Managerial Accounting by James Jiambalvo Chapter 7: The Use of Cost Information In Management Decision Making Slides Prepared by: Scott Peterson Northern State University

Objectives Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions. Define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions. Analyze decisions involving joint costs. Discuss the importance of qualitative considerations in management decisions.

Incremental Analysis Incremental Analysis looks at Incremental Revenue Incremental Cost a.k.a. Relevant cost a.k.a. Differential cost The only thing that matters is what changes.

When Your Boss Asks… You Should Say… There is no single cost number that is relevant for all decisions.

Analysis of Decisions Faced By Managers Engage in additional processing. Make or Buy. Drop a product line.

Additional Processing Decision The key is on incremental revenues and costs. Sunk costs (past costs) are irrelevant.

Additional Processing Example: (7-1)

Make-Or-Buy Decisions The key is on incremental costs. There are no incremental revenues. Note that not all fixed costs are irrelevant. If fixed costs are avoidable, they should be factored into this decision--just like variable costs.

Make-Or-Buy Decisions: Example (7-2)

Dropping a Product Line The key is on the change in net income as a result of dropping the product line. If net income increases, do it; if not, don’t do it!

Dropping a Product Line: Example Single Step (7-6)

Beware of the Cost Allocation Death Spiral! When dropping a product or service, beware of allocating common fixed costs. These costs are not incremental and are therefore irrelevant. They just end up being allocated to other products which in turn may appear unprofitable. Beware!

Summary of Incremental, Avoidable, Sunk, and Opportunity Costs Incremental Cost Avoidable Cost Sunk Cost Opportunity Cost

Decisions Involving Joint Costs Joint products Joint costs Example: raw milk is processed into the following joint products: cream, skim milk and whole milk. The stage of production at which individual products are identified is called the split-off-point.

Allocation of Joint Costs Common input costs must be allocated to joint products for financial reporting purposes. Joint costs are not relevant to individual products beyond the split-off-point. Joint costs are relevant to decisions involving the joint products as a group.

Decisions Involving Joint Costs: Another Example

Additional Processing Decisions And Joint Costs Joint costs are not relevant to the decision. At the split-off-point, the only factors that matter are additional revenues and additional costs. Joint costs incurred prior to the split-off point are sunk and don’t change.

Qualitative Considerations In Decision Analysis The non-monetary factors are also important to the decision analysis. Some fixed costs continue regardless. Morale may be affected. Outsourcing can be more flexible. With outsourcing, a certain level of control is lost.

Appendix: The Theory of Constraints (TOC) The Five-Step Process: Identify the binding constraint. Optimize use of the constraint. Subordinate everything to the constraint. Break the constraint. Identify a new binding constraint.

Appendix: Implications for Inspections, Batch Sizes, and Across the Board Cuts Inspections: should take place before transfer to the constrained department. Batch Sizes: when the production process IS the binding constraint, large batches may be beneficial. Across the Board Cuts: labor/cost cuts should be precise. General, across the board cuts involving cuts to the constrained department have negative profit affects.

Appendix: “You Get What You Measure” Performance measures drive the behavior of managers.

Quick Review Question #1 Which of the following is often not a differential cost? Material. Labor. Variable overhead. Fixed overhead.

Quick Review Answer #1 Which of the following is often not a differential cost? Material. Labor. Variable overhead. Fixed overhead.

Quick Review Question #2 Opportunity costs are: Never incremental costs. Always incremental costs. Sometimes sunk costs. None of the above.

Quick Review Answer #2 Opportunity costs are: Never incremental costs. Always incremental costs. Sometimes sunk costs. None of the above.

Quick Review Question #3 Which of the following should not be taken into consideration when making a decision? Opportunity costs. Sunk costs. Relevant costs. Differential costs.

Quick Review Answer #3 Which of the following should not be taken into consideration when making a decision? Opportunity costs. Sunk costs. Relevant costs. Differential costs.

Quick Review Question #4 Joint costs incurred in a joint product situation: Are incurred before the split-off point. Are incurred after the split-off point. Should only be allocated based on physical attributes. None of the above.

Quick Review Answer #4 Joint costs incurred in a joint product situation: Are incurred before the split-off point. Are incurred after the split-off point. Should only be allocated based on physical attributes. None of the above.

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