slide 7-2 chapter 7 use of cost information in management decision making

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CHAPTER 7CHAPTER 7CHAPTER 7CHAPTER 7

Use of Cost Information in Management Decision

Making

Use of Cost Information in Management Decision

Making

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Incremental AnalysisIncremental AnalysisIncremental AnalysisIncremental Analysis

Incremental RevenueAdditional revenue received by selecting one alternative over another

Incremental CostAdditional cost incurred by selecting one alternative over another

Incremental ProfitDifference between incremental revenue and incremental cost

Learning 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


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Incremental Analysis Incremental Analysis ExampleExample

Incremental Analysis Incremental Analysis ExampleExample


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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 What Does This Product Cost?”Cost?”

““What Does This Product What Does This Product Cost?”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


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Analysis of Decisions Faced Analysis of Decisions Faced by Managersby Managers

Analysis of Decisions Faced Analysis of Decisions Faced by Managersby Managers

Three decisions that managers frequently face:

1.Additional processing of a product2.Make or buy a product3.Drop a product line


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Additional Processing of a Additional Processing of a ProductProduct

Additional Processing of a Additional Processing of a ProductProduct

Manufacturers must occasionally decide whether to:- Sell partially complete product, or- Incur additional costs to complete

Costs incurred to date of decision on partially complete product are not relevant, i.e sunk costs.


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Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example


Summary of cost information


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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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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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Additional Processing DecisionAdditional Processing DecisionAdditional Processing DecisionAdditional Processing Decision


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Make or Buy DecisionsMake or Buy DecisionsMake or Buy DecisionsMake or Buy Decisions

Decision involves no incremental revenues

Analysis concentrates solely on incremental costs


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


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Incremental cost analysis - single column format


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Make-or-Buy DecisionsMake-or-Buy DecisionsMake-or-Buy DecisionsMake-or-Buy Decisions


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


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Evelyn’s farm has two alternatives for the sale of 100 pounds of cucumbers1. Sell as-is (raw) for $0.79 per pound2. Pickle (process) and sell for $6.99 per

poundAdditional pickling costs per pound: materials $1.50; labor $2.00

Should Evelyn sell cucumbers or pickles? PicklesCucumbers Pickles Incremental

Revenue100 lbs X $0.79 $79100 lbs X $6.99 $699 $620

Incremental cost 0100 lbs X $1.50 (150) (150)100 lbs X $2.00 (200) (200)

Incremental profit $270


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Drop a Product LineDrop a Product LineDrop a Product LineDrop 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

Note: Allocated costs are not relevant


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


ToolsHardwareSupplies

GardenSupplies

Total3 products

Sales $120,000 $200,000 $80,000 $400,000Traceable costs:

Cost of goods sold (81,000) (90,000) (60,000) (231,000)Other variable costs (2,000) (4,000) (1,000) (7,000)Direct fixed costs (8,000) (5,000) (3,500) (16,500)

Non-traceable costsCompany fixed costs (24,000) (40,000) (16,000) (80,000)

Division net income $5,000 $61,000 ($500) $65,500

Mercer HardwareProduct Line Income Statement

For the Year Ended December 31, 2006

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 Beware of the Cost Allocation Death SpiralDeath Spiral

Beware of the Cost Allocation Beware of the Cost Allocation Death SpiralDeath 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

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Terminology SummaryTerminology SummaryTerminology SummaryTerminology Summary Sunk costs

- Costs already incurred- Never incremental or relevant i.e. Do not differ between alternatives

Avoidable costs - Costs avoided if an action is undertaken - Always incremental and relevant

Opportunity costs - Benefits foregone by selecting one

alternative over another - Always incremental and relevant

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Which of the following is often not a differential cost?

a. Materialb. Laborc. Variable overheadd. Fixed overhead

Answer: dFixed overhead


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Opportunity costs are:a. Never incremental costsb. Always incremental costsc. Sometimes sunk costsd. Never avoidable costs

Answer: bAlways incremental costs


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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 3: Analyze decisions involving joint costs

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Decisions Involving Joint CostsDecisions Involving Joint CostsDecisions 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

with additional costs

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Joint Products ExampleJoint Products ExampleJoint Products ExampleJoint Products Example


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Allocation of Joint CostsAllocation of Joint CostsAllocation of Joint CostsAllocation of Joint Costs

Cost of the common inputs- Allocated to the joint products for

financial reporting purposes- Can mislead managers about

product line profitability Joint cost information is

- Irrelevant to individual joint product decisions

- It is not an incremental cost


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Joint Cost Allocation Joint Cost Allocation MethodsMethods

Joint Cost Allocation Joint Cost Allocation MethodsMethods

Relative sales value method

Cost allocated to product A:Sales value A / Total sales value x Joint

cost

Physical quantity method

Cost allocated to product A:Physical measure A / Total physical

measure x Joint cost


34 Learning objective 3: Analyze decisions involving joint costs

Joint costs $1,000 Economy grade:

Quantity = 1,ooo poundsSales price = $0.10 per pound

Superior gradeQuantity = 4,000 poundsSales price = $0.30 per pound

Allocate joint costs using physical measure.Weight Allocation

Economy 1,000 1,000 / 5,000= 20% X $1, 000 = $200.00Superior 4,000 4,000 / 5,000 = 80% X $1, 000 = 800.00

Total 5,000 $1,000.00

Percentage

35 Learning objective 3: Analyze decisions involving joint costs

Joint costs $1,000 Economy grade

Quantity = 1,ooo poundsSales price = $0.10 per pound

Superior gradeQuantity = 4,000 poundsSales price = $0.30 per pound

Allocate joint costs using relative sales value.

AllocationEconomy 1,ooo X $0.10 = $100.00 $100 / $1,300 = 8% X $1, 000 = $77Superior 4,ooo X $0.30 = 1,200.00 $1,200 / $1,300 = 92% X $1, 000 = $923

Total $1,300.00 $1,000

PercentageSales Value

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Additional Processing Additional Processing Decisions and Joint CostsDecisions and Joint Costs

Additional Processing Additional Processing Decisions and Joint CostsDecisions and Joint Costs

Joint costs not relevant to decisions made after the split-off point

Joint costs incurred prior to the split-off point are sunk costs

Decisions should be based on incremental analysis


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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

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Qualitative Considerations in Qualitative Considerations in Decision AnalysisDecision Analysis


Many decisions have one or more features that are difficult to quantify but should be considered

Examples include, but are not limited to:- Swings in economy- Loss of control - Quality of product- Quality of service- Company morale


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Qualitative FactorsQualitative FactorsQualitative FactorsQualitative Factors


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

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The Five-Step Process of the The Five-Step Process of the Theory of ConstraintsTheory of Constraints

The Five-Step Process of the The Five-Step Process of the Theory of ConstraintsTheory of Constraints

1. Identify the Binding Constraint2. Optimize Use of the Constraint3. Subordinate Everything Else to the

Constraint4. Break the Constraint5. Identify a New Binding Constraint

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Optimize Use of the Optimize Use of the ConstraintConstraint

Optimize Use of the Optimize Use of the ConstraintConstraint


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Overproduction in Non-Overproduction in Non-Bottleneck DepartmentsBottleneck DepartmentsOverproduction in Non-Overproduction in Non-Bottleneck DepartmentsBottleneck Departments


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slide 7-2 chapter 7 use of cost information in management decision making

Documents

incremental analysis

incremental information

analysis of decisions

management decisions

incremental profit difference

additional costs

relevant costs

complete costs