Chapter 26

Short-Run Alternative Choice Decisions

McGraw-Hill/Irwin

Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

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.

– Decisions relate to a relatively short time horizon.
26-2

Nature of Full and Differential Costs
• Full costs:
– Direct cost + fair share of applicable indirect costs.

• Differential costs:
– Include only those elements of cost that are different under a certain set of conditions.

26-3

• Differential costs: – No comparable system for collecting.Source of Data for Full and Differential Costs • Full costs: – Come from a company’s cost accounting system. – Assembled (sometimes estimated) to meet analytical requirements of a specific problem. 26-4 .

26-5 . • Differential costs: – Relate to future.Historical Cost and Full and Differential Costs • Full cost: – Accounting system collects historical costs. – Show what costs will be if a certain course of action is adopted.

• Focuses on contribution margin: – Total revenue minus total variable cost. 26-6 .Contribution Analysis • A tool for analyzing differential costs.

• Fixed costs: – Total does not vary with volume of activity (within relevant range).Types of Cost • Variable costs: – Total varies proportionately with volume of activity (such as sales). 26-7 . • Indirect costs: – Not directly traceable to cost object. • Direct costs: – Directly traceable to cost object.

• Some problems may not be quantifiable. • Manager chooses best alternative.Alternative Choice Problems • Two or more possible alternative courses of action. too difficult. – Why? Not possible. – Use best judgment. 26-8 . too expensive.

g. • Nonprofit organization: – Provide acceptable quality at lowest possible cost. stabilize employment.Which Alternative is “Best?” • Alternative most likely to achieve objectives of organization. community responsibilities. • Other objectives? – E. 26-9 . maintain market position. • Profit oriented business: – Maximizing value of shareholders’ investment – Satisfactory return on investment (ROI)..

Make decision.Steps in the Analysis 1. 5. 2. – Decision may be to seek additional information. 3. Define problem. 26-10 . Select possible alternatives – Include status quo (base case). 4. Measure and evaluate quantitative factors. Identify and evaluate qualitative factors.

• No general category of costs can be labeled differential. • Also called: – Out-of-pocket costs.Differential Costs • Costs that will be different under the proposed alternative than they are in the base case. incremental costs. • Always relate to specific alternatives being analyzed. relevant costs. 26-11 . avoidable costs.

– Are not differential and may be disregarded (or treated the same under each alternative). • Beware of full cost. • Unaffected costs. – Don’t forget fringe benefits. 26-12 .e.. unaffected). – Allocated costs may not change (i.Mechanics of Calculation • No prescribed format. use most convenient. • Labor cost.

– Not measured in accounting records. – Not associated with cash outlays. capacity of warehouse). – Value lost or sacrificed by giving up an alternative course of action.. – Frequently measured by income that would have been earned had resources been invested otherwise (e. 26-13 .Mechanics of Calculation • Opportunity costs.g. – Frequently difficult to accurately estimate.

may be best estimated by looking at past/historical costs.g. however.Differential Costs • May or may not be the same as variable costs. • May also include fixed costs (e. • Goal is to determine future costs. decision to discontinue a product line).. 26-14 .

all historical costs)..g. is the book value of current equipment a differential cost? What about disposal value? 26-15 . • Question: In the decision to keep or replace equipment. • Not a differential cost.Sunk Cost • Cost that has already been incurred. • Therefore. cannot be changed by any decision currently being considered (e.

only material cost may be differential. • The longer the time span the more items of cost are differential.Importance of Time Span • To make only one additional unit. all items of production cost would be differential. • In the very long run. 26-16 . • To produce an item over foreseeable future. full costs are differential costs.

and investment. • Decisions involving revenues. costs. • Decisions involving revenues and costs.Types of Alternative Choice Problems • Decisions involving only costs. 26-17 .

Where should we store this inventory?.. How should we ship this product? 26-18 . • Methods change decision.g.Decisions Involving Costs • One type of cost is traded for another. Which machine should run this batch?. • Operations planning decision. – E.

– Make alternative more difficult to determine.e. outsourcing). – Trade off between setup (ordering) costs and inventory carrying costs. • Economic order quantity decision.Decisions Involving Costs • Make or buy decision (i.. 26-19 . – Both parts and whole product (service).

– Compare revenue and expense at various prices. after considering affect on volume. 26-20 . – Feasible only if demand schedule can be estimated. • Supply-demand-price analysis decision. revenue and costs.Decisions Involving Both Revenues and Costs • Best alternative is one with most differential income or profit.

e. – Problems: • Will this be considered dumping? (i.. • Will the low price “spoil the market?” 26-21 . – Full cost is normal basis for setting price.. differential revenues exceed differential costs).e. illegal). – Use of contribution price (i.Decisions Involving Both Revenues and Costs • Contribution pricing decision.

26-22 . Why? Product/service is making some contribution to fixed overhead and profit. – Occurs when conventional accounting reports indicate product/service is being sold below full cost. – May discover that is better to keep.Decisions Involving Both Revenues and Costs • Discontinuing a product decision.

adding new flavor of cola).g.Decisions Involving Both Revenues and Costs • Adding services.. – Take care to ensure alternatives do not divert from normal revenues (e. 26-23 . – Finding additional way of using idle capacity.

Decisions Involving Both Revenues and Costs • Sale versus further processing. – Does differential revenue exceed additional processing/marketing costs? • Other marketing tactics.. promotion.e. – Determine how changes in marketing (i. placement) affect differential revenues and costs. 26-24 . product. price.

equity. and Investment • Decisions also involving changes in levels of assets. • E. • Covered in Chapter 27. 26-25 .Decisions Involving Revenues. liabilities. expansion plans.g.. Costs.

Sensitivity Analysis • Considers how sensitive quantitative measurements of alternatives are to changes in assumptions. 26-26 .

fixed costs) have to be added.e. 26-27 . • Solution: Average step-function costs out over the additional units of volume. • At some point step-function costs (i..“Just One” Fallacy • Fallacy is that each additional unit of production adds just variable costs.

. 26-28 .e. • Choose alternative with highest expected value.Expected Values • Discussion has assumed single point estimates (i. best estimates). • Alternative is to use separate possibilities weighted by probabilities to determine expected values.

Decision Tree Analysis • Decision tree diagram shows several decisions (or acts) and possible consequences of each. • Revenues and costs are estimated with probabilities for each outcome to give an expected value for event. 26-29 .

not amount of. Use imagination in selecting alternatives. arguments for or against a decision. However.Practical Pointers 1. 6. don’t slight the numbers. 2. 4. Work with total costs. Don’t overweight your quantitative factors. not unit costs. 26-30 . 3. 5. Be aware of the tendency to underestimate the costs of new ventures. Look at substance of.

10. 26-31 . 9. 8. Identify your assumptions and perform sensitivity analysis.Practical Pointers 7.Do not expect your conclusion to be accepted just because numbers support the decision. Know that delaying too long to decide is a decision. Consider margin of error.

26-32 .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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