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Lesson Plan on Non-routine Short-term Decision Making

The anecdote below typifies a usual decision problem when faced with so many choices to
choose from:

One time while visiting a very rich friend, his housemaid asked me what I wanted to drink, and here's
how it went.

Question : "What would you like to have ..Fruit juice, Soda, Tea, Chocolate, Capuccino, Frapuccino,
or Coffee?"
Answer: "Tea please"

Question : "Ceylon tea, Indian tea, Herbal tea, Bush tea, Honey Iced tea or green tea ?"
Answer : "Ceylon tea "

Question : "How would you like it ? black or white ?"

Answer: "white"

Question: "Milk, Whitener, or Condensed milk ?"

Answer: "With milk "

Question: "Goat milk, Camel milk or cow milk"

Answer: "With cow milk please.

Question: " Milk from Freeze land cow or Afrikaner cow?"

Answer: " Um, I'll just take it black. "

Question: " Would you like it with sweetener, sugar or honey?"

Answer: "With sugar"

Question: " Beet sugar or cane sugar ?"

Answer: "Cane sugar "

Question:" White, brown or yellow sugar ?"

Answer: "Forget about the tea, just give me a glass of water instead."

Question: "Mineral water, tap water or distilled water ? "

Answer: "Mineral water"

Question: "Flavored or non-flavored ?"

Answer: "I'd rather die of thirst "

I. Introduction

Being a managerial accountant requires you to provide the necessary mathematical and numeric
support to the "gut" feel business managers and marketing managers are famous for. As managerial
accountants, we are tasked to provide the numbers or values required to justify their decision
especially when large amounts are involved.

The following are basic steps in dealing with decision problems:

1. Defining the problem.

2. Establishing a decision rule.

3. Identifying the alternative courses of action.

4. Determining the consequences of the action.

5. Evaluating each alternative.

6. Choosing the best alternative.

7. Making the decision.

II. Relevant Costs

The term relevant means it is of importance and must be given due consideration. If something is
defined as irrelevant, we simply ignore it. But if an item is considered relevant, we give it our due
attention. Therefore, only costs which are relevant will be taken into consideration when making a

Relevant costs are defined as future and differential costs. Therefore, for a cost to be relevant, it
must be incurred in the future and it must produce either an incremental (increasing) or decremental
(decreasing) effect on a particular revenue or cost item.

III. Total vs. Incremental approaches to solving decision problems:

Under the total approach, all costs whether relevant or not will be enumerated. All variable
costs and all fixed costs will be included in the computation for all alternatives to show a
comprehensive comparison of all items among the choices given.

Under the incremental approach, only those costs that are considered relevant (future and
more importantly differential) are included. Usually, items included are limited to variable costs and
AVOIDABLE fixed costs.

IV. Decision Scenarios

Note: The decision scenarios discussed in the succeeding sections involve short-run and non-routine
decision cases. These analysis tools are presented to help the manager cope with these types of non-
recurring decision situations.


Decision Question

Should we make an item or perform the service ourselves or should we purchase the item or
avail of the services from a vendor?

Decision Rule:



Data Analysis Format:


Materials and Direct labor Costs Purchase Cost plus handling costs
Variable Overhead Costs Less
Avoidable fixed overhead cost Incremental revenue or earnings from
Other avoidable incremental costs use of released resources

1. A manufacturer of motorcycles has been operating at 80% of plant capacity. In order to
utilize greater capacity, the plant manager is considering making a headlight which had
previously been purchased for P61.00 per unit. The plant has the equipment and labor force
necessary to manufacture this light which the design engineer estimates would cost P14 for
raw materials and P30 for direct labor. The plant overhead is P20.00 per direct labor peso of
which P8.00 is fixed.

What is the net advantage (disadvantage) of making the headlight?

Cost to Make Cost to Buy

Direct Materials P14.00 Purchase Price P61.00
Direct Labor 30.00
Variable Overhead 12.00

Total Cost to Make P56.00 Total Cost to Buy P61.00

Net advantage: P5.00

2. LinLu, owner of Fuchou Restaurant uses 5,000 wanton per month for its famous Soup No. 5.
Current costs are:

Ingredients cost P4.00

Labor and other variable expenses P2.00

Ting Sien offers to sell LinLu dumplings at P8 each. If LinLu buys dumplings, he can
eliminate P4,000 per month in fixed making costs. He thinks he can also earn an additional
P3,000 per month in contribution margin by adding three tables where the wantons had been

Required: Should LinLu accept to offer from Ting Sien?


Decision Question

Will we benefit from special sales generally made at price lower than those charged to our
regular customers?

Decision Rule:


Decision Factors:
1. Excess capacity exists with no alternative use of capacity
2. Special sales should not interfere with regular sales
3. The special sale is a one-time order and will not become repeat business.

Data Analysis Format:

Incremental Revenue
Less Incremental Costs
Variable Costs
Opportunity Costs
(Lost Contribution Margin) (without excess capacity)
Incremental Profits

1. Cj Inc. can make 10,000 banners per month. Cj can sell 9,000 banners per month to PBA
fans for P10 per banner. The companys cost per banner based on making 10,000 banners is:

Prime cost P5.00

Overhead cost 3.00 (Overhead is 2/3 fixed at that volume)

MBA offers to buy 1,000 banners with special MBA insignias for P7 per banner. Printing the special
insignias will cost Cj P200. Required: Should Cj accept this special order?

Data Analysis Format:

Incremental Revenue
(P1,000 x P7) P7,000
Incremental Costs
Prime Cost (1,000 x P5.00) P5,000
Variable Overhead (P3x1/3x1,000) 1,000
Additional Cost for insignia 200 6,200
-------- ---------
Incremental Profit P 800

Decision: Accept the special order for an incremental profit of P800.00

2. Frisco Company has been offered a contract to supply 500,000 basketballs to a large sporting
firm abroad at a price of P75 per ball. Frisco's full cost of producing the ball is P80. The
normal sales price for the balls is P100 to both distributors and some selected retailers.
Variable costs per ball amount to P70; however in order to meet the needs of the foreign
client, Frisco will have to cut its sales to regular customers by 100,000 balls annually. The
foreign client has clearly indicated that it will enter into the agreement only if Frisco will
agree to supply all 500,000 of the balls requested.

Should Frisco accept the offer? What is the net advantage of the decision?


Decision Question

Should the product be sold as is or processing further will increase profits?

Decision Rule:

PROCESS FURTHER If Incremental Revenue > Incremental Costs

Data Analysis Format

Incremental Revenue from Processing Further

(SP After Processing SP at Split Off Point)
Less Incremental Costs
Incremental Profits


1. The Eckel Corp. produces products Aeta , Beta and Ceta from a joint process. Joint
production costs to produce Aeta, Beta and Ceta were P600,000 allocated to the three
products according to the number of units. Each unit product may be sold at its split off point
or processed further.

Product Units produced Sales price per unit Sales price per unit if
At split off point processed further
Aeta 20,000 P30 P60
Beta 20,000 P40 P80
Ceta 20,000 P70 P90

Additional processing costs are P35 per unit for each unit processed further.

Required: Which of the products should be processed further? Why?


Product Incremental Revenue less Incremental Cost = Incl Profit

Aeta (P60-P30) P30 - P35 = -P5
Beta (P80-P40) P40 - P35 = P15
Ceta (P90-P70) P20 - P35 = -P15

Decision: Only Beta should be processed further

2. Canon Company is selling a product for P100 per pound which it is partly processed at a cost
P60. It has been proposed that the 10,000 pounds the company is processing monthly be
further processed at a variable cost of P40 per pound of input to realize 8,000 pounds of
completely processed which can sell for P200 per pound.

Should the company process the product further or should it continue selling it as is? Why


Decision Question

Is the firm more profitable with or without the segment? Will adding a new segment increase
profits to the company?

Decision Rule

Add or Retain Segment Revenues > Direct Costs (Variable and Avoidable Fixed Costs)

Data Analysis Format

Less Variable Costs
Contribution Margin
Less Avoidable Fixed Costs
Net Segment Income

The effect on the total company income is represented by the amount of Segment Contribution Margin

Positive segment contribution margin deleted will result in a decrease in overall company.

Negative segment contribution margin deleted will result in an increase in overall company net


1. Vanderbeek has three product lines. Last years data in thousands are:
Prestige Premium Primer Total
Sales P230 P270 P360 P860
Variable Costs (120) (150) (170) (440)
Unavoidable fixed costs ( 60) ( 60) ( 60) (180)
Avoidable fixed costs ( 80) ( 50) ( 80) (210)
------- ------- ------- -------
Net income (P30) P 10 P 50 P 30
===== ==== ==== =====

Required: Should Vanderbeek drop the Prestige product line?

Sales P230
Less Direct Costs
Variable Costs P120
Avoidable Fixed Costs 80 200
------- ------
Segment Revenue P 30
Decision: Retain Prestige for a net advantage of P30

Using total Approach: Total w/ Total w/o

Prestige Prestige
Sales P860 P630
Variable Costs (440) (320)
Unavoidable fixed costs (180) (180)
Avoidable fixed costs (210) (130)
------- -------
Net income P 30 P 0
===== =====

2. Swiftfoods has a central processing plant and three stores. Recently, profits have been
declining. The projected 200A income statement for the three stores appears below:

Big 250 Plus 250 Max 250 Total

Sales 200,000 175,000 190,000 565,000
Product cost of sausages 120,000 100,000 110,000 330,000
---------- ---------- ---------- ----------
Gross Margin 80,000 75,000 80,000 235,000
Direct Store expenses 60,000 85,000 35,000 180,000
Allocated administrative
overhead expenses 25,000 15,000 20,000 60,000
Net Income ( 5,000) (25,000) 25,000 ( 5,000)
Which of the following alternatives will provide the highest profits for Swiftfoods? Give the total net
income from the decision made.
a. Eliminate Big 250
b. Eliminate Plus 250
c. Eliminate Big 250 and Plus 250
d. Close all stores


Decision Question:

Should the company continue to operate at a loss or decide to temporarily shutdown


Decision Rule:

Continue if Demand > Shutdown Point

Key terminologies

Shutdown Point - indifference point represented in units between making a decision whether to
continue operating at a loss or to temporarily cease operations

Shutdown savings difference between fixed costs under normal operations and shutdown costs.

Shutdown costs cost incurred during the period of shutdown which includes unavoidable fixed
costs and start-up costs.

Abandonment permanent closure of business or stoppage of work

Data Analysis Format

Shutdown point = Shutdown Savings

Contribution Margin per unit

= (Fixed cost normal operations (Unavoidable Fixed Costs +

Additional Shut Down Costs ( if any)
Contribution Margin per unit

The formula was derived from this equation:

Sales (no operations) (P0) Sales at Shutdown Point

Less Variable Costs (P0) Less Variable Costs
------------------------- -----------------------------
Contribution Margin (P0) Contribution Margin
Less Shutdown Costs Less Fixed Cost (Normal Operation)
--------------------------- ------------------------------------------
Loss (Shutdown costs) = Net Loss
================= ========

Continuing Operations at a Loss = Shutdown Costs

X * CM/unit Fixed Costs Normal = 0 (Fixed Costs during Shutdown + Other Shutdown Costs)
X * CM/Unit = Fixed Costs Normal (Fixed Costs during Shutdown + Other Shutdown Costs)
X = Fixed Costs Normal (Fixed Costs during Shutdown + Other Shutdown

Other Applications:

Analysis of Shutdown or Continue need not be limited to situations where there requires prolonged
period of shutdown of operations. This analysis can be used also for closures during specific hours of
the day like restaurant operations.

Most Chinese restaurants operate from selected hours only (11:00 2:00, 6:00 11:00) because there
is no business during times outside the operating hours unless they serve breakfast or merienda

They have calculated that there will be lesser losses if they operate within the specified operating

Another scenario that may necessitate the use of this technique will be that of continuing operations
on a holiday. It may be beneficial to open the store only if the incremental revenues from opening the
store will be greater than the incremental costs.


1. Cassava Enterprises is engaged in bottling of a vegetable mixture used for baking. Monthly
production averages 200,000 bottles per month for the three quarters of the current year.
Each bottle sells for P20 in the market. The annual fixed costs for Cassava is P7,200,000
evenly distributed on a twelve month period.

The first quarter of the year is a critical period for Cassava. It is during this quarter of the year where
the demand of the product is expected to go down due to seasonal variation. During this period, the
demand is estimated to be an average of 40,000 bottles per month.

On the belief that the company will be saved from greater losses, management is considering to
shutdown operations during the first quarter of the following year. A decision to shutdown would
decrease the fixed costs by 30%. However, during the shut down period, additional cost of P140,000
is needed for security and insurance. To restart operations again, the company will spend another

The following data concerning production cost per bottle are gathered from the records of Cassava
Direct Materials P7.00
Direct Labor 4.00
Variable Overhead 3.00
Variable Selling expenses 2.00
Total Variable costs 16.00

a. Determine the shutdown costs
b. Determine the shutdown savings
c. Determine the shutdown point
d. Considering a decision to shutdown or continue operations, which decision should be most
advantageous to the company?


a. Total Fixed Overhead P7,200,000

Shutdown Period x 3/12
Unavoidable Portion of Fixed Overhead x 70%
Unavoidable Fixed Overhead P1,260,000
Additional Costs for Security 140,000
Start Up Costs 50,000
Total Shutdown Costs P1,450,000

b. Fixed Cost (normal Operations)

(P7,200,000 x 3/12) P1,800,000
less Shutdown Costs 1,450,000
Shutdown Savings P 350,000

c. Shutdown Point = Shutdown Savings / CM per unit

= P350,000 / (P20 - P16)
= 87,500 units

Decision: Continue operations since the demand of 120,000 units (40,000 units x 3 months) is higher
than the shutdown point of 87,500 units.

Demand Shutdown Point Shutdown
120,000 units 87,500 units 0 units

CM P 480,000 P 350,000 P 0
Less Fixed Cost 1,800,000 1,800,000 P1,450,000
------------- ------------- --------------
Net Loss (P1,320,000) (P1,450,000) (P1,450,000)
========= ========== ==========

2. Under normal operating conditions, Flipflop Company manufactures 900,000 units of

Lollipop balloons in a 6-month period. Each unit of product contributes P1.60 to fixed
overhead costs and profits. The fixed overhead costs for six months amount to P640,000.
Due to sudden closure of a major department store that buys this product at the start of the
year, the sales projections of this product is cut to a rate of 40,000 units a month. The
company management plans to close the plant for six months as they discuss tie-ups with
foreign buyers of their product. The management expects negotiations to be finalized after
six months. The fixed overhead costs can be reduced to P450,000 for six months if the plant
is closed, but the additional costs to protect the facilities and to start up again have been
estimated at P62,000.

Should the plant be closed? Use shutdown point analysis to justify your decision.


Decision Question

When a productive resource is limited, how do we allocate the use of the scarce resource to
maximize profit or minimize cost?

Decision Rule:

Product or Service with the highest CONTRIBUTION MARGIN (CM) PER UNIT OF
SCARCE RESOURCE should be given priority.

Examples of Scarce Resources:

Machine Hours
Shelf Space in a Grocery Store
Study Time
Seating Capacity in a Popular Restaurant

Data Analysis Format

Sales Price
Less Variable Cost per unit
Contribution Margin per unit
Divided by Scarce Resource needed per Unit of Output
Contribution Margin per unit of scarce resource

***The format is to be applied to all products concerned and the product with the highest CM per
unit will be given first priority subject to market limitations if any.


1. Davincii Company employs highly skilled Filipino artists to produce woodcarvings for sale
in handicraft stores. The artists make large, medium and small woodcarvings. The sales and
production data follows:
Large Medium Small
Sales Price P800 P500 P250
Materials and artist time costs 380 250 160
Hours per piece 1 hour .50 hours .20 hours

Required: Rank the production of woodcarvings by order of priority.

Data Analysis Format

Large Medium Small
Sales Price P800 P500 P250
Materials and artist time costs 380 250 160
------- ------- -------
Contribution Margin P420 P250 P 90
Hours per piece 1 hour .50 hours .20 hours
-------- -------- -------
CM per hour P420 P500 P450

Decision: 3rd 1st 2nd

2. Assuming that market limitations exist as follows:

Large Medium Small
None 300 500

Required: Compute the best product combination assuming that only 500 hours of production time is
available to the company.

Data Analysis Format

Units to be Produced Hours Needed Available Hours
500 hours
Medium 300 units 150 hours 350 hours
(300 x .50 hrs)
Small 500 units 100 hours 250 hours
(500 x .20 hrs)
Large 250 units* 250 hours 0 hours
( 250 x 1hr.)

*The amount 250 units was derived by using up the remaining 250 hours since no product limitation
has been set for the Large woodcarving product.

3. The Hello Company produces two products using a single production process in which the
main constraint is machine hours. The economic data are as follows:

Product Good Product Bye

Selling price per unit P25 P12
Variable cost per unit P18 P6
Machine hours per unit 2.5 hours 2 hours
Market limitation 60,000 units 25,000 units
Total machine hours available 180,000 hours
Total fixed cost P180,000

What is the net profit from the best product combination?


Linear Programming

It is mathematical technique that permits the determination of the best or optimum use of the available

This technique was first developed and applied in 1947 for the U.S. Army by George B.
Dantzig, Marshall Wood and their associates.

Linearity means that the equation or inequality must not contain quadratic components; it is tacitly
assumed that there is a single goal that can be represented by a linear objective function and that all
restrictions are linear in nature.

Programming means developing an algorithm (system of procedures) in solving the issue.

Certainty is assumed thus all parameters of the model should be known.


a. Determination of the product mix to maximize contribution margin.

b. Selection of an investment mix
c. Determination of materials mix to minimize costs.
d. Assignment of jobs to machines
e. Determination of transportation routes.

a. Formulate the objective function - maximize profit or minimize cost (peso values)

b. Formulate the constraints function - limitations of decision variables

1. Explicit constraints apparent limitations as expressed in the problem

2. Implicit constraints implied limitations or more commonly known as the non-negativity

constraints (the variables are not supposed to be a negative value because we cannot produce a
negative number of units)

Computational Methods

a. Graphic method - involves only two variables; optimal solution is represented in corner points of
the graphic solution; solutions are generally confined to the positive quadrant.

Extreme Point Theorem states that If an optimal solution to a linear programming problem
exists, then at least one such optimal solution must be an extreme point solution.

*In a minimization problem optimal point is the point nearest 0 taking into consideration
all points. (least cost as it approaches to 0)

*In a maximization problem optimal point is the point farthest from 0 taking into
consideration all points. (highest revenue is reached farthest from 0)

b. Simplex method - iteration method used to reach the optimal solution; used regardless of the
number of variables involved.

*In a minimization problem optimal solution is reached if the index row does not indicate
any negative value (must be either 0 or positive) meaning the values (cost) can no longer be decreased

*In a maximization problem optimal solution is reached if the index row does not indicate
any positive value (must be either 0 or negative) meaning the values (profits) can no longer be
increased further.

*Slack variable (artificial variable or dummy variable ) is introduced to equalize an


Special Types of Linear Programming:

1. Transportation Problem
2. Assignment Problem

Sensitivity Analysis involves the exploration of changes in model output in response to changes in
input parameters; it can aid in generating alternatives and in planning for responses to unpredictable

1. Changes in objective function coefficients

2. Changes in right hand side values
3. Adding a new variable
4. Adding a new constraint
5. Changes in the constraint coefficients

6. Shadow Pricing - associated with a constraint showing the amount of improvement in the
optimal objective function values as the value of the right hand side of that constraint is
increased by one unit with all other model parameters unchanged.

Exercise on Linear Programming

1. RX produces two products, Chico and Delamar. Product Chico requires two hours of
grinding and four hours of polishing. Product Delamar requires five hours of grinding and
two hours of polishing. The manufacturer has 3 grinders and 2 polishers; therefore in a 40-
hour week, there are 120 hours of grinding capacity and 80 hours of polishing capacity.
There is a ready market for both products and the contribution margin per unit of Product
Chico and Product Delamar are P30 and P40 respectively.

Required: a. Objective function

b. Constraint Functions (explicit and implicit)

2. The Australia Chemicals Company produces a chemical solution called Rainbow Spray,
used for cleaning carpets. Rainbow Spray is made from a mixture of two other chemicals,
Alfie and Alpha which contain cleaning agent Anton and cleaning agent Alonzo. Their
product must contain 175 units of agent Anton and 150 units of Alonzo and weigh at least
100 pounds. Chemical Alfie costs P8 per pound, while chemical Alpha costs P6 per pound.
Chemical Alfie contains one unit of agent Anton and three units of agent Alonzo. Chemical
Alpha contains seven units of agent Anton and one unit of agent Alonzo.

Required: Set up the linear programming model