* USING ACCOUNTING INFORMATION IN DECISION MAKING
* RELEVANT COSTS AND BENEFITS
DECISION MAKING
- the function of selecting courses of action for the future
- The process of examining your possibilities, options, comparing them, and choosing a course of
action.
DECISION MODEL
- A formal method used by managers for making a choice. It often involves both quantitative and
qualitative analyses.
BASIC STEPS IN A DECISION MODEL
IDENTIFY THE PROBLEM. The typical short-term decision-making case may involve questions on:
1. Accept or reject 5. Best product mix
2. Make or buy 6. Profit factors to change
3. Sell or process further 7. Pricing decisions
4. Continue or close business
B. OBTAIN INFORMATION AND MAKE PREDICTIONS
1. QUALITATIVE AND QUANTITATIVE INFORMATION
a. Qualitative factors - cannot be easily and accurately measured in numerical terms
b. Quantitative factors can be more easily expressed in numerical terms
2. RELEVANT INFORMATION relevant and related to the decision making case
a. Relevant Costs and Revenues differ among alternative courses of action
The following are relevant:
1. Differential costs - present in one alternative in a decision-making case, but are absent in whole in part in another
alternative
2. Avoidable costs - can be eliminated when one alternative is chosen over another
3. Opportunity costs- income is lost when one action is taken over the next best alternative course of action
The following are irrelevant:
1. Sunk costs - cost that has been incurred and cannot be avoided
2. Future costs - do not differ between or among the alternatives
C. IDENTIFY AND EVALUATE THE ALTERNATIVE COURSES OF ACTION, THEN CHOOSE THE BEST ALTERNATIVE
^ Only relevant factors should be considered in evaluating alternatives
^ As a general rule, the best alternative is the one will give the organization the highest income (or lowest loss)
D. IMPLEMENT THE DECISION
E. EVALUATE THE PERFORMANCE OF THE DECISION IMPLEMENTED TO PROVIDE FEEDBACK
^ making better decisions in the future
Accept or Reject a Special Order
Special orders or one-time orders usually involve a larger volume and a discounted or lower sales price. Orders
like this should be evaluated considering the costs relevant to the situation, availability of productive capacity and the
goals of the company.
TOTAL APPROACH
Under this type of analysis, the total revenues and costs are determined for each alternative and the results are
compared to serve as bases for making decisions.
DIFFERENTIAL ANALYSIS
The total approach is quite long, requiring the analysis of all the data involved in the case.
A short-cut method to analyze problem can be applied. Under this method of analysis, only the differences or changes
(increases and decreases or increments and decrements) in revenues and costs are considered.
_____________________________________________________________________________________
Dao-oil Company, which sells a chemical product called Fallurin, received a special order for 1,000 litres of Fallurin from
a valued customer. Because of the large volume of this order, the customer is asking for discount of 40% off the regular
selling price of P25 per litre.
Pertinent data about product Fallurin are as follows:
Normal plant capacity 5, 000 litres
Present sales volume-regular customers 3, 500 litres
Production costs: Materials 3.00 per litre: Labor 2.00 per litre;
Factory overhead:
Variable 3.00 per litre
Fixed 7,500 per month
Selling and administrative: Variable 2.00 per litre; Fixed 11,250 per month
It was ascertained that the special order will not require additional selling and administrative costs and that the same
will not affect regular sales. Dao-oil Company wants to make a decision on whether to accept or reject the special order.
____________________________________________________________________________________
Assume that Benedicto Company presently produces and sells 20, 000 units of Product X which represent only 80% of its
normal capacity of P25, 000 units. Its regular selling price is P50 per unit and its manufacturing, selling and
administrative costs are as follows:
Materials P10
Labor 12
Variable Overhead 8
Fixed overhead (P60, 000/20,000) 3
Variable selling and administrative costs 7
Fixed selling and administrative costs
(P40, 000/20,000) 2
Total Unit Cost 42
Benedicto Company received an order from a provincial distributor for 3,000 units. The customer asks for a special
discount of 30%. It is expected that the company will incur no additional selling and administrative costs.
Will the company accept or reject the special order?
____________________________________________________________________________________
SEATWORK:
Daimler companys normal capacity is 60, 000 units, half of this are utilized. For last month, the result of its operations is
summarized in the ff, statement:
Sales (30, 000 units) p 1, 500, 000
Less variable costs 600, 000
Contribution Margin 900, 000
Less fixed costs 500, 000
Profit 400, 000
Of the variable and fixed costs shown on the statements, are manufacturing costs; the balance is selling and
administrative costs:
This month, a customer submitted a proposal to buy 35, 000 units of the product at P25 per unit. The only selling cost to
be incurred for this order is P4 per unit representing freight charges that will be shouldered by Daimler. If this special
order proves to be acceptable, Daimler is willing to reduce sales to regular customers so as not to exceed it normal
capacity.
1. Accept or Reject? 2. Contribution Margin per unit Regular sales?
3. Contribution Margin per unit Special order? 4. Contribution Margin (Pesos) to be lost by reducing sales to regular
customers? 5. Profit or loss from special order?
1. ACCEPT
2. 30
3. 6
4. 150, 000
5. 60, 000
_____________________________________________________________________________________
Continue or Discontinue Operating a Business Segment
Heiko Enterprises sell three products, A, B, and C. Heiko, the owner, is concerned about the losses incurred by C, and is
considering to discontinue its production and sales.
Sales and costs data about Heikos three products are as follows:
A B C TOTAL
Sales price per unit P 5 P 7 P 9 P 21
Variable cost per unit 2 3 7 12
Contribution margin per unit 3 4 2 9
Fixed cost per unit 1 2 3 6
Profit (Loss) Per unit P 2 P 2 P (1) P 3
Fixed costs are allocated among the three products based on the floor are they occupy.
Heiko is thinking that if he would eliminate C, its loss of P1 per unit from P3
(P2 + P2 P1) to P4 (P2 + P2).
Is Heikos analysis correct?
_____________________________________________________________________________________
Ace operates a chain of bookstores with branches in Manila, Quezon City and Makati. A summary of operating results of
the three branches during a typical month is shown below:
MANILA MAKATI QUEZON TOTAL
Sales P 300, 000 P 400,000 P 500,000 P 1,200,000
Costs and expenses:
Variable 120,000 160,000 200,000 480,000
Direct fixed costs 50,000 140,000 70,000 260,000
Allocated home office costs P 90,000 P 120,000 P 140,000 P 350,000
Total costs and expenses 260,000 420,000 410,000 1,090,000
Operating Profit (Loss) 40,000 (20,000) 90,000 110,000
Like in the previous months, Ace observed that the Makati Branch operated at a loss. Due to this, Ace is considering to
close the Makati Branch, hoping that the loss would be eliminated. She disclosed her plan to her accountant who in turn
informed her that if she would push through with her plan, Makatis sales, variable costs and direct fixed costs would all
be eliminated. However, total home office costs would not change; the amount allocated to Makati would just be
absorbed by the other branches.
Should Ace continue operating the Makati Branch despite its operating loss?
__________________________________________________________________________________________________
Temporary Shut Down
This may involve discontinuance of operations of not merely a business segment but the business itself as a whole
This problem arises when some internal or external factors adversely affect the operations of the business on a
temporary basis, which may warrant temporary closure of the business.
Such factors include labor unrest in the company or customers businesses, political and economic instability, building or
road construction within or near the companys premises, or shortage in materials and other supplies.
As soon as situations go back to normal, operations may be resumed.
When a business temporarily shut down its operations, it will stop generating revenue and avoid incurring variable and
some fixed costs. There are costs, however, that the company will continue to incur even when there is no operation.
These are called shut down costs which may include security and maintenance of the facilities and other unavoidable
costs.
Example:
Mr. Juan Cruz operates a snack counter selling sandwiches and soft drinks to students of the school across his store, as
well as to his neighbors and passers-by. Each unit sale is composed of a sandwich and a cup of soft drinks which is sold at
a lot price of P15. Variable cost amounts to P8 per unit. Under normal conditions, Mr. Cruz sells an average of 3, 000
units per month, during which he incurs the following fixed costs:
A joint strike of teachers and students which started the other day dramatically reduced the sales of Mr. Cruz snack
counter composed only 800 units because customers would now be composed only his neighbours and passers-by. Mr.
Cruz is considering shutting down operations for one month to avoid incurring losses due to the reduced sales
volume. He notes that if he shuts down his operations, his share in the allocated cost of utilities would be reduced to
P500, and he could asked to take a forced leave without pay the sales clerk while the business is closed. All the other
fixed costs would be incurred despite the discontinuance of operations
Should the snack counter be shut down for one month?
Rent P 3,000
Allocated cost of utilities 2,000
Salary of Sales Clerk 1,500
Janitor's Salary 1,000
Security agency's billing 2,500
Total 10,000
Shut Down Point
This is also called indifference point, which may be expressed in terms of units or pesos.
This refers to the number of units that must be sold or the amount of sales in pesos that must be generated such that
the resulting loss would be equal to the loss to be incurred if operations were discontinued. The formulas for shutdown
point are:
Fixed costs under continued operations - Shutdown costs
Shutdown point in pesos =
Contribution Margin Ratio
Seatwork:
Tennis Company plans to discontinue a department that has a contribution margin of P24, 000, 4.00, in pesos and per
unit, respectively, sales of P60, 000, and P48, 000 in fixed costs. Of the fixed costs, P21, 000 cannot be eliminated.
1. Total units produced? 5. Profit or loss under 8. Net peso advantage?
continued operation?
2. Variable cost ratio? 9. Shutdown point in units?
6. Profit or loss under
3. Break-even in units? discontinued operation?
4. Break-even in pesos? 7. Continue or discontinue?
10. Shutdown point in pesos?
ANSWERS: 3. 12, too units
1. 6, 000 units 4. P120, 000
2. 60% 5. P24, 000 loss
6. P21, 000 loss 9. 6,750 units
7. Discontinue 10. P67, 500
8. P3, 000
Make or Buy
It involves choosing between producing an item and buying it from outside suppliers.
In most cases, such item involves a tangible product such as a part, subassembly or materials needed in manufacturing
the companys major product line.
Make or buy decision cases are not limited tangible products. At times, they involve service activities
Make or buy decision analysis usually involves comparing the net relevant manufacturing costs with the cost of buying
the item.
COST TO MAKE COST TO BUY
PURCHASE PRICE X
DIRECT MATERIALS X
MATERIALS HANDLING COSTS X X
DIRECT LABOR X
VARIABLE OVERHEAD X
AVOIDABLE FIXED OVERHEAD X
SAVINGS IF THE PART IS BOUGHT (X)
RENTAL INCOME FROM RELEASED FACILITIES (X)
CONTRIBUTION MARGIN FROM NEW
PRODUCT BEING PRODUCED USING THE
RELEASED FACILITIES (X)
RENTAL EXPENSE IF THE PART IS BOUGHT X
TOTAL RELEVANT COST X X
MATERIALS HANDLING COSTS apply to materials and other purchases and are normally allocated based on a purchase
cost. Inasmuch as the cost of purchase changes, consequently, the allocated costs change as well, and therefore are
relevant costs in the short-term decision making.
Seat Company, a manufacturer of furniture sets, is considering to purchase the seat pillows needed for its chairs. The
expected purchase price of these seat pillows is P50 per unit.
Seat has been making its own seat pillows since it started operating. If it would continue to produce these pillows, the
company expects to incur the following costs:
Raw material P 13
Direct labor 15
Variable overhead 5
Fixed overhead(based on the average production
20
requirement of P10, 000 units)
Total production cost per unit P 53
Make or Buy?
Seat Company, a manufacturer of furniture sets, is considering to purchase the seat pillows needed for its chairs. The
expected purchase price of these seat pillows is P50 per unit.
Seat has been making its own seat pillows since it started operating. If it would continue to produce these pillows, the
company expects to incur the following costs:
Raw material P 13
Direct labor 15
Variable overhead 5
Fixed overhead(based on the average production
20
requirement of 10, 000 units)
Total production cost per unit P 53
---- Assume that the 40% of the fixed overhead could be eliminated if the company would discontinue the manufacture
of seat pillows?
Make or Buy?
Purchase price of these seat pillows is P50 per unit.
Costs:
Raw material P 13
Direct labor 15
Variable overhead 5
Fixed overhead(based on the average production
20
requirement of P10, 000 units)
Total production cost per unit P 53
--- Assume that materials and labor costs are expected to increase by 20% next period. Factory overhead costs will
remain the same, except 40% of the fixed overhead will be eliminated in case the company decides to buy the seat
cushions from the other suppliers. Moreover, the facilities presently being used in the manufacture of seat pillows can
be utilized to manufacture another part of the main product in case such facilities become vacant when the company
decides to stop producing the seat pillows. This alternative use of resources would result into cost savings of P100, 000
for Seat Company. Assume further that the companys requirement for seat pillows is expected to increase by 4, 000
units next period.
1. Total fixed cost after increasing the units? 2. Total unit variable cost?
3. Relevant Manufacturing costs? 4. Make or Buy? 5. Net advantage of making or buying the pillows?
1. P200, 000 4. Buy
2. P38.60 5. P20, 400
3. P620, 400
Sell or Process Further
Some firms manufacture products which have a ready market once a certain stage of completion is reached; or the firm
may decide to process the product further to give the product a higher sales value though this may require additional
processing costs.
Should the firm process the product or sell it as is?
In solving this type of decision making problem, the decision maker should compare the differential revenue with
differential costs if the product is processed further.
______________________________________________________________________________________________
Pnoy, Inc. produces a product called Balut. The company buys duck eggs, the materials needed to make balut, from
different suppliers in Pateros at P1.50 each. To convert the eggs into balut, the same process by boiling for about 30
minutes. Processing costs composed of labor and factory overhead average at P0.50 per unit. Pnoy sells the product at
P3.00 per unit.
Pnoys product may be sold as balut, or it may be processed further to come up with another product called pritong
balut which actually is fried balut dipped in bread crumbs or corn starch. Pritong balut has proven to be highly salable
and commands the price of 3.75 per unit. Materials, labor and overhead costs required converting balut into pritong
balut amounts to P0.40 per unit. Pnoy is contemplating to stop selling balut and instead concentrate on selling pritong
balut.
Should Pnoy push through with his plan?
___________________________________________________________________________________________
Joint Products
Sell or process further problems are also encountered by companies engaged in the manufacture of joint products.
These products are linked together by some physical relationships which require simultaneous processing. During this
joint processing, the manufacturing cost, or the joint cost, is incurred in an individual sum for all the products involved.
At the split-off point, where the items emerge as individual products, the total joint costs incurred are allocated to such
individual products using various methods and bases of allocation.
News Paper Products which produces chipboard, newsprint and kraft paper from pulp which it buys at P5 per kilo. On
the average, the company uses 100, 000 kilos of pulp and incurs conversion cost of P500, 000 per month.
Monthly production and sales price figures for each product are as follows:
PRODUCTION SALES PRICE
Chipboard 200, 000 sheets P 2.40 per sheet
Newsprint 50, 000 reams 20.00 per ream
Kraft paper 30, 000 sheets 1.50 per sheet
The total joint cost is allocated based on the weight (in kilos) of the products manufactured during the month. (Assume
that the allocation results are: 17%, 80%, and 3% of the total joint cost is allocated to chipboard, newsprint, and Kraft
paper, respectively.)
One of the joint products, the kraft paper, may be processed further to produce document envelopes which can be sold
at P2.00 per unit. Each sheet of Kraft paper may be converted into one document envelope at a cost of sixty centavos.
Should the kraft paper be sold at the split off point or converted into document envelope?
Seatwork:
Agnes Corporation produces three joint products, X, Y, and Z, form one input. The products can be sold at split-off point
or processed further. The joint production costs for the month allocated among the products based on the relative
physical volume of output are as follows:
Materials P 150 000
Labor 30,000
Factory Overhead 20,000
Total joint costs P 200,000
Additional information about the three products is given in the following tabulation:
Unit Sales Price
Additional processing
Production in units
cost
At Split-off If processed further
Product X 5, 000 P80 P100 P15
Product Y 3, 000 45 60 20
Product Z 2, 000 60 75 10
1. Product to sell at split-off, if any? 2. Amount of joint cost allocated to Z?
3. Additional per unit profit (loss) of X if processed further?
4. Additional per unit profit (loss) of Y if processed further?
5. Total Gross Profit if the company took the most profitable action with respect to each of the three products?
1. Money, machine hours, direct labor hours, Product Y
2. P40, 000
3. P5
4. P5 loss
5. P490, 000
Product Combination/Utilization of Scarce Resources supply of materials, technology, and other business resources
are subject to scarcity.
To optimize scarce resources, sales and production should be allotted to a product that gives the highest profit per
scarce resource. If the scarce resource is direct labor hour, then produce the product that gives the highest contribution
margin per direct labor hour, computed as follows:
CM per hour = UCM / no. of hours per unit
CM per hour = UCM X no. of units per hour
LABANY SINGKAMY MISTISY
Contribution margin per unit P5 P8 P 12
Sales or market limit 10 ,000 UNITS 20, 000 UNITS NONE
Machine hours required to produce one unit 1 HR 4 HRS 12 HRS
Total fixed cost - P100, 000
Total machine hours available: 120, 000 hours
Use all your resources in producing the product that has the highest CM per hour unless such product has market
limitation. In such case, after satisfying all the market need of the product having the highest M per hour, produce and
sell the product that has the next highest CM per hour, and so on, until all available resources are exhausted.
________________________________________________________________________________________
Tisay Co. produces and sells three product lines Labany, Singkamy, and Mistisy. Production and sales data about
these product lines are given below.
What is the best product combination?
Gandalf Manufacturing has assembled the data appearing in the next column pertaining to two products. Past
experience has shown that the unavoidable fixed factory overhead included in the cost per machine hour averages
P10. Gandalf has a policy of filling all sales order, even if it means purchasing units from outside suppliers.
BLENDER ELECTRIC
DIRECT MATERIALS P6 P11
DIRECT LABOR 4 9
FACTORY OVERHEAD AT P6 per hour 6 12
COST IF PURCHASED FROM AN OUTSIDE SUPPLIER 20 38
ANNUAL DEMAND IN UNITS 20, 000 28, 000
If 50, 000 machine hours are available, and Gandalf Manufacturing desires to follow optimal strategy
What is the best product combination?
How many units to buy from outside supplier?
__________________________________________________________________________________________________
_
Gandalf Manufacturing has assembled the data appearing in the next column pertaining to two products. Past
experience has shown that the unavoidable fixed factory overhead included in the cost per machine hour averages P10.
Gandalf has a policy of filling all sales order, even if it means purchasing units from outside suppliers.
BLENDER ELECTRIC MIXER
DIRECT MATERIALS P6 P11
DIRECT LABOR 4 9
FACTORY OVERHEAD AT P6 per hour 6 12
COST IF PURCHASED FROM AN OUTSIDE SUPPLIER 20 38
ANNUAL DEMAND IN UNITS 20, 000 28, 000
50, 000 machine hours are available, and Gandalf Manufacturing desires to follow optimal strategy. The company is able
to reduce the direct materials to P6 per unit.
1. the most profitable product? 2. Contribution margin per hour of the most profitable product? 3. Hours to be allocated
to Blender?
4. Hours to be allocated to Mixer? 5. Total no. of units to be purchased from outside supplier?
1. MIXER 4. 50,000
2. P6 5. 23,000
3. ZERO
Replace or retain an old asset
Old assets need higher budget to maintain than the new one. If the old asset is replaced, there is an immediate outflow
of cash. However, there would be savings derived from reduced operating expenses of maintaining the new asset
compared with that of the old one.
Also, there is a possible inflow from the current residual value of the old asset. If the new cash flow is positive, meaning,
the cash inflows are greater than the cash outflow over the life of the asset, then, it is advisable to replace the old asset
and generate net benefit over its useful life.
All of these are under the assumption that the useful life of the new asset, compared to the old asset, is equal, without
considering the time value of money and effects of taxes.
_____________________________________________________________________________________________
Efem Company is contemplating to replace one of its existing machines and has gathered the following relative data
for analysis:
Old New
Purchase price P1.0 million P2.0 million
Life in years 4 4
Residual value - now P0.25 million n.a.
After 4 years none none
Annual operating expenses P1.2 million P0.65 million
Required:
Without considering the tax effects and the time value of money, determine the net advantage of replacing or
retaining the old machine.
What is the net outflow at the date of buying the new machine?
SEATWORK:
Ysabelle Industries, Inc. has an opportunity to acquire a new equipment to replace one of its existing equipment.
The new equipment would cost P900, 000 and has a five-year useful life, with a zero terminal disposal price.
Variable operating cost would be P1 million per year. The present equipment has a book value of P500, 000 and
a remaining life of five years. Its disposal price now is P50, 000 but would be zero after five years. Variable
operating costs would be P1, 250, 000 per year. Considering the five years in total, but ignoring the time value
and income taxes,
1. Ysabelle should retain or replace the old asset?
2. The total savings in operating costs?
3. Net advantage of retaining/replacing the old equipment?
Retain Replace
Purchase price P900,000
Book value P500,000
Useful life(remaining) 5 years 5 years
Salvage value - now 50,000
Variable operating costs 1,250,000 1,000,000
Annual savings in operating cost
(P1,250,000 -P1,000,000) P250,000
Therefore:
Savings in 5 years (P250,000 x 5 yrs.) P1,250,000
Salvage value of old equipment 50,000
Total cash inflows 1,300,000
Purchase price (900,000)
Net advantage of replacing the old equipment P400,000
Scrap or Rework defective units
There are products that do not meet the standard production specifications. Some of these products are defective which
could be sold as scrap or could be reworked and sold at a higher value.
In deciding whether to sell as scrap or rework, the net profit from reworking should be compared with the net profit of
selling of scrap without regard to the past costs of producing the product.
The past production costs, both variable and fixed, are irrelevant in this situation. They are sunk, historical, and
unalterable.
Panabo Corporation produces 200,000 units where 10% is considered defective. The companying is studying either to
scrap or rework the defective units and has provided the following data for analysis:
Cost of production P30 million
Sales price of regular good units P200 per unit
Sales price as defective units P40 per unit
Sales price of defective units after reworking P75 per unit
Number of units reworked 120 units
Cost of reworking defective units P10 per unit
Required:
Net advantage of the better alternative, scrap or rework.
SEATWORK
A company has 7,000 obsolete toys carried in inventory at manufacturing cost of P6 per unit. If the toys are
reworked for P2 per unit they could be sold for P3 per unit. If the toys are scrapped, they could be sold for P1.85
per unit.
1. Which alternative is more desirable (rework or scrap)?
2. What is the total peso amount of the advantage of that alternative?
Profit from reworking (P7,000 x P1) P7,000
(P3-2)
-Profit from scrapping (7,000 X P1.85) (12,950)
Net advantage of scrapping P(5,950)
