Strategic Cost Management Concepts and Techniques for Decision Making PDF

STRATEGIC COST MANAGEMENT By: NILO N. IGLESIAS, CPA, MBA, REA Concepts and Techniques For Decision Making What is Decision Making and Decision Model? DECISION-MAKING - the function of selecting courses of action for the future DECISION MODEL - a formal method used by manage...

STRATEGIC COST MANAGEMENT By: NILO N. IGLESIAS, CPA, MBA, REA Concepts and Techniques For Decision Making What is Decision Making and Decision Model? DECISION-MAKING - the function of selecting courses of action for the future DECISION MODEL - a formal method used by managers for making a choice. It involves both quantitative and qualitative analyses. BASIC STEPS IN A DECISION MODEL A. IDENTIFY THE PROBLEM. The typical cases may involve questions on: 1. whether to accept or reject a special order or business proposal 2. whether to make or buy a part, sub-assembly, or product line (insourcing vs. outsourcing cases). 3. whether to sell or process a product further 4. whether to continue operating or close a business segment 5. which is the best product-mix considering capacity 6. how profit factors should be changed to achieve a profit goal 7. how much price should be charged for the company's product or services (Pricing decisions). BASIC STEPS IN A DECISION MODEL B. OBTAIN INFORMATION AND MAKE PREDICTIONS 1. QUALITATIVE AND QUANTITATIVE INFORMATION a. Qualitative factors outcomes that cannot easily and accurately be measured in numerical terms b. Quantitative factors outcomes that can more easily be expressed in numerical terms 2. RELEVANT INFORMATION - the information to be gathered should be relevant and related to the decision-making case. Relevant Costs and Revenues - expected future costs and revenues that differ among alternative courses of action. BASIC STEPS IN A DECISION MODEL The following are relevant: i. Differential costs - cost that are present in one alternative in a decision- making case but are absent in whole or in part in another alternative. ii. Avoidable costs - costs that can be eliminated, in whole or in part, when one alternative is chosen over another in a decision-making case. iii. Opportunity cost - refers to the contribution to income that is forgone (or lost) when one action is taken over the next best alternative course of action. The following are irrelevant: i. Sunk cost (or Past cost) - cost that has already been incurred and therefore cannot be avoided regardless of the alternative taken by the decision maker ALTHOUGH PAST (SUNK, HISTORICAL) COSTS ARE ALWAYS IRRELEVANT IN DECISION-MAKING, THEY MAY SERVE AS A BASIS FOR MAKING PREDICTIONS. ii. Future costs that do not differ between or among the alternatives under consideration BASIC STEPS IN A DECISION MODEL C. IDENTIFY AND EVALUATE THE ALTERNATIVE COURSES OF ACTION, THEN CHOOSE THE BEST ALTERNATIVE  Only relevant factors should be considered in evaluating the alternatives.  As a rule, the best alternative is the one that will give the organization the highest income (or lowest loss). D. IMPLEMENT THE DECISION E. EVALUATE THE PERFORMANCE OF THE DECISION IMPLEMENTED TO PROVIDE FEEDBACK. This feedback can help the decision maker in making better decisions in the future. DECISION INVOLVING ALTERNATIVE CHOICES MAKE OR BUY  Make or buy decision involve choosing between producing an item or buying it from outside suppliers.  In most cases, such items involve a tangible project such as part, subassembly or materials needed in manufacturing the company’s major product line.  For instance, should a manufacturer of television sets utilize its own final assembly shop to make the fiberglass frame needed in the final assembly of TV sets or just buy them from outside suppliers?  Or should a hamburger store produce its own buns for hamburger sandwiches or purchase them from other bakers? Make or buy decision cases are not limited to tangible products at time they involve service activities like a realty company may choose between using its own engineering department for the maintenance of its building’s air conditioning units or contracting such job with another company. DECISION INVOLVING ALTERNATIVE CHOICES MAKE OR BUY Example Assume that Lingkod Company, a manufacturer of furniture sets, is considering purchasing the seat cushion needed for its chairs. The expected purchase price of these seat cushion is P50 per unit. Lingkod has been making its own seat cushion since it started operating. If it would continue to produce these cushions, the company expects to incur the following costs: Raw Materials 13 Direct Labor 15 Variable Cost 5 Fixed Overhead (based on the average Production requirement of 10,000 units) 20 Total Production cost per unit 53 DECISION INVOLVING ALTERNATIVE CHOICES MAKE OR BUY  Briefly, it seems that it would be more economical for the company to buy the cushion at P50 each rather than make them at a cost of P53 per unit.  However, it is not right for the decision maker to compare the purchase price with the total manufacturing cost per unit.  Instead, the relevant cost data should first be identified and isolated from irrelevant items. Direct Materials 13 Direct labor 15 Variable Cost 5 Total Variable Manufacturing Cost 33 X No. of Units 10,000 Units Total Variable Manufacturing Cost 330,000 DECISION INVOLVING ALTERNATIVE CHOICES MAKE OR BUY  On the other hand, if the company decides to stop producing the item, the variable cost computed above will not be incurred, instead, the company will incur the purchase cost of P500,000 (10,000 X P50). Make Direct Materials (P13 x 10,000) 130,000 Direct labor ( P15 x 10,000) 150,000 Variable Overhead (P5 x 10,000) 50,000 Total Variable Manufacturing cost 330,000 Fixed Overhead (P20 x 10,000) 200,000 Total Cost 530,000 Buy Purchase Price 50 X No. of Units 10,000 Total Purchase Price 500,000* Fixed Overhead 200,000** Total Cost 700,000 Net advantage of making: (530,000-700,000) 170,000 Note: * Relevant ** Irrelevant DECISION INVOLVING ALTERNATIVE CHOICES MAKE OR BUY A much easier type of analysis that may be applied to this case is the “Differential Cost Analysis” which includes only the relevant costs. Purchase price per unit 50 Less: Relevant manufacturing cost per unit: Materials 13 Labor 15 Variable overhead 5 33 Difference 17 X no. of units 10,000 Net Advantage of making the seat cushions 170,000 DECISION INVOLVING ALTERNATIVE CHOICES ACCEPT OR REJECT A SPECIAL ORDER  Special orders or one-time orders oftentimes possess different characteristics as compared with recurring orders from regular customers.  Usually, they involve a larger volume and a discounted or lower sales price.  Orders like these should be evaluated considering the cost to the situation, availability of productive capacity and the goals of the company. DECISION INVOLVING ALTERNATIVE CHOICES ACCEPT OR REJECT A SPECIAL ORDER Example: Assume that Grace Company presently produces and sells 20,000 units of Product G which represents only 80% of its normal capacity of 25,000 units. Its regular selling price is P50 per unit and its manufacturing, selling and administrative costs are as follows: Materials 10 Labor 12 Variable overhead 8 Fixed Overhead (60,000/20,000) 3 Variable selling and administrative costs 7 Fixed Selling and administrative costs (40,000/20,000) 2 Total Unit Cost 42 Grace Company received an order from a provincial distributor for 3,000 units. The customer asks for a special discount of 30%. It is expected that the company will incur no additional selling and administrative costs. DECISION INVOLVING ALTERNATIVE CHOICES ACCEPT OR REJECT A SPECIAL ORDER Solution:  Grace Company can afford to produce additional 3,000 units since it presently has idle capacity of 5,000 units (25,000 – 20,000).  The special selling price for this order amounts to P35 per unit (50 –[30% of P50]).  A comparison of this selling price with a unit cost of P42 indicates that the company would lose P7 per unit or P21,000 from this special order.  However, the fixed overhead as well as the selling and administrative costs are irrelevant in this case since, they are expected to remain the same whether the order is accepted or rejected.  Hence, a more appropriate cost analysis for this problem is: DECISION INVOLVING ALTERNATIVE CHOICES ACCEPT OR REJECT A SPECIAL ORDER Special Selling Price ( P50 x 75%) 35 Less: Relevant Costs: Materials 10 Labor 12 Variable Overhead 8 30 Marginal Profit 5 X no. of units ordered 3,000 Incremental Profit from accepting the special order 15,000 DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT  This type of business decision problem is sometimes encountered by some business engaged in producing and/or selling multiple products, or by some business establishments which are composed of different profit centers.  One or more products or profit centers may show some losses or unsatisfactory results of operation, in which case, management would have to decide whether to continue or discontinue producing/selling the products or operating the profit center or business segment concerned.  In analyzing this alternative problem, the decision maker must compare the revenue or sales generated by the product or business segment under consideration with their direct avoidable costs.  This are relevant quantitative factors that must be included in the analysis.  If the product’s or business segment’s own revenue is greater than its own costs, the company should continue selling such product or operating such business segments, assuming that no other factors are expected to affect the decision. DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT Example 1: Unprofitable Product Beth Neri Enterprises sells three products, Skinny, Bony and Thinny. Beth, the proprietor, is concerned about the losses incurred by Thinny and is considering discontinuing its production and sales. Sales and costs data about Beth Neri’s three products are as follows: Skinny Bony Thinny Total Sales Price per unit 5 7 9 21 Variable Cost per Unit 2 3 7 12 Contribution Margin per unit 3 4 2 9 Fixed Cost per Unit 1 2 3 6 Profit (Loss) per unit 2 2 (1) 3 Fixed costs are allocated among the three products on floor are they occupy. Beth is thinking that if she would eliminate Thinny, its loss of P1 per unit would likewise be eliminated thereby increasing her total profit per unit from P3 {2 +2 -1] to P4 [ 2 +2] Is Beth’s analysis, correct? DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT Example 1: Unprofitable Product Solution: Continue Discontinue Unit Sale Price 9 0 Unit Variable Cost 7 0 Contribution Margin 2 0 Fixed Cost 3 3 Profit (Loss) per Unit (1) (3) The analysis clearly indicates that if Beth would discontinue production and sales of Thinny, loss would increase further from P1 to P3. This is because with the elimination of Thinny, its sales and variable costs would also be eliminated. Hence, no contribution margin would be earned from this product, but the company would continue to incur fixed cost since this cost is merely allocated among the three products, therefore unavoidable, i.e., it would exist whether sales of any of the products is continued or discontinued. DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT Example 1: Unprofitable Product Solution: Another approach, only relevant factors – sales revenue and variable cost of Thinny are considered: Sales Price 9 Variable Cost 7 Contribution Margin 2 Since Thinny’s own revenue (sales price) is greater than its own cost (variable cost) the company should continue its production and sales because it shares in the recovery of the company’s fixed costs. DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT Example 2: Unprofitable Business Segment Rose Descaya operates a chain of bookstores with branches in Manila, Quezon City and Makati. A summary of operating results of the three branches during a typical month is shown below: Manila Makati Quezon City Total Sales 300,000 400,000 500,000 1,200,000 Cost and Expenses: Variable 120,000 160,000 200,000 480,000 Direct Fixed Costs 50,000 140,000 70,000 260,000 Allocated Home Office Costs 90,000 120,000 140,000 350,000 Total Costs & Expenses 260,000 420,000 410,000 1,090,000 Operating Profit (Loss) 40,000 (20,000) 90,000 110,000 Like in the previous months, Rose observed that the Makati Branch operated at a loss. Due to this, Rose is considering closing the Makati Branch, hoping that the loss would be eliminated. She disclosed her plan to her accountant who in turn informed her that if she would push through with her plan, Makati’s sales, variable costs, and direct costs would all be eliminated. However, total home office cost would not change; the amount allocated to Makati would just be absorbed by the other branch. Should Rose continue operating the Makati Branch despite its operating loss? DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT Example 2: Unprofitable Business Segment Solution: A comparison of operating results under the alternatives continues or discontinue operating the Makati Branch: Continue Discontinue Sales 400,000 0 Less: Cost and Expenses: Variable 160,000 0 Direct Fixed Cost 140,000 0 Allocated Home Office Cost 120,000 120,000 Total Cost and Expenses 420,000 120,000 Profit (Loss) (20,000) (120,000) Operating loss would increase further if the Makati Branch would be discontinued. This is so because the company would continue to incur the allocated home office cost despite the closure of the Makati Branch. DECISION INVOLVING ALTERNATIVE CHOICES CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT Example 2: Unprofitable Business Segment Solution: Another approach may be used showing only the relevant factors: the Makati’s sales and avoidable cost (variable and fixed costs). Allocated home office cost, which is expected to remain the same in total, is irrelevant factor, may be ignored in making cost analysis. Sales 400,000 Less: Avoidable Costs: Variable 160,000 Direct Fixed 140,000 300,000 Contribution to the recovery of home office cost 100,000 Rose should continue operating the Makati Branch because its own revenue is greater than its own costs. It contributes a positive amount to the recovery of home office costs. DECISION INVOLVING ALTERNATIVE CHOICES TEMPORARY SHUT DOWN  This decision-making case is very much related to the alternative choice problem.  However, this may involve discontinuance, operations of operations of not merely business segment but the business itself as a whole.  This problem arises when some internal and external factors adversely affect the operations of the business on a temporary basis, which may warrant temporary closure of the business.  As soon as situations go back to normal, operations may be resumed.  Such factors may include labor unrest in the company or customers’ businesses, political and economic instability, building or road construction within or near the company’s premises, or shortage in materials and other supplies.  When a business firm temporarily shut down its operations, it will naturally stop generating income and avoid incurring variable and some fixed costs.  There are some costs, however, that the company will continue to incur even when there are no operations.  These are called shut down costs which may include security and maintenance of the facilities and other unavoidable costs. DECISION INVOLVING ALTERNATIVE CHOICES TEMPORARY SHUT DOWN Example: Mr. Rene Villiones operates a snack counter selling sandwiches and soft drinks to students at the school across his store, as well as to his neighbors and passers-by. Each unit sale is composed of a sandwich and a cup of soft drinks which is sold at a lot price of P45. Variable cost amounts to P25 per unit. Under the normal conditions, Mr. Villiones sells an average of 3,000 units per month, during which he incurs the following fixed costs: Rent 9,000 Allocated cost of utilities 6,000 Salary of salesclerk 4,500 Janitor’s salary 3,000 Security Agency’s Billing 7,500 Total 30,000 A joint strike of teachers and students which stated the other day dramatically reduced the sales of Mr. Villiones’ snack counter to only 800 units because his customers would now be composed only of his neighbors and passers-by. Accordingly, the strike would last for about a month. Mr. Villones is considering shutting down operations for one month to avoid incurring losses due to the reduced sales volume. He notes that if he shuts down his operations, his share in the allocated cost of utilities would be reduced to P2,000, and he could avoid incurring salary of the salesclerk who would ask to take forced leave without pay while the snack counter is closed. All other fixed cost would be incurred despite the discontinuance of operations. Should the snack counter be shut down for one month? DECISION INVOLVING ALTERNATIVE CHOICES TEMPORARY SHUT DOWN Solution: If Mr. Villiones would continue operating the snack counter despite the reduced sales volume due to ongoing strike, the results of his operation would be as follows: Unit Sales Price 45 Less: Variable Cost 25 Contribution margin per unit 20 X sales in units 800 Total Contribution Margin 16,000 Fixed Costs 30,000 Loss Under Continued Operations 14,000 DECISION INVOLVING ALTERNATIVE CHOICES TEMPORARY SHUT DOWN Solution: On the other hand, if Mr. Villiones decides to shut down operation for one month, no contribution would be earned during the period, but there are some shut down costs to be incurred which would represent loss during the month. The computations are presented below: Contribution Margin 0 Less: Shut Down Costs: Rent 9,000 Cost of utilities 2,000 Janitor’s salary 3,000 Security Agency’s Billing 7,500 21,500 Loss if operations were shut down 21,500 Foregoing analyses indicate that loss would be incurred whether operations are continued or shut down. However, loss under continued operations would amount to only P14,000 as compared with shut down loss of P21,500. It is therefore advisable to continue operating the snack counter despite abnormal situation. DECISION INVOLVING ALTERNATIVE CHOICES SELL OR PROCESS FURTHER  Some firms manufacture products which have a ready market once a certain stage of completion is reached or the firm may decide to process the product further to give the product a higher sales value though this may require additional processing costs.  Should the firm process the product further or sell it as is?  In solving this type of decision-making problem, the decision marker should compare the differential revenue with the differential costs if the product is processed further. DECISION INVOLVING ALTERNATIVE CHOICES SELL OR PROCESS FURTHER Example: Neth Abogada, Inc. produces a product called Balut. The company buys duck eggs, the materials needed to make balut, from different suppliers in Pateros at P10.50. To convert the eggs into balut, the same are processed by boiling for about 30 minutes. The processing costs, composed of labor and factory overhead average at P0.50 per unit. Neth sells the product at P18.00 per unit. Neth’s product may be sold as Balut or may be processed further to come up with another product called Pritong Balut which actually is fried Balut dipped in breadcrumbs or corn starch. Pritong Balut has proven to be highly salable and commands a price of P20 per unit. Materials, labor and overhead costs required to convert balut into Pritong Balut amounts to P2.25. Neth is contemplating to stop selling Balut and instead concentrate on selling Pritong Balut. Should Neth push through with her plan? DECISION INVOLVING ALTERNATIVE CHOICES SELL OR PROCESS FURTHER Solution: The alternative courses of action should be evaluated based on their profitability. A comparison of profit per unit figures are presented below: Pritong Balut Balut Difference Unit Selling Price 18.00 20.00 2.00 Cost to Make Balut: Materials 10.50 10.50 - Labor & Overhead 0.50 0.50 - Total 11.00 11.00 - Additional cost to convert into pritong balut - 2.25 2.25 Total Cost 11.00 13.25 Profit per unit 7.00 6.75 0.25 The foregoing analysis shows that it would be better for Neth not to subject the product to further processing since it would decrease profit from P7.00 to P6.75 per unit. DECISION INVOLVING ALTERNATIVE CHOICES SELL OR PROCESS FURTHER Solution: A shorter solution may be used for this case by comparing differential revenue with differential cost. If Neth decides to sell Pritong Balut instead of plain Balut, sales price could go up from P18.00 to P20.00. However, to earn additional sale value of P2.00 per unit, the company has to incur additional or further processing of P2.25. Since additional revenue is lesser than the additional cost, it is advisable for the company not to process the product further. This solution may be presented as follows: Additional Sales Price per unit (P20.00 – P18.00) 2.00 Less: Further processing cost per unit 2.25 Decrease in profit per unit if processed further 0.25 Note: Manufacturing cost of P11.00 is not included in the above computation because this amount will be incurred whether the product is process further or not. DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS  Sell or process further problems are also encountered by companies engaged in the manufacture of joint products.  These products are linked together by some physical relationships which require simultaneous processing.  During this joint processing, the manufacturing cost, or the joint cost, is incurred in an indivisible sum for all product involved.  At the split-off point, where the items emerge as individual products, the total joint cost incurred is allocated to such individual products using various methods and bases of allocation. DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS EXAMPLE: Batman Paper Products produces chipboard, newsprint and kraft paper from pulp which it buys at P5 per kilo. On the average, the company uses 100,000 kilos of pulp and incurs conversion cost of P500,000 per month. Monthly production and sales price figures for each product are as follows: Production Sales Price Chipboard 200,000 sheets 2.40 per sheet Newsprint 50,000 reams 20.00 per ream Kraft Paper 30,000 sheets 1.50 per sheet DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS EXAMPLE: The total joint cost is allocated based on the weight (in kilos) of the products manufactured during the month. The allocation results are: 17% of the total joint cost is allocated to chipboard, 80% to newsprint and 3% to kraft paper. One of the joint products, the kraft paper, may be processed further to produce document envelopes which can be sold at P2.00 per unit. Each sheet of kraft paper may be converted into one document envelop at a cost of P0.60. Should the kraft paper be sold at the split off point or converted into document envelope? DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS ANALYSIS: Based on the given information, the raw material pulp is processed to simultaneously produce the three products at a total joint cost of P1,000,000 computed as follows: Materials (100,000 @ P5) 500,000 Conversion Cost 500,000 Total Joint Cost 1,000,000 Profit from each type of product assuming that they are sold at the split-off point may be determined as shown below: Chipboard Newsprint Kraft Paper Total Sales value at split-off point 480,000 1,000,000 45,000 1,525,000 Less: Allocated Joint Cost 170,000 800,000 30,000 1,000,000 Profit 310,000 200,000 15,000 525,000 DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS COMPUTATION: Sales value at split-off: Chipboard : 200,000 sheets x P2.40/sheet = 480,000 Newsprint : 50,000 reams x 20.00 /ream = 1,000,000 Kraft paper : 30,000 sheets x 1.50/sheet = 45,000 Total 1,525,000 Allocation of Joint Cost: Chipboard = 1,000,000 x 17% = 170,000 Newsprint = 1,000,000 x 80% = 800,000 Kraft Paper = 1,000,000 x 3% = 30,000 Total 1,000,000 DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS COMPUTATION: If kraft paper is sold at the split off point, profit amounts to P15,000. If this is processed further to produce document envelopes, the result will be as follows: Final Sales Value (30,000 x P2.00) 60,000 Less: Production Costs: Allocated Joint Cost 30,000 Cost beyond split-off (30,000 x 0.60) 18,000 48,000 Profit 12,000 Note that when kraft paper is converted into document envelopes, total production cost is composed of the allocated joint cost and further processing cost or cost beyond split-off. As shown in the computation, profit will go down from P15,000 to P12,000 if the product is processed further. It is therefore much better for the company to sell kraft paper at the split-off point. DECISION INVOLVING ALTERNATIVE CHOICES JOINT PRODUCTS COMPUTATION: Differential analysis may also be applied to analyze this case. As in previous illustrations, only the relevant factors will be shown in the analysis, to wit: Sell at Split-off Process Further Difference Sales Value 45,000 60,000 15,000 Less: Production Costs: Joint Cost 30,000 30,000 Cost beyond split-off - 18,000 18,000 Total Cost 30,000 48,000 18,000 Profit (Loss) 15,000 12,000 (3,000) Observe that whether the product is sold at split-off or processed further, joint cost remains the same. Joint cost, therefore, is irrelevant in deciding whether to sell as is or process further a joint product. The differential analysis for this problem may thus be presented as follows: Additional sales value if processed further (P2.00 – P1.50) 0.50 Less: Further Processing Cost 0.60 Loss per unit if processed further 0.10 X Number of units 30,000 units Total Loss if Processed Further 3,000 DECISION INVOLVING ALTERNATIVE CHOICES PRODUCT COMBINATION/UTILIZATION OF SCARCE RESOURCES  Some business firms engaged in manufacturing of different products or parts of a main product at times encounter problems in determining the quantity of products or parts to manufacture.  This usually happens when there are constraints in resources used in the producing process like labor hours, machine hours, working space, and other facilities.  In some cases, the constraint involves a market limit on some of the products carried by the company.  Solution to this type of problem involve:  Determination of contribution margin or manufacturing cost savings of each product or part involved  Allocation of the scarce resources, considering the contribution margin or savings generated by each product, as well as the other constraints or limitations on production and sales. DECISION INVOLVING ALTERNATIVE CHOICES PRODUCT COMBINATION/UTILIZATION OF SCARCE RESOURCES Example 1 – Quantity to Produce and Sell Tisay Company produces and sells three product lines – Labany, Singkamy, and Mistisy. Production and sales data about these three product lines are given as follows: Labany Singkamy Mistisy Contribution Margin per unit P5.00 P8.00 P12.00 Sales or Market Limit 10,000 units 20,000 units none Machine Hours required to produce 1 unit 1 hr. 4 hrs. 12 hrs. Total Fixed Costs: P100,000 Total Machine Hours available: 120,000 Hrs. What is the best product combination? DECISION INVOLVING ALTERNATIVE CHOICES PRODUCT COMBINATION/UTILIZATION OF SCARCE RESOURCES Analysis: 1) The best product combination is the mixture of products that will yield the highest possible profit or contribution margin considering the given constraints or limitations. 2) To solve this problem, therefore, it is important that we determine how the available number of machine hours should be allocated among the products and how many units of the products should be produced and sold to maximize profit as well as the utilization of scarce resources such as machine hours. 3) If there is constraint in the number of machine hours, the contribution margin should be viewed not on a per unit but on per machine hour basis since we want is to maximize the use of this limited resource. 4) Therefore, determine the contribution margin per hour by dividing the contribution margin per unit by the required machine hours per unit, to wit: DECISION INVOLVING ALTERNATIVE CHOICES PRODUCT COMBINATION/UTILIZATION OF SCARCE RESOURCES Analysis: Labany Singkamy Mistisy Contribution Margin per unit P5.00 P8.00 P12.00 Divide by Required Machine Hours per Unit 1 hr. 4 hrs. 12 hrs. Contribution Margin per Hour P5.00 P2.00 P1.00 5) If no market limit exists, the company should forget about Singkamy and Mistisy and instead use all the available hours to produce 120,000 units of Labany and would result into a total contribution margin of P600,000. 6) However, there is market limit for Labany up to 10,000 units only that would require 10,000 hours (10,000 x 1 hr. per unit) and the remaining 110,000 hours should then be used to produce Singkamy at 80,000 hours (20,000 x 4 hrs. per unit) and the balance of 30,000 hours will be used to produce Mistisy for 2,500 units (30,000 hrs./12 hrs. = 2,500 units), to wit: 10,000 units of Labany 20,000 units of Singkamy 2,500 units of Mistisy DECISION INVOLVING ALTERNATIVE CHOICES PRODUCT COMBINATION/UTILIZATION OF SCARCE RESOURCES Analysis: 7) The total contribution margin that may be earned from this combination is computed as follows: Labany (10,000 x P5) 50,000 Singkamy (20,000 x P8) 160,000 Mistisy (2,500 x P12) 30,000 Total Contribution Margin-Best combination 240,000 8) This can be summarized as follows: Allocation of available Machine Hours: Machine Hours Market Units to Required Hours Product Available Limit Produce Hours Balance 120,000 Labany 120,000 10,000 units 10,000 units 10,000 hrs. 110,000 Singkamy 110,000 20,000 units 20,000 units 80,000 hrs. 30,000 Mistisy 30,000 none 2,500 units 30,000 hrs. - Strategic Cost Management Mr. Nilo N. Iglesias, CPA, MBA, REA Conceptsand Techniquesfor Decision Making Problem1- Continue or Discontinue Unprofitable Product The Osaka Company manufactures and sells three products. Results of operations for the year ended, by products are: Product A Product B Product C Total Sales 300,000 300,000 350,000 950,000 Total Cost 190,000 310,000 210,000 710,000 Product Net Gain (Loss) 110,000 ( 10,000) 140,000 240,000 Variable Cost rate expressed As a percentage of sales 30% 75% 40% Required: Reasons, supported quantitatively, for the pros and cons of discontinuance of the production and salesof Product B. Problem2- Make or Buy Kyoto Company is considering the possibility of buying Part No. 0210 from an outside supplier instead of manufacturing the part as it is now doing. The annual requirement for the part No. 0210 is 80,000 units. The cost to manufacture this part is: Per Unit Direct Materials 14.00 Direct Labor 25.00 Manufacturing Overhead: Variable 12.00 Fixed 24.00 Total Unit Cost 75.00 An offer was received from a supplier to supply the part for P 55.00 per unit. Furthermore, fixed manufacturing overhead will be reduced by 25%if the offer is accepted. Required: Which alternativeshould be chosen byLuzon Company? Problem3- Special Order Kobe Company manufactures different designs of love seats. At the start, the company built a large plant with the expectation that the demand for its product will increase once the market is developed. However, at present, the company utilizes only 70%of its plant capacity. An account executive received an offer froma large motel chain to purchase 150 units of love seats for a price of P 950. Normal sellingprice for these seats is P 1,500 each. Manufacturingcosts for the current period’s production of 350 love seats are presented below. Fixed cost is expected to be unchanged with the acceptance of the order. Production costs for 350 seats Materials P 122,500 Labor 105,000 Factory Overhead (40%fixed) 140,000 The account executive’s commission for this order is 20%. Questions: a) Should the special order be accepted? b) Will your answer change if the account executive’s commission is computed at P 100 per love seat? “The best way to predict the FU TU R E” is to create it” Questio Next ……. ns/ Reactio Pricing ns……… Decision  THANK YOU……. Manageri al Accountin KEEP SAFE g AND BE HEALTHY!!!