Tactical Decision Making

Tactical Decision Making focuses on choosing between available options with a limited end in view.
Tactical decisions usually focus on short-term objectives.

The objective is always to pick the option with the most benefits (usually in the form of higher increases
in profits, but occasionally it is the option that gives the least losses). In the real world, many other points
are taken into consideration that may not necessarily be accounted for in the profit or loss.

Important concepts are the following:

 Relevant costs. These costs are relevant to the decision being made. These must be taken into
consideration, as they will change the outcome of the decision. Relevant costs will always be
future costs that differ between options.
o Sunk costs. These costs are no longer relevant. These costs have already been incurred
and cannot be recovered regardless of the decision being made. Since sunk costs do not
differ between options, they should not be considered in tactical decision making.
 Relevant revenues. Future revenues that differ between options.

To determine whether a cost or revenue is relevant, the key is that it should be different between options.
If the cost or revenue will exist regardless of the option chosen, then it is irrelevant.

Examples are seen below:

The company must choose between making its product or shifting to a buy and sell strategy. The details
are seen below:

Making the product Buying and Selling

Potential sales ₱1,000,000 ₱1,000,000
Direct Material costs 250,000 ─
Direct Labor costs 100,000 ─
Manufacturing warehouse rent 300,000 ─
Payment to supplier ─ 600,000
Freight costs ─ 100,000

The potential sales remain the same regardless of the option. Thus, it is not relevant.
The direct material and direct labor costs will no longer be incurred if the company chooses to buy and
sell. They are relevant, because the outcome will be different. Conversely, the payment to supplier and
freight costs will not be incurred under the first option.

Are fixed costs always irrelevant? The answer is no. Although fixed costs are incurred regardless of
production, this presumes that the service or item is still being used. In the above case, the company won’t
need a manufacturing warehouse if it decides to go the buy and sell route. As a result, the company would
choose to stop renting the warehouse if it decides to buy and sell, thereby eliminating the fixed cost. The
rent is consequently a relevant cost.
What if, for example, the warehouse will instead be used to store the purchased products instead of
manufacturing the products? If no increase or decrease in rent occurs, then the rent becomes irrelevant,
because the warehouse would still be used and the rent would be paid regardless.

More illustrations follow:

Sell or process further

The Company creates Product A. After the process, Product A can either be sold as is for ₱50 per unit or
processed further into Product B for ₱25 and eventually sold for ₱70 per unit. The company spent ₱35 to
create Product A .

At this point, the amounts can be summarized as follows:

Sold as is Process further

Revenue ₱50 ₱70
Cost to produce Product A 35 35
Further processing ─ 25

As can be noticed, the cost to produce Product A is incurred regardless of which option is chosen; it will
always be incurred before this decision can even be made. As a result, it is not relevant. The further
processing cost and the sales differ between options, and so they are relevant.

Keep or drop
The Company’s Northern Mindanao division has done poorly compared to the other divisions. The Board
of Directors has decided to assess whether the division should be closed and discontinued or allowed to
remain. If the division is closed, sales in the region amounting to ₱2,200,000 can no longer be made. On
the other hand, costs of production of ₱1,100,000 will no longer be incurred. The employees in the division
factory are paid ₱600,000 annually. These employees will be relocated to other divisions. Advertising costs
of ₱100,000 will also be dropped. Finally, national supervisors who serve all the divisions are paid
₱1,500,000 annually. Of this amount, ₱200,000 has been normally allocated to the Northern Mindanao
division.

The labor of ₱600,000 is irrelevant. This is because the employees will work in another division and thus
the ₱600,000 will be paid even if the division is closed. Similarly, the ₱200,000 allocation from national
supervisor wages are also irrelevant.

Cost allocation simply means to determine what assets or expenses costs should be attributed to. In the
example above, the supervisors perform administrative work that covers all divisions. However, for
purposes of costing and determining division performance, the expenses for their services must be
allocated across the divisions. This is why there is a ₱200,000 allocation to the Northern Mindanao division.
However, closing the division does not mean that the ₱200,000 is no longer paid. It simply means that it
must be allocated to the other divisions; the amount must still be paid.
To clarify, the supervisors are paid ₱1,500,000 annually. This means that regardless of the number of
divisions they service, they receive ₱1,500,000 as fixed in their employment contract. Even if one division
closes, they are still paid ₱1,500,000. Therefore, the costs of their salaries are irrelevant.

The other costs (cost of production and advertising) are relevant, because if the division is closed, these
costs drop to ₱0. The sales that will be lost is also relevant.

Special Order
The Company is currently operating at 80% of its 10,000 unit capacity. A loyal customer wishes to place a
special order with the Company and is willing to pay ₱850,000. The special order will require ₱250,000 of
raw materials, ₱300,000 of additional labor, and ₱100,000 of special packaging. However, because of the
unique nature of the order, the company will be unable to produce 500 of its regular units. The 500 regular
units would have been sold for ₱400,000 and would’ve cost ₱250,000 in direct materials and labor to
make. The company is currently renting the warehouse for ₱150,000.

The ₱850,000 revenue and ₱400,000 in lost revenue are relevant. The ₱850,000 would not be earned and
the ₱400,000 would not be lost if the special order is not taken. Similarly, the costs of materials, labor and
packaging are all relevant.

The rent is not relevant because regardless of the level of production, the amount remains the same. This
is not the same situation as the first example where the company can choose to stop renting the
warehouse. Here, the warehouse must be rented. It continues to be a fixed cost.

Computation
Tactical decision making follows two different formulae:

Relevant Revenue – Relevant costs = Profit under each alternative

Differential relevant revenue – Differential relevant costs = differential relevant profit

This can be demonstrated through the illustrations above.

Make or buy decision

Using first formula Second formula

Making the product Buying and selling Differential
Direct Material costs (₱250,000) ₱─ (₱250,000)
Direct Labor costs (100,000) ─ (100,000)
Manufacturing warehouse rent (300,000) ─ (300,000)
Payment to supplier ─ (600,000) 600,000
Freight costs ─ (100,000) 100,000
Costs (₱650,000) (700,000) ₱50,000

The differential is obtained by subtracting the amounts under the first option by the second option.
As can be seen above, making the product incurs fewer costs than buying the product. There is a ₱50,000
cost advantage. As a result, the company should choose to make the product. Irrelevant amounts are
ignored since their differential would be 0.

Sell or process further

Using first formula Second formula

Sell Process further Differential
Revenue ₱50 ₱70 (₱20)
Further processing ─ (25) 25
₱50 ₱45 ₱5

The company makes more money from selling the product immediately instead of processing it further.
When it sells the product, it earns ₱50. On the other hand, if it processed the product further, it only earns
₱45 pesos after the additional cost. Selling the product immediately gives them a ₱5 advantage.

Keep or drop

Lost sales if closed (₱2,200,000)

Cost of production saved 1,100,000
Advertising costs saved 100,000
Benefit (loss) (₱1,000,000)

If the company closes the division, they will lose ₱1,000,000 in profits. As a result, the division should not
be closed. Remember that the labor and the supervision allocation are irrelevant because even if the
division was closed, they would continue to be incurred.

In the computation above, any sales gained or costs saved are benefits (positive), while any sales lost or
additional costs are expenses or losses (negative). Benefits increase the profit, while losses decrease the
profit.

Special order

Revenue from special order ₱850,000

Revenue lost from ordinary sales (400,000)
Additional direct mat’ls (250,000)
Additional labor (300,000)
Special packaging (100,000)
Cost of production saved 250,000
Benefit (loss) ₱50,000

The company will obtain a benefit of ₱50,000 if they make the special order. Thus, they should accept the
special order.