11 CH 11

DECISION
MAKING AND
RELEVANT
Chapter
INFORMATION
11
2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Learning Objective 1
Use the five-step decision
process to make decisions.
Information and the

Decision Process
A decision model is a formal method
for making a choice, often involving
quantitative and qualitative analysis.
Feedback
Five-Step Decision Process

Step 1.Gather Information
Historical Costs
Other Information
Step 2. Make Predictions
Specific Predictions
Step 3.
Choose an Alternative
StepImplement
4.
the Decision
Step 5.
Evaluate Performance
Differentiate relevant
from irrelevant
costs and revenues in
decision situations.
The Meaning of Relevance

Relevant costs and relevant revenues are
expected future costs and revenues that
differ among alternative courses of action.
Historical costs
Sunk costs
Differential incomeDifferential costs
Distinguish between quantitative

and qualitative factors in decisions.
Quantitative and Qualitative

Relevant Information
Quantitative factors
Financial
Nonfinancial
Qualitative factors
One-Time-Only
Special Order Example
The Bismark Co. manufacturing plant has a

oduction capacity of 44,000 towels each mont
Current monthly production is 30,000 towels.
osts can be classified as either variable or fixe

with respect to units of output.
One-Time-Only
Variable
Fixed
Costs
Costs
Per Unit
Per Unit
Direct materials
$6.50
$ -0Direct labor
.50
1.50
Manufacturing costs
1.50
3.50
Total
$8.50
$5.00
One-Time-Only
tal fixed direct manufacturing labor is $45,00

Total fixed overhead is $105,000.
Marketing costs per unit are $7
($5 of which is variable).
What is the full cost per towel?
One-Time-Only
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.
One-Time-Only
hat are the relevant costs of making the towel

$8.50 5,000 = $42,500 incremental costs
What are the incremental revenues ?
$57,500 $42,500 = $15,000
Beware of two potential

problems in
relevant-cost analysis.
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.
Outsourcing versus
Insourcing
Outsourcing is
Insourcing is
purchasing goods
producing goods
and services from or providing services
outside vendors. within the organization.
Make-or-Buy Decisions
Example
smark Co. also manufactures bath accessorie
Management is considering producing a part i

needs (#2) or buying a part produced
by Towson Co. for $0.55.
Example
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
Example
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.
Example
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.?
Example
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.
Example
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.
Example
hat is the variable manufacturing cost per uni

Direct material
Direct labor
Variable overhead
Total
$28,000
18,500
15,000
$61,500
$61,500 150,000 = $0.41 per unit

Example
Expected relevant cost to make Part #2:
Manufacturing
Material handling and setups
Total relevant cost to make
*150 $100 = $15,000
$61,500
15,00
$76,
Cost to buy: (150,000 $0.55) $82,500
smark Co. will save $6,000 by making the par

Example
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..
ould Bismark Co. buy the part or make the pa
Example
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

Explain the opportunity-cost

concept and why it is
used in decision making.
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?
Opportunity Costs,
ismark 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 pro

Part #3.
Opportunity Costs,
Expected cost of obtaining 150,000 parts:
Buy Part #2 and do not make Part #3:
Buy Part #2 and make Part #3:
$82,500 $18,000 =
Make Part #2:
$64,5
$76,5
Opportunity Costs,
Opportunity cost is the contribution to income

that is forgone (rejected) by not using a
mited resource in its next-best alternative use
Opportunity Costs,
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.
Opportunity Costs,
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
Opportunity Costs,
Option A: Make 100 purchases of 1,500 units:

Purchase order costs: (100 $40)
$ 4
Purchase costs: (150,000 $0.55) $82,50

Annual interest income:
Relevant costs:
24
$86,524.75
Opportunity Costs,
Option B: Make 1 purchase of 150,000 units:
Purchase order costs: (1 $40)
Purchase costs: (150,000 $0.54)
$81
Annual interest income:

Relevant costs:
$ 2,43
$83,470
Know how to choose which

products to produce when there
are capacity constraints.
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%
ismark Co. has 3,000 machine-hours available
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
Discuss what managers

must consider when
adding or discontinuing
customers and segments.
Profitability, Activity-Based
Costing, and Relevant Costs
Mountain View Furniture supplies furniture

to two local retailers Stevens and Cohen.
The company has a monthly capacity
of 3,000 machine-hours.
ed costs are allocated on the basis of revenue
Stevens
Cohen
Revenues$200,000 $100,000
Variable costs
70,000 60,000
Fixed costs
100,000 50,000
Total operating costs
$170,000 $110,000
Operating income $ 30,000 $(10,000)
Machine-hours required
2,000
1,000
Total
Revenues$300,000
Variable costs 130,000
Fixed costs
150,000
Total operating costs
$280,000
Operating income $ 20,000
3,000
hould Mountain View Furniture drop the Cohe

business, assuming that dropping Cohen would
decrease its total fixed costs by 10%?
New fixed costs would be:
$150,000 $15,000 = $135,000
Stevens Alone
Revenues$200,000
Variable costs
70,000
Fixed costs 135,000
Total operating costs $205,000
Operating income $ (5,000)
3,000
Cohens business is providing a

contribution margin of $40,000.
$40,000 decrease in contribution margi
$15,000 decrease in fixed costs
= $25,000 decrease in operating incom
Assume that if Mountain View Furniture drops

ohens business it can lease the excess capaci
to the Perez Corporation for $70,000.
Fixed costs would not decrease.
hould Mountain View Furniture lease to Perez
Explain why the book value

of equipment is irrelevant in
equipment-replacement decisions.
Equipment-Replacement
Decisions Example
Existing Replaceme
Machine
Machine
Original cost
$80,000 $105,000
Useful life
4 years
4y
Accumulated depreciation $50,000
Book value
$30,000
Disposal price
$14,000
Annual costs
$46,000 $ 10,000
Equipment-Replacement
Decisions Example
Ignoring the time value of money and

income taxes, should the company
replace the existing machine?
The cost savings over a 4-year period will be
$36,000 4 = $144,000.
Investment = $105,000 $14,000 = $91,000
$144,000 $91,000 = $53,000
advantage of the replacement machine.
Explain how conflicts can arise
between the decision model
used by a manager and the
performance evaluation model
used to evaluate the manager.
Decisions and
Performance Evaluation
t is the journal entry to sell the existing mach

Cash
14,000
Accumulated Depreciation
50,000
Loss on Disposal
16,000
Machine
80,000
Decisions and
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.
Decisions and
Top management faces a challenge that is,

making sure that the performance-evaluation
model of subordinate managers is consistent
with the decision model.
END OF
CHAPTER 11

11 CH 11

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DECISION

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

Information and the

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

Five-Step Decision Process

Step 2. Make Predictions

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

The Meaning of Relevance

Differential incomeDifferential costs

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

Distinguish between quantitative

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

Quantitative and Qualitative

The Bismark Co. manufacturing plant has a

osts can be classified as either variable or fixe

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

tal fixed direct manufacturing labor is $45,00

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

A hotel in San Juan has offered to buy

hat are the relevant costs of making the towel

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

Beware of two potential

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

Two Potential Problems in

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

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

smark Co. also manufactures bath accessorie

Management is considering producing a part i

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

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

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

hat is the variable manufacturing cost per uni

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

Cost to buy: (150,000 $0.55) $82,500

smark Co. will save $6,000 by making the par

ould Bismark Co. buy the part or make the pa

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

Bismark would save $3,000 by buying the part

Explain the opportunity-cost

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

ismark Co. has three options regarding Krysta

1. Make Part #2 and do not make Part #3.

3. Buy the part and use the facilities to pro

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

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

Opportunity cost is the contribution to income

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

Option A: Make 100 purchases of 1,500 units:

Purchase costs: (150,000 $0.55) $82,50

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

Purchase costs: (150,000 $0.54)

Annual interest income:

Know how to choose which

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

One unit of Prod. #2 requires 7 machine-hours

One unit of Prod. #3 requires 2 machine-hours

Discuss what managers

Mountain View Furniture supplies furniture

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

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

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

hould Mountain View Furniture drop the Cohe

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