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Decision Making

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You are on page 1of 16

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 "

Answer: "white"

Answer: "With milk "

Answer: "With cow milk please.

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

Answer: "With sugar"

Answer: "Cane sugar "

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

Answer: "Mineral water"

Answer: "I'd rather die of thirst "

1

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 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

decision.

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.

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.

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.

2

MAKE OR BUY

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:

MAKE if RELEVANT BUY COSTS > RELEVANT MAKE COSTS

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

Illustration:

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.

Direct Materials P14.00 Purchase Price P61.00

Direct Labor 30.00

Variable Overhead 12.00

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

Current costs are:

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

made.

3

SPECIAL SALES PRICING

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.

Incremental Revenue

Less Incremental Costs

Variable Costs

Opportunity Costs

(Lost Contribution Margin) (without excess capacity)

-----------------------------

Incremental Profits

==================

Illustration:

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:

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?

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

======

4

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?

5

SELL AS IS OR PROCESS FURTHER

Decision Question

Decision Rule:

(SP After Processing SP at Split Off Point)

Less Incremental Costs

-------------------------------------------------------

Incremental Profits

==============

Illustration:

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.

Solution:

Aeta (P60-P30) P30 - P35 = -P5

Beta (P80-P40) P40 - P35 = P15

Ceta (P90-P70) P20 - P35 = -P15

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

6

ADD, RETAIN OR DELETE A SEGMENT

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)

Sales

Less Variable Costs

-------------------------

Contribution Margin

Less Avoidable Fixed Costs

----------------------------------

Net Segment Income

=================

NOTE:

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

deleted.

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

income.

Illustration:

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

===== ==== ==== =====

7

Solution

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

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:

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

8

CONTINUE OR SHUTDOWN

Decision Question:

operations?

Decision Rule:

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.

-------------------------

Contribution Margin per unit

Additional Shut Down Costs ( if any)

----------------------------------------------------------------------------

Contribution Margin per unit

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

================= ========

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

9

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

dimsum.

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

hours.

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.

Illustration:

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

P50,000.

The following data concerning production cost per bottle are gathered from the records of Cassava

Enterprises:

Direct Materials P7.00

Direct Labor 4.00

Variable Overhead 3.00

Variable Selling expenses 2.00

-------

Total Variable costs 16.00

====

Required:

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?

10

Solution:

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

=========

(P7,200,000 x 3/12) P1,800,000

less Shutdown Costs 1,450,000

--------------

Shutdown Savings P 350,000

========

= 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.

Proof:

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)

========= ========== ==========

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.

11

USE OF SCARCE REOURCES/BEST PRODUCT COMBINATION

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.

Machine Hours

Shelf Space in a Grocery Store

Study Time

Seating Capacity in a Popular Restaurant

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.

Illustration:

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

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

12

Decision: 3rd 1st 2nd

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.

Total

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:

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

13

Appendix:

Linear Programming

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

resources.

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.

Applications

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.

Steps:

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

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

negative number of units)

14

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

further.

*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.

inequality.

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

changes.

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.

15

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.

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.

16

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