Production & Operation Management

1. CHAPTER 4: Relevant Cost Concepts
Response to Questions:
1. As explained on page 4.6, ‘direct’ and ‘indirect’ does not equate to
‘variable’ and ‘fixed’.
2. As explained on page 4.6, the purposes are entirely different. Economic
profit is for company’s internal decision-making and for reviews of the past
management performance. Opportunity cost is an important concept in
these cases.
3. For this decision, the earlier payment of Rs. 5,00,000 is irrelevant. The
case is: 1st
flat costs Rs. 8,00,000 whereas 2nd
flat costs Rs. 7,00,000.
Therefore, I should buy the 2nd
(my friend’s) flat.
4. Certain costs start only after a long time e.g. maintenance costs,
replacement costs, damage (costs) to the environment / ecology, costs to
the society. Short-run costs are obvious: the current capital costs and
operating costs. The soap company, if it is socially conscious (and wants
to be known as one), should think of the costs to environment in the long
run – damage by effluents and non-biodegradable wastes. Management
should also start building up scenarios of political costs, particularly as the
business is getting international.
5. The costs have to be identified for the different products. If these cannot
be ‘directly’ identified, they have to be “allocated” – which introduces a lot
of anomalies into the calculations and the decisions that follow from there.
Perhaps, one could find the breakeven in terms of “percent operating
capacity.” This parameter does away with the ‘allocation’ problem. But this
‘overall’ break-even does not help the management decision-making with
respect to a specific product.
In this case, the “percent operating capacity” has to be applied across the
range of products produced in that facility. This, again, leads to an
approximation and anomaly.
6. If the total revenue function and total costs function are curvilinear, it may
give rise to multiple break-even points. The production is profitable only in
certain ranges of production volumes. One should choose from such
production volumes.
7. Temporary shut-down: Associated costs could be: loss of sales, loss of
customer goodwill, loss of reputation / image (depends upon the reason

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for and duration of the shutdown), set-up costs (when the plant starts
again) of machinery, and loss of supplier goodwill.
Permanent abandonment: If the company as a whole is shutting down, the
relevant cost is the market price obtained (if sold to another firm) minus
the remaining depreciation, the compensation to employees, the payment
of lenders (if any). There may or may not be a loss in reputation,
depending upon the reasons to sell. The stock price of the selling
company may reflect the loss / gain in goodwill.
8. Since the selling company is interested in maximizing its gains, it may not
base it on original cost. Otherwise, the plant would notionally be of nil
value if it is fully depreciated. Much of the depreciation accounting
depends upon: (i) the company’s purpose and (ii) the statutory
requirements. Both have to be satisfied.
9. Based on the information given, we can say the following:
The variable cost is = Rs. 6 per unit.
Excess units will be sold at Rs. 7 per unit, which means, there is a
contribution of (Rs. 7 – Rs.6 =) Rs. 1 towards the fixed cost. The contract
is for 100,000 ± 10 % units. So, produce the maximum i.e. 110,000 units.
There is no point in supplying short as there is a penalty.
The BEP is, obviously irrelevant in this case. However, as a matter of
curiosity, we may compute.
The break-even point, “x” is computed as follows:
Total Revenue = 10 x = Total costs = 6 x + 100000.
Therefore, x = Break-even volume = 25000 units.
10.The costs are mentioned below.
Controllable: Supplies (soap, shampoo, other disposables, cleaning fluids,
Coffee packets for coffee maker, etc.)
Equipment (vacuum pump bags, brooms, brushes, wiping
cloth, implements for cleaning and clearing
bathrooms and toilets, etc.)
Laundry (laundering costs of all linen, towels, etc.).
There can be norms for all these and the Housekeeping Manager can be
held accountable for variations.
Non-controllable: Fixtures: (lamps, bulbs, tubes, lamp-stands etc).
Equipment: (Coffee-maker, AC equipment, Fan, TV,
Radio/Music)

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Furniture: (Beds, cots, sofa set, chairs, desks, safe,
shoe-rack, towel rods, curtains, etc.)
The breakdown of these is beyond the control of housekeeping. One may
argue that proper dusting, cleaning and polishing will prolong the life of
these equipments. This consideration can come in reviewing the
‘effectiveness’ of housekeeping as one of the several parameters.
11. Laundering costs can be directly attributed to the linen. So, it is a direct
cost. With more occupancy and more use, this cost increases. Hence, it is
a variable cost.

4. 4
CHAPTER 4: Relevant Cost Concepts
Objective Questions:
1. ‘Overheads’ are:
a. Fixed costs
b. Opportunity costs
√c. Indirect costs
d. Sunk costs
2. For performance monitoring of an executive, the relevant costs are:
√a. Controllable costs
b. Direct costs
c. Sunk costs
d. Indirect costs
3. An exclusively shirt manufacturing firm has the following costs. Cloth,
thread and buttons comprising the variable cost is Rs. 90 per shirt. The
fixed costs are Rs. 1 crore. If the sales revenue per shirt is Rs. 140 per
shirt, the manufacturing firm will break even at:
a. 10,000 units
b. 20,000 units
c. 100,000 units
√d. 200,000 units
4. Sunk costs are:
√a. irrelevant to future decisions.
b. the fixed part of overheads.
c. the variable part of overheads.
d. the indirect costs.
5. In a ‘make or buy’ decision, the costs of bad quality are:
a. irrelevant
√b. relevant
c. sunk cost
d. opportunity cost
6. In an “incremental cost” analysis one would consider:
a. the particular management decision.
b. the time-frame for which the decision is being made.
c. the level of output or “scale” effects.
√d. all of the above.

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7. The level of output or “scale effect” is important in the relevant cost
analysis, because it decides:
a. how costs change with the output volume.
b. what costs should enter the analysis.
√c. all of the above.
d. none of the above.