MAKE OR BUY A COMPONENT PART...an insourcing vs.

outsourcing issue…Which option gives

a saving?

Cost To Make Cost To Buy

Purchase Price P xx
Direct Materials P xx
Materials Handling Costs P xx P xx
Direct Labor P xx
Variable Overhead P xx
Avoidable Fixed Overhead P xx
Savings If The Part Is Bought (P xx)
Rental Income From Released Facilities (P xx)
Contribution Margin From A New Product
Being Produced Using The Released Facilities (P xx)
Rental Expense If The Part Is Bought P xx
Total Relevant Costs P xx P xx

The avoidable fixed overhead is also a relevant cost since it varies from one option to another.

Materials handling costs apply to materials and other purchases and are normally allocated based on
purchase cost. Inasmuch as the cost of purchase changes, consequently, the allocated costs change as
well, and therefore are relevant costs in the short term decision making.

ACCEPT OR REJECT A SPECIAL SALES ORDER…What matters is profit!

In deciding whether to accept or reject a special order, the paramount consideration is incremental
profit determined as follows:

Incremental sales P xx
Incremental costs (P xx)
Incremental profit ( loss ) P xx
Opportunity costs ( benefit ) from the alternative use of capacity (P xx)
Net advantage ( disadvantage ) of accepting the special sales order P xx

The opportunity costs here refer to the net benefit that could have been derived from another
alternative had the special sales order not been accepted, the idle capacity could be
1. rented out to others
2. used to produce another product and generate additional contribution margin
If there is no idle capacity, the opportunity cost here refers to the lost contribution margin from regular
sales or from the best use of the sacrificed capacity.

CONTINUE OR DROP A BUSINESS SEGMENT (eg, division, product line, or a process )…What is the
balance of the segment margin?

The segment margin can also be computed as:

Contribution Margin P xx
Less: Avoidable Fixed Costs and Expenses (P xx)
Segment Margin P xx

If there is an alternative use of facility, the quantification should be:

Contribution Margin P xx
Less: Avoidable Fixed Costs and Expenses (P xx)
Segment Margin P xx
Less: Net Benefit from the best
alternative use of facilities (P xx )
Net advantage ( disadvantage ) of
continuing the division P xx

Segment margin represents a division’s traceable performance.

If you drop the segment having positive segment margin, the overall profitability of the business will be
diminished by the amount of the positive segment margin.

SELL-AS-IS OR PROCESS FURTHER A PRODUCT…Is there an incremental profit?

Incremental sales P xx
Incremental costs (P xx)
Savings from further processing P xx
Incremental profit ( loss ) P xx

The minimum sales price after further processing shall be the original sales price plus the cost of further
processing.
The joint production costs and all other costs of preceding processes are considered irrelevant in
deciding whether to sell now or process further. These irrelevant joint costs include variable and fixed
production costs.
CONTINUE OR TEMPORARILY SHUT DOWN OPERATIONS?

Either way, continue or shut down, the business will have a loss. The guideline is, which option will give
a lesser amount of loss?

Shutdown costs are costs still incurred even after the operations are stopped.
Examples: salaries of remaining executives and skeletal force of personnel, security, insurance,
and rental

On top of it the business will incur restart-up costs once it resumes its operations.
Examples: costs of rehiring and retraining personnel, refueling, and refurbishing the plant

Shutdown point is where the loss from continuing is equal to the loss from discontinuing.

loss from continuing = contribution margin less fixed costs

loss from discontinuing = 0 less shutdown costs

Shutdown point = Fixed costs – Shutdown costs

Unit Contribution Margin

If
Sales > Shutdown point = continue the operations
Sales < Shutdown point = shut down or discontinue the operations

Joana Corp. is considering temporarily closing its operations in the months of July and August due to
slack business conditions. Also during this time, general reconditioning and repairs would be done in
preparation for the fourth quarter peak services. The following data are gathered in relation to this
proposal:

Entrance fee per guest P 150

Unit variable cost per guest P 60
Regular number of monthly guests 40,000
Estimated number of monthly guests in July and August 4,000

Regular monthly fixed costs and expenses

Salaries P 2,250,000
Rent P 400,000
Promotions and advertising P 250,000
Other fixed costs and expenses P 580,000
Total P 3,480,000
Estimated monthly fixed costs and expenses in July and August if the operations is shut down:
Salaries P 750,000
Rent P 160,000
Promotions and advertising 30% unavoidable based on contracts
Other fixed costs and expenses to be reduced by 60%
Restart-up costs P 300,000
Cleaning and other operating improvements
during the shutdown P500,000
MINIMUM OR MAXIMUM BID PRICE?

The maximum bid price should not be in excess of the expected utility value of the item or object under
bid.
The minimum bid price should not be less than the incremental costs of servicing the activity.
Minimum bid price = Incremental costs + Opportunity costs

Joana Corp. manufactures engines for the military equipment on a cost-plus basis. The cost of a
particular machine the company manufactures is shown below:

Direct materials P 400,000

Direct labor P 300,000
Overhead:
Supervisor’s salary P 40,000
Fringe benefits on direct labor P 30,000
Depreciation P 24,000
Rent P 22,000
Total P 816,000

OPTIMIZATION OF RESOURCES

To optimize scarce resources, sales and production should be allotted to a product that gives the highest
profit per scarce resource. If the scarce resource is direct labor hour, then produce the product that
gives the highest contribution margin per direct labor hour computed as follows:

CM per hour = UCM / No. of hours per unit

CM per hour = UCM x No. of units per hour

Use all your resources in producing the product that has the highest CM per hour unless such product
has a market limitation ( say, the market can accommodate only up to a certain number of units to be
sold ). In such case, after satisfying all the market need of the product having the highest CM per hour,
produce and sell the product that has the next highest CM per hour, and so on, until all available
resources are exhausted.

SELL NOW OR LATER…Which is more profitable?

There are instances where the sales price of a product is expected to increase after a period of time.
Examples of these are fashion, clothes, wines, artifacts, paintings, historical items, and land. If the
product is not sold now, it will be kept, secured and, sometimes, stored in a special place. Keeping the
product would entail storage costs, maintenance costs, and opportunity costs of the money locked in
the product. If the expected incremental sales from selling the item later are greater than the
incremental costs of keeping the product, then sell it later. Otherwise sell it now.

Joan Corp. sells artifacts and other historical items. It is now studying whether to sell now or later one of
its items, a Chinese porcelain dated back in 1541, with the following data

Cost of discovery P 0.7 million

Cost of monthly storage in a special place P 30,000
Selling price now P 2.6 million
Expected sales price 8 months from now P 2.9 million

REPLACE OR RETAIN AN OLD ASSET…What is the net cash flow?

Old assets need higher budget to maintain than the new one. If the old asset is replaced, there is an
immediate outflow of cash. However, there would be savings derived from reduced operating expenses
of maintaining the new asset compare with that of the old one. Also, there is a possible inflow from the
current residual value of the old asset. If the net cash flow is positive, meaning cash inflows are greater
than cash outflow over the life of the asset, then, it is advisable to replace the old asset and generate
net benefit over its useful life.

All of these are under the assumption that the useful life of the new asset, compared to the old asset, is
equal, without considering the time value of money and effects of taxes.

Joana Company is contemplating to replace one of its existing machines ang has gathered the following
relative data for analysis:

OLD NEW
Purchase price P 1.0 million P 2.0 million
Life in years 4 4
Residual value now P 0.25 million n.a
After 4 years none none
Annual operating expenses P 1.2 million P 0.65 million
SCRAP OR REWORK DEFECTIVE UNITS

There are products that do not meet the standard production specifications. Some of these products are
defective which could be sold as scrap or could be reworked and sold at a higher value. In deciding
whether to sell as scrap or rework, the net profit from reworking should be compared with the net profit
of selling as scrap without regard to the past costs of producing the product.

Joana Corp. produces 200,000 units where 10% is considered defective. The company is studying either
to scrap or rework the defective units and has provided the following data for analysis:

Cost of production P 30 million

Sales price of regular good units P 200 per unit
Sales price as defective units P 40 per unit
Sales price of defective units after reworking P 75 per unit
Number of units reworked 120 units
Cost of reworking defective units P 10 per unit

INDIFFERENCE POINT…Whatever decision, the results are equal.

Indifference point is where the outcome of alternatives is the same. Regardless of choice, the manager
will arrive at the same profit or loss.
Examples: breakeven point, shutdown point, EOQ, and Internal rate of return.

REVIEW THE SAMPLE PROBLEM IN YOUR CVP LESSON