Total Contribution on Sale of 20,000 units of Products A and C and 10,000
units of Product B by using imported material
(20,000 units × `10 + 10,000 units × `10 + 20,000 units × `15)
6,00,000
Less:Fixed Costs 7,50,000
Profit / (Loss) (1,50,000)
Add:Lease Rent Received 2,75,000
Net Profit 1,25,000
Conclusion:
The net profit is `1,50,000 in case the company uses local substitute of material and the plant capacity fully for producing 1,00,000 units, whereas by leasing out the plant capacity upto 50,000 of Product B for a rent of `2,75,000, the company makes a profit of `1,25,000. A comparative study of the two alternatives suggests that it will be better for the company to have optimum production of 1,00,000 units by using local substitute of material.
Decision on Subcontracting
Question-55
Lee Electronic manufactures four types of electronic products, A, B, C and D. All these products have a good demand in the market. The following figures are given to you:
A B C D
Material Cost (`/u) 64 72 45 56
Machining Cost (` /u @ ` 8 per hour) 48 32 64 24
Other Variable Costs (`/u) 32 36 44 20
Selling Price (` /u) 162 156 173 118
Market Demand (Units) 52,000 48,500 26,500 30,000
Fixed overhead at different levels of operation are:
Level of Operation (in production hours) Total Fixed Cost (` )
Upto 1,50,000 10,00,000
1,50,000 – 3,00,000 10,50,000
3,00,000 – 4,50,000 11,00,000
4,50,000- 6,00,000 11,50,000
At present, the available production capacity in the company is 4,98,000 machine hours. This capacity is not enough to meet the entire market demand and hence the production manager wants to increase the capacity. The company wants to retain the customers by meeting their demands through alternative ways. One alternative is to sub-contract a part of its production.
The sub-contract offer received as under:
A B C D
Sub-contract Price (`/u) 146 126 155 108
The company seeks your advice in terms of products and quantities to be produced and/or sub-contracted, so as to achieve the maximum possible profit. You are required to also compute the profit expected from your suggestion.
Solution:
Demand (Units)
52,000 48,500 26,500 30,000
A B C D
Selling Price 162 156 173 118
Direct Material 64 72 45 56
Manufacturing Cost 48 32 64 24
Other Variable Cost 32 36 44 20
Contribution (`/u) 18 16 20 18
Machine Hours per unit 6 4 8 3
Contribution (`/ M/c hr.) 3 4 2.5 6
Ranking III II IV I
Sub-Contract Cost `/ u) 146 126 155 108
Contribution (` / u) on (Sub-Contract)
16 30 18 8
Decision
It is more profitable to sub-contract B, since contribution is higher sub-contract.
1st Level of Operations
*Since B is better to be outsourced.
Product Particulars Contribution/
unit
Contribution (`)
A
Produce: 10,000 units 18 1,80,000
Outsource: 42,000 units 16 6,72,000 B Outsource Fully: 48,500 units 30 14,55,000 C Outsource Fully: 26,500 units 18 4,77,000 D Fully Produce: 30,000 units 18 5,40,000
Total Contribution 33,24,000
Less: Fixed Cost 10,00,000
Net Gain 23,24,000
2nd Level of Operation
Both A and C increase contribution by own manufacture only by `2/- per unit. 1,50,000 hrs can produce 25,000 units of A.
Contribution increases by `50,000 (25,000 units × `2) [Difference in Contribution sub- contract and own manufacturing is ` 2]
But increase in Fixed Cost by `50,000.
At the 2nd level of operation, the increase in contribution by own manufacturing is exactly set up by increase in fixed costs by ` 50,000/-. It is a point of financial indifference, but other conditions like reliability or possibility of the sub-contractor increasing his price may be considered and decision may them but towards own manufacture.
3rd Level of Operation
Additional Hrs Available = 1,50,000 hrs.
Unit of A that are Needed = [52,000 – 25,000 (2nd Level) – 10,000
(1st Level)]
= 17,000 units
Hrs. Required for A = 17,000 units × 6 hrs/u
= 1,02,000 hrs.
Balance Hours Available for C = 1,50,000 hrs. – 1,02,000 hrs.
= 48,000 hrs.
Units of C can be Produced = 6,000 units Increase in Contribution over Level 1st or 2nd = `46,000
(A: 17,000 units × `2 + C: 6,000 units × `2)
Increase in Fixed Cost = `50,000
Additional Loss = `50,000 − `46,000
= `4,000
4th Level of Operation
Additional Hrs Available = 1,50,000 hrs.
Additional 1,50,000 can give = 18,750 units of C 1,50,000hrs.
8hrs.
⎛ ⎞
⎜ ⎟
⎝ ⎠
Increase in Contribution = `37,500
(C: 18,750 units × `2)
Increase in Fixed Cost = `50,000
Additional Loss = `50,000 − `37,500
= `12,500
Level 1st Profit will go down by = `12,500 + `4,000
= `16,500
Advice: Do not Expand Capacities.
Summary:
Total Contribution 33,24,000
Less: Fixed Cost 10,00,000
Profit 23,24,000
Question-56
Golden Pet Ltd. specialises in the manufacture of one litre plastic bottles. The firm's customers include dairy processors, fruit juice manufacturers and manufacturers of edible oils.
The bottles are produced by a process called blow moulding. A machine heats plastic to the melting point. A bubble of molten plastic is formed inside a mould, and a jet of hot air is forced into the bubble. This blows the plastic into the shape of the mould. The machine releases the moulded bottle, an employee trims off any flashing (excess plastic around the edge) and the bottle is complete.
The firm has four moulding machines, each capable of producing 100 bottles per hour. The firm estimates that the variable cost of producing a plastic bottle is 20 paise. The bottles are sold for 50 paise each.
Management has been approached by a local toy company that would like the firm to produce a moulded plastic toy for them. The toy company is willing to pay ` 3.00 per unit for toy. The variable cost to manufacture the toy will be ` 2.40. In addition, Golden Pet Ltd. would have to incur a cost of ` 20,000 to construct the needed mould exclusively for this order. Because the toy uses more plastic and is of a more intricate shape than a bottle, a moulding machine can produce only 40 units per hour. The customer wants 1,00,000 units. Assume that Golden Pet Ltd. has the total capacity of 10,000 machine hours available during the period in which the toy company wants the delivery of toys. The firm's fixed costs, excluding the costs to construct the toy mould, during the same period will be ` 2,00,000.
Required:
(a) If the management predicts that the demand for its bottles will require the use of 7,500 machine hours or less during the period, should the special order accepted? Give reasons.
(b) If the management predicts that the demand for its bottles will be higher than its ability to produce bottles, should the order be accepted? Why?
(c) If the management has located a firm that has just entered the moulded plastic business. This firm has considerable excess capacity and more efficient moulding machine and is willing to subcontract the toy job, or any portion of it, for ` 2.80 per unit. It will construct its own toy mould. Determine Golden Pet Ltd 's minimum expected excess machine hour capacity needed to justify producing any portion of the order itself rather than subcontracting it entirely.
(d) The management predicted that it would have 1,600 hours of excess machine hour capacity available during the period. Consequently, it accepted the toy order and subcontracted 36,000 units to the other plastic company. In fact, demand for bottles turned out to be 9,00,000 units for the period. The firm was able to produce only 8,40,000 units because it had to produce the toys. What was the cost of the prediction error failure to predict demand correctly?
Solution:
(a) The Golden Pet Ltd. has a surplus of 2,500 machine hours. The special order for supply of 1,00,000 toys also requires 2,500 hours of machine time (1,00,000 toys / 40 units). In case the Golden Pet Ltd. accepts the order, it will make an extra profit of ` 40,000 as given below:
(`) Sales Revenue (1,00,000 toys × `3) 3,00,000 Less: Variable Costs (1,00,000 toys × `2.40) 2,40,000
Contribution 60,000
Less: Fixed Costs 20,000
Profit 40,000
The Golden Pet Ltd. will thus make an extra profit of ` 40,000 find therefore, it should accept the order.
(b) In case of Golden Pet Ltd., the machine time is a limiting factor and hence it will be appropriate to calculate the contribution per machine hour for both capacities as shown below:
Contribution per hour from Bottle
Contribution per hour from Toys Production in one hour 100 bottles (`) 40 toys (`) Sales Value for one hour
production
(100 × ` 0.50) 50 (40 × ` 3) 120
Less: Variable Cost (100 × ` 0.20) 20 (40 × ` 2.40) 96
Contribution per hour 30 24
The above computation shows that the contribution per hour is higher in case of bottles. Hence, if the management predicts that the demand for bottles will be higher than its capacity to produce them, it should not accept the special order for toys.
Rather, it should use the total available machine hours for production of bottles.
(c) The point of indifference (cost break-even point) between the two alternatives, i.e., producing toys by the Golden Pet Ltd. itself or sub-contracting their production, can be determined as follows:
Let the number of toys to be produced be 'x'.
In case the firm uses the surplus time available for producing toys, the total cost would amount to `20,000 + 2.4x
In case the Golden Pet Ltd. decides in favour of sub-contracting the production of toys, the total cost of toys would amount to 2.80x. On the basis of the above equations, the point of difference can be ascertained as follows:
2.80x = 20,000 + 2.4x Or x = 50,000 units
This means that as long as the Golden Pet Ltd. has the surplus time available to produce more than 50,000 toys, it is better to produce them than to buy them from outside. However, if the firm has time to produce less than 50,000 toys, it would be better give the job to a sub-contractor and thus, avoid the fixed cost of `20,000. Thus, Golden Pet Ltd. must have more than 1,250 hours (50,000/40 units per hour) of machine time to justify the production of toys by itself as compared to sub-contracting the job.
(d) (i) The firm decided to manufacture 64,000 toys and sub-contract the manufacture of 36,000 toys. This has resulted in production of only 8,40,000 bottles. The economics of this decision would be as under:
Particulars Bottles
Sales 4,20,000 1,92,000 1,08,000 7,20,000
Less:Variable Costs
(8,40,000 × `0.20) 1,68,000
(64,000 × `2.40) 1,53,600
(36,000 × `2.80) 1,00,800 4,22,400
Contribution 2,52,000 38,400 7,200 2,97,600
Less:Fixed Costs 2,00,000 20,000 --- 2,20,000
Profit 52,000 18,400 7,200 77,600
(ii) In case the Management is of the opinion that the demand for bottles would be 9,00,000 it would have realised that only 1,000 machine hours would be available. In such a case, since the contribution per hour from bottles is higher as compared to that of toys, the management would have produced 9,00,000 bottles requiring 9,00,000 hours. The entire order for supply of 1,00,000 toys would have been given to the sub-contractor as per analysis in (c) above. The economics of such alternative would be as under:
Particulars Bottles Made
9,00,000 units
Toys Sub-contracted 1,00,000 units
Total
(`) (`) (`)
Sales 4,50,000 3,00,000 7,50,000
Less: Variable costs
(9,00,000 × `0.20) 1,80,000
(1,00,000 × `2.80) 2,80,000 4,60,000
Contribution 2,70,000 20,000 2,90,000
Less: Fixed Costs 2,00,000 --- 2,00,000
Profit 70,000 20,000 90,000
Thus, the Cost of the Prediction Error of ` 12,400, Calculated as under:
Net Profit of Optimal Action [as per (d) (ii)] ` 90,000 Net Profit of Actual Production [as per (d) (i)] ` 77,600
Cost of Prediction Error ` 12,400