Overview of business decisions
A business decision is a choice between two or more actions to reach a goal. In management accounting we compare the money effect of each option.
- Operational decisions: short-term, within the current set-up, small money, easy to change (pricing a one-off order, make or buy, which product to push).
- Structural decisions: long-term, change the shape of the business, large money, hard to undo (new factory, new machine, new product line, closing a branch).
Key rule: use relevant costs only. A cost is relevant when it is a future cash cost that differs between the options. A sunk cost (already spent) is never relevant.
Operational decision making
Common operational decisions:
- Make or buy: compare the extra cost of making (materials, labour, variable overhead) with the price of buying. Costs that stay the same, such as rent, are ignored.
- Special order: if there is spare capacity, accept when extra income is more than extra cost. Check it does not spoil normal prices.
- Limiting factor: when something is short (machine hours), make the product with the highest contribution per unit of that scarce resource first.
- Break-even between options: when making has a fixed cost, find the number of units where both options cost the same.
Contribution = selling price - variable cost per unit.
Structural decision making
Structural decisions spend money now to earn money over many years, so time and risk matter.
- Payback period = investment / yearly cash inflow (when inflows are equal). Shorter is safer, but it ignores money after payback.
- Present value: money later is worth less than money now. Divide a future amount by (1 + rate)^years. If the total present value of inflows is more than the investment, net present value (NPV) is positive and the project is worth doing.
- Also think about risk, people, customers and what happens if the plan fails.
Try it: decide with three numbers
You can bake 20 cupcakes for a fair (flour, sugar, gas: Rs 6 each) or buy them ready at Rs 8 each. Your oven was already yours, so its cost is sunk. Which is cheaper and by how much? Then use the 3D slider: at how many units does a fixed Rs 400 machine start to pay?
Key formulas and definitions
- Relevant cost = future cost that differs between options
- Contribution per unit = selling price - variable cost
- Payback period = investment / yearly inflow
- Break-even units (make vs buy) = fixed cost / (buy price - make variable cost)
- Present value = future amount / (1 + r)^n
- NPV = PV of inflows - investment
Worked examples
1. Making 100 parts costs Rs 700 in materials and labour. Rent of Rs 300 is paid either way. Buying costs Rs 800. Make or buy?
Rent is the same, so ignore it. Make = 700, buy = 800. Making is cheaper by Rs 100.
2. Spare capacity exists. A buyer asks for 50 units at Rs 9. Variable cost is Rs 7 per unit. Accept?
Extra income = 450, extra cost = 350, gain = Rs 100. Accept.
3. A machine costs Rs 600 and brings Rs 200 every year. Find the payback period.
600 / 200 = 3 years.
4. Making needs a Rs 400 fixed cost plus Rs 4 per unit. Buying costs Rs 8 per unit. Find the break-even units.
400 / (8 - 4) = 100 units. Below 100 buy, above 100 make.
5. Machine hours are limited. A gives Rs 12 contribution using 2 hours; B gives Rs 15 using 3 hours. Which first?
A: 12/2 = Rs 6 per hour. B: 15/3 = Rs 5 per hour. Make A first.
6. Invest Rs 1,000 now and receive Rs 1,100 after one year. The rate is 5%. Is it worth it?
PV = 1,100 / 1.05 = Rs 1,047.62. NPV = 47.62, which is positive. Worth doing.
Common mistakes
- Counting a sunk cost (money already spent) as part of the decision.
- Including a cost that is the same in both options, like the rent in make or buy.
- Choosing the product with the biggest contribution per unit, not per scarce hour.
- Treating payback as proof of profit. It ignores cash after payback and the time value of money.