Non-recurring manufacturing and selling situation are constantly faced by controllers [and accountants] when analyzing the manufacturing and selling functions which is a strategic matter of choosing alternative quick courses of action. Typical questions include: What to make? How to make it? Where to sell the product or service? What price should be charged? In the short run, the controller [accountant] is typically confronted with the following non-recurring, non-routine types of decisions: acceptance or rejection of a special order, make or buy, add or drop a certain product line, utilization of scarce resources, sell or process further. Through this post, I reveal those insight analyses with some easy case examples. Enjoy!
Before going to the analysis, you would need to understand some fundamental principle related to the decision that we will discuss later. Read on…
What Are Relevant Costs?
In each of the above situations, the ultimate decision rests upon cost data analysis. Cost data are important in many decisions, since they are the basis for profit calculations. However, not all costs are of equal importance in decision making, and accountants must identify the costs that are relevant to a decision. Such costs are called “relevant costs”.
Which Costs Are Relevant In A Non-recurring Decision?
The relevant costs are the expected future costs which differ between the decision alternatives.
The sunk costs are not relevant to the decision at hand, because they are past, historical costs. The incremental or differential costs are relevant since they are the ones that differ between the alternatives.
Example: In a decision on whether to sell an existing business for a new one, the cost to be paid for the new venture is relevant. However, the initial cost of the old business is not relevant to the decision because it is a sunk cost.
The Incremental Analysis
The method that uses the concept of relevant costs is called the “incremental approach”, also known as the “differential or relevant cost approach”. Under this method, the decision involves the following steps:
- Gather all costs associated with each alternative
- Drop the sunk costs
- Drop those costs that do not differ between alternatives
- Select the best alternative based on the remaining cost data
Assume that Lie Dharma Putra Company is planning to expand its productive capacity. The plans consist of purchasing a new machine for $50,000 and disposing of the old machine without receiving anything. The new machine has a five-year life. The old machine has a five-year remaining life and a book value of $12,500. The new machine will reduce variable operating costs from $35,000 per year to $20,000 per year.
Annual sales and other operating costs are shown below:
At first glance, it appears that the new machine provides an increase in net income of $7,500 per year. The book value of the present machine, however, is a sunk cost and is irrelevant in this decision. Furthermore, sales and fixed costs such as insurance and taxes are also irrelevant since they do not differ between the two alternatives being considered. Eliminating all the irrelevant costs leaves us with only the following incremental costs:
Enough with the fundamentals. Next, let’s start to answer the non-recurring manufacturing and selling questions with some analysis. Read on…
When Should A Company Accept Special Orders?
A company often receives a short-term, special order for its products at lower prices than usual. In normal times, the company may refuse such an order since it will not yield a satisfactory profit.
Recommendation: If times are bad or when there is idle capacity, an order should be accepted if the incremental revenue exceeds the incremental costs involved. Such a price, one lower than the regular price, is called a contribution price. This approach to pricing is called the contribution approach to pricing, also called the variable pricing model. This approach is most appropriate when:
- There is idle capacity
- Faced with sharp competition or in a competitive bidding situation
- Operating in a distress situation
Assume that a company with 100,000-unit capacity is currently producing and selling only 90,000 units of product each year with a regular price of $2. If the variable cost per unit is $1 and the annual fixed cost is $45,000, the income statement shows:
The company has just received an order that calls for 10,000 units @ $1.20, for a total of $12,000. The acceptance of this special order will not affect regular sales. Management is reluctant to accept this order because the $1.20 price is below the $1.50 factory unit cost ($1.50 = $1.00 + $0.50).
Is filling the order advisable?
The answer to this question is yes. The company can add to total profits by accepting this special order even though the price offered is below the unit factory cost. At a price of $1.20, the order will contribute $0.20 (CM per unit = $1.20 – $1.00 = $0.20) toward fixed cost, and profit will increase by $2,000 (10,000 units × $0.20). Using the contribution approach to pricing, the variable cost of $1.00 will be a better guide than the full unit cost of $1.50.
The fixed costs will not increase because of the presence of idle capacity.
Make-or-buy decision is the decision whether to produce a component part internally or to buy it from an outside supplier. This decision involves both quantitative and qualitative factors. The qualitative considerations include ensuring product quality and the necessity for long-run business relationships with the subcontractors. The quantitative factors, dealing with cost, are best seen through incremental analysis. Let’s follow the next case example…
Assume a firm has prepared the following cost estimates for the manufacture of a subassembly component based on an annual production of 8,000 units:
The supplier has offered to provide the subassembly at a price of $16 each. Two-thirds of fixed factory overhead, which represents executive salaries, rent, depreciation, and taxes, continue regardless of the decision.
Should the company buy or make the product?
The key to the decision lies in the investigation of those relevant costs that change between the make-or-buy alternatives. Assuming that the productive capacity will be idle if not used to produce the subassembly, the analysis takes the following form:
The make-or-buy decision must be investigated in the broader perspective of available facilities. The alternatives are:
- Leaving facilities idle
- Buying the parts and renting out idle facilities
- Buying the parts and using unused facilities for other products
To Add or Drop a Product Line
The decision of whether to drop an old product line or add a new one must take into account both qualitative and quantitative factors. Ultimately, any final decision should be based on the impact the decision will have on contribution margin or net income. Let’s follow the next case example…
The Lie Dharma grocery store has three major product lines: produce, meats, and canned goods. The store is considering dropping the meat line because the income statement shows it is being sold at a loss. Note the income statement for these product lines:
In this example, direct fixed costs are those costs that are identified directly with each of the product lines. Allocated fixed costs are the amount of common fixed costs allocated to the product lines using some base such as space occupied. The amount of common fixed costs typically continues regardless of the decision and thus cannot be saved by dropping the product line to which it is distributed.
The following calculations show the effects on the company as a whole with and without the meat line:
From either of the two methods, we see that by dropping meats the store will lose an additional $500. Therefore, the meat product line should be kept.
One of the great dangers in allocating common fixed costs is that such allocations can make a product line look less profitable than it really is. Because of such an allocation, the meat line showed a loss of $1,000. In effect it contributes $500 ($7,000 – $6,500) to the recovery of the store’s common fixed costs.
Making the Best Use of Scarce Resources
In general, the emphasis on products with higher contribution margin maximizes a firm’s total net income, even though total sales may decrease. This is not true, however, where there are constraining factors and scarce resources. The constraining factor is the factor that restricts or limits the production or sale of a given product.
Examples: machine hours, labor hours, or cubic feet of warehouse space.
In the presence of these constraining factors, maximizing total profits depends on getting the highest contribution margin per unit of the factor (rather than the highest contribution margin per unit of product output).
Assume that a company produces products A and B with the following contribution margins per unit.
As is indicated by CM per unit, B is more profitable than A since it contributes more to the company’s total profits than A ($4 vs. $2). But assume that the firm has limited capacity of 10,000 labor hours. Further, assume that A requires two labor hours to produce and B requires five labor hours. One way to express this limited capacity is to determine the contribution margin per labor hour.
Since A returns the higher CM per labor hour, it should be produced and B should be dropped.
The presence of only one limited resource is unrealistic. Virtually all firms encounter multiple constraints: restrictions on materials, labor inputs, demand for each product, warehouse space, display space, and so on. The solution of the product mix problem with multiple constraints is considerably more complex and requires a technique known as “linear programming”.