ACCT20001 Cost Management

Department of Accounting

Tutorial Week 8 Preparation Requirements

REQUIREMENT 1 (past exam question)

Falzoni Fabrication, Inc. (FFI) manufactures 10,000 units of Part M-1 each year for use in its
production of another product, but production of the other product will be discontinued at the
end of the next year. The following total costs were reported last year:

Direct materials ......................................... . $ 20,000

Direct labor ............................................... . 55,000
Variable manufacturing overhead .............. 45,000
Fixed manufacturing overhead .................. 70,000
Total manufacturing cost .......................... . $190,000

Harfoot Pty. Ltd. has offered to sell Falzoni 10,000 units of Part M-1 for $18 per unit. If FFI
accepts the offer, some of the facilities presently used to manufacture Part M-1could be
rented to a third party at an annual rental of $15,000. Additionally, $40,000 of the fixed
overhead applied to Part M-1would be totally eliminated. Direct labour consists of workers
who are paid by the hour.

a) Should FFI accept Harfoot's offer? Support and explain your answer.

b) FFI has recently discontinued production of the QQ-27. Shutdown of the QQ-27 assembly
line has made available 500 square metres of floor space and 175 hours per month of
machine time. The firm is considering allocating the unused capacity to one of two new
products. TC- 513 will require 450 square metres of floor space and demand is expected to
be 875 units per month. GL-745 will require 475 square metres of space and demand is
expected to be 850 units per month. Whichever product is chosen, FFI plans to allocate the
remaining floor space to storage of unused equipment. Any remaining machine time will
go unused.

Which product would you recommend that FFI chose? Explain

Per unit information for the two products is given below.

Machine minutes per unit.. ....

Selling price per unit.. ...........

Variable cost per unit.. ..........
TC-513 GL-745
$494.40 $449.43
$395.20 $345.00

9 12
a)
Alternative 1: Relevant (incremental) cost if make:
 Direct materials : 20,000
 Direct labour: 55,000
 Variable Overhead: 45,000
 Fixed O/H: 40,000
 TOTAL: 160,000

Alternative 2 Relevant incremental cost if bought:

 Purchase cost: 180,000
 Rental income: 15,000
 TOTAL: 165,000

Cost of making is lower than buying >> therefore, MAKE.

Note 1: Sometimes fixed costs can be a relevant (e.g., in this

example, a portion of the fixed cost is relevant)

Note 2: The $30,000 fixed cost component is an irrelevant cost as it

would be incurred under both alternatives and therefore can be
ignored in the analysis. However if you included this $30,000 as a
cost to both alternatives, then you still get a difference of $5,000 in
favour of “Make” – i.e., it doesn’t change the decision. However,
the reason why you should not include this $30,000 is because by
doing so you would add ‘clutter’ to your analysis and may distract
management (if you are preparing the analysis for management)
from being able to quickly understand where the real differences in
costs are between the 2 alternatives.

Note 3: Items can often be incorporated in either side of the

analysis. For example, it is fine if the $40,000 of Fixed O/H is
incorporated as a negative number in Alternative 2 instead of a
positive number in Alternative 1. The difference between the two
options would still be $5,000 in favour of Alternative 1.
b)

As mentioned in the question, FFI will choose 1 (out of 2) new product to manufacture as
there is not enough floor space to manufacture both.

Also, there is sufficient machine time to manufacture the units demanded of TC513 OR
GL745.

 9 x 875 < 175 x 60 mins


 12 x 850 < 175 x 60 mins

TC513’s Total CM = (494.40 – 395.20) x 875 units = 86,800

GL745’s Total CM = (449.43 – 345.00) x 850 units = 88,765

Therefore choose GL745.

It is not necessary to calculate a CM/machine hour since there is not enough floor space to
manufacture both products. Therefore ONLY 1 product can be manufactured.

Note that in the lecture 9 notes, it is stated that when there are no constraints, we should
prioritise the product with the highest CM/unit. This is true when we don’t have
information on units to be sold (which is different to the situation in part c here). In this
scenario (i.e., where we do not have information on units to be sold), then prioritising the
product with the highest CM/unit should also maximize Total CM (all else equal).

However when you have information on the number of units that we expect to sell, then
prioritise the product that will maximize your Total CM as this would also maximize your
Total Profit when fixed costs are unchanged (i.e., Product GL745).
REQUIREMENT 2 – arguably the hardest question in this course – TO BE
SUBMITTED VIA LMS

Sarah’s Confectionery Company is a small manufacturer and wholesaler of lollipops,

jellybabies and other sugary snacks. Sarah’s Confectionery produces around 70% of
the confectionary they sell, with the remaining 30% purchased from local
manufacturers. All confectionary is produced in batches of 100 units. The current
workforce has the capacity to work 1,600 direct labour hours per month.

The selling price and associated costs for lollipops and jellybabies are as follows:

Lollipops Jellybabies
Selling price per batch $54.00 $28.50
Costs per batch:
Sugar $ 4.00 $ 1.80
Setting Agents $ 0.60 $ 0.40
Flavour $ 0.40 $ 0.30
Plastic Stick $ 0.25 None
Direct Labour ($15/hour) $18.75 $ 7.50
Fixed manufacturing OH $3.125 $ 1.25
Variable manufacturing $9.375 $ 3.75
OH
Selling and Admin Cost $13.50 $ 8.50
Total Costs per batch $50.00 $23.50
Profit per batch $ 4.00 $ 5.00

Sarah’s Confectionary uses direct labour hours as the application base for
manufacturing overhead. Direct labour is a variable cost. Included in the selling and
administration costs figure is $4.00 of fixed overhead cost per batch for distribution
(regardless of whether the confectionery items are made by Sarah’s Confectionery
Company or purchased in). The remaining selling and administration costs are variable
costs.

Sarah has demand for a total 1,000 batches of lollipops and 1,200 batches of
jellybabies (made up of many separate orders from different customers) per month.

1. Prepare an analysis that shows the most profitable mix in which to manufacture
lollipops and jellybabies. How many orders of each confectionery item will be
fulfilled?

Phil’s Candy Pty. Ltd., a wholesale supplier, is able to supply Sarah’s Confectionery
with lollipops or jellybabies in whatever quantities that Sarah might require in the
upcoming month.

2. What is the highest price that Sarah should be willing to pay Phil’s for lollipops
for the upcoming month, assuming that purchases from Phil’s will incur selling
and administrative costs of $4 per batch?
 3. What is the highest price that Sarah should be willing to pay Phil’s for
jellybabies for the upcoming month, assuming that purchases from Phil’s will
incur selling and administrative costs of $4 per batch?

4. Name at least three qualitative factors that Sarah should consider when
deciding whether to purchase lollipops and jellybabies from Phil’s.

5. Sarah is considering hiring additional staff to expand the capacity of its

manufacturing department. What information from the analysis performed in
Part 1 could possibly be used to help her make this decision. What are the
underlying assumptions that Sarah needs to make in order to use this
information for decision making.

(Note the additional problems provided on the following page.)

 1. Prepare an analysis that shows the most profitable mix to manufacture of
lollipops (L) and jellybabies (J). How many orders of each confectionery
item will go unfulfilled?

Identify if there is a constraint: Total mixing labour hours required per month:
(1000 L x 1.25 hrs) + (1,200 J x 0.5 hrs) = 1850 hrs.
Each batch of L takes 1.25 hrs direct labour hours (mixing) since $18.75 / 15 =
1.25.
Each batch of J takes 0.5 hrs of direct labour hours (mixing) since $7.50 / 15 =
0.5
Total capacity of mixing labour in a month =1,600 hrs.
Therefore mixing Labour is a constraint.

Calculate unit contribution margins:

Lollipops Jellybabies
Selling price per batch $54.00 $28.50
Costs per batch:
Direct Materials ( 5.25) ( 2.50)
Direct Labour ($15/hour) (18.75) ( 7.50)
Variable manufacturing OH ( 9.375) ( 3.75)
†
Selling and Admin Cost ( 9.50) ( 4.50)
Contribution Margin $11.125 $10.25

DLH (Mixing) per batch: 1.25 0.5

Contribution per hour $8.90 $20.50

†
In calculating the contribution margin, $4.00 of fixed overhead cost per unit for distribution
must be deducted from the selling and administrative cost.

In order to maximize the company’s profitability, Sarah’s Confectionery should

manufacture as many batches of jellybabies as possible, as they maximize the
contribution per direct-labour hour available. We use our scarce direct labour hours
for the most profitable product per unit of scare resource (direct labour hours) first,
then use any remaining direct labour hours for less profitable products per direct
labour hour. This means we make as many jellybabies as possible, then any remaining
direct labour hours should be used to make lollipops. The calculations of this are as
follows:
 Quantity DLH Balance Unit Total
(# of per Total of Contri- Contri-
Item Batches) Unit DLH DLH bution bution
Total hours ................ 1,600
Jellybabies ................. 1,200 0.5 600 1,000 $10.25 $12,300.00
Lollipops.................... 800 1.25 1,000 — 11.125 8,900.00
Total contribution ...... $21,200.00

Therefore, 200 (=1,000 – 800) batches of lollipop orders remain unfulfilled for the
month.

2. What are the highest prices that Sarah should be willing to pay Phil’s for
lollipops assuming that purchases from Phil’s will incur selling and
3. administrative costs of $4 per batch?

The answer for lollipops is simple. Sarah cannot meet the demand. Sarah should be
willing to pay any price less than or equal to $50.00/batch (the $54/batch selling price
less the $4/batch selling and admin cost). At $50/batch Sarah makes zero contribution
margin (i.e. zero incremental operation profit), but fulfils all of her customer demand.

4. What are the highest prices that Sarah should be willing to pay Phil’s for
jellybabies, assuming that purchases from Phil’s will incur selling and
administrative costs of $4 per batch?

The answer for jellybabies is a bit more complicated. Sarah earns $10.25/batch of
contribution margin on each batch of jellybellies, but that does not take into account
the opportunity cost of $4.45 (= 8.90 / 2 since each batch of jellybabies only takes 30
mins to produce) from the use of the scarce resource, mixing department direct labour
hours. Recall, that opportunity cost is the value of the next-best use of any resource. In
this case, the next-best use of direct labours in the mixing department is producing
lollipops for a contribution margin of $8.90/DLH.
Therefore, Sarah should be willing to purchase jellybabies up to a price that would
result in a unit contribution margin greater than or equal to $5.80/batch (10.25 – 4.45).
That is any price of less than or equal to $18.70/batch = (28.50 – 4.00 – 5.80). Note
that this is somewhat greater than Sarah’s variable cost of $18.25/batch to make
jellybabies.

Alternative approach that gives you the same answer $18.70 but more explicitly
considers relevant costs / revenue items:

A.      If Sarah buys Jellybabies, the relevant (i.e., that are different from making it
herself and are in the future) costs and revenues per unit are :
  -          Purchase price from Phil (cost): $X (need to find this)

-          Admin cost (cost) $4

-          Revenue from making 0.5/1.25 lollipops (revenue) x 54 = $21.60

-          Variable cost from making 0.5 / 1.25 lollipops (cost) x 42.875 = $17.15

 B. If Sarah made Jellybabies, relevant (i.e., that are different from buying from Phil
and are in the future) costs and revenues per unit are

  -          Variable costs (cost) 18.25

Since we want a situation where Sarah is indifferent between both options, therefore
equate cost of A to cost of B and solve for X, i.e.,

X + 4 – 21.6 + 17.15 = 18.25

X = $18.70

(Note – subtract $21.60 since this is additional revenue earned from making 0.4
lollipops).

The number of jellybabies batches that Sarah would be willing to purchase at this price
= 500 = (200 unfulfilled lollipop demand x 1.25 DLH for each batch of lollipop) / 0.5
DLH per batch of jellybabies. I.e., getting Phil to make 500 batches of jellybabies will
give Sarah the exact time needed to fulfil the demand for the remaining 200 batches of
lollipops.

Proof that Sarah would be indifferent at a CM of $5.80 for J:

Quantity DLH Balance Unit Total
(# of per Total of Contri- Contri-
Item Batches) Unit DLH DLH bution bution
Total hours ................ 1,600
Jellybabies (buy)….. 500 0 0 1,600 $ 5.80 $ 2,900.00
Jellybabies (make)..... 700 0.5 350 1,250 10.25 7,175.00
Lollipops.................... 1000 1.25 1,250 — 11.125 11,125.00
Total contribution ...... $21,200.00
 2. Name at least three qualitative factors that Sarah should consider when
deciding whether to purchase lollipops and jellybabies from Phil’s.

The usual suspects (quality control, reliability of the supplier, possible negative
customer reaction if they found out that items were made externally) are all valid
responses. Also note the following:
 If Phil’s price provides a net CM of zero, is there a benefit to fulfilling
demand when there is no incremental profit? If Sarah regularly stocks-out of
lollipops, customers who prefer lollipops may begin to shop elsewhere.
Perhaps it is better to try to meet the whole market demand even if some sales
only just breakeven.

3. Sarah is considering hiring additional staff to expand the capacity of the

mixing department. What information from the analysis performed in
Part 1 could possibly be used to help her make this decision. What are the
underlying assumptions that Sarah needs to make in order to use this
information for decision making.

Using the analysis from Part 1, the breakeven labour wage rate that Sarah
would be indifferent between hiring an additional hour of labour and not
adding an additional hour of labour is $23.90. This figure is made up of the
contribution margin of Sarah’s unmet demand from Lollipops ($8.90/dlh) + the
$15.00 current direct labour rate.
She would need to hire an additional (200 x 1.25) = 250 hours of mixing labour
each month to fulfil the unmet demand for lollipops. Assuming that each
worker works 160 hours a month, it would be equivalent to hiring an additional
1.6 workers each month.

Assumptions
 There are no other significant incremental costs to hire additional labour
apart from the hourly wage rate (e.g., no significant incremental hiring
costs and training cost)
 Labour can be hired on an hourly basis – i.e., it is truly a variable cost. In
practice, she may need to / may prefer to hire labour on a longer-term
contractual basis and therefore may have to pay them irrespective of
whether there is work or not – e.g., Lloyd’s Bikes lecture illustration. In
this case, labour becomes a fixed cost over the life of the contract. She
would need to predict the total incremental revenues and costs over the life
of the labour contract (e.g., what is the expected total unmet demand for
Lollipops over the life of the contract and the total cost of hiring additional
labour on a long term basis over the life of the contract) in order to
calculate a more accurate break-even labour hourly wage rate (and use this
to decide whether she would hire additional contract labour or otherwise).
Additional Problems (not required) – answers to these will be provided

Though not required, some students may benefit from working through the following
exercises from the text.

1. Bhimani: 12.11 Relevant-cost approach to short-run pricing decisions.

12.11 Relevant-cost approach to short-run pricing decisions.

1 Analysis of special order:
Sales, 3,000 units × €80 €240,000
Variable costs:
Direct materials, 3,000 units × €35 €105,000
Direct manufacturing labour, 3,000 units × €10 30,000
Variable manufacturing overhead, 3,000 units × €5 15,000
Other variable costs, 3,000 units × €5 15,000
Sales commission 6,000
Total variable costs 171,000
Contribution margin €69,000
Note that the variable costs, except for commissions, are affected by
production volume, not sales euros.
 If the special order is accepted, operating income would be €1,000,000 +
€69,000 = €1,069,000.

2 Whether García-Salve is making a correct decision to quote full price depends on

many factors. He is incorrect if his objective is to increase operating profit in the
short term but his decision causes Xucla to look elsewhere for a supplier, resulting
in continued idle capacity. If the offer to supply at full price is rejected, Alexon, in
effect, is willing to invest €69,000 in immediate gains forgone (an opportunity
cost) to preserve the long-run selling-price structure. The decision to take up the
special order at a lower price of $80 may cause future price concessions to
customers (if other customers find out about and also demand the $80 price)
which will hurt Alexon’s operating income by more than €69,000. A special
(lower) price whenever there is excess capacity may also cause some of its
customers to wait for excess capacity (and price reduction) before placing an
order. García-Salve is correct to stick to a full price quote if he thinks that the
combined negative effect of these 2 scenarios (if the lower price of $80 was
accepted) exceed the $69,000 in short term profits that Alexon would gain.
There is also the possibility that Xuclà Mecàniques Fluvià could become a long-
term customer if their experience on the special order is a positive one. If this
happens, and Alexon is able to charge XMF the normal price for future order, then
this adds to the benefit of taking up this special order at a price of $80.

2. Mountain Goat Cycles – a solution for this problem will be provided

The following question is taken from the 2005 Semester 2 exam paper.

Mountain Goat Cycles (MGC) currently produces a gear shifter used in the manufacture
of its most popular line of mountain bikes. The company’s Accounting Department
reports the following costs of producing 8,000 units of the shifter internally each year:

Per Unit Total for 8,000 Units

Direct Materials $6 $48,000
Direct Labour 4 32,000
Variable Overhead 1 8,000
Supervisor’s Salary 5 40,000
Allocated General Overhead 5 40,000
Total Cost $21 $168,000

An outside supplier has offered to sell 8,000 shifters a year to MGC at a price of $17
each exclusive of freight. The freight charge would be $2 per shifter. If MGC
accept this offer they would no longer employ the supervisor of the shifter
production line. Further, if this went ahead, MGC could use the factory space
currently devoted to the production of shifters to manufacture a new cross-country
bike instead that would generate a contribution of $60,000 per year. The general
overhead allocated represents non-manufacturing costs related to running the
business such as rent of the head-office building which will be incurred irrespective
of whether the external supplier is chosen to supply the shifters or otherwise.
a. Do you think the decision faced by MGC is a make-or-buy or outsourcing
decision? Why?

b. On the basis of a relevant cost/benefit decision analysis should MGC stop

producing the shifters internally and start purchasing them from the outside
supplier? What is the dollar benefit of the decision you suggest? Show all
calculations.

c. What qualitative factors should MGC consider in making this decision?

An acceptable response must include a clear choice of either outsourcing,

or make-or- buy, and an explanation that combines facts of the case with a
general explanation of the distinction between the two options to support
the choice.

It is likely that the decision to go with the external supplier will not be
easily reversible – they would stop employing the supervisor of the line
and use the freed up factory space to manufacture a different product.
Therefore, this is likely to be a longer-term out-sourcing decision.

B.
Total Relevant Costs
(8,000 Units)
Make Buy
Direct Materials (8,000 units @ $6 per unit) $48,000
Direct Labour (8,000 units @ $4 per unit) 32,000
Variable Overhead (8,000 units @ $1 per unit) 8,000
Supervisor’s Salary 40,000
Allocated General Overhead * not relevant
Opportunity Cost – CM forgone on new product line 60,000
Outside Purchase Price (8,000 units @ $17 per unit) $136,000
Freight Cost of Purchase (8,000 units @ $2 per unit) 16,000
Total Costs $188,000 $152,000
Difference in Favour of Purchasing Externally $36,000

*Allocated general overhead are not relevant because it they should not
vary across the two options.

C.
There are many qualitative factors that should be considered. It is not
necessary to provide a complete list, a few would suffice. Better answers
would relate general qualitative factors to be considered in make-or-
buy/outsourcing decisions to specific facts of the case. For example, one
might be:
Quality of the gear shifter being supplied: Is it equivalent to that
manufactured by Mountain Goat? If not, it could have costly
repercussions for brand reputation etc. Can we ensure the quality of the
gear shifter?

Also, reliability of the supplier is another factor to consider.