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Management Accounting for Decision Making

Professor Narasimhan M S
RK Forging Company
RK Forging is a forging company based in Coimbatore serving several sectors including power,
automotive, oil and gas, construction, mining, locomotive, marine and aerospace. The growth is more
of cyclical in nature and currently it is operating at 62% capacity utilization. The company has few
regular customers and the customer base is expanding. Normally, the company gets order for the year
with definite delivery schedule. Under the current costing system, the cost of the product is computed
by adding material cost, direct labour cost, and production overhead. Currently, the production
overhead rate is Rs. 20000 per machine hour1.
The Marketing Department is approached by Rinki Automotive, an overseas automobile company, which
requires 1000 units of the front axle beams to be supplied by June 30th 2014. The production
department estimates the order requires 72 hours of machine shop time and material plus labour cost
of Rs. 500 per unit. The customer also informed that they may order the same quantities for the next
two quarters (September 30th and December 31st) but these orders are uncertain. The order requires
significant investment on product level cost which includes design approval, supply of sample, mold, etc.
Initial estimates show an investment of Rs. 1500000. The issue before the management is how to treat
these product level costs – load it completely on the first order or spread over three orders.
The Executive Committee Discussion
The following is an edited transcript of the discussion of the executive committee regarding the pricing
of the product.
Rahul: So, how do you think we should quote our price for the product required by our new customer
Rinki Automotive? Maybe, we had better start with Tanya [Tanya Sharma; the Chief Accountant], since
she has cost data.
Tanya: In this order, I am of the opinion that we need to discuss about how the mold cost and other
product related costs are to be loaded. Since the subsequent two orders are uncertain, I think that it
would be appropriate to load the entire mold cost on the first order.

Professor Narasimhan M S prepared this case with the assistance of Yogitha C as the basis for classroom discussion
rather than to illustrate either the effective or ineffective handling of administrative situation.


The estimated production overhead for the year is Rs. 29.76 million and total available machine hour is 2400
hours. Production overhead rate is equal to 29760000/(2400*62%)

why don’t we load the entire mold price on the first order and give discounts on the subsequent orders? Siddharth: Of course. This is the methodology we have been following for the last 15 years and it is the same methodology that some of our competitors also follow. Professor Narasimhan M S Siddharth: “This is the sure way of losing the customer”. 20000 per machine hour irrespective of machines that we use. we get justification. Our operating profit margin is declining over the years because we are too liberal in pricing our products and every time we get one reason or other saying if we don’t do this. We are also at the risk of losing a large customer. can you get me some more details of the customer? We should not end up losing money on false promise. which I came to know through our consultant who works for different companies. Tanya: It is true that such liberal pricing will bring customer and keep us busy but profit need not increase. the customer is not willing to give any formal commitment for the next two orders. we are charging Rs. We don’t differentiate our orders and we charge a flat overhead rate. We don’t lose much if subsequent two orders fail. If it is a small order. etc. Siddharth. Our price is valid for the first as well as subsequent two orders if materialized. we need to be very careful in our pricing.Management Accounting for Decision Making . if the customer has not placed the two subsequent orders. Any other issue on the order? Siddharth: I wanted to raise another issue related to production overhead. I think it would be more appropriate to charge one-third of the cost on each order on the assumption that we will get the remaining two orders. The product cost is really large and hence Tanya’s concern is valid. 1 million is significant and not to worth to take such risk. Tanya: We compute budgeted overhead and machine hours of the production department to derive the overhead rate. Rahul: Both of you are right. If we are serious to add new customers. This particular order doesn’t require any of the hi-tech machines and I don’t see the rationale of such high overhead cost. Rahul: So. we will end up incurring huge loss if we charge only 1/3 of product related cost. In our machine shop. They also don’t want to evaluate our order with such conditional pricing. Instead of getting support. If you want us to develop rates for different machines. However. low cost and high cost. She feels a loss of Rs. I don’t understand whether we need to lose business and turn totally uncompetitive just because we don’t want to hire two more persons for our Accounting . Loading the entire mold cost on the first order would lead to a substantial increase in the price of the product. I would have gone with Siddharth and take a chance. old and new. we have different kinds of machine. Currently. we talked about this option. automated and semi-automated. Our price will be definitely higher by 40% than what Rinki is currently buying the item from their regular vendor. We worked hard to get this customer and had to do considerable amount of spending both time and cost to include our name in the vendor list. Siddharth: Our Accounting department has an answer for every problem that we face. then we need additional manpower. I will think about the issue and get back. we will not get the order. In this case. This would make our product less competitive in the market.

you need elaborate your concerns with specific data. Tanya. If this is really an issue and we lose profitable orders. you also need to think on the issue of production overhead and get some shortterm solution. the marketing department has limited power in pricing the product and we always have to use the pricing model prescribed by the Accounting department. Professor Narasimhan M S department. In my view.Management Accounting for Decision Making . Rahul: Well Siddharth. Unlike our competitors. Required: Do you agree with Tanya or Siddharth on charging the product related cost of the new order? Do you see any need for changing the production overhead rates? . I don’t mind in hiring two more staff and establish full-fledged costing department. our operating profit is not showing up any improvement because we lose all profitable orders because of our wrong pricing.

Management Accounting for Decision Making . Professor Narasimhan M S Table 1: Income statement summary (Rs. in millions) Year Net Sales Operating Profit Operating profit Margin 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 24 30 48 64 71 90 130 159 129 137 4 6 9 13 12 15 23 26 20 19 17% 21% 19% 21% 17% 17% 18% 17% 16% 14% 180 160 Net Sales Operating Profit 140 120 100 80 60 40 20 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 .