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Decision-Making and Object of the Theory of Constraints

1) What makes a cost relevant for decision-making? Why are fixed costs not relevant for most short-term decisions?

2) The objective of the theory of constraints is to maximize throughput contribution while minimizing investments and operating costs. The theory of constraints assumes a short-run time horizon. How is this accomplished?

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1) What makes a cost relevant for decision-making? Why are fixed costs not relevant for most short-term decisions?
Costs which are relevant for decision making are called relevant costs. Relevant costs are relevant for one decision and irrelevant for other decisions. Relevant costs are considered in make or buy decisions, accepting special order, sell or keep business unit etc. relevant costs are future costs that differ among alternatives.

What makes the costs relevant for the decision making?
If the costs differ between alternatives, then the costs are relevant for the decision making. For example, the company manufactures products A, B and C .

Costs for the manufacture of product A is as follows:

Direct materials $ 4 per unit
Direct labor $ 3 per unit
Variable overhead per unit $ 2 per unit
Fixed costs per unit $ 3 per unit.

If product A is available in the market at $ 10 per unit, then the company needs to decide about the manufacturing the product in the company or to purchase from the outside supplier. Here, costs to be considered for decision making is direct material, direct labor and variable cost per unit i.e., ($4 + $ 3+ $2) =$9. Here, relevant costs of making the product are $9 and the market price is $10. Therefore, the decision is better to make the product as relevant cost is lesser than purchase price. Here, direct material costs will be ...

Solution Summary

This solution discusses what makes a cost relevant for decision-making, and the object of theory of constraints.

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