AMA-Lecture-5.pdf advance management accounting

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Lecture 5
DECISION MAKING
MANAGEMENT
ACCOUNTING
Dr. Abdullah Hamoud
Main source: Hansen & Mowen (2007). Managerial Accounting (8th ed.). Thomson.

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What is the Decision-Making?
❖ Decision making is choosing among
competing alternatives.
❖ Decision making is one of the core
functions of management.

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The Decision-Making Process
(Decision-Making Model)
1. Clarify the Decision Problem
2. Specify the Criterion
3. Identify the Alternatives
4. Develop a Decision Model
5. Collect the Data
6. Make a Decision
Primarily the
responsibility of the
managerial
accountant.
Information should be:
1. Relevant
2. Accurate
3. Timely

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5. Collect the Data
6. Make a Decision
Relevant
Pertinent to a
decision problem.
Accurate
Information must
be precise.
Timely
Available in time
for a decision

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5. Collect the Data
6. Make a Decision
Qualitative
Considerations

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6. Make a Decision
Select an alternative.
Evaluate decision effectiveness

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Relevant Information
Information is relevant to a decision problem
when . . .
1. It has a bearing on the future,
2. It differs among competing alternatives.

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Importance of Identifying Relevant Costs and
Benefits
1. Generating information is a costly process.
2. People can effectively use only a limited
amount of information. Beyond this, they
experience information overload, and their
decision-making effectiveness declines.

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Relevant Costs
▪ The costs which should be used for decision making
are often referred to as "relevant costs“.
▪ A relevant cost is any cost that can be deemed
avoidable only then making specific business
dictions.
▪ When any business decision is being made, the costs
incurred afterward are relevant costs.
▪ An irrelevant cost is any cost that has already been
paid or accounted for when making a business
decision.

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Relevant costs for decision making
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by
current decisions and they are common to all alternatives that
we may choose.
b) Incremental: ' Meaning, expenditure which will be incurred or
avoided as a result of making a decision. Any costs which
would be incurred whether or not the decision is made are not
said to be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows
and are therefore not relevant. Similarly, the book value of
existing equipment is irrelevant, but the disposal value is
relevant.

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Relevant costs for decision making
Other terms:
Common costs: Costs which will be identical for all alternatives
are irrelevant, e.g. rent or rates on a factory would be incurred
whatever products are produced.
Sunk costs: Another name for past costs, which are always
irrelevant, e.g. dedicated fixed assets, development costs
already incurred.
Committed costs: A future cash outflow that will be incurred
anyway, whatever decision is taken now, e.g. contracts already
entered into which cannot be altered.

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Relevant Costs
Relevant Costs
Relevant costs are future cash flows arising as a
direct consequence of a decision.
(a)Relevant costs are future costs.
(b) Relevant costs are cash flows. => non-cash
flows, so ignore
(c)Relevant costs are incremental or changed
costs. => fixed cost => no change => ignore
(d) Relevant costs are opportunity costs.

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Types of Decisions
Decisions
Operational
Decisions
Tactical
Decisions
Strategic
Decisions
Short-term Long-term

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Types of Decisions
Strategic Decision Making
Is selecting among alternative
strategies so that long term
competitive advantage is established.

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Types of Decisions
Tactical (and operational) Decision
Making
Consists of choosing among
alternatives with an immediate or
limited end in view.

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Decisions Examples
…….
Short-Term Decisions
(Tactical & Operational)
Long-Term Decisions
(Strategic)
Accepting a special production
order
Buying new equipment versus
remodeling old equipment
Determining the best product mix
from current products
Choosing which products to
manufacture
Outsourcing a part or service Expanding into a new area or
country
Further processing or refining a
current product
Diversifying by buying another
business

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A general approach to tactical decision making
includes:
1. Recognize, define the problem
2. Identify alternatives, eliminating those that are
unfeasible
3. Identify costs & benefits
4. Total relevant costs, benefits of each alternative
5. Assess qualitative factors
6. Select alternative with greatest overall benefit
Assess qualitative factors
TACTICAL
MODEL

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Tactical Decision-making- Examples
➢ Make-or-Buy Decisions
➢ Keep or Drop Decisions
➢ Keep or Drop & Replace Decisions
➢ Special order Decisions
➢ Sell or process further Decisions
➢ Pricing Decisions

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Make or Buy Decision is a tactical decision-
making technique wherein the business concerns
choose between – Inhouse Manufacturing
and Subcontracting.
Make or Buy Decision

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Make or Buy Decision is choosing between
manufacturing a product in-house or buying it
from an external supplier.
"Make" signifies carrying out production within
the firm. Whereas "Buy" refers to outsourcing the
complete product or its components.

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⚫ Apple outsources some of its components from
different parts of the world and assembles the
phone in China.
⚫ Due to lower prices, China handles the
production and assembly of many components
of Apple’s products. Apple designs its product
lines in California, manufactures them in
China, and transports them back to the United
States and other regions for sale.

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⚫ The firms can decide among three possible
options:
1- Outsource the complete product from the
supplier.
2- Manufacture the finished product and all its
components internally.
3- Manufacture some parts internally, and
outsource the remaining parts.
Subsequently, assemble all the
components and make the final product.

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Make-or-buy decisions require make-or-buy
analysis.
Make-or-buy analysis is gathering and organizing
data about product requirements and analyzing
them against available alternatives, including the
purchase or internal manufacture of the product.

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Make-or-buy decision analysis analyzes and
compares the cost of manufacturing a product in-
house with the cost of it buying from a supplier.
Many factors affect the make-or-buy decision
analysis.

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Advantages of Make-or-Buy Decision Analysis
⚫ Helps choose the most efficient option to go about in-
house production or outsourcing.
⚫ Helps in the strategic planning of the business.
⚫ Saves Costs: Make-or-buy decisions seek cost-effective
methods in providing a product or service. Therefore,
whether a business chooses to make goods or
subcontract production to a third party, using a make-or-
buy decision method can reduce prices and increase
profitability.
⚫ Access to New Resources: Organizations can use
profits from make-or-buy decisions to expand the
business and gain new resources.

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⚫ Unnecessary Mistakes are Avoided: Make-or-buy
decisions help businesses find the most viable
alternative to clients with knowledge of their capacities.
Mistakes happen when businesses take on more than
they can handle, and a make-or-buy decision helps
avoid this.
⚫ Competitive Advantage: A make-or-buy analysis assists
businesses in gaining a competitive advantage. A
business can focus on its core activity and outsource the
rest. It helps them reduce costs and offers consumers a
better product at a reduced price. It is a competitive
advantage.

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⚫ Unnecessary Mistakes are Avoided: Make-or-buy
decisions help businesses find the most viable
alternative to clients with knowledge of their capacities.
Mistakes happen when businesses take on more than
they can handle, and a make-or-buy decision helps
avoid this.
⚫ Competitive Advantage: A make-or-buy analysis
assists businesses in gaining a competitive advantage.
A business can focus on its core activity and outsource
the rest. It helps them reduce costs and offers
consumers a better product at a reduced price. It is a
competitive advantage.

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When to Make?
Firms choose to make the product/components internally
when it is more economical compared to outsourcing.
Besides, it is preferred when firms want to
achieve complete control over the process.

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Reason to Make
⚫ Less cost
⚫ Quality concerns
⚫ Desire to enhance the manufacturing focus
⚫ Intellectual property concerns
⚫ Integration with the ongoing system
⚫ Absence of the supplier’s availability and reliability
(Inadequate supply of qualified suppliers)
⚫ Optimum utilization of the available resources
⚫ Risk Minimization
⚫ Emotional Motives
⚫ Political considerations

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Criteria for Make
⚫ The cost of the finished product or service
is lower than the offer price of the suppliers.
⚫ Only a limited number of suppliers produce the
demanded product. Moreover, the current supply is
unable to meet the market demand.
⚫ The manufacturing firm doesn’t compromise the quality
of the product or its parts.
⚫ The current facility for manufacturing other items is
sufficient for producing the demanded product or its
parts.

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When to Buy?
⚫ The firms choose to purchase the product, materials or
components externally when it is less costly than
creating it in-house. It is preferred, especially when the
firm aspires to utilize the supplier’s skills and expertise.

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Reasons to Buy
⚫ The following reasons divert manufacturers toward Buy
decision:
⚫ Avail advantages of multiple sourcing
⚫ Insufficient or no manufacturing capacity (Lack of Facilities)
⚫ Fewer units of products in required (Low Demand Quantity)
⚫ Lack of skills and expertise
⚫ Cost considerations (cheaper to buy the item)
⚫ Reduced exposure to risk
⚫ Preferences for certain brands
⚫ Product or service that is not essential to the core business.

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Criteria for Buy
⚫ Manufacturing the product or its parts involves massive
investments. Therefore, the firms prefer to procure the
products from suppliers’ plants.
⚫ The firm does not have sufficient production facilities.
Besides, the firm’s capital can be utilized in other profitable
sources.
⚫ Firms can manufacture other parts efficiently with the
available resources, including facilities.
⚫ The existing human resources don’t have the required
skills to manufacture the product/parts.
⚫ Firms may face some legal issues that restrict them from
producing the required product/part.
⚫ The demand for the required product is seasonal or
temporary.

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Example-1
Suppose Z ltd., a bicycle manufacturing firm, is
planning to launch a sports bicycle.
Top-level management is stuck in a dilemma to
make this cycle in-house or subcontract it.
Continued
Make-or-Buy Decision

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Example-1
Let’s look at the cost of both alternatives.
Alternative: 1
Z ltd. can use the existing machinery for production with some
additional raw materials. They can complete the overall
production of 10 bicycles for $7000.
Alternative: 2
They can also purchase bicycle parts from external suppliers
(industry experts). After assembling all the parts, the total cost
of 10 bicycles is $7400.
Decision:
Z ltd. decided to produce the sports bicycle in-house. The
decision is based on the fact that the total cost of production is
less than subcontracting.

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Swasey Manufacturing currently produces an
electronic component used in one of its printers. In
one year, Swasey will switch production to another
type of printer, and the electronic component will not
be used. However, for the coming year, Swasey must
produce 10,000 of these parts to support the
production requirements for the old printer.
Swasey has been approached by a potential supplier
of the component. The supplier will build the electronic
component to Swasey’s specifications for $4.75 per
unit.
Continued
Example-2

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43
A check with the receiving dock elicited the
information that the receiving and inspecting
crew was at capacity. An additional purchase of
this magnitude would require hiring an additional
half-time employee for the year at a cost of
$8,500. The Purchasing Department had
sufficient excess capacity to handle the
purchase of the component; thus, no additional
cost would be incurred there.
Should Swasey Manufacturing make or buy the
component?
Continued
Example-2

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Total
Cost
Unit Cost
Equipment Rent $ 12,000 $ 1.20
Equipment depreciation 2,000 0.20
Direct materials 10,000 1.00
Direct labor 20,000 2.00
Variable overhead 8,000 0.80
General fixed overhead 30,000 3.00
Total $ 82,000 $ 8.20
Unit costs are
calculated on the
basis of producing
10,000 printers.
Continued
Example-2

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45
Step 1: Define the problem Have component available for old
printer
Step 2: Identify alternatives 1. Make component
2. Buy component
Step 3: Identify costs, benefits 1. Make: $8.20
2. Buy: $4.75
Step 4: Total relevant costs &
benefits
Omit depreciation & allocated
fixed factory overhead.
Step 5: Assess qualitative factors ?
Step 6: Make decision ?
Example-2

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46
Basically, the offer sounds very attractive since the full
manufacturing cost per unit is $8.20.
But, more analysis should be done
Example-2

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Make Buy Cost to Make
Equipment Rent $ 12,000 --- $ 12,000
Direct materials 5,000 --- 5,000
Direct labor 20,000 --- 20,000
Variable overhead 8,000 --- 8,000
Purchase cost --- $ 47,500 (47,500)
Receiving Dept labor --- 8,500 (8,500)
Total $ 45,000 $ 56,000 $ (11,000)
Alternatives Differential
A listing of the total relevant costs for each alternative follows:
Example-2

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The analysis shows that making the product is
$11,000 cheaper than buying it.
The offer of the supplier should be rejected.
Example-2

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Make Buy Cost to Make
Equipment Rent $ 12,000 --- $ 12,000
Direct materials 5,000 --- 5,000
Direct labor 20,000 --- 20,000
Variable overhead 8,000 --- 8,000
Purchased cost --- $ 47,500 (47,500)
Receiving Dept labor --- 8,500 (8,500)
Total 45,000 56,000 (11,000)
Cost per Unit $ 4.5 $ 5.6 $ 1.1
Alternatives Differential
The same analysis can be done on a unit-cost basis.
Example-2

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Thus,
Because Swasey Manufacturing must hire
labor to staff the receiving department, buying
the component will cost $5.60 per unit.
So, Swasey should produce the component
because the component requires $4.50 in
relevant production costs per unit.
Example-2

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AlexCo produces collapsible wagons that are popular with
beachgoers, shoppers, gardeners, and parents. Annual sales have
been 100,000 wagons per year. The retail selling price of each
wagon is $67.00. To date, AlexCo has produced each of the
components used in making the wagons but has been approached
by DAL, Inc. with an offer to provide the axle and wheel assembly for
$18.75 per assembly. AlexCo’s costs to produce the axle and wheel
assembly are $9.00 in direct materials, $6.50 in direct labor, $3.57 in
variable overhead, and $2.50 in fixed overhead. Twenty-five percent
of the fixed overhead is avoidable if the assembly is produced by
DAL.
Should AlexCo continue to make the axle and wheel assembly or
should it buy the assembly from DAL, Inc.?
Example-3

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Solution
Ignoring qualitative factors, it would be more cost effective for AlexCo to
buy the axle and wheel assembly from DAL, Inc. However, AlexCo should
be certain of any qualitative issues and not solely base their decision on
the quantitative analysis.
Example-3

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Keep-or-Drop Decision
⚫ Sometimes when a business sees that a
product, department, or location is losing
money, the first reaction is to shut it down.
⚫ Discontinuing operations is a decision that
should only be taken after careful
consideration and number crunching.
⚫ When deciding to keep or drop a part of the
company, the first thing to do is to create an
income statement broken into segments.

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Norton Materials produces 3 products: blocks,
bricks, and tile. The tile segment has a negative
segment margin and does not contribute to
common fixed expenses.
The controller has prepared the following
estimated income statement for 2008 (in
thousands of dollars):
Example-1
Continued

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Blocks Bricks Tiles Total
Sales $ 500 $ 800 $ 150 $ 1,450
Less Variable exp. 250 480 140 870
Contribution margin $ 250 $ 320 $ 10 $ 580
Less direct fixed exp
Advertising $ 10 $ 10 $ 10 $ 30
Salaries 37 40 35 112
Depreciation 53 40 10 103
Total $ 100 $ 90 $ 55 $ 245
Segment margin $ 150 $ 230 $ (45) $ 335
Less Common fixed exp 125
Operating income $ 210
Continued
Example-1

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Should Norton drop the tile division
Example-1
?

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58
Step 1: Define the problem Tile division does not contribute to
common fixed expenses
Step 2: Identify alternatives 1. Keep division
2. Drop division
Step 3: Identify costs, benefits 1. Keep: saves $10,000 CM
2. Drop: eliminates $45,000
segment loss
Step 4: Total relevant costs &
benefits
Should loss of other sales be
considered?
Step 5: Assess qualitative factors
Step 6: Make decision
Example-1

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NORTON: President’s Analysis (000)
Keep Drop
Keep
Difference
Sales $ 150 --- $ 150
Less Variable exp. 140 --- 140
Contribution margin $ 10 --- $ 10
Less Advertising exp (10) --- (10)
Cost of supervision (35) --- (35)
Total benefit (loss) (35) --- (35)
President’s
analysis suggests
that Tile should
be dropped.
Example-1

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Can the Tile Division be
dropped with no effect on
other divisions?
No. Dropping tiles will
decrease sales of both blocks
and bricks.

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NORTON: Marketing Perspective (000s)
Keep Drop
Keep
Difference
Sales $ 1,450 $ 1,186.0 $ 264.0
Less Variable exp. 870 666.6 203.4
Contribution margin $ 580 $ 519.4 $ 60.6
Less Advertising exp (30) (20.0) (10)
Cost of supervision (112) (77.0) (35)
Total benefit (loss) $ 438 $ 422.4 $ 15.6
Marketing’s
analysis suggests
that Tile should
be kept.
Example-1

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Can the Tile Division be
changed to produce floor tile
for a profit?
Yes. However it might not be
as profitable as the current
product mix.

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NORTON: Production
Perspective (000s)
Keep
Drop &
Replace
Keep
Difference
Sales $ 1,450 $ 1,286.0 $ 264.0
Less Variable exp. 870 706.6 203.4
Contribution margin $ 580 $ 579.4 $ 0.6
Production’s
replacement
suggestion is not
as profitable as
keeping ceiling
tiles.
Example-1

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Because Norton will lose sales in
both blocks and brick if ceiling
tiles are dropped and replacing
ceiling tiles with floor tiles is less
profitable, the firm is better off to
keep the ceiling tile division.
Example-1
Final Decision

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Keep or Drop & Replace
Decision

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Keep-or-Drop & Replace Decision
⚫ A company may consider replacing a fixed
asset it currently owns and operates with one
that is more efficient to reduce operating costs.
⚫ The company can use differential analysis to
compare the cost of keeping its original asset
and the cost of replacing it with something
new.

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⚫ The Replacement Decision analysis or Keep &
Replace analysis is used to make decisions
related to keeping and maintaining existing
equipment or facilities or replacing aging
equipment with new equipment or facilities.

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Replacement Decision Examples
A hospital has an old X-Ray machine which
breaks down on a regular basis. Should they
replace the old equipment with a new, more
productive X-Ray machine?
1

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A city is continually repairing an aging wooden
bridge. Should they:
a) Keep fixing the bridge?
b) Replace with a new wooden bridge?
c) Replace with a steel bridge?
2

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A manufacturing Co. is considering replacing aging
production equipment used to produce plastic bottles with
a more technologically advanced model which will result
in:
⚫ Less rejected products resulting in lower manufacturing costs
per unit
⚫ The new computerized system allows faster set up and less
down time
⚫ Increase in sales because of increased production capacity
⚫ Lower labor costs per unit
Should they invest in the new equipment?
3

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A city is considering whether to replace the
traditional parking meters with parking meter
stations which requires a substantial investment
but will generate additional revenue and reduce
labor costs.
Should they replace the parking meters with
parking meter stations?
4

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McNamara Company is considering selling an existing
piece of equipment for $75,000 and replacing it with
new equipment that will cost $182,000.
The old equipment cost $200,000 and currently has
accumulated depreciation of $120,000.
The estimated annual variable operational costs for the
next six years are $21,000 for the old equipment and
$6,000 for the new equipment.
Should McNamara keep and operate the original
equipment, or replace it with a new equipment?
Example-1
Keep-or-Drop &Replace Decision
Continued

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Example-1
Keep-or-Drop &Replace Decision
Differential Analysis
Keep Replace Difference
Revenue 75,000
$
Costs:
Purchase price 182,000
Operating costs 126,000
$ 36,000
Income (loss) (
126,000
$
( (
143,000
$
( 17,000
$
▪ Replacing the equipment will generate revenue from the sale of the original
asset, but the cost of acquiring the new asset will also be incurred.
▪ Each alternative has different annual operating costs.
▪ The purchase price of the original equipment is a sunk cost that will not be
recovered or changed regardless of the decision; therefore, it is ignored.
▪ Each alternative independently generates a loss, so the choice with the lower
loss is preferable.
So, the company should keep and operate the original equipment.

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Special Order Decision
Special Order Decisions focus on whether a
specially priced order should be accepted or
rejected.

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Example-1
An ice cream company is operating at 80% of its
20 million gallon capacity.
The total costs associated with producing and
selling 16 million units are as follows (in thousands of
dollars):
Continued

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Example-1

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Example-1
The company receives an order to purchase 2
million gallons for $1.55 per gallon. This is below
the wholesale price of $2.00.
Should the company accept the order
?

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79
Step 1: Define the problem Is a special order profitable with excess
capacity?
Step 2: Identify alternatives 1. Accept
2. Reject
Step 3: Identify costs, benefits With excess capacity, opportunity for
profit
Step 4: Total relevant costs & benefits Will the price cover variable product
costs
Step 5: Assess qualitative factors
Step 6: Make decision
Example-1

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Accept Reject
Benefit
Difference
Sales $ 3,100 --- $ 3,100
Dairy ingredients (1,400) --- (1,400)
Sugar (200) --- (200)
Flavoring (300) --- (300)
Direct labor (500) --- (500)
Packaging (400) --- (400)
Other (100) --- (100)
Profit $ 200 --- $ 200
Using relevant
information, the
special order
adds $200,000 to
profit.
Example-1

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Example-1
The company will accept the order.
Final Decision
Even though the special order price for 2 million
gallons of ice cream is below the normal selling
price of $2.00, it will be profitable because there
is spare capacity and only relevant variable costs
are considered in the decision.

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