SESSION 08: TACTICAL DECISION MAKING

Decision making process

In making business decisions, considers both financial and non-

financial information.
 Example of short-run decision making
Step 1. Recognize and define the problem.
Increase capacity for warehousing and production.
Step 2. Identify alternatives as possible solutions to
the problem; eliminate alternatives that are
clearly not feasible.
1. Build new facility
2. Lease larger facility; sublease current facility
3. Lease additional facility
4. Lease warehouse space
5. Outsource production to another company; free
up needed space
 Example of short-run decision making
Step 3. Identify the costs and benefits associated with
each feasible alternative. Classify costs and
benefits as relevant or irrelevant, and eliminate
irrelevant ones from consideration.
Lease warehouse space:
Variable production costs $180,000
Added Second shift costs 90,000
Warehouse lease 100,000
Outsource production to another company:
Purchase price $360,000
 Example of short-run decision making
Step 4. Total the relevant costs and benefits for each
alternative.
Lease warehouse space:
Variable production costs $180,000
Added second shift costs 90,000
Warehouse lease 100,000
Total $370,000
Outsource production to another company:
Purchase price $360,000

Differential cost $ 10,000

 Example of short-run decision making

Step 5. Assess qualitative factors. Quality of shafts

1. Quality of external suppliers and brushing is
2. Reliability of external suppliers significantly
Not reliablelower

Step 6. Make the decision.

 How Incremental Analysis Works

Important concepts used in incremental analysis:

 Relevant cost – costs and revenues that differ across

alternatives.

 Opportunity cost – the lost benefit from choosing a particular

alternative.

 Sunk cost – costs that have already been incurred and will
not be changed or avoided by any present or future
decisions.
Types of Incremental Analysis

1. Make or buy component parts or finished products.

2. Accept an order at a special price.

3. Keep or drop an unprofitable business segment or

product.

4. Sell the joint products at the split-off point or process

them further
Make or Buy (Example 8.1 page 405)
Swasey Manufacturing needed to determine if it would be cheaper
to make 10,000 units of a component in-house or to purchase them
from an outside supplier for $4.75 each. Cost information on internal
production includes the following:
Total Cost Unit Cost
Direct materials $10,000 $1.00
Direct labor 20,000 2.00
Variable overhead 8,000 0.80
Fixed overhead 44,000 4.40
Total $82,000 $8.20

Fixed overhead will continue whether the component is produced

internally of externally. No additional costs of purchasing will be
incurred beyond the purchase price.
What should management do?
Make or Buy (Example 8.1 page 405)

1. What are the alternatives for Swasey Manufacturing?

2. List the relevant cost(s) of internal production and of
external purchase.
3. Which alternative is more cost effective and by how much?
4. Now assume that the foxed overhead includes $10,000 of
cost that can be avoided if the component is purchased
externally. Which alternative is more cost effective and by
how much?
Special Order (Example 8.2 page 407)
Leibnitz Company has been approached by a new customer with an
offer to purchase 20,000 units of model T R 8 at a price of $89 each.
The new customer is geographically separated from the company's
other customers, and existing sales would not be affected. Leibnitz
normally produces 100,000 units of T R 8 per year but only plans to
produce and sell 75,000 in the coming year. The normal sales price is
$14 per unit. Unit cost information for the normal level of activities is
as follows: Direct materials $3.00
Direct labor 2.80
Variable overhead 1.50
Fixed overhead 2.00
Total $9.30
Fixed overhead will not be affected by whether or not the special order
is accepted.
Special Order (Example 8.2 page 407)

1. What are the relevant costs and benefits of the two

alternatives (accept or reject the special order)?
2. By how much will operating income increase or decrease if
the order is accepted?
Segmented income statement (Example 8.3
page 410)
Audiomatronics Inc. produces MP3 players and smartphones in a
single factory. The following information was provided for the
coming year

MP3 Players Smartphones

Sales $400,000 $290,000
Variable cost of goods sold 200,000 150,000
Direct fixed overhead 30,000 20,000 Illustration 7-16

A 5% sales commission is paid for each of the product lines. Direct

fixed selling and administrative expense was estimated to be
$10,000 for the MP3 line and $15,000 for the smartphone line.
Common fixed overhead for the factory was estimated to be
$100,000; common selling and administrative expense was
estimated to be $20,000.
 Keep or drop an unprofitable segment
(Example 8.4 page 412)
Blocks Bricks Tile Total
Sales revenue $500,000 $800,000 $150,000 $1,450,000
Less: Variable expenses 250,000 480,000 140,000 870,000
Contribution margin $250,000 $320,000 $ 10,000 $ 580,000
Less direct fixed expenses:
Advertising (10,000) (10,000) (10,000) (30,000)
Supervision salaries (37,000) (40,000) (35,000) (112,000)
Depreciation (53,000) (40,000) (10,000) (103,000)
Segment margin $150,000 $230,000 $(45,000) $ 335,000

The roofing tile line has a contribution margin of $10,000 (sales of

$150,000 minus total variable costs of $140,000). All variable costs are
relevant. Relevant fixed costs associated with this line include $10,000 in
advertising and $35,000 in supervision salaries.
Keep or drop an unprofitable segment
(Example 8.4 page 412)

1. List the alternatives being considered with respect to the

roofing tile line
2. List the relevant benefits and costs for each alternative
3. Which alternative is more cost effective and by how much?
Keep or drop an unprofitable segment
(Example 8.5 page 414)

Refer to Norton Materials’ segmented income statement

in Example 8.4 (p. 412). Assume that dropping the
product line reduces sales of blocks by 10% and sales of
bricks by 8%. All other information remains the same.

Required:
1. If the roofing tile line is dropped, what is the
contribution margin for the block line? For the brick
line?
2. Which alternative (keep or drop the roofing tile line)
is now more cost effective and by how much?
Sell or Process Further (Example 8.6 page 416)
Appletime grows apples and then sorts them into one of three grades, A,
B, or C, based on their condition. Appletime must decide whether to sell
the Grade B apples at split-off or to process them into apple pie filling.

Sold as 5-pound bags at $1.25

Quantity = 120 bags

Grade B apples

Pie filling processing Sold as pie filling at

Cost = $0.24/can $0.90/can
Quantity = 500 cans
 The use of costs in pricing decisions
1. Cost-based pricing
• Since revenue must cover all costs for the firm to make a profit,
many companies start with cost to determine price
• That is, they calculate product (or service) cost and add the
desired profit
• The mechanics of this approach involve a cost base and a
markup

2. Target cost pricing

• Target costing is a method of determining the cost of a product
or service based on the price (target price) that customers are
willing to pay
• The marketing department determines what characteristics and
price for a product are most demanded by consumers