Chapter 7 The Use of Cost Information in Management Decision Making

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Chapter 7The Use of Cost Information in
Management Decision Making
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Presentation Outline

1. Incremental Analysis
2. Three Decision Managers Frequently Face
3. Decisions Involving Joint Costs
4. Qualitative Considerations in Management
   Decisions
5. The Theory of Constraints (TOC)

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I. Incremental Analysis

• Incremental or differential revenue additional
  revenue received as a result of selecting one
  decision alternative over another.
• Incremental or differential cost additional
  cost incurred as a result of selecting one
  decision alternative over another.
• To answer the question of how much something
  costs, a manager must know why the person wants
  to know. No single cost number is relevant for
  all decisions.

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II. Three Decisions Managers Frequently Face

1. Additional Processing Decision
2. Make or Buy Decision
3. Dropping a Product Line Decision
4. Summary of Concepts

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A. Additional Processing Decision
Costs per Unit Incurred to Date
Costs per Unit to Complete
Material 300 200
Labor 200 100
Variable O/H 100 100
Fixed O/H 200
Totals 800 400
PowerComp Company has partially processed
computers for Model 250 that they are
discontinuing. This has caused a decline of the
selling price. If the units are completed, they
can be sold for 1,000 per unit. That is less
than the total cost of producing the computers --
1,200 per unit (800 cost to date plus 400 of
additional cost to complete the units).
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The Alternatives1. Sell the units as is for
500 each and avoid incurring any additional
processing costs.2. Complete the units and sell
them for 1,000 each.
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The SolutionThe prior production costs are a
sunk cost since they have already been incurred.
Therefore, the only relevant cost is the 400 in
additional processing costs to complete each
unit. Since this is less than the incremental
revenue of 500 (1,000 - 500), the units should
be processed further.
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B. Make or Buy Decision
Should the organization buy the compressors from
an outside source at a cost of 310 per unit?
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Additional Cost Analysis

• The market value of the machinery used to produce
  the compressors is approximately zero.
• Five of the six production supervisors will be
  fired if production of compressors is
  discontinued. However, one of the supervisors,
  who has more than 10 years of service, is
  protected by a clause in a labor contract, and
  will be assigned to other duties, although his
  services are not really needed. His salary is
  110,000.
• If production of compressors is discontinued, the
  company can use the space to store shelving that
  they are currently renting space for at a cost of
  500,000 per year.

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The Solution
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C. Dropping a Product Line Decision
Should the Garden Supplies product line be
dropped since it is showing a net loss of 500?
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Additional Cost Analysis

• Sales revenue will decline by 80,000 if garden
  supplies are dropped.
• Cost of goods sold will decrease by 60,000, and
  other variable costs will decrease by 1,000.
• Direct costs are directly traceable to a product
  line. Whether they decrease depends on the
  nature of these costs. Since the 3,500
  represents a part-time employee who will be
  dropped if garden supplies is dropped, this cost
  is avoidable.
• Allocated fixed costs are not directly traceable
  to an individual product line. Therefore, these
  costs are generally not avoidable.

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The Solution
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Cost Allocation Death Spiral

• In many cases, products or services may not
  appear profitable because they receive
  allocations of common fixed costs.
• However, if the product or service is dropped
  common fixed costs are reallocated to the
  remaining product or services.
• This may result in another product or service
  appearing unprofitable.

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D. Summary of Concepts

• Costs that can be avoided by taking a particular
  course of action are always incremental costs
  and, therefore, relevant to the analysis of a
  decision.
• Costs that are sunk are never incremental costs
  and therefore are not relevant in making a
  decision.
• Opportunity costs represent the benefit forgone
  by selection a particular decision alternative
  over another. There are always incremental costs
  and therefore relevant.
• Fixed costs may be
• Sunk and therefore irrevelant
• Not sunk but still irrelevant
• Not sunk but relevant
• (See Illustration 7-7 on page 246)

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III. Decisions Involving Joint Costs

1. Terminology
2. Allocating Joint Costs Using Physical Quantity
3. Allocating Joint Costs Using Relative Sales Value
4. Additional Processing Decisions Involving Joint
   Costs

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A. Terminology

• Joint Products two or more products that always
  result from common inputs.
• Joint Costs costs of common inputs up to the
  split-off point.
• Split-off Point stage of production at which
  individual products are identified. Beyond this
  point each product may undergo further separate
  processing and may incur additional costs.

500 board feet selling for 1.00 per foot
Grade A Lumber
Split-Off Point
500 board feet selling for .50 per foot
Joint Cost (Common Input Process) Cost of
log 600 Cost of sawing 20
Grade B Lumber
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B. Allocating Joint Cost Using Physical Quantity
This allocation could lead managers to think that
grade B lumber is not profitable and should be
scrapped. But this logic is faulty. If grade B
lumber were scrapped, the company would lose 250
that helped cover the joint cost of 620.
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C. Allocating Joint Cost Using Relative Sales
Value
A good feature of this method is that the amount
of joint cost allocated to a product cannot
exceed its sales value at the split-off point.
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D. Additional Processing Decisions Involving
Joint Costs

• Grade B lumber can be sold at the split-off point
  for .50 per board or pressure treated for an
  additional .20 per board and sold for .75 per
  board. Note that the additional processing
  should occur since the incremental revenue of
  .25 (.75 - .50) is greater than the additional
  processing cost of .20, regardless of the amount
  of the joint cost allocation. Joint costs are
  not incremental and are therefore never relevant
  in further processing decisions.

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IV. Qualitative Considerations in Management
Decisions

• A variety of qualitative factors (e.g., quality
  of goods, employee morale, and customer service)
  need to be considered in making a decision.
• Qualitative factors are often even more important
  than costs and benefits that are easy to quantify.

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V. The Theory of Constraints (TOC)

1. Theory of Constraints Defined
2. An Illustration of the Five-Step Process of TOC
3. Some Implications for TOC
4. Overproduction Incentives for Nonbottleneck
   Departments

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A. Theory of Constraints Defined

• Theory of constraints recognizes that large
  increases in profit can be achieved by
  elimination of bottlenecks in production
  processes. It is an approach to production and
  constraint management.

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B. An Illustration of the Five Step Process of TOC

1. Identify the Binding Constraint
2. Optimize Use of the Constraint
3. Subordinate Everything Else to the Constraint
4. Break the Constraint
5. Identify a New Binding Constraint

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1. Identify the Binding Constraint

• A bottleneck or binding constraint is a process
  that limits throughput (the amount of inventory
  produced in a period). Assume that Department 3
  is a bottleneck.

Department 1
Produce Subassembly
Department 3
Department 4
Make and Test Connections, Install Housing Units
Test, Package, and Ship
Department 2
Produce Subassembly
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2. Optimize Use of the Constraint

• Produce products with the highest contribution
  margin per unit of constraint.

If managers face a choice between using scarce
time in Department 3 to produce Model A70 or
Model B90, they should definitely maximize
production of Model A70 first.
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3. Subordinate Everything Else to the Constraint

• Managers should focus their time on trying to
  loosen the constraint and not concentrate on
  improvements in other departments.
• For example, why should managers improve
  processes in 1, 2, or 4 if they are not limiting
  production.
• Many things may loosen constraints. For example,
  if workers in Dept 3 all take breaks at the same
  time, capacity could be gained by staggering
  breaks.

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4. Break the Constraint

• This can be accomplished in many ways
• Cross-train workers in Depts. 1 and 2 so they can
  help out in Dept. 3
• Outsource some of Dept. 3s work.
• Purchase additional equipment for Dept. 3
• Hire additional workers for Dept. 3
• Train workers in Dept. 3 so that they can perform
  their jobs more efficiently.

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5. Identify a New Binding Constraint

• Once the constraint is broken in Dept. 3, either
  Dept. 1, 2, or 4 will be come a bottleneck.
• Or, if the company has excess capacity in all
  departments, it should focus its attention on
  building demand.

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C. Some Implications of TOC

• Inspections inspections should take place
  before work is transferred to a constrained
  department. Valuable time of the constrained
  department should not be wasted on defective
  items.
• Batch sizes although many companies are going
  to small batch sizes to reduce defects and
  achieve flexibility, using larger batch sizes in
  constrained departments can avoid wasted time in
  numerous machine setups for small production
  runs.
• Across the board cuts although cuts in
  nonbottleneck departments can make sense, cuts in
  departments with a binding constraint can have a
  severe impact on profit.

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D. Overproduction Incentive for Nonbottleneck
Departments

• Incentives for greater production in
  nonbottleneck departments should be avoided when
  there is a bottleneck department.
• For example, if Depts. 1 and 2 are rewarded for
  more production, it will do little if inventory
  is accumulating in front a Dept. 3

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Summary

• Only incremental costs and revenues are relevant
  in making management decisions.
• Sunk costs are irrelevant in deciding whether to
  further process a good.
• Nonavoidable costs are irrelevant in make-or-buy
  decisions.
• Common costs among product lines are generally
  nonavoidable.
• Opportunity costs are relevant in choosing among
  decision alternative.
• Joint Costs are irrelevant in additional
  processing decisions
• Management Decisions must consider qualitative
  characteristics
• Focus process improvements on bottlenecks first.