COLLEGE OF BUSINESS AND ACCOUNTANCY

TOPIC:
Short-term Non-routine Management Decision

LEARNING OBJECTIVES:
At the end of this module, the student should be able to:
1. Comprehend the objective of the short-term non-routine management decision
2. Identify decision guidelines for every short-term non-routine deciding situation
3. Apply relevant costing in decision making

BIBLICAL VALUES INTEGRATION:

If any of you lacks wisdom, let him ask God, who gives generously to all without reproach, and it
will be given.
-James 1:5
INTRODUCTION
There are many situations where the standard operating policies (SOPs) used by the management
are inapplicable (i.e. short-term non-routine decisions) and in those situations, relevant costing is applied.

Short-term Non-routine Decisions Decision Guideline

Make or Buy a component decision Choose the alternative with the lower total
relevant costs.
Accept or Reject a Special Order If the special order results to incremental profit,
accept the order.
Keep or Drop a segment decision If the segment margin is positive, keep the
segment. Consider other effects of dropping the
segment.
Sell as is or Process Futher Process further the product if it will result to
incremental profits; otherwise sell it as is.
Scrap or Rework defective product Rework the product if it will result to incremental
profits; otherwise scrap it.
Continue operate or Shutdown decision Choose the alternative with the lower amount of
loss
Optimizing Scarce Resources Choose the product combination or mix that will
maximize contribution margin on limited
resources.

Indifference Point – point where costs of alternatives are the same. Under this, qualitative information
are heavily relied on.

Illustration:
Newton Motors employ 40 employees to market its automobiles. Average car sells for
P20,000 and a 6% commission is paid to each sales person. Newton Motors is considering a change to
commission arrangement that would pay each sales person as salary of P2,000/month + 2% commission
from sales made by each.

The amount of total monthly car sales as which Newton Motors would be indifferent as to which
plan to select is?

Make or Buy Decision

✓ a.k.a Insourcing or Outsourcing Decision. It is a decision of whether to make or buy components or
services used in making a product or providing service. If you make you avoid the cost of buying,
and if you buy you will avoid the cost of making.

Relevant costs to make Relevant costs to buy

Variable manufacturing costs xx Purchase price xx
Variable material handling costs xx Freight or delivery cost xx
Avoidable fixed costs xx Variable material handling costs xx
Opportunity costs xx Total xx
Total xx

Illustration:
Yuri Company manufactures 10,000 units of COMPONENT X (a component of the finished goods)
annually. The following are the costs to manufacture one unit of COMPONENT X:

Direct materials P5
Direct labor 12
Variable overhead 3
Fixed overhead 8
Total P28

The fixed overhead has the following components: P4.00 overall company overhead; P2.50
depreciation; P1.50 supervisory salaries.
Yuri received an offer from an outside supplier to sell all the components needed by the company
at P24.00 per part. In addition, freight cost of P1.00 for transporting the purchased components is required
to be paid.
If the part is bought from outside supplier, the manufacturing facilities used to produce the
component could be used to produce a new product that is expected to generate a contribution margin of
P20,000. In addition, the supervisory salaries would be eliminated since no production of components is
to be supervised anymore.
The overall company overhead is unaffected whether the components are purchased outside or
manufactured internally.
Requirements:
a. What alternative is better, make or buy the part and by how much is its advantage?
b. What is the indifference price of the two alternatives

Accept or Reject a Special Order

The sales of both manufacturing and service companies may either come from its regular order sales
or special-order sales.

Special order sales have the following characteristics:

✓ Non-recurring or one time order.
✓ The orders are typically for goods or services at a reduced price.
✓ In the short-run, it does not affect the regular sales since it has a distinguishable market.
✓ Supposedly, special orders are to be catered using the excess capacity of the company. If the
company has no excess capacity, a portion of the regular sales are sacrificed to accommodate the
special order. This is the scenario where the special order sales will now have an effect on regular
sales.

A special order should be accepted if it will generate incremental profits.

Incremental sales (# of units x special order price) xx

Incremental costs:
Variable costs (both manufacturing and non-manufacturing) (xx)
Incremental fixed costs (xx)
Opportunity costs = lost CM from regular sales
(# of regular units lost or sacrificed x regular UCM) (xx)
Incremental Profit/Loss xx/(xx)

Basically, this decision situation requires management to determine if the selling price of the special order
is enough to cover the incremental or differential cost of producing the special order.

The minimum selling price of a special order represents the indifferent selling price; the selling price that
covers the incremental costs.

If there is an excess capacity to accommodate the special order, the minimum selling price is computed as
follows:

Minimum selling price of the special order = variable cost per unit + incremental fixed cost per unit

On the other hand, if the is no excess capacity, the minimum selling price is computed as follows:

Minimum selling price of the special order = variable cost per unit + incremental fixed cost per unit +
opportunity cost per unit
*Opportunity cost per unit = Total lost contribution margin / No. of special order units
Illustration:
CASHARPE COMPANY is known for its modern style calculators. Data relating to the coming year’s
planned operations are as follows (based on 80% plant capacity):

Sales (40,000 calculators) P400,000

Cost of goods sold (280.000)
Gross profit 120,000
Selling and administrative expenses (80.000)
Income P40,000

An analysis of costs and expenses reveals that variable cost of goods sold is P4.50 per unit and
variable selling and administrative expenses are P1.50 per unit.

The company received an order for 7,000 calculators at a discounted price of P7.00 per unit. No
variable selling and administrative expenses are to be incurred but a design cost of P1.00 per unit is to be
incurred for the customized nature of the order. Acceptance of the order would result in P5,000 increase
in total fixed costs.

Requirements:
a. Should the company accept the special order? Why or why not?
b. What would be the company's income if it accepted the order?
c. What is the lowest price that the company could accept and still earn the same amount of net income?
d. Repeat the first two requirements assuming that the order is for 12,000 calculators.
e. If the order is for 12,000 calculators, what is the minimum acceptable price of the special order?
f. How many units of sales at the regular price could the company loss before it become unprofitable to
accept the order in requirement (d)?

Keep or Drop a Segment

Keep/continue or drop decision involves an analysis if a business segment, which may be a product
line, a department, or a branch be discontinued. If management sees that a segment or product line incurs
losses, their first reaction is to drop or shut it down. If segment is dropped, then only the traceable revenues
and costs vanish. It’s important to figure out what costs can be avoided and opportunity costs. Only those
costs that can be avoided should be considered in the decision-making process.

The general decision basis for keep or drop decision is the segment margin. If the segment margin
is positive, do not drop the segment because doing so will reduce the overall profit. In addition,
management should also consider other effects if dropping the segment to the other existing segments.
To compute the segment margin:
Sales xx
Variable Costs (xx)
Contribution Margin xx
Direct or Traceable Fixed Costs (xx)
Segment Margin xx
Allocated or Common or Indirect Fixed Costs (xx)
Operating Income xx

To compute the overall impact of dropping the segment

Segment margin (+) (xx)
Segment margin (-) xx
Other effects on the existing segments xx/(xx)
Impact in overall profits xx

The effect of dropping the segment on the segments could either be an increase or decrease depending on
the given information provided by the problem. For example, if the problem mentioned that if the segment
is dropped, the other segment’s sales will increase by 10%, then its impact on overall profits is increase.

Illustration:
XYZ Corp. is operating three major divisions, Division A, Division B, and Division C. The most recent
income statement has provided the following information:
Division A Division B Division C Total
Units sold 3,000 5,000 2,000 10,000

Sales P70,000 P50,000 P40,000 P160,000

Less: Variable costs 32,000 26,000 16,000 74,000
Contribution margin P38,000 P24,000 P24,000 P86,000
Less: Fixed costs
Direct fixed costs 14,000 19,000 12,000 45,000
Allocated fixed costs 6,000 10,000 4,000 20,000
Net income P18,000 P(5,000) P8,000 P21,000

All the allocated costs will continue even if a division is discontinued and these costs are allocated based
on the number of units to be sold.

Management considers dropping Division B because of its net loss. If this happens, it is expected that the
sales of Division A will increase by 10% while the sales of Division C will decrease by 5%.
Requirements:
a. Should Division B be dropped? Why or why not?
b. What will the total income of XYZ Corp. if the Division B is dropped?
c. Refer to the original information provided by the illustration but assume instead that management
is considering discontinuing B and replacing it with Division G.
The introduction of new division will result to an increase in fixed costs of P20,000. Division G’s
contribution margin percentage is 30% and is expecting sales of P90,000. What is the expected new
profit of the company after approving this proposal?

Sell as is or Process further

Joint products and by-products are produced simultaneously from the same manufacturing process,
known as “joint process”. Basically, this is a manufacturing process that uses one input and yields to
multiple outputs. Manufacturing costs are accumulated during the joint process and they are known as
“joint costs”. The objective of the company is to properly allocate these joint costs to joint products and by
products using different method such as physical output method, market value at split-off method and net
realizable value method.

During the joint process, the products are not individually identifiable. The products become
individually identifiable after the split-off point, the point of separation from the joint process. Sell as is or
process further decision is made in the split-off point. Due to the products’ identifiability at split off point,
the company has an option to sell these products as is at their respective selling prices. But the company
can also upgrade the products by processing them further, resulting to an increase in selling price.

In conclusion, sell as is or process further decision involves incremental analysis of whether the
additional revenue of processing further a product can cover the incremental costs of further processing.
The decision guide is: If there is incremental profit, then process it further, otherwise sell the product as us at
split-off point.

Solution guide:
Incremental sales (final sales value – sales value at split-off point) xx
Incremental costs (further processing costs and other incremental fixed costs) (xx)
Incremental(decremental) Profit xx

Illustration:
CEDIE CORP. produces three products from a common manufacturing process. The total joint cost
up to the split-off point is P300,000. These joint costs are allocated based on the relative sales value of the
products at split-off point. The joint products may be sold at split-off point or processed further. The
additional processing does not require any special production facility.
The following information pertains to the three products to help management on their decision making:

Product AAA Product BBB Product CCC

Units produced 10,000 15,000 30,000
Unit selling price at split-off point P3.00 P4.00 P2.50
Unit selling price after further processing 3.50 5.50 3.20
Additional processing costs 3,000 25,000 16,000

Requirement: Which products) is(are) to be processed further?

Scrap or Rework defective product

A product defect is any characteristic of a product which hinders its usability for the purpose for
which it was designed and manufactured.
Defective products are non-compliant products. These are products that do not meet the standard
production specifications. They are either sold as scrap or reworked and sold later at a higher value.

The decision guideline for this situation is to rework the defective product if it will result to
incremental profits, otherwise scrap it.

Solution guide:
Incremental sales (Sales value after Rework - Sales value if scrapped) xx
Incremental costs (Rework costs - Cost of disposal if scrapped) (xx)
Incremental (decremental) profit xx/(xx)

On a simpler note, this decision situation focuses on the concept that a defective product is reworked if it
yields higher benefits than selling them as scrap.

NOTE: Manufacturing or production costs (i.e. direct materials, direct labor and overhead costs) are sunk
costs since these have already been incurred; hence, can no longer be changed and are irrelevant.

Illustration:
Based on the most recent quality inspection of MACALMA CORP., 600 units of finished goods were
found to be defective. The accounting department has furnished the cost accounting report and it was
known that the total manufacturing cost per unit charged to the finished goods amounted to P30 per unit.
These products are supposedly to be sold at a selling price of P50 per unit.

The company has two options on these defective products:

OPTION 1: Scrap the units at an amount of P18,000. No disposal costs are to be incurred since the junkyard
will directly pick-up the defective product from the manufacturing facility
OPTION 2: Rework the defective units to conform with the specified quality at a total cost of P9,000. After
the rework activities, the product could be sold at its regular selling price.

Requirement: What would be the incremental effect on the company's overall profit of reworking and
selling the material rather than selling it as is as scrap?

Shutdown or Continue Operations

Demand affects sales and if sales significantly dropped, management may consider the option of
temporarily shutting down operations to avoid further losses. Whether continue or temporarily shut-down
operations, losses will be incurred. Therefore, the decision guideline is to choose the alternative with a
lower amount of loss. In making a decision, compare the operating loss if operations are continued with
the shutdown costs.
Shutdown costs are the amount of fixed costs that are unavoidable or will continue even after the
operations temporarily stopped, including start-up costs (costs to resume operations).
Shutdown point is used by the company as a guideline when to shutdown operations temporarily.
It is compared against the actual sales or demand (the sales level when operations are continued).

Shutdown point = (fixed costs from continuing – shutdown costs) / unit contribution margin

Shutdown point > actual sales, SHUTDOWN OPERATIONS

Shutdown point < actual sales, CONTINUE OPERATIONS

Illustration:
Historically, HAPPY COMPANY was selling 20,000 units of its product per month. Its regular sales
and cost data are as follows:
Unit Selling Price P15.00
Unit Variable cost per unit (manuf & non-manuf) 10.00
Fixed manufacturing cost per month 40,000
Fixed operating expenses per month 20,000

Due to labor strike in the manufacturing facilities of HAPPY’s major customers, a significant decline
in sales happened in which the sales dropped to 8,000 units per month. Because of this, management has
been contemplating to shut-down temporarily the operations during the months when the strikes are still
happening. Management expects that the strike will last for about 2 months.
If management will temporarily close down its operations, the fixed manufacturing costs would
decrease by P15,000 per month while the fixed operating expenses are expected to decrease to P12,000
per month. Furthermore, the firm is expected to incur start-up cost of P10,000 before resumption of
operations. During the periods of shutdown, the unit selling price and unit variable cost per unit is expected
to remain the same.
Requirements:
a) What is the net advantage or disadvantage of continuing operations in the two months that the
strike is on?
b) Calculate the shutdown point.
Optimizing Scarce Resources
Best product combination and optimizing scare resources involves a company producing multiple
products but is faced with one limited or scarce resource. The decision guide is to prioritize the product
with the highest contribution margin per limited resource. If there is idle capacity, the decision would be
to prioritize the product that has the highest contribution margin per unit. If a company is faced with
multiple product and multiple limited resources issue, it is wise to use linear programming to determine
the best combination of products that will maximize profits.

Illustration:
Mico's Mufflers manufactures three different product lines, Model X, Model Y, and Model Z.
Considerable market demand exists for all models. The following per unit data apply:

Model X Model Y Model Z

Selling price P80 P90 P100
Direct materials 30 30 30
Direct labor (P10 per hour) 15 15 20
Variable support costs (P5 per machine-hour) 5 10 10
Fixed support costs 20 20 20

Requirements:
a. For each model, compute the contribution margin per unit.
b. For each model, compute the contribution margin per machine-hour.
c. If there is excess capacity, which model is the most profitable to produce? Why?
d. If there is a machine breakdown, which model is the most profitable to produce? Why?
e. How can Mico’s encourage her sales people to promote the more profitable model?

REFERENCES:

Strategic Cost Management by Karim G. Abitago, CPA. 2024 Edition.