Module 2

Analysis of Special Decisions

OVERVIEW:

In this module, you will learn the different short-term non-routine decision problems and how to solve
them.

LEARNING OUTCOMES:

After studying this module you should be able to:

1. Prepare an analysis showing whether a product line or other business segment should be added
or dropped.
2. Prepare a make or buy analysis.
3. Prepare an analysis showing whether a special order should be accepted.
4. Determine the most profitable use of a constrained resource.
5. Determine the value of obtaining more of the constrained resource.
6. Prepare an analysis showing whether joint products should be sold at the split-off point or processed
further.

INTRODUCTION:

Short-term, non-routine decision problems are part of the day-to-day task of every manager. Although
these problems have short-term impact on the business, their importance to the overall profitability cannot
be ignored. That’s why careful and thorough analysis should be done before a decision is made.

DISCUSSION OF THE TOPIC:

2.1 Two approaches in solving short-term decision problems

The two approaches in solving short-term decision problems are:

2.1.1 Differential Approach – wherein only differential (relevant) costs/benefits are considered in the
solution

2.1.2 Total Approach – wherein all costs/benefits are considered in the solution, relevant or not.

Illustrative Problem:

Corona Bikes, Inc., currently produces mountain bikes. Management is interested in outsourcing
production of these bikes to a reputable manufacturing company that can supply the bikes for $600 per
unit. Corona Bikes incurs the following unit costs to produce 2,000 mountain bikes annually:

Variable production costs:

Direct materials P400.00
Direct labor 100.00
Manufacturing overhead 50.00
Fixed production costs:
Factory building and equipment lease 90.00
Factory insurance 30.00
Production supervisors’ salary 35.00
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The company sell the bikes for P1,000. Outsourcing production eliminates all variable production costs,
the production supervisor’s salary, and factory insurance costs. Factory building and equipment lease
costs will remain the same regardless of the decision to outsource or to produce internally.

Required: Determine what decision the company should make using differential approach and total
approach.

Differential approach:
Cost to Make: Cost to Buy:
Direct materials P400.00 Purchase Price P600.00
Direct labor 100.00
Manufacturing overhead 50.00
Factory insurance 30.00
Production supervisors’ salary 35.00
Total P615.00
X Total Units Needed 2,000.00 X Total Units Needed 2,000.00
Total Cost 1,230,000.00 Total Cost 1,200,000.00
Differential cost in favor of buying = P30,000
Note: Sales and Factory Equipment and Lease are not included in the solution since they are not
differential (will not change regardless of whether you make or buy) and therefore irrelevant.

Total approach:
Make Buy:
Sales (2,000 x P1,000) P2,000,000.00 Sales P2,000,000.00
Direct materials 800,000.00 Purchase Price 1,200,000.00
Direct labor 200,000.00 Gross Profit 800,000.00
Manufacturing overhead 100,000.00 Less:
Factory and Equipment Lease 180,000.00 Factory and Equipment Lease 180,000.00
Factory insurance 60,000.00 Factory insurance -
Production supervisors’ salary 70,000.00 Production supervisors’ salary -
Net Profit P 590,000.00 Net Profit 620,000.00
Differential revenue in favor of buying = P30,000

Although when done correctly, the two methods always provide the same answer, using the differential
approach is desirable for two reasons:

1. Seldom there will be enough information available to prepare detailed income statements for both
alternatives.
2. As we have discussed in Module 1, too much information is time consuming. Also, mingling irrelevant
costs with relevant costs may confuse decision makers and drive their attention away from information
that is important.

So unless specifically stated in the requirement, solve all problems using differential approach.

2.2 Make or Buy Analysis

A company may choose to carry out all the activities in the value chain or just some of the activities and
outsource the others. A company is vertically integrated when it is involved in more than one activity in
the value chain. For example, Apple Inc. is involved in many activities in its value

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 Module 2 – Analysis of Special Decisions 3

Source: https://mediumsandmessages.org/2017/09/12/vertical-integration/

chain. It has manufacturing facilties for its various components, and it has its own software production
and development. It has also stores worldwide for the distribution of its products. While big companies
like apple choose vertical integration, other companies are content to integrate on a smaller scale by
purchasing many of the parts and materials that go into their finished products. Quite often these
decisions involve whether to buy a particular part or to make
them internally. These decisions will be based on a make or buy analysis.

Illustrative Example:

Mindoro Mountain Bikes manufactures mountain bikes as well as the different components it needs in the
production of the final product like gears and wheels . The company is now producing the heavy-duty
gear shifters used in its most popular line of mountain bikes. The company’s Accounting Department
reports the following costs of producing 10,000 units of the shifter internally each year:

Per Unit Total Cost

(10,000 units)
Direct materials P6.50 P65,000.00
Direct labor 4.25 42,500.00
Variable overhead 1.75 17,500.00
Supervisor’s salary 3.50 35,000.00
Depreciation of special equipment 2.00 20,000.00
Allocated general overhead 5.00 50,000.00
Total cost P23.00 P230,000.00

An outside supplier quoted P165,000 for 10,000 shifters. Should the company make or buy the shifters?

Cost to Make Cost to Buy

Direct materials P65,000.00 Purchase Price P165,000.00
Direct labor 42,500.00
Variable overhead 17,500.00
Supervisor’s salary 35,000.00
Total Cost P160,000.00 P165,000.00
Analysis:

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 Module 2 – Analysis of Special Decisions 4

At first glance, we may think that the purchase price of P16.50 (P165,000/10,000) per unit is cheaper than
the total unit cost of P23.00. But since Depreciation of special equipment is a sunk cost and allocated
general overhead is not differential (since total general overhead will not change regardless of the
alternative) it should not be included in the analysis. Therefore, only the relevant manufacturing cost of
P160,000 should be compared to the purchase cost of P165,000. Therefore, notwithstanding the
qualitative data, it is more advantageous for the company to continue producing the gears.

Now, what if the special equipment could be rented out to another company for P10,000 if Mindoro
Mountain Bikes decided to outsource the production of gears? In this situation the rental income is an
opportunity cost and will be relevant to the decision whether to make or buy. The total relevant cost to
make is now P170,000 and the total cost to buy is still P165,000. Therefore, it will be better now for the
company to purchase the gears from the outside supplier.

2.3 Special Order Analysis

Another problem often faced by managers is the acceptance of a special order at a price different from
the regular price. A special order is a one-time order that is not considered part of the company’s normal
ongoing business. Special order may or may not result to regular business with the customer.

Illustrative Problem
Mindoro Mountain Bikes has just received a request from an NGO (Non-governmental Organization) to
produce 100 specially modified mountain bikes at a price of P3,500 each. The bikes would be used to
transport health workers in this time of pandemic. Mindoro Mountain Bikes can easily modify one of its
mountain bikes model (Model 1000) to serve the purpose. The normal selling price of the Mountain bike
is P4,500, and its unit product cost is P3,600 as shown below:

Direct materials . . . . . . . . . . . . . . . . . . . . . . P1,600.00

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . 1,000.00
Manufacturing overhead . . . . . . . . . . . . . . . 1,000.00
Unit product cost . . . . . . . . . . . . . . . . . . . . . P3,600.00

The variable portion of the above manufacturing overhead is P400 per unit. The order would have no
effect on the company’s total fixed manufacturing overhead costs. The modifications requested by the
NGO consist of welded shields in front of the bikes for protection. These modifications would require
P200 in incremental variable costs. In addition, the company would have to pay a graphics design studio
P10,000 to design and cut stencils that would be used for spray painting the NGO’s logo and other
identifying marks on the bikes.

This order should have no effect on the company’s other sales. The production manager says that she
can handle the special order without disrupting any of the company’s regular scheduled production.

Analyze whether the company should accept this special order.

Analysis:
Incremental revenue P350,000.00
Incremental costs:
Direct materials 160,000.00
Direct labor 100,000.00
VOH 40,000.00
Additional VC 20,000.00
Design 10,000.00
Net benefit (loss) P20,000.00

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 Module 2 – Analysis of Special Decisions 5

Based on quantitative analysis, the company should accept the special order.

2.4 Utilization of Scarce Resource

The Theory of Constraints is the name given to a series of decision making techniques first created by
Dr. Eliyahu M. Goldratt The Theory of Constraints is a methodology for identifying the most important
limiting factor (i.e. constraint) that stands in the way of achieving a goal and then systematically improving
that constraint until it is no longer the limiting factor. In manufacturing, the constraint is often referred to as
a bottleneck.

But what must we do while there is a constraint? We must make the most of the constrained resource
and that’s what we must achieved in this topic.

If there is a production constraint, our goal is to maximize the profit that will be earned under this
condition. To do this, we must prioritize the product with the highest contribution margin per unit of scarce
resource.

Illustrative Problem:

Angel’s Burger Joint is constrained by the size of its 1,000-square-inch cooking grill. Because the Joint is
open eight hours a day, Angel’s has a maximum of 8,000 square-inch-hours of grill time available per day
(1,000 square inches times eight hours).

Suppose that Angel’s Burger Joint has four total items on the menu, with the following contribution
margins and grill time requirements per order:
Item Contribution Margin Grill Time
Deluxe Burger P9.00 8 units
Juicy Grilled Chicken 15.00 12 units
Puffy Hot Dog 6.00 3 units
Vegetarian Pasta Primavera 6.00 0 units

If Angel’s Burger has 500 units daily demand for each product, how much of each item should they
produce to maximize profit?

Analysis:
First, we must find each product’s contribution margin per unit of constrained resource by dividing each
product’s contribution margin per unit by the amount of constrained resource needed to make it. Then
rank the products with the highest cm per unit of constrained resource first and with the lowest last.

Deluxe Burger Juicy Grilled Puffy Hot Dog

Chicken
Contribution Margin P9.00 15.00 6.00
Grill Time 8 12 3
CM/GT 1.125 1.25 2
Ranking 3rd 2nd 1st

Puffy Hot Dog (500x3) 1,500

Juicy Grilled Chicken (500x12) 6,000
Total 7,500
Remaining allocated to Deluxe Burger 500
Divide by Grill Time of Deluxe 8
No. of Deluxe Burgers than can be produced 62.50

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Therefore, to maximize profit, Angel should sell 500 Puffy Hotdogs, 500 Juicy Grilled Chicken and 62.50
Deluxe Burgers (or 62 since we cannot sell half-burger!). Pasta Primavera is not included in the analysis
because it doesn’t require grill time. Angel’s can take as many orders as the customer wants for this
product. In fact, if they run out of grill time, they can ask the customer to order this product instead.

Maximum amount that should be paid for added units of constrained resource

What if we can rent some amount of grill time from an adjoining joint (who has excess capacity of grill
time) what is the maximum amount that we should pay?

Analysis:

Since the only unsatisfied demand is for Deluxe Burger, if ever we will add grill time, it will be to satisfy the
demand for this product. Therefore, the maximum amount that we should pay is P1.125 per unit of grill
time for this resource.

2.5 Sell or Process Further Decisions

There are times when manufacturing businesses become faced with the decision to sell a product at its
current state or process it further and sell for a higher price.
The management must choose the option that will result in higher profits.
The management must choose the option that will result in higher profits.
In relevant costing, if the increase in price is higher than the increase in cost, then it is better to process
the product further as it will result in higher profits.
If further processing costs exceed the increase in revenues, then there is no point in processing the
product further.
Example
ABC Company manufactures three products. In one production batch, the company incurs $25,000
manufacturing costs up to the split off-point (the point in the manufacturing process when the products
can be separately identified). The following summarizes the further processing costs beyond the split-off
point and ultimate sales value.
Further Expected
processing costs sales revenue
Product 1 $72,000 $90,000
Product 2 $12,000 $28,000
Product 3 $2,000 $12,000
The company can sell the products at split-off point. The expected sales revenues at split-off point are:
Product 1 - $24,000, Product 2 - $8,000, Product 3 - $7,000. Which products should be sold at split-off
point and which products should be processed further?

Analysis:
Product 1 Product 2 Product 3
Increase in sales $66,000 $20,000 $5,000
Increase in costs 72,000 12,000 2,000
Effect to profits ($6,000) $8,000 $3,000
Product 1 should be sold at split-off point. The increase in sales revenue amounting to $66,000 (i.e., from
$24,000 to $90,000) is less than the costs to process the product further ($72,000). Hence, it is better to
sell the product at split-off point than process it further. Product 2 and Product 3 could be processed
further since it will result in incremental profits.

Learning Activities:
1. Claxon Company owns a machine with a cost of $305,000 and accumulated depreciation of
$65,000 that can be sold for $262,000, less a 5% sales commission. Alternatively, the machine can
be leased by Claxon Company for three years for a total of $272,000, at the end of which there

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 Module 2 – Analysis of Special Decisions 7

is no residual value. In addition, the repair, insurance, and property tax expense that would be
incurred by Claxon Company on the machine would total $21,600 over the three years. Prepare
a differential analysis on January 12 as to whether Claxon Company should lease (Alternative 1)
or sell (Alternative 2) the machine.

2. Product TS-20 has revenue of $102,000, variable cost of goods sold of $52,500, variable selling
expenses of $21,500, and fixed costs of $35,000, creating a loss from operations of $(7,000). Prepare
a differential analysis as of September 12 to determine if Product TS-20 should be continued
(Alternative 1) or discontinued (Alternative 2), assuming fixed costs are unaffected by the decision.

3. A restaurant bakes its own bread for a cost of $165 per unit (100 loaves), including fixed costs
of $43 per unit. A proposal is offered to purchase bread from an outside source for $110 per
unit, plus $15 per unit for delivery. Prepare a differential analysis dated August 16 to determine
whether the company should make (Alternative 1) or buy (Alternative 2) the bread, assuming
fixed costs are unaffected by the decision.

4. A machine with a book value of $126,000 has an estimated six-year life. A proposal is offered to
sell the old machine for $84,000 and replace it with a new machine at a cost of $145,000. The
new machine has a six-year life with no residual value. The new machine would reduce annual
direct labor costs from $55,000 to $43,000. Prepare a differential analysis dated February
18 on whether to continue with the old machine (Alternative 1) or replace the machine (Alternative 2).

5. Product T is produced for $5.90 per pound. Product T can be sold without additional processing
for $7.10 per pound, or processed further into Product U at an additional cost of $0.74 per pound.
Product U can be sold for $8.00 per pound. Prepare a differential analysis dated August 2 on
whether to sell Product T (Alternative 1) or process further into Product U (Alternative 2).

6. Product R is normally sold for $52 per unit. A special price of $42 is offered for the export market.
The variable production cost is $30 per unit. An additional export tariff of 30% of revenue
must be paid for all export products. Assume there is sufficient capacity for the special order.
Prepare a differential analysis dated October 23 on whether to reject (Alternative 1) or accept
(Alternative 2) the special order.

7. Magna Lighting Inc. produces and sells lighting fixtures. An entry light has a total cost of $125
per unit, of which $80 is product cost and $45 is selling and administrative expenses. In addition,
the total cost of $125 is made up of $90 variable cost and $35 fixed cost. The desired profit is
$55 per unit. Determine the markup percentage on product cost.

8. Product A has a unit contribution margin of $24. Product B has a unit contribution margin of $30.
Product A requires four testing hours, while Product B requires six testing hours. Determine the
most profitable product, assuming the testing is a bottleneck constraint.

FORMATIVE ASSESSMENT:

A quiz will be sent to you later.

SYNTHESIS:
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REFLECTION:

Which topic/s I have understand better?

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Which topic/s is/are still unclear to me?

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