CH – 06 DEC ISION MAK ING

SUMMARY NOTES

CHAPTER
DECISION MAKING
06
These summary notes cover rules and formulas regarding the most
common practical questions of Decision Making. Read this so that you
may spend less time in solving questions of Decision Making and rather
spend more time in understanding how to write analysis in practical
questions as discussed in class. Also use more time to read theory.

A. METHODS TO MAKE PROFIT STATEMENTS

These 2 methods are just for presenting profit statements, not for making Selling Price
Calculations. i.e Selling Price is always calculated using rate method for fix costs.
ABSORPTION COSTING METHOD MARGINAL COSTING METHOD
1. Both variable and fix costs are taken in Only variable costs are taken in product
product costs (i.e. COP) costs (i.e. COP)
2. Fixed costs are taken in product costs Fixed costs are taken separately on total
based on rate basis. basis.
3. Difference in total fix cost is then later No such adjustment is needed as directly
adjusted to get the final profit. [under total fix costs has been taken.
absorption / over absorption].
4. Stock valuation contains both fix and Stock valuation contains only variable
variable costs costs
5. Fix costs are treated as product costs. Fix costs are treated as period costs
6. Format (of concept): Format (of concept):
Sales Sales
(-) COS [Var & Fix (@Rate)] (-) V - COS

∴ Profit ∴ Contribution
(±) Difference in fix costs (-) Fix Costs (Total)

∴ Adjusted Profit ∴ Profit

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7. Detailed Format: (₹) Detailed Format: (₹)

A. Sales A. Sales

B. Less: All Costs: B. Less: Variable Costs:

DM DM

DL DL

V-FOH V-FOH

F-FOH (Absorbed) -

FC V-FC

V-AOH V-AOH

F-AOH (Absorbed)

COP V-COP

(+) Opg FG (+) Opg FG

Total Total

(-) Clg FG (FIFO) (-) Clg FG (FIFO)

COGS V-COGS

(+) Under Abs - F-FOH V-S&D

(+) Under Abs - F-AOH V-COS

Adj. COGS C. Contribution:

C. Gross Profit D. Less: Fixed Costs:
D. Less: Other Costs F-FOH

V-S&D F-AOH

F-S&D (Total) F-S&D

E. Net Profit E. Net Profit

B. CVP ANALYSIS
BASIC FORMULAE:
1. To find Output (units) required to earn a target To find Sales (₹) required to earn a target
𝑂 𝑆𝑎𝑙𝑒𝑠
profit: profit:
𝑈𝑛𝑖𝑡𝑠 . . ₹ / %

So whenever we want the answer in Units → then divide “per unit rate” & whenever we
want the answer in ₹ → then divide “percentage (%) rate”

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2. 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 % 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

3. Break Even Point (BEP): Margin of Safety (MoS):

→ Level of Sale at which profit = 0 → Level of Total Sale above the BEP
→ At BEP, Total Contribution = FC → During MoS, FC = 0. ∴ Total Contri = Profit
𝐵𝐸𝑃 𝐹𝐶 𝑀𝑜𝑆 𝑃𝑟𝑜𝑓𝑖𝑡
𝑈𝑛𝑖𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝. 𝑢. 𝑈𝑛𝑖𝑡𝑠 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝. 𝑢.
𝐵𝐸𝑃 𝐹𝐶 𝑀𝑜𝑆 𝑃𝑟𝑜𝑓𝑖𝑡
₹ 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 % ₹ 𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 %
𝐵𝐸𝑃 𝐵𝐸𝑃 𝑀𝑜𝑆 𝑀𝑜𝑆
100 100
% 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 % 𝑇𝑜𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠
𝐹𝐶 𝑃𝑟𝑜𝑓𝑖𝑡
100 100
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛

CVP ANALYISIS GENERAL NOTES:

4. Whenever we need to calculate profit for a given sales, and BEP is already known, then
profit can be calculated by short-cut method – i.e. for the sales above BEP, any
contribution earned, itself becomes profit.
5. While applying High – Low method, if the FC changes, then High – Low method is not
applicable, we need to reverse the effect of FC change in the Total Cost, then apply High
– Low method. Then later, the FC change can be reapplied. (Refer CW Q 06)
6. P/V Ratio % changes only if SP p.u. or VC p.u. changes, it does not change because of
change in units.
7. With the increase in sales units, BEP (Units) & BEP (Rs) remains same, but BEP (%)
keeps changing.

SHUTDOWN POINT (SDP):

8. It is the level of sales below which it is better to shutdown business temporarily, rather
than continue with higher losses.
9. It the level of sales below which, ‘Loss if Continue’ > ‘Loss if Shutdown’

10. Calculation – By Formula: SDP

. . . / %

Avoidable FC = Total FC if Continue – Total FC if Shutdown

Total FC if Continue includes: Cost of Reopening, Training, Repairs, etc
If estimated level of operation is more than SDP, then continue, otherwise shutdown.
11. Calculation – By Comparison: Shutdown if ‘Loss of Continue’ > ‘Loss of Shutdown’

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MULTI-PRODUCT BEP:
12. When the company has multiple products, each having different contribution p.u., but the
fix costs incurred in the company is ‘Common Fix Costs’ for all products, then the BEP
depends on ‘which product is sold’. That, in turn depends on the ratio of past sales
experience given in the question. Thus, in such case, BEP cannot be calculated unless
such ratio of sales is given in the question.
13. If the ratio given is ratio of Sales Units, then start calculation by assuming no. of Sales
Units equal to the ratio given.
14. If the ratio given is ratio of Sales Rs, then start calculation by assuming value of Sales Rs
equal to the ratio given.
15. If there is shortage of available units in any one category, then 1st calculate the
contribution lost due to the shortage, then recover that lost contribution by selling units of
another available category. (Refer Q 17)

BEP WITH OPENING STOCK:

16. FC is 1st recovered from the units which are sold 1st (depending on FIFO / LIFO / WAM).
Then the remaining FC is recovered from the units which are sold next. Thus, FC is
recovered Step-Wise.

THUS, COMPARISON:
17.Multi – Product BEP (i.e. Ratio Method) BEP With Opening Stock (i.e. Step-Wise Method)
→ There is more than 1 Contribution → There is more than 1 Contribution p.u., but FC
p.u., but FC is Common. is Common.
→ All these Contribution p.u. are → All these Contribution p.u. are earned one –
earned together (at same time) after – another (Step Wise)
→ ∴ Ratio of sale must be given. → ∴ Ratio is not needed.
→ ∴ Ratio Method is followed (Q12) → ∴ Step-Wise Method is followed (Q13)
→ Eg: Multi-Product BEP, BEP with → Eg: BEP with Opening Stock under FIFO /
Opening Stock under WAM LIFO, BEP when initial units are sold at discount,
etc
MERGED PLANT BEP:
18. If plant capacities are merged, then to find BEP of the merged plant, 1st find the basic data
of the merged plant (like Contirbution p.u. & P/V Ratio). To do this, 1st convert all individual
plants into 100% capacity then add their data to get data of merged plant.

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INDIFFERENCE POINT (IDP):

, . .
19. 𝐼𝐷𝑃
. .

20. Rule for selection: if usage is more than IDP, only then, choose the option with higher FC.
(Higher FC is affordable only if usage is more than IDP)
21. If there are 3 options, 1st arrange all options in increasing order of FC. Then calculate FC
only between adjacent options. i.e. option 1 & 2; then option 2 & 3. Don’t calculate IDP
between Option 1 & 3 unless specifically asked.

BEP WITH SVC (BATCH LEVEL COST):

22. [Method – 2] Consider SVC as VC and convert it to SVC p.u. Now Calculate Contribution
p.u. using this SVC p.u. Then calculate BEP with the Contribution. This BEP is
approximate BEP (i.e. Minimum BEP). The correct BEP will definitely come above this
BEP.
23. Now consider SVC as FC and find BEP by trying batches above this BEP. (Trial & Error
method) [Refer Q 22]
24. Similarly, follow such trial & error methods whenever any factor of BEP is changing. (i.e.
SP changes, or VC changes, or FC changes) [Refer Q 24]

CVP ANAYLSIS WITH NORMAL DISTRIBUTION:

25. Question is to find probability using Normal Distribution.
26. 1st find out that which factor follows normal distribution (Units, or Profit, etc). If units follow
normal distribution, then find units (x) required to reach the target profit. Now convert this
‘x’ into ‘z’ by 𝑧

27. P(Profit > _____) = P(Units > x] = P(z > ____).

28. P(z) is identified from z-tables given.

C. RELEVANT COSTING
MEANING:
1. Means expected future costs that differ under different alternatives. All variable costs need
not be relevant, and all fixed costs need not be irrelevant.
2. Sunk Cost: = Cost which is already incurred, Not Relevant for decision making.
3. Opportunity Cost: = Income of next best option that is sacrificed. It is Relevant for
decision making. However, Opportunity Cost exists only if another opportunity is given in
the question, and that opportunity is sacrificed.

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RC FOR MATERIALS:
4. Not in stock, specially purchased: = Current Purchase Price
5. In stock, regular in use: = Current Purchase Price + Contri. Lost (if any)
6. In Stock, not in regular use (Eg: Obsolete = Opportunity Cost (OC) = NRV
Material)
7. If Obsolete Mat. as above has any other = Opportunity Cost (OC)
alternative use. = NRV or Net Savings of that alternative use
(whichever is higher)
8. If Obsolete Mat. as above has any = OC of Obsolete Mat. or Total Cost of
substitute available Substitute
(whichever is lower)
[Refer CW Example]

RC FOR LABOUR (CASUAL LABOUR, i.e. VARIABLE COST):

9. If available in abundant = Labour Cost Paid
10. If in short supply = Labour Cost Paid + Contri. Lost
RC FOR LABOUR (PERMANENT LABOUR, i.e. FIXED COST):
11. If sitting idle = Nil
12. If Busy = Only Contri. Lost
13. If nothing is mentioned, then assume Labour is Variable Cost (i.e. Casual Labour)

RC FOR OVERHEADS:
14. If Variable Oh are based on labour, then it must be considered even on permanent labour.
15. If Fix Oh absorption rate is given in the question, then ignore this rate, as Fix Oh is relevant
only if the total increases due to the new offer.
16. Any Fix Cost is Relevant only to the extent it is Avoidable.
17. If a dept. is working at full capacity and this dept. is required for new offer, then Relevant
Cost will be VC + Contribution Lost (Both).

RC FOR MACHINE:
18. = Value now – Value after use
19. If not in use, in stock = Sale Value Before – Sale Value After use

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20. If Purchased new, and then no other use = Current Purchase Cost – Sale Value After
after this new offer use
21. If Purchased new, and then transfer to = Current Purchase Cost – Cost after use.
other existing business.

GENERAL RULES:
22. Identify all relevant costs on total basis as far as possible.
23. Relevant Cost is always identified for company as a whole, not department-wise. So if the
new offer gives contribution lost in any other department, then it must also be considered.
24. ‘Replacement Cost’ = Current Purchase Cost
25. In case of question based on bankruptcy, then for deciding price for new customer, we
shall charge the following items:
(1) Cost of Completion (if required),
(2) Cost of Modifications (if new customer requests), &
(3) Opportunity cost of materials & parts already used in it (i.e. Scrap Value or Savings of
Alternate use)

VARIANCE RECONCILIATION BY RELEVANT COSTING METHOD:

26. 1ST present Variance Reconciliation by Marginal Costing Method (Refer Chapter 12).
27. Now identify the key factor (Material or Labour) and if this key factor Quantity is wasted,
then identify contribution lost due this wastage of key factor Quantity.
28. This contribution lost is the variance that must be removed from CMVV and added to the
respective key factor Quantity variance (Eg MUV or LTV).

29. Write analysis that why are we shifting contribution lost. That’s it. 😊

D. KEY FACTOR PRODUCT MIX DECISIONS

BASIC STEPS:
1. Calculate Contribution per Key Factor and do Ranking of all products based on that.
2. Allocate the total Key Factor to these products in sequence of the Ranking up to the
maximum demand of each product.
3. Convert this Key Factor allotment into Units allotment to get the Product Mix.
4. If minimum commitment is given for any product, then 1st allot the minimum commitment,
then allot remaining Key Factor based on ranking to all

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5. If any unsuitable key factor is given, then 1st allot the unsuitable key factor to the products
where it suits, then allot the remaining key factor to all products based on ranking.
6. If maximum demand is not given, the entire key factor is given to the best product, hence
we will produce only 1 product then.

IF EXTRA KEY FACTOR IS GIVEN (Eg Overtime):

7. Use extra Key Factor for the product in which demand is still unsatisfied from basic
allotment.
8. If there are more than 1 such products then try using extra key factor for both, finally chose
the one in which extra profit is maximum.
9. Extra key factor must be used only if it gives extra profits.

MULTIPLE KEY FACTORS:

10. If there are 2 products (Product X & Y) and more than 1 key factors, then there are 2
possible methods to solve: Trial & Error Method, or Graph Method (Linear Programming
Problem Method)
11. In case of Trial & Error Method,
Trial 1: 1st try if X is rank 1 and make allotment accordingly, then
Trial 2: try if Y is rank 1 and make allotment accordingly,
Trail 3: then make equations to use entire key factors for X & Y, and solve these equations
to get values of X &Y.
Now choose the trial which gives maximum Contribution.
12. In case of Graph Method,
Objective Function is to maximize Contribution from X & Y,
Identify Equations for conditions and plot them all on a graph,
Find common area of the graph and end points of that common area,
Calculate total contribution for each point of the common area,
Now choose the trial which gives maximum Contribution.

E. MAKE OR BUY DECISIONS

1. Compare Relevant Cost of Make v/s Relevant Cost of Buy. Choose whichever is cheaper.
2. Indifference point between Make & Buy: Make only if the requirement is more than IDP,
otherwise Buy.

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3. If this requirement is predicted is wrong, then due to that the decision to Make or Buy
would go wrong. Now in this case we calculate the cost of prediction error. i.e. difference
between Actual cost incurred v/s Cost that would have been incurred if requirement were
predicted correct. [Refer Q 69]
4. If question involves key factor also, then make as much as possible with the given key
factor (based on ranking), remaining requirement is Buy. However, for that purpose,
ranking is done based on Savings per key factor. Savings = Difference between RC of
Make & RC of Buy. Selling price is never considered here.
5. If Fixed Cost of make is Batch Level Cost, then also check for making 1 batch less if the
last batch is not fully used. [Refer Q 71]
6. Make or But with Capital Budgeting – Decide by calculating NPV of Make option, if it is
positive, then, make, otherwise buy.
7. General Analysis: If buy is chosen then company will have spare capacity, using it they
can satisfy more demand. But if there is no more demand, then company may lay-off
workers to reduce capacity. Also discuss quality and timely issues if buy option is selected.

F. NEW OFFER ACCEPTANCE AND OTHERS

1. Decide by calculating Relevant Cost of new offer. If new offer is in addition to existing
production, then all Variable costs of new offer are relevant, Fix costs are relevant only if
incurred specifically for the new offer, or if they are avoidable.
2. When there are more than 1 types of products, then capacity is always measured in terms
of Hours, not Units.
3. Carrying cost of additional inventory also must be considered for new offer evaluation if
the carrying cost rate is given. Find inventory value of RM, WIP, and FG. Then take Total
Inventory Value × Carrying Cost Rate.
4. Bottleneck is that department due to which the maximum production is restricted. Identify
max. production of each department, then overall max production is which ever is lowest.
Now at this production, only the bottleneck dept is fully utilized, rest of the dept. still have
spare capacity left.

5. Return of Capital Employed (ROCE) = Return in Investment (ROI) =

6. Expansion decision question may require you to make a format of flexible budget as per
your CA Intermediate syllabus.
7. Overtime working means same workers are made to sit extra hours, hence we have to
pay them high overtime premium (mostly 50%). 2nd shift working means new set of
workers are hired for the extra work, in this case we may pay same rate or little extra rate,
however we will also incur extra fix costs like recruitment, etc.
Thus, overtime has higher VC while 2nd shift has extra FC. ∴ We can decide by IDP.

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G. HOW TO ANSWER ANALYSIS

1. Give interpretation for every CVP Analysis calculation done, eg BEP, MOS, SDP, IDP,
BEP by Ratio Method, BEP by Step-Wise Method, BEP with SVC, etc. Also give your
recommendation in the given case based on this interpretation.
2. Explain the logic behind the calculation method as explained in rules for calculation above.
3. For all relevant costing calculations, give explanation for each item that why is it relevant
or why is it not relevant. Explain why is any item is sunk cost or opportunity cost. Finally
give your recommendation.
4. For Key Factor questions, explain that key factor will limit production, also explain that
this key factor might become bottleneck, so, explain bottleneck also. Finally give your
recommendation.
5. For Make or Buy decisions, analyze Relevant Costs as explained in point 3 above and
give recommendation.
6. Give interpretation of IDP between Make or Buy if asked and give recommendation.

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