Unit 11: Decision involving Alternative Choices - Subjective Questions

Concept of Decision Making:

Decision making is the process of selecting the best course of action from among two or more available alternatives to achieve a desired objective. In management accounting, it involves the use of relevant cost and revenue data to choose the most profitable alternative.

Steps Involved in Decision Making:

• Defining the problem: Clearly identify and define the problem or objective requiring a decision.
• Identifying alternatives: List out all possible courses of action available to solve the problem.
• Collecting relevant data: Gather quantitative (costs, revenues) and qualitative information relevant to each alternative.
• Analysing and evaluating alternatives: Compare alternatives using relevant costing, marginal costing, and other techniques. Focus on differential costs and incremental revenues.
• Selecting the best alternative: Choose the option that gives maximum benefit (highest profit or lowest cost).
• Implementing the decision: Put the chosen alternative into action.
• Reviewing and monitoring: Compare actual results with expected outcomes and take corrective action if required.

Only relevant costs (future costs that differ between alternatives) should be considered, while sunk costs and committed costs should be ignored.

Relevant Costs:

These are future costs that differ between alternatives and are affected by the decision under consideration. They are pertinent to a specific decision.

• Examples: Differential cost, marginal cost, opportunity cost, avoidable fixed cost, incremental cost.

Irrelevant Costs:

These are costs that will not be affected by the decision and remain the same regardless of the alternative chosen.

• Examples: Sunk costs (already incurred), committed fixed costs, absorbed overheads that do not change, historical costs.

Key Distinctions:

Illustration: If a machine was bought for $50,000 (sunk cost), this is irrelevant when deciding whether to accept a new order. However, the additional material cost of $10,000 for the order is a relevant cost.

Profit Planning:

Profit planning is the process of determining the level of operations (sales, output, cost structure) necessary to achieve a desired or target profit. It involves planning the future course of action to maximise profits.

Role of Marginal Costing in Profit Planning:

• Contribution analysis: Marginal costing highlights contribution (), which helps determine profit at various sales levels.
• Break-even analysis: Helps identify the point of no profit, no loss:
• P/V Ratio: Measures profitability:
• Margin of safety: Indicates the cushion of safety in sales beyond break-even.
• Target profit determination: Sales required for a desired profit:

Uses in Profit Planning:

• Setting selling prices
• Determining optimum product mix
• Evaluating the effect of cost and volume changes
• Making pricing and expansion decisions

By separating fixed and variable costs, marginal costing enables management to forecast the impact of changes in volume, price, and cost on profit.

Concept of Key Factor:

A key factor, also called a limiting factor or principal budget factor, is a factor that limits or restricts the volume of output or profit of a business at a particular time. It puts a limit on production and sales.

Examples of Key Factors:

• Shortage of raw material
• Limited labour hours
• Limited machine capacity
• Limited sales demand
• Shortage of working capital/finance

Influence on Decisions:

When a key factor exists, profitability is measured by contribution per unit of key factor rather than contribution per unit or P/V ratio alone.

Decision Rule:

• Rank products according to contribution per unit of the limiting factor.
• Give priority to the product with the highest contribution per unit of key factor.
• Allocate the scarce resource accordingly to maximise total contribution.

Illustration: If labour hours are limited, and Product A gives 10/hour) while Product B gives 6/hour), Product A should be preferred despite its lower total contribution per unit.

Step 1: Calculate Contribution per unit

• Product X: per unit
• Product Y: per unit

Step 2: Identify the Key Factor

Machine hours are the limiting factor (10,000 hours available).

Step 3: Calculate Contribution per Machine Hour

Step 4: Ranking

Product X gives higher contribution per machine hour ($20 > $10), so Product X is more profitable.

Step 5: Maximum Contribution

Producing only Product X:

Conclusion: The company should produce Product X to earn a maximum contribution of $200,000, subject to demand and other constraints.

Sales Mix:

Sales mix (or product mix) refers to the relative proportion or combination of different products sold by a firm to achieve maximum profit. It represents the ratio in which various products are sold.

Objective: To determine the combination of products that yields the maximum total contribution/profit.

Factors to Consider in Determining Optimum Sales Mix:

• Contribution per unit: Products with higher contribution are generally preferred.
• Key/limiting factor: If a resource is scarce, contribution per unit of key factor is used to rank products.
• Market demand: Maximum demand for each product must not be exceeded.
• Production capacity: Availability of machine hours, labour, and material.
• Fixed costs: Should remain constant across the mix for valid comparison.
• Sales policy and constraints: Minimum quantities of certain products may need to be maintained.

Decision Rule:

• Rank products based on contribution per unit of the limiting factor.
• Allocate scarce resources to the highest ranked products first, subject to demand and minimum production constraints.
• The mix giving the highest total contribution is the optimum sales mix.

Make or Buy Decision:

This is a decision where management must choose between manufacturing a component/product in-house or purchasing it from an outside supplier. It is a common tactical decision aimed at cost minimisation.

Cost/Quantitative Factors:

• Marginal (variable) cost of making vs purchase price.
• If purchase price is less than the variable cost of making, it is generally better to buy.
• If purchase price is more than the variable cost (but relevant fixed costs are avoidable or capacity is idle), it is generally better to make.
• Opportunity cost: If making the component means giving up production of another profitable product, the lost contribution must be added.
• Avoidable fixed costs: Fixed costs that can be eliminated by buying are relevant.

Decision Rule (with idle capacity):

• Make if:
• Buy if:

Qualitative Factors:

• Quality and reliability of the supplier's product
• Timely delivery and continuity of supply
• Confidentiality of design/technology
• Impact on labour and employee relations
• Long-term dependence on external suppliers
• Utilisation of spare capacity

Case 1: No alternative use of capacity

Cost of Making (Relevant = Variable Cost only):

(Fixed cost of $60,000 is irrelevant if it is unavoidable and continues even after buying.)

Cost of Buying:

Decision: Since cost of making (300,000), the company should MAKE the component and save $60,000.

Case 2: Released capacity earns $80,000 contribution

Effective cost of Making:

Cost of Buying = $300,000

Decision: Since effective cost of making (300,000), the company should now BUY the component and use the capacity for the alternative, gaining a net advantage of $20,000.

Conclusion: Opportunity cost of the released capacity changes the decision from make to buy.

Exploration of New Markets Decision:

This decision relates to whether a firm should sell its products in a new market (often a foreign or additional local market), usually at a price different from the existing market, to utilise spare capacity.

Relevant Considerations:

• Additional contribution: The new market should provide positive contribution (selling price > marginal cost).
• Spare/idle capacity: New market orders should be accepted only if there is unused capacity, or by comparing lost contribution if capacity is diverted.
• Impact on existing market: The lower price in the new market should not spoil the existing market price (dumping risk).
• Additional/incremental costs: Extra selling, packing, transport, or export costs must be covered.
• Fixed costs: Generally ignored if they remain unchanged, but any additional specific fixed cost is relevant.

Decision Rule:

Accept the new market if:

and the additional contribution increases total profit.

Circumstances to Accept:

• There is idle/spare capacity.
• New market price covers variable cost and yields extra contribution.
• The existing market is not adversely affected.
• No cheaper alternative use of the capacity exists.

Qualitative Factors: Legal/anti-dumping regulations, long-term relationship, brand image, exchange rate risks (for exports).

Continue or Discontinue a Product Line:

This decision involves determining whether an unprofitable or low-performing product/department should be continued or shut down. A product showing a net loss under absorption costing may still be worth continuing under marginal costing.

Key Principle:

The decision should be based on contribution, not net profit. A product should be continued as long as it makes a positive contribution towards common fixed costs.

Factors to Consider:

• Contribution earned: If a product gives positive contribution, discontinuing it reduces total profit.
• Avoidable (specific) fixed costs: Fixed costs directly saved on discontinuation are relevant.
• Unavoidable (common) fixed costs: These continue even after dropping the product, hence irrelevant.
• Impact on other products: Complementary sales may fall if a product is dropped.
• Use of released capacity: Whether freed resources can be better used.

Decision Rule:

• Discontinue if: (i.e., product gives negative net benefit)
• Continue if:

Qualitative Factors: Effect on employees, market image, customer loyalty, and future potential of the product.

Step 1: Contribution per Labour Hour

• Product P: per hour
• Product Q: per hour
• Product R: per hour

Step 2: Ranking (highest contribution per hour first)

• Rank 1: Product R ($12)
• Rank 2: Product P ($10)
• Rank 3: Product Q ($8)

Step 3: Allocate 15,000 hours as per ranking (subject to demand)

For Q: units

Step 4: Total Contribution

• R:
• P:
• Q:

Conclusion: The optimum mix is R = 2,500 units, P = 2,000 units, Q = 800 units giving a maximum contribution of $152,000.

Fixed Costs as Irrelevant Costs:

In short-term decision making, fixed costs are usually considered irrelevant because:

• They remain constant regardless of the level of activity or the alternative chosen.
• They are often committed or already incurred (e.g., rent, depreciation, salaries).
• Since they do not change between alternatives, they do not affect the differential analysis.
• Decisions based on contribution (Sales − Variable Cost) are more meaningful in the short run.

When Fixed Costs Become Relevant:

• Avoidable/specific fixed costs: Fixed costs that can be eliminated by choosing a particular alternative (e.g., discontinuing a product saves supervisor salary).
• Incremental/additional fixed costs: New fixed costs incurred due to a decision (e.g., renting extra machinery for a new order).
• Step fixed costs: When increased volume pushes fixed costs to a higher level.
• Long-term decisions: In the long run, all costs become variable and hence relevant.

Conclusion: Only those fixed costs that change as a result of the decision are relevant. Unavoidable and committed fixed costs should be ignored in short-term decisions.

Opportunity Cost:

Opportunity cost is the value of the benefit foregone by choosing one alternative over the next best alternative. It is a notional cost, not recorded in books but relevant for decisions.

• Example: If a machine used to make Product A could instead be rented for $10,000, then $10,000 is the opportunity cost of using it for A.

Differential Cost:

Differential cost is the difference in total cost between two alternatives. When it increases, it is called incremental cost; when it decreases, it is called decremental cost.

• Example: If Alternative A costs $50,000 and Alternative B costs $65,000, the differential cost is $15,000.

Significance in Decision Making:

• Opportunity cost ensures that the true economic sacrifice of a choice is recognised, especially where resources are scarce (make or buy, product mix).
• Differential cost helps compare alternatives directly by focusing only on the amounts that differ (accept/reject an order, expansion decisions).
• Both are relevant costs and are central to marginal and incremental analysis.

Decision Rule: Choose the alternative where incremental revenue exceeds incremental (differential) cost, after accounting for opportunity cost.

Step 1: Compute Contribution

Step 2: Net position shown by product (Absorption view)

At first glance the product shows a loss of $20,000, suggesting it should be dropped.

Step 3: Relevant analysis (identify avoidable costs)

• Contribution lost if dropped = $50,000
• Fixed cost saved if dropped (avoidable) = $30,000
• Common fixed cost of $40,000 will continue even after dropping (irrelevant).

Net effect of dropping the product:

Dropping the product reduces overall profit by $20,000 because the $40,000 common cost would still have to be borne by other products.

Conclusion: The company should CONTINUE product Z, since it earns a contribution of $50,000 which exceeds its avoidable fixed cost of $30,000, thereby covering $20,000 of common fixed overheads.

Special Order Decision:

A special order is a one-time order, usually at a price lower than the normal selling price, often from a new customer or market. The decision rests on relevant/incremental analysis.

Decision Rule:

Accept the special order if:

since any excess over variable cost adds to contribution and profit, provided there is spare capacity.

Factors to Consider:

• Spare capacity: If idle capacity exists, only variable cost is relevant.
• Opportunity cost: If capacity is full, the lost contribution from regular sales must be added.
• Additional/specific costs: Any extra setup, packing, or delivery cost for the order.
• Effect on regular market: The low price should not disturb existing customers or normal prices.

Illustration: If variable cost is $8/unit and a special order offers $11/unit with spare capacity, accept it since it adds $3 contribution per unit. If fixed costs are already covered by regular sales, this directly increases profit.

Qualitative Factors: Future business potential, customer relationship, capacity utilisation, and pricing image.

Given:

• Fixed Cost = $180,000
• P/V Ratio = 30% = 0.30
• Desired Profit = $60,000
• Actual Sales = $900,000

Step 1: Sales required to earn target profit

Step 2: Break-Even Point (Sales)

Step 3: Margin of Safety (at actual sales $900,000)

Conclusion:

• Sales of $800,000 are needed to earn a profit of $60,000.
• Break-even sales = $600,000.
• Margin of safety = $300,000 (33.33%), indicating a comfortable cushion above break-even.

Make or Buy Decision:

• Meaning: Choosing between producing a component in-house or purchasing it from outside.
• Objective: Cost minimisation.
• Relevant costs: Variable cost of making, purchase price, avoidable fixed costs, opportunity cost of capacity.
• Decision rule: Make if variable cost of making < purchase price (considering opportunity cost).

Continue or Discontinue Decision:

• Meaning: Deciding whether to keep or drop a product/department showing poor results.
• Objective: Profit maximisation / loss minimisation.
• Relevant costs: Contribution earned, avoidable (specific) fixed costs.
• Decision rule: Continue if contribution > avoidable fixed cost.

Comparison Table:

Common Principle: Both use the relevant/differential cost approach, ignoring sunk and unavoidable common fixed costs, and consider qualitative factors alongside quantitative analysis.

Step 1: Identify Relevant (Variable) Cost per unit

(Fixed overhead is irrelevant as it remains unchanged and there is spare capacity.)

Step 2: Contribution from Export Order

Step 3: Total Additional Contribution

Step 4: Check Capacity

Firm operates at 60% (6,000 units), so full capacity = 10,000 units. Spare capacity = 4,000 units, which is enough for the 2,000 unit order.

Decision: Since the export price (40) and spare capacity exists, the firm should ACCEPT the export order. It adds $10,000 to total profit.

Qualitative note: The export price (60), so the firm must ensure the export sale does not disturb the domestic market and complies with anti-dumping norms.

Importance of Qualitative Factors:

While quantitative (cost and revenue) analysis identifies the financially superior alternative, qualitative factors are non-monetary considerations that can significantly affect the outcome and long-term interest of the business.

Key Qualitative Factors:

• Quality and reliability: In make or buy, supplier's quality and delivery reliability matter.
• Employee morale and relations: Discontinuing a product or outsourcing may cause layoffs.
• Customer relationships: Dropping a product may affect loyal customers and complementary sales.
• Market/brand image: Selling at low prices in new markets may harm reputation.
• Long-term strategy: Short-term savings may conflict with long-term goals.
• Legal/regulatory issues: Anti-dumping laws, contracts, and compliance.
• Continuity and dependence: Over-reliance on external suppliers is risky.

Why Not Rely on Quantitative Data Alone:

• Numbers reflect only measurable aspects; they ignore strategic and human factors.
• A financially attractive option may damage goodwill or future prospects.
• Some benefits/risks (reputation, flexibility) cannot be quantified but are crucial.

Conclusion: Sound decision making requires balancing quantitative analysis with qualitative judgment to ensure decisions serve both short-term profitability and long-term sustainability.

Management frequently faces decisions where relevant costing and marginal analysis are applied. The common types are:

1. Make or Buy Decision

• Principle: Compare variable cost of making with purchase price (add opportunity cost if capacity is scarce). Make if cheaper to produce.

2. Accept or Reject a Special/Export Order

• Principle: Accept if selling price exceeds marginal cost and spare capacity exists, adding to contribution.

3. Determination of Sales/Product Mix

• Principle: Choose the mix giving the highest total contribution, using contribution per unit of the key factor if a limiting factor exists.

4. Exploration of New Markets

• Principle: Enter if additional contribution is positive and the existing market/price is not harmed.

5. Continue or Discontinue a Product Line

• Principle: Continue as long as the product yields contribution exceeding its avoidable fixed cost.

6. Selection when a Key Factor exists

• Principle: Rank products by contribution per unit of the limiting factor.

7. Shut-down or Continue Operations

• Principle: Compare shut-down costs with the loss from continued operations; continue if contribution exceeds avoidable fixed costs.

Common Underlying Principle: In all cases, focus on relevant costs and contribution, ignore sunk and unavoidable fixed costs, and consider qualitative factors before finalising the decision.