Tactical Decision

Making
Example :a discount department store
Departments ($ ’000)
Total Groceries General Drugs
merchandise
Sales 1900 1000 800 100
Variable costs 1420 800 560 60
Fixed costs 445 210 200 35
Total costs 1865 1010 760 95
Operating income 35 (10) 40 5

Now, the manager needs to make the decision:

keep or drop the groceries department
• What does it cost Eastern Airline Co. to fly a customer on
a round-trip flight from Beijing to Shanghai?
• The Eastern normally charges ￥ 2000 for this round-
trip ticket. Suppose that before the departure, Eastern
finds that there are some spare seats and the ticket
agents decide to sell the ticket for only ￥ 120 to attract
customers.
• Will this decision make additional profit?
 Concepts about Decision Making

Making decisions requires that only those costs and

benefits that are relevant to the alternatives are
considered.

Only the costs and benefits that are affected by

decisions are relevant.
 Relevant cost & Irrelevant cost
Relevant costs are future costs that differ across
alternatives.
A cost must not only be a future cost but must also be
different between alternatives.
Such as: to keep or drop a production line
1. Workers’ wages($30 000/month):
future & different
2.An accountant’s salary($5 000/month):
future but non-different
3.Machine on the production line has no resale value
purchased last year (book value $8000):
past & non-different
 Avoidable costs & Unavoidable costs
Avoidable costs: costs that will not continue if an
ongoing operation changed or deleted.
Such as workers’ wages ( keep or drop a
production line)
Unavoidable costs: costs that will continue even if
an operation is halted.
Such as an accountant’s salary (keep or drop a
production line)
Avoidable costs are (irrelevant/relevant)
relevant costs.
Unavoidable costs are (irrelevant/relevant)
irrelevant costs.
 Different Costs for Different Purposes

Costs that are relevant in one decision situation

may not be relevant in another context.

Workers’ wages of production line A

Decision 1: keep or drop the production line A

Decision 2: add or not add production line B
Example :a discount department store
Departments ($ ’000)
Total Groceries General Drugs
merchandise
Sales 1900 1000 800 100
Variable costs 1420 800 560 60
Contribution margin ? ? ? ?
Fixed costs
Avoidable 265 150 100 15
Unavoidable 180 60 100 20
Total fixed expenses 445 210 200 35
Operating income 35 (10) 40 5
Example :a discount department store
Departments ($ ’000) Effect of
Total Groceries General Drugs Dropping
merchandise
Sales 1900 1000 800 100 ?
-1000
Variable costs 1420 800 560 60 ?
-800
Contribution margin 480 200 240 40 ?
-200
Fixed expenses
Avoidable 265 150 100 15 ?
-150
Unavoidable 180 60 100 20 ?
---
Total fixed expenses 445 210 200 35 ?
-150
Operating income 35 (10) 40 5 ?
-50

Now the
Store depreciation, store isand
heating, considering dropping
general management expenses
theall
that are shared by groceries department.
departments and are unavoidable.
 Store as a whole
Total Effect of Total
Totalafter
after
before dropping dropping
change
change (a) groceries
(b) 900
Sales 1900 -1000 ?
620
Variable costs 1420 -800 ?
280
Contribution margin 480 --200 ?
115
Avoidable Fixed expenses 265 -150 ?
165
Profit contribution to 215 -50 ?
unavoidable costs 180
Unavoidable costs 180 - ?
(15)
Operating income 35 -50 ?
 Relevant Cost Analysis:
A Two-Step Process

Step 1: Eliminate costs and benefits that do not

differ between alternatives.(irrelevant items)
Step 2: Use the remaining costs and benefits that
differ between alternatives in making the decision.
The costs and benefits that remain are the
differential, or avoidable items. (relevant items)
 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:
Current New Differential costs
machine and benefits
Sales (5000 units@40/units) $200 000 $200 000
Variable expenses
direct materials (5000 70 000 70 000
units@$14/units)
(15000)
direct labor(5000 units@$8 and 40 000 25 000 ?
$5/units)
Variable overhead(5000 units@$2/units) 10 000 10 000 (15000)
Total variable expenses 120 000 105 000
80000 95000 15000
Contribution margin ? ?
Fixed expenses
other 62 000 62 000
3000
rent on new machine - 3000
3000
Total fixed expenses 62 000 65 000
$12000
Net operating income $18 000 $30 000
 Differential Cost Approache
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.

We can efficiently analyze the decision by

looking at the different costs and revenues
and arrive at the same solution.
Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000
 Identifying Relevant Costs
Two broad categories of costs are never relevant in any
decision:
Sunk costs: is a cost that had already been incurred
and can not be avoided regardless of what a decision
being made.
Such as the previous salaries paid to the groceries
department’s manager; the costs of the groceries’
refrigerators and shelves purchased years ago with
no resale value.
Future costs that do not differ between the
alternatives.
Such as the salaries of the drugs department’s
manager.
Drop or Keep Decision
 Adding/Dropping Segments
One of the most important decisions managers make is
whether to add or drop a business segment, such as a
product or a store.

Example
Due to the declining popularity of digital watches,
Lovell Company’s digital watch line has not
reported a profit for several years. Lovell is
considering dropping this product line.
 A Contribution Margin Approach
Operating income=CM-fixed costs
DECISION
DECISION RULES
RULES
Increased
Increased CM
CM exceed
exceed the
the increased
increased fixed
fixed cost:
cost: add
add
Decreased
Decreased fixed
fixed cost
cost exceed
exceed the
the Decreased
Decreased CM:
CM: drop
drop

Lovell should drop the digital watch segment only if the

fixed cost savings exceed the lost contribution margin.
 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)
 Investigation
Investigation has
has revealed
revealed thatthat total
total fixed
fixed general
general
factory
factory overhead
overhead and and general
general
administrative
administrative expenses
expenses would
would not
not be
be affected
affected ifif the
the
digital
digital watch
watch line
line is
is dropped.
dropped. The
The fixed
fixed general
general
factory
factory overhead
overhead and and general
general administrative
administrative
expenses
expenses assigned
assigned to to this
this product
product would
would bebe
reallocated
reallocated to to other
other product
product lines.
lines.

The
The equipment
equipment used
used to
to manufacture
manufacture
Relevant
Relevant or digital
digital watches
or irrelevant?
irrelevant? watches has has
no
no resale
resale value
value or alternative
alternative use.
orUnavoidable
Unavoidable use. The
The depreciation
depreciation
irrelevant
irrelevant
would
would flow
flow through
through the
the income
income statement
statement asas aa loss.
loss.
 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 - 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)
 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)

Retain
Retain
 Keep-or-Drop
Keep-or-Drop Decisions
Depreciation
Depreciation isis irrelevant
Decisions irrelevant in
in this
this case
case
Norton Materials, Inc. produces concrete blocks, bricks, and
roofing tile. The controller prepared the following income
statements:
Blocks Bricks Tile Total
Sales revenue $500 $800 $150 $1,450
Less: Variable expenses 250 480 140 870
Contribution margin $250 $320 $ 10 $ 1300 580
Less direct fixed expenses: 730
Advertising $ 10 $ 10 $ 10 $ 57030
Salaries 37 40 35 112
20
Depreciation 53 40 10 103
77
Total $100 $ 90 $ 55 $ 103 245
200
Segment margin $150 $230 $- 45 $ 370 335
Less: Common fixed exp. 125
125
Operating income $ 245
210
 Keep-or-Drop
Keep-or-Drop Decisions
Decisions
Keep Drop
Sales $1450 1300
Variable expenses 870 730
Contribution margin 580 570
Direct fixed expenses
advertising 30 20
salaries 112 77
depreciation 103 103
Total 245 200
Segment margin 335 370
Common fixed exp. 125 125 Drop
Operating income $210 $245
Data
Data Blocks
Blocks Bricks
Bricks Tiles
Tiles Total
Total
after
after Sales
Sales 500-50 800-64 0 1186
Drops
Drops
$‘000 Variable
Variable 250-250*10% 480-480*8% 0 666.6
$‘000
costs
costs
Tom Blackburn determines that dropping the tile section will
reduce sales in all sections as follows: $50,000 for blocks,
$64,000 for bricks, and $150,000 for roofing tile. His summary
in thousands is shown below: Differential

Sales Keep
$1,450 Drop Amount to Keep
$1186 $264
Less: Variable expenses 870
666.6 203.4
Contribution margin $ 580
519.4 $60.6
Less: Advertising -30 -20 -10
Salaries -112 -77 -35
Total $ 438 $422.4 $15.6

Keep
Beware of Allocated Fixed Costs

Why should we keep the digital watch

segment when it’s showing a $100,000 loss?

The answer lies in the way we allocate

common fixed costs to our products.

Some allocation methods can make a

segment look less profitable than it really
is.
Make or Buy
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 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?

 Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 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
The special
special equipment
equipment hashas no
no resale
resale value
value
and
and is
is aa sunk
sunk cost.
cost.
 Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $17 $ 500,000

Direct materials $ 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
Not avoidable;
avoidable; irrelevant.
irrelevant. If
If the
the product
product is
is dropped,
dropped, itit
will
will be
be reallocated
reallocated to
to other
other products.
products.
Make
 Make
Make or
or Buy
Buy
Swasey Manufacturing currently produces an electronic
component used in one of its printers. Swasey must
produce 10,000 of these parts. Enough material is on
hand to make 5,000 parts. But the company can buy the
needed materials at a higher price, which may increase
direct materials to $1.5/unit.
The firm has been approached by a supplier who offers
to build the component to Swasey’s specifications for
$2.75 per unit. In this situation, the Receiving Dept.
labor will be $85 000.
Usually, the cost for the 10,000 parts is computed as
follows:
Total Cost Unit Cost

Rental of equipment $12,000 $1.20

Equipment depreciation 2,000 0.20
Direct materials 10,000 1.00
Direct labor 20,000 2.00
Variable overhead 8,000 0.80
General fixed overhead 30,000 3.00
Total $82,000
38000 $8.20
$3.8

Which items are irrelevant costs?

 Make
Make or
or Buy
Buy
The costs to make or buy 5,000 units are as follows:
Alternatives Differential
Make Buy Cost
Direct materials 7500 ------- 7500
Direct labor 10,000 ------- 10,000
Variable overhead 4,000 ------- 4,000
Purchase cost ------- $13,750 -13,750
Receiving Dept. labor ------- 8,500 - 8,500
Total $21500 $22,250 $-750

Make
Make
 Make-or-Buy Example
GE Company Cost of Making Part N900:

Total Cost for Cost

20,000 Units per Unit
Direct material $ 20,000 $ 1
Direct labor 80,000 4
Variable overhead 40,000 2
Fixed overhead 80,000 4
Total costs $220,000 $11

• Another manufacturer offers to sell GE the same part

for $10.
• Should GE make or buy the part?
• If the $4 fixed overhead per unit consists of costs that
will continue regardless of the decision, the entire $4
becomes irrelevant.
• ? Relevant costs/unit
=$11-$4=$7<$10 make
• If $20,000 of the fixed costs will be eliminated if the
parts are bought instead of made, the fixed costs that
may be avoided in the future are relevant.
• ？
Total relevant cost
=20 000+80 000+40 000+20 000=$160 000
Relevant costs/unit=$160 000/20 000=$8<$10 make
Special Order
 Key Terms and Concepts
A special order is a one-time order that is
not considered part of the company’s
normal ongoing business.

When analyzing a special order, only the

incremental costs and benefits are relevant.
 Special Orders
 Jet, Inc. makes a single product whose normal selling
price is $20 per unit and variable cost is $8 per unit.
 A foreign distributor offers to purchase 3,000 units for
$10 per unit.
 This is a one-time order that would not affect the
company’s regular business.
 Annual capacity is 10,000 units, but Jet, Inc. is currently
producing and selling only 5,000 units.

Should Jet accept the offer?

fixed costs are unaffected by the order.
 Special Orders
If Jet accepts the offer, net operating income
will increase by $?.
Increase in revenue: 3000*$10=$30 000
Increase in costs: 3000*$8=$24 000
Increase in net income: $6 000
 Special-Order
Special-Order Decisions
Decisions

An ice cream company is operating at 80 percent

of its productive capacity (20 million half gallon
units).
The unit costs associated with producing and
selling 16 million units are shown on the next slide.
Idle capacity: usually, the fixed costs will not be
affected
 Special-Order
Special-Order Decisions
Decisions
Variable costs:
Dairy ingredients $ 0.70
Sugar 0.10
Flavoring 0.15
Direct labor 0.25
Wholesale Packaging 0.20
price = $2.00
Commissions 0.02
Distribution 0.03
Other 0.05
Total variable costs $ 1.50
Total fixed costs 0.097
Total costs $1.597
 Special-Order
Special-Order Decisions
Decisions

An ice cream distributor from a geographic

region not normally served by the company has
offered to buy two million units at $1.55 per unit,
provided its own label can be attached to the
product. The distributor has agreed to pay the
transportation cost.
 Special-Order
Special-Order Decisions
Decisions
Variable costs:
Which costs
Dairy ingredients $0.70
are
Sugar 0.10
irrelevant?
Flavoring 0.15
Direct labor 0.25
Packaging 0.20
Accept the offer Commissions 0.02
Accept the offer
($0.10 x 2,000,000 Distribution 0.03
($0.10 x 2,000,000
== $200,000 more Other 0.05
$200,000 more
profit). Total variable costs $1.50
$1.45
profit).
Total fixed costs 0.097
Total costs $1.597
$1.45
 Quick Check 
Northern Optical ordinarily sells the X-lens for $50. The
variable production cost is $10, the fixed production cost
is $18 per unit, and the variable selling cost is $1. A
customer has requested a special order for 10,000 units
of the X-lens to be imprinted with the customer’s logo.
This special order would not involve any selling costs, but
Northern Optical would have to purchase an imprinting
machine for $50,000. What is the rock bottom minimum
price below which Northern Optical should not go in its
negotiations with the customer? There is ample idle
capacity to fulfill the order and the imprinting machine
has no further use after this order.

a. $50 b. $10 c. $15 d. $29

Variable production cost $100,000
Additional fixed cost + 50,000
Total relevant cost $150,000
Number of units 10,000
Average cost per unit =$15
• What does it cost Eastern Airline Co. to fly a customer on
a round-trip flight from Beijing to Shanghai?
• The Eastern normally charges ￥ 2000 for this round-trip
ticket. Suppose that before the departure, Eastern finds
that there are some spare seats and the ticket agents
decide to sell the ticket for only ￥ 160/ticket to attract
customers. Will this decision make profit?
The incremental cost is very small, around ￥ 20 for
beverages, because the other costs(the pilots, fuel, airport
landing fees…) are fixed.
• The relevant cost: ？
• The relevant revenue: ？
 Irrelevance of Past Costs
(sunk costs)
• Two examples of past costs are:

1 The cost of obsolete inventory

2 The book value of old equipment
 Example of Obsolete Inventory
• Suppose General Dynamics has 100 obsolete
aircraft parts in its inventory.
• The original manufacturing cost of these
parts was $100,000.
• General Dynamics can...
1 Remachine the parts for $30,000 and then
sell them for $50,000, or
2 keep them in storehouse.
• Which should it do?
 Example of Obsolete Inventory

Remachine keep
Difference
Expected future revenue
Expected future costs
Relevant excess of
revenue over costs
Accumulated historical
inventory cost*
Net loss on project
 Example of Obsolete Inventory
Remachine keep Difference
Expected future revenue $ 50,000 $ 0 $50,000
Expected future costs 30,000 0 30,000
Relevant excess of
revenue over costs $ 20,000 $ 0 $20,000
Accumulated historical
inventory cost* 100,000 100,000 0
Net loss on project $(80,000) $ (100,000) $20,000

*Irrelevant because it is unaffected by the decision.

Irrelevance of Book Value
of Old Equipment
The book value of equipment is not a
relevant consideration in deciding
whether to replace the equipment.

Why?

Because it is a past, not a future cost.

Two concepts about long-term assets

Depreciation is the periodic allocation of the cost

of equipment.

The equipment’s book value (or net book value)

is the original cost less accumulated depreciation.
 Example of Book Value
Computation
Suppose a $10,000 machine with a 10-year life
has depreciation of $1,000 per year.

What is the book value at the end of 6 years?

Original cost $10,000
Accumulated depreciation (6 × $1,000) 6,000
Book value $ 4,000
 Keep or Replace an Old Machine?
Old Replacement
Machine Machine
Original cost $10,000 $8,000
Useful life in years 10 4
Current age in years 6 0
Useful life remaining in years 4 4
Accumulated depreciation $ 6,000 0
Book value $ 4,000 N/A
Disposal value (in cash) now $ 2,500 N/A
Disposal value in 4 years 0 0
Annual cash operating costs $ 5,000 $3,000
 Relevance of Equipment Data
• In deciding whether to replace or keep
existing equipment, we must consider the
relevance of commonly encountered items:
• Relevant or irrelevant?
1 Book value of old equipment
2 Disposal value of old equipment
3 Cost of new equipment
 Book Value of Old Equipment
• The book value of old equipment is irrelevant
because it is a past (historical) cost(sunk cost).
• Therefore, depreciation on old equipment is
irrelevant.
 Disposal Value of Old Equipment
• The disposal value of old equipment is
relevant (ordinarily) because it is an expected
future cash inflow that usually differs among
alternatives.
 Cost of New Equipment
• The cost of the new equipment is relevant
because it is an expected future outflow that
will differ among alternatives.
• Therefore depreciation on new equipment is
relevant.
 Comparative Analysis
of the Two Alternatives
44 Years
Years Together
Together
Keep Replace
Keep Replace Difference
Difference
Cash operating
Cash operating costs
costs $20,000 $12,000 $ 8,000
4*5000 4*3000

Disposal value
Disposal value – (2,500) 2,500

New machine
New machine
acquisition cost
acquisition cost – 8,000 (8,000)

Total costs
Total costs $20,000 $17,500 $ 2,500
Sell or Process
 Joint Products
Oil

Common
Crude
Production Gasoline
Oil
Process

Chemicals

Split-Off
Point
 Joint Products
Joint
Costs Oil
Separate Final
Processing Sale

Common
Crude Final
Production Gasoline
Oil
Process Sale

Separate Final
Chemicals
Processing
Sale

Split-Off
Point
 Sell or Process Further: An
Example
• Sawmill, Inc. cuts logs from which unfinished
lumber and sawdust are the immediate joint
products.
• Unfinished lumber is sold “as is” or processed
further into finished lumber.
• Sawdust can also be sold “as is” to gardening
wholesalers or processed further into “presto-logs.”
 Sell or Process Further
Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

Are the Allocation joint product costs relevant or

irrelevant?
 Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Sales value after further processing
Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing
 Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

Should we process the lumber further

and sell the sawdust “as is?”
 Dow Chemical Company
——Joint Costs
• Suppose Dow Chemical Company produces
two chemical products, X and Y, as a result of
a particular joint process.
• The joint processing cost is $100,000.
• Both products are sold to the petroleum
industry to be used as ingredients of
gasoline.
 Illustration of Joint Costs

11million
millionliters
litersof
ofXXat
ataa
sellingprice
selling priceofof$.09
$.09==$90,000
$90,000
Joint-processing
cost is $100,000
500,000liters
500,000 litersof
ofYYat
ataa
sellingprice
selling priceof
of$.06
$.06==$30,000
$30,000

Totalsales
Total salesvalue
valueat
atsplit-off
split-off Split-off point
isis$120,000
$120,000
 Illustration of
Sell or Process Further
• Suppose the 500,000 liters of Y can be
processed further and sold to the plastics
industry as product YA.
• The additional processing cost would be $.08
per liter for manufacturing and distribution,
a total of $40,000.
• The net sales price of YA would be $.16 per
liter, a total of $80,000.
 Illustration of
Sell or Process Further
Sell at Split-off Process Difference
as Y Further and
Sell as YA
Revenue ? ? ?
Separable costs? ? ?
beyond split-off
@ $.08
Income effects ? ? ?
 Illustration of
Sell or Process Further
Sell at Split- Process Difference
off as Y Further and
Sell as YA
Revenue $30,000 $80,000 $50,000
Separable costs - 40,000 40,000
beyond split-off
@ $.08
Income effects $30,000 $40,000 $10,000
profitable use of a constrained resource
Key Terms and Concepts
When a limited resource of some type
restricts the company’s ability to
satisfy demand, the company is said to
have a constraint.

The machine or process that is limiting

overall output is called constraint.
 Utilization of a Constrained Resource
Operating income=contribution margin-fixed costs

When a constraint exists, a company should

select a product mix that maximizes the total
contribution margin earned since fixed costs
usually remain unchanged.
A company should not necessarily promote
those products that have the highest unit
contribution margin.
Rather, it should promote those products that
earn the highest contribution margin in
relation to the constraining resource.
Utilization of a Constrained Resource: An Example
Ensign Company produces two products and selected
data are shown below:
Product
No.1 N0.2
Selling price/unit $ 60 $ 50
Variable costs/units 36 35
Contribution margin/unit ? 24 ? 15
Current demand per week(units) 2000 2200
Contribution margin ratio ? 40% ? 30%
Processing time required on 1 min. 0.50 min.
machine A1/unit
 Utilization of a Constrained Resource

Machine
Machine A1A1 is
is the
the constrained
constrained resource
resource and
and is
is
being
being used
used at
at 100%
100% of
of its
its capacity.
capacity.
There
There is
is excess
excess capacity
capacity on
on all
all other
other machines.
machines.
Machine
Machine A1A1 has
has aa capacity
capacity ofof 2,400
2,400 minutes
minutes per
per
week.
week.
Should Ensign focus its efforts on Product No.1
or Product No.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 
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.
With 1 minute,
Product 1: $24 contribution margin,
Product 2: $15*2=$30 contribution
margin.
 Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.

Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.
 Utilization of a Constrained Resource

If
If there
there are
are no
no other
other considerations,
considerations, the
the best
best plan
plan would
would be
be to
to
produce
produce to
to meet
meet current
current demand
demand for
for Product
Product 22 and
and then
then use
use
remaining
remaining capacity
capacity to
to make
make Product
Product 1.
1.
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
perunit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.

Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product11 1,300
1,300 min.
min.
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)

Weekly
Weeklydemand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
perunit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.

Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product11 1,300
1,300 min.
min.
Time
Time required
required per
perunit
unit ÷÷ 1.00
1.00 min.
min.
Production
Production of ofProduct
Product11 1,300
1,300 units
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
(2  600) + (10  100 ) = 2,200 > 2,000
b. No
 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 Chairs Tables
b. 600 chairs and 80 tables Selling price $ 80 $ 400
Variable cost 30 200
c. 500 chairs and 80 tables
Contribution margin $ 50 $ 200
d. 600 chairs and 100 tables Board feet 2 10
CM per board foot $ 25 $ 20

Production of chairs 600

Board feet required 1,200
Board feet remaining 800
Board feet per table 10
Production of tables 80
 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 The additional wood would be
b. $25 per board foot used to make tables. In this use,
each board foot of additional
c. $20 per board foot wood will allow the company to
d. Zero earn an additional $20 of
contribution margin and profit.
 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:
 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 0.050
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 $ 0.569

$1.60 per gallon ÷ 32 MPG

$18,000 cost – $4,000 salvage value ÷
5 years
 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 0.050
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 $ 0.569

Which costs are relevant in Cynthia’s decision?

 Identifying Relevant Costs
Which costs are relevant in Cynthia’s decision?

The cost of the car is a sunk cost and is not relevant to

The
the cost ofdecision.
current the car

The annual cost of insurance is not relevant. It will remain

The if
the same annual cost of
she drives orinsurance
takes the train.

However, the costthe ofcost

gasoline is clearly relevant if she
of gasoline
decides to drive. If she takes the train, the cost would not be
incurred, so it varies depending on the decision.
 Identifying Relevant Costs

The cost of maintenance and repairs is relevant. These

The costdepend
costs of maintenance and
upon miles repairs
driven.

The monthlyThe
school parking
monthly fee isparking
school not relevant
fee because it
must be paid if Cynthia drives or takes the train.

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

$0.569 per mile are relevant and others are not.
 Identifying Relevant Costs
The round-trip train fare is clearly relevant. If she
drives the cost can be avoided.

Relaxing on the train is relevant even though it is

difficult to assign a dollar value to the benefit.

The kennel cost is not relevant because Cynthia will incur

the cost if she drives or takes the train.
 Identifying Relevant Costs
The cost of parking in NY 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.
 From a financial standpoint, Cynthia would be better off
driving to visit her friend. Some of the non-financial factor
may influence her final decision.

Relevant Financial Cost of Driving

Gasoline (460 @ $0.050 per mile) $ 23.00
Maintenance (460 @ $0.065 per mile) 29.90
Parking in New York (2 days @ $25 per day) 50.00
Total $ 102.90

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00
Beware of Allocated Fixed Costs

Why should we keep the digital watch

segment when it’s showing a $100,000 loss?

The answer lies in the way we allocate

common fixed costs to our products.

Some allocation methods can make a

segment look less profitable than it really
is.