Managerial Accounting Profit Planning : Setting Standard ... · Managerial Accounting ... Standard...

FACULTY OF BUSINESS

Nurturing professionals with high moral and ethical values

Managerial Accounting

Assoc. Prof. Dr. Mohd Fuad Mohd [email protected]

019-332 6629

1st. Sept. 2012

Managerial Accounting

Profit Planning : Setting Standard in Decision Making

1

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1. Standard

2. Profit Planning

3. Decision Making

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Standard

Standards are benchmarks or “norms”for measuring performance. Two types

of standards are commonly used.

Quantity standardsspecify how much of aninput should be used to

make a product orprovide a service.

Cost (price)standards specify

how much should bepaid for each unit

of the input.

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Standard Costs

Deviations from standards deemed significantare brought to the attention of management, apractice known as management by exception.

Am

ou

nt Standard

DirectMaterial

Type of Product Cost

Am

ou

nt

DirectLabor

ManufacturingOverhead

Standard

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Variance Analysis Cycle

Identifyquestions

Receive explanations

Takecorrective

actions

Exhibit10-1

Prepare standard cost performance

report

Analyze variances

Begin

Conduct next period’s

operations

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Accountants, engineers, purchasing

agents, and production managers

combine efforts to set standards that encourage

efficient future production.

Setting Standard Costs

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Setting Standard Costs

Should we useideal standards that require employees towork at 100 percent

peak efficiency?

I recommend using practical standards that are currently

attainable with reasonable and efficient effort.

Engineer ManagerialAccountant

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Setting Standards

PriceStandards

QuantityStandards

Summarized in a Bill of Materials.

Final, deliveredcost of materials,net of discounts.

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Setting Standards

Six Sigma advocates have sought toeliminate all defects and waste, rather than

continually build them into standards.

As a result allowances for waste andAs a result allowances for waste andspoilage that are built into standards

should be reduced over time.

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Setting Direct Labor Standards

RateStandards

TimeStandards

Often a singlerate is used that reflectsthe mix of wages earned.

Use time and motion studies for

each labor operation.

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Setting Variable Overhead Standards

RateStandards

ActivityStandards

The rate is the variable portion of the

predetermined overheadrate.

The activity is thebase used to calculate

the predetermined overhead.

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A standard cost card for one unit of product might look like this:

A A x B

Standard Standard Standard

Quantity Price Cost

B

Inputs or Hours or Rate per Unit

Direct materials 3.0 lbs. 4.00$ per lb. 12.00$

Direct labor 2.5 hours 14.00 per hour 35.00

Variable mfg. overhead 2.5 hours 3.00 per hour 7.50

Total standard unit cost 54.50$

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Standards vs. Budgets

Are standards the same as budgets?

A budget is set for total costs.

A standard is a per unit cost.

Standards are often used when

preparing budgets.

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Price and Quantity Standards

Price and and quantity standards are determined separately for two reasons:

� The purchasing manager is responsible for raw� The purchasing manager is responsible for rawmaterial purchase prices and the production manageris responsible for the quantity of raw material used.

� The buying and using activities occur at different times.Raw material purchases may be held in inventory for aperiod of time before being used in production.

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A General Model for Variance Analysis

Variance Analysis

Price Variance

Difference betweenactual price and standard price

Quantity Variance

Difference betweenactual quantity andstandard quantity

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Variance Analysis


Price Variance Quantity Variance

Materials price varianceLabor rate variance

VOH spending variance

Materials quantity varianceLabor efficiency varianceVOH efficiency variance

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Actual Quantity Actual Quantity Standard Quantity× × ×

Actual Price Standard Price Standard Price



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Actual quantity is the amount of direct materials, direct labor, and variable

manufacturing overhead actually used.

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Standard quantity is the standard quantity allowed for the actual output of the period.

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Actual price is the amount actuallypaid for the input used.

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Standard price is the amount that should have been paid for the input used.


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(AQ × AP) – (AQ × SP) (AQ × SP) – (SQ × SP)

AQ = Actual Quantity SP = Standard PriceAP = Actual Price SQ = Standard Quantity


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Glacier Peak Outfitters has the following direct material standard for the fiberfill in its mountain parka.

0.1 kg. of fiberfill per parka at $5.00 per kg.

Material Variances Example

Last month 210 kgs of fiberfill were purchased and used to make 2,000 parkas. The material cost a total of $1,029.

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210 kgs. 210 kgs. 200 kgs.× × ×

$4.90 per kg. $5.00 per kg. $5.00 per kg.



Material Variances Summary


= $1,029 = $1,050 = $1,000

Price variance$21 favorable

Quantity variance$50 unfavorable

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210 kgs. 210 kgs. 200 kgs.× × ×




$1,029 ÷ 210 kgs = $4.90 per kg. $5.00 per kg. $5.00 per kg.

= $1,029 = $1,050 = $1,000



$1,029 ÷ 210 kgs = $4.90 per kg

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210 kgs. 210 kgs. 200 kgs.× × ×




0.1 kg per parka × 2,000 parkas = $4.90 per kg. $5.00 per kg. $5.00 per kg.

= $1,029 = $1,050 = $1,000



0.1 kg per parka × 2,000 parkas = 200 kgs

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Material Variances:Using the Factored Equations

Materials price varianceMPV = AQ (AP - SP)

= 210 kgs ($4.90/kg - $5.00/kg)

= 210 kgs (-$0.10/kg)

= $21 F= $21 F

Materials quantity varianceMQV = SP (AQ - SQ)

= $5.00/kg (210 kgs-(0.1 kg/parka× 2,000 parkas))

= $5.00/kg (210 kgs - 200 kgs)

= $5.00/kg (10 kgs)

= $50 U

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Isolation of Material Variances

I need the price variancesooner so that I can better

identify purchasing problems.

You accountants just don’tunderstand the problems that

purchasing managers have.

I’ll start computingthe price variancewhen material is

purchased rather thanwhen it’s used.

purchasing managers have.

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Material Variances

High Hill purchased and used 1,700 pounds. How

are the variances computed if the amount purchased differs from

the amount used?

The price variance is computed on the entire

quantity purchased.

The quantity variance is computed only on the quantity used.

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Responsibility for Material Variances

Materials Price VarianceMaterials Quantity Variance

Production Manager Purchasing Manager

The standard price is used to compute the quantity varianceso that the production manager is not held responsible for

the purchasing manager’s performance.

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I am not responsible forthis unfavorable material

quantity variance.

You purchased cheapmaterial, so my people

Your poor scheduling sometimes requires me to

rush order material at a higher price, causing unfavorable

price variances.

Responsibility for Material Variances

material, so my peoplehad to use more of it.

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High Hill Bhd. has the following direct material standard to manufacture one Zippy:

1.5 pounds per Zippy at $4.00 per pound

Zippy

Exercise�

Last week, 1,700 pounds of material were purchased and used to make 1,000 Zippies. The material cost a total of

$6,630.

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Zippy

High Hill’s material price variance (MPV)for the week was:

a. $170 unfavorable.

Exercise�

b. $170 favorable.

c. $800 unfavorable.

d. $800 favorable.

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High Hill’s material price variance (MPV)for the week was:


Zippy

Exercise�

b. $170 favorable.


d. $800 favorable. MPV = AQ(AP - SP)MPV = 1,700 lbs. × ($3.90 - 4.00)MPV = $170 Favorable

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Exercise�

High Hill’s material quantity variance (MQV)for the week was:


Zippy


b. $170 favorable.


d. $800 favorable.

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High Hill’s material quantity variance (MQV)for the week was:


Zippy

Exercise�


b. $170 favorable.


d. $800 favorable.

MQV = SP(AQ - SQ)MQV = $4.00(1,700 lbs - 1,500 lbs)MQV = $800 unfavorable

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1,700 lbs. 1,700 lbs. 1,500 lbs.



Zippy

Exercise�

1,700 lbs. 1,700 lbs. 1,500 lbs.× × ×

$3.90 per lb. $4.00 per lb. $4.00 per lb.

= $6,630 = $ 6,800 = $6,000



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High Hill Bhd. has the following material standard to manufacture one Zippy:


Zippy


Last week, 2,800 pounds of material were purchased at a total cost of $10,920, and 1,700 pounds were used to make

1,000 Zippies.

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Actual Quantity Actual QuantityPurchased Purchased

× ×Actual Price Standard Price

2,800 lbs. 2,800 lbs.

Zippy

2,800 lbs. 2,800 lbs. × ×

$3.90 per lb. $4.00 per lb.

= $10,920 = $11,200


Price variance increases because quantity

purchased increases.

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Actual QuantityUsed Standard Quantity

× ×Standard Price Standard Price

1,700 lbs. 1,500 lbs.

Zippy

1,700 lbs. 1,500 lbs.× ×

$4.00 per lb. $4.00 per lb.

= $6,800 = $6,000


Quantity variance is unchanged because actual

and standard quantities are unchanged.

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Understanding the Understanding the processes of profit processes of profit processes of profit processes of profit

planning.planning.

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Planning and Control

PlanningPlanning ––involves developing involves developing objectives and preparing objectives and preparing various budgets to achieve various budgets to achieve

ControlControl ––involves the steps taken by involves the steps taken by management that attempt management that attempt to ensure the objectives are to ensure the objectives are various budgets to achieve various budgets to achieve

these objectives.these objectives.to ensure the objectives are to ensure the objectives are attained.attained.

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The Basic Framework of Budgeting

A budget is a detailed quantitative plan for acquiring and using financial and other resources

over a specified forthcoming time period.

1. The act of preparing a budget is called 1. The act of preparing a budget is called budgeting.

2. The use of budgets to control an organization’s activity is known as budgetary control.

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Advantages of Budgeting

Advantages

Define goalDefine goaland objectivesand objectives

CommunicateCommunicateplansplans

Think about andThink about andplan for the futureplan for the future

Advantages

Uncover potentialUncover potentialbottlenecksbottlenecks

CoordinateCoordinateactivitiesactivities

Means of allocatingMeans of allocatingresourcesresources

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Responsibility Accounting

Managers should be held responsible for those items Managers should be held responsible for those items ——and and onlyonly those items those items —— thatthat

the manager the manager can actually controlcan actually controlto a significant extent.to a significant extent.

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Self-Imposed Budget

MiddleManagement

MiddleManagement

Top Management

A budget is prepared with the full cooperation andA budget is prepared with the full cooperation andparticipation of managers at all levels. A participativeparticipation of managers at all levels. A participative

budget is also known as a budget is also known as a selfself--imposed budgetimposed budget..

Supervisor Supervisor Supervisor Supervisor

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Advantages of Self-Imposed Budgets

1.1. Individuals at all levels of the organization are viewed as Individuals at all levels of the organization are viewed as members of the team whose judgments are valued by top members of the team whose judgments are valued by top management.management.

2.2. Budget estimates prepared by frontBudget estimates prepared by front--line managers are line managers are often more accurate than estimates prepared by top often more accurate than estimates prepared by top managers.managers.managers.managers.

3.3. Motivation is generally higher when individuals Motivation is generally higher when individuals participate in setting their own goals than when the goals participate in setting their own goals than when the goals are imposed from above.are imposed from above.

4.4. A manager who is not able to meet a budget imposed A manager who is not able to meet a budget imposed from above can claim that it was unrealistic. Selffrom above can claim that it was unrealistic. Self--imposed imposed budgets eliminate this excuse.budgets eliminate this excuse.

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Self-Imposed Budgets

Most companies do not rely exclusively upon Most companies do not rely exclusively upon selfself--imposed budgets in the sense that top imposed budgets in the sense that top

managers usually initiate the budget process by managers usually initiate the budget process by issuing broad guidelines in terms of overall issuing broad guidelines in terms of overall

profits or sales.profits or sales.profits or sales.profits or sales.

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Human Factors in Budgeting

The success of budgeting depends upon three important The success of budgeting depends upon three important factors:factors:

1.1. Top management must be enthusiastic and committed Top management must be enthusiastic and committed to the budget process.to the budget process.

2.2. Top management must not use the budget to pressure Top management must not use the budget to pressure employees or blame them when something goes wrong.employees or blame them when something goes wrong.employees or blame them when something goes wrong.employees or blame them when something goes wrong.

3.3. Highly achievable budget targets are usually preferred Highly achievable budget targets are usually preferred when managers are rewarded based on meeting budget when managers are rewarded based on meeting budget targets.targets.

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The Budget Committee

A standing committee responsible for A standing committee responsible for

�� overall policy matters relating to the overall policy matters relating to the budgetbudget

�� coordinating the preparation of the coordinating the preparation of the �� coordinating the preparation of the coordinating the preparation of the budgetbudget

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The Master Budget: An Overview

ProductionBudget

ProductionBudget

Selling andAdministrative

Budget

Selling andAdministrative

Budget

SalesBudgetSalesBudget

EndingFinished Goods

Budget

EndingFinished Goods

Budget

BudgetBudget

DirectMaterialsBudget

DirectMaterialsBudget

ManufacturingOverheadBudget

ManufacturingOverheadBudget

DirectLaborBudget

DirectLaborBudget

CashBudgetCashBudget

Budgeted Financial StatementsBudgeted Financial Statements

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Learning Objective 2

Preparing a Preparing a sales sales budget budget and and schedule of expected schedule of expected and and schedule of expected schedule of expected

cash collections.cash collections.

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Budgeting Example

��Royal Company is preparing budgets for the Royal Company is preparing budgets for the quarter ending June 30.quarter ending June 30.

��Budgeted sales for the next five months are:Budgeted sales for the next five months are:

April April 20,000 units20,000 units

May May 50,000 units50,000 units

June June 30,000 units30,000 units

July July 25,000 units25,000 units

August August 15,000 units.15,000 units.

��The selling price is $10 per unit.The selling price is $10 per unit.

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The Sales Budget

The individual months of April, May, and June are summed to obtain the total projected sales in units and

dollars for the quarter ended June 30th

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Expected Cash Collections

�� All sales are on account.All sales are on account.

�� Royal’s collection pattern is:Royal’s collection pattern is:

70% collected in the month of sale,70% collected in the month of sale,

25% collected in the month following sale,25% collected in the month following sale,25% collected in the month following sale,25% collected in the month following sale,

5% uncollectible.5% uncollectible.

�� The March 31 accounts receivable balance of The March 31 accounts receivable balance of $30,000 will be collected in full.$30,000 will be collected in full.

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From the Sales Budget for April.From the Sales Budget for April.

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From the Sales Budget for May.From the Sales Budget for May.

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Exercise �

What will be the total cash collections for the quarter? What will be the total cash collections for the quarter?

a. $700,000a. $700,000

b. $220,000b. $220,000

c. $190,000c. $190,000c. $190,000c. $190,000

d. $905,000d. $905,000

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What will be the total cash collections for the quarter? What will be the total cash collections for the quarter?

a. $700,000a. $700,000

b. $220,000b. $220,000

c. $190,000c. $190,000

Exercise �

c. $190,000c. $190,000

d. $905,000d. $905,000

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Relevant and irrelevant Relevant and irrelevant costs and benefits in costs and benefits in costs and benefits in costs and benefits in

decision making process.decision making process.

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Cost Concepts for Decision Making

A relevant cost is a cost that differs between alternatives.

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Identifying Relevant Costs

An An avoidable costavoidable cost can be eliminated, in whole or in part, can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable by choosing one alternative over another. Avoidable

costs are relevant costs. Unavoidable costs are costs are relevant costs. Unavoidable costs are irrelevant costs.irrelevant costs.irrelevant costs.irrelevant costs.

Two broad categories of costs are never relevant in any Two broad categories of costs are never relevant in any decision. They decision. They includeinclude: :

��Sunk costs.Sunk costs.

��Future costs that Future costs that do not differdo not differ between the alternatives.between the alternatives.

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Relevant Cost Analysis: A Two-Step Process

Eliminate costs and benefits that do not differ between alternatives.

Use the remaining costs and benefits that differ between alternatives in making the decision. The

Step 1

Step 2between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.

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Different Costs for Different Purposes

Costs that are relevant in one

decision situation decision situation may not be relevant in another context.

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Annual Cost Cost per

Automobile Costs (based on 10,000 miles driven per year)

Veronica, Veronica, a a Penang Penang student, is considering visiting her friend in student, is considering visiting her friend in Kuala Kuala Lumpur. Lumpur. She can drive or take the train. By car, it is 230 miles to her She can drive or take the train. By car, it is 230 miles to her friend’s apartment. She is trying to decide which alternative is less friend’s apartment. She is trying to decide which alternative is less

expensive and has gathered the following information:expensive and has gathered the following information:

Annual Cost

of Fixed Items

Cost per

Mile

1 Annual straight-line depreciation on car 2,800$ 0.280$

2 Cost of gasoline 0.050

3 Annual cost of auto insurance and license 1,380 0.138

4 Maintenance and repairs 0.065

5 Parking fees at school 360 0.036

6 Total average cost 0.569$

$45 per month $45 per month ×× 8 months8 months $1.60 per gallon ÷ 32 MPG

$18,000 cost $18,000 cost –– $4,000 salvage value $4,000 salvage value ÷÷ 5 years5 years

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Annual Cost

of Fixed Items

Cost per

Mile

1 Annual straight-line depreciation on car 2,800$ 0.280$

2 Cost of gasoline 0.050

3 Annual cost of auto insurance and license 1,380 0.138

4 Maintenance and repairs 0.065

5 Parking fees at school 360 0.036


Automobile Costs (based on 10,000 miles driven per year)


7 Reduction in resale value of car per mile of wear 0.026$

8 Round-tip train fare 104$

9 Benefits of relaxing on train trip ????

10 Cost of putting dog in kennel while gone 40$

11 Benefit of having car in New York ????

12 Hassle of parking car in New York ????

13 Per day cost of parking car in New York 25$

Some Additional Information


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Which costs and benefits are relevant in Which costs and benefits are relevant in Veronica’s Veronica’s decision?decision?

The cost of the car is a sunk cost

The annual cost of insurance is not car is a sunk cost

and is not relevant to the

current decision.

However, the cost of gasoline is clearly relevant if she decides to drive. If she takes the train, the

cost would now be incurred, so it varies depending on the decision.

insurance is not relevant. It will remain

the same if she drives or takes the train.

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Which costs and benefits are relevant in Veronica’s decision?

The cost of maintenance and

The monthly school parking

fee is not relevant maintenance and repairs is relevant. In

the long-run these costs depend upon

miles driven.

fee is not relevant because it must

be paid if Veronica drives or

takes the train.

At this point, we can see that some of the average cost of $0.569 per mile are relevant and others are not.

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The decline in resale value due to additional

The round-trip train fare is clearly relevant. value due to additional

miles is a relevant cost. fare is clearly relevant.

If she drives the cost can be avoided.

Relaxing on the train is relevant even though it

is difficult to assign a dollar value to the

benefit.

The kennel cost is not relevant because

Veronica will incur the cost if she drives or

takes the train.

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The cost of parking is relevant because it can be avoided if she takes be avoided if she takes

the train.

The benefits of having a car in Kuala Lumpur and the problems of finding a parking space are both relevant but are difficult to assign a

dollar amount.

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From a financial standpoint, Veronica would be better off taking the train to visit her friend. Some of

the non-financial factor may influence her final decision.

Gasoline (460 @ $0.050 per mile) 23.00$

Relevant Financial Cost of Driving

Gasoline (460 @ $0.050 per mile) 23.00$

Maintenance (460 @ $0.065 per mile) 29.90

Reduction in resale (460 @ $0.026 per mile) 11.96

Parking in New York (2 days @ $25 per day) 50.00

Total 114.86$

Round-trip ticket 104.00$

Relevant Financial Cost of Taking the Train

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Total and Differential Cost ApproachesThe management of a company is considering a new labor saving machine that rents for $3,000 per year. Data about the company’s annual sales and

costs with and without the new machine are:

Current

Situation

Situation

With New

Machine

Differential

Costs and

Benefits

Sales (5,000 units @ $40 per unit) 200,000$ 200,000$ -

Less variable expenses:

Direct materials (5,000 units @ $14 per unit) 70,000 70,000 - Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -

Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000

Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -

Total variable expenses 120,000 105,000 -

Contribution margin 80,000 95,000 15,000

Less fixed expense:

Other 62,000 62,000 -

Rent on new machine - 3,000 (3,000)

Total fixed expenses 62,000 65,000 (3,000)

Net operating income 18,000$ 30,000$ 12,000

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Total and Differential Cost Approaches

Current

Situation

Situation

With New

Machine

Differential

Costs and

Benefits

Sales (5,000 units @ $40 per unit) 200,000$ 200,000$ -

Less variable expenses:

Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -

Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000


As you can see, the only costs that differ between the alternatives are the direct labor costs savings and the increase

in fixed rental costs.


Total variable expenses 120,000 105,000 -

Contribution margin 80,000 95,000 15,000

Less fixed expense:

Other 62,000 62,000 -

Rent on new machine - 3,000 (3,000)

Total fixed expenses 62,000 65,000 (3,000)

Net operating income 18,000$ 30,000$ 12,000

We can efficiently analyze the decision bylooking at the different costs and revenues

and arrive at the same solution.

Decrease in direct labor costs (5,000 units @ $3 per unit) 15,000$

Increase in fixed rental expenses (3,000)

Net annual cost saving from renting the new machine 12,000$

Net Advantage to Renting the New Machine

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Utilization of Constrained / Utilization of Constrained / Utilization of Constrained / Utilization of Constrained / Scare / Limited ResourcesScare / Limited Resources

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Utilization of a Constrained Resource

��When a constraint exists, a company should select When a constraint exists, a company should select ��When a constraint exists, a company should select When a constraint exists, a company should select a product mix that maximizes the total a product mix that maximizes the total contribution margin earned contribution margin earned since since fixed costs fixed costs usually remain unchanged.usually remain unchanged.

��A company should not necessarily promote those A company should not necessarily promote those ��A company should not necessarily promote those A company should not necessarily promote those products that have the highest unit contribution products that have the highest unit contribution margin. margin.

��Rather, it should promote those products that earn Rather, it should promote those products that earn the highest contribution margin in relation to the the highest contribution margin in relation to the constraining resource. constraining resource.

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Design Company produces two products and selected data are shown below:

Product

1 2

Selling price per unit $ 60 $ 50 Selling price per unit $ 60 $ 50

Less variable expenses per unit 36 35

Contribution margin per unit 24$ 15$

Current demand per week (units) 2,000 2,200

Contribution margin ratio 40% 30%

Processing time required

on machine A1 per unit 1.00 min. 0.50 min.

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Machine A1 is the constrained resource and is Machine A1 is the constrained resource and is �� Machine A1 is the constrained resource and is Machine A1 is the constrained resource and is being used at 100% of its capacity. being used at 100% of its capacity.

�� There is excess capacity on all other machines. There is excess capacity on all other machines.

�� Machine A1 has a capacity of 2,400 minutes per Machine A1 has a capacity of 2,400 minutes per week.week.week.week.

Should Should Design Design focus its efforts on focus its efforts on Product 1 or Product 2?Product 1 or Product 2?

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Exercise �

How many units of each product can be processed through Machine A1 in one minute?

Product 1 Product 2

a. 1 unit 0.5 unita. 1 unit 0.5 unit

b. 1 unit 2.0 units

c. 2 units 1.0 unit

d. 2 units 0.5 unit

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Product 1 Product 2


b. 1 unit 2.0 units

c. 2 units 1.0 unit

d. 2 units 0.5 unit

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Product 1 Product 2


b. 1 unit 2.0 units

c. 2 units 1.0 unit

d. 2 units 0.5 unit

I was just checking to make sure you I was just checking to make sure you are with us.are with us.

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What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?

a. Product 1

b. Product 2

c. They both would generate the same profit.c. They both would generate the same profit.

d. Cannot be determined.

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What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2?

a. Product 1

With one minute of machine A1, we could make 1 With one minute of machine A1, we could make 1 unit of Product 1, with a contribution margin of unit of Product 1, with a contribution margin of

$24, or 2 units of Product 2, each with a $24, or 2 units of Product 2, each with a contribution margin of $15. contribution margin of $15.

2 2 ×× $15 = $30 > $24$15 = $30 > $24a. Product 1

b. Product 2

c. They both would generate the same profit.

d. Cannot be determined.

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The key is the contribution margin per unit of the constrained resource.

Product

1 2

Contribution margin per unit $ 24 $ 15

Product 2 should be emphasized.Product 2 should be emphasized. Provides more Provides more valuable use of the constrained resource machine A1, valuable use of the constrained resource machine A1, yielding a contribution margin of $30 per minute as yielding a contribution margin of $30 per minute as

opposed to $24 for Product 1.opposed to $24 for Product 1.


Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.

Contribution margin per minute 24$ 30$

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Product

1 2


The key is the contribution margin per unit of the constrained resource.

If there are no other considerations, the best plan If there are no other considerations, the best plan would be to produce to meet current demand for would be to produce to meet current demand for

Product 2 and then use remaining capacity to Product 2 and then use remaining capacity to make Product 1.make Product 1.


Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.

Contribution margin per minute 24$ 30$

FACULTY OF BUSINESS



FACULTY OF BUSINESS



According to the plan, we will produce 2,200 units According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our of Product 2 and 1,300 of Product 1. Our

contribution margin looks like this.contribution margin looks like this.

Product 1 Product 2

Production and sales (units) 1,300 2,200

Contribution margin per unit 24$ 15$ Total contribution margin 31,200$ 33,000$

The total contribution margin for The total contribution margin for Design Design is $64,200.is $64,200.

FACULTY OF BUSINESS


Interior Design Interior Design makes reproduction colonial furniture makes reproduction colonial furniture from select hardwoods.from select hardwoods.

Chairs Tables

Selling price per unit $80 $400 Variable cost per unit $30 $200 Board feet per unit 2 10 Monthly demand 600 100

The company’s supplier of hardwood will only be able The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?hardwood to satisfy demand?

a. Yesa. Yes

b. Nob. No

Monthly demand 600 100

FACULTY OF BUSINESS


Interior Design Interior Design makes reproduction colonial furniture makes reproduction colonial furniture from select hardwoods.from select hardwoods.

Chairs Tables


The company’s supplier of hardwood will only be able The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand?hardwood to satisfy demand?

a. Yesa. Yes

b. Nob. No(2 ×××× 600) + (10 ×××× 100 ) = 2,200 > 2,000

Monthly demand 600 100

FACULTY OF BUSINESS


The company’s supplier of hardwood will only be The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What able to supply 2,000 board feet this month. What

Chairs Tables


able to supply 2,000 board feet this month. What able to supply 2,000 board feet this month. What plan would maximize profits?plan would maximize profits?

a. 500 chairs and 100 tablesa. 500 chairs and 100 tables

b. 600 chairs and 80 tablesb. 600 chairs and 80 tables

c. 500 chairs and 80 tablesc. 500 chairs and 80 tables

d. 600 chairs and 100 tablesd. 600 chairs and 100 tables

FACULTY OF BUSINESS


The company’s supplier of hardwood will only be The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What able to supply 2,000 board feet this month. What

Chairs Tables


Chairs Tables

Selling price 80$ 400$

Variable cost 30 200

Contribution margin 50$ 200$

Board feet 2 10

CM per board foot 25$ 20$

The company’s supplier of hardwood will only be The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What able to supply 2,000 board feet this month. What plan would maximize profits?plan would maximize profits?

a. 500 chairs and 100 tablesa. 500 chairs and 100 tables

b. 600 chairs and 80 tablesb. 600 chairs and 80 tables

c. 500 chairs and 80 tablesc. 500 chairs and 80 tables

d. 600 chairs and 100 tablesd. 600 chairs and 100 tables

Production of chairs 600

Board feet required 1,200

Board feet remaining 800

Board feet per table 10

Production of tables 80

FACULTY OF BUSINESS


As before, Interior Design’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Interior Design be willing to pay above the usual price to obtain more hardwood?

a. $40 per board foota. $40 per board foot

b. $25 per board foot

c. $20 per board foot

d. Zero

FACULTY OF BUSINESS


As before, Interior Design’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Interior Design be willing to pay above the usual price to obtain more hardwood?

a. $40 per board foot

The additional wood would be used to make tables. In this use, each board foot of

additional wood will allow the company to earn an additional $20 of contribution margin and

a. $40 per board foot

b. $25 per board foot

c. $20 per board foot

d. Zero

an additional $20 of contribution margin and profit.

FACULTY OF BUSINESS


Managing Constraints

Finding ways to process more units through a resource

bottleneck

At the bottleneck itself:At the bottleneck itself:•• Improve the processImprove the process•• Add overtime or another shiftAdd overtime or another shift•• Hire new workers or acquire Hire new workers or acquire

bottleneck •• Hire new workers or acquire Hire new workers or acquire more machinesmore machines

•• Subcontract productionSubcontract production•• Reduce amount of defective Reduce amount of defective

units producedunits produced•• Add workers transferred fromAdd workers transferred fromnonnon--bottleneck departmentsbottleneck departments

FACULTY OF BUSINESS


Decision Making: SplitDecision Making: Split--off off Decision Making: SplitDecision Making: Split--off off PPoint oint or or Processed Processed FFurtherurther..

FACULTY OF BUSINESS


Joint Costs

� In some industries, a number of end products are produced from a single raw material input.

�Two or more products produced from a �Two or more products produced from a common input are called joint productsjoint products.

�The point in the manufacturing process where each joint product can be recognized as a separate product is called the splitsplit--off pointoff point.

FACULTY OF BUSINESS


Joint Products

JointInput

CommonProduction

Oil

GasolineInput

ProductionProcess

SplitSplit--OffOffPointPoint

Gasoline

Chemicals

FACULTY OF BUSINESS


Joint Products

SeparateProcessing

FinalSale

FinalSale

JointInput

CommonProduction

JointJointCostsCosts Oil

Gasoline

SeparateProcessing

FinalSale

Sale

SeparateSeparateProductProduct

CostsCosts

InputProduction

Process

SplitSplit--OffOffPointPoint

Gasoline

Chemicals

FACULTY OF BUSINESS


The Pitfalls of AllocationJoint costs are often allocated Joint costs are often allocated to end products on the basis to end products on the basis of the of the relative sales valuerelative sales value of of

each product or on some each product or on some other basis.other basis.

Allocation Allocation is needed for some is needed for some purpose purpose such as balance sheet such as balance sheet

inventory valuation, inventory valuation, but but allocations allocations of this kind are of this kind are very very dangerous dangerous for decision making.for decision making.

FACULTY OF BUSINESS


Joint costs are irrelevant in decisions regarding Joint costs are irrelevant in decisions regarding what to do with a product from the splitwhat to do with a product from the split--off off

point forward.point forward.

It will always be profitable to continue processing It will always be profitable to continue processing

Sell or Process Further

It will always be profitable to continue processing It will always be profitable to continue processing a joint product after the splita joint product after the split--off point off point so long so long

as as the the incremental incremental revenue exceeds revenue exceeds the the incremental incremental processing processing costs costs incurred incurred after the after the

splitsplit--off pointoff point..

FACULTY OF BUSINESS



�� Timberland Bhd. Timberland Bhd. cuts logs from which cuts logs from which unfinished lumber and sawdust are the unfinished lumber and sawdust are the immediate joint products.immediate joint products.

�� Unfinished lumber is sold “as is” or processed Unfinished lumber is sold “as is” or processed Unfinished lumber is sold “as is” or processed Unfinished lumber is sold “as is” or processed further into finished lumber.further into finished lumber.

�� Sawdust can also be sold “as is” to gardening Sawdust can also be sold “as is” to gardening wholesalers or processed further into “prestowholesalers or processed further into “presto--logs.”logs.”

FACULTY OF BUSINESS



Data about Timberland’s joint products includes:

Per Log

Lumber Sawdust

Sales value at the split-off point 140$ 40$ Sales value at the split-off point 140$ 40$

Sales value after further processing 270 50

Allocated joint product costs 176 24

Cost of further processing 50 20

FACULTY OF BUSINESS



Analysis of Sell or Process Further

Per Log

Lumber Sawdust

Sales value after further processing 270$ 50$

Sales value at the split-off point 140 40 Sales value at the split-off point 140 40

Incremental revenue 130 10

FACULTY OF BUSINESS


Sell or Process FurtherAnalysis of Sell or Process Further

Per Log

Lumber Sawdust


Sales value at the split-off point 140 40 Sales value at the split-off point 140 40


Cost of further processing 50 20 Profit (loss) from further processing 80$ (10)$

FACULTY OF BUSINESS


Analysis of Sell or Process Further

Per Log

Lumber Sawdust


Sales value at the split-off point 140 40




Cost of further processing 50 20 Profit (loss) from further processing 80$ (10)$

Should we process the lumber furtherShould we process the lumber furtherand sell the sawdust “as is?”and sell the sawdust “as is?”

FACULTY OF BUSINESS


Ends of DiscussionEnds of Discussion

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