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

3. 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

4. Incremental Analysis Example

5. Incremental Analysis Example Expanded

6. “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

7. 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

8. 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

9. Additional Processing Decision – Bridge Computer Example
Summary of Cost Information

10. Additional Processing Decision – Bridge Computer Example
Incremental Analysis Summary

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

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

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

14. 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

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

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

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

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

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

20. 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.

21. 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.

22. 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

23. 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

24. Dropping a Product Line – Mercer Hardware Example

25. Dropping a Product Line – Mercer Hardware Example

26. 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

27. 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

28. Joint Products Example

29. 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

30. 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.

31. 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

32. 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, = $ 77

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. Qualitative Factors

40. 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

41. Production Flow

42. Overproduction in Non-bottleneck Departments

43. Copyright
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