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Copyright © 2008 by The McGraw-Hill Companies, Inc. llMcGraw-Hill#Irwin

Decision Making: Relevant Costs and

Benefits

14Chapter Fourteen

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LearningObjective

1

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The Managerial Accountant’sThe Managerial Accountant’s

Role in Decision MakingRole in Decision Making

Designs and implementsaccounting information

system

Designs and implementsaccounting information

system

Cross-functionalCross-functional

management teamsmanagement teamswho makewho make

production, marketing,production, marketing,

and finance decisionsand finance decisions

Cross-functionalCross-functional

management teamsmanagement teamswho makewho make

production, marketing,production, marketing,

and finance decisionsand finance decisions

Make substantiveeconomic decisionsaffecting operations

Make substantiveeconomic decisionsaffecting operations

ManagerialManagerial

AccountantAccountant

ManagerialManagerial

AccountantAccountant

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The Decision-Making rocessThe Decision-Making rocess

1. Clarify the Decision roblem1. Clarify the Decision roblem


!. "pecify the Criterion!. "pecify the Criterion


#. $dentify the Alternatives#. $dentify the Alternatives


%. Develop a Decision Model%. Develop a Decision Model


&. Collect the Data&. Collect the Data


'. Make a Decision'. Make a Decision


(uantitative(uantitative

AnalysisAnalysis

Exh.

14-1

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LearningObjective

!

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ri"aril# theri"aril# theresponsibilit# o$ theresponsibilit# o$ the"anagerial"anagerialaccountant%accountant%

ri"aril# theri"aril# theresponsibilit# o$ theresponsibilit# o$ the"anagerial"anagerial

accountant%accountant%

$nformation should be)$nformation should be)

1. *elevant1. *elevant

!. Accurate!. Accurate

#. +imely#. +imely

$nformation should be)$nformation should be)

1. *elevant1. *elevant

!. Accurate!. Accurate

#. +imely#. +imely

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&ualitativeConsi'erations

&ualitativeConsi'erations

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LearningObjective

(

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RelevantRelevant

Pertinent to a

decision problem.

RelevantRelevant

Pertinent to a

decision problem.

AccurateAccurate

Information must

be precise.

AccurateAccurate

Information must

be precise.

TimelyTimely

Available in time

for a decision

TimelyTimely

Available in time

for a decision

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Relevant )n$or"ationRelevant )n$or"ation

)n$or"ation is relevant to a 'ecisionproble" *hen % % %

)t has a bearing on the $uture+

)t 'i$$ers a"ong co"peting alternatives%

)n$or"ation is relevant to a 'ecisionproble" *hen % % %

)t has a bearing on the $uture+

)t 'i$$ers a"ong co"peting alternatives%

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LearningObjective

,

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)'enti$#ing Relevant)'enti$#ing Relevant

Costs an' ene$itsCosts an' ene$its.unk costs

Costs that have alrea'# been incurre'%The# 'o not a$$ect an# $uture cost an'

cannot be change' b# an# current or $utureaction%

.unk costsCosts that have alrea'# been incurre'%The# 'o not a$$ect an# $uture cost an'

cannot be change' b# an# current or $utureaction%

Sunk costs are irrelevant to decisions.Sunk costs are irrelevant to decisions.

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Relevant CostsRelevant Costs

/orl'*i'e Air*a#s is thinking about replacing a three#ear ol' loa'er *ith a ne*+ "ore e$$icient loa'er%

ew loader

-ist price 1&,.../

Annual operating e0penses %&,...

0pected life in years 1

2ld loader

2riginal cost 1..,.../

*emaining book value !&,... Disposal value now &,...

Annual variable e0penses 3.,...

*emaining life in years 1

ew loader

-ist price 1&,.../

Annual operating e0penses %&,... 0pected life in years 1

2ld loader

2riginal cost 1..,.../

*emaining book value !&,... Disposal value now &,...

Annual variable e0penses 3.,...

*emaining life in years 1

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)$ *e keep the ol' loa'er+ *e *ill have 'epreciation)$ *e keep the ol' loa'er+ *e *ill have 'epreciationcosts o$ 0!+222% )$ *e replace the ol' loa'er+costs o$ 0!+222% )$ *e replace the ol' loa'er+

*e *ill *rite-o$$ the 0!+222 *hen sol'% There is*e *ill *rite-o$$ the 0!+222 *hen sol'% There isno 'i$$erence in the cost+ so it isno 'i$$erence in the cost+ so it is not relevantnot relevant%%

)$ *e keep the ol' loa'er+ *e *ill have 'epreciation)$ *e keep the ol' loa'er+ *e *ill have 'epreciationcosts o$ 0!+222% )$ *e replace the ol' loa'er+costs o$ 0!+222% )$ *e replace the ol' loa'er+

*e *ill *rite-o$$ the 0!+222 *hen sol'% There is*e *ill *rite-o$$ the 0!+222 *hen sol'% There isno 'i$$erence in the cost+ so it isno 'i$$erence in the cost+ so it is not relevantnot relevant%%

The new loader will be depreciated in one year.

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The 0+222 procee's *ill onl# be reali3e' i$ *eThe 0+222 procee's *ill onl# be reali3e' i$ *ereplace the ol' loa'er% This a"ount isreplace the ol' loa'er% This a"ount is relevantrelevant%%

The 0+222 procee's *ill onl# be reali3e' i$ *eThe 0+222 procee's *ill onl# be reali3e' i$ *ereplace the ol' loa'er% This a"ount isreplace the ol' loa'er% This a"ount is relevantrelevant%%

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/e *ill onl# have 'epreciation on the ne* loa'er /e *ill onl# have 'epreciation on the ne* loa'er i$ *e replace the ol' loa'er% This cost isi$ *e replace the ol' loa'er% This cost is relevantrelevant%%

/e *ill onl# have 'epreciation on the ne* loa'er /e *ill onl# have 'epreciation on the ne* loa'er i$ *e replace the ol' loa'er% This cost isi$ *e replace the ol' loa'er% This cost is relevantrelevant%%

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The 'i$$erence in operating costs isThe 'i$$erence in operating costs is relevantrelevant

to the i""e'iate 'ecision%to the i""e'iate 'ecision%

The 'i$$erence in operating costs isThe 'i$$erence in operating costs is relevantrelevant

to the i""e'iate 'ecision%to the i""e'iate 'ecision%

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4ere is an anal#sis that inclu'es onl# relevantcosts5

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LearningObjective

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Anal#sis o$ .pecial Decisions Anal#sis o$ .pecial Decisions

Let’s take a close look at so"e special'ecisions $ace' b# "an# businesses%

4e 5ust received4e 5ust received

a special order. Doa special order. Do

you think we shouldyou think we should

accept it6accept it6

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Accept or Reject a .pecial Or'er Accept or Reject a .pecial Or'er

6 A travel agency offers 4orldwide Airways/1&, for a round-trip flight from 7awaiito 8apan on a 5umbo 5et.

6 4orldwide usually gets /!&, in revenue

from this flight.

6 +he airline is not currently planning to addany new routes and has two planes that are

idle and could be used to meet the needs ofthe agency.

6 +he ne0t screen shows cost data developed

by managerial accountants at 4orldwide.

6A travel agency offers 4orldwide Airways/1&, for a round-trip flight from 7awaiito 8apan on a 5umbo 5et.

6 4orldwide usually gets /!&, in revenue

from this flight.

6 +he airline is not currently planning to addany new routes and has two planes that are

idle and could be used to meet the needs ofthe agency.

6 +he ne0t screen shows cost data developed

by managerial accountants at 4orldwide.

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/orl'*i'e *ill save about 0+222 in reservation/orl'*i'e *ill save about 0+222 in reservation

an' ticketing costs i$ the charter is accepte'%an' ticketing costs i$ the charter is accepte'%

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.ince the charter *ill contribute to $i7e' costs an'.ince the charter *ill contribute to $i7e' costs an'

/orl'*i'e has i'le capacit#+ the co"pan# shoul'/orl'*i'e has i'le capacit#+ the co"pan# shoul'accept the $light%accept the $light%

.ince the charter *ill contribute to $i7e' costs an'.ince the charter *ill contribute to $i7e' costs an'/orl'*i'e has i'le capacit#+ the co"pan# shoul'/orl'*i'e has i'le capacit#+ the co"pan# shoul'

accept the $light%accept the $light%

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/hat i$ /orl'*i'e ha' no e7cess capacit#8 )$/orl'*i'e a''s the charter+ it *ill have to cut

its least pro$itable route that currentl#

contributes 092+222 to $i7e' costs an' pro$its%.houl' /orl'*i'e still accept the charter8

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Worldwide has no excess capacity, so itWorldwide has no excess capacity, so itshould reject the special charter.should reject the special charter.

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/ith e7cess capacit# % % % : Relevant costs *ill usuall# be the variable costs

associate' *ith the special or'er%

/ithout e7cess capacit# % % % : .a"e as above but opportunit# cost o$ using the

$ir"’s $acilities $or the special or'er are alsorelevant%

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Outsource a ro'uct or .erviceOutsource a ro'uct or .ervice

A 'ecision concerning *hether an ite" shoul'be pro'uce' internall# or purchase' $ro" an

outsi'e supplier is o$ten calle' a ;"ake or

bu#< 'ecision%

Let’s look at another 'ecision $ace' b# the

"anage"ent o$ /orl'*i'e Air*a#s%

A 'ecision concerning *hether an ite" shoul'be pro'uce' internall# or purchase' $ro" an

outsi'e supplier is o$ten calle' a ;"ake or

bu#< 'ecision%

Let’s look at another 'ecision $ace' b# the

"anage"ent o$ /orl'*i'e Air*a#s%

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Outsource a ro'uct or .erviceOutsource a ro'uct or .ervice6 An Atlanta baker# has o$$ere' to suppl# the in-

$light 'esserts $or !1= each%

6 4ere are /orl'*i'e’s current cost $or 'esserts5

6 An Atlanta baker# has o$$ere' to suppl# the in-$light 'esserts $or !1= each%

6 4ere are /orl'*i'e’s current cost $or 'esserts5

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ot all of the allocated fi0ed costs will be savedif 4orldwide purchases from the outside bakery.ot all of the allocated fi0ed costs will be savedif 4orldwide purchases from the outside bakery.

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)$ /orl'*i'e purchases the 'essert $or !1=+it *ill onl# save 1= so /orl'*i'e *ill

have a loss o$ >= per 'essert purchase'%

)$ /orl'*i'e purchases the 'essert $or !1=+it *ill onl# save 1= so /orl'*i'e *ill

have a loss o$ >= per 'essert purchase'%

/o*+ that’sno 'eal?

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e*are o$ @nit-Cost DataFor 'ecision-"aking purposes+ uniti3e' $i7e'

costs can be "islea'ing%

e*are o$ @nit-Cost DataFor 'ecision-"aking purposes+ uniti3e' $i7e'

costs can be "islea'ing%

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A'' or Drop a .ervice+ A'' or Drop a .ervice+

ro'uct+ or Depart"entro'uct+ or Depart"ent

One o$ the "ost i"portant'ecisions "anagers "ake is

*hether to a'' or 'rop a

pro'uct+ service or'epart"ent%

Let’s look at ho* the concepto$ relevant costs shoul' beuse' in such a 'ecision%

One o$ the "ost i"portant'ecisions "anagers "ake is

*hether to a'' or 'rop a

pro'uct+ service or'epart"ent%

Let’s look at ho* the concepto$ relevant costs shoul' beuse' in such a 'ecision%

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A'' or Drop a ro'uct A'' or Drop a ro'uct

/orl'*i'e Air*a#s o$$ers itspassengers the opportunit# to join its

/orl' 7press Club% Club"e"bership entitles a traveler to use

the club $acilities at the airport in Atlanta%

Club privileges inclu'e a private lounge

an' restaurant+ 'iscounts on "ealsan' beverages+ an' use o$ a s"allhealth spa%

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Sales $200,000Less !ariable "osts

#ood%evera&e $'0,000

Personnel (0,000

!ariable over)ead 2*,000 +-*,000

"ontribution /ar&in *,000

Less #i1ed "osts

epreciation $-0,000

Supervisor salary 20,000

Insurance 0,000 Airport fees *,000

Allocated over)ead 0,000 + '*,000

Loss $ + 0,000

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344P "L5% 4LI/I6AT4 I##4R46TIALSales $200,000 0 $200,000

#ood%evera&e +'0,000 0 +'0,000

Personnel +(0,000 0 +(0,000

!ariable over)ead +2*,000 0 +2*,000

"ontribution /ar&in *,000 0 *,000

epreciation +-0,000 +-0,000 0

Supervisor salary +20,000 0 +20,000

Insurance +0,000 +0,000 0

Airport fees + *,000 0 + *,000 Allocated over)ead +0,000 +0,000 0

Loss $ +0,000 $+*0,000 $ (0,000

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#ood%evera&e +'0,000 0 +'0,000

Personnel +(0,000 0 +(0,000



epreciation +-0,000 +-0,000 0


Insurance +0,000 +0,000 0


Loss +0,000 +*0,000 (0,000

NOT

AVOID

ABLE

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#ood%evera&e +'0,000 0 +'0,000

Personnel +(0,000 0 +(0,000



epreciation +-0,000 +-0,000 0


Insurance +0,000 +0,000 0


ProfitLoss +0,000 +*0,000 (0,000

A

V

O

I

D

A

B

L

E

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#ood%evera&e +'0,000 0 +'0,000

Personnel +(0,000 0 +(0,000



epreciation +-0,000 +-0,000 0


Insurance +0,000 +0,000 0


ProfitLoss +0,000 +*0,000 $ (0,000

T)e positive $(0,000differential amount reflects

t)e fact t)at t)e company is

$(0,000 better off by

7eepin& t)e club.

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344P "L5% 4LI/I6AT4 I##4R46TIAL

Sales $200,000 0 $200,000

#ood%evera&e +'0,000 0 +'0,000

Personnel +(0,000 0 +(0,000

!ariable over)ead +2*,000 0 +2*,000"ontribution /ar&in 65,000 0 65,000

Avoidable fi1ed costs


Airport fees + *,000 0 + *,000

ProfitLoss $ 40,000 $ 40,000

4orldwide airlines would also lose the contributionmargin of /'&,. +he club contributes /%, to

4orldwide9s fi0ed costs.

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"ontribution mar&in from

&eneral airline operations

t)at 8ill be for&one if club

is eliminated . . . . . . . . . . . $ 0,000 909 $ 0,000


T)e :pportunity "ost of

lost contribution mar&in is$0,000.

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"ontribution mar&in from

&eneral airline operations

t)at 8ill be for&one if club

is eliminated . . . . . . . . . . . $ 0,000 909 $ 0,000ProfitLoss $ (0,000 909 $ (0,000

Monthly profit of

KEEPING the l!" open #$00,000

;;;;;;;

ConclusionConclusion

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Learning

Objective>

. i l D i i i. i l D i i i

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.pecial Decisions in.pecial Decisions in

Manu$acturing Fir"sManu$acturing Fir"s

Boint ro'ucts5.ell or rocess Further

A joint pro'uction process resulting in t*oor "ore pro'ucts% The point in thepro'uction process *here the joint

pro'ucts are i'enti$iable as separatepro'ucts is calle' the split-o$$ point%

Boint ro'ucts5.ell or rocess Further

A joint pro'uction process resulting in t*oor "ore pro'ucts% The point in thepro'uction process *here the joint

pro'ucts are i'enti$iable as separatepro'ucts is calle' the split-o$$ point%

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"ocoa beans"ocoa beans

costin& $*00costin& $*00

per ton per ton

=oint Production=oint Production

process costin& process costin&

$00 per ton$00 per ton

"ocoa butter "ocoa butter

sales valuesales value

$'*0 for $'*0 for

,*00 pounds,*00 pounds

"ocoa po8der "ocoa po8der sales valuesales value

$*00 for $*00 for

*00 pounds*00 pounds

SeparableSeparable process process

costin&costin&

$>00$>00

Instant cocoaInstant cocoa

mi1mi1 sales valuesales value

$2,000 for $2,000 for

*00 pounds*00 pounds

Boint rocessingBoint rocessing

o$ Cocoa eano$ Cocoa eanBoint rocessingBoint rocessing

o$ Cocoa eano$ Cocoa ean

Total joint cost5Total joint cost501+122 per ton01+122 per ton

Split?off pointSplit?off point

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Boint ro'uctsBoint ro'ucts

Relative .ales alue Metho'

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/:& ; /1,!& < '=/:& ; /1,!& < '=

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'= > /1,1 < /'''= > /1,1 < /''

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6 Cocoa butter is sol' at the en' o$ the jointprocessing%

6 Cocoa po*'er "a# be sol' no* or processe'

into instant cocoa "i7% Further processingcosts o$ 0922 *ill be incurre' i$ the co"pan#elects to "ake instant cocoa "i7%

6 Cocoa butter is sol' at the en' o$ the jointprocessing%

6 Cocoa po*'er "a# be sol' no* or processe'

into instant cocoa "i7% Further processingcosts o$ 0922 *ill be incurre' i$ the co"pan#elects to "ake instant cocoa "i7%

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The cocoa powder should beThe cocoa powder should be processed into instant cocoa mix.processed into instant cocoa mix.

) *

Decisions )nvolving Li"ite'Decisions )nvolving Li"ite'

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Decisions )nvolving Li"ite'Decisions )nvolving Li"ite'

ResourcesResources

6 Fir"s o$ten $ace the proble" o$ 'eci'ing ho*li"ite' resources are going to be use'%

6 @suall#+ $i7e' costs are not a$$ecte' b# this'ecision+ so "anage"ent can $ocus on"a7i"i3ing total contribution "argin%

Let’s look at the Martin+ )nc% e7a"ple%

6 Fir"s o$ten $ace the proble" o$ 'eci'ing ho*li"ite' resources are going to be use'%

6 @suall#+ $i7e' costs are not a$$ecte' b# this'ecision+ so "anage"ent can $ocus on"a7i"i3ing total contribution "argin%

Let’s look at the Martin+ )nc% e7a"ple%

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Li"ite' ResourcesLi"ite' Resources

Martin+ )nc% pro'uces t*o pro'ucts an'selecte' 'ata is sho*n belo*5

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6 The lathe is the scarce resource because there ise7cess capacit# on other "achines% The lathe is beinguse' at 122 o$ its capacit#%

6 The lathe capacit# is !+,22 "inutes per *eek%

.houl' Martin $ocus its e$$orts

on /ebs or 4ighs8

6 The lathe is the scarce resource because there ise7cess capacit# on other "achines% The lathe is beinguse' at 122 o$ its capacit#%

6 The lathe capacit# is !+,22 "inutes per *eek%

.houl' Martin $ocus its e$$ortson /ebs or 4ighs8

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Let’s calculate the contribution "argin per unito$ the scarce resource+ the lathe%

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7ighs should be emphasi?ed% )t is the "ore valuableuse o$ the scarce resource the lathe+ #iel'ing a

contribution "argin o$ 0(2 per "inute as oppose' to0!, per "inute $or the /ebs%

7ighs should be emphasi?ed% )t is the "ore valuableuse o$ the scarce resource the lathe+ #iel'ing a

contribution "argin o$ 0(2 per "inute as oppose' to0!, per "inute $or the /ebs%

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$f there are no other considerations, the best plan wouldbe to produce to meet current demand for 7ighs and

then use remaining capacity to make 4ebs.

$f there are no other considerations, the best plan wouldbe to produce to meet current demand for 7ighs and

then use remaining capacity to make 4ebs.

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Li"ite' ResourcesLi"ite' ResourcesLet’s see ho* this plan *oul' *ork%

Allotting the "carce *esource @ +he athe

4eekly demand for 7ighs !,! units

+ime reuired per unit 0 .& minutes+ime reuired to make 7ighs 1,1 minutes

+otal lathe time available !,% minutes+ime used to produce 7ighs 1,1 minutes

+ime available for 4ebs 1,# minutes+ime reuired per unit 0 1. minuteroduction of 4ebs 1,# units

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Accor'ing to the plan+ Martin *ill pro'uce!+!22 4ighs an' 1+(22 /ebs% Martin’s

contribution "argin looks like this%

+he total contribution margin for Martin, $nc. is /'%,!.+he total contribution margin for Martin, $nc. is /'%,!.

Any other combination would result in less contribution.Any other combination would result in less contribution.

+he total contribution margin for Martin, $nc. is /'%,!.+he total contribution margin for Martin, $nc. is /'%,!.

Any other combination would result in less contribution.Any other combination would result in less contribution.

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Theor# o$ ConstraintsTheor# o$ Constraints

in'ing constraints can li"it a co"pan#’spro$itabilit#%

To rela7 constraints "anage"ent can % % %

2utsource2utsource 4ork overtime4ork overtime

*etrain employees*etrain employees*educe non-value-

added activities

*educe non-value-added activities

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@ncertaint#@ncertaint#

One co""on techniEue $or a''ressing thei"pact o$ uncertaint# is

sensitivit# anal#sis - a *a# to 'eter"ine

*hat *oul' happen in a 'ecision anal#sis i$a ke# pre'iction or assu"ption prove' to be*rong%

One co""on techniEue $or a''ressing thei"pact o$ uncertaint# is

sensitivit# anal#sis - a *a# to 'eter"ine

*hat *oul' happen in a 'ecision anal#sis i$a ke# pre'iction or assu"ption prove' to be*rong%

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7pecte' alues7pecte' alues

Fro" the last e7a"ple+ recall the the contribution"argin $or /ebs *as 0!, an' 01 $or 4ighs%

Due to uncertainty, assume Martin has the followin

probable contribution marins for the two products.

/ebs/ebs 4ighs4ighs

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7pecte' alues7pecte' alues

Fro" our last e7a"ple+ recall the the contribution"argin $or /ebs *as 0!, an' 01 $or 4ighs%

ue to uncertainty, assume 8e )ave t)e follo8in&ue to uncertainty, assume 8e )ave t)e follo8in&

probable contribution mar&ins for t)e t8o products. probable contribution mar&ins for t)e t8o products.

/ebs/ebs 4ighs4ighs

Martin *oul' use the e7pecte' valueMartin *oul' use the e7pecte' valuecontribution "argins in its 'ecision aboutcontribution "argins in its 'ecision about

utili3ing its li"ite' resource - the lathe%utili3ing its li"ite' resource - the lathe%

Martin *oul' use the e7pecte' valueMartin *oul' use the e7pecte' valuecontribution "argins in its 'ecision aboutcontribution "argins in its 'ecision about

utili3ing its li"ite' resource - the lathe%utili3ing its li"ite' resource - the lathe%

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Other )ssues in Decision MakingOther )ssues in Decision Making

)ncentives $or

Decision Makers

)ncentives $or

Decision Makers

.hort-Runersus

Long-RunDecisions

.hort-Runersus

Long-RunDecisions

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Learning

Objective

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Other )ssues in Decision MakingOther )ssues in Decision Making

it$alls to Avoi'

Sun7 Sun7 costs.costs.Sun7 Sun7 costs.costs.

5niti@ed5niti@ed

fi1ed costs.fi1ed costs.

5niti@ed5niti@ed

fi1ed costs.fi1ed costs.

AllocatedAllocatedfi1ed costs.fi1ed costs.AllocatedAllocatedfi1ed costs.fi1ed costs.

:pportunity:pportunity

costs.costs.

:pportunity:pportunity

costs.costs.

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n' o$ Chapter 1,n' o$ Chapter 1,

11. chap014_TNx2

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