• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

P. V. Rathnam

IPL LTD uses small castings in one of its finished products. The castings are purchased from a foundry. IPL purchases 54,000 castings per year at Rs 800 per casting.

The castings are used evenly throughout the year in the production process on a 360-day-per-year basis. The company estimates that it costs Rs 9,000 to place a single purchase order and about Rs 300 to carry one casting in inventory for a year. The high carrying costs result from the need to keep the castings in carefully controlled temperature and humidity conditions, and he high cost of insurance.

Delivery from the foundry generally takes six days, but it can take as much as 10. The days of delivery time and percentage of their occurrence are as follows:

Delivery time (days) six, percentage of occurrence,75; 7, 10; 8, 5; 9, 5; and 10, 5.

Required: i) compute the economic order quantity (EOQ); ii) assume the company is willing to assume a 15 per cent risk of being out of stock. What would be the safety stock and the re-order point?; iii) assume the company is willing to assume a 5 per cent risk of being out of stock. What would be the safety stock and the re-order point?; iv) assume 5 per cent stock-out risk. What would be the total cost of ordering and carrying inventory for one year? v) refer to the original data. Assume that using process re-engineering the company reduces its cost of placing a purchase order to only Rs 600. The company estimates that when the waste and inefficiency caused by inventories are considered, the true cost of carrying a unit in stock is Rs 720 a year. Compute the new EOQ.

How frequently would the company be placing an order, as compared to the old purchasing policy?

Solution: i) EOQ = square root of 2AO/C = square root of 2 x 54000 x 9000 / 300 = 1800 castings

ii) Mean delivery time: 6 x 75 per cent = 4.50 days; 7 x 10 per cent = 0.70 days; 8 x 5 per cent = 0.40; 9 x 5 per cent = 0.45; 10 x 5 per cent = 0.50; 100 per cent = 6.55 days

Daily consumption: 54,000 / 360 days = 150 castings

Consumption during maximum delivery time = 10 days at 150 = 1500

Less: Mean delivery time = 6.55 x 150 = 982

Safety stock = 518

Less: 15 per cent risk of being out of stock 15 per cent of 518 = 78

a) Safety stock = 440 castings

b) Re-order point = Safety stock + lead time consumption

440 + 982 = 1422 castings

iii) (a) Safety stock = 518 - 5 per cent = 492 castings

b) Re-order point = 492 + 982 = 1,474 castings

iv) EOQ 1,800 units less 5 per cent stock out risk = 1,710 to be ordered

Ordering cost = 54,000 / 1710 = 32 orders at Rs 9,000 = 2,88,000

Carrying cost 1710 + 0 / 2 x 300 = 2,56,500

Total cost of O + C = 5,44,500

v)(a) EOQ = square root of 2 x 54000 x 600 / 720 = 300 castings

b) No. of orders as per old purchasing policy = 54,000 / 1,800 = 30

That is, 360 / 30 =12 days' frequency.

Note: Daily consumption 54,000 / 360 days = 150 castings

EOQ 1,800 / 150 = 12 days

No. of orders as per new purchasing policy = 54,000 / 300 = 180

That is, 360 / 180 = 2 days' frequency.

Purchase order is to be placed every two days, that is, alternate days.

Activity-based allocation

RST Ltd specialises in the distribution of pharmaceutical products. It buys the products from pharmaceutical companies and resells the same to each of the three different markets, namely, general supermarket chains, drugstore chains and chemist shops.

Table 1 presents data in respect of RST Ltd for April 2004. In the past, RST Ltd had used gross margin percentage to evaluate the relative profitability of its distribution channels. The company plans to use activity-based costing for analysing the profitability of its distribution channels. The activity analysis of RST Ltd is shown in Table 2.

The April 2004 operating costs (other than cost of goods sold) of RST Ltd are Rs 8,27,970. These costs are assigned to five activity areas. The cost in each area and the quantity of the cost-allocation base used in that area for April 2004 are shown in Table 3. Other data for April 2004 are given in Table 4.

Required: i) Compute for April 2004, the gross-margin percentage for each of its three distribution channels and compute RST Ltd's operating income.

ii) Compute the April 2004 rate per unit of the cost-allocation base for each of the five activity areas.

iii) Compute the operating income of each distribution channel in April 2004 using the activity-based costing information. Comment on the results. What new insights are available with the activity-based cost information?

iv) Describe four challenges one would face in assigning the total April 2004 operating costs of Rs 8,27,970 to five activity areas.

i) The statement of gross margin percentage for April 2004 is given in Table 5.

ii) The rate per unit for each activity area is presented in Table 6.

ii) The operating income in activity-based costing is shown in Table 7.

Chemist shops: The first three activities are more in chemist shops and, hence, operating costs are also to be debited at a higher amount.

General supermarket chains: Cartons dispatched are more in this case. Hence, Rs 99,000 apportioned. Shelf-stocking is also more in this case. Hence, Rs 15,840 apportioned.

Operating income is Rs 11,83,828 in ratio of chemist shops, which is computed on the basis of traditional method. This is not correct, as the amount is higher compared to the ABC system. It is Rs 8,86,600, which is arrived at on the basis of activities which are more in the case of chemist shops. This amount is more appropriate on the basis of the ABC system.

New insights: Product costing is important. The management needs accurate costs for strategic product design, manufacturing and marketing decisions. More accurate product costs reduce the chances of making incorrect decisions. Activities are processes or procedures that cause work. Managers also need activity level information from the product costing system to guide continuous improvement.

Challenges: Resistance on the part of managers to accept the new system; failure to obtain commitment at all levels — the top management, the project team and ABC users; failing to form cross-functional teams; and failure to understand strategic nature of the business.

Suggested answers to the May 2004 CA (PE II) paper on cost accounting and financial management.

To access Mentor archives visit: http://www.thehindubusinessline.com/mn/arcmn.htm

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Like tornadoes, inflation can suck in your savings real fast

Copyright © 2004, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line