LEARNING UNIT 7 – RELEVANT COSTING AND DEALING WITH
UNCERTAINTY IN DECISION-MAKING
Activities
Prescribed reading
Leaning unit content
Activities
Total
Notional study hours
3 Chapters (2 hours )
8 minutes
7 Activities (5 hours and 14 minutes)
7 hours 22 minutes hours
THIS LEARNING UNIT CONSISTS OF THE FOLLOWING SUB-UNITS:
UNIT
SUB-UNIT 7.1
TITLE
Decision-making based on price setting and capacity utilisation
information and consideration of qualitative factors
CVP analysis utilisation, uncertainty, volatility or inaccuracy in
decision-making
SUB-UNIT 7.2
LEARNING SUB-UNIT 7.1 Decision-making based on price setting and
capacity utilisation information
LEARNING OUTCOMES AND ASSESSMENT CRITERIA:
The content of this learning unit is based on the following learning outcomes and
assessment criteria:
Learning outcome
Assessment criteria
1. Analyse the costing system used by • Identify financial information relevant to decision-making
the enterprise.
regarding price setting and capacity utilisation and debate
the financial impact of such business decisions.
7.1.1. ASSUMED PRIOR LEARNING
If you wish to refresh your knowledge, please refer to your undergraduate material
and prescribed textbook. For your convenience, we provide references to pages
in the textbook, that is, Management and cost accounting in South Africa, 1st
edition, by Colin Drury et al. Note: The abbreviation ‘Drury SA 1st edition’ is used
to refer to the textbook throughout learning unit 7.
Learning outcome
•
•
•
Drury SA 1st edition
Distinguish between relevant and irrelevant
Chapter 11:
information with regard to a specific decision.
Calculate relevant incremental cash flows in a given Pages 283–303
Drury Note :
scenario.
The application of linear programming to
Make preliminary recommendations supported by management accounting' are available online as
appropriate calculations based on the following part of the digital support resource
advanced scenarios:
o special pricing (special orders)
o product mix when capacity constraints exist
o replacement of equipment
o outsourcing (make or buy)
o discontinuation of products, product lines or
divisions
•
•
•
•
•
•
Define and identify limiting factors in a given scenario.
Calculate the contribution of the limiting factor per unit
in a given scenario.
Determine the optimal allocation of available
resources and the optimal product mix.
Calculate the maximum price for additional supplies of
the limited resources per input unit.
Discuss qualitative issues for each decision, including
but not limited to environmental, social and
governance aspects.
Identify
circumstances
under
which
linear
programming would be required to solve a multiproduct, multi-constraint scenario and which elements
are required to do the programming (instruct the tool).
Interpret the results of such linear programming.
Consider and conclude whether linear programming is
required, but the execution thereof is excluded
7.1.2
INTRODUCTION
In this sub-unit, we measure costs and benefits for non-routine decisions, such as
making a component within the company, buying from an outside supplier, or introducing a new
product and replacing existing equipment. We further mention that in non-routine decisions,
only those costs and benefits relevant to the specific alternative courses of action should be
considered. In this section, we further look at the key concept that should be applied in making
product-mix decisions when capacity constraints exist and also discuss equipment decisions,
explaining why equipment book values are irrelevant in such decisions. Finally, we shall
describe the process of maximising operating profit when confronted with bottleneck and nonbottleneck operations, the theory of constraints (TOC).
7.1.3
PRESCRIBED READING FOR THIS SUB-UNIT
After making sure that you have a good understanding of your prior learning
knowledge, read the following material in the outlined order in your Drury
Management and Cost Accounting in South Africa: 1st Edition textbook:
Chapter 11
Pages
Determining the relevant costs of Direct materials
Determining the relevant costs of Direct labour
Importance of qualitative factors
The theory of constraints and throughput accounting
302 -303
303
286 -287
305 - 307
7.1.4
Estimated
Time
42 minutes
Guidelines for determining material relevancy (summary)
Purchased in the past
•
Sunk cost (only if not regularly used and replaced, then use
the relevant cost to purchase)
Ordered or received, not yet paid
•
In stock and no other use at
present
In stock and could be sold directly
In stock and may be used on
another job (shortage of supply)
In-stock and frequently used
Used as a substitute
•
Sunk cost (already committed to pay), unless able to return
the goods to the supplier or regularly used and replaced,
then use the relevant cost to purchase
No value (0)
•
•
Net realisable value
Lost contribution (opportunity cost)
•
•
Must otherwise be disposed of
•
Replacement cost
The cost saved by not having to purchase other
material
Disposal cost saving
7.1.4.1 Guidelines for Determining Labour Relevancy (summary)
Salaried labourers:
•
Already working at business = No cost
•
Work overtime = Overtime cost is relevant
Additional labourers/wage workers:
•
Employ additional labourers = Basic pay
•
New labourers work overtime = Basic pay plus overtime
•
Specialised labour (scarce) = Opportunity cost of projects sacrificed
Budgeting and variance analysis can be linked to enabling competencies, particularly
those that have business and decision-making acumen.
Activity 7.1 Chef-In-Training Academy (CITA) (adapted)
Activity: CITA
16 marks
Reading
6 minutes
Estimated time
Writing
Marking and
review
24 minutes
6 minutes
Total
36 minutes
The owners have decided to host a gala dinner (one night) on the premises of the campus to raise
funds. CITA trainees will get the opportunity to showcase their creations and gain work experience
at the event.
1. The academy paid a marketing consultant R50 000 to conduct a survey on the feasibility for a
gala dinner.
2. Gala dinner tickets will be sold at R800 per couple. Half of the ticket sales will be donated to
the non-profit organisation. There will be 1 170 couples at the gala dinner.
3. It is estimated that each person will spend an average of R150 on beverages. There is a 50%
mark-up on all beverages purchased.
4. There is sufficient space on campus to host the event. CITA currently pays R100 per square
meter per month for the entire campus of 1 300 m2. The gala dinner will occupy 240 m2. CITA
has received a request from a third party to rent the venue on the same evening as the gala
dinner for an amount of R10 000. They would however have to purchase new tablecloths in the
colour requested by the third party at a cost R2 500.
5. The cooking equipment, crockery and cutlery will be sourced from the academy and returned
after the event. This equipment has a book value of R150 000.
6. The electricity for the month during the gala dinner will increase by 15% because of the event.
The total anticipated electricity bill will be R10 800 for the month.
7. All ingredients for the gala dinner are already in storage as the items are regularly used by
CITA. The standard replacement cost is R40 per person.
8. Gourmet meals and appetisers will be prepared and served by the trainees as part of their
training on a voluntary basis. All food preparation will occur in their practical cooking class. If
professional caterers were used, the charge would be R100 per person for similar quality food.
9. Industry standards indicate that trainees can earn at least R150 worth of tips per guest.
10. An orchestra band will be hired to provide entertainment for the gala dinner. The bands normally
charge R6 000 per event, but due to the nature of the event they have agreed on a 30% discount
on this charge.
11. Despite some of the food items reaching their expiry date on the night of the event, the trainees
asked that all left-over meals be donated to them. Both owners agreed, as the trainees are
aware of the expiry dates and trainees are therefore accepting all the risks.
REQUIRED: Calculate profit on a relevant costing basis and recommend whether CITA should
proceed with the gala dinner.
Solution
Note
1
Marketing specialist (Sunk cost - already paid)
2a
Sales of tickets
2b
50% of ticket sales per couple [800 x 1 170 x 50%]
*ALT* NETT sales (936 000 – 468 000) or [800 x 1 170 x 50%]
Beverage sales [1 170 x 2 x 150]
Beverage cost [x100/150]
*ALT* NETT sales [351 000 – 234 000]
3
R
Description – all marks r/w
936 000
( 468 000)
468 000
351 000
(234 000)
117 000
4
Lease cost (irrelevant does not change due to the event)
Opportunity cost à rental declined = R10 000 – R2 500
5
Cooking equipment and cutlery (not relevant – no cash outflow)
6
Increased electricity due to the event
[10 800 x 15/115]
The 15% increase is already included in the R10 800
(1 409)
7
Ingredient replacement cost as replaced regularly
[1 170 x 2 x 40]
(93 600)
8
9
10
(7 500)
-
Preparation time by trainees (to gain experience and voluntary –
no cash outflow)
-
Caterers not used (irrelevant – no cash outflow)
Tips from guests are irrelevant, not paid by CITA
Orchestra [6 000 x 70%]
Relevant profit
(4 200)
478 291
Conclusion: Given the relevant profit of R478 291, it is recommended that the Gala event should
proceed.
Feedback
Sunk costs are cash flows that will be the same for all alternatives are irrelevant. Cash
flows that have already been incurred are sunk costs and are irrelevant for decisionmaking.
Committed costs (past and future) cannot be relevant to a manager's decision to improve
or maximise profits.
Activity 7.2
Activity:
Robber
20 marks
Reading
8 minutes
Estimated time
Writing
Marking and
review
30 minutes
10 minutes
Attempt question:
SA 1st ed: (Drury textbook) Question 11.22
Total
48 minutes
Solution at the back of the SA 1st ed: (Drury textbook).
Feedback
Financial factors such as cost savings, economies of scale, and potential
revenue are important considerations when making an outsourcing decision.
However, the decision should also consider other non-financial factors such
as customer service, quality control, and legal and regulatory compliance.
Therefore:
1. Relevant cost or benefit – is a future cash flow arising or changing as
a direct consequence of the decision under review. You should be
able to incorporate time value of money into your relevant costing
decisions (relevant cash-flows)!
2.
Costs and benefits independent of a decision (i.e. not influenced
by a decision) are irrelevant and need not be considered when
making the decision. Only differential or incremental cash flows
should be taken into account.
3.
Cash flows that will be the same for all alternatives are irrelevant.
4.
Fixed Costs are irrelevant costs (except for such costs as
incremental and divisible fixed costs).
5.
Total Variable Costs: Variable costs are often considered relevant
costs. Committed variable costs are nevertheless irrelevant to
decision-making.
6.
The total relevant cost of production is usually the variable cost
per unit multiplied by the additional units produced plus (or minus)
any change in the total expenditure on fixed costs.
Activity 7.3 Throughput accounting
Activity: Ride
20 marks
Reading
6 minutes
Estimated time
Writing
Marking and
review
30 minutes
10 minutes
Attempt question: (Drury student manual)
1st SA ed: Example 11.13
Solution
Refer to the solution in the 1st SA ed Drury student manual.
Total
46 minutes
Feedback
A sequential profit approach based on constraints and throughput is followed. This
approach should also be followed in questions where such a detailed requirement was
not presented.
Activity 7.4
Activity: Gear
26 marks
Reading
12 minutes
Estimated time
Writing
Marking and
review
39 minutes
18 minutes
Total
69 minutes
The Gear division (Gear) produces the following products in the following two departments:
o Backpacks department has Day packs (22 litres) and Hiking backpacks (40 litres)
o Tents department has two-person tents and three-person tents
A new financial manager, Mr Brian Ndlovu, was appointed on 1 September 2023. During
his review of the financial records of Gear he noticed 15 rolls (800 metres each) of D100
canvas (canvas) on the slow-moving inventory report. Upon further investigation he found
out that the canvas had been bought in February 2020 for R1 020 000 in total for a new
rugged type of tent but that due to the Covid-19 pandemic the production of the new tent
had been scrapped.
He asked the production manager of the Gear division, Mr Khaya Skosana, for suggestions
about what could be done with the D100 canvas. Mr Skosana suggested the following two
options:
•
Option 1: An African relief organisation has issued a tender for 1 500 large tents that
can accommodate ten people. They use the tents to temporarily accommodate people
who have been displaced by floods. All the tents will be produced during November
2023 for delivery at the end of November 2023.
Mr Skosana was attending a tent expo where he overheard the Chief Executive Officer
(CEO) and Chief Financial Officer (CFO) of TAG’s biggest competitor, Big Tents,
talking about the tender to the African relief organisation. Big Tents’ CFO said that they
had submitted their tender with a price US$ 475 per tent. Mr Skosana has suggested
to Mr Ndlovu that TAG should submit a tender price of US$ 460 and that this price
would definitely win them the tender. The relief organisation will pay at the end of
November upon delivery of the tents. The expected R / US$ spot rate at the end of
November is R18.99.
•
Option 2: Sell the D100 canvas as is to Big Tents for R850 000. TAG will give a 4% early
settlement discount if Big Tents pays within 15 days of invoicing. Mr Ndlovu is 80%
sure that Big Tents would settle early.
Option 1: Large tent information
Mr Skosana provided the material and component information for one large tent as follows:
No.
1
2
3
4
5
6
7
Item description
D100 Canvas
Rope
Centre pole
Side poles
Tent pegs
Hammer
Bags for tent and poles
Quantity
40 metres
80 metres
1 pole
12 poles
36 pegs
1 hammer
1 set of bags
Current cost
R80 000 per roll of 800 metres
R12 000 per roll of 1 000 metres
R750 per pole
R120 per pole
R20 per peg
R150 per hammer
R180 per set
Inventory
Gear only has inventory of tent pegs on hand since they are also used for the 2-person
and 3-person tents. Mr Skosana estimates that there will be 4 000 tent pegs in inventory
on 31 October 2023 that were purchased at R19 per peg. The other materials and
components are not the same as those used for the 2-person and 3-person tents.
Labour
All Gear’s employees are permanently employed. Employees in the Tent and Backpack
departments can produce a large tent in 12 hours.
Before production of the large tents were considered, Mr Skosana expected that there will
be 960 spare labour hours in the Tent department and 1 120 spare labour hours in the
Backpack department during November 2023.
All Gear’s departments are compelled to produce the budgeted quantities for November
and should the labour hours needed exceed the spare capacity, Gear’s employees will
have to work overtime. Employees in the Tent and Backpack departments are available to
work a total of 3 000 combined hours overtime at 1.5 times their normal rate of R60 per
hour for Tent employees and R65 per hour for Backpack employees due to higher skills
needed for backpacks compared to tents.
Temporary employees can be hired at R55 per hour to work in the Tent department during
November. They will however take 10% more time per tent due to not being so
experienced compared to Gear employees. There is no shortage of temporary employees
available.
Production and other costs
Variable production overheads of R65 per tent will also be incurred. Gear uses an
absorption costing system and allocates fixed production overheads based on labour hours
at a rate of R42.90 per labour hour. A special machine will be needed for the tender and
can be rented for R60 000 for November. Administrative and legal fees relating to the
tender will amount to R45 000.
REQUIRED
Advise the financial manager, Mr Brian Ndlovu, about which of the two options for
the D100 canvas would be the best for the Gear division.
• Ignore any time value of money implications.
• Provide motivations where items are excluded, if any.
Discuss other considerations that should be taken into account when considering
the tender for the large tents.
Communication skills – clarity of expression
MARKS
SubTotal
total
15
15
10
1
11
Solution
A sequential profit approach based on constraints and throughput is followed. This
approach should also be followed in questions where such a detailed requirement was not
presented.
(a)
Advise the financial manager, Mr Brian Ndlovu, about which of the two options
for the D100 canvas would be the best for the Gear division.
• Ignore any time value of money implications.
• Provide motivations where items are excluded, if any.
Description
Option 1: African relief
1. Canvas
Total for tender
- On hand (sunk cost) ½ d
- Purchase
2. Rope
Total for tender
Other components
3. Centre pole
4. Side poles
5. Tent pegs*
6. Hammer
7. Bags
*Tent pegs Inventory on
hand
8. Labour
Total for tender
- Spare Tent hrs**
- Spare Backpack hrs**
- Still needed
**Current employees spare
hours
Calculation
15
R
15
Per
tent
/1500
40m x 1 500 =
60 000 m / 800 = 75 rolls
15 rolls x 800m = (12 000) m
(15) rolls
48 000 m
60 rolls
/ 800m = 60 rolls x R80 000
4 800 000
½r
½r
½c
3 200 ½ c
80m x 1 500 = 120 000m /1 000m = 120 rolls
x R12 000
1 440 000
960 1 r
R3 240 per tent x 1 500
R750 +
(12 x R120) +
(36 x R20) +
R150 +
R180
4 860 000
1 125 000
2 160 000
1 080 000
225 000
270 000
Don’t use R19 per peg for the 4 000 pegs on
hand. They are regularly used – use
replacement cost of R20 per peg.
12 hrs x 1 500 tents = 18 000 hrs
(960) hrs
(1 120) hrs
15 920 hrs
Labour is permanently employed Committed cost
–
3 240
750
1 440
720
150
180
½r
½r
½r
½r
½r
–
½d
½r
1r
½d
Overtime vs Temps
9. Variable overhead
10. Fixed overhead
allocation
11. Special machine
12. Admin & legal fees
Total relevant cost
13. Income
14. Profit per tent
Relevant profit
Effective overtime rates / cost per tent alt
Backpack = R65 x1.5 = R97.50 x12 = R1 170
½r
Tent
= R60 x1.5 = R90
x12 = R1 080
½r
Temps = R55 x1.1 = R60.50 x12 = R726
½r
OR
= R55 x (12 x 1.1)
= R726
Temp rate /cost is lowest – choose temps ½
d
15 920 hrs x R60.50 OR (15 920 x 1.1) x R55
1 500 tents x R65
Not incremental
US$460 x R18.99 x 1 500
R558 x 1 500 tents
Option 2: Sell to Big Tents
Sell to Big Tents
R850 000 – (R850 000 x 4% x 80%))
963 160
642 ½ c
97 500
–
65 ½ r
–
½d
60 000
45 000
12 265
660
13 103
100
40 ½ r
30 ½ r
8 177
8 735 ½ r
558
837 440 837 440 ½ c
822 800
548 1 r
Difference: Option 1 & 2
14 640
10 Alt ##
Conclusion: The African relief organisation tender (Option 1) will result in R18 640 more relevant
profit than selling to Big Tents and should, therefore, be chosen.
1 c##
TOTAL Available [16] / MAX [15]
(b)
Discuss other considerations that should be taken into account when considering the
tender for the large tents.
Communication skills – clarity of expression
10
1
1. Determine the condition / quality of the 15 rolls of D100 canvas on hand since 2020. They
could have deteriorated since 2020.
2. Consider what quality control (supervision) should be performed over the large tents and
the cost thereof.
3. Consider whether the temporary staff will need training and the cost thereof.
4. Employing temporary employees will create job opportunities for local people.
5. Consider other omitted costs that the company has not factored into the calculation like
transport costs etc.
6. Determine whether TAG has the necessary liquidity to temporarily fund the tender
requirements.
7. Consider whether the currency risk should be hedged. OR Denominate selling price in
Rands.
8. Consider if there be more tenders / repeat orders from the relief organisation.
9. Large tents may appeal to TAG’s current customers and allow for product diversification.
10. Consider potential growth in market share if there is demand for large tents.
11
1d
1d
1d
1d
1d
1d
1d
1d
1d
1d
11. Price should be reconsidered to also recover fixed costs in the long-term if the tender is to
be repeated.
12. Determine whether the materials and components that have to be purchased and the
machine that has to be rented, are readily available in the market.
13. Ethical and legal considerations of using the tender price of the competitor (Big Tents) that
was overheard by Mr Skosana, the production manager. Possible reputation damage and
legal consequences of using confidential information.
14. Impact on staff morale if temps were hired and permanent employees did not get the
opportunity to work overtime and earn extra money / impact on staff morale of working
overtime (if staff overtime was included in a)).
15. Consider performing a due diligence on the African relief organisation to determine its
credibility and its reputation.
16. Payment will be received upon delivery at the end of November. TAG should assess the
collectability of the money / credit worthiness of the relief organisation / whether the relief
organisation will be able to pay the money.
17. Working with an African relief organisation could improve AWA’s reputation as a socially
responsible organisation.
18. Short timelines given by the relief organisation. Consider whether TAG will be able to deliver
the correct quality within the short time frame.
19. Any other valid point (max 1)
1d
1d
1d
1d
1d
1d
1d
1d
1d
Available [19] / Max [10] + 1 Com = [11]
Feedback
The best option to select will always be the one yielding the highest profit or resulting in
the lowest cost after considering all the relevant costs.
On part (b) Tender is Option 1. Therefore, the following should NOT be discussed:
- Option 2 (Selling to Big Tents)
- loss of sales to existing customers causing customer dissatisfaction since there is no
capacity constraint.
Summary
This section covered how costs and revenues should be measured for a range of nonroutine decisions. We established that in determining the appropriate amount to be
considered for each alternative, it is important only to include items relevant to the
decision and avoid allocating common fixed costs to alternatives. The focus should be on how each
choice will impact the organisation's future cash flows. In cases where resources are scarce, we
recommend selecting the alternative that yields the highest contribution per limiting factor. This
approach ensures that decisions are made with a clear understanding of their financial impact and
benefits the organisation's overall success.
LEARNING SUB-UNIT 7.2 CVP analysis utilisation, uncertainty, volatility
or inaccuracy in decision-making
LEARNING OUTCOMES AND ASSESSMENT CRITERIA:
The content of this learning unit is based on the following learning outcomes and
assessment criteria:
Learning outcome
1. Evaluate financial planning and
control techniques.
Assessment criteria
• Recommend, based on calculations the breakeven point and margin of safety of a business
under different scenarios.
• Conclude on the value of perfect and imperfect
information in the market.
• Distinguish between maximin, maximax and regret
criteria.
• Discuss the implications of pursuing a
diversification strategy.
• Illustrate the principles of decision-making and
uncertainty on profitability analysis.
• Interpret the meaning of expected values.
7.2.1 ASSUMED PRIOR LEARNING
If you wish to refresh your knowledge, please refer to your undergraduate
material and prescribed textbook. For your convenience, we provide
references to pages in the textbook, that is, Management and cost accounting
in South Africa, 1st edition, by Colin Drury et al. Note: The abbreviation ‘Drury
SA 1st edition’ is used to refer to the textbook throughout learning unit 7.
Prior learning
Before studying this topic, you should be able to:
• Calculate a break-even point and margin of safety.
• Calculate sensitivities for changes in any variables in
the CVP model.
• Use CVP analysis to determine the expected effect of
decisions and events on profit or the variables
influencing profitability.
• Make suitable recommendations based on the above
calculations.
• Using appropriate techniques, determine what actions
or decisions are required to achieve a predetermined
outcome in different scenarios.
• Explain the meaning and describe the role of
operating leverage in measuring risk and how it
influences profits.
•
•
•
Distinguish between risk and uncertainty
Describe the different concepts relating to probability
measurements.
Calculate probability distribution and expected value.
Drury SA 1st edition
Applicable references:
Chapter 10:
Cost-Volume-Profit analysis.
Pages 255 – 268.
Chapter 13:
Pages 354–365
•
•
•
•
Identify qualitative factors that may have to be
considered when a decision is made in conditions of
risk and uncertainty.
Explain the meaning of standard deviation and the
coefficient of variation as measures of risk.
Recommend courses of action based on elementary
scenarios involving standard deviation and the
coefficient of variation.
Decision tree analysis
7.2.2
PRESCRIBED READING FOR THIS SUB-UNIT
Chapter 10
Pages
Apply CVP analysis in a multi-product setting.
268 -276
Identify and explain the assumptions on which CVP analysis is
based.
Explain the meaning and describe the role of operating leverage
in measuring risk and how it influences profits.
Chapter 13
Buying perfect and imperfect information
Maximin, Minimax and Regret criteria
Risk reduction and diversification
7.2.3
365 - 370
Estimated
Time
48 minutes
30 minutes
INTRODUCTION
In this sub-unit, we will consider using the same basic financial information for
decision-making through cost-volume-profit (CVP) analysis. In addition, we highlight
that business decisions are influenced by managerial subjectivity as managers normally draw
from their expert knowledge, past experience and situations likely to impact future events due to
the uncertain business environment.
7.2.4
Cost-Volume-Profit (CVP)
CVP is especially valuable during planning and budgeting as it broadly indicates expected
outcomes for different variables in the CVP model at different levels. CVP is also a very useful
tool in measuring the riskiness of various plans or scenarios in the budget. However, it has a
short-term focus.
Cost-Volume-Profit can be linked to enabling competencies, particularly those related to
business acumen and decision-making acumen.
Activity 7.5 – Break-even (Super Beverages (Pty) Ltd)
Activity:
Super Bev
10 marks
Reading
3 minutes
Estimated time
Writing
Marking and
review
15 minutes
8 minutes
Total
26 minutes
SuperBev has the following budgeted information planned for the next financial year ending
31 May 2020:
Superade
Green Soda
Total
Sales
310 000 cases
855 000 cases
1 165 000 cases
Production of finished goods
280 000 cases
809 000 cases
1 089 000 cases
Machine hours
58 900 hours
129 500 hours
188 400 hours
Selling price per case
R180,00 / case
R110,00 / case
Ingredients and packaging
R48,30 per case
R29,00 per case
Variable overheads
R8,50 per case
R6,50 per case
Variable selling and admin costs
R11,20 per case
R9,50 per case
Fixed production overheads
R37 800 000
Fixed selling and admin costs
R23 100 000
Required:
The sales manager is preparing a presentation and has asked you to calculate the following for
Superade and Green Soda for the year ending 31 May 2020:
i.
budgeted break-even number of cases
Solution
i) Calculate Budgeted break-even number of cases
Step 1: Total Fixed costs
Fixed costs
R
Fixed production overheads – given
37 800 000
Fixed selling & admin costs – given
23 100 000
Total
60 900 000
Step 2: Contribution per case
Contribution per case
Superade
R
180,00
Green Soda
R
110,00
Less Variable costs
(48,30 + 8,50 + 11,20; 29 + 6,50 + 9,50)
(68,00)
(45,00)
Contribution
112,00
65,00
Selling price – given
Step 3: Weighted average contribution per case:
= (R112 x 310 000 / 1 165 000) + (R65 x 855 000 / 1 165 000)
= (R112 x 26,6%) + (R65 x 73,4%)
= R29,80 + R47,71
= R77,51 per case
Step 4: Break-even – total number of cases
Must use BUDGETED sales
volume to determine
sales mix ratio
Break-even = Fixed cost / Weighted average contribution per case
= R60 900 000/ R77,51
= 785 705,1
= 785 706 cases in total
Step 5: Break-even number of cases per product:
Superade
= 785 706 x 310 000 / 1 165 000
= 209 071,98
= 209 072 cases
Green Soda
Always show
rounding!
MUST round UP
= 785 706 x 855 000 / 1 165 000
= 576 633,02
= 576 634 cases
Feedback
In case a company produces more than one type of product and incurs shared fixed
costs (common fixed costs) in the process, a multi-product break-even point (BEP)
calculation would be necessary to determine the company's BEP. This would entail a
single BEP calculation using the total fixed costs (common fixed costs) and a weighted
average contribution based on the planned sales mix. The sales mix ratio is always
calculated using the sales units.
Activity 7.6 – Scenario analysis
Activity:
Paramountain
16 marks
Reading
4 minutes
Estimated time
Writing
Marking and
review
24 minutes
6 minutes
Total
34 minutes
Paramountain Ltd manufactures and sells video equipment. Every video recorder sells for R1 150,
and variable costs amount to R850 per unit. Total annual fixed costs amount to R150 000.
The following operating results for the previous year were given:
R
Sales
Less: Variable costs
Contribution margin
Less: Fixed costs
Net income
935 000
330 000
150 000
180 000
1 265 000
REQUIRED
Mark
(a) Determine the break-even point in units;
(2)
(b) Calculate the margin of safety based on sales units, if Paramountain expects to
sell 1 200 video recorders this year;
(1)
(c) Refer to the original data. Management would like to increase the net income from
the previous year. The marketing manager would like an additional amount of
R25 000 set aside for advertising purposes. The sales manager believes that a
12,5% reduction in the selling price, combined with the additional advertising,
should cause annual sales in units to increase by 25%. Prepare a contribution
Profit or Loss statement, showing the results of operations if the changes are
made. Advise management whether or not to adopt the suggested changes.
(6)
(d) Refer to the original data. The financial manager does not want the selling price to
change, as it would lead to a lot of administrative work. Instead, he suggests that
costs should be cut and advertising increased. He suggests negotiating with the
suppliers for a price cut of R90 on a circuit used in the production of the video
recorders and improving productivity in order to save R25 on labour costs per
recorder. The manager believes that additional advertising should also increase
annual sales by 40%. By how much can advertising increase for profits to remain
(4)
unchanged?
(e) Refer to the original data. Assume that the company is only producing 850 video
recorders per year. An order has been received for 600 units on a special price
basis. What unit price would have to be quoted to the buyer if Paramountain Ltd
wants to earn an overall profit of R195 000 for the year? (You may assume that
the present sales will not be affected by the special price order).
(3)
Solution
Scenario analysis is often required as part of the decision-making process.
(a) Break-even point
Break-even point
=
Fixed cost / Contribution
=
R150 000 / (R1 150 - R850)
=
500 units
(2)
(b) Margin of safety
=
(Expected sales - Break-even sales) / Expected sales
=
(1 200 - 500) / 1 200)
=
58,33%
(1)
(c) Proposal: Contribution profit or loss statement
R
Calculation
Sales
Variable costs
Contribution
Fixed costs
Net income
([R1 150 x 87,5%] x 1 100 x 1,25)
(R850 x 1 100 x 1,25)
(150 000 + 25 000)
1 383 594
(1 168 750)
214 844
(175 000)
39 844
(4)
Working:
Calculate last year’s number of units sold:
R1 265 000 / R1 150 = 1 100 units sold
Management should not accept the changes, as it decreases net income.
(d) Net income
NI
R180 000
R180 000
R180 000
Advertising
(1)
(1)
= Sales - Variable costs - Fixed costs
=
SPx – VCx – FC
= (1 100 x 1,4 x R1 150) - (1 100 x 1,4 x [850 - 90 - 25]) - R150 000 –
advertising
= R1 771 000 - R1 131 900 - 150 000 - advertising
= R489 100 - advertising
= R309 100
(3)
Advertising may increase with R309 100, representing the incremental contribution margin,
without affecting the net income.
(e) NI
R195 000
R195 000
600SP
SP
=
SP x - VarCx - FC
= (R1 150 x 850) + (600 x SP) - (1450 x R850) - R150 000
= R977 500 + 600SP - R1 232 500 - R150 000
=
R600 000
= R1 000 per unit
(3)
6.2.4. Decision-making under conditions of risk and uncertainty
In this section, we further look at how the principle of probability theory enables management to
consider the degree of uncertainty associated with each course of action when making business
decisions. We shall also describe and calculate the value of perfect information and introduce the
concept of diversification strategy.
Activity 7.7– Calculate an expected value; buying perfect information
Activity:
Success
20 marks
Reading
7 minutes
Estimated time
Writing
Marking and
review
30 minutes
18 minutes
Total
55 minutes
A newly formed company called Success (Pty) Ltd has obtained a contract to supply the Zac, its
new product, to one of the big national supermarket groups in the country. Success intends to
start production only in March following the installation of new sophisticated machinery. Success’
management has agreed to supply the national supermarkets with whatever quantities of Zac
they require at a price of R40 per unit. The machinery supplier has just informed Success (Pty)
Ltd that delivery of the machinery will be delayed by six months. The sales manager stated that
though the demand is currently uncertain, it would have been well within the capacity of the
permanent machinery they were to have installed.
Here are the best estimates of the total demand for the first half year:
Estimated demand for the first half year:
Quantity
(000 units)
10
14
16
Probability
0,5
0,3
0,2
Success intends to meet its contractual obligations regardless of the level of demand and thus
considers the possibility of hiring equipment on which temporary production can take place. The
details of the three machines that can be hired are as follows:
Production capacity per half year
Variable cost/unit
Other fixed costs total per half year
Machine A
Machine B
Machine C
10 000 units
R6,50
R320 000
12 000 units
R6,00
R350 000
16 000 units
R5,00
R400 000
The total variable costs stabilise once maximum capacity is reached and does not increase.
There will be an additional variable material cost of R5/unit; however, a 20% discount per unit
will be given for purchases in excess of 10,000 units.
If production capacity falls below demand, Success (Pty) Ltd can subcontract production to the
extent of 6 000 units provided
•
•
they pay R30/unit for up to 4 000 units subcontracted
they pay R35/unit in excess of 4 000 units
The sales manager has emphasised the importance of making the choice of which machine to
hire before the exact demand is known, due to the lead-time required for setting up production.
It will however be available in time for scheduling a standard monthly production level to meet
the demand.
The sales manager is also considering enlisting the services of a reputable firm of market
researchers who could accurately inform Success (Pty) Ltd whether demand is to be 10, 14 or
16 thousand units.
(Drury adapted)
Required
(a)
Calculate the possible monetary outcomes for each of the three machines and, using
expected values, advise Success (Pty) Ltd management on its best course of action.
(b)
Calculate the maximum amount that would be worthwhile for the company to pay to the
market researchers to ascertain the details of demand. Assume that the researchers will
produce an accurate forecast and that the demand will be exactly equal to one of the
three demand figures given.
(c)
Considering that perfect information hardly exists, briefly explain the significance of
calculating the expected value of perfect information.
Solution
(a)
Calculation of expected values for each of the three machines.
Estimated
Sales @
Total costs
Profit
Probability
demand
R40/unit
(R000)(A)
(R000)
(000)
(R000)
Machine A
10
400
435
(35)
0,5
14
560
571
(11)
0,3
16
640
649
(9)
0,2
Expected
value
(R000)
(17,5)
(3,3)
(1,8)
(22,6)
Estimated
demand
(000)
Sales @
R40/unit
(R000)
Profit
(R000)
Probability
Expected
value
(R000)
Machine B
10
14
16
Total
costs
(R000)
(B)
400
560
640
460
548
616
(60)
12
24
0,5
0,3
0,2
(30,0)
3,6
4,8
(21,6)
Estimated
demand
(000)
Sales @
R40/unit
(R000)
Profit
(R000)
Probability
Expected
value
(R000)
Machine C
10
14
16
Total
costs
(R000)
(C)
400
560
640
500
536
554
(100)
24
86
0,5
0,3
0,2
(50,0)
7,2
17,2
(25,6)
Calculation of total costs
Note that with machine A you can only produce 10 000 units. Therefore, the additional 4 000 un
to meet demand will be subcontracted.
Machine A
(max capacity of 10 000 units)
Variable cost of R6,50 / unit
(max capacity)
Fixed costs
Material costs
(Note: R5/unit for the first 10 000
units, R4/ (R5 x 80% = R4) unit for
demand > 10 000 units
Subcontracting costs
10 000 units
(R000)
14 000 units
(R000)
16 000 units
(R000)
65
65
65
320
50
320
66
320
74
-
120
190
4 000 x 30 = 120k
(Note: R30/unit for up to 4 000
units, then R35/unit for
subcontracting
> 4 000 units)
Machine B
(max capacity of 12 000 units)
Variable cost of R6,00 / unit
(max capacity)
Fixed costs
Material costs
(Note: R5/unit for the first 10 000
units, R4/unit for demand
> 10 000 units
Subcontracting costs
(Note: R30/unit for up to 4 000 units,
then R35/unit for subcontracting
> 4 000 units)
Machine C
(max capacity of 16 000 units)
Variable cost of R5,00 / unit
(max capacity)
Fixed costs
Material costs
(Note: R5/unit for the first 10 000 units,
R4/unit for demand > 10 000 units
Subcontracting costs
(Note: R30/unit for up to 4 000 units,
then R35/unit for subcontracting
> 4 000 units)
2 000 x
35 = 70k
190k
435
10 000
units
(R000)
571
14 000 units
(R000)
649
16 000 units
(R000)
60
72
72
350
50
350
66
350
74
-
60
120
460
548
616
10 000
units
(R000)
14 000 units
(R000)
16 000 units
(R000)
50
70
80
400
50
400
66
400
74
-
-
-
500
536
554
Recommendation
Management should choose machine B as it yields the lowest expected loss, particularly if the
decision is based on expected values.
It should be noted that though machine C yields the biggest expected loss, it has a 20%
probability of generating a profit of R86 000. A risk-taker might prefer machine C to machine B.
(b)
Calculating the maximum amount that should be paid for perfect information.
(b) (i) With certain information, the following decisions will be made:
Certain demand of 10 000 units:
Purchase machine A, which yields a minimum loss of R35 000.
Certain demand of 14 000 units:
Purchase machine C, which yields a maximum profit of R24 000.
Certain demand of 16 000 units:
Purchase machine C, which yields a maximum profit of R86 000.
With perfect information, the revised expected value will be as follows:
Demand (units)
(000)
10
14
16
Machine
A
C
C
Profit
(R’000)
(35)
24
86
Probability
0,5
0,3
0,2
Value of best decision using imperfect information
Difference
•
Therefore, the maximum amount worthwhile to pay for perfect information is
R28 500.
•
For an explanation of this see ‘Buying perfect and imperfect information’ in:
o
o
(c)
Expected value
(R’000)
(17,5)
7,2
17,2
6,9
(21,6)
28,5
Drury SA 1st edition chapter13 (page 365 – 366)
Drury 10th edition chapter 12 (page 293-294)
The significance of calculating the expected value of perfect information.
•
The expected value of perfect information gives an approximation of the upper limit
on the value of information.
•
Any information, which costs more than this upper limit, is not worth obtaining.
•
The model can be adapted to indicate the expected value of imperfect information.