P2 Decision Making

Question 1

A business has limited resources and is currently analysing its operations in order to assess whether it
may stop producing some products. Describe how management would determine which products may
be discontinued, clearly indicating the type of costs that would be irrelevant for such a decision.

Answer 1

In order to determine which products should be continued management would need to find the
contribution generated by each product. Products having a positive contribution should be continued.
Fixed costs are period costs and thus are irrelevant for such analysis.
The irrelevant costs are: do not affect the decision.
- Sunk costs: money that has already been spent (irrelevant costs)
- Committed costs: future costs that will be spend irrespective of the decision
- Non-cash expenses: any expenses, such as depreciation, that does not affect the cash flow of
the business is not relevant.
- Common costs: A future cost that is the same for al alternatives will not have an effect on
the decision and should not be considered
- Fixed costs: costs that need to be paid no matter what.

Question 2

Discuss the implications that management of the company must keep in mind when deciding whether
to make or buy a product.

Answer 2

Organisations need to weigh the short-term financial impact of outsourcing against long-term
consequences.
Factors to consider:
- Quality - will the external sourcing maintain the same quality?
- Reliability - is the supplier equipped to meet all customer demands when required?
- Control - how important is a specific process / product to the core business?
- Capacity - will the business have idle resources? Will it need to make workers redundant?
- what will be the cost of the redundancy How will its reputation be effected?

Question 3

When should a firm consider subcontracting part of the production process?

Answer 3

First and foremost, the cost of subcontracting should be lower than the cost of producing it in-house.
Factors that need to be taken into consideration:
- The supplier fully maintains to deliver the product on time
- The quality remains the same
- There is still a contribution to cover fixed costs
- There is enough cashflow to pay the supplier
- Redundancies may arise which will result in giving the firm a bad reputation
One should only consider subcontracting if it results in cost savings but taking the above into
consideration as well.

Question 4

Explain the term ‘limiting factor’ and the importance of identifying such a factor in the decision-
making process.

Answer 4

A limiting factor is a scarce resource that limits the company’s productive capacity. In this situation the
company’s ability to meet demand is limited by the availability of that limiting factor.
The limiting factor will affect the ability of the firm to produce the output. The decision of management
to proceed with the production of those products with the highest contribution may have to be
reconsidered in the light of this limiting factor. In such circumstances, it is necessary to calculate the
contribution per unit of the limiting factor.
The company will then come up with a production plan that makes best use of the limiting factor while
maximising profit. It will concentrate on producing that product or mix of products that gives the highest
contribution per unit of limiting factor.

Question 5

What factors need to be considered before a firm decided to open or branch out into a new business
sector?

Answer 5

• Availability of labour and resources
• Demand for the product/services
• Type of market that is being considered
• Whether the firm has the expertise to operate the new business venture
• Competition in the area