Module 6

Nonroutine Operating Decisions

Intended Learning Outcomes:

At the end of the module, you should be able to:
 Differentiate strategic, tactical and operational decisions.
 Differentiate routinary from non-routinary decisions
 Discuss the difference between the relevant costs from irrelevant costs in decision making
 Give examples of nonroutine operating decisions
 Present relevant costs and quantitative analysis in various situations involving nonroutine
operating decisions.

Introduction

Managers must constantly make decisions. In making these decisions, they must estimate how each
decision could affect operating income. The management accountant’s role in this process is to supply
information on changes in cost and revenues to facilitate the decision process. How does accountant
decide which information to present?

Managers often select the course of action that maximizes expected operating income over the period
affected by the decision. To do this, they analyze relevant information. Relevant information is the
expected future data that differ among alternative courses of action.

In decision making, revenue and costs are often the key factors. These revenues and costs of one
alternative must be compared against the revenues and cost of other alternatives as one step in the
decision making process. The problem is that some costs associated with an alternative may not be
relevant to the decision to be made. A relevant cost can be defined as a cost that is applicable to a
particular decision in the sense that it will have a bearing on which alternative the manager selects.

Decision Viewpoints
Decisions drive things to happen or not to happen. Decisions are made in all facets of our life. Decisions
make us. We are who we are because we have decided to be who we are.

Decisions are made in all segments of organizational units. Decisions make an organization.

Decisions may be strategic, tactical or operational. Strategic decisions have long-term effects, its focus is
growth and stability, and it is concerned of meeting the needs of institutional investors. Tactical decisions
are regularly made to impact medium-term organizational activities. Its focus is profitability and liquidity
and it is concerned with customer’s satisfaction. Operational decisions are made on a daily basis where
the judgment call of a supervisor is at its greatest value. Most of the developed science of management
accounting is based on strategic and tactical decisions.

Strategic and tactical decisions are compared below.

Table 6.1. Strategic v. Tactical Decisions

Comparison of Strategic and Tactical Decisions
Variables Strategic Decisions Tactical Decisions
Time-effects Long-term Medium-term and short-term
Concerned management level Top executives Middle and supervisory
managers
Primary interests served Financial investors (i.e., owners Customers
and creditors)
Focus Stability and growth Profitability and liquidity
Management accounting Capital budgeting Standard costing
techniques used Responsibility accounting
Short-term budgeting
Cost-volume-profit analysis
Variance analysis
Nonroutine operating decisions
Frequency Nonrepetitive Repetitive (routinary) and
nonrepetitive (non-routinary)
The nonroutine operating decisions

Nonroutine operating decisions are not covered by standard operating policies (SOPs) normally codified
in a manual. Repetitive or routinary transactions are the ones covered by SOPs. Examples are policies on
expense approval, collections from customers, issuance of checks, receipts of purchases, warehousing and
inventory management, selecting, hiring, and training of personnel, and other regular (ordinary,
repetitive) transactions.

Nonroutine operating decisions have effects on the profitability but have no visible or direct impact on the
long-term stability and strategy of an organization. Profitability is the core driver in making nonroutine
operating decisions.

In making decisions, multifarious qualitative variables are also considered. Sometimes, they are more
important than the measurable ones. However, qualitative variable are not included in this discussion.

Relevant costs

Relevant costs are those used in making a decision. If a cost is not used in a specific situation that needs
to be decided upon, that cost is irrelevant in that situation. A decisional situation needs specific sets of
relevant costs. a cost that is relevant in a particular decision may be irrelevant in another.

Relevant costs have two (2) important features – differential and future-oriented.

Differential costs (or incremental costs) change from one alternative to another. In making a decision, you
have at least two (2) alternatives or options. If a cost differs from one option to another, that cost is
differential. Incremental costs refer to those that increase in costs from one option to another. The normal
examples of incremental costs are direct materials, direct labor, variable overhead and variable expenses.
Avoidable fixed overhead may also be an incremental cost.

Future costs are referred to as planned costs, budgeted costs, projected costs, or estimated costs. Future
costs are yet to be incurred in upcoming activities. If a cost is not a future cost, it is automatically not
relevant.

A cost to be relevant must be both differential and future cost. Sunk cost (or past costs, historical cost)
cannot be changed further, cannot be incurred in the future, and could not be relevant in decision-making.

Nonroutine operating decisions use relevant costs and as such is sometimes referred to as relevant costing,
incremental costing, or differential costing.

Application of Relevant Costing

Relevant costing is applied in all possible situations where standard operating policies are not applicable.
However, only the following decision situations are to be illustrated and discussed in this chapter:

Nonroutine Operating Situations Decision Guidelines

Make or buy (insource or outsource) a component
or part?
Accept or reject a special sales order?
Drop or continue a segment or division?
Sell-as-is or process further a completed product?
Continue or temporarily shutdown operations?
What is the winning bid price, highest or lowest?
Optimization of scarce resources
Sell now or later a product
Replace or retain an old asset?
Least-cost analysis, whichever option results to a
lower relevant cost is better
If there is an incremental profit, accept
If the segment margin is positive, continue. But
also consider the complementary effects.
If there is profit from further processing, then
process further.
If sales are greater than the shut down point, better
continue operating.
Focus on the incremental costs.
Prioritize the product that gives the highest
contribution margin on the limited resource.
If the expected increase in sales is greater than the
incremental cost of storage and other relevant costs,
then sell later.
If the net cash inflows are greater than the net
outflows, replace the asset. (here the time value of

Scrap or rework a defective unit?
Determining the indifference point
money and tax effects are not considered)
Choose the alternative that gives the highest short-
term profitability
Indifference point is where the outcomes of the
alternatives are the same

In making these decisions, the guiding principle is always to maximize profitability.

Make or Buy a Component or Part? … an Insourcing vs. Outsourcing issue…

A product is composed of different parts. Not all parts of the product are manufactured by a company. A
part may be outsourced from a supplier based on the following reasons:
1. Lack of technology, man labor hours, machine hours, systems expertise, or financing.
2. Savings or discontinuance of unprofitable segment operations.
3. Legal or cultural limitations, or,
4. Strategic business relations.

The total relevant costs of each option should be taken when deciding to make or buy a part. Whichever
option gives a lower relevant cost would be a better alternative, assuming no other quantitative and
qualitative factors are to be considered.

Sample Problem 6.1. Make or Buy a Part

Toblerone Corporation manufactures part X-24 for use in its production cycle. The cost per unit for
10,000 units of part X-24 are as follows:

Direct materials P 6.00

Materials handling costs (20%) 1.20
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 11.00
Total P 43.20

Ferrero Company has offered to sell Toblerone Corporation 10,000 units of part X-24 for P 40 per unit.

If Toblerone accepts Ferrero’s offer, P 4 of the fixed overhead per unit could be eliminated. The materials
handling costs pertaining to the cost of receiving and inspecting of incoming materials and other
components are not included in the overhead.

If the part is outsourced from an outside supplier, one-half of the released facilities could be used to
produce a new product. Citrus, which is expected to generate a contribution margin of P 90,000 a year.
Additionally, savings of P 15,000 are expected if the parts are purchased outside. The other half of the
released facilities could be rented out for P 60,000 per annum.

Ferrero Company requires that equipment be leased to meet the order of Toblerone Corporation. The
equipment rental cost of P 80,000 shall be charged to the buying company.

Required: For Toblerone Corporation:

1. What alternative is better, make or buy the part and by how much is its advantage?
2. Indifference price of the two alternatives.
3. Purchase price to have a savings of P 10.00 per part.
4. The sunk cost (or irrelevant cost) in the decision of making or buying part.

Solutions/ Discussions:

 The tabulated relevant costs of making and buying the part are as follows:
 Unit Costs
Computations To MAKE To BUY
Purchase price P 40.00
Direct materials P 6.00
Materials handling costs P 6.60 x 20% 1.20 8.00 (P 40.00 x 20%)
Direct labor 20.00
Variable overhead 5.00
Avoidable fixed overhead 4.00
Savings if the part is bought P 15,000/10,000 (1.50)
Rental income from released facilities P 60,000/10,000 (6.00)
Contribution margin from a new product P 90,000/10,000 (9.00)
Rental expense if the part is bought P 80,000/10,000 8.00
Total relevant costs P 36.20 P 39.50
Savings per unit if the parts are made P 3.30
Total savings if the parts are made 10,000 x P 3.30 P 33,000

 Variable production costs (e.g., direct materials, direct labor, and variable overhead) are
incremental costs, differential cost, and are relevant costs.

 Avoidable fixed overhead costs are also relevant cost since they vary from one option to another.
If a part is manufactured, the avoidable fixed cost is still incurred; but if the part is purchased, it is
avoided.

 Unavoidable fixed overhead cannot be avoided regardless of decisions made whether make or
buy. It does not change, it is irrelevant.

 Materials handling costs apply to both materials and other items being purchased. The rate used
in the allocation of the material handling costs is constant but the amount allocated to various
departments differs depending on the base amount of items purchased. This makes the materials
handling costs relevant for the make or buy short-term decision.

 Savings from parts bought, rental income from released facilities, and contribution margin from a
new product all happen when the part is bought. They are all inflows, either in the form of
savings or additional income, and as such are deducted from the costs of buying.

 Variable and fixed selling and administrative expenses are not considered in the analysis because
they are not affected by the decisions; they will not change, and are irrelevant in the decision on
hand.

 Based on the quantitative analysis above, it is advisable for Toblerone Corporation to make the
part.

2. The indifference price of the alternatives make or buy is computed as follows:

Unit cost to make P 36.20

Added (Deducted) back to the relevant costs to buy,
except for the purchase price and related handling costs:
Rental expenses (8.00)
Contribution margin from a new product 9.00
Rental income from released facilities 6.00
Savings if the part is bought 1.50
Purchase price and handling costs P 44.70
Purchase price from the supplier P 44.70 / 120% P 37.25

The handling costs is 20% of the purchase price.

3. The purchase price with a P 10 – saving per part shall be computed as follows:
Gross purchases price including handling costs P 44.70
Required savings (10.00)
Gross purchase price with savings P 34.70
Net purchase price P 34.70 / 120% P 28.917
4. The sunk cost in the decision to make or buy the part shall be the unavoidable fixed costs of P 7.00
(e.g. P 11 – P 4) or a total of P 70,000 (e.g., 10,000 x P 7)

Accept or Reject a Special Sales Order… Is there an incremental profit?

This pertains to a special sales order outside of the regular sales. In deciding whether to accept or reject a
special sales order, the paramount consideration is incremental profit, which is normally determined as:

Incremental revenue Px
Incremental costs (x)
Incremental profit (loss) P x

The following factors are to be considered in the decision to accept or reject a special order:
 Is unnecessary competition created?

If the acceptance of the special sales order creates an unnecessary competition to the regular
product sales, the special sales order is normally rejected. But if the special sales order is accepted
and regular sales are lost due to the acceptance of a special sales order, the lost contribution
margin thereof becomes an opportunity cost that should be deducted from the incremental profit
of accepting the special order.

Normally, a regular market is distinguished from a special market in that one is domestic and the
other foreign. Or, the products, regular product or special product, can be visibly identified for
each other through marks, color, or other distinguishing features.

 Do we have an idle capacity? Is there an alternative use of the capacity?

If there is no alternative use of capacity, the incremental profit (loss) is the difference between
incremental sales and incremental costs and expenses.

If there is an alternative use of the capacity, the best benefit that may be derived from such should
be deducted from the incremental profit to get the net advantage or disadvantage from accepting
the special sales order.

A tabulated summary of accept or reject a special order analysis is presented in the following table.

Table 6.1. Pro-Forma Analysis for Special Sales Order in Relation to Idle Capacity

Accept or reject a special sales order

With idle or without idle capacity
Situations No alternative use of capacity With alternative use of capacity
With idle Incremental sales Px Incremental sales Px
capacity Incremental costs (x) Incremental costs (x)
Incremental profit (loss) P x Incremental profit (loss) Px
Opportunity costs (benefit lost)
from the alternative use of
capacity (x)
Advantage (disadvantage) of accepting
the special sales order Px

The opportunity costs here refer to the net benefit

that could have been derived from another
alternative had the special sales order not been
accepted.

Examples of opportunity costs are:

 Rented income, or
 New contribution margin from producing
a new product
No idle capacity Incremental sales Px Incremental sales Px
Incremental costs (x) Incremental costs (x)
Incremental profit (loss) P x Incremental profit (loss) Px
Opportunity costs, net of
best benefit foregone
from alternative use of
capacity (x)
Advantage (disadvantage) of
accepting the special sales
order P x

The opportunity costs here refers to the lost

contribution margin from regular sales or from
the best use of the sacrificed capacity.

Sample Problem 6.2. Accept or Reject a Special Sales Order

The manufacturing capacity of NorthWind Corporation’s facilities is 50,000 units of product a year. A
summary of operating results for the year end December 31, 2019 is as follows:

Total Per Unit

Sales (38,000 units) P 3,800,000 P 100.00
Less: Variable costs and expenses 2,090,000 55.00
Contribution margin 1,710,000 P 45.00
Less: Fixed costs and expenses 900,000
Operating income 810,000

A distributor company has offered to buy 12,000 units at P90 per unit in the following year. Assume that
all of the corporation’s costs next year would be at the same levels and rates as in the prior year.

Required: Should NorthWind Corporation accept or reject the special sales order? (Consider the
following cases independently.)

1. The corporation has no alternative use of the idle capacity.

2. The corporation can rent out the idle capacity for P 200,000.
3. The corporation can use the idle capacity to produce a new product that could contribute a P
600,000 contribution margin.
4. If the special order is accepted, 2,000 units of regular sales are expected to be lost.
5. Assuming a distributor has ordered 16,000 units and the corporation has to sacrifice some of its
regular customers to accommodate the special order.

Solutions/ Discussions:

1. Incremental sales (12,000 units x P 90) P 1,080,000

Incremental costs (12,000 units x P 55) 660,000
Incremental profit P 420,000

The incremental costs here refer to variable costs and expenses. The unit variable costs is P 55
(i.e., P 2,090,000/ 38,000 units).

The total fixed costs and expenses are assumed to be the same whether the special order is
accepted or not, and, therefore, are irrelevant in the analysis.

2. Incremental CM (12,000 x P 35) P 420,000

Rent income if the facility is rented out (200,000)
Net advantage of accepting the special order P 220,000

The incremental UCM is P 35 (i.e., P 90 – P 55). The benefit that could be derived from the
alternative use of the facility, in this case rental income, is compared with the incremental profit
from accepting the special order. Since the incremental income from accepting the special sales
order is greater than renting out the facility by P 220,000, it is more advantageous for the business
to accept the special sales order.
 3. Incremental CM (12,000 x P 35) P 420,000
CM from a new product (600,000)
Net advantage of rejecting the special order P 480,000

Still, the incremental profit or loss from accepting the special sales order is compared with the net
benefit derived from an alternative use of the facility, in this case, the contribution margin from a
new product. Inasmuch as the profit from producing a new product is greater than the profit from
accepting the special sales order, the special sales order should be rejected and the new product
be produced.

4. Incremental CM P 420,000
CM lost from regular sales (2,000 units x P 45) (90,000)
Net increase in profit from accepting the special sales P 330,000

The regular UCM is P 45. The CM lost from regular sales out of accepting the special sales order
is an opportunity cost to be deducted from the incremental contribution margin to determine the
net increase in profit in the business operations.

5. Incremental CM (16,000 units x P 35) P 560,000

Lost contribution margin (4,000 units x P 45) (180,000)
Net incremental profit P 380,000

The UCM of the special order is still P 35 (i.e., P 90 – P 55). The 16,000 units ordered on a
special basis is more than the idle capacity of 12,000 units (i.e., 50,000 units – 38,000 units of
regular sales). To accept the special order, 4,000 units of regular sales should be sacrificed (i.e.,
16,000 units – 12,000 units). Accordingly, the contribution margin of the 4,000-unit regular sales
would be lost. Hence, it is deducted from the income arising from special sales.

Continue or drop a business segment…

A business segment represents a division, product line, department or business unit. Depending on what it
intends to describe, segment margin is sometimes labeled as division margin, product margin, or
department margin. If the segment margin is positive, it means that the segment is contributing to the
overall profitability of the organization. If you drop the segment, the overall profitability of the business
will be diminished by the amount of the positive segment margin.

Companies fold up there segment operations for strategic, operating, or financial reasons. Strategically, an
enterprise folds up its business segment when it is consolidating its business either vertically or
horizontally. Financially, business segments are closed to raise funds and finance more profitable
segments. Operationally, an enterprise closes a segment to avoid recurring losses from the segment’s
normal operating activities.

In this situation, the profitability of a segment is measured by its segment margin. If its segment margin is
positive, it contributes to the overall profitability of the enterprise and should be continues, assuming
there is no alternative use of the released facilities if the segment is discontinued. If there is an alternative
use of the released facilities, compare the segment margin from the net benefit of its best alternative use.
If the segment margin is still greater, then continue. Otherwise, discontinue the division and better
undertake the alternative use of the facilities.

Principally, the segment margin is determined as follows:

Contribution margin P x
Less: Avoidable fixed costs and expenses x
Segment margin P x
Alternatively, segment margin is computed as shown below:

Pro-Forma
Marginal Income Statement

Sales Px
Less: Variable costs of goods sold x
Manufacturing margin x
Less: Variable selling and administrative expenses x
Contribution margin x
Less: Controllable direct fixed costs and expenses x
Controllable margin x
Less: Non-controllable direct fixed costs and expenses x
Segment (direct margin) x (focus here)
Less: Indirect (allocated) fixed costs and expenses x
Operating income Px

Sample Problem 6.3. Drop or Continue a Division – 1

Francis Company plans to discontinue a division with a P 200,000 contribution to overhead. Overhead
allocated to the division is P 500,000, of which P 50,000 cannot be eliminated. Should Francis Company
discontinue the division?

Solutions/ Discussions:
 The controllable segment margin is computed as follows:
Contribution margin P 200,000
Less: Avoidable fixed costs (P 500,000 – P 50,000) 450,000
Controllable segment margin P (250,000)

 The division should be discontinued because it has a negative controllable segment margin. If the
division margin is dropped, the loss is eliminated and the overall profit of the enterprise will
increase by P 250,000.

Sample Problem 6.4. Drop or Continue a Division – 2

Samal Company produces and sells two products with the following income statement data in 2019 (in
pesos)

Product A Product B Total

Sales P 300 P 600 P 900
- Variable costs 120 200 320
Contribution margin 180 400 580
- Avoidable fixed costs 100 100 200
Segment margin 80 300 380
- Allocated fixed costs 200 200 400
Profit (loss) (120) 100 (20)

Required: Assuming all things shall be constant in the following business period, except as provided
below, determine the effect of the following independent cases to the overall profit of the enterprise.
1. Product A is dropped.
2. Product A is dropped and 15% of the allocated fixed cost is eliminated.
3. Product A is dropped and the released facility is used to produce and sell 40% more of Product 2.
4. Product A is discontinued and 40% of the product’s avoidable fixed costs would remain with a
corresponding 20% decrease in the sales of product 2.

Solutions/ Discussions:

a. Decrease in profit due to lost positive segment margin of product 1 P (80,000)

b. Decrease in profit due to lost positive segment margin of product 1 P (80,000)
15% drop in allocated fixed cost (P 400,000 x 15%) 60,000
Net decrease in overall profit P (20,000)
 c. Decrease in profit due to lost positive segment margin of product 1 P (80,000)
40% increase in the CM of product 2 (P 400,000 x 40%) 160,000
Net increase in overall profit P 80,000

d. Contribution margin P 180,000

Avoidable fixed costs (60,000) P 120,000
20% decrease in CM of product 2 (P 400,000 x 20%) (80,000)
Net increase in the overall profit P (200,000)

Alternatively, the analysis may be made in “total approach” as follows (amounts in thousands):

Product A Product B Total Total Profit Analysis

a b C d
Sales P 300 P 600 P 900 P 600 P 600 P 840 P 480
-Variable costs 120 200 320 200 200 280 160
Contribution margin 180 400 580 400 400 560 320
- Avoidable fixed costs 100 100 200 100 100 100 140
Segment margin 80 300 380 300 300 460 180
- Allocated fixed costs 200 200 400 400 340 400 400
Profit (loss) P (120) P 100 P (20) (100) (40) 60 (220)
Increase (decrease) in profit P (80) P (20) P 80 P (200)

Sell-as-is or process further a product… Is there an incremental profit?

Goods undergo several conversion processes from original source to final consumption. For example,
eggs may be hatched to chicks, chicks may be raised to hens, hens may be sold live or may be retained to
become layers, chickens may be sold live or otherwise, or may be sold, chopped or cooked. In each
conversion process, the business has an opportunity to sell now or sell after further processing. If the
product is processed further, the unit sales price is expected to increase. However, there is also a cost for
subsequent processing (i.e., cost of further processing, upgrading cost, or cost of additional processing)
which is an incremental costs.

Again, focus on the incremental profit. If the incremental sales are greater than the incremental costs of
further processing, it is advisable to process further the product to maximize profit. The joint production
costs (or common costs) and all other costs of preceding processes are considered irrelevant in deciding
whether to sell now or process further.

Sample Problem 6.5. Sell-As-Is or Process Further a Product – 1

Tarlac Corporation produces three (3) main products. Its production and costs data are given below:

X Y Z
Unit sales price after further processing P 300 P 550 P 220
Unit sales price before further processing 250 530 190
Costs of separate (further) processing 120,000 65,000 190,000
Units produced and sold 2,000 4,000 7,500
Total joint costs, P 1,400,000

Which of the products should be processed further?

Solutions/ Discussions:

 The incremental (decremental) profit of further processing per product is presented below:

X Y Z
Incremental sales (2,000 units x P 50) P 100,000
(4,000 units x P 20) P 80,000
(7,500 units x P 30) P 225,000
Incremental costs (120,000) (65,000) (190,000)
Increase (decrease) in profit P (20,000) P 15,000 P 35,000
  Products Y and Z should be processed further to maximize profit while product X should be sold
now or at split-off point.
 Incremental sales equal increase in unit sales price times the number of units sold. The unit sales
price normally increases after further processing.
 Incremental costs are those incurred in the act of processing further the product.
 The total joint cost is irrelevant in this decision because it does not change regardless of selling
the products at split-off pint or processing further.

Sample Problem 6.6. Sell-As-Is or Process Further a Product – 2

Cyclone Corporation produces three products at segregation point, Kah, Mooh, and Tey. These These
products could be processed further then later sold at higher sales value. The total joint cost in
manufacturing these three products was P 3 million. The data below were made available by the
accounting and production personnel:

Kah Mooh Tey

Production and sales 10,000 units 40,000 units 50,000 units
Unit sales price at split-off point P 80 P 100 P 200
Unit sales price after further processing 90 120 230
Unit variable costs of subsequent processing 8 18 27

If product Kah is processed further, an equipment should be rented at a cost of P 12,000. To process
further product Mooh an outside contractor will be engaged for an amount of P 90,000 because the
company has no available space and manpower for its subsequent processing. Product Tey could be
subsequently processed by using idle machine and manpower time within the company. The total set-up
cost of subsequently processing product Tey is P 120,000.

Required:
1. Which product should be processed further to maximize profit?
2. To maximize profit, what is the minimum sales price for product Kah that should be set after it is
processed further?

Solutions/ Discussions:

1. The increase or decrease in short-term profit shall be determined as follows:

Kah Mooh Tey

Incremental unit sales price P 10 P 20 P 30
Incremental unit variable costs ( 8) ( 18) ( 27)
Incremental unit contribution margin 2 2 3
x units sold 10,000 40,000 50,000
Incremental contribution margin P 20,000 P 80,000 P 150,000
Incremental fixed costs (12,000) (90,000) (120,000)
Incremental (decremental) profit P 8,000 P (10,000) P 30,000

The incremental unit price is the difference in unit sales price at split-off point and after further
processing. The total incremental costs include the incremental variable costs and incremental fixed costs.
the common cost is a sunk costs and is irrelevant in this decision analysis.

Products Kah and Tey should be processed further and product Mooh should be sold at split-off point.

2. The minimum unit sales price for product Kah after further processing should be:
Unit sales price at split-off point P 80.00
Unit variable costs of subsequent processing 8.00
Incremental fixed costs (P 12,000 / 10,000) 1.20
Minimum sales price after further processing P 89.20

Continue operations or shut down … It is only temporary!

Demands for products vary due to seasonal, cyclical or random variations. Products manufactured for
Christmas season may not be highly saleable in other months. Summer clothes are not greatly saleable
during rainy days. Also, there are months in a year where businesses in a given economy experience
slowdowns caused by natural, cultural, or environmental conditions of the place where the business
operates. During slack seasons, businesses incur operating losses. Hence, management may contemplate
temporarily stopping its operations to avoid losses.

Yet, if operations are temporarily shut down, the business will still incur a loss because of the shutdown
costs. Costs incurred even after operations temporarily stopped are called as shutdown costs. Examples
are salaries of remaining executives and skeletal personnel, security, insurance, rental, interests,
depreciation, property taxes, advertising, and similar unavoidable costs. On top of it, the business will
incur restart-up costs once it resumes its operations. Restart-up costs include costs of rehiring and
retraining personnel, refueling, aligning, and returning machineries and equipment, and refurbishing the
plant. Either way, continue or shut down, the business will have a loss. It is a choice between two evils. In
this case, you have to choose the lesser evil. The guideline is, “which option will give a lesser amount of
loss?”

Technically, if continuing the operations will result to sales greater than the shut down point, it is better to
continue operating and be spared of more losses from discontinuing operations.

Shutdown point is the level of operations where the loss from continuing is equal to the loss from
discontinuing (i.e., shut down costs). Expressed mathematically we have,

Loss from continuing = loss from discontinuing

Where: Loss from continuing = (CM – FC)

Loss from discontinuing = (0 - Shutdown costs)

At shutdown point: where:

(CM-FC) = (O – SDC) CM – Contribution margin

QS (UCM) – FC = (O – SDC) FC – Fixed costs
QS (UCM) = FC – SDC SDC – Shutdown costs
UCM – Unit contribution margin
QS – Quantity sold

Therefore, shutdown point equals:

QS = FC – SDC
UCM

Sample Problem 6.7. Shut Down or Continue Operations

FAT Company produces and sells 140,000 units monthly except for the months of July and August when
the number of units sold normally decline to 10,000 units per month. Management contemplates of
temporarily shutting down operations in the months of July and August with the belief that the business
will be spared of more losses during those periods. If the business temporarily shuts down, security and
maintenance amounting to P 220,000 per month would still be incurred. Restarting the operations will
cost the business P 300,000 for mobilization and other costs. The business incurs a total of P 24 million
annual fixed costs allocated evenly over a 12 – month period. This fixed cost is expected to drop by 60%
during the months the operations are shut down.

Other sales and costs data are as follows:

Unit sales price P 300
Unit variable production costs 140
Unit variable expenses 40

Required:
1. How much is the total shutdown cost?
2. What is the shutdown point?
3. Should the business continue or shut down?
Solutions/ Discussions:

1. The shutdown costs of P 2,340,000 is determined as follows:

Allocated fixed costs (P 24 million x 2/12 x 40%) P 1,600,000
Security and insurance (P 220,000 x 2 months) 440,000
Restart-up cost 300,000
Shutdown cost P 2,340,000

2. The total fixed cost in the months of July and August if the operations are continued is P 4
million (i.e., P 24 million x 2/12). The unit contribution margin is P 120 (i.e., P 300 – P 180).
Therefore, the shut down point is 13,834, computed as follows:

Shutdown point = P 4,000,000 – P 2,340,000 / P 120 = 13,833.33 units (say 13,834 units)

To prove, we have:
Contribution margin (13,833.33 x P 120) P 1,660,000
Less: Fixed costs and expenses 4,000,000
Loss from continuing the operations P (2,340,000)
Shutdown costs P 2,340,000

Shutdown point is where the loss from continuing equals the shutdown costs.

3. Continue or shutdown?
Contribution margin (10,000 units x 2 mos. x P 120) P 2,400,000
Less: Fixed costs and expenses 4,000,000
Loss from continuing the operations (1,600,000)
Less: Shutdown costs (2,340,000)
Advantage of continuing the operations P 740,000

Alternatively, the P 740,000 may be computed as follows, [eg. (20,000 – 13,833) x P 120].

Bid price … maximize or minimize?

Pricing is an important part in economic transactions. It is more important when participating in a bidding
process to get a contract or secure a project. The process of bidding could vary depending on the practices
and circumstances of the bidding process. bidding could be done through public auction, or through
sealed bidding or through whispering one’s bid (e.g., “bulungan”) as practiced by some domestic fish
dealers.

Now, assume that you are operating in a purely competitive business environment. In this case, the
concept of incremental costing is of importance. If you are in a construction business and are bidding for
a construction contract, you have to submit the minimum bid price to win the contract. The minimum bid
price should not be less than your incremental costs. If you are bidding for the acquisition of an important
item or object, you have to submit the highest bid to win.
Generally, the minimum bid price is computed as follows:
Minimum bid price = Incremental costs + Opportunity costs – Savings

The opportunity costs refer to the highest possible benefit that may be derived from the best alternative
use of capacity.
Sample Problem 6.8. Minimum Bid Price – 1
Continental Systems, Inc., manufactures car engines for industrial users. The cost of a particular car
engine the company manufactures is shown below:
Direct materials P 300,000
Direct labor 190,000
Overhead:
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Depreciation 50,000
Rent 10,000
Total costs P 609,000
If production of this engine were discontinued, the production capacity would be idle and the supervisor
would be laid off. When asked to bid on the next contract for this engine, what should be the minimum
bid price?

Solutions/ Discussions

 The minimum price should at least be equal to the incremental cost of manufacturing.
Direct materials P 300,000
Direct labor 190,000
Supervisor’s salary 40,000
Fringe benefits on direct labor 19,000
Incremental costs/ Minimum price P 549,000

 The depreciation and rent expenses are unavoidable costs whether the contract is obtained or not.
They are constant regardless of alternatives, they are therefore irrelevant.

Sample Problem 6.9. Maximum Bid Price – 2

Frank Dean Company has its own cafeteria with the following annual costs:
Food P 2,300,000
Labor 820,000
Overhead 550,000
Total P 3,670,000

The overhead is 30% fixed. Of the fixed overhead, P 72,000 go to the salary of the cafeteria supervisor.
The remainder of the fixed overhead has been allocated from total company overhead. Assuming the
cafeteria supervisor remains and that Frank Dean continues to pay the supervisor’s salary, what is the
maximum cost Frank Dean would be willing to pay an outside firm to service the cafeteria?

Solutions/ Discussions:

 The incremental cost of operating the cafeteria is the maximum price that the company should be
willing to pay an outside canteen operator. The incremental cost is P 3,505,000 computed as
follows:

Food P 2,300,000
Labor 820,000
Variable overhead (P 550,000 x70%) 385,000
Incremental costs/ Maximum price P 3,505,000

 The salary of the cafeteria supervisor is irrelevant in the analysis because it will still be incurred
regardless of who operates the cafeteria. The remaining fixed overhead is allocated and is,
therefore, definitely irrelevant because the total allocated overhead would not change regardless
of the option chosen.

Optimization of scarce resources … profit per limiting resource

Wherever and whoever you are, resources will always be limited. We live in a world of scarcity.
Businesses are saddled with the reality that operations are to be done in an environment of scarce
resources. Although, the level of resource scarcity varies from one organization to another, still, the
challenge to management is to produce extraordinary results from scarce resources. Money, machine
hours, direct labor hours, supply of materials, and technology are subject to scarcity.

To optimize scarce resources, sales and production should be allotted to a product that gives the highest
profit per scarce resource. If the scarce resource is direct labor hour, then product the product that gives
the highest contribution margin per direct labor hour. The CM per hour is computed as follows:

Unit contribution margin Px UCM Px

/ Hours per unit x hrs. x Units per hour x
Contribution margin per hour Px CM per hour Px
 4. As much as possible, use all your resources in producing the product that has the highest CM per
hour unless such product has market limitation. In such case, after satisfying all the market need
of the product that has the highest CM per hour, produce and sell the product that has the next
highest CM per hour, and so on.

Sample Problem 6.10. Maximization of Scarce Resources

Panay Corporation has 52,000 available machine hours and has a fixed overhead rate of P 4 per hour. It is
considering to produce two popular products with the following production and costs data:

Dragon Ball Samurai X

Cost if purchased from outside supplier P 70 P 105
Direct materials 11 22
Direct labor 25 38
Factory overhead at P 9 per hour 18 27
Annual demand in units 20,000 15,000

Required:
1. Assuming that there is no market limitation, which product should Panay Corporation produce?
2. Considering the market limits, how would Panay Corporation use its limited machine hours to
maximize profit?
3. Assuming that the unit direct materials cost of Samurai X decreases to P 10 and considering the
market limit, how would the limited machine hours be used to maximize profit?

Solutions/ Discussions:

1. No market limit. The product to be produced and sold should give the highest contribution
margin per machine hour. The unit sales price to be used shall be the unit price offered by
competitors.

Other relevant data not readily given by the problem are computed and presented below:

Dragon Ball Samurai X

Number of hours per unit 2 hrs. 3 hrs. (P 27 per unit/ P 9 per hr.)
(P 18 per unit / P 9 per hour)
Fixed overhead per unit P 8 P 12 (P 4 per hr. x 3 hrs. per unit)
(P 4 per hr. x 2 hrs. per unit)
Variable factory overhead P 10 P 15 (P 27 – P 12)
P 18 – P 8)

The contribution margin per hour is computed below:

Dragon Ball Samurai X

Unit sales price P 70 P 105
Unit direct materials cost (11) (22)
Direct labor (25) (38)
Variable factory overhead (10) (15)
Unit contribution margin 24 30
/ No. of hrs. per unit 2 hrs. 3 hrs.
Contribution margin per hour P 12 P 10
Rank (1) (2)

Panay Corporation should produce and sell Dragon Ball because it has a higher contribution
margin per hour. It should use all its 52,000 machine hours to produce 26,00 units (i.e., 52,000
hrs. / 2 hrs.) of Dragon Ball.

2. With market limits. Given the market limitations as provided in the problem, the 52,000
machine hours would be used as follows:

Product Units Hours per unit Total hours

Rank 1 Dragon Ball 20,000 2 hrs. 40,000
Rank 2 Samurai X 4,000 3 hrs. 12,000 (squeezing balance)
 The 52,000 machine hours will be used to produce 20,000 units of Dragon Ball and 4,000 units of
Samurai X to maximize profit. Take note, Dragon Ball has a market limit of 20,000 units.

3. Sensitivity analysis – e.g., change in unit direct material cost. The unit direct materials of
Samurai X decreases by P 12 (i.e., P 22 – P 10). This means that the unit variable cost decreases
and, correspondingly, the unit contribution margin increases by P 12. The new contribution
margin per hour is determined below:

Dragon Ball Samurai X

Unit contribution margin P 24 P 42
/ No. of hrs. per unit 2 hrs 3 hrs.
Contribution margin per hour P 12 14
Rank (2) (1)

The 52,000 machine hours would be used as follows:

Product Units Hours per unit Total hours

Rank 1 Samurai X 15,000 3 hrs. 45,000
Rank 2 Dragon Ball 3,500 2 hrs. 7,000 (squeezing balance)
Total 52,000

This time Samurai X has a higher CM per hour and is therefore to be prioritized. The 52,000 machine
hours shall be used to produce 15,000 units of Samurai X and 3,500 units of Dragon Ball to maximize
profit.

Sell Now or Later… which is more profitable?

There are instances where the sales price of a product is expected to increase as it ages. Examples of these
are fashion clothes, wines, artifacts, paintings, historical items, jewelries, and land. If the product is not
sold now, it will be secured and, sometimes, stored in a special place. Keeping the product would entail
storage costs, maintenance costs, and opportunity costs of the money locked in the product. If the
expected incremental sales is greater than the incremental costs of keeping the product, then sell it later.

Sample Problem 6.11. Sell Now or Later

Tashima Corporation has 12,000 units of product Laos, a high-end men’s wear, in storage. This product is
now out-of-fad but is expected to regain market acceptance in the next 10 months. The total cost of
producing the product is P 240,000, sixty percent of which is variable. It is now kept in a special storage
of which the company pays monthly rental of P 8,000.

The product has a regular sales price of P 20 per unit but is expected to be sold at P 14 per unit when
fashion acceptability recovers. A merchandiser has offered to buy all the 12,000 units of product Laos at a
price of P 8 per unit who will be picking up the products in the company’s storage.

Should the company sell now or sell the products later?

Solutions/ Discussions:

 The relevant costs analysis is presented below:

Sell Now Sell Later

Sales (12,000 x P 8) P 96,000 P 168,000 (12,000 x P 14)
Storage costs (P 8,000 x 10 mos.) - (80,000)
Incremental profit 96,000 P 88,000
Net advantage P 8,000

 The company should be advised to sell its products now due to its net benefit of P 8,000 over the
alternative of selling the products later.

 The costs of producing products, variable and fixed, are irrelevant costs in this decision-making
situation. These costs are already sunk, past, and unavoidable regardless of decision to make.
Replace or retain an asset … what is the net cash flow?

Over time, assets age. Normally, assets deteriorate or become dysfunctional while others appreciate in
value. Those that deteriorate or become dysfunctional are eventually replaced. Those that become
obsolete due to technological advances would have to be discarded.

The issue here is “when the asset is still functionally useful and has not yet reached its point of
technological or physical obsolescence, should management retain or replace the old asset now?”
Maintenance-wise, the old asset needs higher budget than the new one. If the asset is replaced, there is an
immediate outflow of cash. However, there would be savings that are expected to be derived from a
reduced operating expenses of maintaining the new asset compared with that of the old asset. Also, there
is a possible inflow from the current salvage value of the old asset. If the net cash flow is positive,
meaning, the cash inflows are greater than the cash outflow over the life of the asset, then it is advisable
to replace the old asset and generate net benefit over its useful life.

We do this analysis under the assumption that the useful life of the new asset, compared to the old asset,
is equal, without considering the time value of money and effects of taxes.

Sample Problem 6.12. Retain or replace an old asset -1

Pink Industries, Inc., has an opportunity to acquire a new equipment to replace one of its existing
equipment. The following data are gathered relative to the new and old assets.

Old New
Book value P 700,000
Purchase price P 1,200,000
Life in years 5 years 5 years
Salvage value - current 50,000
Salvage value – after 5 years None None
Variable operating expenses 1,300,000 1,000,000

Should the company retain or replace its old equipment?

Solutions/ Discussions:

 The net cash inflows is determined as follows:

Savings (P 300,000 x 5 yrs.) P 1,500,000

Salvage value of old equipment 50,000
Purchase price of new equipment (1,200,000)
Net cash inflows in favor of replacing (5 years) P 350,000

 It is advisable to replace the old equipment now and generate a net benefit of P 350,000 over a
period of 5 years. It should be noted that the time value of money and tax effects are not included
in the analysis.
mak
 The book value of the old equipment is a sunk cost, unavoidable, and is irrelevant in the decision-
making.

Sample Problem 6.13. Retain or Replace an Old Asset – 2

Boondat operates a cafeteria for its employees. The operations of the cafeteria requires fixed costs of P
980,000 per month and variable costs at 45% of sales. Cafeteria sales currently average P 2,200,000 per
month. the company has the opportunity to replace the cafeteria with vending machines. Gross customer
spending at the vending machines is estimated to be 40% greater than the current sales because the
machines are available at all hours. By replacing the cafeteria with vending machines, the company would
receive 15% of the gross customer spending and avoid all cafeteria costs.

Should Boondat retain its cafeteria operations or sell using vending machines?
Solutions/ Discussions:

 The income from cafeteria operations and vending machines should be compared and determine
which alternative is more advantageous.

Income from vending machine (P 2,200,000 x 140% x 15%) P 462,000

Income from cafeteria operations:
Contribution margin (P 2,200,000 x 55%) P 1,210,000
Less: Fixed costs 980,000 230,000
Net advantage of vending machines P 232,000

Scrap or rework a defective unit

There are products that do not meet the standard production specifications. Some of these products are
defective which could be sold as scrap or could be reworked and sold later at a higher value. In deciding
whether to sell as scrap or rework, the profit from reworking should be compared with the profit of selling
as scrap without regard to the past costs of producing the product.

Sample Problem 6.14. Scrap or Rework

A company has 5,000 obsolete cutting supplies carried in inventory at a manufacturing cost of P 40 per
unit. If the toys are reworked for P8 per unit, they could be sold for P 12 per unit. If the toys are scrapped,
they could be sold for a total of P 15,800.

Required:
1. Should the company sell the cutting supplies as scrap or rework it?
2. What is the sunk cost in the decision to be made?

Solutions/ Discussions:

1. Incremental revenue from reworking (5,000 units x P 12) P 60,000

Incremental costs of reworking (5,000 units x P 8) 40,000
Incremental profit from reworking 20,000
Incremental profit from selling as scrap (15,800)
Net advantage of reworking P 4,200

The manufacturing costs of producing the product are irrelevant cost in this decision situation.
Those costs will not change and will remain constant regardless of decision to make.

2. The sunk cost in this decision is the manufacturing cost of P 200,000 (e.g., 5,000 x P 40). These
costs, either variable or fixed manufacturing costs, have been incurred, can no longer be changed,
and are irrelevant.

Indifference point … whatever decision, the results are equal

Indifference point is where the outcome of alternatives is the same. So, regardless of choices the manager
makes, he will arrive at the same profit or loss. Examples of indifference point computations are the
breakeven point, shutdown point, economic order quantity, and internal rate of return. A special
application of indifference point is to be discussed here.

Sample Problem 6.15. Indifference Point

Charm Motors employs 30 sales personnel to market an office equipment. The average equipment sells
for P 350,000 and the company is currently paying 8% commission to its salespersons. It is considering a
scheme of paying its sales persons a flat rate of P 7,000 per month plus 3% commission on sales made.

What is the amount of sales that would produce the same total compensation paid to sales persons?
Solutions/ Discussions:

 The indifference point is computed as follows:

Let x = units sold
350,000 x = total sales
Commission 1 = 8% (350,000x) = 28,000 x
Commission 2 = 2% (350,000x) + 210,000 * = 7,000x + 270,00

(*210,000 = 7,000 per month x 30 sales personnel)

At indifference point:

Commission 1 = Commission 2

28,000 x = 7,000x + 270,000

21,000 x = 210,000
x = 210,000/21,000
x = 10 units

Total sales = P 350,000 (10 units)

= P 3,500,000

To prove the indifference point of sales, we have:

Commission 1 = 8% (P 3,500,000) = P 280,000

Commission 2 = 2% (P 3,500,000) + P 210,000 = P 280,000

References used:

Agamata, Franklin T. Management Services 2019 Edition. GIC Enterprises & Co., Inc, 2019

Cabrera, Ma. Elenita B. Management Accounting Concepts and Applications. GIC Enterprises & Co., Inc,
2014