SHORT TERM AND

MEDIUM TERM
DECISION MAKING
LEARNING OBJECTIVES
• Dealing with uncertainties in Decision Making:
• Reasons for uncertainties
• Changes within Short term or long term
• Types Of Decision Making
• Relevant Costs and Benefits
• Short Term Decision Making:
• Limiting factor decision making
• Optimum production mix
• Theory of Constraints
• Throughput Accounting
• Make or buy decisions
• Special order decisions
• Discontinuing a segment
• Further processing decisions
• Multi-limiting factors and the use of linear programming and shadow pricing in decision-making
(not examinable)
• Qualitative Factors (Include Human Value/ Professional Ethics) In Decision Making
• Medium-Terms Decision Making-Tactical Decision (Theory Only)

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 A MODEL OF THE DECISION-MAKING
PROCESS

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Exhibit 19.1-Steps in decision making process
 TYPE OF DECISIONS

Accept or reject special Make or buy a

order product

Add or delete a
Sell or further process
product or
joint product
department
 RELEVANT COST AND BENEFITS

• Must refer to relevant information (relevant costs and

relevant benefits)
• Concerned with future and involves choosing
between available alternatives/ options
• Consider both financial & non-financial factors
• Quantitative factors: profitability, contribution etc
• Qualitative factors: employees morale, legal
implication, demand of products, government
regulations etc
 CHARACTERISTICS OF RELEVANT
INFORMATION
 Relevant information relates to costs and
benefits that differ under competing courses of
action
 Relates to the future
 Past costs cannot be affected by the current action
(e.g. sunk costs)
 Timeliness versus accuracy
 More accurate information may take longer to
produce
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 CHARACTERISTICS OF RELEVANT
INFORMATION

 Quantitative or qualitative
 Quantitative information can be expressed in
numeric terms
 Qualitative information cannot be expressed
effectively in numerical terms

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THE IMPORTANCE OF PROVIDING ONLY
RELEVANT INFORMATION

 Generating information is a costly process

 Supplying irrelevant data to managers
can lead to a waste of managerial
resources
 Information overload decreases the
effectiveness of decision making

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 INFORMATION FOR UNIQUE VERSUS
REPETITIVE DECISIONS

 Unique decisions
 Ariseinfrequently or only once
 Relevant information will often be found inside and
outside the organisation
 Repetitive decisions
 Made at regular or irregular intervals
 May draw on a lot of historical data

 Relevant information should be readily available

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RELEVANT COSTS
• Definition: future costs or revenue that will be
changed by a decision
• It will influence the decision to be made
• Why should differentiate relevant cost from
the irrelevant cost:
i. Focusing on relevant info can simplify and
shorten the data gathering process as it is a
costly procedure
ii. To avoid info overload if too much info is
presented
RELEVANT COSTS
• Features :
i. It affects the future
- the costs will be incurred in the future
-historic cost (sunk, past, committed
costs) are irrelevant – do not affect future
actions and cannot be changed – ex:
depreciation, book value of asset
i. It differs between alternative
ii. It is cash in nature
RELEVANT COSTS
• Opportunity cost :
o Potential benefit given up when the choice of one
action forgone by taking different actions
o Only applies to scarce resources

• Avoidable cost :
o Costs that can be saved by not adopting a given
alternative
o Will be identified as potential savings from
discontinuing decisions
o Ex: specific fixed cost to a certain department or
product
IRRELEVANT COSTS
• Sunk costs
 Costs that have been incurred
 Ex: R&D costs already spent
• Committed costs
 Future cash flows but will be incurred because of some
commitment agreed in the past
 Ex: lease on an office building, maintenance cost contract
• Notional costs
 Costs which is hypothetical in nature, imaginary i.e.
something that has no actual existence and is mere
imagination.
 Benefit from the use of something which no actual cash
expense is incurred
 Ex: notional rent charged to a subsidiary
RELEVANT/IRRELEVANT COSTS FOR MATERIALS
Type of cost Relevant Cost Irrelevant Cost
MATERIALS Current cost or market price Past, sunk, historical cost
Future purchase price Current cost becomes
irrelevant when there is
replacement price or future
purchase price given
Replacement cost
Any savings in cost is
relevant and treated as a cost
reduction
Opportunity cost or forgone
profits and forgone
contribution
Any extra gains and
contribution obtained is
treated as a relevant income
RELEVANT/IRRELEVANT COSTS FOR MATERIALS
Type of cost Relevant Cost Irrelevant Cost
MATERIALS Avoidable cost
Variable or marginal
or direct cost
Specific fixed cost
Incremental or
differential cost or
any increase in cost
Savings in disposal
cost if the activity to be
taken up could actually
use the materials
about to be disposed
 RELEVANT/IRRELEVANT COSTS FOR
LABOURS AND OVERHEAD
Type of cost Relevant Cost Irrelevant Cost

LABOUR Overtime rates due to Monthly salary is fixed

extra work effected by and therefore if the
the new project to be workers are taken away to
taken up do extra work, their salary
is irrelevant because
wherever they are, their
salary will still be paid
anyway
Extra wages paid or any
increase in the
remuneration
OVERHEAD Special packaging costs, Fixed overheads
extra overheads
Variable overheads
 QUESTION:
QUESTION 1

Company A is considering accepting a special project for the manufacture of 50

units of Component 124. Materials and labour requirements are given below:

Materials: For the manufacture of component 124, 2,000 kgs of materials Zep is
needed. Company A has exactly 2,000 kga of this material in its stores. These
were bought two years ago at a cost of RM6,000.
This material would have no other use and would be sold as scrap for RM2,000 if
not used for the manufacture of Component 124.

Labour: Labour costs to be incurred is RM8,000. However, labour is in short

supply and if the workers are not working on this project, they can be switched to
another job which would give a contribution of RM15,000.

What is the relevant cost of materials and labour to be included in the

manufacturing cost estimate for Component 124?
 SUGGESTED SOLUTION
 Relevant costs:

Note: Material cost of RM6,000 is irrelevant cost as it is a sunk cost

 TUTORIAL

 Ilyas Razi trades as a contractor to build cruises at the Melaka River Cruise Marina. At
present, he has just received the news that an entrepreneur in Melaka is opening the
tender to build a cruise to be named “TUN TEJA” to be delivered in one year’s time. Ilyas
is interested since he has no other contract in hand, at least for the next few months.

 In order to build “TUN TEJA”, several types of material are required, as follows:

Type In stock (units) Needed for Purchase price Current Current resale
of stock items purchase price price (RM per
contract (units)
(RM per unit) (RM per unit) unit)
A 1,000 10,000 7.70 21.00 14.00

B 11,000 10,000 14.00 6.30 7.00

C - 1,000 - 42.00 -

D 1,000 2,000 28.00 21.00 14.00

E 500,000 50,000 2.00 2.10 2.05

Notes on the material:
 Material A could be sold to a local trader if not used for the
contract.
 Materials B and E are used regularly in this type of business.
 The business has no other use for Material D, the stocks of
which are obsolete.

Required:

 Calculate the relevant costs for materials that Ilyas Razi

should charge its customer, based on the information given
above. Provide brief explanatory notes on each figure you
included in your calculations.
 MAKE OR BUY DECISIONS
• Whether to produce particular goods or services, or
purchase them from an external supplier
• Consider marginal costs of manufacturing versus relevant
purchases in costs
• Opportunity costs are often relevant
– Lost profits from using capacity to make the product

• 2 situations may exist :

 Spare capacity –compare between VC of manufacturing
and purchase price from outsiders
 Full capacity – marginal costs manufacturing will
of include opportunity cost contribution where
(lost of
some existing production may have to be displaced)
 MAKE OR BUY DECISION

 Decision : If relevant cost of making <

relevant cost of buying the component, firm
should make the component. This will
increase the contribution/profit obtained.
TOTAL COSTS OF THE MAKE-OR-BUY
DECISION, WALLABY AIRLINES

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 MAKE OR BUY DECISIONS
Quality of
purchased
product

Other factors
Delivery to consider in Technical
buying capabilities of the
responsiveness supplier
components

Financial
stability of the
supplier
 SPECIAL ORDER DECISION
• Mgt often has to make a decision whether or not to
accept special orders when :
 The units have to be sold below the
normal special price
 There is idle capacity or large access
capacity
 Distress condition/under pressure of not
performing
 Possibility of cultivating the permanent future
patronage of a new customer
 Competitive pressures where the org. has to
lower its regular price
 SPECIAL ORDER DECISION
• Excess capacity
◦ Where equipment, labour or other inputs to
production that are not being utilised and, hence, are
available for other purposes
◦ If incremental revenues are greater than
incremental costs, acceptable on financial grounds
◦ Allocated fixed costs should not be included
◦ No alternative uses for resources needed to fill the
order
• No excess capacity
o Include opportunity costs associated with use of the
capacity
 SPECIAL ORDER DECISION
• Considerations in evaluating special order :
 Only those costs that will be affected by taking the
order are relevant (ex: variable production overhead)
 Fixed manufacturing costs are irrelevant
 Basic problem – determine an acceptable price for the
special order units
 Cost analysis using the contribution approach is a
useful technique to determine the short-run profit
effects of special order transactions
 Mgt should accept a special order if some contribution
is made (incremental revenue > incremental cost)
SPECIAL ORDER QUALITATIVE FACTORS

Quality of Chances of other Whether the

externally customers not special order is the
supplied demanding for best way to utilise
components lower prices the spare capacity

Whether special
order will close up
capacity and not The chances of
be able to use for fixed costs to
future better remain unchanged
business
 DELETING A SEGMENT
• Involves a decision to discontinue a segment in the
organizations e.g function, branch, activity, task, job,
product(s) or services(s).

• Some of the reasons for deleting include unprofitable

products or running costs have become too expensive to
supports its existence or to run the department.

• In the short run, as long as the segment/department

recovers their variable cost and make a contribution towards
the recovery of fixed costs, a firm is better off continuing
operation rather than stop.
 DELETING A SEGMENT
• The factors that need to be considered in this
situation are as follows:-

1. Attributable costs 3. Other factors

- Cost per unit that could be -There could be other
avoided if a product or function influencing factors such
were discontinued without as employees will be
changing the supporting 2. Shut-down decisions made redundant or
organization structure. - The management relocated to other
must identify whether departments. The
-This includes:- employees may need re-
the elimination is short-
a) short-run variable costs run or long-run and training or they can be
b)Fixed costs which are temporary or offered early/ voluntary
directly traceable to the permanent. retirement.
product or function -Another factor is the
c)Other fixed costs which assets which will have to
change if there are significant be transferred or
shifts in the volume of activity disposed.
 DELETING A SEGMENT
• Considerations for continuing operations:-
i. Expenses connected with the shut down of a plant would
be avoided.
ii. Cost incurred to re-open/re-start a closed segment can
also be saved.
iii. Skillful employees would be kept employed.
iv. Recruiting and training costs of new workers is incurred
if the plant is re-opened.
v. Established market is lost if the plant is closed
temporarily. To re-enter a market later requires a re-
education of the consumers.
vi. Temporary shut down does not eliminate all costs (e.g.
depreciation, interest, property taxes and insurance etc.)
 DELETING A SEGMENT
Alternatively, the following benefits has to be
considered:-
i. Avoiding operating losses

ii. Savings in variable costs, maintenance

and repair costs of fixed assets
iii. Savings in indirect labour costs

iv. Savings in fixed costs.

 FURTHER PROCESSING DECISIONS
• Joint products – 2 @ more products that are
produced from a common input
• During production process, there will be a split-
off point whereby it is identifiable as separate
products
• Joint costs – costs of input and joint processing
• Mgt need to decide whether to sell a joint
product at split-off point or process further
before being sold
 JOINT PRODUCT COSTS

Separate Final
Prod A
processing sales

Common Separate Final

Joint input production Prod B
processing sales
process

Prod C Separate
Joint product Final
costs processing sales
Split-off
point
Joint products Separate product
costs
FURTHER PROCESSING DECISIONS

Irrelevant • Joint costs – at the split-off point,

the joint costs have already been
Cost incurred, therefore are sunk costs

Relevant • Those are incurred as a

consequences of the decision to
Costs further process the item

• Extra revenues earned from

Relevant selling the product in its further
Revenues processed instead of selling it in
its semi-processing state
 LIMITING FACTOR
Optimum Production Mix
• Decided when firms not able to produce such
production as it wishes due to limited supply of
resources.
• Ex of scarce resources – restricted supply of
material, max time allowed to operate machines,
limited cash/fund, limited of labor hours worked.
• Steps for LF
• How to choose : rank the product mix according
to the highest “contribution per limiting factor”
ratio
 THEORY OF CONSTRAINTS (TOC)

• Process aimed at identifying and removing

constraints in organization processes that are
standing in the way of organizational goals.
• A constraint is anything that limits an organizational
or entity from moving toward or achieving its goal.

Physical constraints –
something that is rigid and
Non-physical constraint –
in its currents state, has a
Company procedures are
limit on its ability or
another example of a non-
throughput. E.g: a motor
physical constraint. Demand
that can only produce a
for a given product.
given amount of power at a
given time.
 THEORY OF CONSTRAINTS (TOC)
• TOC postulates that the goal is to make (more)
money. It describes 3 avenues to this goal:
• Increase throughput

• Reduce inventory

• Reduce operating expense

• A bottleneck- any resources whose capacity is

less than the demand placed upon it. It limits
the throughput.
• Non-bottleneck – resources have capacity
greater than demand.
 THEORY OF CONSTRAINTS (TOC)

• 5 steps of maximizing operating profit when faced

with bottleneck and non-bottleneck operations:
1. Identify the system’s bottleneck or constraint

2. Decide how to exploit the bottlenecks

3. Subordinate everything else to the decision in

step 2
4. Elevate the system’s bottlenecks

5. If, in the previous steps, a bottleneck has been

broken go back to step 1.
 THROUGHPUT ACCOUNTING(TA)
• Throughput – rate of production of a defined process over a stated period
of time – may expressed in units of products, batches produced, turnover.
• TA is a variation of Variable Cost Accounting (VCA) in which TA assumes
that direct material is the only variable cost. All other costs are
considered fixed costs.
• It is a method of accounting that focuses on throughput and relates costs
of production to throughput
• TA:
Selling price
Less: Material Cost (variable cost)
______________________________
Contribution margin (throughput)
Less Fixed expenses (operating expenses)
______________________________
Profit
 THROUGHPUT ACCOUNTING(TA)

• 3 ways to increase profits:

• Increase throughput (sales)

• Decrease operating expenses (fixed costs)

• Decrease investment (particularly in

inventories)
• Need to achieve sales with items produced
and stocks are only considered desirable
when they can increase throughput
INCENTIVES FOR DECISION MAKERS

  Managers typically make decisions that will

maximise their reported performance and rewards
  Ideally systems should be designed to
encourage managers to make decisions
 consistent with the organisation’s goals and
strategies

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PITFALLS TO AVOID WHEN USING ACCOUNTING
DATA FOR DECISIONS

1. Sunk costs are irrelevant and should be

ignored
2. Beware of unitised fixed costs
3. Beware of allocated fixed costs
4. Remember to determine and include
opportunity costs

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