chapter 5 relevant information and decision making: marketing decisions

Chapter 5Chapter 5Relevant Information Relevant Information and Decision Making:and Decision Making:

Marketing DecisionsMarketing Decisions

The purpose of management accounting as The purpose of management accounting as we emphasized before is:we emphasized before is:

To provide information that enables To provide information that enables managers to make sound decisions. managers to make sound decisions.

Accountants have an important role in the Accountants have an important role in the decision making process, not as a decision decision making process, not as a decision makers but as a collectors and reporters of makers but as a collectors and reporters of

relevant information.relevant information.

The accountant's role in decision making is The accountant's role in decision making is primarily that of a technical expert on financial primarily that of a technical expert on financial analysis who helps managers focus on relevant analysis who helps managers focus on relevant

data, information that will lead to the best data, information that will lead to the best decisions.decisions.

Objective 1Objective 1Discriminate Between Relevant Discriminate Between Relevant and Irrelevant Information for and Irrelevant Information for

Making DecisionsMaking Decisions

This chapter introduces the topic of relevant This chapter introduces the topic of relevant information. Relevant means pertinent or applicable. information. Relevant means pertinent or applicable.

When managers make choices among alternatives, When managers make choices among alternatives, all the relevant costs and revenues associated with all the relevant costs and revenues associated with

each alternative must be considered.each alternative must be considered.

Meaning of RelevanceMeaning of RelevanceMeaning of RelevanceMeaning of Relevance

Decision analysis can be based either on cash Decision analysis can be based either on cash flow changes or on changes in accounting income. flow changes or on changes in accounting income.

Long-run decision analysis generally uses cash flow Long-run decision analysis generally uses cash flow as the decision criterion. Short-run decision as the decision criterion. Short-run decision

analysis, the focus of this chapter, often uses analysis, the focus of this chapter, often uses accounting income, although some past costs, such accounting income, although some past costs, such

as depreciation on old assets, may be excluded.as depreciation on old assets, may be excluded.

Note that:Note that: Relevant information is a prediction of the Relevant information is a prediction of the

future, not a summary of the past.future, not a summary of the past. Historical (past) data are irrelevant to the Historical (past) data are irrelevant to the decision itself, because the decision cannot decision itself, because the decision cannot

affect past data. Decisions affect the future. affect past data. Decisions affect the future. Nothing can alter what has already happened.Nothing can alter what has already happened. Of the expected future data, only those that Of the expected future data, only those that

differ from alternative to alternative are differ from alternative to alternative are relevant to decision. Any item that will remain relevant to decision. Any item that will remain

the same regardless of the alternative the same regardless of the alternative selected is irrelevant. selected is irrelevant.

Relevant information is the predicted Relevant information is the predicted future costs and revenues that will future costs and revenues that will

differ among the alternativesdiffer among the alternatives

Relevance definedRelevance defined

For example,For example, let us consider a situation let us consider a situation where an individual is uncertain as to where an individual is uncertain as to

whether he should purchase a monthly whether he should purchase a monthly rail ticket to travel to work or whether he rail ticket to travel to work or whether he

should use his car. Assuming that the should use his car. Assuming that the individual will keep his car, whether or individual will keep his car, whether or

not he travels to work by train, the cost not he travels to work by train, the cost of his road fund license and insurance will of his road fund license and insurance will be irrelevant since these costs remain the be irrelevant since these costs remain the

same irrespective of his mode of the same irrespective of his mode of the travel. The cost of his petrol will, travel. The cost of his petrol will,

however, be relevant as this cost will vary however, be relevant as this cost will vary depending on which method of transport depending on which method of transport

he chooses.he chooses.

Let us now move on to consider an Let us now move on to consider an

example in a business environment.example in a business environment. A company is considering the alternative of A company is considering the alternative of

either purchasing a component from an outside either purchasing a component from an outside supplier or producing the component itself. The supplier or producing the component itself. The

estimated costs to the company of producing the estimated costs to the company of producing the component are as follows:component are as follows:

Direct materialDirect material300300

Direct laborDirect labor100 100 Variable overheadsVariable overheads5050Fixed overheadsFixed overheads100100

550550

The outside supplier has quoted a figure of L.E. The outside supplier has quoted a figure of L.E. 500 for supplying the component. Should the 500 for supplying the component. Should the

company buy or make the component?company buy or make the component?

The comparative cost statements for the two The comparative cost statements for the two alternatives are as follows:alternatives are as follows:

Company Company To To

Manufacture Manufacture ComponentComponent

L.EL.E..

Company Company To Purchase To Purchase ComponentComponent

L.EL.E..

Direct materialDirect material300300--Direct laborDirect labor100 100 --Variable overheadsVariable overheads5050--Fixed overheadsFixed overheads100100100100Supplier's purchase price Supplier's purchase price --500500

550550600600

it is assumed in this example that the share it is assumed in this example that the share of fixed overheads apportioned to the component of fixed overheads apportioned to the component will still be incurred whether or not the company will still be incurred whether or not the company

purchases the component from an outside purchases the component from an outside supplier. Fixed overheard therefore is irrelevant in supplier. Fixed overheard therefore is irrelevant in

deciding which alternative to choose.deciding which alternative to choose.

It is also assumed that the company will not It is also assumed that the company will not incur the direct material, labor, and variable incur the direct material, labor, and variable

overhead costs if the component is purchased overhead costs if the component is purchased form the outside supplier: These costs will be form the outside supplier: These costs will be

different depending on which alternative will be different depending on which alternative will be chosen and are therefore relevant in making the chosen and are therefore relevant in making the decision. The supplier's purchase price is also a decision. The supplier's purchase price is also a

relevant cost as it will be different for each of the relevant cost as it will be different for each of the alternatives. alternatives.

We can therefore represent the cost We can therefore represent the cost statements for the two alternatives using statements for the two alternatives using

only relevant cots as follows:only relevant cots as follows: Company To Company To Manufacture Manufacture ComponentComponent

L.EL.E..

Company Company To Purchase To Purchase ComponentComponent

L.EL.E..Direct materialDirect material300300--Direct laborDirect labor100 100 --Variable overheadsVariable overheads5050--Fixed overheadsFixed overheads----Supplier's purchase Supplier's purchase price price

--500500

450450500500

You can see that the two approaches can You can see that the two approaches can be used for presenting relevant cost be used for presenting relevant cost

information.information. You can present cost You can present cost

information which information which include irrelevant costs include irrelevant costs

or revenues, (that is, the or revenues, (that is, the fixed cost in this fixed cost in this

example) provided that example) provided that they are included under they are included under

both alternatives and do both alternatives and do not mislead the decision not mislead the decision

maker.maker.

Alternatively, cost Alternatively, cost information could be information could be

presented which excludes presented which excludes the irrelevant costs and the irrelevant costs and revenues because they revenues because they

are identical for both are identical for both alternatives.alternatives.

Both methods show that future costs will be L.E. Both methods show that future costs will be L.E. 50 lower if the company manufactures the 50 lower if the company manufactures the

componentcomponent..

It is important that great care is taken in It is important that great care is taken in presenting financial information for decision presenting financial information for decision

making. If, in the above example, the company had making. If, in the above example, the company had produced the same component in the pervious produced the same component in the pervious

period, the component would be valued at L.E. 550 period, the component would be valued at L.E. 550 for stock valuation as all manufacturing costs for stock valuation as all manufacturing costs

should be taken into account when stock is valued should be taken into account when stock is valued ( for financial accounting purposes) .( for financial accounting purposes) .

For decision making purposes only For decision making purposes only future future costscosts that will be relevant to the decision should that will be relevant to the decision should

be included. Costs accumulated for stock valuation be included. Costs accumulated for stock valuation purposes must not be used for decision making purposes must not be used for decision making

purposes.purposes.

When you are trying to establish which costs When you are trying to establish which costs are relevant to a particular decision you may find are relevant to a particular decision you may find

that some costs will be relevant in one situation but that some costs will be relevant in one situation but irrelevant in another. irrelevant in another.

In the above example direct labor was In the above example direct labor was considered to be a relevant cost, based on the considered to be a relevant cost, based on the

assumption that the company will hire additional assumption that the company will hire additional labor on a causal basis to produce the component. labor on a causal basis to produce the component.

But now consider what the relevant labor cost But now consider what the relevant labor cost will be if the company has a temporary excess will be if the company has a temporary excess

supply of labor and intends to obtain the necessary supply of labor and intends to obtain the necessary labor hours from its existing labor force at no extra labor hours from its existing labor force at no extra

cost? In this situation the labor cost will be the same cost? In this situation the labor cost will be the same whichever alternative is chosen and will not be a whichever alternative is chosen and will not be a

relevant cost.relevant cost.

Let us now take the example a stage furtherLet us now take the example a stage further::

Direct materials will not be a Direct materials will not be a relevant cost if the company has relevant cost if the company has

purchased the materials in the past and purchased the materials in the past and now finds that they are surplus to now finds that they are surplus to

requirements. If the materials have no requirements. If the materials have no alternative use and cannot be sold then alternative use and cannot be sold then the cost will be the same irrespective of the cost will be the same irrespective of

which alternative is chosen. Therefore which alternative is chosen. Therefore the cost of direct materials is not a the cost of direct materials is not a

relevant cost in this situation.relevant cost in this situation.

The above examples show that the The above examples show that the identification of relevant costs depends on the identification of relevant costs depends on the

circumstances. circumstances.

It is not therefore possible to provide It is not therefore possible to provide a list of costs which would relevant in a list of costs which would relevant in particular situations. In each situation particular situations. In each situation

you should follow the principal that the you should follow the principal that the relevant costs are future costs that differ relevant costs are future costs that differ

among alternatives. among alternatives.

In one situation a cost may be relevant In one situation a cost may be relevant but in another situation the same cost but in another situation the same cost

may not be relevant.may not be relevant.

The important question to ask when The important question to ask when determining the relevant cost is: determining the relevant cost is:

It is necessary that the accountant should be It is necessary that the accountant should be aware of all the circumstances under which a decision aware of all the circumstances under which a decision

will be taken and ascertain full details of the changes will be taken and ascertain full details of the changes that will result from the decision, and then proceed to that will result from the decision, and then proceed to select the relevant financial information to present to select the relevant financial information to present to

management.management.

What difference will it makeWhat difference will it make??

In many situations it is difficult to quantify in In many situations it is difficult to quantify in monetary terms all the important elements of a monetary terms all the important elements of a

decision.decision.

Those factors which can be expressed Those factors which can be expressed in monetary terms only with much difficulty in monetary terms only with much difficulty

or imprecision are classified as or imprecision are classified as qualitative qualitative factors.factors. It is essential that qualitative It is essential that qualitative

factors are brought to the attention of factors are brought to the attention of management during the decision-making management during the decision-making

process, as otherwise there may be a process, as otherwise there may be a danger of making a wrong decision.danger of making a wrong decision.

Quantitative and QualitativeQuantitative and Qualitative FactorsFactors

For example,For example, the cost of manufacturing a the cost of manufacturing a component internally may be more expensive than component internally may be more expensive than purchasing from an outside supplier. However, the purchasing from an outside supplier. However, the

decision to purchase form outside supplier could decision to purchase form outside supplier could result in the closing down of the company's result in the closing down of the company's facilities for manufacturing the component. facilities for manufacturing the component.

The effect of such a decision might lead to The effect of such a decision might lead to redundancies and a decline in employee's morale redundancies and a decline in employee's morale

which could affect the future output. In addition the which could affect the future output. In addition the company will become dependent on an outside company will become dependent on an outside

supplier, who may not always deliver on time. The supplier, who may not always deliver on time. The company may not then be in a position to meet company may not then be in a position to meet

customer requirements: In turn this could result in customer requirements: In turn this could result in a loss of customer goodwill and a decline in future a loss of customer goodwill and a decline in future

sales. sales.

It may not be possible to quantify in monetary It may not be possible to quantify in monetary terms the effects of a decline in employees morale terms the effects of a decline in employees morale

or loss of customers goodwill but the accountant in or loss of customers goodwill but the accountant in such circumstances should present the relevant such circumstances should present the relevant

quantifiable financial information and draw quantifiable financial information and draw attention to those qualitative items which may have attention to those qualitative items which may have

an impact on future profitability.an impact on future profitability.

In circumstances such as those given in the In circumstances such as those given in the above example, management must estimate the above example, management must estimate the

likelihood of the supplier failing to meet the likelihood of the supplier failing to meet the company’s demand for future supplies and the company’s demand for future supplies and the

likely effect on customer goodwill if there is a delay likely effect on customer goodwill if there is a delay in meeting orders. If the component can be in meeting orders. If the component can be

obtained from many suppliers and repeat orders for obtained from many suppliers and repeat orders for the company's products are unlikely then the the company's products are unlikely then the

company may give little weighting to these company may give little weighting to these qualitative factors. qualitative factors.

Alternatively, if the component can be Alternatively, if the component can be obtained from only one supplier and the company obtained from only one supplier and the company

relies heavily on repeat sales to existing relies heavily on repeat sales to existing customers, then the qualitative factors will be of customers, then the qualitative factors will be of

considerable importance. considerable importance.

In the latter situation the company may In the latter situation the company may consider that the quantifiable cost savings from consider that the quantifiable cost savings from

purchasing the component from an outside purchasing the component from an outside supplier are insufficient to cover the risk of the supplier are insufficient to cover the risk of the

qualitative factors occurring.qualitative factors occurring.

In the best, information used for decision In the best, information used for decision making would be perfectly relevant and accurate. making would be perfectly relevant and accurate.

However in reality, the cost of such information However in reality, the cost of such information often exceeds its benefits.often exceeds its benefits.

Accountants often trade off relevance versus Accountants often trade off relevance versus accuracy. Of course, relevance information must accuracy. Of course, relevance information must

be reasonably accurate but not precisely so.be reasonably accurate but not precisely so.

Accuracy and RelevanceAccuracy and Relevance

Precise but irrelevant information is worthless Precise but irrelevant information is worthless for decision making. On the other hand, imprecise for decision making. On the other hand, imprecise

but relevant information can be useful. For example, but relevant information can be useful. For example, sales predictions for a new product may be subject sales predictions for a new product may be subject

to great error, but they still are helpful to the to great error, but they still are helpful to the decision of whether to manufacture the product.decision of whether to manufacture the product.

The degree to which information is relevant The degree to which information is relevant or precise often depends on the degree to which it or precise often depends on the degree to which it

is qualitative or quantitative.is qualitative or quantitative.

Those for which measurement in Those for which measurement in pounds and piasters is difficult and pounds and piasters is difficult and

imprecise;imprecise;

Those for which measurement is easy Those for which measurement is easy

and precise.and precise.

Qualitative Aspects are:Qualitative Aspects are:

Quantitative Aspects are:Quantitative Aspects are:

Just as we noted that relevance is more Just as we noted that relevance is more crucial than precision in decision making. So a crucial than precision in decision making. So a qualitative factor may easily carry more weight qualitative factor may easily carry more weight

than a quantitative financial impact in many than a quantitative financial impact in many decisions.decisions.

For example,For example, mangers sometimes mangers sometimes introduce new technology (e.g. advanced introduce new technology (e.g. advanced

computer systems) even though the computer systems) even though the expected quantitative results seen expected quantitative results seen unattractive. Mangers defend such unattractive. Mangers defend such

decisions on the grounds that failure to decisions on the grounds that failure to keep abreast of new technology will keep abreast of new technology will

surely bring unfavorable financial results surely bring unfavorable financial results sooner or later.sooner or later.

Is a cost that would be different if Is a cost that would be different if one alternative, rather than another one alternative, rather than another

alternative, were selected.alternative, were selected.

Concept of Differential Costs Concept of Differential Costs and Revenuesand Revenues

Concept of Differential Costs Concept of Differential Costs and Revenuesand Revenues

Differential CostDifferential Cost

Differential costs are also called Differential costs are also called relevant relevant costscosts. The term refers both to certain items of cost . The term refers both to certain items of cost

and to amounts of cost. Thus in many situations, and to amounts of cost. Thus in many situations, direct labor is an item of differential cost; also, if direct labor is an item of differential cost; also, if

the amount of cost that differs in a certain problem the amount of cost that differs in a certain problem is L.E. 1000, the L.E. 1000 is said to be the amount is L.E. 1000, the L.E. 1000 is said to be the amount

of differential cost. of differential cost.

Differential costs always relate to a specific Differential costs always relate to a specific situation.situation.

There are three important differences There are three important differences between full costs and differential costs:between full costs and differential costs:

Contrasts with Full CostsContrasts with Full Costs

The full cost of a product is the sum of its The full cost of a product is the sum of its direct costs plus its equitable share of indirect direct costs plus its equitable share of indirect

costs. Differential costs (relevant costs) include costs. Differential costs (relevant costs) include only those elements of cost that are different only those elements of cost that are different

under a set of conditions.under a set of conditions.

1.1.Nature of the cost :Nature of the cost :

Each problem is different. Some of the data Each problem is different. Some of the data used to construct differential costs may come used to construct differential costs may come

from the cost accounting system, but some data from the cost accounting system, but some data come from other sources.come from other sources.

Information on full costs is taken directly Information on full costs is taken directly from a company’s cost accounting system. There from a company’s cost accounting system. There

is no comparable system for collecting differential is no comparable system for collecting differential costs. The appropriate items that constitute costs. The appropriate items that constitute differential costs are assembled to meet the differential costs are assembled to meet the

requirements of a specific problem.requirements of a specific problem.

2.2.Source of Data :Source of Data :

Note that the accounting system is Note that the accounting system is designed so that it can provide the raw data that designed so that it can provide the raw data that are used in estimating the differential costs for a are used in estimating the differential costs for a

specific problem.specific problem.

TheThe full cost accounting system collects full cost accounting system collects costs on a historical basis, that is it measures costs on a historical basis, that is it measures what the costs were. Differential costs always what the costs were. Differential costs always

related to the future; they are intended to show related to the future; they are intended to show what the costs would be if a certain course of what the costs would be if a certain course of

action were adopted, rather than what the costs action were adopted, rather than what the costs were in some past period.were in some past period.

3.3.Time perspective :Time perspective :

Differential costs are not necessarily the same as variable costs. Differential costs are not necessarily the same as variable costs.

If in a specific problem, the alternatives being If in a specific problem, the alternatives being considered involve a change in volume, then variable costs, considered involve a change in volume, then variable costs,

by definition, are differential costs. Differential costs may by definition, are differential costs. Differential costs may include fixed costs as well as variable costs. include fixed costs as well as variable costs.

Differential Costs Contrasted with Variable CostsDifferential Costs Contrasted with Variable Costs

Are those that vary directly with the Are those that vary directly with the volume of output.volume of output.

Variable CostsVariable Costs

Thus, variable costs are differential costs in problems Thus, variable costs are differential costs in problems that involve changing the volume of output, but not that involve changing the volume of output, but not

otherwise.otherwise.

A Special type of relevant costs is an opportunity costA Special type of relevant costs is an opportunity cost..

For example, the XYZ company owns a piece of land For example, the XYZ company owns a piece of land acquired at a total cost of L.E. 100,000. The company has acquired at a total cost of L.E. 100,000. The company has

the opportunity to sell the land for L.E. 500,000. The the opportunity to sell the land for L.E. 500,000. The company’s managers decide to keep the land and use it as company’s managers decide to keep the land and use it as

the location for the company’s new headquarter. The the location for the company’s new headquarter. The opportunity cost of this is L.E. 500,000 - the benefit opportunity cost of this is L.E. 500,000 - the benefit

foregone by choosing the alternative of keeping the land foregone by choosing the alternative of keeping the land rather than selling it. The historical cost of L.E. 100,000 is rather than selling it. The historical cost of L.E. 100,000 is

not relevant to the decision; it isnot relevant to the decision; it is a sunk costa sunk cost..

Opportunity CostsOpportunity Costs

Represent a potential benefit that is given up Represent a potential benefit that is given up because one course of action is chosen over because one course of action is chosen over

anther.anther.

AnAn Opportunity CostOpportunity Cost

Opportunity costs are not measured in accounting Opportunity costs are not measured in accounting records. Costs that are collected within the accounting records. Costs that are collected within the accounting

system are based on past payments. Sometimes it is system are based on past payments. Sometimes it is necessary for decision-making to impute costs which will necessary for decision-making to impute costs which will

not require cash outlays, and these imputed costs are not require cash outlays, and these imputed costs are called opportunity costs.called opportunity costs.

It is important to note that opportunity costs only It is important to note that opportunity costs only apply to the use of scarce resources. Where resources are apply to the use of scarce resources. Where resources are not scarce, no sacrifice exists from using these resources.not scarce, no sacrifice exists from using these resources.

Note that opportunity costs are of vital importance Note that opportunity costs are of vital importance for decision-making. If no alternative use of resources for decision-making. If no alternative use of resources

exists, the opportunity cost is zero. But if resources have exists, the opportunity cost is zero. But if resources have an alternative use, and are scarce, then an opportunity an alternative use, and are scarce, then an opportunity

cost does exist.cost does exist.

The term out-of-pocket costs refer toThe term out-of-pocket costs refer to

Out-of-pocket costs therefore are the same Out-of-pocket costs therefore are the same thing as differential costs in many situations. thing as differential costs in many situations.

Opportunity costs however, often are not out-of-Opportunity costs however, often are not out-of-pocket costs, so the out-of-pocket costs is not pocket costs, so the out-of-pocket costs is not

always relevantalways relevant..

Out – Of –Out – Of – Pocket CostsPocket Costs

cost items that will cause the company cost items that will cause the company to pay money out of its “pocket” if the to pay money out of its “pocket” if the

alternative under consideration is alternative under consideration is adopted.adopted.

Sunk cost should have the same meaning of Sunk cost should have the same meaning of past cost or historical cost.past cost or historical cost.

Depreciation is ordinarily a sunk cost Depreciation is ordinarily a sunk cost because depreciation is a write-off of the cost of because depreciation is a write-off of the cost of

fixed asset, and the cost of the asset was incurred fixed asset, and the cost of the asset was incurred when the asset was acquired. Similarly, the book when the asset was acquired. Similarly, the book

value of a fixed asset is a sunk cost, it represents value of a fixed asset is a sunk cost, it represents that portion of the acquisition cost that has not that portion of the acquisition cost that has not

yet been written off as depreciation expense. yet been written off as depreciation expense.

Sunk CostsSunk Costs

Is a cost that has already been incurred and, Is a cost that has already been incurred and, therefore, is irrelevant to the decision making therefore, is irrelevant to the decision making

process. process.

A sunk cost exists because of actions taken in the A sunk cost exists because of actions taken in the past, therefore, a sunk cost is not a differential cost. No past, therefore, a sunk cost is not a differential cost. No

decision made today can change what has already decision made today can change what has already happened.happened.

Sunk costs are irrelevant for decision making, but Sunk costs are irrelevant for decision making, but they are distinguished from they are distinguished from irrelevant costsirrelevant costs because not because not

all irrelevant costs are sunk costs. For example, a all irrelevant costs are sunk costs. For example, a comparison of two alternative production methods may comparison of two alternative production methods may

result in identical direct material expenditure for both result in identical direct material expenditure for both alternatives, So the direct material cost is irrelevant alternatives, So the direct material cost is irrelevant

because it will remain the same whichever alternative is because it will remain the same whichever alternative is chosen, but it is not a sunk cost as it will be incurred in chosen, but it is not a sunk cost as it will be incurred in

the future.the future.

Objective 2Objective 2Diagram the Relationships Diagram the Relationships

Among the Main Elements of Among the Main Elements of the Decision Processthe Decision Process

Exhibit 5-1 presents a diagram of decision process and Exhibit 5-1 presents a diagram of decision process and role of information.role of information.

HistoricalHistoricalInformatioInformatio

nn

OtherOtherInformatioInformatio

nn

Prediction Method

Decision ModelDecision Model

Implementation and Implementation and EvaluationEvaluation

))AA(( (B)(B)))11((

))22((

Predictions as inputs toDecision Model

(3)(3)

Decisions by Managers With Aid of Decision Model

(4)(4)

Feedback

The data in The data in step (1)step (1) help the formulation of predictions help the formulation of predictions in in step (2).step (2).

Box 1 (A)Box 1 (A)::represents historical data from the represents historical data from the accounting system.accounting system.

Box 1 (B)Box 1 (B)::represents other data, such as, price represents other data, such as, price indices or industry statistics gathered indices or industry statistics gathered

from outside the accounting system.from outside the accounting system.

Although historical data may act as a Although historical data may act as a guide to predicting, they are irrelevant guide to predicting, they are irrelevant

to the decision itself.to the decision itself.

Note thatNote that

InIn step (3)step (3) these predictions become inputs these predictions become inputs to the decision model. to the decision model.

Is defined as any method for making a Is defined as any method for making a choice.choice.

Decision ModelDecision Model

Some models often require elaborate Some models often require elaborate quantitative procedures, such as mathematical quantitative procedures, such as mathematical programming. A decision model, however, may programming. A decision model, however, may

also be simple.also be simple.

In step (4)In step (4) once alternative course of action once alternative course of action have been selected, they should be implemented. have been selected, they should be implemented. To monitor performance the accountant produces To monitor performance the accountant produces

performance reports. performance reports.

Provide feedback information by Provide feedback information by comparing planning and actual comparing planning and actual

results.results.

Performance ReportsPerformance Reports

Objective 3Objective 3Analyze Data by Contribution Analyze Data by Contribution

Approach to Support a Decision Approach to Support a Decision for Accepting or Rejecting a for Accepting or Rejecting a

Special Sales OrderSpecial Sales Order

A special order decision requires that A special order decision requires that management determines a sales price below the management determines a sales price below the

normal price.normal price.

Special order situations include:Special order situations include:

The Special Sales OrderThe Special Sales OrderThe Special Sales OrderThe Special Sales Order

1.1. Jobs that require a bid, are taken during slack Jobs that require a bid, are taken during slack periods, or are made to buyer’s specifications.periods, or are made to buyer’s specifications.

2.2. Private – label orders in which buyer’s name Private – label orders in which buyer’s name (rather than the sellers) is used on the product. (rather than the sellers) is used on the product. Companies may accept these jobs during slack Companies may accept these jobs during slack

periods to more efficiently utilize available periods to more efficiently utilize available capacity.capacity.

3.3. Orders of unusual nature (because of quantity, Orders of unusual nature (because of quantity, method of delivery, or packaging), or because method of delivery, or packaging), or because

the products are being tailor-made to customer the products are being tailor-made to customer instructions.instructions.

4.4. Special pricing can be used when producing Special pricing can be used when producing goods for a one- time job, such as an overseas goods for a one- time job, such as an overseas

order that will not affect domestic sales.order that will not affect domestic sales.

Typically, the sales price quoted on a special Typically, the sales price quoted on a special order should be high enough to cover the order should be high enough to cover the

variable costs of the job and any incremental variable costs of the job and any incremental fixed costs and generate a profit.fixed costs and generate a profit.

Some important factors must be considered before Some important factors must be considered before recommending acceptance of a special order:recommending acceptance of a special order:

It is assumed that future selling price will not It is assumed that future selling price will not be affected by selling at a price below the be affected by selling at a price below the

normal or the going market pricenormal or the going market price

It would not affect total fixed costsIt would not affect total fixed costs

It would use some idle manufacturing It would use some idle manufacturing capacitycapacity

It would not require any additional variable It would not require any additional variable selling and administrative expenses.selling and administrative expenses.

Special pricing may provide work for a period of Special pricing may provide work for a period of time, but it can not be continued over the long time, but it can not be continued over the long

run. To remain in business, a company must set run. To remain in business, a company must set selling prices to cover total costs and provide a selling prices to cover total costs and provide a

reasonable profit.reasonable profit.

The Current Income StatementThe Current Income Statement(thousand of dollars )(thousand of dollars )

ExampleExample

Sales (1 million units)Sales (1 million units)20,00020,000

Less: Less:

Manufacturing cost Of goods soldManufacturing cost Of goods sold

(3,000 Fixed + 12,000 variable)(3,000 Fixed + 12,000 variable) (15,000)(15,000)

Gross profit Gross profit 5,0005,000

LessLess

Selling & administrative expensesSelling & administrative expenses(2,900 Fixed + 1,100 variable )(2,900 Fixed + 1,100 variable )

4,0004,000

Operating incomeOperating income 1,0001,000

Contribution Margin Income StatementContribution Margin Income Statement Sales Sales 20,00020,000

Less: Variable expensesLess: Variable expenses

Manufacturing cost Manufacturing cost (12,000)(12,000)

Selling & admin. expensesSelling & admin. expenses(1,100)(1,100)

13,10013,100

Contribution MarginContribution Margin6,9006,900

Less : Fixed expensesLess : Fixed expenses

Manufacturing costManufacturing cost(3,000)(3,000)

Selling & admin. expensesSelling & admin. expenses(2,900)(2,900)

5,9005,900


Suppose a customer offered L.E.13 per unit for a Suppose a customer offered L.E.13 per unit for a 100,000 units special order.100,000 units special order.

Should this company accept or reject this Should this company accept or reject this order?order?

What is the difference in the short run What is the difference in the short run financial results between accepting and not financial results between accepting and not

accepting the order?accepting the order?

Illustrative casesIllustrative cases

1.1. Would not affect the normal prices and Would not affect the normal prices and sales quantitysales quantity

2.2. Would not affect total fixed costsWould not affect total fixed costs3.3. Would not require any additional variable Would not require any additional variable

selling expensesselling expenses4.4. Would use some idle manufacturing Would use some idle manufacturing

capacity.capacity.

Case (1)Case (1) ::

Assuming that special sales order (SSO)Assuming that special sales order (SSO) ::

SolutionSolutionComparative income statementComparative income statement

Without Without SSOSSO

(1000 000 (1000 000 units)units)

Effect of SSOEffect of SSO

(100 000 units)(100 000 units)With SSO With SSO

1100 0001100 000 TotalTotalPer Per

unitunit

Sales Sales 20,000,00020,000,0001,300,0001,300,000131321,300,00021,300,000

Less: Less: Variable costsVariable costs

Manufacturing Manufacturing cost cost

12,000,00012,000,0001,200,0001,200,000121213,200,00013,200,000

Selling & admin. Selling & admin. 1,100,0001,100,000----1,100,0001,100,000

Total variableTotal variable costcost13,100,00013,100,0001,200,0001,200,00014,300,00014,300,000

Contribution MarginContribution Margin6,900,0006,900,000100,000100,0007,000,0007,000,000

Less : Fixed Less : Fixed expensesexpenses

5,900,0005,900,000--5,900,0005,900,000

Operating incomeOperating income 1,000,0001,000,000100,000100,0001,100,0001,100,000

SolutionSolution

Case (2)Case (2) ::

The same assumptions of case (1), but assuming The same assumptions of case (1), but assuming SSO would require additional variable selling SSO would require additional variable selling

expense.expense.

SSO priceSSO priceL.E.13L.E.13

Additional cost :-Additional cost :-

ManufacturingManufacturing1212

Selling & admin.Selling & admin.1.11.1

13.113.1

Decrease in profit Per Decrease in profit Per unit of S.S.Ounit of S.S.O

(0.1)(0.1)

Decrease in profit = 0.1 x 100 000 = L.E. 10 000Decrease in profit = 0.1 x 100 000 = L.E. 10 000

Without Without SSOSSO

))10001000 000000 unitsunits((

Effect of SSOEffect of SSO

))100100 000000 unitsunits((

With SSOWith SSO

11001100 000000 TotalTotalPer Per

unitunit

Sales Sales 20,000,00020,000,0001,300,0001,300,000131321,300,00021,300,000


Manufacturing Manufacturing cost cost

12,000,00012,000,0001,200,0001,200,000121213,200,00013,200,000

Selling & admin. Selling & admin. 1,100,0001,100,000110,000110,0001.11.11,210,0001,210,000

Total variableTotal variable costcost13,100,00013,100,0001,310,0001,310,00013.113.114,410,00014,410,000

Contribution MarginContribution Margin6,900,0006,900,000))10,00010,000((6,890,0006,890,000

Less : Fixed Less : Fixed expensesexpenses

5,900,0005,900,000--5,900,0005,900,000

Operating incomeOperating income 1,000,0001,000,000(10,000)(10,000)990,000990,000

Comparative income statementComparative income statement

SolutionSolution

Case (3)Case (3) ::The same assumption as case (2), but assuming The same assumption as case (2), but assuming

that The special sales order would require additional that The special sales order would require additional variable selling expenses and the variable selling variable selling expenses and the variable selling

expenses include 5 % sales commissionexpenses include 5 % sales commission

Without SSOWithout SSO(1000 000 units)(1000 000 units)

Effect of SSOEffect of SSO))10001000 0000 unitsunits((

With With SSOSSO

11001100 000000 TotalTotalPer unitPer unitTotalTotalPer Per

unitunit

Sales Sales 202020201.31.3131321.321.3

Less: Less: Variable costsVariable costs Manufacturing cost Manufacturing cost 121212120.20.2121213.213.2 Sales commissionSales commission11110.0650.0650.650.651.0651.065 Other sellingOther selling expenseexpense0.10.10.10.10.0100.0100.100.100.1100.110

Total variableTotal variable costcost13.113.113.113.11.2751.27512.7512.7514.37514.375

Contribution MarginContribution Margin6.96.96.96.90.0250.0250.250.256.9256.925

Less : Fixed expensesLess : Fixed expenses 5.95.95.95.9----5,9005,900Operating incomeOperating income 11110.0250.0250.250.251.0251.025

) )In millionsIn millions((

SolutionSolution

Case (4)Case (4) ::

The same assumption as case (2), but assuming The same assumption as case (2), but assuming that the variable selling expenses include 5 % sales that the variable selling expenses include 5 % sales

commission and the special sales order would commission and the special sales order would require additional variable selling expenses require additional variable selling expenses

excluding sales commissionexcluding sales commission

S.S.O price per unitS.S.O price per unitL.E.L.E.1313

Less:- Less:- Unit manufacturing variable cost Unit manufacturing variable cost 1212

Unit selling variable cost Unit selling variable cost 0.10.112.112.1

Increase in profit Per unit Increase in profit Per unit 0.90.9Increase in profit = 0.9 x 100 000 = 90, 000Increase in profit = 0.9 x 100 000 = 90, 000

SolutionSolution

Case (5)Case (5) ::

The same assumption as case (1), except that the The same assumption as case (1), except that the order was for 250 000 units and a selling price of order was for 250 000 units and a selling price of

L.E. 11.5L.E. 11.5

Additional revenue 250.000 units @ 11.5 per unit Additional revenue 250.000 units @ 11.5 per unit 2,875, 000 2,875, 000

Less:- additional costs Less:- additional costs

Manufacturing variable costs 250 000 unit @ Manufacturing variable costs 250 000 unit @

L.E. 12 per unit L.E. 12 per unit 3,000, 0003,000, 000

Decrease in operating income from S.S.O Decrease in operating income from S.S.O 125, 000125, 000

Comparative income statementComparative income statement

Without SSOWithout SSO

(1000 000 units)(1000 000 units) Effect of SSOEffect of SSO

(250 000 (250 000 units)units)

With SSO With SSO

1250 0001250 000 Sales Sales 20,000,00020,000,0002,875,0002,875,00022,875,00022,875,000


Manufacturing cost Manufacturing cost 12,000,00012,000,0003,000,0003,000,00015,000,00015,000,000

Selling & admin. Selling & admin. 1,100,0001,100,000--1,100,0001,100,000

Total variableTotal variable costcost13,100,00013,100,0003,000,0003,000,00016,100,00016,100,000

Contribution MarginContribution Margin6,900,0006,900,000(125,000)(125,000)6,775,0006,775,000

Less : Less : Fixed expensesFixed expenses

Manufacturing cost Manufacturing cost (at an average rate of L.E.3 ×1000,000 = 3,000,000 & at an average rate of L.E.2.4 ×2,500,000)

3,000,0003,000,000--3,000,0003,000,000

Selling & admin.Selling & admin.2,900,0002,900,000--2,900,0002,900,000

Total fixedTotal fixed costcost5,900,0005,900,000--5,900,0005,900,000

Operating incomeOperating income 1,000,0001,000,000(125,000)(125,000)875,000875,000

NoteNote

Notice that no matter how fixed Notice that no matter how fixed costs are spread for unit product costs are spread for unit product

costing purposes, Total fixed cost costing purposes, Total fixed cost are unchanged, even though are unchanged, even though

manufacturing fixed cost per unit manufacturing fixed cost per unit fall from L.E. 3.0 to L.E. 2.4fall from L.E. 3.0 to L.E. 2.4

SolutionSolution

Case (6)Case (6) ::The same assumption as case (1), except that The same assumption as case (1), except that

selling price is L.E. 13.5 instead of L.E. 13.00 but a selling price is L.E. 13.5 instead of L.E. 13.00 but a manufacturers agent who had obtained the potential manufacturers agent who had obtained the potential

order would have to be paid a flat fee of L.E. 40 000 order would have to be paid a flat fee of L.E. 40 000 if the order were accepted, what would be the new if the order were accepted, what would be the new special-order difference in operating income if the special-order difference in operating income if the

order were accepted.order were accepted.

Additional revenue 100 000 x L.E. 13.5Additional revenue 100 000 x L.E. 13.51,350, 000 1,350, 000

Less: Less: additional costsadditional costs

Manufacturing variable costs 100 000 unit @ Manufacturing variable costs 100 000 unit @

L.E. 12 per unit L.E. 12 per unit 1,200, 0001,200, 000

Less: Less: Fixed costsFixed costs

Agent's feeAgent's fee40,00040,000

Increase in operating income from S.S.O Increase in operating income from S.S.O 110, 000110, 000

Objective 5Objective 5Analyze Data by the Relevant- Analyze Data by the Relevant-

Information Approach to Support Information Approach to Support a Decision for Adding or Deleting a Decision for Adding or Deleting

a Product Linea Product Line..

Fixed costs are divided into two categories, avoidable Fixed costs are divided into two categories, avoidable and unavoidable. and unavoidable.

The same principles of relevance applied to special The same principles of relevance applied to special orders apply- albeit in slightly different ways to decisions orders apply- albeit in slightly different ways to decisions

about adding or deleting products or departmentsabout adding or deleting products or departments

Avoidable and Unavoidable Costs:Avoidable and Unavoidable Costs:

Deletion or Addition of products or DepartmentsDeletion or Addition of products or Departments Deletion or Addition of products or DepartmentsDeletion or Addition of products or Departments

Avoidable CostsAvoidable Costs

Costs that will not continue if an ongoing operation Costs that will not continue if an ongoing operation is changed or deleted- are relevant. is changed or deleted- are relevant.

Avoidable costs include department salaries and other Avoidable costs include department salaries and other costs that could be eliminated by not operating the costs that could be eliminated by not operating the

specific department.specific department.

Unavoidable costs include many common costs, which Unavoidable costs include many common costs, which are defined as those costs of facilities and services that are defined as those costs of facilities and services that

are shared by users. Examples are store depreciation, are shared by users. Examples are store depreciation, heating, air conditioning, and general management heating, air conditioning, and general management

expenses.expenses.

Unavoidable CostsUnavoidable Costs

Costs that continue even if an operation is halted- Costs that continue even if an operation is halted- are not relevant because they are not affected by a are not relevant because they are not affected by a

decision to delete the department.decision to delete the department.

Represents the excess of revenues over direct variable expenses and avoidable Represents the excess of revenues over direct variable expenses and avoidable fixed expenses. It is the amount remaining to cover unavoidable fixed expenses and, then, fixed expenses. It is the amount remaining to cover unavoidable fixed expenses and, then,

to provide profits. to provide profits.

Segment Margin (or Product Line Margin):Segment Margin (or Product Line Margin):

The segment margin figureThe segment margin figure

Is the appropriate one on which to base Is the appropriate one on which to base continuation, elimination decisions, since it continuation, elimination decisions, since it

provides a measure of the segment's provides a measure of the segment's contribution to the coverage of unavoidable contribution to the coverage of unavoidable

costs. costs.

Management is considering Management is considering dropping the grocery dropping the grocery

department, which has department, which has consistently shown an operating consistently shown an operating loss. The following table reports loss. The following table reports

the stat’s present annual the stat’s present annual operating incomeoperating income

ExampleExample

DepartmentsDepartments

Groceries Groceries

GeneralGeneral

MerchandiseMerchandiseDrugsDrugsTotal Total

Sales Sales L.E.L.E.

1,0001,000L.E.L.E.

800800L.E.L.E.

100100L.E.L.E.

1,9001,900 Variable Costs of Variable Costs of Goods Sold & Exp.Goods Sold & Exp.

80080056056060601,4201,420

Contribution MarginContribution Margin20020020%20%24024030%30%404040%40%48048025%25%

Fixed ExpensesFixed Expenses ((salaries, Depreciation, salaries, Depreciation,

insurance, Property insurance, Property taxes, etc.)taxes, etc.)::

AvoidableAvoidable1501501001001515265265

UnavoidableUnavoidable60601001002020180180

Total Fixed ExpensesTotal Fixed Expenses2102102002003535445445

Operating income Operating income (10)(10)4040553535

Annual Operating IncomeAnnual Operating IncomeIn thousandsIn thousands((

1.1. The only alternatives to be The only alternatives to be considered are dropping or considered are dropping or

continuing the grocery department. continuing the grocery department.

2.2. The total assets invested would be The total assets invested would be unaffected by the decision. The unaffected by the decision. The

vacated space would be idle, and vacated space would be idle, and the unavoidable costs would the unavoidable costs would

continue.continue.

AssumptionsAssumptions

Segment Margin Income StatementSegment Margin Income Statement

Departments Departments

Groceries Groceries

GeneralGeneral

Merchandise Merchandise Drugs Drugs Total Total

Sales Sales L.EL.E . .

1,0001,000

L.E.L.E.

800800L.E. L.E. 100100

L.E. L.E. 1,9001,900

Less: Variable costsLess: Variable costs800 800 56056060601,4201,420

Contribution MarginContribution Margin200 200 2402404040480480

C M %C M %20%20%30%30%40%40%25%25%

Avoidable fixed expensesAvoidable fixed expenses1501501001001515265265

Segment margin Segment margin 50501401402525215215

Unavoidable Fixed costsUnavoidable Fixed costs180180

Operating income Operating income 3535

) )In thousandsIn thousands((

Store as a WholeStore as a WholeTotal Before Total Before

Change Change

(a) (a)

Effect ofEffect ofdroppingdroppingGroceriesGroceries

(b) (b)

Total AfterTotal After

ChangesChanges

(a)–(b) (a)–(b)

SalesSalesL.E.L.E.

1,9001,900L.E.L.E.

1,0001,000900900

Variable expenses Variable expenses 1,4201,420800800620620

Contribution marginContribution margin480480200200280280


Profit contribution to common Profit contribution to common space And other unavoidable space And other unavoidable costscosts 2152155050165165

Common space and other Common space and other unavoidable costsunavoidable costs180180--180180Operating incomeOperating income 35355050(15)(15)

TheThe preceding analysispreceding analysis shows that groceries shows that groceries bring in contribution margin of L.E. 200,000, bring in contribution margin of L.E. 200,000,

which is L.E.50,000 more than the L.E. 150,000 which is L.E.50,000 more than the L.E. 150,000 fixed expenses that would be saved by closing fixed expenses that would be saved by closing

the grocery department. So the matters would be the grocery department. So the matters would be worse, rather than better, if groceries were worse, rather than better, if groceries were

dropped and vacated facilities left idle.dropped and vacated facilities left idle.

Assume that the space made available by Assume that the space made available by the dropping of groceries could be used to the dropping of groceries could be used to

expand the general merchandise department, and expand the general merchandise department, and this would increase sales by L.E. 500.000, and this would increase sales by L.E. 500.000, and

have avoidable fixed costs of L.E. 70.000.have avoidable fixed costs of L.E. 70.000.

Effects of ChangesEffects of ChangesTotal Before Total Before

Change Change

(a) (a)

DropDrop

GroceriesGroceries

(b) (b)

Expand GeneralExpand General

Merchandise (c) Merchandise (c) Total AfterTotal After

ChangesChanges

(a)–(b)+(c) (a)–(b)+(c)

SalesSalesL.E.L.E.

1,9001,900L.E.L.E.

1,0001,000L.E.L.E.

5005001,4001,400Variable expenses Variable expenses 1,4201,420800800350350970970


Avoidable fixed Avoidable fixed expensesexpenses2652651501507070185185

Contribution to Contribution to common space And common space And other unavoidable other unavoidable costscosts 21521550508080245245

Common space and Common space and other unavoidable other unavoidable costscosts180180----180180Operating incomeOperating income 3535505080806565

Profit Contribution of Given Profit Contribution of Given SpaceSpace

GroceriesGroceries

Expansion of Expansion of

General General

Merchandise Merchandise DifferenceDifference

SalesSalesL.E.L.E.

1,0001,000L.E.L.E.

500500500500

Variable expenses Variable expenses 800800350350450450



contribution to common contribution to common space space and other unavoidable and other unavoidable costscosts505080803030

National Ltd. is a wholesaler who sells its National Ltd. is a wholesaler who sells its

products to a wide range of retailers. products to a wide range of retailers.

Marketing is done through three geographical Marketing is done through three geographical

areas: the south, The Midlands and the North. areas: the south, The Midlands and the North.

The estimates of the costs and revenues for The estimates of the costs and revenues for

each sales territory for the next accounting each sales territory for the next accounting

period are as follows:period are as follows:

Example: Deleting a SegmentExample: Deleting a Segment

SouthSouth MidlandsMidlands NorthNorth TotalTotal SalesSalesL.E.L.E.L.E.L.E.

800800L.E.L.E.L.E.L.E.

900900L.E.L.E.L.E.L.E.

900900L.E.L.E.

2,6002,600Cost of goods Sold (variable)Cost of goods Sold (variable)4004004504505005001,3501,350

Gross profitGross profit4004004504504004001,2501,250

Selling costsSelling costs::

Salesmen's SalariesSalesmen's Salaries 8080100100120120

Sales office & management Sales office & management ExpensesExpenses

404060608080

AdvertisingAdvertising505050505050

Salesmen’s expensesSalesmen’s expenses505060608080

220220270270330330

HeadquartersHeadquarters

Administration ExpensesAdministration Expenses808090909090

Warehousing CostsWarehousing Costs303036363636

Total costsTotal costs33033039639645645611821182

Net profit (or loss)Net profit (or loss) 70705454(56)(56)6868


The products are packed and dispatched The products are packed and dispatched from a central warehouse and it is estimated that from a central warehouse and it is estimated that

50% of the warehousing costs are variable and 50% of the warehousing costs are variable and the remainder are fixed. All of the selling costs the remainder are fixed. All of the selling costs

are fixed with the exception of salesmen's are fixed with the exception of salesmen's expenses, which are variable with sales revenue. expenses, which are variable with sales revenue. All of the administration expenses of the head – All of the administration expenses of the head –

quarters are common and unavoidable to all quarters are common and unavoidable to all alternatives and have been apportioned to sales alternatives and have been apportioned to sales

territories on the basis of sales value. territories on the basis of sales value.

In view of the loss, should the North area be In view of the loss, should the North area be closed?closed?

SolutionSolution

Sales revenue Sales revenue

L.E.L.E.

900,000900,000

Variable Costs:Variable Costs: Cost of goods SoldCost of goods Sold500,000500,000

Salesmen‘s expensesSalesmen‘s expenses80,00080,000 Warehousing CostsWarehousing Costs18,00018,000

598,000598,000

Contribution MarginContribution Margin302,000302,000

Avoidable costs (fixed selling Avoidable costs (fixed selling expenses)expenses)

250,000250,000


Note thatNote that the fixed selling expenses are relevant the fixed selling expenses are relevant to the decision because they will be eliminated if to the decision because they will be eliminated if

the North area is closed.the North area is closed.

You can see from this calculation that profit You can see from this calculation that profit will decline by L.E. 52,000 if the North area is will decline by L.E. 52,000 if the North area is

closed because the company will lose a closed because the company will lose a contribution of L.E 52,000 toward the unavoidable contribution of L.E 52,000 toward the unavoidable

fixed costs (the administration and warehousing fixed costs (the administration and warehousing fixed costs).fixed costs).

Whenever a segment of a business can Whenever a segment of a business can provide a contribution toward meeting common provide a contribution toward meeting common and unavoidable (general) fixed costs it should and unavoidable (general) fixed costs it should

not be closed or dropped, always assuming that not be closed or dropped, always assuming that facilities have no alternative use which would facilities have no alternative use which would

yield a height contribution, and that the sales in yield a height contribution, and that the sales in other segments are unaffected by the decision.other segments are unaffected by the decision.

The projected income statement if the North The projected income statement if the North area is closed is as follows :area is closed is as follows :

SouthSouth MidlandMidlandss

TotalTotal

SalesSalesL.E.L.E.L.E.L.E.800800

L.E.L.E.L.E.L.E.900900

L.E.L.E.1,7001,700

Less: Less: Variable Costs Variable Costs

Cost of goods SoldCost of goods Sold400400450450

Salesmen‘s expensesSalesmen‘s expenses50506060

Warehousing CostsWarehousing Costs15151818

465465528528993993

Contribution MarginContribution Margin335335372372707707

Less: Less: Avoidable Fixed CostsAvoidable Fixed Costs

Salesmen's SalariesSalesmen's Salaries8080100100

Sales office & management expensesSales office & management expenses40406060

AdvertisingAdvertising50505050

170170210210380380

Segment MarginSegment Margin165165162162327327

Less: Less: Unavoidable Fixed CostsUnavoidable Fixed Costs

Administration ExpensesAdministration Expenses(260)(260)

Warehousing CostsWarehousing Costs(51)(51)

Net profit (or loss)Net profit (or loss) 1616


Total profit is reduced by L.E. 52,000Total profit is reduced by L.E. 52,000..

NoteNote

Note that some fixed costs ( for Note that some fixed costs ( for example, fixed selling expenses) may example, fixed selling expenses) may

change when a particular alternative is change when a particular alternative is being considered and can become being considered and can become

relevant costs. relevant costs.

It can be stated, however, as a It can be stated, however, as a general rule that common and general rule that common and

unavoidable fixed costs which are unavoidable fixed costs which are allocated to cost objectives on the basis allocated to cost objectives on the basis

of apportionments are not relevant for of apportionments are not relevant for decision – making purposes.decision – making purposes.

Objective 6Objective 6Compute a Measure of Product Compute a Measure of Product Profitability when Production is Profitability when Production is

Constrained by a Scarce ResourceConstrained by a Scarce Resource..

The contribution approach also applies here, The contribution approach also applies here, because the product to be emphasized or the orders to be because the product to be emphasized or the orders to be

accepted is the one that makes the biggest total profit accepted is the one that makes the biggest total profit contribution per unit of the Limiting factor.contribution per unit of the Limiting factor.

Optimal Use of Limited ResourcesOptimal Use of Limited ResourcesOptimal Use of Limited ResourcesOptimal Use of Limited Resources

A Limiting Factor or Scarce ResourceA Limiting Factor or Scarce Resource

Is the item that restricts or constraints Is the item that restricts or constraints the production or sale of a product or the production or sale of a product or

service.service.

Limiting factors include labor-hours and Limiting factors include labor-hours and machine-hours that limit production and hence machine-hours that limit production and hence

sales in manufacturing firms, and square feet of sales in manufacturing firms, and square feet of floor space or cubic meters of display space that floor space or cubic meters of display space that

Limit sales in department stores.Limit sales in department stores.

The contribution approach must be used The contribution approach must be used wisely, however, Managers sometimes mistakenly wisely, however, Managers sometimes mistakenly

favor those products with the biggest favor those products with the biggest contribution margin or gross margin per sales contribution margin or gross margin per sales

pounds, without regard to scarce resources.pounds, without regard to scarce resources.

ExampleExample

Optimal Use of Limited ResourcesOptimal Use of Limited Resources AABBCC

Sales priceSales price

L.E.L.E.100100

L.E.L.E.5050

L.E.L.E.1010

Per unit variable costPer unit variable cost6060252577

Per unit contribution marginPer unit contribution margin4040252533

RankingRanking112233 C M %C M %40%40%50%50%30%30% RankingRanking221133 Hours needed to produce one unitHours needed to produce one unit8822½½ C M per hourC M per hour5512.512.566 RankingRanking331122 DemandDemand5000500020,00020,00080,00080,000 Hours neededHours needed40,00040,00040,00040,00040,00040,000 TotalTotal120,000120,000 Hours availableHours available100,000100,000

Optimal AllocationOptimal AllocationHours usedHours usedBalanceBalance

(Remaining hours)(Remaining hours)

Product B Product B (20,000 (20,000 ×× 2) 2)40,00040,00060,00060,000

Product C Product C (80,000 (80,000 ×× ½ ) ½ )40,00040,00020,00020,000

Product A Product A (20,000 (20,000 //8)= 8)= 2,5002,500

20,00020,000--

OptimalOptimal mix mixQQPer unit CMPer unit CMTotal CMTotal CM

AA2,5002,5004040100,000100,000

BB20,00020,0002525500,000500,000

CC80,00080,00033240,000240,000

840,000840,000

Total Contribution MarginTotal Contribution Margin

Wrong allocation based on per unit CMWrong allocation based on per unit CMMixMixQQPer unit CMPer unit CMTotal CMTotal CM

AA5,0005,0004040200,000200,000

BB20,00020,0002525500,000500,000

CC40,00040,00033120,000120,000

820,000820,000

Wrong allocation based on CMWrong allocation based on CM%%

MixMixQQPer unit CMPer unit CMTotal CMTotal CM

BB20,00020,0002525500,000500,000

AA5,0005,0004040200,000200,000

CC40,00040,00033120,000120,000

820,000820,000

Difficulties may arise in applying this Difficulties may arise in applying this procedure when there is more than one scarce procedure when there is more than one scarce

resource. It could not be applied if, for example, resource. It could not be applied if, for example, Labor hours were also scarce and the Labor hours were also scarce and the

contribution per labor hour resulted in product Y contribution per labor hour resulted in product Y being ranked first, followed by products X and Z.being ranked first, followed by products X and Z.

In this type of situation where more than one In this type of situation where more than one resource is scarce it is necessary to resort to resource is scarce it is necessary to resort to

linear programming methodslinear programming methods in order to in order to determine the optimal production program.determine the optimal production program.

Thank youThank you