Hilton Maher Selto

13 Cost Management and Decision Making McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.

13-3 Decision-Making Process Stage 1 Setting Goals & Objectives Stage 1 Setting Goals & Objectives Stage 2 Gathering Information Stage 2 Gathering Information Stage 3 Evaluating Alternatives Stage 3 Evaluating Alternatives Stage 4 Planning & Implementation Stage 4 Planning & Implementation Stage 5 Obtaining Feedback Stage 5 Obtaining Feedback Exh. 13-1

13-4 Stage 1: Setting Goals & Objectives Organizations must set goals to provide clear guidance to Tangible Objectives Intangible Objectives Tend to be measureable. They serve as benchmarks against which to gauge performance. Tend to be abstract in nature.

13-5 Using Target Costing & Setting Tangible Objectives  Determine target selling price per unit  Determine target cost, per unit and in total. Determine Target Profit Deduct target gross margin % Back into target cost  Compare target cost to currently feasible total cost. The difference it the Cost-Reduction Target  Redesign products and processes to achieve the cost-reduction target.  Determine target selling price per unit  Determine target cost, per unit and in total. Determine Target Profit Deduct target gross margin % Back into target cost  Compare target cost to currently feasible total cost. The difference it the Cost-Reduction Target  Redesign products and processes to achieve the cost-reduction target.

13-6 Using Target Costing & Setting Tangible Objectives Example Plug-It, Inc. believes it can charge a maximum price of $5 for its 10’ drop cords. They must achieve a gross margin of 40%. Currently, the 10’ drop cords cost $3.25 each to produce. Example Plug-It, Inc. believes it can charge a maximum price of $5 for its 10’ drop cords. They must achieve a gross margin of 40%. Currently, the 10’ drop cords cost $3.25 each to produce. Determine the target cost and the cost- reduction target for Plug-It, Inc. Target Cost = Target Price - Target Gross Margin = $ ($5.00 × 40%) = $ $2.00 = $3.00 Cost-Reduction Target = Current Feasible Cost - Target Cost = $ $3.00 = $.25 or 7.7% (approximately) Target Cost = Target Price - Target Gross Margin = $ ($5.00 × 40%) = $ $2.00 = $3.00 Cost-Reduction Target = Current Feasible Cost - Target Cost = $ $3.00 = $.25 or 7.7% (approximately)

13-7 Stage 2: Gathering Information Relevance Timelines s Objectivity vs. Subjectivity Accuracy

13-8 Identification of Relevant Costs and Benefits Deciding between alternatives requires analyzing only “relevant” costs. Only those costs that DIFFER between alternatives are considered “relevant” to the decision- making process. Costs incurred in the past are called “sunk costs”. They are not relevant costs.

13-9 Identification of Relevant Costs and Benefits Green Ur Enterprises is considering whether to keep its E-Farm internet unit. This year, E-Farm’s projections are: Sales = $1,200,000 Commissions = $200,000 Salaries = $190,000 Marketing = $480,000 Utilities = $375,000 Allocated Overhead = $685,000 Green Ur Enterprises is considering whether to keep its E-Farm internet unit. This year, E-Farm’s projections are: Sales = $1,200,000 Commissions = $200,000 Salaries = $190,000 Marketing = $480,000 Utilities = $375,000 Allocated Overhead = $685,000 We have to decide whether to close the E-Farm Unit. Which of the following items are “relevant”? Note: The salaries are for employees who will be transferred to other areas if E- Farm is dropped.

13-10 Green Ur Enterprises is considering whether to keep its E-Farm internet unit. This year, E-Farm’s projections are: Sales = $1,200,000 Commissions = $200,000 Salaries = $190,000 Marketing = $480,000 Utilities = $375,000 Allocated Overhead = $685,000 Green Ur Enterprises is considering whether to keep its E-Farm internet unit. This year, E-Farm’s projections are: Sales = $1,200,000 Commissions = $200,000 Salaries = $190,000 Marketing = $480,000 Utilities = $375,000 Allocated Overhead = $685,000 Identification of Relevant Costs and Benefits Relevant Costs These all disappear if we close the E-Farm unit.

13-11 Stage 3: Evaluating Alternatives 3. Measure the benefits and costs of each set of outcomes. 1. Display the decision alternatives in the order the decisions will be made. 2. Trace the path of each decision to its ultimate outcome.

13-12 Outsourcing/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”.

13-13 Outsourcing/Make-or-Buy Decision Is it cheaper to make or buy? How dependable is the supplier? What are the relevant costs?

13-14 Outsourcing/Make-or-Buy Decision 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.

13-15 Outsourcing - Example Enviro, Inc. is trying to decide whether to house its e- commerce web site on the premises or outsource the web site management to a third party. Annual cost of outsourcing = $350,000. Should we outsource?

13-16 Outsourcing - Example Since the cost of outsourcing is $350,000. This is $6,000 less than annual in-house hosting of the website. But we must also consider the loss of control, if we outsource. Since the cost of outsourcing is $350,000. This is $6,000 less than annual in-house hosting of the website. But we must also consider the loss of control, if we outsource.

13-17 Decision to Add/Drop a Product, Service or Business Unit If we shut down the U.S. operation, 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.

13-18 Green Ur Enterprises is considering whether to keep its E-Farm internet unit. This year, E-Farm’s projections are: Sales = $1,200,000 Commissions = $200,000 Salaries = $190,000 Marketing = $480,000 Utilities = $375,000 Allocated Overhead = $685,000 Green Ur Enterprises is considering whether to keep its E-Farm internet unit. This year, E-Farm’s projections are: Sales = $1,200,000 Commissions = $200,000 Salaries = $190,000 Marketing = $480,000 Utilities = $375,000 Allocated Overhead = $685,000 Decision to Drop a Business Unit - Example Should we close E-Farm? Determine the impact on Green Ur’s Net Income if we close the E-Farm unit.

13-19 Decision to Drop a Business Unit - Example Considering ONLY the relevant costs, E-Farm adds $145,000 to corporate profit. Even if we close the E-Farm unit, we still will incur the overhead and salaries. We can eliminate the unit level costs. However, the employees can be assigned elsewhere and the facility-level overhead costs are still there.

13-20 Adding or Dropping a Business Unit The term “business unit” can refer to a product, market territory, department, division, subsidiary, or any other business segment. As with the “make or buy” decision, all relevant costs must be considered.

13-21 Pricing Decisions What influences prices?

13-22 Pricing Practices and the Law

13-23 End of Chapter 13