Chapter 7The Use of Cost Information in Management Decision Making

Presentation Outline

I. Incremental Analysis

II. Three Decision Managers Frequently Face

III. Decisions Involving Joint Costs

IV. Qualitative Considerations in Management Decisions

V. The Theory of Constraints (TOC)

I. Incremental Analysis

Incremental or differential revenue – additional revenue received as a result of selecting one

decision alternative over another.Incremental or differential cost – additional cost

incurred as a result of selecting one decision alternative over another.

To answer the question of how much something costs, a manager must know why the person wants to know. No single cost number is relevant for all

decisions.

II. Three Decisions Managers Frequently Face

A. Additional Processing Decision

B. Make or Buy Decision

C. Dropping a Product Line Decision

D. Summary of Concepts

A. Additional Processing Decision

PowerComp Company has partially processed computers for Model 250 that they are discontinuing. This has caused a

decline of the selling price. If the units are completed, they can be sold for $1,000 per unit. That is less than the total cost

of producing the computers -- $1,200 per unit ($800 cost to date plus $400 of additional cost to complete the units).

Material $300 $200

Labor 200 100

Variable O/H 100 100

Fixed O/H 200

Totals $800 $400

Costs per Unit

Incurred to Date

Costs per Unit to

Complete

The Alternatives:1. Sell the units as is for $500 each and avoid incurring any additional processing costs.

2. Complete the units and sell them for $1,000 each.

The Solution:The prior production costs are a sunk

cost since they have already been incurred. Therefore, the only relevant

cost is the $400 in additional processing costs to complete each

unit. Since this is less than the incremental revenue of $500 ($1,000 - $500), the units should be processed

further.

B. Make or Buy Decision

Variable costsDirect material ($100 per unit) $5,000,000Direct labor ($120 per unit) 6,000,000 Variable overhead ($80 per unit) 4,000,000 Total variable cost 15,000,000

Fixed costsDepreciation of building 600,000 Depreciation of equipment 800,000 Supervisory salaries 500,000 Other 350,000 Total fixed costs 2,250,000

Total cost $17,250,000

Cost per unit to make $345

Cost of Manufacturing 50,000 Compressors

Should the organization buy the compressors from an outside source at a cost of $310 per unit?

Additional Cost Analysis

The market value of the machinery used to produce the compressors is approximately zero.

Five of the six production supervisors will be fired if production of compressors is discontinued. However, one

of the supervisors, who has more than 10 years of service, is protected by a clause in a labor contract, and will be

assigned to other duties, although his services are not really needed. His salary is $110,000.

If production of compressors is discontinued, the company can use the space to store shelving that they are currently

renting space for at a cost of $500,000 per year.

The Solution

Cost of buying compressors outside(50,000 units @ $310) $15,500,000

Cost savings (avoidable if compressorsare purchased outside)Variable costs $15,000,000Supervisory salaries (salaries of 5 of 6 supervisors) 390,000Opportunity cost of using the plant to produce compressors (forgone rent savings) 500,000 $15,890,000

Net savings resulting from buying thecompressors outside $390,000

Incremental Cost Analysis

C. Dropping a Product Line Decision

Hardware GardenTools Supplies Supplies Total

Sales $120,000 $200,000 $80,000 $400,000Cost of goods sold 81,000 90,000 60,000 231,000Gross margin 39,000 110,000 20,000 169,000Other variable costs 2,000 4,000 1,000 7,000Contribution margin 37,000 106,000 19,000 162,000Direct fixed costs 8,000 5,000 3,500 16,500Allocated fixed costs 24,000 40,000 16,000 80,000Total fixed costs 32,000 45,000 19,500 96,500Net income (loss) $5,000 $61,000 -$500 $65,500

Product Line Income Statement

Should the Garden Supplies product line be dropped since it is showing a net loss of $500?

Additional Cost AnalysisSales revenue will decline by $80,000 if garden supplies

are dropped.Cost of goods sold will decrease by $60,000, and other

variable costs will decrease by $1,000.Direct costs are directly traceable to a product line.

Whether they decrease depends on the nature of these costs. Since the $3,500 represents a part-time employee who will be dropped if garden supplies is dropped, this

cost is avoidable.Allocated fixed costs are not directly traceable to an

individual product line. Therefore, these costs are generally not avoidable.

The Solution

Lost sales $80,000Cost savings: Cost of goods sold 60,000 Other variable costs 1,000 Direct fixed costs 3,500Total cost savings 64,500Net loss from dropping ($144,500)

Dropping Garden SuppliesIncremental Analysis

Cost Allocation Death SpiralIn many cases, products or

services may not appear profitable because they receive allocations of common fixed costs.

However, if the product or service is dropped common fixed costs are reallocated

to the remaining product or services.

This may result in another product or service

appearing unprofitable.

D. Summary of ConceptsCosts that can be avoided by taking a particular course of

action are always incremental costs and, therefore, relevant to the analysis of a decision.

Costs that are sunk are never incremental costs and therefore are not relevant in making a decision.

Opportunity costs represent the benefit forgone by selection a particular decision alternative over another. There are

always incremental costs and therefore relevant.Fixed costs may be:

Sunk and therefore irrevelantNot sunk but still irrelevant

Not sunk but relevant

(See Illustration 7-7 on page 246)

III. Decisions Involving Joint Costs

A. Terminology

B. Allocating Joint Costs Using Physical Quantity

C. Allocating Joint Costs Using Relative Sales Value

D. Additional Processing Decisions Involving Joint Costs

A. Terminology Joint Products – two or more products that always result from

common inputs. Joint Costs – costs of common inputs up to the split-off point.

Split-off Point – stage of production at which individual products are identified. Beyond this point each product may undergo further separate processing and may incur additional costs.

Joint Cost (Common Input Process)

Cost of log $600 Cost of sawing 20

Split-Off Point

Grade A Lumber

Grade B Lumber

500 board feet selling

for $1.00 per foot

500 board feet selling for $.50 per

foot

B. Allocating Joint Cost Using Physical QuantityGrade A Grade B

Sales revenueA: 500 board feet x $1.00 $500.00B: 500 board feet x $ .50 $250.00

Joint cost allocation:A: $620 joint cost x (500 board feet / 1,000 board feet) $310.00B: $620 joint cost x (500 board feet / 1,000 board feet) $310.00

Gross margin $190.00 -$60.00

This allocation could lead managers to think that grade B lumber is not profitable and should be scrapped. But this logic is faulty. If grade B lumber were scrapped, the company would lose $250 that

helped cover the joint cost of $620.

C. Allocating Joint Cost Using Relative Sales ValueGrade A Grade B

Sales revenueA: 500 board feet x $1.00 $500.00B: 500 board feet x $ .50 $250.00

Joint cost allocation:A: $620 joint cost x ($500 sales / $750 total sales) $413.33B: $620 joint cost x ($250 sales / $750 total sales) $206.67

Gross margin $86.67 $43.33

A good feature of this method is that the amount of joint cost allocated to a product cannot exceed its sales value at the split-off

point.

D. Additional Processing Decisions Involving Joint Costs

Grade B lumber can be sold at the split-off point for $.50 per board or pressure treated for an additional $.20 per board and sold for $.75 per board. Note that the additional processing should occur since the incremental revenue of $.25 ($.75 - $.50) is greater than the additional processing cost of $.20, regardless of the amount of the joint cost allocation. Joint costs are not incremental and are

therefore never relevant in further processing decisions.

Joint Cost (Common Input Process)

Cost of log $600 Cost of sawing 20

Split-Off Point

Grade A Lumber

Grade B Lumber

500 board feet selling

for $1.00 per foot

500 board feet selling for $.50 per

foot

IV. Qualitative Considerations in Management Decisions

A variety of qualitative factors (e.g., quality of

goods, employee morale, and customer service)

need to be considered in making a decision.

Qualitative factors are often even more

important than costs and benefits that are easy to

quantify.

V. The Theory of Constraints (TOC)

A. Theory of Constraints Defined

B. An Illustration of the Five-Step Process of TOC

C. Some Implications for TOC

D. Overproduction Incentives for Nonbottleneck Departments

A. Theory of Constraints Defined

Theory of constraints recognizes that large

increases in profit can be achieved by elimination

of bottlenecks in production processes. It

is an approach to production and

constraint management.

B. An Illustration of the Five Step Process of TOC

1. Identify the Binding Constraint

2. Optimize Use of the Constraint

3. Subordinate Everything Else to the Constraint

4. Break the Constraint

5. Identify a New Binding Constraint

1. Identify the Binding Constraint

A bottleneck or binding constraint is a process that limits throughput (the amount of inventory

produced in a period). Assume that Department 3 is a bottleneck.

ProduceSubassembly

Department 1

ProduceSubassembly

Department 2

Make and TestConnections,

Install HousingUnits

Department 3

Test,Package, and Ship

Department 4

2. Optimize Use of the ConstraintProduce products with the highest contribution

margin per unit of constraint.Model A70 Model B90

Selling price per unit $1,000 $2,000Variable costs per unit: Direct materials 400 900 Direct labor 200 300Contribution margin per unit 400 800Fixed costs per unit 100 300Profit per unit 300 500

Time to complete 1 unit in Dept. 3 .1 hour .3 hourContribution margin per hour in Dept. 3 $4,000 $2,667

If managers face a choice between using scarce time in Department 3 to produce Model A70 or Model B90, they should definitely

maximize production of Model A70 first.

3. Subordinate Everything Else to the Constraint

Managers should focus their time on trying to loosen the constraint and not concentrate on improvements in

other departments.For example, why should managers improve processes

in 1, 2, or 4 if they are not limiting production.Many things may loosen constraints. For example, if

workers in Dept 3 all take breaks at the same time, capacity could be gained by staggering breaks.

4. Break the Constraint

This can be accomplished in many ways:Cross-train workers in Depts. 1 and 2 so they can help

out in Dept. 3Outsource some of Dept. 3’s work.

Purchase additional equipment for Dept. 3Hire additional workers for Dept. 3

Train workers in Dept. 3 so that they can perform their jobs more efficiently.

5. Identify a New Binding Constraint

Once the constraint is broken in Dept. 3,

either Dept. 1, 2, or 4 will be come a

bottleneck.Or, if the company has

excess capacity in all departments, it should focus its attention on

building demand.

C. Some Implications of TOCInspections – inspections should take place before work

is transferred to a constrained department. Valuable time of the constrained department should not be

wasted on defective items.Batch sizes – although many companies are going to

small batch sizes to reduce defects and achieve flexibility, using larger batch sizes in constrained departments can avoid wasted time in numerous

machine setups for small production runs.Across the board cuts – although cuts in nonbottleneck

departments can make sense, cuts in departments with a binding constraint can have a severe impact on profit.

D. Overproduction Incentive for Nonbottleneck Departments

Incentives for greater production in nonbottleneck departments should be avoided when there is a

bottleneck department.For example, if Depts. 1 and 2 are rewarded for

more production, it will do little if inventory is accumulating in front a Dept. 3

Summary Only incremental costs and revenues are relevant in making

management decisions. Sunk costs are irrelevant in deciding whether to further

process a good. Nonavoidable costs are irrelevant in make-or-buy decisions.

Common costs among product lines are generally nonavoidable.

Opportunity costs are relevant in choosing among decision alternative.

Joint Costs are irrelevant in additional processing decisions Management Decisions must consider qualitative

characteristics Focus process improvements on bottlenecks first.