Product decisions

Q: What are the three essential criteria for a cost to be considered "relevant" in short-term decision making?

To be relevant, a cost must be a future cost, an incremental cost, and a cash flow .

P1 – Management Accounting · CIMA (CGMA Professional Qualification) · 5 min read

Welcome to Product Decisions!

Hello there! Welcome to one of the most practical chapters in your P1 journey. In this section, we are diving into Short-term commercial decision making. Essentially, we are learning how to answer the big "What should we do right now?" questions. Should we make a component ourselves or buy it from someone else? Should we stop selling a product that looks like it’s losing money? How do we decide which product to focus on when we don't have enough materials?

Don't worry if management accounting sometimes feels like a lot of numbers. At its heart, this chapter is just about being a smart "business detective." We want to find the path that puts the most cash back into the business in the short term. Let’s get started!

1. The Golden Rule: Relevant Costing

Before we make any product decision, we need to know which costs actually matter. In CIMA P1, we call these Relevant Costs. If a cost doesn't change based on your decision, it's just "noise" and should be ignored.

For a cost to be relevant, it must meet three criteria:

• Future: It hasn't happened yet. (Ignore "Sunk Costs" like money already spent on research).
• Incremental: It is an extra cost that appears only if you choose a specific path.
• Cash Flow: It must be an actual movement of money. (Ignore non-cash items like Depreciation).

The Analogy: Imagine you bought a non-refundable cinema ticket for $10 (Sunk Cost). You then realize the movie is terrible. If you stay, you gain nothing. If you leave to get a $5 pizza, the $10 ticket doesn't matter anymore—it's gone either way! The only relevant cost for your decision now is the $5 for the pizza.

Key Terms to Remember:

Sunk Cost: Money already spent. Ignore it!
Opportunity Cost: The benefit you give up by choosing one option over another. This is ALWAYS relevant.
Avoidable Cost: A cost that disappears if you stop an activity.

Quick Review: Only look at future cash flows that change because of your decision.

2. Make or Buy Decisions (Outsourcing)

Sometimes a business has to decide: "Should we make this part ourselves, or just buy it from an outside supplier?"

The Rule: Compare the Variable Cost of Making the item against the Purchase Price from the supplier. We usually ignore Fixed Costs unless they are "specifically avoidable" (meaning we only pay them if we make the item).

Step-by-Step Process:

1. Calculate the Relevant Cost of Making: Variable Materials + Variable Labor + Variable Overheads + any Specific Fixed Costs.
2. Identify the Purchase Price from the external supplier.
3. Compare the two. If the Purchase Price is lower than your Relevant Making Cost, buying is cheaper!

Common Mistake to Avoid: Don't include "Allocated General Overheads" in your "Make" cost. Things like Head Office rent will be paid whether you make the part or not, so they aren't relevant!

Did you know? Outsourcing isn't just about money. Managers also think about Qualitative Factors, like whether the supplier is reliable or if the quality will be as good as their own.

Key Takeaway: Focus on the extra cost of making vs. the cost of buying.

3. Discontinuing a Product or Department

If a product shows a "Net Loss" in the financial statements, your first instinct might be to kill it off. But wait! In Management Accounting, we look at Contribution.

The Formula:
$ Contribution = Sales - Variable Costs $

As long as a product has a positive contribution (it earns more than its variable costs), it is helping to pay for the company’s fixed costs (like the factory rent). If you scrap the product, that contribution disappears, but the factory rent stays! This would actually make the total company profit lower.

When to actually stop a product:

You should only discontinue if the Contribution Lost is less than the Fixed Costs Saved.

Example: A cafe sells sandwiches. The sandwiches "lose" $100 a month after rent is split. However, the sandwiches bring in $500 in sales and only cost $300 in ingredients (a $200 contribution). If the cafe stops selling sandwiches, they lose that $200 contribution but still have to pay the full rent. The cafe would be $200 worse off!

Quick Review: If Contribution is positive, the product is usually worth keeping in the short term.

4. Limiting Factors (The "Bottle-Neck")

In a perfect world, we would sell as much of everything as we want. In the real world, we run out of things—like machine hours, skilled labor, or raw materials. These are called Limiting Factors.

When you have a limiting factor, you want to get the "biggest bang for your buck" for every unit of that resource you use.

How to decide the Product Mix (The "Ranking" Method):

1. Calculate the Contribution per unit for each product.
2. Identify how much of the Limiting Factor each unit uses (e.g., 2kg of material).
3. Calculate Contribution per unit of Limiting Factor using this formula:
$ \frac{Contribution Per Unit}{Limiting Factor Required Per Unit} $
4. Rank the products. The one with the highest contribution per limiting factor is your #1 priority!
5. Allocate your limited resource to Product #1 first (to meet demand), then Product #2, and so on.

Memory Aid: Think of a limiting factor like "Minutes on a shared Video Game console." If you only have 60 minutes, you’ll play the games that give you the most "fun per minute" first!

Key Takeaway: Don't rank by the highest profit or highest contribution per unit. Rank by Contribution per Limiting Factor.

5. Summary and Final Tips

Short-term decision making is all about comparing the changes in cash. Here is a quick checklist for your exam:

• Is it a future cash flow? If yes, it's probably relevant.
• Is it a sunk cost? If yes, ignore it (even if the numbers look big).
• Do we have a bottleneck? Use "Contribution per Limiting Factor" to rank products.
• Does it have a positive contribution? If yes, it’s usually better to keep it for now.

Don't worry if this seems tricky at first! The more you practice the Ranking Method for limiting factors, the more it will feel like second nature. You are learning to think like a manager, and that is a great skill to have!

Final Quick Review Box:
1. Make or Buy: Compare Variable Cost + Specific Fixed Costs vs. Purchase Price.
2. Discontinue: Only if Savings > Lost Contribution.
3. Limiting Factors: Rank by Contribution per Unit of Resource.

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What are the three essential criteria for a cost to be considered "relevant" in short-term decision making?

To be relevant, a cost must be a future cost, an incremental cost, and a cash flow.

What is a "Sunk Cost" and why is it ignored in management decisions?

A sunk cost is money that has already been spent and cannot be recovered; it is ignored because it cannot be changed by any future decision.

How is "Opportunity Cost" defined and used in product decisions?

Opportunity cost is the benefit sacrificed by choosing one course of action over the next best alternative; it is always a relevant cost.

In a "Make or Buy" decision, what is the basic rule for choosing to outsource?

Buy from a supplier if the external **purchase price** is lower than the internal **relevant cost of making**.

Why should "Allocated General Overheads" be excluded from product decisions?

They are not relevant because they are usually fixed costs that the business will incur regardless of the specific decision being made.

Why is "Contribution" more important than "Net Profit" when deciding whether to keep a product line?

A product with a positive contribution helps cover the company's fixed costs, even if it shows a net loss after overhead allocations.

What is the specific criteria for deciding to discontinue a product or department?

A product should only be discontinued if the **Fixed Costs Saved** (avoidable costs) are greater than the **Contribution Lost**.

What is a "Limiting Factor" and how does it affect production planning?

A limiting factor is a resource in short supply (like machine hours or materials) that prevents a company from meeting total demand.

How do you rank products when faced with a single limiting factor?

Rank products based on their **Contribution per unit of Limiting Factor**.

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