8

14-1

Chapter
Eight

Short term Decision Making:

Relevant Costs and Benefits

McGraw-Hill/Irwin

The Managerial Accountants Role

in Decision Making

14-2

Managerial
Managerial
Accountant
Accountant
Designs
Designs and
and implements
implements
accounting
accounting information
information
system
system

Cross-functional
Cross-functional
management
management teams
teams
who
who make
make
production,
production, marketing,
marketing,
and
and finance
finance decisions
decisions
Make
Make substantive
substantive
economic
economic decisions
decisions
affecting
affecting operations
operations

McGraw-Hill/Irwin

14-3

Relevant Information
Information
Information is
is relevant
relevant to
to aa decision
decision
problem
problem when
when .. .. ..
ItIt has
has aa bearing
bearing on
on the
the future,
future,

It
It differs
differs among
among competing
competing alternatives.
alternatives.

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14-4

Identifying Relevant
Costs and Benefits
Costs and revenues

Revenue
f
o
r
P

Total costs
Variable costs
Fixed costs

s
Los

Units

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it

Identifying Relevant
Costs and Benefits

14-5

Sunk
Sunk costs
costs
Costs
Costs that
already been
that have
have already
been incurred.
incurred.
They
They do
do not
not affect
affect any
any future
future cost
cost and
and
cannot
cannot be
be changed
changed by
by any
any current
current or
or
future
future action.
action.

Sunk costs are irrelevant to decisions.

McGraw-Hill/Irwin

14-6

Relevant Costs: example

You live in King City. You come to class with the GO although you have a car.
A classmate that also lives in King City is willing to come with you in your car and
pay 1.25 times the GO fare.

Current Situation:
Costs: Go bus = 4.45
Alternative situation:
Revenues: 1.25 times the GO bus fare = 5.55
Costs: Gas 1 litre = 1.15
Insurance .?
Lease payments ?
McGraw-Hill/Irwin

Maximum
total costs per
trip: $10

Decision rule:
YES if CMg > 0

14-7

Distortions in Company Reporting

Accrual accounting (meaning of depreciation)
Full cost reporting

See Exhibit 8.1 (page 177):

Full costs $2.25
Proposed selling price $2
Is the new customer offer worthwhile?

Decision rule:
YES if CMg > 0
McGraw-Hill/Irwin

Calculate the
variable costs and
contribution
margin

14-8

Analysis of Special Decisions

Lets take a close look at some special
decisions faced by many businesses.
We just received
a special order. Do
you think we should
accept it?

McGraw-Hill/Irwin

14-9

Accept or Reject a Special Order

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

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

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

The
The next
next screen
screen shows
shows cost
cost data
data developed
developed by
by
managerial
managerial accountants
accountants at
at Worldwide.
Worldwide.
McGraw-Hill/Irwin

14-10

Accept or Reject a Special Order

Worldwide will save about $5,000 in reservation

and ticketing costs if the charter is accepted.
McGraw-Hill/Irwin

14-11

Accept or Reject a Special Order

Since
Since the
the charter
charter will
will contribute
contribute to
to fixed
fixed costs
costs and
and
Worldwide
Worldwide has
has idle
idle capacity,
capacity, the
the company
company should
should
accept
accept the
the flight.
flight.
McGraw-Hill/Irwin

14-12

Accept or Reject a Special Order

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?

McGraw-Hill/Irwin

14-13

Accept or Reject a Special Order

Worldwide has no excess capacity, so it

should reject the special charter.
McGraw-Hill/Irwin

Decisions Involving Limited

Resources

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

Usually,
Usually, fixed
fixed costs
costs are
are not
not affected
affected by
by this
this
decision,
decision, so
so management
management can
can focus
focus on
on
maximizing
maximizing total
total contribution
contribution margin.
margin.
Lets
Lets look
look at
at the
the following
following example.
example.

McGraw-Hill/Irwin

14-14

14-15

Limited Resources
Lets calculate the contribution margin per unit of
the scarce resource.

Highs
Highs should
should be
be emphasized.
emphasized. ItIt is
is the
the more
more valuable
valuable
use
use of
of the
the scarce
scarce resource
resource the
the lathe,
lathe, yielding
yielding aa
contribution
contribution margin
margin of
of $30
$30 per
per minute
minute as
as opposed
opposed to
to
$24
$24 per
per minute
minute for
for the
the Webs.
Webs.
IfIf there
there are
are no
no other
other considerations,
considerations, the
the best
best plan
plan would
would
be
be to
to produce
produce to
to meet
meet current
current demand
demand for
for Highs
Highs and
and
then
McGraw-Hill/Irwin
then use
use any
any capacity
capacity that
that remains
remains to
to make
make Webs.
Webs.

14-16

Accept or Reject a Special Order

With excess capacity . . .

Relevant costs usually will be the variable

costs associated with the special order.

Decision rule: YES if CMg > 0

Without excess capacity . . .

Same as above but opportunity cost of using

the firms facilities for the special order are
also relevant.

Decision rules: YES if CMg Opportunity cost > 0

YES if not the worst CMg
McGraw-Hill/Irwin

14-17

Outsource a Product or Service

A
A decision
decision concerning
concerning whether
whether an
an item
item
should
should be
be produced
produced internally
internally or
or
purchased
purchased from
from an
an outside
outside supplier
supplier is
is
often
often called
called aa make
make or
or buy
buy decision.
decision.
Lets
Lets look
look at
at another
another decision
decision faced
faced by
by the
the
management
management of
of Worldwide
Worldwide Airways.
Airways.

McGraw-Hill/Irwin

14-18

Outsource a Product or Service

An Atlanta bakery has offered to supply the inflight desserts for 21 each.
Here are Worldwides current cost for desserts:

McGraw-Hill/Irwin

14-19

Outsource a Product or Service

Not all of the allocated fixed costs will be saved
if Worldwide purchases from the outside bakery.

McGraw-Hill/Irwin

14-20

Outsource a Product or Service

If Worldwide purchases the dessert for 21, it
will only save 15 so Worldwide will have a
loss of 6 per dessert purchased.
Wow, thats
no deal!

McGraw-Hill/Irwin

14-21

Outsource a Product or Service

Beware
Beware of
of Unit-Cost
Unit-Cost Data
Data
For
For decision-making
decision-making purposes,
purposes, unitized
unitized fixed
fixed
costs
costs can
can be
be misleading.
misleading.

McGraw-Hill/Irwin

Add or Drop a Service,

Product, or Department
One
One of
of the
the most
most important
important decisions
decisions
managers
managers make
make is
is whether
whether to
to add
add or
or drop
drop
aa product,
product, service
service or
or department.
department.
Lets
Lets look
look at
at how
how the
the concept
concept of
of relevant
relevant
costs
costs should
should be
be used
used in
in such
such aa decision.
decision.

McGraw-Hill/Irwin

14-22

14-23

Add or Drop a Product

Due to the declining popularity of digital
watches, Swick Companys digital watch line
has not reported a profit for several years.
If the digital watch line is dropped,
the fixed general factory overhead
and general administrative expenses
will be allocated to other product
lines because they are not avoidable.
The
The equipment
equipment used
used to
to manufacture
manufacture digital
digital
watches
watches has
has no
no resale
resale value
value or
or alternative
alternative use.
use.
McGraw-Hill/Irwin

14-24

Add or Drop a Product

McGraw-Hill/Irwin

14-25

Add or Drop a Product

McGraw-Hill/Irwin

14-26

Summary

DECISION RULE
Swick should drop the digital watch segment
only if its fixed cost savings exceed lost
contribution margin.
McGraw-Hill/Irwin

14-27

Chapter Eight
Short term Decision Making:
Relevant Costs and Benefits

Next chapters
Long term
All costs are variable, therefore
decisions:
all costs are relevant.
McGraw-Hill/Irwin

14-28

After the break:

Discuss questions 2 & 10 + problem 10

Discuss and solve problems 2, 4 and 5

Next class:
Second mid term exam
Chapters 6, 7 and 8
Format: multiple
choices

McGraw-Hill/Irwin