Fourteen
Decision Making:
Relevant Costs and
Benefits
Decisions
affecting operations
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Managerial Accounting and
Decision Making
Firm strategy
Decisions
What is included in affecting operations
an "information system"? 3
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Managerial Accounting and
Decision Making
Firm strategy Those who make decisions
affecting operations
Decisions
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The Decision-Making Process
1. Identify the issue/problem
Problem with profitability
of a product line
2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
Profitability at the
gross margin level
2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
Changes in pricing, 1. Identify the issue/problem
support activities,
processing, volume (sales) 2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
"What if" for various
possibilities transformed
into numbers 2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
Is there any potential
conflict between these 2. Specify the objective(s)
(that is, getting one
may preclude another)?
3. Identify the alternatives
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
Customer needs and
effects of changes
on other business 2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
Avoiding customer
dissatisfaction
2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
Which alternatives
best minimize
alienating customers 2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
Changes in 1. Identify the issue/problem
processing, volume
should generally be
unnoticed by customers 2. Specify the objective(s)
6. Make a decision
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The Decision-Making Process
1. Identify the issue/problem
Estimate effects of
changes in 5. Collect the data
pricing, service on
customers,
gross margin 6. Make a decision
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Relevant Information
Information is relevant (provides
clues as to what is appropriate)
to a decision when it. . .
➊ has a bearing on the future,
➋ differs across alternatives.
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Identifying Relevant Costs and
Benefits
• Sunk costs: costs that have already been
incurred
– Do not affect any future cost
– Cannot be changed by any current or future
action
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Relevant Costs
Worldwide Airways is thinking about replacing a three year old
baggage loader with a new, more portable one.
New loader List price 15,000
Annual op. exp. 45,000
Expected life (yrs) 1
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Irrelevant Costs: Depreciation of the Old
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Relevant Costs
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Relevant Costs
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Relevant Costs
Here is an analysis that includes only relevant costs:
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Analysis of Special Decisions
Let’s take a close look at some special
decisions faced by many businesses.
We just received
a special order. Do
you think we should
accept it?
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Accept or Reject a Special Order
• Characteristics of a “special” order:
– Not part of your normal business
• Could be a new customer or an ongoing customer with a
special need
• Could be a modification of a current product or a custom
product
• Issues of concern:
– Cannibalization or annoying current customers
– Capacity and normal business
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Accept 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 airlines 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.
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Accept 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. Excess capacity
• The airlines 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 relevant cost data.
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Accept or Reject a Special Order
Typical Flight Between Japan and Hawaii
Revenue:
Passenger $ 250,000
Cargo 30,000
Total $ 280,000
Expenses:
Variable expenses 90,000
Allocated fixed expenses 100,000
Total 190,000
Profit $ 90,000
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Accept or Reject a Special Order
• What if Worldwide had no excess capacity?
• To add the charter, it will have to cut a flight
• It would (naturally) choose one on its least
profitable route. This one contributes $80,000 to
cover fixed costs and profits.
• Should Worldwide still accept the charter offer?
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Accept or Reject a Special Order
Assumes no excess capacity
Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Opportunity cost:
Lost contribution on route 80,000 165,000
Total $ (15,000)
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Outsource 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:
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Outsource a Product or Service
Not all of the allocated “fixed costs” will be saved
if Worldwide purchases from the outside bakery.
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Outsource 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.
No deal!
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Outsource a Product or Service
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Add or Drop a Service,
Product, 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.
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Add or Drop a Product
Due to the declining popularity of digital
watches, Swick Company’s digital watch
line has not reported a profit for several
years.
years An income statement for last year is
shown on the next screen.
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Add or Drop a Product
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Add or Drop a Product
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Add or Drop a Product
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Add or Drop a Product
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Add or Drop a Product
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Add or Drop: Alternate View
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Summary
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Special Decisions in
Manufacturing Firms
Joint Products:
Sell Now or Process Further?
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Definitions
• Joint products = two or more "important"
products created from one set of raw
materials using the same process
• Split-off point = the point at which the
products are separately identifiable
• Separable costs = those that can be directly
attributed to one of the joint products
• By-product = incidental product (small
sales value relative to joint products)
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Joint Costs: Diagramming the Process
Skim milk
Milk
Cheese
Whey
Joint product
Byproduct
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Joint Costs: Diagramming the
Process
2x4s
Core lumber
2x6s
Timber
Bark
Particle
Chips
board
Joint product Sawdust
Byproduct
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Joint Costs
• Examples of products that have joint costs
– Timber
– Fruit harvesting
– Petroleum refining
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Example: Sell Now or Later?
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Example: Sell Now or Later?
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Scarce Resources
Martin, Inc. produces two products (data below):
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Scarce Resources
Let’s calculate the contribution margin per unit
(minute) of the scarce resource, the lathe.
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Scarce Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.
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Scarce Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.
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Scarce Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.
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Scarce Resources
Let’s see how this plan would work.
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Scarce Resources
According to the plan, Martin will produce 2,200
Highs and 1,300 Webs. Martin’s contribution
margin looks like this.
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Example: Scarce Resource
• A firm makes two products, U and D.
• Which is more profitable per unit of labor?
U D
Selling price 13.00 31.00 Assume labor is
paid the same
DM 7.00 5.00 per hour for
DL 1.00 6.00 both products
VOH Mfg 1.25 7.50
VC SG&A 0.75 0.50
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Constrained Resource Example
• A firm produces two products, A and B, using the
same material input.
• A uses 2 lbs/unit while B uses 5 lbs/unit.
• The contribution margin is $30 for Juno and $60 for
B.
• The firm’s one source of material is shut down and
they can only use what they have in inventory (16,000
lbs.).
• They wanted to produce 2,000 units of A and 4,000 of
B if the materials were available (this is the maximum
of each they feel they could sell).
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Constrained Resource Example
• How large a contribution margin will the firm earn
if it could produce the planned quantities?
– The contribution margin is $30 for A and $60 for B.
– They wanted to produce 2,000 units of A and 4,000 of
B.
• CM =
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Constrained Resource Example
• How large a contribution margin will the firm earn
if it could produce the planned quantities?
– The contribution margin is $30 for A and $60 for B.
– They wanted to produce 2,000 units of A and 4,000 of
B.
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Constrained Resource Example
• Since materials are constrained, what should they
do to maximize CM and what CM will it produce?
• A B
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Constrained Resource Example
• Since materials are constrained, what should they
do to maximize CM and what CM will it produce?
• A B
• CM/unit $30 $60
• LB/unit 2 5
• CM per LB $15 $12
• Now what?
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Constrained Resource Example
• Since materials are constrained, what should they
do to maximize CM and what CM will it produce?
• A B
• CM/unit $30 $60
• LB/unit 2 5
• CM per LB $15 $12
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Scarce Resource Problem
• First find the CM per unit of the scarce
resource by product:
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Scarce Resource Problem
• Next find the amount of the scarce resource
used up if all sales for the "better" product
are satisfied:
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Scarce Resource Problem
• Next find the amount of the scarce resource
that remains:
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Scarce Resource Problem
• Next find the amount of the "less good"
product that can be made with the scarce
resource that remains:
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Scarce Resource Problem
• Check to make sure your solution works:
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Uncertainty
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.
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Expected Values
From the last example, recall the the contribution
margin for Webs was $24 and $15 for Highs.
Due to uncertainty, assume Martin has the following
probable contribution margins for the two products.
Webs Highs
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Expected Values
FromMartin
our lastwould use recall
example, the expected value
the the contribution
contribution
margin for Websmarginswas in itsand
$24 decision
$15 forabout
Highs.
Due to uncertainty,
utilizing assume
its limited we have -the
resource following
the lathe.
probable contribution margins for the two products.
Webs Highs
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Other Issues in Decision Making
Short-Run
Incentives for Versus
Decision Makers Long-Run
Decisions
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Other Issues in Decision Making
Incentives for
Short-Run
Decision Makers:
Versus
managers “will make
Long-Run
decisions that maximize
Decisions
their perceived
performance evaluations
and rewards”
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Other Issues in Decision Making
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Other Issues in Decision Making
Pitfalls to Avoid
Sunk Allocated
costs: fixed costs:
irrelevant irrelevant
Unitized Opportunity
fixed costs: costs: easy
misleading to forget
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Practice Problems
• P 14-X
• P 14-Y
• P 14-Z
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