Saint Ferdinand College

COLLEGE OF ACCOUNTANCY
Management Science 2

Short Term Non Routine Decision Making

Optimization of scarce resources

To optimize scarce resources, sales and production should be allotted to a product that
gives the highest profit per scarce resource. If the scarce resource is direct labor hour,
then produce the product that gives the highest contribution margin direct labor hour. The
CM per hour is computed as follows:

Decision Guide: Best profitability

Unit contribution margin P xx

Divided by: hours per unit xx hours
Contribution margin per hour xx

Unit contribution margin P xx

Multiply by: Units per hour xx
Contribution margin per hour xx

As much as possible, use all resources in producing the product that has the highest
contribution margin per hour unless such product has market limitation. In such case,
after satisfying all the market need of the product that has the highest CM per
hour, produce and sell the product that has the next highest CM per hour and so on.

Illustrative problem:

Panay corporation has 52,000 available machine hours and has a fixed overhead rate of
4 pesos per hour. It is considering to produce two popular products with the following
production and cost data:

Dragon ball Samurai x

Cost if purchased from outside supplier P 70 P 105
Direct materials 11 22
Direct labor 25 38
Factory overhead at P 9 per hour 18 27
Annual demand in units 20,000 15,000

Required:
1. Assuming that there is no market limitation, which product should Panay
corporation produce?
2. Considering the market limits, how would corporation use its limited
machine hours to maximize profit?
 3. Assuming that the unit direct materials cost of Samurai x decreases to P
10 and considering the market limit, how would the limited machine-hours
be used to maximize profit?

Solutions:
1. No market limit. The product to be produced and sold should give the highest
contribution margin per machine hour. The unit sales price to be used shall be the
unit price offered by competitors.

Contribution margin per hour is computed below:

dragon ball samurai x

Cost if purchased from outside supplier P 70 P 105
Direct materials (11) (22)
Direct labor (25) (38)
Factory overhead at P 9 per hour (10) (15)
Unit CM 24 30
/ No. of hrs per unit 2 3
CM per hour 12 10
Rank 1 2

Panay corporation should produce and sell dragon ball because it has a higher
contribution margin per hour. It should use all its 52,000 machine hours to produce 26,000
units of dragon ball.

2. With market limits. Given the market limitations as provided in the problem,
52,000 machine hours would be used as follows:

Product units hours per unit total hours

rank 1 dragon ball 20,000 2 hours 40,000
rank 2 samurai x 4,000 3 hours 12,000 (Squeeze)
Total 52,000

The 52,000 machine hours will be used to produce 20,000 units of dragon ball and 4,000
units of samurai x to maximize profit. Take note, dragon ball has a market limit of 20,000
units.

3. Sensitivity analysis - e.g., change in unit direct material cost. The unit direct
materials of samurai x decreases by P 12. This means that the unit variable cost
decreases and, correspondingly, the unit contribution margin increases by 12 pesos. the
new contribution margin per hour is determined below:

dragon ball samurai x

Cost if purchased from outside supplier P 70 P 105
Direct materials (11) (10)
Direct labor (25) (38)
 Factory overhead at P 9 per hour (10) (15)
Unit CM 24 42
/ No. of hrs per unit 2 3
CM per hour 12 14
Rank 2 1

The 52,000 machine hours would be used as follows:

Product units hours per unit total hours

rank 1 samurai x 15,000 3 hours 45,000
rank 2 dragon ball 3,500 2 hours 7,000 (Squeeze)
Total 52,000

This time samurai x has a higher CM per hour and is therefore to be prioritized. the 52,000
machine hours shall be used to produce 15,000 units of samurai x and 3,500 units of
dragon ball to maximize profit.

Sell now or later

Decision guide: which is more profitable?

If the product is not sold now, it will be secured and, sometimes, stored in special place.
Keeping the product would entail storage cost, maintenance cost, and opportunity cost of
the money locked in the product. If the expected incremental sales are greater than the
incremental costs of keeping the product, then sell it later.

Illustrative problem

Key corporation has 12,000 units of product Laos, a high end men's wear, in storage.
This product is now out of fashion but is expected to regain market acceptance in the next
10 months. The total cost of producing the product is 240,000 pesos, 60% of which is
variable. It is now kept in a special storage of which the company pays monthly rental of
P 8,000.

The product has a regular sales price of P 20 per unit but is expected to be sold at P
14 per unit when fashion acceptability recovers. A merchandiser has offered to buy all
the 12,000 units of product Laos at a price of P 8 per unit who will be picking up the
products in the company's storage.

Should the company sell now or sell the products later?

Solutions:

Sell now Sell later

Sales (12,000 x 8) 96,000 (12,000 x 14) 168,000
Storage cost 0 (8,000 x 10) (80,000)
Incremental profit 96,000 88,000
Net advantage 8,000

The company should be advised to sell this products now due to its net benefit of 8,000.

Indifference point

Decision guide: whatever decision, the results are equal

Indifference point is where the outcome of alternatives is the same.

Examples of indifference point computations are breakeven point, shutdown point,
economic order quantity, and internal rate of return.

Illustrative problem

Charm motors employees 30 sales personnel to market and office equipment.

The average equipment cells for P 350,000 and the company is currently paying
8% commission to ts salespersons. It is considering a scheme of paying its salespersons
a flat rate of P 7,000 per month plus 2% commission on the sales made.

What is the amount of sales that would produce the same total compensation paid to
salespersons?

Solutions:

(350,000 x 8%) a = (7,000 x 30) + (350,000a x 2%)

28,000 a = (210,000) + (7,000 a)
28,000 a - 7,000 a = 210,000
21,000 a = 210,000
a = 10 units

Total sales = 350,000 x 10 units

= 3,500,000

Proving:
Commission 1: 8% x (350,000 x 10) = 280,000
Commission 2: (210,000) + (7,000 x 10) = 280,000