MARGINAL COSTING _ DECISION MAKING

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MARGINAL COSTING & DECISION MAKING Managerial decision making is an all pervasive functional area in the organization. The decision making process may involve various stages that lead on into another. This may be over a long term or short term period. There are a number of decision making situations that may involve the application of management accounting principles Generally a marginal accounting approach is taken since the decisions may only involve the variable costs. However, where a decision may involve changes in the fixed cost, this will have to be factored in. 1. LIMITING FACTOR A limiting factor exist where a firm produces a number of items and is confronted with a scare supply of a resource, such as raw material, or labour supply. The main issue here is on deciding what is the best product mix, given the scare resource. There are three main steps to be followed when dealing with a limiting factor situation : a. calculate the contribution per unit for each product b. convert the contribution per unit for each product to contribution per unit of the scarce resource c. chose the product mix based on the higher contribution per unit of the scarce resource. However, aside from the higher contribution, the firm may have to take into consideration such factors as the demand limitation, legal obligations, product loss leader policy, etc e.g. Bob the Builder makes two products – windows and doors, with the following data Window \$20 \$10 4 hrs 2m 200 Door \$30 \$18 3 hrs 6m 100

Selling Price Variable Cost Labour Material Max Demand

What is the optimum product mix given that a. Labour is limited to 500 hrs b. Material is limited to 600 m

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Solution : In applying the steps above, we first find the contribution per product unit, then rank that contribution in terms of the scarce resource : Window \$20 \$10 -----\$10 \$2.50 \$5 Door \$30 \$18 -----\$12 \$4 \$2

Selling Price per unit Variable Cost per unit Contribution per unit Contribution per unit of labour Contribution per unit of material

Therefore, if labour is scarce, we make more of the doors and less of the windows, since doors earn more on a per unit of labour basis. Likewise we make more of the windows and less of the door if material is limited The optimum product mix when labour is scarce is as follows : Sales 100 doors @ \$30 50 windows @ \$20 Variable Cost 100 doors @ \$18 50 windows @ \$10 Contribution

3000 1000 -----1800 500 -------

4000

2300 ------1700 =====

If material was the scare resource, the product mix would be as follows : Sales 200 windows @ \$20 33 doors @ \$30 Variable Cost 200 windows @ \$10 33 doors @ \$18 Contribution

4000 990 -----2000 594 -------

4990

2593 ------2396 =====

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2. MAKE OR BUY The firm may be faced with the option of making its products, or to buy them from an outside source. The main approach here is to decide which is the more profitable option. Again the variable costs would be the first consideration. However, the impact on the fixed costs should not be overlooked. e.g. Elmo’s Swirl produces and sells 5,000 units of Noodle Soup with the following data Selling price \$ 25 Variable cost per unit \$13 Fixed costs \$48,000 Elmo received an offer from Dorothy’s Do It All who can supply the noodle soup at a cost of \$14 per unit. This would result in a cutting back on fixed costs by \$16,000. Should Elmo continue to make the soup, or should he buy from Dorothy’s ? Solution TO MAKE -------------\$ Sales 125,000 Variable Cost 65,000 ----------Contribution 60,000 Fixed Costs 48,000 ----------Net Income 12,000 ======= TO BUY --------------Sales Purchases Contribution Fixed Costs Net Income \$ 125,000 70,000 ---------55,000 32,000 ---------23,000 =======

From this analysis, it would be better to buy from Dorothy’s at the higher purchase price, since there is a lower fixed cost involved. However, there may be non accounting factors to consider, such as the control over the quality of the soup, as well as the reliability in the supply. Also what will be the impact on the existing staff morale if there should be a cut back in production staff. Additionally, what if Dorothy’s begin to monopolize the market and then increase its price?

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3. DROPPING A PRODUCT LINE A firm that produces a number of products may be faced with a situation where one of the products shows a net loss. Should this product be eliminated ? e.g. Grover’s Green Grocery trades in three main items : apples, banana, and carrot, with the following result A 10,000 6,000 --------4,000 3,000 --------1,000 ===== B 15,000 8,000 --------7,000 8,000 --------(1,000) ====== C 25,000 12,000 ---------13,000 6,500 ---------6,500 ======

Sales Variable Costs Contribution Fixed Costs Net Income

The issue at hand is should the banana line be dropped? It has been ascertained that \$6,500 of the fixed costs in B would be eliminated if the department is closed. A comparative analysis of the situation would be helpful Keep Banana 50,000 26,000 ---------------24,000 17,500 ---------------6,500 ========== Drop Banana 35,000 18,000 -------------17,000 11,000 -------------6,000 ========= Difference (15,000) 8,000 ------------( 7,000 ) 6,500 ------------(500) ========

Sales Variable Costs Contribution Fixed Costs Net Income

From the above, it can be seen that if the Banana line was to be dropped, there would be reduction in the net income by \$500. As part of the analysis, it can be seen that the Banana line produces a healthy contribution of \$7,000. It would be helpful to determine if the fixed cost allocation is appropriately carried out. Other factors in the issue of dropping a product line are : the effect of the product on the performance of other product, the legal commitment to suppliers or clients, the impact on staff morale, the use of the redundant space and equipment, etc.

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4. SPECIAL ORDER A special order situation exist when a client places an order for a supply of goods at a rate outside the regular selling price. This is usually a one off order, and should not conflict with the firm’s regular trading activities e.g. The Bulla Guinegog is a trader in bulla cakes, with the following details : selling price \$10 each, variable cost \$5 each, while fixed cost total \$40,000. The firm has the capacity to produce 10,000 units. However activities for the year are at 8,500 units. A prospective client has placed a special order to purchase 500 units @\$7.50 each. Should this order be accepted.? The analysis here involves several factors. One is the capacity, i.e. can the existing capacity accommodate this special order, or will it require additional outlay, or interfere with existing output. Another factor that is closely associated with the capacity is the fixed cost. At full capacity fixed cost per unit would be \$4, making the total cost per unit \$9. However, the firm is not at full capacity, and would break even at 8,000 units. Therefore the margin of safety could be valued at a minimum of \$5 each, the variable cost. Thus, the special order is within the margin of safety, and within capacity. It could therefore be accepted. The result would be as follows Existing Plan Alone Sales Variable Cost Contribution Fixed Costs Net Income 85,000 42,500 ---------42,500 40,000 --------2,500 ====== Existing Plan & Special Order 88,750 45,000 ----------43,750 40,000 ----------3,750 =======

Additional factors that may impact on the consideration include the impact of the lowered price on the existing clients, and the prevention of the special order from exploiting the existing market, the continued request for the goods at the special price.

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5. SPECIAL PROJECT Here the firm must chose from one or more projects, which in most cases it is limited to only one. Incorporating the principles from capital budgeting, we take a further look at the analysis of the projects. e.g. Mr. Jacko Haltrade is considering one of two projects – vege patties or kiss cakes, Each has different operating requirements but there is a capacity to produce up to 10,000 units. Current constraints allow for the following budgeted activities : Vege-Patties Sales (6000 @ 20) Vcosts Material @6 Labour @ 5 Expenses @1 Kiss Cakes Sales (6,000 @ 25) 150,000 V Costs Material @ 7 42,000 Labour @ 3 18,000 Expenses @ 1.5 9,000 ---------69,000 ----------Contribution 81,000 Less F Costs 60,000 ---------Net Income 21,000 ======

120,000 36,000 30,000 6,000 -------72,000 ---------48,000 25,000 ---------23,000 ======

Contribution Less F Costs Net Income

Which project should Mr. Haltrade chose? The answer lies beyond the current plan which would tend to indicate that the vegepatties seem more profitable. Remember that the firm has additional capacity, and would not necessarily increase fixed costs with additional output. At present the kiss cakes has variable costs of \$11.50 while the vege – patties have a variable cost of \$12. In the long run the kiss cakes would be more profitable since the contribution per unit is \$13.50, while that for the vege patty is only \$8.00 NON FINANCIAL FACTORS In making decisions, the firm should look beyond the profit line, and incorporate such non financial factors as the impact of a decision on staff morale the impact on quality and quantity of output competition in the market legal or contractual obligations impact of one product on the success of other products

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TUTORIAL QUESTIONS. 1. Sachin Tendulkar manufactures two products : Indian Roti and Vege Soup. Data for the two products for 2001 are as follows : Indian Roti Selling price Variable cost Time to complete Material needed Max. demand Required : a. Calculate the optimum product mix given that : i material is limited to 30,000 g ii labour is limited to 1000 hours c. Calculate the income for each product mix \$50 \$35 1 hr 20 g 500 units Vege Soup \$60 \$40 1 hr 30 g 800 units

2. A manufacturing company has four product lines with the following production data : -------------------PRODUCTS------------------A B C D Selling price (\$) Labour Cost ( @ \$2 per hr) Material Cost ( @ \$1 per kg ) Maximum demand (units ) Required : Based on the above data, what is the most appropriate mix under the assumption that : a. labour hours is limited to 50,000 hrs b. material is limited to 110,000 kg 20 6 6 5000 30 4 18 5000 40 14 10 5000 36 10 12 5000

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3. Fruta is a trader in fruit juice. It has the capacity to make 5,000 unit per annum, with associated costs consisting of raw material @ \$4; direct labour @ 8, and overheads @ \$16. The finished product could be purchased from another supplier @ \$20 each. This would eliminate ¾ of the fixed costs. Should the firm make or buy the product ? Explain.

4.

Among the product lines at the Moyston Manufacturing Co. is the HB Pencil. The Current production level is 50,000 unit per annum, with the following associated costs per unit : Materials Labour Variable OH Fixed OH 2.50 1.25 1.75 3.50

The pencils can be brought from Faber Manufacturing for \$7.75 each. Required : i. Should Moyston continue its pencil production or should it purchase from Faber, given that either of the following situations : a. Fixed OH costs would remain b. Fixed OH would be cut by 50%

ii. What other information would you find useful in the analysis above? 5. A cinema chain in Jamaica operates three cinemas, one each in Kingston, Montego Bay and Ocho Rios. The ticket price in all the cinemas is \$8 each. The income statement for last year was as follows : KGN 700,000 MBY 700,000 OR 400,000

350,000 200,000 195,000 150,000 125,000 80,000 250,000 350,000 175,000 --------------------------650,000 675,000 450,000 -----------------------------Income 50,000 25,000 (50,000) ======= ====== ======= Included in the overhead costs are fixed costs of \$360,000 allocated in the ratio of ticket sales.

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i. ii

Should the Ocho Rios cinema be closed ? . What other information would you wish to incorporate into your analysis?

6. The Spartan are include :

Company has an annual capacity of 25,000 units. Plans for the current

Sales ( 20,000 @ \$50 ) Variable Prod. Costs (20,000 @ 40) Fixed Prod. Costs Variable Selling ( 20,000 @ 7) Fixed Admin

1,000,000 800,000 30,000 140,000 7,000

A special order has been received from a prospective client for 4,000 units at \$45 each. The current sales team will not handle this order, as the client will make all the necessary arrangements. i. ii. Should the order be accepted ? What non financial factors would add to your analysis?

7. The Chan Manufacturing Co. has three product lines with the following data Product 12 Sales Total Costs Product 23 Product 13

32,000 50,000 45,000 36,000 38,000 34,000 ------------------------Net Income ( 4,000) 12,000 11,000 ====== ====== ====== It has been ascertained that the total costs comprise 2/3 variable and 1/3 fixed. The directors are contemplating to drop Product 12. Required : a. b. What would be your recommendation? What other data would you wish to bring to the table ?

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8. The Grey Flannel produces a perfume called Breathless. The company is currently producing 100,000 units, with the following cost considerations : Direct material Direct labour Variable overhead Fixed overhead 6.00 per unit 1.00 per unit 0.50 per unit 0.50 per unit

The firm is considering to purchase the perfume from an overseas firm for \$7.25 per unit, plus an additional cost of 0.40 per unit for shipping and handling. The current productive capacity would be re-deployed to another product line called After Dark, which would result in an increase in its contribution by \$20,000. Required : a. Should the Grey Flannel continue to manufacture Breathless or should it purchase from the overseas supplier? b. What other considerations would you need before making a final decision?

9. The Gas Glow Grill Co. sells three models of barbeque grills : Super Deluxe, Deluxe, and Matchless. Accounting data for the year 1998 was summarized as follows

Sales (\$) Variable Costs Contribution Fixed Costs

SD D M 200,000 240,000 200,000 120,000 180,000 160,000 -----------------------------------------------80,000 60,000 40,000 60,000 50,000 50,000 -----------------------------------------------20,000 10,000 ( 10,000) =============================

Net income

The directors are considering to drop the Matchless line given its net loss. Required ; i. Show by calculation whether it is prudent to drop the product, given that the fixed costs would not be eliminated ii. Assuming that the fixed costs would be eliminated, what other factors would you rely on before making a final decision?

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