30,000 would cost Rs 5,50,000

The difference is 10,000 units and Rs 1,00,000

Variable cost = Rs 1,00,000 / 10,000 units = Rs 10 per unit

Fixed cost = 5,50,000 - (30,000 x 10) = Rs 2,50,000

WN2: The statement of contribution at various forecasts of probable sale is presented in Table 3.

Solution (i): Product P: 18,000 units are to be manufactured and sold.

Product Q: 36,000 units are to be manufactured and sold.

The statement of profit is presented Table 4.

WN3: Labour hours required:

P: 18,000 x 2 = 36,000

Q: 36,000 x 1 = 36,000

Sub-total = 72,000

Available hours = 66,000

To be augmented by 6,000 hours

Solution (ii): Skilled labour cannot be augmented. In such a case, contribution per labour hour is to be ascertained as shown in Table 5.

Product Q: 36,000 units are to be manufactured and sold (36,000 hours)

Product P: 15,000 units are to be manufactured and sold (15,000 x 2 = 30,000 hours)

Total — 66,000 hours

The profit is worked out in Table 6.

Cost of capital

A COMPANY'S capital structure is presented in Table 7.

i) If the company is paying dividend at 27 per cent, calculate the cost of equity and weighted average cost of capital, based on book values.

ii) If the market value of equity shares is Rs 15 each and if the debentures are quoted at Rs 95 each, what is the weighted average cost of capital, based on market values.

Note: Tax rate in both cases is 50 per cent.

Cost of equity: Dividend at 27 per cent, that is, Rs 2.70 DPS.

Ke = D1/Po = 2.70/15 = 0.18, that is,18 per cent

WACC based on book and market values are presented in Tables 8 and 9 respectively.

Profitability

A NEWLY-FORMED company has an installed capacity to manufacture 5,00,000 units of a certain product per annum. Its current capacity utilisation is only 40 per cent and the sale price of the product is Rs 40 per unit. The product has the following cost profile: Direct materials: Rs 20 per unit; total fixed costs per annum = Rs15 lakh

Direct labour: Rs 8 per unit

Variable overheads: Rs 4 per unit

The company is considering the following options to increase profitability by Rs 5 lakh: i) reduce selling price by 5 per cent; ii) spend Rs 5 lakh on sales promotion, keeping selling price unaltered. How many units have to be sold in either case?

WN1: Statement of present profit:

Current production, 40 per cent of 5,00,000 = 2,00,000 units in year.

Selling price, Rs 40

Less: Variable cost, Rs 32

CPU — Rs 8

Total contribution = 2,00,000 units at Rs 8 = Rs 16 lakh

Less: Fixed cost = Rs 15 lakh

Profit = Rs 1 lakh

Solution (i): To increase profitability by Rs 5 lakh, total profit of Rs 6 lakh is required.

Revised selling price, 40 - 5 per cent = Rs 38

Less: Variable cost, Rs 32

CPU — Rs 6

Sales (units) = F + P / CPU = (15 lakh + 6 lakh / 6) = 3,50,000 units are to be sold.

ii) Spend Rs 5 lakh on sales promotion. Then, the fixed cost will be Rs 20 lakh.

Sales = (20 lakh + 6 lakh / 8) = 325000 units are to be sold.

Ratios

THE data shown in Table 10 relates to the operations of a manufacturing company: Calculate: i) efficiency ratio; ii) production volume ratio (activity ratio); and iii) idle capacity ratio of the firm.

Efficiency ratio = Actual production in terms of standard hours / actual hours worked x 100 = 68 / 85 x 100 = 80 per cent

Production volume ratio (activity ratio) = actual production in terms of standard hours / budget production in terms of standard hours x 100 = 68 x 100 / 81 = 83.95 per cent

Note: Budgeted production = planned activity.

iii) Idle capacity ratio = 10 x 100 / 95 =10.53 per cent

Theoretical capacity less unavoidable lost time = 95

Actual capacity = 85

Idle capacity = 10 hours

Leverages

PREPARE the income statement of a firm which gives the following details relating to its operations:

Operating leverage = 4;

financial leverage = 2;

annual interest paid = Rs 10 lakh;

contribution / sales = 0.4; tax rate = 40 per cent

Financial Leverage = EBIT / PBT

2 = EBIT / EBIT - Interest, that is, 2 = EBIT / EBIT - Rs 10 lakh

EBIT = Rs 20 lakh

Operating leverage = Contribution / EBIT

4 = Contribution / Rs 20 lakh

Contribution = 4 x 20 lakh = Rs 80 lakh

Contribution / sales = 0.4, that is, PV ratio = 0.4, that is, 40 per cent

Variable cost ratio = 60 per cent of sales.

If contribution (40 per cent) is Rs 80 lakh, sales (100 per cent) would be Rs 200 lakh

Solution: Income statement is as follows:

Sales — Rs 200 lakh

Less: Variable cost (60 per cent) — Rs 120 lakh

Contribution — Rs 80 lakh

Less: Fixed overheads (B/F) — Rs 60 lakh

EBIT — Rs 20 lakh

Less: Interest (given) — Rs 10 lakh

PBT — Rs 10 lakh

Less: Tax at 40 per cent — Rs 4 lakh

PAT — Rs 6 lakh

Operating cycle

CALCULATE the operating cycle of a company which gives the following details relating to its operations:

Raw materials consumption per annum — Rs 8,42,000

Annual cost of production — Rs 14,25,000

Annual cost of sales — Rs 15,30,000

Annual sales — Rs 19,50,000

Average value of current assets held:

Raw materials — Rs 1,24,000

Work-in-process — Rs 72,000

Finished goods — Rs 1,22,000

Debtors — Rs 2,60,000

The company gets 30 days' credit from its suppliers. All sales made by the firm are on credit only. You may take one year as equal to 365 days.

The calculation of operating cycle is shown in Table 11.

(To be concluded)

(Suggested answers to the December 2002 ICWA (Stage II) paper on cost and management accounting.)

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