Types of financial budgets and their organizational planning functions

Managerial Accounting

Differential revenues and costs are those that are incremental to the decision at hand. In general, the company should take on any project that adds to the profitability of the company. There is no indication that this project is mutually exclusive to any other decision. Thus, the financials for this product are as follows:

Herrestad Product C

Volume

Price

Revenue

Direct Materials

Direct Labor

Variable Overhead

Contribution

The variables that are relevant to this decision are what will be incurred as a result of taking on this project. Thus, fixed costs are not relevant. Variable revenue and variable costs are all relevant. Thus, the decision as to whether or not to take on this project resets on the contribution that the project offers to the company. If the project has a positive contribution to fixed costs, then it will improve profitability and therefore should be accepted. If the project does not have a positive contribution, then it will reduce the profitability of the company and should therefore be rejected.

The sale of this product therefore does not contribute the profitability at Herrestad. The contribution is negative, meaning that the production of this product, if sold at this price ($180) will lower the profitability of the company.

If the company is only willing to pay $160, the profitability of this product is, naturally, even worse:

Herrestad Product C

Volume

Price

Revenue

160000

Direct Materials

105000

Direct Labor

60000

Variable Overhead

40000

Contribution

-45000

If I was the manager, I would not accept this order. The product has a negative contribution at the price the customer is willing to pay, which means that the company is going to reduce profitability if this order is accepted. One of my roles as manager is to maximize profitability of the firm, so taking this order would undermine that.

It is important to consider that an increase in volume will not have an impact on the decision to take this order. Because the contribution is negative, this order will cost Herrestad money if the order size is 1 or 1,000,000. It is important that the customer pays an amount that will give the company a positive contribution, or without this the order should always be rejected.