DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS

cost management accounting  DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS

Introduction

One of the more common decision-making problems is a situation where there are not enough resources to meet the potential sales demand, and so a decision has to be made about what mix of products to produce, using what resources there are as effectively as possible. A limiting factor could be sales if there is a limit to sales demand but any one of the organization’s resources (labor, materials and so on) may be insufficient to meet the level of production demanded. It is assumed in limiting factor accounting that management wishes to maximize profit and that profit will be maximized when contribution is maximized (given no change in fixed cost expenditure incurred). In other words, marginal costing ideas are applied. Contribution will be maximized by earning the biggest possible contribution from each unit of limiting factor. For example if grade A labor is the limiting factor, contribution will e maximized by earning the biggest contribution from each hour of grade A labor worked. The limiting factor decision therefore invoices the determination of the contribution earned by each different product from each unit of the limiting factor.

Example: Limiting Factor

AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows. Ay Be Rs. Rs.

Direct Materials 1 3 Direct Labor (Rs. 3 per hour) 6 3 Variable Overhead 1 1 87

The sales price per unit is Rs. 14 per Ay and Rs. 11 per Be. During July 20X2 the available direct labor is limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for Bes.

Required:

Determine the profit-maximizing production mix, assuming that monthly fixed costs are Rs. 20,000, and that opening stocks of finished goods and work in progress are nil.

Solution: Step 1. Confirm that the limiting factor is something other than sales demand.

Ays Bes Total
Labor hours per unit 2hrs 1hr
Sales demand 3,000 units 5,000 units 8,000hrs
Labor hours needed 6,000 hrs 5,000 hrs 11,000hrs
Labor hours available
Shortfall 3,000hrs

Labor is the limiting factor on production.

Step 2. Identify the contribution earned by each product per unit of limiting factor that is per labor hour worked.

Ays Bes

Rs. Rs. Sales price 14 11 Variable Cost 8 7 Unit contribution 6 4 Labor hours per unit 2 hrs 1 hrs Contribution per labor hour (=unit of limiting factor) Rs. 3 Rs. 4

Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to make one Ay. Because labor is in short supply it is more profitable to make Bes than Ays.

Step 3. Determine the optimum production plan. Sufficient Bes will be made ot meet the full sales demand, and the remaining labor hours available will then be used to make Ays.

(a).

Product Demand Hours required Hours available Priority of manufacture
Bes 5,000 5,000 5,000 1st
Ays 3,000 6,000 3,000 (bal) 2nd
11,000 8,000
(b).
Product Units Hours needed Contribution per unit Total
Rs. Rs.
Bes 5,000 5,000 4 20,000
Ays 1,500 3,000 6 9,000
8,000 29,000
Less fixed costs 20,000
Profit 9,000

In conclusion

a.Unit contribution is not the correct way to decide priorities.

b.Labor hours are the scarce resources, and therefore contribution per labor is the correct

way to decide priorities. The Be earns Rs. 4 contribution per labor hour, and the Ay earns Rs. 3 contribution per labor hour. Bes therefore make more profitable use of the scarce resource, and should be manufactured first.

Exam Focus Point

If an examination question asks you to determine the optimum production plan, follow the five-step approach shown below.

Step 1. Identify the limiting factor. Step 2. Calculate contribution per unit for each product.

Step 3. Calculate contribution per unit of limiting factor.

Step 4. Rank products (make product with highest contribution per unit of limiting factor

first).

Step 5. Make products in rank order until scare resource is used up (optimal production plan).

MAKE OR BUY DECISIONS Introduction In a make or buy situation with no limiting factors, the relevant costs for the decision are the differential costs between the two options. A make or buy problem involves a decision by an organization about whether it should make a product/carry out an activity with its own internal resources, or whether it should pay another organization to make the production/carry out the activity. Examples of make or buy decisions would be as follows.

a.Whether a company should manufacture its own components, or buy the components from an outside supplier.

b.Whether a construction company should do some work with its own employees, or

whether it should subcontract the work to another company. It an organization has the freedom of choice about whether to make internally or buy externally and has no scarce resources that put a restriction on what it can do itself, the relevant costs for the decision will be the differential costs between the two options.

Example: Make or Buy

Buster Ltd 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 2,000 4,000 3,000
Unit marginal costs Rs. Rs. Rs. Rs.
Direct materials 4 5 2 4
Direct labor 8 9 4 6
Variable production overheads 2 3 1 2
14 17 7 12

Directly attributable fixed cost per annum and committed fixed costs are as follows:

Rs.

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) 30,000 50,000

A subcontractor has offered to supply units of W, X, Y and Z for Rs. 12, Rs. 21, Rs. 10, and Rs. 14 respectively.

Required:

Decide whether Buster Ltd should make or buy the components.

Solution:

a. The relevant cots are the differential costs between making and buying, and they consist of difference in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some fixed cost savings.

W X Y Z Rs. Rs. Rs. Rs.

Unit variable cost of making 14 17 7 12 Unit variable cost of buying 12 21 10 14

(2) 4 3 2

W X Y Z


Annual requirements (units) 1,000 2,000 4,000 3,000
Extra variable cost of buying (per annum) Fixed costs saved by buying Extra total cost of buying Rs. (2,000) (1,000) (3,000) Rs. 8,000 (5,000) 3,000 Rs. 12,000 (6,000)6,000 Rs. 6,000 (8,000) (2,000)

b.The company would save Rs. 3,000 pa by subcontracting component W (where the purchase cost would be less than the marginal cost per unit to make internally) and would save Rs. 2,000 pa by subcontracting component Z (because of the savings in fixed costs of Rs. 8,000).

c.In this example, relevant costs are the variable cots in-house manufacture the variable costs of subcontracted units, and the saving in fixed costs.

Other factors to consider in the make or buy decision.

a.If components W and Z are subcontracted, how will the company most profitably use the spare capacity? Would the company’s workforce resent the loss of work to an outside subcontractor?

b.Would the subcontractor be reliable with delivery times, and would he supply components of the same quality as those manufactured internally?

c.Does the company wish to be flexible and maintain better control over operations by making everything itself?

d.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 the fixed cost savings of Rs. 8,000 could really be ‘delivered’ by management.

Question

B Limited makes three components – S, T and W. The following costs have been recorded.

Components S Component T Component W Units Cost Unit Cost Unit Cost Rs. Rs. Rs.

Variable Cost 2.50 8.00 5.00

Fixed Cost 2.00 8.30 3.75

Total Cost 4.50 16.30 8.75

Another company has offered to supply the components to BB Limited at the following prices

Components S Component T Component W

Price each Rs. 4 Rs. 7 Rs. 5.50

Which component(s), if any, should BB Limited consider buying in?

A Buy in all three components

B Do not buy any

Buy in S and W D Buy in T only

Answer

BB Limited should buy the component if the variable cost of making the component is more than the variable cost of buying the component.

Components S Component T Component W Rs. Rs. Rs.

Variable Cost of Making 2.50 8.00 5.00 Variable Cost of Buying 4.00 7.00 5.50

(1.50) 1.00 (0.50)

The variable cost of making component T is greater than the variable cost of buying it. BB Ltd should consider buying in component T only. The correct answer is D.

Make or Buy Decisions and Limiting Factors

In a situation where a company must subcontract work to make up a shortfall in its won production capability, its total costs are minimized if those components/products subcontracted are those with the lowest extra variable cost of buying per unit of limiting factor saved by buying.

Example: Make or Buy and Limiting Factors

Green Ltd manufactures two components, the Alpha and Beta, using the same machines for each. The budget for the next year calls for the production and assembly of 4,000 of each component. The variable production cost per unit of the final product, the gamma, is as follows.

Machine Variable hours cost Rs.

1 unit of Alpha 3 20 1 unit of Beta 2 36 Assembly 20 76

Only 16,000 hours of machine time will be available during the year, and a sub-contactor has quoted the following unit prices for supplying components; Alpha Rs. 29, Beta Rs. 40. Advise Green Ltd.

Solution:

a. There is a shortfall in machine hours available, and some products must be subcontracted.

Product Units Machine hours

Alpha 4,000 12,000

Beta 4,000 8,000 Required 20,000 Available 16,000 Shortfall 4,000

b. The assembly costs are not relevant costs because they are unaffected by the make or buy decision. The units subcontracted should be those which will add least to the costs of Green Ltd. Since 4,000 hours of work must be sub-contracted, the cheapest policy is to subcontract work which adds the least extra costs (the least extra variable costs) per hour of own-time saved.

c. Variable cost of making Variable cost of buying Extra variable cost of buying Alpha Rs. 20 29 Beta Rs. 36 40
Machine hours saved by buying Extra variable cost of buying, per hours saved 3 hours Rs. 3 2 hours Rs. 2

It is cheaper to buy Betas than to buy Alphas and so the priority for making the components inhouse will be in the reverse order the preference for buying them form a subcontractor.

d.

Hours per unit to Hours required in CumulativeComponent make in-house total hours

Alpha 3 hours 12,000 12,000

Beta 2 hours 8,000 20,000

20,000 Hours available 16,000 Shortfall 4,000

There are enough machine hours to make all 4,000 units of Alpha and 2,000 units of Beta. 4,000 hours production of Beta must be sub-contracted. This will be the cheapest production policy available.

e.

Component Machine Number of Units variable Total
hours units cost variable cost
Make Rs. Rs.
Alpha 12,000 4,000 20 80,000
Beta (balance) 4,000 2,000 36 72,000
16,000 152,000
Buy Hours saved
Beta (balance) 4,000 2,000 40 80,000
Total variable cost of components 232,000
Assembly costs (4,000 x Rs. 20) 80,000
Total variable costs 312,000
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