Nuances of Production Budget - Essay Example

product x product y product z £ per unit £ per unit £ per unit Standard costs Direct materials 200 480 360 Variable overhead 48 28 64 Rate per hour £ Hours per unit Hours per unit Hours per unit Department A 10 28 16 30 Department B 12 8 6 10 Department C 8 16 8 30 Unit Costs: product x product y product z Direct materials 200 480 360 Total Labor £ £504.00 £296.00 £660.00 Variable overhead £48.00 £28.00 £64.00 Total Unit Cost £752.00 £804.00 £1,084.00 Original Production Budget product x product y product z Unit sales 15000 12000 12000 Selling Price per Unit £ 840 880 1200 Contribution Margin £88.00 £76.00 £116.00 Contribution Margin % 10.48% 8.64% 9.67% Total Sales £12,600,000.00 £10,560,000.00 £14,400,000.00 Total Unit Costs £11,280,000.00 £9,648,000.00 £13,008,000.00 Total Contribution Margin £1,320,000.00 £912,000.00 £1,392,000.00 Fixed overhead(£2,400,000) Total Income £1,224,000.00 New Production Budget product x product y product z Projected Unit sales 18000 15000 15996 Selling Price per Unit £ 840 880 1200 Contribution Margin £88.00 £76.00 £116.00 Contribution Margin % 10.48% 8.64% 9.67% Total Sales 15120000 13200000 19195200 Total Unit Costs £13,536,000.00 £12,060,000.00 £17,339,664.00 Total Contribution Margin £1,584,000.00 £1,140,000.00 £1,855,536.00 Total Income £2,179,536.00 Profit Maximizing Production Budget product x product y product z Projected Unit sales 18000 15000 7800 Selling Price per Unit £ 840 880 1200 Contribution Margin £88.00 £76.00 £116.00 Contribution Margin % 10.48% 8.64% 9.67% Total Sales £15,120,000.00 £13,200,000.00 £9,360,000.00 Total Unit Costs £13,536,000.00 £12,060,000.00 £8,455,200.00 Total Contribution Margin £1,584,000.00 £1,140,000.00 £904,800.00 Total Income £1,228,800.00 1) The following current production budget was prepared at the end of our fiscal year following a recessionary period resulting in reduced demand for our product line. We have budgeted sales of 15,000 units for product X, 12,000 units for product Y, and 12,000 units of product Z for the coming fiscal year. In order to produce each product type separate labor requirements from department A, B, C are required at different stages of production in order to complete the production of each product type. Additionally each product type has a different variable cost rate for each unit manufactured. This variable cost rate for each department is allocated in order to cover costs such as machine time, electricity, maintenance, and equipment depreciation (Banker, Datar, Kaplan). As we can see our total production cost for each unit of product X, Y, Z consists of a variable cost rate and total labor from all three production departments. The total production costs for each unit of product X was £752, £804 for product Y and £1084 for product Z. Taking into consideration the total required units of production for each product line for the whole year, the total production costs for Product X was £11,280,000, £9,648,000 for Product Y, and £13,008,000 for Product Z. The total revenue for all three product lines was £37,560,000 with total variable production costs of £33,936,000.The fixed overhead costs budget for the plant, regardless of output level is £2,400,000 a year. Total income (total revenue - total variable costs – fixed costs) for the year utilizing the original production budget equals £1,224,000 (Imanet, 2008). 2) According to our sales manager there is a limitation on producing any additional units of production. Department B does not have any additional production capacity due to lack of skilled labor workers which to hire in order to accommodate any additional manufacturing output. By performing a cost volume profit analysis of our product line we can determine which product mixture will provide maximum profit maximization potential based on the manufacturing limitations with relation to Department B (Horngren, Foster, Datar, 2000). The contribution margin of a product provides the user with the amount in pounds that each individual unit sale contributes towards income after all variable expenses have been deducted. Through a comparison of the contribution margin percentage of all three product types we can plainly see that the most profitable product type is X with 10.48% or £88 per item sold. Although Product Z provides the highest gross margin amount with £116, it stands as the second most profitable product with a contribution margin percentage of 9.67%. Product Y is the least profitable with £76 or 8.64%.The company had previously estimated sales in units to be 15,000 of product X, 12,000 of product Y and 12,000 for product Z. Based on a recent up burst in global economic activity the market for each of the products has improved (Accounting4management, 2012). The sales director has recalculated the companys projected sales, he estimates that 20% more units of Product X will be required, 25% more units of Product Y and 33.33% extra units of Product Z will be needed for the coming fiscal year. In order to provide maximum profit maximization we should first produce the total required production units of the products with the highest contribution margins which are Product X and Product Z. Although Products X and Z produce the highest contribution margin percentages, the Department B labor costs associated with product Z are the highest, therefore this severely limits the total unit production for the year due to Department B constrains. Although Product Y has the lowest contribution margin percentage, the difference between Product Z and Y is only around 1%. Since the labor requirements from departments B for Y are the lowest, 6 hours vs. 10 hours for Product Z, the higher contribution margin percentage of Z does not offset the decreased total unit production of all units combined if the maximum units of Z were produced. Whatever labor resources of Department B are left over after the total production of the other more profitable products would be allocated towards manufacturing production of Z. Since we cannot increase the total labor hours of Department B, we have to calculate the total department labor hours available from the department for the coming fiscal year. By multiplying the previous unit sales estimates of each product type by the labor hours required from Department B for each product type, we can calculate the total labor hours available from Department B for the coming year. Total Available Hours; Department B Product X: 15,000 x 8 hrs. = 120,000 hrs. Product Y: 12,000 x 6 hrs. = 72,000 hrs. Product Z: 12,000 x 10 hrs. = 120,000 hrs. Total available hours Department B = 312,000 hrs. Based on the new sales estimates provided by our sales director we will need to manufacture up to 18,000 units of Product X, 15,000 of Product Y and 15,996 of Product Z. Therefore in order to maximize profitability we will produce the maximum number units of Product X and Y which provide the highest total gross income. Manufacturing 18,000 units of X will require 144,000 man hours from Department B and producing 15,000 units of Y will require 90,000 man hours from Department B. We have allocated a total of 234,000 hours for the production of Products X and Y exclusively, therefore we are left over with 78,000 labor hours of Department B for the production of Z. Based on this profit maximization scenario the total production of product Y will be 7800 units, based on the limitations of Department B (Garrison & Noreen, 2003). If all the production of this profit maximizing product mix is sold the total projected income for the year will be: (Total revenue of Products X, Y, Z) – (Total variable Costs) – fixed costs = Total Income before taxes (£15,120,000+£13,200,000+£9,360,000) - (£13,536,000+£12,060,000+£8,455,200) - £2,400,000 = (£37,680,000) - ( £34,051,200) - £2,400,000 = £1,228,800 3) a) Producing the most profitable product mix will provide maximum profitability only if your sales estimate for each product types are correct. There is a high possibility that the increase in demand for Products X and Y will not materialize which would leave the company with unsold inventory which would cut from the bottom line for the year. b) Based on this production scenario we are only producing 7,800 units of product Z which compared with the original sales estimates of 12,000 is only 65% of the original sale estimates and only around 49% of the updated sales projections. We will leave the majority of our customer base around 50% of our potential clients for Product Z without access to it which might prove highly negative to the long term economic future of the company. The unsatisfied customers will be put in a very uncomfortable position of our own making, which will cause us to loose a major proportion of our customer base leaving them with the only alternative of finding a suitable substitute for Product Z from our competitors. Unfortunately even if we are able to resolve the production issues with Department B and are able to step up production of product Z in the future we will probably permanently loose a great majority of those customers due to consumer dissatisfaction. c) The other valid issue to analyze is that the difference in contribution margin between the whole product line is extremely small, yet the risks associated with producing the profit maximizing product mix only amount to a difference of only £4,800 or a mere .3% of the final operating income (Tutorsonnet, 2011). 4) In order to increase production of Product X management can implement a few changes in order to optimize manufacturing. For example the company could improve production methods in order to minimize labor requirements and maximize operating efficiency from each production department, especially Department A which currently require 28 hours of labor and department C which currently uses 16 hours of labor per unit produced. It can also do further work on lowering material costs by minimizing material wastage. Additionally, if there is any additional room for maximizing production efficiency in order to lower the variable overhead inputs required from electricity and machine time can further help to drive production costs down (Fep, 2004). All these cost savings measure can help drive further demand for therefore hopefully increase overall sales for Product X by lowering the sale price (Fep, 2004). 5) Some aspects of the CVP analysis can be modified in order to accommodate multiple cost drivers. Although usually production units is the only cost driver, but if any additional variable costs are driven by units sales such as sales of an optional training course for learning to use your product this new cost driver can be added in the variable cost segment of the formula although the simple formula will have to be modified to accommodate a new cost driver (Prenhall). 6) The overall contribution to sales ratio or contribution margin can be improved by: Maximizing production efficiency through lowering direct material requirements and wastage. By streamlining production processes in order to eliminate and combine production procedures in order to minimize labor costs and variable overhead rate. The company could also decide to increase selling price of the product in order to increase its contribution margin (Carty, 2012). References Accounting4management.com (2012). Contribution Margin Definition. < http://accounting4management.com/contribution_margin_definition.htm> [Accessed 7 December 2012] Banker, R., Datar, S., Kaplan, R. Productivity Measurement and Management Accounting. [Accessed 7 December 2012] Carty, S.L. (2012). What Happens if the Contribution Margin Ratio Increases? [Accessed 7 December 2012] Fed.up.pt (2004). Cost and Cost Minimization. [Accessed 7 December 2012] Garrison, R., Noreen, E. (2003). Managerial Accounting (10th ed.). Boston: McGraw-Hill Irwin. Imanet.org (2008). Definition of Management Accounting. Retrieved December 7, 2012 from http://www.imanet.org/PDFs/Public/Research/SMA/Definition%20of%20Mangement%20Accounting.pdf Horngren, C., Foster, G., Datar, S. (2000). Cost Accounting: A Managerial Emphasis (10th ed.). New Jersey: Prentice Hall. Prenhall.com. Cost-Volume-Profit Analysis. [Accessed 7 December 2012] Tutorsonnet.com (2011). Profit / Volume Ratio, Improvement of P/V Ratio Homework Help, Tutoring. 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