Decision-Making Techniques
Relevant costing
Only future, incremental cash flows are relevant. Sunk costs, committed costs and non-cash items such as depreciation are excluded. Opportunity costs (lost contribution) are included even though no cash changes hands. Traps: treating a general fixed overhead apportionment as incremental, or forgetting that labour already paid and idle has a nil relevant cost unless it can be redeployed.
Limiting factors and linear programming
When one resource is scarce, rank products by contribution per unit of scarce resource, not contribution per unit. With two or more constraints, formulate a linear programme: objective function (maximise contribution), constraints and a feasible region; the optimum lies at a vertex. Read the question carefully to see whether a resource is truly scarce or has spare capacity.
Make-or-buy, shut-down and special orders
Compare relevant cost of making with relevant cost of buying, including lost contribution from released facilities. For a special order, accept only if incremental revenue exceeds incremental cost and spare capacity exists. Traps include allocating existing fixed costs to the order, which makes profitable orders appear loss-making.
Pricing and risk
Know marginal-cost-plus, full-cost-plus and market-skimming/penetration pricing. For uncertainty, use expected values (probability-weighted outcomes) but remember expected value ignores risk attitude and extreme outcomes. A decision tree rolls back expected values from right to left.
Rule of thumb
If contribution per scarce unit is equal across products, the firm is indifferent; if not, prioritise the highest, then re-test capacity.