Chapter 14

Decision
Making:
Relevant Costs
and Benefits

McGraw-Hill/Irwin

Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 1

14-2
14-2

The Managerial Accountants Role in

Decision Making
Managerial
Managerial
Accountant
Accountant
Designs
Designs and
and implements
implements
accounting
accounting information
information
system
system

Cross-functional
Cross-functional
management
management teams
teams
who
who make
make
production,
production, marketing,
marketing,
and
and finance
finance decisions
decisions
Make
Make substantive
substantive
economic
economic decisions
decisions
affecting
affecting operations
operations
14-3

The Decision-Making Process

1.
1. Clarify
Clarify the
the Decision
Decision Problem
Problem
2.
2. Specify
Specify the
the Criterion
Criterion

Quantitative
Analysis

3.
3. Identify
Identify the
the Alternatives
Alternatives
4.
4. Develop
Develop aa Decision
Decision Model
Model
5.
5. Collect
Collect the
the Data
Data
6.
6. Make
Make aa Decision
Decision
14-4

Learning Objective 2

14-5
14-5

The Decision-Making Process

1. Clarify the Decision Problem
2. Specify the Criterion

Primarily the
responsibility of the
managerial
accountant.

3. Identify the Alternatives

4. Develop a Decision Model
5. Collect the Data

Information
Information should
should be:
be:
1.
1. Relevant
Relevant
2.
2. Accurate
Accurate
3.
3. Timely
Timely

6. Make a Decision
14-6

The Decision-Making Process

1. Clarify the Decision Problem
2. Specify the Criterion
3. Identify the Alternatives

Qualitative
Qualitative
Considerations
Considerations

4. Develop a Decision Model

5. Collect the Data
6. Make a Decision
14-7

The Decision-Making Process

Relevant
Relevant
Pertinent
Pertinent to
to aa
decision
decision problem.
problem.

1. Clarify the Decision Problem

2. Specify the Criterion

Accurate
Accurate
Information
Information must
must
be
be precise.
precise.

3. Identify the Alternatives

Timely
Timely
Available
Available in
in time
time
for
for aa decision
decision

5. Collect the Data

4. Develop a Decision Model

6. Make a Decision
14-8

Learning Objective 3

14-9
14-9

Relevant Information
Information is relevant to a decision
problem when . . .
1.
1.
2.
2.

It
It has
has a
a bearing
bearing on
on the
the future,
future,
It
It differs
differs among
among competing
competing
alternatives.
alternatives.

14-10

Learning Objective 4

14-11
14-11

Identifying Relevant
Costs and Benefits
Sunk
Sunk costs
costs
Costs
Costs that
that have
have already
already been
been incurred.
incurred. They
They do
do
not
not affect
affect any
any future
future cost
cost and
and cannot
cannot be
be
changed
changed by
by any
any current
current or
or future
future action.
action.

Sunk costs are irrelevant to decisions.

14-12

Relevant Costs

Worldwide Airways is thinking about replacing a three

year old loader with a new, more efficient loader.
New
New loader
loader
List
List price
price
Annual
Annual operating
operating expenses
expenses
Expected
Expected life
life in
in years
years
Old
Old loader
loader
Original
Original cost
cost
Remaining
Remaining book
book value
value
Disposal
Disposal value
value now
now
Annual
Annual variable
variable expenses
expenses
Remaining
Remaining life
life in
in years
years

$$ 15,000
15,000
45,000
45,000
11
$$100,000
100,000
25,000
25,000
5,000
5,000
80,000
80,000
11
14-13

Relevant Costs
IfIf we
we keep
keep the
the old
old loader,
loader, we
we will
will have
have depreciation
depreciation
costs
costs of
of $25,000.
$25,000. IfIf we
we replace
replace the
the old
old loader,
loader,
we
we will
will write-off
write-off the
the $25,000
$25,000 when
when sold.
sold. There
There is
is
no
no difference
difference in
in the
the cost,
cost, so
so itit is
is not
not relevant
relevant..
We
We will
will only
only have
have depreciation
depreciation on
on the
the new
new loader
loader
ifif we
we replace
replace the
the old
old loader.
loader. This
This cost
cost is
is relevant
relevant..
The
The $5,000
$5,000 proceeds
proceeds will
will only
only be
be realized
realized ifif we
we
replace
replace the
the old
old loader.
loader. This
This amount
amount is
is relevant
relevant..
The new loader will be depreciated in one year.
14-14

Relevant Costs

The
The difference
difference in
in operating
operating costs
costs is
is relevant
relevant
to
to the
the immediate
immediate decision.
decision.
14-15

Relevant Costs
Here is an analysis that includes only
relevant costs:

14-16

Learning Objective 5

14-17

Analysis of Special Decisions

Lets take a close look at some special decisions
faced by many businesses.
We just received
a special order. Do
you think we should
accept it?

14-18

Accept or Reject a Special Order

A
A travel
travel agency
agency offers
offers Worldwide
Worldwide

Airways
Airways $150,000
$150,000 for
for a
a round-trip
round-trip flight
flight
from
from Hawaii
Hawaii to
to Japan
Japan on
on a
a jumbo
jumbo jet.
jet.

Worldwide
Worldwide usually
usually gets
gets $250,000
$250,000 in
in
revenue
revenue from
from this
this flight.
flight.

The
The airline
airline is
is not
not currently
currently planning
planning to
to
add
add any
any new
new routes
routes and
and has
has two
two planes
planes
that
that are
are idle
idle and
and could
could be
be used
used to
to meet
meet
the
the needs
needs of
of the
the agency.
agency.

The
The next
next screen
screen shows
shows cost
cost data
data
developed
developed by
by managerial
managerial accountants
accountants at
at
Worldwide.
Worldwide.
14-19

Accept or Reject a Special Order

Worldwide will save $5,000 in reservation

and ticketing costs if the charter is accepted.
14-20

Accept or Reject a Special Order

Since
Since the
the charter
charter will
will contribute
contribute to
to fixed
fixed costs
costs and
and
Worldwide
Worldwide has
has idle
idle capacity,
capacity, the
the company
company should
should
accept
accept the
the flight.
flight.
14-21

Accept or Reject a Special Order

What if Worldwide had no excess capacity? If
Worldwide adds the charter, it will have to cut
its least profitable route that currently
contributes $80,000 to fixed costs and profits.
Should Worldwide still accept the charter?

14-22

Accept or Reject a Special Order

Worldwide has no excess capacity, so it

should reject the special charter.
14-23

Accept or Reject a Special Order

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 also
relevant.

14-24

Outsource a Product or Service

A
A decision
decision concerning
concerning whether
whether an
an item
item should
should be
be
produced
produced internally
internally or
or purchased
purchased from
from an
an
outside
outside supplier
supplier is
is often
often called
called aa make
make or
or buy
buy
decision.
decision.
Lets
Lets look
look at
at another
another decision
decision faced
faced by
by the
the
management
management of
of Worldwide
Worldwide Airways.
Airways.

14-25

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:

14-26

Outsource a Product or Service

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

14-27

Outsource a Product or Service

If Worldwide purchases the dessert for
21, it will only save 15 so Worldwide
will have a loss of 6 per dessert
purchased.
Wow, thats
no deal!

14-28

Add or Drop a Service,

Product, or Department
One
One of
of the
the most
most important
important
decisions
decisions managers
managers make
make
is
is whether
whether to
to add
add or
or drop
drop
aa product,
product, service,
service, or
or
department.
department.
Lets
Lets look
look at
at how
how the
the
concept
concept of
of relevant
relevant costs
costs
should
should be
be used
used in
in such
such aa
decision.
decision.
14-29

Add or Drop a Product

Worldwide Airways offers its
passengers the opportunity to
join its World Express Club. Club
membership entitles a traveler
to use the club facilities at the
airport in Atlanta.
Club privileges include a private
lounge and restaurant, discounts
on meals and beverages, and
use of a small health spa.
14-30

Add or Drop a Product

Sales
Less: Variable Costs:
Food/Beverage
$70,000
Personnel
40,000
Variable overhead
25,000
Contribution Margin
Less: Fixed Costs:
Depreciation
$30,000
Supervisor salary
20,000
Insurance
10,000
Airport fees
5,000
Allocated overhead 10,000
Loss

$200,000

(135,000)
65,000

( 75,000)
$ ( 10,000)
14-31

Add or Drop a Product

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
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

14-32

Add or Drop a Product

KEEP CLUB ELIMINATE DIFFERENTIAL
Sales
$200,000
0
$200,000
N
A
Food/Beverage
(70,000)
0
(70,000)
O
V
Personnel
(40,000)
0
(40,000)
T
O
Variable overhead (25,000)
0
(25,000)
A
I
Contribution Margin 65,000
0
65,000
V
Depreciation
(30,000)
(30,000) D
0
O
Supervisor salary
(20,000)
0
(20,000)
A
I
Insurance
(10,000)
(10,000) B
0
D
Airport fees
( 5,000)
0
( 5,000)
A
L
B
Allocated overhead (10,000)
(10,000) E
0
L
Loss
(10,000)
(50,000)
40,000
E
The positive $40,000 differential
amount reflects the fact that the
company is $40,000 better off by keeping the club.
14-33

Add or Drop a Product

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
Supervisor salary
(20,000)
0
(20,000)
Airport fees
( 5,000)
0
( 5,000)
Profit/Loss
$ 40,000
$ 40,000
Worldwide airlines would also lose the contribution
margin of $65,000. The club contributes $40,000 to
Worldwides fixed costs.
14-34

Conclusion
KEEP THE CLUB OPEN!
Contribution margin from
general airline operations
that will be forgone if club
is eliminated . . . . . . . . . . . $ 60,000
Profit/Loss
$ 40,000
Monthly profit of
KEEPING the club open

The Opportunity Cost of

lost contribution margin is
$60,000.

0
0

$ 60,000
$ 40,000
$100,000
=======

Worldwide is better off by

$100,000 per month by
keeping its club open.
14-35

Learning Objective 6

14-36

Special Decisions in
Manufacturing Firms
Joint
Joint Products:
Products:

Sell
Sell or
or Process
Process Further
Further
A
A joint
joint production
production process
process resulting
resulting in
in two
two or
or
more
more products.
products. The
The point
point in
in the
the production
production
process
process where
where the
the joint
joint products
products are
are
identifiable
identifiable as
as separate
separate products
products is
is called
called the
the
split-off
split-off point.
point.

14-37

Joint Processing
of Cocoa Bean
Cocoa beans
costing $500
per ton

Joint Production
process costing
$600 per ton

Total joint cost:

$1,100 per ton

Cocoa butter
sales value
$750 for
1,500 pounds
Split-off point
Cocoa powder
sales value
$500 for
500 pounds

Separable
process
costing
$800

Instant cocoa
mix sales value
$2,000 for
500 pounds
14-38

Joint Products
Relative Sales Value Method

$750
$750 $1,250
$1,250 == 60%
60%
60%
60% $1,100
$1,100 == $660
$660
14-39

Joint Products
Cocoa butter is sold at the end of the joint

processing.
Cocoa powder may be sold now or
processed into instant cocoa mix. Further
processing costs of $800 will be incurred if
the company elects to make instant cocoa
mix.

14-40

Joint Products
(

The cocoa powder should be

processed into instant cocoa mix.
14-41

Decisions Involving Limited

Resources

Firms
Firms often
often face
face the
the problem
problem of
of deciding
deciding how
how

limited
limited resources
resources are
are going
going to
to be
be used.
used.

Usually,
Usually, fixed
fixed costs
costs are
are not
not affected
affected by
by this
this
decision,
decision, so
so management
management can
can focus
focus on
on
maximizing
maximizing total
total contribution
contribution margin.
margin.
Lets
Lets look
look at
at the
the Martin,
Martin, Inc.
Inc. example.
example.

14-42

Limited Resources
Martin, Inc. produces two products and selected
data are shown below:

14-43

Limited Resources

The
The lathe
lathe is
is the
the scarce
scarce resource
resource because
because there
there

is
is excess
excess capacity
capacity on
on other
other machines.
machines. The
The
lathe
lathe is
is being
being used
used at
at 100%
100% of
of its
its capacity.
capacity.

The
The lathe
lathe capacity
capacity is
is 2,400
2,400 minutes
minutes per
per week.
week.

Should
Should Martin
Martin focus
focus its
its efforts
efforts
on
on Webs
Webs or
or Highs?
Highs?

14-44

Limited Resources

Lets calculate the contribution margin per unit of

the scarce resource, the lathe.

Highs
Highs should
should be
be emphasized.
emphasized. ItIt is
is the
the more
more valuable
valuable
use
use of
of the
the scarce
scarce resource,
resource, the
the lathe,
lathe, yielding
yielding aa
contribution
contribution margin
margin of
of $30
$30 per
per minute
minute as
as opposed
opposed to
to
$24
$24 per
per minute
minute for
for the
the Webs.
Webs.
If there are no other considerations, the best plan would be to produce to meet current
14-45
demand for Highs and then use remaining capacity to make Webs.

Limited Resources
Lets see how this plan would work.
Allotting the Scarce Resource The Lathe
Weekly demand for Highs
2,200 units
Time required per unit
x .50 minutes
Time required to make Highs 1,100 minutes
Total lathe time available
Time used to produce Highs
Time available for Webs
Time required per unit
Production of Webs

2,400 minutes
1,100 minutes
1,300 minutes
x 1.00 minute
1,300 units
14-46

Limited Resources
According to the plan, Martin will produce 2,200
Highs and 1,300 Webs. Martins contribution
margin looks like this.

The
The total
total contribution
contribution margin
margin for
for Martin,
Martin, Inc.
Inc. is
is $64,200.
$64,200.
Any
Any other
other combination
combination would
would result
result in
in less
less contribution.
contribution.
14-47

Theory of Constraints
Binding constraints can limit a companys
profitability.

To relax constraints management can . . .

Outsource

Retrain employees

Work overtime

Reduce non-valueadded activities

14-48

Uncertainty
One
One common
common technique
technique for
for addressing
addressing the
the impact
impact
of
of uncertainty
uncertainty is
is
sensitivity
sensitivity analysis
analysis -- aa way
way to
to determine
determine what
what
would
would happen
happen in
in aa decision
decision analysis
analysis ifif aa key
key
prediction
prediction or
or assumption
assumption proved
proved to
to be
be wrong.
wrong.

14-49

Expected Values
From the last example, recall the contribution
margin for Webs was $24 and $15 for Highs.
Due to uncertainty, assume Martin has the following
probable contribution margins for the two products.
Webs

Highs

Martin
Martin would
would use
use the
the expected
expected value
value
contribution
contribution margins
margins in
in its
its decision
decision about
about
utilizing
utilizing its
its limited
limited resource
resource -- the
the lathe.
lathe.

14-50

Learning Objective 7

14-51

Other Issues in Decision Making

Incentives
Incentives for
for
Decision
Decision Makers
Makers

Short-Run
Short-Run
Versus
Versus
Long-Run
Long-Run
Decisions
Decisions

14-52

Other Issues in Decision Making

Pitfalls to Avoid
Sunk
costs.

Allocated
fixed costs.

Unitized
fixed costs.

Opportunity
costs.
14-53

End of Chapter 14

14-54