1. Chapter 5 Relevant Information and Decision Making: Marketing Decisions

2. The purpose of management accounting as we emphasized before is:
To provide information that enables managers to make sound decisions. Accountants have an important role in the decision making process, not as a decision makers but as a collectors and reporters of relevant information.
The accountant's role in decision making is primarily that of a technical expert on financial analysis who helps managers focus on relevant data, information that will lead to the best decisions.

3. Objective 1 Discriminate Between Relevant and Irrelevant Information for Making Decisions

4. Meaning of Relevance
This chapter introduces the topic of relevant information. Relevant means pertinent or applicable. When managers make choices among alternatives, all the relevant costs and revenues associated with each alternative must be considered.
Decision analysis can be based either on cash flow changes or on changes in accounting income. Long-run decision analysis generally uses cash flow as the decision criterion. Short-run decision analysis, the focus of this chapter, often uses accounting income, although some past costs, such as depreciation on old assets, may be excluded.

5. Relevance defined
Relevant information is the predicted future costs and revenues that will differ among the alternatives
Note that:
Relevant information is a prediction of the future, not a summary of the past.
Historical (past) data are irrelevant to the decision itself, because the decision cannot affect past data. Decisions affect the future. Nothing can alter what has already happened.
Of the expected future data, only those that differ from alternative to alternative are relevant to decision. Any item that will remain the same regardless of the alternative selected is irrelevant.

6. For example, let us consider a situation where an individual is uncertain as to whether he should purchase a monthly rail ticket to travel to work or whether he should use his car. Assuming that the individual will keep his car, whether or not he travels to work by train, the cost of his road fund license and insurance will be irrelevant since these costs remain the same irrespective of his mode of the travel. The cost of his petrol will, however, be relevant as this cost will vary depending on which method of transport he chooses.

7. Let us now move on to consider an example in a business environment.
A company is considering the alternative of either purchasing a component from an outside supplier or producing the component itself. The estimated costs to the company of producing the component are as follows:
300
Direct material
100
Direct labor 50
Variable overheads
Fixed overheads
550

8. Company To Manufacture
The outside supplier has quoted a figure of L.E. 500 for supplying the component. Should the company buy or make the component?
The comparative cost statements for the two alternatives are as follows:
Company To Purchase
Component
L.E.
Company To Manufacture -
300
Direct material
100
Direct labor 50
Variable overheads
Fixed overheads
500
Supplier's purchase price
600
550

9. it is assumed in this example that the share of fixed overheads apportioned to the component will still be incurred whether or not the company purchases the component from an outside supplier. Fixed overheard therefore is irrelevant in deciding which alternative to choose.
It is also assumed that the company will not incur the direct material, labor, and variable overhead costs if the component is purchased form the outside supplier: These costs will be different depending on which alternative will be chosen and are therefore relevant in making the decision. The supplier's purchase price is also a relevant cost as it will be different for each of the alternatives.

10. Company To Manufacture
We can therefore represent the cost statements for the two alternatives using only relevant cots as follows:
Company To Purchase
Component
L.E.
Company To Manufacture -
300
Direct material
100
Direct labor 50
Variable overheads
Fixed overheads
500
Supplier's purchase price
450

11. You can see that the two approaches can be used for presenting relevant cost information.
You can present cost information which include irrelevant costs or revenues, (that is, the fixed cost in this example) provided that they are included under both alternatives and do not mislead the decision maker.
Alternatively, cost information could be presented which excludes the irrelevant costs and revenues because they are identical for both alternatives.
Both methods show that future costs will be L.E. 50 lower if the company manufactures the component.

12. It is important that great care is taken in presenting financial information for decision making. If, in the above example, the company had produced the same component in the pervious period, the component would be valued at L.E. 550 for stock valuation as all manufacturing costs should be taken into account when stock is valued ( for financial accounting purposes) .
For decision making purposes only future costs that will be relevant to the decision should be included. Costs accumulated for stock valuation purposes must not be used for decision making purposes.

13. When you are trying to establish which costs are relevant to a particular decision you may find that some costs will be relevant in one situation but irrelevant in another.
In the above example direct labor was considered to be a relevant cost, based on the assumption that the company will hire additional labor on a causal basis to produce the component.
But now consider what the relevant labor cost will be if the company has a temporary excess supply of labor and intends to obtain the necessary labor hours from its existing labor force at no extra cost? In this situation the labor cost will be the same whichever alternative is chosen and will not be a relevant cost.

14. Let us now take the example a stage further:
Direct materials will not be a relevant cost if the company has purchased the materials in the past and now finds that they are surplus to requirements. If the materials have no alternative use and cannot be sold then the cost will be the same irrespective of which alternative is chosen. Therefore the cost of direct materials is not a relevant cost in this situation.

15. The above examples show that the identification of relevant costs depends on the circumstances.
In one situation a cost may be relevant but in another situation the same cost may not be relevant.
It is not therefore possible to provide a list of costs which would relevant in particular situations. In each situation you should follow the principal that the relevant costs are future costs that differ among alternatives.

16. The important question to ask when determining the relevant cost is:
What difference will it make?
It is necessary that the accountant should be aware of all the circumstances under which a decision will be taken and ascertain full details of the changes that will result from the decision, and then proceed to select the relevant financial information to present to management.

17. Quantitative and Qualitative Factors
In many situations it is difficult to quantify in monetary terms all the important elements of a decision.
Those factors which can be expressed in monetary terms only with much difficulty or imprecision are classified as qualitative factors. It is essential that qualitative factors are brought to the attention of management during the decision-making process, as otherwise there may be a danger of making a wrong decision.

18. For example, the cost of manufacturing a component internally may be more expensive than purchasing from an outside supplier. However, the decision to purchase form outside supplier could result in the closing down of the company's facilities for manufacturing the component.
The effect of such a decision might lead to redundancies and a decline in employee's morale which could affect the future output. In addition the company will become dependent on an outside supplier, who may not always deliver on time. The company may not then be in a position to meet customer requirements: In turn this could result in a loss of customer goodwill and a decline in future sales.

19. It may not be possible to quantify in monetary terms the effects of a decline in employees morale or loss of customers goodwill but the accountant in such circumstances should present the relevant quantifiable financial information and draw attention to those qualitative items which may have an impact on future profitability.
In circumstances such as those given in the above example, management must estimate the likelihood of the supplier failing to meet the company’s demand for future supplies and the likely effect on customer goodwill if there is a delay in meeting orders. If the component can be obtained from many suppliers and repeat orders for the company's products are unlikely then the company may give little weighting to these qualitative factors.

20. Alternatively, if the component can be obtained from only one supplier and the company relies heavily on repeat sales to existing customers, then the qualitative factors will be of considerable importance.
In the latter situation the company may consider that the quantifiable cost savings from purchasing the component from an outside supplier are insufficient to cover the risk of the qualitative factors occurring.

21. Accuracy and Relevance
In the best, information used for decision making would be perfectly relevant and accurate. However in reality, the cost of such information often exceeds its benefits.
Accountants often trade off relevance versus accuracy. Of course, relevance information must be reasonably accurate but not precisely so.
Precise but irrelevant information is worthless for decision making. On the other hand, imprecise but relevant information can be useful. For example, sales predictions for a new product may be subject to great error, but they still are helpful to the decision of whether to manufacture the product.

22. Qualitative Aspects are: Quantitative Aspects are:
The degree to which information is relevant or precise often depends on the degree to which it is qualitative or quantitative.
Qualitative Aspects are:
Those for which measurement in pounds and piasters is difficult and imprecise;
Quantitative Aspects are:
Those for which measurement is easy and precise.

23. Just as we noted that relevance is more crucial than precision in decision making. So a qualitative factor may easily carry more weight than a quantitative financial impact in many decisions.
For example, mangers sometimes introduce new technology (e.g. advanced computer systems) even though the expected quantitative results seen unattractive. Mangers defend such decisions on the grounds that failure to keep abreast of new technology will surely bring unfavorable financial results sooner or later.

24. Concept of Differential Costs and Revenues
Is a cost that would be different if one alternative, rather than another alternative, were selected.
Differential costs are also called relevant costs. The term refers both to certain items of cost and to amounts of cost. Thus in many situations, direct labor is an item of differential cost; also, if the amount of cost that differs in a certain problem is L.E. 1000, the L.E is said to be the amount of differential cost.

25. Differential costs always relate to a specific situation.
Contrasts with Full Costs
There are three important differences between full costs and differential costs:
Nature of the cost :
The full cost of a product is the sum of its direct costs plus its equitable share of indirect costs. Differential costs (relevant costs) include only those elements of cost that are different under a set of conditions.

26. Source of Data :
Information on full costs is taken directly from a company’s cost accounting system. There is no comparable system for collecting differential costs. The appropriate items that constitute differential costs are assembled to meet the requirements of a specific problem.
Each problem is different. Some of the data used to construct differential costs may come from the cost accounting system, but some data come from other sources.

27. Time perspective :
The full cost accounting system collects costs on a historical basis, that is it measures what the costs were. Differential costs always related to the future; they are intended to show what the costs would be if a certain course of action were adopted, rather than what the costs were in some past period.
Note that the accounting system is designed so that it can provide the raw data that are used in estimating the differential costs for a specific problem.

28. Differential costs are not necessarily the same as variable costs.
Differential Costs Contrasted with Variable Costs
Differential costs are not necessarily the same as variable costs.
Variable Costs
Are those that vary directly with the volume of output.
If in a specific problem, the alternatives being considered involve a change in volume, then variable costs, by definition, are differential costs. Differential costs may include fixed costs as well as variable costs.
Thus, variable costs are differential costs in problems that involve changing the volume of output, but not otherwise.

29. A Special type of relevant costs is an opportunity cost.
Opportunity Costs
A Special type of relevant costs is an opportunity cost.
An Opportunity Cost
Represent a potential benefit that is given up because one course of action is chosen over anther.
For example, the XYZ company owns a piece of land acquired at a total cost of L.E. 100,000. The company has the opportunity to sell the land for L.E. 500,000. The company’s managers decide to keep the land and use it as the location for the company’s new headquarter. The opportunity cost of this is L.E. 500,000 - the benefit foregone by choosing the alternative of keeping the land rather than selling it. The historical cost of L.E. 100,000 is not relevant to the decision; it is a sunk cost.

30. Opportunity costs are not measured in accounting records
Opportunity costs are not measured in accounting records. Costs that are collected within the accounting system are based on past payments. Sometimes it is necessary for decision-making to impute costs which will not require cash outlays, and these imputed costs are called opportunity costs.
It is important to note that opportunity costs only apply to the use of scarce resources. Where resources are not scarce, no sacrifice exists from using these resources.
Note that opportunity costs are of vital importance for decision-making. If no alternative use of resources exists, the opportunity cost is zero. But if resources have an alternative use, and are scarce, then an opportunity cost does exist.

31. The term out-of-pocket costs refer to
cost items that will cause the company to pay money out of its “pocket” if the alternative under consideration is adopted.
Out-of-pocket costs therefore are the same thing as differential costs in many situations. Opportunity costs however, often are not out-of-pocket costs, so the out-of-pocket costs is not always relevant.

32. Sunk Costs
Is a cost that has already been incurred and, therefore, is irrelevant to the decision making process.
Sunk cost should have the same meaning of past cost or historical cost.
Depreciation is ordinarily a sunk cost because depreciation is a write-off of the cost of fixed asset, and the cost of the asset was incurred when the asset was acquired. Similarly, the book value of a fixed asset is a sunk cost, it represents that portion of the acquisition cost that has not yet been written off as depreciation expense.

33. A sunk cost exists because of actions taken in the past, therefore, a sunk cost is not a differential cost. No decision made today can change what has already happened.
Sunk costs are irrelevant for decision making, but they are distinguished from irrelevant costs because not all irrelevant costs are sunk costs. For example, a comparison of two alternative production methods may result in identical direct material expenditure for both alternatives, So the direct material cost is irrelevant because it will remain the same whichever alternative is chosen, but it is not a sunk cost as it will be incurred in the future.

34. Objective 2 Diagram the Relationships Among the Main Elements of the Decision Process

35. Exhibit 5-1 presents a diagram of decision process and role of information.
Historical
Information
Other
Prediction Method
Decision Model
Implementation and Evaluation
(A)
(B)
(1)
(2)
Predictions as inputs to
(3)
Decisions by Managers With Aid of Decision Model
(4)
Feedback

36. represents historical data from the accounting system.:
Box 1 (A)
represents other data, such as, price indices or industry statistics gathered from outside the accounting system.
Box 1 (B)
The data in step (1) help the formulation of predictions in step (2).
Note that
Although historical data may act as a guide to predicting, they are irrelevant to the decision itself.

37. In step (3) these predictions become inputs to the decision model.
Is defined as any method for making a choice.
Some models often require elaborate quantitative procedures, such as mathematical programming. A decision model, however, may also be simple.

38. In step (4) once alternative course of action have been selected, they should be implemented. To monitor performance the accountant produces performance reports.
Performance Reports
Provide feedback information by comparing planning and actual results.

39. Objective 3 Analyze Data by Contribution Approach to Support a Decision for Accepting or Rejecting a Special Sales Order

40. The Special Sales Order
A special order decision requires that management determines a sales price below the normal price.
Special order situations include:
Jobs that require a bid, are taken during slack periods, or are made to buyer’s specifications.
Private – label orders in which buyer’s name (rather than the sellers) is used on the product. Companies may accept these jobs during slack periods to more efficiently utilize available capacity.

41. Orders of unusual nature (because of quantity, method of delivery, or packaging), or because the products are being tailor-made to customer instructions.
Special pricing can be used when producing goods for a one- time job, such as an overseas order that will not affect domestic sales.
Typically, the sales price quoted on a special order should be high enough to cover the variable costs of the job and any incremental fixed costs and generate a profit.

42. Some important factors must be considered before recommending acceptance of a special order:
It is assumed that future selling price will not be affected by selling at a price below the normal or the going market price
It would not affect total fixed costs
It would use some idle manufacturing capacity
It would not require any additional variable selling and administrative expenses.
Special pricing may provide work for a period of time, but it can not be continued over the long run. To remain in business, a company must set selling prices to cover total costs and provide a reasonable profit.

43. The Current Income Statement
Example
The Current Income Statement
(thousand of dollars )
20,000
Sales (1 million units)
Less:
(15,000)
Manufacturing cost Of goods sold
(3,000 Fixed + 12,000 variable)
5,000
Gross profit
Less
4,000
Selling & administrative expenses
(2,900 Fixed + 1,100 variable )
1,000
Operating income

44. Contribution Margin Income Statement
20,000
Sales
Less: Variable expenses
(12,000)
Manufacturing cost
(1,100)
Selling & admin. expenses
13,100
6,900
Contribution Margin
Less : Fixed expenses
(3,000)
(2,900)
5,900
1,000
Operating income

45. Suppose a customer offered L. E
Suppose a customer offered L.E.13 per unit for a 100,000 units special order.
Should this company accept or reject this order?
What is the difference in the short run financial results between accepting and not accepting the order?

46. Illustrative cases Case (1) :
Assuming that special sales order (SSO) :
Would not affect the normal prices and sales quantity
Would not affect total fixed costs
Would not require any additional variable selling expenses
Would use some idle manufacturing capacity.

47. Solution Comparative income statement
With SSO
Effect of SSO
( units)
Without SSO
( units)
Per unit
Total
21,300,000 13
1,300,000
20,000,000
Sales
Less: Variable costs
13,200,000 12
1,200,000
12,000,000
Manufacturing cost
1,100,000 -
Selling & admin.
14,300,000
13,100,000
Total variable cost
7,000,000
100,000
6,900,000
Contribution Margin
5,900,000
Less : Fixed expenses
1,000,000
Operating income

48. Case (2) :
The same assumptions of case (1), but assuming SSO would require additional variable selling expense.
Solution
L.E.13
SSO price
Additional cost :- 12
Manufacturing
1.1
Selling & admin.
13.1
(0.1)
Decrease in profit Per unit of S.S.O
Decrease in profit = 0.1 x = L.E

49. Comparative income statement
With SSO
Effect of SSO
( units)
Without SSO
( units)
Per unit
Total
21,300,000 13
1,300,000
20,000,000
Sales
Less: Variable costs
13,200,000 12
1,200,000
12,000,000
Manufacturing cost
1,210,000
1.1
110,000
1,100,000
Selling & admin.
14,410,000
13.1
1,310,000
13,100,000
Total variable cost
6,890,000
(10,000)
6,900,000
Contribution Margin
5,900,000 -
Less : Fixed expenses
990,000
1,000,000
Operating income

50. Case (3) :
The same assumption as case (2), but assuming that The special sales order would require additional variable selling expenses and the variable selling expenses include 5 % sales commission
Solution
( In millions)
With SSO
Effect of SSO
( units)
Without SSO
( units)
Per unit
Total
21.3 13
1.3 20
Sales
Less: Variable costs
13.2 12
0.2
Manufacturing cost
1.065
0.65
0.065 1
Sales commission
0.110
0.10
0.010
0.1
Other selling expense
14.375
12.75
1.275
13.1
Total variable cost
6.925
0.25
0.025
6.9
Contribution Margin
5,900 -
5.9
Less : Fixed expenses
1.025
Operating income

51. Case (4) :
The same assumption as case (2), but assuming that the variable selling expenses include 5 % sales commission and the special sales order would require additional variable selling expenses excluding sales commission
Solution
L.E.13
S.S.O price per unit
Less:- 12
Unit manufacturing variable cost
0.1
Unit selling variable cost
12.1
0.9
Increase in profit Per unit
Increase in profit = 0.9 x = 90, 000

52. Case (5) :
The same assumption as case (1), except that the order was for units and a selling price of L.E. 11.5
Solution
2,875, 000
Additional revenue per unit
Less:- additional costs
3,000, 000
Manufacturing variable costs
L.E. 12 per unit
125, 000
Decrease in operating income from S.S.O

53. Comparative income statement
With SSO
Effect of SSO
( units)
Without SSO
( units)
22,875,000
2,875,000
20,000,000
Sales
Less: Variable costs
15,000,000
3,000,000
12,000,000
Manufacturing cost
1,100,000 -
Selling & admin.
16,100,000
13,100,000
Total variable cost
6,775,000
(125,000)
6,900,000
Contribution Margin
Less : Fixed expenses
Manufacturing cost (at an average rate of L.E.3 ×1000,000 = 3,000,000 & at an average rate of L.E.2.4 ×2,500,000)
2,900,000
5,900,000
Total fixed cost
875,000
1,000,000
Operating income

54. Note
Notice that no matter how fixed costs are spread for unit product costing purposes, Total fixed cost are unchanged, even though manufacturing fixed cost per unit fall from L.E. 3.0 to L.E. 2.4

55. Case (6) :
The same assumption as case (1), except that selling price is L.E instead of L.E but a manufacturers agent who had obtained the potential order would have to be paid a flat fee of L.E if the order were accepted, what would be the new special-order difference in operating income if the order were accepted.
Solution
1,350, 000
Additional revenue x L.E. 13.5
Less: additional costs
1,200, 000
Manufacturing variable costs
L.E. 12 per unit
Less: Fixed costs
40,000
Agent's fee
110, 000
Increase in operating income from S.S.O

56. Objective 5 Analyze Data by the Relevant- Information Approach to Support a Decision for Adding or Deleting a Product Line.

57. Deletion or Addition of products or Departments
The same principles of relevance applied to special orders apply- albeit in slightly different ways to decisions about adding or deleting products or departments
Avoidable and Unavoidable Costs:
Fixed costs are divided into two categories, avoidable and unavoidable.
Avoidable Costs
Costs that will not continue if an ongoing operation is changed or deleted- are relevant.
Avoidable costs include department salaries and other costs that could be eliminated by not operating the specific department.

58. Unavoidable Costs
Costs that continue even if an operation is halted- are not relevant because they are not affected by a decision to delete the department.
Unavoidable costs include many common costs, which are defined as those costs of facilities and services that are shared by users. Examples are store depreciation, heating, air conditioning, and general management expenses.

59. The segment margin figure
Segment Margin (or Product Line Margin):
Represents the excess of revenues over direct variable expenses and avoidable fixed expenses. It is the amount remaining to cover unavoidable fixed expenses and, then, to provide profits.
The segment margin figure
Is the appropriate one on which to base continuation, elimination decisions, since it provides a measure of the segment's contribution to the coverage of unavoidable costs.

60. Example
Management is considering dropping the grocery department, which has consistently shown an operating loss. The following table reports the stat’s present annual operating income

61. Annual Operating Income
In thousands)
Departments
Total
Drugs
General
Merchandise
Groceries
L.E.
1,900
100
800
1,000
Sales
1,420 60
560
Variable Costs of Goods Sold & Exp.
25%
480
40% 40
30%
240
20%
200
Contribution Margin
Fixed Expenses
(salaries, Depreciation, insurance, Property taxes, etc.):
265 15
150
Avoidable
180 20
Unavoidable
445 35
210
Total Fixed Expenses 5
(10)
Operating income

62. Assumptions
The only alternatives to be considered are dropping or continuing the grocery department.
The total assets invested would be unaffected by the decision. The vacated space would be idle, and the unavoidable costs would continue.

63. Segment Margin Income Statement
( In thousands)
Departments
Total
Drugs
General
Merchandise
Groceries
L.E. 1,900
L.E. 100
L.E.
800
1,000
Sales
1,420 60
560
Less: Variable costs
480 40
240
200
Contribution Margin
25%
40%
30%
20%
C M %
265 15
100
150
Avoidable fixed expenses
215 25
140 50
Segment margin
180
Unavoidable Fixed costs 35
Operating income

64. Store as a Whole 900 L.E. 1,000 1,900 Sales 620 800 1,420
Total After
Changes
(a)–(b)
Effect of
dropping
Groceries
(b)
Total Before
Change
(a)
900
L.E.
1,000
1,900
Sales
620
800
1,420
Variable expenses
280
200
480
Contribution margin
115
150
265
Avoidable fixed expenses
165 50
215
Profit contribution to common space And other unavoidable costs
180 -
Common space and other unavoidable costs
(15) 35
Operating income

65. The preceding analysis shows that groceries bring in contribution margin of L.E. 200,000, which is L.E.50,000 more than the L.E. 150,000 fixed expenses that would be saved by closing the grocery department. So the matters would be worse, rather than better, if groceries were dropped and vacated facilities left idle.
Assume that the space made available by the dropping of groceries could be used to expand the general merchandise department, and this would increase sales by L.E , and have avoidable fixed costs of L.E

66. Effects of Changes 1,400 L.E. 500 1,000 1,900 Sales 970 350 800 1,420
Total After
Changes
(a)–(b)+(c)
Expand General
Merchandise (c)
Drop
Groceries
(b)
Total Before
Change
(a)
1,400
L.E.
500
1,000
1,900
Sales
970
350
800
1,420
Variable expenses
430
150
200
480
Contribution margin
185 70
265
Avoidable fixed expenses
245 80 50
215
Contribution to common space And other unavoidable costs
180 -
Common space and other unavoidable costs 65 35
Operating income

67. Profit Contribution of Given Space
Difference
Expansion of
General
Merchandise
Groceries
500
L.E.
1,000
Sales
450
350
800
Variable expenses 50
150
200
Contribution margin 80 70
Avoidable fixed expenses 30
contribution to common space and other unavoidable costs

68. Example: Deleting a Segment
National Ltd. is a wholesaler who sells its products to a wide range of retailers. Marketing is done through three geographical areas: the south, The Midlands and the North. The estimates of the costs and revenues for each sales territory for the next accounting period are as follows:

69. Total North Midlands South L.E. 2,600 900 800 Sales 1,350 500 450 400
( In thousands)
Total
North
Midlands
South
L.E.
2,600
900
800
Sales
1,350
500
450
400
Cost of goods Sold (variable)
1,250
Gross profit
Selling costs:
120
100 80
Salesmen's Salaries 60 40
Sales office & management Expenses 50
Advertising
Salesmen’s expenses
330
270
220
Headquarters 90
Administration Expenses 36 30
Warehousing Costs
1182
456
396
Total costs 68
(56) 54 70
Net profit (or loss)

70. The products are packed and dispatched from a central warehouse and it is estimated that 50% of the warehousing costs are variable and the remainder are fixed. All of the selling costs are fixed with the exception of salesmen's expenses, which are variable with sales revenue. All of the administration expenses of the head – quarters are common and unavoidable to all alternatives and have been apportioned to sales territories on the basis of sales value. In view of the loss, should the North area be closed?

71. Solution Cost of goods Sold
L.E.
900,000
Sales revenue
Variable Costs:
500,000
Cost of goods Sold
80,000
Salesmen‘s expenses
18,000
Warehousing Costs
598,000
302,000
Contribution Margin
Avoidable costs (fixed selling expenses)
250,000
52,000
Operating income
Note that the fixed selling expenses are relevant to the decision because they will be eliminated if the North area is closed.

72. You can see from this calculation that profit will decline by L. E
You can see from this calculation that profit will decline by L.E. 52,000 if the North area is closed because the company will lose a contribution of L.E 52,000 toward the unavoidable fixed costs (the administration and warehousing fixed costs).
Whenever a segment of a business can provide a contribution toward meeting common and unavoidable (general) fixed costs it should not be closed or dropped, always assuming that facilities have no alternative use which would yield a height contribution, and that the sales in other segments are unaffected by the decision.
The projected income statement if the North area is closed is as follows :

73. Total Midlands South L.E. 1,700 900 800 Sales Less: Variable Costs 450
( In thousands)
Total
Midlands
South
L.E.
1,700
900
800
Sales
Less: Variable Costs
450
400
Cost of goods Sold 60 50
Salesmen‘s expenses 18 15
Warehousing Costs
993
528
465
707
372
335
Contribution Margin
Less: Avoidable Fixed Costs
100 80
Salesmen's Salaries 40
Sales office & management expenses
Advertising
380
210
170
327
162
165
Segment Margin
Less: Unavoidable Fixed Costs
(260)
Administration Expenses
(51) 16
Net profit (or loss)

74. Total profit is reduced by L.E. 52,000.
Note
Note that some fixed costs ( for example, fixed selling expenses) may change when a particular alternative is being considered and can become relevant costs.
It can be stated, however, as a general rule that common and unavoidable fixed costs which are allocated to cost objectives on the basis of apportionments are not relevant for decision – making purposes.

75. Objective 6 Compute a Measure of Product Profitability when Production is Constrained by a Scarce Resource.

76. Optimal Use of Limited Resources
The contribution approach also applies here, because the product to be emphasized or the orders to be accepted is the one that makes the biggest total profit contribution per unit of the Limiting factor.
A Limiting Factor or Scarce Resource
Is the item that restricts or constraints the production or sale of a product or service.

77. Limiting factors include labor-hours and machine-hours that limit production and hence sales in manufacturing firms, and square feet of floor space or cubic meters of display space that Limit sales in department stores.
The contribution approach must be used wisely, however, Managers sometimes mistakenly favor those products with the biggest contribution margin or gross margin per sales pounds, without regard to scarce resources.
Example

78. Optimal Use of Limited ResourcesB A
L.E. 10 50
100
Sales price 7 25 60
Per unit variable cost 3 40
Per unit contribution margin 2 1
Ranking
30%
50%
40%
C M % 8
Hours needed to produce one unit 6
12.5 5
C M per hour
80,000
20,000
5000
Demand
40,000
Hours needed
120,000
Total
100,000
Hours available

79. Total Contribution Margin
Optimal Allocation
Balance
(Remaining hours)
Hours used
60,000
40,000
Product B (20,000 × 2)
20,000
Product C (80,000 × ½ ) -
Product A (20,000 /8)= 2,500
Total Contribution Margin
Total CM
Per unit CM Q
Optimal mix
100,000 40
2,500 A
500,000 25
20,000 B
240,000 3
80,000 C
840,000

80. Wrong allocation based on per unit CM
Total CM
Per unit CM Q
Mix
200,000 40
5,000 A
500,000 25
20,000 B
120,000 3
40,000 C
820,000
Wrong allocation based on CM%
Total CM
Per unit CM Q
Mix
500,000 25
20,000 B
200,000 40
5,000 A
120,000 3
40,000 C
820,000

81. Difficulties may arise in applying this procedure when there is more than one scarce resource. It could not be applied if, for example, Labor hours were also scarce and the contribution per labor hour resulted in product Y being ranked first, followed by products X and Z.
In this type of situation where more than one resource is scarce it is necessary to resort to linear programming methods in order to determine the optimal production program.

82. Thank you