A181 Bkam3023 Topic 5 - Short-Term Decision-Making

TOPIC 5
SHORT-TERM DECISION
MAKING
McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

COST INFORMATION FOR DECISION
13-2
MAKING
• Cost accounting is a task of collecting, analyzing,
summarizing and evaluating various alternative courses of
action. Its goal is to advise the management on the most
appropriate course of action based on the cost efficiency
and capability. Cost accounting provides the detailed cost
information that management needs to control current
operations and plan for the future.

13-3
COST INFORMATION FOR DECISION MAKING
• Since managers are making decisions only for

their own organization, there is no need for the
information to be comparable to similar
information from other organizations. Instead,
information must be relevant for a particular
environment. Cost accounting information is
commonly used in financial accounting
information, but its primary function is for use by
managers to facilitate making decisions.
13-4
SHORT-RUN DECISION MAKING
• Short-run decision making consists of choosing

among alternatives with an immediate or limited
end in view.
• Also referred to as tactical decisions because they
involve choosing between alternatives with an
immediate or limited time frame in mind.
LO-1
The Concept of Relevance

13-6
COST CONCEPTS FOR
DECISION MAKING
A relevant cost is a cost that differs between
alternatives.
2
1

13-7
RELEVANT COSTS DEFINED
• The decision-making approach just described emphasized

the importance of identifying and using relevant costs.
• Relevant costs possess two characteristics:
• they are future costs AND
• they differ across alternatives.
• All pending decisions relate to the future.
• Accordingly, only future costs can be relevant to decisions.
LO-1
13-8
IDENTIFYING RELEVANT COSTS

An avoidable cost can be eliminated, in whole or in
part, by choosing one alternative over another.
Avoidable costs are relevant costs. Unavoidable
costs are irrelevant costs.
Two broad categories of costs are never relevant in

any decision. They include:
Sunk costs.
Future costs that do not differ between the
alternatives.
13-9
OPPORTUNITY COSTS
• Opportunity cost is the benefit sacrificed or foregone when

one alternative is chosen over another.
• An opportunity cost is relevant because it is both a future
cost and one that differs across alternatives.
• An opportunity cost is never an accounting cost, because
accountants do not record the cost of what might happen in
the future (i.e., they do not appear in financial statements).
LO-1
13-10
SUNK COSTS
• A sunk cost is a cost that cannot be affected by any

future action.
• It is important to note the psychology behind managers’
treatment of sunk costs.
• Although managers should ignore sunk costs for relevant
decisions, it unfortunately is human nature to allow sunk
costs to affect these decisions.
LO-1
13-11
SUNK COSTS (CONT.)
• For example, depreciation, a sunk cost, is

sometimes allocated to future periods though
the original cost is unavoidable.
• In choosing between the two alternatives, the
original cost of an asset and its associated
depreciation are not relevant factors.
LO-1
RELEVANT COST ANALYSIS:
13-12
A TWO-STEP PROCESS
Step 1 Eliminate costs and benefits that do not differ

between alternatives.
Step 2 Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable, costs.

DIFFERENT COSTS FOR DIFFERENT
13-13
PURPOSES
Costs that are

relevant in one
decision situation
may not be relevant
in another context.

13-14
Cynthia, a Boston student, is considering visiting her friend in New York.

She can drive or take the train. By car, it is 230 miles to her friend’s
apartment. She is trying to decide which alternative is less expensive
and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)

Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569
$45
$45 per
per month
month × 8 months $1.60 per gallon ÷ 32 MPG
$18,000
$18,000 cost
cost – $4,000 salvage value ÷÷ 55 years
years
13-15

Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569
Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25

13-16
Which costs and benefits are relevant in Cynthia’s

decision?
The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she drives
current decision. or takes the train.
However, the cost of gasoline is clearly relevant

if she decides to drive. If she takes the train,
the cost would now be incurred, so it varies
depending on the decision.

13-17

decision?
The cost of The monthly

maintenance and school parking
repairs is relevant. In fee is not
the long-run these relevant because
costs depend upon it must be paid if
miles driven. Cynthia drives or
takes the train.
At this point, we can see that some of the average

cost of $0.569 per mile are relevant and others are
not.
13-18

decision?
The decline in resale The round-trip train

value due to additional fare is clearly relevant.
miles is a relevant If she drives the cost
cost. can be avoided.
Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.

13-19

decision?
The cost of parking is

relevant because it can
be avoided if she takes
the train.
The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.

13-20
From a financial standpoint, Cynthia would be better

off taking the train to visit her friend. Some of the
non-financial factor may influence her final decision.
Relevant Financial Cost of Driving

Gasoline (460 @ $0.050 per mile) $ 23.00
Maintenance (460 @ $0.065 per mile) 29.90
Reduction in resale (460 @ $0.026 per mile) 11.96
Parking in New York (2 days @ $25 per day) 50.00
Total $ 114.86
Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104.00

TOTAL AND DIFFERENTIAL COST
13-21
APPROACHES
The management of a company is considering a new labor saving
machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000

13-22
TOTAL AND DIFFERENTIAL COST
APPROACHES
As you can see, the only costs that differ between the alternatives are
the direct labor costs savings and the increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
We can efficiently analyze the decision by 62,000

Other
Rent on new machine-
62,000
3,000
-
(3,000)
looking at the different costs and revenues

Total fixed expenses
62,000
Net operating income
$ 18,000 $
65,000
30,000
(3,000)
12,000
and arrive at the same solution.

Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000

13-23
Limiting Factor

13-24
OPTIMAL PRODUCT MIX
Product Mix and Constrained Resources
-A company's product mix determines the proportionate

amount of each product it offers to its customers. Some
companies may produce an equal percentage of each product
for sale. Most small businesses that want to maximize
revenue, however, determine an optimal product mix to take
advantage of their different production strengths and meet
their customers' needs.
-Over the long term, a company can expand its capacity but in
the short term,
it must make important decisions in order to maximize profit.

13-25
PRODUCT MIX AND CONSTRAINED
RESOURCES
• -Constrained resources require businesses to make

decisions about which products to make and in what
quantities.
• -How does a company decide which product
is given priority over constrained resources?
• -We must look at how each product uses the
constrained resource and maximize contribution
margin per hour.

13-26
KEY TERMS AND CONCEPTS
When a limited resource of

some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.
The machine or process

that is limiting overall
output is called the
bottleneck – it is the
constraint.

13-27
UTILIZATION OF A CONSTRAINED
RESOURCE
• When a constraint exists, a company should

select a product mix that maximizes the total
contribution margin earned since fixed costs
usually remain unchanged.
• A company should not necessarily promote those
products that have the highest unit contribution
margin.
• Rather, it should promote those products that
earn the highest contribution margin in relation to
the constraining resource.

UTILIZATION OF A CONSTRAINED RESOURCE:
13-28
AN EXAMPLE
Ensign Company produces two products and selected data are shown below:

13-29
RESOURCE
• Machine
Machine A1
A1 is
is the
the constrained
constrained resource
resource and
and is
is
being
being used
used at
at 100%
100% of of its
its capacity.
capacity.
• There
There is
is excess
excess capacity
capacity on on all
all other
other machines.
machines.
• Machine
Machine A1A1 has
has aa capacity
capacity ofof 2,400
2,400 minutes
minutes per
per
week.
week.
Should
Should Ensign
Ensign focus
focus its
its efforts
efforts on
on
Product
Product 11 or
or Product
Product 2?
2?

13-30
QUICK CHECK 
How many units of each product can be processed through

Machine A1 in one minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit

13-31
QUICK CHECK 
How many units of each product can be

processed through Machine A1 in one minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
I was just checking to make sure
you are with us.
13-32
QUICK CHECK 
What generates more profit for the company,

using one minute of machine A1 to process
Product 1 or using one minute of machine A1
to process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

13-33
QUICK CHECK 
With one minute of machine A1, we could
make 1 unit of Product 1, with a contribution
margin of $24, or 2 units of Product 2, each
with a contribution margin of $15.
2 × $15 = $30 > $24
What
What generates
generates more
more profit
profit for
for the
the company,
company, using
using one
one minute
minute of
of machine
machine A1
A1
to
to process
process Product
Product 11 or
or using
using one
one minute
minute of
of machine
machine A1
A1 to
to process
process Product
Product 2?
2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.

13-34
RESOURCE
The key is the contribution margin per unit of the

constrained resource.
Product 2 should be emphasized. Provides more

valuable use of the constrained resource machine A1,
yielding a contribution margin of $30 per minute as
opposed to $24 for Product 1.

13-35
RESOURCE
The key is the contribution margin per unit of the

constrained resource.
IfIf there
there are
are no
no other
other considerations,
considerations, the
the best
best
plan
plan would
would be
be to
to produce
produce to
to meet
meet current
current
demand
demand for for Product
Product 22 and
and then
then use
use remaining
remaining
capacity
capacity to
to make
make Product
Product 1.
1.

13-36
RESOURCE
Let’s see how this plan would work.

Alloting
Alloting Our
Our Constrained
Constrained Resource
Resource (Machine
(Machine A1)
A1)
Weekly
Weekly demand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.

13-37
RESOURCE
Alloting
Alloting Our
Our Constrained
Resource (Machine
(Machine A1)
A1)
Weekly
Weekly demand
demand for
for Product
Product22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product22 1,100
1,100 min.
min.
Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product11 1,300
1,300 min.
min.

13-38
RESOURCE
Alloting
Alloting Our
Our Constrained
Resource (Machine
(Machine A1)
A1)
Weekly
Weekly demand
demand for
for Product
Product 22 2,200
2,200 units
units
Time
Time required
required per
per unit
unit ×× 0.50
0.50 min.
min.
Total
Total time
time required
required to
to make
make
Product
Product 22 1,100
1,100 min.
min.
Total
Total time
time available
available 2,400
2,400 min.
min.
Time
Time used
used to
to make
make Product
Product 22 1,100
1,100 min.
min.
Time
Time available
available for
for Product
Product 11 1,300
1,300 min.
min.
Time
Time required
required per
per unit
unit ÷÷ 1.00
1.00 min.
min.
Production
Production of of Product
Product 11 1,300
1,300 units
units

13-39
RESOURCE
According to the plan, we will produce 2,200 units of

Product 2 and 1,300 of Product 1. Our contribution
margin looks like this.
Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000
The total contribution margin for Ensign is $64,200.

13-40
QUICK CHECK 
Colonial Heritage makes reproduction colonial furniture from

select hardwoods.
Chairs Tables
Selling price per unit $80 $400
Variable cost per unit $30 $200
Board feet per unit 2 10
Monthly demand 600 100
The company’s supplier of hardwood will only be able to

supply 2,000 board feet this month. Is this enough hardwood
to satisfy demand?
a. Yes
b. No
13-41
QUICK CHECK 
Colonial Heritage makes reproduction colonial furniture from

select hardwoods.
Chairs Tables
The company’s supplier of hardwood will only be able to

supply 2,000 board feet this month. Is this enough hardwood
to satisfy demand?
a. Yes (2  600) + (10  100 ) = 2,200 > 2,000
b. No
13-42
QUICK CHECK 
Chairs Tables
The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month.
What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables

13-43
Chairs Tables
QUICK CHECK Sellingprice $ 80 $ 400
Variable cost 30 200
Chairs Tables
Contribution margin $ 50 $ 200
VariableBoard feet
cost per unit $30 $2002 10
CMper
Board feet perunit
board foot 2 $ 1025 $ 20
Production
The company’s supplier of chairswill only
of hardwood 600be
able to supply 2,000 board
Board feetfeet this month.1,200
required What plan
would maximize profits?
Board feet capacity 2,000
a. 500 chairs andBoard
100 tables
feet remaining 800
b. 600 chairs andBoard feet per table
80 tables 10
c. 500 chairs andProduction
80 tables of tables 80
d. 600 chairs and 100 tables

13-44
QUICK CHECK 
As before, Colonial Heritage’s supplier of hardwood will only

be able to supply 2,000 board feet this month. Assume the
company follows the plan we have proposed. Up to how much
should Colonial Heritage be willing to pay above the usual
price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero

13-45
QUICK CHECK 
As before, Colonial Heritage’s supplier of hardwood will only
be ableadditional
The to supply 2,000 boardwould
wood feet thisbe
month.
usedAssume the
to make
company follows
tables. In the
thisplan we have
use, each proposed.
boardUp to how
foot of much
should Colonial
additional woodHeritage
will be willing
allow to pay
the above the to
company usual
earn
an
priceadditional $20
to obtain more of contribution margin and
hardwood?
a. $40 per board foot
foot profit.
b. $25 per board foot
c. $20 per board foot
foot
d. Zero

13-46
THEORY OF CONSTRAINT
The Theory of Constraints is a methodology for identifying the most important
limiting factor (i.e. constraint) that stands in the way of achieving a goal and
then systematically improving that constraint until it is no longer the limiting
factor. In manufacturing, the constraint is often referred to as a bottleneck.
The theory of constraints states that any system contains a choke point that
prevents it from achieving its goals. This choke point, which is also known as a
bottleneck or constraint, must be carefully managed to ensure that it is
operational as close to all of the time as possible. If not, then goals may not be
achieved. The reason is that no additional throughput (revenue minus all
variable expenses) can be generated unless the capacity of the constraint is
increased.

13-47

13-48
MANAGING CONSTRAINTS
At the bottleneck itself:

• Improve the process
Finding ways to • Add overtime or another
process more units
through a resource
shift
bottleneck • Hire new workers or acquire
more machines
• Subcontract production
• Reduce amount of defective
units produced
• Add workers transferred
from
13-49
THROUGHPUT ACCOUNTING (TA)
Throughput Accounting (TA) is a principle-

based and simplified management accounting
approach that provides managers with decision
support information for enterprise profitability
improvement. TA is relatively new in
management accounting. It is an approach that
identifies factors that limit an organization from
reaching its goal, and then focuses on simple
measures that drive behavior in key areas
towards reaching organizational goals.
13-50
OTHER DECISIONS
make or buy
special order
keep or drop
further processing
(including joint costs
allocation

13-51
LEARNING OBJECTIVE 3
Prepare a make or buy

analysis.

13-52
THE MAKE OR BUY DECISION
When a company is involved in more than one

activity in the entire value chain, it is vertically
integrated. A decision to carry out one of the
activities in the value chain internally, rather than to
buy externally from a supplier is called a “make or
buy” decision.

VERTICAL INTEGRATION-
13-53
ADVANTAGES
Smoother flow of
parts and materials
Better quality
control
Realize profits

VERTICAL INTEGRATION-
13-54
DISADVANTAGE
Companies may fail

to take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous
companies.

13-55
THE MAKE OR BUY DECISION: AN

EXAMPLE
• Essex Company manufactures part 4A that is used in one

of its products.
• The unit product cost of this part is:
Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30

13-56
• The special equipment used to manufacture part 4A has no resale

value.
• The total amount of general factory overhead, which is allocated on
the basis of direct labor hours, would be unaffected by this decision.
• The $30 unit product cost is based on 20,000 parts produced each
year.
• An outside supplier has offered to provide the 20,000 parts at a cost
of $25 per part.
Should we accept the supplier’s offer?

13-57

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000
20,000 × $9 per unit = $180,000

13-58

Cost
Make Buy

Total cost $ 30 $ 340,000 $ 500,000
The
The special
special equipment
equipment hashas no
no resale
resale
value
value and
and is
is aa sunk
sunk cost.
cost.

13-59

Cost
Make Buy

Total cost $ 30 $ 340,000 $ 500,000
Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is
dropped,
dropped, itit will
will be
be reallocated
reallocated toto other
other products.
products.

13-60

Cost
Make Buy

Total cost $ 30 $ 340,000 $ 500,000
Should we make or buy part 4A?

13-61
OPPORTUNITY COST
An opportunity cost is the benefit that is foregone as a

result of pursuing some course of action.
Opportunity costs are not actual dollar outlays and are not
recorded in the formal accounts of an organization.
How would this concept potentially relate to the Essex

Company?

13-62
Prepare an analysis
showing whether a special
order should be accepted.

13-63
KEY TERMS AND CONCEPTS
A special order is a one-time

order that is not considered
part of the company’s normal
ongoing business.
When analyzing a special

order, only the incremental
costs and benefits are
relevant.

13-64
SPECIAL ORDERS
Jet, Inc. makes a single product whose normal selling

price is $20 per unit.
A foreign distributor offers to purchase 3,000 units for
$10 per unit.
This is a one-time order that would not affect the
company’s regular business.
Annual capacity is 10,000 units, but Jet, Inc. is
currently producing and selling only 5,000 units.
Should Jet accept the offer?
13-65
SPECIAL ORDERS
$8 variable cost

13-66
SPECIAL ORDERS
If Jet accepts the offer, net operating income will

increase by $6,000.
Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000
Note: This answer assumes that fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.
13-67
QUICK CHECK 
Northern Optical ordinarily sells the X-lens for $50. The

variable production cost is $10, the fixed production cost is
$18 per unit, and the variable selling cost is $1. A customer
has requested a special order for 10,000 units of the X-lens to
be imprinted with the customer’s logo. This special order
would not involve any selling costs, but Northern Optical
would have to purchase an imprinting machine for $50,000.
(see the next page)

13-68
QUICK CHECK 
What is the rock bottom minimum price below which Northern

Optical should not go in its negotiations with the customer? In
other words, below what price would Northern Optical actually
be losing money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no further use
after this order.
a. $50
b. $10
c. $15
d. $29

13-69
QUICK CHECK 
What is the rock bottom minimum price below which Northern

Optical should not go in its negotiations with the customer? In
other words, below what price would Northern Optical actually
be losing money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no further use
after this order.
a. $50 Variable production cost $100,000
b. $10 Additional fixed cost + 50,000
c. $15 Total relevant cost $150,000
d. $29 Number of units 10,000
Average cost per unit = $15
13-70
Keep or Drop

13-71
ADDING/DROPPING SEGMENTS
One of the most important decisions managers make is

whether to add or drop a business segment, such as a
product or a store.
Let’s
Let’s see
see how
how relevant
relevant costs
costs should
should be
be
used
used in
in this
this type
type of
of decision.
decision.

13-72
Due to the declining popularity of digital

watches, Lovell Company’s digital watch line
has not reported a profit for several years.
Lovell is considering dropping this product
line.

13-73
A CONTRIBUTION MARGIN
APPROACH
DECISION
DECISION RULE
RULE
Lovell
Lovell should
should drop
drop the
the digital
digital watch
watch segment
segment only
only if
if its
its
profit
profit would
would increase.
increase. This
This would
would only
only happen
happen if
if the
the
fixed
fixed cost
cost savings
savings exceed
exceed the
the lost
lost contribution
contribution margin.
margin.
Let’s
Let’s look
look at
at this
this solution.
solution.

13-74
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
13-75
Digital Watches
Sales $ 500,000
Investigation has revealed that total fixed general
Investigation has revealed that
Variable manufacuring costs $ 120,000
total fixed general
factory overhead
overhead and
factory costs
Variable shipping and general
general
5,000
administrative
administrative
Commissions expenses
expenses would not
not be
would75,000 be affected
affected ifif
200,000
the
the digital
Contribution watch
watch line
margin
digital line is
is dropped.
dropped. The The fixed
$ 300,000
fixed
general
general factory
factory overhead
overhead and general
General factory overhead $ 60,000general
and
administrative
administrative expenses
expenses assigned
Salary of line manager assigned to
90,000to this
this product
product
would
would be
Depreciation reallocated
be of equipment to
reallocated to other
other product
product lines.
50,000 lines.
Rent - factory space 70,000

13-76
Digital Watches
Sales $ 500,000
The
The equipment
equipment
Variable used to
to manufacture
usedcosts
manufacturing manufacture
$ 120,000
Variable shipping costs 5,000
digital watches has no resale
digital watches has no resale
Commissions 75,000 200,000
value
value
Contribution or
or alternative
marginalternative use.
use. $ 300,000
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Should
Should Lovell
Lovell retain
retain or
or drop
drop
Rent - factory space the
the digital
digital watch
70,000 segment?
watch segment?

13-77
Prepare an analysis
showing whether joint
products should be sold at
the split-off point or
processed further.

13-78
JOINT COSTS
• In some industries, a number of end products

are produced from a single raw material
input.
• Two or more products produced from a
common input are called joint
joint products.
products
• The point in the manufacturing process where
each joint product can be recognized as a
separate product is called the split-off
split-off point.
point
13-79
JOINT PRODUCTS
Oil
Common
Joint
Production Gasoline
Input
Process
Chemicals
Split-Off
Point

13-80
JOINT PRODUCTS
Joint
Costs Oil
Separate Final
Processing Sale
Common
Joint Final
Production Gasoline
Input Sale
Process
Separate Final
Chemicals
Processing
Sale
Split-Off Separate
Point Product
Costs
13-81
THE PITFALLS OF ALLOCATION
Joint costs are often

allocated to end products on
the basis of the relative
sales value of each product
or on some other basis.
Although allocation is needed for

some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
13-82
SELL OR PROCESS FURTHER
Joint costs are irrelevant in decisions regarding what

to do with a product from the split-off point
forward.
It will always be profitable to continue processing a

joint product after the split-off point so long as the
incremental revenue exceeds the incremental
processing costs incurred after the split-off point.

SELL OR PROCESS FURTHER: AN
13-83
EXAMPLE
• Sawmill,
Sawmill, Inc.
Inc. cuts
cuts logs
logs from
from which
which unfinished
unfinished lumber
lumber
and
and sawdust
sawdust are
are the
the immediate
immediate joint
joint products.
products.
• Unfinished
Unfinished lumber
lumber is
is sold
sold “as
“as is”
is” or
or processed
processed further
further
into
into finished
finished lumber.
lumber.
• Sawdust
Sawdust can
can also
also be
be sold
sold “as
“as is”
is” to
to gardening
gardening
wholesalers
wholesalers or
or processed
processed further
further into
into “presto-logs.”
“presto-logs.”

13-84
Data about Sawmill’s joint products includes:

Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40
Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

13-85

Analysis of Sell or Process Further
Per Log
Lumber Sawdust
Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10

13-86

Per Log
Lumber Sawdust

Profit (loss) from further processing $ 80 $ (10)

13-87

Per Log
Lumber Sawdust

Profit (loss) from further processing $ 80 $ (10)
Should we process the lumber further

and sell the sawdust “as is?”
13-88
QUALITATIVE FACTORS
Definition: Qualitative factors are decision outcomes
that cannot be measured. Examples of qualitative
factors are:
•Morale. The impact on employee morale of adding a

break room to the production area.
•Customers. The impact on customer opinions of a

business if an investment is made in answering their
phone calls in less time by adding customer support
staff.

13-89
QUALITATIVE FACTORS
• Investors. The impact on investors of conducting a road show

to meet as many of them as possible.
• Community. The impact on the local community of allowing
employees to spend a few hours of paid time assisting with
community projects.
• Products. It may be possible to use somewhat cheaper
components in products. However, if this is done too much, it
may create an overall impression of reduced quality, which
may lead customers to buy fewer products.

13-90
QUALITATIVE FACTORS
• A manager should consider qualitative factors as part of

his or her analysis of a decision. Depending on the
manager and the level of investment involved, qualitative
factors can be the deciding point in whether to engage in
a certain activity. For example, if a large investment of
funds is involved, the key decision factors are more
likely to be quantitative, since the investing business has
a great deal at stake in the decision. However, if the
investment of funds is minor, the impact of qualitative
factors could play a more important role in the decision.
13-91
PRICING & BIDDING DECISIONS AND
STRATEGIES
Factors that affect the bidding decisions (eg: construction
company):
1.Project size and value, managerial complexity

-What is the value of the project
-Projected cash flow required during execution
-Desired rate of investment required by company

13-92
FACTORS THAT AFFECT THE BIDDING
DECISIONS
3.Current and projected workload of the tenderer

• Need for work
• Other projects currently out for tender
• Forecast for upcoming projects
2.Regional market conditions
• Economical situation overall
• Situation of the construction industry
• How many projects are currently available n the market
• How many competitors are expected to bid

13-93
FACTORS THAT AFFECT THE BIDDING
DECISIONS
4.Type of client
•Public or private
•Financial capability of the client
•Reputation of the client
5.Type of project
•Site location and accessibility
•Is the project within the company boundaries
•Delivery method of the project

13-94
END OF TOPIC 5

A181 Bkam3023 Topic 5 - Short-Term Decision-Making

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TOPIC 5

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

COST INFORMATION FOR DECISION MAKING

• Since managers are making decisions only for

SHORT-RUN DECISION MAKING

• Short-run decision making consists of choosing

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

COST CONCEPTS FOR

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

RELEVANT COSTS DEFINED

• The decision-making approach just described emphasized

IDENTIFYING RELEVANT COSTS

Two broad categories of costs are never relevant in

• Opportunity cost is the benefit sacrificed or foregone when

• A sunk cost is a cost that cannot be affected by any

SUNK COSTS (CONT.)

• For example, depreciation, a sunk cost, is

Step 1 Eliminate costs and benefits that do not differ

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

Costs that are

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

IDENTIFYING RELEVANT COSTS

Cynthia, a Boston student, is considering visiting her friend in New York.

Automobile Costs (based on 10,000 miles driven per year)

IDENTIFYING RELEVANT COSTS

Some Additional Information

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

IDENTIFYING RELEVANT COSTS

Which costs and benefits are relevant in Cynthia’s

The cost of the The annual cost of

However, the cost of gasoline is clearly relevant

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

IDENTIFYING RELEVANT COSTS

Which costs and benefits are relevant in Cynthia’s

The cost of The monthly

At this point, we can see that some of the average

IDENTIFYING RELEVANT COSTS

Which costs and benefits are relevant in Cynthia’s

The decline in resale The round-trip train

Relaxing on the train is The kennel cost is not

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

IDENTIFYING RELEVANT COSTS

Which costs and benefits are relevant in Cynthia’s

The cost of parking is

The benefits of having a car in New York and

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

IDENTIFYING RELEVANT COSTS

From a financial standpoint, Cynthia would be better

Relevant Financial Cost of Driving

Relevant Financial Cost of Taking the Train

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

We can efficiently analyze the decision by 62,000

looking at the different costs and revenues

and arrive at the same solution.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

OPTIMAL PRODUCT MIX

Product Mix and Constrained Resources

-A company's product mix determines the proportionate

McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc.

• -Constrained resources require businesses to make