Decision Making and Relevant Information - ch11

Decision Making and Relevant Information Chapter 11
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
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Learning Objective 1
Use the five-step decision process to make decisions.
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Information and the Decision Process

A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis.
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Decision Making
Decision making involves a choice between alternative courses of action. Examples are: What products to produce How to produce them How to sell them What prices to charge Where to buy raw materials When to replace equipment How to allocate scarce resources Where to expand production capacity
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Five-Step Decision Process

Step 1. Gather Information Historical Costs Other Information Specific Predictions
Step 2. Feedback
Make Predictions
Step 3.
Choose an Alternative
Step 4. Implement the Decision
Step 5. Evaluate Performance

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Learning Objective 2 Differentiate relevant from irrelevant costs and revenues in decision situations.
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The Meaning of Relevance

Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action. Historical costs Differential income Sunk costs Differential costs
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Learning Objective 3 Distinguish between quantitative and qualitative factors in decisions.
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Quantitative and Qualitative Relevant Information

Quantitative factors
Financial
Nonfinancial
Qualitative factors
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One-Time-Only Special Order Example

The Bismark Co. manufacturing plant has a production capacity of 44,000 towels each month. Current monthly production is 30,000 towels. Costs can be classified as either variable or fixed with respect to units of output.
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Variable Costs Per Unit $6.50 .50 1.50 $8.50 Fixed Costs Per Unit $ -01.50 3.50 $5.00
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Direct materials Direct labor Manufacturing costs Total

Total fixed direct manufacturing labor is $45,000. Total fixed overhead is $105,000.
Marketing costs per unit are $7 ($5 of which is variable). What is the full cost per towel?
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Variable ($8.50 + $5.00): Fixed: Total $13.50 7.00 $20.50
A hotel in San Juan has offered to buy 5,000 towels from Bismark Co. at $11.50/towel for a total of $57,500. No marketing costs will be incurred.
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What are the relevant costs of making the towels ? $8.50 5,000 = $42,500 incremental costs
What are the incremental revenues ?

$57,500 $42,500 = $15,000
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Exercise 7-1 (Helmkamp) Evaluating a Special Order

A company manufacture footballs and has enough idle capacity to accept a speical Order for 20,000 footballs to be sold for $14 each. The footballs normally sell for $20 each. The variable manufacturing costs are $10 per ball and fixed MOH is $5 Per ball. There will be no additional selling or administrative costs related to the Special order, and special order will not affect normal sales. Required: Calculate the effect on net sales if the special order is accepted.
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Two Potential Problems in Relevant-Cost Analysis

1 Incorrect general assumptions: All variable costs are relevant. All fixed costs are irrelevant. 2 Misleading unit-cost data: Include irrelevant costs. Use same unit costs at different output levels.
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Outsourcing versus Insourcing

Outsourcing is purchasing goods and services from outside vendors. Insourcing is producing goods or providing services within the organization.
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Make-or-Buy Decisions Example

Bismark Co. also manufactures bath accessories. Management is considering producing a part it needs (#2) or buying a part produced by Towson Co. for $0.55.
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Bismark Co. has the following costs for 150,000 units of Part #2: Direct materials $ 28,000 Direct labor 18,500 Mixed overhead 29,000 Variable overhead 15,000 Fixed overhead 30,000 Total $120,500
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Mixed overhead consists of material handling and setup costs. Bismark Co. produces the 150,000 units in 100 batches of 1,500 units each. Total material handling and setup costs equal fixed costs of $9,000 plus variable costs of $200 per batch.
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What is the cost per unit for Part #2? $120,500 150,000 units = $0.8033/unit
Should Bismark Co. manufacture the part or buy it from Towson Co.?
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Bismark Co. anticipates that next year the 150,000 units of Part #2 expected to be sold will be manufactured in 150 batches of 1,000 units each.
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Variable costs per batch are expected to decrease to $100.
Bismark Co. plans to continue to produce 150,000 next year at the same variable manufacturing costs per unit as this year. Fixed costs are expected to remain the same as this year.
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What is the variable manufacturing cost per unit? Direct material Direct labor Variable overhead Total $28,000 18,500 15,000 $61,500
$61,500 150,000 = $0.41 per unit

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Expected relevant cost to make Part #2:
Manufacturing Material handling and setups Total relevant cost to make *150 $100 = $15,000 $61,500 15,000* $76,500
Cost to buy: (150,000 $0.55) $82,500 Bismark Co. will save $6,000 by making the part.
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Now assume that the $9,000 in fixed clerical salaries to support material handling and setup will not be incurred if Part #2 is purchased from Towson Co.. Should Bismark Co. buy the part or make the part?
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Relevant cost to make:
Variable Fixed Total Cost to buy: $76,500 9,000 $85,500 $82,500
Bismark would save $3,000 by buying the part.

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Exercise 7-5 Make or Buy Situation

A manufacturer of television sets is considering ways to increase the firms plant capacity utilization because it has recently been operating at 70% of capacity. One proposal is to make a component which is currently being purchased for $75 per unit. The cost to produce the component is: DM $24.00, DL (3hours @ $11.20 per hr) is $33.00, MOH (applied on DL hours) is24.00 = Total cost $81.00 The anticipated work capacity for the year is 250,000 direct labour hours. MOH fixed for the year $1.75 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster million. Reuired: The company make it or buy it. 11 - 28
Learning Objective 5 Explain the opportunity-cost concept and why it is used in decision making.
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Opportunity Costs, Outsourcing, and Constraints

Assume that if Bismark buys the part from Towson, it can use the facilities previously used to manufacture Part #2 to produce Part #3 for Krysta Company.
The expected additional future operating income is $18,000. What should Bismark Co. do?
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Bismark Co. has three options regarding Krysta: 1. Make Part #2 and do not make Part #3.
2. Buy Part #2 and do not make Part #3.

3. Buy the part and use the facilities to produce Part #3.
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Expected cost of obtaining 150,000 parts: Buy Part #2 and do not make Part #3: $82,500
Buy Part #2 and make Part #3: $82,500 $18,000 = Make Part #2:
$64,500 $76,500
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Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.
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Assume that annual estimated Part #2 requirements for next year is 150,000. Cost per purchase order is $40.
Cost per unit when each purchase is 1,500 units = $0.55. Cost per unit when each purchase is equal to or greater than 150,000 = $0.54.
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Average investment in inventory is either: (1,500 .55) 2 = $412.50 or (150,000 $0.54) = $40,500 Annual interest rate for investment in government bonds is 6%. $412.50 .06 = $24.75 $40,500 .06 = $2,430
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Option A: Make 100 purchases of 1,500 units: Purchase order costs: (100 $40) Annual interest income: Relevant costs: $ 4,000.00 $ 24.75
Purchase costs: (150,000 $0.55) $82,500.00

$86,524.75
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Option B: Make 1 purchase of 150,000 units: Purchase order costs: (1 $40) $ 40
Purchase costs: (150,000 $0.54)

Annual interest income: Relevant costs:
$81,000
$ 2,430 $83,470
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Exercise 7-11 Choice of Products with Constraints

Foss company produces three products. During a month, only 600 machine hours are available for production of the three products. Data is as: Product A Product B Product C Selling price ($) 12 16 22 Variable cost 7 8 10 Contribution Mar 5 8 12 Mach time req (minutes) 12 20 30 The firm can sell as much of any product as it can manufacture. Required: Which product should be manufa?
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Learning Objective 6 Know how to choose which products to produce when there are capacity constraints.
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Product-Mix Decisions Under Capacity Constraints

Per unit Product #2 Product #3 Sales price $2.11 $14.50 Variable expenses 0.41 13.90 Contribution margin $1.70 $ 0.60 Contribution margin ratio 81% 4% Bismark Co. has 3,000 machine-hours available.
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Product-Mix Decisions Under Capacity Constraints

One unit of Prod. #2 requires 7 machine-hours. One unit of Prod. #3 requires 2 machine-hours.
What is the contribution of each product per machine-hour? Product #2: $1.70 7 = $0.24 Product #3: $0.60 2 = $0.30
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Discuss what managers must consider when adding or discontinuing customers and segments. Exercise 7-3
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Learning Objective 8 Explain why the book value of equipment is irrelevant in equipment-replacement decisions.
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Exercise 7-8 Equipment Replacement Decision

S company is evaluating to replace an existing machine with a new machine. Existing New Original cost ($) 80,000 120,000 Acc. Depreciation 30,000 0 Residual value 18,000 0 Annual cost savings 0 30,000 Years of useful life 5 5 Required: Whether the new machine should be acquired.
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Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager.
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Decisions and Performance Evaluation

What is the journal entry to sell the existing machine? Cash Accumulated Depreciation Loss on Disposal Machine 18,000 30,000 32,000 80,000
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In the real world would the manager replace the machine? An important factor in replacement decisions is the managers perceptions of whether the decision model is consistent with how the managers performance is judged.
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Top management faces a challenge that is, making sure that the performance-evaluation model of subordinate managers is consistent with the decision model.
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End of Chapter 11
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Decision Making and Relevant Information - ch11

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Decision Making and Relevant Information Chapter 11

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Use the five-step decision process to make decisions.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Information and the Decision Process

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Five-Step Decision Process

Step 4. Implement the Decision

Step 5. Evaluate Performance

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

The Meaning of Relevance

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Learning Objective 3 Distinguish between quantitative and qualitative factors in decisions.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Quantitative and Qualitative Relevant Information

One-Time-Only Special Order Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

One-Time-Only Special Order Example

Direct materials Direct labor Manufacturing costs Total

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

One-Time-Only Special Order Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

One-Time-Only Special Order Example

One-Time-Only Special Order Example

What are the incremental revenues ?

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Exercise 7-1 (Helmkamp) Evaluating a Special Order

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Two Potential Problems in Relevant-Cost Analysis

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Outsourcing versus Insourcing

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Make-or-Buy Decisions Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Make-or-Buy Decisions Example

Make-or-Buy Decisions Example

Make-or-Buy Decisions Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Make-or-Buy Decisions Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Make-or-Buy Decisions Example

Make-or-Buy Decisions Example

$61,500 150,000 = $0.41 per unit

Make-or-Buy Decisions Example

Make-or-Buy Decisions Example

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Make-or-Buy Decisions Example

Bismark would save $3,000 by buying the part.

Exercise 7-5 Make or Buy Situation

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Opportunity Costs, Outsourcing, and Constraints

Opportunity Costs, Outsourcing, and Constraints

2. Buy Part #2 and do not make Part #3.

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Opportunity Costs, Outsourcing, and Constraints

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Opportunity Costs, Outsourcing, and Constraints

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Opportunity Costs, Outsourcing, and Constraints

Opportunity Costs, Outsourcing, and Constraints

Opportunity Costs, Outsourcing, and Constraints

Purchase costs: (150,000 $0.55) $82,500.00

2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster