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.
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 USA USA Nepal USA Nepal USA USA Nepal
Stay in Nepal 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 USA
Types of decisions
- Accept or reject a special offer
- Make or buy a component
- Drop or continue a product line
- 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:
- Sales revenue is considered to be relevant.
- Variable manufacturing cost is considered to relevant
- Fixed manufacturing cost may or may not be relevant unless until it is stated.
- 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.
- Whether the idle capacity is available or not for special offer.
- Consideration for the opportunity costs.
- Consideration of frequency of order.
- 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 unitVariable 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
= 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.
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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