PAPER: ACCOUNTING FOR MANAGERS LESSON: DECISION MAKING LESSON DEVELOPER: MS. YASHA BOTHRA ASSISTANT PROFESSOR, COLLEGE/DEPT: BHARATI COLLEGE UNIVERSITY OF DELHI
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Lesson: Decision Making Table of Contents: 1. 2. 3. 4.
Learning Outcomes Introduction Important Cost Concepts. Different Types of Decisions 4.1 Decision Relating to Key Factors 4.2 Export Order Decision 4.3 Make or Buy Decision 4.4 Pricing Decision 4.5 Cost Plus Pricing 4.5 Decision Relating to Deletion, Addition of Product/Services 4.6 Joint Product Costs Summary Glossary Review Questions References
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1. Learning Outcomes: After reading this lesson, you should be able to understand the relevance and irrelevance of costs, understand about different types of decisions considered by management, determine the affect of relevant costs on various decisions.
2. Introduction: In our everyday life, we have to take many decisions. Some decisions are very trivial like whether to wear a black shirt or a red shirt whereas some are very important like which locality is best to buy a house in. Many of us decide whether to buy a vegetable from a hawker or Is it beneficial to buy it from Big Bazaar and so on. All of us take thousands of decisions everyday knowingly or unknowingly. We all apply our analytical, intuitional and learnt abilities to take such decisions. Similarly, managers of an organization have to take a variety of decisions every day. Some decisions are so insignificant that they do not require much attention. But some decisions are so important that even a single mistake can cost a lot to the company. Thus, it becomes imperative for managers to apply all the available techniques that use maximum of available information and knowledge before reaching any decision. In this lesson we will apply variable costing and C-V-P Analysis technique to understand how managers take decisions in various situations like whether to buy a product or make it in-house, whether to export or not, whether to invest in setting up a toy factory or a steel factory etc. But two things which all managers keep in mind while taking any decision is: 1) Cost Minimization and 2) Profit Maximization. Every manager is therefore, very much interested in knowing costs. In fact not only cost but relevant costs. Cost can be divided into relevant and irrelevant costs. Relevant costs are those costs that affect a person‟s decision. In fact these are avoidable costs that can be eliminated by choosing one alternative over another in a decision.
For example, a company is in business of manufacturing sockets. It has the capacity to manufacture 100 units in a month. Fixed cost of company is Rs40, 000 a month and variable cost of one socket is Rs500 per unit. This company is able to sell 80 units at Rs1,000 per unit. The company has received a proposal of supplying 200 units at Rs800 per unit. A layman would reject the proposal because he would think that the it will lead to a loss of Rs100 per unit assuming that the total cost per unit is 900 (fixed cost of 40,000/100 and variable cost of Rs500 as compared to revenue of RS 800).But a management accountant will go ahead with the proposal because in his opinion this order will yield Rs100 per unit. He knows that the fixed cost of Rs 40,000 is irrelevant because company has to pay it whether it accepts the proposal or not. So actually the cost for additional order is only Rs 500 and there will be profit of Rs 300.So the cost that do not play any role in decision making are irrelevant cost.
Hello friends! ITO is here again. So after C-V-P technique we are now at the stage of taking decisions. By now, we have learnt that for any firm, the most important task is to earn profit out of every project of lifelong learning,But university ofwill Delhi undertaken, otherwise nobodyInstitute would like to do business. here, we learn that a manager has to take decision on the basis of available information, resources and
As a famous proverb goes “There‟s more than one way to skin a cat.” Similarly there are many different ways or alternatives that are available with managers for doing a particular task .Decision makers exist because every problem has more than one solution and they have to pick out the most gainful solution. Before taking any decision, management estimates the total cost and endeavour to reduce it as much as it can. After that, the alternative with low cost and maximum revenue is by and large preferred. At this point, it becomes imperative to define and understand the concept of relevant and irrelevant costs in decision making. A relevant cost is one which changes in future as per changes in alternatives. Whereas those costs that do not affect the decision making or which have no influence in reaching any decision are called irrelevant costs. For example, a company is manufacturing face creams. They sell it in two variants say, fairness cream and anti-wrinkle cream. Suppose, the company wants to drop the manufacturing of anti-wrinkle cream as it is not profitable. In that case, there will be no need to pay salary or wages to those workers and supervisors who are directly related to production of anti-wrinkle cream. So, these salaries and wages are relevant cost here but rent of factory will be an irrelevant cost as it has to be paid whether the company carries on the production or not. It should be kept in mind that a particular cost may be relevant in one decision but it might become irrelevant in another. Figure 1: Relevant and Irrelevant Costs
Hi All! I am doing a business of manufacturing soap cakes. You will be happy to know that our soaps are so much in demand. I am thinking of increasing our production by 10,000 units for which I have to buy a new soap making machine. Now I have to shift my office from Karol Bagh to Janak Puri as my landlord has told me to do so by next month. There will be increase in office rent by Rs. 10,000. Ito is thinking upon his decision to increase the production of Soaps. If this decision is taken then Ito has to buy a new machine.
Ito has to shift his office whether he increases production or not.
This will lead to an increase in cost of production.
Rent will increase whether Ito increases the production or not.
So Here
Cost of machine is relevant in taking decision
Increase in rent is irrelevant in taking decision
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Value Addition 1: An Important Tip Relevant and Irrelevant Cost Whether a cost is relevant or irrelevant, depends on the given situation and purpose of decision making. A cost can be relevant in one situation and irrelevant in other.
3. Important Cost Concepts: Till now we have understood that cost is the most important factor that affects manager‟s decision. There are a number of costs that a firm considers under pertinent circumstances. It is quite vital for a firm to understand the difference between various cost concepts for the purpose of decision making. The following are the various cost concepts/types of costs that may or may not be used in decision making:
Differential Cost
It refers to the difference between cost of one alternative and the cost of another alternative. It can be a fixed or variable cost because it includes all those costs that vary with change in alternatives. For example, a company can manufacture a product by using a labour intensive technique or a capital intensive technique. If the cost of production using the labour intensive technique is Rs. 80,000 and that using capital intensive technique is Rs. 89000, the differential cost is Rs.9000 i.e. difference between production costs by the two methods is Rs 9000. Knowledge of this difference helps to know the difference in cost by switching from one alternative to another alternative. Figure 2: Differential Cost
I want to make a building.I can do it in two ways ALTERNATIVE I
Using Labour Intensive technique
ALTERNATIVE II
Using Capital Intensive technique
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Interactive 2
Opportunity Cost
Opportunity cost is that cost which the firm has incurred by leaving one course of action for another. For example, a firm might choose to invest its resources in plan A rather than plan B. The amount of revenue that a firm could have raised from plan B is the opportunity cost of opting for plan A. So, we can say, opportunity cost is a value of something that must be given up to get something else. Since every resource (land, labour, time, etc.) can be put to alternative uses, every decision has an associated opportunity cost. Opportunity cost is actually the benefit one could get from foregoing alternative.
Figure 3: Opportunity Costs
``
Hi! I have bought a new house. But it is not painted yet.
I DECIDED TO PAINT IT MYSELF
For this I have to take leave from office due to which I will lose one day salary amounting to Rs 2000
The Opportunity cost of using the time in painting the house is Rs 2000 because if I would have been to office rather than spending my time in painting I could have earned that day’s salary. Institute of lifelong learning, university of Delhi
Value Addition 2: Know More To know more about Opportunity Cost click on the link below. Source: http://education-portal.com/academy/lesson/opportunity-cost-definition-real-worldexamples.html#lesson
Interactive 1
Marginal Cost
Sunk Cost
It is the cost of producing an additional unit. One can take it as the variable cost of producing an additional unit because fixed cost remains fixed for change in level of output up to a certain range. For example, suppose a manufacturer was making 800 units of a product initially. If he wants to produce more units of the product then he has to buy more of raw material, labour and also he has to incur additional variable overheads. The cost of this additional raw material, labour and variable overhead is marginal cost. Marginal cost is also called as incremental cost.
This can be understood as a past cost. It refers to those costs that have been incurred in the past and cannot be recovered now. For example, cost of machinery is a sunk cost. Because once machinery is purchased, the amount spent can‟t be recovered whether you go ahead with the use of that machine or do not use it.
Hi Ito! I have to prepare an Economics assignment on Power point. For that I have bought a computer for Rs 50,000.
Ito, why don’t you try to prepare it on my lap top. You can carry it to college also. This will help you to use your free time in college for making assignment.
Oh! Wow. That’s nice. Let me buy a lap top too. But what to do with this computer of Rs. 50,000.I wish if I could recover its cost.
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Sorry Ito I can just say that it’s a SUNK COST because whether you decide to buy a laptop or not this cost of Rs 50,000 can’t be recovered now. Interactive 6
Replacement Cost
It can be explained as a cost that is required to be incurred for replacing an asset. It is the amount that is required to be paid to replace an asset with another asset of similar type. For example, if someone has purchased an asset for Rs. 3000 in 2010 and want to buy a new asset of similar type for Rs. 15000 by discarding the old asset for zero scrap value then Rs. 15000 will be the replacement cost for that asset.
I bought this car for Rs 1, 00,000 fifteen years ago. But it is old now and I want to buy a new car. No one is ready to buy it. I am getting zero resale value.
Hello Ito, I bought this car yesterday for Rs 2, 00,000.So, now if you want to replace your car with a new car then your replacement cost for car will be Rs 2,00,000.
Interactive 4 Out of Pocket Cost As the name suggests, it is the cost which puts burden on payer‟s pocket. In business, there are various types of costs. Some are monetary whereas others are non-monetary i.e. these costs are not required to be paid in monetary terms. For example depreciation is a non-
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monetary cost. It is also called implicit cost. But cost of material, labour, power etc. come under monetary cost. These are out of pocket cost as one actually spends and money flows out of the pocket. They are also called explicit cost.
Conversion Cost
These are the costs that are incurred to convert raw material into finished goods. It includes the cost of direct labour and factory overheads.
Figure 4: Conversion Costs
PLASTIC SHEET P
CONVERSION COST Interactive 5
4. Different Types of Decisions Managers want to know the impact of their decisions on firm‟s profitability. They want to know whether their assent for a proposal will bring earnings or it will impact the firm in an adverse way. Sometimes, a project is very promising but managers may face scarcity of resources to fulfill the requirements of the project. For example, a toy manufacturer knows that he can sell thousand units of toys but he is helpless if he doesn‟t have plastic (raw material) to make those toys or if he has only that much of plastic which is enough for making only eight hundred toys. Many a times, they have to decide whether to supply or sell to foreign customers or not. Sometimes, they have to decide whether to make a component or a part themselves or to buy it from outside and so on. Thus, they have to take various decisions. Let us understand and learn about all these decisions one by one. Figure 5: Different Decisions
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Now it‟s time that we should see how decisions are taken under different situations.
4.1. Decision Relating to Key Factor We all know that nothing is in abundance in this world. Same is the scenario with organizations. One or the other factor such as labour hours, materials, machine hours etc. becomes scarce. This factor is called a key factor. And thus, it becomes important for managers to use such resources in a manner that they contribute maximum towards firm‟s profitability. In such a situation, contribution per unit of key factor is calculated for various alternatives and the alternative which gives maximum contribution per unit of key factor is adopted. By this we can say that key factor is the most important factor in decision making. Example 1: Which of the following products should be manufactured if labour hour is the key factor. PRODUCT ‘X’( ) PRODUCT ‘Y’( ) DIRECT MATERIAL 20 10 32 40 DIRECT LABOUR@ 2 per hour VARIABLE OVERHEADS 15 32 SELLING PRICE 215 220 Solution: Labour hours used in per unit of Product X = 32/2 = 16 Product Y = 40/2 = 20
SELLING PRICE Less:DIRECT MATERIAL
PRODUCT ‘X’ 215 -20
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PRODUCT ‘Y’ 220 -10
-32 -15 148
Less:DIRECT LABOUR@ 2 per hour Less:VARIABLE OVERHEADS CONTRIBUTION
-20 -32 158
Contribution per hour: PRODUCT „X‟ = 148/16 = 9.25 PRODUCT „Y‟ = 158/20 = 7.9 Therefore, product „X‟ should be manufactured. Example 2 : Bothra Enterprises Ltd. is manufacturing two products A and B using the same raw materials. Both the products go through Department X and Y. Following is the detail of a production plan. Product A
Product B
Direct Material
Rs.50 per unit
Rs.60 per unit
Direct Labour Department X (@ Rs.10 per hour) Department Y (@ Rs.12 per hour) Variable Overheads
1 hour 1 hour Rs.20
1.5 hours 1 hour Rs.15
Current Annual Production(units)
50,000
40,000
Selling Price Per Unit
Rs.150
Rs.200
Forecast of Sales (Max. Units)
50,000
60,000
Fixed overheads per annum are Rs.20 lakhs. The labour available in Department X is in short supply. Managers are suspicious about the above stated product mix. You are required to state whether the suggested mix is the optimum one or not.
Solution: Contribution per labour hour and ranking of products Product A Selling Price Variable Cost Direct Material Direct Labour Department X Department Y Variable Overheads
Rs.150
Product B Rs.200
Rs.50
Rs.60
Rs.10 Rs.12 Rs.20
Rs.15 Rs.12 Rs.15
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Contribution
Rs.58
Rs.98
Labour Hours(Department X)
1 hour
1.5 hours
Rs.58
Rs.65.3
II
I
Contribution per Department X Ranking
Labour
Hour
of
Profitability under Present Product Mix Product
Production (Units)
Total Hours of Department X 50,000
Contribution (per unit)
Total Contribution
50,000
Hours Per Unit in Department X 1
A
Rs.58
2900000
B
40,000
1.5
60,000
Rs.65.3
2612000
1,10,000
5512000 Less: Fixed Cost Net Profit
20,00,000 35,12,000
Profitability under Revised Product Mix Product
Production (Units)
Total Hours of Department X 90,000
Contribution (Per Unit)
Total Contribution
60,000
Hours Per Unit in Department X 1.5
A
Rs.65.3
5877000
B
20,000
1
20,000
Rs.58
1160000
1,10,000
7037000 Less: Fixed Cost Net Profit
20,00,000 50,37,000
DECISION: With revised product mix profitability will increase by Rs.15,25,000.
4.2. Export Order Decision With globalization, the entire whole world has become one global village. Anyone from anywhere can contact any person with the help of internet. In fact, there has been a great
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increase in tourism between countries. This has also resulted in the interaction of traders and businessmen across the world. Now one can easily find a good made in China, Russia, America, Japan or any other country in Indian markets and vice versa. This has resulted in the development of demand for products in foreign markets also. Many firms receive orders for their products from foreign markets also. As long as the price paid by importers is equal or greater (rarely) than that charged in domestic market there is no problem in exporting. However, one needs to think and a decision is required when product can be exported only at a price lower than the price in domestic market. In such a situation, a manager must check whether that price (export price) is able to cover the variable cost or not. If variable cost can be covered then order should be accepted. And, if variable cost cannot be covered than the order should be rejected. Fixed cost is the cost which has to be incurred whether the product is exported or not. Therefore, in this case it becomes an irrelevant cost. Example 3: Zingo Ltd. can manufacture 20,000 units of a product in a year. Currently it is working at 75% of its capacity and selling each unit at a price of Rs. 30 .The per unit cost of the firm is as follows: Rs.(Per Unit) Material 8 Labour 6 Factory Overheads: Fixed 2 Variable 1.5 Office Overheads (Fixed) 1 Selling Overheads: Fixed .50 Variable 1
Firm has received an export order for 2000 units at a price of Rs. 18 each unit. Should the order be accepted by the firm? Solution: DOMESTIC MARKET: Rs. SALES (20,000X.75 X 30 )
4,50,000
Less : Material ( 15000 X 8)
1,20,000
Less : Labour (15000 X 6)
90,000
Less : Variable Overheads: Factory (15000 X 1.5)
22500
Selling (15000 X 1)
15000
Contribution
202500
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Less :Fixed Overheads: Factory (15000 X 2)
30,000
Office (15,000 X 1 )
15000
Selling (15000 X .50)
7500
Profit
1,50,000
FOREIGN MARKET:
Sales (2000 X 18 ) Less : Material ( 2000 X 8) Less : Labour (2000 X 6) Less : Variable Overheads: Factory (2000 X 1.5) Selling (2000 X 1) Contribution
Rs. 36000 16000 12000 3000 2000 3000
Decision: Therefore, the firm should accept this export order as it will increase firm‟s earnings by Rs.3000.
Value Addition 3: Know More Fixed Cost Fixed cost of component is not to be compared as it is fixed. It has to be incurred whether the component is made or not.
Example 4: A company manufactures 20,000 units of a product in a year at the cost of Rs.4 per unit. This product can be sold at a price of Rs.4.25 in the market. Other costs details are as follows: Material
Rs.10,000
Wages
Rs.11,000
Fixed Overheads
Rs.8,000
Variable Overheads
Rs.5,000
After a survey, it has been found that 20,000 units can be sold in foreign market also at the price of Rs.3.75. It has been found that if foreign demand will be catered then fixed cost will increase by 10%. Is it worthwhile to sell in foreign market assuming the company has required additional capacity?
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Solution: Home Market
Foreign Market
SALES
85,000
75000
Less: Variable Costs Materials Wages Variable Overheads
Rs.10,000 Rs.11,000 Rs.5,000
Rs.10,000 Rs.11,000 Rs.5,000
Contribution
Rs.59,000
Rs.49,000
Less: Fixed Costs
Rs.8000
Rs.800
Profit
Rs.51000
Rs.48200
Decision: The company should manufacture and sell in foreign market also as it will increase the profit of the company by Rs. 48,200.
4.3 Make or Buy Decision A finished product manufactured by a firm is composed of various components. If a firm has capacity and facility then it can manufacture the components itself. Otherwise it can buy it from a vendor. But here a question comes that if firm has the capacity and ability to produce as well as suppliers are also there for that product then what should the firm do. Again we will do cost comparison here. We will compare the variable cost of manufacturing the component with the price to be paid to supplier. Of course, lower of both is selected. Interactive 3 Example 5: Taxpro Ltd. is manufacturing product „x‟. It requires a component „z‟. The firm has alternatives that either to produce this component themselves or buy it from Hasty Ltd. at a price of Rs.6 per unit. The cost of production is as follows: Materials
Rs.2
Labour
Rs.1
Variable Overheads
Rs.1
Fixed Overheads
Rs.2
Advice the firm whether it should produce the product in house or not? Solution: Total relevant cost of producing the component in house = 2+1+1 =Rs.4 Fixed cost is ignored as it has to be incurred whether the firm produces or not. Cost of buying the component from Hasty Ltd. = Rs.6 Decision: Therefore, it is better to produce the product in-house. Example 6: ABC Company wants to make 6000 units of a component used in a product. With following expected cost:
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Direct Material
Rs.10 per unit
Direct Labor
Rs. 8 per unit
Other Variable Costs
Rs. 9 per unit
Fixed Cost
Rs.1,00,000
It has received an offer from a supplier to get these components at Rs.30 each. Advise the company? Solution: In this question, relevant cost to be considered is variable cost only as fixed cost has to be incurred whether the product is produced or not. Therefore, Cost of producing 600 units: Direct Material
Rs.6000
Direct Labor
Rs. 4800
Other Variable Costs
Rs. 5400
Total Cost
Rs.16,200
Cost of buying: = 600 x 30 = Rs.18000 Decision: It is better to make the product than to buy as it will result in saving of Rs.1800. Example 7: A company uses three different components (materials) in manufacturing its primary product. It manufactures two of the components and purchases one (designated as component I) from outside suppliers. The company can also buy component II from the market at price of Rs.5.20 per unit. Following information is provided.
Material
Component II (Unit Cost) Rs.1.40
Labour
Rs.2.20
Fixed Overhead
Rs.0.40
Variable Factory Overhead
Rs.1
In your opinion, company should buy the product or make it itself? Solution:
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Cost Statement for Component II COMPONENT II (Unit Cost) VARIABLE COST Material
Rs.1.40
Labour
Rs.2.20
Variable Factory Overhead
Rs.1
FIXED COST Fixed Overhead
Rs.0.40
TOTAL
Rs.5
Decision: It is better to make the product as company will save Rs.20 if it produces the product itself. Value Addition 4: Know More
Due increase in globalization and outsourcing activities, make or buy decisions are one of the most popular decisions taken by managers these days. Every company is trying to concentrate on its core activities and outsource (buy) non - core activities.
4.4. Pricing Decision As the name suggests, these decisions relate to deciding the selling prices for products. Generally, in a competitive market, where every firm is trying to create its niche, efforts are made to capture the largest share of market. Each and every firm can do so by charging minimum price for its product. In short run it will be viable if the product is sold at a price which will cover only variable cost of the product. We know that fixed cost has to be incurred whether the firm produces or not, so it will be sufficient to cover only variable cost in short run. But, in long run, no firm can sustain like this. In long run company has to earn so much that it should be able to meet its fixed cost obligations also. Every manager wants to earn profit after covering its total cost. By this, we can easily say that the price that a company charges for its product depends on every firm‟s short term and long term objectives. Interactive 7 Example 8: Fixed cost of manufacturing product Z is Rs.20,000. It requires direct labour of Rs.2 per unit and direct material of 3 per unit. Variable overheads while production is Rs.4 per unit. 1500 units of this product can be sold for Rs.10 in the current market. Advice whether the firm should sell the product or not. Solution: Variable Cost of Manufacturing Product Z is: Direct Material Rs.3 Direct Labour Rs.2
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Variable Overheads
Rs.4
Total Variable Cost (Per Unit)
Rs.9
Selling Price of the Product Z is Rs.10 per unit Contribution (per unit) = 10-9 = 1 Decision: Therefore, it is better that the firm should supply the product at Rs.10 per unit as it is giving a contribution of Rs.1 per unit. Thus, it will contribute Rs. (1500 X 1)=Rs.1500 towards fixed cost and reduces overall loss by such amount. Value Addition 5: Know More Situations When Price of a Product is Less than its Variable Cost Following are some of the circumstances when selling price of a product can be kept below its variable cost: To popularize a new product To eliminate competitors from the market To sell off old stock that may get expired or useless To keep machinery in working condition which if not used at all may deteriorate To maintain the market share
Example 9: Ramananda & Ramakanda Ltd. produce a single product which it is selling at Rs.75 per unit in the domestic market. Currently, the company is working at 50% capacity and manufacturing 40,000 units per month. Variable cost per unit is Rs.50 and fixed cost for a month is Rs.10 Lakhs. The Company is having the option of reducing its selling price by Rs.5 per unit to increase its sales by 10,000 units to improve its profitability. Advice the firm whether it should reduce the selling price or not? Solution: PROFITABILITY STATEMENT Sales @ Rs.75 Per Unit
Sales @ Rs.70 Per Unit
Sales
Rs.3000000
Rs.3500000
Variable Cost
Rs.2000000
Rs.2500000
CONTRIBUTION
Rs.1000000
Rs.1000000
Fixed Cost
Rs.5,00,000
Rs.500000
PROFIT
Rs.5,00,000
Rs.500000
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Decision: Since there is no increase in profit then it is up to firm whether it reduces selling price to capture market share or not.
4.5. Cost Plus Pricing As the name suggests under this method price of product is determined by adding a mark-up to cost. It is normally used in cases where product is unique and the firm is a price setter. It is also used where cost of production keeps fluctuating and thus no single price can be declared for the product. There are two ways of using this technique: 1) Full Cost Plus Pricing: As the name suggests, mark up margin is to be added to full cost of product i.e. variable cost and fixed cost 2) Variable Cost Plus Pricing: In this method, mark up margin is added to variable cost of the product. Example 10: Consider a business with the following costs and volumes for a single product: Fixed Costs: Factory Production Costs
Rs.50,000
Fixed Selling Costs
Rs.5,00,000
Administration And Other Overheads
Rs.1,00,000
Variable Costs Variable Cost Per Unit
Rs.23
Mark-Up Mark-Up % Required
20%
Budgeted Sale Volumes (Units)
100,000
What should the selling price be on a full cost plus method of charging price? Solution: The Total Costs of Production can be calculated as follows: Total Fixed Costs
Rs.6,50,000
Total Variable Costs (23 X 1,00,000 Units)
Rs.23,00,000
Total Costs
Rs.29,50,000
Mark Up Required on Cost (29, 50,000x 20%)
Rs.5,90,000
Total Costs (Including Mark Up)
Rs.3540000
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Divided by Budgeted Production (1,00,000 Units) Selling Price Per Unit
Rs.35.4
Value Addition 6: Important Tip Cost Plus Pricing If cost plus pricing approach is followed then price increases are defensible as and when cost increases. Every firm can easily explain that the reason for increase in price is increase in cost of production.
4.6. Decisions Related to Deletion, Addition of Products, Services or Departments Today, we have many firms selling variety of products or services. For example, Maggi offers Atta noodles, Masala Noodles, Pasta, etc. As we know, adding a new product to the existing product line will involve incremental cash outlay and additional sales revenue. Similarly, dropping a product from existing product line will reduce existing cash outlay and sales revenue. The manager has to decide whether such action should be taken or not by considering its effect on increase or decrease in cost and revenue. Example 11: ABC Ltd. has three different product lines. Their production cost per unit and selling prices are as under: Particulars
LINE A(Rs.)
LINE B(Rs.) LINE C(Rs.)
Production Units
60000
40000
100000
360 140 40 100 640 800 160
180 60 160 920 1200 280
600 200 60 180 1040 1220 180
Cost: Material Wages Variable Overheads Fixed Overheads Total Cost Selling Price Profit
The management wants to discontinue one line and gives the assurance that production in two other lines will rise by 50%. They intend to discontinue the line A, as it is less profitable. Advice the management if its decision is appropriate or not.
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Solution: Total Fixed Cost LINE A LINE B LINE C Contribution = LINE A = LINE B = LINE C =
6,0000 4,0000 10,0000
units @ Rs.100 units @ Rs.160 units @ Rs.180
Rs. 6000000 6400000 18000000 30400000
Selling Price - Variable Cost .800 - 540 260 per unit .1200 - 760 440 per unit 1220 - 860 360 per unit
If LINE A is dropped Sale of LINE B and LINE C will increase by 50%. Then the sales would be LINE B - 60000 units LINE C -150000 units Total Contribution LINE B: 60000 units @ Rs.440 per unit LINE C: 150000 units @ Rs.360 per unit Less: Profit
Rs.. 26400000 54000000 80400000 30400000 50000000
Fixed Cost
If LINE B is dropped Sale of LINE A and LINE C will increase by 50%. Then the sales would be LINE A - 90000 units LINE C - 150000 units Total Contribution LINE A: 90000 units @ Rs..260 per unit LINE C: 150000 units @ Rs.360 per unit
Rs. 23400000 54000000 77400000 30400000 47000000
Less: Fixed Cost Profit
If LINE C is dropped Sale of LINE A and LINE B will increase by 50%. Then the sales would be X - 9,000 units and Y - 6,000 units. Total Contribution LINE A: 90000 units @ Rs.260per unit LINE B: 60000 units @ Rs.440 per unit Less: Profit
= =
Fixed Cost
Rs. 23400000 26400000 49800000 30400000 19400000
From the above, it is clear that, among the three alternatives, the highest amount of profit is earned when LINE A is discontinued. Thus, the management decision to discontinue LINE A is correct.
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Example 12: A company is engaged in production of three different products. Their production cost per unit and selling price are as under:
Product A (6000 units)
Product B (4000 units)
Product C (5000 units)
Material Cost
20
10
15
Wages
15
20
25
Variable Overheads
20
30
25
Fixed Overheads
10
5
15
Selling Price
100
80
90
Profit
35
15
10
The manager wants to put an end to production of one product. They propose to terminate the line which produces product C as it is less gainful. Do you agree? Explain. Solution: Calculation of fixed overheads Product A (6000 X 10) =Rs.60, 000 Product B (4000 X 5) =Rs.20, 000 Product C (5000 X 15) =Rs.75, 000 Total Fixed Overheads =Rs.1, 55,000 Calculation of contribution per unit Product A = 100-45=55 Product B = 80-20=60 Product C = 90-65=25 Profit if production of product A is discontinued Contribution from B=4000X60=2, 40,000 Contribution from C=5000X25=1, 25,000 Total Contribution = 3, 65,000 Less: Fixed Cost = 1, 55,000 Profit = 2, 10,000 Profit if production of product B is discontinued Contribution from A=6000X55=3, 30,000 Contribution from C=5000X25=1, 25,000 Total Contribution = 4, 55,000 Less: Fixed Cost = 1, 55,000 Profit = 3, 00,000 Profit if production of product C is discontinued Contribution from A=6000X55=3, 30,000 Contribution from B=4000X60=2, 40,000 Total Contribution = 5, 70,000
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Less: Fixed Cost Profit
= 1,55,000 = 4, 15,000
Decision: It can be seen that profit is maximum when production of product C is discontinued. Therefore, firm‟s decision to continue with product A and product B is correct.
4.7. Joint Product Costs: Sell or Process Further Some products are obtained from same process. For example, we all have must have studied in science how fractional distillation of crude oil helps in production of lubricating oil, kerosene, gasoline, naphtha, diesel, etc. Those products which are obtained from a single process are called joint products. However, once we get them some of the joint products may require further processing. Thus, we have to split them up and do further processing. The cost of processing them together up to split off point is called joint cost. The cost of processing further after split off point is very easy to be allocated to each product but joint cost needs to be apportioned appropriately. Managers may have to decide whether to sell the product at split off point or to process them further. Here, again they have to consider additional cost and revenue in doing so as to reach a decision. Example 13: Joint products A and B result from a distinct manufacturing process. All products could be sold at the split-off point or alternatively processed further. The following data about the two products are available: Product A Product B Rs. per unit Rs. per unit Common Costs 25 26 Selling Price at Split-Off Point 24 38 Cost of Further Processing 8 12 Selling Price after Processing 32 48 Which product(s) should be sold at the split-off point? Answer: A product should be sold at the split-off point if there is no any incremental earnings from processing the product further. As long as the process as a whole is profitable, it is irrelevant if an individual product is profitable or not. It has to be assumed, in this example, that the process as a whole is profitable. The incremental profit/ (loss) from further processing is calculated as: Product A (Rs. per unit)
Pr
Product B (Rs. per unit)
Incremental Revenue
8 (32– 24)
10 (48– 38)
Incremental Cost
8
12
Incremental Profit/(Loss)
(0)
(-2)
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It can be seen that further processing of product A generates no profit and no loss. So, the firm is indifferent about its further processing. Whereas further processing of product B results in a loss of Rs.2. So, it is not advisable to process it further. Example 14: A company produces four joint products namely product A, product B, product C and product D by using a particular raw material. Out of these four products, there is no need to further process product A. Manufacturing of these products requires raw material worth Rs.20,000. The initial processing costs were Rs.40,000. During the previous year the output of product A, product B, product C and product D were 5000 units,2000 units,3000 units and 4000 units respectively. The further processing costs and sales revenue from the four products during the last year were as follows: PRODUCT
Further Processing costs (Rs.)
Sales Revenue(Rs.)
PRODUCT A
-
50,000
PRODUCT B
5000
20,000
PRODUCT C
2000
40,000
PRODUCT D
4000
60,000
PRODUCT
PRICE (PER UNIT)
PRODUCT A
Rs.10
PRODUCT B
Rs.8
PRODUCT C
Rs.9
PRODUCT D
Rs.12
Kindly advice the firm whether it should process further all the three products or not. Show your workings properly and give your decision. Solution: PRODUCT
A
Sales After Processing
Units
Selling Price Before Processing(Per Unit)
Sales Before Processing
Incremental Revenue
Cost of Further Processing
50,000
5000
Rs. 10
50,000
-
-
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B
20,000
2000
Rs. 8
16,000
4,000
5000
C
40,000
3000
Rs. 9
27,000
13,000
2000
D
60,000
4000
Rs. 12
48,000
12,000
4000
Decision: It is clear from the above table that it is better if product C and D are processed further. Since incremental revenue from product B is Rs.4000 whereas cost of processing it further is Rs.5000.So it is not advisable to process it further.
Summary:
Decision making is the essential function of management which involves choosing the optimum alternative out of available alternatives.
For decision making it is important to distinguish between relevant costs and irrelevant costs.
Relevant costs are the one that will incur if a particular activity is undertaken. Otherwise it can be avoided.
Irrelevant costs are those costs that do not change with change in alternatives.
For short term it is enough if variable cost is covered but in long run efforts are made to cover both variable and fixed cost by earning sales revenue.
There are various kinds of decisions to be done by management. It can be make or buy, export order, processing further, etc.
Optimum product mix is the one which gives highest amount of contribution.
Glossary:
Cost: It is the monetary value of the efforts of various factors of production like land, labour, capital and entrepreneur.
Variable Cost: It is that cost which changes with change in number of units produced.
Fixed Cost: It is a cost which doesn‟t change with change in number of units produced.
Profit: It is difference between revenue from sales and cost of production.
Alternatives: It refers to the possible courses of action or choices available.
Optimum alternative: It refers to the most favourable or best alternative.
Domestic Market: The market within one‟s country‟s own border.
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Exercises: I.
Objective Type Questions:
A. State True or False: 1. Sunk costs are cost of those materials which have no role in production of a product. 2. A cost which is relevant in one decision will be relevant in all decisions. 3. A future cost that does not differ among alternatives under consideration is irrelevant. 4. Opportunity cost is the cost that has to be incurred when a new project is taken. 5. A company should stop selling its output if it is not able to cover the full cost of production. 6. Avoidable costs are also called relevant costs B. Multiple Choice Questions: 1. One of the following is not a relevant cost in replacement decision regarding a machine which can increase production capacity if replaced. a. Direct Material b. Direct Labour c. Variable Manufacturing Overheads d. Rent of Office Building
2. A cost which has no role or doesn‟t affect manager‟s decision is called a) Opportunity cost b) Sunk cost c) Avoidable cost d) Irrelevant cost 3. Costs that change with change in the alternatives chosen by managers are called a) Fixed costs. b) Incremental costs. c) Relevant costs. d) Sunk costs.
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4. Which one of the following does not affect a make or buy decision? a) Variable manufacturing costs b) Opportunity costs c) Incremental revenue d) Direct labor C. Fill in the Blanks: 1. If a particular resource is in limited amount or quantity it is called as ……………… 2. To eliminate competition a firm may sell products below their………………… 3. Direct labour is a ……………………….cost and ………………….. cost. 4. Relevant costs are those costs that relate to …………………… 5. ………………….are irrelevant costs. 6. Depreciation is not an ………………………..cost. 7. Export order may be accepted if the firm is able to cover only ……………….cost. I. Answers to Objective Type Questions: A. State True or False: 1. False
2. False
3. True
4. False
5. False
6. True
B. Multiple Choice Questions: 1. d
2.d
3.c
4.b
C. Fill in the Blanks: 1. Key factor 4. Future 7. Marginal
II.
2. Cost/variable cost 5. Sunk costs
3. Prime and conversion 6. Out of pocket
Answer the Following Questions:
1) What do you understand by decision making? 2) What is differential analysis? 3) Differentiate between relevant and irrelevant costs. 4) Is it always a good option to select a product with positive contribution margin? Explain. 5) How does a manager decide whether to continue or shut down a product or service? 6) Explain the concept of sunk cost.
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7) Write a short note on make or buy decision. 8) Differentiate between marginal cost and differential cost.
Numerical Questions: 1. A soft drink manufacturing company is producing 6000 units of a product which is equivalent to 60% of its capacity. The following information regarding cost of product is available: Sales
Rs.6,00,000
Direct Material
Rs.1,00,000
Direct Labour
Rs.1,20,000
Direct Expenses
Rs.45,000
Factory Overheads
Rs.2,00,000
The company is thinking of introducing a new soft drink by name of “Jag fresh”. The estimated cost for this product is as follows:
Cost Per Unit Direct Materials
Rs.10
Direct Labour
Rs.20
Direct Expenses
Rs.5
Variable Overheads
Rs.10
It is expected that 1000 units of this product can be sold for Rs.100 in the market. Should the new product be introduced by the firm? Show your workings clearly. . 2. Following information is provided to you regarding a product: Material Cost Rs.1,20,000 Labour Cost
Rs.2,40,000
Variable Overheads
Rs.60,000
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Fixed Overheads
Rs.1,20,000
Units Produced
12000 Units
Selling Price Per Unit
Rs.50
Currently the firm can produce 20,000 units annually. Firm can save rupee one per unit in cost of raw material if it produces 5000 more units of the product. It is assumed that firm is able to sell additional units at a price of Rs.40 for one unit in the market. But due to it fixed overheads will increase by Rs.35, 000 and efficiency will fall by 2%. State whether the firm should accept this offer or not. 3. A company sells three of its products in the market. The details of its unit costs and selling prices are as under: Product X Product Y Product Z Selling Price
50
70
100
Direct Material
20
30
25
Direct Labour
10
15
10
Variable Overheads
30
20
25
Fixed cost for this firm is Rs.6, 00,000. Sales for first quarter are as follows: Product X
Product Y
Product Z
January
25,000
10,000
15,000
February
20,000
25,000
20,000
March
30,000
35,000
40,000
Calculate the profit of the firm for the first quarter. 4. A company produces 10,000, 5000 and 8,000 units of product A,B and C. The cost per unit of three products A,B and c are as follows: A (in Rs.)
B (in Rs.)
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C (in Rs.)
Variable Cost
40
40
36
Fixed Cost
6
6
4
Total Cost
46
46
40
Selling Price
55
53
46
Profit
9
7
6
Production of one product has to be given up to increase the production of other products by 50%. Managers are in favour of dropping product C. Do you agree? Answers to Numerical Questions: 1. Yes, new product should be introduced 2. Accept the offer and profit will increase by Rs.200 3. Rs 20,00,000 4. Product B should be given up
References: 1. Suggested Readings: i.
Charles T. Horngreen, Lary L., Sundern and William O. Stratton, “Introduction toManagement Accounting”, Prentice Hall of India Ltd., New Delhi.
ii.
Jawahar Lal, “Managerial Accounting”, Himalaya Publishing House, 2001.
iii.
Khan, M.Y. and P.K.Jain,” Management Accounting”, Tata McGra w Hill, New Delhi
iv.
Kimmel, P.D., J.J. Weygandt and D.E. Kieso, “Financial Accounting: Tools for Business Decisions”, John. Wiley & Sons, 2000.
v.
Arora M.N, ”Management Accounting-theory problems and solutions”, Himalaya Publishing House.
Web References: i.
http://www.bcci.bg/projects/latvia/pdf/3_VG_Full_Course.pdf
ii.
www.willey.com/college/sc/eldenburgh/cho3.pdf
iii.
http://businesscasestudies.co.uk/cima/financial-information-in-decisionmaking/management-accounting.html
iv.
www.thestudentroom.co.uk
v.
http://www.accounting4management.com/assumptions_of_cvp_analysis.htm
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vi.
http://highered.mcgrawhill.com
Video Links: 1) To know more about further processing decision and relevant cost click on the link below: https://archive.org/details/ArslanAhmadF2DecisonMaking3FurtherProcessingDecisionsAndRelev antCost
2) To know more about opportunity cost click on the link below: http://www.investopedia.com/video/play/opportunity-cost/ 3) To know more about marginal cost click on the link below: http://www.youtube.com/watch?v=WQdbdPFEwSo
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