Use of Cost Information

in Management
Decision Making
Management Accounting, PGDM - HRM
  All decisions involve a choice among alternative courses of action.
 The solution to business problems involves incremental analysis.
 Incremental analysis is the analysis of the incremental revenue and
incremental costs incurred when one alternative is chosen over
another.
 Incremental Revenue
Incremental  Additional revenue received by selecting one alternative over
another
Analysis  Incremental Cost
 Additional cost incurred by selecting one alternative over another
 Incremental Profit
 Difference between incremental revenue and incremental cost
  An alternative that yields an incremental profit should
be selected
 Incremental costs are referred to as relevant costs
 Also called differential costs because they are the
costs that differ between decision alternatives
Incremental Example:
 Jensen’s Rapid Copy is considering extending its hours
Analysis  Alternative 1 is the status quo
 Alternative 2 involved the company extending their hours
from 8 pm to midnight
 The next slide shows the incremental costs and revenues
associated with choosing one alternative over another
Incremental
Analysis
Example
 The important decisions that managers frequently face:
Analysis of 1. The decision to engage in additional processing of a
Decisions product
2. The decision to make or buy a product
Faced 3. The decision to drop a product line
by Managers 4. Pricing Special Orders
  Manufacturers must occasionally decide whether to:
 Sell a product in a partially completed stage, or
 Incur additional processing costs required to complete the
product
 Costs incurred to date of decision on partially complete
product are not relevant, i.e sunk costs.
Additional Example
Processing
Decision
  Incremental costs are $400
 Would you spend $400 to generate an additional $500 revenue?

Answer: Yes, incremental profit is $100

Incremental analysis can also be used in decisions to reduce loss.

Sell Partially Sell Fully

Complete Complete Incremental
Revenue $500 $1,000 $500 a
Prior Production Costs (800) (800) 0
Additional Processing Costs 0 (400) (400) b
Gain (loss) per unit ($300) ($200) $100 c

a. Incremental revenue associated with alternative 2

b. Incremental cost associated with alternative 2
c. Incremental profit associated with alternative 2
  Most manufactured goods are made up of numerous components
 In some cases, a company may purchase one or more of these
components from another company or manufacture them
Make or Buy themselves
 The analysis of this decision concentrates solely on incremental
Decisions costs
Make or Buy
Decisions

Additional information:
 If purchased, cost savings include $390,000 in supervisory salaries and all
variable costs.
 Market value of production machinery is zero
 A key issue is to determine which of the above costs are
incremental
 None of the $15 million of variable manufacturing costs will be
incurred if the part is purchased
 The fixed costs associated with depreciation will not be saved
 Note that not all fixed costs are irrelevant sunk costs
 Some fixed costs are avoidable costs
 Avoidable costs can be avoided if a particular action is undertaken
 If the parts are purchased from an outside vendor, the salaries of 5
supervisors will be saved
 The savings total $390,000 of avoidable fixed costs
 It will cost the company an additional $110,000 to purchase the
part
Incremental
Analysis
Incremental
cost analysis -
single column
format
  Suppose the company is currently spending $500,000 per year to rent
space for manufacturing shelving used in the refrigeration units
 If production of compressors is discontinued, the company will not
need to rent the space
 Rent savings would also influence the incremental costs

Incremental
Analysis in
Presence of
Opportunity
Costs
  Analysis involves calculating the change in income that
will result from dropping the product line
 If income increases, the product line should be dropped
 If income decreases, the product line should not be dropped
 This amounts to comparing the incremental revenues and costs
that result from dropping the product line
Dropping a
Example
Product Line
 Mercer Hardware sells 3 product lines, tools, hardware and garden
 Direct fixed costs are directly traceable to each product line
 Allocated fixed costs are not directly traceable to a product line
 Allocated fixed costs are generally not avoidable, thus no common fixed
costs will be saved if the product line is dropped
Dropping a
Product Line

Should the company drop Garden Supplies as it is incurring losses?

 Mercer Hardware
Product Line Income Statement
For the Year Ended December 31, 2006
Hardware Total Total
Tools Supplies 2 products 3 products
Sales $120,000 $200,000 $320,000 $400,000
Dropping a Traceable costs:
Cost of goods sold (81,000) (90,000) (171,000) (231,000)
Product Line Other variable costs
Direct fixed costs
(2,000) (4,000) (6,000) (7,000)
(8,000) (5,000) (13,000) (16,500)
Non-traceable costs
Company fixed costs (30,000) (50,000) (80,000) (80,000)
Division net income ($1,000) $51,000 $50,000 $65,500

Total company fixed costs are $80,000 whether 2 or 3 products are sold
Incremental
Analysis
  When dropping a product line
 Common fixed costs are not incremental
Beware of the  Common fixed cost allocation is spread among remaining product
lines
Cost Allocation  Management must understand and remember this impact
Death Spiral when making decisions
  Special orders are for goods and services not considered part of a
company’s normal business
 Price charged will not affect prices charged in the normal course of
business
 The company may be better off charging a price that is below full
cost
Pricing Special  The special order decision presents two alternatives
 Accept
Orders  Reject
 Income from the main business is the same under both
alternatives
 It is not incremental and need not be considered in the special order
 Need to consider incremental revenues and incremental costs
 The incremental revenue is the revenue associated with the special
order
 Incremental costs can include
 Direct materials
 Direct labor
 Variable overhead
 Incremental fixed costs

 Example
Should Premier Lens accept special order of 20,000 lenses to be sold
to Blix Camera for $73 per lens? Below is the full cost of $75 per lens
 Perform incremental analysis
 Fixed costs are not incremental, they will not change if the order is
accepted