SHORT TERM DECISION MAKING

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LEARNING OBJECTIVES

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A MODEL OF THE DECISION-MAKING PROCESS

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 RELEVANT COSTS

• Future costs or revenue that will be changed by a

decision
• It will influence the decision to be made
• Why should differentiate relevant cost from the
irrelevant cost:
i. Focusing on relevant info can simplify and shorten the data
gathering process as it is a costly procedure
ii. To avoid info overload if too much info is presented

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 RELEVANT COSTS

• Features :
i. It affects the future
🞤 the costs will be incurred in the future
🞤 historic cost (sunk, past, committed costs) are
irrelevant – do not affect future actions and
cannot be changed – ex: depreciation, book
value of asset
ii. It differs between alternative
i. However, a future cost will not be relevant if each alternative will involve
the same amount of cost.

iii. It is cash in nature

i. Non-cash items such as depreciation is irrelevant because it does not
involve any extra cash flow
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 RELEVANT COSTS
• Opportunity cost :
o Potential benefit given up when the choice of one action
forgone by taking different actions
o Only applies to scarce resources
• Avoidable cost :
o Costs that can be saved by not adopting a given alternative
o Will be identified as potential savings from discontinuing
decisions
o Ex: specific fixed cost to a certain department or product
• Incremental cost :
o The increase in cost if a particular option is chosen.
• Differential cost:
o Refers to the difference in costs between decision options.
• Special fixed costs:
o Relate to costs that are incurred as a result of taking the option,
which otherwise would not have been incurred. Thus, this is a
relevant cost. 6
 IRRELEVANT COSTS
• Sunk costs
✔ Costs that have been incurred
✔ Ex: R&D costs already spent
• Committed costs
✔ Future cash flows but will be incurred because of some
commitment agreed in the past
✔ Ex: lease on an office building, maintenance cost
contract
• Book value
✔ Book value of a fixed asset is the original value of the
fixed asset when first acquired, thus considered as
irrelevant for decision-making purposes.

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 RELEVANT/IRRELEVANT COSTS FOR MATERIALS

Relevant Cost Irrelevant Cost

▪ Current cost or market price ▪ Past, sunk, historical cost

▪ Future purchase price ▪ Current cost becomes irrelevant when there is
▪ Replacement cost replacement price or future purchase price given
▪ Any savings in cost is relevant and treated as a
cost reduction
▪ Opportunity cost or forgone profits and forgone
contribution
▪ Any extra gains and contribution obtained is
treated as a relevant income
▪ Avoidable cost
▪ Variable or marginal or direct cost
▪ Specific fixed cost
▪ Incremental or differential cost or any increase in
cost
▪ Savings in disposal cost if the activity to be taken
up could actually use the materials about to be
disposed

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RELEVANT COSTS FOR MATERIAL

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 RELEVANT COSTS FOR MATERIAL - Q
BB Berhad received an order to supply 10,000 unit of BZ10 at RM3.50 each. The following
estimates have been prepared based on 10,000 units of Component BZ10:

Direct Materials: RM
Available materials in stock at 5,000 units of material A 10,000
original cost 3,000 units of material B 3,000
Already ordered but not yet paid 2000 units of material A 5,000
at original cost
Material to be purchased at current 2,000 units of material C 6,000
cost

Additional information:
The production manager does not foresee any other use of both Material A and B in stock.
However, material A can be sold as scrap at RM0.25 per unit and material B’s net realizable value if re-
sold would be its current price less RM1,500 of disposal costs.
Material C can be substituted with Material D. Currently, supplies of Material C are not available in
the market. BB can only get material D from another project Mega, which currently gives RM10
contribution per unit of Mega. A unit of Mega requires 4 units of Material D.

REQUIRED: DETERMINE THE TOTAL RELEVANT MATERIAL COSTS FOR THE PROJECT.

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 RELEVANT COSTS FOR MATERIAL - A
Total Relevant Material Costs of 10,000 BZ10:

Direct Materials: RM
Material A
▪ In-store (Opportunity cost): 5,000 x 1,250
RM0.25
▪ New purchase (future costs) 2,000 units 5,000
Material B: (Opportunity cost): 1,500
RM3,000 – RM1,500
Material C: (Opportunity cost of Material D 5,000
used in Mega) [(2000 ÷4) x RM10]
TOTAL RELEVANT MATERIALS COSTS: 12,750

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RELEVANT COSTS FOR LABOUR

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 RELEVANT COSTS FOR LABOUR - Q
BB Berhad received an order to supply 10,000 units of BZ10 at RM3.50
each. The estimated labour costs based on 10,000 units of Component
BZ10 are shown below:
Direct Labour: RM
Unskilled -1,000 hrs @ RM5 per hour 5,000
Semiskilled - 800 hrs@ RM7 per hour 5,600
Skilled - 600 hrs@ RM10 per hour 6,000
Additional information:

Unskilled labours are fully occupied. However, they are willing to work
overtime at a 50% overtime premium.
Semi-skilled labour is part of the permanent workforce, and the company
currently has a temporary excess supply of this labour.
Skilled labour is in short supply. Presently, they work to manufacture the
product Zeep, which requires 3 skilled labour hours to produce a unit. The
contribution margin per unit of Zeep is RM35.
❑REQUIRED: Determine the total RELEVANT LABOUR costs for the project.
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 RELEVANT COSTS FOR LABOUR - A
Total relevant labour Cost of 10,000 units for BZ10.
Direct Labour: RM
Unskilled: (1,000 hours x RM5 x 150%) 7,500
Semi-skilled: Permanent workforce (excess)* IRC IRC
Skilled: Opportunity costs **
- Product Zeep [(600 hours ÷ 3) x RM35 ] 7,000
TOTAL RELEVANT LABOUR COSTS 14,500

▪ * Semi-skilled labours costs are irrelevant due to they are a permanent

workforce who are paid fixed wages, and the costs are not changed by
the decision.
▪ ** Skilled labours are taken from other production workers who
currently producing product Zeep. If the company decides to produce
BZ10, the workers will not be able to produce Zeep.
▪ OC = contribution margin loss from sales of Zeep.

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RELEVANT/IRRELEVANT COSTS FOR LABOURS AND
OVERHEAD

Type of cost Relevant Cost Irrelevant Cost

• Overtime rates due to • Monthly salary is fixed
extra work effected by the and therefore if the
new project to be taken up workers are taken away
• Extra wages paid or any to do extra work, their
LABOUR increase in the salary is irrelevant
remuneration because wherever they
are, their salary will still be
paid anyway
OVERHEAD • Special packaging costs, • Fixed overheads
extra overheads
• Variable overheads

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LIMITING FACTORS

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 LIMITING FACTOR

🞤 LF is the resource item which is required in the making of a product

but is limited in supply.
🞤 Thus, the CM per LF must be obtained in order to rank the products
to be manufactured.
🞤 6 steps to this approach:
1) Calculate CM/ unit
2) Identify LF per unit
3) Calculate CM/unit/ LF
4) Identify profitability ranking
5) Prepare product planning schedule
6) Prepare profit statement

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 LIMITING FACTOR

Optimum Production Mix

❑ Decided when firms not able to produce such production as it
wishes due to limited supply of resources.
❑ E.g., of scarce resources – restricted supply of material, max time
allowed to operate machines, limited cash/fund, limited of labor
hours worked.
❑ Steps for LF
❑ How to choose : rank the product mix according to the highest
“contribution per limiting factor” ratio

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EXAMPLE OF LIMITING FACTOR DECISION

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EXAMPLE OF LIMITING
FACTOR DECISION

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 THEORY OF CONSTRAINTS (TOC)
❑ Process aimed at identifying and removing
constraints in organization processes that are
standing in the way of organizational goals.
❑ A constraint is anything that limits an organizational
or entity from moving toward or achieving its goal.
❑ Physical constraints – something that is rigid and
in its currents state, has a limit on its ability or
throughput. E.g: a motor that can only produce a
given amount of power at a given time.
❑ Non-physical constraint –Company procedures
are another example of a non-physical constraint.
Demand for a given product.

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 THEORY OF CONSTRAINTS (TOC)

• TOC goal is to make (more) money. It describes 3

avenues to this goal:
• Increase throughput
• Reduce inventory
• Reduce operating expense
• A bottleneck- any resources whose capacity is
less than the demand placed upon it. It limits the
throughput.
• Non-bottleneck – resources have capacity
greater than demand.

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 THEORY OF CONSTRAINTS (TOC)

• 5 steps of maximizing operating profit when faced

with bottleneck and non-bottleneck operations:
1. Identify the system’s bottleneck or constraint
2. Decide how to exploit the bottlenecks
3. Subordinate everything else to the decision
in step 2
4. Elevate the system’s bottlenecks
5. If, in the previous steps, a bottleneck has
been broken go back to step 1.

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 THROUGHPUT ACCOUNTING(TA)
• Throughput – rate of production of a defined process over a stated
period of time – may expressed in units of products, batches produced,
turnover.
• TA is a variation of Variable Cost Accounting (VCA) in which TA
assumes that direct material is the only variable cost. All other costs
are considered fixed costs.
• It is a method of accounting that focuses on throughput and relates
costs of production to throughput
• TA:
Selling price
Less: Material Cost (variable cost)
______________________________
Contribution margin (throughput)
Less Fixed expenses (operating expenses)
______________________________
Profit

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 THROUGHPUT ACCOUNTING(TA)

• 3 ways to increase profits:

• Increase throughput (sales)
• Decrease operating expenses (fixed costs)
• Decrease investment (particularly in
inventories)
• Need to achieve sales with items produced
and stocks are only considered desirable when
they can increase throughput

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MAKE OR BUY

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 MAKE OR BUY DECISIONS
Watch a short video!
https://youtu.be/GUYsOGI9xHE

❖ A business has to make a choice of whether to make or buy a

component, if the latter turns out to be CHEAPER. (Rel cost must be
taken into consideration).
❖ IF there are any special fixed costs that have to be incurred due to
making the product, they can be avoided by choosing to BUY the
product instead.

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 MAKE OR BUY DECISIONS
❑ Whether to produce particular goods or services, or
purchase them from an external supplier
❑ Consider marginal costs of manufacturing versus relevant
purchases in costs
❑ Opportunity costs are often relevant
❑ Lost profits from using capacity to make the product
❑ 2 situations may exist :
❑ Spare capacity –compare between VC of manufacturing and
purchase price from outsiders
❑ Full capacity – marginal costs of manufacturing will include
opportunity cost (lost of contribution where some existing
production may have to be displaced)
❑ Decision : If relevant cost of making < relevant cost of buying
the component, firm should make the component. This will
increase the contribution/profit obtained.

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 MAKE OR BUY DECISIONS
Qualitative Factors Consideration in Make or Buy Decision

Among the non-financial factors that need to be considered before deciding to

make or buy component/product include:

1.The capability of the business in producing acceptable quality

component/products.
2.The availability of facilities and capacity to operate the production line.
3.The capability of employees and their willingness to work on the new product
line.
4.The relationship between the business and the existing supplier of the
components

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EXAMPLE OF MAKE OR BUY DECISIONS

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EXAMPLE OF MAKE OR BUY DECISIONS

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 EXAMPLE OF MAKE OR BUY DECISIONS -Q

Demina Electrical Company (DEC) manufactures small fans. DEC also

manufactures EMT414, a small part used in producing the fans. The data
relating to the production of 32,000 parts is shown below:
RM
Direct material costs 64,000
Direct wages 124,800
Variable manufacturing overhead 73,600
Fixed manufacturing overhead 122,000

DEC can buy EMT414 from Kucai Instruments Bhd for RM13.00 each and if
DEC buys the part, it will be able to reduce fixed manufacturing overhead by
RM50,000 per year. DEC may also rent out some of the facilities it currently
uses to produce EMT414 to Kici Enterprise for RM25,000 per year.

Required:
Advise the management of DEC whether to continue producing EMT414 or not.
Show relevant computations to support.

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 EXAMPLE OF MAKE OR BUY DECISIONS - A

Demina Electrical Company

▪ *Fixed manufacturing cost of RM122,000 is omitted because they are fixed

costs.
▪ **Opportunity cost arises because DEC has to forego the opportunity of
getting the rental income if the parts are manufactured internally.
▪ *** The reduction in fixed manufacturing cost is included because it
involved the change in the fixed costs if the company decided to stop
making the parts internally and start buying the parts from outside
suppliers.
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DELETING SEGMENT

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 DELETING A SEGMENT

Let’s take a look at a short video on this

https://youtu.be/WK4rRw3qHLI

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 DELETING A SEGMENT
• Involves a decision to discontinue a segment in the organizations e.g
function, branch, activity, task, job, product(s) or services(s).

• Some of the reasons for deleting include unprofitable products or running

costs have become too expensive to supports its existence or to run the
department.

• As long as the product/ service contributes to the recovery of fixed o/h, it

should not be dropped. Any product/service that has a –ve contribution
should be dropped as they DO NOT help to cover fixed o/h.

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 DELETING A SEGMENT
The factors that need to be considered in this situation are as
follows:-
❑Attributable costs
Cost per unit that could be avoided if a product or function were
discontinued without changing the supporting organization structure.
This includes:-
a) short-run variable costs
b) Fixed costs which are directly traceable to the product or function
c) Other fixed costs which change if there are significant shifts in the
volume of activity
❑Shut-down decisions
The management must identify whether the elimination is short-run
or long-run and temporary or permanent.
❑Other factors
There could be other influencing factors such as employees will be
made redundant or relocated to other departments. The employees
may need re-training or they can be offered early/ voluntary
retirement.
Another factor is the assets which will have to be transferred or
disposed.
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 DELETING A SEGMENT
Considerations for continuing operations:-
▪ Expenses connected with the shutdown of a plant would be avoided.
▪ Cost incurred to re-open/re-start a closed segment can also be saved.
▪ Skillful employees would be kept employed.
▪ Recruiting and training costs of new workers are incurred if the plant is
re-opened.
▪ Established market is lost if the plant is closed temporarily. To re-enter a
market later requires a reduction of the number of consumers.
▪ Temporary shutdown does not eliminate all costs (e.g. depreciation,
interest, property taxes and insurance etc.)
Alternatively, the following benefits have to be considered:-
▪ Avoiding operating losses
▪ Savings in variable costs, maintenance and repair costs of fixed assets
▪ Savings in indirect labour costs
▪ Savings in fixed costs.

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EXAMPLE OF DELETING A SEGMENT

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EXAMPLE OF DELETING A SEGMENT

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SPECIAL ORDER

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 SPECIAL ORDER DECISION
❑ If a company has spare capacity but cannot increase its current
demand, a special order by a special client might be considered as
long as the outcome is a contribution towards the recovery of o/h
as well as an increase in profits as a wholeExcess capacity??
❑ Where equipment, labour or other inputs to production that
are not being utilised and, hence, are available for other
purposes
❑ If incremental revenues are greater than incremental costs,
acceptable on financial grounds
❑ Allocated fixed costs should not be included
❑ No alternative uses for resources needed to fill the order
❑ No excess capacity??
❑ Include opportunity costs associated with use of the
capacity

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 SPECIAL ORDER DECISION
pg253

❑Management often has to make a decision whether or

not to accept special orders when :
❑The units have to be sold below the normal special
price
❑There is idle capacity or large access capacity
❑Distress condition/under pressure of not
performing
❑Possibility of cultivating the permanent future
patronage of a new customer
❑Competitive pressures where the org. has to lower
its regular price

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 SPECIAL ORDER DECISION
❑ Considerations in evaluating special order :
❑ Only those costs that will be affected by taking the
order are relevant (ex: variable production overhead)
❑ Fixed manufacturing costs are irrelevant
❑ Basic problem – determine an acceptable price for the
special-order units
❑ Cost analysis using the contribution approach is a
useful technique to determine the short-run profit
effects of special-order transactions
❑ Mgt should accept a special order if some contribution
is made (incremental revenue > incremental cost)

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SPECIAL ORDER QUALITATIVE FACTORS

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EXAMPLE OF SPECIAL-ORDER DECISION

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EXAMPLE OF SPECIAL-ORDER DECISION

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EXAMPLE OF SPECIAL-
ORDER DECISION

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FURTHER PROCESSING
DECISIONS

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 FURTHER PROCESSING DECISIONS
⮚Are the choice of selling a product now or processing it
further to earn additional revenue.
⮚This choice is usually based on incremental analysis of
whether the additional revenues to be gained will exceed
the additional costs to be incurred as part of the additional
processing work.
⮚Decision should be based on profitability.
⮚When raw material produces joint products, decisions
must be made as to whether they should be further
processed to get HIGHER PROFIT
⮚Recognition of joint costs and further processes will incur
further processing costs in order to take the joint products
to a more marketable value.

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 FURTHER PROCESSING DECISIONS
• Joint products – 2 @ more products that are produced
from a common input
• During production process, there will be a split-off
point whereby it is identifiable as separate products
• Joint costs – costs of input and joint processing
• Management need to decide whether to sell a joint
product at split-off point or process further before
being sold.

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JOINT PRODUCT COSTS

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 FURTHER PROCESSING DECISIONS

❑Irrelevant Cost
❑Joint costs – at the split-off point, the joint costs
have already been incurred, therefore are sunk
costs
❑Relevant Costs
❑Those are incurred as a consequences of the
decision to further process the item
❑Relevant Revenues
❑Extra revenues earned from selling the product in
its further processed instead of selling it in its
semi-processing state

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 EXAMPLE OF FURTHER PROCESSING DECISIONS

Zin Rubber Bhd processes a basic liquid rubber “Tahrap” through a manufacturing process, which yields three intermediate
substances and a scrap substance, W. Each of these three intermediate substances is processed further into three finished
products namely Silicon, Bilicon and Dilicon. At present, 2,500 liters of “Tahrap”, which costs RM30 per liter, are processed
each time into 1,100 liters of Silicon, 700 liters of Bilicon and 500 liters of Dilicon. The scrap, W, of 200 liters are sold as
scrap at RM10 per liter and the proceeds are used to reduce joint material costs.

The company apportions the joint costs using the following basis: materials are allocated based on final sales value: labour
is allocated based on production volume.
Material Labour
The standard process data per batch is as follows:
Joint Costs RM75,000 RM60,000

Products
Silicon Bilicon Dilicon
Selling price per liter:

Finished products RM85 RM90 RM65

Intermediate substance (if sold at the separation point) RM40 RM55 RM50

Further processing costs incurred after separation point RM12,000 RM10,400 RM8,600

Required:
a. Identify which of the three products should be further processed. Show your calculations.

b. Based on the decision in part (a) above, calculate the profit or loss of each product.

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 EXAMPLE OF FURTHER PROCESSING DECISIONS

a) In order to decide which products should be further processed, we must do the analysis by
comparing the incremental revenue to incremental cost for each product.
▪ If the net incremental value (incremental revenue is more than incremental costs) is positive, we
will further process.
▪ If the value is negative, the decision is to sell at split off point.
▪ The incremental revenue is calculated by comparing the final sales value for finished product to
sales value at split off point.
▪ Incremental cost is the further processed cost to be incurred.

Silicon Bilicon Dilicon

RM RM RM
Incremental revenue if
further processed (RM85-RM40) x 1,100 (RM65-RM50) x 500
(RM90-RM55) x 700 liters
liters liters
= 24,500
= 49,500 = 7,500

Less: Incremental cost if (12,000) (10,400) (8,600)

further processed
Net Incremental value 37,500 14,100 (1,100)
Decision Further process Further process Sell at separation point

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 EXAMPLE OF FURTHER PROCESSING DECISIONS

(b) The Profit and Loss of each product is calculated
by deducting the joint costs and further processing
from the sales revenue.
▪ The sales revenue now is based on decision
in (a), which to further processed Product
Silicon and Product Bilicon, and to sell
Product Dilicon at split off point.
▪ Therefore, the selling price for Silicon and
Bilicon is RM85/liter and RM90/liter
respectively.
▪ As for Product Dilicon that will be sold at the
split-off point, the selling price is RM50/liter.
Now, let’s allocate the materials cost and labour
costs.
Material costs= RM73,000
The final sales value for each product is:
Product Silicon = 85 x 1,100 = RM93,500
Product Bilicon = 90 x 700 = RM63,000
Product Dilicon = 50 x 500 = RM25,000
RM181,500
The allocation of material costs:

▪ The joint costs consist of material cost of Product Silicon = 93,500/181,500 x 73,000
RM75,000 and labour costs of RM60,000. = RM37,606
▪ It was stated in the question, the scrap, W, of Product Bilicon =63,000/181,500 x 73,000
200 liters are sold as scrap at RM10 per liter and
= RM25,339
the proceeds are used to reduce joint material
costs. Product Dilicon =25,000/181,500 x 73,000
▪ So now the materials costs is RM75,000- = RM10,055
(200litres x RM10/litre) = RM73,000.
▪ The company apportions the joint costs using the
following basis:
▪ materials are allocated based on final sales value;
▪ labour is allocated based on production volume

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 EXAMPLE OF FURTHER PROCESSING DECISIONS

Labour cost is RM60,000

The allocation of labour costs:

Product Silicon =1,100/2,300 x 60,000 = RM28,696

Product Bilicon =700/2,300 x 60,000 = RM18,261
Product Dilicon =500/2,300 x 60,000 = RM13,043

The further processing cost will be incurred to Product Silicon and Bilicon but
not for Product Dilicon, since this product will be sold at the split off point.

Silicon Bilicon Dilicon

Quantity 1,100 litres 700 litres 500 litres
RM RM RM
Standard revenue 1,100 x RM85 700 x RM90 500 x RM50

93,500 63,000 25,000

Less: Joint cost
Material (37,606) (25,339) (10,055)
Labour (28,696) (18,261) (13,043)
Less: Further processing cost (12,000) (10,400) 0
Profit/(Loss) 15,198 9,000 1,902

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END OF
TOPIC 3
THANK
YOU

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