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Decision Making and Relevant Information

Chapter

11

Learning Objective 1

Use the five-step decision process to make decisions.

Information and the Decision Process
Information and the
Decision Process

A decision model is a formal method

for

making a choice, often involving

quantitative and qualitative analysis.

Information and the Decision Process A decision model is a formal method for making a choice,
Five-Step Decision Process
Five-Step Decision Process
Gather Information
Gather Information
Five-Step Decision Process Gather Information Historical Costs Other Information Step 1. Step 2. Make Predictions Step

Historical Costs

Other Information

  • Step 1.

Five-Step Decision Process Gather Information Historical Costs Other Information Step 1. Step 2. Make Predictions Step
Step 2. Make Predictions Step 3. Choose an Alternative Step 4. Implement the Decision Feedback
Step 2.
Make Predictions
Step 3.
Choose an Alternative
Step 4.
Implement the Decision
Feedback
Evaluate Performance
Evaluate Performance
  • Step 5.

Five-Step Decision Process Gather Information Historical Costs Other Information Step 1. Step 2. Make Predictions Step

Specific Predictions

Five-Step Decision Process Gather Information Historical Costs Other Information Step 1. Step 2. Make Predictions Step
Learning Objective 2
Learning Objective 2

Differentiate relevant from irrelevant costs and revenues in decision situations.

The Meaning of Relevance
The Meaning of Relevance

Relevant costs and relevant revenues are

expected future costs and revenues that

differ among alternative courses of action.

Historical costs

Sunk costs

Differential income

Differential costs

Learning Objective 3
Learning Objective 3

Distinguish between quantitative and qualitative factors in decisions.

Quantitative and Qualitative Relevant Information
Quantitative and Qualitative
Relevant Information
Quantitative and Qualitative Relevant Information Quantitative factors Financial Nonfinancial Qualitative factors ©2003 Prentice Hall Business Publishing,

Quantitative factors

Quantitative and Qualitative Relevant Information Quantitative factors Financial Nonfinancial Qualitative factors ©2003 Prentice Hall Business Publishing,
Quantitative and Qualitative Relevant Information Quantitative factors Financial Nonfinancial Qualitative factors ©2003 Prentice Hall Business Publishing,

Financial

Quantitative and Qualitative Relevant Information Quantitative factors Financial Nonfinancial Qualitative factors ©2003 Prentice Hall Business Publishing,

Nonfinancial

Qualitative factors

One-Time-Only Special Order Example
One-Time-Only
Special Order Example

The Bismark Co. manufacturing plant has a

production capacity of 44,000 towels each month.

Current monthly production is 30,000 towels.

Costs can be classified as either variable or fixed

with respect to units of output.

One-Time-Only Special Order Example
One-Time-Only
Special Order Example
 

Variable

Fixed

 

Costs

Costs

   

Per Unit

Per

Unit

Direct

materials

$6.50

$

-0-

Direct

labor

.50

1.50

Manufacturing costs

 

1.50

3.50

Total

$8.50

$5.00

One-Time-Only Special Order Example
One-Time-Only
Special Order Example

Total fixed direct manufacturing labor is $45,000.

Total fixed overhead is $105,000.

Marketing costs per unit are $7

($5 of which is variable).

What is the full cost per towel?

One-Time-Only Special Order Example
One-Time-Only
Special Order Example

Variable ($8.50 + $5.00):

$13.50

Fixed:

7.00

Total

$20.50

A

hotel in San Juan has offered to buy

5,000 towels from Bismark Co.

at

$11.50/towel for a total of $57,500.

No marketing costs will be incurred.

One-Time-Only Special Order Example
One-Time-Only
Special Order Example

What are the relevant costs of making the towels

?

$8.50 × 5,000 = $42,500 incremental costs

What are the incremental revenues ?

$57,500 – $42,500 = $15,000

Learning Objective 4
Learning Objective 4

Beware of two potential problems in relevant-cost analysis.

Two Potential Problems in Relevant-Cost Analysis 1 2
Two Potential Problems in
Relevant-Cost Analysis
1
2

Incorrect general

assumptions:

All variable costs

are relevant.

All fixed costs

are irrelevant.

Misleading

unit-cost data:

Include

irrelevant costs.

Use same unit

costs at different

output levels.

Outsourcing versus Insourcing
Outsourcing versus Insourcing

Outsourcing is

purchasing goods

and services from

outside vendors.

Outsourcing versus Insourcing Outsourcing is purchasing goods and services from outside vendors. Insourcing is producing goods
 

Insourcing is

producing goods

or

providing services

within the organization.

Outsourcing versus Insourcing Outsourcing is purchasing goods and services from outside vendors. Insourcing is producing goods
Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

Bismark Co. also manufactures bath accessories.

Management is considering producing a part it

needs (#2) or buying a part produced

by Towson Co. for $0.55.

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

Bismark Co. has the following costs

for 150,000 units of Part #2:

Direct materials

$ 28,000

Direct labor

 

18,500

Mixed

overhead

29,000

Variable overhead

 

15,000

Fixed overhead

 

30,000

Total

$120,500

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

Mixed overhead consists of material

handling and setup costs.

Bismark Co. produces the 150,000 units

in 100 batches of 1,500 units each.

Total material handling and setup costs

equal fixed costs of $9,000 plus variable

costs of $200 per batch.

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

What is the cost per unit for Part #2?

$120,500 ÷ 150,000 units = $0.8033/unit

Should Bismark Co. manufacture the part

or buy it from Towson Co.?

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

Bismark Co. anticipates that next year the

150,000 units of Part #2 expected to

be

sold will be manufactured in 150

batches of 1,000 units each.

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

Variable costs per batch are expected to

decrease to $100.

Bismark Co. plans to continue to produce

150,000 next year at the same variable

manufacturing costs per unit as this year.

Fixed costs are expected to remain the

same as this year.

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

What is the variable manufacturing cost per unit?

Direct material

$28,000

Direct labor

18,500

Variable overhead

15,000

Total

$61,500

$61,500 ÷ 150,000 = $0.41 per unit

 
Make-or-Buy Decisions Example
Make-or-Buy Decisions Example
 

Expected relevant cost to make Part #2:

 

Manufacturing

$61,500

 

Material handling and setups

15,000

*

Total

relevant cost to make

$76,500

*

150 × $100 = $15,000

 
 

Cost to buy: (150,000 × $0.55) $82,500

 

Bismark Co. will save $6,000 by making the part.

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example

Now assume that the $9,000 in fixed clerical

salaries to support material handling and

setup will not be incurred if Part #2 is

purchased from Towson Co ..

Should Bismark Co. buy the part or make the part?

Make-or-Buy Decisions Example
Make-or-Buy Decisions Example
 

Relevant cost to make:

Variable

$76,500

Fixed

9,000

Total

$85,500

Cost to buy:

$82,500

Bismark would save $3,000 by buying the part.

Learning Objective 5
Learning Objective 5

Explain the opportunity-cost concept and why it is used in decision making.

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Assume that if Bismark buys the part from

Towson, it can use the facilities previously

used to manufacture Part #2 to produce

Part #3 for Krysta Company.

The expected additional future operating

income is $18,000.

What should Bismark Co. do?

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Bismark Co. has three options regarding Krysta:

1. Make Part #2 and do not make Part #3.

 

2.

Buy Part #2 and do not make Part #3.

3.

Buy the part and use the facilities to produce

Part #3.

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Expected cost of obtaining 150,000 parts:

 

Buy Part #2 and do not make Part #3:

$82,500

Buy Part #2 and make Part #3:

$82,500 – $18,000 =

$64,500

Make Part #2:

$76,500

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Opportunity cost is the contribution to income

that is forgone (rejected) by not using a

limited resource in its next-best alternative use.

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Assume that annual estimated Part #2

requirements for next year is 150,000.

Cost per purchase order is $40.

Cost per unit when each purchase is

1,500 units = $0.55.

Cost per unit when each purchase is equal

to or greater than 150,000 = $0.54.

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Average investment in inventory is either:

(1,500 × .55) ÷ 2 = $412.50 or

(150,000 × $0.54) = $40,500

Annual interest rate for investment in

government bonds is 6%.

$412.50 × .06 = $24.75

$40,500 × .06 = $2,430

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Option A: Make 100 purchases of 1,500 units:

 

Purchase costs: (150,000 × $0.55)

$82,500.00

Annual interest income:

$

24.75

 

Relevant costs:

$86,524.75

Purchase order costs: (100 × $40)

$ 4,000.00

Opportunity Costs, Outsourcing, and Constraints
Opportunity Costs,
Outsourcing, and Constraints

Option B: Make 1 purchase of 150,000 units:

 

Purchase order costs: (1 × $40)

$

40

Purchase costs: (150,000 × $0.54)

$81,000

Annual interest income:

$ 2,430

Relevant costs:

$83,470

Learning Objective 6
Learning Objective 6

Know how to choose which products to produce when there are capacity constraints.

Product-Mix Decisions Under Capacity Constraints
Product-Mix Decisions
Under Capacity Constraints

Per unit

Product #2 Product #3

Sales price

$2.11

$14.50

Variable expenses

0.41

13.90

Contribution margin

$1.70

$

0.60

Contribution margin ratio

81%

4%

Bismark Co. has 3,000 machine-hours available.

Product-Mix Decisions Under Capacity Constraints
Product-Mix Decisions
Under Capacity Constraints

One unit of Prod. #2 requires 7 machine-hours.

One unit of Prod. #3 requires 2 machine-hours.

What is the contribution of each product

per machine-hour?

Product #2: $1.70 ÷ 7 = $0.24

Product #3: $0.60 ÷ 2 = $0.30

Learning Objective 7
Learning Objective 7

Discuss what managers must consider when adding or discontinuing customers and segments.

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs

Mountain View Furniture supplies furniture

to two local retailers – Stevens and Cohen.

The company has a monthly capacity

of 3,000 machine-hours.

Fixed costs are allocated on the basis of revenues.

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs
 

Stevens

Cohen

Revenues

$200,000

$100,000

 

Variable costs

70,000

60,000

Fixed

costs

100,000

50,000

Total

operating costs

$170,000

$110,000

Operating income

$ 30,000

$(10,000)

Machine-hours required

2,000

1,000

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs
 

Total

Revenues

$300,000

 

Variable costs

130,000

Fixed

costs

150,000

Total

operating costs

$280,000

Operating income

$ 20,000

Machine-hours required

3,000

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs

Should Mountain View Furniture drop the Cohen

business, assuming that dropping Cohen would

decrease its total fixed costs by 10%?

New fixed costs would be:

$150,000 – $15,000 = $135,000

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs

Stevens Alone

 

Revenues $200,000

 

Variable costs

70,000

Fixed costs

135,000

Total operating costs

$205,000

Operating income

$

(5,000)

Machine-hours required

3,000

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs

Cohen’s business is providing a

contribution margin of $40,000.

$40,000 decrease in contribution margin

$15,000 decrease in fixed costs

– = $25,000 decrease in operating income.

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based
Costing, and Relevant Costs

Assume that if Mountain View Furniture drops

Cohen’s business it can lease the excess capacity

to the Perez Corporation for $70,000.

Fixed costs would not decrease.

Should Mountain View Furniture lease to Perez?

Learning Objective 8
Learning Objective 8

Explain why the book value of equipment is irrelevant in equipment-replacement decisions.

Equipment-Replacement Decisions Example
Equipment-Replacement
Decisions Example
 

Existing

Replacement

Machine

Machine

cost

$80,000

$105,000

life

4 years

4

years

$50,000

value

$30,000

$14,000

$46,000

$ 10,000

Original

Useful

Accumulated depreciation

Book

Disposal price

Annual costs

Equipment-Replacement Decisions Example
Equipment-Replacement
Decisions Example

Ignoring the time value of money and

 

income taxes, should the company

replace the existing machine?

The cost savings over a 4-year period will

be

$36,000 × 4 = $144,000.

Investment = $105,000 – $14,000 = $91,000

$144,000 – $91,000 = $53,000

advantage of the replacement machine.

 
Learning Objective 9
Learning Objective 9

Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager.

Decisions and Performance Evaluation
Decisions and
Performance Evaluation

What is the journal entry to sell the existing machine?

Cash

14,000

Accumulated Depreciation

50,000

Loss

on Disposal

16,000

Machine

80,000

Decisions and Performance Evaluation
Decisions and
Performance Evaluation
 

In the real world would the manager

replace the machine?

An important factor in replacement decisions

is

the manager’s perceptions of whether

the

decision model is consistent with how

the

 

manager’s performance is judged.

Decisions and Performance Evaluation
Decisions and
Performance Evaluation

Top management faces a challenge – that is,

making sure that the performance-evaluation

model of subordinate managers is consistent

with the decision model.