Tender Pricing and Cost Classification at Precision Pumps
Precision Pumps Ltd manufactures a single industrial pump in a rented factory. For the year just ended it produced 18,000 pumps and sold 16,500; there is no opening or closing work-in-progress, but 1,500 pumps remain in finished goods. The accountant has compiled the following annual costs: direct materials ₹2,16,00,000; direct production labour ₹1,08,00,000; factory power and consumables ₹36,00,000; factory rent ₹24,00,000; depreciation of production machinery ₹18,00,000; sales commission ₹33,00,000; administrative salaries ₹45,00,000; and a one-off legal settlement ₹7,00,000. The production manager has asked for a ‘full cost per pump’ to quote on a government tender for 2,000 pumps. The sales director wants all annual costs spread over the 18,000 pumps so that the tender ‘carries its share of everything’. The finance director is concerned that such a quote will be uncompetitive and that inventory valuation may be distorted. The company uses absorption costing for external reporting and has no abnormal wastage.
1. Classify each cost as product cost or period cost and compute the inventoriable cost per pump, the total period cost and the value of closing finished goods.
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Product costs are those incurred to bring the pumps to their present saleable condition: direct materials ₹2,16,00,000, direct production labour ₹1,08,00,000, factory power and consumables ₹36,00,000, factory rent ₹24,00,000 and depreciation of production machinery ₹18,00,000. Product cost total = ₹4,02,00,000. Inventoriable cost per pump = ₹4,02,00,000 ÷ 18,000 = ₹2,233.33 per pump.
Period costs are sales commission ₹33,00,000, administrative salaries ₹45,00,000 and the one-off legal settlement ₹7,00,000, totaling ₹85,00,000. These are not included in inventory because they are not part of production.
Closing finished goods = 1,500 pumps × ₹2,233.33 = ₹33,50,000. The legal settlement is non-recurring and not a normal production cost; charging it to inventory would overstate asset value and distort profit.
2. Compute the minimum relevant production cost per pump for the 2,000-pump tender, assuming existing capacity and no tender-specific fixed costs. Compare this with the full production cost and advise on the pricing basis.
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The relevant production cost excludes committed or sunk fixed production costs that will not change with the tender. Relevant variable production cost = direct materials + direct labour + factory power and consumables = ₹2,16,00,000 + ₹1,08,00,000 + ₹36,00,000 = ₹3,60,00,000. Per pump = ₹3,60,00,000 ÷ 18,000 = ₹2,000.
For 2,000 pumps the relevant production cost is 2,000 × ₹2,000 = ₹40,00,000. Factory rent and depreciation do not increase because of the tender, so they are not relevant to the short-run decision. Full production cost is ₹2,233.33 per pump, which includes absorbed fixed production cost of ₹233.33 per pump.
Advice: any price above ₹2,000 per pump contributes towards fixed costs and profit. Full production cost is a useful long-run reference, but using it as a rigid floor may lose a tender when spare capacity exists. The quote should also include any tender-specific costs, such as additional inspection or delivery, if incurred.
3. Evaluate the sales director’s proposal to spread all annual costs, including sales commission and the legal settlement, over 18,000 pumps for the tender. Support your answer with figures.
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Spreading all annual costs gives (₹4,02,00,000 + ₹85,00,000) ÷ 18,000 = ₹4,87,00,000 ÷ 18,000 = ₹2,705.56 per pump. This is ₹705.56 above the relevant production cost of ₹2,000 and ₹472.22 above full production cost.
The proposal is not appropriate for tender pricing. Sales commission is a selling cost and may not be incurred on a government tender; the one-off legal settlement is not caused by the tender and is not a product cost. Allocating such costs over 18,000 pumps is arbitrary and can make the bid uncompetitive. For inventory valuation, only product costs should be included. For the tender, use incremental relevant costs plus any tender-specific costs. If a commission is genuinely payable on the tender, add that actual commission, not the average annual commission per pump.