Chapter Chapter 7 The Use of Cost Information in Making Management Decisions

Chapter 1 -2 The Criterion for Short-term Decisions Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss). To be relevant: 1.An item must differ for the alternatives under consideration. 2.Be in the future (not be sunk).

Chapter 1 -3 Definitions Incremental revenues and costs are the expected future revenues and costs that will differ among the choices that are available.

Chapter 1 -4 Sunk Costs Sunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects. Examples:  Book value of equipment  Original purchase price of building

Chapter 1 -5 Example: Rental income lost if facility is used for production. Opportunity Cost An opportunity cost is the benefit lost by taking one action as opposed to another. Example: The contribution margin of A, assuming the production of A is terminated to produce B.

Chapter 1 -6 Important: Short-term Perspective Typical Short-Term Decisions è Drop a Segment è Make-or-Buy è Joint Product (and additional processing)

Chapter 1 -7 Assume the following: XYTotal Sales units Sales revenue $100,000$75,000$175,000 Less variable expenses: Variable cost of sales 48,00030,00078,000 Variable selling & admin. 5,0003,7508,750 Contribution margin $47,000$41,250$88,250 Less direct fixed expenses: Direct fixed costs 15,00042,50057,500 Product margin $32,000$(1,250)$30,750 Less common fixed costs 15,000 Net income $15,750 Drop a Segment Decision Should product Y be eliminated?

Chapter 1 -8 Drop a Segment Decision (continued) Incremental KeepDropAmount to Keep Sales $75, $75,000 Variable exp. (33,750)----(33,750) Cont. margin $41, $41,250 Direct fixed costs (42,500)----(42,500) Relevant benefit/loss $(1,250) Decision: Drop product Y This assumes that all direct fixed costs would disappear if the segment is dropped.

Chapter 1 -9 Complementary Effects and Loss Leaders Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another. A loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin does not cover its avoidable fixed costs. What if in the prior example, dropping Y would cause us to lose 10% of our sales of X, would the decision change?

Chapter Assume the following cost data relate to the decision to produce 12,000 units of a product or buy from external source: Costs to Make Total CostsUnit Cost Rental of equipment $15,000$1.25 Equip. depreciation 3, Direct materials 12, Direct labor 24, Variable overhead 9, Fixed overhead 36, Total $99,000$8.25 The purchase price from an outside vendor is $5.50 per unit. Make-or-Buy Decision

Chapter Make-or-Buy Decision (continued) Alternatives Incremental MakeBuyCost to Make Rental of equip. $15, $15,000 Direct materials 12, ,000 Direct labor 24, ,000 Variable overhead 9, ,000 Purchase cost $66,000$(66,000) Relevant costs $60,000$66,000$(6,000) Decision: Manufacture parts in-house

Chapter Make-or-Buy Decision (continued) Qualitative issues:  Quality of purchased components  Timely delivery /Potential price increases

Chapter Joint Product Decision When a single manufacturing process invariably produces two or more separate products, the products are called joint products.

Chapter Joint Product Example AlphaOmega Selling price at split-off$1,200$1,600 Joint cost assigned to product $1,000 $1,400 Selling price after additional processing$3,600$2,000 Costs of additional processing, all variable $900$500

Chapter Joint Product Decision (continued) AlphaOmega Incremental revenues$2,400$400 Incremental costs Incremental profits$1,500$(100) Decisions: Process Alpha furtherSell Omega at the split-off point The joint cost assigned is not relevant.

Chapter Allocation of Joint Costs to Joint Products Allocate joint costs using relative sales value at the split off point or physical measures Example - Joint cost is $100,000 and product A sells for $80,000 and Product B sells for $160, /(80+160) or 1/3 of the joint cost would be assigned to product A $33,333 and 2/3 to B $66,667 Allocation of joint cost is not relevant to sell or process further decision!