SHORT TERM DECISIONS Concept of Relevant Costs Relevant costs are future incremental cash flows arising as a direct

t consequence of a decision. The concept of relevant cost can assist the management in short term decision making process Identification of the Relevant Costs 1. Machinery User Cost Once a machine has been purchased, its cost is a sunk cost. Sunk costs are past costs already incurred and therefore irrelevant in decision making process. Depreciation of a machine is not a relevant cost because it is not a cash flow. However, using machinery involves some incremental cost referred to as the user costs and includes: Hire charges of machine Any fall in resale value of owned assets through use Labour Oftenly the labour force will be paid irrespective of the decision and the costs are therefore not incremental However if the labour could be put to an alternative use, the relevant costs will be the variable costs of labour and associated variable overheads plus an opportunity cost in terms of contribution forgone from not being able to put it to its alternative use Material The relevant cost of raw material is generally their current replacement cost, unless the raw materials have already been purchased and would not be replaced once used If materials have already been purchased but will not be replaced then the relevant cost of using them is the higher of: a) Their current resale value b) The value they would obtain if they were put to an alternative use (opportunity cost) The following decisions can be made based on relevant costing concept and the principles of marginal costing: Make or Buy Decisions A make or buy problem involves a decision by an organization on whether it should make a product or whether it should pay another organization to do so. Examples of make or buy decisions are: a) Whether a company should manufacture its own components or buy the components from an outside supplier b) Whether a construction company should do some work with its own employees or whether it should sub-contract the wok to another company

c) Whether a service should be carried out by an internal department or whether an external organization should be employed If an organization has the freedom of choice about whether to make internally or buy externally and has no scarce resources that put restrictions on what it can do itself, the relevant cost for the decision will be the differential cost between the two options. Illustration Hell company manufacture four components F, I, R and E for which costs in the forth coming year are expected to be as follows: F I R E Production (Units) 1000 2000 4000 3000 Unit variable CostShs Shs Shs Shs Direct materials 4 5 2 4 Direct labour 8 9 4 6 Variable production Overhead 2 3 1 2 14 17 07 12 Directly attributable fixed costs per annum and committed are as follows: Shs Incurred as a direct consequence of making W Incurred as a direct consequence of making X Incurred as a direct consequence of making Y Incurred as a direct consequence of making Z Other fixed costs (committed) fixed cost 1000 5000 6000 8000 30000 50000

A sub contractor has offered to supply units of F,I,R and E for Shs 12, Shs 21 Shs 10 and Shs 14 respectively Required: Advice hell Limited on whether to make or buy the components. Note: Make or buy decisions should certainly not be based exclusively on cost considerations. The following factors should also be considered: a) The make option gives the management more direct control over the work. The management should therefore consider on whether they would like to retain control over the work or not b) The buy option often has the benefits of the external organizations having a specialized skill and expertise in the work which should also be considered c) If the components are sub contracted the company will have spare capacity and therefore it should consider on how to use this spare capacity profitably d) The reliability of the sub-contractor with the delivery times and the quality of the product

e) The reliability of the estimates of the fixed costs which are attributable to the products Shut Down Decisions Discontinuance or shut down problems involve the following decisions: a) Whether or not to close a product line, department 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 Illustration A company manufactures three products: Pawns, Rooks and Bishops. The present Net annual income from these products is as follows: Pawns Rooks Bishops Total $ $ $ $ Sales 50000 40000 60000 150000 Variable costs (30000) (25000) (35000) (90000) Contribution 20000 15000 25000 60000 Fixed cost (17000) (18000) (20000) (55000) Profit/loss 3000 (3000) 5000 5000 The company is concerned about its poor profit performance and is considering whether or not to cease selling Rooks. It is felt that selling prices cannot be raised or lowered without adversely affecting net income Shs 5000 of the fixed costs of Rooks are direct fixed costs which would be saved if production ceases. All other fixed costs would remain the same. Required: a) Advice the company on whether to stop the production of product Rooks or not b) Suppose that it will be possible to use the resources realized by stopping production of Rooks and switch to producing a new item, the Crowners which would sell for Shs 50000 and incur a variable cost of Shs 6000, what will be the advice? Other qualitative factors to be considered in a shut down decision a) The impact that the shut down decision will have on employees morale b) The signal that the decision will give to competitors (the reaction of the competitors) c) The reaction of the customers who are likely to lose confidence in the companys product d) The effects on the suppliers. If one supplier suffers disproportionately, there may be a loss of goodwill and damage to future relations

e) The timing of the shut down since some costs may be avoidable in the long run but not in the short run Acceptance or Rejection of Special Order Sometimes an organization may have an income earning opportunity from a customer. In this case an organization will have to decide on whether to accept or reject the customers order The financial aspect of the decision will be based on incremental costs and revenues arising as a direct consequence of the decision Other non financial factors which should also be considered are: i. Availability of raw materials for the special order ii. Other possible investment opportunities iii. The willingness of workers to work extra time in order to execute the special order iv. The customers goodwill which is likely to be affected if the order is rejected LIMITING FACTOR DECISIONS One of the more common decision making problems is a situation where there are no enough resources to meet the potential sales demand, and so a decision has to be made about what mix of products to produce using the available resources as effectively as possible. A limiting factor is any factor that put restrictions in the production activity. It is also referred to as the key factor. A limiting factor may be sales demand if there are sufficient production resources to meet the sales demand Other possible limiting factors are:i. Labour hours. ii. Material available iii. Fund availability iv. Any other resource that is used in the production activity. Optimal production Solution where there is a limiting factor. It is assumed in a limiting factor analysis that management wishes to maximize profit and that profit will be maximized when contribution is maximized (given no change in the fixed cost expenditure incurred) In other words, marginal costing principles are applied in a limiting factor decision. Contribution will be maximized by earning the biggest possible contribution from each unit of limiting factor. The limiting factor decision therefore involves the determination of the contribution earned by each different product from each unit of the limiting factor. Steps followed in limiting factor decisions i. Identify a single limiting factor other than sales demand

ii. iii. iv.

Calculate the contribution per unit of the limiting factor for each product Rank the products by giving the first priority to the ones that generate higher contribution per unit of the limiting factor Make products in rank order until scarce resource is used up i.e. determine the optional production solution.

Illustrations Darling Company manufactures two products, handsome and beauty. Unit variable costs for the products are as follows. Handsome Beauty Shs. Shs. Direct materials 1 3 Direct labour (Shs 3 per hour) 6 3 Variable overhead 1 1 8 7 The selling price per unit for the products are Shs 14 and Shs 11 for handsome and beauty respectively During July 2002,the variable direct labour was limited to 8000 hours Sales demand in July is expected to be 3000 units of handsome and 5000 units of beauty. Required i. Determine the optimal production solution and the maximum profit assuming that monthly fixed cost are Shs 2000 and that opening inventories are nil

COST- VOLUME - PROFIT ANALYSIS OR BREAK EVEN ANALYSIS Break even analysis is the term given to the study of the interrelationship between costs, volume and profit at various levels of activity

 C-V-P analysis uses many of the principles of marginal costing and is an important tool in short term planning. Break - Even Point This is the point at which the total sales revenue equates the total cost and therefore neither profit nor loss is being made i.e. at break even point; Total Cost = Total Revenue Mathematical approach to Break - Even Analysis Break Even Point In Units = Total Fixed Cost Unit Contribution ii. Break Even Point In Sales Value = B.E.P In Units X Selling Price Per Unit i. Illustration The following information relates to product X produced by company Y Expected sales 10000 units at Shs 8 each Variable cost Shs 5 per unit Fixed cost Shs 21000 Required Determine the Break Even Point in; i. Units ii. Sales value

The Contribution to Sales Ratio This is a measure of the amount of contribution earned from each 1 shilling of sales It provides an alternative way of determining the B.E point in sales value i.e. B.E.P in sales value = Total Fixed Cost C/s ratio Where C/s ratio i. = Contribution per unit Selling price per unit

Illustration The contribution to sales ratio of a product W is 20%. IB the manufacturer of product W wishes to make a contribution of $50000 towards fixed costs. How many units of product W must be sold if the selling price is sh10 per unit? ii. A company manufactures a single product with a variable cost of sh44. The contribution to sales ratio is 45% monthly fixed costs are sh36000. What is the B.E.P in units? The Margin of Safety

 This is the difference between the budgeted sales and the Break Even point of sales. It can be expressed in sales volume or sales value. It is sometimes expressed as a percentage of budgeted sales. Illustration Mal De Mar Co. makes and sells a product which has a variable cost of sh30 and which sells for sh4. Budgeted Fixed Costs are sh70000 and budgeted sales are 8000 units. Required i) B.E.P in units and in sales value ii) Margin of safety in units and in sales value Break Even Arithmetic At B.E.P S = V+F Where; S=Sales Revenue V=Variable Cost F= Fixed Cost Substituting V from each side we get S-V=F But S V is the contribution At B.E.P contribution = Fixed Cost (S - V = F) Illustration B limited makes a product which has a variable cost of sh.7 per unit. The fixed costs are sh.63000 per annum. Required: i. Calculate the selling price per unit if the company wishes to break even with a sales volume of 1200units. Target Profits. This is the profit which is intended to be achieved by an organization during a particular period. The target profit is achieved when: S = V + F + P Where: S = Sales Revenue V = Variable Cost F = Fixed Cost P = Target Profit Illustration B limited makes and sells a single product for which the variable costs are as follows: Shs

Direct material Direct labour Variable overhead

10 8 6 24

The selling price is Shs 30 per unit and fixed cost per annum are Shs 68000. the company wishes to make a profit of Shs 16000 per annum Required: Determine the sales required to achieve this profit Graphical approach to B.E.P The B.E.P can also be determined graphically using a break even chart. This chart shows the approximate levels of profit or loss at different sales volume levels within a limited range. The chart has the following axes: i. Horizontal axis showing the sales/output in units ii. A vertical axis showing the sales revenue and cost in value The following graphs are drawn on the break even chart i. The sales graph This is a straight line which starts from the origin and ends at the point signifying the expected sales ii. The fixed cost graph which runs parallel to the horizontal axis and begin at a point which represents the total fixed cost iii. Total cost line which starts at a point where the fixed cost intersects the y-axis and ends where the fixed cost of anticipated sales on the horizontal axis and total cost of anticipated sales on the vertical axis The break even point is the intersection of the sales line and the total cost line The distance between the B.E.P and the expected (budgeted) sales in units indicates the margin of safety Illustration The budgeted annual output of a factory is 120000 units. The fixed overhead amounts to Shs 40000 and the variable costs are Shs 0.5 per unit. The selling price is Shs 1 per unit

Required Construct a break even chart showing the current break even point and profit earned upto the present maximum capacity. Profit Volume Chart The break even chart do not highlight the profit or loss at different volume levels

 To ascertain the profit or loss figures from a break even chart, it is therefore necessary to determine the difference between the total cost and the total revenue line Profit volume chart is a more convenient method of showing the impact of changes in volume of profit

Profit is on the Y axis and comprises profit and contribution towards profit extending above and below the X axis with a zero point at the intersection of the two axes and the negative section below the axis representing fixed cost At zero production, the firm therefore is incurring a loss equal to the fixed cost Volume is on the X axis and comprises of the volume of sales The profit volume line is a straight line starting at the intercept of the Y axis (zero production) representing the level of fixed costs The profit volume line cut the X axis at the break even point of sales volume Any point on the P/V line above the X axis represents the profit to the firm for that particular level of sales Assumption of Break Even Analysis i. It assumes that fixed cost are constant at all levels of output ii. It assumes that variable cost per unit is constant at all levels of output iii. It assumes that the selling price per unit is constant at all levels of output

iv. v. vi. vii.

It assumes that production and sales volumes are the same and therefore inventory levels are ignored It assumes that cost can accurately be divided into their fixed and variable elements It assumes that volume is the only factor that will costs and revenues to change and therefore all other variables remain constant It assumes that a single product or a single pre determined sales mix of a range of products is sold

Limitations of Break Even Analysis i. It can only be applicable to a single product or a single mix of a group of products ii. It ignores the uncertainity in the estimates of fixed costs and variable cost per unit iii. It assumes that all variables other than the one under consideration (production volume) remain constant throughout the analysis and therefore volume is the only factor that will cause cost and revenue to change. However, changes in other variables such as production efficiency, sales mix, price levels and production methods can significantly influence sales revenue and costs iv. The analysis assumes that unit variable cost and selling price are constant. This assumption is only likely to be valid within the relevant range of production v. The analysis assumes that cost can be accurately analysed into fixed and variable elements. The separation of semi variable costs into their fixed and variable elements is sometimes very difficult in practice vi. The break even chart may be time consuming to prepare Economist B.E.P Total Revenue Curve This is assumed to be curvilinear, indicating that the firm is only able to sell increasing quantities of output by reducing the selling price per unit, thus the total revenue line does not increase proportionately with output Total revenue curve will continue to rise as long as the adverse effects of price reduction is less than the benefits of increased sales and reaches the maximum point where the adverse effect of price reduction is equal to the benefits of increased sales volumes Total revenue curve will eventually fall if the adverse effect of price reduction outweighs the benefits of increased sales volume

Total Cost This shows the economies of scale at first and therefore output rises faster tan cost The cost curve then turns upwards and become steeper as the diminishing returns set in

Economies break even chart