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14 Chapter

Fourteen

Decision Making:
Relevant Costs and
Benefits

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002


Managerial Accounting and
Decision Making
Decisions should always
Firm strategy be considered in the
light of firm strategy

Critical information Managers in


(provided via the line positions (such as
information system) production, marketing)

Decisions
affecting operations
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Managerial Accounting and
Decision Making
Firm strategy

Critical information Managers in


(provided via the line positions (such as
information system) production, marketing)

Decisions
What is included in affecting operations
an "information system"? 3
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Managerial Accounting and
Decision Making
Firm strategy Those who make decisions
affecting operations

Critical information Managers in


(provided via the line positions (such as
information system) production, marketing)

Decisions
4
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem
Problem with profitability
of a product line
2. Specify the objective(s)

3. Identify the alternatives


Quantitative
Analysis
4. Decide on the critical variables

5. Collect the data

6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem
Profitability at the
gross margin level
2. Specify the objective(s)

3. Identify the alternatives


Quantitative
Analysis
4. Decide on the critical variables

5. Collect the data

6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
Changes in pricing, 1. Identify the issue/problem
support activities,
processing, volume (sales) 2. Specify the objective(s)

3. Identify the alternatives


Quantitative
Analysis
4. Decide on the critical variables

5. Collect the data

6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem
"What if" for various
possibilities transformed
into numbers 2. Specify the objective(s)

3. Identify the alternatives


Quantitative
Analysis
4. Decide on the critical variables

5. Collect the data

6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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

4. Decide on the critical variables


Information should be:
1. Relevant 5. Collect the data
2. Accurate
3. Timely

6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem
Customer needs and
effects of changes
on other business 2. Specify the objective(s)

3. Identify the alternatives


Qualitative
Considerations
4. Decide on the critical variables

5. Collect the data

6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem
Avoiding customer
dissatisfaction
2. Specify the objective(s)

3. Identify the alternatives


Qualitative
Considerations
4. Decide on the critical variables

5. Collect the data

6. Make a decision
11
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem
Which alternatives
best minimize
alienating customers 2. Specify the objective(s)

3. Identify the alternatives


Qualitative
Considerations
4. Decide on the critical variables

5. Collect the data

6. Make a decision
12
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
Changes in 1. Identify the issue/problem
processing, volume
should generally be
unnoticed by customers 2. Specify the objective(s)

3. Identify the alternatives


Qualitative
Considerations
4. Decide on the critical variables

5. Collect the data

6. Make a decision
13
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
The Decision-Making Process
1. Identify the issue/problem

2. Specify the objective(s)

3. Identify the alternatives


Qualitative
Considerations
4. Decide on the critical variables

Estimate effects of
changes in 5. Collect the data
pricing, service on
customers,
gross margin 6. Make a decision
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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.

Can information that does not


differ across alternatives be relevant?
If so, when?

15
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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

Irrelevant to current decisions: may be included or left out


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Relevant Costs?

• You are trying to figure out whether or not


to purchase a new (replacement) car
• What numbers are relevant?
– What you paid for it?
– The cost of the new transmission you just put
in?
– What you can sell (or trade) it for?
– Other costs?

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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

Old loader Original cost 100,000


Current book value 25,000
What qualitative issue Current salvage 5,000
should immediately spring Salvage in 1 yr 0
to mind when viewing Annual op. exp. 80,000
these alternatives?
Remaining life (yrs) 1

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Irrelevant Costs: Depreciation of the Old

If we keep the old loader, we will have depreciation


costs of $25,000. If we replace the old loader,
we will write-off the $25,000 when sold. There is
no difference in the “cost,” so it is not relevant.
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Relevant Costs

The $5,000 proceeds will only be realized if we


replace the old loader. This amount is relevant
because it differs.

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Relevant Costs

We will only have to pay for the new loader


if we replace the old loader. This cost is relevant.

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Relevant Costs

The difference in operating costs is relevant


to the immediate decision.

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Relevant Costs
Here is an analysis that includes only relevant costs:

The difference is the same whether sunk


costs are included or not 23
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Relevant “Costs”
• What have we not considered in this
analysis that perhaps should be?
– Next year there will be no disposal value but
we still have to buy a new one
– Lifetimes?
– Differences in breakdown potential?
– Benefits to the labor force?
– Other types available? Other means of
accomplishing the same task?
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Relevant Costs?
• You are considering replacing or renovating
a building
• What costs are relevant?

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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

Worldwide will save about $5,000 in reservation


and ticketing costs if the charter is accepted.
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Accept or Reject a Special Order

Fixed costs that do not differ are not relevant.


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Accept or Reject a Special Order

Since the charter will contribute to fixed costs and


Worldwide has idle capacity, the company should
accept the flight (all other things equal).
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Accept or Reject a Special Order

What might make these not


appropriate numbers for this flight?

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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)

If Worldwide has no excess capacity, it


should reject the special charter.
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Accept or Reject a Special Order
With excess capacity . . .
– Relevant costs usually will be the variable costs
of the special order.

Without excess capacity . . .


– Same as above but the opportunity cost of
using the firm’s facilities for the special order
must also be considered.
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Outsource a Product or Service:
Make or Buy

Let’s look at another decision faced by the


management of Worldwide Airways.

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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

Beware of Unit-Cost Data


For decision-making purposes, unitized fixed
costs can be misleading.

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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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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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

If the digital watch line is dropped, the fixed


general factory overhead and general
administrative expenses will be allocated to other
product lines because they are not avoidable.

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Add or Drop a Product

The equipment used to manufacture digital


watches has no resale value or alternative use.

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Add or Drop a Product

Should Swick retain or drop


the digital watch segment?

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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

• Processing raw milk:


Cream

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

• Industries where joint products typically


occur
– Agricultural
– Chemical
– Mining
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Joint Costs: Sell at Split-off or
Process Further?
• Costs and benefits: which ones matter to
this decision?
– Joint costs?
– Costs of further processing?
– Sales value at split-off?
– Sales value after further processing?

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Example: Sell Now or Later?

• Cocoa butter is sold at the end of the joint


processing.
• Cocoa powder may be sold now or
processed into instant cocoa mix.
– Further processing costs of $800 will be
incurred if the company elects to make instant
cocoa mix.

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Example: Sell Now or Later?

The cocoa powder should be


processed into instant cocoa mix
(all other things equal)
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Decisions Involving Scarce Resources
• Firms often face the problem of deciding on the
best way to use limited (scarce) resources.
• Fixed costs are not generally affected by this
decision, so management can focus on
maximizing total contribution margin.

Let’s look at an example.

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Scarce Resources
Martin, Inc. produces two products (data below):

The object is to maximize the contribution margin


generated by the scarce resource
(give up the less profitable business). 60
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Scarce Resources
• The lathe is the scarce resource because, while it
is at 100% of capacity, there is excess capacity on
other machines.
• The lathe capacity is 2,400 minutes per week.

Should Martin focus its efforts


on Webs or Highs?

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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.

Highs should be emphasized.


emphasized It is the more valuable
use of the scarce resource, yielding a contribution
margin of $30 per minute of lathe time as opposed to
only $24 per minute for the Webs.
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Scarce Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.

If there are no other considerations,


considerations the best plan would
be to produce to meet current demand for Highs and
then use any capacity that remains to make Webs.

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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Scarce Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.

What other considerations might exist that might make


this NOT the best alternative?

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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.

The total contribution margin for Martin, Inc. is $64,200.


Any other combination would result in less contribution.
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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
Scarce Resources
Replacing one Web for two Highs: 2,198 Highs
and 1,301 Webs (can’t sell any more Highs so
this is the only direction in which it can change).

The new CM would be only $64,194 versus $64,200.

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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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

Unit CM 3.00 12.00


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Example: Scarce Resource
• A firm makes two products, U and D.
• Which is more profitable per hour of labor?

• U provides $3 of CM per $1 of labor.


• D provides $2 of CM per $1 of labor.

• Thus U provides a higher CM per unit of labor.

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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.

• CM = ($30 x 2,000) + ($60 x 4,000) = $300,000

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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

• A: 2 lbs./unit x 2,000 units = 4,000 lbs.


• B: (16,000 lbs. – 4,000 lbs.)/5 lbs. = 2,400 units
• CM = (2,000 x $30) + (2,400 x $60) = $204,000
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Constrained Resource for
You to Work
• Given the following, what should the firm produce
if contribution margin is the only consideration?
Contribution
Usage per Margin per
unit of Expected unit of
product Unit Sales product
X 5 12,000 28
Y 3 9,000 19

Supply of scarce resource 36,000 gallons

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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:

83
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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McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2002
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

Incentives Short-Run Versus


for Long-Run Decisions:
Decision many of these
Makers decisions have long
run effects, implying
the time value of
money may be relevant
(and that conditions may change over time)

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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

• These are on the Exam 3 webpage

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