Management Decision-Making (Cambridge International A-Level Accounting)
Make-or-buy
Spec point — the usefulness of marginal costing data as a support for management decision-making, including make-or-buy, special orders, closure of business unit, limiting factors, target profit
How is make-or-buy decision-making supported by marginal costing data?
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Sometimes the owners of a business have to decide whether to make a product themselves or buy it from a supplier
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Marginal costing focuses on variable costs
- Variable cost per unit of producing internally can be compared with the purchase price from an external supplier to make decisions on whether it is better to make in-house or buy externally
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Marginal costing excludes fixed overheads from cost calculation
- This prevents overestimating the cost of in-house production, so fair comparisons can be made
Worked Example Company A manufactures Product X and the following budgeted information is available.
Selling price $100 per unit Direct materials $30 per unit Direct labour 5 hours at $10 per hour Monthly capacity 20 000 units Monthly output and sales 14 000 units Company A is aware there is an external supplier that can provide 13 000 units of Product X a month, resulting in a contribution of $30 per unit.
Advise Company A on whether they should continue manufacturing Product X internally or purchase from the external supplier.
Answer:
Contribution per unit of producing internally:
Contribution = Selling price - Direct materials - Direct labour
$100 - $30 - (5 × $10) = $20 per unit
This shows that purchasing from the external supplier would give a greater contribution; $30 per unit compared to $20 per unit.
Purchasing from the external supplier is better than producing Product X internally.
However, Company A must also make note that the external supplier can only supply 13 000 units each month, which is 1 000 units less than the monthly sales, meaning 1 000 units of sales will be lost each month.
Special orders
Spec point — the usefulness of marginal costing data as a support for management decision-making, including make-or-buy, special orders, closure of business unit, limiting factors, target profit
How is decision-making for special orders supported by marginal costing data?
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A special order is when a product is sold a lower price than usual
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Special orders are accepted if they have a positive contribution
- Traditional absorption costing may make a product look unprofitable if fixed overheads are allocated
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However, sometimes orders with negative contributions may be accepted to:
- avoid redundancies
- stimulate future orders
- raise brand awareness
- break into a new market
- dispose of discontinued inventory
Worked Example Z Limited manufactures product Q and the following data is available.
Selling price per unit $35 Contribution per unit $20 Fixed costs per month $19 000 Factory capacity per month 2 000 units (currently the factory is operating at 70% capacity) The directors are considering accepting a special order from a customer. The order is for 500 units and there are slight changes to the product design which will add $2.50 per unit to variable costs. The customer has offered to pay $30 per unit.
Advise the directors whether or not they should accept the special order from the customer.
Answer:
Original variable cost per unit:
Selling price per unit - Contribution per unit
$35 - $20 = $15 per unit
New variable cost per unit:
$15 + $2.50 = $17.50 per unit
Contribution per unit from special order:
$30 - $17.50 = $12.50 per unit
The directors should accept the special order. Although the contribution is less than normal orders ($12.50 per unit compared to $15 per unit), the special order still provides positive contribution. Fixed costs remain unchanged and the special order contributes to covering fixed costs. The factory is currently producing 1 400 units (2 000 × 70%) and is able to accept the 500 unit special order which will prevent redundancies.
The directors must ensure the special order is kept separate from regular orders and that regular orders are met comfortably and prioritised.
Closure of a business unit
Spec point — the usefulness of marginal costing data as a support for management decision-making, including make-or-buy, special orders, closure of business unit, limiting factors, target profit
How is decision-making for the closure of a business unit supported using marginal costing data?
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Decisions regarding discontinuation of a product line and closure of a business unit can be supported using marginal costing data
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Calculating the contribution can help with the decision-making
- If a unit has a positive contribution, closing the unit will reduce overall profit, even if it appears unprofitable after fixed cost allocation
- Positive contributions will help to cover common fixed costs across units
Worked Example A factory manufactures Product C and D. There is a forecasted loss of Product D.
The directors are considering discontinuing Product D.
Discontinuing D would result in redundancy costs of $2 000 (because the supervisor for Product D would no longer be required) but is expected to increase the sales revenue of Product C by 20%.
Product C
$Product D
$Sales revenue 10 000 8 000 Direct materials 5 000 4 000 Direct labour 1 500 2 000 Supervisor fixed salaries 500 1 500 Variable overheads 1 000 500 Fixed factory overheads 500 400 Advise the directors on whether they should discontinue Product D or not.
Answer:
Find the profit/loss for both products
Product C
$Product D
$Revenue 10 000 8 000 Direct materials (5 000) (4 000) Direct labour (1 500) (2 000) Variable overheads (1 000) (500) Contribution 2 500 1 500 Less: Fixed costs Supervisor fixed salaries (500) (1 500) Fixed factory overheads (500) (400) Profit/loss 1 500 (400) Current net profit:
$1 500 - $400 = $1 100
Product C new sale revenue
$10 000 × 20% = $2 000
$10 000 + $2 000 = $12 000
Product C new profit:
$1 500 + $2 000 = $3 500
Redundancy cost incurred $2 000
New net profit
$3 500 - $2 000 = $1 500
The directors should discontinue product D. The net profit increases by $400 if product D is discontinued. However, directors must consider how reliable the forecast that sales revenue will increase by 20% is. They also must consider how staff redundancy will impact staff morale and motivation. Existing customers may also be made unhappy by the discontinuation of product D and may be lost to competitors.
Limiting factors
Spec point — the usefulness of marginal costing data as a support for management decision-making, including make-or-buy, special orders, closure of business unit, limiting factors, target profit
How is decision-making regarding limiting factor supported by marginal costing data?
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Decision-making regarding which products should be prioritised in the product mix when there is a limiting factor can be supported using marginal costing data
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Limited factors could be:
- limited materials
- limited labour
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STEP 1 Calculate contribution per unit of limiting factor
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To identify which product gives the highest return per constrained resource
- E.g. if machine hours are limiting:
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STEP 2 Rank the products by contribution per unit of limiting factor
- Allocate the limiting resource to the higher ranking products first and continue until limiting resource is fully used
Worked Example G Limited manufactures the following products and the following data is available.
Product F: Product G: Product H: Selling price per unit $50 per unit $30 per unit $40 per unit Monthly demand 1 000 units 5 000 units 2 500 units Materials used per unit 10kg 4kg 7kg Material cost per kg $2 per kg $2 per kg $2 per kg Labour cost per unit $15 per unit $12 per unit $8 per unit Monthly fixed costs $5 000 $4 500 $1 900 Only 40 000kg of materials are available in the month of February.
Calculate the optimum production plan to maximise profit.
Answer:
Calculate the contribution per unit per kg
Product F
$Product G
$Product H
$Selling price 50 30 40 Direct materials 2 × 10 (20) 2 × 4 (8) 2 × 7 (14) Direct labour (15) (12) (8) Contribution per unit 15 10 18 Contribution per kg 15 ÷ 10 1.50 10 ÷ 4 2.50 18 ÷ 7 2.57 Use the resources in the following order:
- Priority 1: Product H
- Priority 2: Product G
- Priority 3: Product F
Product H
2 500 units × 7kg = 17 500kg
Product G
40 000kg - 17 500kg = 22 500kg
5 000 units × 4kg = 20 000kg
Product F
22 500kg - 20 000kg = 2 500kg
2 500kg ÷ 10kg = 250 units
The optimum production plan is:
Product F Product G Product H Final answer: 250 units Final answer: 5 000 units Final answer: 2 500 units
Target profit
Spec point — the usefulness of marginal costing data as a support for management decision-making, including make-or-buy, special orders, closure of business unit, limiting factors, target profit
How is decision-making regarding target profit supported by marginal costing data?
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Sales to achieve target profit can be calculated using marginal costing
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Determines how many units must be sold to **reach **a desired profit
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Helps make decisions on** selling price** to ensure the target profit will be reached within expected sales volume
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Identifies how changes in variable costs or fixed costs would impact the ability to reach target profit
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Calculation of margin of safety
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Assists risk assessment
- Shows how much sales can drop before the company fails to meet the target profit
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Worked Example Company Z manufactures a single product and the following data is available for a month.
$ Sales revenue 500 000 Variable costs 150 000 Fixed costs 50 000 The directors require a target profit of $75 000 next month.
Calculate the sale revenue required to achieve the target profit.
Answer:
Calculation the contribution
Contribution = Sales revenue - Variable costs
$500 000 - $150 000 = $350 000
Calculate the contribution to sales revenue
Contribution to sales ratio = Contribution ÷ Sales revenue
$350 000 ÷ $500 000 = 0.70
Use the formula
Sales revenue required to achieve target profit = (Fixed costs + Target profit) ÷ Contribution to sales ratio
($50 000 + $75 000) ÷ 0.70 = $178 571.4286
Final answer: Sales revenue required is $178 572
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