10.2 Decision making based on relevant costing principles

Question 1

There are many decisions that an org might have to make which will either be

Answer 1

• To solve short term problems (scarcity of resources) or once-off in nature (close a division)
• Marginal costing principles are used for short term decision making purposes because it focuses on contribution and not profits
• If a decision is to be made it is sensible to only take into account the costs that will be affected in short term (variable) and not the costs that will remain unchanged (fixed costs)

Question 2

Types of decisions include:

Answer 2

• Limiting factor decisions
• Make or buy decisions
• Discontinuation (shutdown) decisions
• Special selling price decisions
• Further processing decisions

Question 3

Limiting factor decisions

Answer 3

• A limiting factor is a resource that prevents an org from achieving the output and sales that it would like to achieve
• Org will often operate under short term restrictions on resources
• Therefore might not be possible to produce all products that make a positive contribution and will need to priortise and choose between them

Question 4

Single limiting factor

Answer 4

• If there is a single limiting factor then the rule is to maximise the contribution per unit of scarce resource

Question 5

Technique for one limiting factor

Answer 5

• Step 1: Identify the limiting factor (bottleneck)
• Step 2: Calculate the contribution per unit for each product
• Step 3 - Calculate the contribution per unit of the limiting factor for each product
• Step 4 - Rank the products in order of the highest contribution per unit of the limiting factor
• Step 5 - Allocate resources to the products using this ranking

Question 6

Make or buy decisions

Answer 6

• Involves decisions about whether an org should make a product itself (inhouse) or buy it from an external company
• Possible reasons for buying could be the org has limited resources, the external org can produce at a lower price or they are a specialist in producing the product

Question 7

The make or buy decision is an extension

Answer 7

• Of the limiting factor problem
• It is possible to buy in the product and therefore avoid the use of the limiting factor, then the products need to be ranked differently
• Products should be ranked from highest to lowest based on the savings made (difference between the buy in cost and incremental cost of internal production) per usage of the scarce resource

Question 8

In the presence of a limiting factor, the following approach could be used for make or buy decisions

Answer 8

• Step 1: Calculate the saving per unit of each product. Saving = Purchase price - Variable cost to make
• Step 2: Divide this by amount of scarce resources (aka limiting factor) each product uses = Savings per unit of limiting factor
• Step 3: Rank - The higher the saving per unit of limiting factor the greater the priority to make that should be given to the product
• Step 4: Once the priorities have been decided the scarce resource is allocated to the products in order of the priorities until it is fully used up
• Step 5: Any products with unsatisfied demand can be satisfied by buying from the external source

Question 9

Management should also consider a number of non-financial issues before a make or buy decision is made

Answer 9

• Reliability of external supplier (to meet requirements)
• Specialist skills (not available in house)
• Alternative use of resource (outsourcing will free up internal resources which could be used elsewhere)
• Impact on staff (reduced internal workforce, redundancy)
• Customer reaction

Question 10

Discontinuation decisions

Answer 10

• Involves decisions about shutting down a segment of bus, product line or service which appears to be unprofitable
• The reported profit figures for this will include apportioned fixed costs
• These fixed costs may continue even if segment is discontinued
• The focus for these decisions should be whether the costs and revenues are avoidable
• Bus needs to therefore determine the difference between forgone revenue from the closure and incremental cost savings from closure

Question 11

Quantifiable costs or benefits of discontinuation may include

Answer 11

• Lost contribution from area that is being closed (=relevant cost of closure)
• Savings in specific fixed costs from closure (=relevant benefit of closure)
• Penalties and other costs resulting from closure (=relevant cost of closure)
• Reorganisation costs (=relevant cost of closure)
• Any additional contribution from the alternative use of resources released (=relevant benefit of closure)

Question 12

Non financial considerations before making decision to discontinue

Answer 12

• Impact on staff - Employees could be made redundant, plus a knock on impact on wider staff morale (impact staff absence, motivation and loss of key staff)
• Customer reaction - Customers may be left without a product / service
• Wider community - Could be impacted by closure
• Company reputation - If seen to be acting purely on financial interests
• Signals to competitors that bus is unwilling to support its products

Question 13

Special selling price decisions

Answer 13

• When a bus is presented with a decision about whether to accept or reject a one-off project or contract it should apply relevant costing principles
• Where the selling price of contract is already known and it is greater than the relevant costs then order should be accepted
• Where the selling price is not known the minimum price should be set at the incremental costs of manufacturing plus opportunity costs (if any)

Question 14

Special selling price decisions - The minimum pricing approach

Answer 14

• Minimum contract price = The total net relevant cash flows associated with the contract
• This approach is useful in situations where there is a lot of intense competition, surplus production capacity, clearance of old inventories, getting special orders and improving market share of the product
• The minimum price is effectively a break even price, if the contract price does not cover cash flows then it should be rejected, but if higher it will mean bus is better off accepting the project

Question 15

Special selling price decisions - Further considerations

Answer 15

• The price may be acceptable for a one-off contract but not for pricing all contracts and products (fixed costs are ignored but in the longer term this could cause loss)
• The minimum price may be much lower than typical market prices, bus might be reluctant to use this in case other customers demand same price
• Or bus might be willing to accept a loss on a one off contract if it increases chances of winning subsequent contracts

Question 16

Further processing decisions

Answer 16

• With many joint products it is possible to sell the product at the split off point or send it through further processing to enhance it’s value
• There are two rules to following when determining if this is worthwhile:
  
  • Only the incremental costs and revenues of the further process are relevant
  • The joint process costs are irrelevant - they are already sunk at the point of separation

Question 17

Further processing decisions - The main decisions involving joint products are

Answer 17

• To carry out the whole process or not. This is done by considering the total revenues and costs of the process. A decision can’t be taken to produce only some of the products as all are produced simultaneously. The basis of common cost apportionment is irrelevant but the common costs in total are relevant
• Whether or not to further process products. This decision is based on the incremental costs and incremental revenues of further processing. Revenue and cost at the split off point are irrelevant to the decision as they will not change

Question 18

Further processing - Relevant / irrelevant costs

Answer 18

Relevant:
- The total cost of each additional process = incremental total cost
- The unit selling price of each product before and after further processing - this is required to calculate the incremental revenue
- The percentage normal loss of each further process - required to calculate total output per product after further processing
- The actual units of output of each product from the common process - required to calculate total output per product after further processing

Irrelevant:
- Total cost of common process - related to common cost
- The basis of sharing common cost between the products - related to common cost

Question 19

Conflicts with financial accounting - Impact on cash flow vs profits

Answer 19

• These decision making techniques are more concerned with the impact on cash flow rather than profit because it is more objective and harder to manipulate than profits
• Therefore decisions will have a different impact on cash flow than on profits
• This may cause an issue for the org because shareholders are not always provided with the cash impact of decisions (financial info they receive comes from FS that focus on profits)
• In the long term the cash impact and the profit impact of a decision should be equal, however in short term there will be a difference and shareholders are more likely to react to a change in profit

Question 20

Conflicts with financial accounting - performance measurement

Answer 20

• When making decisions managers are encouraged to only consider relevant costs
• But they may find their performance is based on total costs whether relevant or not (total controllable cost)
• Managers performance may look worse despite making a good decision that will benefit org overall

Question 21

Ethical considerations in short term decision making

Answer 21

• Acting ethically means going beyond simple legal or financial impacts of bus decision and instead considering wider set of viewpoints in order to create and preserve org value
• Considering ethical issues as part of bus decisions may result in some options no longer being available but can also open up alternative options
• It will also mean decisions are more in line with the org goals and values which will ultimately help in creating more value for stakeholders

Question 22

Benefits of acting ethically

Answer 22

• It can lower bus risk - should create more stable earnings and make cheaper finance available (if org has reputation of being unethical it would make them high risk to deal with)
• It can make the bus attractive to customers, collaborators and partners
• It can make it more attractive to potential employees
• Less time and cost spent on dealing with investigations by regulatory bodies
• Less spent on paying damages and fines

Question 23

Acting ethically can bring the following problems

Answer 23

• If the sole aim of acting ethically is to differentiate from competitors then this is easily copied and the advantages are short lived
• It typically adds costs to activities
• Success often relies on trial and error
• International bus might have to adopt different ethical approaches in different markets (lack of global consistency)