Decision Making – Cost Accounting

13. 1 Introduction

Marginal costing is the ascertainment of marginal cost and of the effect on profit of changes in volume by differentiating between fixed costs and variable costs. Marginal cost is the amount at any given volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. Marginal costing is a very useful tool for management because of its applications. It is used in providing assistance to the management in vital decision-making both short term and long term. Differential analysis is the process of estimating the consequences of alternative actions that a decision-maker may take.

It is used both for short term and long term decisions. Short term decisions relate to fixing a price for the product, selecting a suitable product mix, diversification of the product, etc. while long term deals with capital budgeting decisions.

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Objectives

After studying this unit, you should be able to:

• Explain the steps involved in the decision-making process
• Know various types of decision choices
• Analyze and interpret various decision choices

13. 2 Decision Making

Decision making is the process of evaluating two or more alternatives leading to a final choice known as alternative choice decisions.

Decision making is closely associated with planning for the future and is directed towards a specific objective or goal. The decision model contains the following decision-making steps or elements:

1. Identify and define the problem
2. Identify alternatives as possible solutions to the problem.
3. Eliminate alternatives that are clearly not feasible
4. Collect relevant data (costs and benefits) associated with each feasible alternative
5. Identify cost and benefits as relevant or irrelevant and eliminate irrelevant costs and benefits from consideration.
6. Identify to the extent possible, non-financial advantage, and disadvantage of each feasible alternative.
7. Total the relevant cost and benefits for each alternative
8. Select the alternative with the greatest overall benefits to make a decision 9. Implement or execute the decision 10. Evaluate the results of the decision made.

13. 3 Types of Costs

A decision involves selecting among various choices. Non-routine types of decisions are crucial and critical to the firm as it involves huge investments and involve much uncertainty.

Short term decision making is based on relevant data obtained from accounting information.

• Relevant Cost is a cost that would change as a result of the decision.
• Opportunity costs are monetary benefits foregone for not pursuing the alternative course. When a decision to follow one course of action is made, the opportunity to pursue some other course is foregone.
• Sunk costs are a historical cost that cannot be recovered in a given situation. These costs are irrelevant in decision making.
• Avoidable costs are costs that can be avoided in the future as a result of managerial choice. It is also known as discretionary costs. These costs are relevant in decision making.
• Incremental / Differential costs are costs that include variable costs and additional fixed costs resulting from a particular decision. They are helpful in finding out the profitability of increased output and give a better measure than the average cost. Self Assessment Questions:

1. Relevant Costs are costs which would _________as a result of the decision.
2. ___________ are historical cost that cannot be recovered in a given situation.
3. Opportunity costs are _________________for not pursuing the alternative course
4. ____________ is also known as discretionary cost.

13. 4 Types of Choices Decisions

The application of incremental/differential costs and revenues for decision making is known as decision situations or types of choice decisions.

• Make or Buy decisions
• Selection of a suitable product mix
• Effect of change in price
• Maintaining a desired level of profit
• Diversification of products
• Closing down or suspending activities
• The alternative course of action
• Own or Lease
• Retain or Replace Change or Status quo
• Export or Local sales
• Expand or Contract
• Take or Refuse the order
• Place special orders
• Select sales territories
• Sell at split-up point or process further.

13. 5 Make or Buy Decisions

Make or buy decisions arise when a company with unused production capacity consider the following alternatives

1. To buy certain raw materials or subassemblies from outside suppliers
2. To use the available capacity to produce the items within the company.
3. The quality and type of item which affects the production schedule
4. The space required for the production of an item
5. Any transportation involved due to the location of the production facility
6. Cost of acquiring special know-how required for the item.

Illustration 1: The Anchor Company Ltd produces most of its electrical parts in its own plant. The company is at present considering the feasibility of buying a part from an outside supplier for Rs. 4. 5 per part. If this were done, monthly costs would increase by Rs. 1,000 The part under consideration is manufactured in Department 1 along with numerous other parts. On account of discontinuing the production of this part, Department 1 would have somewhat reduced operations.

The average monthly usage production of this part is 20,000 units. The costs of producing this part on per unit basis are as follows.

The company should continue the practice of producing the part in Department1. Illustration 2: ABC ltd. plans utilize its idle capacity by making components parts instead of buying them from suppliers.

The following are the data available for the decision to make or buy:

The company purchases the part at a unit cost of Rs. 30. The company has been operating at 75% of normal capacity. The fixed manufacturing cost is 17 lakhs. The cost to manufacture 50000 units is:

Inference: The total incremental cost by producing the part in-house is Rs. 25. 50 while the cost incurred on the purchase of the part from suppliers is Rs. 30. 00. There is a clear advantage to the company to produce the part in-house.

13. 6 Addition or Discontinuance of a Product line or Process

The decision to add or eliminate an unprofitable product is a special case of product profitability evaluation.

When a firm is divided into multiple sales outlets, product lines, divisions, departments it may have to evaluate their individual performance to decide whether or not to continue operations of each of these segments. Illustration 3: The Hi-tech Manufacturing Company is presently evaluating two possible processes for the manufacture of a toy, and makes available to you the following information:

You are required to suggest:

i) Which process should be chosen? Substantiate your answer.

ii) Would you change your answer as given above if you were informed that the capacities of the two processes are as follows: A 6, 00,000 units; B 5, 00,000 units? Why? Substantiate your answer. Solution Comparative Profitability Statement

Process A may be chosen.

Illustration 4: Addition of second shift Ulfa Ltd produces a single product in its plant. This product sells for Rs. 100 per unit. The standard production cost per unit is as follows:

The plant is currently operating at a full capacity of 1, 00,000 units per year on a single shift. This output is inadequate to meet the projected sales manager has estimated that the firm will lose sales of 40,000 units next year if the capacity is not expanded Plant capacity could be doubled by adding a second shift. This would require additional out-of-pocket fixed manufacturing overhead costs of Rs. 10,00,000 annually. Also, a night work wage premium equal to 25 percent of the standard wage would have to be paid during the second shift.

However, if annual production volume were 1,30,000 units or more, the company could take advantage of 2 percent quantity discount on its raw material purchases. You are required to advise whether it would be profitable to add the second shift in order to obtain the sales volume of 40,000 units per year? Solution Decision analysis

Yes, it would be profitable to add the second shift as it would increase profits by Rs. 6, 12,000.

Illustration 5: Assume a company is considering dropping product B from its line because accounting statements show that product B is being sold at a loss.

Additional information:

1. Factory Overhead cost is made up of a fixed cost of Rs. 5850 and variable cost of Rs. 3900.
2. Variable cost by-products are: A – Rs 3000, B – Rs 400 and C – Rs 500
3. Fixed costs and expense will not be changed if product B is eliminated
4. Variable selling and administrative expenses are to the extent of Rs. 11000 can be traced to the product: A-Rs. 7,500; B- Rs. 1500 and C- Rs. 2000
5. Fixed selling and admin expense are Rs. 10000

If the sale of product B were discontinued, the marginal contribution would be lost and the net income would be reduced by Rs. 2,600. Assume that after dropping product B, the sales of product A increased by 10%. The total profit of the firm will not increase by this sales increase. Product A makes only a marginal contribution of 34% (17000/50000)

On additional sales of Rs. 5000 the marginal contribution would be Rs. 700

This contribution is less than Rs. 2,600 now being realized on the sales of product B. it would take additional sales of product A of approximately Rs. 7,647 to equal the marginal contribution of Rs. 2,600 mow being made by product B:

Marginal contribution of product B / Marginal contribution of product A=2,600 / 34% = Rs. 7,647

It is possible that dropping product B may result in a reduction in some of the fixed costs. Products B now contributes to Rs. 2,600 towards the recovery of fixed costs and expenses. Only if the fixed costs and expenses can be reduced by more than this amount, it will be advisable to drop product B.

13. 7 Sells or Process Further

A firm is frequently faced with the problem of continuing with the existing policies or plans or change to new ones. Such change could be in the form of selling a partially processed product (semi-finished) or process further. While taking a decision about such matters, the management must keep in mind the long term consequence and the interest of the firm. Illustration 6: A firm sells a semi-finished product at Rs. 9 per unit. The cost to manufacture the semi-finished product is Rs. 6. Further processing can be done at an additional cost of Rs. 3 per unit and the final product can be sold at Rs. 15 per unit. The firm can produce 10,000 units.

The analysis is shown below:

There is a net advantage of Rs. 30,000 in processing the product further. The market value of the partially processed product (Rs. 90,000) is considered to be the opportunity cost of further processing. The figure for the net advantage of Rs. 30. 00 can be arrived at in the following manner also:

13. 8 Operate or Shutdown

Various factors both external and internal affect the functioning of the firm. In such situations, it becomes necessary for a firm to temporarily suspend or shut down the activities of a particular product, department, or unit as a whole.

Illustration 7: A company operating below 50% of its capacity expects that the volume of sales will drop below the present level of 10,000 units per month. Management is concerned that a further drop in sales volume will create a loss and has under consideration a recommendation that operation is suspended until better market conditions prevail and also a better selling price. The present operation income statement is as follows:

Suggest the management at what point should the operation be suspended. The fixed cost remains only Rs 4000 if the operation is shut down. The following income statements have been prepared for sales at different capacities

It would appear that shutdown is desirable when the sale volume drops below 6,000 units per month, the point at which operating losses exceed the shutdown cost.

13. 9 Exploring New Markets

Decisions regarding entering new markets whether within the country or other the country should be taken after considering the following factors:

• Whether the firm has the surplus capacity to meet the new demand?
• What price is being offered by the new market?
• Whether the sale of goods in the new market will affect the present market for the goods?

Illustration 8: The following figures are obtained from the budget of a company which is at present working at 90% capacity and producing 13,000 units per annum.

Labour and material costs per unit are constant under present conditions. Profit margin is 10 percent.

a) You are required to determine the differential cost of producing 1,500 units by increasing capacity to 100 percent.

b) What would you recommend for an export price for these 1,500 units taking into account that overseas prices are much lower than indigenous prices? Solution

Differential cost analysis can now be done as follows:

a) Different Cost = Rs. 97,267 (Rs. 14,47,267 – 13,50,000)

b) The minimum price for export = Rs. 97,267 / 1,500 = Rs. 64. 84 per unit At this price, there is no addition to revenue; any price above Rs. 64. 84 per unit may be acceptable.

Note: It has been presumed that

i) No capital investment is necessary

ii) No export charges are incurred and

ii) The export price will have no effect on the home market where the product will continue to be sold at the old price. It has also been assumed that necessary precautions have been taken to ensure that the product is not ‘dumped back’.

13. 10 Maintaining a Desired level of profit

When deciding between alternative courses of action the criterion should be to select the project which yields the greatest contribution. Illustration 9: A company is considering expansion. Fixed costs amount to Rs. 4, 20,000, and are expected to increase by Rs. 1, 25,000 when plant expansion is completed. The present plant capacity is 80,000 units a year. Capacity will increase by 50 percent with the expansion. Variable costs are currently Rs. 6. 0 per unit and are expected to go down by Rs. 0. 40 per unit with the expansion. The current selling price is Rs. 16 per unit and is expected to remain the same under either alternative. What are the break-even points under either alternative? Which alternative is better and why?

The profitability after the expansion is very good and hence it is better to expand. Illustration 10: Disposal of inventories ABC Ltd has on hand 5,000 units of a product that cannot be sold through regular sales. These were produced at a total cost of Re. 1, 50,000, and would normally have been sold for Rs. 40 per unit. Three alternatives are being considered.

i. Sell the items as scrap for Rs. per unit

ii. Repackage at a cost of Rs. 20,000 and sell them at Rs. 8 per unit

iii. Dispose of them off at the city dump at removal cost of Rs. 500. Which alternative should be accepted?

Alternative II should be accepted.

13. 11 Summary

• Decision making is the process of evaluating two or more alternatives leading to a final choice known as alternative choice decisions. Decision making is closely associated with planning for the future and is directed towards a specific objective or goal.
• A decision involves selecting among various choices. Non-routine types of decisions are crucial and critical to the firm as it involves huge investments and involves much uncertainty. Short term decision making is based on relevant data obtained from accounting information.
• Relevant Cost is a cost that would change as a result of the decision.
• Opportunity costs are monetary benefits foregone for not pursuing the alternative course. When a decision to follow one course of action is made, the opportunity to pursue some other course is foregone.
• Sunk costs are a historical cost that cannot be recovered in a given situation. These costs are irrelevant in decision making.
• Avoidable costs are costs that can be avoided in the future as a result of managerial choice. It is also known as discretionary costs. These costs are relevant in decision making.
• Incremental / Differential costs are costs that include variable costs and additional fixed costs resulting from a particular decision. They are helpful in finding out the profitability of increased output and give a better measure than the average cost.

13. 12 Terminal Questions

1. Avon garments Ltd manufactures readymade garments and uses its cut-pieces of cloth to manufacture dolls. The following statement of cost has been prepared.

The cut-pieces used in dolls have a scrap value of Rs 1,000 if sold in the market. As there is a loss of Rs. 1,000 in the manufacturing of dolls, it is suggested to discontinue their manufacture. Advise management.

2. ABC Company Ltd produces most of its own parts and components. The standard wage rate in the parts department is Rs. 3 per hour. Variable manufacturing overheads are applied at a standard rate of Rs. 2 per labor – hour and fixed manufacturing overheads are charged at a standard rate of Rs 2. 50 per hour. For its current year’s output, the company will require a new part. This part can be made in the parts department without any expansion of existing facilities.

Nevertheless, it would be necessary to increase the cost of product testing and inspection by Rs. 5,000 per month. The estimated labor time for the new part is half an hour per unit. Raw materials cost has been estimated at Rs. 6 per unit. The alternative choice before the company is to purchase a part from an outside supplier at Rs 9 per unit. The company has estimated that it will need 2,00,000 new parts during the current years. Advise the company whether it would be more economical to buy or make the new parts. Would your answer be different if the requirement of new parts was only 1,00,000 parts?

13. 13 Answers to SAQ and TQs

Answer to SAQ

1. Change
2. Sunk cost
3. Monetary benefits foregone
4. Avoidable cost

Answers to TQs:

1. Discontinue manufacture of dolls

2. Decision analysis: 200000 units – The company is advised to make the new part. The differential costs favoring the decision of making the component is Rs40000

Decision analysis: 100000 units – The company is advised to buy from an outside supplier. The total cost to manufacture 100000 units is Rs. 9,10,000.

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