Chapter 7
The Use of Cost Information in
Management Decision Making
Presentation Outline
I. Incremental Analysis
II. Three Decision Managers Frequently
Face
III. Decisions Involving Joint Costs
IV. Qualitative Considerations in
Management Decisions
V. The Theory of Constraints (TOC)
I. Incremental Analysis
Incremental or differential revenue – additional
revenue received as a result of selecting one
decision alternative over another.
Incremental or differential cost – additional cost
incurred as a result of selecting one decision
alternative over another.
To answer the question of how much something
costs, a manager must know why the person wants
to know. No single cost number is relevant for all
decisions.
II. Three Decisions Managers
Frequently Face
A. Additional Processing Decision
B. Make or Buy Decision
C. Dropping a Product Line Decision
D. Summary of Concepts
A. Additional Processing Decision
Material
Labor
Variable O/H
Fixed O/H
Costs per
Unit
Incurred to
Date
$300
200
100
200
Totals
$800
Costs per
Unit to
Complete
$200
100
100
$400
PowerComp Company has partially processed computers for
Model 250 that they are discontinuing. This has caused a
decline of the selling price. If the units are completed, they
can be sold for $1,000 per unit. That is less than the total cost
of producing the computers -- $1,200 per unit ($800 cost to
date plus $400 of additional cost to complete the units).
The Alternatives:
1. Sell the units as is for $500
each and avoid incurring any
additional processing costs.
2. Complete the units and sell
them for $1,000 each.
The Solution:
The prior production costs are a sunk
cost since they have already been
incurred. Therefore, the only relevant
cost is the $400 in additional
processing costs to complete each unit.
Since this is less than the incremental
revenue of $500 ($1,000 - $500), the
units should be processed further.
B. Make or Buy Decision
Cost of Manufacturing 50,000 Compressors
Variable costs
Direct material ($100 per unit)
Direct labor ($120 per unit)
Variable overhead ($80 per unit)
Total variable cost
Fixed costs
Depreciation of building
Depreciation of equipment
Supervisory salaries
Other
Total fixed costs
Total cost
Cost per unit to make
$5,000,000
6,000,000
4,000,000
15,000,000
600,000
800,000
500,000
350,000
2,250,000
$17,250,000
$345
Should the organization buy the compressors from an outside
source at a cost of $310 per unit?
Additional Cost Analysis
The market value of the machinery used to produce the
compressors is approximately zero.
Five of the six production supervisors will be fired if
production of compressors is discontinued. However, one
of the supervisors, who has more than 10 years of service, is
protected by a clause in a labor contract, and will be
assigned to other duties, although his services are not really
needed. His salary is $110,000.
If production of compressors is discontinued, the company
can use the space to store shelving that they are currently
renting space for at a cost of $500,000 per year.
The Solution
Incremental Cost Analysis
Cost of buying compressors outside
(50,000 units @ $310)
Cost savings (avoidable if compressors
are purchased outside)
Variable costs
Supervisory salaries
(salaries of 5 of 6 supervisors)
Opportunity cost of using the plant to
produce compressors (forgone rent
savings)
Net savings resulting from buying the
compressors outside
$15,500,000
$15,000,000
390,000
500,000
$15,890,000
$390,000
C. Dropping a Product Line Decision
Product Line Income Statement
Sales
Cost of goods sold
Gross margin
Other variable costs
Contribution margin
Direct fixed costs
Allocated fixed costs
Total fixed costs
Net income (loss)
Tools
$120,000
81,000
39,000
2,000
37,000
8,000
24,000
32,000
$5,000
Hardware
Supplies
$200,000
90,000
110,000
4,000
106,000
5,000
40,000
45,000
$61,000
Garden
Supplies
$80,000
60,000
20,000
1,000
19,000
3,500
16,000
19,500
-$500
Total
$400,000
231,000
169,000
7,000
162,000
16,500
80,000
96,500
$65,500
Should the Garden Supplies product line be dropped since
it is showing a net loss of $500?
Additional Cost Analysis
Sales revenue will decline by $80,000 if garden supplies
are dropped.
Cost of goods sold will decrease by $60,000, and other
variable costs will decrease by $1,000.
Direct costs are directly traceable to a product line.
Whether they decrease depends on the nature of these
costs. Since the $3,500 represents a part-time employee
who will be dropped if garden supplies is dropped, this
cost is avoidable.
Allocated fixed costs are not directly traceable to an
individual product line. Therefore, these costs are
generally not avoidable.
The Solution
Incremental Analysis
Dropping Garden Supplies
Lost sales
$80,000
Cost savings:
Cost of goods sold
60,000
Other variable costs
1,000
Direct fixed costs
3,500
Total cost savings
64,500
Net loss from dropping
($144,500)
Cost Allocation Death Spiral
In many cases, products or
services may not appear
profitable because they
receive allocations of
common fixed costs.
 However, if the product or
service is dropped common
fixed costs are reallocated
to the remaining product or
services.
 This may result in another
product or service
appearing unprofitable.
D. Summary of Concepts
Costs that can be avoided by taking a particular course of
action are always incremental costs and, therefore, relevant
to the analysis of a decision.
Costs that are sunk are never incremental costs and
therefore are not relevant in making a decision.
Opportunity costs represent the benefit forgone by selection
a particular decision alternative over another. There are
always incremental costs and therefore relevant.
Fixed costs may be:
 Sunk and therefore irrevelant
 Not sunk but still irrelevant
 Not sunk but relevant
(See Illustration 7-7 on page 246)
III. Decisions Involving Joint
Costs
A. Terminology
B. Allocating Joint Costs Using Physical
Quantity
C. Allocating Joint Costs Using Relative
Sales Value
D. Additional Processing Decisions
Involving Joint Costs
A. Terminology
 Joint Products – two or more products that always result from
common inputs.
 Joint Costs – costs of common inputs up to the split-off point.
 Split-off Point – stage of production at which individual products
are identified. Beyond this point each product may undergo
further separate processing and may incur additional costs.
Split-Off
Point
Joint Cost (Common
Input Process)
Cost of log $600
Cost of sawing 20
Grade A
Lumber
Grade B
Lumber
500 board
feet selling
for $1.00 per
foot
500 board
feet selling
for $.50 per
foot
B. Allocating Joint Cost Using Physical Quantity
Grade A
Sales revenue
A: 500 board feet x $1.00
B: 500 board feet x $ .50
$500.00
Joint cost allocation:
A: $620 joint cost x (500 board feet / 1,000 board feet)
B: $620 joint cost x (500 board feet / 1,000 board feet)
$310.00
Gross margin
$190.00
Grade B
$250.00
$310.00
-$60.00
This allocation could lead managers to think that grade B lumber is
not profitable and should be scrapped. But this logic is faulty. If
grade B lumber were scrapped, the company would lose $250 that
helped cover the joint cost of $620.
C. Allocating Joint Cost Using Relative Sales Value
Grade A
Sales revenue
A: 500 board feet x $1.00
B: 500 board feet x $ .50
$500.00
Joint cost allocation:
A: $620 joint cost x ($500 sales / $750 total sales)
B: $620 joint cost x ($250 sales / $750 total sales)
$413.33
Gross margin
$86.67
Grade B
$250.00
$206.67
$43.33
A good feature of this method is that the amount of joint cost
allocated to a product cannot exceed its sales value at the split-off
point.
D. Additional Processing Decisions Involving Joint Costs
Grade B lumber can be sold at the split-off point for $.50 per board
or pressure treated for an additional $.20 per board and sold for
$.75 per board. Note that the additional processing should occur
since the incremental revenue of $.25 ($.75 - $.50) is greater than
the additional processing cost of $.20, regardless of the amount of
the joint cost allocation. Joint costs are not incremental and are
therefore never relevant in further processing decisions.
Split-Off
Point
Joint Cost (Common
Input Process)
Cost of log $600
Cost of sawing 20
Grade A
Lumber
Grade B
Lumber
500 board
feet selling
for $1.00 per
foot
500 board
feet selling
for $.50 per
foot
IV. Qualitative Considerations in
Management Decisions
A variety of qualitative
factors (e.g., quality of
goods, employee morale,
and customer service)
need to be considered in
making a decision.
Qualitative factors are
often even more
important than costs and
benefits that are easy to
quantify.
V. The Theory of Constraints
(TOC)
A. Theory of Constraints Defined
B. An Illustration of the Five-Step Process of
TOC
C. Some Implications for TOC
D. Overproduction Incentives for
Nonbottleneck Departments
A. Theory of Constraints Defined
Theory of constraints
recognizes that large
increases in profit can be
achieved by elimination
of bottlenecks in
production processes. It
is an approach to
production and
constraint management.
B. An Illustration of the Five
Step Process of TOC
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
1. Identify the Binding Constraint
A bottleneck or binding constraint is a process that
limits throughput (the amount of inventory
produced in a period). Assume that Department 3
is a bottleneck.
Department 1
Produce
Subassembly
Department 2
Produce
Subassembly
Department 3
Make and Test
Connections,
Install Housing
Units
Department 4
Test,
Package,
and Ship
2. Optimize Use of the Constraint
Produce products with the highest contribution
margin per unit of constraint.
Selling price per unit
Variable costs per unit:
Direct materials
Direct labor
Contribution margin per unit
Fixed costs per unit
Profit per unit
Time to complete 1 unit in Dept. 3
Contribution margin per hour in Dept. 3
Model A70
$1,000
Model B90
$2,000
400
200
400
100
300
900
300
800
300
500
.1 hour
$4,000
.3 hour
$2,667
If managers face a choice between using scarce time in Department 3
to produce Model A70 or Model B90, they should definitely
maximize production of Model A70 first.
3. Subordinate Everything Else to the Constraint
Managers should focus their time on trying to loosen
the constraint and not concentrate on improvements in
other departments.
For example, why should managers improve processes
in 1, 2, or 4 if they are not limiting production.
Many things may loosen constraints. For example, if
workers in Dept 3 all take breaks at the same time,
capacity could be gained by staggering breaks.
4. Break the Constraint
This can be accomplished in many ways:
Cross-train workers in Depts. 1 and 2 so they can help
out in Dept. 3
Outsource some of Dept. 3’s work.
Purchase additional equipment for Dept. 3
Hire additional workers for Dept. 3
Train workers in Dept. 3 so that they can perform their
jobs more efficiently.
5. Identify a New Binding
Constraint
Once the constraint is
broken in Dept. 3,
either Dept. 1, 2, or 4
will be come a
bottleneck.
Or, if the company has
excess capacity in all
departments, it should
focus its attention on
building demand.
C. Some Implications of TOC
Inspections – inspections should take place before work
is transferred to a constrained department. Valuable
time of the constrained department should not be
wasted on defective items.
Batch sizes – although many companies are going to
small batch sizes to reduce defects and achieve
flexibility, using larger batch sizes in constrained
departments can avoid wasted time in numerous
machine setups for small production runs.
Across the board cuts – although cuts in nonbottleneck
departments can make sense, cuts in departments with a
binding constraint can have a severe impact on profit.
D. Overproduction Incentive for
Nonbottleneck Departments
Incentives for greater production in nonbottleneck
departments should be avoided when there is a
bottleneck department.
For example, if Depts. 1 and 2 are rewarded for
more production, it will do little if inventory is
accumulating in front a Dept. 3
Summary

Only incremental costs and revenues are relevant in making
management decisions.

Sunk costs are irrelevant in deciding whether to further
process a good.

Nonavoidable costs are irrelevant in make-or-buy decisions.

Common costs among product lines are generally
nonavoidable.

Opportunity costs are relevant in choosing among decision
alternative.

Joint Costs are irrelevant in additional processing decisions

Management Decisions must consider qualitative
characteristics

Focus process improvements on bottlenecks first.