Costing in Pepe Denim*

Kesar Bajaj (Bajaj), chairman of Pepe Denim, a manufacturer and retailer of jeans in India, was
facing tremendous pressure to improve the financial position of the company and its market
valuation.

Bajaj and his younger brother Dinkar had floated Pepe Denim as a private limited company in
Ahmedabad, Gujarat, in 1984. In 1994, the brothers decided to convert the company into a public
limited company. Pepe Denim began manufacturing operations with just one factory in
Ahmedabad district but the brothers put in a lot of hard work and took the company to a level
where in 2011, it had 300 stores spread throughout the country and a workforce of 20,000. It also
used to export its jeans to China, Brazil, and Nepal.

Till 2007, the company did very good business with its sales increasing every year. It earned
exceptional growth in valuation resulting from an increase in the company’s stock prices. After
2007, however, the stock prices of the company started to decline even though sales continued to
be consistent. Though there was no decrease in sales, the profits began to fall. The brothers
thought that the decline in the stock prices and profits was due to the economic slowdown and
recession. Since there was consistency in sales, they concluded that the profits were declining
because of the increase in costs due to inflation. But the stock prices of the company remained
flat and profits continued to decline even after 2010 when the economy had started reviving,
stock indices had started rising, and the stock prices of other companies had also started soaring.

The shareholders of the company raised concerns over the declining profits of the company. As a
result of a heated shareholders’ meeting, Bajaj came under pressure to improve the company’s
financial position and its market valuation. In order to understand the present status of
production, costs, sales, and the future prospects of the company’s product in the market, he
immediately called Vipin, the company’s cost accountant, and Sneha, the marketing manager.

*
This case was prepared by Kavita Wadhwa of IBS, Hyderabad. The case has been prepared for the sole purpose of
being used as the basis for a classroom discussion. It is not a comment or illustration of the correct or incorrect
handling of affairs as mentioned in or inferred from the case.

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Vipin furnished the following cost information (Refer to Exhibit I) for the year ending March 31,
2010, and the changes in costs which were expected in the coming year:

Exhibit - I

Production and Sales……………………………………….………………………..1500000 units

(in 000s)
Sales………………………………………………………………………………….…..1500000
Direct Wages………………………………………………………………………………270000
Direct Materials…………………………………………………………..………………..330000
Factory Overheads…………………………………………………………………….......325000
Administration overheads……………………………………………………………..…...205000
Sales overheads………………………………………………………………………………90000

On account of intense competition, the following changes were estimated in the subsequent year:

1. Production and sales activity would be increased by one third.

2. Material rate would be lowered by 25%. However, there would be a 20% increase in
consumption which would take care of the increase in production level.
3. Direct wages cost would be reduced by 20% due to automation.
4. Out of the above factory overheads (given in Exhibit I), Rs. 45000 were fixed in nature.
The remaining factory expenses would be variable in proportion to the number of units
produced.
5. Total administration expenses would be lowered by 40%.
6. Sales overhead per unit would remain the same.

On the basis of cost and profit estimation for the years ending March 31, 2010, and March 31,
2011, Vipin told Bajaj that 6 % decline in profit on sales was expected in 2011. Bajaj realized
from Vipin’s report that the reason for the decline in profits despite the consistent increase in
sales volume was the heightening competition from other brands in the market. Since Sneha was
in direct contact with the market, Bajaj asked her to carefully analyze the potential of the
company’s product in the market and suggest the options available to overcome the problem. He

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gave Sneha 10 days’ time to do this. After 10 days, Sneha reported back to Bajaj. In order to
carry out a formal analysis of the options available with regard to business opportunities, Bajaj
immediately called a meeting with the board of directors and asked Vipin and Sneha to be
present.

Addressing the meeting, Sneha said that in order to overcome the problem, Pepe Denim needed
to attract new customers and sell more goods to repeat customers. She said the company needed
to add new product lines; however, in order to keep costs down, the product lines had to be such
that they would not require much additional cost. She suggested two new products which would
require the same type of material and similar labor, and would serve the female segment of the
market. Sneha said the two products which could be added easily were Denim Skirts and Denim
Handbags for women as these two items would require the same raw materials. Besides, with a
little training, the same tailors could undertake the stitching activity.

After examining the suggestion, Bajaj thought that the two products would be a good strategic fit
for the existing product line. He sought the opinion of the board of directors and they too gave a
favorable response. With this, it was decided that the company would add these two products as
soon as possible.

After one year of the introduction of the two products i.e. on March 31, 2011, Kesar called Nihit
the CFO (Chief Finance Officer) of the company, to find out about the company’s profitability
and asked him to present Pepe Denim’s income statement. Nihit brought a summarized income
statement which was as follows:

Exhibit - II

Income Statement of Pepe Denim for the year ending March 31, 2011

Particulars Details Amt (in 000s)

Sales 2000000
Less: Cost of goods sold 1263450
Gross Profit 736550
Less: Indirect expenses
Office expenses 129150

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 Selling and distribution expenses 126000 255150
Net Profit before depreciation 481400
Less: Depreciation 16400
Net Profit after depreciation 465000
Less: Tax (40%) 186000
Profit after tax 279000

From the income statement, Bajaj calculated the profit before tax percentage on sales and it
worked out to be 23.25 — 4.25 per cent higher than the previous year’s profit. This improvement
in profit gave him some satisfaction and he was eager to know how the new products were
performing and what their cost structures were. He asked Vipin to present the cost sheet of
Denim Skirts and Denim Handbags. Vipin was not ready with the cost sheets and so presented
the following cost details of all the products:

Exhibit - III

(Amount in 000s)

Denim
Particulars Jeans Denim Skirts
Handbags
Stock of materials as on April 1, 2010 200000 ……….. ………..
Stock of materials as on March 31, 2011 150000 75000 25000
Material purchased during the year 600000 300000 100000
Sale of material (not suitable) 25000
Work-in-progress as on April 1, 2010 100000 ……….. ………..
Work-in-progress as on March 31, 2011 35000 10000 5000
Finished Stock as on April 1, 2010 350000 ……….. ………..
Finished Stock as on March 31, 2011 450000 200000 120000
Salaries (Factory) 15350 10000 5000
Office salaries 25000 15000 5000
Carriage on purchases 12000 6000 2000

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Carriage on sales 13000 5000 2000
Cash discount allowed 1800 550 400
Bad debts written off 8000 1500 500
Repairs of plant, machinery, and tools 8000 4000 1600
Rent, rates, taxes, and insurance (factory) 12000 6000 2000
Rent, rates, taxes, and insurance (office) 2000 700 300
Traveling expenses 7000 5000 3000
Traveler’s salaries and commission 20000 13000 7000
Productive wages 300000 120000 180000
Depreciation written off on plant, machinery,
9000 3000 2000
tools
Depreciation written off on office furniture 1800 400 200
Director’s fees 15000 7000 3000
Dyeing and water charges (factory) 3000 1500 500
Gas and water charges (office) 850 300 100
General charges 12750 5000 3000
Manager’s salary (Office) 8000 5000 2000
Manager’s salary (factory) 10000 6900 5000
Advertising 28000 21000 8750

Required:

1) Vipin told Kesar Bajaj that a 6 % decline in profit on sales was expected in 2011. If the
given information is correct then what would be the selling price of a pair of jeans for the
year ending March 31, 2011?
2) Can you help Kesar Bajaj in getting the total cost estimate of all the three products –
Jeans, Denim Skirts, and Denim Handbags? If yes, what is the total cost of all three
products?
3) You are required to reconcile the profit with the Income Statement.
4) Do you think the decision of the company to add two new products was beneficial? If
yes, how?