Decision Making

DECISION MAKING
OVERVIEW
Objective
To identify relevant costs and appropriate techniques for decision-making

and use them in various decision-making situations.
DECISION The decision-making cycle

MAKING Information requirements
Short run
Long run
RELEVANT CVP INVESTMENT

COSTS ANALYSIS APPRAISAL
Definition Contribution Techniques

Complications Breakeven chart ARR
P/V graph Payback
Calculations NPV
Assumptions IRR
SHORT RUN Multi-product Conclusion
DECISIONS
Discontinuance
Limiting factor
Further processing
Make or buy
Accept or reject
In identifying decision-making as a major topic the Examiner has specifically referred

to:
relevant cost analysis
limiting factors
DCF
allowing for uncertainty.
 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0701

DECISION MAKING
1 DECISION MAKING
1.1 The decision making cycle
Identify objectives
Identify alternative
courses of action
Obtain information
about alternatives
Post Implementation
review/audit
Select one of the

alternatives
Implement the
decision
Compare actual
results

DECISION MAKING
1.2 Information requirements
Data requirements
Qualitative Quantitative
Effect on employees
Opinions of customers
Impact on local area eg Monetary Non-monetary
pollution
Political and economic factors
Costs Resources
eg possible change in tax rates
Revenues required
Possible reaction of
impact on
competitors
market share
A decision should not be made without careful consideration of qualitative factors.
1.3 Short-run decision making
Short term decision making assumes that decisions previously made concerning fixed
plant and equipment cannot be altered.
Such decisions should therefore make best use of existing resources. Relevant costs
must be considered.
1.4 Long-run decision making
In the long term new investment in plant and equipment may be considered.
Looking further into the future requires consideration of the time value of money.
Discounted cashflow techniques are therefore important for long-run decisions.
2 RELEVANT COSTS FOR DECISION MAKING
2.1 Definition
Relevant costs (and revenues) are those pertinent to a particular decision-making

situation.
They are:
future
avoidable
incremental
cash flows.
They many also be opportunity costs.

DECISION MAKING
Non-relevant costs include
sunk costs
committed costs
non-cashflows
allocated
apportioned
Overheads
absorbed
recharged
2.2 Complications
2.2.1 Materials
Materials needed
for project
In stock Not in stock
No alternative Alternative use Use current purchase

use price
Use scrap value Scarce Not scarce
Use material cost plus Use replacement

lost contribution from cost
alternative (opportunity
cost)

DECISION MAKING
2.2.2 Labour
Labour needed
for project
Already employed Hire new workers
No alternative Alternative work Use current wage

work rate
Saved redundancy No spare capacity Spare capacity

costs
Labour cost plus lost Any incremental wages

contribution eg overtime premium
3 SHORT-RUN DECISIONS
Discontinuance Limiting
(shutdown) factor
Decisions
Further processing Make or buy
Accept or reject an order

DECISION MAKING
3.1 Discontinuance decisions
That is, whether to eliminate (shutdown) part of the business.
3.1.1 Decision criteria
Compare loss in revenue to savings in avoidable costs.
3.1.2 Qualitative factors
Adverse publicity regarding redundancies.

Possible adverse reaction by investors – share price might fall.
Effect on morale in remaining segments of the business.
Lost synergy eg shared skills between divisions.
Example 1
Decentro Ltd is a divisionalised company. Divisional results are as follows.
Division Division Division

X Y Z
£ £ £
Sales 50,000 30,000 40,000
Variable costs (30,000) (18,000) (20,000)
Specific fixed costs (12,000) (10,000) (10,000)
Apportioned head-office costs (5,000) (4,000) (5,000)
–––––– –––––– ––––––
Profit/(loss) 3,000 (2,000) 5,000
–––––– –––––– ––––––
Required:
Determine whether or not Division Y should be closed.
Solution
Division Y
£
Sales
Variable costs
––––––
Gross contribution
Specific fixed costs
––––––
Contribution towards head office costs
––––––
It would appear that division Y should

DECISION MAKING
3.2 Limiting factor decision
A factor other than sales limits the level of activity at which the company can
operate.
Maximise the contribution earned per unit of limiting factor.
Example 2
A company produces two products with the following cost and revenue data per unit.
A B
£ £
Selling price 20 10
Variable cost 8 6
Fixed cost 4 3
Budgeted units 2,000 3,000
There are only 7,000 machine hours available to produce both A and B. A requires 4
hours per unit and B requires 1 hour per unit.
Required:
Calculate the profit maximising product mix.
Solution
A B
£ £
SP/unit
Less VC/unit
–— –—
Contribution/unit
Hours/unit
–— –—
Contribution/Unit of limiting factor
–— –—
Ranking
Utilisation: Hours available Production plan
–—–— –—–—
–—–— –—–—

DECISION MAKING
Example 3
Required:
As per Example 2 but we are able to sub-contract the products for an additional
variable cost of £1 per unit for A and £0.50 per unit for B.
Solution
A B
£ £
Contribution foregone/unit purchased (increase in VC/unit)
Hours/unit
–— –—
Contribution forgone/unit of limiting factor
–— –—
Ranking for production
Production and sales plan
Hours available Production and sales plan
–—–—
–—–—
3.3 Further processing decision
Whether to sell at an intermediate point or to further process and sell at an enhanced

value.
We compare incremental revenues of further processing with the incremental costs of

further processing.

DECISION MAKING
Example 4
Selling prices Conversion costs Conversion costs

(variable) (fixed)
C : £5/unit C → F £6/unit
D : £7/unit D → G £6/unit £10,000
E : £8/unit E → H £6/unit
F : £10/unit
G : £14/unit
H : £22/unit
Refining operation
F
C
Input Joint G
D
process
H
E
Budgeted units/demand
C/F 4,000
D/G 2,000
E/H 1,000
Required:
Determine which products should be further processed.
Solution
C/F D/G E/H Total

Incremental £ £ £ £
costs/revenues
Revenue/unit
Less VC/unit
–— –—– –—
Contribution/unit
–—
Budgeted units
–—–— –—–— –—–—
Total contribution
Less Fixed cost
–—–—
Change in profit
––––––
Conclusion:

DECISION MAKING
3.4 Make or buy decision
Whether to make a product in house or to purchase that product from an outside

supplier.
Compare the marginal cost of making with the purchase cost of buying in.
Example 5
Product K is currently produced in house a £15/unit of which £6/kg is fixed. The cost
of purchasing this product from a contractor is £10/unit.
Required:
Determine whether the product should be made in-house.
Solution
Product K
£
Marginal cost of making
Marginal cost of buying in (purchase price)
–—–—
Decision
–—–—
3.5 Accept or reject an order
Are the relevant costs of the decision less or greater than the suggested revenue? An
application of relevant cost analysis.
Example 6
A material P in stock, which is used on the product to be produced is already used as a

substitute for another material Q in common usage. Material Q can be purchased for
£4.00/kg and conversion costs required to P are £2.00/kg. Alternatively P could be
sold for scrap at £1.50/kg.
Required:
Determine the relevant cost of the 3 kg of P required for the product.

DECISION MAKING
Solution
Decision Analysis Revenue/unit

£
Either sell for scrap
Or substitute for material Q
–—–—
Choose to substitute as the next best alternative.
Relevant cost of 3 kg of material P

–—–—
Example 7
Skilled labour needed to fulfil the order would be specially recruited for £50,000.
Unskilled labour would be transferred from another department where it is paid

£30,000. Half is currently idle. The other half generates a contribution of £5,000.
Required:
Calculate the relevant labour cost of the order.
Solution
£
Skilled labour
Unskilled
Idle workers – no incremental cost
Working – labour cost + opportunity cost
––––––
Relevant cost
––––––
4 COST VOLUME PROFIT ANALYSIS (CVP)
4.1 Contribution
£
Revenue X
Variable production costs (X)
Variable non-production costs (X)
–––
Contribution X
–––

DECISION MAKING
4.2 Breakeven charts
Breakeven point occurs where: Total contribution = Total fixed costs.
£
Total
revenue
Total
costs
Fixed costs
Units
Breakeven
point
OR
£
Total
revenue
Total
costs
Total variable
costs
Units
Breakeven
point

DECISION MAKING
4.3 Profit/volume graphs
Profit
£
Total
profit
0 Units or revenue
–
Breakeven point
Fixed
costs
4.4 Calculations
Contribution per unit = Unit selling price – Unit variable costs
Profit = (Sales volume × Contribution per unit) – Fixed costs
Fixed costs
Breakeven sales volume =
Contribution per unit
Margin of safety = Actual or budgeted sales – Breakeven sales
Fixed costs + Target profit

Sales volume to achieve a target profit =

C/S ratio =
Selling price per unit
Fixed costs
Breakeven sales revenue =
C/S ratio
4.5 Assumptions
All costs can be split into fixed and variable.

Fixed costs are constant.
Variable cost per unit is constant.
Selling price per unit is constant.
Stock levels are constant (ie sales = production).
CVP analysis is therefore only useful within a limited range of activity.

DECISION MAKING
4.6 Multi-product
4.6.1 Assumption
CVP analysis can be extended to multi-product situations if a predetermined

sales mix is held to be constant.
4.6.2 Calculation
Calculate a weighted average contribution per unit to depict average

revenues and average costs for the given sales mix.
Use breakeven formulae as for single product analysis.
Number of units calculated will be in total therefore split in mix ratio to state
in terms of individual products.

DECISION MAKING
5 INVESTMENT APPRAISAL
5.1 Techniques
The methods learnt in Paper 3 and Paper 8 are also examinable in Paper 9.
Accounting rate of return (ARR) .

Payback period
Net present value (NPV)
Internal rate of return (IRR) .
5.2 Accounting rate of return
Average annual net profit

× 100
Initial investment
OR Average annual net profit

× 100
Average investment
Cost + scrap
Where average investment =
2
5.2.1 Advantages 5.2.2 Disadvantages
Easily calculated. Arbitrary target ARR.
Easily understood %. Ignores time value of money.
Similar to ROCE used by analysts Profits are subjective.

for company appraisal.
A % measure – does not show the
absolute gain to shareholders.
Use of ARR will not lead to investment decisions which maximise shareholder wealth.
5.3 Payback period
The time it takes for the cash inflows from a project to equal the cash outflows.
Easily calculated. Ignores cashflows after the payback

Easily understood. period.
Uses objective cashflows.
Maximises liquidity. Ignores time value of money.
Favours low risk projects.
Ignores project profitability.
Arbitrary target payback period.
Use of payback will not lead to maximisation of shareholder wealth.

DECISION MAKING
5.4 NPV
The present value of cash inflows less the present value of cash outflows.
Takes into account the time value Difficult to calculate.

of money.
Difficult to explain to non-
Uses objective cashflows. accountants.
An absolute measure of gain to

shareholders.
NPV shows the increase in shareholder wealth from undertaking a project.
Use of NPV will lead to maximisation of shareholder wealth.
5.5 IRR
The discount rate at which NPV = 0.
Takes into account the time value Difficult to calculate.

of money.
Some projects have multiple IRR’s.
Uses objective cashflows.
a % measure – does not show the
Easily understood %. absolute gain to shareholders.
Not reliable where projects are

mutually exclusive.
Use of IRR will not lead to investment decisions which maximise shareholder wealth.
5.6 Conclusion
NPV is the only reliable method of project appraisal.
It is superior to ARR, payback and IRR.
It is also superior to ROI and RI used by divisional managers for project appraisal.

DECISION MAKING
FOCUS
You should now be able to
discuss the decision making process and the information needed for decision
making
deal with various short-run decisions, identifying the relevant costs in each
scenario
use and discuss CVP analysis and investment appraisal methods .

DECISION MAKING
EXAMPLE SOLUTIONS
Solution 1 – Discontinuance
Division Y
£
Sales 30,000
Variable costs (18,000)
––––––
Gross contribution 12,000
Specific fixed costs (10,000)
––––––
Contribution towards head office costs 2,000
––––––
It would appear that division Y should remain open as it makes a positive contribution
towards head office costs.
This assumes that total head office costs will remain the same if division Y closes ie
they are unavoidable.
Solution 2 – Limiting factor
A B
£ £
SP/unit 20 10
Less VC/unit 8 6
–— –—
Contribution/unit 12 4
Hours/unit 4 1
–— –—
Contribution/Unit of limiting factor 3 4
–— –—
Ranking 2 1
Utilisation: Hours available Production plan

7,000 Product B
(3,000) @ 1 hr/unit 3,000 units
–—–— –—–—
4,000 Product A
(4,000) @ 4 hrs/unit 1,000 units
–—–— –—–—

DECISION MAKING
Solution 3 – Purchase alternative
A B
£ £
Contribution foregone/unit purchased (increase in VC/unit) 1.00 0.50
Hours/unit 4 1
–— –—
Contribution forgone/unit of limiting factor 0.25 0.50
–— –—
Ranking for production 2 1
Production and sales plan
Hours available Production and sales plan

7,000
Product B produced
(3,000) @ 1 hr/unit = 3,000 units
–—–—
(4,000) @ 4 hrs/unit Product A produced
–—–— = 1,000 units
Product A bought in (remainder)

1,000 units
Solution 4 – Further processing
C/F D/G E/H Total

Incremental £ £ £ £
costs/revenues
Revenue/unit 5 7 14
Less VC/unit (6) (6) (6)
–— –—– –—
Contribution/unit (1) 1 8
–—
Budgeted units Do not 2,000 1,000
further process –—–— –—–— –—–—
Total contribution 2,000 8,000 10,000
Less Fixed cost (10,000)
–—–—
0
––––––
Using quantitative data only the decision appears marginal.

DECISION MAKING
Solution 5 – Make or buy
Product K
£
Marginal cost of making (15 – 6) 9
Marginal cost of buying in (purchase price) 10
–—–—
Decision Make
–—–—
Solution 6 – Relevant cost analysis
Decision Analysis Revenue/unit

£
Either sell for scrap 1.50
Or substitute for material Q (4 – 2) = 2.00
–—–—
Choose to substitute as the next best alternative.
Relevant cost of 3 kg of material P = 3 × 2 = £6.00

–—–—
Solution 7 – Relevant labour cost
£
Skilled labour 50,000
Unskilled
Idle workers – no incremental cost Nil
Working – labour cost + opportunity cost (15,000 + 5,000) 20,000
––––––
Relevant cost 70,000
––––––

Decision Making

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DECISION MAKING

To identify relevant costs and appropriate techniques for decision-making

DECISION The decision-making cycle

RELEVANT CVP INVESTMENT

Definition Contribution Techniques

In identifying decision-making as a major topic the Examiner has specifically referred

relevant cost analysis

allowing for uncertainty.

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0701

1.1 The decision making cycle

Select one of the

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0702

1.2 Information requirements

A decision should not be made without careful consideration of qualitative factors.

1.3 Short-run decision making

1.4 Long-run decision making

Discounted cashflow techniques are therefore important for long-run decisions.

2 RELEVANT COSTS FOR DECISION MAKING

Relevant costs (and revenues) are those pertinent to a particular decision-making

They many also be opportunity costs.

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0703

Non-relevant costs include

In stock Not in stock

No alternative Alternative use Use current purchase

Use scrap value Scarce Not scarce

Use material cost plus Use replacement

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0704

Already employed Hire new workers

No alternative Alternative work Use current wage

Saved redundancy No spare capacity Spare capacity

Labour cost plus lost Any incremental wages

Further processing Make or buy

Accept or reject an order

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0705

3.1 Discontinuance decisions

That is, whether to eliminate (shutdown) part of the business.

3.1.1 Decision criteria

Compare loss in revenue to savings in avoidable costs.

3.1.2 Qualitative factors

Adverse publicity regarding redundancies.

Decentro Ltd is a divisionalised company. Divisional results are as follows.

Division Division Division

Determine whether or not Division Y should be closed.

It would appear that division Y should

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0706

3.2 Limiting factor decision

3.2.1 Decision criteria

Maximise the contribution earned per unit of limiting factor.

Budgeted units 2,000 3,000

Calculate the profit maximising product mix.

Utilisation: Hours available Production plan

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0707

Ranking for production

Production and sales plan

Hours available Production and sales plan

3.3 Further processing decision

Whether to sell at an intermediate point or to further process and sell at an enhanced

3.3.1 Decision criteria

We compare incremental revenues of further processing with the incremental costs of

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0708

Selling prices Conversion costs Conversion costs

Determine which products should be further processed.

C/F D/G E/H Total

 Accountancy Tuition Centre (Overseas Courses) Ltd 2002 0709