Question

Aston International Products Ltd manufactures four products A, B, C and D. The budget for the upcoming financial year is as follows:

Details	A	B	C	D	Total
	$’000	$’000	$’000	$’000	$’000
Direct materials	20,000	10,000	12,000	24,000	66,000
Direct labour	6.000	4,000	7,000	8,000	25,000
Variable overheads	2,000	1,000	3,000	6,000	12,000
	28,000	15,000	22,000	38,000	103,000
Sales	50,000	19,000	18,000	52,000	139,000
Contribution	22,000	4,000	(4,000)	14,000	36,000
Fixed costs	(8,000)	(6,000)	(2,000)	(7,000)	(23,000)
Profit/(loss)	14,000	(2,000)	(6,000)	7,000	13,000

Required:

Give the company three (3) reasons why orders for Product C should be rejected with immediate effect.

Explain to the company why orders for Product B should be rejected even though it makes a positive contribution.

What could management do to ensure that the production and sale of Product B is profitable?

Do a summary budget for the company to show how profits would be impacted if Product C alone was shut down from the mix.

Advise management on two (2) strategies that could be adopted to earn income if Product C was shut down from the mix.

What are differential costs.

Identify the relevant costs in the budget.

Answer 1

1) Orders for product C should be rejected with immediate effect due to the following reasons:

• Poduct C is having negative contribtuion margin which means this product is not able to cover its variable cost and expenses from its sales. If the company keep making this product they will experiance losses. Hence, the order for Product C should be rejected immediately.
• If the the order for Product C is discontinued then the company could use its freed up resources like machinery and employees for making additional units of another product which are more profitable or make a new product.
• another purpose? Could the company make additional units of another product or make a new product? Assessing these alternatives helps the company decide if there is something more profitable it could do instead.
• Fixed cost could also be eliminated if order for Product C is rejected. Only those types of fixed cost would be eliminated which are direct attributable to the Product C, like rent expense on building or warehouse which is only used for Product C. Resultant to which company's overall profit would be increased.

2) Order for product B should be rejected even though it makes a postive contribution because contribution margin is not high enough to cover its fixed cost.  Remember that after covering the variable costs, those selling prices must then cover the fixed costs in order to achieve profits. Product B is a loss making produc so comany should stop making this.

3) Management should adopt the below alternatives to make product B profitable-

• Raise Selling Prices
• Reduce Variable Cost, or
• Do some combination of the first two.

4) If product is elimiated from product mix then the revised profit as per budget is given below-

Details	A	B	D	Total
	$’000	$’000	$’000	$’000
Direct materials	20,000	10,000	24,000	54,000
Direct labour	6000	4,000	8,000	18,000
Variable overheads	2,000	1,000	6,000	9,000
	28,000	15,000	38,000	81,000
Sales	50,000	19,000	52,000	121,000
Contribution	22,000	4,000	14,000	40,000
Fixed costs	-8,000	-6,000	-7,000	-23,000
Profit/(loss)	14,000	-2,000	7,000	19,000

Please note - The above profit has been calcuated on the basis of assumption that fixed cost would also be eliminated for prouct C while shutting down the production for Product C.

5) Management could adopt the below two strategies to earn income if product C was shut down-

• The company could use its freed up resources like machinery and employees for making additional units of another product which are more profitable or make a new product, resultant to which overall profit of the company would be increased.
• Any idle resources like building, machinery could be given on rent to outside in order to earn income on that idle assets.

6) Differential cost refers to the difference in cost between two or more possible business decisions. When faced with situations that require choosing a solution, business managers must choose the most viable alternative. More often than not, cost and profit are the bottom-line figures that will influence their decision. Managers must determine the cost of both options and see the difference to be able to make a sound decision.

7) A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Relevant cost in the budget are as follows-

• Direct Material
• Direct Labor
• Variable overheads

The above noted costs are the relevant costs which shall continue to be incurred if the order of product still to be continues but it shall be reduced to zero if the order discontinues.