BUSI 0027 MANAGEMENT ACCOUTNING

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BUSI0027 E,FG MANAGEMENT ACCOUNTING I
Session 9 Decision Making and Relevant
Information
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Five-Step Decision-Making Process
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Decision Model
A decision model is a formal method for making a
choice, often involving quantitative and
qualitative analysis.
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Types of Information
Information
numerical
non numerical
Quantitative Information
Qualitative Information e.g., employee morale
non monetary
monetary
Quantitative Financial Information e.g., costs
Quantitative Non-financial Information e.g.,
number of employees
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Characteristics of Relevant Information

• 1) It occurs in the future
• Historical costs, also called Sunk Costs , are
  past costs that are irrelevant to decision making
• 2) It differs among the alternative courses of
  action
• Future costs and revenues that do not differ
  among alternatives are also irrelevant

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Example Information Relevance
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Pricing Decisions
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Types of Short-Term Decisions

• One-Time-Only Special Orders
• Insourcing vs. Outsourcing
• Product-Mix
• Customer Profitability
• Equipment Replacement

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• Example 1
• One-Time-Only Special Orders

Accepting or rejecting special orders when there
is idle production capacity and the special
orders have no long-run implications
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Example 1
1. Total fixed direct cost is 45,000 2. Total
fixed overhead is 105,000 3. Marketing costs are
210,000 4. The Bismark Co. has a monthly
production capacity of 44,000 towels
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Example 1
Current monthly production (sales volume) is
30,000 towels and selling price is 25.
A hotel in Newport has offered to buy 5,000
towels from Bismark Co. at 12/towel.
No additional marketing costs will be incurred.
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Example 1
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Example 1
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Example 1
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Strategic Consideration

• We assume that if special order is not accepted,
  the unused capacity remains idle
• We assume there is no long-run implication for
  accepting the one-time order
• If there is long-run implication, we should
  consider both short-run and long-run implications

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• Example 2
• Insourcing versus Outsourcing
• (Make versus Buy Decision)

Outsourcing is purchasing goods and services
from outside vendors.
Insourcing is producing goods or providing
services within the organization
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Example 2-1
Bismark Co. has the following costs for 150,000
units of Part 2
Direct materials (variable) 28,000 Direct
labor (variable) 18,500 Overheads
Mixed overhead 24,000 Variable
overhead 15,000 Fixed overhead
30,000
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Example 2-1
Bismark produces the 150,000 units in 150 batches
of 1,000 units each.
Mixed overhead consists of fixed costs of 9,000
plus variable costs of 100 per batch.
Bismark is considering buying Part 2 from
Towson Co. for 0.6 each. The fixed 9,000 in
mixed overhead will not be incurred if Part 2
is purchased.
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Example 2-1
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Strategic Qualitative Factors

• Nonquantitative factors may be extremely
  important in an evaluation process, yet do not
  show up directly in calculations
• Quality requirements
• Reputation of outsourcer
• Employee morale
• Logistical considerations distance from plant,
  etc.

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Opportunity Costs
Opportunity cost is the benefits that are
forgone by not using a limited resource in its
next-best alternative use, i.e. the most
valuable forgone alternative.
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Opportunity Costs Example
Opportunity Cost for option 4
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Opportunity Costs Example
Opportunity Cost for Option 1 is the net benefits
that could be generated by Option 2
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Opportunity Costs
Economic Cost Actual Cost Opportunity Cost
Opportunity cost is not recorded in accounting
system, because the second best alternative usage
of money is not happening there is no real
transaction
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Opportunity Costs and Outsourcing/Insourcing
In the previous example, we assume facilities
will remain idle if part 2 is not produced.
Assume that if Bismark buys the part, it can use
the facilities previously used to manufacture
Part 2 to produce Part 3 for Krysta Company.
The expected incremental future operating income
is 8,000.
What should Bismark Co. do?
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Example 2-2
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Carrying Costs of Inventory
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Carrying Costs of Inventory
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• Example 3
• Product Mix Decisions

Which product to produce given resource
constraints
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Example 3
Per unit Product A Product B Sales
price 2 12 Variable
expenses 0.4 10.80 Contribution margin
1.60 1.20 Contribution margin
ratio 80 10 Machine Hours per
unit 8 4
Bismark Co. has 3,000 machine-hours available.
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Example 3
Objective Function for decision makers
Maximize 1.6 XA 1.2 X B s.t. Special
Constraints 8 XA4XBlt3,000 Regular constraints
XAgt0, XBgt0 gtgtgt Max 1.6 XA1.2 (750-2XA)
900 - 0.8XA gtgtgt XA0, XB750
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Example 3
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Example 3
Rule of Thumb Given restricted resource,
managers should choose the product with the
highest contribution margin per unit of the
constraining resource (factor).
What is the contribution of each product per
machine-hour?
Product A 1.60 8 0.2 Product B 1.20 4
0.3
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Example 3 (Cont.)
Bismark Co. has 3,000 machine-hours available.
Bismark has 1,800 square yards of DM available.
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Objective Function and Constraints
Objective Function Maximize
1.6 XA 1.2 X B Special Constraints 8
XA4XBlt3,000 2
XA3XBlt1,800 Regular Constraints XAgt0
XBgt0
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• Example 4
• Customer Profitability

Decisions about adding or dropping customers
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Example 4
Mountain View Furniture supplies furniture to two
local retailers Stevens and Cohen.
The company has a monthly capacity of 3,000
machine-hours.
Fixed costs are allocated on the basis of
revenues.
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Example 4

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  Stevens Cohen
• Revenues 200k 100k
• Variable costs 70k 60k
• Fixed costs 100k 50k
• Operating income 30k
  (10k)
• Machine-hours required 2k
  1k

Should Mountain View Furniture drop the
Cohen business, assuming that dropping Cohen
would decrease its total fixed costs by 10?
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Example 4
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Example 4 (Cont.)
Assume that if Mountain View Furniture
drops Cohens business it can lease the excess
capacity to the Perez Corporation for 70,000.
Fixed costs would not decrease.
Should Mountain View Furniture drop Cohens
business?
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Example 4 (Cont.)
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• Example 5
• Equipment Replacement

Book value of existing equipment is irrelevant
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Example 5

• Further assumptions
• Revenue after deducting other expenses is 1,100k
  per year.
• Ignore time value of money and income taxes
• No effect on production capacity and product
  quality

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Example 5
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Example 5
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Decisions and Performance Evaluation
In the real world would the manager replace the
machine?
An important factor in replacement decisions is
the managers perceptions of whether the decision
model is consistent with how the managers
performance is judged.
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Example 5
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Decisions and Performance Evaluation
Top management faces a challenge that
is, making sure that the performance-evaluation mo
del of subordinate managers is consistent with
the decision model.