prepared by debby bloom-hill cma, cfm. slide 7-2 chapter 7 use of cost information in management...

Prepared by Debby Bloom-Hill CMA, CFM

2

CHAPTER 7CHAPTER 7

Use of Cost Information in Management Decision

Making

Use of Cost Information in Management Decision

Making

3

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 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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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


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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


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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


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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


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


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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.


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Additional Processing Decision – Bridge Computer Example


Summary of cost information


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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


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Incremental analysis summary


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


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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


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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


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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




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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



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Make-or-Buy Decisions – General Refrigeration ExampleIncremental cost analysis – 3 column

format


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Incremental cost analysis - single column format


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


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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


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


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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


Opportunity Costs – General Refrigeration Example

Opportunity Costs – General Refrigeration Example

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Make-or-Buy Decisions – General Refrigeration ExampleIncremental analysis with opportunity

costs


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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


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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


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Dropping a Product Line – Mercer Hardware ExampleDropping a Product Line – Mercer Hardware Example


Profit calculation with three product lines

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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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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 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions

Slide 7-34

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


Slide 7-35

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


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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 3: Analyze decisions involving joint costs

Slide 7-38

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


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Joint Products ExampleJoint Products Example


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Joint Cost Allocation Methods


Physical quantity of output

Joint costs allocated to product A =

Joint costs allocated to product B =


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Relative sales value




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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



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Joint costs of $620 allocated using physical quantity of output


$1 per foot, and 500 feet of grade B lumber that sells for

$0.50 per foot



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Joint costs of $620 allocated using sales value


$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



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Joint costs of $620 allocated using sales value


$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



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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


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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 4: Discuss the importance of qualitative considerations to management decisions

Slide 7-49

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


Slide 7-50



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Qualitative FactorsQualitative Factors


Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)

Slide 7-52

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


Slide 7-53



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


Slide 7-54




3. Subordinate Everything Else to the ConstraintManagers should focus their attention on trying to loosed the constraint and not on process improvements


Slide 7-55




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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prepared by debby bloom-hill cma, cfm. slide 7-2 chapter 7 use of cost information in management...

Documents

incremental information

relevant costs

variable costs

dmaterial costs

notonly costs

selectedincremental

differential costs

decisionsome costs