Cost Management

Concepts and Tools

for Decision
Making
STRATEGIC BUSINESS ANALYSIS
INSTRUCTRESS: NELSIE GRACE PINEDA
Scope
A. Relevant Costs for Non-Routine Decision Making
B. Quantitative Techniques for Decision Making
C. Capital Investment Decision
 Relevant Costs for
Non-Routine Decision
Making
Objectives
a) Describe the decision-making process
b) State the general rule for distinguishing between relevant and
irrelevant costs in a decision making situation
c) Identify sunk costs and explain why they are not relevant in decision
making
d) Identify opportunity costs as well as out of pocket expenses
e) Apply the incremental analysis approach in decision making
f) Make appropriate computations to determine the optimum utilization
of scarce resources
THE DECISION MAKING
PROCESS
Decision making – the process of studying and evaluation two or more available
alternatives leading to a final choice
Steps:
1. Define strategies: business goals and tactics to achieve them
2. Identify the alternative choices or courses in action.
3. Collect and analyze the relevant data on the choices
4. Choose the best alternative to achieve goals
IDENTIFYING RELEVANT COSTS
Any cost that is avoidable is relevant for decision purposes.
Avoidable cost – cost that can be eliminated (in whole or in part) as a
result of choosing one alternative over another in a decision-making
situation. All cost are considered avoidable, except;
1. sunk costs
2. future costs that do not differ between alternatives at hand
IDENTIFYING RELEVANT COSTS
Relevant Costs – expected future costs which differ between the
decision alternatives. These are the cost that will be increased or
decreased as a result of a decision
Involves the ff. analytical steps:
1. Determine all costs associated with each alternative being
considered
2. Drop those costs that are sunk or historical
3. Drop those costs that do not differ between alternatives
4. Make a decision based on the remaining costs.
IDENTIFYING RELEVANT COSTS
Sunk Cost or Historical Costs – never relevant in decision making
because they are not avoidable and therefore they must be eliminated
from the manager’s decision framework
Opportunity Costs
the profit lost by the diversion of an input factor from one use to
another.
they are the net economic benefit given up when an alternative is
rejected
IDENTIFYING RELEVANT COSTS
Out-of-pocket costs – involve either an intermediate or near future
cash outlay.
They are important in decision making because management should
determine whether a proposed project would, at the minimum return
is initial cash outlay
Example:
On December 31,20X3, Company A completed the construction of a
new P900,000 machine. On January 3, 20X4, a salesman from an
equipment supplier offered to sell the company an P800,000
machine that can replace the constructed machine and provide
operating savings of P200,000 per year for the next five years (the
life of both machines). The machine built by Company A has no
salvage value. Which costs are relevant?
Approaches in Analyzing
Alternatives in Nonroutine
Decision Making
Two commonly used approaches are:
A. Incremental or Differential Analysis approach
 Contrasts choices by comparing differential revenues, differential
costs and differential contribution margin
Steps:
1. Gather all costs associated with each alternative
2. Drop the sunk costs and non-differential costs
3. Select the best alternative based on the remaining cost data
Approaches in Analyzing
Alternatives in Nonroutine
Decision Making
Two commonly used approaches are:
B. Total Project Analysis approach or Comparative Statements
approach
 Shows all the items of revenue and cost data (whether they are
relevant or not) under the different alternatives and compares
the net income results.
 Comparative income statements under this approach are
prepared in a Contribution format.
SHORT RUN VS LONG RUN:
OTHER FACTORS TO CONSIDER
In making the final decision, long run factors should be consider:
1. What will be the impact on customers?
2. Should regular customers find out about the special price? Will
they complain at paying more?
3. How will competitors react?
TYPES OF DECISIONS
1) Make Or Buy
2) Add Or Drop A Product or Other Segments
3) Sell Now or Process Further
4) Special Sales Pricing
5) Utilization of Scarce Resources
6) Shut-down or Continue Operations
7) Pricing
MAKE OR BUY
The Make-or-Buy decision is a management decision about whether an
item should be made internally or bought from an outsider supplier. To
put idle capacity to use, firms often consider manufacturing a part or
subassembly they are currently purchasing. For example, a watch
company might use its idle capacity to produce its own bands or bracelet.
Or a company that manufactures cars might use its idle capacity to
manufacture its own stock absorbers instead of buying them from an
outside supplier.
When these opportunities arise, the managerial accountant is often asked
to compare the cost of manufacturing a part internally with the cost of
purchasing it.
ADDING OR DROPPING
PRODUCTS/SEGMENTS
Over time, consumer’s preferences change. Some products become
obsolete and are dropped from product lines, other are developed to
replace them. When management is considering dropping a product
line or customer group, the only relevant costs are those that a
company would avoid by dropping the product or customer. An
important factor in deciding whether to add or drop a product is the
decision’s effect on operating income.
SELL OR PROCESS FURTHER
Firms that produce several end products from a common input are faced with
the problem of deciding how the joint product cost of that input is going to be
divided among the joint products.
Joint product costs are irrelevant in decisions regarding what to do with a
product from the split off point forward because they have already been
incurred and therefore are sunk costs. Cost incurred after the split-off point for
the benefit of only one particular product are called separable costs. They are
relevant costs in the sell-or-process-further decision.
It will always be profitable to continue processing a joint product after the split-
off so long as the incremental revenue from such processing exceeds the
incremental processing costs.
SPECIAL SALES PRICING
Managers often evaluate whether special order should be accepted
or if the order is accepted, the price that should be charged.
A special order is a one-time order that is not considered part of the
company’s ongoing business. Managers may be asked to consider
accepting special order for their product at a reduced price to make
use of the excess or idle facilities. Such orders are worth considering,
provided they will not affect regular sales of the same product.
 UTILIZATION OF SCARCE
RESOURCES
Managers are routinely face with the problem of deciding how scarce resources are
going to be utilized. When the capacity becomes pressed because of a scarce
resource, the firm is said to have a constraint. Because of the constrained scarce
resource, the company cannot fully satisfy demand, so the manager must decide how
the scarce resource should be used.
Fixed costs are usually unaffected by such choices, so the manager should select the
course of action that will maximize the firm’s total contribution margin.
Contribution in Relation to Scarce Resources
◦ To maximize total CM, a firm should not necessarily promote those products that have the
highest contribution margins per unit. With a single constrained resource, the important
measure of profitability is the contribution margin per unit of scarce resource used.
The Problem of Multiple
Constraints
Several constraints???
Limited availability of raw materials
Limited direct labor/manpower
Limited capital
 Problem solving become complex
 Typically solved by computer
 use quantitative technique like linear programming
 SHUTDOWN OR CONTINUE
OPERATIONS
The shutdown point may be used as a guide in making decision whether to continue
operating or shutdown temporarily.
The decision to continue operation or shut down will depend upon the expected
sales of the company in comparison with the shutdown point of units computed as
follows:
Shutdown point = fixed costs under continued operations –
shut down costs
◦ Contribution Margin per unit
Shutdown costs – costs that the company will incur if it shuts down its operations.
PRICING PRODUCTS AND
SERVICES
The pricing decision can be critical because:
1. The prices charged for a firm’s products largely determined the
quantities customers are willing to purchase; and
2. the prices should be high enough to cover all the costs of the firm
Cost-Plus Pricing
Formula:

Products however, may be costed in at least two different ways:

1. By the absorption approach where the cost base is defined as the cost of
manufacture one unit and therefore excludes all selling and
administrative expenses
2. By the contribution approach where cost base consists of all the variable
costs associated with a product including variable selling, general and
admin expenses (SGA)
 DETERMINING THE MARKUP
PERCENTAGE
To facilitate the computation of selling price, formulas can be used to determine the
appropriate markup percentage assuming that the desired Return on Investment (ROI) and
unit sales volume are given.
Under the absorption approach to cost-plus pricing:

Under the contribution approach to cost-plus pricing:

TARGET COSTING
This pricing approach is used when company will already know what price
should be charged and the problem will be to produce the product that can be
marketed profitably.
Target costing – 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.

Formula:
END