This type of situation arises when a manufacturer is faced with the decision as to whether:
(a) to manufacture one of its components in-house, or
(b) to buy such components from an outside supplier. The decision maker will be interested in the difference between the suppliers quotation and the cost of producing in-house. The cost of in-house production of the components is made up of:
(i) The incremental cost of production; and
(ii) Any opportunity cost that may arise from producing in-house.
The following qualitative factors will also be considered in deciding whether or not to produce in-house:
(a) The quality of the product that will be bought from outside;
(b) The reliability of the outside supplier;
(c) The effect of future market prices;
(d) Ability of management to cope with the present and future production capacity;
(e) The possible adverse effects of revealing trade secrets;
(f) The possible problems of transport and handling costs;
and
(g) Government regulations, especially on import from overseas.
Decision Criteria
(a) If the outside supplier‟s quotation is greater than the total variable cost of producing the component in-house, then the component should be manufactured in-house.
(b) If the total variable cost of in-house production is higher than the quotation of the outside supplier, then it will be quite discrete for the management to purchase the component from the supplier.
ILLUSTRATION 10-3
Nakowa Nigeria Plc is considering an opportunity to subcontract the production of a certain component part of its product to another manufacturer. The subcontractor has offered to produce the part for N1.80 per piece. The management accountant makes a study of the savings of cost resulting from subcontracting as follows:
(a) The standard unit cost of material is reduced by 50k (b) The direct labour cost per unit is reduced by 25k
(c) The reduction in variable overhead is estimated at N1.00 per unit.
It is believed by the plant superintendent that supervision costs to the extent of N2,000 per year can be saved if the job is subcontracted and that the cost of special tools will be reduced by N500 per year.
The other relevant cost data in connection with the manufacture of this product are as follows:
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Units sold 14,000
N
Net sales - 14,000 @ N25 each 350,000
Standard cost of goods sold:
Direct materials 70,000
Direct labour 28,000
Factory overheads 140,000
Total Standard cost of goods sold 238,000
Standard Gross Margin 112,000
Less: Unabsorbed factory overheads 36,000
Actual Gross margin 76,000
Less: Selling and distribution expenses 100,000
Net Loss (24,000)
The break-up of factory overheads into their fixed and variable components at normal capacity level of 20,000 units is as follows:
Per Unit Total
N N
Variable 4 80,000
Fixed 6 120,000
10 200,000
The company is working at less than normal capacity which is manufacture of 20,000 units of this product.
You are required to advise management on whether to subcontract the production of the component or to produce it internally.
SUGGESTED SOLUTION 10-3
NAKOWA NIGERIA PLC
Solution to this problem may best be presented in form of differential cost analysis as follows:
Effect of Make or Buy Decision
Make Difference Buy
N N N
Net sales 350,000 350,000
Dir. Materials 70,000 (14,000 x N0.50), i.e – 7000 63,000 Purchased
parts - (14,000 x N1.80), i.e + 25,200 25,200
Direct labour 28,000 (14,000 x N0.25), i.e – 3,500 24,500 Var. overheads 56,000 (14,000 x N1), i.e – 14,000 42,000 Fixed ohds 120,000 (N2,000 + N500), i.e – 2,500 117,500 Total manuf.
Cost 274,000 - 1,800 272,200
Selling &
Admin. cost 100,000 100,000
374,000 - 1,800 372,200
Net sales (24,000) - 1,800 (22,200)
It is to be noted that no change in volume or selling price is assumed so that revenue is not a relevant factor. The benefit lies purely in cost saving which at this level of volume is N1,800.
Despite the fact that the company is operating at less than normal capacity, the small monetary advantage offered by this opportunity may not be considered sufficient to offset the ill- effects of laying off more of the labour force due to the non- manufacture of the component. Inspite of the impact of non- quantitative factors, the differential cost analysis remains at the core of make or buy decision.
10.6.2 Mix of Sales
Usually, business enterprises have a variety of product lines, each making its own contribution to the coverage of fixed expenses. Changes in the operating profit can result from shifts in the mixture of products sold inspite of the fact that sales prices are unchanged and the total volume of sales expressed in terms of money remains the same.
Such a situation may lead to changes in distribution channels, or sales to different classes of customers, as this affects the
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quantum of contribution over variable costs. It is in this context that marginal costing is applicable in informing management regarding the most profitable mix of sales from the entire range of selected alternatives.
ILLUSTRATION 10-4
Per unit Direct materials:
X N8
Y N6
Direct wages:
X 24 hours @ 25k per hour
Y 16 hours @ 25k per hour
Variable overheads 150% of wages Fixed overheads - N750
Selling price:
X N25
Y N20
The directors want to be advised on the desirability of adopting any one of the following alternative sales mixes in the budget for the next period:
(a) 250 units of X and 250 units of Y;
(b) 400 units of Y only;
(c) 400 units of X and 100 units of Y; and (d) 150 units of X and 350 units of Y.
State which of the alternative sales mixes you would recommend to
management.
(Adopted I.C.W.A., London)
SUGGESTED SOLUTION 10-4
Marginal Cost Statement (Per Unit)
Product X Product Y N N
Direct materials 8 6
Direct wages 6 4
Variable overheads 9 6
Marginal cost 23 16
Contribution 2 4
Selling price 25 20
Selection of Sales Alternative
X Y Total N N N (a) 250 units of X and
250 units of Y:
Contribution 500 1,000 1,500
Less: Fixed overheads 750
Profit 750
(b) 400 units of Y only:
Contribution 1,600 1,600
Less: fixed overheads 750
Profit 850
(c) 400 units of X and 100 units of Y;
Contribution 800 400 1,200
Less: Fixed overhead 750
Profit 450
(d) 150 units of X and 350 units of Y:
Contribution 300 1,400 1,700 Less: Fixed overheads 750
Profit 950
As the fourth alternative of manufacturing 150 units of X and 350 units of Y yields the maximum profit and contribution, it is the best sale alternative and would, therefore, be recommended for adoption by the management.
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10.6.3 Acceptance/Rejection of Special Order
This type of situation arises when a company receives an order from a customer at a price lower than its normal selling price.
The company, if working below capacity, may be advised to accept the offer after taking into consideration the marginal cost of its production.
Therefore if the answer to the following questions are in affirmative, the special price quoted by the customer should be accepted:
(a) Does the price quoted by the special customer cover the marginal cost of production?
(b) Does the company have excess capacity?
ILLUSTRATION 10-5
Shukura Nigeria Limited manufactures a special product for ladies called „the slimming stick‟. A stick sells for 20k per unit. Current output is 400,000 sticks which represents 80% level of activity. A customer Gyaranya Stores Limited, recently, placed an order for 100,000 sticks at 13k per unit. The total cost for the period were N56,000 of which N16,000 were fixed costs. This represents a total cost of 14k per slimming stick.
Required:
(a) Based on the above information, advise Shukura Nigeria Limited whether or not to accept the offer.
(b) What other factors may be taken into consideration in taking this type of decision?
SUGGESTED SOLUTION 10-5
(a) SHUKURA NIGERIA LIMITED
Decision to accept/reject the offer:
(i) Present position N
Sales (400,000 units) 80,000
Less: marginal cost (400,000 x 10k) 40,000
Contribution 40,000
Less: Fixed costs 16,000
Net Profit 24,000
(ii) If the order from Gyaranya Stores is accepted:
N
Sales (100,000 x 13k) 13,000
Less: marginal cost (100,000 x 10k) 10,000
Contribution 3,000
Recommendation
The Order from Gyaranya Stores should be accepted, since it will increase profit by N3,000.
(b) Other factors to consider include:
(i) Will the acceptance of one order at a lower than market price make other customers to ask for price reductions?
(ii) Is the so-called special price the most profitable way of utilizing the excess capacity?
(iii) If accepted, will the special order not block the acceptance of offers which may be at true market price?
(iv) Will fixed cost remain constant?
10.6.4 Price Determination Based on Capacity to Sale
The determination of prices of products manufactured or services rendered, by a business is often considered to be a difficult problem generally faced by management of an enterprise.
However, the basic problem involved in pricing is the matching of demand and supply.
The marginal costing technique shows a simple relationship between specific products costs and the different possible selling prices being considered. This is due to the fact that contribution margin is unaffected by the allocation of indirect costs.
ILLUSTRATION 10-6
Mashasha Industries Limited produces and markets industrial containers and packing cases. Due to competition, the company proposes to reduce its selling price. As the present level of profit is to be maintained, indicate the number of units to be sold if the proposed reduction in selling price is 5%, 10% and 15%. The following information is available:
N N Present sales turnover (30,000 units) 300,000 Variable cost (30,000 units) 180,000
Fixed cost 70,000 250,000
Net profit 50,000
257 SUGGESTED SOLUTION 10-6
MASHASHA INDUSTRIES LIMITED Marginal Cost Statement
Present Price Price Price Price Reduction Reduction Reduction
of 5% of 10% of 15%
N N N N
Sales 300,000 285,000 270,000 255,000
Less: variable
costs 180,000 180,000 180,000 180,000
Contribution 120,000 105,000 90,000 75,000 Less: Fixed costs 70,000 70,000 70,000 70,000 Net Profit 50,000 35,000 20,000 5,000 Contribution per unit N4.00 N3.50 N3.00 N2.50 As profit is to be maintained at the present level of N50,000, the contribution has to be N120,000 as at present when the total sales proceeds from 30,000 units are N300,000.
The number of units required to be sold at different levels of price reduction would be calculated as follows:
Total Contribution Required Contribution per unit sold Therefore:
At 5% Reduction: N120,000 = 34,286 units (approximately) N3.50
At 10% Reduction: N120,000 = 40,000 units N3
At 15% Reduction: N120,000 = 48,000 units N2.50
Verification
The result obtained at 10% price reduction can be verified as follows:
N
Sales (40,000 x 270,000) 360,000
30,000
Less: variable costs (40,000 x 180,000)
30,000 240,000
Contribution 120,000
Less: Fixed Costs 70,000
Profit 50,000
The other results can also be similarly verified. It should be noted, however, that the whole analysis depends on the capacity of the company to produce and sell at any of the three levels of production (34,286; 40,000 or 48,000).
10.6.5 Allocation of Scarce Resources
This is another area where marginal analysis may be adopted to good effect. All company resources – materials, plant capacity, management‟s time, machine time or money – are limited (scarce) in supply when compared against their needs and some may be very scarce so much so that decisions affecting their allocation are important. Bad managerial decisions on their allocation may result in poor performance and reduced profitability. Therefore, if management is faced with scarcity of a factor of production (termed a limiting or key factor), it must ensure that the affected factor of production is used in such a way that profits per unit of the factor automatically secure maximum profit.
Scarcity of resources is an economic fact of life which is being faced by all the components of an economy – individuals, firms and governments. Marginal analysis or contribution analysis is the cost and management accounting response to this problem and, so, decisions on how to allocate any scarce resource should be based on marginal analysis otherwise the allocation would not amount to optimum result of performance.
ILLUSTRATION 10-7
Dadin Kowa Ltd manufactures and sells three products: P, Q and R. For the period ended 31 December, 2004, the following data were obtained from the company:
P Q R
Output/Sales volume 4,000 units 3,000 units 3,000 units
Selling Price/unit N50 N30 N20 Variable cost/unit N15 N20 N15 Fixed cost of N100,000 are absorbed on the basis of labour hours which were: P (2,000), Q(1,500) and R(1,500).
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Assuming the company is faced with reduced machine hours since its plant is getting old. It has been estimated that it takes:
5 machine hours to produce a unit of P 2 machine hours to produce a unit of Q 0.5 machine hour to produce a unit of R
The company is planning to replace its plant with a new one, but this can only be ready for operation in January, 2006. Before then the plant can only be used for 30 hours in a week instead of the normal 45 hours per week. Management wants to reconsider the allocation of this scarce resource. Advise management.
SUGGESTED SOLUTION 10-7
DADIN KOWA LIMITED
P Q R Output/Sales (in units) 4,000 3,000 3,000
N N N Sales (Turnover) 200,000 90,000 60,000 Less marginal (variable) costs 60,000 60,000 45,000 Contribution 140,000 30,000 15,000 Contribution per unit = N140,000 N30,000 N15,000
4,000 3,000 3,000 = N 35 N10 N5 Contribution per limiting factor
(machine hour) N35/5 = N7 N10/2 = N5 N5/0.5 = N10
Ranking 2nd 3rd 1st
Comment
From the above relevant data, it is clear that if resources are concentrated on product R (other things being equal), the company will maximise profit. Let‟s check. 30 hours in a week will provide the following results:
P Q R Contribution per
machine hours N7 N5 N 10
Total Contribution 30 x N7= N210 30 x N5 = N150 30 x N10 = N300 In the absence of ceiling (maximum level of production), the whole of the machine hours are to be allocated for the production of R if the company is to maximise profit.