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Slide 7-2
CHAPTER 7CHAPTER 7CHAPTER 7CHAPTER 7
Use of Cost Information in Management Decision
Making
Use of Cost Information in Management Decision
Making
Slide 7-3
Incremental AnalysisIncremental AnalysisIncremental AnalysisIncremental Analysis
Incremental RevenueAdditional revenue received by selecting one alternative over another
Incremental CostAdditional cost incurred by selecting one alternative over another
Incremental ProfitDifference between incremental revenue and incremental cost
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-4
Incremental AnalysisIncremental AnalysisIncremental AnalysisIncremental Analysis
An alternative that yields an incremental profit should be selected
Incremental costs are referred to as relevant costs
Also called differential costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-5
Incremental Analysis Incremental Analysis ExampleExample
Incremental Analysis Incremental Analysis ExampleExample
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-6
Incremental AnalysisIncremental AnalysisIncremental AnalysisIncremental Analysis
Incremental Analysis can be extended to more than two alternatives
Calculate profit for each alternative
The alternative with the highest profit is the best alternative
Difference between its profit and the profit of any other alternative is its incremental profit
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-7
““What Does This Product What Does This Product Cost?”Cost?”
““What Does This Product What Does This Product Cost?”Cost?”
Answer: Why do you want to know?
No single cost number is relevant for all decisions
Must find incremental information that is applicable to the decision- Some costs will change due to the decision, some will not
- Only costs that change are relevant
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-8
Analysis of Decisions Faced Analysis of Decisions Faced by Managersby Managers
Analysis of Decisions Faced Analysis of Decisions Faced by Managersby Managers
Three decisions that managers frequently face:
1.Additional processing of a product2.Make or buy a product3.Drop a product line
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-9
Additional Processing of a Additional Processing of a ProductProduct
Additional Processing of a Additional Processing of a ProductProduct
Manufacturers must occasionally decide whether to:- Sell partially complete product, or- Incur additional costs to complete
Costs incurred to date of decision on partially complete product are not relevant, i.e sunk costs.
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-10
Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example
Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example
Summary of cost information
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-11
Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example
Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example
Incremental analysis summary
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Sell Partially Complete
Sell Fully Complete Incremental
Revenue $500 $1,000 $500 aPrior Production Costs (800) (800) 0Additional Processing Costs 0 (400) (400) bGain (loss) per unit ($300) ($200) $100 c
a. Incremental revenue associated with alternative 2b. Incremental cost associated with alternative 2c. Incremental profit associated with alternative 2
Slide 7-12
Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example
Additional Processing Decision Additional Processing Decision – Bridge Computer Example– Bridge Computer Example
Incremental analysis summary Incremental revenues are $500 Incremental costs are $400 Would you spend $400 to generate
an additional $500?
Answer: Yes, incremental profit is $100
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-13
Additional Processing DecisionAdditional Processing DecisionAdditional Processing DecisionAdditional Processing Decision
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-14
Make or Buy DecisionsMake or Buy DecisionsMake or Buy DecisionsMake or Buy Decisions
Decision involves no incremental revenues
Analysis concentrates solely on incremental costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-15
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration Example
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration Example
Additional information: If purchased, cost savings include $390,000 in
supervisory salaries and all variable costs. Market value of production machinery is zero
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-16
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration Example
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration ExampleIncremental cost analysis – 3 column format
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-17
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration Example
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration Example
Incremental cost analysis - single column format
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-18
Make-or-Buy DecisionsMake-or-Buy DecisionsMake-or-Buy DecisionsMake-or-Buy Decisions
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-19
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration Example
Make-or-Buy Decisions – Make-or-Buy Decisions – General Refrigeration ExampleGeneral Refrigeration ExampleIncremental cost analysis with opportunity costs
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-20
Evelyn’s farm has two alternatives for the sale of 100 pounds of cucumbers1. Sell as-is (raw) for $0.79 per pound2. Pickle (process) and sell for $6.99 per
poundAdditional pickling costs per pound: materials $1.50; labor $2.00
Should Evelyn sell cucumbers or pickles? PicklesCucumbers Pickles Incremental
Revenue100 lbs X $0.79 $79100 lbs X $6.99 $699 $620
Incremental cost 0100 lbs X $1.50 (150) (150)100 lbs X $2.00 (200) (200)
Incremental profit $270
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-21
Drop a Product LineDrop a Product LineDrop a Product LineDrop a Product Line
Analysis involves calculating the change in income that will result from dropping the product line:
If income increases, the product line should be dropped
If income decreases, the product line should not be dropped
Note: Allocated costs are not relevant
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-22
Dropping a Product Line – Dropping a Product Line – Mercer Hardware ExampleMercer Hardware ExampleDropping a Product Line – Dropping a Product Line – Mercer Hardware ExampleMercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
ToolsHardwareSupplies
GardenSupplies
Total3 products
Sales $120,000 $200,000 $80,000 $400,000Traceable costs:
Cost of goods sold (81,000) (90,000) (60,000) (231,000)Other variable costs (2,000) (4,000) (1,000) (7,000)Direct fixed costs (8,000) (5,000) (3,500) (16,500)
Non-traceable costsCompany fixed costs (24,000) (40,000) (16,000) (80,000)
Division net income $5,000 $61,000 ($500) $65,500
Mercer HardwareProduct Line Income Statement
For the Year Ended December 31, 2006
Profit calculation with three product lines
Slide 7-23
Dropping a Product Line – Dropping a Product Line – Mercer Hardware ExampleMercer Hardware ExampleDropping a Product Line – Dropping a Product Line – Mercer Hardware ExampleMercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
ToolsHardwareSupplies
Total2 products
Total3 products
Sales $120,000 $200,000 $320,000 $400,000Traceable costs:
Cost of goods sold (81,000) (90,000) (171,000) (231,000)Other variable costs (2,000) (4,000) (6,000) (7,000)Direct fixed costs (8,000) (5,000) (13,000) (16,500)
Non-traceable costsCompany fixed costs (30,000) (50,000) (80,000) (80,000)
Division net income ($1,000) $51,000 $50,000 $65,500
Total company fixed costs are $80,000 whether 2 or 3 products are sold
Mercer HardwareProduct Line Income Statement
For the Year Ended December 31, 2006
Profit calculation with two product lines
Slide 7-24
Dropping a Product Line – Dropping a Product Line – Mercer Hardware ExampleMercer Hardware ExampleDropping a Product Line – Dropping a Product Line – Mercer Hardware ExampleMercer Hardware Example
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Slide 7-25
Beware of the Cost Allocation Beware of the Cost Allocation Death SpiralDeath Spiral
Beware of the Cost Allocation Beware of the Cost Allocation Death SpiralDeath Spiral
When dropping a product line- Common fixed costs are not
incremental- Common fixed cost allocation is spread
among remaining product lines
Management must understand and remember this impact when making decisions
Learning objective 1: Explain the role of incremental analysis (analysis of incremental costs and revenues) in management decisions
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
Slide 7-26
Terminology SummaryTerminology SummaryTerminology SummaryTerminology Summary Sunk costs
- Costs already incurred- Never incremental or relevant i.e. Do not differ between alternatives
Avoidable costs - Costs avoided if an action is undertaken - Always incremental and relevant
Opportunity costs - Benefits foregone by selecting one
alternative over another - Always incremental and relevant
Slide 7-27
Which of the following is often not a differential cost?
a. Materialb. Laborc. Variable overheadd. Fixed overhead
Answer: dFixed overhead
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
Slide 7-28
Opportunity costs are:a. Never incremental costsb. Always incremental costsc. Sometimes sunk costsd. Never avoidable costs
Answer: bAlways incremental costs
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
Slide 7-29
Which of the following costs should not be taken into consideration when making a decision?
a. Opportunity costsb. Sunk costsc. Relevant costsd. Differential costs
Answer: bSunk costs
Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions
Learning objective 3: Analyze decisions involving joint costs
Slide 7-30
Decisions Involving Joint CostsDecisions Involving Joint CostsDecisions Involving Joint CostsDecisions Involving Joint Costs
Joint Products- When two or more products always result
from common inputs
Joint Costs- Costs of the common inputs
Split-Off Point- Stage of production in which individual
products are identified- Product may undergo further processing
with additional costs
Slide 7-31
Joint Products ExampleJoint Products ExampleJoint Products ExampleJoint Products Example
Learning objective 3: Analyze decisions involving joint costs
Slide 7-32
Allocation of Joint CostsAllocation of Joint CostsAllocation of Joint CostsAllocation of Joint Costs
Cost of the common inputs- Allocated to the joint products for
financial reporting purposes- Can mislead managers about
product line profitability Joint cost information is
- Irrelevant to individual joint product decisions
- It is not an incremental cost
Learning objective 3: Analyze decisions involving joint costs
Slide 7-33
Joint Cost Allocation Joint Cost Allocation MethodsMethods
Joint Cost Allocation Joint Cost Allocation MethodsMethods
Relative sales value method
Cost allocated to product A:Sales value A / Total sales value x Joint
cost
Physical quantity method
Cost allocated to product A:Physical measure A / Total physical
measure x Joint cost
Learning objective 3: Analyze decisions involving joint costs
Slide 7-34 Learning objective 3: Analyze decisions involving joint costs
Joint costs $1,000 Economy grade:
Quantity = 1,ooo poundsSales price = $0.10 per pound
Superior gradeQuantity = 4,000 poundsSales price = $0.30 per pound
Allocate joint costs using physical measure.Weight Allocation
Economy 1,000 1,000 / 5,000= 20% X $1, 000 = $200.00Superior 4,000 4,000 / 5,000 = 80% X $1, 000 = 800.00
Total 5,000 $1,000.00
Percentage
Slide 7-35 Learning objective 3: Analyze decisions involving joint costs
Joint costs $1,000 Economy grade
Quantity = 1,ooo poundsSales price = $0.10 per pound
Superior gradeQuantity = 4,000 poundsSales price = $0.30 per pound
Allocate joint costs using relative sales value.
AllocationEconomy 1,ooo X $0.10 = $100.00 $100 / $1,300 = 8% X $1, 000 = $77Superior 4,ooo X $0.30 = 1,200.00 $1,200 / $1,300 = 92% X $1, 000 = $923
Total $1,300.00 $1,000
PercentageSales Value
Slide 7-36
Additional Processing Additional Processing Decisions and Joint CostsDecisions and Joint Costs
Additional Processing Additional Processing Decisions and Joint CostsDecisions and Joint Costs
Joint costs not relevant to decisions made after the split-off point
Joint costs incurred prior to the split-off point are sunk costs
Decisions should be based on incremental analysis
Learning objective 3: Analyze decisions involving joint costs
Slide 7-37
The 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. Should never be allocated
Answer: aAre incurred before the split-off point
Learning objective 3: Analyze decisions involving joint costs
Learning objective 4: Discuss the importance of qualitative considerations to management decisions
Slide 7-38
Qualitative Considerations in Qualitative Considerations in Decision AnalysisDecision Analysis
Qualitative Considerations in Qualitative Considerations in Decision AnalysisDecision Analysis
Many decisions have one or more features that are difficult to quantify but should be considered
Examples include, but are not limited to:- Swings in economy- Loss of control - Quality of product- Quality of service- Company morale
Learning objective 4: Discuss the importance of qualitative considerations to management decisions
Slide 7-39
Qualitative Considerations in Qualitative Considerations in Decision AnalysisDecision Analysis
Qualitative Considerations in Qualitative Considerations in Decision AnalysisDecision Analysis
Slide 7-40
Qualitative FactorsQualitative FactorsQualitative FactorsQualitative Factors
Learning objective 4: Discuss the importance of qualitative considerations to management decisions
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
Slide 7-41
The Five-Step Process of the The Five-Step Process of the Theory of ConstraintsTheory of Constraints
The Five-Step Process of the The Five-Step Process of the Theory of ConstraintsTheory of Constraints
1. Identify the Binding Constraint2. Optimize Use of the Constraint3. Subordinate Everything Else to the
Constraint4. Break the Constraint5. Identify a New Binding Constraint
Slide 7-42
Optimize Use of the Optimize Use of the ConstraintConstraint
Optimize Use of the Optimize Use of the ConstraintConstraint
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
Slide 7-43
Overproduction in Non-Overproduction in Non-Bottleneck DepartmentsBottleneck DepartmentsOverproduction in Non-Overproduction in Non-Bottleneck DepartmentsBottleneck Departments
Learning objective A1: Understand the five-step approach to the Theory of Constraints (TOC)
Slide 7-44
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