The Hindu Business Line : Frayed topics for finalists

IN THIS paper, only the first question is thought-provoking. The remaining ones are routine and mediocre. For the second time, there is not a single problem from the newly added areas, such as material requirement planning, target costing, JIT, back flush costing, value chain analysis, and so on.

And to preserve the Institute's standards, straightforward theory questions should replaced by case-study-type questions.

What follows is an analysis of the paper:

Make or buy

A COMPANY manufactures two products, EXE and WYE, which pass through two of its departments exclusively used for them. A market research study conducted by the company reveals that the company can sell either 38,500 units of EXE or 31,500 units of WYE in a year. The manufacturing cost and selling price details are as shown in Table 1 and the overheads of the departments are given in Table 2.

Since the quantity which can be sold exceeded the production capacity, the company has been considering the sub-contracting of production facilities. Accordingly, when tenders were floated, two contractors responded:

Contractor DS offers to produce up to a maximum of 17,500 units of EXE or 14,000 units of NVYE in a year for the type of work done by department-1 of the company. The price charged by DS is Rs 138 per unit of EXE and Rs 212 per unit of WYE. These prices included the cost of direct materials used in department-1.

Contractor DW can produce up to a maximum of 11,200 units of EXE, and 7,000 units of WYE in a year for the type of work done by department-2 of the company. The price charged by DW is Rs 150 per unit of EXE and Rs 192 per unit of NVYE. These prices included the cost of direct materials used in department-2.

Required: i) If the company does not wish to use the sub-contracting facility, which of the two products, and what quantity, should be produced and sold by the company by using its own manufacturing capacity to earn maximum profit? Calculate the resultant maximum profit.

ii) If the company wishes to produce either 38,500 units of EXE or 31,500 units of NWE by using sub-contracting facility, state which of the two products should be produced to maximise the profits. Calculate the resultant maximum profit. (16 marks)

The first part of the question requires the students to ascertain the optimum production mix, on an assumption that the company does not intend using sub-contracting facility. It is given that the hours available in department-1 and department-2 are limited to 1,75,000 and 2,80,000 respectively. In order to produce the two products to meet the fullest market demand, the hours required in both the departments are 4,28,750 and 6,03,750 respectively, thus making the departmental hours a limiting factor.

Generally, problems involving limiting factors are solved based on the following steps: a) computation of the product contribution per unit of the limiting factor; b) ranking the products using the results in (a); and c) allocation of limiting factor to the products, according to their ranks.

Following these steps, the rankings given to the products relying on the contribution per hour of department-1 and department-2 are conflicting. Thus, the above steps fail, making it imperative to resort to the linear programming technique.

The objective function can be framed as below:

Maximise contribution = 117X + 165 Y (where `X' represents the units of EXE to be produced; and `Y' represents the units of WYE to be produced)

Subject to the following constraints:

5X + 7.5Y = 1,75,000 (department-1 hour constraint)

7.5X + 10Y= 2,80,000 (department-2 hour constraint)

X= 38,500 (maximum market demand of EXE)

Y= 31,500 (maximum market demand of WYE)

X, Y{gt}=0

Solving using the simplex method, the following results are obtained: Produce 35,000 units of EXE; produce 0 units of WYE; department-1 hours used to the fullest extent; 17,500 hours of departmnt-2 are idle; maximum contribution = (35,000 x 117) = Rs 40,95,000.

Maximum profit = Rs 40,95,000 - Rs 15,00,000 = Rs 25,95,000.

Note: In doing the simplex iteration, initially the product WYE enters the solution and is later driven out by product EXE. The reason is that the latter results in higher total contribution, even though it has a lesser unit contribution.

ii) Using the hours available, one may either produce 35,000 units of EXE or 23,333 units of WYE. This is evident from the results of the simplex table. Now the company has only two alternatives:

Produce 35,000 units of EXE and subcontract 3,500 units and 7,000 units of EXE and WYE respectively. (Alternative-1)

Produce 23,333 units of WYE and subcontract 7,000 units and 11,200 units of WYE and EXE respectively. (Alternative-2)

The contribution from alternative-1 is computed as follows:

The contribution from 35,000 units of EXE = 35,000 x 117 = Rs 40,95,000.

The contribution from 3,500 units of EXE = 3,500 x 87 = Rs 3,04,500.

The contribution from 7,000 units of WYE = 7,000 x 136 = Rs 9,52,000.

The total contribution from alternative-1 = Rs 53,51,500.

The contribution from alternative-2 is computed as follows:

The contribution from 23,333 units of WYE = 23,333 x 165 = Rs 38,49,945

The contribution from 7,000 units of WYE = 7,000 x 136 = Rs 9,52,000.

The contribution from 11,200 units of EXE = 11,200 x 87 = Rs 9,74,400.

The total contribution from alternative-2 = Rs 57,76,345.

Thus, alternative-2 should be preferred.

Note: Rs 87 and Rs 136 respectively represent the unit contribution when the work of EXE and that of WYE are subcontracted.

Comments: Application of linear programming technique is pivotal in tackling this problem. The problem involves tedious computational procedure and the marks allotted are not commensurate with the time involved. The second part of the question is vague and short of clarity.

Variance computation

A COMPANY, which uses standard marginal costing, furnishes details (see Table 3) relating to a single product manufactured and sold in a quarter. The sales budget is based on the expectation of the company's estimate of market share of 12 per cent. The market report reveals that the actual sales of the product in the whole country for the quarter is 60,000 units. Further data are given in Table 4.

Required: i) Compute the following variances for the quarter: gross margin sales; market size variance; market share variance; volume variance; sales price variance; direct materials usage and price variances; direct labour efficiency and rate variances; and variable overheads efficiency and expense variances.

ii) Prepare an operating statement reconciling the budgeted contribution with actual contribution.

This is a straightforward question on standard costing. It involves computation of routine production cost variances and sales margin variances and preparation of an operating statement reconciling the budgeted contribution with the actual contribution. Of course, one new requirement is analysis of the sales margin quantity variance into market share and size variances. If at all the students go wrong, it may be in the computation of actual margin (sales margin variance, that is). They may deduct the actual variable cost instead of standard variable cost from the actual selling price. This problem is too a simple one to merit 12 marks.

Flexible budget

SV LTD manufactures a single product, the selling price of which is Rs 95 per unit. The results obtained by the company during the last two quarters are shown in Table 5.

The company estimates its sales for the next quarter to range between 5,500 units and 6,500 units, the most likely volume being 6,000 units. The manufacturing programme will match with the sales quantity such that no increase in inventory of finished goods is contemplated in the next quarter. The following price and cost changes will, however, apply to the next quarter:

The price of direct material B will increase by 10 per cent. There will be no change in the price of direct material A.

The wage rates will go up by 8 per cent. If the production volume increases beyond 5,500 units, overtime premium of 50 per cent is payable on the increased volume due to overtime, to be done by the variable labour component.

The fixed factory and selling expenses will increase by 20 per cent and 25 per cent respectively.

A discount in the selling price of 2 per cent is allowed on all sales made at the 6,500-unit level of output. The selling price, however, will remain unaltered if the volume of output is below 6,500 units.

While operating at a volume of output of 6,500 units in the next quarter, the company intends to quote for an additional volume of 2,000 units to be supplied to a government department for its captive consumption. The working capital requirement of this order is estimated at 80 per cent of the sales value of the government order. The company desires a return of 20 per cent on the capital employed in respect of this order.

Required: i) prepare a flexible budget for the next quarter at 5,500, 6,000 and 6,500 unit levels and determine the profit at the respective volumes; ii) calculate the lowest price per unit to be quoted in respect of the government order for 2,000 units. (12 marks)

The question requires the students to prepare a flexible budget for three budgeted activity levels for the third quarter. It is stated that the manufacturing programme will match with the sales quantity making the inventory level unchanged. So, in the current quarter, we can infer that production equals sales.

For flexing the costs over the different activity level, it is pertinent to classify the costs into fixed and variable. Since the manufacturing wages, factory overheads and selling overheads have both fixed and variable elements, the segregation becomes necessary. The variable element can be found by dividing the difference in total cost of the two quarters by the corresponding difference in the activity level. Care should be taken to take sales units rather than production units for the purpose of segregation of the selling overheads. Here there is an anomaly.

The variable element in selling overhead works out to Rs 20 per unit [79,000 - 73,000] / [5,100 - 5,800]. The resulting fixed element becomes a negative figure, causing confusion to the students. In flexing, adequate attention should also be paid to the information relating to price increase and sales discount.

The second part requires quoting the lowest price for the government order. In determination the same, consideration should be given only to the variable elements of costs and the interest on funds blocked in working capital.

But for difficult caused due to the inconsistency in selling overheads data, this question should not have created any flutter.

(To be concluded)

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