2,500 To 10,000 In Two Years: Growth Of Veganism Reflected In Annual march

Each extra unit sold would, therefore, generate an extra $10 contribution (selling price direct costs). Hence, accepting the order would actually add to the overall profits for the firm by $3,000*(300*$10 contribution). Providing the selling price exceeds the additional cost of making the product, and then this contribution on each unit will add to profits.Other issues concerned with accepting the order: It will also help the firm to utilize any spare capacity that is currently lying idle. For example, if a firm is renting a factory, then this will represent an indirect cost for the firm. It does not matter how much of the factory is used, the rent will remain the same. By accepting this order the firm may also generate sales with new customers or, via word-of-mouth, with other customers. The firm will have to decide whether the attractions of extra orders and higher sales outweigh the fact that these sales are at a lower selling price than normal. It will want to avoid having too many of its sales at this discounted price, as this lower price may start to be seen as normal. Customers already paying the higher price may be unhappy and demand to be allowed to buy at this lower price.Although the lower price is above the marginal cost of production, it may be that the firm does not cover its indirect and direct costs if too many are sold at the low price. Tough the contribution sold on these discounted units is positive; sales still have to be high enough to allow for enough unit contributions to cover the indirect costs. Orders at Below Cost Price Click on the image to enlarge it and THEN print it Buying in products: Increasing profit can be achieved either by increasing the selling price, which depends on the impact on sales, or reducing costs can increase profits. One possible way to reduce costs for a firm that uses manufactured goods would be if an alternative supplier could be found who can manufacture and sell products (or part of the products, such as components) for a lower price than the present costs of the firm producing these for it self. If this is the case then the firm will have a choice of whether to continue making the products or to buy them in from a supplier.Considerations: When making this decision a firm would probably consider the possible impact on its workforce. If production is being reduced there is likely to be a reduction in the size of the workforce needed. Unless the firm can retrain the workers for other functions within the firm, such as sales, redundancies are likely to occur. This could lead to industrial action or reduction in productivity as seeing co-workers their jobs may demotivate employees.The firm will also have to ensure that the supplier of the product is reliable. If they are located some distance away then the lead-time for delivery will become an important factor. Problems with delivery could lead to production bottlenecks, whereby overall production is halted or orders cannot be met due to unreliable suppliers. This is a particular problem if the firm is adopting just-in-time (JIT) production techniques.The quality of the products will also have to be monitored closely. Depending on the size of the order, the firm may be able to demand their own specifications for the order. On the other hand, if the firm is only a small customer of the supplier, it may have to accept the suppliers own specifications.If the firm does decide to buy in components or products from another supplier, it may close down all or part of the production facilities, unless alternative uses can be found, such as producing goods for other firms. If closures do take place this will save the firm fixed costs in the long-term, although the firm may be committed to paying some of these for the next few months. For example, rent or insurance may be payable annually without rebate if the service is no longer required.Contribution and full costing: When costing, a firm can use either contribution (marginal) costing, whereby the fixed costs are kept separate, or it can apportion overheads and use full costing. If the firm uses full costing then it has to decide how the overheads are to be apportioned or allocated to the different cost centers.Methods of allocating indirect costs: One of the easiest ways to allocate indirect costs is to split the overheads equally between the different cost centers. However, although easier to decide, splitting the indirect cost equally may not be as fair as it initially appears. Methods of allocating indirect costs: Chase Ltd. produces office furniture. It has decided to classify its different products as profit centers. The direct costs incurred in the production of each product are as follows: COMPUTER WORKSTATION SWIVEL CHAIR STANDARD DESK Material costs $20 $15 $10 Labor Costs $25 $8 $12 Packaging and finishing $5 $7 $3 TOTAL DIRECT COSTS $50 $30 $25 Along with the direct costs of production there are also indirect costs that are not specifically related to the production procedure. These total $90,000. Further data relating to Chase Ltd. is as follows: COMPUTER WORKSTATION SWIVEL CHAIR STANDARD DESK Annual Output 5,000 3,000 4,000 Selling price $75 $45 $35 We can produce a costing statement that highlights the costs and revenues that arise out of each profit center: COMPUTER WORKSTATION ($) SWIVEL CHAIR ($) STANDARD DESK ($) Sales Revenue Materials Labor Packaging ang finishing Total direct costs Contribution 375,000 100,000 125,000 25,000 250,000 125,000 135,000 45,000 24,000 21,000 90,000 45,000 140,000 40,000 48,000 12,000 100,000 40,000 If a firm wishes to work out the profit made by each profit center then the overheads will have to be allocated to each one. In the example below, overheads are allocated equally: COMPUTER WORKSTATION ($) SWIVEL CHAIR ($) STANDARD DESK ($) Sales Revenue Materials Labor Packaging and finishing Indirect costs Total costs Profit 375,000 100,000 125,000 25,000 30,000 280,000 95,000 135,000 45,000 24,000 21,000 30,000 120,000 15,000 140,000 40,000 48,000 12,000 30,000 130,000 10,000 It is worth noting that the firms overall profit should not be any different whether it uses contribution of full costing. All that changes is how it deals with the costs-either apportioning them out to the cost or profit centers for full costing or deducting them in total from the total contribution of the centers for contribution costing. If the indirect costs are allocated, the decision about how to allocate them will affect the profit or loss of each profit center, but it will not affect the overall profit of the firm.Allocation rules: Allocating overheads equally is the simplest and quicker means of apportioning indirect costs, but many managers do use other allocation rules. In some cases they also use different allocation rules for different types of indirect costs-this is known as absorption costing. Although these do not attempt to allocate the indirect costs accurately (in the sense that indirect costs cannot clearly be allocated to different cost centers), they attempt to take account of relevant factors that might affect the extent to which different cost centers incur the indirect costs. For example, overall heating costs might be allocated according to the floor space of different departments.Typical Allocation Rules include:Typical indirect costs are connected with the staff of the firm, and then allocating overheads on the basis of labor costs may be suitable. Example of staff costs would include canteen expenses or the costs associated with running the human resources department.For manufacturing firms, the basis of allocating indirect costs may be related to the materials costs incurred by each cost center. This will depend on the costs centers within the organizationIf a firm is operating in an industrial sector using expensive equipment, then the overheads may be allocated on the basis of the value of machinery in each cost center. This is because maintenance, training and insurance costs may be related to the value of machinery in a loose way. In some ways these rules are no more or less accurate than dividing their indirect costs equally although they may appear to be intuitively appealing and in some sense feel fairer.Consequences of unfair overhead allocation: We can rationalize over the reason chosen for the basis of overhead allocation; however, we must realize that no method is perfect. Costs being apportioned require a method to be chosen independently, precisely because there is no direct link between the cost and the cost center. The method chosen can have unfortunate effects on the organization as a whole. If the firm uses departments as cost centers then it is possible that using absorption costing could lead to resentment by staff. This can be illustrated through the following example. Hopkinson Ltd. has decided to allocate fixed overheads using labor costs as the basis of allocation. Fixed overheads for the organization total $360,000 and will be allocated on the basis of labor costs (i.e. in the ratio 2:3:4) between the three branches. A ($) B ($) C ($) Sales Revenue Labor Costs Materials Costs Other Direct Costs 165,000 40,000 20,000 10,000 240,000 60,000 30,000 10,000 300,000 80,000 40,000 10,000 Fixed overheads Profit/loss 80,000 15,000 120,000 20,000 160,000 10,000 Allocating overheads in this way gives the result that branch B generates the highest profit and branch C is the least profitable. The staff at branch C may be labeled as poor performers. This could lead to demotivation, rivalry between branches and lower productivity. Staff at branch C may also be worried that promotions or bonuses may not be available to them due to rating lowest out of three branches. However, this result is arrived at only because the high fixed overheads were allocated in these ways. If we ignored the fixed costs and considered contribution only, the following results occur: A ($) B ($) C ($) Sales Revenue Labor Costs Materials Costs 165,000 40,000 20,000 240,000 60,000 30,000 300,000 80,000 40,000 Other direct costs Contribution 10,000 95,000 10,000 140,000 10,000 170,000 Based on contribution costing, branch C provides the biggest input into earning money for the firm.The problems that can occur when allocating overheads can lead arguments between managers over how they should be divided up. To boost their particular divisions performance, managers will eager to change a method that shifts some of their indirect costs onto another division.In some ways, however, it does not matter what rules are used to allocate indirect costs. Whichever rule is used is inaccurate (by definition indirect costs cannot be clearly be associated with a particular cost center) but the actual process of allocating overheads makes everyone aware of their importance and of the need to monitor and control them. Furthermore, provided the rules are not changed over time, managers will be able to analyze the trend profit figures for different departments, products or regions. A significant increase in indirect costs will decrease the profits of all business units to some degree, regardless of how these costs are allocated. If the indirect costs continue to rise, all the managers will be able to notice this trend in their accounts.If we use the full costing method of allocating indirect overheads then we can illustrate how this information may be used to make a strategic decision in terms of closing down an unprofitable business.In the following question, we will look at the costing data for Beynons Ltd., as small family chain of bakeries. The chain is owned and managed as a family concern, with the father, James Beynon, has been convinced of the merits of segmental reporting. He is worried because his youngest son, who he considers to be inexperienced in retail management, runs the branch. Consider the following breakdown of costs: HIGHFIELDS ($) BRWONDALE ($) NORTON ($) Sales Revenue Staffing costs Supplies Branch running Marketing Central admin. 22,000 7,000 5,000 1,000 2,000 4,000 17,000 8,000 4,000 1,000 2,000 4,000 26,000 9,000 6,000 1,000 2,000 4,000 Other direct costs Contribution 19,000 3,000 19,000 (2,000) 22,000 4,000 The marketing and central administration costs incorporate many of the overall costs associated with running the bakery chain. They are indirect and not related to any one branch in particular. These have been allocated equally across all three branches, as it seemed to be the fairest method of cost allocation.The data in the above appears to confirm the fathers belief that in the long-term interest of the firm, he may have to close down the Browndale branch and concentrate his efforts on the other two branches. If we use contribution costing, however, we see a different picture: HIGHFIELDS ($) BRWONDALE ($) NORTON ($) Sales Revenue Staffing costs Supplies Branch running 22,000 7,000 5,000 1,000 17,000 8,000 4,000 1,000 26,000 9,000 6,000 1,000 Total costs Profit (loss) 19,000 3,000 19,000 (2,000) 22,000 4,000 As we can see, all three branches make a positive contribution to the overall profits. The reason why the father wished to close down the branch was that it appeared to be making a loss. However, it is quite the reverse; if the branch was closed then, the positive contribution from the branch would be lost and overall profits would fall. This is because the indirect costs of production do not vary with output and, therefore, closure of a section of the firm would not lead to immediate savings. This may mean that closing the branch would be a mistake on financial grounds.This mistake is made due to a misunderstanding of nature of cost behavior. If the branch is closed then the only costs that would be saved are the costs directly related to the running of the branch: the staffing costs, the supplies and the branch running costs. The costs are indirect in nature, in this example the marketing and central administration costs, would still have to be paid as they are unaffected by output. For this decision to be made, we should use contribution as a guide for deciding whether or not to close a branch.The Beynons Ltd. example highlighted that contribution is a guide to keeping a branch open that, if we used full costing, could make a loss. This can also be applied to the production of certain product lines, or the cost effectiveness of departments. On financial grounds, contribution is therefore, a better guide in making decisions. Total ($) Overall Contribution Indirect Costs Profit 23,000 18,000 5,000 Continuing production even if the contribution is negative: It is possible that a section of a firm, be it a product line or branch, is kept open even though on financial grounds that particular section is making a negative contribution to the overall profit levels of organization. The reason for this is that closing down a section of a business is likely to lead a firm shedding labor that becomes surplus. The workers employed in that section may no longer be required.If alternative employment cannot be found within the firm then these workers may be redundant. This could impose redundancy costs upon the firm. It is likely that trade unions will be involved that may oppose any redundancies. This could lead to industrial action by workers in other sections of the firm. It may also lead to bad publicity in the media, which may affect the level of sales and profits. In this situation, a business may let natural wastage occur in staff involved, rather than make job cuts, or it may simply decide to keep the section going. Even if there is industrial unrest, the effect of closure on overall morale within the firm could be very important. It is likely that the remaining employees will be demotivated on seeing c0-workers being made redundant. This could lead to unrest, and declining productivity.In the case of a loss-making product, a firm may decide to keep this in production if it has been recently launched. In the early years of product life cycle, sales are likely to be lower than they are expected to be in later years and, as a result, the contribution may be negative. Sales will hopefully eventually rise and the revenues arising from sales will eventually outweigh the costs of running this new product.Complementary products: A loss-making product may also be kept in production because the firm produces complementary products. In this situation a firm may be willing to incur negative contribution in order to maintain or even boost the sales of its other products. Examples of complementary products include:Pottery firms dinner plates, saucers and cupsTextile firms bed sheets, pillowcases and duvet coversAn Example A firm is producing garden furniture, selling parasols, tables and chairs. These form the basis of different cost centers for the firm as they are produced in different sections. The firm has produced the following contribution costing statement: PARASOLS TABLES CHAIRS Sales Revenue Labor Costs Material Costs Other direct costs Contribution 7,000 2,000 2,000 1,000 5,000 2,000 5,000 1,000 500 2,000 3,500 1,500 4,000 1,000 2,000 1,500 4,500 (500) As you can see from the data in table 5.13, the chairs are making a negative contribution and would appear to be lowering the overall profits for the firm. Closing down production of the chairs would appear to lead to higher profits. The profits may be boosted further if the production of the chair producing facility saved some of the indirect costs.It is important to consider the impact on the sales of other products. With a firm selling garden equipment is likely that the three separate products will be purchased together as they form part of a matching set. If the production of one of these complementary products is halted, then it is likely to adversely affect the sales of the other products. This could mean that discontinuing the production of a product with a negative contribution leads to lower overall profits.You may like using the Break-Even Analysis and Costing Analysis JavaScript for performing some sensitivity analysis on the parameters for investigation of their impacts on your decision making.Further Reading:Schweitzer M., E. Trossmann, and G. Lawson, Break-Even Analyses: Basic Model, Variants, Extensions, Wiley, 1991.Modeling the Bidding Process in Competitive MarketsDue to deregulation in most market such as the electrical power markets, the cost minimization utilities used by electric utilities are being replaced by bidding algorithms. Every firm is trying to maximize their profit subject to the price determined by suppliers, consumers and other participants. Finding an opt