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Subject: Cost Accounting
Problem #1 ***
In a factory there are two machines M1 and M2. They are designed to produce the same product Q. M2 is a new model machine and can be handled by semi skilled workers. Pertinent costs are as follows:
Machine Set up cost irrespective of batch size Variable cost of production/Unit
M1 Rs. 800 Rs 7.85
M2 Rs. 1100 Rs 7.10
Which machine should be used for processing various sized orders of product Q received?
Solution:
Though set up cost is more in M1, variable cost per unit is comparitively lower in M2. At a particular level of production the set up cost excess in M2 will get offset by the savings in variable cost in M2. This level of production can be found out by dividing the one time set up cost difference by the difference in variable cost per unit.
Set up cost M2 Rs. 1100
Set up cost M1 Rs. 800
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Rs. 300
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Variable cost per unit M1 Rs. 7.85
Variable cost per unit M2 Rs. 7.10
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Rs. 0.75
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300/0.75 400 Units.
For an order of 400 units either of the machines can be used. For an order below 400 units machine M1 should be used because set up cost is lower. For an order above 400 units machine M2 should be used because variable cost per unit is lower.
Problem #2 ***
Now you would have under stood, that in all situations, where in the comparitive total cost figures, the advantage in variable cost in one set, may be in such a way that it nullifies the fixed cost disadvantage in the other, at a particular level of operation. At that level of operation, the total cost in both the situations will be equal. That level of operation in units, can be found out simply by using the formula: Difference in Fixed cost / Difference in variable cost per unit. There may be a different situation in which you may not know the variable cost per unit. In such cases also, that level of operation in value, can be worked out. Now look at the next problem.
The same concept is applied in this problem that looks a lot different from the previous one. Once you grasp the underlying concept, it is very easy to apply. Let us have a look at Problem No.2
Two firms X & Sons and Y & Brothers sell the same type of product in the same market. Their budget figures for the year ending 31.3.2009 are as follows:
| Particulars | X & Sons | Y & Brothers |
| Sales Variable cost Fixed cost Net profit | Rs. 250000 Rs. 200000 Rs. 15000 Rs. 35000 | Rs. 300000 Rs. 200000 Rs. 35000 Rs. 65000 |
Can there be a sales volume at which both the firms can expect same profit? Which firm is likely to earn greater profits in conditions of:
a) Heavy demand for the product and
b) Low demand for the product.
Compared to X & Sons, in Y & Brothers, total fixed cost is greater. Y & Brothers have higher sales, and their total variable cost is just equal to the total variable cost incurred by X & Sons for a lower level of sales. In other words, variable cost component of sale is lower in Y & Brothers. Therefore, there will be a level of sales at which the disadvantage of higher fixed cost is neutralized by saving in variable cost. At that sales volume, the total cost of sales, in both firms will be equal, resulting in same profit.
Variable cost to sales ratio in X & Sons: (200000/250000) 100 = 80%
Variable cost to sales ratio in Y & Brothers: (200000/300000) 100 = 66.6666%
Variable cost advantage in Y & Brothers = 80 – 66.6666 = 13.3333%
Variable cost ratio and Profit volume ratio are complementary to each other.
P.V. Ratio of X & Sons = 20%
P.V. Ratio of Y & Brothers = 33.3333%
Thus Profit volume ratio of Y & Brothers is higher by 13.3333%.
Excess fixed cost of Y & Brothers = (35000-15000) = Rs. 20000
Sales volume required to off set the excess fixed cost= 20000/13.3333% = Rs. 150000.
At the sale volume of Rs. 150000 both firms will earn same profit, because the total cost in both firms will be equal..
When there is low demand and the sale achieved is less than Rs. 150000, X & Sons will earn greater profits because, fixed cost is lower.
When there is heavy demand for the product, and the sale achieved is higher than Rs.150000, Y & Brothers will earn greater profits because, variable cost is lower.
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