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Chapter 7

Chapter 7. The Use of Cost Information in Making Management Decisions. The Criterion for Short-term Decisions. Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss). To be relevant:

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Chapter 7

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  1. Chapter 7 The Use of Cost Information in Making Management Decisions Chapter 1 -

  2. The Criterion for Short-term Decisions Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss). To be relevant: 1. An item must differ for the alternatives under consideration. 2. Be in the future (not be sunk). Chapter 1 -

  3. Definitions Incremental revenues and costs are the expected future revenues and costs that will differ among the choices that are available. Chapter 1 -

  4. Sunk Costs Sunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects. Examples: • Book value of equipment • Original purchase price of building Chapter 1 -

  5. Opportunity Cost An opportunity cost is the benefit lost by taking one action as opposed to another. Example: The contribution margin of A, assuming the production of A is terminated to produce B. Example: Rental income lost if facility is used for production. Chapter 1 -

  6. Typical Short-Term Decisions • Drop a Segment • Make-or-Buy • Joint Product (and additional processing) Important: Short-term Perspective Chapter 1 -

  7. Drop a Segment Decision Assume the following: X Y Total Sales units 200 100 300 Sales revenue $100,000 $75,000 $175,000 Less variable expenses: Variable cost of sales 48,000 30,000 78,000 Variable selling & admin. 5,0003,7508,750 Contribution margin $47,000 $41,250 $88,250 Less direct fixed expenses: Direct fixed costs 15,00042,50057,500 Product margin $32,000 $(1,250 ) $30,750 Less common fixed costs 15,000 Net income $15,750 Should product Y be eliminated? Chapter 1 -

  8. Drop a Segment Decision (continued) Incremental Keep Drop Amount to Keep Sales $75,000 ---- $75,000 Variable exp. (33,750) ---- (33,750) Cont. margin $41,250 ---- $41,250 Direct fixed costs (42,500) ---- (42,500) Relevant benefit/loss $(1,250) Decision: Drop product Y This assumes that all direct fixed costs would disappear if the segment is dropped. Chapter 1 -

  9. Complementary Effects and Loss Leaders Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another. A loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin does not cover its avoidable fixed costs. • What if in the prior example, dropping Y would cause us to lose 10% of our sales of X, would the decision change? Chapter 1 -

  10. Make-or-Buy Decision • Assume the following cost data relate to the decision to produce • 12,000 units of a product or buy from external source: • Costs to Make • Total CostsUnit Cost • Rental of equipment $15,000 $1.25 • Equip. depreciation 3,000 .25 • Direct materials 12,000 1.00 • Direct labor 24,000 2.00 • Variable overhead 9,000 .75 • Fixed overhead 36,0003.00 • Total $99,000 $8.25 The purchase price from an outside vendor is $5.50 per unit. Chapter 1 -

  11. Make-or-Buy Decision (continued) Alternatives Incremental Make Buy Cost to Make Rental of equip. $15,000 ---- $15,000 Direct materials 12,000 ---- 12,000 Direct labor 24,000 ---- 24,000 Variable overhead 9,000 ---- 9,000 Purchase cost $66,000$(66,000) Relevant costs $60,000 $66,000 $(6,000) Decision: Manufacture parts in-house Chapter 1 -

  12. Make-or-Buy Decision (continued) Qualitative issues: • Quality of purchased components • Timely delivery • Potential price increases Chapter 1 -

  13. Joint Product Decision When a single manufacturing process invariably produces two or more separate products, the products are called joint products. Chapter 1 -

  14. Alpha Omega Selling price at split-off $1,200 $1,600 Joint cost assigned to product $1,000 $1,400 Selling price afteradditional processing $3,600 $2,000 Costs of additionalprocessing, all variable $900 $500 Joint Product Example Chapter 1 -

  15. Alpha Omega Incremental revenues $2,400 $400 Incremental costs 900 500 Incremental profits $1,500 $(100) Decisions: Process Alpha further Sell Omega at the split-off point The joint cost assigned is not relevant. Joint Product Decision (continued) Chapter 1 -

  16. Allocation of Joint Costs to Joint Products • Allocate joint costs using relative sales value at the split off point or physical measures • Example - Joint cost is $100,000 and product A sells for $80,000 and Product B sells for $160,000. • 80/(80+160) or 1/3 of the joint cost would be assigned to product A $33,333 and 2/3 to B $66,667 • Allocation of joint cost is not relevant to sell or process further decision! Chapter 1 -

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