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McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
Define the decision-making process and identify the
types of cost information relevant for decision making
11-3
The Decision-Making Process
First: Determine Organization’s
Competitive Environment
and Strategy Third: Relevant Cost Analysis
and Strategic Analysis
Second: Specify the Criteria
Identify and Collect
and Identify the
Relevant Information
Alternative Actions
Fifth: Evaluate
Performance
11-4
Relevant Cost
Analysis
A relevant cost is a future cost that differs
between the decision alternatives
Both characteristics must be present for a cost to
be relevant
Relevant costs can be variable or fixed, but variable
costs are generally relevant while fixed costs are
not
Relevant cost analysis and total cost analysis
produce the same results
11-7
Relevant Cost Analysis:
Additional Considerations
Batch-level cost drivers should be considered in
relevant cost analysis
11-8
Relevant Cost Analysis:
Additional Considerations
(continued)
Depreciation is not included in relevant cost
analysis except when considering tax implications
11-11
Relevant Cost Analysis and
Strategic Analysis
in Decision Making
This decision framework can be used to
address common management decisions such
as:
11-12
Example: the Special-Order
Decision
A special-order decision occurs when a firm
has a one-time opportunity to sell a specified
quantity of its product or service; these orders
are generally non-recurring
The first step in the decision process is to
consider the relevant costs (an example
follows):
TTS,
TTS, Inc.
Inc. normally
normally charges
charges $9.00
$9.00 per
per T-shirt,
T-shirt, but
but
Alpha
Alpha Beta
Beta Gamma
Gamma has has offered
offered to
to pay
pay $6.50
$6.50 for
for
1,000
1,000 T-shirts.
T-shirts. What
What are
are the
the relevant
relevant costs
costs in
in
determining
determining ifif the
the offer
offer should
should bebe accepted?
accepted?
11-13
The Special-Order Decision
(continued)
TTS, Inc.
Variable Cost of Production
Total Cost for
Cost Type Unit Costs One Batch of 1,000 Un
Relevant Costs
Unit-level Costs
Unprinted T-shirt $ 3.25 $ 3,250
Ink and other supplies 0.95 950
Operating labor 0.85 850
Total Unit-level Costs $ 5.05 $ 5,050
Batch-level Costs*
Setup $ 130
Inspection 30
Materials handling 40
Total ($200/batch and $.20/unit) $ 0.20 $ 200
Total Relevant Costs $ 5.25 5,250
*That vary with number of batches 11-14
The Special-Order Decision
(continued)
TTS, Inc.
The costs that are Fixed Costs
not relevant total Setup $ 29,000
Inspection 9,000
$450,000 Materials handling 7,000
Machine-related 315,000
Other 90,000
$ 450,000
Therefore.....
11-15
The Special-Order Decision
(continued)
Analysis of the net contribution looks favorable
11-20
Lease-or-Buy
Example (continued)
The
The indifference
indifference point,
point, 5,000,000
5,000,000 copies,
copies, is
is lower
lower than
than the
the
expected
expected annual
annual machine
machine usage
usage of of 6,000,000
6,000,000 copies.
copies. So,
So, Quick
Quick
Copy
Copy should
should purchase
purchase the
the machine
machine ifif strategic
strategic factors,
factors, such
such as
as
quality
quality of
of the
the copy,
copy, reliability
reliability of
of the
the machine,
machine, and
and benefits
benefits and
and
features
features of
of the
the service
service contract,
contract, are
are favorable
favorable
11-22
Lease-or-Buy Example (continued)
$140,000
Q = 5,000,000
TTS
TTS has
has suffered
suffered anan equipment
equipment malfunction
malfunction causing
causing
400
400 T-shirts
T-shirts not
not to
to be
be acceptable.
acceptable. The
The shirts
shirts can
can be
be
sold
sold as-is
as-is for
for $4.50
$4.50 each
each or
or run
run through
through the
the printing
printing
process
process again.
again. The
The cost
cost of
of running
running the
the T-shirts
T-shirts through
through
the
the printer
printer aa second
second time
time is
is variable
variable cost
cost of
of $1.80
$1.80 per
per
shirt
shirt and
and the
the cost
cost of
of one
one setup.
setup.
11-24
Sell-or-Process Further Example
(continued)
Analysis of Reprinting 400 Defective T-Shirts
Reprint Sell As Is
Revenue (400 @ $9.00) $ 3,600
(400 @$4.50) $ 1,800
Relevant costs: (@$1.80 variable + setup)
Supplies and ink ($0.95) 380
Labor ($0.85) 340
Setup, inspection, handling 200
Total relevant costs 920
Contribution margin $ 2,680 $ 1,800
An example follows:
Windbreakers, Inc. manufactures three jackets.
Management is concerned about the low profitability of the
“Gale” jacket and is thinking about dropping the product. If
the jacket is dropped, there will be no change in total fixed
costs for the coming year.
11-26
Profitability Analysis (continued)
Profitability Analysis: Gale Deleted
Calm Windy Total
Units sold last year 25,000 18,750
Sales revenue $ 750,000 $ 600,000 $ 1,350,000
Variable costs (600,000) (450,000) (1,050,000)
Contribution margin 150,000 150,000 300,000
Nonrelevant fixed costs 168,000
Net income without Gale $ 132,000
11-29
Short-Term Product Mix
Decision
How to make best use out of existing
resources? That is, how to choose the best
short-term product mix?
Continuing with the Windbreaker’s Inc.
example assume one production constraint:
The Windy and Gale jackets are manufactured in the
same plant—both require an automated sewing
machine for assembly. There are 3 machines that can
be run up to 20 hours per day, 5 days per week (1,200
hours per month). The demand for both jackets exceeds
the capacity of the 3 machines (i.e., there is one
production constraint or limiting resource).
11-30
Short-Term Product Mix Decision:
36,000 –
Units of
Production constraint for
Sales sewing machine. All
for Gale possible sales mixes are
represented on this line.
24,000 –
Units of Sales
Slope = -36,000 ÷ 24,000 = -3/2
for Windy
Intercept = 36,000
11-32
Short-term Product-Mix
Decision:
One Production Constraint
Units of Gale = 36,000 - 3/2 x Units of Windy
Production of Windy only results in a total contribution of:
1,200 x $160 = $192,000 (or $8.00 x 24,000 units)
Production of Gale only results in a total contribution of:
Windy Gale
Contribution margin per unit $ 8 $ 4
Inspection and packing time per jacket 15 min. 5 min.
Number of jackets produced per hour 4 12
Contribution margin per machine hour $ 32 $ 48
Maximum production for each product
(5,600 @ 4) 22,400
(5,600 @ 12) 67,200
11-35
Short-term Product-Mix
Decision:
Two Production Constraints
67,200 –
Production constraint for Inspection and Packaging
Units of
22,400
24,000
Sales for
Windy
Corner Point Analysis
11-36
Behavioral and Implementation
Issues
Managers must be sure to keep the firm’s
strategic objectives in the forefront in any
decision situation to avoid focusing solely on
short-term gains
Predatory pricing occurs when a company has set
prices below average variable cost with a plan to
raise prices later to recover losses from these
lower prices
Courts have found in favor of the defendants time
after time in cases involving predatory pricing
11-39
Chapter Summary (continued)
11-40
Chapter Summary (continued)
• Relevant cost analysis changes significantly
with two or more products and limited resources
– Under conditions of one or more production
constraints, the goal is to find the most profitable
sales mix
– For decision-making purposes, product
profitability must be expressed in terms of
contribution margin per unit of the scare resource
• Managers must be careful to encourage
maximization of contribution margin and
reduction of fixed costs
• Irrelevant, including sunk, costs must not be 11-41