1. Chapter 1 - 1 Chapter 7 The Use of Cost Information in Making Management Decisions

2. 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).

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

4. 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

5. 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.

6. 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)

7. Chapter 1 -7 Assume the following: XYTotal Sales units 200100300 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?

8. Chapter 1 -8 Drop a Segment Decision (continued) Incremental KeepDropAmount to Keep Sales $75,000----$75,000 Variable exp. (33,750)----(33,750) Cont. margin $41,250----$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.

9. 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?

10. Chapter 1 -10 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 3,000.25 Direct materials 12,0001.00 Direct labor 24,0002.00 Variable overhead 9,000.75 Fixed overhead 36,0003.00 Total $99,000$8.25 The purchase price from an outside vendor is $5.50 per unit. Make-or-Buy Decision

11. Chapter 1 -11 Make-or-Buy Decision (continued) Alternatives Incremental MakeBuyCost to Make Rental of equip. $15,000----$15,000 Direct materials 12,000----12,000 Direct labor 24,000----24,000 Variable overhead 9,000----9,000 Purchase cost $66,000$(66,000) Relevant costs $60,000$66,000$(6,000) Decision: Manufacture parts in-house

12. Chapter 1 -12 Make-or-Buy Decision (continued) Qualitative issues:  Quality of purchased components  Timely delivery /Potential price increases

13. Chapter 1 -13 Joint Product Decision When a single manufacturing process invariably produces two or more separate products, the products are called joint products.

14. Chapter 1 -14 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

15. Chapter 1 -15 Joint Product Decision (continued) AlphaOmega Incremental revenues$2,400$400 Incremental costs 900 500 Incremental profits$1,500$(100) Decisions: Process Alpha furtherSell Omega at the split-off point The joint cost assigned is not relevant.

16. Chapter 1 -16 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 $160,000. 80/(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!