BSc. (Hons.

) in Chemical Science Degree Programme

Institute of Chemistry Ceylon

APM 12112: Accounting Concepts and Costing

Handout 5: Special decision making situations.

Ad-hoc Decisions

Businesses such as restaurants, hotels and travel companies are good examples for applying relevant
costing to ad-hoc decision making (Decisions for specific/ one-off purposes).

Example 1:

Chompers Restaurant can cater for 500 meals per day although on average it caters for 400 meals. Fixed
costs for the restaurant is Rs 1,000 per day and the average selling price per meal is Rs 5 with variable cost
amounting to Rs 3 per meal.

On one given day a group of 30 people on a tour arrived at the restaurant and offered to pay a total of Rs.
120 if every member of the party could have a full meal each.

Required:

Would you accept this order?

Answer:

Increase in revenue = Rs 120

Less: Increase in cost = Rs. 90

Increase in contribution = Rs 30

At a glance, Chompers would accept this offer since they make a contribution of Rs 30 form the special
order.

Increase in cost is the RS 3 variable cost per meal for 30 meals, which comes to Rs. 90.

Restaurant has a capacity to supply 500 meals whilst on average, the company supply only 400 meals.
Hence, the business has excess capacity to supply this one off order for 30 meals. Further, since capacity is
available, it is safe to assume that the fixed cost would remain constant at Rs 1,000 regardless of the one-
off request for 30 meals (Since there is no need to create extra capacity).
Therefore, we can conclude that only the increase in revenue and variable cost is relevant for this
decision and the decision would be to accept this offer.

For the same Chompers business, consider the following scenario:

A nearby business enterprise came-up with the following proposal. This new business offered to pay Rs
750 per each working day to provide meals for 200 customers daily. Assume the business has no intention
to expand or increase capacity. What do you think Chompers should do?

Answer:

Chompers has a capacity to cater 500 meals per day while they already supply 400 on average on a daily
basis. Hence, in order to accept the new offer, they have to give-up 100 existing customers daily. Hence
this creates a loss of Rs 500 (100*5) of old revenue. Hence, the incremental revenue is only Rs 250

Further, Chompers has to increase variable costs by of Rs. 600 (3*200) to cater to the new order for 200
meals but it saves Rs 300 (100*3) from not catering to the old 100 customers (displaced customers). Hence
incremental cost is only Rs. 300.

Details can be presented in following format

Additional revenue = Rs 750

Less: Lost revenue = Rs 500

Incremental Revenue = Rs 250

Additional cost = 600

Less: Cost saved = 300

Incremental Cost = 300

Incremental Contribution = 250-300 = -50 (A loss of Rs. 50)

Therefore, the decision must be to reject the proposal.

In summary

Chompers would not accept the proposal in the short term.

In the long term, if the new business can guarantee continuity of the order, Chompers might consider
expanding capacity to cope with both existing and new demand. This may result in economies of scale
which might make the Rs. 750 per day a fair price to pay.

However, if this offer is accepted in the long term another problem which might come-up is that normal
customers might be unhappy about paying Rs 5 per meal while another is paying only 3.72 per meal
(750/200). Chompers would have to decide how to overcome this issue.

Example 2

Make or Buy Decisions

Relevant costing helps to decide on buying vs. manufacturing components for the product. Study the
following example to understand this concept.

Shingle Ltd currently makes one key component that it uses when servicing machinery for clients. Each
component costs Rs 20 to make and the current usage is 10,000components per year. Fixed costs directly
associated with components is Rs 40,000 per year. These fixed costs would be eliminated if the production
of the components stops. After negotiations, Pebble PLC has offered to supply components to Shingle Ltd
at a price of Rs 22 per unit.

Answers:

Cost of making the components

Variable Cost = 20*10,000 = Rs 200,000

Fixed Cost = Rs. 40,000

Total Cost = Rs 240,000

Buying the components from Pebbles:

Total buying cost = 220,000

Saving from buying from Pebbles = RS 240,000 – Rs 220,000= Rs 20,000

From a financial perspective, buying the product seems to be a good option but lets look at qualitative
aspects.

Reliability of Pebble: Can pebbles supply the required 10,000 units in the long term. Is pebbles trying to
overcome a temporary over capacity situation or trying to sell an excess stock. Will pebbles change the
price after Shingle gets rid of the manufacturing operations?
Will the pebbles products be of the same quality if not better compared to products Shingle can produce?

The savings for Shangle is not that great. Its 8% saving compared to cost of producing. How long will it
be before these saving are wiped out?

Will there be other costs such as redundancy costs for Shingle? This can make the buying option much
less attractive.

How will the closing of the manufacturing unit affect moral of remaining employees and how will they
respond to this closure. Their efficiency might drop.

Is pebbles reputed as a socially responsible company? If not Shingle’s customers who value being
socially responsible might reject Shingle due to buying form Pebble PLC

Further Information: If the fixed cost cannot be eliminated, then the buying option may not be that
attractive. Following computation is evidence to that.

Cost of Producing:

Variable Cost = Rs. 200,000

Fixed Cost = Rs. 40,000

Total Cost = Rs. 240,000

Total cost if components are purchased:

Total buying cost = 220,000

Fixed Cost = 40,000

Total Cost = 260,000

Hence, if the fixed cost cannot be eliminated, Decision to buy components would result a loss of Rs
20,000 for the business (260,000-240,000)

Hence both financial and non-financial information becomes critical when decisions such as make or buy
decisions are made.
Example 3

Closure Decisions

Let’s look at another example.

Balty Ltd has three products and uses joint facilities to produce and sell all three products. Each product is
independent of the other two. Relevant information is given below.

Product
A B C Total
Sales per month (units) 900 1,200 700
Selling price per unit (Rs.) 150 115 175
VC per unit (Rs.) 110 90 150
Fixed Cost per month (Rs.) 79,100

Fixed cost have been allocated to each of the products at the rate of 20% of product’s sales. Management
accountant prepare a profit statement for the three products as follows.

Product
A (Rs) B (Rs) C (Rs) Total (Rs)
Sales 135,000 138,000 122,500 395,500
Les: Variable costs 99,000 108,000 105,000 312,000
Contribution 36,000 30,000 17,500 83,500
Less: Allocated Fixed Cost 27,000 27,600 24,500 79,100
Net Profit/Loss 9,000 2,400 -7,000 4,400

Do you think the product C should be discontinued? If so give reasons.

Answer

The key to remember is that even if the product C is discontinued, the fixed cost allocated to the product
will remain. This is because the products are made using a common facility. There is no saving on the
cost of these facilities even if the product is not produced. Therefore, if the product C is discontinued, the
overall group profit of Rs. 4,400 becomes a loss of 13,100.
 Product
A (Rs) B (Rs) C (Rs) Total (Rs)
Sales 135,000 138,000 0 273,000
Les: Variable costs 99,000 108,000 0 207,000
Contribution 36,000 30,000 0 66,000
Less: Allocated Fixed Cost 27,000 27,600 24,500 79,100
Net Profit/Loss 9,000 2,400 -24,500 -13,100

However, if some product fixed costs can be saved by eliminating product C, the overall profit would
become;

Reduction of Fixed Cost relating to product C

75% 50% 25%
New Fixed Cost =24,500*25% =24,500*50% =24,500*75%
=6,125 = 12,250 = 18,375
A (Rs) B (Rs) C (Rs) Total(Rs)
Original Profit/loss from discontinuation 9,000 2,400 -24,500 -13,100
of product C
Profit/loss from discontinuation of 9,000 2,400 - 6,125 5,275
product C (Cost Saving 75%)
Profit/loss from discontinuation of 9,000 2,400 -12,250 -850
product C (Cost Saving 50%)
Profit/loss from discontinuation of 9,000 2,400 -18,375 -6,975
product C (Cost Saving 20%)
Example 4

Profit Maximization and limiting factor analysis.

Management accountant of Cobb Ltd, a shoe repair business has analyzed the businesses products for his
managing director as follows.

Product

A B C
Contribution per unit 2 2.52 3.75
Profitability ranking 3 2 1

Cobb Ltd has sold off three machines. Hence has limited machine capacity available to conduct repair
work.

Answer:

Taking the machine hour availability in to account, Divide the contribution per unit by the number of
units of the limiting factor needed to make the product or provide the services given.

Product
A B C
Machine hours to repair one 0.50 0.60 1.00
pair of shoes.
Contribution Per unit (Rs) 2.00 2.52 3.75
Therefore the contribution per 2.00/0.50 = 4 2.52/0.60 = 4.20 3.75/1 = 3.75
machine hour (Rs)
Ranking based on 2 1 3
contribution per machine hr.

When we look at the contribution per unit, product C seems to be the best option followed by product B
and then A.

But when we look at the contribution per unit of limiting factor, we can see that product B is the most
profitable followed by A and C.
Hence, when we allocate the limiting factor in the most profitable manner, This analysis of contribution
per unit of limiting factor is important.

If Cobb Ltd, has a total machine hours availability of 1,100, how many units of Type A, B and C should be
repaired by Cobb if produced in order to maximize profit. Assume the demand for the product for coming
period is as follows

Product
A B C
Expected Demand 300 600 700

Answer:

Machine hours needed to meet the demand

Product
A B C
Machine Hours required to meet the demand 300 * 0.5 = 150 600 * 0.6 = 360 700 * 1 = 700
Demand * machine hours to repair 1 pair of
shoes)

Allocation of machine hours to cater to the demand for the three products can be shown as follows (Based
on profit maximization focus)

Product Product prioritization Cumulative product time usage

Availability 1,100
Product B =600*0.6 = 360 =1,100-360 = 740
Product A =300*0.5 = 150 =740 – 150 = 590
Product C = 590 * 1 = 590 = 590 – 590 = 0

To cater to the full demand for product C, company needs 700 machine hours as per our calculation. But
only 590 machine hours available. Hence company can only repair 590 (590/1, computed as available
machine hours / machine hours required per unit)