UNIT FIVE :SHORT TERM DECISION MAKING

UNIT FIVE :SHORT TERM DECISION MAKING
Examples include setting profit maximising selling prices, accepting or rejecting customer orders and deciding whether to make or buy in components. These decisions tend to assume a given level of capital investment and often turn around optimising the use of given resources or opportunities from a given market situation. Short term decisions are decisions whose costs will be incurred and whose benefits will be obtained in the short term. Since costs and benefits are all short term ,the financial appraisal of decisions does not have to consider the time value of money.

UNIT FIVE:SHORT TERM DECISION MAKING
Taking a decision means making a choice between two or more possible courses of action. Alternatively it might be a choice between doing something or doing nothing. Yet another type of decision is what to make and sell in order to maximise profits. Management Accountants can help managers to reach decisions that maximise profitability, by providing information about the likely costs and benefits of various decision options.

Accounting for short term decision making is based on common sense: It starts from the position that, whatever a manager decides to do now, the decision cannot affect what has already happened in the past. IT can only affect the future. It also takes the position that the only costs and revenues that are relevant to a decision are the extra costs incurred , or the costs saved or the revenue gained or lost as a result of making the decision.

Costs that will be incurred anyway or revenues that will be earned anyway cannot be relevant to a decision. Thirdly it is also recognised that the relevant consequences of a decision are those that result in higher or lower cash spending or higher or lower cash income. Cash flows are what matter in business not accounting profits. Non cash items are irrelevant for decision making these include depreciation charges and absorbed fixed overheads.

The only costs to be taken into consideration in the financial evaluation of decisions are therefore relevant costs. A relevant cost is a future cash flow arising as a direct consequence of the decision that is taken.

SHORT TERM DECISIONS AND COST VOLUME PROFIT ANALYSIS
In many cases , a short term decision deals with identifying the profit maximising level of production and sales , or the additional costs of doing extra volumes of work. In such cases costs might simply be analysed into fixed and variable costs. Fixed costs are irrelevant to a decision if they will be the same regardless of what decision is taken. On the other hand , variable costs are relevant provided they are cash flow items of expenditure ,because they will be affected by the volume of output or sales.

SPLITTING COSTS It is often necessary to look at the way costs behave in response to changes in production volume. The commonly used method to split variable and fixed costs is the high low method. It is based on the fact that total costs consist of fixed costs plus variable costs. Fixed costs per period are the same regardless of the activity level and unit variable costs are a constant amount at all levels of activity.

SPLITTING COSTS It therefore follows that, since fixed costs are the same at all activity levels, the difference in total costs at two different activity levels must consist of variable costs. The high low method can be summarised into the following simple steps: Step 1 :select the highest and lowest activity levels, and their associated costs. (Note: do not take the highest and lowest costs)

SPLITTING COSTS Step 2: find the variable cost per unit
Cost at highest Cost at lowest level of activity – level of activity ––––––––––––––––––––––––––––––– High level of activity– low level of activity Step 3: find the fixed cost by substitution, using either the high or low activity level. Fixed cost = Total cost at activity level –Total variable cost

SPLITTING COSTS STEP4 : Formulate a model in the form TC =TFC + VCQ that can be used to estimate costs for any given level of activity. Where: TC = total costs for the selected level of activity. TFC = total fixed costs calculated in step 3 above. VC = VC is the variable cost per unit in step 2 above

EXAMPLE :HIGH LOW METHOD
The total costs incurred at various output levels in a factory have been measured as follows: Output Total costs (units) (k) ,566 ,510 ,800 ,985 ,380 ,310 Required: Using the high low method ,analyse the total cost into fixed and variable components.? Calculate total costs if 100 units are to be produced?

SOLUTION :HIGH LOW METHOD
STEP 1:Select highest and lowest activities together with their respective costs as follows: Output Total costs (units) K Highest ,310 Lowest ,566 Difference STEP 2: Calculate variable cost per unit as follows: VC = 744 = K31 per unit 24

Step 3 :Calculate total fixed costs by substituting into highest or lowest level of activity as follows: Total cost = K7,310 Total variable costs = 50 x K31 K1,550 Therefore Total fixed costs = K5,760 Or at lowest activity as follows Total cost = K6,566 Total variable costs = 26 x K31 K806 Therefore total fixed costs = K5,760

STEP 4:Derive the model in the form TC = TFC + VCQ as follows: TC = K5,760 + K31q Where q in the question is 100 TC becomes K5, (K31 x 100) TC = K5, K3,100 = K8,860

RELEVANCE OF VARIABLE COSTS
Variable costs are those costs which change in proportion to changes in the level of activity. Thus whenever a business decision involves increases or decreases in activity, it is almost certain that variable costs will be affected and therefore will be relevant to the decision.

RELEVANCE OF FIXED COSTS
Fixed costs are generally regarded as those costs which are not affected by changes in the level of activity. However, a variation of the basic fixed costs known as stepped fixed costs change if activity exceeds a given range. Thus if a decision causes total fixed costs to change and in such circumstances they are relevant. When fixed costs become relevant to a decision by changing ,the extra fixed costs are usually referred to as the incremental costs.

EXAMPLE HIGH LOW METHOD WITH STEPPED FIXED COSTS 1
A business has experienced the following labour costs: Output Cost (units) K 7, ,000 12, ,000 9, ,500 Fixed costs increase by K15,000 for output in excess of 10,000 units. Using the high low method what is the estimated cost of producing 14,000 units? 142,000 157,000 163,000 178,000

STEP 1:Select highest and lowest activities together with their respective costs as follows: Output Total costs (units) K Highest , ,000 Lowest , ,000 Difference , ,000 Less: stepped Fixed costs (15,000) Variable element 5, ,000

STEP 2: Calculate variable cost per unit as follows: VC = K40,000 = K8 per unit 5,000 units

Step 3 :Calculate total fixed costs after and before stepped fixed costs: After stepped fixed costs at highest activity Total cost = K141,000 Total variable costs = 12,000 x K8 K96,000 Therefore Total fixed costs = K45,000 Total fixed costs before the stepped fixed costs: = K45,000 - K15,000 = K30,000

STEP 4:Derive the model in the form TC = TFC + VCQ based on activity whose cost is to be calculated for 14,000 units the relevant model is: TC = K45,000 + K8q Where q in the question is 14,000 TC becomes K45, (K8 x 14,000) TC = K157,000

EXAMPLE HIGH LOW METHOD WITH STEPPED FIXED COSTS 2
An organisation has the following total costs at three activity levels: Activity level (units) 4,000 6,000 7,500 Total cost K40,800 K50,000 $K4,800 Variable costs per unit is constant within this activity range and there is a step up of 10% in the total fixed costs when the activity level exceeds 5,500 units. What is the total cost at an activity level of 5,000 units? K44,000 K44,800 K45,400 K46,800

STEP 1:Calculate the variable cost per unit by comparing two output levels where fixed costs will be the same Output Total costs (units) K Highest , ,800 Lowest , ,000 Difference , ,800

STEP 2: Calculate variable cost per unit as follows: VC = K4,800 1,500 units = K3.20 per unit

Step 3 :Calculate total fixed costs after and before stepped fixed costs: After stepped fixed costs at highest activity Total cost = K54,800 Total variable costs =7,500 x K3.20 K24,000 Therefore Total fixed costs = K30,800 Total fixed costs before the stepped fixed costs: = 110% = K30,800 100% = X X = 100% x K30,800 110% = K28,000

STEP 4:Derive the model in the form TC = TFC + VCQ based on activity whose cost is to be calculated ,for 5,000 units the relevant model is: TC = K28,000 + K3.2q Where q in the question is 5,000 TC becomes K28, (K3.2 x 5,000) TC = K44,000

RELEVANCE OF SEMI VARIABLE COSTS
Semi –variable costs are those costs which comprise both a fixed and variable element. The variable element is relevant to decision making using the same reasoning as was applied to variable costs. The fixed element is irrelevant unless it is stepped fixed cost element described earlier. It is therefore necessary to separate the fixed and variable components of semi-variable costs to isolate the relevant and non – relevant parts of the cost. The high low method will usually be the most suitable method to apply because of its simplicity.

SHORTTERM DECISION MAKING
DEVELOPING CVP ANALYSIS

ASSUMPTIONS BEHIND C-V-P ANALYSIS
Cost –volume –profit (CVP)/breakeven analysis is the study of interrelationships between costs, volume and profit at various levels of activity. It is based on the following assumptions: All costs can be resolved into fixed and Variable elements. Fixed costs will remain constant in total, and are unaffected by the level of output or activity in the period. Variable are constant per unit irrespective of the number of units produced but total variable costs vary proportionately with activity. 9/18/2018

The selling price is constant per unit irrespective of the number of units to be sold. Over the activity range being considered costs and revenues behave in a linear fashion. That the only factor affecting costs and revenue is volume. That technology, production methods and efficiency remain unchanged. Particularly for graphical methods that the analysis relates to one product only or to a constant product mix. 9/18/2018

There are no stock level changes or that stocks are valued at marginal cost only. It will be apparent that these are over simplifying assumptions for many practical problems. It is because of this that C-V-P analysis can only be an approximate guide for decision making. 9/18/2018

COSTS ,VOLUMES AND PROFITS
As a business produces and sales more output during a period ,its profits will increase. This is partly because sales revenue rises as sales volume goes up. It is also partly because unit costs fall. As the volume of production and sales go up ,the fixed cost per unit falls since the same amount of fixed costs are shared between a larger number of units. 9/18/2018

EXAMPLE 1:UNIT COSTS AND PROFITS
A business makes and sells a single product. Its variable cost is K6 and it sells for K11 per unit. Fixed costs are K40,000 each month. If 10,000 units ,15,000 units and 20,000 units are produced and sold. Show the total profits made. Show the unit costs, revenue and profit Show the total profits and contribution per unit using the marginal costing approach. 9/18/2018

SOLUTION :TOTAL PROFITS
Solution: Total revenue @ 10,000 units= K11 x 10,000 = K110,000. Total variable 10,000 units = K6 x 10,000 = K60,000. Total fixed cost = K40,000. 9/18/2018

SOLUTION :TOTAL PROFITS
TOTAL COSTS,REVENUE AND PROFIT Units 10,000 15,000 20,000 K Total revenue 110,000 165,000 220,000 Less:Total costs Variable costs 60,000 90,000 120,000 Fixed costs 40,000 Total costs 100,000 130,000 160,000 Profit 35,000 9/18/2018

SOLUTION :UNIT COSTS,REVENUES AND PROFITS
As the sales volume goes up, the cost per unit falls and the profit per unit rises. This is because the fixed costs per unit falls as volume increases ,in contrast to unit variable costs and the selling price per unit which are constant at all volumes of sales. 9/18/2018

SOLUTION :UNIT COSTS,REVENUES AND PROFITS
UNIT COSTS,REVENUE AND PROFIT Units 10,000 15,000 20,000 K Total revenue 11.00 Less:Total costs Variable costs 6.00 Fixed costs 4.00 2.67 2.00 Total costs 10.00 8.67 8.00 Profit 1.00 2.33 3.00 9/18/2018

SOLUTION:CALCULATION OF PROFITS USING MARGINAL COSTING
TOTAL COSTS,REVENUE AND PROFIT MARGINAL COSTING APPROACH Units 10,000 15,000 20,000 K K per unit Total revenue 110,000 11.00 165,000 220,000 Less :Total variable costs Variable costs 60,000 6.00 90,000 120,000 Contribution 50,000 5.00 75,000 100,000 Less: Fixed costs 40,000 Profit 35,000 9/18/2018

THE IMPORTANCE OF CONTRIBUTION IN CVP ANALYSIS
Contribution is a key concept in CVP analysis ,because if we assume a constant variable cost per unit and the same selling price at all volumes of output, the contribution per unit is a constant value(and the contribution per K1 of sales is also a constant value). Definitions: Unit contribution =Selling price per unit - variable cost per unit. 9/18/2018

THE IMPORTANCE OF CONTRIBUTION IN CVP ANALYSIS
Total contribution = Volume of sales in units x unit contribution or = Total sales revenue – total variable costs or = Total sales revenue x contribution/sales ratio Contribution /sales ratio or C/S ratio = contribution per unit /sales price per unit or Total contribution /Total sales revenue 9/18/2018

USES OF CVP ANALYSIS CVP analysis is used widely in preparing financial reports for management . It is a simple technique that can be used to estimate profits and make decisions about the best course of action to take. Applications of CVP analysis include: Estimating future profits Calculating the breakeven point for sales Analysing the margin of safety in the budget Calculating the volume of sales required to achieve a target profit Deciding on a selling price for a product 9/18/2018

EXAMPLE ESTIMATING FUTURE PROFITS
CVP analysis can be used to estimate future profits. Example : ZC limited makes and sells a single product. Its budgeted sales for the next year are 40,000 units. The product sells for K18. Variable costs of production and sales are: Direct materials K2.40, Direct labour K5.00, Variable production overheads K0.50 Variable selling overheads K1.25. Fixed expenses are estimated for the year as follows: Fixed production overheads K80,000,Administration K80,000 , Fixed selling costs K90,000. Required calculate the expected profit for the year? 9/18/2018

SOLUTION: ESTIMATING FUTURE PROFITS
Step one: Calculate the total variable cost per unit = K( ) = K9.15 Step two :calculate total fixed costs = K(80, , ,000) = K250,000. Step three: Calculate contribution per unit = K18 - K 9.15 = K8.85. Step four: Calculate total contribution = K8.85 x 40,000 units = K354,000. Step five: Calculate profits = K354,000 - K250,000 = K104,000. 9/18/2018

BREAK EVEN ANALYSIS Break even is the volume of sales at which the business just breaks even, so that it makes neither a loss nor a profit. At breakeven point total costs equal total revenue. Calculating the breakeven point can be useful for management because it shows the minimum volume of sales which must be achieved to avoid making a loss in the period. At breakeven point total contribution is just large enough to cover fixed costs. In other words at breakeven point Total contribution = Fixed costs 9/18/2018

BREAKEVEN ANALYSIS The break-even point in units of sale can therefore be calculated as follows: Breakeven point in units of sale =Total fixed costs contribution per unit 9/18/2018

EXAMPLE:BREAKEVEN ANALYSIS
Example:A business makes and sells a single product, which sells for K15 per unit and which has a unit variable cost of K7.Fixed costs are expected to be K500,000 for the next year. Required: What is the breakeven point in units? What is the breakeven point in sales revenue? What would be the break even point if fixed costs went up to K540,000? What would be the break even point if fixed costs were K500,000 but unit variable costs went up to K9? 9/18/2018

SOLUTION: BREAK EVEN ANALYSIS
Unit contribution = K15 - K7 = K8.Fixed costs = K500,000 Break even point = K500,000 = 62,500 units K8 per unit 62,500 units at K15 each results in a break even sales revenue of K937,500.This figure can also be calculated by using another formula: Break even point in K of sale = Fixed costs C/S ratio In the example the C/S ratio is K8/K15 = The break even point is therefore K500,000/ = K937,500 9/18/2018

SOLUTION: BREAK EVEN ANALYSIS
Unit contribution = K8 .Fixed costs = K540,000 Break even point = K540,000 = 67,500 units K8 per unit Unit contribution = K15 - K9 = K6. Fixed costs = K500,000. Breakeven point = K500,000 = 83,333 units K6 per unit 9/18/2018

MARGIN OF SAFETY Actual sales volume may not be the same as budgeted sales volume. Actual sales may fall short of budget or exceed budget. A useful analysis of business risk is to look at what might happen to profit if actual sales volume is less than budgeted. The difference between the budgeted sales volume and the break even sales volume is known as the margin of safety. It is simply a measurement of how far sales can fall short of budget before the business makes a loss. 9/18/2018

MARGIN OF SAFETY A large margin of safety indicates a low risk of making a loss, whereas a small margin of safety might indicate a fairly high risk of making a loss. It therefore indicates the vulnerability of a business to a fall in demand. It is usually expressed as a percentage of budgeted sales. Margin of safety = (Budgeted sales volume – Breakeven sales volume) ÷ Budgeted sales volume 9/18/2018

EXAMPLE:MARGIN OF SAFETY
Given the following information calculate the margin of safety: Budgeted sales: 80,000 units Selling price: $8 Variable costs: $4 per unit Fixed costs: $200,000 pa 9/18/2018

EXAMPLE:MARGIN OF SAFETY
Breakeven volume : K200,000 = 50,000 units K8 - K4 The margin of safety = (80,000 – 50,000) units = 30,000 units or 37.5% of budget Actual sales would have to be almost 40% less than budgeted before the business made a loss. 9/18/2018

TARGET PROFIT CVP analysis can also be used to calculate the volume of sales that would be required to achieve a target level of profit. To achieve a target profit, the business will have to earn enough contribution to cover all of its fixed costs and then make the required amount of profit. Target contribution = Fixed costs + Target profits. Sales volume required to make target profits = Fixed costs + Target profits Contribution per unit 9/18/2018

EXAMPLE:TARGET PROFIT
NorthCliffe Engineering Ltd has capital employed of K1 million. Its target return on capital employed is 20% per annum. Northcliffe manufactures a standard Product “N1” Selling price of “N1” = K 60 unit Variable costs per unit = K20 Annual fixed costs = K100,000 Required: What volume of sales is required to achieve that target profit? 9/18/2018

SOLUTION:TARGET PROFIT
The target profit is 20% of K1 million = K200,000 K Target profit ,000 Fixed costs ,000 Target contribution 300,000 Target sales volume = Target contribution contribution per unit = K300,000 /K40 = 7,500 units Target sales revenue = Target contribution C/S ratio 9/18/2018

SOLUTION:TARGET PROFIT
C/S ratio = K40 / K60 = Target sales revenue = K300,000 / = K450,000. Proof: Sales volume 7,500 units K Sales revenue 450,000 Less: Variable costs 150,000 Contribution 300,000 Fixed costs 100,000 Profit ,000 9/18/2018

DECIDING ON A SELLING PRICE
CVP analysis can be useful in helping management to compare different courses of action and select the option that will earn the biggest profit. For example management might be considering two or more different selling prices for a product and want to select the profit maximising price. The profit maximising price is the contribution maximising price. 9/18/2018

EXAMPLE DECIDING ON A SELLING PRICE
A company has developed a new product which has a variable cost of K12.Fixed costs relating to this product are K48,000 each month. Management is trying to decide what the selling price for the product should be .A market research report has suggested that monthly sales demand for the product will depend on the selling price chosen as follows: Sales price K16 K17 K18 Expected monthly Sales demand in units17,000 14,500 11,500 Required: Identify the selling price at which the expected profit will be maximised. 9/18/2018

SOLUTION: DECIDING ON A SELLING PRICE
K K K Sales price Variable costs Unit contribution Expected demand 17,000 14,500 11,500 Total contribution K 68,000 72,500 69,000 Less: Fixed costs K 48,000 48,000 48,000 Profits 20,000 24,500 21,000 The profit maximising selling price is the contribution maximising selling price i.e. K17 9/18/2018

CLASS EXERCISE DECIDING ON SELLING PRICE
Your company is about to launch a new product ,ZG, which has a unit variable cost of K8. Management is trying to decide whether to sell the product at K11 per unit or at K12 per unit. At a price of K11,annual sales demand is expected to be 160,000 units. Annual fixed costs relating to the product will be K550,000. Required: Calculate the breakeven and margin of safety in units? Calculate the margin of safety as a %/ Which of the two prices will maximise expected profit? 9/18/2018

SOLUTION:CLASS EXERCISE DECIDING ON SELLING PRICE
Break even point K K =550,000/K3 $550,00/K4 Margin of safety =200,00 = 160,000 Less , ,500 Margin of safety 16, ,500 Margin of safety as% =16,667 x ,500 x 100 200, ,000 8.3% % 9/18/2018

SOLUTION:CLASS EXERCISE DECIDING ON SELLING PRICE
K K Sales price Variable costs 8 8 Unit contribution 3 4 Expected sales demand 200, ,000 Annual contribution K 600, ,000 Annual fixed costs 550, ,000 Annual profit 50,000 90,000 Of the two sales prices under consideration for product ZG a price of K12 appears to be preferable. 9/18/2018

THE BREAK EVEN CHARTs CVP analysis can be presented in the form of a diagram or graph ,as well as in figures. A graphical presentation of CVP analysis can be made in either: A conventional break even chart ; or A profit /volume chart. The conventional break even chart plots total costs and total revenues at different output levels; The y axis represents costs and revenues. The x axis represents the volume of sales in units or K of sale. 9/18/2018

THE CONVENTIONAL BREAK EVEN CHART
A line is drawn on the graph for sales revenue. This is K0 when sales volume is zero. It rises in a straight line. To draw the revenue line, you therefore need to plot one more point on the graph and join this to the origin of the graph(x =0,y=0). For example, if a product has a sales price of K5 ,you might plot the point x = 100 units ,y = K500 on the graph and join this to the origin. A line is drawn for fixed costs. This runs parallel to the x axis and cuts the y axis at the amount of fixed costs. 9/18/2018

A line is then drawn for total costs. To do this ,we must add variable costs to fixed costs. When sales volume is zero, variable costs are K0,so total costs = fixed costs. To draw the total cost line ,you therefore need to plot one more point on the graph and join this to the fixed costs at zero sales volume (x = 0, y = fixed costs). For example, if a product has a variable cost of K2, and fixed costs are K250 you might plot the point x = 100 units ,y = K450 on the graph (variable costs of K200 plus fixed costs of K250) and join this to the fixed costs at zero sales volume ( x = 0, y = fixed costs) 9/18/2018

CONVENTIONAL OR TRADITIONAL BREAK EVEN CHART
9/18/2018

The chart is normally drawn up to the budgeted sales volume. Break even point is where total revenues and total costs are the same. At sales volume below this point there will be a loss. At sales volumes above break even point there will a profit. The amount of profit and loss at any given output can be read of the chart, as the difference between the total revenue and the total cost lines. The margin of safety can also be shown on the chart, as the difference between the budgeted sales volume and break even sales volume. 9/18/2018

CONTRIBUTION BREAKEVEN CHART
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PROFIT /VOLUME CHART Break even charts usually show both costs and revenues over a given range of activity but it is not easy to identify exactly what the loss or profit is at each volume of sales. A graph that simply shows the net profit and loss at any given level of activity is called a profit/volume chart. Given the assumptions of constant selling prices and variable unit costs at all volumes of output, the profit /volume chart shows profit or loss as a straight-line. 9/18/2018

PROFIT /VOLUME CHART The x axis represents sales volume, in units or K. The y axis represents loss or profit. The x axis cuts the y axis at break even point (profit = 0). Losses are plotted below the line and profits above the line. To draw the chart, only two points need to be plotted on the graph. These can be : Profit at planned or budgeted sales volume ;and Loss at zero sales volume ,which is equal to total fixed costs 9/18/2018

P/ V CHART 9/18/2018

CHANGES IN COSTS AND REVENUE
As costs and revenues change the breakeven point and margin of safety will also change. Generally as the selling price of a product increases then, assuming that costs do not change the break even point will fall and the margin of safety will increase. Conversely as costs rise assuming that the selling price remains the same, then the break even point will rise and the margin of safety will fall. 9/18/2018

EXAMPLE:CHANGES IN COSTS AND REVENUE
A company plans to sell 10,000 units at K40 per unit. It has a variable cost of K10 and fixed costs of K90,000. Calculate there current breakeven point and margin of safety. Consider separately the impact of the following changes on breakeven point and margin of safety: A K10 rise in selling price Fixed costs double A 40% increase in variable costs 9/18/2018

SOLUTION:CHANGES IN COSTS AND REVENUE
Current : Breakeven point = K90,000/K(40 -10) = 3,000 units Margin of safety = 10,000 – 3,000 = 7,000 units(70 %) Rise in selling price Breakeven point = K90,000 /K(50 – 10) = 2,250 units Margin of safety = 10,000 – 2,250 = 7,750 units (78%) 9/18/2018

SOLUTION:CHANGES IN COSTS AND REVENUE
Rise in fixed costs: Breakeven point = K180,000 /$(40 -10) = 6,000 units Margin of safety = 10,000 – 6,000 = 4,000 units (40%) It can be seen from this solution that the break even point and margin of safety change in indirect proportion to fixed costs. Rise in variable costs Breakeven point = K90,000 / K(40-14) = =3,462 units Margin of safety =10,000 -3,462 = 6,538 units(65%) 9/18/2018

CLASS EXERCISE CVP ANALYSIS
A company makes and sells widgets. The sales price is $10 per unit. The company does not know what its variable costs and fixed costs are, but the following estimates of total cost have been produced. At sales volume of 55,000 units, total costs =K607,500. At sales volume of 70,000 units, total costs K675,000. Required; Calculate the break even point in sales Calculate the margin of safety if budgeted sales are 68,000 units. Calculate the volume of sales required to achieve a target profit of K40,000.Comment on whether you think this target profit is achievable. 9/18/2018

SOLUTION: CVP ANALYSIS
The first step is to calculate a variable cost per unit using the high –low method. Activity Costs K Highest 70, ,000 Lowest 55, ,000 Change 15, ,500 Variable cost per unit = K67,500/15,000 = K4.50 per unit 9/18/2018

Calculate the total fixed costs by substituting in the highest or lowest activity: Units 70, ,000 Total costs K675,000 K607,500 Less variables @ K4.50 per unit K315,000 K247,500 Therefore fixed costs K360,000 K360,000 Contribution per unit = Sales price – variable cost = K10 - K4.50 = K5.50 Breakeven point = K360,000/K5.50 =65,455 units 9/18/2018

Margin of safety = 68,000 – 65,455 = 2,545 units. As a percentage of budgeted sales this is 3.7%. To achieve a target profit of K40,000 total contribution must be K400,000 ($360,000 fixed costs + K40,000 profit). Required sales = K400,000 / K5.5 contribution per unit = 72,727 units. This is higher sales volume than the high level of costs used in the high low method analysis. This must raise doubts as to whether a sales volume of nearly 73,000 units and a profit of K40,000 are achievable at the current sales price and cost levels. 9/18/2018

ECONOMIST ‘S BREAK EVEN CHART
An alternative set of assumptions can be described in terms of the economist ‘s break even chart. It is unlikely that as the volume of sales rises, the sales price per unit can be kept unchanged. In general prices have to be reduced in order to sell more. Unit costs of materials and labour rise as the output volume increases. 9/18/2018

The beneficial effect of quantity discounts on materials is offset by higher labour costs because of less efficient production and overtime rates or having to take on less skilled labour employees to do the additional work. The economist ‘s concept of break even chart has two breakeven points. 9/18/2018

Cost Total costs and Total revenue revenue (K) Pm Quantity 9/18/2018

Profit is maximised at the level of output Pm where there is the greatest vertical difference between the total cost and total revenue curves. The assumption of constant unit selling price at all levels of output (contained in the accountant ‘s breakeven chart) applies to those markets where there is a going world price such as oil , grain and minerals. One individual supplier can sell as much or as little as he can produce at that price. 9/18/2018

Some observers have suggested that the development of world product in many classes of manufactured good may have extended the concept of a going world price into many new areas of the economy in recent years. 9/18/2018

THE REVENUE CURVES The economist ‘s model of revenue behaviour is based on the principle that in order to sell more units , demand must be increased and to do this the price must be reduced. K A B Quantity 9/18/2018

THE REVENUE CURVES It may be that to push quantity sold beyond a certain point unit selling prices must be reduced to a point where the revenue curve actually starts to fall. However, this chart assumes that the activity levels under review range from zero to maximum, and this is unlikely to be appropriate in reality. It is more likely that the range of activity will lie between points A and B . It can be seen that between these points the revenue curve is virtually a straight line. 9/18/2018

CURVI –LINEAR VARIABLE COSTS
A similar principle applies to variable costs where it could be argued that the effects of quatity discounts on materials , and overtime /inefficiencies on labour costs cause these to be depicted as curves: Materials K A B Quantity 9/18/2018

labour K A B Quantity 9/18/2018

However, two arguments exist to support the accountant ‘s linear model in respect of these costs: If each of these types of cost is added together their total will approximate to a straight line. Within a likely range of activity the curves themselves are virtually linear. Thus ,business decisions may often be made with very limited parameters . 9/18/2018

One may be considering the relative merits of two alternative levels of output which are quite close together. Within the limited range of output levels under review, a cost function may be treated as being linear. 9/18/2018

MULTI PRODUCT PROFIT VOLUME CHART :A MAJOR ASSUMPTION
Organisations typically produce and sell a variety of products and services. To perform breakeven analysis in a multi-product organisation, however, a constant product sales mix must be assumed. In other words, we have to assume that whenever x units of product A are sold, y units of product B and z units of product C are also sold. Such an assumption allows us to calculate a weighted average contribution per mix, the weighting being on the basis of the quantities of each product in the constant mix. 9/18/2018

MULTI PRODUCT PROFIT VOLUME CHART :A MAJOR ASSUMPTION
This means that the unit contribution of the product that makes up the largest proportion of the mix has the greatest impact on the average contribution per mix. The only situation when the mix of products does not affect the analysis is when all of the products have the same ratio of contribution to sales (C/S ratio) 9/18/2018

BREAKEVEN POINT FOR MULTIPLE PRODUCTS
The breakeven point (in number of mixes) for a standard mix of products is calculated as fixed costs/contribution per mix. PL produces and sells two products. The M sells for K7 per unit and has a total variable cost of K2.94 per unit, while the N sells for K15 per unit and has a total variable cost of K4.50 per unit. The marketing department has estimated that for every five units of M sold, one unit of N will be sold. 9/18/2018

BREAKEVEN POINT FOR MULTIPLE PRODUCTS
The organisation's fixed costs total K36,000. Required Calculate the breakeven point for PL. 9/18/2018

SOLUTION BREAKEVEN POINT FOR MULTIPLE PRODUCTS
We calculate the breakeven point as follows. Step 1 :Calculate contribution per unit M N K per unit K per unit Selling price Variable cost Contribution Step 2 : Calculate contribution per mix = (K4.06 × 5) + (K10.50 × 1) = K30.80 9/18/2018

Step 3: Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K36,000/K30.80 = 1,169 mixes (rounded) Step 4 :Calculate the breakeven point in terms of the number of units of the products = (1,169 × 5) 5,845 units of M and (1,169 × 1) 1,169 units of N (rounded) 9/18/2018

Step 5 Calculate the breakeven point in terms of revenue = (5,845 × K7) + (1,169 × K15) = K40,915 of M and K17,535 of N = K58,450 in total It is important to note that the breakeven point is not K58,450 of revenue, whatever the mix of products. The breakeven point is K58,450 provided that the sales mix remains 5:1. Likewise the breakeven point is not at a production/sales level of (5, ,169) 7,014 units. Rather, it is when 5,845 units of M and 1,169 units of N are sold, assuming a sales mix of 5:1. 9/18/2018

CONTRIBUTION TO SALES (C/S) RATIO FOR MULTIPLE PRODUCTS
The breakeven point in terms of sales revenue can be calculated as fixed costs/average C/S ratio. Any change in the proportions of products in the mix will change the contribution per mix and the average C/S ratio and hence the breakeven point. Using the information given earlier calculate the C/S ratio and the breakeven sales revenue for each of the products. 9/18/2018

SOLUTION CONTRIBUTION TO SALES (C/S) RATIO FOR MULTIPLE PRODUCTS
Step 1: Calculate revenue per mix = (5 × K7) + (1× K15) = K50 Step 2 :Calculate contribution per mix = K30.80 (as above) Step 3 :Calculate average C/S ratio = (K30.80/K50.00) × 100% = 61.6% Step 4: Calculate breakeven point (total) = fixed costs ÷ C/S ratio = K36,000/0.616 = K58,442 (rounded) 9/18/2018

SOLUTION CONTRIBUTION TO SALES (C/S) RATIO FOR MULTIPLE PRODUCTS
Step 5 :Calculate revenue ratio of mix = (5 × K7) : (1× K15) = 35:15, or 7:3 Step 6 :Calculate breakeven sales M = K58,442 × 7/10 = K40,909 rounded N = K58,442 × 3/10 = K17,533 rounded 9/18/2018

MARGIN OF SAFETY FOR MULTIPLE PRODUCTS
The margin of safety for a multi-product organisation is equal to the budgeted sales in the standard mix less the breakeven sales in the standard mix. It may be expressed as a percentage of the budgeted sales. 9/18/2018

EXAMPLE: MARGIN OF SAFETY FOR MULTIPLE PRODUCTS
BA produces and sells two products. The W sells for K8 per unit and has a total variable cost of K3.80 per unit, while the R sells for K14 per unit and has a total variable cost of K4.20. For every five units of W sold, six units of R are sold. BA's fixed costs are K43,890 per period. Budgeted sales revenue for next period is K74,400, in the standard mix. Required :Calculate the margin of safety in terms of sales revenue and also as a percentage of budgeted sales revenue 9/18/2018

SOLUTION: MARGIN OF SAFETY FOR MULTIPLE PRODUCTS
Step 1 :Calculate contribution per unit W R K per unit K per unit Selling price Variable cost Contribution Step 2: Calculate contribution per mix = (K4.20 × 5) + (K9.80 × 6) = K79.80 9/18/2018

Step 3 :Calculate the breakeven point in terms of the number of mixes = fixed costs/contribution per mix = K43,890/K79.80 = 550 mixes Step 4: Calculate the breakeven point in terms of the number of units of the products = (550 x 5) 2,750 units of W and (550 x 6) 3,300 units of R 9/18/2018

Step 5 :Calculate the breakeven point in terms of revenue = (2,750 × K8) + (3,300 × K14) = K22,000 of W and K46,200 of R = K68,200 in total 9/18/2018

Step 5 :Calculate the margin of safety = budgeted sales – breakeven sales = K74,400 – K68,200 = K6,200 sales in total, in the standard mix Or, as a percentage = (K74,400 – K68,200)/K74,400 x 100% = 8.3% of budgeted sales 9/18/2018

TARGET PROFITS FOR MULTIPLE PRODUCTS
The number of mixes of products required to be sold to achieve a target profit is calculated as (fixed costs + required profit)/contribution per mix. When an organisation wishes to achieve a certain level of profit during a period. To achieve this profit, contribution must cover fixed costs and leave the required profit: So total contribution required = fixed costs + required profit. 9/18/2018

EXAMPLE: TARGET PROFITS FOR MULTIPLE PRODUCTS
An organisation makes and sells three products, F, G and H. The products are sold in the proportions F:G:H = 2:1:3. The organisation's fixed costs are K80,000 per month and details of the products are as follows. Selling price Variable cost Product K per unit K per unit F G H 9/18/2018

The organisation wishes to earn a profit of K52,000 next month. Calculate the required sales value of each product in order to achieve this target profit. 9/18/2018

Step 1: Calculate contribution per unit F G H K per unit K per unit K per unit Selling price Variable cost Contribution Step 2 ;Calculate contribution per mix = (K6 × 2) + (K3 × 1) + (K6 × 3) = K33 9/18/2018

Step 3 :Calculate the required number of mixes = (Fixed costs + required profit)/contribution per mix = (K80,000 + K52,000)/K33 = 4,000 mixes 9/18/2018

Step 4 :Calculate the required sales in terms of the number of units of the products and sales revenue of each product Sales Selling revenue Product price required Units K per unit K F 4,000 × , ,000 G 4,000 × , ,000 H ,000 × , ,000 Total 464,000 9/18/2018

The sales revenue of K464,000 will generate a profit of K52,000 if the products are sold in the mix 2:1:3. Alternatively the C/S ratio could be used to determine the required sales revenue for a profit of K52,000. The method is again similar to that demonstrated earlier when calculating the breakeven point 9/18/2018

MULTI-PRODUCT BREAKEVEN CHARTS
Breakeven charts for multiple products can be drawn if a constant product sales mix is assumed. A very serious limitation of breakeven charts is that they can show the costs, revenues, profits and margins of safety for a single product only, or at best for a single 'sales mix' of products. 9/18/2018

APPROACH 1: USE THE TOTAL VALUES TO DRAW THE GRAPAH
Assume that budgeted sales are 2,000 units of X, 4,000 units of Y and 3,000 units of Z. A breakeven chart would make the assumption that output and sales of X, Y and Z are in the proportions 2,000: 4,000: 3,000 at all levels of activity, in other words that the sales mix is 'fixed' in these proportions. Given costs of K3, K4 and K5 and selling price of K8, K6 and K6 for X ,Y and Z respectively prepare the traditional break even chart. Total Fixed costs are K10,000. 9/18/2018

APPROACH 1: OUTPUT IN K SALES AND A CONSTANT PRODUCT MIX
We begin by carrying out some calculations. Budgeted costs Costs (K) Revenue(K) Variable costs of X (2,000 × K3) 6,000 X (2,000 × K8) 16,000 Variable costs of Y (4,000 × K4) 16,000 Y(4,000 × K6) 24,000 Variable costs of Z (3,000 × K5) 15,000 Z (3,000 × K6) 18,000 Total variable costs , Budgeted revenue ,000 Fixed costs ,000 Total budgeted costs ,000 9/18/2018

Costs & Revenue Sales Breakeven point Total costs 20 10 , , , , , sales units 9/18/2018

breakeven point is approximately K27,500 of sales revenue. This may either be read from the chart or computed mathematically. The budgeted C/S ratio for all three products together is contribution/sales = K(58,000 – 37,000)/K58,000 = 36.21%. The required contribution to break even is K10,000, the amount of fixed costs. The breakeven point is K10,000/36.21% = K27,500 (approx) in sales revenue. The margin of safety is approximately K(58,000 – 27,500) = K30,500. 9/18/2018

APPROACH 2: PLOT PRODUCTS IN A SEQUENCE
The products could be plotted in a particular sequence (say X first, then Y, then Z). Using the data from Approach 1, we can calculate cumulative costs and revenues as follows Product Cumulative units Cumulative costs Cumulative revenue K K Nil , Nil X(2,000 units) 2, , ,000 Y (4,000 units) 6, , ,000 Z (3,000 units) 9, , ,000 9/18/2018

APPROACH 2: PRODUCTS IN SEQUENCE
Costs & revenues K’ Revenue 50 Breakeven point Total cost Fixed costs 0 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 9/18/2018

In this case the breakeven point occurs at 2,000 units of sales (2,000 units of product X). The margin of safety is roughly 4,000 units of Y and 3,000 units of Z. 9/18/2018

Assume products are sold in descending order of contribution/sales ratio. Example: Budgeted data: Sales Contrbution K K Product A , ,000 Product B , ,000 Product C , ,400 Total , ,400 Total annual fixed costs K8,000. Draw a profit volume chart? 9/18/2018

Start by putting the products in descending order of C/S ratios. Contribution sales ratios (Contribution/sales x 100) Product A = 2,000/10,000 x 100 = 20% 3rd Product B = 7,000/14,000 x 100 = 50% 1st Product C = 2,400/8000 x = 30% nd 9/18/2018

The order of sale and cumulative profit figures will be assumed to be as follows: Rank Product Total Total Fixed Profit/ sales Contrib Costs (Loss) K K K K 1St B , , , (1,000) 2nd C , ,400 22, , , ,400 3rd A , ,000 32, , , ,400 9/18/2018

Profit (K) 8,000 6,000 4,000 A 2,000 C 0 10,000 20,000 30,000 40,000 (Sales K) (2,000) B (4,000) Fixed costs (6,000) (8,000) Loss (K) 9/18/2018

Total sales of the three products are expected to be K32,000 and total contribution will be K11,400, so the weighted average contribution /sales ratio for the period is (11,400/32,000) = or %. The breakeven point assuming that the three products are sold in their budgeted proportions can be calculated in revenue terms as: Contribution required to breakeven /contribution /sales ratio. Fixed costs /contribution /sales ratio. In the example ,the break even point in sales revenue is K8,000/ = K22,456. 9/18/2018

LIMITATIONS OF CVP ANALYSIS
Breakeven analysis is a useful technique for managers as it can provide simple and quick estimates. Breakeven charts provide a graphical representation of breakeven arithmetic. Breakeven analysis does however, have a number of limitations. It can only apply to a single product or a single mix of a group of products. A breakeven chart may be time –consuming to prepare It assumes fixed costs are constant at all levels of output. 9/18/2018

LIMITATIONS OF CVP ANALYSIS
It assumes that variable costs are the same per unit at all levels of output It assumes that sales prices are constant at all levels of output. It assumes production and sales are the same (inventory levels are ignored) It ignores the uncertainty in the estimates of fixed costs and the variable cost per unit 9/18/2018

DECISION MAKING AND RELEVANT COST INFORMATION
Managers often use financial information to help them make decisions. Typically a manager will want to know whether profits will be increased if a particular course of action is taken ,or which of two alternative courses of action will earn more profit. Absorption costing information is of limited value for decision making and can even be misleading. 9/18/2018

This is because absorption costing includes absorbed overhead but fixed overheads often do not change as a result of a decision. For decision making it is necessary to identify the costs and revenues that will be affected as a result of taking one course of action rather than another. The costs that would be affected by a decision are known as relevant costs. 9/18/2018

A managerial decision is a choice between alternative options, possibly including the option of doing nothing. The choice is likely to have cost implications ,in the sense that the amount of some costs will differ depending upon which option is selected . Such costs are described as relevant to the decision ;the manager must consider what will happen to these costs as a result of this decision. 9/18/2018

On the other hand there may be costs which will remain the same no matter which option is selected such costs are not relevant to the decision. A similar argument applies to relevant and non-relevant revenues. Since relevant costs and revenues are those which are different ,the term effectively means costs and revenues which change as a result of the decision. 9/18/2018

Since it is not possible to change the past (because it has already happened),then relevant costs and revenues must be future costs and revenues . Past costs are usually referred to as sunk costs and can never be relevant to a decision. 9/18/2018

RELEVANT COSTS A relevant cost is a future incremental cash flow which arises as a direct result of a decision They have the following features : They are incremental costs: this means that it will change as a direct consequence of the decision. Thus relevant costs are often calculated as any change in contribution plus any change in specific fixed costs. A relevant cost is a future cost. This means that any costs that have been incurred in the past (sunk costs) cannot be relevant to a decision. 9/18/2018

A relevant cost is a cash flow.
RELEVANT COSTS A relevant cost is a cash flow. Any costs that are not cash items are not relevant. These include the following: Non cash charges such as depreciation of non current assets. Notional costs such as notional interest charges. Absorbed fixed overheads 9/18/2018

RELEVANT COSTS Cash overheads incurred are relevant if they change as a result of the decision and are future cash flows ,but absorbed overheads are a notional accounting cost. Absorbed fixed overheads are not avoided as a result of a decision but will have to be reallocated elsewhere. A relevant cost is one that will arise as a direct consequence of the decision being taken. 9/18/2018

RELEVANT COSTS If a cost is a future cash flow that will be incurred anyway regardless of the decision that is taken, it is not relevant to the decision and so should be ignored. As a general rule it is assumed that variable costs are relevant costs and fixed costs are unchanged regardless of a decision and so are irrelevant. However, in many decision situations the effect of a decision could be to alter the variable cost per unit to result in a step rise or fall in total fixed costs. These changes provided that they affect future cash flows, are relevant costs 9/18/2018

SUNK COSTS A sunk cost is a cost that has already been incurred or committed and so cannot be relevant for decision making. For example suppose that a company is wondering whether to sell a new product as part of its summer season range. It has spent K10,000 on market research ,which has shown that if the product is sold for K10 per unit(variable cost of sale = K8 per unit),the company will sell 4,000 units. 9/18/2018

SUNK COSTS The money spent on market research is a sunk cost and irrelevant to the decision . The question for the company ‘s management is: should we make a product for a variable cost of K8 in order to sell 4,000 units at K10 each. The contribution and profit will increase by K8,000. 9/18/2018

AVOIDABLE ,UNAVOIDABLE AND CASH FLOW COSTS
If a cost can be avoided its is a relevant cost because a decision can be taken that will prevent the cost from occurring. If a cost is unavoidable it cannot be relevant to a decision because it will be incurred anyway. Cash flows are those arising in cash terms as a consequence of the decision. Such costs can never include past costs arising from past transactions. 9/18/2018

AVOIDABLE ,UNAVOIDABLE AND CASH FLOW COSTS
Costs such as depreciation based on the cost of an asset already acquired can never be relevant nor can committed costs e.g. Future lease payments in respect of an asset already leased ,nor will reallocations of total cost ever be relevant to the decision . Only costs which change in total because of the decision are relevant costs. 9/18/2018

THE RELEVANCE OF VARIABLE COSTS AND FIXED COSTS
Variable cost are costs that change in total in proportion to changes in the level of activity. Therefore whenever the decision involves increases or decreases in activity it is almost certain that variable costs will be affected and therefore will be relevant to the decision. On the other hand fixed costs are constant regardless of the level of activity. 9/18/2018

THE RELEVANCE OF VARIABLE COSTS AND FIXED COSTS
Unless the decision causes fixed costs to be increased or decreased (in which case the fixed cost would rise or fall as a step cost, fixed costs are irrelevant for a decision and should therefore be ignored. Where unit variable costs are constant and total fixed costs are also constant the relevant costs for a decision are simply marginal costs and CVP analysis can be used for relevant cost analysis. 9/18/2018

OPPORTUNITY COSTS Opportunity cost is the value of the benefit forgone from the next best alternative course of action. Relevant costs may involve incurring a cost or losing a revenue which could be obtained from an alternative course of action. Opportunity cost can only arise when resources are limited or only one option can be selected. Otherwise an organisation will select all profitable options. 9/18/2018

THE RELEVANT COSTS OF MATERIALS
The relevant costs of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In this case the relevant cost of using them is the higher of the following: Their current resale value The value they would obtain if they were put to an alternative use. 9/18/2018

THE RELEVANT COSTS OF MATERIALS
If the materials have no resale value and no other possible use, then the relevant cost of using them for the opportunity under consideration would be nil. The decision tree below can be used to identify the appropriate cost to use for materials 9/18/2018

RELEVANT CASH FLOWS - MATERIALS
9/18/2018

EXAMPLE 1: RELEVANT COSTS FOR MATERIALS
A new contract requires the use of 50 tons of metal ZX 81.This metal is used regularly on all of the firm ‘s projects. There are 100 tons of ZX 81 held in inventory at the moment, which were bought for k200 per ton. The current purchase price is k210 per ton, and the metal could be disposed of for net scrap proceeds of k150 per ton. With what cost should the contract be charged for the ZX 81? 9/18/2018

SOLUTION EXAMPLE 1 The use of the material already held in inventory for the new contract means that more ZX 81 must be bought for normal workings. The cost to the organisation is therefore the money spent on purchase ,no matter whether existing inventory or new inventory is used on the contract . Assuming that the additional purchases are made in the near future, the relevant cost to the organisation is current purchase price i.e. 50 tons x k210 = $10,500. Note that the original purchase price is a sunk cost and is never relevant. 9/18/2018

EXAMPLE 2 Suppose that there is no alternative use for ZX 81 other than a scrap sale, but that there is only 25 tons held in inventory. Solution: The relevant cost of 25 tons is k150 per ton. The organisation must then purchase a further 25 tons and assuming this is the near future it will cost k210 per ton. The contract must be charged with; K 25 K ,750 25 K ,250 Total ,000 9/18/2018

THE RELEVANT COSTS OF LABOUR
9/18/2018

EXAMPLE 1:RELEVANT COSTS FOR LABOUR
A mining operation uses skilled labour costing K4 per hour, which generates a contribution after deducting these labour costs of K3 per hour. A new project is now being considered which requires 5,000 hours of skilled labour. There is a shortage of the required labour. Any use on the new project must be transferred from normal working. What is the relevant cost of using the skilled labour on the project? 9/18/2018

SOLUTION 1:RELEVANT COSTS FOR LABOUR
The contribution cash flow lost if the labour is transferred from normal working is: K Contribution per hour lost from Normal working 3 Add; back labour cost per hour Which is not saved 4 Cash lost per hour as a result of The labour transfer 7 The contract should be charged with 5,000 x K7 = K35,000. 9/18/2018

EXAMPLE 2:RELEVANT COSTS FOR LABOUR
A mining operation uses skilled labour costing K4 per hour, which generates a contribution after deducting these labour costs of K3 per hour. A new project is now being considered which requires 5,000 hours of skilled labour. There is a surplus of skilled labour already employed (and paid) by the business and sufficient to cope with the new project. The presently idle men are being paid full wages What is the relevant cost of using the skilled labour on the project? 9/18/2018

SOLUTION 2:RELEVANT COSTS FOR LABOUR
Solution :What contribution cash flow is lost if the labour is transferred to the project from doing nothing/Answer ;nothing The relevant cost is therefore zero. 9/18/2018

CLASS EXERCISE Z ltd has 50 kg of material P currently held in inventory which was bought five years ago for K70.It is no longer used but could be sold for K3 per kg. Z ltd is currently pricing a job which could use 40 kg of Material .What is the relevant cost of P which should be included in the price? 9/18/2018

EXAMPLE RELEVANT COSTS
A company has been asked by a customer to carry out a job for which materials would have to be purchased, costing K600 and which incur other additional expenses of K200.The labour time required to do the job would be 50 hours and labour is paid at K8 per hour. If the company does the job, the labour to do the work would have to be switched from other operations that earn a contribution of K5 per labour hour. Overheads costs are absorbed at the rate of K10 per direct labour hour. The customer is willing to pay K1,800 for the job. Required Should the company accept the job? 9/18/2018

SOLUTION: RELEVANT COSTS
Here there is an opportunity cost of using the labour to do the job, costing K5 per labour hour. The labour cost of K8 per hour is also a relevant cost, even though the employees will be paid anyway. This is because the contribution of K5 per hour is calculated on the assumption that direct labour is a variable cost. The alternative work therefore earns a contribution of K5 per hour after covering labour costs of K8 per hour. 9/18/2018

Absorbed production overhead is not a relevant cost, because it represents an allocation of overhead that doesn’t change as a result of the decision. The only relevant overhead costs would costs would be any change in actual overhead spending. For example any variable overhead costs would be a relevant cost. In this example there is no suggestion that the overhead costs are variable costs. 9/18/2018

The relevant information is as follows: K Direct materials Other expenses Direct labour (50 hours x K8) 400 Opportunity cost (50 hours x K5) 250 Total relevant costs ,450 Price for the job ,800 Incremental profit If the company wishes to maximise its profits ,it should agree to take on the job for K1,800. 9/18/2018

QUALITATIVE FACTORS Not all aspects of decision making are amenable to a strictly quantitative analysis. The following factors (interested groups ) may be affected by a decision; Employees ;any decision which affects working practices will have a morale affect on employees. Some decisions, such as to close a department , will have a greater effect than others –for example an increase in production –but both will affect employees. 9/18/2018

QUALITATIVE FACTORS Customers; customers will be affected by any decision which changes the finished product or its availability. For example the deletion of a product will force customers to choose an alternative item. Suppliers: Suppliers will be affected by changes to production which require different raw materials or delivery schedules. For example, an increase in production may cause the supplier to increase its production of the raw material. 9/18/2018

QUALITATIVE FACTORS Competitors ;Any decision to change product specifications or pricing will affect competitors ,who will then choose whether or not to respond. Scarce resource management; A change in production as a result of the decision may alter the demand for individual resources and the result of the decision may alter availability. Social and environmental effects of a particular objective. The opinions of customers and employees. 9/18/2018

LIMITING FACTORS AND LIMITING FACTOR DECISIONS
Often the only factor stopping a business from increasing its profits is sales demand. However, situations sometimes arise when a resource is in short supply, and a business cannot make enough units to meet sales demand. A resource in short supply is called a limiting factor ,because it sets a limit on what can be achieved by an organisation. 9/18/2018

A scarce resource is an item in short supply. In the context of decision making in business it is a resource in short supply as a consequence of which the organisation is limited in its ability to provide and sell more products or services Such scarce resources are called limiting factors. 9/18/2018

Typically a scarce resource could be : A limit to the availability of a key item of raw materials or a key component. A limit to the availability of a key type of labour, such as skilled or qualified labour limit to the available machine time. 9/18/2018

For example ,if a business has just two machines for producing a range of products ,the available machine time will be limited to the number of hours in which the two machines can be operated each week or month. When a business has a limiting factor ,a decision must be taken about how the available resource should be used. 9/18/2018

If the business makes and sells more than one product, and all products make use of the scarce resource ,the decision involves allocating the available resources to the production of one or more of the products, up to the point where all the scarce resources are used up. Marginal costing principles can be used to identify how a scarce resource should be used to maximise profits. 9/18/2018

However, in order to do this ,a business must first of all recognise that there is a limiting factor. To identify a scarce resource, it is necessary to: Obtain estimates of sales demand for each of the products (or services) sold by the business. Obtain estimates of the quantities of resources needed to make the units to meet the sales demand. 9/18/2018

IDENTIFYING A SCARCE RESOURCE
From these estimates, calculate how many units of each resource will be needed For each resource, compare the amount needed with the amount available. If the amount needed exceeds the amount available, the resource is in short supply and so is a limiting factor. 9/18/2018

EXAMPLE:IDENTIFYING A SCARCE RESOURCE
X LTD makes two products X and Y ,one unit of product X requires 5 kg of materials and 2 hours of labour. One unit of product Y requires 4 kg of the same material and 3 hours of the same labour. There are only 2,000 hours labour available each week and the maximum amount of material available each week is 3,000 kg. Potential sales demand each week is 300 units of product X and 450 units of product Y. Required: Identify whether materials or labour is a limiting factor. 9/18/2018

SOLUTION:IDENTIFYING A SCARCE RESOURCE
Solution Materials Labour KGs hours Required for 300 units of (300 x 5) (300 x 2) Product X = 1, = 600 Required for 450 units of (450 x 4) (450 x 3) Product Y =1, =1,350 Total required , ,950 Amount available 3, ,000 Surplus /(shortfall) (300) So material is a limiting factor. 9/18/2018

This will maximise total contribution.
LIMITING FACTOR DECISIONS:IDENTIFYING THE MOST PROFITABLE USE OF A SCARCE RESOURCE When a business has a limiting factor, its total sales volume is restricted by the its availability. If the business makes and sells just one product, all it can do is to make and sell as many units of the product that it can with the scarce resource available. This will maximise total contribution. 9/18/2018

LIMITING FACTOR DECISIONS:IDENTIFYING THE MOST PROFITABLE USE OF A SCARCE RESOURCE
If the business makes and sells two or more products and each product makes use of the scarce resource ,profits will be maximised by making the product which has the highest contribution per unit of limiting factor. 9/18/2018

CLASS EXERCISE :LIMITING FACTOR
A Ltd makes two products ,X and Y. Both products use the same machine and a common raw material, supplies of which are limited to 200 machine hours and K500 per week respectively. Individual product details are as follows; Product X Y Machine hours/unit Cost of materials/unit K10 K5 Contribution /unit K20 K15 Required; Identify the limiting factor. Recommend which product A Ltd should make and sell (assuming that demand is unlimited) 9/18/2018

CLASS EXERCISE :LIMITING FACTOR
Production is restricted as follows; Machine hours 200/5 = 40 units of X; or 200/2.5 = 80 units of Y Materials K500/K10 = 50 units of X; or K500/K5 = 100 units of Y Therefore machine hours are the limiting factor since production of Products X and Y are most severely limited by machine hours. Benefit per machine hour Product X K20/5 hours = K4/hour Product Y K15/2.5 hours = K6/hour Product Y should be made because it has the highest contribution per unit of limiting factor (machine hours) 9/18/2018

LIMITING FACTORS AND SALES DEMAND CONSTRAINTS
In the above activity ,the sales demand for the products was unlimited. Once the contribution per unit of the limiting factor has been determined ,the product earning the highest contribution per unit of limiting factor should be made until the scarce resource is fully utilised. The other products will not be made and sold at all, if the aim is to maximise total contribution and total profit. 9/18/2018

In many situations, however , there is a maximum level of sales demand for each product. In these situations, there is no point in making more units of a product than it can sell. The problem is then to decide which products to make and sell , given the limiting factor and the limitations of sales demand. To solve such problems a ranking is approach is used. 9/18/2018

The products (or services) of the business are ranked in order of their contribution per unit of limiting factor. 9/18/2018

The approach ,if there are two or more products all using a scarce resource ,is as follows: Identify the scarce resource. Calculate contribution per unit of product Calculate the units of the scarce resource used by each product. Calculate the contribution per unit of scarce resource. 9/18/2018

Rank products according to the contribution earned per unit of scarce resource (with the highest being ranked first). Allocate the scarce resource according to the ranking. 9/18/2018

EXAMPLE ;LIMITING FACTOR ANSLYSIS
Z Ltd makes two products which both use the same types of material and grade of labour, but in different quantities as shown by the table below: Product A B Labour hours/unit 2 4 Material kg/unit 5 2 Demand (Units) Sales price per unit K30 K36 During each week the maximum number of labour hours available is 1,800 and the quantity of material available is limited to 3,000 kg. The labour rate is K5 per hour and material costs K2 per kg. Required: Advise Z Ltd how many of each product it should make 9/18/2018

SOLUTION ;LIMITING FACTOR ANSLYSIS
Step one: Identify the scarce resource Maximum labour required is (500 x 2) + (250 x 4) = 2,000 hours. There are only 1,800 available so labour is a limiting factor. Step 2: Calculate the contribution per unit of product Product A B K K Sales price Less: Labour costs Material costs Contribution 9/18/2018

Step 3: Calculate the contribution per unit of limiting factor Product A B K K Contribution per Labour hours per unit 2 hours 4 Contribution per labour hour K5 K3 Rank 9/18/2018

Step 4: Determine production plan Product Production hours per unit Total in units hours A x 2 hours = 1,000 B x 4 hours = Total hours ,800 Total contribution =(500 x K10) +(200 xK12) = K7,400 9/18/2018

CLASS EXERCISE RANKING PRODUCTS
C ltd makes three products :A, B and C. All three products use the same type of labour which is limited to 1,500 hours per month. Individual product details are as follows; Product A B C Contribution /unit K25 K40 K35 Labour hours /unit Maximum demand Required: Advise C ltd as to the quantities of each product its should make. 9/18/2018

SOLUTION;RANKING PRODUCTS
Product A B C Contribution per K25 =K5.00K40= K6.6 K35 =K4.375 labour hour Rank order 2nd 1st rd Firstly make 200 units of product B(maximum demand) and then with the remaining 300 hours make 60 units of Product A. 9/18/2018

TWO POTENTIALLY LIMITING FACTORS
It could be that two limiting factors are potentially limiting (and there are also product/service demand limitations). The approach in these situations is to find out which factor (if any) prevents the business from fulfilling maximum demand.

EXAMPLE TWO POTENTIALLY LIMITING FACTORS
Lucky manufactures and sells three products X Y and Z for which budgeted sales demand, unit selling prices and unit variable costs are as follows: X Y Z Budgeted sales demand units 500 units units K’000 K’ K’000 K’ K’ K’000 Unit sales price Variable costs: Materials Labour Unit contribution

EXAMPLE TWO POTENTIALLY LIMITING FACTORS
The organization has exiting inventory of 250 units of X and 200 units of Z, which it is quite willing to use up to meet sales demand. All three products use the same direct materials and the same type of direct labour. In the next year, the available supply of materials will be restricted to K4,800,000(at cost)and the available supply of labour to K6,600,000 (at cost). Required Determine what product mix and sales mix would maximize the organization‘s profits in the next year.

ASSUMPTIONS IN LIMITING FACTOR ANALYSIS
Fixed costs will be the same regardless of the decision that is taken, and so the profit maximizing and contribution maximizing output level will be the same. This may not be true as some fixed costs might be directly attributable to a product or service. The unit variable cost is constant regardless of the output quantity of a product or service. This implies: The price of resources will be unchanged regardless of quantity e.g. there will be no bulk purchase discounts of raw materials.

ASSUMPTIONS IN LIMITING FACTOR ANALYSIS
Efficiency and productivity levels will be unchanged; regardless of output quantity, the direct labour productivity, the machine time per unit, and the materials consumption per unit will remain the same. The estimates of sales demand for each product, and the resources required to make each product are known with certainty

THROUGHPUT ACCOUNTING
The concept of throughput accounting has been developed from TOC (Theory of constraints) as an alternative system of cost and management accounting in a JIT environment. Throughput accounting (TA) assumes that a manager has a given set of resources available These comprise existing buildings, capital equipment and labour force. Using these resources, purchased materials and parts must be processed to generate sales revenue.

THROUGHPUT ACCOUNTING
Given this scenario the most appropriate financial objective to set for doing this is the maximisation of throughput which is defined as: sales revenue less direct material cost

THEORY OF CONSTRAINTS (TOC)
Theory of constraints (TOC) is an approach to production management which aims to maximise sales revenue less material cost. It focuses on factors such as bottlenecks which act as constraints to this maximisation. Bottleneck resource or binding constraint – is an activity which has a lower capacity than preceding or subsequent activities, thereby limiting throughput.

THROUGHPUT ACCOUNTING - BOTTLENECKS
This is a bottleneck & inventory will build up Materials Prep’n Component Prep’n Final Assembly Sales 100 units per hr 50 units per hr 100 units per hr

One process will inevitably act as a bottleneck (or limiting factor) and constrain throughput – this is known as the binding constraint in TOC terminology. Steps should be taken to remove this by buying more equipment, improving production flow and so on. But ultimately there will always be a binding constraint, unless capacity is far greater than sales demand or all processes are totally in balance, which is unlikely.

Output through the binding constraint should never be delayed or held up otherwise sales will be lost. To avoid this happening a buffer inventory should be built up immediately prior to the bottleneck or binding constraint. This is the only inventory that the business should hold, with the exception of possibly a very small amount of finished goods inventory and raw materials that are consistent with the JIT approach. .

Operations prior to the binding constraint should operate at the same speed as the binding constraint, otherwise work in progress (other than the buffer inventory) will be built up. According to TOC, inventory costs money in terms of storage space and interest costs, and so inventory is not desirable. The theory of constraints (TOC) is an approach to production management formulated by Goldratt and Cox in the USA in 1986. Goldratt devised a five-step approach to summarise the key stages of TOC.

Step 1 : Identify the constraint. Step 2 :Decide how to exploit the constraint. Step 3: Subordinate and synchronise everything else to the decisions made in step 2. Step 4: Elevate the performance of the constraint. Step 5: If the constraint has shifted during any of the above steps, go back to step 1. Do not allow inertia to cause a new constraint.

The overall aim of TOC is to maximise throughput contribution (sales revenue – material cost) while keeping conversion cost (all operating costs except material costs) and investment costs (inventory, equipment and so on) to the minimum. A strategy for increasing throughput contribution will only be accepted if conversion and investment costs increase by a lower amount than the increase in contribution

BOTTLENECK RESOURCES The management of bottlenecks (constraints) therefore becomes a primary concern of the manager seeking to increase throughput. There are other factors which might limit throughput other than a lack of production resources (bottlenecks) and these need to be addressed as well. The existence of an uncompetitive selling price The need to deliver on time to particular customers The lack of product quality and reliability The lack of reliable material suppliers The shortage of production resources

COST CLASSIFICATION In throughput accounting system the only costs which are considered to be variable are material costs. Conversion costs(labour and indirect costs ) are classified as being fixed and therefore may be grouped together as total factory costs. A calculation may be made of the cost per factory hour by relating this cost to the number of hours available on the bottleneck resource.

PERFORMANCE MEASURES IN THROUGHPUT ACCOUNTING
Throughput is defined as sales less material costs. Others costs are considered to be fixed so this is similar in principle to the concept of contribution.

RETURN PER FACTORY HOUR
The efficiency with which a particular product makes use of the bottleneck resource is calculated as follows: Return per factory hour = Sales - direct material costs Usage of bottleneck resource in hours (factory hours) This enables businesses to take short-term decisions when a resource is in scarce supply. Notice the similarity of this calculation to the contribution per unit of a limiting factor.

THROUGHPUT ACCOUNTING RATIO
This is the relationship between the return per factory hour and the cost of each factory hour. This is found by: Return per factory hour Total conversion cost per factory hour Again factory hours are measured in terms of use of the bottleneck resource.

THROUGHPUT ACCOUNTING RATIO
Businesses should try to maximise the throughput accounting ratio by making process improvements or product specification changes This measure has the advantage of including the costs involved in running the factory. The higher the ratio, the more profitable the company. (If a product has a ratio of less than one, the organisation loses money every time it is made.)

EXAMPLE THROUGHPUT ACCOUNTING RATIO
A Ltd manufactures a single product ,which it sells for K10 per unit. The direct material cost of the product is K3 per unit. Other factory costs amount to K50,000 per month. The bottleneck factor is the assembly of the unit , which is labour intensive process. There are 20,000 assembly hours available each month ,with each unit taking two hours to assemble. Calculate the throughput accounting ratio for the product.

SOLUTION THROUGHPUT ACCOUNTING RATIO
Return per factory hour = Sales - Material costs Usage of bottleneck resource = K K3 2 = K3.50 Cost per factory hour : = Total factory costs Bottleneck resource hours available = K50,000/20,000 = K2.50

SOLUTION THROUGHPUT ACCOUNTING RATIO
Return per factory hour Cost per factory hour = K3.50 /K2.50 = 1.4

THROUGHPUT AND DECISION MAKING
In a throughput environment, production priority must be given to the products best able to generate throughput, that is those products that maximise throughput per unit of bottleneck resource. The TA ratio can be used to assess the relative earning capabilities of different products and hence can help with decision making.

EXAMPLE:THROUGHPUT AND DECISION MAKING
Corrie produces three products, X, Y and Z. The capacity of Corrie's plant is restricted by process alpha. Process alpha is expected to be operational for eight hours per day and can produce 1,200 units of X per hour, 1,500 units of Y per hour, and 600 units of Z per hour. Selling prices and material costs for each product are as follows. Product Selling price Material cost Throughput contribution K per unit K per unit K per unit X Y Z Conversion costs are K720,000 per day.

EXAMPLE:THROUGHPUT AND DECISION MAKING
Required Calculate the profit per day if daily output achieved is 6,000 units of X, 4,500 units of Y and 1,200 units of Z. Calculate the TA ratio for each product. In the absence of demand restrictions for the three products, advise Corrie's management on the optimal production plan.

SOLUTION:THROUGHPUT AND DECISION MAKING
Profit per day = throughput contribution – conversion cost = [(K70 x 6,000) + (K80 x 4,500) + (K 200 X 1,200)] – K 720,000 = K300,000 TA ratio = throughput contribution per factory hour/ conversion cost per factory hour Conversion cost per factory hour = K720,000/8 = K 90,000 Product Throughput Cost per TA contribution per factory hour factory hour ratio X K 70 X 1,200 = K84, / K90, Y K 80 X 1,500 = K120,000 / K90, Z K 200 X = K120,000 / K90,

SOLUTION:THROUGHPUT AND DECISION MAKING
An attempt should be made to remove the restriction on output caused by process alpha's capacity. This will probably result in another bottleneck emerging elsewhere. The extra capacity required to remove the restriction could be obtained by working overtime, making process improvements or product specification changes. Until the volume of throughput can be increased, output should be concentrated upon products Y and Z (greatest TA ratios), unless there are good marketing reasons for continuing the current production mix. Product X is losing money every time it is produced so, unless there are good reasons why it is being produced, for example it has only just been introduced and is expected to become more profitable, Corrie should consider ceasing production of X.

HOW CAN A BUSINESS IMPROVE A THROUGHPUT ACCOUNTING RATIO?
•Measures: Increase sales price per unit •Consequences : Demand for the product may fall • Measures: Reduce material costs per unit, .e.g change materials and/or suppliers •Consequences : Quality may fall and bulk discounts may be lost • Measures ;Reduce operating expenses • Consequences : Quality may fall and/or errors increase

LIMITATIONS OF THE THROUGHPUT ACCOUNTING RATIO
It is a highly short term perspective on costs, regarding only material as variable or directly activity related. It neglects the costs of overheads and people. As a result there will always be the risk of sub optimal profit performance. TA will only work effectively where material remains a high proportion of the costs or selling price. Also there must be a situation where demand is constant enough or high enough to always put pressure on output and production resources.

LIMITATIONS OF THE THROUGHPUT ACCOUNTING RATIO
The huge majority of organisations cannot produce and market products based on short-term profit considerations alone. Strategic-level issues such as market developments, product developments and the stage reached in the product life cycle must also be taken into account. It is also suggested that TA with its emphasis on direct materials is an ideal complement to ABC, which can draw attention to the overheads. In this way a comprehensive cover of costs can be achieved.

PROBLEMS INVOLVING PRODUCT MIX AND DISCONTINUANCE /SHUTDOWN
It is considered more informative to present comparison statements on a contribution basis. The term contribution describes the amount which a product provides or contributes towards a fund out of which fixed overheads may be paid, the balance being net profit. Where two or more products are manufactured in a factory and share all production facilities the fixed overhead can only be apportioned on an arbitrary basis.

EXAMPLE :PROBLEMS INVOLVING PRODUCT MIX AND DISCONTINUANCE /SHUTDOWN
A factory manufactures three components X ,Y and Z and the budgeted production for the year is 1,000 units ,1,500 units and 2,000 units respectively. Fixed overheads amounts to K6,750 and has been apportioned on the basis of budgeted units :K1,500 to X , K2,250 to Y and K3,000 to Z. Sales and variables costs are as follows: Component X Y Z Selling price per unit K K K5 Variable costs K K K4

Prepare a budgeted profit and loss report based on the following basis: The traditional absorption costing approach. Suitable for short-term decision making using contribution approach and attributable profits approach assuming : All fixed costs are common costs to all the products? Only 50% of the fixed costs are common costs?

Profit statement using the traditional absorption costing approach: Component X Y Z Total Sales units 1,000 1,500 2,000 4,500 K Sales value 4,000 9,000 10,000 23,000 Less :Costs Variable costs 6,000 8,000 15,000 Fixed overheads 2,250 3,000 6,750 Total costs (2,500) (8,250) (11,000) (21,750) Profit /(Loss) 750 -1,000 1,250

Profit statement using the marginal costing approach: Component X Y Z Total Sales units 1,000 1,500 2,000 4,500 K Sales value 4,000 9,000 10,000 23,000 Less : Variable Costs Variable costs (1,000) (6,000) (8,000) (15,000) Contribution 3,000 8,000 Less : Fixed costs (6,750) Net profit 1,250

Profit statement using the attributable profits approach: Component X Y Z Total Sales units 1,000 1,500 2,000 4,500 K Sales value 4,000 9,000 10,000 23,000 Less :Costs Variable costs 6,000 8,000 15,000 Attributable Fixed overheads 750 1,125 3,375 Total costs (1,750) (7,125) (9,500) (18,375) Attributable Profit /(Loss) 2,250 1,875 500 4,625 Less : Common Fixed costs (3,375) Net profit 1,250

CLOSURE OF A BUSINESS SEGMENT
Part of a business may appear to be unprofitable. The segment may for example be a product, a department or channel of distribution. In evaluating closure, the cost accountant should identify: Loss of contribution from the segment. Savings in specific fixed costs from closure Penalties e.g. redundancy , compensation to customers etc. Alternative use for resources released non –quantifiable effects.

EXAMPLE CLOSURE OF A BUSINESS SEGMENT
Harolds department store comprises three departments –Men ‘s wear , Ladies ‘s wear and Unisex. The store budget is as follows: Mens Ladies Unisex Total K Sales value 40,000 60,000 20,000 120,000 Direct cost of sales 36,000 15,000 71,000 Department costs 5,000 10,000 3,000 18,000 Apportioned costs Profit /(loss) 9,000 -3,000 16,000

It is suggested that Unisex be closed to increase the size of Men ‘s and Ladies’. What information is relevant or required: Solution: Lost contribution from Unisex closure: Sales K20,000 Less: Direct cost of sales (K15,000) Less: Department costs (K3,000) Total Contribution lost K2,000 Store costs will be reapportioned to Men's and ladies if Unisex closes they are unavoidable

Profit statement if unisex is closed for the organisation: Mens Ladies Total K Sales value 40,000 60,000 100,000 Direct cost of sales 20,000 36,000 56,000 Department costs 5,000 10,000 15,000 14,000 29,000 Common stores costs Net profit

Other factors to consider include the following: Possible increase in Men’s /Ladies ‘sales volume Will unisex staff be dismissed of transferred to Men’s /Ladies? Reorganisation costs e.g. repartitioning ,stock disposal. Loss of custom because Unisex attracts certain types of customers who will not buy in Mens /Ladies.

COMPARING SEGMENT PROFITABILITY
When presenting information for comparing results or plans for different products, departments etc., it is useful to show gross and net contribution for each segment. The information in the example above could have been presented in the following format:

Mens Ladies Unisex Total K Sales value 40,000 60,000 20,000 120,000 Direct cost of sales (20,000) (36,000) (15,000) (71,000) Gross Contribution 24,000 5,000 49,000 Department costs (5,000) (10,000) (3,000) (18,000) Net contribution 15,000 14,000 2,000 31,000 Common stores costs Net profit 16,000

In addition the statement should include performance indicators relevant to the type of operation. For a department store such indicators would include; C/S ratios (based on gross contribution ) Gross and net contribution per unit of floor space. Gross or net contribution per employee

TEMPORARY SHUT DOWN When a business has experienced trading difficulties which do not appear likely to improve in the immediate future ,consideration may be given to closing down operations temporarily. Factors other than cost which will influence the decision are: Suspending production and sales of products will result in their leaving the public eye. Dismissal of labour force will entail bad feeling and possible difficulty in recruitment when operations are restarted. Danger of plant obsolescence Difficulty and cost of closing down and restarting operations in certain industries e.g. a blast furnace.

TEMPORARY SHUT DOWN The temporary closure of a business will result in additional expenditure e.g. plant will require protective coverings ,services will be disconnected . In the same way, additional expenditure will be incurred when the business restarts. On the other hand, a temporary closure may enable the business to reorganise efficiently to take full advantage of improved trading conditions when they return.

TEMPORARY SHUT DOWN In the short term a business can continue to operate while marginal contribution equals fixed expenses. In periods of trading difficulty , as long as some contribution is made towards fixed expenses, it will generally be worthwhile continuing operations.

EXAMPLE:TEMPORARY SHUT DOWN
A company is operating at 40% capacity and is considering closing down its factory for one year after which time the demand for its product is expected to increase substantially he following data applies: K Sales value at 40% capacity ,000 Marginal costs of sales at 40 % capacity 40,000 Fixed costs ,000 Fixed costs which will remain if the factory is closed amount to K20,000.The cost of closing down operations will amount to K4,000.Prepare a statement to show the best course of action.

STATEMENT OF PROFIT AND LOSS Continuing operation Temporary closure K Sales 60,000 Fixed Expenses (20,000) Marginal cost of sales (40,000) Closing down costs (4,000) Contribution to fixed costs 20,000 Fixed costs (50,000) Net loss (30,000) -24,000

Ignoring non cost considerations the company will minimise its losses by closing down for one year. It is important to note that the marginal contribution of K20,000 does not cover the difference between existing fixed costs and those that remain on closure (i.e. K50,000 – K24,000) = K26,000 compared with K20,000.

DIVESTMENT A company may have to drop existing product -market areas as well as develop new ones. For instance a product might be nearing the end of its life cycle and it might be better to kill it off once sales have fallen below a certain level rather than let it decline to zero. Advertising expenditure to boost the sale of a declining product is often not worthwhile in terms of the return achieved. The precise timing of a decision to drop a certain line (or cease selling it in a particular market) is admittedly difficult, but most companies probably tend to leave it too late.

DIVESTMENT Some of the reasons for the reluctance to drop products are; The company might have invested large sums of money in the project and does not want to abandon it. Companies should be prepared to cut their losses it is no good throwing good money after money. Perhaps the person who designed the product is still with the firm. He and probably many others are attached to the product and want to keep it going. In addition the marketing director might be an optimist who thinks that sales of the product will suddenly turn up again.

DIVESTMENT Attention is directed towards new products and no one thinks what should happen to the old ones(until resources are scarce and there is a search for economies). There is a feeling that customers should be kept happy and a fear that they will be lost to the firm if a particular product line is withdrawn. This fear need have no foundation if a new product is launched as the old one is withdrawn. Anyway , does it matter if some old customers are lost as long as more new ones are gained.

There are however, arguments against this :
DIVESTMENT A very real problem exists of what to do with the work force who have been running an existing production line if it is suddenly shut down. It may be easier to absorb the work force into other areas if production is run down gradually. There are however, arguments against this : Morale among those remaining on the product may fall if they know that their job is eventually going to go and they do not know when or where they will be moved. If this loss of morale is reflected in their work ,the product may become even more uneconomic.

DIVESTMENT A sensible programme of retraining can ensure that workers released from an old line will be available for a new process. It may prove more costly to keep the workers employed on the old process than to pay them for doing nothing until their services are again required elsewhere. The detailed programming of divestment is of course a matter for the administrative and operating plans, but at the strategic level it is important to emphasise that this is one area for examination.

MAKE OR BUY DECISIONS Occasionally a business may have the opportunity to purchase from another company a component part or assembly which it currently produces from its own resources. In examining the choice , management must first consider the following questions : Is the alternative source of supply available only temporarily or for the foreseeable future? Is there spare production capacity available now and /or in the future?

SPARE CAPACITY If the business is operating below maximum capacity , production resources will be idle if the component is purchased from outside. The Fixed costs of those resources are irrelevant to the decision in the short term as they will be incurred whether the component is made or purchased. Purchase would be recommended ,therefore, only if the buying price were less than the variable costs of internal manufacture.

SPARE CAPACITY In long term, however , the business may dispense with or transfer some of its resources and may purchase from outside if it thereby saves more than the extra cost of purchasing. Example: A company manufactures an assembly used in the production of one of its product lines. The department in which the assembly is produced incurs fixed costs of K24,000 pa. The variable costs of production are K2.55 per unit. The assembly could be bought outside at a cost of K2.65 per unit.

SPARE CAPACITY The current annual requirement is for 80,000 assemblies per year . Should the company continue to manufacture the assembly , or should it be purchased from the outside suppliers? Solution: A decision to purchase from outside would cost the company K(2.65 – K2.55 ) = 10 ngwee per unit, which for 80,000 assemblies would amount to K8,000 pa. Thus the fixed costs of K24,000 will require analysis to determine if more than K8,000 would actually be saved if production of the assembly were discontinued.

OTHER CONSIDERATIONS AFFECTING THE DECISION
Management would need to consider other factors before reaching a decision . Some would be quantifiable and some not: Continuity and control of supply: Can the outside company be relied upon to meet the requirements in terms of quantity, quality, delivery dates and price stability? Alternative use of resources : can the resources used to make this article be transferred to another activity which will save cost or increase revenue. Social /Legal :will the decision affect contractual or ethical obligations to employees or business connections?

CAPACITY EXHAUSTED If a business cannot fulfil orders because it has used up all available capacity, it may be forced to purchase from outside in the short term (unless it is cheaper to refuse sales). In the longer term ,management may look to other alternatives such as capital expenditure. It may be however that a variety of components is produced from common resources and management would try to arrange manufacture or purchase to use its available capacity most profitably.

CAPACITY EXHAUSTED In such a situation the limiting factor concept makes it easier to formulate the optimum plans. Priority for purchase would be indicated by ranking components in relation to the excess purchasing cost per unit of limiting factor.

EXAMPLE:CAPACITY EXHAUSTED
Fidgets Ltd manufactures three components used in its finished product. The component workshop is currently unable to meet the demand for components and the possibility of sub-contracting part of the requirement is being investigated on the basis of the following data:

Component A B C K K K Variable costs of production Outside purchase price Excess cost per unit (0.50) Machine hours per unit Labour hours per unit You are required: To decide which component should be bought from outside if the company is operating at full capacity.

To decide which component should be bought from outside if production is limited to 4,000 machine hours per week. To decide which component should be bought from outside if production is limited to 4,000 labour hours per week.

SOLUTION:CAPACITY EXHAUSTED
Component A should always be bought out regardless of any limiting factors , as its variable cost production is higher than the outside purchase price. If machine hours are limited to 4,000 hours: Component B C Excess cost K K6 Machine hours per unit Excess cost per machine hour K K3 Component C has the lowest excess cost per limiting factor and should therefore be bought from outside.

Proof : Component B C Units produced in 4,000 hours , ,000 K K Production costs , ,000 Purchase costs , ,000 Excess cost of purchase 16, ,000

If labour hours are limited to 4,000 hours: Component B C Excess cost K K6 Labour hours Excess cost per labour hour K Therefore component B has the lowest excess cost per limiting factor and should be bought from outside.

Proof : Component B C Units produced in 4,000 hours , ,000 K K Production costs , ,000 Purchase costs , ,000 Excess cost of purchase 4, ,000

EVALUATING PROPOSALS :VOLUME AND COST STRUCTURE CHANGES
Management will require information to evaluate proposals aimed at increasing profit by changing operating strategy. The cost accountant will need to show clearly the effect of the proposals on profit by pin pointing the changes in costs and revenues and by quantifying the margin of error which will cause the proposal to be unviable.

EXAMPLE EVALUATING PROPOSALS :VOLUME AND COST STRUCTURE CHANGES
A company produces and sells one product and its forecast for the next financial year is as follows: K'000 Sales 100,000 8 800 Variable costs: Materials 300 Labour 200 (500) Contribution (K 3 per unit) Fixed costs (150) Net profit 150

EXAMPLE EVALUATING PROPOSALS :VOLUME AND COST STRUCTURE CHANGES
As an attempt to increase net profit two proposals have been put forward: To launch an advertising campaign costing K14,000.This will increase the sales to 150,000 units, although the price will have to be reduced to K7. To produce some components at present purchased from suppliers. This will reduce material costs by 20% but will increase fixed costs by K72,000. Evaluate the two proposals on financial grounds only.

SOLUTION : EVALUATING PROPOSALS :VOLUME AND COST STRUCTURE CHANGES
Proposal (a) will increase the sales revenue but the increase in costs will be greater: K'000 Sales 150,000 7 1,050 Variable costs: Materials (K300,000/100,000 X 150,000) 450 Labour (K200,000/100,000 X 150,000) 300 (750) Contribution (K 3 per unit) Fixed costs (164) Net profit 136

Proposal (a) is therefore of no value and sales must be increased by a further 7,000 units to maintain net profit: Advertising costs = K14,000 Contribution per unit = K2 Additional volume required = 7,000 units Proposal (b) reduces variable costs by K60,000 but increases fixed costs by K72,000 and is therefore not recommended unless the total volume increases as a result of the policy (e.g. if the supply of the components were previously a limiting factor).

The increase in sales needed to maintain profit at K150,000 (assuming the price remains at K8) would be : Reduced profits at 100,000 units = K12,000 Revised contribution per unit = K3.60  Additional volume required = 3,333 units

UTILISATION OF SPARE CAPACITY
Where production is below capacity, opportunities may arise for sales at a specially reduced price example ,export orders or manufacturing under another brand name. Such opportunities are worthwhile if the answer to two key questions is yes: Is spare capacity available? Does additional revenue (units x price ) exceed additional costs (units x variable cost)?

UTILISATION OF SPARE CAPACITY
However , the evaluation should also consider; Is there an alternative more profitable way of utilising spare capacity (e.g. sales promotion ,making an alternative product)? Will fixed costs be unchanged if the order is accepted? Will accepting one order at below normal selling price lead other customers to ask for price cuts? The longer the time period in question ,the more important are other factors.

EXAMPLE :UTILISATION OF SPARE CAPACITY
At a production level of 8,000 units per month, which is 80% of capacity ,the budget of Export Ltd is as shown below? An opportunity arises to export 1,000 units per month at a price of K4 per unit. Should the contract be accepted?

EXAMPLE :UTILISATION OF SPARE CAPACITY
Per unit 8,000 units K Sales 5.00 40,000 Variable costs: Direct labour 1.00 8,000 Raw materials 1.50 12,000 Variable overheads 0.50 4,000 3.00 24,000 Fixed costs Total 4.50 36,000 Budgeted profit

SOLUTION :UTILISATION OF SPARE CAPACITY
Is spare capacity available ? Yes K Additional revenue 1,000 x K ,000 Additional costs ,000 x K ,000 1,000 Increased profitability. Therefore the contract should be accepted. Note that fixed costs are not relevant to the decision and are therefore ignored.

SPECIAL CONTRACT PRICING
A business which produces to a customer ‘s order may be working to full capacity. Any additional orders must be considered on the basis of the following questions: What price must be quoted to make the contract profitable? Can other orders be fulfilled if this contract is accepted? Note: that if other orders cannot be fulfilled if this contract is accept, then the contribution that has to be thereby foregone is an opportunity cost of the contract. In such a situation the limiting factor needs to be recognised so that the contract price quoted will at least maintain the existing rate of contribution per unit of limiting factor.

EXAMPLE :SPECIAL CONTRACT PRICING
Oddjobs Ltd manufactures special purpose gauges to customer’s specifications. The highly skilled labour force is always working to full capacity and the budget for the next year shows: K Sales 40,000 Variable costs: Direct materials 4,000 Direct labour K5) 16,000 Fixed costs 10,000 (30,000) Profit

EXAMPLE :SPECIAL CONTRACT PRICING
An enquiry is received from XY Ltd for a gauge which would use K60 of direct materials and 40 labour hours. What is the minimum price to quote to XY Ltd? Would the minimum price be different if spare capacity were available but materials were subject to a quota of K4,000 per year?

SOLUTION :SPECIAL CONTRACT PRICING
The limiting factor is 3,200 units labour hours and the budgeted contribution per hour is K20,000 ÷ 3,200 hours = K6.25 per hour . Minimum price is therefore : K Materials Wages 40 hours @ K 260 Add: Contribution 40 K Contract price

At the above price ,the contract will maintain the budgeted contribution (check by calculating the effect of devoting the whole 3,200 hours to XY Ltd.) Note however that the budget probably represents a mixture of orders some of which earn more than K6.25 per hour and some less. Acceptance of the XY order must displace other contracts so the contribution rate of contracts displace should be checked.

If the limiting factor is materials ,budgeted contribution per K of materials is K20,000 ÷ 4,000 = K5 per K Minimum price is therefore; K Materials /wages (as above) Contribution K60 X Contract price Because materials are scarce ,oddjobs must aim to earn the maximum profit from its limited supply.

FURTHER PROCESSING DECISIONS
In processing operations ,particularly those involving more than one product , there is often a choice to be made between selling a product in an unfinished state (to another manufacturer) or to process it further into a finished product for sale to the consumer.

RELEVANT COSTS AND REVENUES OF FURTHER PROCESSING DECISIONS
Relevant costs are those which are incurred as a consequence of the decision to further process the item. Thus common costs incurred already, for examples pre –separation costs , should always be ignored. Relevant revenues are the extra revenues earned from selling the product in its further processed state instead of selling it in its semi –processed state.

EXAMPLE :FURTHER PROCESSING DECISIONS
PST Ltd produces three products from a common process which costs K104,000 per month to operate. Typical monthly outputs are : Product output (litres) P ,000 S ,000 T ,000 Each of the products may be further processed. Selling prices and further processing costs per litre are as follows:

EXAMPLE :FURTHER PROCESSING DECISIONS
Product Costs /revenues litre P S T K K K Further processing Selling price: Before further processing After further processing Advise PST Ltd whether it should further process any of its products.

SOLUTION :FURTHER PROCESSING DECISIONS
The common cost is irrelevant only the incremental costs and revenues should be considered: Product P S T K K K Selling price: Before further processing After further processing Incremental revenue Further processing costs (5) (3) (9) Incremental contribution (1) (2)

Based on values per litre further processing of product S is the only further processing activity which leads to an increase in contribution. Therefore PST Ltd should further process product S, but should sell product P and T without further processing them.

EXERCISE :FURTHER PROCESSING DECISIONS
Z Ltd operates a process which produces three products: X , Y and Z. Each of these may be sold without further processing or refined and sold as higher quality products. The following costs/revenues have been determined : Product X Y Z Refining cost/litre (K) Selling prices/litre (K) Refined Unrefined On the basis of the above , which products if any should Z Ltd refine?

Product X Y Z Incremental revenue/litre(K) Incremental cost/litre (K) (3.00) (2.50) 3.50) (0.50) Products X and Y should be refined.

OUTSOURCING Outsourcing is the use of external suppliers for finished products, components or services. This is also known as contract manufacturing or sub-contracting. A significant trend in the 1990s was for companies and government bodies to concentrate on their core competences – what they are really good at (or set up to achieve) – and turn other functions over to specialist contractors. A company that earns its profits from, say, manufacturing bicycles, does not also need to have expertise in, say, mass catering or office cleaning.

OUTSOURCING The relevant costs/revenues in decisions relating to the operating of internal service departments or the use of external services are the differential costs between the two options. Reasons for this trend include: Frequently the decision is made on the grounds that specialist contractors can offer superior quality and efficiency. If a contractor's main business is making a specific component it can invest in the specialist machinery and labour and knowledge skills needed to make that component.

OUTSOURCING Contracting out manufacturing frees capital that can then be invested in core activities such as market research, product definition, product planning, marketing and sales. Contractors have the capacity and flexibility to start production very quickly to meet sudden variations in demand. In-house facilities may not be able to respond as quickly, because of the need to redirect resources from elsewhere.

INTERNAL AND EXTERNAL SERVICES
In administrative and support functions, too, companies are increasingly likely to use specialist companies. Decisions such as the following are now common. Whether the design and development of a new computer system should be entrusted to in-house data processing staff or whether an external software house should be hired to do the work. Whether maintenance and repairs of certain items of equipment should be dealt with by in-house engineers, or whether a maintenance contract should be made with a specialist organisation.

INTERNAL AND EXTERNAL SERVICES
The costs relevant to such decisions are little different to those that are taken into account in a 'conventional' make or buy situation: they will be the differential costs between performing the service internally or using an external provider.

PERFORMANCE OF OUTSOURCERS
Once a decision has been made to outsource, it is essential that the performance of the outsourcer is monitored and measured. Measures could include cost savings, service improvement and employee satisfaction. It is important to have realistic goals and expectations and to have objective ways to measure success. The performance of the outsourcer, whether good or bad, can interfere with the performance assessment of an internal function.

PERFORMANCE OF OUTSOURCERS
For example: Maintenance of equipment could be carried out badly by an outsourcer and this may result in. increased breakdowns and reduced labour efficiency of a production team. If information arrives late or is incorrect, the wrong decision may be made.

EXAMPLE: OUTSOURCING Stunnaz is considering a proposal to use the services of a press cuttings agency. At the moment, press cuttings are collected by a junior member of the marketing department, who is also responsible for office administration (including filing), travel bookings, a small amount of proof reading and making the tea. The total annual cost of employing this person is k150,000 pa. There is concern that the ability of this person to produce a comprehensive file of cuttings is limited by the time available.

EXAMPLE: OUTSOURCING She has calculated that she needs to spend about two hours of her seven and a half hour day simply reading the national and trade press, but usually only has about five hours a week for this job. Press subscriptions currently cost K8,500 pa and are paid annually in advance. The assistant makes use of a small micro-fiche device for storing cuttings. The cuttings are sent to a specialist firm once a month to be put onto fiche. Stunnaz pays K450 each month for this service.

EXAMPLE: OUTSOURCING The micro-fiche reader is leased at a cost of K760 per calendar month. This lease has another 27 months to run. The cuttings service bureau has proposed an annual contract at a cost of K12,500. Several existing users have confirmed their satisfaction with the service they receive. Should Stunnaz outsource its press cuttings work?

SOLUTION: OUTSOURCING
Current annual costs amount to: K Micro fiche service K450 x 12 = ,400 Subscriptions ,500 Total ,900 The monthly leasing charge is a committed cost that must be paid whatever the decision. It is not therefore a decision-relevant cost. Engaging the services of the press cuttings agency therefore has the potential to save Stunnaz K1,400 pa. However, this is not the final word: there are other considerations.

The 'in-house' option should give management more direct control over the work, but the 'outsource' option often has the benefit that the external organisation has a specialist skill and expertise in the work. Decisions should certainly not be based exclusively on cost considerations. Will outsourcing create spare capacity? How should that spare capacity be profitably used? Are there hidden benefits to be obtained from subcontracting?

Would the company's workforce resent the loss of work to an outside subcontractor, and might such a decision cause an industrial dispute? Would the subcontractor be reliable with delivery times and quality? Does the company wish to be flexible and maintain better control over operations by doing everything itself?

EXERCISE: MAKE OR BUY DECISION
Shellfish Co makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected to be as follows. W X Y Z Production (units) 1, , , ,000 Unit marginal costs K K K K Direct materials Direct labour Variable production overheads

EXERCISE: MAKE OR BUY DECISION
Directly attributable fixed costs per annum and committed fixed costs: K Incurred as a direct consequence of making W 1,000 Incurred as a direct consequence of making X 5,000 Incurred as a direct consequence of making Y 6,000 Incurred as a direct consequence of making Z 8,000 Other fixed costs (committed) ,000 Total ,000 A sub-contractor has offered to supply units of W, X, Y and Z for K12, K21, K10 and K14 respectively. Should Shellfish make or buy the components?

SOLUTION:MAKE OR BUY DECISION
The relevant costs are the differential costs between making and buying, and they consist of differences in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some fixed cost savings.

W X Y Z K K K K Unit variable cost of making Unit variable cost of buying (2) Annual requirements (units) 1, ,000 4,000 3,000 K K K K Extra variable cost of buying(per annum)(2,000) 8, , ,000 Fixed costs saved by buying (1,000) (5,000) (6,000) (8,000) Extra total cost of buying (3,000) 3, ,000 (2,000)

The company would save K3,000 pa by sub-contracting component W (where the purchase cost would be less than the marginal cost per unit to make internally) and would save K2,000 pa by subcontracting component Z (because of the saving in fixed costs of K8,000). In this example, relevant costs are the variable costs of in-house manufacture, the variable costs of sub-contracted units, and the saving in fixed costs. Further considerations If components W and Z are sub-contracted, the company will have spare capacity.

How should that spare capacity be profitably used? Are there hidden benefits to be obtained from sub-contracting? Would the company's workforce resent the loss of work to an outside sub-contractor, and might such a decision cause an industrial dispute? Would the sub-contractor be reliable with delivery times, and would he supply components of the same quality as those manufactured internally?

Does the company wish to be flexible and maintain better control over operations by making everything itself? Are the estimates of fixed cost savings reliable? In the case of Product W, buying is clearly cheaper than making in-house. In the case of product Z, the decision to buy rather than make would only be financially beneficial if it is feasible that the fixed cost savings of K8,000 will really be 'delivered' by management. All too often in practice, promised savings fail to materialise!

THE END OF UNIT FIVE

UNIT FIVE :SHORT TERM DECISION MAKING

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