Business Accounting

& Finance
(ACC:501)

Credit Hours- 4 Credits

Hari Dallakoti
 Chapter – Five

Decision Regarding
Alternative Choice
 Introduction
 Decision making is a rational and systematic process.
 It includes objectives of the decision maker, recognition of
constraints, clear success measure or goal for assessing progress
toward solving the problem.
 Controllable and uncontrollable factors need to be enumerated for
decision making purposes.
 Controllable factors are the alternative courses of action and
uncontrollable factors are the uncertainties in the competitive
environment.
 The degree to which information is relevant or precise often depends
on the degree to which it is: qualitative and quantitative.
 It is a fundamental tool for considering “what if” situations.
 It can be used in determining the value of “perfect” information.
 Decision Model

• A decision model is a formal method of making a choice, often

involving both quantitative and qualitative analyses.
• Managers often use some variation of the Five-Step Decision-
Making Process.

Five-Step Decision-Making Process

Step 2:
Make Step 3: Step 4:
Step 1: Step 5:
Predictions Choose Implement
Obtain Evaluate
About An The
Information Performance
Future Alternative Decision
Costs

Feedback
 Relevant and Irrelevant Information
Relevant and Irrelevant information is the information relating to
relevant and irrelevant costs and revenues.
Relevant costs and revenues are expected future costs and revenues that
differ among the alternative courses of action being considered.
Irrelevant costs and revenues are historical costs and revenues because
they are past costs and revenues and, therefore, cannot differ among
alternative future courses of action.
Relevant information depends on the decision being made.
Accountants should use two criteria to determine whether information is
relevant:
1. Information must be an expected revenue or cost and...
2. It must have an element of difference among the alternatives.
 Make or Buy
 The basic make-or-buy question is whether a company should
make its own parts to be used in its products or buy them from
vendors.
 A manager must take the decision relating to this issue.
 It is necessary to identify the costs accurately that takes place
while producing the component or while buying the component.
 The costs so incurred needs to be compared for decision making
purposes.
 This decision is based on qualitative information and quantitative
information.
 In account, such decision will be normally based on the
information relating to costs and profitability.
 Make-or-Buy Decisions Example
GE Company Cost of Making Part N900:
Total Cost for 20,000 Units Cost per Unit
Direct material $ 20,000 $ 1
Direct labor 80,000 4
Variable overhead 40,000 2
Fixed overhead 80,000 4
Total costs $220,000 $11
•Another manufacturer offers to sell GE the same part for $10.
•The essential question is the difference in expected future costs between the
alternatives.
•Should GE make or buy the part?
•If the $4 fixed overhead per unit consists of costs that will continue regardless of the
decision.
•If $20,000 of the fixed costs will be eliminated if the parts are bought instead of made.
 Make-or-Buy Decisions Example
Make Buy
Total Per Unit TotalPer Unit
Purchase cost $200,000 $10
Direct material $ 20,000 $ 1
Direct labor 80,000 4
Variable overhead 40,000 2
Fixed OH avoided by not making 20,000 10 0 0
Total relevant costs $160,000 $ 8 $200,000 $10

Difference in favor of making $ 40,000 $2

Decision:- Since the total costs while making the parts is less by $ 40,000, it will
be
profitable to make the parts by the company. So the company should
take
the decision to make the parts.
 The Special Sales Order Decision
• Frequently, the opportunity arises for management to consider an order for a
quantity of its regular product at a special price (usually less than that charged
regular customers).
• When there is excess or idle production capacity, such an offer may be attractive.
• The firm is inclined to accept special offer because there is an idle capacity – the
current operating level is below full capacity.
• But should it be accepted at the price quotation given by the buyer or some
negotiated price.
• Such a special order will not affect the regular sales of the same product.
• If there is no idle capacity, the question of special order does not arise.
• The decision to accept additional business should be based on incremental costs
and incremental revenues.
• Incremental amounts are those that occur only if the company decides to accept
the new business.
 Example
Jam Co currently sells 100,000 units of its product. The company has
revenue and costs as shown below:
Per Unit Total
Sales $ 10.00 $ 1,000,000
Direct materials 3.50 350,000
Direct labor 2.20 220,000
Factory overhead 1.10 110,000
Selling expenses 1.40 140,000
Adminis trative expenses 0.80 80,000
Total expenses $ 9.00 $ 900,000
Operating income $ 1.00 $ 100,000

Jam Co is approached by an overseas company that offers to purchase

10,000 units at $8.50 per unit. If Jam Co accepts the offer, total factory
overhead will increase by $5,000; total selling expenses will increase by
$2,000; and total administrative expenses will increase by $1,000.
Should Jam Co. accept the offer?
 Solution
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

Since the profit of Jam Co will increase after accepting the special
order, it should accept the order. Even if the sales price of special
offer is less than the normal selling price of the company, the total
profit is increased by $ 20,000. So if the company accept the special
order, Jam Company will enjoy the additional profit of $20,000.
 Cont.
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $8.50 selling price = $85,000

 Cont.
Current Additional
Business Business Combined
Sales $ 1,000,000 $ 85,000 $ 1,085,000
Direct materials $ 350,000 $ 35,000 $ 385,000
Direct labor 220,000 22,000 242,000
Factory overhead 110,000 5,000 115,000
Selling expenses 140,000 2,000 142,000
Admin. expenses 80,000 1,000 81,000
Total expenses $ 900,000 $ 65,000 $ 965,000
Operating income $ 100,000 $ 20,000 $ 120,000

10,000 new units × $3.50 per unit = $35,000

 Cont.
C urrent Ad
ditional
B
u siness Bus
in ess Combined
Sa le s $1,0
0 0,0
0 0 $ 8 5,0
00 $1
,08
5,000
Dire c tm aterials $ 35 0,0
0 0 $ 3 5,0
00 $ 38
5 ,0
00
Dire c tlabor 2
2 0,0
0 0 2 2,0
00 24
2 ,0
00
F
a c to ryo verhe ad 1
1 0,0
0 0 5,0
00 11
5 ,0
00
Se llin ge xpe n
s es 1
4 0,0
0 0 2,0
00 14
2 ,0
00
Ad m in .expe n
s es 8 0,0
0 0 1,0
00 8
1 ,0
00
T
o ta le xpen ses $ 90 0,0
0 0 $ 6 5,0
00 $ 96
5 ,0
00
Op e ra tin
gin co me $ 10 0,0
0 0 $ 2 0,0
00 $ 12
0 ,0
00

10,000 new units × $2.20 per unit = $22,000

 Cont.
C urrent Ad
ditional
B
u siness Bus
in ess Combined
Sa le s $1,0
0 0,0
0 0 $ 8 5,0
00 $1
,08
5 ,0
00
Dire c tm aterials $ 35 0,0
0 0 $ 3 5,0
00 $ 38
5 ,0
00
Dire c tlabor 2
2 0,0
0 0 2 2,0
00 24
2 ,0
00
F
a c to ryo verhe ad 1
1 0,0
0 0 5,0
00 11
5 ,0
00
Se llin ge xpe n
s es 1
4 0,0
0 0 2,0
00 14
2 ,0
00
Ad m in .expe n
s es 8 0,0
0 0 1,0
00 8
1 ,0
00
T
o ta le xpen ses $ 90 0,0
0 0 $ 6 5,0
00 $ 96
5 ,0
00
Op e ra tin
gin co me $ 10 0,0
0 0 $ 2 0,0
00 $ 12
0 ,0
00

Even though the $8.50 selling price is less than the

normal $10 selling price, Jam Co should accept the
offer because net income will increase by $20,000.
 Cont.
We can also look at this decision using contribution margin.
Per Unit Total
Special order revenue $ 8.50 $ 85,000
Direct materials 3.50 35,000
Direct labor 2.20 22,000
Contribution margin $ 2.80 $ 28,000
Increase in fixed costs:
Factory overhead $ 5,000
Selling expenses 2,000
Administrative expenses 1,000
Special order profit $ 20,000

Under this approach also, the profit of Jam Co is $ 20,000 if it

accept the offer so it should accept the special order.
 Drop or Continue Department/ Product
• Decision Rule: Does adding or dropping a customer add operating
income to the firm?
– Yes – add or don’t drop
– No – drop or don’t add
• Decision is based on profitability of the customer, not how much
revenue a customer generates.
• Decision Rule: Does adding or discontinuing a branch or segment add
operating income to the firm?
– Yes – add or don’t discontinue
– No – discontinue or don’t add
• Decision is based on profitability of the branch or segment, not how
much revenue the branch or segment generates.
 Example
A department store that has three major departments:
Groceries, General merchandise and Drugs.
Departments
General
Groceries Mdse. Drugs Total

Sales $1,000,000 $800,000 $100,000 $1,900,000

Variable expenses 800,000 560,000 60,000 1,420,000
Contribution margin $ 200,000 $240,000 $ 40,000 $ 480,000
Fixed expenses:
Avoidable $ 150,000 $100,000 $ 15,000 $ 265,000
Unavoidable 60,000 100,000 20,000 180,000
Total fixed expenses $ 210,000 $200,000 $ 35,000 $ 445,000
Operating income $ (10,000) $ 40,000 $ 5,000 $ 35,000
 Solution

 For this example, assume first that the only alternatives to be considered are dropping
or continuing the grocery department, which shows a loss of $10,000. Assume further
that the total assets invested would be unaffected by the decision. The vacated space
would be idle and the unavoidable costs would continue.

Total Effect of Total

Before Dropping After
Change Groceries Change
Sales $1,900,000 $1,000,000 $900,000
Variable expenses 1,420,000 800,000 620,000
Contribution margin $ 480,000$ 200,000 $280,000
Avoidable fixed expenses 265,000 150,000 115,000
Profit contribution to
common space and
other unavoidable costs $ 215,000 $ 50,000 $165,000
Unavoidable expenses 180,000 0 180,000
Operating income $ 35,000 $ 50,000 $ (15,000)
 Contd.
• Decision- As the operating profit after dropping the Groceries is negative,
it would not be wise to drop the groceries department. The revenues of
the Groceries department has contributed much for the fixed costs of the
Department Stores. Dropping down the Groceries will be beneficial for
the Department Store only at that time when it get success to reduce the
fixed costs. If the store has got success to reduce the unavoidable costs of
Groceries as well, then it would have enjoyed the operating profit. But in
above condition, as the fixed costs of Groceries can not be avoided, it
would not be wise to drop the Groceries as it has contributed for fixed
expenses.
 End of the Chapter

Thank You