1. Activity Resource Usage Model and Tactical Decision Making
Dr Satinder Bhatia
Professor, IIFT

2. The 3 Levels of Decision-making
There are 3 levels of decision-making that need to take place in a business for it to operate at its full potential. The three levels are:
Strategic
Tactical
Operational

3. Strategic Decisions - 'What?'
Strategic decisions deal with the big picture of your business. The focus of strategic decisions is typically external to the business and usually future oriented. Strategic decision-making creates the forward thrust in the business.
It includes decisions about:
What business are you in?
What is your vision for the business?
What's your business' identity?
What do you stand for?
Which direction is the business headed?
How will the business compete?
Corporations often capture their overall business strategy in a "Statement of Intent" and it's an excellent term for describing what strategic decision-making is. Too often people confuse strategic decisions with tactical decisions and fail to really examine the big picture.

4. Tactical Decisions - 'How?'
Tactical decisions involve the establishment of key initiatives to achieve the overall strategy. For example, if you have decided to be the Number 1 provider in your market (a strategic decision) then you will develop tactics (e.g. implement a marketing system, increase number of therapists) to achieve that outcome. In a small business you may have 4 or 5 key tactics that you are going to use to achieve your overall strategy.
Again this layer of decision-making can sometimes be overlooked yet it is the glue that creates a strong connection between your long-term vision and your day-to-day activities. Tactical decision-making is the domain of 'mission' statements.

5. Operational Decisions - 'How will we deploy resources?'
Operational decisions determine how activities actually get done. They are the 'grass roots' decisions about who is going to do what and when. It includes:
How will we spend our money this month?
How will we service that client?
What is our procedure for delivering an order?
Who will be doing quality control?
If you are making decisions involving processes and procedures they are usually operational decisions. Operational decisions are often made in 'real time' and are the result of needing to make quick adjustments or change to achieve the desired outcome.

6. Examples of Strategic and Tactical Decisions
Examples of strategic decisions and tactical decisions from a management
accounting point of view include:
Decision items Strategic Decisions Tactical Decisions
Cash Maintain minimum level
without excessive risk Specific level of cash
Accounts receivable Sell on credit Specific credit terms
Inventory Maintain safety stock Specific level of inventory
Price Be volume dealer by Specific price
setting price lower than
competition
Once a strategic decision has been made, then a specific management tool can be used to aid in making the tactical decision. For example, if the strategic decision has been made to avoid stock outs, then a safety stock model may be used to determine the desired level of inventory.

7. Steps in Tactical Decision-Making
The tactical decision-making process includes the following five steps:
Step 1: Recognize and define the problem.
Step 2: Identify alternatives as possible solutions to the problem, and eliminate alternatives that are not feasible.
Step 3: Identify the predicted costs and benefits associated with each feasible alternative. Eliminate the costs and benefits that are not relevant to the decision.
Step 4: Compare the relevant costs and benefits for each alternative, and relate each alternative to the overall strategic goals of the firm and other important qualitative factors.
Step 5: Select the alternative with the greatest benefit that also supports the organization’s strategic objectives.
The five steps listed above define a simple decision model.
Steps 3 and 4 above define tactical cost analysis.

8. Incorporating Qualitative Factors
Qualitative factors can be handled in the decision-making process as follows:
1. Identify qualitative factors.
2. Quantify the identified qualitative factors using best estimates.
3. Take truly qualitative factors into consideration in the final step of the decision-making model (i.e., the selection of the alternative with the greatest overall benefit).

9. Relevant vs Irrelevant Costs
Tactical decisions involve choosing among alternatives keeping the objective in mind. And to choose among alternatives, it is important to segregate costs into two categories:
Relevant Costs (relevant to decision-making – as these costs differ among alternatives). Thus all future costs may not be relevant costs if they remain the same across the alternatives.
Irrelevant Costs (not relevant to decision-making – as these costs are the same for the different alternatives)

10. Definition: Relevant Costs
Relevant costs (revenues) are future costs (revenues) that differ across alternatives. That is, to be relevant, a cost (revenue) must meet both of the following conditions:
It must be a future cost (revenue), and
It must differ across alternatives.

11. Definition: Irrelevant Costs
Irrelevant costs or revenues include:
A cost or revenue does not differ across alternatives.
A cost (revenue) has no effect on a decision.
Past cost data can be used as the basis for predicting future costs.
Examples of irrelevant costs:
a. Sunk costs are past costs that will remain the same across alternatives (e.g., depreciation, which represents an allocation of a cost already incurred).
b. Future costs will remain the same across alternatives.

12. Relevancy and the Activity Resource Usage Model
The activity resource usage model helps sort out the behavior of various activity costs and assess their relevance. The model has two resource categories: (1) flexible resources and (2) committed resources.

13. Defining Flexible Resources
1. Flexible resources are acquired as used and needed.
2. For flexible resources, the activity resources demanded (used) equals the resources supplied.
a. Resource spending is the cost of acquiring activity capacity.
b. The amount paid for the supply of an activity is the activity cost.
3. The cost of the activity is a relevant cost if the demand for an activity changes across alternatives and, thus, produces changes in the resource spending.

14. Defining Committed Resources
Committed resources are acquired in advance of usage through implicit contracting and are usually acquired in lumpy amounts. Committed resources are often acquired in advance for multiple periodsbefore the resource demands are known. a. Examples include leasing or buying a building.
b. Buying multi-period activity capacity is often accomplished by making commitments up front before the resource demands are known.

15. Implications of Committed Resources
The nature of the committed resources implies that:
a. An increase in the demand for an activity across alternatives may not mean that the activity cost will increase because an activity may have unused capacity available.

16. Implications of Committed Resources - contd
b. The cost of the activity is a relevant cost if a change in demand across activities produces a change in resource supply/spending as follows:
- When the demand for the resource exceeds the supply, resource spending will increase.
- When the demand for the resource drops permanently, and supply exceeds demand enough, the activity capacity can be reduced and the resource spending will decrease.

17. Implications of Committed Resources - contd
The up-front committed resource spending is a sunk cost and, thus, is never relevant because periodic resource spending, such as leasing, is essentially independent of resource usage.
Even if a permanent reduction of activity usage is experienced, it is difficult to reduce resource spending because of formal contractual commitments.

18. Supply – Demand = Unused Capacity
Relevancy, Cost Behavior, and the Activity Resource Usage Model
OBJECTIVE 3
Committed Resources
Supply – Demand = Unused Capacity
a. Demand Increase < Unused Capacity Not relevant
b. Demand Increase > Unused Capacity Relevant
c. Demand Decease (Permanent)
Activity Capacity Reduced Relevant
Activity Capacity Unchanged Not Relevant

19. Relevancy, Cost Behavior, and the Activity Resource Usage Model
OBJECTIVE 3
A company has five manufacturing engineers who supply a capacity of 10,000 engineering hours (2,000 hours each). The cost of this activity capacity is $250,000, or $25 per hour. The firm expects to use 9,000 hours. If the firm decides to reject a special order requiring 500 hours, the cost of engineering would be irrelevant.

20. Relevancy, Cost Behavior, and the Activity Resource Usage Model
OBJECTIVE 3
The firm can purchase a component that will drop the demand from engineering hours from 9,000 to 7,000. Since engineering activity capacity is acquired in chunks of 2,000, the company can lay off one engineer or reassign the engineer to another plant.

21. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model
OBJECTIVE 3
Resource demand and Supply

22. Applications of Activity Resource Usage Model
The activity resource usage model and the concept of relevancy can be valuable in making tactical decisions. Applications include decisions to (1) make or buy a component, (2) keep or drop a segment or product line, (3) accept or reject a special order at less than the usual price, and (4) process a joint product further or sell it at the split-off point.

23. Make or Buy Decisions
Make-or-buy decisions refer to the decisions of whether to make internally or buy externally the components or services used in making a product or providing a service.
Make-or-buy decisions are not short run in nature but fall into the small-scale tactical decision category.
2. Tactical cost analysis for make-or-buy decisions focuses on summarizing and comparing the relevant costs of making versus buying the needed components.
Tactical cost analysis identifies the low-relevant-cost alternative for producing the main product.
3. Managers should also consider qualitative factors, such as choosing to make or buy as a way of increasing the quality of the component, thereby increasing the overall quality of the final product.

24. Example – Make or Buy Decisions
Scooter, Ltd., currently manufactures Part XR-15 in its factory. The manufacturing cost has been calculated as follows: Materials, $22.50; Labor, $2.50; and Overhead, $ Overhead is 40% variable and is applied at 700% of labor costs. An outside supplier has bid a price of $35 to supply all of Scooter’s needs of XR-15 for the next three years. Scooter currently makes 750 parts per month.
Required:
Assume that Scooter has no alternative use for the space or machinery currently used in the manufacturing of XR-15. Should Scooter make the part or buy it from the outside supplier?

25. Solution to Make or Buy Problem
The variable cost of Part XR-15 is $ $ (40% × $17.50) = $32 to make versus $35 to buy.
Scooter should continue to make the part since there are no lost opportunities.

26. Additional Question on Make or Buy Problem
Assume that Scooter could use the space to store materials that are currently stored in leased space. The leased space costs $3,000 per month. What should Scooter do?

27. Solution of the additional question
The cost to make would be $32 × 750 parts per month = $24,000 per month.
The net cost to buy would be $35 × 750 parts = $26,250 less the $3,000 lease cost saved = $23,250.
Scooter could save $24,000 – $23,250 = $750 per month by buying rather than making. The total impact over three years would be $750 × 36 months = $27,000.

28. Example of Functional-Based Analysis
Acme, Inc., has three product lines: Basic, Standard, and Extended. Assume the following information:
Basic Std Extended Prac Capacity
Production (in units) 25,000 60,000 15,000
Selling price $50 $75 $125
Direct materials $15 $20 $27
Labor hours ($10/hr) 10,000 25,000 20,000
Machine hours (total) 7,500 20, , ,000
Purchase orders
Receiving
Handling
Shipping ,000
Advertising costs $25,000 $25,000 $40,000

29. Example contd
All the overhead costs are fixed costs, except for the machine overhead costs. Overhead costs are listed below according to the cost drivers:
Machine hours $1,895,000 ($1,225,000 fixed + $670,000 variable)
Purchase orders 285,000
Receiving 525,000
Handling 540,000
Shipping 275,000
Total $3,520,000
Prepare a functional-based segmented income statement by product line, assuming that labor and overhead are applied to the products on the basis of labor hours.
Prepare an activity-based segmented income statement by product line.

30. Functional-Based Presentation
Acme, Inc Traditional Income Statement
Basic Standard Extended Total
Revenues $1,250,000 $ 4,500,000 $ 1,875, $ 7,625,000
Less variable expenses:
Direct materials (375,000) (1,200,000) (405,000) (1,980,000)
Direct labor (100,000) (250,000) (200,000) (550,000)
Variable overhead (121,818) (304,545) (243,636) (670,000)
Fixed overhead (518,182) (1,295,455)  (1,036,364) (2,850,000)
Gross margin $  135,000 $ 1,450,000 $   (10,000) $ 1,575,000
Less: Advertising     25,000     25,000     40,     90,000
Income before taxes $  110,000 $ 1,425,000 $   (50,000) $ 1,485,000
Variable overhead = Variable machine costs = $670,000 / $550,000 = % of DL$
Fixed overhead = Purchase orders, receiving, handling, and shipping costs + Fixed machine costs
($3,520,000 – $670,000) / $550,000 = % of DL$

31. Limitations of Functional-Based Cost Analysis
Note that a functional-based cost analysis is more limited than an activity-based one and does not supply detailed information about non unit-level activities and costs because:
It identifies and uses only unit-level activity data and classifies all other costs as irrelevant because they do not change as production volume changes.
The use of this limited activity information may lead to erroneous decisions.

32. Activity-Based Cost Analysis
Acme, Inc Income Statement Using Activity Costing
Basic Standard Extended Total
Revenues $1,250,000 $4,500,000 $1,875,000 $ 7,625,000
Variable costs    596,818  1,754,546    848,636   3,200,000
Contribution margin $  653,182 $2,745,454 $1,026,364 $ 4,425,000
Less traceable expenses:
Advertising (25,000) (25,000) (40,000) (90,000)
Machines (262,500) (700,000) (210,000) (1,172,500)
Purchase orders (47,500) (47,500) (59,375) (154,375)
Receiving (131,250) (136,500) (183,750) (451,500)
Handling (135,000) (135,000) (225,000) (495,000)
Shipping  (68,750)  (34,375)  (137,500)   (240,625)
Product margin $(16,818) $1,667,079 $  170,739 $ 1,821,000
Less unused activity expenses:
Machines (52,500)
Purchase orders (30,625)
Receiving (73,500)
Handling (45,000)
Shipping (34,375)
Income before taxes $ 1,485,000

33. Rate Calculation Machines $1,225,000 / 35,000 = $35
Purchase orders $285,000 / 600 = $475
Receiving $525,000 / 500 = $1,050
Handling $540,000 / 600 = $900
Shipping $275,000 / 1,000 = $275

34. Keep-or Drop Decisions
Keep-or-drop decisions use relevant cost analysis to determine whether a segment of a business should be kept or dropped.
Segmented reporting using an activity-based classification and the resource usage model offers a significant improvement in information content over the functional-based segmented report because an ABC-based segmented income statement:
Reports the traceable fixed expenses of batch-level and product-level costs to individual product lines.
Highlights the unused activity expenses.

35. Example – Keep or Drop

36. ABC Segmented Income Statement
An ABC segmented income statement might reveal three possible ways of increasing income by:
a. Reducing resource spending by exploiting current unused activity capacities.
b. Eliminating an unprofitable product line.
c. Using a combination of the two alternatives above.
4. The key to keep-or-drop analysis is assessing how much of the cost of unused capacity can be eliminated if the segment or product line were dropped.
If dropping a product allows the company to reduce the existing unused capacity, causing a reduction in resource spending, this alternative should be chosen to help the company reduce its losses.

37. Special-Order Decisions
1. Special-order decisions focus on whether a specially priced order should be accepted or rejected to increase short-term profits.
a. Special orders refer to those one-time orders from potential customers in markets not ordinarily served.
b. Acceptance of special orders should not jeopardize normal distribution channels or adversely affect other strategic elements.
c. Special orders can be attractive when the firm is operating below its maximum productive capacity and when other activities have sufficient unused capacity to absorb any incremental demands the order may make.

38. Example - Special Order Decisions
XYZ, Inc., has been offered $35 for 1,000 summer-weight sleeping bags by a discount store. XYZ normally sells the bag for $ The costs of the bag have been determined to be as follows:
Materials $15.00
Labor
Variable overhead 5.00
Fixed overhead  15.00
Total $42.50

39. Example - contd
If XYZ has excess capacity in its production line and has no alternative use for the space that is idle, should the special order be accepted?

40. Solution – Special Order Problem
Special order price – Variable costs = $35 – ($ $ $5.00) = $35.00 – $27.50 = $7.50 per unit contribution
Yes, accept the special order.

41. Additional Question on Special Order Problem
Assume that XYZ is operating at full capacity. Should the order be accepted?

42. Solution to Additional Question
If XYZ is operating at full capacity, there are opportunity costs equal to the current contribution margin of $20 ($47.50-$27.50). XYZ should not accept a price less than the current market price of $47.50 unless there are compelling strategic reasons to do so.

43. Tactical Cost Analysis for Special Order Decisions
Tactical cost analysis for special-order decisions focuses on:
Relevant costs, which include:
(1) Resources acquired as needed and
(2) Any other incremental costs attributable to the special order.
Whether the special order produces positive contribution margin by comparing the special order’s revenue and its relevant cost.

44. Decisions to Sell or Process Further
1. Decisions to sell or process further focus on whether a product should be processed beyond the split-off point or should be sold before the additional processing.
Joint products have common processes and costs of production up to a split-off point at which the products become distinguishable.
The split-off point is the point of separation of the joint products (i.e., where the products become separable).
The costs incurred before the split-off point are costs common to all joint products and, thus, are not relevant to the sell-or-process-further decision.

45. Problem – Joint Products
ABC Company processes a chemical through a joint process. At the end of the process, three products are available: A, B, and C. The cost of the process is $450,000. The products can be sold at the split-off point, or they can be processed at an additional cost and sold. The following information is available:
Prod Price1 Volume Add Costs Price2
A $ , $25, $25.00
B , ,
C , ,
1. Determine when each product should be sold, assuming the additional costs of processing are all variable.

46. Solution – Joint Products
Product Sell Now Process Further Rel Revenue Rel Cost
A 10,000 × $15.00 = $150, ,000 × $25.00 = $250,000 $100,000 $25, Decision: Process further
B 15,000 × $17.50 = $262,500 15,000 × $22.50 = $337,500 $75,000 $36,000 Decision: Process further
C 30,000 × $22.50 = $675,000 30,000 × $24.00 = $720,000 $45,000 $85,000 Decision: Sell now
2. Prepare a segmented income statement using the contribution approach and treating the joint processing costs as common fixed expenses.

47. Solution - contd ABC Company Segmented Income Statement A B C Total
Revenues $250,000 $337, $675, $1,262,500
Variable processing  25,  36,000        61,000
Contribution $225,000 $301, $675, $1,201,500
Joint costs ,000
Net income $  701,500

48. Tactical Cost Analysis for Sell-or-Process-Further Decisions
Tactical cost analysis for sell-or-process-further decisions focuses on comparing:
The relevant revenues that would be earned if the joint product is processed further (i.e., relevant revenue).
The relevant costs if the joint product is processed further which may include:
Increase in the demand for resources acquired as needed.
Increase in the spending of the existing resources acquired in advanced of usage.
3. A joint product should be processed further if its relevant revenue is higher than its relevant costs for processing further (i.e., if it produces a positive contribution margin).

49. Ethical Framework for Decisions
When making tactical decisions, decision makers should always keep the decisions within an ethical framework because:
Relevant costs are used in making tactical decisions that have a limited objective in mind.
Reaching objectives is important, but how you get there is perhaps more important.