Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision...

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

Decision Making: Relevant Costs and

Benefits

Decision Making: Relevant Costs and

Benefits

Chapter 14


McGraw-Hill/Irwin

Learning Objective

1

Learning Objective

1

14-3

The Managerial Accountant’s The Managerial Accountant’s Role in Decision MakingRole in Decision Making

Designs and implementsaccounting information

system

Designs and implementsaccounting information

system

Cross-functional Cross-functional management teams management teams

who makewho makeproduction, marketing,production, marketing,and finance decisionsand finance decisions

Cross-functional Cross-functional management teams management teams

who makewho makeproduction, marketing,production, marketing,and finance decisionsand finance decisions

Make substantiveeconomic decisionsaffecting operations

Make substantiveeconomic decisionsaffecting operations

ManagerialManagerialAccountantAccountantManagerialManagerialAccountantAccountant

14-4

The Decision-Making ProcessThe Decision-Making Process1. Clarify the Decision Problem1. Clarify the Decision Problem1. Clarify the Decision Problem1. Clarify the Decision Problem

2. Specify the Criterion2. Specify the Criterion2. Specify the Criterion2. Specify the Criterion

3. Identify the Alternatives3. Identify the Alternatives3. Identify the Alternatives3. Identify the Alternatives

4. Develop a Decision Model4. Develop a Decision Model4. Develop a Decision Model4. Develop a Decision Model

5. Collect the Data5. Collect the Data5. Collect the Data5. Collect the Data

6. Make a Decision6. Make a Decision6. Make a Decision6. Make a Decision

QuantitativeQuantitativeAnalysisAnalysis


McGraw-Hill/Irwin

Learning Objective

2

Learning Objective

2

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The Decision-Making ProcessThe Decision-Making Process1. Clarify the Decision Problem1. Clarify the Decision Problem

2. Specify the Criterion2. Specify the Criterion

3. Identify the Alternatives3. Identify the Alternatives

4. Develop a Decision Model4. Develop a Decision Model

5. Collect the Data5. Collect the Data

6. Make a Decision6. Make a Decision

Primarily thePrimarily theresponsibility of theresponsibility of the

managerialmanagerialaccountant.accountant.

Primarily thePrimarily theresponsibility of theresponsibility of the

managerialmanagerialaccountant.accountant.

Information should be:Information should be:1. Relevant1. Relevant2. Accurate2. Accurate3. Timely3. Timely

Information should be:Information should be:1. Relevant1. Relevant2. Accurate2. Accurate3. Timely3. Timely

14-7







QualitativeConsiderations

QualitativeConsiderations

14-8







RelevantRelevantPertinent to a

decision problem.

RelevantRelevantPertinent to a

decision problem.

AccurateAccurateInformation must

be precise.

AccurateAccurateInformation must

be precise.

TimelyTimelyAvailable in time

for a decision

TimelyTimelyAvailable in time

for a decision


McGraw-Hill/Irwin

Learning Objective

3

Learning Objective

3

14-10

Relevant InformationRelevant Information

Information is relevant to a decision problem when . . .

1. It has a bearing on the future,

2. It differs among competing alternatives.

Information is relevant to a decision problem when . . .

1. It has a bearing on the future,

2. It differs among competing alternatives.


McGraw-Hill/Irwin

Learning Objective

4

Learning Objective

4

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Identifying RelevantIdentifying RelevantCosts and BenefitsCosts and Benefits

Sunk costsCosts that have already been incurred. They do not affect any future cost and

cannot be changed by any current or future action.

Sunk costsCosts that have already been incurred. They do not affect any future cost and

cannot be changed by any current or future action.

Sunk costs are irrelevant to decisions.Sunk costs are irrelevant to decisions.

14-13

Relevant CostsRelevant CostsWorldwide Airways is thinking about replacing a three

year old loader with a new, more efficient loader.

New loader List price 15,000$ Annual operating expenses 45,000 Expected life in years 1 Old loader Original cost 100,000$ Remaining book value 25,000 Disposal value now 5,000 Annual variable expenses 80,000 Remaining life in years 1

New loader List price 15,000$ Annual operating expenses 45,000 Expected life in years 1 Old loader Original cost 100,000$ Remaining book value 25,000 Disposal value now 5,000 Annual variable expenses 80,000 Remaining life in years 1

14-14

Relevant CostsRelevant CostsIf we keep the old loader, we will have depreciationIf we keep the old loader, we will have depreciation

costs of $25,000. If we replace the old loader,costs of $25,000. If we replace the old loader,we will write-off the $25,000 when sold. There iswe will write-off the $25,000 when sold. There is

no difference in the cost, so it is no difference in the cost, so it is not relevantnot relevant..

If we keep the old loader, we will have depreciationIf we keep the old loader, we will have depreciationcosts of $25,000. If we replace the old loader,costs of $25,000. If we replace the old loader,

we will write-off the $25,000 when sold. There iswe will write-off the $25,000 when sold. There isno difference in the cost, so it is no difference in the cost, so it is not relevantnot relevant..

The new loader will be depreciated in one year.The new loader will be depreciated in one year.

The $5,000 proceeds will only be realized if weThe $5,000 proceeds will only be realized if wereplace the old loader. This amount is replace the old loader. This amount is relevantrelevant..The $5,000 proceeds will only be realized if weThe $5,000 proceeds will only be realized if wereplace the old loader. This amount is replace the old loader. This amount is relevantrelevant..

We will only have depreciation on the new loaderWe will only have depreciation on the new loaderif we replace the old loader. This cost is if we replace the old loader. This cost is relevantrelevant..We will only have depreciation on the new loaderWe will only have depreciation on the new loaderif we replace the old loader. This cost is if we replace the old loader. This cost is relevantrelevant..

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Relevant CostsRelevant Costs

The difference in operating costs is The difference in operating costs is relevantrelevantto the immediate decision.to the immediate decision.

The difference in operating costs is The difference in operating costs is relevantrelevantto the immediate decision.to the immediate decision.

14-16

Relevant CostsRelevant Costs

Here is an analysis that includes only relevant costs:


McGraw-Hill/Irwin

Learning Objective

5

Learning Objective

5

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Analysis of Special DecisionsAnalysis of Special Decisions

Let’s take a close look at some special decisions faced by many businesses.

We just receivedWe just receiveda special order. Doa special order. Doyou think we shouldyou think we should

accept it?accept it?

14-19

Accept or Reject a Special OrderAccept or Reject a Special Order• A travel agency offers Worldwide Airways

$150,000 for a round-trip flight from Hawaii to Japan on a jumbo jet.

• Worldwide usually gets $250,000 in revenue from this flight.

• The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.

• The next screen shows cost data developed by managerial accountants at Worldwide.

• A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Hawaii to Japan on a jumbo jet.

• Worldwide usually gets $250,000 in revenue from this flight.

• The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.

• The next screen shows cost data developed by managerial accountants at Worldwide.

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Accept or Reject a Special OrderAccept or Reject a Special Order

Worldwide will save about $5,000 in reservationWorldwide will save about $5,000 in reservationand ticketing costs if the charter is accepted.and ticketing costs if the charter is accepted.

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Since the charter will contribute to fixed costs andSince the charter will contribute to fixed costs andWorldwide has idle capacity, the company shouldWorldwide has idle capacity, the company should

accept the flight.accept the flight.

Since the charter will contribute to fixed costs andSince the charter will contribute to fixed costs andWorldwide has idle capacity, the company shouldWorldwide has idle capacity, the company should

accept the flight.accept the flight.

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What if Worldwide had no excess capacity? If Worldwide adds the charter, it will have to cut

its least profitable route that currently contributes $80,000 to fixed costs and profits.

Should Worldwide still accept the charter?

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Worldwide has no excess capacity, so it Worldwide has no excess capacity, so it should reject the special charter.should reject the special charter.

14-24


With excess capacity . . .– Relevant costs will usually be the variable costs

associated with the special order.

Without excess capacity . . .– Same as above but opportunity cost of using

the firm’s facilities for the special order are also relevant.

14-25

Outsource a Product or ServiceOutsource a Product or Service

A decision concerning whether an item should be produced internally or purchased from an

outside supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the management of Worldwide Airways.

A decision concerning whether an item should be produced internally or purchased from an

outside supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the management of Worldwide Airways.

14-26

Outsource a Product or ServiceOutsource a Product or Service• An Atlanta bakery has offered to supply the

in-flight desserts for 21¢ each.• Here are Worldwide’s current cost for

desserts:

• An Atlanta bakery has offered to supply the in-flight desserts for 21¢ each.

• Here are Worldwide’s current cost for desserts:

14-27

Outsource a Product or ServiceOutsource a Product or ServiceNot all of the allocated fixed costs will be savedif Worldwide purchases from the outside bakery.Not all of the allocated fixed costs will be savedif Worldwide purchases from the outside bakery.

14-28

Outsource a Product or ServiceOutsource a Product or Service

If Worldwide purchases the dessert for 21¢, it will only save 15¢ so

Worldwide will have a loss of 6¢ per dessert purchased.

If Worldwide purchases the dessert for 21¢, it will only save 15¢ so

Worldwide will have a loss of 6¢ per dessert purchased.

Wow, that’sno deal!

14-29

Add or Drop a Service,Add or Drop a Service,Product, or DepartmentProduct, or Department

One of the most important decisions managers make is

whether to add or drop a product, service or

department.

Let’s look at how the concept of relevant costs should be

used in such a decision.

One of the most important decisions managers make is

whether to add or drop a product, service or

department.

Let’s look at how the concept of relevant costs should be

used in such a decision.

14-30

Add or Drop a ProductAdd or Drop a Product

Worldwide Airways offers its passengers the opportunity to join its

World Express Club. Club membership entitles a traveler to use

the club facilities at the airport in Atlanta.

Club privileges include a private lounge and restaurant, discounts on meals and beverages, and use of a small

health spa.

14-31


Sales $200,000Less: Variable Costs: Food/Beverage $70,000 Personnel 40,000 Variable overhead 25,000 (135,000)Contribution Margin 65,000Less: Fixed Costs: Depreciation $30,000 Supervisor salary 20,000 Insurance 10,000 Airport fees 5,000 Allocated overhead 10,000 ( 75,000)Loss $ ( 10,000)

14-32


KEEP CLUB ELIMINATE DIFFERENTIALSales $200,000 0 $200,000 Food/Beverage (70,000) 0 (70,000) Personnel (40,000) 0 (40,000) Variable overhead (25,000) 0 (25,000) Contribution Margin 65,000 0 65,000Depreciation (30,000) (30,000) 0 Supervisor salary (20,000) 0 (20,000) Insurance (10,000) (10,000) 0 Airport fees ( 5,000) 0 ( 5,000) Allocated overhead (10,000) (10,000) 0 Loss $ (10,000) $(50,000) $ 40,000

14-33


KEEP CLUB ELIMINATE DIFFERENTIALSales $200,000 0 $200,000 Food/Beverage (70,000) 0 (70,000) Personnel (40,000) 0 (40,000) Variable overhead (25,000) 0 (25,000) Contribution Margin 65,000 0 65,000Depreciation (30,000) (30,000) 0 Supervisor salary (20,000) 0 (20,000) Insurance (10,000) (10,000) 0 Airport fees ( 5,000) 0 ( 5,000) Allocated overhead (10,000) (10,000) 0 Loss (10,000) (50,000) 40,000

NOTAVOIDABLE

AVOIDABLE

The positive $40,000 differential amount reflects the fact that the company is $40,000 better off by keeping the club.

14-34


KEEP CLUB ELIMINATE DIFFERENTIALSales $200,000 0 $200,000 Food/Beverage (70,000) 0 (70,000) Personnel (40,000) 0 (40,000) Variable overhead (25,000) 0 (25,000) Contribution Margin 65,000 0 65,000Avoidable fixed costs Supervisor salary (20,000) 0 (20,000) Airport fees ( 5,000) 0 ( 5,000)Profit/Loss $ 40,000 $ 40,000

Worldwide airlines would also lose the contribution margin of $65,000. The club contributes $40,000 to

Worldwide’s fixed costs.

14-35

Contribution margin from general airline operationsthat will be forgone if club is eliminated . . . . . . . . . . . $ 60,000 –0– $ 60,000Profit/Loss $ 40,000 –0– $ 40,000Monthly profit of KEEPING the club open $100,000 =======

ConclusionConclusion

Worldwide is better off by $100,000 per month by keeping their club open.

KEEP THE CLUB OPEN!

The Opportunity Cost of lost contribution margin is $60,000.


McGraw-Hill/Irwin

Learning Objective

6

Learning Objective

6

14-37

Special Decisions inSpecial Decisions inManufacturing FirmsManufacturing Firms

Joint Products:Sell or Process Further

A joint production process resulting in two or more products. The point in the production process where the joint

products are identifiable as separate products is called the split-off point.

Joint Products:Sell or Process Further

A joint production process resulting in two or more products. The point in the production process where the joint

products are identifiable as separate products is called the split-off point.

14-38

Cocoa beansCocoa beanscosting $500costing $500

per tonper ton

Joint ProductionJoint Productionprocess costingprocess costing

$600 per ton$600 per ton

Cocoa butterCocoa buttersales valuesales value$750 for$750 for

1,500 pounds1,500 pounds

Cocoa powderCocoa powdersales valuesales value$500 for$500 for

500 pounds500 pounds

SeparableSeparableprocessprocesscostingcosting$800$800

Instant cocoaInstant cocoamix mix sales valuesales value

$2,000 for$2,000 for500 pounds500 pounds

Joint ProcessingJoint Processingof Cocoa Beanof Cocoa Bean

Joint ProcessingJoint Processingof Cocoa Beanof Cocoa Bean

Total joint cost:Total joint cost:$1,100 per ton$1,100 per ton

Split-off pointSplit-off point

14-39

Joint ProductsJoint Products

Relative Sales Value Method

$750 ÷ $1,250 = 60%$750 ÷ $1,250 = 60%

60% × $1,100 = $66060% × $1,100 = $660

14-40


• Cocoa butter is sold at the end of the joint processing.

• Cocoa powder may be sold now or processed into instant cocoa mix. Further processing costs of $800 will be incurred if the company elects to make instant cocoa mix.

• Cocoa butter is sold at the end of the joint processing.

• Cocoa powder may be sold now or processed into instant cocoa mix. Further processing costs of $800 will be incurred if the company elects to make instant cocoa mix.

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The cocoa powder should beThe cocoa powder should be processed into instant cocoa mix.processed into instant cocoa mix.

( )

14-42

Decisions Involving Limited Decisions Involving Limited ResourcesResources

• Firms often face the problem of deciding how limited resources are going to be used.

• Usually, fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin.

Let’s look at the Martin, Inc. example.

• Firms often face the problem of deciding how limited resources are going to be used.

• Usually, fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin.

Let’s look at the Martin, Inc. example.

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Limited ResourcesLimited Resources

Martin, Inc. produces two products and selected data is shown below:

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• The lathe is the scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity.

• The lathe capacity is 2,400 minutes per week.

Should Martin focus its effortson Webs or Highs?

• The lathe is the scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity.

• The lathe capacity is 2,400 minutes per week.

Should Martin focus its effortson Webs or Highs?

14-45

Limited ResourcesLimited ResourcesLet’s calculate the contribution margin per unit

of the scarce resource, the lathe.

Highs should be emphasized. It is the more valuable use of the scarce resource the lathe, yielding a

contribution margin of $30 per minute as opposed to $24 per minute for the Webs.

Highs should be emphasized. It is the more valuable use of the scarce resource the lathe, yielding a

contribution margin of $30 per minute as opposed to $24 per minute for the Webs.

If there are no other considerations, the best plan would be to produce to meet current demand for Highs and then use remaining capacity to make Webs.

14-46

Limited ResourcesLimited ResourcesLet’s see how this plan would work.

Allotting the Scarce Resource – The Lathe

Weekly demand for Highs 2,200 unitsTime required per unit x .50 minutesTime required to make Highs 1,100 minutes

Total lathe time available 2,400 minutesTime used to produce Highs 1,100 minutesTime available for Webs 1,300 minutesTime required per unit x 1.00 minute Production of Webs 1,300 units

14-47


According to the plan, Martin will produce 2,200 Highs and 1,300 Webs. Martin’s

contribution margin looks like this.

The total contribution margin for Martin, Inc. is $64,200.The total contribution margin for Martin, Inc. is $64,200.Any other combination would result in less contribution.Any other combination would result in less contribution.The total contribution margin for Martin, Inc. is $64,200.The total contribution margin for Martin, Inc. is $64,200.Any other combination would result in less contribution.Any other combination would result in less contribution.

14-48

Theory of ConstraintsTheory of Constraints

Binding constraints can limit a company’s profitability.

To relax constraints management can . . .

OutsourceOutsource Work overtimeWork overtime

Retrain employeesRetrain employeesReduce non-value-

added activitiesReduce non-value-

added activities

14-49

UncertaintyUncertainty

One common technique for addressing the impact of uncertainty is

sensitivity analysis - a way to determine what would happen in a decision analysis if a key prediction or assumption proved to be

wrong.

One common technique for addressing the impact of uncertainty is

sensitivity analysis - a way to determine what would happen in a decision analysis if a key prediction or assumption proved to be

wrong.

14-50

Expected ValuesExpected ValuesFrom the last example, recall the the contribution

margin for Webs was $24 and $15 for Highs.

Due to uncertainty, assume Martin has the followingprobable contribution margins for the two products.

WebsWebs HighsHighs

Martin would use the expected valueMartin would use the expected valuecontribution margins in its decision aboutcontribution margins in its decision aboututilizing its limited resource - the lathe.utilizing its limited resource - the lathe.

Martin would use the expected valueMartin would use the expected valuecontribution margins in its decision aboutcontribution margins in its decision aboututilizing its limited resource - the lathe.utilizing its limited resource - the lathe.


McGraw-Hill/Irwin

Learning Objective

7

Learning Objective

7

14-52

Other Issues in Decision MakingOther Issues in Decision Making

Incentives forDecision Makers

Incentives forDecision Makers

Short-RunVersus

Long-RunDecisions

Short-RunVersus

Long-RunDecisions

14-53

Other Issues in Decision MakingOther Issues in Decision Making

Pitfalls to Avoid

SunkSunkcosts.costs.SunkSunkcosts.costs.

UnitizedUnitizedfixed costs.fixed costs.

UnitizedUnitizedfixed costs.fixed costs.

AllocatedAllocatedfixed costs.fixed costs.AllocatedAllocated

fixed costs.fixed costs.

OpportunityOpportunitycosts.costs.

OpportunityOpportunitycosts.costs.

14-54

End of Chapter 14End of Chapter 14

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision...

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Transcript of Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision...