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Free Accounting Essay - Three Divisions of Onata

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1. The three divisions of Onata in the brief were Sept, Oct and Nov and the same names have been used here.

a) Operating income of the company is sales minus fixed and variable costs. Table 1 below shows the operating income of both individual divisions and the company.

Table 1: Operating income of Onata in 2004

in $	Sept	Oct	Nov	Onata
Sales	1200	600	240	2040
Variable expenses	-384	-156	-102	-642
Fixed expenses
Unavoidable	-288	-156	-36	-480
Avoidable	-348	-312	-162	-822
Operating income	180	-24	-60	96

Onata had a $96 operating income in 2004.

b) Contribution is sales minus variable costs. As compared to operating income, contribution doesn’t include fixed costs because it assumes fixed cost to be a sunk cost and hence shouldn’t be involved in decision making. Table 2 shows the contribution of each division.

Table 2: Contribution of each division of Onata in 2004

In $	Sept	Oct	Nov	Onata
Sales	1200	600	240	2040
Variable expenses	-384	-156	-102	-642
Contribution	816	444	138	1398

All three divisions of Onata made positive contribution in 2004. The operating income of each division is shown in table 1.

c) All divisions make positive contribution; their existence is justified in the short run. In the long run, each division should make positive operating income to justify returns on investments. Oct and Nov divisions have positive contribution but negative operating income. So Oct and Nov can be eliminated.

But both Oct and Nov have large avoidable fixed costs. Table 3 shows operating income without avoidable fixed costs.

Table3: Operating income without avoidable fixed costs

In $	Sept	Oct	Nov
Sales	1200	600	240
Variable expenses	-384	-156	-102
Fixed expenses
Unavoidable	-288	-156	-36
Operating income	528	288	102

Now all divisions have positive operating costs. If Onata can reduce fixed cost by eliminating avoidable fixed costs then all three divisions should be kept. If Onata can’t reduce avoidable costs, then it should eliminate Oct and Nov.

2. a) The decision to accept or reject the order is based on the contribution of that order and the presence of nay alternative orders. Let’s assume in this case there are no alternative orders. Table 4 shows the sales and variable costs of the new order.

Table 4: Sales and variable costs of the new order

In $

Number of units	1,000
Sales price per unit	140
Total additional sales	140,000

Current material	1,600,000
20% of material	320,000
Current labour	2,400,000
20% of labour	480,000

Table 5 shows the contribution of the new order. The indirect cost is calculated as the 1% (1,000/100,000) of $1,500,000.

Table 5: Contribution of the new order

In $

Sales	140,000
Variable costs
Material	-320,000
Labour	-480,000
Mould	-10,000
Indirect costs	-15,000
	-825,000

Contribution	-685,000

The new order has a negative contribution and hence Turc Ltd shouldn’t accept the order. Even if we assume that Turc has already hired the labour and has no alternative use of it for the time being, the cost of material itself is more than the sales.

b) Turc may use the order to develop expertise in special manufacturing. So it might accept the order for strategic reasons. Successful completion of this order might lead to subsequent placement of large order by the same customer. Increased economies of scale at higher orders will probably lead to lower direct material and labour costs. Also if it has no other alternative use of labour in the time being, removal of labour costs from the contribution makes the negative contribution quite less.

Turc should also compare the contribution from this order against any other alternative order.

c) Table 6 shows the contribution of the current facility of 100,000 units

Table 6

In $

Sales	15,000,000
Variable costs
Material	-1,600,000
Labour	-2,400,000
Indirect costs	-1,500,000
	-5,500,000

Contribution	9,500,000

Since the existing facility of 100,000 units has a positive contribution, Turc should not accept the new order against the existing facility.

3. Annexure I shows the NPV calculations for proposals S,A and M. Both proposals S and A have negative NPV of -$23,193 and -$21,386 respectively. Only proposal M has a positive NPV of $210,843. So Hovana should select proposal M.

4. The management should evaluate whether it can successfully pass on the increased costs to the buyers or not. This will depend on a large number of factors including the capacity of the industry, average financial gearing, and availability of substitutes. Customers don’t like to see increased prices. The management should undertake a detailed study of each cost component of the product.

Management should use contribution approach to highlight the impact of each cost element. Contribution approach is a method of internal reporting that emphasizes the distinction between variable and fixed costs. By segregating variable costs, management can see whether the product still makes positive contribution in face of higher variable costs or not. If the product doesn’t make positive contribution, then the firm should stop making products or else look at each component of cost for reduction.

Activity based costing assigns the costs of activities to the products and services that caused the activity ((Horngren, Sundem & Stratton, 1999). Managers should identify significant overhead activities and then the costs of overhead resources used to perform these activities are traced to the activities using the most appropriate cost drivers. Such an analysis allows the management to either reduce the cost or outsource certain activities altogether to reduce the variable cost.

Make-or-buy analysis should not only cover variable costs but also parts of fixed costs that can be avoided. Make-or-buy decision will lead to whether certain parts or processes should be done in-house or should be outsourced to reduce costs. But many times make-or-buy decision is not based on numbers only. Companies make certain parts in-house also to keep strategic advantage.
Annexure I – NPV calculations

Proposal S

Cost	100,000
Annual saving	12,500
Estimated life, yrs	10
Desired return	10%

Years	0	1	2	3	4	5	6	7	8	9	10
Costs	-100,000
Annual Savings	12,500	12,500	12,500	12,500	12,500	12,500	12,500	12,500	12,500	12,500
Cash flows	-100,000	12,500	12,500	12,500	12,500	12,500	12,500	12,500	12,500	12,500	12,500
Discounted cash flows	-100,000	11,364	10,331	9,391	8,538	7,762	7,056	6,414	5,831	5,301	4,819
NPV	-23,193

Proposal A

Cost	175,000
Annual saving	25,000
Estimated life, yrs	10
Desired return	10%

Years	0	1	2	3	4	5	6	7	8	9	10
Costs	175,000
Annual Savings		25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000
Cash flows	-175,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000	25,000
Discounted cash flows	-175,000	22,727	20,661	18,783	17,075	15,523	14,112	12,829	11,663	10,602	9,639
NPV	-21,386

Proposal M

Cost	250,000
Annual saving	75,000
Estimated life, yrs	10
Desired return	10%

Years	0	1	2	3	4	5	6	7	8	9	10
Costs	-250,000
Annual Savings		75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000
Cash flows	-250,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000	75,000
Discounted cash flows	-250,000	68,182	61,983	56,349	51,226	46,569	42,336	38,487	34,988	31,807	28,916
NPV	210,843