1. © 2012 Pearson Prentice Hall. All rights reserved. Using Costs in Decision Making Chapter 3

2. Management Accounting Supports Decision Making Cost information is pervasive throughout decision- making situations – Pricing – Product planning – Budgeting – Performance evaluation – Contracting © 2012 Pearson Prentice Hall. All rights reserved.

3. Cost Behaviour Cost Driver an activity which influences how a cost is incurred kilometers traveled is a cost driver for gasoline costs Volume $ $ Variable Cost a cost which changes in direct proportion to changes in the cost driver is constant per unit as volume changes Fixed Cost a cost which is not influenced by changes in the cost driver over the relevant range per unit fixed costs change as volume changes

4. Cost Classifications for Predicting Cost Behaviour

5. © 2012 Pearson Prentice Hall. All rights reserved. Cost-Volume-Profit (CVP) Analysis CVP uses variable and fixed costs to identify the profit generated at various levels of activity Contribution Margin is the difference between total revenue and total variable costs Contribution Margin per Unit is the contribution each unit makes to covering fixed costs and providing a profit Contribution Margin Ratio is the ratio of contribution margin per unit to selling price per unit

6. BEP: Graph Method

7. © 2012 Pearson Prentice Hall. All rights reserved. The CVP Equation Profit = Revenue - Total Costs = Revenue - Variable Costs - Fixed Costs = (Units Sold x Revenue per Unit) - (Units Sold x Variable Cost per Unit) - Fixed Costs = (Units Sold x [Revenue per Unit - Variable Cost per Unit]) - Fixed Costs = (Units Sold x Contribution Margin per Unit) - Fixed Costs

8. Variations of CVP Equation To calculate sales needed to achieve target profit: Required Unit Sales = (Target Profit + Fixed Cost) / Contribution Margin per Unit Impact of income taxes Required Unit Sales = [Target Profit / (1 – Tax Rate) + Fixed Costs] / Contribution Margin per Unit © 2012 Pearson Prentice Hall. All rights reserved.

9. CVP Analysis for Multiple Products There are many combinations of sales levels for multiple products that would allow the organization to break even or reach a target profit An extension of basic CVP analysis called the Bundle Approach assumes a constant product mix A $5 A $5 B $10 B $10 B $10 Sales Mix in units Relative mix based on the # of units sold A = 40%; B = 60%

10. © 2012 Pearson Prentice Hall. All rights reserved. CVP Assumptions Assumptions underlying CVP analysis: – The unit selling price and variable cost remain the same over all levels of production – All costs are either variable or fixed – Fixed costs remain the same over all levels of production – Sales equal production

11. © 2012 Pearson Prentice Hall. All rights reserved. Other Useful Cost Definitions Mixed Cost—a cost that has variable and fixed components Step Variable Cost—a variable cost that increases in steps as the quantity increases Incremental Cost—the cost of the next unit of production Sunk cost—a cost that results from a previous commitment and cannot be recovered

12. © 2012 Pearson Prentice Hall. All rights reserved. Other Useful Cost Definitions Relevant Cost—a cost that will change as a result of a decision Opportunity Cost—the maximum value forgone when a course of action is chosen Avoidable Cost—a cost that can be avoided by taking a specific course of action

13. Equipment-Replacement Decisions Sometimes difficult due to amount of information at hand that is irrelevant: – Original cost, accumulated amortization and book value of existing equipment – these are sunk costs Concentrate on relevant information: – Current disposal price of old machine – Cost of new machine Both are future cash flows and differ between alternatives

14. Equipment Replacement Irrelevance of Past Costs Costs incurred in the past are sunk Only expected future costs & revenues are relevant Example: Consider replacing an old machine with a new machine with expected lower operating costs Keep OldBuy NewDifference Relevant costs: Operating costs$1,600,000$920,000$680,000 Disposal value of old machine(40,000)40,000 Cost of new machine600,000(600,000) Difference 120,000

15. Make-or-Buy: The Outsourcing Decision The financial focus in the make-or-buy decision is whether the costs avoided internally are greater than the added external costs when purchasing a product or service from a supplier Internal costs that can be avoided – Typically all variable costs – Any avoidable fixed costs

16. Make-or-Buy: The Outsourcing Decision External costs incurred to buy – Cost to purchase the product or service – Any transportation costs – Costs involved with dealing with a supplier such as ordering, receiving, and inspection

17. Manufacturing Costs Direct Material—materials that can be traced easily to a unit of output and are of significant economic consequence to final product Direct Labor—labor costs that can be traced easily to the creation of a unit of output Manufacturing Overhead—all other costs incurred by a manufacturing facility that are not direct material or direct labor

18. Drop a Product or a Division Relevant costs to consider when dropping a product or a division – Incremental revenues forgone – Incremental costs avoided Note that there are usually strategic considerations in addition to the economic (relevant cost) analysis 18

19. Special Order Characteristics The special order problem considers the situation where an organization receives a one-time offer to buy a product (good or service). The assumption is that accepting or rejecting this offer will have no future consequences other than the incremental cash flows it creates. For example, accepting a special order to supply a product for $40 that is sold to existing customers for $50 may create problems with existing customers and expectations on the part of the new customer that the special order price of $40 will consider. For this reason, many people believe the assumptions underlying the special order analysis are seldom met in practice. 19

20. Steps Is there sufficient idle capacity to meet this order? – If so, there are no opportunity costs associated with this order – If not, compute the opportunity cost associated with this order Ensure that the special order price covers incremental (variable) costs and opportunity costs 20

21. Decision Flow 21 Is the organization operating at capacity? Ensure that the offer price at least covers the variable cost of filling the order (the floor price) Compute the opportunity cost of filling the order Ensure that the offer price at least covers the variable costs and the opportunity costs of filling the order (the floor price) Yes No

22. Allocating a Scarce Resource The relevant cost concept contributes insight into effective short run resource allocation by focusing on the idea that we should evaluate and compare the incremental benefits of allocating a scarce resource to its alternative uses and making the allocation that provides the highest incremental benefit. This decision is often called the product mix decision because it results in choosing the short run product mix 22

23. Product Mix Decisions Under Constraint SnowmobileBoatEngine Contribution margin per unit$240$375 Machine hours required per unit 2 5 Contribution margin per machine hour$120$75 If machine hours are constrained, maximize income by first producing as many snowmobile engines as can be sold and then shift production to boat engines