Chapter 18. Differential Cost Analysis – Cost Accounting

18

Differential Cost Analysis

LEARNING OBJECTIVES

After studying this chapter you should be able to:

  1. Understand the meaning of "differential costing".

  2. Know the basic features of differential costing.

  3. Understand the similarities and dissimilarities between marginal costing and differential cost analysis.

  4. Apply differential cost analysis in making policy decisions.

  5. Understand the concept of opportunity costing and its applications.

A management of any type of business organization is confronted with the problem of making appropriate decisions. “Behaviour of cost” plays a vital and crucial role in decision-making areas. Although the historical costs serve as an effective tool for predicting future costs, they are not suitable to decision-making process. In the previous two chapters, we have studied the role of variable costs and fixed costs. We are of the view that variable costs are affected by a decision and fixed costs are not affected. But in reality, it is not so; particularly in the long run, no type of cost is fixed. Costs tend to vary due to variations in volume of production, method of production, product mix and the like. Such increase or decrease in the total costs at a particular level of activity has to be analysed. At this juncture, arrives the concept of differential cost. In this chapter, the meaning of differential cost analysis and how it differs from marginal costing is explained in detail. The applications of differential cost analysis and the concept and applications of opportunity cost are all discussed in detail.

18.1 MEANING AND DEFINITION OF DIFFERENTIAL COST ANALYSIS

Differential costs are often confused with marginal costs. The main reason behind such confusion is due to the fact that both (marginal costing as well as differential cost analysis) the techniques are based on the same concept of costs—variable and fixed. But differential cost analysis is a broader and more fundamental concept than the marginal cost. Differential costs deal with all the costs—variable and fixed. It is the change in the total costs associated with each alternative.

AAA Committee on cost concepts and standards says, “It is the increase or decrease in total costs, or changes in specific elements of cost that result from any variation in operations”. Specific elements of cost—total costs—comprise variable and fixed costs.

The increase or decrease in the total costs at a particular level of activity with respect to another is referred to as differential costs. The technique employed to analyse differential cost is known as “differential cost analysis” or “differential costing”. The terminology of CIMA defines differential costing as “a technique used in the preparation of adhoc information in which only cost and income differences between alternative courses of action are taken into consideration”.

18.2 SALIENT FEATURES OF DIFFERENTIAL COST ANALYSIS
  1. In differential cost analysis, costs are usually presented on the basis of total costing technique (absorption costing).
  2. Variable costs are the differential costs when the additional output does not involve the additional fixed costs.
  3. It is used for planning and decision-making only and not incorporated in the accounting records. (books of accounts).
  4. It is intended for the comparison of the expected changes in costs and revenues.
  5. It is applied only to the existing business and not suitable for new business set-up.
  6. Differential costs are future costs.
  7. Differential cost analysis is carried on using only relevant costs.
  8. It ignores the effect of residual costs.
  9. Its purpose is to make a choice among alternatives. That is the cause for subtracting the costs at one level from that of another.
18.3 MARGINAL COSTING VS. DIFFERENTIAL COST ANALYSIS

Both marginal costing as well as differential costing techniques analyse the basic behaviour of costs, that is, the fixed and variable costs. Due to this fact, both techniques are similar in some aspects and vary in some other factors. We focus on the similarities and dissimilarities between these two techniques as follows:

18.3.1 Similarities between Marginal Costing and Differential Costing

Cost analysis: Both are techniques of cost anlaysis—that is behaviour of costs, especially fixed costs and variable costs.

Decision-making: Both techniques undertake cost anlaysis to formulate policies and for taking decisions.

Uniform results: Marginal costing as well as differential costing would provide the same results whereas the fixed costs remain unchanged for alternative course of actions.

Resemblance in concept: An economist’ concept of marginal cost bears resemblance to differential cost concept.

Information to management: Besides decision-making process, both the techniques provide other related information on cost analysis to the management.

18.3.2 Differences Between Marginal Costing and Differential Costing

Basis of Distinction Marginal Costing Differential Costing

1. Accounting system

Marginal costing can be incorporated into the accounting system by keeping proper accounting records.

This is not incorporated into the accounting system as there are no proper recording in the books of accounts. It provides only information.

2. Method of cost presentation

Marginal costs are determined on the basis-of-contribution approach.

Costs are not determined on the contribution approach.

3. Tools used

Marginal costing uses break-even analysis, ratio and CVP analysis as tools for making decisions.

Differential costing makes use of incremental costs, incremental revenue and incremental profits as tools for making decisions.

4. Additional quantity

Marginal costs apply to ANY additional unit of production.

Differential costs apply to a FIXED additional quantity of production.

5. Product costs

In this system, the product costs do not include the fixed costs.

It may include fixed costs if the additional volume involves an additional fixed-cost outlay.

6. Scope

Scope is wider.

It is limited.

18.4 APPLICATIONS OF DIFFERENTIAL COST ANALYSIS OR UTILITIES OF DIFFERENTIAL COST ANALYSIS

Generally, a management may seek the assistance of differential-cost-analysis techniques for taking any valuable policy decision and planning for profit, which are as follows:

  1. Acceptance of order: At times, a management is confronted with the problem—whether or not to accept special orders at a price below the existing price of the product. Differential cost analysis assists in deciding such actions like whether to accept or reject the order.
  2. Make-or-buy decisions: The other problem that frequently daunts the management is whether it is more profitable to make or buy the component parts. This can be solved by applying differential cost analysis.
  3. Further process decision: Some of the products (semi-finished products) may attain a consumable stage. At this stage, the management may not be able to decide on the issue whether the product can be sold in that semi-finished stage itself or to process them further. Differential cost analysis will provide a suitable solution for this.
  4. Pricing decisions: Proper pricing of products is necessary. Interplay of factors—cost and revenue—can be analysed best by this technique.
  5. Operation vs. shut-down decisions: At times of economic recession, many managers may be in a dilemma whether to run the production continuously or shut down temporarily till the economic scenario improves. Proper differential cost analysis will provide an apt decision whether to operate or shut the plant.
  6. Sales policies: Differential cost analysis assists in arriving at a decision with respect to the following:
    1. introduction of a new product.
    2. expansion of selling activities geographically.
    3. Sales promotion activities, etc.
  7. Volume of production: Differential cost analysis is helpful in deciding the volume of production upon which a maximum profit can be earned.

Illustration 18.1

A company is at present working at 90% of its capacity and producing 8,000 units per annum. It operates a flexible-budgetary control system. The following figures are obtained from its budget:

  90% Capacity Rs. 100% Capacity Rs.

1. Sales

12,00,000

15,00,000

2. Fixed expenses

2,50,000

2,50,000

3. Semi-fixed expenses

75,000

1,00,000

4. Variable expenses

1,25,000

1,50,000

5. Units made

9,000

10,000

Labour and the material cost per unit are constant under present conditions. profit margin is 10%.

  1. You are required to determine the differential cost of producing 1,000 units by increasing the capacity to 100%.
  2. What would you recommend for an export price of these 1,000 units taking into account that the overseas prices are much lower than the indigenous prices.

[I.C.W.A. – Modified]

Solution

First, the labour and the material cost have to be determined. Next, the differential cost for each element and for the total costs are to be calculated. Finally, based on the result, a decision has to be arrived at.

STAGE I: Determination of labour and material cost:

  90% Capacity Rs. Rs.

Step 1 → Sales

12,00,000

 

Step 2 → Less: Profit (10% on Rs. 12,00,000)

1,20,000

 

Step 3 → Cost of goods sold (Step 1 – Step 2) (Sales – Profit)

 

10,80,000

Step 4 → Less: (i) Variable expenses:

1,25,000

 

(ii) Semi-fixed expenses:

75,000

 

(iii) Fixed expenses:

2,50,000

4,50,000

Step 5 → Labour and material cost at 90%

*16,30,000

Step 6 → Labour and material cost at 100% capacity

 

 

 

= Rs. 7,00,000*2

 

STAGE II: Determination of differential cost:

STAGE III: Unit differential cost has to be determined:

Decision: Export price should be higher than this unit differential cost price Rs. 120.

Illustration 18.2

A company has a capacity of producing 1,00,000 units of a certain product in a month. The sales department reports that the following schedule of sale prices is possible:

Volume of Production Selling Price Per Unit Re.

60%

1.00

70%

0.90

80%

0.85

90%

0.75

100%

0.69

The variable cost of manufacture between these levels is Re. 0.20 per unit and the fixed cost is Rs. 50,000.

  1. You are required to prepare a statement showing the incremental revenue and the differential cost at each stage. At which volume of production will the profit be at the maximum?
  2. If there is a bulk offer at Re. 0.60 per unit for the balance capacity over the maximum profit volume, as the export and the price quoted will not affect the internal sale, will you advise accepting this bid and why?

[I.C.W.A. – Modified]

Solution

First, the incremental revenue and the differential cost have to be determined at various levels of activity.

Based on the result, the level of production to maximize the profit is ascertained.

Finally, the differential cost for the bulk order has to be worked out.

(a) STAGE I: Statement of Incremental revenue and Differential cost

Result:

  1. The incremental revenue is higher than the differential cost up to the output level of 80%.
  2. At the 90% level of activity, differential costs exceed the incremental revenue.
  3. As the selling prices for volumes between 80% and 90% are not available, of the two levels, the incremental revenue exceeds the differential costs at 80% only.

Decision: Therefore, in order to maximize the profit, the level of production must be set at 80% capacity, that is, 80,000 units.

STAGE II: Computation of a differential cost for the bulk order: The bulk order for the export is 20,000 units.

Result: * The bulk offer for the export of 20,000 units would increase the profit by Rs. 8,000.

Decision: Hence, the export offer may be accepted.

Illustration 18.3

X Ltd is faced with the problem of shutting down or of continuing to operate at a loss. Data from records and estimates made by the company are as follows:

 

Normal capacity of plant

= 1,00,000 units/day

Fixed costs when the plant operates

= Rs. 2,00,000 per annum

Fixed costs when the plant is shut down

= Rs. 1,20,000 per annum

Variable costs (direct labour, direct material, variable overhead) per unit

= Rs. 40

Estimated selling price to meet competition

= Rs. 50

Estimated sales volume at a new selling price

= 10,000 units

 

Advise the company.

Solution

NOTE:

 

1. Incremental revenue is determined as: (No. of units × Estimated selling price) 10,000 ×Rs. 50

= Rs. 5,00,000

2. Differential costs will be determined as: (10,000 units × Rs. 40)

= Rs. 4,00,000

3. Net incremental revenue (1 – 2)

= Rs. 1,00,000*

 

Statement Showing profit/Loss on Two Alternatives
Particulars Alternative I (Plant Operating) Rs. Alternative II (Plant Shut Down) Rs.

Fixed costs

2,00,000

1,20,000

Less: *(Incremental revenue – Differential cost)

1,00,000

Loss

1,00,000

1,20,000

Result:

 

Loss if the plant continues its operation

= Rs. 1,00,000.

Loss if the plant shuts down its operation

= Rs. 1,20,000.

 

Decision: The plant operating at a low capacity level (i.e. 10%) would meet a loss of Rs. 1,00,000 only when compared to Rs. 1,20,000 if the plant is shut down.

The plant may continue its operations so as to retain the skilled labour.

Illustration 18.4

X Ltd can manufacture a part P for a sub-assembly Q. This can be done with the help of present equipment and there is the capacity to produce 1,000 units per month. Another company Y Ltd, the supplier of parts, agrees to supply that part for Rs. 23 each. Of the part that is bought, the equipment can be sold for Rs. 4,000. Evaluate whether to make or buy the part in the following year based on the following data:

  Make Rs. Buy Rs.

Direct material cost per unit

3.75

Conversion cost per unit

14

Specific fixed assets

5,000

Average capital employed

4,000

3,000

(excluding stocks)

 

 

 

7,000

5,000

Solution

Differential cost and differential investment have to be determined.

Then, the differential return on investment is determined by using the formula:

Statement Showing Differential Cost Analysis

Decision: Making the part results in a differential return of 42.85% is high. Hence, it is desirable to make that part instead of buying it from the supplier.

18.5 OPPORTUNITY COSTING

In choosing an alternative proposal, one has to give up one proposal by choosing the other. The rejected proposal too might have generated some revenues. By rejecting this, one has to forego such revenue. This revenue is known as the “opportunity cost”. To put in other words, opportunity costs are the economic resources that have been foregone due to selection of one alternative to another.

18.5.1 Features of Opportunity Costs

  1. A unique feature of the opportunity cost is that no cash changes hands. No explicit cash transactions take place.
  2. These are not shown in the accounting records, as there is no exchange of economic resources.
  3. The concept of opportunity cost is implicit in any evaluation of alternative proposals.
  4. It is not a definition of cost. It is only an expression of a method of approach.
  5. It is treated as an imputed cost while comparing the proposals for generating profit.
  6. Opportunity-cost figures are included in calculations to ascertain profit among the alternative proposals.

Illustration 18.5

Rose Ltd uses iron as a raw material for the manufacture of four finished products. At the beginning of the period, 10,000 units of iron in stock were purchased for Rs. 90 per unit. In case the company decides not to use those 10,000 kg of iron in stock, they can be sold to a scrap dealer for Rs. 50 per unit. Another scrap dealer has offered Rs. 48 per kg unit for the same. The expected future revenues and labour overheads for each unit of the product is as follows:

you are required to decide which would be the best alternative? Apply opportunity-costing approach.

Solution

 

Statement Showing Decision-Making Applying Opportunity Costing

Decision: The highest net advantage is from product A. The lowest being a loss of Rs. 5 from product D. Hence, Product ‘A’ is the best alternative.

Illustration 18.6

Vas & Co. Ltd is engaged in trading business and uses its own building for the purpose. The data obtained from the records of the company show the estimates as follows:

  Rs.

Cost of goods sold per annum

70,000

Other operating expenses per annum

40,000

Building ownership costs p.a.

 

(Rent and rates and maintenance and

15,000

insurance charges for building are not

 

included above

 

Sales per annum

2,50,000

Another firm has offered to take the building on lease for Rs. 7,500 per month. In this case, Vas & Co. Ltd would have Rs. 7,500 per month. In this case, Vas & Co. Ltd would have to discontinue its operations and handover the building to the lessee.

You are required to take a decision using opportunity-costing approach.

Solution

Expected sales revenue and expected future costs have to be calculated to compute the net advantage of leasing. Statement showing decision-making using opportunity costing.

Particulars Amount Rs.

Step 1 → Expected sales revenue (given)

2,50,000

Step 2 → Expected future costs:

(i) Cost of goods sold

70,000

(ii) Other operating expenses

40,000

(iii) Opportunity cost of leasing

90,000

(Rs. 7,500 p.m. × 12 months)

Step 3 → Step 2 (i) + (ii) + (iii)

2,00,000

Step 4 → Net advantage [Step (1) – Step (3)]

50,000

Decision: Leasing yields a net advantage of Rs. 50,000. Hence, it is advisable to discontinue operations and select the option to go in for leasing.

Summary

Differential cost analysis: “A technique used in the preparation of adhoc information in which only cost and income differences between alternative courses of action”.

Salient features:

  1. Costs are presented on the basis of total costing technique.
  2. Variable costs are differential costs when no additional fixed costs are involved.
  3. Not shown in the books of accounts.
  4. Intended for the comparison of the expected changes in the costs and revenues.
  5. They are future costs.
  6. Only the relevant costs are used.
  7. Suitable for the existing business only.
  8. Its aim is to make a choice among the alternatives.

Marginal costing vs. differential costing:

Similarities: Both are techniques of cost analysis, used for decision-making, to provide information to the management and have the same concept on cost.

Dissimilarities:

  1. Differential costing has a wider scope than the marginal costing.
  2. It is difficult to ascertain the differential cost than the marginal cost.
  3. Differential costing can be used for long-term decision-making whereas marginal costing cannot be used.
  4. While marginal costing can be incorporated into the accounting system, differential costing cannot be done so.
  5. Tools used are different.
  6. Differential costing is compatible whereas it is not so in marginal costing.

Application of differential-costing approach: Refer illustrations

Uses of differential costing: Useful to the management to make decisions with respect to

  1. sale or process
  2. make or buy the components
  3. accept or reject orders
  4. operate or shut down the firm
  5. pricing and
  6. sales volume

Opportunity costing: Opportunity costs are the economic resources that have been given up as the result of accepting one alternative course of action instead of another.

Key Terms

Differential Costs: The increase or decrease in the total costs at a particular level of activity with respect to another.

Differential Cost Analysis: The technique employed for the purpose of analysing the differential cost.

Marginal Cost: The additional cost incurred by the production of one extra unit.

Marginal Costing: A system of cost analysis which distinguishes fixed costs from variable costs.

Opportunity Cost: The economic value of benefit sacrificed in favour of an alternative course of action. Example: There are two choices before you: to buy a car and to buy a farm house. You can choose one. Suppose if you choose to buy a car, the opportunity cost of buying the car is the loss of the purchase of farm house.

Bibliography

  1. Marash Dutta; “Cost Accounting” Principles & Practice; Pearson Education; New Delhi
  2. Bhabatosh Banerjee; “Cost Accounting” – The World Press Pvt Ltd; Calcutta.
QUESTION BANK

Objective Questions

 

I. Fill in the blanks with apt words:

  1. Relevant costs are those expected ______ which differ under alternatives in a decision.
  2. ______ costs are affected by a decision, in general.
  3. The technique used for analysing a differential cost is known as _____.
  4. The differential cost is calculated by _______ the cost at one level of production from the cost arising at another level.
  5. Differential costs are _________ costs.
  6. Differential costs include _______ as well as________ costs.
  7. When fixed costs remain unchanged, both marginal costing as well as differential costing would give the _______.
  8. Marginal costing is not used for ________ term decision-making.
  9. Books of accounts are not maintained under ________ approach.
  10. Opportunity concepts are the _______ costs while choosing one alternative.
  11. Opportunity costs are not shown in ________.
  12. Differential return on investment = differential cost by ________.

Answers:

  1. Future costs
  2. Variable
  3. Differential cost analysis
  4. Subtracting
  5. Future
  6. Variable; fixed
  7. Same results
  8. Long
  9. Differential costing
  10. Foregone
  11. Accounting records
  12. Differential investment

II. State whether the following statements are True or False:

  1. Fixed costs are affected by a decision.
  2. If a decision involves a relatively longer time, no type of cost may be said to be fixed.
  3. Differential cost analysis deals with the changes in the variable costs only.
  4. Differential cost analysis is the comparison of the expected changes in the costs and revenues in general.
  5. Differential costing technique can be applied to new business which will be set up shortly.
  6. Differential costs include variable as well as fixed costs.
  7. Differential costs ignore the effect of sunk costs.
  8. In case the fixed costs remain the same for alternative proposals, the results obtained under marginal costing and differential costing will vary.
  9. Differential cost resembles an economist’s concept of marginal cost.
  10. Differential costing cannot be used in long-term decision-making.
  11. In a differential costing, only accounting information is used.
  12. Differential costing can be used under both marginal-costing as well as absorption-costing systems.
  13. There is an exchange of economic resources under opportunity-cost approach.
  14. Opportunity-cost figures are included in the calculation of profit.
  15. Opportunity costs are always recorded in the cost-accounting records.

Answers:

 

1. True

2. True

3. False

4. False

5. False

6. True

7. True

8. False

9. True

10. False

11. True

12. True

13. False

14. True

15. False

 

 

Short Answer Questions

  1. What is differential costing?
  2. What are the salient features of differential costing?
  3. Elucidate the points of similarity between marginal costing and differential costing?
  4. What is the main reason for such similarity between the two systems?
  5. Under what circumstances is differential costing different from marginal costing?
  6. What you mean by opportunity cost?
  7. What is meant by incremental revenue?
  8. How will you ascertain differential cost?
  9. How will you determine the opportunity cost?
  10. What are the salient features of opportunity cost?

Essay Questions

  1. State the reasons for too much reliance by the management on differential costs with simple examples.
  2. Differential costs are basically “specific purpose” costs applicable to a given set of circumstances. Do you agree with this statement? To what extent will it be prudent to take major policy decisions regarding the selling prices based on differential costs alone? Give reasons for your answer.
  3. Explain the importance of “opportunity cost” in management decisions.
  4. Explain the significance of “differential cost” and “incremental revenue” in the present economic and industrial scenario.

Exercises

1. A company is at present working at 90% of its capacity and producing 13,500 units per annum. The following figures are obtained from its budget:

 

 

90%
Rs.

100%
Rs.

Sales

7,50,000

8,00,000

Fixed expenses

1,50,250

1,50,250

Semi-fixed expenses

48,750

50,250

Variable expenses

72,500

74,750

Units produced

13,500

15,000

 

Labour and material cost per unit are constant under the present conditions.

  1. You are required to determine the differential cost of producing 1,500 units by increasing the capacity to 100%.
  2. What would you recommend for an expert price for these 1,500 units taking into account that the overseas prices are much lower than the domestic prices?

[I.C.W.A. – Modified]

[Ans: Price to be fixed at or above Rs. 32.39 per unit.]

2. XYZ Ltd. is faced with the problem of shutting down or of continuing to operate at a loss. Data relating to the company are shown as follows:

 

Normal capacity of a plant day

1,00,000 units/day

Fixed costs when the plant is operating

Rs. 75,000 p.a.

Fixed costs when the plant is shut down

Rs. 50,000 p.a.

Variable costs per unit

Rs. 20

Estimated selling price

Rs. 23

Estimated sales volume at a new selling price: 10,000 units

 

Advise the firm.

 

 

[Ans: Loss: incase of operating: Rs. 45,000; Loss: in case of shut down Rs. 50,000. It is desirable to continue its operations.)

3. A company has a capacity of producing 50,000 units of a certain product in a month. The sales department reports that the following schedule of sales prices is possible.

 

Volume of Production
Selling Price Unit Rs.
60%
0.90
70%
0.80
80%
0.75
90%
0.67
100%
0.61.

 

The variable cost of manufacture between these levels is Re. 0.15 per unit and the fixed cost is Rs. 20,000.

  1. You are required to prepare a statement showing the incremental revenue and the differential cost at each stage. At which volume of production will the profit be the maximum?
  2. If there is a bulk order at Re. 0.50 per unit for the balance capacity over the maximum profit and the volume for export and price quoted will not affect the internal sale, state whether this offer should be accepted and why?

[I.C.W.A. – Modified]

[Ans:

  1. Level of production should be set at 80% level (i.e., 40,000 units) to maximize the profit.
  2. Export order should be accepted as it will increase the profit by Rs. 3,500.]

4. ABC Ltd. manufactures a part of X for a subassembly XX1. This is done with the help of the present equipment and there is a capacity to produce 500 units a month. An outside supplier agrees to supply the needed part for Rs. 28 each. If the part is bought out, the equipment can be sold for Rs. 6,000. Advise whether to make or buy the part in the following year based on the following data:

 

 

Make

Buy

 

Rs.

Rs.

Direct material cost per unit

2.10

Conversion cost per unit

20.50

Specific fixed assets

5,000

Average capital employed (excluding stocks)

6,000

5,000

Stocks

5,000

6,000

 

[Ans: Differential return on investment will be 30%. Hence, it is profitable to make the part.]

5. Assuming that the rated capacity of the factory is 30,000 units, what should be the most profitable level of output?

[Ans:

Hint: (Apply differential cost approach)

 

25,000 units; Incremental revenue Rs 35,000;

 

Differential cost Rs 31,000]

6. The following extracts are taken from the sales budget of a company for the current year:

 

 

Rs.

Sales – 40,000 units @ Rs. 25/unit

1,00,000

Selling costs:

 

Advertising

1,00,000

Salesman salary:

80,000

Travelling expenses

50,000

Rent of sales office

10,000

Others

10,000

 

2,50,000

 

The management is considering a proposal to establish a new market in the eastern region in the next year. It is proposed to increase the advertisement expenditure by 25% and appoint an additional sales supervisor at a salary of Rs. 30,000 per year to establish a market. This will involve additional travelling expenses and the travelling expenses shall increase by 10%.

The target annual sales volume at the existing selling price for the next market is 10,000 units. The estimated variable cost of production is Rs. 12 per unit. Should the company try to establish the new market?

 

[C.S. (Inter); I.C.W.A. (Inter)]

[Ans: The proposal is profitable. Aggregate profit will be Rs. 3,40,000 – higher than the existing profit of Rs. 2,70,000.]

7. The overhead expenses of a factory producing a single article at different operating levels are as follows:

 

Operating-level Capacity
Works Overhead (Rs.)
80%
36,000
100%
40,000
120%
50,000
60%
33,000

 

The factory is currently working at 60% operating level and its annual sales amount is Rs. 1,44,000. Selling prices have the following relationship with costs at this level:

 

Factory cost

66.67% of sales value

Prime cost

75% of factory cost

Administration and selling expenses (of which 75% is variable)

20% of sales value

 

The management receives an offer for carrying out some work for another company valued at Rs. 33,000 per annum, which will take up 40% capacity. The prime cost of the work is estimated at Rs. 20,000. There will be an addition to administration expenses of Rs. 1,500 per annum.

The sales manager estimates that the sales of the company’ own product will increase to 80% capacity by the time the new order materializes.

Calculate the profit of the current production. Give your views, supported by figures, on the advisability of taking on the new work.

 

[M.Com., Sri Venkateswara University, Tirupati, A.P.; Nagarjuna University]

[Ans: profit: Rs. 5,400; The most profitable level of capacity utilization is 80% where the aggregate profit is Rs. 19,200; Not advisable to undertake job from another company].

8. A company has a capacity of producing 50,000 units of a certain product in a month. The sales department reports that the following sales prices are possible:

 

Volume of Sales    
Selling Price / Unit Rs.
50% of production capacity
2.00
60%
1.90
70%
1.85
80%
1.80
90%
1.70
100%
1.60

 

The variable cost of manufacture between the above levels is Re. and the total amount of fixed cost (for 60% capacity) is Rs. 20,000 per month.

You are required to prepare a statement showing the incremental revenue and the differential cost at each of the above levels of production and sales.

At which level of production and sales will the profit be the maximum.

 

[M.Com – Bombay University]

[Ans: At 80% level: Incremental revenue: Rs. 7,250. Differential cost: Rs. 5,000.]

[Model: Opportunity Costing]

9. XY & Co. Ltd uses aluminium as a raw material for the manufacture of four finished products. At the beginning of the period, there are 6,500 units of aluminium in stock that were purchased @ Rs. 60 per unit. In case the company decides not to use the 6,500 units of aluminium in the stock, they can be sold to a scrap dealer for Rs. 55 per unit. Another scrap dealer has offered Rs. 50 per unit for the same. The expected future revenues and the labour overheads for each unit of the product are as follows:

What is the best alternative using opportunity-cost approach?

[Ans: Highest net advantage of Rs. 20 arises from the product A. It is the best alternative.]

10. Rama & Co. Ltd is engaged in trading business and uses its own building for the purpose. The following data available from the firm’s records show the estimates made by the company:

 

 

Rs.

Cost of goods sold per annum

1,00,000

Other operating expenses per annum

75,000

Building ownership costs per annum

37,500

Sales per annum

3,00,000

 

Another firm has offered to take the building on lease for Rs. 8,000 p.m. In this case, Rama & Co. Ltd would have to discontinue its operations and hand over the building to the lessee.

You are required to take a decision using opportunity-costing approach.

[Ans: Leasing yields a net advantage of Rs. 29,000. Hence, it is advisable to discontinue operations and go in for leasing.]