Prepared by Debby Bloom-Hill CMA, CFM CHAPTER 7 Use of Cost Information in Management Decision Making Slide 7-2 Incremental Analysis Incremental analysis All decisions involve a choice among alternative courses of action The solution to business problems involves incremental analysis Incremental analysis is the analysis of the incremental revenue and incremental costs incurred when one alternative is chosen over another Slide 7-3 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Incremental Analysis Incremental Revenue Additional revenue received by selecting one alternative over another Incremental Cost Additional cost incurred by selecting one alternative over another Incremental Profit Difference between incremental revenue and incremental cost Slide 7-4 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Incremental Analysis An alternative that yields an incremental profit should be selected Incremental costs are referred to as relevant costs Also called differential costs because they are the costs that differ between decision alternatives Slide 7-5 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Incremental Analysis Example Jensen’s Rapid Copy is considering extending its hours Alternative 1 is the status quo Alternative 2 involved the company extending their hours from 8 pm to midnight The next slide shows the incremental costs and revenues associated with choosing one alternative over another Slide 7-6 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Incremental Analysis Example Slide 7-7 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Incremental Analysis Incremental Analysis can be extended to more than two alternatives Calculate profit for each alternative The alternative with the highest profit is the best alternative Difference between its profit and the profit of any other alternative is its incremental profit Slide 7-8 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions “What Does This Product Cost?” Answer: 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 Some costs will change due to the decision, some will not Only costs that change are relevant Slide 7-9 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Which of the following is likely to be an incremental cost associated with increasing planned production run of 1,000 units to 1,010 units? a. Set-up costs b. Depreciation of equipment c. Inspection costs d. Material costs Answer: d Material costs are variable costs and usually incremental Slide 7-10 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Analysis of Decisions Faced by Managers Three decisions that managers frequently face: 1. The decision to engage in additional processing of a product 2. The decision to make or buy a product 3. The decision to drop a product line Slide 7-11 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Additional Processing Decision Manufacturers must occasionally decide whether to: Sell a product in a partially completed stage, or Incur additional processing costs required to complete the product Costs incurred to date of decision on partially complete product are not relevant, i.e sunk costs. Slide 7-12 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Additional Processing Decision – Bridge Computer Example Summary of cost information Slide 7-13 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Additional Processing Decision – Bridge Computer Example Incremental analysis summary Incremental revenues are $500 Incremental costs are $400 Would you spend $400 to generate an additional $500? Answer: Yes, incremental profit is $100 Slide 7-14 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Additional Processing Decision – Bridge Computer Example Incremental analysis summary Revenue Prior Production Costs Additional Processing Costs Gain (loss) per unit Sell Partially Sell Fully Complete Complete Incremental $500 $1,000 $500 a (800) (800) 0 0 (400) (400) b ($300) ($200) $100 c a. Incremental revenue associated with alternative 2 b. Incremental cost associated with alternative 2 c. Incremental profit associated with alternative 2 Slide 7-15 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Additional Processing Decision Slide 7-16 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make or Buy Decisions Most manufactured goods are made up of numerous components In some cases, a company may purchase one or more of these components from another company or manufacture them themselves The analysis of this decision concentrates solely on incremental costs Slide 7-17 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make-or-Buy Decisions – General Refrigeration Example Additional information: If purchased, cost savings include $390,000 in supervisory salaries and all variable costs. Market value of production machinery is zero Slide 7-18 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make-or-Buy Decisions – General Refrigeration Example A key issue is to determine which of the above costs are incremental None of the $15 million of variable manufacturing costs will be incurred if the part is purchased The fixed costs associated with depreciation will not be saved Note that not all fixed costs are irrelevant sunk costs Slide 7-19 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make-or-Buy Decisions – General Refrigeration Example Some fixed costs are avoidable costs Avoidable costs can be avoided if a particular action is undertaken If the parts are purchased from an outside vendor, the salaries of 5 supervisors will be saved The savings total $390,000 of avoidable fixed costs It will cost the company an additional $110,000 to purchase the part Slide 7-20 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make-or-Buy Decisions – General Refrigeration Example Incremental cost analysis – 3 column format Slide 7-21 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make-or-Buy Decisions – General Refrigeration Example Incremental cost analysis - single column format Slide 7-22 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Which of the following is not likely to be an incremental cost for a make-or-buy decision? a. Materials cost b. Direct labor cost c. Variable manufacturing cost d. Depreciation of building Answer: d Depreciation of building is not likely to change no matter which alternative is chosen in a make-or-buy decision Slide 7-23 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Opportunity Costs An opportunity cost is the value of benefits foregone by selecting one decision alternative over another For example, if you spend $1,000 instead of investing in a certificate of deposit, the interest that could have been earned is an opportunity cost Since opportunity costs differ depending on the option selected, they are incremental costs Slide 7-24 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Which of the following is true? a. Opportunity costs are never incremental costs b. Opportunity costs are always incremental costs Answer: b Opportunity costs are always incremental costs because they differ depending upon the outcome selected Slide 7-25 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Opportunity Costs – General Refrigeration Example Suppose the Tennessee plant is currently spending $500,000 per year to rent space for manufacturing shelving used in the refrigeration units If production of compressors is discontinued, the company will not need to rent the space In the incremental analysis on the next slide, the rent savings is shown along with the other cost savings Slide 7-26 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Make-or-Buy Decisions – General Refrigeration Example Incremental analysis with opportunity costs Slide 7-27 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Dropping a Product Line Analysis involves calculating the change in income that will result from dropping the product line If income increases, the product line should be dropped If income decreases, the product line should not be dropped This amounts to comparing the incremental revenues and costs that result from dropping the product line Slide 7-28 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Dropping a Product Line – Mercer Hardware Mercer Hardware sells 3 product lines, tools, hardware and garden Direct fixed costs are directly traceable to each product line Allocated fixed costs are not directly traceable to a product line Allocated fixed costs are generally not avoidable, thus no common fixed costs will be saved if the product line is dropped Slide 7-29 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Dropping a Product Line – Mercer Hardware Example Profit calculation with three product lines Slide 7-30 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Dropping a Product Line – Mercer Hardware Example Profit calculation with two product lines Sales Traceable costs: Cost of goods sold Other variable costs Direct fixed costs Non-traceable costs Company fixed costs Division net income Mercer Hardware Product Line Income Statement For the Year Ended December 31, 2006 Hardware Total Tools Supplies 2 products $120,000 $200,000 $320,000 Total 3 products $400,000 (81,000) (2,000) (8,000) (90,000) (4,000) (5,000) (171,000) (6,000) (13,000) (231,000) (7,000) (16,500) (30,000) ($1,000) (50,000) $51,000 (80,000) $50,000 (80,000) $65,500 Total company fixed costs are $80,000 whether 2 or 3 products are sold Slide 7-31 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Dropping a Product Line – Mercer Hardware Example Slide 7-32 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions 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 Slide 7-33 Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions Terminology Summary Avoidable costs Costs that can be avoided by taking a particular course of action Always incremental costs, and therefore relevant to a decision Sunk costs Already occurred and not reversible Are not incremental because they do not differ among alternatives Not relevant in decision making Slide 7-34 Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions Terminology Summary Many students assume that fixed costs are equivalent to sunk costs This is not always the case Fixed costs can be sunk, not sunk and irrelevant, or possibly relevant Opportunity costs Represent the benefit foregone by selecting a particular alternative They are always incremental and relevant to a decision Slide 7-35 Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions Which of the following costs should not be taken into consideration when making a decision? a. Opportunity costs b. Sunk costs c. Relevant costs d. Differential costs Answer: b Sunk costs Slide 7-36 Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions Classify each of the following as sunk and irrelevant, not sunk but still irrelevant, or not sunk and relevant Depreciation on equipment already purchased Sunk and irrelevant (not incremental) President’s salary, which will not change for both action A and action B Not sunk and irrelevant (not incremental) Salary of supervisory who will be retained for action A and fired for action B Not sunk and relevant (incremental) Slide 7-37 Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing 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 Product may undergo further processing and may incur additional costs Slide 7-38 Learning objective 3: Analyze decisions involving joint costs Allocation of Joint Costs For financial reporting, the cost of common inputs must be allocated to the joint products The total joint cost will be incurred no matter what the company does with the joint products beyond the split-off point The joint cost is not incremental to production of an individual joint product and irrelevant to decisions regarding an individual joint product Slide 7-39 Learning objective 3: Analyze decisions involving joint costs Joint Products Example Slide 7-40 Learning objective 3: Analyze decisions involving joint costs Joint Cost Allocation Methods Physical quantity of output Joint costs allocated to product A = 𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐀 ∗ 𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭 (𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐀 + 𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐁) Joint costs allocated to product B = 𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐁 ∗ 𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭 (𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐀 + 𝐏𝐡𝐲𝐬𝐢𝐜𝐚𝐥 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐨𝐟 𝐁) Slide 7-41 Learning objective 3: Analyze decisions involving joint costs Joint Cost Allocation Methods Relative sales value Joint costs allocated to product A = 𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀 ∗ 𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭 (𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀 + 𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁) Joint costs allocated to product B = 𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁 ∗ 𝐉𝐨𝐢𝐧𝐭 𝐂𝐨𝐬𝐭 (𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐀 + 𝐒𝐚𝐥𝐞𝐬 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐁) Slide 7-42 Learning objective 3: Analyze decisions involving joint costs Joint Cost Allocation Example Joint costs of $620 allocated using physical quantity of output Process results in 500 feet of grade A lumber that sells for $1 per foot, and 500 feet of grade B lumber that sells for $0.50 per foot Joint costs allocated to product A = 𝟓𝟎𝟎 𝐟𝐞𝐞𝐭 ∗ $𝟔𝟐𝟎 = $𝟑𝟏𝟎 (𝟓𝟎𝟎 𝐟𝐞𝐞𝐭 + 𝟓𝟎𝟎 𝐟𝐞𝐞𝐭) Slide 7-43 Learning objective 3: Analyze decisions involving joint costs Joint Cost Allocation Example Joint costs of $620 allocated using physical quantity of output Process results in 500 feet of grade A lumber that sells for $1 per foot, and 500 feet of grade B lumber that sells for $0.50 per foot Joint costs allocated to product B = 𝟓𝟎𝟎 𝐟𝐞𝐞𝐭 ∗ $𝟔𝟐𝟎 = $𝟑𝟏𝟎 (𝟓𝟎𝟎 𝐟𝐞𝐞𝐭 + 𝟓𝟎𝟎 𝐟𝐞𝐞𝐭) Slide 7-44 Learning objective 3: Analyze decisions involving joint costs Joint Cost Allocation Example Joint costs of $620 allocated using sales value Process results in 500 feet of grade A lumber that sells for $1 per foot, sales value 500 * 1 = $500, and 500 feet of grade B lumber that sells for $0.50 per foot, sales value 500 * 0.50 = $250 Joint costs allocated to product A = $𝟓𝟎𝟎 ∗ $𝟔𝟐𝟎 = $𝟒𝟏𝟑. 𝟑𝟑 ($𝟓𝟎𝟎 + $𝟐𝟓𝟎) Slide 7-45 Learning objective 3: Analyze decisions involving joint costs Joint Cost Allocation Example Joint costs of $620 allocated using sales value Process results in 500 feet of grade A lumber that sells for $1 per foot, sales value 500 * 1 = $500, and 500 feet of grade B lumber that sells for $0.50 per foot, sales value 500 * 0.50 = $250 Joint costs allocated to product B = $𝟐𝟓𝟎 ∗ $𝟔𝟐𝟎 = $𝟐𝟎𝟔. 𝟔𝟕 ($𝟓𝟎𝟎 + $𝟐𝟓𝟎) Slide 7-46 Learning objective 3: Analyze decisions involving joint costs Additional Processing Decisions and Joint Costs Joint costs not relevant to decisions made after the split-off point because they are not incremental Joint costs incurred prior to the splitoff point are sunk costs and must be incurred no matter what happens after the split-off point Slide 7-47 Learning objective 3: Analyze decisions involving joint costs 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. Should never be allocated Answer: a Are incurred before the split-off point Slide 7-48 Learning objective 3: Analyze decisions involving joint costs Qualitative Considerations in Decision Analysis Many decisions have one or more features that are difficult to quantify but should be given careful consideration Examples include, but are not limited to Slide 7-49 Swings in the economy Loss of control Quality of the product Quality of service Company morale Learning objective 4: Discuss the importance of qualitative considerations to management decisions Qualitative Considerations in Decision Analysis Slide 7-50 Learning objective 4: Discuss the importance of qualitative considerations to management decisions Qualitative Factors Slide 7-51 Learning objective 4: Discuss the importance of qualitative considerations to management decisions Appendix – The Theory of Constraints The Theory of Constraints is an approach to production and constraint management developed by Eli Goldratt Five step process Large increases in profit can be achieved by elimination of bottlenecks in production processes Slide 7-52 Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC) Appendix – The Theory of Constraints Goldratt specified a five step process for dealing with constraints 1. Identify the Binding Constraint The binding constraint is the process that limits throughput 2. Optimize Use of the Constraint Produce products with the highest contribution margin per unit of the constraint Slide 7-53 Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC) Appendix – The Theory of Constraints Goldratt specified a five step process for dealing with constraints 3. Subordinate Everything Else to the Constraint Managers should focus their attention on trying to loosed the constraint and not on process improvements Slide 7-54 Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC) Appendix – The Theory of Constraints Goldratt specified a five step process for dealing with constraints 4. Break the Constraint This can be done many ways including cross training workers, outsourcing, purchasing additional equipment or hiring new workers 5. Identify a New Binding Constraint Identify the additional bottlenecks. If there are no bottlenecks and excess capacity, focus on building demand Slide 7-55 Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC) Copyright © 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Slide 7-56