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Relevant costing and short-term decision making

INTRODUCTION TO MANAGEMENT ACCOUNTINGWEEK 8

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Role of marginal costingUse 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)

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Make or buyThe 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.

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Make or buy - exampleThe following data relates to a company manufacturing modems:Production 50,000 unitsFixed costs £400,000

£/unitMaterial 15.50Labour 17.50Variable overhead 21.00Marginal cost of manufacture 54.00Fixed costs/unit 8.00 £400,000/ 50,000

unitsTotal 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?

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Make or buy – example solutionFixed cost will be incurred irrespective of whether the modems are bought or manufactured therefore: Benefit of manufacture = 59.50 – 54.00 = £5.50/unit

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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)

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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?

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Acceptance of a one off orderOne 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

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One off order – basic example

The following data relates to a company manufacturing keyboards:Production 10,000 unitsFixed 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?

£/unitSelling price 15.00Material 2.50Labour 1.50Variable overhead 3.00Marginal cost of manufacture 7.00

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One off order – basic exampleSOLUTIONAdditional contribution – (£9 - £7) x 3,000 units = £6,000Effect on profit

On financial grounds, accept one off order

Original Original + one off order

£000’s £000’sSales revenue 150 177Variable costs (70) (91)Contribution 80 86Fixed costs (75) (75)Profit 5 11

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One off order – other issuesPossible 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?

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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

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Discontinuing a product - exampleA 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 260Variable costs

330 550 100 160

Fixed costs 100 75 125 110Profit/(loss) 120 125 (25) (10)

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Discontinuing a product - exampleSOLUTIONContribution evaluation -

All products make positive contribution and should therefore be continued

PRODUCT 1 2 3 4£’000s £’000s £’000s £’000s

Sales 550 750 200 260Variable costs (330) (550) (100) (160)Contribution 220 200 100 100

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Discontinuing a product - example

Original production planDiscontinuing products 3 & 4

Effect on profit if products 3 and 4 are discontinued because they are loss making –

£’000’s

Cont. P 1 220Cont. P2 200Cont. P3 100Cont. P4 100Total cont. 620Less F/C 410 (100 + 75 +

125 + 110)

Profit 210

£’000’s

Cont. P 1 220Cont. P2 200

Total cont. 420Less F/C 410 (100 + 75 +

125 + 110)

Profit 10

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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

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Limiting factor 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

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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.

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Limiting factorThe usual objective in questions is to maximise profit. Fixed costs unchanged in the short run hence contribution maximisedStep 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)

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Limiting factor - exampleData relates to a company manufacturing four products:

PRODUCT 1 2 3 4Maximum demand (units) 1,000 1,550 1,250 1,375

£ £ £ £Sales 30 54 20 25VARIABLE COSTS:Material 10 20 6 8Labour 12 24 5 12Contribution 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

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Limiting factor – example solutionAll 4 products have positive contributionWe need 29,750 kg (5x1000+10x1,550+3x1,250+4x1,375)But material limited to 21,750kgTherefore contribution per kg of material (limiting factor) for each product –

Ranking –1st – Product 3 2nd – Product 13rd – Product 44th – Product 2

PRODUCT 1 2 3 4Contribution 8 10 9 5Material needed (kg) 5 10 3 4Contribution per kg of material

1.6 (8/5) 1 (10/10) 3 (9/3) 1.25 (5/4)

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Limiting factor – example solution

Allocating the scarce resource (material) using the rankingMaterial limited to 21,750 kgOptimal Production Plan of material consumption LeftProduct 3 – 1250 units x 3kg = 3,750 kg 18,000Product 1 – 1000 units x 5kg = 5,000 kg 13,000Product 4 – 1375 units x 4 kg = 5,500 kg 7,500Product 2 – 750 units x 10 kg =7,500 kg - 21,750 kg

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Limiting factor – example solution

PRODUCT 1 2 3 4 TOTALProduction plan (units) 1,000 750 1,250 1,375

£ £ £ £ £Contribution per unit 8 10 9 5Contribution 8,000 7,500 11,250 6,875 33,625Fixed 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 -

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Limiting factor – example solutionProduction plan and Profit using ranking of contribution only rather than contribution per limiting factor

Production planProduct 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 4Contribution (£) 8 10 9 5

PRODUCT 1 2 3 4 TOTALProduction plan (units) 500 1,550 1,250 0

£ £ £ £ £Contribution 4,000 15,500 11,250 - 30,750Fixed costs (12,000)PROFIT 18,750