Cost Accounting for Decision-making Lesson 2

Apply Costing Concepts and Techniques in Business Decisions Part II Apply Costing Concepts and Techniques in Business Decisions

Question A Hong Kong airline company launched a ‘Buy 1 Get 1 Free’ campaign to promote its air tickets to Tokyo. Why did the management make such decision? Teacher starts the lesson with above question and explains to students that making business decision is one of the basic functions of a manager.

Decision-making: Definition “Decision-making involves the selection of a course of action from among two or more possible alternatives in order to arrive at a solution for a given problem”. Trewatha & Newport Teacher explains what is decision-making.

Steps for Decision-making Define the problem. Identify feasible options. Identify the costs and benefits for each option; distinguish relevant from irrelevant costs; and eliminate irrelevant ones. Estimate the differential costs. Assess qualitative factors that need consideration. Choose the best option: Select the one with the greatest overall net benefit. Teacher introduces the steps to follow for making business decision.

Point to Note in Making Decisions We focus on relevant revenues, costs and profits. We ignore irrelevant costs. We use contribution margin format to present our answers in order to separate variable costs from fixed costs. If ‘status quo’ is a feasible option, all alternatives are compared with ‘status quo’. If ‘status quo’ is NOT an option, all alternatives are compared with each other. Teacher explains some points that students should keep in mind when making business decisions.

Activity 1 – Accept the order or not? Scenario: A company manufactures coffee cups. It can produce a maximum of 10,000 cups in a month with a fixed costs of $20,000 and variable costs of $6 per cup. Its current demand is 6,000 cups and its selling price is at $10 each. A foreign buyer approaches the company for an order of 3,000 cups at $8 each. Should the company accept the order? Teacher provides an example to illustrate how to make a business decision.

Activity 1 – Accept the order or not? Steps in making the decision: Prepare a columnar income statement using contribution margin method for each of the following situations: a. If the order is not accepted. b. If the order is accepted. Make a conclusion on whether to accept the order or not. Teacher asks students to: construct two income statements; compare the results; and make a decision.

Activity 1 - Solution Column 1 2 3 Do not accept Accept Difference $’000 Revenue 60 84 24 Variable costs (36) (54) 18 Contribution 30 6 Fixed costs (20) - Profit 4 10 Teacher provides answers.

Activity 1 - Solution $20,000 fixed cost will remain the same no matter the order is accepted or not. It is irrelevant for making the decision. The revenue and variable costs in this case are relevant in making the decision. If the order is accepted, they will be changed by $24,000 and $18,000 respectively. Teacher explains the answers and makes conclusion. Since the increase in revenue is more than the increase in variable costs, the order should be accepted as there is a net benefit of $6,000.

Format in Preparing Income Statements Using Contribution Margin Method Generally speaking, there are two presentation format. The first format requires management to construct columnar income statements for each option (see Activity 1–Columns 1 and 2) as well as the net difference options (see Activity 1–Columns 3). The second format requires management to show the net difference between options (see Activity 1–Columns 3), with a separate listing of its relevant costs and benefits only in the comparison. For decision-making purpose, the most efficient way is to use the second format. Teacher explains that there are two formats to present the answers in making a cost decision. Teacher explains that either one can be used in answering this type of question. For the first format, it considers all costs and benefits, both relevant and irrelevant. For the second format, it only considers the incremental costs and benefits. Students can obtain the same answer under both formats. If only incremental information is given, students can just use the second format.

Classwork A company is considering which of these two photocopy machines, A and B, to purchase. The company has the following information: A B $ Revenue arising from the use of the machine 50,000 54,000 Annual operating costs of the machine: Direct materials 10,500 11,300 Direct labor 13,100 14,000 Variable overhead 20,000 18,000 Fixed overhead (include depreciation) 6,000 Teacher goes through the above question.

Classwork Required: Which machine the company should purchase and why? (Elaborate your answer with the use of the second format taught in the previous slides.) Teacher goes through the above requirement.

Suggested Solution Comparing Machine B with Machine A $ Increase in revenue 4,000 (Increase) / Decrease in annual operating costs: Direct materials (800) Direct labor (900) Variable overhead 2,000 Increase in net benefit 4,300 Teacher discusses the calculations and makes a conclusion. The company should purchase Machine B as the net benefit is $4,300.

Homework: Q2 Teacher asks students to do Question 2 at home.

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