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CASE 1

RK Forging Company
Introduction
RK Forging is a forging company based in Coimbatore serving several sectors including power,
automotive, oil and gas, construction, mining, locomotive, marine and aerospace. The growth is
more of cyclical in nature and currently it is operating at 62% capacity utilization. The company
has few regular customers and the customer base is expanding. Normally, the company gets
order for the year with definite delivery schedule. Under the current costing system, the cost of
the product is computed by adding material cost, direct labour cost, and production overhead.
Currently, the production overhead rate is Rs. 20000 per machine hour1.
The Marketing Department is approached by Rinki Automotive, an overseas automobile
company, which requires 1000 units of the front axle beams to be supplied by June 30 th 2014.
The production department estimates the order requires 72 hours of machine shop time and
material plus labour cost of Rs. 500 per unit. The customer also informed that they may order
the same quantities for the next two quarters (September 30 th and December 31st) but these orders
are uncertain. The order requires significant investment on product level cost which includes
design approval, supply of sample, mold, etc. Initial estimates show an investment of Rs.
15,00,000. The issue before the management is how to treat these product level costs load it
completely on the first order or spread over three orders.
The Executive Committee Discussion
The following is an edited transcript of the discussion of the executive committee regarding the
pricing of the product.
Rahul: So, how do you think we should quote our price for the product required by our new
customer Rinki Automotive? Maybe, we had better start with Tanya [Tanya Sharma; the Chief
Accountant], since she has cost data.
Tanya: In this order, I am of the opinion that we need to discuss about how the mold cost and
other product related costs are to be loaded. Since the subsequent two orders are uncertain, I
think that it would be appropriate to load the entire mold cost on the first order.
.

The estimated production overhead for the year is Rs. 29.76 million and total available machine hour is 2400
hours. Production overhead rate is equal to 29760000/(2400*62%)

Siddharth: This is the sure way of losing the customer. We worked hard to get this customer
and had to do considerable amount of spending both time and cost to include our name in the
vendor list. Loading the entire mold cost on the first order would lead to a substantial increase
in the price of the product. This would make our product less competitive in the market. Our
price will be definitely higher by 40% than what Rinki is currently buying the item from their
regular vendor. We are also at the risk of losing a large customer. I think it would be more
appropriate to charge one-third of the cost on each order on the assumption that we will get the
remaining two orders. If we are serious to add new customers, we need to be very careful in our
pricing.
Tanya: It is true that such liberal pricing will bring customer and keep us busy but profit need
not increase. Our operating profit margin is declining over the years because we are too liberal
in pricing our products and every time we get one reason or other saying if we dont do this, we
will not get the order. In this case, if the customer has not placed the two subsequent orders, we
will end up incurring huge loss if we charge only 1/3 of product related cost. She feels a loss of
Rs. 1 million is significant and not to worth to take such risk.
Rahul: So, why dont we load the entire mold price on the first order and give discounts on the
subsequent orders?
Siddharth: Of course, we talked about this option. However, the customer is not willing to give
any formal commitment for the next two orders. They also dont want to evaluate our order
with such conditional pricing. Our price is valid for the first as well as subsequent two orders if
materialized.
Rahul: Both of you are right. If it is a small order, I would have gone with Siddharth and take a
chance. We dont lose much if subsequent two orders fail. The product cost is really large and
hence Tanyas concern is valid. I will think about the issue and get back. Siddharth, can you get
me some more details of the customer? We should not end up losing money on false promise.
Any other issue on the order?
Siddharth: I wanted to raise another issue related to production overhead. Currently, we are
charging Rs. 20000 per machine hour irrespective of machines that we use. In our machine shop,
we have different kinds of machine, old and new, low cost and high cost, automated and semiautomated, etc. We dont differentiate our orders and we charge a flat overhead rate. This
particular order doesnt require any of the hi-tech machines and I dont see the rationale of such
high overhead cost.
Tanya: We compute budgeted overhead and machine hours of the production department to
derive the overhead rate. This is the methodology we have been following for the last 15 years
and it is the same methodology that some of our competitors also follow, which I came to know
through our consultant who works for different companies. If you want us to develop rates for
different machines, then we need additional manpower.

Siddharth: Our Accounting department has an answer for every problem that we face. Instead of
getting support, we get justification. I dont understand whether we need to lose business and
turn totally uncompetitive just because we dont want to hire two more persons for our
Accounting department. In my view, our operating profit is not showing up any improvement
because we lose all profitable orders because of our wrong pricing. Unlike our competitors, the
marketing department has limited power in pricing the product and we always have to use the
pricing model prescribed by the Accounting department.
Rahul: Well Siddharth, you need elaborate your concerns with specific data. If this is really an
issue and we lose profitable orders, I dont mind in hiring two more staff and establish fullfledged costing department. Tanya, you also need to think on the issue of production overhead
and get some short-term solution.
Required: Do you agree with Tanya or Siddharth on charging the product related cost of the
new order? Do you see any need for changing the production overhead rates?

Table 1: Income statement summary


millions)

(Rs. in

Year

Net Sales

Operating Profit

Operating profit
Margin

2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

24
30
48
64
71
90
130
159
129
137

4
6
9
13
12
15
23
26
20
19

17%
21%
19%
21%
17%
17%
18%
17%
16%
14%

Analysis
I start the management accounting course with this case. The
purpose of the case is to highlight the kind of decision making
issues that managers will handle and how they should approach
such problems. The conversational style is mainly to highlight the
kind of conflict that managers face in an organization. Many
executive education students will be able to relate the case with
the kind of conflict that they often face with fellow managers.
Initially, I discuss the case without getting into the numbers. The
question asked is do we have any principle that we can apply in
taking decision of this kind. Students generally argue that we
should convince the customers to pay for full for the first order
and we can give discount for the next two orders. This option is
not feasible. Then students will get divided on either side some
argue that we should not take up the order and others will argue
that we should take the risk. Some students who dont want to
take such decisions feel that we should collect more information
and then decide. At this point, I ask students to work out how the
order will affect the firms profit when we go by marketing
departments pricing and when we go by costing departments
pricing. I will then show even at marketing departments pricing,
the order is profitable.
Current Financial Statement
Sales
Material + Labour
OH
Profit

137000000
88240000
29760000
19000000

Pricing wanted by marketing department


Costing Department
Total Material Cost
Overhead
One-third of product related cost
Total order cost
Add: Mark up

500000
1440000
500000
2440000
392881

Pricing done by

Total Material Cost


Overhead
Full product cost
Total cost
Mark up

500000
1440000
1500000
3440000
553898

Sale value
Price per unit

2832881
Sale value
2833
Price per unit
Difference in Price : 41%

Estimated profit under two different pricing

Marketing Dept.

3993898
3994

Costing Dept.

Total Sales

139832881

140993898

Less: Material

88740000

88740000

Less: Production OH

29760000

29760000

Less: Product cost (New)

1500000

1500000

Profit

19832881

20993898

Current profit

19000000

19000000

The order is profitable even if we go by marketing department


and charge only 1/3rd of product cost for the first order. The
primary reason is production overhead remains same. The order
when examined on incremental profitability basis show an
incremental profit of Rs. 832881 when we charge only one-third of
the product related cost. If the customer turns up with two more
orders, then profitability of the firm in the current year will
increase by Rs. 5.5 million (or 29%).
Total Sales
Less: Material
Less: Production OH
Less: Product cost
(New)
Profit
Current profit

1454986
44
8974000
0
2976000
0
1500000
2449864
4
1900000

Incremental Profit

0
5498644

I conclude the case saying decision making requires deeper


analysis and incremental cost/profitable analysis is always useful.
I avoid any detailed discussion on two different types of machines
used in the factory but using single overhead rate and reserve
this discussion to case 2. However, I highlight or agree with the
students that we need to change the overhead rates and say we
will be discussing this issue in a different case.