week 2 management decision making

FINANCIAL MANAGEMENTPrepared by Tishta Bachoo

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Lecture 2 - overview

Prepared by Tishta Bachoo

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• Decision Making Techniques

• When there is Limiting Factor

• Make or Outsourcing Decision

• Analyze a special Order Decision

Management Decision Making

When running a business, making the right decisions can lead to success, while making the wrongs can result to failure.

With so much riding on each decision, it's important that thoughtful consideration is put into each one that needs to be made.

To help them, many business leaders go through a thoughtful decision-making process.


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Limiting Factor

For some businesses sales are not limited by market demand, but by production limitations.

For example, limited production can be caused by a shortage of any factor such as labour, materials, space or equipment.

In such cases, if an entity has more than one product or service offered to customers it would need to determine which product/service provides the most profitable use of the limited resource.


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Contribution margin per limiting factor is the contribution margin per unit of limited resource

Example 1 Products A B C

. Budgeted sales next year 100 000 50 000 80 000SP per unit $30 $40 $60VC per unit $15 $22 $15Labour time per unit 1 hr 4 hrs 1.5 hrsTotal labour hrs required 100 000 hrs. 200 000 hrs 120 000 hrs

Contribution margin per limiting factor5


By summing the required hours, we find that the firm needs a total of 420 000 hours

BUT let’s assume only 370 000 hours are available for production

Firm wants to know which product it should promote

This means we need to determine the most profitable product

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Contribution margin per limiting factor

Steps to calculate contribution margin per limiting factor

This is calculated when the company has limited resources for production. It can be limited labor hours, materials, etc…

1. Calculate contribution margin for each product

CM= S.P per unit – Variable cost per unit

2. Calculate the CM per limiting factor per unit

CM/ Hr per unit or CM/ Materials per unit

3. The higher the CM/Hr, the more profitable the company is to make the product

4. Choose the most profitable, 2nd profitable and least profitable

5. Deduct the total hours required for the two highly profitable products from the available hours.

6. The number of hours left is the then allocated to the least profitable product.

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A B C CM per unit $15 $18 $45Labour time per unit 1 hr 4 hrs 1.5 hrsTotal labour hrs required 100 000 hrs 200 000 hrs 120 000hrsCM per hour $15 p.h. $4.5 p.h. $30 p.h.

This analysis shows that C is the most profitable by providing more CM per hour The company should therefore focus production on C (120,000 hours) followed by

A (100,000 hours) since this is the second most profitable. The remaining 150 000 hours (370 000– 220,000 hours) allocated towards B.

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Contribution margin per limiting factor

To make sure decisions are based on the right information, the following must be identified where relevant: Relevant costs and relevant income

Incremental costs and incremental income

Opportunity cost

Avoidable costs and unavoidable costs

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Make or Buy (outsourcing)

A make or buy decision requires an entity to choose whether To make or buy a product or service

OR

To outsource the production of that product or service

Such a decision will involve both quantitative and qualitative factors

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Qantas Airlines owns $20,000 worth of parts which were designed for an aircraft that the airline no longer uses. The airline has two options:

Option 1 Sell the existing parts for $17,000 and purchase new parts for $26,000.

Option 2 Modify the existing parts at a cost of $12,000.

Should Qantas Airlines keep or sell the parts?



Solution

Option 1 Option 2Proceeds from sale 17,000 0of parts

Costs to modify parts -12,000

Cost of new parts -26000

Total Cost -$9,000 -$12,000


Solution

Qantas should therefore dispose of the parts and purchase new equipment.

Note the exclusion of the initial cost of the equipment from the analysis. Because this is classified as a sunk cost


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Sunk costs are those which; Have already been incurred Do not affect any future cost and cannot

be changed by any current or future action.

Sunk costs do not meet the definition of relevant information.


Sunk costs

The Potential benefit that is forgone as a result of choosing one alternative over another.

Opportunity costs meet the definition of a relevant cost. They therefore need to be included in

make or buy or special order decisions.


Opportunity costs

On occasions, an organisation will be offered a special, once only order. The price offered for the organisations products will normally

be below the normal selling price.

Using relevant costs and benefits managers must decide whether this order should be accepted or rejected.


Special orders

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Exercise 1 – Qantas AirlinesExcess Capacity

A travel agency has offered to charter a flight from Mauritius to Sydney return for $50,000. Qantas Airlines would normally charge $100,000 for a Mauritius to Sydney return flight.

Expenses per flight are as follows; VC per flight 20,000

FC allocated to each flight 35,000 (FC = $350,000, Qantas Airlines operates 10 flights).

Qantas Airlines has two aircraft which are presently not being used Should the offer be accepted?


SolutionCharter Price $50,000

Less Variable Cost -$20,000

Contribution from Charter $30,000

Since Qantas Airlines has 2 aircraft not currently being used, they should accept the special order.

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Exercise 2Special Order - Full Capacity If Qantas Airlines was at full capacity (i.e. no spare planes)

how would your analysis differ??

To accept the offer Qantas Airlines would need to drop flights from its normal activity. The contribution margin is $80,000 ($100,000- $20,000 {VC}).

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Solution

Charter Price $50,000less: Variable Costs for the Charter -$20,000

less:Opportunity Cost -$80,000

Contribution from the Charter -$50,000

Qantas Airlines should not accept the special order due to a negative contribution margin.

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Question on Limiting Factor


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The management of ABC Ltd has given you the following financial information about three products that they produce: Bottles, Forks and Plates. The normal production of 130 000 products would require a total of 280 000 labour hours. Due to lack of workers, total labour hour which can be allocated to the production of the three products is 200 000 hours. Management does not want to incur any loss neither does he want to close down the business and hence asking you for some advice.

Bottles Forks Plates .

Budgeted sales next year 20 000 40 000 70 000

SP per unit $25 $20 $70

VC per unit $10 $12 $40

Labour time per unit 1.5 hr 3 hrs 2 hrs

Total labour hrs required 30 000 hrs 120 000 hrs 140 000 hrs


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Bottles Forks Plates CM per unit $15 $8 $30Labour time per unit 1.5 hr 3 hrs 2 hrsTotal labour hrs required 30 000 hrs 120 000 hrs 140 000 hrs CM

per hour $10 p.h. $2.67 p.h. $15 p.h.2nd 3rd 1st

This analysis shows that Plates are the most profitable by providing more CM per hour ABC should therefore focus production on Plates (140,000 hours) followed by

Bottles (30,000 hours) since this is the second most profitable. The remaining 30 000 hours (200 000– 170,000 hours) allocated towards Forks.

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Answer (Limiting Factor)

Question on Make or Buy


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Diamond Light Company incurred the following costs to produce 50 000 light switches for floor lamps in 2016.

Direct materials $ 100 000

Direct labour 150 000

Variable manufacturing overhead 80 000

Fixed manufacturing overhead 120 000

Total manufacturing costs $450 000

The Ignition Company has offered to supply the switches for $16 per unit. An analysis of the overhead costs has identified that if the switches are outsourced, Diamond Light Company would eliminate $20 000 of fixed costs, and could use the released production capacity to generate additional income of $56 000 from producing a different product. From a financial perspective, should the light switches be outsourced? Show calculations.


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Answer (Make or Buy)


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Question on Special Order


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ABC Ltd has production capacity of 50,000 plates and they are currently operating at 85 per cent capacity. Their variable manufacturing costs are $15 per unit. Fixed manufacturing costs are $ 300 000. The plates are normally sold directly to a retailer at $40 each.

Now they have an offer from another Company who wants to purchase an additional 7000 plates at $25 per unit from ABC Ltd.

What is ABC Ltd available production capacity?

Calculate the contribution margin per unit for both the current production of plates and the special order plates

Should the special order be accepted? [Show calculations]

What is the opportunity cost if the new company required 12 000 plates?

Would you recommend the special order if the Company required 12 000 plates?


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Answer (Special Order)


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A.Production capacity (maximum capacity) = 50 000 platesABCCompany is currently operating at 85% capacity Current capacity = 50 000 × 0.85 = 42 500 plates compasses for “normal sales” Spare/Idle capacity = 50 000 – 42 500 = 7500 plates

ABC has enough available capacity to produce an additional 7 500 plates

(b) Contribution Margin (CM) = Selling Price –

Variable Costs Contribution margin for “normal/current” sales =

Selling price $40

Variable costs 15

Contribution margin $25 Contribution margin for special order =

Selling Price $20

Variable costs 15

Contribution margin $ 5Prepared by Tishta Bachoo

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C Available capacity = 7500 plates Special Order capacity = 7000 plates Available capacity > Special Order capacity, therefore there is no

opportunity cost Special Order Contribution Margin (CM) = $20 – $15 = $5 per

plate Special Order CM x Special Order capacity = $5 x 7000 plates =

$35000 If ABC accepts the special order its profits will increase by

$35000 Therefore: Yes, the special order should be accepted as profits

will increase by $35000


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D Available capacity = 7500 plates Special Order capacity = 12000 plates Available capacity < Special Order capacity, therefore an

opportunity cost needs to be calculated To accept the special order, it would be necessary to “give up”

4500 units of “normal sales” (available capacity – special order capacity = 7500 – 12000 = -4500 plates)

Opportunity cost of special order represents lost “normal sales” Number of units that need to be “given up” = 4500 plates “Normal” Contribution Margin = $40 - $15 = $25 per compass Opportunity Cost = 4500 plates x $25 = $112500


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E

Benefit of special order Special Order CM x Special Order capacity = $5 × 12 000 compasses = $60000 Opportunity Cost (see (d) above) (112500)Decrease in profit $52500Therefore, if the special order for 12000 plates is accepted, ABC’s profits will decrease by $52500


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END OF SESSION

Next week …

Management Decision Making: Budgeting Cash Management


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week 2 management decision making

Economy & Finance