14-1
Chapter
Eight
Short term Decision Making:
Relevant Costs and Benefits
McGraw-Hill/Irwin
The Managerial Accountant’s Role
in Decision Making
Managerial
Accountant
Designs and implements
accounting information
system
Cross-functional
management teams
who make
production, marketing,
and finance decisions
Make substantive
economic decisions
affecting operations
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14-3
Relevant Information
Information is relevant to a decision
problem when . . .
It has a bearing on the future,
It differs among competing alternatives.
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14-4
Identifying Relevant
Costs and Benefits
Costs and revenues
Revenue
Total costs
Variable costs
Fixed costs
Units
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14-5
Identifying Relevant
Costs and Benefits
Sunk costs
Costs that have already been incurred.
They do not affect any future cost and
cannot be changed by any current or
future action.
Sunk costs are irrelevant to decisions.
McGraw-Hill/Irwin
14-6
Relevant Costs: example
You live in King City. You come to class with the GO
although you have a car.
A classmate that also lives in King City is willing to come
with you in your car and pay 1.25 times the GO fare.
Current Situation:
Costs: Go bus = 4.45
Alternative situation:
Revenues: 1.25 times the GO bus fare = 5.55
Costs: Gas 1 litre = 1.15
Insurance …………….?
Lease payments ………?
McGraw-Hill/Irwin
Maximum
total costs per
trip: $10
Decision rule:
YES if CMg > 0
14-7
Distortions in Company Reporting
Accrual accounting (meaning of depreciation)
Full cost reporting
See Exhibit 8.1 (page 177):
Full costs $2.25
Proposed selling price $2
Is the new customer offer worthwhile?
Decision rule:
YES if CMg > 0
McGraw-Hill/Irwin
Calculate the
variable costs and
contribution
margin
14-8
Analysis of Special Decisions
Let’s take a close look at some special
decisions faced by many businesses.
We just received
a special order. Do
you think we should
accept it?
McGraw-Hill/Irwin
14-9
Accept or Reject a Special Order
A travel agency offers Worldwide Airways
$150,000 for a round-trip flight from Hawaii to
Japan on a jumbo jet.
Worldwide usually gets $250,000 in 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.
McGraw-Hill/Irwin
14-10
Accept or Reject a Special Order
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.
McGraw-Hill/Irwin
14-11
Accept or Reject a Special Order
Assumes 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.
McGraw-Hill/Irwin
14-12
Accept or Reject a Special Order
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?
McGraw-Hill/Irwin
14-13
Accept or Reject a Special Order
Assumes 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.
McGraw-Hill/Irwin
14-14
Decisions Involving Limited
Resources
Firms often face the problem of deciding how
limited resources are going to be used.
Usually, fixed costs are not affected by this
decision, so management can focus on
maximizing total contribution margin.
Let’s look at the following example.
McGraw-Hill/Irwin
14-15
Limited Resources
Let’s calculate the contribution margin per unit of
the scarce resource.
Products
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute
÷
Highs
Webs
$
24
$
15
1.00 min. ÷
0.50 min.
$
24 min.
$
30 min.
Highs should be emphasized. It is the more valuable
use of the scarce resource the lathe, yielding a
contribution margin of $30 per minute as opposed to
$24 per minute for the Webs.
If there are no other considerations, the best plan would
be to produce to meet current demand for Highs and
then use any capacity that remains to make Webs.
McGraw-Hill/Irwin
14-16
Accept or Reject a Special Order
With excess capacity . . .

Relevant costs usually will be the variable
costs associated with the special order.
Decision rule: YES if CMg > 0
Without excess capacity . . .

Same as above but opportunity cost of using
the firm’s facilities for the special order are
also relevant.
Decision rules: YES if CMg – Opportunity cost > 0
YES if not the worst CMg
McGraw-Hill/Irwin
14-17
Outsource a Product or Service
A decision concerning whether an item
should be produced internally or
purchased from an outside supplier is
often called a “make or buy” decision.
Let’s look at another decision faced by the
management of Worldwide Airways.
McGraw-Hill/Irwin
14-18
Outsource a Product or Service
 An Atlanta bakery has offered to supply the inflight desserts for 21¢ each.
 Here are Worldwide’s current cost for desserts:
Variable costs:
Direct material
Direct labor
Variable overhead
Fixed costs:
Supervisory salaries
Depreciation of equipment
Total cost per dessert
McGraw-Hill/Irwin
$
$
0.06
0.04
0.04
0.04
0.07
0.25
14-19
Outsource a Product or Service
Not all of the allocated fixed costs will be saved
if Worldwide purchases from the outside bakery.
Cost per
Dessert
Variable costs:
Direct material
$
Direct labor
Variable overhead
Fixed costs:
Supervisory salaries
Equipment depreciation
Total cost per dessert
$
McGraw-Hill/Irwin
0.06
0.04
0.04
0.04
0.07
0.25
Savings from
Outsourcing
$
$
0.06
0.04
0.04
0.01
0.15
14-20
Outsource a Product or Service
If Worldwide purchases the dessert for 21¢, it
will only save 15¢ so Worldwide will have a
loss of 6¢ per dessert purchased.
Wow, that’s
no deal!
McGraw-Hill/Irwin
14-21
Outsource a Product or Service
Beware of Unit-Cost Data
For decision-making purposes, unitized fixed
costs can be misleading.
McGraw-Hill/Irwin
14-22
Add or Drop a Service,
Product, or Department
One of the most important decisions
managers make is whether to add or drop
a product, service or department.
Let’s look at how the concept of relevant
costs should be used in such a decision.
McGraw-Hill/Irwin
14-23
Add or Drop a Product
Due to the declining popularity of digital
watches, Swick Company’s digital watch line
has not reported a profit for several years.
If the digital watch line is dropped,
the fixed general factory overhead
and general administrative expenses
will be allocated to other product
lines because they are not avoidable.
The equipment used to manufacture digital
watches has no resale value or alternative use.
McGraw-Hill/Irwin
14-24
Add or Drop a Product
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
McGraw-Hill/Irwin
Keep
Watch
$ 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
Watch
Difference
14-25
Add or Drop a Product
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
McGraw-Hill/Irwin
Keep
Watch
$ 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
Watch
$
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)
14-26
Summary
Summary
Contribution margin lost if digital
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
260,000
$ (40,000)
DECISION RULE
Swick should drop the digital watch segment
only if its fixed cost savings exceed lost
contribution margin.
McGraw-Hill/Irwin
8
14-27
Chapter Eight
Short term Decision Making:
Relevant Costs and Benefits
Next chapters
Long term
All costs are variable, therefore
decisions:
all costs are relevant.
McGraw-Hill/Irwin
14-28
After the break:
Discuss questions 2 & 10 + problem 10
Discuss and solve problems 2, 4 and 5
Next class:
Second mid term exam
Chapters 6, 7 and 8
Format: multiple
choices
McGraw-Hill/Irwin