Cost Accounting for Decision-making Lesson 4

Different Types of Business Decisions (Hire, Make or Buy) (2) Part III Different Types of Business Decisions (Hire, Make or Buy) (2)

Five Types of Business Decisions Hire, make or buy Accept or reject an order at a special price Eliminate or retain an unprofitable segment Retain or replace equipment Sell or process further Teacher recaps the first type of decision-making situations – Hire, make or buy, and highlights further discussion on outsourcing will be covered in this lesson.

Question If a company does not have enough machine /labour hours to produce all the products, what should the company do? Teacher starts the lesson with above question and asks students to share their views.

Solutions: The company may consider to do the following: Ask the workers to work overtime Outsource some of the processes or products Invest in additional machines Reduce defective units Teacher explains how to solve the problem of insufficient production capacity.

Managing Constraints Constraint is the limits on resources that a company can provide e.g. Machine hours; labour hours; production capacity. When there are constraints, a company can overcome them either by expanding its production capacity or outsourcing. Teacher explains the ways in managing contraints.

Managing Constraints Before making a decision, we have to consider the following: What constraints are there that hinder the company from producing the quantity demanded? Which product(s) should be produced by the company and which product(s) should be outsourced? Teacher explains the points to note in managing constraints.

Decision Rule in Managing Constraints In the short run, produce the product with the highest contribution margin per unit In the long run, choose the alternative that can overcome the production shortfall (e.g. expanding the company’s production capacity or outsourcing) Teacher explains how to determine the production plan when the company has constraints in its production, and find solutions to overcome the production shortfall.

Example of Managing Constraints The maximum production capacity for a company is restricted to 12,000 machine hours (MH). This year, it can produce X, Y and/or Z. Per unit X ($) Y ($) Z ($) Sale price 30 25 28 Variable costs (18) (15) (22) Contribution margin 12 10 6 Teacher illustrates an example of managing constraints. X Y Z MHs required per unit 6 2 1 Estimated sales demand (Units) 2 000 2000

Does the company has any constraint in its production process? Required: Does the company has any constraint in its production process? In order to maximise profit, calculate the number of units to be produced for each product and their respective. The company does not want to lose sales, what will be the maximum acceptable purchase price if the company outsources the remaining shortfall units? Teacher explains the requirements for the example.

Steps to Follow in Making the Decision Find out the total required machine hours for the production and see whether the company’s maximum capacity poses a constraint here. Calculate the respective contribution margin per machine hour for each product. Rank the order of the products with the highest contribution margin per MH first and so on. Determine the production plan and calculate the total contribution margin. Suggest some alternatives to overcome the production shortfall. Teacher explains the steps in making the decision.

Suggested Solution Since total required machine hours (18,000 hours*) exceeds the company’s maximum capacity (12,000 hours), it poses a constraint to the company in the production process. *6 x 2,000 + 2 x 2,000 + 1 x 2,000 Teacher explains how to determine a constraint to a company

Steps to determine the number of units to be produced for each product and its respective contributions: Step 1: Calculate the contribution margin per machine hour Per unit X Y Z Contribution margin $12 $10 $6 MHs required 6 2 1 Contribution margin per MH $2 $5 Teacher explains how to determine the product mix when there is a constraint in the production process.

Balance of MH available Step 2: Rank the order of products for production Step 3: Determine the number of units for each products to be produced X Y Z Contribution margin per MH $2 $5 $6 Rank 3 2 1 MH used Balance of MH available 2,000 units of Z 2,000 10,000 2,000 units of Y 4,000 6,000 1,000 units of X

Step 4: Calculate the total contribution margin $6 x 2,000 + $10 x 2,000 + $12 x 1,000 = $44,000 So, to maximize profit, the company should produce 2,000 units of Z, 2,000 units of Y and 1,000 units of X. The company does not have machine hours to produce the remaining 1,000 units of X. It has to outsource the shortfall units and the maximum acceptable purchase price of X will be $30 per unit which is equal to the selling price of X. Teacher explains the conclusion.

Classwork Elin Company produces and sells three products: A, B, and C. Data relating to the three products is as follows: Units A B C Estimated demand 1,000 1,500 1,800 Per unit A ($) B ($) C ($) Sale price 80 56 70 Direct materials 24 15 20 Other variable costs 8 14 4 Teacher asks students to complete the classwork.

Classwork The three products use the same raw materials. The company has only 4,500 kg of raw materials on hand, the cost of which is $10 per kg. It is known that the material will be in shortage and not available in local market for purchase in the next few months. Part A Required: Compute the contribution margin per kg of material used in each product. Which product(s) should the company produce and what is the total contribution from the production? Teacher asks students to do the calculations and make decision.

Classwork Part B Two options are now available for the company to consider in overcoming the production shortfall: (i). The company can buy the materials from oversea at a cost of $15 per kg. (ii). A supplier can supply the products at the prices of $50, $38 and $35 for A, B and C respectively. Advise which option the company should adopt?

Suggested Solution Part A 1. Per unit A ($) B ($) C ($) Sale price 80 56 70 Direct materials (24) (15) 20 Other variable costs (8) (14) (4) Contribution margin 48 27 46 Contribution per kg* $20 $18 $23 Rank 2 3 1 Teacher explains the solution for part A and makes a conclusion. * The direct materials (in kg) required for A: $24 / $10 = 2.4 kg; therefore the contribution per kg for A: $48 / 2.4 = $20 The direct materials (in kg) required for B: $15 / $10 = 1.5 kg; therefore the contribution per kg for B: $27 / 1.5 = $18 The direct materials (in kg) required for A: $20 / $10 = 2.0 kg; therefore the contribution per kg for C: $46 / 2.0 = $23

Suggested Solution The company should produce C first, then A: The company should produce 1,800 units of C and 375 units of A. The total contribution is $100,800*. *$18,000 + $82,800 = $100,800 Per unit A B C Contribution per kg $20 $18 $23 Materials used 900 3,600 Total contribution 18,000 82,800

Suggested Solution Part B (i). Additional contribution = $54,000 (ii).Contribution from A = $(80 – 50) x 625 = $18,750 Contribution from B = $(56 – 38) x 1,500 = $27,000 Additional contribution = $45,750 A B Contribution per unit* $36 $21 Number of units 625 1,500 Extra contribution 22,500 31,500 i. New contribution per unit: * A = $(80 – 15 x 2.4 kg – 8) = $36 B = $(56 – 15 x 1.5 kg – 14) = $21

Suggested Solution Conclusion: Option (i) should be adopted because it obtains $8,250* more contribution than Option (ii). *$54,000 - $45,750 = $8,250

Homework: Q5 Teacher asks students to do Question 5 at home.

END