Chapter 14

  • making choices between different options
  • make a product or buy it in?
  • accept additional work?
  • setting prices
  • best use of scarce resources
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Making a choice between action courses

If there are 2 or more strategies that can be carried out then a choice needs to be made. If each choice incurred the same level of fixed cost, marginal costing needs to be considered. The option with the highest contribution should be chosen

Contribution per unit: Selling price p/u - variables cost p/u
Example: James is only able to produce one type of product. He needs to decide whether to produce tables, chairs or sideboards. He provides this information :

                                                tables               chairs         sideboards
predicted production/sales         500                  2,000                500

Selling price per unit                   400                    120                380

Direct material cost per unit         80                       13                   70

Direct labour cost per unit            70                        67                110

Total fixed cost                       50,000                50,000            50,000

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How to choose which product to make

A table needs to be produced showing each of the products contribution. The one with the highest should be chosen

                                                       tables               chairs         sideboards

Selling price per unit                         400                    120                380

Marginal cost per unit                        150                      80                180

Contribution per unit                          250                      40              200

Total contribution                           125,000                80,000           100,000

As tables give a bigger contribution, tabels should be produced in order to get a larger profit. 

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Buy or make decisions

Sometimes a business is faced with two options. 1) they can make the product themselves or 2) they can buy them in from an outised manufacturer.
They can buy these things either as finished goods or patially fnished goods or component parts.

Option 1 - making them.  There will be marginal costs involved in making the product. Also if the business has to stop producing another product in order to produce an alternative, the contribution they were making from the old product will no longer be made.

Option 2 -buying in.   There will be an additional cost: the price the outside manufacturer is quoting.

This can be compared in this way.

Marginal cost of making the product                                        Marginal cost of buying the 
Plus contribution from lost work                 compared to....          product.

In this case, whichever is the lowest is the better option to choose from a financial point of view. 

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Buy or make example

A company manufactures T shirts it can produce 140,000. Fixed costs are 560,000 The selling price per T shirt is £12. Direct materials are £2 and direct labour is £3 (option 1). Another manufacture can make these T shirts meaning the business can buy them in instead. They are charging £7 a T shirt (Option 2)

The cost of making them is £5 compared to buying in cost of £7.
Contribution:option 1 Making them - £12 - £5 = £7 per unit
                
  option 2 Buying them - £12 - £7 = £5 per unit. 

Option 1 profit: 7 x 140,000 = 980,000 - 560,000 = 420,000
Option 2 profit: 5 x 140,000 = 700,000 - 560,000 = 140,000

The business found it can sub let its factory for £300,000 if it chose to buy in.

In house cost + lost rental      v     bought in cost

5 x 140,000 + 300,000                   980,000            bought in is the lowest so it is the 
=1,000,000                                                          preferred option
 

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Non financial factors - buy or make decisions

  • Is the quality of the bought in products the same as those made in house?
  • Is the supplier reliable - will delivery dates be made?
  • How much notice will the supplier give of price increases/ production problems/delays?

Buying in units might mean that:

  • Existing employees might face redundancy
  • Impact on the local community
  • Environmental impact of transport - if bought in units are far away.
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Acceptance of additional work

If a business has spare capacity, then the business may accept extra work additional to normal sales. Normally the additional sales are sold at a lower price than normal. The key factor is whether the additional work makes a contribution to profit, if it doesn't then it isn't worth it.

Example: The climbing frame company makes climbing frames that normally sell at £80 each. It received additional orders:
1) 1,000 climbing frames at £60 each
2) 2,000 climbing frames for £54 each
Direct materials per climbing frame is £21. Direct labout per climbing frame is £32. = £53

1) selling price = £60 - 53 (v.c) = 7 x 1000 = £7000 total contribution
2) selling price = £54 - 53 (v.c) = 1 x 2000 = £2000 total contribution.

£7000 is higher so option 1 should be accepted. 

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Additional work example - table

A good way of showing the mulitiple options is in a table. A local retailer wishes to buy either 100 laptops a week at £240 or 200 laptops at £160. The table we can show this in is called a profit statement. The option with the highest profit should be chosen

                             Existing production             Existing production +          Existing production +
                                ( 300 units)                     100 at £240 (option 1 )        200 at £160 (option 2)

sales:
300 laptops at £400     120,000                               120,000                           120,000
100 laptops at £240                                                 24,000                
200 laptops at £160                                                                                        32,000
                              -----------------------                 ------------------------------            -------------------------
less prodction costs:
Direct materials          24,000                                   32,000                              40,000
Direct labour              30,000                                    40,000                              50,000
Fixed overheads         10,000                                    10,000                             10,000
                             ------------------------                 ------------------------------            -------------------------
profit:                         56,000                                    62,000                             52,000

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Optimum use of scarce/limited resources

A production plan can help look at which option will make the most profit. Example: A business makes 3 products ; A, B and C. The flour is in short supply, only 30,000kg can be obtained.

                                          A                     B               C
selling price p/u                54                       50             105
direct materials p/u           12                       24               30
direct labour p/u                30                      20                60

Marginal cost p/u               42                     44                90
Contribution p/u                  12                     6                 15
Kg of material used p/u         2                     4                  5                 
                                        ----                   -----               -----
Contribution per kg           6                    1.50                3   
Rank                                1st                    3rd              2nd 

Contribution per kg of the flour is found. Contribution per unit / kg of material used per unit = contribution per kg.  - 12/ 2 = 6 etc
They then need to be ranked, The biggest contribution is ranked the highest as the business will make more of a contribution/ profit if they make more of this product. 

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Production plan A,B and C

Production plan: planned production was 2,000 units of A, 3,000 units of B and 4,000 units of C
A was ranked 1st, C 2nd and B 3rd

                                      Units              Direct material            Contribution
 A                                  2,000                 4,000 kg                  24,000            
 C                                  4,000                20,000 kg                 60,000
 B                                  1,500                  6,000 kg                 9,000
                                                              --------------                ------------- 
                                                             30,000 kg                 93,000
Fixed costs                                                                           72,000
                                                                                           -------------
                                                                                            21,000 

The contribution is calculated as selling price - variable costs. Looking at tht table we did previously contribution per unit for product A,B and C were £12, £6 and £15 respectively.
After using up resources to fully produce the planned production of the first 2 ranked units were used, we needed to figure out how much resources we had left. 30,000 -24000 = 6000 kg.
Product B used 4kg of flour per unit. 6000kg/ 4kg = 1500 units 

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Scarce resources

The way we dealt with having limited materials can be used the same way to deal with having limited labour hours.  Instead of labelling the production plan with "direct materialst" it would be labelled "labour hours". This goes for contribution per unit. Instead of it being labelled "contribution per kg"  it would labelled "contribution per labour hour". It would be calculated the same way as we calculated contribution per unit for materials. Remeber fixed costs are still included when contibution is totalled up 

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