Managerial Accountingby James Jiambalvo

Chapter 7:

The Use of Cost Information In

Management Decision Making

Slides Prepared by:Scott PetersonNorthern 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 ata. Incremental Revenueb. 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)

RevenueLess:Prior production costs Material Labor Variable overhead Fixed overhead

Additional Processing costs Material Labor Variable overhead

Gain (loss) per unit

Sell in CurrentState of Completion

(Alternative 1)

CompleteProcessing

(Alternative 2)

IncrementalRevenueand Costs

(Alternavive 2minus

Alternative 1)

$500

300200100200800

0000

($300)

$1,000

300200100200800

200100100

00

200100100400

$100

PowerComp

400($200)

$500

000

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)

Variable Costs Direct Material Direct Labor Variable overheadTotal Variable CostsFixed Costs Depreciation of building Depreciation of equipment Supervisory salaries OtherTotal Fixed CostsCost of buying compressors Total

Incremental Cost Analysis

5,000,0006,000,0004,000,000

800,000

15,500,00017,360,000

00

-15,500,000-110,000

000

600,000800,000

15,000,000

017,250,000

5,000,0006,000,0004,000,000

600,000

CompressorsIncremental

Cost (Savings

390,0000

390,000

500,000350,000

2,250,000

110,000350,000

1,860,000

General Refrigeration

Cost of Cost of

15,000,0000

Manufacturing50,000

Compressors

Manufacturing50,000

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)

Lost SalesCost Savings: Cost of goods sold 60,000 Other variable factors Direct fixed costsTotal Cost savingsNet loss from dropping ($15,500)

1,0003,500

Dropping Garden Supplies

Incremental Analysis

64,500

($80,000)

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. Incremental Cost

2. Avoidable Cost

3. Sunk Cost

4. 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-off-point.

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.

Copyright

© 2004 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.