Decision Making and Analysis
Domain 7 applies marginal costing and relevant costing to short-term decisions: break-even, contribution, margin of safety, special orders, make-or-buy, shutdown and limiting factors. The central rule is that fixed costs are irrelevant to a decision unless the decision changes them.
CVP relationships
Contribution = sales − variable cost. Profit = contribution − fixed cost. BEP (units) = fixed cost ÷ contribution per unit. BEP (sales) = fixed cost ÷ P/V ratio. Margin of safety = actual sales − break-even sales.
Relevant costing
Use future cash flows that differ between alternatives. Exclude sunk costs and allocated common fixed costs. Include opportunity cost when scarce capacity has an alternative use.
Worked example: selling price Rs. 20; variable cost Rs. 12; contribution Rs. 8; fixed cost Rs. 60,000. BEP = 60,000 ÷ 8 = 7,500 units. At 10,000 units, profit = 80,000 − 60,000 = Rs. 20,000; margin of safety = 2,500 units or 25%. P/V ratio = 8/20 = 40%; BEP sales = 60,000 ÷ 0.40 = Rs. 150,000. A special order at Rs. 14 with idle capacity adds Rs. 2 per unit contribution and should be accepted if no better use of capacity exists and fixed costs do not rise.
Traps: treating fixed cost per unit as constant; using absorption profit for a short-term decision; ignoring opportunity cost when capacity is full; including sunk costs; allocating common fixed costs to a segment before deciding; assuming the BEP in units is unchanged when the sales mix changes.