MARGINAL COSTING & DECISION MAKING

Managerial decision making is an all pervasive functional area in the organization. The
decision making process may involve various stages that lead on into another. This may be over
a long term or short term period.

There are a number of decision making situations that may involve the application of
management accounting principles Generally a marginal accounting approach is taken since
the decisions may only involve the variable costs. However, where a decision may involve
changes in the fixed cost, this will have to be factored in.

1. LIMITING FACTOR

A limiting factor exist where a firm produces a number of items and is confronted with a
scare supply of a resource, such as raw material, or labour supply. The main issue here is
on deciding what is the best product mix, given the scare resource.

There are three main steps to be followed when dealing with a limiting factor situation :

a. calculate the contribution per unit for each product

b. convert the contribution per unit for each product to contribution per unit of the
scarce resource
c. chose the product mix based on the higher contribution per unit of the scarce
resource.

However, aside from the higher contribution, the firm may have to take into consideration
such factors as the demand limitation, legal obligations, product loss leader policy, etc

e.g. Bob the Builder makes two products – windows and doors, with the following data

Window Door
Selling Price $20 $30
Variable Cost $10 $18
Labour 4 hrs 3 hrs
Material 2m 6m
Max Demand 200 100

What is the optimum product mix given that

a. Labour is limited to 500 hrs

b. Material is limited to 600 m

1
Solution :
In applying the steps above, we first find the contribution per product unit, then rank that
contribution in terms of the scarce resource :

Window Door
Selling Price per unit $20 $30
Variable Cost per unit $10 $18
------ ------
Contribution per unit $10 $12

Contribution per unit of labour $2.50 $4

Contribution per unit of material $5 $2

Therefore, if labour is scarce, we make more of the doors and less of the windows, since
doors earn more on a per unit of labour basis.

Likewise we make more of the windows and less of the door if material is limited

The optimum product mix when labour is scarce is as follows :

Sales
100 doors @ $30 3000
50 windows @ $20 1000 4000
------
Variable Cost
100 doors @ $18 1800
50 windows @ $10 500 2300
------- -------
Contribution 1700
=====

If material was the scare resource, the product mix would be as follows :

Sales
200 windows @ $20 4000
33 doors @ $30 990 4990
------
Variable Cost
200 windows @ $10 2000
33 doors @ $18 594 2593
------- -------
Contribution 2396
=====

2
2. MAKE OR BUY

The firm may be faced with the option of making its products, or to buy them from an
outside source. The main approach here is to decide which is the more profitable option.

Again the variable costs would be the first consideration. However, the impact on the fixed
costs should not be overlooked.

e.g. Elmo’s Swirl produces and sells 5,000 units of Noodle Soup with the following data
Selling price $ 25
Variable cost per unit $13
Fixed costs $48,000

Elmo received an offer from Dorothy’s Do It All who can supply the noodle soup
at a cost of $14 per unit. This would result in a cutting back on fixed costs by
$16,000. Should Elmo continue to make the soup, or should he buy from Dorothy’s ?

Solution

TO MAKE TO BUY
-------------- ---------------
$ $
Sales 125,000 Sales 125,000
Variable Cost 65,000 Purchases 70,000
----------- ----------
Contribution 60,000 Contribution 55,000
Fixed Costs 48,000 Fixed Costs 32,000
----------- ----------
Net Income 12,000 Net Income 23,000
======= =======

From this analysis, it would be better to buy from Dorothy’s at the higher purchase price,
since there is a lower fixed cost involved.

However, there may be non accounting factors to consider, such as the control over the
quality of the soup, as well as the reliability in the supply. Also what will be the impact on
the existing staff morale if there should be a cut back in production staff. Additionally,
what if Dorothy’s begin to monopolize the market and then increase its price?

3
3. DROPPING A PRODUCT LINE

A firm that produces a number of products may be faced with a situation where one of the
products shows a net loss. Should this product be eliminated ?

e.g. Grover’s Green Grocery trades in three main items : apples, banana, and carrot, with
the following result

A B C
Sales 10,000 15,000 25,000
Variable Costs 6,000 8,000 12,000
--------- --------- ----------
Contribution 4,000 7,000 13,000
Fixed Costs 3,000 8,000 6,500
--------- --------- ----------
Net Income 1,000 (1,000) 6,500
===== ====== ======

The issue at hand is should the banana line be dropped? It has been ascertained that
$6,500 of the fixed costs in B would be eliminated if the department is closed.

A comparative analysis of the situation would be helpful

Keep Banana Drop Banana Difference

Sales 50,000 35,000 (15,000)
Variable Costs 26,000 18,000 8,000
---------------- -------------- -------------
Contribution 24,000 17,000 ( 7,000 )
Fixed Costs 17,500 11,000 6,500
---------------- -------------- -------------
Net Income 6,500 6,000 (500)
========== ========= ========

From the above, it can be seen that if the Banana line was to be dropped, there would be
reduction in the net income by $500.

As part of the analysis, it can be seen that the Banana line produces a healthy contribution
of $7,000. It would be helpful to determine if the fixed cost allocation is appropriately
carried out.

Other factors in the issue of dropping a product line are : the effect of the product on the
performance of other product, the legal commitment to suppliers or clients, the impact on
staff morale, the use of the redundant space and equipment, etc.

4
4. SPECIAL ORDER

A special order situation exist when a client places an order for a supply of goods at a rate
outside the regular selling price. This is usually a one off order, and should not conflict
with the firm’s regular trading activities

e.g. The Bulla Guinegog is a trader in bulla cakes, with the following details : selling price
$10 each, variable cost $5 each, while fixed cost total $40,000. The firm has the capacity
to produce 10,000 units. However activities for the year are at 8,500 units. A prospective
client has placed a special order to purchase 500 units @$7.50 each. Should this order
be accepted.?

The analysis here involves several factors. One is the capacity, i.e. can the existing
capacity accommodate this special order, or will it require additional outlay, or interfere
with existing output. Another factor that is closely associated with the capacity is the fixed
cost. At full capacity fixed cost per unit would be $4, making the total cost per unit $9.
However, the firm is not at full capacity, and would break even at 8,000 units. Therefore
the margin of safety could be valued at a minimum of $5 each, the variable cost.

Thus, the special order is within the margin of safety, and within capacity. It could therefore
be accepted.

The result would be as follows

Existing Existing Plan

Plan Alone & Special Order

Sales 85,000 88,750

Variable Cost 42,500 45,000
---------- -----------
Contribution 42,500 43,750
Fixed Costs 40,000 40,000
--------- -----------
Net Income 2,500 3,750
====== =======

Additional factors that may impact on the consideration include the impact of the lowered
price on the existing clients, and the prevention of the special order from exploiting the
existing market, the continued request for the goods at the special price.

5
5. SPECIAL PROJECT

Here the firm must chose from one or more projects, which in most cases it is limited to
only one. Incorporating the principles from capital budgeting, we take a further look at the
analysis of the projects.

e.g. Mr. Jacko Haltrade is considering one of two projects – vege patties or kiss cakes,
Each has different operating requirements but there is a capacity to produce up to 10,000
units. Current constraints allow for the following budgeted activities :

Vege-Patties Kiss Cakes

Sales (6000 @ 20) 120,000 Sales (6,000 @ 25) 150,000

Vcosts Material @6 36,000 V Costs Material @ 7 42,000

Labour @ 5 30,000 Labour @ 3 18,000
Expenses @1 6,000 Expenses @ 1.5 9,000
-------- ----------
72,000 69,000
---------- -----------
Contribution 48,000 Contribution 81,000
Less F Costs 25,000 Less F Costs 60,000
---------- ----------
Net Income 23,000 Net Income 21,000
====== ======

Which project should Mr. Haltrade chose?

The answer lies beyond the current plan which would tend to indicate that the vege-
patties seem more profitable. Remember that the firm has additional capacity, and would not
necessarily increase fixed costs with additional output.
At present the kiss cakes has variable costs of $11.50 while the vege – patties have a
variable cost of $12. In the long run the kiss cakes would be more profitable since the
contribution per unit is $13.50, while that for the vege patty is only $8.00

NON FINANCIAL FACTORS

In making decisions, the firm should look beyond the profit line, and incorporate such non
financial factors as

- the impact of a decision on staff morale

- the impact on quality and quantity of output
- competition in the market
- legal or contractual obligations
- impact of one product on the success of other products

6
TUTORIAL QUESTIONS.

1. Sachin Tendulkar manufactures two products : Indian Roti and Vege Soup. Data for
the two products for 2001 are as follows :

Indian Vege
Roti Soup

Selling price $50 $60

Variable cost $35 $40
Time to complete 1 hr 1 hr
Material needed 20 g 30 g
Max. demand 500 units 800 units

Required :

a. Calculate the optimum product mix given that :

i material is limited to 30,000 g
ii labour is limited to 1000 hours

c. Calculate the income for each product mix

2. A manufacturing company has four product lines with the following production data :

-------------------PRODUCTS-------------------
A B C D

Selling price ($) 20 30 40 36

Labour Cost ( @ $2 per hr) 6 4 14 10
Material Cost ( @ $1 per kg ) 6 18 10 12

Maximum demand (units ) 5000 5000 5000 5000

Required :

Based on the above data, what is the most appropriate mix under the assumption that :

a. labour hours is limited to 50,000 hrs

b. material is limited to 110,000 kg

7
3. Fruta is a trader in fruit juice. It has the capacity to make 5,000 unit per annum, with
associated costs consisting of raw material @ $4; direct labour @ 8, and overheads @
$16.

The finished product could be purchased from another supplier @ $20 each. This would
eliminate ¾ of the fixed costs. Should the firm make or buy the product ? Explain.

4. Among the product lines at the Moyston Manufacturing Co. is the HB Pencil. The
Current production level is 50,000 unit per annum, with the following associated costs
per unit :

Materials 2.50
Labour 1.25
Variable OH 1.75
Fixed OH 3.50

The pencils can be brought from Faber Manufacturing for $7.75 each.

Required :

i. Should Moyston continue its pencil production or should it purchase from

Faber, given that either of the following situations :

a. Fixed OH costs would remain b. Fixed OH would be cut by 50%

ii. What other information would you find useful in the analysis above?

5. A cinema chain in Jamaica operates three cinemas, one each in Kingston, Montego Bay
and Ocho Rios. The ticket price in all the cinemas is $8 each. The income statement for
last year was as follows :

KGN MBY OR
Receipts 700,000 700,000 400,000

Costs Film 350,000 200,000 195,000

Labour 150,000 125,000 80,000
Overheads 250,000 350,000 175,000
--------- --------- -----------
650,000 675,000 450,000
----------- ---------- -----------
Income 50,000 25,000 (50,000)
======= ====== =======
Included in the overhead costs are fixed costs of $360,000 allocated in the ratio of
ticket sales.

8
i. Should the Ocho Rios cinema be closed ? .
ii What other information would you wish to incorporate into your analysis?

6. The Spartan Company has an annual capacity of 25,000 units. Plans for the current
are include :

Sales ( 20,000 @ $50 ) 1,000,000

Variable Prod. Costs (20,000 @ 40) 800,000
Fixed Prod. Costs 30,000
Variable Selling ( 20,000 @ 7) 140,000
Fixed Admin 7,000

A special order has been received from a prospective client for 4,000 units at $45
each. The current sales team will not handle this order, as the client will make all the
necessary arrangements.

i. Should the order be accepted ?

ii. What non financial factors would add to your analysis?

7. The Chan Manufacturing Co. has three product lines with the following data

Product 12 Product 23 Product 13

Sales 32,000 50,000 45,000

Total Costs 36,000 38,000 34,000
--------- -------- ----------
Net Income ( 4,000) 12,000 11,000
====== ====== ======
It has been ascertained that the total costs comprise 2/3 variable and 1/3 fixed.
The directors are contemplating to drop Product 12.

Required :

a. What would be your recommendation?

b. What other data would you wish to bring to the table ?

9
8. The Grey Flannel produces a perfume called Breathless. The company is currently
producing 100,000 units, with the following cost considerations :

Direct material 6.00 per unit

Direct labour 1.00 per unit
Variable overhead 0.50 per unit
Fixed overhead 0.50 per unit

The firm is considering to purchase the perfume from an overseas firm for $7.25 per
unit, plus an additional cost of 0.40 per unit for shipping and handling. The current
productive capacity would be re-deployed to another product line called After Dark, which
would result in an increase in its contribution by $20,000.

Required :

a. Should the Grey Flannel continue to manufacture Breathless or should it purchase

from the overseas supplier?

b. What other considerations would you need before making a final decision?

9. The Gas Glow Grill Co. sells three models of barbeque grills : Super Deluxe, Deluxe,
and Matchless. Accounting data for the year 1998 was summarized as follows

SD D M
Sales ($) 200,000 240,000 200,000
Variable Costs 120,000 180,000 160,000
------------------------------------------------
Contribution 80,000 60,000 40,000
Fixed Costs 60,000 50,000 50,000
------------------------------------------------

Net income 20,000 10,000 ( 10,000)

=============================

The directors are considering to drop the Matchless line given its net loss.

Required ;

i. Show by calculation whether it is prudent to drop the product, given that the fixed
costs would not be eliminated

ii. Assuming that the fixed costs would be eliminated, what other factors would you rely
on before making a final decision?

10