Decisions Involving

Alternative Choices
Learning objective
Types of Decisions related to cost
accounting.
Steps of decision making
Relevant and irrelevant Cost
Features of Relevant Information
Terminology


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Types of Decisions

One Time Special Order
Make or Buy/Insoursing or outsourcing
Selection of a suitable product mix
Effect of change in price
Maintaining a desired level of profit
Diversification of products
Closing down or suspending activities
Alternative course of action

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Types of Decisions
Own or Lease
Retain or Replace
Export or Local sales
Expand or Contract
Take or Refuse order
Place special orders
Select sales territories
Sell at split-up point or process further

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Decision-making steps
1. Identify and define the problem
2. Identify alternative as possible solutions to
the problem.
3. Eliminate alternatives that are clearly not
feasible
4. Collect relevant data (costs and benefits)
associated with each feasible alternative
5. Identify cost and benefits as relevant or
irrelevant and eliminate irrelevant costs and
benefits from consideration.

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Decision-making steps
6. Identify to the extent possible, non-
financial advantage and disadvantage about
each feasible alternative.
7. Total the relevant cost and benefits for
each alternative
8. Select the alternative with the greatest
overall benefits to make a decision
9. Implement or execute the decision
10. Evaluate the results of the decision
made.
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Relevance
Relevant Information has two
characteristics:
It occurs in the future
It differs among the alternative courses of
action
Relevant Costs expected future costs
Relevant Revenues expected future
revenues

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Relevant Cost: Example
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Terminology
Incremental Cost the additional total
cost incurred for an activity
Differential Cost the difference in total
cost between two alternatives
Incremental Revenue the additional
total revenue from an activity
Differential Revenue the difference in
total revenue between two alternatives

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One-Time-Only Special Orders
Accepting or rejecting special orders when
there is idle production capacity and the
special orders has no long-run implications
Decision Rule: does the special order
generate additional operating income?
Yes accept
No reject
Compares relevant revenues and relevant
costs to determine profitability
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Special Orders
SG limited manufactures 30,000 units of product T per
month. The plant has a capacity to manufactures 48,000
units per month.
SP is $20/ Unit
VC for manufacturing is $7.5/ Unit
VC for marketing is $5/ Unit
FC for manufacturing is $135,000
FC for marketing is $60,000
A buyer has offered to buy 5000 additional unit @$11/unit.
Should SG limited accept the offer?


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Special Order Illustration
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Sell Now or Process Further
Assume that the product being offered
can either be sold currently as is for a
certain sum or processed further, with
additional costs, at which time it can be
sold for a greater amount than now.

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Sell now at $500, Process
Further & sale it at $ 1000
Cost per unit to
date
Further Cost per
unit to complete
Material $300 $200
Labor 200 100
Var. OH 100 100
Fixed OH 200
Total $800 $400
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Sell Now or Process Further
The product is being discontinued and its
price has fallen. If the product is processed
to completion it can be sold for only $1,000.
If sold now they will bring in $500.
What should the management do?
Should the management incur $400 more
cost knowing the management will end up
losing money overall? Is this throwing good
money at bad?
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Differential costs
Sell
Now
Process
Further
Difference
Revenue $500 $1,000 $500
Current
costs
800 800 0
New costs 0 400 <400>
Total costs 800 1,200 <400>
Profit <300> <200> 100
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Sunk Costs
Cost that have already been incurred
and cannot be changed.
Not relevant to any decision
Cost of $800 already incurred in the
previous example are sunk and should
be ignored. They do not change the
situation in any way.
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Make or Buy
Often a company will purchase an ingredient
externally that is part of what they are
making.
They could make this ingredient internally if it
is to their benefit to do so.
These decisions usually only involve costs,
not revenues.
Qualitative factors must be considered.
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Make or Buy
XYZ Co. is considering an offer by outside
company to supply 50,000 units of ingredient
D at a cost of $.32 per unit.
The company is currently producing
ingredient D internally with the following
costs:
(Note: Market value of the machine we use to produce D is
zero if we try to dispose of it. Supervisor can be removed, if
purchased from outside. )

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Variable costs
Direct material ($.10/unit)
$5,000
Direct labor ($.12/unit)
6,000
Variable OH ($.08/unit)
4,000
Total variable costs
15,000
Fixed costs:
Depreciation equip.
800
Depreciation Bldg
600
Supervisor's salary
500
Other
350
Total fixed costs
2,250
Total costs
$17,250
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Make or Buy
Cost to manufacture internally is $.345 =
$17,250 / 50,000
Outside offer is for $.320

Advice the Management



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Internal
Costs
External
Costs
Difference
Variable costs
Direct material ($.10/unit) $5,000 $0 $5,000
Direct labor ($.12/unit) 6,000 0 6,000
Variable OH ($.08/unit) 4,000 0 4,000
Total variable costs 15,000 0 15,000
Fixed costs:
Depreciation equip. 800 800 0
Depreciation Bldg 600 600 0
Supervisor's salary 500 500
Other 350 350 0
Total fixed costs 2,250 1,750 500
Cost of buying outside 0 16,000 (16,000)
Total costs $17,250 $17,750 ($500)
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Avoidable Costs
Not all fixed costs are irrelevant sunk costs
Some fixed costs are avoidable (i.e., they can
be avoided under one alternative)
In the previous example we can terminate
the supervisors, hence this fixed costs is
avoidable and therefore relevant and
differential.
Since avoidable costs of $15,500 is less than
the cost of the external part, we should reject
the offer based on financial grounds.
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Cost of buying externally (50,000
x $.320)
($16,000)
Cost savings (avoidable costs)
Variable costs 15,000
Supervisor salaries 500
Net costs ($500)
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Opportunity Cost
The value of foregone benefits from selecting
one choice over an alternative.
You give up earning money at a job by going
to school full time.

Assume that, in the previous example, if we
no longer make ingredient D internally, we
can save $600 in rent by using the space for
another operation that is currently leasing
warehouse space.
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Cost of buying externally (50,000
x $320)
($16,000)
Cost savings (avoidable costs)
Variable costs 15,000
Supervisor salaries 500
Opportunity cost of using the
plant to produce part D
600
Net savings $100
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Dropping a Product
Need to calculate the change in profit if
the product is dropped versus retained.
Both differential costs and revenues are
considered.
Procedure differs if there is excess
capacity versus at capacity

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Dropping a Store
ABC Ltd. is considering dropping Store #2.
Direct fixed costs are items directly traceable
to the division
Example salary of a worker who spends all his
time in this restaurant
Allocated fixed costs are fixed costs that are
shared between divisions
Example Salary of the regional manager
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#1 #2 #3 Total
Sales
$100,000 $150,000 $210,000 $460,000
Prime cost
45,000 60,000 90,000 195,000
Gross Margin
55,000 90,000 120,000 265,000
Other variable costs
15,000 20,000 30,000 65,000
Contribution Margin
40,000 70,000 90,000 200,000
Direct fixed costs
20,000 65,000 40,000 125,000
Allocated fixed
costs
15,000 20,000 25,000 60,000
Total fixed costs
35,000 85,000 65,000 185,000
Net Income $5,000 $(15,000) $25,000 $15,000
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Dropping a Product
Should #2 be dropped?
It is showing a loss of ($15,000)!
What would happen to the divisions total net
income if the store was dropped?

Assume the direct fixed costs are building
rent that can be avoided.
Allocated fixed costs are the regional
managers salary and some corporate costs.
If Store #2 were dropped, there would not be
any impact on the other stores volume.
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Lost revenue $(150,000)
Cost savings
COGS 60,000
Other variable costs 20,000
Direct fixed costs 65,000
Total cost savings 145,000
Net loss from dropping division $(5,000)
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The Death Spiral
This phenomena is sometimes referred to as
the Dearth Spiral.
You drop one product because it is a loser.
Suddenly other products become losers.
You drop them.
Now other products become losers.
And the spiral continues until you are out of
business!
Equipment Replacement
Decision
Toranto Company is considering replacing an old
machine with a new one. Revenue from both the
machine will remain same $ 11,00,000/annum.

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Old Machine New Machine
Original Cost 1,000,000 600,000
Book Value 400,000 --
Remaining Life 2 yrs 2 yrs
Terminal value 0 0
Current Disposal
Value
40,000 0
Operating Cost/annum 800,000 460,000
Equipment Replacement
Decision
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Equipment Replacement
Decision
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Decisions Involving
Constraints
Basic decision is to keep any product/store
with a positive contribution margin as long as
you can keep selling it.
That changes if making one product affects
another product.
An example is when there is a constraint such
as a limited amount of skilled labor or
machine time
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Decisions Involving Constraints
Product A Product B
Selling Price $100 $80
Variable costs 50 60
Contribution
Margin
$50 $20
Suppose that both products require time on a
specialized machine. A total of 1,000 hours are
available.
Product A requires 10 hours
Product B requires 2 hours
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Decisions Involving
Constraints
Which product should be produced assuming
we can sell as much of either as we produce
at the given prices?
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Decisions Involving
Constraints
Product A has the highest CM, we make
$50 for every one sold versus only $20
for each B.

But what about those machine hours?
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Decisions Involving
Constraints
Since A requires 10 hours and we have 1,000
total, we can produce 100 A.
At $50 each = $5,000 CM
Since B requires only 2 hours we can produce
500 total.
At $20 each = $10,000

Company is better off producing all Product
B.
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Decisions Involving
Constraints
Decision rule:
Under conditions of a constraint, produce the
product with the highest contribution margin per
unit of the constraint.

A has $50/10 hours or $5 per machine hour.
B has $20/2 hours or $10 per machine hour.
Thanks..

Any Question..
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