STRATEGIC

DECISION MAKING
Chapter 20
STRATEGIC DECISION MAKING
Strategic decision making involves selecting among alternative strategies to serve the overall
goals of the organization.

Short - term Long- term Decisions

• A decision is a short-term if it involves a • Long-term decisions involve consideration

period of one year or less. of return on capital employed, discounted
cash flow, etc.

The relevant costs and relevant revenues are those expected future costs and expected
future revenues that differ under different alternative courses of action being considered.
Thus relevant costs and relevant revenues should have two characteristics:
(a) The costs and revenues must relate to future; and
(b) They must differ among different courses of action.

Cost Factors Non-Cost Factors

• Cost factors or quantitative factors are • Non-cost factors are those which cannot
those which can be quantified in monetary be expressed in monetary terms with
terms. accuracy
DECISION MAKING AND MARGINAL COSTINGS

Sales mix
decisions
Selection of a
Make or buy suitable of
decisions method
production

Special
Plant shut
Selling price Decision-
down
decisions making decision
Areas
 SELLING PRICE DECISIONS
Although prices are regulated more by market conditions of demand and supply and other
economic factors than by the decisions of management, the management while fixing prices
has to keep in view the level of profit desired.
(a) Selling prices under normal circumstances: In the long run, under normal
circumstances, the selling price must cover total cost and also give a reasonable
amount of profit. In the short run, the selling price may have to be fixed below total cost
but it should be above variable cost.
(b) Pricing in competition and depression: When there is acute competition or in
periods of depression, products may have to be priced below total cost, if such a step
is necessary to meet the special situation. When marginal cost technique is used for
pricing, the price should be higher than the marginal cost so that it makes a
contribution towards fixed cost and help reduce the loss. When price is just equal to
marginal cost, the amount of loss will also be equal to the amount of fixed cost because
in such situations the selling prices make no contribution towards fixed cost.
(c) Exploring New Markets at Lower Prices to Utilize Spare Plant Capacity: Sometimes,
a company is not able to fully utilize plant capacity when selling at total cost plus profit
basis. In such a case, it may explore new markets and find opportunities to receive
additional bulk order or export order at a price which may be below total cost but above
marginal cost so that the price makes a ‘contribution’.
(d) Pricing of Export Sales: Additional orders may be accepted from a foreign market at
below normal price or below total cost but above marginal cost. Export sales yield
additional contribution when such sales are at a price which is above marginal cost.
 MAKE OR BUY DECISIONS
(IN SOURCING VS OUTSOURCING)

Marginal cost analysis renders useful assistance when a decision has to be

taken by the management on whether a component part should be
manufactured internally or purchased from an outside firm.
Insourcing is producing the goods by the firm itself whereas
outsourcing is the process of purchasing the goods or services from
outside suppliers.
On the face of it, since the only cost to manufacture the component is
its marginal cost, then the amount by which marginal cost falls below
supplier’s price is the saving that arises in making.
Therefore, it will be profitable to buy from outside only when supplier’s price
is below firm’s own marginal cost.
 SALES MIX DECISIONS
Sales mix or product mix denotes the proportion in which various
products are sold or produced. The problem of selecting a profitable
mix of sales thus, arises only when a business enterprise has a
variety of product lines and each making a contribution of its own.

When there is no key (or limiting) factor: When there is no key factor, the product mix that
provides the highest amount of contribution is considered as the most profitable sales mix. This holds
good when fixed cost does not change due to changes in sales mix. However, when changes in sales mix
are associated with changes in fixed cost, then that sales mix which provides the highest profit is
considered as the most profitable sales mix.

When there is a key factor: When a key factor is operating, selection of the most profitable sales mix
is based on contribution per unit of key factor. The product which makes the highest amount of
contribution per unit of key factor, is the most profitable one and its production is pushed up. The second
preference is to be given to product which yields the second highest contribution per unit of key
factor and so on and in the end that product should be produced which yields least contribution per
unit of key factor and to the extent of availability of the key factor.
SELECTION OF PRODUCTION METHOD
AND PLANT SHUT DOWN DECISIONS
Selection of a Suitable Method of Production : Sometimes the management is
confronted with the problem of choosing from amongst alternative methods of production..
The management should select the method which gives the largest contribution (i.e., the
lowest marginal cost), keeping in view the limiting factor.

Plant Shutdown Decisions: The management under certain circumstances might

feel that plant shutdown, i.e., closing down the business, is better than operating at a
loss. This type of decision may be either (a) temporary suspension of production
activities, or (b) permanent closing down of production.
• Temporary Closing Down Temporary suspension of activities is a short-term
measure. The object is usually to stop operations until trade depression has
passed.
• Role of Committed and Discretionary Fixed Costs: Sometimes, certain
fixed costs can be avoided by management when plant is not operative. These
are termed as discretionary fixed costs. Committed fixed costs, are those
that cannot be avoided even if production is discontinued.
• Permanent Shutdown Such a decision should be taken only when in the
long run, the business does not expect to earn a sufficient return to cover the
risk involved.
DIFFERENTIAL COST ANALYSIS
Meaning of Differential Cost: Differential cost is the difference in cost between one
alternative and another. It is obtained by subtracting the cost of one alternative from the
cost of the other alternative. For example, when management is considering a change in
the level of production, differential cost will be calculated by subtracting the cost at lower
level of production from that of a higher level.

Sometimes the term incremental cost is also interchangeably used with differential cost.
incremental cost actually means only an increase in cost from one alternative to another.
In the same way, differential cost may be referred to a decremental cost, were decrease in
output is being considered.

Incremental Revenue Difference in revenue of two alternatives is termed as incremental

revenues. In differential cost analysis, decisions are taken on the basis of comparison of
differential cost with incremental (or decremental) revenue. An alternative is considered
profitable when incremental revenue is more than differential cost.
DIFFERENTIAL COST ANALYSI S VS MARGI NAL
COSTING
Similarities
Both the techniques are based
on the classification of costs Both differential costing and Both the techniques are used
into fixed and variable. When marginal costing are by the management in
fixed costs do not change, the techniques of cost analysis and decision making and
differential cost and marginal presentation. formulating policies.
cost are the same.

Differences
The technique of marginal Marginal costs may be In marginal costing, Differential cost analysis can
costing excludes all fixed incorporated into the contribution, P/V ratio, key be made in the case of both
costs from its analysis, formal accounting system factors, etc., are the main absorption costing as well as
whereas, differential cost while differential costs are yardsticks for evaluation of marginal costing.
analysis includes identifiable worked out separately for performance and making
or traceable fixed costs. reporting to management for decisions while in
making specific decisions. differential cost analysis,
comparison is made
between differential cost and
incremental revenue for
decision-making purposes.
PRACTICAL APPLICATIONS OF DIFFERENTIAL
COST ANALYSIS
Determining
optimum level of
production

Introducing an Accepting a
additional shift special order

Further Adding or
processing of dropping a
joint/by-products product line

Evaluating make or
buy alternatives
• In a multi-product company, the management may have to decide on adding or
dropping a product line. When a new product line is added, its sales and certain costs
Product Line
will also be increased and reverse will happen when a product line is dropped. In Dropping a
order to arrive at such a decision, the management should compare the differential
cost and incremental revenue and study its effect on the overall profit position of the
Adding or
company.
• Sometimes management has to take a decision to accept or refuse an additional order Special Order
for one of its products at a price which is below the customary sale price. Such an order
can prove attractive when a business is working below full production capacity and the
Acceptance of a
price offered results in incremental revenue which is more than differential costs.
Production
• The optimum level is that level of production where profit is the maximum. In
Level of
order to arrive at a decision of this type, the differential costs are compared with Optimum
incremental revenue at various levels of output. So long as the incremental revenue
exceeds differential costs, it is profitable to increase the output.
of the
Determination
COST ANALYSIS
PRACTICAL APPLICATIONS OF DIFFERENTIAL
• When an additional shift is introduced, certain costs are bound to rise. Such Shift
additional costs should be compared with additional revenue so that their net effect on Additional
profit can be known for managerial decision. Thus, differential cost analysis helps Introduction of
management to decide whether additional shift should be introduced or not.
products
• Sometimes management has to take a decision regarding further processing of joint or
Joint /By-
by- products after split-off point. In such a case, apportionment of joint cost upto Processing of
split-off point is not relevant for the purpose of decision making regarding further Further
processing of joint products or by-products. Such decisions are taken an the basis
of comparison of differential cost and incremental revenue.
regarding
Decision
• Make or buy decisions, based on marginal costing, have already been discussed in Alternatives
this chapter. However, when making of a component requires addition investment in
plant, it results in additional fixed costs to be incurred. In such a situation make or buy
Make or Buy
decision is based on comparison of differential cost and incremental revenue and its Evaluating
effect on profit.
COST ANALYSIS
PRACTICAL APPLICATIONS OF DIFFERENTIAL