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P. V. Rathnam
S. Suresh Babu

SVL Ltd uses a basic plan standard costing system in its factory. Unfavourable variances in a process have been about Rs 3,000 a month. If the cause of variance can be found out and if that cause is correctible, it will take two months to correct.

The correction, if made, would be effective for two months. Investigation of variance will cost Rs 980. Correcting the cause, if a cause is found, will cost Rs 2,500.

The management believes the probability of finding a correctible cause is 0.70.

i) Would you recommend launching an investigation?

ii) What is the minimum probability of finding a correctible cause that would justify an investigation?

i) Cost of decision to investigate:

Cost of investigation = Rs 980

Estimated cost of correction = 2,500 x (1- 0.70) = 2,500 x 0.30 = Rs 750

Total cost = Rs 1,730 x

Cost of decision not to investigate (3,000 x 2 months x 0.30) = Rs 1,800 y

As x is less than y, launching of investigation is recommended.

ii) c1 = process out of control; c2 = process in control; a1 = investigate; a2 = do not investigate.

If P = P (c1), then the expected values of the actions are:

E (a1) = -980 P + [-980 (1- P)] = -980

E (a2) = -2500 P + [0 x (1 - P) = -2500 P

The situation should be investigated if the expected value of doing so is higher than the expected value of not investigating, that is, if

-980 is greater than -2500 P

2500 P is greater than 980

P is greater than 980/2500 = 49/125 = 0.39

The minimum probability of finding a correctible cause that would justify an investigation is 0.39.

Activity-based costing

STATUSLINE & Company is a manufacturer of a range of white goods. Cost structure of its different products is as follows:

Standard cost of the products is shown in Table 28. The production overheads is absorbed on the basis of direct labour hours. Statusline wishes to introduce activity-based costing (ABC) system and has identified four major cost pools for production overhead and their associated cost drive. Information on these activity cost pools and their drivers is given in Table 29.

Further, the relevant information on the three products is given in Table 30.

Required: i) calculate the activity-based production cost of all the three products; ii) comment on the differences between the original traditionally calculated costs and the activity-based cost you calculated.

Working note 1: Total cost associated with activity cost pool — Rs 13 lakh

Production overheads were absorbed on the basis of direct labour hours (DLH) as shown in Table 31.

The statement of activity-based production cost is shown in Table 32.

Under traditionally calculated costs, only one basis, that is, DLH, only has been taken as basis for apportionment of production overheads. Product R has been overburdened with Rs 7,50,000.

The basis of DLH alone is not proper when there are various activities, that is, four activities in this case.

The absorption of activity costs on the basis of various activities will be more appropriate instead of one. It reverses position as shown in Table 33.

Absorption of production overheads on the basis of DLH resulted in a wrong picture, whereas apportionment of activity costs on the basis of activities gave the correct picture.

(Concluded)

(Suggested answers to the December 2003 ICWA (Stage II) paper on management accounting.)

(The second part of this article appeared on March 22.)

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