TECHNICAL PAPER

Short-Term Decision Making in Foundry Unit: A Case Study

De v endr a Choudhar y 1 and P Dev endra P.. K. Jain 2
1

Assistant Professor, Department of Mechanical Engineering, Govt. Engineering College Ajmer, Badliya Circle, N. H.- 08 Ajmer, Rajasthan (India), E-mail: dceca@rediffmail.com 2 Modi Foundation Chair Professor, Department of Management Studies, Indian Institute of Technology, Delhi

Break-Even-Point (BEP) analysis and Incremental Analysis (IA) are important techniques which are widely used for short-term planning purposes. BEP seeks to examine the relationship between costs, volume, sales and profit. IA is a useful managerial tool in a variety of situations, including evaluating pricing strategy, determining special order/booking acceptance or choice of sales mix. This study examines the basic BEP and IA model and describes how to make use of information provided by them in the decision-making process in foundry industry. For this, we gathered various cost data from a recently started foundry unit in Ajmer which casts sewing machine table stands. Further, we segregated these data into fixed costs, mixed costs and variable costs. Therefore, the purpose of this case study is to show how to segregate different cost data into fixed and variable costs and perform BEP and IA analysis. During this study, it was observed that many owners of small foundry units in India are very sincere and hard-working, but they do not have any formal education in engineering and finance. It is hoped that this case study will help SME foundry unit owners in short-term decision making.

Finally, it can be used in modernisation and automation programmes, with the aid of which the company can continuously replace variable costs with fixed costs. Traditional breakeven analysis follows some limiting assumptions, of which the most important are the following (Khan and Jain, 2007). It assumes that the total cost can be analysed in fixed and variable costs. The fixed cost remains the same in the analysis. The variable cost changes proportionally to the volume. The price of the product remains the same in the analysis. The profits and the costs can both be analysed in relation to the volume. Everything produced is sold. The existing investments, borne by owner and considered as part of fixed cost, remain unchanged only when the production is within relevant range. In case, the additional investments are required to be incurred to execute decision under consideration, then the additional investments are considered as part of variable costs. Breakeven analysis has remained popular despite criticism of its assumptions of linearity and its failure to recognise uncertainty in all of its parameters (demand, fixed costs, variable costs, and price). Incremental analysis, which takes into account incremental revenues and incremental costs, is an apt and widely used technique for short-run decisions such as acceptance of special order, make or buy, continue to operate or shut-down and dropping of a product line.
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Keyw or ds: Breakeven analysis, Incremental analysis, Foundry, eywor ords: Decision making.

Introduction
Decision making involves the act of selecting the best course of action from various feasible alternatives available. In context of business enterprises, the decision is said to be best when it maximises the profits or minimises the losses in a given situation. Breakeven analysis, often referred to as costvolumeprofit analysis, can illustrate a great number of business decisions. In general, breakeven analysis can be used in three different ways. It can be used in decisions concerning new products by contributing to estimation of sales level of new product for realisation of profit. It can also be used as a tool for determining level of production to achieve desired profit 34
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To make use of the incremental analysis, one should be in a position to identify relevant costs. Costs are said to be relevant, if they are influenced by the decision under consideration. Conversely, costs that are not influenced by the decision are irrelevant costs. Incremental/relevant costs for decision making are variable costs, opportunity costs and additional fixed costs. Existing fixed costs are excluded from the incremental/relevant costs for decision making. The reason is that these costs are incurred irrespective of the decision. Clearly, they are not decisive in decision making. In operational terms, they are unavoidable costs and hence, they are irrelevant costs from the perspective of decision making. Below given case study shows how to apply BEP and IA methodology for short-term decision making in foundry units. major decision-making analysis pre-suppose that costs are either fixed or variable. Method of Least Square is considered to be most scientific method to apportion mixed costs. Fix ed c ost: Cost of inputs which do not change with change in Fixe cost: level of activity within relevant range for a given budget period i.e. these costs are fixed in nature whether production takes place or not. Table-1 shows fixed cost composition.

Table-1 : Fixed Cost Composition

Particulars Cupola Land Construction of Building Heating Furnace Cost Cost of DG Set Cost of Power Connection Salaries of Permanent Staff Per Month Annual Maintenance Cost Minimum Monthly Electricity Bill Minimum Monthly Telephone Bill Cost of Patterns Cost of Machine Block (Air Compressor Sand Blasting, Lathe, Grinding, Drilling etc.) Total Yearly Depreciation of Machine Block Other Costs which are Fixed in nature (Moulding Boxes, Crucibles etc.) Fixed cost ` 5,00,000 2,00,000 10,00,000 3,00,000 1,75,000 3,50,000 35,000 2,00,000 3,000 2,000 3,00,000 13,25,000 @ 15% 25,00,000

Case Study Company Background

Mr. Mehanati is manufacturing wooden table top of sewing machine in Ajmer district of Rajasthan for last 20 years. He supplies these wooden tables top to various sewing machine table stand manufacturers and also sells in open market. Mr. Mehanati also started a foundry unit 20 years before with one partner, but this unit was closed and sold at scrap value due to large losses and dispute with partner after two years. Meanwhile, he earned good profit and reputation in manufacturing wooden table top and visited various sewing machines table stand manufacturing unit in the country for last twenty years. Based on his rich experience in sewing machine manufacturing industry, market, and in order to expand his business, he decided to manufacture sewing machine table stand himself under PUSHKAR brand. For this he decided to set up a new foundry unit to manufacture various table stand cast parts required in sewing machine table in addition to existing wooden top manufacturing unit. To fulfil his wish, Mr. Mehanati purchased an agricultural land 10 kilometre away from city in close proximity of RICCO industrial area and later on converted it into industrial land for setting up new casting unit. He designed a factory layout, cupola, heating furnace and also purchased required machinery and tools for casting within six months based on his experience. The unit started production in April, 2008. Although, Mr. Mehanati is very sincere and hard worker but he does not have any formal education in engineering and finance. His administrative staff is also not well-educated. He is not maintaining any account as per accounting standards. He is worried about his new casting unit because of his lack of formal knowledge in engineering and finance and due to past failure. Therefore, this study was taken up to help Mr. Mehanati.

Assume economic life of plant is seven years as per casting industry is concerned. Annual Fixed Cost= (Cupola+ Land+ Construction of building + Heating Furnace Cost+ DG Set + cost of Power Connection + Cost of Machine Block + Cost of Patterns + Others) /7 + (Annual Maintenance Cost)+ (Salaries of Permanent Staff Per Month + Minimum Monthly Electricity Bill + Minimum Monthly Telephone bill)* 12. Annual Fixed Cost = ` 16,30,000. Yearly Depreciation = 0.15* (Cupola + Heating Furnace Cost + DG Set + Cost of Patterns + Cost of Machine Block + Others) = 0.15*51, 00,000 = ` 7, 65,000 Variabl e Cost: Cost of inputs assumed to vary in direct ariable proportion with change in level of activity within relevant range for a given budget period. Table-2 illustrates variable cost elements and procedure for determining variable cost per unit. 35

Data Collection
Cost data provided by Mr. Mehanati are segregated into the fixed cost, variable cost and mixed cost categories. Further, mixed costs need to be segregated into fixed and variable cost elements as all
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Table-2 : Variable Cost Elements
Particulars Direct Material Cost for Charging Cupola Once Coal @ ` 30 per Kg Cast Iron Scrap @ ` 34 per Kg Flux Others Less scrap @ 5% Total Direct Material Cost 30,000 3,00,000 1000 2,250 12,250 3,21,000 April May June July August October V ariabl e ariable Cost ( ` ) Month

Table-3 : Mixed Cost Composition

To t al ta Unit s Units Produced (X) 1134 1584 2171 2353 1672 4856 17228 To t al XY ta Mixed Cost (Y) 7908 9614 12186 13134 10502 20916 29136 103396 8967672 15228576 26455806 30904302 17559344 72327528 141484416 312927644 X2

1285956 2509056 4713241 5536609 2795584 11957764 23580736 52378946 (1) (2)

September 3458

Direct Labour Cost for Producing Finished Goods for Above Cupola Discharge 50,000 Cost of Machining, Blasting, Painting, Heating, Packaging for all the Products Produced Furing a Charge of Cupola Other Variable Overhead Total Variable Cost for Charging Cupola Once No. of Table Stands Manufactured from Above Discharge of Cupola V ariabl e Cost p er T abl e S tand ariable per Tabl able St W eight of Sewing Machine T abl e S tand Tabl able St

Substituting the values from table of mixed cost gives 103396 = 7a + 17228b 32,000 5,000 4,08,000 600 680 14.75 Kg 312927644 = 17228a + 52378946b Solving equation 1 and 2 gives a 349 b = 5.86 Fixed Cost is ` 349 per month and variable Cost is Rs.5.86 per unit produced. These two cost elements are clubbed with fixed and variable components calculated earlier. To ta l A n n u a l F i x ed C o s t = ` 1 6 , 3 0 , 0 0 0 + ` 3 4 9 * 1 2 = ` 1 6,34,188 Total Variable Cost Per Table Stand = ` 680 + ` 5.86 ` 686

Mix ed Cos t: Cost of inputs which varies with change in level Mixe Cost: of activity but not in direct proportion. For simplicity, we deduct total variable cost from total expenditure for a month to determine total mixed cost. Table-3 shows mixed cost composition. Method of Least Square is explained below for segregation of mixed cost into fixed and variable cost. The basic straight line regression equation is Y = a + bX Where Y = Total Mixed Cost a = Fixed Cost element of Mixed Cost b = Variable Cost Element of Mixed Cost X = Total units produced per month n = No. of months Two linear equation are Y = na + b X XY = a X + b X2 36
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Break-Even Analysis
Figure 1 shows cost-volume-profit graph while Fig.2 shows profit volume graph for the company as determined below. Sales Price Per Unit = ` 800 (excluding 4% VAT and CST) Contribution Margin Per Unit (CMPU) = Sales Price Per Unit Variable Cost Per Unit = ` 114 Contribution to Volume (C/V) Ratio = CMPU / Sales Price Per Unit = 14.25% Variable Cost to Volume (V/V) Ratio = 100% - C/V Ratio = 85.75% BEP (in units) = Total Annual Fixed Cost / Contribution Margin Per Unit (CMPU) = 16,34,188/114 = 14335
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Break-Even Sales Revenue (BESR) = Total Annual Fixed Cost / C/V Ratio = 16,34,188/0.1425 = ` 114, 67,986 Cash Break-Even Point (in units) = (Total Annual Fixed Cost Depreciation) / CMPU = (16,34,1887,65,000)/114 = 7625 Cash Break-Even Sales Revenue (CBESR) = (Total Annual Fixed Cost - Depreciation) / C/V Ratio = ` 60,99,565 Margin of Safety (in units) = Actual Estimated Sales - BEP (in Units) = 30000 14335 = 15665 Sales data are estimated based on past six months sales volume and firm orders which company have received from its customers in near future. Old companies can estimate sales volume by using appropriate forecasting method. Projected EBT or Margin of Safety (in ` ) = 15665*114 = ` 17,85,810 Margin of Safety Ratio = (Margin of Safety / Actual Sales)*100 = 59.53% Desired Sales Volume (in units) to earn EBT of Rs.10,00,000 = (Total Annual Fixed Cost + Desired EBT) / CMPU = (16,34,188 + 10,00,000) / 114 = 23107 Desired Sales Volume (in units) to earn EBT of ` 20,00,000 = (Total Annual Fixed Cost + Desired EBT)/CMPU = (16,34,188 + 20,00,000) / 114 = 31879

Figure-1 : Cost Volume Profit Graph.

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Figure-2 : Profit Volume Graph. Confirmation

Total Sales Revenue (31879*800) Less Variable Cost (31879*686) Total Contribution Less Total Fixed Cost *Small-scale industries are exempted from taxes BEP (in units) if variable cost increases by 8.5% due to inflation. Revised Variable Cost = 686*1.085 ` 745 Revised CMPU = 800 - 745 = 55 Revised BEP (in units) = Total Annual Fixed Cost / Revised CMPU = 16,34,188/55 29713 BEP (in units) if variable cost increases by 5% due to inflation. Revised Variable Cost = 686*1.05 = ` 720.30 Revised CMPU = 800 720.30 = 79.70 38
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Revised BEP (in units) = Total annual fixed cost / revised CMPU 255,03,200 218,68,994 36,34,206 16,34,188 = 16,34,188 / 79.70 = 20504

Incremental Analysis
Mr. Mehanatis foundry unit has capacity to produce 5000 units per month; current plan calls for a monthly production and sales of only 2500 units so his facility is idle for half of the time. Meanwhile, Ajaymeru Industries, maker of flour grinding machines asked Mr. Mehanati to produce 20000 floor grinding machine stands weighing 30 Kg. each at ` 45.50 per Kg (bargaining possible). Accepting this offer will cost further ` 50,000 to Mr. Mehanati for pattern making. Mr. Mehanati estimates that its variable cost will be ` 46.50 per kg (variable cost of sewing machine stand divided by its weight i.e. 14.75 kg). However, its fixed costs, which have been averaging at ` 3.70 per kg (Total Annual Fixed Cost/ Actual Estimated Sales of Sewing Machine stand* its weight) will now be spread over among 1042500 kg castings (30000*14.75+20000*30). As a result, the average fixed cost will drop to ` 1.60 per kg (16,34,188 + 50,000)/1042500). Mr. Mehanati concluded, Sure there will be a loss of ` 1 per kg on variable costs ( ` 46.50 variable cost ` 45.50 selling price) but there will be a gain of ` 2.10 per kg of

Earning Before Tax (EBT)/ Earning After Tax (EAT*) 20,00,018

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castings (` 3.70 per kg - ` 1.60 per kg) by spreading the fixed costs. Therefore, he accepts the offer as it represents an advantage of ` 1.10 per Kg. Do we agree with Mr. Mehanati? No, we do not agree with Mr. Mehanatis view as the acceptance of the order causes loss of ` 6,50,000 (20000 stand*30 kg* ` 1+ ` 50,000 of pattern making). His contention is based on the illusion that spreading the fixed cost causes savings. It is also shown below by the comparative income statement. Comparative Income Statement Al t erna tiv e s Alt ernativ Particulars Sales Revenue Less Variable Cost Total Contribution Less Fixed Cost Profit Before Taxes S ta tus Quo (442500 kg) ` 240,00,000* 205,76,250 34,23,750 16,34,188 17,89,562 Accept Order (1042500 kg) ` 513,00,000** 484,76,250 28,23,750 16,84,188 11,39,562 competitive market. In such a situation, Mr. Mehanati feels that he should earn at least ` 6, 00,000 as profit by accepting Ajaymeru Industries offer. Now, at what bid price he will be able to achieve this profit target considering 8.5% inflation in variable cost. Mr. Mehanati estimates that its new variable cost will be Rs.50.40 per kg (` 46.50*1.085) and fixed cost will drop to ` 1.60 per kg after accepting the order. Further, each kg of casting should fetch profit of Re 1 in order to achieve target profit of ` 6,00,000. Therefore, he estimates bid price ` 53 per kg (50.40+1.60+1). Again, IA plays an important role to decide the competitive price for bidding as illustrated below: Anticipated Variable Cost per kg Additional Fixed Cost per g for Pattern Making (50,000/20000*30) Desired Profit per kg Desired Bid Price per kg of Casting ` 50.40 ` 0.10 ` 1.00 ` 51.50

* (30000 stand ` 800); ** (30000 stand ` 800 + 20000 flour m/c stand 20 kg ` 45.50) Above example clearly demonstrates that the existing fixed costs do not increase with an increase in the output. Another notable aspect related to fixed costs is that spreading of such costs to a larger output base does not yield any decrease in total fixed costs either, in spite of the decrease in the average fixed cost per unit. However, we should not infer that fixed costs are always irrelevant costs. In case, the additional fixed costs are required to be incurred to execute decision under consideration, then the additional fixed costs are as relevant as variable costs. For instance, ` 50,000 for making pattern in above example is fixed in nature but is relevant cost because it is an additional cost caused due to special order. In present scenario, inflation rate of 5-10% in variable cost is quite common in foundry industry. As we see, inflation rate of 8.5%, at anticipated demand of 30,000 sewing machine stand, leads to absence of profits in any year for Mr. Mehanati at present selling price. Further, it is difficult to sell product at higher selling price in

Now, submission of higher bid price may lead to cancellation of Mr. Mehanatis quotation by Ajaymeru Industries. Mr. Mehanati included existing fixed cost ` 1.50 per kg for quoting bid price. A careful look at the cost items would enable that the existing fixed costs are to be incurred irrespective of the present decision. Clearly, the share of existing fixed costs should not be charged to such a new activity; its allocation causes distortion in submission of bid price.

Conclusion
With the help of this case study of foundry industry, we have tried to illustrate the importance of BEP and IA in short-term decision making, say, segregation of costs, determination of break-even point, level of production to achieve desired profit, acceptance of the special order and determination of bid/tender price. It is hoped, that this study will be very useful for owners of SME foundry industries.

References
Khan M. Y. and Jain P. K. (2007), Financial Management: Text, Problems and Cases, 5/E, Tata McGraw-Hill.

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