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PRINCIPLES OF ENGINEERING ECONOMICS & MANAGEMENT TECHNIQUES (PEEMT)

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Chapter 1 : Cost Analysis

Chapter 2 : Replacement Studies

Chapter 3 : Economic Analysis of Investment Alternatives

Chapter 4 : Cost Estimation

Chapter 5 : Depreciation

Chapter 6 : Human Resource Management

Chapter 7 : Procurement and Placement

Chapter 8 : Training and Development

Chapter 9 : Job Satisfaction

Chapter 10 : Integration and Maintainence

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Chapter 1 : Cost Analysis

Q. 1. Define break-even point.

Ans. When the total costs incurred and the total value of sales made are equal, the organisation attains a stage of no loss and no profit i.e., the sale proceeds are just enough to cover the total costs (both the fixed costs and variable costs). This position is called the break-even point. If sales go up beyond the break-even point, organisation makes a profit; if they come down, a loss is incurred. Thus, sales at break-even point is the minimum amount of sales that must be effect in order to avoid any loss. This figure is very useful for accountants in studying the profit factors. In this context acknowledge of the marginal costing method is essential for the study of break - even analysis. It may be said that break — even analysis is simply an extension of the principles of marginal costing.

Q. 2. Describe the significance of, break-even chart.

Ans. Graphically, break-even point is represented in a break-even chart. A break-even chart or profit graph shows the extent of profit or loss at different levels of sales. It is a graphic analysis of the relationship between costs, volumes of activity and profits. Break- even chart is an excellent tool for management planning and control. It can be used to determine the break-even volume, optimum level of output, profit for a given level of output and the effect of change in sales on costs and prices.

A typical break-even chart prepared on the basis of above of illustration is given below

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In this chart quantity of output is shown on the. X-axis. The fixed cost line is horizontal to the X-axis indicating that fixed costs remain unchanged up to 12,000 units of output. The variable cost line is superimposed on the fixed cost line to show total costs. The point at which the total revenue line intersects the total cost line is the break-even point.

At the point the quantity produced and sold is 5,000 units or the sales revenue and costs are Rs. 2,00,000. The excess of actual sales volume over the break-even sales value is called the margin of safety. Greater the safety margin higher would be the profits. A firm should have a reasonable margin of safety as resistance power-avoid losses. If the safety margin is low a firm runs the risk of incurring losses during the period of reduced business activity. The margin of safety may be low either because the actual sales are low or the fixed costs are very high.

Break-even analysis is a simple and inexpensive technique, It can be used for several purposes especially in industries which are not subject to frequent changes in technology, product-mix and factor prices. It presents a microscopic picture of the profit structure of a firm. It highlights the areas of economics strengths and weaknesses and reveals the profit vulnerability of the firm to changes in business conditions. However, breakdown analysis is based on several assumptions which are not true in practice. The selling price, rate of increase in variable cost are assumed to be constant. It is assumed that there will be no changes in input prices, product mix, labour efficiency and technology. Production and sales volumes are assumed to be equal, ie., there is no change in inventory level. Selling costs are ignored. Break-even analysis is a static picture as it assumes constant relationship of output to costs and revenue. Break-even analysis is based on accounting data which may suffer from several limitations like neglect of imputed costs, arbitrary depreciation estimates, inappropriate allocation of overheads, etc.

Q, 3. Describe, Managerial Uses of Break-even Analysis.

Ans. Managerial Uses of Break-even Analysis.

Despite its limitations, break-even analysis has been found useful in several types of managerial decisions. Some of the important managerial applications of break-even analysis are given below:

1. Capacity Planning. Sometimes, management is faced with the problem of deciding whether to expand plant capacity to meet increased demand for the product. The break- even analysis helps in understanding the impact of increase in output on the firm’s fixed costs and profits.

Example. ABC company is examining a proposal to expand its plant capacity which is expected to increase its annual sales from Rs. 40 lakhs to Rs. 60 lakh. The expansion will involve an increase in fixed cost from Rs. 15 lakhs to Rs. 20 lakhs. The variable cost is likely to remain unchanged at 50% of the sales revenue.

Should the company go in for expansion?

Solution.



As the increase in sales (Rs. 20 lakhs) is greater than the increase in break-even point the company should go in, for expansion.

2. Choice of Technique. Break-even analysis is a useful guide in the selection of most economical production process or equipment. It gives a comparative view of costs of using alternative techniques at different levels of output. Generally, simple and traditional process/equipments are more economical at low levels of output because they require minimum costs. But at very high levels to output, highly sophisticated and expensive process/equipments might be more profitable.

3. Product-mix Decision. A multi-product firm has to decide the relative proportion of different products in the total output. The objective here is to find out the best combination (mix) of products that can maximise profits. Beak-even analysis is helpful in determining the most profitable product-mix.

Example. Shilpa Toys Factory has a capacity to provide 3,999 hours per week. The plant can produce two types of toys x and y. Annual costs are Rs. 12,000. The maximum possible sales are estimated to be 4,000 toys of x types and 3,000 y type. Following additional information is available.

Find out the product-mix that will maximise the net profits of the factory.

4. Plant Shutdown Decision. During recession and such other periods when the demand falls considerably, a firm is faced with the problem of deciding whether to close down the plant temporarily or to continue production and sales at prices that do not .cover total costs. Break-even analysis facilitates such a decision by differentiating sunk costs from out of pocket costs. Sunk costs are the fixed costs already incurred and which will be there even it the plant is shut down temporarily. Out of pocket costs are the expenses which need not be incurred if the production is stopped.

Example. A toys factory is facing recession. Its sunk costs are Rs. 50 lakhs per annum while the out of pocket costs are Rs. 80 per unit. The factory has a capacity to produce 24,000 units per years. Due to recession the maximum expected sales for six months are 6,000 units at a selling price of Rs 100 per unit. The recession is expected to last 6 months. Should the factory be shut down for this period?

Solution. If the factory is shut down the total loss will be Rs. 2.5 lakhs (half of annual

sunk costs). But if the factory operates :

The factory should not be shut down.

5. Drop or add a product. In the course of product planning the management has to decide whether to add a product to the existing product line. Similarly, management may feel that an existing product has outlived its utility and should be deleted from the product line. Break-even analysis



is useful in such decisions as it indicates the impact of such decisions on the costs and revenues of the firm.

6. Make or Buy Decisions. Management of a firm has often to take a decision whether to buy a component or to manufacture it. For example, an automobile manufacturer can make spark plugs or buy them from the market Break-even analysis can enable the manufacturer to take a decision of this type.

Example. An automobile manufacturer buys a certain components at Rs. 8 per unit. In case he makes it himself, his fixed and variable Costs would be Rs. 18,000 and Rs. 5 per unit, respectively. Should the manufacturer make or buy the component?

Solution.

So it would be profitable for the manufacturer to make the component if he needs more than 6,000 units per year.

Make or buy decisions, however, should be taken after considering the following points:

(a) Is the supply from the market certain and timely?

(b) Is the required quality available?

(c) Does the supplier try to take any monopoly advantage?

In addition to the above uses, break-even analysis can also be used to determine volume required to earn target profits, to find out impact of changes in costs and prices, to determine promotion mix, etc.

Q. 4. Define Margin of safety.

Ans. Excess of actual sales revenue over the break-even sales revenue, expressed usually as a percentage. The greater this margin, the less sensitive the firm to any abrupt fall in revenue. Formula: (Actual sales revenue-Break-even sales revenue) x 100 ÷ Actual sales revenue.

Margin of safety is a concept used in may areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons ? Probably not. It would be much more prudent to build to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying is at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9.

Q. 5. Define Angle of incidence.

Ans. Angle of incidence indicates the rate at which profit is earned in an organisation after crossing the break-even point. In a break even chart, the angle at which the sales line cuts the total cost line is called the angle of incidence. While the point at which the sales and total cost line cut each other is called the break-even point, the angle at which these lines intersect



is called the angle of incidence. Sales after break even point will bring profit; therefore, this angle indicates the profit earning rate of the business. Hence, it is also called profit angle or profit path1n this sense, the concept of angle of incidence is an important tool for management in times of expansion of the market for the product.

Every business concern would like to have as large an angle of incidence as possible because a wide angle represents a higher rate of profit earning and a narrow angle implies relatively a low rate of return. The consideration of the angle of incidence arises only after meeting the entire amount of fixed costs; therefore, the nature of the angle depends upon the incidence of variable costs. In other words, a norrow angle indicates that variable costs form relatively a large part of the cost of the product and vice versa.

Q. 6. What is Profit-volume ratio (P.V.R.) ?

Ans. This indicates the relation between the sales value and its corresponding contribution. This explains the rate at which sales are contributing towards the recovery of fixed costs and profit. A high ratio means that break even point is achieved soon after which profit is earned at a higher rate and a low ratio implies the opposite. The following formula calculates this ratio.

From the above discussion, we can understand that the term “Profit Volume Ratio” is rather misleading, because the term profit where actually means, the contribution of the sales and the term volume actually means sales value and not the sales volume. Therefore, properly speaking it should be called Contribution Sales Ratio (C.S.R.). However, since the term P.V.R. is widely used, we also use the same name in our lessons. Every organisation strives to improve their P.V. ratio ether by reducing the variable cost per unit or by increasing the selling price per unit whichever is possible. A high P.V. ratio earns profits at an accelerated rate and vice versa. The P.V. ratio can be depicted graphically.

Q. 7. How to construct a profit-volume chart?

Ans. (1) Use the horizontal axis for the sales value and the vertical axis for the costs and profit.

(2) Measure the sales value (in terms of Rupees) on the horizontal axis by drawing “Sales line” just in the middle of the chart so as to cut the graph into two areas, the area above the line representing the “profit area” and the area below the line representing the “loss area”.

(3) Measure the fixed costs on the vertical axis below the sales line (in the loss area) measuring from the zero point (see the chart).

(4) Measure title profit on the vertical axis above the sales line (in the profit area).



(5) Draw a straight line connecting the points of total fixed costs and the profit volume

of the maximum sales.

Q. 8. What are Shortcomings of the Break-even Analysis?

Ans. (1) The Break-even Point (BEP) is based on some assumptions, such as sales -price, costs, production, sales, etc The technique will be only of financial value unless all these assumptions are well calculated. Besides, the technique is a preliminary and supplementary tool in the whole exercise of ratio analysis.

(2) The technique is to provide cost-escalation as built-in safeguard against increase in prices.

(3) The proper analysis of various costs into fixed costs and variable costs is very important. This is so because; some of the items will neither fall under fixed costs nor under variable costs. Hence, semi-variable costs may cost its effect on the BEP. BEP may not prove useful to rapidly growing enterprises and to enterprises that frequently change their product mix.

(4) It has limited utility in case of multi products.

(5) It does not due cognizance of factors like uncertainty and risk involved in estimates for costs, volume and profits.

(6) It is not a patent tool for long Range Planning.

Q. 9. Differentiate Risk and uncertainty.

Ans. “Risk” and “uncertainty” are two terms basic to any decision making framework. Risk can be defined as imperfect knowledge where the probabilities of the possible outcomes are known, and uncertainty exists when these probabilities are not known. A more common usage of these terms would state uncertainty as imperfect knowledge and risk as uncertain consequences. If a person says “I am uncertain about the weather tomorrow, : this would be a value-free statement implying imperfect knowledge about the future. If this same person says, “I am planning a picnic for tomorrow and there is a risk of rain”, now h or she is indicating preference for an alternative consequence. Taking a risk can now be defined as exposing one’s self to a significant chance of injury or loss. Thus risk is variability or randomness that can be quantified. Risk can lead to an unfavourable outcome, but also to a favourable outcome (i.e. there can be a “risk of a positive outcome”). Risk often stems from a process that is repeated many times. Uncertainty is randomness which cannot be described by a distribution. Uncertainty often stems from an infrequently occuring, discrete event.

Q. 10. Effect of Risk and uncertainty on lot size.

Ans. Any project related decision or policy is affected by many variables subject to uncertainty. It does not imply, however, that it is practically impossible to assess the reliabilities of finding from cost benefit analysis. In



many cases, it might be useful to focus on risks which are well-defined and quantifiable and disregard uncertainties which are very unlikely to materialise.

As in mm-max inventory control two points are to be known, i.e. recorder point and the quantity to be ordered. If there is no uncertainty, the graph between the time and the balance on hand shows a pattern as shown in Fig. given below:

Fig. 1.1 Graph between the balance in hand, and time under the condition of certainty.

In this case, when the quantity on hand falls to recorder point, an order must be placed for the ordered quantity. Since there is no uncertainty, this ordered quantity will— arrive just as the stock at hand falls to minimum. Then with the new arrival the stock position reaches to maximum (i.e. minimum + ordered quantity = maximum). As consumption continues, the stock will again fall towards the recorder point.

But under uncertainty, this is not the situation. As if no uncertainty is there, there is no need to maintain the minimum quantity, i.e. safe reserve at all; because the new order would arrive exactly on time, when inventory falls to zero. Now under uncertainty there are two types of uncertainty. Uncertainty about the rate of consumption of inventory an uncertainty about the amount of time required for delivering the new order. The consumption increases with the demand and shows down in periods of declining in sales. The time required for supplying depends upon the supplier and on the transportation facilities — these are subjected to uncertainty. Further if the parts stored are manufactured by the company itself. There is undertinly due to the bottleneck in production, breakdown in machines and so on.

This is clear that mm-max inventory control involves uncertainty, and to solve such problem the theory of probability is used. Now the pattern of graph (Fig. 1.1) changes to graph shown in Fig. 1.2.



Fig. 1.2. Graph between the balance in hand and the condition of uncertainty.

The graph shown in Fig. 1.2 shows that inventory will fall below the minimum, even down to the zero, because of rapid consumption or delay in the delivery or ordered quantity. Many times the inventory will reach above the maximum, because the slower consumption after the order was placed, or because of rapid delivery.

The consumption required for recorder point and ordered quantity is quite tedious

and complicated which requires lengthy statistical procedures and is beyond the scope of this book.

Q. 11. What is life-cycle analysis ?

Ans. Life-cycle analysis

Life-cycle cost analysis involves the consideration of all relevant costs of a project, beginning with the planning and design stage, through development and testing, production operation, and maintenance to the final stage sale or disposal. It is widely used under government contracts, such as defense procurement and public works, in order to minimize the total cost of the project over its useful life In business, life-cycle cost analysis has been costs to justify a project’s price vis-a-vis its competition’s when all other costs associated with owning the project over its lifetime are taken into consideration. When a consumer is faced with the choice between durable good. Such as automobiles or refrigerators, the economic cost of each alternative can be established, using present worth analysis, by adding to the product’s price the present value of all other expenses required to operate and maintain that product over its useful life, or by calculating the equivalent annual cost to own, operate, and maintain the product its lifetime.

Q. 12. What is Bill of materials ?

Ans. In order to ensure proper inventory control, the ‘basic principle to be kept in mind is that proper material is available for production purposes whenever it is required. This aim can be achieved by preparing what is normally called as “Bill of Materials.” A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department.

Q. 13. What are advantages of ABC analysis ?

Ans. Advantage of ABC Analysis

(a) A close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall



material consumption and due to this the costs associated with inventions may be reduced.

(b) The investment in inventory can be regulated in a proper manner and optimum utilisation of the available funds can be assured.

(c) A strict control on inventory items in this manner helps in maintaining a high inventory turnover ratio. However, it should be noted that the success of ABC analysis depends mainly upon correct categorisation of inventory items and hence should be handled by only experienced and trained personnel.

Q. 14. Define Inventory.

Ans. The term ‘inventory’ refers to the stock of raw materials, parts and finished products held by a business firm. It is the aggregate quantity of materials, resources and goods that are idle at a given point of time. In a wider sense. “inventory consists of usable but idle resources. The resources may be of any type; for example, men, materials, machines or money. When the resources involved is materials or goods in any stage of completion, inventory is referred to as stock”. It may, therefore, be said that inventory comprises 4 Ms-men, materials, machines and money. But in a practical sense, inventory consists of the following:

(a) raw materials

(b) work-in-progress, e.g., semi-finished goods

(c) bought out components,

(d) finished products,

(e) maintenance spare parts, and

(f) consumable supplies.

Q. 15. What are the Objectives of Inventory Control?

Ans. The main objectives of controlling inventory are as follows:

(i) to minimise capital investment in inventory by eliminating excessive stocks;

(ii) to ensure availability of needed inventory for uninterrupted production and for meeting consumer demand;

(iii) to provide a scientific basis for planning of inventory needs;

(iv) to tiding over the demand fluctuations by maintaining reasonable safety stock;

(v)to minimise risk of loss due to obsolescence, deterioration etc, and

(vi) to maintain necessary records for protecting against thefts, wastes leakages of inventories and to decide timely replenishment of stocks.

Q. 16. Explain Advantages of Inventory Control

Ans. Scientific inventory control provides the following benefits:



1. It improves the liquidity position of the firm by reducing unnecessary tying up of capital in excess inventories.

2. It ensures smooth production operations by maintaining reasonable stocks of materials.

3. It facilitates regular and timely supply to customers through adequate stocks of finished products.

4. It protects the firm against variations in raw materials delivery time.

It facilitate production scheduling, avoids shortage of materials and duplicate ordering.

6. It helps to minimise loss by obsolescence, deterioration, damage etc.

Q. 17. Describe EOQ.

Ans. It indicates that quantity which is fixed in such a way that the total variable cost of managing the inventory can be minimised. Such cost basically consists of two parts. First, Ordering Cost (which in turn consists of the costs associated with the administrative efforts connected with preparation of purchase requisitions, purchase enquiries, comparative statements and handling of more number of bills and receipts) Second, Carying Cost i.e., the cost of carying or holding the inventory (which in turn consists of the cost like godown rent, handling and upkeep expenses, insurance, opportunity cost of capital blocked i.e. interest etc.) There is a reverse relationship between these two types of costs i.e. if the purchase quantity increases, ordering cost may get reduced but the carying cost increases and vice versa. A balance is to be struck between these two factors and it is possible at Economic Order Quantity where the total variable cost of managing the inventory is minimurn.

It is possible to fix the Economic Order Quantity with the help of mathematical formula. The following assumptions may be made for this purpose.

Let Q be Economic Order Quantity.

A be Annunal Requirement of materials in units.

O be cost of placing an order (which is assumed to remain constant irrespective of size of order.)

C be cost of carrying one unit per year.

Now, if A is the annual requirement and Q is the size of one order, the total number of orders will be A/Q and the total ordering cost will be - A/QxO.

Similarly, if the size of one order is, Q and if it is assumed that the inventory is reduced at a constant rate from order quantity to zero when it is repurchased, the average inventory ill be Q/2 and the cost of carrying one unit per year being C, the total carrying cost will be Q/2XC.

Thus, Total Cost = Ordering Cost + Carying Cost

The intention is that the value of Q should be such that the total cost should be minimum. Hence, taking the first derivative of the equation with respect to Q and setting the result to zero,

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Where

Q = Economic Order Quantity

A = Annual requirements

O = Ordering Cost

C = Unit carrying cost/year.

Q. 18. From the Following data, work out the EOQ of a particular component.

Ans. Annual Demand : 5000 Units

Ordering Cost : Rs. 60 per Order

Price per Unit Rs 100

Inventory carrying Cost : 15% on average inventory,

Solution:

Q. 19. Define:

(i) Lead time (ii) Safety Stock.

Ans. Lead time. It refers to the interval between placing on order for a particular item and its actual receipt. Suppose, an order is placed for a particular item on 1st January and the matrialis is received on February. In this case the lead time is one month. Longer is the lead time, higher will be the average level of inventory.

Safety stock. It implies the stock of inventory held as a safety measure against fluctuation in demand and lead time. Safety stock is a function of lead time. ‘11w longer the lead time, the greater the safety stock. Safety stock is also known as buffer stock or minimum stock. Safety stock should be differentiated from working stock. Safety stock refers to the stock of inventory which is supposed to take care of shortages. On the other hand, working stock refers to the inventory generated by orders.

Q. 20. Consider the following data of a company for the year 1997:



Sales = Rs. 1,20,000

Fixed cost = Rs. 25,000

Variable cost = Rs. 45,00Q

Find the following:

(a) Contribution (b) Profit

(c) BE (d) M.S.

Solution.

(a) Contribution = Sales - Variable costs

= Rs. 1,20,000 - Rs. 45,000

= Rs. 75,000

Q. 21. Consider the following data of a company for the year 1998.

Sales = Rs. 80,000

Fixed cost = Rs. 15,000

Variable cost = 35,000

Find the following:

(a) Contribution (b) Profit

(c) BEP (d) M.S.

Solution.



Q. 22. Alpha Associated has the following details:

Fixed cost = Rs. 20,00,000

Variable cost per unit = Rs. 100

Selling price per unit=Rs. 200 V

Find

(a)The break-even sales quantity,

(b)The break-even sales

(c) If the actual production quantity is 60,000, find (1) contribution; and (ii) margin of safety by all methods.

Solution.

Q. 23. A manufacturing company shows the trading results of records as follows:



(a) P/V ratio

(b) Fixed cost

(c) Break-even point (sales value)

(d)Margin of Satety at a profit of Rs. 3,500.

Solution.

Profit is realised only after meeting the fixed costs fully. Therefore, any variation in the profit will be caused only by a variation in contribution. Here, the increase in Net Profit can be taken as the increase in contribution.

For an increase of Rs. 8,000 in sale, the contribution is increased by Rs. 2,000.

Q. 24. Describe Minimum cost analysis.

Ans. In evaluating alternative investments it is possible to find the best alternative on the basis of minimum cost rather than maximum benefit. The decision is justifiable, if the benefit of cash alternative is expected to the same. Similarly, when considering the optimum size of a project, such as a piece of machinery or equipment, it is proper to determine its minimum cost over a range of relevant values of the independent variable, i.e. size of capacity, provided that the expected benefit is the same. In terms of economic theory, the total cost of a project can be said to be a function of the sum of two cost functions, one which increase directly with the independent variable, and the other decreasing as the independent variable increases as follows :



One of the most frequently encountered total cost functions in engineering economy takes the form

where X is an independent variable in is either zero or a fixed cost and b and c are constants. As shown in Fig 1.3, the increasing cost function is assumed to the linear, the decreasing function is non linear, and their sum, which yields the total cost function, is a polynomial the lowest point of the total cost curve is the minimum cost of the project and corresponds to a value of the independent variable that defines the optimum size or capacity of the project.

Mathematically, the optimum value of the independent variable, Xo, is obtained h’ differentiating the total cost function and setting it equal to zero;

The minimum cost in dollars is then found by substitution X0 in the total cost equation.

A classic application of this model, first observed by Lord Kelvin, is that the economic size of the conductor occurs when the annual investment cost is equal to the annual cost of lost energy this is known as Kelvin’s Law.

Q. 25. Explain value analysis.

Ans. Value analysis is a technique of cost reduction. It involves study of cost in relation to product design. Before making or buying a product/material/equipment, a study of its value (function) is made. The purpose is to reduce the cost of the prescribed function without sacrificing the required standard of performance. First, the required function is determined and then the best way to perform it at a lower cost is found.

Value analysis is a systematic application of established techniques to identify the functions of a product or component and to provide the desired functions at the lowest total cost. It is a creative approach to eliminating unnecessary costs which add neither to quality for to the appearance of the product. Value analysis is a study and structured process consisting of (a)



functional analysis to define the reason for the existence of a product or its components. (b) creativity analysis for generating new and better alternatives, and (c) measurement for evaluating the value of present and future concepts.

Value analysis is closely related to value engineering, though the two are not identical. Value analysis refers to the work done in this regard by purchasing department whereas work which engineers do in this area is called value engineering. Value analysis requires close co-operation between purchase, engineering, production and costing departments and also that of the vendor’s expertise. It is a team job requiring lot of discussion and deliberations. Any new idea is fully investigated to analyse its feasibilities. The product is considered from all angles and all possible alternatives are explored.

The main questions asked under value analysis include

(1) Is the cost vis-a-vis the usefulness of the product reasonable?

(2) Can lower cost design work as well?

(3) Can another less costly item fil1he need?

(4) Will less expensive material do the job?

(5) Does the function contribute value?

(6) Are the features reasonable?

(7) Can scrap be reduced by changing the design or material?

(8) Is there an alternative product/process design which is less expensive?

Some examples of savings through value analysis are as follows

(a) Use of new and cheaper materials in place of traditional materials.

(b) Discarding tailored products where standard components can do the job.

(c) Dispensing product features not required by customers, e.g., doing away with headphone in a radio set.

Q. 26. What is ABC analysis?

Ans. The main objective of inventory control is to minimise the carrying costs of inventory. Very often all items of inventory are not equally important. A small number of important items account for the dominant part of total inventory investment while a large number of items constitute so small a value that they have little effect on the results. Therefore, much greater control is required on the first type of items than on the others. The stock of items which are expensive has to be kept at the minimum. Items which are voluminous but relatively inexpensive are kept in large stocks as frequent ordering of such items is costlier. The two types of items are categorised as “A” and “C”, the items falling midway between these are put into “B” category. Maximum attention is focused on items in category A as they constitute the most important constitute an intermediate position. Items in category C have negligible importance and therefore, minimum attention is paid to them. This selective inventory control is called ABC analysis.

Q. 27. What the required essentials of an effective cost reduction ?



Ans. The foregoing obstacles can be overcome through an effective cost reduction programme. The following points should be incorporated in a sound programme of cost reduction.

(1) The co-operation of every employee should be obtained by identifying his self- interest with the company’s interests. A deep sense of involvement among employees should be generated and their suggestions should be sought. The role and responsibility of each should be made clear to him. The cooperation of trade unions should also be obtained.

(2) Resistance to change should be minimised by disseminating full details about the proposed changes and by convincing the employees that the changes are ultimately in their own interest. The likely benefits of cost reduction should be explained to inspire confidence among employees. -

(3) Cost reduction should be a continuing function rather than ad hoc exercise.

(4) Efforts should be concentrated in the area where the potential savings are likely to be the maximum.

(5) There should be periodic meetings with the employees to review the progress made towards cost reduction.

(6) A proper organisational set-up should be created for cost reduction. Cost reduction requires healthy self-criticism and coordination at all levels of management. The organisation would depend upon the size and nature of business. In a large company, a high powered committee consisting of responsible executives from various functional areas may be constituted. The committee fixes priorities, formulates programmes and monitors implementation. In small firms it may not be possible to have full time staff for cost reduction and the responsibility may be given to the cost accountant or to an outside consultant.

(7) Top management must lend full support and assistance to cost reduction. Sustained interest and commitment of management is essential.

(8) An efficient system of data collection and reporting should be created.

(9) There must be an atmosphere of close co-operation and mutual trust. Well-thought- out procedures should be developed for regular evaluation of the programme.

(10) The programme should not be confined to reduction in expenditures and wastes. It must also seek to eliminate uneconomic activities, to improve productivity, etc. A cost reduction programme must keep in view the cost inter-relationship between different products, processes and departments. For example, reduction in labour cost may result in higher machine cost. Cost reduction is not arbitrary cutting, of expenditure and it must be based on careful analysis or study. Cost reduction must contribute to profit improvement. A crash cost reduction programme cannot offer substantial and continuing operating economies in the long run. A well integrated and systematic approach is needed

Q. 28. Differentiate fixed and variable cost.

Ans. Fixed and Variable Costs -



Fixed costs do not vary in proportion to the quantity of output. General administrative expenses, taxes and insurance, rent building and equipment depreciation, and utilities are examples of cost items that are usually invariant with production volume and hence are termed fixed costs. Such costs may be fixed only over a given range of production; they may then change and be fixed for another range of production. Variable costs vary in proportion to quantity of output. These costs are usually for direct material and direct labor.

Many cost items have both fixed and variable components. For example, a plant maintenance department may have a constant number of maintenance personnel at fixed salaries over a wide range of production output. However, the amount of maintenance work done and replacement parts required on equipment may vary in proportion to production to production output.

Q. 29. Explain the concept of ratio-analysis.

Ans. Ratio is a statistical yardstick which provides a measure of relationship between two figures: This relationship may be expressed as a rate (costs per rupees of sales), as a percentage (cost of sales as a percentage of sales) or as a quotient/proportion (sales as number of times the inventory). Ratios are widely used in the analysis of operations as the use of absolute figures might be misleading. Relative figures are better for control purposes.

Under ratio analysis, a desirable ratio is determined beforehand. The actual ratio is compared with this predetermined ratio and wherever necessary corrective action is taken. It is possible to compute several types of ratios relating to liquidity, profitability, solvency, etc. But for cost reduction, only operating cost ratios are used. Some of the commonly used ratios for cost comparisons are given below

(a) Net profits/Sales

(b) Sales/Direct labour

(c) Sales/Inventory

(d) Sales/Over heads

(e) Sales/ Direct materials

(f) Production cost/Cost of sales

(g) Selling costs/Cost of sales

(h) Administration cost/Cost of sales

(i) Material costs/Cost of production

(j) Labour costs/Cost of production

(k) Overheads/Cost of production.

Ratios serve as standards of comparison for evaluation of performance. They can be used for cost reduction in two ways

(1) A business may compare its ratios with the ratios of other firms in the industry. Sometimes comparison is made with standard ratios in the industry which are average of the results of all firms in the industry.

(2) A firm’s ratios for the period under scrutiny may be compared with similar ratios of previous periods. Such comparison over time would reveal the areas that need attention.



Q. 30. Define Cost reduction.

Ans. Cost reduction implies deliberate savings in the cost of production and distribution through the elimination of water and in efficiency. It involves reduction in unit costs by improvements in product design an4 related techniques or practises. According to the Institute of Costs and Works Accountants of London cost reduction is the achievement of real and permanent reduction in the unit costs of good manufactured or services rendered without impairing their suitability for the use intended

Q. 31. Differentiate Cost reduction and cost control.

Ans. Both cost reduction and cost control are tools of increasing profitability. But the two differ in terms of their procedures and approach. The differences between them are given below:

1. Nature. Cost reduction is a corrective function and it may operate along with a cost control programme. On .the other hand cost control is preventive function as costs are optimised before they are incurred.

2. Emphasis. Cost control lays emphasis on present and past behaviour of costs. The stress in cost reduction is on present and future cost.

3. Standards. Cost control involves setting cost standards, analysing variances from the standards and taking corrective actions. Cost reduction is not concerned with standards. It involves obtained potential savings. Cost control attempts to keep actual costs in line with established cost standards. Cost reduction challenges these standards form with. It tries to reduce costs on a continuous basis. In a cost control programme, standards act as targets but cost reduction questions the standard itself.

4. Application. Cost reduction can be applied to each and every area of business. It has universal application and does not depend on standards. But cost control is limited to areas where standards can be set. It has limited application to items for which standards exists.

5. Aim. Cost control seeks to achieve lowest possible cost under given conditions. On the other hand, cost reduction recognises that no condition is permanent. It calls for change in conditions if they result in lower cost.

6. Content. Cost control represents efforts involved in attaining targets or standards. Cost reduction symbolises achievement in reducing cost.

7. Continuity. Cost reduction programme can be finished. Cost control, on the other hand, is an ongoing or never-ending process

Cost control, as generally practised, takes the dynamic approach to many of the factors affecting costs which planned cost reduction demands. For example, under cost control, the tendency is to accept standards once they are fixed and leave them unchallenged over a period In cost reduction on the other hand, standards must be constantly challenged for improvement. There is no phase of business which is example from cost reduction Products, processes, procedures and personnel are subject to continuous scrutiny to see where and how they cart be reduced in cost.

Q 32 Name the techniques of cost reduction



Ans. The main techniques used for cast reduction are as follows:

1. Cost Accounting and Analyses

2. Ratio Analysis

3 Break-even Analysis

4. Methods Study

5. Management Audit

6. Value Analysis.

Q. 33. Describe Break-even analysis.

Ans. Break-even analysis or cost volume Profit analysis is the study of interrelationship among a firm’s sales, costs and operating profit an various levels of output. It reveals the effect of fixed costs, variable costs, prices, sales mix, etc. on the profitability of a firm. In break-even analysis, break-even point and break-even chart are of particular significance.

Break-Even Point. Break-even analysis involves the determination of the volume at which the firm’s costs and revenues will be equal. The break-even point may be defined as that level of sales at which total revenues and total costs are equal, i.e., the level of operations at which the firm breaks even. It is also known as “no-profit-no-loss point”. If a firm produces and sells more than the level given by the break-even point, it makes profits. In case it produces and sells less than that suggested by the break-even point, the firm would incur losses. Management can change the break-even point by changing fixed cost, variable cost and selling price.

There are two approaches used for representing a break-even point: (a) the algebraic method, and (b) the graphical method.

Algebraic Determination of Break-even Point

Algebraically, break-even point can be determined either in terms of physical units or in terms of sales value or as a percentage of the total capacity. The former method is convenient for a single product firm while the latter is more suitable for a multi-product firm.

Q. 34. ABC Motors purchase 9,000 motor spare parts for its annual requirements, ordering one-month usage at a time. Each spare part costs Rs. 20. The ordering cost per order is Rs. 15 and the carrying charges are 15% of the average inventory per year. You have been



asked to suggest a more economical purchasing policy for the company. What advice would you offer and how much would it save the company per year?

Solution.

Present Policy :

Q. 35. You are given the following information about two competing companies during the year 2008.

A friend of your’s seeks your advice as to which company’s shares he should purchase. Assuming that the capital invested is equal for the two companies, state the advice that you will give.

Ans. The prospects of shareholders in these two companies; must be compared in terms of P.V. ratio. Fixed costs, BEP sales and Margin of Safety as at present. The company which commands more merits that the other must be chosen for investment.



From this table, we ascertain that though theP.V. ratio is higher in the case of company ‘13’, all other factors—namely I3EP sales, Margin of safety and the incidence of fixed costs are in favour of company ‘A’. (Despite higher P.V. ratio company B has to go a long way to reach the BEP and also to suffer from a narrow margin of safety. This is solely because of a huge amount of fixed expences)

Company ‘A’ is preferable.

Q. 36. XYZ Company Ltd., is manufacturing a uniform product. At present, the company incurs the expenses as follows:

Variable cost per unit Rs. 6.

Fixed expenses for one year Rs. 35,000

Consider the price range of substitutes and of similar goods, produced by other concerns, the company has fixed the selling price at Rs. 10 per unit. Management considers that Rs 30,000 as profit will be a fair return on investment for the year. Assuming that the fixed costs, remain constant for the next trading period, find out the volume of sales required to earn the desired profit.

Solution:



Q. 37. XYZ Company Ltd., produces a uniform product, ‘X’. Out of competition, it is forced to reduce the price of its product. The Company plans to announce a price reduction of 10% to capture more market. The accountnant gives the relative data as follows:

Though, price is reduced the company wants to maintain the present volume of profit through increased sales. Therefore, it wants to know the required volume of sales. Assume that fixed expenses will remain constant at the new level of activity.

Since the price is going to be reduced, we have to find out the P.V. Ratio for the same volume of sales (20,000 units) but at the reduced price rate; then only the require volume of sales can be calculated.



Q. 38. ABC Ltd. Data is given below:

You are required to calculate the Break Even point and Margin of safety and also to provide information to the management regarding the possible effects of the following contingencies (each to be considered separately.)

1. Fixed costs increase by 10%

2. Variable costs decrease by 20%

3. Selling price is increased by 20%.

Suitable charts may be presented showing the effect of these change in profit factors

Workings:



Note : Since fixed costs have increased by Rs. 6,000 profit will be reduced to some extent: (because other factors are remaining constant). This can be verified as follows:

Sales = Rs.2,00,000

Note : Since fixed costs have increased the Break-even sales will also be increased, in the chart shown below, the total costs line and the sales line intersect at a point indicating break-even sales of Rs. 1,32,000. Thus break-even sales is increased by Rs.12,000 (i.e., to absorb the additional fixed costs of Rs. 6,000. The company has to effect the sales for Rs. 12,000 more and react the B.E.P.) This can be checked as follows:

i.e., an increase of Rs. 12,000.

At the present level of sales, the break-even sales have increased. Therefore, the remaining margin(Margin of Safety) will be decreased i.e.,

These effect can be depicted by the following chart :



(2) Effects of a decrease in variable cost by 20%

When the variable costs decrease, the contribution ratio (P.V. Ratio) increases, there by reducing the break even sales volume and increasing profits and Margin of Safety. That is, the company reaches the break even point sooner than before, and after that stage profit is earned at an accelerated rate in our illustration 20% decrease in variable cost will give following results.

(a)Increase in Profits

(b) Decrease in the break-even point

Since a reduced variable cost leaves more contribution, fixed costs are absorbed sooner. So the break-even volume is reduced as follows:

(c) Increase m Margin of Safety

\At the same volume of sales, fixed costs are recovered sooner. Therefore, Margin of Safety will be increased as follows :

Thus, a decrease in margin cost by 20% results in an additional contribution of Rs. 20,000 with the consequences of:



(a) Rs. 20,000 increase in profit

(b) Rs. 20,000 increase in Margin of Safety and

(c) Rs. 20,000 decrease in B.E.P. Sales

These are well depicted in the next given chart:

(3) Effects in increase in the selling price by 20%

Other factors remaining constant, the price of the products increased by 20% (i.e. from Rs. 10 to Rs. 12). Therefore, obviously profit will be increased as follows:

These results (a, h, and c) are illustrated in the following chart:



Q. 39. From the given data, Calculate Break-even point sales.

Q. 40. From the following data, calculate B.E.P. and P.V.R.



Q. 41. From the following, calculate the Cash Break-even Point.

Q. 42. Sales are Rs 150,000 producing a profit of Rs. 4,000 in period 1. Sales are Rs. 1,90,000 producing a profit of Rs. 12,000 in period II. Determine the BEP.

Difference in profit = Rs. 8,000



Difference in sales = Rs. 40,000

Since the change in the sale must have led to the change in the profit, P/V ratio:

Rs. 8,000 x 100 = 20%

Rs. 40,000

At BEP, Profit = Nil

If Rs. 20 is to be reduced from profit, sales must be reduced by Rs. 100. To reduce profit by Rs. 4,000 reduction in sale:

(100 x Rs. 4,000/20 = 20,000

B.E.P. = Rs. 1,30,000 (i.e. sales producing profit of Rs. 4,000 less reduction in sales of Rs, 20,000 to wipe out the profit)

Alternatively

Total contribution on Rs. 1,50,000 @ 20% Rs. 30,000

Profit Rs. 4,000

Fixed expenses Rs. 26,000

Q. 43. From the following figures ascertain the break-even sales.

Total cost equals sales, hence, there is neither profit nor loss.

Q44. The sales of company are @ Rs. 200 per unit Rs. 20,00,000

Variable cost Rs. 12,00,000

Fixed cost Rs. 6,00,000

The capacity of the Factory 15,000 units

Determine the BEP. How much profit is the company making?



(* Total number of units is 10,000 since sale at Rs. 200 per units is Rs. 20,00,000. Therefore variable cost per unit is Rs. 12,00,000 ÷ 10,000 = Rs. 120)

Profit being earned

At break-even point, the contribution is just equal to fixed costs, any sales above the Bill’ also provide the profit contribution. But as fixed costs are all met already such contributions become completely profit. The sales above BEP are known as margin of safety 1 he contribution from margin of safety sales is profit As P/V ratio is (contnbution/ sales) x 100 and as profit is the contribution from these sales above BEP (i.e.), margin of safety, the following formula also is true.

Margin of Safety

Thus, in the above illustration margin of safety sales = 2,500 units x Rs. 200 = 5,00,000.

Profit = Rs. 2,00,000

Q. 45. From the following information calculate:

(1) P.V. ratio (ii) Break even point

(iii) Margin of Safety

Total sales Rs. 3,60,000

Fixed cost Rs. 1,00,000

Selling price Rs. 100/Unit

Variable cost (per unit) = Rs. 50

(iv) if the selling price is reduced to Rs. 90 by how much is the margin of safety reduced ?



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