Chapter 14
Decision Making: Relevant Costs and Benefits
ACG 6309
Dr. Chula King
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Student Learning Outcomes
• Describe six steps in the decision‐making process and the managerial accountant's role in that process
• List and explain two criteria that must be satisfied by relevant information
• Identify relevant costs and benefits, given proper Identify relevant costs and benefits given proper
treatment to sunk costs, opportunity costs, and unit costs
• Prepare analyses of various special decisions, properly identifying the relevant costs and benefits
• Analyze manufacturing decisions involving limited resources. © Dr. Chula King
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Decision‐Making Process
•
•
•
•
•
•
Clarify the decision problem
Specify the criteria
Identify the alternatives
Develop a decision model
Collect the data
Make a decision
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Relevant Information
• Information has a bearing on the future
• Information differs among competing alternatives
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Identifying Relevant Costs and Benefits
• Sunk Costs ‐ Costs that have already been incurred in the past
• Opportunity Costs – The potential benefit given up when the choice of one action
given up when the choice of one action precludes selection of a different action.
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Analysis of Special Decisions
• A travel agency offers Worldwide Airways $150,000 for a round‐trip flight from Hawaii to Japan on a jumbo jet.
• Worldwide usually gets $250,000 in revenue yg $
,
from this flight.
• The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.
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Accept or Reject Special Order
Typical Flight Between Japan and Hawaii
Revenue:
Passenger
Cargo
$250,000
30,000
Total
$280,000
Expenses:
Variable expenses
$90,000
Allocated fixed expenses
100,000
Total
190,000
Profit
$90,000
Worldwide would save around $5,000 in reservation and ticketing costs if the charter is accepted.
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Excess Capacity
Special price for charter
Variable cost/flight
Reservation cost savings
Variable cost of charter
Contribution from charter
$150,000
$90,000
(5,000)
85,000
$65,000
Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight.
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No Excess Capacity
• What if Worldwide had no excess capacity?
• If Worldwide adds the charter, it will have to cut its least profitable route that currently contributes $80 000 to fixed costs and profit
contributes $80,000 to fixed costs and profit.
• Should Worldwide still accept the charter?
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No Excess Capacity
Special price for charter
Variable cost/flight
$150,000
$90,000
Reservation cost savings
(5,000)
Variable cost of charter
$85,000
Opportunity cost:
Lost contribution on route
80,000
Total
165,000
Loss
$(15,000)
Worldwide has no excess capacity, so it should reject the special charter.
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Accept or Reject a Special Order
• With Excess Capacity: Relevant costs will usually be the variable costs associated with the special order
• Without Excess Capacity: Relevant costs will Without Excess Capacity: Relevant costs will
usually be both the variable costs associated with the special order, plus the opportunity costs of using the firm’s facilities for the special order.
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Outsouce a Product or Service
• Consider this: An Atlanta bakery has offered to supply the in‐flight desserts for Worldwide for $0.21 each.
Cost
Variable costs:
Variable
costs:
Direct material
$0.06
Direct labor
0.04
Variable overhead
0.04
Fixed costs:
Supervisory salaries 0.04
Equipment depreciation 0.07
Total cost/dessert
$0.25
Relevant
$0.06
0.04
0.04
0.01
‐0‐
$0.15
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Add or Drop a Service, Product or Department
• Consider this: Worldwide Airways offers its passengers the opportunity to join its World Express Club. Club membership entitles a traveler to use the club facilities in the Atlanta
traveler to use the club facilities in the Atlanta airport.
• Club privileges include a private lounge and restaurant, discounts on meals and beverages, and use of a small health spa.
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Add or Drop a Product
Keep Club Eliminate
Sales
$200,000
0
Food/Beverage
(70,000)
0
Personnel
(40,000)
0
Variable overhead
(25,000)
0
Contribution Margin 65,000
0
65 000
Depreciation
(30,000) (30,000)
Supervisor salary
(20,000)
0
Insurance
(10,000) (10,000)
Airport fees
( 5,000)
0
Allocated overhead (10,000) (10,000)
Loss
$ (10,000) $(50,000)
Differential
$200,000
(70,000)
(40,000)
(25,000)
65,000
65 000
0
(20,000)
0
( 5,000)
0
$ 40,000
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Add or Drop a Product ‐ Relevant
Keep Club Eliminate
Sales
$200,000
0
Food/Beverage
(70,000)
0
Personnel
(40,000)
0
Variable overhead
(25,000)
0
Contribution Margin 65,000
65 000
0
Avoidable fixed costs
Supervisor salary
(20,000)
0
Airport fees
( 5,000)
0
Profit/Loss
$ 40,000
Differential
$200,000
(70,000)
(40,000)
(25,000)
65 000
65,000
(20,000)
( 5,000)
$ 40,000
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Additional Analysis
Contribution margin from
general airline operations
that will be forgone if club
is eliminated . . . . . . . . . . . $ 60,000
Profit/Loss
fi /
$ 40,000
40 000
Monthly profit of
keeping the club open
–0–
–0–
0
$ 60,000
$ 40,000
40 000
$100,000
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Decisions Involving Limited Resources
• How should limited resources be used?
• Generally, fixed costs are not affected, so management can focus on maximizing total contribution margin
contribution margin.
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Consider This
Martin, Inc., produces two products. Selected data is shown below:
Products
Webs
Highs
Selling price/unit
$60
$50
Less: Variable expenses/unit
36
35
Contribution margin/unit
$24
$15
Current demand per week (units)
2,000
2,200
Contribution margin ratio
40%
30%
1.00 min.
0.50 min
Processing time required on the lathe/unit
The lathe is a scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity, which is 2,400 minutes/week.
Should Martin focus its efforts on Webs or Highs?
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Contribution Margin/Minute
Products
Webs
Contribution margin/unit
Time required to produce one unit
Contribution margin/minute
Highs
$24
$15
÷ 1.00 min
÷ 0.50 min
$24/min
$30/min
Highs should be emphasized. It is the more valuable to use of the lathe which is a scarce resource. Highs yields a contribution margin of $30 per minute as opposed to $24 per minute for the Webs.
If there are no other considerations, the best plan would be to produce to meet the current demand for Highs and then use the remaining capacity, if any, to make Webs.
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Implementing the Plan
Weekly demand for Highs
Time required/unit
Time required to make Highs
Total lathe time available
Time available for Webs
Time required/unit
Production of Webs
2,200 units
x 0.50 minutes
1,100 minutes
2,400 minutes
1,300 minutes
x1.00 minute
1,300 units
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Limited Resources: Conclusion
Given the lathe capacity of 2,400 minutes, management should choose to make the current demand of 2,200 Highs per week, and 1,300 g p y
Webs with the remaining capacity.
Webs
Production and sales
1,300
Contribution margin/unit
x $24
Total contribution margin $31,200
Highs
2,200
x $15
$33,000
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Theory of Constraints
• Limit to a company’s profitability
• To relax constraints, managements could
– Outsource
– Work overtime
W k
i
– Retrain employees
– Reduce non‐value‐added activities
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Pitfalls to Avoid
•
•
•
•
Sunk costs
Opportunity costs
Allocated fixed costs
Unitized fixed costs
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The Next Step
• Exercises 14‐31, 14‐35, 14‐40
• Problems 14‐44, 14‐45, 14‐48, 14‐53, 14‐54
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