Dean's Office Official Model Question Paper

Answer: Relevant Costs: Future expected costs that differ between alternative courses of action. Costs that remain unchanged regardless of the decision (sunk costs, unavoidable common overheads) are irrelevant. Example: Incremental raw material cost incurred only if a special export order is accepted.

Answer: Sunk Cost: A cost that has already been incurred and cannot be avoided or altered by any current or future decision (e.g., past book value of specialized equipment). It must be ignored because it is identical across all decision alternatives.

Answer: Make-or-Buy Decision Rule: Compare the relevant cost to make (Direct Materials + Direct Labor + Variable Overhead + avoidable fixed costs) with the purchase price from the external supplier. If the relevant cost to make is less than the external purchase price, make internally; otherwise, buy (outsource), subject to quality and supplier reliability.

Answer: Opportunity Cost: The maximum potential economic benefit forgone or sacrificed when choosing one alternative course of action over the next best alternative (e.g., the contribution margin lost on standard production when dedicating machine hours to a special order).

Answer: \nTarget Costing: A customer-driven, market-based pricing and cost management method where maximum allowable product cost is calculated by subtracting the required target profit margin from the competitive market selling price:

$$\text{Target Cost} = \text{Competitive Market Price} - \text{Target Profit Margin}$$

Solution: Special Order Decision Analysis

a) Relevant Costs per Pair for Special Order

• Direct Materials = Rs. 400
• Direct Labor = Rs. 250
• Variable Factory Overhead = Rs. 150
• Additional Export Packaging = Rs. 40
• (Regular Variable Selling Cost is not incurred = Rs. 0)
• (Fixed Factory and Admin Overheads are sunk and unavoidable within current capacity)

$$\text{Total Relevant Cost per Pair} = 400 + 250 + 150 + 40 = \mathbf{\text{Rs. } 840}$$

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b) Incremental Profitability Analysis

• Offered Special Export Price = Rs. 950 per pair

• Relevant Cost per Pair = Rs. 840

• Incremental Contribution Margin per pair:

  $$\text{Incremental CM} = 950 - 840 = \mathbf{\text{Rs. } 110 \text{ per pair}}$$

• Total Incremental Profit on 8,000 pairs:

  $$\Delta \text{Profit} = 8,000 \times 110 = \mathbf{\text{Rs. } 880,000}$$

Decision: ACCEPT the special order. The firm possesses idle capacity ($50,000 - 40,000 = 10,000$ available pairs), and accepting the 8,000 pairs adds Rs. 880,000 to net operating profit without increasing fixed overheads.

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c) Qualitative and Strategic Considerations

1. Protection of Domestic Market: Ensure the foreign retailer cannot re-import or dump these shoes back into the domestic Nepalese market at discounted rates, undermining the regular Rs. 1,500 brand price point.
2. Customer Reactions: Domestic dealers paying Rs. 1,500 must not discover the Rs. 950 export price to avoid demands for price cuts.
3. Future Capacity Pre-emption: Ensure accepting the special order does not pre-empt regular domestic sales if domestic demand unexpectedly rebounds.

Solution: Make-or-Buy Decision with Opportunity Cost

1. Relevant Costs of Making (10,000 units)

• Direct Materials: $10,000 \times 120 = \text{Rs. } 1,200,000$
• Direct Labor: $10,000 \times 80 = \text{Rs. } 800,000$
• Variable Overhead: $10,000 \times 50 = \text{Rs. } 500,000$
• Avoidable Fixed Overhead: $40\% \times 900,000 = \text{Rs. } 360,000$
• Opportunity Cost (Forgone Rental Income): Rs. 150,000

$$\text{Total Relevant Cost to MAKE} = 1,200,000 + 800,000 + 500,000 + 360,000 + 150,000 = \mathbf{\text{Rs. } 3,010,000}$$

$$\text{Relevant Cost per Unit to Make} = \frac{3,010,000}{10,000} = \mathbf{\text{Rs. } 301.00}$$

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2. Relevant Costs of Buying (10,000 units)

• Purchase Price: $10,000 \times 280 = \mathbf{\text{Rs. } 2,800,000}$

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3. Differential Cost Comparison

Conclusion & Decision: BUY (Outsource) Part X-10 from the external vendor. Outsourcing yields a net financial saving of Rs. 210,000 per year (Rs. 21 per unit) after accounting for the released rental opportunity.

Solution: Product Mix Optimization with Constrained Resource

a) Contribution Margin per Constrained Machine Hour

1. Contribution Margin per Unit ($CM$):

   • Alpha: $500 - 300 = \text{Rs. } 200$
   • Beta: $800 - 440 = \text{Rs. } 360$
   • Gamma: $1,200 - 720 = \text{Rs. } 480$

2. Contribution Margin per Machine Hour ($CM/\text{Hour}$):

   • Alpha: $\frac{200}{2} = \mathbf{\text{Rs. } 100 \text{ per hour}}$
   • Beta: $\frac{360}{3} = \mathbf{\text{Rs. } 120 \text{ per hour}}$
   • Gamma: $\frac{480}{6} = \mathbf{\text{Rs. } 80 \text{ per hour}}$

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b) Ranking / Priority

• Rank 1: Product Beta (Rs. 120/hr)
• Rank 2: Product Alpha (Rs. 100/hr)
• Rank 3: Product Gamma (Rs. 80/hr)

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c) Optimal Product Mix Allocation (Total Hours Available = 4,800)

1. Produce Product Beta (Rank 1) to Max Demand:

   • Units = 800 units
   • Machine Hours consumed = $800 \times 3 = 2,400 \text{ hours}$
   • Remaining hours = $4,800 - 2,400 = 2,400 \text{ hours}$

2. Produce Product Alpha (Rank 2) to Max Demand:

   • Units = 1,200 units
   • Machine Hours required = $1,200 \times 2 = 2,400 \text{ hours}$
   • Remaining hours = $2,400 - 2,400 = 0 \text{ hours}$

3. Produce Product Gamma (Rank 3):

   • Zero hours remaining $\implies$ 0 units produced.

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Maximum Monthly Total Contribution Margin:

• From Beta: $800 \text{ units} \times \text{Rs. } 360 = \text{Rs. } 288,000$
• From Alpha: $1,200 \text{ units} \times \text{Rs. } 200 = \text{Rs. } 240,000$
• From Gamma: 0 units = Rs. 0

$$\text{Maximum Total Contribution Margin} = 288,000 + 240,000 = \mathbf{\text{Rs. } 528,000}$$

Responsibility Accounting and Investment Center Evaluation

1. Concept of Responsibility Accounting

A managerial accounting system that personalizes accounting reports by delegating authority and holding managers accountable specifically for the revenues, costs, and assets over which they exercise direct control (controllability principle).

2. The Four Responsibility Centers

1. Cost Center: Manager is accountable only for controlling operational costs within budget (e.g., Accounting Department, Maintenance).
2. Revenue Center: Manager is accountable solely for generating sales revenue (e.g., Regional Sales Office).
3. Profit Center: Manager is responsible for both revenues and expenses, controlling departmental profit (e.g., an individual supermarket branch).
4. Investment Center: Manager controls revenues, expenses, and capital investment in physical assets (e.g., an autonomous corporate business division).

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3. Performance Metrics for Investment Centers

1. Return on Investment (ROI):
   $$ROI = \frac{\text{Operating Income (EBIT)}}{\text{Average Operating Assets}} = \text{Operating Margin} \times \text{Asset Turnover}$$
   • Limitation: May cause sub-optimization—managers may reject profitable corporate projects if their expected return is below the division’s current high ROI.
2. Residual Income (RI):
   $$RI = \text{Operating Income} - (\text{Average Operating Assets} \times \text{Minimum Required Rate of Return})$$
   • Advantage over ROI: Overcomes sub-optimization. Managers accept any project yielding positive residual income, aligning divisional actions with corporate wealth maximization.

Comprehensive Segment Elimination Solution: Gandaki Departmental Store

a) Differential Profit Analysis of Closing the Cafeteria

1. Lost Contribution Margin from Cafeteria:

   $$\text{Lost Cafeteria CM} = -\text{Rs. } 2,500,000$$

2. Savings from Avoidable Direct Traceable Fixed Costs:

   $$\text{Avoidable Direct Fixed Costs Saved} = +\text{Rs. } 1,800,000$$

3. Net Direct Loss on Cafeteria Alone:

   $$\text{Net Direct Segment Loss} = -2,500,000 + 1,800,000 = \mathbf{-\text{Rs. } 700,000}$$
   (Note: The allocated common overhead of Rs. 1,500,000 is unavoidable and irrelevant).

4. Spillover Lost Contribution Margin on Other Divisions:

   • Groceries Sales Decline (5% of Rs. 30,000,000):

     $$\text{Lost Groceries Sales} = 5\% \times 30,000,000 = \text{Rs. } 1,500,000$$
     $$\text{Groceries P/V Ratio} = \frac{9,000,000}{30,000,000} = 30\%$$
     $$\text{Lost Groceries CM} = 30\% \times 1,500,000 = -\text{Rs. } 450,000$$

   • Clothing Sales Decline (8% of Rs. 20,000,000):

     $$\text{Lost Clothing Sales} = 8\% \times 20,000,000 = \text{Rs. } 1,600,000$$
     $$\text{Clothing P/V Ratio} = \frac{9,000,000}{20,000,000} = 45\%$$
     $$\text{Lost Clothing CM} = 45\% \times 1,600,000 = -\text{Rs. } 720,000$$

5. Total Net Financial Impact of Closing Cafeteria:

   $$\Delta \text{Net Store Profit} = \text{Savings in Direct Fixed Costs} - \text{Lost Cafeteria CM} - \text{Lost Groceries CM} - \text{Lost Clothing CM}$$
   $$\Delta \text{Net Store Profit} = +1,800,000 - 2,500,000 - 450,000 - 720,000 = \mathbf{-\text{Rs. } 1,870,000}$$

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b) Recommendation to the Board of Directors

DO NOT ELIMINATE the Cafeteria division.

• The apparent Rs. 800,000 accounting loss is an illusion caused by the arbitrary allocation of unavoidable common store overheads (Rs. 1,500,000). In reality, the Cafeteria generates a positive direct segment margin of Rs. 700,000 toward covering general store overheads.
• Eliminating the Cafeteria will cause total company operating profit to plummet by Rs. 1,870,000 per year (from Rs. 3,700,000 down to Rs. 1,830,000) due to the destruction of customer foot traffic and cross-shopping synergies.

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c) Strategic Interventions to Turn Around the Cafeteria

1. Menu Engineering and Margin Optimization:
   • Redesign the menu to emphasize high-margin bakery items, specialty Himalayan coffee, and teas (gross margins > 70%) while eliminating labor-intensive, low-margin hot meals.
2. Space Subcontracting / Franchise Revenue Model:
   • Outsource cafeteria management to a well-known local bakery franchise (e.g., Himalayan Java / Bakery Cafe) under a fixed rental plus revenue-share arrangement. Eliminates cafeteria operating losses while maintaining customer amenities.
3. Cross-Promotional Loyalty Bundling:
   • Offer ‘Spend Rs. 2,000 in Groceries/Clothing, Get Free Coffee in Cafeteria’ vouchers to stimulate two-way foot traffic and boost average shopping cart sizes.