Week 2 management decision making

FINANCIAL MANAGEMENT
Prepared by Tishta Bachoo
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Lecture 2 - overview
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• Decision Making Techniques
• When there is Limiting Factor
• Make or Outsourcing Decision
• Analyze a special Order Decision

Management Decision Making
 When running a business, making the right decisions
can lead to success, while making the wrongs can result
to failure.
 With so much riding on each decision, it's important that
thoughtful consideration is put into each one that needs
to be made.
 To help them, many business leaders go through a
thoughtful decision-making process.
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Limiting Factor
 For some businesses sales are not limited by market
demand, but by production limitations.
 For example, limited production can be caused by a
shortage of any factor such as labour, materials, space or
equipment.
 In such cases, if an entity has more than one product or
service offered to customers it would need to determine
which product/service provides the most profitable use of
the limited resource.
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Contribution margin per limiting factor is the
contribution margin per unit of limited
resource
Example 1 Products
A B C .
Budgeted sales next year 100 000 50 000 80 000
SP per unit $30 $40 $60
VC per unit $15 $22 $15
Labour time per unit 1 hr 4 hrs 1.5 hrs
Total labour hrs required 100 000 hrs. 200 000 hrs 120 000 hrs
Contribution margin per limiting factor5

By summing the required hours, we find that
the firm needs a total of 420 000 hours
BUT let’s assume only 370 000 hours are
available for production
Firm wants to know which product it should
promote
This means we need to determine the most
profitable product
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Contribution margin per limiting factor

Steps to calculate contribution
margin per limiting factor
 This is calculated when the company has limited resources for
production. It can be limited labor hours, materials, etc…
1. Calculate contribution margin for each product
CM= S.P per unit – Variable cost per unit
2. Calculate the CM per limiting factor per unit
CM/ Hr per unit or CM/ Materials per unit
3. The higher the CM/Hr, the more profitable the company is to make the
product
4. Choose the most profitable, 2nd
profitable and least profitable
5. Deduct the total hours required for the two highly profitable products
from the available hours.
6. The number of hours left is the then allocated to the least profitable
product.
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A B C
CM per unit $15 $18 $45
Labour time per unit 1 hr 4 hrs 1.5 hrs
Total labour hrs required 100 000 hrs 200 000 hrs 120 000hrs
CM per hour $15 p.h. $4.5 p.h. $30 p.h.
 This analysis shows that
 C is the most profitable by providing more CM per hour
 The company should therefore focus production on C (120,000 hours)
followed by A (100,000 hours) since this is the second most profitable.
 The remaining 150 000 hours (370 000– 220,000 hours) allocated towards B.
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Contribution margin per limiting factor

 To make sure decisions are based on the
right information, the following must be
identified where relevant:
 Relevant costs and relevant income
 Incremental costs and incremental income
 Opportunity cost
 Avoidable costs and unavoidable costs
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Make or Buy (outsourcing)

 A make or buy decision requires an entity
to choose whether
 To make or buy a product or service
OR
 To outsource the production of that product or service
 Such a decision will involve both
quantitative and qualitative factors
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 Qantas Airlines owns $20,000 worth of
parts which were designed for an aircraft
that the airline no longer uses. The airline
has two options:
Option 1
 Sell the existing parts for $17,000 and purchase
new parts for $26,000.
Option 2
 Modify the existing parts at a cost of $12,000.
Should Qantas Airlines keep or sell the
parts?

Solution
Option 1 Option 2
Proceeds from sale 17,000 0
of parts
Costs to modify parts -12,000
Cost of new parts -26000
Total Cost -$9,000 -$12,000

Solution
 Qantas should therefore dispose of the parts
and purchase new equipment.
 Note the exclusion of the initial cost of the
equipment from the analysis.
 Because this is classified as a sunk cost

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 Sunk costs are those which;
 Have already been incurred
 Do not affect any future cost and cannot
be changed by any current or future
action.
 Sunk costs do not meet the definition of
relevant information.
Sunk costs

 The Potential benefit that is forgone as a
result of choosing one alternative over
another.
 Opportunity costs meet the definition of a
relevant cost.
 They therefore need to be included in
make or buy or special order decisions.
Opportunity costs

 On occasions, an organisation will be offered a special,
once only order.
 The price offered for the organisations products will normally
be below the normal selling price.
 Using relevant costs and benefits managers must decide
whether this order should be accepted or rejected.
Special orders

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Exercise 1 – Qantas Airlines
Excess Capacity
 A travel agency has offered to charter a flight from Mauritius to
Sydney return for $50,000. Qantas Airlines would normally
charge $100,000 for a Mauritius to Sydney return flight.
 Expenses per flight are as follows;
 VC per flight 20,000
 FC allocated to each flight 35,000
 (FC = $350,000, Qantas Airlines operates 10 flights).
 Qantas Airlines has two aircraft which are presently not being
used
 Should the offer be accepted?

Solution
Charter Price $50,000
Less Variable Cost -$20,000
Contribution from Charter $30,000
Since Qantas Airlines has 2 aircraft not
currently being used, they should
accept the special order.
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Exercise 2
Special Order - Full Capacity
 If Qantas Airlines was at full capacity (i.e. no spare planes)
how would your analysis differ??
 To accept the offer Qantas Airlines would need to drop
flights from its normal activity. The contribution margin is
$80,000 ($100,000- $20,000 {VC}).
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Solution
Charter Price $50,000
less:
Variable Costs for the Charter -$20,000
less:
Opportunity Cost -$80,000
Contribution from the Charter -$50,000
Qantas Airlines should not accept the special order due to
a negative contribution margin.
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Question on Limiting Factor
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 The management of ABC Ltd has given you the following financial information
about three products that they produce: Bottles, Forks and Plates. The normal
production of 130 000 products would require a total of 280 000 labour hours.
Due to lack of workers, total labour hour which can be allocated to the
production of the three products is 200 000 hours. Management does not want
to incur any loss neither does he want to close down the business and hence
asking you for some advice.
Bottles Forks Plates .
Budgeted sales next year 20 000 40 000 70 000
SP per unit $25 $20 $70
VC per unit $10 $12 $40
Labour time per unit 1.5 hr 3 hrs 2 hrs
Total labour hrs required 30 000 hrs 120 000 hrs 140 000 hrs
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Bottles Forks Plates
CM per unit $15 $8 $30
Labour time per unit 1.5 hr 3 hrs 2 hrs
Total labour hrs required 30 000 hrs 120 000 hrs 140 000 hrs
CM per hour $10 p.h. $2.67 p.h. $15 p.h.
2nd
3rd
1st
 This analysis shows that
 Plates are the most profitable by providing more CM per hour
 ABC should therefore focus production on Plates (140,000 hours) followed by
Bottles (30,000 hours) since this is the second most profitable.
 The remaining 30 000 hours (200 000– 170,000 hours) allocated towards Forks.
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Answer (Limiting Factor)

Question on Make or Buy
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Diamond Light Company incurred the following costs to produce 50 000 light
switches for floor lamps in 2016.
Direct materials $ 100 000
Direct labour 150 000
Variable manufacturing overhead 80 000
Fixed manufacturing overhead 120 000
Total manufacturing costs $450 000
The Ignition Company has offered to supply the switches for $16 per unit. An
analysis of the overhead costs has identified that if the switches are outsourced,
Diamond Light Company would eliminate $20 000 of fixed costs, and could use
the released production capacity to generate additional income of $56 000 from
producing a different product.
From a financial perspective, should the light switches be outsourced?
Show calculations.
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Answer (Make or Buy)
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Question on Special Order
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ABC Ltd has production capacity of 50,000 plates and they are currently
operating at 85 per cent capacity. Their variable manufacturing costs are $15
per unit. Fixed manufacturing costs are $ 300 000. The plates are normally
sold directly to a retailer at $40 each.
Now they have an offer from another Company who wants to purchase an
additional 7000 plates at $25 per unit from ABC Ltd.
What is ABC Ltd available production capacity?
Calculate the contribution margin per unit for both the current production of
plates and the special order plates
Should the special order be accepted? [Show calculations]
What is the opportunity cost if the new company required 12 000 plates?
Would you recommend the special order if the Company required 12 000
plates?
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Answer (Special Order)
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A.
Production capacity (maximum capacity) = 50 000 plates
ABCCompany is currently operating at 85% capacity
Current capacity = 50 000 × 0.85 = 42 500 plates compasses for
“normal sales”
Spare/Idle capacity = 50 000 – 42 500 = 7500 plates
ABC has enough available capacity to produce an additional 7 500
plates

(b)
 Contribution Margin (CM) = Selling Price –
Variable Costs
 Contribution margin for “normal/current” sales =
Selling price $40
Variable costs 15
Contribution margin $25
 Contribution margin for special order =
Selling Price $20
Variable costs 15
Contribution margin $ 5
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C
 Available capacity = 7500 plates
 Special Order capacity = 7000 plates
 Available capacity > Special Order capacity, therefore there is no
opportunity cost
 Special Order Contribution Margin (CM) = $20 – $15 = $5 per
plate
 Special Order CM x Special Order capacity = $5 x 7000 plates =
$35000
 If ABC accepts the special order its profits will increase by
$35000
 Therefore: Yes, the special order should be accepted as profits
will increase by $35000
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D
 Available capacity = 7500 plates
 Special Order capacity = 12000 plates
 Available capacity < Special Order capacity, therefore an
opportunity cost needs to be calculated
 To accept the special order, it would be necessary to “give up”
4500 units of “normal sales” (available capacity – special order
capacity = 7500 – 12000 = -4500 plates)
 Opportunity cost of special order represents lost “normal sales”
 Number of units that need to be “given up” = 4500 plates
 “Normal” Contribution Margin = $40 - $15 = $25 per compass
 Opportunity Cost = 4500 plates x $25 = $112500
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E
Benefit of special order
Special Order CM x Special Order capacity = $5 × 12 000
compasses = $60000
Opportunity Cost (see (d) above) (112500)
Decrease in profit $52500
Therefore, if the special order for 12000 plates is accepted,
ABC’s profits will decrease by $52500
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END OF SESSION 

Next week …
 Management Decision Making:
 Budgeting
 Cash Management
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Week 2 management decision making

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