Completion of Accounting Chapter Summaries

quiz is on this chapter, study it extra hard.

Chapter 7: How do you Identify All Information Relevant for a Decision?

1. What are the challenges in identifying information relevant for a decision?

· Managers today are bombarded with too much, and often redundant information .

· Worse still, some relevant information may even be missing in the myriad of information in front of them.

Example: Smoothtalk

Tphone manufactures a single product, a cordless phone. Tphone sells the phones to wholesalers, who then market them to retailers. The manufacturing division produces the phones and is rewarded for reducing the average cost of making a phone. The marketing division sells the phones and is rewarded for increasing the total revenues.

The plant is currently producing and selling 100,000 phones per month at a price of $50 per phone (capacity is 110,000 phones). Following income statement summarizes last month’s operating results.

Each phone costs 45 to produce.

How much did it cost to produce phone, and then all other expenses?

Per unit of a fixed cost comes down the more you produce

Smoothtalk is one of Tphone’s best customers and purchases 10,000 phones every month at price of $50 per unit. Last week, Smoothtalk informed Tphone that it could double its monthly purchase to 20,000 units, provided Tphone is willing to sell the extra 10,000 units at $40 each. Smoothtalk would continue to pay $50 for the usual 10,000 units. Smoothtalk argued that because this is extra business, Tphone will make a profit even at a $40 price.

According to the income statement above, the average cost of producing a phone ($45) is well above the discounted price of $40 that Smoothtalk is requesting for the additional 10,000 phones. Moreover, Tphone’s accounting department reports that increasing total production by 10,000 phones will decrease the average cost only by a dollar to $44 per unit. They admit, however, that the current selling & administrative expenses are all fixed costs as such will remain unchanged by this increased production.

NIETHER ANSWER IS CORRECT

Required: Should Tphone accept the offer?

2. How then can managers identify all relevant information?

· To identify relevant information, managers must

FOCUS ON VALUE and what is value?

THINK INCREMENTALLY!

3. What does it mean to Focus on Value when making a decision?

· To focus on value, first identify the decision maker and the goal of the decision.

· Next, identify all options available to the decision maker.

· Some aspects of each option move the decision maker closer to the goal; they are labeled as benefits. Some aspects might bring u towards or away from goal

· Some aspects of an option move the decision maker away from the goal, they are labeled as costs.

· Decision maker's value of an alternative is the benefits net of costs . Are you moving closer or away from goal?

· The decision maker should choose the alternative that provides the highest value.

· GO SLOW

4. What does it mean to think incrementally when making a decision?

· Note that benefits and costs that do not change between alternatives will not affect the final decision.

· For example, sunk costs are never relevant for a decision.

· Sunk costs: a cost that is gone, u cannot recover. Costs that are incurred!

5A: What is a sunk cost?

Sunk costs are costs that are incurred or committed to be incurred irrespective of the chosen option.

Ex 1: when deciding to whether to accept an offer on the house, the purchase price of the house is a sunk cost.

Do not waste your time on costs that do not change despite alternatives

Ex 2: when deciding to add another product or service, costs such as internet service fee and rent are sunk costs because the firm is already committed to incur them.

Even though irrelevant, decision-makers often waste time by including sunk costs in their analysis.

· One way to overcome this problem is to focus on benefits and costs that change between alternatives.

· A simple way to do this is to identify a benchmark option and calculate the incremental value of other options relative to it.

· The status quo is often a good benchmark because it is easy to think about the changes from where we are now.

5B: What is an Opportunity Cost?

A relevant, and often important, cost that managers ignore is the opportunity cost of an available resource.

Opportunity cost of a resource used in an option is the value foregone by not using that resource in the next best option .

Ex 1: the income forgone from a potential employment is an opportunity cost of studying at SU.

Ex 2: potential income forgone by releasing you to focus on your product or service is an opportunity cost of time.

Production Level vs Costs

Production Level Production Cost $ Average Cost $ 110,000 4,840,000 44.00 100,000 4,500,000 45.00 80,000 3,820,000 47.75 60,000 3,140,000 52.33 40,000 2,460,000 61.50 20,000 1,780,000 89.00 0 1,100,000 N/A Change in units Change in Costs $ UVC $ Fixed Costs $ 10,000 340,000 34.00 1,100,000

Do NOT just focus on value