Short Term Decision Making (OK Na!)

UNIVERSITY OF SAINT LOUIS-TUGUEGARAO
School of Business Administration and Accountancy, 2013-2014

Junior Philippine Institute of Accountants
MEMORY AID IN MANAGEMENT ADVISORY SERVICES
Any form of reproduction of this copy is strictly prohibited!!!
CHAPTER 9:
Short Term Decision Making-Incremental Analysis
☛Short Term Decision Making ☛The Criterion for Short-Term Decisions
Introduction: RULE: Take the action that you expect
Making decisions is choosing among will give the organization the highest income or
alternatives. Most managers and accountants lowest loss.
consider a decision to be short term if it TWO SUBRULES:
involves a period of one year or less. The basic 1. The only revenues and costs that
principles of short term decisions also apply in are RELEVANT in making
the long run but long term decisions require decisions are the expected
additional considerations. FUTURE revenues and costs that
will DIFFER among the available
☛Types of business decisions choices. These are called
1. Strategic decisions are long term in DIFFERENTIAL REVENUES and
effects, its focus is growth and stability COSTS.
and its objective is to meet the needs of 2. Revenues and costs that have
investors (i.e., wealth accumulation). already been earned or incurred
2. Tactical decisions are made regularly and are IRRELEVANT in making
with medium-term effects to decisions.
organizational results.
3. Operational decisions are made on a 1. ☛Relevant Costs are those used in
daily basis where the judgmental call of making a decision. A cost to be relevant
a supervisor is at its greatest use; it is must be both differential and future
made regularly and has short term cost.
effects. 1.1)Differential or Incremental Costs
are costs that are present in one alternative in a
*The focus of tactical and operations decisions decision making case, but are absent in whole
is profitability and liquidity, and their goal is or in part in another alternative.
customer’s satisfaction. 1.2) Avoidable costs are costs that can
*Short-term non-routine decisions are within be eliminated in whole or in part, when one
the ambit of tactical and operational decisions. alternative is chosen over another in a decision
Profitability is a key factor in short-term non- making case.
routine decisions. 1.3) Opportunity Cost is the profit
forgone by selecting one alternative instead of
another.
Management Advisory Services (MAS) Committee: Hazeleen Martinez; Jimmy Joe Miranda; Cliff Mark Confidente;
43 Corina Bariuan; Kristina Gaddon; Rizalyn Taguibao ;Niῆo Rey Mangupag; Marjhon Maramag; Leo Jay Labasan
Adviser: Mary Queen Ramos, CPA
2. Irrelevant costs 2.2) Future costs that DO NOT differ

2.1) Sunk cost is one that has already between or among the alternatives under
been incurred and therefore will be the same consideration
no matter which alternative a manager selects.
.
TYPICAL SHORT TERM DECISIONS:

☛MAKE OR BUY
Cost to make Cost to buy
Purchase Price PX
Direct Materials PX
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 a new product (X)
Rental expense if the part is bought X
TOTAL RELEVANT COSTS PX PX
Illustration:
LJC Company manufactures part GM for use in the production cycle. The cost per unit for 20,000
units of part GM are as follows:
DM P3
DL 15
VOH 6
FOH 8
Total P32
KDG Company has offered to sell LJC 20,000 units of part GM for P30 per unit. If LJC accepts KDG’s offer,
the released facilities could be used to save P45, 000 in relevant costs in the manufacture of part GM. In
addition, P5 per unit of fixed overhead applied to part GM would be totally eliminated. What alternative
is more desirable and by what amount is it more desirable?
SOLUTION:
MAKE BUY
Purchase Price(20,000 units * P30) P600,000
Variable Production Costs[20,000 *(3+15+6 )] 480,000
Avoidable fixed overhead(20,000*P5) 100,000
Savings from released facilities (45,000)

Net relevant Costs P580,000 P555,000
Savings(580,000-555,000) P25,000
☛ACCEPT OR REJECT A SPECIAL SALES ORDER…

In deciding whether to accept or reject a special order, the paramount consideration is INCREMENTAL
PROFIT, determined as follows:
Incremental sales PX
Incremental costs (X)
Incremental profit (loss) X
Opportunity costs (benefit) from alternative use of capacity (X)
Net advantage (disadvantage) of accepting the special sales order PX
The opportunity costs here refers to the net benefit that could have been derived from
another alternative had the special sales order not been accepted. If the order is not
accepted, the idle capacity could be
 Rented out to others, or
 Used to produce another product and generate additional contribution margin
If there is no idle capacity, the opportunity cost here refers to the lost contribution
margin from regular sales or from the best use of the sacrificed capacity.
Illustration:
1. MALAPITNA Co. has a plant capacity of 40,000 units per month. Unit cost capacity are:
DM P110
DL 140
VOH 75
FOH 75
Marketing fixed cost 175
Marketing variable cost 85
Present monthly sales are 39,000 units at P630 each. MALAPITNATALAGA Co. contacted MALAPITNA Co.
about purchasing 1500 units at P600 each. The present sales would not be affected by the special order.
Should MALAPITNA Co. accept or reject the special order?
SOLUTION:
Incremental sales(1500*600) 900,000
Incremental costs[(110+140+75+85)*1500] (615,000)
Incremental Profit P285,000
It is therefore advisable for the business to accept the special order and increase profit by
P285,000.
2. ANGBOARDEXAM Company is a manufacturer of electronic switches. One of their products,

“Sensory Switch”, is used as a component of most electrical appliances. Sensory switch has the
following financial data per unit:
Selling price P180
Variable costs: Materials P24
Labor 18
Factory Overhead 15
Shipping and handling 3 P60
Fixed Costs: Factory Overhead P36

Selling and administrative 14 50
Total P110
during the month, ANGBOARDEXAM Company has received a special one- time order
for 1,500 units of sensory switch.
 Assuming that the company has excess capacity that is enough to produce this special
order without affecting sales to regular customers, and the company wants to improve
its profitability, the price that is acceptable for this special order is in excess of
Answer: Variable costs of 60 per unit
 Assume that the company is operating at full capacity and that it does not want to incur
a loss from this order, the minimum acceptable price is
Answer: Variable costs P60

Opportunity costs ( contribution margin
To be lost from the regular customers
(180-60) 120
Minimum acceptable price P180
 Assume that the excess capacity available for the special order is only 1,000 units so that
if the order were accepted, ANGBOARDEXAM Company have to reduce sales to regular
customers. What is the minimum acceptable price for this special order?
Answer: Variable costs P60
Opportunity costs( contribution margin
To be lost from the regular customers
([1500 units*P120]/1500 units) 40
Minimum acceptable price P100
☛Continue or drop a division, a business segment, a product line, or a process

 Segment margin represents a division’s product lines, or department’s performance.
If the segment margin is positive, continue the division, assuming there is no
alternative use of the released facilities if the division is discontinued. If there is an
alternative use of the released facilities, compare the segment margin from net benefit
of the alternative. If the segment margin is greater, then continue. Otherwise,
discontinue the division and execute the alternative that gives the highest profit.
Segment margin equals:
Contribution margin Px
- Controllable direct fixed costs and expenses x
Controllable margin x
- Non- Controllable direct fixed costs and expenses x
Segment (direct) margin Px
The indirect (or collected) fixed costs and expenses shall be deducted from the
segment margin to arrive at the net income.
Alternatively, segment margin is computed as:

Contribution margin Px
- Avoidable fixed costs and expenses x
Controllable segment margin Px
If there is an alternatively use of facility, the qualification should be:

Segment margin Px
- Net benefit from the best alternative of facilities x
Net advantage (disadvantage) of continuing the division Px
Illustration:
KAYAARALTAYONGMABUTI Co. plans to discontinue a department withP48,000 contribution
overhead, and allocated overhead of P96,000, of which P42,000 cannot be eliminated. What would be
the effect of this discontinuance on KAYAARALTAYONGMABUTI Co.’s pretax income?
The segment margin of the discontinued department should be determined to know the effect of its
discontinuance to profit:
CM P48,000
-Avoidable fixed overhead(P96,000-P42,000) P54,000
Segment Margin P(6,000)
In as much as the segment margin of the department is negative, it should be discontinued to
increase the overall profit of the company by the eliminated negative segment margin.
☛Sell-as-is or process further a product…

The basic computational guideline is:
Incremental sales Px
Incremental costs (x)
Savings from further processing x
Incremental profit (loss) Px
The joint production costs (or common costs) and all the other costs of the preceding
processes are considered irrelevant in deciding whether to sell now or process further.
The incremental unit price is the difference in unit sales price at split –off point and
after further processing. The total incremental costs include the incremental variable
costs and incremental fixed costs. The common cost is a sunk cost and is irrelevant in
this decision analysis.
ILLUSTRATION:
SERYOSONATO Co. operates a joint process that results into two products, Commitment and
Prayers. Each 1,000 pounds of materials yield 600 pounds of Commitment and 400 pounds of Prayers.
SERYOSONATO Co. can sell both Commitment and Prayers at the split-off point or process each product
further. Selling price and cost data per batch (1,000 pounds of materials) are as follows:
Commitment Prayers
Selling price at split-off 600(P2 per pound) 1,200(3 per pound)
Selling price after additional processing 1,800(P3 per pound) 1,600(P4 per pound)
Costs of additional processing all variable 900(P1.50 per pound) 500(P1.25 per pound)
Decide whether to process further the products or sell them at split-off point?
SOLUTION:
Commitment
Incremental revenue (1,800-600) 1,200
Incremental costs 900
Incremental profit, favoring additional processing 300
Prayers
Incremental revenue (1,600-1,200) 400
Incremental costs 500
Incremental profit, favoring sale at split-off (100)
☛Continue operations or shut down…

Either way, continue or shut down, the business will have a loss. The guideline is which
option will give a lesser amount of loss?
 If operations are temporarily shut down, the business will still lose because of the
shutdown costs. SHUTDOWN COSTS are those that will be still incurred during the
shutdown period.
Examples of shutdown costs are salaries of remaining executive and skeletal force of
personnel, security, insurance, rental, interests, depreciation, property taxes,
advertising, and similar unavoidable costs. On top of it, the business will incur restart-up
costs once it resumes its operations. Restart-up costs include costs of rehiring and
retraining personnel, refueling, aligning, retuning machineries and equipment, and
refurbishing the plant.
Shutdown point is the where the loss from continuing the operations is equal to the
loss from discontinuing (i.e., shut down costs).
Therefore: Shutdown point = FC – SDC where: FC = fixed costs
UCM SDC= Shutdown costs
UCM= Unit Contribution margin
Technically, if:
Sales > Shut down point = continue the operations
Sales < Shut down point = shut down (discontinue) the operations
Illustration:
Queen Babies Corporation had been experiencing a slowdown in business activities in August
and September and is considering a temporarily shutting down its operations during those months. The
accounting department has provided the following normal operating data for considerations:
Unit selling price P150
Unit variable production costs 60
Unit variable marketing costs 10
Monthly fixed overhead 500,000
Monthly fixed expenses 200,000
Regular sales in units 10,000 per month
Estimated sales in units in August and September 5,000 per month
If the company shuts down its operations, the following costs are expected to be incurred:
Security and Safety P200,000 per month
Re-startup costs P100,000
Regular fixed overhead 40% of total will remain
Regular fixed expenses will be reduced by 30%
Requirements:
1) The total shutdown costs amounts to
Unavoidable fixed overhead(500,000*40%*2mos) P400,000
Unavoidable fixed expenses(200,000*70%*2mos) 280,000
Security and Safety 400,000
Re-startup costs 100,000

Total shutdown costs P1, 180,000
2) The shutdown point in two months

(1,400,000-1,180,000) = 2,750 units
80
3) Which alternative, continuing or discontinuing the operations is advisable and by how much is
it’s the advantage?
Contribution Margin(5,000*2 mos. *80) P800,000
-Fixed costs and expenses 1,400,000
Loss from continuing the operations (600,000)
-Shutdown costs 1,180,000
Net advantage of continuing the operations 580,000
☛Minimum or maximum bid price

The minimum bid price should not be less than your incremental costs. The maximum
bid price should not be in excess of the expected utility value of the item or object under
bid.
Minimum bid price equals increment costs plus opportunity costs of using the facilities.
If ever a formula is given, just follow the formula in the determination of the bid price.
Illustration:
AJA(FIGHTING) Co. manufactures engines for the military equipment on a cost-plus basis. The
cost of a particular machine the company is shown below:
DM P500,000
DL P200,000
OH:
Supervisor’s salary 30,000
Fringe benefits on direct labor 20,000
Depreciation 15,000
Rent 10,000
TOTAL P775,000
If the production of the engine were discontinued the production capacity would be idle, and
the supervisor will be laid off. Should there be a next contract for this engine; the company should bid a
minimum price of
SOLUTION:
The minimum bid price should at least equal the incremental costs or production plus
opportunity costs, if any. The incremental costs are;
DM P500,000
DL 200,000
Supervisor’s salary 30,000
Fringe benefits on direct labor 20,000
Incremental costs P750,000
☛Optimum use of scarce resources

Money, machine hours, direct labor hours, supply of materials, technology, and other
business resources are subject to scarcity.
To optimize scarce resources, sales and production should be allotted to 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
Illustration:
Data regarding four different products manufactured by TIWALALANG Co. are presented below:
Direct materials and direct labor are readily available from their respective resource markets. However,
the manufacturer is limited to a maximum of P3,000 machine hours per month.
Product A B C D
Selling price per unit (USP) P15 P18 P20 P25
Variable cost per unit (UVC) P17 P11 P10 P16
Units produced per machine hour 3 4 2 3
The product that is most profitable for the manufacturer in this situation is
SOLUTION:
Product A B C D
Unit contribution margin (USP-UVC) P(2) P7 P10 P9
*No. of units per machine hour 3 4 2 3
Contribution margin per machine hour P(6) P28 P20 P27
Rank of priority (4) (1) (3) (2)
Product B must be prioritized in production over the other products because it has the highest rate of
profitability per Machine Hour.
☛Sell now or later… Which is more profitable?

These are instances where the sales price of a product is expected to increase after a
period of time. Examples of these are fashion clothes, wines, artifacts, painting,
historical items, and land. If the product is not sold now, it will be kept, secured and
sometime, stored in a special place. Keeping the product would entail storage costs,
maintenance costs, and opportunity costs of the money locked in the product. If the
expected incremental sales are greater that the incremental costs of keeping the
product, then sell it later. Otherwise, sell it now!
☛Replace or retain an asset…

Illustration:
KAYANATINTOPROMISE! Co. has an opportunity to acquire a new equipment to replace one of
its existing equipment. The new equipment would cost P1,000,000 and has a five year useful life, with a
zero terminal disposal price. Variable operating cost would be a P1,250,000 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 P1,500,000 per year.
Considering the five years in total, but ignoring the time value of money and income taxes,
KAYANATINTOPROMISE! Co. should
SOLUTION:
RETAIN REPLACE
Purchase price P1,000,000
Book value P500,000
Useful life(remaining) 5 years 5 years
Terminal salvage value 0 0
Salvage value now 50,000
Variable operating costs 1,500,000 1,250,000
Annual savings in operating costs
(1,500,000-1,250,000) P250,000
Therefore:
Savings in five years(P250,000*5yrs) P1,250,000
Salvage value of old equipment 50,000
Total cash inflows P1,300,000
Purchase Price (1,000,000)
Net advantage of replacing the old equipment P300,000
☛Scrap or rework
 In deciding whether to sell as scrap reworking should be compared with the net profit of
selling as scrap without regard to the past costs of producing the product.
The past production costs, both variable and fixed, are irrelevant in this situation.
ILLUSTRATION:
100%CPAPASSINGRATE Co. has 8,500 obsolete toys carried in inventory at manufacturing cost of
P6 per unit. If the toys are reworked for P2.5 per unit they could be sold for 4 per unit. If the toys are
scrapped, they could be sold for P1.85 per unit. Which alternative is more desirable and what is the total
peso amount of the advantage of that alternative?
SOLUTION:
Income from reworking [(4-2.5)*8,500] 127,500
-Income from scrapping (1.85*8,500) (15,725)
Net advantage of scrapping (2,975)
☛Indifference Point… whatever decision, the results are equal.

Indifference point is where the outcome of alternatives is the same.
Regardless of a choice the manager makes, he will arrive at the same profit or loss.
Examples of difference point computations are the breakeven point, shutdown point,
economic order quantity, and internal rate of return.
SUMMARY:
☛ Typical Short-Term Decisions
Short-Term Non-Routine Situations Decision Guidelines
1. Make or buy (insource or outsource) a The alternative having lower relevant costs should
component part? be preferred.
2. Accept or reject special sales order? If there is an Incremental profit, accept!
3. Drop or continue an organizational segment If the direct segment margin is positive and there
(e.g., division department, or product is no other more beneficial alternative, then
line)? continue!
4. Sell-as-is or process further? If there is a profit of further processing, then
process further!
5. Continue operations or temporarily shut If sales are greater than the shutdown point,
down the operations? better continue operating!
6. Maximize or minimize bid price Focus on the incremental costs…
7. Optimization of scarce resources Prioritize the product that gives the highest
contribution margin on the limited resource.
8. Sell now or later? If the expected increase in sales is greater than the
incremental cost of storage, then sell later.
9. Replace or retain an old asset? If the net cash inflows is greater than the net
outflows, replace the asset(here the time value of
money and tax effects are not considered)

10. Scrap or rework a defective unit Choose the alternative that gives the higher short-
term profitability.
11. Determining the indifference point Indifference point is the “point of equality”, where
the results of the alternatives are the same, in
terms of profit.

Short Term Decision Making (OK Na!)

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UNIVERSITY OF SAINT LOUIS-TUGUEGARAO

School of Business Administration and Accountancy, 2013-2014

2. Irrelevant costs 2.2) Future costs that DO NOT differ

TYPICAL SHORT TERM DECISIONS:

Savings from released facilities (45,000)

☛ACCEPT OR REJECT A SPECIAL SALES ORDER…

2. ANGBOARDEXAM Company is a manufacturer of electronic switches. One of their products,

Fixed Costs: Factory Overhead P36

Answer: Variable costs P60

☛Continue or drop a division, a business segment, a product line, or a process

Alternatively, segment margin is computed as:

If there is an alternatively use of facility, the qualification should be:

☛Sell-as-is or process further a product…

☛Continue operations or shut down…

Re-startup costs 100,000

2) The shutdown point in two months

☛Minimum or maximum bid price

☛Optimum use of scarce resources

☛Sell now or later… Which is more profitable?

☛Replace or retain an asset…

☛Indifference Point… whatever decision, the results are equal.

Short-Term Non-Routine Situations Decision Guidelines

money and tax effects are not considered)

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