Decision making- relevant costs

& benefits
 Management’s Decision-Making
Process
Management’s decision-making process
frequently involves the following steps:
1 Identify the problem and assign responsibility.
2 Determine and evaluate possible courses of
action.
3 Make a decision.
4 Review results of the decision.
 Management’s Decision-Making
Process
• In making decisions, management ordinarily
considers both financial and nonfinancial
information.
• Although nonfinancial information can be as
important as, and in some cases more important
than, financial information, the following
discussion will primarily be limited to financial
information that is relevant to decisions since
that is the kind of information accounting usually
provides (primarily in steps 2 and 4).
 Sales Mix

• One of the assumptions of CVP analysis is

that if more than one product is involved, the
sales mix of the products remains constant.
• Sales mix is the relative combination in which
a company’s products are sold.
• For example, if 4 chairs are sold with each
table, the sales mix of chairs to tables is 4:1.
 Break-Even Sales
Break-even sales can be computed for a mix of two or
more products by determining the weighted average unit
contribution margin of all the products.

• To illustrate, assume that Vargo Video sells both VCRs

and TVs at the following per unit data:
Unit Data VCRs TVs
Selling price $500 $800
Variable costs 300 400
Contribution margin $200 $400

Sales mix 3 1
 Break-Even Sales

• The total contribution margin for the sales mix of

3 VCRs to 1 TV is $1,000, computed as follows:
[($200 x 3) + ($400 x 1)] = $1,000

 The weighted average unit contribution margin,

which is total CM divided by the number of units
in the sales mix is $250, computed as follows:
$1,000/4 units = $250
 Break-Even Formula:
Sales Mix
Then use the weighted average unit contribution margin to
compute break-even sales as follows:
• Assume Vargo Video has $200,000 of fixed costs.

Weighted


Average Unit = Break-even Point
Fixed Costs
Contribution in Units
Margin
$200,000  $250 = 800 units
 Break-Even Sales
• Note that with a sales mix of 3:1, ¾ of the units sold will be
VCRs and ¼ will be TVs. Therefore, in order to break even,
Vargo Video must sell 600 VCRs (¾ x 800) and 200 TVs (¼ x
800). This can be verified by the following:

Product Unit Sales x Unit CM = Total CM

VCRs 600 x $200 = $120,000
TVs 200 x 400 = 80,000
800 $200,000

Management should continually review the company’s

sales mix. At any level of units sold, net income will be
greater if more high CM units are sold than low CM
units.
• Cauvery Ltd. manufactures two products-A &
B
Particulars A B
Sales quantity (units) 45000 15000
Selling price per unit 50 75
(Rs.)
V.C per unit (Rs.) 35 45
Fixed cost per annum = Rs. 900000
The management desires that the sales mix should
be revised to 2:3 of A & B respectively. Assess the
shift in BEP sales and the effect it will have on
profitability.
 Incremental Analysis
• Business decisions involve a choice among alternative courses of
action.
• The process used to identify the financial data that change under
alternative courses of action is called incremental analysis.
• In some cases, both costs and revenues will change under
alternative choices. In other cases only costs or revenues will vary.
• It is important to recognize that
– variable costs may not change under the alternatives, and
– fixed costs may change.
 Incremental Analysis
• Incremental analysis involves not only
identifying relevant revenues and costs, but
also determining the probable effects of
decisions on future earnings.
• Data for incremental analysis often involves
estimates and uncertainty.
• Gathering data may involve market analysts,
engineers, and accountants.
How Incremental Analysis Works
The basic approach in incremental analysis is illustrated
in the following illustration:
Alternative Alternative Net Income
A B Increase (Decrease)
Revenues 125,000 110,000 (15,000)
Costs 100,000 80,000 20,000
Net income 25,000 30,000 5,000

In this illustration, alternative B is being compared with

alternative A. The net income column shows the
differences between the alternatives. Alternative B will
produce 5,000 more net income than alternative A.
 Key Cost Concepts in Incremental
Analysis
Three important cost concepts used in incremental
analysis follow:
• In incremental analysis, the only factors to be
considered are those costs and revenues that differ
across alternatives. Those factors are called relevant.
Costs and revenues that do not differ across
alternatives can be ignored when trying to chose
between alternatives.
 Key Cost Concepts in Incremental
Analysis
• Often in choosing one course of action, the company
must give up the opportunity to benefit from some
other course of action. This lost benefit is referred to
as opportunity cost.
• Costs that have already been incurred and will not be
changed or avoided by any future decision are
referred to as sunk costs. Sunk costs are not relevant
costs.
 Types of Incremental Analysis
A number of different types of decisions involve
incremental analysis. The more common types of
decisions are whether to:
• Accept an order at a special price.
• Make or buy component parts or finished
products.
• Sell products or process them further.
• Retain or replace equipment.
• Eliminate an unprofitable business segment.
 Make or Buy

• When a manufacturer assembles component parts

in producing a finished product, management must
decide whether to make or buy the components.
• This is often referred to as an outsourcing decision.
• If there is an opportunity to use the productive
capacity for another purpose, opportunity costs
should be considered.
• The decision to make or buy components should be
made on the basis of incremental analysis.
 Make or Buy
Assume that Baron Co. incurs the following
annual costs in producing 25,000 ignition
switches for motor scooters.

Direct materials 50,000

Direct labor 75,000
Variable manufacturing overhead 40,000
Fixed manufacturing overhead 60,000
Total manufacturing costs Rs. 225,000
Total cost per unit (Rs. 225,000  25,000) Rs. 9.00

Alternatively, Baron may purchase the

ignition switches from Ignition, Inc., at
a price of Rs. 8 per unit.
Question:
Should Baron make or buy the
ignition switches?
 Make or Buy:
Incremental Analysis
At first glance, it appears that management should buy the switches for
Rs. 8 instead of make for Rs. 9. However, a review of operations
indicates that if the switches are purchased all of Baron’s variable costs,
but only Rs. 10,000 of its fixed manufacturing costs, will be eliminated.
Thus, Rs. 50,000 of fixed costs will remain. The incremental costs are:
Net Income
Make Buy Increase (Decrease)
Direct materials 50,000 -0- 50,000
Direct labor 75,000 -0- 75,000
Variable manufacturing costs 40,000 -0- 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price -0- 200,000 (200,000)
Illustration 9-6 Total annual cost Rs. 225,000 Rs. 250,000 Rs. (25,000)

Decision:
Barton Company will incur Rs. 25,000 of additional costs by buying the
switches. Therefore, Barton should continue to make the switches.
 Make or Buy with Opportunity Cost:
Incremental Analysis
Assume that through buying the switches, Baron Co. can use the
released productive capacity to generate additional income of Rs.
28,000. This lost income is an additional cost of continuing to
make the switches in the make-or-buy decision. This opportunity
cost is added to the “Make” column, for comparison.
Net Cost
Make Buy Increase (Decrease)
Total annual cost 225,000 250,000 (25,000)
Opportunity cost 28,000 -0- 28,000
Total cost Rs. 253,000 Rs. 250,000 Rs. 3,000

Decision:
It is now advantageous to buy the switches. Barton will save Rs. 3,000
worth of costs with this alternative.