Managerial Accounting
by James Jiambalvo
Chapter 7:
The Use of Cost
Information In
Management Decision
Making
Slides Prepared by:
Scott Peterson
Northern State
University
Objectives
1. Explain the role of incremental analysis
(analysis of incremental costs and revenues)
in management decisions.
2. Define sunk cost, avoidable cost, and
opportunity cost and understand how to use
these concepts in analyzing decisions.
3. Analyze decisions involving joint costs.
4. Discuss the importance of qualitative
considerations in management decisions.
Incremental Analysis
1. Incremental Analysis looks at
a. Incremental Revenue
b. Incremental Cost
 a.k.a. Relevant cost
 a.k.a. Differential cost
2. The only thing that matters is what
changes.
When Your Boss Asks… You Should
Say…
1. There is no single cost number that is
relevant for all decisions.
Analysis of Decisions Faced
By Managers
1. Engage in additional processing.
2. Make or Buy.
3. Drop a product line.
Additional Processing
Decision
1. The key is on incremental revenues
and costs.
2. Sunk costs (past costs) are irrelevant.
Additional Processing
Example: (7-1)
PowerComp
Revenue
Less:
Prior production costs
Material
Labor
Variable overhead
Fixed overhead
Additional Processing costs
Material
Labor
Variable overhead
Gain (loss) per unit
Sell in Current
State of Completion
(Alternative 1)
Complete
Processing
(Alternative 2)
Incremental
Revenue
and Costs
(Alternavive 2
minus
Alternative 1)
$500
$1,000
$500
300
200
100
200
800
300
200
100
200
800
0
0
0
0
0
0
0
0
0
($300)
200
100
100
400
($200)
200
100
100
400
$100
Make-Or-Buy Decisions
1. The key is on incremental costs. There
are no incremental revenues.
2. Note that not all fixed costs are
irrelevant.
3. If fixed costs are avoidable, they
should be factored into this decision-just like variable costs.
Make-Or-Buy Decisions:
Example (7-2)
General Refrigeration
Incremental Cost Analysis
Cost of
Cost of
Manufacturing Manufacturing
50,000
50,000
Compressors
Compressors
Variable Costs
Direct Material
Direct Labor
Variable overhead
Total Variable Costs
Fixed Costs
Depreciation of building
Depreciation of equipment
Supervisory salaries
Other
Total Fixed Costs
Cost of buying compressors
Total
Incremental
Cost (Savings
5,000,000
6,000,000
4,000,000
15,000,000
0
0
0
0
5,000,000
6,000,000
4,000,000
15,000,000
600,000
800,000
500,000
350,000
2,250,000
0
17,250,000
600,000
800,000
110,000
350,000
1,860,000
15,500,000
17,360,000
0
0
390,000
0
390,000
-15,500,000
-110,000
Dropping a Product Line
1. The key is on the change in net income
as a result of dropping the product line.
2. If net income increases, do it; if not,
don’t do it!
Dropping a Product Line:
Example Single Step (7-6)
Incremental Analysis
Dropping Garden Supplies
Lost Sales
Cost Savings:
Cost of goods sold
Other variable factors
Direct fixed costs
Total Cost savings
Net loss from dropping
($80,000)
60,000
1,000
3,500
64,500
($15,500)
Beware of the Cost Allocation
Death Spiral!
1. When dropping a product or service,
beware of allocating common fixed
costs.
2. These costs are not incremental and are
therefore irrelevant.
3. They just end up being allocated to other
products which in turn may appear
unprofitable.
4. Beware!
Summary of Incremental,
Avoidable, Sunk, and
Opportunity Costs
1.
2.
3.
4.
Incremental Cost
Avoidable Cost
Sunk Cost
Opportunity Cost
Decisions Involving Joint
Costs
1. Joint products
2. Joint costs
3. Example: raw milk is processed into the
following joint products: cream, skim
milk and whole milk.
4. The stage of production at which
individual products are identified is
called the split-off-point.
Allocation of Joint Costs
1. Common input costs must be allocated
to joint products for financial reporting
purposes.
2. Joint costs are not relevant to
individual products beyond the split-offpoint.
3. Joint costs are relevant to decisions
involving the joint products as a group.
Decisions Involving Joint
Costs: Another Example
Additional Processing
Decisions And Joint Costs
1. Joint costs are not relevant to the
decision.
2. At the split-off-point, the only factors
that matter are additional revenues
and additional costs.
3. Joint costs incurred prior to the split-off
point are sunk and don’t change.
Qualitative Considerations In
Decision Analysis
1. The non-monetary factors are also
important to the decision analysis.
2. Some fixed costs continue regardless.
3. Morale may be affected.
4. Outsourcing can be more flexible.
5. With outsourcing, a certain level of
control is lost.
Appendix: The Theory of
Constraints (TOC)
The Five-Step Process:
 Identify the binding constraint.
 Optimize use of the constraint.
 Subordinate everything to the
constraint.
 Break the constraint.
 Identify a new binding constraint.
Appendix: Implications for
Inspections, Batch Sizes, and
Across the Board Cuts
1. Inspections: should take place before
transfer to the constrained department.
2. Batch Sizes: when the production
process IS the binding constraint,
large batches may be beneficial.
3. Across the Board Cuts: labor/cost cuts
should be precise. General, across the
board cuts involving cuts to the
constrained department have negative
profit affects.
Appendix: “You Get What You
Measure”
Performance measures drive the behavior
of managers.
Quick Review Question #1
1. Which of the following is often not a
differential cost?
a. Material.
b. Labor.
c. Variable overhead.
d. Fixed overhead.
Quick Review Answer #1
1. Which of the following is often not a
differential cost?
a. Material.
b. Labor.
c. Variable overhead.
d. Fixed overhead.
Quick Review Question #2
2. Opportunity costs are:
a. Never incremental costs.
b. Always incremental costs.
c. Sometimes sunk costs.
d. None of the above.
Quick Review Answer #2
2. Opportunity costs are:
a. Never incremental costs.
b. Always incremental costs.
c. Sometimes sunk costs.
d. None of the above.
Quick Review Question #3
3. Which of the following should not be
taken into consideration when making
a decision?
a. Opportunity costs.
b. Sunk costs.
c. Relevant costs.
d. Differential costs.
Quick Review Answer #3
3. Which of the following should not be
taken into consideration when making
a decision?
a. Opportunity costs.
b. Sunk costs.
c. Relevant costs.
d. Differential costs.
Quick Review Question #4
4. 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. None of the above.
Quick Review Answer #4
4. 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. None of the above.
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