Unit 11: Decision involving Alternative Choices

I. Orientation: The Relevant-Cost Framework

Decisions involving alternative choices are resolved not by full absorption cost but by the marginal-costing and differential-cost approach, which isolates the costs and revenues that actually change between options (developed in management accounting practice through the twentieth century). Fixed costs that persist regardless of the choice are ignored; contribution is the master figure.

• Contribution: Sales value minus variable cost — Contribution = Sales − Variable Cost. It first covers fixed cost, then becomes profit.
• Relevant cost: A future cost that differs between alternatives. Sunk costs and unavoidable fixed costs are irrelevant.
• Differential cost: The change in total cost between two levels or options; the matching change in revenue is the incremental revenue.
• Marginal cost: The variable cost of one extra unit — direct material, direct labour, variable overhead.
• Governing rule: Choose the option that maximises total contribution (or, under a constraint, contribution per unit of the limiting factor), provided qualitative factors do not override it.

II. Concept and Steps Involved in Decision Making

Decision making is the act of choosing the most advantageous course from two or more mutually exclusive alternatives, judged mainly on their differential financial effect.

A. Concept

• Nature: A choice under scarcity — resources are limited, so accepting one option forgoes another (opportunity cost).
• Basis: Rests on incremental analysis; only costs and revenues that vary between alternatives count.
• Scope: Covers pricing, product range, sourcing, market entry and capacity use.

B. Steps Involved

• Define the objective: State what is sought, e.g. maximum profit or lowest cost.
• Identify alternatives: List feasible courses, e.g. make vs buy, accept vs reject an order.
• Gather relevant data: Collect differential costs, incremental revenues and the limiting factor; discard sunk and common costs.
• Evaluate quantitatively: Compute contribution or differential profit for each alternative.
• Weigh qualitative factors: Consider quality, reliability of suppliers, staff morale, customer goodwill.
• Select and implement: Choose the option with the highest net benefit, then monitor the outcome against expectation.

III. Profit Planning

Profit planning is the deliberate arrangement of selling price, volume, cost and product mix so that a target profit is achieved.

A. Principle

• Contribution engine: Profit rises with total contribution once fixed cost is covered; planning manipulates the levers of the CVP relationship.
• Core formula:

Profit = (Sales × P/V ratio) − Fixed Cost
P/V ratio = Contribution ÷ Sales
Break-even Sales = Fixed Cost ÷ P/V ratio
Required Sales = (Fixed Cost + Target Profit) ÷ P/V ratio

where P/V ratio is the profit-volume ratio expressing contribution per rupee of sales.

B. Application

• Target-profit sales: If fixed cost is 4,00,000, target profit 1,00,000 and P/V ratio 40%, required sales = 5,00,000 ÷ 0.40 = 12,50,000.
• Margin of safety: Actual sales minus break-even sales; the cushion before losses begin.
• Levers: Raise price, cut variable cost, lift volume or shift mix toward high-contribution lines — each planned by its effect on the P/V ratio.

IV. Key Factor

A key factor (limiting or governing factor) is the resource whose scarcity restricts output, so decisions must optimise its use rather than total contribution alone.

A. Definition and Types

• Meaning: The constraint that caps the level of activity — the bottleneck.
• Common forms: Shortage of raw material, labour hours, machine hours, floor space, cash, or sales demand itself.

B. Ranking Rule

• Decision measure: Maximise contribution per unit of the key factor, not per unit of product.

Ranking basis = Contribution per unit ÷ Units of key factor per product

• Worked example: Product X earns 60 contribution using 3 machine hours (20 per hour); Product Y earns 50 using 2 hours (25 per hour). Though X has higher unit contribution, scarce machine time is better spent on Y (25 > 20 per hour).
• Multiple constraints: When two or more factors bind at once, linear programming replaces the single-factor ranking.

V. Determination of Sales Mix

Sales mix is the proportion in which several products are sold; its determination seeks the combination that yields the greatest total contribution within existing constraints.

A. Principle

• Objective: Load the mix toward products giving the highest contribution per unit of the limiting factor.
• Constraint respected: The chosen mix must stay within market demand and capacity ceilings.

B. Selecting the Optimum Mix

• Method: Rank products by contribution per unit of key factor, allocate the scarce resource to the best rank first, then the next, until exhausted.
• Worked example: Machine hours limited to 1,000. Product A: contribution 40, 2 hrs (20/hr); Product B: contribution 45, 3 hrs (15/hr). Fill demand for A first (better per-hour return), commit remaining hours to B. Total contribution is thereby maximised.
• Alternative-mix comparison: Where management proposes ready-made mixes, compute total contribution of each and pick the highest; fixed cost, being common, is ignored in the choice.

VI. Make or Buy Decision

The make-or-buy decision compares producing a component in-house against purchasing it from an outside supplier.

A. Principle

• Relevant comparison: Set the supplier's price against the marginal (variable) cost of making, not the full absorption cost.
• Rule:
  • 1. Spare capacity: Buy only if purchase price is below the variable cost of making, since fixed cost continues either way.
  • 2. No spare capacity: Add the contribution lost from displaced production (opportunity cost) to the variable cost before comparing.

Make cost = Variable cost of production (+ opportunity cost if capacity is scarce)
Decision: Buy if Purchase price < Make cost; otherwise Make

B. Application

• Worked example: Variable cost to make a part is 45; supplier quotes 50. With idle capacity, make (45 < 50). If making the part sacrifices 8 of contribution elsewhere, make cost becomes 53, so buying at 50 is now cheaper.
• Qualitative factors: Supplier reliability, quality control, secrecy of design, and continuity of supply can override the arithmetic.

VII. Exploration of New Markets

Exploring a new market means accepting additional business — often a special or export order at a lower price — assessed on its incremental effect only.

A. Principle

• Acceptance test: A new-market order is worthwhile if its price exceeds marginal cost, so long as regular-market prices are protected.
• Condition: The two markets must be separable to avoid the new low price spoiling the existing one.

B. Application

• Spare capacity: With idle capacity, any price above variable cost adds contribution and hence profit; fixed cost is already absorbed by existing sales.
• Worked example: Variable cost 30, home price 50. An export buyer offers 38 for 5,000 units using surplus capacity. Extra contribution = (38 − 30) × 5,000 = 40,000, so accept.
• Cautions: Watch for dumping regulations, additional export or distribution cost, and the risk of home customers demanding the lower price.

VIII. Continue or Discontinue a Product Line

This decision tests whether a loss-showing or weak product should be dropped, using contribution rather than reported net profit.

A. Principle

• Decision rule: Retain any product that yields a positive contribution, because it helps recover common fixed costs; a product apparently loss-making under absorption costing may still be worth keeping.

Retain if: Contribution > 0 and no better use exists for the released capacity
Drop if: Contribution ≤ 0, or freed resources earn more elsewhere

B. Application

• Worked example: A line shows a 10,000 net loss after 30,000 apportioned fixed cost, but earns 20,000 contribution. Dropping it removes 20,000 contribution while the 30,000 fixed cost largely remains, worsening total profit by 20,000 — so continue.
• Avoidable vs unavoidable fixed cost: If part of the fixed cost (say 12,000) disappears on closure, weigh it against the 20,000 contribution lost; net loss from dropping is 8,000, still favouring continuation.
• Qualitative factors: Effect on the sales of complementary products, employee redeployment, and market presence must be judged alongside the numbers.

C. Limitations of the Approach

• Fixed-cost behaviour: Assumes fixed costs stay constant and variable costs move linearly, which holds only within the relevant range.
• Segregation difficulty: Splitting semi-variable costs into fixed and variable parts is approximate.
• Short-run focus: Contribution analysis suits short-term choices; long-term decisions still need full-cost and strategic review.