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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
financial management 47