Decision making
and Relevant Information
Cost Accounting Horngreen, Datar, Foster 1
Introduction
This chapter explores the decision-making process.
It focuses on specific decisions such as accepting or
rejecting a one-time-only special order, insourcing or
outsourcing products or services, and replacing or
keeping equipment.
A decision model is a formal method for making a choice,
often involving quantitative and qualitative analysis.
Cost Accounting Horngreen, Datar, Foster 2
Five-Step Decision Process
1 Gathering information
2 Making predictions
3 Choosing an alternative
4 Implementing the decision
5 Evaluating performance
Cost Accounting Horngreen, Datar, Foster 3
The Meaning of Relevance
Relevant costs and relevant revenues are expected future
costs and revenues that differ among alternative courses of
action.
Historical costs are irrelevant to a decision but are used as
a basis for predicting future costs.
Sunk costs are past costs which are unavoidable.
Differential income (net relevant income) is the difference
in total operating income when choosing between two
alternatives.
Differential costs (net relevant costs) are the difference in
total costs between two alternatives.
Cost Accounting Horngreen, Datar, Foster 4
Quantitative and Qualitative Relevant
Information
Quantitative factors are outcomes that are measured in
numerical terms:
• Financial
• Nonfinancial
Qualitative factors are outcomes that cannot be measured
in numerical terms.
Cost Accounting Horngreen, Datar, Foster 5
One-Time-Only Special Order
Gabriela & Co. manufactures fancy bath towels in Boone, North
Carolina.
The plant has a production capacity of 44,000 towels each month.
Current monthly production is 30,000 towels.
The assumption is made that costs can be classified as either variable
with respect to units of output or fixed.
Variable Fixed
Costs Costs
Per Unit Per Unit
Materials $6.50 $ -0-
Labor .50 1.50
Other manufact. costs 1.50 3.50
Total $8.50 $5.00
Cost Accounting Horngreen, Datar, Foster 6
One-Time-Only Special Order
Total fixed non-manufactoring overhead is $105,000.
Marketing costs per unit are $7 ($5 of which is variable).
What is the full cost per towel?
• Variable ($8.50 + $5.00): $13.50
• Fixed: 7.00
• Total $20.50
A hotel in Puerto Rico has offered to buy 5,000 towels from
Gabriela & Co. at $11.50 per towel for a total of $57,500.
Cost Accounting Horngreen, Datar, Foster 7
One-Time-Only Special Order
No marketing costs will be incurred for this one-time-only
special order.
Should Gabriela & Co. accept this order?
Yes!
Why?
• The relevant costs of making the towels are $42,500.
• $8.50 × 5,000 = $42,500 incremental costs
• $57,500 – $42,500 = $15,000 incremental profits
• $11.50 – $8.50 = $3.00 contribution margin per towel
Cost Accounting Horngreen, Datar, Foster 8
One-Time-Only Special Order
Decision criterion:
Accept the order if the revenue
differential is greater than the cost
differential.
Accept the order if the contribution
margin is positive
But: Beware of aftereffects. Is it really
an isolated one-time-only special order
or does it change the situation for future
business?
Cost Accounting Horngreen, Datar, Foster 9
Potential Problems in Relevant-Cost
Analysis
General assumptions:
– Do not assume that all variable costs are relevant.
– Do not assume that all fixed costs are irrelevant.
Unit-cost data can potentially mislead decision makers:
– Irrelevant costs are included.
– The same unit costs are used at different output levels.
Cost Accounting Horngreen, Datar, Foster 10
Short term production decisions
Income
= revenue − cost
Contribution of a Product
= (variable) revenue − variable costs
Contribution Margin
= contribution ÷ number of product units
Rule 1: Do not produce products with a negative
contribution margin.
Cost Accounting Horngreen, Datar, Foster 11
Constraints
Mostly, a company is not free in its decision but
faces constraints
z procurement constraints
z production constraints
z sales constraints
z Constraints might affect
z only single products (e.g. sales constraints)
z multiple products
several products compete for scarce resources
(e.g. procurement constraints)
Cost Accounting Horngreen, Datar, Foster 12
The formal decision problem
Maximize the firm‘s profit
max xi ( p1 − k1 ) x1 + ... + ( p I − k I ) x I − K f
such that
salesconstraints 0 ≤ xi ≤ X i
production constraints
a j1 x1 + ... + a jI xI ≤ Cap j
procurement constraints
are kept satisfied
Cost Accounting Horngreen, Datar, Foster 13
Special case 1:
Only sales constraints
Rule 2
z Identify all products with a positive contribution
margin
z For each selected product set the production level
equal to the maximum quantity
Cost Accounting Horngreen, Datar, Foster 14
Example
Product i=1 i=2 i=3
Sales price 200 480 1.100
Variable costs 160 400 1.170
Contribution margin 40 80 −70
Sales constraint Xi 300 200 600
Input coefficient a1 2 8 5
Input coefficient a2 9 4 1
Machine j=1 j=2
K =4.000
F
Capacity 2.500 3.700
Cost Accounting Horngreen, Datar, Foster 15
Special case 2:
a single resource constraint
Example:
Resource A Resource 3: a1 Product 1
raw material Machine
(limited
Resource B capacity) a2 Product 2
raw material
Problem: production of an additional unit of product 1
makes production of a1/ a2 units of product 2 impossible
Cost Accounting Horngreen, Datar, Foster 16
When should you expand
production 1?
Expansion should increase total contribution
+ additional contribution (p1 − k1) ·1
− loss of contribution (p2 − k2) · a1/a2
Rule:
( p1 − k1 ) > ( p2 − k2 ) ⋅
a1 p1 − k1 p2 − k 2
or >
a2 a a
1 2
„Relative contribution margins“
(CM per machine hour)
Cost Accounting Horngreen, Datar, Foster 17
Product-Mix Decisions Under
Capacity Constraints
Which product(s) should be produced first?
z The product(s) with the highest contribution margin
per unit of the constraining resource.
Cost Accounting Horngreen, Datar, Foster 18
The detailed rule (rule 3)
Step 1: go for the product with the highest contribution
margin per hour of capacity usage
ª until sales constraint is binding
ª or until capacity constraint is binding
ª if there is capacity left after step 1...
Step 2: go for the product with the second highest
contribution margin per hour of capacity usage
ª until sales constraint is binding
ª or until capacity is binding
ª if there is capacity left after step 2...
go on analogously until there is no capacity left
Cost Accounting Horngreen, Datar, Foster 19
Example
M achine 1 2 p1 − k1 = 40 , p2 − k 2 = 80
Capacity 1.000 3.700
a1 = 2, a2 = 8
p 1 − k 1 40 p 2 − k 2 80
= = 20 = = 10
a1 2 a2 8
x1∗ =300;
Contribution: 16,000
x2∗ =50;
x3∗ =0 Profit: 12,000
Cost Accounting Horngreen, Datar, Foster 20
Insourcing versus Outsourcing
Outsourcing is the process of purchasing goods and
services from outside vendors rather than producing
goods or providing services within the organization,
which is called insourcing.
Cost Accounting Horngreen, Datar, Foster 21
Opportunity Costs, Outsourcing, and
Constraints
Opportunity cost is the contribution to income that is forgone
or rejected by not using a limited resource in its next best
alternative use.
The opportunity cost of holding inventory is the income
forgone from tying up money in inventory and not investing it
elsewhere.
Carrying costs of inventory can be a significant opportunity
cost and should be incorporated into decisions regarding lot
purchase sizes for materials.
Cost Accounting Horngreen, Datar, Foster 22
Opportunity Costs, Outsourcing, and
Constraints
Opportunity costs are not recorded in formal
accounting records since they do not generate
cash outlays.
These costs also are not ordinarily
incorporated into formal reports: ad hoc
analyses required to estimate them
Cost Accounting Horngreen, Datar, Foster 23
Make-or-Buy Decisions
Decisions about whether to outsource or produce within
the organization are often called make-or-buy decisions.
The most important factors in the make-or-buy decision
are quality, dependability of supplies, and costs.
Cost Accounting Horngreen, Datar, Foster 24
Example 1:
A company produces three products (A,B,C). All products
go through a single machine with limited capacity of 8,000 h
per period.
Products A B C
Selling price 4,500 6,000 1,800
Variable prod. costs 2,000 4,000 600
Purchase costs - 4,800 500
Input coefficient 5 2.5 1
Sales constraint 1,000 2,000 4,000
Cost Accounting Horngreen, Datar, Foster 25
Example 1:
Products A B C
Contr. margin 2,500 2,000 1,200
Contr. Margin - 1,200 1,300
outsourcing
rel. CM 500 buy
rel. CM of production - 320
Production sequence 1 2 -
Optimal program:
A: 1,000, B: produce 1,200 and buy 800, C: buy 4,000
Contribution margin:
1,000 x 2,500 + 1,200 x 2,000 + 800 x 1,200 + 1,300 x 4,000
Cost Accounting Horngreen, Datar, Foster 26
Example 2:
Gabriela & Co. also manufactures bath accessories.
Management is considering producing a part it needs
(#2) or using a part produced by Alec Enterprises.
Cost Accounting Horngreen, Datar, Foster 27
Example 2:
Gabriela & 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
• Mixed overhead consists of material handling and setup costs.
• Gabriela & 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.
Cost Accounting Horngreen, Datar, Foster 28
Make-or-Buy Decisions
What is the cost per unit for Part #2?
$120,500 ÷ 150,000 units = $0.8033/unit
Alec Enterprises offers to sell the same part for $0.55.
Should Gabriela & Co. manufacture the part or buy it
from Alec Enterprises?
The answer depends on the difference in expected
future costs between the alternatives.
Gabriela & 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.
Cost Accounting Horngreen, Datar, Foster 29
Make-or-Buy Decisions
Variable costs per batch are expected to decrease to $100.
Gabriela & 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
Variable overhead 15,000
Total $61,500
• $61,500 ÷ 150,000 = $0.41 per unit
Cost Accounting Horngreen, Datar, Foster 30
Make-or-Buy Decisions
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
Gabriela & Co. will save $6,000 by making the part.
Cost Accounting Horngreen, Datar, Foster 31
Make-or-Buy Decisions
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 Alec Enterprises.
Should Gabriela & Co. buy the part or make the part?
Relevant cost to make:
• Variable $76,500
Fixed 9,000
Total $85,500
• Cost to buy: $82,500
• Gabriela would save $3,000 by buying the part.
Cost Accounting Horngreen, Datar, Foster 32
Again: Beware of the long-run consequences
of your decision
dependence on suppliers
technological know-how may be lost
information asymmetry may increase to the
detriment of the buyer
strategic orientation of outsourcing decisions:
intended core competencies will not be outsourced
even if this would be profitable from a pure
accounting standpoint
Cost Accounting Horngreen, Datar, Foster 33
Equipment-Replacement Decisions
Assume that Gabriela & Co. is considering replacing a
cutting machine with a newer model.
The new machine is more efficient than the old machine.
Revenues will be unaffected.
Cost Accounting Horngreen, Datar, Foster 34
Equipment-Replacement Decisions
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
Cost Accounting Horngreen, Datar, Foster 35
Equipment-Replacement Decisions
Ignoring the time value of money and income taxes, should
Gabriela replace the existing machine?
Yes!
The cost savings per year are $36,000.
The cost savings over a 4-year period will be $36,000 × 4 =
$144,000.
Cost Accounting Horngreen, Datar, Foster 36
Equipment-Replacement Decisions
Investment = $105,000 – $14,000 = $91,000
$144,000 – $91,000 = $53,000 advantage of the
replacement machine.
Irrelevance of Past Costs:
• The book value of existing equipment is irrelevant since it is
neither a future cost nor does it differ among any alternatives
(sunk costs never differ).
• The disposal price of old equipment and the purchase cost of
new equipment are relevant costs and revenues because...
– they are future costs or revenues that differ between alternatives to
be decided upon.
Cost Accounting Horngreen, Datar, Foster 37
Decisions and Performance 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
Cost Accounting Horngreen, Datar, Foster 38
Decisions and Performance 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.
Cost Accounting Horngreen, Datar, Foster 39
Decisions and Performance Evaluation
Managers often behave consistent with their short-run
interests and favor the alternative that yields best
performance measures in the short run.
When conflicting decisions are generated, managers tend to
favor the performance evaluation model.
Top management faces a challenge – that is, making sure
that the performance-evaluation model of subordinate
managers is consistent with the decision model.
Cost Accounting Horngreen, Datar, Foster 40
True or False ???
The cost of a machine purchased last year will be relevant
in a decision for next year.
A sunk cost can never be relevant.
Qualitative factors, because they are not measured
numerically, are unimportant in the decision-making
process.
All variable costs are relevant and all fixed costs are
irrelevant.
When the performance evaluation model and the decision
model conflict, managers usually will give preference to the
performance evaluation model.
Cost Accounting Horngreen, Datar, Foster 41
Pick your Choice I:
POP produces three products that all use material A in their production.
Information regarding the products and their costs are as follows (all
information is per unit):
Product 1 Product 2 Product 3
Selling price $200 $400 $500
Variable cost 120 280 340
As used per unit 5 7 9
During the next period, POP will only be able to obtain 5,000 units of
material A. In what order should POP produce the products next period
to maximize profit?
1, 2, 3
2, 3, 1
3, 2, 1
Cost Accounting Horngreen, Datar, Foster 42