Week 8 relevant costing and short-term decision-making
- 1. Relevant costing and short-term decision making INTRODUCTION TO MANAGEMENT ACCOUNTING WEEK 8
- 2. Role of marginal costing Use of contribution – Fixed costs can be ignored (unless incremental) Enables only costs and revenues that change as a result of a particular course of action to be considered Can be used for following short-run decisions: Make or buy, Acceptance of a one off order, Discontinuing a product, Limiting factor/key factor (existence of shortage)
- 3. Make or buy The make or buy decision is essentially the choice between making a product in-house or outsourcing and buying in. A product should be made in-house if the relevant cost of making the product in-house is less than the cost of buying the product externally. Fixed costs are excluded unless they are incremental with regard to the decision.
- 4. Make or buy - example The following data relates to a company manufacturing modems: Production 50,000 units Fixed costs £400,000 £/unit Material 15.50 Labour 17.50 Variable overhead 21.00 Marginal cost of manufacture 54.00 Fixed costs/unit 8.00 £400,000/ 50,000 units Total product cost 62.00 External supplier has offered to supply the modems at £59.50/unit. Production capacity will not be used elsewhere if it were not employed (spare) in the manufacture of modems. Make or buy?
- 5. Make or buy – example solution Fixed cost will be incurred irrespective of whether the modems are bought or manufactured therefore: Benefit of manufacture = 59.50 – 54.00 = £5.50/unit
- 6. Make or buy If spare capacity exists, the relevant cost of making the product in-house is the variable cost of internal manufacture. If spare capacity does not exist, the relevant cost of making the product in-house is the variable cost of internal manufacture, plus the opportunity cost of internal manufacture (e.g. lost contribution from another product)
- 7. Make or buy - Other issues Reliability of external supplier: quantity, quality, price, delivery Alternative use of resource: outsourcing will free up resources which may be used in another part of the business. Social: will outsourcing result in a reduction of the workforce? Redundancy costs should be considered. Legal: will outsourcing affect contractual obligations with suppliers or employees? Confidentiality: is there a risk of loss of confidentiality, especially if the external supplier performs similar work for rival companies. Customer reaction: do customers attach importance to the products being made in-house?
- 8. Acceptance of a one off order One off order usually at a lower than normal price Spare capacity exists therefore normal production would remain unaffected Cost of the order would be of importance Fixed costs excluded unless incremental with regard to the decision Contribution used – Difference between proposed selling price and variable cost of production
- 9. One off order – basic example The following data relates to a company manufacturing keyboards: Production 10,000 units Fixed costs £75,000 A new customer wants to purchase 3,000 keyboards at a price of only £9.00 each. Spare capacity exists. Accept the additional one off order? £/unit Selling price 15.00 Material 2.50 Labour 1.50 Variable overhead 3.00 Marginal cost of manufacture 7.00
- 10. One off order – basic example SOLUTION Additional contribution – (£9 - £7) x 3,000 units = £6,000 Effect on profit On financial grounds, accept one off order Original Original + one off order £000’s £000’s Sales revenue 150 177 Variable costs (70) (91) Contribution 80 86 Fixed costs (75) (75) Profit 5 11
- 11. One off order – other issues Possible non-financial factors to be considered – Reaction of existing customers Better use of spare capacity – more profitable option? Effect on the market – change in pricing policy?
- 12. Discontinuing a product Company produces several products Some products no longer considered profitable Contribution of products evaluated If discontinued, variable costs no longer incurred Fixed costs of business as a whole likely to remain unchanged therefore will have to be borne by remaining products Products with positive contribution should be continued to help pay off fixed costs
- 13. Discontinuinga product - example A company manufactures four products: It has been suggested that products 3 and 4 be discontinued from production as they are both loss making. Should products 3 and 4 be discontinued? PRODUCT 1 2 3 4 £’000s £’000s £’000s £’000s Sales 550 750 200 260 Variable costs 330 550 100 160 Fixed costs 100 75 125 110 Profit/(loss) 120 125 (25) (10)
- 14. Discontinuinga product - example SOLUTION Contribution evaluation - All products make positive contribution and should therefore be continued PRODUCT 1 2 3 4 £’000s £’000s £’000s £’000s Sales 550 750 200 260 Variable costs (330) (550) (100) (160) Contribution 220 200 100 100
- 15. Discontinuinga product - example Original production plan Discontinuing products 3 & 4 Effect on profit if products 3 and 4 are discontinued because they are loss making – £’000’s Cont. P 1 220 Cont. P2 200 Cont. P3 100 Cont. P4 100 Total cont. 620 Less F/C 410 (100 + 75 + 125 + 110) Profit 210 £’000’s Cont. P 1 220 Cont. P2 200 Total cont. 420 Less F/C 410 (100 + 75 + 125 + 110) Profit 10
- 16. Limiting factor/key factor (existence of shortage) A limiting factor or key factor is 'anything which limits the activity of an entity. An entity seeks to optimise the benefit it obtains from the limiting factor. Examples are a shortage of supply of a resource or a restriction on sales demand at a particular price'. - CIMA Official Terminology A limiting factor is any factor which is in scarce supply and which stops the organisation from expanding its activities further, that is, it limits the organisation’s activities. Example machine capacity, skilled labour, material
- 17. Limitingfactor Contribution per unit of limiting factor (scarce resource) is used In a limiting factor situation, contribution will be maximised by earning the biggest possible contribution per unit of limiting factor (scarce resource). The contribution per limiting factor should be maximised as this will in turn maximise the contribution and hence the profit of the business as a whole
- 18. Limiting factor Points to bear in mind – Fixed costs will remain the same irrespective of the production plan Units of output are divisible and optimal output may include fractions of units Limiting factor analysis is a method used for decision making in the short term with one limiting factor. If there are two or more scarce resources, then linear programming should be used instead. One qualitative factor may be the loss of customer goodwill due to the company being unable to supply all of its regular customers.
- 19. Limitingfactor The usual objective in questions is to maximise profit. Fixed costs unchanged in the short run hence contribution maximised Step 1: identify the scarce resource. Step 2: calculate the contribution per unit for each product. Step 3: calculate the contribution per unit of the scarce resource for each product. Step 4: rank the products in order of the contribution per unit of the scarce resource.(highest = 1st) Step 5: allocate resources using this ranking until scarce resource is used up (optimal production plan)
- 20. Limitingfactor - example Data relates to a company manufacturing four products: PRODUCT 1 2 3 4 Maximum demand (units) 1,000 1,550 1,250 1,375 £ £ £ £ Sales 30 54 20 25 VARIABLE COSTS: Material 10 20 6 8 Labour 12 24 5 12 Contribution 8 10 9 5 The same material used for the production of all 4 products is in short supply and costs £2/kg. Only 21,750kg available for the period in question. Fixed costs = £12,000 for this period. Determine the optimal production plan to maximise profits
- 21. Limitingfactor– example solution All 4 products have positive contribution We need 29,750 kg (5x1000+10x1,550+3x1,250+4x1,375) But material limited to 21,750kg Therefore contribution per kg of material (limiting factor) for each product – Ranking – 1st – Product 3 2nd – Product 1 3rd – Product 4 4th – Product 2 PRODUCT 1 2 3 4 Contribution 8 10 9 5 Material needed (kg) 5 10 3 4 Contribution per kg of material 1.6 (8/5) 1 (10/10) 3 (9/3) 1.25 (5/4)
- 22. Limitingfactor – example solution Allocating the scarce resource (material) using the ranking Material limited to 21,750 kg Optimal Production Plan of material consumption Left Product 3 – 1250 units x 3kg = 3,750 kg 18,000 Product 1 – 1000 units x 5kg = 5,000 kg 13,000 Product 4 – 1375 units x 4 kg = 5,500 kg 7,500 Product 2 – 750 units x 10 kg =7,500 kg - 21,750 kg
- 23. Limitingfactor – example solution PRODUCT 1 2 3 4 TOTAL Production plan (units) 1,000 750 1,250 1,375 £ £ £ £ £ Contribution per unit 8 10 9 5 Contribution 8,000 7,500 11,250 6,875 33,625 Fixed costs (12,000) PROFIT 21,625 Product 3 – 1250 units x 3kg = 3,750 kg Product 1 – 1000 units x 5kg = 5,000 kg Product 4 – 1375 units x 4 kg = 5,500 kg Product 2 – 750 units x 10 kg =7,500 kg 21,750 kg PROFIT generated using contribution per limiting factor -
- 24. Limitingfactor – example solution Production plan and Profit using ranking of contribution only rather than contribution per limiting factor Production plan Product 2 – 1550 units x 10kg =15,500 kg Product 3 – 1250 units x 3kg = 3,750 kg Product 1 – 500 units x 5 kg = 2,500 kg Product 4 – 0 units x 4 kg = 0 kg 21,750 kg PRODUCT 1 2 3 4 Contribution (£) 8 10 9 5 PRODUCT 1 2 3 4 TOTAL Production plan (units) 500 1,550 1,250 0 £ £ £ £ £ Contribution 4,000 15,500 11,250 - 30,750 Fixed costs (12,000) PROFIT 18,750