11 - 1 ©2003 prentice hall business publishing, cost accounting 11/e, horngren/datar/foster...

11 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Decision Making andRelevant InformationDecision Making andRelevant Information

Chapter 11


Learning Objective 1

Use the five-step decisionprocess to make decisions.


Information and theDecision Process

Information and theDecision Process

A decision model is a formal methodfor making a choice, often involvingquantitative and qualitative analysis.


Five-Step Decision ProcessFive-Step Decision Process

Gather Information

Make Predictions

Choose an Alternative

Implement the Decision

Evaluate Performance

Step 1.

Step 2.

Step 3.

Step 4.

Step 5.

Historical CostsOther Information

Specific Predictions

Fee

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Learning Objective 2Learning Objective 2

Differentiate relevantfrom irrelevant

costs and revenues indecision situations.


The Meaning of RelevanceThe Meaning of Relevance

Relevant costs and relevant revenues areexpected future costs and revenues that

differ among alternative courses of action.

Historical costs Sunk costs

Differential income Differential costs



Distinguish between quantitativeand qualitative factors in decisions.


Quantitative and QualitativeRelevant Information

Quantitative and QualitativeRelevant Information

Quantitative factors

Financial Nonfinancial

Qualitative factors


One-Time-OnlySpecial Order Example


The Bismark Co. manufacturing plant has aproduction capacity of 44,000 towels each month.

Current monthly production is 30,000 towels.

Costs can be classified as either variable or fixedwith respect to units of output.




Variable FixedCosts Costs

Per Unit Per UnitDirect materials $6.50 $ -0-Direct labor .50 1.50Manufacturing costs 1.50 3.50Total $8.50 $5.00




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?




A hotel in San Juan has offered to buy5,000 towels from Bismark Co. at

$11.50/towel for a total of $57,500.

No marketing costs will be incurred.

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




$8.50 × 5,000 = $42,500 incremental costs

What are the incremental revenues ?

What are the relevant costs of making the towels ?

$57,500 – $42,500 = $15,000



Beware of two potentialproblems in

relevant-cost analysis.


Two Potential Problems inRelevant-Cost Analysis

Two Potential Problems inRelevant-Cost Analysis

Incorrect generalassumptions:

All variable costsare relevant.

All fixed costsare irrelevant.

1 2

Misleadingunit-cost data:

Includeirrelevant costs.

Use same unitcosts at different

output levels.


Outsourcing versus InsourcingOutsourcing versus Insourcing

Outsourcing ispurchasing goodsand services fromoutside vendors.

Insourcing isproducing goods

or providing serviceswithin the organization.


Make-or-Buy Decisions ExampleMake-or-Buy Decisions Example

Bismark Co. also manufactures bath accessories.

Management is considering producing a part itneeds (#2) or buying a part produced

by Towson Co. for $0.55.



Bismark Co. has the following costsfor 150,000 units of Part #2:

Direct materials $ 28,000Direct labor 18,500Mixed overhead 29,000Variable overhead 15,000Fixed overhead 30,000Total $120,500



Mixed overhead consists of materialhandling and setup costs.

Bismark Co. produces the 150,000 unitsin 100 batches of 1,500 units each.

Total material handling and setup costsequal fixed costs of $9,000 plus variable

costs of $200 per batch.



What is the cost per unit for Part #2?

$120,500 ÷ 150,000 units = $0.8033/unit

Should Bismark Co. manufacture the partor buy it from Towson Co.?



Bismark Co. anticipates that next year the150,000 units of Part #2 expected to be

sold will be manufactured in 150batches of 1,000 units each.



Variable costs per batch are expected todecrease to $100.

Bismark Co. plans to continue to produce150,000 next year at the same variable

manufacturing costs per unit as this year.

Fixed costs are expected to remain thesame as this year.



What is the variable manufacturing cost per unit?

$61,500 ÷ 150,000 = $0.41 per unit

Direct material $28,000Direct labor 18,500Variable overhead 15,000Total $61,500



Expected relevant cost to make Part #2:

Cost to buy: (150,000 × $0.55) $82,500

Manufacturing $61,500Material handling and setups 15,000*Total relevant cost to make $76,500*150 × $100 = $15,000

Bismark Co. will save $6,000 by making the part.



Now assume that the $9,000 in fixed clericalsalaries to support material handling and

setup will not be incurred if Part #2 ispurchased from Towson Co..

Should Bismark Co. buy the part or make the part?



Relevant cost to make:

Variable $76,500Fixed 9,000Total $85,500

Cost to buy: $82,500

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



Explain the opportunity-costconcept and why it is

used in decision making.


Opportunity Costs,Outsourcing, and Constraints


Assume that if Bismark buys the part fromTowson, it can use the facilities previously

used to manufacture Part #2 to producePart #3 for Krysta Company.

The expected additional future operatingincome is $18,000.

What should Bismark Co. do?




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.




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 = $64,500

Make Part #2: $76,500




Opportunity cost is the contribution to incomethat is forgone (rejected) by not using a

limited resource in its next-best alternative use.




Assume that annual estimated Part #2requirements for next year is 150,000.

Cost per purchase order is $40.

Cost per unit when each purchase is1,500 units = $0.55.

Cost per unit when each purchase is equalto or greater than 150,000 = $0.54.




Average investment in inventory is either:

(1,500 × .55) ÷ 2 = $412.50 or

(150,000 × $0.54) = $40,500

Annual interest rate for investment ingovernment bonds is 6%.

$412.50 × .06 = $24.75

$40,500 × .06 = $2,430




Option A: Make 100 purchases of 1,500 units:

Purchase order costs: (100 × $40) $ 4,000.00

Purchase costs: (150,000 × $0.55) $82,500.00

Annual interest income: $ 24.75

Relevant costs: $86,524.75




Option B: Make 1 purchase of 150,000 units:

Purchase order costs: (1 × $40) $ 40

Purchase costs: (150,000 × $0.54) $81,000

Annual interest income: $ 2,430

Relevant costs: $83,470



Know how to choose whichproducts to produce when there

are capacity constraints.


Product-Mix DecisionsUnder Capacity Constraints


Per unit Product #2 Product #3Sales price $2.11 $14.50Variable expenses 0.41 13.90Contribution margin $1.70 $ 0.60Contribution margin ratio 81% 4%

Bismark Co. has 3,000 machine-hours available.




One unit of Prod. #2 requires 7 machine-hours.

One unit of Prod. #3 requires 2 machine-hours.

What is the contribution of each productper machine-hour?

Product #2: $1.70 ÷ 7 = $0.24Product #3: $0.60 ÷ 2 = $0.30



Discuss what managersmust consider when

adding or discontinuing customers and segments.


Profitability, Activity-BasedCosting, and Relevant CostsProfitability, Activity-BasedCosting, and Relevant Costs

Mountain View Furniture supplies furnitureto two local retailers – Stevens and Cohen.

The company has a monthly capacityof 3,000 machine-hours.

Fixed costs are allocated on the basis of revenues.


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

Stevens CohenRevenues $200,000 $100,000Variable costs 70,000 60,000Fixed costs 100,000 50,000Total operating costs $170,000 $110,000Operating income $ 30,000 $(10,000)Machine-hours required 2,000 1,000



TotalRevenues $300,000Variable costs 130,000Fixed costs 150,000Total operating costs $280,000Operating income $ 20,000Machine-hours required 3,000



Should Mountain View Furniture drop the Cohenbusiness, assuming that dropping Cohen would

decrease its total fixed costs by 10%?

New fixed costs would be:$150,000 – $15,000 = $135,000



Stevens AloneRevenues $200,000Variable costs 70,000Fixed costs 135,000Total operating costs $205,000Operating income $ (5,000)Machine-hours required 3,000



Cohen’s business is providing acontribution margin of $40,000.

$40,000 decrease in contribution margin– $15,000 decrease in fixed costs= $25,000 decrease in operating income.



Assume that if Mountain View Furniture dropsCohen’s 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?



Explain why the book valueof equipment is irrelevant in

equipment-replacement decisions.


Equipment-Replacement Decisions Example


Existing ReplacementMachine Machine

Original cost $80,000 $105,000Useful life 4 years 4 yearsAccumulated depreciation $50,000Book value $30,000Disposal price $14,000Annual costs $46,000 $ 10,000




Ignoring the time value of money andincome 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 = $53,000advantage of the replacement machine.



Explain how conflicts can arisebetween the decision modelused by a manager and the

performance evaluation modelused to evaluate the manager.


Decisions andPerformance Evaluation


What is the journal entry to sell the existing machine?

Cash 14,000Accumulated Depreciation 50,000Loss on Disposal 16,000Machine 80,000




In the real world would the managerreplace the machine?

An important factor in replacement decisionsis the manager’s perceptions of whether thedecision model is consistent with how the

manager’s performance is judged.




Top management faces a challenge – that is,making sure that the performance-evaluationmodel of subordinate managers is consistent

with the decision model.


End of Chapter 11End of Chapter 11

11 - 1 ©2003 prentice hall business publishing, cost accounting 11/e, horngren/datar/foster...

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