Types of decisions

Make Or Buy
Problem:

Assumes that Washy Naenae is purchasing a 300 kg of dye 30 grams per pack equivalent to 1
000 packs from an outside supplier for P30 per unit.

If the company makes the part internally, the cost will be assigned to the part as follows.

Direct Materials P10,000

Direct labor 10,000

Variable overhead 8,000

Fixed overhead 6,000

P34,000

Per unit Total

Direct Materials P10 P10,000

Direct Labor 10 10,000

Variable overhead 8 8,000

Indifference Cost Volume

6000 + 28x = 30x

6000 = 30x - 28x

6000 = 2x

6000/ 2 = 2x/ 2

x = 3000


Add or Drop A Product Or other Segment
Problem:
Illustrative Problem 18.4. Eliminate or Retain a Product line
Suppose a company furnishes the following recent operating statement for its three product
lines, A, B and C.
A B C Total
Sales P400,000 P360,000 P300.000 P1.060.000
Variable expenses 280,000 (70%) 216,000 (60%) 240,000 (80%) 736,000
Fixed expenses:
Salaries of product
line supervisors 30,000 32,000 40,000 102,000

Marketing cost
allocated to product
lines on basis of
sales 21,200 8,000 7,200 6,000

Administrative costs
allocated equally 22,000 22,000 22,000 66,000
Total expenses 340,000 277,200 308,000 925,200
Operating income
(loss) P 60,000 P82,000 P(8,000) P 134,800

Management is considering discontinuing Product C operations.

The company can sell assets used in Product C operations at book value. They would lay off the
Product C supervisor with no termination pay..

a. Assuming no other changes are expected, should the company drop Product C?

Analysis:

Product C has a positive contribution to indirect costs of P20,000 (P300,000 P240,000 P40,000)
and therefore should not be eliminated. Overall income will decrease by P20,000 if the company
will drop Product C.

b. Assuming that in addition to the data given, the following changes are expected:

1. Sales of Product A and Product B increase by 10% and 15%, respectively.

2. Marketing costs will remain unchanged.
3. Salaries of Product A and B's product line supervisors would increase by 8% and 10%
respectively due to the increased sales.
4. No increase in total assets is required.
Should the company drop Product C?

Analysis: The following schedule shows the projected operating statement assuming the
company discontinued Product C operations.

Product Lines
A B Total
Sales P440,000 P414,000 P854.000
Variable expenses: 308,000 248,400 556,400
Fixed expenses:
Salaries of product line
supervisors 32,400 35,200 67,600
Marketing costs 10,923 10,277 21,200
Administrative costs 33,000 33,000 66,000
Total 384,323 326,877 711,200
Operating income (loss)
before taxes P 55,677 P 87,123 P 142,800
an
an
Based on the computations, the company may decide to drop Product C.

As shown above, overall net income will be P142,800. This is slightly higher than the present
overall income of P134,800 with no increase in total assets required. However, management
should consider other factors, such as the future sales of product C and whether the increased
sales of Product A and B will continue or would occur without eliminating Product C operations.

Sell Now or Process Further

In some industries, a number of end products are produced from a single or common raw
material input.

Assume that three products are derived from a single raw material input. Cost and revenue data
relating to the products are presented before (along with an analysis of which products should
be sold at the split-off point and which should be processed further.)
Product
A B C

Sales value at the split-off point P 60,000 P 75,000 P 30,000

Sales value after further
processing 80,000 120,000 45,000
Allocated joint product costs 40,000 50,000 20,000
Cost of further processing 25,000 30,000 5,000
Which of the product lines should be processed further and which should be sold
at the split-off point?
Analysis: The following evaluation should be made using the relevant data:
Product Lines .
A B C
Incremental revenue from
further processing* P20,000 P45,000 P15,000
Incremental cost of further
processing 25,000 30,000 5,000
Profit (loss) from further
processing P (5,000) P15,000 P10,000
* Sales value after further processing minus Sales value at the split-off point
As shown in the above schedule, Products B and C should be processed further; Product A
should be sold at the split-off point.

Special Sales Pricing

Managers often must evaluate whether a special order should be accepted, or if

a one- the order is accepted, the price that should be charged. A special order i Managers may
be asked to consider accepting a special order for their product at time order that is not
considered part of the company's ongoing business, worth considering, provided they will not
affect regular sales of the same a reduced price to make use of the excess, or idle facilities.
Such orders a product.
Illustrative Problem 18.6. Accept or Reject a Special Order

Sales revenue (2,000 units at P40 each) P80,000

Manufacturing costs:
Variable P24 per unit
Fixed P17,000
Selling and administrative costs:
Variable (commissions on sales) P2.50 per nit
Fixed P2,500
REQUIRED:
Should the company accept a special order for 400 units at a selling price of P32 each, which is
subject to half the usual commission rate per unit? Assume no effect on regular sales at regular
prices.
Analysis:
The special order should be accepted as shown by the following two alternative analysis:
Differential Approach:
Incremental revenue from special
order (400 x P32) P12,800
Less: Incremental costs
Manufacturing (400 x P24) 9,600
Sales commission (400 x P1.25) 500
Total P10,100
Incremental profit P 2,700

Contribution in Relation to scarce resources

Illustrative Problem 18.7. Production Decision
Washey Naynay Company makes two kinds of products: the original Dishwashing liquid and the
dishwashing liquid for sensitive skin. Assume that the company can sell all the products it
produces. Washey Naynay cost and revenue information is presented below:
Original 30ml Sensitive 30ml
Sales revenue per unit P10.00 P9.00
Less variable costs per unit
Materials 4.00 2.50
Labor 1.50 2.00
Variable overhead 0.50 0.50
Total 6.00 5.00
Contribution margin per unit P4.00 P4.00
Fixed manufacturing costs : P800,000 per month
Marketing and administrative costs (all fixed): : P200,000 per month

In this case, the contribution margin of each product is the same, and assuming that the
production time per unit is uniform, the profit-volume relationship is the same regardless of the
mix of products produced and sold.

Suppose that the company's capacity is limited to 720 machine hours per month and the
machines may be used to produce either 300 Dishwashing liquid for sensitive skin per
machine-hour or 500 original per machine-hour. Which product should Company’s produce to
maximize its profit?

This problem could be analyzed as follows:

1) Determine the contribution margin per machine-hour of each product.
2) Rank the product lines according to contribution margin per machine hour.
3) Consider market limitations if any.
4) Compute the units to be produced based on the profitability ranking made.

1. Contribution margin per machine hour:

Dishwashing liquid for sensitive skin :P1,200 (P4.00 x 300 units)

Dishwashing Liquid original : P2,000 (P4.00 x 500 units)

2. Ranking:
1. Original Dishwashing liquid
2. Dishwashing liquid for sensitive skin
3. & 4. Since there is no market limitation, the company should produce 360,000 products (720
hours x 500 units) and generate P1,440,000 contribution margin (360,000 x P4) and P440,000
operating profit (P1,440,000 - P1,000,000 fixed costs).

If only Dishwashing liquid for sensitive skin are produced, the company would generate
P864,000 (216,000 x P4) contribution margin and incur P136,000 loss (P864,000-P1,000,000
fixed cost).

Shut down or Continue operations

The Washy neyney Company, now operating below 50% of its practical capacity expects that
the volume of sales will drop below the level of 5,000 units per month. An operating statement
prepared for the monthly sales of 5,000 units shows the following:
Sales (5,000 units at P18) P90,000
Less:
Variable costs (5,000 units at P12) P60000
Non-variable costs 30,000 90,000
Net Income 0

 ssume that a conservative estimate of costs if plant operations are suspended indicates a
A
shut-down cost of P 50,,000 per month. Since there is no immediate possibility of profit under
present conditions, the problem of the company is the possibility of minimizing the loss.

REQUIRED:
Determine if the company should shut down temporarily or continue operations.

Analysis:

The decision to continue operations or shut down will depend upon the expected sales of the
company in comparison with the shutdown point of 3,000 units computed as follows:

Shutdown point= Fixed Costs if operations are continued - Shutdown Cost

Contribution Margin per unit
P30,0000 - P50,000
P8
= 2,500 units

If the expected demand exceeds 2,500 units but below 5,000 units (break-even volume)
operating loss will be lesser than shutdown loss and therefore the company can continue
operations. If expected demand is less than 2,500 units, the company should discontinue
operations on a temporary basis until favorable conditions prevail.

Pricing Products and Services


In practice, the most common approach to pricing of products is to use some type of cost-plus
pricing formula. The formula is expressed as follows:
Target selling price = [Cost + (Markup percentage X Cost)]

Pricing decisions

Assume that Washey neyney Company is in the process of setting a selling price product that
has just undergone some modifications in design. The following cost estimates for the
redesigned product have been provided by the Accounting Department::
Per Unit Total
Direct materials P12
Direct labor 8
Variable manufacturing overhead 6

Fixed manufacturing overhead P140,000

Variable selling, general and
administrative expenses 4
Fixed selling, general and
administrative expenses 120,000

The costs above are based on an anticipated volume of 10,000 units produced and sold each
period. The company uses cost-plus pricing, and it has the policy of obtaining target selling
prices by adding a markup of 50% of unit manufacturing cost or by adding a markup of 100% of
variable costs.

Assuming that the company uses absorption costing approach to cost-plus pricing, how much
will the target selling price for one unit of product be?

The selling price per unit using the absorption cost to cost-plus pricing is
computed as follows:
Direct materials P12
Direct labor 8
Variable manufacturing overhead 6
Fixed manufacturing overhead (based on
10,000 units) ( 140,000 ÷ 10,000) 14
Unit manufacturing cost P40
Markup to cover selling, general and
administrative expenses and desired
profit 50% of unit manufacturing cost (50% × 40) 20
Target selling price P60

Assuming that the company uses the contribution approach to cost-plus pricing,
what will be the unit selling price of the product?

Under this approach, the unit selling price will be as follows:

Direct materials P12

Direct labor 8
Variable manufacturing overhead 6
Variable selling, general and
administrative expenses 4
Total variable costs per unit P30

Markup to cover fixed costs and desired

profit 100% of variable costs 30
Target selling price P60

Determining the Markup Percentage

the appropriate markup percentage assuming that the desired Return on To facilitate the
computation of selling price, formulas can be used to determine
Investment (ROI) and unit sales volume are given.

Under the absorption approach to cost-plus pricing:

Markup percentage on absorption cost = Desired return on assets employed - SGA expenses
Volume in units X Unit manufacturing cost
Under the contribution approach to cost-plus pricing:
Markup percentage on absorption cost = Desired return on assets employed - Fixed costs
Volume in unitsb X Unit variable

Target costing

This pricing approach is used when company will already know what price should be charged
and the problem will be to produce the product that can be marketed profitably. Target costing is
the process of determining the maximum allowable cost for a new product and then developing
a sample that can be profitably manufactured and distributed for that maximum target cost
figure. The target cost is computed as follows:

Target cost = Anticipated selling price - Desired Profit

Washey neyney., is a producer and distributor of dishwashing liquid. The company desires to
enter a rapidly growing market for better quality dishwashing liquid that is based on a newly
discontinued technology. Management believes that to be fully competitive, the new
dishwashing liquid that the company is planning can not be priced at more than P100. At this
price, management is confident that the company can sell 12,500 dishwashing liquid per year.
The dishwashing liquid would require permanent investment of P500 000 and the desired ROI is
20%. Compute the target cost of one dishwashing liquid.

The target cost per unit is computed as follows:

Target cost = Anticipated selling price - Desired Profit

= P 100 - P80
= P 20
The income statement will appear as follows:

Sales (12,500 x P 1,00) P1,250,000

Less: Costs and expenses (12,500 x P 20) 250,000
Net income P1,000,000
Desired net income
(P500,000 x 20%) P1,000,000