Chapter objectives
Structure of the chapter
Elements of a decision
Relevant costs for decision making
Opportunity cost
Shutdown problems
Key terms
The need for a decision arises in business because a manager is faced with a problem and alternative courses of action are available. In deciding which option to choose he will need all the information which is relevant to his decision; and he must have some criterion on the basis of which he can choose the best alternative. Some of the factors affecting the decision may not be expressed in monetary value. Hence, the manager will have to make 'qualitative' judgements, e.g. in deciding which of two personnel should be promoted to a managerial position. A 'quantitative' decision, on the other hand, is possible when the various factors, and relationships between them, are measurable. This chapter will concentrate on quantitative decisions based on data expressed in monetary value and relating to costs and revenues as measured by the management accountant.
This chapter is intended to provide:
· An overview of the elements required for manager to make informed decisions among alternative courses of action· An explanation of the relevant costs for decision making purposes
· The construction of Cost-Volume-Profit analyses and Breakeven charts and their usefulness in decision making
· The factors affecting the economic choice of whether to make components in-house or buy from outside
· How to make decisions on shutdown, additions or deletions to product lines or ranges, important to marketing managers.
Often "information" is interpreted by marketers as being "external" market based information. However, "internal" sources are just as important, none more so than financial information. The chapter looks at the relevant elements of cost for decision making, then looks at the various techniques including breakeven analysis. Other important business decisions are whether to source components internally or have them brought in from outside, and whether to continue with operations if they appear uneconomic. The chapter examines the techniques useful in helping to make decisions in these areas.
A quantitative decision problem involves six parts:
a) An objective that can be quantified Sometimes referred to as 'choice criterion' or 'objective function', e.g. maximisation of profit or minimisation of total costs.b) Constraints Many decision problems have one or more constraints, e.g. limited raw materials, labour, etc. It is therefore common to find an objective that will maximise profits subject to defined constraints.
c) A range of alternative courses of action under consideration. For example, in order to minimise costs of a manufacturing operation, the available alternatives may be:
i) to continue manufacturing as at present
ii) to change the manufacturing method
iii) to sub-contract the work to a third party.d) Forecasting of the incremental costs and benefits of each alternative course of action.
e) Application of the decision criteria or objective function, e.g. the calculation of expected profit or contribution, and the ranking of alternatives.
f) Choice of preferred alternatives.
The costs which should be used for decision making are often referred to as "relevant costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management decisions'.
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose.b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.
Other terms:
d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatever products are produced.e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred.
f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered.
Relevant costs may also be expressed as opportunity costs. An opportunity cost is the benefit foregone by choosing one opportunity instead of the next best alternative.
Example
A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for $1,000. To buy an equivalent quantity now would cost $2,000. The company has no plans to use the leather for other purposes, although it has considered the possibilities:
a) of using it to cover desk furnishings, in replacement for other material which could cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to exceed $800).
In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would not be costed at $1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunities of either disposing of it for $800 or of using it to save an outlay of $900 on desk furnishings.
The better of these alternatives, from the point of view of benefiting from the leather, is the latter. "Lost opportunity" cost of $900 will therefore be included in the cost of the book for decision making purposes.
The relevant costs for decision purposes will be the sum of:
i) 'avoidable outlay costs', i.e. those costs which will be incurred only if the book project is approved, and will be avoided if it is notii) the opportunity cost of the leather (not represented by any outlay cost in connection to the project).
This total is a true representation of 'economic cost'.
Now attempt exercise 5.1.
Exercise 5.1 Relevant costs and opportunity costs
Zimglass Industries Ltd. has been approached by a customer who would like a special job to be done for him, and is willing to pay $60,000 for it. The job would require the following materials.
|
Material |
Total units required |
Units already in stock |
Book value of units in stock $/unit |
Realisable value $/unit |
Replacement cost $/unit |
|
A |
1000 |
0 |
- |
- |
16.00 |
|
B |
1000 |
600 |
12.00 |
12.50 |
15.00 |
|
C |
1000 |
700 |
13.00 |
12.50 |
14.00 |
|
D |
200 |
200 |
14.00 |
16.00 |
19.00 |
a) Material B is used regularly by Zimglass Industries Ltd, and if units of B are required for this job, they would need to be replaced to meet other production demands.b) Materials C and D are in stock due to previous over-buying, and they have restricted use. No other use could be found for material C, but the units of material D could be used in another job as a substitute for 300 units of material E, which currently costs $15 per unit (of which the company has no units in stock at the moment).
Calculate the relevant costs of material for deciding whether or not to accept the contract. You must carefully and clearly explain the reasons for your treatment of each material.
The assumptions in relevant costing
Some of the assumptions made in relevant costing are as follows:
a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known.b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with certainty.
c) The objective of decision making in the short run is to maximise 'satisfaction', which is often known as 'short-term profit'.
d) The information on which a decision is based is complete and reliable.
Cost-volume-profit (CVP) analysis
CVP analysis involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is therefore concerned with predicting the effects of changes in costs and sales volume on profit. It is also known as 'breakeven analysis'.
The technique used carefully may be helpful in the following situations:
a) Budget planning. The volume of sales required to make a profit (breakeven point) and the 'safety margin' for profits in the budget can be measured.b) Pricing and sales volume decisions.
c) Sales mix decisions, to determine in what proportions each product should be sold.
d) Decisions that will affect the cost structure and production capacity of the company.
The basic principles of CVP analysis
CVP analysis is based on the assumption of a linear total cost function (constant unit variable cost and constant fixed costs) and so is an application of marginal costing principles.
The principles of marginal costing can be summarised as follows:
a) Period fixed costs are a constant amount, therefore if one extra unit of product is made and sold, total costs will only rise by the variable cost (the marginal cost) of production and sales for that unit.b) Also, total costs will fall by the variable cost per unit for each reduction by one unit in the level of activity.
c) The additional profit earned by making and selling one extra unit is the extra revenue from its sales minus its variable costs, i.e. the contribution per unit.
d) As the volume of activity increases, there will be an increase in total profits (or a reduction in losses) equal to the total revenue minus the total extra variable costs. This is the extra contribution from the extra output and sales.
e) The total profit in a period is the total revenue minus the total variable cost of goods sold, minus the fixed costs of the period.
|
Revenue |
X |
|
Variable cost of sales |
(X) |
|
CONTRIBUTION |
X |
|
Fixed Costs |
(X) |
|
PROFIT |
X |
Example: breakeven charts and P/V charts
Sabre Products Ltd. makes and sells a single product. The variable cost is $3/unit and the variable cost of selling is $1/unit. Fixed costs total $6,000 and the unit sales price is $6.
Sabre Products Ltd. budgets to make and sell 3,600 units in the next year.
Draw a breakeven chart, and a P/V graph, each showing the expected amount of output and sales required to breakeven, and the safety margin in the budget.
Solution:
A breakeven chart records the amount of fixed costs, variable costs, total costs and total revenue at all volumes of sales, and at a given sales price as follows:
Figure 5.1 Breakeven chart
The 'breakeven point' is where revenues and total costs are exactly the same, so there is no profit or loss. It may be expressed in terms of units of sale or in terms of sales revenue. Reading from the graph, the breakeven point is 3,000 units of sale and $18,000 in sales revenue.
The 'margin of safety' is the amount which actual output/sales may fall short of the budget without a loss being made, often expressed as a percentage of the budgeted sales volume. It is a rough measure of the risk that Sabre Products might make a loss if it fails to achieve its budget. In our example, the margin of safety is calculated as follows:
|
|
Units |
|
Budgeted sales |
3,600 |
|
Breakeven point |
3,000 |
|
Margin of safety (MOS) |
600 |
As a percentage of budgeted sales; the
= 16.67%.
A high margin of safety shows a good expectation of profits, even if the budget is not achieved.
The Profit/Volume (P/V) graph
The P/V graph is similar to the breakeven chart, and records the profit or loss at each level of sales, at a given sales price. It is a straight line graph, drawn by recording the following:
i) the loss at zero sales, which is the full amount of fixed costs
ii) the profit/(loss) at the budgeted sales level.
The two points are then joined up. In our example above, the PA/graph would look like this:
Figure 5.2 The profit/volume (P/V) graph
The breakeven point may be read from the graph as $18,000 in sales revenue, and the margin of safety is $3,600 in sales revenue or 16.67% budgeted sales revenue.
The arithmetic of CVP analysis
a) To calculate the breakeven point the following formula applies:
S = V+ F at the breakeven point,
where:
S = sales revenue
V = variable costs
F = fixed costs (so that V + F = total costs).
Therefore:
(S - V) = F
At the breakeven point, total contribution (S - V) equals the amount of fixed costs (F).
b) To calculate the amount of sales needed to achieve a target profit the following formula applies:
S = V + F + P
Therefore,
(S - V) = (F + P)
To earn a target profit, the total contribution (S - V) must be sufficient to cover fixed costs plus the amount of profit required (F + P).
Now attempt exercise 5.2.
Exercise 5.2 Arithmetic of CVP analysis
Ndlovu Ltd. manufactures a single product, which has a variable cost of sale of $8/unit and a sales price of $12/unit. Budgeted fixed costs are $24,000.
Required:
Calculate the volume of sales that would be required to achieve the following:
a) Breakeven
b) Earn a profit of at least $6,000.
The contribution/sales ratio (C/S ratio)
The C/S ratio shows how much contribution is earned per $1 of sales revenue earned. Since costs and sales revenues are linear functions, the C/S ratio is constant at all levels of output and sales. It is used sometimes as a measure of performance or profitability, and in CVP analysis to calculate the sales required to breakeven or earn a target profit or the expected total contribution at a given volume of sales and with a given C/S ratio.
As an alternative method of calculation, the breakeven point in sales revenue is calculated as follows:
Similarly, the sales volume needed to achieve a target profit is calculated as follows:
In exercise 5.2, the C/S ratio is
a) The breakeven point is therefore
Required sales to breakeven
= $72,000 or divided by $12
= 6,000 units
b) To achieve a target profit of $6,000 the required sales are calculated as;
= $90,000
or divided by 12
= 7,500 units
Make or buy decisions
A company is often faced with the decision as to whether it should manufacture a component or buy it outside.
Suppose for example, that Masanzu Ltd. make four components, W, X, Y and Z, with expected costs for the coming year as follows:
|
|
W |
X |
Y |
Z |
|
Production (units) |
1,000 |
2,000 |
4,000 |
3,000 |
|
Unit marginal costs |
$ |
$ |
$ |
$ |
|
Direct materials |
4 |
5 |
2 |
4 |
|
Direct labour |
8 |
9 |
4 |
6 |
|
Variable production overheads |
2 |
3 |
1 |
2 |
|
|
14 |
17 |
7 |
12 |
Direct fixed costs/annum and committed fixed costs are as follows:
|
Incurred as a direct consequence of making W |
1,000 |
|
Incurred as a direct consequence of making X |
5,000 |
|
Incurred as a direct consequence of making Y |
6,000 |
|
Incurred as a direct consequence of making Z |
8,000 |
|
Other committed fixed costs |
30,000 |
|
|
50,000 |
A subcontractor has offered to supply units W, X, Y and Z for $12, $21, $10 and $14 respectively.
Decide whether Masanzu Ltd. should make or buy the components.
Solution and discussion
a) The relevant costs are the differential costs between making and buying. They consist of differences in unit variable costs plus differences in directly attributable fixed costs. Subcontracting will result in some savings on fixed cost.
|
|
W |
X |
Y |
Z |
|
$ |
$ |
$ |
$ |
|
|
Unit variable cost of making |
14 |
17 |
7 |
12 |
|
Unit variable cost of buying |
12 |
21 |
10 |
14 |
|
|
(2) |
-4 |
2 |
2 |
|
Annual requirements in units |
1,000 |
2,000 |
4,000 |
3,000 |
|
Extra variable cost of buying per annum |
(2,000) |
8,000 |
12,000 |
6,000 |
|
Fixed cost saved by buying |
1,000 |
5,000 |
6,000 |
8,000 |
|
Extra total cost of buying |
(3,000) |
3,000 |
6,000 |
(2,000) |
b) The company would save $3,000/annum by sub-contracting component W, and $2,000/annum by sub-contracting component Z.
c) In this example, relevant costs are the variable costs of in-house manufacture, the variable costs of sub-contracted units, and the saving in fixed costs.
d) Other important considerations are as follows:
i) If components W and Z are sub-contracted, the company will have spare capacity. How should that spare capacity be profitably used? Are there hidden benefits to be obtained from sub-contracting? Will there be resentment from the workforce?ii) Would the sub-contractor be reliable with delivery times, and is the quality the same as those manufactured internally?
iii) Does the company wish to be flexible and maintain better control over operations by making everything itself?
iv) Are the estimates of fixed costs savings reliable? In the case of product W, buying is clearly cheaper than making in-house. However, for product Z, the decision to buy rather than make would only be financially attractive if the fixed cost savings of $8,000 could be delivered by management. In practice, this may not materialise.
Now attempt exercise 5.3.
Exercise 5.3 Make or buy
The Pip, a component used by Goya Manufacturing Ltd., is incorporated into a number of its completed products. The Pip is purchased from a supplier at $2.50 per component and some 20,000 are used annually in production.
The price of $2.50 is considered to be competitive, and the supplier has maintained good quality service over the last five years. The production engineering department at Goya Manufacturing Ltd. has submitted a proposal to manufacture the Pip in-house. The variable cost per unit produced is estimated at $1.20 and additional annual fixed costs that would be incurred if the Pip were manufactured are estimated at $20,800.
a) Determine whether Goya Manufacturing Ltd. should continue to purchase the Pip or manufacture it in-house.b) Indicate the level of production required that would make Goya Manufacturing Ltd. decide in favour of manufacturing the Pip itself.
Shutdown problems involve the following types of decisions:
a) Whether or not to close down a factory, department, product line or other activity, either because it is making losses or because it is too expensive to run.b) If the decision is to shut down, whether the closure should be permanent or temporary. Shutdown decisions often involve long term considerations, and capital expenditures and revenues.
c) A shutdown should result in savings in annual operating costs for a number of years in the future.
d) Closure results in release of some fixed assets for sale. Some assets might have a small scrap value, but others, e.g. property, might have a substantial sale value.
e) Employees affected by the closure must be made redundant or relocated, perhaps even offered early retirement. There will be lump sums payments involved which must be taken into consideration. For example, suppose closure of a regional office results in annual savings of $100,000, fixed assets sold off for $2 million, but redundancy payments would be $3 million. The shutdown decision would involve an assessment of the net capital cost of closure ($1 million) against the annual benefits ($100,000 per annum).
It is possible for shutdown problems to be simplified into short run decisions, by making one of the following assumptions
a) Fixed asset sales and redundancy costs would be negligible.
b) Income from fixed asset sales would match redundancy costs and so these items would be self-cancelling.
In these circumstances the financial aspects of shutdown decisions would be based on short run relevant costs.
Now attempt exercise 5.4.
Exercise 5.4 Adding or deleting products
Brass Ltd. manufactures three products, Swans, Ducks and Chicks. The present net annual income from each item is as follows:
|
|
Swans |
Ducks |
Chicks |
Total |
|
$ |
$ |
$ |
$ |
|
|
Sales |
50,000 |
40,000 |
60,000 |
150,000 |
|
Variable costs |
30,000 |
25,000 |
35,000 |
90,000 |
|
Contribution |
20,000 |
15,000 |
25,000 |
60,000 |
|
Fixed costs |
17,000 |
18,000 |
20,000 |
55,000 |
|
Profit/(loss) |
3,000 |
(3,000) |
5,000 |
5,000 |
Brass Ltd. is concerned about its poor profit performance, and is considering whether or not to cease selling Ducks. It is felt that selling prices cannot be increased or lowered without adversely affecting net income. $5,000 of the fixed costs of Ducks are direct fixed costs which would be saved if production ceased. All other fixed costs will remain the same.
a) Advise Brass Ltd. whether or not to cease production of Ducks.
b) Suppose, however, it were possible to use the resources realised by stopping production of Ducks, and switch to produce a new item, Eagles, which would sell for $50,000 and incur variable costs of $30,000 and extra fixed costs of $6,000. What will the new decision be?
Breakeven analysis
Contribution/sales ratio
Cost-volume-profit analysis
Decision making
Make or buy decisions
Opportunity costs
Profit-volume charts
Relevant costs
Shutdown
