TOPIC 4

SHORT TERM DECISION MAKING

SHORT TERM DECISION MAKING

What is decision making? A guide to management to choose options/ alternatives

Why decision making is
important?
How does decision making
take place?
and/or make good decision for the betterment of the
business
Because management faces vast amount of alternatives
and problems in dealing with daily activities. Hence it must
choose the best alternative that gives the highest return or
the maximum profitability.
The business needs to consider factors either quantitative
and/or qualitative using appropriate costing method.

Types of short term decision making:

1. Relevant cost and benefits

2. Limiting factors
3. Make or buy
4. Accept or reject special order
5. Drop/ add a segment

RELEVANT COST AND BENEFITS

Relevant cost Irrelevant Cost

Those future costs and revenue that will be Those costs that will NOT be affected by the
changed by a decision decision making

Example: If you are faced with a choice of making a journey using your own car or by public
transportation, the relevant cost and irrelevant cost are:

Relevant cost Irrelevant Cost

Petrol costs, or the public transportation fare Road tax or car insurance

Avoidable cost Unavoidable cost

Those costs that may be saved by not Costs that CANNOT be saved or will
adopting a given alternative or will no longer continue to be incurred even if a subunit or
be incurred if a particular action is taken. activity is eliminated.

Sunk costs Costs that have been incurred in the past and cannot be altered by
any current or future decision. (These costs are the cost of
resources already acquired where the total will be unaffected by the
choice between various alternatives. They are costs that have been
created by a decision made in the past and that cannot be changed
by any decision will be made in the future).

Example: the acquisition cost of equipment previously purchased

and the manufacturing cost of inventory in hand.
(Irrelevant for decision making process)
Notional costs These costs are only a book exercise and do not represent real cash
flow.
Notional costs are intended to make internal decision making more
realistic by assuming that the cost of all resources consumed
reflects the full economic value - usually by applying market prices.
Notional charges are typically used to charge responsibility centers
with a 'market rent', where buildings have been purchased on a
freehold basis. Such a mechanism helps to focus management
attention on making best use of space so that surplus space across
the whole organization might then be sold or rented to another user.
Notional interest is often charged for the use of internally generated
funds.

(Irrelevant for decision making process)

Opportunity costs It is the potential benefit given up when the choice of one action
precludes selection of a different action. (It is a cost that measures
the opportunity that is lost or sacrificed when the choice of one
course of action requires that an alternative course of action be
given up).

Example: if chicken and fish are the available choices for dinner,
the opportunity cost of eating chicken is the forgone pleasure
associated with eating fish.

Committed costs Results from the organization’s ownership or use of facilities and its
basic organizations structure.

Example: property taxes, depreciation of building and equipments,

cost of renting facilities or equipment and the salaries of
management personnel.

(Irrelevant for decision making process)

LIMITING FACTOR

What is limiting factor? The key factor or resources that is in short supply and will restrict
the expected performance of a business.

Examples:
Materials Limited supply (quantities), limited financing (low budget)
Labor Hours limited, payment is dependable on budgets
Machine hours Limited working capacity
Plant capacity Limited space
Sales Limited customers demand
management Inefficient management and lack of know-how technology

Comprehensive illustration 1

Ain Az-Zahra Design makes and sells scarf for local market. The scarf comes in three different
designs: Exclusive, Unique and Trendy.

Below is the unit cost information for the production of scarf for the next year:

Exclusive Unique Trendy

Selling price per unit (RM) 90.00 70.00 50.00
Variable cost (RM) 60.00 50.00 38.00
Direct labour hour per unit 5 hours 4 hours 3 hours
Direct material per unit (meter) 2.5 2 1.5
Forecasted sales (Unit) 12,000 3,000 8,000
Fixed costs (RM) 24,000 22,000 12,000

The management has provided the following information regarding the availability of the
resources for the coming year:

i. The maximum direct labour hours available for the coming year will be 78,000 hours.
No overtime is permitted and it is impossible to employ additional workers.

ii. The material will be supplied by two different suppliers due to unexpected problem
faced by the current supplier A. the current material supplier A can only supplies 55,000
meters and another 15,000 meters will be supplied by supplier B. there is no opening
or closing stock available in the store.

Required:

a) State which is the limiting factor, direct labour or direct material?

Direct Labour
Product Sales/ demand Direct labour hour Direct labour hour
(unit) per unit required (hours)
Exclusive
Unique
Trendy
Total direct labour required
Total direct labour available
Excess/ (shortage)
Direct Material
Product Sales/ demand Direct material Direct material
(unit) per unit required (kg)
Exclusive
Unique
Trendy
Total direct material required (kg)
Total direct material available (kg)
Excess/ (shortage)

Therefore, the limiting factor is ______________________________________

b) Given the above constraints, calculate the most profitable mix of the products to be
produced based on the availability of the limited resource (show all workings)

Exclusive Unique Trendy

Selling price per unit
Less: Variable costs
Contribution margin
Limiting factor per unit
CM/LF
Ranking

Production schedule based on the profitable mix:

Ranking Product Unit DLH per DLH DLH Units

demand unit required available produced

Net profit based on the profitable mix:

Product Workings Total contribution

Total contribution margin

Less: Fixed Costs
Net Profit
MAKE OR BUY

• Manufacturing of products may require parts and sub-assemblies to be incorporated as

part of the products. The latter can either be manufactured or bought-in from suppliers.

• If the cost of making is less than cost of buying the components, then the firm should make
the components. This will increase the contribution/ profit obtained.

• Opportunity cost is considered in a make or buy situation only if there is limited capacity
i.e. where the production of the particular of some other component product.

Illustration 1
Food Sos (M) SB manufactures all kinds of sauces namely, soy sauce, tomato sauce, chili
sauce, oyster sauce and seasoning sauce. The manager is considering whether to buy or
process one ingredient, processed sago. The cost of manufacturing processed sago is
estimated to be:

Direct material RM4,000 Variable overhead RM2,200

Direct labour RM800 Fixed overhead RM4,600

The processed sago can be purchased from an outside supplier for RM7,500. The production
of processed sago requires 1 000 hours of a special machine which is now fully utilized to mix
and process gula Melaka. If production of processed sago is undertaken, production of
processed gula Melaka would be reduced by 4,000 kg resulting in a loss of revenue of
RM2,500. The marginal costs of producing 4,000 kg of processed gula Melaka is RM 1,500.
Should the company make or buy processed sago?

Solution:
Limiting factor = _______________________________________

Calculate Opportunity cost:

Opportunity cost = profit forgone from process gula melaka

RM
Gula Melaka sales revenue
Less: Marginal/ variable cost of gula Melaka
Profit forgone (Opportunity costs)

Comparison statements:
Cost of buying: RM
Purchase costs

Cost of making: RM
Direct materials
Direct labour
Variable overhead
Opportunity costs
Total cost of making

Decision:
_____________________________________________________________________
_____________________________________________________________________