Session 2: Costing and pricing in the short-term Flashcards
A hat manufacturer sells hats for £10. Each hat requires
1 hour of labour at a cost of £5 an hour and material at
a cost of £2. The shop also has a facility rent of £2,000
and other general bills of £1,000 per month. How many
hats have to be sold each month to break even?
We have to use the breakeven in units formula = Fixed costs / Contribution per unit ( selling price per unit - variable cost per unit)
= 2000+1000/10-5-2 = 1000 hats
What are 5 short-term decision problems we will look at?
1) CVP analysis
2) Special pricing decisions
3) Product mix decisions
4) Outsourcing decisions
5) Discontinuation
What is the difference between contribution and contribution per unit and total contribution
Contribution = total sales - total variable costs
Contribution per unit = selling price per unit - variable cost per unit
Total contribution = contribution per unit X number of units sold
What is the forumla for breakeven to get a desired profit in units ?
How do we work out break even in sales?
What does the contribution margin tell you?
youthe aggregate amount of revenue available after variable costs to cover fixed expenses and provide profit to the company,”
What is the forumla for breakeven to get a desired profit in sales?
Work out units required to BE FOR A DESIRED PROFIT and sales required to breakeven for a desired profit.
35-20 = £15
BE in sales units = Fixed costs+ Desired profit / Contribution/unit
45000+30000 /15 =5000 units to BE
5000 x 35 = 175000 are the sales required to break even keeping the selling price and variable cost the same.
Or SALES IN £ = FC + Desired profit / C/S ratio ( contirbution/unit / selling price/ unit)
75000/(3/7)
=175000
Do we want a high or low BE point?
You want to have a low breakeven point because anything below that you are making a loss, so you don’t have to sell a lot of units and spend lots to break even and even make a profit.
What is CVP mainly used for?
Short term decision making, managers use it to ask what if questions and make decsions e,g about short term prices ( offer discount) etc.
What does Operating leverage mean in accounting?
it is how responsive a companys operating income is to changes in sales volume
Will companies with high fixed cost have high operating leverage or low? and explain?
they have high fixed costs compared to variable costs, meaning they take more risks, meaning that the denominator will get smaller pushing ratio up.
What is a special order?
a special order is a one-time customer order, often involving a large quantity and a low price, you need to make decision using relevant information.
How do you approach special order questions?
You only look at the relevant costs
We analysis the relevant costs and revenues and if there is a profit we accept order if not we reject.
If we have idle capacity and profit is positive then what?, if we do not have idle capacity and accept order, what does this mean?
If we have idle capacity and profit is positive we accept.
If we don’t have idle capacity and accept a positive order, we have give up existing production ( opportunity cost of accepting special order, we have to add this to the cost of accepting the order)
Assumptions:
– The excess capacity (10,000 units) is considered temporary
(an increase in demand is expected)
– A new customer offers to buy 4,000 units at p = 25
– The order will not be repeated (one-off)
– No additional marketing and distribution costs associated
with the order
– The product will need to be slightly modified at a cost of £2
per unit
• …Should the special order be accepted?
To do this Compute what costs will be if you reject and accept and the difference and find profit( Total the total costs - sales revenue to give profit.
Irrelevant costs:
DL ( have idle capacity so don’t have to increase labour or i think i the short run you cant increase labour)
DM ( relevant)
Variable Man.OH ( relevant)
Fixed man.OH ( occurred regardless of special order)
Marketing & distrubtion ( Irrelevant due to the question)
Added product customisation.
Incremental revenue > incremental cost, thus accept.
Assume now that:
– demand is not going to increase and idle capacity in the long
term will become permanent
– a customer outside the usual market offers a 3 year
agreement to purchase 10,000 units at p = 22
– the product will have to be customised at a cost of 2 per unit
– if capacity is permanently reduced:
• 20% of direct labour will be made redundant
• Fixed man. OH will decrease by 50,000
• Marketing and distribution costs will decrease by 10,000
– no alternative uses of idle capacity can be found
• … Should the company permanently reduce capacity, or
accept the long-term special order?
HINT ( A REDUCTION IS A COST WHEN REJECT ORDER, IS THE OPPORTUNITY COST OF ACCEPTING ORDER, SO YOU NEED TO ADD THE COST IF YOU ACCEPT ORDER)
DL ( now relevant,thats idle capacity will become long term and it operates at full capacity 10000 X 10 X 0.8)
FOH ( opportunity cost which you add)
Marketing ( Opportunity cost which you add)
Sales revenue = 22 x 10000 add on to the original
Construct a marginal costing income statement and compare operating profits.
Example: component X is currently manufactured internally; an
external supplier offers to provide it at p = 45 per unit for at least
3 years
• Annual volume = 10,000 units
Assume that if production of X ceases:
– Direct labour will become redundant
– Direct materials and variable manufacturing OH will no longer be
incurred
– Fixed manufacturing OH will decrease by 10,000
– Non-manufacturing OH will remain the same
– The capacity freed up will have no alternative use
COMPARE MAKE AND BUY ( HINT REMEMBER TO INCLUDE OUTSIDE PURCHASE COST, AND WHATS THE SIGN OF IT)
We save DL, DM AND VOH
Another outsourcing question?
Lets say you need to make bicycle seats and you can make them internally or buy from an external supplier that offers $10 for 5000 seats ( cost $50000)
so compare costs of making internally to buying.
Origninally if we look at the two costs we would buy from external supplier as total costs of external supplier $50000< $70000.
but this is wrong as we need to look at relevant costs( costs that differ)
Relevant costs : DM, DL, VOH will not exist if we buy from external supplier( as we have saved this)
Depreciation of saddle machine ( sunk costs, no alternative use for machine other than saddle) assuming no salvage value) and Allocation of general overhead ( e.g. keeping lights on, this exists whether or not we buy externally the shop also manufactures over things, so not relevant)
So total cost of producing internally is $46000 which is < $50000, so actually its better to make internally as its cheaper.
Should sales office Y be discontinued?
• Assume that if Y is discontinued, COGS, sales force salaries, sales
office rent and regional and headquarters costs allocated on a
cause-effect basis will be eliminated
• Assume that the regional warehouse was serving office Y but also
other offices: rent for it will still be incurred after discontinuation
of office Y (assume that the space thus freed up cannot be
sublet)
Look at the costs of Keeping Y(overall) and discontinue Y find the difference and see if there is a profit or loss.
We have to look at the relevant costs to see and not base it on the pure numbers.
depreication of office equipment ( irrelevant)
Share of warehouse rent irrelevant
allocated arbitrarily ( ?)
Even if regional office Y operates at a loss, it still generates for the overall firm
a positive contribution of £1,300
Why is regional and headquarter costs allocated on a ‘cause-effect basis a relevant cost but allocated arbitarliy is not?
( the reason why the regional and headquarter for ‘cause-effect basis) cost happens is due to the office y ,assuming OH allocation is reliable, if that is discontinued then we remove cost.)
The reason why regional and headquarter costs allocated arbitrarily means that Y is not the cause of costs, hence, if it discontinues there is no effect, so irrelevant. ( usually OH allocation is not a relevant cost)
What do we do first?
What would happen if there was no limiting factor?
Calculate contribution per limiting factor.
Then rank.
If there was no limiting factor we would only produce C as it gives me the most CM per unit
Now find out how many products to produce of each given rank and how much each product absorbs of the limiting factor.
Do 1) HINT there is a time constraint(LIMITING FACTOR), pick optimal mix only that has highest contribution margin per hour .
Question 2( constraint/limiting factor number of cases)
Plastik is a small manufacturer of moulded plastic objects specialised in the production of plastic dolls. Its moulding machines operate at a maximum capacity of 100 dolls per hour. The variable cost of producing one doll is £1.70, and the unit price of dolls is £2.00. A large toy company has recently approached Plastik with a special order of 100,000 units of a moulded plastic toy which they would pay £3 per unit. To fulfil this order, Plastik would need to construct a new mould specifically needed for this toy, at a cost of £20,000.
Because the toy is of a more complex shape than the dolls, a moulding machine could produce only 50 units per hour. The unit variable cost to manufacture the toy would be £2.50. Plastik has a total capacity of 10,000 machine-hours and its fixed costs, excluding the cost to construct the new toy mould, are £200,000. Summarise this
Assume that the demand for dolls is 800,000 units, and the special order has to be either accepted in full or rejected. Should Plastik accept the special order? ( HINT : SPARE CAPACITY)
- How would your answer to question 1 change if the demand for dolls was:
a. 850,000 units?
b. 900,000 units?
c. 950,000 units?
Assuming that Plastik could accept any partial quantity of the full special toy order,
what would be the optimal mix of dolls and toys to manufacture if the demand for
dolls was:
a. 850,000 units?
b. 900,000 units?
c. 950,000 units?
