Short-run Decision

Analysis

Differential Costs
Differential Costs include variable costs and
differential fixed costs resulting from particular
decision.
Format 1: Incremental Contribution
Incremental revenues (product-wise)
Add cost savings (specify items)
Total incremental revenues
Less lost contribution (product-wise)
Less incremental costs (specify items)
Incremental contribution

22-2

Format 3: Incremental analysis for acceptance of special order is

summarised below.
Particulars
Increase in sales revenue
Less incremental costs of executing sales order
Direct material
Direct labour
Variable manufacturing overheads
Freight costs (if to be incurred by seller)
Production set-up costs
Additional fixed costs (if any)
Incremental profits

Amount

22-3

(1) Special Orders

Typical examples of such types of sales are acceptance of special
orders, one-time quantity sale, and sales to foreign customers. If
such special sales do not affect the normal sales, the acceptreject decision would be based on the incremental contribution.
In case, the special sale would affect the future sales volume
and/or selling price, the opportunity cost in terms of lost revenue
will also be relevant to the decision-making.

22-4

Example 1 (Pricing Special Orders)

Assume that Royal Industries Ltd has excess capacity. The normal plant capacity is
3,00,000 units per year and current production is 2,00,000 units. There is no alternative
use for the idle facilities. The company receives an offer from a foreign customer to buy
1,00,000 units at Rs 10 a unit. The regular market price is Rs 14 a unit. The current
manufacturing and selling costs are:

Particulars
Total variable cost:
Direct labour
Direct material
Variable overheads
Manufacturing cost
Variable selling cost
Fixed overheads:
Manufacturing
Selling
Total cost

Per unit

Total

Rs 2
3
2
7
1
8

Rs 4,00,000
6,00,000
4,00,000
14,00,000
2,00,000
16,00,000

2.50
0.50
11.00

5,00,000
1,00,000
22,00,000

(a) Should the offer be accepted assuming that shipment charges of Rs 50,000 are to be
borne by the seller? There will be a special packing of the products which will involve
packing cost of Rs 0.25 per unit. Being an export order, the management is convinced of
the fact that the regular market price of Rs 14 a unit will not be affected;
(b) Assume that the order is from a local supplier and, therefore, should the order be
accepted, all products in future are to be offered at the special order price and Royal
industries still has to bear the shipment charges and packing cost for the special order
22-5

Solution

The decision analysis in situations (a) and (b) is depicted in Tables 1 and 2.
Table 1 (a) Decision Analysis
Particulars
Sales

Less incremental costs:

Direct labour
Direct material
Variable overheads
Packing costs
Selling costs
Shipment costs
Contribution

Without special
order

With special order

Amount

(2,00,000 Rs Rs 28,00,000
14)
_________
28,00,000

(2,00,0000 Rs 14)
(1,00,000 Rs 10)

Rs 28,00,000
10,00,000
38,00,000

4,00,000
6,00,000
4,00,000

2,00,000

12,00,000

(3,00,000 Rs 2)
(3,00,000 Rs 3)
(3,00,000 Rs 2)
(1,00,000 Rs
0.25)
(2,00,000 Re 1)

6,00,000
9,00,000
6,00,000
25,000
2,00,000
50,000
14,25,000

(2,00,000 Rs 2)
(2,00,000 Rs 3)
(2,00,000 Rs 2)

(2,00,000 Re 1)

Amount

The incremental contribution is 2,25,000 and, therefore, the order should be accepted.

22-6

Table 2 (b) Decision Analysis

Particulars
Sales (3,00,000 Rs 10)
Less relevant costs:
Manufacturing variable costs (3,00,000
Rs 7)
Packing costs (1,00,000 Rs 0.25)
Variable selling costs (2,00,000 Re 1)
Shipment costs
Contribution

Amount
Rs 30,00,000

Rs 21,00,000
25,000
2,00,000
50,000

23,75,000
6,25,000

Since the contribution has declined, the order from the local supplier should not be
accepted.

22-7

(2) Disposing of Inventories

Due to damage/obsolescence or lack of demand, inventory may not be
saleable through normal marketing channels or under normal operating
conditions. In such cases, incremental analysis is appropriate for decisionmaking as all prior costs of producing/acquiring inventory are sunk costs
and, therefore, irrelevant to the decisions.

Example 2 (Disposal of Inventories)

ABC Ltd has on hand 5,000 units of a product that cannot be sold through regular sales. These were produced
at a total cost of Re 1,50,000, and would normally have been sold for Rs 40 per unit. Three alternatives are
being considered:
(i)
Sell the items as scrap for Rs 2 per unit.
(ii) Repackage at a cost of Rs 20,000, and sell them at Rs 8 per unit.
(iii) Dispose them off at the city dump at removal cost of Rs 500.
Which alternative should be accepted?

22-8

Solution
Table 3: Decision Analysis
Alternatives
Particulars

Sales revenue
Less costs:
Repackage cost
Removal cost
Contribution
(Loss)

(I) Sell as scrap

(II) Repackage and sell

(III) Disposal

Rs 10,000

Rs 40,000

10,000

20,000

20,000

500
(500)

Alternative II should be accepted.

22-9

Sell Now or Process Further Decisions

When an item of production passes through various
processes, it is saleable at different stages/points, that is, at
various physical stages of production.

In deciding at what stage to sell the product, the two

critical variables are: (i) Identification of sunk costs and (ii)
Calculation of incremental returns at various sales
alternatives.

22-10

Format 4: Decision analysis for further processing.

Particulars

Without further
processing

Per unit

Total

With further
processing

Per unit

Total

Incremental
revenues/costs

Per unit

Total

Sales revenue
Less costs
Direct material
Direct labour
Variable overheads
Manufacturing
Administrative
Selling
Fixed overheads (if incremental)
Income (loss)

22-11

Example 4 (Additional Processing-Single Product)

Avon Ltd manufactures a single product, which it sells to firms which
process it further before sale. The normal quarterly operating volume for
the company is 50,000 units produced and sold. The relevant cost data are
as follows:
Selling price
Standard costs:
Direct materials
Direct labour
Variable manufacturing overheads
Fixed manufacturing overheads (25,000
per quarter)
Variable selling overheads
Fixed
selling
expenses
(12,500
per
quarter)
Standard profit per unit

Rs 10.00
Rs 3.00
1.50
1.00
0.50
1.00
0.25

7.25
2.75
22-12

The company management is considering the possibility of further

processing it itself, necessary for the operation to sell directly to the
customers. The management estimates that the product can be sold @ Rs
14 per unit after further processing. The following are the estimates of the
additional costs of processing 50,000 units:
Direct labour (per unit)
Variable manufacturing overheads (per unit)
Variable selling costs (per unit)
Additional fixed manufacturing overheads per quarter
Additional fixed sales expenses per quarter

Rs 1.00
0.50
0.20
10,000
5,000

You are required to decide whether further processing should be done or

not.

22-13

Solution
Table 5 presents the decision analysis.
Table 5 Decision Analysis
Particulars

With further processing

Incremental r
and cos

Total

Per unit

Total

Per unit

Rs 5,00,000

Rs 14.00

Rs 7,00,000

Rs 4.00

1,50,000

3.00

1,50,000

0.00

Direct labour

75,000

2.50

1,25,000

1.00

Manufacturing
overheads

50,000

1.50

75,000

0.50

Selling overheads

50,000

1.20

60,000

0.20

1,75,000
25000

5.80
0.70

2,90,000
35000

2.30
0.20

12500
137500

0.35
4.75

17500
237500

0.10
2.00

Sales

Without further
processing

Less incremental costs:

Direct material

Contribution
Less fixed manufacturing
overheads
Fixed selling cost
Incremental Profits

22-14

Make or Buy Decisions

Many firms have to choose between manufacturing certain components

themselves or acquiring them from outside suppliers. Incremental analysis
provides solution to this kind of decision-problems.

22-15

Format 5: Make or buy Decision

Particulars
Direct material
Direct labour
Power
Other variable overheads
Avoidable fixed overheads
Buying costs
Freight costs
Indirect labour (receiving, inspecting
and handling of the purchased parts)

Make costs

Buy costs

22-16

Example 5 (Make or Buy Decision)

ABC Company Ltd produces most of its own parts and components. The
standard wage rate in the parts department is Rs 3 per hour. Variable
manufacturing overheads is applied at a standard rate of Rs 2 per labourhour and fixed manufacturing overheads are charged at a standard rate of
Rs 2.50 per hour.
For its current years output, the company will require a new part. This part
can be made in the parts department without any expansion of existing
facilities. Nevertheless, it would be necessary to increase the cost of
product testing and inspection by Rs 5,000 per month. Estimated labour
time for the new part is half an hour per unit. Raw materials cost has been
estimated at Rs 6 per unit.
The alternative choice before the company is to purchase part from an
outside supplier at Rs 9 per unit. The company has estimated that it will
need 2,00,000 new parts during the current years.
Advise the company whether it would be more economical to buy or make
the new parts. Would your answer be different if the requirement of new
parts was only 1,00,000 parts?
22-17

Solution
The decision analysis is presented in Table 6.
Table 6 (i) Decision Analysis: 2,00,000 Units
Make costs
Particulars

Buy costs

Total

Per unit

Rs 12,00,000

Rs 6.00

Direct wages

3,00,000

1.50

Variable overheads

2,00,000

1.00

60,000

0.30

Raw material

Total Per unit

Additional fixed costs:

Product testing and inspection
(Rs 5,000 12)

Purchase costs
Total costs

17,60,000

Rs 18,00,000
8.80

18,00,000

Rs 9.00
9.00

Differential costs favouring the decision of making the component Rs 40,000 total, Rs
0.20 per component
The company is advised to make the new part.
22-18

(ii) Decision Analysis: 1,00,000 units:

Rs 6,00,000

Rs 6.00

Direct wages

1,50,000

1.50

Variable overheads

1,00,000

1.00

60,000

0.60

Rs 9,00,000

Rs 9.00

9,10,000

9.10

9,00,000

9.00

Raw material

Fixed costs
Purchase costs
Total costs

If the requirement of the new part is 1,00,000 units, the company would be well
advised to buy from an outside supplier.

22-19

Addition/elimination of product lines/decisions/ departments

When a firm is divided into multiple sales outlets, product lines,
divisions, departments (segments), it may have to evaluate their
individual performances to decide whether or not to continue
operations of each of these segments or add a new segment. The
decision criterion would be the segment margin.
Segment Margin
Segment Margin equal segments contribution margin less fixed
costs directly traceable to the segment.

22-20

Short-term Use of Scarce Resources

Incremental analysis can also be used to allocate resources that are

limited in quantity (key factors). The key factor refers to scarce
resource which may be raw material, skilled labour or machine
capacity. If the machine capacity is inadequate to permit manufacture
of all products, the most profitable course of action is to use the
available machine capacity/hours to make the products which
contribute the maximum contribution margin per machine hour. If
materials are in short supply, the management should produce
according to the largest contribution margin per input of material.

22-21

Example 6 (Use of Scarce Resources)

Precision Engineers Pvt. Ltd are producing to specific orders. Their factory capacity
is limited by one major machine forming a critical cost centre through which all
products pass. The factory normally works for 250 days in a year on 24 hours, 3
shifts a day, and 5 days a week basis. The maximum achievable capacity is 80 per
cent, corresponding to the average level of activity in the critical cost centre. The
operating results summarized for management in previous year are as follows (Rs in
lakh):
Sales

Rs 48

Less costs:

Materials

Rs 18.00

Labour-variable costs

5.75

Factory-variable costs (based on LH)

6.25

Factory-fixed costs

3.00

Fixed Selling and administration costs

10.00

43

Profit

22-22

The average profitability experienced during the previous years is being maintained
during the current year also.
The company has an opportunity of taking any one of two large contracts either of
which will substitute for a large amount of current production without affecting the
hourly variable production costs. Details of the contracts are:
Particulars
Material cost per unit
Machine-hours (critical cost centre) per unit
Contract price per unit
Extra selling expenses per unit

Contract X

Contract Y

Rs 375

Rs 1,750

1,500

3,750

25

50

Prepare a report for the managing director making your recommendations as to

which of the two contracts should be preferred.

22-23

Solution

Table 7 Decision Analysis

Particulars

Contract X

Contract Y

2,400 units (4,800 2)

1,600 units (4,800 3)

Per unit

Contract price

Total

Per unit

Total

Rs 1,500

Rs 36,00,000

Rs 3,750

Rs 60,00,000

Material costs

375

9,00,000

1,750

28,00,000

Other variable production cost

500

12,00,000

750

12,00,000

25

60,000

50

80,000

600

14,40,000

1,200

19,20,000

Less incremental costs:

Additional selling expenses

Contribution
Contribution per machine-hour (key
factor)

300*

400**

Less fixed costs:

Factory overheads

Selling and administration

Profit
Present profit

3,00,000

3,00,000

10,00,000

10,00,000

1,40,000

6,20,000
5,00,000

*(Rs 600 2); **(Rs 1,200 3)

The managing director is advised to accept contract Y, as its contribution margin per machine-hour as
well as profit is higher.
22-24

Working Notes
1. Machine-hours available = (Working days 24 hours) = 250 24 =
6,000 hours
Operating capacity available = 0.80 6,000 hours = 4,800 hours
2. Variable production costs (other than materials) per hour: (Rs
5,75,000 + Rs 6,25,000) 4,800 hours = Rs 250 per hour.
3. It is assumed that the company, at present, is operating at its
maximum achievable capacity, that is, 4,800 hours. In operational
terms, the variable production costs (labour and other variable costs)
are at the level of 4,800 hours.
4. The company would be in a position to sell all the units of Y contract.

22-25

Operate or Shut Down

The decision criterion in such a situation will be
based on the comparison of the shut-down losses
and the losses associated with continuing
operations.
In case, shut-down losses are more than the losses
from continuing operations, it would be beneficial for
the firm to continue its business operations.
In case, shut down losses are less than the losses
from continued operations, it would be profitable
for the firm to shut-down its operations.
22-26

Example 8: (Operate or Shut Down)

The annual budget of ABC Ltd at 60 per cent and 80 per cent level of performance is as under

(Rs in thousands):
Particulars
Direct material
Direct labour
Production overheads
Administrative overheads
Selling and distribution overheads
Total

60 per cent
360
480
252
124
136
1,352

80 per cent
480
640
276
132
148
1,676

The company is experiencing difficulties in selling its products and is at present

operating at 50 per cent capacity level.
The sales revenue for the year is estimated at Rs 9,90,000. The directors are seriously
considering suspending operations till the market picks up.
Market research undertaken by the company reveals that in about 12 months, the
sales will pick up and the company can comfortably operate at 75 per cent level of
performance and earn a sales income of Rs 18 lakh in that year.

22-27

The sales personnel of the company do not want to suspend operations for
fear of adverse reactions in the market, but the directors want to decide the
issue purely on financial considerations.
If the manufacturing and other operations of the company are suspended for
a year, it is estimated that:
1. The present fixed cost could be reduced to Rs 2,20,000 per
annum.
2. The settlement cost of personnel not required would amount to
Rs 1,50,000.
3. The maintenance of plant has to go on and that would cost Rs
20,000 per annum.
4. On resuming operations, the expenditure connected with
reopening after shut down would amount to Rs 80,000.
Submit a report to the directors, and indicate therein, based on purely
financial considerations, whether it would be advisable to suspend the
companys operation in the current year.
22-28

Solution
Table 9: Decision Analysis
Particulars

Operate the
factory

Shut-down the
factory

Sales revenue
Less variable costs
Direct material
Direct labour
Variable overheads: (see working notes)
Production
(Rs 72,000 60) 50=60,000
Administration
(Rs 24,000 60) 50= 20,000
Selling and distribution
(Rs 36,000 60) 50=30,000
Contribution
Less fixed costs:
Production
Rs 1,80,000
Administration
1,00,000
Selling and distribution
1,00,000
Settlement costs (personnel)
Maintenance of plant
Overhauling costs
Net income (loss)

Rs 9,90,000
3,00,000
4,00,000

1,10,000

180000

3,80,000

(2,00,000)

Rs 2,20,000
1,50,000
20,000
80,000
(4,70,000)

It is not advisable for the company to suspend operations as shut-down loss is higher than the loss associated
with continued operation of the plant.
22-29

Working Notes
Segregation of various total overheads costs into fixed and variable components.
Nature of

Budgeted expenditure at

Overhead

various capacity levels

cost
60 per cent

Production

Rs 2,52,000

80 per cent

Rs 2,76,000

Difference at
20%

1%

Total

capacity

Capacity

difference

level showing

Variable

Fixed

variable
expenses

Overheads
(60%)

overheads

Rs 24,000

Rs 1,200

Rs 72,000

Rs 1,80,000

Administration

1,24,000

1,32,000

8,000

400

24,000

1,00,000

Selling
and distribution

1,36,000

1,48,000

12,000

600

36,000

1,00,000

22-30

Format 6: Decision analysis (operate or shut-down plant)

Particulars
Sales revenue
Less variable costs
Direct material
Direct Labour
Variable overheads
Manufacturing
Administration
Selling
Contribution
Less fixed costs
Manufacturing
Administration
Selling
Other costs
Settlement cost (personnel)
Other closing down costs
Maintenance of plant
Overhauling costs
Net profit (loss)c

Operate plant

Shut down plant

22-31