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Relevant Cost Decisions
DECISION MAKING IN THE SHORT TERM
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Decisions
A decision model is a formal method of making a choice, often involving both quantitative and qualitative analyses
A relevant cost is a cost that differs between alternatives.
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Five-Step Decision-Making Process
Step 1:Obtain
Information
Step 5:Evaluate
Performance
Step 4:Implement
TheDecision
Step 3:Choose
AnAlternative
Step 2:Make
PredictionsAboutFutureCosts
Feedback
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Relevance
Relevant Information has two characteristics: It occurs in the future It differs among the alternative courses
of action Relevant Costs – expected future
costs Relevant Revenues – expected future
revenues
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Identifying Relevant Costs
Costs that can be eliminated (in whole or in part) by choosing one alternative over another are avoidable costs. Avoidable
costs are relevant costs.Unavoidable costs are never relevant and
include: Sunk costs. Future costs that do not differ between the
alternatives.
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Identifying Relevant Costs
gather all costs associated with the alternatives
eliminate all sunk costs Eliminate all future costs that don’t
differ between alternatives left are the avoidable costs
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Irrelevance
Historical costs are past costs that are irrelevant to decision making Also called Sunk Costs- cost that has
already been incurred and that cannot be avoided regardless of what a manager decides to do
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Types of Information
Quantitative factors are outcomes that can be measured in numerical terms
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction Are just as important as quantitative
factors even though they are difficult to measure
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Terminology Incremental Cost – the additional total
cost incurred for an activity Differential Cost – the difference in
total cost between two alternatives Incremental Revenue – the additional
total revenue from an activity Differential Revenue – the difference
in total revenue between two alternatives
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Types of Decisions
One-Time-Only Special Orders Insourcing vs. Outsourcing Make or Buy Product-Mix Customer Profitability Branch / Segment: Adding or
Discontinuing Equipment Replacement
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One-Time-Only Special Orders
Accepting or rejecting special orders when there is idle production capacity and the special orders have no long-run implications
Decision Rule: does the special order generate additional operating income? Yes – accept No – reject
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One-Time-Only Special Orders
Compares relevant revenues and relevant costs to determine profitability
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Special Orders
Acki Company receives a one-time order that is not considered part of its normal ongoing business.
Acki Company only produces one type of silver key chain with a unit variable cost of TL 16. Normal selling price is TL 40 per unit.
A company in KKTC offers to purchase 3,000 units for TL 20 per unit.
Annual capacity is 10,000 units, and annual fixed costs total TL78,000, but Acki company is currently producing and selling only 5,000 units.
Should Acki accept the offer?Should Acki accept the offer?
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Special Orders
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Special Orders
If Acki accepts the offer, net income will increase by TL 12.000.
Increase in revenue (3,000 × TL20) TL60.000Increase in costs (3,000 × TL16 variable cost) 48.000 Increase in net income TL12.000
Using the incremental approach: Special order contribution margin = TL20 – TL 16 = TL 4 Change in income = TL 4 × 3,000 units = TL 12.000.
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Potential Problems with Relevant-Cost Analysis
Avoid incorrect general assumptions about information, especially: “All variable costs are relevant and all
fixed costs are irrelevant” There are notable exceptions for both
costs
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Potential Problems with Relevant-Cost Analysis
Problems with using unit-cost data: Including irrelevant costs in error Using the same unit-cost with different
output levels Fixed costs per unit change with different
levels of output
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Avoiding Potential Problems with Relevant-Cost Analysis
Focus on Total Revenues and Total Costs, not their per-unit equivalents
Continually evaluate data to ensure that they meet the requirements of relevant information
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Insourcing vs. Outsourcing Insourcing – producing goods or
services within an organization Outsourcing – purchasing goods or
services from outside vendors Also called the “Make or Buy”
decision Decision Rule: Select the option that
will provide the firm with the lowest cost, and therefore the highest profit.
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Qualitative Factors
Nonquantitative factors may be extremely important in an evaluation process, yet do not show up directly in calculations: Quality Requirements Reputation of Outsourcer Employee Morale Logistical Considerations – distance from
plant, etc.
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Opportunity Costs Opportunity Cost is the contribution to operating
income that is forgone by not using a limited resource in its next-best alternative use “How much profit did the firm ‘lose out on’ by not
selecting this alternative?” The economic benefits that are foregone as a result
of pursuing some course of action. Opportunity costs are not actual dollar outlays and are not recorded in the accounts of an organization.
Special type of Opportunity Cost: Holding Cost for Inventory. Funds tied up in inventory are not available for investment elsewhere
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The Make or Buy Decision
A decision concerning whether an item should be produced internally or
purchased from an outside supplier is called a “make or buy” decision.
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The Make or Buy Decision
MA Company is thinking of buying a part that is currently used in one of its products from outside.
The unit cost to make this part is:TL/ u
Direct materials 27 Direct labor 15 Variable overhead 3
Depreciation of special equip. 9Supervisor's salary 6General factory overhead 30Total cost per unit 90
TL/ uDirect materials 27 Direct labor 15 Variable overhead 3
Depreciation of special equip. 9Supervisor's salary 6General factory overhead 30Total cost per unit 90
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The Make or Buy Decision
General factory overhead is allocated on the basis of direct labor hours and is not going to change if the parts are bought from outside.
The 90TL unit cost is based on 20,000 parts produced each year.
An outside supplier has offered to provide the 20,000 parts at a cost of 70TL per part.
Should we accept the supplier’s offer?Should we accept the supplier’s offer?
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Cost Per Unit Cost of 20,000 Units
Make BuyOutside purchase price 70 1.400.000
Direct materials 27 540.000Direct labor 15 300.000Variable overhead 3 60.000Depreciation of equip. 9 0Supervisor's salary 6 120.000General factory overhead 30 0Total cost 90 1.020.000 1.400.000
The Make or Buy Decision
Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.
Not avoidable and is irrelevant. If the product is dropped, it will be reallocated to other products.
Sunk Cost
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The Make or Buy Decision
DECISION RULEIn deciding whether to accept the outside
supplier’s offer, MA isolated the relevant costs of making the part by eliminatingeliminating:
The sunk costs. The future costs that will not differ
between making or buying the parts.
DECISION RULEIn deciding whether to accept the outside
supplier’s offer, MA isolated the relevant costs of making the part by eliminatingeliminating:
The sunk costs. The future costs that will not differ
between making or buying the parts.
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Product-Mix Decisions
The decisions made by a company about which products to sell and in what quantities
Decision Rule (with a constraint): choose the product that produces the highest contribution margin per unit of the constraining resource
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Utilization of a Constrained Resource Firms often face the problem of
deciding how to best utilize a constrained resource.
Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin.
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Utilization of a Constrained Resource
UM Company produces two products and selected data is shown below:
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Utilization of a Constrained Resource
Machine A1 is the constrained resource. There is excess capacity on all other machines. Machine A1 is being used at 100% of its capacity, and has a capacity of 2,400 minutes per week.
Should UM focus its efforts on Should UM focus its efforts on Product 1 or 2?Product 1 or 2?
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Utilization of a Constrained Resource
Let’s calculate the contribution margin per unit of the constrained resource, machine A1.
Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of TL 30 per minute as
opposed to TL 24 for Product 1.
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Utilization of a Constrained ResourceLet’s calculate the contribution margin per unit of the
scarce resource, machine A1.Let’s see how this plan would work.Let’s see how this plan would work.
If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then
use remaining capacity to make Product 1.
If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then
use remaining capacity to make Product 1.
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Utilization of a Constrained Resource
Let’s see how this plan would work.Let’s see how this plan would work.
Allocation of Constrained Resource
Weekly demand for Product 2 2.200 unitsTime required per unit × 0,50 min.Total time required to make Product 2 1.100 min.
Total time available 2.400 min.Time used to make Product 2 1.100 min.Time available for Product 1 1.300 min.Time required per unit ÷ 1,00 min.Production of Product 1 1.300 units
Allocation of Constrained Resource
Weekly demand for Product 2 2.200 unitsTime required per unit × 0,50 min.Total time required to make Product 2 1.100 min.
Total time available 2.400 min.Time used to make Product 2 1.100 min.Time available for Product 1 1.300 min.Time required per unit ÷ 1,00 min.Production of Product 1 1.300 units
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Utilization of a Constrained Resource
According to the plan, we will produce 2,200 units of According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.contribution margin looks like this.
Product 1 Product 2Production and sales (units) 1.300 2.200 Contribution margin per unit TL24 TL15Total contribution margin TL31.200 TL33.000
The total contribution margin for UM is TL 64,200.
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Managing Constraints
Finding ways to process more
units through a resource
bottleneck
Produce only what can be sold.
Streamline production process.
Eliminate waste.
At the bottleneck itself: •Improve the process • Add overtime or another shift • Hire new workers or acquired more machines • Subcontract production
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Adding or Dropping Customers
Decision Rule: Does adding or dropping a customer add operating income to the firm? Yes – add or don’t drop No – drop or don’t add
Decision is based on profitability of the customer, not how much revenue a customer generates
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Adding or DiscontinuingBranches or Segments
Decision Rule: Does adding or discontinuing a branch or segment add operating income to the firm? Yes – add or don’t discontinue No – discontinue or don’t add
Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates
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Sales 1.000.000Less: variable expenses Variable mfg. costs 240.000 Variable shipping costs 10.000 Commissions 150.000 400.000Contribution margin 600.000Less: fixed expenses General factory overhead 120.000 Salary of line manager 180.000 Depreciation of equipment 100.000 Advertising - direct 200.000 Rent - factory space 140.000 General admin. expenses 60.000 800.000Net loss (200.000)
Income Statement for 2007Digital Musical Instruments
Adding/Dropping Segments
General Factory Overhead and General Administrative Expenses are unavoidable costs.
Assume that the equipment used in manufacturing digital instruments has no resale value or alternative use.
Should the company drop digital instruments division?
Should the company drop digital instruments division?
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Incremental Approach
DECISION RULEDECISION RULEUM should drop the digital instruments
division only if the avoided fixed costs of the division exceed lost
contribution margin of this division.
DECISION RULEDECISION RULEUM should drop the digital instruments
division only if the avoided fixed costs of the division exceed lost
contribution margin of this division.
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Incremental Approach
Contribution MarginSolution
Contribution margin lost if digital instrument division is dropped (600.000)Less fixed costs that can be avoided Salary of the line manager 180.000 Advertising - direct 200.000 Rent - factory space 140.000 520.000Net disadvantage (80.000)
What about depreciation?What about depreciation?
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Comparative Income Approach
Prepare comparative income statements showing results with and without the
digital instruments division.
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Comparative Income ApproachSolution
Keep Digital Instrum ents
Drop Digital Instrum ents Difference
Sales 1.000.000 0 (1.000.000)Less variable expenses: 0 Mfg. expenses 240.000 0 240.000 Freight out 10.000 0 10.000 Commissions 150.000 0 150.000Total variable expenses 400.000 0 400.000Contribution margin 600.000 0 (600.000)Less fixed expenses: General factory overhead 120.000 120.000 0 Salary of line manager 180.000 0 90.000 Depreciation 100.000 100.000 0 Advertising - direct 200.000 0 100.000 Rent - factory space 140.000 0 70.000 General admin. expenses 60.000 60.000 0Total fixed expenses 800.000 280.000 260.000Net loss (200.000) (280.000) (340.000)
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Joint Product Costs
In some industries, a number of end products are produced from a single raw material input.
Two or more products produced from a common input are called joint productsjoint products.
The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off pointsplit-off point.
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Joint Products
JointInput
CommonProduction
Process
Split-OffSplit-OffPointPoint
JointJointCostsCosts Oil
Gasoline
Chemicals
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Joint Products
JointInput
CommonProduction
Process
SeparateProcessing
SeparateProcessing
FinalSale
FinalSale
FinalSale
Split-OffSplit-OffPointPoint
JointJointCostsCosts
SeparateSeparateProductProductCostsCosts
Oil
Gasoline
Chemicals
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The Pitfalls of Allocation of Joint Costs
Joint costs are really common costs incurred to simultaneously produce a variety of end products.
Joint costs are often allocated to end products on the basis of the relative relative sales valuesales value of each product or on some other basis.
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Sell or Process Further
Decision Rule: It will always profitable to continue
processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs incurred after the split-off point.
Let’s look at the Kere example.Let’s look at the Kere example.
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Sell or Process Further
Kere Company cuts logs from which unfinished lumber and sawdust are the immediate joint products.
Unfinished lumber is sold “as is” or processed further into finished lumber.
Sawdust can also be sold “as is” to gardening wholesalers or processed further into “ready-logs.”
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Sell or Process Further
Data about Kere’s joint products includes:
Per Log Lumber Sawdust
Sales value at the split-off point TL140 TL40
Sales value after further processing 270 50 Allocated joint product costs 176 24 Cost of further processing 50 20
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Sell or Process Further Analysis
Per Log
Lumber Sawdust
Sales value after further processing TL270 TL50Sales value at the split-off point 140 40 Incremental revenue 130 10 Cost of further processing 50 20 Profit (loss) from further processing TL80 (TL10)
Should Kere process the lumber further and sell the sawdust “as is?”
Should Kere process the lumber further and sell the sawdust “as is?”
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Behavioral Implications Despite the quantitative nature of
some aspects of decision making, not all managers will choose the best alternative for the firm
Managers could engage in self-serving behavior such as delaying needed equipment maintenance in order to meet their personal profitability quotas for bonus consideration