2009 Foster School of Business Cost Accounting L.DuCharme 1 Decision Making and Relevant Information Chapter 11

2009 Foster School of Business Cost Accounting L.DuCharme 2 Overview Decisions Relevant information Examples of common decisions Opportunity costs Capacity constraints Replace equipment Comprehensive example

2009 Foster School of Business Cost Accounting L.DuCharme 3 Information and the Decision Process A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis.

2009 Foster School of Business Cost Accounting L.DuCharme 4 Five-Step Decision Process Gather Information Make Predictions Choose an Alternative Implement the Decision Evaluate Performance Step 1. Step 2. Step 3. Step 4. Step 5. Historical Costs Other Information Specific Predictions Feedback

2009 Foster School of Business Cost Accounting L.DuCharme 5 Differentiate relevant from irrelevant costs and revenues in decision situations.

2009 Foster School of Business Cost Accounting L.DuCharme 6 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 incomeDifferential costs

2009 Foster School of Business Cost Accounting L.DuCharme 7 Quantitative and Qualitative Relevant Information Quantitative factors FinancialNonfinancial Qualitative factors

2009 Foster School of Business Cost Accounting L.DuCharme 8 One-Time-Only Special Order Example Profit is made if the incremental revenue exceeds incremental costs. If excess capacity exists, then relevant cost generally equals variable cost to make special order. Will marketing costs change?

2009 Foster School of Business Cost Accounting L.DuCharme 9 Two Potential Problems in Relevant-Cost Analysis Incorrect general assumptions: All variable costs are relevant. All fixed costs are irrelevant. 12 Misleading unit-cost data: Include irrelevant costs. Use same unit costs at different output levels.

2009 Foster School of Business Cost Accounting L.DuCharme 10 Outsourcing versus Insourcing Outsourcing is purchasing goods and services from outside vendors. Insourcing is producing goods or providing services within the organization.

2009 Foster School of Business Cost Accounting L.DuCharme 11 Make-or-Buy Decisions This is a very common (frequent) decision made by most organizations. Purchase managers report three important factors: (1) Quality (2) Supplier dependability (3) Cost

2009 Foster School of Business Cost Accounting L.DuCharme 12 Make-or-Buy Decisions In making a “make-or-buy” decision it is often times useful and quick to compare the cost to outsource versus the costs saved if you outsource.

2009 Foster School of Business Cost Accounting L.DuCharme 13 Opportunity Costs and Outsourcing Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited resource in its next-best alternative use. Generally, opportunity cost is the benefit foregone by not choosing the next best alternative.

2009 Foster School of Business Cost Accounting L.DuCharme 14 Opportunity Costs and Outsourcing Many decisions have an opportunity cost. What is the opportunity cost for making the decision to come to class today? Give an example of a decision that had no or zero opportunity cost.

2009 Foster School of Business Cost Accounting L.DuCharme 15 Capacity Constraints Deciding which products to produce when there are capacity constraints. Answer: Produce/sell product(s) with the highest CM/unit of constraint!

2009 Foster School of Business Cost Accounting L.DuCharme 16 Product-Mix Decisions Under Capacity Constraints Per unit Product #2 Product #3 Sales price$2.11$14.50 Variable expenses Contribution margin$1.70$ 0.60 Contribution margin ratio 81% 4% Bismark Co. has 3,000 machine-hours available.

2009 Foster School of Business Cost Accounting L.DuCharme 17 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

2009 Foster School of Business Cost Accounting L.DuCharme 18 From a company economic Perspective, the book value of equipment is irrelevant in equipment-replacement decisions.

2009 Foster School of Business Cost Accounting L.DuCharme 19 Conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager.

2009 Foster School of Business Cost Accounting L.DuCharme 20 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

2009 Foster School of Business Cost Accounting L.DuCharme 21 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.

2009 Foster School of Business Cost Accounting L.DuCharme 22 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.

2009 Foster School of Business Cost Accounting L.DuCharme 23 Anatomy of a Decision: Buy a used versus lease a new car Example of decision--See spread sheet analysis. Quantitative and qualitative analysis—you are only part way done with analysis after the quantitative analysis. Use this as a benchmark against the qualitative factors. What qualitative factors have I missed (left out of) in my quantitative analysis?

2009 Foster School of Business Cost Accounting L.DuCharme 24 End of Chapter 11