SHORT RUN PRODUCTION DECISIONS

Report
Decision Making
ACC 2203 REVIEW WORKSHOP
SINDHU BALA
SHORT RUN PRODUCTION DECISIONS
 Managers have to make short-term production decisions on a continual
basis. Some of those production decisions are:
 Adding or dropping a product line. E.g. should GM add a new line of
SUV-Truck hybrids; should it drop its line of Pontiac-Aztek SUVs?
 Making or buying a component part. E.g. should Daimler-Chrysler
make the seats for its cars or should it outsource the seats to a supplier?
 Accepting or rejecting a special order. E.g. should Ford accept/reject a
special order from Hertz for a number of stripped down Ford Escorts?
 Deciding which product to make when facing an input/capacity
constraint. E.g. when there is a shortage of skilled labor, which type of
cars should GM primarily manufacture?
Identifying Relevant Costs
A relevant cost is a cost that differs between
alternatives.
An avoidable cost can be eliminated (in whole
or in part) by choosing one alternative over
another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.
Two broad categories of costs are never relevant in
any decision and include:
Sunk costs.
Future costs that do not differ between the
alternatives.
Relevant Cost Analysis: A Two-Step Process
Step 1 Eliminate costs and benefits that do not differ
between alternatives.
Step 2 Use the remaining costs and benefits that do
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
Adding/Dropping Segments
One of the most important decisions managers
make is whether to add or drop a business
segment, such as a product or a store.
Let’s see how relevant costs should be
used in this type of decision.
Due to the declining popularity of digital watches,
Lovell Company’s digital watch line has not
reported a profit for several years. Lovell is
considering dropping this product line.
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch segment only if its
profit would increase. This would only happen if the
fixed cost savings exceed the lost contribution
margin.
Let’s look at this solution.
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales
Less: variable expenses
Variable manufacturing costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net operating loss
$
500,000
$
200,000
300,000
$
380,000
(80,000)
$ 120,000
5,000
75,000
$
60,000
90,000
50,000
80,000
70,000
30,000
Adding/Dropping Segments
Investigation has revealed that total fixed general factory overhead
and general administrative expenses would not be affected if the
digital watch line is dropped. The fixed general factory overhead and
general administrative expenses assigned to this product would be
reallocated to other product lines.
The equipment used to manufacture digital watches has no resale value or
alternative use.
Should Lovell retain or drop the digital watch segment?
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
Advertising - direct
Rent - factory space
Net (dis)advantage
?
?
?
?
$
-
Comparative Income Approach
The Lovell solution can also be obtained by preparing
comparative income statements showing results with
and without the digital watch segment.
Let’s look at this second approach.
Comparative Income Approach
Solution
Keep
Drop
Digital
Digital
Watches
Watches
Sales
$ 500,000
$
Less variable expenses:
Manufacturing expenses
120,000
Shipping
5,000
Commissions
75,000
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
General factory overhead
60,000
Salary of line manager
90,000
Depreciation
50,000
Advertising - direct
80,000
Rent - factory space
70,000
General admin. expenses
30,000
Total fixed expenses
380,000
Net operating loss
$ (80,000)
Comparative Income Approach
Difference
-
The Make or Buy Decision
A decision to carry out one of the activities in
the value chain internally, rather than to
buy externally from a supplier is called a
“make or buy” decision.
The Make or Buy Decision: An
Example
 Essex Company manufactures part 4A that is used
in one of its products.
 The unit product cost of this part is:
Direct materials
Direct labor
Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Unit product cost
$
9
5
1
3
2
10
$ 30
The Make or Buy Decision
 The special equipment used to manufacture part 4A has
no resale value.
 The total amount of general factory overhead, which is
allocated on the basis of direct labor hours, would be
unaffected by this decision.
 The $30 unit product cost is based on 20,000 parts
produced each year.
 An outside supplier has offered to provide the 20,000
parts at a cost of $25 per part.
Should we accept the supplier’s offer?
The Make or Buy Decision
Cost
Per
Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost
$
9
5
1
3
2
10
$ 30
Cost of 20,000 Units
Buy
Make
$
-
$
Should we make or buy part 4A?
-
Opportunity Cost
An opportunity cost is the benefit that is foregone as a result of
pursuing some course of action.
Opportunity costs are not actual dollar outlays and are not recorded
in the formal accounts of an organization.
How would this concept potentially relate to the Essex Company?
Decision To Make/Buy An Input
Problem – Berta Inc. is a manufacturer of quality mattresses with an annual production and
sales of 10,000 units. Berta currently makes it own spring assemblies but has received an
offer from a supplier to furnish the springs for $48. Berta’s costs of production are as
follows:
Direct materials
Direct labor
Variable overhead
Fixed overhead
TOTAL
Cost per
spring set
$16.00
$3.50
$4.50
$28.00
$52.00
Total costs
$160,000
$35,000
$45,000
$280,000
$520,000
30% of the fixed overhead is traceable to the spring assemblies and the rest is general
overhead that is allocated to each unit.
1. Suppose the company has no alternative use for and cannot rent out the production space
used for making the springs. Should it outsource the springs?
2. Suppose the company can use the production space for springs as a warehouse, replacing
the warehouse it currently rents for $180,000. Should it outsource the springs?
Decision To Make/Buy An Input
Make part Buy part
Revenues: we don’t know anything about the revenues,
though we can assume they are the same in both
cases. We will focus on the costs.
Costs
Costs of purchase
DM
DL
VOH
FOH
Total costs
Key Terms and Concepts
A special order is a one-time order that is not
considered part of the company’s normal ongoing
business.
When analyzing a special order, only the
incremental costs and benefits are relevant.
Accept or Reject Special Order
Note: In the decision making problems that follow we will ignore: (1) all factors not
explicitly given in the problem, (2) the time value of money
Decision To Accept/Reject A Special Order
Problem – Vince Pasta Inc. makes a fancy variety of fresh pasta which it sells for $3/lb.
Vince currently uses 50% of its capacity, producing 150,000 pounds of pasta annually. Vince
recently received an offer from a chain restaurant to supply 100,000 pounds of pasta at $2.20
per pound. Vince budgeted production costs at 150,000 and 250,000 pounds are as follows:
Production quantity
Direct materials ($0.8/lb.)
Direct labor (0.6/lb.)
Factory overhead*
TOTAL COSTS
150,000 lb.
250,000 lb.
$120,000
$90,000
$210,000
$420,000
$200,000
$150,000
$250,000
$600,000
Cost per pound
$2.8/lb.
$2.4/lb.
*
Variable factory OH is $0.4/lb. and fixed factory overhead is $150,000
The company does not expect to receive any additional orders in the near future. The sales
manager wants Vince to accept the order but the production manager does not. The
production manager argues that the order would cause a loss of $0.20 per pound. Should
Vince accept the special order?
Accept or Reject Special Order
 Incremental Approach:
Status quo: making 150,000 lb. egg noodles
New project/activity: special order to make
100,000 lb. of additional noodles.
 Incremental benefits:
 Incremental costs:
Additional DM
Additional DL
Additional VOH
Total:
Accept or Reject Special Order
If Vince had a maximum capacity of 200,000 lb., should it accept the special
order? Assume this is an all or nothing order; Vince either provides all of the
100,000 pounds or none.
Note that now we have opportunity costs. The opportunity costs are the
benefits forgone from not selling 50,000 lb. to regular customers.
 Incremental Approach:
Status quo: making 150,000 lb. egg noodles
New project/activity: special order to make 100,000 lb. of additional
noodles.
 Incremental benefits:
increase in revenue:
 Incremental costs:
Additional DM
Additional DL
Additional VOH
Opportunity costs of 50,000 lb.
Total:
Utilization of a Constrained Resource
Key Terms and Concepts
• When a limited resource of some type restricts the
company’s ability to satisfy demand, the company is said to
have a constraint.
• The machine or process that is limiting overall output is
called the bottleneck – it is the constraint.
 When a constraint exists, a company should select a product


mix that maximizes the total contribution margin earned
since fixed costs usually remain unchanged.
A company should not necessarily promote those products
that have the highest unit contribution margin.
Rather, it should promote those products that earn the
highest contribution margin in relation to the constraining
resource.
Utilization of a Constrained Resource
An Example
Ensign Company produces two products
and selected data are shown below:
Product
2
1
Selling price per unit
Less variable expenses per unit
Contribution margin per unit
Current demand per week (units)
Contribution margin ratio
Processing time required
on machine A1 per unit
$
60
36
$ 24
2,000
40%
1.00 min.
$
50
35
$ 15
2,200
30%
0.50 min.
Utilization of a Constrained Resource
An Example
 Machine A1 is the constrained resource and is being
used at 100% of its capacity.
 There is excess capacity on all other machines.
 Machine A1 has a capacity of 2,400 minutes per
week.
Should Ensign focus its efforts on
Product 1 or 2?
Utilization of a Constrained Resource
An Example
The key is the contribution margin per unit of the
constrained resource.
Utilization of a Constrained Resource
An Example
The key is the contribution margin per unit of the
constrained resource.
Product
2
1
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute
$
÷
24
$
min. ÷
15
min.
Utilization of a Constrained Resource
An Example
Alloting Our Constrained Resource (Machine A1)
Weekly demand for Product 2
Time required per unit
Total time required to make
Product 2
Total time available
Time used to make Product 2
Time available for Product 1
×
2,200 units
0.50 min.
min.
-
min.
min.
min.
Joint Products – Sell or Process further
The decision is whether to sell the joint products at the splitoff point or to process them further and then sell
Joint costs – costs of simultaneously producing two or more
products, called joint products, that must, by the nature of
the process, be produced together.
Examples of joint products: Oil and gas, hamburger and steaks
Split-off point – the point in the production process at
which the joint products become distinct or separate items
Note: In joint products problems where a company has to
decide whether to process joint products further beyond the
split-off point, the costs incurred up to the split-off point are
sunk and hence are irrelevant. Any attempt to allocate such
costs to joint products and to consequently factor them into
the decision process would lead to imprudent production
decisions.
Joint Products – Sell or Process further
Example:
Buy a new car
for $20,000
Incur $2,000 in costs
and sell for $11,000
Current market
value is $8,000
Get it painted and
install new stereo
You can sell as is
This is the
split-off point
Get $8,000
Joint Products – Sell or Process further
Example:
Buy a new car
for $20,000
Incur $2,000 in costs
and sell for $11,000
Get it painted and
To answer
Current
the market
question of sellinstall
as isnew
or stereo
process
value
further,
is $8,000
you need to examine the
incremental costs and incremental benefits
You can sell as is
This is the
split-off point
Get $8,000
Joint Products – Sell or Process further
Problem – Bass Chemicals Inc. produces three chemicals: Acetox, Denox, and Pectix through
one joint process costing $80,000. These chemicals can all be sold at the split-off point or
processed further and sold at a higher price.
Sales value at
Additional costs of
Sales value
split-off point
processing further
if processed further
Acetox
$50,000
$23,000
$65,000
Denox
$25,000
$44,000
$82,000
Pectix
$85,000
$93,000
$184,000
Which of the products should be processed further and which ones should be sold at the split
of point?
If the joint processing costs were $120,000, would you change your answer?

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