Accounting Business Reporting for Decision Making

436 Accounting: Business Reporting for Decision Making

Coconut Plantations has only 270 000 machine hours available for production, which is not enough to

meet all production requirements (370 000 hours). In addition, the entity is planning an advertising cam-

paign particularly for online customers, and the marketing department wants to know which product

should be promoted as the funds available will only support one product. Therefore, it is necessary to

focus on the production limitation, which in this example is machine hours, to determine how to maxi-

mise profits. The first step is to calculate the contribution margin per machine hour for each product by

dividing the contribution margin per unit by the machine hours required per unit.

Candles Soaps Detergents

Contribution margin per unit

Machine hours per unit

Contribution margin per machine hour

$10

1 hour

$10 per hour

$18

4 hours

$4.50 per hour

$5

1.5 hours

$3.33 per hour

The contribution margin per machine hour highlights that, although the soap product provides the

highest contribution margin per unit ($18), it only provides a contribution margin per hour of $4.50

compared with the candle product, which provides a contribution margin of $10 per machine hour.

Therefore, when faced with a machine hour shortfall, the candles will maximise the entity’s profit by

providing a $10 contribution margin per machine hour compared with that of the other products, and

should be the focus of the advertising campaign. To highlight how profit is maximised, let’s compare the

total contribution margin if only one product was produced within the 270 000 hours available.

Candles Soaps Detergents

Machine hours per unit

Total units in 270 000 hours

Contribution margin per unit

Total contribution

1 hour

270 000

$10

$2 700 000

4 hours

67 500

$18

$1 215 000

1.5 hours

180 000

$5

$900 000

The total contribution is maximised by producing 270 000 units of candles as they contribute an

additional $1 485 000 profit over the soap product’s contribution to profit. However, if there was no

machine hour constraint, then the most profitable product would be the product that gives the highest

contribution margin per unit, which for Coconut Plantations is units of soap, which would contribute

$18 per unit to profit compared with $10 per unit of candles and $5 per unit of detergents. Therefore,

in order to maximise profits it is important that the entity identifies any constraints which may impact

on output.

10.8 Relevant information for decision making

LEARNING OBJECTIVE 10.8 Assess relevant information for decision making.

Business decisions usually involve the selection of one alternative over another. An entity may need to

choose whether to accept or reject a one-off customer order, or whether to make a product or deliver

an activity in-house or purchase it externally (known as make or buy or outsourcing). It is impor-

tant that decisions are based on the right information, and this requires identifying relevant costs and

income. Relevant costs and relevant income are those that differ among alternative courses of action,

with the focus being on identifying incremental income and incremental costs, which represent the

additional income/costs resulting from an alternative course of action. It is also important to identify if

there is an opportunity cost (i.e. what is given up if one alternative is chosen over another) as a result

of the decision. For example, if an entity can lease space that has become empty due to outsourcing

a production activity, the loss of rental income would be considered an opportunity cost if the out-

sourcing did not take place. However, remember that the financial analysis is only one input into the