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34 views81 pagesChapter 4
Management
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Avneet OberoiCopyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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/ 81
Decision Making
CHAPTER OUTLINE er)
introduction; Short-term and Long-term decisions; Relevant costs and relevant revenues
Classification of costs for decision-making; Cost and non-cost factors in decision-making:
Decision-making and variable costing; Fixation of selling prices; Exploring new market Export |
gales; Make or buy decisions; Product mix decisions; Plant shut-down decisions; ifferential
ost analysis vs. variable costing; Decision making and differential cost analysis; Adding or |
dropping a product line; Decision regarding further processing; Problems and solutions; Key
terms; Examination questions.
)
Introduction
In any business,
choose one course of action
the basic function of management is to make decisions. Making decisions is to
from a few possible alternatives. For example, the management may have
to decide whether to raise the price of its product, lower it or Jeave it unchanged at its present level.
Te may have to decide whether to continue to sell its product at 2 loss in a falling market or shut
down its operations for the time being, In a company, manufacturing television sets, the management
may have to decide whether to make picture tubes within the Conan © to buy it from an outside
supplier. Thus the management is continuously engaged it evaluating various alternatives and in
sebeting the best out of these. The decision to be taken will be affected by cost and other factors.
Short-term and Long-term Decisions
The focus of this chapter is on short-term decisions, such a5 +
() Whether to sell a product in the domestic rarket or export ity ,
(ii) Whether to make a component part inhouse ‘buy it from an outside supplier,
(ii) Whether to change the present product ‘mix to make it more profitable, ete.
Most managers consider @ decision as a short-term if it involves a period of one year or less, This
cut off period is arbitrary but commonly used, though a better distinction is that tong term decisions
normally require substantial capital investment ‘vith implications for several future years. Moreover
Short-term decisions are more easily reversed than price of a product can always
long-term. For example, pr
be changed according to market conditions, export sales can be stopped, if necessa1¥. and so on.
4a Management
yyed, discounted cash,
in capital employ
rnvolve consideration of retum i" capi
jons i
Long-term decisions ride the scope of this book.
1
decisions are oul ;
ete. Such de reps IN DECISION MAKING PROCES ee
i taken:
5 of decision making, the following steps #1° 7
Ina proces: .
ne problem is thoroughly analysed £9 2s to i
Identify the purpose The tl ee ec oo
come ‘the various aspects es
- 7
i relating to 7
tion has to be gathere a
siomatin Inlofnetore and affected stakeholders a
information
ist
sele
ing to li ideas leading
sainstorming to list down all the i : he
|< frrihe best choice. This is done on the basis ful
of cause and effect study
Brainstorm and
analyse different
alteratives
vet
exd
All alternations are evaluated to select the a
Select the best ]_¢ ____ est alternative. It should be informed decision be
alternative making. 7
in
Decision made is converted into a plan and Di
Execute the decision |~———— _ plan is converted into action by excuting with,
the help of subordinates. ot
c
Fig. 4.1. Steps in Decision Making a
y
Relevant Costs and Relevant Revenues
When management makes decisions, it has to concentrate on only relevant costs and relevat
revenues, Not all costs and revenues are relevant. The relevant costs and relevant revenues are thoe|
expected future costs and expected future revenues that differ under different alternative courses ¢
action being considered. Cost and revenues that remain unaffected by a decision are obviously
inelevent and need not be considered when making a decision.
Thus relevant costs and relevant revenues should have two characteristics :
(a) The costs and revenues must relate to future, and
() They must differ among different alternative courses of action,
The focus is on the future because decision to be made affects only future,
change the past. Management cannot change the cost of
change future costs by its current decisions, Hence,
Nothing can be done tt
plant and machinery purchased in 2001. Ite
relevant costs are future costs that will diffé
decision the same cost may not be relevant. For each dea ion, the manageene ae eat a eleva
@ thos
ses
vious
yne te
It ce
diffe!
othe! |
costs
SPECIAL costs roy
rete are certain costs which are s eae
og decisionmaking. These costs may
ae — 4a
ECISION Mal
i Ki
pecially computed for ue are
ot be reco em
nded in the nae agement forthe purpose
ehfyough afterwords the decision to buy the machine 4
chine is
: fits decisi G
Bijeve the company o! Sion nor any fate gene found uric, no amou
the fact that sunk cost, which are Wistoical aa aeaae ne ests we
co : , ate a
= ent aa vied in detail before decisions about future courses of
bee aX payments twhich vil iffer depending on the cours of coh
siding on the course of action
ser by management, Moreover, an analysis of histor
sce costs il differ under alternative east of aetna feawaetornation obo e
n.
ve =—— Conversion Cost
It sh i
jould be noted that labour cost is a Part of prime cost as well as conversion cost. arvivion NRO
COST AND NON cost 1
Ne "
ey iis lng, te manage ne en METRO Maa
Ung. ust actos CONt Eaebots Or quantitation tare SHOE NOL oH cust fa
Noy soa a detent ate to ae hake wi ste rants cal no
eR it RP po nit the manase ment atl att ay fone te Teuhetln vt eaten te
te BE Le pou aM While the eangey ey intals AGL a dei the sting pate st 100
ia op the wate ant starts setting the ae tS MMUHEL AE 120 er, a eel
es de cas Carseat gat HU A per ue Now theta a et
eres as he wal mts ket eee
rena npauy shout stop alin oat Is € 100 per uit, So, om
Toss of £5 per mit, The manageneut has to seca ae eas Mee wtotuet ecanse setting resus in a
to tcl the To Mle whither to sell at toss or stop puotuction of t
hat Tn suet a situation, it is dittieat “ere
at Ns ; eutt to make a decision o
ant Myf sss ats ot alti tats tetova eth sia atta ea
nie angking process, since othenvise theae isa danger of wton decision beiur at nee aeision
Macemge these which ent be expres in monty A ‘wrong decision bein) mail. How-cost factors ate
ned iy possible to quantity in monetary tens the effect of a RRM accuracy For example, k may not be
TaggQhf stom gos, the company closes dyn the mat tn the morate of employees or toss of
1 ane goa i cmiay loses de the mana iis ata pt
lecision wuuder consideration, For example, a company
i to enter export business and it receive
toes or sles ai receives ant export order at a price which is less than the own
cot cs ators, he expott one nan be outriqhtly rejected because it does not cover even
he cost. However, the management should consider the non-cost factors sich i
the copay fo etn he exo ose as, sig ae rn tanger the ve
and so on. For getting these benefits, the compan der incurti Vand to
a » the company should consider incurring a sn e
amount of loss, if it can afford i sala aaa
Variable Costing and Differential Costing as Aids in Decision Making
Variable or marginal costing and differential cost analysis are the two valuable techniques used for
short-term business decisions.
DECISION-MAKING AND VARIABLE COSTING
costing is the assistance that it renders to the management
hat variable costing is an invaluable aid to management
le costing proves its worth in decision-making are explained
The most useful contribution of variable ci
in vital decision-making. This is to say U
decision-making. Specific areas where variabl
belo
1, Fixation of Selling Price
Although prices are regulated
economic factors than by the decisis
keep in view the level of profit desive
be higher than the total cost as otherwis a
eamed, But frequently circumstances arise for ‘management
consider special conditions and sell its regulat aoa a
Special price which may be lower than the total cost, FUN
selling prices is discussed below +
(a) Under normal circumstances. |
(0) In times of competition and/or trade depression.
onditions of demand and supply and other
the management while fixing prices has to
fhe selling prices of products or services must
more by market
ions of management,
In the long-run, tl
wise the profit cannot beryariaple costing aids in
decisions such as +
« Fixation of selling prices
+ Exploring new markets
# Make or buy
«Product mix
+ operate plant or shut down. 3
a
Management Accoun,
Selling prices under normal circumstance . . wer total cost (Les ai ie
In the long run, under normal circumstances, the selling Lag eee) for the fee, ss
plus fixed cost) and also give a reasonable amount of profit. Survir j
— f ice may have to be fixed
: In the short nm due to adverse market conditions, the sat oaitng price may be temp, beloy,
total cost but it should be above variable cost. In other wore Pee eatuation| depends uta poral
fixed at marginal cost plus contribution basis and the amount Ot ahould be noted that Fate’
ara suply, acuteness of competition, non-cost factors ete, But it sh 7
selling price below total cost may be made only on a short tei .
ee ea ee products may have to be priced b
Met echo cay ie nesceaty to meet the spedal situston. When variable cost technique
oon eae On ae ee ae
tovrards fixed cost Sennen cn ee is just equal to variable cost, the amount ¢
loss will also be equal to the amount of fixed cost because in such situations the selling prices make yy
ution towatds fixed cost. or
parryi special circumstances like the trade depression or competition, if selling price is high
then variable cost, even though it is below total cost, the production should not be stopped. This;
because fixed costs will have to be incurred inrespective of whether production is continued or not, ang
continuing the production will help in reducing the amount of loss.
As.a note of caution, fixation af selling price below total cost should be made only on a short-tem
basis Pricing based on variable cost plus contribution helps companies to take advantage of short te:
opportunities. But at the same time, no firm can afford to incur loss on a long-term basis and thus 5
‘he long-run, the selling price must cover total cost and give a reasonable amount of profit,
Example
Fixed cost % 1,00,000 (total)
Variable cost 27 per unit
Current market price % 8 per unit
Output 50,000 units,
Should company sell or not?
Solution
Variable cost (50,000 units @ 2 7)
Fixed cost ' Foo.cod
Total cost %,50,000
Cost per unit = % 4,50,000 + 50,000 units = Bo
Although the selling Price does not cover the
sell because such a step will reduce the loss (
Profuction is stopped. IF production is stopped, the loss would b 00 ete panel
Cost), but if production is continued the loss wil be 4° flows, © 707000 (the amount of ied
Sales (50,000 units @ & g) ;
Zess: Total cost (Marginal cost + Fixed cost) t soon
Los: “50,
Thus, by continu , ee
; ing to produc cost, the Toss
fom €1,0,000 to sco ae A Sl Blow otal OSE THe reduced by ® 50,000, ie beg
ree be ty When selling price falls betow van
st, the
1g pr a
9 Prices 5. To keep plant and machine
x 1 in o
t fag However, in certain special circumstances
ie 2, To eliminate competitors from the market.
Ny, 8 To maintain production and to keep employees accupied.,
My) 7
tte] oft bass. In such a case, it may explore new markets and find opportunities to receive aditional
1 Circumstances when Selling Price
such an eventuality, it will be better
in production means loss m
stoppaae i Pi rca ase To Td aoe MARIE of Len ecre
the selling price is below the marginal cost” '® following,
1 To populate anew point, A
Knipe soa 0 men hf" POU ited inte ahr may ety
Production may be continued even if
5 to avoid total loss,
ge. Government m
product at low prices. import quota may be more than the loss on exporting the
“i 3, To dispose of perishable products so
4, To export so as to earn foreign excha
exchange earnings and profit from i
cuoners tht can beets whey exec mI
7. To help in the sale of a conjoined product which is making large profits
2, Exploring New Markets
Sometimes, @ company i not able to fully utilise plant capacity when selling at total cost plus
bulk order or export order at a price which may be below total cost but above ry ‘e
price makes a ‘contribution’ The entixe amount of contribution form such sales is ra beens fed
cost is already recovered from current sales at total cost plus profit basis. Such additional sales at below
total cost is possible only because in accepting bulk orders and export sales, price discrimination is
possible. In this way spare plant capacity can be utilised to ear additional profit.
Additional Order for Utilising Spare Capa
When a company has a spare (or idle) capacity which it is not able to utilise because of sales
constraint and it receives a bulk order at below normal selling price, such an order should be accepted,
provided existing sales are not affected by price discrimination. It will eam ‘the company additional
profit, by utilising spare capacity.
Mlustration 4.1
‘A manufacturer of pl
lastic buckets makes an average profit of € 2.50 per piece on a selling price of
% 14,50 by producing and selling 60,000 pieces at 60% of pot
rential capacity. His cost of sales is:
% per piece
Direct materials bo
Direct wages : a0
Factory ovethead (variable) 30
Selling overhead (variable) .
Total fixed cost is € 2,25,000
During the current year, he intends to produc
fixed cost will go up by 10%, and (b) material an
Under these circumstances, he obtains an offer
Brice you would recommend for acceptance to ensure art
e same number of units, but anticipates that (a)
id labour costs will go up by 5% each,
for a further 20% of his capacity. What minimum
overall profit of & 1,60,000.
e the 48 sant | -
a a“
Solution
20% Capacity 0;
Budgeted Statement for the Current Year Prior to Acceptance of pacity Order
— Per piece Total
z
Sales (60,000 pieces) a
Ditect material (7 4 + 5%) :
Direct labour (Re 1 + 5%)
Variable factory overhead
Variable selling overhead
Variable cost
Contribution (Sales - Variable cost)
= € 247,500
fame On PROD * 20% = Contribution - Fixed cost
Pott 3,60,000 - 2,47,500 = % 1,12,500
= 1,60,000
Planned profit | x _
Incsease in profit (or contribution) required = 1,60,000 ~ 1,12,500 = & 47,500
Variable cost of additional 20,000 pieces (order
for 20% capacity, i.e, 20,000 x % 8.50) zg 1.70.000
Add: Additional contribution desired Z 47,500
Z_2.17,500
Total sales value
Selling price per unit = % 2,17,500 + 20,000 units = & 10.875
Thus, minimum price for sale of additional 20,000 units is 10.875 so as to ensure an overall. profit ¢|
= 1,60,000.
Export Sales
Additional orders may be accepted from a foreign market at below normal price or below total ee|
but hove marginal cost. Export sales yield additional contribution when such sales are at a price wid
is above variable cost.
While determining profitability of accepting export orders, the following additional factors sh
be considered.
1. Export sales may result in additional costs like special packing cost, additional quality chet
freight and insurance charges, etc., if not borne by importer. These costs should be deducted firs
con‘ribution to determine profit from export order,
2. Export sales may result in certain cost benefits like export subsidy from government, exemptit
oF concessions in excise duty or duty drawbacks, etc. In determining profit from export order, th
items should be deducted from cost or added in contribution.
Iustration 4,
Indo-British Company has a capacity to produce 5,000 atic ro)
articles for home market at the following costs St AES rodoces nl
Materials z
Wages 40,000
Factory Overheads — Fixed 36,000
12,000 pecion MOK
; — Variable
‘administration overhead — Fixed
Atfing and distribution overheads — Fixed
— Variable
Total Cost
the home market can consume only 2,000 articles at a sellin
aditional order ‘
should
3,000.
solution
(of 3,000 articles for export)
for the supply of 3,000 articles is recei
. 00 ived from a forei cle.
this order be accepted or not, if execution of this order entails Smeal fee aes
Statement of Marginal Cost and Contribution
20,000
18,000
10,000
16,000
1,52,000
price of % 80 per article. An
(U4.Com. Kolkata, Adapted)
Less:
‘Additional profit
‘Acceptance of this export order results i
accepted.
Note: Fixed overhead have not
overhead have already been recoveret
Non-Cost Factors or Qualitative
cost factors should also be kept in mind while making an exporti
.d from sale in the home market.
Factors. Apart from cost and
(a) Foreign exchange earnings.
(b) Export house status.
(o) Enhancement in company Pre
(a) Employment opportunities.
sstige and goodwill, etc.
Conclusion
1. In normal times, prices should be based on total cost
2. In market conditions like trade depression and competition,
plus basis so as to make a contribution. This
capacity,
3. In order to utilise spare plant © a
may be accepted at less than total cost but above margin
company. This is possible only when price discrimination is su
is val
bulk orders from
jal cost.
Materials @ % 20 per article icon
wages @ % 18 per article 54,000
variable overhead — Factory @ © 10 per article 30,000
— Selling and dist. @ & 8 per article 24,000
Marginal cost of sales 1,68,000
Sales (3,000 articles @ & 65) 1,95,000,
Contribution 27,000
‘Additional packing cost 3,000.
24,000,
in additional profit of & 24.
‘been taken into account in deciding the acceptabi
Hing decision. These include =
id only for a short period.
ome market or
(000 and thus the order should be
lity of this order because fixed
profit considerations, certain non-
plus profit.
price may be fixed on marginal cost
from foreign market
‘This adds to the total profit of the
ch sales in different markets is possible. the
= to be taken by the managen,
when 2 decision Fo ochaaed from an ovtide
internally O Eng is the process Purch
mberess oUt 2 may rely on oxtags
4 eer pe marke: 2 2 pice bela fits oy,
i py be misizadina. Such 2 decision cn
eee inal cost. On the face of
ta Coe
ginal cost, then the by obi
cture the component is its MANDI | ving. Therefore, it wil]
Spa tan pg et Es om mal co
pai to side only when suppLEYS PAT vo per unit, consisting of € 80 as vat
profitable to buy from ou i ig € 100 pen wait, consis 2D a ry
For example, ee cost ae outside firm is prepared to supply ts component E50
st and & 20 as fixed cost. Suppose, Brey of cane onal all ag
= that itis cheaper to buy the componsr Bt & i jony of fixed cost. This fixed come he
wnt i panufactured makes a contribution of € 20 towards recove n b
ST smd ‘The real cost of making the component part is only 2 20 whicy
ar pee eae ats unit should not be accepted because if accepted, the
is its variable cost. This offe ar unit should 1 a
component wil wally cost € 110, Le, © 90 of purchase price plus © 20 of fixed cost which cannot iy
saved if component is not produced. | |
Howeven before anivisg 2 fel decision, due consideration should be given to other factors.
example, it should also be considered as to whether plant capacity released by the non-manufacture ¢
the component part is put to some alternative use or not.
Mlustration 4.3
A radio manufacturing co. finds that ¥
it costs 6.25 to make component R-518, the same is
available in the market at @ 5.75 each, with an assurance of continued supply. The break-down of the
cost is :
Materials :
erial 5
ts ws cach
Other variables 0150 each
Depreciation and other fixe i
ion and other fixed costs 1.25 each
(4) Should you make or buy ? =
() What would be your decision,
if the supplier offered the component at & 4.85 each ?
(B.Com. Hons, Delki)
Solution,
aan .
* variable cost of producing the component i shown bel
low
.
Materials z
Labour 2
Other variable Costs te
Vatiable or Margi ;
‘ ginal ¢
1.25
Bre pecision MAKING
sea) sein tete __ an
: ‘on the face of it, it appeats that it i = aa
ot ws 1 ch geeesl
FRR anon cst ff. at sh oe
= tess decided to buy the component instead of matin Brae Mat the Tae cote fare be seve
iy AY at tye £7 Ye omPONEN Ke 5.75 pe pel Se Coronet ped then
ale ease ee
he fact
fact whether the capacity to be released by the ron
a me alternat
fost. If yes. buying will be preferable as the component which yee oe esting in a savin
7 He pe fel sc 88 pe mal ok Be puch ht made by he
a. x15 pie per unt even if the capacity lee canna Be ReHSU at er belseaving
ag. | ice offered is less = Bs Yatlable cost of the product a ra crea aca
. Outsourcing and Idle Capacity. When a firm has
AER ie he tn i i ee a ae
(tke gf consideration. In other work, i il be profitable to buy on ernie opened Pa
x aoe) cost plus loss of contribution of displaced work. The loss of contre eee ee
a.) Se of contribution per unit of Key factor. roo tually bast Jounal by the
stration 4.4
Mlustration 4.4
Manufacture of product A takes 20 hours on machine
: No. 101. It ing pr
marginal cost of € 110. Component part ¥ could be made on machine nesiatiatt est ie ae
Bet of component part is € 9 of which outside suppliers price is @ 15. a ears
Should one make or buy component ¥. Discuss in both situations when—
(a) Machine No. 101 is working at full capacity.
(6) There is idle capacity.
Solution
(a) Contribution per unit of A = & 150 - 110 = & 40
Contribution per machine hour = € 40 + 20 his = © 2 per hour.
If component Y in manufactured then as it takes 4 hours, the loss of contribution is @ 8 (Le, 4 his. @ %2).
The total cost to make component Y will be 9 + % 8 =@ 17.
This is more than supplier's price of & 15 and so it is better to buy than to make component Y
(0) If, however, there is some unutilised machine capacity, then there ‘would be no loss of contribution and
so the cost of making component Y would only be its variable cost, ie, % 9. In such a case, it would be
economical to make the product than buy it.
Non-cost or Qualitative Factors. While making a decision 01
following non-cost factors should also be considered.
(a) Assurance of continued supply, if bought from outside.
(0) Assurance of quality of the product by the supplier
{o) Assurance of no price increase during the period of agreement.
yn make or buy a component, the
4, Product Mix Decisions
eee yi
is i: tes the proportion in which various products are sold or produced.
Seles mi 0 produ ie ot when a business enterprise has a
The problem of selecting a profitable mix of sales thus, arises only . t
variety of product lines Sad each making a contribution ofits own. ‘Any change in sales mix also results
inthe change in profit position. The technique of marginal costing helps the management in de! enmining
| Bemost profitable sale mix
| a
Management Accoyp
i be discussed in two
aiseussion on selection of the most profitable product mix maY ra,
when sors no Key factor, and
5) wen there i @ Key Facto®
imiting) factor ,
in there is no key (OF limiting) f° cost Volume profit Analysis. When
in the chapter OR "Or contribution is considered =
(a) Whe 7
‘The concept of Key factor was °74 tained crest amo
ts t mix that provides the hig! to ch ;
ea Se en tt ae
i with changes in fixed cost, then that sales»:
st profitable sales mix. In other words, rela’
* freir profit and not on the basis of ye]
with change in fixed cost.
mix. ;
However, when changes in sales mix 7% associated
which provides the highest profit s ‘considered as the mo:
profitability of mixes will be ‘evaluated on the basis 0!
Prmibution when a change in product mix 1S associated
Mlustration 4.5
“he fellowing production/sales mix are capable of achievement in a factory:
(i) 2,000 units of product A and 2,000 units of product Cc.
i) 4,000 units of product B.
(ii) 1000 units of product A, 2,000 units of product B and 1,600 units of product C.
Cost per unit is as follows:
| . A B c
Direct materials & 20 16 40
Direct wages 8 10 20
Fixed cost is % 20,000 and variable overheads i
: s € 20, per unit of A, B and C
ee ie ae oe 2 aoe C are % 36, % 40 and % 100 per unit eae fae
ef inal contributic i i _
ae ion per unit of A, B and C and the profits resulting from produg
(B.Con}
Solution
Marginal Cost Statement
Per unit of products
4 B
Selling price ($) z e C
Ditect material 36 ze
Direct wages —_——r cS
Variable overhead 3 16 re
Variable cost 10
Contribution ‘¢ -v) ss
6 30 a
10
32 making
ON ein 43
Statement Showing Comparative Profitability
Contribution
lye: sales Total ne
_ ae Fixed cost Profit
5 sid i A 2,000 units 12,000
ie 000 waits 64,000
ange ‘ 6 2900 a 84,000, 76,000 20,000 56,000
" , (ay 3 4.000 units 40,000 40,000 20,000 20,000
ag] i a 1,000 units en
a 8 2,000 units 20,000
4 ‘i
\ 1.600 units 51,200 77,200 20,000 57,200
ee sales mix (ii) is the most profitable as it yields the highest amount of contribution
and profit.
(0) When there is a key factor
When a key factor is operating, selection of the most profitable sales mix is based on contribution
per unit of Key factor. The product which makes the highest amount of contribution per unit of key
factor, is the most profitable one and its production is pushed up. The second preference is to be given
to product which yields the second highest contribution per unit of key factor and so on and in the
end that product should be produced which yields least contribution per unit of key factor and to the
extent of availability of the key factor.
4 any] Incase a number of Key factors are operating simultaneously the basic principle remains the same but
problem becomes more mathematical in nature and one has to resort to Linear Programming to determine
m id the optimal product mix.
(2) ustration 4.6
‘A company manufactures three products. The budgeted quantity, selling prices and unit costs are
as under :
— A B c
z z z
al Raw materials (@ % 20 per ka) 80 40 20
Direct wages (@ @ 5 per hour) 5 6 10
10 30 20
Variable overheads
=a Fixed overheads 9 22 8
Budgeted production (in units) 6,400 3,200 2,400
140 120 90
Selling price per unit (in %)
Require
(i) Present a statement of budgeted profit.
(ii) Set optimal product-mix and determine the profit, if the supply of raw materials is res
stricted to 18,400 kg.
(B.Com. Hons. Delhi) solution
2,400 ‘
ae 30 89
| 000 x My ‘
on (units) | 216,000 _| 4g 35 oul
‘Budgeted oie ion (1 oT oi eyo
Se 24,000 * Dae
mee sai oa
‘Variable overhead 96,000 we
Teal variable cost (¥) elo
Contribution (S-V) pam?
Lass: fixed cost*
Profit
Caleuation of Fixed Cost = gana
‘A= 6400 unit x89 Bos
= 3,200 uits » 22 tee)
= 2,400 units »@18 43200
Total fixed cost = 3471200
(it) When raw material isthe key faetor _
A B c
1 es
Raw material per unit of output 4g 7 2kg oo a Le
Total raw material consumed (ka) 6400 «4 3200 x 2
5,600 = 6,400 = 2,400
ial - £288,000 _ € 1,12,000 _ 36.000
*Contribution per kg of raw material = 25,600 kg, 400 kg, aon _
= 71125 =%17.50 = 40
Ranks m
“Contribution per kg of raw material is calculated as :
Total contribution + Total raw materials consumed
Suggested sales mix (raw material is the key factor)
Rank I - Product ¢ ~ 2,400 units x 1 kg
= 2,400 kg
Rank I - Product B - 3,200 units x 2 kg = 6,400 kg
‘Rank III ~ Product A - 2,400 units x 4 kg (balance) = 9,600 kg
Total materials available
18,400 kg
Thus the suggested product mix is : A - 2,400 units, B 3,200 units and C 2,400 units
Calculation of Profit Contribution
Product A 2,400 units @ € 45 p.u. % 1,08,000
B 3,200 units @ & 35 p.u, 1,12,000
C 2,400 units @ 40 p. %_96,000
Total contribution 3,16,000
Less: Total fixed cost 1,71,200
Profit 2 1,44,800 sessnmotng
ant shut Down Decisions
" Be anes er than Se ceE ee feel that plant shut down, i.e., closing down
he business, bette rating 3s. However, variable costs is m
grr etn cal as oh a
‘This type of decision may be either (a) temporary suspension of production activities, or (b)
permanent closing down of production. "
‘Temporary Closing Down. Temporary suspension of activities i term 1 i
sg wnEny‘to top operations until trade depression has pase. Tialyimi bee aaragenent
ss wishould operations be suspended? or in other words, how long should operations be continued?
ty, | he answer to this question is that if products are making a contribution tovards fixed cost, then
aking, production should not be is is Hinuit i Al
neraly SP ; | not be suspended, This i so because continuing production will
help ig loss which would be incurred if plant is shut down. Thus, the information needed to
$5
4 is F probe rm i
y a} ive this type of problem involves a comparison between probable toss at a given level of output and
Je oss that would be suffered if production is suspended temporarily.
‘ample: A manufacturing company supplies you the following information:
Normal capacity of plant 10,000 units
Fixed cost 1,00,000
Marginal cost per unit @75
Estimated selling price 80
Estimated sales volume at this selling price 5,000 units
~| Marginal Cost Statement
q
a Total sales (5,000 units x € 80) 4,00,000
won| less: Marsal cost (5,000 urits = 275) 3,75,000
2a Contribution 25,000
oa Fixed cost 1,00,000
i Loss (-) 75,000
TE plant is shut down, the loss due to fixed cost would be & 1,00,000. However if plant is operated, the
tos vould only be % 75,000. This is because selling price is above the marginal cost and is making 2
contribution towards fixed cost.
ty management when plant is not operative. These are
discontinued.
In decisions to close down temporarily, cont
to be incurred when plant is shut down, i.e,, committed fixed cost.
Examples of fixed costs which may be avoided by closing
and development, part of salaries, etc. Longer the period 0
aidable fixed cost is likely to be.
Role of Committed and Discretionary Fixed Costs. Sometimes, certain fixed costs can be avoided
termed as discretionary fixed costs.
Committed fixed costs, on the other hand, are those that cannot be avoided even if production is
ribution should be compared with fixed cost which is
down are: advertisement cost, research
f shut down, the larger the amount of Management 4.
wo
16 10,000 units : ae
‘ :
Eoamptes at capacity of plant 5 ce e
Normal carnen plant 48 operating go
aed cor yen plant is shut down : 2
!
Fit cot per unit Q s
aval cos per Unit
uni :
selina mea hi pie = 5000 nis
ews Marginal Cost Statement
4,00,009
Sales (5,000 units @ € 80) © ra
ess: Marginal cost (5,000 units @ ties
000
Contribution i ‘s
Fixed cost if plant is operating _ os
Loss om
is ., the loss due to fixed cost would be 7 80,000 whereas, if play) 3
ca ey a ae A a The effect of plant operating is only a small amount of loss ow €
390.6, 80,000 ~ 75,000). Thus keeping in view this small amount, operating a plant offers ena|
non-cost advantages Like keeping the plant in gear, retaining the customers, retaining all the sitet)
labour and managerial personnel. Thus, it would be advisable to continue the production even if they
is a small amount of loss because the non-cost factors outweigh the loss.
In case the selling price is below the marginal cost and makes no contribution towards fixed cos,
then on cost considerations, the plant should be temporarily shut down. But a final decision in ty
regard should be taken after considering non-cost factors like effect of shut down on plant, fear o
losing the market, effect on relationship with workers and suppliers, etc.
Permanent Shut Down. So far as permanent closing down of business is concerned, such a
decision isa drastic step and should be taken only when in the long run, the business does not expe
to eam a sufficient retum to cover the risk involved. In other words, in the long-run, selling pie
‘must not only cover the total cost but should also give a reasonable return on the capital employed
DIFFERENTIAL COST ANALYSIS
It has been stated earlier that in decision-making,
alternatives. Differential cost analysis is a special tec!
which shows how costs and revenues would be differer
the management has to compare two or more |
hhnique to help management in decision-making |
nt under different altemative courses of action.
Meaning of Differential Cost
Differential cost is the ference in cost between one alternative and another, It is obtained by
subtracting the Cost of one alternative from the cost of the other alternative, For example, when |
sabe ett is considering a change in the level of production, differential cost will be calculated bi
ubstracting the cost at lower level of production from that of a higher level, J
| TE,
Re,
3
aa
Alternative
1
Alternative
u cont/reven
output (units) eae
a ae
z 7.500 2300
Materials zonvo a -
tne veh ion — seam
4,000 3,000
ied overhead 5,000, eae 2,000
6,000 1.900
35,000
51,000 pao
50,000
70,000 20,000
otal cost
sales
roduce additi it
\ditional 2,500 units, additional cost is % 16,000 (i.e., 51,000 -
Thus, in order to pi
in this
35,000). In other words, differential cost for 2,
her word 500 units is & 1 3 i
sh Ae se na ee um ad Se
teal ow equal to marginal or variable cost. Thus, when fixed costs on cone a
fore Synonymous with the variable costs of producing the neunits, Tt is fr tis 1e3s0n
Ghat differential cost is sometimes referred to as marginal cost.
‘sometimes the term incremental cost is also int :
; iterchangeably used with differential co:
canes er eee tn cc co fn Sera
fo another. In the above example, it costs & 91,000 fo ‘produce 7,500 units and & 35,000 to produce
£000 units, the incremental (and differential) cost of producing additional 2,500 units is & 16,000. In
the same way, differential cost may be referred to a decremental cost, where decrease in output is being
considered.
Incremental Revenue, Difference in revenue of two alte
tn differential cost analysis, decisions are taken on the basis o}
incremental n(or decremental) revenue. An alternative is considered pr
is more than differential cost. In the above example, differential cost is © 16,000 wh:
revenue is © 20,000. This means altemative TI produces additional profit of © 4,000 (ie.
16,000) and is thus, acceptable.
snatives is termed as incremental revenues.
f comparison of differential cost with
ofitable when incremental revenue
reas incremental
20,000 -
s with variable cost. In fact, the theory of
differential costing. These two
fields. The points of similarity
Differential Cost Analysis Vs. Variable Costing
las stated earlier, differential cost may be synovton
sariable costing is only a part of the more ‘comprehensive technique of
techniques are similar in some respects but alsodiffer in certain other
and difference are summarised below :
of costs into fixed and variable. When fixed
st and variable cost are the same.
cost analysis and presentation.
techniques of
remaking and formulating policies.
Similarities
1, Both the techniques
costs do not change,
2. Both differential costing an!
3, Both the techniques are use
are based on the classification
the differential co
\d variable costing are
by the management in decisio Mana
438 geMeNt Acco
Differences,
1. The technique of variable costing excludes all fixed costs from i analysis, whereas, |
cost analysis includes identifiable or traceable fixed costs. (I lentiable fred costs ng ua
which change between alternatives since these are identifiable wit specific alternative,
2. Variable costs may be incorporated into the formal accounting system wile, ferentay
are worked out separately for reporting to management for making specific decisions,
3. In variable costing, contitbution, P/V ratio, key factors, etc, are the main yardtcg
evaluation of performance and making-decisions. In differential cost analysis, on the ot
hand, comparison is made between differential cost and incremental revenue for deg
makin S. ;
4, Differential cost analysis can be made in the case of both absorption costing as well as vag
costing.
DECISION MAKING AND DIFFERENTIAL COST ANALYSIS
Many managerial decisions involving problems of alternative choices are made with the apg
differential cost analysis. Such decisions include the following:
Cost Analysis aids jy
decisions such as :
The optimum level is that level of production where | 1, Determining optimum level of py,
profit is the maximum. In order to arrive at a decision | duction. .
of this type, the differential costs are compared with | 2. Accepting a special order.
incremental revenue at various levels of output. So | 3. Adding or dropping a product line,
long as the incremental revenue exceeds differential | 4- Evaluating make or buy alternatives
costs, it is profitable to increase the output. But as | 5- Further processing of joint/by-product,
soon as the differential cost equals or exceeds ——
incremental revenue, it is no more profitable to increase the volume of output.
Mustration 4.7
1, Determination of the Optimum Level of [pbtesecenc
Production
A company has a capacity of producing 1,00,000 units of a certain product in a month. The alt
department reports that the following schedule of sale prices is possible:
Volume of production Selling price per unit?
At 60% capacity 60,000 units 0.90
‘At 70% capacity 70,000 units 0.80
At 80% capacity 80,000 units 0.75
‘At 90% capacity 90,000 units 0.67
‘At 100% capacity 1,00,000 units 0.61
Variable cost of manufacture is 15 paise per unit and total fixed cost % 40,000.
Prepare a statement showing incremental rev
ment enue and differential cost of each stage. At wha!
volume of production will the profit be maximum ? hy
"
a %
ay
Mey
f Ry Statement of Diftorentiat
' fos a1 Revene
tin te) Gacy | tits | vininbte Hive Tal
_ a bind a al | diferentat | Sater | incre
Won out | a PO ae cmt neal
We ag
" - : : tevenne
- . °
Sn wae | 60,000 9.000} 40,000 | axon
Nay rome | 70.000 | 0.500 | sosonn | tony vo | srose
Pe eo ee
"typ At ao volume of moduction, roll is waxinvnn This because at this ves insemeinal were
£4,000 wheres, differential cost is € 1,500, result Pee € 0
Hs aig
Vel of | products at ay
nA alitlonal profit of & 2,500 (Le
500), AMter HOM% level, differential cost exc ine Scene ete
vemental revenue thereby resulting ina toss.
Acceptance of a Special Order
Sometimes management has Lo take a decision to aecopt or reluse
ice which is below the customary sale pric, §
business is working below full production eapacity au the
which is more than differential e
a additional oxder for one of its
elt an ouet can prove atttactive when a
Dilee offered resus in incremental revenue
ct tg} quystration 4.8
ltemnatig! conti
rei Cont
ing Mlustration 4.7, if Lhete is a butk offer for export at 50 pase per unit for the balance
capacity over the maximum profit volume and the price quoted will not affect the
you advise accepting this bid ancl why?
Solution
: Internal Market Special Order Total
(80,000 units) or export (1,00,000 wits)
(20,000 wits)
oO z z z
2 1,000
arable cost @ 15 paise per unit 12,000 3,000 ss.00
Fined cost 40,000 = ies
Total cost 2,000 3,000 i
Siles 60,000 10,000 10,000
- 15,000
Profit 18,000 1,000
Tis advisable to accept te bulk offer @ & 0:50 pe unit for the baat capacity of 70.000 ults
(ie, 100,000 - 80, (000) for export as it will result int am increase ‘of profit by & 7,000. eo
Management
4.20 Aecoun|
3, Adding or Dropping a Product Line : ; ;
Ina multi-product company, the management may ase ean eae ee eonind an
line. When a new product line is added, its sales and certain eee re
ine i it such a decision, the management
happen when a product line is dropped. In order to amriv® & ent
sarree the eifferential cost and inezemental revenue and study its effect on the overall profit man
of the company.
Mlustration 4.
‘The management of a company is
and replace it with another. Given belo
thinking whether it should drop one item from the product
Ww are present cost and output data:
Product Price Variable costs Percentage
z per unit @ of sales
Book shelf 60 40 30%
Table 100 60 20%
Bed 200 120 50%
Total fixed costs per year = 7,50,000
Sales & 25,00,000
in dropping the line of Tables and adding the line g
The change under consideration consists i
g cost and output data.
Cabinets, If this change is made, the manufacturer forecasts the followin:
‘Product Price Variable costs Percentage
= per unit = of sales
Book shelf 60 40 50%
Cabinet 160 60 10%
Bed 200 120 40%
Total fixed cost per year = 7,50,000
Sales % 26,00,000
Should this proposal be accepted? Comment. (Adapt
Solution
Comparative Profit Statement
Existing situation Proposed situation
Particulars Book ‘Table Bed| — Totall| Book Cabinet Bed| — tot
Shelf Shelf
? = a : z z z t
pe 7,50,000 5,00,000 12,50,000 |25,00,000]|13,00,000 2,60,000 10,40,000 | 26,0000
eSS: us -
Variable cost 5,00,000 300,000 7,50,000/ 15,50,000|| 8,066,667 97,500 6,24,000 | 15.8816
Contribution 2,50,000 2,00,000 5,00,000| 9,50,000|| %,33,333 1,62,500 4,16,000 | 10,1183)
Less: Fixed cost 7,50,000| amit
Profit 2,00,000 2.61.83)
Incremental revenue = % 26,00,000 - % 25,00,000 = & 1,00,000
ifferenti 2 z Bee
Differential cost = & 15,88,167 ~ & 15,50,000 = & 38,167
Additional profit Incremental revenue - Differential cost
% 1,00,000 - 38,167 = % 61,833 I
peso MOD
———_—
oan
shout eeeeting the pope. Ths, the
increased by & 61,83
tat profit has increased by & 61.833 from &
on i fo drop the line of Tables and add the ne 02 :
inet
vorking Notes!
onan cost is catculated as under:
ut shelf (resent situation),
Sales = 25,00,000 x 30% » 2 7,50,
5 50,0
tihen selling price of book shelf is 8 60, its var bu
atiable cost is & 40 Thus:
variable cost = 7,50,000 « © 49.
: Too 7% 5.00,000
soot shelf (Proposed situation)
Sales = 26,00,000 * 50% = % 13,00,000
variable cost = 13,00,000 « <2
Fo
similar calculations are made for other lines of products
= & 866,667
4, Evaluating Make or Buy Alternatives
Make or buy decisions based on variable costin
: \ have already been di i
sonever, when making of @ component requires addition investment in cme ie ee
fred cost to be incurred. In such a situation make or buy decision is based sagareent
fiferential cost and incremental revenue and its effect on profit. peed on loners
5, Decision regarding Further Processing of Joint/By-products
Sometimes management has to take a decision regarding further processing of joi ;
an era example a milk day nay a rea as acho ey paces oat
or ghee. In such a case apportionment of joint cost upto split off point isnot relevant for the purpose
Gf decision-making regarding further processing of joint products or by-products. Such decisions ate
taken an the basis of comparison of differential cost and incremental revenue. It is profitable to further
process a product if incremental revenue is more than differential cost on further processing.
Mlustration 4.10
Tn a company engaged in process industry, four products emerge from a particular process of
operation. The total cost of input for the period ended 30th September 2006 is Z 2,53,000. The details
of output, additional cost after “split-off-point” and sales value of the products are appended below:
Products Output Share in Additional process cost Sales
Kgs. joint cost after split-off point value
z z =
A 8,000 85,000 60,000 1,68,000
B 5,000 67,000 10,000 1,10,000
c 3,000 41,000 2,000 60,000
D 4,000 60,000 18,000 90,000
If the products are sold at “split-off point” without further processing, the sales value would have
een >
A Z 1,15,000
B = 90,000
c = 55,000
D = 80,000 Management
~ stability and advise whether products shonta p,
You are required to prepare a statement of profit ,
7 .
at split off point or should be further processe
—— mental Sales Tray
= Cost Sales at ‘Profit at Inereme’ =
Pedics a Hotted Split off split off A z ror
& we point point
7 z
1,68,000
85,000 115,000 30,000 60,000 68000 Say
5 ema 67,000 90,000 23,000 10,000 10000 2m
E aa 41,000 55,000 14,000 2,000 60, =
D 40 . .
it off point is the difference between sales at split off point and cost allotted
votes Hotumental corti additonal processing cost after split off Poin. aint and ees e
5 srarereantal sevenue is the difference between sales at split off point er ay
processing. 7
