Relevant Costs for Decision Making

UAA – ACCT 202 Principles of Managerial Accounting Dr. Fred Barbee

Information as a Resource

Information resource.

is now regarded as the sixth

Information Anxiety

Source: Information Anxiety Richard S. Wurman

A weekend edition of the NY Times contains more information than the average person was likely to come across in a lifetime in seventeenth-century England.

More new information has been produced in the last 30 years than in the previous 5,000. About 1,000 books are published internationally every day, and the total of all printed knowledge doubles every eight years.

In a single year . . .

• The average American will read or complete 3,000 notices and forms; • Read 100 newspapers and 36 magazines; • Watch 2,463 hours of television;

In a single year . . .

• Listen to 730 hours of radio; • Talk on the phone for 61 hours; and • Read 3 books

The Challenge of Information

%#@!#

Computation Speed . . .

Date 5,000 BC 1945 A.D.

1960s Method Abacus Computer Computer 1970s 1980s Computer Computer 1990s Computer *Instructions per second.

Speed in ips* 2-4 ips 100 ips 100,000 ips 1,000,000 ips 10,000,000 ips 1,000,000,000 ips

Transmission Speed

Date 4,000 BC 1844 A.D.

1980s 1990s *Words per minute Medium Messenger Telegraph Cable/Fibre Fibre Speed in wpm* .01 wpm 50 - 60 wpm 1,000,000,000 wpm 100,000,000,000 wpm

Human Processing Speed

Date 4,000 BC Today 4,000 BC Today 4,000 BC Today *Words per minute Medium Written Written Visual Visual Spoken Spoken Speed in wpm* 300 wpm 300 wpm 100,000,000 bpg** 100,000,000 bpg 120 wpm 120 wpm **Bits per glance

Information Overload

The theory of bounded rationality (Simon, 1955).

Humans are organisms of limited knowledge and computational capacity.

Thus, simplifications (heuristics) are deliberately introduced into the choice mechanism.

Dealing With Information Overload

HELP!

Information Processing

• People are consistency seekers; • People are Information Processors; and • People are Cognitive Misers

People as Information Processors

• Actively seek out information, • Observe facts, and • Reason

People as Cognitive Misers

• Minimize cognitive efforts, and • Take shortcuts.

Managers as Cognitive Misers

• Managers must be selective of information they request.

in the kinds • The key to limiting the flow of data is to request only relevant information.

Information Overload

• Unquestionably we need information in our lives . . .

. . . however, that information must be directly relevant to our daily lives. • The real question today is, “How do we zero in on the relevant and reject the rest?”

Information Literacy

To be information literate, a person must be able to recognize locate , when evaluate information is needed and have the ability to , and use effectively information.

the needed Source: Presidential Committee on Information Literacy

The Need For Cost Data

• Purchase new equipment; • Replace existing equipment; • Introducing new products; • Taking special orders;

The Need For Cost Data

• Make vs. buy decisions.

• Product-pricing decisions • Allocation of scarce resources.

Relevant Costs Are . . .

• Any cost that

differs among alternatives

and will influence the outcome, • Any cost that is

avoidable

, and • Any cost that is a

future

cost.

Relevant Revenues

• Any revenue that differs among alternatives; and • will influence the outcome,

Avoidable Costs

An avoidable cost is . . .

. . . a cost that can be eliminated (in whole or in part) as a result of choosing one alternative over another .

Avoidable Costs

• All costs are considered to be avoidable, except . . .

– Sunk Costs, and – Costs that are the same for each alternative.

When does the cost arise?

Past Future

Does the

Yes

cost differ between alternatives?

No Sunk Sunk Relevant Not Relevant

Different Costs for Different Purposes

Internal Value Chain Activities Design Service Develop Distribute Produce Market

Product Costing Definitions

Value-Chain Operating Traditional Product Costs Product Costs Product Costs Research and Development Production Marketing Customer Service Production Marketing Customer Service Production Pricing Decisions Product-Mix Decisions Strategic Profitability Analysis Strategic Design Decisions Tactical Profitability Analysis External Financial Reporting

Value-Chain Product Costs Research and Development Production Marketing Customer Service

If making these types of decisions, we need to look at

all

costs.

Pricing Decisions Product-Mix Decisions Strategic Profitability Analysis

Operating Product Costs Production Marketing Customer Service Strategic Design Decisions Tactical Profitability Analysis

On the other hand, for these decisions, we might be able to ignore some of the costs.

Product Costing Definitions

Value-Chain Operating Traditional Product Costs Product Costs Product Costs

For external financial reporting, we

Production

need only these costs.

Customer Service Production Pricing Decisions Product-Mix Decisions Strategic Profitability Analysis Strategic Design Decisions Tactical Profitability Analysis External Financial Reporting

Identifying Relevant Costs A Text Example

Identifying Relevant Costs

1 2 3 4 5 6 Automobile Costs (based on 10,000 miles driven per year) Annual straight-line depreciation on car Cost of gasoline Annual cost of auto insurance and license Maintenance and repairs Parking fees at school Total average cost Annual Cost of Fixed Items $ 2,800 1,380 360 Cost per Mile $ 0.280

0.050

0.138

0.065

0.036

$ 0.569

7 8 9 10 11 12 13 Some Additional Information Reduction in resale value of car per mile of wear Round-tip train fare Benefits of relaxing on train trip Cost of putting dog in kennel while gone Benefit of having car in New York Hassle of parking car in New York Per day cost of parking car in New York $ 0.026

$ 104 ????

$ 40 ????

????

$ 25

Text pages 588-589

Identifying Relevant Costs

Option #1 Relevant Financial Cost of Driving Gasoline (460 @ $0.050 per mile) Maintenance (460 @ $0.065 per mile) Reduction in resale (460 @ $0.026 per mile) Parking in New York (2 days @ $25 per day) Total $ 23.00

29.90

11.96

50.00

$ 114.86

Option #2 Relevant Financial Cost of Taking the Train Round-trip ticket $ 104.00

From a financial standpoint, Cynthia would be better off taking the train to visit her friend. Some of the non-financial factor may influence her final decision.

Total and Differential Cost Approaches

The Text Example

Text Example

• Oak Harbor Woodworks is considering a new labor-saving machine that rents for $3,000 per year.

• The machine will be used on the company’s butcher block production line.

• Pertinent data are provided.

Text Example

Text pages 591

Exhibit 13-1 – Total and Differential Costs

Net Advantage to Renting the New Machine Decrease in direct labor costs (5,000 units @ $3 per unit) Increase in fixed rental expenses Net annual cost saving from renting the new machine $ 15,000 (3,000) $ 12,000

Adding and Dropping Product Lines and Other Segments

Exercise 13-3 p. 613

What should Jackson do?

Decision Rule Jackson County should drop the housekeeping segment only

if its profit would increase

. This would happen only if the fixed

cost savings exceed the lost contribution margin

.

Incremental (Differential) Analysis Contribution Margin lost if program is dropped Fixed costs avoided: Liability Insurance Administrator’s Salary Decrease in NOI for firm as a whole ($80,000) $15,000 37,000 52,000 ($28,000)

This same solution can be obtained by using a total cost approach by preparing comparative income statements showing results with and without the Housekeeping segment.

The Total Cost Approach Depreciation is a sunk cost and the van has no salvage value since it would be donated to another organization.

General Administrative overhead is allocated and none of it would be avoided if the program is dropped.

Let’s apply that concept to this problem BEWARE OF ALLOCATED FIXED COSTS! Remember the text discussion of this topic?

Beware of Allocated Fixed Costs

The Make or Buy Decision

The Make or Buy Decision

• A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a “make or buy” decision.

• Exercise 13-4 – Make or Buy a Component (p. 614)

The Make or Buy Decision

• A decision concerning whether an item should be produced internally or purchased from an outside supplier is called a “make or buy” decision.

The Make or Buy Decision

• In the “make vs. buy” decision you need to isolate the relevant costs by: – Eliminating the sunk costs – Eliminating future costs that do not differ between the make or buy decision.

• Exercise 13-4 – Make or Buy a Component (p. 614).

Opportunity Costs

Special Orders

Special Orders

• A special order is a one-time order that is not considered part of the company’s normal ongoing business. • Before acceptance the firm must carefully examine existing capacity.

• Exercise 13-5 – Evaluating a Special Order.

Utilization of a Constrained Resource

Constrained Resources

• Maximize total contribution margin by promoting those products/orders that provide the highest unit contribution margin in relation to the constrained resource.

• Exercise 13-6 – Utilization of a constrained resource.

Managing Constraints

Produce only what can be sold.

At the bottleneck itself: •Improve the process • Add overtime or another shift • Hire new workers or acquire more machines • Subcontract production Eliminate waste.

Streamline production process.

Joint Product Costs

Joint Product Costs

• In some industries, a number of end products are produced from a single raw material input.

• Two or more products produced from a common input are called joint products.

• The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point.

Joint Input

Joint Products

Joint Costs

Oil Separate Processing Common Production Process Gasoline Final Sale

Split-Off Point

Chemicals Separate Processing

Separate Product Costs

Final Sale Final Sale

The Pitfalls of Allocation

Joint costs are really common costs incurred to simultaneously produce a variety of end products.

Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis.