OVERVIEW Objective
To identify relevant costs and appropriate techniques for decision-making and use them in various decision-making situations.
RELEVANT COSTS DECISION MAKING Definition Complications CVP
ANALYSIS INVESTMENTAPPRAISAL Contribution Breakeven chart P/V graph Calculations Assumptions Multi-product
The decision-making cycle Information requirements Short run Long run Techniques ARR Payback NPV IRR Conclusion SHORT RUN DECISIONS Discontinuance Limiting factor Further processing Make or buy Accept or reject
In identifying decision-making as a major topic the Examiner has specifically referred to:
relevant cost analysis limiting factors DCF
1 DECISION MAKING 1.1 The decision making cycle
Identify objectives
Identify alternative courses of action
Obtain information about alternatives
Select one of the alternatives Implement the decision Compare actual results Post Implementation review/audit
1.2 Information requirements Data requirements Qualitative Quantitative Monetary Non-monetary Effect on employees Opinions of customers Impact on local area eg pollution
Political and economic factors eg possible change in tax rates Possible reaction of competitors Costs Revenues Resources required impact on market share A decision should not be made without careful consideration of qualitative factors.
1.3 Short-run decision making
Short term decision making assumes that decisions previously made concerning fixed plant and equipment cannot be altered.
Such decisions should therefore make best use of existing resources. Relevant costs must be considered.
1.4 Long-run decision making
In the long term new investment in plant and equipment may be considered. Looking further into the future requires consideration of the time value of money. Discounted cashflow techniques are therefore important for long-run decisions.
2 RELEVANT COSTS FOR DECISION MAKING
2.1 Definition
Relevant costs (and revenues) are those pertinent to a particular decision-making situation. They are: future avoidable incremental cash flows.
Non-relevant costs include sunk costs committed costs non-cashflows allocated apportioned absorbed recharged Overheads 2.2 Complications 2.2.1 Materials Materials needed for project Not in stock
Use current purchase price
In stock
No alternative use
Alternative use
Use scrap value Scarce Not scarce
Use material cost plus lost contribution from alternative (opportunity
cost)
Use replacement cost
2.2.2 Labour
Labour needed for project
Hire new workers
Use current wage rate Already employed No alternative work Alternative work Saved redundancy costs
No spare capacity Spare capacity
Labour cost plus lost contribution
Any incremental wages eg overtime premium 3 SHORT-RUN DECISIONS Discontinuance (shutdown) Limiting factor Decisions
Further processing Make or buy
3.1 Discontinuance decisions
That is, whether to eliminate (shutdown) part of the business. 3.1.1 Decision criteria
Compare loss in revenue to savings in avoidable costs. 3.1.2 Qualitative factors
Adverse publicity regarding redundancies.
Possible adverse reaction by investors – share price might fall. Effect on morale in remaining segments of the business. Lost synergy eg shared skills between divisions.
Example 1
Decentro Ltd is a divisionalised company. Divisional results are as follows. Division Division Division
X Y Z
£ £ £
Sales 50,000 30,000 40,000 Variable costs (30,000) (18,000) (20,000) Specific fixed costs (12,000) (10,000) (10,000) Apportioned head-office costs (5,000) (4,000) (5,000) –––––– –––––– –––––– Profit/(loss) 3,000 (2,000) 5,000 –––––– –––––– ––––––
Required:
Determine whether or not Division Y should be closed.
Solution Division Y £ Sales Variable costs Gross contribution Specific fixed costs
––––––
Contribution towards head office costs
–––––– –––––– It would appear that division Y should
3.2 Limiting factor decision
A factor other than sales limits the level of activity at which the company can operate.
3.2.1 Decision criteria
Maximise the contribution earned per unit of limiting factor.
Example 2
A company produces two products with the following cost and revenue data per unit.
A B £ £ Selling price 20 10 Variable cost 8 6 Fixed cost 4 3 Budgeted units 2,000 3,000 There are only 7,000 machine hours available to produce both A and B. A requires 4 hours per unit and B requires 1 hour per unit.
Required:
Calculate the profit maximising product mix.
Solution A B £ £ SP/unit Less VC/unit –— –— Contribution/unit Hours/unit
Contribution/Unit of limiting factor
–— –—
–— –— Ranking
Utilisation: Hours available Production plan –—–— –—–— –—–— –—–—
Example 3
Required:
As per Example 2 but we are able to sub-contract the products for an additional variable cost of £1 per unit for A and £0.50 per unit for B.
Solution
A B
£ £
Contribution foregone/unit purchased (increase in VC/unit) Hours/unit
Contribution forgone/unit of limiting factor
–— –—
–— –— Ranking for production
Production and sales plan
Hours available Production and sales plan
–—–— –—–—
3.3 Further processing decision
Whether to sell at an intermediate point or to further process and sell at an enhanced value.
3.3.1 Decision criteria
We compare incremental revenues of further processing with the incremental costs of further processing.
Example 4
Selling prices Conversion costs Conversion costs (variable) (fixed) C : £5/unit C → F £6/unit D : £7/unit D → G £6/unit £10,000 E : £8/unit E → H £6/unit F : £10/unit G : £14/unit H : £22/unit Budgeted units/demand C/F 4,000 D/G 2,000 E/H 1,000 Input D C E Refining operation F G H Joint process Required:
Determine which products should be further processed.
Solution C/F D/G E/H Total Incremental costs/revenues £ £ £ £ Revenue/unit Less VC/unit –— –—– –— Contribution/unit –— Budgeted units –—–— –—–— –—–— Total contribution Less Fixed cost
–—–— Change in profit
–––––– Conclusion:
3.4 Make or buy decision
Whether to make a product in house or to purchase that product from an outside supplier.
3.4.1 Decision criteria
Compare the marginal cost of making with the purchase cost of buying in.
Example 5
Product K is currently produced in house a £15/unit of which £6/kg is fixed. The cost of purchasing this product from a contractor is £10/unit.
Required:
Determine whether the product should be made in-house.
Solution
Product K
£ Marginal cost of making
Marginal cost of buying in (purchase price) Decision
–—–— –—–—
3.5 Accept or reject an order
3.5.1 Decision criteria
Are the relevant costs of the decision less or greater than the suggested revenue? An application of relevant cost analysis.
Example 6
A material P in stock, which is used on the product to be produced is already used as a substitute for another material Q in common usage. Material Q can be purchased for £4.00/kg and conversion costs required to P are £2.00/kg. Alternatively P could be sold for scrap at £1.50/kg.
Required:
Solution
Decision Analysis Revenue/unit £ Either sell for scrap
Or substitute for material Q
–—–— Choose to substitute as the next best alternative.
Relevant cost of 3 kg of material P
–—–—
Example 7
Skilled labour needed to fulfil the order would be specially recruited for £50,000. Unskilled labour would be transferred from another department where it is paid £30,000. Half is currently idle. The other half generates a contribution of £5,000.
Required:
Calculate the relevant labour cost of the order.
Solution
£ Skilled labour
Unskilled Idle workers – no incremental cost
Working – labour cost + opportunity cost Relevant cost
–––––– ––––––
4 COST VOLUME PROFIT ANALYSIS (CVP)
4.1 Contribution
£
Revenue X
Variable production costs (X) Variable non-production costs (X) –––
Contribution X
4.2 Breakeven charts
Breakeven point occurs where: Total contribution = Total fixed costs. £ Total revenue Total costs Fixed costs Units Breakeven point OR £ Total revenue Total costs Total variable costs Units Breakeven point
4.3 Profit/volume graphs Profit £ + 0 – Total profit Units or revenue Fixed costs Breakeven point 4.4 Calculations
Contribution per unit = Unit selling price – Unit variable costs Profit = (Sales volume × Contribution per unit) – Fixed costs
Breakeven sales volume =
unit per on Contributi costs Fixed
Margin of safety = Actual or budgeted sales – Breakeven sales Sales volume to achieve a target profit =
unit per on Contributi profit Target costs Fixed + C/S ratio = unit per price Selling unit per on Contributi
Breakeven sales revenue =
ratio C/S
costs Fixed
4.5 Assumptions
All costs can be split into fixed and variable. Fixed costs are constant.
Variable cost per unit is constant. Selling price per unit is constant.
Stock levels are constant (ie sales = production).
4.6 Multi-product
4.6.1 Assumption
CVP analysis can be extended to multi-product situations if a predetermined sales mix is held to be constant.
4.6.2 Calculation
Calculate a weighted average contribution per unit to depict average revenues and average costs for the given sales mix.
Use breakeven formulae as for single product analysis.
Number of units calculated will be in total therefore split in mix ratio to state in terms of individual products.
5 INVESTMENT APPRAISAL 5.1 Techniques
The methods learnt in Paper 3 and Paper 8 are also examinable in Paper 9. Accounting rate of return (ARR) .
Payback period
Net present value (NPV) Internal rate of return (IRR) .
5.2 Accounting rate of return
investment Initial profit net annual Average × 100 OR investment Average profit net annual Average × 100
Where average investment = 2 scrap Cost + 5.2.1 Advantages 5.2.2 Disadvantages Easily calculated. Easily understood %.
Similar to ROCE used by analysts for company appraisal.
Arbitrary target ARR. Ignores time value of money. Profits are subjective.
A % measure – does not show the absolute gain to shareholders.
Use of ARR will not lead to investment decisions which maximise shareholder wealth.
5.3 Payback period
The time it takes for the cash inflows from a project to equal the cash outflows.
5.3.1 Advantages 5.3.2 Disadvantages Easily calculated.
Easily understood. Uses objective cashflows. Maximises liquidity. Favours low risk projects.
Ignores cashflows after the payback period.
Ignores time value of money. Ignores project profitability. Arbitrary target payback period. Use of payback will not lead to maximisation of shareholder wealth.
5.4 NPV
The present value of cash inflows less the present value of cash outflows.
5.4.1 Advantages 5.4.2 Disadvantages Takes into account the time value
of money.
Uses objective cashflows. An absolute measure of gain to shareholders.
Difficult to calculate. Difficult to explain to non-accountants.
NPV shows the increase in shareholder wealth from undertaking a project. Use of NPV will lead to maximisation of shareholder wealth.
5.5 IRR
The discount rate at which NPV = 0.
5.5.1 Advantages 5.5.2 Disadvantages Takes into account the time value
of money.
Uses objective cashflows. Easily understood %.
Difficult to calculate.
Some projects have multiple IRR’s. a % measure – does not show the absolute gain to shareholders. Not reliable where projects are mutually exclusive.
Use of IRR will not lead to investment decisions which maximise shareholder wealth.
5.6 Conclusion
NPV is the only reliable method of project appraisal. It is superior to ARR, payback and IRR.
FOCUS
You should now be able to
discuss the decision making process and the information needed for decision making
deal with various short-run decisions, identifying the relevant costs in each scenario
EXAMPLE SOLUTIONS Solution 1 – Discontinuance Division Y £ Sales Variable costs 30,000 (18,000) Gross contribution
Specific fixed costs
–––––– 12,000 (10,000) Contribution towards head office costs
–––––– 2,000 –––––– It would appear that division Y should remain open as it makes a positive contribution towards head office costs.
This assumes that total head office costs will remain the same if division Y closes ie they are unavoidable.
Solution 2 – Limiting factor
A B £ £ SP/unit Less VC/unit 20 8 10 6 –— –— Contribution/unit Hours/unit 12 4 4 1 Contribution/Unit of limiting factor
–— 3 –— –— 4 –— Ranking
2
1
Utilisation: Hours available Production plan 7,000 Product B (3,000) @ 1 hr/unit 3,000 units –—–— –—–— 4,000 Product A (4,000) @ 4 hrs/unit 1,000 units –—–— –—–—
Solution 3 – Purchase alternative
A B
£ £
Contribution foregone/unit purchased (increase in VC/unit) Hours/unit
1.00 4
0.50 1 Contribution forgone/unit of limiting factor
–— 0.25 –— –— 0.50 –— Ranking for production
2
1
Production and sales plan
Hours available Production and sales plan 7,000 (3,000) @ 1 hr/unit Product B produced = 3,000 units –—–— (4,000) –—–—
@ 4 hrs/unit Product A produced = 1,000 units
Product A bought in (remainder) 1,000 units
Solution 4 – Further processing
C/F D/G E/H Total Incremental costs/revenues £ £ £ £ Revenue/unit 5 7 14 Less VC/unit (6) (6) (6) –— –—– –— Contribution/unit (1) 1 8 –— Budgeted units Do not 2,000 1,000
further process –—–— –—–— –—–— Total contribution 2,000 8,000 10,000
Less Fixed cost (10,000)
–—–—
0
–––––– Using quantitative data only the decision appears marginal.
Solution 5 – Make or buy
Product K
£ Marginal cost of making (15 – 6)
Marginal cost of buying in (purchase price)
9 10 Decision –—–— Make –—–—
Solution 6 – Relevant cost analysis
Decision Analysis Revenue/unit £ Either sell for scrap
Or substitute for material Q (4 – 2) =
1.50 2.00 –—–— Choose to substitute as the next best alternative.
Relevant cost of 3 kg of material P = 3 × 2 = £6.00 –—–—
Solution 7 – Relevant labour cost
£
Skilled labour 50,000
Unskilled Idle workers – no incremental cost Nil
Working – labour cost + opportunity cost (15,000 + 5,000) 20,000 Relevant cost
–––––– 70,000 ––––––
