IGCSE OPERATIONS MANAGEMENT

THE PRODUCTION/OPERATIONS MANAGER IS RESPONSIBLE FOR:

(a) Choosing the method of production that will increase production and productivity.
(b) Ensuring quality of products
(c) choosing the best location for operations

Productivity

It is the measure of output in relation to input used

It also measures the efficiency of the business
An efficient business uses resources in a cost effective way that is more output is realized after using few
resources.
𝑜𝑢𝑡𝑝𝑢𝑡
𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠

= ------- units per employee

OR
𝑜𝑢𝑡𝑝𝑢𝑡
= 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 ℎ𝑜𝑢𝑟𝑠 𝑢𝑠𝑒𝑑

= units per hour

e.g. in 2003 a business produced 8 000 chocolate bars 500 employees were available. Calculate labor
productivity.
8 000
𝐿𝑎𝑏𝑜𝑢𝑟 𝑃𝑟𝑜𝑑𝑢𝑐𝑖𝑣𝑖𝑡𝑦 = 500

= 16 chocolates per employee

In 2004 12 000 bars were produced using 500 employees. Calculate labor productivity and suggest
reasons for the change as compared to 2003.
12 000
𝐿𝑎𝑏𝑜𝑢𝑟 𝑃𝑟𝑜𝑑𝑢𝑐𝑖𝑣𝑖𝑡𝑦 = 500

= 24 chocolates per employee

Ways of increasing productivity

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  Training existing staff helps employees to be fast and less wasteful. It also increases output per
worker. BUT, it is costly to train. Output is lost during training due to wastages and low work
rate. Trained workers can also become marketable and leave the organization.
 A change in production lay out which helps to eliminate time wastage caused by movement.
 Motivation through performance related payment (piece rate system) which forces employees
to produce more in a given period.
 Effective supervision, which means employees, did not waste time.
 Use of high quality raw materials that are supplied in time. These means production stoppages
are limited.
 Upgrading of machinery. This helps to eliminate leakages of raw materials and down time.
 Use of automated equipment. This reduces labour costs. Increase output. BUT, machines are
expensive to buy. Redundancy payments can be high. Re-training costs can be incurred. Labour
unrest can rise due to a genuine fear of being replaced by machines.

In 2010 6 000 bars were produced using 500 employees. Calculate labour productivity and suggest
reasons for the change.
6 000
𝐿𝑎𝑏𝑜𝑢𝑟 𝑃𝑟𝑜𝑑𝑢𝑐𝑖𝑣𝑖𝑡𝑦 = 500

= 12 chocolates per employee

Causes of decrease in labour productivity

 Ineffective supervision such that employees wasted production time.

 De-motivation of employees which means employees were not putting extra effort leading to
low output.
 Use of old equipment which lead to an increase in leakages and down time.
 Supply chain problems which led to delays in receiving raw materials.

Benefits of increasing productivity

 The cost per unit is reduced because fixed costs will be spread over many units.
 Profitability is increased because more goods will be produced at a lower cost.
 The business will have competitive advantage by producing at a lower cost as compared to
competitors
 Employees can be motivated if high profits are used to increase their salaries.

NB: Inefficiency means input output ratio is low. It also means productivity is low leading to high cost
per unit, loss of competitiveness and failure to satisfy orders.

Labour intensive production

It implies the use of human labour as compared to machinery. This means labour costs will dominate the
production costs. Usually, it is used when the business has limited capital, is serving a small market or if
it intends to create a hand-made image for its products. Labour intensive production may fail to produce

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many goods because human beings can become tired and can be inconsistent which can compromise on
the quality of products.

Capital intensive Production

It implies use of machinery in the production process as compared to labour. The production costs will
be more machine related, output will be high and unit costs will be low. If the business uses this
method, it will benefit from:

(a) Uniformity of products which reduces returns inwards or customer complaints.

(b) Increased output which enables a business to satisfy the needs and wants of a lot of customers.
(c) It reduces labour costs which enables a business to make more profits.
(d) Products will be made quickly which means customer orders can be satisfied on time.

Disadvantages

(a) It requires a lot of capital investment which increases set up costs.

(b) It increases machine related expenses like depreciation and maintenance can reduce profits of a
business.
(c) It may require employees to possess operating skills which means training expenses can be
increased.
(d) It may de-motivate employees because of retrenchments and the fact that work will become
repetitive.

Factors considered when choosing a method of production

(1) The size of the market: if the market is large, capital intensive production will be appropriate
because more output will be produced.
(2) The image the business intends to create: if the business intends to create a handmade image,
labour intensive production will be appropriate.
(3) Availability of finance: if financial resources are available, the business will afford to buy
machinery, hence it will be capital intensive.
(4) Government laws: if the laws restrict the use of machinery at the expense of human labour. The
business must use labour intensive production.
(5) Nature if product: if the product is standardized or uniform, the business can be capital
intensive.
(6) Impact on the cost per unit: the business must use a method that is cost effective so that it will
have competitive advantage. This means the method that produces at lower cost per unit
should be employed. For example, the business produces calculators and is currently labour
intensive. If it employs 100 people who are paid $500 per month. If any given month 10 000
calculators are produced. Management is thinking of introducing machinery and it focused that
costs will be at $40 000 and output will be at 15 000 per month (calculators). Calculate

(a) Cost per unit if labour is used

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 (b) Cost per unit if machinery is used
(c) Advise management on the way forward
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Cost per unitLabour = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

100𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠 ×$500
= 1 000

= $5 per calculator
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
Cost per unitCapital = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

$40 000
= 15 000

= $2.67 per calculator

Advice: The business must adopt capital intensive production because it reduces the cost per unit by
$2.33 per unit.

Exercise:

Given that the number of employees is 200. Average wage is $ 600 per week. Total output per week 800
000 units. Calculate: (a) output per employee per week. (b) labour cost per unit.

Quality

It is the ability of the product to meet customer expectations or to serve its purpose (fitness for
purpose).

Reason for ensuring quality

(1) It helps to reduce customer complaints which mean they can even recommend the quality
product to their friends. This will in turn help to increase sales.
(2) It helps to reduce reworking costs that is costs associated with amending faulty products. This
means the business will not waste time but concentrate on increasing good production.
(3) It helps to create and maintain the image of the business or brand loyalty. These customers will
continue to buy products made by the business which can lead to long product life cycles.
(4) It allows a business to charge a premium of high prices on its products. This will also increase
sales as customers may become less sensitive to price changes.

Problems of poor quality: [CIE N12, P12, Q2d.]

(1) loss of confidence by customer [k] so less sales [an] as customers look for alternative
suppliers (an)
(2) cost of rectification [k] e.g. rework products [an] which will increase costs and could lead
to lower profit [an]
(3) costs of fines/legal action [k]
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 (4) damage to reputation/image [k] so it can cost the business when trying to rebuild los
image (an)
(5) inability to supply on time [k] so could lose important future orders [an].

NB: ensuring quality can increase the expenses of a business because quality controllers may need to be
employed, employees trained and high quality raw materials purchased or bought.

The methods of ensuring quality

1) Training employees: this will improve quality because they will possess the skills required in
production. This means they will do the right thing the first time for example mix the ingredients
correctly , cut cloth pieces correctly or serve customers quickly
2) Inspection: The business can take samples of end product and test it for quality. If products are
not conforming to quality or to standards, the production process will be adjusted and faulty
products reworked for example a manufacturer ob beans can take a few bottles and test
whether the chemical composition is the right one.
3) Continuous improvement or Kaizen: This when an organization keeps on finding new ways of
doing things. The organization will not be satisfied with the status quality, this means the
production quality will be constantly revised and product quality will be improved.
4) Bench marking: it is when a business compares its products to those of the market leader and
tries to improve its products. This means the quality of market leader will be a standard or a
bench mark that has to be reached or surpassed.
5) Quality circles: it is a group of employees who volunteer to meet regularly so as to discuss
production problems and finding ways to improve them. This will help to improve the quality of
products because new ways will be employed in production.

Quality Control versus Quality Assurance

Quality control refers to inspecting the final product and checking whether it is meeting standards. It is
more of reactive approach as corrections will be done after detecting/finding problems.

Quality assurance refers to setting up quality standards across the organization or at all stages of
production. It is a preventative approach to quality.

Input Production Process Output

Feed forward centre/preventative methods Concurrent controls Feedback controls/post action

Controls

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Feed forward controls are measures implemented by the business to ensure that inputs are of high
quality. These include materials, labour and equipment. The methods are proactive, that is they are
implemented before problems occur.

Concurrent controls – these are measures implemented along production process so as to ensure
quality. Goods will be inspected for quality as they will be running on the production line. It is also a
proactive quality approach.

Feedback controls – this involves inspecting of the final product for quality. Poor quality products will be
condemned and changes will be made in the production process. It is a reactive approach to quality.

Inventory management

Inventory refers to items (raw materials, work-in-progress and finished goods) held by the business for
use or for resale purposes. [CIE 15, P13, Q4b.] It includes raw materials, work- in- progress and finished
goods. The production manager must ensure that the business has right quantities of inventory at any
particular time.

Reasons for holding inventory

(1) To meet unexpected increase in demand this helps to maintain customers.

(2) To avoid production stoppages due to stock outs when suppliers fail to deliver goods on time.
(3) It helps to hedge against inflation or price increases.

Problems of Holding Inventory

(1) Capital is tied up in inventory which means the business may have cash flow problems.
(2) It increases storage expenses like insurance, warehouse rent, security costs which can reduce
profit.
(3) Inventory can become out of date or absolute which can reduce the profits of a business.

Methods of Controlling Inventory

(1) Just In Time

It is a method of production where goods are only produced if there is a market order. This
means the business will not keep inventory of raw materials and finished goods. This method
helps to eliminate or reduce storage costs, security expenses, costs associated with inventory
becoming obsolete and capital is freed for other purposes. HOWEVER, just-in-time requires
reliable suppliers of raw materials, flexible employees and the business may also lose bulk
buying discounts.

Production Methods

(a) Job/Unit Production

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 It is the production of individual goods according to customer specifications or requirements.
Each order will be unique and will have to be completed before moving to the next. It can be
used to produce custom made vehicles or clothes, wedding cakes and construction of buildings.

Advantages

 Employees are motivated; hence, quality products are made. This is because they have the
sense of completion or they will be associated with the finished product.
 Customer needs are satisfied which leads to more sales. This is because the goods will be toiler
made to meet their requirements.
 Less capital is required to set up operations. This is because simple tools are used in operations.

Disadvantages

 Cost per unit is usually high which means the goods may not be affordable to customers. This is
because the absence of the absence of economies of scale or short production runs.
 It requires highly skilled employees which can increase labour costs. This is because the method
requires flexible employees who are able to perform a variety of operations.
 Production is usually slow which means customer orders may not be satisfied on time. This is
because of the use of simple tools and varied designs.

(a) Batch production

It is when products are made in groups/blocks, followed by another group/block.

Features (CIE – s10 12, 1c)

 Production is done in discrete groups because usually batches are in response to

market demand
 products in the same batch/block are identical
 variations can be made between batches
 products in the same block/batch pass through the same stage of production together before
moving to the next.
 machinery can be adjusted/re-set when changing to the next batch
 Each product is made in a set. So, once the whole set has been completed the next one
(or modified version) can be started.
 Change-over time needed as modified batches are produced.

It can be used in bakeries to produce bread, rolls and muffins.

Advantages

 A variety of customer needs are met due to the production of varied products e.g. different
flavors of biscuits.
 It gives some variety to workers’ jobs. So employees are motivated to produce quality products.

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  Product cost is relatively low (due to economies of scale) as compared to job production. This
means the goods may be affordable to customers.
 Production is not seriously affected if machinery breaks down.

Disadvantages

 Production time is lost due to change- overs since machines have to be re-set between
production batches.
 Inventory levels are high which increases holding expenses of finished or semi-finished products.
 Warehouse space is needed for stocks for stocks of raw materials and components.

(2) Flow/Line/Mass/Continuous Production

It implies production of similar products in large quantities using a continuous process.

Features (CIE – s10 11 Q1c)

 flow implies a continuous (24 hour) movement of products along a line, continuous flow
means that products move from one operation to another without interruption
 It is normally done for the production of fluids but solid and identical products e.g. cars can also
be assembled using this method
 Each product will move from one stage to another independently.
 Production is capital intensive.
 The products are standardized/uniform/identical
 The production line is divided into processes or units e.g. cleaning, filling, capping and labeling
 it is an inflexible process
 associated with high volumes of output

Advantages of flow production

 Production costs are low which means the products can be sold at a lower price, leading to high
sales. This is because the goods are produced in large quantities which help the business to
enjoy economies of scale.
 Production is fast due to the use of machines. This means customers’ orders can be met quickly.
 Unskilled labour is used which reduces labour costs since low pay and little training is needed.
 Capital intensive production methods are used, therefore reducing labour costs, leading to
increased efficiency
 The firms may benefit from economies of scale in purchasing
 Time is saved, since there is no need to move goods from one part of the factory to another as
with batch production.
 It leads to high output of standardized products hence leading to large volumes of quality
products

Disadvantages

 Expensive machinery is required. This will delay the setting up of operations.

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  Work is repetitive which can de-motivate the employees as they will be doing the same thing
over and over again leading to a reduction in efficiency.
 It is an inflexible method, which means the needs and wants of customers may not be met. This
is because goods are usually standardized or uniform.
 If one machine breaks down, the whole production line will have to be halted

Factors Considered when choosing a method of production

 Nature of the product – job production is used if a unique product specifically tailored to
customer requirements. Flow production can be used if it is possible to mass produce the
product.
 Size of the market: if the market is large, flow production will be used because large quantities
of goods will be produced. BUT, if demand is higher and more products can be sold, but not in
very large quantities, batch production will be used. Small local markets or niche markets will be
served by businesses using batch or job production. International markets are served by
businesses using flow production.
 The capital /financial resources available/ size of the business: if capital employed is limited, we
must use job production because it does not demand complex machines. Small businesses are
more likely to use job or batch production.
 Availability of skilled labour : if skilled labour is available, the business can use job production as
it require employees with a variety of employees.

NB: A business can change from one form of production to another as time progresses. Such changes
may require additional capital and space and may also affect the level of motivation of employees.

Lean Production

These are techniques adopted by a business to improve efficiency and reduce wastage. Techniques
include just-in-time and continuous improvement. By adopting lean production, the business will:

 Improve the quality of products, which can lead to more customers

 Increased profitability by eliminating wastage of raw materials and reducing inventory holding
costs.
 Become competitive because the cost per unit will be reduced through continuous
improvement.

Outsourcing/Subcontracting

It is when a business allows another to perform its operations, for example, a cell phone manufacturer
can allow another business to manufacture batteries or software on its behalf. The business can also
sub-contract another to provide transportation services to its employees or cleaning services or
accounting services. This means the business will concentrate on its core activities.

Benefits of outsourcing (CIE - s10 11 Q1d)

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  High quality products can be made because the components or services will be provided by
specialists.
 It reduces the need for space which reduces rental expenses. This is because the business will
not keep a lot of raw materials.
 It gives the business flexibility, especially if there is a change in customer requirements. This is
because the business can just terminate contracts with old suppliers and just find new ones.
 means of increasing output without increasing capacity, so not having to add capacity
would mean no need for capital outlay
 removes need to employ as many people
 saves time
 lower unit costs
 do not have to hold as much stock, so holding less stock would be cheaper because of
reduced storage requirements

Disadvantages (CIE – s10 12 Q2d)

 It increases the quality control costs because the business must inspect bought in components
from time to time to see whether they are conforming to requirements.
 Customers may doubt the products quality if some of the components is supplied by businesses
with a bad reputation.
 Production can be disrupted if suppliers are not reliable.
 might result in loss of control of quality
 might produce late delivery due to lack of reliability
 higher costs to manufacturer due to profit margin of other firm
 extra transport costs
 the other firm could go out of business.

Factors considered when choosing a supplier

 Quality of raw materials or services: this is because the quality of raw materials will affect the
quality of the final product.
 Reliability of the supplier: this is important so as to avoid production stoppages.
 Terms of trade: this is important because transport costs may be reduced if the supplier (local or
foreign) offers delivery. It may also help to preserve the liquidity position of the business if the
supplier offers credit supplies.
 Prices charged: this is important because it will affect price of the final product.
 Product range offered: a supplier with a wide product range is preferable because time is not
wasted switching from one supplier to the other.

INDUSTRY

Location factors – Qualitative and Quantitative

Factor

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  Availability of power
 Market

Relocation

It refers to a process of moving operations to another place or area. This is done because of:

(a) The need to benefit from low taxes

(b) The need to benefit from cheap labour or skilled labour
(c) Rising rentals
(d) Depletion/exhaustion of raw materials e.g. mines
(e) Rising competition
(f) The need for more space
(g) The need to be close to customers

Production Cost

This is expenditure incurred in converting raw materials into finished goods or bringing products to their
present location or condition. Costs can be classified according to their behavior i.e. fixed and variable
elements.

Fixed costs

They do not vary or change with a change in output, that is, they remain the same over a given level of
activity, for example, rent, salaries for supervisors, depreciation.

Costs ($)

Fixed costs

0 1 2 3 Output

Variable Costs

 They change with a change in output.

 That is they increase as output increases or and decrease as output decreases, for example
direct wages , cost of raw materials and packaging costs, stock costs, component costs.
 They are also called direct costs:
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 Costs ($) Variable Costs

0 1 2 3 Output

NB: the distinction between fixed and variable costs is important as it facilitates decision making, for
example when making pricing decisions, when finding ways of reducing costs, when preparing budgets
and under break-even analysis.

Total Costs

Costs ($)

Total Costs

0 1 2 3 Output

It is the sum of fixed and variable costs.

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠

Where total variable costs = units produced ×variable costs per unit. For example, a business produces
textbooks and provided the following: rent = $1 000, paper cost per book = $2.00. the business
produced 2 000 books, calculate:

(a) Total fixed costs

(b) Total variable costs

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 (c) Total production costs

Total fixed costs = $1 000

Total variable costs = cost/unit × units produced

= $2/unit × 2 000 units

= $4 000

Total production cost = Total Fixed Costs + Total Variable Costs

= 1 000 + 4 000

= $5 000

Production Cost per Unit/Average Cost

𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝐶𝑜𝑠𝑡𝑠
This is expenditure incurred in producing one unit. 𝑈𝑛𝑖𝑡 𝑐𝑜𝑠𝑡 =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑

5 000
=
2 000

= 2.50 per book.

Break – even analysis

It is they study of the relationship between sales, fixed costs, total costs of production and output so
as to establish the break-even point. A break-even point is a point where a business does not make
profit or incur a loss. It is a point where sales revenue is equal to total costs. The point can be
determined graphically or by use of a formula.

Graphical Approach

Steps

(1) Draw the sales revenue line

(2) Draw the fixed costs line
(3) Draw the total cost line

NB: dollars will be shown on the y-axis and output on the x-axis.

For example, a business produces tables and provided the following information. Fixed costs = $500.
Selling price per table = $10 and variable costs per table = $5. The business sold 200 tables. Draw a
break-even chart.

(1) Sales revenue line

output 0 50 100 150 200

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 $ 0 500 1 000 1 500 2 000

Sales revenue = Selling Price/Unit × Output

(2) Fixed cost line

Output 0 50 100 150 200

$ 500 500 500 500 500

(3) Total cost line

Output 0 50 100 150 200

$ 500 750 1 000 1 250 1 500

Sales Revenue Line

Revenue/Costs

($)

Break-even point Total Cost Line

PROFIT REGION

1 000

Fixed Cost Line

LOSS REGION

Margin of Safety

0 50 100 150 200 Output

Break-even output Maximum output

Break-even point

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It is the level of production or sales at which the business does not make profit or incur a loss. A low
break-even point is desirable because the business will quickly make profit and it will have a wide
margin of safety.

Margin of safety

It is a measure of how far a business will be from making a loss. It is calculated as follows: Maximum
output in units/dollars – break –even units/dollars. It is therefore an assessment of risk associated with
different levels of activity. A wide margin of safety is desirable as the business will not be close at
making a loss.

Margin of safety = maximum output – break even output/units

= 200 tables – 100 tables

= 100 tables

Profit or loss = sales revenue – total costs

= selling price per unit – [Fixed costs + variable cost per unit × units sold]

Profit at 200 tables = $2 000 – $1 500

= $500

Break- even by Calculations

Fixed Costs
Break − even in units =
Contribution per unit

Break even in dollars = Break even units × Selling price per unit

= 100 × 10

= $1 000

Assess the usefulness of break- even analysis in decision making (20).

Break even analysis is the study of the relationship between sales revenue, output and total costs. The
tool can be used to make decisions like choosing between options, price determination, choosing a
method of production and output determination.

Firstly, break even analysis can be applied when choosing between options. Generally, the option with a
low break -even point and a wide margin of safety is desirable. This is because it will be a less risk form
of investment because more profits will be realized. For example, given two products A and B as shown
below:

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 A B

Sales revenue

Revenue/Costs Revenue/Costs

$ $ Sales revenue

Total costs Total costs

Fixed costs Fixed costs

0 50 200 Output 0 150 200 Output

In this case, product A will be desirable because of the low break- even point of 50 units as compared to
150 units for product B.

Another area of application is when determining prices. This is because management can study the
effects of reducing prices on the break-even point. If they decide to reduce the price, the break-even
point will be pushed further. This means the business will not make a profit quickly.

Break even can also be used when determining output. This is because it shows the profits that are
earned at different levels of activity. Generally, a high level of activity will help the business to earn
more profits. Management can therefore motivate employees by showing them a break even chart so
that they understand the need to increase output.

The method can also be used when choosing a method of production that is, between capital and labour
intensive production. Generally, capital intensive methods can help reduce total cost, but can also
increase fixed costs. Management can therefore analyze the overall effect of a method on cost
reduction and the break- even point.

HOWEVER, break even analysis can be of limited use because it is based on assumptions like: (i)
everything that is produced will be sold (ii) costs can be easily classified into fixed and variable costs (iv)
the goods are sold at one price and profits increase as output increases. This is not realistic in practice
because businesses can have closing inventory, profits may decrease as output continue to increase due
to diseconomies of scale and there are other factors which affect production and sales like employee
motivation and quality.

IN A NUTSHELL, despite the limitations, break even analysis is useful in making decisions but should be
used with other tools to achieve the best results.

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Other tools/Other Applications of Cost Information

When making decisions, a business may ignore fixed costs and just use variable costs. This is because
fixed costs are unavoidable, that is, they will be incurred even if there is no production. Such decisions
include make or buy, accept or reject a special order and close a department or drop a product.

Make or Buy Decision

This is when a business is considering stopping producing a product and start outsourcing. The business
must compare the buying in price and the marginal cost/variable cost of production. The general
principle is, we buy if – Buying in price is less than variable/marginal cost.

For example, a school produces bread and its variable costs per loaf are $0.60. The school has an option
to buy bread from Proton at $0.50 per loaf. Should the school make or buy? $0.50 versus $0.60

DECISIONS: we buy because the buying price is $0.1 lower than variable cost per unit. NB: other factors
like quality and the reliability of the supplier should be considered too.

Closing down A Department or Dropping A Product

A department or a product making a zero or negative contribution must be closed or dropped. This is
because it will not be contributing anything to the covering of fixed costs. For example, given:

Product A B C
Variable costs/unit 30 39 33
Selling Price/unit 40 41 30

Which product should be dropped and why?

Contribution calculations:

Product A B C
Selling Price/unit 40 41 30
Variable costs/unit 30 39 33
Contribution/unit 10 2 -3

Product C should be dropped because it has a negative contribution.

Special Order

It is when customers offer to buy products at a price lower than the normal price. The business must
accept the order if special order price is greater than variable/marginal costs. Accept if special order
price/unit > variable/marginal cost per unit. That is, it must be positive contribution. It is normally
applied if a business has idle capacity. For example, a bakery has a maximum capacity of 100 000 loaves.
Normally it sells a loaf at $0.90. It is approached by a school with a request to buy 5 000 loaves at $0.65

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per loaf. The cost of ingredients and labour per loaf is $0.5. Should the bakery reject or accept the
special order?

Special order price – Variable cost = contribution

$0.65 - $0.5 = $0.15

Decision: accept because it produces a positive contribution.

NB: when making decisions, a business must also consider qualitative factors not just quantitative
information.

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