Chapter V.

Accounting for Decision Making

Decision making means choosing from at least two alternative courses of action. In making decisions, they choose the
alternative course of action that will be most beneficial to the company or the alternative that will contribute to the
attainment of the organization’s objectives.

Decision-Making Process:
1. Defining the problem
2. Setting of criteria
3. Identifying the alternative courses
4. Determination of possible consequences of the alternatives
5. Evaluating the alternatives
6. Choosing the best alternative and making decision

Qualitative and quantitative factors in decision making

1. Quantitative factors: outcomes measured in numerical terms

2. Qualitative factors: outcomes that cannot be measured in numerical terms

Types of costs used in decision making

A. RELEVANT COSTS – future cost that are expected to be different under each alternative course of action.

B. DIFFERENTIAL COSTS – refer to the increases (increments) or decreases (in total costs between two alternatives)

C. AVOIDABLE COSTS – costs that will be saved or those that will not be incurred if a certain decision is made.

D. OUT OF POCKET COSTS – costs that require current or near future cash outlays or incurring of a liability for a
decision at hand.

E. OPPORTUNITY COSTS – income or benefit sacrificed or forgone when an alternative is chosen.

F. IMPUTED COSTS – assumed or hypothetical costs representing the cost or value of a resource that is utilized for a
specific purpose.

G. SUNK COSTS/HISTORICAL COST – non-recoverable costs incurred in the past.

H. JOINT COSTS – usually encountered in “process further or sell-as-is” problems.

Decisions involving alternative choices

1. Make or buy: choosing between producing an item or buying it from outside suppliers
➢ Should a part be manufactured or bought from a supplier?
➢ Decision Rule: Choose the lower cost option

2. Accept or reject: involves decision whether to accept or reject a special order or one-time order which usually
involves larger volume and a discounted lower sales price.
➢ Should a discount-priced order be accepted when there is idle capacity?
➢ Decision Rule: If Regular Sales are not affected, accept special order when revenue exceeds incremental cost.

3. Continue or discontinue operating a business segment: encountered by some business engaged in producing
and/or selling multiple products, or by some business establishments which are composed of different profit
centers.
➢ Should a segment of the company, such as a product line, be terminated?
➢ Decision Rule: Maintain segment as long as segment margin is positive

4. Best product combination or Utilization of Scarce Resources

➢ Which product(s) should be emphasized when there is limited capacity?
➢ Decision Rule: Prioritize products with the greatest contribution margin per scarce resources
 5. Sell or process further
➢ Decision Rule: Process Further if incremental revenue exceeds incremental cost

6. Temporary shutdown
➢ Decision Rule: If the expected sales figure is greater than the shutdown point, the decision is to continue
operating. If the expected sales level is less than the shutdown point, the decision is to shut down operations.

7. Pricing decisions
A. Cost-plus Pricing
- Price of the product or service should cover all the costs that are traceable to the product and service,
variable as well as fixed.
Target Selling Price = Cost + (Markup Percentage x Cost)

B. Target Costing
• This pricing approach is used when the company will already know what price should be charged and the
problem will be to produce the product that can be marked profitably.
• It is the process of determining the maximum allowable cost for a new product and then developing a sample
that can be profitably manufactured and distributed for that maximum target cost figure.
Total Cost = Anticipated Selling Price – Desired Profit

PROBLEMS

Make or Buy
B Inc. makes a range of products. The company's predetermined overhead rate is 14 per direct labor-hour, which was
calculated using the following budgeted data:
Variable manufacturing overhead 100,000
Fixed Manufacturing overhead 250,000
Direct Labor Hours 25,000
Material X is used in one of the company's products. Each year, B Inc. needs 1,000 units of Material X. This material is
currently produced by B. The unit cost of the material according to the company's cost accounting system is determined
as follows:

Direct Materials 28.0

Direct Labor 56.0
Manufacturing Overhead Applied 39.2
Unit Product Costs 123.2

An outside supplier has offered to supply Material X at 108 each. The outside supplier is known for quality and reliability.
Variable manufacturing overhead is driven by direct labor-hours and total fixed manufacturing overhead would not be
affected by this decision.

➢ Should the company accept the offer of the outside supplier?

➢ Assuming B could rent out the facilities dedicated to the production of Material X to another company and would
give them additional income of 20,000, should B accept the offer?

Special Order
D Incorporated manufactures and sells a single product called Product A. The cost of producing a single unit of Product A at
the company’s normal activity level of 20,000 units is as follows:
Direct Materials 40
Direct Labor 30
Selling and Administrative Expense 10
Fixed Overhead 15
Variable Overhead 12
The normal selling price of Product A is 150 per unit.
The company received a special order for 2,000 units of Product A at 120 each during the month. For this particular order,
no selling and administrative expense will be incurred and fixed overhead costs would be unaffected. However, the buyer
requested for some modifications to the product which would increase direct materials cost by 2 per unit.

➢ If the company has excess capacity, should the company accept the special order?
➢ Assuming that accepting the special order would mean sacrificing 500 units of sales to normal customers,
what would be the minimum acceptable price of the special order?
Continue or Discontinue Operation
X Incorporated provided the following data with respect to one of their products, Product C:

Sales 30,000
Variable Expenses 20,000
Contribution Margin 10,000
Fixed Expenses:
Rent 1,500
Depreciation 1,800
Utilities 1,500
Supervisors’ Salaries 3,000
Maintenance 900
Administrative Expense 5,000
Total Fixed Expenses 13,700
Net Operating Income (3,700)

The following additional information is available:

a. The factory rent of 1,500 assigned to Product C is avoidable if the product were dropped.
b. The company's total depreciation would not be affected by dropping C.
c. Eliminating Product C will reduce the monthly utility bill from 1,500 to 800.
d. All supervisors' salaries are avoidable.
e. If Product C is discontinued, the maintenance department will be able to reduce monthly expenses by 1,000.
f. Elimination of Product C will make it possible to cut two persons from the administrative staff; their combined
salaries total 3,000.

➢ Should Product C be eliminated?

Best product combination or Utilization of Scarce Resources

G Company makes three products in a single facility. These products have the following unit product costs:

Product A Product B Product C

Selling Price 150 110 90
Direct Materials 40 25 40
Direct Labor 30 20 10
Variable Manufacturing Overhead 20 12 10
Fixed Manufacturing Overhead 15 15 15
Direct Labor Hour per unit 1.5 1.0 0.5

Based on the current work force, total direct labor hours available for the company is 10,000 hours annually.

➢ Assuming no demand restrictions, which product shall the company prioritize?

➢ Assuming demand for Product A is 5,000, for Product B is 4,000 while for Product C is 3,000, how many units of
each product should be produced to maximize profit?

Sell or process further

M Incorporated produces two products (Product A and Product B) from a common material. Product A can be further
processed to produce Product X while Product B could be further processed to produce Product Y. The common material
costs 50,000 while the processing cost to produce A and B amounts to 60,000.

Product A could be sold at 50 per unit, but if processed further at a cost of 30 to create Product X, it could then be sold at
100.

Product B could be sold at 60 per unit but if processed further at a cost of 25 to produce Product Y, it could be sold for 80.

➢ Product A and Product B be sold as is, or should it be processed further to produce Product X and Product Y?