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Topic 5
Topic 5
Topic 5
Outline
1. The concept of relevance
2. Information and decision process
3. Decisions based on limiting factors
4. Decisions based on relevancy concept
5. Qualitative factors in decision making
1
Short Term Decision Making
Short term 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.
2
Learning Objective 1
4
Cost Concepts for Decision Making
2
1
5
Identifying Relevant Costs
6
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).
6
Sunk Costs
A sunk cost is a cost that cannot be affected by
any future action.
Managers should ignore sunk costs for relevant
decisions.
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.
7
Relevant Cost Analysis: A Two-Step Process
9
Different Costs for Different Purposes
Costs that are
relevant in one
decision situation
may not be relevant
in another context.
Thus, in each
decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
10
Identifying Relevant Costs
Cynthia, a Malaysian student studying in Penang, is considering visiting
her friend in Kuala Lumpur. She can drive or take the budget airline. By
car, it is 350 kilometers 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 Kilometer
1 Annual straight-line depreciation on car RM2,800 RM0.280
2 Cost of gasoline RM0.100
3 Annual cost of auto insurance and license RM1,380 RM0.138
4 Maintenance and repairs RM0.065
5 Parking fees at school RM360 RM0.036
6 Total average cost RM0.619
RM45
RM45 per
per month
month ×× 88 months
months RM2.70
RM2.70 per
per gallon
gallon ÷÷ 27
27 MPG
MPG
RM24,000
RM24,000 cost
cost –– RM10,000
RM10,000 salvage
salvage value
value ÷÷ 55 years
years
11
Identifying Relevant Costs
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Kilometer
1 Annual straight-line depreciation on car RM2,800 RM0.280
2 Cost of gasoline RM0.100
3 Annual cost of auto insurance and license RM1,380 RM0.138
4 Maintenance and repairs RM0.065
5 Parking fees at school RM360 RM0.036
6 Total average cost RM0.619
12
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?
13
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?
14
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?
15
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?
16
Identifying Relevant Costs
17
Total and Differential Cost 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
18
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:
We
Direct materials canunits
(5,000 efficiently analyze the
@ $14 per unit) decision 70,000
70,000 by -
Direct labor (5,000 units @ $8 and $5 per unit)
looking at the different costs 40,000 and revenues 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same 120,000 .
solution 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
19
Total and Differential Cost Approaches
20
Learning Objective 2
Determine the most
profitable use of a
constrained resource and
the value of obtaining
more of the constrained
resource.
21
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.
22
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 constrained resource.
23
Key Terms and Concepts
The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.
24
Utilization of a Constrained Resource
Fixed costs are usually unaffected in these situations, so the
product mix that maximizes the company’s total
contribution margin should ordinarily be selected.
A company should not necessarily promote those products
that have the highest unit contribution margins.
Rather, total contribution margin will be maximized by
promoting those products or accepting those orders that
provide the highest contribution margin in relation to the
constraining resource.
25
Utilization of a Constrained Resource: An
Example
Ensign Company produces two products and selected data
are shown below:
Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.
26
Utilization of a Constrained Resource: An
Example
27
Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30
28
Utilization of a Constrained Resource
The key is the contribution margin per unit of the
constrained resource.
P roduct
1 2
Contri buti on m a rgi n pe r uni t $ 24 $ 15
Ti m e re qui re d to produce one uni t ÷ 1. 00 m i n. ÷ 0. 50 m i n.
Contri buti on m a rgi n pe r m i nute $ 24 $ 30
Ensign
Ensign can
can maximize
maximize its
its contribution
contribution margin
margin
by
by first
first producing
producing Product
Product 22 to
to meet
meet customer
customer
demand
demand and
and then
then using
using any
any remaining
remaining
capacity
capacity to
to produce
produce Product
Product 1.
1. The
The
calculations
calculations would
would bebe performed
performed as as follows.
follows.
29
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
30
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
31
Utilization of a Constrained Resource
Let’s see how this plan would work.
Alloting Our Constrained Resource (Machine A1)
32
Utilization of a Constrained Resource
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
33
Managing Constraints
It is often possible for a manager to increase the capacity of a
bottleneck, which is called relaxing (or elevating) the constraint,
in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that would be done
at the bottleneck.
3. Investing in additional machines at the bottleneck.
4. Shifting workers from non-bottleneck processes to the
bottleneck.
5. Focusing business process improvement efforts on the
bottleneck.
6. Reducing defective units processed through the bottleneck.
These methods and ideas are all consistent with the Theory
of Constraints.
34
Theory of Constraint
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.
34
Theory of Constraint
The theory of constraints states that any system
contains a choke point that prevents it from
achieving its goals.
36
Throughput Accounting (TA)
Is a principle-based and simplified
management accounting approach that provides
managers with decision support information for
enterprise profitability improvement.
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.
37
Learning Objective 3
39
The Make or Buy Decision
40
Vertical Integration- Advantages
Smoother flow of
parts and materials
Better quality
control
Realize profits
41
Vertical Integration- Disadvantage
Companies may fail to
take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous companies.
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
43
The Make or Buy Decision
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.
44
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
The avoidable
The avoidable costs
costs associated
associated with
with making
making part
part 4A
4A include
include direct
direct
materials,
materials, direct
direct labor,
labor, variable
variable overhead,
overhead, and
and the
the supervisor’s
supervisor’s salary.
salary.
45
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
The
The depreciation
depreciation of
of the
the special
special equipment
equipment represents
represents aa sunk
sunk
cost.
cost. The
The equipment
equipment has
has no
no resale
resale value,
value, thus
thus its
its cost
cost and
and
associated
associated depreciation
depreciation are
are irrelevant
irrelevant to
to the
the decision.
decision.
46
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 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.
47
The Make or Buy Decision
Cost
Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000
Prepare an analysis
showing whether a special
order should be accepted.
49
Key Terms and Concepts
A special order is a one-time
order that is not considered
part of the company’s normal
ongoing business.
51
Special Orders
Jet Corporation
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000$8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000
52
Special Orders
If Jet accepts the special order, the incremental revenue will
exceed the incremental costs. In other words, net
operating income will increase by $6,000. This suggests
that Jet should accept the order.
53
Learning Objective 5
Prepare an analysis
showing whether a product
line or other business
segment should be
dropped or retained.
54
Adding/Dropping Segments
One of the most
important decisions
managers make is
whether to add or drop
a business segment.
Ultimately, a decision
to drop an old segment
or add a new one is
going to hinge primarily To assess this impact,
on the impact the it is necessary to
decision will have on carefully analyze
net operating income. the costs.
55
Adding/Dropping Segments
56
A Contribution Margin Approach
DECISION RULE
Lovell should drop the digital watch
segment only if its profit would increase.
Lovell will compare the contribution
margin that would be lost to the costs
that would be avoided if the line was
to be dropped.
Let’s look at this solution.
57
Adding/Dropping Segments
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)
58
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less:
Anvariable expenses
investigation has
An investigation has revealed
revealed that that the
the fixed
fixed
Variable manufacturing costs $ 120,000
general
general
Variable
factory overhead
overhead and
factorycosts
shipping and fixed
fixed general
5,000 general
administrative
administrative expenses
Commissions expenses will will not
not be
be affected
75,000 affected by
by
200,000
dropping
dropping the
Contribution digital
digital watch
margin
the watch line.
line. The
The fixed
fixed general
$ 300,000
general
Less: fixed expenses
factory
factory overhead
overhead and
and general
general administrative
administrative
General factory overhead $ 60,000
expensesof line assigned
expenses
Salary manager to
assigned to this
this product
90,000 would
product would be be
reallocated
reallocated
Depreciation to
to other
of equipment other product
product lines.
50,000lines.
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
59
Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
The
The equipment
equipment
Variable used to
to manufacture
usedcosts
manufacturing manufacture
$ 120,000
digital
Variable watches
shipping
digital has
costs
watches has no
no resale
resale5,000
Commissions 75,000 200,000
value or
Contribution margin
alternative use.
value or alternative use. $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Should
Should Lovell
Depreciation of equipment Lovell retain
retain or
50,000 or drop
drop
Advertising - direct the digital watch
100,000segment?
the digital watch segment?
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
60
A Contribution Margin Approach
Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)
RRe
ettaai
inn
61
Comparative Income Approach
62
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 IfIf the
the digital
digital watch
watch
Advertising - direct 100,000
Rent - factory space 70,000
line
line is is dropped,
dropped, thethe
General admin. expenses 30,000 company
company loses
loses
Total fixed expenses 400,000 $300,000
$300,000 in
in
Net operating loss $ (100,000)
contribution
contribution margin.
margin.
63
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct On the
the other
On 100,000 other hand,
hand, thethe general
general
Rent - factory space factory
factory overhead
overhead would
70,000 would be
be the
the
General admin. expenses 30,000
Total fixed expenses
same
same under
under both
400,000 both alternatives,
alternatives,
Net operating loss so
so itit is
$ (100,000) is irrelevant.
irrelevant.
64
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
The salary
Manufacturing expenses The salary120,000
of
of the product- line
the product line 120,000
Shipping manager
manager would would5,000disappear,
disappear, - soso 5,000
Commissions itit is relevant 75,000
to the -
decision. 75,000
Total variable expenses
is relevant to
200,000
the decision.
- 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
65
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
The
The
Less depreciation
expenses: is
depreciation
variable is aa sunk
sunk cost.
cost. Also,
Also, remember
remember
- that
that
Manufacturing
the expenses
equipment has no resale120,000
value or -
alternative 120,000
use,
the
Shipping
equipment has no resale value
5,000
or alternative
-
use,
5,000
so
so the
Commissionsthe equipment
equipment and and the depreciation
depreciation expense
the75,000 -expense 75,000
associated
associated
Total variable with
with itit are
expenses are irrelevant
200,000 to
irrelevant to the
the decision.
decision.
- 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)
66
Comparative Income Approach
Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping The
The complete 5,000 comparative
complete comparative
- 5,000
Commissions income
income statements
75,000
statements reveal-
reveal that
that 75,000
Total variable expenses 200,000 - 200,000
Contribution margin Lovell would
Lovell would earn $40,000
300,000earn $40,000 - of
of (300,000)
Less fixed expenses: additional
additional profit
profit by
by retaining
retaining thethe
General factory overhead 60,000 60,000 -
Salary of line manager
digital
digital watch
watch
90,000
line.
line. - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)
67
Beware of Allocated Fixed Costs
68
Beware of Allocated Fixed Costs
69
Beware of Allocated Fixed Costs
70
Learning Objective 6
Prepare an analysis
showing whether joint
products should be sold at
the split-off point or
processed further.
71
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 products.
The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.
72
Joint Products
For example,
Oil in the petroleum
refining industry,
a large number
Common of products are
Joint
Input
Production Gasoline extracted from
Process crude oil,
including
gasoline, jet fuel,
Chemicals
home heating oil,
lubricants,
asphalt, and
Split-Off
various organic
Point chemicals.
73
Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale
Common
Joint Final
Production Gasoline
Input Sale
Process
Separate Final
Chemicals
Processing
Sale
Split-Off Separate
Point Product
Costs
74
The Pitfalls of Allocation
Joint costs are traditionally
allocated among different
products at the split-off point.
A typical approach is to allocate
joint costs according to the
relative sales value of the end
products.
Although allocation is needed for
some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.
75
Sell or Process Further
Joint costs are irrelevant in decisions regarding
what to do with a product from the split-off point
forward. Therefore, these costs should not be
allocated to end products for decision-making
purposes.
76
Sell or Process Further: An Example
Sawmill, Inc. cuts logs from which unfinished
lumber and sawdust are the immediate joint
products.
Unfinished lumber is sold “as is” or processed
further into finished lumber.
Sawdust can also be sold “as is” to gardening
wholesalers or processed further into “presto-
logs.”
77
Sell or Process Further
Data about Sawmill’s joint products includes:
Per Log
Lumber Sawdust
Sales value at the split-off point $ 140 $ 40
78
Sell or Process Further
79
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
80
Sell or Process Further
Analysis of Sell or Process Further
Per Log
Lumber Sawdust
81
Qualitative Factors
Definition: Qualitative factors are decision outcomes
that cannot be measured. Examples of qualitative
factors are:
81
Qualitative Factors
Investors. The impact on investors of conducting a
road show to meet as many of them as possible.
84
Factors that affect the bidding decisions
85
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
86
End of Topic 5
88