MODULE 6

SHORT-RUN DECISION MAKING: RELEVANT COSTING

The Decision Making Process1

Decision making is the process of studying and evaluating two or more available alternatives leading to a
final choice. This selection process is not automatic; rather it is a conscious procedure. Intimately
involved with planning for the future, decision making is directed toward a specific objective or goal.

Although there are innumerable variables or factors that exist and should be considered in making
decisions in the real world, in textbook problems only a few variables that affect decision results will be
taken into account. Therefore, an organized and systematic approach maybe helpful to managers in
making decisions.

The steps are outlined as follows:

1. Define strategies: business goals and tactics to achieve them.
2. Identify the alternative choices or courses of action.
3. Collect and analyze the relevant data on the choices.
4. Choose the best alternative to achieve goals.

Consideration should also be given not only to quantitative analysis but also major qualitative issues in
applying the above steps.

Identifying Relevant Costs2

Any cost that is available is relevant for decision purposes.

Avoidable cost - can be defined as a cost that can be eliminated as a result of choosing one alternative
over another in a decision-making situation

All costs are considered avoidable except:

1. Sunk cost
2. Future costs that do not differ between the alternatives at hand.

Relevant cost – are expected future costs which differ between the decision alternatives. These are
costs that will increased or decreased as a result of a decision.

Under the concept of relevant costs, decision making process involves the following analytical steps: 3
1. Determine all costs associated with each alternative being considered.
2. Drop those costs that are historical or sunk.

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 Discontinue or not the business if its not profitable

 Consider the qualitative and quantitative factors
 3. Drop those costs that do not differ between alternatives.
4. Make a decision based on the remaining costs. These costs will be the future differential or
avoidable costs, and hence the costs relevant to the decision to be made.

Sunk or historical costs are never relevant in decision because they are not avoidable and therefore the
must be eliminated from the manager’s decision framework. Depreciation relating to the book value of
the old equipment is not relevant in decision making. However, it is not it is not correct to assume that
depreciation of any kind is irrelevant in the decision-making process.

Depreciation is irrelevant in decision only if it relates to a sunk cost. Depreciation on a new machine is
relevant because the investment is the new machine has not yet been made and therefore it does not
represent depreciation of a sunk cost.

The resale of disposal value of an existing asset will be relevant in any decision that involves disposing of
the asset.

Lastly, any future cost that does not differ between alternatives in a decision situation is not a relevant
cost so far as that decision is concerned.

Opportunity costs are the profits lost by the deviation of an input factor from one use to another. They
are the net economic benefits given up when an alternative is rejected. They are relevant when a
company is considering eliminating one activity and using plat facility advantageously in another activity.

Out-of-pocket costs involves either an intermediate or near-future cash outlay; they are usually relevant
to decisions. Frequently, variable costs fall into this classification. Out-of-pocket costs are important in
decision making because management should determine whether a proposed project would at the
minimum return is initial cash outlay.

Approaches in Analyzing Alternatives in Nonroutine Decision Making4

The two commonly used approaches in evaluating alternative courses of action are
1. Incremental or differential analysis approach
2. Total project analysis approach or comparative statement approach

Incremental, Differential, or relevant costs analysis contrast choices by comparing differential

revenues, differential costs and differential contribution margins. It has the advantage of showing only
relevant amounts. All sunk and nondifferential items are disregarded.

The following steps are followed in using this approach:

1. Gather all costs associated with each alternative.
2. Drop the sunk costs and differential costs.
3. Select the best alternative based on the remaining cost data.

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 Discontinue or not the business if its not profitable

 Consider the qualitative and quantitative factors
Total project analysis approach shows all the items of revenue and cost data under the differential
alternatives and compares the net income results. Comparative income statement under this approach
are prepared in a contribution format.

Short Run vs. Long Run: Other Factors to consider5

Our special sales order analysis focused only on a short-run factors, the expected effect on operating
income. In making the final decision, however, long-run factors should be such as:

1. What will be the impact on customers?

2. Should regular customers find out about the special price? Will they complain at paying more?
3. How will competitor react?

It is therefore possible that although the order will yield additional income of P275,000, the salles
manager may reject the order to protect its long-run market position. Rejecting the order is like
investing P275,000 in the company’s long-run future.

Types of Decisions6

This chapter examines groups of decision that require particular decision rules, relevant data and
formats. These decisions that commonly occur in all business activities are as follows;

1. Special Orders – accepting or refusing certain orders.

2. Sell or Process further – Determining to sell of process further.
3. Make or Buy – producing internally or buying components parts outside.
4. Scrap or Rework – determining whether to sell as scrap (junk) or to rework (modify).
5. Eliminating a Division or Product Line – determining whether to discontinue a losing product
line or divisions.
6. Shutting Down Operations – determining whether to continue or shut down operations
7. Product mix or Combination- to determine which product should be given priority in production

Pricing Products and Services7

Some business has no pricing problems at all. They may be making a product for which a market price
already exists. Under these circumstances, no price calculations are necessary because every firm charge
whatever is prevailing market price. This usually is true for basic raw materials such as farm products,
minerals, etc.

Cost-Plus Pricing

The most basic approach is pricing decision is that the price of the product or service should cover all the
costs that are traceable to the product and service, variable as well as fixed. If revenues are not

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 Discontinue or not the business if its not profitable

 Consider the qualitative and quantitative factors
sufficient to cover this traceable cost, then the firm is better off without the product or service. In
addition to the traceable costs, all products and services must assist in covering the common cost of the
organization.
In practice, the most common approach to pricing of products is to use some type of cost-plus pricing
formula. The formula is expressed as follows:

Target selling price = [Cost + (markup % x Cost)]

Determining the Markup Percentage8

To facilitate the computation of selling price, formulas can be used to determine the appropriate
markup percentage assuming that the desired return on investment and unit sales volume are given.

Under the absorption approach the cost-plus pricing:

Desired return on assets employed - SGA expenses

Markup % on ABC =
Volume in units x Unit manufacturing cost
Under the contribution approach the cost-plus pricing:

Desired return on assets employed - Fixed costs

Markup % ABC =
Volume in units x Unit varaible costs

Sample Quiz

Multiple Choice Questions9

1. Cost that do not appear in accounting records and do not require peso outlays but do involve a
forgone opportunity by the entity whose costs are being measured are
a. Conversion costs
b. Differential costs
c. Imputed costs
d. Prime cost

2. Pear Company temporarily has unused production capacity. The idle plant facilities can be used to
manufacture a low-margin item. The low-margin item should be produced if it can be sold for more
than its
a. Fixed costs
b. Variable costs
c. Variable costs plus any opportunity cost of the idle facilities
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 Discontinue or not the business if its not profitable

 Consider the qualitative and quantitative factors
 d. Indirect costs plus any opportunity cost of the idle facilities

3. As part of the data presented in support of a proposal to increase the production of clock radios, the
sales manager of Whittaker Electronics reported the total additional cost required for the proposed
increased production level. The increase is total cost is known as
a. Controllable cost
b. Differential cost
c. Opportunity cost
d. Out-of-pocket cost

4. An item whose entire amount is usually a differential cost is

a. Factory overhead
b. Direct cost
c. Conversion cost
d. Period cost

5. In the development of accounting data for decision-making purpose, relevant costs are defined as
a. Future costs which will differ under each alternative course of action
b. The change in prime cost under each alternative course of action
c. Standard cost which are developed by time and motion study techniques of their relevance to
managerial control
d. Historical costs which are the best available basis for estimating future costs.

6. Wiggle Company sells Product A at a selling price of P21 per unit. Wiggle’s cost per unit based on the
full capacity of 200,000 units is as follows:

Direct materials P4
Direct labor 5
Overhead (2/3 of which is fixed) 6

A special order affecting to buy 20,000 units was received from a foreign distributor. The only selling
costs that would be incurred on this order would be P3 per unit for shipping. Wiggles has sufficient
existing capacity. To manufacture the additional units. In negotiating a price for the special order,
Wiggle should consider that the minimum selling price per unit should be
a. P14
b. P15
c. P16
d. P18

7. Kala Company prepared the following tentative forecast concerning product A for 2018

Sales P500,000
Selling price per unit P5.00
Variable costs P300,000
Fixed costs P150,000

 Discontinue or not the business if its not profitable

 Consider the qualitative and quantitative factors
 Study made by the sales manager disclosed that the unit selling price could be increased by 20%,
with an expected volume decrease of only 10%. Assuming that Kala incorporates these changes in its
2018 forecast, what should be the operating income from product A?
a. P66,000
b. P60,000
c. P120,000
d. P145,000

8. Three companies are each manufacturing and selling annually 10,000 units of similar product at a
sales price of P20 per unit. The companies have fixed and variable costs as follows:

Company Fixed Cost Variable Cost per Unit

R P40,000 P12
S 80,000 8
T 120,000 4

Each company contemplates a price decrease from P20 to P16 per unit in the expectation that sales
will increase from 10,000 to 15,000 units per year.

The contribution margin for each company at the present sales level is:
a. R, P80,000 S, P80,000 T, P80,000
b. R, P160,000 S, P120,000 T, P80,000
c. R, P80,000 S, P120,000 T, P160,000
d. R, P40,000 S, P40,000 T, P40,000

9. Refer to number 8. The operating income for each company at the contemplated price and sales
levels are:
a. R, P60,000 S, P120,000 T, P80,000
b. R, P60,000 S, P60,000 T, P80,000
c. R, P40,000 S, P40,000 T, P40,000
d. R, P20,000 S, P40,000 T, P60,000

10. Refer to number 8. The increase (decrease) in operating income for R company resulting from the
price decrease and the sales volume increase is:
a. P(20,000) decrease
b. P20,000 increase
c. P5,000 increase
d. No increase or decrease

Answer Key
1. C 6. A
2. C 7. C
3. B 8. C
4. B 9. D
5. A 10. A

 Discontinue or not the business if its not profitable

 Consider the qualitative and quantitative factors