Decision making

Cost/Management Accounting notes

Nature of Decision-making
Decision-making may fall into any of the following categories

1. Short run operational decisions

2. Short run tactical decisions

3. Longer term strategic planning decisions

Short run operational decisions are made in relation to the achievement of short-term output requirements. A decision may be made to work overtime in a department in order to have a job completed in accordance with a scheduled delivery date to the customer. Such decisions are aimed at ensuring that the current business plan is achieved Short run tactical decisions are related to specific events which management wish to decide upon and which will change the future operation of the business in some way. Its time horizon is short and it is usually within 12 months.
Longer term strategic planning is more concerned with the overall direction of the business plan. It may have a time horizon of 5 to 10 years. For example should a decision be made to install a fully automated production line to replace existing labour intensive machine process. These decisions require consideration of factors such as;

• The level of market likely to be available in future

• An estimation of changing price levels

• The timing of cash flows in relation to the decision

• The degree of uncertainty estimated in relation to data used in the evaluation of the situation

• The strategy which competitors are likely to implement

• The cost of capital or target rate of return
The decision making cycle
Steps in decision-making cycle are:

a) Clearly define the objective, which is to be the focus of the decision. This is important in order that the decision makers have a well-defined problem, which has to be solved and not a vague idea which lacks clarity.

b) Consider the alternative strategies available to the satisfactory attainment of the objective. This is important in order that the final decision agreed upon has taken account of all relevant possibilities.

c) Gather relevant information in order to compare alternative strategies in quantifiable terms. This may require considerable thought and effort in order to ensure that all relevant data are obtained.

d) Consider the qualitative factors, which are likely to influence the decision. This is important as an element in decision making. There may be non-quantifiable costs and benefits, which lead to a final choice of strategy different from the highest quantifiable return.

e) Compare the alternative strategies using both quantitative and qualitative data and then
make a final decision.

f) Re-evaluate your decision; determine if you are achieving the objectives and if not,
repeat the process.
Relevant costs and decision-making
The relevance of costs will depend upon the purpose for which they are being used. Relevance is related to future decision.
The relevance of costs in decision-making is related to whether they are avoidable in relation to the decision made or if they are unavoidable, in that they will remain irrespective of the decision taken. Relevant costs in decision-making are, therefore, said to be incremental and future costs relating to the decision to be made. Costs are incremental if they will result in a difference e.g. avoidable costs result in reduced cots if they are avoided. Future costs are those costs that have not yet been incurred i.e. they are not sunk costs or committed costs. This is explained further in this text.
Limiting factors and decision making
Limiting factor may be defined as ‘any factor, which has a limiting effect on the activities of an undertaking at a point in time over a specific period’

The decision-making strategy, which management wish to pursue, may be constrained because of shortage of manpower, machinery, material, money, markets or a combination of these. It may also be affected by the availability of management expertise and methods improvement capability.

In short term decision making where one or more factors will limit the strategy which may be implemented, it is likely that profit maximization will be seen as a major decision making goal. It should be noted, however, that in practice a number of goals will form part of the objective of an organization. In addition to short term profits management may wish to consider a number of longer term goals, for example

• Consolidation of market share.

• Improving longer term productivity and profitability.

• Quality leadership.

• Employee and customer satisfaction.

• Social responsibility.

This balance between short and long term goals is likely to lead to decisions, which are profit satisfying rather than profit maximizing resulting in the satisfactory profit level being earned in the short term
Single Limiting factor
Where a single limiting factor exists, the decision making sequence may be implemented as
• Calculate the contribution per unit of limiting factor for each product.

• Rank the products in order of size and contribution per unit of limiting factor.

• Allow any minimum retention of less profitable products which is decided upon.

• Use up the total units of the limiting factor in order to fulfill the forecast quantities in order of product ranking.

A company manufacturers and sells three products A, B & C. The unit cost and revenue structure for each product and its maximum forecast demand for the coming period are as follows:-

The company has a maximum of 6000 machine hours available during the coming period. Annual fixed costs incurred amount to Sh20,000.

(i) Calculate the number of units of each product A, B, and C, which should be produced and sold in order to maximize profit

(ii) Calculate the maximum profit earned from the decision strategy per (i) above.

(iii) Suggest other factors which management may wish to consider which could result in a
change in their decision

(iv) Calculate the product units to be produced and sold and the net profit earned if the company wishes to maximize sales of product A because it is thought to be a future market leader

(v) Calculate the product units to be sold and the net profit earned it the company agree to produce a minimum of 70% of the maximum demand of each product in order to maintain market spread.


The above calculation confirms that machine time is a limiting factor, which will restrict the number of products, which can be produced and sold.

*** the figure is the balance of machine hours remaining after allocating to other products in order of ranking.
iii. The profit maximizing mix may not be implemented where management wish to maintain a more balanced market mix or where they wish to concentrate on a future market leader. In addition they may wish to explore the possibility of sub-contracting some production or of acquiring additional machinery either on hire or part of a long term expansion of capacity

iv. Where the sales of product A are to be maximized because it is thought that it will be a
future market leader, the analysis sequence is:

• Utilize the machine hours required to maximize production of A
i.e 500 units x 10 hrs = 5000 hrs

• Use the remaining 1000 machine hours to produce B and C in their ranking order.

Product B has a higher contribution per machine hour. The 1000 machine hours available are sufficient to produce 1000/4 = 250 units of B. This is less than its maximum demand. There are no hours left in which to produce product C.

The sales and profit strategy is therefore:

v. Where sales have to be spread in order to satisfy 70% of the maximum demand of each product as the first criterion, the analysis sequence is

• Utilize the machine hours required to produce 70% of the maximum production of
each product

• Use the residual hours up to the maximum of 6000 hours to produce additional units of the product in their ranking up to the maximum demand in each case so far as it is possible

Direct cost as a relevant cost
Direct costs may be directly chargeable to a product or a cost center. They may be fixed costs or variable costs when it comes to decision-making.
>>> Illustration
A summary of profit and loss reported in each of the three product lines B, C and D is as follows:

Net profit

Required: _5 (2) (12)
(i) Comment on the financial situation as required in the above summary

(ii) Comment on a decision to discontinue product C where

a. 60% of the fixed costs charged to it relate to advertising of product C and are avoidable if discontinued.
b. All the fixed costs charged to product C are avoidable if discontinued

(iii) Discuss whether product D should be discontinued if

a. 90% of fixed costs charged to it are company costs arbitrarily apportioned to it OR

b. Eliminating of its variable costs would result to an increase in the material costs for products B and C because of lost discounts which would have an effect of increasing their variable costs by 5% OR

c. Products B and D are complementary products whose sales demand is directly related to that of each other.

The existing figures show that products Band C are making a contribution towards fixed costs whereas product D is in a negative contribution situation. The cash out flow directly related to product D are not paid for by the cash in flows from sales revenue. Product B shows a net profit of Shs.5000 whereas product C shows a net loss of 2000. The question data has not indicated whether the fixed costs allocated to each product are an arbitrary apportionment of the total company fixed cost

Where 60% of the fixed costs charged to product C relate to advertising of the product and are avoidable if it is discontinued, it is earning a net contribution or net margin of Shs. 10000 – (60% x Shs. 12000) = Shs. 2800. This means that Product C is contributing to the net cash in flows of the company and should be retained in the short term if no more profitable use of the capacity if available

Where all the fixed costs charged to product C are avoidable if it is discontinued, this means that they are directly attributable to product C. The net loss of Shs. 2000 is a true measure of its effects on company cash flows. If the position cannot be improved, the company will save Shs. 2000 in the short term by discontinuing product C

Product D has a negative contribution of Shs. 2000, if 10% of the fixed costs charged to it are directly attributable to the product. This adds a further Shs. 1000 (10% x 10000) to its adverse effect on company cash flow

b) The variable costs of products B and C would increase by 5% if product D is discontinued Increase in cost of products B and C = 5% x Shs.40000+ Shs. 30000) = Shs. 3500 Savings by discontinuing product D = Shs. 2000
Net benefit of retaining product D = Shs. 1500
In this situation the discontinuance of product D will result in net loss to the company of
Shs. 1500 because of the increased costs of products B and C due to loss of discount

c) If products B and D are complementary products, their position must be examined. If product D is discontinued it implies that product B sales will be lost. Product B currently earns a contribution of Shs. 20000, which far outweighs the negative contribution of Shs.2000, which results from product D. Both products should be produced and sold
Incremental costs as relevant costs
An incremental cost is specifically incurred by the following a course of action and avoidable if such action is not implemented. This contrasts with sunk costs, which have already been incurred and cannot be avoided whether the future course of action is taken or not. Incremental costs are relevant in decision-making situations such as:

a) Whether to buy in a component or service or manufacture it using the company’s own resources

b) Whether to further process one of the joint products which emerge from a process
before it is sold or sell it in its existing form without further processing.
>>> Example 3
A company currently makes a component which has the following unit cost structure

Advise the management whether the component should be bought in from outside the company
at Shs.330

1. The total cost to manufacture the component is Shs.490

2. The apparent saving by buying the component is Shs(490 – 330) = Shs.160

3. If the fixed overheads is an apportionment of the company’s fixed overhead, which will be avoided if production is discontinued, the relevant cost of manufacture is Shs.350. This assumes that direct materials, direct labor and variable overheads are all directly variable with the production of the component. This still leaves the purchase of the component for Shs.330 a cheaper option than manufacture at a relevant cost of Shs.350.

4. Other factors which are non quantifiable in the short term should be considered, however, before a final decision is made.

a. Will the quality of the bought in component be as acceptable as that which is manufactured internally?

b. Will the outside supplier be able to supply the components as required or will there be production delays because of late delivery?

c. Will there be industrial relations problem because of the loss of jobs by workers who currently make the component?

5. Further analysis of the solution may reveal that the production capacity currently used to make the component could be used as an alternative manufacturing opportunity which could be sold externally and yield a contribution equivalent of Shs. 50 for each component it replaces
Opportunity costs are relevant costs
Opportunity cost introduces an additional concept which is not available as part of normal cost analysis in the accounting record system

Opportunity cost may be defined as ‘the best opportunity foregone by following a particular course of action’, it may be redefined as the net cash flow lost by choosing one alternative rather than another (value of the next best forgone alternative). Opportunity cost may be used in a number of decision making situations where there is an alternative choice between possible future course of action, Examples are:

a) Whether to close a department immediately or in one years time

b) Whether to operate an internal service department or to use an outside service.

c) Whether to accept one or another of two mutually exclusive contracts

Opportunity costs will be part of an incremental cost and revenue analysis in many decision making situations
>>> Illustration question (marginal costing and absorbtion costing)
Karamoja Plc is a manufacturing company which produces and sells a single product, ‘Moto sana’.
The following is the standard cost per unit of the product:

Fixed manufacturing costs per unit are based on a predetermined rate established at a normal activity level of 18,000 production units per period. Fixed selling and administration costs are absorbed into the cost of sales at 20% of the selling price. Under/over recovery of overheads are transferred to the profit and loss account at the end of each period.
The following information has been provided for two consecutive periods.



a) Income statement for each of the periods under absorption method

b) Income statements for each of the periods under the direct costing method

c) Reconciliation for each period of the profit or loss obtained under the two methods in (a) and (b) above

d) Outline the arguments in favor of

 The full costing method
 The direct costing method

Absorption costing (full costing)


c) Reconciliation

The arguments for marginal and absorption costing are discussed in the topic.

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