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Decision Making
Chapter 1- Decision Making
❖ UNIT-1: BASICS OF MARGINAL COSTING
❖ UNIT-2: RELEVANT COSTING TECHNIQUE
❖ UNIT-3: TARGET COSTING
❖ UNIT-4: PRODUCT LIFE CYCLE COSTING
❖ UNIT-5: ASSET LIFE CYCLE COSTING
❖ UNIT-6: TRANSFER PRICING
❖ UNIT-7: PRICING DECIISONS
❖ UNIT-8: DECISION MAKING USING PROBABILITY
❖ UNIT-9: DECISIONS INVOLVING ALTERNATIVE CHOICES
❖ UNIT-10: MISCELLANEOUS AREAS
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UNIT-1: MARGINAL COSTING-BASICS
CONCEPT-1: BASICS OF MARGINAL COSTING
✓ All short-term decisions are based on the concept of Marginal Cost and Marginal
Revenue.
✓ DECISION MAKING FRAMEWORK:
SCENARIO DECISION
If MR > MC
If MR < MC
WHAT IS MARGINAL COST
✓ It is the change in cost due to change in the level of output.
✓ In other words, it is the extra cost to manufacture one extra unit of output.
✓ Example:
Units Cost
100 units 7000
101 units 7050
Marginal Cost
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BASIC ASSUMPTIONS OF MARGINAL COSTING
UNLESS OTHERWISE SPECIFIED,
1. Selling price per unit is constant
2. Variable Cost per unit is constant
3. Total Fixed Cost is constant
CONCEPT-2: BASIC FORMULAS
(1) CONTRIBUTION
✓ It is the amount which contributes towards recovery of fixed cost and profit.
✓ It is excess of Sales over Variable Cost.
Example:
SP: ₹1000/unit; VC: ₹600/unit; FC = ₹10,000
Particulars 0 units 1 unit 2 units 10 units 25 units
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(2) VARIABLE COST RATIO (VCR) & PROFIT VOLUME RATIO (PVR)
✓ It is compared as a percent of sales.
✓ Variable cost Ratio: It is proportion of variable cost to sales.
✓ Profit Volume Ratio: It is proportion of contribution to sales.
✓ PVR and VCR are both complimentary.
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Particulars Per unit Percentage
Sales
(-) Variable Cost
Contribution
(-) Fixed Cost
Profit/ (Loss)
(3) BREAK EVEN POINT (BEP)
✓ It is a situation of no profit-no loss. In other words, entire fixed cost is recovered
at BEP. (i.e. it is a situation wherein total cost = total sales)
✓ At BEP,
❖ Profit/ Loss = Zero
❖ Total Sales = Total Cost
❖ Contribution = Fixed Cost
Particulars Per unit % BEP
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BEP (UNITS):
BEP (SALE VALUE):
BREAK EVEN POINT
In Units In Sale Value (₹)
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EXAMPLE:
SP = ₹700; VC = ₹455; FC = ₹36750; Total capacity = 750 units. Calculate BEP
Particulars Per unit % BEP
Note: If question does not specify whether BEP in terms of units or BEP (in Sales),
calculate both.
(1) MARGIN OF SAFETY
Total Sale Value = ₹1 Lakh
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✓ Margin of Safety Sale: It is the sale over BEP sale.
✓ We start earning profit from MOS sales. (Till BEP sales, we were recovering fixed
cost.)
BEP Sale Ratio: It is proportion of BEP sale to total sales.
MOS Sale Ratio: It is proportion of MOS sale to total sales.
Both are complimentary.
Example:
SP = ₹700; VC = ₹455; FC = ₹36750; Units sold: 200 units; Calculate BEP Sales,
MOS Sales, Profit.
Solution:
Particulars Per unit %
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BEP MOS
(2) SALES TO ACHIEVE DEZIRED PROFIT/ LOSS
Example:
SP = ₹1000; VC = ₹600; FC = ₹10,000; Desired profit: ₹2,00,000. Calculate units to
be sold and sales.
Solution:
Particulars Per unit %
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MAGIC BOX (ONE BOX TO SOLVE ALL QUESTIONS)
Particulars Per unit % Variant 1 Variant 2
Total BEP MOS
Sales
(-) Variable
Cost
Contribution
(-) Fixed Cost
Profit/ (Loss)
Notes:
Variant 1: Bifurcation of total sales as BEP Sale and MOS Sales
Variant 2: When question asks us to calculate sales to earn dezired profit
1. VCR and PVR are complimentary. If one is known, other can be calculated.
2. AT BEP, profit/Loss is zero. Therefore, Contribution = Fixed Cost.
3. At MOS, additional Fixed Cost is Zero. Contribution = Profit.
4. Begin with Dezired profit and add fixed cost to get dezired contribution. If we
divide dezired contribution with PV ratio, we get dezired sales.
5. BEP Sale Ratio & MOS Sale Ratio are complimentary. If one is known, other can be
calculated.
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 1 to 6 from the Workbook
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CONCEPT-3: SPECIAL SITUATIONS
(1) DIFFERENTIAL FORMULAS
Example:
SP = ₹1000; VC = ₹600; FC = ₹10,000;
Particulars Per unit 50 Units 100 Units Difference
Sales
(-) Variable Cost
Contribution
(-) Fixed Cost
Profit/ (Loss)
Total Cost
OBSERVATIONS:
DERIVATION OF FORMULA
Particulars VCR PVR
Original
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When 2 levels of
Output is given
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 7 & 8 from the Workbook
(2) COST BEP/ COST INDIFFERENCE POINT
When does the situation arise?
When we have 2 or more alternatives to manufacture goods/ services and
✓ One alternative has lower Fixed Cost
✓ One alternative has lower Variable Cost
What is COST INDIFFERENCE POINT?
It is the point where TOTAL COST as per both the alternatives is same.
CALCULATION AND DECISION MAKING
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BLAST FROM PAST: COST INDIFFERENCE POINT IF WE HAVE MORE THAN 2
ALTERNATIVES:
1. Step-1: Take each set of 2 alternatives and calculate COST BEP for the
respective pairs.
2. Step-2: Decision Making Chart:
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 9 & 10 from the Workbook
(3) SHUT DOWN POINT
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PRACTICAL QUESTIONS ALERT!!!
Please solve Example 11 from the Workbook
(4) LIMITING FACTOR DECISIONS (0R) PRODUCT MIX DECISIONS-BASICS
Steps to Solve a Question:
1. Check if the factor is a limiting factor
2. Calculate contribution per unit
3. Calculate contribution per limiting factor
4. Rank based on contribution per limiting factor
5. Allocate resources based on ranking made
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BLAST FROM PAST: IF MINIMUM DEMAND IS TO BE FULFILLED FOR ANY
PRODUCT,
Then
❖ Step-1: First fulfil the MINIMUM DEMAND
❖ Step-2: Now, for the balance resources, allocate as per the ranking made
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 12 from the Workbook
(5) IF THERE IS A CHANGE IN COST STRUCTURE
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A PROMISE WAS ONCE MADE; THAT PROMISE WILL BE KEPT!!!!
❖ Whenever we get Data on Sales (or) Variable Cost:
❖ Whenever we get Data on Fixed Cost:
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 13 & 14 from the Workbook
(6) MARGINAL COST SHEET FORMAT WHEN TAX RATE IS GIVEN
Marginal Cost Sheet Format (when tax rate is given)
Particulars Per unit %
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 15 from the Workbook
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(7) COMPONENTS OF MARGINAL COST
COMPONENTS OF MARGINAL COST
Particulars Amount (₹)
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UNIT-2: RELEVANT COSTING
CONCEPT-1: BASICS OF RELEVANT COSTING
WHAT IS RELEVANT COST?
It is the cost which is relevant to take any decision (i.e. it is the cost which is
incurred only when we make a specific decision).
TWO CONDITIONS FOR A COST TO BE A RELEVANT COST
❖ It should be a future cost
❖ It should be differential cost (i.e. cost is different for different alternatives)
DIFFERENT COSTS & THEIR TREATMENT
1. HISTORIC COST/ SUNK COST/ COMMITTED COST:
• A cost which is already incurred in the past and doesn’t affect the future
decisions.
• It is IRRELEVANT for decision making (i.e. already incurred in past).
• It is irrelevant irrespective of whether it is actually paid (or) still payable.
• Example:
o Research and Development Cost
o Book Value of Assets
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2. FIXED COST/ FIXED OVERHEADS:
FIXED OVERHEADS
ALLOCATED ADDITIONAL
OVERHEADS OVERHEADS
Particulars Allocated Overheads Additional Overheads
Other names • Allocated overheads • Additional
• Absorbed overheads overheads
• Recovered • Specific overhead
overheads • Traceable overhead
• Common overheads • Avoidable overhead
• Existing overheads • Incremental
• Unavoidable overhead
overheads
Relevant (or) Irrelevant It is IRRELEVANT for It is RELEVANT for
decision making purpose decision making purpose
3. OPPORTUNITY COST:
❖ It is the maximum contribution foregone by rejecting other alternatives.
❖ It is just a NOTIONAL COST. It doesn’t involve cash payment.
❖ Opportunity cost is RELEVANT for all business decisions.
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4. OUT OF POCKET COST/ ADDITIONAL COST:
❖ It is the additional cost incurred for taking a specific business decision.
❖ It is RELEVANT for decision making.
CONCEPT-2: RELEVANT COST FOR MATERIAL, LABOUR, OVERHEADS & MACHINE
RELEVANT COST OF MATERIAL
MATERIAL
NOT IN STOCK IN STOCK
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Notes:
1. Purchase Price and Replacement Cost are one and the same.
2. Book Value of Material (i.e. historic cost of purchase) is SUNK COST and hence
IRRELEVANT for decision making.
3. FOR NON-MOVING MATERIAL IN STOCK
a. If data regarding alternate use is not available, consider only REALIZABLE
VALUE.
b. If cost is incurred to dispose the non-moving material, then ‘Cost of Disposal’
is REDUCED to calculate the relevant cost.
Example: Highly toxic chemical in stock which is non-moving. Cost of disposal
is ₹400. So, Relevant Cost =
RELEVANT COST OF LABOUR
LABOUR
EXISTING EMPLOYEES NEW EMPLOYEES
(Permanent Employee) (Additional or Temporary or
casual employees)
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RELEVANT COST OF OVERHEADS
OVERHEADS
VARIABLE OVERHEADS FIXED OVERHEADS
RELEVANT COST OF MACHINES
MACHINES
NOT IN POSESSION IN POSESSION
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SPECIAL POINTERS [BLAST FROM THE PAST]
MATERIAL [Various Interpretations]
SITUATION CORRECT INTERPRETATION
Material Y is ❖ It means that material is already ordered
on order at (but it has not yet reached us)
Contract ❖ Once Raw Material is ordered, it is as good
Price as Material is in Stock (i.e., already
purchased).
❖ Hence, Purchase Cost (i.e. Book Value) is
IRRELEVANT.
Material Z is to be ❖ Material is not yet ordered.
ordered ❖ Hence, Purchase Price will be RELEVANT.
LABOUR [IF LABOUR IS ABOUT TO RETIRE, BUT HELD FOR NEW ORDER]
Example:
Foreman is due to retire immediately at an Annual pension of ₹60,000. However, due to
an emergency special order, he is asked to stay for a further year & defer his pension
for 1 year in return for his Annual Salary of ₹1.5L. Calculate Relevant Cost.
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OVERHEADS [Avoidable Overheads is always RELEVANT]
Example:
General OH is ₹ 12 lac. General OH includes both Specific & absorbed OH. If Contract
is not undertaken, ₹ 4 lac of same can be avoided. Calculate the Relevant Cost.
SPECIAL POINTS FOR MACHINES
❖ ADDITIONAL OPERATING COST OF MACHINE [EG: MACHINEMAN, FUEL ETC]:
❖ IF ROUTINE MAINTENANCE IS GIVEN:
Example:
Routine Maintenance of the Machine is ₹ 40 per month. Due to the use of Machine
for the Contract, the Maintenance cost will Increase to ₹ 60 per month. Calculate
the Relevant Cost.
OTHER MISCELLANEOUS POINTS
❖ PROVISION FOR EXPECTED INCREASE IN COST:
✓ It is just a provision created in Books of Accounts; it does not involve actual
cash flow.
✓ Hence, it is IRRELEVANT for decision making.
❖ MARKET RESEARCH SURVEY COST ALREADY UNDERTAKEN:
✓ Research is already undertaken; hence it is a HISTORIC COST [SUNK COST].
✓ Hence, it is IRRELEVANT for decision making.
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❖ DEFAULT ASSUMPTIONS BY CMA MATERIAL [IN ABSENCE OF SPECIFIC
INFORMATION]:
SITUATION ASSUMPTION
Labour ❖ If nothing is specified, Labour is always
treated as CASUAL or TEMPORARY
LABOUR.
❖ Relevant Cost =
Variable Overheads It is ALWAYS RELEVANT for decision making.
Fixed Overheads ❖ If nothing is specified, Fixed overhead is
always assumed as ALLOCATED or
ABSORBED OVERHEADS.
❖ It is IRRELEVANT for decision making.
❖ IF QUESTION ASKS US TO CALCULATE THE MINIMUM PRICE:
✓ Step-1: We will calculate the RELEVANT COST of accepting the order
✓ Step-2: The RELEVANT COST ITSELF IS THE MINIMUM PRICE TO BE
QUOTED to the customer.
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UNIT-3: TARGET COSTING
CONCEPT-1: BASICS OF TARGET COSTING
❖ TRADITIONAL COSTING VS TARGET COSTING SYSTEM
❖ TARGET COSTING MEANING
✓ It is a structured approach to determine the cost at which a product must be
produced
✓ To generate a desired profit at an anticipated SP.
✓ It is the opposite of COST PLUS MARGIN model.
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❖ STEPS NEEDED TO SOLVE A PRACTICAL QUESTION ON TARGET COSTING
Step-1: Determine the Target Selling Price
Step-2: Determine the dezired Profit Margin
Step-3: Calculate TARGET COST
Step-4: Calculate Present / Estimated Cost of the Product
Step-5: Determine COST GAP/ Cost Reduction Target
Step-6: Apply Cost Reduction Techniques to Eliminate COST
GAP
❖ MISCELLANEOUS POINTS [IMPORTANT FOR MCQ’S]
✓ Target Costing is a market driven system of Cost reduction.
✓ In Target Costing, focus is on managing Costs at Developmental (or) design stage
of the product.
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CONCEPT-2: VARIOUS TYPES OF QUESTIONS FROM TARGET COSTING
TYPE-1 QUESTION: BASIC QUESTIONS [Calculation of Target Selling Price
(or) Target Cost
GOLDEN RULE:
CALCULATION OF TARGET SELLING PRICE (OR) TARGET COST
Particulars Per unit Total
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 1 & 2 from the Workbook
TYPE-2 QUESTION: CALCULATION OF TAREGT SELLING PRICE [When
competitor has to incur some specific costs which need not be incurred by the
Company]
CALCULATION OF TARGET SELLING PRICE & TARGET COST
Particulars Per unit Total
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PRACTICAL QUESTIONS ALERT!!!
Please solve Example 3 from the Workbook
TYPE-3 QUESTION: CALCULATION OF TARGET LABOUR HOURS [to achieve
the desired profit Margin]
GOLDEN RULE: ALWAYS REMEMBER YOUR EX!!!
Steps to solve a question:
Step-1: Calculate Variable Cost per unit by assuming “Labour hours per unit as X Hours”
Step-2: Draw Marginal Cost Sheet & Calculate Profit
Particulars Per unit Total
Step-3: Calculate the value of X [i.e. calculate target labour Hours to manufacture 1
unit]
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 4 from the Workbook
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SPECIAL POINTERS [BLAST FROM THE PAST]
❖ BENEFIT DUE TO IMPROVEMENT IN LABOUR PRODUCTIVITY:
Example:
Existing Labour Cost is ₹40 lakhs by using the current machine. The new Machine is
expected to Improve Productivity of Workers by 10%. Calculate the revised Labour
Cost & savings in Labour Cost. Note that sales volume will be same in existing as well
as revised scenario.
❖ CALCULATION OF BENEFIT DUE TO PURCHASE OF NEW MACHINE:
Example:
A vendor supplying the machine has offered an advanced technology Semi-Automatic
Machine of ₹10 lakhs as a replacement to old machine worth ₹3 lakhs. The vendor has
agreed to take back the old machine at ₹1 lakh only. Depreciation is chargeable at
15% on WDV basis. Maintenance charge of existing machine will be ₹1 lakh per annum
whereas there will be a free warranty services for the new machine for the first 2
years. Assuming Cost of Capital as 15%, calculate the net benefit from buying the new
Machine.
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❖ IF QUESTION HAS GIVEN US ‘FIXED COST PER UNIT’
GOLDEN RULE:
If Question has given us Fixed Cost per unit, then we will calculate total fixed cost at
the same level at which fixed cost per unit is calculated.
Example:
A company has produced 1000 units in January & 1500 units in February. If the
fixed Cost per unit is ₹100 per Unit in January, then calculate the Total Fixed Cost
in February.
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UNIT-4: LIFE CYCLE COSTING
GOLDEN RULE:
Do all the calculations for the ENTIRE LIFE CYCLE OF THE PRODUCT.
CONCEPT-1: BASICS OF PRODUCT LIFE CYCLE COSTING
❖ TRADITIONAL COSTING v/s LIFE CYCLE COSTING
✓ In traditional Costing, we report the revenue, cost & profit for a particular
period (monthly, quarterly or annually).
✓ However, in Life cycle costing, we record the revenue, cost & profit over the
entire Life cycle of the product.
✓ Life Cycle Costing identifies & accumulates the cost, revenues attributable to
a product from its inception to abandonment.
✓ The aim is to maximise the profit over the life time of the product.
❖ 4 PHASES OF A LIFE CYCLE OF A PRODUCT
There are 4 phases in the life cycle of a product namely
✓ INTRODUCTION
✓ GROWTH
✓ MATURITY
✓ DECLINE
Note: In the practical business world, there are 2 additional phases namely,
▪ Development Phase: This phase is normally before the introduction phase
when the product is getting developed. No revenue will accrue to company in
this phase.
▪ Extinction phase: This phase comes after the decline phase when the product
exits from the market.
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TYPE-1 QUESTION: CALCULATION OF LIFE CYCLE OPERATING INCOME
CALCULATION OF LIFE CYCLE OPERATING INCOME
Particulars Total
Note: Life Cycle Costs include all the costs over the Life Cycle of the product [Research
& Development, Product Design, Engineering, Marketing, Selling & Distribution etc].
SPECIAL POINTERS [BLAST FROM THE PAST]
❖ CALCULATION OF NUMBER OF BATCHES:
Example:
Company is engaged in manufacturing of watches. Total watches sold over the life
cycle of the product is 1 lakh watches. The variable cost per Batch is ₹100. We
produce 250 watches in a batch. Calculate the total number of Batches & Total
variable cost incurred.
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UNIT-5: ASSET LIFE CYCLE COSTING
GOLDEN RULE:
Select the Asset whose EQUIVALENT ANNUAL COST [EAC] is minimum.
ASSET LIFE CYCLE COSTING
WHICH ASSET TO
WHEN TO BUY
BUY
TYPE-1 QUESTION: WHICH ASSET TO BUY
GOLDEN RULE: PURCHASE THE ASSET WHOSE EAC IS LOWEST
Steps to solve a question:
Step-1: Calculate PRESENT VALUE OF ALL CASH OUTFLOWS [for every Machine]
Step-2: Calculate EQUIVALENT ANNUAL COST [EAC] for every Machine
Step-3: Decision Making [Select the ASSET WHO EAC IS LOWEST]
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 1 & 2 from the Workbook
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TYPE-2 QUESTION: WHEN TO BUY
Here, there is an existing machine with the company. It is used for quite some time now
& we are thinking of replacing it with a new machine. We need to decide WHEN TO BUY
THE NEW MACINE.
Steps to solve a question:
Step-1: Calculate EQUIVALENT ANNUAL COST [EAC] of the NEW MACHINE
Step-2: Calculate EQUIVALENT ANNUAL COST [EAC] of the EXISTING MACHINE
Year PVF PV of PV of Opportunity EAC of
Maintenance Salvage Cost of Scrap existing
Value [PV terms] Machine
[1] [2] [3] [4] [5] [6] = [3] + [5]
Note:
Step-3: DECISION MAKING
So long as EAC of New Machine is
GREATER than EAC of Existing Machine
Once, EAC of New Machine is LOWER
than EAC of Existing Machine
PRACTICAL QUESTIONS ALERT!!!
Please solve Example 3 from the Workbook
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UNIT-6: DECISION MAKING USING PROBABILITY
GOLDEN RULE:
Whenever different outcomes with probability is given, we will CALCULATE THE
EXPECTED VALUE.
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