Prof.

Prashant Shukla

Quantitative Technique in management Accounting and Finance LEARNING CURVES AND APPLICATIONS
"Practice makes perfect" is a familiar adage (Proverb) which is rarely true: "Practice increases efficiency" can be new proverb that is true: It was observed that when any new type repetitive operation is started (assembly line operation) the first effort may take considerable time. But under repeated performance of the operations, the direct labour (a human input) progressively shows a gradual decline. The study of this phenomenon and representation of the nature of the relationship between the direct labour (or labour costs) and the output forms the subject of learning curve effect also called experience curve effect or manufacturing progress function. In 1925, the Commander of the Wright Patterson Air force Base in Dayton, Ohio, observed that workers exhibited definite learning pattern in manufacturing operations. Since these studies we now know that most aircraft manufacturing tasks experiences an 80% learning rate. In other words, the average direct labour hours required to a factor of 0.8 as the production quantity is doubled. In other words, if the first aircraft assembled requires 100 direct labour hours, two aircraft would average 0.8 x 100 = 80 labour hours. Four aircraft would average 0.8 x 64 = 64 labour hours, 8 would average 0.8 x 64 = 51.2 labour hours and so on. One minus the percentage reduction is known as the learning rate. The learning rate in the present example is 1 - 0.2 = 0.8 or 80 percent. The learning curve concept has found many useful applications in managerial decisions in the areas of marketing, new product start-up, bidding for tenders, make-or-buy decisions. The factors that bring about a learning-curve effect are: i) Labour Efficiency Human being has the capacity to learn by repeated doing and improve on their performance. Further with repetitive experience, maintenance and supervisory activities also become more effective. ii) New Process and Improved Methods In the light of the experience gained progressively, improvements can be brought about in the production processes, methods of operations by technical and industrial Engineering studies. iii) Product Redesign The design of product can be improved, needless and costly features can be eliminated by value analysis.

Prof. Prashant Shukla

iv) Product Standardization - Over repetitive experience, reduction can be brought about in changeover and set-ups. v) Scale Effects -As volumes of activity increase the increase in capacity costs will be at a slower rate bringing about economics of scale. Management and labour are now consciously striving to reduce costs knowing that the learning curve effect it is possible to do so. It should be noted that while studying the costs, subject to learning curve effect, all costs should be compared with reference total standard monetary basis. Use of actual costs subject to inflationary pressures may give erroneous picture, where actual direct labour has decreased it may appear that costs have not decreased because of the increase in the labour cost rate. Hence, in any study of learning curve effect direct measurements on some physical units (such as labours hours, machine-hours) should be used instead of the rupee value costs. Learning-curve Model: The cost behavior under a learning curve effect may be expressed as a mathematical model given under Y = a X-b (1)

Where, Y = Average direct labour hours per unit A = Direct labour hours for the first unit (or batch) X = Cumulative number of units produced to date B = A constant called index of learning rate (0<b<1) NOTE [In some literature the model may be expressed as Y = a Xb, without a negative sign before b. In this case, the computed value of b will negative, whereas in the model used in (1) the value of b will come out positive. The important point to note is that the index over X will always be numerically negative.] The Total labour hours for a cumulative production of X units denoted by L(X) will be L(X) = XY, which may be expressed as a formula: ` L(X) = XY = X.aX-b = aX (1-b) . (2)

Another result often useful is that of incremental direct labour hour per unit or marginal direct labour hour at a particular level of activity X. It is well known from calculus that the incremental value of a function is the same as the derivative (differential coefficient) of the function. Thus we have the following formula: Marginal labour M(X) = (d/dx) L(X) = a (l-b) X-b = (1-b) Y . (3)

Prof. Prashant Shukla

It may be noted that the expression for both the direct labour Y and the marginal direct labour contain the factor X-b multiplied by a constant. See'(l) and (3). This indicates that due to the effect of learning curve both the average and marginal labour decrease at the same rate. The functional form of the learning curve model is negative exponential. As X increase Y should decrease continuously. However, it will be noted that the amount of decrease in Y goes on diminishing. After a stage, the decrease in Y becomes almost insignificant and the average Y almost remains constant for all practical purposes. While human beings do learn at a fast rate initially, there is always a saturation limit beyond which no learning is perceptible.

Specification of Learning Curve Effect (Learning Rate):

The learning curve effect is expressed as a percentage p (less than 100 %). The interpretation of p is that, whenever the output units is doubled the average direct labour hours becomes p times the previous average. (for p = 90% = 0.9) Example: X 1 2 4 8 Y . Y1 = 120 hours Y2=0.9x 120=108 Y4=0.9x 108=97.2 Y8=0.9x97.2=87.48

We have now to relate the learning curve effect expressed as percentage p with the learning curve index used in the model. Consider two levels of output Xl and X2 such X2=2X1 From the model: Yl = aXl -b and Y2 = aX2-b Or log Yl = Log a - b log Xl, log Y2 = log a - b log X2 on solving these two equations Log Y2-logY1 = -b (log X2 - log X l) Log (Y2/Yl) = -b (log X2/X1) = -b log2 Hence b = -log p / log2 Since Y2/Y1 = p and X2/X1 = 2 Given below is table of values of p and corresponding b. You must learn how to compute b given p. These computations can be done directly on a scientific calculator with log function. Using a simple calculator the logarithms have to be read from a table then commutations done on the calculator. (You are advised to practice such computations!) p b 0.95 0.074 0.90 0.1520 0.85 0.2345 0.80 0.3219 0.75 0.4150

Prof. Prashant Shukla

Applications:
The application of learning curve is more important in case where the labour input in an activity is large and the activity is complex. The conducive to learning are ideal in the electronics, home appliance, construction, ship building and machine shop areas. On the other hand, the industries which are capital intensive such as petroleum refining would find the learning curve of little value. 1. Pricing: Since learning curve permit better cost predictions, it seems that they should be employed in pricing decisions. An extension of the pricing use of learning - curve data is in buying from a supplier. Sometimes supplier will experience high initial outlays resulting, from the fact that the supplier is the early stages of its learning curve relative to the job. A purchasing firm might be willing initially to pay a higher price if the supplier agrees to and subsequently lowers the price per unit. 2. Work scheduling: Learning curves increase a firm's ability to predict their required labour input and make it possible to forecast labour needs. These interns permit the firm to do a better job scheduling maintenance and overhead activity, quality control, material purchasing and promotion. Better forecasting and scheduling result in lower costs through better cost control and improved customer relations. 3. Capital Budgeting: One of the most important aspects in capital-budgeting problems is the timing of cash flows. The learning effect suggests that unit cost usually assumed in capital budgeting analysis. Further more, the learning curve permits improved estimates of production levels that can' be attained and thus has implications for cash flows. These modifications can be particularly important where the project start up period is large relative to life of the project. 4. Motivation: Costs are often controlled using standers and variances from standards. If these standards are set without regard to the learning phenomenon, meaningless initial and unfavorable variances may occur with resulting motivational impact. A similar effect is apparent in evaluating divisional performance. Large activities in early phases of activity will experience relatively higher costs and lower output than at later stages. This should be considered when a division managers performance is evaluated. 5. External Reporting: Learning influences profits through its effects on cost and output. Assume a situation when there are early losses expected when the decision to undertake the construction was made. If financial report are to be an aid in evaluation and are to be consistent with decision making, some attempt should be made to separate non recoverable losses from costs that are incurred as part of the learning process. Where there is good reason to believe that learning will take place, it is appropriate to

Prof. Prashant Shukla

capitalize some or all of a firms early losses as assets rather than mislead investors into believing that the financial situation is unfavorable. Example (1) Suppose the Milner Aerospace Company has been producing a guidance system and knows that the average labor hours per unit follows a learning curve. To date it has produced 150 units and these units required a total of 60,000 direct labour hours. For the first 50 units a total 28,500 DLH were required. The Milner Company is evaluating a bid to produce 100 additional units and is interested in knowing the incremental DLH required for this new order. Initially, we must compute the parameters of the Milner Companys Learning curve. We know two points on the curve. When x1=50, y1=28, 500/50=570 and when x2=150 Y2 = 60,000/150 =400. There fore we can use the preceding algebraic development to obtain. 400 Log --------570 b =- --------- = 0.322 (an 80 percent learning curve.) 150 Log -------50 Substituting back, we find Log a = log 570 + o.322 log 50=3.3028 A=2009 With a=2012and b=0.322, the average number of DHL after 250 units are produced is Y = 2009(250)-0.322= 340. Therefore the total DLH to produce 250 units is 250(340) = 85,000. Since 60,000 DLH were used to produce the first 150 units, the incremental DLH to produce the next 100 units equal: 85,000 - 60,000 = 25,000 DLH. Notice that this batch of 100 units requires only 250 DLH per unit, whereas the first 50 unit labor costs. This point clearly demonstrated in table 1, where we display for each batch of 50 units the cumulative total DLH, the average DLH for that cumulative output, and the marginal DLH (MDLH) M(X) to produce the last unit in each batch of 5 units. Notice that both average and marginal DLH are following an 80 percent learning curve: y200 = 0.8y1oo = 0.64y50 and MDLH200 = 0.8 MDLH100 = 0.64 MDLH50. Table 1. Total Average and Incremental Cost for 50-Unit Batch Cumulative Output (X) 50 100 150 200 250 Total DHL L(x) 28500 45600 60000 72900 85000 Average DLH for Cumulative output (y) 570 456 400 365 340 Marginal DHL For 1st item in each batch a(1-b)x-b=(1-b)y 387 310 272 248 231

Prof. Prashant Shukla

Clearly companies whose products are susceptible to learning curve effects can price lower, counting on the increased business to move them even further along the learning curve and making it difficult for competitor to dislodge them from a leading market position. For the Milner Company its historical experience with the first 150 units yielded an average of 400 DLH per unit for the next 100 units it produces. Moreover, if it wins this order, it can expect the following order to have even lower marginal costs. (2) The first unit of a new assembly took 240 direct labour hours. Compute the average labour, total labour and incremental labour for output levels of 5, 10, 20, 50 units. The assembly operation is subject to a learning effect of 85%. (For j = 85%, the value b = 0.2345) X 1 5 10 20 50 Y 240 240 x 5 = 164.55 240 x 10' = 139.87 24-Ox-2 0" =118.88 240 x 50" = 95.90 L(X) 240 822.76 1398.66 2377.66 4797.83 M(X) 240 145.69(for extra 4 units) 115.18(for extra 5 units) 98.10 80.57

(3) Prepare a schedule showing the average, total and incremental direct labour hours for output levels of 1 to 16 in multiples of 2, for a new product subject to learning effect of 75%. The first unit direct labour was 120 hours. (4) The first unit of a new model of a type-writer took 400 hours of Direct Labour. Determine average labour hours when output becomes 4, 8? Find average labour for the Third and the Fourth units. Find the average labour for the Fifth and the Sixth units. This type of assembly is subject to learning effect of 90%. (5) It is known the first unit of a new product took 100 hours of direct labour and repeated assembly is expected to experience a learning effect of ##%. An accountant prepared a statement showing the average, total and incremental labour at various output levels. Unfortunately the statement prepaid got mutilated making some of the figures indecipherable. The statement is reproduced below where ## signifies missing data you are required d to fill in the missing figures Output X 1 3 6 16 Average Labour Y 100 hrs ## ## ## Total Labour L ## 210.63 ## ## Incremental Labour M ## ## 42.13 ##

(Compute all figures to 2 places of decimal) (6)A first batch of 25 transistors of a new model took for assembly a total of 250 hours of DLH. It is required to manufacture another lot of 40 transistors. What will be the average labour hours? If a further lot of 100 units are to be assembled. What will be the average for the third lot? The assembly is subject to 85% learning effect.

Prof. Prashant Shukla

(7) Assuming a learning rate of 80percent that is the average number of labour hours required per unit is reduced by 20 percent as the quantity produced doubles. Required: (a) If the first 100 units require 100 hours, how many total hours will be required to produce 200 units? How many additional hours are required for the second 100 units? (b) Suppose the firm has an opportunity to bid on a contract that will raise its total output from 200 to 500 units, how many labour hours will be involved? (8) If an 80 percent learning model is assumed to apply to the individual for the Xth unit and labour costs R 5 per hour, how much should it cost direct labour to produce 100 units if the first unit takes eighty hours? (9) A first batch of 25 cameras assembled took 200 direct labour hours. Find the cost of an additional 40 units assembled and the cost for a second lot of another 60 units. The labour cost is Rs. 15 per hour. The assembly experience 90% learning effect. (10) Visa U and company have observed that a 90% teaming rate is applied to all labour related cost each time a new model enters production. It is anticipated that 320 units will be manufactured during current year. Direct labour cost for the first lot of 10 units amounts to 1000 hours at a rate of Rs.8 per hour. VOH is assigned to the product at the rate of Rs.2 per DLH. You are required to determine: Total labour and related costs to manufacture 320 units of output. (i) Average cost of (a) the first 40 units produced (b) the first 80 units(c) the first I00units. (ii) Incremental cost of (a) Units 41-80 and (b) Units 101-200. (11) The SNS Co. Ltd. Makes parts for ship navigation system. It has previously made About 10,000 parts exactly like the type ordered by the government for a new Submarine. A new government order calls for 10,000 parts the company's cost records yield the following cost data foe the 10,000 parts made to data. Direct Material Direct labour (8, 00,000 hours) Setup costs (no labour) Variable overhead (50% of DL) Fixed overhead (allocated at Rs. 10 per DLH) Rs. 100 lakhs Rs. 640 lakhs Rs. 6 lakhs Rs. 320 lakhs Rs. 80 lakhs Rs.1146 lakhs. Assuming an 80% learning rate on the average required and no change in unit labour costs per hour, estimate company's additional costs accepting the order. (12) Consider a company that acts as a subcontractor for parts used in the space program. Assume the company has been requested to bid on a contract for 750 units required in the assembly of the re-entry mechanism of a new space capsule. Thus the firm is interested in the contract. The company had recently produced 250 of the items at the

Prof. Prashant Shukla

Following costs as indicated by the accounting records. Direct Material Direct labour (5,000 hours @Rs. 5/-) Tolling (can be reused) Variable overhead (20% of DL) Fixed O/H (25% of DL) Total cost Rs.10,000 25,000 3,000 5,000 6,250 49,250

The company has retained a partial record of the total time required to produce the 250 units. The data are first unit 122 hours, fifteen unit s 2724 hours, 250 units, 5,000 hours. (13) Suraksha, an electronic firm have designed a new model of a fire alarm system and assembled a first unit as a prototype for demonstration purposes. The DLH expected on this unit was 260 hours at a labour rate of rs.30 per hour. The materials used had a cost of Rs.37,600. Following successful demonstration of this equipment, the firm has received an order for supply of 50 such units in the first six months and 75 units in the second six months. Repeated assembly of this type is subject to a learning effect of 80%. In order to popularize this demand, the firm will pass on the benefit accruing from the learning curve effect to the consumers. For the first lot to be supplied in the first six months the material will attract a 5% discount and for the second lot there will be 10% discount. The firm calculates its VOH @ 75% direct labour and FOH @ 25% of the prime cost. It is the policy of the firm is to set a selling price so as to yield 33.33% gross margin. Determine the selling price unit that should be set for the orders in each of the six months. (14) Bandookwala & Co., a fire arms manufacturer as designed a new type of gun and a first lot of 25 guns assembled for test purpose had the following costs: Direct materials Direct labour Variable overheads Fixed overheads Total costs Rs. 24,500 22,500 16,875 proportional to 11,250 direct labour 75,125

BSF being satisfied with this gun have asked the lowest bid for supply of 1000 guns. The company will pass on the benefits of learning of 85% to the client in setting the bid. The company will set a selling price to earn 35% gross profit margin. Determine the unit price that should be bid. (15) EGM, manufacture electrical goods on behalf of various clients as per their requirements. Currently having lost one major client, EGM is left with a large surplus of skilled labour. This labour cannot be retrenched nor can additional be recruited. EGM have located HHDG a marketing firm in household goods for whom it can offer manufacturing facilities to find gainful work for the skilled labour that may be otherwise be otherwise idle. EGM have compiled the following information so as to arrive at a decision whether to undertake manufacture on behalf of HHDG.

Prof. Prashant Shukla

Capital outlay on special machine Rs.2 lakhs (machine having no salvage value). Incremental overheads Rs.1 lakh per annum. Cost of materials Its. 180 per unit. Skilled labour rate Rs.30 per hour. The contract if entered into must be for a period of three years and HHDG will offer a unit price of Rs. 260 valid for all the three years. A first unit run took 10 hours of direct labour of a skilled workman. It is expected that on repetitive production there will be learning effect of 82%. HHDG will accept all the production that EGM is capable of it was also assessed that the surplus skilled labour available will be adequate to manufacture 3000 units in the first year. The cost of capital for EGM is 18%. You may assume that all cash flows occur at the year-end, except for the capital outlay that has to be at the start of year 1. What decision should EGM take with regard to acceptance of the contract for HHDG? (16) GRM, a refrigerator manufacturer, currently buys the compressor from CMCO at a unit price of Rs.2200. ASCMCO has been increasing the prices every year, GRM is evaluating the economics of in-house manufacture. The coming year's requirements are 2000 units and it is expected to increase progressively in the future. As a test of its technical capability in assembly of compressors a first lot of 100 compressors was assembled and found to be of acceptable quality. Cost estimate, as shown under, was prepared based on this test p production. per unit Lot 100 Rs. 80,000 800 Components (outside purchase) Direct assembly labour 1, 20,000 1,200 Factory VOH# 90,000 900 Factory FOH** 48,000 480 General overheads++ 33,800 338 Total cost 3,71,800 3,718

# charged at 75% of DL cost** charged at 40% of DL cost ++taken at 10% of the cost of material, DLH and Factory OH. On the basis of the above analysis it was believed that would not be economical to go in for in-house production. However, the production manager pointed out that assemblies of this type is no different from what the company has been doing for other items and the learning curve effect of 80% could be assumed to be applicable for this item as more and more units are produced, and this factor should be taken into account in deriving the cost, in particular for the quantities required for the coming year. What would be the decision on in-house assembly under this situation? (17) An Electronics firm assembles on behalf of diverse clients various electronic devices as per customer specifications. Recently, the firm has lost the business from one of its major client, resulting in some surplus of skilled assembly labour. The firm has no avenue to re-deploy these personnel nor is it willing to retrench them as such labour is not easy to

Prof. Prashant Shukla

get. Hence the firm is exploring for additional business that could use the surplus skilled labour. One such opportunity has arisen, where a new company expected to have its own factory in three years tome form now, would like to start assembly of one of their products right now. If this new opportunity is taken up then supplies of the assembly will have to undertaken for the full three year period. The new company will accept whatever that is produced and will pay a fixed price of Rs.350/- per unit for the 3-year period. A trial assembly gave the data that cost of components used will be Rs. 190/- per unit and the first unit took 16 hours of skilled labour. Repeated assembly of this type is subject to a learning curve effect of 85%. The firm has estimated that it can assembly 2000 units during the first year. The wage rate for the skilled personnel is Rs. 30/- per hour which will increase by 10% for each year. If assembly is undertaken then the firm will need to purchase a special machine at a cost of Rs. 3 lakhs to start operations. The company has a cost of capital at the rate of 20%. Assume that all cash inflows occur at the end of the year. Compute the production Levels for each of the tree years and hence prepare a statement of cash flows. Would it be worthwhile for the electronics firm to undertake this opportunity and if so what will be the ultimate result? (18) "Micronics" assemble various electronic gadgets on behalf of diverse clients. A firm A has indicated a new burglar alarm and has approached Micronics to assemble such alarms on their behalf. Firm A has indicated that the requirements will be for 300 units in the first six-month and an additional 80 units during the next six-month. To assess its capabilities, Micronics have assembled one test unit successfully. Based on this test assembly, the following information/data have been complied. -The assembly operations will have to be done in two departments A and B, in that sequence. All inputs of components/materials will be in department A. -Information obtained Cost of components/materials Rs /unit Direct labour used in 1st unit hours Variable overhead recovery (As a ratio to direct labour cost) Fixed overhead as a ratio to direct Labour costs Learning curve effect Spare capacity available total over Each six-month periods (labour hours) Profit mark-up on total cost 250* 16 50% 120% 58% 1500 25% 10 50% 120% 80% 800 15%

NOTE: *Components/material costs will be subject to a ten-percent discount during the second six-month. If overtime has to be worked in excess of regular capacity, then the rate will be at one and-half times. Determine the price to be quoted per unit in each of the two periods. Show the full details of your workings in a neat tabular form.