ACCT20001 Cost Management

Department of Accounting

Tutorial Week 8 Solutions

REQUIREMENT 1:

a)
Alternative 1: Relevant (incremental) cost if make:
 Direct materials : 20,000
 Direct labour: 55,000
 Variable Overhead: 45,000
 Fixed O/H: 40,000
 TOTAL: 160,000

Alternative 2 Relevant incremental cost if bought:

 Purchase cost: 180,000
 Rental income: 15,000
 TOTAL: 165,000

Cost of making is lower than buying >> therefore, MAKE.

Note 1: Sometimes fixed costs can be a relevant (e.g., in this example, a

portion of the fixed cost is relevant)

Note 2: The $30,000 fixed cost component is an irrelevant cost as it

would be incurred under both alternatives and therefore can be ignored
in the analysis. However if you included this $30,000 as a cost to both
alternatives, then you still get a difference of $5,000 in favour of “Make”
– i.e., it doesn’t change the decision. However, the reason why you
should not include this $30,000 is because by doing so you would add
‘clutter’ to your analysis and may distract management (if you are
preparing the analysis for management) from being able to quickly
understand where the real differences in costs are between the 2
alternatives.

Note 3: Items can often be incorporated in either side of the analysis.

For example, it is fine if the $40,000 of Fixed O/H is incorporated as a
negative number in Alternative 2 instead of a positive number in

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Alternative 1. The difference between the two options would still be
$5,000 in favour of Alternative 1.

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b)

As mentioned in the question, FFI will choose 1 (out of 2) new product to manufacture as there is
not enough floor space to manufacture both.

Also, there is sufficient machine time to manufacture the units demanded of TC513 OR GL745.

 9 x 875 < 175 x 60 mins


 12 x 850 < 175 x 60 mins

TC513’s Total CM = (494.40 – 395.20) x 875 units = 86,800

GL745’s Total CM = (449.43 – 345.00) x 850 units = 88,765

Therefore choose GL745.

It is not necessary to calculate a CM/machine hour since there is not enough floor space to
manufacture both products. Therefore ONLY 1 product can be manufactured.

Note that in the lecture 9 notes, it is stated that when there are no constraints, we should prioritise
the product with the highest CM/unit. This is true when we don’t have information on units to be
sold (which is different to the situation in part c here). In this scenario (i.e., where we do not have
information on units to be sold), then prioritising the product with the highest CM/unit should also
maximize Total CM (all else equal).

However when you have information on the number of units that we expect to sell, then prioritise
the product that will maximize your Total CM as this would also maximize your Total Profit
when fixed costs are unchanged (i.e., Product GL745).

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REQUIREMENT 2:

1. Prepare an analysis that shows the most profitable mix to manufacture of

lollipops (L) and jellybabies (J). How many orders of each confectionery item
will go unfulfilled?

Identify if there is a constraint: Total mixing labour hours required per month: (1000
L x 1.25 hrs) + (1,200 J x 0.5 hrs) = 1850 hrs.
Each batch of L takes 1.25 hrs direct labour hours (mixing) since $18.75 / 15 = 1.25.
Each batch of J takes 0.5 hrs of direct labour hours (mixing) since $7.50 / 15 = 0.5
Total capacity of mixing labour in a month =1,600 hrs.
Therefore mixing Labour is a constraint.

Calculate unit contribution margins:

Lollipops Jellybabies
Selling price per batch $54.00 $28.50
Costs per batch:
Direct Materials ( 5.25) ( 2.50)
Direct Labour ($15/hour) (18.75) ( 7.50)
Variable manufacturing OH ( 9.375) ( 3.75)
Selling and Admin Cost† ( 9.50) ( 4.50)
Contribution Margin $11.125 $10.25

DLH (Mixing) per batch: 1.25 0.5

Contribution per hour $8.90 $20.50

†
In calculating the contribution margin, $4.00 of fixed overhead cost per unit for distribution
must be deducted from the selling and administrative cost.

In order to maximize the company’s profitability, Sarah’s Confectionery should manufacture

as many batches of jellybabies as possible, as they maximize the contribution per direct-
labour hour available. We use our scarce direct labour hours for the most profitable product
per unit of scare resource (direct labour hours) first, then use any remaining direct labour
hours for less profitable products per direct labour hour. This means we make as many
jellybabies as possible, then any remaining direct labour hours should be used to make
lollipops. The calculations of this are as follows:

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 Quantity DLH Balance Unit Total
(# of per Total of Contri- Contri-
Item Batches) Unit DLH DLH bution bution
Total hours ................ 1,600
Jellybabies ................. 1,200 0.5 600 1,000 $10.25 $12,300.00
Lollipops.................... 800 1.25 1,000 — 11.125 8,900.00
Total contribution ...... $21,200.00

Therefore, 200 (=1,000 – 800) batches of lollipop orders remain unfulfilled for the month.

2. What are the highest prices that Sarah should be willing to pay Phil’s for
lollipops assuming that purchases from Phil’s will incur selling and
administrative costs of $4 per batch?

The answer for lollipops is simple. Sarah cannot meet the demand. Sarah should be willing to
pay any price less than or equal to $50.00/batch (the $54/batch selling price less the $4/batch
selling and admin cost). At $50/batch Sarah makes zero contribution margin (i.e. zero
incremental operation profit), but fulfils all of her customer demand.

3. What are the highest prices that Sarah should be willing to pay Phil’s for
jellybabies, assuming that purchases from Phil’s will incur selling and
administrative costs of $4 per batch?

The answer for jellybabies is a bit more complicated. Sarah earns $10.25/batch of
contribution margin on each batch of jellybellies, but that does not take into account the
opportunity cost of $4.45 (= 8.90 / 2 since each batch of jellybabies only takes 30 mins to
produce) from the use of the scarce resource, mixing department direct labour hours. Recall,
that opportunity cost is the value of the next-best use of any resource. In this case, the next-
best use of direct labours in the mixing department is producing lollipops for a contribution
margin of $8.90/DLH.
Therefore, Sarah should be willing to purchase jellybabies up to a price that would result in a
unit contribution margin greater than or equal to $5.80/batch (10.25 – 4.45). That is any price
of less than or equal to $18.70/batch = (28.50 – 4.00 – 5.80). Note that this is somewhat
greater than Sarah’s variable cost of $18.25/batch to make jellybabies.

Alternative approach that gives you the same answer $18.70 but more explicitly considers
relevant costs / revenue items:

A.      If Sarah buys Jellybabies, the relevant (i.e., that are different from making it herself
and are in the future) costs and revenues per unit are :

  -          Purchase price from Phil (cost): $X (need to find this)

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 -          Admin cost (cost) $4

-          Revenue from making 0.5/1.25 lollipops (revenue) x 54 = $21.60

-          Variable cost from making 0.5 / 1.25 lollipops (cost) x 42.875 = $17.15

 B. If Sarah made Jellybabies, relevant (i.e., that are different from buying from Phil and are
in the future) costs and revenues per unit are

  -          Variable costs (cost) 18.25

Since we want a situation where Sarah is indifferent between both options, therefore equate
cost of A to cost of B and solve for X, i.e.,

X + 4 – 21.6 + 17.15 = 18.25

X = $18.70

(Note – subtract $21.60 since this is additional revenue earned from making 0.4 lollipops).

The number of jellybabies batches that Sarah would be willing to purchase at this price = 500
= (200 unfulfilled lollipop demand x 1.25 DLH for each batch of lollipop) / 0.5 DLH per
batch of jellybabies. I.e., getting Phil to make 500 batches of jellybabies will give Sarah the
exact time needed to fulfil the demand for the remaining 200 batches of lollipops.

Proof that Sarah would be indifferent at a CM of $5.80 for J:

Quantity DLH Balance Unit Total
(# of per Total of Contri- Contri-
Item Batches) Unit DLH DLH bution bution
Total hours ................ 1,600
Jellybabies (buy)….. 500 0 0 1,600 $ 5.80 $ 2,900.00
Jellybabies (make)..... 700 0.5 350 1,250 10.25 7,175.00
Lollipops.................... 1000 1.25 1,250 — 11.125 11,125.00
Total contribution ...... $21,200.00

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 4. Name at least three qualitative factors that Sarah should consider when deciding
whether to purchase lollipops and jellybabies from Phil’s.

The usual suspects (quality control, reliability of the supplier, possible negative customer
reaction if they found out that items were made externally) are all valid responses. Also note
the following:
 If Phil’s price provides a net CM of zero, is there a benefit to fulfilling demand
when there is no incremental profit? If Sarah regularly stocks-out of lollipops,
customers who prefer lollipops may begin to shop elsewhere. Perhaps it is better to try
to meet the whole market demand even if some sales only just breakeven.

5. Sarah is considering hiring additional staff to expand the capacity of the mixing
department. What information from the analysis performed in Part 1 could
possibly be used to help her make this decision. What are the underlying
assumptions that Sarah needs to make in order to use this information for
decision making.

Using the analysis from Part 1, the breakeven labour wage rate that Sarah would be
indifferent between hiring an additional hour of labour and not adding an additional
hour of labour is $23.90. This figure is made up of the contribution margin of Sarah’s
unmet demand from Lollipops ($8.90/dlh) + the $15.00 current direct labour rate.
She would need to hire an additional (200 x 1.25) = 250 hours of mixing labour each
month to fulfil the unmet demand for lollipops. Assuming that each worker works 160
hours a month, it would be equivalent to hiring an additional 1.6 workers each month.

Assumptions
 There are no other significant incremental costs to hire additional labour apart
from the hourly wage rate (e.g., no significant incremental hiring costs and
training cost)
 Labour can be hired on an hourly basis – i.e., it is truly a variable cost. In practice,
she may need to / may prefer to hire labour on a longer-term contractual basis and
therefore may have to pay them irrespective of whether there is work or not – e.g.,
Lloyd’s Bikes lecture illustration. In this case, labour becomes a fixed cost over
the life of the contract. She would need to predict the total incremental revenues
and costs over the life of the labour contract (e.g., what is the expected total unmet
demand for Lollipops over the life of the contract and the total cost of hiring
additional labour on a long term basis over the life of the contract) in order to
calculate a more accurate break-even labour hourly wage rate (and use this to
decide whether she would hire additional contract labour or otherwise).

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Additional Problems:
12.11 Relevant-cost approach to short-run pricing decisions.
1 Analysis of special order:
Sales, 3,000 units × €80 €240,000
Variable costs:
Direct materials, 3,000 units × €35 €105,000
Direct manufacturing labour, 3,000 units × €10 30,000
Variable manufacturing overhead, 3,000 units × €5 15,000
Other variable costs, 3,000 units × €5 15,000
Sales commission 6,000
Total variable costs 171,000
Contribution margin €69,000
Note that the variable costs, except for commissions, are affected by production
volume, not sales euros.
If the special order is accepted, operating income would be €1,000,000 + €69,000
= €1,069,000.

2 Whether García-Salve is making a correct decision to quote full price depends on many
factors. He is incorrect if his objective is to increase operating profit in the short term but
his decision causes Xucla to look elsewhere for a supplier, resulting in continued idle
capacity. If the offer to supply at full price is rejected, Alexon, in effect, is willing to
invest €69,000 in immediate gains forgone (an opportunity cost) to preserve the long-run
selling-price structure. The decision to take up the special order at a lower price of $80
may cause future price concessions to customers (if other customers find out about and
also demand the $80 price) which will hurt Alexon’s operating income by more than
€69,000. A special (lower) price whenever there is excess capacity may also cause some
of its customers to wait for excess capacity (and price reduction) before placing an order.
García-Salve is correct to stick to a full price quote if he thinks that the combined
negative effect of these 2 scenarios (if the lower price of $80 was accepted) exceed the
$69,000 in short term profits that Alexon would gain.
There is also the possibility that Xuclà Mecàniques Fluvià could become a long-term
customer if their experience on the special order is a positive one. If this happens, and
Alexon is able to charge XMF the normal price for future order, then this adds to the
benefit of taking up this special order at a price of $80.

2. Mountain Goat Cycles

A.
An acceptable response must include a clear choice of either outsourcing, or
make-or- buy, and an explanation that combines facts of the case with a general
explanation of the distinction between the two options to support the choice.

It is likely that the decision to go with the external supplier will not be easily
reversible – they would stop employing the supervisor of the line and use the
freed up factory space to manufacture a different product. Therefore, this is
likely to be a longer-term out-sourcing decision.

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B.
Total Relevant Costs
(8,000 Units)
Make Buy
Direct Materials (8,000 units @ $6 per unit) $48,000
Direct Labour (8,000 units @ $4 per unit) 32,000
Variable Overhead (8,000 units @ $1 per unit) 8,000
Supervisor’s Salary 40,000
Allocated General Overhead * not relevant
Opportunity Cost – CM forgone on new product line 60,000
Outside Purchase Price (8,000 units @ $17 per unit) $136,000
Freight Cost of Purchase (8,000 units @ $2 per unit) 16,000
Total Costs $188,000 $152,000
Difference in Favour of Purchasing Externally $36,000

*Allocated general overhead are not relevant because it they should not vary
across the two options.

C.
There are many qualitative factors that should be considered. It is not necessary
to provide a complete list, a few would suffice. Better answers would relate
general qualitative factors to be considered in make-or-buy/outsourcing
decisions to specific facts of the case. For example, one might be:

Quality of the gear shifter being supplied: Is it equivalent to that manufactured

by Mountain Goat? If not, it could have costly repercussions for brand
reputation etc. Can we ensure the quality of the gear shifter?

Also, reliability of the supplier is another factor to consider.