Chapter 10: Management Accounting for Decision Making
Management accounting provides critical information for short-term and long-term business decisions. This chapter covers relevant costing, make-or-buy decisions, special order pricing, product mix with limiting factors, continue or shutdown decisions, and capital budgeting basics — all essential tools for Nepali business managers.
10.1 Relevant Costs for Decision Making
Relevant costs are future costs that differ between alternatives. Only relevant costs should be considered in decision-making. Past costs (sunk costs) are never relevant.
| Cost Type | Relevant? | Reason | Example |
|---|---|---|---|
| Sunk Cost | No | Already incurred; cannot be changed | NPR 5 lakh already spent on market research |
| Future Differential Cost | Yes | Differs between alternatives | Variable costs of producing vs buying |
| Opportunity Cost | Yes | Benefit forgone by choosing one option | Rent lost if factory space used for own production |
| Committed Fixed Cost | No | Cannot be avoided regardless of decision | Factory lease for 5 years already signed |
| Avoidable Fixed Cost | Yes | Can be eliminated if activity stops | Supervisor salary for a product line being considered for closure |
10.2 Make or Buy Decisions
Example: A Nepali electronics company produces 10,000 components/year. An external supplier offers at NPR 45/unit.
| Cost Element | Make (per unit) |
|---|---|
| Direct Material | NPR 15 |
| Direct Labor | NPR 12 |
| Variable Overhead | NPR 8 |
| Fixed Overhead (allocated) | NPR 20 |
| Total | NPR 55 |
Analysis: Relevant cost of making = 15 + 12 + 8 = NPR 35 (variable costs only, since fixed OH continues regardless). Buy price = NPR 45. Since make (35) < buy (45), continue making in-house.
However, if NPR 10 of fixed OH is avoidable: Relevant make cost = 35 + 10 = 45 = buy price → consider qualitative factors (quality control, supply reliability, flexibility).
10.3 Special Order Pricing
Rule: Accept special order if price > variable cost (when spare capacity exists and no impact on regular sales).
Example: Normal SP = NPR 200, VC = NPR 120, FC = NPR 5,00,000 (for 10,000 units). Current sales = 8,000 units. Special order: 1,500 units at NPR 150.
Spare capacity = 10,000 - 8,000 = 2,000 units ✓ (order fits)
Special order price (150) > Variable cost (120) → Accept.
Additional contribution = 1,500 × (150-120) = NPR 45,000 extra profit
10.4 Continue or Shutdown Decision
| Scenario | Decision Rule |
|---|---|
| Contribution > 0 and > avoidable fixed costs | Continue (contributes to overall profit) |
| Contribution > 0 but < avoidable fixed costs | Shutdown (losing money even after contribution) |
| Contribution < 0 (negative) | Shutdown (not even covering variable costs) |
10.5 Product Mix with Limiting Factor
Rule: When a resource is scarce, rank products by contribution margin per unit of the limiting factor.
Example: Machine hours limited to 6,000.
| Product | CM/unit | Machine hrs/unit | CM per machine hr | Rank |
|---|---|---|---|---|
| A | NPR 60 | 3 | NPR 20 | 2nd |
| B | NPR 40 | 1 | NPR 40 | 1st |
| C | NPR 80 | 5 | NPR 16 | 3rd |
Optimal mix: Produce B first (highest CM per machine hour), then A, then C with remaining hours.
10.6 Capital Budgeting Basics
| Method | Formula/Approach | Decision Rule |
|---|---|---|
| Payback Period | Initial Investment / Annual Cash Flow | Accept if payback < target period |
| ARR (Accounting Rate of Return) | Average Annual Profit / Average Investment × 100 | Accept if ARR > required rate |
| NPV (Net Present Value) | PV of cash inflows - Initial investment | Accept if NPV > 0 |
| IRR (Internal Rate of Return) | Rate where NPV = 0 | Accept if IRR > cost of capital |
Payback Example
Investment = NPR 10,00,000. Annual cash flow = NPR 2,50,000.
Payback = 10,00,000 / 2,50,000 = 4 years
10.7 NPV Method for Capital Investment — Detailed Example
A Nepali hydropower company evaluates a micro-hydro project:
Investment: NPR 80,00,000. Life: 8 years. Salvage: NPR 5,00,000. Cost of capital: 12%.
| Year | Cash Inflow | PV Factor @12% | PV of Cash Flow |
|---|---|---|---|
| 1 | 10,00,000 | 0.8929 | 8,92,857 |
| 2 | 12,00,000 | 0.7972 | 9,56,633 |
| 3 | 15,00,000 | 0.7118 | 10,67,669 |
| 4 | 18,00,000 | 0.6355 | 11,43,945 |
| 5 | 18,00,000 | 0.5674 | 10,21,308 |
| 6 | 15,00,000 | 0.5066 | 7,59,934 |
| 7 | 12,00,000 | 0.4524 | 5,42,836 |
| 8 | 10,00,000 + 5,00,000 | 0.4039 | 6,05,871 |
| Total PV of Inflows | 69,91,053 | ||
| Less: Initial Investment | (80,00,000) | ||
| NPV | -10,08,947 (Negative) | ||
Decision: REJECT the project — NPV is negative. The project's returns don't justify the investment at 12% cost of capital. The company should either negotiate a lower construction cost, find ways to increase electricity revenue, or invest elsewhere.
10.8 Transfer Pricing
Transfer pricing is the price charged for goods/services transferred between divisions of the same organization. It affects divisional profit measurement and resource allocation.
| Method | Transfer Price Set At | When Appropriate | Advantage |
|---|---|---|---|
| Market Price | External market selling price | When external market exists | Fair; simulates competitive market |
| Cost-Based | Variable cost or full cost (+ markup) | When no external market | Simple; data readily available |
| Negotiated | Price agreed between divisions | When market price unclear | Flexible; both divisions have input |
| Dual Pricing | Different prices for buying/selling division | When single price causes conflict | Both divisions can show profit |
Example: CG Group's noodle division sells flour to its bakery division.
Variable cost of flour = NPR 40/kg. Full cost = NPR 55/kg. Market price = NPR 70/kg.
If transfer at market price (70): Noodle division earns profit; Bakery division pays market rate — fair but bakery may prefer external cheaper supplier.
If transfer at variable cost (40): Bakery gets cheap flour; but noodle division shows no profit on internal sales — demotivating.
If transfer at full cost + 10% markup (60.50): Both divisions share benefit. Noodle earns some profit; bakery gets below-market price.
10.9 Relevant Cost Analysis — Additional Scenarios
Sell or Process Further Decision
A Nepali dairy produces milk (joint product). At split-off, 10,000 liters can be:
Option A: Sell as raw milk at NPR 80/liter = NPR 8,00,000
Option B: Process into cheese. Additional cost: NPR 3,50,000. Yield: 2,000 kg cheese at NPR 400/kg = NPR 8,00,000
Analysis: Incremental revenue from processing = 8,00,000 - 8,00,000 = 0. Incremental cost = 3,50,000.
Net effect of processing = 0 - 3,50,000 = -3,50,000 (LOSS)
Decision: Sell as raw milk. Joint cost is irrelevant (sunk at split-off). Only incremental revenue vs incremental cost matters.
Replace Equipment Decision
Old machine: Book value NPR 5,00,000. Remaining life 5 years. Salvage now NPR 1,00,000. Annual operating cost NPR 3,00,000.
New machine: Cost NPR 8,00,000. Life 5 years. Salvage NPR 1,50,000. Annual operating cost NPR 1,50,000.
Relevant cost comparison (5-year total):
| Item | Keep Old | Buy New |
|---|---|---|
| Purchase cost | 0 | 8,00,000 |
| Operating costs (5 years) | 15,00,000 | 7,50,000 |
| Salvage of old now | 0 | (1,00,000) |
| Salvage at end | 0 | (1,50,000) |
| Total relevant cost | 15,00,000 | 13,00,000 |
Saving from replacement = 15,00,000 - 13,00,000 = NPR 2,00,000
Decision: REPLACE. Note: Book value of old machine (5,00,000) is SUNK COST — irrelevant! Only future costs matter.
Practice Questions
Short Answer:
1. What are relevant costs? Give examples of relevant and irrelevant costs.
2. Explain the make-or-buy decision framework.
3. When should a special order be accepted?
4. What is a limiting factor? How does it affect product mix?
5. Compare payback period and NPV methods.
Long Answer:
6. A company makes Part X: DM=NPR 30, DL=NPR 20, VOH=NPR 10, FOH(allocated)=NPR 25. Supplier offers at NPR 70. Capacity can be used to earn NPR 50,000. Annual need=5,000 units. Should they make or buy? (15 marks)
7. Three products use limited labor hours (8,000 available). Product P: CM=120, labor=4hrs, demand=1,000. Q: CM=80, labor=2hrs, demand=2,000. R: CM=150, labor=6hrs, demand=800. Determine optimal mix and maximum contribution. (15 marks)
8. A department shows: Sales NPR 5,00,000, VC NPR 3,50,000, Avoidable FC NPR 1,00,000, Allocated FC NPR 80,000. Should the department continue or shutdown? (15 marks)
9. Machine costs NPR 20,00,000. Expected cash flows: Year 1=NPR 6,00,000, Year 2=NPR 7,00,000, Year 3=NPR 8,00,000, Year 4=NPR 5,00,000. Calculate payback and NPV at 10%. (15 marks)
10. Discuss the role of management accounting in business decision-making with examples of at least four types of decisions. (15 marks)
Exam Tips: ✓ Relevant cost analysis is key — always identify relevant vs irrelevant ✓ Sunk costs are NEVER relevant ✓ Special order: accept if price > variable cost AND spare capacity exists ✓ Limiting factor: rank by CM per unit of scarce resource ✓ Show full calculations with clear decision recommendation