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Decisions InvolvingAlternative Choices

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Learning objective

Types of Decisions

Steps of decision making

Relevant and irrelevant Cost Features of Relevant Information

Terminology

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Types of Decisions

One Time Special Order

Make or Buy/Insoursing or outsourcing

Selection of a suitable product mix Effect of change in price

Maintaining a desired level of profit

Diversification of products Closing down or suspending activities

Own or Lease

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Types of Decisions Retain or Replace

Export or Local sales

Expand or Contract

Place special orders

Select sales territories Sell at split-up point or process further

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Decision-making steps 1. Identify and define the problem 2. Identify alternative as possible solutions to

the problem.

3. Eliminate alternatives that are clearly notfeasible

4. Collect relevant data (costs and benefits)

associated with each feasible alternative 5. Identify cost and benefits as relevant or

irrelevant and eliminate irrelevant costs and

benefits from consideration. 5

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Decision-making steps

6. Identify to the extent possible, non-financial advantage and disadvantage abouteach feasible alternative.

7. Total the relevant cost and benefits foreach alternative

8. Select the alternative with the greatest

overall benefits to make a decision 9. Implement or execute the decision

10.Evaluate the results of the decision

made. 6

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Relevance Relevant Information has two

characteristics:

It occurs in the future

It differs among the alternative courses ofaction

Relevant Costs expected future costs Relevant Revenues expected future

revenues

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Terminology Incremental Cost the additional total

cost incurred for an activity

Differential Cost the difference in totalcost between two alternatives

Incremental Revenue the additional

total revenue from an activity Differential Revenue the difference in

total revenue between two alternatives

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Terminology Opportunity costs are monetary benefits foregone

for not pursuing the alternative course.

Sunk costs are historical cost that cannot berecovered in a given situation. These costs areirrelevant in decision making.

Avoidable costs are costs that can be avoided infuture as a result of managerial choice. It is alsoknown as discretionary costs. These costs are

relevant in decision making.

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One-Time-Only Special Orders Accepting or rejecting special orders when

there is idle production capacity and the

special orders has no long-run implications Decision Rule: does the special order

generate additional operating income?

Yes accept

No reject

Compares relevant revenues and relevantcosts to determine profitability

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Special Orders SG limited manufactures 30,000 units of product T per

month. The plant has a capacity to manufactures 48,000units per month.

SP is $20/ Unit

VC for manufacturing is $7.5/ Unit

VC for marketing is $5/ Unit

FC for manufacturing is $135,000 FC for marketing is $60,000

A buyer has offered to buy 5000 additional unit @$11/unit.Should SG limited accept the offer?

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Special Order Illustration

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Sell Now or Process FurtherAssume that the product being offered

can either be sold currently as is for a

certain sum or processed further, withadditional costs, at which time it can besold for a greater amount than now.

ll h

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Sell Now or Process Further

The product is being discontinued and its price has

fallen. If the product is processed to completion itcan be sold for only $1,000 (less than cost incurredof $1,200 = $800 + $400)

If sold now they will bring in $500.

What should we do?

Cost per unit to

date

Further Cost per

unit to completeMaterial $300 $200

Labor 200 100

Var. OH 100 100

Fixed OH 200

Total $800 $400

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Differential costs

SellNow

ProcessFurther

Difference

Revenue $500 $1,000 $500Currentcosts

800 800 0

New costs 0 400

Total costs 800 1,200

Profit 100

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Sunk Costs Cost that have already been incurred

and cannot be changed.

Not relevant to any decision

Cost of $800 already incurred in theprevious example are sunk and should

be ignored. They do not change thesituation in any way.

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Make or Buy Often a company will purchase an ingredient

externally that is part of what they are

making. They could make this ingredient internally if it

is to their benefit to do so.

These decisions usually only involve costs,not revenues.

Qualitative factors must be considered.

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Make or Buy XYZ Co. is considering to purchase 50,000

units of ingredient D at a cost of $.32 per

unit. The company is currently producing

ingredient D internally with the following

costs:

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Variable costs

Direct material ($.10/unit) $5,000Direct labor ($.12/unit)

6,000Variable OH ($.08/unit) 4,000

Total variable costs 15,000

Fixed costs:

Depreciation equip. 800Depreciation Bldg 600Supervisor's salary 500Other 350

Total fixed costs 2,250Total costs $17,250

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Make or Buy Cost to manufacture internally is $.345 =

$17,250 / 50,000

Outside offer is for $.320

Other information: Market value of the machine we use to produce D

is zero if we try to dispose of it

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InternalCosts

ExternalCosts

Difference

Variable costs

Direct material ($.10/unit) $5,000 $0 $5,000Direct labor ($.12/unit) 6,000 0 6,000

Variable OH ($.08/unit) 4,000 0 4,000

Total variable costs 15,000 0 15,000

Fixed costs:

Depreciation equip. 800 800 0

Depreciation Bldg 600 600 0

Supervisor's salary 500 500

Other 350 350 0

Total fixed costs 2,250 1,750 500

Cost of buying outside 0 16,000 (16,000)

Total costs $17,250 $17,750 ($500)

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Avoidable Costs Not all fixed costs are irrelevant sunk costs

Some fixed costs are avoidable (i.e., they can

be avoided under one alternative) In the previous example we can terminate

the supervisors, hence this fixed costs isavoidable and therefore relevant and

differential. Since avoidable costs of $15,500 is less than

the cost of the external part, we should rejectthe offer based on financial grounds.

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Cost of buying externally (50,000x $.320)

($16,000)

Cost savings (avoidable costs)

Variable costs 15,000

Supervisor salaries 500Net costs ($500)

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Opportunity Cost The value of foregone benefits from selecting

one choice over an alternative.

You give up earning money at a job by goingto school full time.

Assume that, in the previous example, if we

no longer make ingredient D internally, wecan save $600 in rent by using the space foranother operation that is currently leasingwarehouse space.

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Cost of buying externally (50,000x $320)

($16,000)

Cost savings (avoidable costs)Variable costs 15,000

Supervisor salaries 500

Opportunity cost of using theplant to produce part D

600

Net savings $100

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Dropping a Product Need to calculate the change in profit if

the product is dropped versus retained.

Both differential costs and revenues areconsidered.

Procedure differs if there is excess

capacity versus at capacity If at capacity need to consider

opportunity costs.

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Dropping a Store

ABC Ltd. is considering dropping Store #2.

Direct fixed costs are items directly traceable

to the division Example salary of a worker who spends all his

time in this restaurant

Allocated fixed costs are fixed costs that are

shared between divisions Example Salary of the regional manager

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#1 #2 #3 Total

Sales $100,000 $150,000 $210,000 $460,000

Cost of sales 45,000 60,000 90,000 195,000

Gross Margin 55,000 90,000 120,000 265,000

Other variable costs 15,000 20,000 30,000 65,000

Contribution Margin 40,000 70,000 90,000 200,000

Direct fixed costs 20,000 65,000 40,000 125,000

Allocated fixedcosts

15,000 20,000 25,000 60,000

Total fixed costs 35,000 85,000 65,000 185,000

Net Income $5,000 $(15,000) $25,000 $15,000

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Dropping a Product Should #2 be dropped? It is showing a loss of ($15,000)!

What would happen to the divisions total net

income if the store was dropped?

Assume the direct fixed costs are buildingrent that can be avoided.

Allocated fixed costs are the regionalmanagers salary and some corporate costs.

If Store #2 were dropped, there would not beany impact on the other stores volume.

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Lost revenue $(150,000)

Cost savings

COGS 60,000

Other variable costs 20,000

Direct fixed costs 65,000

Total cost savings 145,000

Net loss from dropping division $(5,000)

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The Death Spiral This phenomena is sometimes referred to as

the Dearth Spiral.

You drop one product because it is a loser. Suddenly other products become losers.

You drop them.

Now other products become losers. And the spiral continues until you are out of

business!

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Equipment Replacement

Decision Toranto Company is considering replacing an old

machine with a new one. Revenue from both the

machine will remain same $ 1,100,000/annum.

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Old Machine New Machine

Original Cost 10,00,000 6,00,000

Book Value 4,00,000 --

Remaining Life 2 yrs 2 yrs

Terminal value 0 0

Current DisposalValue

40,000 0

Operating Cost/annum 8,00,000 4,60,000

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Equipment Replacement

Decision

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Equipment Replacement

Decision

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Decisions Involving

Constraints Basic decision is to keep any product/store

with a positive contribution margin as long as

you can keep selling it. That changes if, making one product affects

another product.

An example is when there is a constraint such

as a limited amount of skilled labor ormachine time

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Decisions Involving

ConstraintsProduct A Product B

Selling Price $100 $80

Variablecosts

50 60

ContributionMargin

$50 $20

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Decisions Involving

Constraints Suppose that both products require time on a

specialized machine. A total of 1,000 hours

are available. Product A requires 10 hours

Product B requires 2 hours

Which product should be produced assumingwe can sell as much of either as we produceat the given prices?

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Decisions Involving

Constraints Product A has the highest CM, we make

$50 for every one sold versus only $20

for each B.

But what about those machine hours?

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Decisions Involving

Constraints Since A requires 10 hours and we have 1,000

total, we can produce 100 A. At $50 each = $5,000 CM

Since B requires only 2 hours we can produce500 total. At $20 each = $10,000

Company is better off producing all ProductB.

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Decisions Involving

Constraints Decision rule:

Under conditions of a constraint, produce the

product with the highest contribution margin perunit of the constraint.

A has $50/10 hours or $5 per machine hour.

B has $20/2 hours or $10 per machine hour.

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Thanks..

Any Question..