TOPIC 3

SHORT TERM DECISION MAKING

SHORT TERM DECISION MAKING

What is decision making? A guide to management to choose options/ alternatives and/or

make good decision for the betterment of the business
Why decision making is Because management faces vast amount of alternatives and
important? problems in dealing with daily activities. Hence it must choose
the best alternative that gives the highest return or the
maximum profitability.
How does decision making The business needs to consider factors either quantitative
take place? and/or qualitative using appropriate costing method.

Types of short term decision making:

1. Relevant cost and benefits

2. Limiting factors
3. Make or buy
4. Accept or reject special order
5. Drop/ add a segment

RELEVANT COST AND BENEFITS

Relevant cost Irrelevant Cost

Those future costs and revenue that will be Those costs that will NOT be affected by the
changed by a decision decision making

Example: If you are faced with a choice of making a journey using your own car or by public
transportation, the relevant cost and irrelevant cost are:

Relevant cost Irrelevant Cost

Petrol costs, or the public transportation fare Road tax or car insurance

Avoidable cost Unavoidable cost

Those costs that may be saved by not Costs that CANNOT be saved or will continue
adopting a given alternative or will no longer to be incurred even if a subunit or activity is
be incurred if a particular action is taken. eliminated.

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Example: A Worldwide Airways decided to discontinue the operation of its World Express Club
because the CEO of the company worried that the club might not profitable. The financial
controller prepared the following report in regards of the avoidable and unavoidable costs.

Worldwide Airways
Report on the Relevant Costs and Benefits of World Express Club:

Keep the club Eliminate Club Differential

(RM) (RM) amount
(RM)
Sales revenue 200,000 0 200,000
Less: Variable expenses:
Food and beverages 70,000 0 70,000
Personnel 40,000 0 40,000
Variable overhead 25,000 0 25,000
Contribution Margin 65,000 0 65,000
Less: Fixed expenses:
Depreciation 30,000 30,000 0
Supervisors’ salary 20,000 0 20,000
Insurance 10,000 10,000 0
General allocated overhead 10,000 10,000 0
Airport fees 5,000 0 5,000
Profit/ (loss) (10,000) (50,000) 40,000

What are the avoidable costs? What are the unavoidable costs?
Supervisor’s salary Depreciation
Food and beverages Insurance
Personnel General allocated OHD
VOHD
Airport fees

Sunk costs Costs that have been incurred in the past and cannot be altered by any
current or future decision. (These costs are the cost of resources
already acquired where the total will be unaffected by the choice
between various alternatives. They are costs that have been created by
a decision made in the past and that cannot be changed by any
decision will be made in the future).

Example: the acquisition cost of equipment previously purchased and

the manufacturing cost of inventory in hand.
(Irrelevant for decision making process)

Notional costs These costs are only a book exercise and do not represent real cash
flow. Depreciation
Notional costs are intended to make internal decision making more
realistic by assuming that the cost of all resources consumed reflects
18
 the full economic value - usually by applying market prices.
Notional charges are typically used to charge responsibility centers with
a 'market rent', where buildings have been purchased on a freehold
basis. Such a mechanism helps to focus management attention on
making best use of space so that surplus space across the whole
organization might then be sold or rented to another user. Notional
interest is often charged for the use of internally generated funds.

(Irrelevant for decision making process)

Opportunity costs It is the potential benefit given up when the choice of one action
precludes selection of a different action. (It is a cost that measures the
opportunity that is lost or sacrificed when the choice of one course of
action requires that an alternative course of action be given up).

Example: if chicken and fish are the available choices for dinner, the
opportunity cost of eating chicken is the forgone pleasure associated
with eating fish.

Example 2:
Further studies: Knowledge/ degree qualification (choose)
Vs
Working: Salary/ working experience
Opportunity costs (benefit that we have to let go) = salary & working
experience
(relevant for decision making)
Committed costs Results from the organization’s ownership or use of facilities and its
basic organizations structure.

Example: property taxes, depreciation of building and equipments, cost

of renting facilities or equipment and the salaries of management
personnel.

(Irrelevant for decision making process)

19
LIMITING FACTOR

What is limiting factor? The key factor or resources that is in short supply and will restrict the
expected performance of a business.

Examples:
Materials Limited supply (quantities), limited financing (low budget)
Labor Hours limited, payment is dependable on budgets
Machine hours Limited working capacity
Plant capacity Limited space
Sales Limited customers demand
Management Inefficient management and lack of know-how technology

Comprehensive illustration 1 (CTMAF320/JAN2013)

Ain Az-Zahra Design makes and sells scarf for local market. The scarf comes in three different
designs: Exclusive, Unique and Trendy.

Below is the unit cost information for the production of scarf for the next year:

Exclusive Unique Trendy

Selling price per unit (RM) 90.00 70.00 50.00
Variable cost (RM) 60.00 50.00 38.00
Direct labour hour per unit 5 hours 4 hours 3 hours
Direct material per unit (meter) 2.5 2 1.5
Forecasted sales (Unit) 12,000 3,000 8,000
Fixed costs (RM) 24,000 22,000 12,000

The management has provided the following information regarding the availability of the
resources for the coming year:

i. The maximum direct labour hours available for the coming year will be 78,000 hours. No
overtime is permitted, and it is impossible to employ additional workers.

ii. The material will be supplied by two different suppliers due to unexpected problem faced
by the current supplier A. The current material supplier A can only supplies 55,000
meters and another 15,000 meters will be supplied by supplier B. There is no opening or
closing stock available in the store.

Required:

a) State which is the limiting factor, direct labour or direct material?

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Direct Labour hours
Product Sales/ demand (unit) Direct labour hour Direct labour hour
per unit required (hours)
Exclusive 12,000 5 hrs 60,000
Unique 3,000 4 hrs 12,000
Trendy 8,000 3 hrs 24,000
Total direct labour required 96,000
Total direct labour available 78,000
(shortage) (18,000)

Direct Material
Product Sales/ demand (unit) Direct material Direct material
per unit required (m)
Exclusive 12,000 2.5 m 30,000
Unique 3,000 2m 6,000
Trendy 8,000 1.5 m 12,000
Total direct material required (m) 48,000
(55,000 + 15,000) Total direct material available (m) 70,000
Excess 22,000

Therefore, the limiting factor is direct labour hours

b) Given the above constraints, calculate the most profitable mix of the products to be
produced based on the availability of the limited resource (show all workings)

Exclusive Unique Trendy

Selling price per unit 90.00 70.00 50.00
Less: Variable costs (60.00) (50.00) (38.00)
Contribution margin 30 20 12
Limiting factor per unit (DLH) 5 hours 4 hours 3 hours
CM/LF = 30/ 5 5 4
=6
Ranking 1 2 3

Production schedule based on the profitable mix:

Ranking Product Unit DLH per DLH DLH Units

demand unit required available produced
1 Exclusive 12,000 5 60,000 78,000 12,000
2 Unique 3,000 4 12,000 (78000 – 3,000
60000)
=18,000
3 Trendy 8,000 3 24,000 (18000 – 6000/ 3
12000) = 2,000
= 6000

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Net profit based on the profitable mix:

Product Workings (unit produced x CM/u) Total contribution

Exclusive 12,000 x RM30 360,000
Unique 3,000 x RM20 60,000
Trendy 2,000 x RM12 24,000
Total contribution margin 444,000
Less: Fixed Costs (22,000 + 24,000 + 12,000) (58,000)
Net Profit 386,000

Comprehensive illustration 2 (AC/JUN2010 MAF320)

QUALITY BHD made and sold three products; SUN, MOON, STAR. Information regarding the
products is given as follows:

SUN MOON STAR

Direct material usage (kg) 2 2.5 3
Direct labour hours 3 3 5
Variable overhead RM 56 RM 42 RM 65

Budgeted sales are:

Sales revenue RM 500,000 RM600,000 RM 600,000
Selling price per unit RM 200 RM 200 RM 300

Currently the material WIND can be bought at RM15.00 per kg and it is estimated to remain
constant over the next period. Direct labour will be paid RM8.00 per hour worked. The fixed
production overheads for the period are estimated to be RM295,000 and fixed and selling
administration overheads are RM277,000.

The current supplier has informed the company that they are unable to supply the material in
the next period due to some problem. Therefore, the purchasing manager has conduct some
survey and found that the material can be obtained from the different supplier where supplier A
can supply 7,000 kg, supplier B 6,000 kg and supplier C 4,000 kg.

Required:

a) Determine the shortage of the material

(5 marks)

b) Advice the company on the most profitable mix of products to be produced based on the
availability of the that material (show all workings)
(7 marks)

c) How much is the net profit of the company if the proposal in (b) is carried out?
(5 marks)

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 d) What are the disadvantages of determining the products to be produced based on
ranking?
(3 marks)
(Total: 20 marks)
Solution:
a) Shortage of material

Sales/ demand (unit) Direct material / unit Material required (kg)

SUN 2,500 2 5,000
MOON 3,000 2.5 7,500
STAR 2,000 3 6,000
Total Direct material required 18,500
Total Direct material available 17,000
(Shortage) (1,500)

b) Profitable mix
SUN MOON STAR
Selling price 200 200 300
Less: Direct material 2kg x RM15 (37.5) (45)
= (30)
Direct labour 3hrs x RM8 (24) (40)
= (24)
Variable overhead (56) (42) (65)
Contribution margin (CM) 90 96.5 150
Limiting factor per unit (d. material) (LF) 2 2.5 3
CM/LF 45 38.6 50
Ranking 2 3 1

Production based on the profitable mix:

Ranking Product Unit DM/ unit Material Material Units

demand required available produced
1 Star 2,000 3 6,000 17,000 2,000
2 Sun 2,500 2 5,000 11,000 2,500
3 Moon 3,000 2.5 7,500 6,000 (6000/
2.5kg)
= 2,400

c) Net profit of the company

Products Workings Total contribution

Star 2,000 x 150 300,000
Sun 2,500 x 90 225,000
Moon 2,400 x 96.5 231,600
Total contribution margin 756,600
Less: Fixed overhead (295,000)
Less: Fixed selling and admin (277,000)
Net profit 184,600

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 d) What are the disadvantages of determining the products to be produced based on
ranking? (Qualitative factors)
1. Product that has highest demand will be produced last – not given priority to be
produced.
2. It may give negative effect on the relationship with the customers due to the inability
of the business to fulfill the demand.
3. The reputation or image of the business may be tarnished due to dissatisfaction of
customers.
4. Future sales may be negatively affected (decrease in future sales) as the dissatisfied
customer will look for another supplier to fulfill their demand.

Comprehensive illustration 3 (AC/OCT 2012/MAF320)

Healthyware Sdn Bhd manufactures and sells exclusively designed non-toxic containers. These
containers are sold at retail outlets in three designs, namely, Orchid, Rose and Tulip. The selling
price and the sales mix of these containers are listed below:

Orchid Rose Tulip

Selling price (RM) 15.00 25.00 30.00
Sales mix (based on sales units) 50% 30% 20%

The company plans to sell a total of 20,000 units consisting of all designs. It has been
established that the maximum direct labour hours available during the year will be 15,500 hours
and the direct labour rate is RM6 per hour.

The manufacturing costs per unit are as follows:

Orchid Rose Tulip

RM RM RM
Direct material 3.00 5.00 8.00
Direct wages 3.00 6.00 9.00
Factory overhead (70% variable) 4.00 6.00 8.00

Apart from the above costs, the company also incurs variable selling and distribution overhead
of RM0.50 per unit and fixed administration overhead of RM25,000 per annum.

Required:

a) Determine the shortage of direct labour hours (4 marks)

b) Compute the contribution per unit for each product (6 marks)
c) Calculate the profit for the year based on the most profitable mix (10 marks)

Product Sales mix x total sales (Unit) Sales/ demand unit

Orchid 50% x 20,000 10,000
Rose 30% x 20,000 6,000
Tulip 20% x 20,000 4,000

Direct labour hours required:

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 Product Sales/ demand (unit) Direct labour hour Direct labour hour
per unit required (hours)
Orchid 10,000 RM3/ RM6 = 0.5 hr 5,000
Rose 6,000 RM6/ RM6 = 1 hr 6,000
Tulip 4,000 RM9/ RM6 = 1.5 hrs 6,000
Total direct labour required 17,000
Total direct labour available 15,500
(shortage) (1,500)

Profitable mix
Orchid Rose Tulip
Selling price 15.00 25.00 30.00
Less: Direct material 3.00 5.00 8.00
Direct labour 3.00 6.00 9.00
Variable overhead (4 x 70%) 4.2 5.6
2.8
Variable selling overhead 0.50 0.50 0.50
Contribution margin (CM) 5.7 9.3 6.9
Limiting factor per unit 0.5 1 1.5
CM/LF 11.4 9.3 4.6
Ranking 1 2 3

Production schedule:
Ranking Product Unit DLH per DLH DLH Units
demand unit required available produced
1 Orchid 10,000 0.5 5,000 15,500 10,000
2 Rose 6,000 1 6,000 10,500 6,000
3 Tulip 4,000 1.5 6,000 4,500 (4500/1.5)
=3,000

Net Profit:
Products Workings Total contribution
Orchid 10,000 x 5.7 57,000
Rose 6,000 x 9.3 55,800
Tulip 3,000 x 6.9 20,700
Total contribution margin 133,500
Less: Fixed overhead (based on original unit demand)
Orchid: (30% x RM4) x 10,000 (12,000)
Rose: (30% x RM6) x 6,000 (10,800)
Tulip: (30% x RM8) x 4,000 (9,600)
Fixed admin overhead (25,000)
Net profit 76,100

25
MAKE OR BUY

Make-or-buy decisions arise in business when a company must decide whether to produce

goods internally or to purchase them externally. This typically is an issue when a company has
the ability to manufacture material inputs required for its production operations that are also
available for purchase in the marketplace. For example, a computer company may need to
decide whether to manufacture circuit boards internally or purchase them from a supplier.

When analysing a make-or-buy business decision, look at several factors. The analysis must

examine thoroughly all of the costs related to manufacturing the product as well as all
the costs related to purchasing the product. Such analysis must include quantitative factors
and qualitative factors.

The analysis must also separate relevant costs from irrelevant costs and look only at the

relevant costs. The analysis must also consider the availability of the product and the quality of
the product under each of the two scenarios. (LF = opportunity cost)

The make-or-buy decision involves both quantitative analysis and qualitative analysis. You can

calculate and compare quantitative considerations. Qualitative considerations require subjective
judgment and often need multiple opinions. Also, some of the factors involved can be quantified
with certainty, while other factors must be estimated. The make-or-buy decision requires
thorough analysis from all angles.

Quantitative factors to consider may include things such as the availability of production facilities
production capacity and required resources. They may also include fixed and variable costs that
can be determined with certainty or estimated. Similarly, quantitative costs include the price of
the product under consideration as it is being priced by suppliers offering the product in the
marketplace for sale.

Qualitative factors to consider require more subjective judgment. Examples of qualitative factors
include the reputation and reliability of the suppliers, the long-term outlook regarding production
or purchasing the product, and the possibility of changing or altering the decision in the future
and the likelihood of changing or reversing the decision at a future date.

Relevant Costs and Irrelevant Costs

When making the make-or-buy decision, it is necessary to distinguish between relevant and

irrelevant costs. Relevant cost for making the product are all the costs that could be avoided by
not making the product as well as the opportunity cost incurred by using the production facilities
to make the product as opposed to the next best alternative usage of the production facilities.
Relevant costs for purchasing the product are all the costs associated with buying it from
suppliers. Irrelevant costs are the costs that will be incurred regardless of whether the product is
manufactured internally or purchased externally.

 If the cost of making is less than cost of buying the components, then the firm should make
the components. This will increase the contribution/ profit obtained.
 Opportunity cost is considered in a make or buy situation only if there is limited capacity i.e.
where the production of the particular of some other component product.

26
Illustration 1

Food Sos (M) SB manufactures all kinds of sauces namely, soy sauce, tomato sauce, chili
sauce, oyster sauce and seasoning sauce. The manager is considering whether to buy or
process one ingredient, processed sago. The cost of manufacturing processed sago is
estimated to be:
Direct material RM4,000 Variable overhead RM2,200
Drect labour RM800 Fixed overhead RM4,600
(irrelevant cost)

The processed sago can be purchased from an outside supplier for RM7,500. The production of
processed sago requires 1 000 hours of a special machine which is now fully utilized to mix and
process gula Melaka. If production of processed sago is undertaken, production of processed
gula Melaka would be reduced by 4,000 kg resulting in a loss of revenue of RM2,500. The
marginal costs of producing 4,000 kg of processed gula Melaka is RM 1,500. Should the
company make or buy processed sago?

Solution:

Limiting factor = special machine

Calculate Opportunity cost:
Opportunity cost = profit forgone from process gula melaka

RM
Gula Melaka sales revenue 2,500
Less: Marginal/ variable cost of gula Melaka (1,500)
Profit forgone (Opportunity costs) 1,000 (relevant cost for making)

Comparison statements:
Relevant Cost of buying: RM
Purchase costs 7,500

Relevant Cost of making: RM

Direct materials 4,000
Direct labour 800
Variable overhead 2,200
Opportunity costs 1,000
Total cost of making 8,000

Decision: The company should buy processed sago because the cost of buying is cheaper by
RM 500 (RM8,000-7,500).

OR
The company should buy processed sago since it is cheaper and it will increase the profit of the
company by RM500 (8,000 – 7,500).

27
Illustration 2
SLIM BHD manufactures all types of breakfast cereal. Due to the high demand of their products,
the management of the company is considering introducing new product line which require new
ingredient called DELICIOUS. The cost of manufacturing DELICIOUS is estimated as follows:

Direct Material 1,000kg @ RM4 per kg

Direct labour 1,600 hours @ RM0.50 per hour
Variable overhead 1,100 kg @ RM2 per kg

The fixed overhead is estimated to be at RM4,600. The production of DELICIOUS requires

1,000 hours of the special machine. However, the operation manager informed that the special
machine needed to produce the cereal is now fully utilized to mix and process YUMMY. If
production of DELICIOUS is undertaken, production of YUMMY would be reduced by 4,000 kg
resulting in a loss of revenue of RM2,250. The marginal costs of producing 4,000 kg of YUMMY
are RM1,320.

During a meeting, the Purchasing Manager has informed that, to avoid any disruption of
YUMMY production, DELICIOUS can be purchased from outside supplier for RM7,500.
However, to maintain the quality of the cereal, RM650 cost of inspection will be needed. The
company also needs to bear the cost of transportation of RM400, to ensure that the ingredients
will be delivered on time. If the company purchased DELICIOUS, the amount fixed overhead
that can be saved is RM350.(relevant cost)

Limiting factor = Special machine hours

Calculate Opportunity cost: profit forgone for YUMMY.

RM
YUMMY sales revenue 2,250
Less: Variable/ marginal cost of YUMMY (1,320)
Profit forgone (Opportunity costs) 930

Comparison Statement:
Cost of Making RM
DM (1,000kg x RM4 per kg) 4,000
DL (1,600 hours x RM0.50 per hour) 800
VOHD (1,100 kg x RM2 per kg) 2,200
Avoidable FC 350
Opportunity Cost 930
TOTAL 8,280

Cost of Buying RM
Purchased cost 7,500
Inspection cost 650
Transportation cost 400
Less: Cost saving (350)
TOTAL 8,200

Decision: The company should buy DELICIOUS because the cost of buying is cheaper by
RM80 (8280 – 8200).
28
COMPREHENSIVE EXAMPLE 1 – AC/SEP 2015/MAF320

QUESTION

Idaman Seri Sdn Bhd manufactures and supplies landscaping accessories throughout Malaysia.
One of the most popular accessories is a garden fountain called Glittering Fountain. Currently,
the company produces and sells at an average of 3,000 units of Glittering Fountain every
month.

Every unit of Glittering Fountain needs a special pump as the major component. Currently the
pumps are bought from Gerak Bhd at a price of RM90 per unit. However, the supplier has sent
a notice to Idaman Seri Sdn Bhd stated that the price will be increase by 5% in the future.

A suggestion has been made by the financial controller of Idaman Seri Sdn Bhd to manufacture
the pump itself and the production manager is instructed to prepare the cost estimation.

The estimated costs to produce a unit of the pump are given below:

RM
Direct material – Steel 8.00
Motor 15.00
Plastic 7.00
Direct labour 20.00
Production overhead (30% variable) 60.00
Total cost 110.00

Based on the production cost estimation, the production manager suggests that it would be
better for the company to continue buying the pump as the price offered by the supplier is still
lower than the cost of producing it. Furthermore, the following items will also have to be
considered if the pump is produced:

1. The existing production of other landscaping accessory, a herb container, will have to be
decreased by 500 units since the pump will occupy a part of the production area. The
herb container is sold at RM200 per unit at the following cost per unit:

RM
Direct material 60.00
Direct labour 40.00
Production overhead (40% variable) 50.00
Total cost 150.00

2. The company will have to incur inspection cost of RM11,000 for quality purposes.
3. The company’s fixed overhead will increase by RM9,000.
4. A special machine has to be acquired to assemble the pump components at a cost of
RM7,000.

29
Required:

a) Estimate the opportunity cost from the loss of sales for the herb container if Idaman Seri
Sdn Bhd decides to produce the pump internally.
b) Compute the relevant cost of making and relevant cost of buying the pump.
c) Compare the findings in part (b) above. Select the best decision for the company.
d) List four (4) qualitative factors that Idaman Seri Sdn Bhd needs to consider in making the
above decision.

Suggested solution:

a. The opportunity cost from the loss of herb container sales

RM RM
Selling price 200
Less: Variable costs
Direct material 60
Direct labour 40
Variable production overhead (RM50 x 40%) 20 (120)
Contribution Margin 80
x) units forgone 500 units
Total opportunity costs 40,000

b. The relevant cost of making and relevant cost of buying the pump.
The relevant cost of making
Workings RM
DM – steel RM8 x 3000 units 24,000
DM – motor RM15 x 3,000 units 45,00
DM – plastic RM 7 x 3,000 units 21,000
Direct labour RM20 x 3,000 units 60,000
Variable overhead (RM60 x 30%) x 3,000 units 54,000
Opportunity cost 40,000
Inspection 11,000
Additional fixed overhead 9,000
Special machine 7,000
Total cost of making 271,000

Relevant cost of buying

Workings RM
Purchase cost RM90 x 105% x 3000 units 283,500
Cost of buying 283,500

c. Compare the findings and select the best decision

RM
Relevant cost of making 271,000
Relevant cost of buying 283,500
Savings 12,500
30
Decision: The company should make the pump because the cost of making is cheaper by
RM12,500.

Four qualitative factors to consider before making the pump internally.

1 Whether the company has the expertise or technical knowledge in making the pump
internally.

2 Whether the company can produce a good quality pump as offered by the supplier

3 Ability of the company to meet the deadline of the production schedule

4 Whether the company need to acquire special material, machine or skilled labour.

Four qualitative factors to consider before buying the pump.

1 Reliability of the supplier
2 Whether the supplier able to maintain the same quality of the pump in the long-run
3 Whether the supplier is able to offer the same price or give discount in the future
4 Whether the supplier is able to deliver the goods on time.

COMPREHENSIVE EXAMPLE 2 – AC/MAR 2015/ MAF320

QUESTION

Kenyalang Cake House is a very popular bakery in Kuching, baking Sarawak layer cake.
Currently, the business specialized in baking three types of layer cake namely Chocolate
Cheese, Kenyalang Waterfront and Santubong.

The most popular layer cake is the Chocolate Cheese which needs a special cocoa powder and
cheese as the main ingredients. Currently, the cocoa powder is purchased from Nur Dairy Bhd
at a price of RM25 per pack. However, in the next period, the cocoa powder’s price will increase
by 10%. In addition, Kenyalang Cake House has to incur transportation cost of RM3,300 for the
supply of cocoa powder.

The owner of Kenyalang Cake House, Maira, noticed that the demand for Chocolate Cheese
layer cakes shows an increasing trend. So she thought that it will be cheaper if the bakery
makes its own cocoa powder. With the help of the production manager, they estimated the cost
of producing the cocoa powder to be as follows:

Estimated production (cocoa powder) 2,000 packs

Estimated cost per pack:

Direct material: cocoa RM3.00
: special flour RM2.00
Additional material: colouring RM0.80
Direct labour RM2.50
31
Overhead (30% variable) RM6.00
In addition, the bakery has to incur a cost of RM3,100 in setting up the production facilities for
the production of cocoa powder. However, the bakery’s fixed overhead can be reduced by
RM600 if it produces it own cocoa powder.

If the bakery produces the cocoa powder, the production of Santubong layer cakes has to be
discontinued since the production of cocoa powder will be using the same mixing machine.

Currently, the mixing machine is being used to produce 2,500 boxes of Santubong layer cake
sold at RM50 per box.

The costs of baking 2,500 boxes of Santubong layer cake are as follows:

RM
Direct materials 50,000
Direct labour 12,500
Overhead (75% variable) 20,000

Required:

a. Compute the opportunity costs of Santubong layer cake if the production has to be
sacrificed.
b. Compute the relevant cost of making and the cost of buying of 2,000 packs of cocoa
powder.
c. Advise Kenyalang Cake House whether to make or buy the cocoa powder. Calculate the
cost of savings if any.
d. List four (4) qualitative factors to be considered before deciding to make a product.

Suggested solution:

a. The opportunity cost from the loss of Santubong Layer Cake sales

RM RM
Sales (2,500 x RM50) 125,000
Less: Variable costs
Direct material 50,000
Direct labour 12,500
Variable production overhead 15,000 (77,500)
Total opportunity costs 47,500

b. The relevant cost of making and relevant cost of buying the cocoa powder.
The relevant cost of making
Workings RM
DM – cocoa 6,000
DM – special flour 4,000
DM – colouring 1,600
Direct labour 5,000
Variable overhead 3,600
Setting up costs 3,100
32
Opportunity cost 47,500
Less: reduction in fixed OH (600)
Total cost of making 70,200

Relevant cost of buying

Workings RM
Purchase cost RM25 x 110% x 2,000 55,000
Transportation cost 3,300
Cost of buying 58,300

c. Compare the findings and select the best decision

RM
Relevant cost of making 70,200
Relevant cost of buying 58,300
Savings 11,900

Decision: The company the buy coco powder because the cost of buying is cheaper by
RM11,900.

Four qualitative factors for making the product internally:

33
ACCEPT OR REJECT SPECIAL ORDER

What is special order?

- Custom design
- Based customer requirement
- Expensive – if the special order is a single product (car, computer, dress)
- Cheaper – if the special order is in bulk quantity (issue)
Issue
Normal selling price = RM30, Total cost = RM23 = profit of RM7
Special order selling price = discount RM5 = SP ask for RM25.

 In evaluating special order (SO) opportunity costs must be considered if accepting the
SO would displace production on regular sales (i.e. if there is limited capacity)
 any additional orders must be considered on the basis of the following questions:
o What price must be quoted to make the contract profitable?
o Can other orders be fulfilled if the contract is accepted?

When the management often has to make decision on whether or not to accept a SO?
a) the units have to be sold below the normal special price;
b) there is idle capacity or large excess capacity;
c) distress condition/under pressure of not performing;
d) possibility of cultivating the permanent future patronage of a new customer;
e) Competitive pressures where the company has to lower its regular price.

Consideration in evaluating SO:

a) only those costs that will be affected by taking the order are relevant (example variable
production overheads)
b) Fixed manufacturing costs are irrelevant;
c) the basic problem is to determine an acceptable price for SO units;
d) cost analysis using the contribution approach is useful technique to determine the short
run profit effects of SO transactions;
e) Management should accept a SO if some contribution (profit) is made.

Comprehensive Illustration 1 (Accept or reject special order without Limiting Factor)

ABC SB makes and sells a product called Alpha. Currently the company operates at 80%
capacity level and the cost data are presented below:

Per unit (RM) Total (RM)

Sales (8 000 units) 20 160 000
Cost of manufacturing unit:
 DM 5 40 000
 DL 4 32 000
 VPOH 1 8 000
 FPOH 4 32 000
14 112 000

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 Per unit (RM) Total (RM)
Gross margin/profit 6 48 000
Less: Fixed S&A 3 24 000
Net profit 3 24 000

During the year, an order received abroad was for the supply of 2 000 units of product Alpha.
The price offered was RM13 per unit.

Should ABC SB accept the order?

Workings:

Capacity Analysis
% Working Units
Maximum Capacity 100 (8,000 x 100%)/ 80% 10,000
OR
8000 x 1 / 0.8
Current Capacity 80 8,000
Spare/ Excess/ (shortage) 2,000
capacity
Special order requirement 2,000
Additional units required for 0 = no opportunity cost
special order

Accept or reject special order of 2,000 units

RM RM
Special order selling price 13
Less: VC
Direct material 5
Direct labour 4
Variable OHD 1 (10)
Contribution margin per unit 3
x) Units special order 2,000 units
Total contribution 6,000
Less: opportunity costs 0
Net contribution 6,000

Decision: The company should ACCEPT the special order of 2,000 units of Alpha because it will
increase the profit of the company by RM6,000.

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Comprehensive Illustration 2 (Accept or reject special order with limiting factor)

Ello Bhd manufactures compact disc players which sell to the retail outlets at a normal price of
RM950 per unit. The costs of producing one unit of the product are:

RM
Direct material 220
Direct labour 170
Production overhead (30% variable) 260
Selling and distribution overhead 100

Included in the selling and distribution overhead is the salesman commission. This commission
which is 5% of the normal selling price is given only if the salesman sells the products to the
retail outlets.

The management is looking forward of expanding the company’s operation to utilize the spare
capacity of 75 units per month. An offer was received from Rango Supermarket chains of
supplying 100 units of the compact discs players per month for 12 months at a price of RM650
per unit. Rango Supermarket chain will make some modifications on the product and sells them
as its “own branded product”. The modifications will incur additional costs of RM32 per unit. By
accepting this offer, the production and sales for normal sales will have to reduce by 25 units
per month.

Required: Advise the management whether to accept the offer for that year.

Suggested solution:

Workings:
Capacity Analysis
% Units
Maximum Capacity
Current Capacity
Spare/ Excess/ (shortage) capacity 75 units x 12 months = 900
Special order requirement 100 units x 12 months = 1,200
Additional units required for special order 300
The company need to sacrifice from the normal
How to find the additional units sales
required for special order?

1. Opportunity costs = profit forgone from the 300 units of normal sales.

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 RM RM
Selling price (normal sales) 950
Less: VC
Direct material 220
Direct labour 170
Variable OHD (30% x 260) 78
Variable selling and distribution (5% x 950) 47.50 (515.50)
Contribution margin per unit 434.50
x) Units forgone 300 units
Opportunity costs or Total contribution loss 130,350

2. Accept or reject special order of 1200 units

RM RM
Selling price (special order) 650
Less: VC
Direct material 220
Direct labour 170
Variable OHD 78
Variable selling and distribution 0
Modification costs 32 (500)
Contribution margin per unit 150
x) Units special order 1200 units
Total contribution 180,000
Less: opportunity costs (130,350)
Net contribution 49,650

Decision: The company should ACCEPT the special order of 1,200 units of compact disc
players because the profit of the company will increase by RM49,650.

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DROP/ ADD A SEGMENT

 It involves a decision to discontinue a segment in the organization (example: function,

branch, division, activity, task, job, product(s) or service(s)).
 The reasons: Unprofitable or costs are too expensive to support the existing department.
 factors that need to be considered are:

Attributable costs Cost/ unit that could be avoided if a segment is deleted without
changing the supporting organization structure:
 short-run variable cost
 FC which directly traceable to product or function
 other FC which changes when there are significant changes
in volume of activity

FC
1. Direct FC – salary of sv
A - sv
B - sv
C – sv (avoid)

2. General FC – rental of building (unavoidable)

A
B
C

Shut down decision  Its either short-term or long term

 temporary or permanent

Other factors  availability of the employees (redundant/ relocated to other

department)
 Do the employees need re-training?
 Can they be offered early retirement or voluntarily
retirement?
 Do the assets need to be transferred or disposed?

Note: as long as the segment recovers their VC and makes contribution towards recovery of FC,
a firm is better off continuing operations rather than stop.

 consideration for continuing operations: (advantages of not deleting a segment)

o Expenses connected with the shutdown of a plant would be avoided;
o cost incurred to re-open/re-start a closed segment can also be saved;
o skillful employees would be kept employed;
o recruiting and training cost of new workers is incurred if the plant is re-open;
o Established market is lost if the plant is closed. To re-enter a market later requires a
re-education of the consumers;
o temporary shutdown does not eliminate all costs (example: depreciation, interest,
property taxes and insurance, etc)

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 Alternatively, the following benefits has to be considered: (advantages of deleting a
segment)
o Avoiding operating losses;
o Savings in variable costs, maintenance and repair costs of fixed assets
o saving in indirect labor costs
o saving in fixed costs

Segregation of variable and fixed costs

- High and low method

Step 1 – calculate vc per unit

VC per unit = (HC – LC) / (HQ – LQ)

Step 2 – calculate the FC

Formula of cost function (TC = TFC + TVC)

TFC = TC – TVC
TFC = TC – (VC per unit x quantity)

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Comprehensive Illustration 1

40
 a) Prepare the revised Income Statement using marginal costing approach if the
management of Telok Baru Resort decides to close the Café.

Revised Income Statement:

Workings Hotel & Workings River Total
Lodging cruise
RM RM RM
312,000 98,000
Sales
Less: VC
Supplies & (65,000) (20,100)
material
(3,000) (2,500)
Telephone
¾ x 42,000 (31,500) ¾ x 5,400 (4,050)
Utilities
Contribution 212,500 71,350 283,850
Margin

Less: FC
72,000 + (9000 x 2) 90,000 16,600
Salaries
6,000 4,000
Telephone
(¼ x 42,000) 10,500 (1/4 x 5400) + (1/4 4,825
Utilities x 13900)
54000 + (1/4 x 55,500 9200 + (1/4 x 10,700
12000 x 50%) 12000 x 50%)
Administration
51000 + (1/4 x 53,500 30,000 + (1/4 x 32,500
20,000 x 50%) 20,000 x 50%)
Depreciation
215,500 68,625 (284,125)
Less: Additional
costs
Compensation (7,000)
Cost of closure (6,500)
Profit/ (loss) (13,775)

Statement of comparison:
RM
Profit before Café eliminated (20,000 + 3,400 + 11,200) 34,600
Profit after Café eliminated (13,775)
Difference (34,600 – (- 13775) 48,375 (decrease in profit)

Decision: The company should not eliminated café, because it will reduced the profit of
the company by RM48,375 if café is closed.

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 Before café eliminated After café eliminated
Telephone Total cost (RM) FC VC FC
ratio
HL 8000 5 5000 3000 6 (6,000)
C 3700 2 2000 1700
RC 5500 3 3000 2500 4 (4,000)
10,000 10,000

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Comprehensive Illustration 2

Timmy Time Sdn Bhd is producing three types of cookies, Butter, Wheat and Cream. Given
below are the information relates to the products:

Butter Wheat Cream

Sales units (boxes) 100,000 50,000 35,000
RM RM RM
Sales 500,000 350,000 350,000
Less: Total Costs
Direct material 150,000 120,000 200,000
Labour costs 50,000 60,000 70,000
Production overhead 30,000 36,000 54,000
Administration overhead 10,000 57,000 40,000
Marketing overhead 20,000 50,000 36,000
Profit/ (loss) 240,000 27,000 (50,000)

Due to the losses incurred by Cream products, the Managing Director asked you (Finance
Director) to conduct a feasibility study whether to discontinue the production of Cream products
or not. The following information is provided by the Operation Manager to assist you in
conducting the study:

i) Labour consists of fixed and variable elements. The fixed cost of labour is as follows:

Butter Wheat Cream

RM10,000 RM15,000 RM25,000

ii) If the company choose to discontinue Cream Product line,

a) Fixed labour cost can be eliminated, but the company has to pay an amount of
RM40,000 as compensation to the workers.

b) It is expected that the sales for Butter will increase by 20%. However, the sales
for Wheat will reduce by 5%.

Sales increase by 20%, TVC also increase by 20%

Sales reduced by 5%, TVC also reduced by 5%

c) One-third of production overhead is fixed. The fixed production overhead of

Cream product will be transferred to the remaining products based on the
following allocation: Butter (70%), Wheat (30%).

d) Administration overhead and marketing overhead are all fixed in nature. The
fixed administration overhead and marketing overhead of Cream will be borne
equally by the two products.

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Required:
a) Based on the situation, advise the company whether Cream Product should be discontinue
or not.

Workings Butter Workings Wheat Total

RM RM RM
600,000 332,500 932,500
Sales
Less: cost
180,000 114,000
Direct material
48,000 42,750
Labour: variable
10,000 15,000
Labour fixed
24,000 22,800
VOHD
10,000 12,000
FOHD
12,600 5,400
FOHD Cream
10,000 57,000
Admin overhead
Admin OHD 20,000 20,000
Cream
20,000 50,000
Marketing OHD
Marketing OHD 18,000 18,000
Cream
Total cost (709,550)
Less: (40,000)
Compensation
Profit 182,950

Statement of comparison:
RM
Profit before Cream eliminated 217,000
Profit after Cream eliminated 182,950
Difference 34,050 (decrease in profit)

Decision: The company should not eliminate product Cream because the profit will
decrease by RM34,050.

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