OUTCOME 2C(week 4)

By Amy Warren,2014-06-28 20:41
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OUTCOME 2C(week 4)

    Preparing Financial Forecast

    Acceptance of a Special Order

    This concept of marginal costing is useful to consider when a customer requests goods at a price that is less than these goods normally sell for. The crucial factors to consider are:

; The available capacity of your factory

    ; The Opportunity Cost of deploying scarce resources

    to make the goods

    ; The chance of future work from this customer ; The chance for future orders for these goods at a

    higher price

    ; The likelihood of other customers, who are currently

    paying the higher price, finding out that you sold

    goods at a cheaper price and, therefore, demanding a

    price cut for further work.

    Example 2.13

    Echo Limited manufactures a product with variable costs of ?8 per unit and a


    selling price of ?10.50. Foxtrot Limited asks if they can have 2,000 units in addition to their ordinary order but at a special price of ?10 per unit. Should the company agree to the new order?

    Solution to Example 2.13

     From a marginal costing point of view, the solution is simple. As the variable costs of the product are ?8, any selling price

    above this amount will give a contribution; if any activity gives a

    contribution, it is worthwhile undertaking.

     On financial grounds, therefore, it is worthwhile accepting the

    order at the reduced selling price.

     There are other factors, which would need to be

    considered before a decision is taken:

    a) Will the acceptance of one order at a lower price lead other customers

    to demand lower prices as well?

    b) Is this special order the most profitable way of using spare capacity?

    c) Will the special order lock up capacity, which could be used for future

    full- price business?

    d) Is it absolutely certain that Fixed Costs will not alter?

     The management of Echo Limited will require to take these

    considerations into account, before arriving at a decision.


    Sell or Process Further Decision

     Doing something additional with a view to adding value to the firm. The most obvious example is a decision to process a semi-finished

    product further, rather than selling it in its present condition. The justification for processing further must be a net advantage

    over the decision to sell now.

     Other common examples of the sell or process further decision lie

    in the marketing of products, such as improving the presentation of

    a product by improved packaging, and selling a product in a

    differentiated market at a higher price.

    Answer to SAQ 2.4

    Hunter Limited (i)

    Per Unit



    Selling Price 50

    Less: Variable costs


    Direct Material 19

    Direct Labour (4 hours at ?1.75) 7


    Contribution ? 24

    (ii) Contribution per labour hour = Contribution

    Number of hours to make one unit

     ?24 = ?6

     4 hours


    Cost of making Component ?

    1. Materials 150

    2. Labour (20 hours x ?1.75) 35

    3. Opportunity Cost: (20 hours x ?6) 120


Advice: Buy the component from the outside supplier at ?300.



    ? (a) Cost of Contract

    1. Materials 1,800

    2. Component 300

    3. Labour (300 hours x ?1.75) 525

    4. Opportunity Cost: (300 hours x ?6) 1,800


    (b) Additional Profit if Contract accepted ?

    Contract Price 4,800

    Less: Contract Cost 4,425

     ?375 Additional Profit

Option B:

    1. selling price: $680 2. opportunity cost: $5000 3. additional fixed cost: $ 3000

    4. material cost: 85%


Option C:

1. selling price: $ 680

    2. labor cost: 1.5 times

    3. material cost: 85%

    Advice: Hunter Limited should accept the contract


    Ferguson Limited produces 3 products R, S and T. R has a selling price of ?3 per unit. The selling price of S is ?7 per unit, whilst the selling price of T is ?4.


    Direct Labour is paid at the rate of ?4 per hour.

    Trading results for the next six months are expected

    to be:

     R S T Total

     ? ? ? ?

    Sales Revenue 120,000 87,500 120,000 327,500

    Less: Variable Costs

    Direct Materials 47,000 55,000 45,000 147,000

    Direct Labour 21,000 15,000 24,000 60,000

    Direct Overhead 42,000 30,000 21,000 93,000

     110,000 100,000 90,000 300,000

    Contribution 10,000 -12,500 30,000 27,500

    Less: Fixed Costs 20,000

    Profit ? 7,500


    (a).On the basis that Fixed Costs can be charged to products on a basis

    of 33.33% of departmental Direct Labour Cost, calculate the BEP

    in terms of units and sales values for Products R, S and T.

    The management of Ferguson Limited are considering two projects to

    improve profitability.

    (b). Project one would be to reduce labour hours to 10,000 by ceasing


    production of Product S and reducing production of either

    Product R or Product T. Employees affected by this reduction in

    manufacturing would lose their jobs. All of the fixed costs

    attributable to Product S would be reduced to zero. However the

    fixed costs associated with Product R and Product T would

    remain unchanged. Calculate the Change in Profit.

    (c) The second project involves the manufacture of component W,

    which is a vital part of Product R. Half the time in department K

    (where R Is produced) is spent in making 80,000 units of

    component W. This component incurs material costs of 20p per

    unit and variable overhead costs of 10p per unit. This component

    can be bought from an outside supplier for ?23,000. Assuming

    that Ferguson buy-in the component, the labour released could do

    other work, which would make a contribution of ?2,000 to

    Ferguson Limited.

    Advise the Management of Ferguson Limited if the Projects Should Proceed.


     This section of the guide has reviewed short-term

    decision-making techniques.

     The tools applied have adopted the principles of


    marginal costing.

     It is the contribution to fixed costs which is

    considered to be of paramount importance. By maximising contribution, it is assumed that the

    firm will maximise profit.

     These concepts are borrowed from Economics,

    where profit maximisation, as you may recall, is

    considered the prime motivator for economic


    We have considered these principles, in some detail, by applying them to a variety of typical management decisions, namely:

    ; Make a commodity ourselves, or buy in ; Changing the selling price of a commodity ; Changes in the cost structure

    ; Acceptance of an order with special conditions;



    ; It assumes costs can be classified between fixed and variable


    ; Linearity, where revenue and variable costs increase in proportion

    with activity

    ; It ignores qualitative factors (i.e. those which can not be quantified) ; The relevant range may be fairly narrow.

    Concepts you should be aware associated with marginal costing:



     Make or Buy

     Sell or Process Further

     Keep open or close.


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