Cost Management and Decision Making

13
Cost Management
and Decision Making
McGraw-Hill/Irwin
Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.
13-2
Learning Objective 1
McGraw-Hill/Irwin
13-3
Decision-Making Process
Stage 1
Setting goals
and objectives
5
4
3
2
Stage 2
Gathering
information
Stage 3
Evaluating
alternatives
McGraw-Hill/Irwin
Stage 4
Planning and
implementation
Stage 5
Obtaining
feedback
13-4
Stage 1: Setting Goals and Objectives

Intangible objectives:
may provide guidance, but
tend to be abstract and
are difficult to measure
Organizations must set objectives

to provide clear guidance.
Tangible objectives
provide benchmarks
against which to
measure performance.
McGraw-Hill/Irwin
13-5
Target Profit and Target Cost

Determine target selling price.
Contract sales price
Determine target cost.
Estimate based
on market analysis
Determine target profit

Deduct target return on sales
Result is target cost
Competitors pricing
Compare target cost to currently
feasible total cost.
The difference is the cost-reduction

target
Redesign products and processes to
achieve the cost-reduction target.

McGraw-Hill/Irwin
13-6
Stage 2: Gathering Information

Information quality
and
decision usefulness
Relevance
Timeliness
McGraw-Hill/Irwin
Accuracy
Cost
vs.
quality
Objectivity
vs.
subjectivity
13-7
McGraw-Hill/Irwin
13-8
Identification of Relevant Costs and

Benefits
Relevant costs are
costs to be incurred at
some future time and
that differ for each
option available to the
decision maker.
McGraw-Hill/Irwin
Costs incurred in the

past are not relevant.
They are called
called sunk costs.
13-9
Identification of Relevant Costs and

Benefits
Decision: Trading an old car for a new car.

Item
Cost of new car
Cost of old car
Insurance
AAA membership
McGraw-Hill/Irwin
Not
Relevant Relevant
X
X
X
X
Reason
Future cost that differs between alternatives
Sunk cost
Increased amount to cover new car is relevant
Does not differ between alternatives
13-10
Stage 3: Evaluating Alternatives

1. List decision
alternatives in the
order the
decisions must
be made.
2. Trace the
path of each
decision to its
ultimate
outcome.
3. Measure the benefits and costs of

each set of outcomes.
Consider qualitative as
well as quantitative factors.
McGraw-Hill/Irwin
13-11
Stage 3: Evaluating Alternatives

Anticipating future outcomes of each action
Consider the past

Although past costs are
sunk and therefore
irrelevant, they can be
used to help estimate
future costs that are relevant.
McGraw-Hill/Irwin
Completely new products

Use prototype products
to estimate costs.
Rely on consultants
who have knowledge
of similar products.
13-12
McGraw-Hill/Irwin
13-13
Decision Tree
A useful decision aid in diagramming

decisions and alternative outcomes
Allows an evaluation of the costs and
benefits of each alternative (limb)
Steps in creating a decision tree:
Display decision alternatives in order
Identify the set of outcomes resulting

from each decision path
A1 A2 B1 B2 B3
McGraw-Hill/Irwin
Measure costs and benefits of each set

of outcomes
13-14
Decision Tree - Example

Status quo
Maintain
Status quo?
Change
Automate
Status quo is
unacceptable
Higher equipment cost

Lower employment level
Lower unit-level cost
Increase in profit
Automate or improve
Manual process?
Lower equipment cost
Manual
Same employment level
Lower unit-level cost
Increase in profit
McGraw-Hill/Irwin
13-15
McGraw-Hill/Irwin
13-16
Outsourcing or Make-or-Buy Decision

When the company needs goods or services,
should they be made internally or bought
externally?
When goods or
services are
acquired externally,
it is called
outsourcing.
McGraw-Hill/Irwin
13-17
McGraw-Hill/Irwin
13-18

Identify the
variable costs
that would
disappear if we
outsource.
Identify the new

variable costs
that we would
incur if we
outsource.
Identify the fixed costs that we

could avoid if we outsource.
McGraw-Hill/Irwin
13-19

Lets look at a make-or-buy decision faced
by the management of Thor Company.
McGraw-Hill/Irwin
13-20

Thor Co. manufactures 20,000 of part 457 that is
currently used in one of its products. The costs to
make this part are:
Direct materials per unit
Direct labor per unit
Variable overhead per unit
Fixed overhead
Allocated common costs
McGraw-Hill/Irwin
9.00
5.00
1.00
180,000
100,000
13-21

Direct materials
$ 9.00
Direct labor
5.00
Variable overhead
Thor Co. manufactures
20,000 of part 457 that 1.00
is
($180,000 20,000)
currently used inFixed
one overhead
of its products.
The costs9.00
to
Common costs ($100,000 20,000)
5.00
make
Unitthis
cost part are:
$ 29.00
Direct materials/unit
Direct labor/unit
Variable overhead/unit
Fixed overhead
Allocated common costs
9.00
5.00
1.00
180,000
100,000
Fixed manufacturing overhead is the cost of leasing and

operating the equipment necessary to produce part 457.
McGraw-Hill/Irwin
13-22
Common costs are allocated on the basis of

direct labor hours.
Total unit cost of $29 is based on 20,000 parts
produced each year.
An outside supplier has offered to provide the
20,000 parts at a cost of $25 per part.
Should we accept the suppliers offer?
McGraw-Hill/Irwin
13-23

Make-or-buy analysis - 20,000 units
Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
20,000 $5 per unit
Difference
180,000
100,000
20,000
20,000 $9 per unit

20,000 $1 per unit
McGraw-Hill/Irwin
13-24

Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
Difference
180,000
100,000
20,000
180,000
100,000
580,000
20,000 $29 per unit

McGraw-Hill/Irwin
13-25

20,000 $25 purchase price
Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
180,000
100,000
20,000
180,000
100,000
580,000
500,000
100,000
600,000
Difference
$
320,000
(100,000)
(20,000)
(180,000)
$
20,000
The common costs remain unchanged.

McGraw-Hill/Irwin
13-26

Make part
Buy part
Direct costs:
Direct materials
Labor
Variable overhead
Fixed overhead
Common costs
180,000
100,000
20,000
180,000
100,000
580,000
500,000
100,000
600,000
Difference
$
320,000
(100,000)
(20,000)
(180,000)
$
20,000
Should we make or buy

part 457?
McGraw-Hill/Irwin
13-27

What is the relevant unit cost of making part 457?
Direct materials
Direct labor
Variable overhead
Fixed overhead ($180,000 20,000)
Total relevant unit cost
$ 9.00
5.00
1.00
9.00
$ 24.00
Advantage of making
20,000 units ($25.00 $24.00) = $20,000
McGraw-Hill/Irwin
13-28

If Thor could use the space currently being used to make
Part 457 for another purpose, resulting in a cost savings of
$45,000, would you change your decision?
Yes. The cost savings (opportunity cost) of $45,000

overcomes the $20,000 disadvantage of buying.
Now there is a $25,000 advantage to buying.
The real issue is the most profitable use of the space.
McGraw-Hill/Irwin
13-29
Pitfalls of Outsourcing
Supplier
technology and
knowledge base
may not be as
anticipated.
Freed-up
resources
are not used
as planned.
Customers
may object.
Loss of
sensitive
information
to supplier.
McGraw-Hill/Irwin
Customer
contact may
be reduced.
Supplier
quality is not
as high as
anticipated.
13-30
Decision to Add or Drop a Product,

Service, or Business Unit
If we shut down
our U.S. Digital
watch line, we
might anger our
American
customers.
McGraw-Hill/Irwin
. . . Not to
mention
the bad
press!
That is why we
have to consider
the relevant
benefits and the
relevant costs
BEFORE making
a final decision.
13-31

Lets get started.
The digital line
has become less
profitable and it is
difficult to compete
in the market.
McGraw-Hill/Irwin
. . . Not to
mention
the bad
press!
That is why we
have to consider
the relevant
benefits and the
relevant costs
BEFORE making
a final decision.
13-32

Segment Income Statement
Digital watches
Sales
Less: variable expenses
Variable mfg. costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory overhead
Salary of line manager
Depreciation of equipment
Advertising - direct
Rent - factory space
General admin. expenses
Net loss
McGraw-Hill/Irwin
500,000
200,000
300,000
120,000
5,000
75,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
Copyright 2008 The McGraw-Hill Companies,
Inc. All rights reserved.
13-33

Digital watches
Sales
$ 500,000
the digital
watch line is dropped, the
Less:Ifvariable
expenses
fixed
general
factory overhead
and general
Variable
mfg. costs
$ 120,000
Variable
shipping costs
5,000
administrative
expenses will
be allocated
Commissions
75,000
200,000
to other product lines. $ 300,000
Contribution margin
$
60,000
90,000
50,000
100,000
70,000
30,000
400,000
Net loss
$ (100,000)
McGraw-Hill/Irwin
13-34

Digital watches
Sales
The
equipment used to manufacture
digitalmfg.
watches
Variable
costs has no $resale
120,000
Variable
shipping
costs
value
or alternative
use. 5,000
Commissions
Contribution margin
Net loss
McGraw-Hill/Irwin
500,000
200,000
300,000
75,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
13-35

Digital watches
Sales
Variable mfg. costs
Variable shipping costs
Commissions
Contribution margin
Net loss
500,000
Should Market retain or drop

the digital watch line?
$
200,000
300,000
McGraw-Hill/Irwin
120,000
5,000
75,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
13-36

DECISION RULE
Market should drop the digital watch
segment only if its fixed cost savings
exceed lost contribution margin.
Lets look at this solution.
McGraw-Hill/Irwin
13-37

Market Company
Solution
Contribution margin lost if
watches are dropped
Less fixed costs that can be avoided
Salary of the line manager
Net disadvantage
$ (300,000)
90,000
100,000
70,000
260,000
$ (40,000)
Should we drop the digital

watch segment?
McGraw-Hill/Irwin
13-38

The same result can also be obtained
by preparing a differential analysis
showing operating results with and
without the digital watch segment.
Lets look at this approach.
McGraw-Hill/Irwin
13-39

Sales
Less variable expenses:
Mfg. expenses
Freight out
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
Depreciation
Total fixed expenses
Net loss
McGraw-Hill/Irwin
Differential Analysis
Solution
Keep
digital
watches
$ 500,000
120,000
5,000
75,000
200,000
300,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)
Drop
digital
watches
$
60,000
50,000
30,000
140,000
$ (140,000)
Difference
$ (500,000)
120,000
5,000
75,000
200,000
(300,000)
90,000
100,000
70,000
260,000
$ (40,000)
13-40

Keeping the digital watch product line
may have an opportunity cost that we
have not yet considered.
The opportunity cost of retaining the digital
watch line is measured by the differential
profits given up if the next best use of the
production facilities is rejected.
Example: If the idled facilities can be used to make

a product generating $350,000 per year in contribution
margin, with no other change in fixed costs,
might this change your decision?
McGraw-Hill/Irwin
13-41

Measuring cost savings and lost

revenues from closing a business unit is
only part of the story.
The closing will impact . . .
McGraw-Hill/Irwin
Employees personal lives,

Morale of retained employees,
The community at large.
13-42
Relevant Costs of Replacing

Equipment
Which costs are relevant to the decision to
replace an old machine with a new machine?
McGraw-Hill/Irwin
Old machine cost $5,400 when purchased.

Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to
$11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and
would allow two more years of productivity.
Power for either machine is expected to be $2.50
per unit.
Expected level of output: 1,000 units per year.
13-43

Equipment
Which costs are relevant to the decision to
replace an old machine with a new machine?
Relevant
because
of labor
savings
over the
2-year life.
McGraw-Hill/Irwin
Old machine cost $5,400 when purchased.

Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to
$11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and
would allow two more years of productivity.
Power for either machine is expected to be $2.50
per unit.
Expected level of output: 1,000 units per year
13-44

Equipment
1,000 units @ $12.00 for 2 years
1,000 units @ $11.00 for 2 years
Cost
Labor
Repair cost
Purchase cost
Total
Keep old Replace old

machine
machine
$
24,000 $
22,000
4,600
10,000
$
28,600 $
32,000
Conclusion: keep old machine.
McGraw-Hill/Irwin
13-45
Pricing Decisions
What influences prices?

McGraw-Hill/Irwin
13-46
Pricing Decisions
Prices are determined by the market, subject
to costs that must be covered in the long run.
Costs
Market
forces
Prices are based on costs, subject to

reactions of customers and competitors.
McGraw-Hill/Irwin
13-47
Pricing Law in the United States
McGraw-Hill/Irwin
13-48
Special-Order Price Decisions

We just received
a special order. Do
you think we should
accept it?
McGraw-Hill/Irwin
13-49
A travel agency offers Worldwide Airways

$150,000 for a round-trip flight from Japan to
Hawaii on a jumbo jet.
Worldwide usually gets $250,000 in passenger
ticket revenue from this flight.
The airlines 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.
McGraw-Hill/Irwin
13-50

Typical Flight Between Japan and Hawaii
Revenue:
Passenger
$
Cargo
Total
Expenses:
Variable expenses
Allocated fixed expenses
Total
Profit
250,000
30,000
$
280,000
190,000
90,000
90,000
100,000
Worldwide will save about $5,000 in reservation

and ticketing costs if the charter is accepted.
McGraw-Hill/Irwin
13-51

Assuming excess capacity
Special price for charter
Variable cost per flight
Reservation cost savings
Variable cost of charter
Contribution from charter
$ 150,000
$ 90,000
(5,000)
$
85,000
65,000
Since the charter will contribute to fixed costs and

Worldwide has idle capacity, the company should
accept the flight.
McGraw-Hill/Irwin
13-52

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?
McGraw-Hill/Irwin
13-53

Assuming no excess capacity
Special price for charter
Variable cost per flight
Reservation cost savings
Variable cost of charter
Opportunity cost:
Lost contribution on route
Total
$ 150,000
$ 90,000
(5,000)
85,000
80,000
165,000
$ (15,000)
Worldwide has no excess capacity, so it

should reject the special charter, or try to
renegotiate a higher price.
McGraw-Hill/Irwin
13-54

With excess capacity . . .
Relevant costs usually will be the variable costs

associated with the special order.
Without excess capacity . . . .
McGraw-Hill/Irwin
Same as above but opportunity costs of using

the firms facilities for the special order are also
relevant.
13-55
Additional considerations
Impact on regular customers and markets

Will the special order lead to future
regular business?
McGraw-Hill/Irwin
13-56
End of Chapter 13
McGraw-Hill/Irwin

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13

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Stage 1: Setting Goals and Objectives

Organizations must set objectives

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Target Profit and Target Cost

Contract sales price

Determine target cost.

Determine target profit

Compare target cost to currently

feasible total cost.

The difference is the cost-reduction

Redesign products and processes to

achieve the cost-reduction target.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Stage 2: Gathering Information

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Identification of Relevant Costs and

Costs incurred in the

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Identification of Relevant Costs and

Decision: Trading an old car for a new car.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Stage 3: Evaluating Alternatives

3. Measure the benefits and costs of

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Stage 3: Evaluating Alternatives

Consider the past

Completely new products

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

A useful decision aid in diagramming

Display decision alternatives in order

Identify the set of outcomes resulting

Measure costs and benefits of each set

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Decision Tree - Example

Higher equipment cost

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Identify the new

Identify the fixed costs that we

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Fixed manufacturing overhead is the cost of leasing and

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

Common costs are allocated on the basis of

Should we accept the suppliers offer?

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved.

Outsourcing or Make-or-Buy Decision

20,000 $5 per unit

20,000 $9 per unit