COST FOR DECISION MAKING

1.1 Definition of Decision Making

Decision making is the essence of all management activity and naturally, accounting plays a

role in informing decisions. Making correct decisions is one of the most important tasks of a

successful manager.  Every decision involves a choice between at least two

alternatives.  Decision making is a process of choosing among a set of alternative courses of

action with a view to attain the firm’s objectives. The costing system of any organisation is

integral in the decision making process. The costing system of the firm, for which the

accountant is responsible, has to report on the cost of products and services from which

decisions to discontinue redesign, make or buy, etc. have to be made. The quality of the

decision generally reflects the quality of the information provided to management by the

accountant.

Decision making is a future oriented activity; it involves forecasting and planning. What has

happened in the past is only of historical value. The function of decision making is to choose

alternatives for the future. There two perquisites for making efficient and effective decisions.

First, of all possible alternatives should be carefully delineated. A manager may choose a best

alternative form among the alternatives considered by him; but he may fail to consider some

other available alternatives which may be better than the chosen alternative. Second, the

objective should be correctly set. A wrong objective can lead to the adoption of undesirable

and unprofitable course of action.

The decision process may be complicated by volumes of data, irrelevant data, incomplete

information, an unlimited array of alternatives, etc.   The role of the managerial accountant in

this process is often that of a gatherer and summarizer of relevant information rather than the

ultimate decision maker. In this regard, cost data are the most crucial quantitative factors

needed for making decisions. A distinction between relevant and irrelevant cost data should

be drawn. All costs are not relevant in decision making. A cost is relevant if it is pertinent to

the decision under consideration. A relevant cost is also a cost that differs between

alternatives. In other words, cost which varies as a consequence of the decision is a relevant

cost. A relevant cost for a particular decision is one that changes if an alternative course of

action is taken. Relevant costs are also called differential costs. Any cost that does not differ

between alternatives is irrelevant and can be ignored in a decision.  Sunk costs (costs already

irrevocably incurred) are always irrelevant since they will be the same for any alternative.   In

addition, an avoidable cost which can be eliminated (in whole or in part) by choosing one

alternative over another is a relevant cost. Relevant cost includes concepts such as differential

cost and marginal cost and contrition approach.

 

 To identify which costs are relevant in a particular situation, take this three step approach:

1. Eliminate sunk costs

2. Eliminate costs that do not differ between alternatives

3. Compare the remaining costs and benefits that do differ between alternatives to make

the proper decision

1.1.1 Decision Making Process

A manager should take the following steps to make decision s intelligently and skilfully;

1. Definition of objectives/ Identification of problems: The first stage in decision making

process should be to specify the goal and objectives of the organisation. The basic

objective of most businesses is to maximise profit or shareholders’ wealth. Also, the firm

should recognise the problems for which the decisions have to be made.

2. Search for Alternatives: The firm must search for a range of possible alternatives or

courses of action that might help achieve the objectives of the firm or solve the problem

on hand. For decision making be successful, the firm must be able to identify all available

alternatives. It must have information in order to make a valid choice between the

alternative courses of action. The search for alternatives involves information concerning

future opportunities and environments

3. Evaluation of Alternatives: The firm should evaluate the alternatives by analysing the

costs and benefits. All alternatives should be assessed on their own merits to ascertain

their contribution to the attainment of the objectives of the firm. In this regard several

techniques or methodologies can be used to evaluate the viability of the various courses

of action available to the firm.

4. Selection of Alternative: Once alternative courses of action have been selected, they

should be implemented. Implementation forms a crucial aspect of the decision making

process in that no matter how good the decision is, if not implemented, it will not yield

the necessary results.

5. Comparison of Actual to Planned Outcome: After the selected alternative courses of

action have been implemented, the outcome of the implemented course of action is

compared to the planned to ascertain whether the alternative has generated the desired

results.

6. Taking Corrective Measures: The firm should take corrective actions to correct any

deviations in the implemented courses of action.

1.2 Relevant Information for Decision Making

Relevant costs are costs which are influenced by decisions taken. Therefore all other costs are

irrelevant. The same distinction can apply to information concerning revenues. Costs

generally fixed but variable for the period of the decision are relevant while all generally

variable but fixed for the period of the decision are irrelevant. It is important to appreciate

that all in all decision analysis economic values are used and not historical costs which mean

that it will not be possible to extract this data directly from the financial accounts. Some

values in the financial accounts will not be relevant.

1.2.1 Guidelines for Determining Relevant Costs

1. Materials: If raw materials has been acquired and held in the stock records at its

purchase cost this will be the purposes of the financial accounting records. This purchase

cost is not the relevant cost for material for any future decision. The relevant cost of the

material will be determined by whatever courses of action are opened to the firm. If the

material to be used in the production of a product is in regular use, the relevant cost is the

future replacement cost, on the basis that once applied to the chosen decision a further

material purchase will be needed to restore the company to its original state. If, on the

other hand the company cannot conceive of a use for the material except for its use on the

product then the relevant cost to be used is the anticipated disposal value of the material

(realisable value)when evaluating and costing the product. To incorporate this disposal

value into a costing of the product is to use it as an opportunity cost. Finally, if the

material cannot be disposed of and the only option is to use it on the product then the

relevant cost is zero, this material can be used for nothing. Incidentally, its use on the

product saved the company from having to pay for disposal of the material. Notice in no

case is the original acquisition cost used.

If any of the future costs and benefits have applying to them some contractual obligation

this is not relevant. In other words, the company is already committed to them, ay due to a

past contract of some kind, then these committed future costs and benefits are not relevant

to the decision at hand.

2. Labour: The principle here is if there is spare capacity then the labour cost will only be

relevant if either extra hand were contracted or overtime work was done by the workers.

If there is no spare capacity but the production of another product has to be abandoned to

create space, then the relevant cost is the contribution from alternative products which

must be abandoned to create spare capacity. This is against the backdrop that contracts of

employment and acknowledged social responsibility of employers it is possible that

reduction, removal or manipulation of a work force may not be easy or cost free.

3. Overheads: Only future costs and benefits are relevant. Hence only those overheads that

vary as a direct result of the decision taken are relevant overheads. For instance,

depreciation, an overhead cost is never relevant to a decision about its use or non-use.

Short-term management decisions can be made using full costing, variable costing, or

incremental analysis. Full costing often involves preparing side-by-side income statements

and identifying the differences. Incremental analysis is most often the straightest forward, the

shortest, the easiest, and the best approach to decision making because it helps managers

focus on the relevant parts of a decision. A manager that uses full or variable costing wastes a

lot of time capturing and listing costs that will not impact the decision at hand. This is

because they do not differ between decisions. 

Two potential problems that should be avoided in relevant cost analysis are

(i) Do not assume all variable costs are relevant and all fixed costs are irrelevant.

(ii) Do not use unit cost data directly. It can mislead decision makers because

a. it may include irrelevant costs, and

b. comparisons of unit costs computed at different output levels lead to erroneous

conclusions

1.3 Types of Decisions

Relevant cost and revenue information can be used to make decisions with regards to;

a. Make, lease or buy

b. Make special orders

c. Sell or process further

d. Keep or drop products

e. Multiple products and limited resources

1.3.1 Cost Analysis in Make, Lease or Buy Decisions

Management sometimes may have to make a choice between manufacturing the component

parts of a product, or buying them from outside. Such a situation of make or buy decision

may arise whenever the firm has the idle plant capacity and the technical capacity of

manufacturing the component parts. In a make or buy situation, the decision will hinge upon

both qualitative and quantitative factors qualitative consideration include product quality and

the necessity for long-run business relationships with subcontractors. The key quantitative

factors are the differential costs of the make and buy alternatives and the consequences of the

alternative uses of the idle facilities. These factors are best seen through the relevant cost

approach. The relevant cost of the buying alternative will include the purchase price and the

ordering costs. Costs relevant for the make alternative would include the variable costs, viz,

direct material, direct labour and variable overheads and those fixed costs which are

avoidable. If fixed costs are expected to remain unaltered, hey would be irrelevant in the

make or buy decision. The firm should also consider the alternative uses of the idle facilities.

If a more profitable use than manufacturing the parts exists, then the firm may procure the

parts from outside and use facilities for the more profitable alternatives.

Also, you can analyze the costs of the lease or buy problem through discounted cash flows

analysis. This analysis compares the cost of each alternative by considering the timing of the

payments, tax benefits, and interest rate on a loan, the lease rate, and other financial

arrangements. To make t analysis you must first make certain assumptions about the

economic life of the equipment, salvage value, and depreciation. A straight cash purchase

using the firm’s existing funds will almost be more expensive than the lease or loan/buy

options because of the loss of the use of funds.

Reasons to Buy from Outside

Flexibility to meet urgent demand of customers;

Overcome limiting factor problem

Concentrate on its own core competencies; Take advantage of the specialist skill and expertise of the outsiders; Overcome production bottleneck and Solve seasonal demand problem

Illustration 1

Suppose a firm manufactures 1000 units of a part and has the following cost structure:

Cost Per Unit Cost (GH¢) Cost of 1000 units (GH¢)

Direct materials 2 2000

Direct labour 6 6000

Variable overheads 3 3000

Fixed Overheads 4 4000

Total 15 15000

An outside supplier offers to the firm to sell the parts for GH¢13 each. Should the company

accept the offer? One may argue that the answer is obvious. The cost of buying the part GH

¢1 is less than the cost of manufacturing the part (GH¢15), therefore, the part should be

bought. The comparison is not correct. To decide correctly, the differential manufacturing

cost of GH¢4000 should be considered, which may be unavoidable, that is, it will have to be

incurred whether the part is made or bought from outside. Then those fixed costs are not

relevant in making the comparison. The relevant cost of manufacturing part, thus, would be

GH¢11 only. If we assume that the idle facilities cannot be put to an alternative use, then the

firm should decide to me the part rather than buy it from outside.

Illustration 2

For many years Lansing Company has purchased the starters that it installs in its standard line

of garden tractors. Due to a reduction in output, the company has idle capacity that could be

used to produce the starters. The chief engineer has recommended against this move,

however, pointing out that the cost to produce the starters would be greater than the current

GH¢10.00 per unit purchase price. The company’s unit product cost, based on a production

level of 60,000 starters per year, is as follows:

Cost Make (GH¢) (GH¢)

Direct materials 4

Direct labour 2.75

Variable manufacturing overheads 0.5

Fixed manufacturing overheads, traceable 3 180,000

Fixed manufacturing overheads

(allocated based on direct labour hours) 2.25 135,000

12.5

An outside supplier has offered to supply the starter to Lansing for only GH¢10.00 per

starter. One-third of the traceable fixed manufacturing costs represent supervisory salaries

and other costs that can be eliminated if the starters are purchased. The other two-thirds of the

traceable fixed manufacturing costs is depreciation of special manufacturing equipment that

has no resale value. The decision would have no effect on the common fixed costs of the

company and the space being used to produce the parts would otherwise be idle.

Required: Should the company make or buy the starters?

Solution

Relevant Cost

Cost Make (GH¢) Buy(GH¢)

Direct materials 4

Direct labour 2.75

Variable manufacturing overheads 0.5

Fixed manufacturing overheads, traceable 1

Purchase Price 0 10

Total relevant cost 8.25 10

Units produced 60,000 60,000

Total cost 495,000 600,000

The two-thirds of the traceable fixed manufacturing overhead costs that cannot be eliminated,

and all of the common fixed manufacturing overhead costs, are irrelevant. The company

would save GH¢105,000 per year by continuing to make the parts itself. In other words,

profits would decline by GH¢105,000 per year if the parts were purchased from the outside

supplier.

Illustration 3

Jackson Company 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.

Cost (GH¢)

Direct materials 15

Direct labour 10

Variable manufacturing overheads 2

Fixed manufacturing overheads, traceable 4

Fixed manufacturing overheads(allocated) 5

Unit product cost 36

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

Jackson Company for GH¢30 each, based on an order of 5,000 parts per year.

Should Jackson Company accept this offer, or continue to make the parts internally?SolutionCost Make (GH¢) Buy (GH¢)

Direct materials 15

Direct labour 10

Variable manufacturing overheads 2

Fixed manufacturing overheads, traceable 1

Purchase price 0 30

Unit product cost 28 30

Units produced 5,000 5,000

Unit product cost 140,000 150,000

Difference in favor of making: GH¢10,000. The depreciation on the equipment and common

fixed overhead are not avoidable costs. Hence, they are not relevant in the decision making.

Illustration 4

Moo Milk 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 GH¢14.00 per thousand jugs. Moo’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:

Cost (GH¢)

Direct materials 4

Direct labour 2.75

Variable manufacturing overheads 3.5

Fixed manufacturing overheads, traceable 3

Fixed manufacturing overheads, common 2.25

Total Production Cost 15.75

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 GH¢30,000 per year. Moo Milk produces

10,000,000 milk jugs per year.

Required: Should Moo Milk make or buy the milk jugsSolution

Cost Make (GH¢) Buy (GH¢)

Direct materials 4

Direct labour 2.75

Variable manufacturing overheads 3.5

Fixed manufacturing overheads, traceable 1.5

Fixed manufacturing overheads, common 0.5

Purchase price 0 14

Unit product cost 12.25 14

Units produced (in thousands) 10,000 10,000

Sub-total 125,500 140,000

Opportunity cost 30,000 0

Product cost 152,500 140,000

Difference in favour of buying: GH¢12,500. The opportunity cost changed the decision from

making to buying the milk jugs.

1.3.2 Cost Analysis to Make Special Order Decisions

Special order decisions involve determining whether a special order from a customer should

be accepted. This type of decision is usually a one-time order that will not impact a

company’s regular sales. Before considered a special order, the company must have idle

capacity, i.e., it should have the ability to complete the special order without expanding its

operations. In other words, it must have capacity that is sitting idle and not being currently

used. The special order decision is based on the difference between the incremental revenue

and the incremental costs. The profit from a special order equals the incremental revenue less

the incremental costs.  As long as the incremental revenue exceeds the incremental costs and

present sales are unaffected, the special order should be accepted.   

Incremental revenues are the additional revenues generated from accepting the special order

that generates additional sales of the product or service. It does not affect current sales as they

will remain the same. Incremental costs are the additional costs incurred from accepting a

special order. Variable product costs will always be incremental and cause profits to decline.

Other variable costs of operations including selling costs like commissions and shipping costs

will be relevant as well. Rarely will cost savings be a consideration in special order decisions.

 What Amounts Are Not Relevant in Special Order Decisions?

All costs that will be incurred regardless if a special order decision is accepted or not are not

relevant for special order decisions. Most often these will be fixed costs. Occasionally the

acceptance of a special order could cause a change in some fixed costs. However this will be

an obvious fact when you analyze the information concerning the special order. Sunk costs

are not relevant with any special order decision process. 

 

When Should Special Orders Be Accepted?

Special orders should be accepted only if:

Incremental revenue exceeds incremental costs

Present sales are unaffected

The company has idle capacity to handle the order 

Special orders which do not meet these criteria should generally not be accepted. Of course,

soft-benefits should be considered as well.

 

Accept or Reject?

If incremental revenues are less than incremental costs, reject the special order, unless

qualitative characteristics overwhelmingly impact the decision.

 If incremental revenues are greater than incremental costs, accept the special order unless

qualitative characteristics overwhelmingly impact the decision.

 If incremental revenues are equal to incremental costs, focus primarily on qualitative

characteristics to assess the decision.

 Illustration 1

Tony’s T-shirts makes shirts for local soccer, baseball, basketball, and other sports teams.

The owner, Tony, purchases the shirts and prints graphics on the shirts for each team. The

graphics were designed several years ago, so design costs are no longer incurred. On average,

Tony sells 1,000 shirts each month. Typical monthly financial data follow:

Per Unit

( GH¢)

Total Monthly Data for 1000

shirts (GH¢)

Sales revenue 20 20,000

Variable Costs:

Direct materials 8 8,000

Direct labour 2 2,000

Manufacturing overhead 3 3,000

Total variable costs 13 13,000

Contribution margin 7 7,000

Fixed costs (rent, salaries etc) 4,000

Profit 3,000

The monthly information provided relates to the company’s routine monthly operations. A

representative of the local high school recently approached Tony to ask about a one-time

special order. The high school will be hosting a statewide track and field event and is willing

to pay Tony’s T-shirts GH¢17 per shirt to make 200 custom T-shirts for the event. Because

enough idle capacity exists to handle this order, it will not affect other sales. That is, Tony

has the factory space and machinery available to produce more T-shirts. Tony incurs the

same variable costs of GH¢13 per unit to produce the special order, and he will pay a firm

GH¢600 to design the graphics that will be printed on the shirts. This special order will have

no other effect on Tony’s monthly fixed costs. Should Tony accept the special order?

Solution

Reject Special Order Accept Special Order Differential GH¢ Sales revenue 20,000 23,400a - 3,400 Variable costs 13,000 15,600b - 2,600 Contribution margin 7,000 7,800 - 800 Fixed cost 4,000 4,600c - 600

Profit 3,000 3,200 - 200

 a= GH¢ 23,400 = GH¢20,000 + (GH¢17 per shirt × 200 shirts).

b= GH¢15,600 = GH¢13,000 + (GH¢13 × 200 shirts).

c= GH¢ 4,600 = GH¢4,000 + GH¢600 cost for special order design.

Result of Accepting Special Order Sales revenue increase 3,400

Variable costs increase -2,600 Contribution margin increase 800 Fixed cost increase: graphics design -600

Profit increase from accepting special order 200The table above shows the differential revenues and costs for the special order being

considered. If Tony’s T-shirts accepts the special order, sales revenue will increase GH¢

3,400 with a corresponding increase in variable costs of GH¢ 2,600. Fixed costs will increase

by GH¢ 600 because design work is required for the special order. Thus profit will increase

by GH¢ 200 (=GH¢ 3,400 − GH¢ 2,600 − GH¢ 600). Tony should therefore accept the

special order offer.

NB: In cases where the acceptance of the special order is going to affect the normal sales

of the firm negatively, then the fall in sales as a result of the special order should be

accounted for as opportunity cost.

Salient points on Qualitative factor to consider:

In the above case, we have assumed that there is spare capacity but it’s important to ensure

that there is really sufficient capacity before agreeing on special order;

ask whether there is any better alternative than accepting special order;

by accepting special order, needs to ensure that this special order does not affect

customer loyalty or affecting the status quo of the existing product, in the above case

is product X. Basically, we should not endanger the existing products by wanting to

utilize full production capacity.

Illustration 2

Trojan Company produces a single product. The cost of producing and selling a single unit of

this product at the company’s normal activity level of 8,000 units per year is:

GH¢

Direct materials 2.5

Direct labour 3

Variable manufacturing overheads 0.5

Fixed manufacturing overheads 4.25

Variable selling and administrative expense 1.5

Fixed selling and administrative expense 2

The normal selling price is GH¢15.00 per unit. The company’s capacity is 10,000 units per month. An order has been received from an overseas source for 2,000 units at the special price of GH¢12.00 per unit. This order would not affect regular sales.

Required: a) If the order is accepted, how much will monthly profits increase or decrease? (The order will not change the company’s total fixed costs.) b) Assume the company has 500 units of this product left over from last year that are vastly inferior to the current model. The units must be sold through regular channels at reduced prices. What unit cost is relevant for establishing a minimum selling price for these units? Explain.

Solution

a.

GH¢ GH¢

Selling price 12

Direct materials 2.5

Direct labour 3

Variable manufacturing overheads 0.5

Fixed manufacturing overheads 4.25

Variable selling and administrative expense 1.5

Total variable expenses 7.5

Contribution margin 4.5

Units sold 2000

Total Contribution margin 9000

b. The relevant cost is GH¢1.50 (the variable selling and administrative costs). All other

variable costs are sunk, since the units have already been produced. The fixed costs would

not be relevant, since they will not be affected by the sale of leftover units.

1.3.3 Cost Analysis in the Decision to Sell before or after Additional Processing

In some manufacturing processes, several intermediate products are produced from a single

input.  A firm may manufacture and sell an intermediate product. If the facilities are

available,, it may want to process the product further d sell it as completely processed

product. To choose between sell and process further alternatives, the firm should see the

impact of differential cost of further processing on contribution. If the firm obtains more

contribution by selling the completed product, it should process further. In this sell or process

further decision making, joint costs are considered irrelevant since the joint costs have

already been incurred at the time of the decision and therefore represent sunk costs. The

decision will rely exclusively on additional revenue compared to the additional costs incurred

due to further processing.

Additional processing decisions are based on the differences between the incremental

revenues and the incremental costs. Incremental revenues represent the difference between

the revenues generated from selling the product 'as is,' often partially complete, and the

revenues generated after processing the product further to increase its saleability. Incremental

costs are the additional costs incurred from further processing. Costs associated with

producing the product up to the decision point are already incurred in the past and are

considered sunk. All sunk costs are irrelevant. 

Evaluating the Decision

If incremental revenues are less than incremental costs, the product should be sold 'as is.' If

incremental revenues equal incremental costs, qualitative effects must be used to make the

decision. If incremental revenues are greater than incremental costs, the product should be

processed further. Regardless if the choice is to sell as-is or process further; a company

should always consider the 'touchy-feely' aspects of decision making effects. These

include employee morale, goodwill to the community, environmental effects, feasibility,

resource availability, etc.

A sell-or-process-further analysis can be carried out in three different ways:

Incremental (or Differential) Approach calculates the difference between the additional

revenues and the additional costs of further processing. If the difference is positive the

product must be processed further, otherwise not.

Opportunity Cost Approach calculates the difference between net revenue from further

processed product and the opportunity cost of not selling the product at split-off point. If

the difference is positive, further processing will increase profits.

Total Project Approach (or the comparative statement approach) compares the profit

statements of both options (i.e. selling or further processing) separately for each product.

The option generating higher profit is chosen

Illustration 1

Product A and B are produced in a joint process. At split-off point, Product A is complete

whereas product B can be process further. The following additional information is available:

Product A B

Quantity in Units 5000 10000

Selling Price per Unit:

At Split-Off 10 2.5

If Processed further 5

Costs After Split-Off 20000

Fixed selling and administrative expense

Perform sell-or-process-further analysis for product B.

Solution

Method 1 (Incremental Approach) GH¢

Incremental Revenue 25,000

Incremental Costs 20,000

Increase in Profits Due to Further Processing 5,000

Method 2 (Opportunity Cost Approach) GH¢

Sales in Case of Further Processing 50,000

Costs:

Additional Costs 20,000

Opportunity Cost of Not Selling at Split-Off 25,000

Gain on Further Processing 5,000

Method 3 (Total Approach)

Split-Off

Point

Further

Processed

Revenue GH¢25,000 50,000

Costs 0 20,000

Net Revenue 25,000 30,000

Gain from Further Processing 5,000

Illustration 2

A market decline for staplers has caused Sobo Company to drop its selling price per stapler

from GH¢15 to GH¢12. There are 8,000 staplers in work in process (partially finished) that

have costs of GH¢7.80 per unit associated with them. Sobo can sell these units in their

current state for GH¢9.00 each. It will cost Sobo GH¢1.70 per unit to complete the staplers

in process, so that they can be sold for GH¢12 each.

a. How much is the incremental cost if processed further?

b. Use your answer to part A to calculate incremental profit or loss.  

c. List any amounts given in the problem that Sobo should label as ‘sunk’ costs. 

Solution

a. Incremental cost: 8,000 x GH¢1.70 = GH¢13,600

Incremental cost is the difference in cost if the staplers are 'processed further', i.e., completed.

The costs incurred in the past, the GH¢7.80 per stapler is not relevant because it will be the

same no matter if the staplers are processed further or sold as-is. This past cost is a sunk cost,

and sunk costs are never relevant because the cost cannot be changed and is the same

regardless if processed further or sold as-is.

b.

Incremental revenue (GH¢12 -9)*8,000  GH¢24,000

Incremental costs (part A)   (13,600)

Incremental profit if processed further              10,400

Because profits increase, the staplers should be processed further.

Revenue will increase by GH¢3 per unit and costs will increase by GH¢1.70 per unit netting

a profit increase of GH¢10,400. Because this is an incremental analysis, you must only

consider the incremental costs and incremental revenue.

c.   List any amounts given in the problem that Sobo should label as ‘sunk’ costs. Only one

amount is sunk, the GH¢7.80 cost of producing the products to their current state. This

amount has already been incurred and won't change regardless of the decision made.

1.3.4 Joint Product Cost Decisions

In some manufacturing processes, several end products are produced from a single input.

Such end products are known as joint products. The costs associated with making these

products up to the point where they can be recognized as separate products (the split-off

point) are called joint product costs.

Cost allocation problem

Joint product costs are really common costs that are incurred to simultaneously produce a

variety of end products. Unfortunately, these common costs are routinely allocated to the

joint products. Allocated joint product costs are often misinterpreted as costs that could

be avoided by producing less of one of the joint products. However, joint product costs

can only be avoided by producing less of all of the joint products simultaneously. If any of

the joint products is made, then all of the joint product costs up to the split-off point will have

to be incurred. Therefore, in deciding on whether to produce or not produce a particular

product that forms part of the joint products, we use only costs that are incurred in the

production of that product and the revenue generated after the spilt-off point. In this case, the

differential or incremental approach is widely used. Because the analysis is done by taking

account of only increases in revenue and cost after the split-off point.

1.3.5 Cost Analysis in the Decision to Keep or Drop Products or Services

Management is sometimes faced with the problem of dropping an unprofitable product or

department. The decision to drop an old product line or add a new one must take into account

both qualitative and quantitative factors. However, any final decision should be based

primarily on the impact the decision would have on contribution margin or net income.

Therefore the amount of common fixed costs typically continues regardless of the decision

thus cannot be saved by dropping the product line to which it is distributed

Just like other types of short term decisions, segment/product decisions can be made using

either full costing or incremental analysis. Full costing often involves preparing two side-by-

side income statements and looking at the differences. Incremental analysis is most often the

most straight-forward, the shortest, the easiest, and the best approach because it helps

managers focus on the relevant parts of a decision. A manager that uses full costing wastes a

lot of time looking at costs that will not differ between two decisions.  We will focus

primarily on whether a product line or segment should be dropped.

 Decisions

If the decrease in revenue > decrease in costs, do not drop the product line/services. If the

decrease in revenue < decrease in costs, drop the product line/services. If the decrease in

revenue = decrease in costs, consider qualitative issues alone.

Fixed Costs

Fixed costs in total remain the same regardless of activity. The same is generally true

regardless of how many product lines or segments a company has. Fixed costs fall into two

types that can help decide if they are relevant or not for add or drop decisions:

Common fixed costs

Costs that are not traceable to a particular product or segment;

Costs that benefit more than one product or segment; they are allocated/distributed

amongst a number of product/segments.

Not relevant because they continue whether the product or segment is dropped or not.

If one product or segment is dropped, total common fixed costs must be reallocated to

remaining products or segments.

Direct fixed costs

Costs that pertain specifically to one product or segment that are avoidable if that

product/segment is dropped

Relevant because they can be avoided if the product or segment is dropped

 Approaches

Two basic approaches can be used to analyze data in this type of decision.

1. Compare contribution margins and fixed costs. A segment should be added only if the

increase in total contribution margin is greater than the increase in fixed cost. A segment

should be dropped only if the decrease in total contribution margin is less than the decrease in

fixed cost.

2. Compare net incomes. A second approach is to calculate the total net income under each

alternative. The alternative with the highest net income is preferred. This approach requires

more information than the first approach since costs and revenues that don't differ between

the alternatives must be included in the analysis when the net incomes are compared.

Beware of allocated common costs. Allocated common costs can make a segment look

unprofitable even though dropping the segment might result in a decrease in overall company

net operating income. Allocated costs that would not be affected by a decision are irrelevant

and should be ignored in a decision relating to adding or dropping a segment. 

Illustration 1

A company has three products: Product A, Product B and Product C. Income statements of

the three product lines for the latest month are given below:

Product Line A B C

Sales GH¢467,000 GH¢314,000 GH¢598,000

Variable Costs 241,000 169,000 321,000

Contribution Margin 226,000 145,000 277,000

Direct Fixed Costs 91,000 86,000 112,000

Allocated Fixed Costs 93,000 62,000 120,000

Net Income 42,000 − 3,000 45,000

Use the incremental approach to determine if Product B should be dropped.

Solution

By dropping Product B, the company will lose the sale revenue from the product line. The

company will also obtain gains in the form of avoided costs. But it can avoid only the

variable costs and direct fixed costs of product B and not the allocated fixed costs. Hence:

If Product B is Dropped

Gains:

Variable Costs Avoided GH¢169,000

Direct Fixed Costs Avoided GH¢86,000 255,000

Less: Sales Revenue Lost 314,000

Decrease in Net Income of the

Company59,000

Illustration 2

B & B Inc., a retailing company has two departments, X and Y. A recent monthly

contribution format income state for the company follows.

X (GH¢) Y (GH¢) Total(GH¢)

Sales 3,000,000 1,000,000 4,000,000

Variable expenses 900,000 400,000 1,300,000

Contribution margin 2,100,000 600,000 2,700,000

Fixed expenses 1,400,000 800,000 2,200,000

Operating income(loss) 700,000 -200,000 500,000

A study indicates that GH¢340,000 of the fixed expenses being charged to Y are sunk costs

or allocated costs that will continue even if Y is dropped. In addition the elimination of Y will

result in a 10% decrease in the sales of X.

Required: If Department Y is discontinued, will this be a positive move or a negative move

for the company as a whole?

Solution

Contribution margin lost if Y is dropped:

(GH¢)

Department Y contribution margin

lost -600,000

Department X contribution margin

lost -210,000

Total contribution margin lost -810,000

Avoidable fixed costs 460,000

Decrease in operating income -350,000

raw materials,

production capacity, and Other inputs.

Whenever demand exceeds productive capacity, a production constraint (bottleneck)

exists.  This means that the company is unable to fill all orders and some choices have to be

made concerning which orders are filled and which are not filled.  Determining the best use

of a scarce resource requires management to identify company objectives. If an objective is to

maximize company profits, a scarce resource is best used to produce and sell the product

generating the highest contribution margin per unit of the scarce resource. This strategy

assumes that the company must ration only one scarce resource. Total contribution margin

will be maximized by promoting those products or accepting those orders that provide the

highest unit contribution margin in relation to the constrained resource.  

Single Limiting Factor

Where a limiting factor exists, instead of concentrating on those products, which maximise

contribution, we do the following;

(a) Contribution will be maximised by earning the biggest possible contribution per unit of

scarce resource. Thus if Grade A labour is the limiting factor, contribution will be

maximised by earning the biggest contribution per hour of Grade A labour worked.

Similarly, if machine time is in short supply, profit will be maximised by earning the

biggest contribution per machine hour worked.

(b) The limiting factor decision therefore involves the determination of the contribution

earned by each different product per unit of scarce resource.

Steps

Step 1: Identify the scarce resource (limiting factor)

Step 2: Calculate the amount of the limiting factor needed by each product.

Step 3: Confirm that the amount of the limiting factor is insufficient to allow all products to

be produced.

Step 4: Calculate the contribution earned per unit of each product.

Step 5: Calculate the contribution of each product per unit of the limiting factor by dividing

step 4 by step 2

Step 6: Establish production priority by ranking products according to the contribution per

unit of the scarce resource.

Step 7: Allocate the available scarce resource according to the ranking.

Illustration

A company manufactures three products (X, Y and Z). All direct operatives are the same

grade and are paid at GH¢11 per hour. It is anticipated that there will be a shortage of direct

operatives in the following period, which will prevent the company from achieving the

following sales targets:

Product X 3,600 units

Product Y 8,000 units

Product Z 5,700 units

Selling prices and costs are shown below

Product X, Y, and Z Selling Prices and Costs per unit

Product X Product Y Product Z

Selling prices 100.00 69.00 85.00

Variable cost:

Production* 51.60 35.00 42.40

Non-Production 5.00 3.95 4.25

Fixed Costs:

Production 27.20 19.80 21.00

Non-Production 7.10 5.90 6.20

* includes the cost of direct operatives 24.20 16.50 17.60

The fixed costs per unit are based on achieving the sales targets. There would not be any

savings in fixed costs if production and sales are at a lower level

Solution

Step 1: Limiting factor if shortage of direct operatives

Step 2: Calculate the amount of the limiting factor needed by each product.

Product X GH¢24.20/unit ÷ GH¢11/hr = 2.2 hrs per unit × 3,600 units = 7,920 hrs

Product Y GH¢16.50/unit ÷ GH¢11/hr = 1.5 hrs per unit × 8,000 units = 12,000 hrs

Product Z GH¢17.60/unit ÷ GH¢11/hr = 1.6 hrs per unit × 5,700 units = 9,120 hrs

Total hours needed = 29,040 hrs

Step 3: Confirm that the amount of the limiting factor is insufficient to allow all products to

be produced.

Direct labour hours available are 2,640 less (26,400 - 29,040) than those required to achieve

the sales targets.

Step 4: Calculate the contribution earned per unit of each product.

Contribution is sales revenue less variable costs (both production and non-production). Thus:

Product X GH¢100.00 - GH¢56.60 (51.60 + 5.00) = GH¢43.40 per unit

Product Y GH¢69.00 - GH¢38.95 (35.00 + 3.95) = GH¢30.05 per unit

Product Z GH¢85.00 - GH¢46.65 (42.40 + 4.25) = GH¢38.35 per unit

Step 5: Calculate the contribution of each product per unit of the limiting factor by dividing

step 4 by step 2

The contribution per unit of scarce resource can be calculated either as a GH¢ contribution

per hour of direct operative time or as a GH¢ contribution per GH¢ cost of direct operatives.

Thus:

Product X GH¢43.40/unit ÷ 2.2 hrs/unit = GH¢19.73 per direct operative hour

Product Y GH¢30.05/unit ÷ 1.5 hrs/unit = GH¢20.03 per direct operative hour

Product Z GH¢38.35/unit ÷ 1.6 hrs/unit = GH¢23.97 per direct operative hour

Or

Product X GH¢43.40/unit ÷ GH¢24.20/unit = GH¢1.793 per GH¢ cost of direct operatives

Product Y GH¢30.05/unit ÷ GH¢16.50/unit = GH¢1.821 per GH¢ cost of direct operatives

Product Z GH¢38.35/unit ÷ GH¢17.60/unit = GH¢2.179 per GH¢ cost of direct operatives

Step 6: Establish production priority by ranking products according to the contribution per

unit of the scarce resource.

On the basis of the contribution per unit of the scarce resource, Product Z would be

manufactured as the first priority (GH¢23.97/hr or GH¢2.179/GH¢ cost), followed by

Product Y (GH¢20.03/hr or GH¢1.821/GH¢ cost) and finally Product X (GH¢19.73/hr or GH

¢1.793/GH¢ cost). The same conclusion would be reached whichever of the calculations in

stage 4 was used because the basis is the same.

Step 7: Allocate the available scarce resource according to the ranking.

The scarce resource of direct operative hours needs to be allocated according to the

production priority established in stage 5 above. Product Z has first priority and so the direct

operative hours will be allocated up to the limit required to achieve the sales target of 5,700

units. This was calculated in stage 1 to be 9,120 hours. The next priority is Product Y. The

allocation of the 26,400 hours available can be set out as follows:

Product Z= 9,120 hours 5,700 units

Product Y =12,000 hours 8,000 units

21,120 hours

Product X = 5,280 hours 2,400 units

(26,400 - 21,120) (5,280 hours ÷ 2.2 hours/unit) 26,400 hours

Multiple Limiting Factors-Linear Programming

When the production process requires two or more production constraints, the choice of sales

mix involves a more complex analysis, and in contrast to the case of one production

constraint which solves for a single product, the solution can include both products when two

constraints are involved. When there are more than one limiting factor, then a technique

known as linear programming is used. In formulating a linear programming problem the steps

involved are as follows;

Define the unknowns, i.e. the variables that need to be determined

Formulate the constraints, i.e. the limitation that must be placed on the variables

Formulate the objective function that needs to be maximised or minimised

Graph the constraints and objective functions

Determine the optimal solution to the problem by reading the graph.

Note that non-negativity constraints will be needed to ensure that there are no negative

values.

Linear programming problems could also be solved using algebra

Illustration 1

John manufactures chairs and tables. Each product passes through a cutting process and an

assembling process. One chair makes a contribution of GH¢50 and take 6 hours cutting time

and 4 hours assembly time. One table makes a contribution of GH¢40 and takes 3 hours

cutting time and 8 hours assembly time. There is a maximum of 36 cutting hours available

each week and 48 assembly hours. Find the output that maximises contribution.

Solution

Let x = number of chairs produced each week and y= number of tables produced each week.

Constraints are:

6x+3y = 36

4x+8y = 48

Solving for x and y simultaneously, x = 4 and y = 4

Thus maximum contribution = (4 * 50 ) + (4*40) = GH¢360

1.4 Behavioural, Implementation and Issues in Decision Making

A well-known problem in business today is the tendency of managers to focus on short-term

goals and neglect the long-term strategic goals because their compensation is based on short

term accounting measures such as net income. Many critics of relevant cost analysis have

raised this issue. As noted, it is critical that the relevant cost analysis be supplemented by a

careful consideration of the firm’s long-term, strategic goals. Without strategic

considerations, management could improperly use relevant cost analysis to achieve a short-

term benefit and potentially suffer a significant long-term loss. For example, a firm might

choose to accept a special order because of a positive relevant cost analysis without properly

considering that the nature of the special order could have a significant negative impact on

the firm’s image in the marketplace and perhaps a negative effect on sales of the firm’s other

products. The important message for managers is to keep the strategic objectives in the

forefront in any decision situation.

Further, people are affected by decisions. The people may be customers, or buyers for

corporate customers. They may also be suppliers. However, employees will be most affected

by decisions that a company takes. The decision would mean more overtime, redundancy or

changed work procedures. They have to be paid and then they are no longer employees. This

affects morale of the remaining employees. The morale of the employees affects the

productivity of the shop floor, the reject rate and the rate of labour turnover.

Trade union organisations may consider sending the company to court is the decision is to

render some staff members redundant. This might dent the image of the company which

could be translated into low demand for goods produced. Some customers regard certain

goods as jointly demanded and so its withdrawal will lead to the reduction in demand for the

other product. For instance, if the production of saucers is withdrawn, the demand for tea

cups will reduce.

1.5 Cost-Volume-Profit (CVP) Analysis

In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could

look into a crystal ball and find out exactly how many customers were going to buy our

product, we would be able to make perfect business decisions and maximise profits. One of

the most important decisions that needs to be made before any business even starts is ‘how

much do we need to sell in order to break even?’ By ‘break even’ we mean simply covering

all our costs without making a profit.

CVP analysis is designed to illustrate the effects of changes in volume or output of work done

or sales made upon sales revenue and costs. As a consequence the effect upon profit is shown

as the difference between total revenue and total costs. CVP analysis looks primarily at the

effects of differing levels of activity on the financial results of a business.  In performing this

analysis, there are several assumptions made, including:

Sales price per unit is constant.

Variable costs per unit are constant.

Total fixed costs are constant.

Everything produced is sold.

Costs are only affected because activity changes.

If a company sells more than one product, they are sold in the same mix.

The time scale necessary to implement any decision based upon the analysis is

relatively short.

Cost and revenue are linear

The contribution relationships are valid and constant

Either one product is made or a combination is made in the same proportion

throughout.

All costs behave in the manner assumed and can be split into fixed or variable.

Useful relationships

1. Profit = Revenue- Costs

2. Total Cost= Variable costs- Fixed costs

3. Profit = (Revenue – Variable costs)- Fixed costs

4. Contribution= Revenue – Variable costs

5. Total contribution = Quantity of sales * Contribution per unit

6. At Break-Even: Revenue =Total Costs

7. At Break-Even: Total contribution = Fixed costs and

8. Break-Even quantity = Fixed costs/Contribution per unit

Contribution margin and contribution margin ratio

Key calculations when using CVP analysis are the contribution margin and the

contribution margin ratio. The contribution margin represents the amount of income or

profit the company made before deducting its fixed costs. Said another way, it is the amount

of sales dollars available to cover (or contribute to) fixed costs. When calculated as a ratio, it

is the percent of sales dollars available to cover fixed costs. Once fixed costs are covered, the

next dollar of sales results in the company having income.

The contribution margin is sales revenue minus all variable costs. It may be calculated using

dollars or on a per unit basis. If The Three M's, Inc., has sales of GH¢750,000 and total

variable costs of GH¢450,000, its contribution margin is GH¢300,000. Assuming the

company sold 250,000 units during the year, the per unit sales price is GH¢3 and the total

variable cost per unit is GH¢1.80. The contribution margin per unit is GH¢1.20. The

contribution margin ratio is 40%. It can be calculated using either the contribution margin in

dollars or the contribution margin per unit. To calculate the contribution margin ratio, the

contribution margin is divided by the sales or revenues amount.

Contribution MarginGH¢ Per Unit (GH¢)

Sales 750,000 3Variable Costs 450,000 1.8

300,000 1.2

Contributionmargin ratio=Contribution marginSales

=300,000750,000

40 %∨1.23

=40 %

Break-even point

The break-even point represents the level of sales where net income equals zero. In other words, the point where sales revenue equals total variable costs plus total fixed costs, and total contribution margin equals fixed costs.

¿ terms of sales units(break−even point∈units)= ¿ costCont ribution per unit

¿ terms of sales revenue(break−even point∈sales)= ¿costContributionratio

Using the previous information and given that the company has fixed costs of GH¢300,000.

Break-even point in dollars: The break-even point in sales dollars of GH¢750,000 is

calculated by dividing total fixed costs of $300,000 by the contribution margin ratio of 40%.

¿ terms of sales revenue (break−even point∈sales )=300,0000.4

=GH ¢750,000

Break-even point in units: The break-even point in units of 250,000 is calculated by

dividing fixed costs of GH¢300,000 by contribution margin per unit of GH¢1.20.

¿ terms of sales units (break−even point∈units ) 300,0001.2

=250,000 units

Targeted income

CVP analysis is also used when a company is trying to determine what level of sales is

necessary to reach a specific level of income, also called targeted income. To calculate the

required sales level, the targeted income is added to fixed costs, and the total is divided by the

contribution margin ratio to determine required sales dollars, or the total is divided by

contribution margin per unit to determine the required sales level in units.

Required sales∈GH ¢=¿Cost+Targeted IncomeContribuion margin ratio

Required sales∈units= ¿Cost+Targeted IncomeContribuion margin per unit

Using the data from the previous example, what level of sales would be required if the

company wanted GH¢ 60,000 of income? The GH¢60,000 required is called the targeted

income. The required sales level is GH¢900,000 and the required number of units is 300,000.

Remember that there are additional variable costs incurred every time an additional unit is

sold, and these costs reduce the extra revenues when calculating income.

Required sales∈GH ¢=300,000+60,0000.4

=GH ¢900,000

Required sales∈units=300,000+60,0001.2

=300,000 units

Note that this calculation of targeted income assumes it is being calculated for a division as it

ignores income taxes. If a targeted net income (income after taxes) is being calculated, then

income taxes would also be added to fixed costs along with targeted net income.

Margin of Safety

This is the amount by which the sales in units or a percentage of budgeted sales can fall below before a loss is made.

Marginof safety∈units=Budgeted sales−Break−even sales

Marginof safety asa% of sales= Budgeted sales−Break−evensalesBudgeted sales

∗100 %=¿

Using the data from the above example with additional information of budgeted sales for the

period of 350,000 units, calculate the margin of safety in units and calculate the margin of

safety as a % of budgeted sales.

Marginof safety∈units=350,000−250,000=100,000 units

Marginof safety asa% of sales=350,000−250,000250,000

∗100 %=40%

Sensitivity Analysis

A business environment can change quickly, so a business should understand how sensitive

its sales, costs, and income are to changes. Sensitivity analysis is a “what if” technique that

managers use to examine how an outcome will change if the original predicted data are not

achieved or if an underlying assumption changes. In the context of CVP analysis, sensitivity

analysis examines how operating income (or the breakeven point) changes if the predicted

data for selling price, variable cost per unit, fixed costs, or units sold are not achieved. The

sensitivity to various possible outcomes broadens managers’ perspectives as to what might

actually occur before they make cost commitments. CVP analysis using the break-even

formula is often used for this analysis. For example, marketing suggests a higher quality

product would allow The Three M’s Inc, to raise its selling price 10%, from GH¢ 3.00 to GH

¢ 3.30. To increase the quality would increase variable costs to GH¢ 2.00 per unit and fixed

costs to GH¢ 350,000. If The Three M's, Inc., followed this scenario, its break-even in units

would be 269,231.

Break−evensales units= ¿ costContribution perunit

= 350,000(3.30−2)

=269,231units

These changes in variable costs and sales result in a higher break-even point in units than the

250,000 break-even units calculated with the original assumptions. The critical question is,

“Will the customers continue to purchase, and are new or existing customers identified that

will purchase the additional 19,231 units of the product required to break even at the higher

sales price?”

CVP with Multiple Product Mix

In cases where a company deals in multiple products, the analysis is similar to the single

product in that the concepts and formulae remain the unchanged. The only modification

however is that the analysis is performed by using weighted averages components. For

example, instead of contribution, weighted contribution margins and selling prices are used.

Limitation of CVP Analysis

1. Profits are calculated on a variable cost basis or, if absorption costing is used, it is

assumed that production volumes are equal to sales volumes.

2. Fixed costs remain constant over the ‘relevant range’ – levels of activity in which the

business has experience and can therefore perform a degree of accurate analysis. It will

either have operated at those activity levels before or studied them carefully so that it can,

for example, make accurate predictions of fixed costs in that range.

3. Costs can be divided into a component that is fixed and a component that is variable. In

reality, some costs may be semi-fixed, such as telephone charges, whereby there may be a

fixed monthly rental charge and a variable charge for calls made.

4. The total cost and total revenue functions are linear. This is only likely to hold true within

a short-run, restricted level of activity.

5. All other variables, apart from volume, remain constant, ie volume is the only factor that

causes revenues and costs to change. In reality, this assumption may not hold true as, for

example, economies of scale may be achieved as volumes increase. Similarly, if there is a

change in sales mix, revenues will change. Furthermore, it is often found that if sales

volumes are to increase, sales price must fall. These are only a few reasons why the

assumption may not hold true; there are many others.

Illustration 1

Ababio Plastic Company produces plastic buckets which are distributed all over the country. During the years 2009 and 2010, the following data were extracted:

Sales (GHC) Profits (GHC)

Year 2009 1,200,000 80,000

Year 2010 1,400,000 130,000

You are required to calculate the following:

i. Profit –Volume Ratio (P/V Ratio)

ii. Break – Even Point in Sales value

iii. Profit when the sales value is GHC1,800,000

iv. The Sales Value required to make a profit of GHC120,000

v. The Margin of Safety in the Year 2010

Solution

Sales (GHC) Profit (GHC)

Year 2009Year 2010Difference

1,200,0001,400,000

200,000

80,000130,000

50,000

(i) P/V Ratio = 50,000 x 100 = 25% 200,000

Contribution in 2009 (1,200,000 x 25%) 300,000

Less Profit 80,000 Fixed Cost 220,000

(ii) Break-even point in sales value:Fixed Cost = 220,000 = GHC880,000 P/V Ratio 25%

(iii) Profit when sales is GHC1,800,000: GHC

Contribution (GHC1,800,000 x 25%) 450,000

Less Fixed Cost 220,000

Profit 230,000

(iv) Sales to earn a profit of GHC120,000:Fixed Cost + Target Profit = 220,000 + 120,000 P/V Ratio 25%

= GHC1,360,000(v) Margin of safety in 2010:

Actual sales - Break-en sales1,400,000 - 880,000 = GHC520,000

Practice Questions

1. Dolow produces computer component A for sale at GH¢47 per unit to a Manufacturer of computers. The company currently produces 15,000 units of the component per annum. Total cost of production and unit cost are as follows:

Production Cost (GH¢) Unit Cost (GH¢)Direct Materials 210,000 14Direct labour 180,000 12Variable production cost 30,000 2Fixed manufacturing overhead 150,000 10Share of non-production overhead 105,000 7

675,000 45

A supplier has offered to supply 15,000 units of the components per annum at a price of GH¢39 per unit over a four-year period without any change in price. If Dolow accepts the offer, the following are the effects on current operation. (1) Direct labour will be redundant but at a redundancy cost of GH¢5,000. (2) Direct materials and variable production cost will be avoidable (3) Fixed manufacturing cost will be reduced by GH¢18,750 per annum (4) Share of non-production overhead cost will stay as it is.

Assuming further that, the extra capacity for accepting the contract offer from the supplier can be used to produce and sell 15,000 units of component Z at a price of GH¢43 per unit with the following assumptions: (1) All of the labour force required to manufacture component A will be used to make

component Z. (2) Variable manufacturing overhead will remain same. (3) The fixed manufacturing overhead will remain same. (4) Non-manufacturing overhead will be the same. (5) The materials for component A will not be needed but additional materials at a cost of GH¢15 per unit will be required for production.

Required:

(a) Should Dolow make or buy component A? (b) Should Dolow accept the offer and use the available space to manufacture component Z?

2. Xexe Ltd produces 4 products and is planning its production mix for the next period. Estimated cost, sales and production data are shown below:

A B C DSelling price/unit (GH¢) 50 70 80 100Materials @GH¢4/kg 12 36 20 24Direct labour@GH¢2/hr 6 4 14 10Maximum demand( units) 3000 3000 3000 3000

Required: (i) Assuming labour hours is a limiting factor in the period, advise management on the most appropriate mix if labour hours is limited to 45,000 hours.

(ii) Assuming, materials is a limiting factor in the period, advise management on the most appropriate mix if materials is limited to 55,000 kgs in the period.

3. A Sports Kit manufacturer, in conjunction with a Software house, is considering the launch of a new sporting simulator based on video-tapes that enables greater realism to be achieved. Two proposals are being considered. Both use the same production facilities and, as these are limited, only one product can be launched. The following data are the best estimates the firm has been able to obtain:

Football Simulator Cricket SimulatorAnnual volume (units) 40,000 30,000Selling price (per unit) GH¢65 GH¢100Variable cost of production GH¢40 GH¢50Fixed production cost GH¢300,000 GH¢300,000Fixed selling and administrative cost GH¢225,000 GH¢675,000

The higher selling and administrative costs for the cricket simulator reflect the additional advertising and promotion costs expected to be necessary to sell the more expensive cricket system. The firm has a minimum target of GH¢100,000 profit per year for new products. The management recognizes the uncertainty in the above estimates and wishes to explore the sensitivity of the profit on each product to changes in the values of the variables (volume, price, variable cost per unit and fixed costs).

You are required to calculate for each of the products: (a) The expected profit from each product (b) (i) The units to be produced if the targeted profit is GH¢100,000

(ii) The unit selling price per product, if the expected profit per year is GH¢100,000