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Performance management
Ian Janes shows how to solve a problem featuring a minimum demand
constraint resulting from the existence of a contract with a penalty clause.
My previous article on decision-making budgeted unit contribution and resource We need to work out whether Scarsprey
concepts (November/December 2009) requirements of each of these products are should go ahead and satisfy the contract and
showed that a decision should be taken with shown in table 1. The kettles are made from then prioritise production in the normal way
reference to the relevant costs and benefits an advanced heat-resistant material that gives or whether it should consider breaching the
relating directly to it. In particular, it showed the firm a competitive advantage. An e-mail contract and incurring the penalty.
that the contribution per unit of scarce from the purchasing manager has informed us First, let’s look at the situation that would
resource can be used to prioritise production that, because of a problem with the supplier, occur if the firm were to fulfil the contract by
in cases where there are insufficient quantities it should be assumed that the year’s supply of considering once again the issue of
of one material. this special material is limited to 28,000kg. prioritising production. From table 1 we can
Let’s now extend the analysis to cover a We can also assume that, since Scarsprey see that Basic kettles would have a
situation where there is a minimum demand operates just-in-time production methods, contribution of $8.00 ÷ 2.00kg = $4.00 per
constraint owing to the existence of a opening and closing inventory levels are zero. kg of special material; Deluxe kettles would
contract containing a penalty clause for any The sales director has already accepted an have a contribution of $3.00 per kg; and
failure to fulfil its obligations. Suppose that order for 1,000 Deluxe kettles that, if not Super kettles would have a contribution of
the Scarsprey Company manufactures fulfilled, would incur a financial penalty of $3.50 per kg. This means that the order of
three types of kettle: Basic, Deluxe and $2,000. This order is included in the Deluxe’s production priority would be Basic first,
Super. The maximum market demand, maximum market demand figure. Super second and Deluxe third.
Of course, there is a more pressing priority
1 Key budgeting data for Scarsprey’s three makes of kettle if we are determined to satisfy the contract:
the company must make the 1,000 Deluxe
Basic Deluxe Super kettles before using the rest of the special
Maximum demand (units per year) 4,500 2,000 4,000 material to make Basic kettles, then Super
Contribution per kettle ($) 8.00 15.00 28.00 kettles and then – if there’s any material left –
Special material used per kettle (kg) 2.00 5.00 8.00 more Deluxe kettles (see table 2).
The contribution resulting from this
production plan is as follows:
2 Production plan if the contract is to be honoured
n 4,500 Basic units x $8.00 = $36,000.
Basic Deluxe Super Total n 1,000 Deluxe units x $15.00 = $15,000.
Minimum units to satisfy contract 1,000 n 1,750 Super units x $28.00 = $49,000.
Special material required for contract 5,000kg 5,000kg This makes a total contribution of $100,000.
Now we can consider the impact of
Units to satisfy max demand (Basic) 4,500 0 1,750
breaking the contract and whether doing so
or use remaining resources (Super)
is financially worthwhile. To do this, we simply
Material to be used in production 9,000kg 0 14,000kg 23,000kg ignore the requirement for a minimum of
of Basic and Super kettles 1,000 Deluxe kettles and, using fundamental
Material available and used 28,000kg principles, reformulate the production plan as
Total number of units produced 4,500 1,000 1,750 in table 3. The contribution resulting from this
revised production plan is as follows:
3 Production plan if the contract is to be broken n 4,500 Basic units x $8.00 = $36,000.
n 2,375 Super units x $28.00 = $66,500.
Basic Deluxe Super Total This makes a total contribution of $102,500
Units to satisfy max demand (Basic) 4,500 0 2,375 – ie, an increase of $2,500 on the first plan.
or use remaining resources (Super) With practice, you should be able to take a
Material to be used in production 9,000kg 0 19,000kg 28,000kg shorter, more efficient route to the new
of Basic and Super kettles situation: by not making 1,000 Deluxe kettles,
we release 1,000 x 5kg = 5,000kg of material.
Material available and used 28,000kg
This was yielding a contribution of 1,000 x
Total number of units produced 4,500 0 2,375 $15.00 = $15,000, which is now sacrificed to

46 financial management
PAPER P2

make way for alternative n What are the long-term effects


production ($15,000 of vacating the market for exam practice
could be described as Deluxe kettles? It’s likely that
the opportunity cost). Scarsprey’s rivals would move Try the following question to test your
Instead, we can use quickly to fill the gap. understanding. The solution will appear
5,000kg of material to make Clearly, Scarsprey will want in CIMA’s student e-magazine, Velocity
5,000kg ÷ 8kg per unit = to get to the root of the (www.cimaglobal.com/velocity).
625 more Super kettles. problem: the dearth of special Assume that one year has passed
These kettles will yield material. So, working from the since the situation described in the main
contribution of 625 x $28.00 = revised plan, if the company is able text arose for Scarsprey, but that the
$17,500, which represents the same increase to find extra material from elsewhere, then restriction on the supply of specialist
of $2,500 we calculated before. clearly it should do so, as long as the material remains – ie, only 28,000kg of it
Alternatively, the rate at which contribution premium* for each kilogram (the cost over is available for the coming year.
was earned on Deluxe kettles was $3 per kg, and above that already being paid) is less All other information is as previously
but is $3.50 per kg on the Super kettles. The than $3.50. Since the contribution per stated, except the following:
scarce 5,000kg of material is, therefore, now kilogram of material used in producing the n Scarsprey has rebranded the Super
earning $0.50 more per kg, representing an Super kettle is $3.50, this would make it kettle as a premium product and has
increase in contribution of $2,500. worthwhile to obtain material from another increased the selling price such that it
Whichever way you look at it, the revised supplier. This figure is referred to as the yields a contribution of $34 per unit.
production plan increases contribution by shadow (or dual) price of a kilogram of But this means that the maximum
$2,500, which exceeds the $2,000 financial material, but will stay at $3.50 per kg only as demand for Super kettles has fallen to
penalty for breaking the contract. long as the material is being used to make 2,000 units this year.
In simple financial terms, there is a net gain Super kettles – ie, up to the maximum n The sales director has taken an order
of $500 for failing to honour the contract and demand of 4,000 units. In this case it would for 800 Deluxe kettles that, if not
redirecting scarce resources. Indeed, as long be another 1,625 units x 8kg = 13,000kg. supplied in full, would incur the same
as the penalty is less than $2,500, it would be Once the maximum demand for Super penalty as before – ie, $2,000. This
financially worthwhile for Scarsprey to breach kettles is satisfied, any further special material quantity is included in the maximum
the contract. But this isn’t the complete that can be found would in theory be used to market demand figure of 2,000 units.
picture, since a range of non-financial factors make Deluxe kettles, when the maximum You can continue to assume that,
that have financial implications need to be premium to be paid would then switch to $3 since Scarsprey operates just-in-time
considered if a good decision is to be made. per kg. But by now we’re looking at finding production methods, the opening and
Key issues to consider in this case include: about 50 per cent more material than we first closing inventory levels are zero.
n Will the customer, whose contract we thought was available, so this seems unlikely You are required to:
would have reneged on, ever come back – as indeed is making enough of these units 1 Formulate the company’s optimum
to us for more business? to avoid the financial penalty. production plan for the year, including
n Should the news of our failure to fulfil a Decision-making problems in P2 involve a an evaluation of whether it’s financially
contract become common knowledge in degree of complexity that you may not have worthwhile for the company to breach
the trade, then the damage to Scarsprey’s seen in your earlier studies. In this case, we the contract.
reputation and the consequent loss of considered whether it was financially 2 State the shadow price of a kilogram
goodwill could amount to far more, in worthwhile to breach a contract in order to of the specialist material and calculate
terms of lost sales and contribution, than increase contribution levels. Such a choice the quantity (in kilograms) of material
the net gain of $500. should come with a warning, because non- to which this price applies.
n Will the decision to make only two types of financial issues such as damage to goodwill,
kettle instead of three have a harmful a loss of reputation and a reduction in future
effect on customer loyalty and sales sales and contribution must all be considered. * Note that we refer to the premium for each kilogram,
demand? This could happen if the since the normal cost of a kilogram of material, which
customers are retailers who wish to offer Ian Janes is CIMA course leader at we assume remains the same, is already factored into
as wide a range of products as possible. Newport Business School. the contribution per unit.

financial management 47

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