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Sunday, October 24, 2010

Decision making in accountancy


Chapter – 5                                                          Decision making
Decision making: Decision making is a main tool of management accounting. Decision-making involves the art of selecting one course of action among the various feasible available alternatives. It involves forecast & planning. It is the process of evaluating project on the basis of financial choice to attain goals and objective for future.
It is the art of selecting best alternative among the various alternatives available to solve the given problem. In case of business, a best alternative is one, which is likely to provide maximum profits or minimum cost without violating the social responsibilities.
Concept of relevant costs: The cost and benefits that must be taken into consideration while making the decisions are relevant costs. In other words the relevant costs and benefits required for decision-making are only those that will affected by decisions. Costs and benefits that are independent of a decision are obviously not relevant need not to be considered when making that decision.
Incremental/ differential cost: Incremental costs are defined as the change in overall cost that results from particular decision being made. Incremental cost may be fixed & variable. In short period incremental cost will consists of variable costs like; additional cost of labour, raw materials, which is the result of new decision being made by the firm.
Future & Past costs: Past cost are historical cost which are actually incurred in the past, they are always in the income statement and required to measure for record keeping activity.

Future costs are reasonably expected to be incurred in some future period of time. For managerial use the future costs are relevant for cost control, projection of future profit & loss statement, for introducing the new product line, expansion program and pricing.
Opportunity costs: The opportunity costs or alternative costs are the return from the second best use of firm’s resources. In other words the opportunity costs are sacrificed by the firm in order to avail itself of the return from the best use of resources. Even though these costs are most important for some decision situation for decision maker; these costs are not recorded by the accountant. (Opportunity cost of accepting a special order = Regular sales volume sacrifice ´  contribution margin per unit on regular sales)
Decision making process: a. Define the problem b. Identify the alternatives c. Collect relevant information, d. Make differential revenue/cost analysis e. consider the opportunity costs f. Qualitative factors, g. Management report
Example: Suppose presently you are working as an officer in a commercial Bank in Nepal at a monthly remuneration of Rs. 25,000 of which Rs. 5,000 is spent for living cost and now trying to go to USA for the purpose of employment. Why an individual thinks to work in USA even if he/she has already an employment in Nepal? It is perhaps for some incremental earning in USA over the present earning in Nepal. Suppose you are informed to earn $2500 per month (Suppose, $1=NPR 80, $2500= NPR 2,00,000) in USA. Living cost all together is likely to be $1,000 per month ($1=NPR 80, $1,000= NPR 80,000) there. How much would you save there? How much incremental earning per month would be in USA over the earning already you have in Nepal?. See the following differential analysis:
                                                                                                   Stay in Nepal                       Difference                            Go to USA
Gross earning per month                                       Rs. 25,000                             Rs. 1,75,000                         Rs. 2,00,000
Living cost per month                                                    5,000                                       75,000                                   80,000
Net saving per month                                                    20,000                                   1,00,000                                1,20,000
The differential statement shows that you can earn Rs. 1,00,000 more if you go to USA. It is not important that how much can you earn in USA, rather the important fact is how much difference would you have between these two alternatives. In each case of decision making you should see this kind of differential analysis.
Types of decisions
  1. Accept or reject a special offer

  2. Make or buy a component

  3. Drop or  continue a product line

  4. Replacement of existing assets new assets

1.       Accept or reject a special offer: The Company should make the decision regarding to accept or reject the special offer only when there is excess or idle capacity is available. In special order/offer the selling price of the product will lower than that of normal selling price & the special offer sales does not affect the regular sales of the same product.

Suppose that you are thinking to make merry during this season. There are three candidates in consideration. It means you are considering making merry with the best one among the three alternative candidates. You collected the following comparative information in this regard;





Candidates

A
B
C
Age
Education
Character
Beauty
Job
24
BBA
OK
Moderate
Unemployed
24
+2
OK
Moderate
Clerk
24
BBA
OK
Moderate
Assistant Manager
Based on above facts, which candidate would you prefer? Rationally, it would be preferably C one. Why? Which factor /factors made you to prefer C among the three? From age point of view, there is no difference. So it is irrelevant factor. Education? You reject B and consider now only A and C. Therefore education is relevant factor here. Because it compelled you to reject B. Character and beauty is almost same for all three, you find no difference and so you are helpless to prefer any one. In such a case you would be indifferent. The information, which does not help you to prefer any one alternative, is irrelevant for decision-making. Job perspective, of course, encourages you to prefer C one, because he/she is in the highest rank among three.
What would be your final decision? Perhaps, you might decide to merry with C. The age, character and beauty are same for all three. So, these do not matter here. From education perspective you less prefer to B because he/she is only +2 whereas other two are BBA. From job perspective you prefer C, because he/she is in higher rank position. Here, education and job factors encouraged you to select C. If all five factors would be same for all three, you would be helpless to prefer any one and perhaps, you would make random decision.
 Factors to be considered while making the decision regarding to accept or reject the special offer:
    1. Sales revenue is considered to be relevant.

    2. Variable manufacturing cost is considered to relevant

    3. Fixed manufacturing cost may or may not be relevant unless until it is stated.

    4. In the absence of clear information regarding other expenses like; marketing, advertising, freight outward and selling & administrative expenses such expenses should not be included in special offer.

    5. Whether the idle capacity is available or not for special offer.

    6. Consideration for the opportunity costs.

    7. Consideration of frequency of order.

    8. Impact of reduction of selling price upon regular customers.

Cost analysis Statement for Special offer













Cost Elements
Without Offer
Differential
With Offer
Sales Unit
××××××
×××××
××××××
Sales Revenue
××××××
×××××
××××××
Less: Variable Costs:



Direct material
××××
××××
××××
Direct Labour
××××
××××
××××
Variable manufacturing expenses
××××
××××
××××
Variable Selling & Adm. Expenses
××××
××××
××××
Total variable cost
××××××
××××
××××××
Contribution margin
×××
×××
×××
Less: Fixed Costs:
××××
×××
××××
Net Income
××××
××××
××××
Decision: If the differential income is resulted the offer is acceptable considering other qualitative factors & if the differential is loss is resulted the offer is not acceptable.

Demonstrative Problem: A company with a normal capacity of 25,000 DLH was been able to utilize only 80% of its capacity in the past. The company received an offer to supply 30,000 units of it’s product but in the other brand name at a price of Rs. 15 per unit. The regular selling price and cost of manufacturing one unit of output have been detailed below:







Selling price per unit
Rs. 20
Direct material
Rs. 5
Direct Labour 0.25 hour
Rs. 5
Manufacturing overhead cost 0.25 hour
Rs. 6
Total manufacturing cost
Rs. 16
The selling and distribution cost would be Rs. 2 per unit and budgeted fixed manufacturing cost for normal capacity volume would be Rs. 300,000
Required:
a.       Deferential cost analysis
b.       Desirability of offer
c.        Opportunity of offer if any
Solution: Normal capacity = 25,000 DLH     Normal Capacity in units = 25,000×4 = 100,000 units
                Operating Capacity in units = 100,000×0.8 = 80,000 units
                Standard fixed manufacturing overhead rate (SFOR)                 = Fixed manufacturing overhead
                                                                                                             Normal Capacity in units
                                                                                                        = 300,000
                                                                                                           100,000              = Rs. Rs. 3 per unit
Variable manufacturing overhead rate = Rs. 6 – Rs. 3 = Rs. 3 per unit














Cost Elements
Without Offer
Differential
With Offer
Sales Unit
80,000
20,000
100,000
Sales Revenue @ Rs. 20 & 15
1600,000
250,000
1,850,000
Less: Variable Costs:



Direct material @ Rs. 5
400,000
100,000
500,000
Direct Labour @ Rs. 5
400,000
100,000
500,000
Variable manufacturing expenses @ Rs. 3
240,000
60,000
300,000
Variable Selling & Adm. Expenses @ Rs. 2
160,000
(20,000)
140,000
Total variable cost
1,200,000
240,000
1,440,000
Contribution margin
400,000
10,000
410,000
Less: Fixed Costs:
300,000
-0-
300,000
Net Income
100,000
10,000
110,000
b. The company should accept the offer considering other qualitative factors because accepting the offer will increase company’s profit by Rs. 10,000
c. Sales revenue for 10,000 units in regular sales i.e. 20×10,000                                 = Rs. 200,000
    Sales revenue for 10,000 units for special offer i.e. Rs. 15×10,000               = Rs. 150,000
Opportunity cost (Revenue sacrificed by the company due to the acceptance of special offer)
     = Rs. 50,000 (i.e. Rs. 200,000 – Rs. 150,000)
Verification:
        Sales units                                                                           30,000
        Sales revenue @ Rs. 15                                                  450,000
Less: Variable cost @ Rs. 13 per unit                                  390,000
        Contribution Margin                                                         60,000
Less: Opportunity cost                                                             50,000
        Net Income                                                                         10,000

2.  Decision to Drop a Product Line:When the firm is divided into multiple sales outlet, products lines, divisions, departments, it may have to evaluate their individual performances to decide whether or not to continue operations of each of these segments or add a new segment. The decision criterion would be the segment margin. The segment margin equals segments contribution margin less fixed costs that are directly traceable to that segment. The decision criterion in operates or shut down situation will be based on the comparisons of the shutdown losses and the losses associated with continuing operations

Qualitative Factors in Drop or Continue Decision Before a decision can be made on the question of dropping a product line, factors other than immediate profit maximization must be considered.
1. Capacity utilization
2. Effect on discontinued product on other products.
3. Customer goodwill
4. Can employees in Dropped line be released without effects on company morale?
Example: Nayabaneshwor Cold store has three major product lines; Coke, Fenta & Sprite. The store is considering dropping the Fenta line because the income statement shows that it is operating at a loss. Note the income statement for these product lines below:
                                                Coke                                      Fenta                                      Sprite                                      Total
Sales (in Rs.)                         10,000                                   15000                                    25000                                    50000
Less: Variable Costs             6000                                     8000                                       12000                                    26000
CM                                         4000                                       7000                                       13000                                    24000
Less: Fixed costs                 
Direct                                     2000                                       6500                                       4000                                       12500   
Allocated                               1000                                       1500                                       2500                                       5000
Total                                      3000                                       8000                                       6500                                       17500
Net Income                           1000                                       (1000)                                    6500                                       6500      
Required: a. Prepare a combined income statement for Coke and Sprite on the assumption that Fenta is                   discontinued with no effect on sales of the other product lines
                  b. On the basis of analysis in a, would you advise dropping the Fenta?
Solution:
                                                Keep Fenta                           Drop Fenta                            Difference                            
Sales (in Rs.)                         50000                                    35000                                    15000
Less: Variable Costs             26000                                  18000                                    8000_
CM                                         24000                                    17000                                    (7000)
Less: Fixed costs                 
Direct                                     12500                                    6000                                       6500                                      
Allocated                               5000                                       5000                                       __0___
Total                                      17500                                    11000                                    (6500)_
Net Income                           6500                                       6000                                       (500)__
On the basis of above analysis we see that by dropping Fenta will lose an additional Rs. 500. Therefore, the Fenta product line should be kept.
Incremental approach:
Sales revenue lost                                                                                                                15000
Gains:
Variable cost avoided                                                         8000
Direct fixed cost avoided                                                   6500                                       14500
Increase (decrease) in net income                                                                                    (500)

3.  Decision to make or buy a component: Many firms have to choose between manufacturing certain components themselves or acquiring them from outside suppliers. Incremental analysis provides solution to this kind of decision problems. The relevant information is the committed/avoidable costs if the firm has adequate idle capacity to make the component. This is so because the firm wouldn't be required to incur fixed costs to produce the components. If, however, there is need to enlarge the capacity of existing plant or the existing capacity of the plant is diverted for the production of the components, opportunity costs in terms of lost contribution will be relevant to the decision analysis.

Qualitative Factors in make or buy decision: Before a decision can be made on the question of making or buying a component, factors other than immediate profit maximization must be considered.
1.       Quality of the purchased components
2.       Reliability of delivery to meet production schedules
3.       The financial stability of the supplier.
4.       Development of an alternate source of supply.
5.       Alternate uses of component manufacturing capacity.
6.       The long run character and size of the market.
Example: JK manufacturing Corp. is using 10,000 units of part no. 300 as a component to assemble one of tis products. It costs the company Rs. 18 per unit to produce it internally, computed as follows:
                                                                Direct material                                     Rs. 45000
                                                                Direct labour                                                 50000
                                                                Variable overheads                                     40000
                                                                Fixed overheads                                          45000
                                                                Total cost                                                      180,000
An outside vendor has just offered to supply the part for Rs. 16 per unit. If the company stops producing this part, one-third of the fixed overhead would be avoided. Should the company make or buy?
Solution:                                                                                                                       10,000 Units
                                                                                                                                                                                                               
                                                                                                        Make                                                 Buy
                                        Outside purchase price                                                                                   160000
                                        Direct material                                     45000
                                        Direct labour                                         50000
                                        Variable overhead                               40000
                                        Fixed overhead                                    15000                                                                           
                                        Total cost                                             150000                                              160000
As indicated above, the company is better off making the part.
Assets Replacement Decision:  Some time choice is to be made between retention or replacement of equipment. Basically, replacement of machine or equipment is a capital investment or long-term decision requiring use of discounted cash flow technique. But, here discussion is confined to short range problems. Therefore, only one aspect of replacement will be dealt with i:e. how to deal with written down book value of old equipment? And differential cost approach is primarily followed because replacement will invariably involve additional fixed cost. Major consideration for relevant to decision are:
Relevant items of cash inflow and outflow is to be determined.
Loss on sale of old machinery is irrelevant for decision.
Sale proceeds of old machine is relevant
Replacement may bring down the cost per unit but initial cash outlay is required.
Profit on sale of old assets may affect tax payment.
Example: A company purchased a machine two years ago at a cost of Rs. 60000.  The machine has no salvage value at the end of it six years of useful life and the company is charging depreciation according to SL method. The company learns that a new equipment can be purchase at a cost of Rs. 80000 to do the same fob and having an expected economic life of 4 years without any salvage value. The advantage of the new machine lies in its greater operating efficiency, which will reduce the variable operating expenses from the present level of Rs. 165000 to Rs. 130000 per annum. The sales volume is expected to continue at Rs. 200000 per annum for the next four years.  You are required to evaluate the usefulness of the proposal.
Solution:  Statement showing the profitability of the present and the new machine over a period of 4 years
                                                                                                Present                   Old                          Difference
                Sales 200000x4                                                   800,000                 800,000                 _____
                Variable cost 165000x4 & 130000x4             660,000                 520,000                 (140,000)
                Capital cost or depreciation of new machine                                _____                    80,000   80,000
                Total cost                                                              660,000                 600,000                 (60,000)
                Profit                                                                      140,000                 200,000                 60,000
Average annual incremental income (60,000/4)           = Rs. 15,000
Incremental investment (80,00-0)                                   = Rs. 80,000
Return on incremental investment                                   = 18.75%
Decision: The Company should replace the existing equipment with new one costing Rs. 80,000 as the above income/Profitability statement shows the return of 18.75% on additional investment.


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