Example 2: Franklin Company

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1 ACCTG 533, Section 1: Lecture: Profitability Analysis 2 Profitability Analysis 2 Profitability Analysis 2: Continuing on with our examples. Buy Make Unit selling price (stove) $340 $340 Volume (per month) Unit variable costs (for stove) $88 $95 Purchased handles (per unit) $8-0- Fixed costs $4,700 $5,500 Franklin Company manufactures wood stoves. It is discovered that it can buy the handles for its stoves at $8 per unit. The cost would be affected as follows: our selling price for the stove is $340 per stove, we sell 500 per month, the variable cost per stove if the handle is purchased would be $8 with an additional $8 to purchase the handle. If we make the handle, the variable costs are $95 per stove. The fixed costs if we buy the handle is $4700 and if we make the handle is $5500. Differential Analysis (500 units) Make Buy Difference Revenue $170,000 $170,000 Variable costs to produce (47,500) (44,000) 3,500 Variable costs of purchased parts (4,000) (4,000) Total contribution margin $122,500 $122,000 (500) 1

2 Fixed costs (5,500) (4,700) 800 Operating profit $117,000 $117, So one way to approach the differential analysis would be to compute the difference based on the entire 500 stoves that we produce and sell every month. So, the revenue would be the same: we re going to have $170,000 in revenue from selling 500 stoves. The variable cost to produce the stoves, however, differ. If we make the stove, it ll cost us $47,500 if we buy the stoves it ll cost us $44,000. So immediately we see a savings of $3,500 under the option to buy because it will cost us $44,000 instead of $47,500. But then we go on to the next line and see that if we re buying the handle we re going to incur an additional $4,000 to purchase the handles. So now we have $4,000 in additional costs resulting from the option to purchase. The total contribution margin ends up with a difference of an excess cost of 500 dollars if we decide to buy the handles instead of make them. But now when we move on to fixed costs we see that there s a savings of $800 in our fixed costs if we elect to buy the handles instead of make them. So the net result is there s a savings of $300 overall if we elect to buy the handles instead of making them. Buy Make Difference Unit variable costs $88 $95 Purchased parts (per 4-0- unit) Total unit variable $96 $95 ($1) costs 500 units $48,000 $47,500 ($500) Fixed costs $4,700 $5,00 $800 Savings to purchase $300 Another way to get the same answer would be to do it on a per stove basis and now we simply start out with our unit variable costs: $88 to buy and $95 to make, an additional $8 to buy the handle, so total unit variable costs of $96 versus $95. So a difference of $1, it ll cost us $1 more if we buy the handles. For 500 units, it ll cost us $500 more, but we have $800 in savings from our fixed costs, so we end up with $300 in savings if we opt to purchase the handles. So based solely on those numbers, we would elect simply to buy the handles and to stop making them. 2

3 2. What other factors should be considered? Quality needed and ability to control quality Transportation Volume changes Other suppliers if needed What other factors, however, should be considered? For Franklin Company, they need to think about what kind of quality they need in the handles and how important it is for them to be able to control the quality of the handles that they re including in the stove. Perhaps handles aren t very important, but, on the other hand, they are pretty important. If every time you tried to open the door of your stove the handle fell off, clearly there would be a problem in selling the stoves. So if they are convinced that the supplier will be able to provide the quality that they need and will continue to provide the quality that they need then they would go ahead and opt to purchase. They may also want to think about transportation. If there are problems in getting the part form the supplier to their location of if potentially problems could occur, that might be something to keep in mind. If volume changes. What if all of a sudden they get a big order and they re able to start selling 1000 a month? Would the supplier be able to provide the extra 500 handles that they would need if that kind of situation occurred? And then finally another factor that could be tossed in there is: What if they need other suppliers? What if something happens to the first supplier and all of a sudden they might need additional suppliers? So are there other suppliers that could be counted on to produce handles if they need them? So, again, other factors besides just the numbers need to be considered. The problem with considering them is that it s not as easy to weight them. I mean, there s not an automatic numeric scale that you can use for these other factors whereas with the numbers, the numbers added up and you ve got $300 in savings, so why not go with that? So, again, I m just pointing out that other factors are important as well. Example 3: Robert Company Selling price $180 $270 $240 Less variable expenses: Direct materials Other variable expenses

4 Total variable expenses Contribution margin $54 $108 $60 Contribution margin ratio 30% 40% 25% Next example: Robert Company. Robert Company manufactures three products: 101, 201 and sells for $180, has variable expenses of $126 and produces a contribution margin of $54 with a CM ratio of 30%. Product 201 sells for $270, produces a contribution margin of $108 with a CM ration of %40. Product 301 sells for $240, has a contribution margin of $60 and a CM ration of %25. The same raw material is used in all three products. Robert Company has only 5,000 pounds of the material that s needed on hand. It s not going to be able to obtain more for several weeks due to flooding in the supplier s plant. Management is trying to decide which product to work on in filling its backlog of orders. The material costs $8 per pound. Which order would you recommend that the company work on next week 101, 201, or 301? So it s assumed that there s a backlog of orders for all three. So in attempting to answer this question initially you might think to look at the CM ratio and you would immediately jump and say that we should work of 201 because 201 produces the greatest CM ration, it s 40%. Example 3: Robert Company Direct materials $24 $72 $32 Pounds used per product ($8/lb) Contribution margin $54 $108 $60 CM / pound used $16 $12 $15 However, when you are working with a constrained resource and that s the situation that we have here: it s the same raw materials that s used in all three products, we only have 5,000 pounds and we re not going to be able to get more for several weeks. So now we need to calculate the contribution margin per unit of constrained resource. So we take the direct material cost for 101, 201 and 301 and then we divide by $8 because, remember, the cost for the material was $8 per 4

5 pound. If we take 24$ and divide by $8, product 101 uses 3 pounds, product 201 uses 9 pounds and product 301 uses 4 pounds. The contribution margin for 101 is $54, for 201 is $108 and for 301 is $60. We take the contribution margin and divide it by the number of pounds that the product uses. $54 divided by 3 pounds gives a contribution margin per pound of direct materials of $16. For 201, the contribution margin of $108 divided by 9 gives a contribution margin per pound of $12 and the same computation for production 301 gives is $15. We now select product 101 because each pound of direct materials in product 101 produces $16 per pound of contribution margin. So if we only have 5,000 pounds of materials left, we need to maximize the contribution margin per pound of direct materials. So we will choose to work on product 101. Fixed costs are not usually affected by a constrained resource so the best action is to maximize the firm s total contribution margin. Example 4: Fidel Company Unit Total Direct materials $15 $450,000 Direct labor 8 240,000 Variable mfg. overhead 3 90,000 Fixed mfg. overhead 9 270,000 Variable selling expenses 4 120,000 Fixed selling expense 6 180,000 Total cost $45 $1,350,000 Production range: 25,000 to 30,000 Treats per year. Example four: Fidel Company. Fidel Company manufactures and sells a single product: The Treat. Operating at capacity, the company can produce and sell 30,000 Treats per year. The Treats normally sell for $50 each. Fixed manufacturing overhead is constant at $270,000 per year within a production range of 25,000 through 30,000 Treats per year. Costs associated with this level of production and sale are: we have direct materials of $15, direct labor of 8, variable manufacturing overhead of 3, fixed manufacturing overhead of 9, variable selling expenses of 4 and fixed selling expenses of 6. So a total product cost of $45. So for 30,000 Treats our costs would add up to $1,350,000. Our product range is 25,000 to 30,000 Treats per year so you can think of that as the relevant range. Due to the faltering economy, Fidel Company expects to sell only 25,000 Treats through regular channels next year. A government agency has offered to buy 5,000 Treats as a one-time purchase. The agency would pay $30 per Treat. There would be no variable selling expenses related to the order. Should Fidel Company accept this order? 5

6 The computation that you want to make this time looks like this (remember you only want to consider those things that will change, those elements that differ between the alternatives): Example 4: Fidel Company Differential Analysis Unit Total (5,000 Treats) Incremental revenue $30 $150,000 Incremental expense: Direct materials 15 Direct labor 8 Variable mfg. overhead 3 Tot. incremental exp ,000 Incremental profit $4 $20,000 Fixed costs do not change so are not relevant So, in this case, we will have a selling price of $30 (the agency has offered to give us $30 per Treat), the costs that will incur will be the direct materials of $25, the direct labor of $8, the variable manufacturing overhead of $3, and then remember we aren t going to have any selling expenses. So our total incremental expense is going to be $26 giving us an incremental profit of $4. For 5,000 Treats, we would make $20,000. So, yes, we should accept this special order because we would make an additional $20,000. Remember our fixed costs don t change so they re not relevant to our decision. 6