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Cost
& Management Accounting
(MGT-402)
VU
LESSON
# 42
DECISION
MAKING
Companies
are often faced with
the problem of whether to
close down temporarily a
part of the
plant
during periods of low
demand.
How
long operations should be
continued?
As
long as products contribute
fixed expenses, a company
seems to be better off than
if the plant
were
shut down.
Size
of fund
The
fund required to continue production is
the difference between the
following:
(a)
Fixed costs at normal operations,
(b)
Fixed costs when plant is
shut down.
Arguments
against shut-down
(a)
If the company continues operation,
expenses that would be
incurred with the closing
down
of
the plant will be saved;
e.g. an increase in factory
security.
(b)
Continued operation means
saving (he expenses that
will otherwise be incurred if the
plant is
reopened
again at a later stage.
(c)
A shut-down for a short period of
fine will not eliminate all
costs. Rent, rates,
depreciation
and
insurance will have to be
incurred during the shutdown
period.
(d)
If the factory is shut down,
this will affect not
only morale but also its market standing
if it
cannot
meet consumer demand.
Illustration
Lanka
Manufacturing Company is considering
temporarily closing down a division
due to an
unexpected
fall in demand. On the basis
of the following information
you are required by
the
board
of directors to prepare a statement in such a way as to
show clearly whether or not it
is
advisable
to close down the division
temporarily.
Production
capacity
50%
70%
90%
100%
Units
50,000
70,000
90,000
100,000
Prime
cost
Rs.
210,000
Rs.
294,000
Rs.
378,000
Rs.
420,000
Production
overhead
200,000
240,000
290,000
300,000
Other
overhead
90,000
102,000
114,000
120,000
The
division is operating at 60 percent capacity
with a turnover of Rs.
515,000. If it is decided to
close
the division temporarily, it is
estimated that:
(a)
expenses
that would be incurred with
the closing down of the
division would
amount
to Rs. 60,000
(b)
present
fixed costs would be reduced
by Rs. 54,000 per
annum;
(c)
plant
maintenance during shut-down
would be Rs 10,000 per
annum;
(d)
On
reopening, the cost of overhauling
plant, training and
engagement of new
personnel
would be Rs. 30,000
It
is expected that in about
twelve month's time it may
be possible to work at 80 percent
capacity.
229
Cost
& Management Accounting
(MGT-402)
VU
Differential
Costing for Short-Term Decision
Making
The
role of fixed
costs
If
the decrease or increase in
the level of activity affects
fixed costs then these
costs should be
considered
differential costs. It is generally
accepted that if the plant
has excess capacity then
new
or
additional volume may be accepted if
the selling price ii greater
than variable costs. In such
a
situation,
fixed costs arc not
relevant if they remain fixed at an
increased level of output.
But if
they
are incurred because of the
increased level of activity
then they are certainly
variable. Once
incurred,
if they arc committed fixed
costs, they become a
permanent feature and the
company
may
find (hat it has capacity
far in excess of requirements.
The
following illustration has
been prepared so as to place
particular emphasis on the
role of fixed
costs.
Illustration
Sena
of London operates at 100 percent of
normal capacity. At this
volume it produces
50,000
units
of a product.
Income
statement
Sales
(50,000 units at Rs. 10
each)
Rs.
500,000
Prime
cost (Rs. 5 per
unit)
Rs.
250,000
Rs.
250,000
Variable
production overhead (Rs. 1
per unit)
Rs.
50,000
Rs.
200,000
Fixed
production overhead
Rs.
100,000
Factory
profit
Rs.
100,000
The
marketing director reports that an
overseas customer has offered to
pay Rs. 7.50 per
unit for
an
additional 20,000 units. To produce the
additional order fixed costs
would increase by Rs.
25,000.
Would you advise the
company to accept the
order?
Differential
cost statement-method 1
Present
business
With
Difference
additional
business
Sales
Rs.
500,000
Rs.
650,000
Rs.
150,000
Prime
cost
250,000
350,000
100,000
Variable
production overhead
50,000
70,000
20,000
Fixed
production overhead
100,000
125,000
25,000
Factory
profit
Rs.
100,000
Rs.
105,000
Rs.
5,000
Differential
cost statement method 2
Present
Additional
Total
Sales
Rs.
500,000
Rs.
150,000
Rs.
650,000
Prime
cost
250,000
100,000
350,000
Variable
production overhead
50,000
20,000
70,000
Fixed
production overhead
100,000
25,000
125,000
Factory
profit
100,000
5,000
105,000
230
Cost
& Management Accounting
(MGT-402)
VU
Traditional
statement for additional
business
Sales
(20,000 units at Rs.
7.50)
Rs.
150,000
Prime
cost (20,000 at Rs.
5)
100,000
Variable
production overhead (20,000 at
Rs. 1)
20,000
Joint
fixed production overhead (using
a
predetermined
rate of absorption:
Rs.
100,000/50,000 = Rs. 2 (20,000 at
Rs. 2)
40,000
Separable
fixed costs
25,000
Loss
on additional business
(Rs.
35,000)
The
traditional cost statement for additional
business would cause
management to reject the
offer.
Management
may also not accept
the offer because as
computed under the
traditional method
absorption
costing the price offered
per unit is less than
the total cost per
unit and also because
it
is
less than the current
selling price of Rs. 10 per
unit:
Price
offered per unit
Rs.
7.50
Cost
per unit
Rs.
Prime
cost
5.00
Variable
production overhead
1.00
Joint
fixed costs
2.00
Separable
fixed costs (Rs.
25,000/20,000)
1.25
Loss
per unit
Rs.
(1.75)
In
the differential cost
statements (methods 1 and 2)
the additional business has
been charged with
differential
cost only. It should be
noted that the reason
for the differential profit
is that the regular
sales
were not affected by the
acceptance of additional business. If the
acceptance of additional
business
caused the price to be
reduced to Rs. 7.50 per
unit on all sales then
the result would be a
loss
of Rs. 20,000 for the
company:
Revised
income statement all sales at
7.50
Sales
(70,000 units at Rs.
7.50)
Rs.
525,000
Variable
costs (70,000 at Rs.
6)
420,000
Joint
fixed production
costs
100,000
Separable
fixed production
costs
25,000
Loss
Rs.
(20,000)
The
role of variable costs
In
differential cost studies, if
the plant is not operating at practical
capacity owing to lack of
orders,
variable
costs usually represent the
differential cost whether
they are incremental or
avoidable. The
term
refers to those costs that
will change. It is often
assumed that the variable
cost per unit
will
remain
constant regardless of the
level of activity.
One
may question the validity of
the above assumption. What if
the variable cost per
unit does not
remain
constant at various levels of activity? An
increased level of activity
may cause the
variable
cost
per unit to change for a
variety of reasons.
Examples
are:
(a)
At
a higher level of output material
cost per unit may be
reduced by bulk buying
at
lower
prices;
231
Cost
& Management Accounting
(MGT-402)
VU
(b)
Direct
labour cost per unit
may increase as a result of
overtime working if there is
a
labour
shortage;
(c)
Greater
spoilage and waste with
increase production.
Illustration
that
follows puts particular
emphasis on the role of
variable costs:
The
following are
assumed:
Sena
of London produces 40,000
units operating at 50 per cent
capacity.
Production
fixed costs
Rs.
20,000
Other
fixed costs
Rs.
40,000
Variable
cost per unit:
Direct
material
Rs.
3.00
Direct
labour
2.00
Variable
overhead
1.00
Rs.
6.00
Selling
price per unit: Rs.
10
An
overseas customers offer to buy
increased quantities during the
forthcoming year at
the
following
prices:
10,000
units at Rs. 9
20,000
units at Rs. 8
30,000
units at Rs. 7
40,000
units at Rs. 6
If
the offer is accepted then
the variable cost per
unit is expected to change as
follows:
First
10,000 units
Would
cause a drop in the material
cost per unit due
to
large
scale purchases
Next
10,000 units
A
further reduction in the material
cost per unit but
an
increase
in direct wages
Next
10,000 units
Would
involve some overtime and so
variable overhead
per
unit would increase.
Next
10,000 units
A
further reduction in material cost
per unit, and
increase
labour
cost per unit and
variable cost per
unit.
Summary
of expected changes
Units
1st
10,000
2nd
3rd
10,000
4th
10,000
10,000
Material
per unit
(5%)
(5%)
-
(5%)
Labour
per unit
-
5%
+
-
5%
+
Variable
overhead per unit
-
-
5%
+
5%
+
Variable
cost per unit at various
levels of activity
Normal
Additional
Additional
Additional
Additional
(Rs.)
10,000
20,000
30,000
40,000
Direct
material
3.00
2.85
2.7075
2.7075
2.572
Direct
labour
2.00
2.00
2.1000
2.1000
2.205
Direct
expenses 1.00
1.00
1.0000
1.0500
1.1025
Variable
cost
6.00
5.85
5.8075
5.8575
5.8795
per
unit
232
Cost
& Management Accounting
(MGT-402)
VU
Differential
cost statement
Normal
Additional
Additional
Additional
Additional
40,000
10,000
20,000
30,000
40,000
Sales
value per Rs. 10
Rs.
9.00
Rs.
8.00
Rs.
7.00
Rs.
6.00
unit
Variable
cost per 6
5.85
5.8075
5.8575
5.8795
unit
Contribution
per Rs. 4
Rs.
3.15
Rs.
2.1925
Rs.
1.1425
Rs.
0.1205
unit
Fund
160,000
31,500
43,850
34,275
4,820
233
Table of Contents:
- COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
- IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
- FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
- FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
- PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
- MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
- MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
- CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
- ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
- ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
- LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
- PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
- PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
- LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
- ALLOCATION AND APPORTIONMENT OF FOH COST
- FACTORY OVERHEAD COST:Marketing, Research and development
- FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
- JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
- PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
- PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
- PROCESS COSTING SYSTEM:Normal Loss at the End of Process
- PROCESS COSTING SYSTEM:PRACTICE QUESTION
- PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
- PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
- COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
- COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
- MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
- MARGINAL AND ABSORPTION COSTING:Contribution and profit
- COST – VOLUME – PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
- COST – VOLUME – PROFIT ANALYSIS:Target Contribution Margin
- BREAK EVEN ANALYSIS – MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
- BREAKEVEN ANALYSIS – CHARTS AND GRAPHS:Usefulness of charts
- WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
- Production & Sales Budget:Rolling budget, Sales budget
- Production & Sales Budget:Illustration 1, Production budget
- FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
- FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
- TYPES OF BUDGET:Format of Cash Budget,
- Complex Cash Budget & Flexible Budget:Comparing actual with original budget
- FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
- DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
- DECISION MAKING:Size of fund, Income statement
- DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
- DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
- DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS