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# Decision Making and Relevant Information Chapter 11

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## Information and the Decision Process

A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis.

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## Five-Step Decision Process

Step 1. Gather Information Historical Costs Other Information Specific Predictions

Step 2. Feedback

Make Predictions

Step 3.

Choose an Alternative

## Step 5. Evaluate Performance

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Learning Objective 2 Differentiate relevant from irrelevant costs and revenues in decision situations.
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## The Meaning of Relevance

Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action. Historical costs Differential income Sunk costs Differential costs

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## Quantitative and Qualitative Relevant Information

Quantitative factors Financial Nonfinancial

Qualitative factors
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## One-Time-Only Special Order Example

The Bismark Co. manufacturing plant has a production capacity of 44,000 towels each month. Current monthly production is 30,000 towels. Costs can be classified as either variable or fixed with respect to units of output.

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## One-Time-Only Special Order Example

Variable Costs Per Unit \$6.50 .50 1.50 \$8.50 Fixed Costs Per Unit \$ -01.50 3.50 \$5.00
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## One-Time-Only Special Order Example

Total fixed direct manufacturing labor is \$45,000. Total fixed overhead is \$105,000. Marketing costs per unit are \$7 (\$5 of which is variable). What is the full cost per towel?

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## One-Time-Only Special Order Example

Variable (\$8.50 + \$5.00): Fixed: Total \$13.50 7.00 \$20.50

A hotel in San Juan has offered to buy 5,000 towels from Bismark Co. at \$11.50/towel for a total of \$57,500. No marketing costs will be incurred.
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## One-Time-Only Special Order Example

What are the relevant costs of making the towels ? \$8.50 5,000 = \$42,500 incremental costs What are the incremental revenues ? \$57,500 \$42,500 = \$15,000

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## Two Potential Problems in Relevant-Cost Analysis

1 Incorrect general assumptions: All variable costs are relevant. All fixed costs are irrelevant. 2 Misleading unit-cost data: Include irrelevant costs. Use same unit costs at different output levels.
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## Outsourcing versus Insourcing

Outsourcing is purchasing goods and services from outside vendors. Insourcing is producing goods or providing services within the organization.

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Bismark Co. also manufactures bath accessories. Management is considering producing a part it needs (#2) or buying a part produced by Towson Co. for \$0.55.

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Bismark Co. has the following costs for 150,000 units of Part #2: Direct materials Direct labor Mixed overhead Variable overhead Fixed overhead Total \$ 28,000 18,500 29,000 15,000 30,000 \$120,500
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## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Mixed overhead consists of material handling and setup costs. Bismark Co. produces the 150,000 units in 100 batches of 1,500 units each. Total material handling and setup costs equal fixed costs of \$9,000 plus variable costs of \$200 per batch.
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What is the cost per unit for Part #2? \$120,500 150,000 units = \$0.8033/unit Should Bismark Co. manufacture the part or buy it from Towson Co.?

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Bismark Co. anticipates that next year the 150,000 units of Part #2 expected to be sold will be manufactured in 150 batches of 1,000 units each.

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Variable costs per batch are expected to decrease to \$100. Bismark Co. plans to continue to produce 150,000 next year at the same variable manufacturing costs per unit as this year. Fixed costs are expected to remain the same as this year.
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What is the variable manufacturing cost per unit? Direct material Direct labor Variable overhead Total \$28,000 18,500 15,000 \$61,500

## \$61,500 150,000 = \$0.41 per unit

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Expected relevant cost to make Part #2: Manufacturing Material handling and setups Total relevant cost to make *150 \$100 = \$15,000 \$61,500 15,000* \$76,500

Cost to buy: (150,000 \$0.55) \$82,500 Bismark Co. will save \$6,000 by making the part.
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Now assume that the \$9,000 in fixed clerical salaries to support material handling and setup will not be incurred if Part #2 is purchased from Towson Co.. Should Bismark Co. buy the part or make the part?

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Relevant cost to make: Variable Fixed Total Cost to buy: \$76,500 9,000 \$85,500 \$82,500

## Bismark would save \$3,000 by buying the part.

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Learning Objective 5 Explain the opportunity-cost concept and why it is used in decision making.

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## Opportunity Costs, Outsourcing, and Constraints

Assume that if Bismark buys the part from Towson, it can use the facilities previously used to manufacture Part #2 to produce Part #3 for Krysta Company. The expected additional future operating income is \$18,000. What should Bismark Co. do?
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## Opportunity Costs, Outsourcing, and Constraints

Bismark Co. has three options regarding Krysta: 1. Make Part #2 and do not make Part #3. 2. Buy Part #2 and do not make Part #3. 3. Buy the part and use the facilities to produce Part #3.

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## Opportunity Costs, Outsourcing, and Constraints

Expected cost of obtaining 150,000 parts: Buy Part #2 and do not make Part #3: \$82,500 Buy Part #2 and make Part #3: \$82,500 \$18,000 = Make Part #2: \$64,500 \$76,500

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## Opportunity Costs, Outsourcing, and Constraints

Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use.

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## Opportunity Costs, Outsourcing, and Constraints

Assume that annual estimated Part #2 requirements for next year is 150,000. Cost per purchase order is \$40. Cost per unit when each purchase is 1,500 units = \$0.55. Cost per unit when each purchase is equal to or greater than 150,000 = \$0.54.
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## Opportunity Costs, Outsourcing, and Constraints

Average investment in inventory is either: (1,500 .55) 2 = \$412.50 or (150,000 \$0.54) = \$40,500 Annual interest rate for investment in government bonds is 6%. \$412.50 .06 = \$24.75 \$40,500 .06 = \$2,430
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## Opportunity Costs, Outsourcing, and Constraints

Option A: Make 100 purchases of 1,500 units: Purchase order costs: (100 \$40) Purchase costs: (150,000 \$0.55) Annual interest income: Relevant costs: \$ 4,000.00 \$82,500.00 \$ 24.75 \$86,524.75

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## Opportunity Costs, Outsourcing, and Constraints

Option B: Make 1 purchase of 150,000 units: Purchase order costs: (1 \$40) Purchase costs: (150,000 \$0.54) Annual interest income: Relevant costs: \$ 40 \$81,000 \$ 2,430 \$83,470

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Learning Objective 6 Know how to choose which products to produce when there are capacity constraints.

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## Product-Mix Decisions Under Capacity Constraints

Per unit Product #2 Product #3 Sales price \$2.11 \$14.50 13.90 Variable expenses 0.41 Contribution margin \$1.70 \$ 0.60 Contribution margin ratio 81% 4% Bismark Co. has 3,000 machine-hours available.

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## Product-Mix Decisions Under Capacity Constraints

One unit of Prod. #2 requires 7 machine-hours. One unit of Prod. #3 requires 2 machine-hours. What is the contribution of each product per machine-hour? Product #2: \$1.70 7 = \$0.24 Product #3: \$0.60 2 = \$0.30
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Learning Objective 7 Discuss what managers must consider when adding or discontinuing customers and segments.
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## Profitability, Activity-Based Costing, and Relevant Costs

Mountain View Furniture supplies furniture to two local retailers Stevens and Cohen. The company has a monthly capacity of 3,000 machine-hours. Fixed costs are allocated on the basis of revenues.

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## Profitability, Activity-Based Costing, and Relevant Costs

Revenues Variable costs Fixed costs Total operating costs Operating income Machine-hours required Stevens Cohen \$200,000 \$100,000 70,000 60,000 50,000 100,000 \$170,000 \$110,000 \$ 30,000 \$(10,000) 2,000 1,000
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## Profitability, Activity-Based Costing, and Relevant Costs

Revenues Variable costs Fixed costs Total operating costs Operating income Machine-hours required Total \$300,000 130,000 150,000 \$280,000 \$ 20,000 3,000
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## Profitability, Activity-Based Costing, and Relevant Costs

Should Mountain View Furniture drop the Cohen business, assuming that dropping Cohen would decrease its total fixed costs by 10%? New fixed costs would be: \$150,000 \$15,000 = \$135,000

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## Profitability, Activity-Based Costing, and Relevant Costs

Revenues Variable costs Fixed costs Total operating costs Operating income Machine-hours required Stevens Alone \$200,000 70,000 135,000 \$205,000 \$ (5,000) 3,000
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## Profitability, Activity-Based Costing, and Relevant Costs

Cohens business is providing a contribution margin of \$40,000. \$40,000 decrease in contribution margin \$15,000 decrease in fixed costs = \$25,000 decrease in operating income.

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## Profitability, Activity-Based Costing, and Relevant Costs

Assume that if Mountain View Furniture drops Cohens business it can lease the excess capacity to the Perez Corporation for \$70,000. Fixed costs would not decrease. Should Mountain View Furniture lease to Perez?

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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Learning Objective 8 Explain why the book value of equipment is irrelevant in equipment-replacement decisions.

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## Equipment-Replacement Decisions Example

Existing Replacement Machine Machine Original cost \$80,000 \$105,000 Useful life 4 years 4 years Accumulated depreciation \$50,000 Book value \$30,000 Disposal price \$14,000 Annual costs \$46,000 \$ 10,000
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## Equipment-Replacement Decisions Example

Ignoring the time value of money and income taxes, should the company replace the existing machine? The cost savings over a 4-year period will be \$36,000 4 = \$144,000. Investment = \$105,000 \$14,000 = \$91,000 \$144,000 \$91,000 = \$53,000 advantage of the replacement machine.
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Learning Objective 9 Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager.
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## Decisions and Performance Evaluation

What is the journal entry to sell the existing machine? Cash Accumulated Depreciation Loss on Disposal Machine 14,000 50,000 16,000 80,000

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## Decisions and Performance Evaluation

In the real world would the manager replace the machine? An important factor in replacement decisions is the managers perceptions of whether the decision model is consistent with how the managers performance is judged.

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## Decisions and Performance Evaluation

Top management faces a challenge that is, making sure that the performance-evaluation model of subordinate managers is consistent with the decision model.

## 2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

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End of Chapter 11

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