DECISION MAKING

SHORT TERM DECISION OR TACTICAL DECISION- decision that doesn’t need involvement of

changes in capacity – related resources.- only relevant data are taken into accounts.

Long term Short term

CHARACTERISTICS OF RELEVANT INFORMATION

• The costs and benefits are different at different option

• The costs and benefits are related to the future.• Timely and accurate• Qualitative or quantitative• Cash flow

ITEMS OF RELEVANT INFORMATION

out - of - pocket cost

sunk cost

opportunity cost

potential benefits that the management should give up

- is the cost that already incurred

additional cost that will be incurred in the selected option.

DECISION MAKING PROCESS

Clarify the problem

Identify alternative option from selected decision

Identify relevant costs and benefits

Compare the costs and benefits form each option

Select an option

LIMITING FACTOR DECISION MAKING

1) Optimum production mix• this approach give guideline to management

how much can every type of products can be maximize produce in bottle-neck and non-bottleneck situation.

• this approach based on priority of products contribution per unit.

• the products are ranking based on its profitability and reallocate the production for each type of products

2) Theory of constraints - is approach to minimize cost and produce high sale. - involve 5 process :

Elevate the system’s bottleneck

Subordinate everything else to the decision in step 2

If the bottleneck has been broken back to step 1

Decide how to exploit the bottleneck

Identify the constraints

3) Throughput cost accounting- main objective is to make money.- assume that material is the only variable cost, the others are fixed.- throughput here meaning contribution margin which when sale less material.-3 ways to increase profits

: increase throughput : decrease fixed cost: decrease investment (usually inventories)

Example

Details Product A Product BMachine hours / unit 60 20Selling price / unit RM 600 RM 480Variable / unit 300 360Contribution margin RM 300 RM 120c/s ratio 50 % 25 %

Factory capacity is at 600 000 working hours

contribution margin approach

Product A Product B

A B C

Contribution per unit

RM 9 RM 10 RM 7

Hours required 3 5 1

Contribution per margin hour

3 2 7

Profitability ranking 2 3 1

- The company have 18 000 capacity hour- Demand A : 6 000 units

B : 5 000 units C : 4 000 units

- Allocation of capacity 18 000 hoursProduct C 4 000Balance 14 000- Product A require 18 000 hours to fulfill demand, but the balance only 14 000= 14 000 3= 4 667 units

DISCONTINUING SEGMENT.• consideration of to add or to delete any department or

any one of the products.• benefits for continuing : expenses of shutdown will be

avoided. : trained employee will be

keep. : cost open new segment is

avoidable.• benefit of discontinuing : avoid losses.

: saving in various type of costs.

• there are 2 approaches in comparing the costs and benefits which is comparative income statement and incremental approach.

EXAMPLE ADD OR DELETE SEGMENT.Cutting department Sewing department Packaging department

Salary 54 000 15 000 48 000

Utilities 8 000 5 500 3 700

Materials 47 000 18 500 34 000

Maintenance 24 000 3 800 13 900

Administrative cost 36 000 8 200 12 000

Depreciation 33 000 30 000 20 000

The management want to close the packaging department. The below information are also provided :1. if the department close, they will save one line leader and another one supervisor salary. They have same salary which is RM 12 000 per year2. the utilities are expected to reduce by 30 %.3. all the materials are no longer needed.4. All of the equipment can be sold at RM 100 000.5. Maintenance and administrative cost will be apportion to the other 2 departments. 6. Additional cost for closing the department is RM 20 000.7. The sale is RM 1 200 000

Incremental approach.Loss from contribution of deleted department

-

+ cost saving / relevant costSalary 24 000Utilities 12 040Material 34 000Administrative cost -Maintenance -Equipment 100 000Closing cost ( 20 000)Additional cost saving or profit. 150 040

Comparative approach.Continue Delete

Sales 1 200 000 1 200 000

+ incomeProceed from sales of equipment 100 000

- ExpensesSalary 117 000 93 000Utilities 17 200 12 040Materials 99 500 65 500Maintenance 41 700 41 700Administrative cost 56 200 56 200Closing cost 20 000Net profit 868 400 1 011 560

CLOSE

Special order decision

• Management often has to make a decision on whether / not to accept a special order

• Additional orders must be considered on the basis of: 1. price that must be quoted to enable profit 2. whether the other orders be fulfilled if the contract is

accepted• Considerations needed:

1. only those costs that will be affected by taking the order are relevant

2. fixed manufacturing costs are irrelevant 3. should accept the special order if some contribution is

made

ExampleGiven, AB Sdn BhdProduction : 150 000 units Selling price : RM 100 per unit

Operating expenses Marketing expensesFixed - RM 3 000 000 Fixed – RM 1 500 000Variable – RM 40 per unit Variable – RM 10 per unit

- XY Sdn Bhd offered to buy 20 000 units at RM 80 per unit. The delivery cost will be incurred by XY Sdn Bhd. AB Sdn Bhd will not incur any marketing expenses.

Approach 1 : comparative income statementWithout SP With SP Difference

150 000 units 170 000 units 20 000 units150 000 x RM 100 150 000 x RM 100

20 000 x RM 80Income RM 15 000 000 RM 16 600 000 RM 1 600 000Variable expenses• Operating

•Marketing

Fixed expenses• Operating• Marketing

[150 000 x 40]RM 6 000 000

[150 000 x 10]RM 1 500 000

RM 3 000 000RM 1 500 000

[170 000 x 40]RM 6 800 000

[150 000 x 10]RM 1 500 000

RM 3 000 000RM 1 500 000

RM 800 000

-

--

Profits RM 3 000 000 RM 3 800 000 RM 800 000

Approach 2 : incremental approach

Income (20 000 x RM 80) RM 1 600 000Less : variable operating expenses(20 000 x RM 40) RM 800 000Incremental profit RM 800 000

Qualitative effects to be considered

Make / Buy decision• Manufacturing of products may require components to be

incorporated of the products. • The components can either be manufactured / bought in

from suppliers.• Cost of making < cost of buying

~ firm should make the components• Opportunity cost is considered only if there is limited

capacity

example• Cost of manufacturing Component X:DM- RM 4000 Variable O/H- RM 2200DL- RM 800 Fixed O/H- RM 4600

• If production of Component X is undertaken, production of Component Y would be reduced by 4 000 kg result in loss of revenue of RM 2 500. the marginal cost of producing 4 000 kg of processed Component Y is RM 1 500.

• Cost of purchasing Component X : RM 7500

Should the company make / buy Component X ?

Comparison statementCost of manufacturing: DM 4 000 DL 800 V. O/H 2 200 Opp. Cost (2500-1500) 1 000 8 000Cost of purchasing 7 500

- Company should buy Component X since it is cheaper than cost of manufacturing.- The contribution lost from processed Component Y is part of the cost, thus represents the opportunity cost.

Joint input

Common production

process

Product C

Product B

Product A

Separate processing

Separate processing

Separate processing

Final sales

Final sales

Final sales

Joint product

costs

Split-off points

Joint products

Separate product costs

2 / more products that are produced from a

common input

Point at which the joint products can be

recognized as individual units of

output

Joint product costs & the contribution approach

• Using incremental analysis to make short-term 'process further' decisions on whether to sell a product 'as is' or process it further by adding additional costs.

• Incremental analysis helps focus on the relevant parts of a decision.

• Based on the differences between the incremental revenues and the incremental costs.

Sell / Further processing decision

example

Cost of producing 3 products = RM 104 000

PA PB PC

Monthly output (kg) 10 000 5 000 8 000

Further processing (RM) 5.00 3.00 9.00Selling price (RM) : Before FP After FP

11.0015.00

14.0019.00

13.0020.00

Should further process or not?

Solution

PA PB PCSelling price (RM) : Before FP After FP

11.0015.00

14.0019.00

13.0020.00

Incremental revenueLess: Further processing cost

4.00(5.00)

5.00(3.00)

7.00(9.00)

Incremental contribution

(1.00) 2.00 (2.00)

• Further processing of Product PB is the only further processing activity which leads to an increase in contribution• Therefore, should further processing Product PB, but should sell Product PA & PC without further processing

Multi limiting factors in decision making

• As a result of limited supply of resources constraint, a company normally cannot produces as many products as it wish.

• Limited supply of resources can be in many forms: - limited cash, labour time, material / machine

availability & others.• In line with the limited resources, the production

manager therefore needs to plan the production mix in order to maximize its profit.

• To establish the proper production mix, the rule is to rank the products according to the:

CONTRIBUTION PER LIMITING FACTOR

1. Social- Employee’s welfare

- Relationship between suppliers

3. Technology- To improve quality

of products

4. Law & legal- All decisions must

comply the law

2. Surrounding- Image of company

- Quality of environment

5. Competitors & markets expectations of competitor reaction may influence the

price adjustment

4. Product life cycle stages the product life may influence the firm’s pricing

policy (introduction, growth, maturity, saturation &

decline)

1. Organizational goals Selling price must be set to

achieve the goals

2. Product mix if there are multi products, the SP must be set for each

individual product

3. Price / demand relationship

the effect of price elasticity of demand can determine

the optimum price to be set

5. Other pricing strategies

4. Special order pricing

3. Optimum price / output pricing

2. Demand pull pricing

1. Cost & pricing policy

POLICING POLICIES

3. Optimum price / output pricing

4. Special order pricing

For a one off order, where a minimum pricing rule may be applied

Pricing policy where profit is maximized - where MR = MC