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
Assumethat
thatBaron
BaronCo.
Co.incurs
incursthe
thefollowing
following
annual
annualcosts
costsin
inproducing
producing25,000
25,000ignition
ignition
switches
switchesfor
formotor
motorscooters.
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,
Alternatively,Baron
Baronmay
maypurchase
purchasethe the
ignition
ignitionswitches
switchesfrom
fromIgnition,
Ignition,Inc.,
Inc.,at
at
aaprice
priceof Rs.88per
ofRs. perunit.
unit.
Question:
Question:
Should
ShouldBaron
Baronmake
makeor
orbuy
buythe
the
ignition
ignitionswitches?
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:
Decision:
Barton
BartonCompany
Companywill
willincur Rs.25,000
incurRs. 25,000of
ofadditional
additionalcosts
costsby
bybuying
buyingthe
the
switches.
switches. Therefore,
Therefore,Barton
Bartonshould
shouldcontinue
continuetotomake
makethe
theswitches.
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:
Decision:
ItItis
isnow
nowadvantageous
advantageoustotobuy
buythe
theswitches.
switches. Barton
Bartonwill
willsave Rs.3,000
saveRs. 3,000
worth
worthofofcosts
costswith
withthis
thisalternative.
alternative.
• Auto parts ltd. has an annual production of 90,000 units for a
motor components. The components cost structure is given
below: Particulars Rs.
Direct materials 270 per unit
Direct Labour (25% fixed) 180 per unit
Expenses: Variable 90 per unit
Fixed 135 per unit
Total cost 675 per unit

•The purchase manager has an offer from a supplier who is willing to supply
the components at Rs. 540. should the component be purchased and
production stopped?
•Assume the resources, now used for this component’s manufacture are to
be used to produce another new product for which the selling price is Rs.
485 per unit and the material price will be Rs. 200 per unit and variable
labour and expenses are the same for production of 90,000 units.
Suggest the company whether to manufacture the new product and
purchase the existing component from market.
Accept an Order at a Special Price
• Sometimes a company may have an opportunity to obtain
additional business if it is willing to make major price
concessions to a specific customer.
• An order at a special price should be accepted when the
incremental revenue from the order exceeds the
incremental costs.
• It is assumed that sales in other markets will not be affected
by the special order. If other sales were affected, the lost
sales would have to be considered in making the decision.
• If the units can be produced within existing plant capacity,
generally only variable costs will be affected.
Accept an Order at a
Special Price
To
Toillustrate,
illustrate,assume
assumethatthatSunbelt
SunbeltCompany
Company
produces
produces100,000
100,000automatic
automaticblenders
blendersper per
month,
month,which
whichisis80%
80%of ofplant
plantcapacity.
capacity.
Variable
Variablemanufacturing
manufacturingcostscostsare Rs.88per
areRs. per
unit,
unit,and
andfixed
fixedmanufacturing
manufacturingcosts costsareare
Rs.400,000,
Rs. 400,000,or Rs.44per
orRs. perunit.
unit. The
Theblenders
blenders
are
arenormally
normallysold
soldtotoretailers
retailersat Rs.20
atRs. 20each.
each.
Question:
Question:
Sunbelt
Sunbelthas
hasan anoffer
offerfrom
fromMexico
MexicoCo.Co.
to
topurchase
purchasean anadditional
additional2,000
2,000
blenders
blendersat Rs.11
atRs. 11per
perunit.
unit.
Acceptance
Acceptanceof ofthis
thisoffer
offerwould
wouldnotnot
affect
affectnormal
normalsales
salesof
ofthe
theproduct,
product,
and
andthe
theadditional
additionalunits
unitscancanbebe
manufactured
manufacturedwithout
withoutincreasing
increasing
plant capacity.
 Accept an Order at a
Special Price: Incremental Analysis
If management makes its decision on the basis of total cost per unit of Rs. 12 (Rs.
8 + Rs. 4), the order would be rejected, because costs (Rs. 12) would exceed
revenues (Rs. 11) by Re.1 per unit. However, since the units can be produced
within existing plant capacity, the special order will not increase fixed costs. The
relevant data for the decision, therefore, are the variable manufacturing costs per
unit of Rs. 8 and the expected revenue of Rs. 11 per unit.

Reject Accept Net Income

Order Order Increase (Decrease)
Revenues -0- 22,000 22,000
Costs -0- 16,000 (16,000)
Net income Rs. -0- Rs. 6,000 Rs. 6,000

Decision:
Decision:
Sunbelt
Sunbeltwill
willincrease
increaseits
itsnet
netincome
incomeby Rs.6,000
byRs. 6,000when
whenaccepting
acceptingthis
this
special
specialorder.
order.
 Sell or Process Further
• Many manufacturers have the option of selling
products at a given point in the production cycle or
continuing to process with the expectation of selling
them at a higher price.
• The sell-or-process further decision should be made
on the basis of incremental analysis.
• The basic decision rule in a sell or process further
decision is: Process further as long as the
incremental revenue from such processing exceeds
the incremental processing costs.
 Sell or Process Further
Assume
AssumethatthatWoodmasters,
Woodmasters,Inc.Inc.makes
makestables.
tables.
The
The cost to manufacture an unfinished tableis
cost to manufacture an unfinished table is
Rs.35,
Rs. 35,computed
computedasasfollows:
follows: Direct materials 15
Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Total manufacturing costs Rs. 35
The
Theselling
sellingprice
priceperperunfinished
unfinishedunit
unitis Rs.50.
isRs. 50.
Woodmasters
Woodmasterscurrently
currentlyhashasunused
unusedproductive
productive
capacity
capacitythat
thatisisexpected
expectedto tocontinue
continueindefinitely
indefinitelyand
and
can
canbe
beused
usedto tofinish
finishthe
thetables
tablesand
andsell
sellthem
themfor Rs.60
forRs. 60
each.
each.For
Foraafinished
finishedtable
tabledirect
directmaterials
materialsand anddirect
direct
labor
laborcosts
costswill
willincrease
increaseRs.Rs.22and Rs.4,4,respectively.
andRs. respectively.
Variable
Variableoverhead
overheadwill willincrease
increaseby Rs.2.40
byRs. 2.40(60%
(60%of
of
direct
directlabor).
labor).There
Therewill
willbe
benonoincrease
increasein infixed
fixed
overhead.
overhead.
Question:
Question: Should
ShouldWoodmasters
Woodmasterssell
sellthe
the
unfinished
unfinishedtables
tablesor
orprocess
processthem
themfurther?
further?
 Sell-or Process Further:
Incremental Analysis
The incremental analysis on a per unit basis is as follows:
Process Net Income
Sell Further Increase (Decrease)
Sales per unit Rs. 50.00 Rs. 60.00 Rs. 10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 -0-
Total Rs. 35.00 Rs. 43.40 Rs.(8.40)
Net income per unit Rs. 15.00 Rs. 16.60 Rs. 1.60

Decision:
Decision:
ItItwould
wouldbe beadvantageous
advantageousforforWoodmasters
Woodmastersto toprocess
processthe
thetables
tables
further.
further. In
Inthis
thiscase,
case,the
theper
perunit
unitincremental
incrementalrevenue
revenueof Rs.10.00
ofRs. 10.00from
from
the
theadditional
additionalprocessing
processingis Rs.1.60
isRs. 1.60higher
higherthan
thanthe
theper
perunit
unit
incremental
incrementalprocessing
processingcosts
costsof Rs.8.40.
ofRs. 8.40.
 Retain or Replace Equipment
• Management often has to decide whether to
continue using an asset or replace it.
• In a decision to retain or replace equipment,
management compares the costs which are affected
by the two alternatives. Generally, these are variable
manufacturing costs and the cost of the new
equipment.
• The book value of the old machine is a sunk cost
which is a cost that cannot be changed by any
present or future decision. Sunk costs are not
relevant in incremental analysis.
• Any trade-in allowance or cash disposal value of the
existing asset is relevant, however.
Retain or Replace Equipment
Assume
Assumethat thatJeffcoat
JeffcoatCompany
Companyhas hasaa
factory
factorymachine
machinewith
withaabook
bookvalue
valueof ofRs.
Rs.
40,000
40,000and andaaremaining
remaininguseful
usefullife
lifeof
offour
four
years.
years. AAnew newmachine
machineis isavailable
availablethatthatcosts
costs
Rs.120,000
Rs. 120,000and andisisexpected
expectedto tohave
havezero
zero
salvage
salvagevaluevalueatatthe
theend
endof ofits
its4-year
4-yearuseful
useful
life.
life.IfIfthe
thenew
newmachine
machineis isacquired,
acquired,variable
variable
manufacturing
manufacturingcosts costsare
areexpected
expectedto to
decrease
decreasefrom Rs.160,000
fromRs. 160,000to Rs.125,000
toRs. 125,000
annually
annuallyand andthe
theold
oldunit
unitwill
willbebescrapped.
scrapped.

Question:
Question:
Should
ShouldJeffcoat
JeffcoatCompany
Company
retain
retainor
orreplace
replacethe
themachine?
machine?
 Retain or Replace:
Incremental Analysis

The incremental analysis for the 4-year period is as follows:

Net Income
Retain Replace Increase (Decrease)
Variable manufacturing costs Rs. 640,000a Rs. 500,000b Rs. 140,000
New machine cost 120,000 (120,000)
Total Rs. 640,000 Rs. 620,000 Rs. 20,000
a
(4 years x $160,000)
b
(4 years x $125,000)

Decision:
Decision:
In
Inthis
thiscase,
case,ititwould
wouldbe
beto
tothe
thecompany’s
company’sadvantage
advantageto
toreplace
replacethe
the
equipment.
equipment. TheThelower
lowervariable
variablemanufacturing
manufacturingcosts
costsdue
duetoto
replacement
replacementmore morethan
thanoffset
offsetthe
thecost
costof
ofthe
thenew
newequipment.
equipment.
 Eliminate an Unprofitable Segment

• Management sometimes needs to decide whether to

eliminate an unprofitable business segment.
• Again, the key is to focus on the data that change under the
alternative courses of action.
• Often fixed costs allocated to the unprofitable segment must
be absorbed by the other segments. It is possible, therefore,
for net income to decrease when an unprofitable segment is
eliminated.
• In deciding whether to eliminate an unprofitable segment,
management should choose the alternative which results in
the highest net income for the company as a whole.
Eliminate an Unprofitable Segment

Assume
Assumethat
thatMartina
MartinaCompany
Companymanufactures
manufactures
tennis
tennisracquets
racquetsin
inthree
threemodels:
models: Pro,
Pro,Master,
Master,
and
andChamp.
Champ. Pro
Proand
andMaster
Masterare
areprofitable
profitable
lines,
lines,whereas
whereasChamp
Champoperates
operatesat
ataaloss.
loss.
Condensed
Condensedincome
incomestatement
statementdata
dataare:
are:

Pro Master Champ Total

Sales 800,000 300,000 100,000 1,200,000
Variable expenses 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed expenses 80,000 50,000 30,000 160,000
Net income Rs. 200,000 Rs. 40,000 Rs.(20,000) Rs. 220,000

Question:
Question:
Should
Shouldthe
theChamp
Champsegment
segmentbe
beeliminated?
eliminated?
 Eliminate an Unprofitable Segment

Although
Althoughititappears
appearsthat
thatincome
incomewould
wouldincrease
increaseififthe
the
Champ
Champlinelinewas
wasdiscontinued,
discontinued,ititis
ispossible
possibleforforincome
incometo to
decrease
decreaseififChamp
Champwaswasdiscontinued.
discontinued. The
Thereason
reasonis isthat
that
the
thefixed
fixedexpense
expenseallocated
allocatedtotoChamp
Champwillwillhave
havetotobebe
absorbed
absorbedby bythe
theother
otherproducts.
products.To
Toillustrate,
illustrate,assume
assume
that
thatthe Rs.30,000
theRs. 30,000of
offixed
fixedcosts
costsare
areallocated
allocated2/3
2/3to
toPro
Pro
and
and1/3
1/3to
toMaster.
Master.The
Therevised
revisedincome
incomestatement
statementdata
datais:
is:

Pro Master Total

Sales 800,000 300,000 Rs. 1,100,000
Variable expenses 520,000 210,000 730,000
Contribution margin 280,000 90,000 370,000
Fixed expenses 100,000 60,000 160,000
Net income Rs. 180,000 Rs. 30,000 Rs. 210,000

Decision:
Decision: Total
Totalnet
netincome
incomehas
hasdecreased Rs.10,000
decreasedRs. 10,000(220,000
(220,000––210,000).
210,000).
 Unprofitable Segment:
Incremental Analysis

This result is also obtained in the following incremental

analysis:
Net Income
Continue Eliminate Increase (Decrease
Sales 100,000 -0- (100,000)
Variable expenses 90,000 -0- 90,000
Contribution margin 10,000 -0- (10,000)
Fixed expenses 30,000 30,000 -0-
Net income (20,000) ( 30,000) Rs. (10,000)

Decision:
Decision:
Once
Onceagain,
again,total
totalnet
netincome
incomehashasdecreased Rs.10,000
decreasedRs. 10,000(220,000
(220,000––
210,000).
210,000).This
Thiscorresponds
correspondsto tothe
theChamp
Champsegment’s
segment’scontribution
contribution
margin.
margin. Thus,
Thus,management
managementshould
shouldnot
notdiscontinue
discontinuethe
theChamp
Champ
segment
segmentunless
unlessother
otherlines
linescan
canrecover
recoversome
someororall
allof
ofthe
the
sales/contribution
sales/contributionmargin
marginlost
lostby
bythe
thediscontinued
discontinuedsegment.
segment.
 Limited Resources
• When a company has limited resources (floor space, raw
materials, or machine hours), management must decide
which products to make and sell in order to maximize net
income.
• In an allocation of limited resources decision, it is necessary
to find the contribution margin per unit of limited resource.
• This is obtained by dividing the contribution margin per unit
of each product by the number of units of the limited
resource required for each product.
• Production should be geared to the product with the highest
contribution margin per unit of limited resource.
Limited Resources
Assume
Assumethat
thatCollins
CollinsCo.
Co.manufactures
manufacturesdeluxe
deluxe
and
andstandard
standardpen
penand
andpencil
pencilsets.
sets. The
Thelimited
limited
resource
resourceis
ismachine
machinecapacity,
capacity,which
whichisis600
600
hours
hoursper
permonth.
month. Relevant
Relevantdata
dataconsists
consistsof:of:

Deluxe Standard
Contribution margin per unit Rs. 8 Rs. 6
Machine hours required per unit .4 .2

Question:
Question:
Should
ShouldCollins
CollinsCo.
Co.shift
shiftits
itssales
salesmix
mix
toward
towarddeluxe
deluxeor
orstandard
standardsets?
sets?
 Limited Resources
Based
Basedononthe
theprevious
previousdata,
data,ititmight
mightappear
appearthat
thatdeluxe
deluxe
is
ismore
moreprofitable
profitablesince
sincethey
theyhave
haveaahigher
highercontribution
contribution
margin.
margin. However,
However,standard
standardsets
setstake
takefewer
fewermachine
machine
hours.
hours. Therefore,
Therefore,ititis
isnecessary
necessaryto tofind
findthe
thecontribution
contribution
margin
marginper
perunit
unitof
oflimited
limitedresource,
resource,as asshown
shownbelow:
below:

Deluxe Standard
Contribution margin per unit (a) Rs. 8 Rs. 6
Machine hours required per unit (b) .4 .2

Contribution margin per unit of

limited resource (a  b) Rs. 20 Rs. 30

Decision:
Decision: Since
Sincethe
thestandard
standardset
sethas
has
the
thehigher
highercontribution
contributionmargin
marginper
per
unit
unitof
oflimited
limitedresource,
resource,sales
salesmix
mix
should
shouldshift
shifttowards
towardsthat
thatproduct.
product.
 Limited Resources:
Incremental Analysis

This result is confirmed by the following incremental analysis:

If Produce If Produce
Deluxe Sets Standard Sets
Machine hours (a) 600 600
Contribution margin per unit of
limited resource (b) Rs. 20 Rs. 30
Contribution margin (a x b) Rs. 12,000 Rs. 18,000

Decision:
Decision:
Once
Onceagain,
again,ititis
isclear
clearthat
thatstandard
standardsets
setsproduce
producemore
morecontribution
contribution
margin.
margin. Thus,
Thus,given
givenadequate
adequatedemand
demandforforstandard
standardsets,
sets,the
thesales
sales
mix
mixshould
shouldshift
shiftto tothat
thatproduct
productin
inorder
ordertotomaximize
maximizeCollins
Collins
Company’s
Company’sincome.
income.
• MHK LTD. manufactures and sells three products. Sales
demand for the product in the next period is estimated to be
product X = 6200 units and Y = 8000 units and Z= 11500 units.

X (Rs.) Y (Rs. ) Z (Rs.)

Selling price 97 111 138
Costs: Direct material 28 39 49
Direct labour 24 24 32
Variable overheads 9 9 12
Fixed overheads 27 27 36

The company is facing shortage of direct labour and estimates the maximum
of 8500 hours will be available for the next year.
Required: (a) List the product in order of their production priority(most
profitable first) with direct labour as the limiting factor.
(b) Determine the product mix for the next period to maximize profit.