2009 Foster School of Business Cost Accounting L.DuCharme 1

Decision Making andRelevant Information

Chapter 11

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Overview

• Decisions

• Relevant information

• Examples of common decisions

• Opportunity costs

• Capacity constraints

• Replace equipment

• Comprehensive example

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Information and theDecision Process

A decision model is a formal methodfor making a choice, often involvingquantitative and qualitative analysis.

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Five-Step Decision Process

Gather Information

Make Predictions

Choose an Alternative

Implement the Decision

Evaluate Performance

Step 1.

Step 2.

Step 3.

Step 4.

Step 5.

Historical CostsOther Information

Specific Predictions

Fee

db

ack

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Differentiate relevantfrom irrelevant

costs and revenues indecision situations.

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The Meaning of Relevance

Relevant costs and relevant revenues areexpected future costs and revenues that

differ among alternative courses of action.

Historical costs Sunk costs

Differential income Differential costs

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Quantitative and QualitativeRelevant Information

Quantitative factors

Financial Nonfinancial

Qualitative factors

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One-Time-OnlySpecial Order Example

Profit is made if the incremental revenue exceeds incremental costs.

If excess capacity exists, then relevant cost generally equals variable cost to make special order.

Will marketing costs change?

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Two Potential Problems inRelevant-Cost Analysis

Incorrect generalassumptions:

All variable costsare relevant.

All fixed costsare irrelevant.

1 2

Misleadingunit-cost data:

Includeirrelevant costs.

Use same unitcosts at different

output levels.

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Outsourcing versus Insourcing

Outsourcing ispurchasing goodsand services fromoutside vendors.

Insourcing isproducing goods

or providing serviceswithin the organization.

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Make-or-Buy Decisions

This is a very common (frequent) decision made by most organizations.

Purchase managers report three important factors: (1) Quality (2) Supplier dependability (3) Cost

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Make-or-Buy Decisions

In making a “make-or-buy” decision it is often times useful and quick to

compare the cost to outsource versus the costs saved if you outsource.

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Opportunity Costs andOutsourcing

Opportunity cost is the contribution to incomethat is forgone (rejected) by not using a

limited resource in its next-best alternative use.

Generally, opportunity cost is the benefit foregone by not choosing the next best

alternative.

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Opportunity Costs andOutsourcing

Many decisions have an opportunity cost.

What is the opportunity cost for making the decision to come to class today?

Give an example of a decision that had no or zero opportunity cost.

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Capacity Constraints

Deciding whichproducts to produce when there

are capacity constraints.Answer: Produce/sell product(s) with the highest CM/unit of constraint!

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Product-Mix DecisionsUnder Capacity Constraints

Per unit Product #2 Product #3Sales price $2.11 $14.50Variable expenses 0.41 13.90Contribution margin $1.70 $ 0.60Contribution margin ratio 81% 4%

Bismark Co. has 3,000 machine-hours available.

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Product-Mix DecisionsUnder 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 productper machine-hour?

Product #2: $1.70 ÷ 7 = $0.24Product #3: $0.60 ÷ 2 = $0.30

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From a company economic Perspective, the book valueof equipment is irrelevant in

equipment-replacement decisions.

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Conflicts can arisebetween the decision modelused by a manager and the

performance evaluation modelused to evaluate the manager.

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Decisions andPerformance Evaluation

What is the journal entry to sell the existing machine?

Cash $14,000Accumulated Depreciation 50,000Loss on Disposal 16,000 Machine $80,000

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Decisions andPerformance Evaluation

In the real world would the managerreplace the machine?

An important factor in replacement decisionsis the manager’s perceptions of whether thedecision model is consistent with how the

manager’s performance is judged.

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Decisions andPerformance Evaluation

Top management faces a challenge – that is,making sure that the performance-evaluationmodel of subordinate managers is consistent

with the decision model.

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Anatomy of a Decision: Buy a used versus lease a new car

• Example of decision--See spread sheet analysis.

• Quantitative and qualitative analysis—you are only part way done with analysis after the quantitative analysis. Use this as a benchmark against the qualitative factors.

• What qualitative factors have I missed (left out of) in my quantitative analysis?

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End of Chapter 11