CA BUSINESS SCHOOL
POSTGRADUATE DIPLOMA IN BUSINESS AND FINANCE
SEMESTER 1 : FINANCIAL PLANNING AND CONTROL
Special Decision Making
[best use of Management Accounting]
M B G Wimalarathna
[FCA, FCMA, MCIM, FMAAT, MCPM][MBA–PIM/USJ]
Introduction
Key management personnel of most manufacturing entities are taking
useful short term specific decision by using data/information
produced by the costing/management accounting system.
Most of these decisions will be taken based on the relevant cost
(relevant income). Relevant cost is the cost which specifically arise
based on the decision of the management or any cost that will have to
incur due to decision undertake by the management.
Relevant cost will be either one of the following two or both.
 Incremental cost : element of cost which will increase due to
management decision. It is certain that variable costs surrounds the
decision will increase while possibility for fixed costs too.
 Opportunity cost : value of the benefit forgone from next best
option due to selection of the best option in the given circumstance.
Relevant Vs. Irrelevant Cost
Following will be treated as non-relevant cost in the event of short
term specific decision making. (should not be considered)
 Sunk cost : already incurred. Will not change based on the
decision.
 Committed cost : already committed to pay in the future based
on past decision. (moreover sunk cost)
 Notional cost : not a real cost. Instead it will indicate the cost of
using resources in the business. (depreciation/amortization)
 Absorbed fixed overheads : fixed overheads which have already
agreed to absorb based on pre determine rates. This should not
be the actual incremental fixed costs identified in above.
Relevant Cost of Materials
It is important to ascertain the relevant cost of raw materials in the
event of special decision making mostly in manufacturing entity.
 Replacement cost : when such raw materials can use for another
production, it has to replace.
 Resale value
:raw materials cannot use in other production
but they can sell in the market if not use (scrap).
 No relevant cost
:when no other possible use and/or no resale
value of the raw materials, there is no cost of using such R/M.
 Relevant income
:when entity expected to incur some cost at
the event of removing raw materials in future, such value should
be treated as relevant income in the production since such raw
materials used now in the production.
Qualitative Factors in Decision Making
 Availability of cash (at now and capability of getting when need arise)
 Key economic factors (macro)
 Legal constraints (BOI/TRC/CEA)
 Current market position and expected trend
 Pressure from the employees/unions
 Competition in the market (existing and prospective)
 Power of the suppliers/trust between each parties
 Reaction of the key customers/existing key suppliers
 Behaviour of the shareholders & other stakeholders
 Threat to the overall goodwill/image of the company
 Perception of the key management personnel
 Degree/level of impact with PEST factors
Types of Short Term Decisions
By considering above relevant costs and relevant income along with
qualitative factors, key management attempt to take following short term
decisions.
 Determining best sales mix when resources are limited
 Make or Buy decision
 Accept or Reject (orders) decision
 Shutdown or Continue decision
 Decision on working extra shift or not
Types of Short Term Decisions (Contd.)
 Determining best sales mix with limiting factors
An entity attempts to maximize its overall profit by determining most
productive limiting factors and profitable sales mix.
Limiting factor : any factor (resource) which is scares/limited at
current and limit the activities of an entity accordingly.
Key steps;
1. Identify the limiting factor
2. Determine the contribution per unit of each product
3. Determine the number of units required from limiting factor
4. Calculate the contribution per limiting factor
5. Rank the products based on results on above 4 (max ~ min)
6. Determine the sales/production mix in line with above 5
(Maximum units of production should be the demand from market)
Types of Short Term Decisions
 Make or Buy decision
Determining the best. Total relevant costs incurred in manufacturing
in-house compare with available best price (to buy) in the market.
(sometimes this could even consider with limiting factors)
Following costs should consider as relevant when do in-house;
1. Incremental/relevant cost : VC + any incremental FC
2. Opportunity cost : value of contribution foregone that would have
earned by deploying resources in other production which used to
do in house now.
Following qualitative factors also to be noted;
a. Trustworthy/strong relationship of the supplier
b. Quality of the products (confidence built among customers)
c. Fluctuations of the prices
d. Actions and reactions of the existing employees(union)
e. Effect to the corporate image/goodwill
Types of Short Term Decisions
 Accept or reject the orders
An entity considers special order received from the external buyer
(customer) for the product/service which is not entity is manufacture
and sell frequently.
For the evaluation purpose, this could be divided into;
1. Fulfil the order within existing capacity
2. Extra capacity need for the fulfilment of the order
When
revenue
received
from
the
order
exceeds
incremental/relevant costs of the order, entity will proceed with the
order and vice versa. (need considers qualitative factors too)
Relevant cost : VC + Op. Cost
(any loss of the contribution enjoyed from
other products at current)
Note : in above 2, additional Fixed Costs will also be part of relevant cost.
Types of Short Term Decisions
 Shutdown the product/line of business or continue decision
Shutdown of a particular production line and/or a product or
continue will be at a question.
Decision will be taken based on the revenue recognized by an entity
being operating such production line/producing product as opposed
to relevant costs incurred in such an event.
Relevant cost : VC + Op. Cost + additional FC
Opportunity cost will be the loss of contribution that would have
earned if resources utilized in this event deployed in another
production line and/or producing another product.
Types of Short Term Decisions
 Decision on working extra shift or not
Decision as to whether do additional extra shift in order to fulfil the
customers’ need or not.
Decision will be taken based on the revenue recognized by an entity
being engaging extra shift as opposed to relevant costs incurred in
the event of engaged in extra shift.
Relevant cost : VC + Op. Cost + additional FC
Opportunity cost will be the loss of contribution that would have
earned if resources utilized in this event deployed in the production
of another product.
Exercise:
Variable Costs of manufacturing one unit of “X” & “Y” will be as
follows. All figures are in LKR.
DM
DL (LKR 5 Per hour)
VOHs
X
20
10
20
Y
30
15
25
Selling price of one unit of X & Y are LKR 80 and LKR 100 respectively.
Total labour hours are limited to 18,000. Expected sales of X & Y are
3,000 units and 5,000 units respectively.
a. Determine the profit maximization sales mix
b. Calculate the profit/loss if fixed cost is LKR 110,000 based on the
above sales mix
c. If additional labour is available, calculate the maximum rate per
hour that company can afford to obtain such additional labour
Exercise:
Cost structure of manufacturing one unit of “Y” will be as follows;
DM
DL
VOHs
FOHs
LKR
350
280
170
150
Total capacity is 1,000 units. External supplier has agreed to deliver
the product Y at LKR 825
a. Determine whether make or buy product Y
b. If company incurred an additional Fixed Costs of LKR 12,000 to
produce Y, will the decision in above (a) be changed?
c. If company can manufacture product Z using resources allocated
to manufacture Y and if Z gives contribution of LKR 75 per unit,
will the decision change? Additional Fixed Costs of LKR 35,000 will
be incurred in producing Z and total quantity is 1,000 units. Details
in above (b) will remains unchanged.
Exercise:
ABC & company is currently engaged in manufacturing product “A”
at its factory. One unit of A will be sell at LKR 60 and variable costs of
manufacturing one unit of A is LKR 40.
Special order received from the customer for 1,000 units of A.
customer agreed to pay LKR 45 per unit.
As a result of the accepting new order, existing production will be
lose by 200 units.
a. Determine whether to accept or reject the order.