CHAPTER 6

Relevant Costs and Decision- Making

Learning Objectives
After completing this chapter you will be able to:
 Identify the Relevant Costs that are affected as a result of a decision under consideration.
 Distinguish between the Relevant Cost items and the Non-Relevant Cost items.
 Understand the concept of Analytical Framework for various short-term operating decisions,
such as, whether to accept the special sales order offering price below total cost, drop the
product line, make or buy, operate or shut down, optimal product/sales mix and use of scarce
resources.
 Appreciate Incremental Analysis (which takes into account increase in revenues and reckons
incremental costs only) as a technique of decision-making.
 Prepare comparative income statements showing profit (loss) under present and proposed
situations.

INTRODUCTION

Decision-making involves the act of selecting the best course of action form the various
feasible alternatives available. In context of business enterprises, the decision is said to be the
best when it maximises the profits or minimises the losses in a given situation. Since these
decisions relate to the ‘future’; therefore, and only the future revenues lik
future costs likely to be incurred constitute Relevant data for decision-making purposes. Clearly,
coststobeincurred(duetothedecisionstakeninthepast),infuture,irrespe
decision (under consideration) are irrelevant costs.
The objective of this chapter is to provide the subject matter, which would be of immense
use to business executives in the tasks related to the short-run operating decisions. It may be
noted that the term short-run is applied to decision-horizons of one-year period during which
capacity will not change. Included in this category are, decisions related to acceptance of special

6.1
order, make or buy decisions, decisions to continue to operate or shut down, decisions to drop a
product line/product mix and so on.
Finally, it should be borne in mind that the actual decision-making, in practice, is
influenced both by quantitative (financial) and qualitative (non-financial) set of factors.
However, our focus will be exclusively on quantifiable aspects relevant for decision-making.
Incremental analysis (also known as Differential analysis) captures all the relevant data and
hence it has been used in this chapter as a technique for various short-run operating decisions
mentioned above.

RELEVANT COST DATA FOR DECISION-MAKING

Costs that are influenced (increase or decrease) as a result of the decision under
consideration are referred to as relevant costs. In contrast, costs which are not affected by the
decision, are called irrelevant costs. Evidently, only the relevant costs form part of the analytical
framework, referred to as Incremental/Differential analysis. Let us explain the process of
selecting the right/appropriate costs (and revenues) for decision-making through a simple
example.
Example 6.1 (Acceptance of Special Order/Offer)
Suppose Mr. Smith, a fresh Engineering graduate, opens a factory. His fixed costs
consisting of factory rent, lease rent of plant, factory insurance, salary of permanent staff and so
on are Rs 3 lakh per quarter. His variable costs that consist of material cost, power and other
variable expenses/overheads are Rs 8 per unit. The normal plant capacity is 30,000 units per
quarter. His experience of the past two quarters is that he can sell only 20,000 units at Rs 25 per
unit. Given the current state of competition, he is not hopeful of bigger market at least for a year.
He has an excess capacity of 10,000 units and there is no alternative use for the idle capacity.
At this stage, he receives an offer from a foreign customer who is ready to buy 10,000
units on quarter basis for a year at Rs 15 a unit.
Should he accept the order? Assume that the shipment charges of Rs 25,000 are to be
borne by the buyer. However, products need to be especially packed and this will amount to an
additional cost of Re 1 per unit to Mr. Smith. Since it is an export order, Mr. Smith is convinced
that the regular marketing price of Rs 25 per unit will not be affected.

6.2
 To facilitate his decision-making on the subject, he carries out the cost estimation
exercise in the following way:
(i) Total fixed costs required to produce normal capacity output of 30,000 units, yielding a
standard fixed cost component of Rs 10 per unit (Rs 3,00,000 Budgeted fixed costs/30,000
Normal capacity in units).
(ii) To this component of Rs 10, he adds Rs 8 as an existing variable cost per unit and Re 1 as an
additional variable cost (caused due to special packing).
(iii) Thus, he arrives at Rs 19 as his full cost estimate per unit.
By considering the fixed costs in the analysis, Mr. Smith is including irrelevant cost data.
The reason is, the fixed costs are to be incurred irrespective of the fact whether the special order
of supplying 10,000 units is accepted or rejected and being unavoidable in nature, these costs are
not relevant costs for the present decision.
In other words, he should consider only Rs 9 variable costs (Rs 8 existing + Re 1
additional) as relevant costs to earn additional revenue of Rs 15 per unit. Clearly, he should
accept the overseas offer as it promises incremental profit of Rs 6 per unit (Rs 15 – Rs 9) on
additional sales of 10,000 units. This fact is eloquently brought out by incremental analysis,
(shown in Table 6.1).
Table 6.1: Incremental Analysis whether to Accept the Overseas Offer of Selling 10,000
units or not
Particulars Amount
Incremental sales revenue (10,000 units × Rs 15) Rs 1,50,000
Less incremental costs:
Existing variable costs (Rs 8 × 10,000 units) 80,000
Additional packing costs (Re 1 × 10,000 units) 10,000
Incremental profits (Rs 6 × 10,000 units) 60,000

Evidently, incremental analysis is very handy and appropriate for such decisions.
Alternatively, a comparative income statement (emphasizing contribution) can be prepared
(Table 6.2) which obviously also shows incremental profit of Rs 60,000 (Rs 1,00,000 - Rs
40,000).

6.3
 Table 6.2: Comparative Income Statement
Particulars Alternatives
Status quo Accept special order
Sales revenue Rs 5,00,000 Rs 6,50,0001
Less variable costs 1,60,000 2,50,0002
Total contribution 3,40,000 4,00,000
Less fixed costs 3,00,000 3,00,000
Profit before taxes 40,000 1,00,000
1. Rs 5,00,000 Existing sales revenue + Rs 1,50,000 Incremental sales revenue.
2. Rs 1,60,000 Existing variable costs + Rs 90,000 Additional variable costs
(Note: You must have noted that total fixed costs remain at Rs 3,00,000 whether the order is
accepted or not and, hence fixed costs are irrelevant costs.)
However, from the above, you should not infer that fixed costs are always irrelevant costs. In
case, the additional fixed costs are required to be incurred to execute decision under
consideration then the additional fixed costs are as relevant costs as variable costs. For instance,
if Mr. Smith in Example 6.1 is to make a separate/new dye to manufacture the export units, the
cost of dye (one-time cost) is fixed in nature but is relevant cost because it is an additional cost
caused due to the special order. If in the above Example, we assume that the owner is to incur an
outlay of Rs 65,000 to have a new dye, then it will not be profitable for him to accept the order
because it will cause loss of Rs 5,000.
Example 6.1 clearly demonstrates that the existing fixed costs do not increase with an
increase in the output. Another notable aspect related to fixed costs is that spreading of such
costs to a larger output base does not yield any decrease in total fixed costs either, in spite of the
decrease in the average fixed cost per unit (Example 6.2).

Example 6.2: (Illusion related to Spreading of Fixed Costs)

Assume ABC Corporation, a major heavy engineering group of the country, has
envisaged major power reforms in the country in the past. Further, based on the Government
policy and initiative on the subject, it has envisaged a huge demand of pressure vessels and
boilers in the country. Accordingly, it has beefed up its operations to cater to the growing
demand. But some unexpected happenings due to the sluggishness on part of the Government to

6.4
 make investments in power sector projects, have belied all its projections. This has saddled the
company with many idle facilities.
At this juncture, a major power company, National Power Company, has approached
ABC Corporation to supply 50 boilers at Rs 20 lakh a unit.
The Finance Department of ABC Corporation has estimated variable cost of Rs 25 lakh
per boiler. However, its fixed costs, which were averaging Rs 20 lakh per unit on the production
of existing 50 boilers, (Total fixed costs Rs 1,000 lakh/50 Boilers) will now be distributed over
twice as much volume, (100 boilers) and as a result will decrease to Rs 10 lakh per boiler (Rs
1,000 lakh/100 Boilers). Therefore, this order was expected to increase its profits. Its existing
fixed costs are Rs 10 crore, variable costs are Rs 12.5 crore and sales revenues of Rs 20 crore.
After studying the cost analysis, the Chairman concluded: “Sure, we shall
lakh per boiler on the variable cost front (Rs 25 lakh variable cost – Rs 20 lakh sale price) but we
will save Rs 10 lakh (Rs 20 lakh existing average fixed cost per unit – Rs 10 lakh) by spreading
our fixed costs. Therefore, we should take the offer because it represents a net advantage of Rs 5
lakhperunit”.
However, Chairman’sviewis incorrect as incrementalcost ofproductionis h
25 lakh), vis-à-vis, incremental revenue of Rs 20 lakh per boiler, entailing a further loss of Rs 5
lakh per unit and total loss of Rs 250 lakh (Rs 5 lakh × 50 Boilers).
Incremental analysis (Table 6.3) and Comparative Income Statement (Table 6.4)
substantiate the point.

Table 6.3: Incremental Analysis

Particulars Amount
Incremental revenue (50 Boilers × Rs 20 lakh) Rs 1,000 lakh
Less incremental costs:
Variable costs (50 Boilers × Rs 25 lakh) 1,250
Loss (Decrease in profits) 250 lakh

Table 6.4: Comparative Income Statement

Particulars Alternatives

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 Status quo Accept offer
Sales revenue Rs 2,000 lakh Rs 3,000 lakh
Less variable costs 1,250 2,500
Total contribution 750 500
Less total fixed costs 1,000 1,000
Loss 250 500

In other words, the order, if accepted, will result in cash inflows of Rs 1,000 lakh, cause
cash outflows of Rs 1,250 lakh and there will be no cash inflows/savings due to spreading of
fixed costs (as conceived by the Chairman). Clearly, there is a net cash outflow of Rs 250 lakh.
Therefore, it is important for you to remember that change in the average fixed cost per unit is
of no relevance in the decision-making; only changes in the total fixed costs are relevant.
As a logical corollary of the preceding discussion it is concluded that in case of the multi-
product firms, the firm-related fixed costs will not decrease if a product-line is discontinued;
only product-line related fixed costs would decrease. In such situations, the decision-criterion
would be the segment margin. The segment margin is an extension of the contribution approach
and it equals segment’s con
tribution (selling price – variable costs) less fixed costs that are
directly traceable to that segment. Example 6.3 illustrates such a decision.

Example 6.3 (Dropping of a Product Line)

Income Statement (product-wise) for the current year of a Multi-product firm is given
below: (Amount in Rs lakh)
Particulars Product A Product B Product C Total
Sales revenue Rs 500 Rs 300 Rs 200 Rs 1,000
Less variable costs 200 150 140 490
Contribution margin 300 150 60 510
Less fixed costs for the product line 100 50 20 170
Segment margin 200 100 40 340
Less firm-related fixed costs 130 70 50 250
Net income (loss) 70 30 (10) 90

6.6
 Income statement, prima-facie, indicates that the product line (C) should be discontinued
as it entails a loss of Rs 10 lakh. However, this would be a wrong decision; as dropping of a
product line C can only save variable costs of Rs 140 lakh and fixed costs of Rs 20 lakh of this
product line (C). These costs are aptly referred to as avoidable costs. The firm related fixed costs
are unavoidable costs; they will be incurred in any event and, hence, they are irrelevant costs. In
this Example, Rs 50 lakh fixed costs allocated to product-line C cannot be eliminated, therefore,
Product C should be retained. Without Product C, the profit of the multi-product firm would be
less at Rs 50 lakh (the existing profits are Rs 90 lakh) as shown in Table 6.5.

Particulars Status quo Product A + B

Sales revenue Rs 1,000 lakh Rs 800 lakh
Less variable costs 490 350
Contribution margin 510 450
Less attributable fixed costs 170 150
Segment margin 340 300
Less firm-related fixed costs 250 250
Net income (before taxes) 90 50

We hope that the previous 3 examples would have helped you comprehend the nature of
the existing fixed costs. You would be now convinced of their irrelevance in the varied short-run
operating decisions. The operational significance of the existing fixed costs is that the
undertaking of a new activity may not cause the firm to incur additional fixed costs; it may so
happen that its existing infrastructure/capacity, which hitherto is lying idle can be utilised for the
purpose. Clearly, the share of existing fixed costs should not be charged to such a new activity;
its allocation causes distortion in the correct decision. Comprehensive Example 6.4 is a case in
point. We would like you to solve it on your own before studying its solution as this example is
based on the concepts that have already been covered.
Example 6.4 (Irrelevance of Allocation of Existing Costs)

6.7
 Robust Automobile Company Limited has invited, among others, Average Automobile
Company Limited to submit a design for CNG bus and also to submit a bid to produce 100 such
buses.
Average Automobile has suffered from considerable excess capacity due to the recession
in the industry and perceives little prospects of improving the situation in the future.
Consequently, it readily accepts the invitation of Robust Automobile spends Rs 12 lakh on the
cost and design studies (specially suited for Indian road conditions).
Average Automobiles Ltd. has submitted a bid price of Rs 15 lakh per bus on the basis of
the following budgeted income statement:
Revenues (100 buses × Rs 15 lakh) Rs 1,500 lakh
Less costs:
Materials Rs 500 lakh
Existing labour cost 200
Additional labour cost 100
Variable manufacturing costs 200
Fixed manufacturing costs apportioned 250
Additional fixed costs 50
Design and cost studies 10
Transportation costs 15 1,325
Profit (before tax) 175

Robust Automobile prefers Average Company’s design,

vis-à-vis, others but considers a
bid price of Rs15 lakh per bus too high as compared to other competitors; it makes a counter
offer to award the contract at a price of Rs 11 lakh per bus.
Would you as Finance Manager of Average Automobile advise the company to accept
the contract?
We hope that by this time you would have been convinced of the immense usefulness of
the incremental analysis as a technique of decision-making. You would have certainly developed
skills/mindset to pick-up relevant costs also. A careful look at the cost items would enable you to
identify that the existing labour costs (Rs 200 lakh) and the fixed manufacturing costs d (Rs

6.8
 250 lakh) are irrelevant cost items as these costs are to be incurred irrespective of the present
decision of accepting production of 100 CNG buses.
There is one more item, which is an irrelevant/sunk cost item. Can you pinpoint it? Yes,
it is the cost spent on design and cost studies; as the firm in Example has already incurred these
costs at the time of submission of the bid price, these costs do not constitute relevant costs to
evaluate financial viability of the present decision of accepting counter-offer of supplying CNG
buses at Rs 11 lakh each.
Incremental analysis based on the exclusion of these 3 items is shown in Table 6.6.
Table 6.6: Incremental Analysis Whether to Accept the Counter-off of Supplying 100 CNG
Buses at Rs 11 lakh each
Particulars Amount
Sales revenues (Rs 11 lakh × 100) Rs 1,100 lakh
Less incremental costs:
Materials Rs 500 lakh
Additional labour cost 100
Variable manufacturing costs 200
Additional fixed costs 50
Transportation costs 15 865
Incremental profit/Decrease in existing losses 235 lakh

Evidently, it will be profitable for Average Automobile to accept the counter-offer as it

augments its present profits or helps in reducing its losses by Rs 235 lakh.
Example 6.4 is notable in that it highlights one major point i.e. all the additional costs
already incurred for the decision are not the relevant costs; only future costs are the relevant
costs. In other words, in decision-making, the emphasis is on the future. Accordingly, the
decision-maker should reckon only those costs, which are likely to be affected in future as a
result of the present decision. For instance, design and cost studies were irrelevant cost items
(being incurred in the past) in evaluating counter-offer option. The short Example 6.5
demonstrates this point more clearly.

Example 6.5 (Irrelevance of Additional Fixed Costs Already spent)

6.9
 Assume Mr. Joshi, a Delhi based broker in the jewellery business, has a diamond
necklace on sales or return basis (within two days) at Rs 2 lakh. He recollects that a customer in
Mumbai had sometime back spoken to him to buy such a necklace. He immediately telephones
the customer to apprise him of all the attributes of the necklace and the customer has shown
interest. Accordingly, the broker purchases a return air ticket to Mumbai for Rs 9,000 for the
next day flight. He incurs Rs 300 as taxi charges from his place of residence to Airport in Delhi
and Rs 200 from Mumbai Airport to the hotel where he usually stays. For half-a-day, the hotel
charges are Rs 1,000. On arrival, he telephones the customer (local telephone facility without
charges is allowed at the hotel ) and the customer reaches the hotel in no time.
The broker quotes a selling price of Rs 2,30,000 for the necklace. However, the
customer finds it too high a price and he stops at a final quote of Rs 2,07,000. You are to advise
the broker whether he should sell the necklace or not.
You should carry out the cost analysis in the following way:
(i) Telephone cost from Delhi (assume Rs 100) has already been spent and hence irrelevant
cost.
(ii) Likewise, he has already incurred Rs 10,500 (Rs 9,000 Air fare, Rs 500 Taxi charges and
Rs 1,000 Restaurant charges). Would you not consider these costs to be irrelevant costs?
Obviously yes.
(iii) While coming back he is to incur taxi charges (assume Rs 500 – the amount he has spent
when he came to Mumbai)
(iv) Thus, his total loss will turn out to be Rs 11,100 (Rs 100 + Rs 10,500 + Rs 500).
(v) Now, if he decides to sell at Rs 2,07,000, he recovers Rs 7,000 (Rs 2,07,000 – Rs
2,00,000 cost of necklace) out of Rs 11,100; as a result his loss gets reduced to Rs 4,100
(Rs 11,100 – Rs 7,000).
The merit of this example is that it gives us a principle; where profits cannot be
maximised, we should minimise losses.
It is on account of the above principle, we find, business firms sometimes decide to sell
their products/inventories at a loss. In fact, this may be a good decision. In case, the inventory is
not sold now at a loss, it may be sold at a greater loss in future or it may have to be written off
completely in case it cannot be sold at all. Evidently, under such circumstances, the decision to
sell now is better unless there is a possibility of selling it at a higher price later. Besides, by

6.10
 selling now, the decision-maker should recognise that the firm saves carrying cost of the
inventory also.
In job-order situations, where inventory/material has already been purchased to cater to
the job-order needs, the minimisation of losses concept may prove to be of immense usefulness.
Example 6.6 illustrates the concept.

Example 6.6 (Relevant cost for existing materials purchased)

A company has been making a machine as per the order of a customer. However, the
customer has been declared bankrupt and there are no prospects of receiving any money from
him. Cost incurred to-date in manufacturing this machine is Rs 2,50,000 and the progress
payment of Rs 1,00,000 has already been received from the customer prior to his bankruptcy.
The sales department has found another customer willing to buy the machine for Rs 1,25,000
once it is completed. To complete the work, the following costs are to be incurred:
(i) Material: It has been purchased at a cost of Rs 35,000 and it has no other immediate or
futureuse.Incase,thematerialisnotutilisedtomakethemachine,it’ll
for Rs 5,000.
(ii) Processing costs: Additional processing costs consisting of outside labour, variable
overheads and other out-of-pocket cash expenses are estimated at Rs 50,000.
(iii) Sale of machine as it is: The semi-finished machine (in the existing state) can be sold
only at Rs 25,000. What will be your advice to the company?

Solution:
Table 6.7: Incremental Analysis Whether to Accept the Order from a Customer to Buy
Machine at Rs 1,25,000
Particulars Amount
Incremental sales revenue Rs 1,25,000
Less incremental costs:
Material Rs 5,000
Processing costs 50,000
Sale value of semi finished machine 25,000 80,000
Incremental profit/Decrease in loss 45,000

6.11
 The recommendation is that the company should complete the machine and sell it for Rs
1,25,000.
You may be wondering why material costs have been taken at Rs 5,000 and not at its
acquisition costs of Rs 35,000. The reason is that the company has already purchased the
material and its sales value at present is Rs 5,000 only. In practical terms, the opportunity cost of
using the material in making the machine is Rs 5,000 only. (Opportunity costs are the costs of
the next best alternative forgone). In other words, by using the material in making of the existing
machine, the company has lost the opportunity of selling the material in the market at Rs 5,000.
Evidently, opportunity costs are the relevant costs for decision-making. For the same reason,
sale value of the semi-finished machine at Rs 25,000 constitutes opportunity cost for the present
decision.
In case you are not fully convinced, it will be useful for you to work out the amount of
loss suffered in the two comparative situations (in simple mathematical sense): (i) when machine
is sold as it is and (ii) when it is completed and then sold.
Table 6.8: Income Statement
Sale of machine
Particulars As it is After
completing
Costs already incurred Rs 2,50,000 Rs 2,50,000
Material costs 35,000 35,000
Additional processing costs -- 50,000
(a) Total costs 2,85,000 3,35,000
Progress payment received Rs 1,00,000 Rs 1,00,000
Sale of material 5,000 --
Sale of existing machine 25,000 --
Sale of completed machine -- 1,25,000
(b) Total receipts/revenues 1,30,000 2,25,000
(c) Loss [(a) – (b)] 1,55,000 1,10,000
(d) Decrease in Loss when machine is completed and sold Rs 45,000*
* The same answer as is provided by earlier solution.

6.12
 We believe that by now, you are likely to feel more confident in identifying the
relevant data for decision-making. With the help of real life-like examples of business situations,
we have tried to comprehend various myths/illusions related to full cost fallacy. These examples
have established very clearly the irrelevance of the existing fixed costs in various types of
decisions, say, acceptance of the special order at a price below total cost, dropping a product line,
selling now or process further, determination of bid/tender price, and so on. Besides these
situations, the concept can be applied/adapted to many other business situations. The important
ones remained to be covered are: continue to operate or shut down, make or buy decisions,
product-mix and use of scarce resources.
Operate or Shut Down: Often, business firms are confronted with a decision whether to operate
the plant at below capacity or to opt for temporary shut down until demand picks up. In the case
of temporary shut down, preparations are to be made for storing plant and machinery;
maintenance may still be required to protect unused machinery. Besides, costs in respect of
property taxes, insurance and salaries of the unretrenched staff may continue to be incurred.
Above all, there may be re-opening costs as well. In brief, all the fixed costs may not be
avoidable costs in a shutdown situation.
In contrast, when operations are continued, the sales revenue or more precisely
contribution from sales revenue may not be adequate enough to cover the fixed costs. Thus, the
business firm may be confronted with a loss situation, in both the events. The decision criterion
in such a situation will obviously be based on the comparison of the shutdown losses and the
losses associated when operations are continued; clearly, the firm will prefer a situation where
losses are less (Example 6.7).
Example 6.7 (Operate or Shut-down)
A paint manufacturing company manufacturers 4,0 small sized tins of “Spray
Paints” per annum when it works at full normal
acity. cap cost per unit of
Its variable
manufacturing and selling is as follows:
Direct material Rs 15
Direct labour 4
Variable manufacturing overheads 6
Variable administrative and selling overheads 5
Total 30

6.13
 Each unit (tin) of the product is sold at Rs 50. The company is experiencing difficulties in
selling its products and at present is operating at 25 per cent capacity (1,00,000 units). The
directors of the company are seriously considering suspending the operations till the market
picks up.
Market research undertaken bythe companyreveals that in about a year’
will pick up and the company can comfortably operate at 70 per cent level of capacity.
The sales personnel of the company do not want to suspend operations for the fear of
adverse reactions in the market, but the directors want to decide the issue exclusively on
financial considerations. For the purpose, the following data are collected:
(i) In the event of closure, the present fixed costs of Rs 30 lakh per annum could be reduced
to Rs 12 lakh.
(ii) The settlement cost of the personnel not required would amount to Rs 3 lakh.
(iii) Additional costs of plant shutdown are estimated at Rs 50,000.
(iv) On resuming operations, the expenditure connected with reopening after shutdown is
estimated at Rs 1,00,000.
Advise the company whether the plant should be shutdown in the current year.

Solution:
The solution requires preparation of a comparative income statement showing the amount
of loss when plant is shutdown and when plant continues to operate. Such a statement is shown
in Table 6.9.
Table 6.9: Comparative Income Statement (Continue to Operate or Shut-down)
Particulars Situations
Operate plant Shut-down
Sales revenue (1,00,000 units × Rs 50) Rs 50,00,000 --
Less variable costs:
Direct material (1,00,000 units × Rs 15) 15,00,000 --
Direct labour (1,00,000 units × Rs 4) 4,00,000 --
Manufacturing overheads (1,00,000 units × Rs 6) 6,00,000 --
Administrative and selling overheads (10,00,000 units × Rs 5) 5,00,000 --

6.14
Total contribution (1,00,000 units × Rs 20) 20,00,000 --
Less fixed costs 30,00,000 12,00,000
Less shut down costs:
Settlement costs of Personnel Rs 3,00,000
Plant shut-down costs 50,000
Re-opening costs 1,00,000 -- 4,50,000
Loss 10,00,000 16,50,000

Clearly, the management is advised to operate the plant, as shutdown loss is higher than
the loss caused by operating the plant.

Make or Buy Decision: Frequently, the business firms are confronted with a choice between
manufacturing certain components themselves or acquiring them from the outside market. Before
deciding in favour of making, the business firm should make sure that it can produce component
parts of the desired quality in the required quantity.
Incremental analysis could be applied in “make or buy” decisions as well wh
buy costs of the component parts are compared with the estimated incremental costs associated
with manufacturing such parts on its own. The decision criterion in such a situation will be based
on the comparison of the buy costs with make costs. In case, make costs are lower, it will be
profitable for the firm to manufacture components; purchase from outside is economical if buy
costs are lower.
You should remember that make costs will be exclusive of the existing fixed costs if the
firm has idle capacity to make the components (Example 6.8). However, if the capacity of the
existing plant is to be enlarged, additional fixed costs that will incurr for the purpose will form
relevant costs for decision-analysis. Such decisions are capital budgeting decisions and are
discussed in Chapter 8.
Example 6.8 (Make or Buy Decision)
Assume XYZ Limited is considering to make a part which it hitherto has been purchasing
from outside at a unit cost Rs 30. Its annual requirement for such a part is 50,000 units. The costs
of producing this part on per unit basis are estimated as follows:
Direct material Rs 12.50

6.15
Direct labour 5.00
Variable manufacturing overheads 8.00
Fixed costs (apportioned) 8.50
34.00

Additional information: The firm at present is operating at 80 per cent of normal capacity and in
the foreseeable future there is no use for the excess capacity except for the plausible production
of the part. Production of this part will enable the company to operate at its full normal capacity.
Fixed manufacturing overhead costs of the firm are Rs 21,25,000, which are to remain
unchanged whether it operates at 80 per cent capacity or 100 per cent capacity.
The accounts clerk explains the rationale of including fixed costs in the analysis as
follows. The production of component utilises 20 per cent capacity. Therefore, he has allocated
20 per cent of total fixed manufacturing cost of Rs 21,25,000 (i.e., Rs 4,25,000) to the making of
the parts. Since 50,000 parts are to be produced, per unit cost works out to be (Rs
4,25,000/50,000) Rs 8.5 per unit.
On the basis of the above cost analysis the management of the company decides to
continue to buy from the outside. Do you think management has taken the correct decision?

Solution:
The management of ABC Limited has not taken the right decision. It has included fixed
costs in cost analysis whereas only the costs, which are to increase on acc
decisions were to be included. Therefore, it has over-estimated ‘make costs’
s 8.5 by
perR unit;
the correct make costs are at Rs 25.5 (Rs 34 – Rs 8.5) which are lower than buy costs of Rs 30
per unit. Therefore, it will be profitable for the firm to produce parts on its own (Table 6.10).
Table 6.10: Incremental Analysis (Make or Buy Decision)
Particulars Amount
Cost savings/Increase in revenue (50,000 units × Rs 30 Buy cost per part) Rs 15,00,000
Less incremental costs of making parts:
Direct material (50,000 units × Rs 12.50) 6,25,000
Direct labour (50,000 units × Rs 5) 2,50,000
Variable manufacturing overheads (50,000 units × Rs 8) 4,00,000

6.16
Net cost savings/Net increase (before taxes) in profits (50,000 units × Rs 4.50) 2,25,000

PRODUCT MIX DECISIONS AND USE OF SCARCE RESOURCES

Product mix decisions assume significance in the case of multi-product firms. Evidently,
the effort of the management should be to have such a product/sales mix that yields maximum
profit. Given the firm-wide fixed costs, the decision rule is to choose a product that provides the
highest contribution margin per unit.
The above stated principle works well when there are no constraints with respect to either
production capacity or sales capacity. However, in practice, this is very unlikely to be a valid
proposition. In most of the situations, in the real business world, the firms are confronted with
production as well as market constraints in that they can produce a specified number of units (in
the short-run) and likewise a market may absorb only a limited number of units.
The problem gets further compounded if the firm is faced with scarce resources required
to produce each product. Such scarce resources, known as key factor, may be scarce raw
material, skilled labour or machine capacity. In such situations, the contribution per unit of the
key factor forms the decision criterion and the products are ranked according to the descending
order of their contribution per unit of key factor. Examples 6.9 and 6.10 will help you
comprehend such product/sales mix problems with constraints.
Example 6.9 Product Mix with Raw material as a Constraint
The following particulars (per unit basis) are taken from the records of a multi-product
company
Particulars Product X Product Y
Selling price Rs 200 Rs 240
Direct material cost 20 30
Direct wages cost 30 20
Other Direct Costs 10 12
Variable overheads 30 40
Other data:
Consumption of material (kgs) 2 3
Machine hours used 5 4

6.17
 Labour hours used 3 2

Both the products use the same material, machine and labour. You are required to rank
the products X and Y in order of profitability in each of the following situations. (Assume each
situation is independent of another):
(a) (i) Total sales potential is limited,
(ii) Raw material is in short supply,
(iii) Production capacity (in terms of machine hours) is the key/limiting factor, and
(iv) Direct labour hours are in short supply.
(b) Assuming raw material as the key factor, availability of which is 16,000 kgs and maximum
sales potential of each product being 5,000 units, advise the product mix that the company
should opt for. Also determine the profit at such a mix, assuming its fixed cost at Rs
3,00,000.

Solution:
(a) The decision criterion in constraint situations is to maximise the contribution per unit of the
key factor. Solution Table 6.11 provides inputs on this premise.
Table 6.11: Statement of Profitability of Products X and Y in Different Situations
Particulars Product X Product Y
Selling price per unit Rs 200 Rs 240
Less variable costs per unit:
Direct material cost 20 30
Direct wages cost 30 20
Other direct cost 10 12
Variable overheads 30 40
Total variable costs per unit 90 102
Contribution margin per unit sold 110 138
Contribution margin per rupee of materials used 5.51 4.61
Contribution margin per rupee machine-hour used 22.02 34.52
Contribution margin per labour-hour used 36.673 69.03
Profitability of products X and Y
(represented by rank 1 and 2 in order of their profitability) when
(i) Total sales potential in units is limited Rank 2 Rank 1
(ii) Raw material is in short supply 1 2
(iii) Production capacity (machine hours) is key factor 2 1

6.18
(iv) Labour hours are key factor 2 1
1. Product X (Rs 110/Rs 20 = Rs 5.5), Product Y (Rs 138/Rs 30 = Rs 4.6)
2. Product X (Rs 110/5 = Rs 22), Product Y (Rs 138/4 = Rs 34.5)
3. Product X (Rs 110/3) = Rs 36.67), Product Y (Rs 138/2 = Rs 69.0)

(b) Since raw material is a scarce resource, Product X will be accorded the first preference in
production/sales as it promises higher contribution per rupee of material used; it will be
produced in 5,000 units which market can absorb. The leftover material will be used to
produce Product Y. Optimal product mix is 5,000 units of X and 2,000 units of Y as shown
by Table 6.12.
Table 6.12: Statement showing utilisation of Raw Material in Producing X and Y
Total raw material available (kgs) 16,000
Less raw material required to produce 5,000 units of Product X (5,000 units × 2 kgs) 10,000
Raw material left to be used to produce Y 6,000
Maximum number of units plausible to be produced of Product Y (6,000 kgs/3 kgs per unit) 2,000
Optimal product mix: X 5,000 units and Y 2,000 units

Table 6.13: Income Statement (in condensed form) at Optimal Product Mix
Particulars Products Total
X Y
Sales revenue Rs 10,00,000 Rs 4,80,000 Rs 14,80,000
Less variable costs 4,50,000 2,04,000 6,54,000
Total contribution 5,50,000 2,76,000 8,26,000
Less fixed costs -- -- 3,00,000*
Profit (before tax) 5,26,000
* Since the total fixed cost does not change, its apportionment between products X and Y is not
called for.
Evidently, optimal product mix will be different if machine hours or labour hours happen to
be scarce resource. It may be noted that Product Y has first rank in both these situations. You are
advised to have some hypothetical values of machine hours/labour hours and arrive at a revised
optimal product mix.
Example 6.10: Product Mix with Sales and Labour Hours as constraints
A multi-product company produces four products X, Y, Z and W. The cost data per unit
is as follows:

6.19
 X Y Z W
Selling price Rs 90 Rs 71 Rs 100 Rs 86
Direct material 30 20 40 40
Direct labour 24 18 30 12
Variable overheads 12 9 15 6

The fixed costs are estimated at Rs 2,50,000 per month. The company employs 500 direct
workers working eight effective hours a day for 25 days a month. The direct wage rate is Rs 6
per hour. It is not feasible for the company to increase its labour force in the short-run or to allow
workovertime.Thecompany’spolicydoesnot allowsub
-contracting the work.
The sales manager has projected the following demand for a month:
Product Units
X 5,000
Y 10,000
Z 12,000
W 15,000

The management wants you to advise the optimal product-mix, given the above
constraints. Also determine profit of a month at such a mix.

Solution:
The following steps are involved: (i) Determination of the contribution margin, product-
wise, (ii) Determination of the contribution margin per direct labour hour (key factor) and (iii)
Arrangement of the products in descending order of their profitability, based on the contribution
margin per direct labour hour.
Table 6.14: Determination of Contribution Margin per Direct Labour Hour for Products
X, Y, Z and W.
Particulars Products

X Y Z W
Selling price per unit Rs 90 Rs 71 Rs 100 Rs 86
Less variable costs per unit
Direct material 30 20 40 40
Direct labour 24 18 30 12

6.20
 Variable overheads 12 9 15 6
Total variable cost per unit 66 47 85 58
Contribution margin per unit 24 24 15 28
Direct labour hours (DLH) (Direct labour cost/Rs 6) 4 3 5 2
Contribution margin per (DLH)
(Contribution margin/DLH) Rs 6 Rs 8 Rs 3 Rs 14
Rank (in order of profitability) 3 2 4 1

Table 6.15: Statement Showing Utilisation of Direct Labour Hours Yielding Optimal
Product-Mix
Total direct labour hours available (500 workers × 25 Days × 8 Hours) 1,00,000
Less labour hours required to produce
Product W (15,000 units × 2 Hours) 30,000
Product Y (10,000 units ×3 Hours) 30,000
Product X (5,000 units × 4 Hours) 20,000 80,000
Hours available to produce Z 20,000
Units of Z possible to Produce (20,000/5) = 4,000 units

Table 6.16: Income Statement for a month

Particulars Product
X Y Z W Total
Number of units produced & sold 5,000 10,000 4,000 15,000
Selling price per unit Rs 90 Rs 71 Rs 100 Rs 86
Variable costs per unit 66 47 85 58
Total sales revenue 4,50,000 7,10,000 4,00,000 12,90,000 28,50,000
Total variable costs 3,30,000 4,70,000 3,40,000 8,70,000 20,10,000
Total contribution 1,20,000 2,40,000 60,000 4,20,000 8,40,000
Less total fixed costs 2,50,000
Profit (before tax) 5,90,000

To sum up the discussion, it may be reasonable to state that it will be useful for a
business firm to be guided by the principle of the incremental costs only (consisting of variable
costs and additional fixed costs) in the short-run, in particular, when it happen to have

6.21
idle/excess capacity. However, in the long-run, all costs (including existing fixed costs) must be
covered; otherwise, the very survival of the firm will be at stake.

SUMMARY OF KEY POINTS

 Decision-making is an exercise of selecting the best course of action among the various
feasible alternatives. Our focus is only on financial considerations; however, in practice, non-
financial considerations may be equally important.
 While the ‘full cost’ principle may be very appropriate
ng-run, it isin the
not lo to
desirable
apply in respect of short-run decision-making situations when firms happen to have
excess/idle capacity.
 In short-run decisions (such as acceptance of special order, make or buy, continue to operate
or shut-down, dropping of a product-line), incremental revenues and incremental costs are
relevant data inputs.
 Incremental revenues are the additional revenues and/or cost savings likely to accrue on
account of the decision; incremental costs are the additional costs that are incurred to carry
out the decision.
 Incremental analysis, which takes into account incremental revenues and incremental costs,
is an apt and widely used technique for such decisions.
 Included in the incremental/relevant costs for decision-making are: (i) variable costs, (ii)
opportunity costs and (iii) additional fixed costs.
 Existing fixed costs are excluded from the incremental/relevant costs for decision-making.
The reason is that these costs are incurred irrespective of the decision. Clearly, they are not
decisive in decision-making. In operational terms, they are unavoidable costs and hence, they
are irrelevant costs from the perspective of decision-making. In other words, avoidable costs
are relevant costs.

6.22
 Existing fixed costs are also called sunk costs as they are caused due to the past
commitments; they will be there in any event and hence merit no consideration. It is therefore
rightly said, that “Do not cry over spilt should
milk” be the management’s attitude tow
such costs. Their inclusion in decision-making causes distortion and the firm runs the risk of
taking wrong decisions.
 To make use of the incremental analysis, you should be in a position to identify relevant
costs. Costs are said to be relevant (irrespective of the category) if they are
influenced/affected by the decision under consideration. Conversely, costs that are not
influenced by the decision are irrelevant costs.
 Whenever, there is a confusion whether a particular cost is relevant or irrelevant for decision-
making, try to ascertain whether this cost will be affected by the decision or not. If the
answer is the positive, the cost item under consideration is relevant; it is irrelevant if the
response is in the negative.
 Incremental analysis suggests that it will be profitable for the firm to sell below total costs
but higher than incremental costs (which primarily consist of variable costs). The reason is
that it helps in recovering part of the existing fixed costs. Thus, it is guided by the principle
“whereprofitscannot
imised,
bemaxweshouldtrytominimiselosses”
 However, in the long run all costs should be recovered. No firm can survive for a long period
of time by recovering only variable costs.
 Preparation of comparative income statement under present and proposed alternatives is
another useful technique, widely prevalent, in decision-making. An alternative with
maximum profit or minimum loss is adopted.
Product-mix decisions are very important for multi-product firms. With no sales and production
constraints, the guiding principle is to choose a product, which yields the maximum contribution
per unit. In the case of production/sales constraint situations, the principle is to maximise
contribution per unit of scarce resource say, raw material, skilled labour and machine capacity.

6.23
 OBJECTIVE TYPE QUESTIONS

6.1. Indicatewhetherthefollowingstatementsare‘True’or‘False’.
(i) Incremental costs consist of variable costs only.
(ii) All fixed costs are irrelevant costs for decision-making.
(iii) Opportunity costs are relevant costs for decision-making.
(iv) Sunk costs are not considered for decision-making.
(v) Fixed costs are unavoidable costs.
(vi) Avoidable costs are relevant costs for decision-making.
(vii) Fixed costs are apportioned costs.
(viii) In case, a firm produces multiple products and one of its products (though yields positive
contribution) incurs losses, its production should be discontinued.
(ix) Plant should be temporarily shut down if it causes negative contribution.
(x) Incremental costs consist of variable costs, additional fixed costs and opportunity costs.
Answers: (i) False, (ii) False, (iii) True, (iv) True, (v) True, (vi) True, (vii) True, (viii) False,
(ix) False, (x) True.

6.2. Fill in the blanks (out of choices provided).

(i) ______________ pricing decisions are appropriate for long-term decision-making. (Full
cost based/incremental cost based)
(ii) ______________ pricing decisions are appropriate for short-term decision- making. (Full
cost based/incremental cost based)
(iii) All costs, which are influenced by decision-making, are referred to as ____________.
(Relevant costs/Irrelevant costs)

6.24
(iv) _____________ are irrelevant costs for decision-making. (Sunk costs/Variable costs)
(v) Opportunity costs ____________ business decisions. (Influence/Do not influence)
(vi) In practice, business decisions are affected by ______________. (Quantitative data/Both
quantitative data and qualitative factors)
(vii) _____________ fixed costs are irrelevant costs. (Existing/Additional)
(viii) _____________ fixed costs are relevant costs. (Existing/Additional)
(ix) Special order decisions framework presupposes that regular price is _____________.
(Affected/not affected)
(x) Sunk costs are ______________ costs. (Committed/Avoidable)

Answers: (i) Full cost based, (ii) Incremental cost based, (iii) Relevant, (iv) Sunk costs, (v)
Influence, (vi) Both quantitative data and qualitative factors, (vii) Existing, (vii) Additional, (ix)
Not affected, (x) Committed.

EXERCISES

6.1. What are the relevant costs in short-run decision-making situations?

6.2. What are sunk costs? Are they relevant in short-run decisions?
6.3. What is an opportunity cost? Are such costs relevant in managerial decisions?
6.4. Assume your firm (operating below capacity) has received a special order to be supplied at
a price, which is below total costs. Will you accept or reject it? Justify your answer.
6.5. What factors should a firm consider before dropping a product-line that incurs losses?
6.6. Whatrelevantdataareusefulin‘operateorshutdown’decisions?
6.7. What do you mean by make or buy decisions? How such decisions are arrived at?
6.8. Distinguish between the following:
(i) Relevant and Irrelevant costs
(ii) Avoidable and Unavoidable costs
(iii) Incremental and Variable costs
6.9. Enumerate the steps required to formulate optimal product-mix when machine hours are the
limiting factor.

6.25
 6.10. What is the decision-criterion in respect of the product decisions when sales is not a
constraint?

Numerical Exercises

6.11. Royal Industries, a maker of variety of metal and plastic products, is in the midst of a
business downturn and is saddled with idle capacity. The State Hospital Supply Company has
approached Royal Industries to produce 1,00,000 disposal plastic buckets at Rs 12 each.
Royal Industries estimates that its variable cost will be Rs 13 each. However, its fixed
costs, which have been averaging at Rs 10 per unit on a variety of other products (total is
1,50,000 units with total fixed cost of Rs 15 lakh) will now be spread over among 2,50,000 units.
As a result, the average fixed cost will drop to Rs 6 per unit (total fixed costs Rs
15,0/2 units). The Chairman of the company contended, say, “ Sure, there will be a
loss of Re 1 each on variable costs (Rs 13 variable cost – Rs 12 selling price) but there will be a
gain of Rs 4 per unit (Rs 10 existing average fixed cost - Rs 6 revised average fixed cost) by
spreading the fixed costs. Therefore, the firm should go for the offer as it represents an advantage
ofRs3perunit”.
Do you agree with the Chairman? Why? Suppose the regular business of selling 1,50,000
units fetches it sales revenue of Rs 30 lakh, variable costs of Rs 19.5 lakh and fixed costs of Rs
15 lakh. Prepare comparative income statement when the offer is accepted and when it is not
accepted.
6.12. Although Ajoy Limited has the capacity to produce 16,000 units per month; current plan
calls for a monthly production and sales of only 10,000 units at Rs 15 each. Cost per unit is as
follows:
Direct material Rs 5.00
Direct labour 3.00
Variable factory overheads 0.75
Fixed factory overheads (allocated) 1.50

6.26
Variable selling expenses (freight) 0.25
Fixed administrative expenses 1.00
11.50

(i) Should the firm accept a special order of supplying 5,0 units (at customer’s pl
Rs 10 per unit?
(ii) What is the maximum price the firm should be willing to pay to an outside supplier who
is interested in manufacturing this product.

6.13. Due to industrial recession, a plant is running at present at 50 per cent of its capacity. The
following details are available
Cost of production per unit
Direct material Rs 2
Direct labour 1
Variable overheads 3
Fixed overheads 2
Total cost per unit 8
Production per month 20,000 units
Total cost of production Rs 1,60,000
Sales revenue (20,000 units × Rs 7) 1,40,000
Loss 20,000
An exporter offers to buy 10,000 units at the rate of Rs 6.50 per unit and the company hesitates
to accept the offer for the fear of increasing its already large accumulating losses. Advise,
whether the company should accept or decline this offer.
6.14. A manufacturer has planned his level of operations at 50 per cent of his plant capacity for
30,000 units. His expenses are estimated as follows at 50 per cent of plant capacity (i.e., at
15,000 units).
Direct material Rs 82,800
Direct wages 1,11,600
Variable manufacturing and other expenses 39,600
Total fixed expenses irrespective of capacity 60,000

6.27
 The product is presently sold at Rs 20 per unit. Recently, the manufacturer has reviewed
an overseas offer for supplying 10,000 units at a price of Rs 14 per unit. As a professional
management accountant what would be your suggestion regarding acceptance or rejection of the
offer?
6.15. Auto Parts Ltd. produces various motor part components. It has an annual production of
90,unitsforonesuchmotorcomponent.Thecomponent’scoststructureisasbelow:
Cost per unit
Direct material Rs 270
Direct labour (25 per cent fixed) 180
Variable overheads (allocated) 90
Fixed overheads (allocated) 135
Total cost per unit 675
The purchase manager has an offer from a supplier who is willing to supply a component
at Rs 540 at the factory premises of Auto Parts. If the component is purchased from an outside
supplier, indirect labour of Auto Parts Limited will increase by Rs 4 lakh annually because of
receiving, inspecting and handling of purchased component. Should this component be
purchased or continued to be produced?
6.16. Stoners Limited. uses three different components (material) in manufacturing its primary
product. Stoner produces two of the components and purchases one (designated as component 1)
from outside suppliers. The company is currently developing the annual profit plan. Assume that
the sales are highly seasonal and component 2 cannot be acquired from outsiders; however,
component 3 can be purchased. The three components have critical specifications. The following
data is provided. Component 3 (unit cost at 12,000 units)
Direct material Rs 1.40
Direct labour 2.20
Fixed overheads (apportioned) 0.40
Annual machine rental (special machine used for component 3) 0.50
Variable factory overheads 1.00
Average storage cost per year (fixed) 0.40
Total 5.90

6.28
 The purchase manager investigates outside suppliers and finds one who is willing to sign
a one-year contract to deliver 12,000 top quality units as needed during the year at Rs 5.20 per
unit. If component 3 is purchased from an outside supplier, average freight cost of Re 0.30 per
unit is will incurred. A serious consideration is being given to this alternative. Should Stoners
Limited. make or buy component 3? Explain the relevant factors influencing your decision.
6.17. An industrial concern, which had no costing system appointed a cost accountant. After
installation of a system of cost data, the cost accountant observed that out of the three products,
that were being produced independent of each other, loss was being incurred on product B. He
immediately decides to advise the management to discontinue the manufacturing of this product
supported by the following tabulation:
Products
A B C
Sales revenues Rs 1,00,000 Rs 65,000 Rs 4,90,000
Variable manufacturing costs 52,000 26,000 1,40,000
Fixed manufacturing costs (apportioned) 6,500 19,000 1,05,000
Variable selling and administration costs 18,000 17,000 18,000
Fixed selling and administration costs 4,600 4,600 4,000
Total costs 81,100 66,600 2,67,000
Net profit (loss) 18,900 (1,600) 2,23,000

Doyouagreewiththecostaccountant’sconclusions?Justifyyourdecisionbased
6.18. Avon Garments Ltd. manufactures readymade garments and uses the cloth cut-pieces to
manufacture dolls. The following statement of cost has been prepared:
Particulars Readymade garments Dolls Total
Direct material Rs 80,000 Rs 6,000 Rs 86,000
Direct labour 13,000 1,200 14,200
Variable overheads 17,000 2,800 19,800
Fixed overheads 24,000 3,000 27,000
Total cost 1,34,000 13,000 1,47,000
Sales 1,70,000 12,000 1,82,000
Profit (loss) 36,000 (1,000) 35,000

6.29
 The cut-pieces used in dolls have a scrap value of Rs 1,000 if sold in the market. As there
is a loss of Rs 1,000 in the manufacture of dolls, it is suggested to discontinue their manufacture.
Advise the management.

6.19. The management of a factory is considering to drop an unprofitable product C. Tender your
advice based on the following data: (Rs in lakh)
Particulars Product A Product B Product C
Sales 10.00 8.00 2.00
Direct material 2.95 3.36 0.75
Direct labour 1.18 1.12 0.45
Variable overheads 1.77 1.12 0.30
Fixed overheads 3.30 1.80 0.90
Profit/(Loss) 0.80 0.60 (0.40)

(a) In the event of discontinuance of product C, some supervisory staff for that product could be
discharged. The salary of the discharged staff would amount to Rs 20,000, which is included in
the fixed expenses. Should product C be dropped?
(b) The management on reconsideration proposes to drop product C, retain their supervisory staff
and increase production of product A that will yield extra sales of Rs 2 lakh. Give your advice
whether it will be profitable proposition. (Note: Treat situations a and b independent)

6.20. The following particulars are taken from the records of a company engaged in
manufacturing two products, A and B, from a certain material:
Particulars Product A (per unit) Product B (per unit)
Sales Rs 2,500 Rs 5,000
Direct materials (Rs 50 per kg) 500 1,250
Direct labour (Rs 30 per hour) 750 1,500
Variable overheads 250 500
Total fixed overheads Rs 10,00,000

6.30
 Comment on the profitability of each product when:
(i) Total sales in units is limited.
(ii) Total sales in value is limited.
(iii) Total raw material is in short supply.
(iv) Production capacity/Direct labour is the limiting factor.
(v) Total availability of raw material is 20,000 kgs. and maximum sales potential of each
product is 1,000 units. Find the product-mix to yield maximum profits.

6.21. From the following particulars find the most profitable product-mix and prepare a
statement of its profitability.

Particulars Product A Product B Product C

Units budgeted to be produced and sold 1,800 3,000 1,200
Selling price per unit Rs 60 Rs 55 Rs 50
Requirement per unit:
Direct materials (kgs) 5 3 4
Direct labour (hours) 4 3 2
Variable overheads Rs 7 Rs 13 Rs 8
Cost of direct materials per kg 4 4 4
Direct labour-hour rate 2 2 2
Maximum possible units of sales 4,000 5,000 1,500

All the three products are produced from the same direct material using the same type of
machines and labour. Direct labour is limited to 18,60 hours. Firm’s total fixed cost
60,000.

6.22. In a factory producing two different kinds of products, the limiting factor is availability of
material but the same material is used in both the products.

Cost per unit: Product P Product Q

6.31
Material Rs 30 Rs 20
Labour 12 9
Variable overheads 4 2
Fixed overheads 12 9
Total cost per unit 58 40
Selling price per unit 70 50
The demand during each period for the two products is 10,000 units of P and 8,000 units
of Q. The total availability of raw material for some time will be restricted to Rs 3,40,000 only.
(a) Show how the available raw material should be utilised and determine the contribution at
such an optimal-mix.
(b) Will your answer be different, if the firm is willing to meet at least half the demand stated
above in all circumstances?

6.23 Strong company invited Not Well Company to submit a design for a crane and also to
submit a bid for a contract to produce 10 such cranes. Similar invitations were sent to other crane
manufacturing companies.
Not Well Company has suffered from considerable excess capacity during the past three
years and has little prospects of improving the situation in the near future. Consequently, it
readily responded to Strong Company’s invitation and has spent Rs 03, on design a
studies in connection with it. As a result of this exercise, a bid of Rs 4,00,000 per crane has been
submitted on the basis of the following budgeted income statement for the period.
Revenue (10 cranes x Rs 4,00,000) Rs 40,00,000
Less:
Material costs (Rs 1,50,000 x 10) Rs 15,00,000
Director labour (Rs 1,00,000 x 10) 10,00,000
Variable manufacturing overheads (Rs 70,000 x 10) 7,00,000
Fixed overheads allocated 5,00,000
Freight 35,000
Design and cost studies 30,000 37,65,000
Profit before tax 2,35,000

Strong Company has replied that it prefers the Not Well design to any of the others
submitted but the bid price of Rs 4,00,000 is too high. It has made a counter offer to award the

6.32
 contract to the company at a price of Rs 3,40,000 per crane. Would it be profitable for the Not
Well Company to accept the contract at the offered price of Rs 3,40,000 per crane?

6.24 Electric Manufacturing Company is engaged in producing a variety of precision instruments

and other specialized electric components. The company is presently following a policy pricing
all of its products at 150 per cent of variable costs of produce and sell them. Recently, the
Government has invitedtendersforuseat TVstations.Thecompany’smanagemen
the possibility of the firm entering the Government contract. The management accountant has
prepared the following costs for the purpose:
Direct materials Rs 8,00,000
Direct labour 5,50,000
Variable overheads 2,25,000
Fixed manufacturing overheads (allocated) 3,00,000
Production set-up costs (additional) 1,25,000
Special tools 3,00,000
23,00,000

The Government requires delivery of all 1,000 units within one year. In order to meet that
schedule, the company would have to forego regular sales order of the value of Rs 22,50,000.
You are required to state the price the company could bid on the contract for the components
assuming no sale value of special tools.

Solution to Numerical Exercises

6.11. Incremental Analysis Whether to Accept Offer of Supplying 1,00,000 Disposal Plastic
Buckets at Rs 12 per unit.
Particulars Amount
Incremental sales revenue (1,00,000 units × Rs 12) Rs 12,00,000
Less incremental costs:
Variable costs (1,0,000 units × Rs 13) 13,00,000
Incremental loss 1,00,000

6.33
 We do not agree with the Chairman’s view as the acceptance of the
causes loss of order
Rs1, 00,000. His contention is based on the illusion that spreading the fixed cost causes savings.
It is also eloquently borne out by increase in the loss shown by the comparative income
statement.

Comparative Income Statement

Particulars Preset situation Proposed situation
(1,50,000 units) (2,50,000 units)
Sales revenue:
Regular business Rs 30,00,000 Rs 30,00,000
Present offer Nil 12,00,000
Total sales revenue Rs 30,00,000 Rs 42,00,000
Less variable costs @ Rs13 per unit 19,50,000 32,50,000
Total contribution 10,50,000 9,50,000
Less total fixed costs 15,00,000 15,00,000
Loss 4,50,000 5,50,000

6.12. (i) Incremental Analysis Whether to Accept Special Order of Supplying 5,000 units at
Rs 10 per unit.
Particulars Amount
Incremental sales revenue (5,000 units × Rs 10) Rs 50,000
Less incremental costs:
Direct material (5,000 units ×Rs 5) 25,000
Direct labour (5,000 units × Rs 3) 15,000
Variable factory overheads (5,000 units ×Re 0.75) 3,750
Variable selling expenses (5,000 units × Re 0.25) 1,250
Incremental profit (5,000 units × Re 1) 5,000

(ii) Statement Showing Relevant Make Costs

Particulars Cost per unit

6.34
Direct material Rs 5.00
Direct labour 3.00
Variable factory overheads 0.75
8.75

The company should be willing to pay to an outside supplier the maximum price of Rs
8.75 per unit.

6.13. Incremental Analysis Whether to Accept Export Offer of Supplying 10,000 units at Rs
6.50 per unit
Particulars Amount
Incremental sales revenue (10,000 units × Rs 6.50) Rs 65,000
Less incremental costs:
Direct material (10,000 units × Rs 2) 20,000
Direct labour (10,000 units × Re 1) 10,000
Variable overheads (10,000 units × Rs 3) 30,000
Incremental profit 5,000

The firm is advised to accept this offer as it has the potential of earning additional profits of Rs
5,000.

6.14. Incremental Analysis Whether to Accept Overseas Offer for supplying 10,000 units at
Rs 14 per unit
Particulars Amount
Incremental sales revenue (10,000 units × Rs 14) Rs 1,40,000
Less incremental costs:
Direct materials (Rs 82,800 ×10/15) 55,200
Direct wages (Rs 1,11,600 × 10/15) 74,400
Variable manufacturing and other expenses (Rs 39,600 × 10/15) 26,400
Incremental loss/Decrease in existing profits 16,000

6.35
 Since overseas offer entails loss, the manufacturer is advised not to accept the overseas offer.

6.15. Comparative Statement Showing Relevant Make Costs and Buy Cost of 90,000 units
(Amount in Rs lakh)
Particulars Make costs Buy costs
Make costs:
Direct materials (90,000 units × Rs 270) Rs 243 --
Direct labour (90,000 units × Rs 135@) 121.5 --
Variable overheads (90,000 units × Rs 90) 81.00 --
Buy costs:
Purchase costs (90,000 units × Rs 540) -- 486
Indirect labour cost 4
Total 445.5 490
Difference favouring making of parts 44.5
@ (Rs 180 × 0.75 variable)
Auto parts Limited is advised continue to produce the component as it yields cost savings of Rs
44.5 per unit.
6.16. Comparative Statement Showing Relevant Make Costs and Buy Costs of 12,000 units
of Component 3
Particulars Make Costs Buy Costs
Make Costs:
Direct material (12,000 units × Rs 1.40) Rs 16,800 --
Direct labour(12,000 units × Rs 2.20) 26,400 --
Machine lease rent (12,000 units × Re 0.50) 6,000 --
Variable factory overheads (12,000 units × Re 1.00) 12,000 --
Buy Costs:
Purchase costs (12,000 units × Rs 5.20) 62,400
Freight cost (12,000 units × Re 0.30) 3,600
Total 61,200 66,000

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 Difference favouring making of Component 3 4,800
Stoners Limited is advised to produce the component 3 on its own, as it is more economical.
6.17. Income Statement (with Products A and C) to Decide Whether to Drop Product B (as
suggested by Cost Accountant)
Particulars Products Total
A C
Sales revenues Rs 1,00,000 Rs 4,90,000 Rs 5,90,000
Less variable costs:
Manufacturing 52,000 1,40,000 1,92,000
Selling and administration 18,000 18,000 36,000
Total contribution 30,000 3,32,000 3,62,000
Less total fixed costs:
Manufacturing (Rs 6,500 + 19,000 + 1,05,000) 1,30,500
Selling and administration (Rs 4,600 + 4,600 + 4,000) 13,200
Net profit (before taxes) 2,18,300

Existing Income (with Products A, B and C):

Product A Rs 18,900
Product C 2,23,000
Less loss from Product B (1,600) 2,40,300
Difference (Decrease in profit) favouring continuation of Product B 22,000
We do not agree with the Cost Accountant’s view, as it will cause decrease in
22,000. (Note: The mistake made by the Cost Accountant is that he feels that fixed costs
apportioned to Product B will decrease with its discontinuation which is not true).

6.18. Incremental (Differential) Analysis whether to Discontinue Manufacturing of Dolls

Particulars Amount
Decrease in sales revenue Rs 12,000
Decrease in costs
Direct material 6,000
Direct labour 1,200
Variable overheads 2,800
Scrap value of cut-pieces (opportunity cost of using them in making dolls) 1,000

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 11,000
Difference favouring making dolls 1,000
Avon Garments is advised not to discontinue the manufacture of dolls, as decrease in the revenue
is more than the decrease in costs. In other words, its discontinuation will decrease profit.

6.19 (a). Differential Analysis Whether to Discontinue Product C

Particulars Amount
Decrease in sales revenue Rs 2,00,000
Decrease in costs:
Direct material 75,000
Direct labour 45,000
Variable expenses 30,000
Salary of supervisory staff (avoidable fixed costs) 20,000
1,70,000
Difference favouring continuation of Product C 30,000

(b). Income Statement With Enlarged Production/Sales of Product A (Due to dropping of

C) and Existing Sales of B.
Particulars Product Total
A B
Sales revenue 12,00,000 Rs 8,00,000 Rs 20,00,000
Less variable costs:
Direct material 3,54,000@ 3,36,000 6,90,000
Direct labour 1,41,600@ 1,12,000 2,53,600
Variable expenses 2,12,400@ 1,12,000 3,24,400
Total contribution 4,92,000 2,40,000 7,32,000
Less fixed costs
(Rs 3,30,000 + Rs 1,80,000 + Rs 90,000) -- -- 6,00,000
Profit (before taxes) in proposed situation 1,32,000

6.38
Existing profit:
Product A Rs 80,000
Product B 60,000
Product C (40,000) 1,00,000
Difference favouring dropping of C Product and increase capacity of 32,000
Product A
Since variable costs are assumed to vary in direct proportion to output/sales, these costs have
been assumed to increase by 20 per cent due to increase in sales revenue by 20 per cent.
Alternatively, direct material cost ratio is 29.5% of sales, direct labour cost ratio is 11.8% of
sales and variable overhead ratio is 17.7% of sales.

6.20. Determination of Contribution per unit, Contribution-volume Ratio, Contribution

per unit of Key Factor
Particulars Product A Product B
Selling price per unit Rs 2,500 Rs 5,000
Less variable costs per unit:
Material cost 500 1,250
Direct labour 750 1,500
Variable overheads 250 500
Contribution per unit 1,000 1,750
Contribution to volume (C/V) Ratio 40% 35%
Contribution per rupee of materials used Rs 2 Rs 1.40
Contribution per rupee of labour used Rs 1.33 Rs 1.17
(i) Profitability when total sales in units is limited: As contribution per unit is higher in
case of Product B (Rs 1,750) as compared to Product A (Rs 1,000), production and sales
of Product B will be more profitable.
(ii) Profitability when total sales in value is limited: Since C/V ratio is higher for Product A
(40%) vis-à-vis Product B (35%), it is more profitable to produce and sell Product A.
(iii) Profitability when total raw material is in short supply: As contribution per rupee of
raw material used is higher in Product A (Rs 2) than of Product B, Product A is more
profitable to produce and sell.

6.39
 (iv) Profitability when production capacity in terms of Direct Labour is the limiting factor:
As contribution per rupee of direct labour is higher in the case of Product A (Rs 1.33 as
compared to Rs 1.17 for B), Product A obviously is more profitable to produce and sell.
(v) Statement Showing Optimal Utilisation of 20,000 kgs. of Raw Material

Materials available 20,000 kgs.

Less materials used in producing Product A (1,000 units × 10 kg*) 10,000
Materials left to produce Product B 10,000 kgs.
Materials required per unit (Rs 1,250/Rs 50 per kg) 25
Units of B possible to be produced (10,000 kgs/25 kgs) 400
*Rs 500/Rs 50 per kg = 10 kgs
Income statement (at Optimal Product Mix)
Particulars Product A Product B Total
Number of units 1,000 400 --
Sales revenue Rs 25,00,000 Rs 20,00,000 Rs 45,00,000
Less variable costs:
Material cost 5,00,000 5,00,000 10,00,000
Direct labour 7,50,000 6,00,000 13,50,000
Variable overheads 2,50,000 2,00,000 4,50,000
Total contribution 10,00,000 7,00,000 17,00,000
Less fixed overheads -- -- 10,00,000
Profit (before tax) 7,00,000

6.21. Determination of Contribution per Direct Labour Hour

Particulars Products
A B C
Selling price per unit Rs 60 Rs 55 Rs 50
Less variable costs per unit

6.40
 Direct material cost 20 12 16
Direct labour cost 8 6 4
Variable overhead cost 7 13 8
Total variable cost per unit 35 31 28
Contribution per unit 25 24 22
Labour hours 4 3 2
Contribution per rupee of labour hour Rs 6.25 8 11
Rank (in order of profitability) 3 2 1

Statement Showing Utilisation of Direct Labour Hours to have Optimal Product-Mix

Direct labour hours available 18,600
Less hours needed to produce Product C (1,500 ×2) 3,000
Hours left to produce A and B 15,600
Less hours needed to produce Product B (5,000 × 3) 15,000
Hours left to produce A 600
Number of units possible to be produced of Product A(600 Hours/4) 150
Optimal product mix:
Product C 1,500 units
B 5,000
A 150
Income Statement (condensed form) at Optimal Product Mix
Particulars Product Total
A B C
Number of units to be produced & sold 150 5,000 1,500
Sales revenue Rs 9,000 Rs 2,75,000 Rs 75,000 Rs 3,59,000
Less variable costs 5,250 1,55,000 42,000 2,02,250
Total contribution 3,750 1,20,000 33,000 1,56,750
Less total fixed costs -- -- -- 60,000
Profit (before taxes) 96,750

6.41
 6.22 (a) Statement Showing Contribution per Rupee of Material used for Products P and
Q
Particulars Product P Product Q
Selling price per unit Rs 70 Rs 50
Less variable cost per unit:
Material 30 20
Labour 12 9
Variable overheads 4 2
Contribution per unit 24 19
Contribution margin per rupee of materials used 0.80 0.95
Rank (in order of profitability) 2 1

Statement Showing Utilisation of Raw materials of Rs 3,40,000

Value of raw materials available Rs 3,40,000
Less materials used to produce Product Q (8,000 units × Rs 20) 1,60,000
Value of raw materials left to produce P 1,80,000
Number of units of Product P possible to be produced (Rs 1,80,000/Rs 30) 6,000 units
Thus, optimal product mix:
Product Q 8,000 units
Product P 6,000 units

Income Statement Showing Contribution at Optimal Product-Mix

Particulars Products Total
P Q
Number of units to be produced and sold 6,000 8,000
Sales revenue Rs 4,20,000 Rs 4,00,000 Rs 8,20,000
Less variable costs 2,76,000 2,48,000 5,24,000
Total contribution 1,44,000 1,52,000 2,96,000

6.42
 (b) Statement Showing Utilisation of Raw Materials when Minimum Demand is to be
met
Value of raw materials available Rs 3,40,000
Less value of raw materials consumed
Product P (5,000 units × Rs 30) 1,50,000
Product Q (4,000 units × Rs 20) 80,000
Value of raw materials left to produce Q and P 1,10,000
Less value of raw materials consumed to produce Q (4,000 units × Rs 20) 80,000
Value of materials available to Produce P 30,000
Number of units of P possible to produce (Rs 30,000/Rs 30) 1,000 units
Thus, product-mix:
Product Q (4,000 units + 4,000 units) = 8,000 units
Product P (5,000 units + 1,000 units) = 6,000 units

No, answer does not change.

Solution 6.23:
Incremental Analysis whether to accept counter offer to sell cranes at Rs. 3,40,000 per
crane

Incremental Revenue Rs. 34,00,000

(Rs. 3,40,000 X 10)
Less: Incremental Costs
Material Costs (Rs. 1,50,000 X 10) Rs. 15,00,000
Direct Labour (Rs. 1,00,000 X 10) 10,00,000
Variable manufacturing overheads 7,00,000
(Rs. 70,000 X 10)
Freight 35,000 Rs. 32,35,000
Increase in Profit Rs. 1,65,000

Decision: Not Well company should accept the counter offer of selling 10 cranes at Rs. 3,40,000
per crane.
Notes: (1) Design and cost studies have already been occurred. Therefore, they are irrelevant
costs.
(2) Fixed costs (allocated) are not the additional costs, hence ignored.

6.43
Solution 6.24:

Statement showing the Lowest Price of the tender to be quoted

Particulars Amount
Incremental Costs:
Direct Materials Rs.8,00,000
Direct Labour 5,50,000
Variable Overheads 2,25,000
Production set-up Costs 1,25,000
Special tools and dyes 3,00,000
Total Incremental Costs Rs. 20,00,000
Add: Opportunity Cost (reduction in regular sales): Contribution
sacrificed
[Rs. 22,50,000 X 1/3 (P/V ratio)] Rs. 7,50,000
Total Relevant Costs Rs. 27,50,000

Thus, Rs. 27,50,000 is the lowest bid price the company should quote to carry out the contract
for supplying 1,000 electric components.

Assumptions:
(a) Fixed manufacturing overheads are allocated costs and not incremental costs.
(b) Company would be able to recapture regular sales order (of Rs. 22,50,000) now foregone in
future years.

6.44