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Module 1: Breakeven Point and Sensitivity Analyses in Cost Accounting

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Case of Ayur Pharma

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Namaste. In the last few sessions, we are discussing CVP analysis, BEP analysis, and its applications in various type of decision-making scenarios. If, you remember we have already done a few cases which involved the calculation of BEP, calculation of PV ratio, then the calculation of margin of safety, not only for one product but also for various types of product mix, then choosing which product mix is more suitable. We also have seen that if the pay and productivity deal is to be offered to employees is it advisable to go for it and so on.Today, we will continue with the cases and we will go for the fourth case right away.I hope you have got the printout of these cases please take it with you, if you do not have it take the printout right now and try to solve the case along with me. So, that you get the feel of finding the solution yourself. So now, question 4 case 4 Ayur Pharma, it is manufacturing 3 products.And, the cost details are given for all the 3 product lines like sales, material, labour costs, variable overheads, fixed overheads and so on. Now, the company imports its raw material and the management is planning to close down one of the lines of products and utilize the material for the other two lines for improving the profitability.Kindly prepare a report for the closure of one of the lines for improving profitability ok.A simple very small case; now how will you go about it? So, management perhaps wants to close one of the product lines. Temporarily it is not a permanent closure; it is a case of temporarily closing one of the products in the hope of improving the profitability.Now, how to go about? First is, of course, the basic calculation tries to take the sales and all the cost data and compute profit for each of the product lines as at today. Based on the current data and then decide which product line can be closed.So, this is the current data please make three sheets giving XYZ, 3 product lines and the total. And, then we have to decide the first we let us calculate the profitability. Now, to make the decision let us also calculate a few basic things like PV ratio contribution and so on. I will advise you to divide the cost into a variable and fix separately.So, that will know contribution and based on the contribution we will also be able to calculate PV ratio. Now make the three columns and one by one start showing the calculating the profitability based on the current data. So, you know that the direct costs are variable. So, DM, DL, that is direct material, direct labour, and variable overheads are considered as variable costs. So, for all the three products, please note the variable cost first, then take the total of variable costs and try to compute the contribution, please do it with me. So, for product X the variable cost is 140 200000s minus 140 gives you a contribution of 60,000, same way for why the total is 190 and contribution is 210 for Z the contribution is 75. Now, from this 3 6 costs are also known to try to reduce the fix costs and compute the profitability for all the three products.So, it is 25 160 and 50 for the 3 products X Y Z. Now, the question is if one of the product lines is to be closed temporarily which product line should be closed. So, what is your suggestion? Shall we go for the closure of X, because X has the lowest profitability and if you see the sales of X is also the lowest, is it better to close X, based on the sales or profit or there is something else. Let us try to compute the PV ratio.So, you know the formula; do you remember contribution upon sales, write now it is 0.3.5to 5 and 0.3. If you go by absolute contribution also you will find that X has 60 Y has 10 and Z has 75. So, PV ratio of X and Z both is same Yhas better profitability, if you look in the relative terms. So, what is your opinion now shall we close X? Because anyway PV ratio is the same for X and Z or any other calculation you would like to do. I think one more thing what you can do is compute the breakeven point, what is the formula? In breakeven point we want to recover the fixed cost, you know the fixed costs. So, take fix costs divided by what is the formula for BEP?If you remember there are 2 formulas 1 is FC upon contribution per unit, but nowhere is the number of units given. That formula cannot be used, because the number of units is not known or maybe it is not a homogeneous production, but we know PV ratio. So, other formulas contribute FC upon PV ratio. So, using that formula let us try to compute the BEP.So, the breakeven point is 116 95 and 833. So, based on breakeven point which product is the worse, I think again X because higher P, BEP is not advisable X has higher BEP.So, X appears to be a proper candidate for closure, do you agree? Let us go back to the problem and read it carefully, it is a very small case. Now, what is happening is companies importing it is raw material and management wants to close down one of the lines, what is the objective of closure to utilize the material for the other two lines; that means, that imported raw material is in short supply. They want to optimally use the raw material.So, instead of using it for the less profitable product, it can be transferred for a more profitable product. Now based on these what do you see now, what will be the criteria for decisionmaking? About the ranking of the three products, we will go to the calculations many times our ranking depends on contribution per unit. That cannot be done here because we do not know the number of instead of that sometimes we can rank based on PV ratio or profitability or BEP, but in this case, none of this is useful, because of the whole focus in on utilization of raw material. So, we should find that product where your raw material utilization is more efficient or more profitable; that means since you all know that fixed cost is not going to change; it is not worth being considered for decisionmaking. So, our decision will be based on the contribution, but the absolute contribution of 60 210 and 75 is also not of much use, because the contribution is being generated by using raw material. And, our main purpose is to use raw material more effectively. So, we will calculate contribution per rupee of raw material consumption, that is why let us calculate this formula contribution per raw material consumption. So, it will be B 9 upon B 5 got it.So, let us calculate it for X it is 0.6 much better for why 1.4 and Z it is again 0.6.So, if you go for a rank based on this our rank will be 2 1 and 2. Because, again itis very clear that both X and Z have the same contribution per direct material consumed, that is why their rank is 2, why is much superior? So, why should not be close to this very clear?Between X and Z which one we will look before to close is it better to close X because of less profit. So, you will realize why is the best product should not be closed, between X and Z which one is preferred. Shall we go for the closure of X, because it has a lesser profit actually that will be misleading? Because our main objective is to release raw material and use it for a more profitable product, more profitable product is Y.So, let us see which product amongst X and Z is using more raw material, you will realize that Z is using more raw material; that means, by closing Z. We can release 1, 25,000 of raw material which will be transferred to Y and can be used more profitably, that is why advice is it is better to close Z, do you all agree? Now, let us check what we have done, whether it gives more profitability, if yes how much more?As of now, the profit total profit is 2, 35,000 from the use of these three products.Now, as per our advice, we are trying to closed Y sorry close Z and Z will release 1, 25,000 rupees of raw material, which will be used for Y. That means as per as raw material is concerned, less of raw material for Z is 125 and increase of raw material in Y is 1251, 25, 000. Now, how much extra contribution will be generated? We know the formula that for product Z contribution per raw material consumption is 0.6, but for Y it is 1.4; that means, same 1, 25, 000 was generating a contribution of 75 in Z will be now 1.4 times the material which you use.So, from Z reduction in contribution will be 75, whereas from Y how will you getting it 75, 1, 25, 000 into 0.6, but if you transfer the same raw material to Y, the extra raw material contribution generated will be 125 into 1.4; that means, 1, 75, 000 of additional contribution is generated, but the contribution of 75 is lost. So, there is an incremental contribution of 1, 00000 are you getting me.I hope it is getting clear to you. So, there is no other need for any calculation. So, what is happening is 1 point will go here and we will try to do the calculation also in a complete way, what we did here was also correct, but it was a shortcut, which shows that contribution will increase by 100000. Since fixed cost is unchanged the profit will also be increased by 100000 so, profit will go from 235 to 335, but I will also show you the full calculation please do it with me let us do the profitability statement once again.Compute the new sales of X and Z and Y; Y there is no question of new sales because now Y sorry Z is completely closed for Y how much will be the new sales; the new sales will be 733333. How are you able to calculate it? Because now earlier you were allowing275, now you are getting some extra raw material for Y and they are having enough capacity?So, it is 1.833 times more production of Y, which is possible, which is the ratio of 275to 150, I hope you are getting it. If you are not getting it clear I will once again show, you see the raw material consumption for Y was only 1, 50,000.Now they are getting extra raw material of 125; that means, new raw material consumption will be 275, 275 upon 150 will be the new level of production. You know that the raw material is a variable cost any increase in the raw material gives the same increase in the other variable cost and also same increase in the sales, that is why this is 1.83333times increase of capacity of Y. Now, I will go back each of the costs in Y will also increase by 1.83 times write. Raw material I think we do not have to calculate we already knew that it is 150 plus 125, but still, we have just cross-checked it becomes 275 direct labour and variable overheads are recalculated. So, compute the new VC now. New variable cost is a total of this which is 348333. Now, 7333 minus 348333 will be the new contribution, which is 3, 85,000. You can just compare with an old contribution which was 210. So, we have increased the contribution substantially, because of better utilization of sorry we have increased it from 210 to 385 this is the extra contribution generated. Now, let us go for X X there will be no change same figures as earlier there repeated.What about Y? Y also there will be no change, but no change in a sense now it has become0. Earlier there was some production in Y now the production of Y sorry production of Z becomes 0.But keep in mind that fixed cost of Z will not go away, because it is not a permanent closure, it is a temporary closure of Z we will not do away with their machinery or maintenance of machinery etcetera. So, we will continue with the fixed costs now compute the new profit. Net profit for X is unchanged for Y there is a substantial increase in the profit; you can see here it was 160. Now, it has become 335 for Z, there is a loss of 25. Because, there fixed costs continue, but the sales and variable cost have become 0. So, now, you can take the total profit which now becomes 335, earlier it was 235 we are already done this calculation that there will be an increase in the profit by 100000.You can, of course, take all the totals for cross-checking purposes, if you take totals you will realize that new contribution is 445 fixed cost is unchanged. So, profit is335. What will be the new PV ratio and BEP?Compute the revised PV ratio and BEP. Till the PV ratio change actually no it is to Pto calculate PV ratio again because whatever was PV ratio for X and Y will continue, We have stopped producing, but X and Y again have seen just by changing the level of operations do not change PV ratio. Neither does it change BEP ok. So, the breakeven point is also not going to change, what has happened is we have increased the capacity utilization of Y, cut down Z and you can see there is a substantial increase in profit from 235to 335, this is also a product mixed problem, where we have improved product mix. Now, do you have any other intelligent suggestion to offer, because in the case it stopped just by asking kindly prepare a report for the closure of one of the product lines for improving profitability? So, this solution is correct we are our opinion was closed Z and the profitability is 335 revised profits any other suggestion will you want to make. I think you can make a suggestion company might as well close product X because product X also as the contribution of only 0.6 per raw material consumption whereas Y is much more profitable 1.4.So, if you release this 1, 00000 of raw material and there is a better utilization by 0.8.It will increase profitability further by 80, 000. Though it is not asked just for better understanding, you may further comment that closure of X and transfer in that raw material to why will further improve the profitability. Of course, we have to consider, whether there is enough demand for Y, because now we are zooming off the sales of Y there should be demand for it. Secondly, the company may not be wanting to close 2 products.Because then companies solely depend becomes dependent on one product. Right now they are having three products they have already decided to close Z, if they close X also they become dependent on Y only one product Y. So, risk of the company increases these are the qualitative issues of course, as far as the case is concerned, this is enough that closure of Z and transfer to Y. Further, there is a possibility of closure of X and transfer to Y provided other things are taken care, any other suggestion you want to make, there is also a possibility to permanently closed Z. Because, that will further reduce the cost by 25,000, but the company has to check what will happen to long term customers.Who was buying Z from us will it shrink our overall market share is there a risk involved in closing Z, all these qualitative factors will have to be considered by the company before deciding on permanent closure. As we have already discussed the technique of marginal costing or CVP is primarily useful for short term decisions. However, they may give you some hints for long term decision by making some extra study by making some extra market research company may or may not go for a long term decision based on these inputs. So, in one of the earlier cases, we are discussed about product mix. This particular case of Ayur Pharma is also a product mix case where we are improving the product mix, but it has one more unique feature, that one of the raw material one of the items of production that is raw material is in short supply. That is why all over decision making revolves around better utilization of raw material. In such a scenario raw material is considered as a key factor or sometimes it is called as a principal budgetary factor. Now, what other key factors can you think of just as in this case raw material was in short supply, sometimes labour is in short supply. If the number of labour hours is in short supply the decision making will be based on contribution per labour hour. If total labour cost is in short supply it can be contributed per labour cost, like in this case, it was on the raw material.Sometimes power is in short supply, in which case it will be contribution per mega megahertz of power. Sometimes the total sales potential in terms of rupees of sales or the size of the market is limited. Then, how will be the decision taken, the decision will be taken as per PV ratio. Because, PV ratio is contribution divided by sales, sometimes the market potential in terms of a number of units is limited, then the decision is taken by contribution per unit getting it. So, what we are discussing now those factors become very important. Normally, only one factor is in short supply that is called as a key factor, sometimes it is called as a limiting factor or a principal budgetary factor.So, the decision making will be given primarily based on a key factor, in case a particular key factor is being given please keep this in mind.With this will stop here. Namaste Thank you.