F5 Performance Management

2 Section B: Decision Making Techniques Designed to give you knowledge and application of: B1. Relevant cost analysis B2. Cost volume profit analysis B3. Limiting factors B4. Pricing decisions B5. Make-or-buy and other short-term decisions B6. Dealing with risk and uncertainty in decision-making B1. Relevant cost analysis B2. Cost volume profit analysis B3. Limiting factors B4. Pricing decisions B5. Make-or-buy and other short-term decisions B6. Dealing with risk and uncertainty in decision-making

3 B5: Make-or-buy and other short-term decisions Learning outcomes  Explain the issues surrounding make vs. buy and outsourcing decisions. [2]  Calculate and compare “make” costs with “buy-in” costs. [2]  Compare in-house costs and outsource costs of completing tasks and consider other issues surrounding this decision. [2]  Apply relevant costing principles in situations involving shut down, one-off contracts and the further processing of joint products. [2]

4 The important terms used in short-term decision-making The issues surrounding make-or- buy and outsourcing decisions Example Jill, a management accountant in Cosco, has two options. The first is to register for ACCA under the sponsorship of the company, and the other is a salary increase of $75,000 per year. If she opts to register herself for ACCA, the opportunity cost will be $150,000 ($75,000 x 2 years), if it takes two years to complete ACCA. This $150,000 will be the opportunity cost for taking the decision of whether to accept the pay rise or to pursue ACCA. Relevant costs: The costs pertinent to the making of a specific managerial decision. These are essentially the future costs and should differ amongst the possible alternative courses of action.  The differential costs amongst the alternative courses of action are relevant  Future costs are relevant  Only cash costs are relevant Opportunity cost:  The value of the benefits sacrificed when one course of action is chosen, in preference to an alternative. Continued…

5 Outsourcing involves the transfer of organisational functions to a third party to get the work done by them. Avoidable costs: the specific costs of an activity or sector of a business which would be avoided if that activity or sector did not exist. Case study The Boots Company Plc, a UK health-care manufacturer and retailer, has outsourced its IT activities to another IT service providing company. Boots estimates that it will save costs to the extent of $100 million over ten years by outsourcing the IT facilities. Therefore, the decision to outsource is taken on the basis of cost comparisons between ‘to make’ and ‘to outsource’. Boots Company Plc Annual report 2003 Example Coco Ltd has stopped production of one of its products. The variable costs related to that product such as material, labour etc. can be avoided fully but administration costs would continue to be incurred. The important terms used in short-term decision-making Continued…

6 Factors affecting ‘make or buy’ and outsourcing decisions Quantitative factors CostIdle capacity Balancing capacity / limiting factor New entrant Qualitative factors Technology QualityResponse time Impact on core activities Increase responsiveness

7 Calculate and compare “make/ in-house” costs with “buy-in / outsource” costs Process of make or buy decision Cost of manufacturing (COM) = Number of units sold (n) x Variable cost per unit (v) + Relevant fixed cost (F) Cost of purchase (COP) = Number of units sold (n) x Purchase cost per unit (p)+ Transportation cost (t) Make / buy Cost of manufacturing (COM) includes:  Direct material  Direct labour  Variable overheads  Increase in fixed costs Cost of purchase (COP) includes:  Cost of purchase  Cost of transportation COM > COP ? Yes Buy Make No Refer to Test Yourself 2 on page 181

8 The decision to shut down may be a long-term or short-term decision Application of relevant costing principles in situations involving shut down, one-off contracts and the further processing of joint products Shut down / continue:  Decision may be long-term or short-term.  In the case of trade recession, management may be compelled to consider suspending the production for a few days and a temporary shut down decision is taken.  When a unit, department, product or any other activity is running at a loss, a decision may be taken to shut down the plant permanently.  Shut down point = Total fixed cost – (Unavoidable fixed costs + Additional fixed cost)/Contribution per unit. If decision of shut down is taken Identify cost relevant for shut down Avoidable fixed costs are relevant Additional fixed costs are also relevant Identify shut down point Refer to Example on page 182

9 Relevant cost principles in further processing of joint products:  Cost of further processing is relevant.  Joint cost up to the split off point is irrelevant.  Incremental revenues ( = Revenue after further processing - Revenue as a result of sale at the split off point) are relevant. Refer to Example on page 185 Relevant cost principles

10 RECAP  Explain the issues surrounding make vs. buy and outsourcing decisions. [2]  Calculate and compare “make” costs with “buy-in” costs. [2]  Compare in-house costs and outsource costs of completing tasks and consider other issues surrounding this decision. [2]  Apply relevant costing principles in situations involving shut down, one-off contracts and the further processing of joint products. [2]