# Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
VU
LESSON # 44 & 45
DECISION MAKING
CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
Introduction
One of the more common decision-making problems is a situation where there are not enough
resources to meet the potential sales demand, and so a decision has to be made about what mix of
products to produce, using what resources there are as effectively as possible.
A limiting factor could be sales if there is a limit to sales demand but any one of the organization's
resources (labor, materials and so on) may be insufficient to meet the level of production
demanded. It is assumed in limiting factor accounting that management wishes to maximize profit
and that profit will be maximized when contribution is maximized (given no change in fixed cost
expenditure incurred). In other words, marginal costing ideas are applied.
Contribution will be maximized by earning the biggest possible contribution from each unit of
limiting factor. For example if grade A labor is the limiting factor, contribution will e maximized by
earning the biggest contribution from each hour of grade A labor worked.
The limiting factor decision therefore invoices the determination of the contribution earned by
each different product from each unit of the limiting factor.
Example: Limiting Factor
AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows.
Ay
Be
Rs.
Rs.
Direct Materials
1
3
Direct Labor (Rs. 3 per hour)
6
3
1
1
8
7
The sales price per unit is Rs. 14 per Ay and Rs. 11 per Be. During July 20X2 the available direct
labor is limited to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000
units for Bes.
Required:
Determine the profit-maximizing production mix, assuming that monthly fixed costs are Rs.
20,000, and that opening stocks of finished goods and work in progress are nil.
Solution:
Step 1. Confirm that the limiting factor is something other than sales demand.
Ays
Bes
Total
Labor hours per unit
2hrs
1hr
Sales demand
3,000 units
5,000 units  8,000hrs
Labor hours needed
6,000 hrs
5,000 hrs
11,000hrs
Labor hours available
Shortfall
3,000hrs
Labor is the limiting factor on production.
Step 2. Identify the contribution earned by each product per unit of limiting factor that is
per labor hour worked.
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Cost & Management Accounting (MGT-402)
VU
Ays
Bes
Rs.
Rs.
Sales price
14
11
Variable Cost
8
7
Unit contribution
6
4
Labor hours per unit
2 hrs
1
hrs
Contribution per labor hour (=unit of limiting factor)
Rs. 3
Rs. 4
Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to
make one Ay. Because labor is in short supply it is more profitable to make Bes than Ays.
Step 3. Determine the optimum production plan. Sufficient Bes will be made ot meet the full sales
demand, and the remaining labor hours available will then be used to make Ays.
(a).
Hours
Hours
Priority
of
Product
Demand
required
available
manufacture
1st
Bes
5,000
5,000
5,000
2nd
Ays
3,000
6,000
3,000 (bal)
11,000
8,000
(b).
Hours
Contribution
Product
Units
Total
needed
per unit
Rs.
Rs.
Bes
5,000
5,000
4
20,000
Ays
1,500
3,000
6
9,000
8,000
29,000
Less fixed costs
20,000
Profit
9,000
In conclusion
a. Unit contribution is not the correct way to decide priorities.
b. Labor hours are the scarce resources, and therefore contribution per labor is the correct
way to decide priorities.
The Be earns Rs. 4 contribution per labor hour, and the Ay earns Rs. 3 contribution per
labor hour. Bes therefore make more profitable use of the scarce resource, and should be
manufactured first.
Exam Focus Point
If an examination question asks you to determine the optimum production plan, follow the
five-step approach shown below.
Step 1. Identify the limiting factor.
Step 2. Calculate contribution per unit for each product.
Step 3. Calculate contribution per unit of limiting factor.
Step 4. Rank products (make product with highest contribution per unit of limiting factor
first).
Step 5. Make products in rank order until scare resource is used up (optimal production
plan).
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