Module 02: Discussion 1 of 2

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Chapter 14

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Decision Making: Relevant Costs and Benefits

Chapter 14: Decision Making: Relevant Costs and Benefits

Learning Objective 14-1 – Describe seven steps in the decision-making process and the managerial accountant’s role in that process.

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Learning Objective 14-1. Describe seven steps in the decision-making process and the managerial accountant’s role in that process.

The Managerial Accountant’s Role in Decision Making

Designs and implements

accounting information

system

Cross-functional

management teams

who make

production, marketing,

and finance decisions

Make substantive

economic decisions

affecting operations

Managerial

Accountant

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The accountant is increasingly a part of the upper-management decision-making team.

Management accountants are called to deliver relevant information to the team from the accounting information system.

These teams then make decisions regarding production, marketing, and financing affecting their organization.

The management accountant is considered a business advisor in many organizations. (LO 14-1)

The Decision-Making Process (1 of 4)

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

4. Develop a Decision Model

5. Collect the Data

6. Select an alternative

Quantitative

Analysis

7. Evaluate decision

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Seven steps generally characterize a typical decision-making process.

Defining the problem, determining the objectives of the decision, identifying alternative courses of action, determining what information is relevant, collecting information to support the decision, then selecting the appropriate alternative. (LO 14-1)

Learning Objective 14-2 – Explain the relationship between quantitative and qualitative analyses in decision making.

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Learning Objective 14-2. Explain the relationship between quantitative and qualitative analyses in decision making.

The Decision-Making Process (2 of 4)

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

4. Develop a Decision Model

5. Collect the Data

6. Select an alternative

Primarily the

responsibility of the

managerial

accountant.

Information should be:

1. Relevant

2. Accurate

3. Timely

7. Evaluate decision

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Accounting data is typically kept in quantitative measures, and, is important in the decision–making process.

Managers must use their skills, their judgment and their ethics to make difficult decisions.

While involved in all stages of the decision-making process, the managerial accountant’s primary role is to provide quantitative data and analysis that are relevant, accurate, and timely to the decision being made. (LO 14-2)

The Decision-Making Process (3 of 4)

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

4. Develop a Decision Model

5. Collect the Data

6. Select an alternative

Relevant

Pertinent to a

decision problem.

Accurate

Information must

be precise.

Timely

Available in time

for a decision

7. Evaluate decision

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A managerial accountant might ask, “What sort of information should the accountant gather?”

Information that is useful to a decision has some common characteristics. The information should be relevant, timely, and accurate. Relevant information means that only the information required to make the decision is presented. Information must also be accurate in order to be useful. The accuracy of the information is sometimes sacrificed in order to be timely. Information that is delivered after a decision has been made is of little use. If accountants had unlimited time, the information could be extremely accurate. Accuracy suffers as the time period shortens.

The management accountant’s job is to determine what information is relevant and provide accurate and timely data keeping a proper balance of accuracy and timeliness. (LO 14-2)

The Decision-Making Process (4 of 4)

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

4. Develop a Decision Model

5. Collect the Data

6. Select an alternative

Qualitative

Considerations

7. Evaluate decision

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Qualitative characteristics are the factors in a decision problem that cannot be expressed effectively in numerical terms.

Sometimes, a decision can be made that goes against the quantitative analysis, because the effect on the company, their employees, or their customers would be negative. (LO 14-2)

Learning Objective 14-3 – List and explain two criteria that must be satisfied by relevant information.

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Learning Objective 14-3. List and explain two criteria that must be satisfied by relevant information.

Relevant Information

Information is relevant to a decision

problem when . . .

It has a bearing on the future

It differs among competing alternatives

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Relevance has certain characteristics also. Relevant information is future oriented. To demonstrate this characteristic, you cannot make a decision on what to have for breakfast yesterday. Why? Because the decision has already been made! You have either already eaten or skipped yesterday’s breakfast. You can make a decision on what to have for breakfast tomorrow, in the future. Relevant information differs between the alternatives. This makes a difference in the decision. If one item costs $100, and the second item costs $100, there is no difference in the cost. In other words, it is not relevant to the decision.

If the second item cost $115, there would be a difference, so it would be relevant to the decision.

Relevant information makes a difference in a decision. (LO 14-3)

Learning Objective 14-4 – Identify relevant costs and benefits, giving proper treatment to sunk costs, opportunity costs, and unit costs.

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Learning Objective 14-4. Identify relevant costs and benefits, giving proper treatment to sunk costs, opportunity costs, and unit costs.

Identifying Relevant Costs and Benefits

Sunk Costs Costs that have already been incurred. They do not affect any future cost and cannot be changed by any current or future action.

Sunk costs are irrelevant to decisions.

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Sunk costs are costs that have been incurred in the past, and are not relevant to the future, and not relevant to a future decision. A decision has already been made, in the past, and that specific decision cannot be changed. A new decision can be made regarding the past decision, but, that is a new decision. Sunk costs cannot be changed.

Sunk costs are never relevant to a future decision. (LO 14-4)

Relevant Costs (1 of 4)

Worldwide Airways is thinking about replacing a three year old loader with a new, more efficient loader.

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An example might help clarify relevant costs.

In this example, a business is considering the replacement of a loading machine. (LO 14-4)

Relevant Costs (2 of 4)

If we keep the old loader, we will have depreciation

costs of $25,000. If we replace the old loader,

we will write-off the $25,000 when sold. There is

no difference in the cost, so it is not relevant.

The $5,000 proceeds will only be realized if we

replace the old loader. This amount is relevant.

We will only have depreciation on the new loader

if we replace the old loader. This cost is relevant.

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Depreciation of the old loader is not relevant. The cost of the old loader was incurred in the past, and cannot be changed.

If we decide to replace the old loader, we can sell it for $5,000. This is relevant to the decision because we will only sell the loader in the future, if the decision to replace the machine is made. The $5,000 is relevant to the decision to replace the loader. We will only have depreciation on the new machine if we replace it. The depreciation cost of the new loader is relevant. (LO 14-4)

Relevant Costs (3 of 4)

The difference in operating costs is relevant

to the immediate decision.

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If we buy the new loader, there will be differences between the operating costs of the current loader and the new one.

The differences in operating costs is relevant to the decision to replace the old loader. (LO 14-4)

Relevant Costs (4 of 4)

Here is an analysis that includes only

relevant costs:

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The final analysis of the relevant costs of purchasing the new loader shows that the new loader would have a positive effect of $25,000 to the business.

The decision to purchase a new loader is appropriate. (LO 14-4)

Opportunity Costs

The potential benefit given up when the choice of one action precludes a different action.

People tend to overlook or underestimate the importance of opportunity costs.

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An opportunity cost is the potential benefit given up when the choice of one action precludes you from choosing a different action. Although people tend to overlook or underestimate the importance of opportunity costs, they are just as important as out-of-pocket costs in evaluating decision alternatives. (LO 14-4)

Learning Objective 14-5 – Prepare analyses of various special decisions, properly identifying the relevant costs and benefits.

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Learning Objective 14-5. Prepare analyses of various special decisions, properly identifying the relevant costs and benefits.

Accept or Reject a Special Order (1 of 6)

A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Hawaii to Japan on a jumbo jet.

Worldwide usually gets $250,000 in revenue from this flight.

The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.

The next screen shows cost data developed by managerial accountants at Worldwide.

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A travel agency e-mails us. They want to charter one of our aircraft for a round trip flight from Japan to Hawaii. We have two airplanes that could potentially be used to fly this trip. The managerial accountant prepared some information to help the team make the decision whether or not to accept this offer. (LO 14-5)

Accept or Reject a Special Order (2 of 6)

Worldwide will save $5,000 in reservation

and ticketing costs if the charter is accepted.

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Normally, we would earn revenues of $280,000 and incur expenses of $190,000 on a trip such as this.

However, we would not have to provide ticketing and reservation services and would save $5,000 in these costs. (LO 14-5)

Accept or Reject a Special Order (3 of 6)

Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight.

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Since we have two airplanes that are not being used, we only need to consider our variable costs of making the trip.

We would also save the ticketing costs, reducing our variable costs by $5,000.

Even though we would normally receive $250,000 for a trip such as this, we should accept the offer.

The trip would contribute to paying our fixed costs, or, if our fixed costs are already paid, it would contribute this amount directly to profit.

Worldwide should accept this offer. (LO 14-5)

Accept or Reject a Special Order (4 of 6)

What if Worldwide had no excess capacity?

If Worldwide adds the charter, it will have to cut its least profitable route (that currently contributes $80,000 to fixed costs and profits).

Should Worldwide still accept the charter?

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What should we do if all of our airplanes are busy and we would have to pull our airplane from a regular route? (LO 14-5)

Accept or Reject a Special Order (5 of 6)

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

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Since we would not earn the revenues from our regular route, we would have to charge for the lost revenue of the route that was not taken, a lost opportunity.

The total cost to us exceeds the amount of the offer so we should reject the special offer. (LO 14-5)

Accept or Reject a Special Order (6 of 6)

With excess capacity…

Relevant costs will usually be the variable costs associated with the special order.

Without excess capacity…

Same as above but opportunity cost of using the firm’s facilities for the special order are also relevant.

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The decision to accept or reject a special offer can be summed up like this.

If we do have excess capacity, the relevant costs will usually be the variable costs.

If we do not have excess capacity, we would have to add the opportunity cost of using our facilities. (LO 14-5)

Outsource a Product or Service (1 of 4)

A decision concerning whether an item should be produced internally or purchased from an outside supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the management of Worldwide Airways.

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Sometimes the decision is whether we should produce a product, or whether we should have someone else produce that product.

This is called a make buy decision. (LO 14-5)

Outsource a Product or Service (2 of 4)

An Atlanta bakery has offered to supply the in-flight desserts for 21¢ each.

Here are Worldwide’s current cost for desserts:

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We currently make our own desserts that are served on flights.

Our cost summary is shown here. (LO 14-5)

Outsource a Product or Service (3 of 4)

Not all of the allocated fixed costs will be saved

if Worldwide purchases from the outside bakery.

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Our variable costs will remain in the analysis, but some of our allocated fixed costs will not be relevant to this decision.

We will incur somewhat less in supervisor salaries, but will still have some since someone needs to make sure the desserts are delivered and loaded properly.

Our depreciation will not change under either decision, so that cost is not relevant.

Our relevant costs are 15 cents per dessert. (LO 14-5)

Outsource a Product or Service (4 of 4)

If Worldwide purchases the dessert for 21¢, it will only save 15¢ so Worldwide will have a loss of 6¢ per dessert purchased.

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If we bought from the outside source, our cost would be 21 cents, and our relevant cost for this decision are 15 cents.

We should not accept this special offer, since we would lose 6 cents per dessert served.

Beware of Unit-Cost Data for decision-making purposes, unitized fixed costs can be misleading.

Fixed costs often are allocated to individual units of product or service for product-costing purposes.

For decision-making purposes, however, unitized fixed costs can be misleading.

Remember that fixed costs are fixed in total, not on a per unit basis.

Also, many fixed costs remain, regardless of a decision to outsource or to continue to produce. (LO 14-5)

Add or Drop a Service, Product, or Department

One of the most important decisions managers make is whether to add or drop a product, service, or department.

Let’s look at how the concept of relevant costs should be used in such a decision.

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Sometimes, managers want to drop a product or service because it appears to be unprofitable. (LO 14-5)

Add or Drop a Product (1 of 5)

Worldwide Airways offers its passengers the opportunity to join its World Express Club. Club membership entitles a traveler to use the club facilities at the airport in Atlanta.

Club privileges include a private lounge and restaurant, discounts on meals and beverages, and use of a small health spa.

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Worldwide Airways offers its passengers the opportunity to join its World Express Club.

Club membership entitles a traveler to use the club facilities at the airport in Atlanta.

Club privileges include a private lounge and restaurant, discounts on meals and beverages, and use of a small health spa. (LO 14-5)

Add or Drop a Product (2 of 5)

Sales $200,000

Less: Variable Costs:

Food/Beverage $70,000

Personnel 40,000

Variable overhead 25,000 (135,000)

Contribution Margin 65,000

Less: Fixed Costs:

Depreciation $30,000

Supervisor salary 20,000

Insurance 10,000

Airport fees 5,000

Allocated overhead 10,000 ( 75,000)

Loss $ ( 10,000)

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The president of Worldwide Airways, is worried that the World Express Club might not be profitable. Her concern is caused by the statement of monthly operating income shown. In her weekly staff meeting, Wing states her concern about the World Express Club’s profitability.

The controller responds by pointing out that not all of the costs on the club’s income statement would be eliminated if the club were discontinued.

The vice president for sales adds that the club helps Worldwide Airways attract passengers who it might otherwise lose to a competitor.

As the meeting adjourns, Wing asks the controller to prepare an analysis of the relevant costs and benefits associated with the World Express Club. (LO 14-5)

Add or Drop a Product (3 of 5)

KEEP CLUB ELIMINATE DIFFERENTIAL

Sales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)

Personnel (40,000) 0 (40,000)

Variable overhead (25,000) 0 (25,000)

Contribution Margin 65,000 0 65,000

Depreciation (30,000) (30,000) 0

Supervisor salary (20,000) 0 (20,000)

Insurance (10,000) (10,000) 0

Airport fees ( 5,000) 0 ( 5,000)

Allocated overhead (10,000) (10,000) 0

Loss $ (10,000) $(50,000) $ 40,000

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The management accountant’s report contains two parts.

Above, the focus is on the relevant costs and benefits of the World Express Club only, while ignoring any impact of the club on other airline operations. In the first column the accountant has listed the club’s revenues and expenses from the income statement. The second column lists the expenses that will continue if the club is eliminated. The third column is the differential, or the difference between the two columns. (LO 14-5)

*Not Avoidable *Avoidable

Add or Drop a Product (4 of 5)

KEEP CLUB ELIMINATE DIFFERENTIAL

Sales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)

Personnel (40,000) 0 (40,000)

Variable overhead (25,000) 0 (25,000)

Contribution Margin 65,000 0 65,000

Depreciation (30,000) (30,000) 0

Supervisor salary (20,000) 0 (20,000)

Insurance (10,000) (10,000) 0

Airport fees ( 5,000) 0 ( 5,000)

Allocated overhead (10,000) (10,000) 0

Loss (10,000) (50,000) 40,000

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These expenses are called unavoidable expenses. In other words, these costs will continue if the club is either kept or eliminated. Depreciation, insurance, and allocated overhead costs will continue regardless of the decision, therefore Worldwide cannot avoid them.

In contrast, the expenses appearing in the first column but not the second are avoidable expenses. The airline will no longer incur these expenses if the club is eliminated. Notice that all variable costs are avoidable. In addition, supervisor salaries and airport fees will be eliminated if the club is closed. The positive $40,000 differential amount reflects the fact that the company is $40,000 better off by keeping the club. (LO 14-5)

Add or Drop a Product (5 of 5)

KEEP CLUB ELIMINATE DIFFERENTIAL

Sales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)

Personnel (40,000) 0 (40,000)

Variable overhead (25,000) 0 (25,000)

Contribution Margin 65,000 0 65,000

Avoidable fixed costs

Supervisor salary (20,000) 0 (20,000)

Airport fees ( 5,000) 0 ( 5,000)

Profit/Loss $ 40,000 $ 40,000

Worldwide airlines would also lose the contribution margin of $65,000 but only $25,000 in fixed expenses. The club contributes $40,000 to Worldwide’s fixed costs.

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The conclusion of the first part of the controller’s report is that the club should not be eliminated.

If the club is closed, the airline will lose more in contribution margin, $65,000, than it saves in avoidable fixed expenses, $25,000.

Thus, the club’s $65,000 contribution margin is enough to cover the avoidable fixed expenses of $25,000 and still contribute $40,000 toward covering the airline’s overall fixed expenses. (LO 14-5)

Contribution margin from

general airline operations

that will be forgone if club

is eliminated: $ 60,000 –0– $ 60,000

Profit/Loss: $ 40,000 –0– $ 40,000

Monthly profit of

KEEPING the club open $100,000

=======

Worldwide is better off by $100,000 per month by keeping its club open.

The Opportunity Cost of lost contribution margin is $60,000.

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Conclusion: Keep the Club Open!

Now consider the second part of the controller’s analysis, the effect on Worldwide as a whole. As the vice president for sales pointed out, the World Express Club is an attractive feature to many travelers.

The controller estimates that if the club were discontinued, the airline would lose $60,000 each month in forgone contribution margin from general airline operations. This loss in contribution margin would result from losing to a competing airline current passengers who are attracted to Worldwide Airways by its World Express Club. This $60,000 in forgone contribution margin is an opportunity cost of the option to close down the club. Considering both parts of the controller’s analysis, Worldwide Airways’ monthly profit will be greater by $100,000 if the club is kept open.

Recognition of two issues is key to this conclusion. First, only the avoidable expenses of the club will be saved if it is discontinued. Second, closing the club will adversely affect the airline’s other operations. Worldwide should keep the club open. (LO 14-5)

Learning Objective 14-6 – Analyze manufacturing decisions involving joint products and limited resources.

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Learning Objective 14-6. Analyze manufacturing decisions involving joint products and limited resources.

Special Decisions in Manufacturing Firms

Joint Products:

Sell or Process Further A joint production process resulting in two or more products. The point in the production process where the joint products are identifiable as separate products is called the split-off point.

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Joint production processes make two or more different products using some similar beginning process.

An example of this might be a basic coffee maker. The basic coffee maker is produced, then a timer is added to the premium coffee maker. The split-off point is where we have two differently identifiable products. (LO 14-6)

Cocoa beans

costing $500

per ton

Joint Production

process costing

$600 per ton

Cocoa butter

sales value

$750 for

1,500 pounds

Cocoa powder

sales value

$500 for

500 pounds

Separable

process

costing

$800

Instant cocoa

mix sales value

$2,000 for

500 pounds

Total joint cost:

$1,100 per ton

Split-off point

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Joint Processing of Cocoa Beans

Cocoa beans are processed for all finished chocolate products. When the cocoa beans are finished, they can be used to produce two different finished products, cocoa butter and cocoa powder.

The cocoa powder can then be sold as is, or, used to produce instant cocoa mix. (LO 14-6)

Joint Products (1 of 3)

Relative Sales Value Method

$750 ÷ $1,250 = 60%

60% × $1,100 = $660

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The decision to sell or produce further can be solved by using the relative sales value method.

First, we determine the relative sales value at the split-off point. Then we calculate the relative sales proportion of the cocoa butter. We then allocate the joint costs to the cocoa butter.

We follow a similar procedure to allocate the joint costs to the cocoa powder. The cocoa butter is a finished product and can be sold. (LO 14-6)

Joint Products (2 of 3)

Cocoa butter is sold at the end of the joint processing.

Cocoa powder may be sold now or processed into instant cocoa mix. Further processing costs of $800 will be incurred if the company elects to make instant cocoa mix.

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Cocoa powder can be sold as a finished product, or processed further into instant cocoa mix for $800. (LO 14-6)

Joint Products (3 of 3)

The cocoa powder should be

processed into instant cocoa mix.

( )

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Because the benefit of further processing is positive, we should process the powder further into the instant cocoa mix.

While it costs us more to produce the instant mix, we also earn more revenue from the mix. (LO 14-6)

Decisions Involving Limited Resources

Firms often face the problem of deciding how limited resources are going to be used.

Usually, fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin.

Let’s look at the Martin, Inc. example.

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Organizations typically have limited resources. Limitations on floor space, machine time, labor hours, or raw materials are common.

Fixed cost often continue regardless of the decision, so maximizing the contribution margin is most often the appropriate decision. (LO 14-6)

Limited Resources (1 of 5)

Martin, Inc. produces two products and selected data are shown below:

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Martin Company produces two products with the costs shown. (LO 14-6)

Limited Resources (2 of 5)

The lathe is the scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity.

The lathe capacity is 2,400 minutes per week.

Should Martin focus its efforts

on Webs or Highs?

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The lathe is used 100% of the time in production. It is working at its maximum capacity, and is the scarce, or limited resource. Sometimes this is known as the bottleneck. (LO 14-6)

Limited Resources (3 of 5)

Let’s calculate the contribution margin per unit

of the scarce resource, the lathe.

Highs should be emphasized. It is the more valuable use of the scarce resource, the lathe, yielding a contribution margin of $30 per minute as opposed to $24 per minute for the Webs.

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Webs have a contribution margin of $24 per minute. Highs have a contribution margin of $30 per minute. All other things being equal, and if the company can sell all the highs it can produce, the company should produce and sell all the highs it can.

Webs should only be produced when more highs cannot be sold, and they have excess capacity to produce webs. If there are no other considerations, the best plan would be to produce to meet current demand for Highs and then use remaining capacity to make Webs. (LO 14-6)

Limited Resources (4 of 5)

Let’s see how this plan would work.

Allotting the Scarce Resource – The Lathe

Weekly demand for Highs 2,200 units

Time required per unit x .50 minutes

Time required to make Highs 1,100 minutes

Total lathe time available 2,400 minutes

Time required to make Highs 1,100 minutes

Time available for Webs 1,300 minutes

Time required per unit x 1.00 minute

Production of Webs 1,300 units

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The weekly demand for highs is 2,200 units and would use 1,100 minutes of lathe time. This leaves 1,300 minutes worth of lathe time to produce Webs. (LO 14-6)

Limited Resources (5 of 5)

According to the plan, Martin will produce 2,200 Highs and 1,300 Webs. Martin’s contribution margin looks like this.

The total contribution margin for Martin, Inc. is $64,200.

Any other combination would result in less contribution.

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Martin would have a total contribution margin of $64,000. If Martin was able to sell more highs, it would increase production of highs to the maximum capacity of the lathe. (LO 14-6)

Theory of Constraints

Binding constraints can limit a company’s profitability. To relax constraints management can…

Outsource all or part of the bottleneck operation.

Invest in additional production equipment and employ ‘parallel processing.’

Work overtime at the bottleneck operation.

Retrain employees, shift them to the bottleneck.

Eliminate any non-value-added activities at the bottleneck operation.

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Among the ways that management can relax a constraint by expanding the capacity of a bottleneck operation are the following:

Outsourcing (subcontracting) all or part of the bottleneck operation.

Investing in additional production equipment and employing parallel processing, in which multiple product units undergo the same production operation simultaneously.

Working overtime at the bottleneck operation.

Retraining employees and shifting them to the bottleneck.

Eliminating any non–value-added activities at the bottleneck operation.

(LO 14-6)

Uncertainty

One common technique for addressing the

impact of uncertainty is sensitivity analysis—a way to determine what would happen in a decision analysis if a key prediction or assumption proved to be wrong.

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Sensitivity analysis is a technique for determining what would happen in a decision analysis if a key prediction or assumption proved to be wrong. (LO 14-6)

Expected Values

From the last example, recall the contribution margin for Webs was $24 and $15 for Highs. Due to uncertainty, assume Martin has the following probable contribution margins for the two products.

Webs

Highs

Martin would use the expected value contribution margins in its decision about utilizing its limited resource – the lathe.

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Another approach to dealing explicitly with uncertainty is to base the decision on expected values. The expected value of a random variable is equal to the sum of the possible values for the variable, each weighted by its probability.

Suppose the contribution margins per case for Webs and Highs are uncertain.

In other words, there is a 30% probability that webs will have a contribution margin of $23, a 50% chance the contribution margin will be $24, and a 20% probability that the contribution margin will be $25.

As the slide shows, the choice as to which product to produce with excess lathe time may be based on the expected value of the contribution per machine hour. Statisticians have developed many other methods for dealing with uncertainty in decision making. (LO 14-6)

Learning Objective 14-7 – Explain the impact of an advanced manufacturing environment and activity-based costing on a relevant-cost analysis.

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Learning Objective 14-7. Explain the impact of an advanced manufacturing environment and activity-based costing on a relevant-cost analysis.

Relevant Cost Analysis and Activity-Based Costing

The concepts underlying a relevant-costing analysis continue to be completely valid in an advanced manufacturing setting

The objective of the decision analysis is to determine the costs and benefits that are relevant to the decision.

What will be different in a setting where activity-based costing is used is the decision maker’s ability to determine what costs are relevant to a decision

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The concepts underlying a relevant-costing analysis continue to be completely valid in an advanced manufacturing setting and in a situation where activity-based costing is used. The objective of the decision analysis is to determine the costs and benefits that are relevant to the decision. As we found earlier in this chapter, relevant costs and benefits have a bearing on the future and differ among the decision alternatives.

What will be different in a setting where activity-based costing is used is the decision maker’s ability to determine what costs are relevant to a decision. Under ABC, the decision maker typically can associate costs with the activities that drive them much more accurately than under a conventional product-costing system. (LO 14-7)

Other Issues in Decision Making (1 of 2)

Incentives for

Decision Makers

Short-Run

Versus

Long-Run

Decisions

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There is an important link between decision making and managerial performance evaluation. Managers typically will make decisions that maximize their perceived performance evaluations and rewards.

This is human nature. If we want managers to make optimal decisions by properly evaluating the relevant costs and benefits, then the performance evaluation system and reward structure should be consistent with that perspective. (LO 14-7)

Other Issues in Decision Making (2 of 2)

Pitfalls to Avoid

Sunk

costs.

Unitized

fixed costs.

Allocated

fixed costs.

Opportunity

costs.

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Decision-making analysis is very similar in an ABC, or activity-based-costing environment. The difference in the analyses lies in the superior ability of the ABC data to properly identify what the avoidable costs are. We must use caution to avoid the pitfalls of not recognizing sunk costs, allocated or shared costs, fixed costs per unit as opposed to total fixed costs, and opportunity costs which are not present in the accounting system. (LO 14-7)

End of Chapter 14

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New loader List price 15,000$ Annual operating expenses 45,000 Expected life in years 1 Old loader Original cost 100,000$ Remaining book value 25,000 Disposal value now 5,000 Annual variable expenses 80,000 Remaining life in years 1

New loader

List price 15,000$

Annual operating expenses45,000

Expected life in years 1

Old loader

Original cost 100,000$

Remaining book value 25,000

Disposal value now 5,000

Annual variable expenses 80,000

Remaining life in years 1

Sheet1


	New loader
	List price	$ 15,000
	Annual operating expenses	45,000
	Expected life in years	1
	Old loader
	Original cost	$ 100,000
	Remaining book value	25,000
	Disposal value now	5,000
	Annual variable expenses	80,000
	Remaining life in years	1

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Keep Old Loader

Replace Old Loader

Differential Cost

Depreciation of old loader 25,000$ Write-off of old loader 25,000$ -$ Proceeds from sale of old loader (5,000) 5,000 Depreciation of new loader 15,000 (15,000) Operating costs 80,000 45,000 35,000 Total costs 105,000$ 80,000$ 25,000$

Keep Old

Loader

Replace Old

Loader

Differential

Cost

Depreciation of old loader 25,000$

Write-off of old loader 25,000$ -$

Proceeds from sale of old loader (5,000) 5,000

Depreciation of new loader 15,000 (15,000)

Operating costs 80,000 45,000 35,000

Total costs 105,000$ 80,000$ 25,000$

Sheet1


	Keep Old Loader	Replace Old Loader	Differential Cost
Depreciation of old loader	$ 25,000
Write-off of old loader		$ 25,000	$ - 0
Proceeds from sale of old loader		(5,000)	5,000
Depreciation of new loader		15,000	(15,000)
Operating costs	80,000	45,000	35,000
Total costs	$ 105,000	$ 80,000	$ 25,000

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Relevant Cost Analysis Savings in variable expenses provided by the new loader 35,000$ Cost of the new loader (15,000) Disposal value of old loader 5,000 Net effect 25,000$

Relevant Cost Analysis

Savings in variable expenses

provided by the new loader35,000$

Cost of the new loader(15,000)

Disposal value of old loader5,000

Net effect 25,000$

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Relevant Cost Analysis
Savings in variable expenses provided by the new loader	$ 35,000	$ 1,000,000	$ - 0
Cost of the new loader	(15,000)	(400,000)	100,000
Disposal value of old loader	5,000	(350,000)	- 0
Net effect	$ 25,000	$ 250,000	$ 100,000

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Revenue: Passenger 250,000$ Cargo 30,000 Total 280,000$ Expenses: Variable expenses 90,000 Allocated fixed expenses 100,000 Total 190,000 Profit 90,000$

Typical Flight Between Japan and Hawaii

Revenue:

Passenger 250,000$

Cargo 30,000

Total 280,000$

Expenses:

Variable expenses 90,000

Allocated fixed expenses100,000

Total 190,000

Profit 90,000$

Typical Flight Between Japan and Hawaii

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Typical Flight Between Japan and Hawaii
Revenue:
Passenger	$ 250,000
Cargo	30,000
Total		$ 280,000
Expenses:
Variable expenses	90,000
Allocated fixed expenses	100,000
Total		190,000
Profit		$ 90,000

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Special price for charter 150,000$ Variable cost per flight 90,000$ Reservation cost savings (5,000) Variable cost of charter 85,000 Contribution from charter 65,000$

Assumes excess capacity

Special price for charter 150,000$

Variable cost per flight90,000$

Reservation cost savings(5,000)

Variable cost of charter 85,000

Contribution from charter 65,000$

Assumes excess capacity

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Assumes excess capacity
Special price for charter		$ 150,000
Variable cost per flight	$ 90,000
Reservation cost savings	(5,000)
Variable cost of charter		85,000
Contribution from charter		$ 65,000

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Special price for charter 150,000$ Variable cost per flight 90,000$ Reservation cost savings (5,000) Variable cost of charter 85,000 Opportunity cost: Lost contribution on route 80,000 165,000 Total (15,000)$

Assumes no excess capacity

Special price for charter 150,000$

Variable cost per flight90,000$

Reservation cost savings(5,000)

Variable cost of charter85,000

Opportunity cost:

Lost contribution on route80,000 165,000

Total (15,000)$

Assumes no excess capacity

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Assumes no excess capacity
Special price for charter		$ 150,000
Variable cost per flight	$ 90,000
Reservation cost savings	(5,000)
Variable cost of charter	85,000
Opportunity cost:
Lost contribution on route	80,000	165,000
Total		$ (15,000)

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Variable costs: Direct material 0.06$ Direct labor 0.04 Variable overhead 0.04 Fixed costs: Supervisory salaries 0.04 Depreciation of equipment 0.07 Total cost per dessert 0.25$

Variable costs:

Direct material 0.06$

Direct labor 0.04

Variable overhead 0.04

Fixed costs:

Supervisory salaries 0.04

Depreciation of equipment0.07

Total cost per dessert 0.25$

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Variable costs:		Variable costs:		Variable costs:
Direct material	$ 0.06	Direct material	$ 0.06	Direct material	$ 0.06
Direct labor	0.04	Direct labor	0.04	Direct labor	0.04
Variable overhead	0.04	Variable overhead	0.04	Variable overhead	0.04
Fixed costs:		Fixed costs:		Fixed costs:
Supervisory salaries	0.04	Supervisory salaries	0.04	Supervisory salaries	0.04
Depreciation of equipment	0.07	Depreciation of equipment	0.07	Depreciation of equipment	0.07
Total cost per dessert	$ 0.25	Total cost per dessert	$ 0.25	Total cost per dessert	$ 0.25

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Cost per Dessert

Savings from Outsourcing

Variable costs: Direct material 0.06$ 0.06$ Direct labor 0.04 0.04 Variable overhead 0.04 0.04 Fixed costs: Supervisory salaries 0.04 0.01 Equipment depreciation 0.07 - Total cost per dessert 0.25$ 0.15$

Cost per

Dessert

Savings from

Outsourcing

Variable costs:

Direct material 0.06$ 0.06$

Direct labor 0.04 0.04

Variable overhead 0.04 0.04

Fixed costs:

Supervisory salaries0.04 0.01

Equipment depreciation0.07 -

Total cost per dessert0.25$ 0.15$

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	Cost per Dessert	Savings from Outsourcing
Variable costs:
Direct material	$ 0.06	$ 0.06
Direct labor	0.04	0.04
Variable overhead	0.04	0.04
Fixed costs:
Supervisory salaries	0.04	0.01
Equipment depreciation	0.07	- 0
Total cost per dessert	$ 0.25	$ 0.15

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Joint Costs Joint Products Sales Value at Split-Off

Relative Proportion

Allocation of Joint Costs

Cocoa Butter 750$ 60% 660$ Cocoa Powder 500 40% 440

1,250$ 100% 1,100$

1,100$

Joint CostsJoint Products

Sales Value

at Split-Off

Relative

Proportion

Allocation of

Joint Costs

Cocoa Butter750$ 60%660$

Cocoa Powder500 40%440

1,250$ 100%1,100$

1,100$

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Joint Costs	Joint Products	Sales Value at Split-Off	Relative Proportion	Allocation of Joint Costs
$ 1,100	Cocoa Butter	$ 750	60%	$ 660
	Cocoa Powder	500	40%	440
		$ 1,250	100%	$ 1,100

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Sales value of instant cocoa mix 2,000$ Sales value of cocoa powder 500 Incremental revenue 1,500$ Less: separable processing costs (800) Net benefit of further processing 700$

Process Further

Sales value of instant cocoa mix2,000$

Sales value of cocoa powder 500

Incremental revenue 1,500$

Less: separable processing costs(800)

Net benefit of further processing 700$

Process Further

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	Process Further
	Sales value of instant cocoa mix	$ 2,000
	Sales value of cocoa powder	500
	Incremental revenue	$ 1,500
	Less: separable processing costs	(800)
	Net benefit of further processing	$ 700

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Products

Webs

Highs

Selling price per unit

$ 60

$ 50

Less: variable expenses per unit

Contribution margin per unit

Current demand per week (units)

2,000

2,200

Contribution margin ratio

40%

30%

Processing time required

on the lathe per unit

1.00

min.

0.50

min.

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	Products
	Webs		Highs
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 the lathe per unit	1.00	min.	0.50	min.

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Products Webs Highs

Contribution margin per unit $ 24 $ 15 Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min. Contribution margin per minute 24$ min. 30$ min.

Products

Webs

Highs

Contribution margin per unit $ 24 $ 15

Time required to produce one unit÷1.00 min.÷0.50 min.

Contribution margin per minute

24$ min.30$ min.

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		Products
		Webs			Highs
Contribution margin per unit		$ 24			$ 15
Time required to produce one unit	÷	1.00	min.	÷	0.50	min.
Contribution margin per minute		$ 24	min.		$ 30	min.

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Webs Highs Production and sales (units) 1,300 2,200 Contribution margin per unit 24$ 15$ Total contribution margin 31,200$ 33,000$

WebsHighs

Production and sales (units) 1,300 2,200

Contribution margin per unit24$ 15$

Total contribution margin

31,200$ 33,000$

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	Webs	Highs
Production and sales (units)	1,300	2,200
Contribution margin per unit	$ 24	$ 15
Total contribution margin	$ 31,200	$ 33,000

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Possible value

of contribution

margin Probability

Expected

Value

23.00$ 30%6.90$

24.00 50%12.00

25.00 20%5.00

23.90$

Possible value

of contribution

margin

Probability

Expected

Value

14.00

10%

1.40

15.00

40%

6.00

16.00

50%

8.00

15.40

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Possible value of contribution margin	Probability	Expected Value
$ 23.00	30%	$ 6.90
24.00	50%	12.00
25.00	20%	5.00
		$ 23.90

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Possible value of contribution margin	Probability	Expected Value
$ 14.00	10%	$ 1.40
15.00	40%	6.00
16.00	50%	8.00
		$ 15.40