McGraw-Hill/Irwin
Chapter Highlights
Alternative choice decisions:
Manager seeks to choose best out of several alternatives. Focus on differential costs and revenues.
Different under one set of conditions than under another.
Differential costs:
Include only those elements of cost that are different under a certain set of conditions.
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Differential costs:
No comparable system for collecting. Assembled (sometimes estimated) to meet analytical requirements of a specific problem.
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Differential costs:
Relate to future. Show what costs will be if a certain course of action is adopted.
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Contribution Analysis
A tool for analyzing differential costs. Focuses on contribution margin:
Total revenue minus total variable cost.
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Types of Cost
Variable costs:
Total varies proportionately with volume of activity (such as sales).
Fixed costs:
Total does not vary with volume of activity (within relevant range).
Direct costs:
Directly traceable to cost object.
Indirect costs:
Not directly traceable to cost object.
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Nonprofit organization:
Provide acceptable quality at lowest possible cost.
Other objectives?
E.g., maintain market position, stabilize employment, community responsibilities.
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3. Measure and evaluate quantitative factors. 4. Identify and evaluate qualitative factors. 5. Make decision.
Decision may be to seek additional information.
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Differential Costs
Costs that will be different under the proposed alternative than they are in the base case. Also called:
Out-of-pocket costs, avoidable costs, incremental costs, relevant costs.
No general category of costs can be labeled differential. Always relate to specific alternatives being analyzed.
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Mechanics of Calculation
No prescribed format; use most convenient. Unaffected costs.
Are not differential and may be disregarded (or treated the same under each alternative).
Labor cost.
Dont forget fringe benefits.
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Mechanics of Calculation
Opportunity costs.
Value lost or sacrificed by giving up an alternative course of action. Not associated with cash outlays. Not measured in accounting records. Frequently measured by income that would have been earned had resources been invested otherwise (e.g., capacity of warehouse). Frequently difficult to accurately estimate.
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Differential Costs
May or may not be the same as variable costs. May also include fixed costs (e.g., decision to discontinue a product line). Goal is to determine future costs; however, may be best estimated by looking at past/historical costs.
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Sunk Cost
Cost that has already been incurred. Therefore, cannot be changed by any decision currently being considered (e.g., all historical costs). Not a differential cost. Question: In the decision to keep or replace equipment, is the book value of current equipment a differential cost? What about disposal value?
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Sensitivity Analysis
Considers how sensitive quantitative measurements of alternatives are to changes in assumptions.
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Expected Values
Discussion has assumed single point estimates (i.e., best estimates). Alternative is to use separate possibilities weighted by probabilities to determine expected values. Choose alternative with highest expected value.
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Practical Pointers
1. 2. 3. 4. 5. Use imagination in selecting alternatives. Dont overweight your quantitative factors. However, dont slight the numbers. Work with total costs, not unit costs. Be aware of the tendency to underestimate the costs of new ventures. 6. Look at substance of, not amount of, arguments for or against a decision.
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Practical Pointers
7. Consider margin of error. 8. Know that delaying too long to decide is a decision. 9. Identify your assumptions and perform sensitivity analysis. 10.Do not expect your conclusion to be accepted just because numbers support the decision.
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Summary Comment
Differential costs and revenues rarely provide a definitive answer to any business problem. Simply assist in making a sound decision.
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