Decision Making a the process of identifying, evaluating and choesing from at least two alternative courses of action. For business, management must choose in favor of the option most beneficial to the company in order to achieve Company objectives. Decision making process 1. Define the problem 2. Specify the objective and criteria Identifying the alternative courses of action Determining and evaluating the possible consequen i Choosing the best alternative and making the de decision of the atematves Evaluating the results of the decision Sy ae Relevant costs are future costs that are expected to be different among alternatives; it is oftentimes used interchangeably with terms like ‘differential costs’ and ‘avoidable costs’ What makes a cost relevant? A: The requisites are: © It must differ between the decision alternatives. Costs that differ between the alternatives are called-differential costs co It must be incurred in the future rather than the past. Cost incurred in the past are called sunk costs. Irrelevant costs are those that will not influence a decision. ee Concept of Opportunity Costs Opportunity costs — income sacrificed or foregone when a certain alternative is chosen over another alternative. Note that the opportunity cost is zero when no alternative use for the productive facility is available. Other types of costs and terminologies used in decision making 1. Differential costs — increases or decreases in total costs that result from selecting ‘one alternative instead of the other 2. Avoidable costs — costs that will be saved or Certain decision is made. 3. Sunk costs — costs that are already incurred and cannot be avoided regardless of What decision is made. : 4 Out pocket costs ~ costs that will require expenditure of cash or incurrence of liabilities because of a management decision. 5. Joint costs — costs incurred in simultaneously manufacturing two or more products that are difficult to identify individually as separate types of Brodie until the Products reach a certain processing stage knows as the ‘split-off point 6. Spltoff point ~ a point in the manufeturing proces whee Some or all of joint Products can be recognized as distinct and separat ucts. 7. Further processing costs — costs incurred beyond the spit-off point as separated Joint products are to be processed further. : those that will not be incurred if a Scanned with CamScanner8. Bottleneck resources - any resource or operation where the capacity i es thay the demand placed upon it. Approaches _in in Iternatives in Rout, Decisions ches in solving problems that involve decision-making ApproacTotal approach — the total revenues and costs are determined for alternative, and the results are compared to serve as a basis for making decisions 2. Differential approach — only the differences or changes in costs and revenues are considered, Exercise 1. Total and differential analyses. ABC Company has single product called Nabirac. The Company normally produces and sells 25,000 units each year at a seling price of Php13.00 per unit. The company’s unit cost at this level of activity is given below: Direct materials Php3.20 Direct labor 2.50 Variable overhead 1.20 Fixed overhead 2.10 Variable selling and administrative expenses 0.50 Fixed selling and administrative expenses 1.00 Total unit cost 10.50 Required: 1. Determine the profit of ABC Company. Php62,500 J ‘Types of Decisions Nature of | Decision problem en Pp Decision guidelines < Make or buy a | should a part or product be | Choose the option that involves part or a product | manufactured or fees lower cost. In most cases, fired cose line from an outside supplier? | @f€ irrelevant. Consider costs, if any. pacieonel In this case, the selling | Accept the order when the 2° rr price is usually lower than | Fevenue from the | SPetv te Accept or | the regula i exceeds additional cost, PTO 4 tn regular selling price be affected: Reject a special | because of the special | "edular market will not De 2 ant = order. Is the order worth | Most cases, fixed costs are WF" Tose 5 : red in oo accepting? Are regular | OPPortunity cost is onside socrced sales affected? there are regular sales $70) . order to meet the special O° ife Continue gy | Should a business | Continue if avoidable reves, is Shutdown 4 | Segment, which may be a | segment involved is greater nse! business Product line, a department, | avoidable costs; otherwise O° cince segment ora branch be continued or | shutting down the ae discontinued? allocated fived cost 7 Scanned with CamScanneras _y, inavoldable, itis considered Should 3 product, aay peelevant. Sell or Process | undergoing the - rurther | process, be sold at ant | Process futher if additional revenue product, split-off point Processi ing further is greater than or a processed further?” P& | further processing costs, Which product/s should be | Identify and ‘Measure the constraint on proouct Produced and sold when | the limited resource/s Rank the combination | there are limited resources | Product/s according to the highest or bottleneck operations? | Contribution marain per unit of limited Should any of the profit resource. factors (selling price, unit | !entify the factor to change and the sales, variable cost, fixed | #TOunt of contemplated change. cost and sales mix) be | Change the profit factor if it will cause manipulated to increase | 2" improvement on the company’s | profit? overall profit position. Make or Buy Decisions GUIDELINE: Compare the cost to make with the cost to buy and choose the least costly option. The possible costs for each are provided below: Cost to Make Cost to Buy | Avoidable variable costs: Purchase price Direct materials Materials handling Materials handling Direct labor Variable manufacturing overhead ‘Avoidable fixed costs Opportunity cost Q: What are those material handling costs? ‘ A: These are costs allocated to the product that passes thru the receiving department. The receiving department would check the validity of the material or Product that enters the company and the costs incurred for checking would be allocated to the product. Q: Why are direct materials, direct labor and variable manufacturing A Berause ea the conan chooses to purchase or Otsure fom an ouse supplier, then it would no longer produce or make the product. These costs are avoidable, ¢ Are all variable costs avoidable? . ‘No, Vaableseling and acmnistratve expenses ae variable costs Du re Desa: HRTake or buy decisions, we are taking about ether producing our own pros aa on the 2) or purchasing the same from an outside suppl. EITHER WAY, we wil tit sell Re product where "we will incur variable selling expenses. way, “ministrative expenses will still be incurred. Scanned with CamScannerQ: What are opportunity costs in Make or Buy decisions? ‘A: Some common examples are: 1, The facilities used to manufacture the product may be used to manufacture different product that will generate additional contribution margin to the company, The amount of contribution margin is an opportunity cost. fe 2. The facilities used to manufacture the product may be rented out to another Party, The amount of rent income is an opportunity cost. ™ There is no limitation as to what constitute opportunity costs, so we rely on its definition. Opportunity costs are the income sacrificed or foregone when a certain alternative is chosen over another alternative. Exercise 2. Make or Buy. ABC Manufacturing uses 10 units of Part X each month in the production of Product A. The unit cost to manufacture 1 unit of Part X is presented below: Direct materials Php1,000 Materials handling (20% of direct materials cost) 200 Direct labor 8,000 Manufacturing overhead (150% of direct labor) 12,000 Total manufacturing cost Php21,200 Materials handling represents the direct variable costs of the Receiving Department that are applied to direct materials and purchased components based on their cost. This is separate charge in addition to manufacturing overhead. ABC’s annual manufacturing overhead budget is 1/3 variable and 2/3 fixed. XYZ Company, one of ABC's reliabl vendors offered to supply Part X at a unit price of Php15,000. . Required: 1. If ABC purchases Part X from XYZ, the capacity ABC used to manufacture these parts would be idle. By how much would the unit cost of Part X increase oF derrea se should ABC decide to purchase the parts from XYZ? Increase bY p4,800. 2. Assume ABC Manufacturing can rent all idle capacity for Php25,000 per mont. If ABC decides to purchase the 10 units from XYZ Company, by how mu would ABC's monthly cost for Part X increase or decrease? I! Php23,000. - Exercise 3. Make or Buy. ABC Company manufactures ice-makers for installation i" igerators. The cost per unit, for 20,000 units of ice-makers, are as follows: Direct materials Php7 Variable overhead PPS Direct labor 12 Fixed overhead 10 if XYZ Inc., has offered to sell 20,000 ice-makers to ABC Cor a vee od fe , mpany for Php2! ‘ABC accepts XYZ's offer, two alternatives are available for the ice-maker manu Plant: the plant can be idle, or it can be retooled to produce water filtration units: Required: If ABC retools its existing plant, revenues from the sale of water ft i. units are estimated at Php80,000, with variable costs amounting to 60% of 52g. addition, Php6 per unit of the fixed overhead associated with the manufacture © Scanned with CamScannermakers could be eliminated. For ABC Company to determine the most appropriate action to this situation, what are the total relevant costs to make vs. buy, respectively? exercise 4. Make or buy. Chito Company uses 6 units of raw material X per month in the production of one if its main products. Currently, it makes its own raw material X. ‘The cost to make one unit of this raw material is presented below: Materials Php2,300 Handling cost* 230 Direct labor 11,500 Overhead (40% fixed) 23,000 *handling cost is applied at 10% of cost of direct materials and/or any purchased parts. Aknown supplier who supplies raw material X approaches Chito Company. The supplier is willing to sell the raw material for only Php27,600 per unit. If Chito Company considers the purchase of raw material, the freed-up resources can be used to make another product of Chito which would generate additional profit of Php12,000 per month. Required: Determine whether the Company should make or buy raw material X. By what benefit? MAKE — Php3,180 benefit 2. Accept or Reject A Special Order GUIDELINE: Accept the order when the incremental revenue’ exceeds the incremental Cost. Incremental costs would depend whether the company has excess capacity to satisfy the special order or not (the latter would incur opportunity costs). The formula is as follows: Incremental revenue PhpXxx : Incremental costs: : Direct materials PhpXxx Direct labor xox Variable manufacturing overhead XK Variable selling expenses XK Opportunity costs xox . Additional fixed cost : xx 000) ‘ncTemental profit 5 PhpXXX Q: Why are direct materials, direct labor and variable manufacturing Overhead incremental costs? A: Because in order to comply with the special order, the company would still need ‘© produce the product to be sold. It would still Incur expenses for direct costs and Variable manufacturing overhead. However, some special orders may require different materials so direct materials may be higher or lower than "gular production. Q: Why not fixed manufacturing overhead? Fixed manufacturing is also a manufacturing cost. Scanned with CamScannerA: Fixed manufacturing overhead is just applied to the finished goods, These expenses would still be incurred whether we accept the special order or not. These are irrelevant costs. Q: How come Variable selling expenses are included in the computation? It wasn’t included in Make or Buy decisions. A: Because in special order decisions, when we choose to accept the special order, we SELL to the one who made the special order. The act of selling to the buyer would trigger variable selling expenses. So aside from producing the product to be sold, we also consider the expenses related to the sale itself. Opportunity costs would depend on whether we have enough units to satisfy the special order. Take note, these are special orders. We also have regular orders, If all units are already sold to regular orders, then in order to satisfy the sale to the special order, we may need to cancel regular sales. The contribution margin lost on cancelled regular sales is our opportunity cost. : Q: Are there other sources of opportunity costs? A: Yes. We still go back to the definition of opportunity costs. Q: What does the problem mean when it says, “without excess capacity”? A: If we are talking about special orders, it may result from 1 of 2 scenarios. 1) When the company is selling at full capacity, which means, all units produced are to be sold to regular customers. So, if we were to cancel sales to regular customers, the lost contribution margin would be our opportunity costs. 2) When the company is producing at full capacity, which means, if the company wants to accept the special order, then it must acquire additional fixed costs in order to produce additional units for the special order. Why are additional fixed costs included? A: Normally, fixed costs are irrelevant. However, when the special order requires additional fixed factory overhead (e.g. supervision and clerical costs), then these should be included in our analysis. Exercise 5. Special order decision; special order pricing. Kamikaze Company selling its product at Php60 per unit. The costs of producing and selling this product are presented below: Manufacturing costs Amount Direct materials Php26.00 per unit ~ Direct labor 5.00 per unit Variable overhead 1.00 per unit Fixed overhead 836,000 per month Selling and administrative expenses amount Variable Php1.50 per unit Fixed 292,000 per month ‘An order has been received from a customer for 2,400 units at a special discounted price of Php45 per unit. Scanned with CamScanneree red: Decid beara and eee ere ¢ Company should accept or reject the special - ine the minimum selling price for each rio: 1. The Company has excess capacity. Accept; Phy $350 7 2. The Company is operating at full capacity. Reject; Php60. 00 Exercise 6. Special order. A manufacturer has been approached by a new customer who wants to place a one-time order for a component similar to one that the manufacturer makes for another customer. Existing sales will not be affected by acceptance of this order. The manufacturer has a policy of setting its targeted selling price at 60% over full manufacturing cost. The manufacturing costs and the targeted selling price for the existing product are presented as follows: Direct materials Direct labor : rea Variable manufacturing overhead (applied at 75% of direct labor cost 2.70 Fixed manufacturing overhead (applied at 150% of direct labor cost) 5.40 Total manufacturing cost Php14.00 Markup (60% of full manufacturing cost) 8.40 “Targeted selling price Php22.40 The manufacturer has excess capacity to produce the quantity of the component desired by the new customer. The direct materials used in the component for the new customer would cost the manufacturer Php0.25 less than the component currently being made. The variable selling expenses (packaging and shipping) would be the same, or Php0.90 per unit. Required: What is the minimum price at which the mani special order? Php9.25. wufacturer would accept the Industries manufactures a product that is used as a Exercise 7. Special order. ABC rers. It has the following price and cost structure: subcomponent by other manufactur Selling price Php300 Costs ? ; * Direct materials Php40 Direct labor 30: Variable manufacturing overhead 24 Fixed manufacturing overhead - Variable selling Fixed selling and administrative : 20 180) Operating margin Phpi20 er 000 of the above parts. Assuming 1. ABC recel ial, one-time order for 1,000 of the s ABC oes cen, what is the minimum unit price for this special, one- ti Php100. coe 2. ABC ed 2 special one-time order for 1,000 units ofits product. However, ABC recelved 2 hate use for this capacity that wil svt contribution of Php20,000. What is the minimum unit price for this special, one-time order? Php120. Scanned with CamScannerExercise 8. Special order. Capacity. ABC Co. is a producer ‘of Product X. It has the | following selling price and costs per unit: Selling price ‘ Php300 Direct materials ™ 125 Direct labor 25 Variable manufacturing overhead 50 Shipping and handling 5 Fixed manufacturing overhead 15 Fixed selling and administrative 10 Total costs Php230 Required: : __ 1. ABC has recently received a special, one-time order for 2,000 units of Product X. ABC currently has enough excess capacity for this order. What should be the minimum price charged by ABC? Php205. 2. ABC has again received a special, one-time offer for 2,000 units of Product X. ABC is now operating at full capacity, 10,000 units, at a total cost of Php2,300,000. To produce this order would cause a 20% increase in fixed costs. What is the minimum price that is acceptable for this one-time, special order? Php230. Exercise 9. Special order. Comprehensive. ABC Company manufactures a variety of industrial valves. Currently, the company i$ operating at about 70% capacity and is earning a satisfactory return on investment. Management has been approached by XYZ Industries with an offer to buy 120,000 units of pressure valve. XYZ manufactures a value that is almost identical to ABC’s pressure valve; however, a fire in XYZ's valve plant has shut down its manufacturing operations. XYZ needs the 120,000 valves over the next 4 months to meet commitments to its regular customers; the company is prepared to Pay Php19 each for the valves, FOB shipping point. ABC's product cost, based on current attainable standards, for the pressure valve is as follows: Direct materials Php5.00 . Direct labor 6.00 Manufacturing overhead 9.00 Manufacturing overhead is applied to production at the rate of Php18 Per standard direct labor hour. This overhead rate is made up of the following components: Variable factory overhead Php6.00 Fixed factory overhead-direct _ 8.00 Fixed factory overhead-allocated 4.00 ‘Applied manufacturing overhead rate Php18.00_ In determining selling prices, ABC adds @ 40% markup to product cost. This provides a Php28 suggested selling price for the pressure valve. The Marketing Department, however, has set the current selling price at Php27 to maintain market share. Production management believes that it can handle the XYZ Industries order without disrupting its scheduled production. The order would, however, require additional fixed factory overhead of Php12,000 per month in the form of supervision and clerical costs. If management _accepts the order, 30,000 pressure valves will be manufactured and Scanned with CamScannered to XYZ Industries each month f i for th sip nsignmeats, FOB shipping point. }€ Next 4 months. Shipments will be made in required ditional 4, How many a nal direct labor hi a the XYZ order? 15,000 DLH, > “Ould be required each month to fill What is the incremental profit (| i 2. pm552,000 Profit (loss) before tax associated with the XYZ order? . What is the minimum unit price . : > income? Php14.40 Price that ABC could accept without reducing net GUIDELINE 1: Continue if avoidable revenue is greater than its avoidable cost. { Avoidable revenues | [ Avoidable costs |_Sales revenue Variable costs [Opportunity costs Traceable fixed costs ‘Avoidable common fixed costs Other avoidable costs LINE 2: Look for the segment margin. If it is positive, better to continue. If the ‘company has no choice but to drop a segment, drop the one with the least segment margin. You will recall the computation of segment margin: PhpXxox Sales "Less: Variable expenses 0) Contribution margin __ 0000 Less: Traceable fixed SES 0x ‘Segment margin PeamGommon eed expenses Net income Are fixed expenses relevant in continue or shutdown lecistopenses which are AN all Only traceable fied expenses are relevant COUT ct be realocated to "allocated to the segment would stil be incurred a remaining segments, Tese fied expenses are g2neray TI? O How A 2 €an there be opportunity costs? woul cag’, 25° the shutdown of ee product Hie, segment of rane nto ranch then there "8 buying the other product line or buying Fre product line, : Mould be benefits foregone if you do not droP the Fre, ecment, product ine May also be instances where the discontinuance Oring of one product line May h will affect the remaining branch negatively, €-9- hae se the sales in another product line. Scanned with CamScannerExercise 10. Continue or shutdown. Decision making proper. ABC Com; currently has three divisions: A, B, and C. The B Division does not seem to be doing well, and the president of the company is considering dropping this line. If ‘itis dropped, the revenues associated with the B Division will be lost and the related variable costs saved, Also, 50% of the fixed costs allocated to the Division B would be eliminated. The income statements, by divisions, are as follows: Division A_ _Division B_ _DivisionC__ ABC Com Sales 550,000 850,000 1,000,000. 2,400,000 Variable costs (400,000) _(720,000)_ _(820,000) (1,940,000) Contribution margin 150,000 130,000 180,000 “460,000 Fixed costs (100,000) —_(200,000) _(110,000) (410,000) ‘Operating profit (loss) 50,000 — (70,000) 70,000 50,000 Required: Should the Company discontinue Division B and if it does drop Division B, how much would the profit increase or decrease? No. Decrease by Php30,000 Exercise 11. Continue or shutdown. Changes after shutdown. Current business ‘segment operations for Whitman, a mass retailer, are presented below: Merchandise Automotive Restaurant Total Sales 500,000 400,000 100,000 1,000,000 vc (300,000) (200,000) (70,000) (570,000) FC (100,000) (100,000) _ (50,000) (250,000) Income (loss) 100,000 100,000 (20,000) 180,000 Management is contemplating the discontinuance of the Restaurant segment since “it is losing money’. If this segment is discontinued, Php30,000 of its fixed costs will ‘be eliminated. In addition, Merchandise and Automotive sales will decrease 5% from their current levels, ™ Required: What will ABC’s total contribution margin. be if the Restaurant segment is discontinued? Php380,000 Exercise 12. Shutting down operations. c The Branch managers have recently ‘submitted their respective income statements: QC Branch _ Manila Branch Total Sales Php1,000,000 Php880,000 ~ Php1,880,000 vc -_ (670,000) (396,000) __(1,066000)_ cM 330,000 484,000 814,000 Traceable FC (294,000) _(198,000)_ (492,000) Segment margin 36,000 286,000 322,000 Common FC (252,000) (132,000) (384,000) - Net income (216,000) 154,000 (62,000) Because of the negative income contri considering its elimination. If the QC expenses could be avoided. The total would be unaffected. ibution of the’ QC branch, the company Is branch is eliminated, then: its traceable fixed ‘common fixed expenses are merely allocated and Required: 1. If the Company eliminates the Decrease by Php36,000 QC branch, what would happen to overall ce Scanned with CamScannerAssume that only 1/4 of the traceable epee Seana CURE ED traceable fixed costs would continue unchanged, Php109,500 3. Assume that because t would increase by Increase in he QC branch Would close, sales in the Manila branch 10%, 20 Shou i Company shut down the QC branch? Yes. 4 il or Pi e1 GUIDELINE: Compare the additional els to additional costs. Additional revenue is the n ling price) after processing further while additional costs mainly pertains to the costs of Processing further. Note that joint manufacturing costs are irrelevant for these are costs incurred in the past and would not differ in the two decision alternatives (whether to sell at split-off or process further), Suggested formula: Revenue or selling price after processing further PhpXXX Less: Revenue or selling price at split-off XXX) Additional revenue OC Less: Cost of processing further xX) Incremental revenue PhpXxXx, Exercise 13. Sell or process further. ABC Company produces four products for a joint Cost of Php23,200. The products are currently processed beyond split-off point. The Company is deciding whether it should sell the products at split-off point or continue to process the same beyond split-off point. The following data are presented for decision- making: [Product Sales revenue | Additional processing cost | Revenue at split-off A Php92,800 Php60,320 Php34,800 B 69,600 32,480 25,520 Cc 46,400 37,120 4,640 D 5,800 6,960 : Required: . 1. Which products should the firm sell at split-off point? Products A and D 2. If ABC Company takes the most profitable action, what will be its profit? Php58,000 Exercise 14. Sell or process further. ABC Corporation uses a joint process to produce three products: X, Y, and Z, all derived from one input. The company can sell these products at the point of split-off (end of the joint process) or process them further. The Joint production costs during October were Php10,000. ABC allocates joint costs to the Products in proportion to the relative physical volume of output. Additional information is presented below: If processed further i = = Foi produced split-off price Sost A 1,000 Php4.00 Php5.00 |” Php0.75 | B 2,000 2.25 4.00 1.20 co 1,500 3.00 3.75 0.90 Scanned with CamScannerRequired: 1. the gross profit from the production process? Php3,000 perform additional processing on products A and B. scrapped, they could be sold for Php1.85 per unit. advantage of that alterative? Scrap, Php5,950. 5. Product Combination If all products were sold at the split-off point during October, what would be 2. Assuming sufficient demand exists, ABC could sell all the products at the prices previously mentioned at either the split-off point or after further processing. To maximize its profits, which product/s should be sold at split-off and which product/s should be processed further? Sell product C at split-off and Exercise 15. Sell or process further. Rework or scrap. A company has 7,000 obsolete toys carried in inventory at a manufacturing cost of Phpé per unit. If the toys are reworked for Php2 per unit, they could be sold for Php3 per unit. If the toys are Required: Which alternative is more desirable and what is the total peso amount of the i Compute for the contribution margin per constrained resource and rank them GUIDELINE: from highest to lowest. The suggested formula is presented below: Scanned with CamScanner Product Product Se Selling price PhpXXx PhpXxx Less: Variable cost per unit 0000), (000) Contribution margin per unit (CM/u) XK XX Divide: Constrained resource per unit (CR/u) 4g. “it takes 2 machine hours to produce 1 unit” OR xx OK Multiply: Number of units produced per constrained resource (u/CR) e.g. "2 units are produced per machine hour” Contribution margin per constrained resource (CM/CR) PhpXXX_ PhpXXK Exercise 16. Product combination. ABC Corporation makes two types of motors for Use in various products. Operating data and unit cost information for its products are presented below. : Product A_ Product B Annual unit capacity 10,000 20,000 Annual unit demand 10,000 20,000 Selling price : Phy Variable manufacturing cost es) Fixed manufacturing cost (10) (10) Variable selling & administrative (10) (11) Fixed selling & administrative (5) (4) _Fixed other administrative QQ) 0) Unit operating profit Php20 Phplo ‘Machine hours per unit 2.00 1.50Required: 1, What is ABC's relevant contribution idl Product priorities for the coming year? 6.00 for product B. lon margin that ABC can generate in the Php18.50 for product A and Php1 2. What is the maximum total contributi coming year? Php690,000. Exercise 17. Product combination. Least Costly. ABC, Inc., produces a component that is popular in many refrigeration systems. Data on three of the five different models of this component are as follows: Model - A B Cc Units of production 5,000 6,000 3,000 Manufacturing cost: Variable direct costs Phpi0 Php24 Php20 Variable overhead 5 10 15 a Fixed overhead 11 20 17_- Total manufacturing costs Php26 Php54 Php52 Cost if purchased -"Php2i___Php42___ Php39) ABC applies variable overhead based on machine hours at the rate of Php2.50 per hour. Models A, B and C are manufactured in the Freezer Department, which has a capacity of 28,000 machine processing hours. : Required: : 1. How many units of each model should be produced? 5,000 units of Model A and 4,500 units of Model B. 2. . How many units of each mode! should be purchased? 1,500 units of Model B.and 3,000 units of Model C. : ; ; 3. What would your answers for the first two items be if the purchase price for Model C is changed to Php50 per unit? 1) 5,000 units of Model A and 3,000 units of Model C; 2) 6,000 units of Model B. Scanned with CamScanner