Chapter 26

McGraw-Hill/Irwin

Chapter 26

Short-Run Alternative Choice

Decisions

Copyright © 2011. The McGraw-Hill Companies. All Rights Reserved.

26-2

Chapter Highlights

• Alternative choice decisions:– Manager seeks to choose best out of several

alternatives.– Focus on differential costs and revenues.

• Different under one set of conditions than under another.

– Decisions relate to a relatively short time horizon.

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Nature ofFull and Differential Costs

• Full costs:– Direct cost + fair share of applicable indirect

costs.• Differential costs:

– Include only those elements of cost that are different under a certain set of conditions.

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Source of Data forFull and Differential Costs

• Full costs:– Come from a company’s cost accounting

system.• Differential costs:

– No comparable system for collecting.– Assembled (sometimes estimated) to meet

analytical requirements of a specific problem.

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Historical Cost andFull and Differential Costs

• Full cost:– Accounting system collects historical costs.

• Differential costs:– Relate to future.– Show what costs will be if a certain course

of action is adopted.

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Contribution Analysis

• A tool for analyzing differential costs.• Focuses on contribution margin:

– Total revenue minus total variable cost.

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Types of Cost• Variable costs:

– Total varies proportionately with volume of activity (such as sales).

• Fixed costs:– Total does not vary with volume of activity (within

relevant range).• Direct costs:

– Directly traceable to cost object.• Indirect costs:

– Not directly traceable to cost object.

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Alternative Choice Problems

• Two or more possible alternative courses of action.

• Manager chooses best alternative.• Some problems may not be quantifiable.

– Why? Not possible, too difficult, too expensive.– Use best judgment.

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Which Alternative is “Best?”

• Alternative most likely to achieve objectives of organization.

• Profit oriented business:– Maximizing value of shareholders’ investment– Satisfactory return on investment (ROI).

• Nonprofit organization:– Provide acceptable quality at lowest possible cost.

• Other objectives?– E.g., maintain market position, stabilize

employment, community responsibilities.

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Steps in the Analysis

1. Define problem.2. Select possible alternatives

– Include status quo (base case). 3. Measure and evaluate quantitative factors.4. Identify and evaluate qualitative factors.5. Make decision.

– Decision may be to seek additional information.

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Differential Costs

• Costs that will be different under the proposed alternative than they are in the base case.

• Also called:– Out-of-pocket costs, avoidable costs, incremental

costs, relevant costs.• No general category of costs can be labeled

differential.• Always relate to specific alternatives being

analyzed.

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Mechanics of Calculation

• No prescribed format; use most convenient.• Unaffected costs.

– Are not differential and may be disregarded (or treated the same under each alternative).

• Beware of full cost.– Allocated costs may not change (i.e., unaffected).

• Labor cost.– Don’t forget fringe benefits.

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Mechanics of Calculation

• Opportunity costs.– Value lost or sacrificed by giving up an alternative

course of action.– Not associated with cash outlays.– Not measured in accounting records.– Frequently measured by income that would have

been earned had resources been invested otherwise (e.g., capacity of warehouse).

– Frequently difficult to accurately estimate.

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Differential Costs

• May or may not be the same as variable costs.

• May also include fixed costs (e.g., decision to discontinue a product line).

• Goal is to determine future costs; however, may be best estimated by looking at past/historical costs.

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Sunk Cost

• Cost that has already been incurred.• Therefore, cannot be changed by any decision

currently being considered (e.g., all historical costs).

• Not a differential cost.• Question: In the decision to keep or replace

equipment, is the book value of current equipment a differential cost? What about disposal value?

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Importance of Time Span

• To make only one additional unit, only material cost may be differential.

• To produce an item over foreseeable future, all items of production cost would be differential.

• The longer the time span the more items of cost are differential.

• In the very long run, full costs are differential costs.

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Types of Alternative Choice Problems

• Decisions involving only costs.• Decisions involving revenues and costs.• Decisions involving revenues, costs, and

investment.

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Decisions Involving Costs

• One type of cost is traded for another.• Methods change decision.• Operations planning decision.

– E.g., Which machine should run this batch?, Where should we store this inventory?, How should we ship this product?

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Decisions Involving Costs

• Make or buy decision (i.e., outsourcing).– Both parts and whole product (service).– Make alternative more difficult to

determine.• Economic order quantity decision.

– Trade off between setup (ordering) costs and inventory carrying costs.

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Decisions Involving Both Revenues and Costs

• Best alternative is one with most differential income or profit.

• Supply-demand-price analysis decision.– Compare revenue and expense at various

prices, after considering affect on volume, revenue and costs.

– Feasible only if demand schedule can be estimated.

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Decisions Involving Both Revenues and Costs

• Contribution pricing decision.– Full cost is normal basis for setting price.– Use of contribution price (i.e., differential

revenues exceed differential costs).– Problems:

• Will this be considered dumping? (i.e., illegal).• Will the low price “spoil the market?”

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Decisions Involving Both Revenues and Costs

• Discontinuing a product decision.– Occurs when conventional accounting

reports indicate product/service is being sold below full cost.

– May discover that is better to keep. Why? Product/service is making some contribution to fixed overhead and profit.

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Decisions Involving Both Revenues and Costs

• Adding services.– Finding additional way of using idle

capacity.– Take care to ensure alternatives do not

divert from normal revenues (e.g., adding new flavor of cola).

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Decisions Involving Both Revenues and Costs

• Sale versus further processing.– Does differential revenue exceed additional

processing/marketing costs?• Other marketing tactics.

– Determine how changes in marketing (i.e., product, price, promotion, placement) affect differential revenues and costs.

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Decisions Involving Revenues, Costs, and Investment

• Decisions also involving changes in levels of assets, liabilities, equity.

• E.g., expansion plans.• Covered in Chapter 27.

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Sensitivity Analysis

• Considers how sensitive quantitative measurements of alternatives are to changes in assumptions.

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“Just One” Fallacy

• Fallacy is that each additional unit of production adds just variable costs.

• At some point step-function costs (i.e., fixed costs) have to be added.

• Solution: Average step-function costs out over the additional units of volume.

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Expected Values

• Discussion has assumed single point estimates (i.e., best estimates).

• Alternative is to use separate possibilities weighted by probabilities to determine expected values.

• Choose alternative with highest expected value.

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Decision Tree Analysis

• Decision tree diagram shows several decisions (or acts) and possible consequences of each.

• Revenues and costs are estimated with probabilities for each outcome to give an expected value for event.

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Practical Pointers

1. Use imagination in selecting alternatives.2. Don’t overweight your quantitative factors.3. However, don’t slight the numbers.4. Work with total costs, not unit costs.5. Be aware of the tendency to underestimate

the costs of new ventures.6. Look at substance of, not amount of,

arguments for or against a decision.

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Practical Pointers

7. Consider margin of error.8. Know that delaying too long to decide is a

decision.9. Identify your assumptions and perform

sensitivity analysis.10.Do not expect your conclusion to be

accepted just because numbers support the decision.

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Summary Comment

• Differential costs and revenues rarely provide a definitive answer to any business problem. Simply assist in making a sound decision.