1 Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Mowen/Hansen Short-Run Decision Making: Relevant Costing and Inventory Management Chapter Twelve Cornerstones of Managerial Accounting 2e

2 Short-Run Decisions Small-scale actions that serve a larger purpose Decisions are made using a decision model ◦Used to structure the thinking process ◦Organizes information Consists of choosing among alternatives with an immediate or limited end in view

3 Decision-Making Model 1.Define the problem 2.Identify the alternatives 3.Identify the costs and benefits associated with each feasible alternative 4.Total the relevant costs and benefits for each alternative Relevant costs are future costs that differ across alternatives 5.Assess the qualitative factors 6.Select alternative with the greatest benefit

4 Relevant Costs Can consist of both variable and fixed costs ◦Additional fixed costs associated with an alternative are relevant Changes in supply and demand for resources must be considered ◦Costs which fluctuate with changes in supply and demand across alternatives are relevant costs Also known as differential or incremental costs Practical interpretation ◦All costs that are different

5 Make-or-Buy Decisions Decisions involving a choice between internal and external production Decision process ◦Identify feasible alternatives ◦Identify which costs are relevant ∙Fixed overhead costs are most likely irrelevant since they will not differ ◦Compare the total relevant costs of manufacturing with the cost of buying ◦Make a choice

6 Special Order Decisions Focus on whether a specially priced order should be accepted or rejected Orders can be attractive ◦Especially when firm is operating below maximum productive capacity

7 Keep-or-Drop Decisions Decision to keep or drop a segment such as a product line Variable costing segment financial reports provide information ◦Contribution margin ◦Segment margin Relevant costing provides structure to decision making

8 Further Processing of Joint Products Joint products Include both common processes and costs up to split-off point Split-off point ◦The point at which separate products become distinguishable Common costs are not relevant to the decision making

9 Product Mix Decisions Organizations have wide flexibility in choosing their product mix ◦Mix has significant impact on profitability Maximizing total profit is the goal ◦Fixed cost will not change with mix, therefore not relevant Focus should be on maximizing total contribution margin Limitations on resources are called “constraints”

10 Cost-Based Pricing Most companies start with cost to determine price Formula: ◦Price = Product cost + Markup ◦Markup is percentage of base cost ∙Includes: ▫Costs not in base cost ▫Desired profit Advantage – Ease of use

11 Target Costing and Pricing Determining price based on what customers are willing to pay Company then must design and develop product ◦Cost must be low enough to allow for desired profit

12 Ordering Costs Costs of placing and receiving an order Examples: ◦Order processing costs ◦Cost of insurance for shipment ◦Unloading costs

13 Carrying Costs Costs of carrying inventory Examples: ◦Insurance ◦Inventory taxes ◦Obsolescence ◦Opportunity cost of funds ties up in inventory, handling costs, and storage space

14 Stockout Costs Occur when demand is not known Costs of not having: ◦Product available when demanded by a customer ◦Raw material available when needed for production Examples: ◦Lost sales ◦Costs of expediting ◦Costs of interrupted production

15 Economic Order Quantity (EOQ): The Traditional Inventory Model Number of units in the optimal size order Minimizes total inventory-related costs Formula: 2 x CO x D/CC Cost of placing one order

16 Economic Order Quantity (EOQ): The Traditional Inventory Model Number of units in the optimal size order Minimizes total inventory-related costs Formula: 2 x CO x D/CC Annual demand in units

17 Economic Order Quantity (EOQ): The Traditional Inventory Model Number of units in the optimal size order Minimizes total inventory-related costs Formula: 2 x CO x D/CC Cost of carrying one unit in inventory

18 Just in Time (JIT) Goods pushed through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand Each operation produces only what is necessary to satisfy the demand of the succeeding operation Reduces all inventories to very low levels Reduces inventory carrying costs