Managerial Accounting by James Jiambalvo Chapter 6: The Use of Cost Information in Management Decision Making. Slides Prepared by: Scott Peterson Northern State University

Chapter 6: The Use of Cost Information in Management Decision Making Chapter Themes: It’s all at the margin! Look at what changes. The only thing that matters is what is different. Learning 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 consideration in management decisions.

Incremental Analysis The solution to all business problems involves incremental analysis—the analysis of incremental revenues and incremental expenses. Incremental revenue: the additional revenue received as a result of selecting one decision over another. Incremental cost: the additional cost incurred as a result of selecting one alternative over another. Related Learning 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 consideration in management decisions.

Incremental Analysis: Additional Processing Decision One application of incremental analysis is the additional processing decision. The key here is what the incremental revenues and costs are from this point forward. Sunk costs (past costs) are irrelevant here. Related Learning 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 consideration in management decisions.

Incremental Analysis: Make-or-Buy Decisions Another application of incremental analysis is the make-or-buy decision. The key here rests solely on incremental costs since there are no incremental revenues. It is important to note that not all fixed costs are irrelevant. If they are avoidable, then they should be factored into the decision, just like variable costs. Related Learning 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 consideration in management decisions.

Incremental Analysis: Dropping a Product Line Another application of incremental analysis is whether or not to drop a product line. The key is to determine what the change in net income will be as a result of dropping the product line. If net income increases, do it; if not don’t do it! Related Learning 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 consideration in management decisions.

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! Related Learning 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 consideration in management decisions.

Summary of Incremental, Avoidable, Sunk, and Opportunity Costs Incremental Cost: a cost incurred as a result of selecting one alternative over another. Avoidable Cost: a cost that can be avoided if a certain decision is made. These are relevant. Sunk Cost: a cost that is already incurred and irreversible. These are not relevant. Opportunity Cost: a cost that represents the benefit forgone by selecting on alternative over another. Related Learning 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 consideration in management decisions.

Decisions Involving Joint Costs When two or more products always result from common inputs, they are known as joint products. The costs of the common inputs are referred to as joint costs. For example, raw milk is processed into the following joint products: cream, skim milk and whole milk. Note: the stage of production at which individual products are identified is called the split-off-point (see the next slide). Related Learning 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 consideration in management decisions.

The Split-Off-Point Related Learning 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 consideration in management decisions.

Allocation of Joint Costs For financial reporting purposes, the cost of the common inputs must be allocated to the joint products. But care must be taken to ensure that the resulting information does not mislead managers about the profitability of the joint products. Joint costs are not relevant to individual products beyond the split-off-point, but are relevant to decisions involving the joint products as a group. Related Learning 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 consideration in management decisions.

Additional Processing Decisions and Joint Costs Joint costs do not play a part in this decision because they are not incremental. That is, at the split-off-point, the only factors that matter are additional revenues and additional costs. Related Learning 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 consideration in management decisions.

Qualitative Considerations in Decision Analysis Until now, the discussion has focused on quantitative factors (revenues and costs). But qualitative factors are important too. Consider the make-or-buy decision. On the one hand, it is easier to use outside suppliers because when demand slows, fewer components can be ordered from a supplier. If components were made in-house, the fixed costs would continue. On the other hand, some degree of control is lost. And employee morale is a factor. Related Learning 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 consideration in management decisions.

Appendix A: Pricing Decisions Pricing decision play a very important role in the success of a company. Most managers consider pricing to be an art. Economists focus on the “demand function.” In this section we consider the following: Cost-Plus Pricing. Pricing Special Orders. Taking Demand Into Consideration in Setting Prices. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Cost-Plus Pricing Perhaps because of the difficulty of estimating demand functions, many companies use so-called cost-plus pricing. Here, the firm begins with an estimate of cost and then adds a markup to arrive at the price which allows for a reasonable level of profit. This method is simple, but limited. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Pricing Special Orders Generally, products are not sold for less than full cost. In some cases it may be beneficial to charge a lower price. If the special order will not affect demand for a firm’s other products (or current sales), a company may be better off charging a price below full cost. Note: in this situation, all fixed costs are considered irrelevant because they will not change whether the special order is accepted or not. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

Taking Demand Into Consideration in Setting Prices Pricing should not be determined by cost alone. Demand for the product is highly important. If managers can determine what demand for products will be at various prices, it is a simple task of calculating the optimal price. Related Learning Objectives: Calculate a price based on marking up cost. Perform incremental analysis for a special order. Explain how to consider demand in setting prices.

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