14 Bbma3203 T10

Topic X Short-Term
10 Decision
Making
LEARNING OUTCOMES
At the end of this topic, you should be able to:
1. Identify the roles of the management accountant in the decision
making process;
2. Recognise the relevant information for decision making;
3. Describe the constraints faced by organisations; and
4. Examine and apply five types of decision making.
X INTRODUCTION
Making decisions is one of the roles and functions of a manager. In performing
these daily tasks, the manager is often faced with problems in decision-making,
such as:
(a) How many units of products need to be sold for every existing product
line;
(b) What method of production to be used;
(c) Will the company be producing the components or acquiring them from
suppliers;
(d) Should the existing production lines be maintained or closed down; and
(e) Many other decisions related to the daily operations of the company.
Making decisions is not a simple task and therefore needs to be performed by

highly skilled and knowledgeable managers. In the process of decision making,
cost has always been an important factor which needs to be considered. The cost
for each alternative has to be considered as one of the steps in making decisions.
Copyright © Open University Malaysia (OUM)
232 X TOPIC 10 SHORT-TERM DECISION MAKING
The problem is, not all costs are relevant for decision making. Therefore, a
manager has to be quick in evaluating the cost information so that only relevant
information is taken into account when making decisions.
This topic will discuss the roles of management accountants in decision making,
identifying the relevant cost information and employing the relevant cost in the
process of making the following decisions: the decisions whether to produce or
buy, retain or remove the product, make special orders, sell at a split-off point or
perform additional processes as well as decisions regarding product mix.
10.1 ROLE OF A MANAGEMENT ACCOUNTANT

IN DECISION MAKING
One of the most significant roles of management accounting is to prepare
information which satisfies the requirements specified by managers and
employees who make every effort to achieve the objectives of the organisation.
As you are aware, the key role of a manager involves making decisions. The
question now is what type of information must the management accountant
provide to the managers?
There are three main features of good accounting information for making
decisions, namely relevancy, accuracy and timeliness.
(a) Relevancy
The information is said to be relevant if it is useful for making a

decision. The information given by the accountant must be in
conformity with the type of decision making which must be made by
the managers.
This is due to the fact that, the type or structure of decision making may
differ from one manager to another. For instance, managers of marketing,
production and purchasing require different accounting information to
make decisions in their fields.
Marketing managers may be interested in knowing the cost of advertising.

Production managers, on the other hand, will be interested in knowing the
cost of setting up the machines. Thus, only relevant information needs to be
provided by the management accountant to be used in making decisions.
Nevertheless, at the managerial level, managers need to understand the
financial implication of each decision made. The management accountants
TOPIC 10 SHORT-TERM DECISION MAKING W 233
are responsible for obtaining and analysing the relevant information while
individual managers are responsible for acquiring the information,
analysing them and making final decisions.
(b) Accuracy
Accuracy of information refers to the information given to the

managers which must be accurate in terms of its facts, calculations and
so on.
Accurate information is necessary in decision making to ensure the

usefulness of the information.
(c) Timeliness
Besides the above criteria, relevant and accurate information needs to be
provided on time in order for it to be useful to the decision makers when
making decisions.
A management accountant must understand the need for different types of

information within the organisation. For example, the top management
may only require monthly summary reports from every department or
section. An engineer responsible for hourly production schedules may
require current and continuous information as well as comprehensive
information on alternative costs for various methods of producing a
product.
The information provided by the accountant has its own costs associated
with it, which may be difficult to measure at times. The cost of obtaining
such information increases with increases in the degree of its accuracy,
volume requested and urgency of its delivery. Moreover, it is also common
for managers to request for additional information to reduce any
uncertainties arising from various actions taken. However, some managers
may request for information without being aware of the additional cost
associated with it. Thus, the decision makers often have to balance the costs
against the benefits of the information. The information is said to be
beneficial if the managers cannot perform the decision making without it.

ACTIVITY 10.1
Assuming that you are an accountant in company A, what roles should
you assume in helping your company to make sound business
decisions? What information needs to be prepared as reference materials
for the company?
Example 10.1
For instance, a sales manager requests for information regarding all the
overhead costs involved in producing a product. Assuming that one of the costs
is related to the consumption of glue, if the manager only wants the complete
and accurate costs, the management accountant then has to spend a lot of time
in allocating the cost of glue incurred to the product, even though the total cost
of the glue is only RM200, compared to the overall overhead cost of RM5
million.
Then again, if the management accountant is consuming too much time to

obtain accurate information regarding the cost of glue incurred, then the cost of
obtaining the information will be higher and possibly cause a delay in its
delivery to the sales manager. Subsequently, the information may not be useful
if a decision has been made before it arrives.
10.2 RELEVANT INFORMATION

One of the criteria of quality information is the relevancy of the information.
Relevance here refers to different information for different alternatives which
will be useful for making decisions.
In previous topics, you have studied various concepts of costs, such as variable
costs, fixed costs, and opportunity costs, incremental or differential costs as well
as sunk costs. Which of these costs do you think is the relevant cost?
Any avoidable cost can be defined as a cost which could be eliminated

(entirely or partially) resulting from choosing an alternative over other
available alternatives in the process of making decisions.

All costs can be considered as avoidable costs except for sunk costs and future
costs, which are indifferent between available alternatives.
Example 10.2
Suppose you wish to trade in your old car for a new car. The relevant
information is the cost of a new car and the selling price of the old car. On the
other hand, the cost of the old car is irrelevant and is considered as sunk cost as
it has been incurred in the past and cannot change any future decisions. Sunk
costs are the costs that have been incurred in the past and cannot be avoided
no matter which course of action is taken. Thus, the sunk cost is irrelevant to
future events and has to be disregarded in the decision making process.
To identify avoidable costs, the following steps can be taken:
Step 1: Obtain all costs related to the alternatives under consideration.

Step 2: Identify sunk costs and ignore these costs.
Step 3: Identify which of the costs are indifferent between alternatives and
ignore them.
Step 4: Make decisions based on the remaining costs after performing Step 2
and Step 3. The remaining cost information is called differential cost
or incremental cost.
In management accounting, terms like differential cost, incremental cost,

avoidable cost and relevant cost are often used alternately but ultimately mean
the same, that is, relevant cost.
To carry out the above steps, consider this example. Suppose you have an old
car. The book value for the old car is:
Cost of Acquiring The Old Car RM90,000

Less: Accumulated Depreciation Value RM50,000
Book Value RM40,000
The old car can be resold at a price of RM15,000. Apart from the annual
depreciation value of RM10,000, you also have variable operating costs (petrol,
maintenance, etc.) which amount to RM10,000 per annum. You are considering
purchasing a new car that costs RM120,000, has 10 years of lifespan and an

expected variable operating cost of RM6,000 in a year. To perform this decision

making, consider the following:
(a) Gather the cost information: The costs involved are the cost of acquiring the
old car, accumulated depreciation value, book value, price of the new car,
depreciation of the new car, operating cost for the old and new car,
respectively and the selling price of the old car;
(b) The sunk costs are the book value and the depreciation of the old car;
(c) There are no future costs which are indifferent; and
(d) Relevant costs are the selling price of the old car, depreciation of the new
car and annual operating costs.
Therefore, we can perform analysis as illustrated in Table 10.1.
Table 10.1: Decision to Replace a Car
Retaining Old Acquiring New Differential Cost

Car Car (RM)
(RM) (RM)
Income from Selling Old Car - (15,000) 15,000
Depreciation of New Car - 12,000 (12,000)
Operating Cost 10,000 6,000 4,000
Total 10,000 3,000 7,000
The differential cost column shows the difference in each item of costs incurred
between the two alternatives. From the analysis shown in Table 5.1, it is
evidently better that you buy a new car than retaining the old car.
We can now conclude that for a cost to be relevant, it has to satisfy two
requirements, i.e. it must be cost-effective in the future and must provide
different cost-effectiveness between alternatives.
10.3 THEORY OF CONSTRAINTS

Constraints theory is a theory developed by Dr Eliyah Goldratt for the purpose
of managing constraints faced by an organisation. The theory of constraints states
that:

Every process is said to have constraints or resources bottlenecks and thus

production cannot move as fast due to the existence of the constraints.
The purpose of the constraints theory is to maximise the throughput, which is the
selling income minus the direct raw materials cost.
This theory can be associated with decision making since every organisation will
face at least one constraint. Thus, in performing decision making analysis, the
accountant should take into account the constraint factors faced by the
organisation. Moreover, the managers have to be smart in determining the best
manner to use limited resources in order to achieve the objectives of the
organisation.
Constraint refers to anything that hinders an organisation from achieving its

objectives. Constraints can be divided into internal constraints and external
constraints, as illustrated in Table 10.2.
Table 10.2: Two Types of Constraints
Constraints Type Explanation

Internal Constraint Internal constraints refer to the constraints which can be
managed and controlled by organisations, for example,
insufficiency in labour force, machines, raw materials, storage
areas and others.
External Constraint External constraints refer to the constraints which cannot be
managed or controlled by the organisations, for example,
inadequacy in raw materials as a result of reduction in its
supply in the market.
In the short term, managers will not be able to overcome the constraints easily.
The reason is that, in order to overcome a constraint, the companyÊs long term
financial condition will be affected. For instance, a company is short of machines
in the production process. The decision to buy machines is a long-term decision
as it involves high cost and the company must therefore perform a thorough
analysis on the costs and benefits of purchasing such machines.

ACTIVITY 10.2
What are the constraints that you can think of, which are normally faced
by managers when making decisions in an organisation?
How can we identify a constraint? Consider Example 10.3.
Example 10.3
Puteri Idaman Sdn. Bhd. is a well-known company that produces school

uniforms in the northern region of Malaysia. The demand for the school
uniforms is 350 pairs per month. Puteri Idaman has four production
departments, namely the Cutting Department, Sewing Department, Finishing
Department and Packaging Department. Every department has its own capacity
that differs from the others, as illustrated:
Department Monthly Capacity

Cutting 200 pairs
Sewing 300 pairs
Finishing 400 pairs
Packaging 500 pairs
You are required to:
Determine the process which constitutes a constraint to Puteri Idaman Sdn. Bhd.
Based on the information given in Example 5.3, it is obvious that the process
which constitutes a production constraint is the process in the Cutting
Department, which is only able to complete 200 pairs in a month. That means
Puteri Idaman will not be able to meet all of its customersÊ demands as its
maximum production capacity is only 200 pairs per month.
In general, a company will have more than one constraint. Nevertheless,

discussions in this topic will be focused on single constraint only. The application
of the theory of constraints will be demonstrated later when we discuss decision
making issues related to product mix.

10.4 TYPES OF DECISION MAKING

In this topic, we will discuss several types of decision-making (refer to
Figure 10.1).
Figure 10.1: Types of decision making
Discussions on decision making in this topic will focus on short-term decision

making, which is usually known as tactical decision making.
Tactical decision making means the process of choosing from among a

selection of alternatives, which is performed with urgency or under limited
consideration.
In making tactical decisions, we will be using relevant data and cost information
which will best benefit the organisation.
Before we proceed to look at each of the types of decision making, we will

observe the steps to be taken in the decision making process, as illustrated below
in Figure 10.2.

Figure 10.2: Steps in the decision making process
10.4.1 Decision to Eliminate or Retain a Product

Sometimes, some of the products we produce do not receive good response from
customers, thus incurring losses to the company. In this situation, the company
will decide whether to retain or remove the product from the production lines. In
addition, this decision may include closing business segments, branches or
departments related to the product within the organisation. A decision to
eliminate or continue a product often leads to another decision of whether or not
the company will introduce new products or add business segments.
Useful information that will assist in making such decisions can be obtained from
the income statements by segments, which are prepared according to products or
business segments, depending on the type of decision required.

Income statement by segment refers to condensed income statements

prepared for each type of product or segment.
Example 10.4
For example, Kaya Company has three product lines, namely, product A, B and
C. Therefore, the accountant of Kaya Company needs to prepare income
statements by segment, specifically for product A, B and C. From these income
statements (by segments), the accountant will be able to see clearly the profits
generated by each product.
Bear in mind, however, that the income statements by segments must be

prepared in the marginal income statement format. Why? The reason is that, as
previously discussed; only variable costs are relevant in decision making as fixed
costs are irrelevant and must be ignored. Hence, income statements based on the
marginal format can provide the type of information required above.
Problems which may arise in making decisions are usually related to fixed costs.
Note that fixed costs can be divided into two categories, namely direct fixed costs
and joint fixed costs.
(a) Direct Fixed Costs
Direct fixed costs refer to fixed costs that can be traced or assigned
directly to each product.
For example, the salary of a supervisor can be traced directly to product A,

B and C. It is often assumed, when a product is eliminated, that the related
costs can be avoided (whether totally or partially, depending on the given
situation). In this case, we assume that the direct fixed cost satisfies both
criteria of relevant cost and thus must be taken into account when making
decisions. However, if the direct fixed cost cannot be avoided, then the cost
is said to be irrelevant and must be ignored.

(b) Joint Fixed Costs
Joint fixed costs refer to fixed costs which are shared between the
existing products.
For instance, the salary of a general manager of a company which cannot be

allocated directly to each product will be considered as a joint cost.
Example 10.5
Puteri Idaman is a company producing a variety of school essentials, such as

school uniforms, school bags and shoes. For the past two years, the sales of
school uniforms have been quite poor, which have resulted in losses in the last
two consecutive years. The management of the company is worried about this
situation and is thinking of discontinuing the product. The management
accountant has been asked to prepare an analysis to help in making a decision.
Following is the information which has been collected successfully:
1. Condensed Income Statement by Segment.
Bags Shoes Uniforms Total

Sales 90,000 120,000 100,000 310,000
Less: Variable Expenses 48,000 60,000 48,000 156,000
Contribution Margin 42,000 60,000 52,000 154,000
Less: Direct Fixed Expenses
SupervisorÊs Salary 12,000 10,800 24,000 46,800
Warehouse Rent 3,000 1,800 9,000 13,800
Insurance 1,900 2,100 2,400 6,400
Promotion 3,500 4,200 7,100 14,800
Transportation 10,950 7,000 12,750 30,700
Total 31,350 25,900 55,250 112,500
Product Margin 10,650 34,100 (3,250) 41,500
Less: Joint Fixed Cost 27,950
Net Profit 13,550

2. Additional Information:
(a) The supervisor for uniform products has been transferred to another
section with the same salary.
(b) There are two warehouses storing clothing products; one of them is
owned by the company while the other warehouse is rented from a
tenant under a revocable lease contract (RM750 per month). The
storage warehouse owned by the company can be rented out to other
parties at a rental rate of RM350 per month.
(c) Insurance taken is based on the number of products and can be
revoked without incurring additional costs.
You are required to:

Determine whether the company should discontinue the uniform product or
retain the product from its manufacturing lines as shown in Table 10.3.
Table 10.3: Decision Whether to Retain or Discontinue the Production of Uniform

Product
Retain (RM) Discontinue (RM)
Sales 100,000 -0-
Less: Variable Expenses 48,000 -0-
Contribution Margin 52,000 -0-
Other Income (Warehouse Rental) 4,200
Less: Direct Fixed Expenses
SupervisorÊs Salary 24,000 24,000
Warehouse Rent 9,000 -0-
Insurance 2,400 -0-
Promotion 7,100 -0-
Transportation 12,750 -0-
Total 55,250 24,000
Increment (Reduction) in Income (3,250) (19,800)
The purpose of the analysis illustrated in Table 5.3 is to compare the income
received if the product is retained and if the product is discontinued. Based on
this analysis, we can observe that continuing the product will cause the company
to incur a loss of RM3,250 per year. On the other hand, discontinuing the product
will result in an increase in losses of RM16,550 (that is, the difference between the
two losses of RM3,250 and RM19,800). Thus, the company should not
discontinue the uniform product.

Supposing a detailed analysis is not performed and the management depends

totally on the information from the income statements by segments to decide, the
management may actually arrive at the wrong decision by discontinuing the
production of the uniform product. A negative profit margin of the uniform
product does not necessarily imply that its production must be discontinued.
This is because the information provided in the segmental income statements do
not take into account other information which are related to avoidable costs and
opportunity costs.
Based on the analysis above, the avoidable costs that will result from
discontinuing the uniform product include the cost of supervisorÊs salary,
warehouse rental, insurance, promotion and transportation. On the other hand,
the opportunity cost for discontinuing the uniform product is the warehouse
rental income from an outside party. At this juncture, cost analysis can also be
carried out, as shown in Table 10.4.
Table 10.4: Cost Analysis if Production of Uniform Product is Discontinued
(RM) (RM)
Avoidable Cost (Cash In-Flows):
Variable Costs 48,000
Warehouse Rent 9,000
Insurance 2,400
Promotion 7,100
Transportation 12,750 79,250
(+) Warehouse Rental Income 4,200
(-) Opportunity Cost (Cash Out-Flows):
Sales Income (100,000)
Reduction in Income (16,550)
10.4.2 Decision to Produce or Buy

Deciding whether to produce or buy is a common type of decision faced by an
organisation. To produce or to buy here refers to the companyÊs choice between
producing in-house components required to produce the product and buying
from external parties.

For example, in the process of producing computers, the components required

are the mouse, monitor, processor, disc and many others. Some of these
components are produced in-house by the company manufacturing computers
while other components are bought from external suppliers.
In fact, in some cases, it will be more profitable to buy components from external
suppliers than to produce them while in other cases it will be more profitable to
produce than to buy the components. Hence, the managers need to perform a
more comprehensive analysis before deciding on whether to produce or buy the
components.
Similar to the types of decision making that have been discussed previously,
there are two types of analyses which can be carried out in the produce or buy
decision.
(a) The first step in the analysis is to look at the differential cost between the
buying alternative and the alternative of producing in-house. The
alternative which provides the best benefits will be selected.
(b) The second analysis to be performed is to look at avoidable costs.
Avoidable costs refer to the savings made by the company. If an alternative
results in higher savings than the cost, then the alternative will be chosen.
Example 10.6
Mercury Berhad is a company that produces washing machines. One of the

components required in producing the washing machines is called SPF-10.
Currently, the company produces 20,000 units of SPF-10 at the following
production costs:
Direct Materials RM100,000

Direct Labour 40,000
Variable Overheads 20,000
Fixed Overheads 80,000
Total Manufacturing Cost RM240,000
Manufacturing Cost Per Unit RM12.00
Income from Sales of Washing Machines RM300.00
Recently, a company known as Techno Company offers to sell SPF-10 components

at the price of RM9.00 per unit. If Mercury decides to purchase the components
from an outsider, a fixed overhead cost of RM5,000 can be eliminated. The
question is, should Mercury Berhad accept the offer?

At a glance, we can see that Mercury should buy the components from Techno
Company since the offer price of RM9.00 per unit is lower than the per unit
manufacturing price of RM12.00. Nonetheless, we cannot just compare the per
unit costs but must also perform some analyses related to relevant costs.
Table 10.5 provides all costs incurred regardless of whether or not they are
relevant for decision-making.
Table 10.5: Relevant and Irrelevant Cost Information
Relevant Irrelevant
Direct Materials Selling Price
Direct Labour
Variable Overheads
Fixed Overheads (Partial)
Purchase Cost
After identifying the relevant and irrelevant costs, we have to perform relevant
cost analysis, as shown in Table 10.6.
From the analysis given in Table 10.6, it is obvious that Mercury Berhad will incur
an additional loss of RM15,000 if purchases are made from an external party. This
is in contrast with our earlier perception that buying from an external party is
cheaper than producing the components. Based on the analysis, Mercury should
continue producing the component SPF-10 and reject the offer from Techno
Company.
Table 10.6: Relevant Cost Analysis (for 20,000 units) to Determine Whether to Produce or
Buy Component SPF-10
Produce Buy Net Income Increase

(Decrease)
Direct Materials RM100,000 - RM100,000
Direct Labour 40,000 - 40,000
Variable Overhead 20,000 - 20,000
Fixed Overhead 80,000 75,000 5,000
Purchase Cost SPF-10
(RM9 × 20,000) - 180,000 (180,000)
Total Cost RM240,000 RM255,000 RM(15,000)

The second form of analysis to be conducted by Mercury involves identifying

avoidable costs and additional costs as shown in Table 10.7.
Table 10.7: Relevant Cost Analysis (for 20,000 units) to Determine Whether to Produce or
Purchase Component SPF-10
Avoidable Cost Approach: (If component SPF-10 is purchased)

Cost Savings/Avoidable Costs:
Direct Materials RM100,000
Direct Labour 40,000
Variable Overheads 20,000
Fixed Overhead s 5,000 RM165,000
Incremental Costs:
Purchasing Cost 180,000
Net Incremental Cost RM(15,000)
Occasionally, the company has to consider opportunity cost. As we discussed

earlier, opportunity cost is a type of relevant cost. Referring to Mercury Berhad,
we assume that the company has decided to purchase the component from
Techno Company. The capacity that was previously used to produce component
SPF-10 can now be used to produce other products, which can generate an
additional income of RM20,000. Letting go of this income is an additional cost to
produce the component in-house in the „produce or purchase‰ decision making
process. Accordingly, this opportunity cost has to be included in the „buy‰
column for the purpose of comparison. Thus, the new relevant cost analysis will
be as follows:
Table 10.8: Relevant Costs analysis (for 20,000 units) to Determine Whether to Produce or
Buy Component SPF-10
Produce Buy Net Income

Increase (Decrease)
Total Cost RM240,000 RM255,000 RM(15,000)
Opportunity Cost 20,000 - 20,000
New Total Cost RM260,000 RM255,000 RM5,000

From the analysis in Table 5.8, we can see that after taking into account the
opportunity cost, the cost of producing the component in-house is now higher
than the cost of buying it from an external party. Therefore, Mercury Berhad
should choose to purchase the component from an external party in order to
attain an additional net income of RM5,000.
The company must also consider other qualitative factors in making decisions,
such as releasing employees whose work involves producing the SPF-10
component. Besides, the company must evaluate the ability of the external party
to produce the components in the long run and ensure that the quality of the
component if produced by the supplier is better than if it is produced in-house.
ACTIVITY 10.3
After studying the earlier sections, if you are a manager in Company X

who is considering whether to produce or to buy a product from
Company Y, what are the factors which must be considered apart from
the relevant costs?
10.4.3 Decision to Sell Before or After Additional

Process
A joint production process produces two or more products called a joint product.
For example, processing a raw pineapple can produce canned pineapples and
natural pineapple juices. Thus, pineapple serves as the input for the joint
production process, which produces two joint products, namely, canned
pineapple and natural pineapple juice. In this example, the pineapple is
processed through the joint production process which cannot be allocated until it
reaches a point known as the split-off point. The two different products can only
be identified at the split-off point. Please refer to Figure 5.3 that illustrates the
joint process for producing pineapples.

Figure 10.3: Joint process for pineapple production
From Figure 5.3, we can see that the joint cost of RM1,000 consists of the raw
materials cost of RM200 and the conversion cost of RM800. The output from the
joint process cost is 1,000 kg of canned pineapple and 1,800 kg of pineapple juice.
It is quite common for managers in a manufacturing company to have joint

production processes, hence facing a situation which involves deciding whether
to sell the products at the split-off point or to carry on with an additional process
before selling the products to customers. Assume that at the split-off point, a
manager of Ros Company is considering whether to proceed with the additional
process of converting natural pineapple juice into cordial juice. In other words,
should the company perform an additional process to produce cordial pineapple
juice? Referring to Figure 5.3, we can also see that by converting natural
pineapple juice into cordial juice, the company will generate sales value of
RM800. Given the information above, what should the manager do? What costs
and benefits need to be considered?
Let us consider each of the costs involved carefully. First, the company has
incurred a joint production cost of RM1,000. Is this cost relevant for making the
aforementioned decision? The joint production cost is actually irrelevant and
must be ignored in this decision making since it does not change regardless of
the decision made by the manager. If the manager decides to sell at the split-off
point, the cost of RM1,000 will be incurred and similarly, if the manager decides
to proceed with the additional process, the cost of RM1,000 will still be incurred.
That is what we mean by the cost is unchanged and is therefore, irrelevant.

The question now is, what are the relevant costs and benefits involved here?
Only different costs and income arising from different alternatives will be
considered here, as shown in Table 5.9.
Table 5.9: Analysis of Income and Cost for Determining Whether to Sell at the Split-off
Point or After Additional Process
Sales Income from Cordial Pineapple Juice RM800

Sales Income from Natural Pineapple Juice (400)
Increment in Income from Additional Process 400
Separate Process Cost (100)
Net Benefit from Additional Process RM300
The analysis shown in Table 5.9 is performed by comparing between the

additional income arising from the additional process and the separate process
cost, which is the cost involved at the split-off point. From this analysis, if the
company gains net benefit from the additional cost, then it should proceed with
the additional process. Conversely, if the additional income from the additional
process is less than the cost of the additional process, then the company should
sell the product at the split-off point and should not proceed with the additional
process which will incur loss to the company.
Based on the above analysis, we can conclude that the company should perform
the additional process on the natural pineapple juice and sell cordial pineapple
juice as the company can raise its income by RM300.
10.4.4 Special Orders
A special order refers to an order received from customers which is outside

the companyÊs ordinary production or expected orders.
It has been a common practice for companies to undertake early planning

regarding production level, which is done through a production budget.
Nonetheless, there are situations where the company receives orders other than
the normal orders. This kind of order is known as a special order. Usually,
special orders are orders made specifically according to customersÊ requirements
where the products may need to be modified to suit the customersÊ needs.

There are several decisions which must be made by managers regarding special
order products.
(a) First of all, is it reasonable to accept this special order?
(b) Secondly, the setting of the price for the special order.
To answer the first question, that is whether or not to accept the special order, the
company should first consider its capacity. If the company has extra capacity,
then it can accept the order as long as that order provides an increase in the
companyÊs operating income. On the other hand, if the company does not have
additional capacity (that is, the company is already operating under full
capacity), then it should consider the opportunity cost and the increase in cost in
order to decide whether to accept the special order or not. In the above situation,
the company will accept the order as long as the increase in the companyÊs
operating income is more than the opportunity cost plus the increase in cost. We
will first discuss special orders for a company which has additional capacity.
Later on under the setting of price section, we will explore the situation where a
company receives a special order when it is already operating at full capacity.
Consider Example 10.7 for a discussion on the decision to accept a special order.
Example 10.7
IndahSari Company is a manufacturer of ready-made clothing. The companyÊs

practical production level is 20,000 pairs per year. However, currently the
company only produces 15,000 pairs. Recently, the company received a special
order of 500 pairs of clothing from a manager of Kolej Utara for the selling price
of RM120.00 for each pair. The manager has requested the clothing be altered to
suit the corporate image of the college. The alteration will involve an additional
cost of RM5.00 per pair. The company also has to hire a designer, which involves
an additional cost of RM1,000.00. In addition to the above, two more machines
must be rented to cater for this special order with the total rental costing
RM800.00 for the two machines.
Normally, the ready-made clothes produced by IndahSari Company are sold at a

price of RM150.00 per pair. The costs involved in getting each of the pair ready
are:

Direct Materials RM15.00

Direct Labour 20.00
Variable Manufacturing Overheads 25.00
Fixed Manufacturing Overheads 40.00
Per Pair Cost RM100.00
What type of analysis should be carried out to assist IndahSari Company in this
decision making? Like any other decision making, we will consider once again
the relevancy of its costs and benefits. Therefore, we need to first identify the
relevant costs and benefits for the above special order. The difference or increase
in operations is illustrated in Table 10.10.
Table 10.10: Income and Cost Analysis for Decision Making with Respect to the Special
Order
Per Pair Total

Increase in Income RM120.00 RM60,000
Increase in Costs:
Direct Materials RM15.00 7,500
Direct Labour 20.00 10,000
Variable Overheads 25.00 12,500
Alteration 5.00 2,500
Machine Rental 800
Total Increase in Costs: 33,300

Increase in Operating Income RM26,700
The calculation above suggests that the new order must be accepted as it
provides a total profit of RM 26,700, even though the selling price of the special
order is lower (RM120) than the normal selling price (RM150). If we observe the
above analysis carefully, it does not take into account the fixed overhead cost in
the analysis. This is due to the fact that the fixed cost does not increase with the
increased number of orders. The reason is that it remains unchanged whatever
alternatives we choose, and thus it is irrelevant and should be ignored in this
analysis.

Example 10.8
Rasa Sayang Berhad is a company that manufactures ice-cream. Currently, the

company produces two flavours of ice-cream: namely vanilla and strawberry.
The capacity of its factory is limited to the number of existing machine hours. A
total of 600 machine hours is available for usage every month. Rasa Sayang
Company can sell as many ice-creams it produces in both flavours. Thus, the
production is only restricted to one capacity, that is machine hours.
Data on the costs of producing and selling (per box) are given below:
Vanilla Strawberry
Direct Materials RM1.50 RM2.80
Direct Labour 2.00 3.00
Variable Manufacturing Overhead 2.50 1.20
Selling Price 10.00 9.50
Required Labour Hour Per Box 0.5 1
Required Machine Hours Per Box 0.08 0.04
Monthly Demand (in boxes) 10,000 12,000
Table 10.11 illustrates the calculation of the contribution margin per box for both
products of Rasa Sayang Company.
Table 5.11: Contribution Margin Per Box
Vanilla Strawberry
Sales 10.00 9.50
Less: Variable Expenses
Direct Materials RM1.50 RM2.80
Direct Labour 2.00 3.00
Variable Manufacturing Overheads 2.50 1.20
Total Variable Cost 6.00 7.00
Contribution Margin 4.00 2.50
At a glance, the analysis seems to imply that the vanilla flavour ice-cream is more
profitable than the strawberry flavour. It is true that vanilla ice-cream has a
higher contribution margin which helps to cover the companyÊs fixed costs as
well as contributing towards its profit. Nevertheless, there is an important factor

to be considered in Table 10.11. Recall that the companyÊs capacity is limited to
600 machine hours per month. This information needs to be taken into account in
the analysis.
To maximise the companyÊs total contribution which can cover the fixed cost and
profit, managers of the company must use every machine hour efficiently. The
relevant question here is no longer which product gives the maximum
contribution margin per box but rather which product gives the maximum
contribution margin per machine hour. The answer to this question is provided
in Table 10.12.
Table 10.12: Contribution Margin Per Machine Hour
Vanilla Strawberry
(a) Contribution Margin RM4.00 RM2.50
(b) Required Machine Hours Per Box 0.08 0.04
(a) ÷ (b) Contribution Margin Per Machine Hour RM50.00 RM62.50
From the calculation in Table 10.12, we can see that every machine hour used to
produce vanilla ice-cream will provide a contribution of RM50.00 to cover the
fixed costs and consequently contribute towards the companyÊs profit. On the
other hand, the machine hours used to produce strawberry ice-cream will
provide a contribution of RM62.50. Therefore, as soon as we take into account the
limited resources of Rasa Sayang Company, the product which contributes most
towards the companyÊs profit is the strawberry flavoured ice-cream.
After knowing which product is profitable, the next question is how many boxes
of strawberry and vanilla flavoured ice-cream can be produced? Table 10.13
illustrates the best use of the limited resources based on the contribution margin
per limited capacity as previously computed in Table 10.12.
Table 10.13: Sales Mix
Product Machine Hours Required Production Units

Strawberry 12,000 boxes × 0.04 machine hours = 480 hours 12,000
Vanilla 1,500 boxes × 0.08 machine hours = 120 hours 1,500*
Computation Steps*
(600 hours ă 480 hours) / 0.08 hours = 1,500 boxes.

From the analysis in Table 10.13, the company will give priority to all demands
for strawberry ice-creams as it is the most profitable product. Therefore, out of
600 available machine hours, 480 hours will be used to produce strawberry ice-
cream. The remaining machine hours of 120 hours (that is, 600 hours ă 480 hours)
will be fully utilised to produce the less profitable product per limited capacity,
which is the vanilla ice-cream.
It is evident here that the company can only produce 1,500 boxes of vanilla ice-
cream, that is by using the remaining capacity of the available machine hours.
Thus, the sales mix per month of Rasa Sayang Company is 12,000 boxes of
strawberry flavoured ice-cream and 1,500 boxes of vanilla flavoured ice-cream,
which results in the maximum contribution margin of RM36,000 [i.e. (RM2.50 ×
12,000 boxes) + (RM4.00 × 1,500 boxes)].
How does a special order affect this sales mix? In the previous section, we
discussed special order under excess capacity. Now, we will explore what will
happen when a company accepts a special order under full capacity.
Supposing that an officer of the Malaysian National Service Centre (MNSC) has
requested that Rasa Sayang Company supply 500 boxes of strawberry flavoured
ice-cream to the centre. Should the company accept or reject this special order?
Bear in mind that the company has fully utilised its existing capacity for the
normal production of both of its products. In other words, if the company agrees
to accept this special order, then it has to sacrifice its existing production. Which
product should be sacrificed? Obviously, it has to be the product with the lowest
contribution margin per limited capacity, which is the vanilla flavoured ice-
cream. Table 10.14 provides calculations that help the company to arrive at this
decision.
Table 10.14: Machine Hours Required for Special order
Required Machine Hours for Special Order:

500 boxes × 0.04 hours 20 machine hours
Number of Sacrificed Boxes of Vanilla Ice-Cream:
(20 hours Á 0.08 hours) 250 boxes
From the above analysis illustrated in Table 10.14, we will first need to determine
the required number of machine hours for the special order; i.e., 20 machine
hours are required to produce 500 boxes of strawberry flavoured ice-cream. The
20 required machine hours will be taken from the existing machine hours used to
produce vanilla ice-creams.

This means Rasa Sayang Company must reduce the production of vanilla ice-
cream by 250 boxes to allow the company to complete the special order. The total
amount of the contribution margin belonging to the sacrificed production is
considered an opportunity cost which equals to the loss of potential income to be
obtained by the company as a result of no longer producing the product. Thus in
this situation, the opportunity cost for Rasa Sayang is RM1000 (that is, 250 boxes
× contribution margin per unit of RM4.00).
With the new decision to accept the special order, the sales mix will be affected.
The new sales mix is given by Table 10.15.
Table 10.15: New Sales Mix
Product Production Units Machine Hours Required

Strawberry 12,000 + 500 = 12,500 500 hours
Vanilla 1,500 ă 250 = 1250 100 hours
The production of strawberry ice-cream will be increased to 12,500 boxes

including the special order and 500 machine hours will be used to produce this
product. On the other hand, the production of vanilla ice-cream will be decreased
to 1250 boxes which will only use up 100 machine hours after letting go 250
boxes of this product to cater for the special order. Hence, the whole machine
hour capacity of 600 hours is fully utilised again.
Now, what about the price setting of the special order? In setting the price for the
special order, we must take into consideration the increase in cost as well as the
opportunity cost (in the case of full capacity). Please refer to Table 10.16.
Table 10.16: Manufacturing Costs of the Special Order
Cost Per Unit Total

Variable Cost RM7.00 RM3,500
Opportunity Cost RM2.00 RM1,000
Total Increment in Costs RM9.00 RM4,500
* RM1000 Á 500 boxes = RM2.00
Based on the calculations in Table 10.16, the total increase in cost to be incurred if
the company accepts the special order is RM4,500, which consists of RM3,500 of
variable manufacturing cost and RM1,000 of opportunity cost. In other words,
the lowest (minimum) price for the special order that is acceptable to the
company is RM9.00 per box since it provides a similar profit as the profit lost
from the vanilla product by choosing the special order over the vanilla product.
In conclusion, the special order can be accepted provided that the price of the
special order is no less than RM9.00 per box, otherwise it will be a loss to the
company.
Ć Relevant information is crucial in the decision making process. The relevant

information can be quantitative or qualitative. Whatever form the relevant
information takes, be it quantitative or qualitative, it is a vital source to those
involved in the process of decision making. Every piece of relevant
information will usually have an effect on the decision made for each
alternative.
Ć In the decision making process, the information required as well as the

analysis for the information provided will differ according to the type of
decisions made. Since daily operations involve different types of information,
then separating between the relevant and irrelevant information is a difficult
but an important process to perform. As soon as the relevant information is
separated from the irrelevant information, the subsequent process of
analysing the relevant information can be performed, thus helping the
management to obtain more accurate and sound decisions. The decisions
made will affect the profitability of the company, both in the short and long
term.
Accuracy Joint fixed cost

Avoidable cost Opportunity cost
Constraints/resources bottlenecks Relevancy
Decision making Sales mix
Direct fixed cost Special order
External constraint Split-off point
Income statement by segment Tactical decision making
Internal constraint Timeliness

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Topic X Short-Term

Making decisions is not a simple task and therefore needs to be performed by

10.1 ROLE OF A MANAGEMENT ACCOUNTANT

The information is said to be relevant if it is useful for making a

Marketing managers may be interested in knowing the cost of advertising.

Accuracy of information refers to the information given to the

Accurate information is necessary in decision making to ensure the

A management accountant must understand the need for different types of

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Then again, if the management accountant is consuming too much time to

10.2 RELEVANT INFORMATION

Any avoidable cost can be defined as a cost which could be eliminated

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To identify avoidable costs, the following steps can be taken:

Step 1: Obtain all costs related to the alternatives under consideration.

In management accounting, terms like differential cost, incremental cost,

Cost of Acquiring The Old Car RM90,000

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expected variable operating cost of RM6,000 in a year. To perform this decision

Therefore, we can perform analysis as illustrated in Table 10.1.

Table 10.1: Decision to Replace a Car

Retaining Old Acquiring New Differential Cost

10.3 THEORY OF CONSTRAINTS

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Every process is said to have constraints or resources bottlenecks and thus

Constraint refers to anything that hinders an organisation from achieving its

Table 10.2: Two Types of Constraints

Constraints Type Explanation

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How can we identify a constraint? Consider Example 10.3.

Puteri Idaman Sdn. Bhd. is a well-known company that produces school

Department Monthly Capacity

You are required to:

In general, a company will have more than one constraint. Nevertheless,

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10.4 TYPES OF DECISION MAKING

Figure 10.1: Types of decision making

Discussions on decision making in this topic will focus on short-term decision

Tactical decision making means the process of choosing from among a

Before we proceed to look at each of the types of decision making, we will

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Figure 10.2: Steps in the decision making process

10.4.1 Decision to Eliminate or Retain a Product

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Income statement by segment refers to condensed income statements

Bear in mind, however, that the income statements by segments must be

(a) Direct Fixed Costs

For example, the salary of a supervisor can be traced directly to product A,

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(b) Joint Fixed Costs

For instance, the salary of a general manager of a company which cannot be

Puteri Idaman is a company producing a variety of school essentials, such as

1. Condensed Income Statement by Segment.

Bags Shoes Uniforms Total

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You are required to:

Table 10.3: Decision Whether to Retain or Discontinue the Production of Uniform

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Supposing a detailed analysis is not performed and the management depends

Table 10.4: Cost Analysis if Production of Uniform Product is Discontinued

Reduction in Income (16,550)

10.4.2 Decision to Produce or Buy

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