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Cost and Management Accounting

<<< Previous DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS
 
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MAKE OR BUY DECISIONS
Introduction
In a make or buy situation with no limiting factors, the relevant costs for the decision are the
differential costs between the two options.
A make or buy problem involves a decision by an organization about whether it should make a
product/carry out an activity with its own internal resources, or whether it should pay another
organization to make the production/carry out the activity. Examples of make or buy decisions
would be as follows.
a. Whether a company should manufacture its own components, or buy the components
from an outside supplier.
b. Whether a construction company should do some work with its own employees, or
whether it should subcontract the work to another company.
It an organization has the freedom of choice about whether to make internally or buy externally
and has no scarce resources that put a restriction on what it can do itself, the relevant costs for
the decision will be the differential costs between the two options.
Example: Make or Buy
Buster Ltd makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows.
W
X
Y
Z
Production (units)
1,000
2,000
4,000
3,000
Unit marginal costs
Rs.
Rs.
Rs.
Rs.
Direct materials
4
5
2
4
Direct labor
8
9
4
6
Variable production overheads
2
3
1
2
14
17
7
12
Directly attributable fixed cost per annum and committed fixed costs are as follows:
Rs.
Incurred as a direct consequence of making W
1,000
Incurred as a direct consequence of making X
5,000
Incurred as a direct consequence of making Y
6,000
Incurred as a direct consequence of making Z
8,000
Other fixed costs (committed)
30,000
50,000
A subcontractor has offered to supply units of W, X, Y and Z for Rs. 12, Rs. 21, Rs. 10, and Rs. 14
respectively.
Required:
Decide whether Buster Ltd should make or buy the components.
Solution:
a.
The relevant cots are the differential costs between making and buying, and they consist
of difference in unit variable costs plus differences in directly attributable fixed costs.
Subcontracting will result in some fixed cost savings.
W
X
Y
Z
Rs.
Rs.
Rs.
Rs.
Unit variable cost of making
14
17
7
12
Unit variable cost of buying
12
21
10
14
(2)
4
3
2
W
X
Y
Z
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Annual requirements (units)
1,000
2,000
4,000
3,000
Rs.
Rs.
Rs.
Rs.
Extra variable cost of buying (per annum)
(2,000)
8,000
12,000
6,000
Fixed costs saved by buying
(1,000)
(5,000)
(6,000)
(8,000)
Extra total cost of buying
(3,000)
3,000
6,000
(2,000)
b.
The company would save Rs. 3,000 pa by subcontracting component W (where the purchase
cost would be less than the marginal cost per unit to make internally) and would save Rs.
2,000 pa by subcontracting component Z (because of the savings in fixed costs of Rs. 8,000).
c.
In this example, relevant costs are the variable cots in-house manufacture the variable costs
of subcontracted units, and the saving in fixed costs.
Other factors to consider in the make or buy decision.
a.
If components W and Z are subcontracted, how will the company most profitably use the
spare capacity? Would the company's workforce resent the loss of work to an outside
subcontractor?
b.
Would the subcontractor be reliable with delivery times, and would he supply components
of the same quality as those manufactured internally?
c.
Does the company wish to be flexible and maintain better control over operations by
making everything itself?
d.
Are the estimates of fixed cost savings reliable? In the case of Product W, buying is clearly
cheaper than making in-house. In the case of product Z, the decision to buy rather than
make would only be financially beneficial if the fixed cost savings of Rs. 8,000 could really
be `delivered' by management.
Question
B Limited makes three components ­ S, T and W. The following costs have been recorded.
Components S  Component T  Component W
Units Cost
Unit Cost
Unit Cost
Rs.
Rs.
Rs.
Variable Cost
2.50
8.00
5.00
Fixed Cost
2.00
8.30
3.75
Total Cost
4.50
16.30
8.75
Another company has offered to supply the components to BB Limited at the following
prices
Components S  Component T  Component W
Price each
Rs. 4
Rs. 7
Rs. 5.50
Which component(s), if any, should BB Limited consider buying in?
A
Buy in all three components
B
Do not buy any
C
Buy in S and W
D  Buy in T only
Answer
BB Limited should buy the component if the variable cost of making the component is more than
the variable cost of buying the component.
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Components S  Component T  Component W
Rs.
Rs.
Rs.
Variable Cost of Making
2.50
8.00
5.00
Variable Cost of Buying
4.00
7.00
5.50
(1.50)
1.00
(0.50)
The variable cost of making component T is greater than the variable cost of buying it.
BB Ltd should consider buying in component T only.
The correct answer is D.
Make or Buy Decisions and Limiting Factors
In a situation where a company must subcontract work to make up a shortfall in its won
production capability, its total costs are minimized if those components/products subcontracted
are those with the lowest extra variable cost of buying per unit of limiting factor saved by buying.
Example: Make or Buy and Limiting Factors
Green Ltd manufactures two components, the Alpha and Beta, using the same machines for each.
The budget for the next year calls for the production and assembly of 4,000 of each component.
The variable production cost per unit of the final product, the gamma, is as follows.
Machine Variable
hours
cost
Rs.
1 unit of Alpha
3
20
1 unit of Beta
2
36
Assembly
20
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Only 16,000 hours of machine time will be available during the year, and a sub-contactor has
quoted the following unit prices for supplying components; Alpha Rs. 29, Beta Rs. 40. Advise
Green Ltd.
Solution:
a.
There is a shortfall in machine hours available, and some products must be sub-
contracted.
Product  Units
Machine hours
Alpha
4,000
12,000
Beta
4,000
8,000
Required
20,000
Available
16,000
Shortfall
4,000
b.
The assembly costs are not relevant costs because they are unaffected by the make or buy
decision. The units subcontracted should be those which will add least to the costs of Green Ltd.
Since 4,000 hours of work must be sub-contracted, the cheapest policy is to subcontract work
which adds the least extra costs (the least extra variable costs) per hour of own-time saved.
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c.
Alpha
Beta
Rs.
Rs.
Variable cost of making
20
36
Variable cost of buying
29
40
Extra variable cost of buying
Machine hours saved by buying
3 hours
2 hours
Extra variable cost of buying, per hours saved
Rs. 3
Rs. 2
It is cheaper to buy Betas than to buy Alphas and so the priority for making the components in-
house will be in the reverse order the preference for buying them form a subcontractor.
d.
Hours per unit to Hours required in Cumulative
Component
make in-house
total
hours
Alpha
3 hours
12,000
12,000
Beta
2 hours
8,000
20,000
20,000
Hours available
16,000
Shortfall
4,000
There are enough machine hours to make all 4,000 units of Alpha and 2,000 units of Beta. 4,000
hours production of Beta must be sub-contracted. This will be the cheapest production policy
available.
e.
Component
Machine
Number
of Units
variable Total
hours
units
cost
variable cost
Make
Rs.
Rs.
Alpha
12,000
4,000
20
80,000
Beta (balance)
4,000
2,000
36
72,000
16,000
152,000
Buy
Hours saved
Beta (balance)
4,000
2,000
40
80,000
Total variable cost of components
232,000
Assembly costs (4,000 x Rs. 20)
80,000
Total variable costs
312,000
SHUT DOWN DECISIONS
Shut down decisions involve the following:
 Whether or not to shut down a factory, department, or product line either because it is
making a loss or it is too expensive to run.
 If the decision is to shut down, whether the closure should be permanent or temporary.
Example: Shut Down Decisions
Suppose that a company manufactured three products, Corfus, Cretes and Zantes. The
present net profit from these is as follows.
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Corfus
Cretes
Zantes
Total
Rs.
Rs.
Rs.
Rs.
Sales
50,000
40,000
60,000
150,000
Variable costs
30,000
25,000
35,000
90,000
Contribution
20,000
15,000
25,000
60,000
Fixed costs
17,000
18,000
20,000
55,000
Profit/loss
3,000
(3,000)
5,000
5,000
The company is concerned about its poor profit performance, and is considering whether
or not to cease selling Cretes. It is felt that selling prices cannot be raised or lowered
without adversely affecting net income. Rs. 5,000 of the fixed costs of Cretes are
attributable fixed costs which would be saved if production ceased. All other fixed costs
would remain the same.
Solution:
a. By stopping production of Cretes, the consequences would be a Rs. 10,000 fall in
profits.
Rs.
Loss of contribution
(15,000)
Savings in fixed costs
5,000
Incremental loss
(10,000)
b. Suppose, however, it were possible to use the resources realized by stopping
production of Cretes and switch to producing a new item, Rhodes, which would sell
for Rs. 50,000 and incur variable costs of s. 30,000 and extra direct fixed costs of Rs.
6,000. A new decision is now required.
Cretes
Rhodes
Rs.
Rs.
Sales
40,000
50,000
Less variable costs
25,000
30,000
Contribution
15,000
20,000
Less direct fixed costs
5,000
6,000
Contribution to shared fixed costs and profit
10,000
14,000
It would be more profitable to shut down production of Cretes and switch resources to
making Rhodes, in order to boost contribution to shared fixed costs and profit from
Rs. 10,000 (from Cretes) to Rs. 14,000 (from Rhodes).
ONE-OFF CONTRACTS
i.
Introduction
The decision to accept or reject a contract should be made on the basis of whether or not the
contract increases contribution and profit.
This type of decision-making situation will concern a contract which would utilize an
organization's spare capacity but which would have to be accepted at a price lower than that
normally required by the organization. In general you can assume that a contract will
probably be accepted if it increases contribution and hence profit, and rejected it reduces
contribution (and hence profit). Let us consider an example,
ii.
Example: One-off Contracts
Belt and Braces Ltd makes a single product which sells for Rs. 20. It has a full cost of Rs. 15
which is made up as follows:
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Rs.
Direct Material
4
Direct Labor
6
Variable Overhead
2
General Fixed Overhead
3
15
The labor force is currently working at 90% of capacity and so there is a spare capacity for 2,000
units. A customer has approached the company with a request for the manufacture of a special
order of 2,000 units for which he is willing pay Rs. 25,000. Assess whether the contract should be
accepted.
Solution:
Rs.
Rs.
Value of order
25,000
Cost of order
Direct materials (Rs. 4 x 2,000)
8,000
Direct labor (Rs. 6 x 2,000)
12,000
Variable overhead (Rs. 2 x 2,000)
4,000
Relevant cost of order
24,000
Profit form order acceptance
1,000
Fixed costs will be incurred regardless of whether the contract is accepted and so are not relevant
to the decision. The contract should be accepted since it increases contribution to profit by Rs.
1,000.
Other factors to consider in the one-off contract decision.
a.
The acceptance of the contract at a lower price may lead other customers to demand lower
prices as well.
b.
There may be more profitable ways of using the spare capacity.
c.
Accepting the contract may lock up capacity that could be used for future full-price business.
d.  Fixed costs may, in fact, if the contract is accepted.
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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