Cost Management and Decision Making

1. 13 Cost Management and Decision Making

2. Learning Objective 1

3. Stage 1 Setting goals and objectives Stage 2 Gathering information Stage 3 Evaluating alternatives Decision-Making Process 5 4 3 2 1 Stage 4 Planning and implementation Stage 5 Obtaining feedback

4. Stage 1: Setting Goals and Objectives Intangible objectives: may provide guidance, but  tend to be abstract and  are difficult to measure Organizations must set objectivesto provide clear guidance. Tangible objectives provide benchmarks against which to measure performance.

5. Contract sales price Estimate based on market analysis Competitors’ pricing Target Profit and Target Cost • 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.

6. Stage 2: Gathering Information Information qualityanddecision usefulness Accuracy Cost vs.quality Relevance Timeliness Objectivity vs. subjectivity

7. Learning Objective 2

8. Costs incurred in the past are not relevant. They are called called “sunk costs”. Identification of Relevant Costs and Benefits Relevant costsare costs to be incurred at some future time and that differ for each option available to the decision maker.

9. Identification of Relevant Costs and Benefits Decision: Trading an old car for a new car.

10. Stage 3: Evaluating Alternatives 1. List decision alternatives in the order the decisions must be made. 2. Trace the path of each decision to its ultimate outcome. 3. Measure the benefits and costs of each set of outcomes. Consider qualitative aswell as quantitative factors.

11. Stage 3: Evaluating Alternatives Anticipating future outcomes of each action • Completely new products • Use prototype productsto estimate costs. • Rely on consultantswho have knowledgeof similar products. Consider the past Although past costs aresunk and thereforeirrelevant, they can beused to help estimatefuture costs that are relevant.

12. Learning Objective 3

13. 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

14. Decision Tree - Example Status quo is unacceptable Status quo Maintain Status quo? Higher equipment cost Lower employment level Lower unit-level cost Increase in profit Automate Change Automate or improve Manual process? Lower equipment cost Same employment level Lower unit-level cost Increase in profit Manual

15. Learning Objective 4

16. Outsourcing or Make-or-Buy Decision 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.

17. Outsourcing or Make-or-Buy Decision What are the relevant costs? Is it cheaper to make or buy? How dependable is the supplier?

18. Outsourcing or Make-or-Buy Decision Identify the variable costs that would disappear if we outsource. Identify the new variable costs that we would incur if we outsource. Identify the fixed costs that we could avoid if we outsource.

19. Outsourcing or Make-or-Buy Decision Let’s look at a make-or-buy decision faced by the management of Thor Company.

20. Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to make this part are:

21. Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to make this part are: Fixed manufacturing overhead is the cost of leasing andoperating the equipment necessary to produce part 457.

22. Outsourcing or Make-or-Buy Decision • 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?

23. Outsourcing or Make-or-Buy Decision 20,000 × $9 per unit 20,000 × $5 per unit 20,000 × $1 per unit

24. Outsourcing or Make-or-Buy Decision 20,000 × $29 per unit

25. Outsourcing or Make-or-Buy Decision 20,000 × $25 purchase price The common costs remain unchanged.

26. Outsourcing or Make-or-Buy Decision Should we make or buy part 457?

27. Outsourcing or Make-or-Buy Decision What is the relevant unit cost of making part 457? Advantage of making 20,000 units × ($25.00 – $24.00) = $20,000

28. Outsourcing or Make-or-Buy Decision 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.

29. Pitfalls of Outsourcing Supplier technology and knowledge base may not be as anticipated. Freed-up resources are not used as planned. Customers may object. Supplier quality is not as high as anticipated. Loss of sensitive information to supplier. Customer contact may be reduced.

30. Decision to Add or Drop a Product, Service, or Business Unit That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision. . . . Not to mention the bad press! If we shut down our U.S. Digital watch line, we might anger our American customers.

31. Decision to Add or Drop a Product, Service, or Business Unit That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision. Let’s get started.The digital line has become lessprofitable and it isdifficult to compete in the market. . . . Not to mention the bad press!

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

33. Decision to Add or Drop a Product, Service, or Business Unit If the digital watch line is dropped, the fixed general factory overhead and general administrative expenses will be allocated to other product lines.

34. Decision to Add or Drop a Product, Service, or Business Unit The equipment used to manufacture digital watches has no resale value or alternative use.

35. Decision to Add or Drop a Product, Service, or Business Unit Should Market retain or drop the digital watch line?

36. Decision to Add or Drop a Product, Service, or Business Unit DECISION RULE Market should drop the digital watch segment only if its fixed cost savingsexceedlost contribution margin. Let’s look at this solution.

37. Decision to Add or Drop a Product, Service, or Business Unit Should we drop the digital watch segment?

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

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

40. Decision to Add or Drop a Product, Service, or Business Unit 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 theproduction facilities is rejected. Example: If the idled facilities can be used to makea product generating $350,000 per year in contributionmargin, with no other change in fixed costs,might this change your decision?

41. Decision to Add or Drop a Product, Service, or Business Unit • 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.

42. Relevant Costs of Replacing Equipment • 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. Which costs are relevant to the decision to replace an old machine with a new machine?

43. Relevant Costs of Replacing Equipment • 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 Which costs are relevant to the decision to replace an old machine with a new machine? Relevantbecauseof laborsavingsover the2-year life.

44. Relevant Costs of Replacing Equipment 1,000 units @ $12.00 for 2 years 1,000 units @ $11.00 for 2 years Conclusion: keep old machine.

45. What influences prices? Pricing Decisions Product life cycle Product costs Competitors Political issues Customers

46. Costs Marketforces Pricing Decisions 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.

47. Pricing Law in the United States Price fixing Price discrimination Predatory pricing

48. Special-Order Price Decisions We just received a special order. Do you think we should accept it?

49. Special-Order Price Decisions • 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.

50. Special-Order Price Decisions Worldwide will save about $5,000 in reservation and ticketing costs if the charter is accepted.