2. Slide 7-2 CHAPTER 7 Use of Cost Information in Management Decision Making

3. Slide 7-3 Incremental Analysis  Incremental Revenue Additional revenue received by selecting one alternative over another  Incremental Cost Additional cost incurred by selecting one alternative over another  Incremental Profit Difference between incremental revenue and incremental cost Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

4. Slide 7-4 Incremental Analysis  An alternative that yields an incremental profit should be selected  Incremental costs are referred to as relevant costs  Also called differential costs Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

5. Slide 7-5 Incremental Analysis Example Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

6. Slide 7-6 Incremental Analysis  Incremental Analysis can be extended to more than two alternatives  Calculate profit for each alternative  The alternative with the highest profit is the best alternative  Difference between its profit and the profit of any other alternative is its incremental profit Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

7. Slide 7-7 “What Does This Product Cost?” Answer: 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 - Some costs will change due to the decision, some will not - Only costs that change are relevant Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

8. Slide 7-8 Analysis of Decisions Faced by Managers Three decisions that managers frequently face: 1.Additional processing of a product 2.Make or buy a product 3.Drop a product line Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

9. Slide 7-9 Additional Processing of a Product  Manufacturers must occasionally decide whether to: - Sell partially complete product, or -Incur additional costs to complete  Costs incurred to date of decision on partially complete product are not relevant, i.e sunk costs. Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

10. Slide 7-10 Additional Processing Decision – Bridge Computer Example Summary of cost information Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

11. Slide 7-11 Additional Processing Decision – Bridge Computer Example Incremental analysis summary Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

12. Slide 7-12 Additional Processing Decision – Bridge Computer Example Incremental analysis summary  Incremental revenues are $500  Incremental costs are $400  Would you spend $400 to generate an additional $500? Answer: Yes, incremental profit is $100 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

13. Slide 7-13 Additional Processing Decision Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

14. Slide 7-14 Make or Buy Decisions  Decision involves no incremental revenues  Analysis concentrates solely on incremental costs Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

15. Slide 7-15 Make-or-Buy Decisions – General Refrigeration Example Additional information:  If purchased, cost savings include $390,000 in supervisory salaries and all variable costs.  Market value of production machinery is zero Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

16. Slide 7-16 Make-or-Buy Decisions – General Refrigeration Example Incremental cost analysis – 3 column format Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

17. Slide 7-17 Make-or-Buy Decisions – General Refrigeration Example Incremental cost analysis - single column format Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

18. Slide 7-18 Make-or-Buy Decisions Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

19. Slide 7-19 Make-or-Buy Decisions – General Refrigeration Example Incremental cost analysis with opportunity costs Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

20. Slide 7-20 Evelyn’s farm has two alternatives for the sale of 100 pounds of cucumbers 1.Sell as-is (raw) for $0.79 per pound 2.Pickle (process) and sell for $6.99 per pound Additional pickling costs per pound: materials $1.50; labor $2.00 Should Evelyn sell cucumbers or pickles? Pickles Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

21. Slide 7-21 Drop a Product Line Analysis involves calculating the change in income that will result from dropping the product line:  If income increases, the product line should be dropped  If income decreases, the product line should not be dropped Note: Allocated costs are not relevant Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

22. Slide 7-22 Dropping a Product Line – Mercer Hardware Example Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Profit calculation with three product lines

23. Slide 7-23 Dropping a Product Line – Mercer Hardware Example Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Profit calculation with two product lines

24. Slide 7-24 Dropping a Product Line – Mercer Hardware Example Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

25. Slide 7-25 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 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions

26. Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions Slide 7-26 Terminology Summary  Sunk costs - Costs already incurred - Never incremental or relevant i.e. Do not differ between alternatives  Avoidable costs - Costs avoided if an action is undertaken - Always incremental and relevant  Opportunity costs - Benefits foregone by selecting one alternative over another - Always incremental and relevant

27. Slide 7-27 Which of the following is often not a differential cost? a.Material b.Labor c.Variable overhead d.Fixed overhead Answer: d Fixed overhead Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions

28. Slide 7-28 Opportunity costs are: a.Never incremental costs b.Always incremental costs c.Sometimes sunk costs d.Never avoidable costs Answer: b Always incremental costs Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions

29. Slide 7-29 Which of the following costs should not be taken into consideration when making a decision? a.Opportunity costs b.Sunk costs c.Relevant costs d.Differential costs Answer: b Sunk costs Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions

30. Learning objective 3: Analyze decisions involving joint costs Slide 7-30 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 -Product may undergo further processing with additional costs

31. Slide 7-31 Joint Products Example Learning objective 3: Analyze decisions involving joint costs

32. Slide 7-32 Allocation of Joint Costs  Cost of the common inputs - Allocated to the joint products for financial reporting purposes - Can mislead managers about product line profitability  Joint cost information is - Irrelevant to individual joint product decisions - It is not an incremental cost Learning objective 3: Analyze decisions involving joint costs

33. Slide 7-33 Joint Cost Allocation Methods Joint Cost Allocation Methods  Relative sales value method Cost allocated to product A: Sales value A / Total sales value x Joint cost  Physical quantity method Cost allocated to product A: Physical measure A / Total physical measure x Joint cost Learning objective 3: Analyze decisions involving joint costs

34. Slide 7-34Learning objective 3: Analyze decisions involving joint costs Joint costs $1,000  Economy grade: Quantity = 1,ooo pounds Sales price = $0.10 per pound  Superior grade Quantity = 4,000 pounds Sales price = $0.30 per pound Allocate joint costs using physical measure.

35. Slide 7-35Learning objective 3: Analyze decisions involving joint costs Joint costs $1,000  Economy grade Quantity = 1,ooo pounds Sales price = $0.10 per pound  Superior grade Quantity = 4,000 pounds Sales price = $0.30 per pound Allocate joint costs using relative sales value.

36. Slide 7-36 Additional Processing Decisions and Joint Costs  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 should be based on incremental analysis Learning objective 3: Analyze decisions involving joint costs

37. Slide 7-37 The joint costs incurred in a joint product situation: a.Are incurred before the split-off point b.Are incurred after the split-off point c.Should only be allocated based on physical attributes d.Should never be allocated Answer: a Are incurred before the split-off point Learning objective 3: Analyze decisions involving joint costs

38. Learning objective 4: Discuss the importance of qualitative considerations to management decisions Slide 7-38 Qualitative Considerations in Decision Analysis  Many decisions have one or more features that are difficult to quantify but should be considered  Examples include, but are not limited to: - Swings in economy - Loss of control - Quality of product - Quality of service - Company morale

39. Learning objective 4: Discuss the importance of qualitative considerations to management decisions Slide 7-39 Qualitative Considerations in Decision Analysis

40. Slide 7-40 Qualitative Factors Learning objective 4: Discuss the importance of qualitative considerations to management decisions

41. Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC) Slide 7-41 The Five-Step Process of the Theory of Constraints 1.Identify the Binding Constraint 2.Optimize Use of the Constraint 3.Subordinate Everything Else to the Constraint 4.Break the Constraint 5.Identify a New Binding Constraint

42. Slide 7-42 Optimize Use of the Constraint Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)

43. Slide 7-43 Overproduction in Non- Bottleneck Departments Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)

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