Model Answer
0 min readIntroduction
In the realm of operations management, organizations frequently encounter situations requiring decisions about resource allocation and production mix. Relevant costing, a crucial managerial accounting technique, focuses on costs and revenues that differ between alternative courses of action. This question presents a scenario where a company with existing capacity for brake production must decide whether to continue with its current operation or utilize that capacity for the production of agricultural equipment. The decision hinges on maximizing profitability, considering both explicit costs and implicit opportunity costs. A thorough analysis of fixed and variable costs, alongside the potential profit contribution from each option, is essential to arrive at an optimal solution.
Understanding the Scenario
The company currently produces brakes. The question implies that the existing capacity is underutilized or that demand for brakes is insufficient to justify maintaining full production. An alternative use for this capacity has emerged: the production of agricultural equipment. This alternative is projected to cover all fixed and variable costs associated with utilizing the capacity and generate an additional profit of ₹1,00,000.
Analyzing Brake Production
The question doesn’t provide details about the profitability of brake production. However, it implicitly suggests that brake production is *not* generating a profit of ₹1,00,000. If brake production were more profitable, the question wouldn’t present the alternative. We need to consider the following:
- Fixed Costs: These costs remain constant regardless of production volume (e.g., rent, salaries of permanent staff).
- Variable Costs: These costs vary directly with production volume (e.g., raw materials, direct labor).
- Revenue: The income generated from selling brakes.
- Profit (or Loss): Revenue - (Fixed Costs + Variable Costs).
Without knowing the exact profit from brake production, we can only assume it is less than ₹1,00,000. If brake production is incurring a loss, the decision to switch is even more straightforward.
Analyzing Agricultural Equipment Production
The scenario clearly states that agricultural equipment production will cover all fixed and variable costs *and* contribute a profit of ₹1,00,000. This means:
- Revenue from Agricultural Equipment: Fixed Costs + Variable Costs + ₹1,00,000
- Profit from Agricultural Equipment: ₹1,00,000
This represents a guaranteed profit contribution, making it an attractive option.
Comparative Analysis
To clearly illustrate the comparison, let's consider a hypothetical scenario. Assume the brake production currently generates a profit of ₹50,000. The following table summarizes the comparison:
| Production Option | Profit Contribution |
|---|---|
| Brake Production (Hypothetical) | ₹50,000 |
| Agricultural Equipment Production | ₹1,00,000 |
Even in this hypothetical scenario, agricultural equipment production is more advantageous. If brake production is incurring a loss, the difference is even more significant.
Opportunity Cost
The concept of opportunity cost is crucial here. By continuing to produce brakes, the company forgoes the opportunity to earn ₹1,00,000 from agricultural equipment production. This forgone profit represents the opportunity cost of continuing brake production. Rational decision-making requires choosing the option with the highest net benefit, considering both explicit costs and opportunity costs.
Qualitative Factors
While the quantitative analysis strongly favors agricultural equipment production, some qualitative factors should also be considered:
- Market Demand: Is there a sustainable market for the agricultural equipment?
- Technical Feasibility: Can the existing machinery be easily adapted for agricultural equipment production?
- Skillset: Do the existing employees have the skills required for agricultural equipment production, or will retraining be necessary?
- Long-Term Strategy: Does agricultural equipment production align with the company’s long-term strategic goals?
Conclusion
Based on the information provided, switching to agricultural equipment production is demonstrably more advantageous than continuing brake production. The guaranteed profit contribution of ₹1,00,000 significantly outweighs any potential profit from brake production, especially considering the implicit suggestion that brake production is less profitable. While qualitative factors should be considered, the strong quantitative advantage makes the shift to agricultural equipment production the rational decision. Further investigation into market demand and technical feasibility is recommended before final implementation.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.