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Chapter 14 DECISION MAKING: RELEVANT COSTS AND BENEFITS

1. Decision Making Process (1) Six Steps in the Decision Making Process (a) Clarify the decision problem (b) Specify the criterion (c) Identify the alternatives (d) Develop a decision model: The model includes the criterion, the constraints, and the alternatives. (f) Collect the data (g) Select an alternative Note) Although the managerial accountant collects and presents quantitative information (e.g., cost or profit), a skilled manager should rely on his or her judgment and experience to evaluate the qualitative factors of each situation, factors which often do not easily fit into decision models. (2) Determining Usefulness of Information (a) Relevance: Information is relevant if it is pertinent to a decision problem. (b) Accuracy: Information must be precise. (c) Timeliness: Information must be available in time for a decision. (3) Managerial Accountant's Primary Role in the Decision Making Process To provide information relevant to the decisions faced by managers; That is, (a) Decide what information is relevant to each decision problem, and (b) Provide accurate and timely data, keeping in mind the proper balance between these often conflicting criteria. 2. Identifying Relevant Revenues/Costs A relevant revenue/cost is a revenue/cost that is applicable to a particular decision that should have a bearing on which alternative a manager selects. Avoidable costs are relevant costs that can be eliminated (in which or in part) as a result of choosing one alternative over another. All revenues/costs are avoidable, EXCEPT: (1) Sunk costs: A cost that has already been incurred and that cannot be avoided regardless of which course of action a manager may decide to take. (2) Future revenues/costs that do not differ between the alternative at hand. 3. Analysis of Decisions (1) Accept or Reject a Special Offer (a) With excess (idle) capacity: Only variable costs associated with the special offer are relevant. Fixed costs are usually irrelevant. (b) No excess capacity: The opportunity cost of the lost contribution margin from regular higher priced sales and variable costs associated with the special offer are relevant. (2) Make or Buy a Product or Service The key is the proper handling of fixed costs. Since the per-unit cost of a product includes a unitized portion of fixed costs (i.e., fixed costs that may continue even if the product is purchased elsewhere at a lower price), the information should be presented to emphasize that total costs will not change with the number of units produced. (3) Add or Drop a Service, Product, or Department The key is the proper handling of fixed costs & opportunity cost. (a) Ascertain whether fixed costs are avoidable or unavoidable because although a product line cannot cover ALL its fixed costs, it may be covering its AVOIDABLE fixed costs and at least contributing toward the unavoidable fixed costs; (b) The opportunity cost of lost CM, including the effects on the other operation, should be also factored into the decision. (4) Joint Products: Sell or Process Further The key is considering only the increase in process costs after split-off point (called separable processing
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cost) and comparing it to the increase in revenue the extra processing brings. The split-off point is the point in the process at which the products are distinguishable from one another. All manufacturing costs up to that point are joint costs (which are usually allocated to the each product based on relative sales value method). Those joint costs are sunk costs and irrelevant to sell now or process further decision. (5) Decisions Involving Limited Resources The key is that a decision should be made on the basis of the CM per unit of scare resource, not on the basis of the CM per product, when there are limitations on machine time, labor hours, or raw materials (scarce resources). A decision model which considers multiple scarce resources is linear programming (See appendix). (6) Techniques for Addressing the Impact of Uncertainty (a) Sensitivity analysis: A technique for determining what would happen in a decision analysis if a key prediction or assumption proves to be wrong. (b) Decisions based on expected values: The expected value of a random variable (e.g., CM) is equal to the sum of the possible values for the variable, each weighted by its probability. 4. Activity-Based Costing and Decision Making (1) The relevant-costing concepts in an activity-based-costing environment do not change. What will change is the decision makers ability to determine costs and benefits that are relevant to the decision. (2) Costs that are fixed under a conventional costing system, for example, may not be fixed when multiple (and more appropriate) cost drivers are used. 5. (1) (2) (3) (3) The Common Pitfalls in Decision Making Sunk costs are irrelevant. Fixed costs may be misleading if presented on a per-unit basis. Allocated common fixed costs may be unavoidable and irrelevant; The avoidable costs should be identify. Opportunity costs are relevant, and therefore, should be identified and included in a decision analysis.

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EXAMPLES 1. Sunk Costs are not Relevant Costs A manager at White Co. wants to replace an old machine with a new, more efficient machine. New machine: List price Annual variable expenses Expected life in years $90,000 80,000 5 Old machine: Original cost Remaining book value Disposal value now Annual variable expenses Remaining life in years $72,000 60,000 15,000 100,000 5

A manager at White Co. wants to replace an old machine with a new, more efficient machine. Whites sales are $200,000 per year. Fixed expenses, other than depreciation, are $70,000 per year. Should the manager purchase the new machine? (Analysis 1) The manger recommends that the company not purchase the new because: Remaining book value Disposal value Loss from disposal $60,000 (15,000) $45,000

(Analysis 2: Comparative income analysis) For Five Years Sales Variable expenses Other fixed expenses Depreciation - new Depreciation - old Disposal of old machine Total net income Keep Old Machine $1,000,000 Purchase New Machine $1,000,000 Difference $ -

(Short Analysis: Relevant cost analysis) Relevant Cost Analysis Savings in variable expenses provided by the new machine Cost of the new machine Disposal value of old machine Net effect

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2. Special Orders Jet, Inc. receives a one-time order that is not considered part of its normal ongoing business. Jet makes a single product with a unit variable cost of $8. Normal selling price is $20 per unit. A foreign distributor offers to purchase 3,000 units for $10 per unit. Annual capacity is 10,000 units, and annual fixed costs total $48,000, but Jet, Inc. is currently producing and selling only 5,000 units. Should Jet accept the offer? Increase in revenue Increase in variable costs Increase in fixed costs Increase in net income or

3. The Make or Buy Decision (Outsourcing) Essex manufactures part 457A that is currently used in one of its products. The unit cost to make this part is: Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Total cost per unit $ 9 5 1 3 2 10 $ 30

The special equipment used to manufacture part 457A has no resale value. General factory overhead is allocated on the basis of direct labor hours. The $30 total unit cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part. Should we accept the suppliers offer? Cost Per Unit Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 9 5 1 3 2 10 $ 30 Cost of 20,000 Units Make Buy

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4. Adding/Dropping Segments Due to the declining popularity of digital watches, Lovell Companys digital watch line has not reported a profit for several years. An income statement for last year is: Segment Income Statement Digital Watches Sales Less: variable expenses Variable mfg. costs Variable shipping costs Commissions Contribution margin Less: fixed expenses General factory overhead Salary of line manager Depreciation of equipment Advertising direct Rent - factory space General admin. expenses Net loss $ 500,000 $ 120,000 5,000 75,000

200,000 $ 300,000

60,000 90,000 50,000 100,000 70,000 30,000

400,000 $ (100,000)

Assuming all of the general expenses and depreciation are unavoidable, should Lovell retain or drop the digital watch segment? (Analysis 1: Comparative income analysis) Comparative Income Solution Keep Digital Watches Sales Less variable expenses: Mfg. expenses Freight out Commissions Total variable expenses Contribution margin Less fixed expenses: General factory overhead Salary of line manager Depreciation Advertising direct Rent - factory space General admin. expenses Total fixed expenses Net loss $ 500,000 120,000 5,000 75,000 200,000 300,000 60,000 90,000 50,000 100,000 70,000 30,000 400,000 $ (100,000)

Drop Digital Watches $ -

Difference

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(Short Analysis: Relevant cost analysis) Contribution Margin Solution Contribution margin lost if digital watches are dropped Less fixed costs that can be avoided Salary of the line manager Advertising direct Rent - factory space Net disadvantage

5. Joint Product: Sell or Process Further Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products. Unfinished lumber is sold as is or processed further into finished lumber. Sawdust can also be sold as is to gardening wholesalers or processed further into presto-logs. Data about Sawmills joint products includes: Per Log Lumber Sawdust $ 140 $ 40 270 50 176 24 50 20

Sales value at the split-off point Sales value after further processing Allocated joint product costs Cost of further processing

Should we process the lumber further and sell the sawdust as is? Analysis of Sell or Process Further Per Log Lumber Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing Profit (loss) from further processing Sawdust

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6. Utilization of Scarce Resources Ensign Company produces two products and selected data is shown below: Products 1 Selling price per unit Less: variable expenses per unit Contribution margin per unit Current demand per week (units) Contribution margin ratio Processing time required on machine A1 per unit $ 60 36 $ 24 2,000 40% 1.00 min. $ 2 50 35 $ 15 2,200 30% 0.50 min.

Machine A1 is the scarce resource because there is excess capacity on other machines. Machine A1 is being used at 100% of its capacity. Machine A1 capacity is 2,400 minutes per week. Should Ensign focus its efforts on Product 1 or 2? (Step 1) Products 1 Contribution margin per unit Time required to produce one unit Contribution margin per minute min. /min. 2 min. /min.

(Step 2) Allotting Our Scarce Resource (Machine A1) Weekly demand for Product 2 Time required per unit Total time required to make Product 2 Total time available Time used to make Product 2 Time available for Product 1 Time required per unit Production of Product 1 (Step 3) Product 1 Production and sales (units) Contribution margin per unit Total contribution margin Product 2 units min. min. min. min. min. min. units

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7. From the last example (example 6), recall the contribution margin for Product 1 was $24 and $15 for Product 2. Due to uncertainty, assume Martin has the following probable contribution margins for the two products. Product 1
Possible value of CM Probability

Product 2
Possible value of CM Probability

23.00 24.00 25.00

30% 50% 20%

14.00 15.00 16.00

10% 40% 50%

Compute the expected values. Product 1

Possible value of CM Probability Expected Value Possible value of CM

Product 2
Probability Expected Value

23.00 24.00 25.00

30% 50% 20%

14.00 15.00 16.00

10% 40% 50%

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