Because learning changes everything.

Chapter 14

Decision Making:
Relevant Costs and
Benefits

Twelfth Edition

© 2020 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Segment 1: Decision-making and evaluating relevance of
information

© McGraw Hill 2
 The Managerial Accountant’s Role in Decision Making

Managerial
Accountant

Cross-functional
Designs and implements management teams
accounting information who make
system production, marketing,
and finance decisions

Make substantive
economic decisions
affecting operations

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 The Decision-Making Process 1

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Quantitative
4. Develop a Decision Model
Analysis
5. Collect the Data

6. Select an alternative

7. Evaluate decision

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 The Decision-Making Process 2

1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the
responsibility of the 3. Identify the Alternatives
managerial accountant.
4. Develop a Decision Model

5. Collect the Data

Information should be:
1. Relevant 6. Select an alternative
2. Accurate
7. Evaluate decision
3. Timely

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 The Decision-Making Process 3

Relevant 1. Clarify the Decision Problem

Pertinent to a
decision problem. 2. Specify the Criterion

3. Identify the Alternatives

Accurate
Information must 4. Develop a Decision Model
be precise.
5. Collect the Data

Timely 6. Select an alternative

Available in time
for a decision 7. Evaluate decision

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 The Decision-Making Process 4

1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

4. Develop a Decision Model

Qualitative
Considerations 5. Collect the Data

6. Select an alternative

7. Evaluate decision

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 Relevant Information

Information is relevant to a decision

problem when . . .
• It has a bearing on the future
• It differs among competing
alternatives

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 Identifying Relevant Costs and Benefits

Sunk Costs
Costs that have already been incurred. They do not
affect any future cost and cannot be changed by any
current or future action.

Sunk costs are irrelevant to decisions.

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 Relevant Costs & Sunk Cost Example

Worldwide Airways is thinking about replacing a three year

old loader with a new, more efficient loader.
New loader
List price $ 15,000
Annual operating expenses 45,000
Expected life in years 1
Old loader
Original cost $ 100,000
Remaining book value 25,000
Disposal value now 5,000
Annual variable expenses 80,000
Remaining life in years 1

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 Relevant Costs 2

Depreciation of the old loader is not relevant. The

cost of the old loader was incurred in the past, and
cannot be changed.

We will only have depreciation on the new loader

if we replace the old loader. This cost is relevant.

The $5,000 proceeds will only be realized if we

replace the old loader. This amount is relevant.

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 Relevant Costs 3

Keep Old Replace Old Differential

Loader Loader Cost
Depreciation of old loader $ 25,000
Write-off of old loader $ 25,000 $ -
Proceeds from sale of old loader (5,000) 5,000
Depreciation of new loader 15,000 (15,000)
Operating costs 80,000 45,000 35,000
Total costs $ 105,000 $ 80,000 $ 25,000

The difference in operating costs is relevant

to the immediate decision.

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 Relevant Costs 4

Here is an analysis that includes only

relevant costs:

Relevant Cost Analysis

Savings in variable expenses
provided by the new loader $ 35,000
Cost of the new loader (15,000)
Disposal value of old loader 5,000
Net effect $ 25,000

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 Opportunity Costs

The potential benefit given up when the choice

of one action precludes a different action.

People tend to overlook or underestimate the

importance of opportunity costs.

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 Segment 2: Prepare analyses of various special
decisions, properly identifying the relevant costs and
benefits.

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 Accept or Reject a Special Order 1

A travel agency offers Worldwide Airways $150,000 for

a round-trip flight from Hawaii to Japan on a jumbo jet.

Worldwide usually gets $250,000 in revenue from this

flight.

The airline 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.

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 Accept or Reject a Special Order 2

Typical Flight Between Japan and Hawaii

Revenue:
Passenger $ 250,000
Cargo 30,000
Total $ 280,000
Expenses:
Variable expenses 90,000
Allocated fixed expenses 100,000
Total 190,000
Profit $ 90,000

Worldwide will save $5,000 in reservation

and ticketing costs if the charter is accepted.

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 Accept or Reject a Special Order 3

Assumes excess capacity

Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Contribution from charter $ 65,000

Since the charter will contribute to fixed costs and

Worldwide has idle capacity, the company should
accept the flight.

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 Accept or Reject a Special Order 4

What if Worldwide had no excess capacity?

If Worldwide adds the charter, it will have to cut its least

profitable route (that currently contributes $80,000 to fixed
costs and profits).

Should Worldwide still accept the charter?

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 Accept or Reject a Special Order 5

Assumes no excess capacity

Special price for charter $ 150,000
Variable cost per flight $ 90,000
Reservation cost savings (5,000)
Variable cost of charter 85,000
Opportunity cost:
Lost contribution on route 80,000 165,000
Total $ (15,000)

Worldwide has no excess capacity, so it should

reject the special charter.

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 Accept or Reject a Special Order 6

With excess capacity…

• Relevant costs will usually be the variable costs

associated with the special order.

Without excess capacity…

• Same as above but opportunity cost of using the firm’s

facilities for the special order are also relevant.

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 Outsource a Product or Service 1

A decision concerning whether an item should be

produced internally or purchased from an outside
supplier is often called a “make or buy” decision.

Let’s look at another decision faced by the

management of Worldwide Airways.

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 Outsource a Product or Service 2

An Atlanta bakery has offered to supply the in-flight desserts

for 21¢ each.
Here are Worldwide’s current cost for desserts:

Variable costs:
Direct material $ 0.06
Direct labor 0.04
Variable overhead 0.04
Fixed costs:
Supervisory salaries 0.04
Depreciation of equipment 0.07
Total cost per dessert $ 0.25

© McGraw Hill 23
 Outsource a Product or Service 3

Not all of the allocated fixed costs will be saved

if Worldwide purchases from the outside bakery.
Savings from
Cost per Dessert Outsourcing
Variable costs:
Direct material $ 0.06 $ 0.06
Direct labor 0.04 0.04
Variable overhead 0.04 0.04
Fixed costs:
Supervisory salaries 0.04 0.01
Equipment depreciation 0.07 -
Total cost per dessert $ 0.25 $ 0.15

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 Outsource a Product or Service 4

If Worldwide purchases the

dessert for 21¢, it will only save
15¢ so Worldwide will have a loss
of 6¢ per dessert purchased.

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 Add or Drop a Service, Product, or Department

One of the most important decisions

managers make is whether to add or drop a
product, service, or department.

Let’s look at how the concept of relevant

costs should be used in such a decision.

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 Add or Drop a Product 1

Worldwide Airways offers its passengers the

opportunity to join its World Express Club.
Club membership entitles a traveler to use
the club facilities at the airport in Atlanta.

Club privileges include a private lounge and

restaurant, discounts on meals and
beverages, and use of a small health spa.

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 Add or Drop a Product 2

Sales $200,000
Less: Variable Costs:
Food/Beverage $70,000
Personnel 40,000
Variable overhead 25,000 (135,000)
Contribution Margin 65,000
Less: Fixed Costs:
Depreciation $30,000
Supervisor salary 20,000
Insurance 10,000
Airport fees 5,000
Allocated overhead 10,000 (75,000)
Loss $ (10,000)

© McGraw Hill 28
 Add or Drop a Product 3

KEEP CLUB ELIMINATE DIFFERENTIAL

Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Depreciation (30,000) (30,000) 0
Supervisor salary (20,000) 0 (20,000)
Insurance (10,000) (10,000) 0
Airport fees (5,000) 0 (5,000)
Allocated overhead (10,000) (10,000) 0
Loss $ (10,000) $(50,000) $ 40,000

© McGraw Hill 29
 Add or Drop a Product 4

KEEP CLUB ELIMINATE DIFFERENTIAL

Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Depreciation (30,000) (30,000) 0
Supervisor salary (20,000) 0 (20,000)
Insurance (10,000) (10,000) 0
Airport fees (5,000) 0 (5,000)
Allocated overhead (10,000) (10,000) 0
Loss $ (10,000) $(50,000) $ 40,000
*Not Avoidable *Avoidable

© McGraw Hill 30
 Add or Drop a Product 5
KEEP CLUB ELIMINATE DIFFERENTIAL
Sales $200,000 0 $200,000
Food/Beverage (70,000) 0 (70,000)
Personnel (40,000) 0 (40,000)
Variable overhead (25,000) 0 (25,000)
Contribution Margin 65,000 0 65,000
Avoidable fixed costs
Supervisor salary (20,000) 0 (20,000)
Airport fees (5,000) 0 (5,000)
Profit/Loss $ 40,000 $ 40,000

Worldwide airlines would also lose the

contribution margin of $65,000 but only $25,000
in fixed expenses. The club contributes $40,000
to Worldwide’s fixed costs.
© McGraw Hill 31
 Conclusion: Keep the Club Open!

Contribution margin from

general airline operations
that will be forgone if club
is eliminated: $ 60,000 –0– $ 60,000
Profit/Loss: $ 40,000 –0– $ 40,000
Monthly profit of
KEEPING the club open $100,000

The Opportunity Cost Worldwide is better off

of lost contribution by $100,000 per month
margin is $60,000. by keeping its club open.

© McGraw Hill 32
 Exercise 14-35

Armstrong Corporation manufactures bicycle parts. The company currently has a

$21,000 inventory of parts that have become obsolete due to changes in design
specifications. The parts could be sold for $9,000, or modified for $12,000 and
sold for $22,300.
Which of the data above are relevant to the decision about the obsolete parts?
Purchase price, $21,000, for obsolete inventory

Current selling price for obsolete inventory, $9,000

Cost to modify obsolete inventory, $12,000

Selling price for modified inventory, $22,300

© McGraw Hill 33
 Exercise 14-36

Intercontinental Chemical Company, located in Buenos Aires, Argentina,

recently received an order for a product it does not normally produce.
Since the company has excess production capacity, management is
considering accepting the order. In analyzing the decision, the assistant
controller is compiling the relevant costs of producing the order.
Production of the special order would require 8,000 kilograms of theolite.
Intercontinental does not use theolite for its regular product, but the firm
has 8,000 kilograms of the chemical on hand from the days when it used
theolite regularly. The theolite could be sold to a chemical wholesaler for
14,500 p. The book value of the theolite is 2.00 p per kilogram.
Intercontinental could buy theolite for 2.40 p per kilogram. (p denotes the
peso, Argentina’s national monetary unit. On the day this exercise was
written, Argentina’s peso was worth .104 US Dollars)

© McGraw Hill 34
 Exercise 14-36 (continued)

What is the relevant cost of theolite for the purpose of analyzing the
special-order decision?

© McGraw Hill 35
 Problem 14-54

Chenango Industries uses 10 units of part JR63 each month in the production of
radar equipment. The cost of manufacturing one unit of JR63 is given below.
Material handling represents the direct variable costs of the Receiving
Department that are applied to direct materials and purchased components on the
basis of their cost. This is a separate charge in addition to manufacturing
overhead. Chenango Industries’ annual manufacturing overhead budget is one-
third variable and two-thirds fixed. Scott Supply, one of Chenango Industries’
reliable vendors, has offered to supply part number JR63 at a unit price of
$15,000

Direct material $1,000

Material handling (20% of DM cost) 200
Direct labor 8,000
Manufacturing overhead (150% of direct labor) 12,000
Total manufacturing cost $21,200

© McGraw Hill 36
 Problem 14-54 (continued)

If Chenango Industries purchases the JR63 units from Scott, the capacity
Chenango Industries used to manufacture these parts would be idle. Should
Chenango Industries decide to purchase the parts from Scott, the unit cost of
JR63 would increase (or decrease) by what amount?

© McGraw Hill 37
 Problem 14-54 (continued)

Assume Chenango Industries is able to rent out all its idle capacity for $25,000
per month. If Chenango Industries decides to purchase the 10 units from Scott
Supply, Chenango’s monthly cost for JR63 would increase (or decrease) by what
amount?

© McGraw Hill 38
 Problem 14-54 (continued)

Assume that Chenango Industries does not wish to commit to a rental agreement
but could use its idle capacity to manufacture another product that would
contribute $52,000 per month. If Chenango’s management elects to manufacture
JR63 in order to maintain quality control, what is the net amount of Chenango’s
cost from using the space to manufacture part JR63?

© McGraw Hill 39
 Segment 3: Analyze manufacturing decisions involving
joint products and limited resources.

© McGraw Hill 40
 Decisions Involving Limited Resources

Firms often face the problem of deciding how limited

resources are going to be used.
Usually, fixed costs are not affected by this decision,
so management can focus on maximizing total
contribution margin.

Let’s look at the Martin, Inc. example.

© McGraw Hill 41
 Limited Resources 1

Martin, Inc. produces two products and selected

data are shown below:
Products Products
Webs Highs
Selling price per unit $ 60 $ 50
Less: variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,000
Contribution margin ratio 40% 30%
Processing time required
on the lathe per unit 1.00 min. 0.50 min.

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 Limited Resources 2

The lathe is the scarce resource because there is

excess capacity on other machines. The lathe is
being used at 100% of its capacity.
The lathe capacity is 2,400 minutes per week.

Should Martin focus its efforts on Webs or Highs?

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 Limited Resources 3

Let’s calculate the contribution margin per unit

of the scarce resource, the lathe.
Products Products
Webs Highs
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 min. $ 30 min.

Highs should be emphasized. It is the more valuable

use of the scarce resource, the lathe, yielding a
contribution margin of $30 per minute as opposed to
$24 per minute for the Webs.

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 Limited Resources 4

Let’s see how this plan would work.

Allotting the Scarce Resource – The Lathe

Weekly demand for Highs 2,200 units

Time required per unit × .50 minutes
Time required to make Highs 1,100 minutes

Total lathe time available 2,400 minutes

Time required to make Highs 1,100 minutes
Time available for Webs 1,300 minutes
Time required per unit × 1.00 minute
Production of Webs 1,300 units

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 Limited Resources 5

According to the plan, Martin will produce 2,200 Highs and

1,300 Webs. Martin’s contribution margin looks like this.
Webs Highs
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Martin, Inc. is $64,200.

Any other combination would result in less contribution.

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 Theory of Constraints

Binding constraints can limit a company’s profitability.

To relax constraints management can…

Outsource all or part of the bottleneck operation.

Invest in additional production equipment and employ

‘parallel processing.’

Work overtime at the bottleneck operation.

Retrain employees, shift them to the bottleneck.

Eliminate any non-value-added activities at the bottleneck

operation.

© McGraw Hill 47
 Problem 14-44

Kitchen Magician, Inc., has assembled the following data

pertaining to its two most popular products. Past experience
has shown that the fixed manufacturing overhead component
included in the cost per machine hour averages $10. Kitchen
Magician’s management has a policy of filling all sales
orders, even if it means purchasing units from outside
suppliers.
Blender Electric Mixer
Direct material $6 $11
Direct labor 4 9
Manufacturing overhead @ $16/machine hr 16 32
Cost if purchased from an outside supplier 20 38
Annual demand (units) 20,000 28,000

© McGraw Hill 48
 Problem 14-44 (continued)
If 50,000 machine hours are available, and management
desires to follow an optimal strategy, how many units of each
product should the firm manufacture? How many units of
each product should be purchased?

© McGraw Hill 49
 Problem 14-44 (continued)
Each machine hour devoted to the production of
blenders saves the company more than a machine hour
devoted to mixer production.

© McGraw Hill 50
 Problem 14-44 (continued)
With all other things constant, if management is able to
reduce the direct material for an electric mixer to $6 per unit,
how many units of each product should be manufactured?
Purchased?

© McGraw Hill 51
 Problem 14-44 (continued)
Now the mixer results in the greater cost savings

© McGraw Hill 52
 End of Main Content

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© 2020 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom.
No reproduction or further distribution permitted without the prior written consent of McGraw Hill.