Decision Making:

Relevant Costs and Benefits

Chapter 14

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

The Decision-Making ProcessThe Decision-Making Process1. Clarify the Decision Problem1. Clarify the Decision Problem

2. Specify the Criterion2. Specify the Criterion

3. Identify the Alternatives3. Identify the Alternatives

4. Develop a Decision Model4. Develop a Decision Model

5. Collect the Data5. Collect the Data

6. Make a Decision6. Make a Decision

Primarily thePrimarily theresponsibility of theresponsibility of the

managerialmanagerialaccountant.accountant.

Primarily thePrimarily theresponsibility of theresponsibility of the

managerialmanagerialaccountant.accountant.

Information should be:Information should be:1. Relevant1. Relevant2. Accurate2. Accurate3. Timely3. Timely

Information should be:Information should be:1. Relevant1. Relevant2. Accurate2. Accurate3. Timely3. Timely

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The Decision-Making ProcessThe Decision-Making Process1. Clarify the Decision Problem1. Clarify the Decision Problem

2. Specify the Criterion2. Specify the Criterion

3. Identify the Alternatives3. Identify the Alternatives

4. Develop a Decision Model4. Develop a Decision Model

5. Collect the Data5. Collect the Data

6. Make a Decision6. Make a Decision

QualitativeConsiderations

QualitativeConsiderations

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The Decision-Making ProcessThe Decision-Making Process1. Clarify the Decision Problem1. Clarify the Decision Problem

2. Specify the Criterion2. Specify the Criterion

3. Identify the Alternatives3. Identify the Alternatives

4. Develop a Decision Model4. Develop a Decision Model

5. Collect the Data5. Collect the Data

6. Make a Decision6. Make a Decision

RelevantRelevantPertinent to a

decision problem.

RelevantRelevantPertinent to a

decision problem.

AccurateAccurateInformation must

be precise.

AccurateAccurateInformation must

be precise.

TimelyTimelyAvailable in time

for a decision

TimelyTimelyAvailable in time

for a decision

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Relevant InformationRelevant InformationInformation is relevant to a decision

problem when . . .1. It has a bearing on the future, 2. It differs among competing

alternatives.

Information is relevant to a decision problem when . . .

1. It has a bearing on the future, 2. It differs among competing

alternatives.

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Identifying RelevantIdentifying RelevantCosts and BenefitsCosts and Benefits

Sunk costsCosts that have already been incurred. They do

not affect any future cost and cannot be changed by any current or future action.

Sunk costsCosts that have already been incurred. They do

not affect any future cost and cannot be changed by any current or future action.

Sunk costs are irrelevant to decisions.Sunk costs are irrelevant to decisions.

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Relevant CostsRelevant CostsHere is an analysis that includes only

relevant costs:

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Accept or Reject a Special OrderAccept or Reject a Special OrderA travel agency offers Worldwide

Airways $150,000 for a round-trip flight from Hawaii to Japan on a jumbo jet.

Worldwide usually gets $250,000 in revenue from this flight.

The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.

The next screen shows cost data developed by managerial accountants at Worldwide.

A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Hawaii to Japan on a jumbo jet.

Worldwide usually gets $250,000 in revenue from this flight.

The airline is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.

The next screen shows cost data developed by managerial accountants at Worldwide.

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Accept or Reject a Special OrderAccept or Reject a Special OrderWith excess capacity . . .

Relevant costs will usually be the variable costs associated with the special order.

Without excess capacity . . .Same as above but opportunity cost of using the

firm’s facilities for the special order are also relevant.

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Outsource a Product or ServiceOutsource a Product or ServiceA decision concerning whether an item should be

produced internally or purchased from an outside supplier is often called a “make or buy”

decision.

Let’s look at another decision faced by the management of Worldwide Airways.

A decision concerning whether an item should be produced internally or purchased from an

outside supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the management of Worldwide Airways.

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Add or Drop a Service,Add or Drop a Service,Product, or DepartmentProduct, or Department

One of the most important decisions managers make is whether to add or drop

a product, service, or department.

Let’s look at how the concept of relevant costs should be used in such a

decision.

One of the most important decisions managers make is whether to add or drop

a product, service, or department.

Let’s look at how the concept of relevant costs should be used in such a

decision.

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Special Decisions inSpecial Decisions inManufacturing FirmsManufacturing Firms

Joint Products:Sell or Process Further

A joint production process resulting in two or more products. The point in the production

process where the joint products are identifiable as separate products is called the

split-off point.

Joint Products:Sell or Process Further

A joint production process resulting in two or more products. The point in the production

process where the joint products are identifiable as separate products is called the

split-off point.

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Cocoa beansCocoa beanscosting $500costing $500

per tonper ton

Joint ProductionJoint Productionprocess costingprocess costing

$600 per ton$600 per ton

Cocoa butterCocoa buttersales valuesales value$750 for$750 for

1,500 pounds1,500 pounds

Cocoa powderCocoa powdersales valuesales value$500 for$500 for

500 pounds500 pounds

SeparableSeparableprocessprocesscostingcosting$800$800

Instant cocoaInstant cocoamix mix sales valuesales value

$2,000 for$2,000 for500 pounds500 pounds

Joint ProcessingJoint Processingof Cocoa Beanof Cocoa Bean

Joint ProcessingJoint Processingof Cocoa Beanof Cocoa Bean

Total joint cost:Total joint cost:$1,100 per ton$1,100 per ton

Split-off pointSplit-off point

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Joint ProductsJoint ProductsRelative Sales Value Method

$750 ÷ $1,250 = 60%$750 ÷ $1,250 = 60%

60% × $1,100 = $66060% × $1,100 = $660

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Joint ProductsJoint ProductsCocoa butter is sold at the end of the

joint processing.Cocoa powder may be sold now or

processed into instant cocoa mix. Further processing costs of $800 will be incurred if the company elects to make instant cocoa mix.

Cocoa butter is sold at the end of the joint processing.

Cocoa powder may be sold now or processed into instant cocoa mix. Further processing costs of $800 will be incurred if the company elects to make instant cocoa mix.

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Joint ProductsJoint Products

The cocoa powder should beThe cocoa powder should be processed into instant cocoa mix.processed into instant cocoa mix.

( )

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Decisions Involving Limited Decisions Involving Limited ResourcesResources

Firms often face the problem of deciding how limited resources are going to be used.

Usually, fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin.

Let’s look at the Martin, Inc. example.

Firms often face the problem of deciding how limited resources are going to be used.

Usually, fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin.

Let’s look at the Martin, Inc. example.

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Limited ResourcesLimited ResourcesMartin, Inc. produces two products and selected

data are shown below:

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Limited ResourcesLimited ResourcesThe lathe is the scarce resource because

there is excess capacity on other machines. The lathe is being used at 100% of its capacity.

The lathe capacity is 2,400 minutes per week.

Should Martin focus its effortson Webs or Highs?

The lathe is the scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity.

The lathe capacity is 2,400 minutes per week.

Should Martin focus its effortson Webs or Highs?

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Limited ResourcesLimited ResourcesLet’s calculate the contribution margin per unit of

the scarce resource, the lathe.

Highs should be emphasized. It is the more valuable use of the scarce resource, the lathe, yielding a

contribution margin of $30 per minute as opposed to $24 per minute for the Webs.

Highs should be emphasized. It is the more valuable use of the scarce resource, the lathe, yielding a

contribution margin of $30 per minute as opposed to $24 per minute for the Webs.

If there are no other considerations, the best plan would be to produce to meet current demand for Highs and then use remaining capacity to make Webs. 14-20

Theory of ConstraintsTheory of ConstraintsBinding constraints can limit a company’s

profitability.

To relax constraints management can . . .

OutsourceOutsource Work overtimeWork overtime

Retrain employeesRetrain employeesReduce non-value-

added activitiesReduce non-value-

added activities

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UncertaintyUncertaintyOne common technique for addressing the impact

of uncertainty issensitivity analysis - a way to determine what would happen in a decision analysis if a key

prediction or assumption proved to be wrong.

One common technique for addressing the impact of uncertainty is

sensitivity analysis - a way to determine what would happen in a decision analysis if a key

prediction or assumption proved to be wrong.

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Other Issues in Decision MakingOther Issues in Decision Making

Incentives forDecision Makers

Incentives forDecision Makers

Short-RunVersus

Long-RunDecisions

Short-RunVersus

Long-RunDecisions

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Other Issues in Decision MakingOther Issues in Decision MakingPitfalls to Avoid

SunkSunkcosts.costs.SunkSunkcosts.costs.

UnitizedUnitizedfixed costs.fixed costs.

UnitizedUnitizedfixed costs.fixed costs.

AllocatedAllocatedfixed costs.fixed costs.AllocatedAllocated

fixed costs.fixed costs.

OpportunityOpportunitycosts.costs.

OpportunityOpportunitycosts.costs.

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