1. Prepared by Debby Bloom-Hill CMA, CFM

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 analysis
All decisions involve a choice among alternative courses of action
The solution to business problems involves incremental analysis
Incremental analysis is the analysis of the incremental revenue and incremental costs incurred when one alternative is chosen over another
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

4. 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
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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

5. Incremental Analysis
An alternative that yields an incremental profit should be selected
Incremental costs are referred to as relevant costs
Also called differential costs because they are the costs that differ between decision alternatives
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

6. Incremental Analysis Example
Jensen’s Rapid Copy is considering extending its hours
Alternative 1 is the status quo
Alternative 2 involved the company extending their hours from 8 pm to midnight
The next slide shows the incremental costs and revenues associated with choosing one alternative over another
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

7. Incremental Analysis Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

8. 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 the profit for this alternative and the profit of any other alternative is the incremental profit
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

9. “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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

10. Test Your Knowledge 1
Which of the following is likely to be an incremental cost associated with increasing planned production run of 1,000 units to 1,010 units?
Set-up costs
Depreciation of equipment
Inspection costs
Material costs
Answer: d
Material costs are variable costs and usually incremental
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

11. Analysis of Decisions Faced by Managers
Three decisions that managers frequently face:
The decision to engage in additional processing of a product
The decision to make or buy a product
The decision to drop a product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

12. Additional Processing Decision
Manufacturers must occasionally decide whether to:
Sell a product in a partially completed stage, or
Incur additional processing costs required to complete the product
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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

13. 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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

14. 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
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15. 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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

16. Additional Processing Decision
Slide 7-16 16

17. Make or Buy Decisions
Most manufactured goods are made up of numerous components
In some cases, a company may purchase one or more of these components from another company or manufacture them themselves
The analysis of this decision concentrates solely on incremental costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

18. 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
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19. Make-or-Buy Decisions – General Refrigeration Example
A key issue is to determine which of the above costs are incremental
None of the $15 million of variable manufacturing costs will be incurred if the part is purchased
The fixed costs associated with depreciation will not be saved
Note that not all fixed costs are irrelevant sunk costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

20. Make-or-Buy Decisions – General Refrigeration Example
Some fixed costs are avoidable costs
Avoidable costs can be avoided if a particular action is undertaken
If the parts are purchased from an outside vendor, the salaries of 5 supervisors will be saved
The savings total $390,000 of avoidable fixed costs
It will cost the company an additional $110,000 to purchase the part
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

21. 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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

22. 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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

23. Test Your Knowledge 2
Which of the following is not likely to be an incremental cost for a make-or-buy decision?
Materials cost
Direct labor cost
Variable manufacturing cost
Depreciation of building
Answer: d
Depreciation of building is not likely to change no matter which alternative is chosen in a make-or-buy decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

24. Opportunity Costs
An opportunity cost is the value of benefits foregone by selecting one decision alternative over another
For example, if you spend $1,000 instead of investing in a certificate of deposit, the interest that could have been earned is an opportunity cost
Since opportunity costs differ depending on the option selected, they are incremental costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

25. Test Your Knowledge 3 Which of the following is true?
Opportunity costs are never incremental costs
Opportunity costs are always incremental costs
Answer: b
Opportunity costs are always incremental costs because they differ depending upon the outcome selected
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

26. Opportunity Costs – General Refrigeration Example
Suppose the Tennessee plant is currently spending $500,000 per year to rent space for manufacturing shelving used in the refrigeration units
If production of compressors is discontinued, the company will not need to rent the space
In the incremental analysis on the next slide, the rent savings is shown along with the other cost savings
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

27. Make-or-Buy Decisions – General Refrigeration Example
Incremental analysis with opportunity costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

28. Dropping 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
This amounts to comparing the incremental revenues and costs that result from dropping the product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

29. Dropping a Product Line – Mercer Hardware
Mercer Hardware sells 3 product lines, tools, hardware and garden
Direct fixed costs are directly traceable to each product line
Allocated fixed costs are not directly traceable to a product line
Allocated fixed costs are generally not avoidable, thus no common fixed costs will be saved if the product line is dropped
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

30. Dropping a Product Line – Mercer Hardware Example
Profit calculation with three product lines
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

31. Dropping a Product Line – Mercer Hardware Example
Profit calculation with two product lines
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32. 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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

33. 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, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

34. Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental
Avoidable costs
Costs that can be avoided by taking a particular course of action
Always incremental costs, and therefore relevant to a decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

35. Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental
Sunk costs
Already occurred and not reversible
Are not incremental because they do not differ among alternatives
Are not relevant in decision making
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

36. Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental
Many students assume that fixed costs are equivalent to sunk costs
This is not always the case
Fixed costs can be sunk, not sunk and irrelevant, or possibly relevant
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

37. Summary of Incremental, Avoidable, Sunk and Opportunity Costs
Basic approach is to compare decision alternatives in terms of costs and revenues that are incremental
Opportunity costs
Represent the benefit foregone by selecting a particular alternative
They are always incremental and relevant to a decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

38. Test Your Knowledge 4
Which of the following costs should not be taken into consideration when making a decision?
Opportunity costs
Sunk costs
Relevant costs
Differential costs
Answer: b
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

39. Test Your Knowledge 5
Classify each of the following as sunk and irrelevant, not sunk but still irrelevant, or not sunk and relevant
Depreciation on equipment already purchased
Sunk and irrelevant (not incremental)
President’s salary, which will not change for both action A and action B
Not sunk and irrelevant (not incremental)
Salary of supervisory who will be retained for action A and fired for action B
Not sunk and relevant (incremental)
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions, and define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

40. 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 and may incur additional costs
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

41. Allocation of Joint Costs
For financial reporting, the cost of common inputs must be allocated to the joint products
The total joint cost will be incurred no matter what the company does with the joint products beyond the split-off point
The joint cost is not incremental to production of an individual joint product and irrelevant to decisions regarding an individual joint product
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

42. Joint Products Example
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

43. Joint Cost Allocation Methods
Physical quantity of output
Joint costs allocated to product A =
𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐀 (𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐀+𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐁) ∗𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭
Joint costs allocated to product B =
𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐁 (𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐀+𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐁) ∗𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭
Slide 7-43 43

44. Joint Cost Allocation Example
Slide 7-44 44

45. Joint Cost Allocation Methods
Relative sales value
Joint costs allocated to product A =
𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀 (𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀+𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁) ∗𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭
Joint costs allocated to product B =
𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁 (𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀+𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁) ∗𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭
Slide 7-45 45

46. Joint Cost Allocation Example
Slide 7-46 46

47. Additional Processing Decisions and Joint Costs
Joint costs not relevant to decisions made after the split-off point because they are not incremental
Joint costs incurred prior to the split-off point are sunk costs and have no effect on what happens after the split-off point
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

48. Test Your Knowledge 6
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
Should never be allocated
Answer: a
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

49. Qualitative Considerations in Decision Analysis
Many decisions have one or more features that are difficult to quantify but should be given careful consideration
Examples include, but are not limited to
Swings in the economy
Loss of control
Quality of the product
Quality of service
Company morale

50. Qualitative Considerations in Decision Analysis
Slide 7-50 50

51. Qualitative Factors
Learning objective 2: Analyze decisions involving joint costs, and discuss the importance of qualitative considerations in management decisions.

52. Appendix – The Theory of Constraints
The Theory of Constraints is an approach to production and constraint management developed by Eli Goldratt
Five step process
Large increases in profit can be achieved by elimination of bottlenecks in production processes
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

53. Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
Identify the Binding Constraint
The binding constraint is the process that limits throughput
Optimize Use of the Constraint
Produce products with the highest contribution margin per unit of the constraint
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

54. Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
Subordinate Everything Else to the Constraint
Managers should focus their attention on trying to loosen the constraint and not on process improvements
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

55. Appendix – The Theory of Constraints
Goldratt specified a five step process for dealing with constraints
Break the Constraint
This can be done many ways including cross training workers, outsourcing, purchasing additional equipment or hiring new workers
Identify a New Binding Constraint
Identify the additional bottlenecks. If there are no bottlenecks and excess capacity, focus on building demand
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

56. Implications of The Theory of Constraints
Inspections
Should take place before work is transferred to a constrained department
Batch sizes
When a production process is a binding constraint, it may be better to have large batch sizes
The time of the constrained department is not wasted setting up equipment for numerous batches
Across the board cuts
Cuts in bottleneck departments may make sense, but across the board cuts can have a serious negative impact on profits
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

57. You Get What You Measure and The Theory of Constraints
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC).

58. Copyright
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