Chapter 17: Accounting for decision making: with and without resource restraints 17–1

Module 8 Decision making with and without constraints

Question 1: Discuss the reasons why accrual accounting methods are not appropriate for
decisions concerning the future.
Accrual accounting methods primarily evolved from the need to report historical events for
internal and external users of accounting information so that they were able to assess the
economic consequences of past decisions made. Since decision making about the future
use of economic resources, in contrast, relates to the future consequences of a decision to
be made rather than the past, it is not surprising that several concepts underlying accrual
accounting are not appropriate to such forward-looking decision- making needs.
Nonetheless, it should be noted that past costs can be useful in predicting future costs. The
costs of producing a particular product in a past period will be very useful in forming
estimates of the costs of producing the same product in the future.
Question 2: In the majority of cases, fixed costs are irrelevant in decision making, but on
some occasions, they are relevant. Describe the circumstances when fixed costs are relevant
to future decisions.
Fixed costs in the majority of cases will be unavoidable in that they will be incurred whether
or not an opportunity is accepted or rejected. However, in some cases fixed costs are
avoidable; that is, they will only be incurred if an opportunity is accepted. For example, if a
firm has the opportunity to increase its product range, additional manufacturing facilities
may need to be procured to meet the increased production volume. Costs associated with
the procurement of any additional manufacturing facility (e.g. rent, depreciation and a
portion of utilities), are fixed by behaviour and are also avoidable. In these circumstances,
such costs would be relevant to the decision of whether or not the range of products is
increased.
Question 5: Drills-R-Us manufactures a critical component it uses in assembling automated
drilling rigs. It has received an offer from an overseas supplier for a version of the
component that is 5 per cent lower than the company’s cost of making. Identify and discuss
two qualitative factors Drills-R-Us should consider when deciding if it will continue to make
the component, or buy it.
Given that Drills-R-Us has received an offer for outsourcing of a critical
component the firm uses in assembling its automated drilling rigs, qualitative
factors can be highly significant to the decision to be made by the company. As
the selling price offered by the overseas supplier is only 5 per cent of Drills-R-Us
of the cash cost of manufacturing the component, outsourcing its manufacture
offers only a modest cost saving that might be too little when taking into account
relevant qualitative factors. Furthermore, whilst it might be inferred that
qualitative factors are not readily quantifiable, unless properly accounted for
they ultimately will have a quantifiable impact. The qualitative factors that Drills-
R-Us should take into account include:
a The quality of the component supplied. Given that the component is identified as
 Chapter 17: Accounting for decision making: with and without resource restraints 17–2

being critical, conformance to design and performance specifications is highly

important. If there is any doubt as to the ability of the overseas supplier to
consistently deliver components to the design and performance standards
specified by Drills-R-Us, then it would better to continue to manufacture the
component itself. If the ability of the overseas supplier to deliver consistently
high-quality components is not properly assessed, Drills-R-Us may find that it
experiences disruptions in the manufacture and supply of automated drilling rigs
due to poor quality components sourced from the overseas suppliers. Not only
may such disruptions increase the costs of producing the automated drilling rigs
but also lead to reputational effects flowing from the delayed delivery of rigs to its
customers and, potentially, the need for Drills-R-Us to remedy faults subsequent to
delivery.
b The overseas supplier’s ability to deliver components on-time and in-full. Whilst
it is unclear if Drills-R-Us use a just-in-time (JIT) inventory management system,
it would need to have the supplied component consistently delivered on time and
in-full if it is to avoid disruption to the production schedule for automated drilling
rigs. Not only does the sourcing of the critical component from an overseas
supplier increase the length of the supply chain and, given the need for shipped
components to pass through ports and to be subject to customs and quarantine
inspections, it makes the procurement process significantly more complex. Again,
if Drills-R-Us fails to take into account the ability of the overseas supplier to
deliver on-time and in-full, it many need to increase the inventory of components
it keeps so as to avoid stock-outs. Not only will additional costs be incurred in
stocking a higher level of component inventory (e.g. storage, security and
insurance), having working capital locked up in this additional inventory incurs
the opportunity cost of not being able to use those funds for other purposes.
Finally, whilst it is unclear as to whether or not Drills-R-Us is a sufficiently large enough
business as to be required to assess the presence of modern slavery within its supply
chain, it may need to pay greater attention to the potential risks that sourcing the
component from an overseas supplier may bring.
The reputation of the overseas suppliers in terms its customer relationship
management practices. Whilst Drills-R-Us might be expecting that all of the
business it does with the overseas supplier will be problem free, the quality of the
relationship will be impacted by how well the supplier attends to expeditiously
and economically shipping urgent orders to Drills-R-Us and in promptly and
professionally addressing disputes and other after-sale issues. If the overseas
supplier lacks credible evidence as to the quality of its customer relationship
management practices, Drills-R-Us may find that greater managerial attention will
need to be directed to resolving supplier-related issues.
Apart from the cost of sourcing the component from the overseas supplier, Drills-R-Us
will ‘incur’ other costs. Have these been fully factored into the analysis of the cost
savings to be realised from a decision by Drills-R-Us to outsource? For example,
in setting-up the supply agreement, administrative and legal costs will be incurred.
In placing orders and having components shipped, procurement costs will
increase. In making payment for components received from the overseas supplier,
additional bookkeeping and foreign currency exchange costs will be incurred.
These additional costs may make a significant dent in the 5 per cent cost saving
expected to have been realised from a decision to outsource.
Finally, for what period is the supply contract to be in-place? If too short a time-
period, given that Drills-R-Us no longer makes the critical component itself, the
 Chapter 17: Accounting for decision making: with and without resource restraints 17–3

overseas supplier might unilaterally increase the price its asks to a level above
what would have been the historical cash cost incurred by Drills-R-Us but below
that which might incline the firm to recommence making the component itself. If
too long, Drills-R-Us may be locked into a contract that either is too costly to
break or means that it has to continue sourcing from a supplier who is no longer
cost competitive with other manufacturers.

Problem 2: Calculators Ltd manufactures and sells pocket calculators. The price of these
calculators is $22. The company’s current output is 45,000 units per month, which
represents 90 percent of its productive capacity. Kodix, a chain-store customer which
specialises in selling electronic goods, offers to buy 4000 calculators as a special order at
$16 each. The calculators would be sold under the name of Kodix. The total costs per
month are $800,000, of which $215,000 are fixed costs.
• A. What is the current break-even point in sales units for calculators Ltd?
• B. Advise Calculators Ltd on whether it should accept the special order.
• C. Would your advice change if Kodix wanted 10,000 calculators?
• D. What would be the minimum acceptable price per unit if Calculators Ltd was
prepared to accept the special order for 10,000 units made by Kodix and be no less
profitable than if it declined the offer.
Calculators Limited
a Breakeven point for Calculators Limited:
Breakeven point = Total fixed costs ÷
Contribution margin per unit. Total fixed costs = $215 000
Total variable costs = Total costs – Total fixed costs
= $800 000 - $215 000
= $585 000
Variable costs per unit = Total variable costs ÷ Units produced and
sold
= $585 000 ÷ 45 000 units
= $13.00 per unit
Contribution margin per unit = Selling price per unit – Variable cost per unit
= $22.00 - $13.00
= $9.00 per unit
Breakeven point = $215 000 ÷ $9.00
= 23 888.88 units (say 23
889 units rounded up)

b. Calculators Limited accept or reject the special order for 4 000 units at a
selling price of $16.00 per unit
Determination of available capacity to fill special order proposed by
Kodix Total capacity available
= Existing production and sales units ÷ Current capacity utilisation
= 45 000 units ÷ 90% (or 0.90)
= 50 000
Surplus capacity to use for special order of 4 000 units proposed by Kodix
 Chapter 17: Accounting for decision making: with and without resource restraints 17–4

= Total capacity available - Current capacity utilisation

= 50 000 units - 45 000 units
= 5 000 units

As the surplus manufacturing capacity of 5 000 units is greater than the

special order of 4 000 units, Calculators Ltd can accept the order if it has a
positive impact on the company’s total contribution margin.

Contribution margin per unit if special order is accepted and variable costs are
$13.00 per unit:
= $16.00 - $13.00
= $3.00
Total contribution if special order for 4 000 units is accepted:
= $3.00 × 4 000 units
= $12 000

Calculators Ltd should accept the special order, assuming that fixed costs are irrelevant,
since the company’s total contribution would be increased by $12000. Note that this
recommendation is based on an assumption that Calculators Ltd’s existing regular sales
of 45 000 units would not be affected by the supply of 4000 units to Kodix.

c. Calculators Ltd, due to its limited capacity, can only make 5 000 additional units.
Assuming that Kodix will only proceed if their special order for no less than 10 000
pocket calculators is accepted, Calculators Ltd can:
 Sell the 10 000 units to Kodix by using up the existing idle manufacturing capacity of 5
000 units (i.e. 5 000 = 50 000 – 45 000) and reduce their other regular sales sold for $22
per unit by the additional 5 000 units required to fill the special order requested by Kodix of 10
000 units. This would reduce the number of regular sales to 40 000 units (i.e. 40 000 = 50 000 –
10 000) . The total contribution margin generated by Calculators Ltd comprises two parts: the
contribution margin on normal sales of 40 000 units and the contribution margin on special
order sales of 10 000 units to Kodix.

This would result in a total contribution of $390 000.

Regular sales
40 000 units x $9.00 $360 000
Special order sales to Kodix
10 000 units x $3.00 $30 000
Total contribution margin $390 000

Reject the order from Kodix and sell 45 000 at $22 per unit; the total
contribution for this option would be:
= 45 000 units x $9.00 per unit
= $405 000

In purely financial terms, the second option is preferable to Calculators Ltd by

$15 000 (i.e. $15 000 = $405 000 – $390 000). Alternatively, the decrease in
total contribution margin from accepting the special order of 10 000 units
from Kodix can be determined by examining the contribution margin from the
sale of 10 000 units to Kodix versus the contribution margin forgone of the
regular sales of 5 000 units.
 Chapter 17: Accounting for decision making: with and without resource restraints 17–5

Regular sales forgone

5 000 units x $9.00 $45 000
Contribution margin from special order
sales to Kodix
10 000 units x $3.00 $30 000
Contribution margin forgone from loss of
regular sales $15 000

Whilst a possibility is for Calculators Ltd to increase its production capacity,

it is likely that total fixed costs would increase. As no additional information
is provided, it is not possible to assess this as being a feasible option.

d. The minimum price that would be acceptable:

Total value of lost sales = $45,000 (5000 units above capacity x CMu at normal price $13.00)
Variable costs of the 10000 units produced = 13.00 x 10000 = 130000
Total incremental cost fo the order = $175000 / 10,000 units = 17.50 per unit.

Problem 4: Argo Company produces 10,000 units of part 7021 for its products. The unit cost
of part 7021 is as follows:

$
Direct materials 5
Direct Labour 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 8
Total 29

Argo can purchase 10,000 units of part 7021 for $25 each. If the part is purchased, Argo can
make another product and provide a contribution margin of $10,000. However, if the part is
purchased, 75 % of the total fixed manufacturing overhead costs will still be incurred.
Required: Should Argo make or buy the part?
Agro will need to compare the costs avoided from no longer manufacturing Part 7021.

Details Amount
 Chapter 17: Accounting for decision making: with and without resource restraints 17–6

Total variable costs if made

Direct materials per unit $5.00
Direct labour per unit $10.00
Variable manufacturing overhead per unit $6.00
Total variable costs to make per unit $21.00
Total variable costs for making 10 000 units
10 000 units x $21.00 per unit $210,000
Total costs if purchased and not made
Purchase cost per unit if not made $21.00
Total variable costs for purchasing 10 000 units
10 000 units x $25.00 $250,000
Less Fixed costs avoided and contribution
margin from other product
Fixed manufacturing overhead avoided
($8.00 per unit x 10 000 units) x 25% ($20 000)
Contribution margin from other product ($10 000)
Net total costs if purchased $220 000
Total additional costs of buying 7021 $10 000

Alternatively:
Details Amount
Additional cost to buy
Variable cost per unit, to buy $25.00
Less Variable cost per unit, to make ($21.00)
Additional cost to purchase per unit $4.00
Production in units per annum 10 000
Additional total costs to buy $40 000

Less Fixed costs avoided and contribution

margin from other product
Fixed manufacturing overhead avoided
($8.00 per unit x 10 000 units) x 25% ($20 000)
Contribution margin from other product ($10 000)
Net additional cost if purchased $10 000

Or:
Make compared
to buy
Variable cost per unit $21.00
Fixed cost per unit that could be avoided
$20 000 ÷ 10 000 units $2.00
Contribution margin from other product forgone
$10 000 ÷ 10 000 units $1.00
Effective cost per unit of making $24.00
Cost per unit if purchased $25.00
Cost per unit saved if made and not purchased $1.00
 Chapter 17: Accounting for decision making: with and without resource restraints 17–7

Problem 13: Pigeon Ltd proposes a production plan for this year, aiming to maximise profits.
The following details are available:

A B C D E F

Labour hours per 7.00 9.00 5.00 10.00 6.00 7.00

unit
Machine hours per 4.00 3.00 1.00 3.00 1.00 5.00
unit
Maximum demand 2500 1200 700 1100 700 2900

Selling Price 420.00 590.00 245.00 580.00 360.00 500.00

Costs:

Direct material 140.00 140.00 70.00 60.00 90.00 80.00

Direct Labours 140.00 180.00 100.00 200.00 120.00 140.00

Fixed Overhead 140.00 180.00 100.00 200.00 120.00 140.00

Total Cost 420.00 500.00 270.00 460.00 330.00 360.00

Profit 0.00 90.00 - 25.00 120.00 30.00 140.00

Total fixed overhead, estimated to cost $1346000 irrespective of what products are
manufactured and sold, is applied at 100 per cent of direct labour cost.
A maximum of 63800 direct labour hours is expected to be available
Calculate the optimal profit-maximising production schedule and explain the reasons for
your choice.
 Problem 13 Pigeon Ltd.
1: With a maximum of 63 800 Direct Labour Hours (DLH) being available, the first step is to calculate the total DLH
required if all six products were to be manufactured.
Production requirements in DLH Product A Product B Product C Product D Product E Product F Total
Maximum demand in units 2 500 1 200 700 1 100 700 2 900 -
Direct labour hours per unit 7.00 9.00 5.00 10.00 6.00 7.00 -
Total direct labour hours required 17 500 10 800 3 500 11 000 4 200 20 300 67 300

Total direct labour hours required to produce all six products = 67 300 DLH
2: With 67 300 DLH being required to produce all six products, this is greater than the available capacity of 63 800 DLH.
Thus, the contribution margin per DLH for the six products must be calculated so as to rank each from the highest to
the lowest contribution margin per DLH
Contribution margin per unit and DLH Product A Product B Product C Product D Product E Product F
Selling price per unit $420.00 $590.00 $245.00 $580.00 $360.00 $500.00
Variable costs per unit:
Direct materials per unit ($140.00) ($140.00) ($70.00) ($60.00) ($90.00) ($80.00)
Direct labour per unit ($140.00) ($180.00) ($100.00) ($200.00) ($120.00) ($140.00)
Total variable costs per unit ($280.00) ($320.00) ($170.00) ($260.00) ($210.00) ($220.00)
Contribution margin per unit $140.00 $270.00 $75.00 $320.00 $150.00 $280.00
Direct labour hours per unit 7.00 9.00 5.00 10.00 6.00 7.00
Contribution margin per DLH $20.00 $30.00 $15.00 $32.00 $25.00 $40.00
Rank in terms of contribution margin per 5 3 6 2 4 1
DLH
Optimal production schedule Produce DLH per A B C D E F Total
unit
Maximum capacity available 63 800
Optimal production schedule
Ranked 1: Product F 2 900 7.00 20 300 (20 300)
Remaining DLH capacity 43 500
Ranked 2: Product D 1 100 10.00 11 000 (11 000)
Remaining DLH capacity 32 500
Ranked 3: Product B 1 200 9.00 10 800 (10 800)
Remaining DLH capacity 21 700
Ranked 4: Product E 700 6.00 (4 200)
4 200
Remaining DLH capacity 17 500
Ranked 5: Product A 2 500 7.00 (17 500)
17 500
Remaining DLH capacity 0
Ranked 6: Product C
0
No DLH capacity for Product C
Total DLH by product line 17 500 10 800 0 11 000 4 200 20 300 63 800
Contribution margin per DLH $20.00 $30.00 $32.00 $25.00 $40.00
Total contribution margin $350 000 $324 000 $352 000 $105 000 $812 000 $1 943 000

With Product C being the lowest ranked contribution margin per DLH, this will be the last product to be manufactured should there
be any remaining direct labour hours. As the shortfall in DLH between the maximum hours required to manufacture all six
products and Pigeon Ltd’s available direct labour capacity is 3 500 DLH (i.e. 3 500 DLH = 67 300 DLH in maximum required
for all six products – 63 800 DLH in maximum available capacity), there will be no available capacity for making Product C
(i.e. Product C’s direct labour hour requirements of 3 500 DLH equals the shortfall in available DLH).
Problem 15: You have recently been appointed as a consultant to the Murphy Manufacturing Company.
The management of the company has prepared a report showing certain data concerning the two
products Mox and Tox. The following information has been extracted from this report:

Mox Tox

Monthly sales in units 1000 2000

Selling price 3.00 1.50
Costs
Direct materials 0.80 0.50
Direct Labour 1.00 0.20
Fixed overheads 1.40 0.50
Total cost 3.20 1.20
Profit (loss) 0.20 0.30

In view of the poor results shown by Mox, the following changes have been proposed by
management:
No longer manufacture Mox and buy in 1000 units per month for $2800. The quality of the
purchased product is identical and selling price will remain unchanged.
Use the spare capacity to make cox. It is estimated that 1000 units could be sold at $1.00 each.
Material costs are $0.40 per unit and labour costs $0.20.
All overheads are fixed and are expected to remain unchanged from the present cost of $2000 per
month. No inventories are held.
a. Comment on the suitability of management’s approach to assessing product profitability, as
illustrated in the report, and indicate any ways in which you think it could be improved.
b. Prepare a monthly statement of comprehensive income for the present program and the
proposed new program. Do the proposed changes appear to be profitable? Explain your
reasons.
Solutions

d. Murphy Manufacturing Company

Note to instructors:
The stimulus material suggests that total fixed costs are $2 000 per month. However, a
calculation of total fixed overheads suggests that the monthly amount would be $2 400.
This is calculated as follows:
Mox: Monthly sales of 1 000 units with a fixed overhead cost of $1.40 per unit.
= $1.40 x 1 000 units
= $1 400
Tox: Monthly sales of 2 000 units with a fixed overhead cost of $0.50 per unit.
= $0.50 x 2 000 units
= $1 000
Total fixed overheads for Mox and Tox
= $1 400 + $1 000
= $2 400

As the fixed costs are irrelevant to the production plan, the difference between given
and calculated monthly fixed overhead costs will not alter the recommended course of
action to be taken by the management of Murphy Manufacturing. However, the profit
reported will be affected by this difference were the calculated fixed overhead of $2 400
were to be used in place of the given cost of $2 000 per month.

a The management’s statement of the profitability of Mox and Tox includes fixed
costs that are not expected to change from the present total costs of $2 000 per
month. Therefore, as fixed costs are unavoidable, they will be incurred whether or
not the firm manufactures and sells both products. Thus, it follows that in the
decision regarding the optimal production plan, fixed costs are irrelevant and
should be ignored.
b Profit from present program.
Calculation of contribution per unit:

Mox Tox
Selling price $3.00 $1.50
Variable costs
Direct materials ($0.80) ($0.50)
Direct labour ($1.00) ($0.20)
Total variable costs ($1.80) ($0.70)
Contribution margin per unit $1.20 $0.80
Calculation of net profit:

Mox Tox Total

Contribution margin per unit $1.20 $0.80
Units sold 1 000 2 000
Total contribution margin $1 200 $1 600 $2 800
Fixed costs $2 000
Total profit $800

Abandon production of Mox and buy in 1 000 units for $2 800:

Mox Tox Cox

Variable cost per unit
Mox: purchase costs ($2.80)
Tox and Cox: manufacturing costs
Direct materials ($0.50) ($0.40)
Direct labour ($0.20) ($0.20)
Total variable costs ($2.80) ($0.70) ($0.60)
Selling price per unit $3.00 $1.50 $1.00
Contribution margin per unit $0.20 $0.80 $0.40
Units sold 1 000 2 000 1 000
Total contribution margin $200 $1 600 $400
All three product lines
Total contribution margin $2 200
Fixed costs $2 000
Total profit $200

The present program is the most profitable. Therefore, it is strongly

suggested that no changes be implemented.