The Marginal Income Report prepared by consultant highlights some of the following features of Moti and Heera (P)

Limited: Mumbai
Income Variable Cost Contribution to Mumbai Fixed OH Sunk Cost Escapable Fixed Cost Total Fixed Cost Contributin to Local Company OH Mumbai OH Contribution to Company OH and Profits Poster EX 3 3,55,231 1,07,621 2,47,610 96,155 89,651 1,85,806 61,804 Paint EX 4 2,06,261 72,305 1,33,956 32,344 51,502 83,846 50,110 2,300 2,300 24,344 Commercial EX 5 81,363 54,719 26,644 Location Total Company TOTAL

6,42,855 2,34,645 4,08,210 1,28,499 1,43,453 2,71,952 1,36,258 89,482 46,776

Fixed Cost to Sales Break Even Income Location Cont./ Sales Ratio Cont to Sales (P/v Ratio)

0.52 1,85,806 0.17 0.70

0.41 83,846 0.24 0.65

0.03 2,300 0.30 0.33

0.42 2,71,952 0.21 0.63

Delhi
Income Variable Cost Contribution to Delhi Fixed OH Sunk Cost Escapable Fixed Cost

Poster EX 6 99,899 40,619 59,280 13,608 15,938

Paint EX 7 23,318 3,867 19,451 4,068 5,518

Commercial EX 8 14,516 9,884 4,632 1,37,733 54,370 83,363 (28,993) 592 1,12,356 7,80,588 2,89,015 4,91,573 99,506 2,55,809

Total Fixed Cost Contributin to Local Company OH Delhi OH Contribution to Company OH and Profits Company OH Company Profit/Loss

29,546 29,734

9,586 9,865 4,040

592

83,363 43,639 31,011 12,628 1,79,897 1,20,493 59,404 1,00,061 (40,657)

Fixed Cost to Sales Break Even Income Location Cont./ Sales Ratio Cont to Sales (P/v Ratio)

0.30 29,546 0.30 0.59

0.41 9,586 0.42 0.83

0.04 592 0.28 0.32

0.61 83,363 0.32 0.61

0.58

In addition to the accounts classification, breakeven information is also given at the end of the table, which has been extracted from the case details.

Questions:
1. What is the purpose of separating sunk fixed costs and escapable fixed costs? What is the meaning of these terms? How is this breakdown relevant? Ans: Both sunk costs and escapable fixed costs are constituent of total specific fixed cost allocated to any particular department of any location. Sunk cost is that component of fixed cost that is bound to occur even if the production of that particular department is halted immediately, while escapable fixed cost is that component of fixed cost which is incurred as long as the production is carried. For the purpose of drawing break even charts, both types of fixed costs are taken together. But the consultants report is prepared for taking a business decision i.e. shutting down a part of business completely. In order to get such insights from the report it is beneficial to separate the two costs. Loss (if plant is operational): Total Cost Total Revenues = Sunk Costs + Esc. F.C +Variable Costs Total Revenues = Sunk Costs + Esc. F.C Total Contribution And, Loss (if plant is shutdown): Sunk Cost So, its better to operate the plant if: Loss (if plant is shutdown) > Loss (if plant is operational)

i.e. Sunk Cost > Sunk Cost + Esc. F.C Total Contribution or, Total Contribution > Esc. F.C Thus the plant can be operated below B.E.P also if the above derived condition is fulfilled. 2. What is the meaning of specific fixed costs as used in the consultants report? Ans: The consultant divided the total overhead/fixed costs of company as follows: a) Company-wide overhead b) Local overhead c) Specific fixed costs The company-wide overhead is that part of total overhead which cannot be linked to any particular location. Location overheads are those overheads which can be associated with a particular location but cannot be associated with a particular product at that location. While Specific Fixed Costs are those overhead which can be clearly attributed to a particular product in a particular location. In Break-even charts, it is this Specific Fixed Costs that is used. Since each individual product break-even chart shows profit, this implies that the contributions are sufficient to cover the Specific Fixed Costs but are not able to cover the total overheads of th company (as the company is overall making losses). This Specific Fixed Costs is further divided into two parts, and thus can also be represented as: Specific Fixed Costs = Sunk Costs + Esc. F.C

3. Would an overall breakeven chart for the company serve the purpose just as well as the individual P/V charts? Ans: No. The individual P/V charts gives us various insights that the overall breakeven chart cannot give. P/V charts give us information about which product of a particular location is contributing more to the companys income. The P/V ratios available from individual charts indicate which product will result in maximum increase in income on unit increment in sales and thus indicate the direction in which the future investments are to be made. The overall breakeven chart, however show the overall income of the company which these individual charts do not show directly, but it make more sense to draw these overall breakeven charts if we are sure that all the fixed costs are associated with the production of either of these products which is not the case here since there are certain fixed overhead costs under company and location overhead which cannot be associated with the production of any of these items.

4. What is the meaning and significance of the breakeven points shown on the P\V charts? Ans: The P/V charts are the graphical representation of how the companys profits\contributions vary with the sales. These have been drawn by first plotting the specific fixed costs (both sunk and escapable), which is a horizontal line, of a particular department of a particular location. Then, the P/V line is plotted, which is nothing but the incremental income (additional income minus added variable costs) at increasing sales volumes sales pertaining to that department of that particular location. Simply put, this line has the slope, which equals the fraction of incremental income over sales of the specified location. The intersection of the P/V and the fixed costs line is the breakeven point. At this breakeven point, the specific fixed costs (income minus variable costs) are covered by the amount of sales generated. Whatever excess income is garnered beyond this point will cover the local and company overheads or simply will add to the profits. 5. Three types of contributions are shown in the exhibit (or the table above). What is the significance of each? Ans: The three levels of contributions are: a. Total contribution to Specific Fixed Costs The sum of the - income minus variable costs, of the local department at the given region. b. Total contribution to Local company overheads Contribution from the given region (ex: Bombay and Delhi). c. Contribution to Company overheads and profit Total contribution of the company. The clear picture of the contributions of each department in each location will give the managers good clarity in deciding the most profitable\useful department in the company. 6. What purposes could be served by this type of analysis? Ans: Marginal accounting or cost volume profit analysis (CVP) simplifies computation of the break even points in breakeven analysis and allows simple computation of target income sales. It simplifies analysis of short run tradeoffs in operational decisions. Accountants often perform CVP analysis to plan future levels of operating activity and provide information about: y y Potential products or services to emphasize Break out of different products and their individual contribution

y y y

The amount of revenue needed to avoid losses and to break even etc Profitability of different departments Volume of sales needed to achieve the targeted profits

7. What are the limitations of this type of analysis? Ans: The main limitation of this type of analysis is that it makes some key assumption, as under: y Cost function is linear o Fixed costs remain constant o Variable costs per unit remains constant y Revenue function is linear o Sales mix remains constant o Prices remain constant CVP analysis is difficult in cases where separation of fixed and variable costs is difficult. Also, future volumes, revenues and costs are unknown, so the above CVP assumptions might not hold. Because of this, factors such as the quality of data used, suitability of CVP analysis and the sensitivity of CVP results to changes in input data must also be taken into consideration, before making any decisions based on this analysis.