Utilization of Scarce Resources

Choosing which products to manufacture and sell is a common managerial

decision. Managers are routinely faced with the problem of deciding how
scarce resources are going to be utilized.
Contribution in Relation to Scarce Resources
Illustrative Problem - Production Decision
Aeon Company makes two kinds of bread- hard rolls and soft rolls. Assume
that the company can sell all the bread it produces. Aeon's cost and revenue
information is presented below:
Hard Rolls
Sales Revenue per Unit
P9.00

Soft Rolls

P10.00

Less: Variable Costs per Unit

Materials

4.00

2.50

Labor

1.50

2.00

Variable Overhead

0.50

0.50

Total

6.00

5.00

Contribution Margin per Unit

P4.00

P4.00

Fixed Manufacturing Costs

: P800,000 per month

Marketing and Administrative Costs (all fixed) : P200,000 per month

The Problem of Multiple Constraints

Constraints may refer to limited availability of raw materials, limited direct
labor-hours available, limited capital available for investments and many
more. As more constraints and products are added, solving product mixes
becomes more complex. Although it is possible to solve these problems by
hand, they are typically solved by computer. The optimal proper combination
of "product mix" can be found by use of a quantitative method known as
linear programming which was covered in quantitative techniques.

Shut Down or Continue Operations

Shut down point= Fixed costs if operations are continued - Shut down costs
Contribution Margin Per Unit
Illustrative Problem
The ABC Company, now operating below 50% of its poractical capacity
expects that the volume of sales will drop below the level of 5,000 units per
month. An operating statement prepared for the monthly sales of 5,000 units
shows the following:

Sales ( 5,000 units at P3 )

P15,000

Less:
Variable Costs ( 5,000 units at P2 )
Non-variable costs
Net Income

P10,000

5,000

15,000
-0-

Shut down cost of P2,000 per month

Pricing Products and Services

The pricing decision can be critical because
1. the prices charged for a firm's product largely determine the quantities
customers are willing to purchase and
2. the prices should be high enough to cover all the costs of the firm.

Cost-Plus Pricing
The most common baisc approach in opricing decision is that the price of the
product or service should cover all the costs that are traceable to the product
and service, variable as well as fixed. If revenues are not sufficient to cover
these traceable costs, then the firm would be better off without the product
or service. In addition to treaceable costs, all products and services must
assist in covering the common costs of the organization. These common

costs may include general factory, selling and administrative costs. And of
course, the selling price should not only cover all the costs of the organization
but also provide a return on invested capital.
The Cost-Plus Pricing formula
Target Selling Price = [ Cost + ( Markup percentage x Cost) ]
Products however, may be costed in at least two different ways:
1. By the absorption approach where the cost base is defined as the cost to
manufacture one unit and therefore excludes all selling general and
administrative expenses.
2. By the contribution approach where cost base consists of all the variable
costs associated with a product including variable selling, general and
administrative expenses (SGA).
Illustrative Problem
Assume that Knox Company is in the process of setting a selling price on a
product that has just undergone some modifications in design. The following
cost estimates for the redesigned prtoduct have been provided by the
Accounting Department:
Per Unit
Total
Direct Materials
Direct Labor
Variable manufacturing overhead

P12
8
6

Fixed manufacturing overhead

P140,000
Variable selling, general and administrative expenses

Fixed selling, general and administrative expenses

120,000
The costs above are based on an anticipated volume of 10,000 units
produced and sold each period. The company uses cost-plus pricing, and it
has the policy of obtaining target selling prices by adding a markup of 50% of
unit manufacturing cost or by adding a markup of 100% variable costs.

Assuming that the company uses absorption costing approach to cost-plus

pricing, how much will the target selling price for one unit of product be?

Determining the Markup Percentage

To facilitate the computation of selling price, formulas can be used to
determine the appropriate markup percentage assuming that the desired
Return on Investment (ROI) and unit sales volume are given.
Under the absorption approach to cost-plus pricing:

Markup percentage on absorption cost= Desired return on assets employed SGA expenses
Volume in units x Unit manufacturing costs

Under the contribution approach to cost-plus pricing:

Markup percentage on absorption cost= Desired return on assets employed Fixed costs
Volume in units x Unit variable costs

Target Costing
This pricing approach is used when company will already know what price
should be charged and the problem will be to produce the product that can
be marketed profitably. Target Costing is the process of determining the
maximum allowable cost for a new product and then developing a sample
that can be profitably manufactured and distributed for that maximum target
cost figure.
The target cost is computed as follows:
Target cost = Anticipated Selling Price - Desired Profit
Illustrative Problem
Karate Auto Supply, Inc., is a producer and distributor of auto supplies. The
company desires to enter a rapidly growing market for long-life batteries that
is based on a newly discontinued technology. Management believes that to

be fully competitive, the new battery that the company is planning can not be
priced at more than P1,300. At this price, management is confident that the
company can sell 12,500 batteries per year. The batteries would require
permanent investment of P5,000,000 and the desired ROI is 20%. Compute
the target cost of one battery.