The Use of Cost Information in Management Decision Making CHAPTER 7 The Use of Cost Information in Management Decision Making

Incremental Analysis Incremental Revenue Incremental Cost Additional revenue received by selecting one alternative over another Incremental Cost Additional cost incurred by selecting one alternative over another Relevant Costs, Differential Costs Incremental Profit Difference between incremental revenue and incremental cost

Incremental Analysis Example

Incremental Analysis Example Expanded

“What does this product cost?” Why do you want to know? No single cost number is relevant for all decisions Must find incremental information that is applicable to the decision

Analysis of Decisions Faced by Managers The following decisions faced by managers require analysis of incremental costs and/or revenues Additional Processing of a Product Make or Buy a Product Drop a Product Line

Analysis of Decisions Faced by Managers Additional Processing of a Product Decision to sell a product in a partially completed stage or incur the additional processing costs

Additional Processing Decision – Bridge Computer Example Summary of Cost Information

Additional Processing Decision – Bridge Computer Example Incremental Analysis Summary

Make or Buy Decisions Make or Buy a Product Decision involves no incremental revenues Analysis concentrates solely on incremental costs

Make-or-Buy Decisions – General Refrigeration Example Incremental Cost Analysis

Make-or-Buy Decisions – General Refrigeration Example Incremental Cost Analysis Summary

Terminology Summary Sunk Costs Avoidable Costs Opportunity Costs Costs that are already incurred Are never incremental costs because they never differ among decision alternatives Avoidable Costs Costs that can be avoided if a particular action is undertaken Opportunity Costs Value of benefits foregone by selecting one decisions alternative over another

Study Break #1 Which of the following is often not a differential cost? Material Labor Variable Overhead Fixed Overhead

Study Break #1 Which of the following is often not a differential cost? Material Labor Variable Overhead Fixed Overhead

Study Break #2 Opportunity costs are: Never incremental costs Always incremental costs Sometimes sunk costs None of the above

Study Break #2 Opportunity costs are: Never incremental costs Always incremental costs Sometimes sunk costs None of the above

Make-or-Buy Decisions – General Refrigeration Example Incremental Cost Analysis with Opportunity Costs

Example Exercise #1 Finn’s Seafood Restaurant has been approached by New England Investments, which wants to hold an employee recognition dinner next month. Lillian summer, a manager of the restaurant, agreed to a charge of $65 per person for food, wine, and dessert, for 150 people. She estimates that the cost of unprepared food will be $30 per person and beverages will be $12 per person.

Example Exercise #1 Continued In order to accommodate the group, Lillian will have to close the restaurant for dinner that night. Typically, she would have served 160 people with an average bill of $50 per person. On a typical night, the cost of unprepared food is $18 per person and beverages are $13 per person. No additional staff will need to be hired to accommodate the group from New England Investments. Calculate the incremental profit or loss associated with accepting the New England Investments group.

Example Exercise #1 Solution Calculate the incremental profit/loss New England Investments group Revenue ($65 x 150) $9,750 Costs Incurred ($42 x 150) $6,300 $3,450 Typical Evening Revenue ($50 x 160) $8,000 Costs Incurred ($31 x 160) $4,960 $3,040 Incremental Profit New England Investments Group $3,450 Typical Evening $3,040 $ 410

Drop a Product Line A very significant decision Analysis involves calculating the change in income that will result from dropping the product line. If income will increase, the product line should be dropped If income will decrease, the product line should be kept

Dropping a Product Line – Mercer Hardware Example

Dropping a Product Line – Mercer Hardware Example

Beware of the Cost Allocation Death Spiral When dropping a product line Common fixed costs are not incremental Common fixed cost allocation is spread among remaining product lines Management must understand and remember this impact when making decisions CASH

Decisions Involving Joint Costs Joint Products When two or more products always result from common inputs Joint Costs Costs of the common inputs Split-Off Point Stage of production in which individual products are identified

Joint Products Example

Allocation of Joint Costs Cost of the common inputs Allocated to the joint products for financial reporting purposes Joint cost information is Irrelevant to individual joint product decisions It is not an incremental cost Joint cost information is relevant to decisions regarding joint products as a group

Example Exercise #2 The American Produce Company purchased a truckload of cantaloupe (weighing 5,000 pounds) for $1,000 American Produce separated the cantaloupe into two grades: superior and economy. The superior grade cantaloupe had a total weight of 4,000 pounds which sells for $0.30 per pound The economy grade cantaloupe totaled 1,000 pounds which sells for $0.10 per pound Allocate the $1,000 cost of the truckload to the superior grade and economy grade cantaloupe using the physical quantity method and relative sales value method.

Example Exercise #2 Solution Physical Quantity Method Superior Grade = (4,000/5,000) x $1,000 = $800 Economy Grade = (1,000/5,000) x $1,000 = $200

Example Exercise #2 Solution Relative Sales Value Method Total Sales Superior Grade 4,000 x $0.30 = $1,200 Economy Grade 1,000 x $0.10 = $100 Total Sales $1,300 Cost Allocation Superior Grade (1,200/1,300) x $1,000 = $923 Economy Grade (100/1,300) x $1,000 = $ 77

Additional Processing Decisions and Joint Costs Not relevant to decisions made after the split-off point Joint costs incurred prior to the split-off point are sunk costs Decisions based on incremental analysis

Study Break #3 Which of the following costs should not be taken into consideration when making a decision? Opportunity costs Sunk costs Relevant costs Differential costs

Study Break #3 Which of the following costs should not be taken into consideration when making a decision? Opportunity costs Sunk costs Relevant costs Differential costs

Study Break #4 The joint costs incurred in a joint product situation: Are incurred before the split-off point Are incurred after the split-off point Should only be allocated based on physical attributes None of the above

Study Break #4 The joint costs incurred in a joint product situation: Are incurred before the split-off point Are incurred after the split-off point Should only be allocated based on physical attributes None of the above

Qualitative Considerations in Decision Analysis Most make-or-buy decisions have one or more features that are difficult to quantify but should be considered Swings in Economy Loss of Control Quality of Product Quality of Service Company Morale

Qualitative Factors

The Five-Step Process of the Theory of Constraints Identify the Binding Constraint Optimize Use of the Constraint Subordinate Everything Else to the Constraint Break the Constraint Identify a New Binding Constraint

Production Flow

Overproduction in Non-bottleneck Departments

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