Post on 27-Dec-2015
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CHAPTER 7CHAPTER 7
Use of Cost Information in Management Decision
Making
Use of Cost Information in Management Decision
Making
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Incremental AnalysisIncremental Analysis
Incremental analysis All decisions involve a choice
among alternative courses of action The solution to business problems
involves incremental analysis Incremental analysis is the analysis
of the incremental revenue and incremental costs incurred when one alternative is chosen over another
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Incremental AnalysisIncremental Analysis
Incremental Revenue Additional revenue received by
selecting one alternative over another
Incremental Cost Additional cost incurred by
selecting one alternative over another
Incremental Profit Difference between incremental
revenue and incremental costLearning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Incremental AnalysisIncremental Analysis
An alternative that yields an incremental profit should be selected
Incremental costs are referred to as relevant costs
Also called differential costs because they are the costs that differ between decision alternatives
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Incremental Analysis Example
Incremental Analysis Example
Jensen’s Rapid Copy is considering extending its hours Alternative 1 is the status quo Alternative 2 involved the company
extending their hours from 8 pm to midnight The next slide shows the
incremental costs and revenues associated with choosing one alternative over another
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Incremental Analysis Example
Incremental Analysis Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Incremental AnalysisIncremental Analysis
Incremental Analysis can be extended to more than two alternatives Calculate profit for each
alternative The alternative with the highest
profit is the best alternative Difference between its profit and
the profit of any other alternative is its incremental profit
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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“What Does This Product Cost?”
“What Does This Product Cost?”
Answer: Why do you want to know? No single cost number is relevant
for all decisions Must find incremental information
that is applicable to the decision Some costs will change due to the decision, some will not
Only costs that change are relevant
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Which of the following is likely to be an incremental cost associated with increasing planned production run of 1,000 units to 1,010 units?
a. Set-up costsb. Depreciation of equipmentc. Inspection costsd. Material costs
Answer: dMaterial costs are variable costs and usually incremental
Slide 7-10 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Analysis of Decisions Faced by Managers
Analysis of Decisions Faced by Managers
Three decisions that managers frequently face:
1. The decision to engage in additional processing of a product
2. The decision to make or buy a product
3. The decision to drop a product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Additional Processing DecisionAdditional Processing Decision
Manufacturers must occasionally decide whether to: Sell a product in a partially
completed stage, or Incur additional processing costs
required to complete the product Costs incurred to date of decision
on partially complete product are not relevant, i.e sunk costs.
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Additional Processing Decision – Bridge Computer Example
Additional Processing Decision – Bridge Computer Example
Summary of cost information
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Additional Processing Decision – Bridge Computer Example
Additional Processing Decision – Bridge Computer Example
Incremental analysis summary Incremental revenues are $500 Incremental costs are $400 Would you spend $400 to generate
an additional $500?
Answer: Yes, incremental profit is $100
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Additional Processing Decision – Bridge Computer Example
Additional Processing Decision – Bridge Computer Example
Incremental analysis summary
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Sell Partially Complete
Sell Fully Complete Incremental
Revenue $500 $1,000 $500 aPrior Production Costs (800) (800) 0Additional Processing Costs 0 (400) (400) bGain (loss) per unit ($300) ($200) $100 c
a. Incremental revenue associated with alternative 2b. Incremental cost associated with alternative 2c. Incremental profit associated with alternative 2
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Additional Processing DecisionAdditional Processing Decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Make or Buy DecisionsMake or Buy Decisions
Most manufactured goods are made up of numerous components In some cases, a company may
purchase one or more of these components from another company or manufacture them themselves
The analysis of this decision concentrates solely on incremental costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Additional information: If purchased, cost savings include $390,000 in
supervisory salaries and all variable costs. Market value of production machinery is zero
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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A key issue is to determine which of the above costs are incremental None of the $15 million of variable
manufacturing costs will be incurred if the part is purchased
The fixed costs associated with depreciation will not be saved Note that not all fixed costs are irrelevant sunk costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
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Some fixed costs are avoidable costs Avoidable costs can be avoided if a
particular action is undertaken If the parts are purchased from an
outside vendor, the salaries of 5 supervisors will be saved The savings total $390,000 of
avoidable fixed costs It will cost the company an
additional $110,000 to purchase the part Learning objective 1: Explain the role of incremental analysis (analysis of
incremental costs and revenues) in management decisions
Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration ExampleIncremental cost analysis – 3 column
format
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration Example
Incremental cost analysis - single column format
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Which of the following is not likely to be an incremental cost for a make-or-buy decision?
a. Materials costb. Direct labor costc. Variable manufacturing costd. Depreciation of building
Answer: dDepreciation of building is not likely to change no matter which alternative is chosen in a make-or-buy decision
Slide 7-23 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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An opportunity cost is the value of benefits foregone by selecting one decision alternative over another For example, if you spend $1,000
instead of investing in a certificate of deposit, the interest that could have been earned is an opportunity cost
Since opportunity costs differ depending on the option selected, they are incremental costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Opportunity CostsOpportunity Costs
Which of the following is true?
a. Opportunity costs are never incremental costs
b. Opportunity costs are always incremental costs
Answer: bOpportunity costs are always incremental costs because they differ depending upon the outcome selected
Slide 7-25 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Suppose the Tennessee plant is currently spending $500,000 per year to rent space for manufacturing shelving used in the refrigeration units
If production of compressors is discontinued, the company will not need to rent the space In the incremental analysis on the
next slide, the rent savings is shown along with the other cost savings
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Opportunity Costs – General Refrigeration Example
Opportunity Costs – General Refrigeration Example
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Make-or-Buy Decisions – General Refrigeration Example
Make-or-Buy Decisions – General Refrigeration ExampleIncremental analysis with opportunity
costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Dropping a Product LineDropping a Product Line
Analysis involves calculating the change in income that will result from dropping the product line If income increases, the product
line should be dropped If income decreases, the product
line should not be dropped This amounts to comparing the incremental revenues and costs that result from dropping the product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Dropping a Product Line – Mercer Hardware
Dropping a Product Line – Mercer Hardware
Mercer Hardware sells 3 product lines, tools, hardware and garden Direct fixed costs are directly
traceable to each product line Allocated fixed costs are not directly
traceable to a product line Allocated fixed costs are generally not avoidable, thus no common fixed costs will be saved if the product line is dropped
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Dropping a Product Line – Mercer Hardware ExampleDropping a Product Line – Mercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Profit calculation with three product lines
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Dropping a Product Line – Mercer Hardware ExampleDropping a Product Line – Mercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
ToolsHardwareSupplies
Total2 products
Total3 products
Sales $120,000 $200,000 $320,000 $400,000Traceable costs:
Cost of goods sold (81,000) (90,000) (171,000) (231,000)Other variable costs (2,000) (4,000) (6,000) (7,000)Direct fixed costs (8,000) (5,000) (13,000) (16,500)
Non-traceable costsCompany fixed costs (30,000) (50,000) (80,000) (80,000)
Division net income ($1,000) $51,000 $50,000 $65,500
Total company fixed costs are $80,000 whether 2 or 3 products are sold
Mercer HardwareProduct Line Income Statement
For the Year Ended December 31, 2006
Profit calculation with two product lines
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Dropping a Product Line – Mercer Hardware ExampleDropping a Product Line – Mercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
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Beware of the Cost Allocation Death Spiral
Beware of the Cost Allocation Death Spiral
When dropping a product line Common fixed costs are not
incremental Common fixed cost allocation is
spread among remaining product lines
Management must understand and remember this impact when making decisions
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
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Terminology SummaryTerminology Summary
Avoidable costs Costs that can be avoided by taking
a particular course of action Always incremental costs, and
therefore relevant to a decision Sunk costs
Already occurred and not reversible Are not incremental because they
do not differ among alternatives Not relevant in decision making
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
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Terminology SummaryTerminology Summary
Many students assume that fixed costs are equivalent to sunk costs This is not always the case Fixed costs can be sunk, not sunk
and irrelevant, or possibly relevant Opportunity costs
Represent the benefit foregone by selecting a particular alternative
They are always incremental and relevant to a decision
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Which of the following costs should not be taken into consideration when making a decision?
a. Opportunity costsb. Sunk costsc. Relevant costsd. Differential costs
Answer: bSunk costs
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
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Classify each of the following as sunk and irrelevant, not sunk but still irrelevant, or not sunk and relevant
Depreciation on equipment already purchasedSunk and irrelevant (not incremental)
President’s salary, which will not change for both action A and action B
Not sunk and irrelevant (not incremental)Salary of supervisory who will be retained for action A and fired for action B
Not sunk and relevant (incremental)
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
Learning objective 3: Analyze decisions involving joint costs
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Decisions Involving Joint CostsDecisions Involving Joint Costs
Joint Products When two or more products always
result from common inputs Joint Costs
Costs of the common inputs Split-Off Point
Stage of production in which individual products are identified
Product may undergo further processing and may incur additional costs
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Allocation of Joint CostsAllocation of Joint Costs
For financial reporting, the cost of common inputs must be allocated to the joint products The total joint cost will be incurred
no matter what the company does with the joint products beyond the split-off point
The joint cost is not incremental to production of an individual joint product and irrelevant to decisions regarding an individual joint product
Learning objective 3: Analyze decisions involving joint costs
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Joint Products ExampleJoint Products Example
Learning objective 3: Analyze decisions involving joint costs
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Joint Cost Allocation Methods
Joint Cost Allocation Methods
Physical quantity of output
Joint costs allocated to product A =
Joint costs allocated to product B =
Learning objective 3: Analyze decisions involving joint costs
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Joint Cost Allocation Methods
Joint Cost Allocation Methods
Relative sales value
Joint costs allocated to product A =
Joint costs allocated to product B =
Learning objective 3: Analyze decisions involving joint costs
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Joint Cost Allocation Example
Joint Cost Allocation Example
Joint costs of $620 allocated using physical quantity of output
Process results in 500 feet of grade A lumber that sells for
$1 per foot, and 500 feet of grade B lumber that sells for
$0.50 per foot
Joint costs allocated to product A =
Learning objective 3: Analyze decisions involving joint costs
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Joint Cost Allocation Example
Joint Cost Allocation Example
Joint costs of $620 allocated using physical quantity of output
Process results in 500 feet of grade A lumber that sells for
$1 per foot, and 500 feet of grade B lumber that sells for
$0.50 per foot
Joint costs allocated to product B =
Learning objective 3: Analyze decisions involving joint costs
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Joint Cost Allocation Example
Joint Cost Allocation Example
Joint costs of $620 allocated using sales value
Process results in 500 feet of grade A lumber that sells for
$1 per foot, sales value 500 * 1 = $500, and
500 feet of grade B lumber that sells for $0.50 per foot, sales value 500 * 0.50 = $250
Joint costs allocated to product A =
Learning objective 3: Analyze decisions involving joint costs
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Joint Cost Allocation Example
Joint Cost Allocation Example
Joint costs of $620 allocated using sales value
Process results in 500 feet of grade A lumber that sells for
$1 per foot, sales value 500 * 1 = $500, and
500 feet of grade B lumber that sells for $0.50 per foot, sales value 500 * 0.50 = $250
Joint costs allocated to product B =
Learning objective 3: Analyze decisions involving joint costs
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Additional Processing Decisions and Joint Costs
Additional Processing Decisions and Joint Costs
Joint costs not relevant to decisions made after the split-off point because they are not incremental
Joint costs incurred prior to the split-off point are sunk costs and must be incurred no matter what happens after the split-off point
Learning objective 3: Analyze decisions involving joint costs
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The joint costs incurred in a joint product situation:
a. Are incurred before the split-off point
b. Are incurred after the split-off point
c. Should only be allocated based on physical attributes
d. Should never be allocated
Answer: aAre incurred before the split-off point
Learning objective 3: Analyze decisions involving joint costs
Learning objective 4: Discuss the importance of qualitative considerations to management decisions
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Qualitative Considerations in Decision Analysis
Qualitative Considerations in Decision Analysis
Many decisions have one or more features that are difficult to quantify but should be given careful consideration
Examples include, but are not limited to Swings in the economy Loss of control Quality of the product Quality of service Company morale
Learning objective 4: Discuss the importance of qualitative considerations to management decisions
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Qualitative Considerations in Decision Analysis
Qualitative Considerations in Decision Analysis
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Qualitative FactorsQualitative Factors
Learning objective 4: Discuss the importance of qualitative considerations to management decisions
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
The Theory of Constraints is an approach to production and constraint management developed by Eli Goldratt Five step process Large increases in profit can be
achieved by elimination of bottlenecks in production processes
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
1. Identify the Binding ConstraintThe binding constraint is the process that limits throughput
2. Optimize Use of the ConstraintProduce products with the highest contribution margin per unit of the constraint
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
3. Subordinate Everything Else to the ConstraintManagers should focus their attention on trying to loosed the constraint and not on process improvements
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
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Appendix – The Theory of Constraints
Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
4. Break the ConstraintThis can be done many ways including cross training workers, outsourcing, purchasing additional equipment or hiring new workers
5. Identify a New Binding ConstraintIdentify the additional bottlenecks. If there are no bottlenecks and excess capacity, focus on building demand
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