Module 6:

Decision Making: Relevant Costs

and Benefits.
Hilton & Platt 13e, Chapter 14

Slides are based on and adapted from Hilton, R.W. & D.E. Platt, 2023, Managerial Accounting: Creating Value in a Dynamic Business Environment, 13e, McGraw Hill Education
(Australia) Pty Ltd.

© McGraw Hill 1
 Lecture Outline

• Describe the decision-making process and the managerial accountant’s role in

the process.
• Explain the relationship between quantitative and qualitative analyses in
decision making.
• List and explain what relevant information is.
• Identify relevant costs and benefits.
• Prepare analyses of various special decisions, using relevant costs and
benefits.
• Analyse manufacturing decisions involving joint products and limited resources.

© McGraw Hill 2
 The Management Accountant’s Role in Decision Making

Management
accountant

Cross-functional
Designs and implements management teams
accounting information who make
system production, marketing,
and finance decisions

Make substantive
economic decisions
affecting operations

© McGraw Hill 3
 The Decision-Making Process

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Quantitative
4. Develop a Decision Model
Analysis
5. Collect the Data, and Analyse

and Provide Information

6. Select an Alternative

7. Evaluate Decision

© McGraw Hill 4
 The Decision-Making Process (continued)

1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the role of the 3. Identify the Alternatives

management
accountant
4. Develop a Decision Model
5. Collect the Data, and Analyse

Information should be:

and Provide Information
6. Select an Alternative
1. Relevant
2. Accurate
7. Evaluate Decision
3. Timely

© McGraw Hill 5
 The Decision-Making Process (continued)

Relevant 1. Clarify the Decision Problem

Pertinent to a
decision problem. 2. Specify the Criterion

3. Identify the Alternatives

Accurate
Information must 4. Develop a Decision Model
be precise. 5. Collect the Data, and Analyse

and Provide Information

Timely 6. Select an Alternative
Available in time
for a decision 7. Evaluate Decision

© McGraw Hill 6
 The Decision-Making Process (continued)

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Combine 4. Develop a Decision Model

Quantitative and 5. Collect the Data, and Analyse
Qualitative
Considerations and Provide Information,
6. Select an Alternative

7. Evaluate Decision

© McGraw Hill 7
 Relevant Information

Information is relevant to a decision problem when:

• It has an effect on the future
• It differs among available alternatives

SUNK COSTS: Costs that have already been incurred

or committed. They do not affect any future cost and
cannot be changed by any current or future action.
Hence, sunk costs are irrelevant to decisions.

OPPORTUNITY COSTS: The potential benefit given

up when the choice of one action precludes a different
action.
© McGraw Hill 8
 Illustration: Relevant costs

Company X is thinking about replacing a three-year old

machine with a new, more efficient machine.

New machine (2 years economic life)

List price $ 30,000 Relevant
Annual operating expenses 45,000 Relevant
Expected life in years 2
Old machine (5 years economic life)
Original cost $ 100,000
Remaining book value 40,000 Not Relevant
Current disposal value 5,000 Relevant
Annual operating expenses 80,000 Relevant
Remaining life in years 2

© McGraw Hill 9
 Illustration: Relevant costs (continued)

Relevant Cost Analysis

YEAR 1 YEAR 2 TOTAL

Annual savings in operating expenses $35,000 $35,000 $70,000
provided by the new machine
($80,000 - $45,000)
Annual depreciation cost of the new ($15,000) ($15,000) ($30,000)
machine
($30,000 / 2 years economic life)
Disposal value of old machine $5,000 $5,000
Net effect $25,000 $20,000 $45,000

© McGraw Hill 10
 Accept or Reject a special order

Company X currently at 80% capacity, producing and selling 80,000 units of its
product. The company sells its product at $10 each. The variable cost per unit
for the product is $7.60, and the total annual fixed costs are $140,000.
A current buyer of Company X’s products wants to purchase additional units of
its product and export them to another country. This buyer offers to buy 10,000
units of the product at $8.50 per unit, or $1.50 less than the current price.
Company X is considering the offer because it has an excess capacity, and it
plans to use its idle capacity if it accepts the offer. If Company X accepts this
offer, it will need to spend a one-off administrative cost of $1,000.
Should Company X accept the offer?

© McGraw Hill 11
 Accept or Reject a special order (continued)

Company X currently at 80% capacity, producing 80,000 units of its product. It means that
it still has 20% idle capacity that can be used to produce a maximum of 20,000 units of its
product (more than enough to produce the additional order of 10,000 units).
The special order will not affect normal unit production and sales and will not increase
fixed overhead and will only add a $1,000 one-off administrative cost.

Revenue from the additional purchase ($8.50 x 10,000) $ 85,000

Variable cost ($7.60 x 10,000) $ 76,000
Contribution margin $9,000
One-off administrative cost $1,000
Profit $ 8,000

Should Company X accept this offer?

© McGraw Hill 12
 Accept or Reject a special order – with no excess capacity

Company X currently at 100% capacity, producing and selling 80,000 units of

its product. The company sells its product at $10 each. The variable cost per
unit for the product is $7.60, and the total annual fixed costs are $140,000.
A current buyer of Company X’s products wants to purchase additional units of
its product and export them to another country. This buyer offers to buy 10,000
units of the product at $8.50 per unit, or $1.50 less than the current price.
Company X knows it has no excess capacity, and it wants to know whether
there will be a profit if it accepts the offer. If Company X accepts this offer, it will
need to spend a one-off administrative cost of $1,000.
Should Company X accept the offer?

© McGraw Hill 13
 Accept or Reject a special order – with no excess capacity (continued)

Company X currently at 100% capacity, producing 80,000 units of its product. It means
that it has no idle capacity to produce the additional order of 10,000 units.

The special order will not increase fixed overhead and will only add a $1,000 one-off
administrative cost, but it will affect normal unit production and sales. It means that if
Company X wants to accept the offer, it must use the existing used capacity to produce
this special order.

Profit from the additional purchase: $ 8,000

Loss from the reduced normal sales: $24,000 *
* ($10 - $7.60) x 10,000 = $24,000

Should Company X accept this offer?

© McGraw Hill 14
 Accept or Reject a special order – with no excess capacity (case 2)

Company X currently at 100% capacity, producing and selling 80,000 units of

its product. The company sells its product at $10 each. The variable cost per
unit for the product is $7.60, and the total annual fixed costs are $140,000.
After receiving the rejection for the additional purchase, the current buyer of
Company X’s products comes back with another offer to buy 10,000 units of
the product at $11.50 per unit, or $1.50 more than the current price.
Company X knows it has no excess capacity, and it wants to know whether
there will be a profit if it accepts this new offer. If Company X accepts this offer,
it will need to spend a one-off administrative cost of $1,000.
Should Company X accept the new offer?

© McGraw Hill 15
 Accept or Reject a special order – with no excess capacity (case 2) (continued)

Company X currently at 100% capacity, producing 80,000 units of its product. It means
that it has no idle capacity to produce the additional order of 10,000 units.

The special order will not increase fixed overhead and will only add a $1,000 one-off
administrative cost, but it will affect normal unit production and sales. It means that if
Company X wants to accept the offer, it must use the existing used capacity to produce
this special order.

Revenue from the additional purchase ($11.50 x 10,000) $ 115,000

Variable cost ($7.60 x 10,000) $ 76,000
Contribution margin $39,000
One-off administrative cost $1,000
Profit $38,000

© McGraw Hill 16
 Accept or Reject a special order – with no excess capacity (case 2) (continued)

Profit from the additional purchase: $38,000

Loss from the reduced normal sales: $24,000 *
* ($10 - $7.60) x 10,000 = $24,000

Should Company X accept this new offer?

© McGraw Hill 17
 Outsource a Product or Service

A decision concerning whether an item should be produced internally or

purchased from an outside supplier is often called a “make or buy” decision.

Illustration: Company Y currently provides lunch to its employees.

A local bakery has offered to supply desserts for $0.21 each. Currently Company
Y makes its own desserts.
Variable costs:
Direct material $ 0.06

Here are Company Y’s Direct labor 0.04

current cost for desserts: Variable overhead 0.04

Variable fixed costs: 0.11

Total cost per dessert $ 0.25

© McGraw Hill 18
 Outsource a Product or Service (continued)

Cost per Savings from

dessert Outsourcing
Variable costs:
Direct material $ 0.06 $ 0.06 If Company Y
Direct labor 0.04 0.04 purchases the dessert
Variable overhead 0.04 0.04 for $0.21, it will only
save $0.14 - a loss of
Variable fixed costs: 0.11 - $0.07 per dessert
purchased.
Total cost per dessert $ 0.25 $ 0.14

© McGraw Hill 19
 Drop, Keep or Add a Service, Product, or Department

Another one of the most important decisions managers make is whether to

drop, keep or add a product, service, or department.

Illustration: Coconut Airways offers its passengers the opportunity to join its
Coconut Express Club. Club membership entitles a traveler to use the club
facilities at the airport in Fiji.

Club privileges include a private lounge and restaurant, discounts on meals

and beverages, and use of a small health spa.

The president of Coconut Airways is worried that the Coconut Express Club
might not be profitable and wants to evaluate whether it is better to
discontinue the service.
© McGraw Hill 20
 Drop, Keep or Add a Service, Product, or Department (continued)

Monthly operating income for the Coconut Express Club

Sales $200,000
Less: Variable Costs:
Food/Beverage $70,000
Personnel 40,000
Variable overhead 25,000 (135,000)
Contribution Margin 65,000
Less: Fixed Costs:
Depreciation $30,000
Supervisor salary 20,000
Committed insurance 10,000
Airport fees 5,000
Allocated overhead 10,000 (75,000)
Loss $ (10,000)

© McGraw Hill 21
 Drop, Keep or Add a Service, Product, or Department (continued)

ELIMINATE
KEEP CLUB CLUB DIFFERENTIAL

Sales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000) Should
Contribution Margin 65,000 0 65,000 Coconut
Depreciation (30,000) (30,000) 0
Airways
Supervisor salary (20,000) 0 (20,000)
discontinue its
Committed insurance (10,000) (10,000) 0
Express Club?
Airport fees (5,000) 0 (5,000)
Allocated overhead (10,000) (10,000) 0
Loss $ (10,000) $(50,000) $ 40,000

Unavoidable Avoidable
© McGraw Hill 22
 Drop, Keep or Add a Service, Product, or Department (continued)

Additional information:

In the weekly staff meeting, the Vice President for sales adds that the club
helps Coconut Airways attract passengers who it might otherwise lose to a
competitor. The managerial accountant estimates that if the club were
discontinued, the airline would lose $60,000 each month resulted from losing
to a competing airline current passengers who are attracted to Coconut
Airways by its Coconut Express Club.

The Opportunity Cost Coconut Airways is

of potential lost of better off by $100,000
passengers is per month by keeping its
$60,000. club open.

© McGraw Hill 23
 Special decisions in manufacturing firms –
Joint Products: Sell or Process Further
Illustration: Cocoa butter
sales value
Joint processing of cocoa beans
$750 for
1,500 pounds
Cocoa beans Joint production
costing $500 process costing Split-off
per ton $600 per ton point Additonal
Cocoa powder process for
sales value 500 pounds
Total joint cost: $500 for costing
$1,100 per ton 500 pounds $800

Instant cocoa
Should the cocoa powder be sold as a finished mix sales
product, or processed further into instant cocoa mix? value
$2,000 for
500 pounds
© McGraw Hill 24
 Illustration: Joint processing of cocoa beans (continued)

Allocation of the joint production costs:

Relative Sales Value Method
Sales Value Relative Allocation of
Joint Costs Joint Products at Split-Off Proportion Joint Costs
60% × $1,100 = $660
$ 1,100 Cocoa Butter $ 750 60% $ 660

Cocoa Powder 500 40% 440

$ 1,250 100% $ 1,100 40% × $1,100 = $440

$750 ÷ $1,250 = 60%

$500 ÷ $1,250 = 40%

© McGraw Hill 25
 Illustration: Joint processing of cocoa beans (continued)

Sold as cocoa powder

Sales value of cocoa powder $ 500
Process further and sold as instant cocoa mix
Joint production cost allocation (440)
Sales value of instant cocoa mix $ 2,000
Net benefit $ 60 Joint production cost allocation (440)
Additional process cost (800)

Net benefit $ 760

Additional $700 benefit if

the cocoa powder is
processed into instant
cocoa mix.

© McGraw Hill 26
 Decisions involving limited resources
Firms often face the problem of deciding how limited resources are going to be
used. Contribution margin per limiting factor can be used to prioritise the use of
the limited resource.

Illustration: A factory has an annual production capacity of 270 000 machine hours

© McGraw Hill 27
 Decisions involving limited resources: Illustration (continued)

Required hours: 370 000 hours. Available machine hours: 270 000 hours.
Limiting factor: time (machine hours).

Which product to promote?

Determine ‘most profitable product’ based on contribution margin per machine hour.
© McGraw Hill 28
 Decisions involving limited resources: Illustration (continued)

This analysis shows that:

• soap product is most profitable per unit based on
contribution margin per unit
• but candle product will maximise profit by providing
more contribution margin per machine hour

© McGraw Hill 29
 Decisions involving limited resources: Illustration (continued)

How should the company use the available 270 000 machine hours capacity?

• First priority - Candles: 60,000 hours (remaining hours 210,000 hours)

• Second priority - Soaps: 160,000 hours (remaining hours 50,000 hours)
• Third priority - Detergents: 50,000 hours (all hours are used)

© McGraw Hill 30
 Next Module:

Module 7: Budgeting

© McGraw Hill 31