Decision Making and Relevant Information

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Decision Making andRelevant Information

• Chapter 11

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Learning Objective 1

• Use the five-step decision
• process to make decisions.

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Information and theDecision Process
A decision model is a formal method for making a
choice, often involving quantitative and
qualitative analysis.
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Five-Step Decision Process
Historical Costs Other Information
Gather Information
Step 1.
Make Predictions
Step 2.
Specific Predictions
Choose an Alternative
Step 3.
Feedback
Implement the Decision
Step 4.
Evaluate Performance
Step 5.
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Learning Objective 2
Differentiate relevant from irrelevant costs and
revenues in decision situations.
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The Meaning of Relevance
Relevant costs and relevant revenues are expected
future costs and revenues that differ among
alternative courses of action.
Historical costs
Sunk costs
Differential income
Differential costs
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Learning Objective 3
Distinguish between quantitative and qualitative
factors in decisions.
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Quantitative and QualitativeRelevant Information
Quantitative factors
Financial
Nonfinancial
Qualitative factors
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One-Time-OnlySpecial Order Example
The Bismark Co. manufacturing plant has
a production capacity of 44,000 towels each month.
Current monthly production is 30,000 towels.
Costs can be classified as either variable or
fixed with respect to units of output.
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One-Time-OnlySpecial Order Example
Variable
Fixed Costs Costs Per
Unit Per Unit Direct materials 6.50
-0- Direct labor .50
1.50 Manufacturing costs 1.50
3.50 Total 8.50 5.00
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One-Time-OnlySpecial Order Example
Total fixed direct manufacturing labor is 45,000.
Total fixed overhead is 105,000.
Marketing costs per unit are 7 (5 of which is
variable).
What is the full cost per towel?
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One-Time-OnlySpecial Order Example
Variable (8.50 5.00) 13.50 Fixed
7.00 Total 20.50
A hotel in San Juan has offered to buy 5,000
towels from Bismark Co. at 11.50/towel for a
total of 57,500.
No marketing costs will be incurred.
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One-Time-OnlySpecial Order Example
What are the relevant costs of making the towels ?
8.50 5,000 42,500 incremental costs
What are the incremental revenues ?
57,500 42,500 15,000
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Learning Objective 4
Beware of two potential problems in relevant-cost
analysis.
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Two Potential Problems inRelevant-Cost Analysis
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Incorrect general assumptions
Misleading unit-cost data
All variable costs are relevant.
Include irrelevant costs.
All fixed costs are irrelevant.
Use same unit costs at different output levels.
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Outsourcing versus Insourcing
Outsourcing is purchasing goods and services
from outside vendors.
Insourcing is producing goods or providing
services within the organization.
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Make-or-Buy Decisions Example
Bismark Co. also manufactures bath accessories.
Management is considering producing a part
it needs (2) or buying a part produced by Towson
Co. for 0.55.
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Make-or-Buy Decisions Example
Bismark Co. has the following costs for 150,000
units of Part 2
Direct materials 28,000 Direct labor
18,500 Mixed overhead 29,000 Variable
overhead 15,000 Fixed overhead
30,000 Total 120,500
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Make-or-Buy Decisions Example
Mixed overhead consists of material handling and
setup costs.
Bismark Co. produces the 150,000 units in 100
batches of 1,500 units each.
Total material handling and setup costs equal
fixed costs of 9,000 plus variable costs of 200
per batch.
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Make-or-Buy Decisions Example
What is the cost per unit for Part 2?
120,500 150,000 units 0.8033/unit
Should Bismark Co. manufacture the part or buy it
from Towson Co.?
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Make-or-Buy Decisions Example
Bismark Co. anticipates that next year
the 150,000 units of Part 2 expected to be sold
will be manufactured in 150 batches of 1,000
units each.
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Make-or-Buy Decisions Example
Variable costs per batch are expected to decrease
to 100.
Bismark Co. plans to continue to produce 150,000
next year at the same variable manufacturing
costs per unit as this year.
Fixed costs are expected to remain the same as
this year.
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Make-or-Buy Decisions Example
What is the variable manufacturing cost per unit?
Direct material 28,000 Direct labor
18,500 Variable overhead
15,000 Total 61,500
61,500 150,000 0.41 per unit
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Make-or-Buy Decisions Example
Expected relevant cost to make Part 2
Manufacturing 61,500 Material handling
and setups 15,000 Total relevant cost to
make 76,500 150 100 15,000
Cost to buy (150,000 0.55) 82,500
Bismark Co. will save 6,000 by making the part.
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Make-or-Buy Decisions Example
Now assume that the 9,000 in fixed
clerical salaries to support material handling
and setup will not be incurred if Part 2
is purchased from Towson Co..
Should Bismark Co. buy the part or make the part?
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Make-or-Buy Decisions Example
Relevant cost to make
Variable 76,500 Fixed
9,000 Total 85,500
Cost to buy 82,500
Bismark would save 3,000 by buying the part.
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Learning Objective 5
Explain the opportunity-cost concept and why it
is used in decision making.
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Opportunity Costs,Outsourcing, and Constraints
Assume that if Bismark buys the part from Towson,
it can use the facilities previously used to
manufacture Part 2 to produce Part 3 for Krysta
Company.
The expected additional future operating income
is 18,000.
What should Bismark Co. do?
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Opportunity Costs,Outsourcing, and Constraints
Bismark Co. has three options regarding Krysta
1. Make Part 2 and do not make Part 3.
2. Buy Part 2 and do not make Part 3.
3. Buy the part and use the facilities to
produce Part 3.
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Opportunity Costs,Outsourcing, and Constraints
Expected cost of obtaining 150,000 parts
Buy Part 2 and do not make Part 3 82,500
Buy Part 2 and make Part 3 82,500 18,000
64,500
Make Part 2 76,500
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Opportunity Costs,Outsourcing, and Constraints
Opportunity cost is the contribution to
income that is forgone (rejected) by not using
a limited resource in its next-best alternative
use.
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Opportunity Costs,Outsourcing, and Constraints
Assume that annual estimated Part 2 requirements
for next year is 150,000.
Cost per purchase order is 40.
Cost per unit when each purchase is 1,500 units
0.55.
Cost per unit when each purchase is equal to or
greater than 150,000 0.54.
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Opportunity Costs,Outsourcing, and Constraints
Average investment in inventory is either
(1,500 .55) 2 412.50 or
(150,000 0.54) 40,500
Annual interest rate for investment in government
bonds is 6.
412.50 .06 24.75
40,500 .06 2,430
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Opportunity Costs,Outsourcing, and Constraints
Option A Make 100 purchases of 1,500 units
Purchase order costs (100 40) 4,000.00
Purchase costs (150,000 0.55) 82,500.00
Annual interest income 24.75
Relevant costs 86,524.75
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Opportunity Costs,Outsourcing, and Constraints
Option B Make 1 purchase of 150,000 units
Purchase order costs (1 40) 40
Purchase costs (150,000 0.54) 81,000
Annual interest income 2,430
Relevant costs 83,470
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Learning Objective 6
Know how to choose which products to produce when
there are capacity constraints.
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Product-Mix DecisionsUnder Capacity Constraints
Per unit Product 2 Product 3 Sales
price 2.11 14.50 Variable expenses
0.41 13.90 Contribution margin 1.70
0.60 Contribution margin ratio 81
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Bismark Co. has 3,000 machine-hours available.
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Product-Mix DecisionsUnder Capacity Constraints
One unit of Prod. 2 requires 7 machine-hours.
One unit of Prod. 3 requires 2 machine-hours.
What is the contribution of each product per
machine-hour?
Product 2 1.70 7 0.24 Product 3 0.60
2 0.30
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Learning Objective 7
Discuss what managers must consider when adding
or discontinuing customers and segments.
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Profitability, Activity-BasedCosting, and
Relevant Costs
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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Profitability, Activity-Based Costing, and
Relevant Costs

• 
  Stevens Cohen
• Revenues 200,000 100,000
• Variable costs 70,000 60,000
• Fixed costs 100,000 50,000
• Total operating costs 170,000 110,000
• Operating income 30,000 (10,000)
• Machine-hours required 2,000 1,000

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Profitability, Activity-Based Costing, and
Relevant Costs

• Total
• Revenues 300,000
• Variable costs 130,000
• Fixed costs 150,000
• Total operating costs 280,000
• Operating income 20,000
• Machine-hours required 3,000

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Profitability, Activity-Based Costing, and
Relevant Costs
Should Mountain View Furniture drop the
Cohen business, assuming that dropping Cohen
would decrease its total fixed costs by 10?
New fixed costs would be 150,000 15,000
135,000
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Profitability, Activity-Based Costing, and
Relevant Costs

• Stevens Alone
• Revenues 200,000
• Variable costs 70,000
• Fixed costs 135,000
• Total operating costs 205,000
• Operating income (5,000)
• Machine-hours required 3,000

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Profitability, Activity-Based Costing, and
Relevant Costs
Cohens business is providing a contribution
margin of 40,000.
40,000 decrease in contribution margin 15,000
decrease in fixed costs 25,000 decrease in
operating income.
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Profitability, Activity-Based Costing, and
Relevant Costs
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 lease to Perez?
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Learning Objective 8
Explain why the book value of equipment is
irrelevant in equipment-replacement decisions.
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Equipment-Replacement Decisions Example
Existing Replacement Machine
Machine Original cost 80,000 105,000 Useful
life 4 years 4 years Accumulated
depreciation 50,000 Book value 30,000 Disposal
price 14,000 Annual costs 46,000 10,000
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Equipment-Replacement Decisions Example
Ignoring the time value of money and income
taxes, should the company replace the existing
machine?
The cost savings over a 4-year period will
be 36,000 4 144,000.
Investment 105,000 14,000 91,000
144,000 91,000 53,000 advantage of the
replacement machine.
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Learning Objective 9
Explain how conflicts can arise between the
decision model used by a manager and
the performance evaluation model used to evaluate
the manager.
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Decisions andPerformance Evaluation
What is the journal entry to sell the existing
machine?
Cash 14,000 Accumulated Depreciation 50,000
Loss on Disposal 16,000 Machine 80,000
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Decisions andPerformance 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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Decisions andPerformance 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.
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End of Chapter 11