Short-Term

Decision Making
Module 5

Lecture 4:
Strategic Business Analysis
Bernard M. Gersale, CPA
Short-Term Decision Making

• Short-Term Decision Making which are non-routine is usually not

covered by standard operating procedures (SOP’s) of an
organization. SOP’s are usually codified through the drafting of a
manual.
• Examples of routine activities are cash or expense approvals,
collections of sales, issuances of checks, warehousing or inventory
monitoring, and many other repetitive transactions.
• Examples of non-routine activities are whether to buy a land and
building or lease out an existing one, whether make a component
part or buy it outside, whether to sell as is or process further, and
other non-repetitive transactions that has a significant impact on
the business.
Short-Term Decision Making
Non-Routine Activity
Make or buy a component part?
Accept or reject a special sales order?
Drop or continue a division?
Sell as is or process further?
Sell now or sell later?
Replace or retain an old asset?
Scrap or rework a defective unit?
Decision Guidelines
Where can we save?
If there is an incremental profit, accept!
If the direct segment margin is positive, continue!
If there is a profit from further processing, go ahead!
If incremental sales is higher than incremental costs
of warehousing, then sell later
If net cash inflows is greater than net cash outflows,
replace the asset
Choose the alternative that gives the highest short-
term profitability
Relevant Cost

• Relevant costs are those that are used in making a decision. If a

cost is not used in a particular decision-making, that cost is
irrelevant in that situation. A cost that is relevant in a particular
decision may be irrelevant to another.
• Relevant Cost have two features:
• Differential – is a cost that changes from one alternative to another
• Future-Oriented – refers to planned costs, budgeted costs, projected costs,
or estimated costs. These are costs that are yet to be incurred
• Short-term non-routine decisions use relevant costs. Relevant
Costing is applied in all possible situations where standard
operating policies are not available.
Make or Buy Decision

• A product is composed of different parts and not all parts of the

products are manufactured by a company. A part may be
outsourced from a supplier based on the following reasons:
• Lack of technology
• Lack of man-labor hours and/or machine hours
• Lack of systems expertise
• Lack of financing money
• Unprofitable operations
• Savings
• GENERAL RULE: whether to make or buy a part, the total relevant
cost must be taken into consideration. Whichever option gives a
lower relevant costs would be a better alternative.
Accept or Reject a Special Sales Order

• Special orders refer to those sales outside the regular operations

of the business. In deciding whether or not to accept a special
sales order, the paramount consideration is incremental profit
which is determined:
Incremental Revenue xx
Less: Incremental Costs xx
Incremental Profit/Loss xx
• GENERAL RULE: The following factors are to be considered in the
decision to accept or reject a special sales order:
• Is unnecessary competition created?
• Do we have an idle capacity?
Continue or Drop a Division or Segment?

• An organizational segment refers to any business unit such as a division,

product line, or geographical operations. Companies fold there segment
operations for:
• Strategic reason
• Financial reason
• Operating reason
• In this discussion, we will only look into operating reason where the
continuance of a segment is anchored on its ability to be profitable
• GENERAL RULE: If its segment margin is positive, continue the division
assuming there is no alternative use of its released facilities if the
division is discontinued. If there is an alternative use of the released
facilities, compare the segment margin from the net benefit of the
alternative – if the present segment margin is still higher, then continue.
Otherwise, discontinue the division.
Sell as is or Process Further?

• This decision arises from the fact that goods undergo several
conversion processes from original source to final consumption. In
each conversion process, the business has an opportunity to sell
now or process further processing.
• If the product is processed further, normally unit sales price will
increase. However, there is also a cost for subsequent processing
which is an incremental costs.
• GENERAL RULE: If the incremental sales are higher than the
incremental costs of further processing, then process further the
product to maximize profit.
Sell Now or Sell Later?

• There are cases when the selling price of a product is expected to

increase after a period of time. If the product is not sold now, the
business will incur storage costs, handling costs, maintenance
costs, and opportunity costs of the money locked in the product.
• Examples of products with fluctuating prices are:
• Fashion clothes
• Painting and Artifacts
• Jewelry
• Land
• GENERAL RULE: If the expected incremental sales is greater than
the incremental costs of keeping the product, then sell it later.
Replace or Retain an Old Asset?

• Normally, assets deteriorate or become dysfunctional over time and may

sometimes need replacement. There are also cases when an asset is fully
discarded due to its obsolescence as a result of advancement in
technology.
• The issue under this decision making process is, “when the asset is still
functionally useful and has not yet reached its point of technological or
physical obsolescence, should management retain or replace the old
asset now?
• If the old asset is replaced, there is an immediate outflow of cash but
there will be savings in the long run due to reduced maintenance costs
of the new asset. Furthermore, there is a possible inflow of cash from
selling the old asset.
• GENERAL RULE: If the net cash flow is positive in replacing the old
asset, then go with replacement. Otherwise, choose to retain the asset.
Scrap or Rework a Defective Unit?

• There are products that do not meet the standard production

specifications. Some of these products are defective which could
be sold as scrap or could be reworked and sold later at a higher
value.
• GENERAL RULE: In deciding whether to scrap or rework a
defective unit, the net profit from reworking should be compared
with the net profit of selling as scrap without regard to the past
costs of producing the product.
Make or Buy Decision
Tobleron Corporation manufactures Part X-24 for use in its production cycle. The
cost per unit for 10,000 units of Part X-24 are as follows:
Direct Materials 6.00
Handling Costs (20% of Materials Cost) 1.20
Direct Labor 20.00
Variable Overhead 5.00
Fixed Overhead 11.00
Total 43.20

Ferrero Company has offered to sell Tobleron Corporation 10,000 units of Part X-
24 for P40 per unit. If Tobleron accepts the offer, P4 of the fixed cost per unit will
be eliminated. If the part is outsourced, one-half of the facilities could be used to
produce a new product called Citrus, which is expected to generate a contribution
margin of P90,000 per year. Additionally, a savings of P12,000 is expected if the
parts are purchased outside. The other half of the facilities could be rented out
for P60,000 per annum. The outside supplier requires the leasing of an equipment
at P80,000.

Required: Should Tobleron Company make or buy Part X-24?

Make or Buy Decision

Make Part X-24 Buy X-24

Purchase Price 10,000 x P40 400,000
Direct Materials 10,000 x P6 60,000
Handling Cost 10,000 x P1.2 / 400,000 x 20% 12,000 80,000
Direct Labor 10,000 x P20 200,000
Variable Overhead 10,000 x P5 50,000
Avoidable Fixed Overhead 10,000 x P4 40,000
Savings if Part is bought (12,000)
Rental Income from released facilities (60,000)
Contribution Margin from Citrus (90,000)
Equipment Lease paid to Ferrero 80,000
Total Relevant Cost 362,000 395,000

What should be the decision? Tobleron should continue making Part X-24
Accept or Reject a Special Sales Order
The manufacturing capacity of North Wind Corporation’s facilities is 50,000
units a year. A summary of operating results for the year ended December 31
is as follows:
Total Per Unit
Sales (38,000 units) 3,800,000 100
Less: Variable costs and expenses 2,090,000 55
Contribution Margin 1,710,000 45
Less: Fixed Costs and expenses 900,000
Operating Income 810,000

A distributor company has offered to buy 12,000 units at P90 per units
during the year and that all of the corporations costs would be the same.

Required: Should North Wind Corporation accept or reject the special sales
order assuming the corporation can rent out the idle capacity for P200,000.
Accept or Reject a
Special Sales Order

Incremental Sales 12,000 x 90 1,080,000

Incremental Variable Costs 12,000 x 55 660,000
Incremental Contribution Margin 420,000

Rent Income if the Facility is rented out 200,000

What should be the decision? North Wind should accept the special sales order
Continue or Drop a Division or Segment?
Mill Company plans to discontinue a division with a P200,000
contribution to overhead. Overhead allocated to the division is
P500,000 wherein P50,000 cannot be eliminated.

Required:
• Should Mill Company continue or drop the division?
• Suppose, the division contributes P400,000 to overhead and
dropping it would not eliminate P150,000. Should Mill Company
continue or drop the division?
Continue or Drop a
Division or Segment?

Contribution Margin 200,000

Less: Avoidable Fixed Costs 450,000
Controllable Segment Margin (250,000)

What should be the decision? Mill Company should drop the division

Contribution Margin 400,000

Less: Avoidable Fixed Costs 350,000
Controllable Segment Margin 50,000

What should be the decision? Mill Company should continue the division
Sell as is or Process Further?
Tarlac Corporation produces three main products. Its production and
costs data are given below:
X Y Z
Unit sales price after further processing 300 550 220
Unit sales price before further processing 250 530 190
Costs of separate (further) processing 120,000 65,000 190,000
Units produced and sold 2,000 4,000 7,500
Total Joint Costs 1,400,000

Which of the products should be processed further?

Sell as is or Process
Further?

X Y Z
Incremental Sales:
X (2,000 x P50) 100,000
Y (4,000 x P20) 80,000
Z (7,500 x P30) 225,000
Incremental Costs (120,000) (65,000) (190,000)
Increase/(Decrease) in Profit (20,000) 15,000 35,000

What should be the decision? Tarlac Corporation should sell Product X as is and
process further Products Y and Z.
Sell Now or Sell Later?
Tashima Corporation has 12,000 units of product Laos, a high-end men’s
wear, in storage. This product is now out of fashion but is expected to
regain market acceptance in the next ten months. The total cost of
producing the product is P240,000, sixty percent of which is variable. It is
not kept in a special storage of which the company pays monthly rental of
P8,000.

The product has a regular sales price of P20 per unit but is expected to be
sold at P14 per unit when fashion acceptability recovers. A merchandiser has
offered to buy all the 12,000 units of product Laos at a price of P8 per unit
who will be picking up the products in the company’s storage.

Required: Should the company sell now or sell later?

Sell Now or Sell
Later?

Sell Now Sell Later

Sales (12,000 x P8) 96,000
Sales (12,000 x P14) 168,000
Storage Costs (P8,000 x 10 months) (80,000)
Incremental Profit 96,000 88,000

What should be the decision? Tashima Corporation should sell the products now
Replace or Retain an Old Asset?
Pink Industries Inc., has an opportunity to acquire a new equipment
to replace one of its existing equipment. The following data are
gathered relative to the new and old assets:
Old New
Book Value P700,000
Purchase Price P1,200,000
Life in years 5 5
Salvage Value - current 50,000
Salvage Value – after 5 years 0 0
Variable operating expenses 1,300,000 1,000,000

Required: Should the company retain or replace its old equipment?

Replace or Retain
an Old Asset?

Savings in Opex (300,000 x 5 years) 1,500,000

Salvage Value of Old Equipment 50,000
Purchase Price of New Equipment (1,200,000)
Net Cash Inflow 350,000

What should be the decision? Pink Industries should replace the old equipment
Scrap or Rework a Defective Unit?
A company has 5,000 obsolete cutting supplies carried in inventory at
a manufacturing cost of P40 per unit. If the toys are reworked for P8
per unit, they could be sold for P12 per unit. If the toys are scrapped,
they could be sold for a total of P15,800.

Required: Should the company sell the cutting supplies as scrap or

rework it?
Scrap or Rework a
Defective Unit?

Incremental Revenue from reworking (5,000 x P12) 60,000

Incremental costs of reworking (5,000 x P8) 40,000
Incremental Profit from reworking 20,000
Incremental Profit from selling a scrap (15,800)
Net advantage of reworking 4,200

What should be the decision? A company should rework the scrap units