Decision-Making

Question 1

Distinguish between relevant and irrelevant costs in decision making, giving TWO examples of each.

Answer 1

Relevant Costs: change as a result of a decision. They are usually variable costs
Examples:
- Variable Costs
- Direct Materials
- Variable OH

Irrelevant Costs: they will not change in the future when you make a decision versus another. Since they are mainly fixed costs they are not relevant for decision making.
Examples:
- Sunk Costs
- Rent
- Water and Electricity.

Question 2

TWO considerations that a company must keep in mind in making or buying a product.

Answer 2

The organisation will need to determine the cost of making the product or component and the cost of buying it. The cheaper alternative is to be selected.

However, management has to consider the opportunity cost of releasing capacity when subcontracting. At times, the cost of buying is more expensive but the released resources can be put to a better use.

The contribution gained by utilising the released resources in an alternative manner can be higher than the costs saved by making the product.

Question 3

Describe an adequate business plan with a limiting factor.

Answer 3

Management is to focus on the scarce resource. It should determine the best use of the limited resource to maximise profits. Management must determine the optimum allocation of the limited resource to minimise the loss of profit.
They will have to produce a lower level of output, thus the profit for the period may decline.
Moreover, management will need to establish the product-mix that will generate the highest profit for the period. This is because the normal level of activity cannot be reached due to a shortage of resources.

Question 4

What is the mathematical technique that assists accountants to separate costs into their fixed and variable elements.

Answer 4

Managers sometimes need to identify the variable element present in a semi-variable cost. This is especially so when marginal costing techniques are being used. This can be done by what is known as the high-low method.

This method involves taking from the set of actual data, the highest level of activity and the lowest level of activity and comparing the changes in costs which result form the two levels. If the variable costs are constant per unit and fixed costs remain the same, it is then possible to determine the fixed and variable costs.