Managerial Accounting: Decision Making

Using cost concepts to help management in decision making:

(1) The decision of delete a product or production line

The rule of deleting a product:
- If the revenue of the product covers both variable cost and avoidable fixed cost,
we continue to produce this product.
- If the revenue of a product is less than both variable cost and avoidable fixed
cost, we advise to delete it.

Fixed cost can be divided into avoidable fixed cost and unavoidable fixed cost.
Avoidable fixed cost: fixed cost that related with specific product (such as a rent for a
store to this product) and in case we delete that product we will delete the rent too.
Unavoidable fixed cost: the items of fixed cost which remains fixed regardless
deleting a product or not. Such as the salary of the manager of the factory, it will be
the same whether we delete a product or not.

Example: the following is the income statement for XYZ Company:

Total Product C Product B Product Description
A
?? 75,000 40,000 45,000 Sales Revenue (units * price)
?? 50,000 30,000 30,000 Less: Variable cost
?? ?? ?? ?? Contribution margin
?? - )12,000( )10,000( Less: Avoidable fixed cost
?? )11,000( )6,000( )8,000( Less: Unavoidable fixed cost
?? ?? ?? ?? Net income

Required:
1- Complete the income statement.
2- Do you advice the company to delete any product or not? Justify?
Solution:
The Income Statement

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 Total Product C Product B Product A Description
160,000 75,000 40,000 45,000 Sales Revenue
)110,000( )50,000( )30,000( )30,000( Less: Variable cost
50,000 25,000 10,000 15,000 Contribution margin
)22,000( - )12,000( )10,000( - Avoidable fixed cost
)25,000( )11,000( )6,000( )8,000( - Unavoidable fixed cost

3,000 14,000 )8,000( )3,000( Net income (loss)

We have 2 products (A & B) have net loss; shall we delete both of them or not?
We must delete the product which its revenue is less than both variable cost and
avoidable fixed cost.
So we must delete product B only as follows:
Product A B
Revenue 45,000 40,000
Less: Variable cost (30,000) (30,000)
Less: Avoidable fixed cost (10,000) (12,000)
5,000 (2,000)
Continue Delete
The income statement after deleting product B
Total Product C Product A Description
120,000 75,000 45,000 Sales Revenue
80,000 50,000 30,000 - Variable cost
40,000 25,000 15,000 Contribution margin
10,000 - 10,000 - Avoidable fixed cost
25,000 15,625 9,375 - Unavoidable fixed cost

5,000 9,375 )4,375( Net income (loss)

The total unavoidable fixed cost will be the same = 25,000, but it will be distributed
between product A & product C.
Assume that unavoidable fixed cost is distributed according to sales revenue, so it will
be distributed as follows:
Total unavoidable fixed cost = 25,000
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Revenue of A = 45,000, Revenue of C = 75,000
Total revenue = 45,000 + 75,000 =120,000
Unavoidable cost for A = 25,000*(45,000/120,000) = 9,375
Unavoidable cost for C = 25,000*(75,000/120,000) = 15,625
The total net income of the company increases from 3000 to 5000 after deleting
product B.
Prepare the income statement in case of deleting product A and produce only product C
The income statement
Product C Description
75,000 Sales Revenue
50,000 - Variable cost
25,000 Contribution margin
- - Avoidable fixed cost
25,000 - Unavoidable fixed cost

0 Net income (loss)

We advise not to delete product A because the net income will be decreased from
5000 to zero
Recall: the total unavoidable fixed cost will be the same 25000 in all cases except in
case of closing the factory, in this case no variable or fixed cost.
Example 2: the following is the income statement of Giza Co. for the period ended
December 31, 2011:
Total Product Z Product Y Product X Description
200,000? 100,000 60,000 40,000 Sales Revenue
125,000? 55,000 40,000? 30,000? Less: Variable cost
75,000? 45,000 ? 20,000? 10,000 Contribution margin
20,000? 4,000 5,000 11,000 Less: Avoidable fixed cost
40,000? 20,000? 12,000 8,000 Less: Unavoidable fixed cost
15,000? 21,000 3,000 -9000? Net income (loss)

Required:
1- Complete the income statement
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 2- Do you advise the company to delete any product?
3- If the company can increase the sales of all products by 20%, do you still
advice the company to delete any product? Justify?
The solution:
The Income Statement
Total Product Z Product Y Product Description
X
200,000 100,000 60,000 40,000 Sales Revenue
125,000 55,000 40,000 30,000 Less: Variable cost
75,000 45,000 20,000 10,000 Contribution margin
20,000 4,000 5,000 11,000 Less: Avoidable fixed cost
40,000 20,000 12,000 8,000 Less: Unavoidable fixed cost
15,000 21,000 3,000 (9,000) Net income (loss)

We advise the company to delete product X because its revenue (40000) cannot
cover both variable cost and avoidable fixed cost (30000+11000).
Total Product Z Product Y Description
160,000? 100,000 60,000 Sales Revenue
95,000? 55,000 40,000? Less: Variable cost
65,000? 45,000 ? 20,000? Contribution margin
9,000? 4,000 5,000 Less: Avoidable fixed cost
40,000? 25,000 ? 15,000 Less: Unavoidable fixed cost
16,000 16,000 0 Net income (loss)

The income statement in case of increasing sales by 20%:

Total Product Z Product Y Product X Description
240,000 120,000 72,000 48,000 Sales Revenue (+20%)
150,000 66,000 48,000 36,000 - Variable cost (+20%)
90,000 54,000 24,000 12,000 Contribution margin
20,000 4,000 5,000 11,000 - Avoidable fixed cost
40,000 20,000 12,000 8,000 - Unavoidable fixed cost

30,000 30,000 7,000 )7,000( Net income (loss)

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 We advise to continue producing product A because the revenue (48000) is cover
both variable cost and avoidable fixed cost (36000+11000)
Remark:
In case of increase sales, both revenue and variable cost increase but fixed cost
does not increase.

Exercise:
The following is the income statement of Giza Co. for the period ended December
31, 2011:
Total Product Z Product Y Product Description
X
? 90,000 60,000 50,000 Sales Revenue
? 72,000 ? 30,000 - Variable cost
? ? 15,000 ? Contribution margin
? 20,000 5,000 ? - Avoidable fixed cost
? 5,000 12,000 10,000 - Unavoidable fixed cost

? ? ? 2,000 Net income (loss)

Required:
1. Complete the income statement
2. Do you advise the company to delete any product?
3. If the company can increase the sales of all products by 20%, do you still
advice the company to delete any product? Justify?
The answer:
Total Product Z Product Y Product Description
X
200,000? 90,000 60,000 50,000 Sales Revenue
147,000? 72,000 45,000 ? 30,000 - Variable cost
53,000? 18,000 ? 15,000 20,000 Contribution margin
33,000? 20,000 5,000 8000 - Avoidable fixed cost
27,000 ? 5,000 12,000 10,000 - Unavoidable fixed cost

7000- ? 7000- ? 2000- ? 2,000 Net income (loss)

We advise deleting product Z

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If the company can increase the sales of all products by 20%, do you still advise the
company to delete any product? Justify?

Total Product Z Product Y Product Description

X
240,000 108,000 72,000 60,000 Sales Revenue (increase 20%)
176,400 86,400 54,000 36,000 -Variable cost (increase 20%)
63,600 21,600 18,000 24,000 Contribution margin
33,000 20,000 5,000 8000 - Avoidable fixed cost
27,000 5,000 12,000 10,000 - Unavoidable fixed cost

3,600 3,400- 1000 6,000 Net income (loss)

We advise continuing producing all products.

(2) Accepting special offer with low price

There are 3 terms to accept special offer with low price:
1. There is idle capacity
2. The low price is greater than relevant cost (variable cost)
3. The low price will not affect the normal (regular or ordinary) price.
Example 1:
The normal price per unit $100
Total cost per unit $80 (include 30 fixed cost and 50 variable cost)
A customer from Tunis would like to import 2000 units to sell in Tunis for price 60.
The maximum capacity is 10.000 units
The local demand is 7000 units.
Do you advise the company to accept this special offer? Justify your answer?

There are 3 terms to accept special offer:

1- There is idle capacity = 10,000 - 7000 = 3000 units
2- The low price is greater than relevant cost (variable cost in example)=
Offer price = 60, variable cost =50
There is a profit = 60 -50 = $10 per unit
3- The low price will not affect the normal price (Tunis is another country).
So we accept the offer because it will make a profit = 2000 units × $10 =
$20.000

Example 2: if the customer in the previous example seeks to receive the goods in
Tunis, and the cost of transportation is $15 per unit,
Do you advise the company to accept the offer in this case?
The low price = 60
The solution:
The relevant cost is =$50 variable cost + $15 transportation cost = 65

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 So we reject (refuse) the offer because it will make loss=60 – 65 = $5 per unit
The total loss = 2000 units × $5 = $10,000

Example 3:
ABC Company produces chairs, the price per unit is $100, and the total cost per unit is
$90 ($50 variable and $40 fixed).
The maximum capacity 10000 units
The maximum sales 8000 units (there is idle capacity 2000 units)
There is a special order from AC University to produce 2000 units for only $80.
Do you accept or reject this offer? Justify your answer?

The answer: we accept the offer because:

1- There is idle capacity.
2- The offer's price ($80) is more than the variable cost ($50)
3- No effect on the regular price.
The profit from this offer=2000 units * (80-50) = $60000
Relevant cost= variable cost = $50
Irrelevant cost = f
ixed cost = $40
Exercise:
The normal price per unit $120
Total cost per unit $90 (40% fixed cost)
A customer from Nigeria would like to import 2500 units to sell in Nigeria for
price $80 per unit.
The maximum capacity is 10,000 units
The local demand is 7000 units.
Do you advise the company to accept this special offer? Justify your answer?
If the customer seeks to receive the goods in Nigeria, and the cost of shipping is
$15 per unit,
Do you advise the company to accept the offer in this case?
The answer:
Fixed cost = 90*40%=36, So variable cost 90-36 = 54
There is idle capacity
Other country
Price = 80 is more than 56, so we accept the offer
The profit = 2500 units * (80 -54) = 2500 * 26 =
2-the relevant cost = 54+15=69 is less than the price
We accept, the prfit = 2500 * (80 – 69) = 2500*11=

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 (3) Make or Buy Decision

Sometimes a manufacturing company purchases a part or component of the

product form suppliers, and the company may think that it is better to produce that
component inside the company instead of purchasing it. The decision – in this case
– depends on the cost of each alternative, the lowest cost is the best.
Example:
A company produces mobile and purchasing the battery for $ 10 per unit.
The management thinks to produce the battery instead of purchasing it.
The cost of producing is as follows:
Variable cost $6
Fixed cost $5 divided into: $3 old fixed cost and $2 new fixed cost to rent new
equipment to produce the battery.
Do you advise the company to produce the battery or not?
The solution:
The relevant cost for producing=
Variable cost + new fixed cost= 6+2=$8
Irrelevant cost= old fixed cost = $3 so we ignore it
The decision:
The comparison between purchase and produce:
Make Buy
Cost $8 $10
So we advise the company to produce the battery.
Exercise: A company produces Cars and purchasing the wheels for $ 100 per unit.
The management thinks to produce the wheels instead of purchasing it.
The cost of producing is as follows:
Variable cost $45
Fixed cost:
New fixed cost to rent new equipment to produce the wheels $200,000
General fixed cost (old fixed cost) $100,000.
The quantity of wheels 5000 units
Do you advise the company to produce the wheels or not? Justify?
The answer:
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 New Fixed cost per unit = 200,000/5000= 40
The relevant cost to produce = 45 variable + 40 new fixed = 85
The comparison between purchase and produce:
Make Buy
Cost $85 $100
So we advise the company to produce the wheels.

(4) Using Marginal Analysis Resources Allocation

(Determining the production plan)
Any company has limited resources and would like to allocate these resources
between several products that the company can produce, we use marginal analysis
to choose the products that maximize the profit of the company.
Example
The 4 sisters Co. can produce 2 products A & B; the following data is estimated to
help in preparing the production plan for the coming period to maximize the profit:
A B
Price $ 30 $50
Variable cost 20 30
Demand (maximum sales) 2000 units 5000 units
Machine hours per unit 2 hours 5 hours
The fixed cost for the Co. is $10000 regardless the production plan.
The total machine hours are 10000 hours (maximum capacity).
Required: prepare the production plan.
The solution:
Computing the Contribution margin per hour
A B
Price $ 30 $50
Less: Variable cost 20 30
Contribution margin per unit 10 20
÷ Machine hours per unit ÷ 2 hours ÷ 5 hours
Contribution margin per hour 5 4
We start to produce A (higher Contribution margin per hour) then B
We produce from A the maximum demand= 2000 units
The hours needed to produce 2000 units from A = 2000 * 2 hours per unit =4000
hours
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 The remaining hours = maximum capacity – hours for A
= 10000 – 4000 = 6000 hours
We use the remaining hours to produce B
Quantity of B = 6000 hours / 5 hours to produce 1 unit of B= 1200 units
The production plan
A 2000 units
B 1200 units
Example 2:
Nile Co. can produce 2 products A & B; the following data is estimated to help in
preparing the production plan for the coming period to maximize the profit:
A B
Price $ 30 $50
Variable cost 20 20
Demand (maximum sales) 2000 units 4000 units
Machine hours per unit 2 hours 5 hours
The fixed cost for the period is $10,000 regardless the production plan.
The total machine hours are 30,000 hours (maximum capacity).
Required: prepare the production plan.
The solution:
A B
Price $ 30 $50
Less: Variable cost 20 20
Contribution margin per unit 10 30
÷ Machine hours per unit ÷ 2 hours ÷ 5 hours
Contribution margin per hour 5 6

We produce B first (higher contribution margin per hour)

We produce 4000 units of B
Hours for B = 4000 units * 5 hours per unit= 20000 hours
Remaining hours for A = total hours – 20000= 30000 – 20000=10000
But we can sell only 2000 units of A
Hours for A = 2000 units * 2 hours per unit = 4000 hours
The total hours needed for A & B = 20000 + 4000 = 24000 hours
There are idle hours = total hours 30000 – 24000 = 6000 hours

Example 3:

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 Giza Co. can produce 3 products A, B & C; the following data is estimated to help
in preparing the production plan for the coming period to maximize the profit:
A B C
Price $ 40 $50 $30
Variable cost 20 35 18
Demand (maximum sales) 1000 units 4000 units 4000 units
Machine hours per unit 4 hours 5 hours 2 hours
The fixed cost for the Co. is $10,000 regardless the production plan.
The total machine hours are 15,000 hours (maximum capacity).
Required: prepare the production plan.
The solution:
A B C
Price $ 40 $50 $30
Less: Variable cost 20 35 18
Contribution margin per unit 20 15 12
÷ Machine hours per unit 4 hours 5 hours 2 hours
Contribution margin per hour 5 3 6
We start to produce C then A and finally (if there are available hours, we can produce B
C = 4000 units * 2 hours = 8000 hours
A = 1000 units * 4 hours = 4000 hours
The remainder hours= total 15,000 hours – (8000 + 4000) = 3000 hours
So, we use 3000 hours to produce B:
Quantity of B = 3,000 / 5 hours per unit = 600 units
So, the productions plan:
Product A B C
Quantity 1000 Units 600 Units 4000 Units
Exercise:
Alexandria Co. can produce 3 products A, B & C; the following data is estimated to
help in preparing the production plan for the coming period to maximize the profit:
A B C
Price $ 30 $50 $30
Variable cost $ 18 35 24
Demand (maximum sales) 1000 units 4000 units 4000 units
Machine hours per unit 3 hours 3 hours 3 hours
The fixed cost for the Co. is $10000 regardless the production plan.
The total machine hours are 15,000 hours (maximum capacity).
Required: prepare the production plan.
The answer:
A B C
Price $ 30 $50 $30
Less: Variable cost $ 18 35 24
Contribution margin per unit 12 15 6
÷ Machine hours per unit 3 hours 3 hours 3 hours
Contribution margin per hour 4 5 2
Produce B = 4000 units * 3 hours = 12,000 hours
The remainder hours = 15,000 – 12,000 = 3000 hours
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Produce A = 1000 units * 3 hours = 3000 units
Remainder hours for C = 3000 – 3000 = 0
The production plan:
Product A B C
Quantity 1000 4000 0

Pricing decision

The rule of determining the price:

The minimum price of a product is the full cost (to recover all costs) while the
maximum price is the market price.
For example, if the full cost is $30 and market price is $50
If we sell the product for less than $30, we will make loss, if we sell for more than
$50 the customers will buy from competitors.
The common method of pricing is called cost-plus method.
The price = cost + profit
Example 1:
The cost of a product = $40
The profit margin is 20% of cost
The price = 40 + (40 * 20%) = 40 + 8 = $48
Example 2:
The cost of a product = $40
The profit margin is 20% of price
The price = cost + profit= 40 + (20%*price)
Assume price is X, so
X = 40 + (20% * X)
X - (20% * X) = 40
100% X – 20% X = 80% X = 40
X = 40 / 80% = 50
Example 3:
The cost of a product = $150
The profit margin is 25% of price
The price is X
X = 150 + 25%*X
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X – 25%X = 150
100%X – 25%X = 150
75% X = 150
X = 150/75% = 200

Example 3:
Variable cost per unit = $60
Total fixed cost = $40000
Total units = 1000 units
Compute the price per unit in the following cases:
1-Profit margin is 30% of cost.
Fixed cost per unit = 40,000/1000 units =40
Total cost per unit = 60 + 40 = 100
Price = 100 + 30% * 100 = 100 + 30 = 130
2- Profit margin is 30% of price.
The price is X
X = 100 + 30%X
X – 30%X = 100
70%X = 100
X = 100 / 70% = 143
3- The price is variable cost plus 70% of variable cost
Price = 60 + 60*70%= 60 + 42 = 102
4- The price is total cost plus 70 % of variable cost.
Price = 100 + 60*70% = 100 + 42 = 142
The solution:
1- Price = cost + 30% of cost
Cost = variable + fixed
= $60 + (40000/1000) = 60 + 40 = 100
Price = cost + 30% of cost = 100 + (100*30%)=
= 100 + 30 = 130 per unit
2- Price = cost + 30% of price=
Price = 100 + (30% * price)
Price – 30%*price = 100
70% price = 100
Price = 100/ 70% = $143
3- Profit margin is 70 % of variable cost.
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 Price = variable cost + 70% of variable cost
Price = 60 + (70% * 60) = 60 + 42= $102
4- The price = 100 + 70 % * 60 = $142

In some cases, the price may be less than total cost, such as special offer with low
price.

Example 4: determining the price that achieves the targeted return on assets:
The total assets $2000,000
The total cost of the production $1000,000
Total quantity 50.000 units
The target profit 20% of the total assets.
Determine the price?

The target profit = 2000.000 * 20% = 400.000

The price = (total cost + target profit)/quantity
= (1000.000 + 400.000)/50,000
= 1,400,000 / 50,000 = $28 per unit
Exercise:
Total cost per unit $80
Compute the price in case of:
1- The price equal cost plus 20% of cost = 80 +(80*20%) = 96
2- The price equal cost plus 20% of price = 80 + (20%price) =
Price = 80 + 20%price
Price – 20% price = 80
80% price = 80
Price = 80 / 80% = 100
3- The price that achieves return on assets 15% (total assets 3000.000 and the
quantity of sales 100,000 units)
Profit = 15% * total assets = 15% * 3,000,000 = 450,000
Profit per unit = 450,000 / 100,000 = 4.5
Price = cost + profit = 80 + 4.5 = 84.5

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