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Monday, Feb 21, 2005

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Economic ordering when vendor offers quantity discounts

P. V. Ratnam

P. V. Ratnam suggests answers to the November 2004 CA (PE II) paper on cost accounting and financial management

RST Ltd has received an offer of quantity discount on its order of materials as shown in Table 9.

The annual requirement for the material is 500 tonnes. The ordering cost per order is Rs 12,500 and the stock holding cost is estimated at 25 per cent of the material cost per annum.

Required: Compute the most economical purchase level; compute EOQ if there are no quantity discounts and the price per tonne is Rs 10,500.

i) In case of varying discounts, we have to ascertain the total cost of purchasing cost, ordering cost and carrying cost (P + O + C) and decision taken for economical purchase level.

The statement of comparative total cost (annual requirement 500 tonnes) is presented in Table 10.

The economical purchase level = 100 tonnes. At this level, the total cost will be lowest at Rs 47,36,500.

ii) EOQ = square root of 2AO / C = square root of 2 x 500 x 12,500 / square root of 25 per cent of 10,500

Square root of 2 x 500 x 12500 / square root of 2625 = 69 tonnes

Cost sheet

POPEYE Company is a metal and wood cutting manufacturer, selling products to the home construction market. Consider the data given in Table 11 for the month of October 2004.

Required: i) Prepare an income statement with a separate supporting schedule of cost of goods manufactured; ii) For all manufacturing items, indicate by V or F whether each is basically a variable cost or a fixed cost (where the cost object is a product unit).

The statement of cost and income and the schedule of cost of goods manufactured are given in Tables 11 and 12 respectively. The manufacturing items are presented in Table 14.

Activity-based costing

MNP suits is a ready-to-wear suit manufacturer. It has four customers: two wholesale-channel and two retail-channel customers.

MNP suits has developed the an activity-based costing system as shown in Table 15.

List selling price per suit is Rs 1,000 and average cost per suit is Rs 550. The CEO of MNP suits wants to evaluate the profitability of each of the four customers in 2003 to explore opportunities for increasing profitability of his company in 2004. The data given in Table 16 are available for 2003:

Required: i) Calculate the customer-level operating income in 2003.

ii) What do you recommend to the CEO of MNP suits to increase the company's operating income in 2004?

iii) Assume MNP suits' distribution channel costs are Rs 17,50,000 for its wholesale customers and Rs 10,50,000 for the retail customers. Also, assume that its corporate sustaining costs are Rs 12,50,000. Prepare the income statement of MNP suits for 2003.

The statement of customer level operating income in 2003 is presented in Table 17.

Note: In the absence of further particulars, rates in 2004 have been taken into account while computing operating income in 2003.

The recommendations are presented in Table 18.

The recommendations will increase the company's operating income in 2004, which is as shown in Table 19.


CONSIDER a firm that has existing assets in which it has capital invested of Rs 100 crore. The after-tax operating income on assets-in-place is Rs 15 crore. The return on capital employed of 15 per cent is expected to be sustained in perpetuity, and company has a cost of capital of 10 per cent. Estimate the present value of economic value added (EVA) of the firm from its assets-in-place.

Return on capital employed (ROCE) — 15 per cent

WACC = 10 per cent or COCE 10 per cent

Value of assets in place = Rs 100 crore.

Economic value added (EVA) from assets in place = (.15 - .10) (100)/0.10 = Rs 50 crore.

The same can be calculated through the DCF method also:

EBIT (I - t) in perpetuity = Rs 15 crore

PV of EBIT (I - t) = 15/0.10 = Rs 150 crore

PV of EVA = PV of EBIT (I - t) - Investment = Rs 150 - 100 = Rs 50 crore.

Operating leverage

TABLE 20 summarises the percentage changes in operating income, percentage changes in revenues, and betas for four pharmaceutical firms.

Required: i) Calculate the degree of operating leverage for each of these firms.

ii) Use the operating leverage to explain why these firms have different beta.

Formula: Degree of operating leverage (DoL) = percentage change in operating income / percentage change in sales

PQR Ltd = 25 per cent / 27 per cent = 0.93 times

RST Ltd = 32 per cent / 25 per cent = 1.28 times

TUV Ltd = 36 per cent / 23 per cent = 1.57 times

WXY Ltd = 40 per cent / 21 per cent = 1.90 times

Comments: The operating leverage occurs due to the presence of fixed costs in the cost of production. Operating leverage increases as fixed costs rise and variable costs fall. It can be seen that Firm WXY Ltd has the highest DoL.

DoL measures how sensitive a firm (or project) is to its fixed costs, or DOL is the responsive change of operating income to change in revenue (sales).

The determinants of beta are a) business risk — cyclicity of revenues; and operating leverage; and b) financial risk — financial leverage.

Operating leverage magnifies the effect of cyclicity on beta. Cyclical firms whose earnings are strongly related to the business cycle tend to be high beta firms. This is why beta is high for firms whose DoL is high.

Credit to customers

A FIRM is considering offering 30-day credit to its customers. The firm like to charge them an annualised rate of 24 per cent.

The firm wants to structure the credit in terms of a cash discount for immediate payment. How much would the discount rate have to be?

Thirty days' credit: Annualised rate is 24 per cent i.e. monthly rate 2 per cent

Cash discount for immediate payment:

Rs 100 if paid immediately

Rs 102 if paid after 30 days.

102 -- 2

100 -- ?

This comes to 1.96 per cent.

Credit terms: 1.96 / 100 net 30

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