lesson three short term decision

8/12/2019 Lesson Three Short Term Decision

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LESSON THREE

SHORT TERM DECISIONS

OBJECTIVES

Examination of cost volume profit analysis and relevant cost decisions

INSTRUCTIONS

1. Read the Study Text and Chapter 8 and 9 of Management and Cost ccounting !y Colin "rury#. ttempt the reinforcing $uestions at the end of the lesson under examination conditions

%. Compare your ans&ers &ith those given in 'esson 1(

CONTENTS

%.1 Cost )*olume +rofit ,C-*-+ analysis /ntroduction%.# naly0ing the Cost volume Relationship%.#.1 lge!raic nalysis%.#.# raphic nalysis%.%. 2rea3 Even nalysis%.4 C-*-+ nalysis-Multiple +roducts%.5 C-*-+ nalysis 6nder 6ncertainity%.5.1 +oint Estimate of +ro!a!ilities

%.5.# Continuous +ro!a!ility "istri!ution,use of normal distri!ution%.7 C-*-+ nalysis and Computer pplications%. Relevant Cost for on Routine "ecisions%..1 Ma3e or 2uy "ecisions ,no limiting factors%..# Ma3e or 2uy "ecisions 6nder 'imiting :actors%..% !andonment "ecisions%..4 Temporary Closure of :actory or "epartment%..5 +ermanent !andonment of +remises%..7 Extra Shift "ecision%.. ;oint +roducts decisions


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3.1 COST-VOLUME PROFIT (C-V-P) ANALYSIS INTRODUCTION

/n this section< you &ill learn to use cost-volume-profit analysis.=ou can use cost-volume-profit analysis to analy0e the natural relationship !et&een cost< volume< andprofit in pricing decisions. /n cost-volume-profit analysis< you>

Should consider only short-term operations. The short term may !e defined as a period too shortto permit facilities expansion or contraction or other changes that might affect overall pricingrelationships.

ssume that a straight line can reasona!ly !e used in analysis. ?hile actual price !ehavior maynot follo& a straight line< its use can closely approximate actual cost !ehavior in the short run.

/f purchase volume moves outside the relevant range of the availa!le data< the straight-lineassumption and the accuracy of estimates !ecome $uestiona!le.

/f you 3no& that product varia!le costs per unit are decreasing as $uantity increases< considerusing the log-linear improvement curve concept. /mprovement curves are particularly useful inlimited production situations &here you can o!tain cost@price information for all units sold.

/n the short run< costs can !e of three general types>

Fixed C!". Total fixed costs remain constant as volume varies in the relevant range ofproduction. :ixed cost per unit decreases as the cost is spread over an increasing num!er of units.Examples include> :ire insurance< depreciation< facility rent< and property taxes.

V#$i#%&e C!". *aria!le cost per unit remains constant no matter ho& many units are made in therelevant range of production. Total varia!le cost increases as the num!er of units increases.Examples include> +roduction material and la!or. /f no units are made< neither cost is necessaryor incurred. Ao&ever< each unit produced re$uires production material and la!or.

Se'i#$i#%&e C!". Semivaria!le costs include !oth fixed and varia!le cost elements. Costs mayincrease in steps or increase relatively smoothly from a fixed !ase. Examples includeSupervision and utilities< such as electricity< gas< and telephone. Supervision costs tend toincrease in steps as a supervisorBs span of control is reached. 6tilities typically have a minimumservice fee< &ith costs increasing relatively smoothly as more of the utility is used.

Cost-volume-profit analysis is an estimating concept that can !e used in a variety of pricing situations.=ou can use the cost-volume relationship for>

E#&*#"i+, i"e' $ie i+ $ie #+#&/!i!.Cost-volume-profit analysis assumes that total cost iscomposed of fixed and varia!le elements. This assumption can !e used to explain price changesas &ell as cost changes. s the volume !eing ac$uired increases unit costs decline. s unit costsdecline< the vendor can reduce prices and same ma3e the same profit per unit.

E#&*#"i+, di$e" !"! i+ $ii+, +e0 +"$#"!.uantity differences &ill often affect directcosts -- particularly direct material cost. "irect material re$uirements often include a fixedcomponent for development or production operation set-up. s that direct cost is spread over anincreasing volume unit costs should decline.

E#&*#"i+, di$e" !"! i+ $ii+, +"$#" #+,e!.Ao& &ill an increase in contract effort

increase contract priceD Some costs &ill increase others &ill not. The concepts of cost-volume-profit analysis can !e an invalua!le aid in considering the effect of the change on contract price. E#&*#"i+, i+di$e" !"!.The principles of cost-volume-profit analysis can !e used in indirect

cost analysis. Many indirect costs are fixed or semivaria!le. s overall volume increases< indirectcost rates typically decline !ecause fixed costs are spread over an increasing production volume.


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Te '#i+ #!!*'"i+! $e2*i$ed i+ C-V-P #+#&/!i! #$e

1. The relationship holds only &ithin the relevant range. The relevant range is a !and of activity &ithin&hich a given cost !ehaviour is defined.

#. The !ehaviour of total cost and total revenue has relia!ly !een determined and is lineal &ithin therelevant range.

%. ll costs can !e divided into fixed and varia!le such that mixed costs are decomposed into their fixedand their varia!le components.4. Selling prices are constant therefore &e ignore $uantity discounts.5. Efficiency and productivity remain the same so that &e therefore ignore the learning curve effect.7. +rices of factors of production remain constant.. There are no limiting factors

3. ANALY4IN5 THE COST-VOLUME RELATIONSHIP

This section examines alge!raic and graphic analysis of the cost-volume relationship.

3..1 AL5EBRAIC ANALYSIS

The assumption of linear cost !ehavior permits use of straight-line graphs and simple linear alge!ra in

cost-volume analysis.

Total cost is a semi-varia!le costsome costs are fixed< some costs are varia!le< and others are semi-varia!le. /n analysis< the fixed component of a semi-varia!le cost can !e treated li3e any other fixed cost.The varia!le component can !e treated li3e any other varia!le cost. s a result< &e can say that>

Total Cost F :ixed Cost G *aria!le Cost 6sing sym!ols> C F : G *

?here> C F Total cost : F :ixed cost

* F *aria!le cost

Total varia!le cost depends on t&o elements>*aria!le Cost F *aria!le Cost per 6nit x *olume +roduced

6sing sym!ols>

* F *u, ?here> *6F *aria!le cost per unit F uantity ,volume produced

Su!stituting this varia!le cost information into the !asic total cost e$uation< &e have the e$uation used in

cost-volume analysis>C F : G *6,I&&*!"$#"i+ .1

/f you 3no& that fixed costs are Sh.5((< varia!le cost per unit is Sh.1(< and the volume produced is 1


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iven total cost and volume for t&o different levels of production< and using the straight-line assumption

*6 F Change in Total Cost Change in *olume F C#) C1 #) 1

?here>C1F Total cost for uantity 1C#F Total cost for uantity #1F uantity 1

#F uantity #

I&&*!"$#"i+

=ou are analy0ing an offerorBs cost proposal. s part of the proposal the offeror sho&s that a supplieroffered 5

S"e 1. De"e$'i+e "e !#&e "#" /* 0i&& *!e.


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*olume is considered the independent varia!le and &ill !e graphed on the hori0ontal axis. Cost isconsidered the dependent varia!le and &ill !e graphed on the vertical axis. The scales on the t&o axes donot have to !e the same. Ao&ever< on each axis one !loc3 must represent the same amount of change asevery other !loc3 of the same si0e on that axis. Each scale should !e large enough to permit analysis< andsmall enough to permit the graphing of all availa!le data and anticipated data estimates.

S"e . P&" "e ##i%&e !"-&*'e d#"#.

:ind the volume given for one of the data points on the hori0ontal axis. "ra& an imaginary vertical linefrom that point. :ind the related cost on the vertical axis and dra& an imaginary hori0ontal line from thatpoint. The point &here the t&o lines intersect represents the cost for the given volume. ,/f you do not feelcomforta!le &ith imaginary lines you may dra& dotted lines to locate the intersection. Repeat this stepfor each data point.

S"e 3. Fi" # !"$#i," &i+e " "e d#"#.

/n this section of text< all data points &ill fall on a straight line. ll that you have to do to fit a straight lineis connect the data points. Most analysts use regression analysis to fit a straight line &hen all points donot fall on the line.

S"e 7. E!"i'#"e "e !" 6$ # ,ie+ &*'e.

"ra& an imaginary vertical line from the given volume to the point &here it intersects the straight linethat you fit to the data points. Then move hori0ontally until you intersect the vertical axis. That point isthe graphic estimate of the cost for the given volume of the item.Example of Graphic Analysis. The four steps of cost-volume-profit analysis can !e used to graph andanaly0e any cost-volume relationship. ssume that you have !een as3ed to estimate the cost of 4(( unitsgiven the follo&ing data>

U+i"! C!"

#(( I1((


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The estimated cost &ill !e I 15(.(((.

3.3 BREA8 EVEN ANALYSIS

2rea3 even analysis is mainly used to explain the relationship !et&een the cost incurred< the volumeoperated at and the profit earned. To compute the !rea3 even point &e let

S !e selling price per unit*u!e varia!le cost per unit !e !rea3-even $uantities: !e total fixed costs

t 2rea3 even point>Total revenue ,TR F Total Cost ,TC

Total revenue &ill !e given !y S &hile Total cost ,TC F *u G :

t !rea3-even point ,2E+ therefore>

S F *u G :

F JJJ:JJJ S- *u

2.E.+ ,in units F :S- *u

I&&*!"$#"i+

ssume that you are planning to sell !adges at the forthcoming airo!i Sho& at Sh.9 each. The !adgescost Sh.5 to produce and you incur Sh.#((( to rent a !ooth in the Sho& ground.


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Re2*i$ed

a Compute the !rea3even point! Compute the margin of safetyc Compute the num!er of units that must !e sold to earn a !efore tax profit of #(K

d Compute the num!er of units that must !e sold to earn an after tax profit of Sh.174(< assuming that thetax rate is %(K.

S&*"i+

#) B$e#9 ee+ i+"

2E+ units F #(((@,9-5 F 5(( units

2E+ Sh. F 5(( x 9 F 45((@-

%) M#$,i+ 6 !#6e"/

The margin of safety is the amount !y &hich actual output or sales may fall short of the !udget &ithout

the company incurring losses. /t is a measure of the ris3 that the company might ma3e a loss if it fails toachieve the target. high margin of safety means high profit expectation even if the !udget is notachieved. Margin of safety ,MHS can !e computed as follo&s>

MHS F Expected sales - 2rea3 even sales Expected sales

F 7((-5(( F 17.K 7((

) T#$,e" %e6$e "#x $6i" (Y)

'et L !e the num!er of units to produce

L F : G = S - *u

L F #((( G (.# ,9L 9-5

LF #((( G 1.8L 4

L F 9(9.(9 approximately 91( units.

d) A6"e$ T#x $6i"

'et !e the after tax profit

= F JJ / ) t Therefore


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L F : G 0@1-t S ) *u F #((( G 174(

1-(.%9-5

L F 1(85.1

pproximately 1(87 units.

3.7 C-V-P ANALYSIS : MULTIPLE PRODUCTS

The simple product C*+ analysis can !e extended to handle the more realistic situations &here the firmproduces more than one product. The o!Nective in such a case is to produce a mix that maximises totalcontri!ution.

Total 2E+ units F Total fixed cost

verage CM

verage CM F ttn

t

t VS .,

1

=

&here Otis the sales mix of product t. St is the selling price of product t.

*tis the varia!le cost of product t.n is the num!er of units of product t sold

2E+t unitsF Ot,Total 2E+units

2E+ tsh. F 2E+t,unitsxSt

I&&*!"$#"i+

ssume that 2C 'td produces t&o products< product and 2 and the follo&ing !udget has !een prepared.

2 Total1#(


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dvice the Co. on &hether this change is desira!le.

S&*"i+

2Sales mix ,units (.5 (.#5 1Sales mix ,Shs (.7( (.4( 1

verage CM F ttn

t

t VS .,

1

=

F (.5 ,1 G (.(5, F #.5

Total 2E+ units F Total fixed cost F %((((( verage CM #.5

F 1#(


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et +rofit %4(


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?orst possi!le 45((( (.% 2est possi!le %.5 (.%(Most li3ely 5(((( (.7 Most li3ely 4.( (.552est possi!le 55((( (.1 ?orst possi!le 5.5 (.15

:ixed cost F Sh.#4(

2 C " E : ,:xDe'#+d P$%. U+i" VC P$%. C+"$ P$6i" Ji+" 0ei,"ed

P$%. P$6i"

45((( (.% %.5 (.%( #9#5(( 5#5(( (.(9 4#54.( (.55 #(((( %(((( (.175 495(5.5 (.15 #(#5(( ,%5(( (.(45 ,178.5

5(((( (.7 %.5 (.% %#5((( 85((( (.18 15%((4.( (.55 %((((( 7(((( (.%% 198((5.5 (.15 ##5((( ,15((( (.(9 ,1%5(

55((( (.1 %.5 (.% %55(( 115(( (.%% %5#54.( (.55 %%(((( 9(((( (.(55 495(5.5 (.15 #45(( 5(( (.(15 11#.5

Expected profit 5(%#5

! The +,+rofit Q( F (.(45 G (.(9 F (.1%5N"e

This can !e read from the a!ove ta!le

c +,profit Q 7((((F (.% G (.(9 G (.(15F (.4(5

ex#'&e


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Thunder manufacturing company produces a toxic product< coros that must !e sold in the month producedor else discarded. Thunder can manufacture coros itself at a varia!le cost of Sh4( per unit or they canpurchase it from an outside supplier at a cost of Sh( per unit. Thunder can sell coros at Sh8( per unit.+roduction levels must !e set at the start of the period and cannot !e changed during the period. Theproduction process is such that at least 9"emand +ro!a!ility,units4


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d The standard deviation from purchasing and selling is>/ ) ,/ ) U + ,million,4


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F ,1((-7( 1((( )%7((( F Sh.4(((

,profitFdemandx CM F 9( x 4( FSh.%7((

! +,profit Q(

0 F x ) u F ( - 4((( F -1.11 %7((

:rom the ta!les the value F (.1%%5Therefore +,profitQ( F (.1%%5

c + ,profit Q - 14((

F -14(( ) 4((( F -1.5

%7((

:rom the ta!les the value F (.(778

Therefore +,profit Q-14(( F (.(778

3.= CVP ANALYSIS AND COMPUTER APPLICATIONS

The output from a C*+ model is only as good as the input. The analysis &ill include assumptions a!outsales mix< production efficiency< price loads< total fixed costs< varia!le costs and selling price per unit.

The C*+ e$uation can !e used to develop financial planning programs. These programs $uic3ly calculatethe effects of changes in price< costs and volume on an organisations profits. They ans&er such X&hat- ifY$uestions as>i Ao& could a 5K increase in the sales price affect operating incomeDii /f :ast :ood Co. increases its advertising !udget !y Sh1 million< ho& many ham!urgers must it sell to

cover the increase in fixed expensesDiii /f the campus !oo3store extends its hours< ho& much additional revenue must it earn to cover the

increased operating expenseDiv /f varia!le production costs are reduced !y K< ho& many units of product must !e sold to earn

Sh#((


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Sensitivity analysis is one approach for coping &ith changes in the values of the varia!les. /t focuses on ho&a result &ill !e changed if the original estimates or the underlying assumptions change.

The &idespread use of spreadsheet pac3ages &hich do not re$uire programming expertise< has ena!ledmanagement accountants to develop C*+ computerised models. The impact of alternative revised plans is$uic3ly identified and changes only implemented &hen it is apparent that the original estimates are incorrect.

3.> RELEVANT COSTS FOR NON-ROUTINE DECISIONS

relevant cost is a cost that is appropriate to a specific management decision. To !e relevant< a cost must !e>

1. :uture cost ) decision is usually a!out the future Z management not &hat has already !eendone. cost that has already !een incurred is therefore irrelevant to any decision !eingmade no& e.g. costs already paid or costs committed !y decisions made in the past.

#. Relevant costs are cash flo&s ) /t is assumed that decisions are ta3en &hich &ould maximi0ethe satisfaction of the company o&ners Z therefore such decisions must not !e ignored. Suchcosts include depreciation< notional rent or notional interest or a!sor!ed H@A.

%. Relevant costs arise as a direct conse$uence of ma3ing a decision. /t should !e anincremental cost i.e. the difference !et&een the cost &ith the decision Z the cost &ithout thedecision.

A!!*'"i+!

The 3ey assumptions made in relevant costing are>1. The cost !ehaviour is 3no&n.#. The amount of fixed costs< unit varia!le costs< selling prices and sales demand are 3no&n &ith

certainty.%. The o!Nective of the decision ma3er in the short-term is to maximi0e satisfaction &hich can !e

defined as maximi0ation of short-term profit.4. The information on &hich the decision is !ased is complete and relia!le.

There are various types of decisions that can !e considered in this section< Examples include>a. Ma3e or 2uy decisions!. Shut do&n pro!lemsc. Extra shift decisionsd. ;oint cost decisions

3.>.1 MA8E OR BUY DECISIONS (NO LIMITIN5 FACTORS)

The choice !et&een ma3ing or !uying a given component is one &hich is li3ely to face all !usinesses atsome time. /t is often one of the most important decisions for management for the critical effect on profitsthat may ensue. The choice is critical< too< for the management accountant &ho provides the cost data on&hich the decision is ultimately !ased.

ma3e or !uy pro!lem involves a decision !y an organisation a!out &hether it should ma3e a product orcarry out an activity &ith its o&n internal resources or &hether it should pay another organisation to carryout the activity. The ma3e option gives management more direct control over the &or3< !ut the !uyoption may have !enefits in that the external organisation has expertise and special s3ills in the &or3ma3ing it cheaper.


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There are certain situations &here the ma3e or !uy decision is not really a choice at all. There can !e noalternative to ma3ing< &here product design is confidential or the methods of processing are 3ept secret. Hnthe other hand< patents held !y suppliers may preclude the use of certain techni$ues and then there is nochoice other than !uying or going &ithout. The supplier &ho has developed a special expertise or &ho useshighly speciali0ed e$uipment may produce !etter-$uality &or3 &hich suggests !uying rather than ma3ing./n other cases< the special $ualities demanded in the product may not !e availa!le outside and so ma3ing

!ecomes necessary.

?here technical considerations do not influence the ma3e or !uy decision< the choice !ecomes one ofselecting the least-cost alternative in each decision situation. Comparative cost data are necessary. MA8E OR BUY DECISIONS UNDER LIMITIN5 FACTORS.

Hne reason for !uying products@services from another organisation is the scarcity of resources< so that thecompany may !e una!le to ma3e all its components. /n such a case the company should com!ine internalresources &ith !uying externally to increase profita!ility. /n situations &here a company must su!-contract &or3 to ma3e up short fall in its in-house capa!ility< then its cost &ill !e minimi0ed &here themarginal cost of !uying is least for each unit of scarce resource saved !y !uying externally.

I&&*!"$#"i+

ssume that 2C 'td ma3es four components &ith the follo&ing information>? @ Y 4

+roduction ,units 1((( #((( 4((( %(((6nit marginal costs"irect material 4 5 # 4

"irect la!our 8 9 4 7*aria!le H@A # % 1 #

14 1 1#

ttri!ute :ixed Cost su! contractor priceS. S.

TH ? 1((( ? 17L 5((( L #1= 7((( = 1(

8((( 18Committed :ixed Costs are Sh.%((((ssume that machine hours per unit re$uired to produce the components are>

Machine Aours? 4L 5= % 7The total machine hours availa!le is #((( hours during the !udget period.

Re2*i$ed

dvice the company on &hich products to ma3e and the ones to !uy externally.

S&*"i+

Re$uired machine hours? 4L1(((F 4(((L 5L#(((F 1((((= %L4(((F 1#((( 7L%(((F 18(((


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/ 44(((vaila!le hours #(((Shortfall 1(((

Machine hours is therefore a limited resource

? L = Cost of !uying per unit 17 #1 1( 18Cost of ma3ing *C 14 1 1#JJJJJExtra varia!le cost of !uying # 4 % 7o. of units 1((( #((( 4((( %(((JJJTotal extra *. Cost of !uying #((( 8((( 1#((( 18((('ess attri!uta!le : C ,1((( ,5((( ,7((( ,8(((JJet extra cost of !uying 1((( %((( 7((( 1(((("ivide the no. of mhrs saved 4((( 1(((( 1#((( 18(((JJet extra costs of !uying perMachine hours saved (.#5 (.%( (.5 (.57

+riority for !uying 1 # % 4+riority for ma3ing 4 % # 1

3.>.3 ABANDONMENT DECISIONS

:rom time to time management &ill !e faced &ith the pro!lem of deciding to a!andon an unprofita!leactivity. This is really a least-cost alternative decision and so made on the criterion of relative marginalcosts.

Ce#!i+, P$d*"i+ 6 Ce$"#i+ P$d*"!

/t is sometimes suggested that< &here a given product is apparently ma3ing a loss< manufacture and@ormar3eting of this product should cease< to improve the companyBs overall profit performance.

8ENBAR CYCLES LIMITED

PROFIT AND LOSS STATEMENT FOR YEAR ENDED 31.1.1..

Mde& A1= Mde& E3; Mde& N7< T"#&


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8ENBAR CYCLES LIMITED

PROFIT AND LOSS STATEMENT FOR YEAR ENDED 31.1.1..

Mde& A1= Mde& E3; Mde& N7< T"#&


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3.>.= E@TRA SHIFT DECISION

These decisions are concerned &ith &hether or not a company should &or3 for 8 hrs< 17hrs< or #4 hrs aday or &ee3 days only or &ee3ends also. The factors to consider are>

i. ?hether the &or3 force &ould !e &illing to &or3 extra shifts Z if so &hat overtime orshift premium they &ould accept.

ii. ?hether extra hours have to !e &or3ed Nust to remain competitiveiii. ?hether extra hours &ould resort in extra revenue or &hether there &ould !e in demandpattern from customers.

I&&*!"$#"i+

L= currently operates a single production shift &hich incurs costs and earns revenue stated !elo&>[

Sales ,1(((( units %7(((("irect material 1#(((("irect la!our 1(((((*aria!le H@As #(((( ,#4((((Contri!ution 1#((((

:ixed Cost ,9((((+rofit %((((+rofit margin 8.%7K

Sales demand exists for an extra 7((( units &hich can !e made in a #ndshift at current selling price. Thela!our in the #ndshift &ill !e paid at time Z \. dditional fixed cost of [1(((( &ill !e incurred !ut dueto the increase in purchase of materials a $uantity discount of 5K &ill !e given on all materialspurchased.Re2*i$ed

dvice the company on &hether to operate the # ndshift.

S&*"i+ A+#&/!i! 6 Se+d !i6"

[

Sales ,7(((x%7 #17((("irect la!our ,1.#5x1(((( 1#5


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,1 /f the Noint product can !e sold at existing condition at the split-off point or after further separateprocessing< then a decision should !e made on &hether to process further.

,# /f extra demand for a Noint product exists and not others then it is necessary to 3no& &hether it is&orth ma3ing more output of the Noint product so as to ma3e a profit on one and dispose off theother.

,% /f it is possi!le to change the input so as to change the product mix< then product mix decisionsshould !e made.

Ji+" P$d*" 6*$"e$ $e!!i+, dei!i+!

/n these decisions the relevant costs are the additional costs of further processing< &hich should !ecompared &ith the incremental revenue of further processing. The Noint costs incurred !efore the split-offpoints are irreverent.

I&&*!"$#"i+.

2C 'td produces product Z2 from the same process. ;oint processing costs of I15(


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Cost +rocess 1 process # process %Ra& materials I4(


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*aria!le costs %1.fter the split off point the products can !esold for industrial use or ta3en to mixing plant for !lending and refining. ,the #ndoption usuallyfollo&ed. The follo&ing information is given for a specific &ee3>


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S#&e! P

#((( litres 1(((litres+rice per litre I%5 I7(Sales revenue I(

lesson three short term decision

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