Using Relevant Cost for

Decision Making
CVP Analysis Approach
Decision Making
 Define the problem
 Identify the alternatives
 Collect information on alternatives
 Examine irrelevant information
 Make a decision with the remaining
relevant information
How managers make decisions

 Gather and analyse information to

compare alternatives
 Select an alternative
 Implement the decision
 Compare actuals with expectation
 Review and Follow up
Relevant Information
 It has a bearing on the future
 It differs among competing alternatives
Relevant Information
 Focus on costs and revenues that are
relevant to the decisions

 Is expected future data

 Data differs among alternatives

Irrelevant costs
 Costs that do not affect your decision

 Example : Sunk costs

Relevant information for business
decisions

 Opportunity costs

 Out of pocket costs

 Differential costs

 Marginal costs
Relevant Non financial
information
 Closing manufacturing plants
 Laying off employees
 Outsourcing
 Offering discounted prices to select
customer
Keys to making short-term
special decisions
 Focus on relevant revenues, costs and
profits

 Use a contribution margin approach that

separates variable costs from fixed costs
Types of decisions
 1.Special sales order
 2. When to drop a product, department
or territory
 3. Product mix decisions
 4. Outsourcing decisions (Make/Buy)
 5. Sell as is or Process further decisions
Special Sales Order
 A special order occurs when a customer
request a one time order at reduced sales
 Considerations:
 i) Do we have excess capacity available to fill
this order?
 ii) Will the reduced sales price be high enough
to cover the incremental costs of filling the
order? (V.C & any additional F.C)
 Will the special order affect regular sales in the
long run?
Decision Rule
 If expected increase in revenues
exceeds expected increase in variable
and fixed costs --- ACCEPT THE
ORDER
 If expected increase in revenues is less
than expected increase in variable and
fixed costs --- REJECT THE ORDER
Drop a Product, Department or
Territory
 Does the product provide a positive
contribution margin?
 Will fixed costs continue to exist even if
we drop the product?
 Are there any direct fixed costs that can
be avoided if we drop the product?
 What could we do with the fixed
capacity?
Decision Rule
 If lost revenues from dropping a
product/department/territory exceeds the
costs savings from dropping – DO NOT
DROP

 If total cost savings exceed revenues

from dropping a product/dept/territory -
DROP
Product Mix Decisions
 When companies do not have unlimited
resources

 Constraints that restrict production or

sale of a product vary from company to
company
Considerations
 What constraint(s) stop us from making
all of the units we can sell?
 Which products offer the highest
contribution margin per unit of the
constraint?
 Would emphasizing one product over
another affect fixed costs?
Constraints
1. A reference to scarce resources.
2. Examples of constraints include
manufacturing space, labor, parts and
materials etc..
3. The focus shifts away from Contribution
Margin and to the scarce resource or
constraint.
Decision Rule

 EMPHASIZE THE PRODUCT WITH

THE HIGHEST CONTRIBUTION PER
UNIT OF THE CONSTRAINT
Outsourcing decisions
(Make/Buy)
 How best to use available resources.
 Considerations:
 i) How do our variable costs compare to
the outsourcing cost?
 ii) Are any fixed cost avoidable if we
outsource?
 iii) What could we do with the fixed
capacity?
Decision Rule
 If incremental costs of making exceed
the incremental costs of outsourcing ---
OUTSOURCE

 If incremental costs of making are less

than the incremental costs of
outsourcing --- DO NOT OUTSOURCE
Sell as is or Process further
decisions
 At what point in processing should a
company sell its product?

 Typical of : food processing or natural

resource industry
Considerations
 How much revenue will we receive if we
sell the product as is?
 How much revenue will we receive if we
sell the product after processing it
further?
 How much will it cost to process the
product further?
Decision Rule
 If the extra revenue (from processing
further) exceeds extra cost of processing
further --- PROCESS FURTHER

 If extra revenue (from processing further)

is less than extra cost of process further
--- DO NOT PROCESS FURTHER