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Copyright

2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Decision Making:

Relevant Costs andBenefits

Chapter 14

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14-2

The Managerial Accountants

Role in Decision Making

Designs and implementsaccounting information

system

Cross-functional

management teamswho make

production, marketing,and finance decisions

Make substantiveeconomic decisionsaffecting operations

ManagerialAccountant

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The Decision-Making Process

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

4. Develop a Decision Model

5. Collect the Data

6. Make a Decision

QuantitativeAnalysis

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5. Collect the Data

6. Make a Decision

Primarily theresponsibility of themanagerialaccountant.

Information should be:1. Relevant2. Accurate3. Timely

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5. Collect the Data

6. Make a Decision

Relevant

Pertinent to a

decision problem.

Accurate

Information must

be precise.

Timely

Available in time

for a decision

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Relevant Information

Information is relevant to a decisionproblem when . . .

1. It has a bearing on the future,

2. It differs among competing alternatives.

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Identifying RelevantCosts and Benefits

Sunk costsCosts that have already been incurred.They do not affect any future cost and

cannot be changed by any current or futureaction.

Sunk costs are irrelevant to decisions.

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Relevant Costs

Worldwide Airways is thinking about replacing athree year old loader with a new, more efficient

loader.New loader List price 15,000$

Annual operating expenses 45,000Expected life in years 1

Old loader

Original cost 100,000$

Remaining book value 25,000Disposal value now 5,000

Annual variable expenses 80,000

Remaining life in years 1

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Relevant Costs

If we keep the old loader, we will have depreciationcosts of $25,000. If we replace the old loader,we will write-off the $25,000 when sold. There is

no difference in the cost, so it is not relevant.

The new loader will be depreciated in one year.

The $5,000 proceeds will only be realized if wereplace the old loader. This amount is relevant.

We will only have depreciation on the new loaderif we replace the old loader. This cost is relevant.

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Relevant Costs

Kee p Old

Loader

Re place Old

Loader

Differential

Cost

De pre ciation of old loade r 25,000$

Write -off of old loade r 25,000$ -$

P roce e ds from s ale of old loade r (5,000) 5,000

De pre ciation of n e w loade r 15,000 (15,000)Ope ratin g cos ts 80,000 45,000 35,000

Total cos ts 105,000$ 80,000$ 25,000$

The difference in operating costs is relevantto the immediate decision.

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Relevant Costs

Here is an analysis that includes only relevantcosts:

Relevant Cost AnalysisSavings in variable expenses

provided by the new loader 35,000$

Cost of the new loader (15,000)Disposal value of old loader 5,000

Net effect 25,000$

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Analysis of Special Decisions

Lets take a close look at some specialdecisions faced by many businesses.

We just receiveda special order. Doyou think we should

accept it?

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Accept or Reject a Special Order

A travel agency offers Worldwide Airways$150,000 for a round-trip flight from Hawaiito Japan on a jumbo jet.

Worldwide usually gets $250,000 in revenue

from this flight.

The airline is not currently planning to addany new routes and has two planes that are

idle and could be used to meet the needs ofthe agency.

The next screen shows cost data developed

by managerial accountants at Worldwide.

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Revenue:

Passenger 250,000$

Cargo 30,000

Total 280,000$Expenses:

Variable expenses 90,000

Allocated fixed expenses 100,000

Total 190,000Profit 90,000$

Typical Flight Between Japan and Hawaii

Worldwide will save about $5,000 in reservationand ticketing costs if the charter is accepted.

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Special price for charter 150,000$

Variable cost per flight 90,000$

Reservation cost savings (5,000)Variable cost of charter 85,000

Contribution from charter 65,000$

Assumes excess capacity

Since the charter will contribute to fixed costs andWorldwide has idle capacity, the company should

accept the flight.

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What if Worldwide had no excess capacity? IfWorldwide adds the charter, it will have tocut its least profitable route that currently

contributes $80,000 to fixed costs andprofits. Should Worldwide still accept the

charter?

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Special price for charter 150,000$

Variable cost per flight 90,000$

Reservation cost savings (5,000)Variable cost of charter 85,000

Opportunity cost:

Lost contribution on route 80,000 165,000

Total (15,000)$

Assumes no excess capacity

Worldwide has no excess capacity, so itshould reject the special charter.

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With excess capacity . . . Relevant costs will usually be the variable costs

associated with the special order.

Without excess capacity . . . Same as above but opportunity cost of using

the firms facilities for the special order are alsorelevant.

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Outsource a Product or Service

A decision concerning whether an item shouldbe produced internally or purchased from an

outside supplier is often called a make or

buy decision.

Lets look at another decision faced by the

management of Worldwide Airways.

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Outsource a Product or Service An Atlanta bakery has offered to supply the

in-flight desserts for 21 each.

Here are Worldwides current cost for

desserts:

Variable costs:

Direct material 0.06$

Direct labor 0.04

Variable overhead 0.04

Fixed costs: Supervisory salaries 0.04

Depreciation of equipment 0.07

Total cost per dessert 0.25$

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Cost per

Dessert

Savings from

Outsourcing

Variable costs: Direct material 0.06$ 0.06$

Direct labor 0.04 0.04

Variable overhead 0.04 0.04

Fixed costs: Supervisory salaries 0.04 0.01

Equipment depreciation 0.07 -

Total cost per dessert 0.25$ 0.15$

Not all of the allocated fixed costs will be savedif Worldwide purchases from the outside bakery.

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If Worldwide purchases the dessert for21, it will only save 15 so

Worldwide will have a lossof 6 perdessert purchased.

Wow, thatsno deal!

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Add or Drop a Service,Product, or Department

One of the most importantdecisions managers make is

whether to add or drop a

product, service ordepartment.

Lets look at how the conceptof relevant costs should beused in such a decision.

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Add or Drop a Product

Worldwide Airways offers itspassengers the opportunity to join its

World Express Club. Clubmembership entitles a traveler to use

the club facilities at the airport inAtlanta.

Club privileges include a private lounge

and restaurant, discounts on mealsand beverages, and use of a smallhealth spa.

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Sales $200,000Less: Variable Costs:

Food/Beverage $70,000

Personnel 40,000

Variable overhead 25,000 (135,000)

Contribution Margin 65,000

Less: Fixed Costs:

Depreciation $30,000

Supervisor salary 20,000

Insurance 10,000Airport fees 5,000

Allocated overhead 10,000 ( 75,000)

Loss $ ( 10,000)

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KEEP CLUB ELIMINATE DIFFERENTIALSales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)

Personnel (40,000) 0 (40,000)

Variable overhead (25,000) 0 (25,000)

Contribution Margin 65,000 0 65,000

Depreciation (30,000) (30,000) 0

Supervisor salary (20,000) 0 (20,000)

Insurance (10,000) (10,000) 0

Airport fees ( 5,000) 0 ( 5,000)Allocated overhead (10,000) (10,000) 0

Loss $ (10,000) $(50,000) $ 40,000

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KEEP CLUB ELIMINATE DIFFERENTIALSales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)

Personnel (40,000) 0 (40,000)

Variable overhead (25,000) 0 (25,000)

Contribution Margin 65,000 0 65,000

Depreciation (30,000) (30,000) 0


Insurance (10,000) (10,000) 0

Airport fees ( 5,000) 0 ( 5,000)Allocated overhead (10,000) (10,000) 0

Loss (10,000) (50,000) 40,000

NOTA

VOIDA

BLE

A

V

O

ID

A

B

LE

The positive $40,000 differential amount reflects the fact that the

company is $40,000 better off by keeping the club.

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KEEP CLUB ELIMINATE DIFFERENTIAL

Sales $200,000 0 $200,000

Food/Beverage (70,000) 0 (70,000)

Personnel (40,000) 0 (40,000)

Variable overhead (25,000) 0 (25,000)Contribution Margin 65,000 0 65,000

Avoidable fixed costs


Airport fees ( 5,000) 0 ( 5,000)Profit/Loss $ 40,000 $ 40,000

Worldwide airlines would also lose the contributionmargin of $65,000. The club contributes $40,000 to

Worldwides fixed costs.

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Special Decisions inManufacturing Firms

Joint Products:Sell or Process Further

A joint production process resulting in twoor more products. The point in theproduction process where the joint

products are identifiable as separateproducts is called the split-off point.

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Cocoa beans

costing $500

per ton

Joint Production

process costing

$600 per ton

Cocoa butter

sales value

$750 for

1,500 pounds

Cocoa powder

sales value

$500 for

500 pounds

Separable

process

costing

$800

Instant cocoa

mix sales value

$2,000 for

500 pounds

Joint Processingof Cocoa Bean

Total joint cost:$1,100 per ton

Split-off point

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Joint Products

Relative Sales Value Method

Joint

Costs Joint Products

Sales Value

at Split-Off

Relative

Proportion

Allocation

of Joint

CostsCocoa Butter 750$ 60% 660$

Cocoa Powder 500 40% 440

1,250$ 100% 1,100$

1,100$

$750 $1,250 = 60%

60% $1,100 = $660

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Joint Products

Cocoa butter is sold at the end of the jointprocessing.

Cocoa powder may be sold now or processed

into instant cocoa mix. Further processingcosts of $800 will be incurred if the companyelects to make instant cocoa mix.

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Joint Products

Sales value of instant cocoa mix 2,000$

Sales value of cocoa powder 500

Incremental revenue 1,500$

Less: separable processing costs (800)

Net benefit of further processing 700$

Process Further

The cocoa powder should beprocessed into instant cocoa mix.

( )

D i i I l i Li it d

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Decisions Involving LimitedResources

Firms often face the problem of decidinghow limited resources are going to be used.

Usually, fixed costs are not affected by thisdecision, so management can focus onmaximizing total contribution margin.

Lets look at the Martin, Inc. example.

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Limited Resources

Martin, Inc. produces two products andselected data is shown below:

Products

Webs Highs

Selling price per unit $ 60 $ 50Less: variable expenses per unit 36 35

Contribution margin per unit 24$ 15$

Current demand per week (units) 2,000 2,200

Contribution margin ratio 40% 30%

Processing time required on the lathe per unit 1.00 min. 0.50 min.

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Limited Resources

The lathe is the scarce resource becausethere is excess capacity on othermachines. The lathe is being used at

100% of its capacity. The lathe capacity is 2,400 minutes per

week.

Should Martin focus its efforts

on Webs or Highs?

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Limited ResourcesLets calculate the contribution margin per unit

of the scarce resource, the lathe.

Highs should be emphasized. It is the more valuableuse of the scarce resource the lathe, yielding a

contribution margin of $30 per minute as opposed to$24 per minute for the Webs.

Products

Webs Highs

Contribution margin per unit $ 24 $ 15

Time required to produce one

unit 1.00 min. 0.50 min.

Contribution margin per minute 24$ min. 30$ min.

If there are no other considerations, the best plan would be to produce to meet currentdemand for Highs and then use remaining capacity to make Webs.

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Limited ResourcesLets see how this plan would work.

Allotting the Scarce ResourceThe Lathe

Weekly demand for Highs 2,200 units

Time required per unit x .50 minutesTime required to make Highs 1,100 minutes

Total lathe time available 2,400 minutesTime used to produce Highs 1,100 minutesTime available for Webs 1,300 minutesTime required per unit x 1.00 minuteProduction of Webs 1,300 units

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Limited Resources

According to the plan, Martin will produce2,200 Highs and 1,300 Webs. Martins

contribution margin looks like this.

Webs HighsProduction and sales (units) 1,300 2,200

Contribution margin per unit 24$ 15$

Total contribution margin 31,200$ 33,000$

The total contribution margin for Martin, Inc. is $64,200.Any other combination would result in less contribution.

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Other Issues in Decision Making

Incentives for

Decision Makers

Short-RunVersus

Long-RunDecisions

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Other Issues in Decision Making

Pitfalls to Avoid

Sunkcosts.

Unitized

fixed costs.

Allocatedfixed costs.

Opportunity

costs.

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End of Chapter 14

hilton 12 chap014

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