Management Control
Tutorial Summary on:
Ch.11 Decision Making and Relevant Information
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Defining relevant costs and
relevant revenues
• Relevant costs and relevant revenues are expected
future costs and revenues that differ among
alternative courses of action.
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Defining relevant costs and
relevant revenues
•
Two very important points to remember:
1.
Our focus is on future costs and revenues as nothing can
be done to alter the past.



Historical costs/past costs are sunk costs (i.e. costs
that are already incurred), and they are irrelevant to
a decision!
Why? Because they are already incurred and
unavoidable! No matter which alternative is taken,
these costs cannot be changed.
Though past costs are irrelevant, they can be used
as a basis for predicting future costs.
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Defining relevant costs and
relevant revenues
In a decision of whether to buy a new car and trade-in
your old car or just keep your old car, which of the
following are sunk costs?
a. The cost of licensing the new car.
b. The cost of licensing your old car next year if you
keep it.
c. The amount you paid for your old car.
d. The amount you paid to repair your old car last
month in case you wanted to sell it.
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Defining relevant costs and
relevant revenues
2.
The costs and revenues must differ among alternatives

Costs and revenues do not differ will not matter.

Example:
Two alternatives open to a company. One is to
reorganize the firm and the other one is not to
reorganize. No matter which alternative is chosen,
the marketing cost still remains at $1,000,000.
Then, the marketing cost is irrelevant to the decision
as this cost will not be differed no matter which
alternative is chosen.
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Different Costs for Different Purposes
Costs that are relevant in one decision situation are not
necessarily relevant in another. In each decision situation
the manager must examine the data at hand and isolate
the relevant costs.
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The concept of relevant costs/revenues can be used for making
the following decisions:
1. Special order acceptance
2. Make/buy
3. Add/drop
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Decision on One-time-only
Special Orders
•
Defining one-time-only special order
–
No subsequent sales will be made with the
customer who offers you the special order.
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Decision on One-time-only
Special Orders
• Assumptions:
1. If there is idle capacity (extra capacity) in a firm,
accepting the one-time-only special order will not affect
the firm’s normal production and no opportunity costs
will be incurred (the opportunity cost will be the income earned
from using the facility to produce the existing normal products).
2. Accepting the special order has no long-run or strategic
implications to the firm. (very often, the per unit revenue
earned from the special order customer is lower than that of the
regular or normal customers. If the normal customers realize that
the firm is willing to accept a lower revenue per unit, probably, they
will also bargain for a cheaper price with the firm.)
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Decision on One-time-only
Special Orders
Example 1:
• Jet, Inc. makes a single product whose normal selling price is $20
per unit.
• A foreign distributor offers to purchase 3,000 units for $10 per unit.
• This is a one-time order that would not affect the company’s regular
business.
• Annual capacity is 10,000 units, but Jet, Inc. is currently producing
and selling only 5,000 units. (That means, the company has extra
capacity to handle the special order).
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Decision on One-time-only
Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20)
$ 100,000
Variable costs:
Direct materials
$ 20,000
Direct labor
5,000
Manufacturing overhead
10,000 $8 variable cost
Marketing costs
5,000
Total variable costs
40,000
Contribution margin
60,000
Fixed costs:
Manufacturing overhead
$ 28,000
Marketing costs
20,000
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Total fixed costs
48,000
Net income
$ 12,000
Decision on One-time-only
Special Orders
If Jet accepts the offer, net income will increase by
$6,000.
Increase in revenue (3,000 × $10)
Increase in costs (3,000 × $8 variable cost)
Increase in net income
$ 30,000
24,000
$ 6,000
Note: It is assumed that fixed costs are unaffected by the
order and that variable marketing costs must be incurred on
the special order.
Do not automatically assume all fixed costs are
unaffected. Look at the question carefully!
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Question 11-24
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Incremental revenue (1,000 x $100)
Less: Incremental costs
Direct materials ($35 x 1,000) 35,000
Direct labor ($37.5 x 1,000)
37,500
Setups, materials handling,
QC, etc ($500 x 25 batches) 12,500
Incremental income
100,000
(85,000)
15,000
======
Conclusion: Accept/reject the special order.
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$100,000/10000 = $10 per unit
Incremental income (from part 1)
Less: opportunity cost
[500* x (150-35-37.5-10)]
Incremental income/loss
Current production
15,000
(33,750)
(18,750)
========
Special order
*10500 – 10,000 – 1,000 = -500 meaning that the company needs to release
500 units from the current production order in order to handle the special
order
Conclusion: Accept/reject the special order
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Incremental income (from part 1)
15,000
Less: loss in operating income
from regular customers ($10 x 10,000) (100,000)
______
Incremental income/loss
(85,000)
========
Conclusion: Accept/reject the special order
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Make or Buy (Insourcing or
Outsourcing) Decision
• Insourcing refers to the process of producing goods
and services within the organization.
• Outsourcing refers to the process of purchasing
goods and services from outside suppliers.
• The decisions about whether to outsource of produce
within the organization are often called make-or-buy
decisions.
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Make or Buy (Insourcing or
Outsourcing) Decision
• Example:
• Essex manufactures part 4A that is currently used in one
of its products.
• The cost per unit of this part is:
Direct materials
$ 9
Direct labor
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Variable overhead
1
Depreciation of special equip.
3
Supervisor's salary
2
General factory overhead
10
Total cost per unit
$ 30
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Make or Buy (Insourcing or
Outsourcing) Decision
• The special equipment used to manufacture part 4A has no
resale value.
• The total amount of general factory overhead, which is
allocated on the basis of direct labor hours, would be
unaffected by this decision.
• The $30 total cost per unit 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 the company accept the supplier’s offer?
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Make or Buy (Insourcing or
Outsourcing) Decision
Cost
Per
Unit
Outside purchase price
$ 25
Direct materials
Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total relevant cost
$
9
5
1
3
2
10
$ 30
Relevant costing approach
Cost of 20,000 Units
Buy
Make
$ 500,000
180,000
100,000
20,000
40,000
$ 340,000
$ 500,000
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So, make is cheaper than buy
Make or Buy (Insourcing or
Outsourcing) Decision
DECISION RULE
In deciding whether to accept the outside supplier’s offer,
Essex isolated the relevant costs of making the part by
eliminating:
– The sunk costs (i.e. depreciation).
– The future costs that will not differ between making
or buying the parts (i.e. general factory O/H).
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Question 11-25
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Variable manufacturing costs:
DM (170 x 10,000)
DL (45 x 10,000)
Setups (1,500 x 80)
Fixed manufacturing costs
Avoidable
Unavoidable
Total manufacturing costs
$
1,700,000
450,000
120,000
320,000
800,000
3,390,000
Per unit manufacturing cost = 3,390,000/10,000 = $339
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The opportunity cost of using capacity to make CMCBs is zero since
Svenson would keep this capacity idle if it purchases CMCBs from
Minton.
Relevant costing approach
Direct materials
Direct labor
Setup etc. $120,000/10,000
Avoidable FC $320,000/10,000
Purchase cost
Make
$170
45
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-$259
=====
It’s cheaper to make/buy.
Buy
----$300
$300
=====
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As there will be incremental loss of $150,000 by using the facility to
produce CB3s
 Svenson would prefer to leave the facility idle.
The opportunity cost of making the CMCBs is zero (i.e. no income to
forgo by using the facility to produce CMCBs).
 Therefore, Svenson should continue to make the CMCBs.
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Add/Drop Decision
• One of the most important decisions managers made
is whether to add or drop a business segment such
as a product or a store.
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Add/Drop Decision
• Example:
– Due to the declining popularity of digital watches,
Lovell Company’s digital watch line has not
reported a profit for several years. The company
is now considering to drop this unprofitable
segment.
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Add/Drop Decision
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)
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Add/Drop Decision
Investigation has revealed that total fixed general factory
overhead and general
administrative expenses would not be affected if the
digital watch line is dropped. The fixed general factory
overhead and general administrative expenses assigned
to this product would be reallocated to other product
lines.
The equipment used to manufacture
digital watches has no resale
value or alternative use.
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Add/Drop Decision
The total approach
Comparative Income Approach Solution
Keep
Drop
Sales
$ 500,000
$
Less variable expenses:
Mfg. expenses
120,000
Freight out
5,000
Commissions
75,000
Total variable expenses
200,000
Contribution margin
300,000
Less fixed expenses:
General factory overhead
60,000
60,000
Salary of line manager
90,000
Depreciation
50,000
50,000
Advertising - direct
100,000
Rent - factory space
70,000
General admin. expenses
30,000
30,000
Total fixed expenses
400,000
140,000
Net loss
$ (100,000)
$ (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)
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Add/Drop Decision
DECISION RULE
Lovell should drop the digital watch segment only if its profit
would increase. This would only happen if the fixed cost
savings exceed the lost contribution margin.
Three types of fixed costs cannot be saved/unavoidable:
1. General factory O/H
2. Depreciation
3. General admin. expenses
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Add/Drop Decision
Incremental Approach
Contribution Margin Solution
Contribution margin lost if digital
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
$ 90,000
Advertising - direct
100,000
Rent - factory space
70,000
Net disadvantage
$ (300,000)
260,000
$ (40,000)
The company should not drop the line!
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Question 11-30
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Disadvantage: loss in revenue
(860,000)
Advantage: cost savings
COGS
660,000
Rent
75,000
Labor costs
42,000
Utilities
46,000
Allocated corp. O/H 44,000 867,000
Incremental income
7,000
Conclusion: Lopez’s statement is correct/incorrect.
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New store
Revenues
Less: Operating costs
COGS
660,000
Rent
75,000
Labor costs
42,000
Depreciation of eq.
22,000
Utilities
46,000
Allocated Corp. O/H
4,000
Incremental income
860,000
849,000
11,000
Conclusion: Lopez’s statement is correct/incorrect.
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