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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
Variable Overhead
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.
241
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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).
242
Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS