Week 11- tactical decision making PDF

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Financial Information for Decision Making...

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Week 11- tactical decision making

pull out data points that are relevant to the decision you are making • • •

We use our knowledge of cost behavior (week 10 how they behave as the level of activity changes) to help us in a wide range of tactical or short term decision making. Long term strategic decisions are not considered and therefore capital investment is not an available option short term decisions only. When measuring costs for decision-making purposes, it is useful to identify relevant costs, and exclude those costs that are not relevant to the decision

Relevant cost • Relevant information is different under competing courses of action • Relevant information relates to the future • Consider ONLY costs and benefits that vary across the possible courses of action Depends on the decision being made and only relates to the future. It does not consider historical costs. If the cost or benefit does not change across alternatives don’t need to consider that information as it has no bearing. • • •

Consider Opportunity costs Avoidable versus unavoidable fixed costs In addition, we must consider qualitative factors.

Opportunity costs • In identifying relevant costs we need to be aware of opportunity costs • Defined as: The benefit given up or sacrificed when one alternative is chosen over another • For example: The opportunity cost of studying full time is the full time salary you are giving up, or, the difference between your full time salary and your part time salary

Avoidable vs Unavoidable

• •

Avoidable costs – costs that will not be incurred in the future if a particular decision is made Avoidable in the future relevant Unavoidable costs – costs that will continue to be incurred no matter which alternative is chosen. Unavoidable costs are irrelevant to the decision. Non avoidable irrelevant

Sunk costs *must be familiar with • Sunk costs – costs that have already been incurred and cannot be affected by any future action • Sunk costs are never relevant costs These costs are already incurred therefore they are NEVER RELEVANT

Relevant Costing decisions • In decisions involving limited periods of time or small variations from usual practice, fixed costs tend to be irrelevant • Such decisions include: o deciding whether to make or buy o accepting/rejecting special orders/contracts o making the most efficient use of scarce resources o closing or continuing a department Make or buy decisions • KSK needs a component for one of its products. It can be made by a subcontractor for $20. KSK can produce the components internally for total variable costs of $15 each. KSK has spare capacity.

•

Should it subcontract or produce the component in-house?

Make or buy (spare capacity) To make To Buy Variable costs to make: Direct materials $3 Direct labour $10 Variable overhead $2 RELEVANT COST TO MAKE $15 Purchase cost $20 Therefore RELEVANT COST TO BUY $20 DECISION: Make the component in house: KSK would save $5/component No spare capacity • In a situation where the business has no spare capacity, it would be necessary to incorporate the opportunity costs of any time spent working on the component. • In summary, where there is no spare capacity opportunity costs MUST be considered. Qualitative factors need to be considered if you have decided to outsource • Quality of the supplier • Reputation in the industry (yours and the business you have outsourced to) • Reliability of the supplier… The most efficient use of scarce resources • Sometimes there is a limit on production capacity resulting from factors such as a shortage of labour, raw materials, space or machinery that limits sales potential • Some aspect of the business (e.g. lack of sales demand) which will stop it from achieving its objectives to the maximum extent • The most profitable combination of products occurs when the contribution per unit of the limiting factor is maximised

Lecture illustration-Scarce resources RLR makes three different products, the details of which are provided below From the information provided, determine which products in which quantities RLR should plan to make and sell next year. Product Clock Toaster Steamer Unit selling price ($) Unit variable cost ($)

45 27

37 24

32 26

Daily demand (units)

30

48

60

Machine time per unit (hour) Material per unit (metres)

.75 1.5

.25 1.3

.20 2.0

Labour per unit (minutes)

15

20

Contribution margin/hour of machine time Clock Toaster SP 45 37 VC 27 24 CM/unit 18 13 ÷ MH .75 .25 CM/mh 24 52

25

Steamer 32 26 6 .20 30

The clock has the highest CM per unit therefore you would make the clock over the other products. The constraint is the machine hours.  after taking into consideration make and sell as many toasters as possible highest CM per unit. Every organisation has constraints and you need to be able to identify them. Compute the contribution for each remaining input factor. CLOCK

TOASTER

STEAMER

Contribution per unit

18

13

6

Per metre of material

12 (18/1.5)

10 (13/1.3)

3 (6/2)

Per hour of labour

72 (18 x 60/15)

39 (13x 60/20)

14.40 (6 x 60/25)

Ranking Clock

Toaster

Steamer

Machine time

3

1

2

Materials

1

2

3

Labour

1

2

3

Ranking referring to different constraints. Don’t want to produce more products than the market will take. Assuming the limiting factor is machine hours with a maximum of 45 hours per day, identify the optimum production strategy. The market demand for products is as follows: •

• • •

Toasters: 48/day Steamers: 60/day Clocks: 30/day

Max machine hours is 45 • Machine hours available Toasters: 48 x .25 Steamer: 60 x .20 Clock : 28 X .75

45 12 33 12 21 21 0

21 ÷ .75=28 12+12+21=45 Able to sell 30 clocks per day but only able to produce 28 clocks. 1. What is the total contribution margin the company will make? CM – Toasters $13 per unit x 48 units = $624 CM – Steamers $6 per unit x 60 units = $360 CM – Clocks $18 per unit x 28 units = $504 Total CM $1,488 2. What strategies could the company consider in order to meet the extra demands of the market place which they are currently unable to fulfill? Could outsource, use machines out of hours, staff work overtime or hire or rent a new machine for the short term. Number of units going to sell x CM per unit CM=selling price-varibale cost per unit Accept or reject a special order • Deciding whether or not to supply a customer with a single one off order for goods or services at a special price • There are two situations that can occur 1. The business has spare capacity 2. The business does not have spare capacity When a new client comes forward need to sacrifice an existing client to take on new one. With spare capacity • Tran Ltd manufactures lawn mowers. The business is growing and additional plant has been installed to increase capacity by 500 units. The current output is 20,000 units per year that sell for $400 each Variable costs: • Parts $1,600,000 • Labour $2,400,000 • Other variable costs $1,500,000 • Fixed costs $2,000,000 • A new customer wants to buy 400 mowers at $350 each

Analysis - part one • Variable costs per mower • Parts $1,600,000/20,000 = $80 • Labour $2,400,000/20,000 = $120 • Other variable costs $1,500,000/20,000 = $75 • Total variable costs per unit $275 Plus one piece of special equipment costing $2,000 will be required but has no other use than for the special order Analysis – part two Incremental income and relevant costs: • Revenue 400 X $350 = $140,000 • Relevant costs 400 X $275 = ($110,000) - variable costs • Incremental fixed cost ($2,000) - one off special piece of equipment • Total incremental cost ($112,000) • Surplus $28,000 The financial analysis suggests accept the proposal as profits will increase by $28,000 after taking account of the one off fixed cost 140,000 vs 112,00 would accept the offer selling mowers to the new customers cheaper existing customers paying $50 more. With no Spare capacity • Assume the same data as before but no additional plant capacity • The surplus as a result of accepting special order was $28,000 • But Tran would lose the sale of 400 units sold at $400 each which contribute $400 less $275 = $125 per unit to profits, a total contribution of $50,000 No spare capacity profitable customer build a relationship with them. Give up supply of 400 units to existing customers giving up sale of 400 items lose CM. • • • • •

Accepting the special contract costs Tran Surplus from accepting special contract Less the opportunity cost of acceptance Loss generated by accepting special order DECISION : REJECT when no spare capacity

$28,000 $50,000 $22,000

No spare capacity opportunity cost. Giving up 50,000 to get 28,000. • • •

The decision to accept or reject a special order is a tactical one that is common in manufacturing and service industries The correct analysis focuses on incremental costs and benefits When there is no spare capacity the opportunity cost of using the firms facilities is also relevant

Closing or continuing a section or department • James Ltd makes, Concrete blocks, Bricks and Tiles • The accountant has provided you with the following information. Total

Blocks

Bricks

Tiles

Sales

$1450

$500

$800

$150

Costs

1115

350

570

195

Profit/Loss

$335

$150

$230

$(45)

Closing or continuing a section or department • Quick Conclusion • Close the department that manufactures the tiles • The business would be more profitable by $45,000 assuming that last years performance is a reasonable indication of the future income and costs Recast the data separating the fixed and variable costs Total

Blocks

Bricks

Tiles

Sales

$1450 (-)

$500

$800

$150

Variable costs

870

250

480

140

Contribution margin

580

250

320

10

Direct fixed costs

245

100

90

55

Segment margin

$335

$150

$230

$(45)

Common Fixed costs

$125

Operating profit

$210

(=)

Closing or continuing a section or department Analysis of the costs

• •

Retain the tile manufacturing department. Closing the tile department would result in losing the current $10,000 contribution to fixed costs but the fixed costs would remain.

•

Remember we are discussing short term decision making and fixed costs continue in the short term.

Variable costs change with the level of activity. Keep the division open sales 150. Sales reduced to 1,300 shut down lose contribution of 10.

Closing or continuing a section or department • Issues • Can the business grow the sales for the tile department • Would closing the department effect the sales of the other departments, builders may want to obtain all their purchases from the one supplier. People can now not buy all their products from you might go to a new supplier who can accommodate them. • Closing the department may allow another more profitable product to be introduced  bring in a more profitable new product. Relevant costs • Relevant costs and income need to be identified for short term decision making. • Relevant costs and income are those that differ for each alternative • For special orders current fixed costs are considered irrelevant because it is expected that such costs will not change within the relevant range in the short term • Capacity is an important determinate of opportunity cost for special order decisions • Avoidable costs need to be identified for outsourcing decisions...