Decision Making and
Relevant Information
Chapter 11
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Learning Objective 1
Use the five-step decision
process to make decisions.
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Information and the
Decision Process
A decision model is a formal method
for making a choice, often involving
quantitative and qualitative analysis.
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Feedback
Five-Step Decision Process
Step 1.
Gather Information
Historical Costs
Other Information
Step 2.
Make Predictions
Specific Predictions
Step 3.
Choose an Alternative
Step 4. Implement the Decision
Step 5. Evaluate Performance
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Learning Objective 2
Differentiate relevant
from irrelevant
costs and revenues in
decision situations.
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The Meaning of Relevance
Relevant costs and relevant revenues are
expected future costs and revenues that
differ among alternative courses of action.
Historical costs
Sunk costs
Differential income
Differential costs
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Learning Objective 3
Distinguish between quantitative
and qualitative factors in decisions.
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Quantitative and Qualitative
Relevant Information
Quantitative factors
Financial
Nonfinancial
Qualitative factors
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One-Time-Only
Special Order Example
The Bismark Co. manufacturing plant has a
production capacity of 44,000 towels each month.
Current monthly production is 30,000 towels.
Costs can be classified as either variable or fixed
with respect to units of output.
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One-Time-Only
Special Order Example
Direct materials
Direct labor
Manufacturing costs
Total
Variable
Costs
Per Unit
$6.50
.50
1.50
$8.50
Fixed
Costs
Per Unit
$ -01.50
3.50
$5.00
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One-Time-Only
Special Order Example
Total fixed direct manufacturing labor is $45,000.
Total fixed overhead is $105,000.
Marketing costs per unit are $7
($5 of which is variable).
What is the full cost per towel?
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One-Time-Only
Special Order Example
Variable ($8.50 + $5.00):
Fixed:
Total
$13.50
7.00
$20.50
A hotel in San Juan has offered to buy
5,000 towels from Bismark Co. at
$11.50/towel for a total of $57,500.
No marketing costs will be incurred.
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One-Time-Only
Special Order Example
What are the relevant costs of making the towels ?
$8.50 × 5,000 = $42,500 incremental costs
What are the incremental revenues ?
$57,500 – $42,500 = $15,000
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Learning Objective 4
Beware of two potential
problems in
relevant-cost analysis.
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Two Potential Problems in
Relevant-Cost Analysis
1
Incorrect general
assumptions:
All variable costs
are relevant.
All fixed costs
are irrelevant.
2
Misleading
unit-cost data:
Include
irrelevant costs.
Use same unit
costs at different
output levels.
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Outsourcing versus Insourcing
Outsourcing is
purchasing goods
and services from
outside vendors.
Insourcing is
producing goods
or providing services
within the organization.
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Make-or-Buy Decisions Example
Bismark Co. also manufactures bath accessories.
Management is considering producing a part it
needs (#2) or buying a part produced
by Towson Co. for $0.55.
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Make-or-Buy Decisions Example
Bismark Co. has the following costs
for 150,000 units of Part #2:
Direct materials
$ 28,000
Direct labor
18,500
Mixed overhead
29,000
Variable overhead
15,000
Fixed overhead
30,000
Total
$120,500
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Make-or-Buy Decisions Example
Mixed overhead consists of material
handling and setup costs.
Bismark Co. produces the 150,000 units
in 100 batches of 1,500 units each.
Total material handling and setup costs
equal fixed costs of $9,000 plus variable
costs of $200 per batch.
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Make-or-Buy Decisions Example
What is the cost per unit for Part #2?
$120,500 ÷ 150,000 units = $0.8033/unit
Should Bismark Co. manufacture the part
or buy it from Towson Co.?
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Make-or-Buy Decisions Example
Bismark Co. anticipates that next year the
150,000 units of Part #2 expected to be
sold will be manufactured in 150
batches of 1,000 units each.
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Make-or-Buy Decisions Example
Variable costs per batch are expected to
decrease to $100.
Bismark Co. plans to continue to produce
150,000 next year at the same variable
manufacturing costs per unit as this year.
Fixed costs are expected to remain the
same as this year.
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Make-or-Buy Decisions Example
What is the variable manufacturing cost per unit?
Direct material
Direct labor
Variable overhead
Total
$28,000
18,500
15,000
$61,500
$61,500 ÷ 150,000 = $0.41 per unit
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Make-or-Buy Decisions Example
Expected relevant cost to make Part #2:
Manufacturing
Material handling and setups
Total relevant cost to make
*150 × $100 = $15,000
$61,500
15,000*
$76,500
Cost to buy: (150,000 × $0.55) $82,500
Bismark Co. will save $6,000 by making the part.
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Make-or-Buy Decisions Example
Now assume that the $9,000 in fixed clerical
salaries to support material handling and
setup will not be incurred if Part #2 is
purchased from Towson Co..
Should Bismark Co. buy the part or make the part?
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Make-or-Buy Decisions Example
Relevant cost to make:
Variable
Fixed
Total
Cost to buy:
$76,500
9,000
$85,500
$82,500
Bismark would save $3,000 by buying the part.
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Learning Objective 5
Explain the opportunity-cost
concept and why it is
used in decision making.
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Opportunity Costs,
Outsourcing, and Constraints
Assume that if Bismark buys the part from
Towson, it can use the facilities previously
used to manufacture Part #2 to produce
Part #3 for Krysta Company.
The expected additional future operating
income is $18,000.
What should Bismark Co. do?
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Opportunity Costs,
Outsourcing, and Constraints
Bismark Co. has three options regarding Krysta:
1. Make Part #2 and do not make Part #3.
2. Buy Part #2 and do not make Part #3.
3. Buy the part and use the facilities to produce
Part #3.
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Opportunity Costs,
Outsourcing, and Constraints
Expected cost of obtaining 150,000 parts:
Buy Part #2 and do not make Part #3: $82,500
Buy Part #2 and make Part #3:
$82,500 – $18,000 =
Make Part #2:
$64,500
$76,500
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Opportunity Costs,
Outsourcing, and Constraints
Opportunity cost is the contribution to income
that is forgone (rejected) by not using a
limited resource in its next-best alternative use.
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Opportunity Costs,
Outsourcing, and Constraints
Assume that annual estimated Part #2
requirements for next year is 150,000.
Cost per purchase order is $40.
Cost per unit when each purchase is
1,500 units = $0.55.
Cost per unit when each purchase is equal
to or greater than 150,000 = $0.54.
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Opportunity Costs,
Outsourcing, and Constraints
Average investment in inventory is either:
(1,500 × .55) ÷ 2 = $412.50 or
(150,000 × $0.54) = $40,500
Annual interest rate for investment in
government bonds is 6%.
$412.50 × .06 = $24.75
$40,500 × .06 = $2,430
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Opportunity Costs,
Outsourcing, and Constraints
Option A: Make 100 purchases of 1,500 units:
Purchase order costs: (100 × $40)
$ 4,000.00
Purchase costs: (150,000 × $0.55) $82,500.00
Annual interest income:
$
Relevant costs:
$86,524.75
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Opportunity Costs,
Outsourcing, and Constraints
Option B: Make 1 purchase of 150,000 units:
Purchase order costs: (1 × $40)
$
Purchase costs: (150,000 × $0.54)
$81,000
Annual interest income:
$ 2,430
Relevant costs:
$83,470
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Learning Objective 6
Know how to choose which
products to produce when there
are capacity constraints.
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Product-Mix Decisions
Under Capacity Constraints
Per unit
Product #2 Product #3
Sales price
$2.11
$14.50
Variable expenses
0.41
13.90
Contribution margin
$1.70
$ 0.60
Contribution margin ratio 81%
4%
Bismark Co. has 3,000 machine-hours available.
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Product-Mix Decisions
Under Capacity Constraints
One unit of Prod. #2 requires 7 machine-hours.
One unit of Prod. #3 requires 2 machine-hours.
What is the contribution of each product
per machine-hour?
Product #2: $1.70 ÷ 7 = $0.24
Product #3: $0.60 ÷ 2 = $0.30
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Learning Objective 7
Discuss what managers
must consider when
adding or discontinuing
customers and segments.
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Profitability, Activity-Based
Costing, and Relevant Costs
Mountain View Furniture supplies furniture
to two local retailers – Stevens and Cohen.
The company has a monthly capacity
of 3,000 machine-hours.
Fixed costs are allocated on the basis of revenues.
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Profitability, Activity-Based
Costing, and Relevant Costs
Revenues
Variable costs
Fixed costs
Total operating costs
Operating income
Machine-hours required
Stevens Cohen
$200,000 $100,000
70,000
60,000
100,000
50,000
$170,000 $110,000
$ 30,000 $(10,000)
2,000
1,000
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Profitability, Activity-Based
Costing, and Relevant Costs
Revenues
Variable costs
Fixed costs
Total operating costs
Operating income
Machine-hours required
Total
$300,000
130,000
150,000
$280,000
$ 20,000
3,000
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Profitability, Activity-Based
Costing, and Relevant Costs
Should Mountain View Furniture drop the Cohen
business, assuming that dropping Cohen would
decrease its total fixed costs by 10%?
New fixed costs would be:
$150,000 – $15,000 = $135,000
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Profitability, Activity-Based
Costing, and Relevant Costs
Revenues
Variable costs
Fixed costs
Total operating costs
Operating income
Machine-hours required
Stevens Alone
$200,000
70,000
135,000
$205,000
$ (5,000)
3,000
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Profitability, Activity-Based
Costing, and Relevant Costs
Cohen’s business is providing a
contribution margin of $40,000.
$40,000 decrease in contribution margin
– $15,000 decrease in fixed costs
= $25,000 decrease in operating income.
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Profitability, Activity-Based
Costing, and Relevant Costs
Assume that if Mountain View Furniture drops
Cohen’s business it can lease the excess capacity
to the Perez Corporation for $70,000.
Fixed costs would not decrease.
Should Mountain View Furniture lease to Perez?
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Learning Objective 8
Explain why the book value
of equipment is irrelevant in
equipment-replacement decisions.
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Equipment-Replacement
Decisions Example
Existing Replacement
Machine Machine
Original cost
$80,000 $105,000
Useful life
4 years
4 years
Accumulated depreciation $50,000
Book value
$30,000
Disposal price
$14,000
Annual costs
$46,000 $ 10,000
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Equipment-Replacement
Decisions Example
Ignoring the time value of money and
income taxes, should the company
replace the existing machine?
The cost savings over a 4-year period will be
$36,000 × 4 = $144,000.
Investment = $105,000 – $14,000 = $91,000
$144,000 – $91,000 = $53,000
advantage of the replacement machine.
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Learning Objective 9
Explain how conflicts can arise
between the decision model
used by a manager and the
performance evaluation model
used to evaluate the manager.
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Decisions and
Performance Evaluation
What is the journal entry to sell the existing machine?
Cash
Accumulated Depreciation
Loss on Disposal
Machine
14,000
50,000
16,000
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80,000
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Decisions and
Performance Evaluation
In the real world would the manager
replace the machine?
An important factor in replacement decisions
is the manager’s perceptions of whether the
decision model is consistent with how the
manager’s performance is judged.
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Decisions and
Performance Evaluation
Top management faces a challenge – that is,
making sure that the performance-evaluation
model of subordinate managers is consistent
with the decision model.
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End of Chapter 11
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