CMA

PGP 23- Sec DEF

Pankaj Baag
Faculty Block 01, Room No 21

Mob: 8943716269
Ph (O): 0495-2809121
Ext. 121
Email: baagpankaj@iimk.ac.in

1
Problem
 • Decision making : Application :More examples
• The CVP analysis helps in price determination of
a product wrt recession
• Eg 1 In the face of the trade recession, M/s Modern Engineering Ltd., is having a
difficult period due to lack of government orders and is operating below 60 per
cent of its normal capacity. This is, however, considered to be a temporary phase
and the management has taken a decision not to retrench labour. An enquiry has
been received for 10,000 units of a product which could be manufactured by the
company under the existing capacity, and the cost data is as follows :

• Direct labour Re. 1 per hour

• Time required 1 hour per unit
• Direct material Rs. 2 per unit
• Variable O.H. 400 per cent of direct labour
• Fixed O.H. 600 per cent of direct labour
• Cost of special tools Rs. 25,000
• What is the minimum price you would recommend ?
Eg 2 An umbrella manufacturer makes an average net profit of Rs. 2.50 per piece in a selling
price of Rs. 14.30 by producing and selling 60,000 pieces or 60% of the potential capacity. His
cost of sales is :

Direct material Rs. 3.50

Direct wages Rs. 1.25
Works overheads Rs. 6.25 (50% fixed)
Sales overheads Re.0.80 (25% varying)

During the current year he intends to produce the same number but anticipates that his fixed
charge will go up by 10% while the rates of direct labour and direct material will increase by
8% and 6% respectively. But he has no option of increasing the selling price (because of
recession). Under this situation, he obtains an offer for a further 20% of his capacity. What
minimum price you will recommend for acceptance to ensure the manufacturer an overall
profit of Rs. 1.673 lakhs?
Eg 3 AB Ltd. makes a single product which sells for $ 20. There is
great demand for this product. The unit variable cost of $12 shows
the following details :

Per unit $
Direct materials 4
Direct labour (2 hours) 6
Variable overheads 2
Total 12

The labour force is currently working at full capacity and no extra

time can be made available. A customer has approached AB Ltd.
with a request for the manufacture of a special order, for which he
is willing to pay $5,500. The costs of the order would be $ 2,000
for direct materials and 500 labour hours will be required.
Should the order be accepted?
Solutions
 1 Item Costs per unit (Rs.)

Direct Material 2.00

Direct Labour 1.00
Variable Overhead 4.00
(400% on direct labour)
Cost of special tool 2.5
(Rs.25000 on 10000 units) ______
Total 9.5
(Fixed cost is not relevant)

Minimum price recommended is Rs. 9.5 per unit.

2
Rs. per unit (Under new situation) Rs. per unit
Price 14.30
Direct Material 3.71
Price 14.30 Direct wages 1.35
Direct Material 3.50 Works O.H. 3.125
Direct wages 1.25 Sales O.H. 0.20 8.385
Works O.H. 3.125 Contribution 5.915
Current fixed costs 223500
Sales O.H. 0.20 8.075 Additional (10%) 22350
Contribution 6.225 Target profit 167300
Profit 2.50 Contribution required 413150
Fixed costs 3.725 Contribution currently available
(60000 X 5.915) 354900
Total fixed costs Rs.223500 Remaining contribution to be 58250
(60000 X 3.725) recovered from 20000 units, i.e., 2.9215

Min price = Marginal cost +

Contribution
= 8.385 + 2.9215
= Rs. 11.2975 per unit
3

Items Per unit cost ($)

Price 20
Variable cost 12
Contribution 8
Contribution per labour hour 8 / 2 = $4
Cost involved for special order
Direct material $ 2000
Direct labour (500 X 3) $ 1500
Variable overhead $ 500
Total $ 4000
Loss of contribution (opportunity cost) $ 2000
Total cost of the order $ 6000
Price $ 5500
(Hence loss of $ 500)
Decision : Not to accept
 The margin of safety calculation answers a very important question:
 If budgeted revenues are above the breakeven point, how far can
they fall before the breakeven point is reached.
 In other words, how far can they fall before the company will begin
to lose money.

The margin of safety is an aspect of sensitivity analysis that answers the specific question ---The answer to this
question gives managers information they can use to take action and potentially prevent a fall in revenues below
breakeven.

3-10
 Anindicator of risk, the margin of safety (MOS), measures the
distance between budgeted sales and breakeven sales:
 MOS = Budgeted Sales – BE Sales
 The MOS ratio removes the firm’s size from the output, and expresses
itself in the form of a percentage: Looking at the MOS as a ratio
 MOS Ratio = MOS ÷ Budgeted Sales removes the size of the firm from
the output.
MOS in units angle indicates rate at which
= MOS/SP per units profits are being made. Large
angle of incidence is an
indication that profits are being
made at a high rate.
On the other hand, a small
angle indicates a low rate of
profit and suggests that variable
costs from the major part of
cost of production.
3-11
 The Margin of Safety in Dollars
The margin of safety in dollars is the excess of budgeted (or
actual) sales over the break-even volume of sales.

Margin of safety in dollars = Total sales - Break-even sales

Let’s look at Racing Bicycle Company and

determine the margin of safety.

12
The Margin of Safety in Dollars
If we assume that RBC has actual sales of
$250,000, given that we have already
determined the break-even sales to be
$200,000, the margin of safety is $50,000
as shown.
Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000
13
 The Margin of Safety Percentage
RBC’s margin of safety can be expressed as 20% of sales.
($50,000 ÷ $250,000)

Break-even
sales Actual sales
400 units 500 units
Sales $ 200,000 $ 250,000
Less: variable expenses 120,000 150,000
Contribution margin 80,000 100,000
Less: fixed expenses 80,000 80,000
Net operating income $ - $ 20,000

14
 The Margin of Safety
The margin of safety can be expressed in terms of the
number of units sold. The margin of safety at RBC is
$50,000, and each bike sells for $500; hence, RBC’s
margin of safety is 100 bikes.
Margin of $50,000
= = 100 bikes
Safety in units $500

15
 Cp..5
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is $1.49
and the average variable expense per cup is $0.36. The
average fixed expense per month is $1,300. An average of
2,100 cups are sold each month. What is the margin of safety
expressed in cups?
a. 3,250 cups
b. 950 cups
c. 1,150 cups
d. 2,100 cups

16
 Managers make strategic decisions that affect the cost structure of
the company.
 The cost structure is simply the relationship of fixed costs and
variable costs to total costs.
 We can use CVP-based sensitivity analysis to highlight the risks and
returns as fixed costs are substituted for variable costs in a
company’s cost structure.
 The risk-return trade-off across alternative cost structures can be
measured as operating leverage.

Managers make strategic decisions that affect the structure and that information is, of course, used in the CVP
analysis we’ve been learning about.

3-17
 Cost Structure and Profit Stability

Cost structure refers to the relative proportion of fixed and

variable costs in an organization. Managers often have some
latitude in determining their organization’s cost structure.
Some companies have high fixed
expenses relative to variable
expenses.

utility companies?

Because of the heavy

investment in property, plant,
and equipment, many utility
companies have a high
proportion of fixed costs. 18
 Cost Structure and Profit Stability
There are advantages and disadvantages to high fixed cost (or low variable cost)
and low fixed cost (or high variable cost) structures.
A disadvantage of a high fixed
An advantage of a high fixed cost structure is that income
cost structure is that income will be lower in bad years
will be higher in good years compared to companies
compared to companies with lower proportion of
with lower proportion of fixed costs.
fixed costs.

Companies with low fixed cost structures enjoy greater stability in income
across good and bad years.
19
 Organizations with a high
proportion of fixed costs in
 Operatingleverage (OL) describes the effect that their cost structure are
said to have high operating
fixed costs have on changes in operating income as leverage.
changes occur in units sold and contribution
margin. In this type of structure,
small decreases in sales
 OL = Contribution Margin = Degree of result in large decreases in
Operating Income operating leverage operating income.

Remember what fixed

costs are. They are costs
that do not change, in the
short run, with the level
Notice that the difference between the numerator of sales.
and the denominator in our formula = our fixed
costs. These costs will exist
whether sales are higher
or lower, within that
relevant range.

3-20
The formula to estimate the change in operating income that will
result from a percentage change in sales is:

Operating Leverage X % Change in Sales = OP increase%

If sales increase 50% and operating leverage is 1.67, you should expect
operating income to increase 83.5%.

Operating leverage is more than just an indication of the cost structure.

It can also be used to estimate the change in operating income that will result from a change in sales.

3-21
 Operating Leverage
To illustrate, let’s revisit the contribution income statement
for RBC.
Actual sales
500 Bikes
Sales $ 250,000
Less: variable expenses 150,000
Contribution margin 100,000
Less: fixed expenses 80,000
Net income $ 20,000

Degree of
Operating $100,000
= $20,000 = 5
Leverage
22
 Operating Leverage
With an operating leverage of 5, if RBC increases its sales
by 10%, net operating income would increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5
Percent increase in profits 50%

Here’s the verification!

23
 Operating Leverage
Actual sales Increased
(500) sales (550)
Sales $ 250,000 $ 275,000
Less variable expenses 150,000 165,000
Contribution margin 100,000 110,000
Less fixed expenses 80,000 80,000
Net operating income $ 20,000 $ 30,000

10% increase in sales from

$250,000 to $275,000 . . .

. . . results in a 50% increase in

income from $20,000 to $30,000.
24
 Cp6.
Coffee Klatch is an espresso stand in a downtown office
building. The average selling price of a cup of coffee is
$1.49 and the average variable expense per cup is $0.36.
The average fixed expense per month is $1,300. An
average of 2,100 cups are sold each month. What is the
operating leverage?
a. 2.21
b. 0.45
c. 0.34
d. 2.92

25
 Cp….7
At Coffee Klatch the average selling price of a cup of
coffee is $1.49, the average variable expense per cup
is $0.36, the average fixed expense per month is
$1,300, and an average of 2,100 cups are sold each
month.
If sales increase by 20%, by how much should net
operating income increase?
a. 30.0%
b. 20.0%
c. 22.1%
d. 44.2%

26
 Verify Increase in Profit
Actual Increased
sales sales
2,100 cups 2,520 cups
Sales $ 3,129 $ 3,755
Less: Variable expenses 756 907
Contribution margin 2,373 2,848
Less: Fixed expenses 1,300 1,300
Net operating income $ 1,073 $ 1,548
% change in sales 20.0%
% change in net operating income 44.2%
27
LSB Company has the following
income statement:
• Revenues $100,000
• Variable Costs 40,000
• Contribution Margin 60,000 9. If LSB’s sales
• Fixed Costs 30,000 increase by $20,000, what
• Operating Income 30,000 will be the company’s
operating profit?
a. $42,000
• 8. What is LSB’s DOL? b. $12,000
a. 3.33 c. $50,000
b. 2.00 d. $30,000
c. 0.50
d. 1.00

28
 Structuring Sales Commissions
Companies generally compensate salespeople by paying them
either a commission based on sales or a salary plus a sales
commission. Commissions based on sales dollars can lead to
lower profits in a company.

Let’s look at an example.

29
 Structuring Sales Commissions
Pipeline Unlimited produces two types of surfboards, the XR7 and the
Turbo. The XR7 sells for $100 and generates a contribution margin per
unit of $25. The Turbo sells for $150 and earns a contribution margin
per unit of $18.

The sales force at Pipeline Unlimited is compensated based on sales

commissions.
30
 Structuring Sales Commissions
If you were on the sales force at Pipeline, you would push hard to sell
the Turbo even though the XR7 earns a higher contribution margin per
unit.

To eliminate this type of conflict, commissions can be based on

contribution margin rather than on selling price alone.

31

 The formulae presented to this point have
assumed a single product is produced and
sold.
 A more realistic scenario involves multiple
products sold, in different volumes, with
different costs and different margins.
 In this case, we use the same formulae,
but use average contribution margins for
the multiple products.
 This technique assumes a constant mix at
different levels of total unit sales.
Let’s turn now to the topic of sales mix.
More usually, a company has multiple
products with varying contribution
margins.
We can still use the tools of CVP
analysis but instead of using the
contribution margin for the one
product, we will use an average
contribution margin.
The average CM is calculated based on a
defined product mix.
In other words, the CM is determined
based on a specific relationship of sales
of product 1 to total sales and sales of
product 2 to total sales.
If that relationship of sales changes, so
will our average CM.
3-32
 The Concept of Sales Mix
• Sales mix is the relative proportion in which a
company’s products are sold.

• Different products have different selling prices, cost structures, and

contribution margins.

• When a company sells more than one product, break-even analysis

becomes more complex as the following example illustrates.

Let’s assume Racing Bicycle Company sells bikes and carts and that
the sales mix between the two products remains the same.

33
 Multi-Product Break-Even Analysis
Bikes comprise 45% of RBC’s total sales revenue and the carts comprise the
remaining 55%. RBC provides the following information:

Bicycle Carts Total

Sales $ 250,000 100% $ 300,000 100% $ 550,000 100.0%
Variable expenses 150,000 60% 135,000 45% 285,000 51.8%
Contribution margin 100,000 40.0% 165,000 55% 265,000 48.2%
Fixed expenses 170,000
Net operating income $ 95,000

Sales mix $ 250,000 45% $ 300,000 55% $ 550,000 100%

$265,000 = 48.2% (rounded)

$550,000
34
 Multi-Product Break-Even Analysis
Dollar sales to Fixed expenses
=
break even CM ratio

Dollar sales to $170,000

= = $352,697
break even 48.2%

Bicycle Carts Total

Sales $ 158,714 100% $ 193,983 100% $ 352,697 100.0%
Variable expenses 95,228 60% 87,293 45% 182,521 51.8%
Contribution margin 63,485 40% 106,691 55% 170,176 48.2%
Fixed expenses 170,000
Net operating income Rounding error $ 176

Sales mix $ 158,714 45% $ 193,983 55% $ 352,697 100.0%

35
 CVP isn’t just for merchandising and CVP, though more prevalent for manufacturing
and merchandising companies, is certainly
manufacturing companies. useful for service and not-for-profits as well.
 Service and Not-for-Profit businesses
The challenge here is to focus on a measure of
need to focus on measuring their output which is generally going to be different
output which is different from the from the measure of “units sold” that we’ve
been dealing with so far.
units sold that we’ve been dealing
with.
 For example, a service agency might
measure how many persons they
assist or an airline might measure
how many passenger miles they fly.

3-36
Problem
 • Decision making : Application :More examples
• CVP analysis can be used for deciding additional
capacity utilisation
• Eg 4 A company is working at 60% of potential capacity. The Sales Manager has
reported two available solutions for increasing sales :
• (a) By an overseas contract which calls for delivery, spread equally for a period of
three years totaling Rs.15,00,000
• (b) Local sales can be increased by 50 per cent if Rs.50,000 is spent on special
advertising.
• The following is a summarised analysis of the profit and loss account for the
previous year :
• Rs. lakhs
• Materials used 4.50
• Direct labour 5.10
• Manufacturing expenses : Fixed 1.75
• Variable 0.75
• Selling expenses Variable 1.50
• Administration expenses : Fixed 1.00
• ------------
14.60
• Profit 0.40
• -----------
• Sales 15.00
• It is estimated that additional selling expenses on export sales will be 5 per cent of
sales value. Decide whether the directors would adopt (a) or (b) or a feasible
combination of (a) and (b).
 • Decision making : Application :More
examples
• Deciding on change in product mix (sales Mix)
• Eg 5
• Calculate the effect of change in ’Sales Mix’ from the following data :
• Product
• M N O P Total
• Sales (in Rs.) 40,000 50,000 20,000 10,000 1,20,000
• Variable cost (in Rs.) 24,000 34,000 16,000 4,000 78,000
• Fixed cost (in Rs.) 29,400
• The sales mix changed to : (Rs.)
•
• M 30,000
• N 44,000
• O 40,000
• P 6,000
• --------------
• 1,20,000
• -------------
•
Solutions
4

Overseas Contract Cost Domestic sales

New sales : Rs. 22.50 lacs
Item Rs. in lacs Item Rs. In lacs
Material 6.75
Material 1.50
Direct labour 7.65
Labour 1.70 Variable :
Variable: Manufacturing 1.125
Manufacturing 0.25 Selling 2.25 3.375
17.775
Selling 0.50 Price 22.50
Additional 0.25 1.00 Contribution 4.725 (21% to price)
4.20 Fixed cost (2.75 + 0.50) 3.25
Price 5.00 Profit 1.475

Contribution 0.80
Combination of domestic and export sales
Profit from domestic sales 0.40 Export sales 5.00 Contribution 0.80
Total profit 1.20 Domestic 20.00 Contribution 4.20
Total Contribution 5.00
Fixed costs 3.25
Profit 1.75
5

Product
M N O P Total
Sales (in Rs.) 40,000 50,000 20,000 10,000 1,20,000
Variable cost (in Rs.) 24,000 34,000 16,000 4,000 78,000
Contribution 16,000 16,000 4,000 6,000 42,000
Contribution/sales 0.4 0.32 0.2 0.6
Fixed costs 29,400
Profit 12,600

New Product mix

30000 44000 40000 6000 120000
Contribution 12000 14080 8000 3600 37680
Fixed costs 29400
Profit 8280
Relevant costing & Decision making

43
Managers usually follow a decision model for
choosing among different courses of action.

A decision model is a formal method of making a

choice that often involves both quantitative and
qualitative analyses.
 Management accountants analyze and present
relevant data to guide managers’ decisions.
 Managers use the usual five-step decision-making
process presented discussed earlier to make
decisions.

44
 Primarily the
Information should be:
1. Relevant
responsibility of the
2. Accurate managerial
3. Timely accountant.

Relevant
Pertinent to a
decision problem.

Accurate
Information must
be precise.

Timely
Available in time
for a decision 11-45
 Relevant information has two characteristics:
 It occurs in the future
 It differs among the alternative courses of action.
 Relevant costs are expected future costs.
 Relevant revenues are expected future Revenues.
 Past costs (historical costs) are never relevant and are also
called sunk costs.

46
  Quantitative factors are outcomes that can be measured in
numerical terms.
 Qualitative factors are outcomes that are difficult to measure
accurately in numerical terms, such as satisfaction.
 Qualitative factors are just as important as quantitative factors even
though they are difficult to measure.

Managers divide the outcomes of decisions into two broad categories: quantitative and qualitative.

Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in financial
terms.

Although qualitative factors and quantitative nonfinancial factors are difficult to measure in financial
terms, they are important for managers to consider.
47
 Past (historical) costs may be helpful as a basis for making predictions. However,
past costs themselves are always irrelevant when making decisions.
 Different alternatives can be compared by examining differences in expected total
future revenues and expected total future costs.
 Not all expected future revenues and expected future costs are relevant.
Expected future revenues and expected future costs that do not differ among
alternatives are irrelevant and, hence can be eliminated from the analysis. The
key question is always, What difference will an action make?
 Appropriate weight must be given to qualitative factors and quantitative
nonfinancial factors.

Costs which are incremental or additional – basically the variable cost

48
 Costs that have already occurred and cannot be
changed are classified as sunk costs.
 Sunk costs are excluded because they cannot be
changed by future actions.

49
• Incremental Cost – the additional total cost incurred for an
activity
• Differential Cost – the difference in total cost between two
alternatives
• Incremental Revenue – the additional total revenue from an
activity
• Differential Revenue – the difference in total revenue between
two alternatives

Note that incremental cost

and differential cost are
sometimes used
interchangeably in
practice.

50
 Short-run pricing decisions or One-Time-Only Special Orders
 Insourcing vs. outsourcing (Make-or-Buy)
 Product-mix with capacity constraints
 Branch/segment: adding or discontinuing
 Equipment replacement

3-51
 One-Time-Only Special Orders
• Accepting or rejecting special orders when there is idle production
capacity and the special orders has no long-run implications
• Decision Rule: does the special order generate additional operating
income? Yes – accept –or-- No – reject
• Compares relevant revenues and relevant costs to determine
profitability
Potential Problems with Relevant-Cost Analysis
• Avoid incorrect general assumptions about information, especially:
“All variable costs are relevant and all fixed costs are irrelevant”
There are notable exceptions for both costs

• Problems with using unit-cost data:

Including irrelevant costs in error
Using the same unit-cost with different output levels
 Fixed costs per unit change with different levels of output
 Or….Short-run pricing decision
A special order decision is, in many respects, a short-run pricing
decision.
Sometimes, the decision is simply about setting an acceptable
price.
Remember the decision rule?
Any price above incremental costs will improve operating
income; however, consideration must be given to capacity
constraints, current market conditions, customer demand,
competition, etc.
The focus here is on the price setting itself rather than on
whether or not to accept an order at a particular price.
11-53
 Analysis of Special Decisions
Let’s again take a close look at some special
decisions faced by many businesses.

We just received An unexpected order

a special order. Do arrived from a potential
customer. We need to
you think we should decide whether or not to
accept it? accept this special order.

One-Time-Only

Special Orders

14-54
 Accept or Reject a Special Order
A travel agency e-mails us. They want to charter one of our aircraft for a round trip
flight from Japan to Hawaii. We have two airplanes that could potentially be used
to fly this trip. The managerial accountant prepared some information to help the
team make the decision whether or not to accept this offer.

• A travel agency offers Worldwide Airways $150,000

for a round-trip flight from Hawaii to Japan on a
jumbo jet.
• Worldwide usually gets $250,000 in revenue from this
flight.
• The airline is not currently planning to add any new
routes and has two planes that are idle and could be
used to meet the needs of the agency.
• The next screen shows cost data developed by
managerial accountants at Worldwide.
14-55
 Accept or Reject a Special Order
Normally, we would earn revenues of $280000, and incur expenses of
$190,000 on a trip such as this. However, we would not have to
provide ticketing and reservation services and would save $5,000 in
these costs.
Typical Flight Between Japan and Hawaii
Revenue:
Passenger $ 250,000
Cargo 30,000
Total $ 280,000
Expenses:
Variable expenses 90,000
Allocated fixed expenses 100,000
Total 190,000
Profit $ 90,000

Worldwide will save about $5,000 in reservation

and ticketing costs if the charter is accepted. 14-56
 Accept or Reject a Special Order
Since we have two airplanes that are not being used, we only need to consider our variable
costs of making the trip. We would also save the ticketing costs, reducing our variable costs by
$5,000.
Even though we would normally receive $250,000 for a trip such as this, we should accept the
offer. The trip would contribute to paying our fixed costs, or, if our fixed costs are already paid,
it would contribute this amount directly to profit.

Assumes excess capacity

Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Contribution from charter $ 65,000

Since the charter will contribute to fixed costs and Worldwide has
idle capacity, the company should accept the flight. 14-57
 Accept or Reject a Special Order
What if Worldwide had no excess capacity? If
Worldwide adds the charter, it will have to cut its
least profitable route that currently contributes
$80,000 to fixed costs and profits. Should
Worldwide still accept the charter?

What should we do if all of our

airplanes are busy and we would
have to pull our airplane from a
regular route?

14-58
 Accept or Reject a Special Order
Since we would not earn the revenues from our regular route, we would have to charge for the
lost revenue of the route that was not taken, a lost opportunity. The total cost to us exceeds the
amount of the offer and we should reject the special offer.

Assumes no excess capacity

Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Opportunity cost:
Lost contribution on route 80,000 165,000
Total $ (15,000)

Worldwide has no excess capacity, so it

should reject the special charter. 14-59
 Accept or Reject a Special Order
With excess capacity . . .
– Relevant costs will usually be the variable costs
associated with the special order.

Without excess capacity . . .

– Same as above but opportunity cost of using the firm’s
facilities for the special order are also relevant.

So…….The decision to accept or reject a special offer can be summed up

like this.
If we do have excess capacity, the relevant costs will usually be the
variable costs.
If we do not have extra capacity, we would have to add the opportunity
cost of using our facilities. 14-60
 opportunity cost
Opportunity Cost is the contribution to operating
income forgone by not using a limited resource in
its next-best alternative use.
Opportunity Costs are not recorded in financial
accounting systems because historical record
keeping is limited to transactions involving
alternatives that managers actually selected rather
than alternatives that they rejected.
One type of opportunity cost is the carrying cost of
inventory: the operating income forgone by tying
up money in inventory and not investing it
elsewhere.
11-61
When making this type of decision, it is important to keep in mind those qualitative
factors. For example, what if all customers began demanding the lower price? How
would that affect profitability?
 Avoiding Potential Problems with Relevant-Cost Analysis
• Focus on Total Revenues and Total Costs, not their per-unit
equivalents
• Continually evaluate data to ensure that it meets the requirements
of relevant information

Insourcing versus Outsourcing

• Insourcing – producing goods or services within an organization
• Outsourcing – purchasing goods or services from outside vendors
• Also called the “Make or Buy” decision
• Decision Rule: Select the that option will provide the firm with the
lowest cost, and therefore the highest profit.

Same as special order: choose the alternative that maximizes operating income.
 Qualitative Factors
• Nonquantitative factors may be extremely
important in an evaluation process for each
of the decisions we cover here, yet do not
show up directly in calculations:
– Quality requirements
– Reputation of outsourcer
– Employee morale
– Logistical considerations—distance from plant,
and so on
– For make/buy decisions, buying can be risky,
especially if sourcing internationally.

11-64
 Outsource a Product or Service
A decision concerning whether an item should be
produced internally or purchased from an outside
supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the

management of Worldwide Airways.

Sometimes the decision is whether we should produce a product, or

whether we should have someone else produce that product. This is
called a make buy decision.

Insourcing versus Outsourcing

make or buy 14-65

 Outsource a Product or Service
• An Atlanta bakery has offered to supply the in-
flight desserts for 21¢ each.
• Here are Worldwide’s current cost for desserts:

We currently make Variable costs:

our own desserts
that are served on Direct material $ 0.06
flights. Our cost Direct labor 0.04
summary is shown Variable overhead 0.04
here.
Fixed costs:
Supervisory salaries 0.04
Depreciation of equipment 0.07
Total cost per dessert $ 0.25
14-66
 Outsource a Product or Service
Our variable costs will remain in the analysis, but some of our allocated fixed costs will
not be relevant to this decision. We will incur somewhat less in supervisor salaries,
but will still have some since someone needs to make sure the desserts are delivered
and loaded properly. Our depreciation will not change under either decision, so that
cost is not relevant.
Not all of the allocated fixed costs will be saved
if Worldwide purchases from the outside bakery.
Cost per Savings from
Our relevant Dessert Outsourcing
costs are .15 Variable costs:
per dessert. Direct material $ 0.06 $ 0.06
Direct labor 0.04 0.04
Variable overhead 0.04 0.04
Fixed costs:
Supervisory salaries 0.04 0.01
Equipment depreciation 0.07 -
Total cost per dessert $ 0.25 $ 0.15
14-67
 Outsource a Product or Service
•If we bought from the If Worldwide purchases the
dessert for 21¢, it will only
outside source, our cost save 15¢
would be 21 cents, and But will pay 21¢
our relevant savings for so Worldwide will have a loss of
this decision are 15 cents. 6¢ per dessert purchased.
• We should not accept
this special offer, since we
would lose 6 cents per Wow, that’s
dessert served. no deal!

Beware of Unit-Cost Data

For decision-making purposes, unitized
fixed costs can be misleading.
14-68
 Outsource a Product or Service
Beware of Unit-Cost Data
For decision-making purposes, unitized fixed
costs can be misleading.
•Fixed costs often are allocated to
individual units of product or service
for product-costing purposes.
•For decision-making purposes,
however, unitized fixed costs can be
misleading.
• Remember that fixed costs are fixed
in total, not on a per unit basis.
•Also, many fixed costs remain,
regardless of a decision to outsource
or to continue to produce.