4. On page 38, read the first and second paragraphs of the section named "Incremental Analysis", Please distinguish between relevant costs and irrelevant costs in this scenario, and explain why Mr. Mehanati made the wrong decision. Profit TECHNICAL PAPER 5000000 4000000 3000000 2000000 1000000 -1000000 -2000000 5000 10000 15000 20000 25000 30000 35000 40000 45000 50000 Confirmation Total Sales Revenue (51879*800) Less Variable Cost (31879 686) Total Contribution Sales volume in units Figure-2: Profit Volume Graph. 255.03.200 218.68,994 36.34,206 Less Total Fixed Cost 16.34,188 Earning Before Tax (EBT)/ Earning After Tax (EAT) 20.00.018 Small-scale industries are exempted from taxes BEP (in units) if variable cost increases by 8.5% due to inflation Revised Variable Cost 686 1.085-745 Revised CMPU-800-745-55 Revised BEP (in units) Total Annual Foxed Cost/Revised CMPU - 16.34.188/55 -29713 BEP (in units) if variable cost increases by 5% due to inflation Revised Variable Cost 686 1.05-720.30 Revised CMPU-800-720.50 79.70 38 Vol 56 Ne 11 November 2010 Revised BEP (in units) Total annual fixed cost/revised CMPU 16.34.188/79.70 - 20504 Incremental Analysis Mr. Mehanati's foundry unit has capacity to produce 5000 units per month; current plan calls for a monthly production and sales of only 2500 units so his facility is idle for half of the time. Meanwhile, Ajaymeru Industries, maker of flour grinding machines asked Mr. Mehanati to produce 20000 floor grinding machine stands weighing 30 Kg. each at 45.50 per Kg (bargaining possible). Accepting this offer will cost further 50,000 to Mr. Mehanati for pattern making Mr. Mehanati estimates that its variable cost will be 46.50 per kg (variable cost of sewing machine stand divided by its weight Le 14.75 kg). However, its fixed costs, which have been averaging at 3.70 per kg (Total Annual Fixed Cost/ Actual Estimated Sales of Sewing Machine stand its weight) will now be spread over among 1042500 kg castings (30000 14.75+20000*30). As a result, the average fixed cost will drop to 1.60 per kg (16.34.188 +50,000/10425001. Mr. Mehanati concluded, "Sure there will be a loss of 1 per kg on variable costs (46.50 variable cost- 45.50 selling price) but there will be a gain of 2.10 per kg of Indian Foundry Journal castings (3.70 per kg-1.60 per kg) by spreading the fixed costs. Therefore, he accepts the offer as it represents an advantage of 1.10 per Kg Do we agree with Mr. Mehanati? No, we do not agree with Mr. Mehanati's view as the acceptance of the order causes loss of 6,50,000 (20000 stand 30 kg 1+ 50,000 of pattern making). His contention is based on the illusion that spreading the fixed cost causes savings. It is also shown below by the comparative income statement. Comparative Income Statement Particulars Alternatives Status Quo (442500 kg) Sales Revenue Less Variable Cost *240,00,000* Total Contribution Accept Order (1042500 kg) competitive market in such a situation, Mr. Mehanati feels that he should earn at least 6,00,000 as profit by accepting Ajaymeru Industries offer. Now, at what bid price he will be able to achieve this profit target considering 8.5% inflation in variable cost Mr. Mehanati estimates that its new variable cost will be Rs.50.40 per kg 46.50*1.085) and fixed cost will drop to 1.60 per kg after accepting the order. Further, each kg of casting should fetch profit of Re 1 in order to achieve target profit of 6,00,000. Therefore, he estimates bid price 53 per kg (50.40+1.60+1). Again, IA plays an important role to decide the competitive price for bidding as illustrated below Anticipated Variable Cost per kg Additional Fixed Cost per g for Pattern Making (50,000/20000*30) 513,00,000** 205.76,250 484.76,250 Desired Profit per kg 34,23,750 28.23,750 Desired Bid Price per kg of Casting 16.34,188 17,89,562 16.84,188 11.39.562 50.40 0.10 1.00 51.50 Less Fixed Cost Profit Before Taxes *(30000 stand x 800); (30000 stand x 800+ 20000 flour m/c stand x 20 kg x 45.50) Above example clearly demonstrates that the existing fixed costs do not increase with an increase in the output. Another notable aspect related to fixed costs is that spreading of such costs to a larger output base does not yield any decrease in total fixed costs either, in spite of the decrease in the average fixed cost per unit. However, we should not infer that fixed costs are always irrelevant costs. In case, the additional fixed costs are required to be incurred to execute decision under consideration, then the additional fixed costs are as relevant as variable costs. For instance, 50,000 for making pattern in above example is fixed in nature but is relevant cost because it is an additional cost caused due to special order. In present scenario, inflation rate of 5-10% in variable cost is quite common in foundry industry. As we see, inflation rate of 8.5%, at anticipated demand of 30,000 sewing machine stand, leads to absence of profits in any year for Mr. Mehanati at present selling price. Further, it is difficult to sell product at higher selling price in Now, submission of higher bid price may lead to cancellation of Mr. Mehanati's quotation by Ajaymeru Industries. Mr. Mehanati included existing fixed cost 1.50 per kg for quoting bid price. A careful look at the cost items would enable that the existing fixed costs are to be incurred irrespective of the present decision. Clearly. the share of existing fixed costs should not be charged to such a new activity, its allocation causes distortion in submission of bid price. Conclusion With the help of this case study of foundry industry, we have tried to illustrate the importance of BEP and IA in short-term decision making, say. segregation of costs determination of break-even point. level of production to achieve desired profit, acceptance of the special order and determination of bid/tender price. It is hoped. that this study will be very useful for owners of SME foundry industries References Khan M. Y. and Jain P.K. (2007), "Financial Management: Text Problems and Cases, 5/E. Tata McGraw-Hill 39 Indian Foundry Journal Vol 56 No. 11-November 2010