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CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (620)

PART I
KNOWLEDGE BROUGHT FORWARD - CAF
Different Component of Cost

1. This is called inventory cost as it forms part of cost of inventory carried forward and
charged in the period when these goods are sold as per IAS-2.
2. All non-production cost are period cost i.e. charged in the Income Statement of the period
in which these are incurred i.e. it is generally assumed that their benefit is restricted to one
accounting period.
3. Generally Variable, exceptions may exist.
4. We will use variable portion of these for some purpose other than inventory measurement.
5. Generally Direct cost exceptions may exist.
6. Generally Indirect cost exceptions may exist.
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COMPANY NAME
COST OF GOODS SOLD STATEMENT
FOR THE PERIOD ENDED XX=XX=XXXX
(Rupees) (Rupees)
1 RAW MATERIAL / DIRECT MATERIAL / BASIC MATERIAL
Opening Stock Note 10,000
Add: Purchases 210,000
Add: Carriage / Freight / Transportation a 3,000
Less: Returns b (5,000)
Net Purchases c 208,000
Raw Material Available for Consumption 218,000
Less: Closing Stock (8,000)
Raw Material Consumed 210,000
2 DIRECT LABOUR / WAGES
Wages 110,000
Prime Cost / Direct Cost / Basic Cost / Flat Cost 320,000
3 FACTORY OVERHEADS
Indirect Material -
Indirect Labor -
Depreciation -
Rent -
Insurance -
- -
- -
90,000
Factory Cost / Production Cost / Manufacturing Cost 410,000
4 WORK IN PROCESS
Add: Opening Stock 25.000
Cost to be accounted for 435,000
Less: Closing Stock (30,000)
Cost of Goods Manufactured (CGM) 405,000
5 FINISHED GOODS
Add: Opening Stock 45,000
Cost of Goods Available for sale 450,000
Less: Closing Stock (50,000)
Cost of Goods Sold (CGS) 400,000

Notes:
a) It represents these expenses on purchases. Such expenses on Sales are classified as Selling Exp.
If Question is silent, treat as against Purchases and give a note for the alternate. Delivery
Expenses are normally classified as Selling Expenses.
b) Sales Returns are shown on the face of Income Statement after Sales.
c) Discount on Purchases is treated as Other Income and on Sales as Selling Expense.
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (622)

Cost Behaviour
Total Per unit
* Increase * Fixed
Variable cost ** Decrease ** Fixed
*** Variable (∝) *** Fixed
* Fixed * Decrease
Fixed cost ** Fixed ** Increase
*** Fixed *** Variable (1/∝)
* Increase * Decrease
Total cost ** Decrease ** Increase
*** Variable (∝) *** Variable (1/∝)

* Increasing Production Volume situation


** Decreasing Production Volume situation
*** Variable Production Volume situation

Product Alpha
Selling price Rs. 10 pu
Variable cost Rs. 6 pu
Fixed cost Rs. 10,000 in total (Say per month)

Operating Level
0 1,000 2,000 2,500 4,000 5,000
(Units)
Per Per Per Per Per
Total unit Total unit Total unit Total unit Total unit Total

Sales - 10 10,000 10 20,000 10 25,000 10 40,000 10 50,000


Less: Var. Cost - (6) (6,000) (6) (12,000) (6) (15000) (6) (24,000) (6) (30,000)
Contribution - 4 4000 4 8000 4 10,000 4 16,000 4 20,000
Less: Fixed Cost (10,000) (10) (10,000) (5) (10,000) (4) (10,000) (2.5) (10,000) (2) (10,000)
Profit/ (Loss) (10,000) (6) (6,000) (1) (2,000) 0 - 1.5 6,000 2 10,000
Total cost - 16 16,000 11 22,000 10 25,000 8.5 34,000 8 40,000

KEY POINT

 Variable Cost is variable in total but fixed on a per unit basis


 Fixed Cost is fixed in total but variable on a per unit basis
 As output increases per unit variable cost decreases and vice versa, commonly known as economics
of scale.

Problem of varied per unit Cost


Varying operating level affects the amount of per unit total cost based on which future business decisions
are difficult and at times impractical. Let’s consider the following example.
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (623)

Illustration # 1
Product: Alpha
Variable Cost = Rs. 6 per unit
Fixed Cost = Rs. 10,000 in total
Pricing Policy Selling Price (SP) = Cost + 30% on Cost
Required:
Compute per unit cost (rounded to two decimal places) for 2,000, 4,000 & 6,000 units operating level.

Answer
2,000 4,000 6,000
VC – PU 6.00 6.00 6.00
FC – PU 5.00 2.50 1.67
11.00 8.50 7.67
Profit @30% 3.30 2.55 2.30
SP –PU 14.30 11.05 9.97
The issue is resolved by computing per unit Fixed Cost at Normal Capacity (IAS-2). The computation will be
as follows: (assuming that Normal Capacity of the Company is 5,000 units).
5,000
VC – PU 6.00
FC – PU 2.00
8.00
Profit @ 30% 2.40
SP – PU 10.40

This selling price would be used irrespective of the actual operating level being higher, lower or at normal
capacity.
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (624)

PART II
MARGINAL AND ABSORPTION COSTING
Absorption and Marginal Costing
Introduction
Definition In Absorption Costing, fixed manufacturing overheads are absorbed into cost units. Thus,
stock is valued at absorption cost and fixed manufacturing overheads are charged in the
profit and loss account of the period in which the units are sold.
Definition In Marginal Costing, fixed manufacturing overheads are not absorbed into cost units.
Stock is valued at marginal (or variable) cost and fixed manufacturing overheads are treated
as period costs and are charged in the profit and loss account of the period in which the
overheads are incurred.
KEY POINT
Fixed Manufacturing Overheads are absorbed into Cost Units (FG) based on Normal Capacity and a per unit
total Cost computed thereof. Rules for Normal Capacity are (to be applied sequentially)
(i) Given
(ii) 100% (if computable)
(iii) Highest Production (Actual / Budgeted)
Contribution
Contribution is “sales less variable cost”. Initially only variable manufacturing costs will be considered. Later
variable selling and admin also discussed.
Marginal costing and absorption costing compared
To produce Financial Statements in accordance with IAS2, absorption costing must be used. But either
marginal or absorption costing can be useful for internal management reporting. The choice made will affect:
(a) the level of reported profit if sales do not exactly equal production (i.e. stock is increasing or
decreasing)
(b) the way in which profit information is presented.
Illustration # 1
Co.: W Ltd.
FG: Alpha
SP:pu (Rs.) 25
VC:pu (Rs.) 12 (DM + DL + VMOH)
Manufacturing Fixed Cost: Total (Rs.) 80,000 per month
Opening Units 2,000 units
Normal Capacity: 10,000 units
Jan Feb Mar
Production (Units) 10,000 10,000 10,000
Sales (Units) 7,000 11,000 10,000
Required:
(i) Income Statement under following for each of the three months.
(a) Marginal Costing
(b) Absorption Costing
(ii) Profit Reconciliation (PAC)
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (625)

Answer

(i) (a) W Ltd.


Income Statement (Under Marginal Costing)
For each of first three months
………………… (Rs.) …………………
Jan Feb Mar
Sales ( 7 / 11 / 10 * 25) 175,000 275,000 250,000
Less: Variable CGS
Op. Stock (2/5/4 * 12) (W1&2) 24,000 60,000 48,000
+ Prod. Cost (10/10/10 * 12) 120,000 120,000 120,000
- Cl. Stock (5/4/4 * 12) (W1) (60,000) (48,000) (48,000)
Variable CGS 84,000 132,000 120,000
Contribution 91,000 143,000 130,000
Less: Fixed Cost (80,000) (80,000) (80,000)
Gross Profit / (Loss) 11,000 63,000 50,000

W-1 Stock Movement: (units) Jan Feb Mar


Opening 2,000 5,000 4,000
Add: Production 10,000 10,000 10,000
Total Available 12,000 15,000 14,000
Less: Sales (7,000) (11,000) (10,000)
Closing 5,000 4,000 4,000

W-2 Per Unit Cost: (Rs.)


Under Marginal Costing (Variable Cost) 12
Add: Per Unit Fixed OH ( 80 / 10) 8
Under Absorption Costing (Total Cost) 20
20
(i) (b)
W Ltd.
Income Statement (Under Absorption Costing)
For each of first three months
………………… (Rs.) …………………
Jan Feb Mar
Sales ( 7 / 11 / 10 * 25) 175,000 275,000 250,000
Less: CGS
Op. Stock (2/5/4 * 20) (W1&2) 40,000 100,000 80,000
+ Prod. Cost (10/10/10 * 20) 200,000 200,000 200,000
- Cl. Stock (5/4/4 * 20) (W1) (100,000) (80,000) (80,000)
CGS 140,000 220,000 200,000
Gross Profit 35,000 55,000 50,000
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (626)

(ii) Profit Reconciliation (Rs.) Jan Feb Mar


Profit - as per Marginal Costing 11,000 63,000 50,000
Jan
Less Closing Stock - as per Marginal
Profit Reconciliation: (Rs.) (60,000) (48,000) (48,000)
Less
: Opening Stock - as per Absorption (40,000) (100,000) (80,000)
:
Add Opening Stock - as per Marginal 24,000 60,000 48,000
:
Add Closing Stock - as per Absorption 100,000 80,000 80,000
:Profit - as per Absorption Costing 35,000 55,000 50,000
- - -
KEY POINT
 If Production > Sales; Stock level rising; P : AC > P : MC
 If Production < Sales; Stock level falling; P : AC < P : MC
 If Production = Sales; Stock level constant or zero; P : AC = P : MC
 (If no Inflation):
Difference in Profit (Rs) = Difference in Inventory Units x Per Unit Fixed Manufacturing Cost
(P : AC – P: MC) (Closing units – Operating Units)
 If Product ≠ Normal Capacity:
Adjustment of per unit Fixed Manufacturing Overheads is made in GP as per Absorption Costing only.
Adjustment (Rs.) = (Production Units x P.U. Fixed Cost) – Total Fixed Cost

Illustration # 2

Co.: W Ltd.
FG: Alpha
SP:pu (Rs.) 25
VC:pu (Rs.) 12 ( DM + DL + VMOH)
FMOH: Total (Rs.) 80,000 per month
Opening Units 2,000 units
Normal Capacity: 10,000 units
Jan Feb Mar
Production (Units) 11,000 8,000 10,000
Sales (Units) 7,000 11,000 10,000
Required:

(i) Income Statement under following for each of the three months.
(a) Marginal Costing
(b) Absorption Costing
(ii) Profit Reconciliation (PAC)
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (627)

Answer
(i) (a)
W Ltd.
Income Statement (Under Marginal Costing)
For each of first three months
………………… (Rs.) …………………
Jan Feb Mar
Sales ( 7 / 11 / 10 * 25) 175,000 275,000 250,000
Less: Variable CGS
Op. Stock (2/6/3 * 12) (W1 & 2) 24,000 72,000 36,000
+ Prod. Cost (11/8/10 * 12) 132,000 96,000 120,000
- Cl. Stock (6/3/3 * 12) (W1) (72,000) (36,000) (36,000)
Variable CGS 84,000 132,000 120,000
Contribution 91,000 143,000 130,000
Less: Fixed Cost (80,000) (80,000) (80,000)
Gross Profit / (Loss) 11,000 63,000 50,000

W- Stock Movement: (units) Jan Feb Mar


1 Opening 2,000 6,000 3,000
Add: Production 11,000 8,000 10,000
Total Available 13,000 14,000 13,000
Less: Sales (7,000) (11,000) (10,000)
Closing 6,000 3,000 3,000

W-2 Per Unit Cost: (Rs.)


Under Marginal Costing (Variable Cost) 12
Add: Per Unit Fixed OH ( 80,000 / 10,000) 8
Under Absorption Costing (Total Cost) 20
(i) (b)
W Ltd.
Income Statement (Under Absorption Costing)
For each of first three months
………………… (Rs.) …………………

Jan Feb Mar


Sales ( 7 / 11 / 10 * 25) 175,000 275,000 250,000
Less: CGS
Op. Stock (2/6/3 * 20) (W1 & 2) 40,000 120,000 60,000
+ Prod. Cost (11/8/10 * 20) 220,000 160,000 200,000
- Cl. Stock (6/3/3 * 20) (W1) (120,000) (60,000) (60,000)
CGS 140,000 220,000 200,000
Gross Profit - Before Adjustment 35,000 55,000 50,000
Adj. for Und. / Over app. Fx. OH 8,000 (16,000) -
(Production * PU Fx - Tot. Fixed)
Adjusted Gross Profit / (Loss) 43,000 39,000 50,000
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (628)

(ii)
Profit Reconciliation: (Rs.) Jan Feb Mar
Profit - as per Marginal Costing 11,000 63,000 50,000
Less Closing - as per Marginal (72,000) (36,000) (36,000)
: Opening - as per Absorption
Less (40,000) (120,000) (60,000)
: Opening - as per Marginal
Add: 24,000 72,000 36,000
Add: Closing - as per Absorption 120,000 60,000 60,000
Profit - as per Absorption Costing 43,000 39,000 50,000
Net contribution = Sales – Total variable cost
Gross contribution = Sales – variable manufacturing cost
Net contribution = Sales – Variable selling & Admin. cost
KEY POINT
Net Contribution = Sales - Total Variable Cost
Gross Contribution = Sales - Variance Manufacturing Cost
Net Contribution = Sales - Variable Selling & Admin Cost
Advantages of Marginal Costing
Advantages relative to absorption costing
Preparation of routine operating statements using absorption costing is considered less informative because:
(a) Build-up or run-down of stocks of finished goods can distort comparison of period operating
statements and obscure the effect of increasing or decreasing sales.
(b) Comparison between products can be misleading because of the effect of arbitrary apportionment of
fixed costs. Where two or more products are manufactured in a factory and share all production
facilities, the fixed overhead can only be apportioned on an arbitrary basis.
(c) Marginal costing emphasizes variable cost per unit and fixed costs in total whereas absorption costing
unitizes all production costs.
(d) Marginal costing reflects the behavior of costs in relation to activity. Since most decision-making
problems involve changes to activity, marginal costing is more appropriate for short-run decision-
making than absorption costing.

Advantages of Absorption Costing


Advantages relative to marginal costing
The arguments used in favour of absorption costing are:
(a) That fixed costs are incurred within the production function, and that without those facilities
production would not be possible. Consequently such costs can be related to production and should be
included in stock valuation.
(b) Absorption costing follows the matching concept by carrying forward a proportion of the production
cost in the stock valuation to be matched against the sales value when the items are sold.
(c) It is necessary to include fixed overhead in stock values for financial statements, routine cost
accounting using absorption costing produces stock values which include a share of fixed overhead;
(d) Overhead allotment is the only practicable way of obtaining job costs for estimating prices and profit
analysis;
(e) Analysis of under / over absorbed overhead is useful to identify inefficient utilization of production
resources.
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (629)

Illustration # 3
Company name: Star Plc.
Selling Price: Rs.100 per unit
Cost Details: Direct Material Rs.25 per unit
Direct Labour Rs.13 per unit
Variable Production Overheads Rs.12 per unit
Variable Selling Overheads Rs.7 per unit
Variable Admin. Overhead Rs.5 per unit
Fixed Production Overheads Rs.120,000
Fixed Selling Overheads Rs.96,000
Fixed Admin. Overheads Rs.54,000
Normal Capacity 12,000 units
Yr-1 Yr-2 Yr-3
Production (units) 12,000 11,000 12,800
Sales (units) 11,500 12,200 13,500
Opening Stock for the Year 1 = 2,000 units
Required:-
(a) Compute (Per unit)
(i) Variable marginal cost
(ii) Fixed marginal cost
(iii) Total marginal cost
(iv) Gross contribution
(v) Variable Selling, Admin.
(vi) Fixed Selling, Admin.
(vii) Total Selling, Admin.
(viii) Total cost
(ix) Net contribution
(b) Prepare Income Statement for the three years
(i) As per Marginal Costing
(ii) As per Absorption Costing
(c) Prepare profit reconciliation statement for the three years (PAC)
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (630)

Answer
(All amounts
in Rupees)
Star Plc
Income Statement (Under Marginal Costing)
For year ended Yr 1 to Yr 3
Yr 1 Yr 2 Yr 3
Sales (11,500/12,200/13,500 @ 100) 1,150,000 1,220,000 1,350,000
Less: Variable cost of sales
Opening Stock (2,000/2,500/1,300*50) 100,000 125,000 65,000
Add: P. C. (12,000/11,000/12,800*50) 600,000 550,000 640,000
Less: Closing Stock (2,500/1,300/600*50) 125,000 65,000 30,000
575,000 610,000 675,000
Gross Contribution 575,000 610,000 675,000
Less: Variable Selling Overheads (@ 7)* Units Sold 80,500 85,400 94,500
Variable Admin Overheads (@ 5)* Units Sold 57,500 61,000 67,500
138,000 146,400 162,000
Net Contribution 437,000 463,600 513,000
Less: Fixed Production Overheads 120,000 120,000 120,000
Fixed Selling Overheads 96,000 96,000 96,000
Fixed Admin Overheads 54,000 54,000 54,000
270,000 270,000 270,000
Net Profit / (Loss) 167,000 193,600 243,000

Star Plc
Income Statement (Under Absorption Costing)
For year ended Yr 1 to Yr 3
Yr 1 Yr 2 Yr 3
Sales (11,500/12,200/13,500 @ 100) 1,150,000 1,220,000 1,350,000
Less: Cost of goods sold
Opening Stock (2,000/2,500/1,300*60) 120,000 150,000 78,000
Add: P. C. (12,000/11,000/12,800*60) 720,000 660,000 768,000
Less: Closing Stock (2,500/1,300/600*60) 150,000 78,000 36,000
690,000 732,000 810,000
Gross Profit before Adjustment 460,000 488,000 540,000
Adjustment for under/over Fixed FOH - (10,000) 8,000
Adjusted Gross Profit 460,000 478,000 548,000
Less: Selling Overheads - Total 176,500 181,400 190,500
Admin Overheads - Total 111,500 115,000 121,500
288,000 296,400 312,000
Net Profit / (Loss) 172,000 181,600 236,000
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (631)

Profit Reconciliation Yr 1 Yr 2 Yr 3
Rs. Rs. Rs.
Profit as per MC 167,000 193,600 243,000

Less: Closing Stock as per MC (125,000) (65,000) (30,000)

Less: Opening Stock as per AC (120,000) (150,000) (78,000)


Add: Closing Stock as per AC 150,000 78,000 36,000
Add: Opening Stock as per MC 100,000 125,000 65,000
Profit as per AC 172,000 181,600 236,000

Workings
Per unit cost of the company is as follows:
Variable Cost - Marginal (25+13+12) 50
Fixed Cost (Per Unit) (120,000/12,000) 10
Total Cost (Per Unit) 60
Stock Movement is as follows: Yr 1 Yr 2 Yr 3
Opening 2,000 2,500 1,300
Add: Production 12,000 11,000 12,800
Less: Sales 11,500 12,200 13,500
Closing 2,500 1,300 600
Formula for Under / Over Absorbed Fixed FOH is as follows:
=(Actual Production * Per Unit Fixed FOH) - Actual Fixed FOH
Both Variable Selling and Admin. Overheads are based on units sold.

KEY POINT
If Cost structure changes from period to period (eg. because of inflation) opening inventory would be
measured at last period rates and closing inventory at current period rates, assuming FIFO system being
applicable.

Illustration # 4

ATF LIMITED
Following information has been extracted from the financial records of ATF Limited:
Production during the year units 35,000
Finished goods at the beginning of the year units 3,000
Finished goods at the end of the year units 1,500
Sale price per unit Rs. 200
Fixed overhead cost for the year Rs. 1,000,000
Administration and selling expenses Rs. 200,000
Annual budgeted capacity of the plant units 40,000
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (632)

The actual cost per unit, incurred during the year, was as follows:
Rupees
Material 70
Labour 40
Variable overheads 30
Company uses FIFO method for valuation of inventory. The cost of opening finished goods inventory
determined under the absorption costing method system was Rs. 450,000. Fixed overhead constituted 16% of
the total cost last year.
Required

(a) Prepare profit statements for the year, under absorption and marginal costing systems.
(b) Prepare reconciliation between the net profits determined under each system. (Adapted)
(12)

Answer
ATF LIMITED
Absorption Costing Marginal Costing
(Rs.) (Rs.)
Sales (3,000 + 35,000-1,500) × Rs. 200 7,300,000 7,300,000
Cost of goods manufactured
Opening Inventory 450,000 378,000*
Add: Cost of goods manufactured
(35,000 × 165) & (35,000 / 140) 5,775,000 4,900,000
6,225,000 5,278,000
Less: Ending inventory
(1,500 x 165) & (1,500 × 140) (247,500) (210,000)
(5,997,500) 5,068,000
Gross profit / contribution margin 1,322,500 2,232,000
Less: unabsorbed overheads
[(25x35,000) -1,000,000] (125,000) -
Less: Administration and selling expenses (200,000) (200,000)
Fixed overheads - (1,000,000)
Net Profit 997,500 1,032,000
*Cost of opening finished goods under marginal costing Rs. 450,000 × (100-16%) = Rs. 378,000
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (633)

Computation of Cost of goods manufactured (COGM) & Ending Inventory:

Rupees
Material Cost 70
Labour Cost 40
Variable overhead 30
Cost per unit under marginal costing system 140
Fixed overhead (Rs. 1,000,000/40,000) 25
Cost per unit under absorption costing system 165

Reconciliation between the net profits determined under Marginal & Absorption costing:
Rupees
Net Profit under Absorption Costing 997,500
Add: Difference in opening finished goods (Rs. 450,000 – 378,000) 72,000
Less: Difference in ending finished goods (Rs. 247,500 – 210,000) (37,500)
Net Profit under Marginal Costing 1,032,000
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (634)

PART III
LEARNING CURVE
Executive Summary:

Learning Curve is basically the reduction in future labor cost of Product when you expect your labor to learn and produce same
goods in less time in future. As the learning continues over the periods therefore the key challenge is compute its effect on future
production time. The technique used is Learning Curve by applying the Learning Rate (LR) on “cumulative” future production

What is Learning Curve Theory and where does it apply?


Labor time should be expected to get shorter, with experience, in the production of items which exhibit any
or all of the following features.
 Made largely by labor effort (rather than by a highly mechanized process)
 Brand new or relatively short-lived (learning process does not continue indefinitely)
 Complex and made in small quantities for special orders
Eventually, however, after adequate experience, nothing new to learn. So the learning process will stop.
Generally it is assumed that learning rate cannot be below 50% i.e. minimum 50% reduced in time because of
learning curve effect in a single period. However, the cumulative average time per units may reduce as much
as possible till the learning stops (specifically mentioned in question if applicable.) (The period of time is
adjustable according to production cycle.)

Approaches to Learning Curve Problems


There are three methods that can be used to address learning curve scenarios.
 Method 1. The tabular approach (Only applicable where starting with one unit, cumulative output is
doubling)
 Method 2. The graphical approach (Not accurate, therefore not discussed)
 Method 3. The algebraic approach

The Tabular Approach: Cumulative Average Time and the Learning Rate
Under this approach, a table is set up to show levels of output, cumulative average time required per unit and
incremental time for additional units. The cumulative average time per units produced is assumed to decrease
by a constant percentage every time total output of the product doubles.

For instance, where an 80% learning effect occurs, the cumulative average time required per unit of output is
reduced to 80% of the previous cumulative average time when output is doubled.
(a) By cumulative average time, we mean the average time per unit for all units produced so far, back to
and including the first unit made.
(b) The doubling of output is an important feature of the learning curve measurement. The primary
challenge is the computation of cumulative average time required per units when cumulating x units
are produced.
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (635)

Example: an 80% learning curve


The first unit of output of a new product requires 100 hours. An 80% learning curve applies. The production
times would be as follows:

Cumulative Cumulative avg. Cumulative Incremental time for


Number of time Total time additional units
units required per unit required
produced
1 100.0 (x1) 100.0

2* (80%) 80.0 (x2) 160.0 60.0 (for 1 extra unit)


4* (80%) 64.0 (x4) 256.0 96.0 (for 2 extra units) 80% of 60
i.e.48 p.u
8* (80%) 51.2 (x8) 409.6 153.6 (for 4 extra units) 80% of 48
i.e. 38.4 p.u
*Output is being doubled each time.
** First three columns are generally required in exams; rest of the columns is explanation.

The algebraic approach


The formula for the learning curve is Y = axb where b, the learning coefficient or learning index, is defined as
(log of the learning rate/log of 2). The learning curve formula can be used to solve all learning curve
scenarios.
The formula for the learning curve is Y = axb
Where Y is the cumulative average time per unit to produce x units
x is the cumulative number of units
a is the time taken for the first unit of output
b is the index of learning (logLR/log2)
LR is the learning rate as a decimal
The learning rate (LR) is reverse of time saved e.g. if Average time saved is 20%, this means LR is 80% and
so on. The learning rate remains constant over the life of the product.

Logarithms and the value of b


When y = axb in learning curve theory, the value of b = log of the learning rate/log of 2. The learning rate is
expressed as a number, so that for an 80% learning curve, the learning rate is 0.8, and for a 90% learning
curve it is 0.9, and so on.
For an 80% learning curve, b = log 0.8/log 2. Using the button on your calculator marked ‘log’
-0.0969
b  0.322
0.3010

KEY POINT
Linkage of Algebraic Approach with Table
 “Y” is 2nd Column of Table
 “a” is first entry in 2nd & 3rd Column
 “x” is 1st Column
 “b” uses Learning Rate as done b/w Column 1 & 2
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (636)

Illustration # 1

In a learning curve model, a = 10 hours and b = -0.322 at a learning rate of 80%. You are required to
calculate:
(i) Average time for 20 units.
(ii) Total time for 30 units.
(iii) Time for 10 additional units (31 to 40). (08)
(ICAP Module F, Summer 2005, Q.5)

Answer
Learning curve is:
y = ax-b

(i) AVERAGE TIME FOR 20 UNITS


y = 10 x (20)-0.322
= 3.811 hours per unit

(ii) TOTAL TIME FOR 30 UNITS


30y = 10 x (30)-0.322 x 30
Total time for 30 minute = 100.34 hours

(iii) TIME FOR ADDITIONAL 10 UNITS (31-40)


Total time for 40 units
Y = 10 x 40-322 x 40 = 121.95
Less: time required for 30 units (ii) = (100.34)
Time required for additional 10 units 21.61 hrs.

KEY POINT
Adoption of Algebraic Approach for “Labor Costs” / “Time” – Only Changes (Other factors like “x” and
“b” are same). “Y” is the Cumm. average cost to produce “x” units. “a” is cost for first unit.
Illustration # 2
Suppose, for example, that an 80% learning curve applies to production of item ABC. To date (the end of
June) 230 units of ABC have been produced. Budgeted production for July is 55 units.
The labor cost of the very first unit of ABC, in January was Rs.120.
Required
Calculate the budgeted total labor cost for July. (PAC)

Answer
To solve this problem, we need to calculate three things.
(a) The cumulative total labor cost so far to produce 230 units of ABC.
(b) The cumulative total labor cost to produce 285 units of ABC that is adding on the extra 55 units for
July.
(c) The extra cost of production of 55 units of ABC in July, as the difference between (b) and (a).
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (637)

Calculation (a)
Y = axb and we know that for 230 cumulative units, a = Rs.120 (cost of first unit), x = 230 (cumulative units)
and b = -0.322 (80% learning curve) and so y = 120 x (230-0.322) = Rs. 20.83.
So when x = 230 units, the cumulative average cost per unit is Rs. 20.83.
Calculation (b)
Now we do the same sort of calculation for x = 285.
If x = 285, y = 120 x (285-0.322) = Rs.19.44
So when X = 285 units, the cumulative average cost per unit is Rs.19.44.
Calculation (c)
Cumulative units Average cost per unit Total cost
Rs. Rs.
230 20.830 4,790.90
285 19.440 5,540.40
Incremental cost for 55 units 749.50

Illustration # 3
Please redo question # 4 if learning stops at 250 units. (PAC)

Answer

To solve this problem, we need to calculate three things.


(a) The cumulative total labor cost so far to produce 230 units of ABC.
(b) The cumulative total labor cost to produce 250 units of ABC that is adding on the extra 20 units for
July.
(c) The extra cost of producing 20 units of ABC in July, as the difference between (b) and (a)
Firstly we will calculate the average cost and total cost for 250 units and compare it with that of 230 units
Unit Current Average Cost Per Unit Commutative Total Cost
250 20.280 5,070.00
230 20.830 4,790.90
279.1
(d) The cost of producing 249 units. The cost of 250th unit is the difference b/w (b) & (d)
(e) The cost of producing 35 extra units i.e. 35x (d)
Therefore the cost of 20 units i.e. from unit # 231 to Unit # 250 would be Rs. 279.10.
Now we will calculate cost of 249 units and compare it with cost of 250 units to calculate the cost of 250 units:
Unit Current Average Cost Per Unit Commutative Total Cost
250 20.280 5,070.000
249 20.305 5,055.945
14.055
Therefore the cost of next 35 units will (35 x 14.055) Rs. 491.925 and total cost of 55 units as Rs. 771.025
(A higher cost than earlier because of learning stoppage)
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (638)

KEY POINT
 Learning Curve can result in reduction of Material Loss in future. This is in addition to the learning
curve effect on Labor Cost and Overheads based on Labor
 Concept of average time per unit in case of production in batches (It is the average time for all units
in that particular batch)
 Rules for Log:
 Log (A x B) = Log A + Log B
 Log (A / B) = Log A – Log B
 Log (A)^B = B Log A
Illustration # 4

Hamid (Private) Limited (HPL) has received an order for supply of a new product. The planning department
has estimated that for the first batch of 500 units, the per unit revenue/costs would be as follows:
Selling price Rs. 450
Direct material 1 kg @ Rs. 180 per kg.
Direct labor 2 labor hours @ Rs. 100 per hour
Variable production overheads 25% of direct labor costs
Fixed production overheads Rs. 30
Selling expenses Rs. 20
HPL has a learning curve of 80% for all new products. The units are produced in batches of 500 units and
the learning effect applies to the first 8 batches only.
Note: log 0.8/log 2 = –0.322
Required:
Compute the minimum quantity that would allow HPL to earn a contribution margin of 20% of sales. (15)
(ICAP Module F, Winter 2014, Q.5 (b))
Answer
Rs.per unit
Sales price 450
Less: Contribution margin (20% of sale price) 90
Maximum variable cost 360
Less: Variable costs other than labor & OH
Raw material (180)
Selling expenses (20)
Maximum labor and overheads that can be incurred A 160
Cost of labor and overhead of first batch (200 × 1.25) B 250
Labor hours per unit for 1st batch 2
Maximum labor hours allowed (A*2)/B 1.28
CHAPTER - M KNOWLEDGE BROUGHT FORWARD - CAF (639)

Assuming that 'x' is the no of batches for which average labor hours per unit would be 1.28 and using the
formula we have: 2x-0.322 = 1.28*
x-0.322 = 0.64
x0.322 = 1/0.64
1
1 0.322
x = (0.64)
Hence x = 4
Minimum number of units for which the company would be able to earn a contribution margin of
20% = 4 x 500 = 2000 units
* Alternatively
Existing L + OH = 250
(2 x 100) + (200 x 0.25) = 250
Required (x x 100) + (100x x 0.250) = 160
125x = 160
x = 1.28

Illustration # 5

ABC Limited manufactures heavy equipment for use in various industries. It has recently developed and
supplied eight units of special equipment to an important customer. It took about 5,000 hours to build the
first unit but thereafter a learning curve of 80% has taken effect which is expected to continue for the next 56
units.
Direct labor cost is Rs. 100 per hour. Cost of direct material is Rs. 400,000 per unit and variable overheads
are estimated at Rs. 80 per direct labor hour.
Required:
A new customer has placed an order for eight units of equipment. Determine the price that the company may
charge to earn a profit of 20% of sales. (06)
(ICAP Module F, Summer 2008, Q.3 (b)
Answer

No. of units Average hours Total hours


1 5,000 5,000
2 4,000 8,000
4 3,200 12,800
8 2,560 20,480
16 2,048 32,768
Hours used for 9-16 units (32,768 – 20,480) 12,288
Cost of labor (12,288 x 100) Rs. 1,228,800
Direct materials (8 x 400,000) Rs. 3,200,000
Variable overheads (1,228,800 x 80%) Rs. 983,040
5,411,840
Margin 1,352,960
Sale price - Total Rs. 6,764,800
Per unit price the company should charge is Rs. 845,600 per unit (6,764,800 ÷8).