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SCEMP

FINAL-SCMPE

Q-1

Wireless is a manufacturer of mobile phones. The company operates in a market that is dynamic, extremely competitive and consumer centric. The market is broadly fragmented into those customers who are price conscious looking only for basic features and those who are technology savvy wanting to try out the latest offering. Wireless manufactures phones that cater to both these segments.

Mobile A has the very basic features that a customer requires from a phone. It is marketed to attract the price conscious customers. There are many other manufacturers who have similar product offering for this market. Mobile Z offers the latest technology features and an attractive design. Wireless has invested substantial amount in research and development that has resulted in Mobile Z having many unique features. It is marketed to attract customers willing to try out newer products. The research has also yielded results whereby a large section of the design of Mobile A and Z can be standardized to have a similar components and engineering. This would enable Wireless to enter into agreements with its suppliers to provide components Just in Time based on the production schedule. With this change, the quality of Mobile A is expected to improve, thereby improving its sales off take manifold.

Online shopping has given customers complete access to the prices of phones offered by different manufacturers. This channel of shopping contributes to almost 70% of the sales. Huge discounts by its rivals has forced Wireless to reduce the prices of Mobile A as well. This has stretched its profit margins. Various cost reduction measures have been initiated to maintain profitability. Mobile Z on the other hand is currently doing well since it is targeted at a more niche segment of customers. Wireless is able to charge premium price for Mobile Z. The latest news in the industry of personal devices like mobiles, laptops etc. is the use of Artificial Intelligence and Augmented Reality to enhance user experience. The technical staff at Wireless feel that this could be the next new frontier that could really change the way we use our devices, most of which could even go redundant.

Required

(i) IDENTIFY the strategy that Wireless is using for Mobile A and Mobile Z.

(ii) DISCUSS the risks involved in each of these strategies.

(iii) ADVISE Wireless to sustain its current strategy for Mobile A? (Study Material)

(i) Wireless is following the “low cost strategy” for Mobile A and “differentiation strategy” for Mobile Z. Mobile A is being offered at discounted rates to meet the prices of its competitors. This is being done in order to gain market share from its competitors. To maintain its profitability, Wireless has to find means to keep its manufacturing, distributing and other costs low. Mobile Z is being perceived by customers as a unique product, with features different from its competitors. This is “differentiation strategy”. Differentiation can be achieved from superior product quality, innovation and customer responsiveness.

(ii) The risks involved in a “low cost strategy” for Mobile A is that any price reduction by Wireless will be followed by an equivalent price reduction by its competitors. This price war will ultimately eliminate players who are unprofitable. This strategy will put margins under pressure. The company has to find ways to its costs low on a sustained basis. The “low cost advantage” will be lost once its competitors find a way to lower their costs as well. The other risk would be to that the quality of the product could be impacted negatively due to lowering of costs.

The risks in differentiation strategy is that it will work only when customers are not price sensitive. The mobile market that Wireless operates is a competitive market. As long as certain customers are will to pay extra for additional features, Mobile Z will have a competitive advantage. If these customers also become price sensitive, they fail to see the value for paying extra for the additional features, the sales of Mobile Z will start falling. The other risk in this strategy would be in the ability of competitors to replicate the features of Mobile Z. Therefore, Wireless should protect its intellectual property rights in order to prevent its competitors from replicating the design and features of Mobile Z. It only when these risks are contained, that Wireless would be able to maintain its premium price for Mobile Z for its unique features.

An external risk factor for Wireless would also be from the developments in the fields of Artificial Intelligence and Augmented Reality. Wireless has to constantly monitor and assess how these technological developments can impact its business. It must be flexible to adapt to changes as they take place, in order not to become redundant in business.

(iii) “Low cost advantage” can be maintained by copying designs rather than creating them, attaining economies of scale by high-volume sales, getting discounts on bulk purchases and gaining learning and experience curve benefits.

Learnings and experience from research for Mobile Z can be leveraged for Mobile A. Standardization of design for Mobile Z and A would improve the quality of the product since the design is based on a product that has premium range of customers. Since these features can improve the sales of Mobile A, costs would benefit from economies of scale due to larger production volumes.

Bulk purchase of components for Mobile A and Z gives Wireless the advantage of negotiating for discounts on purchases. It could also negotiate for favourable delivery terms, like just in time purchasing agreements. This would reduce the inventory holding costs for Wireless.

All this contributes towards lowering the costs of production of Mobile A. This will help Wireless sustain its low-cost advantage.

Q-2

Sprinter Sportswear is a multi-national company 10 years ago as a budget hotel in the vicinity of Mumbai airport. It provides accommodation for cost-conscious travelers visiting the city for short stay lasting a day or two. Typically, a room would provide comfortable beds, high speed internet connection, air conditioning facility, coffee machine, fridge and free television service. Food service based on a limited menu is provided on the premises. It has few conference rooms that provide space for guests to hold business meetings. This saves them precious time otherwise wasted in travelling on congested city roads. The hotel provides free shuttle service to and from the airport at specific times during the entire day. Hotel’s proximity to the airport, the free shuttle service and convenience of conducting work at the conference rooms have been marketed to attract guests to stay here. The guests also comprise of people who are in transit between airports. Also, when there are long duration delays in flight operations due to which passengers need to be provided overnight accommodation, few airline operators host their guests here. Like all other guests, these airline operators are also interested in Staywell for its location and low-cost room rental.

Over the past decade, management of Staywell has ploughed in profits from this establishment to acquire similar properties in other major cities. They function based on business model similar to the original establishment in Mumbai. All of them are now functioning as well- established budget hotels near city airports for cost-conscious business travelers. In all, Staywell hotels have 18 properties spread over 15 cities. To keep its costs of operations within control, Staywell hotels has outsourced its cleaning and food service to specialized vendors. Cleaning service includes cleaning of kitchen crockery, bedding, laundry and housekeeping of premises. The entire set of activities related to preparation of food has been outsourced. Vendor service has been satisfactory, barring few instances where guests have complained of unhygienic rooms or non- palatable food service. However, due to high guest volume and quick turnover of guests due to short stay periods, this has never been a hindrance to business.

This business model has been profitable since its establishment. Staywell Hotels has a sizeable market share in this segment. Competition has increased in the recent past. Price wars have put pressure on profit margins in this segment. The management plans to continue to operate in this segment to maintain its market presence. At the same time, to sustain business in the long term, the management of Staywell Hotels now wants to foray into developing properties for luxury resorts. Target guest segment are vacationing tourists interested in an enjoying a laid- back time in scenic places. These guests would not mind paying premium for availing good quality service.

Required

(i) IDENTIFY and EXPLAIN the various primary activities of Staywell in its value chain.

(ii) IDENTIFY and EXPLAIN the stage of product life-cycle.

(iii) EVALUATE the risks of outsourcing cleaning and food services for the luxury resort properties.

(i) The five Primary Activities of Michael Porter’s Value Chain Model Inbound Logistics

Activities related to receiving, handling of materials from the supplier and their storage until further use later in operations. In the case of Staywell Hotels, materials would include food service received from the vendor. This needs to be stored and maintained properly until the item is ordered by the guest. Similarly, the vendor delivering freshly laundered crockery, bedding and laundry would be materials that need to be stored until their use to serve the guests. These are inbound logistics for the hotel.

Operations

Activities related to converting inputs into production of output or service. In the case of Staywell Hotels, operations would include maintenance of hotel premises including guest rooms, conference rooms and common area. Activities related to ensuring cleanliness and safety of rooms, working order of facilities offered like TV and internet service, coffee machines, shuttle service are part of hotels operations.

Outbound Logistics

Storage and movement of the end product from the production line to the customer. In the case of Staywell Hotels, it includes activities such as maintaining “non- smoking” rooms as such, so that when the customer finally uses it comes across as a “non-smoking” room. Likewise, the food should be prepared in a professional manner, stored in such a way that it ensures customer satisfaction and safety. Therefore, the review of food items to remove the ones past expiry would be part of Outbound Logistics. Therefore, any activity relating to making sure that the guests get what they have ordered for, would be part of outbound logistics.

Marketing and Sales

The activities related to communicating, selling, and delivering the product or service to the customer. In the case of Staywell Hotels, advertising its properties to the cost and time conscious traveller would be a marketing activity. Free shuttle service is a promotional activity to attract guests. Any agreement with airline companies to accommodate guests would also form part of this activity.

Service

All types of service such as after sale service, handling customer complaints, customer support, training etc. In the case of Staywell, service is one of the most important activities in their value chain model. Good service ensures happy guests. Therefore, all activities from front-desk, room service, catering, repair services, shuttle service would be included here. All employees have to trained to handle needs of the guests in an effective and efficient manner.

(ii)Product Life-cycle Stage of Staywell Hotels

“Budget Accommodation” to the cost and time conscious traveller is the current product offering of Staywell Hotels. Starting out with a single establishment, Staywell Hotels ploughed in profits to expand its business offering to other cities as well. The product has been well established in the past decade. Competition is intense indicating similar offering by rivals. Price wars have put pressure on profit margins. Staywell Hotels plans to continue in this segment due to its sizeable market share. This information indicates that Staywell Hotels is in the maturity stage of its product lifecycle. It has a well-established product, with a sizeable market share at the same time it is now facing competition. Business has hit a plateau. Hence, Staywell Hotels needs to improve its product offering to beat competition. The management's plans to foray into luxury resort business is an indication of its future plans to sustain business.

(iii)Risks of Outsourcing Cleaning and Food Service under the Luxury Resort Model

Staywell Hotels is a budget accommodation provider to the cost and time conscious traveller. Primary feature of this model is "value for money". To remain profitable the cleaning and food service has been outsourced, which enables Staywell Hotels to keep the costs of operation low. There have been instances of dis-satisfaction among guests as regards quality of cleaning and food service. However, since the turnover of guests is quick due to high volume and short stay period, it has not negatively impacted business.

In the luxury resort business, the target guests are travellers on leisure. The primary feature of this model would be "good quality of service". Maintaining cleanliness of premises and food service are critical activities in the operation of luxury hotels. Therefore, customer satisfaction on these metrics is paramount to sustain and grow business. With the ability to post reviews online on booking portals, any negative review (whether justified or not) can reach very easily to a large number of potential guests. This can negatively impact future business. Hence, Staywell Hotels has to ensure that the quality of service that it provides in terms of cleanliness and food should meet and beat the guest’s expectation.

Outsourcing these services to well established vendors is advantageous since the focus can remain on improving guest experience. It may also be cost advantageous in many cases. However, there a number of risks in this model. Detailed service level agreements need to be drawn up to ensure that the required quality of service is being provided. Staywell Hotels should be able to monitor the performance of these vendors. In cases of non-delivery of the required level of service, the agreement should provide for means of redressal. This could vary from compensation for any loss in business to immediate termination of service. Staywell Hotels should ensure that it can easily and economically switch service providers if required.

For this it has to identify alternate vendors who can provide the same level of service as the current ones. The other risk in outsourcing could be of instances where well performing vendors could go bankrupt and shut shop. In such cases, Staywell Hotel’s operations could be immediately impacted since such services can no longer be availed from these vendors. Again, list of alternate service providers is a necessary back-up that the hotel should have.

Alternatively, since these are very critical activities to business operations, Staywell Hotels may choose to have complete control over them. This can be achieved by having in-house departments that cater to cleanliness and food service. Control over factors such as input material used, the performance of service, equipment used, training of staff and other essential activities can ensure that the required service quality can be achieved. Better service enhances guest experience. Compared to outsourcing, this might be a costlier option. However, since the guests are ready to pay a premium for service quality, within reasonable limits cost need not be a primary concern for Staywell Hotels for this business model.

Q-3

Westwood Solar Solutions (WSS) has mastered the art of developing Solar Domestic Water Heater that fulfil customer’s needs. WSS’s designers and product developers focus on solutions to get rid of everyday hassles and transform these into a pleasant experience. WSS also has a wide service network that spans the length and breadth of India to ensure good care of customers and products, by providing a prompt and pleasant service experience. In the past, WSS had a dominant position in the Indian market. However, over the past four years, it has been found that its profits and its share in the market have come down.

WSS has business Model comprising of following steps: -

Firstly, WSS’s highly qualified and skilled experts visit customer’s locations to identify and design the appropriate heater as per customer’s requirements. WSS’s experts are recognized as the best in the industry, and customers agree that they produce the most effective solutions to their complaints.

• At WSS, in the laboratories, the heater design goes through intricate, complex, and dynamic process. Prototypes are developed on the basis of discussions in previous step. Thereafter, these prototypes are tested. Once a final design is decided, such design is passed to the manufacturing division for production.

• Then, WSS manufactures appropriate Solar Water Heater to the desired specification and installs at the customer’s location.

• After the heater’s installation, WSS renders annual maintenance services for which it is well- known in the industry.

WSS’s customers pay a total price for design, manufacture and initial installation of the Solar Water Heater and an annual maintenance charge after that. Total prices are quoted before design work begins.

Although customers appreciate the high quality of the solutions provided by WSS’s team, however, they are complaining that the overall prices are too high. Customers have said that although other suppliers do not solve their problems as WSS does, they do charge less. Consequently, WSS has lower down its prices to compete in the market. There is a doubt that the manufacturing and installation stages of the business model are not contributing sufficiently to the firm since costs at both stages are going high.

Partners of WSS have considered that this situation should no longer continue and have recommended that a value chain analysis to be conducted as to identify the way forward for WSS. Although majority of partners are in the agreement with the proposed value chain analysis, however senior partner ‘W’ has stated that value chain analysis is inappropriate idea. She says that she has heard a number of criticisms of the value chain model.

Assuming yourself as management accountant of WSS, answer the following questions:

Required

(i)DISCUSS the benefits that may accrue to WSS from conducting a value chain analysis.

(ii)DISCUSS the criticisms of Porter’s value chain model in the context of WSS

(ii)EXPLAIN other form of Value Chain Analysis that may be more suitable for WSS

(i) There are following benefits accruing to WSS through a value chain analysis:

• Value chain analysis is a process by which a firm identifies and analysis various activities that add value to the final product. The idea is to identify those activities which do not add value to the final product/service thereafter eliminating such non-value adding activities. The analysis of value chain help a firm in obtaining cost leadership or improve product differentiation. For WSS, value chain can provide with more unambiguous picture of the value of the manufacturing function as perceived by customers.

• This model also helps in analyzing other firms within the same industry. As WSS observed that other firms in the industry are considered to be more cost effective in terms of manufacturing, it may plan to use the value chain model to examine the reason for the same.

• The value chain will assist WSS to determine ways to get best approach towards developing higher level competitive performance. This model assists firms in finding ways to develop higher level of performance either by cost leadership or product differentiation. Right now, WSS is in a situation wherein it is being defeated on price by some of its competitors, however is recognized as the best solutions provider to customer's problems. Through detailed value chain analysis, WSS may be able to ascertain the reason of falling down in such situation and partners may be able to take decision regarding the future vision of the firm.

• Through this analysis, WSS may apply other relevant management techniques as well. Post value chain analysis, WSS will be in a position to decide whether it is worthwhile to continue the technique of benchmark (processes and performance) against its rivals, to develop an information systems strategy, to carry out a business process re- engineering process or to adopt activity based management.

• Further, WSS may decide to outsource manufacturing and keep focus on design and services by following value chain analysis model. This technique may be appropriate for WSS as by outsourcing manufacturing, WSS may be able to focus on its core area for which it is well- known in the industry.

• Value Chain analysis will also facilitate the development of performance metrics for WSS. By developing such metrics WSS may be able to identify which aspects of its business model are not contributing to the overall value and profits of the firm. Although currently WSS has suspicion that manufacturing and installation are the weak parts of its operation, development of transparent and appropriate metrics would enable WSS to recognize where value and profit are being added in the business model.

(ii)Number of criticisms of the value chain developed by Michael Porter have been:

• This value chain analysis cannot easily be applied to firms belonging to service industries. This criticism is particularly imperative in the context of WSS which has upward profits from rendering solutions and services rather than that from manufacturing tangibles products. Many people appreciate that the model is more suitable to manufacturing-based industries, rather than service based industries.

• Often this model is seen as complicated and perhaps could be a source of frustration for the management of a firm. Although the staff of WSS includes bright and intelligent experts, they may not see the value in-depth analyses of business which is required for a full value chain analysis.

• This analysis has a linear approach and ignores the concept of value networks. This criticism is specifically relevant to WSS because its major business resort to the cooperative relationship that the experts have with their customers. If, WSS decides to outsource manufacturing and focus on design and service, this will become even more relevant where relationships are utmost important.

• Often value chain analysis is perceived as time consuming and expensive as a whole. However, if the analysis is to be completed timely, there will be requirement of reliable data such as cost of components in business model. However, in the absence of good cost capturing system, this model could prove to be a costly process. After completion of this process, still there is no guarantee that the process lead to have upward trend in profitability and where it does, it may take some time in realization.

(iii) WSS requires to acknowledge that the nature of its business is turning from manufacturing zone to a solutions provider or professional services firm.

From this point of view, it would be better for WSS to analyse its business using the Professional Services Value Chain/ Value Shop Model. The concept of Value Shop came in to lime light holding the hand of Charles B. Stabell and Oystein D. Fjeldstad in 19 98.This concept aims to serve firms from service sector. It only deals with problems, figure out the main area requiring service and finally come with the solution. This approach is designed to solve customer’s problems rather than creating value by producing output from an input of raw materials.

A Value Shop mobilizes resources (say: people, knowledge or money) to solve specific problems such as delivering a solution to business problem. This shop model is iterative, involving repeatedly performing a generic set of activities until a solution is reached.

Secondary activities in the Professional Service Value Chain have same support activities as those in the porter’s value chain, However the primary activities are described differently to recognize the different nature of a service-oriented business. In value shop, primary activities are performed in a circle within a firm to perform generic set of activities iteratively before reaching a conclusion. Since WSS team communicate with customers to find a solution before testing of developed prototypes, so they will find the vale shop, compatible and effective model to use.

Q-4

Cellwell Technologies Ltd. is a manufacturer of mobile phones. It has been an established player in the market having launched various cell phone models in the last 10 years. With the preference for usage of cell phones increasing, the company has grown rapidly since inception. During the last two years, sales have been increasing but at a slower rate. Competition has increased and hence sales growth has been slowing down.

Cellwell Technologies plans to introduce a new smart phone model called XXX21. The company’s research and development team has come up an additional feature for this cell phone model. This feature will periodically inform the customer using the cell phone regarding any software update required for the model. By installing these updates many existing bugs in the software model and security issues to the software can be fixed. This process can be executed remotely with the help of the new technology that the research and development team has developed. This improves the cell phone performance and keeps it running smoothly. It improves compatibility of the software with that used in other applications and devices. It also enhances customer experience as the software update will bring out new software features (like newest emotions / updated dictionary) that can be used by the customer.

Consequently, the general utility of the cell phone life will improve by almost a year. There will be less complaints due to performance / compatibility related issues.

The business development team has come up with a proposal for sales promotion. As per this proposal, customers can trade in older model of their cell phone in order to buy the latest XXX21 model. Due to the trade, customers can buy the latest model XXX21 at a substantial discount.

After discussion with the research and development team, they conclude that this would have an additional advantage. Cellwell Technologies can refurbish (repair and renovate) these older models and resell them in the market at a substantially lower price. Typically, students or customers in the lower income groups who look for cheaper models may find this offer interesting. This creates a new market space for the company to target.

Those older cell phones traded in, that cannot be refurbished or are beyond repair / use can be recycled. Various parts of these phones can be recycled and fitted into the new cell phone models that are being made. Any cell phone model contains various precious metals like gold, copper, platinum as also rare earth elements like neodymium, terbium to name a few. These are difficult to obtain and need to be mined out of the earth causing huge damage to the environment. With the demand for cell phone slated to increase, the need for these materials is going to increase as well. Therefore, if these materials can be extracted from old cell phones that would otherwise have been disposed-off into a landfill, it would benefit the environment while providing an alternate source of material procurement.

Since billions of cell phones are used globally, every small measure makes an impact. With increasing awareness about environment hazards, such a proposal is likely to find support among customers. It is also helpful to improve the company’s brand image.

Both proposals to introduce software upgrade feature in the cell phone as well as the trade in sales promotional offer are unique as no other competitor has such features in their products or have made such offers yet.

Required

(i)IDENTIFY the lifecycle phase of Cellwell Technologies Ltd. JUSTIFY your response with reference to the case facts.

(ii) DISCUSS the impact of the decision to allow trade in of the company’s older cell phone models on the product lifecycle of such phone models.

(i) Cellwell Technologies Ltd. is in the “Maturity” stage of product lifecycle. It has been an established player in the cell phone market. The company has seen rapid sales growth. Over the last 2 years sales have been increasing at a slower rate due to increased competition. Therefore, the company has decided to introduce a new product model in the form of XXX21.

Retention of existing customers and trying to win over the competitor’s customers is the strategy being used by Cellwell Technologies. The XXX21 model that enables customers to upgrade the software of their smartphone enhances its product features. This differentiates the company’s product with that of its competitors. Technology changes at a fast pace. By enabling customers to upgrade their mobiles would definitely improve performance, lower customer complaints due to breakdown or compatibility issues due to older software. Improved performance along with longer product life would definitely enhance customer satisfaction as well as attract newer customers. The add on benefit is that the execution of this update can be managed from remote locations without the need for in person assistance.

The offer to trade in old cell phones while buying the latest XXX21 model would appeal to price sensitive customers. It will also evince interest of customers who are looking to dispose their cell phones that would otherwise end up in the landfill. The trade in offers monetary benefit in the form of a discount. This sale promotional offer to trade old phones for a discount in the price of the latest model XXX21 would definitely help Cellwell Techonogies to effectively compete with its competitors. Cellwell Technologies would have the first mover advantage by implementing both the product enhancing / differentiating feature in model XXX21 as well as the trade in options to customers. This shows that the management has a clear plan on how to effectively beat the competition. This indicates that the company is now in the “Maturity” stage of product lifecycle.

(ii) Cellwell Techonogies has introduced a sales feature to allow trade in of older cell phone models in exchange for model XXX21 at a substantial discount. These phones would then be used in 2 ways (1) by refurbishing (repairing and renovating) or (2) recycling useful product parts and extracting precious metals and earth elements from the phones.

The refurbished phones would be sold at a substantially lower price to customers like students or lower income groups. Thus, the older cell phone model gets a new lease of product life after the requisite repairs. This extends its product life cycle by a further time frame until there may be no use of the cell phone model at all.

In the case of phones that are of no use/ completely dead, usable parts are being recycled into existing products. Thus, this becomes an alternate source of material procurement for the company at a much lower cost. Consistent use of this measure would definitely reduce the cost of production by a certain margin.

The product lifecycle of such cell phones (dead phones) is not being extended. However, they continue to provide value to the company with the help of the recycling process. The intangible benefit of this measure would be the positive impact that recycling would have on the environment. A move that would definitely enhance the company’s brand image.

Q-5

A company produces and sells a single product. The cost data per unit for the year 2017 is predicted as below

 PARTICULAR Rs. per unit Direct material 35 Direct labour 25 Variable overheads 15 Selling price 90

The company has forecast that demand for the product during the year 2017 will be 28,000 units. However to satisfy this level of demand, production quantity will be increased?

There are no opening stock and closing stock of the product.

The stock level of material remains unchanged throughout the period.

The following additional information regarding costs and revenue are given:

• 12.5% of the items delivered to customers will be rejected due to specification failure and will require free replacement. The cost of delivering the replacement item is Rs. 5 per unit.

• 20% of the items produced will be discovered faulty at the inspection stage before they are delivered to customers.

• 10% of the direct material will be scrapped due to damage while in storage. Due to above, total quality costs for the year is expected to be Rs. 10, 75,556.

• The company is now considering the following proposal:

1. To introduce training programmes for the workers which, the management of the company believes, will reduce the level of faulty production to 10%. This training programme will cost Rs. 4, 50,000 per annum.

2. To avail the services of quality control consultant at an annual charges of Rs. 50,000 which would reduce the percentage of faulty items delivered to customers to 9.5%.

Required

(i) Prepare a statement of expected quality costs the company would incur if it accepts the proposal. Costs are to be calculated using the four recognised quality costs heads.

(ii)Would you recommend the proposal? Give financial and non-financial reasons.

(i) Statement Showing ‘Expected Quality Costs’

 Particulars Current Situation (Rs.) Proposed Situation (Rs) Prevention Costs --- 4,50,000 Appraisal Costs --- 50,000 External Failure Costs 3,20,000 2,35,120 Internal Failure Costs 7,55,556 3,91,538 Total Quality Costs 10,75,556 11,26,658

Workings

External Failure Cost

 Particulars Current Situation Proposed Situation Customer’s Demand 28,000 units 28,000 units Number  of   units  Dispatched  to  Customers .................................(B) 32,000 units 30,939 units Number of units Replaced ……(B)–(A) 4,000 units 2939 units External Failure Cost  {4,000 units ×Rs.(35+25+15+5)}; {2,939 units ×Rs.(35+25+15+5)} Rs.3,20,000 Rs.2,35,120

Internal Failure Cost

 Particulars Current Situation Proposed  Situation Number of units Dispatched to Customers …(A) 32,000 units 30,939 units Number of units Produced & Rejected …(B) 40,000 units 34,377 units Number of units Discovered Fault … (B) – (A) 8,000 units 3,438 units Cost of Faulty Production    …(D)  {8,000 units × Rs. (35+25+15)};  {3,438 units × Rs. (35+25+15)} Rs. 6,00,000 Rs. 2,57,850 Material Scrapped 4,444.44 units 3,819.67 units Cost of Material Scrapped …(E) Rs. 1,55,556 Rs. 1,33,688 {4,444.44 units × Rs. 35}; {3,819.67 units × Rs. 35} Internal Failure Cost …(D) + (E) Rs. 7,55,556 Rs. 3,91,538

(ii) On purely financial grounds the company should not accept the proposal because there is an increase of Rs. 51,102 in quality costs. However there may be other factors to consider as the company may enhance its reputation as a company that cares about quality products and this may increase the company’s market share.

On balance the company should accept the proposal to improve its long-term performance.

Q-6

Cool Air Private Ltd. manufactures electronic components for cars. Car manufacturers are the primary customers of these products. Raw material components are bought, assembled and the electronic car components are sold to the customers.

The market demand for these components is 500,000 units per annum. Cool Air has a market share of 100,000 units per annum (20% market share) for its products. Below are some of the details relating to the product:

 Selling price Rs.2,500 per unit Raw material cost Rs.900 per unit Assembly & machine cost Rs.500 per unit Delivery cost Rs.100 per unit Contribution Rs.1,000 per unit

The customers due to defects in the product return 5,000 units each year. They are replaced free of charge by Cool Air. The replaced components cannot be repaired and do not have any scrap value. If these defective components had not been supplied, that is had the sale returns due to defective units been nil, customers’ perception about the quality of the product would improve. This could yield 10% increase in market share for Cool Air, that is demand for its products could increase to 150,000 units per annum.

Required

(i)ANALYZE, the cost of poor quality per annum due to supply of defective items to the customers.

(ii) The company management is considering a proposal to implement an inspection process immediately before delivery of products to the customers. This would ensure nil sales returns.The cost of having such a facility would be Rs.2 crores per annum, this would include

(iii) Materials and equipment for quality check, overheads and utilities, salaries to quality control inspectors etc. ANALYZE the net benefit, if any, to the company if it implements this proposal

(iv)Quality control investigations reveal that defective production is entirely on account of inferior quality raw material components procured from a large base of 30 suppliers. Currently there is no inspection at the procurement stage to check the quality of these materials. The management has a proposal to have inspectors check the quality control at the procurement stage itself. Any defective raw material component will be replaced free of cost by the supplier. This will ensure that no product produced by Cool Air is defective. The cost of inspection for quality control (materials, equipment, salaries of inspectors etc.) would be Rs.4 crores per annum. ANALYZE the net benefit to the company if it implements this proposal? Please note that scenarios in questions (ii) and are independent and not related to each other.

Between inspection at the end of the process and inspection at the raw material procurement stage, ADVISE a better proposal to implement (a) in terms of profitability and (b) in terms of long term business strategy?

(i) Customer demand for Cool Air’s products is 100,000 units per annum. However, 5,000 defective units supplied are to be replaced free of charge by the company. Therefore, the total number of items supplied to customers per annum = 100,000 + 5,000 units = 105,000 units. The cost of replacement would include raw material cost, assembly & machining cost and delivery cost of 5,000 units = 5,000 units × (900+500+100) per unit = 5,000 units × Rs.1,500 per unit = Rs.75,00,000 per annum. Further, had the sale returns not happened, market share would have increased by 50,000 units. Contribution is Rs.1,000 per unit, for 50,000 units contribution would be Rs.5,00,00,000. Therefore, the cost of poor quality per annum = cost of replacement + contribution from lost sales = Rs.75,00,000 + Rs.5,00,00,000 = Rs.5,75,00,000 per annum.

(ii) Inspection at the end of the process would detect defects before delivery to the customers. This would ensure that the sale returns would be nil. Given in the problem, 5,000 units supplied are defective and would need to be replaced, in other words, they need to be manufactured again. In other words, inspection after production, before delivery to customers would not prevent production of defective units. However, compared to the current scenario, since these defective units have not yet been delivered to the customer, the cost for additional delivery of replaced products would be saved. This savings in the extra delivery cost = 5,000 units × Rs.100 per unit = Rs.5, 00,000 per annum. Further, had the sale returns not happened, market share would have increased by 50,000 units. Contribution is Rs.1,000 per unit, for 50,000 units it would be Rs.5,00,00,000 per annum. Therefore, the total benefit from the inspection process before delivery to customers = savings on delivery costs + contribution from incremental sales = Rs.5, 00,000 + Rs.5, 00, 00,000 = Rs.5, 05,00,000 per annum. The cost to the company to maintain good quality of its products through inspection = Rs.2, 00, 00,000 per annum. Therefore, the net benefit to the company would be Rs.3, 05, 00,000.

(iii) Inspection of raw material at the procurement stage could entirely eliminate defective production. The benefit would be two-fold, the current replacement cost for 5,000 units will no longer be incurred. Secondly, due to better customer perception, market share would increase, resulting in an increased contribution / revenue to the company. In other words, the cost of poor quality will be nil. As explained in solution (i), the cost of poor quality per annum = cost of replacement + contribution from lost sales = Rs.75,00,000 + Rs.5,00,00,000 = Rs.5,75,00,000 per annum. This would be the benefit by implementing the proposal. Cool Air has to incur an inspection cost to ensure this highest standard of quality (0% defects) which would cost Rs.4,00,00,000 per annum. Therefore, the net benefit to the company would be Rs.1,75,00,000 per annum.

(iv) (a) The proposal to implement inspection immediately before delivering goods to the customers results in a net benefit of Rs.3,05,00,000 per annum. Alternately, the proposal to implement inspection at the raw material procurement stage results in a net benefit of Rs.1,75,00,000 per annum. Therefore, from a profitability point of view, inspection immediately before delivery of goods to the customer would the preferred option.

(b) The drawback of inspection at the end of the production process is that (1) it cannot prevent production of defective goods and (2) information regarding the root cause of defective production, in this case, supply of defective raw materials will not get tracked. Therefore, inspection at the end of production does not contribute to resolving the root cause of defective production. On the other hand, inspection at the procurement stage can eliminate production of defective goods. This will ensure a much higher quality of production, better utilization of resources and production capacity. Therefore, from a long-term strategy point of view, inspection at the raw material procurement stage will be very beneficial. Currently the cost of ensuring this highest quality of production (0% defects) is Rs.4 crores per annum. The cost of ensuring 100% quality is quite high, such that the net benefit to the company is lesser than the other proposal. However, due to its long-term benefit, Cool Air may consider some minimum essential quality control checks at the procurement stage. Although selective quality check might not ensure complete elimination of defective production, it can contribute towards reducing it. At the same time cost of selective quality check would not be so high as to override its benefits. To determine the extent of quality control inspection, Cool Air should determine its tolerance limit for defective production and do an analysis of the quality / cost trade-off.

Q-7

EKS Ltd. manufactures a single product, which requires three components. The company purchases one of the components from three suppliers. DE Ltd., PE Ltd. and ZE Ltd. The following information are available:

 PARTICULAR DE Ltd. PE Ltd. ZE Ltd. Price quoted by supplier (per hundred units) Rs.240 Rs.234 Rs.260 % of Defective of total receipts 3% 5%

If the defectives are not detected they are utilized in production causing a damage of Rs.200 per 100 units of the component. Total requirements are 12,000 units of the components.

The company intends to introduce a system of inspection for the components on receipt. The inspection cost is estimated at Rs.26 per 100 units of the components. Such as inspection will be able to detect only 90% of the defective components received. No payment will be made for components found to be defective in inspection.

Required

(i) Advice whether inspection at the point of receipt is justified.

(ii) Which of the three suppliers should be asked to supply?

(i) A: Statement Showing Computation of Effective Cost before Inspection

 Particulars DE Ltd. PE Ltd. ZE Ltd. Units Supplies (No.s) 12,000 12,000 12,000 Defectives Expected (No.s) 360 600 240 Costs: Purchase of Components 28,800 28,080 31,200 Add: Production Damage  on  Defective  Components (@ Rs.200 per 100 components) 720 1,200 480 Total 29,520 29,280 31,680 Good Components (Nos.) 11,640 11,400 11,760 Cost per 100 Good Component 253.61 256.84 269.39

B: Statement Showing Computation of Effective Cost after Inspection

 Particulars DE Ltd. PE Ltd. ZE Ltd. Units Supplies (No.s) 12,000 12,000 12,000 Defects Not Expected (No.s) 36 60 24 Defectives Expected (No.s) 324 540 216 Components Paid For 11,676 11,460 11,784 Costs: Purchase of Components 28,022.40 26,816.40 30,638.40 Add: Inspection Cost 3,120.00 3,120.00 3,120.00 Add: Production Damage on Defective  Components (@ Rs.200 per 100 components) 72.00 120.00 48.00 Total 31,214.40 30,056.40 33,806.40 Good Components (Nos.) 11,640 11,400 11,760 Cost per 100 Good Components 268.16 263.65 287.47

Advice Whether Inspection at the Point of Receipt is Justified

On comparing the cost under situation, A and B shown above, we find that it will not be economical to install a system of inspection.

Further we also need to consider that presently many organizations are undergoing Just in Time (JIT) implementation. JIT aims to find a way of working and managing to eliminate wastes in a process. Achievement of this is ensured through eliminating the need to perform incoming inspection. Inspection does not reduce the number of defects, it does not help in improving quality. In general inspection, does not add value to the product. It simply serves as a means of identifying defects the supplier has failed to recognize subsequent to the manufacturing of the product.

As a matter of fact, organizations implementing JIT are seeking eventually to eliminate the need for performing incoming inspection activities through a combination of reducing the supplier base, selection through qualification and vendor development. Vendor development and its proper management seeks to assist the supplier who maintains an interest in striving to provide 100% defect free materials and parts.

So, to decision whether inspection at the point of receipt is justified or not will also depend on Qualitative factors as well.

(ii) On comparing the buying cost of components under different situations, as analysed and advised above, if company decides not to install a system of inspection, supplier DE would be cheaper otherwise supplier PE would be cheaper and company may choose supplier accordingly.

Q-8

Z Plus Security (ZPS) manufactures surveillance camera equipment that are sold to various office establishments. The firm also installs the equipment at the client’s place to ensure that it works properly. Each camera is sold for Rs.2,500. Direct material cost of Rs.1,000 for each camera is the only variable cost. All other costs are fixed. Below is the information for manufacturing and installation of this equipment:

 Particulars Manufacture Installation Annual Capacity (camera units) 750 500 Actual Yearly Production and Installation (camera units) 500 500

Required

The questions below are separate scenarios and are not related to each other.

(i) IDENTIFY the bottleneck in the operation cycle that ZPS should focus on improving. Give reasoning for your answer.

(ii) An improvement in the installation technique could increase the number of installations to 550 camera units. This would involve total additional expenditure of Rs.40,000. ADVISE ZPS whether they should implement this technique?

(iii) Engineers have identified ways to improve manufacturing technique that would increase production by 150 camera units. This would involve a cost Rs.100 per camera unit due to necessary changes to made in direct materials. ADVISE ZPS whether they should implement this new technique.

(i) Identification of Bottleneck: Installation of cameras is the bottleneck in the operation cycle. The annual capacity for manufacturing and installation are given to be 750 camera units and 500 camera units respectively. Actual capacity utilization is 500 camera units, which is the maximum capacity for the installation process. Although, ZPS can additionally manufacture 250 camera units, it is constrained by the maximum units that can be installed. Therefore, the number of units manufactured is limited to 500 camera units, subordinating to the bottleneck installation operation. Therefore, ZPS should focus on improving the installation process.

(ii) Improving Capacity of Installation Technique: Every camera sold increases the through put contribution by Rs.1,500 per camera unit (sale price Rs.2,500 per camera unit less direct material cost Rs.1,000 per camera unit). By improving the current installation technique an additional 50 camera units can be sold and installed. This would involve total additional expenditure of Rs.40,000. Hence, the incremental benefit would be:

 Particulars Amount (Rs.) Increase in throughput contribution (additional 50 camera units Rs.1,500 per camera unit) 75,000 Less: Increase in total expenditure 40,000 Incremental benefit 35,000

Since the annual incremental benefit is Rs.35,000 per annum, ZPS should implement this improvement to installation technique, the current bottleneck operation.

(iii) Improving Manufacturing Capacity: Every camera sold increases the throughput contribution by Rs.1,500 per camera unit (sale price Rs.2,500 per camera unit less direct material cost Rs.1,000 per camera unit). By improving the current manufacturing technique an additional 150 camera units can produced. This would involve a cost Rs.100 per camera unit due to necessary changes to made in direct materials. Therefore, number of units manufactured can increase to 650 camera units. However, production of 150 camera units will not translate into additional sales, because each sale also requires installation by ZPS. In a year only 500 camera installations can be made, leading to an inventory pile up of 150 camera units. This is detrimental to ZPS, since it does not earn any contribution by holding inventory. Therefore, ZPS should not go ahead with the proposal to improve the manufacturing technique.

Q-9

The CEO of P Limited is concerned with the amounts of resources currently spent on customers’ warranty claims. Each box of its product is printed with the logo: “satisfaction guaranteed or your money back”. P Limited is having difficulty competing with X Limited because it does not have the reputation for high quality that X Limited enjoys. Since the warranty claims are so high, the CEO of P Limited would like to evaluate what costs are being incurred to ensure the quality of the product. Following information is collected from various departments within the company relating to 2019-20

 Particulars of Costs (Rs.) Warranty claims 4,25,000 Employee training costs 1,20,000 Rework 3,00,000 Lost profits from lost customers due to impaired reputation 8,10,000 Cost of rejected units 50,000 Sales return processing 1,75,000 Testing 1,70,000

For the year 2020-21, the CEO is considering spending the following amounts on a new quality programme:

 Inspect raw material 1,20,000 Reengineer the production process to improve product quality 7,50,000 Supplier screening and certification 30,000 Preventive maintenance on plant equipment 70,000

P Limited expects the new quality programme to save costs by the following amounts:

 Reduction in lost profits from lost sales due to impaired reputation 8,00,000 Reduction in rework costs 2,50,000 Reduction in warranty costs 3,25,000 Reduction in sales return processing 1,50,000

Required

(i) PREPARE a ‘Cost of Quality Statement’ for the year 2019-20 showing the percentage of the total costs of quality incurred in each cost category.

(ii) PREPARE a ‘Cost Benefit Analysis’ of the new quality programme showing how the quality initiative will affect each cost category.

(iii) STATE how the manager trade-offs among the four categories of quality costs.

(i) Cost of Quality Statement For the year 2019-20

 Particulars of costs Cost Incurred  Rs. Total Cost  Incurred Rs. % of Total  Costs of quality Preventive Costs: Employee Training 1,20,000 1,20,000 5.85% Appraisal Costs: Testing 1,70,000 1,70,000 8.29% Internal Failure Costs: Rework 3,00,000 3,50,000 17.08% Cost of rejected units 50,000 External Failure Costs: Lost profits from lost sales due  to impaired reputation 8,10,000 14,10,000 68.78% Sales return processing 1,75,000 Warranty costs 4,25,000 Total Cost of Quality 20,50,000 100%

(ii)Cost Benefit Analysis of New Quality Programme

 Particulars of costs Additional (costs)/ Cost Savings Rs. Total New (Costs) / Cost Saving Rs. Preventive Costs: Reengineer the production process (7,50,000) (8,50,000) Supplier Screening and certification (30,000) Preventive maintenance on equipment (70,000) Appraisal Costs: Inspect Raw Materials (1,20,000) (1,20,000) Internal Failure Costs : Reduction in rework Costs 2,50,000 2,50,000 External Failure Costs: Reduction of lost profits from lost sales 8,00,000 12,75,000 Reduction From sales return 1,50,000 Reduction from warranty costs 3,25,000 Total Savings/ (Costs) From Quality Programme 5,55,000

(iii) Investment in prevention costs and appraisal costs (also known as costs of good quality), reduces internal and external failure costs (also known as cost of poor quality). Costs incurred before actual production begins, to prevent defects and other product quality issues, are known as preventive costs. In the given example, reengineering production process, screening / certification of suppliers and preventive maintenance of equipment are preventive costs. Likewise, appraisal costs are incurred to ensure that activities conform to desired quality requirements. They are incurred in all stages of production. In the given example inspection of raw material is an appraisal cost. While preventive and appraisal costs would not directly improve the quality of the product, they would definitely reduce internal failure costs like rework costs or external failure costs like sales returns or warranty claims. These would also enhance the reputation of the product for its standard of quality. Conversely, it follows that internal failure costs may be preferable to external failure costs since it affects the company’s brand image.

Costs incurred to ensure conformance to quality will ensure higher chances of detection of defects in the product. At the same time ensuring zero defective rate may require huge resources and therefore may be costly. Instead, companies may have the ability to absorb costs incurred due to rework, warranty claims or lost sales. Therefore, they must determine a reasonable threshold defective rate that is acceptable, a normal cost in business operations. Tools for quality production management like Total Quality Management (TQM) will help in determining the optimum cost of quality that the company is willing to bear. TQM focus on continuous improvement of an organization’s business activities. This creates an awareness of quality that the company comes to expect from various processes. Things need to be done right the first time, consequently eliminating defects and waste from operations. At the same time, an in-depth knowledge of business processes provides information that can help the management set acceptable threshold limits for reasonable level of defects it is willing to bear.

Q-10

CIMZ is a new banking company which is about to open its first branch in INDIA. CIMZbelieves that in order to win customers from the market, it needs to offer potential customers anew banking experience. Other banking companies are focusing on interest rates and bankcharges, whereas CIMZ believes that quality and timely availability of service is an importantfactortoattractcustomers.

Required

EXPLAIN how Total Quality Management would enable CIMZ to gain competitive advantage in the banking sector.

Total Quality Management is a management philosophy. It concerns itself with managing the processes and people to make sure that the customer is satisfied at each and every stage. This means making the needs of the customer the priority, expanding the relationship beyond traditional services and incorporating the customer’s needs in the company’s business plan and corporate strategy. In TQM, the concept of “quality” is perceived exclusively from the frame of reference of the customer. These customers can be internal, such as, those working in another department and there can be external customers who are the end recipients of the product or services. The organisation should attempt for continuous improvement in the quality that it delivers with the ultimate aim of achieving zero defects in this quality.

TQM should be view as an investment rather than as a cost that should be minimised. There are many ways in which investment can be made in TQM.:

• fine-tuning the product mix,

• fine-tuning of the processes of ensuring quality,

• introducing employee development programmes with the nature of an academic course,

• empowering the employees professionally and personally,

• improving the top management commitment to quality,

• monitoring of the performances and proper rewarding based on achievements,

• ensuring the customer satisfaction etc.

CIMZ could provide its employees with training in the technical aspects of banking practice as well as in customer care. Customers would thus get a better service not only technically but also from a customer care perspective. This should lead to smaller customer complaints and greater customer satisfaction. It could also motivate customers to recommend others to use this bank. TQM also requires CIMZ to respond to its customer’s requirements immediately for example by providing more staff to reduce the lengths of queues in festive/ seasonal/ busy time. If Bank could also be opened for longer hours to allow customers to complete their bank related requirements and have meetings with bank employees at a time that is more convenient for the customer, this would lead to more satisfaction to customers.

In long run, if bank continue to follow TQM, the bank would have higher profits and competitive advantage in banking sector despite incurring additional expenditure to improve quality.

Q-11

Sun Electronics manufactures and sells various electronic goods like mobile phones, laptops, televisions, refrigerator etc. The company sells these goods through the 30 stores situated in different parts of the country. The store managers place a request to the centralised team situated in Mumbai on a monthly basis. One store can send only one requisition per month.

The requirements of the stores are forwarded to the production planning team which is responsible for scheduling the manufacturing of these products. Once the goods are manufactured, the goods are sent to a central warehouse in Mumbai and are dispatched to different stores according to the store requirements. The time taken from placing a request from store to the delivery of product to the store takes about 30-40 days on an average. In the process the company procures parts from more than 100 vendors. The company has faced quality related issues with many vendors leading to delay in production. The average holding period of inventory in Sun Electronics is very high at 45 days as against an industry average of 15 days. Since the order to delivery time at a store is very high, the company has traditionally allowed high inventory holding to reduce the stock outs at store level. The company is under severe pressure to improve its working capital cycle.

A high amount of inventory held at each store also means that the products become obsolete quickly. In case of products like mobile phones, new and upgraded versions are available in the market as early as six months from the date of initial launch of a particular model. A significant portion of inventory of mobile phones becomes obsolete every year. The company generally resorts to a discounted sale to liquidate such obsolete models.

The management at Sun Electronics has identified e-commerce as an opportunity for faster growth, both in terms of revenues and profitability. The company is considering launch of its own e-commerce website to sell all products which are currently being sold in physical stores. Depending upon the success of online sales, the company might choose to optimize and close certain physical stores in the next couple of years. The management of the company is cognizant of the fact that existing inventory procurement and management system will not fit in the new e-commerce business. E-commerce works on a inventory light model and quick as well as on time delivery of products of the customers. The fact that customers could be from a location other than those where Sun Electronics has physical presence makes the matter complex.

Required

The company is considering implementation of a supply chain management system. Will a supply chain management system be of use to Sun Electronics in light of the e -commerce venture? You are required to EXPLAIN the concept of Supply Chain Management and EVALUATE the applicability of in the current case.

Sun electronics manufactures and sells various electronic products through its physical stores. The existing manufacturing system does not take into consider the demand of products in the market. Store managers are allowed to submit only one order per month. A high level of inventory can be seen at Sun Electronics as compared to the industry average.

The store managers tend to keep high level of inventories as a safeguard against stock-outs. Whereas, keeping inventory to meet customer requirement is good, high level of inventories due to inefficient processes is not advisable.

The company also has a longer working cycle because of a long order to deliver time and excess holding of inventory. A significant amount of working capital is blocked due to this practice. Technology changes rapidly and the company is expected to roll out latest products in the market. A product like mobile gets outdated very soon and the company has to resort to discounted sales. This results in financial losses to the company. The company has identified an opportunity in e-commerce. E-commerce businesses require leaner models and faster response time. The production must be based on the demand from the customer and not on an ad-hoc basis. In the following paragraphs, the importance of supply chain management (SCM) and its applicability in the current case is discussed.

Supply Chain Management (SCM)

Supply Chain Management can be defined as the management of flow of products, services and information, which begins from the origin of products and ends at the product’s consumption at consumer’s end. SCM also involves movement and storage of raw material, work-in-progress and finished goods. In other words, supply chain management involves management of all activities associated with moving goods from the raw materials stage to the end user. An important objective of SCM is to correlate the production and distribution of goods and services with demand of the product.

The following are the various activities which an organisation carries out to meet the customer requirements (Primary activities under value chain model) –

• Inbound Logistics covering procurement and related activities.

• Operations covering conversion of raw materials into finished products

• Outbound Logistics covering movement of products from plants to end users

• Marketing and Sales

• Service

Supply Chain Management looks each of the above activities as integrated and interrelated to each other. None of the activities can be looked in silos. In the case of Sun Electronics , there is a restriction on number of orders which a store manager can place. This would lead to excess ordering because of the fear of stock outs.

The customer demand is completely ignored and hence the production is not in sync with the market demand. This could lead to excess production, higher inventory holding and longer working capital cycles.

The facts presented in the case indicate the following problems at Sun Electronics:

• Production planning is not based on customer demand & is done on an ad-hoc basis.

• Inventory Holding period is very high (45 days against an industry average of 15 days).

• The working capital cycle is longer.

• The time take to fulfil an order from the store is very high.

• The production is dispatched to a central warehouse for further deliveries to the stores. This could be an inefficient process.

• Liquidation of products at discount for products with low shelf life.

SCM Process and applicability to Sun Electronics

The SCM process is explained below:

• Plan - The first step in SCM process is to develop a plan to address the requirements of the customer. Sun Electronics must shift its focus from ad hoc and predetermined production planning to understanding the requirements of customers. Production must be planned based on the demand of products. The focus must be on producing what the customer wants.

• Develop (procure) - In this step, the materials required for production is sourced from various suppliers. A good relationship with supplier is required to ensure that the parts/materials are received as and when required by the production team. It is also important that the vendors supply quality material which is not the case in Sun Electronics. The company must select suppliers which are dependable and can deliver quality products in the stipulated time. The company must focus in reducing the lead time required for sourcing materials which will reduce the inventory holding period.

• Make - The third step is making or manufacturing the products required by the customer. This is quite different from the existing practice in Sun Electronics where store managers are allowed to place only one order. This would mean that the company is not considering the ever changing demands and tastes of the customers.

• Deliver - The fourth stage is to deliver the products manufactured for the customers. This stage is concerned with logistics. The time required to deliver to the store in case of Sun Electronics is very high. The company must evaluate if the centralised warehouse is causing delay in delivery of products to the stores.

Logistics is one of the important component of the entire supply chain process. Right from procurement of material, movement of raw material in the plants and final delivery of products of customers, logistics play a critical role. An excellent system must be in place to ensure that the movement of materials and final product are uninterrupted.

Warehousing also plays an important role in today’s business environment. The company has a centralised warehouse to meet the needs of all its stores. This would not be the most efficient way. The company must evaluate creation of additional storage facility which would ensure timely delivery of goods to the stores. Newer products can reach the market faster.

Benefits of SCM to Sun Electronics

SCM looks at the entire value chain process as an integrated process. There is a seamless flow of information and products between suppliers and customers. The customer’s requirements would be captured to plan the production. The suppliers would be intimated to supply the materials according the the production plan. An effective logistics system ensures that movement of materials is seamless. Sun Electronics can also consider implementing an integrated ERP which would also interact with vendors on real time basis.

The following benefits of SCM can be envisaged for Sun Electronics –

• Better Customer Service as customer is supplied with what he/she wants in the minimum time.

• Better delivery mechanism for goods.

• Improves productivity across various functions and departments.

• Minimises cost (both direct and indirect).

• Reduces the inventory holding time and improves the working capital cycle.

• Enhances inventory management and assists in implementation of JIT systems.

• Assists companies in minimising wastes and reduce costs.

• Improves supplier relationship.

E-Commerce and SCM

The SCM is the backbone of E-commerce industry. Customers buying products online want deliveries to be faster. Another distinct feature of e-commerce is that buyers could be located in any corner of the country and not just restricted to the cities where Sun Limited has physical presence. This definitely means that the company must have an effective Supply Chain Management in place which could meet the customer’s requirement. The existing practice of one order per month from each store would not work in the e - commerce space. Orders can come at any time and from anywhere. Supply Chain Management would be required for success of e-commerce business.

Customer Orders

The company must have an effective mechanism to capture customer orders and feed it into the production planning on a real time basis. An integrated ERP system would be required for this purpose. Any delay in intimating the production team would mean delay in production and delivery which would not be taken positively by the customers. The existing system of one order per month from a store would not fit the purpose. A real time flow of information would mean lower inventory holding.

Procurement

The material requirements must be communicated to suppliers seamlessly. The company must identify those vendors who can deliver quality materials in the required time frame. A delay in supplies would delay the production process. A company cannot afford this in e- commerce business. Automatic exchange of information using EDI (Electronic Data Interchange) or Integrated ERP systems would ensure that the vendors receive material requirements in a timely manner.

Production

As discussed earlier, the production must be in accordance with the customer order. This requires a shift in approach of the production team. Business environments have shifted from “Customer will buy what we produce” to “We have to produce what the customers require”. The company would ideally not produce products to store them and sell later.

Logistics

Logistics would be the backbone of entire e-commerce set up. Right from sourcing of materials to delivery of products at the customer’s door step, logistics would play an important role. If the company has an inhouse logistics facility, the logistics team must be trained with the requirement of the new business. If the company has outsourced the logistics, vendors must be briefed about the requirements of the e-commerce. The company might have to tie up with new logistic vendors to avoid any delay in deliveries.

Q-12

United Video International Company (UVIC) sells package of blank video tapes to its customer. It purchases video tapes from Indian Tape Company (ITC) @ Rs. 140 a package. ITC pays all freight to UVIC. No incoming inspection is necessary because ITC has a superb reputation for delivery of quality merchandise. Annual demand of UVIC is 13,000 packages. UVIC requires 15% annual return on investment. The purchase order lead time is two weeks. The purchase order is passed through Internet and it costs Rs. 2 per order. The relevant insurance, material handling etc Rs. 3.10 per package per year. UVIC has to decide whether or not to shift to JIT purchasing. ITC agrees to deliver 100 packages of video tapes 130 times per year (5 times every two weeks) instead of existing delivery system of 1,000 packages 13 times a year with additional amount of Rs. 0.02 per package.

UVIC incurs no stock out under its current purchasing policy. It is estimated UVIC incurs stock out cost on 50 video tape packages under a JIT purchasing policy. In the event of a stock out, UVIC has to rush order tape packages which costs Rs. 4 per package. Comment whether UVIC should implement JIT purchasing system.

Hindustan Tape Company (HTC) also supplies video tapes. It agrees to supply @ Rs. 136 per package under JIT delivery system. If video tape purchased from HTC, relevant carrying cost would be Rs. 3 per package against Rs. 3.10 in case of purchasing from ITC. However HTC. doesn’t enjoy so sterling a reputation for quality. UVIC anticipates following negative aspects of purchasing tapes from HTC.

• To incur additional inspection cost of 5 paisa per package.

• Average stock out of 360 tapes packages per year would occur, largely resulting from late deliveries. HTC cannot rush order at short notice. UVIC anticipates lost contribution margin per package of Rs. 8 from stock out.

• Customer would likely return 2% of all packages due to poor quality of the tape and to handle this return an additional cost of Rs. 25 per package.

Required

Comment whether UVIC places order to HTC.

Comparative ‘Statement of Cost’ for Purchasing from ITC under ‘Current Policy’ & ‘JIT’

 Particulars Current Policy (Rs.) JIT (Rs.) Purchasing Cost 18,20,000  (13,000 Packages × Rs.140) 18,20,260 (13,000 Packages × Rs.140.02) Ordering Cost 26.00 (Rs.2 × 13 Orders) 260.00 (Rs.2 ×130 Orders) Opportunity / Carrying Cost 10,500.00 (1/2 × 1,000 Packages ×Rs.140 × 15%) 1,050 (1/2 × 100 Packages × Rs.140.02 × 15%) Other  Carrying   Cost (Insurance, Material Handling etc) 1,550.00 (1/2 × 1,000 Packages ×Rs.3.10) 155.00 (1/2 × 100 Packages × Rs.3.10) Stock Out Cost --- 200 (50 Packages × Rs.4.00) Total Relevant Cost 18,32,076 18,21,925

As may be seen from above, the relevant cost under the JIT purchasing policy is lower than the cost incurred under the existing system. Hence, a JIT purchasing policy should be adopted by the company.

‘Statement of Cost’ for Purchasing from HTC under ‘JIT’

 Particulars JIT (Rs.) Purchasing Cost 17,68,000 (13,000 Packages × Rs.136) Ordering Cost 260.00 (Rs.2 ×130 Orders) Opportunity / Carrying Cost 1,020 (1/2 × 100 Packages × Rs. 136 × 15%) Other Carrying Cost  (Insurance, Material Handling etc) 150.00 (1/2 × 100 Packages × Rs.3.00) Inspection Cost 650 (13,000 Packages × Rs.0.05) Stock Out Cost 2,880 (360Packages × Rs.8.00) Customer Return Cost 6,500 (13,000 Packages × 2% × Rs.25.00) Total Relevant Cost 17,79,460

The comparative costs are as follows:

Under Current Policy                              Rs.18, 32,076

Under Purchase under JIT from ITC       Rs.18, 21,925

Under Purchase under JIT from HTC     Rs.17, 79,460

Packages should be bought from HTC under JIT as it is the cheapest.

Q-13

Kiwi Ltd. manufactures spare parts and can be called "high volume based" manufacturing environment. The company is using the system of Total Productive Maintenance for maintaining and improving the integrity of manufacturing process. There are several different automated manufacturing machines located in the plant, through which manufacturing of spare parts are done and supplied to cater the demand in the market. A 12 hour shift is scheduled to produce a spare part in APZ Company Ltd. as shown in the schedule below. The shift has three 15 minute breaks and a 10 minute clean up period.

Production Schedule for Automated machine A 10:

Cycle: 10 (seconds),

Spare parts Manufactured: 3,360, SCRAP: 75, Unplanned Downtime: 36 minutes

Required

(i) CALCULATE OEE (Overall Equipment Effectiveness) and comment on it.

(ii) The management of company has decided to ensure that things are done right the first time and that the defects and waste are eliminated from operations. Thus, they are planning to implement Total Quality Management (TQM) also.

(iii) SUMMARIZE the connection between Total Quality Management (TQM) and Total Productive Maintenance (TPM).

(i) Calculation of Loss of Time Per Shift

 Mins. Break 45 Clean up Period 10 Unplanned Downtime 36 Total Time Loss Per Shift 91

Availability Ratio per shift =

$${ 720 min−91 min\over 720min} × 100%$$%

= 87.36%

Actual Production = 3,360 parts Standard time = 10 seconds

Standard Time Required = 3,360 parts x 10 seconds /60 (Ideal Time) Actual mins.

= 560 minutes

Time taken = 720 mins. – 91mins.

= 629 minutes

Performance Ratio =

= 89.03%

Quality Ratio =

$${3,360 parts−75 parts \over 3,360 parts}× 100%$$ %

Thus, OEE = 0.8736 x 0.8903 x 0.9777

= 76.04%

Comment

Since OEE of APZ Company Ltd. is lesser than 85 % i.e. World Class Performance Level, Company is advised to improve its each ratio i.e. availability ratio, performance ratio and quality ratio by collecting information related to all downtime and losses on machines, analyzing such information through graphs and charts, making improvement decisions thereon like autonomous maintenance, preventive maintenance, reduction in set up time etc. and implementing the same.

(ii) The connection between TQM and TPM are summarized below:

• TQM and TPM make company more competitive by reducing costs, improving customer satisfactions and slashing lead times. Involvement of the workers into all phases of TQM and TPM is necessary.

• Both processes need fundamental training and education of participants.

• TPM and TQM take long time to notice sustained tangible benefits.

• Commitment from top managements is necessary for success of implementation.

Q-14

M. India Ltd. (MIL) is an automobile manufacturer in India and a subsidiary of Japanese automobile and motorcycle manufacturer Leon. It manufactures and sells a complete range of cars from the entry level to the hatchback to sedans and has a present market share of 22% of the Indian passenger car markets. MIL uses a system of standard costing to set its budgets. Budgets are set semi-annually by the Finance department after the approval of the Board of Directors at MIL. The Finance department prepares variance reports each month for review in the Board of Directors meeting, where actual performance is compared with the budgeted figures. Mr. Suzuki, group CEO of the Leon is of the opinion that Kaizen costing method should be implemented as a system of planning and control in the MIL.

Required

RECOMMEND key changes vital to MIL’s planning and control system to support the adoption of ‘Kaizen Costing Concepts’.

Kaizen Costing emphasizes on small but continuous improvement. Targets once set at the beginning of the year or activities are updated continuously to reflect the improvement that has already been achieved and that are yet to be achieved.

The suggestive changes which are required to be adopted Kaizen Costing concepts in MIL are as follows:

Standard Cost Control System to Cost Reduction System: Traditionally Standard Costing system assumes stability in the current manufacturing process and standards are set keeping the normal manufacturing process into account thus the whole effort is on to meet performance cost standard. On the other hand Kaizen Costing believes in continuous improvements in manufacturing processes and hence, the goal is to achieve cost reduction target. The first change required is the standard setting methodology i.e. from earlier Cost Control System to Cost Reduction System.

Reduction in the periodicity of setting Standards and Variance Analysis: Under the existing planning and control system followed by the MIL, standards are set semi-annually and based on these standards monthly variance reports are generated for analysis. But under Kaizen Costing system cost reduction targets are set for small periods say for a week or a month. So the period covered under a standard should be reduced from semi-annually to monthly and the current practice of generating variance reports may be continued or may be reduced to a week.

Participation of Executives or Workers in standard setting: Under the Kaizen Costing system participation of workers or executives who are actually involved in the manufacturing process are highly appreciated while setting standards. So the current system of setting budgets and standards by the Finance department with the mere consent of Board of Directors required to be changed.

Q-15

Gold-Star Limited deals in manufacturing of traditional cycles. Recently apart from manufacturing old style cycles, GSL starts assembly of electronic cycles.

Since GSL didn’t expand the factory area, post starting assembly of electronic cycles; hence production floor largely remains over-occupied with all sort of material, jigs, and tools; some of them are frequently useful, some are often and other are less often; even some are quite rare.

Workers usually complaint that all categories of jigs and tools are not available, tools which are available also of those belongs to those product design which are outdated (majority of such product are not further manufactured by GSL) accessible. Although floor manager is of opinion instead saying tools are not available, it can be said they are not accessible; because workers pick the tool from tool kit or tool board; but not place it back after use; hence it become difficult to locate such tool later or identify worker; with whom these may available. On name of maintenance department, there are only two staff members, who are responsible for ensuring that every machine or equipment must be in running order and effective. Due to shortage of staff in maintenance department, requests for repairs of plant or machines are not handled within reasonable time frame and same will result in sharp deterioration of utility/ effectiveness of such plant or machine. Even in some of circumstances, replacements become/ remain only alternative. GSL has reasonable standardise operating procedure for manufacturing of cycles business, but scenario is worse in case of assembly of electronic cycles. Since GSL is recently entered into assembly of electronic cycles, hence KPIs are not established for all factors which are part of assembly process including critical success factors.

At GSL, the attrition rate at senior management positions is quite high and no formal hierarchy tree is established, which result in drastic shifts in workplace culture (due to frequently changing role & responsibility).

Regarding safety of man and material, GSL is on front foot, taking all reasonable care; which is essential for purpose of eliminating any possibility of workplace accident. But assembly line of electronic cycles witness an incident recently, where one of model “x- 2” during assembly caught fire because wires set of “x-2” come into exposure of sparking from the light point near to such assembly line. Such fire causes burn of some of other material too, which are lying near to such assembly line. Post such incident, CEO call for meeting with all the top tier executives, majorly including production and operation manager, safety staff, maintenance staff and store manager apart from management accountant. During the meeting while production and operation manager highlights some of problem areas, management accountant quoted 5S as solutions to problems faced by GSL. CEO asked Management Accountant to be ready with report and presentation on 5S, which can highlight the operational aspect of 5S.

Required

You are deputy to management accountant and asked by him to prepare a case, in form of report; in favour of implementing/ APPLYING 5S at GSL and EXPLAINING the expected benefit from implementation of 5S.

Report

Addressed to; Office of CEO, Gold Star Limited (GSL).

Dated – 07th Jan 2020

Report on operational aspect of 5S and expected advantage

5S represent scientific way of workplace management so that work can be performed effectively, efficiently, and safely. 5S was come into practice as part of Toyota Production System in early of mid-20th century. 5S is usually considered as essential component of lean manufacturing, and foundation of eight pillars of TPM. The 5S refer to five Japanese words- seiri (sort), seiton (set in order), seiso (shine), seiketsu (standardize), and shitsuke (sustain). They define a system for workplace organization and standardization. Sort means to separate needed and unneeded materials and to remove latter. Set in Order means to arrange materials and equipment so that they are easy to find and use. Shine means to conduct a clean-up campaign. Standardize means to formalize procedures and practices to ensure that all steps are performed correctly.

Finally, sustain means to form habit of always following first four Ss through training, communication etc.

Note - Later 6th S was also introduced and i.e. safety.

S1 - Sorting

In order to over-come the problem of ‘idle laying over material’ all across production floor area, sorting of material is need to be done in following categories:

• Not needed at all – to be moved to red tag area.

• Needed but not now – need to be moved to store with yellow tag.

• Needed but not here – to be moved to red tag area.

• Needed but not so much quantity.

For purpose of doing sorting GSL need to be answered following questions:

• What is required?

• How much required?

• When it is required?

• Where it is required?

Sorted material depending upon category can be separated and made ready for movement/ shift, in order to segregate the sorted material; visual aid technique can be used by attaching coloured tags to each category of material (called visual sorting). Following two categories of tag can be used:

Red tag – A card containing detailed information of ‘unwanted things’ with a given time limit for further action to be taken.

Yellow tag – A card containing detailed information of ‘needed things’, but not now with a given time limit for further action to be taken – usually kept in store.

Sorting can help GSL to identify:

1. Obsolete material; parts (jigs/tooling) not required as the design has become obsolete.

2. Defective material; part can’t be used as it is.

3. Scrap material.

4. Material which not in place – kept at wrong place.

5. Unnecessary/extra/not useful material.

Sorting can also help GSL in reduction of material lying vacant on production floor, by segregating them into different categories and ensure that rarely used material either removed or tagged in red tape area. If material were sorted than ‘loss of material’ which was lying vacant near to assembly line during fire incident could be saved.

S2 - Set in order

Systemic arrangement by ensuring ‘place for everything and everything in its place’. Purpose is to save search time and eliminate motion waste, through visual management; with search-free and count free arrangement.

Colour can be best visual aid – RYGB

 R – Red – Critical Y – Yellow – Reorder G – Green – Design B – Blue – Excess

Note – Mapping of RYGB to feature is purely illustrative.

In order to implement systematic arrangement, GSL need to consider and answer;

• Analyse status.

• Decide – Which things will belong where?

• Decide – How they should be put away?

• Get everybody to follow rules through indexing, labelling etc.

Expected benefits of set in order to GSL

1. Faster retrieval of things results in elimination of search time.

2. Opportunity to correct the abnormalities faster as visibility improve by system itself.

3. Space saving by systematic arrangement.

4. Efficiency of work improves as things are available when they are actually needed. Thus, S can solve the specifically problem of non-accessibility of tools.

S3 – Shine

Ensure there must be cleanliness ‘in and of’ everything. Obviously, if there less number of items, then there is less to clean.

• Cleaning should be with meaning.

• Cleaning is inspection (from all aspects – front, rear, left right, top and bottom).

Shine will help GSL to keep things in order with regular cleaning and upkeep, so that maintenance become ‘preventive function’ rather corrective and any incident, likewise fire occurrence on assembly-line; must be avoided. This will ensure larger utility out of Machine and Plants which will increase replacement cycle and save investment by lowering down maintenance and replacement cost.

S4 – Standardization

Establishing the ‘standards’ and make ‘operating procedure’ to create consistency and ensure that all steps are performed correctly. There are;

• Fix responsibilities for implementing & evaluating system.

• Integrate these responsibilities into routine work.

• Check how well the system is working and sustaining itself.

In order to ensure TPM all 5S are essential, but standardisation is key, GSL is facing large set of problem in assembly of electronic cycles and reason being absence of SOPs. Hence, by establishing the standardised process GSL can identify Critical Success Factors (CSFs) and benchmark the Key

Performance Indicator (KPIs) against each CSFs.

S5 – Sustain

In order to sustain with the established standard, it is required to do;

• Daily monitoring

• Improving ownership by allocating areas

• Using ‘red tag campaign’

• Communicating visually through fixed point photography

• Structured communication

• Continuous training of all employees

• Periodic audits at all level

• Motivating staff through recognition

Since 5S is not a onetime exercise, it is continuous process, hence, it is essential to sustain the practices followed during earlier 5Ss. GSL witness the high attrition rate at top management level, hence, it is important that GSL must inculcate practice of 5S in the system and work culture and sustain them on continuous basis, irrespective of attrition.

Sixth S is ‘safety’ which was added later on, in order to ensure safety while performing all the remaining 5S.

Further details can be tabled on requisition basis.

Closure of Report Management Accountant

(For Management Accounting Division) Gold Star Limited

Q-16

In the ‘Five Forces Model’, one of the crux is that companies or divisions compete with their buyers and suppliers. The same model can be used to evaluate the competitive environment of the divisions of large, complex companies. In such companies, some of the divisions may be buyer and supplier to one another. This leads to management accountants becoming involved in negotiations leading to the agreement of suitable transfer prices between these divisions.

Required

i) EXPLAIN, how the forces applied in a relationship between supplier and buyer led Michael Porter to reach a conclusion that companies compete with their buyers and suppliers.

ii) DISCUSS, the issues of negotiating and agreeing transfer prices between divisions within a large, complex organization. Make references to Michael Porter’s model, and your arguments in part (i) where appropriate

i) Michael Porter concluded that companies or divisions compete with their buyers and suppliers because they exercise bargaining power over one another. The relative competitive advantage is determined by the degree of bargaining power of each of the parties. Porter viewed competition as activity that affects margins where buyers and suppliers struggle to steal margin from each other. The competitive forces between buyer and supplier affect price and quality. A large order or powerful buyer will exercise force by trying to encourage the supplier to improve quality, either of the product or service being provided, or of the services supporting the product. As another option, a powerful buyer might be willing to accept the standard product, but demands a discount, thus increasing its own margin at the expense of the supplier.

Thus, companies and divisions “compete" with their buyers and suppliers. However, this depends on how broad the definition of “competition” is. Michael Porter started from the premise of a very broad definition, consequently could prove his hypothesis.

(ii) In a large and complex company, divisions may have been developed or acquired along a supply chain. This means that, within the company, there are divisions that are buyers and suppliers for each other. The logic behind establishing this structure is that it reduces transaction costs, cuts out supplier margins and secures reliable supply of raw materials or components. In this situation, the company faces the risk of sacrificing any saving in transaction costs if management needed to invest considerable time in transfer pricing negotiation.

In effect, the divisions concerned will be competing with one another like buyer and supplier during the negotiation, in the same way as described in Part (i). The transfer price agreed will affect, to some extent, the profitability of each of the divisions. If bonuses are paid to managers as per divisional performance, the transfer price will determine the level of bonus paid. Thus, managers may have a personal interest in enduring negotiations that will destroy value in the company.

The parent company must determine whether the transfer price is in the best interests of the company. If it is, it should simply be imposed. This finish off competition but may discourage managers, especially when divisional bonuses are paid. In most companies, some level of negotiation is allowed, but this may be not realistic if transfer is necessary. In this case, the bargaining power of the supplier division is vastly increased, thus destroy the balance of the negotiation.

The opposite is the case if the supplier division is not allowed to make external sales, or if there is no external market (for example, for a special component). In this situation, the bargaining power clearly lies with the buyer division, as the supplier has no choice but to make the transfer. However, if the special component or supply is not available from elsewhere, the bargaining power may shift to the supplier division as its product is of different nature.

The outcome of any transfer price negotiation must be ended in a transfer at a fair price. In this case, fair means that the price must be comprehended as fair by the division concerned. Any other outcome may lead to loss of motivation in one or both of the divisions. A fair price can be easily determined if there is a free market of the product, component or service being transferred (in other words, it can be both sold and bought outside). If this case does not exist, the range of transfer prices may fall between marginal cost of a unit and full cost plus normal margin.

In corporate terms, the most important transfer pricing issue is that while consolidating the accounts, the transfer price cease to exist. While consolidating the supplier and buyer division accounts, the revenue from the transfer price cancels out the cost of purchase, so the net result is that the transfer disappears. In entire development, most of time and efforts are wasted and simply rise in internal transaction costs. Accordingly, any competition between the divisions is worthless. If the management accountants comprehend this, and the relative bargaining power of the divisions concerned, it is possible to determine negotiations quickly, thus distorting as little value as possible.

Q-17

Identify the correct pair of statement→

 A During ____________ stage there is space for all, competitorsand firms are focusing on keeping up with customer demandand not looking into the future. (i) Diversification B When the buyer has more access to information then he/ she can possibly switch products or even perhaps backwards integrate and make the products themselves. ___________ Power would decrease. (ii) Centralised C A health insurance firm moving into the operating fitness centre is an example of  _______ strategy. (iii) Maturity D Lower switching costs mean that ___________ will have more power. (iv) Supplier’s E Major product differentiation and __________ is usually considered a barrier to entry. (v) Growth F A ___________ organisation has many levels of management vests decision-making authority at the top. (vi) Buyers G The_______________ is a high-level position and helps capture the organisation’s fundamental purpose. (vii) Branding H A wine producer that uses grapes grown in its own winery is an example of _________ (viii) Mission I The life cycle stage  is characterised by slower growth, increased buyer power, supply meeting demand, and a shift towards efficiency. (ix) Vertical Integration J ______________helps management to report on the achievement of strategic goals/ objectives. (x) KPIs

Correct Pair

 A B C D E F G H I J v iv i vi vii ii viii ix iii x

Q-18

Cineworld is a movie theater is located in a town with many colleges and universities around it. The town has a substantial student population, most of whom are avid movie goers. Business for Cineworld has been slow in the recent years due to the advent of streaming websites that show the latest and popular movies online. However, the management of Cineworld continue to feel students would still enjoy the watching movies on big-screen, along with the facilities and ambience that only a movie theater can offer. Accordingly, they have framed a plan to attract students by offering discounts on movie tickets. The average time a student spends at the college or university is 4 years, which i s the average duration of any course. For a nominal one-time subscription fee, Cineworld plans to offer students discounts on movie tickets for a period of 4 years. By attracting more footfalls, Cineworld targets to cross sell it food & beverages and souvenirs. This would help it sustain a reasonable revenue each year.

Cineworld would attract attention to the plan by initially offering free tickets, food and beverage and gift vouchers. This one time initial expense, net of the one-time subscription fee collected, would cost Rs.5, 000 per student. On subscription to the plan, the viewership and purchases of each student is expected to be as follows:

 Particulars Years 1 and 2 Years 3 and 4 Spend on movie tickets per year 2,000 1,500 Spend on food and beverage per year 4,000 3,000 Spend on souvenirs and accessories per year 2,250 750

Assumptions

i) Only 50% of the subscribers are expected to visit the theatres in years 3 and 4 Across all years, only 75% of the subscribers who visit the theatre are expected to buy food and beverage.

ii) Only 25% of the subscribers who visit are expected to buy souvenirs in years 1 and 2, and 10% of them in years 3 and 4.

Given that PVIFA of Rs.1 for 4 years at 10% = 3.169 and PVIFA of Rs.1 for 2 years at 10% = 1.735.

Required

CALCULATE the customer lifetime value per subscriber for the above plan.

Customer lifetime value per subscriber can be found by calculating the present value of the revenue that is generated over the period of 4 years. This netted out with the cost incurred to attract subscribers, would give the customer lifetime value per subscriber.

 Sr.No. Particulars Revenue (per year) PVIFA PV of Revenue Probability of Usage Net Revenue 1 Net cost of  attracting students (onetime expense) 5,000 2 Net revenue   from   movie tickets 2,000 1.735 3,470 100% 3,470 Years 1-2 2,000 1.735 3,470 100% 3,470 Years 3-4 (refer note 1) 1,500 1.434 2,151 50% 1,076 3 Sale of food and beverages Years 1-2 4,000 1.735 6,940 75% 5,205 Years 3-4 (refer note 2) 3,000 1.434 4,302 37.5% 1,613 4 Sale of souvenirs and accessories Years 1-2 2,250 1.735 3,904 25% 976 Years (refer note 3) 750 1.434 1,076 5% 54 5 Total revenue (Steps 2+3+4) 12,394 6 Net revenue from subscription plan (steps 5-1) 7,394

Note 1:

PVIFA (10%, 4 years) = 3.169 and PVIFA (10%, 2 years) is 1.735.

Therefore , PVIF for years 3 and4 = PVIFA (10%, 4 years) - PVIFA (10%, 2 years) = 3.169 - 1.735 = 1.434.

Note 2:

Only 50% of the subscribers are expected to attend in years 3 and 4. Out of those only 75% are expected to buy food and beverage. Therefore, only 38% of the subscribers (75% of 50% subscribers who visit) are expected to buy souvenirs in years 3 and 4.

Note 3:

Only 50% of the subscribers are expected to attend in years 3 and 4. Out of those only 10% are expected to buy souvenirs. Therefore, only 5% of the subscribers (10% of 50% subscribers who visit) are expected to buy souvenirs in years 3 and 4

Present value of total revenue generated over the four -year period by a customer is Rs.12,393 while the corresponding expense is Rs.5,000. Therefore, the customer lifetime value per subscriber is Rs.7,393. Cineworld has to multiply this with the expected number of subscribers each year, to find out if this would be a profitable proposition.

Q-19

Pearson Metal and Motor Works (PM2W) deals in manufacturing of the copper wired electronic motor, which is specifically designed. PM2W is thinking to shift from traditional system to JIT system as part of process innovation.

CEO among the other top bosses at PM2W are hopeful that implementation of JIT will not only improve value in value chain for end consumer, but also improve overall manufacturing cycle efficiency. JIT pre-implementation team was formed to evaluate the probabilities, which collects following actual and estimated data about process;

 Activity Category Traditional System (Actual) JIT System (Estimated) Inspection 40 30 Storage 80 20 Moving 20 10 Processing 60 40

# All data in minutes

Further, PM2W decided to practice single piece flow under JIT. PM2W received an order which is due to manufacture and delivered for 10 such motors. Total available production time to produce what customer demands is 480 minutes out of which it normal practice that 30 minutes will be spent in shutdown and cleaning. CEO is also considering JIT purchase apart from JIT production.

Required

i) EXPLAIN just in time.

ii) CALCULATE the ‘takt time’ and INTERPRET the results.

iii) ADVISE whether company should shift to JIT.

(i) Just-in-time (JIT) is a collection of ideas that streamline a company’s production process activities to such an extent that wastage of all kind viz., of time, material and labour systematically driven out of the process with single piece flow after considering takt time. In JIT, production facility is required to be integrated with vendor system for signal (Kanban) based automatic supply which depends upon demand based consumption. Under JIT system of inventory storage cost is at lowest level due to direct issue of material to production department as and when required and resultantly less/no material lying over in store or production floor. Prerequisite of JIT system is integration with vendor, if vendor is not integrated properly or less reliable, then situation of stock out can arise and which can result into loss of contribution.

Multitasking by employee is another key feature of JIT, group of employees should be made based upon product instead based upon function. Hence, functional allocations of cost become less appropriate.

Overall, JIT enhance the quality into the product by eliminating the waste and continuous improvement of productivity.

(ii) Takt Time is the maximum available time to meet the demands of the customer; this will help to decide the speed of/ at manufacturing facility.

Takt time is the average time between the start of production of one unit and the start of production of the next unit, when these production starts are set to match the rate of customer demand.

Takt Time =

Available Production Time Total Quality Required

Here, Available Production Time is ‘total available time for production’ – ‘planned downtime i.e. spent in shutdown and cleaning’ i.e. 450 minutes = 480 minutes – 30 minutes.

Total Quantity required is 10 units

Takt Time =450minutes /10units

= 45 Minutes

Note - Heijunka can be applied in order to reduce variation between ‘Takt times’ over the production.

Interpretation

Customer’s demand is 10 units, to calculate the takt time, divide the available production time (in minutes) by the total quantity required. The takt time would be 45 minutes. This means that process must be set up to produce one unit for every 45 minutes throughout the time available.

As order volume increases or decreases, takt time may be adjusted so that production and demand are synchronized. Advise on Shifting to JIT

To evaluate how much of the old cycle time was spent in inventory, we need to know how organizations assess the efficiency of their manufacturing processes. One commonly used measure is process cycle efficiency and to calculate the same every process is breakdown into combination of activities such as value added activities, non-value added activities and non- value added activities but strategic activities. In order to generate highest value to customer, only value added activities are included in process. But those non-value added activities, which are strategic in nature, also need to be part of process. Therefore, it may be possible that entire process is not efficient.

To measure efficiency of process, managers keep track of the relation between ‘times taken by value added activities’ in comparison ‘total cycle time’. Such relation/ratio is processing cycle efficiency.

Process Cycle Efficiency =Value Added /Time Cycle Time

Processing time is considered as value added time; whereas time spend on inspection, storage and moving is non-value added time and included in cycle time. The higher the percentage, less the time (and costs) needs to be spent on non- value added activities such as moving and storing etc.

Computation of Processing Cycle Efficiency

 Sr. No. Activity Category Traditional System (Actual) JIT System (Estimated) A Inspection 40 30 B Storage 80 20 C Moving 20 10 D Processing 60 40 E Value Added Time …(D) 60 40 F Cycle Time …(A)+(B)+(C)+(D) 200 100 G Process Cycle Efficiency (E)/ (F)×100 30% 40%

Of the 200 minutes required for manufacturing cycle under PM2W’s traditional system, only 60 minutes were spent on actual processing. The other 140 minutes were spent on non- value added activities, such as inspection, storage, and moving. The process cycle efficiency formula shows that processing time equaled to 30% of total cycle time. The cycle time is reduced substantially in the JIT system from 200 minutes to 100 minutes. In addition to this, the amount of time that used up in inventory i.e. nonvalue-added activities is also reduced. Therefore, process cycle efficiency has been increased from 30% to 40%. This significant improvement in efficiency over the previous system comes from the implementation of JIT system. Therefore, it is advantageous to shift to JIT system.

Q-20

IPL is a leading manufacturing company. Under increasing pressure to reduce costs, to control inventory level and to improve services, IPL’s Costing Department has recently undertaken a decision to implement a JIT System.

The management of IPL is convinced of the benefits of their changes. But Supplies Manager “W” fears with the Costing Department’s decision. He said: “We’ve been driven by suppliers for years ... they would insist that we could only purchase in thousands, that we would have to wait weeks, or that they would only deliver on Mondays!”

Required

COMMENT on Mr. W’s viewpoint.

“For successful operation of JIT inventory system, the suppliers chosen must be willing to make frequent deliveries in small lots. Rather than deliver a week’s or a month’s material at one time, suppliers must be willing to make deliveries several times a day and in the exact quantities specified by the buyer.”

It is described in the problem that suppliers are not willing to

• make frequent deliveries and

• make supplies in the exact quantities as required.

Accordingly Mr. W’s doubt is correct on successful implementation of JIT System

Q-21

NEC Ltd., forms a Committee consisting of its Production, Marketing, and Finance Directors to prepare a budget for the next year. The Committee submits a draft budget as detailed below:

 Particulars Rs. Selling Price per unit 50 Less: Direct Material Cost per unit 9 Direct Labour Cost per unit 9 Variable Overhead per unit (3 hrs. @ Rs.2) 6 Contribution per unit 26 Budgeted Sales Quantity 25,000 units Budgeted Contribution (25,000 × Rs.26) 6,50,000 Less: Budgeted Fixed Cost 5,00,000 Budgeted Profit 1,50,000

The Management is not happy with the budgeted profit as it is almost equal to the previous year's profit.

Therefore, it asks the Committee to prepare a budget to earn at least a profit of Rs.3,00,000. To achieve the target profit, the Committee reports back with the following suggestions:

The unit selling price should be raised to Rs.55.

The sales volume should be increased by 5,000 units.

To attain the above said increase in sales, the company should spend Rs.40,000 for advertising. The production time per unit should be reduced.

To win the acceptance of the workers in this regard the hourly rate should be increased by Rs. 3 besides an annual group bonus of Rs.30,000.

There is no change in the amount and rates of other expenses. The company has sufficient production capacity. As the implementation of the above proposal needs the acceptance of the work force to increase the speed of work and to reduce the production time per unit, the Board wants to know the extent of reduction in per unit production time.

Required

i) CALCULATE the target production time per unit and the time to be reduced per unit.

ii) IDENTIFY the other problems that may arise in production due to decrease in unit production time and also suggest the remedial measures to be taken.

iii) STATE the most suitable situation for the adoption of Target Costing.

(i) Target Production Time per unit

(Rs.3 + Rs.3 + Rs.2) × hrs. × 30,000 units = Rs.5,10,000

Hrs. =2.125

Time to be reduced per unit = 3 hrs. – 2.125 hrs.

= 0. 875 hrs.

Workings

Statement Showing Target Cost (Direct Labour and Variable Overhead)

 Particulars Amount (Rs.) Target Sales (Rs.55 × 30,000 units) 16,50,000 Less: Target Profit 3,00,000 Less: Direct Material Cost (Rs.9 × 30,000 units) 2,70,000 Less: Budgeted Fixed Costs 5,00,000 Less: Proposed Advertising 40,000 Less: Proposed Annual Group Bonus 30,000 Target Cost (Variable Overhead and Direct Labour) for 30,000 units 5,10,000

(ii) Problem

The target-costing method is applicable particularly for repetitive manufacturing. It should however be recognised that some products often bear a high degree of repetition and that there often are considerable repetitions where reduction targets could come into play as a framework for improving design. Working under pressure to finish new design assignments in a short time may take development resources away from efforts to optimise or re-engineer production processes. If approaching product design as an activity to be optimised independently there is a risk that target costing may not succeed to satisfactorily addressing overall performance, so in short decrease in unit production time may lead to unwanted pressure on design and its implementation stage.

Remedial Measures

As a remedial action organisation should retain strong control over the design teams headed by a good team leader. This person must have an exceptional knowledge of the design process, good interpersonal skills, and a commitment to staying within both time and cost budgets for a design project. If the time is too short even an organisation may reject a project for the time being. Later, it can be tried out with new cost reduction methods or less expensive materials to achieve target cost and control overall production activities. Target costing is most useful in situations where the majority of product costs are locked in during the product design phase. This is the case for most manufactured products, but few services. In the services area, such as consulting, the bulk of all activities can be reconfigured for cost reduction during the “production” phase, which is when services are being provided directly to the customer. In the services environment, the “design team” is still present but is more commonly concerned with streamlining the activities conducted by the employees providing the service, which can continue to be enhanced at any time, not just when the initial services process is being laid out.

Q-22

P & G International Ltd. (PGIL) has developed a new product “K” which is about to be launched into the market and anticipates to sell 80,000 of these units at a sales price of Rs.300 over the product’s life cycle of four years. Data pertaining to product “K” are as follows:

 Costs of Design and Development of Molds, Dies, and Other Tools Rs. 8,25,000 Manufacturing Costs Rs. 125 per unit Selling Costs Rs. 12,500 per year + Rs.100 per unit Administration Costs Rs. 50,000 per year Warranty Expenses 5 Replacement Parts per 25 units at Rs.10 per part ; 1 Visit per 500 units (Cost Rs. 500 per visit)

Required

i) Compute the product “K”’s ‘Life Cycle Cost’.

ii) Suppose PGIL can increase sales volume by 25% through 10% reduction in selling price. Should PGIL choose the lower price?

Statement Showing “K’s Life Cycle Cost (80,000 units)”

 Particulars Amount (Rs.) Costs of Design and Development of Molds, Dies, and Other Tools 8,25,000 Manufacturing Costs (Rs.125 × 80,000 units) 1,00,00,000 Selling Costs (Rs.100 × 80,000 units + Rs.12,500 × 4) 80,50,000 Administration Costs (Rs.50,000 × 4) 2,00,000 Warranty  (80,000 units / 25 units × 5 parts × Rs.10)  (80,000 units / 500 units × 1 visit × Rs.500) 1,60,000 80,000 Total Cost 1,93,15,000

Statement Showing “K’s Life Cycle Cost (1,00,000 units)”

 Particulars Amount (Rs.) Costs of Design and Development of Molds, Dies, and Other Tools 8,25,000 Manufacturing Costs (Rs.125 × 1,00,000 units) 1,25,00,000 Selling Costs (Rs.100 × 1,00,000 units + Rs.12,500 × 4) 1,00,50,000 Administration Costs (Rs.50,000 × 4) 2,00,000 Warranty  (1,00,000 units / 25 units × 5 parts × Rs.10)  (1,00,000 units / 500 units × 1 visit × Rs.500) 2,00,000  1,00,000 Total Cost 2,38,75,000

Statement Showing “K’s Life Time Profit”

 Particulars Amount (Rs.) for 80,000 units Amount (Rs.) for 100,000 units Sales 2,40,00,000 (80,000 × Rs.300) 2,70,00,000 (1,00,000 × Rs.270) Less: Total Cost 1,93,15,000 2,38,75,000 Profit 46,85,000 31,25,000

Decision

Reducing the price by 10% will decrease profit by 33% (Rs.15,60,000). Therefore, PGIL should not cut the price.

Q-23

P & G International Ltd. (PGIL) has developed a new product ‘α3’ which is about to be launched into the market. Company has spent Rs. 30,00,000 on R&D of product ‘ α3 ’. It has also bought a machine to produce the product ‘α3’ costing Rs. 11,25,000 with a capacity of producing 1,100 units per week. Machine has no residual value.

The company has decided to charge price that will change with the cumulative numbers of units sold:

 Cumulative Sales (units) Selling Price Rs. per unit 0 to 2,200 750 2,201 to 7,700 600 7,701 to 15,950 525 15,951 to 59,950 450 59,951 and above 300

Based on these selling prices, it is expected that sales demand will be as shown below:

 Weeks Sales Demand per week (units) 1-10 220 11-20 550 21-30 825 31-70 1,100 71-80 880 81-90 660 91-100 440 101-110 220 Thereafter NIL

Unit variable costs are expected to be as follows:

 Rs. per unit First 2,200 units 375 Next 13,750 units 300 Next 22,000 units 225 Next 22,000 units 188 Thereafter 225

PGIL uses just-in-time production system. Following is the total contribution statement of the product ‘ α3 ’ for its Introduction and Growth phase:

 Introduction Growth Weeks 1 - 10 11 - 30 Number of units Produced and Sold 2,200 5,500 8,250 Selling Price per unit (Rs.) 750 600 525 Variable Cost per unit (Rs.) 375 300 300 Contribution per unit (Rs.) 375 300 225 Total Contribution (Rs.) 8,25,000 16,50,000 18,56,250

Required

(i) Prepare the total contribution statement for each of the remaining two phases of the product’s life cycle.

(ii) Discuss Pricing Strategy of the product ‘ α3 ’.

(iii) Find possible reasons for the changes in cost during the life cycle of the product ‘ α3 ’.

Note: Ignore the time value of money.

(i) Total Contribution Statement

Statement Showing “Total Contribution- for remaining two phases”

 Particulars Maturity Decline Weeks 31 - 50 51 - 70 71 - 110 Number of units Produced and Sold 22,000 22,000 22,000 Selling Price per unit (Rs.) 450 450 300 Less: Unit Variable Cost per unit (Rs.) 225 188 225 Unit Contribution (Rs.) 225 262 75 Total Contribution (Rs.) 49,50,000 57,64,000 16,50,000

(ii)Pricing Strategy for Product α3

PGIL is following the skimming price strategy that’s why it has planned to launch the product α3 initially with high price tag.

A skimming strategy may be recommended when a firm has incurred large sums of money on research and development for a new product. In the problem, PGIL has incurred a huge amount on research and development. Also, it is very difficult to start with a low price and then raise the price. Raising a low price may annoy potential customers.

Price of the product α3 is decreasing gradually stage by stage. This is happening because PGIL wants to tap the mass market by lowering the price.

(iii)Possible Reasons for the changes in cost during the life cycle of the product ‘ α3 ’

Product life cycle costing involves tracing of costs and revenues of each product over several calendar periods throughout their entire life cycle. Possible reasons for the changes in cost during the life cycle of the product are as follows: PGIL is expecting reduction in unit cost of the product α3 over the life of product as a consequence of economies of scale and learning / experience curves. Learning effect may be the possible reason for reduction in per unit cost if the process is labour intensive. When a new product or process is started, performance of worker is not at its best and learning phenomenon takes place. As the experience is gained, the performance of worker improves, time taken per unit reduces and thus his productivity goes up. The amount of improvement or experience gained is reflected in a decrease in cost.

Till the stage of maturity, PGIL is in the expansion mode. The PGIL may be able to take advantages of quantity discount offered by suppliers or may negotiate the price with suppliers.

Product α3 has the least variable cost Rs.188 in last phase of maturity stage; this is because a product which is in the mature stage may require less marketing support than a product which is in the growth stage so, there is a saving of marketing cost per unit.

Again the cost per unit of the product α3 jumps to Rs.225 in decline stage. As soon as the product reaches its decline stage, the need or demand for the product disappear and quantity discount may not be available. Even PGIL may have to incur heavy marketing expenses for stock clearance.

Workings

Statement of Cumulative Sales along with Sales Price and Variable Cost

 Weeks Demand per  week Total Sales Cumulative Sales Selling Price per unit (Rs.) Variable Cost per unit (Rs.) 1 – 10 220 2,200 2,200 750 375 11 – 20 550 5,500 7,700 600 300 21 – 30 825 8,250 15,950 525 300 31 – 50 1,100 22,000 37,950 450 225 51 – 70 1,100 22,000 59,950 450 188 71 – 80 880 8,800 68,750 300 225 81 – 90 660 6,600 75,350 300 225 91 - 100 440 4,400 79,750 300 225 101 - 110 220 2,200 81,950 300 225

Q-24

The following information is given about the type of defects during a production period and the frequencies of their occurrence in a spectacle manufacturing company:

 Defect No. of items End Frame not equidistant from the centre 10 Non-uniform grinding of lenses 60 Power mismatches 20 Scratches on the surface 110 Spots / Stains on lenses 5 Rough edges of lenses 70 Frame colours-shade differences 25

Required

PREPARE a frequency table so that a Pareto Chart can be constructed for the defect type. Also, IDENTIFY key areas of focus.

Statement Showing “Pareto Analysis of Defects”

 Defect Type Defect Type % of Total Items Cumulative Total Scratches on the surface 110 36.67% 36.67% Scratches on the surface 70 23.33% 60.00% Non-uniform grinding of lenses 60 20.00% 80.00% Frame          colours-shade differences 25 8.33% 88.33% Power mismatches 20 6.67% 95.00% End frame not equidistant from  the centre 10 3.33% 98.33% Spots/ Strain on lenses 5 1.67% 100.00% 300 100.00%

The company should focus on eliminating scratches on the surface, rough edges of lenses and grinding of lenses related defects which constitute 80% portion, according to Pareto Theory.

Q-25 The information given below pertains to ABC Enterprises, a specialized car garage door installation company. ABC Enterprises use to get multiple service calls from the customers with variety of requirements. They may have to Install, Replace, Adjust or Lubricate some part or other to make the door functional. They work with 5 parts as given in the table, namely Door, Motor, Track, Trimmer and T -Lock.

 Parts Type of Service Total Install Replace Adjust Lube 1 Door 2 5 1 0 8 2 Motor 3 2 16 9 30 3 Track 5 0 6 6 17 4 Trimmer 14 6 0 0 20 5 T-Lock 5 0 1 0 6 6 Miscellaneous 0 2 1 1 4 Total 29 15 25 16 85

Required

i) Using the above data, carry out a Pareto Analysis (80/20 rule) of Total Parts.

ii) Using the same data carry out the second level Pareto Analysis on the type of services with respect to Motors only.

iii) Give your RECOMMENDATIONS on the basis of your calculations in (i) and (ii) above.

(i) Statement Showing “Pareto Analysis of Total Parts”

 Parts No. of Items % of Total Items Cumulative Total Motor 30 35.29 35.29% Trimmer 20 23.53 58.82% Track 17 20.00 78.82% Door 8 9.41 88.23% T-Lock 6 7.06 95.29% Miscellaneous 4 4.71 100.00%

ii) Statement Showing “Pareto Analysis of Type of Services (Motor)

 Type of Services No. of Items % of Total Items Cumulative Total Adjust 16 53.33 53.33% Lube 9 30.00 83.33% Install 3 10.00 93.33% Replace 2 6.67 100.00% 30

iii) Pareto Analysis is a rule that recommends focus on most important aspects of the decision making in order to simplify the process of decision making. The very purpose of this analysis is to direct attention and efforts of management to the product area where best returns can be achieved by taking appropriate actions. Pareto Analysis is based on the 80/20 rule which implies that 20% of the products account for 80% of the revenue. But this is not the fixed percentage rule. In general business sense, it means that a few of the products, goods or customers may make up most of the value for the firm.

The present case stands in a difference to 80/20 rule. Because the company installs doors, they sometimes have multiple service calls to install each door piece by piece. They may have to install, replace, adjust, or lubricate some part to get the door working properly. They work with five main parts: door, motor, track, trimmer and t- lock. The service calls with reference to motors are heavy and accounted for as much as 35.29% of the number of calls attended. Motor together with trimmer accounted for 58.82%. So, these two parts are to be considered as key parts and ABC enterprises must be ever ready to cater to all provisional requirements for attending these classes without any inordinate delay. Any delay in service these calls is likely to damage its service rendering reputation within a very short span of time. Further, the second level Pareto Analysis on motors has revealed a particular reference to the service problems related to motors. Adjustments and Lubrication issues cover up 83.33% of the total service problems exclusively connected to Motors. So, ABC Enterprise must direct its best efforts and develop specific expertise to solve these problems in the best interest of the customers.

Q-26 Storewell Industries Ltd. manufactures standard heavy duty steel storage racks for industrial use. Each storage rack is sold for Rs.750 each. The company produces 10,000 racks per annum. Relevant cost data per annum are as follows:

 Cost Component Budget Actual Actual Cost p.a (Rs.) Direct Material 5,00,000 sq. ft. 5,20,000 sq. ft. 20,00,000 Direct Labour 90,000 hrs. 1,00,000 hrs. 10,00,000 Machine Setup 15,000 hrs 15,000 hrs. 1,50,000 Mechanical Assembly 200,000 hrs 200,000 hrs 30,00,000

The actual and budgeted operating levels are the same. Actual and standard rates of material procurement and hourly labor rate are also the same. Any variance in cost is solely on account of difference in the material usage and hours required to complete production. Aggressive pricing from competitors has driven down sales. A comparable rack is available in the market for Rs.675 each. Vishal, the marketing manager has determined that in order to maintain the company’s existing market share of 10,000 racks, Storewell Industries must reduce the price of each rack to Rs.675.

Required

(i) CALCULATE the current cost and profit per unit. IDENTIFY the non-value added activities in the production process.

(ii) CALCULATE the new target cost per unit for a sales price of Rs.675 if the profit per unit is maintained.

(iii) RECOMMEND what strategy Storewell Industries should adopt to attain target cost calculated in (ii) above.

(i) The current cost and profit per unit are calculated as below:

 Cost Component Units Actual Cost p.a. for 10,000 racks (Rs.) Actual cost per rack  (Rs.) Revenue 10,000 racks 75,00,000 750 Direct material 5,20,000 sq. Ft. 20,00,000 200 Direct labour 1,00,000 hrs. 10,00,000 100 Machine Setup 15,000 hrs. 1,50,000 15 Mechanical 2,00,000 hrs. 30,00,000 300 Total cost 61,50,000 615 Profit 13,50,000 135

Therefore, the current cost is Rs.615 p.u. while the profit is Rs.135 p.u. Machine setup is the time required to get the machines and the assembly line ready for production. In this case, 15,000 hours spent on setting up does not add value to the storage racks directly. Hence, it is a non-value add activity.

(ii) New sale price per rack is Rs.675 per unit. The profit per unit needs to be maintained at Rs.135 per unit. Hence, the new target cost per unit = new selling price per unit – required profit per unit = Rs.675 - Rs.135 = Rs.540 per unit.

(iii) As explained above, current cost per unit is Rs.615 while the target cost per unit is Rs.540. Hence, the cost has to be reduced at least by Rs.75 per unit. Analysis of the cost data shows the variances between the budget and actual material usage and labor hours. It is given that the material procurement rate and labor hour rate is the same for budgets and actuals. Hence, the increment in cost of direct materials and labor is due to inefficient use of material and labor hours to complete the same level of production of 10,000 storage racks.

Corrective actions to address these inefficiencies could result in the following savings:

a) Inefficiencies resulted in use of extra 20,000 sq. ft. of material. Material cost per sq. ft. = Actual cost / Actual material usage = Rs.20,00,000 / 5,20,000 sq. ft. = Rs.3.85 per sq. ft.

Therefore, inefficiencies resulted in extra cost = 20,000 sq. ft. × Rs.3.85 per sq. ft. = Rs.77,000. If corrective action is taken, for 10,000 racks this translates to a saving of Rs.7.70 per unit.

b) Inefficiencies resulted in extra 10,000 hrs. to be spent in production. Labor cost per hr. = Actual cost / Actual labor hrs. = Rs.10,00,000 / 10,000 hrs. = Rs.10 per hr. Therefore, inefficiencies resulted in extra cost = 10,000 hrs. × Rs.10 per hour = Rs.100,000. If corrective action is taken, for 10,000 racks this translates to a saving of Rs.10 per unit.

c) Machine setup cost is a non-value added cost. Value analysis can be done to determine if the setup time of 15,000 hrs. can be reduced. However, since these activities have been carried out for a reason, care should be taken to ensure that this change should not adversely impact the production activity later down the stream.

d) Mechanical assembly cost is almost half of the total cost. These are costs incurred during the production process on the assembly line. Value analysis can be done to determine if the production process can be made more efficient. For example, the process can be streamlined, such that steps can be combined that can be handled by fewer people (process centering). Similarly, value analysis / value engineering can focus on the product design.

Some questions to raise may be:

• Can the product be designed better to make the production more efficient?

• Can the design be minimized to include fewer parts and thus make it easier and efficient to manufacture?

• Can be substitute parts to make it more efficient? Or

• Is there simply a better way of producing the same product?

While target costing is a dynamic and corrective approach, care must the taken the product quality, characteristics and utility are maintained.

Q-27

Following three independent situations pertaining to environmental management and sustainability are provided to you:

Situation I

Wasco Limited is a chemical company which uses chloro-fluorocarbons (CFC) in the production of chemical. As awareness of the environmental damage caused by CFC spread, Wasco Limited stopped using CFC in its production processes and analysed and redesigned its product range much before the legislation controlling use of CFC introduced by the Government.

Situation II

Energy drink manufacturer Cool Limited was ordered to submit a yearly report to the Ministry of Environment and Forests on activities, which contains information concerning collection, recovery and recycling of packaging waste, fulfilment of the targets, volume of recovered and recycled packaging waste by type of material and declaration that all compulsory contributions and taxes have been paid.

Situation III

KOA Limited has achieved a 25% reduction of energy consumption through its “Go Renewable” initiative. For, the company a 25% reduction represents a cost saving of about Rs. 30,00,000/-.

Required

Read the above three situations and EXPLAIN:

i)Why Wasco Limited stopped using CFC and redesigned its product range much before legislation introduced by Government?

ii)The risk exposure of Cool Limited.

How focusing on environmental sustainability provides opportunity to KOA Limited for reducing costs?

(i) Ever increasing and demanding environmental regulation is forcing companies to change their practices. In many countries, numerous pieces of legislation cover areas such as air quality, climate change, hazardous substances, packaging, waste, and water quality.

The trend is very much in the direction of increased and more stringent legislation. Environment sustainability is not an issue that can be avoided by any organisation. Organisations need to consider how environmental regulation will impact their operations and the cost of doing business.

By stopping the use of CFC much before the legislation, Wasco Limited gained advantages over its rivals. Wasco’s actions were integral to its own strategic success, and instrumental in driving through the subsequent legislation from which the company later benefited. This will also help Wasco Limited to improve their brand image among the stakeholder as corporate citizen.

ii) Organizations increasingly have to demonstrate that they are managing all of their risks systematically and responsibly. This includes environmental risks- risks that are a result of impacts of the organization on the environment. By assessing the environmental risks associated with their activities, processes, product,   and services, organizations can identify their potential legal and business exposure. Non-compliances can cause enormous financial impacts, such as fines, penalties, legal costs, and damages. Thus, Cool Ltd is exposed to environmental risks.

iii) Focusing on environmental sustainability will often provide opportunities for reducing costs. For example, reducing carbon impacts often also saves energy costs. Similarly, programmes for reducing wastes improve environmental performance and reduce operating costs. Reducing environmental impacts can also reduce or eliminate associated fines, levies, and other compliance costs.

Focusing on environmental sustainability thereby making investments in developing clean technologies and more energy-efficient products and processes will not only save the organization money, but could also be patented and/ or sold to other organizations, providing an additional source of income. KOA Limited may have carbon credit for efficiency in reducing energy and sell on the open market, thereby actually generating revenue.

Q-28

Queenstown Wood Co. (QWC) began 20 years ago, as a small family-run business supplying custom-made school furniture. Now QWC has grown into a thriving hub of experts specializing in either custom-made, locally sourced or quality imported commercial grade furniture. The newly appointed CFO is concerned about the trends in dropping sales volumes, increasing costs, and hence falling profits over the last three years. He observed that the reason of these trends is increased cut-throat competition that has emerged over the last three years. For many years, QWC has been known for high quality but now this quality is being matched by the competitors. QWC’s share of the market is declining due to equivalent products being sold by competitors at lower prices. It is considered that, to offer such low prices, the furniture’s production costs of the competitors must be lower than QWC’s.

Required

ADVISE how QWC can improve its sales volumes, costs and profits using Value Analysis and Functional Analysis.

Value Analysis is viewed as a reduction in cost and problem solving technique. Such technique analyses an existing product to identify and cutback or eliminate any cost which do not give any contribution to performance or value. It is a planned, scientific approach to c ost reduction which reviews the material composition of a product and production design so that modifications and improvements can be made which do not reduce the value of the product to the customer or to the user. (i.e. quality for purpose should not be compromised.)

Functional analysis is applied to the design of new products and breaks the product down into functional parts. For example, a new chair may have the moveable feature. The value that the customer places on each feature is considered and added to give a target cost. Thus, functional analysis aims to increase profits by reducing costs through elimination of unnecessary features and/or by adding cost-effective new features that are so attractive to customers that the product becomes more lucrative.

The result of the above analysis is to improve the value of the furniture while maintaining costs and/or cutback the costs of the furniture without compromising with value. It is clear from the scenario that QWC needs to cut back its selling prices to compete in the market. This selling price reduction can only be possible by a reduction in QWC’s unit costs; however, such reduction must not be accomplished by compromising with quality. Both value analysis and functional cost analysis may be used for QWC; however, value analysis is likely to be a more useful technique because office tables and chairs are such items which are demanded more on the basis of their use value rather than their esteem value.

Q-29 CNB Oil Ltd., an Indian oil company, is the leading manufacturer of all streams of oil and engaged in refining (processing capacity 50 MMTPA of crude oil), pipeline transportation and marketing of petroleum products to research & development, exploration & production, marketing of natural gas and petrochemicals. The company has high-caliber employees, sophisticated technologies and leading-edge R&D. By venturing itself into the renewables and the nuclear energy, CNB has grown and evolved itself from a pure petroleum re fining and marketing company to a full-fledged energy company. Due to government’s new environmental policy, environmental report is mandatorily required to be submitted yearly for the prescribed industries polluting environment substantially otherwise would be penalized.

Energy sector also falls in these prescribed industries. CNB has already taken initiatives to control air pollution and water pollution like use of low sulphur fuel oil in boilers and heaters & NOx burners to minimize gas emission, network of underground sewers for segregated collection of various wastewater streams for waste water management, however while preparing and analyzing environmental report, Mr. K V Sharma, CEO, is not happy with high environmental cost in terms of Waste (oily / chemical / biological sludge, scrape batteries, e- waste, chemical containers, effluents etc.),

Raw Material Consumption, Water Consumption, Energy and Transportation. He raised his concern with Board of Directors and they have decided to appoint you as an environmental management accounting expert to manage environmental cost.

Required

APPLY Environmental Management Accounting in CNB to manage environmental costs.

Environmental Management Accounting (EMA) is the process of collection and analysis of the information relating to environmental cost for internal decision making. EMA identifies and estimates the cost of environment related activities and seek to control theses cost.

In CNB, during refinery operations, waste water, fugitive emissions, flue gases and solid wastes are generated. Due to this excess waste and gas emission, environmental cost rises. Scarce natural resources should be used in such a way so that their consumption is sustainably optimized. In order to cutback environmental cost, EMA can be applied as follows:

Waste

CNB should measure, manage and monitor waste from operations in order to minimise impact on people and the environment. ‘Mass balance’ approach can be used to determine how much material is wasted in production, whereby the weight of materials bought is compared to the product yield. From this process, potential cost savings may be identified.

In CNB, wastes are oily / chemical / biological sludge, scrape batteries, e–waste, chemical containers, effluent etc. Waste generated in operations is either treated within the premise or disposed through approved waste treatment, storage, and disposal facility. To avoid the usage of chemical drums/ containers in large quantity, separate storage tanks can be created for bulk storage of additives to reduce the drum procurement and disposal.

Further, refineries in operation should be upgraded from time to time to minimize waste.

Water Management

Businesses pay for water twice – first, to buy it and second, to dispose of it. If savings are to be made in terms of reduced water bills, it is important for CNB to identify where water is used and how consumption can be decreased.

For water conservation, sustainable water management techniques should be adopted. In refining operation, water is mainly used in boilers and cooling units. Collective efforts should be made to optimize water consumption and maximum reuse of used water. Advanced treatment system like rain water harvesting, ultra-filtration, reverse osmosis etc. may be used for water purification for further use. This would lead to substantial reduction in intake of fresh water.

In addition, CNB staff should be alerted for water conservation through seminars, presentations, conference, awareness campaigns.

Energy

Often, energy costs can be reduced significantly at very little cost. Environmental Management Accounts may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings. Some of energy conservation initiatives may be taken by CNB like:

• Conducting periodic energy audits for identifying energy saving opportunities.

• Phasing out conventional lights and replacement with LED lights/induction lights.

• Power factor improvement by installation of capacitor banks.

• Installation of 5 star rated energy equipment.

• Prevention of idle running of equipment.

• Installation of solar lights.

• Use of Nano molecular thermal additives in ACs.

• Installation of efficient energy monitoring system for energy intensive equipment.

• Capacity improvement for batteries.

Consumables and Raw Material

Refineries ‘refine’ crude oil in massive quantities, to produce the fuels need. There should be continuously monitoring on optimum utilization of crude oil to improve gross refining margin. The gross refining margin is the difference between the total value of petroleum products coming out of an oil refinery (output) and the price of the raw material, (input) which is crude oil. Even not only crude oil there should also be optimum and sustainable utilization of resources like additives, chemicals etc. from procurement to production stages.

CNB may use recyclable technology for raw material and consumable wastages which provides sustainability in terms of environmental protection and reduction in carbon footprint. Periodic testing should be performed to assess the health of equipment and pipelines as to have better process of raw materials and consumables.

Transport

Again, EMA may be used to identify saving in terms of transport of goods and materials. At CNB, in order to cutback emission and fuel consumption due to transportation, route optimization activity may be used like allocation of customer on the basis of nearest depots and locations as to reduce distance, real time fleet tracking using GPS (to make sure that vehicles do not deviate from assigned shortest route) etc.

Q-30

Sheetal Paper Mart (SPM) is in process of getting ISO 14001:2004 Environmental Management Systems (revised ISO 14001:2015) certification. SPM is selling eco-friendly and wheat straw-based paper of different sizes (A3, A4, and A5) and GSM under the brand ‘Prime’. Prime is a famous name among both commercial and household consumers.

For purpose of getting certified, a cross-functional team is constituted, which is responsible ‘to improve the environmental impact & image of SPM as eco-friendly enterprise and control environmental cost’, which collects the following particulars relating to the H1 and H2 (first and second half of the relevant fiscal year respectively) Disposing of the toxic material costs Rs.1.2 crores to SPM in H2 which is 20% lesser than what was spent during H1. Committee responsible for formulating policy matters on environment related aspects in SPM has departmental budget of Rs.6 lakhs p.a., in H1 the utilisation rate was 80% and in H2 it was 110%.

Environmental audits earlier used to conduct on a half-yearly basis, but management decided to reduce the frequency to quarter each, in the mid of such year. Each such audit cost Rs.8 lakhs to SPM. In the H2 SPM extends the production capacity and installed the new plant & machinery which has put to use cost of Rs.77.25 crores, this is the premium version of the plant and machine due to its capability to reduce the generation of waste.

Erection and other installation costs including dry-run were Rs.65 lakhs and the same for all versions. The standard version has on-board cost of Rs.76.20 crores. SPM is practicing the recycling policy, which was formulated around three years ago; for the scrap, it generates in its plant. The review of the recycling policy is pending for the last 12 months. The cost incurred during the fiscal year was Rs.2.75 crores, spent in alignment to scrap generated during the year. The policy document also states– ‘zero discharge of waste/scrap into the environment, in order to be true-sense eco-friendly enterprise’.

In H2 contamination test was performed which cost Rs.4 lakhs to SPM. The monitoring cost incurred during the year was Rs.78 lakhs; in H2 this was double then H1.

Required

i) PREPARE the environmental cost statement as per the classification suggested by ‘Hanson and Mendoza’.

ii) ANALYSE the elements of environmental cost at SPM.

iii)EVALUATE whether the cross-functional team is successful in serving their ‘terms of reference’. Note- Clearly State the assumptions (if any).

Annexure

Scrap Generated (during the year)

 Quarter First Second Third Fourth Scrap generated and recycled 1,572 MT 1,428 MT 1,114 MT 886 MT

(i) Sheetal Paper Mart Environmental Cost Statement

 Particulars H1 H2 Amount (in lakhs) % to total Amount (in lakhs) % to total Environmental Prevention Costs Creating Environment policies [(6/2) x 0.8] [(6/2) x 1.1] 2.4 0.68 3.3 0.96 Investment  in   protective equipment [(7,725 – 65) –7,620] - - 40* 11.58 Sub-Total (a) 2.4 0.68 43.3 12.54 Environmental Detection Costs Monitoring (78 in the ratio of 1:2) 26 7.40 52 15.06 Performing          Contamination test - - 4 1.16 Environmental Audit [1 x 8] [2x 8] 8 2.28 16 4.63 Sub-Total (b) 34 9.68 72 20.85 Environmental internal failure costs Recycling Scrap (275 in the ration of 3:2) 165 46.95 110 31.86 Disposing of Toxic Material 150 42.69 120 34.75 Sub-Total (c) 315 89.64 230 65.65 Grand Total (a + b + c) 351.4 100 345.3 100

# Since the details regarding useful economic life of the newly erected plant and the machine is not given, hence the entire incremental cost recognised in H2 only (when put to use); despite the benefit will arise over the useful economic life in form of a reduction in generation of waste

(ii)Analysis

The environmental cost incurred in H2 (Rs.345.3 lakhs) is comparatively less than what was incurred in H1 (Rs.351.4 lakhs). Environmental internal failure costs reduced in H2 (Rs.230 lakhs) in comparison to H1 (Rs.315 lakhs), but still a substantial component of total environmental costs (66.61% in H2 against 89.64% in H1). The reduction of environmental internal failure costs is the outcome of increased environmental prevention costs (12.54% in H2 against 0.68% in H1) and environmental detection costs (20.85% in H2 against 9.68% in H1). Note – Since the policy document also states ‘zero discharge of waste/scrap into the environment, in order to be true-sense eco-friendly enterprise’ hence there are no environmental external failure costs.

(iii)Evaluation

Apart from getting the certificate, the cross-functional team has terms of reference ‘to improve the environmental impact & image of SPM as eco-friendly enterprise and control environmental cost’ In the context of controlling environmental cost, the team attained a reasonable reduction in total environmental cost, impact in this environmental cost statement (over H1 and H2) seem low because the incremental cost due to purchase of premium version of plant and machine is charged in H2, which will benefit in form reduced waste over the useful economic life.

In the context of improving the image of SPM as an eco-friendly enterprise, the policy document which in practice also states– ‘zero discharge of waste/scrap into the environment, in order to be true-sense eco-friendly enterprise’ and same is also visible through environmental cost statement as there are no environmental external failure costs

In the context of improving the environmental impact, SPM able to generate low waste in H2 (2,000 MT) in comparison of H1 (3,000 MT) just by installing new plant and machine which produce less waste, increased monitoring, and audits. Hence it can be concluded that the team is successfully serving the terms of reference.

Q-31

Color paints is a manufacturer of industrial dyes. It has received an order for 200 kgs of powder dye that needs to be customized to certain specifications. The job would require the following materials:

 Material Total units required Units already in inventory Book value of the units in inventory (Rs.per unit) Realizable value (Rs. per unit) Replacement cost (Rs. per unit) A 2,000 0 NA NA 8 B 3,000 1,200 7 8 10 C 2,000 1,400 12 9 14 D 500 500 9 12 15

1. Material B is used regularly in production of all types of dyes that Color plaints produces. Therefore, any stock used towards this job order would need to be replaced to meet other production demands.

2. Inventory of material C and D are from stock that was purchased in excess previously. Material C has no other use other than for this special order. Material D can be used as a substitute for 700 units of material Z which currently costs Rs.11 per unit. The company does not have any inventory of material Z currently.

Required

ANALYSE the relevant costs of material while deciding whether to accept the order or not?

Material A

The requirement of 2,000 units of Material A has to be purchased in entirety since there are no units in stock. Therefore, the relevant cost will be the replacement cost at Rs.8 per unit, which for 2,000 units is Rs.16,000 (2,000 units × Rs.8 per unit).

Material B

There is a requirement of 3,000 units of Material B, of which 1,200 units are in stock. Material B used regularly in the production of all types of dyes. If the 1,200 units in stock are used, they need to be replenished (replaced) in order to meet production demands of other dyes. In addition, for the special order, additional 1,800 units of Material B is required to be procured from the market. Therefore, 3,000 units of Material B has to be procured if the special order is undertaken. The relevant cost will be the replacement cost at Rs.10 per unit, which for 3,000 units is Rs.30,000 (3,000 units × Rs.10 per unit).

Material C

There is a requirement of 2,000 units of Material C, of which 1,4 00 units are in stock. The balance 600 units have to be procured at the replacement (market) price of Rs.14 per unit, which would be Rs.8,400. Material C has no other use, so if the special order is not undertaken the stock of 1,400 units can be sold at Rs.9 per unit. So, the opportunity cost of undertaking this order is Rs.12,600. Therefore, the relevant cost for Material C is procurement cost of 600 units plus the opportunity cost of not disposing the current stock of 1,400 units, which would be Rs.8,400 + Rs.12,600 = Rs.21,000.

Material D

The entire requirement of 500 units of Material D is in stock. If the special order is not accepted, Color paints has two options (i) sell the excess material at Rs.12 per unit or (ii) use it as a substitute for Material Z, which would otherwise need to be procured.

1. The realizable value of Material D is Rs.6,000 (500 units × Rs.12 per unit).

2. Material D can be used as a substitute for 700 units of Material Z. Since there is no stock of Material Z currently, if the special order is accepted, the entire quantity would have to be procured at Rs.11 per unit. This would cost the company Rs.7,700 (700 units × Rs.11 per unit).

Both options (i) and (ii) represent opportunity cost if the special order is accepted. The relevant cost for Material D, if the special order is accepted would be higher of either of these two opportunity costs. The higher opportunity cost of that of procuring Material Z from the market at Rs.7,700. Therefore, the relevant cost for Material D is Rs.7,700.

Therefore, the relevant cost to accepting the special order would be the cumulative of the relevant cost for Materials A, B, C, and D. This works out to Rs.74,700.

Q-32 BNZ Ltd. is engaged in the manufacture of plastic bottles of a standard size and produced by a joint process of machines. The factory has 5 machines and capable of producing 40 bottles per hour. The variable cost per bottle is Rs.0.32 and the selling price is Rs.0.80 each. The company has received an offer from another company for manufacture of 40,000 units of a plastic moulded toy. The price per toy is Rs.30 and the variable, cost is Rs.24 each. In case of the company takes up the job, it has to meet the expenses of making a special mould required for the manufacture of the toy. The cost of the mould is Rs.1,00,000. The company's time study analysis shows that the machines can produce only 16 toys per hour. The company has a total capacity of 10,000 hours during the period in which the toy is required to be manufactured. The fixed costs excluding the cost of construction of the mould during the period will be Rs.10 Lakh. The company has an order for the supply of 3,00,000 bottles during the period.

Required

1. Do you ADVISE the company to take up the order for manufacturing plastic moulded toys during the time when it has an order in its book for the supply of 3,00,000 bottles.

2. If the order for the supply of bottles increases to 4,00,000 bottles, will you ADVISE the company to accept the order for the supply of plastic moulded toys? State the reasons.

3. An associate company of BNZ Ltd. has idle capacity and is willing to take up the whole or part of the manufacturing of the plastic moulded toys on sub-contracting basis. The subcontract price inclusive of the cost of construction of mould is Rs.28 per toy. DETERMINE the minimum expected excess machine hour capacity needed to justify producing any portion of the toy order by the company itself rather than subcontracting.

Workings

Statement Showing “Contribution / Machine Hour”

 ‘Bottle’ ‘Toy’ Demand (units) 3,00,000 40,000 Sales (Rs./u) 0.80 30.00 Less: Variable Cost (Rs./u) 0.32 24.00 Less: Specific Fixed Cost (Rs./u) --- 2.50

 Contribution (Rs./u) 0.48 3.5 Machine Hours Required per unit 0.025 0.0625 Contribution / Machine Hour 19.2 56

Advice on Supply of 3,00,000/ 4,00,000 Bottles

1. BNZ Ltd. can accept plastic moulded toy’s order as sufficient number of hrs. i.e. 2,500 hrs. (10,000 hrs.- 3,00,000 bottles × 0.025 hrs.) are available and would be able to generate additional benefit of Rs.3.50 per unit on 40,000 units of toys i.e. Rs.1,40,000.

2. If the order for the supply of bottles increases to 4,00,000 bottles, then 2,500 more hrs. will be required to produce the additional bottles. BNZ Ltd. has to decide whether to utilize 2,500 hrs. for existing bottle order or for toy Order.

Machine time is limiting factor. Therefore, contribution per machine hour from both the activities (i.e. bottles and toys) should be calculated to decide whether the order should be accepted. Contribution per hour is more in case of toys (refer workings). Therefore, BNZ Ltd. should utilize the remaining 2,500 hours for manufacturing toys rather than to fulfil the order for supply of additional bottles.

Prioritizing production based on contribution per machine hour would maximize profits. However, existing order fulfilment is necessary for building long term and sustainable customer relationship. Developing and maintaining long term and intimate relationships with the profitable customers provides valuable benefits to the company as the relationships between company and customers grow, a customer who is satisfied with the company’s products and services, tends to commit the relationship, and buy more over time. Cost of keeping the existing customers is less expensive than the cost of acquiring new customers.

Hence, BNZ Ltd. should be taken into consideration long term supplier relation before accepting the toy order based on financial consideration as contribution per hour is more in case of toys. Further, company may also explore outsourcing opportunities for production of toys.

3. Minimum number of toys needed to be manufactured to justify the increase in fixed cost of Rs.1,00,000 to make the mould is 25,000 toys {1,00,000/ (Rs.28 - Rs.24}. Thus, as long as company has excess capacity available to manufacture more than 25,000 toys

Q-33

DBA, manufactures and sells 25,000 table fans annually. One of the components required for fans is purchased from an outside supplier at a price of Rs.190 per unit. Annually it is purchasing 25,000 components for its usage. The Production Manager is of the opinion that if all the components are produced at own plant, it is possible to maintain better quality in the finished product. Further, he proposed that the in-house production of the component with other items will provide more flexibility to increase the annual production by another 5,000 units.

He estimates the cost of making the component as follows:

 Rs. per unit Direct Material 80 Direct Labour 75 Factory overhead (70% variable) 40 Total cost 195

The proposal of the Production Manager was referred to the Marketing Manager for his remarks. He pointed out that to market the additional units, the overall unit price should be reduced by 5% and additionally Rs.1,00,000 p.m. should be incurred for advertising. Present selling price and contribution per fan are Rs.2,500 and Rs.600 respectively. No other increase or decrease in all other expenses as a result of this proposal will arise.

Required

Since the making cost of the component is more than the buying cost, the Management asks you to:

i) ANALYSE the make or buy decision on unit basis and total basis.

ii) RECOMMEND the most profitable alternative.

(i) DBA purchases 25,000 units of components to manufacture 25,000 fans annually. The external purchase price per component is Rs.190 per unit. It has the option of manufacturing these components in house. The cost structure of manufacturing these components would be as below:

 Cost Structure Cost per component unit (Rs.) Direct Materials 80 Direct Labor 75 Variable Factory Overhead (70% of Rs.40) 28 Total 183

Analysis

If DBA decides to manufacture the components in-house, the following would be the financial impact:

1. Production Capacity will increase from 25,000 fans to 30,000 fans.

2. Variable Cost of Production of fan would be Rs.1,710 [(2,500 - 600) -190] per unit.

3. Fixed Factory Overhead of Rs.12 per component would be incurred irrespective of whether component is produced or not. Therefore, this cost is not considered.

4. Increase in advertising expense would be Rs.100,000 per month or Rs.12,00,000 annually.

5. Overall selling price would reduce from the current rate of Rs.2,500 per fan to Rs.2,375 (95% of Rs.2,500) per fan.

6. Current contribution considering a procurement price of Rs.190 per component unit, is Rs.600 per fan. As calculated above, if produced in house, the variable cost would be Rs.183 per component unit. This would result in an increase in contribution by Rs.7 per fan (procurement price of Rs.190 per component unit less variable cost of Rs.183 per component unit). In addition, there is an impact of Rs.125 on account of reduction in selling price. Therefore, the contribution if component produced in house would be Rs.482 per fan (Rs.600+Rs.7-Rs.125).

To summarize the above figures:

 Particulars procurement 25,000 Components Produce 30,000 Components Per Fan (Rs.) Total Rs. Per Fan (Rs.) Total Rs. Selling price per fan 2,500 6,25,00,000 2,375 7,12,50,000 Contribution per fan 600 1,50,00,000 482 1,44,60,000

Therefore, incremental loss by switching to in house production (on a total basis) would be Rs.17,40,000 (incremental loss Rs.5,40,000 – additional advertising expenses Rs.12,00,000). On a per unit basis, it would result in a loss of Rs.58 per fan.

(ii) Recommendation

As explained above, if production increases from 25,000 fans to 30,000 fans, it would not be profitable to make these components in house. Overall profit decreased by Rs.17,40,000. However, DBA may prefer to make component, even though it could be financially beneficial to buy from outside supplier. Sometimes qualitative factors become very import ant and can override some financial benefit. This can be coupled with uncertainty about the supplier ’s ability or intention to maintain the price, quality, delivery dates of the components etc. Alternatively, DBA may continue with the sale of 25,000 units without any price reduction and advertising expenses. The component required for the 25,000 fans may be produced internally at a cost of Rs.183 per unit. In this situation, the contribution shall be increased by Rs.1,75,000 (Rs.7 ×25,000 units).

Thus, DBA may choice the alternative after due and careful consideration of the facts illustrated above.

Q-34

‘S’ manages the school canteen (approximately 1,600 students) at Noida. The current cash payment system requires three clerks (paid Rs.90 per hour), employed for about 4 hours a day. The canteen operates approximately 240 days a year.

‘S’ is considering a Wireless Cash Management System (WCMS), where a student could just swipe an ID card for payment. This system would cost Rs.1, 25,000 to setup and Rs.36,000 per year to operate. ‘S’ believes that he could manage with one clerk if he were to implement the system.

Required

ADVISE ‘S’ on the choice of a plan, assuming working life of WCMS as 5 years. (Ignore the time vale of money)

For each day, ‘S’ spends Rs.360 per clerk (Rs.90 per hr. × 4 hrs.). Therefore, ‘S’ spends Rs.1,080 per day to employ three clerks. Annually, this outlay amounts to Rs.2, 59,200 (Rs.1,080 per day × 240 days). Over five years, the outlay would be Rs.12, 96,000. If the WCMS is implemented, the initial cost is Rs.1, 25,000. If we add the annual cost of Rs.36,000, the total cost over five years amounts to Rs.3, 05,000. Since one clerk will be needed as well, ‘S’ has to incur Rs.4, 32,000 over five years to pay clerk (Rs.4, 32,000 = Rs.90 × 4 hrs. × 1 clerk × 240 days × 5 years). Therefore, the total cost of this option is Rs.7, 37,000. Accordingly, there is cost saving of Rs.5, 59,000 from WCMS implementation. Relevant Non-Financial

Considerations

The WCMS may be a lot more efficient, but more rigid. For instance, what if, a student forgets to bring his/ her card or transaction failure due to connectivity issue, and may not have enough cash to pay. Automated systems may be less able to handle these situations. Having clerks may add an aspect of flexibility and a human aspect that is hard to quantify.

Conclusion

Obviously, WCMS option is more cost effective for ‘S’ because there is a cost saving of Rs.5, 59,000. But, non-financial factors should also be taken into consideration.

Q-35

Recently, Ministry of Health and Family Welfare along with Drug Control Department have come hard on health care centres for charging exorbitant fees from their patients. Human Health Care Ltd. (HHCL), a leading integrated healthcare delivery provider company is feeling pinch of measures taken by authorities and facing margin pressures due to this. HHCL is operating in a competitive environment so; it’s difficult to increase patient numbers also. Management Consultant of the company has come out with some plan for cost control and reduction.

HHCL provides treatment under package system where fees is charged irrespective of days a patient stays in the hospital. Consultant has estimated 2.50 patient days per patient. He wants to reduce it to 2 days. By doing this, consultant has targeted the general variable cost of Rs. 500 per patient day. Annually 15,000 patients visit to the hospital for treatment.

Medical Superintendent has some concerns with that of Consultant’s plan. According to him, reducing the patient stay would be detrimental to the full recovery of patient. They would come again for admission thereby increasing current readmission rate from 3% to 5%; it means readmitting 300 additional patients per year. Company has to spend Rs. 25,00,000 more to accommodate this increase in readmission. But Consultant has found bless in disguise in this. He said every readmission is treated as new admission so it would result in additional cash flow of Rs. 4,500 per patient in the form of admission fees.

Required

1. Calculate the impact of Management Consultant’s plan on profit of the company.

2. Also comment on result and other factors that should be kept in mind before taking any decision.

1. Impact of Management Consultant’s Plan on Profit of the HHCL

Human Health Care Ltd.

Statement Showing Cost Benefit Analysis

 Particulars Rs. Cost: Incremental Cost due to Increased Readmission 25,00,000 Benefit: Saving in General Variable Cost due to Reduction in Patient Days[15,000 Patients × (2.5 Days – 2.0 Days) × Rs.500) 37,50,000 Revenue from Increased Readmission (300 Patients × Rs.4,500) 13,50,000 Incremental Benefit 26,00,000

2. Comment

Primary goal of investor-owned firms is shareholder wealth maximization, which translates to stock price maximization. Management consultant’s plan is looking good for the HHCL as there is a positive impact on the profitability of the company (refer Cost Benefit Analysis). Also HHCL operates in a competitive environment so for its survival, it has to work on plans like above. But there is also the second side of a coin that cannot also be ignored i.e. humanity values and business ethics. Discharging patients before their full recovery will add discomfort and disruption in their lives which cannot be quantified into money. There could be other severe consequences as well because of this practice. For gaining extra benefits, HHCL cannot play with the life of patients. It would put a question mark on the business ethics of the HHCL.

May be HHCL would able to earn incremental profit due to this practice in short run but It will tarnish the image of the HHCL which would hurt profitability in the long run. So, before taking any decision on this plan, HHCL should analyze both quantitative as well as qualitative factors.

Q-36

Some statements are given below. Identify name of the cost with examples and state whether it is relevant/non-relevant in decision making.

i) Costs are historical costs which have already been incurred and cannot change by any decision made in future.

ii) It is measure of benefits foregone by rejecting the second best alternative of resources in favour of the best.

iii) It is portioning of cost which involves payments to outsiders i.e., it gives rise to cash expenditure as opposed to such costs as depreciation.

Cost used in evaluation of a product to reflect the use of resources but that have no observable cost.

Relevant / Not Relevant

 S.No. Name of the Cost Example Relevant / Not Relevant (i) Sunk Cost Written down value of machine already purchased. Not Relevant in decision making. (ii) Opportunity Cost Funds invested in business or deposited into bank. Useful in decision making. (iii) Out of Pocket Cost Commission to salesman on sales, Carriage inward. Relevant for decision making. (iv) Notional Cost Notional Rent for use of space Relevant, if company benefit by using resource.

Q-37 Nutty Bites produces many edible snacks that are very popular especially among children. Peanuts, Peanut oil are essential ingredients in many of its products. They are currently facing this ethical issue –

“Medical studies have indicated peanut allergic reactions are on the rise. The prevalence is more profound among children. Reactions can range from hives around the mouth to potentially life threatening reactions when exposed even to the slightest trace of peanuts. There is growing media campaign to force companies like Nutty Bites to make disclosure about the presence of peanut on its package labelling”

Nutty Bites is a mid-size company that has a growing market. Risk to peanut exposure can come not just from the presence of peanuts in its products. Some of its bought-in ingredients (raw material input) are cooked in peanut oil. There are risks of “cross- contamination” amongst products. Let us say, an equipment has been used produce cookies that has peanuts. Next, the equipment is used, without being cleaned, to produce chips that does not have peanuts as an ingredient. Some portion of the peanuts / peanut oil could contaminate that specific batch of chips produced. Since labels of chips would not mention “peanuts” as an ingredient, it poses a potential risk of causing allergic reaction to a customer unaware of this contamination.

Management of Nutty Bites has called for a meeting to discuss this issue. “The issue need not be addressed at all. After-all Nutty Bites is doing nothing against the law” is the opinion of many members on the board of the company.

Required

(i) EXPLAIN why Nutty Bites should attempt to address this issue.

(ii) STATE potential benefits that business can garner by addressing this issue.

(iii) RECOMMEND, with reasons, the avenues available to Nutty Bites to address this ethical issue.

(iv) EVALUATE the recommended solutions.

(i) Modern organizations have a moral duty of care to a wider range of stakeholders not just its owners / investors. In this case, it owes a duty of care to anybody who consumes its products. The presence of peanuts or peanut oil makes it a potential “health hazard” to some consumers. Food safety is a fiduciary duty that Nutty Bites owes to the society. Corporate Social Responsibility (CSR) is the duty an organization has towards a wider community.

(ii) Addressing this ethical issue will help Nutty Bites to become a morally responsible organization. The long- term benefits to its business could be as follows:

1. Avoid bad publicity that could potentially damage its reputation and brand image.

2. Avoid potential legal action for tort, committing a civil wrong.

3. Operating environment within the business is more ethical, giving a sense of well-being to its employees.

(iii) Following could be some of the responses that Nutty Bites could take to address the issue:

1. A clear warning in the ingredients box that the factory uses peanuts while manufacturing some of its products. This should be included even in products that do not contain peanuts, to avoid any harm due to risk of cross- contamination. Customers who suffer this allergy, would then be aware of the potential risk of consuming products of Nutty Bites. Protection from potential lawsuits counters any loss of business for Nutty Bites.

2. Segregate areas to have separate processing lines for products with peanuts / peanut oil and those without it. If possible, have segregated staff for the two production lines in order to avoid the risk of cross-contamination. If this is not possible, staff have to be well trained on the risks of cross- contamination. Gloves need to be provided while handling material during production of food products. This should be changed each time staff handle production changes from “peanut variety” to the “non-peanut variety”.

3. Equipment should be thoroughly cleaned while switching production from one variety to another. Fewer changeovers in the production cycle, that is producing products in larger batches, reduces the number of switches during production of different varieties of food products.

4. Storage of peanut material should be well segregated and monitored to avoid contamination.

5. If Nutty Bites has the resources, it could invest in pharma companies that are finding a medical solution to this problem. The food industry could benefit from research and development of treatments to address this life- threatening allergy. A break-through would address a societal problem, while also having a positive impact for growth of Nutty Bites.

(iv) Risk of product safety is an important issue that needs constant review. Review would be of the production process, storage, material handling as well as ingredient of purchased raw materials. The benefit of constant review is that Nutty Bites can immediately identify danger of contamination. For example, is a supplier of raw material changes the production of the ingredients to include peanut / peanut oil, then Nutty Bites can be immediately aware of the change due to its review process. In case of any future litigation, Nutty Bites could defend itself by proving that it had a robust review process in place.

On the other hand, constant review requires time and money, with an ever-present possibility of contamination. It is not feasible to ensure complete safety. Reviewers / quality inspectors could become negligent once the process is well established. This could lead to instances of contamination, even with a review process in place.

To conclude, Nutty Bites is morally responsible to spread awareness that some of its products may contain allergy causing peanuts / peanut oil. It should streamline its storage and production process to avoid risk of cross-contamination.

Q-38

Micro-Guard Industries Limited (MGIL) is a renowned company for a unique range of thought fully engineered products, designed to provide simplified solutions and upscale your home interiors. MGIL engaged in the manufacturing of Power Systems, Batteries, Wires & Cables, Switch Gears & Modular Switches etc. But MGIL is largely famous for its wide range of Voltage Stabilizers. Each product is manufactured in a separate division.

While planning regarding voltage stabilizers division (VSD) for the first half of the fiscal year 20- 21 amid the outbreak of COVID-19, the board get through a report from internal expert committee pertaining to crystal series of voltage stabilizers which says– ‘due to restricted availability of the input factors (on account of lock-down by the government), only 40,000 crystal voltage stabilizers (CVS) is expected to manufactured and sold during the first half of fiscal, against the normal capacity of 75,000 per quarter; that too at 1,600/- per CVS’. At normal capacity level it incurs the following cost to manufacture and sell single unit of CVS–

 Particulars Amount Direct material 575 Direct labour 215 Variable overhead 310 Fixed overhead 300 Cost per unit 1,400

One of the directors suggested– ‘since migrant workers moved to their home states and expected to come back in 3-5 months’ time hence it is better to temporary discontinue (lock- out) the production for the first half of fiscal’. Another director support him by stating– ‘it will give the opportunity to our suppliers (or retailers) to clear the old stock available with them’. On the reference by the board, you (chief management accountant at MGIL) pro vide an estimate to management that 1/3rd fixed overhead at a normal capacity level is unavoidable and additional cost due to discontinue (lock-out) of plant for 6 months and resumption thereafter is 35 lacs.

Required

You are required to ADVISE the management–

(i) Shall they continue the production of CVS or temporary discontinue (lock-out) for the first half of the fiscal year? (Consider monetary aspects)

(ii) The qualitative factors which need to consider, while deciding either discontinue (lock-out) or continue.

(iii) What are the minimum number of CVS that VSD needs to manufacture and sell; in order to economically justify the continuation of the production?

Note– In a legal sense, Lock-out means the temporary closing of a place of employment or the suspension of work, or the refusal by an employer to continue to employ any number of persons employed by him; which is way different from shut-down. But in management accounting lock-out and shutdown both carry the same meaning.

(i) Demand function

b = change in price/change in quantity b = Rs.4/8,000 units = 0.0005

The maximum demand for Rifmn is 10,00,000 units, so where P = 0, Q = 10,00,000, so ‘a’ is established by substituting these values for P and Q into the demand function:

0 = a – (0.0005 × 10,00,000)

0 = a – 500

Therefore, a = 500

Demand function is therefore: P = 500 – 0.0005Q

Marginal cost

 Total (Rs.) Salt X 367.50g x Rs. 0.08 29.40 Salt Y 301.50g x Rs. 0.40 120.60 Labour Given in question 38.60 Machine running cost (30/60 x Rs. 40.00) 20 Total marginal cost per batch 208.60

Marginal revenue function: MR = a – 2bQ

Equate MC and MR and insert the values for 'a' and 'b' from the demand function in step 1

⇒ 208.60 = 500 – (2 × 0.0005 × Q)

Solve the MR function (to determine optimum quantity, Q)

⇒ 208.60 = 500 – 0.001Q

⇒ 0.001Q = 291.4

⇒ Q = 291,400 batches Calculate the optimum price

⇒ P = 500 – (0.0005 × 291,400)

⇒ P = Rs.354.30

Calculate Profit

 Rs. Revenue (2,91,400 batches x Rs. 354.3) 10,32,43,020 Less: Variable costs (2,91,400 batches x Rs. 208.60) 6,07,86,040 Less: Fixed costs (3,00,000 batches x Rs. 35) 1,05,00,000 Profit 3,19,56,980

(ii) Firms often use different pricing strategies when their products are first launched into the market. The most two common approaches are price skimming and penetration pricing.

In penetration pricing, low price is charged initially, thought behind this is that low price will make the product accessible to large number of buyers, so high sales will compensate the low price being charged getting the benefits of economy of scale. This approach works best when customers are price sensitive, R & D and marketing expenses are low, or when competitors will quickly enter the market.

In this case, medicines are highly inelastic in nature so any reduction in price will not increase the demand of the drug, which clearly indicates that market penetration pricing will not help. Skimming Pricing refers to charging high price initially than lower the prices. High price in the early stage of the product’s life cycle is expected to generate high initial cash flows, which will help the company to recover high development cost.

This would enable the company to take advantage of unique nature of the product. In present case, the unique nature of drug, entry barrier (since company has taken patent) requires huge initial investment and considering this market skimming pricing strategy would be more favorable pricing strategy. However, this strategy only works as long as drug is protected by patent.

In addition, a drug firm is required to consider the expected reactions from national price controllers who in turn may be influenced by political factors and public opinion.

Q-39

(a) Modem Packaging Corporation specialised in the manufacture of one litre plastic bottles. The firm has four moulding machines, each capable of producing 100 bottles per hour. The firm estimates that the variable cost of producing a plastic bottle is Rs. 20. The bottles are sold Rs.50 each. Management has been approached by a local toy company that would like the firm to produce a moulded plastic toy for them. The toy company is willing to pay Rs.300 per unit for the toy. The variable cost to manufacture the toy will be Rs.240. In addition, Modem Packaging Corporation would have to incur a cost of Rs. 20, 00,000 to contract the needed mould exclusively for this order. Because of more intricate shape of the toy, a moulding machine can produce only 40 units per hour. The customer wants 1, 00,000 units. Assume that total capacity of all the four machines combined is 10,000 machine hours available during the period in which the toy company wants the delivery of toys. The firm's fixed cost, excluding the costto construct the toy mould, during the same period will be Rs.2, 00, 00,000.

Required

(i) If the management predicts that the demand for its bottles will require the use of 7,500 machine hours or less during the period, should the special order be accepted? Give reasons

(ii) If the management predicts that the demand for its bottles will be higher than its ability to produce bottles, should the order be accepted? Why?

(iii) If the management has located a firm that has just entered the moulded plastic business. This firm has considerable excess capacity and more efficient moulding machines and is willing to subcontract the toy job, or any portion of it for Rs. 280 per unit. It will contract its own toy mould.

DETERMINE Modem Packaging Corporation minimum expected excess machine hour capacity needed to justify producing any portion of the order itself rather than subcontracting it entirely.

(a) Workings

Statement Showing “Contribution / Machine Hour”

 ‘Bottle’ ‘Toy’ Sales (Rs./u) 50.00 300.00 Less: Variable Cost (Rs./u) 20.00 240.00 Less: Specific Fixed Cost (Rs./u) --- 20.00 Contribution (Rs./u) 30.00 40.00 Machine Hours Required per unit 0.01 0.025 Contribution/Machine Hour 3,000 1,600

(i) Modern Packaging Corporation can accept plastic moulded toy’s order as sufficient number of hrs. i.e., 2,500 hrs. (10,000 hrs.- 7,500 hrs.) are available and would be able to generate additional benefit of Rs.40.00 per unit on 1,00,000 units of toys i.e., Rs.40,00,000.

(ii) If the demand for bottle is higher, then more hrs. will be required to produce the additional bottles. Modern Packaging has to decide whether to utilize 2,500 hrs. for bottles or for toy Order.

Machine time is limiting factor. Therefore, contribution per machine hour from both the activities (i.e., bottles and toys) should be calculated to decide whether the order should be accepted. Contribution per hour is less in case of toys (refer workings). Therefore, Modern Packaging should utilize the remaining 2,500 hours for manufacturing bottles rather than to fulfil the order for supply of toys. Prioritizing production based on contribution per machine hour would maximize profits.

(iii) Minimum number of toys needed to be manufactured to justify the increase in fixed cost of Rs.20,00,000 to make the mould is 50,000 toys {20,00,000/ (Rs.280 - Rs.240}.

Thus, as long as company has excess capacity available to manufacture more than 50,000 toys it is cheaper to produce than to buy from subcontractor. Minimum Expected Excess Machine Hour Capacity to justify =

= 50,000 toys / 40 toys

= 1,250 hours

Q-40

The budgeted cost data of a product manufactured by Ayudhya Ltd. is furnished as below:

 Budgeted units to be produced 2,00,000 Variable cost (Rs.) 32 per unit Fixed cost (Rs.) 16 lacs

It is proposed to adopt cost plus pricing approach with a mark-up of 25% on full budgeted cost basis. However, research by the marketing department indicates that demand of the product in the market is price sensitive. The likely market responses are as follows:

 Selling price (Rs. per unit) 44 48 50 56 60 Annual Demand (units) 1,68,000 1,52,000 1,40,000 1,28,000 1,08,000

Required

Analyse the above situation and determine the best course of action.

Analysis of Cost plus Pricing Approach The company has a plan to produce 2,00,000 units and it proposed to adopt Cost plus Pricing approach with a markup of 25% on full budgeted cost. To achieve this pricing policy, the company has to sell its product at the price calculated below:

 Qty 2,00,000 units Variable Cost (2,00,000 units × ₹ 32) 64,00,000 Add: Fixed Cost 16,00,000 Total Budgeted Cost 80,00,000 Add: Profit (25% of ₹ 80,00,000) 20,00,000 Revenue (need to earn) 1,00,00,000 Selling Price per unit 50 PU

However, at selling price Rs. 50 per unit, the company can sell 1, 40,000 units only, which is 60,000 units less than the budgeted production units.

After analyzing the price-demand pattern in the market (which is price sensitive), to sell all the budgeted units market price needs to be further lowered, which might be lower than the total cost of production.

Statement Showing “Profit at Different Demand & Price Levels”

 I II III IV V Qty. (units) 1,68,000 1,52,000 1,40,000 1,28,000 1,08,000 Rs. Rs. Rs. Rs. Rs. Sales 73,92,000 72,96,000 70,00,000 71,68,000 64,80,000 Less: Variable Cost 53,76,000 48,64,000 44,80,000 40,96,000 34,56,000 Total Contribution 20,16,000 24,32,000 25,20,000 30,72,000 30,24,000 Less: Fixed Cost 16,00,000 16,00,000 16,00,000 16,00,000 16,00,000 Profit (Rs.) 4,16,000 8,32,000 9,20,000 14,72,000 14,24,000 Profit (% on total cost) 5.96% 12.87% 15.13% 25.84% 28.16%

Determination of the Best Course of Action

1. Taking the above calculation and analysis into account, the company should produce and sell 1,28,000 units at Rs. 56. At this price company will not only be able to achieve its desired mark up of 25% on the total cost but can earn maximum contribution as compared to other even higher selling price.

2. If the company wants to uphold its proposed pricing approach with the budgeted quantity, it should try to reduce its variable cost per unit for example by asking its supplier to provide a quantity discount on the materials purchased.

Q-41

Amber Ltd. is a leading company in the Footwear Industry. The company has four factories in different locations with state of the art equipments. Due to competition in the market, company is continually reviewing its product range and enhancing its existing products by developing new models to satisfy the demands of its customers.

The company currently has a production facility which has a capacity of 3,500 standard hours per week.

Product 'Comfort' was introduced to the market six months ago and is now about to enter the maturity stage of its life cycle.

However, research by the marketing department indicates that demand of the product 'Comfort' in the market is price sensitive. The likely market responses are as follows:

 Selling price per unit (Rs.) 1,750 1,600 1,525 1,450 1,300 Sales demand per week (units) 550 725 1,000 1,150 1,200

The variable cost per unit of manufacturing 'Comfort' is Rs. 750. Standard hours used to manufacture one unit is 2 hours.

Product 'Sports' was introduced to the market two months ago using a penetration pricing policy and is now about to enter its growth stage. Each unit has a variable cost of Rs. 545 and takes 2.50 standard hours to produce. Market research has indicated that there is a linear relationship between its selling price and the number of units demanded, of the form P = a - bx. At a selling price of Rs. 1,000 per unit demand is expected to be 1,000 units per week. For every Rs. 100 increase in selling price the weekly demand will reduce by 200 units and for every Rs. 100 decrease in selling price the weekly demand will increase by 200 units.

Product 'Ethnic' is currently being developed and which is about to be launched in the market. This is a highly innovative designer product which the company believes that it will have a revolutionary impact on the market and consumer behaviour. The company has decided to use a market skimming approach to pricing this product during its introduction stage.

Required

(i) ADVISE which of the above five selling prices should be charged for product 'Comfort', in order to maximize its contribution during its maturity stage.

(ii) CALCULATE the number of units to be produced of product 'Sports' in order to utilize all of the spare capacity from your answer to (i) above and the selling price per unit of product 'Sports' during its growth stage.

(b) COMPARE penetration and skimming pricing strategies during the introduction stage, using product 'Ethnic' to illustrate your answer.

(c) EXPLAIN with reasons, for each of the stages of 'Ethnic's product life cycle, the changes that would be expected in the

(i) average unit production cost

(ii) unit selling price

(i)Selling Price for “Comfort” that would maximize its contribution at Maturity Stage

Contribution per unit of “Comfort” = Selling Price per unit – Variable Cost per unit Total Contribution = Contribution per unit × Units sold

All figures in Rupees

 Sales (units) per week 550 725 1,000 1,150 1,200 Selling Price per unit 1,750 1,600 1,525 1,450 1,300 Less: Variable Cost per unit 750 750 750 750 750 Contribution per unit 1,000 850 775 700 550 Total Contribution 5,50,000 6,16,250 7,75,000 8,05,000 6,60,000

Total contribution is maximum when sales are 1,150 units. Therefore, the selling price per unit of “Comfort” should be Rs. 1,450 per unit.

(ii) Production Number of “Sports” and Selling Price per unit

Amber Ltd. has a production capacity of 3,500 hours per week. As explained in (i) above, it would manufacture 1,150 units of “Comfort” per week. Each unit of “Comfort” requires 2 hours of production. Therefore, total production hours for Comfort would be 1,150 units × 2 hours = 2,300 hours per week.

Production capacity remaining to manufacture “Sports” = 3,500 hours – 2,300 hours = 1,200 hours per week. Each unit of “Sports” requires 2.5 hours of production.

Therefore, the number of “Sports” units that can be produced = 1,200 hours / 2.5 hours = 480 units per week.

Linear relationship between Selling Price and Number of Units Demanded has been given to be P= a – bx.

P = Selling Price per unit

a = Selling Price when demand will be zero

b (slope) = Change in Price / Change in Quantity x = Quantity Demanded

Given, at a Selling Price of Rs.1,000 per unit, Quantity Demanded will be 1,000 units per week. For every Rs.100, per unit increase / decrease in Selling Price, the Quantity Demanded will decrease / increase by 200 units per week respectively. A Rs.500 per unit increase in Selling Price will result in fall of 1,000 units of Sales per week. The Selling Price at which Sales will be Zero i.e. a = Rs.1,500 per unit.

b (slope) = Change in Price / Change in Quantity = Rs.100 / 200 = 0.50

Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than short term profit maximization. Thus, substituting the values in the equation to find the Selling Price of “Sports” when the Quantity Sold is 480 units:

P = a – bx

= 1,500 – 0.50 × (480)

= 1,500 – 240

= Rs.1,260

Sports should be sold at Rs.1,260 per unit during the growth stage.

Alternative

Hours after production of Product ‘Comfort’ (3,500-1,150×2) =1,200 hours to be utilized to produce product ‘Sports’.

1,200 hours/ 2.5 = 480 units

10% increase in selling price will lead to 20% decrease in demand of units of product “Sports”. Here we can produce only 480 units which amounts to 52% decrease in units so the selling price should be increased by 26% as per given price demand function. So, the selling price per unit will be 1,260 for 480 units of product “Sports”.

(b) “Ethnic” is given to be a highly innovative product that is about to be launched into the market. The product with unique features that will differentiate it from other products leading to a revolutionary impact on market and customer behaviour. There seem to be no competitors providing similar products.

Skimming Price Strategy is adopted to charge high prices in the introduction stage in order to recover costs. Skimming Price will be suitable for “Ethnic” because:

• Market for the product is not yet established. Initially high promotional expense may have to be incurred to create customer awareness and build a market for the product.

• Due to its innovative feature, the customers would not mind paying a premium for the unique product offering. Demand would be inelastic.

• The market demand is unknown. Initial capital outlay to produce this product may be high, resulting in high cost of production.

• Production and promotional costs in the initial years is likely to be high. Therefore, a higher selling price would help Amber Ltd. to recover the costs. Since demand is likely to be inelastic, charging a premium may not be a problem.

• The price can be gradually reduced once the market for the product is established. Competitors may reverse engineer and offer similar products, due to which price may have to be lowered in the long run to retain customers.

Penetration Pricing is adopted to charge a low price in the initial stage for penetrating the market as quickly as possible. For a new product, this low-price strategy will popularize the product. Once the market is established, the price may be increased. Penetration pricing will be suitable when:

• Demand for the product is elastic, more demand when prices are low.

• Large scale production of the product yields economies of scale.

• Threat of competition requires prices to be set low. It serves as an entry barrier to prospective competitors as well.

Product “Ethnic” is an innovative product that the manufacturer believes will change the whole market once it is launched. A strategy of penetration pricing could be effective in discouraging potential new entrants to the market. However, the product is believed to be unique and as such demand is likely to be fairly inelastic. In this instance a policy of penetration pricing could significantly reduce revenue without a corresponding increase in sales. Thus, this strategy is not suitable for “Ethnic”.

(c) Impact on Unit Selling Price and Average Cost of Production per unit at each stage of “Ethnic” Product Lifecycle

Introduction Stage

As explained in (b) above, at the Introduction Stage of Lifecycle, due to high cost of production and initial promotion expenditure, the unit cost of production will be high. Using Skimming Price Policy, the unit selling price will also be high.

Growth Stage

This is the second phase of the Life-Cycle, product awareness among customers would result in increased demand. Therefore, scale of production likely to increase. The new market segment would attract competitors, who are like to reverse engineer and offer similar products in the market. Promotional activities and marketing activities need to continue to maintain and gain market share.

Accordingly, the unit selling price would reduce from the introduction stage on account of the following reasons:

•  Competitors offering similar product would take away the uniqueness feature of “Ethnic”.

• Again, to gain market share, the unit selling price may have to be lowered to make it attractive to a larger segment of customers.

The unit cost of production is also likely to reduce due to the following reasons:

• Increased production would result in increased material procurement from suppliers.

• Bulk purchasing discounts can be negotiated with them to lower cost of production.

• Learning curve and experience would enable the labor force to become more efficient. This leads to higher production with the same level of resources leading to cost savings.

• Larger production batches due to increase in scale of operations will reduce the unit variable overhead cost.

•  Economies of scale would result due to fixed overhead cost being spread over larger number of units.

Maturity Stage

The third phase of Product Life-Cycle that is characterized by an established market for “Ethnic”. After rapid growth in sale volume in the previous stages, growth of sales for the product will saturate. Competition would be high due to large number of rivals in the market, this may lead to decreasing market share.

It is likely that the price of the product will be lowered further at the maturity stage in a bid to preserve sales volumes. The company may attempt to preserve sales volumes by employing an extension strategy rather than reducing the selling price. For example, they may introduce product add-ons to the market that are compatible with “Ethnic”.

Unit production cost will remain constant

• Direct material cost will remain constant. If procurement is lower than the growth phase, it might even lead to slightly higher prices since supplier may not extend bulk discounts.

• The benefits of efficient production due to the effect of learning and experience may also have waned. Therefore, unit labour cost is also likely to remain constant.

• Since scale of production is no longer increasing, the unit variable overhead costs are also likely to remain constant.

Decline Stage

This last stage in the product cycle is characterized by saturated market, declining sales, change in customer’s tastes etc. Profitability may slowly start decreasing with fall in sales.

At the decline stage, Product “Ethnic” is likely to have been surpassed by more advanced products in the market and consequently will become obsolete. The company will not want to incur inventory holding costs for an obsolete product and is likely to sell “Ethnic” at marginal cost or perhaps lower. Sales volumes at the decline stage are likely to be low as the product is surpassed by new exciting products that have been introduced to the market. Furthermore, the workforce may be less interested in manufacturing a declining product and may be looking to learn new skills. For both of these reasons, unit production costs are likely to increase at the decline stage.

Q-42

Rapid Heal Tech Ltd. (RHTL) is a leading IT security solutions and ISO 9001 certified company. The solutions are well integrated systems that simplify IT security management across the length and depth of devices and on multiple platforms. RHTL has recently developed an Antivirus Software and company expects to have life cycle of less than one year. It was decided that it would be appropriate to adopt a market skimming pricing policy for the launch of the product. This Software is currently in the Introduction stage of its life cycle and is generating significant unit profits.

Required

(i) Explain, with reasons, the changes, if any, to the unit selling price that could occur when the Software moves from the Introduction stage to Growth stage of its life cycle.

(ii) Also suggest necessary strategies at this stage.

Following acceptance by early innovators, conventional consumers start following their lead. New competitors are likely to now enter the market attracted by the opportunities for large scale production and profit. RHTL may wish to discourage competitors from entering the market by lowering the price and thereby lowering the unit profitability. The price needs to be lowered so that the product becomes attractive to different market segments thus increasing demand to achieve the growth in sales volume.

Strategies at this stage may include the following

1. Improving quality and adding new features such as Data Theft Protection, Parental Control, Web Protection, Improved Scan Engine, Anti Spyware, Anti Malware etc.

2. Sourcing new market segments/ distribution channels.

3. Changing marketing strategy to increase demand.

4. Lowering price to attract price-sensitive buyers.

Q-43

State the appropriate pricing policy in each of the following independent situations:

(i) 'A' is a new product for the company and the market and meant for large scale production and long term survival in the market. Demand is expected to be elastic.

(ii) 'B' is a new product for the company, but not for the market. B's success is crucial for the company's survival in the long term.

(iii) 'C' is a new product to the company and the market. It has an inelastic market. There needs to be an assured profit to cover high initial costs and the usual sources of capital have uncertainties blocking them.

(iv) 'D' is a perishable item, with more than 80% of its shelf life over.

 Situation Appropriate Pricing Policy (i) ‘A’ is a new product for the company and the market and meant for large scale production and long term survival in the market.  Demand is expected to be elastic. Penetration Pricing (ii) ‘B’ is a new product for the company, but not for the market. B’s success is crucial for the company’s survival in the long term. Market Price or Price Just Below Market Price (iii) ‘C’ is a new product to the company and the market. It has an inelastic market. There needs to be an assured profit to cover  high initial costs  and the unusual sources of capital have uncertainties blocking them. Skimming Pricing (iv) ‘D’ is a perishable item, with more than 80% of itsshelf life over. Any Cash Realizable Value*

(*) this amount decreases every passing day.

Q-44

Zutus Ltd. is a leading Indian Pharmaceutical company which is a fully integrated, global healthcare provider. With in-depth domain expertise in the field of healthcare, it has strong capabilities across the spectrum of the pharmaceutical value chain. Zutus has earned reputation worldwide amongst harmaceutical companies for providing comprehensive and complete healthcare solutions.

One of the drugs, Rifmn is an antibiotic used to treat contagious disease “Tbis”. Rifmn is a patented medicine. The patent for which is now going to expire, and several other competitors are expected to enter in the market for selling the medicine using the same components of chemicals, under different other name. In order to reposition itself in the market, the company is reviewing its pricing policy considering the market change and other threat.

The market research for Rifmn indicates that for every Rs.4 decrease in price, demand would be expected to increase by 8,000 batches, with maximum demand for Rifmn being one million batches.

Each batch of Rifmn is currently made of using chemical salts:

Salt X: 367.50 gm at Rs.0.08 per gm Salt Y: 301.50 gm at Rs.0.40 per gm

Each batch of Rifmn requires 30 minutes of machine time to make and the variable running costs for machine time are Rs.40 per hour. The fixed production overhead cost is expected to be Rs.35 per batch for the period, based on a budgeted production level of 3, 00,000 batches. The skilled workforce who has been working on Rifmn until now are being shifted onto the production of Zutus Company’s new antiviral drug (injection) for Viral Disease-19 which costs millions of to develop. Zutus has obtained patent for this revolutionary drug and it is expected to save millions of lives all across the world. The launch of this drug is excitedly anticipated all over the world, while its demand in unknown and no other similar specific drug exists. The average labor cost (outsourcing) of each batch of Rifmn is Rs.38.60. The management of Zutus considers that pricing decision of Rifmn should be based on each batch.

Required

(i) CALCULATE the optimum (profit-maximizing) selling price for Rifmn and the resulting annual profit which Zutus will make from charging this price.

(ii) RECOMMEND the pricing strategy for launching of new antiviral drug. [Note– If P = a - bQ, then MR = a - 2bQ]

(i) The loss in case of temporary discontinue is 185 lakhs which is less than the loss in case of continuing the production of CVS (i.e., 250 lakhs), hence considering monetary aspects it is advised to discontinue (lockout) the production of CSV for the first half of the fiscal year 2020- 21.

Comparative Cost and Benefit for the first half of the fiscal year 2020-21

 Continue – 40,000 units Dis-continue (Lock-out) Particulars Amount in Rs. Particulars Amount in Rs. Contribution (Rs. 500 x 40,000 units) 200 lakhs Additional Cost (resumption) 35 lakhs Fixed Cost 450 lakhs Fixed Cost (unavoidable) 150 lakhs Loss 250 lakhs Cost 185 lakhs

Working note 1 – Contribution per unit

 Particulars Amount in Rs. Sale Price 1,600 Variable Cost (575 + 215 + 310) 1,100 Contribution 500

Working note 2 – Fixed Cost & Avoidable Component

 Particulars Amount in Rs. Total Fixed Cost for the first half [(75,000 x 2) units x 300] 450 lakhs Unavoidable (1/3rd) 150 lakhs Balance – Avoidable (2/3rd) 300 lakhs

(ii) Qualitative factors, while deciding either discontinue (lock-out) or continue.

1. Government advisory regarding lock-down and lock-in – MGIL is legally bound to observe and comply with government advisories regarding lock-down and lock-in.

2. Customer relations – Discontinuing the production, even temporary may cause adverse reactions from customers, they may move to another product or brand which capable to substitute CVS. Further as per the director's opinion old stock will be cleared during such period, this may cause a loss of reputation.

3. Supplier relations – The trade relation with suppliers of VSD/MGIL may turn bitter if supply halted. May also cause a loss of goodwill. Although the director argued that supplier can sell the old stock available with them, but it is nowhere mentioned that whether all the supplier or retailer have a requisite amount of stock in order to cater the need of their customers.

4. Employee/Worker relations – One of the directors mentioned that migrant workers moved to their home states and expected to come back in 3-5 months. It is important to identify– how much of the workforce at VSD is migrant and what is the duration of lock-down announced by the government, is there any relaxation in the same (for example working with 1/3 or 1/2 capacity)? VSD also need to consider guideline and term of the agreement with workers, in regard to the compensation they will get, if it is decided to lock-out (temporarily discontinue the production). Apart from this, staff (or workers) morale is also an important factor to consider.

5. Timing of shutdown – Timing (when to lock and unlock) and duration of lockout, both are important form preview of VSD, because the kind of product in which MGIL deals either in demand during the relevant season or near festival season (during sales and bonanzas).

6. Whether discontinuing a segment have adverse effects on the sale of other products – CVS is a complementary product to other models sold by VDS and product sold by MGIL. Hence, impact of discontinuing the production of CVS on sale of these relate products need to be considered.

In order to economically justify the decision of continuing the production, VSD need to manufacture and sell such number of CVS; so that loss (if continued) shall be less than or equal to the loss/ cost of 185 lakhs (which is due to discontinue (lockout) of plant for the first half of fiscal 2020-21).

So, let presume ‘x’ is such number of CSV 450 Lakhs – ( 500 × ’x’) ≤ 185 Lakhs

⇒ 500x ≥ 265 Lakhs x ≥ 53,000 Units

Hence, VSD need to manufacture and sell at least 53,000 units of CVS; in order to economically justify the continuation of the production

Q-45

State the most appropriate pricing policy to be adopted in the following independent situations: (Situations need not be copied. Only policy name is required.)

(i) The company manufactures original equipment and does railways contract work. Other companies are also there in the market who also undertake similar projects.

(ii) Patented Drug for COVID 19 ready to be launched in the market.

(iii) A bike manufacturer is launching an innovative, technologically advanced bike in the highly priced segment.

(iv) A company making a variant of sanitizers, trying to enter the market. The same varieties of sanitizers are already successfully capturing the market.

(v) A successful mobile manufacturing company has built into its latest tablet, an additional sliding screen and improved processing capabilities so that the tablet is almost a laptop.

 i Sealed Bid Pricing ii Skimming Pricing iii Premium Pricing/Skimming Pricing iv Market Price v Demand Based Pricing

Q-46

Water Utilities Services (WUS) is a parastatal company established with an aim for supplyand distribution of water in Mumbai as well as supply of water to the various local authoritiesfor distribution to villages and other small cities adjacent to Mumbai. This involved planning,operating,treating,maintaining,anddistributingwaterresourcesinthecountry’surbancentres and other areas mandated by Maharashtra Government. Its mission is “To providesustainablewaterin acosteffectiveandenvironmentallyfriendlymannertotheeconomy”.

The government ensures that WUS does not take advantage of its monopoly position in the regional area by increasing prices. The government controls majority of services through its water regulatory body which determines an acceptable margin level (ROCE) and ensures that the pricing of WUS within these areas does not break this level. The remaining work i.e. a water bottle operation (WBO) is not regulated by government and WUS charges a market rate for water supply in bottle. The regulator compute return on capital employed (ROCE) of WUS based on its own valuation of the capital assets which are used in operation and the profit from those services.

Acceptable level of ROCE set by the regulator is 7.00%. If WUS breach this level, then the company would be penalized. WUS board is trying to improve the performance for the benefit of the shareholders. In order to communicate the objective of maximizing shareholders’ wealth, the directors have decided to consider economic value added (EVA) as the key performance indicator.

Compute EVA of WUS based on the following information for the year ending 31 March 2019:

 Particulars Water Distribution Operation (WDO) Water Bottle Operation (WBO) Total Rs. in Crore Rs. in Crore Rs. in Crore Revenue 555.00 186.00 741.00 Less: Operating Cost 460.00 119.00 579.00 Operating Profit 95.00 67.00 162.00 Less: Finance Charges 46.00 Profit Before Tax 116.00 Less: Tax at 30% 34.80 Profit After Tax 81.20 Capital Employed 2018-19 2017-18 Rs. in Crore Rs. in Crore Audited Accounts 1,616.20 1,495.00 Determined by the Regulator (for WDO Only) 1,558.00 1,422.00

Notes

1. Operating Costs includes:

 Particular 2018-19 2017-18 Rs.in Crore Rs. in Crore Depreciation 118 114 Provision for doubtful debts 4 1 Research and Development 24 --- Other non-cash items 14 12

Economic depreciation is Rs.166 Crore in 2018-19. In FY 2017-18, economic and accounting depreciation were assumed to be the same.

2. Current year tax paid is (Rs.18crore) and deferred tax provisions of Rs.1.50 crore has been adjusted. There was no deferred tax balance before 2018-19. The provision for doubtful debts was Rs.9 crore in the 2018-19 balance sheet.

3. Research and development has been non-capitalized. It belongs to a new project that will be developed over five years and is expected to be of long-term benefit to the company. 2018-19 is the first year of this project.

4.Cost of Capital

 Equity 14% Debt (Pre-tax) 6%

5. Gearing of WUS

 Equity 45% Debt 55%

Required

(i) EVALUATE the financial performance of WUS using EVA.

(ii) ASSESS whether WUS comply with its acceptable ROCE level Advise on how to improve profitability.

(i) Computation of NOPAT

 Particulars Rs. in Crore Operating Profit 162.00 Add: Non-Cash Items 14.00 Accounting Depreciation 118.00 Doubtful Debts 4.00 Research and Development 24.00 Less: Economic Depreciation 166.00 Tax Paid 18.00 Tax Saving on Interest (Rs.46 × 30%) 13.80 NOPAT 124.20

Computation of Capital Employed

 Particulars Rs. in Crore Capital Employed as on 31.03.2018 1,495.00 Add: Provision for Doubtful Debt as on 31.03.2018 5.00 Other Non-Cash Items (incurred in 2017-18) 12.00 Adjusted Opening Capital Employed 1,512.00

WACC = 0.45 × 14% + 0.55 × 6% × (1 – 30%)) = 8.61%

EVA = NOPAT – (WACC × Capital Employed) = – 5.98 Crores

Evaluation

Presently, WUS is distorting value as it is not able to meet the economic cost of its own capital. This put the company into the question of perpetual succession and lead the company against shareholder’s interest. The reason could be a higher cost of equity for WUS. The investing risk should be low since 75% of the services that the company renders are important for the economy and demand is guaranteed in future. Optionally, WUS needs to either increase its NOPAT enough for break even on economic value added or slash its capital employed by selling unutilized or under-utilized assets.

(ii) Regulatory ROCE: Target 7.00%

ROCE = $${Operating Profit\over capital employed} 100%$$%

Operating Profit

= $${95\over 1422}$$ x  100.00%

= 6.68% The ROCE is within the acceptable ROCE of 7.00%.

(iii)Operating Margins

Water Distribution Operation = 17.12% Water Bottle Operation = 36.02% Advise

Operating margin from WBO is 36.02% compared to 17.12% (WDO). WUS may use the WDO activities as a trusted source of cash profit to reinvest in expansion of the WBO. Expansion through acquisition of appropriate non-regulated businesses using the cash generated by the regulated activities might be a good decision.

Further, WUS may improve profitability by controlling costs within WDO activities through performance measurement. The regulatory body cannot argue that the company is overcharging its customers to increase profit margin. This is possible through strict observance of expenses and using cost savings techniques through efficiency improvements. In order to control cost within WDO, targets should be based on minimal variances and adopting cost cutting methods.

Overall, In WDO, there is only a limited scope for increase in the operating profit since the maximum operating profit allowed is Rs.99.54 crore i.e. 7.00% of Rs.1,422 crore of capital employed. Thus, WUS should go to expand its WBO as this is producing higher operating profit margins.

Q-47

Beta Control (BC) is a global leader in manufacturing of commercial building control systems with over 250 distributors and many thousands of installations in more than 50 countries. Control systems involve air conditioning systems, facility management, energy and water management, access control and security controls etc. At BC, manufacturing is done at a number of factory sites where some products are easy and largely produced and have a long life while other products are intricated and have a short life due to changing technologies. BC’s mission statement is ‘to keep you ahead through control systems that improve productivity and save energy’.

A Newly appointed chief executive officer (CEO) is anxious about declining share price of BC in the last two years. She identified that the business has grown through acquisition and senior management have focused on making corporate deals but not on making control systems. She announced that the BC’s focus must be on optimization and upgradation of its value generation rather than just getting bigger through acquisitions.

Assuming yourself as a performance management expert of BC, the CEO has asked you to aid her in her improvement programme. Firstly, she wants your views on the use of EVA as the key performance metric at BC. You are given the current EVA computation (Annexure1) but there is some suspicion about whether the assistant who has done this work is sufficiently well trained about this method. So, she requires you to examine his accuracy and the assumptions forming part of the calculation.

Required

Write a report to the chief executive officer to EVALUATE the accuracy of the EVA calculation and the assumptions.

Annexure 1

NOPAT

 Particulars Year ended 31st March 2019 Rs. In lacs Notes Operating Profit 1,102.80 Add: Non-Cash Expenses 30.20 Marketing Expenditure Capitalised 46.20 7 Less: Tax 269.60 9 Lost Tax Relief on Interest 48.96 Net Operating Profit After Tax (NOPAT) 860.64

Capital Employed

 Particulars Year ended 31st March 2019 Rs. In lacs Notes From the Statement of Financial Position 4,802.00 10 Add: Marketing Expenditure Capitalized 46.20 7 Adjusted Capital Employed 4,848.20

WACC = (1/2 × 15%) + (1/2 × 7·8%)

= 11.40%

EVA = NOPAT – (WACC × Capital Employed)

= Rs.860.64 L – Rs.4,848.20 L × 11.40% =

= Rs.860.64 L – Rs.552.69 L

= Rs.307.95 L

Assumptions and Notes

1. Debt/Equity 1:1

2. Cost of Equity is 15.00%

3. Cost of Debt (pre-tax) is 7.80%

4. Tax Rate is 30.00%

5. Interest charged in the period was Rs.163.20 L.

6. In current fiscal year, BC spend Rs.80.00 L in Training and Development by leveraging the latest digital technologies including virtual classrooms to deliver highly relevant training to staff at the point of need.

7. Marketing Expenditure has been Rs.46.20 L each year for the last two years to build the long- term brand.

8. The total R & D spending was Rs.20 L during this year for in- depth study of the TCP/IP protocols. The TCP/IP based products have not been launched yet.

9. BC has paid Tax of Rs.260 L while the tax charged per the accounts was Rs.269.60 L.

10. Capital employed during the Period (from the statement of financial position)

 Opening 4,564.00 L Closing 4,802.00 L

Report

To: CEO, Beta Control

From: Performance Management Expert Date: 31st May 2019 Subject: Evaluation of EVA at Beta Control

EVA provides a link between decisions, performance measures and rewards, which focuses managers on performing better. Incentive schemes based on EVA provide better quality information and motivation in making decision which in turn maximise shareholder’s wealth. In other words, EVA links the operating returns to the assets that were used to generate those returns. The learning which flows from EVA analyses can be perceptive and can allow the manager not only to identify areas of weakness in performance but also to easily find solutions. BC is a multiproduct company having number of factory sites. EVA can help to appraise divisional contributors to, or detractors from, overall profitability. Thus, managers may be educated through EVA and pursue such objectives that improve operating profits investing more capital. In addition, this report deals with evaluation of the accuracy and assumptions used in the calculation of BC’s EVA. There are many errors in the present calculation of EVA. These have been discussed below and revised calculations are enclosed.

• Non-Cash Expenses have been correctly added back to the profit as these are expenses which do not affect the cash flow of a given period.

• Addition back of Marketing Expenditure is also correct as spending contributes to future valuecreation. For the same reason, the prior year spending is also added in to capital employed.

• Training and Development Expenses should be capitalised. Training and Development Expenses have been treated as an expense in the income statement, they should be added back to profit, and added to capital employed (at the end of the year).

• Research and Development (R & D) Expenses should be treated as marketing expenditure for long period.

• The tax expenses in the EVA calculation should be the tax paid with adjustment for lost tax relief on interest and not the adjusted amount of tax charged in the accounts.

• The WACC is incorrect because it should be based on post-tax cost of debt.

• Generally, a company takes, at least, a year’s time to earn a return on investment. Thus, the capital employed figure should be based on the beginning numbers.

NOPAT

 Particulars Year ended 31st March 2019 (Rs. in Lacs) Operating Profit 1,102.80 Add: Non-Cash Expenses 30.20 Marketing Expenditure Capitalised 46.20 Training & Development Expenses 80.00 R & D Expenses 20.00 Less: Tax 260.00 Lost Tax Relief on Interest 48.96 Net Operating Profit After Tax (NOPAT) 970.24

Capital Employed

 Particulars Rs. in Lacs From the Statement of Financial Position (Starting) 4,564.00 Marketing Expenditure Capitalized 46.20 Adjusted Capital Employed 4,610.20

WACC =(1/2 × 15%) + (1/2 × 7·8% × 70%)

=10.23%

EVA =NOPAT – (WACC × Capital Employed)

= Rs.970.24 L – Rs.4,610.20 L × 10.23%

=Rs.498.62 L

The recomputed EVA has increased from Rs.307.95 Lacs to Rs.498.62 Lacs which shows a positive position for BC as it adds up the shareholder ’s wealth.

Q-48

AKG Limited has three autonomous divisions. The divisions are evaluated on the basis of ROI, with year end bonuses given to divisional managers who have the highest ROI. Operating results of Division II for the last year are given below:

 Rs. Sales 2,10,00,000 Less: Variable Expenses 1,26,00,000 Contribution margin 84,00,000 Less: Fixed Expenses 67,20,000 Net Operating Income 16,80,000 Divisional Operating Assets 52,50,000

The company's overall ROI for the last year was 18% (considering all divisions). Division II has an opportunity to add a new product line that would require an investment of Rs. 30,00,000. Other details of the new product line are as follows:

 Rs. Sales Rs. 90,00,000 per annum Variable Expenses 65% of sales Fixed Expenses Rs. 25,20,000 per annum Life cycle of the product line 5 years

Though Division II is performing well, but many a times, the customers complained that they had to wait for long after placing the orders. The company is interested in cutting the amount of time between when a customer places an order and when the order is completed. For the last year, the following data were reported in respect of Division II:

 Inspection time = 0.5 days per batch Process time = 2.8 days per batch Wait time = 16.0 days per batch Queue time = 4.0 days per batch Move time = 0.7 days per batch

In addition to financial performance measures, the company wishes to introduce a variety of non-financial performance measures.

The company has set aggressive targets in both sales growth and ROI for the coming year. The company's strategy for achieving these goals includes a campaign aimed at building brand recognition, customer retention, and improvement in product quality, on time delivery to customers, expansion of eco-friendly product line and introduction of limited edition items.

Required:

i) CALCULATE last year's ROI of Division II.

ii) DISCUSS whether the manager of Division II would accept or reject the new product line, if he takes his decision based solely on divisional ROI.

iii) ADVISE how residual income approach can be used as an alternative financial measure for evaluation of managerial performance in the best interest of the company.

iv) CALCULATE Manufacturing Cycle Efficiency (MCE) and interpret the result.

v) STATE what percentage of the production time is spent in non-value added activities.

vi) CALCULATE the delivery cycle time.

vii) CALCULATE the new MCE if by using Lean Production all queue time can be eliminated.

viii) Based on the above information and using a Strategy Map TABULATE two objectives and two measures for each perspective across the four dimensions of a balanced scorecard in the following format :

 Perspective Strategic Objective Measure

(i) Calculation of last year ROI of Division II

= Controllable Profit/ Controllable Net Asset

= Rs.16,80,000/ Rs.52,50,000

= 32%

(ii) Calculation of ROI of New Product Line

 Particulars Amount (Rs.) Sales 90,00,000 Less: Variable Cost 58,50,000 Controllable Contribution 31,50,000 Less: Fixed Cost 25,20,000 Controllable Profit 6,30,000 Investment Available 30,00,000 Return on the Proposed Line (ROI) 21%

The manager of Division II would be unwilling to invest the additional Rs.30 lacs because this would decrease the Division II’s ROI of 32% to 28%. [Rs.16,80,000+Rs.6,30,000/ (Rs.52,50,000+Rs.30,00,000)]

iii) Generally, a manager who is evaluated based on ROI will reject any project whose rate of return is below the Division’s current ROI even if the rate of return of the project is above the company’s minimum required rate of return. In contrast, managers who are evaluated using residual income will pursue any project whose rate of return is above the minimum required rate of return, because it will increase their residual income. So, in the best interest of the company as a whole, residual income approach can be used for evaluation of managerial performance.

Alternative

To overcome some of the dysfunctional consequences of ROI, the residual income approach can be used. For the investment decision for Divisions II, the residual income calculations are as follows:

 Proposed Investment Rs. 30,00,000 Controllable Profit Rs.6,30,000 Cost of Capital (18%) Rs.5,40,000 Residual Income(RI) 90,000

This calculation indicates that the residual income of Division II will increase if manager accept the project. However, it is important to note that Residual Income does not always point to the right decision, because notional interest on accounting capital employed is not the same as IRR on cash investment. This Project has 1.65% IRR. Overall, Residual Income is more likely than ROI to improve when managers make correct investment decisions, and so is probably a ‘safer’ basis than ROI on which to measure performance.

(iv)Manufacturing Cycle Efficiency (MCE)

= Processing Time/Inspection Time + Process Time + QueueTime + Move Time + Wait Time

= 2.8 days/0.5 days + 2.8 days + 4.0 days + 0.7 days + 16.0 days

= 11.67%

Interpretation

In AKG, the MCE is 11.67%, which means that 88.33% of the time a unit is in process is spent on the activities that do not add value to the product. Monitoring the MCE helps companies to reduce non - value added activities and thus get products into the hands of customers more quickly and at a lower cost.

(v)Percentage of Time Spent on Non- Value Added Activities

= 100% -11.67%

= 88.33%

(vi)Delivery Cycle Time

= 0.5 days + 2.8 days + 4.0 days + 0.7 days + 16 days = 24 days

(vii)Revised MCE

=$${2.8 days\over 0.5 days + 2.8 days + 0 days + 0.7 days + 16 days}$$

= 14%

(viii)

 Perspective Strategic Objective Measure Financial Improve ROI % increase in ROI Increase Sales % increase in sales Customer Perspective Improve brand recognition % of target audience who recognize brand Customer retention %of complaints responded  % increase in repeat customers Internal Perspective Improve in product quality % reduction in defect rate Improve on time delivery to  customers % of orders on time Reduction in time spent in  non-value added activities % increase in MCE Learning & Innovation Expansion of eco-friendly product line No of eco-friendly products  developed. Introduction of limited edition items No of limited editions introduced

Q-49 Healthcare hospital provides medical care to patients to all strata of the society at nominal cost. Hospital has been operating for the last 15 years. It gets grant from the government that helps it sustain its operations. Each year an annual report is submitted to the officials in the health ministry that is in charge of giving out grants to hospitals. Each year over the last 15 years, grants given to the hospital has been increasing. This increment was found necessary to meet the increase in operational costs due to inflation. While operations have been moderately successful in the recent years, the grants committee is of the opinion that the hospital can manage its funds better. To benchmark performance, performance of Healthcare hospital is being compared with the performance of another government funded hospital within the same city, Lifeline hospital. Both hospitals have similar scale of operations and get the same amount of grant. Given below are some of the parameters that are tracked at both hospitals:

 Operational Parameters Healthcare Hospital Lifeline  Hospital Budget Actual Actual Total inpatients 1,10,000 96,000 1,00,000 Delay in admission due to unavailability of beds Number of inpatients waiting for more than 1 week 1,100 2,880 500 Number of inpatients waiting for more than 2 weeks - 960 - Total outpatients 90,000 95,000 93,000 Delay in appointment due to unavailability of  medicalstaff Number of outpatients waiting for more than 1 week 900 1,900 465 Number of outpatients waiting for more than 2 weeks - 475 - Number of emergency admissions 400 600 500 Delay   in   providing   medical   care   to   emergency  admissions - 5 - Number of medical staff shortages (positions not  filled for more than one month) 3 5 1 Cancelled or delayed operations (due to non-  clinicalreasons) 5 20 6 Number of complaints received related to medical care 500 1,350 600 Number of complaints resolved within 15 days 500 1,080 550 Number of deaths post operation (all inpatients) 4,400 2,880 2,000 Number of medical negligence case that the hospital  lost 2 5 - Number of errors in prescription of drugs 15 45 10 Number of infection outbreaks within the hospital - 2 - Bed occupancy rate 90% 85% 94% Average patient stay (days) 4 6 5 Operating theatre utilization rate 95% 90% 95% Revenue including government grant (in crores) 15 13 16 Operating expenses (in crores) 12 12 12 ROI 8% 5% 6% Staff Training sessions (hours) 500 500 600 Research publications 5 3 6

• Both hospitals have 50 wards with 10 beds in each ward.

• Each hospital has 50 doctors from various specialties and 75 nurses.

• Both hospitals were open all days of the year.

Required

(i) The grants committee wants to ANALYZE performance of both hospitals with respect to:

• Clinical performance

• Efficiency of operations - Financial management

• Innovations

(ii) While preparing the balanced scorecard, how will you CATEGORIZE the above performance measures?

Access to services is an indicator of whether patients are able to get medical care when they need it. Better access to medical service will improve chances of recovery for the patients. Given the information in the problem, this can be assessed using the following parameters:

(a) Delay in admission to inpatients due to unavailability of beds.

(b) Delay in appointments to outpatients due to unavailability of medical staff.

(c) Delay in providing medical care for emergency admission.

(d)Number of medical staff shortages.

(e) Cancelled or delayed operations.

The hospital should aim at reducing the delay and shortages in order to provide patients with better access to medical services.

(a) Delay in admission to inpatients due to unavailability of beds :

As per the hospitals’ policy, patients who need admission have to be accommodated within 1 week to get access to services. Any delay beyond this period is tracked by their information system. For delays, due to unavailability of beds, the hospitals are tracking two time lags, delay by more than a week and delay by more than 2 weeks. Unavailability of beds shows that there are constraints in the capacity of patients to whom the hospital can provide service.

 Operational Parameters Healthcare  Hospital Lifeline  Hospital Budget Actual Actual Total inpatients 1,10,000 96,000 1,00,000 Delay in admission due to unavailability of beds Number of inpatients waiting for more than 1 week 1,100 2,880 500 Number of inpatients waiting for more than 2weeks - 960 - Percentage of inpatients denied access to service by more than 1 week 1.00% 3.00% 0.50% by more than 2 weeks 0.00% 1.00% 0.00%

As can be seen, Healthcare hospital has a target to provide admission within a week to 99% of inpatients, delay beyond a week may happen only in 1% of cases. Delay beyond 2 weeks should not occur. However, actual performance indicates that Healthcare hospital could provide admission within a week only to 96% of inpatients. There has been a time lag of more than a week in providing admission to 3% of the inpatients. This is already 2% more than the target. Further, time lag beyond 2 weeks in providing admission has occurred in 1% of inpatients.

Therefore, 4% of the inpatients had to wait for more than a week, in some cases more than 2 weeks, to get admission. In contrast at Lifeline hospital, only 0.5% of inpatient faced time lag of more than a week in getting admission to the hospital. There were no instances where patients requiring admission had to wait more than 2 weeks.

This shows that Lifeline hospital provides better access to services as compared to Healthcare hospital.

(b)Delay in getting appointment due to unavailability of medical staff:

 Operational Parameters Healthcare Hospital Lifeline Hospital Budget Actual Actual Total outpatients 90,000 95,000 93,000 Delay in appointment due to unavailability of medicalstaff Number of outpatients waiting for more than 1 week 900 1,900 465 Number of outpatients waiting for more than 2 weeks - 475 - Percentage of inpatients denied access to service by more than 1 week 1.00% 2.00% 0.50% by more than 2 weeks 0.00% 0.50% 0.00%

As per the hospitals’ policy, outpatients should be able to get appointment within a week to meet the medical staff. Delay beyond a week is tracked by the hospital’s information system as delay beyond a week and delay beyond two weeks. Healthcare hospital targets to provide appointments to meet medical staff within 1 week to 99% of the outpatients. Delays due to unavailability of medical staff can occur only in 1% of the cases. However, actual appointment schedule indicates that 2% of the outpatients had to wait for more than 1 week and 0.5% of the outpatients had to wait for more than 2 weeks to meet the doctor. This, indicates that Healthcare hospital has not been able to meet its target. To improve performance, the reason for unavailability of medical staff has to be understood. It might indicate that more hiring is needed or high medical staff turnover.

In comparison, Lifeline hospital has provided better services to outpatients, only 0.5% of the patients had to wait beyond a week to get appointment with the doctor This shows that Lifeline hospital provides better access to services as compared to Healthcare hospital.

(c)Delay in providing medical care to emergency admission patients:

In the case of Healthcare hospital, there were 5 instances when medical car e could not be provided to emergency admission patients immediately. The hospital aims never to have such instances however this target has not been met. In case of emergencies, medical care is required urgently, any delay may impact recovery of the patient. Reasons for the delay in providing medical care to such patients ha ve to be investigated. Lifeline hospital has been able to provide medical care immediately to all its emergency admission patients.

This shows that Lifeline hospital provides better access to services as compared to Healthcare hospital.

(d)Medical staff shortages:

The hospital should have enough doctors and nursing staff at any point in time to be able to provide good quality of medical care to patients. If there are vacancies, the existing staff have to bear extra patient load. This could lead to delays, some of which have been outline above. This results in patients getting lesser access to medical services when they need it. Healthcare hospital has 5 medical staff vacancies that have been vacant for more than a month, as compared to the target of 3. There are lesser resources available to provide patient care. In comparison, Lifeline hospital has only 1 position that was vacant for more than a month.

This shows that Lifeline hospital provides better access to services as compared to Healthcare hospital.

(e)Cancelled or delayed operations due to non-clinical reasons:

When operations are cancelled or delayed are cancelled due to non-clinical reasons, it indicates that there are administrative issues that deny patients access to medical care. Possible reasons could be unavailability of operation theaters, unavailability of medical staff or unavailability of required instruments or medicines. Compared to an expected 5 such instances, the actual cancellations or delays have been 20 in the case of Healthcare hospital. This is a huge variation that needs to be investigated. Given in the problem that operation theaters are used only to 90% of their availability. Possibly cancellations are not due to unavailability of operation theaters. It could be due to medical staff shortage or unavailability of instruments. Reasons have to be investigated to take appropriate action. Comparatively, such instances are fewer in the case of Lifeline hospital.

Clinical Performance

Clinical performance can be evaluated by looking at the quality of actual work performed. The parameters to look at are:

 Operational Parameters Healthcare Hospital Lifeline Hospital Budget Actual Actual Number of complaints received related to medical care 500 1,350 600 Number of complaints resolved within 15 days 500 1,080 550 Number of deaths post operation (all inpatients) 4,400 2,880 2,000 Number of medical negligence case that the hospital lost 2 5 - Number of errors in prescription of drugs 15 45 10 Number of infection outbreaks within the hospital - 2 -

(a)Number of complaints received related to medical care:

As can be seen from the table, the number of complaints received by Healthcare hospital is more than twice the expected volume. Only 80% of these have been resolved within the time frame of 15 days. Comparatively, Lifeline hospital gets fewer complaints also the complaint resolution rate within the given framework is much higher at 92%.

(b)Number of deaths post operation:

The actual deaths post operation are much lesser. While this is a good indication of quality, the objective of the hospital should be to keep this as low as possible. Lifeline hospital has a lower mortality than Healthcare. Good quality medical care can contribute towards preventing deaths post operation.

(c)Number of medical negligence case that the hospital has lost:

The fact that the hospital has lost a case of medical negligence shows that the quality of clinical care provided is questionable. In this case of Healthcare hospital, the number of such cases lost is 5. This is in excess of an expected loss of 2 cases. This indicates that quality of clinical care is found wanting at Healthcare hospital. Lifeline hospital has not lost any case of medical negligence implying that quality of medical care is better than Healthcare.

(d)Errors in prescription of drugs:

Prescription of drugs to cure an aliment should always be accurate. Any errors could be disastrous to the patient’s health. Compared to the expectation, Healthcare has three times the number of prescription errors. This shows that medical staff have been negligent in providing their service. Again, Lifeline hospital has a better record comparatively.

(e)Infection outbreak in hospital premises:

Outbreak of infection within hospital premises indicates that proper standards of hygiene are not being maintained at Healthcare hospital.

Efficiency of Operations

Operating efficiency can be assessed using the following parameters:

 Operational Parameters Healthcare Hospital Lifeline Hospital Budget Actual Actual Bed occupancy rate 90% 85% 94% Average patient stay (days) 4 6 5 Operating theatre utilization rate 95% 90% 95%

(a)Bed occupancy rate:

Bed occupancy is a factor that is dependent on the number of inpatient admissions. While this factor cannot be controlled by Healthcare, it is important to track this ratio to look at capacity utilization. The bed occupancy rate is lower than the expected rate. If this persists over a longer period, the hospital may want to explore the option of scaling down the number of wards and beds. The space freed up can be utilized for some other productive purpose.

However, as explained in point (a) above, 4% of the inpatients at Healthcare hospital are being denied admission due to unavailability of beds. This is a contradiction that needs to be investigated. Possible reasons could be administrative ones like inability to get the room and bed on time once the previous patient vacates. Else there may be mis-communication between the department discharging patients and the department admitting patients. Bed occupancy may not be tracked on real time basis due to which these delays in admission have occurred. Lifeline hospital has an occupancy of 94% that shows that it has just the sufficient number of beds to meet demand.

(b)Average patient stay (days) in the hospital:

On an average a patient is staying in the hospital for 2 days more than the target of 4 days. While this factor is dependent on the type of ailment, lower the patient stay the higher can be the bed occupancy rate. That means more patients can utilize the same resources if patient stay is shorter. This may be needed when there is a constraint on the beds available, which is not the scenario in the current case.

However, before taking action to improve bed occupancy rate, a hospital should ensure that quality of medical care given is not compromised. In the given problem, bed occupancy is only 90% at Healthcare hospital. Therefore, the hospital can afford to have longer patient stay. Lifeline hospital has 1 lesser patient stay day, only marginally different from Healthcare’s record. In both cases, since there is no constraint on bed occupancy, higher average patient stay can be managed without any constraint.

(c)Operating theater utilization rate:

Utilization of operating theater is subject to the nature of treatment, something that cannot be controlled by a hospital. However, it is necessary to track this parameter since it shows whether the facilities that are currently in place are sufficient and are utilized properly. Again, at 90% Healthcare hospital has a lower operating theater utilization rate compared to the expected usage. If this continues in the long run, the number of operating theaters can be reduced to make resources available for other uses. Lifeline hospital has a higher utilization rate at 95%, indicating more efficient use of resource.

(d)Medical staff shortage:

Medical staff is the most important resource at a hospital. Higher vacancies could imply higher staff turnover. A possible reason could be dis-satisfaction with the employer. Healthcare should understand the reason for have 5 positions that it has not been able to fill in within 30 days. Since this reduces the number of staff available, efficiency of the hospital will suffer. Comparatively, Lifeline makes better use of its medical staff since only one position was vacant for more than a month.

Financial Management

Healthcare hospital has an actual surplus of Rs.1 crore compared to a budget of Rs.3 crores. (Surplus = Revenue – Operating expense). ROI of 5% is below the target of 8%. The grants committee feels that there is a wastage of funds at the hospital. Therefore, areas of wastage should be identified such that operating expenses can be controlled better. Lifeline hospital has a surplus of Rs.4 crores. Since there are other hospitals like Lifeline that are vying for grant, Healthcare has to make itself competitive in this respect. Therefore, it has to be more efficient, effective and economical in its operations.

Innovations

Research publications indicate that newer discoveries have been made in fields that can further the horizons of knowledge. Therefore, research publications are an important indicator of innovation. While staff training is not directly related to innovations, they do keep the experts up to date in their subject area of expertise.

(ii) Performance Measures Categorized into the Balance Scorecard

• Customer Perspective would include availability of service measures and clinical performance measures.

• Internal Processes Perspective would include measures used to determine efficiency of operations.

• Financial Perspective would include details of the surplus generated and ROI.

• Learning and Growth Perspective would include staff trainings and research publications.

Combined with other parameters that the grant committee finds important the balanced scorecard can benchmark the hospital’s performance with its own targets and the performance of Lifeline hospital. Decision to extend grants and its quantum can be decided on this basis.

Q-50 B. Steels is a leading manufacturer of flat and long products and have state-of the-art plants. These plants manufacture value added products covering entire steel value chain right from coal mining to manufacturing Pig Iron, Billets, HR Coils, Black Pipe/GI Pipe, Cable Tapes etc. conforming to international standards. The rock-solid foundation combined with nonstop upgradation and innovation has enabled the B. Steels to surpass its goals constantly. Its vision and values for sustainable growth is balancing economic prosperity and social equality while caring for the planet. It is preparing its balanced scorecard for the year 2018-19. It has identified the following specific objectives for the four perspectives.

 Improve post-sales service Improve employee morale Improve employee job satisfaction Increase gross margin Increase number of customers Increase profitability of  core product line Increase plant safety Increase customer retention

B. Steels has collected Key Performance Indicators (KPIs) to measure progress towards achieving its specific objectives. The KPIs and corresponding data collected for the year 2018-19 are as follows:

 Key Performance Indicator Goal Actual Average replacement time (number of days) 2 1.5 Gross margin growth percentage 15% 16% Number of customers 15,000 15,600 Number of plant accidents 0 2 Percentage of repeat customers 83% 81% Core product line profit as a percentage of core-product line sales 5% 4.4% Employee turnover rate (number of employees leaving/ Average  number of total employees) 2% 3% Employees satisfaction rating (1-5, with 1 being the most satisfied) 1 1.2

For preparation of Balanced Scorecard report, the following format has been developed:

 B. Steels Balanced Scorecard Report For the year ended March 31, 2019 Perspective Objective KPI Goal Actual goal Achieved (Yes or No) Financial × × × × × Customer × × × × × Internal Business Process × × × × × Learning and Growth × × × × ×

Required

(i) PREPARE a balanced scorecard report using the above-mentioned format. Place objective under the appropriate perspective heading in the report. Select a KPI from the list of KPIs that would be appropriate to measure progress towards each objective.

(ii) B. Steels desires to integrate sustainability and corporate social responsibility related KPIs in their balance scorecard to adhere vision and values. ADVISE B. Steels, using TBL framework.

(i) B. Steels Balanced Scorecard Report For the year ended March 31, 2019

 Perspective Objective KPI Goal Actual Goal Achieved  (Yes or No) Financial Increase Gross Margin Gross margin growth percentage 15% 16% Yes Increase Profitability of Core Product Line Core product line profit asa percentage of core product line sales 5% 4.4% No Customer Increase number of cuustomers Number of Customers 15,000 15,600 Yes Increase customer retention Percentage of repeat customers 83% 81% No Internal Business Process Improve post sales service Average replacement time (number of days) 2.0 1.5 Yes Increase plant safety Number of plant accidents 0 2 No Learning and Growth Improve employee job satisfaction Employees satisfaction rating (1-5, with 1 being the most satisfied) 1 1.2 No Improve employee morale Employee turnover rate (Number of employees leaving/ Average number  of total employees) 2% 3% No

(ii) “Triple Bottom Line” concept encourages companies to measure not only their financial profits, but also the impact that its operations have on the society and environment. Therefore, this framework measures the full cost of doing business by measuring the following bottom lines (i) Profit (ii) People and (iii) Planet.

Diminishing non-renewable resources have forced businesses to focus on sustainable manufacturing. This term refers to managing manufacturing processes such that they minimize any negative impact on the environment by conserving energy and natural resources. In many instances, improved operational efficiency not only reduces waste (thereby costs) but also improves product safety, it strengthens the brand’s reputation and builds public’s trust about the company. As a long- term strategy, this improves business viability and provides a competitive edge to the company. This concept is the “Planet Bottom Line” within the Triple Bottom Line framework. Metrics on the following aspects may be investigated to find out the environment impact of business operations:

1. Material consumption

2. Energy consumption

3. Water utilization

4. Emissions, treatment of effluents and waste (include emissions affecting air, water, and land)

5. Fuel consumption by tracking freight and transportation costs

6. Land utilization

7. Recyclability and disposal of product  //     “Corporate Social Responsibility” enables the company to become conscious of the impact its operations has on the society. CSR programs, through philanthropy and volunteer efforts can forge a stronger bond between itself, its employees, and the wider community. Again, this improves both the brand image as well as builds public’s trust about the company. This concept is the “People Bottom Line” of the Triple Bottom Line framework. Metrics on the following aspects maybe investigated to find out the social impact of business operations:

8. Work place environment and labour relations

9. Occupational health and safety, accident rates

10. Human rights practices – child labour, employee work-place security policies

11. Training and education

12. Equal opportunity employer – diversity of workforce and opportunities available for employees’ growth

13. Suppliers – local sourcing versus sourcing from external markets

14. Philanthropy and volunteer programs organized

15. Product safety in terms of customer health and safety

16. Pricing of essential products to enable wider reach within the society

17. Transparent and ethical business practices

B. Steels can study these aspects, determine the relevant metrics, and prepare periodic KPI reports that can help in measuring responsibilities towards sustainability and social impact.

Q-51

Learning Horizons is an educational institute that conducts courses for students in accounting, law and economics. The institute is partially funded by the government. The institute aims to provide quality education to students of all backgrounds. The institute admits students who can fund their education privately as well as those who get sponsorship from the government. Knowledgebase is another educational institute in the same city providing courses similar to Learning Horizons. It is entirely private funded college where students arrange to pay for their own fees. It can be taken as a peer institution for comparison purposes.

Information about their operations for the year ended March 31, 2019 are as follows:

1. Both Learning Horizons and Knowledgebase offer their courses that last the entire year. All of them are regular classroom lectures conducted through the week.

2. Budget and actual fee rate structure for the year are the same. Information about the fees for each course are as follows:

 Course Type Learning Horizons Knowledge base Privately Funded Government Funded Privately Funded Accounting 1,20,000 75,000 1,00,000 Law 1,20,000 90,000 1,50,000 Economics 80,000 60,000 1,00,000

Budget and Actual Fees in Rs.

3. Salary details for lecturers and administrative staff are as follows: Salaries in Rs.

 Staff Type Learning Horizons Knowledgebase Budget Actual Actual Lecturers 5,00,000 5,50,000 6,00,000 Administrative staff 3,00,000 3,00,000 4,00,000

(4)Budgeted costs for the year based on 8,500 students per annum for Learning Horizons are as below:

 Costs Amount Rs. Variable Cost % Fixed Cost % Tuition Material 40,00,00,000 100% --- Catering 10,00,00,000 75% 25% Cleaning 1,00,00,000 25% 75% Other operating costs* 5,00,00,000 25% 75% Depreciation 1,00,00,000 --- 100%

*includes cost of freelance staff

(5)Actual costs (other than salary costs) incurred during the year:

 Costs Learning Horizon Knowledgebase Tuition Material 42,00,00,000 40,00,00,000 Catering 10,00,00,000 13,00,00,000 Cleaning 1,00,00,000 1,50,00,000 Other Operating Costs* 6,00,00,000 5,00,00,000 Depreciation 1,00,00,000 1,50,00,000

*includes cost of freelance staff

6) Keeping in line with latest technological developments, the management of Knowledgebase is introducing on-line tuition support by its lecturing staff. Learning Horizons on the other hand offers distance learning course. A general feedback from prospective students has revealed that some students would like weekend courses since during the week they focus on their regular jobs. Also, some students have requested for intermediate qualification, in the event that they discontinue the course halfway due to inability to complete the course or for other personal reasons.

7) Both Learning Horizon and Knowledgebase have a policy to have a lecture staff of 50 throughout the year. When there is a shortfall in teaching staff available, instead of recruiting a fulltime lecturer, Knowledgebase substitutes the requirement with freelance staff for lectures. The cost of freelance staff is much lower than regular staff.

8) Appendix with further details:

Sundry Statistics

For the year ended 31st March 2019

 Particulars Learning Horizons Knowledgebase Budget Actual Actual Number of students: Accounting 4,000 3,800 4,100 Law 2,500 2,550 2,500 Economics 2,000 1,500 1,200 Total students 8,500 7,850 7,800 Student mix (%) for each course: Privately funded 80% 70% 100% Government funded 20% 30% 0% Number of enquiries received: Accounting 4,500 4,500 4,600 Law 2,800 2,700 3,050 Economics 2,200 1,600 1,225 Total enquiries 9,500 8,800 8,875 Number of lecturers employed during the year 50 50 50 Number of lecturers recruited during the year: Accounting 2 4 1 Law 1 3 - Economics 1 3 - Total recruitment 4 10 1 Number of administrative staff 12 12 9 Pass Rate: Accounting 95% 99% 93% Law Economics 95% 95% 95% Overall Pass rates for the courses 95% 97% 93% Days in a year when freelance lecturers were  used - - 30 Number of new courses under  development - - 6

You are the management accountant of Learning Horizons. The results for the year are to be reviewed next week by the management. To assess performance, you want to prepare the report as per the Fitzgerald and Moon model.

Required

(i) Using the “Results” dimension of performance as per the Fitzgerald Moon model prepare a variance ANALYSIS of Learning Horizons actual and budgeted financial performance. Also, based on the information given in the problem, collate the actual financial figures for Knowledgebase, use it as a basis to prepare ANALYSIS of competitiveness of Learning Horizons and Knowledgebase.

ii) Using the “Determinants” dimension of performance as per the Fitzgerald Moon model EXPLAIN

a) Quality of service

b)Flexibility

c) Resource utilization

d) Innovation

iii) Course fees set by the government for various subjects cannot be increased beyond an average of Rs.75,000 per student. If the costs are maintained within this budget, the government can provide more sponsorship or grants in future. ADVISE a method that the management of Learning Horizons can use to resolve this.

(i) Analysis of the “Results” dimension of performance as per the Fitzgerald and Moon model

Financial Performance of Learning Horizons and Knowledgebase

The original budget had been prepared for 8,500 students, while actual enrollments are 7,850 students. At the very onset, reasons for lower enrollments have to be found and analyzed. For comparison of actual and budget, the budget of Learning Horizons has to be flexed to scale. Hence the budget needs to be scaled down to 7,850 for preparing a variance analysis.

 Particulars Learning Horizons Knowledgebase Budget Actual Actual Number Amount Rs. Number Amount Rs. Number Amount Rs. Revenue (a) Private Funded Accounting 2,955 35,46,00,000 2,660 31,92,00,000 4,100 41,00,00,000 Law 1,847 22,16,40,000 1,785 21,42,00,000 2,500 37,50,00,000 Economics 1,478 11,82,40,000 1,050 8,40,00,000 1,200 12,00,00,000 subtotal (a) 6,280 69,44,80,000 5,495 61,74,00,000 7,800 90,50,00,000 (b)     Government Funded
 Accounting 739 5,54,25,000 1,140 8,55,00,000 --- --- Law 462 4,15,80,000 765 6,88,50,000 --- --- Economics 369 2,21,40,000 450 2,70,00,000 --- --- Subtotal (b) 1,570 11,91,45,000 2,355 18,13,50,000 --- --- Total Revenue (a)+(b) 7,850 81,36,25,000 7,850 79,87,50,000 7,800 90,50,00,000 Expenditure Salaries Lecturers 50 2,50,00,000 50 2,75,00,000 50 3,00,00,000 Administrative staff 12 36,00,000 12 36,00,000 9 36,00,000 subtotal of salaries 62 2,86,00,000 62 3,11,00,000 59 3,36,00,000 Tuition Material 36,94,11,765 42,00,00,000 40,00,00,000 Catering 9,42,64,706 10,00,00,000 13,00,00,000 Cleaning 98,08,824 1,00,00,000 1,50,00,000 Other Operating Costs 4,90,44,118 6,00,00,000 5,00,00,000 Depreciation 1,00,00,000 1,00,00,000 1,50,00,000 Total Expenditure 56,11,29,413 63,11,00,000 64,36,00,000 Net Profit 25,24,95,587 16,76,50,000 26,14,00,000

1. Original revenue budget is for 8,500 students. Actual enrolments are 7,850 students. For comparison, the budgeted revenue has also been adjusted to 7,850 students. The mix between private and government funded students is 80:20 as per the budget. The adjusted student strength is allocated between the courses based on the original budget student strength.

For example, out of the total strength of 7,850 students, based on the budget ratio, 80% are taken to be privately funded. This works out to 6,280 students. The strength for flexible budget for accounting course will be = (6,280 × 4,000/8,500) = 2,955 students. Likewise, the strength for flexible budget for other courses is calculated in a similar manner.

2. The budgeted expenses are for 8,500 students. Actual students are 7,850. For comparison, variable costs in the budget have been adjusted for 7,850 students. Fixed costs remain the same. For example, tuition material has a budget of Rs.40 crore for 8,500 students. This is 100% variable, therefore adjusted budget for 7,850 students would be Rs.40 crore /8,500 × 7,850 students. The total budgeted cost for 7,850 students is therefore 37 crore.

Semi-variable costs in the budget, are separated as fixed portion and variable portion for the purpose of recalculation. For example, catering cost is Rs. 10 crore for 8,500 students, of which Rs.2.5 crore is fixed. The balance Rs.7.5 crore is for 8,500 students are is variable. The budgeted cost per student is therefore Rs. 8,823. For 7,850 students, the variable cost works out to Rs.6.93 crore. Adding the fixed cost, the total budget for catering for 7,850 students is Rs.9.43 crore.

Likewise, the budgeted cost for cleaning and other operating expenses is calculated in a similar manner.

Analysis of Actual Financial Performance with respect to Budget

1. Originally the student strength was expected to be 8,500 in comparison to an actual number of 7,850. The reason for this shortfall in enrollment should be analyzed by looking into non- financial performance measures.

2. On the revenue side, actual revenue of Rs.80 crore is marginally lower than the adjusted budget of Rs.81.4 crore. Since the budget and actual course fee rates are the same, the reason for this difference is on account of the mix between the private and government funded students. Actual enrollments had a greater ratio of government funded students, for which the fees are lower. As per the flexed budget, government funded students were expected to be 1,570 versus an actual of 2,355, higher by 50%. Reasons for the change in student mix from a budget of 80:20 to actual mix of 70:30 has to be analyzed.

3. On the expenditure side, actual costs of Rs.63 crore is 12% more than the corresponding budget of Rs.56 crore. The increase for salaries over budget is because a higher market rate that has to be paid for a lecturer. Given that Knowledgebase also pays a higher rate, the budget may need to be amended to reflect a more realistic salary rate. The other major variance is on account of the tuition materials procured for the students. While the budget for 7,850 students is only Rs.37 crore, the actual expenditure is Rs.42 crore. Reasons for this large variation has to be analyzed. Reasons could reflect the quality of education imparted. If in reality better quality study materials costs more, the management has to decide whether they would be willing to incur this additional cost. This might have a further impact on the fees charged to privately funded students and the management may also want to ask for increase in the government sponsored fee rate.

4. Overspend is noticed in other operating costs as well, actual cost is Rs.6 crore versus Rs.4.9 crore budget. As mentioned in the problem, 75% of this cost is fixed in nature, amounting to Rs.3.75 crore (75% of Rs.5 crore original budget). This portion of the cost should remain the same irrespective of variation in student enrollments. The remaining portion of the budget Rs.1.15 crore is variable. The actual spend is Rs.6 crore, of which ideally Rs.3.75 crore would be fixed. If there is any variation in fixed cost, it should be looked into. If justified, future budgets need to be adjusted to reflect the higher cost. The remaining variable portion should also be analyzed to understand the reason for the higher spend.

5. Overall, the impact of lower revenue and higher cost, has resulted in a shortfall of Rs.8.48 crore (34% shortfall) as compared to the adjusted budget for 7,850 students. Action should be taken by further studying other parameters like competitor’s performance and other non- financial factors like quality of education, pass rate, innovation.

Competitive Performance of Learning Horizons and Knowledgebase

The average revenue and cost per student for Learning Horizons and Knowledgebase are as below:

Average Revenue and Cost per student

 Particulars Learning Horizons Knowledgebase Budget Actual Actual Total revenue (Rs.) 81,36,25,000 79,87,50,000 90,50,00,000 Number of students 7,850 7,850 7,800 Revenue per student (Rs.) 1,03,646 1,01,752 1,16,026 Total cost (Rs.) 56,11,29,413 63,11,00,000 64,36,00,000 Number of students 7,850 7,850 7,800 Cost per student (Rs.) 71,481 80,395 82,513

The cost per student at Learning Horizons is marginally lower than Knowledgebase. However, the revenue per student at Knowledgebase is much higher. Analyzing the components further:

1. Student Mix: Knowledgebase has higher revenue by more than 10 crore, almost 13.3% higher compared to Learning Horizons. Reasons could be on account a higher fee rate structure at Knowledgebase as compared to Learning Horizons, where part of the fee structure is government funded at a lower rate.

2. Course Rate: Learning Horizons charges Rs.1,20,000 per year for its accountancy course which is higher compared to Knowledge base’s rate of Rs.100,000 per year. This might be a reason for a higher enrolment at Knowledgebase of 4,100 students compared to Learning Horizons enrolment of 3,800 for the same course. The management has to verify if this higher rate is sustainable.

3. Course Rate: Learning Horizons charges Rs.120,000 for its law course compared to Rs.150,000 at Knowledgebase. However, despite being lower, the enrolment for the course is almost the same. The management has to look at non-financial parameters related to quality, in order to improve enrollments for this course.

4. Course Rate: Learning Horizons charges Rs.80,000 for its economics course compared to Rs.100,000 at Knowledgebase. Consequently, it is able to have higher enrolment for its economics course.

5. Compared to Learning Horizons, Knowledgebase is incurring Rs.2 crore lesser on tuition materials. As pointed out earlier, Learning Horizons must try to find out reasons for its higher cost and try to economize on this expense, if required.

6. Knowledgebase has been using freelance staff for 30 days in a year to keep its expenses lower. Therefore, although it has a higher pay scale for its lecturers, it uses a lower cost resource to meet its teaching staff requirements. Compared to 1 new recruitment by Knowledgebase, Learning horizons has 10 new recruitments during the year. Knowledgebase has substituted any shortfall in teaching staff by hiring freelancers during the year. At the same time, non-financial aspects like quality of education need to be assessed while using the service of freelancers.

7. The other indicator of competitive performance, the take up rate, the rate of conversion of enquiries from prospective students into enrollments for the course. Reference to the budget here is the original budget prepared for 8,500 students, which represents the capacity that Learning Horizons wants to achieve.

 Particulars Learning Horizons Knowledge. Budget Actual Actual Accounting - number of students 4,000 3,800 4,100 Number of enquiries 4,500 4,500 4,600 Take up rate 89% 84% 89% Law - number of students 2,500 2,550 2,500 Number of enquiries 2,800 2,700 3,050 Take up rate 89% 94% 82% Economics - number of students 2,000 1,500 1,200 Number of enquiries 2,200 1,600 1,225 Take up rate 91% 94% 98% Overall - number of students 8,500 7,850 7,800 Number of enquiries 9,500 8,800 8,875 Take up rate 89% 89% 88%

The take up rate is lower for accounting course at Learning Horizons as compared to Knowledgebase. As explained in point (b), this may be attributed to the higher rate that Learning Horizons charges privately funded students. The higher rate should be justifiable.

The take up rate for law is higher compared to Knowledgebase. As explained in point

(c) this could be due to the lower fee rate. Higher enrolment could indicate the popularity of the course. At the same time the comparative pass rate may have to be looked into to judge the quality of the course. The take up rate for economics is marginally lower than Knowledgebase. However, overall enrolment for this course is much higher compared to Knowledgebase, possibly to the substantially lower rate offered for the course. The management could look at better publicity to improve the take up rate.

ii) Analysis of the “Determinants” dimension of performance as per the Fitzgerald and Moon model

Quality of Service

The pass rate for each course indicates the quality of course offered. Summarizing from the problem:

Pass rate

 Learning Horizons Knowledgebase Budget Actual Actual Accounting 95% 99% 93% Law 95% 98% 90% Economics 95% 95% 95% Overall Pass rates for the courses 95% 97% 93%

The targeted pass rate of 95% has been met in all courses, thereby it indicates that a satisfactory level of education is being imparted. In comparison with Knowledgebase the pass rate for all courses is higher, which is a good indicator. This could be a reason to justify the use of full time staff instead of substituting it with freelancer staff.

In the case of accountancy, the management can use the higher pass rate to justify the higher course rate, which may lead to better enrollments for the course. In the case of law, it has the potential of becoming a very popular course, lower course fee with higher pass rate. This can be used to improve enrollments. In the case of economics, the pass rates are at par. The management may use the lower course fee to attract students else may find other ways to make the course more attractive to have higher enrollments. Feedback from current students and the institute’s alumni also provide value information about the quality of the courses and opportunities to improve.

Flexibility

The management of Learning Horizons has to consider the feedback from current and prospective students in order to bring in flexibility to their services. While long distance learning offers some flexibility, the management has to look at alternate channels of delivery like online lecture support by faculty similar to the model that Knowledgebase has developed. Also, offering weekend courses could help improve enrollments. Providing the option to get an intermediate degree gives flexibility to students who are not able to cope up with the course. While this cannot be a main objective of the institute, it still can maintain its motto of imparting quality education for students of all backgrounds.

Resource Utilization

The main resource of an educational institute is its staff. Management of Learning Horizon has to look at the teacher student ratio and compare it to benchmarks of peer institutes. Learning Horizons is having a higher recruitment of 10 lecturer s for the year as compared to a budget of 4 recruitments for the year. Reasons for the same need to be looked into. One reason could be a higher turnover ratio among lecturers due to lower salary paid in comparison to the market rate. In comparison, Knowledgebase has a more stable staff, having a recruitment of only 1 lecturer during the entire year. This might be due to the use of freelance teaching staff. Learning Horizon can explore options of using freelance teaching staff to meet its teaching needs, without compromising quality of education.

Innovation

From the information provided, Learning Horizons has a better quality of service in terms of pass rates. However, Knowledgebase planning to offer 6 new courses in the future. Learning Horizons has to explore options to improve on its current course offerings in order to maintain its market share.

iii) There is a limit to fees sponsored by the government. Currently, government funded revenue is Rs.18 crore, almost 23% of the total revenue of 80 crore. Average actual cost per student, referring to the table above, is Rs.80,395. Since, the government is unwilling to spend more than Rs.75,000 per student, the management could look at target costing methods to resolve this issue. This reduction of Rs. 5,395 per student can be achieved by identifying opportunities to economize on costs. If feasible, the cost per student can be calculated for each of the courses, to identify where these economies can be achieved. This drive should encompass the administration and support services too. Thus, using target costing approach, the cost can be reduced below Rs.75,000 to make government funded education profitable, within reasonable limits.

Q-52

West Coast community operates Homelessness Services (HS) on a not-for-profit basis as a local solution to local housing needs. The primary objective is to meet the accommodation needs of persons within its locality targeting those living in the low/middle income groups and senior citizens. Accommodation is basically furnished; it consists of a small house, with kitchen, bathroom, bedroom/(s), and a sitting room. HS manages 450 such houses across various localities. Exclusive Services (ES) is a profit-seeking organisation which provides rented accommodation to the public. ES manages 200 such houses across localities similar to HS’ operations.

Income and Expenditure accounts for the year ended 31st March 2019 were as follows:

 HS (Rs.) ES (Rs.) Rent Received 1,02,98,600 1,09,98,000 Less: Employee Costs 24,00,000 38,00,000 Planned Maintenance and Substantial Repairs 34,19,500 10,41,000 Running Repairs 23,91,600 6,38,000 Miscellaneous Operating Costs 15,27,500 11,75,000 Insurance, Property Taxes, and Interest etc. 13,15,500 18,75,000 Operating (Deficit)/ Surplus (7,55,500) 24,69,000

Operating Information in respect of the year ended 31st March 2019 was as follows: House and rental information:

 Size of House Number of Houses Rent per Week (Rs.) HS ES HS ES 1 Bedroom + 40 20 400 750 2 Bedrooms + 80 40 450 800 3 Bedrooms + 250 140 500 1,175 4 Bedrooms + 80 Nil 700 N.A.

HS had certain houses that were unoccupied during part of the year. The rents lost as a consequence of unoccupied properties amounted to Rs. 18,17,400. ES did not have any unoccupied houses at any time during the year.

Employees were paid as follows:

 Number of Staff Salary per Staff Member (Rs.) per annum HS ES HS ES 1 2 3,00,000 5,00,000 2 2 2,50,000 3,00,000 4 11 2,00,000 2,00,000 8 - 1,00,000 -

Planned maintenance and substantial repairs undertaken:

 Nature of Work Number of Houses Cost per House (Rs.) HS ES HS ES Miscellaneous Building Work 10 - 12,500 - Sanitary Fittings (Kitchen + Bathroom) [allare  the same size] 45 5 26,100 52,200 AC Upgrades/ Replacements 8 - 15,000 - Replacement of Wooden Structure for 3 Bedroomed Houses 50 13 40,000 60,000

Running Repairs Information:

 Classification of Repair Number of Repair Undertaken Total Cost (Rs.) HS ES HS Emergency 480 160 6,72,000 Urgent 990 376 11,28,000 Non-urgent 560 102 5,91,600

Each repair undertaken by ES costs the same irrespective of the classification of repair.

Required

i) Critically EVALUATE how the management of Homelessness Services could measure the ‘Value for Money’ of its service provision during the year ended 31 March 201 9.

ii) IDENTIFY, 2 performance measures in relation to Flexibility and Service Quality (dimensions of performance measurement).

iii) ANALYSE, 3 performance measures relating to ‘Cost and Efficiency’ that could be utilised by the management of Homelessness Services when comparing its operating performance against that achieved by Exclusive Services.

(i) For commercial enterprises, generating profits is a very important objective. Likewise, not-for-profit enterprises have certain cultural, social or educational objectives for which they are created. Regardless of the type of organization, it is important to know whether the internal operations meet certain performance benchmarks, that will ensure that the organization achieves its objectives in a better manner. Moreover, even if the organization does not operate for profits, it is important for it to be “cost effective”. Resources (including money) should be used optimally to achieve intended outcomes. For example, HS can use this benchmarking tool to look into the following questions:

1. Does the organization function in an efficient and cost effective manner?

2. Does the estate management make best use of the buildings to achieve the objectives of the organization?

3. Does the estate management function manage upkeep of buildings in terms of repairs and improvements in an effective manner?

4. Are the tenants satisfied with the service provided by the estate management and the suitability of the accommodation for their needs?

“Value for Money (VFM)” is an assessment made based on the criteria of economy, efficiency and effectiveness.

Economy involves minimising resource consumption while meeting specified requirements of quality and quantity. Minimize the cost of resources / required inputs (implies to spend less) while ensuring that the desired quality of service is achieved. For HS, inputs could be purchases made for maintenance and repair work like sanitary fittings, AC, wooden structure for the houses etc., while resources could be the labour employed to carry out these services. HS should aim at purchasing required quality of inputs at the least possible price. Skilled labour needed for this job should be procured at the lowest pay scale possible. Procuring these at lower cost leads to savings for HS. At the same time, HS should ensure that cost cutting / saving does not come at the cost of quality. Lower quality, implies inferior service levels, which ultimately will compromise HS’ social commitment to provide quality housing to needy members of its community.

Efficiency involves maximising the ratio between resources (input) and the output of goods, services or other results.

The focus of efficiency is on the process of rendering service. The objective of efficient operations is to maximize output using minimum resources. Improved productivity means that resources procured are used in an optimal way (implies spending well).

In the case of HS, one of the resources is the labour employed for repair and maintenance work. Efficiency (productivity) measured would be the relationship between the employees available and the repair work performed by them. If the pool of employees do more repair work than the benchmark set, productivity is higher. This also closely ties up with economy (cost) of operations.

If the given pool of employees (resources), who are paid optimum salary (cost), cater to more repair and maintenance work, economy of operations is achieved due to higher productivity of operations. In case these activities are outsourced, efficiency and economy can be achieved by calling for tenders. Select the tender that provides maximum work for least cost. In addition, HS may explore options for efficiencies from business process improvements, shared services as well as further efficiencies with in assets management.

Effectiveness involves ensuring that the outcome achieves the desired policy aims and objectives. Have the objectives been achieved, how does the impact of the actual output / service compare with its intended impact? (implies to spend money wisely to achieve desired objectives). In the case of HS, effectiveness could be assessed based on the following questions

1. Are the housing needs of the targeted community members met?

2. Are the tenants satisfied with the accommodation?

3. Given its social cause, are the staff friendly, courteous and hospitable to the customers?

4. Do the housing accommodations comply with safety standards and other legal requirements?

Each measure is inter linked with the other. For example, HS has replaced sanitary fittings in the kitchen and bathroom in 45 houses for Rs. 26,100 each, costing a total of Rs.11,74,500. Compared to ES that has spent Rs. 52,200 on each house for sanitary fitting replacement. For the cost of Rs. 11,74,500 ES could have replaced fittings in only 22 houses (Rs.11,74,500 / 52,000) as compared to HS’ ability to replace fittings in 45 houses.

Therefore, HS’ decision has been economical, getting more work done for same cost. At the same time, this does not indicate whether the fittings replaced by HS are of similar or better quality as compared to ES. ES could have used better quality fittings that last longer, enhance customer experience, safety etc. The spending by ES could have been more effective than HS because it helps achieve the desired objective of customer satisfaction, safety and lesser running cost for maintenance. Therefore, to achieve economy, HS may have compromised on effectiveness.

Benchmarking is a good method of measuring performance it enables a comparison of the process, costs etc. with those of a close competitor. Services will be expected to use benchmarking information to learn from best practice, change procedures and processes to achieve enhanced methods of working, and reduce unnecessary expenditure.

However, benchmarking of performance against ES is not ideal. The performance of HS can be better measured by adopting benchmarking against similar charities whose primary objective is the provision of accommodation to the communities in which they operate.

Thus, HS must have permanent membership of the House Benchmarking Organisations, which helps social housing property-owners to compare the costs of service delivery, resources, and key performance indicators across all areas of the business. For example, the management of HS can enquire about a norm in respect of the repair charges, sanitary charges or wood structure replacement charges etc. of similar non profit seeking organisations.

Further, benchmarking should be conducted annually to analyse all areas of the business and is used to identify high performing, low cost services. Using the annual benchmarking exercise results, the HS can plan to target those areas that are low performing and high cost.

Overall, HS should have strong commitment to value for money, which needs to be reflected in the business plan and in service-delivery plans. By applying these principles HS would be able to achieve the optimum utilisation of resources, which will in turn lead to extra capacity and allow HS to provide better services.

ii) The Building Block Model proposed by Fitzgerald and Moon, gives six dimensions of performance measurement including service quality and flexibility.

Service Quality

Service quality is the measurement of how well a delivered service conforms to the customer’s expectations. As a not for profit organization, HS provides housing services to cater to the needs of lower and middle income groups as well as senior citizens in the local community. Although service is provided at a concessional rate compared to its commercial peer ES, quality of HS’ service needs to be judged based on certain parameters that were promised by the organization to its tenants. These could be used as parameters to assess service quality. Some of them could be:

• Behaviour, attitude, proactivity of staff employed by HS.

• Quality of basic amenities provided.

• Availability of on-site service for the residents

• Safety within and around the residential unit

Data for assessment of quality can be collected from feedback of tenants, analysing the number and nature of complaints made by tenants, tenant retention rate/loyalty etc. Feedback form tenants can be taken on specific issues or could be general in nature.

Flexibility

Flexibility is the ability of the organization to adapt to customers’ requirements. This can be measured through service delivery time, promptness in responding to customer requests, ability of employees to perform different kinds of work etc. In the case of HS, the following performance measures can be used to assess the flexibility:

• The average waiting time for a tenant for a house to become available. Lower the wait time better the flexibility as it indicates that there are sufficient housing units available for rental accommodation.

• Following change in requirements, ability to meet the tenant’s request for another house of a different size. This indicates whether the range of housing units offered is sufficient (flexible) to cater to the tenants’ changing demand.

• Waiting time for undertaking repairs of an emergency nature, once notified by a tenant. Lower the waiting time during emergencies indicates the availability of appropriate personnel to carry of the repairs on short notice.

Students are only required to provide two performance measures. These others have been given for completeness.

iii) The management of HS could use the following performance measures An organization should aim at achieving results with maximum efficiency at the least possible cost. Efficiency measures the relationship between the input resources utilized and the output service achieved. Few of the measures that HS could use to compare performance with ES are:

The Average Employee Cost per week per house

Here, the resource (input) are the employees, which is 15 in case of both HS and ES. The employees at HS cater to 450 houses as compared to 200 houses catered by ES. Therefore, HS is more efficient as compared to ES.

Likewise, cost of resources to HS is the employee cost, for which the pay structure and remuneration policies are different in both the organizations. HS has the ability to hire most of its resource at an annual salary of Rs.100,000, which is the least level in the pay structure. Comparatively, ES also hires cheaper labour but at a slightly higher pay level of Rs. 200,000 annual salary. Therefore, the total cost of labour is higher by Rs.14,00,000 (58%) for ES as compared to HS.

To compare the figures on a common factor, the employee cost can be calculated per week per house.

 HS ES The Average Employee Cost per week per house [Rs.24,00,000^/ (450@ × 52)] and [Rs.38,00,000^/ (200@ × 52)] ^ Employee cost from the income and expenditure table @ Number of houses (given): HS = 450; ES = 200 Rs.102.56 Rs.365.38

The average employee cost per week per house of ES is Rs. 365.38 (2.46 times) more than of HS. It can be concluded that HS is both efficient, in terms of being able to cater more houses with same number of employees, as well as cost effective due to the use of cheaper labour.

The Average Day to Day Repair Cost per week per house

Here, the resource (input) is measured in terms of the cost spent on repairs to maintain the rental houses. Running repairs are generally do not add much value to the rental houses. Therefore, lesser the repairs, higher the efficiency. From the income and expenditure table, it can be seen that HS has spent Rs.23,91,600 as running repair cost for 450 houses versus ES that has spent Rs.6,38,000 for 200 houses. To compare them on a common factor, the average repair cost per week per house has been calculated.

 HS ES The Average Day-to-Day Repair Cost per week per house [Rs.23,91,600^/ (450@ × 52)] and [Rs.6,38,000^/ (200@ × 52)] ^ Running repair cost from the income and expenditure table @ Number of houses (given): HS = 450; ES = 200 Rs.102.21 Rs.61.35

The average day to day repair cost per week per house for ES is Rs.40.86 less than that of HS (- 40%). This may be due to the fewer repairs required and the fact that there is no extra cost required for emergency and urgent repairs.

The cost of repairs whether emergency, urgent or non-urgent to ES is the same, Rs.1,000 [Rs.6,38,000/ (160 + 376 + 102)] whereas the cost of emergency repairs to HS is Rs.1,400 (Rs.6,72,000/480), urgent Rs.1,139 (Rs.11,28,000/990) and for non-urgent repairs it is Rs.1,056 (Rs.5,91,600/560).

ES’s low cost of repairs (which is identical for all types of repairs – emergency, urgent and non- urgent) may have been achieved through entering into a contractual agreement for repairs. HS should also think of entering into such contracts in order to save money.

Percentage of Rent Lost

Occupancy of rental houses indicate whether the capacity (in terms of houses rented) is being optimally utilized. Lesser the vacancy better the efficiency in terms of capacity utilization. This represents opportunity cost of not letting out the property.

 HS ES Percentage of Rent Lost (= Rent Lost / Gross Rent) [(Rs.18,17,400/ Rs.1,21,16,000]  Gross Rent = Rent Earned + Rent Lost    = Rs.1,02,98,600 + Rs.18,17,400 = Rs.1,21,16,000 15% ---

ES did not have any unoccupied properties at any time during the year; it has 100% occupancy. This shows that ES’s properties are in high demand. On the other hand, HS has lost rent worth Rs. 18,17,400 through un occupied properties; this is about 15% of the gross rent receivable. The management of HS should identify the reasons why the houses remained unoccupied when the occupancy rate is 100% for an organisation like ES, a peer organisation should be used to benchmark the performance.

Q-53

Fair Limited manufactures and sells motor vehicles in India and different parts of the world. The company has its head office in New Delhi and three regional offices. The manufacturing plants are situated in Pune and Bhubaneswar. The company has over 10,000 employees who are paid a fixed salary and a performance related pay (PRP).

The PRP is determined using the financial performance as a measure. The performance of departments which are profit centers is based upon the revenues and profits the departments generate. The performance of cost centers is based upon the cost savings against the budget. Of late, the company has identified critical issues with the motor vehicles manufactured and sold in the market. In the last one year, itself, the company has recalled mor e than 2 lakh vehicles owing to quality issues like faulty gearbox, issues with axle, braking systems etc. The company was also penalized for selling vehicles which does not meet the emission norms.

The board of directors carried out an internal review of these frequent recalls and issues with the vehicles. In most of the cases, it appeared that the recall of vehicles was on account of lower quality of material and parts used. A couple of critical quality and emission checks were ignored to dispatch more vehicles in the limited time, leading to higher sales and profits.

The board is concerned with the reputational risk with the issue related with recalls. The company was consumer’s most trusted brand for last three years in a row. It is unlikely to win the award this year due to negative feedback from customers. The board wants to win the trust of the customers back and be profitable as well.

Required

1. STATE advantages and disadvantages of using financial measure as a performance measure.

2. ADVISE an alternative performance measure which includes non-financial measures as well.

3. IDENTIFY 2 critical success factors and 2 Key Performance Indicators for the performance measure chosen in (ii).

What is the issue?

Fair limited is into manufacturing of motor vehicles. The company has used financial measures for performance. Of late, the company has faced quality related issues leading to vehicle recalls. The company has also been penalized for violating emission norms. Since the company has been using financial measures only, it appears that non-financial aspects related to quality have been ignored. The company has adopted the principle of profit at any cost which can be seen from use of low quality materials and parts as well as skipping key quality checks.

Financial Performance Measure

Financial performance measures focus on financial results or aspects. These measures focus on the profits made by a business or a unit of business. They also include costs saved against budgets. Various financial performance indicators include – growth in revenue, profitability, variance from budget, Return on Capital Employed etc.

In the case of Fair limited, the performance of employees is done on the basis of financial performance indicator. When performance is evaluated on financial parameters, the employees and managers tend to focus only on profitability in anticipation of higher bonuses and pays.

The problems related to quality issues in vehicles produced by Fair limited might be linked to the use of financial performance measure. Low quality parts are used to save costs and improve profitability. The quality checks prior to sales were also skipped to sell more vehicles with limited resources. This is an apparent case of compromise in quality for seeking higher profits and revenues. In light of above, the advantages and disadvantages of financial performance measures are given below.

− Focus on financial objectives and is linked to the overall objective of wealth creation of shareholders.

− Such measures are objective.

− Quantification of results is possible.

− The measures are comparable across companies of a particular industry.

− The framework to measure financial performance is established in most of the cases.

− Focus on short term profits and Ignores long term sustainable growth. As can be seen in the case of fair limited, the company has compromised quality for short term profits. This is harmful to the company in the longer run.

− This measure can be distorted by inflation. A 5% growth in sales might be good but if the inflation is 6%, the real growth is negative.

− Financial information might be manipulated to show a better performance.

Non-financial performance measures use measures other than financial to measure performance of employees and departments. The advantages of non-financial measures are

− Non-financial measures help business to measures every area whether financial or non- financial. Financial measure would not be able to suitably measure areas like performance of IT department.

− It focuses on qualitative aspects as well.

− These measures take a long-term view unlike financial measures where employees tend to take a short term view.

The disadvantages of Non-Financial measures are:

− These require huge amount of information to measure each area of performance and might lead to shift of focus from core goals and values.

− These can be subjective as non-financial measures cannot be generally quantified.

− Non-financial measures like measures of quality are difficult to measure.

Balanced Scorecard

An alternative performance measure which focuses on both financial and non -financial measures is the Balanced Scorecard. It outlines four key areas in which company and divisional performance should be measured to focus on both the short and long term needs of the organisation. The key idea is that managers are to be appraised on a variety of measures which include non-financial measures so that their focus is both long and short term.

As discussed earlier, it appears that managers at Fair limited have ignored long term sustainable growth and qualitative factors and focused on short term profits and sales. This is one of the key disadvantages of a financial measure of performance. The company can start measuring performance both on financial as well as non-financial aspects. This would ensure that employees are not short sighted on profits alone.

The four areas or perspectives in a Balanced Scorecard are –

-Financial Perspective

Financial perspective focuses on financial performance of the business and divisions. The various financial measures used by companies are profitability, revenue growth, cost control etc. This is currently being used in Fair limited to measure performance.

-Customer Perspective

This perspective views organizational performance from the point of view the customer or other key stakeholders that the organization is designed to serve. These could include measures like customer satisfaction index, percentage of returns, percentage of goods delivered on time etc.

This perspective views organizational performance through the lenses of the quality and efficiency related to product or services or other key business processes. The measures under internal business perspective could be number of defective products produced, production performance per unit of time etc.

-Training and Development/ Learning and Growth Perspective

This perspective views organizational performance through the lenses of human capital, infrastructure, technology, culture and other capacities that are key to breakthrough performance. The key measures could be number of new products produced, amount invested in training and development etc.

In each category/Perspective, the organisation must follow through from the business strategy, to ensure they are focused on the long-term direction of the business. Clear objectives should be set under each category according the SMART criteria (Specific, Measurable, Achievable, Relevant and Time-bound), measured at the end of the period, and lessons learnt from actual results to help to improve performance in future periods and keep the organisation on track to achieve its strategic goals.

Applying Balanced Scorecard to Fair Limited

The issues related to quality have arisen at Fair Limited as the managers and divisions focused on profits at the cost of quality. The recall of vehicles was primarily on account of use of sub- standard parts. The company should consider using non-financial measures as well as a performance measure. Balance scorecard can be effective tool to apply financial and non- financial measure.

The company must take steps to put focus on quality related aspects as well as financial aspects. A proper application of various Key Performance Indicators under the respective Critical Success Factors can help the company overcome the current issue.

Critical success factor (CSF) is a management term for an element that is necessary for an organization or project to achieve its mission. It is a critical factor or activity required for ensuring the success of a company or an organization. These are the key areas in which the organisation has to do well if they are to remain competitive and profitable. The critical success factors have to be linked with the overall strategy of the organisation.

Key Performance Indicators (KPIs) are the ways in which the organisation’s performance for the CSF can be measured. It is a measurable value that demonstrates how effectively a company is achieving key business objectives. Organizations use KPIs to evaluate their success at reaching targets.

The Critical Success Factors and Corresponding KPIs for Fair limited for each of the perspective in the balanced scorecard is given below:

 Perspective Critical Success Factors Key Performance Indicator Financial Be the Most Profitable Company in Motor Vehicle Industry. Profitability ratios. Revenue growth. Become the No.1 Company by in terms of Market Share in five years. Variance to budget. Number of vehicles sold. Customer Be No.1 Choice of  Customers. Implement Zero Recall Policy. Number of vehicles sold vis-à-vis those sold by competitors. Number of recalls of vehicles. On time delivery of vehicles. Internal Business Total Quality Management. Zero Idle Time at Factory. Number of defective cars produced. Number of cars returned by customers as faulty. Number of hours spent in waiting by labours at assembly line. Training and Development Upto Date Technology used in Manufacturing Facilities.  Skill Development for Labour and Supervisors. Amount spent  in research and development year on year. Number of training hours undergone by workers and supervisor. Number   of   new   model   of   vehicles launched.

Q-54

Grab and Go is a fast food joint operating in a very competitive business environment. It is a profitable business with very good prospects for growth. A strategy development meeting is underway to chalk out a plan to improve business growth in a very systematic measurable manner. The following information is given to you:

Grab and Go has the following mission statement “Derive strength to grow in scale using our passion for the craft of cooking and service that will satisfy our customers, employees and other stakeholders.” Grab and Go is a closely held partnership firm with five partners. It started at a scale of operations that catered to the local demand within a locality. Reputation for good quality food and service has help it scale up its operations in the recent years. Most of the key decisions relating to operations like decision about the menu and its method of preparation, product pricing, finance, marketing, administration etc. are centralized. Skilled chefs, managers for various functions and the firm’s partners are part of this core team.

A general survey published in a food trade magazine highlighted people’s perception about fast food diet. Predominant opinion was that the current food platter available in food joints across the town were not healthy option. People want healthier choices in the menu when they dine out. At the same time, they do not want to compromise on taste or presentation of the food item. The other focal point for improvement was the order taking system.

In most food joints, the current system is manual where the order taking staff note down a customer’s order on paper, send it to the kitchen and then delivers the order on intimation from the kitchen, which is also done manually by the kitchen staff. This system has problems like errors in taking down orders, most times delivery staff are unaware of the content in an item or its availability, delays in delivery leading to customers complaining about food served cold etc.

This problem takes away the pleasure of dining out and is leaving customers dissatisfied. Another scope for improvement is that customers want more payment options other than cash to settle their bills. With the advent of plastic money and mobile e wallet payments carrying cash around has become cumbersome for most of them. The partners have decided to use this as an opportunity to develop Grab and Go as the niche food joint addressing the customer’s concerns, while managing to remain profitable. Consequently, Grab and Go plans to expand by providing more choices along with its regular menu to health-conscious customers. Also, revamping its ordering, delivery and payment system would improve customer experience. A reasonable return at the overall firm level would be a return on equity (Net Income / Total Partnership Capital) of 25% each year.

Capital structure will remain unchanged. The partners are not interested in diluting their share by bringing in new partners or take external funding with ownership stake. They may however utilize bank financing for expansion, but only if required.

Expansion of business will entail opening new branches in other localities as well as forging franchise with other stakeholders. However, Grab and Go is not clear how to measure market share since the fast food industry market is not entirely an or ganized sector. There is no clear information about the overall revenue of the whole sector.

In the past, it was quality of its products that drove growth. The management wishes to maintain high quality standards across branches and franchisee. Therefore, an internal quality control department may be established to look into the same. External certifications from government food inspectors and other recognized agencies would also be required to be met. Quality refers to both product quality and service quality, in this case, service being an inherent part of customer experience.

The staff at Grab and Go are also excited at this opportunity. Expansion of the food joint would present a more dynamic work culture. Chefs would have the opportunity to enhance the ir skill by trying out various ways to cater to the consumer’s palate. Ordering and delivery staff would have the opportunity to enhance their people management skills. This learning opportunity would definitely be an impetus for their career growth. With expansion chances of promotion within the organization increase. Financially, better business leads to the expectation of better pay and reward system.

Consequently, the management is intent on developing a performance management system that tracks performance across the organization. Among the different models, the Building Block Model is being considered.

Required

ADVISE the partners how the Building Block Model at Grab and Go could be implemented.

Performance management using the Building Block Model poses three questions based on which the performance measurement system is developed:

What dimensions of performance should the company measure?

Dimensions are the goals that the company wants to achieve based on its overall strategy, those goals that define its success.

How to set the standards (benchmarks) for those measures?

What are the rewards needed to motivate employees to achieve these standards?

Dimensions

Dimensions (goals) include financial and non-financial goals. Dimensions are further categorized as into results and determinants. Results are tracked as (a) financial performance and (b) competitive performance. Determinants are tracked as (a) quality, (b) flexibility, (c) innovation, and (d) resource utilization. Determinants influence results.

Results

a) Financial Performance: Grab and Go is a closely held partnership with 5 partners. Partners are interested in earning profits that have been benchmarked at an overall return on equity of 25% each year. This can be derived from periodic financial statements that get prepared as part of the accounting function. Partners want to retain the current capital structure. This implies that they do not have any plans to go public or have other external funding with ownership stake. They may take loans from banks for funding their expansion.

Consequently, if they want to expand, the firm has to make sufficient profits that will yield ample cash reserves. Therefore, Grab and Go’s financial performance dimensions should also include profitability ratios like gross profit ratio, net profit ratio, operating margin, return of capital employed (if bank loans are taken) etc. Cash profit and changes in cash reserves may also be included as dimensions of performance. These measures should be tracked at the firm’s overall level as well at the individual branch/franchisee level.

b) Competitive Performance: Grab and Go was to be a niche joint in a highly competitive segment. However, to measure how it compares with its peers there is a limitation in terms of availability of information due to the unorganized nature of the fast food industry. All the same, one of the measures that can be helpful are the number of branches / franchisees the firm is able to open.

Grab and Go is also likely to have a competitive edge because it is foraying into providing healthier food choices along with its regular menu. Since this is unique among its segment, it will retain a competitive edge until its peers start replicating the same. Therefore, one other measure for competitive performance could be the spread and uniqueness of Grab and Go’s menu as compared to its peers. Information for this could be gathered from published / researched sources like trade magazines as well as informal sources like customer feedback / word of mouth

Determinants

a) Quality: Quality drove past performance and it will continue to drive performance even after expansion. For product quality, the management should track if internal quality checks and external certifications are met periodically. Quality control should cover all branches and franchisees. Non-compliance may require immediate attention of the management. For service quality, periodic training programs can be initiated to educate the staff with people management skills. Therefore, Grab and Go should determine parameters that the management would be interested in ensuring that quality standards are met and how non- compliance should be reviewed.

b) Innovation: Innovation involves experimenting with the appropriate inputs which make them healthy. At the same time, the healthier option should satisfy the taste and presentation preference of customers. This requires innovative efforts from qualified and skilled chefs. This will give the competitive edge to Grab and Go. Innovation has to be constant and not a onetime exercise. Therefore, management may review the number of new variants that have been introduced in the menu, regularity of these introductions and customer feedback of the same.

c)Flexibility: Growth in scale of operations combined with a competitive business environment implies that Grab and Go should have some flexibility in its operations. This could mean ability to hire staff quickly, cater to seasonal surges in customer’s demand etc.

d) Resource utilization: Better utilization of resources help business function efficiently. Revamping the order, delivery and payment system would improve the way resources (kitchen, ordering and delivery staff) operate. Lesser errors and delays would increasecapacity utilization, freeing up time to cater to more customers. Consequently, pressure on resources decreases. Therefore, some indicators to be tracked can be overtime / idle time of kitchen, ordering and delivery staff, turnaround time in these functions, table occupancy rate, breakage, or wastage of material etc. Again here, the management should chart out the appropriate dimensions that will help them track resource utilization.

Standards

Standards are the benchmarks or targets related to the performance metric that is being tracked under each dimension. To be useful, standards should have the following characteristics:

a) Ownership: It is important to establish who in the organization structure is responsible for achievement which performance metric. Grab and Go has to consider this very carefully. As explained in the problem, many key management functions like decisions about the menu and its preparation are determined by a core team. Similarly, the centralized core team is handling finance and marketing. However, at the branch level, managers of various operational functions can be held accountable for performance of that specific process. For example, the chief at a particular branch can be held accountable for the quality of food prepared in that branch (Dimension: Quality). Similarly, the head of the order taking staff at a particular branch can be held accountable for the overtime that the staff at putting in at that branch (Dimension: Resource utilization).

b) Achievability: Benchmarks and targets will be useful only if they are achievable. The managers who have ownership for the achievement of performance metric have to be involved in setting benchmarks or targets. They should be clearly defined, preferably quantifiable. At the same time, they should be in line with the firm’s overall strategy. If the target is set very high staff can get de-motivated. If set too low, will not raise the bar for performance. If not in line with the firm’s overall strategy, there will be discord or gap between the firm’s performance and what it wants to achieve.

c) Equity: Benchmarks should be equally challenging for all parts of the business. Grab and Go should customize its performance measure for each function like kitchen staff, order and delivery staff, finance staff, advertising staff etc. For example, while turnaround time to meet a customer’s order would be relevant metric to the kitchen, ordering and delivery staff, popularity of the advertisement jingle for Grab and Go would be the relevant metric for the advertisement department. The rigor of the target should be uniform across departments. Otherwise the staff would view the benchmark system as being biased towards select functions within the firm.

Rewards

This relates to the reward structure within the firm that includes compensation package, bonus, rewards, awards, facilities provided to employees etc. Proper reward system is required for achievement of standards while maintaining costs at optimum levels. Grab and Go should have a well-defined HR policy for compensation, bonus, promotion, and reward. A good system should have the following characteristics:

a) Motivation: Does the reward system drive the people to achieve targets and standards? A low reward system would not induce staff to work towards the goal. Goal clarity and participation in target/benchmark setting can motivate staff to achieve standards.

While some part of compensation may be fixed, other parts can be made variable. For example, bonus of the advertising staff can be aligned to the sales generated, Chefs can be rewarded bonus based on sales as well quality measures etc. Better job prospects in a growing environment would also be a good motivator. Grab and Go’s management should track various metric in this regard. Some of them could be percentage of bonus paid to the overall compensation package categorized staff cadre, attrition rate, internal promotions, cross training programs etc.

b) Clarity: The reward package should be clearly communicated to the staff. It should be understood by the staff concerned. They should be told what kind of performance will be rewarded and how their performance will be measured. Grab and Go may consider having a dedicated HR team for this purpose.

c) Controllability: Unlike the traditional understanding, rewards need not be based only on the financial element that the staff can control. There may be other non -financial elements for which rewards can be given. Both aspects however need to be controllable by the staff concerned. For example, the chef can come up with a popular menu. If the pricing of the product, managed by the central core team, is such that it results in a loss to Grab and Go, the chef may not get the much-deserved bonus. This is not a good reward system and might lead to attrition.

Q-55

The town of Silver Sands is located along the coast of the Caribbean Sea. Known for its beautiful coastline and pleasant weather, the town attracts a lot of tourists from all around the world. The town has two beaches that are maintained by the local government and can be used by the general public. In order to preserve the natural ecosystem, other beaches on the coastline are not accessible to the general public. Tourism is the main source of livelihood for its residents. Consequently, cleanliness of beaches is of paramount importance in order to sustain and develop this industry.

The local government has recently employed a contractor to clean up the beaches using beach cleaning machines. The contractor has been selected through a competitive tendering / bidding process. The contractor uses sand cleaning machines that are pulled by tractors. Sand is scooped onto a conveyor or screening belt. It is either raked through (combed using prongs) or sifted through (filtered), in order to separate the waste from the sand. The cleaned sand is left behind on the beach while the waste is removed. Majority of the litter comprises of plastic waste (bags, bottles etc.) while some portion also includes sea weed, glass, aluminum cans, paper, timber, and cardboard. A detailed log is kept by the contractor about the stretch of beach that has been cleaned, time taken for the clean-up, number of    tractors used etc. This log is also checked and signed by a local government official. This record is used to process payments at the end of the month.

In addition to contracting with the vendor to clean machines, the local government has also placed bins at various locations on the beach for the public to dispose their waste. The town’s municipality workers clean these bins every morning. Again, detailed logs of the man power and other resources employed is kept by the responsible department. In addition, the government has opened a mobile messaging system, whereby the public can message the government department if they find litter anywhere in the beach. Depending on whether it is from overflowing bins or buried debris in the sand, the municipality workers or the contractor will take action to clear it within 24 hours. A detailed log of these operations is also maintained. Patrons can also suggest measures for improving cleanliness on the beaches.

Due to its importance to the economy, the local government has allotted substantial budget for these operations. At the same time, it is essential to know if this is sufficient for the purpose of keeping the beaches clean. Therefore, the government wants to assess whether the town is getting “good value for money” from this expenditure. The “value for money” concept can be looked at from three perspectives: (i) economy, (ii) efficiency and (iii) effectiveness. The Internal Audit (IA) department that has been requested to undertake this study has requested for guidelines on whether the audit should focus on economy and efficiency of the beach cleaning operations or on effectiveness of the same. Economy and efficiency audit assess whether the same level of service can be procured at lower cost or resources while effectiveness audit assess whether better service can be procured at same cost.

Depending on the outcome of the audits, if required, policy decisions like requesting for additional funding from the state government, alternate policy measures like levying penalty for littering etc. can be taken.

Required

Prepare a letter addressed to the IA department.

(i) RECOMMEND guidelines to assess economy and efficiency of beach cleaning operations.

(ii) RECOMMEND guidelines to assess effectiveness of beach cleaning operations.

(iii) IDENTIFY challenges involved in assessment of effectiveness?

(iv) RECOMMEND general guidelines, how the audit team may conclude the audit based on the combined outcomes of economy, efficiency, and effectiveness?

Date 30- July -2018

Dear Sirs,

Re: The economy, efficiency and effectiveness of beach cleaning activities

(i) Economy and efficiency audit of an operation focuses on the consumption of resources and the output achieved. Economy assesses the financial aspects of the activity i.e. are the objectives of the activity being achieved at reasonable cost? Efficiency assesses the volume of input consumed to derive the desired output i.e. are the resources and funds being consumed to get maximum output? To look at Economy of Operations, cleaning expenses need to be bifurcated into payments made to the contractor and the expenses of emptying waste from bins. Any further subcategories of these expenses, like labour, material, disposal van expenses etc. also need to be collated from the accounting or cost records. These then have to be compared to the budgets that were approved by the government of Silver Sands. The competitive tendering process can be reviewed to ensure that the contractor getting the order is offering the required quality of service at the lowest price. If the quality of cleaning has been achieved, by staying within budget, the operation is economical. However, if the actual exceed the budget, the government has to compare them with cost of similar cleaning activities carried by neighbouring towns. On comparison, if Silver Sands operations are expensive compared to other towns, it indicates that not only are the operations uneconomical they may not be efficient either.

Efficiency of Operations can be determined by checking the log records maintained for beach cleaning by the contractor and municipality workers. These would have detailed of activities carried out and the resources utilized for each of them. For each of these services (beach cleaning and emptying out bins), the cost drivers can be identified and certain metrics can be developed for analysis. For example, the cost of running the tractors can be divided by the total number of tractors operated to get the cost of operations per tractor or alternatively, by the kilometres of beach cleaned to arrive at a tractor-kilometre rate. While analysing these activities, certain operational considerations have to be given. For example, certain stretches of the beaches may take more time or resources to clean due to issues like rocks or soft sand. Therefore, if resources for operations disproportionate for certain parts of the beaches, the cost of maintaining those stretches need to be worked out. Data to get this information will depend on the extent of detailed maintained i n the logs. This information has to be tracked over some period of time in order to understand trends in operations and related expenses.

The data collected from the mobile messaging system should also be investigated. How often and in what stretches of the beach are complaints frequent or maximum? Reasons for these lapses need to be taken from the contractor (for beach cleaning operation) and the concerned department (for emptying bins) in order to find out whether resources are being employed properly.

On this basis, deviations and exceptions should be investigated. The local government can then decide if there can be alternate sites along the coastline that may be more economical and efficient to operate.

(ii) An audit about Effectiveness of Operations would focus how the actual cleanliness of beaches compares with the desired level as laid out in the policy initiative. To assess whether performance has been met, clear guidelines and metrics have to be defined during policy implementation. To begin with, it should be clear as to what constitutes litter. From an operational angle, it would be difficult to clean out every bit of paper lying on the beach.

However, it is possible to pick up every soft drink aluminum can. Hence, the government authorities must be clear on what constitutes litter? Which are the refuse that must be cleared within exception (example food refuse, animal droppings, glass bottles, tin cans, trash bins etc.) and tolerance level for certain other types of litter (e.g. Paper, seawee d etc.) that may get left behind even after cleaning. Quantity of waste collected would be the indicator to make the above assessment.

Certain other parameters like safety standards can also be defined. Safety problems could be cuts from sharp objects like glass, incidents of vector borne diseases in the area or health problems from polluted sea water. Assessment has to be made whether these standards have been met.

For this, the primary source of information about cleanliness would be feedback from the beach patrons. These could be in the form of complaints received directly or those through the mobile messaging system would provide data to work out the metrics. This would be an indicator of “customer satisfaction”. Other inputs could also be the suggestions given by the patrons about ways to improve cleanliness on thebeach. Observation by making surprise visits to inspect the beaches immediately after the cleaning operations would also provide sufficient evidence about the effectiveness of operations.

(iii) Challenges Involved in assessment of effectiveness would be:

1. Defining standards about what constitutes litter and acceptable level of cleanliness? These are subjective guidelines, the perception of which may differ from person to person.

2. Beach patrons also play an important role in making this initiative effective. There has to be a conscious civic sense of duty not to litter, failing which this initiative will most likely be ineffective. Therefore, while measuring performance for effectiveness, collection of more litter does not necessarily indicate effective operations . More litter requires more cleaning and more resources, therefore is actually not a positive indicator of effectiveness. On the contrary, in the long run, lesser litter collected to maintain desired level of cleanliness would be a good indicator of effectiveness.

(iv)The outcome of the audits can indicate achievement any or none of the three parameters of economy, efficiency and effectiveness of the beach cleaning operation. To form an integrated conclusion based on the different outcomes of individual audits, the audit team may consider the following guidelines:

1. Has the objective of the cleaning operation been achieved as per the guidelines in the relevant policy? i.e. have the operations been effective?

2. If the answer to (a) is yes, are the expenses within budget. If so, then the operations are economical and efficient. Given that the operations have been effective at the same time economy and efficiency have been achieved, the team can conclude that the cleaning operations policy has been a success.

A cost-over run can also be justified if the operations have been effective. In that case, the audit team has to conclude whether all expenses incurred are indeed justified and that the resources have been put to the best possible use. If not, can the operations be made more economical or efficient?

3. If the answer to (a) is no, the operation has not been effective, then is the difference from the target marginal or huge? If the operations have not been entirely effective, but only by a marginal gap say 95% success, then analysis of expenses can be made similar to the point (b) mentioned above. However, if the operations have been ineffective to a larger extent, then the cleaning drive initiative has been ineffective.

The government has to look at alternate solutions of tackling the problem. These could include imposing heavy penalty for littering, requesting for more funding from the state government to employ better resources etc.

Therefore, it can be seen that achievement of one objective does not automatically lead to achievement of other objectives. A holistic approach would be needed to draw conclusions about the performance of the cleaning operations.

Should you have any further queries, please do not hesitate to ask.

Yours Faithfully Management Accountant

Q-56

Centurion Co. operates a Pulp Division that manufactures Wood Pulp for use in production of various paper goods. The following information are available:

 Rs. Selling Price 210 Less: Variable Expenses 126 Contribution 84 Less: Fixed Expenses (based on a capacity of 1,00,000 kgs per year) 54 Net Income 30

Centurion Co. has just acquired a small company that manufacturers paper cartons. This company will be treated as a division of Centurion with full profit responsibility. The newly formed Carton Division is currently purchasing 10,000 kgs of pulp per year from supplier at a cost of Rs.210 per kg less a 10% quantity discount. Centurion's President is anxious that the Carton Division begins purchasing its pulp from the Pulp Division if an acceptable transfer price can be worked out.

Situation I

If the Pulp Division is in a position to sell all of its pulp to outside customers at the normal price of Rs.210 per kg, will the Managers of the Carton and Pulp Division agree to transfer 10,000 kgs of pulp next year at a determined price? EXPLAIN with reasons.

Situation II

Assuming that the Pulp Division is currently, selling only 60,000 kgs of pulp each year to outside customers at the stated price of Rs.210 per kg will the Managers agree to a mutually acceptable transfer price for 10,000 kgs of pulp in next year? EXPLAIN with reasons.

Situation III

If the outside supplier of the Carton Division reduces its price to Rs.177 per kg, will the Pulp Division meet this price? EXPLAIN. If the Pulp Division does not meet the price of Rs.177 per kg, what will be the effects on profits of the company as a whole?

Situation I

He Pulp Division will refuse to transfer at a price less than Rs.210 per kg.

The Carton Division can buy pulp from an outside supplier for Rs.210 per kg, less a 10% quantity discount of Rs.21, or Rs.189 per kg. Therefore, the Division would be unwilling to pay more than Rs.189 per kg.

Transfer Price ≤ Cost of Buying from Outside Supplier = Rs.189

The requirements of the two divisions are incompatible. The Carton Division won’t pay more than Rs.189 and the Pulp Division will not accept less than Rs.210. Thus, there can be no mutually agreeable transfer price and no transfer will take place.

Situation II

The Pulp Division has idle capacity, so transfers from the Pulp Division to the Carton Division do not cut into normal sales of pulp to outsiders. In this case, the minimum price as far as the Carton Division is concerned is the variable cost per kg of Rs.126.

The Carton Division can buy pulp from an outside supplier for Rs.189 per kg and would be unwilling to pay more than that for pulp in an internal transfer. If the managers understand their own businesses and are cooperative, they should agree to a transfer and should settle on a transfer price within the range:

Rs.126 £ Transfer price £ Rs.189

Situation III

Yes, Rs.177 is a bona fide outside price. Even though Rs.177 is less than the Pulp Division’s Rs.180 “full cost” per unit, it is within the range and therefore will provide some contribution to the Pulp Division.

If the Pulp Division does not meet the Rs.177 price, it will lose Rs. 5,10,000 in potential profits.

 Price per kg Rs.177 Less: Variable Costs Rs.126 Contribution margin per kg Rs.51

10,000 kgs × Rs.51 per kg = Rs. 5,10,000 potential increased profits.

This Rs.5,10,000 in potential profits applies to the Pulp Division and to the company as a whole.

For situation III also considered that “the Pulp Division is currently selling only 60,000 kgs of pulp each year to outside customers”.

Q-57

GL Ltd. is a multiproduct manufacturing concern functioning with four divisions. The Electrical Division of the company is producing many electrical products including electrical switches. This division functioning at its maximum capacity sells its switches in the open market at Rs.25 each. The variable cost per switch to the division is Rs.16.

The Household Division, another division of GL Ltd., functioning at 70% capacity asked the Electrical Division to supply 5,000 switches per month at the rate of Rs.18 each to fit in night lamps produced by it. The total cost per night lamp is being estimated as detailed below;

 Rs. Components purchased from outside suppliers 50.00 Switch if purchased internally 18.00 Other variable costs 40.00 Fixed overheads 21.00 Total cost per night lamp 129.00

The Household Division is marketing night lamps at a price of Rs.130 each, with a very small margin, as it is doing business in a very competitive environment. Any increase in price made by the division will push out the division from the market. Therefore, the division cannot pay anything more to switches if they the Electrical Division. Further, the manager of the division informed that it is very much essential to keep on the market share for night lamps by the Household Division to retain the experienced workers of the division. The company is using return on investments (ROI) as a scale to measure the divisional performances and also marginal costing approach for decision making.

Required

(i) Would you RECOMMEND the supply of switches to Household Division by Electrical Division at a price of Rs.18 each? Substantiate your recommendation with suitable reasons.

(ii) ANALYZE whether it would be beneficial to the company as a whole the supply of switches to Household Division at a unit price of Rs.18 by Electrical Division.

(iii) Do you feel that- the Divisional Managers should accept the inter-divisional transfers in principle? If yes, what should be the range of transfer price?

(iv) SUGGEST the steps to be taken by the chief executive of the company to change the attitude of divisional heads if they are against the inter-divisional transfers.

(i) Electrical Division is operating at full capacity and selling its switches in the open market at Rs.25 each. Therefore, it can transfer its production internally by giving up equal number of units saleable in the open market. In this situation, transfer price should be based on variable cost plus opportunity cost {Rs.16 + (Rs.25 - Rs.16)} = Rs.25/-.

As the price quoted by Household Division Rs.18 is less than the transfer price based on opportunity cost, the Electrical Division should not accept internal transfer. Further, the company is measuring divisional performances based on ROI. Therefore, transferring for a price which is less than the minimum price would affect the return on investments and divisional performance severely.

(ii) In the total cost per night lamp, the Fixed Overheads being a fixed cost is not relevant for decision making. Similarly, the variable cost of switch (Rs.16 p.u.) included in the cost of night lamp is also irrelevant as it is common for both internal and external transfers. The only relevant cost is the loss of revenue when units are transferred internally.

Accordingly, the benefit from internal transfer would be {Rs.130 - (Rs. 50 + Rs. 40) –Rs. 25) = Rs. 15/- on each unit sale on night lamp. Therefore, it is beneficial to the company as a whole to the extent of Rs.15 per unit of night lamp sold.

Hence, internal transfer is profitable to the company as a whole. Further, Household Division is operating at 70% capacity and has experienced workers which may be utilized for other divisions requirements if any and based on contribution earned fixed cost could be minimized due to large scale of production.

(iii) Internal transfer pricing develops a competitive setting for managers of each division, it is possible that they may operate in the best interest of their individual performance. This can lead to suboptimal utilization of resources. In such cases, transfer pricing policy may be established to promote goal congruence. The market price of Rs.25 per switch leaves Electrical Division in an identical position to sale outside. Thus, Rs.25 is top of the price range. Division Household will not pay to Electrical Division anything above (Rs.130 - Rs.50 - Rs.40) = Rs.40/-. The net benefit from each unit of night lamp sold internally is Rs.15. Thus, any transfer price within the range of Rs.25 to Rs.40 per unit will benefit both divisions. Divisional Managers should accept the inter divisional transfers in principle when the transfer price is within the above range.

(iv) Transfer at marginal cost are unsuitable for performance evaluation since they do not provide an incentive for the supplying division to transfer goods and services internally. This is because they do not contain a profit margin for the supplying division. Chief Executive’s intervention may be necessary to instruct the supplying division to meet the receiving division's demand at the marginal cost of the transfers. Thus, divisional autonomy will be undermined. Transferring at cost plus a mark-up creates the opposite conflict. Here the transfer price meets the performance evaluation requirement but will not induce managers to make optimal decisions.

To resolve the above conflicts the following transfer pricing methods have been suggested:

Dual Rate Transfer Pricing System

The supplying division records transfer price by including a normal profit margin thereby showing reasonable revenue. The purchasing division records transfer price at marginal cost thereby recording purchases at minimum cost. This allows for better evaluation of each division’s performance. It also improves co-operation between divisions, promoting goal congruence and reduction of sub-optimization of resources.

Two Part Transfer Pricing System

This pricing system is again aimed at resolving problems related to distortions caused by the full cost based transfer price. Here, transfer price = marginal cost of production + a lump-sum charge (two part to pricing).

While marginal cost ensures recovery of additional cost of production related to the goods transferred, lump-sum charge enables the recovery of some portion of the fixed cost of the supplying division. Therefore, while the supplying division can show better profitability, the purchasing division can purchase the goods at lower rate compared to the market price.

Q-58

Bright Furniture Company has two divisions Division’ FXR’ and Division ‘FQR’. Both divisions are independent. Each division serves a different market in the furniture industry.

Division ‘FXR’ manufactures furniture that is used by the canteens/ coffee bars. The division plans to introduce cushioned seat for the counter chairs. A cushioned seat currently made by the Division ’FQR’ for use on its stylish stool could be modified for use on the new counter chair. Division ‘FQR’ can make the necessary modifications to the cushioned seat easily.

The raw materials used in Division ’FXR’ seat are slightly different and should cost about 20 percent more than those used in Division ‘FQR’ stylish stool. However, the labour time should be the same because the seat fabrication operation is basically the same.

Division ‘FQR’ is operating at full capacity. By making the cushion seats for Division ‘FXR’, Division ‘FQR’ have to cut its production of stylish stools. However, Division ‘FQR’ can increase its production of normal stools. The labour time freed by not having to fabricate the frame or assemble the stylish stool can be shifted to the frame fabrication and assembly of the normal stool.

Division ‘FQR’ can switch its labour force between these two models of stools without any loss of efficiency. Labour hours cannot be increase. Division ‘FQR’ has excess demand for both products. Following are Division ’FQR’’s standard costs for the two stools and a schedule of Division ‘FQR’‘s manufacturing overhead.

‘FQR’ DIVISION

Standard Selling price and Cost

 Stylish Stool Normal Stool (Rs.) (Rs.) (Rs.) (Rs.) Selling Price 225.00 160.00 Less: Raw Materials Framing 32.60 39.04 Cushioned Seat - Padding 9.60 --- - Vinyl 16.00 ---
 Moulded Seat (Purchased) --- 58.20 24.00 63.04 Less: Direct Labour Frame Fabrication - (0.5 × Rs. 30.00/DLH#) 15.00 --- - (0.5 × Rs. 30.00/DLH) --- 15.00 Cushion Fabrication - (0.5 × Rs. 30.00/DLH) 15.00 --- Assembly* - (0.5 × Rs. 30.00/DLH) 15.00 --- - (0.3 × Rs. 30.00/DLH) --- 45.00 9.00 24.00 Less: Manufacturing Overhead - (1.5 DLH × Rs. 51.20/DLH) 76.80 --- - (0.8 DLH × Rs. 51.20/DLH) --- 40.96 Profit / (Loss) 45.00 32.00

(*)Attaching seats to frames and attaching rubber feet (#)DLH refers to Direct Labour Hour

‘FQR’ DIVISION

 Overhead Item (Rs.) Indirect Material (Variable - at Current Market Prices) 16,80,000 Indirect Labour (Variable) 15,00,000 Supervision (Non Variable) 10,00,000 Power (Use Varies with Activity; Rates are Fixed) 7,20,000 Heat and Light (Non Variable - Same Regardless of Production) 5,60,000 Miscellaneous Overheads (Non Variable - Any Change in Amounts or Rates is Independent of Production) 8,00,000
 Depreciation (Fixed) 68,00,000 Employee Benefits (20% of Supervision, Direct and Indirect labour) 23,00,000 Total Overhead 1,53,60,000 Capacity in DLH 3,00,000 Overhead Rate / DLH Rs. 51.20

Required

Assume that you are the corporate controller. What transfer price would you recommend for a 200 unit lot of seats?

Working Note

(1)Statement Showing Variable Cost per 200-unit lot

 (Rs.) (Rs.) Cushion Material: - Padding 9.60 - Vinyl 16.00 Total Cushion Material 25.60 Cost Increase by 20% 5.12 Cost of Cushioned Seat 30.72 Cushion Fabrication Labour (Rs. 30 × 0.5) 15.00 Variable Overhead (W.N.-2) (Rs. 20 × 0.5) 10.00 Variable Cost per Cushioned Seat 55.72 Total Variable Cost per 200-unit lot (Rs. 55.72 × 200) 11,144

2. Statement Showing Fixed Overhead & Variable Overhead Rate per Direct Labour Hour

 Variable Amount (Rs.) Fixed Amount (Rs.) Total Per DLH Total Per DLH Indirect Material 16,80,000 5.60 --- --- Indirect Labour 15,00,000 5.00 --- --- Supervision --- --- 10,00,000 3.33 Power 7,20,000 2.40 --- --- Heat and Light --- --- 5,60,000 1.87 Miscellaneous Overheads --- --- 8,00,000 2.67 Depreciation --- --- 68,00,000 22.67 Employee Benefits: - 20% Direct Labour* 18,00,000 6.00 --- --- - 20% Supervision --- --- 2,00,000 0.66 - 20% Indirect Labour 3,00,000 1.00 --- --- 60,00,000 20.00 93,60,000 31.20

Variable Overhead Rate = Rs.60,00,000 ÷ 3,00,000

= Rs.20.00 / DLH

Fixed Overhead Rate = Rs.93,60,000 ÷ 3,00,000

= Rs.31.20 / DLH

• Direct Labour Cost

0.2 (Rs. 10, 00,000 + DL + Rs.15, 00,000)      = Rs.23, 00,000

0.2 DL= Rs.18, 00,000

DL= Rs.90, 00,000

(3)Statement Showing “Loss of Contribution Margin from Outside Sales”

 Stylish Stool (Rs.) Normal Stool (Rs.) Selling Price 225.00 160.00 Less: Material 58.20 63.04 Less: Labour 45.00  (Rs.30.00 × 1.5) 24.00  (Rs.30.00 × 0.8) Less: Variable Overhead 30.00  (Rs.20.00 × 1.5) 16.00  (Rs.20.00 × 0.8) Contribution Margin per unit 91.80 56.96 Units Produced (units) 200 250  (W.N.- 4) 18,360 14,240

Amount of Contribution Margin Lost as a result of shifting production to the Normal Stool Rs.4,120 (Rs.18,360 – Rs.14,240).

(4)Number of Economy Office Stools that can be produce

Labour Hours to make a 200-unit lot of Stylish Stools (1.50 × 200) 300 Hrs

Less: Labour Hours to make a 200-unit lot of Cushioned Seats (0.50 × 200) 100 Hrs Labour Hours available for Normal Stool 200Hrs

Labour hours required to make one Normal Stool 0.8 Hrs / Stool

Use of Extra Labour devoted to Normal Stool Production (200 / 0.8) 250 Stools

Since the ‘FQR’ Division is operating at Full Capacity, the Transfer Price must consider the Division’s Variable Costs of Manufacturing the Seat plus the Lost Contribution Margin that will result from losing outside sales. Thus, the Transfer Price (W.N.-1 & 3) equals to Rs.15,264 (Rs.11,144 + Rs.4,120).

Q-59

A company has a division A producing three products called X, Y, Z. Each product can be sold in the open market in the following manner.

Maximum external sales are X 800 units, Y 500 units, Z 300 units. All figures in Rs.

 Particulars X Y Z Selling Price per unit 96 92 80 Variable Cost of Production in Division A 33 24 28 Labour Hours Required per unit in Division A 6 8 4

Product Y can be transferred to Division B, but the maximum quantity that might be required for transfer is 300 units of Y.

Division B could buy similar product in the open market at a price of Rs.45 p.u.

(i) What should be the transfer price per unit for 300 units of Y, if the total labor hours available with Division A are:

(a) 13,000 hours

(b) 8,000 hours and

(c) 12,000 hours.

(ii) Indicate the transfer pricing range that can promote goal congruence.

Division A has two type of clientele, external customers and Division B. Capacity in Division A is defined by the number of labor hours available for production.

The total hours needed to meet external demand is 10,000 hours as explained below: Statement of Hours Needed for External Sales

 External Sales Qty Hours p.u. Total Hours Needed X 800 6 4,800 Y 500 8 4,000 Z 300 4 1,200 Hours Needed for External Sales 10,000

Case 1: When 13,000 hours are available, after meeting the external demand requiring 10,000 hours, Division A will have surplus capacity of 3,000 hours.

Hours needed to produce 300 units of Y = 300 × 8 hours = 2,400 hours. Since Division A has surplus capacity, it can meet the demand of Division B also without curtailing its external sales. Hence, there is no opportunity cost on account of lost contribution.

Transfer price range: Minimum Transfer Price p.u.

= Marginal Cost of Production p.u. of Y = Rs.24. Maximum Transfer Price

= Lower of Net Marginal Revenue and the External Buy-in Price

The Maximum Transfer Price would be the External Procurement Pri=ce for Division B

= Rs.45 p.u.

Note: Additional cost information related to Division B would be needed to calculate net marginal revenue.

Case 2: When 8,000 hours are available, Division A has limited capacity as explained below.

The total hours needed for external sales is 10,000 and those need for internal transfer is 2,400 hours. In all, 12,400 hours are needed, when only 8,000 hours are available. There is a shortfall of 4,400 hours. Capacity is hence limited.

Therefore, labor hours have to be utilized optimally. This is determined by calculating the contribution per hour from sale each product that is sold externally. It determines how valuable each hour is product wise.

Statement of Product Wise Contribution per hour

 Sr. No. Particulars X Y Z 1 Selling Price p.u. 96 92 80 2 Less: Variable Cost p.u. 33 24 28 3 = 1 - 2 Contribution p.u. 63 68 52 4 Labour hours needed p.u. 6 8 4 5 = 3 / 4 Contribution per hour 10.50 8.50 13.00 6 Ranking high to low II III I

Product Z gives the maximum contribution per hour, hence ranked 1. Product X and Y follow at rank 2 and 3 respectively. This is the basis to allocate limited hours for optimal production in Division A.

The entire demand of Product Z will be produced first. This requires 1,200 hours. Out of the balance 6,800 hours, Product X will require 4,800 hours. This leaves a balance of 2,000 hours for Product Y. Product Y requires 8 hours p.u. Hence maximum production of product Y = 2,000 hours / 8 = 250 units.

Statement of Optimum Mix

 Total Hours Available 8,000 Priority External Sales Qty Hours p.u. Total Hours Needed Remaining Hours 1 Z 300 4 1,200 6,800 2 X 800 6 4,800 2,000 3 Y 250 8 2,000 - Total Hours Needed for External Sale 8,000

If Division A accepts to produce 300 units of Y for Division B, the total hours required for internal sales would be 2,400 hours. This can be catered to by curtailing its external sales. 2,000 hours from production of external sales of Product Y is first diverted and the balance 400 hours are diverted from production of Product X. Hence this results in lost contribution, an opportunity cost that has to be included in transfer pricing.

Contribution Lost from Reduced External Sales

= Product Y (2000 hours × contribution per hour of Rs.8.5) + Product X (400 hours × contribution per hour of Rs.10.5)

= Rs.17,000 + Rs.4,200

= Rs.21,200

On a per unit basis, lost contribution works out to 21,200 / 300 units = Rs.70.66 Therefore, Transfer Price

= Marginal Cost p.u. + Contribution Lost from Reduced External Sales

= Rs.24 + Rs.70.66 Rs.94.66

Since Division B can source at Rs.45, it would be cheaper to purchase the component from outside

Case 3: When 12,000 hours are available, Division A has limited capacity as explained below.

The total hours needed for external sales is 10,000 and those need for internal transfer is 2,400 hours. In all, 12,400 hours are needed, when only 12,000 hours are available. There is a shortfall of 400 hours. Capacity is hence limited.

Therefore, labor hours have to be utilized optimally. Again, as explained in Case 2 , this is determined by calculating the contribution per hour from sale each product that is sold externally. Referring to the table above, Contribution per hour is X: Rs.10.5; Y: Rs.8.5 and Z: Rs.13. Accordingly, production wise Z will be given first priority, followed by X and then Y.

The entire demand of Product Z will be produced first. This requires 1,200 hours. Out of the balance 10,800 hours, Product X will require 4,800 hours. This leaves a balance of 6,000 hours for Product Y. Product Y requires 8 hours p.u. External sales of product require 4,000 hours (500 units × 8 hours p.u.).

Statement of Optimum Mix

 Total Hours Available 8,000 Priority External Sales Qty Hours p.u. Total Hours Needed Remaining Hours 1 Z 300 4 1,200 10,800 2 X 800 6 4,800 6,000 3 Y 500 8 4,000 2,000 Total Hours Needed for External Sales 10,000

This leaves 2,000 hours available for production of 300 units of Y to be sold to Division B. These 300 units will require 2,400 hours (300 units × 8 hours p.u.). Hence, there is a shortfall of 400 hours to meet this internal demand. This shortfall of 400 hours will be made up with diverting hours earmarked for external sale of Product Y (Rank 3 as explained in the table above). Loss of contribution on account of curtailed sales would then be built into the transfer price.

Contribution Lost by Diverting 400 hours from Product Y for External Sales

= 400 hours × contribution per hour

= 400 hours × Rs.8.5

= Rs.3,400.

On a per unit basis,

= 3,400 / 300 units

= Rs.11.33

Therefore, Transfer Price

= Marginal Cost p.u. + Contribution Lost from Reduced External Sales

= Rs.24 + Rs.11.33

= Rs.35.33

Division B can source this at Rs.45 p.u. from outside. Hence transfer price can be in the range Rs.35.33 to Rs.45.

Q-60

LNG Limited has three divisions. Its desired rate of return is 14%. The operating assets and income for each division are as follows:

 Divisions Operating Assets (Rs.) Operating Income (Rs.) L 19,20,000 3,45,600 N 10,50,000 1,73,250 G 12,30,000 1,67,280 Total 42,00,000 6,86,130

LNG Limited has Rs. 8,00,000 of additional cash to invest in one of its divisions.

The divisional managers have identified investment opportunities that are expected to yield the following ROIs–

 Divisions Expected ROIs for additional investment L 16% N 12% G 15%

Required

(i) (CALCULATE ROIs at present for each division and STATE which division manager is currently providing the highest ROI.

(ii)  Based on ROI, IDENTIFY the division manager who would be the most eager to accept the additional investment funds.

(iii) Based on ROI, IDENTIFY the division manager who would be least eager to accept the additional investment funds.

(iv) STATE the division that offers the best investment opportunity for LNG limited.

(v) DISCUSS the conflict between requirements (ii) and (iv) above.

(vi) ADVISE how the residual income performance measure could be used to motivate the managers to act in the best interest of the company.

(i) Present ROI of each division

 Divisions Operating Assets (Rs.) Operating Income (Rs.) ROI L 19,20,000 3,45,600 18% N 10,50,000 1,73,250 16.5% G 12,30,000 1,67,280 13.6%

The division manager of L division is currently providing the highest ROI of 18% among the three divisions.

(ii) The manager of division G would be most eager to accept the additional fund of Rs. 8,00,000 because of ROI of the proposed investment is more than the present ROI of 13.6% and the acceptance of the proposal would increase the division’s ROI.

(iii) The managers of division L and N, both would be reluctant to invest the additional fund of Rs. 8,00,000. Because the return on the proposed project is 16% for L and 12% for N against their existing ROI of 18% and 16.5% respectively.

However, the manager of division N would be least likely to accept the additional investment because the proposed ROI of the project is 4.5% less than present ROI.

(iv) Division L offers the best investment opportunity of 16% for LNG limited.

(v) Lack of goal congruence between divisions and organisation as a whole is the reason. The divisional managers are forced to choose between the best interests of their division (because their individual performance is linked to division performance) and the best interests of the company as a whole.

In requirement (ii) decision of mangers of division G is in the best interest of the division but at the expense of their company, resulting sub optimisation; whereas in requirement (iv) decision is taken from the perspective of LNG limited as a whole.

(vi) To avoid sub optimisation, the divisional performance can be measured using Residual Income (RI). Since under RI divisional managers don’t reject the proposed projects with lower returns than existing rate of return of division, hence in the interest of organisation as a whole division is ready to accept the investment projects with the returns equal to or greater than the predetermined required rate of return (i.e. 14%). RI being absolute measures have shortcoming too that performance of divisions with different sizes can’t be compared.

Hardware Ltd. manufactures computer hardware products in different divisions whichoperateasprofitcenters.PrinterDivisionmakesandsellsprinters.ThePrinterDivision’sbudgeted income statement, based onasalesvolume of 15,000units is given below. ThePrinter Division’sManager believesthat salescan be increased by 2,400 units, if the sellingprice is reduced by Rs. 20 per unit from the present price of Rs. 400 per unit, and that, for thisadditionalvolume,no additionalfixedcostswillbeincurred.

Printer Division presently uses a component purchased from an outside supplier at Rs. 70 per unit. A similar component is being produced by the Components Division of Hardware Ltd. and sold outside at a price of Rs. 100 per unit. Components Division can make this component for the Printer Division with a small modification in the specification, which would mean a reduction in the Direct Material cost for the Components Division by Rs. 1.5 per unit. Further, the Component Division will not incur variable selling cost on units transferred to the Printer Division. The Printer Division’s Manager has offered the Component Division’s Manager a price of Rs. 50 per unit of the component.

Component Division has the capacity to produce 75,000 units, of which only 64,000 units can be absorbed by the outside market.

The current budgeted income statement for Components Division is based on a volume of 64,000 units considering all of it as sold outside.

 Printer Division (Rs. ‘000) Component Division (Rs.‘000) Sales Revenue 6,000 6,400 Manufacturing Cost Component 1,050 - Other Direct Materials, Direct Labour & Variable 1,680 1,920
 Fixed Overhead 480 704 Variable Marketing Costs 270 384 Fixed Marketing and Administration Overhead 855 704 Operating Profit 1,665 2,688

Required

1. Should the Printer Division reduce the price by Rs. 20 per unit even if it is not able to procure the components from the Component Division at Rs. 50 per unit?

2. Without prejudice to your answer to part (i) above, assume that Printer Division needs 17,400 units and that, either it takes all its requirements from Component Division or all of it from outside source. Should the Component Division be willing to supply the Printer Division at Rs. 50 per unit?

3. Without prejudice to your answer to part (i) above, assume that Printer Division needs 17,400 units. Would it be in the best interest of Hardware Ltd. for the Components Division to supply the components to the Printer Division at Rs. 50?

 Particulars Printer Division Component Division Existing Price Reduction in Selling Price If Component is Purchased Internally Existing If Transfer Effected Selling Price 400 380 380 100 50 Less: Component Cost 70 70 50 - - Less: Other Direct Materials, Direct Labour & Variable 112 112 112 30 28.50
 Overhead Less: Variable Marketing Cost 18 18 18 6 - Contribution 200 180 200 64 21.50 Volume (units) 15,000 17,400 17,400 64,000 17,400 Total Contribution 30,00,00 31,32,000 34,80,000 40,96,000 3,74,100

 Volume Lost in the Market (units) 6,400* Contribution Lost (6,400 units × Rs.64) 4,09,600

(*) 17,400 units – Spare Capacity i.e. 11,000 units (75,000 units – 64,000 units)

(i) Yes, Printer Division should reduce price of its Printer by Rs.20, as there is an increment in net income by Rs.1,32,000 (Rs.31,32,000 – Rs.30,00,000). Incremental operating profit can be found in the as below: (Rs.)

Contribution Margin of Sales increase (Rs.180 × 2,400 units)     =    4,32,000

Less: Loss in Contribution Margin on Original Volume arising from decrease in Selling Price (15,000 units × Rs.20)  =  3,00,000

Increase in Operating Profit     =   1,32,000

(ii) No, The Component Division should not sell all 17,400 units to Printer Division for Rs.50. If the Component Division does sell all 17,400 units to Printer Division, Component Division will only be able to sell 57,600 units to outside customers instead of 64,000 units due to the capacity restrictions. This would decrease Component Division’s profit by Rs.35,500. Supporting calculations are as follows: (Rs.)

Contribution from Sales to Printer (Rs. 21.50 × 17,400 units) 3,74,100

Less: Loss in Contribution from Loss of Sales to outsiders (Rs. 64 × 6,400 units) 4,09,600

Decrease in Operating Profit 35,500

(iii) Yes, it would be in the best interest of Hardware Ltd. for the Component Division to sell the units to the Printer Division at Rs.50 each. The net advantage to the Hardware Ltd. is Rs.3,12,500 as shown below. The net advantage is the result of the cost savings from purchasing the Component unit internally and the contribution margin lost from 6,400 units that the Component Division otherwise would sell to outsiders.

 Total company (Rs. ‘000) Incremental Contribution- If the component is transferredwithin Rs. (3,480 – 3,132) 348.00 Contribution to the Component Division 374.10 Total incremental Contribution 722.10 Less: Contribution Lost by the Component Division 409.60 Net Contribution Gain 312.50

Q-62

ABC miners operates two divisions, one in Japan and other in United Kingdom (U.K.). Mining Division is operated in Japan which is rich in raw emerald.

The other division is United Kingdom Processing Division. It processes the raw emerald into polished stone fit for human wearing.

The cost details of these divisions are as follows:

 Division Japan Mining Division United Kingdom Processing Division Per carat of raw emerald Per carat of polished emerald Variable Cost 2,500 Yen 150 Pound Fixed Cost 5,000 Yen 350 Pound

Several polishing companies in Japan buy raw emerald from other local Mining Companies at 9,000 Yen per carat. Current Foreign Exchange Rate is 50 yen = 1 Pound. Income Tax rates are 20% and 30% in Japan and the United Kingdom respectively.

It takes 2 carats of Raw Yellow emerald to yield 1 carat of Polished Stone. Polished emerald sell for 3,000 Pounds per carat.

Required

(i) COMPUTE the transfer price for 1 carat of raw emerald transferred from Mining Division to the Processing Division under two methods - (a) 200% of Full Costs and (b) Market Price.

(ii) 1,000 carats of raw emerald are mined by the Japan Mining Division and then processed and sold by the U.K. Processing Division. COMPUTE the after tax operating income for each division under both the Transfer Pricing Methods stated above in (i).

(i) Transfer Price: 200% of Full Cost Basis

= 200% of (¥ 2,500 + ¥ 5,000)

= ¥ 15,000 or £300 (¥ 15,000/ 50)

Transfer Price: Market Price Basis =  ¥ 9,000 or £180 (¥ 9,000/ 50)

(ii) Statement Showing “Operating Income”

 Particulars Japan Mining Division UK Processing Division Transfer Price Transfer Price ¥15,000 ¥9,000 £300 £180 Selling Price (Polished Stone) --- --- £3,000 £3,000 Transfer Price (Raw Emerald) ¥ 15,000 ¥ 9,000 --- --- Raw Emerald --- --- £600 (£300 × 2) £360 (£180 × 2) Variable Cost ¥ 2,500 ¥ 2,500 £150 £150 Fixed Cost ¥ 5,000 ¥ 5,000 £350 £350 Profit Before Tax ¥ 7,500 ¥ 1,500 £1,900 £2,140 Less: Tax 20%/ 30% ¥ 1,500 ¥ 300 £570 £642 Profit After Tax per Carat of Raw Emerald ¥ 6,000 ¥ 1,200 £1,330 £1,498 Raw Emerald 1,000 Carats 1,000 Carats 500 Carats 500 Carats Total Profit ¥ 60,00,000 ¥ 12,00,000 £6,65,000 £7,49,000 Or Or Total Profit (£) £1,20,000 £24,000 £6,65,000 £7,49,000

Q-63

Global Multinational Ltd. (GML) has two Divisions ‘Dx’ and ‘Dz’ with full profit responsibility. The Division ‘Dx’ produces Component ‘X’ which it sells to ‘outside’ customers only. The Division ‘Dz’ produces a product called the ‘Z’ which incorporates Component ‘X’ in its design. ‘Dz’ Division is currently purchasing required units of Component ‘X’ per year from an outside supplier at market price.

New CEO for Indian Operations has explored that ‘Dx’ Division has enough capacity to meet entire requirements of Division ‘Dz’ and accordingly he requires internal transfer between the divisions at marginal cost from the overall company’s perspective.

Manager of Division ‘Dx’ claims that transfer at marginal cost are unsuitable for performance evaluation since they don’t provide an incentive to the division to transfer goods internally. He stressed that transfer price should be ‘Cost plus a Mark-Up’.

New CEO worries that transfer price suggested by the manager of Division ‘Dx’ will not induce managers of both Divisions to make optimum decisions.

Required

DISCUSS transfer pricing methods to overcome performance evaluation conflicts.

To overcome the optimum decision making and performance evaluation conflicts that can occur with marginal cost-based transfer pricing following methods has been proposed:

Dual Rate Transfer Pricing System

“With a ‘Dual Rate Transfer Pricing System’ the ‘Receiving Division’ is charged with marginal cost of the intermediate product and ‘Supplying Division’ is credited with full cost per unit plus a profit margin”. Accordingly Division ’Dx’ should be allowed to record the transactions at full cost per unit plus a profit margin. On the other hand Division ‘Dz’ may be charged only marginal cost. Any inter divisional profits can be eliminated by accounting adjustment.

Impact:

− Division ’Dx’ will earn a profit on inter-division transfers.

− Division ’Dz’ can chose the output level at which the marginal cost of the component ’X’ is equal to the net marginal revenue of the product ’Z’.

Two Part Transfer Pricing System

“The ‘Two Part Transfer Pricing System’ involves transfers being made at the marginal cost per unit of output of the ‘Supplying Division’ plus a lump-sum fixed fee charged by the ‘Supplying Division’ to the ‘Receiving Division’ for the use of the capacity allocated to the intermediate product.”

Accordingly Division ‘Dx’ can transfer its products to Division ‘Dz’ at marginal cost per unit and a lump-sum fixed fee.

Impact :

− ‘Two Part Transfer Pricing System’ will inspire the Division ’Dz’ to choose the optimal output level.

− This pricing system also enable the Division ’Dx’ to obtain a profit on inter-division transfer.

Q-64

Rohni Steel Company produces three grades of steel - super, good and normal grade. Each of these products (Grades) has high demand in the market and company is able to sell as much as it can produce these products.

The furnace operation is a bottle-neck in the process. The company is running at 100% of capacity. The company wants to improve its profitability. The variable conversion cost is Rs.100 per process hour. The fixed cost is Rs.48,00,000. In addition, the Cost Accountant was able to determine the following information about the three products (grades):

 Super Grade Good Grade Normal Grade Budgeted units produced 6,000 6,000 6,000 Total process hours per unit 12 12 10 Furnace hours per unit 6 5 4 Unit selling price Rs. 3,600 Rs. 3,400 Rs. 3,000 Direct material cost per unit Rs. 2,100 Rs. 1,900 Rs. 1,720

The furnace operation is part of the total process for each of these three products. Thus furnace hours are the part of process hours.

Required

(i) DETERMINE the unit contribution margin for each product.

(ii) Give an ANALYSIS to determine the relative product profitability, assuming that the furnace is a bottleneck.

(iii) Managements wishes to improve profitability by increasing prices on selected products. At what price would super and good grades need to be offered in order to produce the same relative profitability as normal grade steel?

(i)  Contribution Margin per unit

 Particulars Super Grade (Rs.) Good Grade (Rs.) Normal Grade (Rs.) Selling price per unit 3,600 3,400 3,000 Less: Variable Conversion Cost per unit 1,200 (Rs. 100 x 12 hrs.) 1,200 (Rs. 100 x 12 hrs.) 1,000 (Rs. 100 x 10 hrs.) Less: Direct Material Cost per unit 2,100 1,900 1,720 Contribution Margin per unit 300 300 280

(ii) The contribution margin per unit may give false signals when an organization has production bottlenecks. Instead, Company should use the contribution margin per bottleneck hour to determine relative product profitability, as follows:

 Particulars Super Grade Good Grade Normal Grade Contribution Margin per unit (Rs.) 300 300 280 Furnace Bottleneck hrs. Per unit 6 5 4 Contribution Margin per furnace hour 50 60 70

Analysis

The Super and Good Grade steel have the highest contribution margin per unit (Rs.300); however, the normal grade has the highest contribution margin per furnace hour (Rs.70). Thus, using production bottleneck analysis indicates that the Normal Grade is actually more profitable at a Rs.70 contribution margin per furnace hour than Super Grade’s Rs.50 or Good Grade’s Rs.60 contribution margin per furnace hour. Therefore, the company would want to sell product in the following preference order:

(iii) One way is to revise the pricing would be to increase the price to the point where all three products produce profitability equal to the highest profit product. This would be determined as follows:

Contribution Margin per furnace hour for Normal Grade =

Or

$$Rs. 70 = {(???????????????????????????? ???????????????????? ???????? ???????????????????? ????????????????????−????????.(1,200+2,100)) \over 6 hrs.}$$

Or,

Rs. 420 = Revised Price of Super Grade – Rs. 3,300

Super grade steel would require a revised price of Rs. 3,720 in order to deliver the same contribution margin per bottleneck hour as does Normal Grade steel.

Contribution Margin per furnace hour for Normal Grade =

Or

$$Rs. 70 = {???????????????????????????? ???????????????????? ???????? ???????????????? ????????????????????−????????.(1,200+1,900) \over 5 ℎ????????. }$$

Good grade steel would require a revised price of Rs. 3,450 in order to deliver the same contribution margin per bottleneck hour as does Normal Grade steel.

Q-65

ABC Airlines has two divisions organised as profit centre, the Passenger Division and the Cargo Division. The following divisional information were given for the year ended 31st March 2019:

 Particulars Cargo Division Passenger Division Total Number of personnel trained 200 800 1,000 Number of flights 350 250 600 Number of reservations requested Nil 7,000 7,000 Revenue Rs. 42,00,000 Rs. 42,00,000 Rs.84,00,000 Operating expenses (excluding  service department charges) Rs. 36,00,000 Rs. 28,50,000 Rs.64,50,000 Service Department Charges Training Rs.3,20,000 Rs.3,20,000 Rs.6,40,000 Flight Scheduling Rs.1,50,000 Rs.1,50,000 Rs.3,00,000 Reservation Rs.1,05,000 Rs.1,05,000 Rs.2,10,000

The service department charge rate for the service department costs was based on revenue. Since the revenue of both the divisions were the same, the service department charges to each division were also the same.

Required

(i) Comment on whether the income from operations for the two divisions accurately measures performance.

(ii) Prepare the divisional income statement using the activity bases provided above in revising the service department charges.

(i) The reported income from operations does not accurately measure performance because the service department charges are based on revenue. Revenue is not associated with the profit centre manager’s use of the service department services. For example, the Reservations Department serves only the Passenger Division and number of reservation requested by Cargo Division is NIL. Thus, by charging this cost based on revenue, these costs are incorrectly charged to the Cargo Division. Further, the Passenger Division requires additional personnel. Since these personnel must be trained, the training costs assigned to the Passenger Division should be greater than the Cargo Division.

(ii) ABC Airlines Divisional Income Statement for the Year Ended March 31, 2019

 Particulars Cargo Division  (Rs.) Passenger Division (Rs.) Total (Rs.) Revenue 42,00,000 42,00,000 84,00,000 Less:  Operating  Expenses  (excluding   service department charges) 36,00,000 28,50,000 64,50,000 Gross Margin 6,00,000 13,50,000 19,50,000
 Less: Service Department Charges Training 1,28,000 5,12,000 6,40,000 Flight Scheduling 1,75,000 (350 x 3,00,000)/600 1,25,000  (250 x 3,00,000)/600 3,00,000 Reservation Nil 2,10,000  (7,000 x 2,10,000)/7,000 2,10,000 Operating Income 2,97,000 5,03,000 8,00,000

Q-66

XYZ Ornamental Company has been a name to count on for quality and service. It has been designing wide range of ornamental products for more than two decades using the highest - quality standard. Such quality is achieved through years of experience and the integrity that is maintained by its employees. They are known for their perfection. VGG approached XYZ to make inquiry of two products. The two products are indoor fountain known as ‘The Star’ and a large gnome known as ‘Dwarfs’ for garden. Mr. Bob, the management accountant of XYZ, has estimated the variable costs per unit of ‘The Star’ and ‘Dwarfs’ as being Rs.622.50 and Rs.103.75 respectively. He estimated his calculations based on the following information:

(1) Products Data

 The Star Dwarfs Other Products Production/ Sales (units) 10,000 20,000 80,000 Total Direct Material Costs Rs.22,50,000 Rs.7,50,000 Rs.60,00,000 Total Direct Labour Cost Rs.15,00,000 Rs.5,00,000 Rs.60,00,000

1. Total variable overheads for XYZ are Rs. 120,00,000 out of which 30% belong to the procurement, warehousing and use of direct materials. While all other variable overheads are related to direct labour

2. XYZ presently allocate variable overheads into products units using percentage of total direct material cost and total direct labour cost.

3. VGG is willing to purchase ‘The Star’ at Rs.740 per unit and ‘Dwarfs’ at Rs.151 per unit.

4. XYZ will not accept any work yielding an estimated contribution to sales ratio less than 28%.

The directors of XYZ are considering switching to an activity-based costing system and recently appointed a management consultants firm to undertake an in-depth review of existing operations. As result of that review, the consultants concluded that estimated relevant cost drivers for material and labour related overhead costs attributable to ‘The Star’ and ‘Dwarfs’ are as follows:

 The Star Dwarfs Other Products Direct Material Related Overheads: (The volume of raw materials held to facilitate production of each product is the cost driver.) Material Ratio per product unit 5 8 5 Direct Labour related overheads: (The number of labour operations performed is the cost driver.) Labour Operations per product unit 7 6 5

Required

(i) Give a financial Analysis of the decision strategy which XYZ may implement about the manufacture of each product using the unit cost information available.

(ii)Discuss whether activity-based management should be adopted in companies like XYZ.

(i) Analysis

The product costs per unit along with the respective contribution per unit may be calculated either by employing an ABC approach or alternatively by using the existing basis for the allocation of variable overhead cost. The current scenario of product costing suggests that ‘Dwarfs’ should be produced as per the request of VGG because the contribution to sales ratio is 31 .29%. However, the current scenario of product costing also suggests that XYZ should not undertake production of ‘The Star’ at a selling price of Rs.740 per unit since the estimated contribution to sales ratio is 15.88% is lower than the desired contribution to sales ratio of 28%. Activity based costing approach ensures greater accuracy by using multiple cost drivers and determines areas generating the greatest profit or loss. Table [(d)] shows how much the contribution to sales (%) for each product changes when the overhead allocation method changes to ABC. As shown in Table, contribution to sales ratio on ‘The Star’ increased to 31.87% from 15.88% while contribution to sales ratio on ‘Dwarfs’ reduced from 31.87% to - 29.23%. Thus, XYZ should opt to produce ‘The Star’ for VGG as contribution to sales ratio is 31.87 which is higher than the desired one.

(ii) The term Activity based management (ABM) is used to describe the cost management application of ABC. The use of ABC as a costing tool to manage costs at activity level is known as Activity Based Cost Management (ABM). ABM is a discipline that focuses on the efficient and effective management of activities as the route to continuously improving the value received by customers and to improve strategic and operational decisions in an organisation. Kaplan and Cooper divide ABM into Operational and Strategic.

Operational ABM covers the actions that increase efficiency, lower cost (i.e. reduce the cost driver rate of activities) and lead to higher revenue through better resources utilisation- in short, the action required to do things right. In other words, it is all about ‘doing things right’, using ABC information to improve efficiency. It also helps in identifying and improving valueadded activities and removing non -value added activities as to reduce cost without distorting product value.

Strategic ABM is about ‘doing the right things’. It uses ABC information to determine which products is to be manufactured and which activities is to be used. XYZ can also use this for customer profitability analysis, identifying that which customers are the most profitable and focusing on them more. A risk with ABM is that some activities have an implicit value are not reflected in a financial value added to any product. For example, a good and pleasant working environment can attract and retain the best human resources, but might not be identified as value added activities in operational ABM.

ABM provides managers an understanding of costs and helps teams to make certain decisions that benefit the whole organizations and not just their own activities .

Therefore, some companies like XYZ may adopt ABM to improve their operations and obtain useful activity information.

Workings

(a) Direct Material Cost per unit

 The Star Dwarfs Total Costs (Rs.) 22,50,000 750,000 Production units 10,000 20,000 Cost per unit (Rs.) 225·00 37.50

(b)Direct Labour Cost per unit

 The Star Dwarfs Total Costs (Rs.) 15,00,000 5,00,000 Production units 10,000 20,000 Cost per unit (Rs.) 150·00 25·00

Material Related

Overhead Cost = 30% × Rs.120,00,000 = Rs.36,00,000 Total Volume Factor

 Particulars Units Required per unit Total Volume The Star 10,000 5 50,000 Dwarfs 20,000 8 1,60,000 Other 80,000 5 4.00,000 Total Volume Factor 6,10,000

Overhead per unit of volume = Rs.36,00,000/ 6,10,000 = Rs.5.90. Therefore, Overhead Cost per product unit will be as follows:

 The Star 5 Rs.5.90 29.5 Dwarfs 8 Rs.5.90 47.2

Labour Related

Overhead Cost = 70% × Rs.120,00,000 = Rs.84,00,000 Total Operations Factor

 Particulars Units Required per unit Total Volume The Star 10,000 7 70,000 Dwarfs 20,000 6 1,20,000 Other 80,000 5 4.00,000 Total Operations Factor 5,90,000

Overhead per operation = Rs.84,00,000/ 5,90,000 = Rs.14.24. Therefore, Overhead Cost per product unit will be as follows:

 The Star 7 Rs. 14.24 99.68 Dwarfs 6 Rs. 14.24 85.44

(a) Product Information (by unit) is as follows:

 Particulars The Star Dwarfs Current Scenario ABC Basis Current Scenario ABC Basis Selling Price                              …(A) 740.00 740.00 151.00 151.00 Direct Material Cost 225.00 225.00 37.50 37.50 Direct Labour Cost 150.00 150.00 25.00 25.00 Variable Overhead Cost: Material Related 90.00 29.50 15.00 47.20 Labour Related 157.50 99.68 26.25 85.44 Total Variable Cost                              …(B) 622.50 504.18 103.75 195.14 Contribution …(A) - (B) 117.50 235.82 47.25 (44.14) Contribution to Sales (%) 15.88 31.87 31.29 (29.23)

Q-67

A and B are two customers of XYZ Electronics Ltd., a manufacturer of audio players. Sellingpriceper unitisRs.5,400. ItscostofproductionperunitisRs.4,420.

Additional costs are: Order Processing Cost.................................................................................................................. Rs.2,000 per order

Delivery Costs.................................................................................................................. Rs.3,500 per delivery

Details of customers A and B for the period are given below:

 Customer A Customer B Audio Players purchased (nos.) 350 500 No. of orders 5 (each of 70 units) 10 (each of 50 units) No. of deliveries 5 0

The company’s policy is to give a discount of 5% on the selling price on orders for 50 units or more, and to further give 8% discount on the undiscounted selling price if a customer uses his own transport of collect the order. Assume that production levels are not altered by these orders.

Required

(i) Analyse the profitability by comparing profit per unit for each customer.

(ii) Comment on the discount policy on delivery

Customer’s Profitability Statement

 Particulars Customer- A Customer- B Sales (units) 350 500 (Rs.) (Rs.) Selling Price per unit 5,400 5,400 Less: Discount (Quantity) 270 (Rs. 5,400 × 5%) 270 (Rs. 5,400 × 5%) Less: Discount (Delivery) --- 432 (Rs. 5,400 × 8%) Selling Price (Net of Discounts) per unit 5,130 4,698 Less: Variable Cost per unit 4,420 4,420 Contribution per unit 710 278 Total Contribution 2,48,500 (Rs.710 × 350 units) 1,39,000 (Rs.278 × 500 units) Less: Additional Overheads Delivery Cost 17,500 (5 × Rs.3,500) --- Order Processing Cost 10,000 (5 × Rs.2,000) 20,000 (10 × Rs.2,000) Profit per customer* 2,21,000 1,19,000 Profit per customer per unit 631.43 238.00

(i)Analysis

Even though A has lower sales volume (30% lesser from B), it is contributing almost double profit that is being contributed by B as overall discount offered to customer A is quite less.

(ii)Comments on the “Discount Policy on Delivery”

Discount on delivery offered to customer B is Rs.432 per unit. If transport for delivery is provided to customer B then the cost would have been Rs.70 per unit (10 deliveries × Rs. 3,500

/ 500 units), which is lesser by Rs.362. It may also be noted that delivery cost in case of customer A is only Rs.50 per unit (Rs.17,500 ÷ 350 units). Hence, company needs to review discount policy on delivery but significance of profitability of customer B should also be kept in mind while doing so.

Q-68

ANCA Limited has decided to analyse the profitability of its four retail customers. It buysproduct 'Bioaqua' at Rs.218 per case and sells to them at list price less discount. The datapertainingtofourcustomers are:

 Particulars Customer A B C D No. of cases sold 7,580 38,350 78,520 15,560 List selling price Rs.250 Rs.250 Rs.250 Rs.250 Actual selling price Rs.245 Rs.236 Rs.228 Rs.232 No. of sale visits 6 12 16 10 No. of purchase orders 12 18 35 24 No. of delivery kilometers 280 350 450 400

It's four activities and cost drivers are:

 Activity Cost Driver Rate Sale visits Rs.750 per sale unit Order taking Rs.800 per purchase order Deliveries Rs.10.50 per delivery km travelled Product handling cost Rs.2.50 per case sold

Required

i) Compute the customer level operating income.

ii) Analyze the profitability for each customer.

Customer’s Profitability Statement

 Particulars Customer- A Customer- B Customer- C Customer- D Sales (cases) 7,580 38,350 78,520 15,560 (Rs.) (Rs.) (Rs.) (Rs.) List Price per case 250 250 250 250 Less: Discount 5 14 22 18 (Rs.250 × 2%) (Rs.250 × 5.6%) (Rs.250 × 8.8%) (Rs.250 × 7.2%) Actual Selling Price (Net of Discounts) per case 245 236 228 232 Less: Variable Cost per unit 218 218 218 218 Contribution per unit 27 18 10 14
 Total Contribution 2,04,660 (Rs.27 × 7,580 units) 6,90,300 (Rs.18 × 38,350 units) 7,85,200 (Rs.10 ×78,520 units) 2,17,840 (Rs.14 ×15,560 units) Less: Additional Overheads Visit Cost 4,500 9,000 12,000 7,500 (6 × Rs.750) (12 × Rs.750) (16 × Rs.750) (10 × Rs.750) Order Processing Cost 9,600 14,400 28,000 19,200 (12 × Rs.800) (18 × Rs.800) (35 × Rs.800) (24 × Rs.800) Delivery Cost 2,940 3,675 4,725 4,200 (280 × Rs. 10.50) (350 × Rs.10.50) (450 × Rs.10.50) (400 × Rs.10.50) Product Handling Cost 18,950 (7,580×2.50) 95,875 (38,350 × Rs.2.50) 1,96,300 (78,520 × Rs.2.50) 38,900 (15,560 × Rs 2.50) Profit per customer 1,68,670 (11.81% of total) 5,67,350 (39.72% of total) 5,44,175 (38.10% of total) 1,48,040 (10.37% of total) Profit per customer per Case 22.25 14.79 6.93 9.51

(ii) Going by volume of cases sold, customer C is the biggest customer accounting for 56% of total sales volume, followed by customer B (27%), customer D (11%) and customer A (6%). However, in terms of profit per customer, Customer B is the most profitable accounting for 39.72% of the cumulative customer profits of Rs.14,28,235. Customer C contributes to 38.10% of the same. Comparing customers B and C, customer B is more profitable despite accounting for sales volume that is less than half of customer B (customer C’s 56% of sale volume versus customer B’s 27%). The primary reason for this is because the discount given to customer C

(8.8%) is higher than that given to customer B (5.6%). The difference is terms of sale could be due to the fact that customer C is the biggest customer and hence is able to negotiate for a higher discount.

Consequently, for each case sold, customer C gets an additional discount of Rs.8 as compared to customer B. This is reflected in the contribution generated per case. Sale of one case to customer C generates Rs.10 contribution versus sale of one case to customer B generates Rs.18 contribution. This has a huge impact on profitability. In terms of profit generated per case sold, customer C has the lowest contribution at Rs.6.93 per case. The company may review whether this difference in terms of sale to each of its customers is justified. If the discount to customer C at 8.8% was initially extended to promote sales, negotiations can be made to reduce this to mutually acceptable rates. However, care must be taken not to lose customer C to competitors. Customer D is the least profitable accounting for just 10.37% of the total customer profits. In terms of sale volume, the customer ranks third providing 11% volume. However, the customer is not profitable because of the following reasons:

a) A discount rate of 7.2% is provided to the customer. Each case sold after a discount of Rs.18 per case, generates a contribution per case of only Rs.14 per case. This is much lower compared to the contribution per case of customer A (Rs.27 per case) and customer B (Rs.18 per case). This discount policy may need to be reviewed. One scenario where such a high discount may be justified would be where customer D supplies the products that it manufactures at a discounted rate to a sister concern of the company. Therefore, at a parent company / overall level, the higher discount rate for a low volume customer D may be justified.

b) For a customer that provides 11% of volume, the number of site visits during the year were 10. Customer C giving 56% of volume had only 16 visits and customer B giving 27% of volume had only 12 visits. This indicates that customer D, although a smaller customer, requires more visits than regular customers. Therefore, site visit costs are higher for this customer. The reason for a higher handholding by the company for this customer has to be analyzed. For example, one possible reason could be that customer D requires the cases customized to its production requirement. This may require more site visits by the company’s personnel. To resolve this, due to the extra work involved, the company may wish to charge a higher sale price for the cases customized for customer D. In another other scenario, it may choose to charge the customer a fixed rate for each site visit.

c) For a customer that provides 11% of volume, the number of orders placed in a year are 24. Customer C giving 56% of volume placed 35 orders in a year and customer B giving 27% of volume placed 18 orders in a year. This indicates that customer D, although a small customer, places orders more frequently than other larger customers. Therefore, order processing costs are higher for customer D. The company may revise ordering schedule for this customer or find out the reason for higher proportion of purchase orders, in order to pass on some of the cost to the customer. For example, let us say, customer D has an agreement with the company to provide cases “just in time” resulting in more frequent orders as compared to other customers. Therefore, the company is providing flexibility in procurement to customer D. For this convenience, it may pass on some of the ordering cost to customer D by way of a higher selling price or a lower discount.

d) Again, given the volume, the number of deliveries to customer D (400) is at a higher proportion compared to the larger customers C (450) and B (350). The company may revise delivery schedule for this customer or find out the reason for higher proportion of deliveries, in order to pass on some of the cost to the customer. For example, let us say, customer D has an agreement with the company to provide cases “just in time” resulting in more frequent deliveries as compared to other customers.

Therefore, the company is providing flexibility in procurement to customer D. For this convenience, it may pass on some of the delivery cost to customer D by way of a higher selling price or a lower discount. Customer A is the smallest customer providing only 6% of total sale volume. However, with a contribution per case at Rs.27 per case and a profit per case at Rs.22.25 per case, it is the most profitable of all customers. The primary reason for this is the discount of 2% offered is much lower than other customers. Each case sold to customer A yields a contribution of Rs.27 as compared to a contribution of Rs.10 from customer C, the biggest customer. Possible reason for a lower discount maybe customer A, being a smaller player, may have lesser bargaining power compared to other customers. If the company wishes to have a longer business relationship with customer A, it may wish to provide more favorable discount terms to this party. However, since customers B and C are much larger customers, any benefit passed onto customer A should not impact the company adversely in the long run. For example, in order get more orders from customer A, the company gives a 10% discount to the party. Consequently, the profitability of customer A will decrease. Let us say customer A places huge orders due to which there are capacity constraints within the company. Sales to customers B and C, the current larger customers, may be impacted. This could affect the company adversely in terms of lost sales to customers B and C and loss of business relationships with these parties. Therefore, careful consideration should be given before extending discounts to improve sales from customer A.

As regards product handling cost, each customer is currently charged Rs. 2.5 per case sold. The company, if feasible, apply Activity Based Costing technique to find out if this can be allocated based on the cost driver for each customer. Let us say, packing cost before shipment is part of product handling cost. If customer B requires special packing to ship the goods, then customer B needs to be allocated a higher packaging cost as compared to the others. This cost can be recouped from customer B through a higher selling price.

Q-69

Queenstown Furniture (QF) manufactures high-quality wooden doors within the forests of Queenstown since 1952. Management is having emphasize on creativity, engineering, innovation and experience to provide customers with the door they desire, whether it is a standard design or a one-of-a-kind custom door. The following information pertains to operations during April:

 Processing time 9.0 hrs.* Waiting time 6.0 hrs.* Inspection time 1.5 hr.* Move time 7.5 hrs.* Units per batch 60 units

(*) average time per batch

Required

Compute the following operational measures:

1. Average non-value-added time per batch

2. Average value added time per batch

3. Manufacturing cycle efficiency

4. Manufacturing cycle time

1.  Average Non-Value Added Time per batch

= Inspection Time + Waiting Time + Move Time

= 1.5 hr. + 6.0 hrs. + 7.5 hrs.

= 15 hrs.

2. Average Value Added Time per batch

= Processing Time

= 9 hrs.

3. Manufacturing Cycle Efficiency

$$={ 9.0 Hrs\over9.0 Hrs+1.5 Hrs.+6.0 Hrs+7.5 Hrs}$$

= 37.5%

4. Manufacturing Cycle Time

= Total Production Time Unit per Batch

= 24 Krc/60 Unitc

= 0.40 hrs. per unit

Q-70

6-Twelve is an Indian – Japanese international chain of convenience stores for food, snacks, hot and cold beverages is formulating its activity-based budget for January 2019. 6- Twelve has only three product types: Soft Drinks, Fresh Drinks, and Ready to Eat Food. The budgeted data relating to three products are as under:

 Activity and Driver Cost Driver Rates Jan 2019 Budgeted 2018 Jan 2019 Amount of Driver Used Actual Rate (Rs.) Budgeted Rate (Rs.) Soft Drinks Fresh Drinks Ready to Eat Food Ordering (per purchase order) 5,000 4,500 16 20 16 Delivery (per delivery) 4,000 4,100 13 60 20 Shelf-Stocking (per hour) 1,000 1,050 15 170 93 Customer Support (per item sold) 10 9 4,500 34,600 10,500

6-Twelve has a continuous improvement system to budgeting monthly activity costs for each month of 2019. February's budgeted cost-driver rate is 0.996 times the budgeted January 2019 rate. March's budgeted cost-driver rate is 0.996 times the budgeted February 2019 rate and so on.

Required

(i) Compute total budgeted cost for each activity in January 2019.

(ii)Discuss advantages might 6-Twelve gain by using an activity-based budgeting approach over, say, an approach that allocates the cost of these activities to products as a percentage of the cost of goods sold.

(iii) Compute total budgeted cost for each activity in March 2019 if March 2019 has the same budgeted amount of cost-driver usage as January 2019.

(iv) State benefits of 6-Tweleve adopting a kaizen budgeting approach. Identify limitations?

(i) Calculation of Total Budgeted Cost for Each Activity     (Rs.)

 Activity Cost  Hierarchy Soft Drinks Fresh  Drinks Ready to Eat  Food Total Ordering  (Rs.4,500 × 16; 20; 16) Batch-Level 72,000 90,000 72,000 2,34,000 Delivery (Rs.4,100 × 13; 60; 20) Batch-Level 53,300 2,46,000 82,000 3,81,300 Shelf stocking  (Rs.1,050 × 15; 170; 93) Output Unit  Level 15,750 1,78,500 97,650 2,91,900 Customer support (Rs.9× 4,500; 34,600;  10,500) output Unit Level 40,500 3,11,400 94,500 4,46,400 Total Budgeted Costs 1,81,550 8,25,900 3,46,150 13,53,600

(ii) An Activity Based Budgeting approach identifies how different products require different mixes of support activities. The relative percentage of how each product area uses the cost driver at each activity area is:

 Activity Cost Hierarchy Soft Drinks (%) Fresh Drinks (%) Ready to Eat Food (%) Total (%) Ordering Batch-Level 30.77 38.46 30.77 100.0 Delivery Batch-Level 13.98 64.52 21.50 100.0 Shelf Stocking Output Unit Level 5.40 61.15 33.45 100.0 Customer Support Output Unit Level 9.07 69.76 21.17 100.0

By identifying these differences, 6-Tweleve managers are better able to budget for different unit sales levels and different mixes of individual product-line items sold. Using a single cost driver such as ‘Cost of Goods Sold’ considers similarity in the use of indirect costs (support activities) across product lines which does not occur at 6- Twelve.

Other benefits cited by managers include:

1. Better identification of resource needs.

2. Clearer linking of costs with staff responsibilities, and

3. Identification of budgetary slack.

(iii)March 2019 Rates (Rs.)

 Activity Cost Hierarchy January February March Ordering Batch-Level 4,500.00 4,482 4,464.07 Delivery Batch-Level 4,100.00 4,083.60 4,067.27 Shelf-stocking Output Unit Level 1,050.00 1,045.80 1,041.61 Customer support Output Unit Level 9.00 8.96 8.93

These March 2019 rates can be used to compute the total budgeted cost for each activity area: (Rs.)

 Activity Cost Hierarchy Soft Drinks Fresh  Drinks Ready to Eat  Food Total Ordering (Rs.4,464.07 × 16; 20; 16) Batch-Level 71,425 89,281 71,425 2,32,131 Delivery (Rs.4,067.27 × 13; 60;20) Batch-Level 52,875 2,44,036 81,345 3,78,256 Shelf-Stocking  (Rs.1,041.61 × 15;170;93) Output Unit  Level 15,624 1,77,073 96,870 2,89,567 Customer support (Rs.8.93 × 4,500;34,600;10,500) Output Unit Level 40,185 3,08,978 93,765 4,42,928 Total Budgeted Costs 1,80,109 8,19,368 3,43,405 13,42,882

(iv) A kaizen budgeting approach indicates management's commitment to organized cost reduction. Compare the budgeted costs from previous part.

 Ordering Delivery Shelf-Stocking Customer Support Part (i) 2,34,000 3,81,300 2,91,900 4,46,400 Part (iii) 2,32,131 3,78,256 2,89,567 4,42,928

Q-71

Apple Ltd., is following three variances method to analyse and understand production overhead variances. The three variances for a particular year were reported as given below:

 Rs Production overhead expenditure variance 94,000 A Production overhead volume variance 1,00,000 F Production overhead efficiency variance 48,000 F

The other particulars furnished from the records of the company are:

 Standard machine hours for the year 11,500 Closing balance in the production overhead control account Rs. 18,00,000 Fixed overhead rate per hour Rs. 125 Variable overhead rate per hour Rs. 80

Required

COMPUTE the following by considering the additional information also :

(i)Actual machine hours

(ii)Budgeted machine hours

• Expenditure variance was computed totally for fixed and variable overheads.

• Volume variance is applicable to fixed overhead only.

• Efficiency variance is applicable only to variable overhead and fixed overhead efficiency variance was already included in volume variance )

(i) Calculation of Actual Machine Hours

Efficiency Variance = Rs. 48,000 (F) given

= Standard Variable Overhead Rate per Hour × (Standard Hours – Actual Hours)

Rs.48,000(F) = Rs.80 × (11,500 hrs. – Actual Hours) Actual Hours = 10,900 hrs.

(ii)Budgeted Machine Hours

Volume Variance = Rs.1,00,000 (F)

= Standard Fixed Overhead Rate per Hour × (Standard Hours – Budgeted Hours) Rs.1,00,000 (F) = Rs.125 × (11, 500 hrs. – Budgeted Hours)

Budgeted Hours = 10,700 hrs.

Fixed Production Overhead = Standard Fixed Overhead Rate per Hour × Budgeted Hours

= Rs.125 × 10, 700 hrs.

= Rs.13,37,500

• Assumed Budgeted

= Standard Overhead Rate per Hour × Standard Hours

= Rs.205 × 11, 500 hrs.

= Rs.23,57,500

Q-72

Mr. Benn, oversees the diverse operations of Bennsys, a large multinational company by using a much decentralized management structure. According to its 2019 annual report,

Bennsys had 1, 25,000 employees and earned over $100 billion in revenue. Mr. Benn managed this empire from his headquarters in London, that consists of 20 employees and occupies only 10,000 square feet, although the company's vice-chairman, Simon, who works out of London, occupies another 600 square feet. The total payroll, including benefits, of both locations was only just above$2 million in 2019. Mr. Benn was invited as the chief guest in a business summit organized at New Delhi during March, 2020. Asked about how an organization of that magnitude could be managed with such a small resources as to space and manpower. Mr. Benn's own description about his and Mr. Simon's management style is, "we delegate almost to the point of abdication (renouncing everything)." An exaggeration perhaps, but clearly a decentralized style and he and his deputy are the stable believers of FOUR recognized levels of decentralization. In the context of responsibility accountings DISCUSS the levels of decentralization which Mr. Benn was referring to and do you concede to the view that Mr. Benn is exaggerating the success of his Divisional organization structure.

(b) In a business context, decentralisation is the delegation of decision-making authority to smaller local units at lower levels of the organisation. This takes some control away from the hub and will often result in an upward flow of information – the opposite of what happens in a centralised organisation. An organisation with divisional structure has various divisions operating autonomously as business under a broad corporate framework according to geographical areas, markets or products and services; there by limiting the centralized monitoring and scrutinizing of each and every element of functioning. This would spare the top management from deploying time and efforts by sitting on the top at gigantic corporate offices. ‘Bennsys’ is a good example of a decentralised business. Mr. Benn is managing a staff of over 1,25,000 persons which is earning revenue over \$100 billion in revenue with small resources.

Responsibility accounting is apt where top management has a willingness to delegate the authority to make decisions. The idea behind the responsibility accounting is that each manager’s performance should be judged by how well he or she manages those items under his or her control. There are four recognised levels of decentralisation in the context of responsibility accounting which Mr. Benn was referring to are detailed below:

Revenue Centre managers are having control over the generation of revenue from operation with no responsibility for costs.

Cost Centre managers exercise control over costs but not revenues and investments.

Their responsibility is to minimize the cost of producing a specified level of output or the cost of providing a specified level of service. The objective of cost centre managers is to improve the efficiency of operations by finding ways to cut costs and minimize waste. Profit Centre managers are having focus on profit. Their goal is to both maximize revenues and to minimize costs.

Managers of Investment Centres make decisions that influence costs, revenues, and investments. Their responsibility is to maximize the returns from invested capital, or to put the capital invested by owners and shareholders of their organizations to the best profitable use.

Organizations vary considerably in the extent to which they decentralize because decisions about whether and how much to decentralize involves numerous costs and benefits. Moreover, the scale of these costs and benefits depends on specific facts. A major chunk of top management’s responsibility is to find out how to   maximize the benefits and minimize the costs associated with decentralization. An organisation can increase benefits by carefully identifying the decisions under each manager’s purview, matching the scope of decisions with the manager’s skills and knowledge. It can also help lower-level managers in understanding the firm’s values, goals, and strategy. Mr. Benn clearly expressed the management style that has focus on abdication. Abdication, like delegation, involves allocating duties and responsibilities to a team - but without the measuring and managing part. It sounds reasonable to believe that Mr Benn’s style of functioning leads to the decentralization of decision-making process where in the division heads are free to set selling prices, choose which markets to tap in, make product mix and output decisions and select suppliers.

If decentralized business model is ideally crafted to suit the desired style of functioning, how voluminous the organisation be, could be well managed by the top management by occupying reasonably small space with very minimum number of employees and act on the basis of management by exception.