1 Bruce Bowhill University of Portsmouth ISBN: © 2008 John Wiley & Sons Ltd.

Chapter 3 Further Decision-Making Problems

3 A decision making approach –Identify the objectives to be achieved –Identify options for achieving the objectives –Evaluate the alternatives For short term decisions to evaluate alternatives –Identify the revenue and cost that will change if a particular alternative is chosen. Check for the existence of constraints. –Evaluate the change in revenue and costs –Identify the non-financial or qualitative factors © 2008 John Wiley & Sons Ltd.

4 Some typical short-term problems in organisations Should a service or product be withdrawn from the market or a segment of an organisation be closed? Is the most profitable sales plan being followed or will alternatives lead to higher profits. Should a component be made (or service provided) by the company or should it be bought in from another supplier? Is the optimum sales and production plan being followed, given a shortage of a key resource such as labour skills, raw materials or machine capacity? © 2008 John Wiley & Sons Ltd.

5 Richmond PLC Budgeted Profit and Loss Account for 20X0 £ Revenue 1,581,500 Total costs 1,487,750 Profit 93,750 The total costs include fixed costs of £247,250. Calculation of the fixed overhead per unit i) Budgeted fixed overheads are £247,250 ii) Budgeted output is 21,500 units sold (6,500 units of product X, 8,000 units of product Y, 7,000 units of product Z). iii) To calculate the fixed cost per unit, the fixed overheads of £247,500 are divided by 21,500 units. This gives a fixed cost of £11.50 per unit. © 2008 John Wiley & Sons Ltd.

6 Richmond PLC - profit per unit Product X Y Z Budgeted sales (units) 6,500 8,000 7,000 £ £ £ Sales price per unit Variable cost per unit Fixed overhead per unit* Total/full cost per unit Profit per unit Fixed overhead per unit = £247,250 = £ ,500 Should Richmond PLC stop sales and production of product X? © 2008 John Wiley & Sons Ltd.

7 (1) Should Richmond PLC stop sales and production of product X? ProductX Budgeted sales (units) 6,500 £ Sales price per unit 45 Variable cost per unit 39 Contribution per unit 6 Product X generates a contribution of £6 per unit towards general overheads. Since 6,500 units are sold, a total contribution of £39,000 is generated. © 2008 John Wiley & Sons Ltd.

8 Note that as an alternative, a total contribution statement can be produced. This will show the total revenue, variable costs and contribution for the 6,500 units of product X. A total contribution statement for product X. ProductX Budgeted sales (units) 6,500 £ Revenue 292,500 Total variable cost 253,500 Total contribution 39,000 © 2008 John Wiley & Sons Ltd.

9 (2) The marketing director of Richmond PLC has suggested a different marketing strategy in order to increase sales. The marketing director’s proposal: A special advertising campaign costing an additional £120,000 should be undertaken. This will increase sales of all products by 25% for the year. © 2008 John Wiley & Sons Ltd.

10 Marketing directors proposal Product X Y Z Total Budgeted sales (units) 8,125 10,000 8,750 £ £ £ £ Sales price per unit Variable cost per unit Contribution per unit Total contribution 48, , ,250 General fixed overheads 247,250 Additional advertising campaign 120,000 Net Profit 59,000 Profit given original plan was £93,750, so the new proposal is not worthwhile. © 2008 John Wiley & Sons Ltd.

11 (3) Evaluating whether to make or buy a product- Product Z for £87 £ Variable cost of making 77 Buy-in price 87 Financial benefit of making 10 ‘Qualitative’ reasons might wish to make rather than buy? -Quality -On-time delivery -Maintain core competencies © 2008 John Wiley & Sons Ltd.

12 (4) Identifying the optimum product or service mix given a constraint in resources Example 1: Alpha Ltd sells two products, product A and product B. The following information is available about sales price and variable costs. Product AProduct B ££££££££ Sales price 1512 Material cost46 Labour cost 63 Total variable cost10 9 Contribution per unit 5 3 All the fixed costs are general overheads. Product A takes one hour to manufacture and product B takes 30 minutes. © 2008 John Wiley & Sons Ltd.

13 (4) Identifying the optimum product or service mix given a constraint in resources Example 2 - Optimum production plan for Richmond PLC, given a limitation of labour hours Step 1 Identify whether there is a constraint on labour Budgeted Hours per Hours Cumulative Sales Unit Required Hours Product X 6, ,000 13,000 Product Y 8, ,000 37,000 Product Z 7, ,500 82,500 This is more than the 70,000 hours available i.e. there is a constraint © 2008 John Wiley & Sons Ltd.

14 Identify the contribution generated per labour hour for each product and rank the products according to their relative profitability Product X Y Z Contribution £ Hours Contribution £/hr Ranking © 2008 John Wiley & Sons Ltd.

15 Step 2 Optimum production plan if the business is to maximise its profits Budgeted Hours per Hours Cumulative Cont’n sales unit required hours £ Product Y 8, ,000 24, ,000 Product X 6, ,000 37,000 39,000 Product Z 5, ,994 69,994 91,368 Total 306,368 Qualitative/difficult to quantify factors e.g. problem of not selling a full product mix © 2008 John Wiley & Sons Ltd.

16 Cost terms Incremental costs are those that change as a result of a decision and include identifiable fixed costs. Relevant and irrelevant costs. In decision making, relevant costs are the costs that change because of a decision. Irrelevant costs are general overheads and other costs that do not change. Sunk costs are those that have already been spent or the commitment has been made to spend them. Sunk costs are not relevant to a decision. Opportunity cost is a cost that measures the opportunity that is lost or sacrificed when an opportunity is foregone. © 2008 John Wiley & Sons Ltd.

17 Profitability of Product A £ Revenue 40,000 Variable costs 20,000 Lease of machine (Note 1) 5,000 Overheads (Note 2) 8,000 Market research (Note 3) 5,000 Product development (Note 4) 9,000 Total cost 47,000 Loss on product A (7,000) Note 1 A machine will need to be leased for £5,000. Note 2 General overheads are allocated to projects on the basis of 20% of revenue. Note 3. The cost of the market research exercise carried out earlier this year. Note 4. £4,000 on product development has already been spent and a further £5,000 is committed. © 2008 John Wiley & Sons Ltd.

18 Contribution with launch of Product A £ £ Revenue 40,000 Variable costs 20,000 Lease of machine 5,000 Total additional cost 25,000 Contribution from sale of product A 15,000 The decision to progress with the sale of product A should therefore lead to a contribution to overheads of £15,000 based on the assumptions provided. © 2008 John Wiley & Sons Ltd.

19 XYZ company has 100 kgs of material A in stock. This material originally cost £300 to buy. It is not used in any existing product then the material could be resold to the wholesaler for £200. To purchase an extra 100 kgs of material from the wholesaler would cost £400. What is the relevant cost assuming: a) Material A cannot be used on any other contract? b) Material A is in constant use on a range of contracts. © 2008 John Wiley & Sons Ltd.