13
Cost Management
and Decision Making
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
13-2
Learning Objective 1
13-3
Decision-Making Process
Stage 1
Setting goals
and objectives
5
4
3
2
Stage 2
Gathering
information
Stage 3
Evaluating
alternatives
1
Stage 4
Planning and
implementation
Stage 5
Obtaining
feedback
13-4
Stage 1: Setting Goals and Objectives
Intangible objectives:
 may provide guidance, but
 tend to be abstract and
 are difficult to measure
Organizations must set objectives
to provide clear guidance.
Tangible objectives
provide benchmarks
against which to
measure performance.
13-5
Target Profit and Target Cost
 Determine target selling price.
Contract sales price
 Determine target cost.
Estimate based
on market analysis



Determine target profit
Deduct target return on sales
Result is target cost
 Compare target cost to currently
feasible total cost.

The difference is the cost-reduction
target
 Redesign products and processes to
achieve the cost-reduction target.
Competitors’ pricing
13-6
Stage 2: Gathering Information
Information quality
and
decision usefulness
Relevance
Timeliness
Accuracy
Cost
vs.
quality
Objectivity
vs.
subjectivity
13-7
Learning Objective 2
13-8
Identification of Relevant Costs and
Benefits
Relevant costs are
costs to be incurred at
some future time and
that differ for each
option available to the
decision maker.
Costs incurred in the
past are not relevant.
They are called
called “sunk costs”.
13-9
Identification of Relevant Costs and
Benefits
Decision: Trading an old car for a new car.
Item
Cost of new car
Cost of old car
Insurance
AAA membership
Not
Relevant Relevant
X
X
X
X
Reason
Future cost that differs between alternatives
Sunk cost
Increased amount to cover new car is relevant
Does not differ between alternatives
13-10
Stage 3: Evaluating Alternatives
1. List decision
alternatives in the
order the
decisions must
be made.
2. Trace the
path of each
decision to its
ultimate
outcome.
3. Measure the benefits and costs of
each set of outcomes.
Consider qualitative as
well as quantitative factors.
13-11
Stage 3: Evaluating Alternatives
Anticipating future outcomes of each action
Consider the past
Although past costs are
sunk and therefore
irrelevant, they can be
used to help estimate
future costs that are relevant.
Completely new products
 Use prototype products
to estimate costs.
 Rely on consultants
who have knowledge
of similar products.
13-12
Learning Objective 3
13-13
Decision Tree


A
B

A useful decision aid in diagramming
decisions and alternative outcomes
Allows an evaluation of the costs and
benefits of each alternative (limb)
Steps in creating a decision tree:

Display decision alternatives in order

Identify the set of outcomes resulting
from each decision path
A1 A2 B1 B2 B3 
Measure costs and benefits of each set
of outcomes
13-14
Decision Tree - Example
Status quo
Maintain
Status quo?
Change
Automate
Status quo is
unacceptable
Higher equipment cost
Lower employment level
Lower unit-level cost
Increase in profit
Automate or improve
Manual process?
Lower equipment cost
Manual
Same employment level
Lower unit-level cost
Increase in profit
13-15
Learning Objective 4
13-16
Outsourcing or Make-or-Buy Decision
When the company needs goods or services,
should they be “made” internally or “bought”
externally?
When goods or
services are
acquired externally,
it is called
outsourcing.
13-17
Outsourcing or Make-or-Buy Decision
13-18
Outsourcing or Make-or-Buy Decision
Identify the
variable costs
that would
disappear if we
outsource.
Identify the new
variable costs
that we would
incur if we
outsource.
Identify the fixed costs that we
could avoid if we outsource.
13-19
Outsourcing or Make-or-Buy Decision
Let’s look at a make-or-buy decision faced
by the management of Thor Company.
13-20
Outsourcing or Make-or-Buy Decision
Thor Co. manufactures 20,000 of part 457 that is
currently used in one of its products. The costs to
make this part are:
Direct materials per unit
Direct labor per unit
Variable overhead per unit
Fixed overhead
Allocated common costs
$
9.00
5.00
1.00
180,000
100,000
13-21
Outsourcing or Make-or-Buy Decision
Direct materials
$ 9.00
Direct labor
5.00
Thor Co. manufactures
20,000 of part 457 that 1.00
is
Variable overhead
($180,000 ÷ 20,000)
currently used inFixed
one overhead
of its products.
The costs9.00
to
Common costs ($100,000 ÷ 20,000)
5.00
make
this
part
are:
Unit cost
$ 29.00
Direct materials/unit
Direct labor/unit
Variable overhead/unit
Fixed overhead
Allocated common costs
$
9.00
5.00
1.00
180,000
100,000
Fixed manufacturing overhead is the cost of leasing and
operating the equipment necessary to produce part 457.
13-22
Outsourcing or Make-or-Buy Decision



Common costs are allocated on the basis of
direct labor hours.
Total unit cost of $29 is based on 20,000 parts
produced each year.
An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?
13-23
Outsourcing or Make-or-Buy Decision
Make-or-buy analysis - 20,000 units
Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
20,000 × $5 per unit
$
Difference
180,000
100,000
20,000
20,000 × $9 per unit
20,000 × $1 per unit
13-24
Outsourcing or Make-or-Buy Decision
Make-or-buy analysis - 20,000 units
Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
$
$
180,000
100,000
20,000
180,000
100,000
580,000
20,000 × $29 per unit
Difference
13-25
Outsourcing or Make-or-Buy Decision
20,000 × $25 purchase price
Make-or-buy analysis - 20,000 units
Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
$
$
180,000
100,000
20,000
180,000
100,000
580,000
$
500,000
$
100,000
600,000
Difference
$
320,000
(100,000)
(20,000)
(180,000)
$
20,000
The common costs remain unchanged.
13-26
Outsourcing or Make-or-Buy Decision
Make-or-buy analysis - 20,000 units
Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
$
$
180,000
100,000
20,000
180,000
100,000
580,000
$
500,000
$
100,000
600,000
Difference
$
320,000
(100,000)
(20,000)
(180,000)
$
20,000
Should we make or buy
part 457?
13-27
Outsourcing or Make-or-Buy Decision
What is the relevant unit cost of making part 457?
Direct materials
Direct labor
Variable overhead
Fixed overhead ($180,000 ÷ 20,000)
Total relevant unit cost
$ 9.00
5.00
1.00
9.00
$ 24.00
Advantage of making
20,000 units × ($25.00 – $24.00) = $20,000
13-28
Outsourcing or Make-or-Buy Decision
If Thor could use the space currently being used to make
Part 457 for another purpose, resulting in a cost savings of
$45,000, would you change your decision?
Yes. The cost savings (opportunity cost) of $45,000
overcomes the $20,000 disadvantage of buying.
Now there is a $25,000 advantage to buying.
The real issue is the most profitable use of the space.
13-29
Pitfalls of Outsourcing
Supplier
technology and
knowledge base
may not be as
anticipated.
Freed-up
resources
are not used
as planned.
Customers
may object.
Loss of
sensitive
information
to supplier.
Customer
contact may
be reduced.
Supplier
quality is not
as high as
anticipated.
13-30
Decision to Add or Drop a Product,
Service, or Business Unit
If we shut down
our U.S. Digital
watch line, we
might anger our
American
customers.
. . . Not to
mention
the bad
press!
That is why we
have to consider
the relevant
benefits and the
relevant costs
BEFORE making
a final decision.
13-31
Decision to Add or Drop a Product,
Service, or Business Unit
Let’s get started.
The digital line
has become less
profitable and it is
difficult to compete
in the market.
. . . Not to
mention
the bad
press!
That is why we
have to consider
the relevant
benefits and the
relevant costs
BEFORE making
a final decision.
13-32
Decision to Add or Drop a Product,
Service, or Business Unit
Segment Income Statement
Digital watches
Sales
Less: variable expenses
Variable mfg. costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net loss
$
$
$
500,000
$
200,000
300,000
120,000
5,000
75,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
13-33
Decision to Add or Drop a Product,
Service, or Business Unit
Segment Income Statement
Digital watches
Sales
$ 500,000
If
the
digital
watch
line
is
dropped,
the
Less: variable expenses
fixed
general
factory overhead
and general
Variable
mfg. costs
$ 120,000
Variable
shipping costs
5,000
administrative
expenses will
be allocated
Commissions
75,000
200,000
to other product lines. $ 300,000
Contribution margin
Less: fixed expenses
General factory overhead
$
60,000
Salary of line manager
90,000
Depreciation of equipment
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
400,000
Net loss
$ (100,000)
13-34
Decision to Add or Drop a Product,
Service, or Business Unit
Segment Income Statement
Digital watches
Sales
The
equipment used to manufacture
Less: variable expenses
digitalmfg.
watches
Variable
costs has no $resale
120,000
value
or alternative
use. 5,000
Variable
shipping
costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net loss
$
500,000
$
200,000
300,000
75,000
$
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
13-35
Decision to Add or Drop a Product,
Service, or Business Unit
Segment Income Statement
Digital watches
Sales
Less: variable expenses
Variable mfg. costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net loss
$
500,000
Should Market retain or drop
the digital watch line?
$
200,000
300,000
$
$
120,000
5,000
75,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
13-36
Decision to Add or Drop a Product,
Service, or Business Unit
DECISION RULE
Market should drop the digital watch
segment only if its fixed cost savings
exceed lost contribution margin.
Let’s look at this solution.
13-37
Decision to Add or Drop a Product,
Service, or Business Unit
Market Company
Solution
Contribution margin lost if
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
Advertising - direct
Rent - factory space
Net disadvantage
$
$ (300,000)
90,000
100,000
70,000
Should we drop the digital
watch segment?
260,000
$ (40,000)
13-38
Decision to Add or Drop a Product,
Service, or Business Unit
The same result can also be obtained
by preparing a differential analysis
showing operating results with and
without the digital watch segment.
Let’s look at this approach.
13-39
Decision to Add or Drop a Product,
Service, or Business Unit
Sales
Less variable expenses:
Mfg. expenses
Freight out
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising - direct
Rent - factory space
General admin. expenses
Total fixed expenses
Net loss
Differential Analysis
Solution
Keep
digital
watches
$ 500,000
120,000
5,000
75,000
200,000
300,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
Drop
digital
watches
$
60,000
50,000
30,000
140,000
$ (140,000)
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
$ (40,000)
13-40
Decision to Add or Drop a Product,
Service, or Business Unit
Keeping the digital watch product line
may have an opportunity cost that we
have not yet considered.
The opportunity cost of retaining the digital
watch line is measured by the differential
profits given up if the next best use of the
production facilities is rejected.
Example: If the idled facilities can be used to make
a product generating $350,000 per year in contribution
margin, with no other change in fixed costs,
might this change your decision?
13-41
Decision to Add or Drop a Product,
Service, or Business Unit


Measuring cost savings and lost
revenues from closing a business unit is
only part of the story.
The closing will impact . . .



Employees’ personal lives,
Morale of retained employees,
The community at large.
13-42
Relevant Costs of Replacing
Equipment
Which costs are relevant to the decision to
replace an old machine with a new machine?








Old machine cost $5,400 when purchased.
Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to
$11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and
would allow two more years of productivity.
Power for either machine is expected to be $2.50
per unit.
Expected level of output: 1,000 units per year.
13-43
Relevant Costs of Replacing
Equipment
Which costs are relevant to the decision to
replace an old machine with a new machine?




Relevant
because
of labor
savings
over the
2-year life.




Old machine cost $5,400 when purchased.
Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to
$11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and
would allow two more years of productivity.
Power for either machine is expected to be $2.50
per unit.
Expected level of output: 1,000 units per year
13-44
Relevant Costs of Replacing
Equipment
1,000 units @ $12.00 for 2 years
1,000 units @ $11.00 for 2 years
Cost
Labor
Repair cost
Purchase cost
Total
Keep old Replace old
machine
machine
$
24,000 $
22,000
4,600
10,000
$
28,600 $
32,000
Conclusion: keep old machine.
13-45
Pricing Decisions
What influences prices?
13-46
Pricing Decisions
Prices are determined by the market, subject
to costs that must be covered in the long run.
Costs
Market
forces
Prices are based on costs, subject to
reactions of customers and competitors.
13-47
Pricing Law in the United States
13-48
Special-Order Price Decisions
We just received
a special order. Do
you think we should
accept it?
13-49
Special-Order Price Decisions




A travel agency offers Worldwide Airways
$150,000 for a round-trip flight from Japan to
Hawaii on a jumbo jet.
Worldwide usually gets $250,000 in passenger
ticket revenue from this flight.
The airlines 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.
The next screen shows cost data developed by
managerial accountants at Worldwide.
13-50
Special-Order Price Decisions
Typical Flight Between Japan and Hawaii
Revenue:
Passenger
$
Cargo
Total
Expenses:
Variable expenses
Allocated fixed expenses
Total
Profit
250,000
30,000
$
280,000
$
190,000
90,000
90,000
100,000
Worldwide will save about $5,000 in reservation
and ticketing costs if the charter is accepted.
13-51
Special-Order Price Decisions
Assuming excess capacity
Special price for charter
Variable cost per 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.
13-52
Special-Order Price Decisions
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 profits.
Should Worldwide still accept the charter?
13-53
Special-Order Price Decisions
Assuming no excess capacity
Special price for charter
Variable cost per flight
Reservation cost savings
Variable cost of charter
Opportunity cost:
Lost contribution on route
Total
$ 150,000
$ 90,000
(5,000)
85,000
80,000
165,000
$ (15,000)
Worldwide has no excess capacity, so it
should reject the special charter, or try to
renegotiate a higher price.
13-54
Special-Order Price Decisions
With excess capacity . . .

Relevant costs usually will be the variable costs
associated with the special order.
Without excess capacity . . . .

Same as above but opportunity costs of using
the firm’s facilities for the special order are also
relevant.
13-55
Special-Order Price Decisions
Additional considerations
•Impact on regular customers and markets
•Will the special order lead to future
regular business?
13-56
End of Chapter 13