Decision Making and Relevant Information

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Decision Making and Relevant Information. Chapter 11. Information and the Decision Process. A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis. Five-Step Decision Process. Historical Costs Other Information. Step 1.

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### Decision Making andRelevant Information

Chapter 11

Information and theDecision Process

A decision model is a formal method

for making a choice, often involving

quantitative and qualitative analysis.

Five-Step Decision Process

Historical Costs

Other Information

Step 1.

Gather Information

Step 2.

Make Predictions

Specific Predictions

Step 3.

Choose an Alternative

Feedback

Step 4.

Implement the Decision

Step 5.

Evaluate Performance

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

Quantitative and QualitativeRelevant Information

Quantitative factors

Financial

Nonfinancial

Qualitative factors

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.

One-Time-OnlySpecial Order Example

Variable Fixed

Costs Costs

Per UnitPer Unit

Direct materials \$6.50 \$ -0-

Direct labor .50 1.50

Manufacturing costs 1.50 3.50

Total \$8.50 \$5.00

One-Time-OnlySpecial Order Example

Total fixed direct manufacturing labor is \$45,000.

Marketing costs per unit are \$7

(\$5 of which is variable).

What is the full cost per towel?

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.

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

Two Potential Problems inRelevant-Cost Analysis

1

2

Incorrect general

assumptions:

unit-cost data:

All variable costs

are relevant.

Include

irrelevant costs.

All fixed costs

are irrelevant.

Use same unit

costs at different

output levels.

Outsourcing versus Insourcing

Outsourcing is

and services from

outside vendors.

Insourcing is

producing goods

or providing services

within the organization.

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.

Bismark Co. has the following costs

for 150,000 units of Part #2:

Direct materials \$ 28,000

Direct labor 18,500

Total \$120,500

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.

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.?

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.

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.

What is the variable manufacturing cost per unit?

Direct material \$28,000

Direct labor 18,500

Total \$61,500

\$61,500 ÷ 150,000 = \$0.41 per unit

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.

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?

Relevant cost to make:

Variable \$76,500

Fixed 9,000

Total \$85,500

Bismark would save \$3,000 by buying the part.

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.

income is \$18,000.

What should Bismark Co. do?

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.

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

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.

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.

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

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

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

Product-Mix DecisionsUnder Capacity Constraints

Per unit Product #2Product #3

Sales price \$2.11 \$14.50

Variable expenses 0.41 13.90

Contribution margin \$1.70 \$ 0.60

Contribution margin ratio 81% 4%

Bismark Co. has 3,000 machine-hours available.

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

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.

StevensCohen

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

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

Profitability, Activity-Based Costing, and Relevant Costs
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

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

Profitability, Activity-Based Costing, and Relevant Costs
Profitability, Activity-Based Costing, and Relevant Costs

contribution margin of \$40,000.

\$40,000 decrease in contribution margin

– \$15,000 decrease in fixed costs

= \$25,000 decrease in operating income.

Profitability, Activity-Based Costing, and Relevant Costs

Assume that if Mountain View Furniture drops

Cohen’s 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?

Equipment-Replacement Decisions Example

Existing Replacement

MachineMachine

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

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

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

Decisions andPerformance Evaluation

In the real world would the manager

replace the machine?

An important factor in replacement decisions

is the manager’s perceptions of whether the

decision model is consistent with how the

manager’s performance is judged.

Decisions andPerformance Evaluation

Top management faces a challenge – that is,

making sure that the performance-evaluation

model of subordinate managers is consistent

with the decision model.