Module 6: Non-Routine Decision Making
At the end of this module, you should be able to:1. Describe the nature of decision making and the related process as applied into business
2. Differentiate between relevant and irrelevant financial data in decision making
3. Depict the process of making a make or buy decision 4. Determine whether to accept or reject a special order 5. Resolve whether a segment will be drop or maintained 6. Demonstrate how a sell or process further decision is made 7. Illustrate how to solve limited capacity problem.
Decision Making in Business
Decisions are the determination of future actions from a given set of alternatives. Decisions pertain to the future and most of the time, in some aspect, will depend on predicting how future events will occur. However, predicting future events are usually based on data retrieved from historical events and how these historical events is expected to be constant or altered. Making decisions is something that cannot be taken lightly for it can make or break a business. One erroneous decision can make a financially healthy company bankrupt in just a flick of a finger. In
business, managerial activities always require decision making. During the planning phase, the selection of an objective, strategy and plan of actions needs decision making. Under the execution phase, to whom a particular task will be assigned and how the employees will be motivated, the same with the controlling phase, deciding whether a particular variance is worth analyzing and the corrective action related to such variance requires decision making. All managerial activities require decisions and this is the reason why they are called managers, they manage by determining the courses of actions to be taken.
There are two types of decision for managers, routine and non-routine. Routine decisions are made under a specific process and certainty. Decisions are recurring and there are already sets of programmed responses. Valuable time and resources should not be expended each time routine decisions are to be made. Thus, usually, companies create a manual of procedure to guide managers on how to deal with routine decisions. Examples of Routine Decisions includes replenishment of inventory, sending delinquency notes to customers, and giving employees raised among others. Generally, routine decisions are activities that are part of the normal operating cycle or the day-to-day activities in business. Non-Routine Decisions are made using the discretion of the decision maker in addressing situations that are uncommon and isolated. It is quite risky wherein bad decision is irrevocable and causes material damages. Usually, when critical non-routine
decisions are made, the normal operating cycle of the company is being altered. For example, when a company is contemplating whether to make or buy a particular product or materials, it is actually deciding whether to be a manufacturer or a merchandiser which has a different operating cycle. Another will be, if management
is evaluating whether to drop or to maintain a segment of the company might increase or decrease the number of business unit that is being managed. The Scientific Process
Since non-routine decisions are critical to the survival and success of businesses, the trial-and-error and wait-and-see approach cannot be utilized in this kind of situation. A proven, tried-and-tested, approach will be more appropriate that stems out of years of study, from researches and debates of scholars and seasoned
business managers, which is often called the scientific approach. It is composed of the following step:
1. Define the Problem: The root cause or hidden problem of variances in a company’s operation is identified. There are a lot of business model like the fish bone, pareto method, etc. that can be used in order to define the
problem.
2. Specify the criteria: Determine the perspective that will be used as the basis for the solution. Usually, the main functional business area are the basis for the criteria; finance, marketing, operations and/or production, and human resource. In determining the criterion, it is about identifying the objectives, for example maximizing profit, increasing market share, better social services, etc.
3. Identify different alternatives: Courses of actions or Options that can be taken to address the problem by achieving the objectives. Courses of actions should consider situations of both internal and external environment. The availability of resources, capacity of the management and work-force, competitors’ action, economic and political stability among other things that should be considered in developing alternative courses of actions.
4. Develop the decision model: Simplify the problem, define what will be
relevant and irrelevant, and then bring together all elements of the problem – criteria, constraints, and alternatives.
5. Gather Data: This is to facilitate objectivity in the decision making process. Data may be primary or secondary. It must be up-to-date, timely and
accurate. Data are gathered in order to provide information that will support or negate the different alternative courses of actions.
6. Evaluate the different alternatives: the best options that can address the objective/s set. It should be based on the decision model and criteria created. 7. Make a conclusion/decision: A well defined solution will include an action plan
that identify the step-by-step activities, the people involve, resources required, and the timeline of each activities.
It is to be noted that although business decisions involve both qualitative and quantitative aspect, we will focus on quantitative, specifically, the financial aspect of decision making. Since the basic role of controllers is to provide quantitative information that can be used by managers in their decision making capacity, we will focus more on how different costs affects decisions made by managers.
One of the critical steps in the scientific approach is the gathering of data, for the data acquired can be used in order to support or contradict a propose alternative course of action, hence, an erroneous information caused by irrelevant and unreliable data can result to wrong decisions. The key to prevent providing
erroneous information from happening is classifying costs as relevant and irrelevant costs. Relevant Costs are any expected future cost which will differ among
alternative courses of actions while irrelevant costs are either future costs that will not change or past cost that was already incurred. There are two types of relevant cost, differential costs and opportunity costs while irrelevant costs can be classified as committed (unavoidable) fixed cost and sunk costs.
Differential Costs
These are costs that differ among alternative courses of actions. It can also be called as incremental or avoidable costs depending on the perspective of the decision to be made. Incremental costs are costs that will be incurred or will increase if a decision is made while an avoidable cost are cost that will be prevented from being incurred if a decision is made. In a decision whether to buy a car or not, the fare being incurred from jeepneys, taxis, and other means of transportation can either be an incremental or avoidable cost. If you are on the perspective of buying a car, the fare will be considered as an avoidable cost since if a person bought a car and use it, he does not have to pay for any fare. However, if you are on the perspective on not buying a car, the fare is an incremental cost since not having a car will require a person to commute, hence the need to pay for the different fare. As a rule of thumb, whatever costs that were classified as incremental in one perspective will be classified as avoidable in the other perspective.
Opportunity Costs
These are benefits foregone when a particular alternative courses of action is not chosen. For an item to be considered as an opportunity costs it has to be a possible benefit in an alternative. A benefit in accounting literature is anything that increases cash either through additional revenue or cost savings. In a decision whether to get a job or continue studying, under the alternative of getting a job, possible benefits exist like the salary that can be earned, and the amount of tuition fee and allowances that can be saved. Cost savings is no different from avoidable costs. However, tuition fees and
allowances will be classified as incremental costs under the alternative of continue studying while the salaries that can be earned will be classified as opportunity cost.
Committed Fixed Costs
These are on-going fixed costs which cannot be altered or affected by a particular decision because a company will continue to incur the fixed cost that is committed regardless of which decision alternative is selected. For example, the amount of monthly rental payment to be made in a decision whether to accept or reject a special order from a one-time customer especially if the company has enough excess idle capacity. The rental payment is a committed fixed cost since it will remain to be the same
amount, due and outstanding regardless whether the order was accepted or rejected.
Sunk Costs
These are cost which was incurred in the past and cannot be altered or affected by a particular decision. Sunk costs, like committed costs, will continue to have been incurred by the company regardless of which of the available courses of action the company may choose to take in the future. In relation to the special order decision in the previous section, the amount spent by the company in researching and developing its product is a sunk cost since it has already been incurred and the company will not be able to avoid or incur additional research and development costs.
Before solving or rendering any decision, it is very important that a solid foundation on identifying relevant and irrelevant cost has been attained. The different cost classification will be used alternately in analyzing and solving the different
problems. Generally, management’s non-routine decisions fall into, but not limited to, the following categories:
1. Make or Buy decision or Outsourcing decision 2. Accept or Reject Decision of Special Orders
3. Dropping or Maintaining a Business Segment which can also include temporary shut-down decisions
4. Sell or Process Further after the joint processing 5. Addressing Limited Capacity Problems
As a general rule or a good rule of thumb, the following are to be assumed: 1. Generally, variable costs and changes in fixed costs are differential costs 2. Additional revenues and the current market value of old properties and
equipments are opportunity costs
3. Depreciation, Original Purchase Price of the Old Equipment and Net Book Value are considered to be Sunk Costs
4. Unchanged Fixed Costs are considered to be committed costs.
Make or Buy Decision
This kind of decision present a situation in which a company must decide whether it should manufacture a component part for its own use or purchase this part from an outside supplier. It also include decision pertaining to setting up service
departments like security, maintenance, accounting, etc. or contracting external business processing companies to perform such services for the company. Thus, make or buy decision it is also called as Outsourcing Decision. The key in solving these problems is to exclude all committed fixed costs as being irrelevant to the analysis and then compare the alternatives presented based on the incremental revenues and incremental costs of each alternative. Remember the general
objective in this kind of decision is to select the alternative that will result to a lower cost. The following table shows how cost can generally be considered in the
decision analysis.
Cost to Make Cost to Buy
Direct Labor xx Other directly attributable cost of buying the material (i.e. Freight,
Inspection, Ordering Cost, etc.)
Variable Overhead xx
Incremental Fixed Overhead (if any)
xx Opportunity Cost (if any –
alternative usage of the
space) xx
xx
TOTAL xx TOTAL xx
To illustrate: Tarlac Corporation is now making a small part that is used in one of its products. The company’s accounting department reports the following per unit costs of producing the part internally:
Direct Materials P15.00
Direct Labor 10.00
Variable Manufacturing Overhead 2.00 Fixed Manufacturing Overhead, traceable 9.00
Depreciation of the production equipment specifically used for the production of the small part represents two-thirds of the traceable fixed manufacturing overhead cost with indirect labor representing the balance. The indirect labor could be avoided if production of the part were discontinued. An outside supplier has offered to sell the part to Tarlac Corporation for P32 each, based on an order of 5,000 parts per year. In determining whether to make or buy the small part, it is very important to
determine whether the cost is relevant or irrelevant. As a guide, we have to identify whether the cost is incremental or avoidable. Under the make decision, if the Tarlac will decide on making the small part itself, direct materials, direct labor, and
variable overhead will be classified as incremental costs so as the indirect labor since it was specifically stated that it will be avoided if production of the small part will be stopped, thus it is an incremental cost when making the small part, while these costs will be considered as avoidable if we will change our perspective to the buy decision. The depreciation on the production is sunk costs while the purchase price from the outside supplier is an incremental cost on the point of view of buying decision while an avoidable cost on the point of view of a make decision.
The analysis of the decision in two perspectives, make decision and buy decision as follows:
Make Decision Buy Decision
Incremental Costs: Direct Materials (15.0 0) Incremental Costs: Purchase Price (32.0 0) Direct Labor (10.0
0) Less: Avoidable Cost:
Variable Overhead ( 2.0
0) Direct Materials 15.00
Incremental Fixed Overhead
(indirect labor: P9 x 1/3%) ( 3.0 0)
Direct Labor
Variable Overhead 10.00 2.00 Total incremental cost to (30.0 Incremental Fixed
make 0) Overhead Less: Avoidable Cost
(Purchase Price) 32.00 (Indirect labor: P9 x 1/3%) 3.00 Advantage of Making (per
unit) 2.00 Disadvantage of Buying (per unit) ( 2.00) The total advantage of making is P 10,000 or 5,000 units multiplied by the
advantage per unit of P2.00. Incidentally, the highest purchase price that Tarlac can accept in order for it to favor buying the small part is P30.00 or equal to the total incremental cost per unit. Anything that is higher than that will result to a higher cost of buying, while any price that is lower than that will provide an advantage on the perspective of buying.
Effect of Opportunity Costs
Supposing that Tarlac Corporation has an option to rent out the facility that it currently uses to manufacture the small part for an annual fee of P 15,000 if Tarlac will decide to purchase the small part instead of making it, will it still be
advantageous for the company to make the small part?
In this situation, a change in the analysis will be required due to the fact that since the company is making the small part, it was actually incurring an opportunity cost in the form of the rental fee that it cannot earn unless Tarlac purchase the small part and stop production. Thus, the revised analysis/solution will be as follows:
Make Decision Buy Decision
Incremental Costs: Direct Materials (15.0 0) Incremental Costs: Purchase Price (32.0 0) Direct Labor (10.0 0) Avoidable Cost: Variable Overhead ( 2.0 0) Direct Materials 15.00
Incremental Fixed Overhead
(indirect labor: P9 x 1/3%) ( 3.0 0)
Direct Labor
Variable Overhead 10.00 2.00 Opportunity Cost
(P15,000/5,000 units) ( 3.00) Incremental Fixed Overhead
Total Relevant cost to make (33.0
0) (Indirect labor: P9 x 1/3%) 3.00 Less: Avoidable Cost
(Purchase Price) 32.00 Additional Rental Revenue 3.00 Disadvantage of Making (per
unit)
( 1.0 0)
Advantage of Buying (per unit)
In the presence of an alternative usage or income-generating activity for the facility that will be abandoned once a buying decision is made, the analysis now favors a buying decision for a per unit advantage of P1.00 or total advantage of buying the small part amounting to P 5,000 or (5,000 units x P1.00)
Accept or Reject a Special Order
This kind of decision often arises when a company receives from a potential
customer a special one-time order at a selling price which is below the company’s regular selling price. A special order is a one-time order that is not considered part of the company’s normal ongoing business and is not expected to recur and be part of the normal operating cycle.
To address this kind of situation, the key usually is to exclude any committed cost as being irrelevant in the analysis and then compare the available courses of action based on the additional or incremental revenues and costs that will result under each alternative. When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would generally not be affected by the decision to accept or reject the order, they are considered to irrelevant. In analyzing the situation, the general objective is to determine whether the incremental revenue (Special offer price) would be higher than the incremental cost to be incurred. The following table shows how cost can generally be considered in the decision analysis.
Incremental Revenue (Sales) xx
Less: Incremental Cost to Make and Sell
Direct Materials xx
Direct Labor xx
Variable Manufacturing Overhead Xx Variable Selling and Administrative (if
required) Xx
Special Equipment and other
requirements (if any) Xx
Lost Contribution Margin – if required to sacrifice regular sales due to lack of
capacity. Xx
(xx )
Incremental Income xx
To illustrate: Angeles Corporation sells its product for P35 per unit. The company’s unit product cost based on the full capacity of 400,000 units is as follows:
Direct materials P 8 Direct labor 10 Variable manufacturing overhead 4 Fixed Manufacturing overhead 8
Unit product cost P 30
A special order offering to buy 40,000 units has been received from a foreign customer for P30 per unit. The only selling costs that would be incurred on this order would be P6 per unit for shipping. The company has sufficient idle capacity to manufacture the additional units.
Should Angeles accept the order? Just like in the make or buy decision, one of the key factor in solving this problem is to identify the relevant cost, however, this time, we will focus more on the incremental cost rather than the avoidable cost. In the given problem, direct materials, direct labor, variable overhead and variable selling cost will be considered as incremental cost, thus relevant, while fixed manufacturing overhead will be disregarded since this will be considered as a committed cost that will remain to be incurred regardless whether the special order is accepted or rejected. The complete solution will be as follows:
Incremental Revenue per unit P 30
Less: Incremental Cost to Make and Sell
Direct Materials P
8
Direct Labor 10
Variable Manufacturing Overhead 4
Variable Selling and Administrative 6 (28)
Incremental Income per unit P 2
Multiply by: Number of Units Ordered: x 40,000 Total advantage of accepting the order P 80,000 Effect of Special Costs
Supposing that the order of the foreign customer will be needing a unique labeling that will require a special engraving tool equipment that cost P 60,000 and will have no other use for Angeles after it has serve the special order, should Angeles still accept the special order?
The incremental cost, that is, the purchase price of the additional machine that will be specifically acquire for this order will be spread out to the number of units to be ordered and will be added as part of incremental cost to make and sell. The revised solution for this special order problem follows:
Incremental Revenue (Sales) P 30.00
Less: Incremental Cost to Make and Sell
8.00
Direct Labor 10.00
Variable Manufacturing Overhead 4.00 Variable Selling and Administrative (if
required) 6.00
Special Equipment and other requirements
(P60,000/40,000 units) 1.50 (29.50)
Incremental Income per unit 0.50
Multiply by: Number of Units Ordered: x
40,000
Total advantage of accepting the order P
20,000 Alternatively, the Total advantage of P 20,000 can be determined by simply deducting the P 60,000 purchase price to the original advantage of P 80,000. Effect of Lack of Idle Capacity
Supposing that aside from the P 60,000 special engraving tool, Angeles Corporation currently is already able to sell 370,000 units. Should Angeles still accept the
special order?
In this kind of situation, we are to determine if the company has enough excess capacity to accommodate the special order being made by the customer, this is done through comparing the company’s idle capacity and the number of units being ordered. The company’s idle capacity is simply computed by deducting the current sales level by the total or normal capacity. Thus,
Total capacity (in units) 400,000
Current sales level (in units) (370,00
0)
Idle Capacity (in units) 30,000
Number of units being ordered (40,000
)
Shortage in Idle Capacity (10,000
) The shortage in idle capacity can be addressed by either buying additional
equipment or sacrificing regular sales. Since we have already discussed the effect of required additional cost in the form of special equipment, we will assume the
second alternative which is sacrificing regular sales which will result to loss
contribution margin, an opportunity cost. First, we need to determine the amount of the regular contribution margin per unit; second, we multiply such amount to the number of shortage unit to determine the total contribution margin loss.
Regular Selling Price P 35.00
Less: Variable Cost
Direct Materials P
8.00
Variable Manufacturing Overhead 4.00 Variable Selling and Administrative (if
required) 6.00 28.00
Regular Contribution Margin per unit 7.00
Multiply by: Number of Shortage Units (see
above) x 10,000
Total Loss Contribution Margin P 70,000
The analysis whether to accept or reject the special order will be revised as follows:
Incremental Revenue (Sales) P 30.00
Less: Incremental Cost to Make and Sell
Direct Materials P
8.00
Direct Labor 10.00
Variable Manufacturing Overhead 4.00 Variable Selling and Administrative (if
required) 6.00
Special Equipment and other
requirements 1.50
Lost Contribution Margin
(P70,000/40,000) 1.75 (31.25)
Disadvantage per unit (1.25)
Number of Units Ordered 40,000
Total Disadvantage if the order is accepted P (50,000) The negative P 50,000 can also be computed by simply deducting the purchase price of the special equipment and the total loss contribution margin to the original total advantage of accepting the order, thus, it is simply the P 80,000 – P 60,000 – P 70,000 = P (50,000). Hence, the company should not anymore accept the special order.
Drop or Maintain a Segment
This situation arises when a particular segment, a product line, a branch, or a business unit, seems to be incurring operating losses and management would like to determine whether it still worth keeping the segment open and operational or will the company be better off without such segment. There are two approaches in analyzing this type of decision, the traditional approach and opportunity approach.
Traditional Approach
In analyzing this type of decision, the key is to exclude committed fixed costs as being irrelevant and then compare the alternatives presented based on the incremental revenue and incremental cost f each available alternative. To illustrate, Pampanga Corporation sells two (2) different product lines in its retail store. Pampanga’s operating income results last year were as follows:
Product A Product B Total Sales P 100,000 P 200,000 P 300,000 Variable Costs 60,000 100,000 160,000 Contribution Margin 40,000 100,000 140,000 Fixed Costs 60,000 50,000 110,000 Profit (20,000) 50,000 30,000
Pampanga is considering discontinuing Product A because it is unprofitable. If Pampanga does decide to discontinue Product a, the P35,000 fixed cost representing salaries of sales personnel for product A will be eliminated, but the remaining fixed costs of renting, heating, and lighting the store will be unaffected by this decision. Should Pampanga eliminate Product A?
Before making the decision, we need to re-compute Product A’s profit that does not include any committed cost. Based on the illustration, only the P 35,000 out of P 60,000 of total fixed cost for Product A will be eliminated, meaning P 25,000 will remain regardless of the decision to be made. Thus, in determining whether to drop or maintain product A, we re-compute its profit as follows:
Sales P 100,000
Variable Costs 60,000
Contribution Margin 40,000
Avoidable Fixed Costs 35,000
Decrease in profit if Product A is
eliminated P 5,000
Alternatively, the P 5,000 opportunity cost (since it is a profit that will be foregone if Product A is dropped) can be computed as follows:
Net Loss (20,000)
Add Back: Committed Fixed Costs 25,000 Decrease in profit if Product A is
eliminated P 5,000
Hence, Pampanga should not drop product A since it will result to a decrease in profit by P5,000.
Opportunity Cost Approach
Although a lot of managerial accounting books presents problem and solutions on the perspective of traditional approach, another approach can still be used which focuses on the two types of opportunity cost, loss
contribution margin and the avoidable cost. The focus is determine whether in dropping a segment, is a company losing more contribution margin rather than avoiding costs or will it be the other way around. In the case that the company will lose more contribution margin than avoiding more cost, the segment should be kept open.
Using the same situation under the traditional approach, Pampanga’s analysis using the opportunity cost approach follows:
Loss Revenue (100,000)
Avoidable Variable Costs 60,000
Avoidable Fixed Costs 35,000
Disadvantage of eliminating Product
A (5,000)
As you can see, the same amount of disadvantages has been arrived at using two different approaches.
Effect of Incremental Costs
Closing a segment is not as simply as just telling people that the segment will be closed, separation pay for employees, penalties for contracts that will be violated, disposal cost of some resources among other things will be incurred, thus, should be considered in the drop or maintain decision.
Assuming that Pampanga will be incurring a total of P 10,000 in closing cost if it will decide to close Product A down. Using the opportunity cost approach, the analysis will be as follows:
Loss Revenue (100,000)
Avoidable Variable Costs 60,000
Avoidable Fixed Costs 35,000
Incremental Cost (Closing Cost) (10,000) Disadvantage of eliminating Product
A
(15,000)
As we can see, the incremental cost further increase the disadvantage of eliminating Product A since Pampanga will be incurring this cost if Product A will be dropped.
Effect of Complimentary Products
Complimentary Products are those products that are purchased together, like toothpaste and toothbrush, bread and butter, flashlight and batteries, are just among the hundreds of the product pairing that compliments each other. For management considering dropping a product line, it must consider the effect of dropping the product to its complimentary product. Usually, as a product is eliminated, its complimentary product will drop in sales creating loss revenue for the company. But, as what we have already established in the previous module, as sales decreases, total variable cost also decreases, thus creating an avoidable cost.
To illustrate, disregarding the closing cost discussed in the previous section, what if Product A and B are complimentary and if Product A is dropped, Product B’s total sales will decreased by 20%, should product A still be dropped? The analysis of this decision will be as follows:
Loss Revenue – Product A (100,000)
Avoidable Variable Costs 60,000
Avoidable Fixed Costs 35,000
Loss Revenue – Product B (P200,000 x 20%) (40,000) Avoidable Variable Costs – Product B
(P100,000 x 20%) 20,000
Disadvantage of eliminating Product A (25,000)
Product B being a complimentary product of Product A further increases the total disadvantage of eliminating Product A to P 25,000. Notice the same percentage decreased in Product B’s total sales and total variable costs since the assumption is that sales and variable costs are constantly proportionally related.
Effect of Substitute Products
A substitute product is those that can replace another product and still satisfy the needs that the original product was intended to address. Example of substitutes includes rice and bread, juices and soft drinks, blank CD and USB among other things. Unlike complimentary product, if a substitute is
eliminated, it will increase the sales and variable cost of the other product. To illustrate, disregarding both the closing cost and Product B being a
complimentary product that were provided in the previous sections, assume now that Product B is a substitute of Product A, and Product B’s sale will increased by 20% if product A will be dropped. What action should Pampanga take?
Loss Revenue – Product A (100,000)
Avoidable Variable Costs 60,000
Avoidable Fixed Costs 35,000
Incremental Revenue – Product B (P200,000 x
20%) 40,000
Incremental Variable Costs – Product B
(P100,000 x 20%) (20,000)
Advantage of eliminating Product A 15,000
Notice now that from a disadvantage it now becomes an advantage for Pampanga to eliminate product A. Also, it is worth pointing out that although the same amount was involve in the increase of Product B’s sales and
variable cost, the treatment was reversed since the point of view changes, from a complimentary to a substitute. Incremental revenue, which will
increase cash inflow, is shown as a positive item while an incremental cost, which will increase cash outflow, is shown as a negative item.
Shutdown or Continue Operating and the Shutdown Point
This is applicable for companies with products that have seasonal, cyclical or
random variation in demand. It is also applicable to those companies that are in the process of restructuring its operation. This is a kind of situation wherein regardless of the alternative chosen, the company will incur loss. Thus, the main objective here is to choose the alternative that will result to the lower loss or as a popular saying goes choosing the lesser evil.
The concept in this section is no different from the drop or maintain concept in the previous section, the major difference between the two is under the shutdown or continue decision, if a shutdown decision was arrived at, the shutdown is temporary in nature and operation will resume in the very near future. In a drop or maintain decision, if a drop decision was made, such is considered to be permanent. In analyzing the situation, just like the drop or maintain decision, we can use to approaches, the traditional approach which is analysis approach through exclusion of committed fixed cost or the opportunity cost approach which is simply comparing the lost revenue to the avoidable costs.
To illustrate: Bataan Corporation manufactures and sells a single product, Taco. At normal capacity of 50,000 units per annum, the unit cost of manufacturing and selling the product is:
Manufacturing Costs
Direct materials P 5.40
Direct labor P 5.60
Variable Manufacturing Overhead P 2.40 Fixed Manufacturing Overhead P 4.00 Total Production Cost per unit P 17.40 Selling Costs
Variable Selling P 1.60
Fixed Selling P 1.00
Total Selling Cost per unit P 2.60
Due to the increasing competition, the company expects to be able to sell only 20,000 units at a reduced selling price of P20.00 each, next year. The company is restructuring its operations for a better competitive position. In the meantime, management is faced with the problem of whether to shut down completely or continue limited operations at a loss. In the event of a shut down, it is expected that all fixed costs can be reduced by about 60%. Additional costs of shutting down and re-opening the plant for one year are estimated at P 80,000.
Traditional Approach
Under this approach only incremental and avoidable costs are considered in the computation of the expected operating income or loss and excluding any committed fixed cost.
Continue Operating Shutdown Sales (20,000 @ P20) 400,00 0 Sales -0-Variable Cost (20,000 @ P 15.00*) (300,000) Variable Cost -0-Contribution Margin 100,00 0 Contribution Margin
-0-Avoidable Fixed Costs
(250,000**x60%) (150,00
0)
Fixed Costs
Shutdown Costs (80,000 -0-) Incremental Operating Loss (50,000
)
Incremental Operating Loss
(80,000 )
*add all variable cost (direct materials, direct labor, variable overhead and variable selling) **add the two fixed costs per unit and multiply by the normal capacity of 50,000 units.
Bataan should continue operation even though the expected result is a
negative figure since it has a lower loss as compared to shutting down. Hence there is an advantage of P30,000 or 50,000 less 80,000 in favor of continuing operations. The P100,000 committed fixed cost (total fixed cost x 40%) was not considered in any of the alternative since it will not differ and will still be incurred regardless of the decision to be made.
Opportunity Cost Approach
As ready been discussed in the previous section, this approach focuses on the two types of opportunity costs, loss revenues and avoidable costs or cost savings. We will be solving the situation on the point of view of shutting down. Shutting Down Loss Revenue (20,000 @ P20) (400,000) Avoidable Cost Variable Cost (20,000 @ P15) 300,000 Fixed Cost 150,000
Incremental Cost of Shutting Down ( 80,000 ) Disadvantage of Shutting Down ( 30,000 )
What if Bataan can only sell 10,000 units, should Bataan stay open and operate or should it temporarily shut down its operation?
Using the traditional approach, there will be a total disadvantage of P 20,000 will be incurred if the company will continue operating since the incremental loss under continue operating will now be P 100,000 while the incremental loss under shutdown will remain the same. The computation follows:
Continue Operating Shutdown
Sales (10,000 @ P20) 200,00
0 Sales
-0-15.00) 0)
Contribution Margin 50,000 Contribution Margin
-0-Avoidable Fixed Costs
(250,000**x60%) (150,00 0) Fixed Costs Shutdown Costs -0-(80,000 ) Incremental Operating Loss (100,00
0) Incremental Operating Loss (80,000) Using the opportunity approach, the same amount of disadvantage will be computed as follows: Shutting Down Loss Revenue (10,000 @ P20) (200,000) Avoidable Cost Variable Cost (10,000 @ P15) 150,000 Fixed Cost 150,000
Incremental Cost of Shutting Down ( 80,000 ) Advantage of Shutting Down 20,000 The Shut Down Point
If the company will be able to sell 20,000 units, it must remain open for an advantage of P30,000, if it will be able to only sell 10,000 units, it must shutdown to avoid a disadvantage of P20,000, the question is what is the minimum number of units that the company must be able to sell for its decision to be indifferent between continue operating and shutting down? This is called the shutdown point. The shutdown point will act as the
threshold or the point of reference of knowing when to continue operating or when to shutdown. It is the level of sales were in the advantage of continue operating or shutting down is equal to zero. To illustrate the computation:
Shutting Down
Loss Revenue (__________ @ P20) ?
Avoidable Cost
Variable Cost (___________ @ P15) ?
Fixed Cost 150,000
Incremental Cost of Shutting Down ( 80,000 )
Advantage of Shutting Down
-0-As you can see in the pro-forma solution, we are yet to determine the loss revenue and avoidable variable cost since they will depend on the number of units to be sold. While avoidable fixed cost and incremental cost of shutting down will remain the same regardless of the number of units to be sold. We can express the table in the following formula. Let x be number of units to be sold.
−20 x +15 x+150,000−80,000=0
Solving for X;20 x−15 x=150,000−80,000
5 x=70,000
x=
70,000
5
x=14,000 units
To prove that at 14,000 units there will be no advantage or disadvantage; Shutting Down
Loss Revenue (14,000 @ P20) (280,000) Avoidable Cost
Variable Cost (14,000 @ P15) 210,000
Fixed Cost 150,000
Incremental Cost of Shutting Down ( 80,000 )
Advantage of Shutting Down
-0-Knowing that at 20,000 units (above the shutdown point) the company will be better off continue operating while at 10,000 units (below the shutdown point) the company must shutdown, we can form a general conclusion that any sales level that is above the shutdown point, the company must continue operating while any level below the shutdown point will already require the company to shutdown.
Sell or Process Further
This is a situation that arises when management must decide whether to sell the products at split-off or, alternatively, incur additional cost beyond split-off (called separable cost) and then sell the goods for a higher price. This happen in a
manufacturing environment that has a joint production process, which is the result of the commingling manufacturing of two or more products, called joint products. The joint products become identifiable from each other at the split-off point. Imagine manufacturing donuts, a basically they have the same process of dough preparation but after the donut is formed, the management may choose to sell it at its current state or add flavoring to the donut. The following diagram illustrates the flow of joint production cost, the split-off point and further processing.
Split-off Point Further Processing Joint Production
The key in addressing this kind of situation is to segregate sunk cost and consider only incremental revenue and incremental cost. Joint costs incurred prior to split-off are not relevant when making the sell-at-split-off or-process-further decision, since such cost is assumed to have already been incurred before the need for the decision arises. Remember, it is only after the joint production process was finished that the need to make the decision arises. The correct decision is made by comparing the separable cost incurred against the amount of increased sales revenue.
The pro-forma solution guide in solving this kind of situation follows:
Sales after further processing xx
Sales at Split-off point (xx
)
Incremental Revenue xx
Cost to be incurred when process further (Incremental Cost)
(xx ) Net Incremental Profit (if positive) xx
To illustrate, Laguna Company produces donuts. The production phase begins with a joint process that cost P 7,000 and each product can be sold at split-off or
processed further. Details of producing the three donut flavors from a standard batch are as follows:
Choco Nut StrawberryFilled BavarianCrumble Joint Production costs
allocated to each product
up to split-off P 4,000 P 1,000 P 2,000
Sales value at split off 2,000 6,000 8,000
Sales value if processed
further 4,800 9,000 14,000
Processing cost beyond split-off
1,600 3,500 5,000
As already been discussed, the joint production cost will be disregarded since it is a type of sunk cost in as far as this type of decision is concern. The first step is to determine the incremental revenue by simply comparing the sales value at split off and after further processing.
Choco Nut StrawberryFilled BavarianCrumble Sales value if processed
further 4,800 9,000 14,000
Sales value at split off (2,000) (6,000) (8,000)
Incremental Revenue 2,800 3,000 6,000
The second step is to compare the incremental revenue computed to the incremental cost which is the processing cost to be incurred for processing the
products further to determine the total advantage or disadvantage of further processing the products.
Choco Nut StrawberryFilled BavarianCrumble
Incremental Revenue 2,800 3,000 6,000
Incremental Cost (1,600) (3,500) (5,000)
Advantage/(Disadvantage) 1,200 ( 500) 1,000
As we can see, processing Choco Nut and Bavarian Crumble further will provide an advantage of 1,200 and 1,000 respectively while Strawberry Filled will have a 500 disadvantage if process further, hence, it will be wise for Laguna not to further process strawberry filled donut.
Limited Capacity Problem
This situation arises when a constraint exist. A constraint or a bottleneck is any limitations under which a company must operate, such as limited available direct labor or machine time or raw materials, which restricts the company’s ability to satisfy demand. A constraint or bottleneck limits a company’s ability to grow by limiting the total output of the entire system. Limited capacity problem may involve the use of limited labor hours, limited materials, and limited machine time.
The main decision criterion in this type of problem is that when only one limited resource is present, a company should focus on products that would be maximizing the profit in relation to the given scarce/limited resource.
To illustrate, Leyte Company produces wooden plaques and trophies, the following limited information about the two products follows:
Plaques Trophies
Selling Price Per Unit P 36 P 30
Variable Cost Per Unit 24 15 Contribution Margin Per
Unit P 12 P 15
The company only has one sander that is being used to sand the wood which is the main component for both the plaques and the trophies. Generally, the wood
required for each plaque takes 2 hours to sand, while the wood required for each trophy takes 3 hours to sand. Currently, the sander can only be used for a total of 900 hours, which of the two products should Leyte prioritize?
If the contribution margin per unit will be the basis, then it will be Trophies that will be prioritize since a unit of Trophy will yield P15 as compared to a unit of Plaques which only earns P12. However, the constraint here is not the units but rather the machine time of the sander, and knowing that a unit of Plaque and Trophy requires 2 and 3 hours, respectively, in the sanding machine, we have to determine which of the two products will be providing the highest contribution margin in relation to the
constraint. We can do this by simply assuming that the total machine time will be devoted to one product and computing the total number of units that can be produced and multiplying it to the contribution margin per unit to determine the total contribution margin.
Plaques Trophies
Total Sanding Hours Available 900 900
Divided by: Hours required per unit 2 3
Maximum number of units that can be
produced 450 300
Multiplied by: Contribution Margin Per
Unit P 12 P 15
Total Contribution Margin P 5,400 P 4,500
As we can see, assuming that all the available sanding time will be devoted to plaques, the maximum earnings that the company will earn is P 5,400 while, if it will be devoted to Trophies, the company will only earn P 4,500. Another way of looking at it is the amount of contribution margin earned per available sanding time, for plaques, it will be P6 or (P 5,400/900) while it will be P5 (P 4,500/900) for Trophies. This means that a plaque will contribute more than a trophy on per sanding hour basis. This means that Leyte should prioritize Plaques rather than Trophies in order for the company to maximize profit. An alternative and easier way of determining the contribution margin per hour is simply dividing the contribution margin per unit by the hours required per unit.
Plaques Trophies
Contribution Margin Per Unit P 12 P 15
Divided by: Hours required per unit 2 3
Contribution Margin per Constrained
Resource P 6 P 5
Total Sanding Hours Available 900 900
Total Contribution Margin P 5,400 P 4,500
Effects of Market Sales Limit
Sometimes, a product has a maximum demand, meaning the company can only sell as many as what the market demand, thus, there is no point of producing more than what is being demanded by the market since we cannot force the market to buy our product. This is called the Saturation Point.
If the product line with the highest contribution margin per constrained resource has a maximum market demand limit, the remaining limited resources still left may be devoted to the other product line. Assuming that Leyte can only sell 150 plaques and 300 trophies, how many of each product should Leyte produce and sell?
Since plaques has a higher contribution margin per constrained resources, it will be prioritize, the only problem is that although Leyte can produce as many as 450 plaques, it can only sell 150 plaques, hence, there is no sense of producing all 450 plaques. Some of the available sanding time should also be given to Trophies. The allocation will be as follows:
Total Sanding Hours Available 900 Hours required for Plaques (150 Plaques x 2 hours
per plaque) (300)
Total Sanding Hours Available for Trophies 600 Divided by the Hours required per Trophy 3
Number of Trophies to be produced 200
As the solution shows, Leyte will be producing 150 plaques and 200 trophies.
Chapter Summary
1. Describe the nature of decision making and the related process as applied into business
Decision making is necessary for managerial activities. There are two types of decision, routine and non-routine. Routine decisions are those that are recurring and already have programmed set of responses which is usually included in a company’s procedures manual. Non-Routine Decisions are results of uncommon situation and may materially affect how a business operates. Non-routine decisions must be sold using the scientific approach. 2. Differentiate between relevant and irrelevant financial data in decision
making
Relevant Costs are those that should be considered when making decisions, there are two types of relevant costs, differential and opportunity costs, while irrelevant costs should be disregarded. Committed and Sunk Costs are the two types of irrelevant costs.
3. Depict the process of making a make or buy decision
Also called outsourcing decision, make or buy decision arises when a company needs to determined whether it should continue making its own materials or simply buy from a supplier. The important decision criterion is to determine the total relevant cost to make and comparing such to the total relevant cost to buy.
4. Determine whether to accept or reject a special order
Accept or Reject Decisions exist when a company receives a special order from a one-time customer. To make this kind of decision, the company needs to determine whether the special price, which is usually lower than the regular price, is higher than the total relevant cost to make and sell. 5. Resolve whether a segment will be drop or maintained
A segment, which can be a product line, a branch or a business unit, should only be drop if the total loss revenue will be lower than the total avoidable cost. Additional dropping costs, complimentary and substitute products should also be considered.
A decision of whether processing a product further coming from a joint production process or selling it immediately at split-off will be made by determining if the incremental revenue of further processing will be higher than the incremental costs. Any joint production costs is considered to be a sunk cost, thus, irrelevant in the decision.
7. Illustrate how to solve limited capacity problem.
Limited Capacity is a result of constraint or bottleneck. When such condition exists, a company must choose which of its product it should prioritize by referring to the contribution margin per constrained resources which can be computed by dividing the total contribution margin per unit to the required constrained resource per unit.
Chapter Exercises
Problem 1: Multiple Choice Theory Question
1. The cost of a machine purchased last year and used in the production process is called a(n):
a. opportunity cost c. incremental cost b. relevant cost d. sunk cost
2. Which of the following would NOT be relevant in a make-or-buy decision? a. direct materials c. direct labor
b. factory depreciation d. variable overhead
3. Which of the following should not be considered for every option in the decision process?
a. Incremental Revenues c. Future costs b. Historical costs d. Opportunity costs 4. Which of the following is not a correct use of the term opportunity cost?
a. Opportunity costs are considered period costs rather than inventoriable costs for accounting purposes.
b. Opportunity costs must be considered by managers when making decisions.
c. Opportunity cost plus the incremental future revenues and costs equal the relevant revenues and costs of any alternative when capacity is
constrained.
d. The opportunity cost of holding inventory is the income forgone by tying up money in inventory and not investing it elsewhere.
5. What is always the question to ask to determine if revenues or costs are relevant?
b. What difference will an action make? c. Who will be responsible?
d. How much will it cost? 6. Differential cost is:
a. Relevant revenue from one alternative minus relevant cost from that alternative
b. Relevant revenue for the company’s product minus cost of goods sold c. Relevant cost from one alternative minus relevant cost from another
alternative
d. Relevant cost of one alternative minus actual cost of another alternative 7. In the decision to replace an old machine with a new machine, which of the
following would be considered a relevant cost? a. The book value of the old equipment
b. Depreciation expense on the old equipment c. The loss on the disposal of the old equipment d. The current disposal price for the old equipment 8. The decision to drop a product line should be based on:
a. the fact that the product line shows a net loss over several periods
b. the ability of the firm to eliminate some fixed costs as a result of dropping the product
c. whether the fixed costs that can be avoided by dropping the product line are less than the contribution margin that will be lost
d. whether the fixed costs that can be avoided by dropping the product line are greater than the contribution margin lost
9. To maximize total contribution margin, a firm should:
a. promote those products having the highest unit contribution margins b. promote those products having the highest contribution margin ratios c. promote those products having the highest contribution margin per unit of
a constrained resource
d. promote those products having the highest contribution margins and contribution margin ratios
10. Two or more products produced from a common input are termed:
a. common costs c. joint products
b. joint costs d. by-products
11. In a decision to sell or process further beyond the split-off point, a manager should base the decision on
a. the amount of joint product costs allocated
b. the incremental revenue attainable beyond the split-off point c. the incremental cost incurred beyond the split-off point
d. the incremental operating income attainable beyond the split-off point 12. Costs that are always relevant in decision-making are
a. Avoidable costs c. Fixed Costs
b. Sunk Costs d. Variable Costs
13. The managers of a firm are in the process of deciding whether to accept or reject a special offer for one of its products. A cost that is not relevant to their decision is the
a. common fixed overhead that will continue if the special offer is not accepted
b. direct materials
c. fixed overhead that will be avoided if the special offer is accepted d. variable overhead
a. will help the decision maker concentrate on the pertinent data b. will only include future costs
c. will only include costs that differ among alternatives d. All of these answers are correct.
15. When making decisions:
a. quantitative factors are the most important b. qualitative factors are the most important
c. appropriate weight must be given to both quantitative and qualitative factors
d. both quantitative and qualitative factors are unimportant 16. Opportunity costs are:
a. not used for decision making c. the same as variable costs. b. the same as historical costs d. relevant to decision making. 17. Freestone Company is considering renting Machine Y to replace Machine X. It is
expected that Y will waste less direct materials than does X. If Y is rented, X will be sold on the open market. For this decision, which of the following factors is (are) relevant?
a. Cost of direct materials used c. Both a and b b. Resale value of Machine X d. None of the above
18. In a sell or process further decision, which of the following costs are relevant? a. A variable production cost incurred prior to the split-off point.
b. An avoidable fixed production cost incurred after the split-off point. c. Both a and b
d. Neither a nor b
19. VIGAN Corporation is contemplating dropping a product because of ongoing losses. Costs that would be relevant in this situation would include variable manufacturing costs as well as:
a. Factory depreciation c. Corporate administrative costs. b. Avoidable fixed costs d. Unavoidable fixed costs. 20. Which of the following statements regarding relevant costs and sunk costs is
incorrect?
a. A serious drawback associated with the incremental approach of relevant cost study is that the incremental approach is cumbersome if more than two alternatives are considered.
b. The type of cost presented to management for an equipment replacement
decision should be limited to relevant costs.
c. A sunk cost is a cost which cannot be avoided because it already has been
incurred.
d. Relevant costs can be studied using an incremental approach but should
not be considered with a full project approach. Problem 2: Relevant and Irrelevant Costs
Required: Identify whether the cost is a relevant or irrelevant cost. If a cost is a relevant cost, identify whether it is a differential or an opportunity costs, if it is an irrelevant cost, identify whether it is a committed or sunk cost.
a) Rental Fee to be earned as alternative usage of plant space b) Joint production costs incurred
c) Research and development costs incurred in the prior months
d) Cost of special device that is necessary if a special order is accepted e) Cost of obsolete inventory acquired several years ago.
f) Purchase price of the old machine
h) Executive Managers’ Salaries
i) Real Property Taxes of the Plant/Factory j) Direct Materials and Direct Labor
k) Additional Fixed selling Costs to be incurred due to increase in sales l) Utilities, Indirect Materials and Indirect Labors
m) Depreciation of the production equipment
n) Cost of Further Processing a product after the joint production process o) Shutdown cost to be incurred if a factory will be temporarily closed Problem 3: Relevant and Irrelevant Costs
A number of costs are listed below that may be relevant in a decision faced by the management of Bulacan Company. Bulacan normally runs at capacity and the old Model Printing machine is the company’s constraint. Management is considering purchasing a new printing machine, and the old one will be sold. The new machine is more efficient and can produce 20% more units than the old one. Demand for Bulacan’s product is greater than what they can supply. If the new machine is purchased, there should be a reduction in maintenance costs however the new machine is very costly and the company will need to borrow money in order to make the purchase. The increase in volume will be large enough to require increases in fixed selling expense, but general administrative expenses will remain unchanged. Required: For each cost listed determine whether the cost is relevant or irrelevant to the decision to replace the old printing machine.
a) Sales Revenue b) Direct materials c) Direct labor
d) Variable manufacturing overhead e) Rent on the factory building f) Janitorial salaries
g) President’s salary h) Book Value of CY1000 i) Cost of CY1000
j) Cost of CZ4000
k) Interest on money borrowed to make purchase. l) Shipping costs
m) Market value of old machine CY1000 n) Insurance on factory building
o) Salaries paid to personnel in sales office Problem 4: Make or Buy
Tarlac Corporation is now making a small part that is used in one of its products. The company’s accounting department reports the following per unit costs of producing the part internally:
Direct Materials P15.00
Direct Labor 10.00
Variable Manufacturing Overhead 2.00 Fixed Manufacturing Overhead, traceable 4.00 Fixed Manufacturing Overhead, allocated 5.00
Depreciation of special equipment represents 75% of the traceable fixed
manufacturing overhead cost with supervisory salaries representing the balance. The special equipment has no resale value and does not wear out through use. The
supervisory salaries could be avoided if production of the part were discontinued. An outside supplier has offered to sell the part to Tarlac Corporation for P30 each, based on an order of 5,000 parts per year and Tarlac will be incurring an additional P2 per unit for quality inspection of incoming parts.
Required:
1. Should Tarlac accept this offer, or continue to make the parts internally? 2. Assuming that if Tarlac accept the offer it will have enough idle capacity to
produce another product that will have a contribution margin of P 15,000, should Tarlac accept the offer or continue to make the parts internally? Problem 5: Make or Buy
Abra Corporation makes the 1-gallon plastic milk jugs used to package its premium goat’s milk. The company has been approached by a plastic molding company with an offer to produce the milk jugs at a cost of P14.00 per thousand jugs. Abra
Corporation’s president believes the company should continue to produce the jugs and the plant manager has recommended accepting the offer because the cost to produce the jugs is greater than the purchase price. The company’s cost to produce one thousand jugs is as follows:
Direct materials P4.00
Direct labor 2.75
Variable manufacturing overhead 3.50 Fixed manufacturing overhead, traceable 3.00 Fixed manufacturing overhead, common 2.50
Total production cost P15.75
One-half of the traceable fixed manufacturing costs represent supervisory salaries and other costs that can be eliminated if the milk jugs are purchased. The balance of the traceable fixed manufacturing costs is depreciation of manufacturing
equipment that has no resale value. Some of the space being used to produce the milk jugs could be used to store empty jugs, eliminating a rented warehouse and reducing common fixed costs by 20%. The rest of the space could be rented to another company for P 30,000 per year. Abra Corporation produces 10,000,000 milk jugs per year.
Required: Should Abra Corporation make or buy the milk jugs?
Problem 6: Make or Buy
Cebu Corporation makes steel blades for lawn mowers that is heat treats, assembles, and sells. The cost accounting system gives the following data:
Direct Materials P 50,000
Direct Labor P 30,000
Variable Factory Overhead P 60,000 Fixed Factory Overhead P 90,000
Units Produced 100,000 units
Cebu has an opportunity to purchase its 100,000 blades from an outside supplier at a cost of P2.20 per blade. Inspection of the purchased blades will cost an additional P 5,000 in the quality assurance department. Certain leased equipment, which costs P 30,000 and is included in fixed overhead, can be avoided if the blades are
purchased. The released space could be used to make a part that is not purchased, which would net Cebu a savings of P 46,000.
Required: Should Cebu buy the blades from the outside suppler? Problem 7: Make or Buy
The Tagaytay Company is now producing a sub-assembly that does into its final product. The company reports the following costs of producing the sub-assembly:
Per unit 8,000 units
Direct materials P 3 P 24,000
Direct labor 4 32,000
Variable overhead 4 32,000
Fixed overhead, direct 5 40,000
Fixed overhead, common ( but
allocated) 8 64,000
TOTAL P 24 P192,000
The Tagaytay Company has received an offer from a supplier who will provide 8,000 sub-assemblies a year at a firm price of P21 each. The space now being used to produce the sub-assemblies could be used to produce a new product line that would generate a segment margin of P50,000 net per year:
Required: The president asks your opinion on whether or not Tagaytay, should stop producing the sub-assemblies and start purchasing them from the suppliers.
Problem 8: Accept or Reject
Pampanga Corporation manufactures two pizzas, Hawaiian and Italian. Direct material is the only variable manufacturing cost because the production process is fully automated. The only variable selling cost is a 5% commission on the selling price. All other manufacturing, selling, general and administrative costs are fixed and the production capacity is limited to 235,000 machine hours. Budgeted information for the year:
Hawaiian Italian
Budgeted sales (units) 100,000 90,000
Regular selling price P300 P450
Direct materials P100 P160
Machine time per unit 1 hour 1.4 hours
Manufacturing costs, other than direct materials, budgeted for the year are P
1,590,000 and are allocated to Hawaiian and Italian based on units. Selling, general and administrative costs, other than commission, budgeted for the year are P
3,895,000 and are allocated to Hawaiian and Italian based on sales revenue. Required:
1. Buyer Ltd. has approached Pampanga Corporation and would like to purchase 10,000 customized units of the Hawaiian for P 440 each. Because of capacity concerns, possible opportunity costs, and a one-time setup cost of P 100,000, the manager of sales is willing to cut the commission from the regular 5% to 3% on this special order. The opportunity cost in accepting the special order is:
2. If Pampanga Corporation accepts the special order, its income will increase/ (decrease) by:
Problem 9: Accept or Reject
KFC Corporation has the following cost per unit information about its only product Zinger: Direct Materials P 40.00 Direct Labor 30.00 Variable Overhead 20.00 Fixed Overhead 10.00* Other Costs:
Variable Selling Expenses 15.00
Fixed Selling Expenses 50,000
*Based on 10,000 units of normal production
The company is currently operating at 90% of normal capacity. A prospective customer has approach management offering to buy 1,500 units at a special price of P 95.00 instead of the regular price of P130.00. The company will be able to save on variable selling expenses while variable overhead will decrease by 25% but will be required to purchase special equipment amounting to P 10,000 which will have no other use after the order has been served.
Required:
1. What should be the minimum price of the special order for KFC to accept such? 2. What should have been the current operating capacity of in the company in order for the decision to be indifferent?
Problem 10: Accept or Reject
BATANGAS Corporation manufactures and sells a type of knife. The company has never been able to sell all it can produce (which is 50,000 knives, meaning it has enough excess capacity). The cost sheet for the knife appears below:
Direct material P 6.00
Direct labor 7.00
Overhead @ 100% of direct labor 7.00
TOTAL COST P 20.00
Variable overhead is P2.00 per unit and variable selling and administrative expense is P1.00 per unit. The company received an order from a new customer for 5,000 knives at a special price of P 18.00 instead of the regular price of 25.00.
Required:
1. Based on the foregoing information, how much is the net advantage (disadvantage) if the company accepts the special order?
2. What if the company is currently able to sell 48,000 knives to its regular customers, how much is the net advantage (disadvantage) of accepting the special order?
3. What if the company has enough excess capacity but the special order requires a special tool worth P 30,000 that will have no other use after the order has been served, how much is the net advantage (disadvantage) of accepting the special order?
Problem 11: Accept or Reject
The Samar Corporation has an annual plant capacity of 25,000 units. Predicted data on sales and costs are given below:
Sales (20,000 units @ P50) P 1,000,000
Variable (materials, labor, and overhead) P 40 per unit
Fixed overhead P 30,000
Selling and administrative expenses:
Variable (sales commission – P 1 per unit) P 2 per unit
Fixed P 7,000
A special order has been received from outside for 6,000 units at a selling price of P 45 each. This order will have no effect on regular sales. The usual sales commission on this order will be reduced by one-half. However, special equipment costing P 12,000 will be needed to be acquired by Samar to make the special features that the outside customer is requesting.
Required: Should the company accept the order? Problem 12: Drop or Maintain
Sophisticates' Corner sells clothing, shoes, and accessories at a suburban location near Boston. Information for the just concluded calendar year follows.
Clothing Shoes Accessori es Sales P 850,000 P 320,000 P 150,000
Less: Variable Costs P
510,000 270,000P P 82,500 Fixed Costs 290,000 70,000 42,000 Operating Income 50,000 (20,000) P 25,500
Management is considering closing the shoe operation because of the loss and to permit expanding the space that is currently devoted to accessories sales. A
salaried salesperson in the shoe department who earns P 45,000 will be terminated; however, all other departmental fixed costs will continue to be incurred.
Sophisticates' Corner will spend P 16,000 on remodeling costs and anticipates that accessories sales will increase by P 70,000. This additional sales revenue is
expected to generate a 35% contribution margin for the firm. Finally, because clothing customers often purchased shoes and feel strongly about "one-stop shopping," clothing sales are expected to fall by 15% if the shoe department is closed.
Required: Determine whether the shoe department should be closed. Problem 13: Drop or Maintain
Rustic Shoe Company produces and sells shoes to domestic retailers. For one brand of shoe, the company sells 10,000 pairs in the general market and 10,000 pairs to a single customer. The market price is P13 per pair and the price to the single
customer is P10 per pair. The production and selling costs are as follows: Variable production cost P6.50 per pair
Variable selling costs P1.75 per pair (market sales) P0.75 per pair (single customer)
Fixed production costs P 34,000
Fixed selling costs P 20,000
Capacity 20,000 pairs
The company is considering not selling the 10,000 pairs to the single customer, but instead also selling these pairs in the general marketplace. It is confident that the market can absorb the additional 10,000 pairs. In order to sell to the general
the same as they are now. An increase of P 5,000 in fixed selling expenses will also be necessary.
Required:
1. What is the advantage (disadvantage) of discontinuing selling to a single customer?
2. Disregarding capacity, determine the number of units the single customer should order in order for the company’s management’s decision to be indifferent.
Problem 14: Drop or Maintain
Romblon Corporation produces and sells shoes to domestic retailers. For one brand of shoe, the company sells 10,000 pairs in the general market and 10,000 pairs to a single customer. The market price is P13 per pair and the price to the single
customer is P10 per pair. The production and selling costs are as follows: Variable production cost P6.50 per pair
Variable selling costs P1.75 per pair (market sales) P0.75 per pair (single customer)
Fixed production costs P 34,000
Fixed selling costs P 20,000
Capacity 20,000 pairs
The company is considering not selling the 10,000 pairs to the single customer, but instead, also selling these pairs in the general marketplace. Romblon Corporation is confident that the market can absorb the additional 10,000 pairs. In order to sell to the general marketplace, the company’s variable selling expenses on the additional pairs will be the same as they are now. An increase of P5,000 in fixed selling
expenses will also be necessary. Required:
1. What is the advantage (disadvantage) of discontinuing selling to a single customer?
2. Disregarding capacity, determine the number of units the single customer should order in order for the company’s management’s decision to be indifferent.
Problem 15: Drop or Maintain
Camarines Company currently operates 3 departments: Bedding, Furniture and Kitchen departments. The income statement of the company for the year ended March 2012 shows the Furniture department is making a loss as follows:
Bedding Furniture Kitchen
Sales P
800,000 500,000 600,000
Cost of Sales 600,000 420,000 400,000
Gross Margin 200,000 80,000 200,000
Less: Operating costs
Head office overhead 120,000 64,000 80,000 Selling overhead 30,000 20,000 20,000 Administrative
overhead 20,000 27,000 10,000
Net Profit/(Loss) P 30,000 P
(31,000) P 90,000 The losses that Furniture department made had lowered down the overall company’s profit to P89,000. He suggests that the department be closed
