Chapter 7 The Use of Cost Information in Management Decision Making

Presentation Outline Incremental Analysis Three Decision Managers Frequently Face Decisions Involving Joint Costs Qualitative Considerations in Management Decisions The Theory of Constraints (TOC)

I. Incremental Analysis Incremental or differential revenue – additional revenue received as a result of selecting one decision alternative over another. Incremental or differential cost – additional cost incurred as a result of selecting one decision alternative over another. To answer the question of how much something costs, a manager must know why the person wants to know. No single cost number is relevant for all decisions.

II. Three Decisions Managers Frequently Face Additional Processing Decision Make or Buy Decision Dropping a Product Line Decision Summary of Concepts

A. Additional Processing Decision Costs per Unit Incurred to Date Costs per Unit to Complete Material $300 $200 Labor 200 100 Variable O/H Fixed O/H Totals $800 $400 PowerComp Company has partially processed computers for Model 250 that they are discontinuing. This has caused a decline of the selling price. If the units are completed, they can be sold for $1,000 per unit. That is less than the total cost of producing the computers -- $1,200 per unit ($800 cost to date plus $400 of additional cost to complete the units).

The Alternatives: 1. Sell the units as is for $500 each and avoid incurring any additional processing costs. 2. Complete the units and sell them for $1,000 each.

The Solution: The prior production costs are a sunk cost since they have already been incurred. Therefore, the only relevant cost is the $400 in additional processing costs to complete each unit. Since this is less than the incremental revenue of $500 ($1,000 - $500), the units should be processed further.

B. Make or Buy Decision Should the organization buy the compressors from an outside source at a cost of $310 per unit?

Additional Cost Analysis The market value of the machinery used to produce the compressors is approximately zero. Five of the six production supervisors will be fired if production of compressors is discontinued. However, one of the supervisors, who has more than 10 years of service, is protected by a clause in a labor contract, and will be assigned to other duties, although his services are not really needed. His salary is $110,000. If production of compressors is discontinued, the company can use the space to store shelving that they are currently renting space for at a cost of $500,000 per year.

The Solution

C. Dropping a Product Line Decision Should the Garden Supplies product line be dropped since it is showing a net loss of $500?

Additional Cost Analysis Sales revenue will decline by $80,000 if garden supplies are dropped. Cost of goods sold will decrease by $60,000, and other variable costs will decrease by $1,000. Direct costs are directly traceable to a product line. Whether they decrease depends on the nature of these costs. Since the $3,500 represents a part-time employee who will be dropped if garden supplies is dropped, this cost is avoidable. Allocated fixed costs are not directly traceable to an individual product line. Therefore, these costs are generally not avoidable.

The Solution

Cost Allocation Death Spiral In many cases, products or services may not appear profitable because they receive allocations of common fixed costs. However, if the product or service is dropped common fixed costs are reallocated to the remaining product or services. This may result in another product or service appearing unprofitable.

D. Summary of Concepts Costs that can be avoided by taking a particular course of action are always incremental costs and, therefore, relevant to the analysis of a decision. Costs that are sunk are never incremental costs and therefore are not relevant in making a decision. Opportunity costs represent the benefit forgone by selection a particular decision alternative over another. There are always incremental costs and therefore relevant. Fixed costs may be: Sunk and therefore irrevelant Not sunk but still irrelevant Not sunk but relevant (See Illustration 7-7 on page 246)

III. Decisions Involving Joint Costs Terminology Allocating Joint Costs Using Physical Quantity Allocating Joint Costs Using Relative Sales Value Additional Processing Decisions Involving Joint Costs

A. Terminology Joint Products – two or more products that always result from common inputs. Joint Costs – costs of common inputs up to the split-off point. Split-off Point – stage of production at which individual products are identified. Beyond this point each product may undergo further separate processing and may incur additional costs. 500 board feet selling for $1.00 per foot Grade A Lumber Split-Off Point 500 board feet selling for $.50 per foot Joint Cost (Common Input Process) Cost of log $600 Cost of sawing 20 Grade B Lumber

B. Allocating Joint Cost Using Physical Quantity This allocation could lead managers to think that grade B lumber is not profitable and should be scrapped. But this logic is faulty. If grade B lumber were scrapped, the company would lose $250 that helped cover the joint cost of $620.

C. Allocating Joint Cost Using Relative Sales Value A good feature of this method is that the amount of joint cost allocated to a product cannot exceed its sales value at the split-off point.

D. Additional Processing Decisions Involving Joint Costs Grade B lumber can be sold at the split-off point for $.50 per board or pressure treated for an additional $.20 per board and sold for $.75 per board. Note that the additional processing should occur since the incremental revenue of $.25 ($.75 - $.50) is greater than the additional processing cost of $.20, regardless of the amount of the joint cost allocation. Joint costs are not incremental and are therefore never relevant in further processing decisions. Joint Cost (Common Input Process) Cost of log $600 Cost of sawing 20 Split-Off Point Grade A Lumber Grade B Lumber 500 board feet selling for $1.00 per foot 500 board feet selling for $.50 per foot

IV. Qualitative Considerations in Management Decisions A variety of qualitative factors (e.g., quality of goods, employee morale, and customer service) need to be considered in making a decision. Qualitative factors are often even more important than costs and benefits that are easy to quantify.

V. The Theory of Constraints (TOC) Theory of Constraints Defined An Illustration of the Five-Step Process of TOC Some Implications for TOC Overproduction Incentives for Nonbottleneck Departments

A. Theory of Constraints Defined Theory of constraints recognizes that large increases in profit can be achieved by elimination of bottlenecks in production processes. It is an approach to production and constraint management.

B. An Illustration of the Five Step Process of TOC Identify the Binding Constraint Optimize Use of the Constraint Subordinate Everything Else to the Constraint Break the Constraint Identify a New Binding Constraint

1. Identify the Binding Constraint A bottleneck or binding constraint is a process that limits throughput (the amount of inventory produced in a period). Assume that Department 3 is a bottleneck. Department 1 Produce Subassembly Department 3 Department 4 Make and Test Connections, Install Housing Units Test, Package, and Ship Department 2 Produce Subassembly

2. Optimize Use of the Constraint Produce products with the highest contribution margin per unit of constraint. If managers face a choice between using scarce time in Department 3 to produce Model A70 or Model B90, they should definitely maximize production of Model A70 first.

3. Subordinate Everything Else to the Constraint Managers should focus their time on trying to loosen the constraint and not concentrate on improvements in other departments. For example, why should managers improve processes in 1, 2, or 4 if they are not limiting production. Many things may loosen constraints. For example, if workers in Dept 3 all take breaks at the same time, capacity could be gained by staggering breaks.

4. Break the Constraint This can be accomplished in many ways: Cross-train workers in Depts. 1 and 2 so they can help out in Dept. 3 Outsource some of Dept. 3’s work. Purchase additional equipment for Dept. 3 Hire additional workers for Dept. 3 Train workers in Dept. 3 so that they can perform their jobs more efficiently.

5. Identify a New Binding Constraint Once the constraint is broken in Dept. 3, either Dept. 1, 2, or 4 will be come a bottleneck. Or, if the company has excess capacity in all departments, it should focus its attention on building demand.

C. Some Implications of TOC Inspections – inspections should take place before work is transferred to a constrained department. Valuable time of the constrained department should not be wasted on defective items. Batch sizes – although many companies are going to small batch sizes to reduce defects and achieve flexibility, using larger batch sizes in constrained departments can avoid wasted time in numerous machine setups for small production runs. Across the board cuts – although cuts in nonbottleneck departments can make sense, cuts in departments with a binding constraint can have a severe impact on profit.

D. Overproduction Incentive for Nonbottleneck Departments Incentives for greater production in nonbottleneck departments should be avoided when there is a bottleneck department. For example, if Depts. 1 and 2 are rewarded for more production, it will do little if inventory is accumulating in front a Dept. 3

Summary Only incremental costs and revenues are relevant in making management decisions. Sunk costs are irrelevant in deciding whether to further process a good. Nonavoidable costs are irrelevant in make-or-buy decisions. Common costs among product lines are generally nonavoidable. Opportunity costs are relevant in choosing among decision alternative. Joint Costs are irrelevant in additional processing decisions Management Decisions must consider qualitative characteristics Focus process improvements on bottlenecks first.