Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Short-Run Alternative Choice Decisions 26

26-2 Chapter Highlights Alternative choice decisions: manager seeks to choose best out of several alternatives. Introduces construct of differential costs and revenues for several types of problems, each having a relatively short time horizon.

26-3 Differential Costs and Revenues Costs that are different under one set of conditions than under another. Revenues that are different under one set of conditions than under another.

26-4 Nature of Full and Differential Costs Full cost of a product or other cost object = sum of direct cost + fair share of applicable indirect costs. Differential costs include only those elements of cost that are different under a certain set of conditions.

26-5 Source of Data for Full and Differential Costs Full costs come from a company’s cost accounting system. No comparable system for collecting differential costs. Differential costs are assembled to meet analytical requirements of a specific problem.

26-6 Historical, Full and Differential Costs Full cost accounting system collects historical costs. Differential costs relate to future. Differential costs show what costs will be if a certain course of action is adopted.

26-7 Contribution Analysis A tool for analyzing differential costs. Focuses on contribution margin. Contribution for a company (or for a product line, division, or other segment of a company) is the difference between its total revenue and its total variable costs.

26-8 Variable and Fixed Costs Variable costs (or expenses) are variable because they vary proportionately with volume of activity, such as sales. Fixed costs = in total do not vary with activity (within relevant range).

26-9 Direct and Indirect Costs Direct costs = costs that are traced directly to cost object. Indirect costs = costs that are not traced directly to cost object.

26-10 Alternative Choice Problems 2 or more possible alternative courses of action. Manager chooses best alternative. Some choices may be quantified, but this is only one aspect of analysis and may not be most important factor.

26-11 Objective of Alternative Choice Problem Seek alternative most likely to achieve objectives of organization. In a profit oriented business: –Maximizing value of shareholders’ investment by making alternative choices that earn a satisfactory return on investment. –Return on investment is usually measured using an accounting and not a market-determined measure of return. –Other factors are also likely to influence decision.

26-12 Steps in the Analysis Define problem. Select possible alternative solutions including status quo. For each alternative, measure and evaluate consequences in quantitative terms. Identify consequences that cannot be expressed in quantitative terms. Evaluate measured quantitative and non- quantitative consequences. Make decision.

26-13 Differential Costs Out of pocket costs = avoidable costs = costs that will be different under the proposed alternative than they are in the base case. No general category of costs can be labeled differential. Always relates to specific alternatives being analyzed.

26-14 Mechanics of Calculation No prescribed format; use most convenient. Cost items unaffected by decisions are not differential and may be disregarded (or treated the same under each alternative).

26-15 Opportunity costs Value lost or sacrificed by giving up an alternative course of action. Not associated with cash outlays. Not measured in accounting records. If an alternative requires resources that would otherwise be used for income producing purposes, opportunity cost is measured by income that would have been earned had resources been invested otherwise. Iffy costs.

26-16 Differential Costs Differential costs = incremental costs = relevant costs = out-of-pocket costs = avoidable costs = variable costs(=marginal costs), if all alternatives involve operating at different volume levels within the relevant range. May also include fixed costs if any alternative results in changes in step-function costs. Future costs, which may be best estimated by looking at past/historical costs. Usually estimates are not precise unless determined by contract.

26-17 Sunk Cost = a cost that has already been incurred and therefore cannot be changed by any decision currently being considered. e.g. all historical costs. Not a differential cost. If asset is used it is depreciated, if it is disposed of it is written off, in either event it is expensed.

26-18 Disposal Value Relevant and differential cost/revenue if one alternative is to keep equipment and another alternative is disposal.

26-19 Importance of Time Span To make only one additional unit, only material cost may be differential. To produce an item over foreseeable future, all items of production cost would be differential. The longer the time span the more items of cost are differential. In the very long run full costs are differential costs.

26-20 Types of Alternative Choice Problems Problems involving Costs. Problems involving revenues and costs. Differential investments.

26-21 Problems Involving Costs One type of cost is traded for another. Change of method of operation. Make or buy decisions. Economic order quantity decision. –Trade off setup costs and inventory carrying costs.

26-22 Problems Involving both Revenues and Costs Best alternative has most differential income or profit. Supply and demand analysis. Contribution pricing. Discontinuing a product. Adding a service.

26-23 Supply and Demand Price Analysis Compare revenue and expense at various prices, after considering affect on volume, revenue and costs.

26-24 Contribution Pricing Full cost is normal basis for setting price. Orders may be accepted when differential revenues exceed differential costs. –Such a selling price is called a contribution price to distinguish it from a normal price. –A version of this is referred to as dumping and may be illegal.

26-25 Other Problems Involving Both Revenues and Costs Discontinuing a product. –Adding services such as a grocery store opening on Sundays, a fast food restaurant opening for breakfast. Sale versus further processing. Other marketing tactics such as consolidating warehouses, how often to call on customers.

26-26 Differential Revenues, Costs, and Investment Problems In addition, to revenues and costs, considers changes on investment associated with alternatives. Consider changes in current assets (e.g. accounts receivable, inventories) and current liabilities (e.g. accounts payable). Covered in Chapter 27.

26-27 Sensitivity Analysis Considers how sensitive quantitative measurements of alternatives are to changes in assumptions.

26-28 “Just One” Fallacy Each additional unit of production adds just variable costs. If many units are added step function costs (i.e. fixed costs) are added. Therefore, step function costs are averaged out over the additional units of volume.

26-29 Expected Values Discussion has assumed single point estimates, that is, best estimates. Alternative is to use separate possibilities weighted by probabilities to determine expected values. –Choose alternative with highest expected value.

26-30 Decision Tree Analysis Diagram shows several decisions, or acts, and possible consequences. Revenues and costs are estimated with probabilities for each outcome to give an expected value for event.

26-31 Practical Pointers 1.Use imagination. 2.Don’t overweight quantitative factors. 3.Don’t slight approximations. 4.Work with total not unit costs when possible. 5.Tendency to underestimate costs with something new.

26-32 Practical Pointers (continued) 6. Don’t overweight number of arguments rather substance. 7. Consider margin of error. 8. Delaying too long to decide is a decision. 9. Identify assumptions & sensitivity analysis. 10. Do not expect conclusion to be accepted just because numbers are worked out.

26-33 Summary Comment Differential costs and revenues rarely provide answer to any business problem, but facilitate a sound decision.

Chapter McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. End of Chapter 26 26