Chapter 14

Decision Making:
Relevant Costs and
Benefits

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the
responsibility of the 3. Identify the Alternatives
managerial
accountant. 4. Develop a Decision Model

5. Collect the Data

Information
Information should
should be:
be:
1.
1. Relevant
Relevant
2.
2. Accurate
Accurate 6. Make a Decision
3.
3. Timely
Timely
14-2
The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Qualitative
Qualitative
Considerations 4. Develop a Decision Model
Considerations

5. Collect the Data

6. Make a Decision
14-3
The Decision-Making Process
1. Clarify the Decision Problem
Relevant
Relevant
Pertinent
Pertinent to
to aa
decision 2. Specify the Criterion
decision problem.
problem.

Accurate
Accurate 3. Identify the Alternatives
Information
Information must
must
be
be precise.
precise. 4. Develop a Decision Model

Timely
Timely 5. Collect the Data
Available
Available in
in time
time
for
for aa decision
decision 6. Make a Decision
14-4
Relevant Information
Information is relevant to a decision problem
when . . .
1.
1. It
It has
has aa bearing
bearing on
on the
the future,
future,
2.
2. It
It differs
differs among
among competing
competing alternatives.
alternatives.

14-5
Identifying Relevant
Costs and Benefits
Sunk
Sunk costs
costs
Costs
Costs that
that have
have already
already been
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.

14-6
Relevant Costs
Here is an analysis that includes only relevant costs:

14-7
Accept or Reject a Special Order
A
 A travel
travel agency
agency offers
offers Worldwide
Worldwide Airways
Airways
$150,000 for a round-trip flight from Hawaii to
Japan on a jumbo jet.
Worldwide
 Worldwide usually
usually gets
gets $250,000
$250,000 in
in revenue
revenue from
from
this flight.
The
 The airline
airline is
is not
not currently
currently planning
planning to
to add
add any
any
new routes and has two planes that are idle and
could be used to meet the needs of the the agency.
The
 The next
next screen
screen shows
shows cost
cost data
data developed
developed by
by
managerial accountants at Worldwide.

14-8
Accept or Reject a Special Order
With 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.

14-9
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.

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

14-10
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 toto add
add or
or drop
drop aa
product,
product, service,
service, or
or department.
department.

Let’s
Let’s 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.

14-11
Special Decisions in
Manufacturing Firms
Joint
Joint Products:
Products:
Sell
Sell or
or Process
Process Further
Further

AA joint
joint production
production process
process resulting
resulting in
in two
two or
or more
more
products.
products. The The point
point inin the
the production
production process
process where
where the
the
joint
joint products
products are
are identifiable
identifiable asas separate
separate products
products is
is
called
called the
the split-off
split-off point.
point.

14-12
 Joint Processing Cocoa butter
of Cocoa Bean sales value
$750 for
1,500 pounds

Cocoa beans Joint Production

costing $500 process costing Split-off point
per ton $600 per ton

Cocoa powder Separable

sales value process
Total joint cost: $500 for costing
$1,100 per ton 500 pounds $800

Instant cocoa
mix sales value
$2,000 for
500 pounds
14-13
Joint Products
Relative Sales Value Method

$750
$750 ÷÷ $1,250
$1,250 == 60%
60%

60%
60% ×× $1,100
$1,100 == $660
$660
14-14
Joint Products
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.

14-15
Joint Products

( )

The cocoa powder should be

processed into instant cocoa mix.

14-16
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.

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

14-17
Limited Resources
Martin, Inc. produces two products and selected data are shown
below:

14-18
Limited Resources
The
 The lathe
lathe is
is the
the scarce
scarce resource
resource because
because there
there is
is
excess
excess capacity
capacity on
on other
other machines.
machines. The
The lathe
lathe is
is
being
being used
used at
at 100%
100% ofof its
its capacity.
capacity.
The
 The lathe
lathe capacity
capacity is
is 2,400
2,400 minutes
minutes per
per week.
week.

Should
Should Martin
Martin focus
focus its
its efforts
efforts
on
on Webs
Webs or
or Highs?
Highs?

14-19
Limited Resources
Let’s calculate the contribution margin per unit of the scarce
resource, the lathe.

Highs
Highs should
should be be emphasized.
emphasized. ItIt isis 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 asas opposed
opposed to to
$24
$24 per
per minute
minute for
for the
the Webs.
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 Constraints
Binding constraints can limit a company’s profitability.
To relax constraints management can . . .

Outsource Work overtime

Reduce non-value-
Retrain employees
added activities

14-21
Uncertainty
One
One common
common technique
technique for for addressing
addressing the
the impact
impact of
of
uncertainty
uncertainty is
is
sensitivity
sensitivity analysis
analysis -- aa way
way toto determine
determine what
what would
would happen
happen
in
in aa decision
decision analysis
analysis ifif aa key
key prediction
prediction or
or assumption
assumption
proved
proved to to be
be wrong.
wrong.

14-22
Other Issues in Decision Making

Short-Run
Short-Run
Incentives
Incentives for
for Versus
Versus
Decision
Decision Makers
Makers Long-Run
Long-Run
Decisions
Decisions

14-23
Other Issues in Decision Making
Pitfalls to Avoid

Sunk Allocated
costs. fixed costs.

Unitized Opportunity
fixed costs. costs.
14-24