CHAPTER 7
The Use of Cost Information in
Management Decision Making
Incremental Analysis
Incremental Revenue
 Additional revenue received by selecting
one alternative over another
Incremental Cost
 Additional cost incurred by selecting
one alternative over another
 Relevant Costs, Differential Costs
Incremental Profit
 Difference between incremental revenue
and incremental cost
Incremental Analysis Example
Incremental Analysis Example
Expanded
“What does this product cost?”
Why do you want to know?
 No single cost number is relevant for all
decisions
 Must find incremental information that
is applicable to the decision
Analysis of Decisions Faced by
Managers
The following decisions faced by
managers require analysis of
incremental costs and/or revenues
 Additional Processing of a Product
 Make or Buy a Product
 Drop a Product Line
Analysis of Decisions Faced by
Managers
 Additional Processing of a Product
 Decision to sell a product in a partially
completed stage or incur the additional
processing costs
Additional Processing Decision –
Bridge Computer Example
Summary of Cost Information
Additional Processing Decision –
Bridge Computer Example
Incremental Analysis Summary
Make or Buy Decisions
 Make or Buy a Product
 Decision involves no incremental revenues
 Analysis concentrates solely on
incremental costs
Make-or-Buy Decisions – General
Refrigeration Example
Incremental Cost Analysis
Make-or-Buy Decisions – General
Refrigeration Example
Incremental Cost Analysis Summary
Terminology Summary
Sunk Costs
 Costs that are already incurred
 Are never incremental costs because they never differ
among decision alternatives
Avoidable Costs
 Costs that can be avoided if a particular action is
undertaken
Opportunity Costs
 Value of benefits foregone by selecting one decisions
alternative over another
Study Break #1
Which of the following is often not
a differential cost?
a.
b.
c.
d.
Material
Labor
Variable Overhead
Fixed Overhead
Study Break #1
Which of the following is often not
a differential cost?
a.
b.
c.
d.
Material
Labor
Variable Overhead
Fixed Overhead
Study Break #2
Opportunity costs are:
a.
b.
c.
d.
Never incremental costs
Always incremental costs
Sometimes sunk costs
None of the above
Study Break #2
Opportunity costs are:
a.
b.
c.
d.
Never incremental costs
Always incremental costs
Sometimes sunk costs
None of the above
Make-or-Buy Decisions – General
Refrigeration Example
Incremental Cost Analysis with Opportunity Costs
Example Exercise #1
Finn’s Seafood Restaurant has been
approached by New England Investments,
which wants to hold an employee
recognition dinner next month. Lillian
summer, a manager of the restaurant,
agreed to a charge of $65 per person for
food, wine, and dessert, for 150 people.
She estimates that the cost of unprepared
food will be $30 per person and beverages
will be $12 per person.
Example Exercise #1
Continued
 In order to accommodate the group, Lillian will
have to close the restaurant for dinner that
night. Typically, she would have served 160
people with an average bill of $50 per person.
On a typical night, the cost of unprepared food is
$18 per person and beverages are $13 per
person.
 No additional staff will need to be hired to
accommodate the group from New England
Investments.
 Calculate the incremental profit or loss
associated with accepting the New England
Investments group.
Example Exercise #1 Solution
Calculate the incremental profit/loss
 New England Investments group
Revenue ($65 x 150)
Costs Incurred ($42 x 150)
$9,750
$6,300
$3,450
 Typical Evening
Revenue ($50 x 160)
Costs Incurred ($31 x 160)
$8,000
$4,960
$3,040
 Incremental Profit
New England Investments Group
Typical Evening
$3,450
$3,040
$ 410
Drop a Product Line
 A very significant decision
 Analysis involves calculating the change in
income that will result from dropping the
product line.
 If income will increase, the product line
should be dropped
 If income will decrease, the product line
should be kept
Dropping a Product Line –
Mercer Hardware Example
Dropping a Product Line –
Mercer Hardware Example
Beware of the Cost Allocation
Death Spiral
When dropping a product line



Common fixed costs are not incremental
Common fixed cost allocation is spread
among remaining product lines
Management must understand and
remember this impact when making
decisions
Decisions Involving Joint Costs
Joint Products
 When two or more products always result
from common inputs
Joint Costs
 Costs of the common inputs
Split-Off Point
 Stage of production in which individual
products are identified
Joint Products Example
Allocation of Joint Costs
Cost of the common inputs
 Allocated to the joint products for financial reporting
purposes
Joint cost information is
 Irrelevant to individual joint product decisions
 It is not an incremental cost
Joint cost information is relevant to decisions
regarding joint products as a group
Example Exercise #2
 The American Produce Company purchased a truckload of
cantaloupe (weighing 5,000 pounds) for $1,000
 American Produce separated the cantaloupe into two
grades: superior and economy.
 The superior grade cantaloupe had a total weight of 4,000
pounds which sells for $0.30 per pound
 The economy grade cantaloupe totaled 1,000 pounds which
sells for $0.10 per pound
 Allocate the $1,000 cost of the truckload to the superior
grade and economy grade cantaloupe using the physical
quantity method and relative sales value method.
Example Exercise #2 Solution
Physical Quantity Method
 Superior Grade
= (4,000/5,000) x $1,000
= $800
 Economy Grade
= (1,000/5,000) x $1,000
= $200
Example Exercise #2 Solution
Relative Sales Value Method
 Total Sales
 Superior Grade
 Economy Grade
 Total Sales
4,000 x $0.30 = $1,200
1,000 x $0.10 = $100
$1,300
 Cost Allocation
 Superior Grade (1,200/1,300) x $1,000 = $923
 Economy Grade (100/1,300) x $1,000 = $ 77
Additional Processing Decisions
and Joint Costs
 Joint costs
 Not relevant to decisions made after the
split-off point
 Joint costs incurred prior to the
split-off point are sunk costs
 Decisions based on incremental
analysis
Study Break #3
Which of the following costs should
not be taken into consideration
when making a decision?
a.
b.
c.
d.
Opportunity costs
Sunk costs
Relevant costs
Differential costs
Study Break #3
Which of the following costs should
not be taken into consideration
when making a decision?
a.
b.
c.
d.
Opportunity costs
Sunk costs
Relevant costs
Differential costs
Study Break #4
The joint costs incurred in a joint
product situation:
a. Are incurred before the split-off point
b. Are incurred after the split-off point
c. Should only be allocated based on physical
attributes
d. None of the above
Study Break #4
The joint costs incurred in a joint
product situation:
a. Are incurred before the split-off point
b. Are incurred after the split-off point
c. Should only be allocated based on physical
attributes
d. None of the above
Qualitative Considerations in
Decision Analysis
Most make-or-buy
decisions have one
or more features
that are difficult to
quantify but
should be
considered





Swings in Economy
Loss of Control
Quality of Product
Quality of Service
Company Morale
Qualitative Factors
The Five-Step Process of the
Theory of Constraints
1. Identify the Binding Constraint
2. Optimize Use of the Constraint
3. Subordinate Everything Else to the
Constraint
4. Break the Constraint
5. Identify a New Binding Constraint
Production Flow
Overproduction in Nonbottleneck Departments
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