Indian Institute of Management Rohtak

Management Accounting
Session 8

Cost Analysis for

Decision Making
By
Prof Archana Patro
The Managerial Accountant’s Role in
Decision Making

Managerial
Accountant
Cross-functional
management teams
Designs and implements who make
accounting information production, marketing,
system and finance decisions

Make substantive
economic decisions
affecting operations
 The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Quantitative
Analysis
4. Develop a Decision Model

5. Collect the Data

6. Make a Decision
 The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the
responsibility of the 3. Identify the Alternatives
managerial
accountant. 4. Develop a Decision Model

5. Collect the Data

Information should be:
1. Relevant
2. Accurate 6. Make a Decision
3. Timely
 The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Qualitative
Considerations 4. Develop a Decision Model

5. Collect the Data

6. Make a Decision
 Learning Objective 1

Identify relevant and irrelevant

costs and benefits in a
decision.
Cost Concepts for Decision Making

A relevant cost is a cost that differs

between alternatives.
 Identifying Relevant Costs
An avoidable cost is a cost that 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. They 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.
Use the remaining costs and benefits that
Step 2
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.
 Different Costs for Different
Purposes

Costs that are relevant in one decision

situation may not be relevant in another
context. Thus, in each decision situation,
the manager must examine the data at
hand and isolate the relevant costs.
 Identifying Relevant Costs
Cynthia, a Boston student, is considering visiting her friend in New York.
She can drive or take the train. By car, it is 230 miles to her friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45 per month × 8 months $2.70 per gallon ÷ 27 MPG

$24,000 cost – $10,000 salvage value ÷ 5 years

 Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25
 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.

However, the cost of gasoline is clearly relevant if she

decides to drive. If she takes the train, the cost would
not be incurred, so it varies depending on the decision.
 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of The monthly school

maintenance and parking fee is not
repairs is relevant. In relevant because it
the long-run these must be paid if Cynthia
costs depend upon drives or takes the
miles driven. train.

At this point, we can see that some of the average cost

of $0.619 per mile are relevant and others are not.
 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The decline in resale The round-trip train

value due to additional fare is clearly relevant.
miles is a relevant If she drives the cost
cost. can be avoided.

Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.
 Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The cost of parking in

New York is relevant
because it can be
avoided if she takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
 Identifying Relevant Costs
From a financial standpoint, Cynthia would be better
off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.

Relevant Financial Cost of Driving

Gasoline (460 @ $0.100 per mile) $ 46.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 137.86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00
 Total and Differential Cost Approaches

The management of a company is considering a new labor saving

machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
 Total and Differential Cost Approaches

As you can see, the only costs that differ between the
alternatives are the direct labor costs savings and the
increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
We
Direct materials canunits
(5,000 efficiently analyze the
@ $14 per unit) decision 70,000
70,000 by -
Direct labor looking
(5,000 units at
@ $8 anddifferent
the $5 per unit) costs 40,000
and revenues 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same 120,000 .
solution 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
 Total and Differential Cost Approaches

Using the differential approach is desirable for

two reasons:
1. Only rarely will enough information be
available to prepare detailed income
statements for both alternatives.
2. Mingling irrelevant costs with relevant costs
may cause confusion and distract attention
away from the information that is really
critical.
 Learning Objective 2

Prepare an analysis showing

whether a product line or
other business segment
should be dropped or
retained.
Adding/Dropping Segments
One of the most important decisions
managers make is whether to add or
drop a business segment. Ultimately, a
decision to drop an old segment or add
a new one is going to hinge primarily on
the impact the decision will have on net
operating income.

To assess this impact, it is necessary to

carefully analyze the costs.
 Adding/Dropping Segments

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 discontinuing this
product line.
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch
segment only if its profit would increase.
Lovell will compare the contribution
margin that would be lost to the costs
that would be avoided if the line was
to be dropped.
Let’s look at this solution.
 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
An
Less: investigation
variable expenses has revealed that the fixed
Variable manufacturing costs $ 120,000
general factory
Variable shipping costs
overhead and fixed general
5,000
administrative
Commissions expenses will not75,000
be affected200,000
by
dropping the
Contribution digital watch line. The fixed general
margin $ 300,000
Less: fixed expenses
factory overhead and general administrative
General factory overhead $ 60,000
expenses
Salary of line assigned
manager to this product
90,000 would be
reallocated
Depreciation to other product
of equipment lines.
50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
 Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The equipment
Variable used costs
manufacturing to manufacture
$ 120,000
digital
Variable watches
shipping has no resale5,000
costs
Commissions
value or alternative use. 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Should Lovell
Depreciation of equipment retain or drop
50,000
Advertising - direct the digital watch
100,000segment?
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
 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 Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 If the digital watch
Advertising - direct 100,000
Rent - factory space 70,000
line is dropped, the
General admin. expenses 30,000 company loses
Total fixed expenses 400,000 $300,000 in
Net operating loss $ (100,000)
contribution margin.
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct On 100,000
the other hand, the general
Rent - factory space factory overhead would be the
70,000
General admin. expenses 30,000
same under both alternatives,
Total fixed expenses 400,000
Net operating loss so it is irrelevant.
$ (100,000)
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses
The salary of the
120,000
product -
line 120,000
Shipping manager would 5,000disappear, - so 5,000
Commissions it is relevant to the decision.
75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
The
Less depreciation
variable expenses: is a sunk cost. Also, remember - that
Manufacturing
the equipment expenses
has no resale120,000 -
value or alternative 120,000
use,
Shipping 5,000 - 5,000
so
Commissionsthe equipment and the depreciation
75,000 expense
- 75,000
associated
Total variable with it are irrelevant
expenses 200,000 to the decision.
- 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
 Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping The complete 5,000 comparative- 5,000
Commissions income statements
75,000 reveal- that 75,000
Total variable expenses 200,000 - 200,000
Contribution margin
Lovell would
300,000
earn $40,000
-
of (300,000)
Less fixed expenses: additional profit by retaining the
General factory overhead 60,000
digital 60,000
watch line. -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)
Beware of Allocated Fixed Costs

Why should we keep the

digital watch segment
when it’s showing a
$100,000 loss?
 Beware of Allocated Fixed Costs

The answer lies in the

way we allocate
common fixed costs
to our products.
 Beware of Allocated Fixed Costs

Including unavoidable Our allocations can

common fixed costs make a segment
makes the product line look less profitable
appear to be unprofitable. than it really is.
Learning Objective 3

Prepare a make or buy

analysis.
 The Make or Buy Decision
Insourcing /Outsourcing
When a company is involved in more than
one activity in the entire value chain, it is
vertically integrated. 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.
Vertical Integration- Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits
Vertical Integration- Disadvantage
Companies may fail to take advantage of
suppliers who can create economies of
scale advantage by pooling demand from
numerous companies.

While the economics of scale factor can be

appealing, a company must be careful to retain
control over activities that are essential to
maintaining its competitive position.
 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 $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 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 Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The avoidable costs associated with making part 4A include direct

materials, direct labor, variable overhead, and the supervisor’s salary.
 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The depreciation of the special equipment represents a sunk

cost. The equipment has no resale value, thus its cost and
associated depreciation are irrelevant to the decision.
 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not avoidable; irrelevant. If the product is

dropped, it will be reallocated to other products.
 The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A? Given that the total

avoidable costs are less than the cost of buying the part,
Essex should continue to make the part.
Product-Mix Decisions
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.
 Utilization of a Constrained
Resource
• Fixed costs are usually unaffected in these situations, so the
product mix that maximizes the company’s total
contribution margin should ordinarily be selected.
• A company should not necessarily promote those products
that have the highest unit contribution margins.
• Rather, total contribution margin will be maximized by
promoting those products or accepting those orders that
provide 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
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 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 Product 2?
 Quick Check 
How many units of each product can be
processed through Machine A1 in one
minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
 Quick Check 
How many units of each product can be
processed through Machine A1 in one minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

Just checking to make sure you are with us.

 Quick Check 
What generates more profit for the company, using
one minute of machine A1 to process Product 1 or
using one minute of machine A1 to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
 Quick Check 
With one minute of machine A1, we could make 1
unit of Product 1, with a contribution margin of
What generates more profit for the company, using
$24, or 2 units of Product 2, each with a
one minute of machine A1 to process Product 1 or
contribution margin of $15.
using one minute of machine A1 to process Product 2?
a. Product 12 × $15 = $30 > $24
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
 Utilization of a Constrained
Resource
The key is the contribution margin per unit of the
constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Ensign should emphasize Product 2 because it

generates a contribution margin of $30 per minute
of the constrained resource relative to $24 per
minute for Product 1.
 Utilization of a Constrained
Resource
The key is the contribution margin per unit of the
constrained resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Ensign can maximize its contribution margin

by first producing Product 2 to meet customer
demand and then using any remaining
capacity to produce Product 1. The
calculations would be performed as follows.
Utilization of a Constrained
Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.
Utilization of a Constrained
Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Utilization of a Constrained
Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units
 Utilization of a Constrained
Resource
According to the plan, we will produce 2,200
units of Product 2 and 1,300 of Product 1.
Our contribution margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Ensign is $64,200.

 Quick Check 
Colonial Heritage makes reproduction
colonial furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will

only be able to supply 2,000 board feet
this month. Is this enough hardwood to
satisfy demand?
a. Yes
b. No
 Quick Check 
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month. Is
this enough hardwood to satisfy demand?
a. Yes
b. No (2  600) + (10  100 ) = 2,200 > 2,000
 Quick Check 
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100

The company’s supplier of hardwood will only be

able to supply 2,000 board feet this month. What
plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
 Chairs Tables
Quick Check 
Selling price $ 80 $ 400
Variable cost 30 200
Chairs Tables
Contribution margin $ 50 $ 200
Selling price per unit $80 $400
Variable cost Board feet $30
per unit $200 2 10
Board feet perCM per board foot
unit 2 $10 25 $ 20
Monthly demand 600 100
Production of chairs 600
The company’s supplier of hardwood
Board will only
feet required be
1,200
able to supply 2,000 board
Boardfeet this month. What
feet remaining 800
plan would maximize Board
profits?
feet per table 10
a. 500 chairs and 100Production
tables of tables 80
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
 Quick Check 
As before, Colonial Heritage’s supplier of hardwood
will only be able to supply 2,000 board feet this
month. Assume the company follows the plan we
have proposed. Up to how much should Colonial
Heritage be willing to pay above the usual price to
obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
 Quick Check 
As before, Colonial Heritage’s supplier of hardwood
The additional
will only wood
be able to would
supply 2,000be used
board feettothis
make
tables.
month. In this
Assume the use, eachfollows
company boardthe
foot
planofwe
additional woodUp
have proposed. will
to allow the company
how much to earn
should Colonial
Heritage
an be willing
additional $20to ofpay above the usual
contribution marginpriceand
to
obtain more hardwood? profit.
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
 Product-Mix Decisions-Summary

• The decisions made by a company about which products to

sell and in what quantities

• Decision Rule (with a constraint): choose the product that

produces the highest contribution margin per unit of the
constraining resource
 Managing Constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the
constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be
done at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the
bottleneck.