Cost Management and Decision Making

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

13Cost Management

and Decision Making

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Learning Objective 1

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Decision-Making Process

Stage 4Planning and

implementation

Stage 4Planning and

implementation

Stage 5Obtaining feedback

Stage 5Obtaining feedback

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34

5

Stage 3Evaluating alternatives

Stage 3Evaluating alternatives

Stage 1Setting goals

and objectives

Stage 1Setting goals

and objectives

Stage 2Gathering

information

Stage 2Gathering

information

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Stage 1: Setting Goals and Objectives

Organizations must set objectivesto provide clear guidance.

Organizations must set objectivesto provide clear guidance.

Tangible objectives provide benchmarks

against which to measure performance.

Tangible objectives provide benchmarks

against which to measure performance.

Intangible objectives: may provide guidance, but tend to be abstract and are difficult to measure

Intangible objectives: may provide guidance, but tend to be abstract and are difficult to measure

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Determine target selling price. Determine target cost.

Determine target profit Deduct target return on sales Result is target cost

Compare target cost to currently feasible total cost.

The difference is the cost-reduction target

Redesign products and processes to achieve the cost-reduction target.

Determine target selling price. Determine target cost.

Determine target profit Deduct target return on sales Result is target cost

Compare target cost to currently feasible total cost.

The difference is the cost-reduction target

Redesign products and processes to achieve the cost-reduction target.

Contract sales price

Estimate based on market analysis

Competitors’ pricing

Contract sales price

Estimate based on market analysis

Competitors’ pricing

Target Profit and Target Cost

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Stage 2: Gathering Information

RelevanceRelevance

TimelinessTimelinessObjectivity

vs. subjectivity

Objectivity vs.

subjectivity

AccuracyAccuracyInformation quality

anddecision usefulness

Cost vs.

quality

Cost vs.

quality

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Identification of Relevant Costs and Benefits

Relevant costs are costs to be incurred at some future time and

that differ for each option available to the

decision maker.

Relevant costs are costs to be incurred at some future time and

that differ for each option available to the

decision maker.

Costs incurred in the past are not relevant.

They are called called “sunk costs”.

Costs incurred in the past are not relevant.

They are called called “sunk costs”.

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Item RelevantNot

Relevant ReasonCost of new car X Future cost that differs between alternativesCost of old car X Sunk costInsurance X Increased amount to cover new car is relevantAAA membership X Does not differ between alternatives

Decision: Trading an old car for a new car.

Identification of Relevant Costs and Benefits

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Stage 3: Evaluating Alternatives

3. Measure the benefits and costs of each set of outcomes.

3. Measure the benefits and costs of each set of outcomes.

1. List decision alternatives in the

order the decisions must

be made.

1. List decision alternatives in the

order the decisions must

be made.

2. Trace the path of each

decision to its ultimate

outcome.

2. Trace the path of each

decision to its ultimate

outcome.

Consider qualitative aswell as quantitative factors.

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Anticipating future outcomes of each action

Stage 3: Evaluating Alternatives

Consider the pastAlthough past costs are

sunk and thereforeirrelevant, they can beused to help estimate

future costs that are relevant.

Consider the pastAlthough past costs are

sunk and thereforeirrelevant, they can beused to help estimate

future costs that are relevant.

Completely new products Use prototype products

to estimate costs. Rely on consultantswho have knowledgeof similar products.

Completely new products Use prototype products

to estimate costs. Rely on consultantswho have knowledgeof similar products.

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Decision Tree A useful decision aid in diagramming

decisions and alternative outcomes Allows an evaluation of the costs and

benefits of each alternative (limb)

Steps in creating a decision tree:

Display decision alternatives in order

Identify the set of outcomes resulting from each decision path

Measure costs and benefits of each set of outcomes

A B

A1 A2 B1 B2 B3

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Decision Tree - Example

Maintain Status quo?

Automate or improveManual process?

Status quo isunacceptable

Higher equipment costLower employment levelLower unit-level costIncrease in profit

Lower equipment costSame employment levelLower unit-level costIncrease in profit

Change

Status quo

Automate

Manual

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Outsourcing or Make-or-Buy Decision

When the company needs goods or services, should they be “made” internally or “bought”

externally?

When the company needs goods or services, should they be “made” internally or “bought”

externally?

When goods or services are

acquired externally, it is called

outsourcing.

When goods or services are

acquired externally, it is called

outsourcing.

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Is it cheaper t

o

make or buy?

How dependable is the supplier?

What are the

relevant costs?


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Identify the fixed costs that we could avoid if we outsource.

Identify the fixed costs that we could avoid if we outsource.

Identify the variable costs

that would disappear if we

outsource.

Identify the variable costs

that would disappear if we

outsource.

Identify the new variable costs that we would

incur if we outsource.

Identify the new variable costs that we would

incur if we outsource.


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Let’s look at a make-or-buy decision faced by the management of Thor Company.


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Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to

make this part are:

Direct materials per unit $ 9.00 Direct labor per unit 5.00 Variable overhead per unit 1.00 Fixed overhead 180,000 Allocated common costs 100,000

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Fixed manufacturing overhead is the cost of leasing andoperating the equipment necessary to produce part 457.

Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to

make this part are:

Direct materials/unit $ 9.00 Direct labor/unit 5.00 Variable overhead/unit 1.00 Fixed overhead 180,000 Allocated common costs 100,000

Direct materials 9.00$ Direct labor 5.00 Variable overhead 1.00 Fixed overhead ($180,000 ÷ 20,000) 9.00 Common costs ($100,000 ÷ 20,000) 5.00 Unit cost 29.00$

Direct materials 9.00$ Direct labor 5.00 Variable overhead 1.00 Fixed overhead ($180,000 ÷ 20,000) 9.00 Common costs ($100,000 ÷ 20,000) 5.00 Unit cost 29.00$


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Common costs are allocated on the basis of direct labor hours.

Total unit cost of $29 is based on 20,000 parts produced each year.

An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.

Should we accept the supplier’s offer?Should we accept the supplier’s offer?

Common costs are allocated on the basis of direct labor hours.

Total unit cost of $29 is based on 20,000 parts produced each year.

An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.

Should we accept the supplier’s offer?Should we accept the supplier’s offer?


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20,000 × $5 per unit 20,000 × $9 per unit

20,000 × $1 per unit


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20,000 × $29 per unit


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The common costs remain unchanged.

20,000 × $25 purchase price


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Should we make or buyShould we make or buypart 457?part 457?


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Direct materials 9.00$ Direct labor 5.00 Variable overhead 1.00 Fixed overhead ($180,000 ÷ 20,000) 9.00 Total relevant unit cost 24.00$

Direct materials 9.00$ Direct labor 5.00 Variable overhead 1.00 Fixed overhead ($180,000 ÷ 20,000) 9.00 Total relevant unit cost 24.00$

What is the relevant unit cost of making part 457?

Advantage of making20,000 units × ($25.00 – $24.00) = $20,000


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If Thor could use the space currently being used to make Part 457 for another purpose, resulting in a cost savings of

$45,000, would you change your decision?

Yes. The cost savings (opportunity cost) of $45,000overcomes the $20,000 disadvantage of buying.

Now there is a $25,000 advantage to buying.

The real issue is the most profitable use of the space.


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Pitfalls of Outsourcing

Loss of sensitive

information to supplier.

Freed-up resources

are not used as planned.

Supplier quality is not as high as

anticipated.

Customers may object.

Customer contact may be reduced.

Supplier technology and knowledge base may not be as

anticipated.

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Decision to Add or Drop a Product, Service, or Business Unit

If we shut down our U.S. Digital watch line, we

might anger our American

customers.

If we shut down our U.S. Digital watch line, we

might anger our American

customers.

. . . Not to mention the bad press!


That is why we have to consider

the relevant benefits and the relevant costs

BEFORE making a final decision.




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Let’s get started.The digital line

has become lessprofitable and it is

difficult to competein the market.




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Segment Income StatementDigital watches

Sales 500,000$ Less: variable expenses Variable mfg. costs 120,000$ Variable shipping costs 5,000 Commissions 75,000 200,000 Contribution margin 300,000$ Less: fixed expenses General factory overhead 60,000$ Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net loss (100,000)$


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If the digital watch line is dropped, the fixed general factory overhead fixed general factory overhead and general general administrative expenses administrative expenses will be allocated

to other product lines.


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The equipment used to manufacturedigital watches has no resale

value or alternative use.


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Should Market retain or dropShould Market retain or dropthe digital watch line?the digital watch line?


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DECISION RULEDECISION RULE

Market should drop the digital watch segment only if its fixed cost savings

exceedexceed lost contribution margin.

Let’s look at this solution.Let’s look at this solution.


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Market CompanySolution

Contribution margin lost if watches are dropped (300,000)$

Less fixed costs that can be avoided Salary of the line manager 90,000$ Advertising - direct 100,000 Rent - factory space 70,000 260,000 Net disadvantage (40,000)$

Should we drop the digitalwatch segment?


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The same result can also be obtained by preparing a differential analysis showing operating results with and without the digital watch segment.

Let’s look at this approach.Let’s look at this approach.


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Differential AnalysisSolution

Keep digital

watches

Drop digital

watches Difference Sales 500,000$ -$ (500,000)$ Less variable expenses: - Mfg. expenses 120,000 - 120,000 Freight out 5,000 - 5,000 Commissions 75,000 - 75,000 Total variable expenses 200,000 - 200,000 Contribution margin 300,000 - (300,000) Less fixed expenses: General factory overhead 60,000 60,000 - Salary of line manager 90,000 - 90,000 Depreciation 50,000 50,000 - Advertising - direct 100,000 - 100,000 Rent - factory space 70,000 - 70,000 General admin. expenses 30,000 30,000 - Total fixed expenses 400,000 140,000 260,000 Net loss (100,000)$ (140,000)$ (40,000)$


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Example: If the idled facilities can be used to makea product generating $350,000 per year in contribution

margin, with no other change in fixed costs,might this change your decision?

Keeping the digital watch product line may have an opportunity cost that we

have not yet considered.

The opportunity cost of retaining the digitalwatch line is measured by the differentialprofits given up if the next best use of the

production facilities is rejected.


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Measuring cost savings and lost revenues from closing a business unit is only part of the story.

The closing will impact . . . Employees’ personal lives, Morale of retained employees, The community at large.

Measuring cost savings and lost revenues from closing a business unit is only part of the story.

The closing will impact . . . Employees’ personal lives, Morale of retained employees, The community at large.


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Which costs are relevant to the decision to replace an old machine with a new machine?


Old machine cost $5,400 when purchased. Old machine has a book value of $1,500. Purchase price of a new machine is $10,000. New machine will reduce labor from $12.00 to

$11.00 per unit. New machine is expected to last two years. Repairs to old machine would be $4,600 and

would allow two more years of productivity. Power for either machine is expected to be $2.50

per unit. Expected level of output: 1,000 units per year.




per unit. Expected level of output: 1,000 units per year.

Relevant Costs of Replacing Equipment

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per unit. Expected level of output: 1,000 units per year




per unit. Expected level of output: 1,000 units per year

Relevantbecauseof laborsavingsover the

2-year life.




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CostKeep old machine

Replace old machine

Labor 24,000$ 22,000$ Repair cost 4,600 Purchase cost 10,000 Total 28,600$ 32,000$

1,000 units @ $12.00 for 2 years

1,000 units @ $11.00 for 2 years

Conclusion: keep old machine.


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Pricing Decisions

What influences prices?What influences prices?

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CostsMarketforces

Prices are determined by the market, subjectto costs that must be covered in the long run.

Prices are based on costs, subject toreactions of customers and competitors.

Pricing Decisions

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Pricing Law in the United States

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We just receiveda special order. Doyou think we should

accept it?

Special-Order Price Decisions

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

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

The airlines 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 Japan to Hawaii on a jumbo jet.

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

The airlines 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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Worldwide will save about $5,000 in reservationand ticketing costs if the charter is accepted.


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Since the charter will contribute to fixed costs andSince the charter will contribute to fixed costs andWorldwide has idle capacity, the company shouldWorldwide has idle capacity, the company should

accept the flight.accept the flight.

Since the charter will contribute to fixed costs andSince the charter will contribute to fixed costs andWorldwide has idle capacity, the company shouldWorldwide has idle capacity, the company should

accept the flight.accept the flight.


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What if Worldwide had no excess capacity? If Worldwide adds the charter, it will have to cut

its least profitable route that currently contributes $80,000 to fixed costs and profits.

Should Worldwide still accept the charter?


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Worldwide has no excess capacity, so it should reject the special charter, or try to

renegotiate a higher price.


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With excess capacity . . . Relevant costs usually will be the variable costs

associated with the special order.

Without excess capacity . . . . Same as above but opportunity costs of using

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


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Additional considerations

•Impact on regular customers and markets

•Will the special order lead to future regular business?

Additional considerations

•Impact on regular customers and markets

•Will the special order lead to future regular business?


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End of Chapter 13

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Cost Management and Decision Making