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Session 5:Decision Making

Workshop on
Management Accounting for
non -finance executives

BY: ABDUL RAHIM SURIYA


FCA, FCMA
BUSINESS DECISSION MAKING

o Making decisions is one of the basic functions of a manager.

o Managers are constantly faced with problems of deciding


what products to sell, what services to offer,what price to
quote, whether to make or buy component parts, what channels
of distribution to use,whether to accept special assignment at
special prices, whether to out-source any extra services
required or hire staff and so forth.

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BUSINESS DECISSION MAKING

o Decision making is often a difficult task that is complicated


by the existence of numerous alternatives and massive amounts
of data, only some of which may be relevant.

o Every decision involves choosing from among at least two


alternatives.

o In making a decision, the costs and benefits of one alternative


must be compared to the costs and benefits of other
alternatives.
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WHAT IS DECISION MAKING?
o Decision making is defined as the process
of:
o identifying problems,
o considering and evaluating the alternatives,
o arriving at a decision,
o taking action, and
o assessing the outcome.

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STEPS IN AN EFFECTIVE
DECISION MAKING PROCESS
o Decision-making experts note that managers are
more like to be effective decision makers if they
follow the general approach as detailed below.
Identify the problem
1. Generate alternative solutions
2. Evaluate and choose an alternative
3. Implement and monitor the chosen solution

o Although these steps do not guarantee all


decisions will have the outcomes desired, they
do increase the likelihood of success.
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PROBLEMS CLASSIFICATION
o For decision making it is important to understand
the types of problems , decisions and conditions
that managers face .

o Problem can be classified into :


o Crisis problem
o Non crisis problems, or
o Opportunity problems

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TYPE OF DECISION

o Programmed Decisions
A manager makes a programmed decision when
a situation occurs so often or is so well-
structured that it can be handled through the use
of preset decision rules.

o Non-Programmed Decisions
Decisions for which predetermined decision
rules are impractical due to novel and/or ill-
structured situations.
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DAY TO DAY BUSINESS DECISION

o Managers come across various


situations in day to day business
activities where decision are required.

o Decision making require accurate data


which of course need to be analyzed
and evaluated properly by decision
maker before reaching at a decision.
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DECISION MAKING
RELEAVANT AND IRRELEVANT COST
o Distinguishing between relevant and irrelevant cost is critical
for two reasons :

o First, irrelevant data can be ignored and need not be analyzed.


This can save decision maker’s tremendous amounts of time
and effort.

o Second, bad decisions result from erroneously including


irrelevant cost and benefit data when analyzing alternatives.

o To be successful in decision making, managers must be able to


recognize the difference between relevant and irrelevant data
and must be able to correctly use the relevant data in analyzing
alternatives. 9
DECISION MAKING
NON-QUANTATIVE FACTORS
Financial and quantitative information is used as a basis for
decision making. It should not be used exclusively. However, in
most decisions there are a number of factors which need to be
balanced and weighed before the final point is reached and the
decision actually made.
Most of the factors are qualitative ones that are not easily
expressed in terms of money.
Example
A decision to close a department or a factory the cost of making
staff redundant can be calculated quite easily. But the effect in
terms of loss of morale of other staff , decrease in productivity
etc cannot be easily measured. 10
Different costs for differing purposes

o We need to recognise that cost are relevant in one decision situation are not
necessarily relevant in another.

o For one purpose , a particular group of cost may be relevant;for another


purpose , an entirely different group cost may be irrelevant.

o Thus , in each decision situation the manager must examine the data at
hand and isolate the relevant costs.Otherwise , the manager runs the risk of
being misled by irrelevant data.

o Nearly 70 years ago, eminent economist J. Maurice Clarke stated that


“Accountants use different costs because of
their differing objectives.”

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Different costs for differing purposes

o The concept of “different cost for different purposes”


is basic to managerial accounting.

o The business world has certainly become a lot more


complicated since Professor Clarke’s insightful
comment. Management accountants today are
expected to be a lot more conversant and
knowledgeable about business operations. They are
expected to add value to their company by their
ability to bring the right information to bear on a
decision. To do that, management accountants must
be able to identify, analyze, and help solve problems.
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DIFFERENCIAL COST
o Differential cost is the difference in the cost of
alternative choices.

o It deal with the determination of incremental revenue,


cost, and margins.

o Historical costs drawn from the financial accounting


records generally do not give management the
differential cost information needed to evaluate
alternative courses of action.
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DIFFERENCIAL COST
o Differential cost is often referred to as marginal or
incremental cost.

o The term “marginal cost” is widely used by


economists.

o Engineers generally speak of “incremental costs” as


the added cost incurred when a project or an
undertaking is extended beyond its originally
intended goal.
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OPPORTUNITY COSTS
o Opportunity costs are the measurable
value of an opportunity or potential
benefits given up when one alternative
is selected over another.

o The opportunity cost is not the usual


outlay of cash rather they represent
economic benefits that are foregone as a
result of pursing another course of
action. 15
OPPORTUNITY COSTS
o Opportunity costs require the measurement of
sacrifices associated with alternatives. If a decision
requires no sacrifice, there is no opportunity cost.

Example 1
o Miss Monica has a part-time job that pays her Rs.
1000 per week while attending college. She would
like to spend a week at the beach during spring break,
and her employer has agreed to give her the time off,
but without pay. The lost wages of Rs 1000 would be
an opportunity cost of taking the week off to be at the
beach.
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OPPORTUNITY COSTS
EXAMPLE - 2
o An engineer quite his job with INTEL to start his own business. The data
are:

If open an If continue
Independent as an INTEL
Business Employee

Salary income from INTEL - Rs. 1.2 Million


Revenue from business Rs. 3.0 Million
Total expenses Rs. 1.6 Million -
-
Net income Rs. 1.4 Million Rs. 1.2 Million

The opportunity cost of starting a new business is the Rs. 1.2 million
salary that could be received from INTEL. 17
SUNK COSTS
o A sunk cost is a cost that has already been
incurred and that cannot be changed by
any decision made now or in the future.

o Sunk cost are irrelevant cost for decision


making and should be ignored.

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CASE STUDY
SUNK COSTS
o Management of the Shaheen Chemical Company is
reviewing a research project that was initiated for the
purpose of developing a new product.

o Expenditures to date on the project total Rs. 252,000.


o The Research and Development Department now
estimates that an additional Rs. 48,000 will be
required to produce a marketable product.
o Current market estimates indicate a lifetime profit
potential having a present value of Rs. 80,000 for the
product, excluding research and development
expenditure.

o Q- Advise Management for spending additional Rs.


48,000.
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SUNK COSTS
o An understanding of the distinction between future
costs and sunk costs can help avoid confusion and
possible error when management is faced with a
decision involving two material amount of cost that
has been incurred in the past.

o This question typically arises in deciding whether to


continue or to terminate a project already in
progress.

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MODULES OF DIFFERENCIAL COSTS

o Various Situations where Differential Cost


Analysis is used by management for decision
making:

o Pricing decision for a special order.


o Price cut in a competitive market.
o Pricing in case of full capacity.
o Increasing, curtailing, or stopping
production of certain products.
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MODULES OF DIFFERENCIAL COSTS

o Evaluating make-or-buy alternatives.


o Expanding or reducing plant capacity.
o Cost benefit analyses- spending additional amounts
for sales promotion.
o Selecting new sales territories.
o Further processing decision
o Addition of new machinery vs. putting plant on
double shift/OT.
o Utilization of spare capacity
o Replacing present equipment with new machinery.
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o Decision to shut down plant.
SPEICAL PRICING FOR SPECIAL ORDERS

o The differential cost aids management in deciding


at the price the company can afford to accept an
additional order for sale of goods or services.

o These additional orders may be for


o Government institutions or
o Export etc

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CASE STUDY- 1
SPEICAL PRICING FOR SPECIAL ORDERS

o A company manufactures 450,000 units. The fixed factory


overhead is Rs. 335,000. The variable cost is Rs. 3.7 per
unit. Each unit sells for Rs. 5.

o The sales department reports that a customer has offered to


pay Rs.4.25 per unit for an additional 100,000 units. To
make the additional units, an annual rental cost of
Rs.10,000 for new equipment would be incurred.

o Q- Advise Management to accept the order or not.

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SOLUTION TO CASE STUDY- 1
SPEICAL PRICING FOR SPECIAL ORDERS

The traditional accountant may project loss on this order as follows:

Sales (100,000 units @ Rs.4.25) Rs. 425,000


Cost of goods sold:
Variable cost @ Rs. 3.7 370,000
Fixed factory overhead (100,000 units @.*74) 74,000 44,000

NET LOSS ON ACCEPTING OFFER AT Rs. 4.25 19,000

Based on above management would reject the offer.

Fixed Cost per unit : 335000 / 450000 = 0.74

Alternate : Fixed Cost per unit : 345,000 / 550,000 = 0.627

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SOLUTION TO CASE STUDY- 1
SPEICAL PRICING FOR SPECIAL ORDERS

Management may decide to evaluate it further based on differential


cost concept:

Sales Prices (4.25 x 100000) Rs. 425,000


Variable Costs (3.70 x 100000) 370,000
55,000
Less : Increase in fixed cost 10,000
Incremental gain on accepting the offer 45,000

o When a differential cost analysis leads management to accept an


additional order , it is to be ensured that the order is not going to
disturb the market of the existing products.

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CASE STUDY- 2
SPEICAL PRICING FOR SPECIAL ORDERS

Polaski Company manufactures and sells a single product. Operating at capacity, the
company can produce and sell 30,000 units per year. Costs associated with this level
of production and sales are given below:
Unit Total
Direct materials ………………………………… Rs. 15 Rs. 450,000
Direct labor……………………………………… 8 240,000
Variable manufacturing overhead………………. 3 90,000
Fixed manufacturing overhead………………… 9 270,000
Variable selling expense……………………….. 4 120,000
Fixed selling expense…………………………... 6 180,000
Total cost …………………………... 45 1,350,000

Unit sales price is Rs. 50 each. Fixed manufacturing overhead is constant at Rs.
270,000 per year within the range of 25,000 through 30,000 units per year.

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CASE STUDY- 2
SPEICAL PRICING FOR SPECIAL ORDERS

Assume that due to a recession, Polaski Company expects to sell only


25,000 units through regular channels next year. A large retail chain has
offered to purchase 5,000 units if Polaski is willing to accept a 16% discount
off the regular price. There would be no sales commissions on this order;
thus, variable selling expenses would be slashed by 75%. However, Polaski
Company would have to purchase a special machine to engrave the retail
chain’s name on the 5,000 units. This machine would cost Rs. 10,000.
Polaski Company has no assurance that the retail chain will purchase
additional units any time in the future.

Required:
Determine the impact on profits next year if this special order is accepted.

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SOLUTION TO CASE STUDY- 2
SPEICAL PRICING FOR SPECIAL ORDERS

Existing Fixed expenses are not irrelevant. However Cost of new machine is
relevant and be considered & recovered from this order.
Existing New order
Sale price 50 42
Direct Material 15 15
Direct Labour 8 8
Variable Overhead 3 3
Variable Selling 4 1
Special Machine (10000 ÷ 5000) - 2
30 29
Contribution Margin 15 13

CONCLUSION: Incremental revenue from new order is 65000 (13*5) 29

Order be accepted at 16% discount provided it will not effect existing sales.
UTILIZATION OF SPARE CAPACITY

o In cases where production is below capacity,


opportunities may arise for.
o sales at a specially reduced price ,
o introducing new products ,
o manufacturing under another brand name.
o tolling options
o biding for Government or export for bulk
supplies

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CASE STUDY-3
UTILIZATION OF SPARE CAPACITY

SUPRA LTD is operating at 80% of its capacity and produce 8,000 units per month.
The budget is as follows:
Per unit -Rs Rupees
Sales 10 80,000
Variable costs:
Raw materials 3 24,000
Direct labour 2 16,000
Variable overheads 1 8,000
6 48,000
Fixed costs 3 24,000
Total Costs 9 72,000
Budgeted profit 1 8,000

There is an offer to export 1,000 units per month at a price of Rs. 8/- per unit.

Q - Advise Management, should the offer be accepted?


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SOLUTION TO CASE STUDY
UTILIZATION OF SPARE CAPACITY
a) Capacity assessment
The spare capacity available is 20% i.e. 2000 units, so we can consider
this offer.

b) Increment revenue vs. incremental Cost

Additional revenue (1,000 x 8) Rs. 8,000


Additional costs (1,000 x 6) 6,000
Increased profitability (assuming no change in fixed cost) 2,000

c) Conclusion
Based on above,the contract should be accepted to gain from spare
capacity available as the fixed costs will remain same and have no
relevance here for decision, and therefore not to be considered for this
additional order.

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MAKE OR BUY DECSION
o A manufacturer may evaluate options to make-or-buy few
components of the product being manufactured.

o This problem arises particularly in connection with the possible use


of:
o idle equipment
o idle space
o idle labor

o Make or buy decision are evaluated for outsourcing .An enterprises


despite of available in-house resources might opt for outsourcing.

Examples
o Garment factory --- fusing cutting inside or buy readymade collar
o Catering Business 33
CASE STUDY-4
MAKE OR BUY DECSION
o National Automobile Company produces an assembly used in
the production of one of its product lines.

o The department in which the assembly is produced incurs


annual fixed costs of Rs. 500,000.

o The variable cost of production is Rs. 51 per unit.

o The assembly could be bought outside at a cost of Rs. 53 per


unit.

o The current annual requirement is for 100,000 assemblies.

Q- Advise Management, should the company continue to make34


or buy?
SOLUTION TO CASE STUDY
MAKE OR BUY DECSION
Per unit Total
Cost to Buy 53 5,300,000
Cost to Make: VC 51 5,100,000
FC 5 500,000
5,600,000
Conclusion

o A decision to make in house would cost the company extra Rs. 300,000 but
that depend how much fixed cost can be saved if bought from outside.

o Therefore in case of buying from outside, the fixed costs of Rs. 500,000 will
require analysis to determine what would actually be saved if in-house
production of the assembly were discontinued.
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MAKE OR BUY DECSION
o Other factors need to be considered by the Management

1. Continuity and control of supply. Can the outside company be


relied upon to meet the requirements in terms of quantity, quality,
delivery, timely supply and price stability?

2. Alternate supplier. Is alternate suppliers available to avoid monopoly


in future

3. Alternative use of resources. Can the resources used to make this


article be transferred or utilised to another activity which will save
cost or increase revenue?

4. Social/legal. Will the decision affect contractual or ethical obligations


to employees or business connections?
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DECISION TO SHUT DOWN

o Differential cost analysis is also used when a business is


confronted with the possibility of a shutdown of
manufacturing and/or marketing facilities.

o In the recent years few companies have experienced shut down


of their marketing department and entered into outsourcing
contract to perform its marketing function and in some cases
companies despite of own manufacturing facilities have
preferred to go for Tolling options.

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EXAMPLES
DECISION TO SHUT DOWN

o Orgnon and Reckitt have shut down their pharmaceuticals


plant completely and are concentrating on marketing function.
Their products are being manufactured by ABBOT AND
MECTOR/GETZ respectively.

o Some companies are getting their few products toll through


other pharmaceutical companies like :
o WYTH for SPENCER and MECTOR
o PHARM EVO for ASIAN PHARMA
o SANTE from ELKO
o ICI and BYER from GETZ PHARMA

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DECISION TO SHUT DOWN
o A shutdown of facilities or a project or a department does
not eliminate all costs. Some expenses like depreciation,
interest, and insurance may continue during complete
inactivity.

o If operations continues (even in loss situation), certain


expenses connected with the shutting down of the
facilities would be saved such as costs that would have to
be incurred on shut down when a closed facility is
reopened.

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DECISION TO SHUT DOWN
o Other aspect of shutdown:
1. the loss of established markets.
2. morale of other employees,
3. danger of plant obsolescence
4. training of new employees when project will restart.

o In periods of trading difficulty, a business can


continue to operate while marginal contribution
equals fixed expenses i.e. in Breakeven situations.

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CASE STUDY-5
DECISION TO SHUT DOWN
o Delta Corporation is considering closing down its plant for one year, after
which time the demand for its product is expected to increase substantially.

o At present it is operating at 40% capacity.


o
o Rs 000
o Sales value 60,000
o Variable costs 40,000
o Fixed costs 50,000

o Other data
o Fixed costs of Rs18 million will continue to incur even if the plant is
closed.
o The cost of closing down operations for one year will be Rs. 14 million.

Q- Advise Management best course of action.

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SOLUTION TO CASE STUDY
DECISION TO SHUT DOWN
Statement of profit or loss
In case of In case of
Continuing operation Temporary closure
Rs’000 Rs’000
Sales 60,000 Fixed expenses 18,000
Variable cost of sales 40,000 Closing down costs 14,000
Contribution margin 20,000
Fixed costs 50,000
Net loss (30,000) (32,000)

CONCLUSION
The company can minimize its losses by not closing down.

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DISCONTINUE PRODUCT/ SEGMENT

o There may arise circumstances where


management decide to discontinue certain
products or department or segment divisions or
types of customer in case they are yielding
o net loss or
o an inadequate profit.

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FOCUS ON CURRENT PRACTICE
A bakery distributed its products through route
salespersons, each of whom loaded a truck with an
assortment of products in the morning and spent the day
calling on customers in an assigned territory.

Believing that some items were more profitable than


others, management asked for an analysis of product costs
and sales.

The accountants to whom the task was assigned allocated


all manufacturing and marketing costs to products to
obtain a net profit for each product.
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FOCUS ON CURRENT PRACTICE
The resulting figures indicated that some of the products
were being sold at a loss, and management discontinued
these products.

However, when this change was put into effect, the


company’s overall profit declined. It was then seen that by
dropping some products, sales revenues had been reduced
without commensurate reduction in costs because the
common manufacturing costs and route sales costs had to
be continued in order to make and sell the remaining
products.

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DISCONTINUE PRODUCT/ SEGMENT

IMPACT ON OTHER PRODUCTS


o In case financial data suggest to discontinue a product or
division it is important to analyze and evaluate the extent
to which sales of other products will be adversely
affected.

o Example
i. a life saving drug if discontinued may directly effect
entrance of Sales officers in doctors’ clinic, which of course
will effect sales of other products and overall image of the
company.
ii. Angised and Digixon of GLAXOWELLCOME
iii. Hospital: If one unit like X Ray not yielding profit even
then management may continue so that business of high 46
yield division like Laboratory may not be effected.
DISCONTINUE PRODUCT/ SEGMENT
o Classification of fixed cost

o Separable fixed cost


It exists only because the segment exists; it will be eliminated
if the segment is discontinued. For example salary of a branch
manager or a department.

o Joint fixed costs


It remain after the disposal or discontinuing segment and be
absorbed by the remaining segments. For example
Depreciation of factory building, salaries of security and head
office cost etc.

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CASE STUDY-6
DISCONTINUE PRODUCT/ SEGMENT
o Citi International a manufacturer of 3 consumer products, is considering dropping
SOAP, which is presently losing money as detailed below:

Shampoo Soap Conditioner Total


Sales revenue 500,000 300,000 400,000 1,200,000
Variable costs 270,000 202,000 220,000 692,000
Contribution Margin 230,000 98,000 180,000 508,000

Fixed costs
Separable 56,000 59,000 45,000 160,000
Joint* 100,000 60,000 80,000 240,000
Total 156,000 119,000 125,000 400,000

Profit (loss) 74,000 (21,000) 55,000 108,000

* Allocated on the basis of total sales value.

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SOLUTION TO CASE STUDY
DISCONTINUE PRODUCT/ SEGMENT
From the previous slide, it appears that by dropping the SOAP line, Citi
International would save Rs.21,000 a year. However, incremental analysis
leads to quite a different picture:

On Discontinuing Soap:
Decrease in revenue a 300,000
Less:
Variable costs avoided 202,000
Separable fixed costs avoided 59,000
Total costs avoided b 261,000

Decrease in net income a-b 39,000

CONCLUSION

Profit of Citi International will decrease by Rs. 39,000 if the Soap line were
dropped. Fixed cost Rs. 60,000 will continue to incur inspective of SOAP.
(60,000 – 21,000 = 39,000 Loss)
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SOLUTION TO CASE STUDY
DISCONTINUE PRODUCT/ SEGMENT
Alternate working - P/L A/c after discontinuing Soap

Shampoo Conditioner Total

Sales revenue 500,000 400,000 900,000


Variable Cost 270,000 220,000 490,000
Contribution margin 230,000 180,000 410,000
Fixed costs
- Separable 56,000 45,000 101,000
- Joint* 133,333 106,667 240,000
Total 189,333 151,667 341,000
Profit 40,667 28,333 69,000

Previous Profit (3 products) 108,000


New Profit (2 products) 69,000
Decrease in profits by dropping SOAP line 39,000

Conclusion :
It is advisable to continue Soap line since overall profit is declining by
Rs 39,000
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DISCONTINUE PRODUCT/ SEGMENT

o Other non-financial factors


o On elimination of the SOAP line there be may
considerable effect on the sales of the other
products.

o Few consumer may stop buying the shampoo and


conditioner if the Soap is not available and may
switch to competitor’s products.

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CASE STUDY-7
RELEVANT COSTS
A merchandising company has two departments, A and B. Monthly income statement
for the company is as follows for a recent month :
Department
Total A B
Sales …………………………Rs. 4,000,000 Rs. 3,000,000 Rs. 1,000,000
Less variable expenses……… 1,300,000 900,000 400,000
Contribution margin …..…… 2,700,000 2,100,000 600,000
Less fixed expenses ………… 2,200,000 1,400,000 800,000
Net operating income (loss) …Rs. 500,000 Rs. 700,000 Rs. (200,000)

A study indicates that Rs. 340,000 of the fixed expenses being charged to Department B
are sunk costs or allocated costs that will continue even if B is dropped. In addition, the
elimination of Department B will result in a 10% decrease in the sales of Department A.
Required: What will be the effect on the net operating income of the company as a
whole if Department B is dropped ? 52
SOLUTION TO CASE STUDY
RELEVANT COSTS

Impact on Contribution Margin


Department B 600,000
Department A 210,000
810,000
Saving in fixed cost (800 - 340) 460,000
Net decrease in profit if Dept B is closed 350,000
Alternate working
Dept B - 200,000 – 340,000 140,000
Dept A - Contribution margin impact 210,000
53

350,000
CASE STUDY
PRODUCT PROCESS EFFICIENCY

o It is often possible to elevate the constraint at very low


cost.

o Western Textile Products makes pockets, waistbands, and


other clothing components. The constraint at the
company’s plant in Greenville, South Carolina, was the
slitting machines. These large machines slit huge rolls of
textiles into appropriate widths for use on other machines.

o Management was contemplating adding a second shift


to elevate the constraint. However, investigation
revealed that the slitting machines were actually being
run only one hour in a nine-hour shift. 54
CASE STUDY
PRODUCT PROCESS EFFICIENCY
o The other eight hours were required to get materials, load
and unload the machine, and do setups. Instead of adding
a second shift, a second person was assigned to each
machine to fetch materials and do as much of the setting
up as possible off-line while the machine was running.”

o This approach resulted in increasing the run time to four


hours. If another shift had be added without any
improvement in how the machines were being used, the
cost would have been much higher and there would have
been only a one-hour increase in run time.

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ADDITIONAL CONTRACT PRICING
LIMITING FACTORS

o In case a business is operating at full capacity, an additional


orders be considered on the basis of limiting factor so that
the price quoted will at least maintain the existing rate of
contribution per unit of limiting factor.

o Limiting factor may be material, labour etc.

CASE STUDY-8
Sitara Ltd manufactures special purpose gauges to customers’
specifications. The highly skilled labour force is always
working to full capacity. The budget for the next year shows
following data :
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CASE STUDY
ADDITIONAL CONTRACT PRICING

Sitara Ltd manufactures special purpose gauges to


customers’ specifications.

The highly skilled labour force is always working to


full capacity.

The budget for the next year shows following data :

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CASE STUDY-9
ADDITIONAL CONTRACT PRICING
Rs in 000’s
BUDGETED P/L A/C
Sales 540
Direct materials 40
Direct wages 3,200 hours @ Rs. 93.75 300
Contribution margin 200
Fixed overhead, 100
Profit 100

An enquiry is received from Lanka Ltd for a gauge which would use Rs. 600 of direct
materials and 40 labour hours.

Q-1 What is the minimum price to quote to Lanka Ltd when maximum work
hours are 3200.
Q-2 Would the minimum price be different if spare capacity were available but
materials were subject to a quota of Rs. 40,000 per year?

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SOLUTION TO CASE STUDY
ADDITIONAL CONTRACT PRICING

1. The limiting factor is Rs. 3,200 labour hours. Budgeted contribution


per hour is Rs.200,000  3,200 hours = Rs. 62.50 per hour.
Minimum price is to be quoted:

Rs.
Materials 600
Wages 40 hours @ 93.75 3,750
4,350
Add: Contribution 40 hours @ 62.5 2,500
To Quote Contract price (minimum) 6,850

Minimum Price quotation should be Rs 6,850 at which


the contract will maintain the budgeted contribution.

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SOLUTION TO CASE STUDY
ADDITIONAL CONTRACT PRICING

2. If the limiting factor is materials, budgeted contribution


per rupee of materials is Rs. 5 (. Rs.200,000  Rs.
40,000 )
Rs.
Materials & wages (actual cost) 4,350
Contribution Rs. 600 x 5 3,000
To Quote Contract price (minimum) 7,350

Sitara must aim to earn the maximum profit from its


limited supply .Price quoted should be minimum Rs
7,350 as it will maintain the existing profit by way of
recovering contribution margin plus additional cost
incurred.
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FURTHER PROCESSING DECISION

o In processing operations, particularly those involving more


than one product, often there is a choice between:
o Selling a product in an unfinished form, or
o to further process it into a finished product.

o If relevant costs of further processing are re-covered by the


incremental revenue, a product may be further processed, else
not.

o Example
o Textile: Gray Cloth – Dying – Printing
o Mining: Oil - Gas
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CASE STUDY-10
FURTHER PROCESSING DECISION

Shezad Ltd produces three products from a common process.


o Total joint costs is Rs.104,000 per month
o Each of the products may be further processed:
o Selling prices and further processing costs per litre are as follows:

Product
A B C
Cost of further processing Rs. 5.00 3.00 9.00
Selling price:
o Before further processing 11.00 14.00 13.00
o After further processing 15.00 19.00 20.00
Monthly out put (in liters) 100.00 50.00 80.00

Q - Advise Shezad Ltd about further processing any of its products.

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SOLUTION TO CASE STUDY
FURTHER PROCESSING DECISION

o The incremental costs and revenues be considered.


o The common cost is irrelevant for decision to process further or not.

Product
A B C
Selling price:
o Before further processing 11.00 14.00 13.00
o After further processing 15.00 19.00 20.00
Incremental revenue on processing further 4.00 5.00 7.00
Further processing cost (5.00) (3.00) (9.00)
Incremental contribution (1.00) + 2.00 (2.00)

The above calculation shows that the further processing of product B is the only further
processing activity which leads to an increase in contribution.

CONCLUSION
Shezad Ltd may further process product B only, and sell products A and C without further
processing them.
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CASE STUDY – 11
FURTHER PROCESSING DECISION

Wexpro, Inc., produces several products from processing of 1 ton


of clypton, a rare mineral. Material and processing costs total Rs.
60,000 per ton, one-fourth of which is allocated to product X.
Seven thousand units of product X are produced from each ton of
clypton. The units can either be sold at the split-off point for Rs. 9
each, or processed further at a total cost of Rs. 9,500 and then sold
for Rs. 12 each.

Required:
Advise whether product X be processed further or sold at the split-
off point?
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SOLUTION TO CASE STUDY
FURTHER PROCESSING DECISION

Increment Sales Revenue if


further processed (12 - 9 x 7000 ) = 21,000
Increment Cost = 9,500
Net incremental income on
further processing 11,500

CONCLUSION
Product X be processed further
65
CONCEPT REVIEW EXERCISE
Fill in the blank from choices given.

1. ____________ cost are the measurable value of an


opportunity by passed by rejecting an alternative use of
resources.
a) Marginal b) Sunk c) Opportunity

2. ____________ cost in the difference in the cost of alternative


choices.
a) Opportunity b) Sunk c) Differential

3. Differential cost is after referred to as ___________ cost.

a) Marginal b) Sunk c) Opportunity


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THE END

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