14-1

14 Chapter
Fourteen

Decision Making:
Relevant Costs and
Benefits

McGraw-Hill/Irwin
 14-2

The Managerial Accountant’s Role

in Decision Making
Managerial
Managerial
Accountant
Accountant
Cross-functional
Cross-functional
Designs management
management teams
teams
Designs and
and implements
implements
accounting who
who make
make
accounting information
information
system production,
production, marketing,
marketing,
system
and
and finance
finance decisions
decisions

Make
Make substantive
substantive
economic
economic decisions
decisions
affecting
affecting operations
operations
McGraw-Hill/Irwin
 14-3

Exh.

The Decision-Making Process 14-1

1.
1. Clarify
Clarify the
the Decision
Decision Problem
Problem

2.
2. Specify
Specify the
the Criterion
Criterion

3.
3. Identify
Identify the
the Alternatives
Alternatives
Quantitative
Analysis
4.
4. Develop
Develop aa Decision
Decision Model
Model

5.
5. Collect
Collect the
the Data
Data

6.
6. Make
Make aa Decision
Decision

McGraw-Hill/Irwin
 14-4

The Decision-Making Process

1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the
responsibility of the 3. Identify the Alternatives
managerial
accountant. 4. Develop a Decision Model

5. Collect the Data

Information
Information should
should be:
be:
1.
1. Relevant
Relevant
2.
2. Accurate
Accurate 6. Make a Decision
3.
3. Timely
Timely
McGraw-Hill/Irwin
 14-5

The Decision-Making Process

1. Clarify the Decision Problem
Relevant
Relevant
Pertinent
Pertinent to
to aa
decision 2. Specify the Criterion
decision problem.
problem.

Accurate
Accurate 3. Identify the Alternatives
Information
Information must
must
be
be precise.
precise. 4. Develop a Decision Model

Timely
Timely 5. Collect the Data
Available
Available in
in time
time
for
for aa decision
decision 6. Make a Decision

McGraw-Hill/Irwin
 14-6

The Decision-Making Process

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Qualitative
Qualitative
Considerations 4. Develop a Decision Model
Considerations

5. Collect the Data

6. Make a Decision

McGraw-Hill/Irwin
 14-7

Relevant Information
Information
Information is
is relevant
relevant to
to aa decision
decision
problem
problem when
when .. .. ..

 ItIt has
has aa bearing
bearing on
on the
the future,
future,
 It

It differs
differs among
among competing
competing alternatives.
alternatives.

McGraw-Hill/Irwin
 14-8

Identifying Relevant
Costs and Benefits
Sunk
Sunk costs
costs
Costs
Costs that
that have
have already
already been
been incurred.
incurred.
They
They dodo not
not affect
affect any
any future
future cost
cost and
and
cannot
cannot be
be changed
changed byby any
any current
current or
or
future
future action.
action.

Sunk costs are irrelevant to decisions.

McGraw-Hill/Irwin
 14-9

Relevant Costs
Worldwide Airways is thinking about replacing a three
year old loader with a new, more efficient loader.
New
New loader
loader
List
List price
price $$ 15,000
15,000
Annual
Annual operating
operating expenses
expenses 45,000
45,000
Expected
Expected life
life in
in years
years 11
Old
Old loader
loader
Original
Original cost
cost $$100,000
100,000
Remaining
Remaining bookbook value
value 25,000
25,000
Disposal
Disposal value
value now now 5,000
5,000
Annual
Annual variable
variable expenses
expenses 80,000
80,000
Remaining
Remaining lifelife in
in years
years 11

McGraw-Hill/Irwin
 14-10

Relevant Costs

IfIf we
we keep
keep the
the old
old loader,
loader, we
we will
will have
have depreciation
depreciation
costs
costs of
of $25,000.
$25,000. IfIf we
we replace
replace the the old
old loader,
loader,
we
we will
will write-off
write-off the
the $25,000
$25,000 when
when sold. sold. There
There isis
no
no difference
difference inin the
the cost,
cost, so
so itit is
is not
not relevant
relevant..

The new loader will be depreciated in one year.

McGraw-Hill/Irwin
 14-11

Relevant Costs

The
The $5,000
$5,000 proceeds
proceeds will
will only
only be
be realized
realized ifif we
we
replace
replace the
the old
old loader.
loader. This
This amount
amount isis relevant
relevant..

McGraw-Hill/Irwin
 14-12

Relevant Costs

WeWe will
will only
only have
have depreciation
depreciation on
on the
the new
new loader
loader
ifif we
we replace
replace the
the old
old loader.
loader. This
This cost
cost is
is relevant
relevant..

McGraw-Hill/Irwin
 14-13

Relevant Costs

The
The difference
difference in in operating
operating costs
costs is
is relevant
relevant
to
to the
the immediate
immediate decision.
decision.

McGraw-Hill/Irwin
 14-14

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

McGraw-Hill/Irwin
 14-15

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?

McGraw-Hill/Irwin
 14-16

Accept or Reject a Special Order

 A
A travel
travel agency
agency offers
offers Worldwide
Worldwide Airways
Airways
$150,000
$150,000 forfor aa round-trip
round-trip flight
flight from
from Hawaii
Hawaii toto
Japan
Japan on on aa jumbo
jumbo jet.
jet.
 Worldwide
Worldwide usually
usually gets
gets $250,000
$250,000 in in revenue
revenue
from
from this
this flight.
flight.
 The
The airlines
airlines is
is not
not currently
currently planning
planning toto add
add any
any
new
new routes
routes andand has
has two
two planes
planes that
that are
are idle
idle and
and
could
could bebe used
used to to meet
meet the
the needs
needs ofof the
the agency.
agency.
 The
The next
next screen
screen shows
shows cost
cost data
data developed
developed by by
managerial
managerial accountants
accountants at at Worldwide.
Worldwide.

McGraw-Hill/Irwin
 14-17

Accept or Reject a Special Order

Worldwide will save about $5,000 in reservation

and ticketing costs if the charter is accepted.
McGraw-Hill/Irwin
 14-18

Accept or Reject a Special Order

Since
Since the
the charter
charter will
will contribute
contribute toto fixed
fixed costs
costs and
and
Worldwide
Worldwide has
has idle
idle capacity,
capacity, thethe company
company should
should
accept
accept the
the flight.
flight.

McGraw-Hill/Irwin
 14-19

Accept or Reject a Special Order

What if Worldwide had no excess capacity? If
Worldwide adds the charter, it will have to cut
its least profitable route that currently
contributes $80,000 to fixed costs and profits.
Should Worldwide still accept the charter?

McGraw-Hill/Irwin
 14-20

Accept or Reject a Special Order

Worldwide has no excess capacity, so it

should reject the special charter.
McGraw-Hill/Irwin
 14-21

Accept or Reject a Special Order

With excess capacity . . .
 Relevant costs usually will be the variable
costs associated with the special order.

Without excess capacity . . .

 Same as above but opportunity cost of
using the firm’s facilities for the special
order are also relevant.
McGraw-Hill/Irwin
 14-22

Outsource a Product or Service

A
A decision
decision concerning
concerning whether
whether an
an item
item
should
should bebe produced
produced internally
internally or
or
purchased
purchased from
from an
an outside
outside supplier
supplier is
is
often
often called
called aa “make
“make or
or buy”
buy” decision.
decision.

Let’s
Let’s look
look at
at another
another decision
decision faced
faced by
by the
the
management
management of of Worldwide
Worldwide Airways.
Airways.

McGraw-Hill/Irwin
 14-23

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:

McGraw-Hill/Irwin
 14-24

Outsource a Product or Service

Not all of the allocated fixed costs will be saved
if Worldwide purchases from the outside bakery.

McGraw-Hill/Irwin
 14-25

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.

Wow, that’s
no deal!

McGraw-Hill/Irwin
 14-26

Outsource a Product or Service

Beware
Beware of
of Unit-Cost
Unit-Cost Data
Data
For
For decision-making
decision-making purposes,
purposes, unitized
unitized fixed
fixed
costs
costs can
can be
be misleading.
misleading.

McGraw-Hill/Irwin
 14-27

Add or Drop a Service,

Product, or Department
One
One ofof the
the most
most important
important decisions
decisions
managers
managers make
make is
is whether
whether to
to add
add or
or drop
drop
aa product,
product, service
service or
or department.
department.

Let’s
Let’s look
look at
at how
how the
the concept
concept ofof relevant
relevant
costs
costs should
should be
be used
used in
in such
such aa decision.
decision.

McGraw-Hill/Irwin
 14-28

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. An income statement for last year
is shown on the next screen.

McGraw-Hill/Irwin
 14-29

Add or Drop a Product

McGraw-Hill/Irwin
 14-30

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.

McGraw-Hill/Irwin
 14-31

Add or Drop a Product

The
The equipment
equipment used
used to
to manufacture
manufacture digital
digital
watches
watches has
has no
no resale
resale value
value or
or alternative
alternative use.
use.

McGraw-Hill/Irwin
 14-32

Add or Drop a Product

Should Swick retain or drop

the digital watch segment?

McGraw-Hill/Irwin
 14-33

Add or Drop a Product

McGraw-Hill/Irwin
 14-34

Add or Drop a Product

McGraw-Hill/Irwin
 14-35

Summary

DECISION RULE
Swick should drop the digital watch segment
only if its fixed cost savings exceed lost
contribution margin.
McGraw-Hill/Irwin
 14-36

Special Decisions in
Manufacturing Firms
Joint
Joint Products
Products::
Sell
Sell or
or Process
Process Further
Further

A
A joint
joint production
production process
process resulting
resulting inin
two
two oror more
more products.
products. TheThe point
point in
in the
the
production
production process
process where
where the
the joint
joint
products
products are
are identifiable
identifiable as
as separate
separate
products
products isis called
called the
the split-off
split-off point
point..

McGraw-Hill/Irwin
 14-37
Joint Processing Cocoa butter
of Cocoa Bean sales value
$750 for
1,500 pounds

Cocoa beans Joint Production

costing $500 process costing Split-off point
per ton $600 per ton

Cocoa powder Separable

sales value process
Total joint cost: $500 for costing
$1,100 per ton 500 pounds $800

Instant cocoa
mix sales value
$2,000 for
500 pounds
McGraw-Hill/Irwin
 14-38

Joint Products
Relative Sales Value Method

McGraw-Hill/Irwin
 14-39

Joint Products
Relative Sales Value Method

$750
$750 ÷÷ $1,250
$1,250 == 60%
60%

McGraw-Hill/Irwin
 14-40

Joint Products
Relative Sales Value Method

60%
60% ×× $1,100
$1,100 == $660
$660

McGraw-Hill/Irwin
 14-41

Joint Products
Relative Sales Value Method

McGraw-Hill/Irwin
 14-42

Joint Products
 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.

McGraw-Hill/Irwin
 14-43

Joint Products

The cocoa powder should be

processed into instant cocoa mix.

McGraw-Hill/Irwin
 14-44

Decisions Involving Limited

Resources
 Firms
Firms often
often face
face the
the problem
problem ofof deciding
deciding how
how
limited
limited resources
resources areare going
going to
to be
be used.
used.
 Usually,
Usually, fixed
fixed costs
costs are
are not
not affected
affected by
by this
this
decision,
decision, so
so management
management can can focus
focus on
on
maximizing
maximizing total
total contribution
contribution margin.
margin.

Let’s
Let’s look
look at
at the
the Martin,
Martin, Inc.
Inc. example.
example.

McGraw-Hill/Irwin
 14-45

Limited Resources
Martin, Inc. produces two products and selected
data is shown below:

McGraw-Hill/Irwin
 14-46

Limited Resources
 The
The lathe
lathe is
is the
the scarce
scarce resource
resource because
because there
there
is
is excess
excess capacity
capacity on
on other
other machines.
machines. The The
lathe
lathe is
is being
being used
used at
at 100%
100% ofof its
its capacity.
capacity.
 The
The lathe
lathe capacity
capacity is
is 2,400
2,400 minutes
minutes perper week.
week.

Should
Should Martin
Martin focus
focus its
its efforts
efforts
on
on Webs
Webs oror Highs?
Highs?

McGraw-Hill/Irwin
 14-47

Limited Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.

McGraw-Hill/Irwin
 14-48

Limited Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.

McGraw-Hill/Irwin
 14-49

Limited Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.

Highs
Highs should
should be be emphasized.
emphasized. ItIt isis the
the more
more valuable
valuable
use
use of
of the
the scarce
scarce resource
resource the
the lathe,
lathe, yielding
yielding aa
contribution
contribution margin
margin of
of $30
$30 per
per minute
minute asas opposed
opposed toto
$24
$24 per
per minute
minute for
for the
the Webs.
Webs.

McGraw-Hill/Irwin
 14-50

Limited Resources
Let’s calculate the contribution margin per unit of
the scarce resource, the lathe.

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 forfor Highs
Highs and
and
then
then use
use any
any capacity
capacity that
that remains
remains to
to make
make Webs.
Webs.

McGraw-Hill/Irwin
 14-51

Limited Resources
Let’s see how this plan would work.

McGraw-Hill/Irwin
 14-52

Limited Resources
According to the plan, Martin will produce 2,200
Highs and 1,300 Webs. Martin’s contribution
margin looks like this.

The
The total
total contribution
contribution margin
margin for
for Martin,
Martin, Inc.
Inc. is
is $64,200.
$64,200.
Any
Any other
other combination
combination would
would result
result in
in less
less contribution.
contribution.

McGraw-Hill/Irwin
 14-53

Theory of Constraints
Binding constraints can limit a company’s
profitability.
To relax constraints management can . . .

Outsource Work overtime

Reduce non-value-
Retrain employees
added activities

McGraw-Hill/Irwin
 14-54

Uncertainty
One
One common
common technique
technique forfor addressing
addressing the
the
impact
impact of
of uncertainty
uncertainty is is
sensitivity
sensitivity analysis
analysis -- aa way
way to
to determine
determine
what
what would
would happen
happen inin aa decision
decision analysis
analysis
ifif aa key
key prediction
prediction or
or assumption
assumption proved
proved to
to
be
be wrong.
wrong.

McGraw-Hill/Irwin
 14-55

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

McGraw-Hill/Irwin
 14-56

Expected Values
From our last example, recall the the contribution
Martin
margin would
Martinfor Websuse
would wasthe
use the expected
and $15 value
expected
$24 value
for Highs.
contribution
contribution margins
margins inin its
its decision
decision about
about
Due to uncertainty,
utilizing
utilizing its assume
its limited
limited we have --the
resource
resource thefollowing
the lathe.
lathe.
probable contribution margins for the two products.
Webs Highs

McGraw-Hill/Irwin
 14-57

Other Issues in Decision Making

Short-Run
Short-Run
Incentives
Incentives for
for Versus
Versus
Decision
Decision Makers
Makers Long-Run
Long-Run
Decisions
Decisions

McGraw-Hill/Irwin
 14-58

Other Issues in Decision Making

Pitfalls to Avoid

Sunk Allocated
costs. fixed costs.

Unitized Opportunity
fixed costs. costs.

McGraw-Hill/Irwin
 14-59

End of Chapter 14

McGraw-Hill/Irwin