Ogallo Notes

8/2/2019 Ogallo Notes

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SHORT TERM DECISIONSConcept of Relevant Costs

Relevant costs are future incremental cash flows arising as a directconsequence of a decision.

The concept of relevant cost can assist the management in short term

decision making process

Identification of the Relevant Costs1. Machinery User Cost

Once a machine has been purchased, its cost is a sunk cost. Sunkcosts are past costs already incurred and therefore irrelevant indecision making process.

Depreciation of a machine is not a relevant cost because it is not acash flow. However, using machinery involves some incremental costreferred to as the user costs and includes:

Hire charges of machine Any fall in resale value of owned assets through use

Labour

Oftenly the labour force will be paid irrespective of the decision and thecosts are therefore not incremental

However if the labour could be put to an alternative use, the relevantcosts will be the variable costs of labour and associated variableoverheads plus an opportunity cost in terms of contribution forgonefrom not being able to put it to its alternative use

Material

The relevant cost of raw material is generally their current replacementcost, unless the raw materials have already been purchased and wouldnot be replaced once used

If materials have already been purchased but will not be replaced thenthe relevant cost of using them is the higher of:

a) Their current resale valueb) The value they would obtain if they were put to an alternative

use (opportunity cost)

The following decisions can be made based on relevant costing concept

and the principles of marginal costing:

Make or Buy Decisions

A make or buy problem involves a decision by an organization onwhether it should make a product or whether it should pay anotherorganization to do so. Examples of make or buy decisions are:

a) Whether a company should manufacture its own components or buythe components from an outside supplier

b) Whether a construction company should do some work with its ownemployees or whether it should sub-contract the wok to another

company


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c) Whether a service should be carried out by an internal department orwhether an external organization should be employed

If an organization has the freedom of choice about whether to makeinternally or buy externally and has no scarce resources that putrestrictions on what it can do itself, the relevant cost for the decision

will be the differential cost between the two options.

Illustration

Hell company manufacture four components F, I, R and E for whichcosts in the forth coming year are expected to be as follows:

F I R EProduction (Units) 1000 2000 4000 3000Unit variable CostShs Shs Shs ShsDirect materials 4 5 2 4Direct labour 8 9 4 6

Variable productionOverhead 2 3 1 214 17 07 12

Directly attributable fixed costs per annum and committed fixed costare as follows:

ShsIncurred as a direct consequence of making W 1000Incurred as a direct consequence of making X 5000Incurred as a direct consequence of making Y 6000Incurred as a direct consequence of making Z 8000

Other fixed costs (committed) 3000050000

A sub contractor has offered to supply units of F,I,R and E for Shs 12,Shs 21 Shs 10 and Shs 14 respectively

Required:

Advice hell Limited on whether to make or buy the components.Note:

Make or buy decisions should certainly not be based exclusively on

cost considerations. The following factors should also be considered:a) The make option gives the management more direct control over thework. The management should therefore consider on whether theywould like to retain control over the work or not

b) The buy option often has the benefits of the external organizationshaving a specialized skill and expertise in the work which should alsobe considered

c) If the components are sub contracted the company will have sparecapacity and therefore it should consider on how to use this sparecapacity profitably

d) The reliability of the sub-contractor with the delivery times and the

quality of the product


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e) The reliability of the estimates of the fixed costs which are attributableto the products

Shut Down Decisions

Discontinuance or shut down problems involve the following decisions:a) Whether or not to close a product line, department or other activity

either because it is making losses or because it is too expensive to runb) If the decision is to shut down, whether the closure should be

permanent or temporary

Illustration

A company manufactures three products: Pawns, Rooks and Bishops.The present Net annual income from these products is as follows:

Pawns Rooks Bishops Total

$ $ $ $Sales 50000 40000 60000 150000Variable costs (30000) (25000) (35000) (90000)Contribution 20000 15000 25000 60000Fixed cost (17000) (18000) (20000) (55000)Profit/loss 3000 (3000) 5000 5000

The company is concerned about its poor profit performance and isconsidering whether or not to cease selling Rooks. It is felt that sellingprices cannot be raised or lowered without adversely affecting netincome

Shs 5000 of the fixed costs of Rooks are direct fixed costs which wouldbe saved if production ceases. All other fixed costs would remain thesame.

Required:a) Advice the company on whether to stop the production of product

Rooks or notb) Suppose that it will be possible to use the resources realized by

stopping production of Rooks and switch to producing a new item, theCrowners which would sell for Shs 50000 and incur a variable cost of

Shs 6000, what will be the advice?

Other qualitative factors to be considered in a shut down decisiona) The impact that the shut down decision will have on employees

moraleb) The signal that the decision will give to competitors (the reaction of the

competitors)c) The reaction of the customers who are likely to lose confidence in the

companys productd) The effects on the suppliers. If one supplier suffers disproportionately,

there may be a loss of goodwill and damage to future relations


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e) The timing of the shut down since some costs may be avoidable in thelong run but not in the short run

Acceptance or Rejection of Special Order

Sometimes an organization may have an income earning opportunity

from a customer. In this case an organization will have to decide onwhether to accept or reject the customers order

The financial aspect of the decision will be based on incremental costsand revenues arising as a direct consequence of the decision

Other non financial factors which should also be considered are:i. Availability of raw materials for the special orderii. Other possible investment opportunitiesiii. The willingness of workers to work extra time in order to execute the

special orderiv. The customers goodwill which is likely to be affected if the order is

rejected

LIMITING FACTOR DECISIONS

One of the more common decision making problems is a situationwhere there are no enough resources to meet the potential salesdemand, and so a decision has to be made about what mix of productsto produce using the available resources as effectively as possible.

A limiting factor is any factor that put restrictions in the productionactivity. It is also referred to as the keyfactor.

A limiting factor may be sales demand if there are sufficient productionresources to meet the sales demand

Other possible limiting factors are:-i. Labour hours.ii. Material availableiii. Fund availabilityiv. Any other resource that is used in the production activity.

Optimal production Solution where there is a limiting factor.

It is assumed in a limiting factor analysis that management wishes tomaximize profit and that profit will be maximized when contribution ismaximized (given no change in the fixed cost expenditure incurred)

In other words, marginal costing principles are applied in a limitingfactor decision.

Contribution will be maximized by earning the biggest possiblecontribution from each unit of limiting factor.

The limiting factor decision therefore involves the determination of thecontribution earned by each different product from each unit of thelimiting factor.

Steps followed in limiting factor decisionsi. Identify a single limiting factor other than sales demand


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ii. Calculate the contribution per unit of the limiting factor for eachproduct

iii. Rank the products by giving the first priority to the ones thatgenerate higher contribution per unit of the limiting factor

iv. Make products in rank order until scarce resource is used up i.e.

determine the optional production solution.

Illustrations

Darling Company manufactures two products, handsome and beauty.Unit variable costs for the products are as follows.

Handsome BeautyShs. Shs.

Direct materials 1 3Direct labour (Shs 3 per hour) 6 3Variable overhead 1 1

8 7

The selling price per unit for the products are Shs 14 and Shs 11 for

handsome and beauty respectively During July 2002,the variable direct labour was limited to 8000 hours

Sales demand in July is expected to be 3000 units of handsome and5000 units of beauty.

Requiredi. Determine the optimal production solution and the maximum profit

assuming that monthly fixed cost are Shs 2000 and that openinginventories are nil

COST- VOLUME - PROFIT ANALYSIS OR BREAK EVEN ANALYSIS

Break even analysis is the term given to the study of the

interrelationship between costs, volume and profit at various levels ofactivity


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C-V-P analysis uses many of the principles of marginal costing and is animportant tool in short term planning.

Break - Even Point

This is the point at which the total sales revenue equates the total cost

and therefore neither profit nor loss is being made i.e. at break evenpoint; TotalCost=TotalRevenue

Mathematical approach to Break - Even Analysisi. Break Even Point In Units = Total Fixed Cost

Unit Contributionii. Break Even Point In Sales Value = B.E.P In Units X Selling Price

Per Unit

Illustration

The following information relates to product X produced by company YExpected sales 10000 units at Shs 8 eachVariable cost Shs 5 per unitFixed cost Shs 21000

RequiredDetermine the Break Even Point in;

i. Unitsii. Sales value

The Contribution to Sales Ratio

This is a measure of the amount of contribution earned from each 1shilling of sales

It provides an alternative way of determining the B.E point in salesvalue i.e.

B.E.P in sales value = Total Fixed CostC/s ratio

Where C/s ratio = Contribution per unitSelling price per unitIllustration

i. The contribution to sales ratio of a product W is 20%. IB themanufacturer of product W wishes to make a contribution of $50000towards fixed costs. How many units of product W must be sold if theselling price is sh10 per unit?

ii. A company manufactures a single product with a variable cost of sh44.The contribution to sales ratio is 45% monthly fixed costs are sh36000.What is the B.E.P in units?

The Margin of Safety


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This is the difference between the budgeted sales and the Break Evenpoint of sales. It can be expressed in sales volume or sales value.

It is sometimes expressed as a percentage of budgeted sales.

Illustration

Mal De Mar Co. makes and sells a product which has a variable cost ofsh30 and which sells for sh4. Budgeted Fixed Costs are sh70000 andbudgeted sales are 8000 units.

Requiredi) B.E.P in units and in sales valueii) Margin of safety in units and in sales value

Break Even Arithmetic

At B.E.P

S = V + FWhere; S=Sales RevenueV=Variable CostF= Fixed Cost

Substituting V from each side we get

S - V = FBut S V is the contribution

At B.E.P contribution = Fixed Cost(S - V = F)

Illustration

B limited makes a product which has a variable cost of sh.7 per unit.

The fixed costs are sh.63000 per annum.

Required:i. Calculate the selling price per unit if the company wishes to break even

with a sales volume of 1200units.

Target Profits.

This is the profit which is intended to be achieved by an organizationduring a particular period.

The target profit is achieved when: S = V + F + PWhere: S = Sales Revenue

V = Variable CostF = Fixed CostP = Target Profit

Illustration

B limited makes and sells a single product for which the variable costsare as follows:

Shs


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Direct material 10Direct labour 8Variable overhead 6

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The selling price is Shs 30 per unit and fixed cost per annum are Shs68000. the company wishes to make a profit of Shs 16000 per annum

Required:

Determine the sales required to achieve this profit

Graphical approach to B.E.P

The B.E.P can also be determined graphically using a break even chart.This chart shows the approximate levels of profit or loss at differentsales volume levels within a limited range.

The chart has the following axes:i. Horizontal axis showing the sales/output in unitsii. A vertical axis showing the sales revenue and cost in value

Thefollowinggraphsaredrawnonthebreakevenchart

i. The sales graph

This is a straight line which starts from the origin and ends at the pointsignifying the expected sales

ii. The fixed cost graph which runs parallel to the horizontal axis andbegin at a point which represents the total fixed cost

iii. Total cost line which starts at a point where the fixed cost intersectsthe y-axis and ends where the fixed cost of anticipated sales on thehorizontal axis and total cost of anticipated sales on the vertical axis

The break even point is the intersection of the sales line and the totalcost line

The distance between the B.E.P and the expected (budgeted) sales inunits indicates the margin of safety

Illustration

The budgeted annual output of a factory is 120000 units. The fixed

overhead amounts to Shs 40000 and the variable costs are Shs 0.5 perunit. The selling price is Shs 1 per unit

Required

Construct a break even chart showing the current break even point andprofit earned upto the present maximum capacity.

Profit Volume Chart

The break even chart do not highlight the profit or loss at differentvolume levels


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To ascertain the profit or loss figures from a break even chart, it istherefore necessary to determine the difference between the total costand the total revenue line

Profit volume chart is a more convenient method of showing theimpact of changes in volume of profit

Profit is on the Y axis and comprises profit and contribution towardsprofit extending above and below the X axis with a zero point at theintersection of the two axes and the negative section below the axisrepresenting fixed cost

At zero production, the firm therefore is incurring a loss equal to thefixed cost

Volume is on the X axis and comprises of the volume of sales The profit volume line is a straight line starting at the intercept of the Y

axis (zero production) representing the level of fixed costs

The profit volume line cut the X axis at the break even point of salesvolume

Any point on the P/V line above the X axis represents the profit to thefirm for that particular level of sales

Assumption of Break Even Analysisi. It assumes that fixed cost are constant at all levels of outputii. It assumes that variable cost per unit is constant at all levels of output

iii. It assumes that the selling price per unit is constant at all levels ofoutput


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iv. It assumes that production and sales volumes are the same andtherefore inventory levels are ignored

v. It assumes that cost can accurately be divided into their fixed andvariable elements

vi. It assumes that volume is the only factor that will costs and revenues

to change and therefore all other variables remain constantvii. It assumes that a single product or a single pre determined sales mix

of a range of products is sold

Limitations of Break Even Analysisi. It can only be applicable to a single product or a single mix of a group

of productsii. It ignores the uncertainity in the estimates of fixed costs and variable

cost per unitiii. It assumes that all variables other than the one under consideration

(production volume) remain constant throughout the analysis andtherefore volume is the only factor that will cause cost and revenue tochange. However, changes in other variables such as productionefficiency, sales mix, price levels and production methods cansignificantly influence sales revenue and costs

iv. The analysis assumes that unit variable cost and selling price areconstant. This assumption is only likely to be valid within the relevantrange of production

v. The analysis assumes that cost can be accurately analysed into fixedand variable elements. The separation of semi variable costs into theirfixed and variable elements is sometimes very difficult in practice

vi. The break even chart may be time consuming to prepare

Economist B.E.PTotal Revenue Curve

This is assumed to be curvilinear, indicating that the firm is only able tosell increasing quantities of output by reducing the selling price perunit, thus the total revenue line does not increase proportionately withoutput

Total revenue curve will continue to rise as long as the adverse effectsof price reduction is less than the benefits of increased sales andreaches the maximum point where the adverse effect of pricereduction is equal to the benefits of increased sales volumes

Total revenue curve will eventually fall if the adverse effect of pricereduction outweighs the benefits of increased sales volume

Total Cost

This shows the economies of scale at first and therefore output risesfaster tan cost

The cost curve then turns upwards and become steeper as the

diminishing returns set in


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Economies break even chart

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