Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13 Cost Management and Decision Making

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-2 Learning Objective 1

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-3 Decision-Making Process Stage 4 Planning and implementation Stage 4 Planning and implementation Stage 5 Obtaining feedback Stage 5 Obtaining feedback Stage 3 Evaluating alternatives Stage 3 Evaluating alternatives Stage 1 Setting goals and objectives Stage 1 Setting goals and objectives Stage 2 Gathering information Stage 2 Gathering information

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-4 Stage 1: Setting Goals and Objectives Organizations must set objectives to provide clear guidance. Tangible objectives provide benchmarks against which to measure performance. Intangible objectives:  may provide guidance, but  tend to be abstract and  are difficult to measure Intangible objectives:  may provide guidance, but  tend to be abstract and  are difficult to measure

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-5  Determine target selling price.  Determine target cost. Determine target profit Deduct target return on sales Result is target cost  Compare target cost to currently feasible total cost. The difference is the cost-reduction target  Redesign products and processes to achieve the cost-reduction target.  Determine target selling price.  Determine target cost. Determine target profit Deduct target return on sales Result is target cost  Compare target cost to currently feasible total cost. The difference is the cost-reduction target  Redesign products and processes to achieve the cost-reduction target.  Contract sales price  Estimate based on market analysis  Competitors’ pricing  Contract sales price  Estimate based on market analysis  Competitors’ pricing Target Profit and Target Cost

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-6 Stage 2: Gathering Information Relevance Timeliness Objectivity vs. subjectivity Accuracy Information quality and decision usefulness Cost vs. quality

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-7 Learning Objective 2

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-8 Identification of Relevant Costs and Benefits Relevant costs are costs to be incurred at some future time and that differ for each option available to the decision maker. Costs incurred in the past are not relevant. They are called called “sunk costs”.

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 13-9 Decision: Trading an old car for a new car. Identification of Relevant Costs and Benefits

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Stage 3: Evaluating Alternatives 3. Measure the benefits and costs of each set of outcomes. 1. List decision alternatives in the order the decisions must be made. 2. Trace the path of each decision to its ultimate outcome. Consider qualitative as well as quantitative factors.

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Anticipating future outcomes of each action Stage 3: Evaluating Alternatives Consider the past Although past costs are sunk and therefore irrelevant, they can be used to help estimate future costs that are relevant. Consider the past Although past costs are sunk and therefore irrelevant, they can be used to help estimate future costs that are relevant. Completely new products  Use prototype products to estimate costs.  Rely on consultants who have knowledge of similar products. Completely new products  Use prototype products to estimate costs.  Rely on consultants who have knowledge of similar products.

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 3

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision Tree A useful decision aid in diagramming decisions and alternative outcomes Allows an evaluation of the costs and benefits of each alternative (limb) Steps in creating a decision tree: Display decision alternatives in order Identify the set of outcomes resulting from each decision path Measure costs and benefits of each set of outcomes AB A 1 A 2 B 1 B 2 B 3

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision Tree - Example Maintain Status quo? Automate or improve Manual process? Status quo is unacceptable Higher equipment cost Lower employment level Lower unit-level cost Increase in profit Lower equipment cost Same employment level Lower unit-level cost Increase in profit Change Status quo Automate Manual

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Learning Objective 4

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Outsourcing or Make-or-Buy Decision When the company needs goods or services, should they be “made” internally or “bought” externally? When goods or services are acquired externally, it is called outsourcing.

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Is it cheaper to make or buy? How dependable is the supplier? What are the relevant costs? Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Identify the fixed costs that we could avoid if we outsource. Identify the variable costs that would disappear if we outsource. Identify the new variable costs that we would incur if we outsource. Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Let’s look at a make-or-buy decision faced by the management of Thor Company. Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to make this part are:

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Fixed manufacturing overhead is the cost of leasing and operating the equipment necessary to produce part 457. Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to make this part are: Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Common costs are allocated on the basis of direct labor hours. Total unit cost of $29 is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part. Should we accept the supplier’s offer? Common costs are allocated on the basis of direct labor hours. Total unit cost of $29 is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part. Should we accept the supplier’s offer? Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin ,000 × $5 per unit 20,000 × $9 per unit 20,000 × $1 per unit Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin ,000 × $29 per unit Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The common costs remain unchanged. 20,000 × $25 purchase price Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Should we make or buy part 457? Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin What is the relevant unit cost of making part 457? Advantage of making 20,000 units × ($25.00 – $24.00) = $20,000 Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin If Thor could use the space currently being used to make Part 457 for another purpose, resulting in a cost savings of $45,000, would you change your decision? Yes. The cost savings (opportunity cost) of $45,000 overcomes the $20,000 disadvantage of buying. Now there is a $25,000 advantage to buying. The real issue is the most profitable use of the space. Outsourcing or Make-or-Buy Decision

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Pitfalls of Outsourcing Loss of sensitive information to supplier. Freed-up resources are not used as planned. Supplier quality is not as high as anticipated. Customers may object. Customer contact may be reduced. Supplier technology and knowledge base may not be as anticipated.

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision to Add or Drop a Product, Service, or Business Unit If we shut down our U.S. Digital watch line, we might anger our American customers.... Not to mention the bad press! That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision.

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision. Let’s get started. The digital line has become less profitable and it is difficult to compete in the market.... Not to mention the bad press! Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin If the digital watch line is dropped, the fixed general factory overhead general fixed general factory overhead and general administrative expenses administrative expenses will be allocated to other product lines. Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The equipment used to manufacture digital watches has no resale value or alternative use. Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Should Market retain or drop the digital watch line? Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin DECISION RULE exceed Market should drop the digital watch segment only if its fixed cost savings exceed lost contribution margin. Let’s look at this solution. Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Should we drop the digital watch segment? Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The same result can also be obtained by preparing a differential analysis showing operating results with and without the digital watch segment. Let’s look at this approach. Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Example: If the idled facilities can be used to make a product generating $350,000 per year in contribution margin, with no other change in fixed costs, might this change your decision? Keeping the digital watch product line may have an opportunity cost that we have not yet considered. The opportunity cost of retaining the digital watch line is measured by the differential profits given up if the next best use of the production facilities is rejected. Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Measuring cost savings and lost revenues from closing a business unit is only part of the story. The closing will impact... Employees’ personal lives, Morale of retained employees, The community at large. Measuring cost savings and lost revenues from closing a business unit is only part of the story. The closing will impact... Employees’ personal lives, Morale of retained employees, The community at large. Decision to Add or Drop a Product, Service, or Business Unit

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Which costs are relevant to the decision to replace an old machine with a new machine? 3 Old machine cost $5,400 when purchased. 3 Old machine has a book value of $1, Purchase price of a new machine is $10, New machine will reduce labor from $12.00 to $11.00 per unit. 3 New machine is expected to last two years. 3 Repairs to old machine would be $4,600 and would allow two more years of productivity. 3 Power for either machine is expected to be $2.50 per unit. 3 Expected level of output: 1,000 units per year. 3 Old machine cost $5,400 when purchased. 3 Old machine has a book value of $1, Purchase price of a new machine is $10, New machine will reduce labor from $12.00 to $11.00 per unit. 3 New machine is expected to last two years. 3 Repairs to old machine would be $4,600 and would allow two more years of productivity. 3 Power for either machine is expected to be $2.50 per unit. 3 Expected level of output: 1,000 units per year. Relevant Costs of Replacing Equipment

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Old machine cost $5,400 when purchased. 3 Old machine has a book value of $1, Purchase price of a new machine is $10, New machine will reduce labor from $12.00 to $11.00 per unit. 3 New machine is expected to last two years. 3 Repairs to old machine would be $4,600 and would allow two more years of productivity. 3 Power for either machine is expected to be $2.50 per unit. 3 Expected level of output: 1,000 units per year 3 Old machine cost $5,400 when purchased. 3 Old machine has a book value of $1, Purchase price of a new machine is $10, New machine will reduce labor from $12.00 to $11.00 per unit. 3 New machine is expected to last two years. 3 Repairs to old machine would be $4,600 and would allow two more years of productivity. 3 Power for either machine is expected to be $2.50 per unit. 3 Expected level of output: 1,000 units per year Relevant because of labor savings over the 2-year life. Which costs are relevant to the decision to replace an old machine with a new machine? Relevant Costs of Replacing Equipment

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin ,000 $12.00 for 2 years 1,000 $11.00 for 2 years Conclusion: keep old machine. Relevant Costs of Replacing Equipment

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Pricing Decisions What influences prices?

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Costs Market forces Prices are determined by the market, subject to costs that must be covered in the long run. Prices are based on costs, subject to reactions of customers and competitors. Pricing Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Pricing Law in the United States

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin We just received a special order. Do you think we should accept it? Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Japan to Hawaii on a jumbo jet. Worldwide usually gets $250,000 in passenger ticket revenue from this flight. The airlines 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. A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Japan to Hawaii on a jumbo jet. Worldwide usually gets $250,000 in passenger ticket revenue from this flight. The airlines 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. Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Worldwide will save about $5,000 in reservation and ticketing costs if the charter is accepted. Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight. Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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? Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Worldwide has no excess capacity, so it should reject the special charter, or try to renegotiate a higher price. Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin With excess capacity... Relevant costs usually will be the variable costs associated with the special order. Without excess capacity.... Same as above but opportunity costs of using the firm’s facilities for the special order are also relevant. Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Additional considerations Impact on regular customers and markets Will the special order lead to future regular business? Additional considerations Impact on regular customers and markets Will the special order lead to future regular business? Special-Order Price Decisions

Copyright © 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin End of Chapter 13